AUSTRALIAN TAX HANDBOOK 2017. 9780864699213, 0864699212

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Australian Tax Handbook 2017 R L DEUTSCH BEc LLB (Hons) LLM (Cantab) M L FRIEZER BCom LLB (NSW) LLM (Syd) CA I G FULLERTON BA LLB FCA P J HANLEY LLB T J SNAPE MA (Cantab)

Published in Sydney by Thomson Reuters (Professional) Australia Limited ABN 64 058 914 668 19 Harris Street, Pyrmont NSW 2009 Customer Support: Ph 1800 074 333 E-mail: [email protected] Website: https://tax.thomsonreuters.com.au Printed by Ligare Pty Ltd, Riverwood, NSW, Australia National Library of Australia Cataloguing-in-Publication entry Australia ISSN 1325-7935. ISBN 978 0 864 69921 3 Material code: 42019607

© 2017 Thomson Reuters (Professional) Australia Limited This publication is copyright. Other than for the purposes of and subject to the conditions prescribed under the Copyright Act 1968, no part of it may in any form or by any means (electronic, mechanical, microcopying, photocopying, recording or otherwise) be reproduced, stored in a retrieval system or transmitted without prior written permission. Inquiries should be addressed to the publishers.

AUTHORS R L DEUTSCH BEc LLB (Hons) LLM (Cantab) Robert Deutsch is a Deputy President of the AAT and Professor of Taxation, School of Taxation & Business Law, the University of New South Wales. His areas of specialisation include, in particular, international tax, capital gains tax and superannuation. M L FRIEZER BCom LLB (NSW) LLM (Syd) CA Mark Friezer is a partner of Clayton Utz, Lawyers, Sydney, specialising in taxation law. He previously worked in investment banking at Deutsche Bank and at a major international accounting firm in both Australia and, for several years, the US. I G FULLERTON BA LLB FCA Ian Fullerton is a barrister at Ground Floor, Wentworth Chambers, Sydney, specialising in taxation law, commercial law and the law of trusts. He previously worked at Ashurst Australia, National Australia Bank and Commonwealth Bank in Sydney and Price Waterhouse in Sydney and London. P J HANLEY LLB Peter Hanley is a taxation and property consultant and general counsel, John Harris Property Group, Brisbane. T J SNAPE MA (Cantab) Trevor Snape is a senior tax writer with Thomson Reuters, Sydney. He has been commentating on Australian tax issues for many years.

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ACKNOWLEDGMENTS The contributions of the following persons for this edition are particularly significant and are gratefully acknowledged. S JONES BEc LLB Stuart Jones is a senior tax writer with Thomson Reuters, Sydney. He is the author of the superannuation chapters in this publication and also of Thomson Reuters’ Australian Superannuation Handbook. I MURRAY-JONES BA BEc CA FTIA Ian Murray-Jones is a senior tax writer with Thomson Reuters, Sydney. He is the author of Thomson Reuters’ Australian GST Handbook. J REILLY BA LLB Jerry Reilly is a senior tax writer with Thomson Reuters, Sydney. He is a co-author of Thomson Reuters’ Guide to Taxation of Financial Arrangements. J TU BComm BSc CA ATIA Jane Tu is a tax writer with Thomson Reuters, Sydney. She is the author of Thomson Reuters’ Tax Rates & Tables. K WILSON BA LLB Kirk Wilson is a senior tax writer with Thomson Reuters, Sydney. He is the author of the CGT chapters in this publication and assistant author of Thomson Reuters’ Australian CGT Handbook. A ZIARAS BA LLB (Hons) (Melb), LLM (Monash) Anna Ziaras is a freelance tax writer, and is the author of Thomson Reuters’ Australian Trusts Tax Handbook and The A-Z of Trusts. Contributions from the following persons are gratefully acknowledged. Dr P HILL BBus MTax Peter Hill is a Senior Tax Counsel - Policy & Advocacy at Latitude Legal. P KOIT BCom LLB (Hons I) (Syd) LLM (Syd) Solicitor FTIA CA Peter Koit is a freelance tax writer. S MISHRA BCom LLB (Macq) LLM (Syd) FTIA Seema Mishra is a Special Counsel at Henry Davis York, Sydney, specialising in income tax, capital gains tax and GST. A G SOMMER BSc LLM Andrew Sommer is a Partner of Clayton Utz, specialising in the area of indirect taxation. L R WOLFERS BEc LLB (Hons) (Syd) MTAX (Hons) (Syd) Solicitor FTIA Lachlan Wolfers is the Head of Indirect Tax, KPMG China, and KPMG’s Regional Leader, Asia Pacific Indirect Tax. He is also a member of KPMG’s global leadership team for indirect taxes. G YOUNG LLB (Hons) (UWA) Grahame Young is a Barrister with Francis Burt Chambers in Perth. THOMSON REUTERS WRITERS T Hayes BBus CPA FTIA EDITORIAL Annie Luu (Product Manager) Virginia Barton (Team Leader) Angela Irrgang (Senior Editor and Project Manager) Becky Beech (Senior Editor), Caroline Stirling (Editor) and Khoan Adams (Editor) Puddingburn Publishing Services Pty Ltd (Indexers)

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PREFACE 2017 promises to be a very interesting year in many respects (and happy New Year to all our readers) but perhaps not for tax (which is probably a good thing). There appear to be few significant measures on the horizon, other than the proposed tax cut for companies. It is hard to predict what the Senate will agree to, but in all likelihood small businesses should benefit from a 1% tax cut, backdated to 1 July 2016. It is even possible that businesses with an annual turnover of up to $10m (and not just $2m) will benefit. But it seems unlikely that multinational companies will get a tax cut in 10 years time. Changes to Div 7A were flagged in last year’s Budget but we have no details as yet. Working holiday makers have a new tax regime, but surely the headlines generated by this were disproportionate to the significance of the measures. One area which will produce more excitement is superannuation, as a number of significant changes come into effect on 1 July 2017. Whatever the future holds, the present tax system in Australia is covered in detail in the Australian Tax Handbook. It is an invaluable tool to help tax professionals and students navigate their way through the law. Nowhere will readers find a clearer, more comprehensive or more authoritative coverage of Australian tax law in one volume. Central to the quality of the Handbook is the collective experience and knowledge of the authors. This edition of the Australian Tax Handbook – the Australian Tax Handbook 2017 – is the 74th print edition. The Handbook is published twice a year in print format, in January and August, and is updated 4 times a year online – in January, April, August and October. This edition states the law as at 1 January 2017 (for trivia buffs, the National Day of Brunei, Cameroon, the Czech Republic, Haiti and Sudan and also Polar Bear Swim Day). Other Thomson Reuters publications Thomson Reuters Tax Examples is an ideal companion to the Australian Tax Handbook. This publication contains over 200 worked examples, all of them linked to the Handbook. Other publications in the Handbook series are the Australian GST Handbook and the Australian Superannuation Handbook. There are no better publications for a comprehensive analysis of GST and the superannuation system respectively. Another valuable Thomson Reuters resource for tax professionals is the daily and weekly news reporting services, in particular Latest Tax News and the Weekly Tax Bulletin. They are the most comprehensive tax news services in Australia. For details of our news and other services, log on to the Thomson Reuters website at https://tax.thomsonreuters.com.au or contact Customer Support on 1800 074 333. Trevor Snape MA (Cantab) Technical Editor January 2017

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TABLE OF CONTENTS Authors ..................................................................................................................................... iii Acknowledgments ..................................................................................................................... iv Preface ....................................................................................................................................... v Table of Contents ..................................................................................................................... vi Abbreviations ............................................................................................................................ ix Year in Review .......................................................................................................................... xi

AUSTRALIAN TAX SYSTEM 1 Australian tax system ................................................................................................ 1 2 Residence and source .............................................................................................. 24 INCOME 3 Income – general principles .................................................................................... 40 4 Employment income ................................................................................................ 72 5 Business income .................................................................................................... 109 6 Income – specific categories ................................................................................. 136 7 Exempt income ...................................................................................................... 183 DEDUCTIONS 8 Deductions – general principles ............................................................................ 230 9 Deductions – specific items .................................................................................. 268 10 Capital allowances ............................................................................................... 361 11 Specific incentives ............................................................................................... 454 CAPITAL GAINS TAX 12 CGT – overview .................................................................................................. 492 13 CGT events .......................................................................................................... 502 14 Cost base, capital proceeds and calculation matters .......................................... 546 15 CGT – exemptions and concessions ................................................................... 573 16 CGT roll-overs ..................................................................................................... 615 17 CGT – special topics ........................................................................................... 654 18 CGT – international aspects ................................................................................ 702 ENTITIES 19 Individuals ........................................................................................................... 713 20 Companies ........................................................................................................... 762 21 Companies – dividends and imputation ............................................................. 802 22 Partnerships .......................................................................................................... 881 23 Trusts .................................................................................................................... 912 24 Consolidation ..................................................................................................... 1024 SPECIAL CLASSES OF TAXPAYERS 25 Small business entities ...................................................................................... 26 Minors ................................................................................................................ 27 Primary producers ............................................................................................. 28 Special professionals ......................................................................................... vi

1070 1087 1099 1141

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29 Natural resource industries ................................................................................ 1151 30 Life insurance companies .................................................................................. 1158 FINANCIAL ARRANGEMENTS 31 Debt and equity rules ........................................................................................ 1173 32 Financial transactions ........................................................................................ 1203 33 Asset-based financing ........................................................................................ 1275 INTERNATIONAL TAXATION 34 Residents and foreign source income ............................................................... 35 Taxation of foreign residents ............................................................................ 36 Double taxation agreements .............................................................................. 37 Transfer pricing ................................................................................................. 38 Thin capitalisation .............................................................................................

1301 1333 1369 1392 1399

SUPERANNUATION 39 Superannuation contributions ............................................................................ 1413 40 Superannuation benefits .................................................................................... 1498 41 Superannuation funds ........................................................................................ 1563 ANTI-AVOIDANCE PROVISIONS 42 General anti-avoidance – Part IVA ................................................................... 1605 43 Specific anti-avoidance provisions .................................................................... 1627 44 Financial transaction reporting and exchange control ..................................... 1631 RULINGS, RETURNS, ASSESSMENTS AND OBJECTIONS 45 Tax rulings system ............................................................................................. 1636 46 Returns and record-keeping .............................................................................. 1660 47 Assessments ....................................................................................................... 1679 48 Objections and appeals ...................................................................................... 1692 COLLECTION, RECOVERY AND AUDITS 49 Payment of tax – general .................................................................................. 1709 50 PAYG withholding ............................................................................................. 1731 51 PAYG instalments .............................................................................................. 1767 52 RBA & BAS ...................................................................................................... 1790 53 Tax audits and investigations ............................................................................ 1800 OTHER ADMINISTRATION 54 Penalties and offences ....................................................................................... 1825 55 Tax File Numbers and Australian Business Numbers ...................................... 1855 56 Tax agents .......................................................................................................... 1869 FRINGE BENEFITS TAX 57 FBT – introduction ............................................................................................ 1885 58 Categories of fringe benefits ............................................................................. 1913 59 FBT – collection and administration ................................................................ 1964 OTHER TAXES 60 GST .................................................................................................................... 1973 © 2017 THOMSON REUTERS

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61 Pay-roll tax ........................................................................................................ 2013 62 Stamp duty ......................................................................................................... 2022 TAX PLANNING 63 Tax planning ...................................................................................................... 2036 TABLES AND READY RECKONERS 100 Tax rates and tables – individuals .................................................................. 2067 101 Tax rates and tables – trustees and companies .............................................. 2072 102 Tax rates and tables – CGT, FBT, withholding tax ....................................... 2078 103 Tax rates and tables – superannuation and retirement ................................... 2090 104 Tax rates and tables – miscellaneous items .................................................... 2094 105 Tax payable ready reckoner ............................................................................ 2104 106 Depreciation rates ............................................................................................ 2144 107 Tax calendar ..................................................................................................... 2344 Legislation Table ..................................................................................................... 2346 Cases Table ............................................................................................................. 2377 Rulings Table .......................................................................................................... 2394 Index ........................................................................................................................ 2406

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ABBREVIATIONS IMPORTANT NOTE – IDENTIFICATION OF SECTIONS Australia has 2 income tax assessing Acts. Each Act adopts a different numbering system. ITAA 1997 ITAA 1936 (Income Tax Assessment Act 1997) (Income Tax Assessment Act 1936) Sections are hyphenated Sections are mostly not hyphenated (eg s 6-5, s 8-1) (eg s 97, s 128A) To avoid repeating the description ‘‘ITAA 1936’’ or ‘‘ITAA 1997’’ every time reference is made to a section, hyphenated section references are to ITAA 1997 and unhyphenated section references are to ITAA 1936 throughout the Handbook, unless otherwise indicated. Chapter 1 explains the dual Act system.

List of abbreviations The following is a list of abbreviations used in the Handbook: “AAT” Administrative Appeals Tribunal “AAT Act” Administrative Appeals Tribunal Act 1975 “AAT Regs” Administrative Appeals Tribunal Regulation 2015 “ABN” Australian Business Number “ACNC” Australian Charities and Not-for-profits Commission “ADF” Approved deposit fund “ADJR Act” Administrative Decisions (Judicial Review) Act 1977 “AFOF” Australian venture capital fund of funds “APRA” Australian Prudential Regulation Authority “ASIC” Australian Securities and Investments Commission “ATO” Australian Taxation Office “ATO ID” ATO Interpretative Decision “ATR” Australian Tax Reports “BAS” Business Activity Statement “BEPS” Base Erosion and Profit Shifting “CGT” Capital gains tax “CTBR” Commonwealth Taxation Board of Review “DCT” Deputy Commissioner of Taxation “DICTO” Dependant (invalid and carer) tax offset “DTA” Double tax agreement “DWT” Dividend withholding tax “ESIC” Early Stage Innovation Company “ESVCLP” Early stage venture capital limited partnership “ETP” Employment termination payment “FBT” Fringe benefits tax “FBT Act” Fringe Benefits Tax Act 1986 “FBTAA” Fringe Benefits Tax Assessment Act 1986 “FBT Regs” Fringe Benefits Tax Regulations 1992 “FCT” Federal Commissioner of Taxation “FITO” Foreign income tax offset “FSR” Financial Services Reform “FTB” Family Tax Benefit “GIC” General interest charge “GST” Goods and services tax “GST Act” A New Tax System (Goods And Services Tax) Act 1999 “GST Regs” A New Tax System (Goods and Services Tax) Regulations 1999 “GSTD” GST Determination “GSTR” GST Ruling “HELP” Higher Education Loan Programme © 2017 THOMSON REUTERS

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“IAS” Instalment Activity Statement “I-GT” Inspector-General of Taxation “IntAA” International Tax Agreements Act 1953 “IT” Income Tax Ruling (old series) “ITAA 1936” Income Tax Assessment Act 1936 “ITAA 1997” Income Tax Assessment Act 1997 “ITA Regs” Income Tax Assessment Regulations 1997 “ITA (1936 Act) Reg” Income Tax Assessment (1936 Act) Regulation 2015 “IWT” Interest withholding tax “LAFHA” Living-away-from-home allowance “LCG” Law Companion Guidelines “MT” Miscellaneous Tax Ruling “MYEFO” Mid-year Economic and Fiscal Outlook “NANE” Non-assessable non-exempt “NTLG” National Tax Liaison Group “PAYG” Pay As You Go “PCG” Practical compliance guidelines “PDF” Pooled development fund “PE” Permanent establishment “PS LA” Law Administration Practice Statement “PSI” Personal services income “PST” Pooled superannuation trust “R&D” Research and development “Rates Act” Income Tax Rates Act 1986 “RWT” Royalty withholding tax “SAP” Substituted accounting period “SAPTO” Senior Australians and Pensioner Tax Offset “SGAA” Superannuation Guarantee (Administration) Act 1992 “SGA Regs” Superannuation Guarantee (Administration) Regulations 1993 “SGD” Superannuation Guarantee Determination “SGR” Superannuation Guarantee Ruling “SIC” Shortfall interest charge “SIS Act” Superannuation Industry (Supervision) Act 1993 “SIS Regs” Superannuation Industry (Supervision) Regulations 1994 “SMSF” Self-managed superannuation fund “SMSFD” Self-managed Superannuation Fund Determination “SMSFR” Self-managed Superannuation Fund Ruling “SUMLM” Superannuation (Unclaimed Money and Lost Members) Act 1999 “TAA” Taxation Administration Act 1953 “TA Regs” Taxation Administration Regulations 1976 “TAS Act” Tax Agent Services Act 2009 “TAS Regs” Tax Agent Services Regulations 2009 “TBRD” Taxation Board of Review Decisions “TD” Taxation Determination “TFN” Tax file number “TOFA” Taxation of Financial Arrangements “TOFA Act” Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 “TPA” Income Tax (Transitional Provisions) Act 1997 “TP Regs” Income Tax (Transitional Provisions) Regulations 2010 “TR” Taxation Ruling “TSL” Trade support loan “TTR” Transition to retirement “UCA” Uniform Capital Allowance “VCLP” Venture capital limited partnerships x

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YEAR IN REVIEW Introduction This list highlights income tax, FBT and superannuation developments that happened in the 2016 calendar year. The developments are grouped under the main topics as they appear in the Handbook and are generally listed in chapter order, with certain exceptions. This is a brief summary only and readers should refer to the relevant paragraphs for more information, including the date of commencement of relevant legislation. Australian tax system Chapters 1-2, 63 The Commissioner will be given the power to modify the operation of a taxation law to ensure that it is administered consistently with its purpose or object … [1 090] The government has proposed to allow the ATO to disclose to Credit Reporting Bureaus information about certain business tax debts … [1 360] A taxpayer who was employed in Oman for 20 months remained a resident of Australia (Re Landy, AAT) … [2 060], [2 070] The High Court has upheld a decision that companies were Australian residents as they were controlled by an Australian resident (Bywater Investments, High Ct) … [2 150] A draft ruling considers the application of the s 6CA source rules to ‘‘override royalties’’ (Draft Ruling TR 2016/D3) … [2 210] A discussion paper proposing greater protection for tax whistleblowers has been released … [63 020] The Board of Taxation has developed a voluntary tax transparency code for large and medium businesses … [63 033] Income Chapters 3-7 The High Court has confirmed that compensation for the loss of the taxpayer’s right to participate in the company’s ‘‘profit participation plan’’ on termination of his employment was assessable income (Blank, High Ct) … [3 050], [3 300] Redemption payments under the Return to Work Act 2014 (SA) are considered to be assessable under s 6-5 ITAA 1997 (Determination TD 2016/18) … [4 130] The Tax Office has set out its views about a conditional contractual right that becomes a right to acquire a beneficial interest in a share under an employee share scheme (Determination TD 2016/17) … [4 170] Legislation making it easier for start-ups to offer shares to employees has been introduced into Parliament … [4 160] A lump sum payment representing arrears of workers compensation payments was assessable (Re Gupta, AAT) … [4 100] The standard values of trading stock used for private or domestic purposes have been revised (Determination TD 2016/9) … [5 250] Ex-gratia disaster recovery payments made to certain New Zealand visa holders will be exempt … [7 100] The tax exemption for certain non-military government employees who deliver official development assistance overseas ceased as from 1 July 2016 … [7 150] The High Court will hear an appeal against a decision that income earned by a UN project manager in Sudan was exempt (Jayasinghe, Full Fed Ct) … [7 620] Deductions Chapters 8-11 New laws and proposed changes The cents-per-kilometre rate for 2016-17 is 66 cents per km … [9 110] © 2017 THOMSON REUTERS

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The R&D offset rates have been reduced by 1.5 percentage points as from the 2016-17 income year … [11 030] Innovation Australia has been replaced by a new body called Innovation and Science Australia … [11 090] Non-refundable tax offsets are available for post-30 June 2016 investments in qualifying Early Stage Innovation Companies and for certain limited partners who make contributions to ESVCLPs … [11 200], [11 560] Rulings and cases The Tax Office has modified its views on deductions for the operators of retirement villages (Practical Compliance Guideline PCG 2016/15) … [8 150] A taxpayer was not considered to be an itinerant worker as he was not required to travel to different locations in the course of his employment (Re Hill, AAT) … [9 050] A deduction for transporting equipment to and from work was denied as the taxpayer was provided with secure storage facilities at work (Re Reany, AAT) … [9 050] Annual fees for airport lounge membership for use by employees are deductible to the employer, where the membership is provided because of the employment relationship (Determination TD 2016/15) … [9 580] A beneficiary of a trust cannot claim a deduction for an unpaid present entitlement that is written off (Determination TD 2016/19) … [9 720] Health insurance premiums were not deductible (Re Thambiannan, AAT) … [9 950] Home office expenses were worked out on a floor area basis (Re HWZG, AAT) … [9 980] A ruling considers the deductibility of expenditure on developing and maintaining a website (Ruling TR 2016/3) … [9 1290], [10 790] The cost of a gift to a client may be deductible if the gift is characterised as being for the purpose of producing future assessable income (Determination TD 2016/14) … [9 1290] A new ruling setting out the effective lives of depreciating assets (applicable from 1 July 2016) has been released (Ruling TR 2016/1) … [10 650], [106 030] The car cost limit for 2016-17 has increased to $57,581 (Determination TD 2016/8) ... [10 1300] A decision not to extend the deadline to register for R&D purposes was upheld (Re Silver Mines, AAT) … [11 090]

CGT Chapters 12-18 CGT assets acquired by Norfolk Island residents after 23 October 2015 are subject to the normal operation of the CGT rules from 1 July 2016 … [12 120] CGT event L6 may happen where a head company retirement village operator of a consolidated group has a net overstated amount in respect of an entity that joined the group before 26 November 2014 (PCG 2016/15) … [13 860] Legislation providing a CGT ‘‘look-through’’ treatment for earnout arrangements has been enacted … [14 210], [14 330], [17 335] A resident beneficiary cannot use capital losses or the CGT discount to reduce a capital gain from property of a foreign trust that is not ‘‘taxable Australian property’’ (Draft Determination TD 2016/D5) … [14 380], [14 390], [17 070] The fact that the taxpayer, in his capacity as trustee of a family trust, signed the trust’s balance sheets was sufficient acknowledgment that a debt was still legally in existence as an asset of the family trust (Breakwell, Fed Ct) … [15 510] xii

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The AAT was required to decide the market value of a non-controlling one-third shareholding in a private company (Re Miley, AAT – on appeal) … [15 510] The proposal to increase the small business entity turnover threshold from $2m to $10m will not apply in relation to the CGT small business concessions … [15 520] Certain CGT concessions are available for an investor who acquires shares on or after 1 July 2016 in a qualifying Early Stage Innovation Company … [15 600] The ESVCLP and VCLP regimes have been amended to make them more attractive to investors and to encourage investment in innovation companies … [15 650] CGT roll-over relief is available from 2016-17 for small business entities that restructure. The Tax Office has issued guidelines about this measure (LCG 2016/2-3) … [16 500] The AAT correctly valued mining information (AP Energy, Fed Ct) … [18 105] From 1 July 2016, purchasers of certain Australian CGT assets from foreign residents are subject to a 10% non-final withholding obligation. The Tax Office has issued guidelines about this measure (LCG 2016/5-7) … [18 145] The foreign resident CGT withholding rules do not apply where an LPR, a beneficiary or a surviving joint tenant acquires an Australian CGT asset following the death of a foreign resident … [18 145] A number of Determinations concerning the foreign resident CGT withholding rules have been registered … [18 145]

Entities and Special classes of taxpayer Chapters 19-30, 100 New laws and proposed changes The private health insurance offset and Medicare levy surcharge thresholds have been frozen for an additional 3 years, to 2020-21 … [19 470], [19 790] The beneficiary offset will apply to Income Support Allowance paid to certain New Zealand visa holders impacted by a disaster … [19 520] The threshold at which the individual income tax rate rises from 32.5% to 37% increased from $80,000 to $87,000 from 1 July 2016 … [19 700], [100 020], [100 030] From 1 January 2017, working holiday makers pay tax at a special rate … [19 700], [100 030] Proposals to reduce the company tax rate over a 10-year period are contained in a Bill before Parliament … [20 030] Draft legislation to replace the same business test with a more flexible ‘‘predominantly similar business’’ test has been released … [20 360] Changes to the Div 7A rules were flagged in the 2016-17 Budget … [21 250] A proposed amendment will prevent the distribution of franking credits where a distribution to shareholders is funded by particular capital raising activities … [21 860] The Government has proposed to introduce special income tax regimes for 2 types of collective investment vehicle … [23 680] New rules for the taxation of ‘‘attribution managed investment trusts’’ have been enacted ... [23 685] The corporate unit trust provisions in Div 6B have been repealed and the public trading trust provisions in Div 6C amended … [23 1550], [23 1610] Measures announced in the 2016-17 Budget will modify proposed amendments to the allocable cost amount rules … [24 320] The small business entity turnover threshold is proposed to increase from $2m to $10m, but not for all purposes … [25 020] © 2017 THOMSON REUTERS

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The tax rate for companies that are small business entities has been reduced to 28.5% from 2015-16. The Government has proposed a further reduction to 27.5% as from 2016-17 … [25 250] A small business entity that is not a company is entitled to a tax discount by way of a tax offset (maximum $1,000) from 2015-16. Legislation to introduce greater flexibility where an individual is a partner or beneficiary has been enacted … [25 250] The small business entity turnover threshold for the purpose of accessing the small business offset is proposed to increase from $2m to $5m … [25 250] Measures to allow primary producers to re-enter the averaging system after 10 income years are contained in a Bill … [27 460] Amendments designed to make the farm management deposit regime more flexible have been enacted … [27 610] Rulings and cases The purpose of a share buyback was to facilitate the sale of shares in another company and not to return capital that was surplus to the taxpayer’s needs (Cable & Wireless, Fed Ct – on appeal) … [20 710], [35 160] The Div 7A benchmark interest rate for 2016-17 is 5.40% (Determination TD 2016/11) … [21 280], [21 320] Payments between related entities were caught by the Div 7A interposed entity rules (NR Allsop Holdings, Full Fed Ct) … [21 300] The Tax Office has released guidelines explaining its administrative treatment of the acquisition and disposal of interests in ‘‘no goodwill’’ professional partnerships … [22 260] The taxpayer was not a partnership and therefore could not be a limited partnership (D Marks Partnership, Full Fed Ct) … [22 400] A foreign resident cannot elect to treat their interest in a limited partnership as an interest in a foreign hybrid limited partnership (Draft Determination TD 2016/D2) … [22 440] The High Court has upheld a Full Federal Court decision concerning the meaning of a ‘‘unit trust’’ (ElecNet (Aust), High Ct)… [23 050], [23 1610] The Tax Office has commented on the consequences of a CGT event happening to a CGT asset (that is not taxable Australian property) of a foreign trust (Draft Determinations TD 2016/D4, TD 2016/D5) … [23 210], [23 550] The Tax Office is reviewing certain contrived trust income reduction arrangements (Taxpayer Alert TA 2016/12) … [23 320] A number of Law Companion Guides and a Practical Compliance Guideline dealing with the new regime for ‘‘attribution managed investment trusts’’ have been released … [23 685] Draft guidelines about the Commissioner’s discretion to treat an interest in a trust as a fixed entitlement have been released (Draft PCG 2016/D16) … [23 950] The time of acquisition of an asset for the purposes of working out the allocable cost amount is the date of actual acquisition (Financial Synergy, Full Fed Ct – special leave to appeal to the High Ct refused) … [24 320] Reimbursed fuel costs were included in the annual turnover of an entity that did oil and gas drilling (Doutch, Fed Ct) … [25 030] The Commissioner’s preliminary views on assessing the risk of non-compliance regarding claims for exploration and prospecting expenditure have been released (Draft PCG 2016/D17) … [29 030]

Financial arrangements Chapters 31-33 A provision in a company’s constitution requiring the company to automatically redeem shares at their issue price was an effectively non-contingent obligation to provide a financial benefit (D Marks Partnership, Full Fed Ct) … [31 160] xiv

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A determination considers whether certain costs relating to certain foreign source income are deductible (Determination TD 2016/6) … [31 260] The Tax Office intends to issue a determination discussing when non-share equity interests are issued by an Australian bank through a foreign permanent establishment … [31 320] Draft legislation proposing to replace the related scheme rules with a single ‘‘aggregate scheme’’ rule has been released … [31 360] Reforms to the TOFA rules were foreshadowed in the 2016-17 Budget … [32 050] A ruling discusses the application of s 230-120 to swaps (Ruling TR 2016/2) … [32 120] The RBA indicator rate relevant for capital protected borrowing arrangements is the investor housing loan rate (Determination TD 2016/10) … [32 610] The Government has proposed to remove key barriers to the use of asset backed financing arrangements … [33 020]

International taxation Chapters 34-38, 63 Certain debt interest amounts incurred in deriving foreign branch income or foreign equity distributions are not deductible (Determination TD 2016/6) … [34 110], [34 120], [38 050] A draft ruling considers whether an equity distribution received by an Australian corporate tax entity from a foreign company is NANE income (Draft Ruling TR 2016/D2) … [34 110] Two draft determinations consider the circumstances where a partnership or trust can be taken to hold a direct control interest in a foreign company (Draft Determinations TD 2016/D6, TD 2016/D7) … [34 110] Guidelines concerning the source of certain hedging gains for the purposes of calculating the FITO limit have been released (PCG 2016/6) … [34 220] Various conditions will be imposed on foreign investment applications, with the intention of making multinational companies investing in Australia pay tax on their Australian earnings … [35 015], [63 025] Payments by an Australian TV company to the IOC for the use of a signal were not royalties (Seven Network Ltd, Full Fed Ct – Commissioner is seeking special leave to appeal to the High Ct) … [35 410], [36 230] Decision that payments made in Australia for certain services undertaken in India constituted ‘‘royalties’’ was upheld on appeal (Tech Mahindra, Full Fed Ct) … [35 410], [36 230] The Government announced in the 2016-17 Budget that it would implement OECD rules to eliminate hybrid mismatch arrangements … [36 020], [63 038] The revised Australia-Germany DTA entered into force on 7 December 2016 … [36 050] A draft ruling considers the application of Australia’s tax treaties to ‘‘override royalties’’ (Draft Ruling TR 2016/D3) … [36 220], [36 230] Legislation to implement the OECD Standard for Automatic Exchange of Financial Account Information in Tax Matters (CRS) in Australia has been enacted … [36 320], [63 036] A number of legislative and others measures will give effect in Australia to various BEPS initiatives … [36 320], [63 038] A Practice Statement considers transfer pricing adjustments in relation to imported goods upon which customs duty has been levied (PS LA 2016/1) … [37 030] The maximum penalties that may be imposed on significant global entities that enter into tax avoidance and profit shifting schemes have doubled … [37 060] © 2017 THOMSON REUTERS

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The Tax Office has raised issues concerning the incorrect calculation of the value of debt capital treated wholly or partly as equity for accounting purposes (Taxpayer Alert TA 2016/9) … [38 270]

Superannuation Chapters 39-41 New laws and proposed changes Individuals up to age 75, regardless of their employment circumstances, will be able to claim a deduction for personal contributions from 1 July 2017 … [39 210] Individuals with a total superannuation balance less than $500,000 will be able to make additional catch-up concessional contributions for unused cap amounts for the previous 5 years (starting from 1 July 2018) ... [39 300] The concessional and non-concessional contributions caps are unchanged for 2016-17 ... [39 300], [39 400] The concessional contributions cap will reduce to $25,000 from 1 July 2017 … [39 300] The Div 293 tax threshold will reduce from $300,000 to $250,000 from 1 July 2017 ... [39 325] The low income superannuation contribution is to be replaced with a low income superannuation tax offset from 1 July 2017 … [39 330] Contributions and allocations made from 1 July 2017 in respect of defined benefit interests in untaxed or unfunded superannuation schemes and constitutionally protected funds will be counted towards an individual’s concessional contributions cap … [39 340] The non-concessional contributions cap will reduce to $100,000 pa from 1 July 2017 (or $300,000 over 3 years for those under 65). Individuals with a total superannuation balance of $1.6m or more will be prevented from making non-concessional contributions from 1 July 2017 … [39 400], [39 410], [39 450] Changes to the spouse contributions tax offset, including an increase in the low income threshold to $37,000, will apply from 1 July 2017 … [39 610] The lump sum low rate cap for 2016-17 is $195,000 ... [40 180] The untaxed plan cap for 2016-17 is $1.415m … [40 210] The rate of tax paid on superannuation payments when a working holiday maker leaves Australia will increase from 1 July 2017… [40 260] From 1 July 2017, it may be possible to roll over a superannuation death benefit paid to a dependent beneficiary … [40 300] A pension transfer balance cap of $1.6m applies from 1 July 2017 to limit the total amount of accumulated superannuation that can be transferred into retirement phase … [40 500], [40 520], [41 310] Defined benefit pension income exceeding $100,000 pa may be subject to income tax from 1 July 2017 … [40 500] The exceptions to the restrictions on commutation of certain superannuation income streams will be expanded … [40 510] The Government has proposed to remove tax barriers to the development of new retirement income products … [40 510] The tax exemption on earnings for pension assets supporting a TRIS will be removed from 1 July 2017 (irrespective of when the pension commenced) and individuals will no longer be able to make an election to treat a pension payment as a lump sum … [40 550] Transitional CGT relief is available for complying superannuation funds (including SMSFs) with pension assets impacted by the $1.6m pension transfer balance cap … [41 200] An anti-detriment deduction will no longer be available as from 1 July 2017 … [41 390] xvi

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Rulings and cases The Tax Office has released draft guidelines concerning a number of aspects of the superannuation reforms (Draft LCG 2016/D8, D9, D10, D11) … [39 340], [40 500], [41 200] The AAT took too narrow a view of what constitutes ‘‘special circumstances’’ for the purposes of the Commissioner’s discretion to disregard excess contributions (Ward, Full Fed Ct) … [39 530], [39 550] Decisions by the Commissioner refusing to exercise his discretion to reallocate excess contributions have been upheld (Re Brady and Re Azer, AAT) … [39 550] The Full Federal Court has ruled that ‘‘sham’’ transactions with an offshore bank amounted to the illegal early release of superannuation benefits (Millar, Full Fed Ct – special leave to appeal to the High Ct refused) … [40 230] The Federal Court has imposed a civil penalty of $40,000 on a SMSF trustee for making ‘‘loans’’ in breach of the SIS Act (Rodriguez, Fed Ct) … [41 510] A determination considers whether income of an SMSF will be non-arm’s length income where the parties to a scheme have entered into an LRBA that is not at arm’s length (Determination TD 2016/16) … [41 230], [41 520]

Anti-avoidance and Administration Chapters 42-56 New laws and proposed changes Draft legislation proposing a diverted profits tax for significant global entities has been released … [42 095] The PAYG withholding rules for managed investment trusts have been modified as a result of the proposed new regime for attribution managed investment trusts … [50 090] Employers of working holiday makers are required to register with the Tax Office, otherwise they will be required to withhold tax at a rate of 32.5% … [50 300] The Single Touch Payroll reporting system will affect employers with 20 or more employees from 1 July 2018 … [50 200], [52 085] The 2016-17 GDP adjustment for PAYG instalments purposes is 2% ... [51 250] Certain exemptions from the third party reporting system have been declared … [53 045] Draft legislation proposes to rewrite the offshore information notice provisions (s 264A) in Sch 1 TAA … [53 180] The value of a penalty unit will increase to $210 from 1 July 2017 … [54 020] Proposals to increase certain administrative penalties that may be imposed on significant global entities are contained in draft legislation … [54 070], [54 150] From 1 January 2017, an employee can make a TFN declaration using the Tax Office’s online service … [55 100] From 1 July 2017, tax (financial) advisers will be generally subject to the same registration regime as registered tax agents … [56 030], [56 070] New education, training and ethical standards for financial advisers will be phased in between 1 January 2019 and 1 January 2024 … [56 180] Rulings and cases A Practice Statement dealing with Pt IVA issues has been updated and rewritten (PS LA 2005/24) … [42 150] A taxpayer could not rely on examples in a ruling as his factual circumstances were different to those in the examples (Re Hill, AAT) … [45 080] The Tax Office has started publishing Law Companion Guidelines and Practical Compliance Guidelines … [45 110], [45 320] © 2017 THOMSON REUTERS

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Taxpayers have failed to prove that assessments were invalid on grounds of conscious maladministration (Bosanac, Fed Ct – on appeal; Anglo American, NSW Sup Ct) … [47 060] If the Commissioner alleges fraud or evasion, the onus is on the taxpayer to prove otherwise (Binetter, Full Fed Ct) … [47 160], [48 110] Taxpayers have been refused an extension of time to lodge objections (Jonshagen, Fed Ct; Re DTMP, AAT) … [48 070] A decision refusing an extension of time to lodge an application for review with the AAT was upheld on appeal (Benjamin, Fed Ct) … [48 100] A tax debt cannot be paid by providing a promissory note (Woods, Qld Dct Ct) … [49 080] The Commissioner may allow the controllers of a company to provide personal guarantees that the company will pay its tax debt by way of instalments (Croft, Qld Sup Ct) … [49 100] A defence to a director’s penalty notice on grounds of non-participation in the management of the company was rejected (Holton, Vic County Ct) … [50 360] The fact that the envelope containing a DPN was returned to the Tax Office was not considered to be proof of non-delivery (Tannous, NSW Sup Ct) … [50 360] The promoters of a tax exploitation scheme were ordered to pay penalties of $180,000 each (Ludekens (No 2), Fed Ct) … [54 210] The Tax Practitioners Board has released information on whether labour hire/on hire firms and payroll service providers need to register (TPB(I) 26/2016, 31/2016) … [56 030] Seminars run by professional accounting bodies were not recognised courses for BAS agent registration purposes (Re Walsh, AAT) … [56 040] A company was fined $77,500 for providing tax agent services while unregistered (Lamede Group, Fed Ct) … [56 090]

FBT Chapters 57-59 A grossed-up cap of $5,000 applies from 1 April 2016 for salary packaged meal entertainment and entertainment facility leasing expense benefits for employees of public and not-for-profit hospitals, public ambulance services, PBIs and health promotion charities … [57 120], [57 130], [58 600], [58 610], [58 620] A small business entity can provide multiple portable electronic devices to an employee and still qualify for the FBT exemption (from the 2016-17 FBT year) … [57 260] An employer with a fleet of 20 or more ‘‘tool of trade’’ cars can use a simplified average business use percentage if using the operating costs method … [58 140] All meal entertainment benefits are now reportable benefits (from 1 April 2016) … [59 200]

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INTRODUCTION Overview ......................................................................................................................... [1 010] CONSTITUTIONAL ISSUES Constitutional framework ................................................................................................ [1 020] Constitutional and other limitations in relation to the States ........................................ [1 030] INCOME TAX LEGISLATION The Assessment Acts ...................................................................................................... Structure of the Assessment Acts ................................................................................... International tax agreements ........................................................................................... Legislative instruments ................................................................................................... Administration of the tax system ...................................................................................

[1 [1 [1 [1 [1

050] 060] 070] 080] 090]

INCOME TAX EQUATION Calculating income tax ................................................................................................... [1 100] Tax accounting ................................................................................................................ [1 110] Substituted accounting periods ....................................................................................... [1 120] Residence and source ...................................................................................................... [1 130] Capital gains tax .............................................................................................................. [1 140] Special classes of taxpayer ............................................................................................. [1 150] International taxation ...................................................................................................... [1 160] Anti-avoidance provisions .............................................................................................. [1 170] Self-assessment ................................................................................................................ [1 180] Rates Acts ........................................................................................................................ [1 190] INTERPRETING TAX LEGISLATION The intention of Parliament ............................................................................................ [1 Use of extrinsic material ................................................................................................. [1 Interpretation of rewritten tax law .................................................................................. [1 Conflicting provisions ..................................................................................................... [1 Retrospective legislation ................................................................................................. [1 Elements of an Act .......................................................................................................... [1 Particular words and phrases .......................................................................................... [1 Precedent ......................................................................................................................... [1 Form and substance ........................................................................................................ [1

250] 260] 270] 280] 290] 300] 310] 320] 330]

AUSTRALIAN TAXATION OFFICE Australian Taxation Office – overview ........................................................................... [1 Secrecy requirements ...................................................................................................... [1 Freedom of information requests .................................................................................... [1 Taxpayers’ Charter .......................................................................................................... [1 Tax Office commitments ................................................................................................. [1 Taxpayers’ rights and obligations ................................................................................... [1

350] 360] 370] 380] 390] 400]

OTHER ORGANISATIONS Board of Taxation ........................................................................................................... [1 450] Inspector-General of Taxation ........................................................................................ [1 460]

INTRODUCTION [1 010] Overview The Australian Tax Handbook principally deals with income tax, but also discusses other taxes such as fringe benefits tax (see Chapters 57-59) and goods and services tax (see Chapter 60). © 2017 THOMSON REUTERS

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This chapter provides an overview of the Australian tax system. The topics covered are: • constitutional issues, namely the extent to which the Constitution gives the Commonwealth government the power to make laws in respect of taxation: see [1 020]-[1 030]; • the income tax legislation and how it is structured: see [1 050]-[1 080]; • the income tax ‘‘equation’’ and issues relevant to working out a taxpayer’s income tax liability: see [1 100]-[1 190]; • rules concerning the interpretation of legislation: see [1 250]-[1 330]; and • organisations integral to the operation of the Australian tax system, in particular the Australian Tax Office: see [1 350]-[1 460].

CONSTITUTIONAL ISSUES [1 020] Constitutional framework Section 51(ii) of the Constitution gives the Commonwealth the power to ‘‘make laws for the peace, order, and good government of the Commonwealth with respect to … Taxation’’. This section therefore empowers the Commonwealth to levy income tax. Although the States have the power to levy income tax, no State has done so since 1942. GST revenue is paid to the States (and Territories) in accordance with the June 1999 Intergovernmental Agreement on the Reform of Commonwealth-State Financial Relations and the A New Tax System (Commonwealth-State Financial Arrangements) Act 1999. The States also raise revenue through taxes such as pay-roll tax, stamp duty and land tax. There is no exhaustive definition of a ‘‘tax’’, although Latham CJ’s statement in Matthews v The Chicory Marketing Board (Vic) (1938) 60 CLR 263 at 276 that a tax is ‘‘a compulsory exaction of money by a public authority for public purposes, enforceable by law, and is not a payment for services rendered’’ is seen as a useful guide: eg Air Caledonie International v Commonwealth (1988) 165 CLR 462 at 467. However, it is not essential to the concept of a tax that the exaction be by a public authority: Australian Tape Manufacturers Association Ltd v Commonwealth (1993) 176 CLR 480 at 501. Other criteria of a ‘‘tax’’ recognised by the High Court are that a tax is not by way of a penalty and it is not arbitrary (ie liability to a tax can only be imposed by reference to ascertainable criteria that are sufficiently general in their application): eg MacCormick v FCT (1984) 15 ATR 437 at 446; DCT (Qld) v Truhold Benefit Pty Ltd (No 2) (1985) 16 ATR 466 at 469; and the Air Caledonie case at 467. Whether an Act is a law ‘‘with respect to’’ taxation depends on the true nature and character of the Act: see Fairfax v FCT (1965) 114 CLR 1 at 7. Provided the Act possesses a substantial connection with the relevant head of Commonwealth power, it does not matter that the legislation may be intended to achieve some other purpose. For example, the High Court has held that the Fringe Benefits Tax Assessment Act 1986 (FBTAA) is primarily a law with respect to taxation (and not a law to discourage the provision of fringe benefits): State Chamber of Commerce & Industry v Commonwealth (1987) 19 ATR 103. Similarly, the superannuation guarantee charge (see [39 790]) is a valid ‘‘tax’’ made for a public purpose: Roy Morgan Research Pty Ltd v FCT & Anor (2011) 80 ATR 1. Note that s 90 of the Constitution gives the Commonwealth the exclusive power to impose customs and excise duties. Restrictions There are various restrictions in the Constitution on the Commonwealth’s power to make laws with respect to taxation. In particular, s 55 of the Constitution provides that laws imposing taxation ‘‘shall deal only with the imposition of taxation, and any provision therein 2

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[1 030]

dealing with any other matter shall be of no effect’’ and ‘‘shall deal with one subject of taxation only’’. A consequence of this is that one Act imposes income tax (the Income Tax Act 1986) and another sets the rates of income tax (the Income Tax Rates Act 1986). Section 53 of the Constitution requires that money Bills, ie proposed laws which impose tax or appropriate revenue, can only originate in the House of Representatives and cannot be amended by the Senate. At most, the Senate can only request the House of Representatives to agree to an amendment.

Administrative issues Section 51(ii) of the Constitution also empowers the Commonwealth to pass laws relating to the payment and collection of tax, as well as other administrative matters (eg the lodgment of returns, assessments, penalties and rulings). Note that the expression in s 55 ‘‘dealing with the imposition of taxation’’ does not include administration and machinery provisions: Re Dymond (1959) 101 CLR 11. See also MacCormick and DCT (WA) v Fontana (1988) 19 ATR 1699. Section 8AAZH of the Taxation Administration Act 1953 (TAA), which deals with liability for RBA deficit debts (see [52 040]), is a machinery provision that does not impose taxation and is therefore not unconstitutional: H’Var Steel Services Pty Ltd v DCT (2005) 59 ATR 5. [1 030] Constitutional and other limitations in relation to the States Although the Commonwealth has the broad power to make laws with respect to taxation (see [1 020]), there are constitutional limitations on its powers to tax State governments and instrumentalities. 1. Section 51(ii) of the Constitution forbids any Commonwealth tax law from discriminating between States or parts of States. It is the formal character of the legislation itself, rather than the effects of its operation, that is important. Therefore, a law of general application will not be unconstitutional merely because it operates differently in different States or localities (FCT v Clyne (1958) 7 AITR 220). 2. Section 114 of the Constitution precludes the Commonwealth from imposing any tax ‘‘on property of any kind belonging to a State’’. This has been interpreted by the High Court as protecting a State from tax being imposed on it by virtue of, or by reason of, its ownership or holding of property: see State of Queensland v Commonwealth of Australia (1987) 18 ATR 158 and South Australia v Commonwealth of Australia (1992) 23 ATR 10. In the State of Queensland case, it was held that FBT is essentially a tax on transactions affecting property rather than on property itself (and thus can apply to benefits provided by a State). In contrast, in the State of South Australia case, the High Court held that CGT is a tax on property and therefore a State superannuation fund was exempt from CGT. Note that the term ‘‘State’’ in s 114 can include State instrumentalities. The question is whether the particular entity is ‘‘discharging governmental functions for the State’’, ie, is the State carrying on business through the entity (see DCT v State Bank of New South Wales (1992) 23 ATR 1 at 6-9 and SGH Limited v FCT (2002) 49 ATR 521 at 527). 3. There is an implied constitutional prohibition against Commonwealth laws discriminating against States or singling them out for special adverse treatment. However, this implied restriction is not infringed if a Commonwealth law of general application subjects a State government or instrumentality to a liability to pay a tax in common with others similarly placed (State Chamber of Commerce & Industry v Commonwealth (1987) 19 ATR 103 at 117-118). 4. There is a wider implied restriction in that the Commonwealth may not pass a law that ‘‘substantially interferes’’ with the ‘‘State’s capacity to govern’’ and thus endangers the ‘‘continued functioning of the State’’ (Melbourne Corporation v Commonwealth (1947) 74 CLR 31; Commonwealth v Tasmania (1983) 158 CLR 1 at 139 (the Tasmanian Dam case)). © 2017 THOMSON REUTERS

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Subject to these restrictions, it seems clearly established that the Commonwealth may impose a tax by a law of general application upon a State government or instrumentality. Accordingly, a statutory corporation established by a State government will not enjoy any special exemption or immunity from tax merely by virtue of its status as a State instrumentality (although an exemption as a State/Territory body (STB) may be available: see [7 500]). Note that there is a general presumption or rule of construction that legislation is not intended to bind the Crown unless there is an express provision or necessary implication to that effect, and this presumption applies to the Crown in right of a State: Bradken Consolidated Ltd v Broken Hill Proprietary Co Ltd (1979) 145 CLR 107. Since the ITAA 1997 contains no express provision referring to the Crown in right of any State (in contrast, for example, to s 4 FBTAA) it may be inferred that the ITAA 1997 does not bind the Crown (either in right of the Commonwealth or in right of a State).

INCOME TAX LEGISLATION [1 050] The Assessment Acts There are 2 main bodies of income tax law: the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997). By the early 1990s, the ITAA 1936 had become so complex and unwieldy that the Tax Law Improvement Project (TLIP) was established to rewrite and restructure the income tax law to make it more user-friendly. The result was the ITAA 1997, which is now the principal income tax Act. The structure of the ITAA 1997 and ITAA 1936 is considered at [1 060]. Topics that are principally located in the ITAA 1997 include income, exempt income, deductions, capital gains tax, capital allowances, tax offsets (with certain exceptions such as zone offsets), foreign tax offsets, imputation, tax losses, trading stock, primary production, income averaging, consolidation, financial arrangements, the R&D and film concessions and superannuation contributions and benefits. Topics that are still located in the ITAA 1936 (as at 1 January 2017) include dividends, trusts, partnerships, certain personal offsets such as the zone and overseas forces and civilians offsets/rebates, withholding tax, controlled foreign companies, general anti-avoidance provisions, returns and assessments. Administrative matters (other than returns and assessments) are largely dealt with by the Taxation Administration Act 1953 (TAA): see [1 090]. Income tax is formally imposed by the Income Tax Act 1986 at the rates specified in the Income Tax Rates Act 1986. However, other Acts impose income tax in specialised situations: see [1 190]. Tax practitioners also need to be aware of the many announced changes to tax laws that have not been legislated or even incorporated in a Bill – the so-called ‘‘legislation by media release’’. These announced changes are incorporated in this publication where appropriate. Thomson Reuters’ Weekly Tax Bulletin is an invaluable resource for those wishing to keep abreast of the latest developments. Note that legislation has been enacted which provides protection to taxpayers who have reasonably, and in good faith, anticipated the impact of proposed retrospective amendments to the tax law which will not be implemented: see [47 190]. Interaction of ITAA 1936 and ITAA 1997 Sections 4-10 and 4-15 ITAA 1997 specify how to work out taxable income and the amount of income tax (other than withholding tax) payable on that income: see [1 100]. However, both the ITAA 1997 and ITAA 1936 are relevant for the purposes of determining taxable income, tax offsets (ITAA 1997 terminology) or rebates and credits (ITAA 1936 terminology). Relevant provisions in the ITAA 1936 are given effect for the purposes of 4

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determining taxable income under the ITAA 1997 by the mechanism of defining the term ‘‘the Act’’ in the ITAA 1997 to include the ITAA 1936 as well as the ITAA 1997: s 995-1 ITAA 1997. In contrast, the provisions the in the ITAA 1936 dealing with withholding tax on cross-border payments of dividends, interest and royalties are not dependent on the operation of the ITAA 1997. In some cases, a provision in the ITAA 1936 continues to apply in the current year even though, for most purposes, it has been superseded by a provision in the ITAA 1997. Such situations are covered in the Income Tax (Transitional Provisions) Act 1997 (TPA).

[1 060] Structure of the Assessment Acts The ITAA 1997 is divided into chapters, each of which consists of one or more Parts. The numbering of the Parts is linked to the numbering of the chapters (eg Chapter 2 consists of Pts 2-1 to 2-42). Each Part consists of one or more Divisions, each of which contains sections which may be organised into Subdivisions. The numbering of the Divisions is not linked to the numbering of Parts (eg Div 70 is in Pt 2-25) but is linked to the numbering of sections within the Division (eg ss 70-1 to 70-120 are within Div 70). The ITAA 1936 is divided into Pts I to XII, plus Schedules. Some Parts are divided into Divisions and some Divisions are further divided into Subdivisions. The numbering of sections and subsections is consecutive throughout the Act and bears no relation to the numbering of Parts, Divisions or Subdivisions. In order to accommodate new sections within an existing sequence, lettering is used to supplement the use of numerals. Since the ITAA 1936 originally came into existence, the need to squeeze new sections between existing sections has led to the creation of bizarre section numbers such as ss 159GZZZZH, 160AQCNCH and 160ZZRDB. The style of a section reference usually indicates whether the section is in the ITAA 1997 or the ITAA 1936. Section numbers in the ITAA 1997 are hyphenated (eg s 8-1, commonly referred to as ‘‘section 8 dash 1’’), whereas section numbers in the ITAA 1936 are not hyphenated (except for sections in the Schedules to the ITAA 1936 which use the ITAA 1997 style, eg s 265-5 in Sch 2F and s 326-5 in Sch 2H). For the sake of simplicity, a reference to the ITAA 1997 or the ITAA 1936 in this publication is not always included after a section is mentioned and only appears where necessary for identification purposes. In this publication, section ranges are always preceded by ‘‘ss’’ and referred to as, for example, ss 8-1 to 8-10 (if in the ITAA 1997) or ss 128A to 128TF (if in the ITAA 1936). Person, taxpayer, you and entity The familiar words ‘‘person’’ and ‘‘taxpayer’’ in the ITAA 1936 have largely been replaced in the ITAA 1997 by the words ‘‘you’’ and ‘‘entity’’. Section 4-5 states that ‘‘you’’ applies to entities generally unless its application is expressly limited. Section 9-1 contains a list of ‘‘entities’’ liable to pay income tax. The list covers individuals, companies (both incorporated and unincorporated associations other than partnerships), corporate limited partnerships, mutual insurance organisations, trustees of various kinds of trust and other trustees in respect of various kinds of income. The ways in which the income tax laws apply to different entities are discussed in Chapter 19 to Chapter 24. [1 070] International tax agreements The International Tax Agreements Act 1953 (InTAA) gives statutory effect to Australia’s Double Taxation Agreements (DTAs). Section 4(1) InTAA provides that ‘‘the Assessment Act [which is defined to mean the ITAA 1936 or ITAA 1997] is incorporated and shall be read as one with this Act’’. In the event of a conflict between the provisions of the InTAA and the Assessment Acts (ITAA 1936 or ITAA 1997), or any other Act imposing Australian tax, the InTAA prevails except in relation to the general anti-avoidance provisions of the ITAA 1936 and the FBTAA: see [36 040]. Australia’s DTAs are discussed in Chapter 36. © 2017 THOMSON REUTERS

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Legislative instruments

Legislative instruments are written instruments made in exercise of power delegated by the Parliament, eg regulations, ordinances and determinations. Legislative instruments must be registered under the Legislation Act 2003 (previously called the Legislative Instruments Act 2003) to be enforceable. The principal legislative instruments prescribing various matters for the purposes of the income tax legislation are the Income Tax Assessment Regulations (ITA Regs), which are made under the ITAA 1997, and the Income Tax Assessment (1936 Act) Regulation 2015 (the ITA (1936 Act) Reg), which is made under the ITAA 1936. The ITA (1936 Act) Reg replaced the Income Tax Regulations 1936 as from 2015-16. The numbering of regulations in the ITA Regs adopts the style used in the ITAA 1997 (see [1 060]), eg regulations are hyphenated. The numbering of regulations in the ITA Regs also reflects the section in the ITAA 1997 to which the regulation relates. The official version of the Income Tax Assessment (1936 Act) Regulation 2015 (on the Federal Register of Legislation website) uses the term ‘‘section’’ rather than ‘‘regulation’’ (although this publication uses ‘‘regulation’’ or ‘‘reg’’). The numbers used in the Regulation bear no relationship to the number of the relevant section in the ITAA 1936. The Federal Register of Legislation comprises a comprehensive and complete database of legislative instruments and explanatory statements. The Register is publicly accessible via https://www.legislation.gov.au. The Acts and Instruments (Framework Reform) Act 2015 established a category of instruments called notifiable instruments, which can be registered in authoritative form. Notifiable instruments are not legislative in character, and as such they will generally not be made subject to parliamentary scrutiny or sunsetting. The category of notifiable instruments is designed to cover instruments that are not appropriate to register as legislative instruments. Note that s 13 of the Legislation Act 2003 provides that the Acts Interpretation Act 1901 applies to legislative instruments (eg regulations) as if they were Acts (unless the contrary intention appears). A similar provision applies to instruments that are not legislative instruments or notifiable instruments: s 46 Acts Interpretation Act 1901.

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Administration of the tax system

Administration of the Australian tax system is largely effected via the TAA. That Act deals with issues such as the payment and collection of tax (including through the PAYG withholding and instalment systems), running balance accounts (RBAs), the objection and appeal processes and administrative penalties (eg for making false or misleading statements in a tax return or lodging a tax return after the due date). These administrative matters are discussed in Chapters 48 to 54. The tax file number (TFN) and Australian business number (ABN) systems are discussed in Chapter 55. A separate Act – the Tax Agent Services Act 2009 – deals with the registration of tax agents and BAS agents: see Chapter 56. Proposed Div 370 in Sch 1 TAA will enable the Commissioner to make a disallowable legislative instrument modifying the operation of a provision of a taxation law, to ensure that the provision is administered consistently with its purpose or object. The Commissioner must consider the modification to be reasonable and the Department of the Treasury or the Department of Finance must advise the Commissioner that any impact on the Commonwealth budget would be negligible. The Commissioner must also be satisfied that any appropriate and reasonably practicable consultation has been undertaken. An entity must not apply a modification if it would produce a less favourable result for the entity. It is intended that the power should be exercised only as a last resort. These measures are contained in the Tax and Superannuation Laws Amendment (2016 Measures No 2) Bill 2016. 6

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INCOME TAX EQUATION [1 100] Calculating income tax The formula for determining a taxpayer’s income tax liability for the financial year (as set out in s 4-10(3) ITAA 1997) is: income tax = (taxable income × rate) − tax offsets

For the 2016-17 income year, the steps to be taken are (s 4-11 TPA): Step 1 – work out the taxable income for the income year (this is assessable income less allowable deductions). Note that if deductions exceed assessable income, the taxpayer may have a tax loss which can be utilised in that income year or a later year. Step 2 – work out the basic income tax liability on the taxable income, using the relevant income tax rates and any special provisions (eg income averaging for special professionals: see Chapter 28). The rates of tax for 2016-17 for residents and foreign residents are set out in Chapter 100. Subdivision 355-G (clawback of R&D recoupments: see [11 080]) and s 392-35(3) (extra income tax payable by a primary producer under the averaging system: see [27 530]) may increase a taxpayer’s basic income tax liability. Note that the basic income tax liability does not include the temporary budget repair levy or the Medicare levy. Step 3 – work out the tax offsets for the income year. Step 3A – subtract the tax offsets from the basic income tax liability. Step 3B – add the temporary budget repair levy (2%) if appropriate. Step 4 – subtract any foreign income tax offset (FITO) remaining after applying it in accordance with the rules in s 63-10 ITAA 1997: see [19 040]. The result after applying Step 4 is the income tax liability for the income year. The concepts of assessable income and taxable income are discussed at [3 020]. Chapter 3 to Chapter 6 discuss what amounts are income (either according to general concepts or specific provisions of the income tax legislation). Allowable deductions, including capital allowances and tax losses are discussed in Chapter 8 to Chapter 10. Various industry-related incentives are discussed in Chapter 11. Tax offsets (called tax rebates and credits in the ITAA 1936) reduce a taxpayer’s basic income tax liability (ie they are only taken into account once the basic income tax liability has been calculated): s 4-10. Note that tax offsets (except FITO) do not reduce the Medicare levy (or surcharge). Personal tax offsets are discussed in Chapter 19, the franking offset in Chapter 21 and the foreign income tax offset in Chapter 34. The R&D tax offset and the various film tax offsets are discussed in Chapter 11. In some cases, an excess offset (if an amount remains after the tax payable is reduced to nil) is refunded to the taxpayer, but in other cases it is lost: see [19 040]. In limited cases, any excess offset may be carried forward to a later income year: see [19 050]. Note that Australia operates a self-assessment system under which the Tax Office calculates a taxpayer’s income tax liability on the information provided in the tax return: see [1 180].

[1 110] Tax accounting Income tax is payable under s 4-10(1) in respect of each financial year. The expression ‘‘financial year’’ is defined in s 995-1 as a period of 12 months beginning on 1 July, although in s 4-10(1) the same meaning is obtained by referring to it as the year ending on 30 June. Hence, the financial year runs from 1 July to 30 June each year. Thus, for example, the 2016-17 financial year is the period from 1 July 2016 to 30 June 2017. The rate of tax that applies for a particular financial year is determined under the Income Tax Rates Act 1986 (the Rates Act). The rate varies according to the category of taxpayer, eg whether an individual, a company or a trustee: see [1 190]. © 2017 THOMSON REUTERS

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Although income tax is payable in respect of a financial year, it is worked out by reference to a taxpayer’s taxable income for an income year: s 4-10(2). If a taxpayer has a substituted accounting period (SAP), it is the income year that is altered and not the financial year: see [1 120].

Individuals For most individuals the income year is the same as the financial year. Thus, for example, income tax payable by an individual in respect of the financial year ended 30 June 2017 (at the rates declared in the Rates Act for that year) is based upon the taxable income of that individual arising during the income year ended 30 June 2017 (ie the period from 1 July 2016 to 30 June 2017). Companies In the case of a company, s 4-10(2) provides that the income year is the previous financial year. Consequently, a company’s income tax for a financial year should be based on its taxable income for the previous financial year. However, under the PAYG instalment system in Sch 1 to TAA, quarterly instalments of tax are prima facie based on a company’s assessable income for that quarter and the final assessed tax for a financial year is calculated by reference to the taxable income for the equivalent income year (although certain companies may pay quarterly instalments based on the previous year’s taxable income). Notwithstanding those exceptions, there appears to be a conflict between s 4-10(2) and the PAYG instalment system (the PAYG provisions should prevail as they were enacted later: see [1 280]). The PAYG instalment system is discussed in Chapter 51. Venture capital entities Special rules (in s 18A ITAA 1936) apply if an entity becomes or ceases to be a venture capital limited partnership (VCLP), an early stage venture capital limited partnership (ESVCLP), an Australian venture capital fund of funds (AFOF) or a venture capital management partnership (VCMP) during an income year. In such a case, the entity’s income year is split into 2 periods, one from the beginning of the year to the change date and the other from the change date to the end of the income year. Each period is treated as a separate income year. If an entity has an accounting period that is not the same as the financial year, the accounting period is treated as an income year: s 9-5(2) ITAA 1997. Other entities The rules in s 4-10 apply to all ‘‘entities’’ (as defined in s 960-100) who have to pay income tax. These are listed in s 9-1, eg an individual has to pay income tax but a partnership, other than a corporate limited partnership, does not. Section 9-5(1) identifies any entities for which income tax is payable by reference to an amount other than taxable income, eg the net income of a corporate unit trust. Section 9-5(2) provides that the income year of a corporate unit trust (see [23 1550]) and a public trading trust (see [23 1600]) is the previous financial year. However, such entities are covered by the PAYG instalment system and therefore, as discussed above, there appears to be a conflict between s 9-5(2) and the PAYG instalment provisions. [1 120] Substituted accounting periods Any person or entity (including trusts and partnerships) may, with the Commissioner’s permission, adopt a 12-month substituted accounting period (SAP) that ends on a date other than 30 June, and thereafter on the corresponding date of succeeding years (unless the Commissioner allows some other date to be adopted): s 18 ITAA 1936. In such a case, the income year (and not the financial year) is changed. Thus, if an accounting period ended 31 December is adopted in lieu of the following 30 June, the income year becomes the period 1 January to 31 December. In other words, income tax is worked out by reference to the taxable income calculated for that period, but the financial year to which the income year corresponds remains as the year ended 30 June. Note the special rules discussed at [1 110] 8

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that apply if an entity’s status changes as a result of becoming or ceasing to be a VCLP, ESVCLP, AFOF or VCMP during an income year. The Commissioner’s views on when to allow a SAP are set out in Practice Statement PS LA 2007/21. It states that leave to adopt a SAP will generally be granted if it can be demonstrated that the circumstances take the case out of the ‘‘ordinary run’’ (a phrase used in the MLC Investments case at 673). Generally factors that would be relevant to determining what is the ‘‘ordinary run’’ is a consideration of the various typical business needs relevant to the efficient administration of the taxpayer’s business in their market. In considering whether granting leave would result in inconvenience in the administration of the income tax law, generally it is appropriate to consider the consequences of making the same decision in relation to similarly situated taxpayers. It is also appropriate to have regard to the aggregate effect of grants of SAPs. Circumstances indicative of being out of the ordinary run include, but are not limited to: • an ongoing event, industry practice, business driver or other ongoing circumstance which makes 30 June either inappropriate or impractical as a basis to calculate taxable income; and/or • alignment (also known as synchronisation) of balance dates within a group. The Tax Office expects all entities within the same economic group (a SAP group), including foreign entities, to synchronise their balance dates. If the controlling entity is a foreign entity, the Tax Office will usually allow the subsidiaries to align their balance date with that of the controlling entity, or allow a balance date not more than 3 months before the balance date of the controlling entity: Practice Statement PS LA 2007/21. In MLC Investments Ltd v FCT (2003) 54 ATR 671, the Federal Court held that although gaining a competitive advantage could not, by itself, provide a proper basis for granting a SAP, it could not be used as a disqualifying factor. Practice Statement PS LA 2007/21 states that an application for a SAP must be in writing, lodged in a timely fashion and ideally at the time when the circumstances which form the basis of the SAP application first arise. An application form is available on the Tax Office’s website. The application must be signed by a person authorised to sign on behalf of the entity. The onus is on the applicant to provide evidence and establish that the granting of leave for a SAP is warranted. Note that it is unlikely that an individual non-business taxpayer will be given permission to adopt a SAP. A separate ruling deals with companies that seek leave to adopt an accounting period ending between 1 December and 30 June in lieu of the succeeding 30 June: Ruling IT 2433. If a company has an approved non-standard balance date, it may not unilaterally decide to close its books at a date other than the last day of the approved SAP: Ruling IT 2467.

[1 130] Residence and source As a general principle, an Australian resident is subject to tax in Australia on income derived (directly or indirectly) from all (worldwide) sources, whereas a foreign resident is only subject to tax in Australia on income derived (directly or indirectly) from Australian sources: s 6-5. A third category of taxpayer – a temporary resident – generally only pays tax on Australian-sourced income, foreign employment income not otherwise exempt and capital gains on ‘‘taxable Australian property’’. The concepts of residence and source are discussed in Chapter 2. Definition of ‘‘Australia’’ The ordinary meaning of ‘‘Australia’’, when used in a geographical sense, includes the States, the ACT and the Northern Territory and their internal waters and any islands that are part of those States and Territories. For various tax purposes, including income tax and fringe benefits tax, the meaning of ‘‘Australia’’ is extended by s 960-505 ITAA 1997 to include Australia’s external Territories (Norfolk Island, the Coral Sea Islands, Ashmore and Cartier © 2017 THOMSON REUTERS

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Islands, Christmas Island, Cocos (Keeling) Islands, Heard Island and the McDonald Islands), an offshore area for the purpose of the Offshore Petroleum and Greenhouse Gas Storage Act 2006 and the Joint Petroleum Development Area (within the meaning of the Petroleum (Timor Sea Treaty) Act 2003). Note that the coastal sea of Australia is effectively part of Australia (see s 15B Acts Interpretation Act 1901) and that the offshore area and the Joint Petroleum Development Area include the exclusive economic zone and the continental shelf of Australia.

[1 140] Capital gains tax The concept of ‘‘ordinary income’’ by definition excludes capital gains, but statutory income specifically includes net capital gains calculated under Pt 3-1 ITAA 1997. Net capital gains are capital gains reduced by capital losses. Net capital losses are carried forward separately from other (revenue) losses. Note that, although commonly referred to as capital gains tax (CGT), the capital gains and losses provisions do not constitute a separate tax. It is important to note that the capital gains provisions are residual provisions, which apply to many routine transactions that are not on capital account. If both a capital gain and ordinary or statutory income arise from the same event, double taxation is avoided by a reduction in the amount of the gain (s 118-20), nevertheless there may still be a gain (eg because of deeming rules, including market value rules, in the capital gains provisions). The CGT provisions are principally dealt with in Chapter 12 to Chapter 17. International aspects of CGT, eg the CGT liability of foreign residents and the CGT consequences if a taxpayer changes residence, are discussed in Chapter 18. [1 150] Special classes of taxpayer Chapter 25 to Chapter 30 discuss the special treatment accorded to income derived by special classes of taxpayer, namely small business entities, minors, primary producers, special professionals (authors, inventors, performing artists, production associates and sportspersons), natural resource industries and life insurance companies. The taxation of superannuation entities is dealt with in Chapter 41. [1 160] International taxation The general principle that a non-resident is assessable on Australian source income is modified extensively by excluding from assessment, and instead subjecting to withholding tax, certain outbound payments, in particular dividends, interest and royalties. The general principle that an Australian resident is assessable on income derived from all sources is modified extensively by rules that include, as statutory income, amounts ‘‘attributed’’ from certain foreign companies and trusts, and rules that exempt certain foreign dividend income derived by companies. If there is an international element (eg if foreign source income is derived by an Australian resident), a Double Tax Agreement (DTA) may be relevant in determining in which jurisdiction an amount is taxed. If an amount is taxable in both jurisdictions, an offset may be available for the foreign tax paid by the Australian resident (the foreign income tax offset). These and other international tax issues are covered in Chapter 34 to Chapter 38. [1 170] Anti-avoidance provisions The principal income tax anti-avoidance provisions are contained in Pt IVA ITAA 1936. There is a general anti-avoidance provision which deals with schemes entered into for the sole or dominant purpose of obtaining a tax benefit, ie avoiding assessable income, incurring a deduction, creating a capital loss, obtaining a foreign income tax offset (but not other rebates or offsets) or avoiding withholding tax. Part IVA also contains provisions dealing with dividend stripping schemes and schemes entered into in order to obtain an imputation benefit. 10

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[1 190]

Part IVA is discussed in Chapter 42, except for the imputation benefit provisions which are discussed at [21 860] and [21 870]. Chapter 43 covers a group of specific anti-avoidance provisions. Other specific anti-avoidance transactions are dealt with in the chapters to which they relate. The tax scheme promoter penalty regime, designed to deter the promotion of tax avoidance and tax evasion schemes, is discussed at [54 210].

[1 180] Self-assessment The central characteristic of the income tax assessment system (in Pt IV ITAA 1936) is self assessment. Self-assessment means that the Tax Office makes an assessment based on the information provided by the taxpayer in the relevant income tax return. The system is more fully developed for companies and superannuation entities than for individuals. For companies and superannuation entities, an assessment is deemed to be made when the entity lodges an income tax return showing tax payable, whereas the Commissioner issues assessment notices to individuals. If a taxpayer fails to lodge an income tax return, the Commissioner may make a default assessment. There are specific rules about amending assessments if the original assessment turns out to be wrong. These topics are discussed in Chapter 47. The rulings system (in Pt 5-5 Sch 1 TAA) is an important part of the self-assessment system. The object of the rulings system is to give taxpayers certainty as to how tax laws are administered by the Commissioner, thereby reducing the risks of uncertainty when taxpayers are self-assessing or otherwise working out their tax obligations and entitlements. Rulings may be public rulings, private rulings or oral rulings. The rulings system is discussed in Chapter 45. Underpinning the self-assessment system are the Commissioner’s powers to obtain information about taxpayers’ tax affairs and to audit taxpayers (including random audits). See Chapter 53. [1 190] Rates Acts The major Act containing rates of tax is the Income Tax Rates Act 1986 (the Rates Act). Note that, for constitutional reasons, income tax is imposed by a separate Act – the Income Tax Act 1986: see [1 020]. Sections 3 and 4 of the Rates Act define various terms used throughout the Act, often by reference to the interpretation of such terms in ITAA 1997 or ITAA 1936. Sections 5 to 20 in conjunction with various Schedules, contain rates of tax applicable to individuals, beneficiaries and trustees. In particular, the rates applicable to individuals are set out in Sch 7 (s 12(1)) and the rates applicable to trustees assessable under s 98 or s 99 ITAA 1936 (see [23 120]) are set out in Sch 10 (subject to ss 13 to 15): s 12(6). Each Schedule is divided into 2 Parts, Pt I applicable to residents and Pt II applicable to foreign residents. There are also specific provisions relating to matters such as: • the extra income tax payable in respect of primary production income subject to averaging (see [27 530]: s 12A); • uncontrolled partnership income (see [22 370]: s 12(7) and 12(8)); and • the ‘‘unearned’’ income of minors (see [26 250]: ss 13 to 15 and Schs 11 and 12). Sections 21 to 29 contain rates of tax applicable to companies, superannuation entities, corporate unit trusts, public trading trusts and trustees of certain trusts with corporate non-resident beneficiaries. The rates of tax imposed by the Rates Act are applicable to any assessments in respect of income derived between the end of the income year and the setting of new rates for a year if, for exceptional reasons, such assessments are issued between those dates. The rates of tax for 2016-17 are set out in Chapter 100 and Chapter 101. Chapter 100 also lists various tax offsets (or rebates) that may be relevant in working out tax payable. A © 2017 THOMSON REUTERS

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ready reckoner allowing the user to quickly calculate the income tax payable (on taxable income) for 2016-17 can be found in Chapter 105.

Medicare levy The Medicare levy is collected with income tax but is payable by resident individuals only. The rate is 2% of taxable income, subject to low income concessions. Higher income taxpayers who do not have private patient hospital insurance may be liable to pay a 1% Medicare levy surcharge in addition to the general levy. The Medicare levy and surcharge are discussed in Chapter 19. Other ratings Acts There are a number of other ratings Acts that impose rates of tax in accordance with specialised provisions of the ITAA 1997 or ITAA 1936. The rates of tax imposed by these Acts are generally detailed in the specific chapters dealing with the subject matter of the Acts. Some of the more significant rating Acts are: • Income Tax (Dividends and Interest Withholding Tax) Act 1974: see [35 150]; • Income Tax (Bearer Debentures) Act 1971: see [35 320]; • New Business Tax System (Franking Deficit Tax) Act 2002: see [21 750]; • New Business Tax System (Over-franking Tax) Act 2002: see [21 720]; • New Business Tax System (Venture Capital Deficit Tax) Act 2003: see [11 520]; • Family Trust Distribution Tax (Primary Liability) Act 1998: see [23 900]; • Family Trust Distribution Tax (Secondary Liability) Act 1998: see [23 910]; • Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No 1) 2007: see [23 1490]; • Superannuation (Excess Non-concessional Contributions Tax) Act 2007: see [39 510]; • Superannuation (Departing Australia Superannuation Payments Tax) Act 2007: see [40 260]; and • Superannuation Guarantee Charge Act 1992: see [39 790].

INTERPRETING TAX LEGISLATION [1 250] The intention of Parliament The fundamental rule of interpretation is to ascertain what Parliament intended as expressed by the words used. Section 15AA of the Acts Interpretation Act 1901 now provides that, in interpreting a provision of an Act, the interpretation that would best achieve the purpose or object of the Act is to be preferred, whether or not that purpose or object is expressly stated in the Act. Ultimately, the task of the courts is to construe the language of the relevant legislation. Generally, if the language of a statutory provision is clear and unambiguous, and is consistent and harmonious with the other provisions of the enactment and can be intelligibly applied to the subject matter with which it deals, it will be given its ordinary and grammatical meaning. However, the courts will prefer an interpretation of a statute which will give effect to the legislative purpose, as opposed to one that will not. Thus, if the operation of the statute on a literal reading does not conform to the legislative intent, the courts may depart from the literal meaning of the words, particularly if a literal interpretation would give rise to an absurd, capricious or irrational result. See, for example, FCT v Westraders (1979) 9 ATR 558, per 12

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Deane J at 568; Cooper Brookes (Wollongong) Pty Ltd v FCT (1981) 11 ATR 949, per Gibbs CJ at 955 and Mason and Wilson JJ at 965-966. The context in which the words appear is important in ascertaining the legislative intent and is not simply a factor to be considered if there is an ambiguity. As Gibbs CJ said in Cooper Brookes at 955, ‘‘no part of a statute can be considered in isolation from its context – the whole must be considered’’. Indeed, the modern approach to statutory interpretation ‘‘insists that the context be considered in the first instance, not merely at some later stage when ambiguity might be thought to arise, and uses ‘context’ in its widest sense to include such things as the existing state of the law and the mischief which… one may discern the statute was intended to remedy’’ (FCT v BHP Billiton Finance Ltd (2010) 76 ATR 472 at para 98). See also MLC Ltd v DCT (2002) 51 ATR 283 at 292, CIC Insurance Ltd v Bankstown Football Club Ltd (1997) 187 CLR 384 at 408, Metlife Insurance Ltd v FCT (2008) 70 ATR 125 at para 40. If the meaning of words in a statute is ambiguous (ie fairly and equally open to different interpretations), the court will adopt that construction which conforms to the legislative intent as appearing from the provisions of the statute including the policy which can be discerned from it: Cooper Brookes at 966-967; MLC Ltd at 291. ‘‘This requires the Court to identify that purpose, both by reference to the language of the statute itself and also any extrinsic material which the Court is authorised to take into account’’ (BHP Billiton at para 99). The various rules of statutory interpretation outlined in this chapter may be used to ascertain the legislative purpose. One method of ascertaining the intention of Parliament is to consider the reason or purpose for the passing of the legislation – ie to discover the ‘‘mischief’’ and defect for which the law did not provide before the legislation was enacted (the ‘‘mischief rule’’). See, for example, Metlife Insurance Ltd v FCT (2008) 70 ATR 364 at para [23]. Other points that should be noted are: • a proviso cannot be used to force plain words in the enactment to which it is appended away from their natural meaning, unless of necessity; • there is a general presumption that Parliament will not impose double taxation, unless the intention to do so is clear beyond any doubt: see, for example, Dixon J’s statement in Executor Trustee and Agency Co of SA Ltd v FCT (1932) 48 CLR 26 at 44; and • commercial and accountancy practice is of limited relevance in determining the taxable income of a taxpayer.

[1 260] Use of extrinsic material Section 15AB of the Acts Interpretation Act 1901 is an important provision allowing the use of material extrinsic to an Act to: • confirm that the ordinary meaning of a provision is appropriate; • resolve the meaning of ambiguous or obscure provisions; or • determine the meaning of a provision if the ordinary meaning is manifestly absurd or unreasonable. However, extrinsic material cannot be used to contradict the meaning of the language of the operative text. Extrinsic material that can be considered includes the explanatory memorandum (or supplementary explanatory memorandum) to the Bill introducing the particular provision, the speech made by the Minister to Parliament when moving the motion that the Bill be read a second time, any relevant report (eg of a Parliamentary Committee, Law Reform Commission, Royal Commission or committee of inquiry) laid before Parliament before the provision was enacted, any other relevant document laid before Parliament before the © 2017 THOMSON REUTERS

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provision was enacted and any relevant material in Hansard. The explanatory memoranda to Bills amending the income tax legislation can be found in Thomson Reuters’ Bills and Explanatory Memoranda service. In Brooks v FCT (2000) 44 ATR 352, the Full Federal Court was wary of considering the explanatory memorandum relevant to a provision in the ITAA 1997 when interpreting the corresponding provision in the ITAA 1936. The court also noted (at 369) that explanatory memoranda have turned out to be wrong. However, in Re Finlayson and FCT (2002) 51 ATR 1029, the AAT was prepared to consider the explanatory memorandum accompanying s 158G ITAA 1936 (concerning the averaging of professional income) when considering the meaning of the equivalent provision in the ITAA 1997 (s 405-30). In MLC Ltd v DCT (2002) 51 ATR 283, in construing s 82(2) ITAA 1936, Hill J referred to an explanatory handbook (issued by authority of the Commonwealth Treasurer in August 1936) showing the differences between the ITAA 1936 and the Income Tax Assessment Act 1922. His Honour said (at 293) that, although the handbook was issued after the date of assent of the ITAA 1936, regard might be had to the handbook as indicating the mischief to which s 82(2) was directed, that subsection having no counterpart in the 1922 Act. His Honour added that the handbook did ‘‘not stand in the same position as’’ explanatory memoranda to legislation. In IRG Technical Services Pty Ltd & Anor v DCT (2007) 69 ATR 433, Allsop J considered that the Ralph Report (1999) could be used to assist in the interpretation of the alienation of personal services income rules in Pt 2-42 ITAA 1997. In Re Ward and FCT [2015] AATA 138, the AAT considered the explanatory memorandum to an amending Bill in order to give a particular provision, which was otherwise ‘‘manifestly absurd’’, its intended meaning.

[1 270] Interpretation of rewritten tax law Section 1-3(1) ITAA 1997 provides that that Act contains the provisions of the ITAA 1936 in a rewritten form. Section 1-3(2) states that the mere use of different words to express what appears to be the same idea in a clearer or simpler style does not by itself mean that the ideas are intended to be different. Thus, the use of different words and a different style (in the ITAA 1997) does not result in a different meaning unless that is clearly intended. The purpose of s 1-3 is to ensure that the precedent value of the large body of case law that has evolved in interpreting the ITAA 1936 is not lost, especially as most provisions have been rewritten without any intention of changing their effect. The note to s 1-3 and the provisions to which it refers achieve the same aim as s 357-85 in Sch 1 to TAA in relation to the Commissioner’s rulings: see [45 060]. Note that, in Metlife Insurance Ltd v FCT (2008) 70 ATR 125 at para 47, Emmett J expressed doubt that s 1-3 applied if a provision in the ITAA 1936 is rewritten in that Act (and not in the ITAA 1997) – in overturning Emmett J’s decision on the substantive issue (see [47 170]), the Full Federal Court (in Metlife Insurance Ltd v FCT (2008) 70 ATR 364) did not comment on Emmett J’s observations. Problems with applying s 1-3 While the concept is simple, there are problems in the application of s 1-3. First, the section refers to an idea rather than a legislative effect or outcome, with no guidance as to the interpretation of that concept. Second, the ITAA 1997 must appear to express the same idea for s 1-3 to apply. Just how different do words need to be before the idea expressed appears not to be the same? Even if the above criteria are satisfied, the effect of s 1-3 is not to require that the words be given the same interpretation as the old provisions, but merely that the use of different wording alone shall not be taken to result in the ideas being taken to be different. In other words, s 1-3 negates the rule of judicial interpretation that if something was changed it must have been to achieve a different result. If the words used in a provision in the ITAA 1997 are clear, there is little jurisprudence on whether the courts will consider themselves bound to interpret that provision by reference to the established meaning of a corresponding 14

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superseded provision in the ITAA 1936. In Re Finlayson and FCT (2002) 51 ATR 1029, the AAT effectively concluded that s 405-30 ITAA 1997 and its predecessor, s 158G ITAA 1936 (concerning the averaging of professional income), expressed the same idea. Similarly, s 51(1) ITAA 1936 and s 8-1 ITAA 1997 (dealing with deductible expenditure) effectively express the same idea (any differences between the sections are not material): see Macquarie Finance Ltd v FCT (2004) 57 ATR 115, per Hill J at 129 and FCT v Citylink Melbourne Ltd (2006) 62 ATR 648, per Crennan J at 669. In contrast, in Re Sherlinc Enterprises Pty Ltd and FCT (2004) 55 ATR 1001, the AAT decided that the words of former s 123-10 ITAA 1997 (concerning an earlier version of the small business CGT roll-over relief) were sufficiently clear and that the relevant idea expressed in that section was materially different from that expressed in the equivalent provision in the ITAA 1936 (Div 17A of Pt III). This issue was also touched upon by the Full Federal Court in Brooks v FCT (2000) 44 ATR 352. See also G Hill, “A Judicial Perspective on Tax Law Reform” (1998) 72 Australian Law Journal 685.

Importance of changes identified in explanatory memoranda In view of the uncertainty described above, the explanatory memoranda accompanying the introduction of the various instalments of the tax law rewrite are of vital importance in resolving whether the apparent meaning of a new provision could be challenged on the basis that it differs from that of a predecessor provision. The permissible use of explanatory memoranda on a general basis in interpreting the law is explained at [1 260]. If the explanatory memorandum specifically identifies a change as having occurred, it would no longer be a case of ideas being taken to be different merely because of different words being used. Rather, it would be that they were intended to be different; hence, s 1-3 could have no role in relation to preserving the meaning of the old provision, at least insofar as it relates to the particular point identified as being different. It is equally arguable that if the explanatory memorandum does not identify any intended difference, the wording of the old provision and its interpretation could be considered, at least in circumstances where the new provision has not been amended. However, the failure of the explanatory memorandum to identify a change in the law does not mean that the law is unchanged. In Re Sherlinc Enterprises, the relevant explanatory memorandum did not identify any change, but the AAT decided that the inference that no change was intended could not displace the clear words of former s 123-10 which expressed a different idea. Of course, care should be taken in using explanatory memoranda as they have occasionally turned out to be wrong or misleading (eg see the Full Federal Court’s comment in Brooks at 369). [1 280] Conflicting provisions If it is not possible to reconcile apparently inconsistent sections relating to a matter, a specific provision will usually prevail over a general provision. If the inconsistency is in respect of sections that are either both general or both particular, the section that appears later in the Act will generally override the earlier. Sometimes, an Act itself may contain tiebreaker provisions: see, for example, s 6-25(2) ITAA 1997. If a later Act is inconsistent with an earlier Act, in general the later Act prevails. An amending Act may provide that a particular amendment is not to be taken into account for the purposes of interpreting a particular section as it was before the amendment. In other words, the fact of the amendment is not meant to imply that the section in question as enacted before the amendment is to be interpreted differently. This may happen if it is uncertain that a particular provision will be interpreted by the courts in the Commissioner’s favour and Parliament amends the law to clarify the provision, but does not want taxpayers to be able to use the amendment to support an interpretation (of the provision before its amendment) that is unfavourable to the Commissioner. [1 290] Retrospective legislation The Commonwealth Parliament may make retrospective laws with respect to taxation, even when they impose additional burdens in respect of transactions completed before the © 2017 THOMSON REUTERS

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passing of those laws. However, retrospective legislation will be only upheld if the intention to make retrospective legislation is demonstrably clear: MacCormick v FCT (1984) 15 ATR 437; Gray v FCT (1989) 20 ATR 649. There is a presumption that accrued rights are determined under the law as it stood when the rights accrued, unless a contrary intention is clearly disclosed: Repatriation Commission v Keeley (2000) 98 FCR 108 at p 123. The Tax Office’s administrative treatment of a law affected by an announced measure, that has a retrospective effect, until the measure is enacted is set out in Practice Statement PS LA 2007/11.

[1 300]

Elements of an Act

Title and preamble To resolve uncertainty as to the meaning and real intention of an Act, it is permissible to refer to the title and preamble, but not so as to contradict or diminish the force of operative provisions that are clear and unambiguous in themselves: see Birch v Allen (1942) 65 CLR 621 at 625-626. Headings The Acts Interpretation Act 1901 provides that the headings of Parts, Divisions and Subdivisions into which any Act is divided are deemed to form part of the Act, but headings to sections do not. This rule applies in relation to the ITAA 1936. The ITAA 1997 contains its own rules which are the same as the Acts Interpretation Act 1901 rules, except that section and subsection headings are also deemed to be part of the Act: s 950-100. The headings may be referred to if there is doubt as to the meaning of provisions following such headings, but not to give a different effect if the meaning of the words used in a section is plain: Martins v Fowler [1926] AC 746, per Lord Darling at 750. Guides and signposts Guides and signposts are a form of orientation and navigational material that are extensively used in the ITAA 1997 (and to a lesser extent in the ITAA 1936). Guides can be used as an aid in interpreting operative provisions, but only to the extent of determining the provision’s purpose or underlying object, confirming the ordinary meaning conveyed by the text taking into account the context (or by clarifying that such ordinary meaning was not intended if the result would be absurd or unreasonable) and by assisting in determining the meaning if the provision is ambiguous or obscure: s 950-150(2). Notes Marginal notes and footnotes are generally not part of an Act (s 13 Acts Interpretation Act 1901; s 950-105 ITAA 1997), but they may be referred to as an aid to interpretation: Joyce v Paton (1941) 58 WN (NSW) 88 (Street J). Notes, but not footnotes and endnotes, are part of the ITAA 1997: s 950-105. [1 310] Particular words and phrases If there is no statutory definition, words are generally to be construed according to their ‘‘ordinary’’, ‘‘natural’’ or ‘‘popular’’ meaning, provided this does not involve absurdity or inconsistency with the context in which they appear. Technical words are to be taken in their technical legal sense unless the contrary intention appears. Note that the Acts Interpretation Act 1901 defines certain terms for the purposes of legislation generally (unless the contrary intention appears in an Act). For example, ‘‘Australia’’ includes the whole of the Commonwealth of Australia, ‘‘person’’ and ‘‘party’’ includes a body politic or corporate as well as an individual and ‘‘month’’ effectively means a calendar month. In addition, unless the contrary intention appears, words importing a gender include every other gender (eg masculine includes feminine) and words in the singular include the plural and words in the plural include the singular. 16

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[1 310]

Specific rules of interpretation that may assist with the interpretation of particular words and phrases are: • the noscitur a sociis rule – the meaning of doubtful words may be ascertained by reference to words of analogous meaning with which they are coupled; and • the ejusdem generis rule – if at least 2 particular things which are enumerated have some common characteristic that constitutes them a class or genus, the general words will be restricted as referring to the same kind of things as those enumerated.

Legislative definitions The majority of definitions for the purposes of the ITAA 1997 (and, where appropriate, the ITAA 1936) are contained in s 995-1, which is part of, known as The Dictionary. These terms are identified with an asterisk (eg *business): s 2-10. Terms are not asterisked in the non-operative material, nor are certain basic terms (eg company, individual, partnership, trustee, assessable income and deduction): s 2-15. In many instances, however, the Dictionary is merely a repository to enable location of definitions and simply contains a cross-reference to the particular section in which the term is defined. Section 6 ITAA 1936 is a general interpretation section, declaring the meaning that certain words and phrases are intended to bear for the purposes of both that Act and, where appropriate, the ITAA 1997. These definitions serve to simplify and abbreviate sections of the ITAA 1936. The definitions in s 995-1 or s 6 are generally expressed to apply unless the contrary intention appears. If words and phrases are used in different senses in the ITAA 1936, definitions are inserted in Divisions and sections dealing with a particular subject in relation to which certain words are intended to have a special meaning. The ITAA 1997 attempts to avoid giving the same term different meanings and will use a different term if necessary. Deeming provision The phrase ‘‘taken to be’’ (usually used in the ITAA 1997) or the word ‘‘deemed’’ (usually used in the ITAA 1936) may be used to give an artificial construction of a word or phrase or to remove uncertainty from a particular construction: see Lord Radcliffe in St Aubyn v A-G (No 2) [1952] AC 15; [1951] 2 All ER 473 at 53 (AC). However, in Barclay’s Bank Ltd v IRC [1960] 2 All ER 817 at 820, Lord Simonds expressed the view that ‘‘its primary function is to bring in something which would otherwise be excluded’’. Shall and may The word ‘‘may’’ in its natural meaning is permissive or enabling only and must be taken in this sense unless, as a matter of construction of the Act, it can be shown that the intention is to impose an obligation. In some circumstances the word ‘‘may’’ is merely designed to enable the Commissioner to carry out an otherwise unlawful act and is not a discretionary power. The word ‘‘shall’’ is mandatory but, as in the case of ‘‘may’’, it is necessary to have regard to the whole scope of the particular provision of the Act and there is no rule that defines precisely the difference between discretion and obligation: see Gibbs J Finance Facilities Pty Ltd v FCT (1971) 2 ATR 194 at 205-6 and Windeyer J on appeal (1971) 2 ATR 573 at 578-9. Time limits Section 36(1) of the Acts Interpretation Act 1901 sets out specific rules about how to interpret periods of time in legislation. For example, if a period of time is expressed to begin at, on or with a specified day, the period includes that day, but not if the period is expressed to begin from a specified day. Other rules are that if a period of time is expressed to continue until a specified day, the period includes that day, and if a period of time is expressed to occur between 2 days, the period includes both days. © 2017 THOMSON REUTERS

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If a tax debt is required to be paid, or a form is required to be lodged with the Tax Office, on a Saturday, Sunday or public holiday, it can be paid or lodged (as appropriate) on the next business day: s 8AAZMB and 388-52 Sch 1 TAA (see also s 36(2) Acts Interpretation Act 1901).

[1 320] Precedent Precedent plays a major part in the interpretation of any law. If courts have interpreted the law in previous cases, it is to be assumed that similar interpretations will be placed upon the legislation considered until such time as a superior court overrules the judgment. In Australia, the order of precedence of the various courts adjudicating upon income tax legislation is the High Court of Australia, the Federal Court of Australia (the Full Court takes precedence over a single judge) and the various Supreme Courts of the States and Territories (the Supreme Courts are no longer involved in the general appeal process but may have collection and recovery actions brought before them). Whether Australian courts are bound by Privy Council decisions (handed down before appeals to the Privy Council were abolished) is uncertain, although the better view seems to be that Australian courts are not bound to follow Privy Council decisions: see Viro v R (1976) 141 CLR 88 per Barwick CJ, Gibbs and Murphy JJ and National Employers Mutual General Association Ltd v Waind (No 2) [1978] 1 NSWLR 466. [1 330] Form and substance In applying the income tax legislation to a particular transaction, it is necessary to ascertain the true character in law of the transaction. This involves a 3-stage inquiry. 1. What is the true legal nature of the transaction/step (bearing in mind that mere labels may be deceptive)? 2. Disregarding anti-avoidance provisions, how does the income tax law apply to the transaction/step (taking account of the true legal nature of the transaction/step)? 3. If any statutory anti-avoidance provisions are potentially relevant, how do they affect the analysis? Note that the doctrine of fiscal nullity (which requires that any step inserted in a preordained series of steps in order to achieve a particular tax outcome must be disregarded) does not apply in Australia: John v FCT (1989) 20 ATR 1.

AUSTRALIAN TAXATION OFFICE [1 350] Australian Taxation Office – overview While Treasury is responsible for Commonwealth tax legislation, the Australian Taxation Office (the Tax Office or ATO) is the Federal government’s principal revenue collection agency. The major sources of revenue are income tax and GST, but the Tax Office also collects excise on tobacco, petrol and alcohol. The Tax Office also plays a role in Australia’s superannuation system and in administering the private health insurance offset and higher education contributions scheme (HELP). The Tax Office also operates a register of foreign ownership of agricultural land and is responsible for enforcing foreign investment rules relating to residential real estate. From 1 July 2017, the Tax Office will also be responsible for maintaining a register of foreign interests in registrable water entitlements and contractual water rights. The national office is in Canberra, but the daily administration of the tax system is generally conducted through branch and regional offices in each State and Territory. The chief officer of the Tax Office is the Commissioner of Taxation (Mr Chris Jordan AO). There are various Second Commissioners, First Assistant Commissioners and Deputy Commissioners. 18

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AUSTRALIAN TAX SYSTEM [1 360]

Revenue legislation generally states that the Commissioner (and not the Tax Office) has the general administration of that legislation, eg s 8 ITAA 1936 (which also covers the ITAA 1997), s 3A TAA and s 3 FBTAA. The Tax Office is simply the agency that carries out the Commissioner’s administrative duties. This is achieved through the exercise of the Commissioner’s powers of delegation (see s 8 TAA). Practice Statement PS LA 2009/4 explains the process for escalating a proposal requiring the exercise of the Commissioner’s powers of general administration if the matter is non-routine or a practical compliance solution, including the publication of a Practice Statement, is being recommended. Note the proposal to provide the Commissioner with a statutory remedial power to ensure that taxation laws can be administered consistently with their purpose or object: see [1 090]. The Commissioner presents an annual report to Parliament containing information on the operation of the Tax Office, including its organisational structure and strategies, and various revenue statistics. The Commissioner’s annual report and other information about the Tax Office can be found on its website at https://www.ato.gov.au. The website contains a legal database, including public rulings, Practice Statements, ATO Interpretative Decisions (see Practice Statement PS LA 2001/8), policy papers and Freedom of Information material. The Tax Office also gives advice to the government on the administration of the tax system. A Statement of Expectations (issued by the government) and a Statement of Intent (the Tax Office’s response) are available on the Tax Office website. A strategic framework for the Tax Office’s dealings with registered tax agents is also available on its website. If a taxpayer suffers damage as a result of negligent, defective or incorrect administration of the taxation laws by the Tax Office, compensation may be payable under the Compensation for Detriment caused by Defective Administration Scheme. The Tax Office website states that defective administration is unreasonable conduct and behaviour by the Tax Office that falls so far short of acceptable standards that it warrants the payment of compensation. However, human error in processing and administration does not of itself constitute defective administration. A taxpayer may also complain to the Inspector-General of Taxation in certain circumstances: see [48 150].

[1 360]

Secrecy requirements

Standardised secrecy provisions protecting confidential information about taxpayers are now contained in Div 355 in Sch 1 to TAA. It is an offence for taxation officers (ie Tax Office staff and entities and individuals engaged to provide services relating to the Tax Office) to disclose tax information that identifies an entity, or is reasonably capable of being used to identify an entity, except where the information is already publicly available or in certain specified circumstances. The exceptions (in Subdiv 355-B) are wide ranging and include where the information is disclosed: in performing duties as a taxation officer (this includes disclosure for the purposes of administering a taxation law and exchanging information under an international agreement); to government Ministers and Department heads for certain specified purposes; to certain organisations for certain specified purposes (eg ASIC, APRA, Innovation and Science Australia, the Commissioner of the ACNC, the Superannuation Complaints Tribunal, the Project Wickenby Taskforce, the Trusts Taskforce and the Phoenix Taskforce); for specified law enforcement activity purposes, including recording or disclosing protected information to support or enforce a proceeds of crime order; and to an Australian government agency for the purposes of preventing, detecting, disrupting or investigating conduct related to a matter of security (as defined in the ASIO Act). Disclosure in the course of AAT or court proceedings that are related to a taxation law is also permitted (see DCT v Frangieh (No 2) [2016] NSWSC 310). This may include where disclosure is pursuant to a notice to produce (see 12 Years Juice Foods Australia Pty Ltd v FCT [2015] FCA 741). A taxation officer may also disclose details of an individual’s superannuation interests and superannuation benefits to a regulated superannuation fund, public sector superannuation scheme, ADF or RSA provider © 2017 THOMSON REUTERS

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for certain superannuation purposes. A taxation officer is also allowed to disclose to a foreign government agency certain information to assist that agency (or another government agency of the same foreign country) to recover outstanding student loan amounts from persons living in Australia. The government has proposed to allow the Tax Office to disclose to Credit Reporting Bureaus information about the tax debts of businesses that have an ABN, where a debt of more than $10,000 is at least 90 days overdue: see the 2016-17 Mid-Year Economic and Fiscal Outlook (MYEFO). There are also restrictions (in Subdivs 355-C and 355-D) on an entity who is not a taxation officer disclosing protected information, except in certain specified circumstances. Notwithstanding the secrecy provisions, the Tax Office is required to publish information about the total income and taxable or net income of, and tax payable by, larger corporate tax entities: ss 3C to 3E TAA; ss 355-47, 355-172 Sch 1 TAA. The information is obtained from the entity’s tax return or, in the case of a consolidated group or MEC group, from the head company’s tax return. The report identifies taxpayers by their name and ABN. The most recent ‘‘corporate tax transparency report’’ published by the Tax Office (in December 2016) contains information relating to the 2014-15 income year. These reporting requirements apply to corporate tax entities that have total income of at least $100m for the income year, and which are Australian residents (unless private companies at the end of the income year), or which are members of a wholly-owned foreign group or are more than 50% owned by a foreign entity. Australian resident private companies are covered by these reporting requirements if their total income for the income year is at least $200m. If an entity has a tax loss, the quantum of the loss will not be published. In addition, the Board of Taxation has developed a voluntary tax transparency code for the increased public disclosure of tax information by businesses: see [63 033]. The heads of ASIO and ASIS may declare that Commonwealth tax laws do not apply to a specified entity in relation to a specified transaction, provided they are satisfied that it is necessary for the proper performance of the functions (respectively) of ASIO or ASIS (see Div 850 in Sch 1 to TAA). This ensures that the tax authorities will not need to obtain information that should remain secret in the interests of national security. Note the Government’s proposal to introduce appropriate protections for tax whistleblowers: see [63 020].

[1 370] Freedom of information requests The Tax Office has extensive powers to obtain information about a taxpayer’s affairs. These powers are discussed in Chapter 50. In contrast, taxpayers are required to rely on the Freedom of Information Act 1982 (FOI Act) to ascertain what information the Tax Office holds about a particular taxpayer and/or obtain copies of any non-published guidelines used by the Tax Office The FOI Act also allows individuals to request that their personal details be amended or annotated if they are incorrect: ss 48 and 49. In Re Wytkin and DCT (2003) 52 ATR 1001, the AAT affirmed a Tax Office decision refusing to annotate its transcript of a meeting with 2 tax agents. The FOI Act can be a useful tool to ascertain the methodology of the approach being taken by the Tax Office. For instance, a request for information relating to the tax audit of one’s affairs (see [53 060]) can identify the conclusions reached by the Tax Office. That information can then be used in negotiating a settlement with the Tax Office. The Office of the Australian Information Commissioner (AIC) oversees the operation of the FOI Act and reviews decisions made by agencies and ministers under that Act. What documents may be obtained? All documents may be obtained by a person unless they are exempt documents under the FOI Act. Exempt documents include: • documents affecting enforcement of the law and protection of public safety (s 37); 20

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AUSTRALIAN TAX SYSTEM [1 390]

• documents to which secrecy provisions of enactments apply, except in so far as the document contains personal information about the applicant (s 38) – information about a partnership or trust of which the applicant is a member is not personal information for these purposes (Re Collie and FCT (2003) 54 ATR 1048); • documents containing material obtained in confidence (s 45); and • documents disclosing trade secrets or commercially valuable information (s 47). There are also various public interest conditional exemptions, eg if disclosure of a document would prejudice the effectiveness of procedures or methods for the conduct of tests, examinations or audits by an agency, would disclose deliberative matter, would involve the unreasonable disclosure of personal information about any person or would unreasonably affect a person adversely in respect of his or her lawful business or professional affairs (ss 47B to 47J). Access must generally be given to a conditionally exempt document unless it would be contrary to the public interest (see s 11A). The Tax Office commonly relies on ss 37 and 38 of the FOI Act to refuse an FOI request. Section 37 provides an exemption if disclosure would jeopardise a tax audit or the conduct of an investigation, eg AAT Case 8092A (1993) 25 ATR 1015 and Re Mitab Pty Ltd and FCT (2007) 68 ATR 82. Section 38 provides an exemption if documents are subject to secrecy provisions in Commonwealth Acts (see [1 360]), eg Re Allrange Tree Farms Pty Ltd and DCT (2004) 57 ATR 1092 and Re Petroulias and FCT (2006) 62 ATR 1175). The Tax Office is obliged to take all reasonable steps to find a document (s 24A), but it may refuse a request for access to a document if compliance with the request would substantially and unreasonably divert the Tax Office’s resources (this is subject to a consultation process) or if the Tax Office is satisfied that the document cannot be found or does not exist: ss 24 to 24A. If it is reasonably practical for the Tax Office to delete certain information from a document so that it ceases to be an exempt document, the Tax Office should provide such an edited copy: s 22. A fee may be payable for FOI requests. If information is stored on a computer, the Tax Office is required to produce it in documentary form provided the computer does not have to be used in a manner that is not ‘‘ordinarily available’’ to the Tax Office: s 17. In Collection Point Pty Ltd v FCT (2013) 95 ATR 334, the Full Federal Court confirmed that s 17 did not apply where a new computer program would have had to be written in order to produce the requested information. FOI requests should be in writing and contain sufficient information to enable the Tax Office to identify the particular document: s 15. A person refused access to a document, or whose request for personal records to be amended or annotated is refused, may have the decision reviewed internally or by the AIC (see Pts VI and VII). Internal review decisions may be reviewed by the AIC (see Pt VII) and decisions of the AIC may be reviewed by the AAT (see Pt VIIA).

[1 380] Taxpayers’ Charter A Taxpayers’ Charter (the Charter) sets out the service and other standards taxpayers can expect from the Tax Office (see [1 390]), taxpayers’ rights under the law (see [1 400]) and taxpayers’ important tax obligations (see [1 400]). The Charter has no legal effect, but the Commissioner has said that the Tax Office will always follow the Charter. The Inspector-General of Taxation has conducted a review of the Charter, including the adequacy and clarity of the Charter in protecting taxpayers’ rights and in setting out their obligations, and released the report in December 2016 – see Review into the Taxpayers’ Charter and Taxpayer Protections on the IG-T website. [1 390] Tax Office commitments The Tax Office undertakes to deal with taxpayers with courtesy, consideration and respect and to exercise its powers impartially in a fair, professional and reasonable manner in accordance with the law. The Tax Office also undertakes to act consistently and treat taxpayers as individuals, taking into account relevant circumstances. © 2017 THOMSON REUTERS

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The Charter sets out the Tax Office’s anticipated turnaround times for various matters, for example: processing ELS return – 14 days; processing paper return – 42 days; refund request (BAS) – 14 days; refund request (overpaid tax) – 28 days; dealing with standard objection – 56 days; private ruling request – 28 days (any further information will be requested within 14 days); application for TFN – 28 days; correcting clerical or administrative error – 14 days. The Tax Office undertakes to treat taxpayers as being honest in their tax affairs, unless it has reason to think otherwise. The Tax Office will sometimes check the accuracy of information that has been provided. The penalty regime (discussed in Chapter 54) distinguishes between honest mistakes, lack of reasonable care, recklessness and intentional disregard of a taxpayer’s obligations.

Offering professional service and assistance In day-to-day dealings the Tax Office will meet its service standards, provide contact names and numbers if necessary and deal with issues in a timely manner. The Tax Office also undertakes to provide advice, information and assistance to help taxpayers understand their obligations and their rights and entitlements. The Tax Office will try to use plain and clear language in its communications. The Tax Office also undertakes to address specific needs, including language difficulties, geographical remoteness and disabilities. Reliable advice The Charter states that the Tax Office aims to provide complete, accurate and consistent advice and information that helps taxpayers understand their taxation obligations, rights and entitlements. The Charter outlines the different forms that its taxation pronouncements take (public and private rulings, other interpretations and advice, oral information and advice and publications) and the circumstances in which each of the different forms can be relied upon. Other commitments The Charter states that the Tax Office takes very seriously the need to be accountable and to meet its commitments in the Charter. The Tax Office is committed to administering the taxation system in a way that minimises the costs to taxpayers in fulfilling their obligations. The Tax Office is involved in a number of initiatives aimed at reducing compliance costs without compromising revenue collection. The Client Service Feedback Line may be contacted on 1800 199 010 with any comments or suggestions. The Charter outlines the requirements of the Privacy Act 1988 as they affect the activities of the Tax Office. It also outlines the secrecy provisions discussed at [1 360]. Review and reasons for decisions The Tax Office undertakes to provide taxpayers with clear explanations of decisions made regarding their taxation affairs, subject to legal impediments. This entitlement is in the Administrative Decisions (Judicial Review) Act 1977. The Charter outlines the availability of formal and informal review of its decisions. It also outlines the nature of available remedies, including interest and compensatory damages. The avenues available for formal review include access to information pursuant to the Freedom of Information legislation (see [1 370]), Tax Office internal review under the objection process (see [48 020]), review by the AAT or Federal Court (see Chapter 48) and investigation by the Commonwealth Ombudsman (see [48 150]) and the Privacy Commissioner. A taxpayer who is not satisfied with a Tax Office decision, service or action should first try to resolve the problem with the tax officer they have been dealing with. If still dissatisfied, the taxpayer should talk to the tax officer’s manager. If the taxpayer is not satisfied with the way their complaint is being handled, they should phone the complaints line on 13 28 70. 22

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AUSTRALIAN TAX SYSTEM [1 460]

[1 400] Taxpayers’ rights and obligations The Charter sets out 6 important obligations that apply to those dealing with the Tax Office on tax matters (including superannuation). 1. Honesty – Taxpayers are required to provide complete and accurate information in preparing returns and ruling requests. 2. Record-keeping – Taxpayers are required to keep the records required by law to support the positions taken in relation to their taxation affairs. Generally, records must be kept in English for a period of 5 years. 3. Reasonable care – Taxpayers are required to take reasonable care to fulfil their taxation obligations. Assistance may be obtained from the Tax Office. 4. Timely lodgment – Documents are required to be lodged by the dates (if any) specified in the legislation. If an extension is required, taxpayers should contact the Tax Office. 5. Prompt payment – Taxpayers are obliged to ensure that taxes and other amounts are paid by the due date. Taxpayers experiencing payment difficulties should contact the Tax Office to discuss the possibility of an extension of time to pay. 6. Compliance and co-operation – The tax system is based on taxpayers complying with the tax laws voluntarily and co-operating with the Tax Office. Taxpayers are asked to treat tax officers with the same courtesy, consideration and respect they are expected to give taxpayers. The use of a tax agent does not absolve taxpayers from responsibility for their taxation affairs.

OTHER ORGANISATIONS [1 450] Board of Taxation The Board of Taxation is an independent non-statutory body established to advise the government on the development and implementation of tax legislation and the ongoing operation of the tax system. It is also the Board’s responsibility to ensure that there is full and effective community consultation in the design and implementation of tax legislation (eg seeking input from all stakeholders and road-testing draft legislation). Information on the Board’s past and present activities can be found on its website at http://www.taxboard.gov.au. The Board’s chairperson is Mr Michael Andrew. [1 460] Inspector-General of Taxation The Inspector-General of Taxation (I-GT) is an independent statutory officer whose role is to ‘‘improve the administration of the tax laws for the benefit of all taxpayers, provide independent advice to the government on the administration of the tax laws and identify systemic issues in the administration of the tax laws’’ (see the Inspector-General of Taxation Act 2003). The I-GT cannot review taxation policy, tax rates or the imposition of tax. Further, the I-GT cannot review tax laws except in order to improve tax administration. For information on the I-GT’s past and present activities, including the work program, see the I-GT’s website http://www.igt.gov.au. The present I-GT is Mr Ali Noroozi. The I-GT and the Commissioner have signed a protocol establishing a framework for a ‘‘productive, professional, efficient and effective working relationship’’ between their offices. The protocol is available on the I-GT and Tax Office websites. A Statement of Expectations (issued by the government) and a Statement of Intent (the I-GT’s response) are also available on the I-GT’s website. © 2017 THOMSON REUTERS

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INTRODUCTION Overview ......................................................................................................................... [2 010] RESIDENCE Residence – introduction ................................................................................................ [2 020] Table of residency rules .................................................................................................. [2 030] INDIVIDUALS Introduction ..................................................................................................................... [2 Ordinary concepts of residence ...................................................................................... [2 Domicile and permanent place of abode test ................................................................. [2 183-day and usual place of abode test ........................................................................... [2 Commonwealth superannuation scheme test .................................................................. [2 Temporary residents ........................................................................................................ [2

050] 060] 070] 080] 090] 100]

OTHER ENTITIES Companies ....................................................................................................................... [2 150] Partnerships ..................................................................................................................... [2 160] Trusts ............................................................................................................................... [2 170] SOURCE Introduction ..................................................................................................................... [2 Statutory source rules ...................................................................................................... [2 Non-statutory source rules .............................................................................................. [2 Summary of source rules ................................................................................................ [2

200] 210] 220] 240]

INTRODUCTION [2 010]

Overview

This Chapter considers 2 important issues – a taxpayer’s country of residence and the source of income. These are important issues because, as noted at [1 130], an Australian resident may be subject to tax in Australia on all income whatever its source (Australia or overseas), whereas a foreign resident can only be taxed in Australia on income that has an Australian source: see [1 130]. The chapter is structured as follows: • general principles: see [2 020]-[2 030]; • an individual’s country of residence: see [2 050]-[2 100]; • an entity’s country of residence (ie a company, partnership or trust): see [2 150]-[2 170]; and • the source of income (or a capital gain): see [2 200]-[2 240]. The residency and source rules are summarised in tables at [2 030] and [2 240] respectively. 24

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[2 020]

RESIDENCE [2 020] Residence – introduction The term ‘‘Australian resident’’ is defined in s 995-1 ITAA 1997 by reference to the definition of the term ‘‘resident’’ (or ‘‘resident of Australia’’) in s 6(1) ITAA 1936, which itself partly adopts common law principles. If a taxpayer does not fall within the specific definition of ‘‘resident’’, the taxpayer will automatically be regarded as a foreign resident. This is because a foreign resident (or a ‘‘non-resident’’: see below) is simply defined in s 6(1) as a person (which includes a company) who is not a resident of Australia. The question of a taxpayer’s residence is to be determined on a year-by-year basis – the fact that a taxpayer is a resident of Australia in a particular year does not necessarily determine the taxpayer’s residence for future years. In practice, however, while it is possible for a taxpayer to be an Australian resident in a particular year and a foreign resident in the next, the Commissioner may treat the taxpayer as a resident of Australia until it can be clearly established that the taxpayer has cut all relevant ties with Australia. If a person becomes or ceases to be a resident during an income year, the tax-free threshold applicable to residents is pro-rated: see [19 700]. Australia divides individuals and entities into 3 categories for tax purposes: • residents of Australia; • temporary residents (a class recognised only for individuals); and • foreign residents. The rules applicable to each class of person or entity are outlined below.

Residents of Australia Entities classified as residents of Australia pay Australian tax on their worldwide income whether derived in or out of Australia, subject to certain exceptions: ss 6-5(2) and 6-10(4) ITAA 1997. In respect of foreign sourced income, a resident pays tax in Australia on that income but receives a foreign income tax offset for any overseas tax they are personally liable to pay on that foreign income (see [34 200]-[34 250]). The main categories of exempt foreign income are: (a) foreign source employment income received by certain Australian resident individuals if foreign service exceeds 90 days: see [7 150]; (b) foreign source non-portfolio dividend income paid to an Australian resident company: see [34 110]; and (c) foreign branch income derived by an Australian resident company: see [34 120]. If residents have interests in foreign companies or trusts they may, in certain circumstances, be subject to Australian tax on the income of the foreign company or trust under the controlled foreign company (CFC) or transferor trust rules. These are discussed in Chapter 34.

Temporary residents Essentially, if an individual is classified as a ‘‘temporary resident’’ see [2 100], the individual will only pay tax in Australia on: • Australian-sourced income; • foreign employment income not otherwise exempt from tax; • capital gains if the CGT asset in question is ‘‘taxable Australian property’’. This includes real property in Australia and shares in companies if their principal assets are real property: see [18 100]; © 2017 THOMSON REUTERS

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• discounts on assessable employee share scheme (ESS) interests: see [4 150]-[4 260]; and • alienated personal services income included in the individual’s assessable income under the alienation of personal services income rules in the ITAA 1997: see [6 100]-[6 220]. The income tax exemptions for temporary residents are discussed at [7 110]. A company cannot be a temporary resident.

Foreign residents The term ‘‘foreign resident’’ is found only in the ITAA 1997. The equivalent term in the ITAA 1936 is ‘‘non-resident’’. The difference in terminology is of no practical importance. The term ‘‘foreign resident’’ is used as the standardised term in this publication. Entities classified as foreign residents pay tax on: • unfranked dividends, interest and royalties that flow from Australia, irrespective of the source: see [35 160]-[35 220]); • capital gains if the CGT asset in question is ‘‘taxable Australian property’’ see [18 100]; • certain specific categories of income – shipping income and insurance with non-residents: see [35 710] and [35 720]; and • all other income that is sourced in Australia: see [1 130]. See ATO ID 2009/95 for an explanation of how income derived by a foreign resident in the Joint Petroleum Development Area (in the Timor Sea) is taxed in Australia.

General comments It should be noted that: • certain income is exempt under a variety of provisions in the ITAA 1997 and ITAA 1936 (see Chapter 7) and is not taxed in Australia, irrespective of the residence of the taxpayer and the source of the income; • from 2016-17, income derived by Norfolk Island residents which has its source in the Norfolk Islands or outside Australia is no longer exempt from income tax; • marginal tax rates (under the Income Tax Rates Act 1986 Sch 7 Pts I and II) differ for a resident of Australia and a foreign resident: see [35 040] and [100 020]-[100 050]; • the residence of the payer of interest, unfranked dividends or royalties, and the residence of the recipient of such income, are significant in determining the application of withholding tax: see [35 020]-[35 060]; • under Div 815 of ITAA 1997, the Commissioner has certain powers to reallocate income and deductions under the transfer pricing provisions: see Chapter 37; and • the dividend imputation provisions apply only to resident companies: see [21 440].

Key issues Clearly there are a number of important issues, but the 2 key ones which are covered in this chapter are: • how to classify residents, temporary residents and foreign residents (see [2 050]-[2 170]); and • how to determine the source of income (see [2 200]-[2 240]). 26

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[2 030]

Dual residency – double tax agreements An entity or person could be a resident of more than one country under the respective tax laws of those countries. If so, many double tax agreements (DTAs) contain ‘‘tie-breaker’’ provisions, which allocate residency to one of the jurisdictions, albeit only for the purposes of the DTA. See further [36 140].

[2 030]

Table of residency rules

The table below summarises the residency rules discussed in this chapter.

Individual

Australian domestic law DTA’s usual tie-breaker provision Resident of Australia for a year of Resident of Australia if: income if: 1. Resident of Australia according to 1. Permanent home in Australia and ordinary concepts: see [2 060]; not in DTA partner country; or or 2. Domiciled in Australia unless the 2. Personal economic relations are closer to Australia; Commissioner is satisfied that the permanent place of abode is or overseas: see [2 070]; 3. Habitual abode in Australia and or not in DTA partner country; 3. 183 days presence in Australia in or year of income unless: 4. National of Australia and not of the DTA partner country. (a) the usual place of abode is overseas; and (b) the person does not intend to take up residence in Australia: see [2 080];

4.

Company

1.

2.

3.

Trust estate

At 1.

2.

or Member of certain Commonwealth government superannuation schemes or is spouse or child under 16 of such a person: see [2 090]. Incorporated in Australia; or (a) centrally managed and controlled in Australia; and (b) carried on business in Australia; or (a) voting power controlled by Australian resident shareholders; and (b) carried on business in Australia: see [2 150]. any time during the year of income: the trustee was a resident of Australia; or central management and control of the trust estate was in Australia: see [2 170].

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Place of effective management is in Australia.

No provision

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INDIVIDUALS [2 050] Introduction Section 6(1) ITAA 1936 provides 4 exhaustive tests of residence for individuals. In summary, an individual is a ‘‘resident of Australia’’ for Australian domestic tax purposes if he or she satisfies any of the following tests. 1. The individual is a resident of Australia according to ordinary concepts – this test arises from the use of the words ‘‘who resides in Australia’’ in the preamble portion of the definition before the 3 specific statutory inclusions: see [2 060]. 2. The individual is domiciled in Australia unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia: see [2 070]. 3. The individual has been in Australia for more than half of the income year (ie in excess of 183 days) unless the Commissioner is satisfied that the individual’s usual place of abode is outside Australia and that he or she does not intend to take up residence in Australia: see [2 080]. 4. The individual is a member of certain Commonwealth government superannuation schemes or is the spouse or child under 16 of such an individual: see [2 090]. Consequently, an individual who does not fall within any of the 3 specific rules (ie 2 to 4 above) may nevertheless be treated as a resident of Australia on the basis of the common law concept of residence.

[2 060] Ordinary concepts of residence The primary test for deciding residency status is whether the individual ‘‘resides’’ in Australia according to the ordinary meaning of that word. If an individual satisfies this common law test of residency, the other tests in the definition of ‘‘resident’’ in s 6(1) seemingly do not have to be considered. The test is generally applied by looking at the taxpayer’s circumstances over the whole of the relevant tax year and not just focussing on the circumstances as they exist at 30 June of the relevant year: see Re ZKBN and FCT (2013) 96 ATR 201. Ruling TR 98/17 discusses whether an individual who enters Australia (eg a migrant, academic teaching or studying in Australia, student studying in Australia, visitors on holiday or a worker with a pre-arranged employment contract) is a resident for income tax purposes according to the common law test of residency. The ruling refers to dictionary meanings of the word ‘‘reside’’ as being ‘‘to dwell permanently or for a considerable time; have one’s abode for a time’’ and ‘‘to dwell permanently or for a considerable time; to have one’s settled or usual abode; to live in or at a particular place’’. The Tax Office does not consider that the period of physical presence or length of time in Australia is, by itself, decisive. This has been demonstrated in numerous cases. In Re Joachim and FCT (2002) 50 ATR 1072, a Sri Lankan seaman and his family emigrated to Australia in 1994. He was unable to find employment in Australia and ended up working on ships sailing under the Sri Lankan flag. His family stayed in Australia and he spent his leave with them. Although he was outside Australia for more than 80% of the income year, he was held to be a resident according to ordinary concepts. Similarly, in Re Shand and FCT (2003) 52 ATR 1088, a Canadian who lived in Australia for almost 20 years, eventually taking out Australian citizenship, and who then spent the majority of the next 5 years working overseas in Canada and then Kuwait, was still a resident of Australia during the 2 years he worked in Kuwait (the years in dispute). Rather than simply looking at the time spent in Australia, the question is whether an individual’s behaviour over a considerable period of time (6 months according to the Tax 28

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Office) has the degree of continuity, routine or habit that is consistent with residing here. Of course, an individual who is in Australia for less than 6 months may still establish that he or she is a resident. The following factors are considered to be relevant in determining whether an individual is a resident under the common law test of residency: the individual’s living arrangements (eg whether his or her usual place of abode is in Australia and whether any children are enrolled in school in Australia); the purpose, frequency and duration of visits to Australia (the individual’s presence in Australia must be more than just being a traveller, even if he or she obtains casual employment to pay for the visit); the extent of any business/employment ties with Australia; the extent of family and social ties with Australia (eg has the individual joined any sporting and/or community organisations); ownership of real estate in Australia; the location of other assets and personal effects; where bank accounts are maintained; and the nationality and citizenship of the individual. Whether a person is a resident under the common law test of residency is a question of fact. This makes it difficult to advise on the test with any certainty and readers should look at relevant cases (some are discussed below). As stated in Re Nordem and FCT (2013) 93 ATR 946, it is necessary to look at the totality of the facts and the evidence.

Case examples In AAT Case 13,559 (1998) 41 ATR 1156, a baggage handler for an airline was considered to be an Australian resident during the 1988 to 1996 income years despite working in England from 1987 to 1990. During those years he returned to Australia frequently to be with his wife. The AAT considered that he ‘‘resided’’ in Australia according to ordinary concepts. The relevant factors identified by the AAT were the taxpayer’s decision to migrate to Australia in 1987, his obtaining Australian citizenship, family and social ties and the location of his assets in Australia. The taxpayer in Re Murray and FCT (No 3) (2012) 90 ATR 394 was also considered to be a resident of Australia in the income year under consideration. It was particularly significant that the taxpayer occupied a residential property in Australia for 5 months of the year, just as he had during an earlier period when he accepted that he was a resident, and continued to carry on business activities in Australia. The AAT also noted that documents relating to his business affairs continued to be addressed to him at the Australian residence and he described this address as his residence. This decision is on appeal. In another case – Re Sneddon and FCT (2012) 89 ATR 739 – the following factors were considered to be relevant in determining that the taxpayer (who worked in Qatar) maintained a ‘‘continuity of association’’ with Australia for the relevant period and was therefore an Australian resident according to ordinary concepts: • he was only in Qatar for work purposes and only for a finite period; • he was paid in Australian dollars; • he maintained a property in Australia which he intended to live in; and • he maintained bank accounts in Australia and was a member of an Australian superannuation fund. For similar decisions where the taxpayer was considered to be an Australian resident, see Re Pillay and FCT (2013) 94 ATR 933 (doctor working overseas for 9-11 months each year), Re ZKBN and FCT (2013) 96 ATR 201 (engineer working in a number of different countries) and Re Hughes and FCT [2015] AATA 1007 (pilot employed by Korean Air). In Re Sully and FCT (2012) 89 ATR 991, on the other hand, owning a property and maintaining bank accounts in Australia was insufficient for the taxpayer to be considered to be a resident. In Re Murray and FCT (2013) 96 ATR 953, the taxpayer was not considered to be a resident of Australia as he had made a home in Bali. Claiming Medicare benefits on trips to Australia was not a significant factor. One factor that could have been significant was the © 2017 THOMSON REUTERS

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taxpayer’s frequent trips to Australia, but the AAT decided that they did not destroy the continuity of his association with Bali. An important difference between this case and the Re ZKBN case is that the taxpayer in the latter case did not rent premises in the UK, and indeed did not even live in the UK for part of the period in question. The taxpayer in Re Agius and FCT (2014) 99 ATR 923 lived in Vanuatu but visited Australia quite regularly for business purposes and to see his family. Although he sometimes stayed for weeks at a time, the AAT decided that his connection to Australia lacked ‘‘the permanent, long-term or non-transient quality that is suggested by the word ‘reside’’’ (at [57]). (This aspect of the decision was not challenged on appeal in Agius v FCT [2015] FCA 707.) In Re Shord and FCT [2015] AATA 355, the taxpayer’s physical, emotional and financial ties to Australia were considered very important in concluding that he was a resident of Australia in certain income years. This aspect of the decision was not challenged on appeal in Shord v FCT [2016] FCA 761 and is therefore not the subject of the further appeal to the Full Federal Court. Information provided on a passenger immigration card (eg an individual describing him or herself as a resident returning to Australia) may not be significant where the individual in question has not considered, or sought legal advice in relation to, issues of residency when completing the relevant forms: see Re Murray and FCT (2013) 96 ATR 953, Re Guissouma and FCT (2013) 96 ATR 242 and Re The Engineering Manager and FCT [2014] AATA 969. However, the information on such cards was considered to be relevant in Re Shord. Ruling IT 2681 provides guidelines for determining the residency status for tax purposes of a person who comes to Australia under the Business Migrant Program or the Business Skills Category. The factors to be taken into account in determining the status of such business migrants are similar to those listed in Ruling TR 98/17, and include such factors as: the extent of return trips to the country of origin; family and business ties; employment in the country of origin; whether a place of abode is maintained in the country of origin; the location of personal effects and assets; and whether a business has been established in Australia. In Re Bezuidenhout and FCT (2012) 91 ATR 232, a pilot who was living in Australia on a business migration permanent resident visa was considered to be a resident. A key factor was the fact that, in the visa application, he indicated his desire to live in Australia on a long term basis, although having his wife and children with him and holding an investment property in Australia were also relevant factors. In another AAT decision, a taxpayer who was away from Australia from 4 January 2008 to September 2009, while employed in Oman, was nonetheless held to be resident in Australia during that time as he had not severed his connections with Australia or established enduring and lasting ties with Oman: Re Landy and FCT [2016] AATA 754. Intending migrants will only be treated as commencing to reside in Australia from the date of their first arrival in Australia (ie part-year residency is possible). See Ruling TR 98/17, which states that a ‘‘migrant who comes to Australia intending to reside here permanently is a resident from arrival’’ (para 16).

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Domicile and permanent place of abode test

The first of the 3 specific tests in the definition of ‘‘resident’’ in s 6(1) requires the individual to be domiciled in Australia. A detailed examination of this question is beyond the scope of this publication, but some broad principles can be stated. A person’s domicile is determined by common law rules as modified by the Domicile Act 1982 (Cth). There are essentially 3 types of domicile – domicile of origin, domicile of choice and domicile of dependency. 30

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Basically, the domicile of origin of an individual is the domicile of the individual’s father at the date of birth unless the child is illegitimate, in which case special rules apply: Udny v Udny (1869) LR 1 Sc & Div 441 at 457 and Re AM McKenzie, deceased (1951) 51 SR (NSW) 293 at 297. For an individual to acquire a domicile of choice, they must reside in another country and have an intention to make their home indefinitely in that country: s 10 Domicile Act. For a case where the taxpayer retained his Australian domicile, see Re Landy and FCT [2016] AATA 754. Note that the domicile of choice continues to apply until the person acquires a new domicile (the domicile of origin is not revived): s 7 Domicile Act. A domicile of dependency normally only exists for minors or individuals who are of unsound mind.

Permanent place of abode Even if an Australian domicile is established, the individual will not be a resident of Australia for tax purposes if the individual’s permanent place of abode is outside Australia. This is a question of fact to be determined in light of all the circumstances of the particular case. However, it is clear that ‘‘permanent’’ does not mean everlasting or eternal but is used in the sense of being contrasted with temporary or transitory: FCT v Applegate (1979) 9 ATR 899. If the taxpayer has an intention to make a home outside Australia, that will be an important element in characterising the home as a permanent place of abode. The relevant factors in determining an individual’s permanent place of abode are listed in Ruling IT 2650 and include: the intended and actual length of the individual’s stay overseas; the continuity of the individual’s stay overseas; whether the individual intends to return to Australia at some definite point of time; whether the individual has established a home overseas; and whether any residence exists in Australia or has been abandoned. As a rule of thumb, an absence from Australia of 2 years or more is indicative of non-resident status: see Ruling IT 2650. However, this should not be adopted as a matter of routine, as there have been a number of cases finding that individuals were residents of Australia despite lengthy absences from the country. In Re Shand and FCT (2003) 52 ATR 1088, a Canadian who lived in Australia for almost 20 years and then spent the majority of the next 5 years working overseas, predominantly in Canada and Kuwait, did not abandon his domicile of choice (Australia) and did not have a permanent place of abode outside Australia. Likewise, in Re Boer and FCT (2012) 90 ATR 431, where the taxpayer worked in Oman on rotation (eg 35 days on and 35 days off), the AAT decided that the taxpayer did not have a permanent place of abode outside Australia principally because he lived in shared accommodation in Oman, he spent all his rostered time off outside Oman, he retained ownership of a house in Australia and he kept the bulk of his possessions in Australia. A similar decision was reached in Re Iyengar and FCT (2011) 85 ATR 924, where the taxpayer worked overseas for 2 years while his family remained in Australia, and Re Landy and FCT [2016] AATA 754, where the taxpayer worked in Oman for 20 months. In Sully v FCT (2012) 89 ATR 991, the taxpayer’s connection with Dubai was not strong enough for the AAT to conclude that he had a permanent place of abode there (the taxpayer spent most of the income year in question in other countries, especially the USA). In contrast to those cases, a taxpayer who was transferred to work in Vanuatu for a 3-year period was held to have a permanent place of abode in that country: see FCT v Jenkins (1982) 12 ATR 745. Similarly, a taxpayer who moved to Fiji with her husband, who had been appointed principal of a school for 3 years, had her permanent place of abode in Fiji. Key factors were the taxpayer taking special leave from her own job, the sale of the family home in Australia and putting their household goods into storage: Re Wessling and FCT (2002) 50 ATR 1187. Another taxpayer who worked overseas for 15 years, living the last 4 of those years in the Philippines, had his permanent place of abode in the Philippines during those 4 years as he was in a domestic relationship in that country and had established his home there, even though he intended to eventually return to Australia (and did so): Re Mynott and FCT (2011) 84 ATR 594. © 2017 THOMSON REUTERS

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In Re Mayhew and FCT (2013) 92 ATR 907, the taxpayer was found to have a permanent place of abode outside Australia even though he owned residential premises and cars in Australia (the premises were leased to his children, who used the cars). These cases (and the relevant ATO IDs) highlight the fact that whether a person’s permanent place of abode is in Australia is a question of fact, and the length of the overseas stay is just one of a number of factors to be considered.

[2 080] 183-day and usual place of abode test An individual will satisfy the second specific test in the definition of ‘‘resident’’ in s 6(1) if he or she has been in Australia for more than half of the income year (ie at least 183 days during the period from 1 July to the following 30 June), unless the Commissioner is satisfied that the individual’s usual place of abode is outside Australia and he or she does not intend to take up residence in Australia. If the person intends to reside permanently in Australia, the person is arguably a resident from the time of first arrival in Australia: Ruling TR 98/17, para 16. The minimum 183-day period need not be a continuous period. Separate visits within an income year will be added together. A business migrant who is present in Australia for at least 183 days in an income year is likely to be an Australian resident for that year under the 183-day test: Ruling IT 2681. As noted above, the 183-day test will not be met if the Commissioner is satisfied that a person’s usual place of abode is outside Australia and he or she does not intend to take up residence in Australia. In FCT v Executors of the Estate of Subrahmanyam (2001) 49 ATR 29, the Full Federal Court commented that a person may be a ‘‘bird of passage’’ and have no usual place of abode anywhere (and thus prima facie be a resident of Australia if present here for at least 183 days). In that case, the deceased, who was a citizen of Singapore, had been in Australia for almost 4 years, essentially for medical treatment, and her lifestyle had been severely restricted by her health problems. She had closed her medical practice in Singapore, sold her house and transferred the proceeds of sale to Australia. However, she had left valued possessions in Singapore, maintained her Singapore medical registration and travelled back there on a few occasions. The AAT, on hearing the matter for the second time, decided that the deceased did not have a usual place of abode outside Australia: see Re Executors of the Estate of Subrahmanyam and FCT (2002) 51 ATR 1173. There is some uncertainty whether a person who satisfies the 183-day test is deemed to be an Australian resident throughout the income year or only for the actual days (if less than 365) he or she is present in Australia. The latter – a resident only for the days he or she is present in Australia – is arguably the correct view: see Case 29 (1985) 28 CTBR(NS) 29 and Re Groves and FCT (2011) 85 ATR 323. The issue may be significant because if the person is deemed to be a resident throughout the income year, s 6-5(2) will operate to include in assessable income any foreign source income derived before he or she arrives in Australia: see [2 010]. That will not be the case, however, if the person is deemed to be a resident only for those days he or she is present in Australia, although the tax-free threshold will be pro-rated: see [19 710]. Even if a taxpayer is outside Australia for more than 183 days in a given year of income, he or she may nonetheless be a resident of Australia based on his or her domicile being in Australia and having a permanent place of abode here. Whilst this may seem obvious, it was one of the key conclusions reached in Re Gunawan and FCT (2012) 87 ATR 315. Overseas students and backpackers As a rule, the Commissioner will treat overseas students studying in Australia as residents if the course of study extends beyond 6 months: Ruling TR 98/17. Individuals visiting Australia on a working holiday (eg backpackers) are usually not residents of Australia as they generally do not ‘‘reside’’ here (within the ordinary meaning of that term: see [2 060]) and, even if present in Australia for more than 183 days, their usual place of abode is normally outside Australia. This is exemplified by Re Clemens and FCT 32

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[2015] AATA 124, Re Jaczenko and FCT [2015] AATA 125 and Re Koustrup and FCT [2015] AATA 126. However, each case must be decided on its own facts and, in certain circumstances, a visiting working holiday maker may be a resident of Australia. From 1 January 2017, a working holiday maker’s residency status is no longer relevant as, from that date, all individuals who satisfy the definition of ‘‘working holiday maker’’ in the Income Tax Rates Act 1986 will pay tax at the same rates on their “working holiday taxable income”, whether a resident or a foreign resident: see [19 700]. Note that entities that employ working holiday makers are required to register with the Tax Office: see [50 300].

[2 090] Commonwealth superannuation scheme test The third specific test in the definition of ‘‘resident’’ in s 6(1) concerns Commonwealth superannuation fund members and their families. Its application relies on membership of the Commonwealth government superannuation schemes established pursuant to the specific statutes listed, or having the specified relationship to a member of such a scheme. For an example, see Re Baker and FCT (2012) 87 ATR 928. Persons no longer employed by the Australian Public Service are former members, and thus not ‘‘members’’, of the Public Sector Superannuation Scheme (established under the Superannuation Act 1990). This includes a retired person in receipt of a Comsuper pension. Such a person cannot be a resident under the third test: see ATO ID 2002/1064. [2 100] Temporary residents There are tax exemptions (in Subdiv 768-R ITAA 1997) for ‘‘temporary residents’’: see [7 110], [17 440] and [18 100]. A person is a ‘‘temporary resident’’ for these purposes if: • he or she is the holder of a temporary visa granted under the Migration Act 1958 – if a New Zealand citizen who was present in Australia as the holder of a Special Category Visa departs Australia, they are considered to still ‘‘hold a temporary visa’’: see Determination TD 2012/18; • he or she is not an Australian resident within the meaning of the Social Security Act 1991; and • his or her spouse (if he or she has one) is not an Australian resident within the meaning of the Social Security Act. An ‘‘Australian resident’’, for the purposes of the Social Security Act, is a person who resides in Australia and is an Australian citizen, the holder of a permanent visa or a protected special category visa holder. Thus, a person will not be a ‘‘temporary resident’’ if he or she, or his or her spouse, is an Australian resident citizen, a permanent resident or a protected special category visa holder. There is no time limit on how long the tax concessions are available. However, a person cannot be a temporary resident if, at any time after the legislation commenced, he or she has been a resident.

OTHER ENTITIES [2 150] Companies A company is a resident of Australia if (s 6(1)): • it is incorporated in Australia; • it both carries on business and has its central control and management in Australia (the CM&C test); or • it both carries on business in Australia and has its voting power controlled by Australian resident shareholders (the ‘‘voting power’’ test). © 2017 THOMSON REUTERS

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Incorporation If a company is incorporated in Australia it will be treated as a resident for domestic Australian tax purposes, regardless of any other factors. CM&C test Under the CM&C test, a company is a resident of Australia if it carries on business in Australia and has its central management and control in Australia. Where, and if, a business is being carried on is a question of fact: see [5 020]. The Tax Office considers that a company that has major operational activities (eg trading, manufacturing or mining activities) carries on business wherever those activities take place and not necessarily where its central management and control is located: Ruling TR 2004/15. On the other hand, a company whose income earning outcomes are dependent on the investment decisions made in respect of its assets, is considered to carry on its business where these decisions are made. The Tax Office also seems to consider that simply holding some board meetings in Australia and the occasional presence in Australia of senior executives are of themselves insufficient to conclude that a business is being carried on in Australia: see ATO ID 2002/46. It has been suggested that Malayan Shipping Co Ltd v FCT (1946) 3 AITR 258 is authority for the proposition that the location of the central management and control in Australia itself constitutes carrying on business in Australia. If so, the mere presence of the central management and control in Australia would be sufficient to satisfy the CM&C test. However, it is arguable that the decision in Malayan Shipping should be confined to its facts (the business consisted of one asset that was tightly managed by the sole owner shareholder) and that, generally, other acts of carrying on a business need to exist before the CM&C test is satisfied. This accords with the Tax Office’s view as set out in Ruling TR 2004/15. Central management and control is, generally speaking, the place where the directors of the company meet to conduct the business of the company: Koitaki Para Rubber Estates Ltd v FCT (1940) 2 AITR 136. According to the Tax Office, the level of management and control required to satisfy the CM&C test involves high level decision making processes, covering matters such as general policies and strategic directions, major agreements, significant financial matters, monitoring of the company’s overall corporate performance and the review of strategic recommendations: Ruling TR 2004/15. If the central management and control of a company is exercised by a board of directors at board meetings, the Tax Office generally accepts that the central management and control is in Australia if the majority of the board meetings are held in Australia: Ruling TR 2004/15. The exception to this is if the circumstances indicate an artificial or contrived outcome. As stated by the High Court in Bywater Investments Ltd v FCT [2016] HCA 45 at [41], the place where board meetings are held will not be conclusive if the board ‘‘abrogates its decision-making power in favour of an outsider and operates as a puppet or cypher, effectively doing no more than noting and implementing decisions made by the outsider as if they were in truth decisions of the board’’. The Bywater case concerned a number of companies incorporated in Switzerland, the UK and Samoa. Although board meetings were held in those countries, which was where the relevant directors lived, the companies were Australian residents because one individual, who was resident in Australia, ‘‘was pulling all of the strings from Sydney’’ (Bywater Investments Ltd v FCT [2015] FCAFC 176 at [10] – the Full Federal Court decision was upheld by the High Court). It is possible for central management and control to exist in more than one country, although this would not occur very often. If the directors never physically meet (eg they use the internet or video-conferencing facilities to conduct meetings) other criteria will need to be considered. If a company is a resident of Australia and another country, the relevant double tax agreement (if any) may provide that the company will be deemed to be a resident of the country in which its place of effective management is situated. The OECD Commentary states 34

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at para 24 on Model Article 4 that the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business are in substance made (see ATO ID 2006/127).

Voting power test A company is also treated as a resident of Australia if it carries on business in Australia and has its voting power controlled by Australian resident shareholders. See above for comment on the question of whether a foreign company is carrying on a business in Australia. The presence of controlling shareholders who are residents of Australia creates a clear link between the test of residence for companies and that which applies for individuals. In order to determine the residence of a company under this test, it is necessary to examine the residence of controlling shareholders based on the principles discussed at [2 150]-[2 170]. Prescribed dual resident companies Certain tax concessions are not available to a company that is a ‘‘prescribed dual resident’’: see [35 060]. [2 160] Partnerships There are no specific provisions relating to the residence of partnerships as in themselves they are not tax-paying entities. The impact of Australian tax on partnership income is determined by reference to the residence of the partners themselves and the source of partnership income, since the partnership income is attributed to the partners. Section 90 ITAA 1936 requires a partnership for the purpose of its tax return to calculate its income, deductions and exempt income as if it were a resident taxpayer: see [22 100]. [2 170] Trusts Trust estates are required to calculate net income as if the trustee were a resident taxpayer (subject to certain minor exceptions). There is, however, a definition of ‘‘resident trust estate’’ in s 95(2) ITAA 1936. This is particularly relevant for the determination of liability under either s 99 or s 99A and exposure to special taxing rules that may apply to certain non-resident trust estates: see Chapter 23. A trust estate is taken to be a resident trust estate if, at any time during the income year, a trustee of the trust estate was a resident or the central management and control of the trust estate was in Australia. Section 995-1 ITAA 1997 defines ‘‘resident trust for CGT purposes’’ separately for unit trusts and non-unit trusts. The non-unit trust definition is similar to the one contained in s 95(2) (see above). The separate definition for CGT purposes is significant should a trust cease to be a resident trust for CGT purposes: see [18 150]. The CGT consequences of a trust becoming a resident are considered at [18 110]. The residency status of superannuation funds is discussed at [41 070].

SOURCE [2 200] Introduction The ‘‘source’’ of income is extremely important because, as noted at [1 130], an Australian resident is taxable in Australia on income derived (directly or indirectly) from all (worldwide) sources, whereas a foreign resident is only taxable in Australia on income derived (directly or indirectly) from Australian sources: s 6-5 ITAA 1997. ‘‘Source’’ is used in 2 senses: the geographical source or the classification of certain income, such as dividends, interest, royalties or income from personal exertion. In this chapter ‘‘source’’ is used in the former sense, to identify that income which has such a clear geographic connection with Australia that it can be described as having a source in Australia. © 2017 THOMSON REUTERS

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The relevant source rules (which are summarised in a table at [2 240]) are a combination of both statutory rules (see [2 210]) and certain common law principles: see [2 220]. Domestic source rules must always be read subject to the operation of any applicable DTA, for example, in relation to independent professional services, salary and wages, income of public entertainers and athletes, real property income and royalties. Double tax agreements may also have general source rules, such as Art 27(1)(a) of the USA DTA. For further information, see Chapter 36.

[2 210] Statutory source rules There are very few specific statutory source rules in the ITAA 1936 (the definition of ‘‘Australian source’’ in s 995-1 ITAA 1997 merely adopts the ITAA 1936 rules). Some of the classes of income for which specific rules are prescribed are considered below. Note that income earned from service in the Joint Petroleum Development Area (in the Timor Sea) is considered to have an Australian source: see ATO ID 2009/95. Beneficially entitled to income Income beneficially derived by a person is deemed to be derived from the source to which the income can be directly or indirectly attributed (eg see ATO ID 2007/108): s 6B(2A) ITAA 1936. Similar tracing rules (in s 6B) apply to income that is attributable to dividends, interest income and deemed passive income (see also [21 030]). Outgoing royalties Section 6C deems certain royalties (being broadly those that are paid by an Australian business to a foreign resident) to have an Australian source. There is a substantial class of royalty payments not covered by this provision (eg inbound royalties). The source of those royalties is determined by applying the general principles described below. The relevant definition of ‘‘royalty’’ in s 6(1) is extremely broad: see [6 360] and [35 410]. Draft Ruling TR 2016/D3 considers the application of s 6CA to what are known as ‘‘override royalties’’. Certain types of natural resource income The effect of s 6CA is that, for certain purposes, ‘‘natural resource income’’ (defined in s 6CA(1)) is deemed to have an Australian source. The section broadly follows the pattern of s 6C although, significantly, the geographic limitations in s 6C are not in s 6CA. Thus, the section may need to be read down as regards payments by one foreign resident to another. Certain dividends Section 44(1)(b) provides that the assessable income of a foreign resident shareholder includes dividends paid by any company to the extent to which they are paid out of profits derived by the company from Australian sources. Although not expressed as a conventional source rule, s 44(1)(b) effectively provides a source rule for dividends. Miscellaneous provisions In quite specific circumstances, other provisions apply: • a proportion (5%) of income arising from the shipment of goods, passengers, live stock or mail out of Australia will, in certain circumstances, be deemed to be Australian source assessable income and therefore subject to tax at the relevant Australian rates (Div 12 of Pt III ITAA 1936): see [35 710]; • a special tax regime (Div 15 of Pt III ITAA 1936) applies in relation to premiums derived by foreign resident insurers and re-insurers: see [35 720]. This regime may apply to captive insurance companies: see Practice Statement PS LA 2007/8; • interest on loans raised in Australia by a foreign government or authority, and received directly or indirectly by an Australian resident, is deemed to have an Australian source: s 27(1) ITAA 1936; and 36

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• special rules apply to determining the taxable income of non-DTA airlines (see Practice Statement PS LA 2008/2 (GA)).

Capital gains A foreign resident makes a capital gain or loss only if a CGT event happens to a CGT asset that is ‘‘taxable Australian property’’, as defined in s 855-15 ITAA 1997: see [18 100]. [2 220] Non-statutory source rules Often there are no specific statutory source rules. In such cases, reliance must be placed on the general common law source rules. The general principle for tax purposes is that one looks for the place at which the substantial elements of production of income occur. However, while there are many factors to consider, the question of source is determined by looking at the practical realities of the situation: Nathan v FCT (1918) 25 CLR 183; Thorpe Nominees Pty Ltd v FCT (1988) 19 ATR 1834. The classes of income that are mentioned below are far from being rigid categories and it will be necessary in each case to determine the true nature of the payment in question in order to determine the applicable source rule. The most significant common law source rules are summarised below. Personal services Income from personal services in a conventional employer/employee relationship would ordinarily have its source in the place in which the services are performed: FCT v French (1957) 98 CLR 398 and Esquire Nominees Ltd v FCT (1973) 129 CLR 177 at 224 (see also ATO ID 2002/178 and ATO ID 2007/9). In ATO ID 2006/25, a lump sum received by a UK resident from his employer before commencing employment in Australia was considered to have an Australian source. However, other considerations may apply, particularly in cases where special skills or creative talents are being exercised (FCT v Mitchum (1965) 113 CLR 401), where the remuneration consists of directors’ fees or where independent personal services are being rendered. Factors such as the place of negotiation and conclusion of the contract and the place of payment are then relatively more important: see also Esquire Nominees at 224-5, FCT v Efstathakis (1979) 9 ATR 867 and AAT Case 6172 (1990) 21 ATR 3630. In Agius v FCT [2015] FCA 707, the Federal Court upheld an AAT decision (Re Agius and FCT (2014) 99 ATR 923) that income earned by a foreign resident taxpayer from providing consulting services to clients in Australia had an Australian source. In ATO ID 2012/30, the most significant factor in deciding that prize money won by a foreign resident racehorse trainer in Australia had an Australian source was that the services (training and racing the horse) were performed in Australia. ATO ID 2010/110 considers the source of an employment termination payment (ETP). The most important elements in determining the source of the ETP were considered to be the employer’s decision to terminate the employment and the consequent legal liability of the employer to pay an ETP to the taxpayer under the employment contract. Since the employer’s decision to terminate the employment contract occurred in Australia, the employment contract which entitled the taxpayer to an ETP was entered into in Australia and the employer paid the ETP from Australia, the source of the ETP was Australia.

Business income Relevant factors for business income include where the contract is negotiated and made, where the contract is performed, where the payment flowing from it is made and the residence of the payer (see Ruling TR 2002/4 on indemnification payments). As a rule of thumb, if a majority of such factors occur outside Australia the income will have a non-Australian source. However, close regard must be had to the main factors in any case. If the only substantial element of a contract is its performance, the place of performance is the principal relevant factor: Commissioner of Taxation v Cam & Sons Ltd (1936) 36 SR (NSW) 544; 4 ATD 32 at p 34. © 2017 THOMSON REUTERS

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One of the issues considered in Ruling TR 2014/7 is where a foreign currency hedging transaction is formed.

Sales income The source of sales income depends on the type of property sold. For real property, the source is generally where the property is situated: eg Thorpe Nominees. However, options over real property present more difficult questions. For shares, the logical source is where the shares are registered, but it seems that this is not necessarily the case and the source of profits from the sale of shares may be where the sales contract was made. In Determination TD 2011/24, the Tax Office confirms that while the place of execution of the contract for the purchase and sale of shares can be important, the source of the income depends on the overall circumstances. In AMI v DCT (WA) (1946) 180 CLR 9, the High Court held that where shares are situated outside Australia and are sold outside Australia, the source of the profit is outside Australia. See also ATO ID 2010/54 (sale of foreign shares) and ATO ID 2010/55 (sale of Australian shares). In Re Picton Finance Ltd and FCT (2013) 93 ATR 876, income derived by a Vanuatu entity from the sale of shares listed on the Australian stock exchange had an Australian source, as the ‘‘off market’’ transfer forms were prepared and executed in Australia on the instructions of an Australian citizen and the ‘‘on market’’ transactions occurred in Australia. If the sale of tangible property (eg goods) is involved, no single factor is determinative. Relevant factors include the place of contract, the place of negotiation and the place of payment. Similar considerations probably apply to sales of intangible property (eg patents and copyrights), although a variant of the general royalty source rule arguably should apply, namely the location of the intangible property or the place where it is used. In Re Crown Insurance Services Ltd and FCT (2011) 85 ATR 905, the AAT held that income derived by a Vanuatu based company from contracts entered into with Australian member companies who provided funeral benefits on the death of Australian residents was not income sourced in Australia. On appeal, a majority of the Full Federal Court decided that the appeal did not raise a question of law and accordingly did not disturb the AAT decision: see FCT v Crown Insurance Services Ltd (2012) 91 ATR 269. Jessup J, however, disagreed and concluded that the income in question was indirectly derived from an Australian source for the purposes of s 6-5. Dividends The general source rule for dividend income is the place where the fund of profits enabling the payment of the dividend arises. In the case of an investment company, it was the place where the company was centrally managed and controlled and where investment decisions were made: Esquire Nominees Ltd v FCT (1972) 3 ATR 105. Interest The source of interest is to be ascertained by a range of factors. In Spotless Services Ltd v FCT (1993) 25 ATR 344, the most significant factors were held to be the place where the contract for the loan was made and the place where the money was lent. On appeal, the Full Federal Court unanimously held in FCT v Spotless Services Ltd (1995) 32 ATR 309 that the trial judge’s findings on this issue, that the tests resulted in a Cook Islands source, were open on the evidence. There was no appeal to the High Court on the question of source (FCT v Spotless Services Ltd (1996) 34 ATR 183 – the High Court applied the general anti-avoidance provisions in Pt IVA ITAA 1936 to strike down the arrangements: see [42 100]). Source is not determined solely by these factors. Other factors may include where the principal and interest are repaid or the place where the borrower carries on business. Rental income The source of rental income from real property is clearly the place where the real property is located, even if the relevant lease is executed elsewhere. On the other hand, in the 38

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case of rental income from goods, the place where the contract is entered into is likely to have greater significance than the place where the goods are located or used: see James Fenwick & Co Ltd v FCT (1921) 29 CLR 164 and ATO ID 2009/93.

Pensions and annuities The source of a pension is usually the location of the fund from which the pension is paid. The source of an annuity is usually the place where the contract is executed. Similarly, the source of a superannuation fund payment is the location of the particular fund or branch of the fund against which the payment is finally charged, and not the place where the employee’s services are performed: Ruling IT 2168. Thus, in ATO ID 2002/1065, a superannuation pension paid by an Australian fund to a foreign resident who was previously a resident of Australia had an Australian source. [2 240] Summary of source rules The following table summarises the source rules discussed at [2 210] and [2 220]. Category of income Business profits

Employment income

Independent services income Interest Dividends

Royalties Pensions Annuities

Common law source

Statutory source

Range of factors – if the essence of the Nil business is the making of contracts, the place where the contracts are made; otherwise the place where the contract is performed is usually paramount Place where services performed (French; Nil Efstathakis) Place where contract created can be more important, particularly where creative powers or special knowledge is used (Mitchum; AAT Case 6172 (1990) 21 ATR 3630) Place where contract executed Nil Range of factors – most important is place where loan contract made or credit is given (Spotless; Philips Gloelampenfabriken) Place where company paying dividend made profits out of which dividend paid (Esquire Nominees) Usually place from where royalty payment flows Location of paying fund Place where contract executed

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Nil s 44(1)(b) ITAA 1936 – effective source rule for out-going dividends ss 6C and 6CA ITAA 1936 Nil Nil

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3

INTRODUCTION Overview ......................................................................................................................... [3 010] Income, assessable income and taxable income ............................................................ [3 020] ORDINARY INCOME Income according to ordinary concepts ......................................................................... [3 050] Natural incident of business activities ............................................................................ [3 060] Isolated transactions – intention to make gain .............................................................. [3 070] CAPITAL V INCOME Capital or income ............................................................................................................ [3 100] Periodicity ........................................................................................................................ [3 110] Profit-making plans ......................................................................................................... [3 120] Pre-CGT property ............................................................................................................ [3 130] ASSIGNMENT OF INCOME-PRODUCING PROPERTY Introduction ..................................................................................................................... [3 150] Assignment of right to future income ............................................................................ [3 160] Statutory restrictions ....................................................................................................... [3 170] MEASUREMENT OF AMOUNTS Non-cash consideration ................................................................................................... [3 200] Market value .................................................................................................................... [3 210] Currency conversion ....................................................................................................... [3 220] DERIVATION OF INCOME Introduction – income derived ........................................................................................ [3 Deemed receipt and constructive receipt ....................................................................... [3 Alternative accounting methods ..................................................................................... [3 Selecting the appropriate method ................................................................................... [3 Estimated or disputed income ........................................................................................ [3 Income derived from employment ................................................................................. [3 Income from the provision of knowledge or skill ......................................................... [3 Income from sale of goods and commodities ................................................................ [3 Income from sale of real property .................................................................................. [3 Rent, interest and other income from property .............................................................. [3 Business income: deferred entitlement to receipt .......................................................... [3 Business income: payment received in advance ............................................................ [3 Business income: long-term construction contracts ....................................................... [3 Miscellaneous timing rules ............................................................................................. [3

250] 260] 270] 280] 290] 300] 310] 320] 330] 340] 350] 360] 370] 380]

INTRODUCTION [3 010] Overview A taxpayer’s liability to income tax for an income year is based on their taxable income for the year. Taxable income is assessable income less allowable deductions. Assessable income consists of ordinary income and statutory income. Ordinary income is income according to ordinary concepts and statutory income is income that is assessable by virtue of a specific provision in the income tax legislation (the ITAA 1997 and ITAA 1936). Some income is not assessable, either because it is exempt income or non-assessable non-exempt income. These concepts – taxable income, assessable income, exempt income and non-assessable non-exempt income – are considered further at [3 020]. 40

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[3 020]

This chapter primarily discusses ordinary income, ie income according to ordinary concepts. The chapter explains the meaning of income under the common law and its position as the basis of direct taxation in Australia: see [3 050]-[3 070]. The chapter also considers the distinction between capital and income: see [3 100]-[3 130]. The distinction is still important despite the introduction of capital gains tax (CGT), because not all capital receipts are covered by the CGT provisions and a different amount of tax may be payable on a capital profit. The CGT rules are discussed in Chapters 12 to 18. This chapter also considers: • the taxation consequences of assigning income-producing property and the right to future income: see [31 150]-[3 170]; • the rules for measuring amounts, eg where consideration for a transaction is in a form other than money (these rules are relevant for measuring both assessable income and allowable deductions): see [3 200]-[3 220]; and • timing issues, namely when is income ‘‘derived’’ for income tax purposes – this is important so that assessable income is allocated to the correct income year: see [3 250]-[3 380].

[3 020] Income, assessable income and taxable income The concept of income is the basis of Australia’s system of direct taxation (as opposed to indirect taxes, such as GST, which are not levied directly on the person or entity intended to ultimately bear the burden of the tax). A leading Australian judicial statement on what is income is contained in Scott v FCT (NSW) (1935) 35 SR (NSW) 215, where Jordan CJ at 219 said: The word ‘‘income’’ is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts. Importantly, Australia’s income tax legislation does not tax all income. Rather, income tax is worked out by reference to a taxpayer’s ‘‘taxable income’’ for the income year: s 4-10(2) ITAA 1997. Taxable income is in turn worked out by determining ‘‘assessable income’’ and then subtracting ‘‘deductions’’: s 4-15(1). It is therefore the concepts of assessable income and deductions that really form the basis of determining a person’s liability to income tax, although the amount of income tax payable depends on the applicable rate(s) of tax and whether any tax offsets (or rebates) are available: see Chapter 19. Reference should also be made to the jurisdictional limits on the taxation of income discussed in Chapter 2. Categories of income Income is split into ordinary income and statutory income (see below). Income (whether ordinary or statutory) can only be assessable income, exempt income or non-assessable non-exempt income (ie neither assessable nor exempt income). If an amount is one type of income, it cannot be either of the other 2 types: s 6-1(5). In other words, assessable income, exempt income and non-assessable non-exempt income are mutually exclusive concepts. Income that is neither ordinary nor statutory income cannot be assessable income, exempt income or non-assessable non-exempt income. Ordinary income ‘‘Ordinary income’’ is defined in s 6-5(1) as ‘‘income according to ordinary concepts’’, a term that is generally accepted to mean ‘‘income’’ as understood at common law (it is not always easy to determine if an amount is income according to ordinary concepts): see [3 050]. © 2017 THOMSON REUTERS

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Ordinary income is assessable income unless it is exempt income or non-assessable non-exempt income: ss 6-5, 6-15. It is exempt income if a provision (in any Commonwealth Act) states that the amount is exempt income or the ITAA 1997 or ITAA 1936 excludes it from assessable income by implication: s 6-20(1), (2). Ordinary income is only non-assessable non-exempt income if a provision (in any Commonwealth Act) states that the amount is non-assessable non-exempt income: s 6-23. ‘‘Ordinary income’’ is included in a taxpayer’s assessable income when it is ‘‘derived’’ (not always a straightforward issue). Timing issues are discussed at [3 250]-[3 380]. In general, an amount received or receivable is either wholly income or wholly capital in nature. There are circumstances, however, in which a profit on a particular transaction (rather than a gross amount received or receivable) is ordinary income: see [3 050]. Even if an amount is ordinary income, a specific section may modify the manner in which the assessable amount is to be calculated or otherwise treated for taxation purposes.

Statutory income Section 10-5 contains a comprehensive table of provisions, scattered throughout the ITAA 1997 and ITAA 1936, under which statutory income may accrue to a taxpayer. Statutory income is assessable income unless it is exempt income or non-assessable non-exempt income: ss 6-10, 6-15. It is exempt income only if a provision (in any Commonwealth Act) expressly states that the amount is exempt income: s 6-20(1), (3). Statutory income is only non-assessable non-exempt income if a provision (in any Commonwealth Act) states that the amount is non-assessable non-exempt income: s 6-23. Although an amount is statutory income because it has been included in assessable income under a provision of the ITAA 1997 or ITAA 1936, it may be made exempt income or non-assessable non-exempt income under another provision. Some kinds of statutory income are covered in this chapter and Chapter 4 to Chapter 6. Other kinds of statutory income are mentioned in later chapters, for example Chapter 34 which deals with complex provisions under which income accruing to a foreign company or trust may be assessable in the hands of an Australian resident. Assessable income Assessable income consists of ‘‘ordinary income and statutory income’’, but excludes ‘‘exempt income’’ and ‘‘non-assessable non-exempt income’’: s 6-1. If an amount is not ordinary income and is not statutory income, it is not included in assessable income: s 6-15(1). Similarly, amounts that are exempt income or non-assessable non-exempt income are not included in assessable income: s 6-15(2), (3). If an amount is both ordinary income and statutory income, it is only included in assessable income once; it will be assessed as statutory income unless the contrary intention appears: s 6-25. Previously assessable amounts which have to be repaid in a later income year, and which are not deductible, are non-assessable non-exempt income: see [7 700]. Exempt income The 2 main classes of exempt income (ordinary and statutory income) are: • the income of tax-exempt entities: s 11-5; and • ordinary or statutory income that is exempt income: s 11-15. Exempt income is dealt with in Chapter 7.

Non-assessable non-exempt income Non-assessable non-exempt income (NANE income) is ordinary or statutory income that a provision of an Act expressly states is neither assessable income nor exempt income: s 6-23. That express provision can be in the ITAA 1997, ITAA 1936 or any other Commonwealth 42

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law. NANE income is considered at [7 700]-[7 710]. Ordinary or statutory income that is non-assessable non-exempt income is not exempt income: s 6-20(4).

Mutual income The principle of mutuality may apply to make non-assessable receipts that would otherwise be assessable income. This principle is discussed at [7 420].

ORDINARY INCOME [3 050] Income according to ordinary concepts Legislatures and courts have consistently declined to define the limits of the term ‘‘income’’ and have referred to ‘‘income according to ordinary concepts and usages’’. Numerous tests have been defined by the courts, but ‘‘income’’ is not a term of art and there is no single test that meets every situation. However, income according to ordinary concepts has generally been held to include 3 categories, namely income from rendering personal services including employment income (see Chapter 4), income from carrying on a business (see Chapter 5) and income from property such as rent, interest and dividends (see Chapter 6). In many instances there can be no dispute as to the character of a receipt. For example, salaries and wages, fees received by a professional person and receipts (by a business) from sales are quite clearly income according to ordinary concepts. Similarly, interest paid on a genuine loan is income of the lender. However, the loan itself is not income of the borrower and repayments of principal are not income of the lender. The gains arising from a transaction that is a natural incident of the taxpayer’s business activities are assessable as ordinary income (see [3 060]). The gains arising from an isolated transaction may also be assessable as ordinary income (see [3 070]). Note that the motives of the person making the payment do not determine whether an amount is income, although they are a relevant consideration: Scott v FCT (1966) 117 CLR 514 at 526. A bequest of money or property is not income in the hands of the recipient (unless it is a payment to the executor for the performance of her or his executorial duties), but if it is invested any amounts earned are income. The CGT consequences of a bequest of an asset are considered at [17 110]. Superannuation contributions by an employer on behalf of an employee are not income of the employee: Constable v FCT (1952) 86 CLR 402; ATO ID 2007/205. In FCT v McNeil (2007) 64 ATR 431, a majority of the High Court held that the proceeds received on the realisation of sell-back rights (issued as part of the St George Bank off-market share buy-back) were assessable as ordinary income. The majority said that the gain made by the taxpayer upon grant of the sell-back rights and the subsequent receipt of the proceeds of sale on her behalf was not the receipt of a distribution of any form of the assets of St George Bank. Nor was the sell-back scheme provided ‘‘in satisfaction’’ of the rights of shareholders under the constitution of St George Bank. Rather, the gain from the sell-back rights arose independently of the taxpayer’s shareholding by virtue of the performance of the covenants in the deed poll arrangement which established the buy-back scheme. The impact of McNeil’s case is ameliorated by s 59-40 ITAA 1997, which will ensure that, if an entity issues to a taxpayer who owns an interest in the issuing entity rights to acquire a relevant interest in that entity, the market value of the rights, as at the time of issue, will be non-assessable non-exempt income (subject to certain conditions): see [17 380]. In Pre Paid Professional Administration Ltd v DCT (2008) 73 ATR 779, a US company operated a business of selling service warrants that entitled the holder to the provision of pre-paid legal and other professional services. A New Zealand wholly-owned subsidiary resident in Australia, which was an administrator under the scheme, banked to its own © 2017 THOMSON REUTERS

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account funds received under the scheme, including fees to which it was entitled. The Federal Court rejected the taxpayer’s submission that it received the funds solely as an agent and held that all the funds were assessable. The amount payable to a taxpayer under a settlement agreement ($US160 million) with his former employer was held to be assessable as ordinary income in Blank v FCT [2015] FCAFC 154, as the payment was deferred compensation following the loss of the taxpayer’s right to participate in the company’s “profit participation plan” on termination of his employment (upholding the first instance decision in Blank v FCT (No 2) (2014) 98 ATR 379). The High Court unanimously dismissed the taxpayer’s appeal in Blank v FCT [2016] HCA 42, finding that the amount received under the settlement agreement was income according to ordinary concepts, as it was deferred compensation for services the taxpayer had performed in the course of his employment. The amount was not compensation for the disposal of rights taxable as a capital gain. See also [3 300]. Determination TD 2010/9 discusses whether a payment received by an investor in a non-forestry managed investment scheme upon the winding-up of the scheme, that does not involve the disposal of their interest in the scheme, is assessable income. The Tax Office considers that ‘‘retail premiums’’, which are amounts debited against a company’s share capital amount and paid to non-participating shareholders in rights issues, are ordinary income (if not assessable dividends: see [21 020]): see Ruling TR 2012/1. A State Government grant, paid to assist an individual with temporary living expenses that arise as a result of a natural disaster, is not income: see ATO ID 2011/69.

Foreign currency If income is earned or received in a foreign currency, it must be translated into Australian currency for the purpose of calculating the Australian tax liability: s 960-50 ITAA 1997; s 20 ITAA 1936. The rules for conversion of foreign income into Australian currency are discussed in detail at [34 050]-[34 080]. Bitcoins Bitcoins are the product of an online payment system which have reached the status of a pseudo currency, but not the status of an actual currency. They have become significant enough for the Tax Office to release a guidance paper, a GST ruling and 4 Determinations on the potential tax effects of transactions dealing with Bitcoins. According to the Tax Office, the value of Bitcoins received for goods or services provided as part of a taxpayer’s business have to be recorded in Australian dollars in the financial records of the business as ordinary income. Conversely, a deduction will be allowed for the purchase of business goods and services using Bitcoins based on the arm’s length value of the items acquired. There may also be CGT consequences as Bitcoin holding rights are considered to be property (and thus a CGT asset): see [13 050]. Taxpayers who acquired Bitcoin as an investment but are not carrying on a business will not be assessed on any profits resulting from the sale. However, if the transactions amount to a profit-making undertaking or plan, the profits on disposal will be assessable income. Determination TD 2014/25 puts forward the view that Bitcoins are not foreign currency for the purposes of Div 775 of ITAA 1997. [3 060] Natural incident of business activities There is considerable overlap between the natural incident of business activities test and the considerations that arise when examining isolated transactions outside the normal course of business: see [3 070]. Cases will often examine together the criteria applicable to both when deciding if an amount is income. Whether a taxpayer is carrying on a business as such is considered at [5 020]. If the taxpayer’s activities amount to a hobby and not a business, the receipts will not be income: see [5 030]. 44

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Realisation of investments Profit on the sale of investments will generally be assessable if it is established that buying and selling investments is part of the ordinary business of the taxpayer. In London Australia Investment Co Ltd v FCT (1977) 7 ATR 757, the High Court dealt with the assessability of profits on the sale of investments by a public company that relied on dividends from companies as its main source of income. In the year in question, the company was involved in buying and selling shares on a substantial scale and its criterion for investment was the capital growth potential of the shares. The High Court held that the profit on the sale of shares was assessable income and was part of the ordinary business income of the taxpayer. The London Australia Investment decision was distinguished in AGC (Investments) Ltd v FCT (1992) 23 ATR 287. The taxpayer in that case was a wholly owned subsidiary of an insurance company. Its sole activity was to invest funds provided by its parent company. In September 1987, the taxpayer sold about 50% of its portfolio in the belief that the market was overvalued. The Full Federal Court held that, on the evidence, the objective of investing in shares in listed public companies was long-term dividend investment income and capital growth. Accordingly, the profits realised were on capital account and were not assessable income. The Full Court commented that it is clear from the banking and insurance cases that the need to maintain liquidity continuously in order to conduct that kind of business is the reason why profits generated by the purchase and sale of securities by banks and insurance companies are usually treated as income (eg Colonial Mutual Life Assurance Society Ltd v FCT (1946) 73 CLR 604 at 620). However, those circumstances were not present in the AGC case. It was not part of the corporate scheme that the taxpayer buy equities in order to maintain liquidity for the insurance operations of the AGC Group. See also FCT v Equitable Life and General Insurance Co Ltd (1990) 21 ATR 364 and GRE Insurance Ltd v FCT (1992) 23 ATR 88. A payment to a former partner of an accounting firm of part of the surplus from the firm’s professional indemnity self-insurance arrangements was held to be ordinary income, because the insurance arrangements were a necessary incident of the firm’s business and, therefore, the payment was incidental and connected to the taxpayer’s former membership of the firm: Re Mews and FCT (2008) 71 ATR 887. Investments in SMEs Specific provisions in Div 11B of Pt III ITAA 1936 (ss 128TG to 128TL) apply to eligible equity investments made by lending institutions in small and medium enterprises (SMEs). However, these provisions are effectively redundant and the Treasury Legislation Amendment (Repeal Day 2015) Bill 2016 proposed to repeal Div 11B from the 2015-16 income year but the Bill lapsed when Parliament was dissolved for the July 2016 Federal election. For information about Div 11B, see the Australian Tax Handbook 2015 at [3 060]. Contractual and other receipts Contractual and other receipts are generally assessable in the hands of the taxpayer, and the leading cases in that area are diverse but instructive. The High Court, in GP International Pipecoaters Pty Ltd v FCT (1990) 21 ATR 1, held that establishment costs for the construction of plant paid by the State Energy Commission of Western Australia to a contractor were a gain made in the ordinary course of the taxpayer’s business and must be classified as a receipt of income. The court refused to separate this receipt from ordinary receipts, as both types of receipt were received under the one contract and the part applicable to establishment costs was not severable. See also FCT v GKN Kwikform Services Pty Ltd (1991) 21 ATR 1532, where the profit made from ‘‘compensation’’ received for the non-return of equipment hired out by the taxpayer was held to be a regular, expected and ordinary incident of the taxpayer’s business (and thus assessable income). In MIM Holdings Ltd v FCT (1997) 36 ATR 108, the Full Federal Court held that payments received by a holding company, so as to ensure its subsidiary reserved electricity © 2017 THOMSON REUTERS

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generating capacity to supply electricity to a particular region, were income according to ordinary concepts. The contract under which the payments were made was critical in determining their character to the taxpayer, regardless of their description as non-refundable capital contributions. The court concluded that the payments were made as consideration for the taxpayer’s undertaking that its subsidiary would supply electricity to the Queensland Government. In addition, the role played by the taxpayer was regarded as an ordinary incident of carrying out its business activities. Applying well-established principles, including that amounts paid in consideration of the performance of services will almost always be income, the payments clearly had the character of income. An ex gratia payment to a car dealer upon termination of its distributorship agreement was held to be assessable in FCT v Co-operative Motors Pty Ltd (1995) 31 ATR 88. In Integrated Insurance Planning Pty Ltd v FCT (2004) 54 ATR 722, an insurance company waived business development loans to its agents. The Federal Court held that the waived amounts were a natural incident of the agents’ business activities and were therefore ordinary income in their hands.

[3 070] Isolated transactions – intention to make gain If a transaction is a natural incident of business activities, the gains will be assessable as ordinary income for that reason: see [3 060]. However, the gains arising from an isolated transaction may also constitute ordinary income under other tests. The relevant considerations are usually intertwined and will often be examined together when determining if an amount is income. The Myer Emporium decision The decision of the High Court in FCT v Myer Emporium Ltd (1987) 18 ATR 693 expanded the notion of what is income according to ordinary concepts. It is one of the most important decisions on assessable income in the past 30 years. In that case, Myer needed to obtain external funds to finance expansion but was restricted from doing so by the borrowing ratio stipulated in a debenture trust deed relating to other existing borrowings. The company lent $80m to a subsidiary for a period of 7 years and 3 months. Interest totalling $72m was to be paid over the period of the loan. The taxpayer assigned the right to receive the interest on the loan to Citicorp Canberra Pty Ltd, a finance company with large tax losses. Myer received a lump sum of over $45m for the assignment. The High Court unanimously held that the amount was in the nature of income and was assessable under s 25(1) ITAA 1936 (the predecessor to s 6-5). The fact that the profit or gain was made as a result of an isolated or ‘‘one-off’’ transaction did not preclude it from being properly characterised as income. The principle established by the court (at 698) is: a receipt may constitute income, if it arises from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer’s business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction. Of course, the Myer decision does not mean that any amounts received in the course of business operations that are intended to produce a profit is assessable income (FCT v Spedley Securities Ltd (1988) 19 ATR 938 at 942). For example, the transaction might simply be the realisation of an asset which is an affair of capital: see further [3 120].

Significant cases In Moana Sand Pty Ltd v FCT (1988) 19 ATR 1853, the taxpayer company acquired 93 acres of beachfront land with the twofold purpose of working and/or selling the sand and then, when appropriate, selling it for subdivision. The Full Federal Court held that the amount received by the taxpayer was assessable income according to ordinary concepts. Notwithstanding that the sale of the land was an isolated business transaction, it gave effect to an intention, existing at the time of acquisition, of profit-making by sale. 46

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[3 070]

The Myer principle was applied by the Full Federal Court in FCT v Cooling (1990) 21 ATR 13 to find that a lease incentive paid to a firm of solicitors was assessable as income according to ordinary concepts: see [6 420]. The potential width of application of the Myer principle was restricted by the Full Federal Court in Westfield Ltd v FCT (1991) 21 ATR 1398. The court stated that, where a transaction falls outside the ordinary scope of the business of a taxpayer, for the profit to be taxable, the property that generates the gain must be acquired in a business or commercial transaction and there must exist a purpose of profit-making by the very means by which the profit was in fact made. This last point was considered to be implicit from the Myer decision. The Myer decision has been applied to make assessable the gains from commercial transactions that were not part of the taxpayer’s business operations. In Glennan v FCT (1999) 41 ATR 413, a barrister received $1.365m as settlement of a dispute under a joint venture agreement relating to research he did on the possibility of a tunnel under Sydney Harbour. He did the research hoping to make money. Under the joint venture agreement, he was to be paid for his services if the project went ahead. The Full Federal Court held that the $1.365m was assessable income. The fact that it was received as settlement of a dispute did not change the nature of the payment. Similarly, in Re Applicant and FCT (2005) 58 ATR 1256, payments totalling just over $1.228m received by the taxpayer to end his involvement in a joint venture for a large infrastructure project were held to be assessable income. This was on the basis that the joint venture was a commercial enterprise, which was not part of the taxpayer’s ordinary business activities, and that he had intended to exploit his interest in the joint venture as best he could, including by negotiating the cessation of his involvement. In FCT v Haass (1999) 42 ATR 529, the taxpayer took out a life insurance policy intending to eventually receive cash on surrendering the policy in a few years time. However, within 2 years the policy lapsed after the taxpayer took out the maximum loan available under the policy and on which he did not pay principal or interest. The Federal Court held that the taxpayer had entered into a commercial transaction and he simply received the money earlier than anticipated. The gain (the loan less premiums) was assessable income. In Gutwenger v FCT (1995) 30 ATR 82, the Full Federal Court held that the profit from the sale of subdivided lots was not income according to ordinary concepts. The land was purchased by the taxpayer’s wife in 1982 and transferred to him as an unsolicited gift in 1987, one month before it was subdivided. There was also no gain, for CGT purposes, on the sale as the market value of the land at the date of transfer was deemed by s 160ZH(9) (the predecessor to the market value substitution rule in s 112-20) to be the consideration for the gift. See also Casimaty v FCT (1997) 37 ATR 358 (noted at [3 120]) and Rosgoe Pty Ltd v FCT [2015] FCA 1231, where the proceeds from the sale of subdivided land were not assessable (the Rosgoe decision is on appeal). For a contrasting case where the profit from the sale of a number of shops was held to be income according to ordinary concepts, see August v FCT (2013) 94 ATR 376 which is noted at [3 120].

Commissioner’s views Ruling 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. See also Determination TD 2011/21, which considers the characterisation (income or capital) of gains made by the trustee of a trust. Amounts paid as an indemnification of tax under an indemnification of tax clause in a cross-border loan agreement may be assessable under these principles: Ruling TR 2002/4 (see also [5 070] and [35 350]). © 2017 THOMSON REUTERS

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Determination TD 2010/21 considers whether the profit made by a private equity entity from the disposal of the target assets it has acquired is assessable income in accordance with the Myer decision. The Tax Office considers that this will depend on the circumstances of each particular case, but will involve a weighing up of the relevant importance of the key factors driving returns (cash flows from operations, operational improvements to increase earnings over the life of the investment and disposing of the shares of the target entity for a higher amount than was originally paid), the investment strategy agreed to by the parties before acquiring the assets and the legal form and substance of the arrangements and structures used to implement these strategies. The gains from financial spread betting were considered to be assessable income in ATO ID 2010/56, as the relevant contracts were entered into with an intention of making a profit. The assessability of a gain from a financial contract for differences is considered at [32 710]. The assessability of lease surrender payments is considered at [6 440].

Other aspects of the Myer decision The second strand of the Myer decision, concerning the assignment of income from property without an assignment of the underlying property and the substitution of future income for present income, is discussed at [3 160].

CAPITAL v INCOME [3 100] Capital or income One of the principal issues in tax law is distinguishing between receipts that are capital and receipts that are income. The income-capital distinction is still very important despite the introduction of the capital gains tax (CGT) provisions. This is because not all capital receipts are caught by the CGT provisions (eg gains arising on the disposal of some CGT assets are exempt) and the amount of tax payable on a receipt is likely to differ depending on whether it is taxed under the income tax or CGT regime (eg the 50% CGT discount may apply). The CGT provisions are discussed separately in Chapter 12 to Chapter 18. It is possible for a receipt to fall within both the ordinary income and CGT provisions. Section 118-20 operates to avoid double taxation (see [14 500]). It has been said that income is what comes in and that income tax is a tax on income (see Lord Macnaghten in London County Council v A-G [1901] AC 26 at 35). However, this does not assist in deciding whether a receipt is income or capital, or whether it falls within the third category of gifts and windfall gains. Income is derived from 2 major sources, one being the payment for services rendered and the other from the use of assets or capital. The difficulty in determining the character of a receipt has resulted in substantial litigation. However, the many court and tribunal decisions on the income-capital distinction do no more than indicate the principles to be applied to determine the classification of a particular receipt. On occasions, the courts have seen fit to refer to these difficulties and it has even been said that some decisions could just as easily have been decided by tossing a coin. Some of the principles established by the cases are discussed at [3 110] and following. Whether compensation payments and damages are of an income or capital nature is considered at [6 500] and, in the context of a business, [5 080]. The character of moneys in the hands of one party to a transaction does not determine the character of that money in the hands of the other party. There are numerous examples of payments which are income in the hands of one party and are either capital or private expenditure in the hands of the other party. An obvious example is where groceries and other household items are purchased for domestic consumption. The money received by the shop or supermarket is clearly income, but from the purchaser’s point of view the expenditure is clearly of a private or domestic nature. 48

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[3 120]

Special issues arise in respect of the taxation of retirement villages and related transactions: see Ruling TR 2002/14. Note that a capital amount may be deemed to be income by a provision of the ITAA 1936 or ITAA 1997 (the amount would be statutory income: see [3 020]).

[3 110] Periodicity One of the major tests to be applied to distinguish between receipts of a capital nature and receipts of an income nature is the periodicity or the recurrent quality of that receipt. Regular or periodic receipts are more likely to be income: eg FCT v Dixon (1952) 86 CLR 540. However, this is no more than an indicator and income may be received in a lump sum and a capital amount may be paid in instalments (see the comments of Lord Romer in Prendergast v Cameron (1940) 23 TC 122 at 151). For example, lump sum adjustments to a pension were considered to be assessable income in Re Harrison and FCT (2013) 96 ATR 437. In Cohen v FCT (2000) 44 ATR 443, fortnightly commission advances to an insurance agent were held to be income derived by the agent as and when paid and were not loans. In Re Maber and DCT (2001) 46 ATR 1096 and Re Horn and FCT (2003) 52 ATR 1139, it was held that periodical payments, in respect of a failed mortgage scheme, were paid to the relevant taxpayers as interest on the money lent, even though they were likely to lose some or all of the principal. See also APA Fixed Trust Co Ltd v FCT (1948) 8 ATD 369 (annual sinking fund payments received from the tenant of a warehouse to help meet the cost to the taxpayer of building the warehouse were capital receipts). In an interesting decision, the AAT determined in Re Harrison that lump sum payments received as backdated adjustments to a UK pension were assessable under s 6-5 ITAA 1997 as ordinary income and there was no specific exception to take them outside the general rule. [3 120] Profit-making plans Section 15-15 provides that the assessable income of a taxpayer includes the profit arising from the carrying on or carrying out of a profit-making undertaking or plan. The section does not apply to a profit that is assessable as ordinary income under s 6-5 (see [3 050]-[3 070]), or a profit that arises in respect of the sale of property acquired on or after 20 September 1985. Accordingly, s 15-15 only applies if a profit is not ordinary income assessable under s 6-5 and the profit arises from either a profit-making undertaking or plan which does not involve the sale of property (eg a financial contract for differences: see Ruling TR 2005/15), or a profit-making undertaking or plan which involves the sale of pre-CGT property whether or not acquired with a profit-making intention. Although the application of s 15-15 is very limited, it always needs to be considered where there is a sale of pre-CGT property, especially if the property is developed into allotments or strata-titled units. If a profit-making undertaking or plan exists, s 15-15 will apply even if the property was acquired with an intention to make a profit by sale, because s 25A(1B) provides that it will override the continuing operation of the first limb of s 25A(1). If both pre-CGT and post-CGT property are involved in the plan, the profit on the post-CGT property should be calculated separately because of the availability of indexation or the 50% discount: see [14 390]. Realisation of an asset or profit-making plan There is a distinction between the ‘‘mere realisation of an asset’’, which is on capital account, and a profit-making undertaking or plan (a question of fact to be decided on the circumstances of each case). The extensiveness and the nature of the value added to the property is important in deciding the issue: see Statham v FCT (1988) 20 ATR 228. Although of limited application, the case of FCT v Whitfords Beach Pty Ltd (1982) 12 ATR 692 is instructive. A company acquired land in Western Australia as a capital asset, but © 2017 THOMSON REUTERS

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a life insurance company later acquired all the shares in the company which then proceeded to spend substantial amounts to develop and dispose of the resulting allotments in a businesslike manner. The High Court held that the proceeds of sale were assessable as ordinary income, but remitted the matter to the Federal Court to determine what amount was assessable. The Federal Court held (in Whitfords Beach Pty Ltd v FCT (1983) 14 ATR 247) that the profit was assessable and that the base for determining the profit was the market value of the land at the time the new shareholders took over the company. In London Australia Investment Co Ltd v FCT (1974) 4 ATR 638, the profit on the sale of investments was held to be assessable income: see [3 060]. For examples of the ‘‘mere realisation of an asset’’, see: AGC (Investments) Ltd v FCT (1992) 23 ATR 287 (discussed at [3 060]); Casimaty v FCT (1997) 37 ATR 358 (the subdivision and sale of rural land which the taxpayer had originally acquired for farming purposes, but which proved unprofitable, was on capital account); and Price Street Professional Centre Pty Ltd v FCT (2007) 67 ATR 544 (sale of land not acquired for a profit-making purpose). For a contrasting case where the profits from the sale of various properties were considered to be assessable as ordinary income, see August v FCT (2012) 89 ATR 66. In that case, the Court rejected the taxpayers’ contention that the properties were acquired as long-term investments, a decision that was upheld on appeal in August v FCT (2013) 94 ATR 376. The Tax Office considers that the market value of land is to be determined on the basis of the ‘‘highest and best use for which the land is adapted’’ and that due weight should be given to the land’s potential use and the probability of consent being given for such potential use: Determination TD 97/1 (see also [3 210]). Note that deductions under Div 43 may be taken into account to reduce the assessable profit (or increase the deductible loss) on the sale of a building: see MLC Ltd v DCT (2002) 51 ATR 283.

[3 130] Pre-CGT property The tax consequences of disposing of post-CGT assets (ie assets acquired on or after 20 September 1985) are generally covered by the CGT provisions (discussed in Chapter 12 to Chapter 18). There are certain exceptions, in particular, trading stock (see [5 200] and following), depreciating assets that are used wholly for income-producing purposes (see Chapter 10) and traditional securities (see [32 450] and following). In the case of property acquired before 20 September 1985 (ie pre-CGT property), the first limb of s 25A(1) ITAA 1936 includes in assessable income the profit arising from the sale by the taxpayer of such property if it was acquired by the taxpayer for the purpose of profit-making by sale. The test for determining whether the taxpayer had the intention of profit-making by sale is what was the dominant purpose behind the acquisition of the property. The relevant time to determine intention is the time of acquisition. Where a taxpayer acquires shares (ie pre-CGT shares) in a company for the purpose of profit-making by sale, and that company subsequently issues bonus shares or grants rights to take up shares in the company after 23 August 1983, those bonus shares or rights are deemed by s 25A(4) to have been acquired for the purpose of profit-making by sale. The assessable profit is calculated by deducting related expenses from the gross proceeds of sale, and is determined according to ordinary concepts unless one of the specific anti-avoidance provisions in s 25A applies (these relate to interposed entities, parties not dealing at arm’s length and a lack of legal identity between what was bought and what was sold). Capital expenditure may be deducted if it would be normally correct to do so in accepted accounting procedures. If a taxpayer is deemed to have acquired property for the purpose of profit-making by sale, the assessable profit is so much of the proceeds of sale which, in the Commissioner’s opinion, is appropriate (taking into account various matters set out in s 25A(10)). If losses are incurred in the transaction, s 25-40 ITAA 1997 will apply to allow a deduction: see [9 1040]. 50

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[3 160]

Note that s 25A(1) does not apply to a profit arising from the carrying on or carrying out of a profit-making undertaking or scheme (the second limb); s 15-15 ITAA 1997 may apply instead (see [3 120]). In practice, s 25A(1) is likely to be relevant in a limited number of cases. For further information on s 25A(1), see the Australian Tax Handbook 2006 at [8 060].

ASSIGNMENT OF INCOME-PRODUCING PROPERTY [3 150] Introduction There is a distinction (both for general and tax law purposes) between the assignment of income-producing property and the assignment of the right to future income produced by property without assigning the property itself. The tax consequences of assigning just the right to future income are considered at [3 160]. Where a taxpayer disposes of income-producing property, both the property and the income it generates are transferred to the transferee. Thereafter, future income from the property is derived for tax purposes by the transferee. This may be achieved by sale, gift or settlement on a trustee. The owner of income-producing property may declare a trust in respect of the property on behalf of herself or himself and others: DCT v Purcell (1921) 29 CLR 464. Such a declaration is effective despite the retention of wide powers of management or a power to vary the beneficial interests: Tunley v FCT (1927) 39 CLR 528. The disposal of income-producing property has CGT consequences (see Chapter 12 to Chapter 18), unless it is a pre-CGT asset (see [12 020]) or a depreciating asset used solely to produce assessable income: see [15 080]. A transfer of income-producing property is not affected by Div 6A (discussed at [3 170] and following). In addition, the Commissioner has ruled that a ‘‘simple’’ disposition of income-producing assets does not attract the operation of Pt IVA: Rulings IT 2121, IT 2330 and IT 2501. The stamp duty implications of such transactions must not be overlooked: Reynolds v Commissioner of State Taxation (WA) (1986) 17 ATR 987. [3 160] Assignment of right to future income A right to future income from property is capable of assignment by way of gift or for consideration (which may or may not reflect the market value of the right assigned). State laws concerning the assignment of a chose in action may have to be complied with. In Shepherd v FCT (1965) 113 CLR 385, an immediate gift of 90% of the assignor’s right to royalties, payable over a 3-year period, under a manufacturing licence was held to be an effective equitable assignment that vested the right to royalties in the assignee, without the need for consideration. If a present assignment of future income is made for value, equity will treat it as an agreement by an intending assignor to assign the income when it comes into existence. In Norman v FCT (1963) 109 CLR 9, a gift by the taxpayer of his right to future interest on a loan repayable at any time was held to be ineffective since the future interest was merely an expectancy. A gift of undeclared future dividends on shares held by the taxpayer was also held to be ineffective, in part for the same reason. Tax consequence – Myer Emporium decision Where the right to future income is assigned for consideration, whether the amount received (likely to be a lump sum) is assessable income or a capital amount is determined in accordance with the general principles discussed in this Chapter. Thus, if the transaction is entered into by the assignor with the intention or purpose of making a profit or gain, the amount received is likely to be assessable income, even if the transaction is an isolated business or commercial transaction outside the ordinary course of the assignor’s business, in accordance with the first strand of the decision in FCT v Myer Emporium Ltd (1987) 18 ATR 693: see [3 070]. © 2017 THOMSON REUTERS

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The amount received on the assignment of the right to future income may also be assessable income in accordance with the second strand of the Myer Emporium decision. In that case, the parent company of a group of companies, in the course of a reorganisation of the group, lent $80m to a subsidiary company at a commercial rate of interest for a period just in excess of 7 years. The parent company then assigned the right to receive the interest on the loan for a period of just over 7 years to an unrelated finance company, in consideration for the payment of a lump sum of approximately $45m. The amount of the payment was calculated by discounting the outstanding interest payable under the loan at the rate of 16% per annum and was arrived at after arm’s length commercial negotiation. The principal of the loan was not assigned. The High Court also held that where a lender sells a mere contractual right to interest, severed from the debt for the principal sum, in return for the payment of a lump sum, the lump sum is received in exchange for, and ordinarily as the present value of, the future interest that the lender would have received. The court concluded that the making of the loan and the sale of the right to interest on the money lent constituted the sale of the right to interest for a price, which represented a profit or income gain, of a similar character to the interest for which it was exchanged. The taxpayer was held to have simply converted future income into present income. This second strand of the Myer Emporium decision is discussed in Ruling TR 92/3 at paras 59-71 and 95-96. Transfers in the circumstances of this case are now subject to s 102CA(1), which, in similar circumstances, would include the consideration received (or receivable) in the assessable income of the transferor, irrespective of the term of the assignment, any connection or otherwise with the business of the transferor, and whether or not the transferor acted with an intention or purpose of making a profit: see [3 170].

Application of Myer Emporium principles In Moneymen Pty Ltd v FCT (1990) 21 ATR 1142, the Full Federal Court applied the Myer Emporium principle to treat monthly payments derived from an assigned right as assessable income. In Henry Jones (IXL) Ltd v FCT (1991) 22 ATR 328, the holding company of a group of companies, with a subsidiary company, entered into a licence agreement with 2 other companies under which the Henry Jones group granted to the other 2 companies the right to use the Henry Jones brands and labels for 10 years, in return for annual royalty payments equal to 5% of the net value of worldwide sales. Henry Jones then assigned to Citicorp all its rights under the licence agreement for a lump sum consideration of $7.58m (the present value of the income stream). The Full Federal Court held that the company did not enter into the licence agreement with the purpose of profit-making by sale and therefore the first strand of the Myer Emporium decision did not apply. However, applying the second strand, the court held that, except in the case of an assignment of an annuity, where there is an assignment of income from property without an assignment of the underlying property right, no matter what its form, the consideration for the assignment will be on revenue account. This is because it is merely a substitution for the future income that would otherwise be derived. In other words, the consideration was as much income as the stream it replaced and it was immaterial that it was paid in a lump sum rather than by periodical payments. An assignment of an annuity is an exception to this rule because the income arises from the very contract assigned. Of course, the circumstances of the Henry Jones case preceded both s 102CA(1) and capital gains tax. A lump sum consideration for an assignment was also held to be assessable, by virtue of the second strand of the Myer Emporium decision, in SP Investments Pty Ltd (as trustee for the LM Brennan Trust) v FCT; Perron Investments Pty Ltd v FCT (1993) 25 ATR 165. In 1979-1980 (before s 102CA and capital gains tax) the trustee of a family trust assigned an interest held in a mining royalty agreement to an unrelated entity under 2 assignments each for 7 years and 3 months, for a total consideration of $3.96m. Any royalty payments under the 52

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[3 170]

assignment in excess of $50,000 per month were held in trust for the assignor, with certain guarantees in the event of any shortfall in monthly royalty payments. The Full Federal Court held that the interest in the royalty agreement was not acquired for the purpose of profit-making by sale and, in addition, no profit was derived by virtue of the assignment. Therefore, the first strand of the Myer Emporium decision did not apply. However, there was an equitable assignment of a precise amount out of the right to receive royalties for a period of years in return for a sum calculated as the present value of that income stream, in circumstances where the assignor sought to substitute for income receivable in the future the present value of that income. A part only of the rights held by the trustee had been assigned, with the assignor retaining the underlying right to take action against the other party to the royalty agreement. In that sense, the underlying chose in action had been retained subject to the assignment. It was held that the consideration received for the assignment had the same income character as the income stream that it replaced. Unlike in the Myer Emporium and Henry Jones (IXL) cases, the taxpayer in SP Investments (the trustee of the family trust) was not carrying on a business activity in relation to its rights under the royalty agreement. Accordingly, the second strand of the Myer Emporium decision is not restricted to receipts in the course of business. In addition, the Full Court stated that no inferences contrary to these conclusions could be drawn from the existence of Div 6A, either in its original form or as amended by the insertion of s 102CA. For debt defeasance arrangements, involving a payment to another party to take over a liability, see [32 760].

Partnership interests A member of a professional partnership may make a valid assignment of her or his right to a share of the net partnership income (called an ‘‘Everett assignment’’). The tax consequences of Everett assignments, including the CGT consequences, are discussed at [22 250]. [3 170] Statutory restrictions Division 6A of Pt III ITAA 1936 (ss 102A to 102CA) is an anti-avoidance measure that deals with situations where the right to receive income from property is transferred but the income-producing property is not transferred. ‘‘Income from property’’ is all income that is not income from personal exertion. The right that is transferred must be in existence at the time of the transfer: Booth v FCT (1987) 19 ATR 514. Division 6A does not apply if the right to receive income is transferred by will or a codicil. Short-term transfers to associates Section 102B deals with transfers of the right to income from property by a transferor to an associate of the transferor for less than 7 years otherwise than for an arm’s length consideration. The section applies if: • the right to receive income from property is transferred, other than by a will or a codicil, without the transfer of the underlying income-producing property. Income derived by a trust estate from a business carried on by the trustee is deemed to be income that will or may be derived from property: s 102A(3); • the transfer is to an ‘‘associate’’ of the transferor (defined by reference to s 318: see [4 220]); • the transfer either will, or may for any reason other than the death of any person or the associate becoming subject to a legal disability, terminate before the expiry of 7 years from the date that income is first paid, applied or accumulated under the transfer – examples include if there is a specific term making early termination possible, the transfer is expressed to be revocable within the 7-year period, the © 2017 THOMSON REUTERS

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underlying property will cease to exist, or may be disposed of by the transferor, during the 7-year period or, in the case of a lease whose term exceeds 7 years, the lease allows for termination before the end of the 7-year period (see Davis v FCT (1989) 20 ATR 548 and SP Investments Pty Ltd (as trustee for the LM Brennan Trust) v FCT; Perron Investments Pty Ltd v FCT (1993) 25 ATR 165 (discussed at [3 160])); and • any consideration for the transfer is less than the arm’s length amount (the concept of dealing at arm’s length is considered at [5 260]). If s 102B applies, the transfer is ignored for tax purposes and income that is the subject of the transfer is treated as income of the transferor and not of the transferee (assessments, other than the transferor’s assessment, may be amended at any time to give effect to this). The transferor is not also taxed on any consideration received in respect of the transfer, unless Pt IVA (discussed in Chapter 42) applies to the transfer. For the purposes of the income tax law (other than Div 6A), eg the deduction provisions, the transferor is deemed to have paid an amount equal to that income to the transferee for the purpose for which the right was transferred: s 102C. In addition, if the whole or part of the payment received under the transfer would have been assessable income in the transferee’s hands, it remains assessable income despite the other provisions of Div 6A: s 102C. Such a position could arise if the transferor made the transfer as a means of repaying a loan including interest. The section does not apply if the transfer may terminate before the expiry of the 7-year period solely because of the death of any person or the transferee becoming under a legal disability.

Other transfers Section 102CA applies if the right to receive income from property is transferred, other than by a will or a codicil, without the transfer of the underlying income-producing property and s 102B does not apply (except if the right is transferred to an associate through an interposed associate). In such a case, any consideration received or is receivable in respect of the transfer is included in the transferor’s assessable income in the income year in which the right is transferred. There is no requirement that the consideration be an arm’s length consideration. Section 102CA does not apply if the right to income is a ‘‘Division 230 financial arrangement’’ under the TOFA measures: see [32 070]. Common provisions A declaration that a person holds the right to receive income from property on trust for another person, or the transfer of the right to receive income to a trustee to be held on trust for another person, is deemed to be a transfer of the right to receive income: s 102A(4). If there is more than one ‘‘beneficiary’’, the right is deemed to be separately transferred to each person. If there are 2 or more joint transferors of an interest in property or a right to receive income from property, each is individually deemed to have transferred an interest in that property, or a right to receive income from that property, as the case may be: s 102A(5). It seems that both ss 102B and 102CA apply to assignments of a part, as well as the whole, of a right to receive income: Booth. Exceptions Generally, Div 6A does not apply if the right to income transferred was not a right that arose from the ownership by the transferor of an interest in the property. In the event of the death of the transferor of a right to receive income from property or, if the transferor is a company, it ceases to exist, s 102B ceases to apply in relation to income derived either after the date of death of the transferor or, if the transferor is a company, after it ceases to exist. 54

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[3 210]

Section 102B also ceases to apply if the transferor of the right to income later transfers the property to the transferee or another person (but not in the case of transfers to associates through interposed associates). Section 102B does not apply in relation to maintenance payments that are not exempt under s 51-30 ITAA 1997 because the maintenance payer divested income-producing assets or income that is otherwise assessable (s 51-50(3): see [7 050]).

MEASUREMENT OF AMOUNTS [3 200] Non-cash consideration In general, the income tax law only takes account of amounts that can be expressed in monetary terms. Where ‘‘upon any transaction’’ any consideration is paid or given otherwise than in cash, the money value of that consideration is deemed to have been paid or given: s 21 ITAA 1936. This rule does not provide an independent basis of assessment: see FCT v Energy Resources of Australia Ltd (1994) 29 ATR 553 at 583. It merely determines the amount of consideration, in monetary terms, that a taxpayer is taken to have paid or given in a transaction, where the consideration was not provided in cash. This in turn enables one to determine whether the payment or provision of the consideration has any consequences for any taxpayer under the rest of the income tax law. In Grimwade v FCT (1949) 78 CLR 199, Latham CJ and Webb J considered (at 220) that a transaction by a person must be a transaction with some other person, and Rich J stated (at 222) that ‘‘transaction in its dictionary meaning is an act, doing, negotiation or dealing’’. For a ‘‘transaction’’ to exist, the taxpayer’s involvement may have to be active rather than passive. In Re Taxpayer and FCT (2005) 59 ATR 1118, there was no ‘‘transaction’’ where a shareholder in a company received shares in a subsidiary following a reorganisation of the assets of the company. Section 21 does not apply to consideration that is ‘‘a promise to pay money’’: Burrill v FCT (1996) 33 ATR 133. The court held that the term ‘‘non-cash consideration’’ referred only to consideration that does not ‘‘find expression in money’’ or does not ‘‘sound in money’’. An important consequence of the Burrill decision is that if an amount receivable or payable in the future is expressed in money, the relevant amount for the purposes of the income tax law is the amount expressed in money, not the present value of that amount. The tax consequences of transactions involving Bitcoins are considered at [3 050]. Note that Div 45 ITAA 1997 deems the consideration receivable for the direct or indirect disposal of certain interests in leases to be the sum of the money value received or receivable plus the amount of any reduction in a liability of the taxpayer and the market value of any other benefit obtained: see [10 1020]. Non-cash benefits Non-cash benefits will be assessable income if they are convertible into money and in the nature of income according to ordinary concepts: see [3 050]. Non-cash benefits that are not convertible to cash are less likely to be income. For example, in Payne v FCT (1996) 32 ATR 516, free air travel that accrued primarily from work-related travel under a frequent flyer scheme was not transferable or convertible into cash. The benefits were held not to be assessable income (see also [6 560]). Such benefits may, however, be subject to fringe benefits tax (see Chapter 58 and Chapter 59). [3 210] Market value Many provisions in the ITAA 1936 and ITAA 1997 require the ascertainment of market value, for example, where an asset is disposed of in a non-arm’s length transaction (eg involving related entities), where there are no capital proceeds from a CGT event or where © 2017 THOMSON REUTERS

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property is donated to a deductible gift recipient. Market value may also need to be ascertained for the purposes of valuing a fringe benefit. In certain cases, ‘‘market value’’ is specifically defined (eg for the purposes of the employee share scheme provisions: see [4 180]), but in most cases it has its ordinary meaning (see below). However, the meaning of ‘‘market value’’ is affected by Subdiv 960-S ITAA 1997, which provides as follows: (a) the market value of an asset is reduced by the amount of any input tax credits, to the extent that such credits relate to a taxable supply, ie market value is GST-exclusive (s 960-405); and (b) anything that would prevent or restrict conversion of the benefit to money is to be disregarded in determining market value (s 960-410). The Commissioner also has the power to approve (by legislative instrument) market value methodologies which will be binding on the Commissioner: s 960-412. The taxpayer can choose another methodology if they believe that methodology is more appropriate. Note also that a taxpayer can apply to the Tax Office for a market value private ruling: see [45 160].

Ordinary meaning of market value Typically, ‘‘market value’’ means the price that would be negotiated in an open and unrestricted market between a willing but not anxious buyer and a willing but not anxious seller, acting at arm’s length, who are both aware of current market conditions (see Spencer v The Commonwealth of Australia (1907) 5 CLR 418 at 418). The Tax Office (in guidelines published on its website) considers that market value should be assessed at the ‘‘highest and best use’’ of the asset as recognised in the market. The concept of ‘‘highest and best use’’ takes into account any potential for a use that is higher than the current use. All inter-related assets should be valued on the same assumption regarding use. The market value may be something less than the selling price if special circumstances exist. In Re Miley and FCT [2016] AATA 73, the AAT applied a 16.7% discount to the actual consideration received as the market value of the taxpayer’s shares in a private company. The taxpayer was 1 of 3 equal shareholders in the company, and the sale agreement was for the whole of the issued capital, giving the buyer complete control of the company. As the taxpayer was not a controlling shareholder, what he received was effectively more than the market value. The Commissioner has appealed to the Federal Court. The Tax Office’s guidelines acknowledge that particular valuation methods are more appropriate for some valuations than others, although each instance needs to be considered in light of the information available. In practice, it is common to use one or more secondary methods to cross-check or confirm the value derived from the primary method. The Tax Office considers that where comparable arm’s length sales data is available (eg in a market for a commodity product), this is generally considered the most appropriate method. Where a market exists for an asset, that market is widely considered to be the best evidence of market value of the asset. The guidelines also discuss valuation methods that are generally used for valuing real property, plant and equipment, a business, securities and intangible assets. In Tomanovic v One Australia Pty Limited [2015] NSWCA 11, the NSW Court of Appeal accepted an earnings based methodology using discounted cash flows to value shares in a mortgage broking company, in preference to an assets-based valuation, even though there was a vast difference between the 2 methods ($2.9m and $12.215m). [3 220] Currency conversion An taxpayer’s Australian income tax liability is payable in Australian dollars. This means that assessable income received in a foreign currency must be converted into Australian dollars. In certain cases, a foreign currency may be used to determine a net amount which is 56

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[3 250]

then translated into Australian dollars. The currency conversion rules are contained in Subdivs 960-C and 960-D ITAA 1997 and are discussed at [34 050]-[34 080]. In limited circumstances the ITAA 1936 rules still apply.

DERIVATION OF INCOME [3 250]

Introduction – income ‘‘derived’’

Section 6-5 ITAA 1997 provides that ‘‘ordinary income’’ ‘‘derived’’ by a taxpayer is included in the assessable income of the taxpayer: see [3 020]. Conversely, under s 8-1, a ‘‘general deduction’’ is recognised for tax purposes in the income year in which it is ‘‘incurred’’: see [8 300]. The concepts of derivation and incurrence are not symmetrical. For example, a company may incur a salary cost in June by employing a person during that month at an agreed salary. This would entitle the company to claim a deduction for the amount of the salary in the income year ending 30 June, whether or not it is legally payable by 30 June. However, if the salary is not payable until after 30 June, the employee will not derive it until the following income year. Statutory income (see [3 020]) is included in assessable income at the time specified in the provisions dealing with that income. For example, the TOFA rules recognise gains and losses from financial arrangements when they are ‘‘made’’ (see [32 080]) and dividends are assessable when they are ‘‘paid’’ (see [21 030]). Ordinary income (see [3 020]) is included in assessable income when it is derived, unless a specific provision includes the amount in assessable income at some other time. Section 10-5 contains a list of provisions that deal with statutory income or vary or replace rules that would otherwise apply to ordinary income. The time at which an amount of ordinary income is ‘‘derived’’ depends on the tax accounting method used by the taxpayer to report the amount as income. The basic question to be resolved in each case is whether the amount should be reported as income on a cash (receipts) basis or an accruals (earnings) basis: see [3 270]. The Arthur Murray principle is also relevant – that an advance (refundable) payment for the supply of goods or services is not income derived until the payment has been “earned” (ie by making relevant supply): see [3 360]. Accounting principles, commercial practice and ordinary business concepts are relevant in determining whether income has been derived, although the accounting treatment of an item is not conclusive of its tax treatment: Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314; Brent v FCT (1971) 2 ATR 563; Ruling TR 92/5. Income can be derived even if an item of income is not paid over to the taxpayer. If the cash method applies, ordinary income is taken to be received as soon as it is applied or dealt with in any way on the taxpayer’s behalf or as the taxpayer directs (s 6-5(4)): see [3 260]. The income does not need to be received as money; it is sufficient if it is received in the form of money’s worth: see [3 200]. Income may be derived by an entity (eg an agent or trustee) on behalf a taxpayer, in which case the taxpayer derives the income in the income year in which it is derived on the taxpayer’s behalf: Ruling TR 2004/5. Determining whether an amount is ‘‘income’’ is preliminary to the question of when an amount of income has been derived. An example is Tagget v FCT (2010) 78 ATR 126. The Federal Court held that the conditional rights obtained by the taxpayer on entering into a deed relating to the transfer of land to the taxpayer by a property developer did not constitute income assessable under s 6-5 or a benefit assessable under s 21A ITAA 1936 (non-cash business benefits: see [5 100]). This was confirmed by the Full Federal Court on appeal: Tagget v FCT (2010) 80 ATR 399. The concept of ‘‘income’’ is considered at [3 050]. © 2017 THOMSON REUTERS

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Meaning of “derived” The definition of ‘‘derive’’ in s 995-1(1) states only that it has a meaning affected by s 6-5(4) ITAA 1997. Accordingly, ‘‘derive’’ has its ordinary meaning, but it may be extended by the constructive receipt rule in s 6-5(4) (discussed at [3 260]). As early as 1917, the High Court said that the term has no special meaning and is the same as other words like ‘‘arising’’ or ‘‘accruing’’: Harding v FCT (1917) 23 CLR 119. In FCT v Clarke (1927) 40 CLR 246 at 261, Isaacs J said that ‘‘derived’’ simply means ‘‘obtained’’ or ‘‘got’’ or ‘‘acquired’’ and that ‘‘all income is derived from something and by someone’’. In FCT v Thorogood (1927) 40 CLR 454 at 458, Isaacs J added that ‘‘derived’’ does not necessarily mean actually received, although receipt is the ordinary mode of derivation. Essentially, income is derived when it ‘‘comes in’’ or ‘‘comes home’’, in whatever sense is most appropriate in the particular circumstances: Commissioner of Taxes (SA) v Executor Trustee and Agency Co of South Australia Ltd (1938) 63 CLR 108 (Carden’s case). The application of this general concept to particular practical situations is considered at [3 270]-[3 380]. If an amount of income cannot be quantified or is subject to a genuine dispute, it has not been derived: see [3 290]. This is in contrast with s 8-1, where a loss or outgoing can be incurred even if the precise amount cannot be quantified: see [8 310]. When an amount is received subject to a legal or commercial requirement to reimburse the amount if certain events occur or do not occur, a question arises as to whether the receipt constitutes the derivation of income or whether derivation is deferred until the point at which the amount is no longer refundable. In AAT Case 10,103 (1995) 30 ATR 1238, a partner in an accounting firm was held to be assessable in full on his share of a lease incentive paid to the firm, despite the fact that he was later required to pay his share back to the firm when he resigned from the partnership. In the year of receipt there was no obligation to repay, nor any restriction on the use of the money. By way of contrast, see the discussion on the Arthur Murray case at [3 360] in which an amount received was considered not to be ‘‘income derived’’ until such time as the services to which it related had been performed. Annual tax accounting An entity’s taxable income and income tax payable is determined for an ‘‘income year’’. For most entities, the income year is the year ending 30 June: see [1 110]. A substituted accounting period in lieu of the year ending 30 June may be used if approved by the Tax Office: see [1 110]. [3 260] Deemed receipt and constructive receipt In working out whether a taxpayer has derived an amount of ordinary income and when it was derived, the taxpayer is taken to have received the amount when it is applied or dealt with in any way on the taxpayer’s behalf or as the taxpayer directs: s 6-5(4). This provision was designed to be the equivalent of s 19 ITAA 1936 which it replaced. It applies where, for example, a creditor directs a debtor to pay the amount of a debt to a third party. If such an amount would be assessable in the hands of the creditor upon receipt, it still becomes assessable as a deemed receipt under s 6-5(4) when it is paid to the third party. On the other hand, interest in default would not be deemed by s 6-5(4) to have been received on the due date, even if the defaulting debtor credits the amount of interest owing to the creditor’s account in the debtor’s books. Similar provisions are contained in s 99C (Certain applications of trust income) and s 128A(2) (Interest paid to non-residents) and s 103-10 in the capital gains tax provisions. The explanatory memorandum to the Bill introducing s 6-5(4) stated that the rule applies to statutory and ordinary income accounted for on a receipts basis. 58

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[3 260]

Section 6-5(4) does not actually deem an amount to be derived; rather it deems receipt. Unless the taxpayer is on the cash receipts basis of returning income, there is not necessarily any derivation at that point. Of course, mere receipt or derivation does not make an amount assessable anyway. In order to be assessable, an amount must not only be derived but must also be ordinary income or statutory income. Section 6-10(3) broadens the deeming rule in s 6-5(4) in relation to amounts that are statutory income, not ordinary income. If an amount of statutory income has not been received (but is otherwise assessable by virtue of a provision of the ITAA 1997) it is considered statutory income within the terms of s 6-10(2) when it is applied or dealt with in any way on the taxpayer’s behalf or as the taxpayer directs. This provision removes a possible argument to the effect that an amount that would be statutory income if received does not become statutory income unless and until it is actually received in cash or the equivalent of cash.

Interest offset arrangements The Tax Office treatment of loan account (interest) offset arrangements is outlined in Ruling TR 93/6, which indicates the limits of single and dual account offset arrangements that the Commissioner considers acceptable: see [6 260]. For both types of accounts the Tax Office considers that there must be no entitlement to receive interest on credit balances, otherwise it may be assessable when applied to reduce the amount of interest payable on a debit balance or loan. In relation to offset arrangements with insurance companies, see Ruling IT 2546 in which s 6-5(4) is applied to funds deposited with insurers.

Salary sacrifice arrangements Salary sacrifice arrangements are discussed in Ruling TR 2001/10. These are arrangements under which an employee accepts a non-salary benefit (such as a contribution to a superannuation fund) in lieu of salary or a bonus to which the employee would otherwise be entitled. The Commissioner concludes in the ruling that the benefit is not assessable under s 6-5 as if it were salary, provided the employee agreed to the arrangement before becoming entitled to the foregone salary or bonus. In contrast, a benefit provided in lieu of salary or a bonus is treated as an assessable receipt if the amount is ‘‘earned’’ before the employee directs that it be paid in the form of a non-salary benefit. For example, in Re Wood and FCT (2003) 51 ATR 1227, the AAT held that a taxpayer’s direction to his employer to pay his accrued performance bonuses and accrued long service leave payments to a superannuation fund upon his retirement was not an effective salary sacrifice arrangement, as the amounts had already been earned by the time of the direction.

Constructive receipt Section 6-5(4) (discussed above) is an expression of the principle of constructive receipt. It is also possible that there could be a constructive receipt without the need to rely on s 6-5(4). The limits of this principle are not clearly established, although it appears to involve a notion of control of, or the capacity to control, an amount that is receivable or otherwise held in a manner satisfying the concept of derivation. If an amount is properly regarded as derived when received, it may be regarded as having been received (and so having been derived) when it is readily available to the taxpayer, who need not necessarily take physical possession of it. For example, in AAT Case 10,999 (1996) 33 ATR 1034 the AAT held that in relation to commission income set aside and invested pending the settlement of a dispute between the parties, the amount was derived by the taxpayer in the income year in which the dispute was settled, as it was from this time that the money was dealt with on the taxpayer’s behalf. This was the case even though the amount was not paid over to the taxpayer until the next income year when the investment matured. However, interest on the investment was held not to have © 2017 THOMSON REUTERS

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been derived until it was received as it was ‘‘passive income’’ not derived from the taxpayer’s business, and the appropriate time at which such income is taken to be ‘‘derived’’ is the time of receipt: see Ruling TR 98/1, para 47.

Crediting without direction or agreement Crediting an amount in an account or record (other than a bank account) does not necessarily mean that the amount has been received. In Clarke v FCT (1992) 23 ATR 102, it was held that a sum credited to an ‘‘investment account’’ maintained by a life insurance company under a type of life insurance policy called a ‘‘variable income annuity’’ was not income derived by the holder of the policy in the year the amount was credited, and that s 19 (the predecessor to s 6-5(4)) did not apply. It was also held that the provisions of s 26AH (see [6 640]) did not apply and reference was made to s 26AH(5), which excludes from ‘‘receipt’’ amounts reinvested so as to increase the amount payable at surrender or maturity. A comparison was made with the accounts maintained in the superannuation fund considered in Constable v FCT (1952) 86 CLR 402. An appeal against the decision in Clarke was dismissed: see FCT v Clarke (1992) 24 ATR 230. In addition, an amount credited in a company’s profit and loss account may not represent income if the credit entry does not represent a quantified amount payable to the company. Dividends and life insurance premiums Dividends are assessable under s 44(1) ITAA 1936 when they are ‘‘paid’’ and not when they are ‘‘derived’’ (assuming the conditions for assessability are met): see [21 060]. For this purpose, ‘‘paid’’ includes ‘‘credited or distributed’’: s 6(1). Note, however, that the withholding tax provisions apply to dividends when they are derived by a foreign resident and not when paid: see [3 360] and [35 160]. The assessable income of a life insurance company includes life insurance premiums paid to the company in the income year (see [30 030]). [3 270]

Alternative accounting methods

Cash and accruals methods The time at which an amount of ordinary income, other than ordinary income for which the time of inclusion in assessable income is varied by a specific provision (see s 10-5), represents ‘‘income derived’’ depends on the nature of the income and, in some cases, the circumstances in which it is derived. The basic question to be resolved in each case is whether an amount should be reported as income on a cash basis (sometimes referred to as a receipts basis) or on an accruals basis (sometimes referred to as an earnings basis). In essence, under the cash method, income is derived when it is received by the taxpayer, while under the accrual method, income is derived when the taxpayer has the right to receive it. The appropriate basis of reporting income is determined according to the principles discussed at [3 280]-[3 380]. The method of reporting income may affect not only the timing of reporting of income but also the amount of income. In Business & Research Management Ltd (in liq) v FCT (2008) 74 ATR 525, the Federal Court held that the full amount of fees paid to the taxpayer through the delivery of bills of exchange was income, not the lesser amount of cash subsequently paid. The Court noted that if it was correct to assess the income on a cash basis, the fees would have been derived when the bills were delivered. The Court decided that the accruals basis was more appropriate and, on that basis, applied the Arthur Murray principle (see [3 360]) to determine the income year in which the income was assessable. In general, the assessable income derived by a taxpayer from a transaction is the gross amount received or receivable if the amount has the character of income: see Business & Research Management Ltd (in liq) v FCT. In contrast, where a ‘‘revenue asset’’ that is not trading stock is disposed of, the assessable income that is to be reported is the net profit arising from the transaction: London Australia Investment Co Ltd v FCT (1977) 7 ATR 757 60

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[3 280]

and FCT v Myer Emporium Ltd (1987) 18 ATR 693: see [3 060] and [3 070]. The time at which the net profit is assessable depends on the nature of the asset sold. In general, income comprising a net profit from the sale of real estate will arise when the sale is completed, whereas income from the sale of other property will arise when the sale price is received: see [3 320] and [3 330]. Income from long-term construction contracts can be reported on an estimated profits basis: see [3 370].

Transition between methods Only one method of reporting income from a particular activity is appropriate: see [3 280]. As a result, a change of method is generally not possible unless there is a change of circumstances which justifies a change in the method of reporting income. If, for whatever reason, there is a change of method, only one method applies in any income year. The High Court case of Henderson v FCT (1970) 1 ATR 596 illustrates the principles. In the first income year, the partnership in which the taxpayer was a partner reported its income on a cash basis and this was accepted by the Commissioner. For the following 2 income years, the partnership reported its income on an accruals basis, but the Commissioner assessed the taxpayer’s income from the partnership on a cash basis. Barwick CJ found that the accruals basis was the appropriate basis for assessing the partnership income for the years in dispute (the second and third income years). The fact that the taxpayer’s income from the partnership for the first income year had been assessed on a cash basis, did not justify including in the taxpayer’s earnings-based taxable income for the second income year the taxpayer’s share of the cash received by the partnership in that year which related to first year’s earnings. If a taxpayer’s circumstances change, it might be appropriate to adopt a different method of reporting income. In Commissioner of Taxes (SA) v Executor Trustee & Agency Co of South Australia Ltd (1938) 63 CLR 108 (Carden’s case) it was held that the cash method was appropriate for reporting income from the taxpayer’s medical practice while it was continuing, but the Commissioner was entitled to adopt the accruals method for the final income period up until the date of death: see [3 280]. In Dormer v FCT (2002) 50 ATR 55, the taxpayer sold two-thirds of his accountancy practice to 2 former employees with effect from 1 July 1997, thereby creating a partnership with each partner having a one-third interest. All work in progress of the practice at 30 June 1997 was billed to clients, but the resulting debts did not become assets of the partnership. The taxpayer had always reported his income from the practice on a cash basis, but the partnership reported its income on an accruals basis. For the 1997-1998 and 1998-1999 income years, the taxpayer included his share of the partnership’s profits, calculated on an accruals basis, in his assessable income but, relying on Henderson’s case, he did not report any income from the collection of debts owed at 30 June 1997. The Federal Court found that the taxpayer had 2 sources of professional income during 1997-1998 and 1998-1999 – the old sole practitioner business and the new partnership. The court decided that it was appropriate to continue to apply the cash basis to the earnings from the old sole practitioner business, even though it was appropriate to use the accruals basis to calculate the income of the partnership. It followed that the amounts collected in 1997-1998 and 1998-1999 from debtors outstanding at 30 June 1997 were assessable. This decision was upheld by the Full Federal Court on appeal: Dormer v FCT (2002) 51 ATR 353.

[3 280]

Selecting the appropriate method

In Ruling TR 98/1, the Commissioner emphasises that only one method is appropriate for any one item of income (para 30); see also Henderson v FCT (1970) 1 ATR 596, discussed at [3 270]. It is not a matter for the Commissioner’s or the taxpayer’s discretion, and once the correct method is ascertained (by the application of the principles derived from case law to the facts) it must be applied. The correct method will only change where the taxpayer’s circumstances change. Of course, this principle does not mean that income from different sources cannot be reported differently (ie income from one source on a cash basis and income from another source on an accruals basis): see, for example, Dormer v FCT (2002) 50 ATR 55 discussed at [3 270]. © 2017 THOMSON REUTERS

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The phrase ‘‘substantially correct reflex of the taxpayer’s true income’’ is often quoted as the definitive test of the appropriateness of a particular accounting method in particular circumstances: see, for example, Ruling TR 98/1, paras 6 and 17. This phrase was first used in the judgment of Dixon J in Commissioner of Taxes (SA) v Executor Trustee & Agency Co of South Australia Ltd (1938) 63 CLR 108 (Carden’s case), in the following passage: Unless in the statute itself some definite direction is discoverable, I think that the admissibility of the method which in fact has been pursued must depend upon its actual appropriateness. In other words, the inquiry should be whether in the circumstances of the case it is calculated to give a substantially correct reflex of the taxpayer’s true income. The question of whether the cash or accruals basis of reporting income is the most appropriate method for particular kinds of income is considered at [3 300]-[3 380]. The appropriate method of calculating assessable income under s 6-5 for a taxpayer who carries on a business of debt acquisition and recovery is a profit emerging basis: see ATO ID 2008/39.

[3 290] Estimated or disputed income For a taxpayer who reports income of a particular kind on a cash basis, the question of whether estimated or disputed income has been derived does not arise because the amount is not correctly regarded as having been derived until received. For income that is correctly reportable on an accruals basis, Henderson v FCT (1970) 1 ATR 596 and Barratt v FCT (1992) 23 ATR 339 establish that an amount is not derived on an accruals basis until it has been quantified, accepted and charged (see also [3 350]). An amount which cannot be ascertained has not been derived: Farnsworth v FCT (1949) 78 CLR 504. If there is a bona fide dispute between an accruals taxpayer and a customer, the taxpayer does not have to account for the disputed income until the dispute is resolved. See also BHP Billiton Petroleum (Bass Strait) Pty Ltd v FCT (2002) 51 ATR 520, which involved a dispute over the entitlement of 2 taxpayers to increase their charges to their clients to recover the costs of the resources rent tax. The Full Federal Court stated that for derivation of income to be deferred, there must be more than a mere denial of liability by the purchaser, ie there must be a genuine dispute. In this case, there was a genuine dispute and the court unanimously held that the income was derived when the dispute was settled, whether through arbitration, litigation or settlement, and not when the gas was supplied. The court also suggested that if a disputed amount was received before the dispute was settled, it may be derived when received. [3 300] Income derived from employment Employment income is derived when the income is actually received, irrespective of the period of time which the payment covers: see Ruling TR 98/1. If a person receives pay in advance for either holidays or long service leave, the full amount falls to be assessed in the year in which the payment is received. The same position applies where the employee in the ordinary course either receives the money as it accrues in accordance with normal pay periods or at the end of the period of leave. Arrears of salary, eg paid after resolution of a dispute, are assessable in the year of receipt: Case U152 (1987) 87 ATC 894 and AAT Case 4188 (1988) 19 ATR 3336. The deferred salary component under a deferred salary payment agreement is assessable when received (or otherwise applied or invested for the taxpayer’s benefit): Determination TD 93/242. Certain types of income received in arrears may be eligible for a rebate of tax, to overcome any disadvantage in the amount being taxed in the year of receipt: see [19 650]. Similarly, income such as directors’ fees, bonuses and other payments are derived for tax purposes at the time the income is paid or otherwise made available to the recipient, notwithstanding that the services giving rise to the income may have been performed in a previous income year: see Ruling IT 2534. This view is confirmed in Ruling TR 98/1. This is the case even if the service to which the salary relates was performed before the taxpayer became an Australian resident: see Re Tong and FCT (2007) 66 ATR 412. 62

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[3 310]

In some circumstances, the Tax Office regards salary forgone under a salary sacrifice arrangement as ‘‘derived’’ when the benefit in lieu of salary is provided: see [3 260]. In Blank v FCT (No 2) (2014) 98 ATR 379, a compensation payment for services rendered, arising from negotiating a settlement in relation to the taxpayer’s right to participate in the ‘‘profit participation plan’’ for the group of companies which included the taxpayer’s employer, was payable in instalments over a 5-year period. The original settlement agreement was executed in the 2007 income year, but the payment terms were varied in January 2008 so that the first 4 instalments were withheld by the paying company in order to pay the taxpayer’s Swiss dividend withholding tax liability. After finding that the total payment was assessable income (see [3 050]), the Federal Court held that, because the taxpayer could not, in effect, call for the withheld amounts to be paid to him until the 2008 income year in terms of the settlement agreement, those particular amounts were derived in the 2008 income year. The decision was upheld by a majority of the Full Federal Court in Blank v FCT [2015] FCAFC 154. The High Court also held that the total payment was assessable income but declined to deal with the timing issue: see Blank v FCT [2016] HCA 42. This case is also considered at [7 150] (whether the s 23AG ITAA 1936 exemption applied). An arrangement involving the issuing of bonus units in a trust to an employee and the subsequent cancellation of those units is discussed in Ruling TR 2010/6. In Sent v FCT (2012) 85 ATR 1, the Federal Court held that the whole amount of accrued and future bonus entitlements, extinguished by payment into an executive share trust on the taxpayer’s behalf, was assessable as ordinary income (decision upheld in Sent v FCT (2012) 87 ATR 223, where the Full Federal Court also confirmed the 50% administrative shortfall penalties imposed by the Commissioner, as the taxpayer had failed to discharge the onus of proof that the penalties were excessive). Certain arrangements designed to defer the point at which salary or wages or bonus income is derived may be challenged by the Tax Office: see Determination TD 2010/11. The arrangements involve the provision of an interest free loan to an employee instead of salary. The loan is used to acquire an income-producing asset and in later years salary payments are offset against the loan balance.

[3 310]

Income from the provision of knowledge or skill

Non-business income Non-business income arising from the provision of knowledge or skill is derived when received. In Brent v FCT (1971) 2 ATR 563, an amount was due and payable under an agreement for information provided by a taxpayer to a newspaper company, but only part had been paid in the relevant income year. It was held, firstly, that the cash method was the appropriate method for the taxpayer in question and secondly, that the unpaid amount had not been dealt with on the taxpayer’s behalf, so s 19 (the predecessor to s 6-5(4)) had no application to the unpaid amount. The taxpayer did not ask for payment and the company refrained from making payment. It was held that even if the taxpayer had requested the company to refrain from making payment, s 19 would not have applied as there would have been no use of the money on behalf of the taxpayer and the company would have remained under an obligation to pay it to her. The cash (or receipts) basis of taxation of income from the provision of knowledge or skill is accepted in Ruling TR 98/1. The question of whether income arises from the taxpayer’s provision of knowledge or skill, or from a business which involves more than the provision of the taxpayer’s knowledge or skill, is considered below.

Business income In Ruling TR 98/1, the Commissioner states that the cash basis is likely to be appropriate for business income ‘‘derived from the provision of knowledge or the exercise of skill possessed by the taxpayer in the provision of services’’ unless: • the taxpayer’s income-producing activities involve the sale of trading stock; © 2017 THOMSON REUTERS

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• the outgoings incurred by the taxpayer, in the day to day conduct of the business, have a direct relationship to income derived; • the taxpayer relies on circulating capital or consumables to produce income; or • the taxpayer relies on staff or equipment to produce income. The Commissioner considers that if any of those factors is present ‘‘to a significant degree’’, the accruals method may be the most appropriate basis of reporting income: see paras 18, 45 and 46 of Ruling TR 98/1. The principles set out in Ruling TR 98/1 are consistent with principles developed by the courts in a series of cases involving professional practices. Thus, the cash method has been held to be the appropriate method for a sole practitioner solicitor (FCT v Firstenberg (1976) 6 ATR 297) and chartered accountant (FCT v Dunn (1989) 20 ATR 356). The cash method has also been held to be appropriate for a business taxpayer who relied solely or principally on his own personal exertion (Re Delandro and FCT (2006) 64 ATR 1129). In Henderson v FCT (1970) 1 ATR 596, it was held that the accruals method was the appropriate method (rather than the cash method that had previously been used) for a very large firm of chartered accountants. There were 60-70 profit sharers, 295 employees, of whom 150 were qualified accountants, significant annual fees earned and the business was run by a board of management. In Barratt v FCT (1992) 23 ATR 339, the Full Federal Court held that the accruals method was appropriate for a partnership of 5 medical practitioners carrying on a pathology practice. Significantly, it was held that it is permissible, when evaluating the size and complexity of ‘‘the enterprise’’, to take into account the nature and extent of the services and equipment provided by a service entity established to provide services to the partnership. Reference was made to the substantial number of staff employed by the partnership and the service entity, the number of collection rooms, the number of patients and the size of gross turnover. On the basis of these and other matters, it was held that the practice was a ‘‘substantial enterprise’’: see also [3 350]. The Commissioner considers that the commission income of insurance agents and insurance brokers is generally derived when the payment of the commission has matured into a recoverable debt, and the agent or broker is not obliged to take any further step before becoming entitled to payment of the commission: see Ruling IT 2626. Determination TD 93/149 deals with the commission income of travel agents and Ruling TR 97/5 deals with the commission income of real estate agents.

[3 320] Income from sale of goods and commodities The accruals method is the appropriate method for taxpayers carrying on trading or manufacturing and for most businesses generally: Carden’s case (see [3 280]) and Fincon (Construction) Ltd v IRC (NZ) (1969) 1 ATR 319. Income from manufacturing or trading is derived when earned: see Ruling TR 98/1 (para 20). The question of when income is ‘‘earned’’ from particular kinds of business activity is considered at [3 350]-[3 370]. Sales under conditional contracts or subject to contingencies For a taxpayer who reports the derivation of income from the sale of goods on an accruals basis, the Commissioner considers that income is derived when the contract is entered into, even if the contract entitles the purchaser to return the goods to the seller: Ruling TR 97/15. The ruling does not apply if the contract contains a ‘‘Romalpa’’ clause that defers the passing of property in the goods to the purchaser. The basis of the ruling is that the passing of property (including dispositive power over the property) from the seller to the purchaser, as a result of the completion of the contract of sale, is the relevant business event giving rise to the income. Under a ‘‘take or pay’’ contract, the purchaser of a product (such as natural gas) undertakes to pay for a specific quantity of the product annually, whether or not the purchaser 64

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[3 320]

takes delivery of that quantity of the product in that period. If the purchaser takes delivery of less than the contracted quantity in a period, the purchaser can require the undelivered quantity to be delivered in a subsequent period after having taken delivery of the specified quantity for that period. According to Ruling TR 96/5, for a product that has already been delivered, income is derived by the seller of the product at the time the product is sold and a debt created. A payment received by the seller of the product for a product that has not yet been delivered, is not income until the product to which the payment relates is delivered. For commercial software developers, where an amount properly attributable to a contractual obligation is subject to a ‘‘contingency of repayment’’, the amount is derived when the obligations under the agreement are fully performed or when the contingency lapses: see Ruling TR 2014/1.

Retailers: special cases Where a retailer regularly provides credit facilities to customers, interest owing by customers at year’s end is derived in that year and not when received: Ruling TR 98/1, discussed at [3 280]. A trader who sells goods on credit and offers a prompt payment discount is taken to have derived the full sale price at the time of sale. The Commissioner regards the discount as an allowable deduction when the customer accepts the discount and the trader’s account receivable from the customer is satisfied: Ruling TR 96/20. The treatment of lay-by sales by a seller on an accruals basis is dealt with in Ruling TR 95/7. Pharmaceutical chemists who return income on an accruals basis derive income under the Pharmaceutical Benefits Scheme when the goods are dispensed and sold to the customers: Ruling TR 96/19. Prompt payment discount offered by wholesaler Where a prompt payment discount is offered by a wholesaler to a retailer (which may be accumulated, applied to the acquisition of shares in the wholesaler or transferred to an affiliate), the retailer is entitled to claim a deduction for the full undiscounted purchase price for the goods at the time of contract. If the discount is taken, the amount of the discount is assessable at the time that the liability is satisfied for the lesser discounted amount. Where the retailer transfers the discount or acquires shares with it, it remains assessable to the retailer pursuant to s 19 ITAA 1936 (now s 6-5(4) ITAA 1997): Determination TD 96/45. Trade incentives offered by sellers to buyers of trading stock The Commissioner considers that a trade incentive received by a buyer of trading stock, in the form of a discount, rebate or other incentive, is a reduction in the cost of the trading stock if it relates directly to the purchase of the trading stock: see Ruling TR 2009/5. If the incentive does not relate directly to the purchase of the trading stock (eg if conditions have to be satisfied before it is due), it is assessable income that is derived when ‘‘earned’’. Where it relates to future acts and/or services to be performed by the buyer, it is derived when the relevant acts or services are performed, in accordance with the Arthur Murray principle: see [3 360]. Motor vehicle sales – holdback amounts and amounts relating to warranties Where a motor vehicle manufacturer or distributor credits to an account on behalf of a dealer a percentage of the purchase price of a vehicle delivered to the dealer and pays the amount to a dealer at a later time, the Commissioner’s view is that ‘‘holdback’’ income is derived by the dealer at the time a vehicle is purchased by the dealer from the manufacturer/distributor or finance company: Ruling IT 2648. The ruling also deals with the time at which ‘‘holdback’’ payments are ‘‘incurred’’ for the purposes of s 51(1) (now s 8-1). Where a vehicle is sold by a manufacturer, distributor or dealer subject to a warranty, the Commissioner considers that the entire sale proceeds represent income derived at the time of sale and the Arthur Murray principle (see [3 360]) does not apply to spread derivation of the portion of the sale price relating to the warranty over the period of the warranty: Ruling IT © 2017 THOMSON REUTERS

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2648. This is consistent with the judgment of the Privy Council on appeal from the New Zealand Court of Appeal in IRC (NZ) v Mitsubishi Motors NZ Ltd (1995) 31 ATR 350, except that it was suggested in that case that the position may have been different if a specific charge had been made for the warranty.

Gold forward sale agreements Income arising from a forward sale of gold is considered to be derived only when the gold is delivered to the purchaser: Ruling TR 92/5. Payments for the production of wheat, grain, cotton and wool For taxpayers on a cash basis of accounting, the Commissioner considers that income from sales of wheat, barley and other commodities to AWB (International) Limited, AWB (Australia) Limited, ABB Grain Export Limited and ABB Grain Limited is derived when the cash is paid, and for taxpayers on an accruals basis of accounting, income is derived when the sale occurs: Rulings TR 2001/1 and TR 2001/5. Pool distributions made to cash basis taxpayers are assessable in the year in which they are received, and pool distributions made to accruals basis taxpayers are assessable in the year in which they are declared. The income of cotton growers is dealt with in Ruling TR 94/13, while Ruling TR 97/9 deals with the timing of derivation of income from the sale of wool. [3 330] Income from sale of real property The sale of real property (land and improvements to land) is often an affair of capital which does not result in ordinary income. In general, a capital gain or loss arises on the disposal of real property and the time of the event (under CGT event A1) is when the contract for disposal is entered into: see [13 050]. However, where a sale of real property results in gross income (because the property is trading stock) or results in a profit that is assessable as income (because the property is a ‘‘revenue asset’’), the income arises at the time of settlement, not when the contract is entered into, nor when all conditions other than transfer of the property are satisfied. A mere loss of dispositive power over property, without delivery of the property by the seller to the purchaser on settlement of the sale, was not considered to result in the derivation of assessable income in Gasparin v FCT (1994) 28 ATR 130. The Full Federal Court held that the income under the various contracts of sale of the land was derived at settlement, when a debt fell due from each purchaser. The same principle was applied in ATO ID 2004/439 to income derived by a property developer from an ‘‘off the plan’’ sales contract. In the case of a person who carried on a business of buying properties and then selling them under instalment sale contracts, with instalments payable over a substantial period such as 25 years, the Commissioner considered that the sales income represented by each instalment payment was not derived until settlement (ie on payment of the last instalment): ATO ID 2004/27. In contrast, the interest payable by the purchaser with each instalment was assessable when received. An assessable profit from an instalment sale of a joint venture interest in property by a person who was not in the business of property development, but who held that interest as a ‘‘revenue asset’’, was considered by the Tax Office to arise in the income year in which final settlement occurred: ATO ID 2004/407. In contrast, in ATO ID 2004/406, the Tax Office states that the share of each instalment retained by the developer as a fee for arranging the instalment sales was assessable when received, as it was not contingent on the ultimate settlement of the sale contract.

Forfeited deposits A forfeited deposit in relation to a sale of land held as trading stock was regarded by the Tax Office as assessable income in the year in which the purchaser defaulted: ATO ID 2004/28. 66

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[3 340]

[3 340] Rent, interest and other income from property Income from property (such as interest or rent) is generally derived when it is actually received (ie the cash basis of reporting income). In ATO ID 2003/526, however, the Tax Office considered that a lump sum payment in exchange for a life time right to reside in a property, which had the character of rent received in advance, was to be brought to account progressively in accordance with the Arthur Murray principle: see [3 360]. As discussed at [3 260], crediting of income to a bank account constitutes actual or constructive receipt on general principles or deemed receipt under s 6-5(4). However, the crediting of an amount in a debtor’s books does not cause the income to be derived by the creditor unless the crediting amounts to an application of the amount for the benefit of the creditor, in which case s 6-5(4) would deem the income to have been received by the creditor. If income from property arises in the context of an actively managed business, it is derived when ‘‘earned’’: see Ruling TR 98/1, paras 47 and 48. Financial institutions It is generally accepted that banks, finance companies, insurance companies and other financial institutions that deal in money derive interest income on an accruals basis, no later than the time at which it is debited to the customer: IRC (NZ) v National Bank of New Zealand (1976) 7 ATR 282. The position where the relevant interest period has not expired and the interest is not due and payable has not been conclusively resolved, but the Tax Office view relies on the general rule that interest accrues from day to day: see Ruling TR 93/27. Interest received in advance by financial institutions is covered in Ruling TR 1999/11. The Commissioner’s view on the appropriate treatment of interest on securities purchased or sold cum interest (not only by financial institutions) is provided by Ruling TR 93/28. In ATO ID 2006/217, a securitisation vehicle that was not a financial institution was allowed to account for interest income (and interest expenditure) using a straight line daily accruals method. In relation to assessable income from finance transactions involving the leasing of motor vehicles, the Full Federal Court held in FCT v Citibank Ltd (1993) 26 ATR 423 that the proper method of accounting for tax purposes was to return gross rentals as assessable income and separately deduct allowable deductions such as depreciation. In other words, the ‘‘operating method’’ had to be used, rather than the ‘‘finance’’ or ‘‘actuarial’’ method, which would have merely returned a net profit component on each lease. The basis of this view was that the income tax law provided a specific regime for the depreciation of assets and the disposal of depreciated assets. Note that financial arrangements may now be dealt with under the TOFA rules discussed at [32 050]-[32 190]. Non-accrual loans Ruling TR 94/32 deals with the assessability of interest on loans under which the borrower’s obligations to pay interest to a financial institution are not being met in full. The term ‘‘non-accrual loan’’ is used in the ruling to refer to a loan in respect of which there is little or no likelihood that accrued interest will be received. Criteria are provided for establishing when a loan should be classified as non-accrual. The ruling specifies that interest on ‘‘non-accrual loans’’ is not regarded as having been derived until it is actually received. See also ATO ID 2013/44. If the borrower’s circumstances improve to such an extent that the loan should no longer be classified as a ‘‘non-accrual loan’’, the ruling specifies that all interest accrued and all interest accruing thereafter is to be returned as income. Dividends Section 44(1) ITAA 1936 provides that the assessable income of a shareholder includes ‘‘dividends paid to him by the company’’. ‘‘Paid’’ is defined in relation to dividends to include ‘‘credited or distributed’’. © 2017 THOMSON REUTERS

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Although the declaration of a final dividend by the company in general meeting creates a debt and an enforceable right on the part of the shareholder to the dividend, it is not assessable to the shareholder until credited or paid: Brookton Co-operative Society Ltd v FCT (1981) 11 ATR 880. See further [21 030] and [21 060]. Note, however, that the withholding tax provisions apply to dividends when they are derived by a foreign resident and not when paid: see [35 160]. In ABB Australia Pty Ltd v FCT (2007) 66 ATR 460, it was held that a non-resident parent company derived a dividend at the time the dividend was declared by its wholly owned Australian subsidiary (payment of the dividend was deferred and, in the meantime, the parent company assigned the dividend to a third party). The Federal Court decided that it was appropriate to treat the parent company as an accruals taxpayer, largely on the basis of the nature of the parent’s business as an investor, the accounting practices of the parent and the subsidiary and the fact that the parent effectively made the decision to declare the dividend and defer payment. The making of a mere entry in the books of a company without the assent of the shareholder does not establish a payment to the shareholder: see [21 060]. The Commissioner’s views on the circumstances in which a dividend is ‘‘paid’’ when not paid in cash are set out in Ruling IT 2603, relating to ‘‘scrip dividends’’. A dividend paid by a foreign company into a foreign bank account of a resident company is assessable income of the resident company whether or not the funds can be transferred out of the foreign country: Determination TD 96/13.

[3 350] Business income: deferred entitlement to receipt The Commissioner considers that in general business income is ‘‘earned’’ when a recoverable debt comes into existence, and this point may occur before the point at which the taxpayer can legally enforce recoverability of the debt: Ruling TR 98/1, paras 9 and 10. This view is consistent with the principle applied in Barratt v FCT (1992) 23 ATR 339. In that case, the provisions of the medical practitioners legislation prevented recovery action until 6 months after service of a bill. The Full Federal Court held that, in determining whether income is ‘‘derived’’, a distinction must be drawn between conditions precedent to the existence of a debt and the operation of impediments to enforcement. The enforced delay in the taking of recovery action, should a bill not be paid, was not a condition precedent to the existence of the debt. Therefore the fees were ‘‘derived’’ by the partnership when the patients were billed (see also [3 310]). FCT v Australian Gas Light Co (1983) 15 ATR 105 was distinguished as a case where the statutory regime created conditions precedent to the existence of the debts. The situation in the latter case is dealt with in Ruling IT 2095. This does not mean, however, that a mere right to sue in restitution, before a debt has become due in contract, constitutes the derivation of income. In Re Lee McKeand and Son Pty Ltd and FCT (2005) 59 ATR 1157, the AAT found that management fees that accrued in a subsidiary’s accounts for services provided to the parent company without prior agreement that they would be payable, were not income derived until they had been ‘‘quantified, accepted and charged’’. Ruling TR 93/11, which concerns the treatment of professional fees, acknowledges the decision in the Barratt case, but places emphasis on the test as to whether a recoverable debt has arisen, where no further steps need be taken for entitlement to payment. Instalment sales Income from the sale of goods on an instalment basis is derived when the goods are sold and a debt is created: J Rowe & Son Pty Ltd v FCT (1971) 2 ATR 497. In that case, a retailer sold household goods on a deferred payment basis. Customers paid an initial amount, followed by instalments over a period of years for a total amount that incorporated an interest component for the period over which the periodical payments were made. A bill of sale was obtained from the customer to secure payment of the instalments. The High Court considered that the full sale price of goods sold in the income year was assessable in that year, and the interest component of each instalment payment was assessable when the instalment was due 68

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[3 360]

and payable. This decision was followed in IRC (NZ) v Farmers’ Trading Co Ltd (1982) 13 ATR 334. Note that a sale of real property on an instalment basis is treated differently: see [3 330]. For comment on income subject to dispute, see [3 290]. For the Commissioner’s view on the derivation of income under conditional contracts and ‘‘take or pay’’ contracts, see [3 320].

Work in progress The question of whether work in progress of professional services practices should be valued and reported as income only arises if it has been determined that the practice should report its income on an accruals basis. If the accruals basis is the appropriate basis (see [3 270]), the issue is whether income is ‘‘earned’’ when work is done, or when it is billed, or at some other time. A number of cases established that a payment received by a retiring partner for her or his share of the work in progress of the partnership was assessable income: eg Stapleton v FCT (1989) 20 ATR 996; Crommelin v FCT (1998) 39 ATR 377. On the other hand, an amount paid by the new partnership in respect of the work in progress of the old partnership has been held to be a non-deductible capital amount: Coughlan v FCT (1991) 22 ATR 109. As a result, the same amount could be taxed a second time, albeit in the hands of the new partnership, when the work is completed and the client billed. This anomaly has been addressed by s 25-95, which provides a deduction for a ‘‘work in progress amount’’, and s 15-50, which confirms that such a payment is assessable in the hands of the recipient. In relation to manufacturers, partly manufactured goods that are not ‘‘finished’’ goods are treated as trading stock and it is necessary to determine the value of stock-on-hand at the beginning and end of the income year: see [5 300]. Expenditure incurred by suppliers under incomplete contracts is deductible in accordance with the rules concerning losses or outgoings ‘‘incurred’’: see [3 380]. [3 360] Business income: payment received in advance Amounts received by a supplier of services, in advance of the supply of services, are generally not derived until the services to which they relate have been supplied. Arthur Murray (NSW) Pty Ltd v FCT (1965) 114 CLR 314 involved advance payments for dancing tuition courses to be performed in future years. There was no contractual right to a refund but refunds were occasionally made. The taxpayer’s financial accounting employed a suspense account from which transfers were made to an ‘‘Earned Tuition Account’’ when dance lessons, to which the fees related, were given. Those transfers were reported as assessable income. In endorsing the taxpayer’s treatment of the fees, the High Court held that the practical possibility of a refund was a contingency that prevented the full advance payments being derived at the time of initial receipt. In contrast, in AAT Case 5181 (1989) 20 ATR 3694, fees paid for pest treatment work were held to be derived when received even though part of the service involved inspecting the property 10 years after the initial treatment and, if necessary, conducting remedial work. The AAT distinguished the Arthur Murray case on the basis that, in this case, ordinary business practice would recognise the fees as income in the year in which they were received. The Arthur Murray case was also distinguished in National Mortgage Company Pty Ltd v FCT (2008) 69 ATR 543. The taxpayer was a mortgage broking company which received monthly management fees under an agreement with a bank to ‘‘originate and manage mortgages’’ on behalf of the bank. The taxpayer asserted that amounts received from the bank were not origination fees, but instead were advances that were repayable in future by offset against origination fees payable by the bank. The Federal Court did not accept this argument, finding instead that the amounts received were origination fees. The court held that the Arthur Murray principle did not apply to delay the derivation of the fees until all the loan services had been rendered, on the basis that that was not the business practice in the mortgage broking industry and part of the services had been performed before the fees were received. © 2017 THOMSON REUTERS

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The Tax Office has decided that membership fees received by a taxpayer for access to its website for as long as the website was operational, were derived when received, despite the entitlement of the members to a refund if they cancelled their memberships: ATO ID 2004/426.

Receipts subject to a condition The Tax Office states in ATO ID 2004/193 that a government grant received by a taxpayer is derived when the conditions of the grant (in the relevant deed) are satisfied. Similarly, instalments paid to a Cooperative Research Centre (CRC) company under the Commonwealth Agreements for the CRC Programme are not derived until applied towards the conduct of the ‘‘Activities’’, as specified in the Agreements: see ATO ID 2006/122. See also ATO ID 2004/149, where a government grant to a school bus operator for the purchase of a new bus was considered to be assessable in the year the grant was spent. [3 370] Business income: long-term construction contracts If a business undertakes a project spanning more than one income year, there is an issue as to whether – and if so, how – the profit or loss on the project should be apportioned between each of the income years in which the work was done. The Commissioner considers that there are 2 acceptable methods of accounting for long-term construction contracts: the ‘‘basic’’ method, which is essentially the ordinary accruals method, though with rules for the treatment of up-front payments and retention moneys, and the ‘‘estimated profits’’ basis: see Ruling IT 2450. Under the estimated profits method, which draws on the method commonly used for financial accounting purposes, the estimated profit or loss is spread over the years taken to complete the contract, the balance of profit or loss being recognised in the final year. The ruling also comments on the powers of amendment conferred by s 170(9), mentioned below. The ‘‘completed contracts’’ method is ruled unacceptable. The appropriate basis to determine the derivation of assessable income under a long-term construction contract was considered by the Full Federal Court in Grollo Nominees Pty Ltd v FCT (1997) 36 ATR 424. The court considered that the ‘‘estimated profits’’ basis and ‘‘basic’’ approach reflected the periodic accomplishment of the company so as to give a substantially correct reflex of the taxpayer’s true income. The completed contracts method contended by the taxpayer was not acceptable. The court’s comments in Grollo are not binding as the court concluded that the issue was a question of fact and did not disturb the finding of the AAT, but the case nevertheless supports the position taken in Ruling IT 2450, mentioned above. The Commissioner has rejected the use of a ‘‘management reserve’’ when calculating ‘‘estimated profits’’ arising from a long-term construction contract: Determination TD 94/65. Only costs that can be identified as being likely to be incurred over the contract can be taken into account when calculating ‘‘estimated profits’’. In Determination TD 92/131 it is stated that tender costs are not to be taken into account in calculating ‘‘estimated profits’’ from a long-term construction contract and instead are deductible under s 8-1 ITAA 1997 in the year in which they are incurred. According to Determination TD 92/186, a construction contract which runs for less than 12 months can be regarded as a long-term construction contract for the purposes of Ruling IT 2450. Note that the Commissioner has an extended period of time within which to amend an assessment where the ultimate profit varies from the anticipated profit used to calculate the assessable income for a particular income year: s 170(9) ITAA 1936. [3 380]

Miscellaneous timing rules

General insurance companies and reinsurers A general insurance policy typically straddles 2 or more income years and therefore a portion of premium income derived by a general insurance company is unearned at the end of the income year. Subdivision 321-B ITAA 1997 provides that gross premium income is 70

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included in assessable income in the year it is received or receivable. Net premium income that relates to risk exposure in subsequent years is allocated to the unearned premium reserve. The value of the unearned premium reserve at the end of the income year is compared with the value of that reserve at the end of the previous income year. Increases in the value of the unearned premium reserve over the income year are deductible and decreases are assessable. Ruling TR 95/5 deals with the assessability of premium income derived by reinsurers (and related timing issues) and is to be read in conjunction with Ruling IT 2663 which deals with the treatment of insurance premiums (the Tax Office’s views in Ruling IT 2663 were confirmed by Subdiv 321-B in Sch J).

Life insurance companies The assessable income of a life insurance company includes the total amount of life insurance premiums ‘‘paid to the company in the income year’’: s 320-15(1)(a) ITAA 1997. The Tax Office considers that the term ‘‘paid to’’ in this context includes an amount that is due to a company but remains unpaid at the end of the income year: Determination TD 2007/41. Profit emerging method The profits emerging basis involves calculating the anticipated profit. This may be the appropriate method where a profit-making scheme extends over more than one year, because bringing to account for tax purposes the difference between receipts and disbursements in any one particular income year may not give a true reflection of the profit earned or loss sustained for that year. The profit emerging basis is considered to be the appropriate method of determining assessable income for a taxpayer who carries on a business of debt acquisition and recovery: see ATO ID 2008/39. The profit emerging basis does not apply on the disposal of a CGT asset because the capital gain (if any) arises when the CGT event occurs, which under CGT event A1 is generally when the contract for disposal is entered into (see [13 050]), irrespective of when the sale price is received. Note that, where an assessment includes an estimated amount of income in a situation where the relevant transaction continues over more than one income year (eg where the profit emerging method is used), the Commissioner may amend the assessment at any time within 4 years after ascertaining the total profit or loss actually derived from the transaction: s 170(9) ITAA 1936. Other situations Where a retailer association negotiates and receives volume rebates from wholesalers, and the arrangement between the association and its members in relation to those receipts is properly characterised as one of agency, the amounts receivable by the association are assessable in the hands of the members when derived on their behalf by the association: Ruling TR 2004/5. The timing of fees payable to a computer supplier under a warranty and maintenance agreement is discussed in Ruling TR 93/20, at para 27. See also Determination TD 95/33 relating to certain payments received by pharmaceutical companies. Ruling TR 97/6 deals with the impact of disbursements and recoupments on the derivation of income by solicitors. Ruling TR 2002/14 deals comprehensively with the derivation of income by owners of retirement villages. Ruling TR 2006/3 deals with the assessability (and related timing issues) of bounties, subsidies, grants and rebates paid or funded by the Commonwealth or a State, Territory or local government or a government agency to assist the recipient to continue, commence or cease business. In ATO ID 2012/15, an energy retailer derived assessable income where it supplied electrical and gas energy to NSW mass market customers even though that energy remained unbilled at the end of the income year. © 2017 THOMSON REUTERS

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INTRODUCTION Overview ......................................................................................................................... [4 010] EMPLOYMENT INCOME – GENERAL Earnings ........................................................................................................................... [4 Tips and allowances ........................................................................................................ [4 Services rendered ............................................................................................................ [4 Fringe benefits ................................................................................................................. [4 Gifts from employers ...................................................................................................... [4 Defence forces ................................................................................................................. [4 Sportspersons ................................................................................................................... [4

020] 030] 040] 050] 060] 070] 080]

EMPLOYMENT INCOME – SPECIAL PAYMENTS Workers compensation .................................................................................................... [4 100] Other compensation payments ........................................................................................ [4 110] Car expense reimbursements .......................................................................................... [4 120] Return to work payments ................................................................................................ [4 130] EMPLOYEE SHARE SCHEMES Introduction ..................................................................................................................... [4 Application of Div 83A .................................................................................................. [4 Key concepts ................................................................................................................... [4 Upfront taxation of discount ........................................................................................... [4 Deferred taxation ............................................................................................................. [4 Real risk of forfeiture or loss ......................................................................................... [4 Takeovers and restructures .............................................................................................. [4 Associates and relationships similar to employment ..................................................... [4 CGT treatment of ESS interests ..................................................................................... [4 Deduction for ESS employer .......................................................................................... [4 Forfeiture of ESS interests .............................................................................................. [4 ESS reporting by employer ............................................................................................ [4 TFN withholding tax (ESS) ............................................................................................ [4

150] 160] 170] 180] 190] 200] 210] 220] 225] 230] 240] 250] 260]

EMPLOYMENT TERMINATION PAYMENTS Employment termination payments ................................................................................ [4 12-month rule .................................................................................................................. [4 Relationship between payment and termination of employment .................................. [4 Taxation of life benefit employment termination payments .......................................... [4 Pre-July 83 segment ........................................................................................................ [4 Invalidity segment ........................................................................................................... [4 Concessional ETP cap amount ....................................................................................... [4 Death benefit employment termination payments .......................................................... [4

300] 310] 320] 330] 340] 350] 370] 380]

OTHER PAYMENTS Genuine redundancy payments ....................................................................................... [4 Early retirement scheme payments ................................................................................. [4 Unused annual leave payments ...................................................................................... [4 Unused long service leave payments ............................................................................. [4 Foreign termination payments ........................................................................................ [4

400] 410] 420] 430] 440]

INTRODUCTION [4 010] Overview Chapter 4 considers the taxation of employment income and employment-related payments and benefits. The topics covered are: 72

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[4 020]

• employment income generally, such as salary and wages, tips, allowances and other benefits resulting from employment: see [4 020]-[4 060]. Separate paragraphs consider the assessable income of defence force personnel and sportspersons: see [4 070] and [4 080]; • specific employment-related payments such as workers compensation payments, car expense reimbursements and return to work payments: see [4 100]-[4 130]; • employee share schemes: see [4 150]-[4 260]; and • employment termination payments, including accrued leave payments: see [4 300]-[4 440].

EMPLOYMENT INCOME – GENERAL [4 020] Earnings A person’s earnings for services he or she provides are assessable as ordinary income under s 6-5 ITAA 1997. Obvious examples are wages and salary derived by employees, fees charged by professional persons and directors’ fees. These are also among the most common examples of income according to ordinary concepts. Amounts mistakenly paid as salary or wages to an employee who is not beneficially entitled to the payments, and who is obliged to repay them, are clearly not assessable income of the employee: Determination TD 2008/9. Whether a person is an employee or an individual contractor is considered at [50 030]. Bonuses and commission paid to an employee are assessable under s 6-5 (eg AAT Case 7422 (1991) 22 ATR 3450, where a bonus paid to a professional footballer was assessable). For payments to defence force personnel and sportspersons, see [4 070] and [4 080] respectively. An employee generally derives employment income, including sick pay and holiday pay, when he or she receives it (or is deemed to receive it): see [3 300]. Reference should be made to the alienation of personal services income provisions (in Pt 2-42 ITAA 1997) which deem certain income derived by an entity for the personal efforts or skill of an individual to be assessable income of the individual: see [6 100]-[6 220]. For the Commissioner’s views on salary sacrifice arrangements, see [3 260], [7 060] and [39 130]. As regards certain earnings under international agreements, see [36 200] and following. Other assessable amounts Payments made under the Paid Parental Leave Scheme are assessable income. A lump sum received on commencing employment is assessable as ordinary income: eg ATO ID 2006/25. An amount paid to a person upon joining a new employer as compensation for rights given up as a result of leaving the person’s former employment (share scheme rights forfeited) was held to be income according to ordinary concepts in Pickford v FCT (1998) 40 ATR 1078. A retention payment made by a parent company to a senior manager of a subsidiary, as an incentive to ensure he or she remained in the employ of the subsidiary after it is sold, is likely to be assessable as ordinary income, as the payment relates to the recipient’s activities as an employee: McLean v FCT; Dean v FCT (1996) 32 ATR 647. In Reuter v FCT (1993) 27 ATR 256, a payment of $8m to the taxpayer as consideration for entering into a covenant not to sue for a larger amount payable under another contract for his services was so closely associated with those services that the amount was income according to ordinary concepts. This was followed in AAT Case [1999] 1026 43 ATR 1282 © 2017 THOMSON REUTERS

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where payments to a retired partner were held to relate to his past services. See also Brown v FCT (2002) 49 ATR 301, where the value of a unit given to the taxpayer for his services was held to be assessable income: see [6 540]. Amounts received by an employer and trainee (other than a living-away-from-home allowance) under government training schemes are assessable to both employer and trainee: Ruling IT 2364. In Integrated Insurance Planning Pty Ltd v FCT (2004) 54 ATR 722, the Federal Court held that an insurance agent was assessable under both s 6-5 ITAA 1997 and the ITAA 1936 equivalent of s 15-2 ITAA 1997 (s 2n6(e)) on the amounts of agency development loans waived by a life insurance company (the conclusion reached in Ruling TR 2001/9): see also [3 060] and [5 070]. Section 15-2 is considered at [4 040]. Ruling TR 2010/6 discusses the tax consequences for employees, employers and trustees if bonus units are issued to employees under an employee benefits trust (as described in the ruling), and if bonus units are redeemed by employees. A payment received by an employee on redemption of a bonus unit is assessable as ordinary income of the employee under s 6-5 or s 15-2 ITAA 1997. See also [3 300]. Contributions to employee remuneration trusts on behalf of an employee (or at the direction of an employee) will normally be treated as assessable income of the employee under s 6-5 (they may also be assessable as dividends): see FCT v White (2010) 79 ATR 498 and Draft Ruling TR 2014/D1. The Tax Office has announced that a new draft of TR 2014/D1 will be issued as the Commissioner’s views at paragraphs 40, 297 and 298 are being reviewed.

[4 030] Tips and allowances If the payment is a reward for services, it is not essential that the employer makes the payment. Ex gratia payments such as tips to taxi drivers, waiters, hotel porters, etc are assessable income of the recipient. They are assessable as ordinary income under s 6-5. They would also constitute a payment for services rendered within the meaning of s 15-2 ITAA 1997, which specifically includes gratuities: see [4 040]. Allowances Allowances paid by an employer (eg travel, entertainment and uniform allowances) are generally assessable income of the employee either under s 6-5 or s 15-2 (they will appear on the employee’s payment summary). Note that the PAYG withholding system applies to allowances paid to employees: see [50 030]. An allowance must be distinguished from a reimbursement. In general terms, an allowance is a payment intended to cover expenses expected to be incurred regardless of whether they are incurred, whereas a reimbursement is compensation for an expense that has been incurred: see Ruling TR 92/15. If a payment is in truth a reimbursement, it will not be assessable income but may be a fringe benefit subject to FBT: see [4 050] and [58 450]. Examples of assessable allowances include: ‘‘hardlying’’ allowances paid to compensate a seaman for the inconvenience of working on an offshore oil drilling rig or a self-propelled drilling vessel (see Re Best and FCT (2005) 59 ATR 1151 and Re Crane and FCT (2005) 60 ATR 1170); a sleepover allowance paid to a support worker who assists people with disabilities (see ATO ID 2002/232); and an attendant care allowance received by the taxpayer from the Veterans’ Affairs Department for providing attendant care services (see ATO ID 2002/767). The Tax Office has released a series of rulings that deal, among other matters, with allowances and reimbursements in particular occupations: see [9 1100]. Living-away-from-home allowances A living-away-from-home allowance (LAFHA) paid to an employee to compensate them for the additional costs of living away from their usual place of residence (if required to do so by their employer) is generally a fringe benefit subject to FBT: see [58 550]. It is 74

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[4 050]

non-assessable non-exempt income in the hands of the employee: see [4 050]. However, an allowance that does not qualify as a LAFHA for FBT purposes is assessable as income.

[4 040] Services rendered The assessable income of a taxpayer includes the value to the taxpayer of all allowances, gratuities, compensations, benefits, bonuses and premiums provided to the taxpayer in respect of, or for or in relation directly or indirectly to, any employment of, or services rendered by, the taxpayer (including as a member of the Australian Defence Force) s 15-2 ITAA 1997. This is so whether the allowance, gratuity, benefit, etc was provided in money or in any other form (eg land, goods, meals or the use of premises). Section 15-2 is the ITAA 1997 equivalent of s 26(e) ITAA 1936 (cases, rulings and ATO IDs concerning s 26(e) will be relevant in considering the application of s 15-2). A payment received by an employee on redemption of a bonus unit in an employee benefits trust is considered to be ordinary income of the employee and assessable under s 6-5 or s 15-2: see Ruling TR 2010/6. It should be noted that the value to be assessed under s 15-2 is the value to the taxpayer, which does not necessarily equal the cost to the employer of providing the allowance, etc. However in the case of a cash allowance, this will not be significant. Section 15-2 is not restricted to an employment situation and the section may apply to a payment for services rendered if there is no employer/employee relationship: eg FCT v Holmes (1995) 31 ATR 71, where a salvage reward received as a matter of personal right under Admiralty Law was held to be assessable. See also Glennan v FCT (1999) 41 ATR 413 (discussed at [3 070]) and Ruling TR 2001/9 (noted at [5 070]). Commission paid to the executor of a deceased estate (for services performed as executor) is considered to be assessable under s 15-2: see ATO ID 2014/44. Section 15-2 does not apply if the particular allowance, gratuity, benefit, etc is assessable as ordinary income under s 6-5 (see [3 020]). Nor does the section apply if the particular amount is an employment termination payment (see [4 300]), a payment in respect of unused annual leave and/or long service leave: see [4 420] and [4 430]), a superannuation lump sum (see [40 170]), or a dividend or non-share dividend (including an amount that is deemed to be a dividend under s 109: see [21 250]). In addition, s 15-2 does not apply if the benefit is a fringe benefit (see [4 050]). As to whether a gift will be caught by s 15-2, see [4 060]. The following are considered not to be assessable under s 15-2: • payments to a volunteer respite carer to cover expenses incurred in providing care for a disabled person: Determination TD 2004/75; and • standard or basic foster care subsidies (plus additional loadings or allowances) paid to volunteer foster carers (that are not employees of foster care agencies): Determination TD 2006/62. Superannuation contributions by an employer on behalf of an employee are not assessable to the employee under s 15-2 (nor are they income of the employee: see [3 050]). In addition, remuneration forgone by a local government councillor which is paid by the council in the form of contributions to a complying superannuation fund (that are assessable to the fund) is not assessable to the councillor: ATO ID 2007/205.

[4 050] Fringe benefits Fringe benefits made available in a non-cash form (ie payments in kind) are, in effect, assessable to the employer under the FBTAA. The FBT system is discussed in detail in Chapter 57 to Chapter 59. Common examples of benefits received by employees that are treated as fringe benefits rather than income of the employee include the provision of motor vehicles for private use, low-interest loans and fully paid holidays and payments of an employee’s personal expenses such as phone costs and health insurance premiums. Income derived by way of a fringe benefit is non-assessable non-exempt income in the hands of the employee under s 23L(1) ITAA 1936: see [7 060]. Income derived by way of a © 2017 THOMSON REUTERS

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benefit that would be a fringe benefit except for the fact that it is an exempt benefit (see [57 150]) is exempt income: s 23L(1A). However, this does not apply to reimbursed car expenses which are assessable: see [4 120]. Generally, the Tax Office considers that benefits (that are convertible to money) provided to or on behalf of an employee under an effective salary sacrifice agreement (SSA) are fringe benefits and are therefore non-assessable non-exempt income under s 23L, whereas benefits provided to or on behalf of an employee under an ineffective SSA are assessable income of the employee under s 6-5 or s 6-10: Ruling TR 2001/10. An effective SSA involves the employee agreeing to receive part of her or his total amount of remuneration as benefits before the employee has earned the entitlement to receive that amount as salary or wages; an ineffective SSA involves the employee directing that an entitlement to receive salary or wages that has already been earned is to be paid in a form other than as salary or wages. For an example of an ineffective SSA, see Re Wood and FCT (2003) 51 ATR 1227 (the taxpayer simply asked his employer to pay accrued bonuses and long service leave to his superannuation fund). Certain payments made in cash, such as allowances (see [4 040]), are still assessable income of the employee, although an exception to this is a living-away-from-home allowance (LAFHA), which is a fringe benefit taxable under the FBTAA: see [58 550]. Note the requirement for the grossed-up value of certain fringe benefits to be identified on an employee’s payment summary: see [59 200].

[4 060] Gifts from employers Gifts to employees are likely to be fringe benefits under FBTAA, unless it can be established that the gift was made to the employee in her or his capacity as an individual unrelated to her or his status as an employee: see [57 250]. For example, a one-off gift to an employee on the occasion of her or his marriage will not be assessable income, either according to ordinary concepts (see [3 020]) or under s 15-2 ITAA 1997 (see [4 040]); nor would it be a fringe benefit if it is not in respect of the person’s employment. (Note that fringe benefits of less than $300 may be exempt from FBT: see [57 250].) [4 070] Defence forces The assessable income of a member of the Australian Defence Force includes the value to her or him of all allowances, gratuities, benefits, compensation and bonuses provided to that person, whether as money or in any other form (s 15-2 ITAA 1997): see [4 040]. It is important to note, however, that certain allowances and bounties are specifically exempt under s 51-5 ITAA 1997 and that the pay and allowances of ADF members serving in certain operational areas are also exempt: see [7 090]. Ruling TR 95/17 is a detailed ruling dealing with income and deductions of defence personnel, including the assessability of various specific allowances and reimbursements received. Determination TD 1999/63 deals with deductions for cadet officers. See also Re Davy and FCT (2003) 53 ATR 1011 and ATO ID 2003/260, noted at [4 100]. [4 080] Sportspersons In many cases, payments to sportspersons are clearly assessable income, eg salary and wages paid to professional footballers and cricketers and prize money won by professional golfers and tennis players. However, other payments and awards are not so obviously assessable in the hands of the sportsperson. These include grants, signing-on fees and payments for restrictive covenants. The Commissioner’s views on the assessability of payments and benefits received from involvement in sport are set out in Ruling TR 1999/17. Prizes, grants and awards In the case of prizes, grants and awards, the nature of the taxpayer’s involvement in the sport is likely to be critical, essentially whether the sportsperson is a professional or amateur, 76

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[4 080]

as a professional sportsperson may be carrying on a business of a professional sportsperson (a question of fact depending on the facts and circumstances of the particular case). In FCT v Stone (2005) 59 ATR 50, the High Court held that a world class javelin thrower’s athletic pursuits constituted a business even though her principal motivations were the pursuit of excellence and the pursuit of honour for herself and her country. This was on the basis that she had exploited her athletic talent to earn money and the amounts involved were not trivial. Similarly, in Spriggs and another v FCT (2009) 72 ATR 148, a professional Australian rules player and a professional rugby league player were held to be carrying on a business of commercially exploiting their sporting prowess and associated celebrity, even though they were also employees of their respective clubs. As a consequence, management fees paid in connection with negotiating contracts with new clubs were sufficiently connected with that business to be deductible in accordance with the general principles discussed in Chapter 8. The issue of whether a taxpayer is carrying on a business is considered in detail at [5 020] onwards. The Stone, Spriggs and Riddell decisions clearly indicate that there may be difficult questions of fact and degree in determining whether a sportsperson is carrying on a business, eg of exploiting their sporting talent. See also the Tax Office’s Decision Impact Statement on the Spriggs and Riddell decision (available on its website). If a sportsperson is carrying on a business, it is clear from the decision in Stone that nearly all receipts will be assessable income, including sponsorship moneys, appearance fees, prizes and government grants (eg amounts under the Medal Incentive Funding program). If a sportsperson is not carrying on a business, sponsorship moneys and appearance fees, but not prizes and government grants, are likely to be assessable income (see the first instance and Full Federal Court Stone decisions – Stone v FCT (2002) 51 ATR 297 and Stone v FCT (2003) 53 ATR 214 respectively). Class Ruling CR 2007/36 confirms that payments by the Australian Olympic Committee under the Medal Incentive Funding program provided to sportspersons not carrying on a business are not assessable income. Medals (including Olympic medals) and trophies are not assessable (whether or not the recipient is carrying on a business) as they are given and received on purely personal grounds: Ruling TR 1999/17. Payments received from a testimonial function may be assessable to a professional, but could qualify for treatment as an employment termination payment provided the necessary relationship to the termination of employment exists. Payments received under amended cl 8.10 of the Australian Rugby Collective Bargaining Agreement Mark III (underpayments paid to players no longer employed by the ARU or a State rugby body) are considered to be assessable income (and not employment termination payments): Class Ruling CR 2007/66.

Signing-on fees In relation to signing-on fees, the nature of the payment will need to be examined to determine whether it is in truth a reward for services to be performed, in which case it will be income, or whether it is correctly categorised as a payment or compensation for giving up rights, such as relinquishment of amateur status. In the case of a professional sportsperson swapping clubs, a signing-on fee will invariably be a reward for services. In other situations there have been cases going either way. In Ruling IT 2307, the Commissioner indicates his view that lump sum signing-on fees will normally be regarded as assessable income in the absence of specific evidence to the contrary. A signing-on fee paid to a rugby league player to join Super League was held to be assessable in AAT Case [1999] AATA 882 43 ATR 1156, even though the drawer of the cheque was not the taxpayer’s proposed employer. Restrictive covenants Restrictive covenants are usually capital according to ordinary concepts and therefore do not fall within the ordinary income provisions. However, their creation constitutes a CGT event D1 and the capital proceeds from creating a restrictive covenant can give rise to a capital gain under s 104-35: see [6 530] and [13 150]. This would also apply to any signing-on fees that are not regarded as income. © 2017 THOMSON REUTERS

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Moneys accumulated in trust Many athletes, while still classified as amateur by the relevant sporting bodies, are allowed to accumulate sponsorship payments in trust on condition that they are not accessed until the completion of their amateur careers. The Tax Office considers that these payments are assessable income of the athlete and, by virtue of s 6(4), are taken to be received by the athlete in the year they are paid into the trust (see [3 260]): see Ruling TR 1999/17, para 28. See also Re Oliver and FCT (2001) 46 ATR 1126, where payments made to an AFL player through a trust, in order to get around the AFL salary cap, were found to be assessable wages and salary of the player. Above-average income A special averaging system is available for calculating the tax payable by sportspersons on certain income from their sporting activities: see Chapter 28.

EMPLOYMENT INCOME – SPECIAL PAYMENTS [4 100] Workers compensation In the case of workers compensation and other statutory personal injury compensation payments, the character of the payment is derived from the relevant scheme: FCT v Slaven (1984) 15 ATR 242; FCT v Inkster (1989) 20 ATR 1516. Periodical (eg weekly or fortnightly) payments to replace lost income are clearly of an income nature (in accordance with general principles: see [6 500]) and are therefore assessable. In certain circumstances, however, such compensation payments are exempt under s 51-33 ITAA 1997: see [7 090]. A lump sum representing lost earnings is assessable as ordinary income under s 6-5 ITAA 1997: Inkster, Re Purdon and FCT (2001) 46 ATR 1161, Re Cooper and FCT (2003) 52 ATR 1199, Re Applicant and FCT (2006) 63 ATR 1008, Re Edwards and FCT [2016] AATA 781 and Re Gupta and FCT [2016] AATA 914 (these cases involved a lump sum payment in arrears of weekly or fortnightly compensation or, as in Re Cooper, an invalidity pension). On the other hand, a lump sum representing the loss of earning capacity (eg for the loss of a limb) is of a capital nature and is not assessable. A lump sum received in redemption of the taxpayer’s entitlement under Commonwealth legislation to weekly workers compensation payments was held to be capital, and therefore not assessable, as once the taxpayer turned 65 the weekly amounts were paid for loss of earning capacity and not for lost earnings: Re Coward and FCT (1999) 41 ATR 1138. In Re Maher and FCT (2005) 58 ATR 1341, the taxpayer did not redeem compensation payments under the relevant Commonwealth legislation and the weekly payments he received were not a lump sum that was paid periodically. For a decision concerning a lump sum in redemption of entitlement to weekly partial disability payments under earlier Commonwealth legislation (where the lump sum was held to be capital), see Re Barnett and FCT (1999) 43 ATR 1221. In contrast, in Re Davy and FCT (2003) 53 ATR 1011, a lump sum paid in commutation of a compensation and rehabilitation pension to a former soldier for an injury suffered in the course of his duties was not exempt income; and in Re Brackenreg and FCT (2003) 53 ATR 1116, a lump sum representing the commutation of weekly compensation payments which took account of the taxpayer’s ‘‘normal weekly earnings’’ (paid under Commonwealth legislation) was assessable income. A domestic assistance payment under the NSW workers compensation legislation was considered to be assessable as ordinary income, as the purpose of the payment was to compensate the care giver for income lost as a result of giving up their job in order to look after the injured person: see Re Riley and FCT [2014] AATA 664. See also [4 300] and following for a discussion of whether a lump sum payment is an employment termination payment. Lump sum compensation payments are exempt from CGT under s 118-37: see [15 100]. 78

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[4 130]

In Reiter v FCT (2001) 47 ATR 533, the taxpayer obtained a judgment for common law damages for injuries sustained at work. However, he continued to receive compensation payments from WorkCover (SA) after judgment was entered, although they were eventually repaid. The Federal Court held that amounts paid to the taxpayer by WorkCover after the expiry of the stay of execution of the judgment were not assessable as he was not beneficially entitled to them. However, amounts paid after judgment was entered but before the expiry of the stay of execution of the judgment were assessable. Workers compensation payments mistakenly paid to a person who is not beneficially entitled to the payments, and who is obliged to repay them, are not assessable income of that person: Determination TD 2008/9.

[4 110] Other compensation payments Where an employee receives compensation for wrongful dismissal, discrimination or harassment, the principles outlined at [4 100] and [6 500] generally apply. The exceptions for personal injury compensation under the employment termination payment (see [4 300]) and CGT provisions (see [15 100]) are also relevant. In Re Allman and FCT; AAT Case 13,012 (1998) 39 ATR 1081, a wrongful dismissal payment was held to be assessable as ordinary income because it was in substitution for the income the taxpayer would have earned rather than being for loss of earning capacity. Annuities and lump sums purchased under the terms of a structured settlement or structured order (called ‘‘personal injury annuities’’ and ‘‘personal injury lump sums’’ respectively) that satisfy the provisions of Div 54 ITAA 1997 are exempt from income tax: see [7 070]. [4 120] Car expense reimbursements If a taxpayer who is an employee is reimbursed by her or his employer for the use of the employee’s motor vehicle on the employer’s business, the amount of the reimbursement is not, in the majority of cases, a fringe benefit (see [58 460]) but is assessable income of the employee pursuant to s 15-70 ITAA 1997. The employee is entitled to claim an allowable deduction for car expenses incurred by the employee in connection with the use of the motor vehicle on behalf of the employer (eg registration, insurance, maintenance and fuel costs). Any deduction claimed must be in accordance with one of the specific alternative methods allowable for claiming car expenses and the related operation of the substantiation provisions: see [9 100]-[9 250]. Even if assessable under s 15-70, a reimbursement is not an allowance or ‘‘salary or wages’’ for PAYG withholding purposes (see [50 030]) and, therefore, the employer is not required to withhold an amount in respect of tax. A reimbursement is not assessable to the recipient, where either it is not made on a cents-per-kilometre basis or it relates to: relocation transport; transport for the purpose of attending an employment interview or selection test; transport for the purpose of attending a work-related medical examination, work-related preventative health care, work-related counselling or migrant language training; holiday transport; or transport undertaken after the employee has ceased employment with the employer. [4 130] Return to work payments An amount received under an arrangement entered into for a purpose of inducing the recipient to resume working for, or providing services to, any entity is assessable under s 15-3 ITAA 1997. This would cover, for example, an inducement to break a strike. The liability for taxation arises irrespective of who makes the payment. Payments falling into this category are those made under any type of arrangement – express, implied, enforceable or unenforceable – where the purpose of the arrangement is to cause the resumption of work. In Determination TD 2016/18 the Tax Office ruled that redemption payments under the Return to Work Act 2014 (SA) are assessable under s 6-5 ITAA 1997, and are not termination payments under s 82-130(1). The determination applies to agreements made on or after 10 August 2016. © 2017 THOMSON REUTERS

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One-off, voluntary payments from a strike fund (established to provide financial support during a strike) to striking employees who satisfy financial hardship criteria are considered not to be assessable: Ruling TR 2002/8. Nor are they assessable under s 15-2 ITAA 1997, as the payments are not in respect of services rendered by the recipient or her or his employment: see [4 040]. However, if a member has an expectation of receiving regular, fixed payments from the strike fund, and is accordingly able to rely on the payments for her or his regular expenditure, the Tax Office considers that the payments are assessable income.

EMPLOYEE SHARE SCHEMES [4 150] Introduction The rules governing the taxation of benefits under an Employee Share Scheme (ESS) are contained in Div 83A ITAA 1997. They replaced the previous rules in Div 13A of Pt III ITAA 1936 (ss 139 to 139GH). The Div 83A rules are intended (s 83A-5): to ensure that benefits provided to an employee under an ESS are subject to income tax at the employee’s marginal rate of tax (and not subject to fringe benefits tax); and increase the extent to which the interests of employees are aligned with those of their employers, by providing a tax concession to encourage lower and middle income earners to buy shares under an ESS. The Div 83A rules generally apply to ESS interests (see [4 170]) acquired on or after 1 July 2009 and also to ESS interests acquired before that date, where the taxing point was deferred beyond 30 June 2009 (see [4 160]). For a detailed discussion of the previous rules, see the Australian Tax Handbook 2009 at [4 500]-[4 590]. [4 160] Application of Div 83A The rules governing the application of the ESS rules in Div 83A ITAA 1997 are contained in Div 83A TPA. The Div 83A ESS rules apply to ESS interests (see [4 170]) acquired on or after 1 July 2009. A tiebreaker rule in s 83A-5(1) TPA provides that if the time of acquisition differs between the previous rules in Div 13A ITAA 1936 and the Div 83A rules, the time of acquisition under Div 13A will apply. The Div 83A ESS rules also apply to ESS interests acquired before 1 July 2009, on which tax has been deferred (under the previous rules) beyond 1 July 2009 (‘‘transitioned ESS interests’’). ESS interests that have not been brought within the Div 83A rules continue to be governed by the relevant provision in the ITAA 1936. Thus, if the ESS interests were acquired before 1 July 2009 and after 27 March 1995, they continue to be governed by the rules in Div 13A. If the ESS interests were acquired before 28 March 1995, they continue to be governed by s 26AAC ITAA 1936. An employee who acquired shares under an ESS governed by Div 13A (or s 26AAC) will pay tax at the time determined by reference to those previous rules. However, the 30-day rule relating to the ESS deferred taxing point (see [4 190]) will apply to the old taxing points for shares and rights that have been brought within the Div 83A rules. The deferred taxing point is moved to the time the employee disposes of the interest, if it is disposed of within 30 days of the original deferred taxing point. Consistent with the previous rules in Div 13A, employees will not pay tax on transitioned ESS interests to the extent that the shares or rights relate to the employee’s employment outside Australia: 83A-5(4) TPA. Section 83A-5(2A) TPA ensures that ESS interests acquired while an individual is undertaking employment outside Australia before 1 July 2009, which would have been qualifying shares or rights under Div 13A, are transitioned to the Div 83A rules, regardless of whether the period of employment that relates to Australia is served after Div 13A was repealed. 80

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[4 170]

The Commissioner may amend an income tax assessment at any time, for the purposes of taxing an employment benefit which becomes an ESS interest: s 83A-15 TPA.

Post-30 June 2015 ESS interests Various changes to the tax treatment of ESS interests were made by the Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015 (‘‘ESS Amendment Act 2015’’). They apply to ESS interests acquired on or after 1 July 2015. These measures include: • altering one of the taxing points for ESS interests that are rights so that it applies not at the point at which a right can be exercised but at the point at which it is exercised (subject to the share obtained by exercising the right not being further subject to a real risk of forfeiture or genuine restrictions on sale): see [4 190]; • increasing the maximum deferral period from 7 years to 15 years for ESS interests subject to deferred taxation: see [4 190]; • introducing a concession for employees of certain start-up companies: see [4 180]; and • allowing the Commissioner to approve market value methodologies: see [3 210].

Further proposed changes Additional changes to the tax treatment of ESS interests were announced in the 2015-16 Budget. These proposed amendments, which were not incorporated in the ESS Amendment Act 2015, are outlined at [4 180]. The Treasury Laws Amendment (2016 Measures No 1) Bill 2016 proposes to amend s 1274 of the Corporations Act 2001 to prevent ESS disclosure documents lodged with ASIC by certain start-up companies from being searched by the public. This will ensure otherwise non-disclosing companies can offer shares to employees without revealing commercially sensitive information to competitors. This measure will apply to start-up companies if: • the offer is of an ESS interest under an ESS; • the disclosure document states that the ESS interests relate only to ordinary shares and they will be made available only to employees of the issuing company or its subsidiaries; • none of the equity interests of the issuing company, or of any the companies in its group (if any), are listed for quotation on the official list of an approved stock exchange at the end of the issuing company’s most recent income year (the ‘‘pre-lodgment year’’); • the issuing companies and all companies in its group (if any) were incorporated less than 10 years before the end of the pre-lodgment year; and • the issuing company has an aggregated turnover not exceeding $50m for the pre-lodgment year.

[4 170]

Key concepts

Definition of terms An ‘‘employee share scheme’’ is defined in s 83A-10(2) as a scheme under which ESS interests in a company are provided to employees, or associates of employees, of the company or subsidiaries of the company in relation to the employees’ employment. Employees include past or prospective employees. An ‘‘ESS interest’’, in a company, is defined in s 83A-10(1) to mean a beneficial interest in a share in the company (the ‘‘ESS company’’), or in a right to acquire a beneficial interest in a share in the company. © 2017 THOMSON REUTERS

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If an employee acquires a beneficial interest in a right and the right later becomes a right to acquire a beneficial interest in a share, eg because a condition in the contract of acquisition is satisfied, s 83A-340 treats the right as if it had always been a beneficial interest in the share. An example is where the taxpayer acquires a right to acquire, at a future time, shares with a specified value, rather than a specified number of shares, or an indeterminate number of shares. Determination TD 2016/17 states that a right that becomes a right to acquire a share when a condition of a contract is satisfied must be enforceable against the other party under the terms of the contract, even if only to the extent of the condition. The relevant condition to be satisfied (whether by the employee or the employer) must be an essential or required precondition for the right to acquire a share being provided. The Determination was issued in response to the decision in Davies v DCT [2015] FCA 773, where the Tax Office’s previous views on the matter were rejected. Davies is discussed at [4 180].

Interests in a trust Because an ESS interest is defined as a beneficial interest in a share (or in a right to acquire the beneficial interest in a share), employees with a beneficial interest in shares in an employee share trust are taxed as though they were the legal owners of those shares. Further, to overcome trust law restrictions on identifying assets for which an employee holds a beneficial interest when they are held within a single pool of unidentifiable assets in a trust, particular shares, or rights to acquire shares, in a trust are treated as though they were beneficially owned by particular employees: s 83A-320. If a trust holds multiple classes of assets, the rules are applied separately to each class of assets. Stapled securities Stapled securities acquired under an ESS are subject to the Div 83A rules as if the stapled security were a share in a company: s 83A-335. Rights to stapled securities are treated in the same way as rights to shares. If a stapled security includes interests in 2 or more companies, the entities are to be regarded as one entity and non-corporate entities are taken to be a part of the corporate entity: s 83A-335(3). Application of CGT provisions The ultimate disposal of ESS interests is usually governed by the CGT provisions, unless the ESS interest is trading stock. The specific CGT rules applying to the disposal of ESS interests (in Subdiv 130-D ITAA 1997) are discussed at [4 225]. [4 180] Upfront taxation of discount If an ESS interest is acquired under an employee share scheme at a discount, the discount is included in the taxpayer’s assessable income for the income year in which the interest is acquired: ss 83A-20, 83A-25(1). The amount included in the assessable income of an employee depends on residency status and the source of the income. If the employment is performed outside Australia, the discount income on an ESS interest is from a source outside Australia: s 83A-25(2). The discount is calculated by deducting any consideration paid or payable by the employee from the market value of the ESS interest. In calculating the discount (if any) on the issue of shares in a ‘‘no goodwill’’ incorporated practice, the market value of the practice interest at the time of acquisition is treated as being equal to the amount the taxpayer pays (including nil) in respect of the acquisition: see Administrative treatment: acquisitions and disposals of interests in ‘no goodwill’ professional partnerships, trusts and incorporated practices on the Tax Office website. The precise date of acquisition of the taxpayer’s ESS interest is important because the market value of shares (particularly listed shares) can fluctuate significantly over a given period of time. In Fowler v FCT (2012) 90 ATR 360 (which concerned the ITAA 1936 rules), the Federal Court held that it was clear from the documents and other evidence that the 82

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[4 180]

taxpayer’s ESS options were acquired when the shareholders approved the issue at the AGM and not when the board of directors, at an earlier date, approved the issue subject to the shareholders’ approval. The discount income would have been substantially less if calculated at the date of the relevant board meeting rather than at the date of the shareholders’ meeting. The decision was upheld in Fowler v FCT (2013) 92 ATR 595. See also Watsford v FCT (2013) 97 ATR 877. The Fowler decision was distinguished by the Federal Court (Perram J) in Davies v DCT [2015] FCA 773. In that case, the taxpayer entered into a deed to subscribe for shares under an ESS, subject to the company obtaining shareholder approval. Because the shares in the company traded at a lower value on the date of the deed than on the date of shareholder approval, the tax position was significantly different depending on which date was relevant for assessment of the discount on the shares. The court held that the date of entering into the deed was the relevant date. It also held that, even though the deed was subject to a condition precedent, the condition precedent should be construed under the general rule as going to performance (the earlier date) rather than going to formation (the later date). Determination TD 2016/17, considered at [14 170], was issued in response to the Davies decision. Note the concessions for employees of eligible start-up companies, discussed below.

Market value of an ESS interest An ESS interest (and the underlying share or right) is taken to have been acquired for its market value rather than its discounted value: s 83A-30. If this was not the case, because the primary discount income is assessed to the employee initially (whether upfront or deferred), it would lead to double taxation if the amount of the discount was not added to the cost base of the capital asset, the gain on which would, in the usual course, be assessed to CGT. The ordinary meaning of market value is used to determine the value of an ESS interest but, in some cases, the ordinary meaning may be affected by the rules in Subdiv 960-S ITAA 1997. If the ITA Regs specify an amount for market value, that amount must be used to determine market value: s 83A-315. If an unlisted right must be exercised within 15 years (10 years before 1 July 2015) after the date on which the beneficial interest in the right is acquired and the taxing point is not aligned with the time of disposal of the right or underlying share, the taxpayer has the option of using the market value of the right or the amount determined in accordance with the ITA Regs: reg 83A-315.01. That amount is the greater of the market value of the underlying share, reduced by the lowest amount that must be paid to exercise the right, and the amount calculated in accordance with regs 83A-315.06 to 83A-315.09. If the lowest amount that must be paid to exercise the right is nil or cannot be ascertained, the value of the right is the same as the market value of the underlying share: reg 83A-315.03. Regulations 83A-315.08 and 83A-315.09 contain valuation tables that can be used to determine the value of an ESS right. These tables have been updated to reflect current market conditions. Note that the Commissioner may approve (by legislative instrument) methods of working out the market value of assets: see [3 210]. Tax concession for upfront inclusion of income Employees who pay tax upfront on ESS interests acquired at a discount may be entitled to a tax concession if certain conditions are met: s 83A-35(1) The maximum concession is $1,000, except where the total discount on the ESS interest is less than $1,000, where the concession is reduced to the amount of the discount under s 83A-35(2). The tax concession is subject to an income test, which limits the concession to employees whose adjusted income does not exceed $180,000. Adjusted income is the sum of the taxpayer’s taxable income, reportable fringe benefits total (see [59 200]), reportable superannuation contributions (see [39 140]) and total net investment loss (see [19 160]) for the income year. The conditions to be met for the tax concession to apply are: © 2017 THOMSON REUTERS

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• the employee must be employed by the ESS company or a subsidiary of the company: former s 83A-35(3), s 83A-45(1); • the ESS interest offered must relate to ordinary shares: former s 83A-35(4), s 83A-45(2). An interest in a corporate limited partnership is treated as an ordinary share for these purposes if the interest does not give the holder preferential rights with respect to distributions out of profits or capital, or on winding up of the limited partnership (see ATO ID 2010/62); • the ESS company must not be predominantly in the business of acquiring, selling or holding shares, securities or other investments: former s 83A-35(5), s 83A-45(3); • the ESS must be operated on a non-discriminatory basis in relation to at least 75% of Australian resident permanent employees with at least 3 years of service (whether continuous or not): s 83A-35(6); • the ESS interest offered must not be at real risk of forfeiture or loss under the scheme conditions (see [4 200]): s 83A-35(7); • the ESS must be operated so that the employee is not allowed to dispose of the ESS interest for at least 3 years after acquiring the ESS interest, unless the employee ceases to be employed by the employer at an earlier time: former s 83A-35(8), s 83A-45(4)-(5) – the 2015-16 Budget contained a proposal to give the Commissioner a discretion in relation to the minimum 3-year holding period where circumstances beyond the employee’s control make it impossible to meet this criterion (applicable from 1 July 2015): and • the ESS interest does not result in the employee holding a beneficial interest in more than 5% of the shares in the ESS company, or controlling more than 5% of the votes at a general meeting of the company: former s 83A-35(9). The 5% threshold is doubled to 10% for ESS interests acquired on or after 1 July 2015: s 83A-45(6). In determining the employee’s effective ownership and voting rights, the employee must take into account the holdings they could obtain by exercising rights they have over shares in their employer (regardless of whether those rights are ESS interests acquired under an ESS or not) and the holdings of their associates: ss 83A-45(7).

Start-up companies The ESS Amendment Act 2015 (see [4 160]) contains measures relating to certain start-up companies. ESS interests acquired on or after 1 July 2015 at a small discount (no more than 15% of market value) by employees of eligible start-up companies are not subject to up-front taxation: s 83A-33. In relation to shares, the discount is not subject to income tax and the share, once acquired, is then subject to CGT with a cost base reset at market value. In relation to rights, the discount is not subject to upfront taxation and the right is then subject to CGT with a cost base equal to the employee’s cost of acquiring the right. A start-up company is one which has an aggregated turnover of not more than $50m, is not listed on the ASX and has been incorporated for less than 10 years. Note that where a share is acquired by exercising a right that was an ESS interest subject to the start-up concession, the time of acquisition for CGT discount purposes is the time at which the right was acquired, and not the time at which the share was acquired: see [14 400]. The temporary and foreign residents CGT concessions (see [4 225]) do not apply in relation to ESS interests subject to the start-up concessions: ss 768-915(2), 768-955(4), 855-45(4). The following changes to the start-up concessions (to apply from 1 July 2015) were announced in the 2015-16 Budget, but were not incorporated in the ESS Amendment Act 2015 (see [4 160]): • eligible venture capital investments will be excluded from the aggregated turnover test and grouping rules in relation to the start-up concessions; and 84

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[4 190]

• the CGT discount will apply to ESS interests that are subject to the start-up concession, where options are converted into shares which are sold within 12 months of the exercise of the option.

[4 190] Deferred taxation Taxation of the ESS interest is deferred (and the discount is not taxed upfront) in the situations set out in s 83A-105. Note that deferred taxation does not apply to ESS interests issued by certain start-up companies: see [4 180]. If the ESS interest is a beneficial interest in a share, deferred taxation applies if: • at least 75% of Australian resident permanent employees of the company with at least 3 years of service (whether continuous or not) are, or have been, entitled to acquire ESS interests under the scheme, or ESS interests in the employer company or its holding company (if any) under another scheme (s 83A-105(2)); and • there is a real risk, under the conditions of the ESS, of the ESS interest being forfeited or lost (other than by disposing of it) or the ESS interest was acquired under a salary sacrifice arrangement, the discount equals the market value of the ESS interest at the time of acquisition and the total market value of ESS interests acquired by the taxpayer during the year in the employer company and its holding company (if any) does not exceed $5,000 (s 83A-105(3)-(4)). If the ESS interest is a beneficial interest in a right to acquire a beneficial interest in a share, deferred taxation applies if there is a real risk, under the conditions of the ESS, of the ESS interest being forfeited or lost (other than by disposing of it, exercising the right or letting the right lapse) or, if the right is exercised, there is a real risk, under the conditions of the ESS, of the beneficial interest in the share being forfeited or lost (other than by disposing of it) (s 83A-105(3)). The Tax Office considers that, for there to be a real risk of forfeiture, a reasonable person must consider that there is an actual possibility of forfeiture and the risk must be genuine and not nominal, artificial or contrived (see ATO ID 2010/61). In all cases, the conditions set out in former s 83A-35(3), (4), (5) and (9) or (for ESS interests acquired on or after 1 July 2015) s 83A-45(1), (2), (3) and (4) must also be satisfied. These conditions relate to the taxpayer’s employment, the type of shares available under the ESS, the type of business the ESS company cannot be carrying on and the taxpayer’s shareholding and voting power in the ESS company (see [4 180]). Deferral of tax will be denied if an ESS is contrived to present an appearance of the risk of forfeiture, outside the purpose of the ESS rules. Under amendments made by the Tax and Superannuation Laws Amendment (Employee Share Schemes) Act 2015, deferred taxation is also available to an ESS interest acquired on or after 1 July 2015 that is a beneficial interest in a right to acquire a beneficial interest in a share where (s 83A-105(6)): • the relevant scheme is a scheme in which employees can access ESS interests that are rights; • the scheme genuinely restricts the employee immediately disposing of those rights; and • the scheme rules expressly state that the scheme is subject to deferred taxation.

Amount included in assessable income If taxation is deferred, an amount is to be included in assessable income for the income year in which the ESS deferred taxing point occurs (see below). The amount to be included is the market value of the ESS interest at the deferred taxing point, reduced by the cost base of the ESS interest: s 83A-110(1). The ordinary meaning of market value is used to determine © 2017 THOMSON REUTERS

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the value of ESS interests, but this value may be affected by Subdiv 960-S ITAA 1997 (see [3 210]). An alternative method of valuation specified in the ITA Regs may also be used: see [4 180]. The cost base includes not only the consideration paid or given for the ESS interest, but also incidental costs such as brokerage fees and stamp duty and holding costs. The cost base also takes into account such events as value shifting and a reduction of capital. Cost base issues are discussed in Chapter 14. The market value substitution rules in ss 112-20 and 116-30 do not apply to ESS interests. An amount included in an employee’s assessable income under s 83A-110(1) is to be treated as derived from a non-Australian source to the extent that it relates to employment outside Australia: s 83A-110(2). In such a situation, the tax position will depend on the employee’s resident status and the source of the income. Note that, for the purposes of the income tax law (eg for CGT purposes), the ESS interest (and the share or right of which it forms part) is taken to have been acquired immediately after the deferred taxing point for its market value, unless the taxing point occurs at the time the interest is disposed of: s 83A-125.

Deferred taxing point for shares If the ESS interest is a beneficial interest in a share, the deferred taxing point is the earliest of (s 83A-115(2)): (a) the time when there is no real risk that the interest will be forfeited or lost (other than by disposing of it) and there are no longer any genuine restrictions on the taxpayer immediately disposing of the interest; (b) the time when the employment in respect of which the interest was acquired ends; and (c) 7 years after the taxpayer acquired the interest (extended to 15 years for ESS interests acquired on or after 1 July 2015: see [4 180]). However, if the taxpayer disposes of the interest within 30 days of the earliest deferred taxing point, the time of disposal becomes the deferred taxing point: s 83A-115(3). An employee ceases employment when no longer employed by the employer, a holding company or subsidiary of the employer or another subsidiary of the holding company: s 83A-330.

Deferred taxing point for rights to acquire shares If the ESS interest is a beneficial interest in a right to acquire a beneficial interest in a share, the deferred taxing point is the earliest of (s 83A-120(2), (4)-(7)): (a) the time when there is no real risk that the interest will be forfeited or lost (other than by disposing of it, exercising the right or letting the right lapse) and there are no longer any genuine restrictions on the taxpayer immediately disposing of the interest; (b) the time when the employment in respect of which the interest was acquired ends; (c) 7 years after the taxpayer acquired the interest (extended to 15 years for ESS interests acquired on or after 1 July 2015: see [4 180]); and (d) the time when there are no longer any genuine restrictions on the exercise of the right, or on the resulting shares being disposed of (such as by sale), and there is no real risk of the right or underlying share being forfeited or lost (other than by disposing of it, exercising the right or letting the right lapse) – for ESS interests acquired on or after 1 July 2015, this alternative applies when an employee exercises the right (rather than when the employee can exercise the right) and, after 86

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exercising the right, there is no real risk of forfeiture of the underlying share and the restrictions on sale of the share are lifted. However, if the taxpayer disposes of the interest within 30 days of the earliest deferred taxing point, the time of disposal becomes the deferred taxing point: s 83A-120(3).

[4 200] Real risk of forfeiture or loss The concept of a real risk of forfeiture or loss means that there must be some risk which is more than a mere possibility. There is a real risk if a reasonable person would regard the risk as likely to occur, not a rare eventuality or possibility. Real risk includes situations where a share or right is subject to reasonable performance targets, or to the completion of a minimum term of employment. However, according to the Explanatory Memorandum to the 2009 Budget Measures No 2 Act, a condition that merely restricts an employee from disposing of an ESS interest for a specified time will not carry a real risk of forfeiture. [4 210] Takeovers and restructures There are provisions to ensure that taxpayers are not adversely affected by takeovers and restructures that affect ESS interests. Section 83A-130 allows the Div 83A rules to continue to apply to employees who have deferred tax by means of a roll-over of the ESS deferred taxing point if the original company becomes a subsidiary of another company, or if the interests in the original company are replaced by interests in one or more other companies. A taxing point will still arise at the earliest taxing point as worked out under the rules discussed at [4 190]. Interests in the new company acquired as a result of the takeover or restructure are treated as a continuation of the original ESS interests, provided that the taxpayer stops holding the old interests and the new interests (which must be ordinary shares or rights over ordinary shares) can be regarded as matching the old interests. The taxpayer is not entitled to receive any additional benefit from the takeover or restructure. The value of the new shares or rights should match the value of the old shares or rights. If the new interests are not treated under s 83A-130(2) as a continuation of the old interests, there is a disposal of the old interests for the purposes of s 83A-130(5). Employment by the new company, any of its subsidiaries, its holding company, or other subsidiaries of its holding company is regarded as a continuation of employment for the purposes of the ESS. Any cost base of the original ESS interests may be apportioned over the matching ESS interests according to their market values immediately after the corporate restructure. This enables the calculation of the discount to be taxed for those interests subject to the roll-over and those not subject to the roll-over. Section 83A-130 only applies to those employees who are continuing employees, and to those employees who do not hold a beneficial interest in more than 5% of the shares in the new company, or control the voting power of more than 5% of the votes that might be cast at a general meeting of the new company. The 5% threshold has been extended to 10% for ESS interests acquired on or after 1 July 2015: see [4 180]. [4 220] Associates and relationships similar to employment Section 83A-305 deals with the situation where an associate of an individual (other than an employee share trust) acquires an ESS interest resulting from the individual’s employment. The interest acquired by the associate is treated as an acquisition by the individual employee, with the consequence that the employee (not the associate) is taxed on the discount received on the ESS interest and the gain made on any subsequent disposal (see [17 440]). Meaning of ‘‘associate’’ The term ‘‘associate’’, for Div 83A (and other) purposes, has the same meaning as in s 318 ITAA 1936: s 995-1. Under s 318, the categories of persons and entities that are associates of another person or entity (P) include (not all these are relevant for Div 83A purposes): © 2017 THOMSON REUTERS

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• if P is a natural person, a relative – ‘‘relative’’ means a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant, adopted child of P or of her or his spouse, the spouse of P and the spouse of a relative (spouse includes a de facto spouse, including of the same sex: see [19 160] for the definition of ‘‘spouse’’); • a partner (whether P is a natural person, corporation or partnership), the spouse or child of a partner (if the partner is a natural person) or a partnership in which P is a partner (except if P is a partnership); • if P is a partnership, the associate of any partner; • if P is a company, a person or entity if P is sufficiently influenced by that person or entity; • if P is a company, a person or entity that (together with any of their associates) controls more than 50% of the maximum number of votes that may be cast at a general meeting of the company, or any associate of that person or entity; • a company that is sufficiently influenced by P (whether a natural person or a corporation) and/or P’s associate(s); • a company where more than 50% of the maximum number of votes that may be cast at a general meeting of the company is controlled by P (whether a natural person or a corporation) and/or P’s associates; • the trustee of a trust where P (whether a natural person or a corporation) or any associate of P benefits, or is capable of benefiting, under the trust, whether directly or indirectly through interposed entities; or • if P is a trustee, any person who benefits, or is capable of benefiting, under the trust, whether directly or indirectly through interposed entities and any associate of such a person (whether a natural person or a corporation). A company is ‘‘sufficiently influenced’’ by another person or entity if the company, or its directors, are accustomed or under an obligation (formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the person or entity (however those directions, instructions or wishes are communicated).

Relationships similar to employment The Div 83A rules also apply to individuals in a relationship with the company similar to employment, for example directors and other office holders: s 83A-325. As a result, directors and other office holders may participate in the ESS. The rules also cover individuals who are independent contractors to the company. Section 83A-325 contains a comprehensive table setting out the various relationships which are covered by the rules. [4 225] CGT treatment of ESS interests The CGT treatment of shares, rights and stapled securities acquired on or after 1 July 2009 under an ESS is dealt with in Subdiv 130-D ITAA 1997. For the CGT treatment of shares, rights and stapled securities acquired under an ESS before 1 July 2009, see the Australian Tax Handbook 2009 at [16 560]. Exemption from CGT events until discount taxed An ESS interest will be exempt from CGT until the interest has been taxed under the ESS rules. This is subject to an exception for CGT events E4, G1 and K8 that affect the cost base of the ESS interest: s 130-80(1). There is a further exception where CGT event C2 applies on any ‘‘forfeiture’’ of the shares (see below): s 130-80(2). CGT treatment of an ESS interest after taxing point Once the discount on an ESS interest has been taxed under the ESS rules, the ESS interest is taxed under the CGT regime in the same manner as other CGT assets. 88

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[4 225]

For ESS interests that are taxed under the ‘‘upfront’’ method (see [4 180]), the interest (and the share or right of which it forms part) is taken to have been acquired for its market value at the time the taxpayer initially acquired the ESS interest for CGT purposes: s 83A-30. EXAMPLE [4 225.10]

Upfront tax Mackenzie acquires ESS interests in her employer for $3,000. The interests have a market value of $6,000 and therefore she acquires the interests at a $3,000 discount. The scheme is subject to upfront taxation and Mackenzie includes $3,000 in her assessable income under the ESS rules. Mackenzie is taken to have acquired her ESS interests at market value for CGT purposes at the time the ESS interests were acquired by her. As a result, the cost base is reset to $6,000 and any subsequent gains or losses will be recognised under the CGT regime.

On the other hand, for ESS interests that are taxed under the ‘‘deferral’’ method, the ESS interest (and the share or right of which it forms part) is taken to have been reacquired immediately after the ESS deferred taxing point (see [4 190]): s 83A-125. Note that this reacquisition rule for ESS interests taxed under the deferral method also resets the acquisition time to the ‘‘deferred taxing point’’: s 109-60 (Item 11A). This is relevant to an employee’s eligibility for the CGT discount (see [14 390]) on a later disposal of the ESS interests. EXAMPLE [4 225.20]

Deferred tax Eloise acquires shares in her employer for $2,000 under an ESS. The shares have a market value of $3,000, so she acquires the shares at a $1,000 discount. As the ESS meets the conditions for deferral of tax, she is not taxed on the discount until the ESS deferred taxing point occurs. While tax is deferred, any CGT events are generally disregarded. Four years after she acquired the shares, Eloise ceases employment with her employer, triggering the deferred taxing point. The ESS interests now have a market value of $4,000. The ESS rules require her to include the value of the discount and subsequent market gains (current market value less the cost base) in her assessable income ($2,000). At this point, the shares are taken to be reacquired for CGT purposes for their market value of $4,000. Eloise chooses to sell the shares 2 years after the ESS deferred taxing point has occurred, at the market value of $7,000. She will realise a capital gain of $3,000 (ie $7,000 less the cost base of $4,000). She will be able to apply the 50% CGT discount as she has held the shares for more than 12 months from the date of their (re)acquisition.

Employee share trust An employee who acquires an ESS interest through an ‘‘employee share trust’’ (EST) is considered to be ‘‘absolutely entitled’’ to the share or right to which the ESS interest relates from the time they acquire the ESS interest: s 130-85(1) and (2). To achieve this, CGT event E5 (becoming fully entitled to a trust asset: see [13 240]) is brought forward to the employee’s acquisition time. Note that an employee may be treated as absolutely entitled to an interest in an EST, even if that interest does not correspond to particular shares: s 130-100(c). As a result, CGT only applies to the employee, and not to the EST, from the point of time that the share or right is acquired by the employee. However, before that time, the EST will be liable for any capital gains on the shares or rights. Note that, with effect from 1 July 2009, any capital gain or loss made by an EST will be disregarded if it arises as a result of a beneficiary of the trust becoming absolutely entitled to © 2017 THOMSON REUTERS

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an employee share scheme, or as a result of a disposal of an employee share scheme or right to a beneficiary. However, capital gains or losses will not be disregarded if the employee share trust itself makes a cash profit from the transaction. EXAMPLE [4 225.30]

Employee share trust Hegrisad Pty Ltd operates an ESS utilising an employee share trust. The company issues 1,000 Hegrisad Pty Ltd shares with a market value of $5,000 to the employee share trust. Three months later Hegrisad Pty Ltd provides its employee, Arkhip, with ESS interests in 1,000 Hegrisad Pty Ltd shares in the employee share trust for no cost to Arkhip. The shares now have a market value of $5,500, and Arkhip is treated as being absolutely entitled to these shares. Arkhip’s scheme is not eligible for deferred tax and she will be taxed upfront. She is not eligible for the upfront concession. Arkhip becoming absolutely entitled to the shares triggers CGT event E5, resulting in the trustee of the employee share trust being taxed on the $500 of accrued capital gain in the shares. Arkhip will include the value of the discount in her assessable income, ie $5,500. Any further gains or losses on these shares will be recognised as belonging to Arkhip under the CGT regime (unless she forfeits the shares and is eligible for a refund of tax: see below). Note that an ‘‘employee share trust’’ is a trust which obtains ESS interests in a company and provides them on behalf of employers to employees of that company or their associates, or one that carries out activities incidental to the holding and providing of ESS interests: s 130-85(4). See also ATO ID 2010/108.

Shares held to satisfy issued rights to shares Capital gains or losses are disregarded for certain CGT events that occur in relation to shares acquired by an employee share trust to satisfy the future exercise of a right to acquire a share provided under an ESS. The CGT events for which these gains or losses are disregarded are CGT event E5 (beneficiary becoming entitled to a trust asset: see [13 240]) and CGT event E7 (disposal to a beneficiary to end capital interest: see [13 260]): s 130-90(1). However, the gains or losses will not be disregarded if the employee acquires the share for more than its cost base in the hands of the employee share trust: s 130-90(2). Employee share trusts and forfeiture of an interest If an employee is entitled to a refund of tax on the forfeiture of an ESS interest on which the discount has been taxed (see [4 180]), the ESS rules are taken never to have applied: s 83A-310. As a result, previous assessments of the employee and the employee share trust may need to be amended. This also means that the employee will not have been entitled to ESS interests acquired from an employee share trust to which they were previously treated as having been absolutely entitled. Note that if an ESS interest is forfeited, s 116-30 (market value when no capital proceeds: see [14 250]) will not apply: s 130-80(4). This ensures that an employee who pays money to acquire ESS interests will receive a capital loss in respect of this payment if they subsequently forfeit those ESS interests, or lose them other than by disposing of them: s 130-80(2). Associates The ESS rules treat ESS interests provided to associates of employees in relation to an employee’s employment as though the interest was in fact acquired by the employee rather than the associate: s 83A-305. This rule also applies for the purposes of exempting the ESS interests from CGT events during the period of deferred taxation (with certain exceptions). See [4 220] for the definition of ‘‘associate’’. 90

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[4 230]

For these purposes, an employee will also be considered to be absolutely entitled to the relevant share or right if an associate of the employee acquires an ESS interest, related to the employee’s employment, through an employee share trust: s 130-100(b). However, after the employee is taxed under the ESS rules, the associate is considered to be absolutely entitled to the relevant ESS interests. As a result, the CGT regime will recognise any further gains or losses as belonging to the associate: s 130-85(3).

Foreign residents and temporary residents The rules in Subdiv 130-D apply to foreign residents in respect of ESS interests that are ‘‘taxable Australian property’’: see [18 100]. In the case of temporary residents, capital gains realised on such interests which are not taxable Australian property are eligible for the CGT exemption, regardless of whether a taxing point has occurred or not. The former rules in ss 768-920 to 768-940 relating to temporary residents, which apply in relation to ESS interests acquired before 1 July 2009, are discussed in the Australian Tax Handbook 2009 at [16 270]. No CGT consequences for company issuing an ESS interest For the reasons discussed at [17 350] and [17 380], the issue of an ESS interest does not give rise to any CGT implications for the company if the share or right is newly created. Start-up companies Special rules dealing with certain ESS interests acquired on or after 1 July 2015 by employees of eligible start-up companies are considered at [4 180]. [4 230] Deduction for ESS employer The costs incurred by an employer in implementing and administering an ESS that complies with Div 83A are deductible under s 8-1 ITAA 1997: see ATO ID 2014/42. This should also be the case if the scheme does not comply with Div 83A: see [9 1200]. Contributions by a company to the trustee of its employee share trust, to fund the acquisition of shares in the company by the trust, are also deductible under s 8-1: see Private Ruling Authorisation Number 1011345829099. In addition, in order to encourage employers to provide ESS interests to employees, an employer (or the holding company of the employer) can deduct an amount for ESS interests provided to an employee under an ESS if the employee is eligible for the upfront tax concession in s 83A-35 (see [4 180]), disregarding the $180,000 adjusted income threshold: s 83A-205. The amount of the deduction is the amount by which the employee’s assessable income is reduced under s 83A-35 (maximum $1,000: see below). By ignoring the $180,000 adjusted income threshold for the purposes of the deduction, an employer (or its holding company) can still get a deduction even if the employee does not qualify for the tax concession because his or her adjusted income exceeds $180,000. The maximum deduction in respect of each employee is $1,000, the maximum amount by which an employee may reduce the discount on the ESS interest that is included in her or his assessable income. Two or more employers jointly providing an ESS interest can apportion the deduction on a reasonable basis. Although not clearly worded, s 83A-210 delays the deduction until the employee actually acquires the ESS interest, thus preventing an employer from artificially bringing forward deductions by means of an arrangement using an employee share trust or some other medium. In ATO ID 2010/103, s 83A-210 applied to determine the timing of a deduction for money provided to an employee share trust, but only in respect of the amount of money provided to purchase shares in excess of the number required to meet obligations arising in the particular income year from the grant of options. See also Private Ruling Authorisation Number 1011345829099, where s 83A-210 applied in relation to cash contributions made to an employee share trust before the acquisition of the relevant ESS interests. Note that if under an employee share scheme an employee is granted a right to acquire a share from an employee share trust, which requires the employee to pay an amount (the © 2017 THOMSON REUTERS

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exercise price) to the employer, the amount paid by the employee to the employer is assessable income of the employer under section 6-5: see ATO ID 2010/155.

[4 240] Forfeiture of ESS interests An employee is entitled to a refund of tax paid in relation to the discount on forfeited shares and rights provided that the forfeiture did not result from a choice of the employee (with exceptions) or from a condition of the ESS which protects the employee against a fall in market value of the ESS interests: s 83A-310(1). The employee may claim a refund of tax by applying to amend their income tax assessment by removing income (the discount) previously returned as assessable income. The Commissioner can amend an assessment relating to an ESS at any time under s 170(10AA) ITAA 1936 (see [47 170]). The requirement that the forfeiture did not result from a choice of the employee does not extend to a choice to cease the particular employment or (in relation to ESS interests acquired on or after 1 July 2015 where the ESS interest is a beneficial interest in a right) a choice not to exercise the right before it lapsed or a choice to allow the right to be cancelled: s 83A-310(2). In other words, a refund of tax will still be available in those situations. Transitional provisions Transitional provisions have also been included to ensure the introduction of the Div 83A rules does not affect an employee’s eligibility for a refund in respect of rights they acquired before 1 July 2009. Employees may claim a refund of tax paid on the right, if they forfeit the right and a refund would have been available under the rules applying at the time that they acquired the right: s 83A-5(4) TPA. [4 250] ESS reporting by employer Division 392 in Sch 1 TAA provides for a reporting regime by companies which issue ESS interests (called the provider). Each financial year, a provider must give statements to the Commissioner and to each individual member of an ESS containing information about ESS interests provided during the year. The statements must be in the approved form in terms of s 392-5(3). The information to be provided may include, but is not limited to, the provider’s ABN, the individual’s full name, address and TFN, the individual’s ABN if services are provided for acquisition of ESS interests and details of the interests provided. The statements must be given to each individual by 14 July after the end of the financial year, and to the Commissioner by 14 August after the end of the financial year. [4 260] TFN withholding tax (ESS) TFN withholding tax (ESS) is payable under Subdiv 14-C in Sch 1 TAA if an employer has provided discounted shares or rights to an employee and the employee does not quote a TFN or, in the case of an independent contractor (see [4 220]), an ABN by the end of the income year: s 14-155. The rate of withholding tax for 2016-17 is 49% of the amount included in the employee’s assessable income under Div 83A (the withholding tax is imposed by the Income Tax (TFN Withholding Tax (ESS)) Act 2009). The requirement to withhold TFN withholding tax does not apply to transitioned ESS interests (ie shares and rights acquired before 1 July 2009 that are covered by the Div 83A rules: see [4 160]).

EMPLOYMENT TERMINATION PAYMENTS [4 300] Employment termination payments An employment termination payment (ETP) is a lump sum payment made in consequence of the termination of a person’s employment or office (including the cessation of employment because of death): s 82-130 ITAA 1997. Whether an ETP is made ‘‘in consequence’’ of the termination of a person’s employment is considered at [4 320]. 92

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[4 300]

An ETP received by a taxpayer whose employment is terminated is a ‘‘life benefit termination payment’’ (see Subdiv 82-A ITAA 1997), whereas an ETP received by the taxpayer after another person’s death in consequence of the termination of the other person’s employment is a death benefit termination payment (see Subdiv 82-B ITAA 1997). A ‘‘golden handshake’’ is a common example of a life benefit ETP. Other examples are genuine redundancy (see [4 400]) and early retirement scheme payments (see [4 410]) in excess of the tax-free amount, amounts in lieu of notice, amounts for unused rostered days off, testimonial payments and settlements of legal disputes with an employer. The characterisation of an employment-related payment is crucial since the tax consequences that result can vary substantially depending on the nature of the payment. Note that an employee cannot roll over an employer ETP to superannuation.

Excluded payments The following payments are not ETPs (s 82-135): • superannuation benefits: see [40 050]; • payments from a pension or an annuity (to exclude from these provisions an income stream which may be paid by an employer); • unused annual leave payments or unused long service leave payments: see [4 420]; • the tax-free part of a genuine redundancy payment (see [4 400]) or an early retirement scheme payment: see [4 410]; • foreign termination payments: see [4 440]; • a payment (or part of one) made by a company or trust as mentioned in s 152-310(2) (ie a payment in respect of a capital gain disregarded under the small business CGT retirement exemption: see [15 580]); • advances or loans on arm’s length terms; • a deemed dividend under the ITAA 1997 (eg a payment to a shareholder or an associate deemed to be a dividend under Div 7A (see [21 250]) or an excessive payment to a shareholder, director or an associate: see [21 360]); • reasonable capital payments for personal injury in so far as the payment is reasonable having regard to the nature of the personal injury and its likely effect on the person’s capacity to derive income from personal exertion; • reasonable capital payments for restraint of trade; • payments resulting from the commutation of a superannuation income stream that are wholly applied in paying any superannuation contributions surcharge; and • employee share scheme amounts included the taxpayer’s assessable income.

Capital payments for personal injury Capital payments for, or in respect of, personal injury to a taxpayer are not ETPs, insofar as the payment is reasonable having regard to the nature of the personal injury and its likely effect on the taxpayer’s capacity to ‘‘derive income from personal exertion’’ (within the meaning of that term in s 6(1) ITAA 1936). Such a payment may instead be classified as a non-assessable capital amount that is also exempt from CGT under s 118-37 ITAA 1997 (see [15 100]). Personal injury encompasses injury or disease of a physical or psychological nature (including anxiety and depression) but does not extend to anguish, distress or embarrassment: FCT v Scully (2000) 43 ATR 718; Dibb v FCT (2003) 53 ATR 290. Unlike the ‘‘invalidity segment’’ of an ETP under s 82-150 (see [4 350]), the reference to the taxpayer’s capacity to © 2017 THOMSON REUTERS

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derive income from personal exertion in s 82-135(i) is not limited by the nature of the employment for which the taxpayer was reasonably qualified. Importantly, to exclude all or part of an amount from a settlement payment under s 82-135(i), there must be an identifiable amount which has been calculated in respect of the personal injury that is capable of being dissected from the total settlement sum under the principle in McLaurin v FCT (1961) 104 CLR 381; Dibb v FCT (2004) 55 ATR 786. In Re Employee and FCT (2010) 80 ATR 999, the AAT rejected a taxpayer’s argument that a settlement payment for alleged age discrimination was a capital payment in respect of personal injury. The AAT noted that the settlement amount was a single, undissected lump sum with no attribution of any portion of it to any of the various heads of relief claimed by the taxpayer. The AAT also rejected the taxpayer’s argument that the settlement payment was a CGT exempt capital gain covered by s 118-37 ITAA 1997 (see [15 100]).

Legal costs Ruling TR 2012/8 considers whether amounts received in respect of legal costs incurred in a dispute concerning the termination of employment can be included in assessable income, either as an ETP or an assessable recoupment (see [6 580]). Whether such legal costs are deductible is considered at [9 650]-[9 660]. Transitional arrangements for entitlements as at 9 May 2006 Transitional arrangements applied if a person was entitled, as at 9 May 2006, to a life benefit termination payment under a written contract, a Commonwealth, State, Territory or foreign law, an instrument under such a law or a workplace agreement, and the payment was made before 1 July 2012: Div 82 TPA. Such a payment was called a transitional termination payment: s 82-10 TPA. For further information about the transitional arrangements, see the Australian Tax Handbook 2015 at [4 360]. [4 310] 12-month rule To qualify as a life benefit termination payment, it must be received no later than 12 months after the termination: s 82-130(1)(b). However, the Commissioner may relax the 12-month rule if he considers the time between the employment termination and the payment is reasonable: s 82-130(4) – (8). In this respect, the Commissioner has issued a determination providing an exemption from the 12-month rule if there is a legal dispute in relation to the termination, provided it is commenced within 12 months of the termination: see Employment Termination Payments (12 month rule) Legislative Instrument 2007. See also the Employment Termination Payments Redundancy (12 month rule) Determination 2009. If an ETP is not made within 12 months of the employment termination, it may be included in the assessable income of the taxpayer and taxed at marginal rates or potentially be treated as a tax-free payment where it is of a capital nature. [4 320] Relationship between payment and termination of employment The essential character of an ETP is that it must have arisen ‘‘in consequence of’’ the termination of a person’s employment: s 82-130(1)(a)(i). That is, the receipt of the payment must have ‘‘followed on’’ from the termination of employment. Alternatively, if an amount is not regarded as an ETP, it may be included in the individual’s assessable income or potentially treated as a tax-free payment if it is of a capital nature. This concept of there being a ‘‘following on’’ was clearly affirmed by the High Court in Reseck v FCT (1975) 5 ATR 538. Although there must be some nexus between the termination and the payment, the termination does not need to be the dominant cause of the payment: McIntosh v FCT (1979) 10 ATR 13. As a result, the definition of an ETP is broad enough to capture most payments from an employer surrounding the termination of employment. Since Reseck and McIntosh, the definition has been considered in a number of other cases, including Le Grand v FCT (2002) 51 ATR 139 and Dibb v FCT (2004) 55 ATR 786. 94

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[4 320]

These cases make it clear that the termination of employment need not be the dominant cause of the payment, it need only be one of several causes. Ruling TR 2003/13 outlines the Tax Office’s views on the phrase ‘‘in consequence of’’ in the context of the termination of employment under (repealed) s 27A(1) ITAA 1936. Although the Tax Office adopts the key principles established in Reseck and McIntosh, it acknowledges that divergent views as to the correct interpretation of the phrase have been expressed in several cases. The Tax Office prefers the narrower view, namely, that there must be a causal connection in the sense that the payment follows as an effect or result of the termination of employment. That is, but for the termination of employment the payment would not have been made to the taxpayer. The alternative broader view, not accepted by the Tax Office, is that the termination must either be a cause of the payment or an antecedent event; see also Paklan Pty Ltd (in liq) v FCT (1983) 14 ATR 457. If at the time of termination the taxpayer has the right to commute a pension to a lump sum amount at a later date, the subsequent exercise of that right will be considered to be in consequence of the termination of employment: Ruling TR 2003/13. In Dibb v FCT (2004) 55 ATR 786, the Full Federal Court held that a payment received under a deed of release following the settlement of legal proceedings against the taxpayer’s former employer was made in consequence of the termination of employment. However, in Advanced Prosthetic Centre Pty Ltd v Appliance & Limb Centre (Int) Pty Ltd (2002) 53 ATR 331, payments by an employer to former employees (who were also shareholders) were held not to be ETPs. While the court considered that the terminations could not be completely excluded from the causative circumstances leading to the payments, it held that their part in the outcome was too distant and attenuated for the payments to be characterised as ETPs. In Forrest v FCT (2010) 78 ATR 417, the Full Federal Court ruled that a $3.5m donation to a charitable trust by the taxpayer’s employer upon his resignation as CEO was made in consequence of the termination of his employment and, therefore, was an ETP. However, the Full Court reduced to nil the 50% penalty imposed by the Commissioner for recklessness (see [54 070]) after ruling that the taxpayer’s accountant was not ‘‘grossly careless’’ in taking a view (albeit wrong) that the donation was a pre-existing obligation to resolve the battle for control of the company of which the taxpayer was a minority shareholder. Lump sum payments made to former Qantas pilots under a ‘‘loss of licence insurance’’ scheme if they lost their pilots’ licences for medical reasons were assessable to the pilots as ETPs in Bond v FCT [2015] FCA 245; Purvis v FCT [2015] FCA 246; Kentish v FCT [2015] FCA 247 (the cases were heard together). The term ‘‘employment’’ is defined to include the holding of an office: s 80-5. In AAT Case 5066 (1989) 20 ATR 3509 it was held that a minister of religion held an office for the purpose of this provision. See also AAT Tribunal Case 61 (1987) 18 ATR 3433. The most common example of a payment falling within this limb of the definition of an ETP is what is often referred to as a ‘‘golden handshake’’. A payment in lieu of notice to terminate employment will also qualify, but payment of salary referable to work undertaken while serving out a period of notice will not: Determination TD 94/62. If a reorganisation of a company group occurs and employees of a company ceasing to carry on business are transferred to another group company, a termination of employment with the first company has nevertheless occurred and any payment made in consequence may qualify as an ETP: Determination TD 93/140. However, in Re Taxpayer and FCT (2006) 65 ATR 415, the AAT held there was no termination of employment at the time a taxpayer transferred from the United Kingdom to her Australian position nor when she subsequently accepted new employment arrangements within the group of companies. The payment does not necessarily have to come from the employer to qualify as an ETP. Payments received from a testimonial function may qualify, provided the necessary relationship to the termination of employment exists. © 2017 THOMSON REUTERS

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An ETP is taxed in the year in which it is received, even if, as in Re Hannavy and FCT (2001) 47 ATR 1018, the payment included an amount in substitution for wages normally payable in the next financial year. A transfer of non-cash property for the benefit of a person is deemed to be a payment equal to the value of the property immediately before the transfer (less any consideration provided): s 80-15.

Payments for unlawful dismissal Doubt surrounds the correct treatment of payments for wrongful or unlawful dismissal. Two issues arise. First, whether the payment can be said to be in consequence of termination of employment and hence prima facie an ETP. Second, whether the exclusion for consideration of a capital nature in respect of personal injury to the taxpayer applies: see [4 300]. On the first issue, the Tax Office takes the view in Ruling IT 2424 that such a payment is in consequence of termination and is therefore an ETP. Patterson v Middle Harbour Yacht Club (1996) 32 ATR 603 takes the same view (where an amount awarded as compensation for wrongful dismissal was grossed-up to reflect tax payable on the award as an ETP), although contrary arguments exist. In Le Grand v FCT (2002) 51 ATR 139, a settlement payment in relation to legal proceedings involving a wrongful dismissal claim, together with a claim for misleading and deceptive conduct, was held to be made in consequence of the termination of employment. The court considered that the settlement of the misleading and deceptive conduct component of the claim did not break the casual relationship that existed between the settlement payment and the termination of the taxpayer’s employment. Relying on the precedent in Le Grand, the Tax Office takes the view that when a payment is made to settle a claim brought by a taxpayer for wrongful dismissal or claims of a similar nature that arise as a result of an employer terminating the employment of the taxpayer, the payment will have a sufficient causal connection with the termination of employment. As such, the Tax Office considers that the payment will be taken to have been made in consequence of the termination of employment because it would not have been made but for the termination: Ruling TR 2003/13. The approach taken in Le Grand was also adopted in Dibb v FCT (2004) 55 ATR 786. See also Re McMahon and FCT (1999) 41 ATR 1056; Re Applicant and FCT (2005) 59 ATR 1161. A taxpayer may also be entitled to a tax deduction for legal expenses incurred in respect of an ETP: see [9 660].

[4 330]

Taxation of life benefit employment termination payments

Employment termination payments are only taxed on 2 components, the tax-free component (s 82-140) and the taxable component: s 82-145.

Tax-free component The tax-free component comprises any ‘‘pre-July 83 segment’’ (see [4 340]) and ‘‘invalidity segment’’ (defined in s 82-150 where the person has stopped being gainfully employed because he or she suffered from physical or mental ill-health: see [4 350]). The tax-free component is treated as non-assessable non-exempt income (see [7 700]) which is not counted in working out the tax payable on a taxpayer’s other assessable income.

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[4 330]

Taxable component The taxable component is determined by subtracting any tax-free component from the total value of the life benefit ETP: s 82-145. The taxable component is included in the taxpayer’s assessable income, but a tax offset under (s 82-10) effectively limits the maximum applicable tax rate as outlined in the following table. Age1 of recipient 556+

Tax-free component Tax free7

0-546

Tax free7

Life benefit ETP – 2016-17 Taxable component2, 3, 4, 5 15% – $0-$195,000 47% – $195,001+ 30% – $0-$195,000 47% – $195,001+

1 Age is determined on the last day of the income year in which the person receives the payment. 2 The entire taxable component of the life benefit termination payment is included in the taxpayer’s assessable income and a tax offset applies to effectively cap the maximum tax rate. Medicare levy of 2% may also be payable if a tax rate greater than 0% applies. 3 Life benefit termination payments are subject to a ‘‘whole of income cap’’ of $180,000: see below. 4 The ETP cap amount is indexed annually, but only in $5,000 increments: see [4 370]. 5 The 47% rate reverts to 45% from 2017-18. 6 Preservation age of 55 phasing to age 60 for those born after 1 July 1960: see [40 020]. 7 Non-assessable non-exempt income (ie not counted in working out tax payable on taxpayer’s other assessable income): see [7 700]. If taxable income includes an ETP above the individual’s ‘‘ETP cap amount’’, taxable income is split between ordinary taxable income and the ‘‘employment termination remainder’’ of the taxable income: s 3 Income Tax Rates Act 1986. The ordinary taxable income is taxed in the same manner as if it were the only taxable income and the employment termination remainder of the taxable income is taxed separately at the top marginal rate under Pt I, Sch 7 of Income Tax Rates Act 1986. In FCT v Boyn (2013) 92 ATR 533, the Federal Court decided that the Commissioner was not required to allocate all available deductions (including prior year losses) in the manner that was most favourable to the taxpayer, ie by first offsetting the deductions and prior year losses against the employment termination remainder, with the balance to be offset against the ETP cap amount. The AAT had reached a different conclusion in Re Boyn and FCT (2012) 90 ATR 942. Note that an employee cannot roll over an employer ETP to superannuation. The taxable component of an ETP is only included in a foreign resident’s assessable income if it has an Australian source and Div 82 ITAA 1997 does not apply to include it in the foreign resident’s assessable income on some basis other than it having an Australian source: see ATO ID 2010/111.

‘‘Whole-of-income cap’’ The amount of an ETP that attracts the ETP tax offset is dependent on an individual’s total taxable income (including the ETP) in the year they receive an ETP. The part of a taxable component of an ETP that, when added last to an individual’s other taxable income, is equal to or below a ‘‘whole-of-income cap’’ of $180,000 will continue to be eligible for the ETP tax offset. Any amount of a taxable component of an ETP that takes a person’s total taxable income over $180,000 will be taxed at marginal rates. Note that the $180,000 whole-of-income cap is not indexed. © 2017 THOMSON REUTERS

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The indexed ETP cap ($195,000 for 2016-17) works in conjunction with the whole-of-income cap so that, regardless of other taxable income, the offset is only available for ETP amounts up to a maximum of the ETP cap amount. EXAMPLE [4 330.10] Elena retired from her job as a civil engineer with Traffic Pty Ltd in September 2016 at age 63. Traffic Pty Ltd paid Elena $60,000 in leave entitlements as a lump sum and $60,000 in salary and wages during the income year in which her employment ended. In addition, Elena’s employer paid her an ETP of $100,000 in the form of a golden handshake in recognition of her lifelong contribution to the business. This ETP comprises a taxable component of $80,000 and a tax free component of $20,000 (relating to service before July 1983). Her employment termination does not meet the criteria of a genuine redundancy. Elena’s ETP is a non-excluded ETP so that the lesser of her 2 caps (ie the whole-of-income cap) is applied. As the ETP is not a genuine redundancy, Traffic Pty Ltd will classify the payment as a ‘‘golden handshake’’. Using the following steps, Traffic Pty Ltd works out which cap to apply and the withholding rate: Step 1: Add up all taxable payments (excluding the ETP) received by Elena during the income year = $60,000 + $60,000 = $120,000. Step 2: Subtract the Step 1 amount of $120,000 from the $180,000 whole-of-income cap (not indexed) = $60,000 (ie the calculated whole-of-income cap). Step 3: Elena’s $60,000 calculated whole-of-income cap (in Step 2) is less than her ETP cap amount ($195,000) so that this $60,000 calculated whole-of-income cap applies to her life benefit ETP. Step 4: As Elena had reached her preservation age, Traffic Pty Ltd withholds at the rate of 17% (ie 15% plus Medicare levy) from the $60,000 calculated whole-of-income cap (in Step 2) = $60,000 × 17% = $10,200. Step 5: For the remaining $20,000 taxable component over the calculated whole-ofincome cap (ie $80,000 taxable component of the ETP less $60,000), Traffic Pty Ltd withholds at the rate of 49% (ie the top marginal rate plus Medicare levy) = $20,000 × 49% = $9,800. Step 6: Therefore, from the total ETP amount of $100,000 to be paid to Elena, Traffic Pty Ltd will withhold $20,000 (ie $10,200 + $9,800), leaving $80,000 to be paid to Elena.

The whole-of-income cap does not apply to those who: • receive a genuine redundancy payment (or who would have but for existing age or retirement restrictions on genuine redundancy payments); • lose their job due to invalidity (regardless of how close to retirement); • receive compensation due to a genuine employment related dispute relating to personal injury, harassment, discrimination or unfair dismissal (where the payment is currently considered an ETP); or • receive a non-superannuation death benefit ETP.

[4 340] Pre-July 83 segment An ETP includes a ‘‘pre-July 83 segment’’ if any of the employment to which the payment relates occurred before 1 July 1983: s 82-155. Any pre-July 83 segment is worked out under s 82-155(2) as follows: Step 1: Subtract any invalidity segment (see [4 350]) from the ETP. Step 2: Multiply the amount at step 1 by the fraction: Number of days of employment to which the payment relates that occurred before 1 July 1983 Total number of days of employment to which the payment relates

[4 350] Invalidity segment An ETP includes an ‘‘invalidity segment’’ under s 82-150 if: 98

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[4 380]

• the payment was made to a person because he or she stops being ‘‘gainfully employed’’; and • the person stopped being gainfully employed because he or she suffered from ill-health (whether physical or mental); and • the gainful employment stopped before the person’s last retirement day; and • 2 legally qualified medical practitioners have certified that, because of the ill-health, it is unlikely that the person can ever be gainfully employed in capacity for which he or she is reasonably qualified because of education, experience or training. Amount of ETP ×

Days to retirement Employment days + Days to retirement

if: days to retirement is the number of days from the day on which the person’s employment was terminated to the ‘‘last retirement day’’ (ie the day on which he or she would turn 65, unless an earlier age or period of service applies in respect of an individual’s particular employment or office: s 995-1). employment days is the number of days of employment to which the payment relates. The medical certificate requirements for an invalidity segment are essentially the same as those required for a ‘‘disability superannuation benefit’’ under s 995-1: see [40 220]. In Re Sills and FCT (2010) 80 ATR 908, the medical certificates supplied by a medically discharged police officer were held to satisfy the requirements for an invalidity segment under s 82-150(1)(d). The AAT rejected the Commissioner’s argument that the medical certificates did not properly address the capacity of the taxpayer to be employed, his qualifications, training and other relevant factors which the Commissioner had claimed were mandatory considerations. Rather, the AAT said that the certification under s 82-150(1)(d) reposes in the medical practitioners, and not the Commissioner (or the AAT). See also FCT v Pitcher (2005) 60 ATR 424.

[4 370] Concessional ETP cap amount The ‘‘ETP cap amount’’ under s 82-160 applies in respect of life benefit termination payments received in an earlier income year for the same employment. As a result, splitting the payment over 2 income years (but still within 12 months of termination) will not work to effectively double the ETP cap amount. The ETP cap amount for life benefit and death benefit ETPs operate independently from each other. Life benefit ETPs will not count towards the death benefit ETP concessional cap, nor will death benefits count towards the life benefit concessional cap. The cap on concessionally taxed ETPs for 2016-17 is $195,000: s 82-160. This concessional cap is indexed annually, but only increases in $5,000 increments: s 960-285. The death benefit ETP concessional cap applies to any death benefit ETPs payable for the same employment termination. No life benefit ETPs are included in the death benefit concessional cap.

[4 380]

Death benefit employment termination payments

If a death benefit payment is made from the deceased’s employer (rather than via a superannuation fund), the tax consequences of such a payment are governed by Subdiv 82-B ITAA 1997. © 2017 THOMSON REUTERS

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The taxable component of a death benefit termination payment paid to a ‘‘death benefits dependant’’ (see [40 360]) is tax free up to the recipient’s concessional ETP cap amount ($195,000: see [4 370]): s 82-70(1). The remainder of the taxable amount (if any) is taxed at the top marginal rate plus Medicare levy. The taxable component of a death benefit termination payment paid to a non-dependant that is within the recipient’s ETP cap amount is included in assessable income but a tax offset applies to effectively limit the maximum tax rate to 30% plus Medicare levy: s 82-70(2). The remainder of the taxable component (if any) is taxed at the top marginal rate plus Medicare levy. The ETP cap amount is reduced for each death benefit termination payment received in an earlier income year in respect of the same employment. Any death benefit termination payments are not counted towards the life benefit ETP cap amount (see [4 370]) and vice versa. Recipient of death benefit Dependant1 Non-dependant

Death benefit termination payment – 2016-17 Tax-free component Taxable component2, 3, 4 Tax free5 0% – $0-$195,000 47% – $195,001+ Tax free5 30% – $0-$195,000 47% – $195,001+

1 See [40 360] for the definition of a ‘‘death benefits dependant’’. 2 The entire taxable component of the death benefit termination payment is included in the recipient’s assessable income and a tax offset applies to effectively cap the maximum tax rate. Medicare levy of 2% may also be payable if a tax rate greater than 0% applies. 3 The ETP cap amount is indexed annually, but only in $5,000 increments: see [4 370]. 4 The 47% rate reverts to 45% from 2017-18. 5 Non-assessable non-exempt income (ie not counted in working out tax payable on taxpayer’s other assessable income): see [7 700].

Death benefits paid to trustee of deceased estate If a death benefit termination payment is paid to the trustee of a deceased estate for the benefit of another person, the payment is taxed in the hands of the trustee in the same way as it would be taxed if it had been paid directly to the other person: s 82-75. That is, to the extent that one or more beneficiaries of the estate who were ‘‘death benefits dependants’’ (see [40 360]) of the deceased have benefited, or may be expected to benefit from the death benefit termination payment, the payment is deemed to be treated as if it had been made to the trustee as a person who was a dependant of the deceased: s 82-75(2). Likewise, to the extent that a non-dependant of the deceased may be expected to benefit from the payment, the payment is deemed to be treated as if it had been made to the trustee as a person who was not a dependant of the deceased: s 82-75(3). A death benefit termination payment made to the trustee of a deceased estate is taken to be income to which no beneficiary is presently entitled. If an amount is included in the assessable income of a deceased taxpayer under Div 82 ITAA 1997 in respect of a payment received by the trustee of the estate of the deceased taxpayer, that amount is included in the assessable income of that year of income of the trust estate: s 101A(3) ITAA 1936.

OTHER PAYMENTS [4 400] Genuine redundancy payments Payments made to a taxpayer in consequence of her or his dismissal from employment arising out of the genuine redundancy of that taxpayer are received tax free up to the limit imposed by s 83-170 ITAA 1997. The rewritten redundancy provisions in Subdiv 83-C ITAA 100

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[4 400]

1997 are intended to retain the same concessional tax treatment that applied to bona fide redundancy payments under former s 27F ITAA 1936 prior to 1 July 2007: see Australian Tax Handbook 2007 at [9 305]. A ‘‘genuine redundancy payment’’ is so much of a payment received by an employee, who is dismissed from employment because the employee’s position is genuinely redundant, as exceeds the amount that could reasonably be expected to be received by the employee in consequence of the voluntary termination of his or her employment at the time of the dismissal: s 83-175. A payment in lieu of notice may form part of a bona fide redundancy payment if it would not be expected on voluntary termination: Ruling TR 2009/2, para 64. If there is more than one contributing cause to the employee’s dismissal, the redundancy of the relevant position must be the prevailing or most influential reason: see Ruling TR 2009/2. The term ‘‘employment’’ is defined to include the holding of an office: s 80-5. In AAT Case 5066 (1989) 20 ATR 3509 it was held that a minister of religion held an office for the purpose of this provision. See also AAT Tribunal Case 61 (1987) 18 ATR 3433.

Conditions for genuine redundancy payments The 4 necessary components to qualify as a genuine redundancy payment are: 1. the payment being tested must be received ‘‘in consequence of’’ an employee’s termination: see also [4 320]; 2. that termination must involve the employee being dismissed from employment; 3. that dismissal must be caused by the redundancy of the employee’s position; 4. the redundancy payment must be made genuinely because of a redundancy. To qualify as a genuine redundancy payment, all of the following conditions must also be satisfied under s 83-175(2): • the employee must have been dismissed before the day he or she turned 65. If the employee’s employment would have terminated upon reaching a particular age or completing a particular period of service, the employee must have been dismissed before reaching that age or completing that period of service (as appropriate). See also Ruling TR 2009/2 and Ruling IT 2490; • if the dismissal was not at arm’s length, the payment must not exceed the amount that could reasonable be expected to be made if the dismissal was at arm’s length; and • at the time of the dismissal, there was no arrangement between employee and the employer, or between the employer and another person, to employ the employee after the dismissal. In withdrawn ATO ID 2002/144, the Tax Office considered that the conditions for a bona fide redundancy under former s 27F ITAA 1936 was not satisfied where, prior to termination of employment, a taxpayer established a consultancy company which entered into an agreement with the employer to supply the taxpayer’s services as a contractor to the employer. If a payment does not qualify as a genuine redundancy payment, it may instead be taxed as an ETP under s 82-135 ITAA 1997: see [4 300]. An employer may request the Commissioner to issue a legally binding Class Ruling (see [45 120]) confirming the tax treatment of a genuine redundancy payment in relation to a specified class of persons: Class Ruling CR 2001/1 (see [45 120]).

Excluded payments A genuine redundancy payment does not include any part of a payment that was received by the employee in lieu of ‘‘superannuation benefits’’ (see [40 050]) to which the employee may have become entitled at the time of the payment or at a later time. See Ruling IT 2490, Ruling IT 2620 and AAT Case 7211 (1991) 22 ATR 3337. © 2017 THOMSON REUTERS

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In addition, an ETP under s 82-135 ITAA 1997 (apart from s 82-135(e)) is not a genuine redundancy payment: s 83-175. Section 82-135(e) provides that the tax-free amount of a genuine redundancy payment or an early retirement scheme is not an ETP: see [4 300]. A genuine redundancy payment cannot also be an early retirement scheme payment (see [4 410]) because of the nature of each of these types of payments.

Tax-free amount of redundancy payment So much of the genuine redundancy payment that does not exceed the tax-free amount worked out using the following formula in s 83-170(3) is non-assessable non-exempt income (see [7 700]): Base amount + (Service amount × Years of service)

The base amount and service amount are indexed annually in accordance with ss 960-270, 960-275 and 960-280 ITAA 1997. For 2016-17, the ‘‘base amount’’ is $9,936 and the ‘‘service amount’’ is $4,969. ‘‘Years of service’’ means the number of whole years in the period, or sum of periods, of employment to which the payment relates. Any amount in excess of the tax-free amount is taxed as an ETP under s 82-135: see [4 300].

Meaning of ‘‘redundancy’’ and ‘‘dismissal’’ The words ‘‘dismissal’’ and ‘‘redundancy’’ are not defined, but the ordinary meaning of ‘‘dismissal’’ involves a termination by the employer without the employee’s consent. An employee’s position is ‘‘redundant’’ when an employer determines that it is superfluous to the employer’s needs (including where the duties and functions attached to the position are reallocated to another position) and the employer does not want the position to be occupied by anyone. Ruling TR 2009/2 confirms that an employee can be ‘‘dismissed’’ even though he or she has expressed an interest in accepting a redundancy package if the employer, with a view to maintaining industrial harmony, enters into discussions with its employees as to who would like to nominate for a package. In those circumstances, the employer retains ultimate control over whose employment is terminated. Dismissal also includes constructive dismissal if the employee has little option other than resigning. In Dibb v FCT (2004) 55 ATR 786, the Full Federal Court considered that it was more accurate to say that an employee becomes redundant when his or her job (described by references to the duties attached to it) is no longer to be performed by any employee of the employer. The Court also said that an employee is dismissed by reason of her or his bona fide redundancy, if in good faith an employer considers that the employee is not suitable (within the employee’s capacity) to perform any available job existing after the re-allocation of duties, and for that reason dismisses the employee. As pointed out in Weeks v FCT (2012) 88 ATR 183, there is a difference between a situation where an employer no longer requires a job to be done by any employee, and a situation where an employer no longer wants a job to be done by a particular (former) employee. In the latter case, the termination of employment may not be a redundancy (as in Weeks). The taxpayer’s appeal to the Full Federal Court was unanimously dismissed in Weeks v FCT (2013) 88 ATR 368. In Sukumaran v FCT (2000) 44 ATR 538, the Federal Court held that no part of a Tax Office employee’s early retirement package should be taxed concessionally as a bona fide redundancy payment or an approved early retirement scheme payment. A relevant factor in the decision was that the employer (the Tax Office) had an unlimited right to veto the acceptance of applications for early retirement. In Hughes v Loy Yang Power Management Pty Ltd [2010] FMCA 81, the Federal Magistrates Court ruled that a settlement payment for an alleged unlawful termination of employment should be treated as a genuine redundancy payment for withholding tax purposes. 102

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[4 410]

In Re Marriott and FCT (2004) 56 ATR 1265, a termination payment received by a Tax Office employee was held to be neither a payment made in consequence of involuntary dismissal nor a payment made by reason of bona fide redundancy. The termination was not involuntary as the taxpayer initiated and drove the termination process despite a proposed Tax Office restructure. Further, although the taxpayer’s duties would have changed as a result of the workplace restructure, the AAT said he could not claim constructive dismissal as his existing skills and experience were intended to be used in a similar role in the new structure. In Re Cowling and FCT (2006) 64 ATR 1025, there was no redundancy where the taxpayer’s CEO position was filled by another person, albeit on a temporary basis, pending a restructuring of the organisation.

[4 410] Early retirement scheme payments Payments made to an employee due to her or his retirement under an early retirement scheme are received tax free up to the limit imposed by s 83-170 ITAA 1997. The rewritten early retirement scheme provisions in Subdiv 83-C ITAA 1997 are intended to retain the same concessional tax treatment that applied to approved early retirement schemes under former s 27E ITAA 1936 before 1 July 2007: see Australian Tax Handbook 2007 at [9 303]. Early retirement scheme payment An ‘‘early retirement scheme payment’’ is so much of a payment received by an employee because the employee retires under an ‘‘early retirement scheme’’ as exceeds the amount that could reasonably be expected to be received by the employee in consequence of the voluntary termination of her or his employment at the time of the retirement: s 83-180. The term ‘‘employment’’ is defined to include the holding of an office: s 80-5. See also AAT Case 5066 (1989) 20 ATR 3509. If a payment does not qualify as an early retirement scheme payment, it may instead be taxed as an ETP under s 82-135 ITAA 1997: see [4 300]. Conditions for early retirement scheme payments To qualify as an early retirement scheme payment, all of the following conditions must be satisfied under s 83-180(2): • the employee retires before the day he or she turned 65. If the employee’s employment would have terminated when he or she reached an earlier particular age or completed a particular period of service, the employee must have retired before the day he or she would reach that particular age or complete the period of service (as the case may be). See also Ruling IT 2490; • if the retirement was not at arm’s length, the payment must not exceed the amount that could reasonably be expected to be made if the retirement was at arm’s length; and • at the time of the retirement, there was no arrangement between employee and the employer, or between the employer and another person, to employ the employee after the retirement.

Early retirement scheme A scheme is an ‘‘early retirement scheme’’ under s 83-180(3) if: • all the employer’s employees who comprise such a class of employees as the Commissioner approves may participate in the scheme; and • the employer’s purpose in implementing the scheme is to rationalise or re-organise the employer’s operations by making any change to the employer’s operations, or the nature of the work force, that the Commissioner approves; and © 2017 THOMSON REUTERS

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• before the scheme is implemented, the Commissioner, by written instrument, approves the scheme as an early retirement scheme for the purposes of s 83-180. The Commissioner’s views on the application of Subidv 83-C are now generally contained in Class Rulings. An employer may request the Commissioner to issue a Class Ruling in relation to a particular early retirement scheme. The ruling will be legally binding provided the scheme actually carried out is carried out in accordance with the scheme described in the ruling: see [45 120]. In AAT Case 123 (2000) 44 ATR 1023, the taxpayer did not succeed in arguing that a payment he received was an early retirement scheme payment because, even though the employer had such a scheme, no mention was made of it in negotiations and the terms he received were more generous than those offered under the employer’s scheme. See also Sukumaran v FCT (2000) 44 ATR 538, noted at [4 400].

Commissioner’s discretion If the conditions for an ‘‘early retirement scheme’’ under s 83-180(3) are not present, the Commissioner may approve the scheme as an early retirement scheme by written instrument, before the scheme is implemented, if the Commissioner is satisfied that special circumstances exist in relation to the scheme that make it reasonable to approve the scheme: s 83-180(4). Excluded payments An early retirement scheme payment does not include any part of a payment that was received by the employee in lieu of ‘‘superannuation benefits’’ (see [40 050]) to which the employee may have become entitled at the time of the payment or at a later time: s 83-180(5). See Ruling IT 2490, Ruling IT 2620 and AAT Case 7211 (1991) 22 ATR 3337. In addition, an ETP under s 82-135 (apart from s 82-135(e)) is not an early retirement scheme payment: s 83-180(6). Section 82-135(e) provides that the tax-free amount of an early retirement scheme payment or a genuine redundancy payment is not an ETP: see [4 300]. An early retirement scheme payment cannot also be a genuine redundancy payment (see [4 400]) which involves dismissal as opposed to retirement. Tax-free amount of early retirement scheme payment So much of an early retirement scheme payment that does not exceed the tax-free amount worked out using the following formula in s 83-170(3) is non-assessable non-exempt income (see [7 700]): Base amount + (Service amount × Years of service)

The base amount and service amount are indexed annually in accordance with ss 960-270, 960-275 and 960-280 ITAA 1997. For 2016-17, the ‘‘base amount’’ is $9,936 and the ‘‘service amount’’ is $4,969. ‘‘Years of service’’ means the number of whole years in the period, or sum of periods, of employment to which the payment relates. Any amount in excess of the tax-free amount is taxed as an ETP under s 82-135: see [4 300].

[4 420] Unused annual leave payments Unused annual leave payments and unused long service leave payments, made upon retirement or termination, are excluded from the definition of ‘‘employment termination payment’’: see [4 300]. Nevertheless, similar concessional tax treatment applies under Subdivs 83-A and 83-B ITAA 1997 in respect of such payments (whether made as an entitlement or a privilege) to the extent to which they accrued before 18 August 1993 or were paid as a result of bona fide redundancy, invalidity or an approved early retirement scheme. The tax treatment of unused long service leave payments is considered at [4 430]. A payment received in consequence of the termination of employment is an ‘‘unused annual leave payment’’ if (s 83-10(3)): 104

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[4 420]

• it is for annual leave that the taxpayer has not used; • it is a bonus or other additional payment for annual leave the taxpayer has not used; or • it is for annual leave, or a bonus or other additional payment for annual leave, to which the taxpayer was not entitled just before the employment termination, but that would have been made available at a later time if it were not for the employment termination. This captures situations in which a taxpayer, while not entitled to annual leave, is entitled to a pro rata payment upon termination of employment, such as a taxpayer who has not had 12 months’ service with the employer whose service he or she is leaving. Subdivision 83-A applies to annual leave to the following types (whether it is made available as an entitlement or as a privilege): • leave ordinarily known as annual leave, including recreational leave and annual holidays; • any other leave made available in circumstances similar to those in which the leave mention above is ordinarily made available: s 83-10(1). Accrued ‘‘sick leave’’ is not subject to any special provisions and may constitute an ETP (see [4 300]) if paid in consequence of retirement or termination of employment.

Tax treatment When a taxpayer retires from an office or employment, or has an office or employment terminated, any amount paid in respect of unused annual leave, including bonus loading or any additional payment due, is subject to tax under Subdiv 83-A ITAA 1997 which includes the whole amount in assessable income: s 83-10(2). In Re Heinrich and FCT (2011) 81 ATR 903, payments of unused annual leave were assessable under s 83-10 and could not be treated as part of a salary sacrifice arrangement. However, a tax offset applies to ensure that the rate of tax does not exceed 30% (plus Medicare levy) to the extent that is made in connection with a genuine redundancy payment, early retirement scheme payment, the individual’s invalidity or relates to employment before 18 August 1993: s 83-15. The result is that an amount paid in respect of employment on or after 18 August 1993 is fully assessable without any limit on the rate of tax, unless the amount is paid in connection with a payment that includes or consists of a genuine redundancy payment (see [4 400]), an approved early retirement scheme payment (see [4 410]) or the invalidity segment (see [4 350]) of an ETP or superannuation benefit. The ITAA 1997 does not provide any formula for determining the proportion of the payment made in respect of service before 18 August 1993. However, in relation to the former provisions of s 26AC ITAA 1936, Determination TD 94/8 provided the following formula for determining the pre-18 August 1993 portion of the payment for the purposes of the ITAA 1936 equivalent provisions (s 26AC): Payment ×

No of days in accrual period that occurred before 18 August 1993 No of days in accrual period

However, this in fact does nothing more than indicate that the calculation should be done on the basis of the number of days in each period according to the manner in which the entitlement arises under the ordinary conditions of employment in relation to the particular employee, to which the meaning of ‘‘accrual period’’ is linked, subject only to the proviso that leave taken is regarded as relating to entitlements arising in chronological order, meaning unused leave relates to the latest period of service. Note that s 101A(2) ITAA 1936 provides that an amount received by the trustee of a deceased estate is not assessable income of the trust to the extent to which, if it had instead © 2017 THOMSON REUTERS

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been received by the deceased person during his lifetime, it would have been included in the assessable income under s 83-10 ITAA 1997: see [23 520]. Cause of payment and period during which accrued (inclusive) General termination or retirement – 17/8/1993 18/8/1993 + Redundancy, invalidity or early retirement – all

Assessable portion

Maximum rate %

100% 100% 100%

30 Marginal 30

[4 430] Unused long service leave payments A payment received in consequence of the termination of employment is an ‘‘unused long service leave payment’’ if (s 83-75): • it is for long service leave that the taxpayer has not used; or • it is for long service leave to which the taxpayer was not entitled just before the employment termination, but that would have been made available at a later time if it were not for the employment termination. Subdivision 83-B applies to long service leave to the following types (whether it is made available as an entitlement or as a privilege): • leave ordinarily known as long service leave, including long leave, furlough and extended leave; • any other leave made available in circumstances similar to those in which the leave mention above is ordinarily made available: s 83-70(1); • if the employer has entered into a scheme or arrangement for leave and, because of the existence and nature of the scheme or arrangement, the employer does not have to comply with the requirements of a law of the Commonwealth, or of a State or Territory, relating to leave mentioned above, leave made available under the scheme or arrangement.

Tax treatment When a taxpayer retires from an office or employment or has an office or employment terminated, any unused long service leave payment received is included in assessable income under s 83-80 according to the extent to which the payment is attributable to the periods outlined in the table below. Note that an amount received by the trustee of a deceased estate is not assessable to the trust to the extent to which, if it had instead been received by the deceased during her or his lifetime, it would have been assessable under s 83-80 (s 101A(2) ITAA 1936): see [23 520]. Cause of payment and period payment attributable to (inclusive) General termination or retirement – 15/8/1978 16/8/1978 – 17/8/1993 18/8/1993 + Redundancy, invalidity or early retirement – 15/8/1978 16/8/1978 +

Assessable portion %

Maximum rate %

5 100 100

Marginal 30 Marginal

5 100

Marginal 30

If the unused long service leave payment is attributable to ‘‘pre-16/8/78 period’’, only 5% of the lump sum received is treated as assessable income. The remainder of that part (if any) of an unused long service leave payment that is attributable to the pre-16/8/78 period is non-assessable non-exempt income: s 83-80(2). However, a tax offset applies under s 83-85 to ensure that the rate of tax does not exceed 30% (plus Medicare levy) on the amount that is the part of the unused long service leave payment included in the taxpayer assessable income, to the extent that: 106

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[4 430]

• it is attributable to the pre-18/8/93 period (ie it accrued in respect of service that occurred after 15 August 1978 and before 18 August 1993: s 83-90); • it is attributable to the post-17/8/93 period (ie relates to employment that occurred after 17 August 1993) if the payment was made in connection with a genuine redundancy payment, early retirement scheme payment, the individual’s invalidity or relates to employment before 18 August 1993. The result is that, to the extent to which unused long service leave payments are attributable to an employment period that occurred on or after 18 August 1993, that portion is fully assessable without any limit on the rate of tax, unless the amount is paid in connection with a payment that includes or consists of a genuine redundancy payment (see [4 400]), an approved early retirement scheme payment (see [4 410]) or the invalidity segment (see [4 350]) of an ETP or superannuation benefit. In Re Heinrich and FCT (2011) 81 ATR 903, payments of unused long service leave were assessable under s 83-80 and could not be treated as part of a salary sacrifice arrangement. Unused long service leave payments in relation to a period of foreign service may be exempt under s 23AG (see [7 150]): see ATO ID 2011/29.

Amount attributable to each period The amount of an unused long service leave payment that it attributable to the pre-18/8/93 period or the post 17/8/93 period is worked out as follows (s 83-95(2)): Amount of payment ×

Unused long service leave days in the relevant period Total unused long service leave days

For the pre-16/8/78 period, the sum of the amounts for the other 2 periods is subtracted from the total amount of the payment: s 83-95(1)(b). Total unused long service leave days means the total number of unused days of long service leave in the long service leave employment period for the payment. Unused long service leave days in the relevant period means the number of ‘‘unused days of long service leave’’ in the pre-18/8/93 period or the post-17/8/93 period (as applicable) worked out under s 83-100. The number of unused days of long service leave for each of the pre-16/8/78 period, the pre-18/8/93 period and the post-17/8/93 period is the number of days of long service leave that accrued during that period less the number of days of long service leave used in the period. To the extent that the number of days of long service leave used during the pre-18/8/93 period or the post-17/8/93 period exceeds the number of days of long service leave that accrued during the period, the excess days are applied in accordance with the table in s 83-100(2) to determine the number of unused days of long service leave.

Long service leave accrued in each period The number of days of long service leave that accrued during both the pre-18/8/93 period and post-17/8/93 period is worked out as follows (s 83-105(2)): Days of long service leave that accrued during long service leave employment period

×

Days in relevant period Days in long service leave employment period

For the pre-16/8/78 period, the sum of the number of days worked out under the above formula for the other 2 periods is subtracted from the total number of days of long service leave accrued during the long service leave employment period: s 83-105(1)(b). If long service leave accrued during the pre-18/8/93 and post-17/8/93 periods, but not during the pre-16/8/78 period, and the number of days worked out under the formula for the post-17/8/93 period includes a fraction, the fraction is treated as having accrued during the pre-18/8/93 period: s 83-105(3).

Employment partly full-time and partly part-time If a taxpayer’s long service leave employment period includes one or more periods of employment on a full-time and part-time basis, the amount of the unused long service leave © 2017 THOMSON REUTERS

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payment must be apportioned to the extent that the payment is attributable to the periods of employment representing the full-time payment and the part-time payment: s 83-110.

Long service leave taken at less than full pay If a taxpayer used days of long service leave at a rate of pay that is less than the rate to which he or she was entitled, the number of days of long service leave that are taken to have been used (disregarding fractions of days) is worked out as follows (s 83-115): Actual days of long service leave ×

Rate of pay at which leave was actually taken Rate of pay to which taxpayer was entitled when taking leave

[4 440] Foreign termination payments A foreign termination payment received by a taxpayer in consequence of the termination of her or his employment in a foreign country is non-assessable non-exempt (NANE) income (see [7 700]) if it relates only to a period of employment when the taxpayer was not an Australian resident: s 83-235. If, however, the taxpayer was an Australian resident during the period of employment, such a payment (or a payment received in consequence of the termination of an engagement on qualifying service on an approved project for the purposes of s 23AF ITAA 1936: see [7 200]), is NANE income under s 83-240 if: • the payment relates only to the period of that employment or engagement; and • the payment is not exempt from tax under the law of the foreign country (see ATO ID 2013/67 for an example of where the payment was exempt) and the foreign employment earnings are exempt under s 23AG ITAA 1936 (see [7 150]) or the eligible foreign remuneration from the qualifying service is exempt under s 23AF (see [7 200]), as appropriate. In all cases, a payment cannot be NANE income (under s 83-235 or s 83-240) if the payment is a superannuation benefit (see [40 050]) or a payment of a pension or annuity. A number of decisions highlight the importance of a taxpayer who is working overseas taking steps to ensure that any termination payment is paid solely in respect of a period of employment or service overseas, eg by segregating such a payment in the relevant contract: see, for example, Re Taxpayer and FCT (2006) 65 ATR 415 and AAT Case 1080 (2000) 46 ATR 1025. In Branson v FCT (2008) 73 ATR 864, the Federal Court held that no part of a termination payment to a bank employee seconded to Tokyo could be apportioned and classified as an exempt non-resident foreign termination payment under former ss 27A and 27CD ITAA 1936. The re-written provisions of Subdiv 83-D are intended to have the same effect. Segregation will not always ensure that a termination payment will qualify as NANE income, but it should increase the chances of successfully achieving that outcome. Note that a foreign termination payment is not an ETP under Div 82 ITAA 1997: see [4 300] and ATO ID 2010/111. Superannuation lump sum benefits received from certain foreign superannuation funds are taxed separately under Subdiv 305-B ITAA 1997: see [40 050].

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5

BUSINESS INCOME Overview ......................................................................................................................... [5 010]

BUSINESS INCOME Carrying on a business .................................................................................................... [5 020] Business or hobby generally ........................................................................................... [5 030] Gambling and betting ...................................................................................................... [5 040] Breeding, racing and training horses .............................................................................. [5 050] Share traders .................................................................................................................... [5 060] Assessability of business receipts ................................................................................... [5 070] Compensation payments ................................................................................................. [5 080] GST-related payments ..................................................................................................... [5 090] Non-cash business benefits ............................................................................................. [5 100] Bounties and subsidies .................................................................................................... [5 110] Insurance or indemnity receipts ...................................................................................... [5 120]

TRADING STOCK GENERAL PRINCIPLES Meaning of trading stock ................................................................................................ [5 Purchases of trading stock .............................................................................................. [5 Tax consequences of stock-on-hand ............................................................................... [5 Tax and accounting treatment ......................................................................................... [5 Lost or destroyed stock ................................................................................................... [5 Change of use .................................................................................................................. [5 Non-arm’s length purchases ........................................................................................... [5

200] 210] 220] 230] 240] 250] 260]

VALUATION OF TRADING STOCK Options for valuing trading stock at end of year .......................................................... [5 Cost .................................................................................................................................. [5 Market selling value ........................................................................................................ [5 Replacement value .......................................................................................................... [5 Obsolete stock ................................................................................................................. [5 Specific industries ........................................................................................................... [5 Cost price of bonus shares .............................................................................................. [5 Choses in action .............................................................................................................. [5

300] 310] 320] 330] 340] 350] 360] 370]

DISPOSALS NOT IN ORDINARY COURSE OF BUSINESS Deemed disposal at market value ................................................................................... [5 Determination of market value ....................................................................................... [5 Change of interests .......................................................................................................... [5 Election to adopt value other than market value ........................................................... [5 Conditions for valid election .......................................................................................... [5 Business restructures ....................................................................................................... [5 Devolution on death ........................................................................................................ [5 Gifts of trading stock ...................................................................................................... [5

400] 410] 420] 430] 440] 445] 450] 470]

CARBON PRICING Registered emissions units .............................................................................................. [5 500] © 2017 THOMSON REUTERS

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BUSINESS INCOME [5 010] Overview Chapter 5 is divided into 2 sections, one dealing with business income and the other dealing with trading stock. The first section of the chapter examines business income including the concepts of a ‘‘business’’, which is defined in the income tax laws, and ‘‘carrying on a business’’ which is not defined in the income tax laws: see [5 020]. Specific activities are then examined to determine whether the activity is a business or a mere hobby: see [5 030]-[5 060]. The rest of the first section of the chapter considers the assessability of business and other receipts, whether ordinary income or statutory income. The second section of the chapter deals principally with trading stock issues, namely: • general principles, the tax consequences, accounting treatment, changes of use, and non-arm’s length transactions: [5 200]-[5 260]; • valuation options, including the rules affecting specific industries, bonus shares and choses in action: [5 300]-[5 370]; and • disposals not in the ordinary course of business: [5 400]-[5 470]. The taxation consequences of acquiring, holding and disposing of registered emissions units under the (now repealed) carbon pricing scheme are also considered in this chapter, at [5 500].

BUSINESS INCOME [5 020] Carrying on a business The term ‘‘business’’ is defined in s 995-1(1) ITAA 1997 (and s 6(1) ITAA 1936) to include any profession, trade, employment, vocation or calling, but it does not include occupation as an employee. The definition is not exhaustive and therefore the term ‘‘business’’ includes (for ITAA 1997 and ITAA 1936 purposes) any activities that would ordinarily be understood to be a business. Although the term ‘‘business’’ is defined, the concept of carrying on a business is not defined in either the ITAA 1997 or the ITAA 1936. The significance of whether a taxpayer’s activities amount to carrying on a business is important in determining whether receipts are assessable income or outgoings are allowable deductions. Whether a business is being carried on is a question of fact to be determined in an objective manner on the specific facts of each case: eg Evans v FCT (1989) 20 ATR 922 at 939; Hart v FCT (2003) 53 ATR 371. From the many court and tribunal decisions concerning this issue (eg Thomas v FCT (1972) 3 ATR 165, Ferguson v FCT (1979) 9 ATR 873, Hope v Bathurst City Council (1980) 12 ATR 231, FCT v Radnor Pty Ltd (1991) (1991) 22 ATR 344 and Spriggs and Riddell v FCT (2009) 72 ATR 148) it seems that the following factors are particularly relevant (ie the presence of these factors is indicative of a business being carried on): • the purpose and intention of the taxpayer in engaging in the activities (to be assessed objectively); • an intention to make a profit from the activities (to be assessed objectively), even if only a small profit is made or a loss is incurred (although if a loss is incurred every year for a number of years, that suggests the activity may be more in the nature of a hobby). It seems that an intention to make a profit is not of itself sufficient; 110

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• the size and scale of the activities – they must be in excess of domestic needs, but need not be the only activities of the taxpayer and can be carried on in a small way; • repetition and regularity of the activities – however, the expression ‘‘carry on’’ does not necessarily require repetition (see FCT v Consolidated Press Holdings Ltd; CPH Property Pty Ltd v FCT (2001) 47 ATR 229 at 245) and an isolated activity may constitute the commencement of a business; • the activities being carried on in a systematic and businesslike manner usual for that type of business (eg detailed and up-to-date records and accounts should be kept); and • the existence of a business plan. The factors must be considered in combination and as a whole, and no one factor is likely to be decisive: see Ruling TR 97/11. A person may carry on a business even if not actively engaged in the business: Puzey v FCT (2003) 53 ATR 614 at 624; Sleight v FCT (2003) 53 ATR 667 at 682 (decision upheld on appeal in FCT v Sleight (2004) 55 ATR 555). Cases where the taxpayer has been held to be carrying on a business include FCT v E A Marr and Sons (Sales) Ltd (1984) 15 ATR 879, FCT v Stone (2005) 59 ATR 50, Spriggs and Riddell (2009) 72 ATR 148 (see [4 080]), Hance v FCT (2008) 74 ATR 644 and Re WWXY and FCT [2015] AATA 130. A case where the taxpayer was held not to be carrying on a business was Ell v FCT (2006) 61 ATR 661. A taxpayer was not carrying on a property development business in Re XTJT and FCT (2013) 96 ATR 464, nor in Rosgoe Pty Ltd v FCT [2015] FCA 1231 (on appeal). The issue of whether a person is carrying on a primary production business is considered further at [27 020].

Statutory criteria for deducting losses Division 35 ITAA 1997 now generally determines whether an individual taxpayer can offset business losses against other assessable income. In essence, an individual may only offset a loss arising from a business activity (whether carried on alone or in partnership) against other income derived in the same income year if the business activity satisfies at least one of the 4 commerciality tests – the assessable income, profits, real property and other assets tests: see [8 600]-[8 620]. A non-deductible loss may be carried forward and applied in a future income year against assessable income from the particular activity. Note that there is an exemption for those who carry on a primary production or professional arts business and whose assessable income for the year from other sources does not exceed $40,000. It should also be noted that the Commissioner has a limited discretion to override the provisions of Div 35: see [8 640]. Self-consumption of products The Tax Office regards the activities of multi-level marketers involved in the formation of buying clubs as not carrying on a business as their activities are directed towards obtaining discounts for self-consumption items: see AAT Case 11,164 (1996) 33 ATR 1165 (it was decided that there was no product distribution business as most of the stock was for private use). [5 030] Business or hobby generally Whether an activity is being carried on as a business or as a hobby is a question of fact to be determined according to the circumstances of each particular case: see [5 020]. Activities such as gambling and betting, quiz participation and collecting (stamps, coins, silverware etc) do not normally constitute a business, giving rise to income and deductions, although there may be CGT consequences. In contrast, share trading, farming and viticulture often amount to carrying on a business. Gambling, horse racing related activities (including © 2017 THOMSON REUTERS

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training and breeding) and share trading are considered further at [5 040]-[5 060]. Whether a primary production business is being carried on is considered further at [27 020]. Examples of where activities constituted a hobby rather than a business include Hart v FCT (2003) 53 ATR 371 (performing aerobatics and demonstrating aircraft at air shows) and Re Gilbert and FCT (2010) 80 ATR 951 (motorcycle sidecar racing). Collectors of stamps, coins, art, china, porcelain or similar collectables are generally engaged in a hobby and not a business activity, unless the collecting is done as part of the occupation of the taxpayer (such as an antique dealer or art dealer). Most collectables with an acquisition cost exceeding $500 fall within the definition of ‘‘collectable’’ in s 108-10(2) and (3) for CGT purposes. The CGT consequences arising on the disposal of collectables are considered at [12 180]. Lengthy appearances on a particular quiz show, if a person defeats successive challengers, do not amount to a business in normal circumstances. Prizes won are neither ordinary income (see [6 550]) nor subject to CGT, although the disposal of assets obtained from quiz shows etc may be subject to CGT: see [15 080]. Returning to a quiz show for a ‘‘champion of champions’’ challenge is unlikely to be regarded as a business activity, but any appearance fees paid are assessable income. It may be different if the taxpayer appears regularly on a number of different quiz shows and is engaged full-time in studying for and appearing on quiz shows. The only decisions on the issue of quiz contestants are 2 old Taxation Board of Review cases which lend some support for the view that prizes won on a quiz program may be ordinary income for services rendered in the form of exercising proven skills and abilities: see Case 37 (1966) 13 CTBR(NS) 37 and Case 43 (1968) 14 CTBR(NS) 43.

[5 040] Gambling and betting In the vast majority of cases, gambling (or betting, gaming or wagering) is a hobby or a compulsion rather than a business, with the consequence that wins are not assessable and losses are not deductible. Gambling is rarely so systematic as to amount to a business but gambling wins may be income if they are related to some wider business activity, particularly in the racing industry. The CGT provisions do not apply to winnings from gambling, a game or a competition with prizes (see [15 080]), although CGT may apply to the disposal of any assets obtained from gambling etc. A number of criteria need to be examined to determine whether a business of gambling or betting exists: • the degree to which the taxpayer’s activities rely solely on chance without any system or organisation; • the extent to which a taxpayer’s involvement in the activity stems from a love of horses (or the particular activity) as opposed to gambling alone; • the extent to which the entertainment/compulsion element is paramount rather than a profit-making motive; • the period of time engaged in the activity is normally irrelevant; and • the scale of activities is important but the size of bets is irrelevant. From an analysis of the many cases on this topic, it seems that gambling (or betting) will seldom be classified as a business, irrespective of the size of the wins and losses (see also Ruling IT 2655), unless the taxpayer is involved in the racing industry in a business capacity (such as a trainer, breeder or jockey). If so, betting activities are more likely to form part of that business with the consequence that betting wins would be assessable and losses would be deductible (in the case of jockeys, it is irrelevant that they are generally not allowed to bet on races). The key question is whether the betting activities are a natural incident and form part of the taxpayer’s other business activities. See also [5 050]. 112

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The more important cases on whether the taxpayer was carrying on a business of gambling or betting include: Evans v FCT (1989) 20 ATR 922 (taxpayer not a professional punter as his gambling lacked the essential element of system or organisation); Babka v FCT (1989) 20 ATR 1251 (taxpayer’s large betting activities were only a pastime); and Brajkovich v FCT (1989) 20 ATR 1570 (the elements of sport, excitement and amusement were the main attraction to the taxpayer). Note that, in ATO ID 2010/56, the Tax Office considered that financial spread betting was not recreational gambling (and thus the gains were assessable: see [3 070]).

[5 050] Breeding, racing and training horses The general principles discussed at [5 020] also apply in determining whether the racing of horses, the training of horses and the breeding of horses, or any combination of those activities, constitutes a business. However, Ruling TR 2008/2 states that it would be a rare case where the racing of horses as a stand-alone activity amounted to the carrying on of a business. On the other hand, the Tax Office considers that if racing activities are an integral part of a training or breeding business, the horse racing activities will form part of that business. Woods v DCT (1999) 43 ATR 491 is an example of a taxpayer failing to establish that combined activities of breeding and racing constituted a business. In Re D’Arcy and FCT [2008] AATA 709; (2008) 71 ATR 695, it was decided that the taxpayer’s horse breeding activities did not amount to carrying on a business (nor was he carrying on an enterprise for ABN and GST purposes). As regards breeding horses, Ruling TR 2008/2 lists various industry factors that should be taken into account in determining if a business is being carried on. These include the quality and number of horses, whether the taxpayer is regularly selling stock to the general public, whether the mares are being serviced regularly, whether the taxpayer is using their stallion rights and whether the taxpayer maintains horses which are inappropriate for breeding (excluding horses that are being raced). Stallion syndicates, including whether there is a partnership for taxation purposes, are dealt with in Ruling TR 93/26. [5 060] Share traders Buying and selling shares is a business if it amounts to share trading or dealing in shares. In such a case, the shares purchased constitute trading stock of the business. Applying the general principles discussed at [5 020], the more significant factors in determining whether a person is a share trader are: an intention to buy and sell at a profit rather than hold for investment; the frequency and volume of transactions; whether the taxpayer is operating to a plan, setting budgets and targets and keeping records; whether the taxpayer maintains an office; whether the share transactions are accounted for on a gross receipts basis; and whether the taxpayer is engaged in another full-time profession (eg see FCT v Radnor Pty Ltd (1991) 22 ATR 344 and AAT Case [2011] AATA 545 (2011) 84 ATR 659). In Radnor, the taxpayer’s activities amounted to investing in shares in order to obtain dividends rather than carrying on a business of dealing in shares. Using an investment adviser to help manage a share portfolio does not, of itself, mean that a business is being carried on: see Radnor, per Hill J at p 357. There are also comments in Radnor by Gummow and Hill JJ (at pp 346, 355-357) concerning whether investment activities undertaken by an entity in their capacity as a trustee amount to the carrying on of a business. Two AAT decisions that the taxpayers in question were carrying on share trading businesses – Re Mehta and FCT (2012) 88 ATR 290 and Re Wong and FCT (2012) 88 ATR 305 – reflect a rather lenient approach by the AAT. This was particularly so in Wong’s case, where a medical practitioner who purchased listed units in an aged care property trust from her family trust at a value some 43% above the traded value on the stock exchange at the purchase date and gave them a nil value (as trading stock) at the end of the relevant income year, was considered to be a share trader. The resultant unrealised loss made up a large part of © 2017 THOMSON REUTERS

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her $1m loss for the income year in question. In contrast, Re Hartley and FCT (2013) 93 ATR 985 reflects a more studied approach. In that case, the AAT acknowledged that the matter was ‘‘finally balanced’’ but concluded that the factors weighing against the existence of a share trading business (in particular the irregularity of the share trades, the absence of a business plan and the fact the taxpayer had a full-time job unrelated to share trading) were more significant than those in favour. In both Re Executor for the late Joan E Osborne and FCT (2014) 94 ATR 241 and Re Devi and FCT [2016] AATA 67 it was concluded that a share trading business was not being carried on. AGC (Investments) Ltd v FCT (1992) 23 ATR 287 is an example of a case in this area producing an unexpected result. The taxpayer company was a wholly-owned subsidiary of an insurance company and was used for investing in shares and securities. The funds were provided by the parent company. In September 1987 it sold about 50% of its portfolio in the belief that the market was overvalued. The Full Federal Court held that, even though the taxpayer was an investment vehicle for its parent company, the investments were made on a long-term basis and, accordingly, the profits realised were on capital account. If the taxpayer is a share trader, losses may be deductible against other income (see [8 450] and following). If the taxpayer is not a share trader, indexation or the CGT 50% discount may apply to reduce the capital gain: see [14 390]. Ruling TR 96/4 deals with the application of the cost price method of valuing shares which are held as revenue assets, whether or not the shares are trading stock.

[5 070] Assessability of business receipts Revenue from the sale of goods and services is ordinary income under s 6-5 ITAA 1997: see [3 050]. Two of the main issues in relation to sales revenue are the timing of the derivation of the income and the treatment of discounts. These are dealt with at [3 350]-[3 380]. Other business receipts that are a natural or regular incident of the business activities being carried on are also ordinary income: see [3 050]. Any receipts that are not income may be subject to the CGT provisions. Because a capital gain is taxed differently to income (see [14 420]), the distinction between income and capital receipts is still relevant: see [3 100]. For a discussion of the issues relating to debt defeasance arrangements, see [32 760]. The Tax Office’s views on the assessability of volume rebates paid by wholesalers to retailer associations, whether the retailer or association is entitled to the rebate, are set out in Ruling TR 2004/5. Work-in-progress payments are assessable under s 15-50: see [22 220]. Note also s 15-45 (certain amounts received under forestry agreements assessable: see [8 400]) and s 15-46 (certain amounts received by manager of forestry managed investment scheme assessable: see [11 600]). One-off transactions A number of cases and rulings support the view that gains by a business from one-off (or isolated) transactions are likely to be income. The principal case is FCT v Myer Emporium Ltd (1987) 18 ATR 693, where the profit from a one-off transaction was held to be assessable income because of the profit-making purpose: see [3 070]. Other cases and rulings include: • Re Pope and FCT (2001) 46 ATR 1172 – compensation amount incorrectly paid by the Tax Office to a firm of accountants, but which was not sought to be recovered, was assessable as an incident of the firm’s business as tax agents; • Ruling TR 2000/1 – the proceeds from the sale of an insurance register by an insurance agent are generally capital if the register is a presently existing asset, but ordinary income if the register is an expectancy; • Ruling TR 2001/9 – amounts of an agency development loan (ADL) to an insurance agent that are forgiven by the insurer are generally ordinary income of the agent, unless the amount is consideration for the grant of a restrictive covenant (see also 114

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Integrated Insurance Planning Pty Ltd v FCT (2004) 54 ATR 722, noted at [3 060]). If an ADL is written off, the written-off amount will retain the character of a loan amount in the hands of the agent and will not be assessable income; and • Ruling TR 2002/4 – indemnification amounts paid under an indemnification of tax clause in a cross-border loan agreement are ordinary income if the loan is made in the course of a money-lending business. Ruling TR 2005/15, which considers the assessability of the gain from a financial contract for differences, is considered at [32 710].

Sale of property used in a business If property used in a business is a CGT asset, the CGT provisions (discussed in Chapter 12 to Chapter 18) apply on its disposal unless it is a pre-CGT asset. If it is a pre-CGT asset, the receipts on disposal are likely to be capital in nature unless the asset was acquired for profit-making by sale (unlikely if not sold by now), in which case s 25A ITAA 1936 applies: see [3 130]. If the property is a depreciating asset, the balancing adjustment provisions in Div 40 will apply (see [10 850]) unless the asset was used partially for non-business purposes, in which case the CGT provisions will apply: see [15 080]. The tax consequences of disposing of trading stock are considered at [5 210] and following. Business restructures Div 615 ITAA 1997 provides roll-over relief for certain arrangements that ‘‘reorganise the affairs’’ of a company or unit trust, where the original shares/units are held as revenue assets. The roll-over relief is available where a company is interposed between: • shareholders and an original company, and the shares are disposed of, redeemed or cancelled in exchange for non-redeemable shares in the interposed company; or • unit holders and a unit trust, and the units are disposed of, redeemed or cancelled in exchange for non-redeemable shares in the interposed company. Where the conditions for Div 615 roll-over relief are satisfied, s 615-45 provides revenue asset roll-over relief under s 615-55 if: • immediately before the disposal, redemption or cancellation, the taxpayer held the original shares or units as revenue assets; and • the replacement shares issued in the interposed company are also the taxpayer’s revenue assets. If the taxpayer chooses to obtain revenue asset roll-over under s 615-55, the gross proceeds for the disposal, redemption or cancellation are taken to be an amount that would result in the taxpayer not making a profit or loss on the realisation of those shares or units: s 615-55(1). This amount would typically be the consideration paid by the taxpayer to acquire the original shares/units. In calculating any future profit or loss on a replacement share, the taxpayer is deemed to have acquired the replacement share for the amount determined under s 615-55(1) divided by the number of replacement shares that are revenue assets: s 615-55(2). The effect of s 615-55 is that no net tax consequence arises from the reorganisation of the original entity’s affairs in accordance with Div 615. The roll-over relief is also available where the original shares/units are held as trading stock (see [5 445]) or CGT assets (see [16 160]). Roll-over relief is also available for small businesses that change their legal structure after 30 June 2016: see [16 500].

Transfer of assets on winding-up of an entity Division 620 provides a general roll-over to defer taxation consequences where an original body is wound up and, as part of the process of changing its incorporation status, it transfers revenue assets to a new company. Division 620 is discussed at [16 400]. © 2017 THOMSON REUTERS

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[5 080] Compensation payments The assessability of compensation payments or damages must be determined in accordance with general principles (see [6 500]) and the facts of the particular case. However, compensation or damages for the loss of anticipated profits as a result of the cancellation or variation of a contract is likely to be of an income nature: see Heavy Minerals Pty Ltd v FCT (1966) 115 CLR 512 and Allied Mills Industries Pty Ltd v FCT (1988) 20 ATR 457. Similarly, compensation or damages for breach by the purchaser of a contract for the sale of goods are likely to be of an income nature (and thus assessable), as the amount takes the place of the income that would have been derived if the sale had taken place. On the other hand, compensation or damages for the loss of the whole or a substantial part of the business will be of a capital nature (see [3 060]): eg Californian Oil Products (in liq) v FCT (1934) 52 CLR 28 (payment for cancellation of an exclusive agency agreement, causing the business to cease operation). If the compensation is received for the loss of a minor part of the business operations, the receipt is more likely to be of an income nature. The question is one of degree in each case, since what may be a major part of a business operation of one taxpayer may only be a minor part of the business operation of another taxpayer. Compensation for the loss of trading stock is generally assessable income according to ordinary concepts but, in any event, s 70-115 would apply to bring the sum received to account as assessable income: see [5 080]. The assessability of insurance proceeds etc is discussed at [5 120]. Defective materials Damages received for the supply of defective goods or materials are of an income nature if they represent compensation for loss of profits: Liftronic Pty Ltd v FCT (1996) 32 ATR 557. In that case, the taxpayer carried on a business of selling, installing and maintaining lift systems. Damages were awarded to the taxpayer for defective components supplied by a third party. The damages were held to have been awarded for loss of profits rather than for loss of goodwill (ie reputation) and thus were assessable income. Section 15-30 may apply if any receipt is not ordinary income: see [5 120]. Damages in relation to non-revenue aspects of a business, eg for faulty air conditioning affecting the employees’ comfort, are likely to be on capital account and not assessable. [5 090] GST-related payments Division 17 Pt 2-1 ITAA 1997 sets out the effect of GST on assessable income. The GST and GST-related terms used below are discussed in Chapter 63. Note that Subdiv 27-B, and not Div 17, applies to depreciating assets or expenditure for which amounts are deductible under Div 40 (the Uniform Capital Allowance regime) or Div 328 (small business entities): see [10 480] and [10 810]. The effect of GST on income tax deductions is considered at [9 420]. For an overview of GST, see Chapter 60. The following are neither assessable income nor exempt income (s 17-5): • GST receivable on a taxable supply. A business taxpayer who is not registered for GST, and is not required to be registered, does not make taxable supplies and any GST collected on behalf of the taxpayer (eg if stock is sold on a consignment basis through a third party) is included in the latter’s assessable income under s 6-5; • the amount of any increasing adjustment relating to a supply; and • the amount of any increasing adjustment relating to an acquisition giving rise to a recoupment that is included in assessable income (if an entity’s net GST liability increases because an amount paid in acquiring something is refunded and the refund is an assessable recoupment, the increasing adjustment is excluded from the assessable amount). 116

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The amount of a decreasing adjustment arising under Div 129 or Div 132 of Pt 3-3 GST Act is assessable unless the entity with the adjustment is an exempt entity: s 17-10. Division 129 provides for increasing and decreasing adjustments because of changes in the creditable purpose of an acquisition or importation. Division 132 deals with decreasing adjustments where an item used in making financial supplies is sold. If the amount becomes a net input tax credit (as defined in s 995-1), s 17-10(2) provides that the amount of the decreasing adjustment is not assessable income to the extent that a reduction is made under s 103-30 (reduction of cost base etc by net input tax credits: see [14 080]). In calculating an amount to be included in assessable income, the GST component of that amount is excluded: s 17-15. GST (and related increasing adjustments) are excluded from amounts received or receivable, and amounts corresponding to input tax credits (and related decreasing adjustments) are excluded from amounts paid or payable. The GST liability of the representative member of a GST group, or of the joint venture operator of a GST joint venture, is treated as if it were payable on the taxable supplies and taxable importations made by each group member or joint venture participant: s 17-20(1), (2).

[5 100] Non-cash business benefits The Full Federal Court in FCT v Cooke and Sherden (1980) 10 ATR 696 held that non-cash business benefits could only be assessable income under s 25(1) ITAA 1936 (now s 6-5 ITAA 1997) if the benefits were convertible to cash and in the nature of income according to ordinary concepts. The court also held that the benefits could only be assessable income under s 26(e) if the recipient had rendered services to the provider. This meant that non-cash business benefits that were not convertible to cash were not assessable. As a consequence, s 21A ITAA 1936 was enacted to deal with non-cash benefits. Section 51AK ITAA 1936 was also enacted to deny a deduction for non-cash benefits provided as an inducement to purchase plant and equipment. Benefits of an income nature not convertible to cash Section 21A(1) treats non-cash business benefits in the nature of income that are not convertible to cash as if they were convertible to cash. Section 21A(2) then brings to account all non-cash business benefits, whether or not convertible to cash, that are income according to ordinary concepts. The assessable amount is the arm’s length value of the benefit (reduced by any contribution in cash by the recipient). Note that if the benefit is not convertible to cash, any conditions that would restrict the conversion of the benefit to cash are disregarded in determining the arm’s length value: s 960-410 ITAA 1997 (see [3 210]). Interest-free loans from a principal to contractors made before 31 August 1988 were non-cash benefits for s 21A purposes after that date, because the benefit carried over for the whole of the loan term and did not stop at the commencement of the agreement: AAT Case 11,589 (1997) 34 ATR 1209. Rulings, etc that refer to the potential application of s 21A include: Ruling TR 1999/6, Determination TD 1999/34 and Ruling TR 96/6. The provision of the exclusive use of plant and equipment, at no charge, by partners to the partnership does not constitute a non-cash business benefit and therefore s 21A does not apply (in calculating the net income of the partnership): ATO ID 2004/955. Note that s 21A does not apply to an ESS interest (see [4 170]) if the discount under the ESS interest is taxed under Div 83A ITAA 1997: s 21A(7). Reduction and exemption of benefits The amount of a non-cash business benefit that is assessable income is reduced by: (a) the deductible percentage – if the recipient had, at the time the benefit was provided, incurred and paid expenditure (which is not reimbursed) equal to the arm’s length value of the benefit and would have been entitled to a once-only deduction in respect of the expenditure (ie the expenditure is not written off over time like © 2017 THOMSON REUTERS

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depreciation), the benefit is reduced by the same proportion as the deduction available to the taxpayer bears to the relevant expenditure: s 21A(3); or (b) the non-deductible entertainment percentage – if a percentage of any expenditure incurred in the provision of the benefit is non-deductible entertainment expenditure to the provider (such as the provision of a free holiday as in Cooke and Sherden), there is a pro rata reduction in the value of the benefit: s 21A(4). If the non-cash business benefits derived by a taxpayer in an income year are less than $300, the income is treated as exempt income by s 23L(2) ITAA 1936 and thus will reduce carry forward losses.

[5 110] Bounties and subsidies A taxpayer’s assessable income includes any bounty or subsidy received in relation to the carrying on of a business: s 15-10. However, if the bounty or subsidy is ordinary income, ie income according to ordinary concepts (see [3 020]-[3 070]), it is assessable under s 6-5 and not under s 15-10. In effect, this means that bounties and subsidies received in relation to carrying on a business are assessable under s 6-5 if of an income nature and under s 15-10 if of a capital nature. To be assessable under s 15-10, the payment must relate to the carrying on of a business. This means that there must be a real connection between the payment and the carrying on of a business (even if it is only an indirect connection): First Provincial Building Society Ltd v FCT (1995) 30 ATR 207 (this case concerned s 26(g) ITAA 1936, which was the predecessor to s 15-10). A payment to assist with the capital costs of restructuring a business, to improve the manufacturing, processing, distribution, administrative or other operations of a business or to assist that business to improve its overall efficiency, is received in relation to carrying on a business: see Ruling TR 2006/3. A consequence of the requirement that the payment relates to the carrying on of a business is that a payment to commence or cease a business is not assessable under s 15-10 (nor under s 6-5). However, if a grant is received by the taxpayer as it commences its business and the decision to commence the business is not dependent upon the receipt of grant, the grant is considered to be received in relation to the carrying on of the business and thus is assessable under s 15-10 (see ATO ID 2010/38). If not assessable under s 15-10, such a payment may give rise to an assessable recoupment under Subdiv 20-A (see [6 580]): see Ruling TR 2006/3, para 26. The terms ‘‘bounty’’ and ‘‘subsidy’’ are not defined in the ITAA 1997 (nor in the ITAA 1936) and therefore they have their ordinary meanings. A bounty is ‘‘a premium or reward, especially one offered by a government’’ (Macquarie Dictionary 2001, revised 3rd edition) and a subsidy is ‘‘aid provided by government to foster or further some undertaking or industry’’ (Placer Development Ltd v Cth (1969) 121 CLR 353 at 373). When the terms are positioned together, the compound term is interpreted as describing financial assistance given to assist business (The Squatting Investment Company Limited v FCT (1953) 86 CLR 570 at 576). Of course, not all government grants are bounties or subsidies for these purposes and it is necessary to determine what the grant is actually for by reference to the relevant agreement or the terms that created in the recipient the right to the grant. For example, in ATO ID 2006/292, funding provided by a State government under an industry investment incentive scheme was not assessable as the funding was in essence a loan. Some legislation provides that payments are deemed to be subsidies for the purposes of s 15-10, for example, an energy or cleaner fuel grant (s 8 of the Products Grants and Benefits Administration Act 2000) and payments to dairy farmers under the Dairy Structural Adjustment Program Scheme (cl 75 Sch 1 to the Dairy Industry Adjustment Act 2000). Ruling TR 2006/3 sets out the Tax Office’s views on the assessability of government payments to industry (whether under s 6-5 or s 15-10). The following government payments are considered to be ordinary income and therefore assessable under s 6-5: to provide income support because of an actual or expected reduction in business income; to assist with business 118

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operating costs or liabilities; to evaluate current business operations in relation to expanding a recipient’s business; and for loss of profits because of government policy or industry restructure. Other payments that are assessable under s 6-5 as ordinary income include diesel fuel rebates (Determination TD 97/25). Of course, these payments may also be assessable under s 15-10. The following are considered to be assessable under s 15-10: a government grant paid to a school bus operator to assist with the purchase of a new bus (ATO ID 2004/149); a grant received from the Dairy Regional Assistance Program (Re Plant and FCT (2004) 58 ATR 1070); and a government payment (repayable on the happening of certain events) to enable the recipient to undertake activities to develop a new product to the stage where it can be taken to market (ATO ID 2010/147). Other amounts that are assessable (whether under s 6-5 or 15-10) are export incentive grants, Medicare payments to medical practitioners, medical indemnity insurance subsidies, employee subsidies and drought relief payments. In Re Berghofer and FCT (2008) 73 ATR 964, the AAT decided that payments under the Queensland Vegetation Management (Enterprise Assistance) Scheme were not bounties or subsidies assessable under s 15-10, but were assessable as ordinary income under s 6-5. The Tax Office disagrees with the finding that the payments were not bounties or subsidies (see the Decision Impact Statement on the Tax Office’s website). Certain government payments to businesses affected by natural disasters are either non-assessable non-exempt income (see [7 700]) or exempt income: see [7 100].

[5 120]

Insurance or indemnity receipts

Insurance or indemnity receipts may be assessable as ordinary income under s 6-5, but they may also be statutory income under special provisions of the ITAA 1997: • s 15-30 – insurance proceeds or other amounts received by way of indemnity to compensate for loss of income that would have been assessable; • s 20-20(2) – recoupment, by way of insurance or indemnity, of a deductible loss or outgoing (eg insurance moneys received for funds embezzled by an employee would be assessable if a deduction for the loss is claimed under s 25-45: see [9 1270]); and • s 70-115 – insurance proceeds, or other amounts received by way of indemnity, for lost trading stock (and which are not ordinary income). If an amount is both statutory income and ordinary income, it is treated as statutory income unless the contrary intention appears: s 6-25. The following insurance or indemnity receipts are also assessable income: moneys received as a result of the death of an employee insured under an accident policy taken out by the employer (Murphy v Thomas E Gray & Co Ltd [1940] 3 All ER 214 and Carapark Holdings Ltd v FCT (1967) 115 CLR 653); compensation received on the destruction of diseased cattle (FCT v Wade (1951) 84 CLR 105); and a payment under the HIH rescue package in settlement of a claim under a general insurance policy with an HIH company: s 322-5. An amount received for loss or destruction of a depreciating asset under an insurance policy is treated as part of the termination value (s 40-300(2) item 8): see [10 890]. A lump sum received under a mortgage protection policy on suffering a total permanent disablement is not assessable (either as ordinary income under s 6-5 or statutory income under s 6-10): see ATO ID 2003/204.

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119

[5 200]

BUSINESS INCOME

TRADING STOCK GENERAL PRINCIPLES [5 200] Meaning of ‘‘trading stock’’ ‘‘Trading stock’’ is widely defined in s 70-10 to include anything produced, manufactured or acquired for the purposes of manufacture, sale or exchange in the ordinary course of a business. For there to be an ‘‘exchange’’ for these purposes, ATO ID 2009/97 states that ownership of the relevant item must pass. ‘‘Trading stock’’ includes items such as harvested agricultural produce (eg Determination TD 2010/9), coal, metal ores, sand and gravel once removed from the earth; land for a property developer or land trader (FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452, Barina Corporation Limited v FCT (1985) 17 ATR 134 and Determination TD 92/124); shares for a share trader (Investment & Merchant Finance Corporation Ltd v FCT (1971) 2 ATR 361, Hua Wang Bank Berhad & Ors v FCT (2014) 100 ATR 244); computer software (Ruling TR 93/12); computer spare parts (Ruling TR 93/20); containers, labels, packing materials, binding materials and accessories (Ruling TR 98/7); spare parts and other materials (Ruling TR 98/8); and newsprint (Determination TD 92/156). ‘‘Trading stock’’ also includes live stock: see [27 060]. Units in a pooled development fund are not treated as trading stock: see [11 550]. The High Court held in FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 16 ATR 567 that it is not even necessary, in certain circumstances, to be the legal owner of goods for them to be trading stock. The case concerned a wholesaler of cars displayed under a floor plan, which were legally owned by a finance company until purchased by a customer. The High Court said that the ordinary meaning of ‘‘trading stock’’ was ‘‘goods held by a trader in such goods for sale or exchange in the ordinary course of his trade’’, and the cars in question were within this meaning. Rulings IT 2325 and IT 2472 set out the Commissioner’s views on this decision and whether goods on consignment or in transit are trading stock. Bitcoins are considered to be trading stock when they are held for sale or exchange in the ordinary course of a business: see Determination TD 2014/27. In ATO ID 2008/130, the Tax Office concludes that an entity which acquires motor vehicles, leases them and assigns all of its rights under the leases, including an amount specified as the residual value of the motor vehicles, to a special purpose entity under a securitisation arrangement does not hold the vehicles for the purposes of sale and therefore they are not trading stock of the entity. The following are also not trading stock (s 70-10): • financial arrangements under the TOFA rules (referred to as ‘‘Division 230 financial arrangements’’). The TOFA rules are considered at [32 050] and following; and • CGT assets owned by a complying superannuation fund, complying ADF or a PST, or which are complying superannuation assets of a life insurance company (see [30 200]), which are subject to capital treatment under Subdiv 275-B (managed investment trusts: see [12 350]) (applicable in relation to CGT assets owned after 7.30 pm on 10 May 2011 AEST, unless owned and held as trading stock before that time): see [41 190].

Trading stock under consolidation Under the consolidation regime, trading stock is a ‘‘reset cost base asset’’ when allocating tax setting costs to a head company in acquiring assets of a joining entity: see [24 340]. 120

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[5 210]

Value shifting Note that the value shifting provisions of Divs 723, 725 and 727 ITAA 1997 can apply if there is value shifting involving trading stock: see [17 800]-[17 970]. [5 210] Purchases of trading stock The cost of trading stock (including freight, taxes, insurance and other acquisition costs) is deductible under s 8-1 ITAA 1997. Section 70-25 goes on to provide that expenditure on the purchase of trading stock is not an outgoing of capital or of a capital nature. If the parties are not at arm’s length, s 70-20 requires that the price be an arm’s length price. A trade incentive received by a buyer of trading stock, in the form of a discount, rebate or other incentive, is considered to be a reduction in the cost of the trading stock if it relates directly to the purchase of the trading stock: see Ruling TR 2009/5. See also [3 320]. Timing of deduction Section 70-15 defers a deduction for purchases of trading stock until the stock has actually become trading stock-on-hand of the purchaser, or an amount has been included in assessable income in connection with its disposal (eg if it is sold before it has been received). EXAMPLE [5 210.10] Assume the following: Cost per item $2 Selling price per item Year 1

$10

Stock-on-hand at beginning of year Purchases during year Deliveries during year Sales during year Stock-on-hand at year-end Stock purchased but not on hand at year-end Calculation of taxable income Assessable income Sales: 250 @ $10 Stock adjustment (s 70-35) ie ($500 − $300) Total assessable income Deductions Purchases: 500 @ $2 Less stock not on hand at year-end (s 70-15) ie 150 × $2 Total deductions Taxable income Year 2 Stock-on-hand at beginning of year Deliveries during year of stock purchased in previous year Purchases during year Deliveries during year of stock purchased during year Sales during year Stock-on-hand at year-end Stock purchased but not on hand at year-end © 2017 THOMSON REUTERS

No of items 150 500 350 250 250 150

Cost/sale value ($) 300 1,000 700 2,500 500 300

$

$

2,500 200 2,700 1,000 300 700 2,000 No of items 250 150 600 400 500 300 200

Cost/sale value ($) 500 300 1,200 800 5,000 600 400

121

[5 220]

BUSINESS INCOME

Cost per item Year 1

$2

Selling price per item

$10 No of items

Cost/sale value ($)

$

$

Calculation of taxable income Assessable income Sales: 500 @ $10 Stock adjustment (s 70-35) ie ($600 − $500) Total assessable income Deductions Purchases: 600 @ $2 Deliveries (s 70-15) ie 150 × $2 Less stock not on hand at year-end (s 70-15) ie 200 × $2 Total deductions Taxable income

5,000 100 5,100 1,200 300 1,500 400 1,100 4,000

[5 220] Tax consequences of stock-on-hand The value of all trading stock-on-hand at the beginning of the income year, and of all trading stock-on-hand at the end of that year, must be taken into account in ascertaining the taxable income of the taxpayer if any business is carried on by the taxpayer: s 70-35(1). The arrangements applying to small business entities are discussed at [25 200]-[25 210]. The tax effect of taking trading stock-on-hand into account is as follows. 1. If the value of all trading stock-on-hand at the end of the income year exceeds the value of all trading stock-on-hand at the beginning of that year, the assessable income of the taxpayer includes the amount of the excess: s 70-35(2). 2. If the value of all trading stock-on-hand at the beginning of the income year exceeds the value of all trading stock-on-hand at the end of that year, the amount of the excess is deductible: s 70-35(3). 3. The value of trading stock-on-hand at the end of the income year (see [5 300]) becomes the value of trading stock-on-hand at the beginning of the next income year: s 70-40(1). If an item’s closing value in the previous year was not taken into account at all, the item’s opening value is nil: s 70-40(2). The Full Federal Court has confirmed that s 70-40(2) requires the opening value of trading stock to be valued at nil if no assessment (of the value of the trading stock) was made for the preceding income year: Bywater Investments Ltd v FCT [2015] FCAFC 176. The taxpayer was granted special leave to appeal to the High Court, but on grounds not relating to the trading stock issue. If one year’s closing value is amended, the next year’s opening value will change to reflect that amendment. If the closing value cannot be amended (eg because the statutory time limits in s 170 ITAA 1936 for amending the relevant assessment have expired: see [47 120] and following), that recorded closing value will be next year’s opening value (this is different to the position under the equivalent provision in ITAA 1936: s 29).

When is trading stock actually on hand? The test applied by the Tax Office to determine if stock is on hand is whether a taxpayer has the power to dispose of the trading stock (referred to as the dispositive power): Ruling IT 2670. Generally, the person having property in trading stock has dispositive power. Ruling IT 122

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[5 230]

2670 states that the time when property in goods passes is determined by the intention of the parties but, in the case of unascertained goods, it cannot be before ascertainment. The intention of the parties is determined by reference to the terms of the contract, the conduct of the parties and commercial practice. Ruling IT 2670 relies mainly on Farnsworth v FCT (1949) 4 AITR 258, where the High Court held that dried fruit delivered by the taxpayer to a packing house where it was mixed with the fruit of other growers was not stock-on-hand of the taxpayer (rulings on other pooled schemes for primary producers are listed at [27 070]). Because the test of whether trading stock is on hand is dispositive power, trading stock may be on hand even though it is not in the physical possession of the taxpayer, for example if the taxpayer holds documents of title to the goods (eg bills of lading) giving it power to dispose of those goods: All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874. See also FCT v Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 16 ATR 567, discussed at [5 200]. Land (including buildings on the land) which is trading stock of a property developer presents a special case. Gasparin v FCT (1994) 28 ATR 130 (discussed as [3 340]) held that the date of settlement of the contract of sale is the time when land ceases to be trading stock, as the power of disposal has only then been lost. There are a number of rulings and determinations on the issue including Ruling TR 95/7 (goods subject to a lay-by sale agreement in the possession of the seller are stock-on-hand of the seller); Ruling TR 97/15 (goods delivered under a conditional contract to the buyer are the buyer’s stock-on-hand if they are in the buyer’s possession at the end of the income year, but revert to the seller when returned); and Determination TD 95/48 (demonstration computers of a wholesaler lent to a prospective purchaser remain stock-on-hand of the wholesaler, but those sent to a retailer for display purposes only remain stock-on-hand of the wholesaler while the retailer holds them on display). If a beekeeper has more than 500 hives for use in a honey production business, the beekeeper is required to account for changes in the value of trading stock: see Practice Statement PS LA 2008/4 (GA). See also [5 350].

[5 230] Tax and accounting treatment The ITAA 1997 adopts a different approach to accounting for trading stock from that found in the financial accounts of a business, but the accounting income and the taxable income will be the same if an identical method of valuing trading stock is adopted and the same items of stock are treated as being on hand. Permanent differences will only occur if the provisions of the income tax law require that a different amount be applied for purchases (s 70-20 dealing with non-arm’s length transactions) or sales (s 70-90 dealing with sales not in the ordinary course of business: see [5 400]). EXAMPLE [5 230.10] Trading account for taxpayer for the year ending 30 June, Tax Year 1 $ Sales ............................................................................................... Less cost of goods sold Opening stock (1 July, tax year 1 – at cost) ...................... Purchases ........................................................................... Freight inwards ................................................................... Insurance ............................................................................ Less closing stock (30 June, tax year 1 – at cost) ............ Gross profit .....................................................................................

20,000 60,000 5,000 2,000 87,000 27,000

$ 100,000

60,000 $40,000

Tax format © 2017 THOMSON REUTERS

123

[5 240]

BUSINESS INCOME

The trading account above can be set out in the following way to highlight the manner in which s 70-35(2) applies: Sales ............................................................................................... Less purchases .................................................................. Freight, insurance ............................................................... Add, applying the s 70-35(2) formula: Closing stock ...................................................................... Less opening stock ............................................................. Gross profit .....................................................................................

100,000 60,000 7,000

27,000 20,000

67,000 33,000

7,000 $40,000

If the value of opening stock had exceeded the value of closing stock, s 70-35(3) would have required a deduction and a reduced gross profit.

[5 240] Lost or destroyed stock The inclusion of an item of trading stock-on-hand at the beginning of the income year, and the exclusion of that item from trading stock-on-hand at the end of the income year, effectively allows a deduction for the cost of trading stock disposed of during the year. If trading stock is lost or destroyed by fire, flood or theft, the taxable income of a taxpayer is reduced because such items of trading stock are no longer on hand, and are not taken into account at the end of the income year. Compensation received by way of insurance for any loss of trading stock is assessable income under s 70-115: see [5 120]. Note also that Subdiv 385-E allows a primary producer to elect to spread over 5 years assessable proceeds arising from the death or forced disposal of live stock if certain circumstances exist, or alternatively, to apply the profit towards the cost of replacement stock: see [27 170]. [5 250] Change of use An item held as trading stock may undergo a change of use in a business. For example, the item may be used for private purposes or may become a depreciating asset. If a taxpayer starts to hold as trading stock an item not previously held as trading stock, the taxpayer is treated as having sold the item for either its cost or its market value (see [5 410]) just before it became trading stock and as having immediately bought it back for the same amount: s 70-30(1). The taxpayer must make an election under s 70-30(2) for whichever value is to be used. The election is to be made before lodging the return for the income year in which the event occurs (the Commissioner may grant an extension of time). Cost is to be worked out as cost for the purposes of s 70-45 (see [5 300]), disregarding s 70-55 (acquiring live stock by natural increase): s 70-30(3). If the item was originally acquired for no consideration, cost is calculated using the table in s 70-30(4). The section does not apply to standing or growing crops, crop stools or trees planted and tended for sale which become trading stock because they are severed from the land: s 70-30(5). If a taxpayer stops holding an item as trading stock but still owns it, the taxpayer is treated as having sold it for its cost just before the change in use and as having bought it back for the same amount: s 70-110. An example is where a grazier kills live stock for personal consumption or for rations for employees. The cost of the live stock is assessable income in both cases, although in the case of rations for employees a deduction is available for the same amount. Fringe benefits tax will also apply but, under the existing valuation procedures, there will be little or no tax liability: see [27 120]. Section 70-110 may also apply to a change from trading stock to a depreciating asset or to a capital asset (eg see ATO ID 2014/8, where capital works ceased to be held as trading stock). The Commissioner’s views in relation to valuing trading stock taken for private use by sole traders or partners in a partnership are set out in Practice Statement PS LA 2004/3 (GA). The practice statement also sets out relevant record-keeping requirements. 124

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Using trading stock for private or domestic purposes is common in a number of businesses, eg bakers, butchers, greengrocers, milk bars, general stores, convenience stores, restaurants, cafes and delicatessens. The Commissioner publishes standard values (excluding GST) that can be used by proprietors of such businesses. Determination TD 2016/9 lists the standard values for the 2015-16 income year: see [104 100]. The Tax Office recognises that different values may be appropriate in particular cases. If a taxpayer is able to justify a lower value for goods taken from stock than the value in the Determination, the lower amount may be used. Where the values are greater, the actual amount should be used.

[5 260] Non-arm’s length purchases If the taxpayer buys or obtains delivery of trading stock for an amount greater than market value, and the taxpayer and the seller did not deal with each other at arm’s length, s 70-20 substitutes market value for that greater amount. This is an anti-avoidance provision designed to stop the purchase price being artificially inflated above market value (see [5 410] for commentary on ‘‘market value’’). The section applies to both buyer and seller. The expression ‘‘dealing at arm’s length’’ is not defined as such in the ITAA 1997. Section 995-1 simply provides that, in determining whether parties are dealing at arm’s length, any connection between the parties and any other relevant circumstance is to be considered. In Granby Pty Ltd v FCT (1995) 30 ATR 400, Lee J said (at 403) that ‘‘the expression ‘dealing at arm’s length’ involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction’’. In other words, the expression refers to the conduct of the parties in respect of a transaction rather than their actual relationship. The question to be asked is whether the parties behaved ‘‘in the manner in which parties at arm’s length would be expected to behave in conducting their affairs’’ so that ‘‘the outcome of their dealing was a matter of real bargaining’’ (Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123 at 1132; Granby Pty Ltd at 403). See also ATO ID 2005/156. This approach should also apply in relation to s 70-20: Pontifex Jewellers (Wholesale) Pty Ltd v FCT (1999) 43 ATR 643 at 646-47. In Quality Publications Australia Pty Ltd v FCT (2012) 88 ATR 145, the relevant parties were found to be dealing with each other at arm’s length as the evidence clearly indicated that, in negotiating the particular arrangements, they acted severally and independently and in their own interests. If a taxpayer and a supplier of goods are associated, it is more likely that they will be regarded as negotiating at arm’s length if the supplier freely makes the same goods available to third parties on the same terms and conditions. Generally, parties to a transaction are not dealing with each other at arm’s length if one party is under the control or influence or the other party: Jowett’s Dictionary of English Law, 2nd ed; see also Australian Trade Commission v WA Meat Exports Pty Ltd (1987) 75 ALR 287. If parties are not at arm’s length, then it may be harder to establish that their dealings are at arm’s length.

VALUATION OF TRADING STOCK [5 300] Options for valuing trading stock at end of year At the end of an income year, a taxpayer is required to value each item of trading stock-on-hand (including live stock) at either its cost, market selling value or replacement value: s 70-45(1). This does not apply, however, to obsolete stock: see [5 340]. There is no requirement to adopt permanently any one of the 3 methods of valuation. A taxpayer may value closing stock at cost and, in the succeeding income year, value it at market selling value. Further, a taxpayer is allowed to value each item of trading stock at its cost, market selling value or replacement value and there is no compulsion to use one of the © 2017 THOMSON REUTERS

125

[5 310]

BUSINESS INCOME

prescribed alternatives for all closing stock. Thus, cost price may be adopted for some items, market selling value for others and replacement value for the rest. The cost, market selling value or replacement value of any item of trading stock is the GST-exclusive cost or value: s 70-45(1A). If an item of trading stock is purchased in a foreign currency, that amount must be translated into Australian dollars in accordance with the rules in Div 960 ITAA 1997. If an item of trading stock on hand at the end of an income year is valued at cost, the value is translated at the exchange rate prevailing at the time when the item became stock-on-hand: s 960-50(6), item 3. If the item is valued at market selling value or replacement value, the value is translated at the exchange rate prevailing at the end of the income year: s 960-50(6), item 4. These rules, which may be modified by regulation, are considered further at [34 060]. Special arrangements or restrictions are imposed in a number of situations including where the taxpayer is a small business entity: see [25 200]-[25 210].

[5 310] Cost ‘‘Cost’’ means the cost of acquiring trading stock plus any further expenditure, including indirect expenditure, incurred in getting the stock into its then existing condition and location: Philip Morris Ltd v FCT (1979) 10 ATR 44; Ruling IT 2350 and Ruling TR 2006/8. Any input tax credit is disregarded (s 70-45(1A)). Ruling TR 2009/5 discusses the treatment of discounts, rebates and other trade incentives in relation to both the seller and the buyer of trading stock (see [3 330] and [3 370]). In the wholesale and retail industries, the absorption cost method, as opposed to the direct or variable cost method, should be used: see Ruling TR 2006/5. Absorption cost takes into account material costs, direct labour costs, variable production overheads and fixed production overheads. It excludes expenses or overheads that have no relationship to production, such as marketing, advertising, selling and distribution expenses, interest and general administrative expenses unrelated to the operation of the warehouse or distribution centre. Rulings IT 2350 and TR 2006/8 set out details of costs which should be included or excluded (see also Ruling IT 2402). The application of absorption costing accords with accepted industry practice: Accounting Standard AASB 102 and International Accounting Standard IAS 2. Many problems exist in valuing land as trading stock. In withdrawn Draft Ruling TR 95/D15 the Tax Office sought to apply the absorption cost method to land, without giving consideration to infrastructure costs relating to facilities external to the actual land that do not relate to the individual allotments developed. In withdrawing the draft ruling, the Tax Office indicated that the decision in FCT v Kurts Development Ltd (1998) 39 ATR 493 addressed the major issues and a final ruling would not be issued. In Kurts’ case, the Full Federal Court held that infrastructure costs (as seen by the court) and external costs of subdivision formed part of the cost of the individual allotments. [5 320] Market selling value ‘‘Market selling value’’ is the current selling value of the article of trading stock in the particular taxpayer’s selling market. Thus, in the case of a wholesaler, it is the wholesaler’s selling market. The notional sale for the purpose of determining this figure would be under normal market conditions and a forced sale, ie a sale of the whole stock within a relatively short period of time, is not contemplated: Australasian Jam Co Pty Ltd v FCT (1953) 10 ATD 217. Any input tax credit is disregarded: s 70-45(1A): see [5 300]. [5 330] Replacement value ‘‘Replacement value’’ is the cost of replacing the particular item of trading stock and normally would only be applicable in the case of a person purchasing the item as a complete unit. In the case of a manufacturer, manufactured goods would be normally valued at cost price, which, subject to costs remaining the same, would also be ‘‘replacement value’’. Any input tax credit is disregarded: s 70-45(1A): see [5 300]. 126

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There may be circumstances in which valuation at replacement cost is not an option under s 70-45. In Parfew Nominees Pty Ltd v FCT (1986) 17 ATR 1017 the items of trading stock concerned were strata title units in a city building, which the taxpayer company valued at replacement cost. The court refused to accept replacement cost valuation and said that even though only a notional replacement was required, the replacement must be possible and not defy business reality. Determination TD 92/198 states that to be able to use replacement value, the relevant items must be available in the market and be substantially identical to the replaced items.

[5 340] Obsolete stock A taxpayer who has obsolete trading stock may elect to value an item of stock below the values in s 70-45 (see [5 300]) if it is warranted because of obsolescence or any other special circumstances relating to the item, and the value selected is reasonable: s 70-50. The Commissioner’s views on the meaning of obsolescence, what constitutes special circumstances and acceptable valuation methods are set out in Ruling TR 93/23. [5 350] Specific industries Ruling TR 93/29 deals with the application of the cost, market selling value and replacement value methods of valuation to motor vehicles acquired as trade-ins by motor vehicle dealers and retained for resale. Ruling IT 2648 discusses the application of the replacement price method to vehicles used as demonstrators. The application of all possible methods of valuation to computer spare parts that constitute trading stock is discussed in Ruling TR 93/20. The applicability of average cost as a method of determining the cost price of newsprint is commented on in Ruling IT 2289 and Determination TD 92/155. The determination of the cost of shares held as trading stock, including shares which cannot be separately identified, is dealt with in Ruling TR 96/4. Ruling TR 97/9 deals with stock valuation and other tax implications of wool sales and Ruling TR 2001/5 concerns certain trading stock issues and recognition of income from sales of grain. Ruling TR 98/2 deals with tax issues concerning trading stock in the general mining and petroleum and quarrying industries. Oyster farmers who use the ‘‘per stick’’ method to calculate the value of trading stock at the end of each income year will be accepted as having complied with the law: Practice Statement PS LA 2006/3 (GA). The ‘‘per stick’’ method may also be used by oyster farmers who have previously accounted for their trading stock in some other way. The ‘‘per stick’’ method may only be used in respect of oysters that were acquired as spat either during the income year or in previous years, and that have not been harvested at the end of the income year. Oyster trading stock that has been harvested, or is acquired by any other means cannot be accounted for using the ‘‘per stick’’ method. According to Practice Statement PS LA 2008/4 (GA), bees on hand must be valued at the end of the income year using a live hive of bees as the unit of measurement. The beekeeper may value each live hive at cost, market selling value or replacement value. See also [5 220]. [5 360] Cost price of bonus shares Bonus shares are deemed to have been acquired for no consideration unless there has been included in the taxpayer’s assessable income an amount in respect of the issue. In these circumstances, the amount of assessable income is deemed to be the cost price: s 6BA. [5 370] Choses in action Section 52A is an anti-avoidance provision to counter schemes designed to generate tax deductions as part of artificial arrangements. It applies only to certain ‘‘prescribed property’’ and includes schemes taking advantage of deductibility under s 8-1 for purchases of trading stock. The term ‘‘prescribed property’’ is defined in s 52A(4) to mean any chose in action. This would include assets such as shares or debentures, which provide certain rights of action. If a © 2017 THOMSON REUTERS

127

[5 400]

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taxpayer acquires such property, either by purchase, issue or allotment, in circumstances where that property is either trading stock or will be the subject of a transaction giving rise to a profit that will be assessable income or a loss that will be an allowable deduction, s 52A permits the Commissioner to examine the consideration paid to determine whether that consideration is reasonable having regard to a number of prescribed factors. If an examination leads the Commissioner to the conclusion that the consideration paid was on a basis other than a mere acquisition and disposal of the property without other factors coming into account, the Commissioner may determine the cost for the purposes of the ITAA 1936 or ITAA 1997 and that cost is the base upon which any liability for income tax is determined, including the valuation of that particular item if it is still on hand as at the end of the income year. To determine whether the consideration paid in respect of the acquisition of prescribed property is the amount to be taken into account as the cost of that prescribed property, the Commissioner is required to have regard to a number of factors set out in s 52A(3). In broad terms, this section raises the question as to whether money or its equivalent is to be obtained from sources other than from the disposal of that property, and looks to whether there are features in the acquisition of the property that would not come into it under normal circumstances if there was merely a purchase of trading stock.

DISPOSALS NOT IN ORDINARY COURSE OF BUSINESS [5 400] Deemed disposal at market value Section 70-90(1) provides that if a taxpayer disposes of an asset that is an item of trading stock outside the ordinary course of a business carried on by the taxpayer, the market value of the item on the day of disposal (see [5 410]) must be included in the taxpayer’s assessable income. If the disposal is by way of a tax-deductible gift and the taxpayer has obtained a valuation from the Commissioner under s 30-212, that valuation may be used instead of market value, provided the valuation was made no more than 90 days before or after the disposal: s 70-90(1A). Section 70-90(2) provides that any amount actually received for the disposal is not included in assessable income nor is it exempt income: see [7 030]. Any person or entity acquiring the trading stock is treated as having bought it for the amount included in the seller’s assessable income: s 70-95. The adjustment made under ss 70-90 and 70-95 is reflected in the determination of the assessable income of both the vendor and purchaser, the same figure being brought to account in each case. It is important that the price agreed between the vendor and purchaser can vary from this statutorily determined figure under s 70-90 and in negotiations on price the adjustment required should be kept in mind. For a discussion of the best evidence of the prevailing market value, see AAT Case 130 (1999) 41 ATR 1214. The purpose of s 70-90 is to include in assessable income receipts from sales such as clearing sales or walk-in-walk-out sales (which otherwise might not be treated as ‘‘income’’). It also deals expressly with gifts. Inclusion of crops, trees and live stock Standing or growing crops or crop stools, in addition to severed crops, are treated the same as trading stock in the case of a disposal that is not in the ordinary course of business. Section 70-85 also includes in the taxpayer’s assessable income the value on disposal of growing timber that has been commercially afforested; sales of other growing timber are not, however, within the scope of s 70-90. The disposal of live stock by a primary producer is discussed at [27 150] onwards. 128

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Types of disposals caught by s 70-90 There is no definition of the word ‘‘dispose’’, but in Rose v FCT (1951) 9 ATD 334 the High Court stated that the words ‘‘dispose of’’ include ‘‘every alienation’’ of trading stock and that ‘‘disposition’’ and ‘‘dispose of’’ have a very wide meaning. In that case, it was held that the ITAA 1936 equivalent to s 70-90 (s 36(1)) was directed at the disposal of the entirety of ownership in the assets, not the vesting in another or others of an undivided share or shares or the conversion of single ownership into collective ownership. This led to the introduction of s 36A (replaced by ss 70-85 and 70-100): see [5 420]. If a transaction is effected in several steps, it is permissible to look to the whole transaction to determine whether a disposal of property has been effected: Benwerrin Developments Pty Ltd v FCT (1981) 12 ATR 335. A distribution of trading stock in specie by a liquidator upon a winding up of a company constituted a disposal otherwise than in the ordinary course of carrying on a taxpayer’s business for the purposes of s 36(1): see FCT v St Hubert’s Island Pty Ltd (1978) 8 ATR 452. It seems that the destruction of trading stock by a third party or event, eg the intervention of a government authority, if there is no alienation of property, did not constitute a sale for the purposes of s 36: FCT v Wade (1951) 84 CLR 105. (However, the special provisions of Subdiv 385-E might apply in the case of live stock: see [27 060].) In Kratzmann’s Hardware Pty Ltd v FCT (1985) 16 ATR 274, it was held that s 36(1) applied to the sale of shares by a company that were originally purchased as trading stock but which were subsequently held as a capital investment. Although a sale by a company to an associated company upon terms that allow the latter to make a substantial profit and give the former less profit than would otherwise be the case is not necessarily a sale outside the ordinary course of business, if such a transaction is an extreme one, eg because of an arbitrary and very low price, it may be considered to be outside the ordinary course of business: Pastoral & Development Pty Ltd v FCT (1971) 2 ATR 401; see also Case 139 (1984) 27 CTBR(NS) 139. When a company purchases trading stock in exchange for issuing shares in the purchaser company, and the disposal is treated as being outside the ordinary course of the vendor’s business, the purchaser company is treated as having bought the assets for the amount included in the vendor’s assessable income for the assets. The purchaser company has a corresponding cost for the assets purchased: see Ruling TR 2008/5.

Change of incorporation A specific provision deals with the situation where a body incorporated under a law other than the Corporations Act (or a similar foreign law) is ‘‘converted’’ to a Corporations Act company (or a company under a similar foreign law) and the original body ceases to exist. In that situation, trading stock that is transferred from the original body to the new corporation is taken to be sold and bought (in the ordinary course of business under an arm’s length transaction) for the cost of the item for the original body or, if the item was held by the original body at the start of the income year, the value of the item at the time of disposal: s 620-40. This ensures a tax-neutral consequence. These provisions also apply to an indigenous corporation which converts from a Corporations Act corporation to a Corporations (Aboriginal and Torres Strait Islander) Act 2006 corporation.

[5 410]

Determination of market value

It is considered that ‘‘market value’’ for trading stock purposes means the price at which a purchaser can buy goods in their market on the day of disposal. A fair and reasonable ‘‘estimate’’ of the market value on the day of disposal must be made in the absence of evidence of an actual market value (Case 110 (1951) 1 CTBR(NS) 110). Market value is the GST-exclusive price (if the supply of the item in question is a taxable supply): s 960-405 ITAA 1997. The concept of market value is considered at [3 210]. © 2017 THOMSON REUTERS

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[5 420] Change of interests Section 70-100(1) treats a change of interests in trading stock (including live stock) as a disposal of the trading stock outside the ordinary course of business if it stops being trading stock-on-hand of the transferor and, immediately afterwards, the transferor is not the sole owner of the trading stock. If s 70-100(1) applies, the market value of the trading stock (on the day it stops being trading stock) is included in the transferor’s assessable income, while the entity (or entities) that own the trading stock immediately after the change in interests are treated as having bought the trading stock for the same value (ie market value) on that day: s 70-100(2) and (3). See [3 210] for ‘‘market value’’. Note that if the transferor is the sole owner after it stops being trading stock on hand, s 70-110 applies instead: see [5 250]. Section 70-100(1) to (3) are particularly relevant if there is a change in the composition of a partnership (eg if a retiring partner sells her or his interest to the remaining partners or to a new partner) or if a sole trader takes someone into partnership. These provisions do not apply if there is a change in partnership interests but no change in the composition of the partnership (eg a 50/50 partnership becomes a 60/40 partnership but still involving the same 2 people). Section 70-100, like s 70-90 (see [5 400]), applies not only to disposals of trading stock as defined in s 995-1, but also to disposals of standing or growing crops, crop stools, and trees planted and tended for the purposes of sale. [5 430] Election to adopt value other than market value The extension of the principles underlying s 70-90 (see [5 400]) to any change of ownership or interest in trading stock if the transferor is not the sole owner would, in many instances, result in the taxation of unrealised profits. For example, if one partner sold her or his share in a continuing partnership, s 70-90 would, but for the safeguards provided, require the transaction to be regarded as a disposal of the whole of the assets by the partnership, as formerly constituted, to the partnership as newly constituted. Moreover, the market value of trading stock and/or live stock included in those assets would be deemed consideration received for the disposal of the stock. The partners remaining in the business might thus be required to pay tax on a notional profit arising from the disposal of trading stock before it became a realised profit. If s 70-100(1) applies (see [5 420]), s 70-100(4) allows the transferor(s) and transferee(s) to jointly elect to treat the trading stock as having been disposed of for what would have been its value as trading stock of the transferor on hand at the end of an income year ending on that day (ie the day it stops being trading stock of the transferor). If such an election is made, that value is included in the transferor’s assessable income for the income year that includes the relevant day and the transferee is treated as having bought the trading stock for the same value on the same day: s 70-100(5). In the absence of an agreement under s 70-100, the market value of the trading stock (including live stock) is included in the assessable income of the person or persons who owned the trading stock before the change of interest. For example, in the case of a pastoral business where the former partnership has adopted cost price as the basis of valuing live stock, the consideration received by that partnership for the deemed disposal of live stock, if the agreement is duly made, is the cost price of that stock. Conversely, the new owners would be deemed to have bought the live stock at that price. The practical effect of making an agreement under s 70-100 in those circumstances is that the tax liability on any profit arising from the disposal of the live stock is deferred until the stock is actually sold, and the difference between the deemed cost and the sale price becomes part of the income of the purchasers. In other words, an election under s 70-100 virtually transfers the tax liability on a deemed disposal of trading stock from the former owners to the new owners (hence the need for both the former and the new owners to make the election). 130

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[5 440]

The effect of such an election is to expose the purchaser or person acquiring the new interest to tax on an appropriate part of the difference between the income tax value and the market value of the trading stock at the time of the election, notwithstanding the consideration that may have been paid. In the rearrangement of family affairs this is frequently of no concern, but if the parties are at arm’s length this additional cost must be borne in mind when negotiating a purchase price.

[5 440] Conditions for valid election Four conditions must be satisfied before any election can be made under s 70-100(4) (s 70-100(6)): • immediately after the item stops being trading stock-on-hand of the transferor, it must be an asset of a business carried on by the transferee; • immediately after the item stops being trading stock-on-hand of the transferor, the entities that owned it immediately beforehand must have (between them) interests in the item whose total value is at least 25% of the item’s market value on that day; • the value elected must be less than market value; and • the item must not be a chose in action. The stamp duty consequences of making an election under s 70-100 should be kept in mind. An election under s 70-100(4) must be in writing and signed by or on behalf of each of the transferor(s) and transferee(s): s 70-100(8). If one party has died, it may be signed by her or his legal personal representative: s 70-100(9). The election must be made before 1 September following the end of the income year in which the change in interest occurs, although the Commissioner may grant an extension of time: s 70-100(7). It is not necessary to lodge the election with the Commissioner unless requested to do so. Section 70-100(10) provides that the election under s 70-100(4) to transfer an item for the value for which the original entity would have taken it into account at the end of the year is not effective if: • the item stops being trading stock-on-hand of the transferor outside the course of ordinary family or commercial dealing; and • the consideration receivable by the transferor (or by any of the entities constituting the transferor) substantially exceeds what would reasonably be expected to be the consideration receivable by the entity concerned if the market value of the item, immediately before it stops being trading stock-on-hand of the transferor, was the value elected under s 70-100(4). The operation of the ITAA 1936 equivalent to s 70-100 (s 36A) in relation to transfers to trusts are discussed in Determinations TD 96/1, TD 96/2, TD 96/3 and TD 96/4. Basically, these determinations take the view that s 36A cannot apply to transfers to or creation of discretionary trusts, because the nature of the interests held after the change in a discretionary trust is not sufficient to attract the operation of s 36A. An exception is if the trustee of the discretionary trust had an interest before the transfer, as in that case the legal interest held by the trustee can attract the operation of the section. Transfers to a unit trust, if the units have fixed interests, can also attract the operation of the section. EXAMPLE [5 440.10] Assume that A and B are equal partners in a retail business. On 31 December, tax year 1, B retired and sold his share in the partnership to C who joined A in the firm.

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If s 70-90 applied (since it clearly involves a disposal of stock not in the ordinary course of business), the value of the trading stock at the date of the change would be market value, regardless of any contractual provision. If the market value significantly exceeded other values that might be applied for tax purposes, the application of s 70-90 could have a substantial impact upon the allocation of profits between the parties. Assuming that the trading stock at 31 December, tax year 1 was valued at cost at $8,000 and $14,000 at market value, the following trading accounts would show the effect of s 70-90: A and B trading account for 1 July-31 December, tax year 1 $ Sales ............................................................................................... Less cost of goods sold Opening stock 1 July, tax year 1 (at cost) ......................... Purchases ........................................................................... Less closing stock 31 December, tax year 1 (at market) .. Gross profit ..................................................................................... A and C trading account for 1 January-30 June, tax year 1 Sales ............................................................................................... Less cost of goods sold Opening stock 1 January, tax year 1 (ie purchased from A and B) ................................................................................. Purchases ........................................................................... Less closing stock 30 June, tax year 1 (at cost) ............... Gross profit .....................................................................................

4,000 36,000 40,000 14,000

$ 48,000

26,000 22,000 36,000

14,000 40,000 54,000 24,000

30,000 6,000

However, s 70-100 applies because: • there has been a change in the interests of persons in the trading stock; • one of the persons who owned the stock before the change (A) has an interest in the property after the change (s 70-100(1)); • the stock, upon the change, has become an asset of the business carried on by the owners of the property after the change (s 70-100(6)); • one of the persons who owned the property before the change (A) holds, after the change, an interest in the property of a value of not less than 25% of the value of the property (A holds 50%) (s 70-100(6)); and • the market value of the trading stock ($14,000) is greater than the value that would have been taken into account at the end of the income year if there had been no disposal and the income year had ended on the change ($8,000) (s 70-100(6)). Consequently, all parties involved may elect that s 70-100 will apply. This must be done by 31 August, tax year 2, or such later date as the Commissioner determines, and the election must be signed by A, B and C: s 70-100(7). ELECTION UNDER s 70-100 When such an election is made, the parties are removed from s 70-90 and the options in s 70-45 are open. Assuming the parties value at cost the following trading accounts would apply: A and B trading account for 1 July-31 December, tax year 1 $ Sales ............................................................................................... Less cost of goods sold Opening stock 1 July, tax year 1 (at cost) ......................... Purchases ...........................................................................

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$ 48,000

4,000 36,000 40,000

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Less closing stock 31 December, tax year 1 (at cost) ....... Gross profit ..................................................................................... A and C trading account for 1 January-30 June, tax year 1 Sales ............................................................................................... Less cost of goods sold Opening stock 1 January, tax year 1 ................................. Purchases ........................................................................... Less closing stock 30 June, tax year 1 (at cost) ............... Gross profit .....................................................................................

$ 8,000

$ 32,000 16,000 36,000

8,000 40,000 48,000 24,000

24,000 12,000

In essence, the effect of the s 70-100 election is that the difference in value of stock at 31 December, tax year 1 between cost and market ($6,000) has been reflected at the end of the income year rather than at the time of the partnership change, with consequent changes in the profit shares of the 3 parties. Expressed another way, in the absence of any election the gross profit of A and B would be inflated by the unrealised book profit. Upon making an election, that unrealised book profit is not assessed in the hands of A and B, and instead the actual profit for tax purposes from the sale of the stock in the ordinary course of business is assessed in the hands of A and C.

[5 445] Business restructures Division 615 ITAA 1997 provides roll-over relief for certain arrangements that ‘‘reorganise the affairs’’ of a company or unit trust, where the original shares/units are held as trading stock. The roll-over relief is available where a company is interposed between: • shareholders and an original company, and the shares are disposed of, redeemed or cancelled in exchange for non-redeemable shares in the interposed company; or • unit holders and a unit trust, and the units are disposed of, redeemed or cancelled in exchange for non-redeemable shares in the interposed company. The replacement shares/units must also be trading stock. If the taxpayer chooses to obtain trading stock roll-over relief under s 615-50, an amount must be included in the taxpayer’s assessable income in respect of the disposal, redemption or cancellation of the shares/units. If the shares/units were trading stock since the start of the income year in which the reorganisation occurred, the assessable amount is their value as at the start of the income year plus any increase in their value up to the time of disposal, redemption or cancellation: s 615-50(1)(a). In all other situations, eg if the shares/units were acquired after the start of that income year, the amount to be included is their cost at the time of the reorganisation: s 615-50(1)(b). A notional amount is then calculated for the amount paid for the replacement shares. This notional amount is the amount included as assessable income under s 615-50(1) divided by the shares the entity receives in the interposed company: s 615-50(2). The effect of s 615-50 is that the value of the original shares/units is equal to the value of the replacement shares. To ensure the market value trading stock rules in Div 70 do not apply (see [5 400]), the disposal, redemption or cancellation of the taxpayer’s shares/units in the original entity is deemed to be an arm’s length transaction undertaken in the ordinary course of business: s 615-50(3). As a result, no net tax consequence arises from the reorganisation of the original entity’s affairs in accordance with Div 615. Any unrealised gain or loss in respect of the original shares/units will be subject to tax when the replacement shares are disposed of (subject to any subsequent events that may affect this gain or loss). The roll-over relief is also available where the original shares/units are held as revenue assets (see [5 070]) or CGT assets (see [16 160]). © 2017 THOMSON REUTERS

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Note that roll-over relief is available for small businesses that change their legal structure after 30 June 2016: see [16 500].

Transfer of assets on winding-up of an entity Division 620 provides a general roll-over to defer taxation consequences where an original body is wound up and, as part of the process of changing its incorporation status, it transfers trading stock to a new company. Division 620 is discussed at [16 400]. [5 450] Devolution on death If a taxpayer dies, the market value (at the date of death) of trading stock of her or his business (if any) is included in assessable income up to the time of the taxpayer’s death: s 70-105(1). The entity on which the trading stock devolves is deemed to have bought it for that same value: s 70-105(2). If the business is carried on after death, the deceased’s legal personal representative can elect to have a different value included in the deceased’s assessable income, namely the amount that would have been the value of the trading stock at the end of an income year ending on the day of death: s 70-105(3). The election can only be made if the trading stock continues to be held (after the deceased’s death) as trading stock of the business: s 70-105(5). If an election is made, the entity on which the trading stock devolves is taken to have bought the stock for that same value: s 70-105(6). Note that in the case of standing or growing crops, crop-stools and trees planted and tended for sale, the legal personal representative may elect a nil value (instead of market value): s 70-105(4). An election under s 70-105 must be made on or before the day on which the legal personal representative lodges the deceased’s return up to the date of death, although the Commissioner may grant an extension of time: s 70-105(7). [5 470] Gifts of trading stock A gift of trading stock (ie a disposal not in the ordinary course of business: see [5 400]) is an allowable deduction under s 30-15, if the conditions for deductibility are satisfied: see [9 980]. Note that there is no requirement that the trading stock must have been purchased within the preceding 12 months. If the taxpayer has made or makes an election under s 385-105 or s 385-110, a deduction is not available under s 30-15 for the gift.

CARBON PRICING [5 500] Registered emissions units Division 420 ITAA 1997 deals with the taxation consequences of acquiring, holding and disposing of registered emissions units under the former carbon pricing scheme (which was effectively repealed as from 1 July 2014). International issues are covered by Div 13 ITAA 1936 (transfer pricing: see Chapter 37) and Australia’s double tax agreements. From 1 July 2014, Div 420 applies in relation to Kyoto units and Australian carbon credit units (ACCUs) only (and no longer in relation to carbon units and prescribed international units). Taxation issues Division 420 contains an exclusive code for assessing and deducting amounts relating to registered emissions units: ss 420-65, 420-70. A ‘‘registered emissions unit’’ is defined to mean a Kyoto unit or an ACCU for which there is an entry in an Australian Registry account: s 420-10. If a nominee entity holds a unit for another entity in its Registry account, the other entity is taken to hold the unit: s 420-12. 134

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Expenditure incurred in becoming the holder of a registered emissions unit can be deducted in the income year in which a taxpayer starts to hold the unit, but the taxpayer cannot deduct expenditure incurred in acquiring registered emissions units where the sale proceeds would not be assessable income. Market value is substituted when a unit is acquired under a non-arm’s length transaction or a transaction with an associate: s 420-20. Incoming registered emissions units held as trading stock or revenue assets on a foreign registry are valued at cost on transfer to the Australian Registry, while registered emissions units held otherwise are valued at market value on transfer to the Australian Registry: s 420-21. An amount a taxpayer is entitled to receive on ceasing to hold a registered emissions unit (eg by transferring or surrendering it) is treated as having an Australian source and is included in assessable income: s 420-25. Non-arm’s length transactions and transactions between associates are taken to be at market value: s 420-30. Once a unit ceases to be registered in Australia, Div 420 no longer applies and the unit comes under the general provisions of the income tax law: s 420-35. If an entity ceases to hold a registered emissions unit in a situation unrelated to gaining assessable income, s 420-40 provides for a claw back of any deduction claimed in relation to that unit. Expenditure incurred in ceasing to hold a unit is deductible: s 420-42. Section 420-45 provides for a rolling balance treatment of registered emissions units so that a taxpayer must bring into account the difference in value between units held at the beginning of the income year and units held at the end of the year. If the value of the units at the end of the income year exceeds the value at the beginning of the year, the excess is included in the taxpayer’s assessable income. If the value of the units at the end of the year is less than the value at the beginning of the year, the difference is deductible. The value of a unit at the beginning of an income year is the value of that unit at the end of the previous income year: s 420-50. A registered emissions unit can be valued by using FIFO (first in, first out) cost, actual cost or market value: s 420-51. The choice of method must be made before lodging a tax return for the relevant income year: ss 420-55, s 420-57. The choice is irrevocable. If a choice is not made for the first year in which the taxpayer first holds units at the end of the year, FIFO cost must be used. Registered emissions units are expressly excluded from the definition of trading stock (ss 70-12 and 995-1), even though they appear to be treated in the same way as trading stock. The head company of a consolidated group is regarded as the holder of registered emissions units for the group. The purchase and sale of registered emissions units is GST free under Subdiv 38-S of the GST Act. Transitional provisions ensure that the carbon unit shortfall provisions continue to operate in relation to the periods for which the shortfall charge can be applied. Note that where a carbon unit issued at auction is cancelled, the refund amount is assessable: s 20-30(1), item 1.27A.

Emissions reduction fund The Tax Office has stated on its website that the tax treatment of eligible ACCUs created under the Emissions Reduction Fund is intended to be consistent with arrangements that were in place under the Carbon Farming Initiative.

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6

INTRODUCTION Overview ......................................................................................................................... [6 010] Checklist of assessable items .......................................................................................... [6 020] PERSONAL SERVICES INCOME Introduction ..................................................................................................................... [6 050] Income splitting ............................................................................................................... [6 060] ALIENATION OF PERSONAL SERVICES INCOME – STATUTORY RESTRICTIONS Introduction ..................................................................................................................... [6 100] Meaning of personal services income ............................................................................ [6 110] Limitation on individual’s deductions ............................................................................ [6 120] Personal services income derived through an entity ..................................................... [6 130] Deductions of personal services entity ........................................................................... [6 140] Personal services business .............................................................................................. [6 150] Results test ...................................................................................................................... [6 160] Unrelated clients test ....................................................................................................... [6 170] Employment test .............................................................................................................. [6 180] Business premises test .................................................................................................... [6 190] Agents .............................................................................................................................. [6 200] Personal services business determinations ..................................................................... [6 210] Application for determination ......................................................................................... [6 220] INTEREST Assessability .................................................................................................................... [6 Mortgage or loan interest offset schemes ...................................................................... [6 Children’s bank accounts ................................................................................................ [6 First Home Saver Accounts ............................................................................................ [6 Bearer debentures ............................................................................................................ [6 Investment-related lottery winnings ............................................................................... [6 Interest on compensation and damages .......................................................................... [6

250] 260] 270] 280] 290] 300] 310]

RENT AND ROYALTIES Rent .................................................................................................................................. [6 350] Royalties .......................................................................................................................... [6 360] INCOME FROM LEASED PROPERTY Sale of leased cars .......................................................................................................... Luxury car leases – treatment as loans .......................................................................... Lease incentives .............................................................................................................. Sale of leased property ................................................................................................... Surrender of lease ........................................................................................................... Compensation for lessee’s failure to repair leased premises ........................................ Lease premiums ..............................................................................................................

[6 [6 [6 [6 [6 [6 [6

400] 410] 420] 430] 440] 450] 460]

MISCELLANEOUS CATEGORIES Compensation and damages ............................................................................................ [6 Insurance receipts ............................................................................................................ [6 Maintenance payments .................................................................................................... [6 Restrictive covenants ...................................................................................................... [6 Voluntary payments and gifts ......................................................................................... [6 Windfall gains ................................................................................................................. [6 Incidental rewards – frequent flyer/fly buy programs ................................................... [6 Barter and countertrade transactions .............................................................................. [6 Recoupments and reimbursements ................................................................................. [6

500] 510] 520] 530] 540] 550] 560] 570] 580]

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[6 020]

Illegal receipts ................................................................................................................. [6 Educational assistance ..................................................................................................... [6 Pensions and Social Security Act payments .................................................................. [6 Veterans’ Entitlements Act payments ............................................................................. [6 Life insurance bonuses .................................................................................................... [6 Short-term life insurance policies ................................................................................... [6

590] 600] 610] 620] 630] 640]

INTRODUCTION [6 010] Overview This chapter considers the extent to which certain categories of income not dealt with in Chapters 3 to 5 are assessable in the hands of the recipient. These categories include: • personal services income, in particular the special rules (in the ITAA 1997) governing the alienation of personal services income: see [6 100]-[6 220]; • ‘‘income from property’’, such as interest (see [6 250]-[6 310]), rent (see [6 350]) and royalties (see [6 360]) (the assessability of dividends is considered in Chapter 21); • income from leased property (including amounts received on the sale of leased cars, lease incentives, amounts received on the surrender of leases and lease premiums): see [6 400]-[6 460]; • compensation, damages and insurance receipts: see [6 500]-[6 510]; • social security payments: see [6 610]; • recoupments: see [6 580]; • voluntary payments and gifts: see [6 540]; and • the proceeds of short-term life insurance policies: see [6 640]. A checklist of taxable items is provided at [6 020]. Amounts that are exempt from income tax, or are non-assessable non-exempt income, are considered in Chapter 7.

[6 020] Checklist of assessable items A checklist of assessable items is set out below. It is designed to facilitate access to commentary on the most common items of income and does not cover every item. Note that: • references are to the first or most relevant numbered paragraph in the text where commentary on the particular item is located; and • the fact that an item appears in the checklist does not necessarily indicate that the item is automatically assessable. The text should be consulted for full details. Item Accrued leave transfer payment .. Alienated personal services income ......................................... Allowances ................................... Annual leave – accrued ............... Annuities – part ............................ Austudy ........................................ © 2017 THOMSON REUTERS

Para [9 1230] [4 020] [4 [4 [40 [6

030] 420] 560] 610]

Item Back pay ...................................... Balancing adjustment .................. Barter transactions – some ......... Bonuses ....................................... Bonus shares ............................... Bounties ....................................... Business income ..........................

Para [4 020] [10 850] [6 570] [4 020] [21 080] [5 110] [5 020]

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Item Business loans – waived amount ...................................................... Capital gains ................................ Car expense reimbursements ..... Clubs – non-member receipts ..... Commission ................................. Compensation – business ........... Compensation – interest .............. Compensation – some ................. Concessional superannuation contributions – excess ................. Consultancy fees ......................... Consumer loyalty rewards – some ............................................ Controlled foreign companies ...... Countertrades – some ................. Crops – primary producers .......... Cyclones Larry & Monica payments ..................................... Dairy adjustment payments ......... Damages – some ........................ Death benefit payment ................ Death benefits – some ................ Debt defeasance .......................... Debt returns ................................. Depreciating assets – balancing adjustment ................................... Distributions ................................. Dividends ..................................... Drought relief payments .............. Early retirement – excess ............ Earnings ....................................... Education or training payments – some ............................................ Employee share schemes ........... Employment termination payment ...................................................... Equine influenza payments – some ............................................ Exceptional circumstances payments – some ........................ Exchange gains ........................... Export incentive grants ................ Family assistance payments – some ............................................ Farm family support – some ........ Fees ............................................. Foreign income ............................ Forex realisation gain .................. Frequent flyer rewards – some ... Golden handshakes ..................... Government payments to industry ......................................................

138

Para [3 060] [12 [4 [7 [3 [5 [6 [6 [39

090] 120] 420] 320] 080] 310] 500] 325]

[3 050] [6 560] [34 [6 [27 [7

360] 570] 050] 710]

[5 110] [6 500] [4 380] [40 350] [32 760] [31 270] [10 150] [21 030] [21 020] [5 110] [4 410] [4 020] [7 270] [4 150] [4 300] [4 110] [7 100] [32 260] [5 110] [7 100] [7 100] [4 080] [34 100] [32 260] [6 560] [4 300] [5 110]

Item Grants .......................................... Hardlying allowance ..................... Holiday pay .................................. Illegal receipts .............................. Indemnity payments ..................... Insurance – business ................... Insurance receipts – some .......... Interest ......................................... Interest on early paid tax ............. Interest on overpaid tax ............... Interest – post-judgment .............. Leased motor vehicle – sale ....... Lease incentives .......................... Lease premiums .......................... Lease surrender payments – some ............................................ Liquidator’s distributions .............. Live stock – primary producers ... Loyalty programs – some ............ Long service leave – accrued ..... Lottery wins – investment-related ...................................................... Management fees ........................ Newstart allowance ...................... No-TFN contributions income ...... Non-cash business benefits ........ Non-share dividends .................... Overseas income ......................... Parental leave pay ........................ Partnership income ...................... Pension bonus ............................. Pensions – allocated ................... Pensions – government – some .. Pensions – non-government ........ Pensions – overseas ................... Pensions – veterans – some ....... Personal services income ............ Prizes – sportspersons – some ... Profit-making plans ...................... Recouped deductions .................. Redundancy payment – excess .. Rent ............................................. Restrictive covenants ................... Retirement payments ................... Return to work payments ............ Royalties ...................................... Salary ........................................... Sales – income ............................ Share buybacks ........................... Sharetrading ................................

Para [5 110] [4 030] [4 080] [6 590] [5 120] [5 120] [6 510] [6 250] [6 050] [6 250] [6 500] [6 430] [6 420] [6 460] [6 440] [21 [27 [6 [4 [6

150] 060] 560] 430] 300]

[3 [6 [41 [5 [31 [34 [4 [22 [7 [40 [6 [40 [40 [6 [4 [4 [3 [6 [4 [6 [13 [4 [4 [6 [4 [5 [20 [5

060] 610] 240] 100] 320] 010] 020] 100] 100] 540] 610] 510] 560] 620] 020] 080] 120] 580] 400] 350] 150] 330] 130] 360] 020] 070] 700] 060]

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INCOME – SPECIFIC CATEGORIES [6 050] Item Short-term life policies ................. Sick leave – accrued ................... Sickness allowance ..................... Sick pay ....................................... Signing-on fees ............................ Social security payments – some ...................................................... Sportspersons – some ................. Strike-breaking inducements ....... Student assistance schemes ....... Subsidies ..................................... Superannuation benefits – some . Superannuation contributions – excess concessional ....................

Para [6 640] [4 420] [6 610] [4 020] [4 080] [6 610] [4 080] [4 130] [6 600] [5 110] [40 010] [39 310]

Item Testimonials – some .................... Tips .............................................. Trading stock ............................... Traditional securities .................... Transition to retirement pension – part ............................................... Trust income ................................ Veterans’ payments – some ........ Wages .......................................... Workers compensation – some ... Work in progress payments ......... Youth allowance ...........................

Para [4 080] [4 030] [5 220] [32 450] [40 550] [23 110] [6 620] [4 020] [4 100] [3 350] [6 610]

PERSONAL SERVICES INCOME [6 050] Introduction Personal services income (PSI) is considered to be income that an individual taxpayer earns predominantly as a direct reward for his or her personal efforts by, for example, the provision of services, the exercise of skills or the application of labour: see Ruling IT 2639. This is similar to the statutory definition in the alienation of PSI rules: see [6 110]. Obvious examples of PSI are salary and wages, fees earned by a professional person on his or her own account, income payable under a contract for services, where the payment under the contract relates wholly or principally to the labour of the person concerned, and income derived by a professional sportsperson or entertainer from the exercise of his or her particular skills. Ruling IT 2639 notes that PSI is to be contrasted with ‘‘income from personal exertion’’ as defined in s 6(1) ITAA 1936 (although the 2 concepts overlap). Assigning personal services income Subject to statutory rules, in particular the alienation of PSI rules discussed at [6 100]-[6 220], assigning the right to PSI is seemingly valid, provided it is not assigned in a way that causes the income to be first derived as income by the assignee: see FCT v Everett (1980) 10 ATR 608 and Ruling IT 2403. In other words, an assignment of a right to income must cause the income, when it accrues, to be derived by and assessed to the assignee and not the assignor. In AAT Case 4611 (1988) 19 ATR 3895, however, a medical practitioner’s attempt to assign to his wife by gift 99% of his interest in certain book debts of the practice, representing fees for services rendered, was unsuccessful. See also Re Oliver and FCT (2001) 46 ATR 1126 (payments made to a professional footballer through a trust, to avoid salary cap restrictions, were held to be derived by the taxpayer as salary and wages) and Re Ho and FCT (2008) 73 ATR 583 (a doctor derived Medicare-type payments that were directed to the entity that operated the clinic where she worked). Determination TD 2002/24 considers an ineffective scheme under which the personal services of unrelated individuals were contracted out through a partnership. If a taxpayer’s actions fail to bring about an effective assignment, they will be considered to be merely an application of the income after it has first been derived by the taxpayer, who is therefore assessable. In Liedig v FCT (1994) 28 ATR 141, Hill J rejected the proposition that personal services income can never be derived by a person as trustee in such a way as to exonerate that person from a personal liability to tax outside the rules dealing with the taxation of trust income (discussed in Chapter 23). © 2017 THOMSON REUTERS

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[6 060] Income splitting There have been a number of cases where a taxpayer (usually a professional person such as a doctor or computer analyst) has restructured her or his working arrangements so as to provide services through a family trust. The taxpayer’s personal services income is treated as income of the family trust, available for distribution to family members who are beneficiaries. The taxpayer is paid a salary by the trust. Such arrangements may well be caught by the general anti-avoidance provisions of Pt IVA (discussed in Chapter 42), unless the arrangements can be explained by reference to ordinary business or family dealings and the avoidance of tax is not the dominant purpose (eg AAT Case 165 (1999) 41 ATR 1249 and Re Egan and FCT (2001) 47 ATR 1180). In a number of cases, an earlier anti-avoidance provision – s 260 ITAA 1936 – was applied to void such arrangements: eg Tupicoff v FCT (1984) 15 ATR 1262, FCT v Gulland; Watson v FCT; Pincus v FCT (1985) 17 ATR 1 and Bunting v FCT (1989) 20 ATR 1579. See also Rulings IT 2121 and IT 2330. If incorporation can be explained as an ordinary commercial or business step to take and does not result in any splitting of PSI, and the incorporated business activity is conducted along normal business lines, it will be accepted for income tax purposes: Ruling IT 2373. Ruling IT 2503, which considers some practical aspects of the incorporation of professional practices, reiterates the basic requirement that there be no diversion of income from the personal services of the professional practitioner to family members or other persons. In Service v FCT (2000) 44 ATR 71, the taxpayer received over $600,000 in directors’ fees which he passed on to his family company. The fees were deductible as they were outgoings incurred by the taxpayer in gaining or producing his assessable income (salary and potential income from superannuation benefits). It did not matter that the payments were to a family company in which other family members were shareholders. See also FCT v Mochkin (2003) 52 ATR 198, where the Full Federal Court held that stockbroking commissions derived by the corporate trustee of a discretionary family trust were not PSI derived by the individual controlling the company. Of course, arrangements that were once successful may now be caught by the statutory alienation of PSI rules discussed at [6 100]-[6 220].

ALIENATION OF PERSONAL SERVICES INCOME – STATUTORY RESTRICTIONS [6 100] Introduction There are specific rules in Divs 84 to 87 ITAA 1997 dealing with personal services income (PSI): see [6 110] for the definition of PSI. If an entity such as a company or trust derives income that is the PSI of an individual, the PSI will be attributed to the individual unless the entity is carrying on a personal services business (PSB) or the PSI was promptly paid to the individual as salary and wages: see [6 130]. The entity will also be denied certain deductions: see [6 140]. Similarly, an individual who derives PSI is denied certain deductions unless carrying on a PSB: see [6 120]. To carry on a PSB, the entity or individual must satisfy one of a number of tests: see [6 150]. The most important test is the results test: see [6 160]. If 80% or more of the PSI comes from the one source and the results test is not met, the relevant individual or entity must obtain a PSB determination from the Tax Office, otherwise the PSI rules will apply: see [6 210]. In Fowler v FCT (2008) 72 ATR 64, the Federal Court rejected an argument that, notwithstanding the PSI rules, a taxpayer cannot be taxed on PSI unless the taxpayer has ‘‘derived’’ the income (as required by ss 6-1 and 6-5: see [3 250] and following) at least beneficially (ie so that taxpayer is the beneficial owner of the income). 140

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[6 110]

In Russell v FCT (2011) 79 ATR 315, the Full Federal Court held that the PSI rules applied to the personal services income of an Australian resident derived from a New Zealand company (a non-resident). The Court also held that no double taxation arose under the Australia-NZ DTA as the PSI was effectively excluded from the New Zealand company’s taxable income by the fact it was a deduction from assessable income. The Russell decision could arguably be extended to apply to most DTAs. Note the following: • the PSI rules are modified in relation to agents who bear entrepreneurial risk in providing services: see [6 200]; and • the PSI rules do not deem an individual to be an employee for the purpose of any Australian law or agreement: s 84-10.

[6 110] Meaning of personal services income ‘‘Personal services income’’ (PSI) is ordinary income or statutory income (see [3 020]) that is derived mainly as a reward for the personal efforts or skills of an individual: s 84-5(1) and 84-5(2). Income derived by an entity (company, trust or partnership) from the personal efforts or skills of an individual also comes within the definition. The use of the word ‘‘mainly’’ implies that more than one-half of the relevant income must be a reward for an individual’s personal efforts or skills, otherwise it is not PSI: Ruling TR 2001/7. Income generated by the use of assets (eg dividends or rental income), the supply of goods, a business structure or granting a right to use property is not ‘‘personal services income’’, because it is not a reward for the personal efforts or skills of an individual. For the purposes of the definition of PSI, it does not matter whether the income is for doing work or for producing a result: s 84-5(3). The fact that income is paid under a contract does not stop the income from being mainly a reward for the personal efforts or skills of an individual: s 84-5(4). The true nature of contractual obligations, ie whether the arrangement involves the rendering of personal services or is for the production of a result from the provision of personal services, depends on the facts and circumstances of the particular case, including the commercial substance of the arrangements between the parties. The Tax Office considers that determining whether income is mainly a reward for an individual’s personal efforts or skills requires the exercise of practical judgment as to whether the value contributed by the individual’s efforts or skills exceeds the value of any other inputs, eg the efforts of other workers and the use of plant, machinery, tools or intellectual or other property: Ruling TR 2001/7 (the ruling lists a number of relevant factors to be considered, none of them decisive). Payments received by a personal services entity from a service acquirer during a period the service provider is not providing services to the service acquirer until further called upon (including ‘‘gardening leave’’ payments), are still considered to be PSI: see Determination TD 2015/1. Section 84-10 ensures that the alienation of PSI rules do not imply that individuals affected by the rules are employees for any legal purposes, eg industrial awards, superannuation guarantee legislation, pay-roll tax legislation or occupational, health and safety legislation. Examples of PSI Obvious examples of PSI are salary and wages, income of a professional person (eg accountant, architect or lawyer) practising as a sole practitioner, and income paid wholly or principally for the labour or services of an individual (including, for example, entertainers and consultants). In 4 separate cases, income earned by a company from hiring out the services of an IT consultant was held to be the PSI of the consultant: Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162; Re Dibarr Pty Ltd and FCT (2004) 57 ATR 1183; Re Nguyen and FCT © 2017 THOMSON REUTERS

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(2005) 60 ATR 1178; and Fowler v FCT (2008) 72 ATR 64. Similarly, in Re Skiba and FCT (2007) 67 ATR 682, income earned by a company from hiring out the services of an electrical engineer was held to be PSI of the engineer. See also Re Clark and FCT (2010) 79 ATR 262 (income earned by a company hiring out the services of an individual who worked overseas as a contracts manager was the individual’s PSI). The income of a trust derived from radio and television appearances and media interviews by a professional sportsperson would be mainly a reward for the personal efforts or skills of the sportsperson and thus PSI of the sportsperson: see ATO ID 2004/511. For the method of working out the PSI of a director of a personal services entity, see Re The Engineering Company and FCT (2008) 74 ATR 272 (the AAT decided that, where possible, each discrete amount of income received by the entity should be analysed to see if it was the individual’s PSI). Examples of income that will not be regarded as being PSI are freight received by a truck owner-operator, the price of a painting sold by an artist, fees from the hire of plant and equipment and licence fees for the use of a computer program developed by an individual computer programmer. The income of a trust derived from the use and exploitation of the name, image, likeness, talents, identity, reputation and signature of a professional sportsperson would not be PSI of the sportsperson: see ATO ID 2004/511.

[6 120] Limitation on individual’s deductions The PSI rules contain limitations (in Div 85) on the deductions that an individual may claim against PSI. These limitations are discussed in Ruling TR 2003/10. The fundamental rule is that an amount is not deductible to the extent that it relates to gaining or producing PSI if the income is not payable to the individual as an employee and the amount would not be deductible if the income were payable to the individual as an employee: s 85-10(1). Consequently, an individual is limited to the deductions that can be claimed against salary and wages by an employee. For example, an individual (who is not an employee) who works from an office at home would not be able to claim car or other travelling expenses for a journey from home to a client’s business premises because the individual could not deduct these expenses if he or she were an employee. Other amounts that an individual cannot deduct are: 1. rent, mortgage interest, rates or land tax in relation to her or his residence or an associate’s residence (or part of a residence) to the extent that the amount relates to gaining or producing PSI: s 85-15; 2. any payment to an associate, or any amount incurred arising from an obligation to an associate, in relation to producing PSI, unless the payment relates to engaging the associate to perform work that is part of the principal work for which the PSI is produced: s 85-20 (note that non-deductible amounts are non-assessable non-exempt income: see [7 700]); and 3. contributions to a fund or an RSA to provide superannuation benefits for an associate, to the extent that the associate’s work relates to gaining or producing PSI: s 85-25(1). However, if the work performed by the associate forms part of the individual’s principal work, the contributions are deductible, but only for the amount required to satisfy the individual’s obligations under the superannuation guarantee scheme (see Chapter 68) in respect of the associate: s 85-25(2) to 85-25(4).

Personal services business There is the overriding exception that Div 85 does not apply to an amount, payment or contribution to the extent that it relates to income from an individual carrying on a personal services business: s 85-30. Division 87 defines what is a personal services business: see [6 150]. Specific exceptions There are various situations (specified in s 85-10(2)) where the fundamental rule in s 85-10(1) does not operate to deny a deduction. In those situations, the relevant amount is 142

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[6 130]

deductible (provided the requirements of s 8-1 or any other relevant provision are satisfied). Thus, amounts may be deductible to the extent that they relate to: • gaining work (eg advertising and quoting for jobs); • insuring against loss of income or income-earning capacity (eg sickness, accident and disability insurance); • insuring against liability arising from acts or omissions in earning income (eg public liability and professional indemnity insurance); • engaging an entity that is not an associate to perform work; • engaging an associate to perform work that forms part of the principal work for which PSI is gained or produced (s 85-20 unnecessarily reiterates that other amounts paid to, or because of an obligation to, an associate that relate to gaining or producing PSI are not deductible); • contributing to a fund to obtain superannuation benefits; • meeting obligations under a workers compensation law to pay premiums, contributions or similar payments or to make payments to an employee in respect of compensable work-related trauma; or • meeting obligations or exercising rights under the GST law. As regards exception (e) (s 85-10(2)(e)), the Explanatory Memorandum to the New Business Tax System (Alienation of Personal Services Income) Bill 2000 states that the ‘‘principal work’’ (not defined in the ITAA 1997) of an individual can be described as the work that is central to meeting the individual’s obligations under agreements with the person or entity requiring the personal services. The explanatory memorandum goes on to say that it is work that is essential to the generation of income of the relevant individual or entity from the personal services of the individual. It therefore appears that principal work does not include ancillary work such as administrative or secretarial duties. Thus, if a non-associate is engaged to perform administrative and secretarial work the cost is deductible, but it is not deductible if an associate is engaged to do exactly the same work (a rather nonsensical result). In addition, if the individual satisfies the personal services business tests under Div 87 (see [6 150]), the amounts paid to an associate for administrative or secretarial duties are deductible. An ‘‘associate’’ has the same meaning as in s 318 ITAA 1936 (s 995-1): see [4 220].

Employees and office holders Division 85 does not apply to an amount, payment or contribution to the extent that it relates to PSI received as an employee or as an office holder (ie those referred to in s 12-45(1) Sch 1 TAA), which includes members of Parliament, local councillors, ADF members, police officers and other public servants (see [50 030]): s 85-35(1). Division 85 also does not apply to payments, etc relating to income received by a religious practitioner from which an amount must be withheld under the PAYG withholding provisions (see [50 030]): s 85-35(2). Substantiation rules Note that Div 85 does not have the effect of applying the work expense substantiation rules in Subdiv 900-B (see [9 200]-[9 250] and [9 1450]-[9 1500]) to an individual who is not an employee: s 85-40. However, if the rules apply regardless of Div 85, substantiation is necessary. [6 130] Personal services income derived through an entity The object of Div 86 is to ensure that individuals cannot reduce or defer income tax and other liabilities by diverting their personal services income to companies, partnerships or trusts that are not conducting personal services businesses: s 86-10. Division 86 does not © 2017 THOMSON REUTERS

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contain a ‘‘threshold test’’, so that the PSI provisions can apply irrespective of whether there is a demonstrated deferral or reduction of income tax under an arrangement: see Re Horner and FCT (2009) 76 ATR 102. Note that, even if an entity is conducting a personal services business, the general anti-avoidance provisions of Pt IVA ITAA 1936 (discussed in Chapter 42) may still apply if income is diverted through the entity (see the note to s 86-10 and Ruling TR 2001/8). The fundamental rule in Subdiv 86-A is that ordinary income or statutory income of a personal services entity that is the PSI of an individual is attributed to the individual, ie it is included in the individual’s assessable income: s 86-15(1). If an amount is not assessable income of the personal services entity (disregarding Div 86), it is not included in the individual’s assessable income: s 86-15(5). For example, if the service provided is a taxable supply, GST is payable but the amount of the GST is not included in the individual’s assessable income because GST is neither assessable income nor exempt income: see [5 090]. Section 86-15(1) does not operate to attribute to a foreign resident income derived by an Australian resident personal service entity, which is the PSI of the foreign resident, unless that income has an Australian source: see ATO ID 2010/214. A personal services entity is a company, partnership or trust whose ordinary income or statutory income includes the PSI of one or more individuals: s 86-15(2). For an example of a personal services entity, see ATO ID 2002/802 (company hired out its 3 employees, 2 of whom were also shareholders, to a licensed dealer in securities, which in turn appointed them as proper authority holders). A foreign resident entity can be a personal services entity for these purposes: Russell v FCT (2011) 79 ATR 315. Section 86-15 does not apply if an amount is income from a personal services entity that is carrying on a personal services business (see [6 150]): s 86-15(3). The section also does not apply to the extent that the personal services entity pays an amount of salary or wages to the individual as an employee and the payment is made before the end of the 14th day after the PAYG payment period during which the amount became ordinary income or statutory income of the entity: s 86-15(4). The entity is obliged to withhold amounts from salary or wages before the end of that day: see [50 180]. Note that there are PAYG withholding obligations (in Div 13 in Sch 1 TAA) imposed on a personal services entity in relation to PSI that is attributed to an individual under Div 86: see further [50 100]. Attributed PSI seemingly does not attract superannuation guarantee obligations with one exception: see [39 760]. The attribution rules in Div 86 are explained in Ruling TR 2003/6. See also Determination TD 2002/24 (schemes promoting arranged partnerships).

Reduction of PSI The amount of the PSI included in the assessable income of an individual under Div 86 may be reduced (but not below nil) by the amount of deductions to which the personal services entity is entitled: s 86-20. The method used to work out the reduction (s 86-20(2)) is set out below. Step 1 Step 2 Step 3 Step 4 Step 5 Step 6

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Work out for the income year the amount of any deductions (other than entity maintenance deductions) to which the personal services entity is entitled relating to PSI. Work out for the income year the amount of any entity maintenance deductions (see [6 140]) to which the personal services entity is entitled. Work out for the income year the personal services entity’s assessable income other than PSI (of the individual or anyone else). Subtract the amount under step 3 from the amount under step 2. If the amount under step 4 is greater than 0, the amount of the reduction is the sum of the amounts under steps 1 and 4. If the amount under step 4 is not greater than 0, the amount of the reduction is the amount under step 1.

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[6 130]

EXAMPLE [6 130.10] AB Pty Ltd’s income includes Y’s PSI AB’s deductions relating to the PSI other than entity maintenance deductions (step 1) AB’s entity maintenance deductions (step 2) AB’s investment income (disregarding any PSI) (step 3) Step 4 amount (step 2 amount minus step 3 amount) Step 4 amount is less than 0 so step 6 applies Reduction amount is the step 1 amount Y’s assessable income ($156,000 – $64,000)

$ 156,000 64,000 6,000 28,000 –22,000 64,000 92,000

EXAMPLE [6 130.20] CD Pty Ltd’s income includes X’s PSI CD’s deductions relating to the PSI other than entity maintenance deductions (step 1) CD’s entity maintenance deductions (step 2) CD’s investment income (disregarding any PSI) (step 3) Step 4 amount (step 2 amount minus step 3 amount) Step 4 amount is greater than 0 so step 5 applies Reduction amount is step 1 amount + step 4 amount X’s assessable income ($104,000 – $50,000)

$ 104,000 45,000 8,000 3,000 5,000 50,000 54,000

If the ordinary income or statutory income of the personal services entity also includes another individual’s PSI which is included in the latter’s assessable income under s 86-15, and the amount worked out under step 4 above is greater than zero, the entity maintenance deductions are apportioned among the individuals (see the formula in s 86-25). An individual who derives PSI through a personal services entity is entitled to a deduction for any net PSI loss arising in an income year. There will be a net loss if the ‘‘personal services deduction amount’’ (ie the amount of deductions relating to PSI worked out under step 1 above, increased by the amount (if greater than zero) worked out under step 4) exceeds the ‘‘unreduced personal services income’’ (ie the PSI that would have been included in the individual’s assessable income for the income year if there had not been any reduction under s 86-20): s 86-27. If the individual does not have sufficient other income to absorb the loss, the net loss will be able to be carried forward under the rules in Div 36 ITAA 1997: see [8 460]-[8 470].

Other income tax consequences Personal services income which is included in the assessable income of an individual under s 86-15(1) is neither assessable income nor exempt income of the personal services entity (and thus also not a capital gain): s 86-30 If an amount paid by a personal services entity to an individual or her or his associate has already been included in the individual’s assessable income under s 86-15(1), that amount is neither assessable income nor exempt income of the recipient and is not deductible to the payer (nor is it a capital loss): s 86-35. This also applies if the individual or associate is © 2017 THOMSON REUTERS

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entitled to a share of the income of the personal services entity or associates, or if there is a chain of entities. The intention is to prevent double taxation by ignoring those payments for income tax purposes. Payments of PSI as salary or wages before the end of 14 July after the end of an income year are taken to have been received on 30 June of the preceding income year and thus will be included in the individual’s assessable income for that preceding year (this does not affect the time at which the personal services entity is treated as having paid the salary or wages): s 86-40.

[6 140] Deductions of personal services entity A personal services entity is denied a deduction for an amount to the extent that it relates to gaining or producing an individual’s PSI: s 86-60. This general rule (in Subdiv 86-B) does not apply, however, if the individual could have deducted the amount under the ITAA 1997 as an individual, or the entity received the PSI of the individual in the course of carrying on a personal services business. Ruling TR 2003/10 discusses these limitations on a personal services entity’s deductions. There is an interaction between Div 85 and Subdiv 86-B in that the individual must have been able to claim a deduction for the loss or outgoing (if they had incurred it) before the entity can claim a deduction for the amount incurred. If the individual would not have been able to claim a deduction for the loss or outgoing, the entity cannot deduct the amount. The total amount of the deductions which a personal services entity is entitled to for an income year is reduced by the amount of any deductions that an individual, whose PSI is ordinary or statutory income of the entity for that income year, is entitled to under s 86-27 (see [6 130]): s 86-87. Exceptions ‘‘Entity maintenance deductions’’ are deductible under s 86-65. These are: (a) fees or charges payable by the entity for opening, operating or closing an account with an ADI (authorised deposit-taking institution); (b) tax-related expenses deductible under s 25-5: see [9 400]-[9 470]; (c) outgoings incurred in preparing or lodging any document the entity is required to lodge under the Corporations Act 2001, except payments to an associate; and (d) fees or charges payable for any licence, authorisation, registration or certification (however described) under an Australian law. Car expenses (as defined in Div 28: see [9 100]) for a car that has no private use are deductible: s 86-70(1). If a car has private use, car expenses and FBT payable for a car fringe benefit are deductible, but only for one car: s 86-70(2). If there is more than one car with private use, the entity must choose which car is to be the subject of the deduction: s 86-70(3). However, if 2 or more individuals work through the same entity, the entity may provide a car to each individual for private use provided the individuals work independently of each other and one is not engaged to do the work of the other. If a deduction is denied under these provisions, the expenses may constitute a fringe benefit, thereby potentially giving rise to double taxation (ie FBT – albeit deductible – and income tax on the income attributed to the personal services entity). Contributions made by a personal services entity to a superannuation fund or RSA for an individual whose PSI is included in the entity’s ordinary or statutory income are deductible against the PSI of the individual: s 86-75(1). However, if the individual performs less than 20% (by market value) of the entity’s principal work, and the individual is an associate of another individual whose PSI is included in the entity’s ordinary or statutory income, the deduction is limited to the amount necessary to satisfy the entity’s obligations under the superannuation guarantee scheme in respect of the individual (see Chapter 68): s 86-75(2). 146

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[6 150]

Salary or wages paid to the individual before the end of the 14th day after the PAYG payment period (see [50 030]) during which the amount became ordinary income or statutory income of the entity are deductible: s 86-80. A personal services entity that derives income attributed to an individual would not normally be entitled to claim deductions against the PSI because it is not the entity’s income and the expense would not be incurred in gaining or producing the entity’s assessable income. Section 86-85 addresses this problem and allows the entity to claim a deduction against the PSI for the amounts incurred.

Substantiation rules Note that the deduction rules in Subdiv 86-B do not have the effect of applying the car expenses rules in Div 28 and the substantiation rules in Div 900 (see Chapter 9): s 86-90. However, Divs 28 and 900 can still apply to a personal services entity that is a partnership. [6 150] Personal services business The PSI rules in Divs 84 to 86 discussed at [6 100]-[6 140] do not apply if the PSI is derived by the relevant individual or a personal services entity in the course of carrying on a personal services business. Personal services businesses are defined in Div 87. The Tax Office’s views on what is a personal services business are set out in Ruling TR 2001/8. The PSI rules are structured so that an individual or a personal services entity carries on a personal services business if (s 87-15(1)): • the individual or, if the individual’s PSI is included in a personal services entity’s income, the entity meets the results test: see [6 160]; or • the individual or entity meets at least one of the unrelated clients, employment and business premises tests (this is only relevant where less than 80% of the individual’s or entity’s PSI in an income year comes from the one client, or the one client and their associates): see [6 170]-[6 190]; or • a personal services business (PSB) determination is in force: see [6 210]. A PSB determination is necessary if the ‘‘80% threshold’’ and the results test are not met: see below.

80% threshold If the ‘‘80% threshold’’ is exceeded, the relevant individual or personal services entity will not be carrying on a personal services business unless a PSB determination is in force at the time the PSI is gained or produced. In effect, a PSB determination is required if (s 87-15(3)): • 80% or more of an individual’s PSI (with certain exceptions) during an income year is income from the one entity (or one entity and their associates) – for an example, see Russell v FCT (2011) 79 ATR 315; and • the results test is not met in the income year by the individual or, if her or his PSI is included in a personal services entity’s income, by the entity. If the entity carrying on the personal services business applies for the determination, the individual’s PSI must be from the entity. It can be seen that, if the results test is met (see [6 160]), a PSB determination is not required even if 80% or more of PSI comes from one entity (or from the one entity and their associates). Certain categories of income are not taken into account in determining whether the 80% threshold is exceeded (nor for the purposes of the results test). These categories are (s 87-15(4)): © 2017 THOMSON REUTERS

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• income the individual receives as an employee (ie salary and wages); • income the individual receives as an office holder (eg an ADF member, member of a police force, a public servant or a local councillor) that is subject to the PAYG withholding arrangements under s 12-45(1) in Sch 1 TAA: see [50 030]); and • income received by a religious practitioner that is subject to the PAYG withholding arrangements under s 12-47 in Sch 1 TAA: see [50 020]. For the purposes of determining whether the 80% threshold is exceeded, Commonwealth, State and Territory departments, agencies and authorities are treated as separate entities and are not associates of each other: s 87-35. For example, if 70% of PSI is received from the Commonwealth Treasury and 30% from the Tax Office, the PSI is treated as being from 2 separate entities and the 80% threshold is not exceeded. The application of the 80% threshold is modified in relation to agents who bear entrepreneurial risk in providing services: see [6 200].

[6 160] Results test The results test is the most important of the 4 tests. If the results test is met, that is the end of the matter and the PSI rules do not apply. An individual or personal services entity satisfies the results test in an income year if, in relation to at least 75% of the individual’s or entity’s PSI during the income year (s 87-18(1)): • the income is for producing a result – this requires that the PSI of the individual be paid to her or him as ‘‘the contract quid pro quo for producing a result’’ and not be paid until and unless the result is produced: see Re Skiba and FCT (2007) 67 ATR 682 and Re Prasad Business Centres Pty Ltd and FCT [2015] AATA 411; • the individual or entity is required to supply the plant, equipment or tools necessary to perform the work (the results test is not failed simply because no tools, etc are required to perform the work: Ruling TR 2001/8); and • the individual or entity is liable for the cost of rectifying any defective work. The custom and practice in the industry concerned must be taken into account in determining whether the above 3 conditions are satisfied: s 87-18(4). The AAT commented in Re Park and FCT (2011) 84 ATR 672 that industry custom could not be of assistance where there is a written agreement specifying that the person is entitled to payment for doing something that does not amount to producing a result. For the purposes of the results test, an individual’s PSI does not include the categories of income that are excluded in determining whether the 80% threshold is exceeded (see [6 150]): s 87-18(2). The results test is based on common law criteria for characterising an independent contractor (as distinct from an employee/employer relationship). However, if any of the 3 conditions listed above are not satisfied, the results test will not be met even if many other factors suggesting the individual in question is an independent contractor are present: see IRG Technical Services Pty Ltd & Anor v DCT (2007) 69 ATR 433. In that case, Allsop J held on the facts that the income of the individuals in question was for their work as part of a team of skilled engineers and not for producing a result. His Honour also concluded that those individuals were not required to provide the necessary equipment and tools (eg office and computer systems) and that the requirement to rectify any defective work was, in effect, irrelevant. Allsop J also commented that the method of payment may be important in determining whether a contract is for results (eg payment for time spent at work may indicate that the contract is not for a result). The results test was failed in Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162 and in Re Dibarr Pty Ltd and FCT (2004) 57 ATR 1183. In both cases, a company controlled 148

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by an IT consultant hired out the consultant’s services to essentially only one client. In Scimitar, the AAT held that the relevant contract was for the efforts and skill of the particular consultant and not for producing a result. The other 2 factors – supplying equipment and being liable for the cost of rectifying defects – were also absent. In Dibarr, the AAT decided that, on the facts, the taxpayer was paid in arrears for labour supplied by it to its only client on a month-by-month basis and not to produce a result. A similar conclusion was reached in Re Nguyen and FCT (2005) 60 ATR 1178, which was another case where the services of an IT consultant were hired out by his family company. Relevant factors in the decision that the contracts were for work and not for producing a result included that the fees were payable at a specified hourly rate, the work performed was at the direction of the client, there was little discretion in the way the work was carried out and there was no scope for substitution or delegation. Other cases involving the services of an IT consultant being hired out through a company and where the results test was failed are Re Taneja and FCT (2009) 77 ATR 605, Re BRMJCQ Pty Ltd and FCT (2010) 79 ATR 220 and Re Park and FCT (2011) 84 ATR 672. The results test was also failed in Re Skiba, where an electrical engineer’s services were hired out by his family company. The key factors were that the work was completed by teamwork, the engineer was not permitted to sign off on his own work, work could only be delegated with the approval of relevant third parties (eg the entity to whom the services were provided), no specified result had to be produced before the company was paid, the company and the engineer were not required to provide the necessary tools and equipment and the company was not liable for the cost of rectifying any defect in the work. Another case where the results test was failed is Re Prasad Business Centres, where the taxpayer was contracted to provide the services of its sole director as a task specific project manager for an amount determined by reference to an agreed daily fee. The Tax Office considers that an entity which merely hires out labour is unlikely to pass the results test, since a contract of hire is arguably not a contract for producing a result: see ATO ID 2002/803, which involved a company hiring out its employees to a licensed dealer in securities, which in turn appointed them as proper authority holders. The Tax Office has said that courier-owner drivers who operate under typical industry contracts (including the Courier and Taxi Truck Contract Determination 2000 and the General Couriers Contract Determination 1995) will pass the results test: see Tax Office media releases Nat 01/72 (21 August 2001) and Nat 01/75 (31 August 2001).

[6 170] Unrelated clients test The unrelated clients test is satisfied in an income year if (s 87-20): • the individual or the personal services entity gains or produces income during the year from providing services to 2 or more entities not associated with each other or with the individual or the personal services entity; and • the services are provided as a direct result of the individual or personal services entity advertising or otherwise offering the services to the public at large, or to a section of the public. Although this condition is not satisfied by registering with a labour hire firm or employment or personnel agency (s 87-20(2)), the Tax Office will interpret it broadly to include any form of solicitation to the public or a section of the public (and not just advertising): Ruling TR 2001/8. In Re Yalos Engineering Pty Ltd and FCT (2010) 79 ATR 282, a small number of companies engaged in offshore petroleum exploration and mining were considered to be a section of the public for these purposes. In the same case, regular personal contact with those companies to assess their needs, the opportunity to provide specialised services via word of mouth and personal recommendations from others in the industry constituted offering to provide services. However, using personal contacts and relationships did not amount to ‘‘making offers or invitations to the public at large or a section of the public’’ in Cameron v FCT (2012) 88 ATR 518 (upholding the decision in Cameron v FCT (2011) 86 ATR 195). © 2017 THOMSON REUTERS

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The unrelated clients test was failed in Re The Engineering Company and FCT (2008) 74 ATR 272, where the taxpayer obtained most of its work by responding to advertisements and by making direct approaches to entities which the taxpayer thought might be able to use its employees’ skills (‘‘cold calling’’). For other examples of where the unrelated clients test was not satisfied, see ATO ID 2002/804, Re Skiba and FCT (2007) 67 ATR 682 and Re BRMJCQ Pty Ltd and FCT (2010) 79 ATR 220. Australian government agencies are not treated as associates of each other and each agency (as covered in the Public Service Act 1999) is a separate entity. Each part of a State or Territory government or authority that has a status corresponding to a Commonwealth agency is also treated as a separate entity and not as an associate of any other part of that government or authority, or of any Australian government agency: s 87-35. The Tax Office considers that the ‘‘direct result’’ requirement is satisfied if the offers made to the public can reasonably be said to have given rise to the work. The unrelated clients test is modified in relation to agents who bear entrepreneurial risk in providing services. If the relevant conditions are satisfied (see [6 200]), the services are treated as being provided to the customer by the agent, and not the principal, for the purposes of the unrelated clients test: s 87-40(5). For a case discussing the unrelated clients test and unusual or exceptional circumstances excusing non-compliance, see Re Metaskills Pty Ltd and FCT (2005) 60 ATR 1055.

[6 180] Employment test An individual satisfies the employment test in an income year if he or she engages one or more entities (excluding associates of the individual that are not individuals) to perform work and the entity or entities perform at least 20%, by market value, of the individual’s principal work for that year: s 87-25(1). A personal services entity satisfies the employment test in an income year if it engages one or more entities (excluding associates of the entity that are not individuals) to perform work which has a market value (see [3 210]) of at least 20% of the entity’s principal work for the year: s 87-25(2). The entities engaged must not be individuals whose PSI is included in the entity’s ordinary or statutory income. For an example of where the employment test was not satisfied on this basis, see ATO ID 2002/805. The ID involved a company hiring out its 3 employees to an entity, which paid commissions to the company determined by reference to the individuals’ performances. The individuals were paid a salary by the company. As the commission income was mainly a reward for the efforts and skills of the individuals, it was characterised as their PSI (see [6 050]-[6 220]). Since this was included in the company’s ordinary income and it did not engage any other entity to do work, the employment test was not satisfied. For other examples of where the employment test was failed, see Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162 and Re The Engineering Company and FCT (2008) 74 ATR 272. If the personal services entity is a partnership, work performed by a partner is taken to be work that the entity engages another entity to perform: s 87-25(2A). Partnerships are therefore treated in the same way as companies and trusts and a partnership will not fail the employment test simply because a partner performs principal work that is helping to generate PSI of another partner. The Tax Office considers that the term ‘‘engages’’ in s 87-25 is not limited to employment type relationships and that ‘‘principal work’’ is that work which fulfils the obligations under the agreement with the service acquirer: Ruling TR 2001/8. In Re The Engineering Company and FCT, the AAT said that ‘‘principal work’’ in this context means the principal activity undertaken by the personal services entity in question. Ruling TR 2001/8 also states that if the parties are dealing at arm’s length, the amount paid (if at least 20% of the contract price) will be the market value for these purposes. 150

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[6 190]

An individual or a personal services entity also satisfies the employment test in an income year if the individual or entity has one or more apprentices for at least half the income year: s 87-25(3).

[6 190] Business premises test The business premises test is satisfied in an income year if the individual or personal services entity maintains and uses business premises at all times during the income year that meet the following conditions (s 87-30(1)): • the business premises must be the premises at which the individual or entity conducts activities from which the PSI is derived; • the individual or entity must have exclusive use of the premises; • the premises must be physically separate from any premises that the individual or entity, or their associates, use for private purposes; and • the premises must be physically separate from the premises of the entity, or of any associates of the entity, to which the individual or the personal services entity provides services. The same premises need not be maintained and used throughout the income year: s 87-30(2). Ruling TR 2001/8 sets out the Tax Office’s views on the business premises test, including: • the individual or personal services entity is required to have business premises on each day during the income year in which activities producing the individual’s PSI are conducted (eg if the activities are conducted only on each Monday and Tuesday, the individual or entity need not have business premises on any other days); • the exclusive use requirement does not disqualify the shared use of common areas if they are the subject of separate arrangements; • an individual or entity does not have exclusive use of premises if they are occupied under licence or mere possession; and • if the business premises are within a larger building, in certain circumstances they may be regarded as physically separate from the rest of the building (the ruling lists various factors to be taken into account). In Re Dixon Consulting Pty Ltd and FCT (2006) 62 ATR 1104, a personal services entity operated its consulting business from an office above a garage, which was in a building situated on the same land as, but separate from, the residence of the entity’s controlling individual and his family. The cars that were parked in the garage were owned by entity and used for both business and private purposes. The AAT decided that the business premises test was satisfied. The absence of a bathroom or toilet in the office and the fact that the residence and office shared a driveway were not considered to be significant. On appeal, in FCT v Dixon Consulting Pty Ltd (2006) 65 ATR 290, the Federal Court held that the AAT had misdirected itself as to whether the company had exclusive use of the garage and whether the garage was physically separate from premises used for private purposes and remitted the matter to the AAT for re-determination. On re-hearing the matter, the AAT decided that the business premises test was not satisfied: Re Dixon Consulting Pty Ltd and FCT (2007) 67 ATR 257. Although the personal services entity was the only entity that used the building in question, there were various private uses of the garage area by the individual and his family that precluded a finding of ‘‘exclusive use’’ by the personal services entity. Those private uses were not sufficiently insignificant so as to be disregarded under the de minimis principle. For other examples of where the business premises test was failed or where unusual or exceptional circumstances excusing non-compliance were raised, see Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162 and Re Metaskills Pty Ltd and FCT (2005) 60 ATR 1055. © 2017 THOMSON REUTERS

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If more than one business is conducted by the taxpayer from the same premises, the time spent in conducting the respective businesses (in addition to other relevant matters) is an important consideration in determining whether the business premises test is satisfied: Cameron v FCT (2012) 88 ATR 518 (upholding the decision in Cameron v FCT (2011) 86 ATR 195).

[6 200] Agents The 80% threshold (see [6 150]) and the unrelated clients test (see [6 170]) are modified in relation to agents who bear entrepreneurial risk in providing services: s 87-40. The 80% threshold and unrelated clients test are modified if the individual or personal services entity (s 87-40(2)): • is an agent of another entity (the principal) but not the principal’s employee; • receives income from the principal for services the agent provides to customers on the principal’s behalf; • receives at least 75% of that income as commissions, or fees, based on the agent’s performance in providing services to those customers; • actively seeks other customers to whom the agent could provide services on the principal’s behalf; and • does not provide any services to the customers, on the principal’s behalf, using premises that the principal or an associate of the principal owns or has a leasehold interest in, unless the agent uses the premises under an arm’s length arrangement. If the above conditions are satisfied, the PSI of the agent (whether an individual or a personal services entity) is treated as income from the customer, and not from the principal, for the purposes of the 80% threshold: s 87-40(3), (4). For the purposes of the unrelated clients test, the services provided are treated as being provided to the customer by the agent and not to the principal: s 87-40(5).

[6 210] Personal services business determinations As discussed at [6 150], in certain circumstances a personal services business (PSB) determination must be in force, otherwise an individual or entity will be treated as not carrying on a personal services business: s 87-15(1). The PSB determination must relate to the individual’s PSI or, in the case of a personal services entity, to the individual(s) whose PSI is included in the entity’s income. Although a PSB determination must be obtained if the ‘‘80% threshold’’ is not met (see [6 150]) and the results test is not met (see [6 160]), any taxpayer may apply to the Commissioner for a determination, irrespective of whether 80% or more of their PSI comes from the one source, eg if the individual is not sure if he or she meets any of the 4 personal services business tests. The Commissioner must not make a PSB determination for an individual (s 87-60(3)) or a personal services entity (s 87-65(3)) unless he is satisfied that one or more of the following conditions are met in the income year in which the determination first has effect. • The individual or the entity could reasonably be expected to meet, or have met, one or more of the results test, the employment test or the business premises test and the relevant PSI was, or could reasonably be expected to be, from the individual or entity conducting activities that met one or more of those tests: ss 87-60(3A) and 87-65(3A). • If not for unusual circumstances applying to the individual or the entity (see below), the individual or entity would have met, or could reasonably have been expected to meet, one or more of the results test, the employment test or the business premises test and the relevant PSI was, or could reasonably be expected to be, from the 152

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individual or entity conducting activities that met one or more of those tests: ss 87-60(3B) and 87-65(3B). In Re The Engineering Company and FCT (2008) 74 ATR 272, the AAT declined to make a PSB determination as the taxpayer was unable to show that relevant PSI could reasonably be expected to be from engaging other entities to perform work (activities that would meet the employment test). • The individual or the entity met, or could reasonably be expected to meet, the unrelated clients test; 80% or more of the relevant PSI would have been, or could reasonably have been expected to be, income from the same entity (or the entity and its associates) because of unusual circumstances applying to the individual or entity; and the relevant PSI was, or could reasonably be expected to be, from the individual or entity conducting activities which met the unrelated clients test: ss 87-60(5) and 87-65(5). FCT v Yalos Engineering Pty Ltd (2009) 77 ATR 542 exemplifies the importance of not only considering whether unusual circumstances exist, but also considering whether the taxpayer would have met, or could be reasonably expected to meet, the unrelated clients test but for those circumstances. • If not for unusual circumstances applying to the individual or entity, the individual or entity would have met, or could reasonably have been expected to meet, the unrelated clients test; if 80% or more of the relevant PSI would have been, or could reasonably have been expected to be, income from the same entity (or the entity and its associates), that is only because of unusual circumstances in the relevant year; and the relevant PSI was, or could reasonably have been expected to be, from the individual or entity conducting activities which met the unrelated clients test: ss 87-60(6) and 87-65(6). This fourth condition ensures that the Commissioner may not provide a PSB determination in relation to those taxpayers who, but for unusual circumstances, would satisfy the unrelated clients test but did not satisfy, and would not normally have satisfied, the 80% rule. Note that if an entity applies for a PSB determination, the relevant PSI is the individual’s PSI that is included in the entity’s assessable income. In Re Metaskills Pty Ltd and FCT (2005) 60 ATR 1055, the taxpayer was not entitled to a PSB determination as the relevant income was derived by a director of the taxpayer and was not assessable to the taxpayer. If an individual applies for a PSB determination, the relevant PSI is the individual’s PSI. Unusual circumstances for the purposes of ss 87-60(3B)(a) and 87-65(3B)(a) include (ss 87-60(4), 87-65(4)): • if the unrelated clients test (see [6 170]) is not satisfied because the individual or entity starts a business during the income year, but can be expected to satisfy the test in subsequent years; or • if the individual or entity provides services to only one entity during the income year, but satisfied the unrelated clients test in one or more preceding years and can reasonably be expected to do so in subsequent years. If the individual or entity seeks to rely on having satisfied the test in one or more preceding years, it is not necessary that the test be satisfied in the immediately preceding year: Re Creaton Pty Ltd and FCT (2002) 51 ATR 1047. The Tax Office considers that the term ‘‘unusual circumstances’’ refers to exceptional circumstances that are temporary, with the likelihood that the usual circumstances will resume in the short term: Ruling TR 2001/8. In Re Creaton, however, the AAT specifically rejected the Commissioner’s contention that unusual circumstances cannot last for more than one income year. In that case, the AAT considered that unusual circumstances existed for 2000-01 where the taxpayer company would have met the unrelated clients test from 1987 to 1994, was engaged solely by a not-for-profit company from 1994 to September 2000 (and therefore would have failed the test) but met the test again (after September 2000) in 2000-01. However, because making a personal services determination is discretionary, the AAT remitted the matter to the Commissioner for reconsideration. © 2017 THOMSON REUTERS

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Unusual circumstances that exist (or are likely to exist) for less than 12 months would not be regarded by the Tax Office as having become usual circumstances, except where that time period is significant having regard to the nature of the activity: Ruling TR 2001/8 (this must be read in conjunction with the decision in Re Creaton). The prevailing economic conditions, either in the industry in question or the place where the taxpayer is located, were held not to amount to unusual circumstances in Re Scimitar Systems Pty Ltd and DCT (2004) 56 ATR 1162. In that case, the AAT rejected the taxpayer’s argument that the downturn in the IT industry in Perth following the ‘‘Y2K problem’’ and the introduction of GST constituted unusual circumstances. For another case where there were no unusual circumstances, see Re Dibarr Pty Ltd and FCT (2004) 57 ATR 1183. In Re The Engineering Company and FCT (2008) 74 ATR 272, a long-term client indicating that it had no plans to engage the taxpayer’s services for the foreseeable future and the resignation of a key employee who took another client with him were considered to be unusual circumstances. However, as noted above, the AAT declined to make a PSB determination. In Re Yalos Engineering Pty Ltd and FCT (2010) 79 ATR 282, the extension of a contract, to oversee the design and installation of an offshore pipe line, because of unforeseen problems with the project constituted unusual circumstances.

[6 220] Application for determination An application for a PSB determination, or a variation of a determination, must be in the approved form (see [46 200] as to the requirements for an ‘‘approved form’’) and contain the required information: s 87-70(1). There is no specified time for making a determination, but if not decided within 60 days an applicant may treat the application as having been refused (the 60-day period excludes any period from the Commissioner requesting to the applicant supplying information): s 87-70(3) to 87-70(5). The Commissioner must give written notice of a PSB determination and also of any variation of a determination: ss 87-60(1) and 87-65(1). Period of determination A PSB determination or variation has effect from the day specified in the notice or, if no day is specified, the day on which the notice is given: s 87-75(1). The notice may also specify the period for which the determination has effect: ss 87-60(2) and 87-65(2). The determination ceases to have effect when a condition is not met, the Commissioner revokes the determination or the determination period ends, whichever happens first: s 87-75(2). A determination will be revoked if the Commissioner is no longer satisfied that there are grounds on which the determination could be made: s 87-80. Review A person dissatisfied with a decision to make, vary or revoke a PSB determination, or to refuse to make a determination, has objection and review rights in accordance with Pt IVC TAA (see Chapter 48): s 87-85.

INTEREST [6 250] Assessability Interest income is assessable under s 6-5(1) as ‘‘ordinary income’’ (ie income according to ordinary concepts: see [3 010] and [3 020]). The usual rules of residence and source apply in determining assessability, in addition to one specific statutory source rule. Interest is ‘‘the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal’’ (FCT v Century Yuasa Batteries Pty Ltd (1998) 38 ATR 442 at 444). In the Century Yuasa case, the Full Federal Court held that amounts paid to a lender by a borrower under an 154

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[6 250]

indemnification of tax clause were neither interest nor amounts in the nature of interest (although the Tax Office considers that such amounts may be assessable income: see [35 350]). Whether a payment by a borrower is assessable interest or a non-assessable return of capital is generally a question of fact. However, there are now specific rules (in Div 974 ITAA 1997) that classify ‘‘schemes’’ that are financing arrangements or membership interests in companies as ‘‘debt interests’’ or ‘‘equity interests’’. The debt/equity rules are discussed in Chapter 31. An ‘‘early repayment benefit’’, received by the taxpayer upon early repayment of her or his fixed interest rate home loan, is not assessable income: ATO ID 2004/275. Interest is generally derived when it is received: see [3 340]. However, special timing rules (in Div 16E of Pt III ITAA 1936) apply to certain discounted and other deferred interest securities: see [32 400]-[32 500]. Interest paid under the Taxation (Interest on Overpayments and Early Payments) Act 1983 on refunds of overpaid tax (eg as a result of a successful objection or appeal against an assessment (see [49 070]) or on early payments of tax (see [49 060])) is assessable: s 15-35. The interest is assessable in the income year in which it is paid (or applied to discharge a liability to the Commonwealth).

Interest derived by residents Interest derived by a resident from sources in Australia is assessable under s 6-5(2). Interest derived by a resident from sources out of Australia is assessable under s 6-5(3), although a tax offset will generally be available against any liability for tax paid outside Australia under the foreign income tax offset system: see [34 200]. Most of Australia’s double tax agreements include special provisions dealing with interest. The agreements provide for tax in a withholding form to be imposed by the country of source and for the interest to be subject to tax in the country of residence on a foreign tax credit basis. Reference should be made to the appropriate agreement where applicable. A receipt of prepaid interest by a financial institution is assessable under s 6-5 when it is received unless the terms of the loan agreement allow for repayment if the loan is paid out early. In that case, it should be brought to account as income over the period to which it relates: Ruling TR 1999/11. Interest derived by non-residents Interest paid to a non-resident may be subject to withholding tax, in which case it is neither assessable nor exempt income (s 128D): see [35 250]. Deemed derivation of interest Although ‘‘derived’’ means only ‘‘obtained’’, ‘‘got’’ or ‘‘acquired’’, s 6-5(4) ITAA 1997 provides that an amount of income shall be taken to be received ‘‘as soon as it is applied or dealt with in any way on your behalf or as you direct’’. The object of s 6-5(4) is to prevent a taxpayer claiming that interest etc available, but not actually received in her or his hands, is not assessable income because it has been either capitalised or otherwise held on her or his behalf. EXAMPLE [6 250.10] A customer places $10,000 on fixed deposit with a bank on 5 January Year 1 for 1 year at 5%. Instead of drawing the year’s interest ($500) on the due date, 5 January Year 2, the customer arranges for the principal and interest ($10,500) to be reinvested for another year. The $500 is assessable income of the year ended 30 June Year 2.

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It is clear from Brent v FCT (1971) 2 ATR 563 that the amount in question must be income before s 6-5(4) can operate (the case concerned s 19 ITAA 1936, the predecessor to s 6-5(4)). The section does not cause the amount of any capitalisation, accumulation or reinvestment to be income, but states that income accumulated is deemed to have been derived. Section 128A(2) ITAA 1936 contains similar provisions to s 6-5(4) and applies to interest payable to a non-resident that is subject to withholding tax. There are anti-avoidance provisions (ss 82KH to 82KL ITAA 1936) that may defer a deduction for interest paid to an associate of the taxpayer under a scheme designed to defer the associate’s liability for tax in respect of the interest.

Interest on unclaimed money Interest paid by the Commonwealth in relation to unclaimed First Home Saver Accounts, bank accounts, corporate property and life insurance amounts is exempt from income tax, with the exception of unclaimed money for former temporary residents: s 51-120. Interest paid by the Commonwealth on unclaimed superannuation payments (excepting for former temporary residents) is a tax-free component of a superannuation benefit (and thus non-assessable non-exempt income): see [40 100]. [6 260] Mortgage or loan interest offset schemes Interest offset arrangements allow borrowers to apply savings towards an effective reduction in the amount of their home mortgages or other debts rather than to deposits in separate accounts. In one such scheme a borrower’s savings and mortgage accounts are linked. Borrowers can make deposits and withdrawals as with normal savings accounts, but the account does not earn interest. Instead, the customer is entitled to a reduction in the home loan interest rate. The amount in the savings account is set off daily against the balance outstanding on the loan. Money lodged in this special linked account will be available at call and no bank fees or charges will apply. EXAMPLE [6 260.10] A borrower with a $130,000 home loan and a $6,000 savings account balance could have the accounts linked. The bank will charge the current market rate on $120,000 of the loan and a discounted rate on the remaining $10,000. This would considerably reduce the term of the loan and result in a large saving in interest payments. The tax saving results because, as the savings account earns no interest, no such income is returned for tax purposes (as would otherwise be the case with interest-bearing accounts).

A loan account offset arrangement that is acceptable to the Tax Office will involve either a single account or a dual account: Ruling TR 93/6. In a single account the customer is granted a line of credit and interest is payable only on the amount that is drawn down, with the customer able to deposit funds in the account at any time to reduce the balance of the loan. In a dual account, the customer operates both a loan account and a deposit account. An arrangement involving a single account will be acceptable to the Tax Office if the account is in debit, but will not be acceptable if the account is in credit. If the customer is entitled to interest on credit balances in the account, the full amount of that interest will be assessable income. An arrangement involving a dual account will be acceptable if the customer has no entitlement, either in law or in equity, to receive interest payments on the amounts credited to the deposit account. The customer will not be liable to tax on the amounts credited to the deposit account under an acceptable loan account offset arrangement and Pt IVA will not apply. However, the offset benefit will be assessable under s 6-5(1) (via s 6-5(4)) if the arrangement is unacceptable. 156

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[6 270] Children’s bank accounts Ruling IT 2486 deals with ownership of interest income accruing to a child’s savings account, ie whether it belongs to the child or the parent (a child is someone under 18). The ruling makes the following points. • If the parent provided the money and can spend it as he or she likes, the money is the parent’s and the parent will be assessed (even if it is intended to use the money for the benefit of the child, eg for his or her education). • If the account contains a large sum of money, the question of ownership will be carefully examined. • If the account is made up of money from presents, pocket money or casual work performed by the child (eg newspaper rounds, child minding), the money will be regarded as belonging to the child (see also Determination TD 93/148). • If the Tax Office is satisfied that the money belongs to the child, the strict application of the trust provisions will not be required if the parent operates the account as trustee. • If the income is included in a return lodged by the child, a trust tax return will not be necessary. • If the unearned income of the child does not exceed $416, no return will be required and no tax will be payable.

[6 280] First Home Saver Accounts The First Home Saver Accounts (FHSAs) scheme allowed an individual aged 18 or over (and under 65) who had not previously owned a dwelling in Australia as their main residence to open an FHSA (which includes a life policy) with an FHSA provider (an FHSA Trust, an ADI or a life insurance company). Certain tax concessions were intended to encourage investment in an FHSA. For further information, see [6 280] of the Australian Tax Handbook 2016. The FHSA scheme was repealed from 1 July 2015 for accounts opened in respect of applications made before 7:30 pm on 13 May 2014. Accounts opened after that time are not eligible FHSAs. The repeal of the tax concessions applies from 1 July 2015. FHSA misuse tax may be imposed (by the Income Tax (First Home Saver Accounts Misuse Tax) Act 2008) on an account holder who used the account for an improper purpose: s 345-100. The misuse tax is designed to claw back the benefits of having an FHSA. Note that interest paid by the Commonwealth in relation to unclaimed FHSAs is generally exempt from income tax: see [6 250]. [6 290] Bearer debentures Under Div 11 of Pt III ITAA 1936 (ss 126 to 128), a company that pays or credits interest on certain bearer debentures is required to supply the name and address of the debenture holder to the Commissioner. This only applies to bearer debentures issued in Australia or which pay interest in Australia. If the holder’s name and address is not provided to the Commissioner, the company must pay income tax on the amount paid or credited (or the amount that would have been paid or credited but for retention of funds to pay the tax): s 126(1). Assessments of such tax payable by a company may be amalgamated in respect of more than one debenture holder. This liability to tax is separate from, and does not affect the liability of the paying company in respect of, other income tax payable by it. The rate of tax payable is set out in the Income Tax (Bearer Debentures) Act 1971. The rate is that applicable under that Act at the time of payment. The rate is 47% for 2016-17 and will revert to 45% from 2017-18. © 2017 THOMSON REUTERS

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By applying the top marginal individual rate of tax in most cases, s 126 is designed to coerce disclosure of debenture holders’ names, where available, so as to discourage tax avoidance through use of bearer debentures. The paying company is authorised to deduct an equivalent amount to the tax from the interest otherwise payable and retain it for its own use: s 126(2).

Exclusions Section 126 does not apply to interest which is subject to withholding tax under Div 11A of Pt III ITAA 1936 (ie interest paid overseas on bearer debentures issued overseas by an Australian company). In addition, s 126 does not apply if any of the following sections apply to the interest (s 126(1)): • s 128EA (Interest on certain borrowings by Australian Industry Development Corporation); • s 128F (Interest on bearer debentures held by non-residents and satisfying the requirements of that section), but only to the extent the section applies to non-residents not carrying on business in Australia at or through a permanent establishment; or • s 128GB (Interest payments on offshore borrowings by offshore banking units). Interest coming under the provisions of any of the above sections will thus not be subject to any Australian tax under either Div 11 of Pt III or the withholding tax provisions.

Refunds and adjustments If the Commissioner is satisfied that the recipient (with one exception) is not liable to furnish a return, the Commissioner is required by s 126(3) to refund to the recipient the proportion of tax paid by the company in respect of the debentures. If a company pays tax on interest paid on a bearer debenture, and that interest is assessable to the person to whom it was paid or credited, the proportionate amount of tax paid by the company is deducted from the total tax payable by the person: s 127. If the tax payable under the assessment is less than the tax deducted under s 126, there is no power in the ITAA 1936 or ITAA 1997 to refund the excess to the taxpayer. [6 300] Investment-related lottery winnings Some financial institutions offer the chance to win a prize in a lottery instead of paying interest on deposits made to certain accounts or in addition to low rates of interest. Section 26AJ ITAA 1936 assesses the value of prizes won in a lottery or similar arrangement if the chance to win the prize arises because the taxpayer holds an investment with an investment body such as a bank and the betting chance is not otherwise taxable. Ordinary lottery arrangements of the traditional kind such as lotteries, caskets, art unions, lotto and raffles are not affected by the section. [6 310] Interest on compensation and damages Court awards of compensation or damages may often include an amount for interest on the principal sum awarded, either from the date of the event giving rise to the claim to the date of judgment (pre-judgment interest) or from the date of award to the date of payment (post-judgment interest). Pre-judgment interest on damages in a personal injury case is not assessable: Whitaker v FCT (1998) 38 ATR 219. In that case, the Full Federal Court also held that post-judgment interest in personal injury cases was assessable. However, s 51-57 ITAA 1997 exempts from tax post-judgment interest imposed on the sum awarded between the date of the original judgment and the time the judgment is ‘‘finalised’’. A judgment is finalised when the final judgment (after any appeals) takes effect, when the appeal period expires (if no appeal is lodged) or when any appeal is settled or discontinued, as applicable. 158

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Post-judgment interest, accruing from the date the judgment is finalised to the date of payment, continues to be assessable. EXAMPLE [6 310.10] Peter is awarded damages in a personal injury case. The defendant unsuccessfully appeals against the decision. No further appeal is lodged. The exempt post-judgment interest is the interest accruing from the date of the original judgment to the time when any right to appeal, or to seek special leave to appeal, against the subsequent judgment expires.

EXAMPLE [6 310.20] Paul is awarded damages in a personal injury case. He is dissatisfied with the amount of the damages and appeals. The damages are increased on appeal and no further appeal is lodged, either by Paul or the defendant. The exempt post-judgment interest is the interest accruing (on the increased amount) from the date of the original judgment to the time when any right to appeal, or to seek special leave to appeal, against the subsequent judgment expires.

EXAMPLE [6 310.30] Mary unsuccessfully sues for damages for personal injury. On appeal, however, the appeal court awards her damages. The High Court grants the defendant leave to appeal but dismisses the appeal. Post-judgment interest is payable on the judgment debt arising from the appeal court’s decision. The interest accruing from the date of the appeal judgment to the time the High Court’s decision takes effect is exempt.

EXAMPLE [6 310.40] Skye is awarded damages in a personal injury case. The defendant lodges an appeal, but before the appeal is heard it is settled on terms less favourable to Skye. The exempt post-judgment interest is the interest accruing from the date of the original judgment to the time when the settlement takes effect.

In non-personal injury cases, whether the interest is assessable depends on whether there is an identifiable amount (eg as in Re Taxpayer and FCT (2004) 58 ATR 1152) or whether the amount is paid as an undissected sum (in which case the capital or income nature will be decided in relation to the sum as a whole): see [6 500].

RENT AND ROYALTIES [6 350] Rent Rental income is generally assessable under s 6-5 as ordinary income, ie income according to ordinary concepts: see [3 050] and [3 340]. See [3 020] for the distinction between ordinary income and statutory income. Rental income is always income from property unless a taxpayer is carrying on a business of renting out properties. Rental income is generally not assessable if it is paid as part of close intra-family arrangements. The key factor is whether the arrangements in question are commercial in character, so that payments have the character of rent. For example, ‘‘board’’ paid by a student to her or his parents will not be treated as assessable income of the parents (but the © 2017 THOMSON REUTERS

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parents will not be able to claim deductions against the payments): see Ruling IT 2167. In FCT v Groser (1982) 13 ATR 445, where the taxpayer let a house to his parents and brother for a nominal rent, the rent was not assessable (and related outgoings were not deductible). Similarly, if the owner of a residence allows others to share the residence on the basis that all the occupants, including the owner, bear an appropriate proportion of the costs actually incurred on food, electricity, etc, payments received by the owner are not assessable income: see Ruling IT 2167. Amounts received by a host family under a homestay arrangement (where a student lives with the host family) are unlikely to be assessable: see ATO ID 2001/381. As to the division of rental income between co-owners (a ‘‘tax law partnership’’), see [22 040]. Deductions allowable against rental income are dealt with at [9 1380].

[6 360] Royalties The assessable income of a taxpayer includes any amount received as, or by way of, a royalty within the ordinary meaning of that term (unless s 15-22 applies: see below): s 15-20. Royalties are usually regarded as income from property, but if they arise as part of the proceeds of the business of the taxpayer or from personal services (eg authors), they are income from personal services. The ordinary meaning of the term ‘‘royalty’’ is considered in Ruling IT 2660. According to the ruling, the key characteristics of a royalty within the ordinary meaning of the term are: • it is a payment made in return for the right to exercise a beneficial privilege or right (eg to remove minerals or natural resources, to use a copyright or to produce a play); • the payment is made to the person who owns the right to confer that beneficial privilege or right; • the consideration payable is determined on the basis of the amount of use made of the right acquired; and • the consideration payable will usually be paid as and when the right acquired is exercised. Section 6(1) ITAA 1936 expands the meaning of ‘‘royalty’’ to include certain amounts which may not be royalties within the ordinary meaning of that term. If an amount is a ‘‘royalty’’ within the ordinary meaning of the word and it is of an income nature, it is assessable under s 6-5. If, however, a ‘‘royalty’’ within the ordinary meaning of the word is of a capital nature, it is assessable under s 15-20 (as statutory income). If an amount is not a royalty within the ordinary meaning of that term, but falls within the extended definition of ‘‘royalty’’ (ie as defined in s 6(1) ITAA 1936), it is not assessable under s 15-20, but may still be assessable under s 6-5 if of an income nature. Section 6C ITAA 1936 deals with the source of royalties. Difficulties sometimes arise in determining the character of an amount that is calculated by the quantity of the asset acquired by the purchaser. For a consideration of the factors that determine whether the amount is a royalty, see McCauley v FCT (1944) 69 CLR 235, Stanton v FCT (1955) 92 CLR 630 and Rolls-Royce Ltd v Jeffrey [1962] 1 All ER 801. The statutory definition of ‘‘royalty’’ is considered in detail at [35 410] (in the context of the royalty withholding tax provisions: see below). However, briefly, a ‘‘royalty’’ includes payments and credits for the use of, or the right to use, materials supplied by or rights held by another person, including copyrights, patents, trademarks, scientific, technical, industrial or commercial knowledge, industrial, commercial or scientific equipment and visual images or sounds transmitted to the public by satellite or cable, optic fibre or similar technology. The definition of ‘‘royalty’’ also captures a payment or credit that is consideration for an agreement not to make available to third parties the use of, or right to use, any such property or the right to use films, television films or video or radio tapes. However, a payment for the 160

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exclusive right to use a broadcasting licence and an apparatus licence is not a royalty: ATO ID 2006/307 and ATO ID 2006/308. A payment for the surrender of data licensing rights is also not a royalty: ATO ID 2007/4 and ATO ID 2007/5. The Tax Office’s views on the meaning of ‘‘royalty’’, in the context of the royalty withholding tax provisions (whether an amount paid or credited as consideration for the assignment of copyright is a ‘‘royalty’’), are set out in Ruling TR 2008/7. Draft Ruling TR 2016/D3 considers the treatment of what are called ‘‘override royalties’’ (typically made by the holder of a mining right to an entity that does not have an interest in the right, based upon the value of natural resources produced and/or sold). Ruling IT 2660 states that, as a general proposition, the term ‘‘royalty’’ does not include a payment for services. Payments for services that are ancillary to enabling relevant technology, information, know-how, copyright or machinery or equipment to be transferred or used will be royalty payments. It is determined having regard to all circumstances. Royalties paid to non-residents are generally subject to the withholding tax system in the same manner as dividends and interest (discussed in Chapter 35), although a double tax agreement may provide otherwise (eg ATO ID 2006/282). The Tax Office considers that if a person’s royalty withholding tax liability is indemnified by another person, the indemnity amount is itself a royalty if, upon the proper construction of the relevant indemnity agreement, it can be said to be ‘‘consideration’’ for any of the matters listed in the s 6(1) definition of ‘‘royalty’’: Ruling TR 2004/17. If a copyright collecting society (as defined in s 995-1) collects royalties on behalf of a member of the society, the relevant amounts will be included in the member’s assessable income when distributed to the member, except to the extent that the directors of the society are assessed under s 98, s 99 or s 99A ITAA 1936 (see [23 160]) in respect of the payment: s 15-22. A ‘‘member’’ is defined in s 995-1 to include a person who has authorised the society to license the use of her or his copyright material. The same rules apply to any other amounts paid by the society to the member (eg interest on the royalties). The corollary of this is that the copyright collecting society is exempt on such amounts: see [7 480]. Similar provisions apply to royalties paid by a resale royalty collecting society to an entity entitled to a share of a resale royalty (on the commercial resale of an artwork): s 15-23. The resale royalty collecting society is exempt on such amounts: see [7 480]. If a copyright collecting society makes a payment to a member, the society must at the same time give the member a written notice containing various information, including the amount of the payment on which the directors are or have been assessed under s 98, s 99 or s 99A of and the amount of the payment to be included in the member’s assessable income: s 410-5 ITAA 1997. If the society fails to give the notice, an administrative penalty of 20 penalty units may be imposed under s 288-75 in Sch 1 TAA (see [54 020] for the value of a penalty unit). The Commissioner has the discretion to remit the penalty: see [54 410]. Similar provisions apply to a resale royalty collecting society that makes a payment to an entity entitled to a share of a resale royalty: s 410-50.

INCOME FROM LEASED PROPERTY [6 400] Sale of leased cars In broad terms, Subdiv 20-B ITAA 1997 (ss 20-100 to 20-160) includes in assessable income the profit made on the disposal of a leased car if the lease payments were deductible. A ‘‘car’’, for these purposes, is any motor-powered vehicle, including a 4-wheel drive vehicle, designed to carry a load of less than 1 tonne and fewer than 9 passengers, but does not include a motor cycle or similar vehicle: see the definitions in s 995-1 of ‘‘car’’ and ‘‘motor vehicle’’. The Subdivision applies if (s 20-110): © 2017 THOMSON REUTERS

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• a car designed mainly for carrying passengers is leased to the taxpayer; • the lease payments paid or payable by the taxpayer are deductible, in whole or in part, by the taxpayer or another entity (ie the car must have been used for income-producing purposes) – s 20-110 will not apply if the car is the subject of a split fully novated lease arrangement as the lease payments are not paid or payable by the employee taxpayer; • the taxpayer acquired the car from the lessor; and • the taxpayer later disposes of the car at a profit. The Subdivision also applies if (s 20-125): • a car designed mainly for carrying passengers is leased to the taxpayer or an associate of the taxpayer (‘‘associate’’ has the same meaning as in s 318 ITAA 1936: see [4 220]); • the lease payments are deductible, in whole or in part, by the taxpayer, the associate or another entity (ie the car must have been used for income-producing purposes); • the taxpayer, an associate of the taxpayer or entities that include the taxpayer or the associate acquired the car from the lessor, or another entity acquired the car from the lessor under an arrangement that enabled the taxpayer or the associate to use the car; and • the taxpayer later disposes of the car at a profit.

Calculating the profit The profit on the disposal of the car is the amount by which the consideration receivable exceeds the cost (to the taxpayer) of acquiring the car plus any capital expenditure the taxpayer incurred on the car after acquiring it: s 20-115(1). The ‘‘consideration receivable’’ means (s 20-115(2)): • if the car is sold for a specific price – the sale proceeds, less any sale expenses (eg advertising costs, sales commission); • if the car is sold with other property and no specific price is allocated to the car – the proportion of the total sale proceeds that is reasonably attributable to the car, less the proportion of any reasonably attributable sale expenses; • if the car is traded in for another car – the value of the trade-in, plus any other consideration received by the taxpayer (eg any reduction in the cost of the new car, including a reduction in lease payments if the new car is leased: see Ruling TR 98/15); • if the other car is sold and another entity buys another car – the amount by which the cost of the other car is reduced by the sale, plus any other consideration received by the taxpayer; • if the car is lost or destroyed and is disposed of to the insurer – the amount or value received or receivable under the insurance policy. If the disposal of the car is a taxable supply for GST purposes, the consideration receivable is reduced by an amount equal to the GST payable on the supply: s 20-115(3).

Assessable amount Although ss 20-110 and 20-125 provide that the ‘‘profit’’ on the disposal of a previously leased car is included in the taxpayer’s assessable income, ss 20-110(2) and 20-125(2) limit the amount that is assessable under Subdiv 20-B to the smallest of: 162

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• the total lease payments that were deducted or deductible – if the taxpayer, or an associate of the taxpayer, has leased the car more than once from the same lessor, or an associate of that lessor, this amount is increased by the total of the lease payments under those previous leases that have been deducted or are deductible: ss 20-110(3), 20-125(3); • the amount of notional depreciation for the lease period – if the taxpayer, or an associate of the taxpayer, has leased the car more than once from the same lessor, or an associate of that lessor, this amount is increased by the amount of notional depreciation for the period of each previous lease: ss 20-110(3), 20-125(3); and • if an entity other than the taxpayer, or entities that include the taxpayer, acquired the car from the lessor (ie the disposal by the taxpayer is not the first disposal after the car was acquired from the lessor) – the amount by which the consideration receivable (by the taxpayer) exceeds the cost of the car to the entity (or entities) that acquired the car from the lessor, increased by any capital expenditure on the car incurred by that entity (or those entities): s 20-125(2). If the car has been leased more than once and, as a result, there are different amounts that could be included in the taxpayer’s assessable income on disposal of the car, only the largest of those amounts is included: s 20-130. The amount of notional depreciation is calculated under s 20-120 by comparing the cost of the car to the lessor under Subdiv 40-C (ie for depreciation purposes: see [10 700]) and its termination value (for the purposes of s 40-300: see [10 890]) when the lessor disposed of it. See the note to Example [6 400.10] for comment on whether the lessor’s or lessee’s termination value is used. If the car’s cost exceeds the termination value, the notional depreciation is the amount worked out using the following formula: (Cost − termination value) ×

number of days in lease period number of days lessor owned the car

If the car’s cost does not exceed the termination value, the notional depreciation is zero.

Reduction in assessable amount The amount included in a taxpayer’s assessable income under Subdiv 20-B is reduced if, after the lease began but before the taxpayer disposed of the car, there was an earlier disposal: s 20-140. The reduction amount is: • if the taxpayer or another entity disposed of the car and an amount was included in assessable income under s 20-110 or s 20-125 – the assessable amount; • if the taxpayer or another entity disposed of the car and an amount would have been included in assessable income under s 20-110 or s 20-125 but for the exclusion provided under s 20-145 for inherited cars (see below) – the assessable amount; and • if the taxpayer or another entity disposed of the car and the amount included in assessable income was reduced under s 20-150 because the disposal was taxed under another provision of the income tax law (see below) – the amount of the reduction. The amount to be included in the taxpayer’s assessable income under Subdiv 20-B is also reduced by any amount that another provision of the income tax law (other than the Div 40 balancing adjustment provisions: see [10 850]) makes assessable as a result of the disposal of the car, eg if the amount received is assessable under s 6-5 as ordinary income: s 20-150. In effect, therefore, provisions such as s 6-5 take precedence over Subdiv 20-B. Section 6-5 would apply if the taxpayer bought and re-sold the car as a normal part of their business (see [3 060]) or entered into the particular transaction with the intention of making a profit (see [3 070]). © 2017 THOMSON REUTERS

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No amount is included in the taxpayer’s assessable income if: • after the lessor disposed of the car but before the taxpayer disposed of the car, another entity disposed of the car for at least market value and the market value amount is included in that entity’s assessable income: s 20-135; or • the taxpayer inherited the car: s 20-145.

Disposal of interest in car If the taxpayer disposes of an interest in the car, the provisions discussed above apply in the same way as they apply to the disposal of the car itself, except that (s 20-160): • the assessable amount is so much of the profit on the disposal that is reasonable – note that the limits in ss 20-110(2) and 20-125(2) do not apply; • the cost of the interest to the taxpayer is taken to be a reasonable amount; • s 20-135 (no amount assessable if previous disposal by another entity for market value) and s 20-140 (reduction in assessable amount if previous disposal) do not apply; and • no amount is assessable if the taxpayer inherited the car or the interest in the car (ie s 20-145 applies).

Exceptions The Subdivision does not apply if: • the car is let on hire under a hire purchase agreement or under an agreement for the temporary hire of the car, eg on a daily, weekly or monthly basis: s 20-155; or • the car was allocated by a small business entity to a pool under Subdiv 328-D ITAA 1997 (see [25 120]) at any time during the income year in which the car was disposed of: s 20-157. A disposal of the car outside Australia by a taxpayer who was no longer a resident would presumably not be caught by Subdiv 20-B since the source of the profit would be the place where the sale took place: s 6-5(3). EXAMPLE [6 400.10] Assume that a car has been leased for a period of 3 years at an annual lease payment of $9,000. The cost of the car to the lessor was $35,000 and the residual value in the lease agreement was $20,000, which was paid by the lessee to acquire the car. Assume that the lessee sold the car for $25,000 (ie a $5,000 profit). For the purpose of determining the amount of assessable income the following are relevant: $ 1. Notional depreciation Cost of car 35,000 Less termination value 20,000 Notional depreciation 15,000 2. Deductible lease charges (3 years at $9,000 pa) 27,000 3. Actual profit made 5,000 The assessable income is the lowest of these 3 amounts, ie $5,000.

Section 20-120 does not make it clear whether you should use the lessor’s ($20,000) or lessee’s ($25,000) termination value. Note 1 to the section states that the notional depreciation for the lease represents the amount you (ie the lessee) could have deducted for the decline in value if you owned the car instead of leasing it, adjusted by the balancing 164

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[6 410]

adjustment if you (ie the lessee) had disposed of it at the end of the period. In this example, the lessee disposed of the car for $25,000 not $20,000. The Explanatory Memorandum to the legislation (Tax Law Improvement Act 1997) adopts the disposal by the lessor as the termination value, but it makes no reference to the actual words of s 20-120. EXAMPLE [6 400.20] Assume the same facts as in Example [6 400.10] except that the residual value is $16,000 and the car was used only 50% for income-producing purposes. The relevant amounts are those allowed or deemed to have been allowed as a deduction for income tax purposes: $ 1. Notional depreciation Cost of car 35,000 Less termination value 20,000 15,000 2. Proportion of deductible lease charges (3 years at $9,000 pa ÷ 2) 13,500 3. Actual profit made 9,000 The assessable income is $9,000, being the lowest of the 3 amounts.

[6 410] Luxury car leases – treatment as loans Luxury car leases entered into after 7.30 pm on 20 August 1996 AEST, other than genuine short-term hire arrangements, are treated as if they are notional sale and loan transactions for tax purposes. Luxury cars are those whose cost would exceed the car cost limit for depreciation purposes: see [10 1300]. The luxury car lease rules are contained in Div 242 ITAA 1997. The rules are designed to overcome the use of luxury car leasing arrangements involving offshore lessors, tax-exempt lessors or tax-preferred lessors (such as superannuation funds) to avoid the intended effect of the luxury car cost limit. The intended result is that the effect of the luxury car cost limit on the after-tax cost of a leased car to its end-user will become comparable to the effect of that limit on the after-tax cost of buying or otherwise financing the car. Lessee – tax treatment The lessee of a luxury car, rather than the lessor, will be treated as the owner until the lease term ends or the lease is terminated before that time: s 242-15. When a lease is entered into, the lessor is taken to make a notional loan to the lessee equal to the cost of the car subject to payment of a finance charge. Lease payments are regarded as repaying the notional loan and paying the finance charge: s 242-25. If the car is used for the purposes of gaining assessable income, the lessee will not be able to deduct that part of the lease rental representing notional loan repayments, but will be entitled to deduct the finance charge component (under s 8-1 ITAA 1997) and the decline in value (under Div 40 ITAA 1997) based on the cost of the car (subject to the luxury car cost limit in s 40-230). Note that a balancing adjustment event (under Subdiv 40-D: see [10 850]) does not occur when the lessee acquires the car from the lessor at the expiration of the lease, or on the early termination of the lease, as the lessee does not stop holding the car for Div 40 purposes: see ATO ID 2003/756. Lessor – tax treatment The lessor will lose entitlement to the capital allowance deductions, but will not be required to return the lease payments as assessable income. The lease payments are taken into account in calculating the accrual amounts included in the lessor’s assessable income: s © 2017 THOMSON REUTERS

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242-35. The accrual amounts for the lease payment periods under the lease are defined in s 242-35 as that part of the finance charge relating to the lease payment period (or accrual period), calculated by multiplying the outstanding notional loan principal by the implicit interest rate under the lease. A balancing adjustment event (under Subdiv 40-D: see [10 850]) happens upon the notional sale of the car to the lessee (and also when the lessor eventually sells the car after re-acquiring it from the lessee).

Subleases If the lessee subleases the car, the rules will treat the sublessee as the owner eligible for capital allowance deductions. Neither the lessor’s assessable return on investment nor the lessee’s equivalent deductible amount will be affected and the sublessee’s entitlement to deductions will be calculated by reference to its own lease payments instead of the lessee’s lease payments. Non-resident lessors The rules do not affect a non-resident lessor that is not required to return car lease income in Australia (eg if the non-resident does not have a permanent establishment in Australia). Lease payments to non-resident lessors continue to be taxed as royalties under the withholding tax provisions. However, resident lessees who lease luxury cars from non-residents are subject to the rules. Genuine short-term hire arrangements Short term hire arrangements involving luxury cars are not covered by the luxury car lease rules: s 242-10. However, successive agreements for the hire of the same luxury car, whether to the taxpayer or an associate of the taxpayer, are not short-term hire agreements if there is substantial continuity of hiring (see the definition of ‘‘short-term hire agreement’’ in s 995-1). Partial novation and car lease Ruling TR 1999/15 sets out the Commissioner’s views on the tax consequences of an employee arranging a partial novation of a car lease to her or his employer (for an example of a full novation, see Re Jones and FCT (2005) 60 ATR 1096). If the partial novation occurs in the creation of a sublease to the employer, the employee (sub-lessor) is in receipt of a benefit under that sublease and is assessable on the value of that benefit. The ruling applies to luxury car and non-luxury car partial novation arrangements entered into after 17 June 1998 (partial novations before then are accepted as full novations). In the case of a non-luxury car, the employee is assessable when the lease payment obligations are transferred. The benefit is calculated by reference to the value, equivalent to the lease payments, of the consideration received. When the partial novation involves a luxury car, the employee is assessed on the accrual amount of the notional loan in relation to the luxury car lease. The accrual amount is calculated by reference to the consideration for the granting of the right to possession or use of the motor vehicle by the employee to the employer. That consideration is equal to the amount of the lease payment obligation transferred to the employer. The employee is not entitled to a deduction for lease payments made by the employer to the finance company, as no expense has been incurred or paid by the employee. There may also be FBT consequences: see [58 020]. [6 420] Lease incentives Lease incentives are inducements offered by lessors to potential lessees or their nominees to enter into leases. They most often arise with new commercial office buildings where it is sought to attract prestigious tenants, such as large professional firms, in order to ensure the success of the project and attract other tenants. They may take the form of upfront cash 166

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[6 420]

payments, goods such as cars or boats, a free fit-out of the premises by the lessor, rent-free periods or various combinations of similar inducements. In FCT v Cooling (1990) 21 ATR 13, the inducement was in the form of lump sum cash payments by a lessor to members of a firm of solicitors upon the firm’s service company entering into a lease. The Full Federal Court held that the incentive payment was income according to ordinary concepts (and therefore assessable) as the transaction was commercial and formed part of the business of the firm. Decisions subsequent to Cooling, however, suggested that the decision was to be confined to its facts. In Selleck v FCT (1997) 36 ATR 558, the Full Federal Court held that a contribution to a fit-out of leased office premises made by a landlord to a firm of solicitors in which the taxpayer was a partner was not assessable income, even though the contribution enabled the partnership to make a cash distribution to the partners. The Full Court concluded that there was no relevant purpose of profit-making as the decision to move to the particular premises was not influenced by the contribution to the fit-out. Therefore, the lease incentive was on capital account (there were no CGT consequences as the amounts were received or agreed to be paid before 20 September 1985). Other decisions casting doubt on Cooling’s case include Lees & Leech Pty Ltd v FCT (1997) 36 ATR 127 (contribution towards costs of fitting out new leased premises not assessable as there was no gain and the right to remove tenants’ fixtures at the end of the lease was effectively valueless) and Wattie v IRC (1997) 18 NZTC 13,297 (a Privy Council decision). However, the Cooling decision has since been ratified by the High Court in FCT v Montgomery (1999) 42 ATR 475. The taxpayer in that case was a partner in a firm of solicitors which entered into a lease agreement for new premises through its nominee. A second agreement provided for payment to the nominee of $29.3m over 3 years, as an inducement to enter into the lease agreement. The nominee paid the inducement amounts to the firm, which then dispersed the money to its partners. By a majority, the High Court held that the firm used or exploited its capital (whether the lease agreement or its goodwill) in the course of carrying on its business, albeit in a singular or extraordinary transaction, to obtain the inducement payments. The payments were not some growth or increment of value in its profit-yielding structure, but were something that came in or were derived from that profit-yielding structure for the benefit and disposal of the firm and its members as they saw fit. The inducement payments were therefore assessable income. The majority of the High Court was unable to accept the reasoning in Wattie as it was based upon symmetry between deductibility and assessability, a notion expressly rejected by the High Court in FCT v Rowe (1997) 35 ATR 432 at 436 and 446. In O’Connell v FCT (2002) 50 ATR 331, an incentive paid to a firm of accountants to lease new premises was held to be assessable income as a ‘‘substantial and motivating factor and purpose’’ in the decision to enter into the lease was the receipt and distribution to the partners of the incentive payment. The agreement to lease the particular premises was a commercial transaction entered into with a view to a profit or gain. See also Re Proctor and FCT (2005) 59 ATR 1064 (the taxpayer in that case was a partner in the same firm as the taxpayer in O’Connell). The Tax Office’s views on the assessability of cash lease incentives (under s 6-5) and non-cash lease incentives (under s 21A) are set out in Ruling IT 2631, which issued after Cooling’s case. In light of the Montgomery decision, this ruling appears to be valid. The ruling is summarised in the following table. Type of incentive Cash payment Rent-free periods and rent discounts Interest-free loans Free fit-outs

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Tax result Fully assessable Not taxable if rent or higher rent would have been deductible to lessee: s 21A(3) Effectively tax-free, provided they are genuine business loans If landlord owns the fit-out – not taxable: s 21A(3) If tenant owns the fit-out – assessable but depreciation allowed

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Type of incentive Free plant eg computers Holiday packages Removal expenses Surrender payments

Tax result Assessable to lessee but depreciation allowed Complete packages effectively tax-free to the tenant Generally fully assessable Generally fully assessable

Ruling IT 2631 also considers the value of the benefits and the lessor’s deductions. It should be noted, however, that this ruling was issued prior to the redrafting of ss 160M(6) and 160M(7) ITAA 1936 and the rewriting of the CGT provisions. The assessability of lease surrender payments is considered at [6 440].

[6 430] Sale of leased property Whether any profit arising on the sale of leased property is assessable income or a capital gain depends on general principles discussed in Chapter 4. A profit made by the lessor of leased plant on its disposal may be assessable under Div 45 ITAA 1997: see [10 1020]. Specific statutory provisions deal with the sale of leased cars: see [6 400]. If previously leased property is sold for an amount in excess of the payout figure under the lease, the excess is assessable income if the leased property was used by the taxpayer in business activities and the sale is part of those activities (eg FCT v Reynolds (1981) 11 ATR 629) or if the transaction was entered into for the purpose of making a profit: see [3 120]-[3 130]. [6 440] Surrender of lease In Rotherwood Pty Ltd v FCT (1996) 32 ATR 276, the Full Federal Court held that a payment for the surrender of a lease of premises was assessable as income according to ordinary concepts. This was because it was the business of the service trust that received the payment to dispose of property so as to best serve the practice of the law firm with which it was associated. The fact that it was the final act in this business, because the services of the trust were being terminated, did not change its character as part of that business. In Ruling TR 2005/6, the Tax Office states that a payment for the surrender of a lease of land and/or a building is assessable income in the hands of the recipient (under s 6-5) if received: • in the ordinary course of carrying on a business of, in the lessee’s case, trading in leases or, in the lessor’s case, granting and surrendering leases; • as an ordinary incident of a business activity (even though it was unusual or extraordinary compared to the usual transactions of the business); or • as a profit or gain from an isolated business operation or commercial transaction entered into otherwise than in the ordinary course of carrying on a business and with the intention or purpose of making the relevant profit or gain. Otherwise, the payment will be on capital account (eg in the case of the lessee, if received for the surrender of a lease that formed part of the profit-yielding structure of the lessee’s business). If on capital account, CGT event A1 is relevant to the lessee (see [13 050]) and CGT event C2 is relevant to the lessor: see [13 080]. A payment for a variation or waiver of a term of a continuing lease is dealt with under Subdiv 104-F: see [13 300]-[13 340]. Ruling TR 2005/6 states that the anti-avoidance provisions of Pt IVA may apply if a technical variation or waiver of a term of a lease is used to effect a substantive surrender.

[6 450] Compensation for lessee’s failure to repair leased premises Any amount received by a lessor for breach by a lessee of an obligation in a lease to repair the leased property is assessable income of the lessor: s 15-25. A deduction is available to the lessee under s 25-15: see [9 600]. The lessor would be entitled to a deduction under s 25-10 (see [9 600]) for repairs carried out on the leased property. 168

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[6 460] Lease premiums A premium for granting a lease or for assigning a lease is governed by the CGT provisions if the lease was granted after 19 September 1985: see [13 050] (assignment of lease) and [13 300]-[13 310] (grant of lease). In the case of a pre-CGT lease of property (ie a lease granted before 20 September 1985), a premium (or a payment in the nature of a premium) in respect of the assignment of the lease (or assent to the assignment) is assessable under s 26AB(2) ITAA 1936 if the property is not intended to be used to produce assessable income. If the property is intended to be used partly for producing assessable income, the assessable amount is the amount the Commissioner considers may reasonably be attributed to the intended use of the property for purposes other than gaining or producing assessable income: s 26AB(3). Such a situation could arise if a pre-CGT lease of a shop and private dwelling is assigned. It is the assignee’s intention (at the date of the assignment or when assent to the assignment was given) that determines whether the property is intended to be used (wholly or partly) for non-income producing purposes. Section 26AB does not apply to certain premiums, for example a premium received in connection with the assignment of a mining lease: s 26AB(5). In addition, an amount in respect of goodwill or a licence, and a payment to obtain the surrender of a lease, is not a ‘‘premium’’ for s 26AB purposes: s 26AB(1).

MISCELLANEOUS CATEGORIES [6 500] Compensation and damages An amount paid as compensation or damages generally acquires the character of that for which it is substituted: FCT v Dixon (1952) 86 CLR 540. Thus, compensation payments which are a substitute for income will be income according to ordinary concepts, even if received as a lump sum: FCT v Inkster (1989) 20 ATR 1516; Determination TD 93/58. Examples are payments under a disability insurance policy to replace lost salary or wages and workers compensation payments: see [4 100]-[4 110]. Disability pensions received from overseas have also been held to be assessable: Re Moss and FCT (2005) 59 ATR 1129. In contrast, a lump sum paid as compensation for the loss of physical abilities, eg under workers compensation legislation for the loss of a limb, will be a capital receipt, eg see ATO ID 2004/943; see also [4 300]. A payment received by the taxpayer as compensation for pain, suffering and medical expenses, as a result of personal wrong, injury or illness, will also be a capital receipt. See also [5 080] and [5 120], where the assessability of compensation and insurance proceeds received by a business is discussed. The relevance of the effect of income tax on determining the amount of damages for personal injury was considered in Todorovic v Waller (1981) 12 ATR 632. The receipt of regular voluntary payments from his former employer to make up the level of his wartime pay to that which would have applied had he not enlisted and remained with his employer were held to be a substitute for income and therefore of the same nature as the income it replaced: FCT v Dixon (1952) 86 CLR 540. Lump sum amounts calculated by reference to periodical payments of income (eg weekly earnings) are likely to be assessable: see Re Cooper and FCT (2003) 52 ATR 1199, Re Gorton and FCT (2008) 72 ATR 201 and Re Senior and FCT [2015] AATA 353. Defamation damages received by a company were capital and not income because the damages were awarded for harm to the company’s business reputation and not for lost profits (even though the damages were calculated by reference to lost profits): Sydney Refractive Surgery Centre Pty Ltd v FCT (2008) 70 ATR 874 (the Commissioner’s appeal against this decision was dismissed in FCT v Sydney Refractive Surgery Centre Pty Ltd (2008) 73 ATR © 2017 THOMSON REUTERS

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28). In Murdoch v FCT (2008) 68 ATR 490, the Full Federal Court held that a settlement payment made to a life tenant beneficiary of several trusts, for breach of fiduciary duty by the trustees, was capital and not income on the basis that the character of a settlement payment follows the nature of the claim (a matter of capital in this case). See [4 300] and following for a discussion of whether a lump sum payment is an employment termination payment.

Composite claims Lump sum damages or out-of-court settlements may be a compromise of a claim made up of a number of items, some being of a revenue nature and others of a capital nature. In these circumstances, if the gross amount is not specifically allocated to the various items making up the claim and it cannot be dissected into its component parts, the compensation (which would be taxable if received in respect of a particular part of the claim) will be of a capital nature: see McLaurin v FCT (1961) 104 CLR 381 and Allsop v FCT (1965) 113 CLR 341. In FCT v CSR Ltd (2000) 45 ATR 559, a lump sum was paid to the taxpayer by its insurer in settlement of an action arising from the insurer’s refusal to indemnify the taxpayer in respect of asbestos-related claims. The Full Federal Court held that as the payment was for the release of a number of causes of action, some of which related to income and some to capital, it was an undissected capital amount (assessable as a capital gain). In contrast, in Re Taxpayer and FCT (2004) 58 ATR 1152, compensation paid to the taxpayer for the compulsory acquisition of land could be dissected into capital and interest components, even though the compensation was partly in the form of replacement blocks of land (the interest component was assessable income). Different components of a lump sum compensation payment can sometimes be identified and those components that are of an income nature (eg to compensate for loss of income) will be assessable as such: Determination TD 93/58. See [6 310] in relation to interest paid on or as part of claims. Compensation under anti-discrimination legislation Ruling IT 2424 deals with the assessability of compensation payments under anti-discrimination legislation. In brief, payments to compensate for psychological and emotional injury, loss of enjoyment of work and impairment for future promotion or earning capacity are of a capital nature (and thus not assessable income), but payments to compensate for loss of earnings are assessable income. If one undissected sum of money is paid and it is not possible to allocate any part of it to the loss of earnings, the whole amount will be of a capital nature. CGT provisions Amounts in the form of compensation and damages may be subject to assessment under the CGT provisions in Pt 3-1 ITAA 1997 (see, in particular, Chapter 12 to Chapter 14). However, compensation or damages for any wrong or injury suffered by a taxpayer either personally or in her or his occupation are excluded from the application of the CGT provisions: see [15 100]. Structured settlements Personal injury annuities and lump sums purchased under structured settlements or structured orders (after 26 September 2001) are exempt from income tax: see [7 070]. [6 510] Insurance receipts In accordance with general principles discussed in Chapter 3, a payment under an insurance policy to compensate for the loss of income that would have been assessable is itself assessable: eg FCT v Smith (1981) 11 ATR 538 (they may also be assessable under 15-30 ITAA 1997: see [5 120]). Examples include payments under an income replacement or 170

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[6 540]

protection policy including a sickness and disability or personal accident policy (eg see ATO ID 2002/175 and ATO ID 2004/662). Similarly, payments under an insurance policy that represent loss of earning capacity (eg for the loss of a limb) are capital in nature and not assessable. They are also exempt from CGT: see [15 100]. In Sommer v FCT (2002) 51 ATR 102, a lump sum paid to a doctor in settlement of his claim under an income replacement policy was assessable on the basis it was in substitution for his original claim under the policy for lost income. See also Re Gorton and FCT (2008) 72 ATR 201, where the AAT followed the Sommer decision. In Watson v DCT (2010) 75 ATR 224, payments under an income replacement policy for partial disability were personal to the taxpayer and were not assessable income of his financial planning business (and thus could not be offset against business losses under Div 35 ITAA 1997: see [8 600]). Payments under a trauma insurance policy to an employee or self-employed person are not considered to be assessable: Determination TD 95/41; ATO ID 2004/942. A lump sum paid under a mortgage protection policy when the taxpayer suffered a total permanent disablement was considered to be a non-assessable capital amount in ATO ID 2003/204. Benefits under funeral policies and scholarship plans issued by a life insurance company after 31 December 2002 are assessable under ss 15-55 and 15-60 ITAA 1997 respectively (if not ordinary income or assessable under some other provision). The benefit received under a scholarship plan issued before 1 January 2003 is also assessable if no amount attributable to the plan that is received by the issuing company on or after that date is non-assessable non-exempt income of the company (see [30 080] and [30 320]). In every case, the assessable amount is the benefit received by the taxpayer, reduced by the premiums that are reasonably related to the benefit and any fees and charges assessable in the hands of the issuing company (see [30 030]) that are reasonably related to the benefit. A payment under the HIH rescue package in settlement of a claim under a general insurance policy held with an HIH company is treated as if it had been paid under the policy (eg if the payment represents compensation for lost earnings, the payment is assessable): s 322-5.

[6 520] Maintenance payments Periodical amounts or regular receipts to which the taxpayer looks to maintain herself or himself or her or his family are of an income nature: see FCT v Dixon (1952) 86 CLR 540. However, maintenance payments made to a former spouse for the benefit of a child are generally exempt: see [7 050]. [6 530] Restrictive covenants A sum received as consideration for the recipient entering into a covenant not to compete with the payer is generally of a capital nature, as the recipient has restricted her or his rights to earn income and has thereby lost part of her or his ‘‘profit-earning capacity’’. In Higgs v Sir Laurence Olivier (1952) 33 TC 136, the famous actor was paid a sum of money not to appear in any capacity while a film that he had produced was exhibited in the United Kingdom. The sum was held to be a capital receipt. Entering into such a restrictive covenant may constitute CGT event D1 (the creation of a contractual right in another entity), in which case the proceeds may be assessed as capital gains: see [13 150]. If, however, the payment for the covenant was in the form of an amount per week for an indefinite time (instead of being a lump sum), the weekly payments are likely to be income and assessable under s 6-5. In Dickenson v FCT (1958) 98 CLR 460, it was held that a sum of money received by a garage proprietor to sell the products of only one oil company was of a capital nature in the hands of the recipient; see also Murray v Imperial Chemical Industries Ltd [1967] 2 All ER 980 and Thompson (Insp of Taxes) v Magnesium Elektron Ltd [1944] 1 All ER 126. [6 540] Voluntary payments and gifts The actual character of a voluntary payment in the hands of the ‘‘donee’’ depends upon the particular facts. Some ‘‘gifts’’ are clearly not income, eg pocket money paid to a child, © 2017 THOMSON REUTERS

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whereas others are generally income, eg tips: see [4 030]. However, there is a substantial grey area where the assessability of a ‘‘gift’’ is less certain. In these cases, the key issue is whether the gift was made on personal grounds or by reference to the position occupied, or services rendered, by the recipient of the gift. The leading Australian cases on gifts establish that a benefit given voluntarily will be income if it is the ‘‘product’’ of an income producing activity: FCT v Squatting Investment Co Ltd (1954) 88 CLR 413, Hayes v FCT (1956) 96 CLR 47 and Scott v FCT (1966) 117 CLR 514 (see also FCT v Co-operative Motors Pty Ltd (1995) 31 ATR 88, noted at [3 060]). The corollary of this is that a voluntary payment made because of some personal quality of the recipient is more likely to be a mere gift and not income. The question in each case is what is the character of the receipt in the hands of the recipient (an objective, and not a subjective, test). The motives of the donor may be relevant, but they do not determine the answer: Scott at 526. The decision in Brown v FCT (2002) 49 ATR 301 gives a clearer example because there was no close personal relationship established between the giver and the receiver of the gift. The taxpayer (a former federal Cabinet Minister) was given a beachfront unit and other benefits by an Australian property developer, for introducing a foreign company which subsequently bought $21m worth of property from a company controlled by the developer and his associates. The taxpayer also made representations to the Foreign Investment Review Board on behalf of the foreign company. The Full Federal Court upheld the trial judge’s decision that the unit and other benefits were not gifts, but were a reward for introducing and otherwise assisting the foreign company. Accordingly, the value of the unit and other benefits was assessable income. Government grants and ex-gratia payments to non-business taxpayers are less likely to be income, eg FCT v Rowe (1997) 35 ATR 432, where a government ex-gratia payment to a non-business taxpayer in reimbursement of his legal costs was held not to be income: see [6 620]. In FCT v Stone (2005) 59 ATR 50, the High Court held that government grants to an athlete were assessable as she was carrying on a business: see [4 080]. The assessability of grants and subsidies paid to business taxpayers is considered at [5 110]. It should be noted that ex gratia payments may be assessable if they are a substitution for income: see [6 620]. Ruling IT 2674 discusses the position with gifts to church workers. The Tax Office considers that the following are assessable income: an ex-gratia payment by the Commonwealth Government to compensate an AFP officer for tax paid while serving in East Timor (ATO ID 2003/263) and an Emergency and General Assistance payment made under the Volunteer Fire Fighters Assistance package: ATO ID 2003/512. However, one-off financial assistance provided by a charity to an individual who suffers personal hardship as the result of a disaster or emergency will not be treated as assessable income: Determination TD 2006/22 and ATO ID 2003/568. Standard and basic foster care subsidies (plus additional loadings or allowances) paid to volunteer foster carers are generally not assessable: Determination TD 2006/62. An act of grace payment approved under s 33 of the Financial Management and Accountability Act 1997 was not assessable in ATO ID 2004/512. The assessability of tips is considered at [4 030] and the assessability of voluntary payments from a strike fund is considered at [4 130]. The assessability of a gift from an employer to an employee is considered further at [4 060].

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Windfall gains

Windfall gains are generally not income according to ordinary concepts. They lack the regularity or periodicity of income and are not usually an inherent part of any occupation or business activity. See, for example, Ruling TR 1999/17 (occasional voluntary payments to sportspeople paid on personal grounds not assessable). However, if a gain is income according to ordinary concepts, eg a profit on the sale of shares made by a person who trades in shares, the fact that the gain is larger than expected due to some windfall circumstance, 172

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such as the company finding rich mineral deposits, has no bearing on the matter. The whole gain is income according to ordinary concepts. The most common examples of windfall gains are winnings in a lottery or a game with prizes. Gambling wins are also usually windfall gains and not assessable, except where the taxpayer’s activities amount to a business. Investment-related lottery winnings are assessable: see [6 300]. In Re Pope and FCT (2001) 46 ATR 1172, an amount paid to a firm of accountants by the Tax Office under its Compensation for Detriment Caused by Defective Administration scheme was assessable: see [5 070]. The AAT considered that if a person makes a claim, based on executive government policy, which will be paid if it satisfies certain criteria, the payment is not a windfall gain. However, an act of grace payment approved under s 33 of the Financial Management and Accountability Act 1997 is not assessable: see ATO ID 2004/512.

[6 560] Incidental rewards – frequent flyer/fly buy programs Rewards received under consumer loyalty programs will be assessable if the reward is received as part of an income earning activity and: • there is a business relationship between the recipient of the reward and the reward provider; and • the benefit is convertible directly or indirectly to money’s worth, or the taxpayer is carrying on a business and s 21A ITAA 1936 operates to include the reasonable value of the non-cash business benefit in the taxpayer’s assessable income (see [3 200]): see Ruling TR 1999/6 and Practice Statement PS LA 2004/4 (GA). Similarly, if the activities associated with the obtaining of a reward amount to a business or commercial activity and the reward is a non-cash business benefit in terms of s 21A, the reward will be assessable. However, rewards earned in the course of performing employment activities are not assessable (under s 6-5 or 15-2) if they are the result of personal arrangements entered into by the taxpayer and are not granted in connection with the employment or because of services rendered. Frequent flyer points earned in the course of travel on employment duties are not assessable, even if arising from employer-paid travel, because they arise from a personal contractual relationship that is not employment or business linked: Payne v FCT (1996) 32 ATR 516; Ruling TR 1999/6. Determination TD 1999/34 extends the same principle to other consumer loyalty programs where the rewards result from private expenditure. As a consequence of the lack of nexus to income-producing activities, Determination TD 1999/35 confirms that joining and annual fees are not deductible. Note that FBT also generally does not apply: see [58 780]. Flight rewards will be assessable if received by an individual who renders a service or who has received the flight reward as a result of business expenditure, where the person renders a service on the basis that an entitlement to a flight reward will arise (eg a person enters into a secretarial service contract with an understanding that a flight reward will be received): Ruling TR 1999/6; Practice Statement PS LA 2004/4 (GA). In a business context, rewards will be assessable if the activities associated with the obtaining of the benefits amount in themselves to a business activity.

[6 570] Barter and countertrade transactions A barter transaction involves the provision of goods or services in exchange for other goods or services rather than cash. A countertrade transaction involves arrangements typically controlled by member-only organisations where credit units are the medium of exchange. The Commissioner’s views on whether such transactions give rise to a receipt in the nature of income are discussed in Ruling IT 2668. In general, if the transaction is a business one, the consideration will be assessable income provided it is in money’s worth or in a form which © 2017 THOMSON REUTERS

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can be employed in the acquisition of some other right or commodity. If the consideration is received by an employee, the fringe benefits tax regime will apply. Ruling IT 2668 (as updated) states that, in valuing the consideration arising from barter or countertrade transactions, the Tax Office will accept a fair market value as adequately reflecting the money value or arm’s length value, as applicable. In most cases, the fair market value will be the cash price that the taxpayer would normally have charged a stranger for the services or for the sale of the goods or property. However, in the case of a business-oriented countertrade organisation, the fair market value of each of their credit units is deemed to equal one Australian dollar, unless it can be shown that the organisation’s credit units are being traded consistently at a different value.

[6 580] Recoupments and reimbursements Subdivision 20-A deals with recoupments, including by way of insurance or indemnity, for deductible losses and outgoings. A ‘‘recoupment’’ is defined to include any kind of recoupment, reimbursement, refund, insurance, indemnity or recovery (however described) and a grant in respect of the particular loss or outgoing: s 20-25(1). It also includes a payment by another entity for the taxpayer in respect of a loss or outgoing incurred by the taxpayer: s 20-25(2). A recoupment is not assessable under s 20-20 if it is ordinary income (and thus assessable under s 6-5) or is statutory income by virtue of any other provision in the income tax law: s 20-20(1). Insurance or indemnity payment A recoupment of a loss or outgoing is assessable under s 20-20(2) if: • it is received by way of insurance or indemnity; and • an amount for the loss or outgoing is deductible in the current year or was deductible in an earlier income year under any provision of the income tax law. An indemnity contemplates an obligation (whether by virtue of a contract, statute or a breach of some common law duty of care) to make good, or to compensate for, a loss: Commercial Banking Company of Sydney Ltd v FCT (1983) 14 ATR 142. That and other cases make it clear that an amount received by way of indemnity is not restricted to payments received under a contract or deed of indemnity. For example, a payment by way of damages can be an indemnity. In Re Falk and FCT [2015] AATA 392, a payment of just over $500,000 to meet the taxpayer’s legal costs was considered to be a recoupment received by way of indemnity and thus assessable under s 20-20(2), notwithstanding that the payer considered it to be an ex gratia payment. In Batchelor v FCT (2014) 98 ATR 153, the Full Federal Court concluded that the refund of the major part of a deductible deposit on a retirement village was not received ‘‘by way of insurance or indemnity’’ and was not an assessable recoupment in terms of s 20-20(2). The amount was not received as compensation for a loss, but was received by the taxpayer as a return of what she had contributed to the venture. As a result, the Tax Office withdrew ATO ID 2009/119, which had expressed a view inconsistent with the Batchelor decision. A reduction in the shortfall interest charge (SIC) following a credit amendment to an assessment (resulting from a successful objection) is considered to be an amount received by way of indemnity: see ATO ID 2012/59. In ATO ID 2011/82, insurance proceeds received for the destruction of capital works were not an assessable recoupment under s 20-20(2) as the taxpayer could not deduct an amount for the loss for which the insurance proceeds were received (although a deduction may have been available under Div 43 ITAA 1997 in relation to the original construction of the capital works). Ruling TR 2012/8 discusses the assessability under s 20-20(2) of amounts received in respect of legal costs incurred in disputes concerning a termination of employment. 174

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Other recoupments A recoupment for a loss or outgoing (other than by way of insurance or indemnity) is assessable under s 20-20(3) if it is deductible in the current income year, or was deductible in an earlier income year, under any of the provisions listed in s 20-30. The amounts caught by s 20-20(3) include recoupments for bad debts, tax-related expenses, the GIC and SIC (see ATO ID 2012/59), amounts embezzled or misappropriated by employees, contributions relating to fund-raising events and auctions, capital allowances (but not capital works deductions under Div 43 ITAA 1997), R&D expenditure and forex realisation losses (provided the relevant amount is or was deductible or, in the case of R&D expenditure, is or was notionally deductible). A recoupment of tax or rates is assessable to the extent those amounts are deductible under s 8-1 (see [9 400]), eg FBT or an instalment of FBT: Determination TD 2004/21. A government rebate received by a rental property owner for the purchase of an energy saving appliance for use in the rental property (ie a depreciating asset) is an assessable recoupment under s 20-20(3) (it may be assessable as ordinary income if the rental property owner is carrying on a rental property business): Determination TD 2006/31. See also ATO ID 2010/218, which concerns the grant of a right to create Renewable Energy Certificates under the Renewable Energy (Electricity) Act 2000. The remission by the Commissioner of the general interest charge or the shortfall interest charge (see [54 420]) is taken to be a recoupment of the remitted amount: s 20-25(2A). As the GIC and the SIC are tax-deductible expenses, the remitted amount is an assessable recoupment.

Timing and assessable amount If the deduction was allowable in a single year, the recoupment is assessable in the year of receipt: s 20-35(1); see also Determination TD 2004/21 (refund or recoupment of a deductible FBT liability). If the recoupment is received in a year before the year in which the deduction is allowable, the recoupment is assessable in the deduction year: s 20-35(3). If the deduction is allowable over more than one year, the amount of the recoupment that is assessable in the year of receipt is limited to the amount previously deducted (including in the year of receipt): s 20-40 (and see Determination TD 2006/31). In any event, the amount of the recoupment that is assessable cannot exceed the amount allowable as a deduction. If an assessable recoupment relates to property in respect of which there is a balancing charge (ie on the disposal, loss or destruction of the property), the amount of the deduction is reduced for these purposes by the balancing charge: s 20-45(2). If a loss or outgoing is only partly deductible, the assessable recoupment is reduced proportionately: s 20-50. For example, if a taxpayer is allowed a deduction for only 80% of expenditure of $6,000 (because 20% is for non-income-producing purposes), and $2,000 is recouped, the taxpayer is taken for these purposes to have received an assessable recoupment of $1,600 (ie 80% × $2,000) and to have incurred expenditure of $4,800 (ie 80% × $6,000). The assessable amount will be $1,600. There are special rules dealing with the situations where: • an entity can deduct a loss or outgoing incurred by another entity and the latter receives a recoupment of the loss or outgoing – Subdiv 20-A will apply as if the first entity incurred the loss or outgoing and received the recoupment: s 20-60; and • an entity incurs a loss or outgoing and 2 or more entities (which may include the first entity) can deduct the loss or outgoing and the first entity receives a recoupment of the loss or outgoing – each taxpayer will be taken to have incurred the loss or outgoing and to have received the recoupment to the extent to which each has claimed deductions (deductions for the loss or outgoing are reversed in the order in which they were claimed): s 20-65. © 2017 THOMSON REUTERS

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Recoupments under the general law Whether a recoupment, otherwise than by way of insurance or indemnity, of an amount that was deductible under a provision of the ITAA 1997 or ITAA 1936 not listed in s 20-30 is assessable depends on general principles. This includes, in particular, refunds of losses and outgoings deductible under s 8-1. If the repayment to the taxpayer is a direct recoupment of a business expense that has been allowed as a deduction, the courts have held that that amount, or part of that amount, forms part of the proceeds of the business and is assessable income of the year in which it is received: HR Sinclair & Son Pty Ltd v FCT (1966) 114 CLR 537; and Warner Music Australia Pty Ltd v FCT (1996) 34 ATR 171. Other assessable recoupments of deductible expenditure include: reimbursed disbursements incurred by a solicitor otherwise than as an agent of the client (Ruling TR 97/6); rebates under the Diesel Fuel Rebate Scheme if paid as a consequence of the recipient’s income producing activities (Determination TD 97/25). If the amount recouped is totally in respect of revenue losses, the decision in Sinclair’s case would apply. In the case of compensation for capital losses, the amount received would be of a capital nature. If the amount represents income and capital items, an apportionment will be required if the amount is divisible into its income and capital components (see also [6 500]). The income tax law may, of course, bring to account as assessable income an amount received in respect of capital or a capital loss (eg s 40-285, which concerns balancing adjustments for depreciating assets, and the CGT provisions). In a non-business situation, the High Court held in FCT v Rowe (1997) 35 ATR 432 that a government ex gratia reimbursement of previously deductible legal expenses was not a reward for services, but was compensation for a wrong done and was not income according to ordinary concepts. The High Court unanimously held that there is no general principle of Australian tax law to the effect that amounts received by way of reimbursement or compensation for deductible expenses are assessable. The receipt must be income according to ordinary concepts to be assessable (or specifically made assessable by legislation) and an amount is not income simply because it is a recoupment of a deductible expense. Contrast the situation in Re Pope and FCT (2001) 46 ATR 1172 (noted at [6 550]). Note that previously assessable income is non-assessable non-exempt income if the taxpayer is required to repay it in a later income year (and it is not deductible): see [7 700]. [6 590] Illegal receipts An amount that is characterised as income retains its character as income even if it is received illegally. For example, bets received by an SP bookmaker, the proceeds of a business of handling and receiving stolen goods and the moneys received from drug operations are assessable income: eg Partridge v Mallandaine (1886) LR 18 QBD 276; FCT v La Rosa (2003) 53 ATR 1. These cases illustrate the proposition that the day-to-day receipts from regular activities are likely to be income, irrespective of whether the activities are legal or illegal. A similar view is adopted by the Commissioner in Ruling TR 93/25, which also deals with the situation where the proceeds are recovered and repaid. [6 600] Educational assistance Scholarships, bursaries, educational allowances and other forms of educational assistance paid to a full-time student are exempt under s 51-10 ITAA 1997, although certain payments are made assessable by s 51-35 or s 51-40: see [7 300]-[7 350]. Otherwise, amounts payable under student educational assistance schemes are ordinary income on the basis of periodicity (see [4 070]) or because the student relies on them for her or his maintenance (see [4 150]). Certain government training scheme payments are also exempt.

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[6 610]

[6 610]

Pensions and Social Security Act payments

A pension, including a government pension and a pension from an overseas source, is generally ordinary income and therefore assessable under s 6-5 ITAA 1997. For a discussion of the meaning of the term ‘‘pension’’, see ATO ID 2009/5. A number of government pensions, benefits and allowances are specifically made exempt under Div 52 or Div 53 ITAA 1997: see the table below and [7 100]. Exempt payments under the Veterans’ Entitlements Act 1976 are listed at [6 620]. For a checklist of exempt payments, see [7 030]. Subdivision 52-A ITAA 1997 deals with various payments under the Social Security Act 1991 (SSA). The tax status of these payments is listed below. Pension, benefit or allowance Advance pharmaceutical supplement Age pension Australian Government Disaster Recovery Payment Australian Victim of Terrorism Overseas Payment Austudy payment Bereavement allowance Carer allowance and one-off payments (carer allowance related) Carer payment • carer or care receiver over pension age • carer and care receiver under pension age (or care receiver deceased)

Basic amount Exempt Assessable Exempt Exempt Assessable Assessable Exempt

Supplementary amount N/A Exempt1 N/A N/A Exempt1 Exempt1 N/A

Assessable Exempt Exempt

Exempt1 Exempt1 N/A

Exempt Exempt Exempt

N/A N/A N/A

Assessable Exempt

Exempt2 Exempt2

Exempt Assessable Exempt Exempt Exempt Exempt Assessable

N/A Exempt4 N/A N/A N/A N/A Exempt3

Assessable Assessable

Exempt3 Exempt3

Assessable Exempt Exempt Exempt

Exempt3 N/A N/A N/A

• one-off payments (carer payment related) Carer supplement Child disability assistance Crisis payment Disability support pension • over pension age • under pension age Double orphan pension Education entry payment Fares allowance Household stimulus payment Income support bonus 5 Mobility allowance6 Newstart allowance Parenting payment • pension PP (single) • benefit PP (partnered) Partner allowance Pensioner education supplement7 Quarterly pension supplement Seniors supplement © 2017 THOMSON REUTERS

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INCOME – SPECIFIC CATEGORIES Pension, benefit or allowance

Sickness allowance Special benefit Special needs disability support pension • over pension age

Basic amount Assessable Assessable

Supplementary amount Exempt1 Exempt1

Assessable Exempt

Exempt1 Exempt1

Assessable Exempt Exempt Exempt Assessable Assessable

Exempt1 N/A N/A N/A Exempt3 Exempt1

Assessable Exempt

Exempt1 Exempt1

• under pension age Special needs widow B pension Telephone allowance Training and learning bonus Utilities allowance Widow allowance Widow B pension Wife pension • taxpayer or partner over pension age • taxpayer and partner under pension age (or partner deceased) Youth allowance Assessable Exempt3 Bereavement payments Special provisions apply to various bereavement payments (or increases in pensions in lieu of bereavement payments) made after the death of various persons in respect of a number of the above pensions and allowances. This includes the necessity to pro-rate such payments into assessable and exempt portions in some instances. 1 Increased amounts because of rent assistance, pharmaceutical allowance, remote area allowance, pension supplement and energy supplement. 2 Increased amounts because of rent assistance, remote area allowance, pharmaceutical allowance, incentive allowance, language, literacy and numeracy supplement, pension supplement and energy supplement. 3 Increased amounts because of rent assistance, remote area allowance, pharmaceutical allowance, language, literacy and numeracy supplement, pension supplement, energy supplement and farm household allowance. 4 The Social Services Legislation Amendment (Budget Repair) Bill 2016 proposes to cease payment of the education entry payment from the first 1 January or 1 July occurring after the day the Bill receives assent. 5 Income support bonus is no longer payable from 1 January 2017. 6 The Social Services Legislation Amendment (Transition Mobility Allowance to National Disability Insurance Scheme) Bill 2016 proposes to end payment of the Mobility Allowance from 1 July 2020, with the NDIS becoming the main source or support. 7 The Social Services Legislation Amendment (Budget Repair) Bill 2016 proposes to cease payment of the pensioner education supplement from the first 1 January or 1 July occurring after the day the Bill receives assent.

The matched savings scheme (income management) payment and voluntary income management incentive payment are exempt from income tax: s 52-10 ITAA 1997. However, these payments are to be abolished and s 52-10(1EA) will be repealed from 1 July 2017. The job commitment bonus (which ceased to be payable from 1 January 2017) is also exempt: s 52-10(1EB). Amounts received under the pension loans scheme under the Social Security Act 1991 are not assessable as it is accepted that they are loans: Determination TD 96/14.

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[6 620]

[6 620] Veterans’ Entitlements Act payments Subdivision 52-B ITAA 1997 deals with various payments under the Veterans’ Entitlements Act 1986 (VEA). See also [7 100]. Pension, benefit or allowance Age service pension Attendant allowance Carer service pension • carer and care receiver under pension age and care receiver receiving invalidity service pension

Basic amount Assessable Exempt

Supplementary amount Exempt1 N/A

Exempt Exempt Assessable

Exempt1 Exempt1 Exempt1

Exempt Exempt

N/A N/A

Exempt

N/A

• carer under pension age and care receiver deceased and care receiver immediately before death receiving invalidity service pension • other Clothing allowance Decoration allowance Defence Force income support allowance • social security pension or benefit that is also payable

Income support bonus under the Veterans’ Children Education Exempt Scheme Income support supplement Exempt • taxpayer under pension age and permanently Exempt incapacitated for work Exempt • taxpayer and severely disabled person who taxpayer Assessable personally provides constant care for both under pension age

N/A

Exempt1 Exempt1 Exempt1 Exempt1

• taxpayer and partner under pension age and partner receiving invalidity service pension, disability support pension or permanently incapacitated for work and receiving income support supplement • other Invalidity service pension 1. over pension age

Assessable Exempt

Exempt1 Exempt1

Exempt

N/A

Exempt Exempt Assessable

Exempt1 Exempt1 Exempt1

Exempt

N/A

2. under pension age Loss of earnings allowance Partner service pension • taxpayer and veteran under pension age and veteran receiving invalidity service pension • taxpayer under pension age and veteran deceased and veteran immediately before death receiving invalidity service pension • other Quarterly pension supplement © 2017 THOMSON REUTERS

179

[6 630]

INCOME – SPECIFIC CATEGORIES Pension, benefit or allowance

Basic amount

Supplementary amount N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A

Recreation transport allowance Exempt Section 98A VEA bereavement payment Exempt Section 99 VEA funeral benefit Exempt Section 100 VEA funeral benefit Exempt Seniors supplement Exempt Special assistance Exempt Temporary incapacity allowance Exempt Travelling expenses Exempt Vehicle Assistance Scheme Exempt Veterans supplement Exempt Victoria Cross allowance Exempt Bereavement payments Bereavement payments made after the death of various persons in respect of a number of the above pensions and allowances are exempt. 1 Increased amounts because of rent assistance, remote area allowance, pension supplement, energy supplement and dependent children.

A lump sum payment under s 198N of the Veterans’ Affairs Legislation Amendment (Budget Measures) Act 2009 is exempt from income tax: s 52-65(1E).

[6 630] Life insurance bonuses Any amount received as or by way of bonus on a life insurance policy, other than a reversionary bonus, is assessable income: s 15-75 ITAA 1997. Certain reversionary bonuses are assessable under s 26AH ITAA 1936: see [6 640]. See Ruling IT 2346 for what constitutes a ‘‘bonus’’. [6 640] Short-term life insurance policies Section 26AH ITAA 1936 deals with the assessability of reversionary bonuses received under short-term life insurance policies. A reversionary bonus is one where the entitlement to the bonus only accrues upon the maturity, forfeiture or surrender of the policy. See Ruling IT 2346 for what constitutes a ‘‘bonus’’ for these purposes. Section 26AH can apply to bonuses received within a prescribed time limit from the commencement of any life insurance policy, such as a non-short-term policy that is not held for its full duration. However, it does not apply to bonuses that are merely notionally credited during the life of such a policy but cannot actually be received until the expiry of the policy. Eligible policy An ‘‘eligible policy’’ is a life insurance policy (other than a funeral policy issued on or after 1 January 2003) where the date of commencement of risk is after 27 August 1982. The ‘‘eligible period’’ in relation to an eligible policy is the period of 10 years, commencing on the date of commencement of risk of the policy. The date of ‘‘commencement of risk’’ is the date of commencement of the period covered by the first or only premium paid or, if the first or only premium paid was not paid in respect of a period, the date on which that premium was paid: s 26AH(1). The date of commencement of risk does not recommence if a replacement policy is issued as a result of a court-approved merger or takeover of a life insurance company, provided the original contractual terms are otherwise unaltered: Determination TD 92/145. The ‘‘assurance year’’ in relation to policies covered by this provision is the period of 12 months commencing on any anniversary of the date of commencement of risk of the policy. Bonuses received before prescribed time A reversionary bonus received under an eligible policy (if the date of commencement of risk is after 7 December 1983) is assessable as follows (s 26AH(6)): 180

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INCOME – SPECIFIC CATEGORIES [6 640]

• if the bonus is received within the first 8 years of the eligible period (ie the 10-year period beginning on the date of commencement of risk) – the full amount is assessable; • if the bonus is received in the 9th year – two-thirds of the bonus is assessable; and • if the bonus is received in the 10th year – one-third of the bonus is assessable. If received after the 10th year, the bonus is tax-free. Bonuses paid to non-complying superannuation funds at any time during the eligible period are fully assessable to the fund: s 26AH(6A). These rules also apply if the bonus is reinvested or otherwise dealt with in accordance with the taxpayer’s directions (but not if reinvested to increase the amount that might reasonably be expected to be received on the surrender or maturity of the policy): s 26AH(4), (5). The issue of a replacement policy as a result of a court-approved merger or takeover of a life insurance company is not considered to be a reinvestment or dealing, provided there is no change in the contractual terms: Determination TD 92/144. See also Determination TD 94/82 (exercising a ‘‘switching’’ option is generally a mere variation in the contract).

Exemptions Reversionary bonuses are not assessable under s 26AH if (s 26AH(7)): • received as a result of any accident, illness or other disability suffered by, or the death of, the life insured; • the eligible policy is a retirement savings account: see [41 110]; • received under an eligible policy held by the trustee of a complying fund, ADF or pooled superannuation trust; • received under an eligible policy issued by a life insurance company if the liabilities under the policy are to be discharged out of complying superannuation assets (see [30 170]) or segregated exempt assets (see [30 230]); or • received on the surrender, forfeiture or other termination of an eligible policy (or part of an eligible policy) because of the taxpayer’s serious financial difficulties (but not if the policy was acquired with a view to it being forfeited etc, within 10 years). The Commissioner may disregard the operation of s 26AH if he considers that it is reasonable to do so having regard to the premiums paid, amount received and surrender value and any other relevant matters: s 26AH(8).

Deemed bonuses If a taxpayer receives moneys under an eligible policy within the eligible period otherwise than as or by way of bonus, and the Commissioner determines that the moneys were received as or by way of bonus, the amount is assessable as if the moneys had been received as a bonus: s 26AH(9). If, at a subsequent date, the taxpayer actually receives bonuses equal to the whole or part of the deemed bonus, that subsequent receipt is not assessable: s 26AH(10). Section 26AH(9) will also apply to a loan or advance received from an insurer in relation to an eligible policy, or received from a third party under an agreement with the insurer, if the loan or advance is interest-free or the interest payable is less than would reasonably be expected in an arm’s length transaction (see [5 260]): s 26AH(11). In these circumstances, the loan or advance is deemed to be a bonus to the extent that, pursuant to s 26AH(9), the Commissioner considers that it represents a bonus. Similar treatment may be accorded to moneys received on the sale or assignment of a short-term policy to the extent that the Commissioner considers that the proceeds include an accrued bonus: s 26AH(12). © 2017 THOMSON REUTERS

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Anti-avoidance provisions There are anti-avoidance measures which effectively re-start the 10-year eligible period if the premium for one insurance year exceeds by more than 25% the premium payable under the policy in the immediately preceding insurance year: s 26AH(13). Rebate If s 26AH applies to include an amount in a taxpayer’s assessable income, the taxpayer may be entitled to a rebate under s 160AAB. The entitlement arises when the policy has been issued by a life insurance company or a friendly society that is itself subject to income tax or by a government insurance office that, while not paying income tax, makes a contribution to a State Treasury equal to the income tax that would be payable but for the exemption. In the case of trusts, partnerships or superannuation funds a similar rebate is allowable to the beneficiary, trustee or partner (as is appropriate) who is in receipt of assessable income from short-term life insurance policies assessable under s 26AH. The amount of the rebate for 2016-17 is 30% of the amount assessable under s 26AH.

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7

EXEMPT INCOME

INTRODUCTION Overview ......................................................................................................................... [7 010] Exempt income – introduction ....................................................................................... [7 020] Checklist .......................................................................................................................... [7 030] INDIVIDUALS – GENERAL Maintenance payments .................................................................................................... [7 050] Employees – fringe benefits ........................................................................................... [7 060] Personal injury annuities and lump sums ...................................................................... [7 070] Pensions ........................................................................................................................... [7 080] Defence forces ................................................................................................................. [7 090] Miscellaneous exemptions – individuals ........................................................................ [7 100] Temporary residents – foreign source income ............................................................... [7 110] INDIVIDUALS – FOREIGN EMPLOYMENT Overseas employment income ........................................................................................ [7 Foreign earnings .............................................................................................................. [7 Foreign service ................................................................................................................ [7 Foreign earnings not exempt under s 23AG .................................................................. [7 Non-exempt income and the average rate method ........................................................ [7 Approved overseas projects ............................................................................................ [7 Approved overseas projects – eligible foreign remuneration ........................................ [7

150] 160] 170] 180] 190] 200] 210]

EDUCATION Scholarships – full-time education ................................................................................. Non-exempt scholarships/educational assistance payments .......................................... Commonwealth education and training payments ......................................................... Commonwealth assistance – secondary or isolated education ...................................... Commonwealth scholarships – visiting students ........................................................... Other exemptions ............................................................................................................

[7 [7 [7 [7 [7 [7

250] 260] 270] 280] 290] 300]

CHARITIES AND OTHER NOT-FOR-PROFIT ORGANISATIONS Exempt institutions – overview ...................................................................................... [7 Registered charities ......................................................................................................... [7 Registration and endorsement ......................................................................................... [7 Ancillary funds ................................................................................................................ [7 Public educational institutions ........................................................................................ [7 Scientific organisations ................................................................................................... [7 Sporting, cultural and recreational clubs or societies .................................................... [7 Community service organisations ................................................................................... [7 Hospitals and medical benefits organisations ................................................................. [7 Common conditions for the exemption .......................................................................... [7 Mutual income ................................................................................................................ [7

350] 360] 365] 370] 380] 390] 400] 410] 420] 430] 440]

BUSINESS AND INDUSTRY Trade unions, employee and employer associations ...................................................... Non-profit aviation, tourism and other associations ...................................................... Venture capital exemptions ............................................................................................. Other business and industry exemptions ........................................................................

[7 [7 [7 [7

450] 460] 470] 480]

GOVERNMENT State and Territory bodies – exemptions ........................................................................ [7 Public authorities and municipal corporations ............................................................... [7 Government officials ....................................................................................................... [7 Foreign governments and diplomats .............................................................................. [7

500] 510] 520] 530]

CONVERSIONS Tax exempt entities that become taxable ....................................................................... [7 550] © 2017 THOMSON REUTERS

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[7 010]

EXEMPT INCOME

INTERNATIONAL Dividend and other exemptions ...................................................................................... [7 Foreign residents ............................................................................................................. [7 International organisations and officials ......................................................................... [7 Overseas representatives and expert advisers ................................................................ [7 US Government projects in Australia ............................................................................ [7

600] 610] 620] 630] 640]

NON-ASSESSABLE NON-EXEMPT INCOME Introduction ..................................................................................................................... [7 700] Types of non-assessable non-exempt income ................................................................ [7 710]

INTRODUCTION [7 010] Overview As discussed at [3 010], a taxpayer’s liability to income tax for an income year is based on the taxpayer’s taxable income for the year. Taxable income is assessable income less allowable deductions. Not all income is assessable. Some income is exempt from income tax and other income is non-assessable non-exempt income (ie it is not exempt as such but it is not assessable). This chapter considers the various categories of exempt income, in particular: • exemptions that apply to individuals: see [7 050]-[7 300]; • exempt organisations (ie entities that are exempt regardless of the type of income): see [7 350]-[7 480]; • exemptions available to government bodies and officials: see [7 500]-[7 530]; and • exemptions that have an international connection: see [7 600]-[7 640]. Types of non-assessable non-exempt income are considered at [7 700]-[7 710]. A checklist of non-assessable entities and items is located at [7 030].

[7 020] Exempt income – introduction There are 2 main categories of exempt income (whether ordinary or statutory income). These are: • the ordinary or statutory income of the entities listed in s 11-5; and • ordinary or statutory income of a type listed in s 11-15. The lists in ss 11-5 and 11-15 identify whether a particular item of exempt income is governed by a provision in the ITAA 1997 or ITAA 1936. The principal ITAA 1997 provisions relating to exempt income and exempt entities are contained in Divs 50-54 as follows: • Div 50 – entities whose entire income (both ordinary and statutory) is exempt; • Div 51 – receipts that are exempt; • Div 52 – pensions, benefits and allowances that are wholly or partly exempt; • Div 53 – miscellaneous receipts that are wholly or partly exempt; and • Div 54 – certain annuities and lump sums purchased under the terms of a structured settlement or structured order that are exempt. Division 55 specifically provides that certain payments that have similar characteristics to exempt receipts are in fact not exempt, namely Federal government occupational superannuation payments (see [7 100]) and education entry payments (see [7 260]). 184

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[7 030]

Ordinary income can be exempt income, either expressly or by implication. Statutory income (which by definition cannot be ordinary income: see [3 020]) is only exempt income if made so by a provision outside Div 6 ITAA 1997: s 6-20. It is, in fact, possible for an amount that is not income to nevertheless be exempt income if the ITAA 1997 specifically makes it such (this could be disadvantageous for taxpayers: see below). Otherwise, exempt income cannot include that which is not income (eg an accretion to capital such as a surplus on realisation of an investment). For example, the fact that capital gains are made assessable income under Pt 3-1 ITAA 1997 does not make them ‘‘income’’. Therefore any non-assessable element (such as the 50% CGT discount: see [14 390]) does not become exempt income; and any exempt gains do not become exempt income if they are not otherwise of an income nature. Note that although capital gains (and losses) arising from a CGT asset used solely to produce exempt income are disregarded by virtue of s 118-12 (subject to certain exceptions: see [15 040]), such gains are not exempt income as such. This distinction is important if exempt income is brought into the calculation of allowable deductions, eg losses of previous years: see [8 460]. Details of exempt income need not be disclosed in a tax return unless specifically requested. For example, certain exempt foreign employment income is included in the Supplementary return for individuals.

Consequences of deriving exempt income Although exempt income is not assessable income (s 6-15(2)), and is therefore not part of taxable income, exempt income cannot be ignored in examining the tax position of a taxpayer. The derivation of exempt income may also reduce or limit deductions. In particular, net exempt income is taken into account in calculating a tax loss for an income year and a loss carried forward from an earlier year is first set off against net exempt income (if any): see [8 450]-[8 480]. Note that non-assessable non-exempt income does not reduce or limit deductions: see [7 700]. Exempt income may also affect the rate of tax applicable to taxable income. For example, overseas employment income that is exempt under s 23AF or s 23AG ITAA 1936 is taken into account in determining the rate applicable to other assessable income, but other exempt income is not: see [7 190]. [7 030] Checklist Below is a checklist of various categories of income and types of entity that are not assessable – ie the income is exempt income or non-assessable non-exempt income, or the entity is an exempt entity. The paragraph number provided is the most relevant paragraph in this publication where the exemption is discussed. The list is not exhaustive. Item ADF members – some receipts ... Ancillary funds ............................. Apprenticeship wage top-up ........ Apprenticeship bonus .................. Art societies Australian Victim of Terrorism Overseas Payment ....................... Bequests ...................................... Betting wins ................................. Board – family members ............. Branch profits – some................... Business – miscellaneous ........... © 2017 THOMSON REUTERS

Para [7 090] [7 370] [7 300] [7 300] [7 400] [7 100] [3 [5 [6 [7 [7

050] 040] 350] 710] 480]

Item Call options – some ..................... Carer adjustment payment .......... Charities ....................................... Charity handouts .......................... Childcare benefit .......................... Child disability assistance ............ Children with autism payments ... Clubs – member receipts ............ Compensation – some ................. Community service organisations ...................................................... Consular officials .........................

Para [17 220] [7 100] [7 360] [6 540] [7 100] [7 100] [7 100] [7 440] [6 500] [7 410] [7 530]

185

[7 030]

EXEMPT INCOME

Item Consumer loyalty rewards – some ............................................ Continence Aids payments .......... Cultural organisations – non-profit ...................................................... Damages – some ........................ Death benefit payment – part ...... Death benefits – some ................ Defence Force members ............. DFISA bonus ................................ DFISA bonus bereavement payment ....................................... Diplomats ..................................... Disaster clean-up grants .............. Disaster recovery payments – some ............................................ Disaster relief grants .................... Disability services payments ....... Early retirement – part ................. Educational assistance – some .... Employee associations ................ Employer associations .................. Family tax benefit ........................ Family trust distributions – some . Farm household allowance .......... Flood ex gratia payment .............. Fly buy program rewards – some ...................................................... Foreign employment – some ....... Foreign income – some ............... Foreign residents – overseas income ......................................... Frequent flyer rewards – some ... Fringe benefits ............................. Gambling wins ............................. Gifts .............................................. Government payments – some ... GST .............................................. HECS-HELP benefits.................... Hobbies ........................................ Hospitals ...................................... Income support bonus ................. Industrial associations – non-profit ...................................... Industry – miscellaneous ............. Interest – offset accounts ............ Interest – pre-judgment ............... Interest on unclaimed moneys – some ............................................ International organisations and officials – some ............................ Invalidity payments ......................

186

Para [6 560] [7 100] [7 400] [6 [40 [40 [7 [7 [7

500] 350] 350] 090] 100] 100]

[7 530] [7 710] [7 100] [7 [7 [4 [7 [7 [7 [7 [7 [7 [7 [6

710] 100] 410] 280] 450] 450] 100] 710] 100] 100] 560]

[7 150] [34 020] [35 050] [6 [4 [5 [6 [7 [5 [7 [5 [7 [7 [7

560] 050] 040] 540] 710] 090] 300] 030] 420] 100] 460]

[7 [6 [6 [6

480] 260] 310] 250]

[7 620] [4 350]

Item Job commitment bonus ............... Lease surrender payments – some ............................................ Literary societies Living-away-from-home allowance ..................................... Local government ........................ Lottery winnings – general .......... Loyalty programs – some ............ Maintenance payments ................ Managed investment trust withholdings Marriage breakdown settlement .. Matched savings scheme (income management) payment (up to 30 June 2017) .................... Mining payments – some ............ Miscellaneous – individuals ......... Musical societies........................... Mutual income ............................. Non-assessable non-exempt ....... Non-portfolio dividends ................ Non-profit organisations ............... Overseas employment – some .... Overseas government officials – some ............................................ Overseas projects – some ........... Overseas representatives – some ...................................................... PDF dividends ............................. Pensions – government – some .. Pensions – veterans – some ....... Pension bonus bereavement payment ....................................... Pension bonus ............................. Personal injury annuities ............. Personal injury lump sums .......... Pocket money .............................. PM’s Prizes/Awards ..................... Principal residence – sale ........... Private health insurance payments ..................................... Private health insurers ................. Prizes – sportspersons – some ... Public authorities ......................... Public educational institutions ..... Put options – some ...................... Quiz prizes ................................... Redundancy payment – part ....... Reimbursements – some ............. Religious institutions .................... Repaid amounts ...........................

Para [6 610] [6 440] [7 400] [4 030] [7 510] [6 550] [6 560] [7 050] [50 110] [15 120] [6 610] [29 [7 [7 [7 [7 [7 [7 [7 [7

100] 100] 400] 440] 700] 710] 350] 150] 530]

[7 200] [7 630] [11 [6 [6 [7

540] 610] 620] 100]

[7 [7 [7 [6 [6 [15 [7

100] 070] 070] 250] 100] 300] 100]

[7 [4 [7 [7 [17 [6 [4 [6 [7 [7

420] 080] 510] 380] 230] 550] 400] 580] 360] 710]

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EXEMPT INCOME Item Research fellowships – some ...... Retirement payment – part .......... Scholarships – some ................... Schoolkids bonus ......................... Scientific organisations ................ Small business capital gains – some ............................................ Social security payments – some ...................................................... Sporting clubs – non-profit .......... Sportspersons – some ................. State bodies ................................. Strike fund payments ................... Superannuation amounts – NZ sourced ........................................ Superannuation benefits – some . Temporary residents .................... Terminally ill – lump sum payments ..................................... Territory bodies ............................ Thalidomide payments – some ... Tourism associations – non-profit ......................................................

Para [7 300] [40 100] [7 250] [7 100] [7 390] [15 500] [6 610] [7 [4 [7 [4 [40

400] 080] 500] 130] 320]

[40 100] [7 110] [40 420] [7 500] [7 100] [7 460]

Item Trade learning scholarships ......... Training assistance – some ......... Transition to retirement pension – part ............................................... Transitional Farm Family Payment – part ............................ UK pensions – some ................... Unions .......................................... US government projects – some . Veterans’ payments – some ........ Venture capital investments ......... Voluntary income management incentive payment (up to 30 June 2017) ............................................. Windfall gains .............................. Withholding tax – amounts subject to ..................................... Workers compensation – some ... Wrongful dismissal – some ......... WWII payments – some ..............

[7 060] Para [7 300] [7 280] [40 550] [7 100] [7 [7 [7 [6 [7 [6

100] 450] 640] 620] 470] 610]

[6 550] [35 150] [4 100] [4 110] [7 100]

INDIVIDUALS – GENERAL [7 050] Maintenance payments Periodic maintenance payments are exempt if made to a spouse or former spouse, or to or for the benefit of a child of the payer or spouse/former spouse: ss 51-30 Item 5.1 and 51-50. A ‘‘spouse’’ includes a de facto spouse: see [19 150]. See [19 180] for the definition of ‘‘child’’. Payments made indirectly through a third party may qualify for the exemption. Examples would include payments (under the Child Support Act 1988) through the Child Support Trust Account, a State collection agency or a solicitor’s trust account. However, in ATO ID 2011/55, the exemption did not apply to payments from a discretionary trust established by the taxpayer’s father which were made after the father’s death. Note that payments may be received for the benefit of a child, eg by a parent, relative, guardian or welfare officer. The exemption does not apply if, for the purpose of making the payments, the payer has divested herself or himself of an income-producing asset, or has diverted income upon which he or she would otherwise have been taxable: s 51-50(3). See also [3 170]. Maintenance payments are not deductible to the payer: see [9 1050]. [7 060] Employees – fringe benefits Fringe benefits made available by an employer to an employee are taxed by assessment of the employer under the Fringe Benefits Tax Assessment Act 1986, unless exempt benefits (see Chapter 60 to Chapter 62). Income derived by way of a fringe benefit (unless an exempt benefit) is non-assessable non-exempt (NANE) income (see [7 030]): s 23L(1) ITAA 1936. For example, see Ruling IT 2364 (Australian Traineeship Scheme) and Re Experienced Tours Pty Ltd and FCT (2006) 63 ATR 1147. Benefits under an effective salary sacrifice arrangement (ie if an employee agrees to receive remuneration as benefits before the employee has earned the entitlement to that remuneration) are generally fringe benefits and therefore NANE income: see also Ruling TR 2001/10. © 2017 THOMSON REUTERS

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Although income derived by way of a fringe benefit is generally NANE income, income derived by way of fringe benefits that are exempt benefits (see Chapter 60) are exempt income rather than NANE income. This does not apply to a reimbursement that is an exempt car expense payment benefit (under s 22 FBTAA: see [58 460]) as the reimbursement is assessable under s 15-70 ITAA 1997: see [6 580].

[7 070] Personal injury annuities and lump sums Annuities and lump sums purchased under the terms of a structured settlement or structured order (called ‘‘personal injury annuities’’ and ‘‘personal injury lump sums’’ respectively) that satisfy the provisions of Div 54 ITAA 1997 are exempt from income tax. A structured settlement (defined in s 54-10(1)) is a settlement of a claim for compensation or damages for, or in respect of, a personal injury where the claim is based on the commission of a wrong or on a statutory right. The settlement must be in the form of a written agreement (whether or not approved by the court). A structured order (defined in s 54-10(1A)) is a court order in respect of a claim for compensation or damages for, or in respect of, a personal injury where the claim is based on the commission of a wrong or on a statutory right (but not a court order approving or endorsing a structured settlement). A structured order made by a foreign court will qualify: see ATO ID 2003/1066. ‘‘Personal injury’’ is not defined for these purposes and has its ordinary meaning (and thus covers mental illness as well as physical injury and illness). The particular claim (ie to which the structured settlement or structured order relates) must be made by the injured person or her or his personal representative. The settlement or order must provide that some or all of the compensation is to be used to purchase an annuity (or an annuity and a lump sum) from a life insurance company registered under the Life Insurance Act 1995 or a State insurer (thus an annuity purchased from a foreign life insurance company does not qualify for the exemption: see ATO ID 2003/1065). If the claim is also for some other remedy (eg damages for loss of property), Div 54 will not apply to that part of the claim: s 54-10(3). The exemption under Div 54 for personal injury annuities and personal injury lump sums is not available where the claim: • is made against a person in her or his capacity as the injured person’s employer (or associate of the employer); or • is under workers compensation law or could instead be made under workers compensation law (eg if the claimant opts out of a workers compensation claim to pursue a common law claim): s 54-10(1).

Personal injury annuities A personal injury annuity is only exempt under s 54-15 if: • the compensation or damages, if paid in a single lump sum, would not have been assessable: s 54-20. Note that compensation or damages for personal injury are effectively exempt from CGT: see [15 100]; • the annuity instrument allows for payments to be made only to the injured person, a trust of which the injured person is the beneficiary, a reversionary beneficiary or the injured person’s estate: s 54-25; • the annuity payments are made at least annually over a minimum period of 10 years or for the life of the injured person: s 54-30(1). If there is a group of annuities, it is not necessary that all of the annuities be provided over the life of the annuitant; • the annuity instrument contains certain information, including the actual date of the first and (if for a fixed period of years) last payments and the amount of each periodic payment: s 54-30(2), (5); 188

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• an annuity payment can only be increased either to maintain its real value (by indexation) or by a percentage specified in the annuity instrument (s 54-30(3), (4)) – this means that allocated pensions and ‘‘with-profit’’ annuities cannot be used in structured settlements or structured orders; and • the annuity (or annuities paid under a structured settlement or structured order as a whole) provides a minimum monthly level of support over the injured person’s life, determined under s 54-40(2) and (3) by reference to the maximum basic rate of the age pension (indexed). The annuity instrument may provide for the annuity payments to be paid to the injured person’s estate or to a reversionary beneficiary if the injured person dies within 10 years after the date of the settlement (the guarantee period): s 54-35(1), (2). The reversionary beneficiary, who has to be named, must have the choice of receiving the payments periodically or commuting them into a lump sum: s 54-35(3). The injured person’s estate may only be paid a commuted lump sum: s 54-35(4). The commuted lump sum is the policy termination value of the relevant life policy (ie the annuity instrument), as calculated by an actuary as at the date of the injured person’s death (disregarding any annuity payments due to be made after the end of the guarantee period and any personal injury lump sums also provided for by the policy): s 54-35(5).

Personal injury lump sums A personal injury lump sum is only exempt under s 54-45 if it is made in conjunction with a personal injury annuity and the compensation or damages, if paid to the injured person, would not have been assessable: ss 54-45, 54-50. The requirements concerning the instrument under which the lump sum is paid are similar to those relating to the instrument under which a personal injury annuity is paid (see above): ss 54-55, 54-60. A personal injury lump sum can only be paid to the injured person or to a trust of which the injured person is the beneficiary. It cannot be paid to a reversionary beneficiary or the injured person’s estate: s 54-55.

Trusts A personal injury annuity payment or a personal injury lump sum received by a reversionary beneficiary or trust (of which the injured person is the beneficiary) is exempt from income tax if the amount would have been exempt in the hands of the injured person: ss 54-65, 54-70. If an amount is exempt in the hands of a trustee, the exemption continues to apply if the amount is paid to the beneficiary or is applied for her or his benefit. A trustee may include a Public Trustee, State or Territory protective office or other legal guardian. The exemption under Div 54 does not extend to investment income of the trust.

[7 080] Pensions Division 52 exempts certain pensions and other payments under the Social Security Act 1991 and the Veterans’ Entitlements Act 1986. Payments under those Acts that are not listed as exempt in Div 52 are generally assessable as ordinary income, unless exempt under another provision. The tax treatment of pensions and other payments under those Acts is considered at [6 610]-[6 620]. Certain overseas pensions are exempt under s 768-105 ITAA 1997: see [7 100]. Various other government assistance/welfare payments are also exempt: see [7 100]. The tax treatment of annuities and superannuation pensions is considered at [40 500]-[40 560]. Certain personal injury annuities are exempt under Div 54: see [7 070]. [7 090]

Defence forces

The pay and allowances received by members of the Australian Defence Forces (ADF) and Reserves are generally assessable as ordinary income, or under s 15-2 ITAA 1997 (see [4 © 2017 THOMSON REUTERS

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070]), unless they are a fringe benefit for FBT purposes: see [7 060]. The table below lists amounts received by ADF members that are exempt. Provision s 51-5 Items 1.1 and 1.2

Types of payments and allowances that are exempt The following allowances paid to an ADF member or paid to a third person in respect of an ADF member (Defence Determination DD 2005/15 and reg 51-5.01 ITA Regs): • a deployment allowance paid under Div 1 of Pt 9 of Chapter 17 of the Determination; • a disturbance allowance paid under Div 2 of Pt 1 of Chapter 6 of the Determination; • a reimbursement of education costs for a child (while the member is resident in Australia) paid under Pt 4 of Chapter 8 of the Determination; • a reimbursement in place of a child’s scholarship paid under Div 3 of Pt 4 of Chapter 8 of the Determination; • a reimbursement of education costs for a child educated in Australia, or at the location of the ADF member while the member is on a long term posting overseas, paid under Pt 6 of Chapter 15 of the Determination; • a separation allowance paid under Div 1 of Pt 1 of Chapter 6 of the Determination; • a transfer allowance paid under Div 3 of Pt 3 of Chapter 14 of the Determination; and • a rent allowance paid under Pt 6 of Chapter 7 of the Determination to a member without dependants, or to a member with dependants (separated), within the meaning of the Determination.

s 51-5 Item 1.1

s 51-5 Item 1.4

ss 51-5 Items 1.1A and 1.5, 51-32, 51-33

• The market value of rations and quarters supplied to ADF members without charge.

• Pay and allowances paid to a Reservist, but only for part-time services. However, pay and allowances for continuous full-time service are not exempt.

• Compensation paid under the Safety, Rehabilitation and Compensation Act 1988 or the Military Rehabilitation and Compensation Act 2004 to an ADF member for loss of pay or an allowance for warlike service, provided the injury or disease in respect of which the compensation is paid was sustained while the ADF member was covered by a certificate in force under s 23AD (see above) and the injury or disease caused the loss of the pay or allowance: s 51-5 Item 1.1A and s 51-32. • A similar exemption applies for compensation paid under the Safety, Rehabilitation and Compensation Act 1988 or the Military Rehabilitation and Compensation Act 2004 for the loss of a deployment or other allowance payable under a determination under the Defence Act 1903 for non-warlike service, if the relevant injury or disease caused the loss of the allowance.

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[7 090]

Types of payments and allowances that are exempt • Compensation paid under the Safety, Rehabilitation and Compensation Act 1988 or the Military Rehabilitation and Compensation Act 2004 to a former Reservist for loss of pay or an allowance, if paid in respect of an injury suffered or disease contracted while serving as a Reservist (but not while on continuous full-time service) and the pay or allowance was payable because of that service: s 51-5 Item 1.5 and s 51-33. If the compensation is payable under the Military Rehabilitation and Compensation Act 2004, it must be worked out by reference to the taxpayer’s normal earnings as a part-time reservist for the exemption to apply.

s 51-5 Item 1.6

s 51-5 Item 1.7

• An ex-gratia payment from the Commonwealth known as the ‘‘F-111 Deseal/Reseal Ex-gratia Lump Sum Payment’’.

• A payment made under the Defence Abuse Reparation Scheme.

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Provision s 52-114

Types of payments and allowances that are exempt The following compensation payments under the Military Rehabilitation and Compensation Act 2004 (including, where appropriate, payments made because of a person’s death): • alterations to aids and appliances relating to rehabilitation; • compensation for journey and accommodation costs; • compensation for permanent impairment; • compensation for financial or legal advice; • compensation for incapacity (for an ADF member or a Reservist); • compensation by way of Special Rate Disability Pension; • compensation under the Motor Vehicle Compensation Scheme; • compensation for household services and attendant care services; • MRCA supplement; • compensation for loss or damage to medical aids; • compensation for a wholly dependent partner for a member’s death; • continuing permanent impairment and incapacity, etc, compensation for a wholly dependent partner; • compensation for eligible young persons who were dependent on deceased member; • continuing permanent impairment and incapacity, etc, compensation for eligible young persons; • education and training, or a payment, under the education scheme for certain eligible young persons under 16; • compensation for other persons who were dependent on deceased member; • compensation for cost of a funeral; • compensation for treatment costs; • special assistance; • energy payment (formerly clean energy payment); and • income support bonus payments under the education scheme for certain eligible young persons.

s 842-105 Item 6

• Pay and allowances earned in Australia by a member of a foreign defence force if not paid, given or granted by the Australian Government. • Income derived in Australia by an overseas visitor whose visit and work are primarily and principally directed to assisting in the defence of Australia, provided the income is not exempt in the country where the visitor is ordinarily resident.

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[7 100]

Types of payments and allowances that are exempt • Pay and allowances earned by an ADF member while a certificate (issued by the Chief of the Defence Forces) is in force to the effect that the ADF member is on eligible duty with a specified organisation in a specified area overseas. See also Ruling TR 97/2. A retention benefit was considered to fall within the term ‘‘pay and allowances’’ in ATO ID 2004/80. Duty with the following operations qualifies as eligible duty for these purposes (reg 6 ITA (1936 Act) Reg): – Operations Accordion and Manitou in the Middle East region (until 30 June 2017); – Operation Augury in Jordan; – Operation Palate II in Afghanistan (until 31 December 2016); – Operation OKRA in various countries of Europe and the Middle East (until 30 June 2017); – Operation Highroad in Afghanistan (until 30 June 2017). Serving as an attaché at an Australian embassy or legation is not eligible duty and therefore does not attract the s 23AD exemption. Similarly, the s 23AD exemption does not extend to an APS employee of the Department of Defence deployed outside Australia (see ATO ID 2010/118).

s 23AB

s 23AG

• Compensation paid in respect of the incapacity, impairment or death of a civilian serving with UN armed forces: s 23AB. The section also releases the estate of a civilian who dies while performing service with UN armed forces from paying any unpaid tax in respect of pay and allowances: s 23AB(10). In addition, living allowances paid in respect of service with UN armed forces are assessable only as to $2 per week: s 23AB(6) and (6A). Section 23AB also provides a rebate of tax: see [19 600]. As at 1 January 2017, s 23AB applies to AFP members serving with the UN peacekeeping force in Cyprus: reg 5 ITA (1936 Act) Reg.

• Foreign earnings derived while engaged in UN peacekeeping operations for at least 91 days: see [7 150] and [7 180].

Cash payments to ADF members made under the Military Skills Award program are assessable, but such payments to Reservists are exempt under s 51-5 Item 1.4: see Ruling IT 2474. Exemptions under s 23AD are not subject to ‘‘exemption with progression’’. Accordingly, foreign income that is exempt under s 23AD is not taken into account in calculating the Australian tax on other non-exempt income of a resident taxpayer: see [7 190]. Note that ADF personnel serving overseas may be entitled to a tax offset under s 79B (the overseas forces offset): see [19 590].

[7 100] Miscellaneous exemptions – individuals Section 11-15 lists all the payments that are exempt from income tax. These include (the relevant sections should be consulted for any particular restrictions): • post-judgment interest on damages for personal injury, subject to certain limitations (see [6 310]): s 51-57; • family tax benefit, child care benefit and child care rebate (child care benefit and child care rebate will be replaced by a new child care subsidy from 1 July 2018): s 52-150; • child disability assistance: s 52-10(1AA); • the schoolkids bonus (this ceased to be payable from 1 January 2017): s 52-150; © 2017 THOMSON REUTERS

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• single income family supplement paid under the A New Tax System (Family Assistance) Act 1999: s 52-150; • payments from the Thalidomide Australia Fixed Trust to, or applied for the benefit of, a beneficiary of the Trust, or to another individual in respect of a beneficiary of the Trust: s 51-30; • Prime Minister’s Prize for Australian History, Prize for Science and Literary Awards: s 51-60; • Outer Regional and Remote payments under the Helping Children with Autism scheme and the Better Start for Children with Disability initiative: ss 52-170, 52-172; • payments under the Continence Aids Payment Scheme: s 52-175; • payment of pension bonus and pension bonus bereavement payment under Pt 2.2A of the Social Security Act 1991 or Pt IIIAB of the Veterans’ Entitlements Act 1986: ss 52-10(1A), 52-65(1A); • income support bonus under the Social Security Act 1991 (ceased to be payable from 1 January 2017): s 52-10(1M); • income support bonus under the Veterans’ Children Education Scheme: s 52-65(1K); • DFISA bonus and DFISA bonus bereavement payment under Pt VIIAB of the Veterans’ Entitlements Act 1986: s 52-65(1A); • job commitment bonus (s 52-10(1EB)) – these payments ceased from 1 January 2017 (except where entitlement to the payment arose before that date); • Australian Victim of Terrorism Overseas Payment: s 52-10(1K); • clean energy payments under the repealed carbon pricing scheme: ss 52-10(1L), 52-65(1G), 52-114, 53-10 (Item 1A); • supplementary amount of payments made, in certain specified circumstances, to the parent of a deceased member of the Australian Defence Forces (the recipient must be of pension age or older, unless the mother of the deceased person and also a widow or divorced or deserted woman) and pensions payable under Repatriation Acts repealed by the Veterans’ Entitlements Act 1986 and which continue to be payable because of s 4(6) of the Veterans’ Entitlements (Transitional Provisions and Consequential Amendments) Act 1986: ss 52-105, 52-110; • NDIS amounts (these are amounts paid under the National Disability Insurance Scheme in respect of reasonable and necessary supports funded under a participant’s plan): s 52-180; • payments made by Australian or UK Governments that are similar to payments under the Veterans’ Entitlements Act 1986 that are exempt under Subdiv 52-B (see [6 620]) and payments similar to payments that are made because of the Veterans’ Entitlements (Transitional Provisions and Consequential Amendments) Act 1986 and which are exempt under s 52-105 or 52-110 (eg UK war widows pensions and war widows supplementary pensions: ATO ID 2008/6 and ATO ID 2008/7: s 53-20; • disability services payments under Pt III of the Disability Services Act 1986: s 53-10; • carer adjustment payment: s 53-10; • Farm Household Allowance: see the notes to ss 52-10(3) and 52-15; 194

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[7 150]

• Interim Farm Household Allowance, to the extent it is in lieu of clean energy advance or by way of clean energy supplement (not payable after 30 September 2014): s 53-10; • wounds and disability pensions of the kind specified in s 315(2) of the UK Income and Corporation Taxes Act 1988 (or under s 641 of the UK Income Tax (Earnings and Pensions) Act 2003) and which are similar in nature to payments that are exempt under Div 52 or 53 (as listed at [6 610] and [6 620] or above): s 53-10; • travelling expenses paid under Pt 3 of the Australian Participants in British Nuclear Tests (Treatment) Act 2006: s 52-117; • certain foreign source compensation payments arising out of World War II or the National Socialist regime of Germany during the National Socialist period (eg ATO ID 2007/126), but not if the payment is made directly or indirectly by an associate: s 768-105; and • prisoner of war recognition supplement: s 52-65(1F). Many payments under the Social Security Act 1991 and the Veterans’ Entitlements Act 1986 not listed above (and similar payments) are also tax exempt: see [6 610]-[6 620]. The Treasury Laws Amendment (2016 Measures No 1) Bill 2016 proposes to provide an income tax exemption for ex-gratia disaster recovery payments made to New Zealand special category visa (subclass 444) holders in Australia, for a disaster that occurred during 2014-15 or a later income year and for which a determination under s 1061L of the Social Security Act 1991 has been made: proposed s 51-30, item 5.2. Interest paid by the Commonwealth on or after 1 July 2013 in relation to unclaimed First Home Saver Accounts (FHSA), bank accounts, corporate property and life insurance amounts is generally exempt from income tax: see [6 250]. Note that the FHSA scheme has been abolished: see [6 280].

Commonwealth Government occupational superannuation Various payments, mostly in the nature of occupational superannuation paid to former Australian Defence Force members, former Commonwealth public servants and other former employees of the Commonwealth Government, are specifically not exempt under Div 52 or 53 (or other provisions of Pt 2-15 ITAA 1997): s 55-5. [7 110] Temporary residents – foreign source income Foreign source income derived by a ‘‘temporary resident’’ (eg investment income) is non-assessable non-exempt (NANE) income: s 768-910(1) ITAA 1997. However, foreign source income that is remuneration for employment undertaken, or services provided, while the recipient is a temporary resident is not NANE income under s 768-910 (although it may be NANE income under another provision): s 768-910(3). Personal services income derived by an entity but attributed to an individual under the rules in Div 86 ITAA 1997 (see [6 130]) is also not NANE income. As to who is a ‘‘temporary resident’’, see [2 100]. An example of NANE income would be a pension from a foreign country: see ATO ID 2006/161 and ATO ID 2006/163. On the other hand, trust income (paid by a foreign resident trust to a temporary resident) that is Australian sourced is assessable: see ATO ID 2007/108. The CGT exemptions for temporary residents are discussed at [15 190], [18 100] and [18 140].

INDIVIDUALS – FOREIGN EMPLOYMENT [7 150] Overseas employment income Foreign earnings derived by a limited category of Australian resident individuals engaged in service in a foreign country for a continuous period of not fewer than 91 days are © 2017 THOMSON REUTERS

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exempt from Australian tax under s 23AG. The exemption is restricted to certain aid workers, charitable workers and government employees (eg ADF personnel attached to a peacekeeping force). See [7 160] for the meaning of ‘‘foreign earnings’’. (Note that foreign earnings derived before 1 July 2009 that are received after that date may still be exempt under the former s 23AG.) Foreign earnings are only exempt under s 23AG if the foreign service is directly attributable to (s 23AG(1AA)): • the delivery of Australian official development assistance (ODA) by the individual’s employer. This concept is discussed in Ruling TR 2013/7. However, the exemption will not apply from 2016-17 if the employer is an Australian government agency (ie the Commonwealth, a State or a Territory or a Commonwealth, State or Territory agency); • the activities of the individual’s employer in operating a developing country relief fund (that is a registered charity) or a disaster relief fund (established and maintained by a registered PBI) in a developed country other than Australia (see [9 860]) – see, for example, ATO ID 2010/117 and ATO ID 2010/179; • the activities of the individual’s employer, where the employer is a registered charity located or pursuing objectives outside Australia which is exempt from Australian income tax pursuant to Item 1.1 or former Item 1.2 of s 50-5 (see [7 350]) – the prescribed organisations are listed in regs 50-50.02 and 50-55.01 of the ITA Regs; • the individual’s deployment outside Australia by an Australian government (or an Australian government authority) as a member of a disciplined force – see below; or • an activity of a kind specified in regulations. For these purposes, an employee’s foreign service is ‘‘directly attributable to’’ the activities of the employer of the employee where the requisite activities of the employer are the immediate and controlling reason why the employee is engaged in that foreign service: see Ruling TR 2013/7. Similarly, the foreign service of an employee deployed as a member of a disciplined force is ‘‘directly attributable to’’ that deployment where that deployment is the immediate and controlling reason why the employee is engaged in foreign service. This condition must be satisfied throughout the continuous period of foreign service in respect of which the foreign earnings are derived before the earnings can be eligible for exemption under s 23AG. A ‘‘disciplined force’’ refers to the Australian Defence Force (ADF), Australian Federal Police (AFP) and the State and Territory police forces: Ruling TR 2013/7. Any person subject to the strict code of conduct governing those forces is a ‘‘member’’ of such a force. This will ordinarily include those employees who have undertaken the requisite oath or affirmation required to perform operational duties. The term ‘‘member’’ includes an ADF member or Australian police officer who, in their capacity as an ADF member or police officer, is part of an international peacekeeping force. Australian Public Service and State and Territory Public Service employees deployed alongside the disciplined force are members of a disciplined force where they are effectively integrated into the disciplined force and are subject to the same command structure and the same rules of conduct as regular members of the force. The exemption does not extend to a civilian employee of an international peacekeeping force: see ATO ID 2010/51. Determination TD 2013/14 states that a person is ‘‘deployed’’ (as a member of a disciplined force) if, and only if, they have been directed to perform duties overseas by the Commonwealth, a State or a Territory or an authority thereof in their capacity as a member of a disciplined force. This includes the member being sent overseas to undertake or participate in study or training activities in their capacity as a member of the relevant disciplined force. 196

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[7 160]

In applying s 23AG, the following should be noted: • the foreign earnings must be exclusively derived from foreign service, and not from service which is in part foreign service and part not foreign service (as in Blank v FCT (No 2) (2014) 98 ATR 379 – that decision was approved by the Full Federal Court in Blank v FCT [2015] FCAFC 154, and the issue was not considered on appeal to the High Court); • income does not have to be assessable in Australia (under s 6-5) for the exemption to apply; and • Australia has joint sovereignty over the Joint Petroleum Development Area and therefore that area is not a ‘‘foreign country’’ for the purposes of s 23AG. Note that if non-exempt foreign employment income is subject to Australian income tax, the taxpayer will be able to claim a non-refundable foreign income tax offset (FITO) for foreign income tax paid on that income: see [34 200]. Note that the limitations imposed by s 23AG(1AA) effectively mean that s 23AG will not apply to the types of employment which lead to attributed personal services income (under the alienation of PSI rules discussed at [6 100] and following).

[7 160] Foreign earnings ‘‘Foreign earnings’’ are defined in s 23AG(7) to mean income consisting of earnings, salary, wages, commission, bonuses or allowances (eg ATO ID 2011/52). Workers compensation payments received in substitution for salary and wages (that are earned overseas) are likely to be ‘‘foreign earnings’’: see ATO ID 2004/280. However, in AAT Case [2011] AATA 462 (2011) 83 ATR 977, a lump sum paid under an income protection policy was attributable to the policy and not to the taxpayer’s service overseas and therefore did not qualify as ‘‘foreign earnings’’. In Re Boyd and FCT (2013) 95 ATR 136, the AAT decided that the exemption extended to that part of the annual and long service leave components of an ETP that was attributable to the taxpayer’s period of foreign service (the payment was an eligible termination payment caught by the ITAA 1936 rules, but the decision can be applied to unused annual leave and unused long service leave payments that are dealt with under the ITAA 1997 rules: see [4 420] and [4 430]). ‘‘Foreign earnings’’ also include amounts assessable under the employee share scheme (ESS) rules in Div 83A ITAA 1997 (and also under the previous ESS rules in Div 13A) (see [4 150]-[4 260]). Exclusions Various amounts are specifically excluded from the definition of ‘‘foreign earnings’’ and are therefore subject to the ordinary taxation provisions, including any applicable double taxation agreements (DTAs). These include: • employment termination payments (see [4 300]); • assessable superannuation benefits (see [40 120]); • amounts transferred from a foreign superannuation fund if included in the assessable income of the transferee fund (see [41 170]); • tax-free genuine redundancy payments (see [4 400]); • tax-free early retirement scheme payments (see [4 410]); • foreign termination payments (see [4 440]); • reasonable capital payments for personal injury; and © 2017 THOMSON REUTERS

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• reasonable capital payments for a legally enforceable restraint of trade agreement. However, certain exempt foreign termination payments may need to be taken into account in the same manner as earnings exempt under s 23AG in determining the rate of Australian tax on other income: see [7 190].

[7 170] Foreign service One of the criteria for the s 23AG exemption to apply is that the taxpayer be engaged in ‘‘foreign service’’ for a continuous period of at least 91 days. ‘‘Foreign service’’ means service in a foreign country as the holder of an office or in the capacity of an employee: s 23AG(7). In Chaudhri v FCT (2001) 47 ATR 126, an officer of an international trading vessel was not considered engaged in ‘‘foreign service’’ by virtue of his ship being registered in Panama and outside Australian territorial waters for more than 91 days. The Full Federal Court said that the term ‘‘foreign country’’ looks towards a political entity, whether a tract of land, a district or group of islands, and does not extend to a region of the sea, thereby rejecting the taxpayer’s argument that a ship at sea takes on the status of an extension of the country it is from. Note that the Joint Petroleum Development Area in the Timor Sea is not a foreign country: see ATO ID 2004/288 and ATO ID 2006/107. In Overseas Aircrew Basing Ltd v FCT (2009) 74 ATR 850, the Federal Court concluded that Cathay Pacific pilots (employed by the taxpayer company) who were based in Australia were not engaged in service in a foreign country. The court said that s 23AG is intended to exempt from tax in Australia salaries derived in a foreign country in which those salaries are taxed. It does not exempt from tax in Australia salaries derived by pilots in Australia, in Australian airspace, in international airspace, in the airspace of other countries of the world or in other countries to and from which their employer directs them to fly aircraft. For the purposes of s 23AG, an ‘‘employee’’ has its normal meaning, but is also defined to include a person employed by a government, government authority or international organisation or a member of a disciplined force (which is intended as a reference to a defence force or peacekeeping force): s 23AG(7). In Lopez v DCT (2005) 60 ATR 387, the Full Federal Court confirmed that it was appropriate to confine the meaning of the term ‘‘in the capacity of an employee’’ as used in s 23AG to that of ‘‘employee’’ in its strict sense. As a result, consultancy and management fees derived by the taxpayer as an independent contractor were held not to be exempt under s 23AG. In Re Clark and FCT (2010) 79 ATR 262, the AAT confirmed that the s 23AG exemption cannot apply to income attributable to an individual under the alienation of personal services income rules in Div 86 ITAA 1997: see [6 130]. Period of foreign service In determining the period of continuous foreign service, temporary absences from work are disregarded if they are in accordance with the terms and conditions of the employee’s service: s 23AG(6). These include recreation leave on full pay, sick leave, rostered days off, flex days, public holidays, weekends, compassionate leave and other approved absences: see Determination TD 2012/8. Such leave will therefore not constitute an interruption in a period of foreign service. However, this does not apply to certain forms of leave (which will bring about a discontinuity in a period of foreign service), such as maternity/parental leave, long service leave, extended leave, furlough, any leave similar to long service leave, extended leave or furlough, purchased leave and leave without pay or on reduced pay: see also Determination TD 2012/8. Leave wholly or partly attributable to a period of service or employment other than foreign service will also bring about a discontinuity of service. Determination TD 2013/18 discusses the extent to which the s 23AG exemption applies to earnings derived by an ADF member from a period of leave as a result of an accident or illness that occurred while deployed overseas as a member of a disciplined force. In essence, the exemption will apply to the extent the earnings are derived during the period the ADF 198

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EXEMPT INCOME [7 170]

member would otherwise have remained deployed overseas had the accident or illness not occurred. Sick leave payments cannot be exempt under s 23AG where the leave accrued during a period of foreign service and the leave is then taken after the period of foreign service has ceased (see ATO ID 2013/27). It should be emphasised that an appropriate absence (eg recreation leave or sick leave) is only disregarded if it is in accordance with the terms and conditions of the employee’s foreign service. In Re McCabe and FCT (2008) 73 ATR 642, time spent in Australia by a casual employee who worked overseas constituted an interruption in his period of foreign service as it was not recreation leave (instead he was between contracts of employment). Work-related trips directly related to the foreign service also do not constitute an interruption in a period of foreign service provided the absences are not excessive: see Determination TD 2012/8. Note that if the employment contract provides that the foreign employment begins on the employee’s first working day in the foreign country, the period of foreign service will commence on that day. Continuity of foreign service will be maintained despite a period (or periods) of absence if, at any time, the total period of absence is not greater than one-sixth of the total period of foreign service (the ‘‘one-sixth rule’’): ss 23AG(6A) and (6B). If that is the case, 2 or more periods in which a person has been engaged in foreign service will be taken together to constitute a continuous period of foreign service. However, if at any time the period of absence exceeds one-sixth of the total period of foreign service (at that time), there will be a break in the foreign service (ie continuity is lost) and the taxpayer may not meet the 91 days requirement. EXAMPLE [7 170.10] Lisa, an Australian resident, is engaged in foreign service for 65 days. She then has 5 days off sick (which is in accordance with the terms and conditions of her employment). Those 5 days are included in the first period of foreign service. She then takes off 10 days that are not considered to be part of her foreign service. She then re-commences the foreign service for a further 40 days. As the period of absence (10 days) is less than one-sixth of the first period of foreign service (70 days), continuity is not lost and the second period of foreign service (40 days) may be added to the first period to constitute one continuous period (totalling 110 days). Since Lisa’s total period of absence (10 days) at the end of the second period is less than one-sixth of the total period of foreign service at that point (110 days), her earnings will be exempt under s 23AG (assuming the exemption is not excluded because of the rules discussed at [7 180]).

EXAMPLE [7 170.20] Assume the same facts as in Example [7 170.10], except that Lisa has 20 days of absence (instead of 10 days) that are not considered to be part of foreign service. After 12 days of absence, Lisa’s total period of absence will exceed one-sixth of the period of foreign service up to that point and therefore she will lose continuity. The second period of foreign service cannot be added to the first period. As the first period of foreign service is only 70 days, Lisa’s earnings from that period cannot qualify for the s 23AG exemption. When Lisa recommences work, she will start a completely new period of foreign service and will need 91 days of service before any of her earnings for the second period of foreign service are exempt under s 23AG.

Death of taxpayer If a person dies at a time when they have been engaged in foreign service for a continuous period of less than 91 days, that person is deemed to have been engaged in foreign service for a continuous period of 91 days if he or she would have otherwise continued to be © 2017 THOMSON REUTERS

199

[7 180]

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engaged in the foreign service, and his or her continuous period of engagement in the foreign service would have otherwise been a period of at least 91 days: s 23AG(1A).

Assessments Section 23AG(6F) authorises the Commissioner to make assessments in respect of foreign earnings on the basis of a period of continuous service anticipated at the time of the making of the assessment. If events turn out differently, the standard time limits for amending assessments apply: see [47 140]. [7 180] Foreign earnings not exempt under s 23AG Foreign earnings derived in a foreign country are not exempt from tax under s 23AG if the amount is exempt from income tax in the foreign country only because of (s 23AG(2)): • a DTA or a foreign law giving effect to a DTA; • the foreign country generally exempting employment or personal services income from income tax at the federal or national level (see below for what is ‘‘income tax’’). Examples are UAE (see ATO ID 2006/316) and Vanuatu. Employment income is not ‘‘generally exempt from income tax’’ if, under the foreign law, the exemption only applies to certain persons delivering certain services: see ATO ID 2011/36. If the foreign country imposes tax on the income but fails to collect the tax, the s 23AG exemption is not excluded: see withdrawn ATO ID 2004/305; • the application of an international agreement dealing with diplomatic or consular privileges and immunities, or immunities and privileges in relation to persons connected with international organisations. Australia is not a party to an international agreement when participating in a UN peace-keeping operation and therefore this exclusion does not apply to Australian Defence Force members who are part of such an operation (and thus the s 23AG exemption may apply): Determination TD 2005/37; or • a law of a foreign country corresponding to the International Organisations (Privileges and Immunities) Act 1963 or regulations made under that Act. The effect of s 23AG(2) is that foreign earnings of an Australian resident that are exempt from foreign income tax solely because of any one or more of the 4 grounds listed above (eg because of a DTA or a foreign law giving effect to a DTA) are not exempt under s 23AG and are assessable under s 6-5: see Determination TD 2005/14. If foreign earnings are exempt from foreign income tax under more than one of the grounds mentioned in s 23AG(2), eg a DTA applies but an exemption also exists due to a specific inter-government agreement relating to aid workers, the requirements for the s 23AG(2) exclusion will not be met and the foreign income will be exempt under s 23AG(1) (see also Determination TD 2005/15). Similarly, the s 23AG(2) exclusion does not apply (and thus the foreign earnings will be exempt under s 23AG) if those earnings are exempt from foreign income tax for a reason not listed in s 23AG(2). If, by virtue of a DTA, foreign earnings of an Australian resident are taxable only in a foreign country and are not subject to Australian tax, the treaty takes precedence and the s 23AG exemption is not needed.

Meaning of income tax References to ‘‘income tax’’ in relation to the foreign country are defined to mean national or federal taxes and not a state or municipal income tax: s 23AG(7). Whether a payment made to the authority of a foreign country is ‘‘income tax’’ is not determined by reference solely to the relevant laws of the foreign country: see the discussion in withdrawn ATO ID 2009/17. Compulsory contributions by a segment only of the population of Saudi Arabia (wage-earning workmen) that were paid into a special bank 200

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account, as distinct from consolidated revenue, and were used for a specific purpose (to pay benefits to a restricted class of persons) were not considered to be income tax in Case 122 (1984) 27 CTBR(NS) 122. In contrast, in Case 58 (1985) 28 CTBR(NS) 58, compulsory contributions made to the US Federal Insurance Fund, which were deducted from salary and calculated according to a statutory formula, were considered to be income tax, even though US law deemed the contributions not to be tax.

[7 190] Non-exempt income and the average rate method Foreign earnings of an Australian resident that are exempt from Australian tax under s 23AG ITAA 1936 (or s 23AF) are taken into account in calculating the Australian tax on any other assessable income derived by the person, in order to prevent the relevant exemption under s 23AG (or s 23AF) from reducing the Australian tax payable on that other income. An exemption of this kind is generally referred to as an ‘‘exemption with progression’’. This is achieved through applying an average rate method to the non-exempt income of a taxpayer entitled to the s 23AG (or s 23AF) exemption, so as not to tax it as though it were the top marginal slice. Australian tax on the non-exempt income is calculated by applying to the non-exempt component the notional average rate of tax payable on the total of the exempt income and non-exempt income: ss 23AG(3) and (4) and 23AF(17A). Income that is exempt under sections other than s 23AF or s 23AG is not taken into account in calculating Australian tax on any non-exempt income. Calculation of tax on non-exempt income If an Australian resident derives both foreign earnings that are exempt under s 23AG (or s 23AF) and other non-exempt income, the amount of tax payable on the non-exempt income is calculated using the formula in s 23AG(3): Notional gross tax × Other taxable income Notional gross taxable income

where: “Notional gross tax” refers to the income tax that would be payable (excluding any tax offsets and rebates) on the amount that would be the total taxable income if the exempt amount (including any foreign termination payment otherwise exempt under ss 83-240 or 305-65 ITAA 1997) other than the portion which represents the taxpayer’s own contributions) was assessable income. The reference to income tax includes the Medicare levy and surcharge: see s 251R(7); “Notional gross taxable income” refers to the amount that would be the total taxable income if the exempt amount was assessable income (ie total income from all sources less all deductions). Accordingly, any deductions that relate to the exempt income are allowed as if the exempt income was assessable income, eg employment-related expenses are deducted from the exempt employment income (see ATO ID 2004/282); and “Other taxable income” refers to the amount remaining after deducting from the other income that is assessable income any allowable deductions that are attributable to that other income. Income earned overseas must be converted into Australian dollars: see below. There are 3 classes of deduction that are allowable for the purposes of calculating other taxable income: • deductions that relate exclusively to the taxpayer’s other assessable income (eg interest payments on a mortgage of rental property may be deducted from the rental income); • so much of any other deductions, other than ‘‘apportionable deductions’’, as the Commissioner considers may appropriately be related to the taxpayer’s other assessable income (eg bank fees may relate to both rental income and the exempt foreign employment income); • apportionable deductions – rates, land tax and most tax-deductible gifts other than gifts of trading stock (effectively deductions that have no connection with the © 2017 THOMSON REUTERS

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[7 190]

EXEMPT INCOME

production of assessable income). These are apportioned in accordance with the formula: Apportionable deductions ×

Other taxable income Apportionable deductions + Notional gross taxable income

Note that in this formula ‘‘other taxable income’’ has the same meaning as explained above, except that apportionable deductions are excluded: s 23AG(3)(f) and (4). Deductible tax agents’ fees and superannuation contributions are not ‘‘apportionable deductions’’ for these purposes and are treated as relating exclusively to assessable income: AAT Case 11,375 (1996) 34 ATR 1034; and Determination TD 2000/12.

Currency conversion For all purposes of the income tax legislation, including s 23AG, both foreign income and foreign tax are to be translated into Australian currency for the purpose of assessing Australian tax and any allowable foreign income tax offsets. The relevant rules are set out in s 960-50 ITAA 1997 and are discussed at [34 050]-[34 080]. In essence, salary and wages are to be translated into Australian currency using either the exchange rate prevailing at the time of receipt (which is usually also the time of derivation) or an average exchange rate for a period not exceeding 12 months. That rate is also used to translate into Australian currency the tax paid by the taxpayer (for the purposes of calculating the foreign income tax offset: see [34 200]). EXAMPLE [7 190.10] Calculation of non-exempt income In 2016-17, a resident taxpayer, Mai, derives exempt overseas employment income of $55,000 from working overseas for a continuous period of 5 months during the year. In addition, she derives the following non-exempt income: 1. Australian employment income of $36,000; and 2. Australian bank interest of $1,000. Mai incurs the following expenses: 1. in deriving the exempt foreign earnings – $5,000; and 2. in deriving the Australian employment income – $2,000. She is not liable for the Medicare levy surcharge. The notional gross taxable income is:

Less

$ 55,000 36,000 1,000 5,000 2,000

The other taxable income (for the average rate calculation) is: Other income Less deductions relating exclusively to that income Notional gross tax (at 2016-17 rates) on $85,000 (including Medicare levy): The tax payable on the non-exempt income, using the average rate method is (ignoring cents): Notional gross tax × Other taxable Notional gross taxable income income

202

$

92,000 7,000 85,000 37,000 2,000 35,000 20,872

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EXEMPT INCOME $ $20,872 $85,000

×

[7 190] $

$35,000

= $8,594 (an average rate of tax of 24.555%)

EXAMPLE [7 190.20] Calculation of apportionable deductions Cheryl, a resident taxpayer, derives income in 2016-17 of $67,000 consisting of: $ Exempt foreign earnings 55,000 Rent received in Australia 12,000 67,000 Cheryl incurred expenses of $1,000 in deriving the exempt foreign earnings and $2,300 in deriving the rent. She also made deductible gifts totalling $900 and is entitled to a dependant (invalid and carer) offset (DICTO) of $1,105. She is not liable for the Medicare levy surcharge. Cheryl’s ‘‘notional gross taxable income’’ is the total income from all sources less all the deductions: $

$ 67,000

1,000 2,300 900 Notional gross taxable income: Notional gross tax (at 2016-17 rates) on $62,800 (including Medicare levy): ‘‘Apportionable deductions’’ are calculated as follows:

4,200 62,800 13,213

Other taxable income Apportionable deductions + Notional gross taxable income (Note that in this calculation ‘‘other taxable income’’ is worked out without deducting any apportionable deductions.) Apportionable deductions ×

$900 ×

$9,700 (ie $12,000 − $2,300) = $137 $900 + $62,800

‘‘Other taxable income’’ (for the average rate calculation) is: Other income Less deductions relating exclusively to that income Apportionable deductions – gifts (see above) Other taxable income:

12,000

2,300 137

2,437 9,563

The tax payable using the average rate is calculated as follows (ignoring cents): Notional gross tax × Other taxable income Notional gross taxable income (Note that in this calculation ‘‘other taxable income’’ is the amount mentioned above, which takes account of apportionable deductions.) $13,213 $62,800 © 2017 THOMSON REUTERS

×

$9,563 =

$ 2,012

203

[7 200]

EXEMPT INCOME

Less DICTO Tax payable on non-exempt income

$ 1,105 907

[7 200] Approved overseas projects Section 23AF ITAA 1936 applies to exempt income derived from personal services rendered overseas by an Australian individual either as an employee or as a contractor. The income that will be exempt from tax will be that derived as a result of rendering service on an overseas project approved. If an Australian resident individual has been engaged in qualifying service on a particular approved project for a continuous period of not fewer than 91 days, any eligible foreign remuneration attributable to that qualifying service is exempt from tax: s 23AF(1). As to Australian tax payable on any non-exempt income derived by the taxpayer, tax is calculated by determining a notional average rate of tax applicable to the total of exempt and non-exempt income and applying it to the taxpayer’s non-exempt income: s 23AF(17A) to (17C). This average rate method is similar to that applied under s 23AG: see [7 190]. [7 210] Approved overseas projects – eligible foreign remuneration The income that qualifies for the concession under s 23AF is referred to as ‘‘eligible foreign remuneration’’, ie salary, wages, commissions, bonuses (eg ATO ID 2007/26) or allowances derived by the taxpayer as an employee of an eligible contractor or income derived under a contract with an eligible contractor which is wholly or substantially for the personal services of the taxpayer. ‘‘Eligible foreign remuneration’’ also includes: amounts assessable under the employee share scheme (ESS) rules in Div 83A ITAA 1997 in relation to ESS interests acquired on or after 1 July 2009; and amounts assessable under the previous ESS rules in Div 13A (see [4 150]) if the employee shares and rights were acquired on or after 26 June 2005 or if the employee shares and rights were acquired at any time (including before 26 June 2005) by a person who does not become an Australian employee until that or a later day. Payments received under an income protection policy, to replace salary and wages, are not considered to be ‘‘eligible foreign remuneration’’: see ATO ID 2010/120. To qualify for the exemption, the income must be directly attributable to a period of qualifying service on an approved project (income, such as a bonus or accrued arrears, received after a period of qualifying service has ended may still be directly attributable to that period: see ATO ID 2007/26). Any payment received in lieu of eligible leave that accrued in respect of a period during which the taxpayer was a resident, and was engaged in qualifying service on an approved project, may also qualify. If a person takes leave (other than long service leave) immediately after completion of a period of qualifying service on the eligible project, that period of leave constitutes part of the period of qualifying service. Income is excluded from the application of the provision if it is (s 23AF(17)): • exempt under s 23AG; • an assessable superannuation benefit or employment termination payment, or an amount transferred from a foreign superannuation fund in relation to the taxpayer; • exempt in the country in which the services are rendered and is exempt only by reason of the application of an international agreement between that country and Australia; or • the income consists of payments in lieu of long service leave or by way of superannuation or pension. 204

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Long service leave (defined in s 23AF(18) as long leave, furlough, extended leave or leave of a similar kind) does not qualify as eligible leave for the purpose of determining the period of service. The Commissioner has ruled that if persons are engaged for 5 weeks on a project, and then have 5 weeks off during which they return to Australia, they are to be deemed to be continuously engaged on the overseas project provided the period of employment is equal to a minimum of 10 × 40 hours: Ruling IT 2015. The term ‘‘employee’’ is defined in s 23AF(18) to include Commonwealth, State and Territory public servants, persons employed by authorities of the Commonwealth, a State or a Territory, members of the Australian Defence Force and persons employed by a foreign government.

Conditions of exemption An eligible project is a project for the design, supply or installation of any equipment or facilities; the construction of works; the development of an urban or a regional area; the development of agriculture; a project consisting of giving advice or assistance relating to the management or administration of a government department or of a public utility; or a project included in a class of projects approved in writing for the purposes of s 23AF by the Trade Minister: s 23AF(18). The following types of project have been approved (Ruling IT 2064): • projects for the development of natural resources; • projects for the supply of agricultural services carried out on behalf of governments, public utility or a corporation owned by a government or operated under government authority; and • projects for the development, installation, management or administration of medical programs and facilities.

Qualifying service A person is engaged in a period of qualifying service while (s 23AF(3)): • outside Australia and engaged in the provision of personal services in connection with an approved project; • travelling between Australia and the site of the project, provided that the time taken for the journey is reasonable (s 23AF(4)); • incapacitated due to an accident or illness occurring while he or she was engaged on the project or travelling to or from the project; or • on eligible leave, being leave that accrued in respect of the period during which he or she was engaged on the approved project. If a person has been incapacitated, the period of incapacity does not qualify unless he or she resumes the qualifying service immediately after the incapacity ceases: s 23AF(5). The periods of qualifying service must be continuous if they are to be aggregated for the purpose of determining the proportion of income that is exempt: eg see ATO ID 2001/152 (83-day period of service performed 8 months after a 24-month period of service did not qualify); and ATO ID 2001/256 (104 days spent overseas but s 23AF did not apply as the longest continuous period was only 32 days). If a person has been engaged on a specified project and is unable to continue by reason of illness or other incapacity, for the purpose of determining the period of time spent on the project, not only is the actual period of service taken into account, but also such further period as the Commissioner considers the taxpayer would have served on qualifying service.

Artificial inflation of income An anti-avoidance provision prevents income during a period of qualifying service from being inflated. If the Commissioner is satisfied that the income has been inflated, he can reduce the exemption amount to the figure that he considers reasonable: s 23AF(10). © 2017 THOMSON REUTERS

205

[7 250]

EXEMPT INCOME

EDUCATION [7 250] Scholarships – full-time education A scholarship, bursary, educational allowance or educational assistance paid to a full-time student at a school, college or university is exempt from tax, unless it is a payment specified in s 51-35: s 51-10 Item 2.1A. Payments specified in s 51-35 are not exempt: see [7 260]. The exemption can apply to payments under various private scholarships and similar educational awards received by a full-time student at a school, college or university in Australia or overseas. In Re Muir and FCT (2001) 47 ATR 1006, a scholarship that was paid to allow the taxpayer to undertake further studies and research in pain management was not exempt as the studies were undertaken at a hospital (in a specialised unit) and not at a college or university. What constitutes a scholarship or bursary? An amount is a scholarship, bursary or other educational allowance (regardless of its description) if it is given primarily for the education of a student: FCT v Hall (1975) 5 ATR 450; FCT v Ranson (1989) 20 ATR 488. It is the purpose of the provider, rather than the use by the student, that is important. The provider is determined from the terms and conditions of the scholarship, the source and control of the funds and the manner of payment. In the case of an educational institution providing a scholarship, the institution is the provider if the scholarship is financed from either the institution’s general funds or from funds provided by an external body over which the institution has allocative control. However, if the external body retains control of the funds, the external body is the provider. Ruling TR 93/39 states that a scholarship, bursary etc is a reward for merit attained as a result of competition or selection on the basis of general criteria (see also Class Ruling CR 2010/11). Note that the Tax Office has issued Taxpayer Alert TA 2002/6 and Taxpayer Alert TA 2007/6, which both concern arrangements where an education or scholarship trust is established by relatives of a student for the provision of the student’s education. By issuing the Alerts, the Tax Office is signalling its concerns about these particular arrangements, eg payments to a student may not be a scholarship, bursary or other educational allowance or the anti-avoidance provisions of Pt IVA ITAA 1936 may apply. [7 260] Non-exempt scholarships/educational assistance payments The following scholarships and other educational assistance payments (specified in s 51-35) are not exempt: (a) a payment under a ‘‘Commonwealth education or training program’’: see [7 270]; (b) a payment made on condition that the student will (or will if required) become, or continue to be, an employee; (c) a payment made on condition that the student will (or will if required) enter into, or continue to be a party to, a contract that is wholly or principally for the labour of the student; (d) a payment under a scholarship that is not provided principally for education purposes; and (e) an education entry payment under Pt 2.13A Social Security Act 1991 (the Social Services Legislation Amendment (Budget Repair) Bill 2016 proposes to cease this payment from 1 January 2017, unless entitlement to the payment arose before that date). 206

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[7 270]

Payments received by a student in the capacity of employee rather than as a scholar are not scholarships. Payments to have research on a specific topic carried out for the benefit of the provider, and which incidentally require the recipient to be a full-time student, are also not scholarships. This would still appear to be the case under s 51-35(e) (ie (d) above). Allowances paid to research workers are indistinguishable in nature from salaries and continue to be subject to tax: Case 63 (1965) 12 CTBR(NS) 63. The references in (b) and (c) above to a ‘‘condition’’ do not require that there be a contract between the parties or any form of legal relationship. It is sufficient for the loss of the exemption if it can be said that the receipt of the amount is, as a matter of ordinary language, conditional upon the recipient becoming an employee or entering into a contract principally for labour. FCT v Ranson (1989) 20 ATR 488 took this approach in relation to the former condition in s 23(z) regarding rendering of services. See also AAT Case 5453 (1990) 20 ATR 4135 and Ruling IT 2612 in relation to the assessability of fellowship moneys received from an overseas university. In Polla-Mounter v FCT (1996) 34 ATR 447, the taxpayer accepted an offer to play for a football club and applied for and was granted a tertiary scholarship from the local leagues club. The Full Federal Court held that the fact that the scholarship could continue even if the taxpayer stopped playing football was irrelevant if it was nevertheless an initial condition of the scholarship that services be rendered. The evidence in this case, however, did not support this position. It was also doubtful whether any services were rendered to the scholarship provider, the leagues club, as opposed to the football club, but in any event rendering services alone did not negate the exemption provided there was no condition to do so. These principles would appear to apply equally to an employment situation or contract for labour (as distinct from a contract for services). Note that a Commonwealth payment for assistance for secondary education or in connection with the education of isolated children is not exempt under Item 2.1A in s 51-10, but may be exempt under Item 2.1B s 51-10: see [7 280].

[7 270] Commonwealth education and training payments As noted at [7 250], a Commonwealth education or training payment (as defined) is not exempt: s 51-35. However, the supplementary amount is exempt (see below). The term ‘‘Commonwealth education or training payment’’ is defined in s 52-145(1) as an allowance or reimbursement paid by the Commonwealth (or by someone else in connection with such a payment by the Commonwealth) to or on behalf of a participant in a Commonwealth labour program, or to or on behalf of a student (who has turned 16) under: • ABSTUDY; • the Assistance for Isolated Children (AIC) Scheme; • the Veterans’ Children Education (VCE) Scheme; • the Youth Allowance scheme; or • the Austudy Payment scheme. A payment or reimbursement under s 258 of the Military Rehabilitation and Compensation Act 2004 (see [7 090]) to provide education and training for dependent children of present, former or deceased ADF members is also a ‘‘Commonwealth education or training payment’’: s 52-145(1). As mentioned above, the supplementary amount of a Commonwealth education or training payment is exempt: s 52-140(2). The supplementary amount is the total of various amounts included in the payment, eg to assist with (or as reimbursement for) rent, telephone bills, travel to courses or interviews, participation in courses or training, books, equipment, living away from one’s usual residence and discharging a compulsory repayment amount (under the Higher Education Support Act 2003), any pharmaceutical allowance and any energy supplement. © 2017 THOMSON REUTERS

207

[7 280]

EXEMPT INCOME

The training and learning bonus and the education entry payment supplement (payable under the Social Security Act 1991) are also exempt: see [6 610]. Note that the Social Services Legislation Amendment (Budget Repair) Bill 2016 proposes to cease the education entry payment supplement from 1 January 2017, unless entitlement to the payment arose before that date. Note that deductions are not allowable against taxable government assistance payments that are eligible for a rebatable benefit: see [9 960].

[7 280]

Commonwealth assistance – secondary or isolated education

A payment to a student, or to someone else in respect of a student (eg a parent or guardian), under a Commonwealth scheme for assistance of secondary education or the education of isolated children is exempt from tax, unless it is a payment specified in s 51-40: s 51-10 Item 2.1B. Section 51-40 excludes 2 payments from the operation of the Item 2.1B exemption (ie they are not exempt from tax): • a Commonwealth education or training payment, although the supplementary amount is exempt: see [7 270]; and • an education entry payment: see [7 260]. Subdivision 52-E (ss 52-131 to 52-134) explains which payments under the ABSTUDY scheme are wholly are partly exempt.

[7 290]

Commonwealth scholarships – visiting students

Certain allowances paid by the Commonwealth to students or trainees who are in Australia for the sole purpose of pursuing a course of study or training are exempt: s 842-105 (Item 7) ITAA 1997. The exemption extends to allowances paid by the Commonwealth to part-time students and trainees visiting Australia under the New Colombo Plan or a Commonwealth aid program. It also covers the situation where, for example, the visiting student is in part-time employment gaining experience that supplements her or his study.

[7 300]

Other exemptions

Other payments exempt from income tax under s 51-10 include: • a grant made by the Australian American Educational Foundation (Item 2.1); • a Commonwealth Trade Learning Scholarship (Item 2.3); • an Apprenticeship Wage Top-Up (Item 2.4); • research fellowships under the Endeavour Awards and Endeavour Executive Awards, whether or not the recipient is a full-time student (Item 2.5); • a bonus for early completion of an apprenticeship – the bonus must be provided under a specific State or Territory scheme and the apprenticeship must be for a specific occupation and must be completed within a specific time frame (see s 51-42 and reg 51-42.01 of the ITA Regs) (Item 2.6 and s 51-42); • payments under the Skills for Sustainability for Australian Apprentices and the Tools For Your Trade programs – this includes the bonus of up to $1,700 payable to eligible apprentices as they reach milestones in their training (Items 2.7 and 2.8); and • HECS-HELP benefits (Item 2.9) – these payments will cease from 1 July 2017 (except where entitlement to the payment arose before that date). 208

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EXEMPT INCOME

[7 360]

CHARITIES AND OTHER NOT-FOR-PROFIT ORGANISATIONS [7 350] Exempt institutions – overview The ordinary and statutory income of various not-for-profit organisations is exempt under s 50-1 ITAA 1997 if the organisation is listed in a table in Subdiv 50-A. These include registered charities (see [7 360]), ancillary funds (see [7 370]), public educational institutions (see [7 380]), various scientific organisations (see [7 390]), various sporting, cultural and recreational organisations (see [7 400]) and community service organisations (see [7 410]). Certain common conditions must be satisfied for an organisation to qualify for the exemption: see [7 430]. [7 360] Registered charities The income of a registered charity is exempt under s 50-5 (Item 1.1), provided certain conditions are satisfied: see [7 430]. (Before 3 December 2012, the exemption applied to charitable institutions, religious institutions and certain funds established for public charitable purposes by will or instrument of trust.) Note that if an organisation is an ‘‘ACNC type of entity’’ (effectively a charity), it will not be exempt from income tax unless registered under the Australian Charities and Not-for-profits Commission Act 2012 (the ACNC Act). In addition, a registered charity must be endorsed by the Commissioner. See [7 365]. Statutory definition of ‘‘charity’’ The Charities Act 2013 contains a statutory definition of ‘‘charity’’. The definition largely follows the spirit and intendment of the Statute of Elizabeth, which effectively codified the common law definition of ‘‘charity’’. Note that the Charities (Definition of Government Entity) Instrument 2013 excludes certain types of government entities (including local governing bodies and entities with privileges and immunities of the Crown) from being a charity. To qualify as a charity under the Charities Act, an organisation must be a non-profit organisation (see [7 430]), have only charitable purposes that are for the public benefit (or have purposes that are incidental to or ancillary to, and in furtherance or in aid of, charitable purposes that are for the public benefit): s 5 Charities Act. See below for the various categories of charitable purpose. Broadly, the purpose of an organisation is determined having regard to its constituent documents and activities in particular, but any legislation governing its operation, its history and who controls the organisation may also be relevant factors: eg FCT v The Triton Foundation (2005) 60 ATR 451 at 458; Ruling TR 2011/4. An entity may have incidental or ancillary purposes that may be non-charitable when viewed in isolation but which must aid or further the charitable purpose. An individual, political party or government entity cannot be a charity. Charitable purposes The categories of charitable purposes are listed in s 12 of the Charities Act. They are: • advancing health (see also s 14 of the Charities Act); • advancing education; • advancing social or public welfare (see also s 15 of the Charities Act); • advancing religion; • advancing culture (see also s 16 of the Charities Act); • promoting reconciliation, mutual respect and tolerance between groups of individuals that are in Australia; © 2017 THOMSON REUTERS

209

[7 360]

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• promoting or protecting human rights; • advancing the security or safety of Australia or the Australian public; • preventing or relieving the suffering of animals; • advancing the natural environment; • any other purpose beneficial to the general public that may reasonably be regarded as analogous to, or within the spirit of, any of the purposes listed above; and • promoting or opposing a change to any matter established by law, policy or practice in the Commonwealth, a State, a Territory or another country, in furtherance or protection of one or more of the purposes listed above. It therefore seems that if an organisation has political purposes (including lobbying), it can still be a charity if it has a purpose of ‘‘generating public debate with a view to influencing legislation, government activities or government policy’’ in relation to subject matters that come within one or more of the categories of charitable purpose, ‘‘as long as the ends to be achieved are not inconsistent with the rule of law and the established system of government’’: see Ruling TR 2011/4 and Aid/Watch Inc v FCT (2010) 77 ATR 195. Funding charity-like government entities does not prevent a contributing fund from satisfying the definition of ‘‘charity’’: s 13 Charities Act. Charitable purpose will extend beyond the relief of individual distress after a disaster to include assisting with the rebuilding of a community within specified limits. Funding charity-like government entities would not prevent a contributing fund from being charitable for the purposes of Commonwealth law.

Public benefit condition A purpose is for the public benefit if the achievement of the purpose would be of public benefit and the purpose is directed to a benefit that is available to the members of the general public or a sufficient section of the general public: s 6 Charities Act The following purposes are presumed as being for the public benefit unless there is evidence to the contrary (s 7 Charities Act): • preventing and relieving sickness, disease or human suffering; • advancing education; • relieving the poverty, distress or disadvantage of individuals or families; • caring for and supporting the aged or people with disabilities; and • advancing religion. An organisation that directs benefits to persons who are related may fail the public benefit test. However, where the purpose of an organisation that has land-rights related assets would fail a public benefit test solely because the organisation directs benefits to indigenous Australians who are related, the purpose is treated as being for the public benefit: s 9 Charities Act. In addition, as outlined in Ruling TR 2011/4, an organisation that can distribute surpluses to its owners or members can still satisfy the public benefit requirement if: • its sole purposes is charitable; • its constituent documents allow it to distribute its surplus or profit to another organisation in order to effect that sole charitable purpose; and • the owners or members who can receive the distributions are themselves charitable organisations that have the same charitable purpose as the organisation itself. Note that in Study and Prevention of Psychological Diseases Foundation Inc and FCT (2013) 96 ATR 992, the AAT affirmed that a foundation was not a charity as there was little 210

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public utility for the foundation’s activities and expenditure was in general for the personal benefit of members. Although the Federal Court set aside this decision in Study and Prevention of Psychological Diseases Foundation v FCT [2015] FCA 1117 and remitted the matter to the AAT, the Court effectively endorsed the AAT’s decision and the issue to be considered in the rehearing is the effective date of the revocation of the taxpayer’s endorsement. Open and non-discriminatory self-help groups, closed or contemplative religious orders and organisations whose purpose is to relieve the necessitous circumstances of one or more individuals in Australia, generally do not have to satisfy the public benefit test: ss 8, 10 Charities Act. An individual, political party or government entity cannot be a charity: s 5 Charities Act. However, an organisation may still be charitable if, in carrying out its purpose, it has the effect of helping achieve government policy (as long as it independently carries out its purpose): see Central Bayside General Practice Association Ltd v CSR (Vic) (2006) 63 ATR 220. A purpose of engaging in, or promoting, activities which are unlawful or contrary to public policy is a disqualifying purpose: s 11 Charities Act. Public policy refers to such matters as the rule of law and system of government. It does not refer to government policies. In addition, a purpose of promoting or opposing a political party or candidate is also a disqualifying purpose.

Commercial or business-like activities Ruling TR 2011/4 acknowledges that commercial or business-like activities can be compatible with a charitable purpose. Thus, an organisation undertaking commercial or business-like activities can maintain its charitable status provided: • its sole purpose is charitable and it carries on a business or commercial enterprise to give effect to that charitable purpose. In these circumstances it does not matter that the activities themselves are not intrinsically charitable; • it has a business or commercial purpose that is simply incidental or ancillary to its charitable purpose; • its activities are intrinsically charitable but they are carried on in a commercial or business-like way; or • it holds passive investments to receive a market return to further its charitable purpose. An organisation carrying on a business or commercial enterprise will not be charitable simply because it is controlled by another organisation that is charitable. It is the purpose of the organisation itself which must be charitable.

[7 365] Registration and endorsement As noted at [7 360], an ‘‘ACNC type of entity’’ is not entitled to an income tax exemption unless registered with the Australian Charities and Not-for-profits Commission (ACNC). An ACNC type of entity is a not-for-profit organisation that is a charity. The ACNC is a statutory body which administers the regulatory framework (contained in the ACNC Act) for the not-for-profit sector. Information about registered organisations can be found on the ACNC Register (available on the ACNC website). To be registered with the ACNC, an ‘‘ACNC type of entity’’ must be a charity of a type listed in the ACNC Act, have an ABN and comply with certain governance and external conduct standards (the governance standards are set out in the Australian Charities and Not-for-profits Commission Regulation 2013). ACNC-registered charities also have ongoing obligations in order to remain registered, eg they must lodge annual information and financial reports. Small charities (revenue under $250,000) are not obliged to lodge financial reports. © 2017 THOMSON REUTERS

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Various organisations in existence before the ACNC Act came into operation on 3 December 2012 are treated as having been registered on that date, eg charities endorsed by the Commissioner and health promotion charities and public benevolent institutions endorsed as deductible gift recipients. Note that the Government has abandoned its plan to abolish the ACNC because there is considerable support for the ACNC within the not-for-profit sector.

Endorsement by Tax Commissioner Registered charities (and ancillary funds: see [7 390]) are not entitled to the income tax exemption under s 50-5 unless they are endorsed by the Commissioner of Taxation under Subdiv 50-B ITAA 1997: s 50-52. Entities that apply to the ACNC for registration as a charity can use the same application form to request endorsement by the Tax Office. The provisions governing applications for endorsement are located in Div 426, Sch 1 TAA. The objection and appeal provisions of Pt IVC TAA (discussed in Chapter 48) apply to a refusal for endorsement. If an organisation is endorsed, a statement to that effect will be included in the Australian Business Register (see [55 210]): s 426-65. [7 370] Ancillary funds Non-charitable ancillary public funds and private ancillary funds which provide money, property and benefits to exempt funds or organisations eligible to receive tax-deductible gifts (whether or not the fund or organisation is a charity) are treated as registered charities and thus qualify for tax-exempt status under s 50-50 (see [7 360]) subject to certain conditions (see [7 430]). To obtain the tax exempt status, ancillary funds are required to be endorsed by the Commissioner (see [7 365]). [7 380] Public educational institutions The income of public education institutions is exempt under s 50-5 (Item 1.4), provided certain conditions are satisfied: see [7 430]. The meaning of ‘‘public educational institution’’ is not limited to a body engaged in systematic or formal education and may include a pony club controlling body: AAT Case 5109 (1989) 20 ATR 3582. However, a purely coordinating role was held not to be sufficient in AAT Case 9723 (1994) 29 ATR 1102. The Taxpayers’ Association of NSW’s activities were not considered to be educational in Re Taxpayers’ Association (NSW) and FCT (2001) 46 ATR 1213. The terms ‘‘public’’ and ‘‘institution’’ are considered at [9 860] in the commentary on PBIs. Determination TD 2004/6 provides that a school’s tax exempt status is not disturbed by allowing prepayment of school fees or by offering a discount for a prepayment. Note that if an organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption: see [7 365]. [7 390] Scientific organisations The income of various scientific organisations is exempt under s 50-5, provided certain conditions are satisfied: see [7 430]. These organisations are scientific institutions (Item 1.3), certain scientific research funds (Item 1.6) and societies, associations or clubs established for the encouragement of science (Item 1.7). A society or association for the encouragement of science need not be incorporated to be income tax exempt. An organisation whose activities are mainly or predominantly directed towards the promotion or advancement of scientific knowledge will generally be a ‘‘scientific institution’’ (see the commentary at [9 860] on PBIs for the meaning of ‘‘institution’’). Science, in this context, is not confined to abstract or speculative science. Thus, the Royal Australasian College of Surgeons was held to be a scientific institution in Royal Australasian College of Surgeons v FCT (1943) 2 AITR 490 because the promotion of surgical science was the 212

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[7 400]

primary object of the College. In contrast, in Australian Dental Association (NSW Branch) v FCT (1934) 3 ATD 114, the Association was held to be a professional rather than a scientific body. In Australian Tea Tree Oil Research Institute Ltd (in liq) v FCT (2008) 74 ATR 812, an entity that conducted scientific research on behalf of a third party and its associates was held not to be a scientific institution (this decision is on appeal). Note that if an organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption: see [7 365].

Scientific research funds The income of a scientific research fund is exempt from income tax under s 50-65 if the organisation is established for the purposes of enabling scientific research to be conducted principally in Australia or by or in conjunction with a public university or public hospital. Alternatively, the fund can be one that is eligible to receive tax deductible gifts under Items 1 or 2 in the table in s 30-15(2): see [9 800]-[9 870]. [7 400] Sporting, cultural and recreational clubs or societies The income of non-profit societies, associations and clubs established for the encouragement of animal racing, art, a game or sport, literature or music, or established for musical purposes, is exempt under s 50-45 (Items 9-1 and 9-2) subject to certain conditions: see [7 430]. A society, association or club need not be incorporated to be exempt. The requirement for an organisation to be a non-profit organisation is considered at [7 430]. Note that if an organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption (s 50-47): see [7 365]. Sporting bodies The ‘‘encouragement or promotion’’ of a game or sport covers both directly carrying on activities and supporting them less directly, eg by providing financial support (providing the ‘‘main purpose’’ requirement is met). The terms ‘‘game’’ and ‘‘sport’’ are not defined and should be given their wide natural meanings. Thus, it is not essential that the game or sport be athletic, nor is it essential that human beings be the sole participants. Non-athletic games such as chess and bridge are included, as is motor racing. Mountaineering (though noncompetitive) is included, as are the activities of pony clubs. However, in AAT Case 8635 (1993) 26 ATR 1009 it was held that model railways did not qualify; and Determination TD 94/30 states that stamp collecting is not considered to be a game or sport (nor the encouragement of art). The requirements of the game or sport limb have been considered in detail in Ruling TR 97/22. In Cronulla Sutherland Leagues Club Ltd v FCT (1990) 21 ATR 300, it was held that the main purpose of the club was the provision to its members of social amenities and licensed club facilities, not the encouragement or promotion of rugby league football, and therefore it was not entitled to an exemption. In contrast, in both Terranora Lakes Country Club Ltd v FCT (1993) 25 ATR 294 and St Marys Rugby League Club Ltd v FCT (1997) 36 ATR 281, the club in question was able to satisfy the ‘‘main purpose’’ requirement despite its social activities. The test of whether an organisation satisfies the non-profit condition is to be applied each year. Other considerations Non-profit clubs or societies may also be able to rely upon the mutuality principle: see [7 440]. Certain non-profit business and industrial societies and associations are dealt with in more detail at [7 460]. Companies that qualify as ‘‘non-profit companies’’ (see [20 180]) are subject to tax at the rate prescribed for them and are not entitled to an exemption merely by virtue of their status. To be exempt their income must fall within one of the prescribed exemptions or the mutuality principle. © 2017 THOMSON REUTERS

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[7 410] Community service organisations The income of non-profit organisations established ‘‘for community service purposes’’ is exempt, provided certain conditions are satisfied (see [7 430]): s 50-10 Item 2.1. The requirement for an organisation to be a non-profit organisation is considered at [7 430]. According to the Explanatory Memorandum to Taxation Laws Amendment Bill (No 2) 1990, which introduced s 50-10’s predecessor (s 23(g)(v) ITAA 1936), the term ‘‘community service purposes’’ is not limited to purposes beneficial to the community that are also charitable. They extend to a range of altruistic purposes, including promoting, providing or carrying out activities, facilities or projects for the benefit or welfare of the community or of any members of the community who have particular need of those activities, facilities or projects by reason of their youth, age, infirmity or disablement (intellectual or physical), poverty or social or economic circumstances. The emphasis is on present activities, even if the constitution, formation or history suggest a different purpose in the past. The explanatory memorandum also stated that, as the provision does not impose a geographic limit, altruistic purposes beneficial to the community may properly be carried out overseas or among people everywhere. They need not be confined to the population, or part of the population, of a particular region. Incorporation is not a prerequisite. Note that if an organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption: see [7 365]. In Douglas v FCT (1997) 36 ATR 532, it was held that a trustee of a meeting hall, to be used for meetings of certain religious affiliations and other bodies acceptable to the trustee, was not a ‘‘society, club or organisation’’, nor did it undertake activities for the benefit or welfare of the community. Accordingly, it was not eligible for the exemption under s 23(g)(v). Similarly, the Victorian Healthcare Association Ltd was a body providing services to and for the benefit of its members and was not established for community service purposes: Re Victorian Healthcare Association Ltd and FCT (2010) 79 ATR 890. In contrast, in FCT v Wentworth District Capital Ltd (2011) 82 ATR 894, a not-for-profit company established to facilitate the provision of face-to-face banking services (under a franchise arrangement with Bendigo Bank) in a town that did not have such services was considered to be an organisation established for community service purposes, notwithstanding that it was run on a commercial basis. Political or lobbying exclusion Bodies established for political or ‘‘lobbying’’ purposes are not exempt under s 50-10 (although they may qualify as a charity: see [7 360]). Political or lobbying purposes include standing candidates for election and campaigning for changes to the law or to government policy. Community service organisations may engage in political or lobbying activities, provided they are no more than merely incidental to other purposes beneficial to the community. Specific organisations Examples of exempt community service organisations mentioned in the explanatory memorandum include ‘‘traditional service clubs’’ such as Apex, Rotary, Lions, Zonta, Quota and the like, and community service organisations such as the Country Women’s Association of Australia and its constituent Associations. Determination TD 93/190 also considers the scope of this exemption. Probus clubs are regarded as social outlets and do not qualify. [7 420] Hospitals and medical benefits organisations The income of a public hospital or of a non-profit hospital carried on by a society or association is exempt under s 50-30 (Items 6.1 and 6.2). To be eligible for the exemption, the hospital must satisfy certain conditions: see [7 430]. The requirement for a private hospital to be a non-profit organisation is considered at [7 430]. Section 50-30 (Item 6.3) also exempts the income of non-profit private health insurers. 214

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[7 430]

[7 430] Common conditions for the exemption There are various common conditions to be satisfied for the income of an organisation of a type considered in the previous paragraphs to qualify for the income tax exemption, namely: • registered charities (see [7 360]): s 50-50; • public educational institutions (see [7 380]): s 50-55; • scientific institutions (see [7 390]): s 50-55; • scientific research funds (see [7 390]): s 50-65; • organisations established for the encouragement of science (see [7 390]): s 50-70; • organisations established for community service purposes (see [7 400]): s 50-70; • organisations established for the encouragement of animal racing, art, a game or sport, literature or music or for musical purposes (see [7 410]): s 50-70; and • public and private hospitals (see [7 420]): s 50-55. In all cases, the organisation in question must comply with all the substantive requirements in its governing rules and apply its income and assets solely for the purpose for which it was established: s 50-70(2). According to Ruling TR 2015/1, the ‘‘governing rules’’ of an organisation are the rules that authorise the policy, actions and affairs of the organisation. The written documents under which an organisation was formed will usually be the main source of the organisation’s governing rules, but there may be other sources (such as relevant legislation). The ‘‘substantive requirements’’ (in an organisation’s governing rules) are the requirements which define the rights and duties of the organisation, including those that give effect to the organisation’s object or purpose, relate to its non-profit status, require financial statements to be prepared and kept and relate to the winding-up of the organisation: Ruling TR 2015/1. The requirement to apply an organisation’s income and assets solely for the purpose for which it is established was considered by the High Court in FCT v Bargwanna (2012) 82 ATR 273 (which concerned a fund established for public charitable purposes). The High Court said that the term ‘‘applied’’ is used in the sense of ‘‘so administered as to give effect to the trusts established by the relevant instrument’’, rejecting an argument that ‘‘applied’’ means ‘‘substantially applied’’ or ‘‘on the whole, applied’’. The Court added that not all breaches of trust will mean that the fund has not been applied for the relevant purpose. In the Bargwanna case, however, the High Court concluded that mixing trust moneys with other funds in breach of trust, failing to obtain interest on those moneys and using trust moneys in an interest offset account to reduce the interest payable on the trustees’ personal home loan were acts of maladministration which justified the Commissioner’s decision not to endorse the trust in question. Ruling TR 2015/1 confirms that the requirement that an organisation must ‘‘apply’’ its income and assets solely for the purpose for which the organisation is established means that an entity must make use of its income and assets solely for the relevant purpose. According to the Ruling, this requirement is applied continuously throughout the income year. In addition, there are 3 alternative conditions, one of which must be satisfied. They are: (a) the organisation has a physical presence in Australia and, to that extent, incurs expenditure and pursues its objectives principally in Australia (in the case of a scientific research fund, the organisation must be located in and incur its expenditure principally in Australia): see below. Distributions of gifts (which need not be tax deductible) or government grants received by the organisation, and distributions from a fund eligible to receive tax deductible gifts that is operated by the organisation, are ignored in determining if the expenditure condition is satisfied: s 50-75; or © 2017 THOMSON REUTERS

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(b) the organisation is eligible to receive tax deductible gifts under Item 1 in the table in s 30-15 see ([9 800]-[9 860]); or (c) the organisation is a prescribed organisation that is located outside Australia and is exempt from income tax in its country of residence (as at 1 January 2017, the only prescribed organisation is the International Cricket Council Development (International) Limited). See also Determination TD 1999/7. Alternatively, in the case of a registered charity only, it may be a prescribed institution that has a physical presence in Australia but which incurs its expenditure and pursues its objectives principally outside Australia.

Pursuing objectives principally in Australia As noted above, one of the alternative conditions to be satisfied for the income tax exemption to apply is that an eligible organisation pursue its objectives principally in Australia. In FCT v Word Investments Ltd (2008) 70 ATR 225, the High Court held that a company established to provide financial support for the Australian arm of an international religious organisation satisfied this requirement despite the fact that the organisation carried out much of its work outside Australia. This was because the decision to make the payments was taken in Australia and the payments were made in Australia to an Australian organisation. This decision was contrary to the views expressed in Ruling TR 2000/11 and therefore that ruling has been withdrawn. Draft legislation (the Draft Tax and Superannuation Laws Amendment (2014 Measures No 3) Bill) and regulations propose to re-state and centralise the ‘‘in Australia’’ special condition for eligible organisations (the draft legislation is available on the Treasury website). Broadly, a new s 30-18 will centralise and standardise the conditions for obtaining the income tax exemption. The centralised conditions will largely be the same as the conditions that currently exist. However, the draft legislation also proposes to replace the expenditure based test with a test that states an entity must operate and pursue its purposes principally in Australia. This change is designed to apply to a wider range of circumstances where an entity will be considered to be ‘‘in Australia’’. In the Explanatory Memorandum (EM) to the draft legislation, it is indicated that to be operating principally in Australia, an entity will be expected to be an Australian resident or have sufficient connection and presence in Australia. It is stated that a comparison can be drawn with the test for determining the existence of a permanent establishment. Further, in determining whether an entity operates and pursues its purposes in Australia, consideration is to be given to any monies donated by the entity to other entities. However, the EM indicates that minor and incidental activities outside Australia will not breach the ‘‘in Australia’’ requirement. In relation to deductible gift recipients, the draft legislation proposes that they must generally be established in Australia, operate solely in Australia and pursue their purposes solely in Australia: see [9 800]. Non-profit condition The requirement for an organisation to be a non-profit organisation (where applicable) means that it must not be carried on for the profit or gain of its individual members (ie an organisation cannot distribute its assets among or apply its assets to the individual benefit of its members, and must apply them to the furtherance of its object): FCT v Co-operative Bulk Handling Ltd (2010) 81 ATR 312. The Cooperative Bulk Handling case is authority for the proposition that an organisation is not necessarily carried on for the profit or gain of its members just because the members benefit from its activities – it is the purpose for which those activities are carried on that is relevant. An entity that distributes profits to a member cannot be a non-profit organisation: see ATO ID 2003/1088. To satisfy the non-profit condition, an organisation’s current activities must meet the relevant purpose. In addition, the relevant purpose has to be the main object or purpose of the 216

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organisation in question, and need not be the exclusive or sole purpose (a question of fact): Cronulla Sutherland Leagues Club Ltd v FCT (1990) 21 ATR 300 (discussed at [7 390]).

ACNC types of organisation A not-for-profit organisation that is a charity (called an “ACNC type of entity”) is entitled to be registered under the Australian Charities and Not-for-profits Commission Act 2012: see [7 365]. If not registered, an ACNC type of entity will not be entitled to the exemption: s 50-47. [7 440] Mutual income Payments received by an individual or entity that are made by the individual or entity are not ‘‘income’’ by virtue of the mutuality principle. This recognises that amounts are not ‘‘derived’’ for income tax purposes unless they are received from an external source. ‘‘Mutual income’’ is therefore not assessable in the absence of a specific provision bringing it to assessment (although such amounts are not income as such, the term ‘‘mutual income’’ is commonly used). The principle is that if a number of people agree to contribute sums to a fund for a common purpose that is created and controlled for their mutual benefit, as in the case of certain insurance funds and clubs or societies, any repayments from that fund to the contributing members do not have the character of income in their hands. The essential element of the mutuality principle, as expressed by the Full Federal Court in North Ryde RSL Community Club Ltd v FCT (2002) 49 ATR 579 (at 595), is ‘‘the refund or recoupment by the clubs of what, in substance, are their own moneys contributed by them [or their members] to the common fund’’. The mutuality principle applies to a variety of organisations, including clubs, mutual insurance companies, cooperatives, credit unions and company title or strata title bodies. The application of the mutuality principle to strata title bodies is considered further below. Although the mutuality principle has been displaced in certain areas by specific legislative provisions (see below), it may still apply to the extent that it has not been excluded by statute: Sydney Water Board Employees’ Credit Union Ltd v FCT (1973) 4 ATR 157. Problem areas The application of the mutuality principle faces difficulties in 3 areas: • if there are differences of identity between those who are contributors and those who are beneficiaries upon a return of surplus, and where the amounts of surplus returned are not proportional to the amounts contributed; • if there are accretions to the ‘‘common fund’’ not arising from contributions by members, eg investment gains; and • if there are receipts from non-members with respect to the provision of services or facilities to them. Ruling TR 2004/5 sets out the Commissioner’s views on the taxation consequences, including the application of the mutuality principle, of arrangements whereby an association of retailers negotiates with wholesalers for its members to get volume rebates (cash amounts) on their purchases.

Lack of identity – contributors v beneficiaries In Revesby Credit Union Co-operative v FCT (1965) 112 CLR 564 (decided before the introduction of s 23G in 1974), it was held that the mutuality principle did not apply to a dividend paid out of a credit union’s end of year surplus. An influential factor was the disparity of identity between the contributors (the members who had current loans) and the beneficiaries (all the current members receiving the dividend). The court concluded that the dividend was income, being a distribution from the proceeds of the society’s business dealings with a section of its members. © 2017 THOMSON REUTERS

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In Sydney Water Board Employees’ Credit Union Ltd v FCT (1973) 4 ATR 157, the taxpayer unsuccessfully contended that interest paid by borrowing members of the credit union constituted a common fund paid for the common purpose of enabling the credit union to meet its administrative and operating expenses, including interest payable to depositor members, with any surplus refundable to borrower members. The court accepted a slightly looser formulation of the identity requirements. The identity between contributors and participants need not be an identity of individuals and identity between classes of individuals is sufficient. Further, the refund to contributors need not be precisely proportional to the contributions made; it is sufficient if there is a ‘‘reasonable relationship’’ between the member’s contribution and the amount received from the fund. However, it was held that the principle of mutuality did not apply, because the borrowing members could not be considered to be a class of members in the required sense and the interest paid was not maintained as a common fund in which the borrowing members as a class had any rights. Interest was paid by borrowers in discharge of their legal obligations and became part of the general funds of the credit union; it was not paid as a contribution to the mutual liabilities incurred on behalf of borrowers. See also ATO ID 2006/325. The mutuality principle cannot apply if a clause in an entity’s constitution prohibits the distribution to its members of any surplus on a winding up or dissolution, because there is a lack of identity between the contributors and the participants in any surplus: Coleambally Irrigation Mutual Co-operative Ltd v FCT (2004) 57 ATR 104. However, s 59-35 ensures that an amount that would be mutual income of an entity but for the fact that the entity’s constituent document prevents it from making any distribution (whether in money, property or otherwise) to its members (and would be assessable income because of s 6-5, ie ordinary income) is non-assessable non-exempt income: see also [15 040].

Non-member contributions Many clubs and associations derive income from both members and non-members. Transactions with non-members have generally been treated as trading activities and excluded from the operation of the mutuality principle (without affecting the application of the principle to receipts from members). The taxpayer in Royal Automobile Club of Victoria v FCT (1973) 4 ATR 567 was a club that received, in addition to contributions and payments by members, payments from non-members for services and facilities provided to them, together with commissions from third parties, interest on investments and rent from property. It was held that, in each case, mutual dealings with members had to be distinguished from business dealings and that receipts should be apportioned between those categories. It was accepted that if the activity is mutual, the fact that some members only take advantage of the facilities available does not affect the element of mutuality. The receipts from the activities that lacked mutuality amounted to trading activities and were assessable; related outgoings were deductible. See also ‘‘The Waratahs’’ Rugby Union Football Club v FCT (1979) 10 ATR 33. In FCT v Australian Music Traders Association (1990) 21 ATR 471, it was held that the receipt of an amount by a musical trade association paid by the organiser from the proceeds of an annual trade fair lacked the required reasonable relationship between contributions and benefits and was received merely as part of the general funds of the Association. Therefore, the mutuality principle was not applicable and the sum received was assessable income. Similarly, commission earned by an RSL club from operating keno games was held to be assessable income of the club in North Ryde RSL Community Club Ltd v FCT (2002) 49 ATR 579. The commission was paid under an agreement between the club and the licensee for the conduct of keno and was characterised by the Full Federal Court as a trading receipt. Further, when a member paid a subscription to participate in a keno game, the member was not contributing to a common fund. This decision affirms the Commissioner’s views as set out in Determination TD 1999/38. The determination also states that TAB commission income received by clubs is assessable (seemingly correct in view of the North Ryde RSL decision). 218

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Commissioner’s approach If it is not possible to identify and separate receipts between members and non-members, the method of apportionment chosen by the taxpayer will be accepted by the Tax Office provided there is a reason for apportioning the receipts, the method chosen is reasonable and not arbitrary and it gives a correct reflection of the income earned (see the Tax Office website). The Tax Office’s views on how a licensed club should apportion expenses between members and non-members are set out in Determination TD 93/194. The tax treatment of strata title bodies, including the application of the mutuality principle, is dealt with in Ruling TR 2015/3. For example, amounts levied on proprietors by a strata title body in accordance with State or Territory legislation which form part of a fund used for the day-to-day expenses, general maintenance and repair of common property, or for the establishment of special purpose funds as set out under State or Territory legislation, are mutual receipts and therefore are not assessable to the strata title body. Whether other receipts from members are mutual receipts depends on the nature of the transaction. For example, interest paid by a proprietor where levies are paid late is considered to be mutual income, but a penalty paid by a proprietor for the breach of a by-law is not considered to be mutual income. See also [20 200]. A generic tax framework for the demutualisations of non-insurance companies is contained in Sch 2H ITAA 1936: see [17 390]. Statutory modifications Examples of statutory modifications to the mutuality principle include ss 50-10 (Certain clubs or societies) and 50-45 (see [7 390]); s 50-40 (Certain business and industry associations) (see [7 460]); ss 117 to 121 ITAA 1936 (Co-operatives) (see [20 150]); and s 23G (Credit unions).

BUSINESS AND INDUSTRY [7 450] Trade unions, employee and employer associations The income of a trade union, and the income of an association of employers or employees registered under the Fair Work (Registered Organisations) Act 2009 or any Australian law relating to the settlement of industrial disputes, is exempt provided the union or association is located in Australia and incurs expenditure in the pursuit of its objectives principally in Australia (see [7 430]): s 50-15 (Items 3.1 and 3.2). Distributions of gifts (which need not be tax deductible) or government grants received by the organisation, and distributions from a fund eligible to receive tax deductible gifts that is operated by the organisation, are ignored in determining if the expenditure condition is satisfied: s 50-75. In Norseman Amalgamated Distress and Injustices Fund v FCT (1995) 30 ATR 356, it was held that a fund established by a trade union to provide financial assistance to its members was not itself a trade union for the purposes of the predecessor to s 50-15 (s 23(f) ITAA 1936), as it was not formed to deal with employers and further conditions of employment. Similarly, to qualify as an employers’ association, the members must associate in their capacity as employers of labour, not merely because they pursue a common calling: Associated Newsagents Co-operative Ltd v FCT (1970) 1 ATR 609. An association of contractors was not considered to be an employers’ association in ATO ID 2006/155. Note that if the organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption: see [7 365]. [7 460] Non-profit aviation, tourism and other associations The income of a non-profit society or association established for the purpose of promoting the development of any of the following is exempt under s 50-40: • aviation or tourism (Item 8.1); © 2017 THOMSON REUTERS

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• the agricultural, pastoral, horticultural, viticultural, manufacturing, industrial, fishing or aquacultural resources of Australia (Item 8.2); or • Australian information and communications technology resources (Item 8.3). The income of the Global Infrastructure Hub Ltd is also exempt under s 50-40, from 24 December 2014 to 30 June 2019 (s 50-40, Item 8.4). The ‘‘not for profit’’ requirement is considered at [7 390]. Note that if the organisation is an ‘‘ACNC type of entity’’, it must be registered under the ACNC Act to qualify for the exemption: see [7 365]. The term ‘‘industrial resources’’ (in Item 8.2) refers to resources of industries such as the building, mining, quarrying, shipping and transport industries and therefore an association formed to promote the insurance industry was not entitled to the exemption under the predecessor to s 50-40 (s 23(h) ITAA 1936): Australian Insurance Association v FCT (1979) 10 ATR 333. See also Ruling IT 2415. The term ‘‘agricultural resources’’ (in Item 8.2) includes the means by which agricultural produce is transported, stored and loaded and is not restricted to growing, harvesting and breeding activities: see Cooperative Bulk Handling Ltd v FCT (2010) 79 ATR 582. In that case, the Federal Court held that the exemption under s 50-40 applied to the major operator of grain bulk handling in Western Australia. This decision was upheld on appeal by the Full Federal Court in FCT v Co-operative Bulk Handling Ltd (2010) 81 ATR 312. In AAT Case 5127 (1989) 20 ATR 3597, a company formed to promote the chemical industry was held to be entitled to the s 23(h) exemption. However, in Tribunal Case 80 (1987) 18 ATR 3579, a company formed by sugar cane growers to finance a water storage project was not exempt. A surveyors’ association does not qualify (AAT Case 9723 (1994) 29 ATR 1102). Non-profit societies or associations may also be able to rely on the mutuality principle: see [7 440]. In Australian Wool Testing Authority Ltd v FCT (1990) 21 ATR 877, the revocation of advice that the taxpayer was exempt from income tax was held to be reviewable under the Administrative Decisions (Judicial Review) Act 1977: see [48 160].

[7 470] Venture capital exemptions There are a number of exemptions relating to eligible venture capital investments. These are summarised below. See [15 650] for which investments qualify as ‘‘eligible venture capital investments’’. There are also CGT exemptions (under Subdivs 118-F and 118-G) in relation to eligible capital venture investments: see [15 650] and [15 660]. • Eligible foreign resident partners in an unconditionally registered venture capital limited partnership (VCLP: see [15 650]) are exempt from tax on their share of the profit made on the disposal by the VCLP of an eligible venture capital investment: s 51-54. The exemption only applies if the Subdiv 118-F CGT exemption were to apply, assuming there was a disposal of a CGT asset. This means that the s 51-54 exemption only applies if the investment was owned by the VCLP for at least 12 months. • Eligible venture capital partners in an unconditionally registered Australian venture capital fund of funds (AFOF: see [15 650]) are exempt from tax on their share of the profit made on the disposal of an eligible venture capital investment: s 51-54. This applies if the AFOF is a partner in a VCLP which owns the investment or if the AFOF invests directly in a company in which a VCLP, in which the AFOF is a partner, has already made an eligible venture capital investment. In either case, the exemption only applies if the Subdiv 118-F CGT exemption were to apply, assuming there was a disposal of a CGT asset. This means that the s 51-54 only applies if the VCLP has owned its investment for at least 12 months. • Eligible venture capital investors (see [15 650]) are exempt from tax on the profit made on the disposal or other realisation of eligible venture capital investments: s 51-54. The exemption only applies if the Subdiv 118-F CGT exemption were to 220

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apply, assuming there was a disposal of a CGT asset. This means that the s 51-54 exemption only applies if the investment was owned by the investor for at least 12 months. • The profit made by a venture capital entity, or by a limited partnership if all the partners (except the managing partner) are venture capital entities, on the disposal of venture capital equity in a resident investment vehicle (see [15 660]) is exempt from tax: s 51-55. The exemption only applies if the Subdiv 118-G CGT exemption were to apply, assuming there was a disposal of a CGT asset. This means that the s 51-55 exemption only applies if the investment was owned by the investor for at least 12 months. • A partner in a registered early stage venture capital limited partnership (ESVCLP: see [15 650]) is exempt from tax on its share of any income derived from eligible early stage venture capital investments, provided the investment meets certain investment requirements: s 51-52. If the taxpayer is a general partner, it must be an Australian resident or a resident of a country with which Australia has a double tax agreement in force. The income tax exemptions (in s 51-54) for any gains or profits arising from the disposal of eligible venture capital investments for partners in VCLPs and AFOFs (see above) also applies to partners in ESVCLPs. Note that to the extent a capital gain from the disposal of an eligible venture capital investment would only be partially exempt, only the equivalent amount of gain or profit will be exempt income. The venture capital measures are summarised at [11 560]. Note the tax incentives for investments in a non-listed Early Stage Innovation Company (ESIC) discussed at [11 200]-[11 230].

[7 480] Other business and industry exemptions Specific business and industry tax exemptions are listed below. The relevant sections should be consulted for any particular restrictions. (Note that other business related payments may be non-assessable non-exempt: see [7 710].) Section ITAA 1997 British Phosphate Commissioners Banaba Contingency Fund 50-35 HIH Claims Support Trust and any other entity prescribed for the purposes of 322-10 Div 322 (HIH rescue package) ITAA 1936 Interest income paid to a small credit union by members (who are not 23G companies) in respect of loans to the members: see [20 170] Non-cash business benefits (within the meaning of s 21A) if the total amount 23L(2) does not exceed $300: see [5 100] Certain income of superannuation funds, ADFs, PSTs and RSAs: see Subdiv 295-F ITAA Chapter 41 1997

Other organisations are tax-exempt under the legislation establishing the particular organisation, eg Screen Australia and the Australian Renewable Energy Agency.

Copyright and resale royalty collecting societies Copyright collecting societies (as defined in s 995-1) are not taxed on copyright income (eg royalties and interest on royalties) they collect or derive: s 51-43. In addition, non-copyright income derived by copyright collecting societies is exempt to the extent it does not exceed the lesser of 5% of the total amount of the entity’s copyright and non-copyright income for the income year and $5m (or other prescribed amount). Resale royalties, and interest on resale royalties, collected or derived by resale royalty collecting societies are also exempt: s 51-45. The exemption also applies to other ordinary and statutory income derived by a resale royalty collecting society, to the extent it does not © 2017 THOMSON REUTERS

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exceed the lesser of 5% of the total amount of the society’s ordinary and statutory income collected and derived by the society during the income year and $5m (or other prescribed amount).

Shipping activities Income from certain shipping activities that take place after 30 June 2012 are exempt: see [11 700]. Payments out of the National Guarantee Fund A payment under s 891A of the Corporations Act 2001 out of the National Guarantee Fund is exempt income (although any income derived from that amount, eg interest, will be assessable). A payment under s 891A is made by the Securities Exchanges Guarantee Corporation Limited to a prescribed corporate body that has made adequate arrangements covering all or part of the clearing and settlement system.

GOVERNMENT [7 500] State and Territory bodies – exemptions Sections 24AK to 24AZ ITAA 1936 give effect to the agreement between the Commonwealth and States for tax uniformity and competitive neutrality between activities undertaken by government trading enterprises and the private sector. The following key elements emerge from the legislation. 1. State/Territory bodies (STBs) are generally exempt from income tax because of tax equivalent regimes (ie shadow taxes at the State or Territory level) having been put in place in relation to such bodies: s 24AM. 2. Municipal corporations and other local government bodies, public education institutions and public hospitals are excluded because they are not intended to be subject to a tax equivalent regime. However, bodies owned or controlled by a municipal corporation or other local governing body may be STBs. 3. State Government Insurance Offices are excluded (s 24AN) and are generally taxed in accordance with Div 320 ITAA 1997 (see Chapter 30). 4. Other bodies may also be excluded by agreement between the States and the Commonwealth. A body is an STB if: • it is a company limited solely by shares and the shares are beneficially owned by one or more government entities: s 24AO; • it is established by State or Territory legislation (and is not a company limited solely by shares) and only government entities have the power to direct, appoint or dismiss the governing body, or all its profits must be distributed to one or more government entities: ss 24AP to 24AR; or • it is not established by State or Territory legislation and is not a company limited solely by shares, but all legal and beneficial interests are held by one or more government entities and only government entities have the rights to vote or to direct, appoint or dismiss the governing body: s 24AS.

[7 510] Public authorities and municipal corporations Section 50-25 (Item 5.2) exempts the revenue of a public authority constituted under any Australian law. Public authorities constituted under State or Territory laws are included by virtue of the operation of the definition of ‘‘Australian law’’. The term ‘‘public authority’’ is 222

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[7 520]

not defined. However, factors indicating that a body is a ‘‘public authority’’ seemingly include (see FCT v Bank of Western Australia Ltd; FCT v State Bank of NSW (1995) 32 ATR 380): • the body should be an agency or instrument of government set up to achieve a government purpose; • the body should exercise control, power or command for the public advantage or execute a function in the public interest; and • the body should have exceptional powers or authority. The Tax Office seemingly considers that a ‘‘public authority’’ should have public duties, functions or powers to perform and these would ordinarily be carried out under statutory authority for the benefit of the public: see Ruling IT 2632, which considers the meaning of ‘‘public authority’’ for the purposes of former Div 16D of Pt III ITAA 1936. The ruling states that the derivation of profits for distribution to shareholders or members would not ordinarily be a characteristic of a ‘‘public authority’’. Although the body must be ‘‘constituted’’ under an Australian law, it need not be incorporated under a statute. Whether any, or a percentage, of direct or indirect private ownership is permissible has not been expressly resolved. However, a private body established for profit cannot be a public authority. Bodies formed by governments and wholly owned and controlled by them are generally accepted as public authorities. In Coal Mining Industry (LSLF) Corp v FCT (1998) 41 ATR 374, it was held that the applicant Corporation was an exempt public authority. Particularly important factors in this decision were that the scheme administered by the Corporation was funded by the use of the Commonwealth’s taxing power and that the Commonwealth had delegated to the Corporation powers of administering and recovering the tax. The Future Fund is a public authority for the purposes of s 50-25 and therefore its income is exempt: s 30 Future Fund Act 2006.

Public authorities that are not exempt Special provisions in the Acts constituting many government bodies specify whether the exemption in s 50-25 is available to them (ie it may be overridden by provisions in those Acts). Local government Section 50-25 (Item 5.1) also exempts the income of municipal corporations and other local governing bodies (eg shire councils). The income of a trading body owned or controlled by a municipal corporation or other local governing body will also be exempt if it qualifies as an STB within the meaning of ss 24AO to 24AS: see [7 500]. Central borrowing authorities If a security issued by a government or semi-government authority is converted into a security issued by a central borrowing authority, no income is derived at that time provided that the new security is substantially identical in terms and conditions with the replaced security. The derivation of income occurs upon maturity or sale of the new substituted security: s 23K ITAA 1936. [7 520] Government officials The official salary (and income derived from non-Australian sources) of the government officials listed below is tax exempt (the section specified should be consulted for any particular restrictions): • representatives (who are not Australian citizens and are not ordinarily resident here) in Australia of the government of any country or a member of the official staff of © 2017 THOMSON REUTERS

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such representatives, provided a corresponding exemption exists in that country for Australian government representatives: s 768-100 (Item 1) ITAA 1997; and • an officer of the government of a Commonwealth country temporarily in Australia for certain purposes, if there is a corresponding income tax exemption for salaries of Commonwealth government officers temporarily in the Commonwealth country: s 768-100 (Item 2) ITAA 1997. Income derived by the representative of any government visiting Australia on behalf of that government, or by any member of the representative’s entourage, in an official capacity is also tax exempt: s 842-105 (Item 2) ITAA 1997. Income derived from sources in Australia by any of the above officials, other than their official salaries, is assessable.

[7 530] Foreign governments and diplomats Income derived by foreign governments from commercial activities is generally subject to income tax. However, passive income derived by foreign governments (eg dividends, interest and rent) is exempt by virtue of the doctrine of sovereign immunity. Diplomatic and consular officers of foreign countries are exempt from income tax by virtue of the applicable Vienna Conventions, which are given the force of law by their ratifying Acts (the Diplomatic Privileges and Immunities Act 1967 and the Consular Privileges and Immunities Act 1972). The exemptions extend to persons who are not Australian citizens or who do not permanently reside in this country and include not only diplomatic and consular officers, but also members of their families, except in respect of private income derived from sources in Australia (eg ATO ID 2007/125). Honorary officers (who are not Australian nationals or permanent residents of Australia) are exempt in respect of remuneration for consular functions, but their families receive no concessions. Administrative and technical staff (but not domestic or private staff) are considered under the exemptions in s 768-100: see [7 520]. The exemption under the Vienna Convention on Consular Relations, given the force of law by the Consular Privileges and Immunities Act 1972, does not provide an exemption in respect of an Honorary Consul who is an Australian national or permanent resident of Australia: Morris v FCT (1989) 20 ATR 1666. An exemption from the Medicare levy applies to staff of a diplomatic mission, consular officers and household family members who are not Australian citizens and are not ordinarily resident in Australia: s 251U(1)(e); see also [19 810].

CONVERSIONS [7 550] Tax exempt entities that become taxable There are transitional rules for dealing with entities (transition taxpayers) that convert or change status from being tax exempt to being taxable (eg privatisation of a government business). The rules are contained in Sch 2D ITAA 1936: ss 57-1 to 57-115. The provisions of Sch 2D are designed to allocate income, deductions, gains and losses to the periods before and after loss of exemption. In broad terms, they: • deny deductions for superannuation payments, bad debts, ETPs and employee leave entitlements to the extent that they relate to the period when the entity was exempt. However, any surplus in a defined benefit superannuation scheme at the transition time is deductible and the amount of bad debt deductions disallowed is reduced if a bad debt is sold at or after the transition time; • allocate income and deductions relating to the pre-transition or post-transition period and ensure that losses of the exempt period are not recognised for tax purposes; 224

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[7 610]

• value assets and liabilities of the entity at market value as at the transition time in order to allocate gains and losses to the pre-transition and post-transition period; • ensure that changes in the value of trading stock are calculated from the time the entity becomes taxable; • ensure that expenditure that provides an enduring benefit (eg mining allowable capital expenditure) is notionally written down during the exemption period (see below for limitations on capital allowance/depreciation deductions); • ensure that no deduction is available for mining exploration and prospecting expenditure incurred before the transition time; and • cancel any franking surplus of any taxable wholly owned subsidiary of the tax exempt entity at the transition time, so that it cannot be passed on to third parties, including cancellation of any subsequent franking credits or debits relating to the pre-transition period.

Capital allowances There are special rules in Div 58 ITAA 1997 which modify the calculation rules in Div 40 ITAA 1997 (capital allowances) for depreciating assets where a tax exempt entity becomes taxable, or where a taxable entity acquires plant/depreciating assets from a tax exempt entity: see further [10 430].

INTERNATIONAL [7 600] Dividend and other exemptions There are a number of categories of foreign sourced income derived by Australian residents that are non-assessable non-exempt income in Australia: see [7 700]. These are: (a) certain foreign branch profits of Australian resident companies derived from carrying on business at or through a permanent establishment in a foreign country: s 23AH; see further [34 120]; (b) non-portfolio dividend income derived by Australian resident companies if the dividend is received from a foreign company: s 23AJ; see further [34 110]; (c) dividend income received by an Australian resident if it is paid out of profits that have previously been subjected to attribution under the CFC or transferor trust regimes: see in particular ss 23AI, 99B(2)(d) and 23AK; see further [34 140]. Note that the income referred to in (a) and (b) is never taxed in Australia, whereas the ‘‘exemption’’ referred to in (c) is merely designed to avoid double taxation, the profits out of which the dividends (or trust distributions) are paid having already been taxed in Australia. This can have serious consequences in relation to gearing foreign investments: see further Chapter 34. Certain forms of foreign employment income derived by Australian residents is exempt: see [7 150]-[7 210]. Other exemptions are listed at [7 100].

[7 610] Foreign residents Income derived by a foreign resident from sources wholly outside Australia is generally not assessable. However, certain provisions specifically impose Australian income tax on certain classes of income which, under ordinary principles, would be considered to have been derived by sources outside Australia (see the deemed source rules discussed at [2 210]). Foreign residents are not subject to the Medicare levy: s 251U(1)(d) ITAA 1936. © 2017 THOMSON REUTERS

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The taxation of Australian sourced income derived by foreign residents is considered in Chapter 35. The application of any double tax agreements (DTAs) may have to be considered: see Chapter 36.

[7 620] International organisations and officials The income of a large number of international organisations is exempt pursuant to regulations under the International Organisations (Privileges and Immunities) Act 1963. The official salary and emoluments of certain officials of prescribed international organisations are also exempt, to the extent and upon the conditions set out in the regulations (eg see ATO ID 2004/286, ATO ID 2004/287, ATO ID 2006/240 and ATO ID 2006/241). In FCT v Jayasinghe [2016] FCAFC 79, a majority of the Full Federal Court found that a project manager in Sudan for the United Nations Office for Project Services held ‘‘an office in an international organisation’’ (under s 6(1)(d) of the Act) and was therefore exempt from tax on his earnings. The High Court has granted the Commissioner special leave to appeal against this decision. The term ‘‘salary and emoluments’’ does not cover monthly pension payments under a retirement plan. This conclusion was reached in Macoun v FCT [2015] HCA 44, where the High Court unanimously upheld a Full Federal Court decision (in FCT v Macoun [2014] FCAFC 162) that an early retirement pension received by a former employee of the International Bank for Reconstruction and Development was not exempt from tax under the International Organisations (Privileges and Immunities) Act 1963. The court held that s 6(1)(d) of (and Fourth Schedule to) that Act, and related regulations, did not confer an exemption in respect of pension payments received from a fund established under the IBRD’s staff retirement plan at a time when the taxpayer had ceased to hold office. In AAT Case 10,901 (1996) 32 ATR 1279, it was held that these exemptions did not extend to a former official, even though the income derived resulted from service with the organisation. The operation of these exemptions, and the organisations and officials to which they apply, are described in detail in Ruling TR 92/14. These exemptions are not subject to the ‘‘exemption with progression’’ rules that are contained in ss 23AF and 23AG and therefore the exempt income is not taken into account in calculating the Australian tax on any non-exempt income: see [7 190]. Note that salary and emoluments received by certain staff and officials of various international organisations with a presence in Australia may be exempt from income tax pursuant to a Legislative Instrument (eg the Asian Development Bank and the Asian Infrastructure Investment Bank). [7 630] Overseas representatives and expert advisers The following income is also exempt: • remuneration paid by an Australian government to a foreign resident for expert advice to that government or as a member of a Royal Commission: s 842-105 (Item 1) ITAA 1997: • income derived in the capacity of a representative of any society or association established for educational, scientific, religious or philanthropic purposes, by any person visiting Australia in that capacity for the purpose of attending international or Commonwealth conferences or for the purpose of carrying on investigation or research for such society or association: s 842-105 (Item 3) ITAA 1997; and • income derived in the capacity of a representative of the press outside Australia, by any person visiting Australia in that capacity for the purpose of reporting the proceedings relating to any matters referred to above: s 842-105 (Item 4) ITAA 1997: see also [7 520]. 226

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ATO ID 2003/1010 states that income derived by a member of an overseas religious association, for services rendered as a church minister in Australia, was not exempt under the predecessor to s 842-105 (Item 3) (s 23(c) ITAA 1936) as the taxpayer was not ‘‘visiting’’ Australia.

[7 640] US Government projects in Australia Foreign contractors, foreign employees, members of the US Forces and US resident civilians accompanying the US Forces, and their dependants, who are present in Australia solely for purposes relating to an ‘‘approved project’’ of the United States Government in Australia are deemed not to be residents of Australia, with the result that income they derive from an approved project is exempt: s 23AA ITAA 1936. Approved projects include the US Naval Communications Station at North West Cape, the Joint Defence Space Research Facility, the Sparta Project, the Joint Defence Space Communications Station and a Force Posture Initiative. The exemptions cannot apply to Australian companies, citizens, residents or persons normally resident in Australia. Note that the s 23AA deeming provisions do not affect entitlement to concessional offsets such as the dependant (invalid and carer), low income and medical expenses offsets (discussed in Chapter 19): see ATO ID 2004/758.

NON-ASSESSABLE NON-EXEMPT INCOME [7 700] Introduction The ITAA 1997 contains an explicit framework for what is called “non-assessable non-exempt income” (NANE income). Broadly, assessable income is income (whether ordinary or statutory income) that is counted in working out the taxable income that is subject to tax. Exempt income is not counted in working out taxable income, but is counted in reducing prior year tax losses that can be deducted in the current year and in reducing tax losses carried forward to later years. In other words, exempt income will reduce a taxpayer’s tax losses before they can be used to offset assessable income. In contrast, NANE income is not counted in working out taxable income and, unlike exempt income, has no effect on tax losses. NANE income therefore truly has no effect on the income tax system. An amount of income (ordinary or statutory) can only be one type of income – assessable, exempt or NANE income (see [3 020]): ss 6-15(2), (3), 6-20(4). The CGT exemption arising under s 118-12 if a CGT asset is used solely to produce exempt income or NANE income does not apply if the asset was used to produce certain categories of NANE income: see [15 040]. [7 710] Types of non-assessable non-exempt income Non-assessable non-exempt (NANE) income is ordinary or statutory income that is expressly made neither assessable income nor exempt income: s 6-23. That express provision can be in ITAA 1997, ITAA 1936 or any other Commonwealth law. The categories of NANE income are listed in s 11-55 ITAA 1997. They include: • the market value of certain call options issued to an existing shareholder or unitholder: see [17 380]; • non-deductible alienated personal services income payments to an associate (see [6 120]) and certain personal services income derived through an entity that is assessable to an individual: see [6 130]; • GST payable on a taxable supply and increasing adjustments: see [5 090]; © 2017 THOMSON REUTERS

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• amounts received upon the disposal of trading stock outside the ordinary course of business: see [5 400]; • amounts received on the redemption of special bonds: see [32 800]; • fringe benefits: see [7 060]; • income arising from a CGT event in respect of an asset continuously owned for 15 years by a company or trust: see [15 560]; • shares, rights and payments received in connection with the demutualisation of a health insurance company: see [17 390]; • payments from a related entity if the deduction to the payer is reduced: see [9 1050]; • certain amounts received by an initial investor in a forestry scheme upon disposal of their investment: see [8 400]; • payments or non-cash benefits received in relation to a taxpayer’s participation in the National Rental Affordability Scheme: see [11 630]; • demerger dividends: see [21 030]; • private company dividends set off against shareholder loans treated as notional dividends: see [21 340]; • amounts subject to family trust distributions tax: see [23 900]; • interest and dividends paid by resident companies to foreign superannuation funds: see [41 100]; • certain amounts derived by life insurance companies and friendly societies: see [30 040] and [30 320]; • mining payments for the benefit of Aboriginals that are subject to withholding tax: see [29 100]; • certain exploration benefits provided under farm-in farm-out arrangements: see [10 1270]; • previously attributed controlled foreign company income (and previously attributed foreign investment fund income): see [34 410] and [34 430]; • foreign equity distributions from a foreign company (previously called non-portfolio dividends): see [34 110]; • branch profits of Australian companies: see [34 120]; • dividends, interest and royalties subject to withholding tax: see [35 160], [35 250] and [35 420]; and • amounts subject to managed investment trust withholding tax: see [50 110]. Other amounts and payments that are NANE income include: • the tax-free amount of an early retirement scheme payment, an employment termination payment, a foreign termination payment, the tax-free amount of a genuine redundancy payment and an unused long service leave payment (pre-16/8/78 period): see [4 300]-[4 440]; • various superannuation benefits discussed in Chapter 40, including the commutation of an income stream (under 25 years), death benefits, departing Australia superannuation benefits, member benefits, roll-over superannuation benefits, lump sum benefits paid to a person with a terminal medical condition and unclaimed money payments; 228

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• payments in relation to release authorities (excess concessional contributions, excess non-concessional contributions and Div 293 tax): see [39 325], [40 230]; • amounts transferred from a KiwiSaver scheme to an Australian complying superannuation fund: see [40 320]; • certain business assistance payments relating to specific natural disasters; • payments subject to Seasonal Labour Mobility Program withholding tax (see [50 100]): s 840-915; • qualifying water infrastructure improvement payments made under an eligible Sustainable Rural Water Use and Infrastructure program (SRWUIP): s 59-65. A SRWUIP payment is only a qualifying payment to the extent that it originates from the Commonwealth; • refunded amounts subject to franchise fees windfall tax or Commonwealth places windfall tax: ss 59-20, 59-25; • compensation payments under firearms surrender arrangements for any loss of business: s 59-10; and • native title benefits provided to an Indigenous holding entity or an Indigenous person (or applied for the benefit of an Indigenous person): s 59-50. If an Indigenous holding entity provides a native title benefit to another Indigenous holding entity or to an Indigenous person, the native title benefit will retain its NANE income status. Any payment or benefit provided out of a native title benefit to meet administration costs, or for remuneration or consideration for the provision of goods and services, is not NANE income. Nor is income derived from investing a native title benefit.

Repayments of previously assessable income If a taxpayer has included an amount in assessable income but subsequently has to repay that amount, it will be recharacterised as NANE income if the taxpayer cannot deduct the repayment (even if the repaid amount is only part of the amount that was initially assessable): s 59-30. It does not matter when the obligation to repay an amount came into existence. If the amount is recharacterised as NANE income, the assessment for the year in which the amount was originally treated as assessable income can be amended at any time to allow the recharacterisation to be recognised: s 170(10AA). If the taxpayer can claim a deduction in respect of the repayment of previously assessable income (eg if the taxpayer is carrying on a business and the repayment occurs as part of carrying on that business), the amount may be assessable or exempt income. In addition, s 59-30 does not apply if a taxpayer has received instalments of money (eg workers compensation payments) that have to be repaid upon receipt of a lump sum for compensation for a wrong or injury suffered in the taxpayer’s occupation, if the lump sum includes an amount equal to the amount of tax paid or payable by the recipient. If a balancing adjustment amount arising on the sale of a depreciating asset is included in assessable income but is repaid in a later income year, s 59-30 does not apply to treat the amount in question as NANE income: see ATO ID 2011/94.

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8

INTRODUCTION Overview ......................................................................................................................... [8 010] GENERAL PRINCIPLES – S 8-1 The scheme of s 8-1 ....................................................................................................... [8 Losses and outgoings ...................................................................................................... [8 Apportionment ................................................................................................................. [8 First limb – gaining or producing assessable income ................................................... [8 Second limb – meaning of necessarily incurred ............................................................ [8 At what point must assessable income materialise? ...................................................... [8 Expenditure before income-earning activity starts ........................................................ [8 Expenditure after income-earning activity ceases .......................................................... [8

020] 030] 040] 050] 060] 070] 080] 090]

CAPITAL V REVENUE EXPENDITURE Tests and indicia – introduction ..................................................................................... [8 Enduring benefits ............................................................................................................ [8 Recurring v once-and-for-all expenditure ...................................................................... [8 Payments out of profits – distribution or expense? ....................................................... [8 Preservation of assets ...................................................................................................... [8

150] 160] 170] 180] 190]

PRIVATE OR DOMESTIC EXPENDITURE Meaning of private or domestic ..................................................................................... [8 250] TIMING OF DEDUCTIONS When losses and outgoings are incurred – introduction ............................................... [8 Outgoings incurred or anticipated but not paid until a later income year .................... [8 Provisions and accrued expenses .................................................................................... [8 Outgoings and losses referable to future years .............................................................. [8

300] 310] 320] 330]

PREPAYMENTS Prepayments – introduction ............................................................................................ [8 Excluded expenditure ...................................................................................................... [8 Small business entities and non-business individuals .................................................... [8 Other taxpayers ............................................................................................................... [8 Tax shelter arrangements ................................................................................................ [8 Forestry expenditure ........................................................................................................ [8

350] 360] 370] 380] 390] 400]

TAX AND OTHER LOSSES Tax losses – overview ..................................................................................................... [8 Prior year tax losses – deduction ................................................................................... [8 Order of deduction .......................................................................................................... [8 Net exempt income – meaning ....................................................................................... [8 Order of recoupment ....................................................................................................... [8 Limit on certain deductions – tax loss situation ............................................................ [8 Venture capital losses ...................................................................................................... [8 Partnership and trust losses ............................................................................................ [8 Foreign capital losses ...................................................................................................... [8 Losses before bankruptcy ............................................................................................... [8

450] 460] 470] 480] 490] 500] 540] 560] 570] 580]

NON-COMMERCIAL LOSSES Restriction on deducting non-commercial losses ........................................................... [8 Where restrictions do not apply ..................................................................................... [8 Commerciality tests ......................................................................................................... [8 Pre-business and post-business capital expenditure ....................................................... [8 Commissioner’s discretion not to apply non-commercial loss rules ............................ [8

600] 610] 620] 630] 640]

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[8 020]

COMMERCIAL DEBT FORGIVENESS Commercial debt forgiveness – adjustments .................................................................. [8 700] STATUTORY LIMITATIONS Limitations on deductibility ............................................................................................ [8 750]

INTRODUCTION [8 010] Overview A taxpayer’s liability to income tax for an income year is based on the taxpayer’s taxable income for the year: see [3 050]. Taxable income is assessable income less allowable deductions: s 4-15(1) ITAA 1997. A ‘‘deduction’’ is an amount that a taxpayer can deduct: see ss 995-1, 8-1 and 8-5 ITAA 1997. Allowable deductions are divided into general deductions and specific deductions. A general deduction is a loss or outgoing that is deductible under the general deduction section, s 8-1. A specific deduction is a loss or outgoing that is deductible under another provision of the income tax legislation: s 8-5. This chapter is mainly concerned with the interpretation of the general deduction section (s 8-1) and the tests and principles that have been developed to assist in determining whether an amount falls within, or is excluded from, its ambit. In particular this chapter discusses: • the structure and general application of s 8-1, including the positive and negative limbs: see [8 020]-[8 090]; • the distinction between expenditure of a revenue nature (deductible) and expenditure of a capital nature (not deductible, unless allowed by a specific provision, eg the capital allowance provisions): see [8 150]-[8 190]; and • private or domestic expenditure (generally not deductible): see [8 250]. Other topics of a general nature considered in this chapter include: • timing issues – ie when is a deduction “incurred” so that it can be allocated to the correct income year: see [8 300]-[8 330]; • specific rules governing prepayments: [8 350]-[8 400]; • losses – how they are calculated and their treatment for tax purposes: see [8 450]-[8 580]; • the non-commercial loss rules: see [8 600]-[8 640]; and • the commercial debt forgiveness rules: see [8 700]. A table at [8 750] summarises various statutory limitations on claiming a deduction for certain types of expenditure. Particular types of deductible expenditure are considered in Chapter 9, as well as specific restrictions on allowable deductions. Chapter 10 discusses the special rules governing deductions for certain capital expenditure, namely capital allowances (ie depreciation) and capital works.

GENERAL PRINCIPLES – s 8-1 [8 020] The scheme of s 8-1 Section 8-1 allows a deduction in general terms for losses and outgoings incurred as part of income-producing activities, provided they are intended to give rise to assessable income. A loss or outgoing that is deductible under s 8-1 is called a general deduction: s 8-1(3). © 2017 THOMSON REUTERS

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As both s 8-1 (and its predecessor, s 51 ITAA 1936) use general expressions and principles, their interpretation is based almost entirely on the large volume of case law considering those provisions. Since the operative wording of ss 8-1 and 51 is virtually identical and, in general, no change in meaning was intended by the tax law rewrite (see [1 270]), case law on s 51 forms the basis, and guides the interpretation, of s 8-1. This was confirmed by Crennan J in her judgment in FCT v Citylink Melbourne Ltd (2006) 62 ATR 648 at 669. Section 8-1 is divided into 2 subsections, corresponding to what were commonly referred to as the positive and negative limbs of s 51.

Positive limbs The ‘‘positive limbs’’ in s 8-1(1) provide that a taxpayer can deduct from assessable income any loss or outgoing to the extent that: • it is incurred in gaining or producing assessable income (referred to as the first limb); or • it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income (referred to as the second limb). Although the expression in the second (business) limb “in carrying on a business for the purpose of gaining or producing” lays down a different test to that implied by the words “in gaining or producing” used in the first (non-business) limb, the latter words have a very wide operation and, in most instances, the words of the second limb add little in practice: see the comments of the High Court in Ronpibon Tin NL v FCT (1949) 78 CLR 47 at 56. Whether a taxpayer is carrying on a business is discussed at [5 020].

Negative limbs or exclusions The ‘‘negative limbs’’ in s 8-1(2) provide that a taxpayer cannot deduct a loss or outgoing under s 8-1 to the extent that: • it is a loss or outgoing of capital or of a capital nature; • it is a loss or outgoing of a private or domestic nature; • it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income (arguably this is unnecessary in view of the need to satisfy the positive limbs); or • a provision of the ITAA 1997 prevents it from being deductible. The use, in both limbs, of the phrase to the extent means that s 8-1 contemplates apportionment of losses and outgoings. This is discussed at [8 040].

Meaning of incurred A loss or outgoing is only deductible under s 8-1 if it has actually been ‘‘incurred’’ by the taxpayer. In general terms, a loss or outgoing is incurred, for these purposes, when the taxpayer is ‘‘definitively committed’’, or has ‘‘completely subjected’’ itself, to the loss or outgoing in question. These timing issues in relation to when a loss or outgoing is deductible are discussed further at [8 300]-[8 330]. Special rules in relation to certain prepaid expenditure are discussed at [8 350]-[8 400]. Note that there are also specific rules for substantiating certain work-related and travel expenses claimed as deductions. These are discussed in Chapter 9. Double deductions – which section applies? Many specific deductions in sections other than s 8-1(1) may also constitute losses and outgoings of a nature falling within the ambit of s 8-1(1), although most do not. In addition, some specific deduction provisions in the ITAA 1997 provide that they only apply if s 8-1 232

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does not. Section 8-10 provides that if an item of expenditure would be a deduction under more than one section, it is deductible only under the provision that is most appropriate. Restrictions in the CGT provisions (s 118-20) prevent a deduction and a capital loss arising from a single economic loss: see [14 500].

[8 030] Losses and outgoings Section 8-1 allows a deduction for ‘‘losses and outgoings’’ that satisfy the relevant tests. The term ‘‘outgoing’’, according to Hill J in FCT v Ogilvy and Mather Pty Ltd (1990) 21 ATR 108, contemplates that there be something that ‘‘flows out from the taxpayer’’. It may be a monetary payment or a liability. A loss, again according to its ordinary meaning connotes something rather different. Examples include bad debts written off (AGC (Advances) Ltd v FCT (1975) 5 ATR 243) and the theft of business takings (Charles Moore & Co (WA) Pty Ltd v FCT (1956) 95 CLR 344). It may be that an outgoing requires a degree of volition, as distinct from a loss (IRC (NZ) v Webber (1956) 6 AITR 291). An outgoing may be deductible even though it is not a cash outgoing: FCT v Citylink Melbourne Ltd (2006) 62 ATR 648 (discussed at [8 160]). However, Ruling TR 2008/5 states that no loss or outgoing is incurred by a company if it issues shares as consideration for the acquisition of assets or the provision of services. Note that a deduction will be allowed for the purchase of business goods and services using Bitcoins based on the arm’s length value of the items acquired: see [3 050]. A loss on an isolated transaction which was entered into by a taxpayer with the intention of making a profit may be deductible (see Ruling TR 92/4). For an example, see Visy Packaging Holdings Pty Ltd v FCT (2012) 91 ATR 810, where a deduction was allowed for losses on the resale of recently acquired businesses. The amount of the loss may be determined after a calculation is done which nets individual items of income and expenditure or loss, in order to arrive at a net amount that is allowable as a deduction. In ATO ID 2012/91, however, the Tax Office determined that a bank was not entitled to a deduction on a net basis for ‘‘negative spread’’ (being the excess of interest expense over interest income). [8 040] Apportionment Section 8-1 provides that losses and outgoings are deductible to the extent to which they are incurred in earning assessable income or are necessarily incurred in carrying on a business for that purpose. Accordingly, in appropriate circumstances, the section allows for an apportionment between the deductible and non-deductible components of a loss or outgoing: Ronpibon Tin NL v FCT (1949) 78 CLR 47 at 56. In that case administrative expenses were found to be only partly deductible since they did not exclusively relate to the production of income but were also incurred to maintain the corporate structure. The High Court also undertook an apportionment of the interest deduction claimed in Fletcher v FCT (1991) 22 ATR 613 by limiting the deduction to the amount of assessable income returned based on an analysis of the taxpayer’s purpose (see [9 1390]). The method of apportionment should be fair and reasonable in all the circumstances: Ronpibon Tin NL v FCT (1949) 78 CLR 47 at 56 (see also Ruling TR 95/33 at para 14). [8 050] First limb – gaining or producing assessable income A loss or outgoing is deductible under the first positive (non-business) limb of s 8-1 if it is incurred ‘‘in gaining or producing’’ assessable income. As stated at [8 020], the meaning of this expression is determined by the many cases concerning s 8-1 and its predecessor, s 51 ITAA 1936. It has been pointed out that, if viewed narrowly, no outgoing in itself actually ever produces income since a payment, being an outgoing, is by its nature a diminution of the taxpayer’s resources: W Nevill & Co Ltd v FCT (1937) 56 CLR 290, per Latham CJ at 301. This is perhaps even more apparent in the case of losses. Thus, in Charles Moore & Co (WA) © 2017 THOMSON REUTERS

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Pty Ltd v FCT (1956) 95 CLR 344, the taxpayer was able to claim a deduction in respect of trading receipts which were stolen while being taken to the bank, even though such a loss clearly could not result in the generation of income. Various tests have been developed by case law to explain the connection (the ‘‘nexus’’) between a loss or outgoing and the production of assessable income that is required to justify deductibility. To satisfy the first positive limb of s 8-1, the loss or outgoing must be incidental and relevant to the operations or activities from which the assessable income is produced: W Nevill & Co Ltd at 305; Ronpibon Tin NL v FCT (1949) 78 CLR 47; Steele v DCT (1999) 41 ATR 139 at 151. In both Fletcher v FCT (1991) 22 ATR 613 and Ronpibon Tin, the High Court held that the question of whether a loss or outgoing was ‘‘incidental and relevant’’ to the business operations is resolved by asking whether or not the occasion of the outgoing is to be found in whatever is productive of the assessable income or, if no assessable income is produced, what is expected to produce assessable income. The question of whether a loss or outgoing was incurred in gaining or producing assessable income looks to the ‘‘essential character’’ of the loss or outgoing, rather than to the purpose for which the loss or outgoing was incurred: Charles Moore & Co; Lunney v FCT (1958) 100 CLR 478. As Brennan J said in Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276 at 279, neither motive nor purpose, whether subjective or objective, is a ‘‘criterion of deductibility’’. Although the characterisation of a loss or outgoing is in general determined objectively, that does not mean that the taxpayer’s subjective purpose in incurring expenditure (voluntarily) is irrelevant. The taxpayer’s subjective purpose, although evidentiary only, may have a significant role in ascertaining the character of the expenditure in a particular case: see Magna Alloys at 284; John v FCT (1989) 20 ATR 1 at 6; and FCT v Studdert (1991) 22 ATR 762 at 767-768. The taxpayer’s intentions are more likely to be relevant if no assessable income can be identified or if the relevant assessable income is less than the outgoing the taxpayer seeks to deduct: Fletcher v FCT (1991) 22 ATR 613 (see [9 1390]) and Ruling TR 95/33. In such cases the concept of ‘‘colourable purpose’’ is relevant. That requires an inquiry into whether the taxpayer was motivated otherwise than by the prospect of earning assessable income (eg by obtaining a tax deduction). In corporate groups it has been held that outgoings by a holding company which do not directly give rise to assessable income may be allowable deductions because they strengthen the corporate group and in so doing increase the prospect of dividend income. Thus, if a company carries on business by investing in subsidiary companies, the expenditure incurred by way of interest on moneys borrowed to lend to such subsidiary companies, even under circumstances where no interest is payable by the subsidiary, is an allowable deduction to the parent company: FCT v Total Holdings (Aust) Pty Ltd (1979) 9 ATR 885. Similarly, in FCT v EA Marr and Sons (Sales) Ltd (1984) 15 ATR 879, the taxpayer was a group company which made available to subsidiaries plant and equipment it leased from a finance company. It made no money from the leasing of the equipment in its own name as it received no rental income. The Full Federal Court held that there was a sufficient nexus between the payments to a finance company relating to the plant and equipment and the carrying on of the taxpayer’s business. Contrast these decisions with P & G Rocca Pty Ltd v FCT (2002) 50 ATR 184, where the taxpayer was not entitled to a deduction for interest paid on borrowings that it on-lent interest-free to a related entity. The related entity used the money to buy a property that was to be used by the taxpayer for its business. The Federal Court held that there was an insufficient nexus between the interest payments and the production of the taxpayer’s assessable income. Similarly, in Fitzroy Services Pty Ltd v FCT (2013) 93 ATR 855 the Federal Court held that on-lending to associated non-group companies could not be used to justify a deduction for interest on borrowed funds. The amount expended by a taxpayer is essentially a matter for the taxpayer. It is not for the Commissioner to say how much should have been expended by a taxpayer in relation to its income-earning activities. See also [8 060]. 234

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[8 070]

Second limb – meaning of necessarily incurred

Under the second positive limb of s 8-1, a loss or outgoing can be deducted to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. The courts have not given the word ‘‘necessarily’’ a strict interpretation in the sense of being a compulsory payment. In Ronpibon Tin NL v FCT (1949) 78 CLR 47, the majority stated that the word ‘‘necessarily’’ no doubt limits the operation of the second limb, but probably is intended to mean no more than ‘‘clearly appropriate or adapted for’’. In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276, it was held that an outgoing is necessarily incurred in carrying on a business if, viewed objectively, it is reasonably capable of being seen as desirable or appropriate from the point of view of the pursuit of the business ends of the business (that is being carried on for the purpose of earning assessable income) (see also Ruling TR 95/33). The term ‘‘necessarily’’ appears to include all: • losses and outgoings that are obligatory or compulsory, such as rates, taxes, annual registration and licence fees; • losses inevitably resulting from the nature of the business, eg damages for libel by a newspaper proprietor (Herald & Weekly Times Ltd v FCT (1932) 48 CLR 113) or damages for injury by a transport company; and • expenditure incurred voluntarily on grounds of commercial expediency. The scope of the second limb of s 8-1 is such that if, because of some abnormal event or situation, the exigencies of the business demand that the expenditure should be incurred, the expenditure is deductible. For example, legal costs incurred by a company defending itself before a Royal Commission appointed to inquire into alleged unfair trading practices by the company were deductible: FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431. In FCT v Rothmans of Pall Mall (Australia) Ltd (1992) 23 ATR 620, it was accepted that levies paid to a tobacco industry association to campaign against proposed government legislation that would restrict the industry’s mode of advertising were incidental, and had a clear relation, to the carrying on of the company’s business, therefore clearly falling within the second positive limb of s 8-1. It is not for the Commissioner to say how much the taxpayer should expend in operating a business: Ronpibon Tin. The Commissioner’s concern is only with the amount in fact spent and whether the necessary connection to the production of assessable income exists. If the connection exists, it is irrelevant that it was extravagant or could have been done in a less expensive manner. These are commercial decisions for the taxpayer. Of course, if expenditure is commercially realistic, it is more likely to be deductible: eg FCT v Phillips (1978) 8 ATR 783 (see also Ruling IT 276) and Lau v FCT (1984) 15 ATR 932.

[8 070]

At what point must assessable income materialise?

To establish a sufficient nexus for deductibility, it is not necessary that a loss or outgoing results in the production of assessable income in the same year as the loss or outgoing is incurred. The concept of matching is irrelevant. It is sufficient if it relates to the production of future assessable income or it relates to the reduction of future outgoings. Assessable income in this context means the assessable income of the taxpayer generally without regard to a division into accounting periods: AGC (Advances) Ltd v FCT (1975) 5 ATR 243. Deductibility is not dependent on the result of the expenditure. Thus, if expenditure is not successful in generating assessable income, a deduction is still available if it satisfies the requirements of s 8-1: eg Steele v DCT (1999) 41 ATR 139, FCT v R & D Holdings Pty Ltd (2007) 67 ATR 790 and Guest v FCT (2007) 65 ATR 815. © 2017 THOMSON REUTERS

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If a nexus is established, the accounting period in which a deduction is allowable depends on when it was incurred and the concept of referability: see [8 300]-[8 330]. The deductibility of expenditure that is to be incurred over a period of time is considered at [8 350]-[8 400].

[8 080] Expenditure before income-earning activity starts Expenditure on activities preparatory to carrying on an income-earning activity, eg a business, is not deductible under s 8-1 as it is expended too soon to be incurred in carrying on that business. For example, a company cannot deduct expenditure incurred before incorporation. Similarly, expenditure incurred in obtaining employment is not deductible: FCT v Maddalena (1971) 2 ATR 541. Expenditure incurred in feasibility studies is generally not deductible under s 8-1 as it is incurred too soon. For example, the costs of a feasibility study into a paper mill was held not to be deductible in Softwood Pulp & Paper Ltd v FCT (1976) 7 ATR 101. An investment in a tea-tree oil project was found to be wholly related to research and development and thus was non-deductible preliminary expenditure in Howland-Rose v FCT (2002) 49 ATR 206 In Re Smeding and DCT (2001) 48 ATR 1084, a married couple was not allowed a deduction for expenses directed at establishing their Amway business (eg the cost of business-building aids and demonstration materials), while expenses that were directed at both establishing and conducting the business had to be apportioned (eg vehicle, travel, telephone and printing costs). The Commissioner’s views (in ruling TR 2004/4) on whether interest incurred in a period before the derivation of relevant assessable income are considered at [9 450]. Note that capital expenditure incurred before the commencement of a business activity may be deductible under s 40-880: see [10 1150]. [8 090] Expenditure after income-earning activity ceases A business taxpayer may be entitled to a deduction if the business has been suspended or, indeed, even if it has completely ceased. It will be important to demonstrate that the occasion of the expenditure was the production of assessable income of an earlier year. In fact, considerable time may pass between the suspension or cessation of the business and the expenditure being incurred. Some of the leading cases are discussed below. In Placer Pacific Management Pty Ltd v FCT (1995) 31 ATR 253, the taxpayer was sued by a customer for supplying an allegedly defective conveyor belt. The customer commenced proceedings shortly after the taxpayer sold its conveyor belt operations. About 4 years later, the action was settled by the taxpayer paying the customer a sum of money. The Full Federal Court allowed the taxpayer a deduction for that sum plus its legal fees, on the basis that the occasion of the loss or outgoing was the business arrangement entered into between the taxpayer and its customer for the supply of the conveyor belt. The fact that the division had subsequently been sold and its active manufacturing business terminated did not deny deductibility. In FCT v Brown (1999) 43 ATR 1, the Full Federal Court allowed as a deduction the taxpayer’s share of interest on a bank loan to purchase a delicatessen in relation to years of income after the business had ceased. The court held that the period of time between the cessation of the business and the interest being incurred was sufficiently proximate to be deductible. A similar conclusion was reached in Guest v FCT (2007) 65 ATR 815, where interest on a loan used to invest in a blueberry growing project was held to be deductible, despite a 10-year lapse in time between the payment of the interest and the end of the taxpayer’s involvement in the project and despite his earlier failure to repay the loan by the due date or to accept an offer to settle the debt. See also FCT v Jones (2002) 49 ATR 188 (interest on both the original and the refinanced bank loan deductible after cessation of the business) and 236

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Re Doyle and FCT (2000) 44 ATR 1177 (interest on loan used to invest in a horse-breeding venture was deductible, even after the venture had collapsed). The Commissioner’s views (in Ruling TR 2004/4) on the deductibility of interest after the cessation of the relevant income-earning activity are set out at [9 450].

CAPITAL v REVENUE EXPENDITURE [8 150] Tests and indicia – introduction Losses or outgoings of capital or of a capital nature are not deductible: s 8-1(2). This is the ‘‘first negative limb’’ of s 8-1. There is no statutory definition of ‘‘revenue’’ or ‘‘capital’’ expenditure and a satisfactory judicial definition has proved elusive. As Sir Wilfred Greene MR remarked in IRC v British Salmson Aero Engines Ltd [1938] 2 KB 482 at 498, ‘‘in many cases it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons’’. The leading Australian judgment on the distinction between capital and revenue expenditure is that of Dixon J in Associated Newspapers Ltd v FCT; Sun Newspapers Ltd v FCT (1938) 61 CLR 337. Dixon J said that there were 3 matters to be considered: • the character of the advantage sought; • the manner in which it is to be used, relied upon or enjoyed; and • the means adopted to obtain it. In order to determine the character of the advantage sought, one looks to the use or enjoyment secured by the relevant outlay. The inquiry is a substantive one, not being confined to the words of the document pursuant to which the payment is made. As Dixon J states in Hallstroms Proprietory v FCT (1946) 72 CLR 634 at 648: What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process. It is clear that the label given to expenditure is not determinative. In FCT v BHP Co Ltd (2000) 45 ATR 507, the taxpayer bought the shares in the Utah group of companies for just over US$2.4bn. Under the sale agreement, BHP also agreed to pay the vendor what was described as ‘‘interest’’ on the sale price at the rate of 12% pa for the period from 1 January 1983 to settlement in April 1984. The Full Federal Court held that there was no loan and that the so-called ‘‘interest’’ payment was merely part of the overall purchase price. It was therefore on capital account. The courts will take into account the overall background and context of a transaction in determining if relevant expenditure is on capital or revenue account. For example, in both Macquarie Finance Limited v FCT (2005) 61 ATR 1 and St George Bank Limited v FCT (2009) 73 ATR 148, the Full Court held that interest outgoings were not deductible, notwithstanding that they satisfied the first and/or second limb requirements of s 8-1: see further [9 460]. A ‘‘support payment’’ made by a parent entity to a subsidiary is considered to be of a capital nature since it has the purpose of maintaining the subsidiary’s capital structure thereby securing the subsidiary as a source of future income: see Determination TD 2014/14. Whether outgoings incurred by the operator of a retirement village are of a capital or revenue nature is considered in Ruling TR 2002/14 (see also Practical Compliance Guideline PCG 2016/15). © 2017 THOMSON REUTERS

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Note that, in the case of joint expenditure, it is possible for the expenditure to be on revenue account for the one taxpayer but to be on capital account for the other taxpayer: see Poole v FCT; Dight v FCT (1970) 1 ATR 715, where the taxpayers, who carried on business in partnership, paid rent in respect of agricultural farm leases.

[8 160] Enduring benefits The courts often look to whether the advantage sought in incurring expenditure is an enduring one going to issues of structure. If so, the expenditure is capital in nature. Expenditure associated with the acquisition of a non-trading asset will generally be capital in nature. The enduring benefit concept was expressed by Viscount Cave in British Insulated and Helsby Cables Ltd v Atherton [1926] AC 205 at 213-214 as follows: But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital. Dixon J in Sun Newspapers similarly referred to the ‘‘lasting qualities’’ of the character of the advantage sought. In Hallstroms, Dixon J goes on to say: ... it may be useful to recall the general consideration that the contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organization and carrying on the business; between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it. Several decisions of interest have arisen in the context of State projects where the distinction between deductible outgoings and payments to secure an enduring advantage have often been blurred. These are considered below. In United Energy Ltd v FCT (1997) 37 ATR 1, the Full Federal Court held that the taxpayer was not entitled to a deduction for over $100m in electricity franchise fees (or monopoly rent) payable to the Victorian Government. In Jupiters Limited v FCT (2002) 50 ATR 236, the taxpayer and the Queensland Government entered into an agreement whereby the taxpayer was given exclusive rights to operate a casino in Brisbane on a government-owned site for 10 years. However, the evidence suggested that the taxpayer expected de facto exclusivity for a much longer period. In addition to rent and a lease premium, the taxpayer was required to pay ‘‘special rental’’ of $7m per year for 10 years. The Full Federal Court held that the ‘‘special rental’’ payments were consideration for the exclusivity arrangements and they were therefore on capital account, notwithstanding that they were labelled ‘‘rent’’ and were made periodically. The issue of whether a rental prepayment was capital was considered in FCT v Star City Pty Ltd (2009) 72 ATR 431. The taxpayer was the successful bidder for a casino licence being offered by the NSW State Government. The contractual arrangements required an upfront payment of $120m, which was calculated as the present value of the first 12 years rent of a 99-year lease of the land. The Full Federal Court held that the payment was of a capital nature. The Full Court said that the juridical character of the payment (ie rent) was not determinative of its nature. In particular, it was important to look to what the prepayment was calculated to effect from a practical and business perspective. As in the Jupiters case, it was held that the payment was largely connected with the exclusivity of the casino licence and therefore was an outgoing of capital. In FCT v Citylink Melbourne Ltd (2006) 62 ATR 648, the High Court held that the taxpayer was entitled to a deduction for over $220m in concession fees payable to the Victorian State Government for the right to construct and operate the Melbourne Citylink 238

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project. The agreement allowed for the taxpayer to defer its liability to actually pay the fees until 2034 (or some earlier date). The taxpayer exercised this option, but claimed deductions for the accrued liabilities as they arose. Crennan J emphasized that the taxpayer did not obtain permanent ownership rights over the roads or the land used as all rights would revert to the State on the expiry of the concession period.

[8 170]

Recurring v ‘‘once-and-for-all’’ expenditure

One of the tests that has been adopted to determine the character of a payment is whether the expenditure has been made once and for all. This was first proposed by Dunedin LJ in Vallambrosa Rubber Co Ltd v Farmer (1910) 5 TC 529 at 536, where his Honour said: I do not say that this consideration is absolutely final or determinative, but in a rough way I think it is not a bad criterion of what is capital expenditure … to say that capital expenditure is a thing that is going to be spent once and for all, and income expenditure is a thing that is going to recur every year. A payment that is made “once and for all” is prima facie of a capital nature. However, recurrence is but one factor to be considered. As stated by Fullagar J in Colonial Mutual Life Assurance Society Ltd v FCT (1953) 89 CLR 428 at 454: It does not matter how they are calculated or how they are payable, or when they are payable, or whether they may for a period cease to be payable. If they are paid as parts of the purchase price of an asset forming part of the fixed capital of the company, they are outgoings of capital or of a capital nature. The real test is between expenditure made to meet a continuous demand for expenditure as opposed to expenditure made once and for all. It is not necessary that the expenditure be made annually or even at fixed intervals for it to fall within the category of a revenue outgoing. A need for expenditure may not arise at regular intervals, but this would not alter the revenue nature of the expenditure if it fell within the category of continuous demand. An example of this is in connection with repairs, where the need for repairs may arise at very infrequent intervals merely because of regular maintenance that is carried out keeping the item in working condition. The deductibility of expenditure on repairs is considered at [9 600]. In National Australia Bank Ltd v FCT (1997) 37 ATR 378, the Full Federal Court held that a one-off $42m payment to the Commonwealth to become the sole provider of loans to Defence Force personnel was not capital despite its one-off nature. It was for expansion of the customer base and the flow of income and was more like a commission, franchise fee or marketing expense. Similar issues were addressed in older authorities such as BP Australia Ltd v FCT (1965) 112 CLR 386, where the Privy Council allowed the taxpayer a deduction for lump sum payments to service station operators under exclusive dealing arrangements. The average period covered by the payments was 5 years. The NAB case can be seen to be aligned to the BP Australia case as being a payment incurred in the ordinary course of business (or, as stated above, to meet a continuous demand), rather than being a payment to effectively prevent competition.

[8 180]

Payments out of profits – distribution or expense?

Section 8-1 provides for a deduction for expenditure designed to produce assessable income. However, if the payment is made out of profits and the payment is conditional on profits being earned, the payment may not be made to earn profits and consequently may not be deductible: see Commissioner of Taxation (WA) v Boulder Perseverance Ltd (1937) 58 CLR 223. In AusNet Transmission Group Pty Ltd v FCT [2015] HCA 25, the taxpayer sought a deduction for certain government charges it was required to pay in connection with its © 2017 THOMSON REUTERS

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purchase of a government owned electricity transmission business. The High Court held that the charges were capital in nature, being an integral part of the consideration for the purchase of the assets of the business. This decision should be contrasted with the judgment of Kitto J in Midland Railway Co of Western Australia Ltd v FCT (1950) 81 CLR 384, where payments in redemption of reversionary certificates issued 34 years earlier in respect of a contingent liability for interest were held to be deductible. In that case, Kitto J rejected the proposition that if the profits of a business are the exclusive source of a payment of interest (on money borrowed for the purposes of the business), the interest payment must always be non-deductible.

[8 190] Preservation of assets Expenditure designed to eliminate or restrict competition, and thus to preserve the assets of the business, is of a capital nature. High Court decisions on this particular aspect conflict with English decisions and the latter must be viewed with some reservation (eg John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30 at 38). Many cases dealing with the deductibility of legal costs involve the ‘‘preservation of assets’’ principle. For example, in the Fairfax case, costs incurred in defending legal title to a newly acquired asset (a substantial shareholding in another newspaper company) were held to be of a capital nature and therefore not deductible. See also Smithkline Beecham Laboratories (Australia) Ltd v FCT (1993) 26 ATR 260 at 265-266, where Hill J said that there can be little doubt that expenditure incurred to preserve or to protect a business as such will ordinarily be expenditure of capital. His Honour cited FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281, where the Full Federal Court disallowed a deduction for legal costs incurred in defending the taxpayer’s monopolistic rights to technology. The deductibility of legal costs is considered in detail at [9 650]-[9 660]. In FCT v Rothmans of Pall Mall (Australia) Ltd (1992) 23 ATR 620, it was held that levies paid to a tobacco industry association to campaign against proposed government legislation that would restrict the industry’s mode of advertising was not expenditure to protect any capital asset and the existence of the business was not threatened, nor was any enduring advantage gained. The expenditure was designed merely to maintain the company’s existing market share and was incidental to the carrying on of its business, even though not recurrent. Accordingly, it was of a revenue nature and deductible. The Commissioner accepts this decision: Ruling TR 95/1.

PRIVATE OR DOMESTIC EXPENDITURE [8 250] Meaning of ‘‘private or domestic’’ The second negative limb of s 8-1 denies a deduction for losses or outgoings of a private or domestic nature. Expenditure that must be incurred in order to earn income can still be of a private or domestic nature for s 8-1 purposes. Although the terms ‘‘private and domestic’’ are often used in combination to describe expenditure which is excluded from deductibility, it is relevant to distinguish private from domestic expenditure. So, for example, ‘‘private’’ expenditure will generally be expenditure which is not incurred in gaining assessable income. As Menzies J said in FCT v Hatchett (1971) 2 ATR 557, in most cases the categories would seem to be exclusive. This is not to say that it might nevertheless be necessary for private expenditure to be incurred in order to earn assessable income. Childminding costs (Jayatilake v FCT (1991) 22 ATR 125) and travel between home and work (Lunney v FCT (1958) 100 CLR 478) are examples of private expenditure which is not deductible, even though they are expenses that may only be incurred on account of a taxpayer’s employment. The question that needs to be asked is whether the essential character of the expenditure is private. 240

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[8 300]

Domestic expenditure on the other hand may be excluded, notwithstanding it falls within the positive limbs of s 8-1 (see Handley v FCT (1981) 11 ATR 644). Certain types of expenditure generally considered to be of a private or domestic nature are considered in Chapter 9, in particular expenditure on travel ([9 050] and [9 1460]), meals ([9 300]), clothing ([9 310]), accommodation ([9 320]) and self-education ([9 960].

TIMING OF DEDUCTIONS [8 300] When losses and outgoings are incurred – introduction A deduction is allowable under s 8-1 when a loss or outgoing is “incurred”. In general, a loss or outgoing is ‘‘incurred’’ if the taxpayer is ‘‘definitively committed’’ (or ‘‘completely subjected’’) to the loss or outgoing, irrespective of whether there has been an actual disbursement. The question of when a loss or outgoing is ‘‘incurred’’ is considered in the following paragraphs ([8 310]-[8 330]). The question cannot be resolved by reference to generally accepted principles of accounting. The Commissioner’s views on the meaning of “incurred” are set out in Ruling TR 97/7. A useful discussion of the case law on the meaning of ‘‘incurred’’ is contained in Ruling IT 2682, which deals with interest rate swaps, and FCT v Malouf (2009) 75 ATR 335. Agency The actions of an agent are generally treated as actions of the principal. If a retailer association incurs expenses on behalf of its members, and the arrangement between the association and its members in relation to those expenses is properly characterised as one of agency, the Tax Office considers that amounts payable by the association are deductible to the members when incurred on their behalf by the association: Ruling TR 2004/5. Taxpayers on a cash basis of accounting Some small business entities which were Simplified System Taxpayers may still use the mandatory cash accounting rules under the STS system. If so, all outgoings that are deductible under ss 8-1 (general deductions), 25-5 (tax-related expenses) and 25-10 (repairs) are deemed to be incurred when paid. In all other cases, the taxpayer’s basis of accounting for income (ie cash or accruals: see [3 270]) does not affect the time at which a loss or outgoing is incurred: see Ruling TR 97/7. For example, the Tax Office considers that arrears of land tax are not deductible in the year in which they are paid, but are deductible in the respective income years in which the liability for land tax was incurred (under the terms of the relevant State legislation): see the Tax Office’s Rental properties Guide 2015 and withdrawn ATO ID 2010/192. Measurement of amounts In general, the income tax law only takes account of amounts that can be expressed in monetary terms. Section 21 ITAA 1936 provides that where ‘‘upon any transaction’’ any consideration is paid or given otherwise than in cash, the money value of that consideration is deemed to have been paid or given. This provision is considered at [3 200]. Many provisions in the income tax law require the ascertainment of market value, for example, where an asset is disposed of in a non-arm’s length transaction (eg involving related entities). The concept of ‘‘market value’’ is considered at [3 210]. An taxpayer’s Australian income tax liability is payable in Australian dollars. This means that expenditure in a foreign currency which is deductible must be converted into Australian dollars. The currency conversion rules (primarily contained in Subdivs 960-C and 960-D ITAA 1997) are discussed at [34 050]-[34 080]. © 2017 THOMSON REUTERS

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Anti-avoidance provision If a transaction involving payments to an associate is made in such circumstances that the payment is an allowable deduction in the income year in which it is incurred, while the receipt of the amount is not income of the associate until a future year, s 82KK ITAA 1936 will deny a deduction to the taxpayer making the expenditure until such time as the expenditure becomes assessable income in the hands of the recipient associate: see [43 020]. [8 310]

Outgoings incurred or anticipated but not paid until a later income year A loss or outgoing may be incurred in one income year even if the amount is not actually paid until a later year. The leading cases – W Nevill & Co Ltd v FCT (1937) 56 CLR 290; New Zealand Flax Investments Ltd v FCT (1938) 61 CLR 179; FCT v James Flood Pty Ltd (1953) 88 CLR 492; Nilsen Development Laboratories Pty Ltd v FCT (1981) 11 ATR 505; FCT v Firstenberg (1976) 6 ATR 297; and FCT v Energy Resources of Australia Ltd (1996) 33 ATR 52 – establish that, in the absence of any special legislative provision, an outgoing is incurred when the taxpayer is ‘‘definitively committed’’ (or ‘‘completely subjected’’) to the loss or outgoing. It is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the current income year that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum (see also [8 320]). These principles apply whether the taxpayer operates on a cash (or receipts) basis or on an accruals (or earnings) basis (see [3 270]): Ruling TR 97/7. The commitment or liability to pay an outgoing may arise before the due date for payment and it may even arise before it is possible to quantify the outgoing precisely (see below). In contrast, an anticipated outgoing to which the taxpayer has not become definitively committed is not incurred (and is therefore not deductible) even if it can be quantified. Note that the outgoing must also be properly referable to the income year in which the deduction is sought: see [8 330]. In determining whether a taxpayer has a presently existing liability, the cases referred to above establish various principles. • A taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities). • A taxpayer may have a presently existing liability even if the liability is defeasible by others. • Whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise. • In the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer’s funds), the expense is incurred when the money is paid. These principles are illustrated in various decided cases. In Hooker-Rex Pty Ltd v FCT (1988) 19 ATR 1241, an undertaking was given by a parent company relating to an assessed income tax liability of a subsidiary company in the course of liquidation but, by agreement, payment was deferred pending resolution of a related point of law by a final judicial decision. Some years later, following judgment on the point, payment under the indemnity was demanded. It was held that the outgoing was not ‘‘incurred’’ until the later demand and until then the liability was merely threatened or contingent. In Ogilvy and Mather Pty Ltd v FCT (1990) 21 ATR 841 an advertising agency claimed deductions for advertising fees, which had not yet been paid, for advertisements that had been booked but not published. The agency argued that the fees were ‘‘payable’’ once the 242

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contractual period for non-cancellation (so many days before publication of the advertisement) had been reached. The Full Federal Court held that the deductions were not allowable until the year in which the advertisements were published as, despite the existence of a non-cancellation period, no liability to pay the fees attached to the agency until the relevant advertisement was published, or time or space had been made available for the advertisement on the agreed date. In contrast, in FCT v Citylink Melbourne Ltd (2006) 62 ATR 648, the High Court held that concession fees payable by a toll road operator to the Victorian State Government, which were satisfied semi-annually by the issuing of non-interest bearing ‘‘concession notes’’, were incurred and deductible in the periods for which the fees were payable and the notes were issued. This was the case even though the project documents provided that: • the concession notes could not be presented for payment until the following conditions were met: (i) the owner’s rate of return for the period of the concession, to 4 months before presentation of the notes, was at least 10% pa; and (ii) the total amount payable under the note presented, and other notes presented in the financial year, must not exceed 30% of the ‘‘Distributable Cashflow’’ for the previous financial year; • while any project debt remained outstanding, all amounts represented by the concession notes were stated to be ‘‘owing’’ but ‘‘not due for payment’’; • no payment on the concession notes could be made to the State government except to the extent that a positive balance existed on the ‘‘Distributions Account’’; and • the concession notes had to be redeemed no later than January 2034. The deductions claimed by the owner and disputed by the Commissioner were for the income years ended 30 June 1996, 1997 and 1998, the first 3 years of the project. The base case financial model assumed that the concession notes would be presented and redeemed from 2013 onwards. In arriving at its conclusion, the High Court rejected the Commissioner’s argument that the amounts represented by the concession notes were in effect contingent liabilities. The Court found that the liability to pay the concession fees arose when each fee became due. The effect of the third clause referred to above (contained in the Master Security Deed) was not to render the liabilities to pay concession fees contingent, but was to set out an order for payment of the owner’s liabilities. Furthermore, the liability on the notes themselves was not contingent as they were required to be redeemed by a certain date. In relation to the application of the ‘‘properly referable’’ doctrine, see also [8 330]. In FCT v Malouf (2009) 75 ATR 335, the issue was whether the obligation to pay the balance of the purchase price for a retirement village was incurred in the income year in which the contract was entered into. The Full Federal Court unanimously decided that the contract was not an unconditional agreement, essentially because the obligation to pay the balance of the purchase price was conditional upon the vendor completing ‘‘Stage 1’’ of the project. In contrast, in FCT v Raymor (NSW) Pty Ltd (1990) 21 ATR 458 (see below) and FCT v Woolcombers (WA) Pty Ltd (1993) 27 ATR 302 (see [8 330]), the contract was unconditional (subject only to defeasance by unforeseen events). The fact that the contract involved the sale of land, and the fact that the development of the retirement village had not occurred when the contract was entered into, and consent for the preferred version of the development had not been obtained, meant that the taxpayer’s obligation to pay a further amount on settlement was not unconditional. Instead, the court found that the taxpayer’s liability to pay would arise only after the vendor had fulfilled its obligation to complete Stage 1 of the development (which, in the event, did not occur). In a case where a taxpayer failed to self-assess its liability to pay-roll tax, the Full Federal Court held that, pursuant to the relevant pay-roll tax legislation, the liability was incurred at the end of the month in which the taxable wages were paid or payable. The employer’s liability to pay taxable wages (and © 2017 THOMSON REUTERS

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therefore pay-roll tax) was a contingent liability that matured into a debt which was owing when it was ascertainable at the end of each month: Layala Enterprises Pty Ltd (in liq) v FCT (1998) 39 ATR 502.

Tax Office’s views on timing of deductibility of amounts payable in future The Tax Office considers that a provider of loyalty points cannot deduct the expense representing the cost of redeeming the points until goods or services are actually supplied on redemption of the points: Determination TD 2003/20. The rationale for this is that until the points are redeemed, the provider’s liability to provide goods or services is subject to a number of contingencies. A gaming machine operator was considered not to be entitled to a deduction for accumulated jackpot amounts until the jackpot was actually won: Determination TD 96/12. An employer’s FBT liability for an FBT year (imposed under s 5 FBTAA on the fringe benefits taxable amount for the year) is considered to arise at the end of that FBT year: Ruling TR 95/24. The same principle applies if the FBT liability arises under a default or amended FBT assessment (issued under s 73 or s 74 FBTAA) and therefore the assessed FBT is incurred at the end of the FBT year to which the assessment relates: Determination TD 2004/20. The Tax Office cites the Layala Enterprises case as authority for this view. The time at which solicitors incur disbursements is considered in Ruling TR 97/6. Unquantified liability As noted above, a deduction may be available for a loss or outgoing even if it cannot be quantified precisely. It is sufficient if the amount is “capable of approximate calculation based on probabilities”: RACV Insurance Pty Ltd v FCT (1974) 4 ATR 610 at 618; Commonwealth Aluminium Corporation Ltd v FCT (1977) 7 ATR 376 and Coles Myer Finance Ltd v FCT (1993) 25 ATR 95 at 109. In FCT v Raymor (NSW) Pty Ltd (1990) 21 ATR 458, the Full Federal Court held that amounts which the taxpayer was contractually committed to pay in respect of the supply of copper tubing, were incurred and deductible in the years in which the relevant supply agreements were entered into, even though the copper tubing would not be supplied until after the end of the income year in which the supply contracts were entered into and the price payable could subsequently vary as a result of fluctuations in the price of copper. Interest expenses and expenses on other financial transactions Interest accrues on a day-to-day basis and is deductible on an accruals basis (unless the terms of the loan specifically provide otherwise): Alliance Holdings Ltd v FCT (1981) 12 ATR 509; FCT v Australian Guarantee Corporation Ltd (1984) 15 ATR 982 (note that in certain cases the special timing rules in Div 16E (see [32 400]) or the TOFA rules (see [32 050]) will apply. The Tax Office considers that a securitisation vehicle which is not a financial institution can account for interest expenditure using a straight line daily accruals method: see ATO ID 2006/217. The use of the ‘‘Rule of 78’’ method, in relation to a fixed-term or extended borrowing, to apportion instalments between principal and interest is dealt with in Ruling TR 93/16. The deductibility of interest rate swap payments is dealt with in Ruling IT 2682, discussed at [32 730]. For further detail on the treatment of financial transactions, see Chapter 32. SIC and GIC The Tax Office considers that the shortfall interest charge (SIC) is incurred in the income year the Commissioner gives a taxpayer the relevant notice of amended assessment. This is the case even if the SIC liability is notified separately from the notice of amended assessment, or if the SIC is unpaid at the end of that income year: Determination TD 2012/2. The SIC is considered at [54 360]. 244

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[8 320]

Similarly, the general interest charge (GIC) is deductible in the income year in which the relevant assessment (ie for the unpaid tax debt) issues: FCT v Nash (2013) 95 ATR 251. The GIC is considered at [54 370].

Acquisition of trading stock Ruling TR 97/15 deals with the timing and deductions for acquisitions of trading stock on a ‘‘sale or return’’ basis. If a wholesaler offers a prompt payment discount to a retailer, the retailer can deduct the full undiscounted purchase price for goods at the time of the contract: Determination TD 96/45 (see also [3 320]). A trade incentive provided by a seller of trading stock, in the form of a discount, rebate or other incentive, is considered by the Tax Office to be a reduction in the sale price of the trading stock if it relates directly to the sale of the trading stock: Ruling TR 2009/5. If the incentive does not relate directly to the sale of the trading stock (eg if a condition has to be satisfied before it is due and that condition is not virtually certain to be satisfied), it is a business expense that is deductible when incurred. Consequences of not claiming a deduction when incurred If a taxpayer could have claimed a deduction for an outgoing that was incurred but not paid in a particular year but failed to do so, the taxpayer cannot claim a deduction in the year in which the liability is discharged, as the outgoing was not incurred in that year. The appropriate remedy is by way of amendment of the assessment of the previous year, within the statutory limits: eg see Ruling IT 2625, relating to adjustments in respect of accrued audit fees. [8 320] Provisions and accrued expenses Charges in a profit and loss account representing provisions for outgoings are not deductible unless they represent specific liabilities to which the taxpayer is definitively committed: see [8 310]. The following situations illustrate this principle with specific reference to the deductibility of amounts provided for in an entity’s accounts at the end of an income year. Annual leave accruals An accrued amount, relating to annual leave of employees, was held by the High Court not to have been incurred in FCT v James Flood Pty Ltd (1953) 88 CLR 492. This principle would generally prevent deductibility of amounts provided for future salary payments to employees during periods of annual leave, long service leave or sick leave (or in lieu of annual leave, long service leave or sick leave), but s 26-10 ITAA 1997 puts the matter beyond doubt by specifically denying a deduction for such amounts until paid to the employee (or if the employee has died, to the employee’s dependant or legal personal representative) or an ‘‘accrued leave transfer payment’’ is made: see [9 1230]. See also Ransburg Australia Pty Ltd v FCT (1980) 10 ATR 663 (insurance against future liability for long service leave and annual leave payments not deductible), Ruling IT 2557 (transfer of provisions upon sale of a business not deductible) and Determination TD 2006/25 (margin payments made in respect of exchange-traded option and futures contracts not deductible). Accrued bonuses and directors’ fees For a company to qualify for a deduction for directors’ fees, bonuses or other payments it must, before the end of the income year, be definitively committed to the payment of a quantified amount, eg by passing a properly authorised resolution: see Ruling IT 2534. It is not sufficient if an amount is authorised and brought to account after the close of the income year as if the amount had been determined and authorised during the year. In Merrill Lynch International (Australia) Ltd v FCT (2001) 47 ATR 611, bonuses paid by 3 Merrill Lynch companies after the end of the income year (ending 31 December) were not deductible in the years to which the bonuses related, but instead were deductible when paid. Bonus amounts were progressively allocated to a special reserve during the income year, but the final © 2017 THOMSON REUTERS

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amounts were subject to adjustment and confirmation early in the following income year (ie in January) and it was only then that employees were advised whether they would be receiving a bonus.

Accrued audit fees The time at which audit fees are deductible is considered in Ruling IT 2625. It is stated that the question of when an audit fee has been ‘‘incurred’’ can be determined only by reference to the particular facts of each case, and especially by reference to the terms of the contract or arrangement entered into between the auditor/accountant and the taxpayer. In particular, it is necessary to determine when, under the contract or arrangement, there is a presently existing liability to make a payment either immediately or in the future. Insurers, self-insurers and providers of warranties Insurance companies incur liabilities of which they may be unaware until a later time, frequently after the finalisation of accounts for a period in which a liability may later be found to have arisen. It is therefore necessary for such companies to include an estimate of such liabilities in their accounts. The courts have allowed deductions for such estimated claims even if the insured party may have forfeited her or his right to be reimbursed for loss by the insurance company because of failure to meet the statutory or contractual time limit imposed in the terms of the insurance policy: RACV Insurance Pty Ltd v FCT (1974) 4 ATR 610, followed in Commercial Union Assurance Co of Australia Ltd v FCT (1977) 7 ATR 435. The RACV Insurance principle was extended to a self-insurer in Australia and New Zealand Banking Group Ltd v FCT (1994) 27 ATR 559. The Full Federal Court held that a bank was entitled to a deduction in respect of provisions made in its accounts for accident claims that had been reported but were unresolved and unpaid, and for claims that had not been reported by injured workers, under the Victorian ‘‘Workcare’’ system of workers compensation. It was held that a presently existing liability was imposed on the employer in respect of both lump sum and weekly payments, from the moment that an employee suffered injury in the course of employment. Further, the amount of the liability was capable of reasonable estimation. The estimate was made by reference to a case-by-case analysis of files by an expert and was adopted without qualification in the audited accounts of the bank (see also Determination TD 97/14). The methodology accepted by the Commissioner for calculating deductible estimates of future claims in a general insurance business is set out in Ruling IT 2663. The ruling provides that the deductible amount is ‘‘the additional amount that has to be set aside or ‘earmarked’ each year to pay year-end outstanding claims in the future’’, plus a further amount set aside as a ‘‘prudential margin’’. However, the prudential margin has to be recommended by an actuary, considered appropriate on the basis of the insurer’s experience and adequately documented. This methodology (ignoring any ‘‘prudential margin’’) clearly produces a discounted figure, when compared with the face value of the estimated claims. The face value, not merely the discounted value, of future claims was held to be deductible in FCT v Mercantile Mutual Insurance (Workers Compensation) Ltd (1999) 42 ATR 8. However, Subdiv 321-A ITAA 1997 provides that the provision for future claims of a general insurance business or a self-insurer must, for income tax purposes, be calculated on a present value basis. Increases in the value of the provision for outstanding claims are deductible and decreases in the value of the provision for outstanding claims are assessable. Note that the method statement in s 321-60 specifically allows a deduction for certain reinsurance premiums. The taxation treatment of outstanding claims for companies that self-insure for workers compensation purposes (in Subdiv 321-C) is consistent with the rules in Subdiv 321-A for general insurance companies. A self-insurer can deduct amounts paid in respect of workers compensation claims: s 321-95. The UK Privy Council, on appeal from the New Zealand Court of Appeal, held in IRC (NZ) v Mitsubishi Motors NZ Ltd (1995) 31 ATR 350 that an assembler and supplier of motor 246

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[8 330]

vehicles was entitled to deduct an estimate of the cost of meeting warranty claims from sales income in the year in which the vehicles were sold. While liability did not arise until a defect was discovered during the warranty period, nevertheless it was a fair inference that defects covered by the warranty were present at the time of sale, and the taxpayer was therefore entitled to deduct a statistical estimation of liabilities arising from existing facts which happened to be unknown.

Other situations Determination TD 93/188, dealing with provisions made against contingent liabilities, is an example of the application of the general rule that amounts set aside to provision accounts are non-deductible. This general principle has no application, however, if the amount represents a liability that has ‘‘come home’’. In Ballarat Brewing Co Ltd v FCT (1951) 82 CLR 364 the taxpayer, in working out its taxable income in an accounting period, was allowed to bring into account all discounts and rebates to which its customers were entitled (eg for prompt payment) as, in the light of past experience and policy, there was virtual certainty that the discounts and rebates would not be disallowed. In contrast, if a specific loss can be estimated but is unrealised, in that it may or may not “come home”, it has not been incurred and is not deductible until it has been realised. In ATO ID 2006/313, the Tax Office determined that a loss on a sold exchange traded option was not deductible until the option was exercised by the buyer or was closed out by the seller (or expired unexercised). [8 330] Outgoings and losses referable to future years The general position regarding the time at which an expected or possible future outgoing is incurred, and is therefore deductible, is set out in [8 300]. However, the High Court’s decision in Coles Myer Finance Ltd v FCT (1993) 25 ATR 95 seemed to revise to some degree the previous interpretation of s 51(1) ITAA 1936 (s 8-1 ITAA 1997) regarding the time at which losses or outgoings are deductible, where a liability is not satisfied until after the end of the year in which it is incurred. That case involved the proper basis of deducting discounts incurred in respect of accommodation bills of exchange and promissory notes that matured in the succeeding income year, but were not within the scope of Div 16E in Pt III ITAA 1936 (discussed at [32 400]-[32 430]). The court held that a present legal liability, on revenue account, to pay an amount in a future income year, is not sufficient to ensure that the amount is deductible in full in the income year in which the liability arises. The court held that it is also necessary to determine the extent to which the outgoing or loss is “referable to” the income year. The majority noted that the outgoing represented the cost of acquiring funds which the taxpayer put to profitable advantage in both the current and the succeeding income year. It was held that the discount should be regarded as deductible in the years to which it was ‘‘properly referable’’. On that basis, the court considered that the deduction should be apportioned on a straight-line basis over the term of the instruments. The Coles Myer Finance decision is discussed in more detail at [32 360]. The Tax Office considers that the decision in Coles Myer Finance is limited to situations where a liability comes into existence in one year but is not discharged until a subsequent year (see Ruling TR 94/25 at paras 10 and 11 and Ruling TR 94/26 at para 15) and that the ‘‘properly referable’’ rule will be most relevant to financing transactions or where liabilities accrue on a daily or periodical basis (see Ruling TR 94/26 and Ruling TR 97/7, para 26). An example of this is the general interest charge (GIC): see [8 310]. See also [8 350] (prepaid expenses). A separate ruling, Ruling TR 93/21, was issued regarding the treatment of deductions for discounts on commercial bills with terms less than 12 months: see [32 360]. The following cases illustrate the application and limitations of the ‘‘properly referable’’ principle. © 2017 THOMSON REUTERS

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In FCT v Woolcombers (WA) Pty Ltd (1993) 27 ATR 302, the Full Federal Court held that certain amounts incurred under forward contracts for the purchase of wool from woolgrowers were wholly deductible in the income year in which the contracts were entered into, not the later year in which the wool was shorn, delivered and paid for. The decision in Coles Myer Finance was distinguished on the ground that the outgoing in question was incurred in respect of the acquisition of trading stock, which was inherently different from a loss (ie a discount expense) incurred by a financier in obtaining funds used in a money-lending business. It was held that the payments were properly referable or attributable to the income year in which they were incurred and should not be apportioned over that and the following year. The Woolcombers case confirmed, therefore, that the principle established in Raymor and other cases (see [8 310]) was not overridden by the Coles Myer Finance case. In FCT v Citylink Melbourne Ltd (2006) 62 ATR 648 (see [8 310]), the High Court rejected the Commissioner’s argument that concession fees for the right to operate a toll road, incurred semi-annually but payable on the redemption of ‘‘concession notes’’ many years later, were ‘‘properly referable’’ to the periods in which the notes would be redeemed as their payment fell to be made out of assessable income of those years. The court found that the advantages or gains referable to each concession fee came home in the period in respect of which the fee was payable, not in the period in which the fee was actually payable. In contrast, in Merchant v FCT (1999) 41 ATR 116, it was held that the Coles Myer Finance decision would apply to lease and management fees payable under an afforestation scheme.

Prepaid expenses The Tax Office considers that the decision in the Coles Myer Finance case does not apply to prepaid amounts if the liability is fully discharged by the payment and does not continue into a new income tax year: Ruling TR 94/25. There are, however, statutory restrictions affecting the timing of deductions for prepaid expenses, including interest, lease payments and insurance premiums. The prepayment rules are discussed at [8 350]-[8 400]. A prepayment may be non-deductible capital expenditure, such as the 25-year lease prepayment in AAT Case 10,297 (1995) 31 ATR 1058. Contrast this with FCT v Brand (1995) 31 ATR 326, where a 7-year prepayment of licence fees was held to be fully deductible in the year in which it was made. A prepaid expense (that is, a payment that relates to the doing of a thing after the payment is made) must be distinguished from an amount paid for an immediate commitment or service. See, for example, ATO ID 2004/716, where the taxpayer was allowed an immediate deduction for the initial management fee in relation to an investment project since, on the facts, the taxpayer and the project manager had finalised the terms of their agreement and intended to be immediately bound to carrying them out, even though the agreement was not formally executed until the following income year. This should be contrasted with the situation in Merchant v FCT (1999) 41 ATR 116 in which the fee related to services to be provided over time: see above.

PREPAYMENTS [8 350] Prepayments – introduction Expenditure that is deductible under s 8-1 is generally deductible in full in the year it is incurred: see [8 300]. However, there are special prepayment rules in Subdiv H Div 3 in Pt III ITAA 1936 (ss 82KZL to 82KZO) that affect the timing of deductions for certain prepaid expenditure relating to a period extending beyond the income year in which the expenditure is incurred. The main features of the prepayment rules are considered in the following paragraphs. The status of the payer – individual (business and non-business expenditure), small business entity or other (business and non-business expenditure) – determines the period over 248

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[8 370]

which the deduction for the prepaid expenditure must be apportioned, if any. For the purposes of the prepayment rules, R&D activities constitute a business: s 82KZL(3). Note that the prepayment rules do not apply to a financial arrangement covered by Subdiv 250-E ITAA 1997 (see [33 100]) or a financial benefit that is provided or received in relation to such an arrangement: s 82KZLA. In addition, the prepayment rules will not apply to a Div 230 financial arrangement under the TOFA rules (see [32 050] and following). Note also that Subdiv H applies to deductible R&D expenditure incurred to associates in earlier income years (which is deductible under s 355-480): s 82KZLB.

[8 360] Excluded expenditure The prepayment rules do not apply to ‘‘excluded expenditure’’, namely expenditure that is (s 82KZL(1)): • less than $1,000 (this is the GST-exclusive amount if the taxpayer is entitled to an input tax credit in respect of the expenditure: see ATO ID 2004/398); • required to be made by a Commonwealth, State or Territory law or by a court order. Expenditure required to be made by a Commonwealth, State or Territory law is seemingly intended to cover statutory fees and charges (eg car registration fees) and does not cover audit fees as they are not required to be paid by law (even though the Corporations Act 2001 requires a company to have its accounts audited each year): see ATO ID 2006/218; • under a contract of service (ie salary or wages); • of a capital nature and does not qualify for a notional deduction under the R&D tax concessions in Div 355 ITAA 1997 (see [11 070]); • of a private or domestic nature; • incurred by a general insurance company by way of apportionable issue costs (commonly referred to as acquisition costs in the general insurance industry); or • incurred by a general insurance company in payment of treaty non-proportional reinsurance premiums and reinsurance premiums that are not deductible because of s 148(1) ITAA 1936 (see [35 720]). If 2 or more prepayments, each of less than $1,000 are made for the purpose of exploiting the $1,000 threshold for ‘‘excluded expenditure’’, Pt IVA may be invoked to deny the advantage: Determination TD 93/118. If a payment includes an amount in advance and an amount in arrears, the prepayment rules do not apply to that part of the payment which is in arrears: see ATO ID 2003/1073.

[8 370] Small business entities and non-business individuals The 12-month prepayment rule applies if (s 82KZM(1)): • the taxpayer is a small business entity (see [25 020]) and it has not chosen to apply s 82KZMD (see [8 380]) – note that s 82KZM will also apply to an entity that is winding up a business and which was an STS taxpayer for the year in which it stopped carrying on that business(s 328-111 TPA); • the taxpayer is an individual and the expenditure is not incurred in carrying on a business; or • the obligation to pay the expenditure arises from an agreement made before 11.45 am on 21 September 1999 AEST and the taxpayer cannot unilaterally escape this obligation (a ‘‘pre-RBT obligation’’). In all cases, the prepaid expenditure must not be excluded expenditure (see [8 360]) and must be deductible under s 8-1 ITAA 1997 or Div 355 (this is a notional deduction in respect of R&D expenditure: see [11 020]-[11 090]). © 2017 THOMSON REUTERS

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If the eligible service period is longer than 12 months, or is 12 months or less but ends after the end of the income year following that in which the expenditure is incurred, the deduction is spread (on a daily basis) over the eligible service period: s 82KZM(1). The ‘‘eligible service period’’ for the purposes of the prepayment rules generally starts on the day when the thing to be done is required or permitted to commence being done and ends on the day when it is required or permitted to cease being done or 10 years from the start date, whichever is the earlier (ie the ‘‘eligible service period’’ cannot exceed 10 years): s 82KZL(1). The eligible service periods for prepayments of interest, rent, lease payments and insurance premiums are respectively (s 82KZL(2)): • the period to which the interest relates (not the term of the loan); • the period to which the rental or lease payment relates (not the term of the rental or the lease agreement); and • the period during insurance cover is provided. A consequence of the prepayment rule is that, if the eligible service period is 12 months or less and ends in the expenditure year or the income year immediately following, the expenditure is deductible outright. Note that the prepayment rules operate subject to the commercial debt forgiveness provisions and thus the deductible amount of prepaid expenditure may be reduced where a commercial debt is forgiven: see [8 700]. EXAMPLE [8 370.10] Company A (a small business entity) renegotiates the lease of its business premises. The lessor is prepared to offer a discount for early payment. Company A accepts the offer and pays 2 years’ rent in advance, with the term and the renegotiated lease commencing on 1 March 2017. The amount paid in advance is: $ Monthly rental $6,000 for 24 months 144,000 less 10% discount for early payment (14,400) Rental payment $129,600 The eligible service period for the rental payment is 24 months: s 82KZL(2). Company A (which has not chosen to apply s 82KZMD) is entitled to deduct the rental payment according to the following formula: Number of days in year × Rental paid Number of days in eligible service period The schedule for deduction would thus be (amounts are rounded): 122 × $129,600 = $21,660 730 365 2017-18: × $129,600 = $64,800 730 243 2018-19: × $129,600 = $43,140 730 2016-17:

If a payment is considered to be high in relation to later payments (a ‘‘balloon’’ payment), s 82KZM may be applied to spread the payment over the period to which it relates, possibly the entire period of the agreement: Determination TD 93/119. If a taxpayer’s rights under a prepayment arrangement are transferred or are otherwise discharged, any remaining undeducted amounts may be claimed in the year of discharge or transfer: s 82KZN. If the transferee gives consideration for the transfer, the rights to deductibility are subject to these prepayment rules. 250

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[8 390]

The formation or dissolution of a partnership has the effect of transferring the rights to deductibility from the taxpayer who incurred the expenditure to the relevant new taxpayer: s 82KZO. A proportionate deduction is allowable in the year of change. All prepayments, other than those eligible for the 12-month prepayment concession discussed above, are only deductible over the period to which the expenditure relates.

[8 380] Other taxpayers Section 82KZMD determines the timing of deductions for prepaid expenditure incurred after 11.45 am on 21 September 1999 AEST by business taxpayers, including individuals, that are not small business entities that have chosen to apply s 82KZMD (the choice must be made before the relevant income tax return is lodged or such further time as the Commissioner allows): s 82KZMA(2), (3). Section 82KZMD also applies to prepaid non-business expenditure incurred by entities that are not individuals. In all cases, the prepaid expenditure must not be excluded expenditure (see [8 360]) and must not meet a pre-RBT obligation (see [8 370]). The prepaid expenditure must be deductible under s 8-1 ITAA 1997 or Div 355 (this is a notional deduction in respect of R&D expenditure: see [11 020]-[11 090]): s 82KZMA(1). Different rules apply to expenditure incurred under a tax shelter arrangement (see [8 390]) and forestry expenditure: see [8 400]. The prepaid expenditure is deductible over the eligible service period: s 82KZMD. Thus, if the eligible service period (see [8 370]) is confined to one income year, the expenditure is deductible in that year. If it covers more than one income year, the expenditure is apportioned (on a daily basis) over those years (to a maximum of 10 years) in accordance with the formula: Expenditure ×

No of days of eligible service period in the year of income Total number of days of eligible service period

EXAMPLE [8 380.10] On 10 April 2017, Chan’s Commemorative Plates Pty Ltd (which is not a small business entity) enters into an agreement with Proud Decorative Painting Pty Ltd for the latter to paint commemorative plates over a 3-year period ending on 11 April 2020. The annual fee payable by Chan’s Commemorative Plates is $50,000 and on 10 April 2017 the company prepays $150,000 to Proud Decorative Painting. The eligible service period is 1,098 days (2020 is a leap year). The deduction is apportioned over the 3-year period as follows (amounts are rounded): Income year 2016-17 (for period 10/04/17-30/06/17) $150,000 × 82/1,098 = $11,202 2017-18 $150,000 × 365/1,098 = $49,863 2018-19 $150,000 × 365/1,098 = $49,863 2019-20 (for period 1/07/19-11/04/20) $150,000 × 286/1,098 = $39,072

Sections 82KZN (transfer of rights under agreement) and 82KZO (partnership changes), discussed at [8 370], also apply in relation to expenditure covered by ss 82KZMA to 82KZMD.

[8 390] Tax shelter arrangements Section 82KZMF applies to deny immediate deductibility for certain prepaid expenditure incurred after 1 pm on 11 November 1999 AEST under ‘‘tax shelter’’ arrangements which would be otherwise deductible under s 8-1 or Div 355 (this is a notional deduction in respect of R&D expenditure: see [11 020]-[11 090]): s 82KZME(1). A ‘‘tax shelter’’ arrangement has the following features (s 82KZME): • the taxpayer’s allowable deductions for the expenditure year attributable to the arrangement exceed assessable income (if any) for the income year attributable to the arrangement; © 2017 THOMSON REUTERS

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• the taxpayer (eg in a passive investment such as a retail financial product or other managed investment that does not constitute the carrying on of a business) does not have day-to-day control over the operation of the arrangement whether or not the taxpayer has the right to be consulted, give directions or arrange finance or occasionally participates in activities: see Determination TD 2005/26; and • there is more than one participant in the arrangement in the same capacity as the taxpayer, or the manager or promoter of the arrangement, or an associate of that person, manages or promotes similar arrangements for other taxpayers. If s 82KZMF applies, the deduction is spread evenly over the 2 income years in question. EXAMPLE [8 390.10] Kirk makes a prepayment of $50,000 for services in relation to a managed vineyard. The services are to be provided between 20 March 2017 and 27 November 2017 (253 days in total). The deduction is spread over the 2 income years as follows: 2016-17: $50,000 × 105/253 = $20,751 2017-18: $50,000 × 148/253 = $29,249

Excluded prepayments The rules do not apply to prepaid expenditure that is: • an insurance premium for building, contents or rent protection insurance; • interest on a loan to acquire real property (or an interest in real property), publicly listed shares or units in widely held unit trusts where the only income derived (or reasonably expected) from the arrangement is rent, dividends or trust income and the arrangement is conducted at arm’s length (see [5 260] for a discussion of whether parties are dealing at arm’s length). This covers investments that are usually negatively geared. This would also apply to an investment in instalment warrants over certain stapled securities: ATO ID 2003/1119; • excluded expenditure: see [8 360]; • expenditure under a pre-RBT obligation: see [8 360]; and • expenditure under an arrangement covered by a Tax Office product ruling made on or before 1 pm on 11 November 1999 AEST, or in response to an application on or before that time, if the ruling specifies the expenditure is deductible.

[8 400] Forestry expenditure Initial investors in a forestry managed investment scheme (MIS) are entitled to an immediate deduction (under Div 394 ITAA 1997) for their investment, provided at least 70% of the expenditure is ‘‘direct forestry expenditure’’. Division 394 is discussed at [11 600]. The manager of an agreement for the planting and tending of trees is assessable on any amount received under the agreement, provided the requirements of s 82KZMG are satisfied: s 15-45. The amount is assessable in the income year in which the investor paying the amount is first able to claim the corresponding deduction. Note TA 2008/11, which raises concerns about the application of Div 394 to land impairment trust arrangements associated with a forestry MIS.

TAX AND OTHER LOSSES [8 450] Tax losses – overview Taxpayers other than corporate tax entities may be able to treat tax losses that arose in earlier income years (prior year tax losses) as an allowable deduction against assessable 252

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[8 450]

income derived in the current income year: s 36-15. A similar provision (s 36-17) allows corporate tax entities to deduct prior year tax losses (but subject to special rules relating to the ownership or control of the entity, or the business carried on by the entity): see [20 250]-[20 400]. The extent to which a prior year tax loss can be deducted will depend on the amount of assessable income and other deductions of the current income year, when the tax loss was incurred, the type of tax loss, whether the taxpayer has also derived any exempt income and special rules applicable to particular taxpayers. A prior year loss may only be deducted to the extent it has not already been utilised: s 960-20(1). Note the restrictions in Div 35 ITAA 1997 on deducting losses from non-commercial business activities: see [8 600].

What is a tax loss? A tax loss arises in any income year in which the taxpayer’s allowable deductions exceed assessable income (ignoring tax losses of earlier income years), provided that excess also exceeds any net exempt income for the year: s 36-10. This can be expressed as the following formula: Tax loss = [Allowable deductions − Assessable income] − Net exempt income

Assessable income includes net capital gains: see [14 360]. The deductible amount for certain types of allowable deductions may be limited under s 26-55 if to deduct the full amount otherwise deductible would result in a tax loss arising or increase a tax loss: see [8 500]. This limitation is applied on an overall basis to the total of all deductions of this type. The amount used for allowable deductions in the above formula is the amount after taking into account the limit on these types of deductions. Note that under the shipping reforms discussed at [11 700], if the taxpayer has exempt income from shipping activities (ie under s 51-100), 90% of so much of the taxpayer’s net exempt income as directly relates to that exempt income is to be disregarded: s 36-10(5). In Re McEvoy and FCT (2001) 46 ATR 1183, an assets betterment statement and a list of creditors was not sufficient to establish that the taxpayer had made a tax loss. In Re The Trustee for the Payne Superannuation Fund and FCT [2015] AATA 58, the taxpayer could not carry forward the excess of losses and outgoings relating to its exempt income to be offset against exempt income of a future year.

Capital losses – exclusion Capital losses are ‘‘quarantined’’ in that they are only taken into account in determining the amount of a net capital gain or net capital loss (and are not deductible in their own right). A prior year net capital loss will therefore only be taken into account in determining the amount of a net capital gain in a later income year. See [14 360]-[14 380]. The rules governing the treatment of capital losses of a corporate tax entity are considered at [20 270]. The treatment of foreign capital losses is dealt with at [8 570].

Other losses – special treatment The rules about deductibility and use of tax losses require them to be divided into various categories. The basic treatment per the above formula for determining a tax loss and the rules as to deductibility and use outlined at [8 450]-[8 580] apply generally to Australian source tax losses of a revenue nature incurred by a taxpayer. Special restrictions apply to foreign capital losses (see [8 570]). In relation to deductibility in the current income year or future income years of some Australian prior year tax losses, different rules apply according to the year in which they were incurred and whether they were primary production losses or not. © 2017 THOMSON REUTERS

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Specific taxpayers – special rules Special rules governing the treatment of tax losses apply to the following entities: • corporate tax entities (eg companies): see [20 260]; • listed public companies: see [20 550]-[20 590]; • trusts: see [23 230]; • pooled development funds: see [11 530]; and • CFCs: see [34 350] and following.

[8 460]

Prior year tax losses – deduction

The method for deducting prior year tax losses incurred by taxpayers other than corporate tax entities is governed by s 36-15. The derivation in any income year of exempt income not only affects the manner in which a tax loss for an income year is calculated (see [8 450]), it also affects the manner in which prior year tax losses are deducted or utilised. This applies not just in the year in which there is excess assessable income for a tax loss to be offset against, but also where exempt income is derived in intervening years between the year in which the tax loss was incurred and the first year in which an excess of assessable income is available. The effect of the commercial debt forgiveness provisions on prior year losses should be noted: see [8 700]. It is prudent for a taxpayer who has incurred a tax loss, or made a net capital loss, for an income year to retain records relevant to the ascertainment of that loss until the later of the end of the statutory record retention period (eg under s 262A ITAA 1936: see [46 300]) and the end of the statutory period of review for an assessment for the income year when the tax loss is fully deducted or the net capital loss is fully applied (see [47 120] and following): see Determination TD 2007/2.

Deducting a tax loss Deduction of a tax loss is used in 2 distinct senses. It can either be deducted against an excess of assessable income over other allowable deductions or it can be deducted against net exempt income. It can also be deducted against some combination of each. Note that non-assessable non-exempt income (see [7 700]) has no effect on a tax loss. Which of these alternatives applies will depend upon the extent and timing of the derivation of such excess assessable income or net exempt income, the amount of the tax loss, when it was incurred in comparison to other available tax losses and the rules laid down in s 36-15. It is not a matter of choice as to whether to apply the tax loss against excess assessable income or net exempt income, nor is it a matter of choice as to when to deduct a tax loss. Section 36-15 is obligatory in its application (AAT Case 5150 (1989) 20 ATR 3607 decided the same issue under the former provisions).

Deduction against excess assessable income When a tax loss is deducted against excess assessable income, it is treated for this purpose the same as any other allowable deduction incurred in an income year, except that the maximum deduction for use of a tax loss in this manner is always limited to the amount of that excess. In other words, deduction of a tax loss cannot itself give rise to a new tax loss. What would otherwise be the taxable income for the year is reduced by the deduction for the carried forward tax loss. Any unused portions of a tax loss that is deducted in this manner or any other unused carried forward tax losses remain attached to the year in which they were incurred and continue to be carried forward. 254

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[8 480]

Deduction against net exempt income When a tax loss is deducted against net exempt income (see [8 480]), both the tax loss and net exempt income are used up to the extent of the deduction and are therefore not regarded as existing for other purposes for which it would otherwise be necessary to have regard to them. Thus, the tax loss (to the extent that it is used against net exempt income) is no longer available for deduction against excess assessable income either in the current income year or by carry forward into future income years. [8 470] Order of deduction Disregarding carried forward prior year tax losses, a taxpayer’s assessable income may exceed allowable deductions (excess assessable income) or allowable deductions may exceed assessable income (excess allowable deductions). In either case this may or may not be accompanied by the derivation of net exempt income. If there are excess allowable deductions for an income year, whether a new tax loss will be created for that year and its amount depends upon whether there was also net exempt income in that year: see [8 480]. A carried forward tax loss is deducted in later income years in accordance with the following rules: (a) if there is excess assessable income and no net exempt income, the tax loss is deducted from the excess assessable income: s 36-15(2); (b) if there is excess assessable income and also net exempt income, the tax loss is deducted first from the net exempt income, with any remainder being deducted from the excess assessable income: s 36-15(3); and (c) if there are excess allowable deductions and also net exempt income, the tax loss is deducted from the net exempt income, but only to the extent that the net exempt income exceeds the excess allowable deductions: s 36-15(4). Section 36-15 does not provide for a situation where assessable income is equal to allowable deductions and net exempt income is derived. On a literal reading of the ITAA 1997, a taxpayer would not need to deduct a tax loss against net exempt income in these circumstances. However, it is submitted that it is the intention of the provisions as a whole that this should be treated in the same manner as situation (c) above, with excess deductions being regarded as zero and the tax loss being deducted against the net exempt income. In deducting carried forward tax losses in the above manner, they are deducted in the order in which they were incurred (ie earlier years first): s 36-15(5); see also [8 460]. A tax loss can be deducted only to the extent it has not already been utilised: former s 36-15(6), s 960-20. Similar rules apply in relation to carried forward tax losses of a corporate tax entity: see [20 260]. Note that, under the commercial debt forgiveness provisions, the amount of a debt that is forgiven first reduces prior year revenue losses: see [8 700].

[8 480] Net exempt income – meaning ‘‘Net exempt income’’, which is used in determining whether a tax loss exists (see [8 450]) and the manner in which that tax loss is required to be deducted (see [8 470]), is defined in s 36-20. The meaning varies depending upon whether the taxpayer is a resident or foreign resident. ‘‘Exempt income’’ is defined in s 6-20. In essence, ordinary income is exempt income if specifically made exempt or if excluded (expressly or by implication) from being assessable income, whereas statutory income is only exempt income if specifically made exempt: see [7 020]. © 2017 THOMSON REUTERS

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Resident For a resident, net exempt income is the amount by which exempt income from all sources exceeds the total of non-capital losses and outgoings incurred in deriving it and taxes payable outside Australia on it: s 36-20(1). Losses and outgoings in this context seemingly do not include losses and outgoings of earlier income years: see Re The Trustee for the Payne Superannuation Fund and FCT [2015] AATA 58. Non-assessable non-exempt income (see [7 700]) is ignored in calculating net exempt income. This includes (where appropriate): • foreign source income arising under ss 23AH, 23AI, 23AK, 99B(2)(d), or 99B(2)(e) ITAA 1936 or Subdiv 768-A ITAA 1997 (see generally Chapter 34); • employee benefits taxed as fringe benefits: s 23L (see [7 060]); and • certain personal services income included in the assessable income of an individual (see [6 130]).

Foreign resident For a foreign resident, net exempt income is the amount by which exempt income from sources in Australia and exempt film income (under s 26AG) exceeds the total of non-capital losses and outgoings incurred in deriving either and taxes payable outside Australia on the exempt film income: s 36-20(2). Losses and outgoings in this context seemingly do not include losses and outgoings of earlier income years: see Re The Trustee for the Payne Superannuation Fund and FCT [2015] AATA 58. [8 490] Order of recoupment Tax losses are in most cases deducted in the order in which they were incurred (ie earlier years first): ss 36-15(5), 36-17(7). EXAMPLE [8 490.10] A taxpayer carries on business in Australia with the following results. $ Year 1 ....................................................................................... 10,000 Loss Year 2 ....................................................................................... 5,000 Loss Year 3 ....................................................................................... 3,000 Loss Year 4 ....................................................................................... 500 Profit Year 5 ....................................................................................... 3,000 Profit Year 4 – deduction of part of loss $ Taxable income before adjusting for losses for prior years...................... 500 Loss incurred Year 1 ................................................................................. 10,000 Balance of loss Year 1 to be carried forward ........................................... 9,500 Year 5 – deduction of part of loss Taxable income before adjusting for losses for prior years...................... 3,000 Balance on loss Year 1 ............................................................................. 9,500 Balance of loss Year 1 to be carried forward ........................................... 6,500 This procedure continues in future years until the Year 1 loss is used up and then the Year 2 loss commences to be used.

[8 500] Limit on certain deductions – tax loss situation Various categories of otherwise allowable deductions cannot produce or increase a tax loss for any taxpayer, including corporate tax entities: s 26-55. These categories are: • gifts (see [9 800] onwards); 256

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[8 580]

• conservation covenants (see [9 900]); • personal superannuation fund contributions (see [39 200]); and • pensions, gratuities or retiring allowances (see [9 1210]). The total of these categories of deductions is limited to the amount of assessable income remaining after deducting from the assessable income of the income year all other deductions, except prior year tax losses (see [8 460]) and deductions for farm management deposits (see [27 600]). Note that s 26-55 does not operate to limit a deduction available under another provision of the income tax legislation, such as s 8-1. EXAMPLE [8 500.10] Generous Pty Ltd made a gratuitous payment of $150,000 to its retiring major shareholder and managing director, Happy Worker, and claimed a deduction pursuant to s 25-50. Generous Pty Ltd’s assessable income before the payment amounted to $81,000. The amount of the deduction under s 25-50 is $81,000, ie Assessable income less retirement payment – limited to extent of taxable income Taxable income Deduction forgone

$ 81,000 81,000 Nil 69,000

[8 540] Venture capital losses An eligible non-resident partner in a venture capital limited partnership (VCLP), an early stage venture capital limited partnership (ESVCLP) or an Australian venture capital fund of funds (AFOF), or an eligible venture capital investor, cannot deduct its share of any loss made on the disposal of an eligible venture capital investment: s 26-68 ITAA 1997. Conversely, any profits made on the disposal of such investments are exempt: see [7 470]. There are also CGT exemptions: see [15 650]. A tax loss incurred by a limited partnership before it becomes a VCLP, ESVCLP, AFOF or venture capital management partnership (VCMP) is not deductible to the relevant entity: s 195-65. However, if a limited partnership ceases to be a VCLP, ESVCLP, an AFOF or a VCMP, any tax loss that occurred before the partnership became such an entity will qualify for a deduction under Div 36: s 195-70. If the status of a VCLP, ESCVLP, AFOF or VCMP changes during an income year, the entity will have at least 2 income years, in which case, the Commissioner may modify the operation of the income tax law to take account of the fact that a particular accounting period is less than 12 months: s 195-75. [8 560] Partnership and trust losses A partnership loss is available for allocation to the partners in accordance with their respective interests in the partnership: see [22 100] and [22 110]. A trust may have to satisfy ownership, control and/or income injection tests in order to deduct a prior year or current year loss: see [23 800]-[23 1270]. [8 570] Foreign capital losses Special rules concerning foreign capital losses of an overseas permanent establishment of a resident company (s 23AH ITAA 1936) are considered at [34 120]. [8 580] Losses before bankruptcy Section 36-35(1) provides that if, before the income year, a taxpayer has become a bankrupt, or has been released from any debts by the operation of an Act relating to © 2017 THOMSON REUTERS

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bankruptcy, any tax losses incurred before the date on which the taxpayer became a bankrupt or was so released are not deductible. In Re Scott and FCT (2002) 51 ATR 1001, an argument that this restriction only applies to amounts that the taxpayer is no longer required to pay because of the bankruptcy was rejected. If a bankruptcy is annulled pursuant to arrangements under which debts are released, the annulment is ignored and the tax losses are still not deductible: s 36-35(2). As to the effect of other annulments, see Oates v FCT (1990) 21 ATR 1165. However, if the taxpayer subsequently pays a debt incurred in a preceding year and the debt (at least in part) arose from the incurrence of an outgoing that formed part of a loss disqualified from deductibility under the above provisions, the deduction for that part of the loss actually subsequently paid (in paying the debt) can be obtained in that year of payment (subject to certain safeguards): ss 36-40 and 36-45; see also Determination TD 93/10.

NON-COMMERCIAL LOSSES [8 600] Restriction on deducting non-commercial losses The non-commercial loss rules in Div 35 in Pt 2-5 ITAA 1997 are designed to restrict losses from a non-commercial business activity from being offset against income from other sources, unless the activity satisfies one of the ‘‘commerciality tests’’ discussed at [8 620] or the Commissioner exercises the discretion not to apply the rules (see [8 640]). If the rules apply, the non-commercial loss is deferred and may be offset in a later year against profits from the same activity or, in certain circumstances, against other income. Division 35 does not apply to ‘‘low income’’ primary producers and professional artists: see [8 610]. Note also that non-commercial losses made by taxpayers with an adjusted taxable income exceeding $250,000 are quarantined: see below. The rules apply if an individual, either alone or in partnership, carries on a ‘‘non-commercial’’ business activity and the deductions attributable to that activity in an income year exceed the assessable income (if any) from that activity in that income year (ie a loss is made). The loss cannot be offset against other assessable income in that year unless an exception applies: (see [8 620]): s 35-10(2). For these purposes, the amounts attributable to the business activity that an individual taxpayer can otherwise deduct are all those amounts otherwise deductible under the income tax law, to the extent that they relate to the carrying on of the particular business activity in the income year in question: Ruling TR 2001/14. According to the ruling, the expression ‘‘attributable to’’ requires a ‘‘causative connection’’ with the activity, in the sense of being sourced from or originating in some element of the business activity. This view is supported by the decision in Watson v DCT (2010) 75 ATR 224 (noted at [8 620]). If a deduction is attributable to more than one income-producing activity and one is a non-commercial business activity, the deduction may have to be apportioned: see Determination TD 2006/61. Business activities The non-commercial loss rules only apply to losses from a business activity. The meaning of ‘‘business’’ is discussed at [5 020]. In this context, the distinction between a business and a hobby may be important: see [5 030] and following. The Division does not apply to activities that do not constitute the carrying on of a business, for example the receipt of income from a passive investment (eg rental income from an investment property or dividends from shares where the taxpayer is not a share trader): s 35-5(2); Ruling TR 2001/14. An activity will be a ‘‘business activity’’ if it is capable of standing alone as an autonomous commercial undertaking: Ruling TR 2001/14. In Re HVZZ and FCT [2015] AATA 133, investing significant capital and introducing new stock in a horse breeding business, as well as employing an expert farm manager, did not create a new business activity. A beneficiary of a trading trust is not considered to be carrying on the business of the 258

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[8 600]

trust: Doherty v FCT (1933) 48 CLR 1 and Tindal v FCT (1946) 72 CLR 608. Ruling TR 2005/1 provides guidance in determining whether a business of a professional artist is being carried on. Business activities of a similar kind may be grouped together as one activity: s 35-10(3). This is not compulsory although it is likely to benefit the taxpayer. For example, an olive grower who produces and sells olive oil may also start an olive bottling business. These are similar activities and may be treated as one activity. However, if the olive grower also produces an insecticide for olives and earns royalties from its patent, that activity is of a different kind so would be treated separately. It is a question of fact and degree whether business activities are of a similar kind. Ruling TR 2001/14 states that this involves a comparison of the relevant characteristics of each business, for example the location(s) where they are carried on, the type(s) of goods and/or services provided, the market(s) conditions in which those goods and/or services are traded, the type(s) of assets employed in each and any other features affecting the manner in which they are conducted. The ruling also states that the broader in nature any business activities are, the more likely it is that they will have similar characteristics. See also Re Heaney and FCT (2013) 96 ATR 150, where it was held that the taxpayer’s cattle and sheep farms constituted discrete business activities and not a single farming business. If an individual taxpayer carries on multiple business activities in partnership, any excess of their share of otherwise allowable deductions over their share of any assessable income, for each separate business activity, will be subject to the requirements of Div 35, and may be deferred under s 35-10(2) to the next year the activity in question is carried on: see Ruling TR 2003/3. The application of Div 35 to business activities carried on in partnership is considered further at [22 120]. When a business ceases, certain ongoing expenses (such as interest) may continue to be deductible in later income years: see [8 090]. Such amounts are not subject to the non-commercial loss rules as no business activity is being conducted in the year the expenses are incurred: see Ruling TR 2001/14, paras 58 and 131-132.

Loss may be carried forward If s 35-10(2) prevents a loss from a non-commercial business activity being offset against other assessable income, the loss may be carried forward and offset against assessable income from the same activity for the next income year in which the activity is carried on. In addition, the loss is no longer deferred if, in a future income year, the particular business activity ceases to be non-commercial (ie in that year the activity passes one of the 4 commerciality tests). In that case, the loss may be offset in that year against assessable income from other sources. However, if the business activity ceases, any unused deferred loss is effectively forfeited unless that, or a similar, business activity recommences. Similarly, if a sole trader incorporates, any non-commercial losses cannot be carried forward and used by the company. A non-commercial loss that is carried forward under Div 35 is to be reduced by any net exempt income that has not already been utilised under the tax loss rules in Div 36 in Pt 2-5 (see [8 450]-[8 500]): s 35-15. The reduction occurs before the loss is offset against assessable income from the business activity. Section 35-15 will not apply in relation to deferred pre-business or post-business capital expenditure (see below). If a taxpayer becomes bankrupt, or is released from a debt under bankruptcy law or a scheme of arrangement, before any deferred non-commercial loss has been offset, the loss is no longer available for deduction: s 35-20 (this will also apply in relation to post-business capital expenditure: see below). Income test for high income earners Taxpayers with an adjusted taxable income of $250,000 or more are prevented from offsetting excess deductions from non-commercial business activities against salary and wage income: s 35-10(2E). Adjusted taxable income is the sum of the taxpayer’s taxable income, © 2017 THOMSON REUTERS

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reportable fringe benefits total (see [59 200]), reportable superannuation contributions (see [39 140]) and net investment losses (see [19 160]) for the income year. Those taxpayers will instead have excess deductions quarantined to the business activity, although they will still be able to request the Commissioner to exercise the discretion to not apply the rules (see [8 640]). EXAMPLE [8 600.10] Edmund is the CEO of an Australian company. His salary for 2016-17 is $380,000. He also has a ‘‘hobby farm’’, valued at over $1m, which runs at a loss each year. In 2016-17, the farm makes a loss of $40,000. Edmund cannot deduct the losses in working out his 2016-17 taxable income. The losses are retained, but they can only be used to offset future income from the farm.

[8 610] Where restrictions do not apply The restrictions in Div 35 on deducting a non-commercial loss do not apply in the following circumstances: • the loss does not arise from a business activity: see [8 600]; • the loss arises from a primary production or professional arts business and the taxpayer’s assessable income for the year from other sources is less than $40,000: see below; • the taxpayer satisfies one of the ‘‘commerciality tests’’ (ie the assessable income, profits, real property or other assets test): see [8 620]; or • the Commissioner exercises the discretion not to apply Div 35: see [8 640].

Primary producers/professional artists exemption The Div 35 Pt 2-5 rules do not apply to losses from a primary production or professional arts business if assessable income for the year from other sources that do not relate to that activity (eg salary and wages) is less than $40,000 (net capital gains are excluded): s 35-10(4). Such losses may therefore be offset against other assessable income. Persons carrying on a professional arts business include authors, playwrights, artists, sculptors, composers, performing artists and production associates: s 35-10(5). The Tax Office’s views on whether an artist is carrying on business as a ‘‘professional artist’’ are set out in Ruling TR 2005/1. The manager or agent of a professional artist will not be carrying on a professional arts business, nor it seems is an art gallery owner who exhibits other people’s works. Perhaps unsurprisingly, a driving instructor who used his own written materials for lessons was held not to be a professional artist in Re Farnan and FCT (2005) 58 ATR 1350. Re Pedley and FCT (2006) 62 ATR 1014 is an example of where a taxpayer was carrying on business as a professional artist. [8 620] Commerciality tests The non-commercial loss rules do not prohibit the offset of losses if any of the following commerciality tests are satisfied: s 35-10(1). 1. Assessable income test – assessable income (ie ordinary and statutory income) from the business activity for the income year is at least $20,000, or would reasonably be estimated to be at least $20,000 if the activity were carried on for the whole year: s 35-30. Ruling TR 2001/14 discusses how to make a reasonable estimate (there is nothing in the ITAA 1997 that allows an estimate to be later revoked). The ruling also states that funds repaid from a farm management deposit may be assessable income from the particular business activity (see Example 5A). Any increase in value of the taxpayer’s trading stock that is brought to account under s 70-35(2) (see 260

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[8 620]

[5 230]) and a balancing adjustment that arises if the termination value of a depreciated asset exceeds the written down value (see [10 850]) should be assessable income for the purposes of this test as they are ‘‘from the business activity’’. Interest from a business bank account should also be included. In Watson v DCT (2010) 75 ATR 224, payments under an income replacement policy to an individual who carried on a financial planning business were not income from the business activity as they were personal to the taxpayer. Accordingly, those payments could not be offset against losses from the business. 2. Profits test – the activity has made a profit (for tax purposes) in at least 3 of the past 5 income years, including the current year (in the case of a partnership, it is the taxpayer’s share of partnership income and deductions that is taken into account): s 35-35. A change of ownership in a particular year will not seemingly prevent ‘‘profits’’ from a business activity, made under a previous owner, from being taken into account for the purpose of this test, provided there is a sufficient continuity of identity of the business activity (this may include where the taxpayer purchases a primary production business from a family trust: see Example 6A in Ruling TR 2001/14). Quarantined pre-business capital expenditure otherwise deductible under s 40-880 (see [10 1150]) but for the operation of s 35-10(2C) (see [8 630]) will not affect the operation of the profits test in the current income year. 3. Real property test – the total value of real property, or interests in real property, used on a continuing basis in carrying on the activity is at least $500,000: s 35-40. The higher of market value (see [3 210]) or reduced cost base is used, worked out at the end of the year or, if appropriate, when the business activity ceased or the asset was disposed of. Dwellings, and adjacent land used in association with the dwelling, used mainly for private purposes are excluded, along with any tenant’s fixtures (see Ruling TR 2001/14, paras 64A-64C). If real property has become a partnership asset that is used in carrying on the partnership business activity, a partner who does not have legal title to the property may include the value of the property for the purposes of determining whether they satisfy the real property test: see Ruling TR 2001/14, para 63C. 4. Other assets test – the total value of other assets used on a continuing basis in carrying on the activity is at least $100,000: s 35-45. Other assets relevant for this test are depreciable assets, trading stock, assets leased from another entity and trademarks, patents, copyrights and similar rights (in ATO ID 2004/715, the Tax Office said that ‘‘similar rights’’ refers to any rights which protect the product of one person’s work by hand or brain against unauthorised use or exploitation by another – the ATO ID was withdrawn but only because it was considered to be a straightforward application of the law). Cars, motorcycles and similar vehicles are excluded (see [9 100] for the definition of a ‘‘car’’). All-terrain Vehicles (ATVs) and agricultural motorcycles (ag-bikes) are considered to be motorcycles for these purposes and are therefore excluded. A 2-tonne truck is not a ‘‘car’’ or ‘‘similar vehicle’’ and therefore can be included. A rally car may be a ‘‘car’’ for these purposes (see Example 7B in Ruling TR 2001/14). The value of an asset depends on what type it is, eg written down value if a depreciating asset (see [10 540]), closing value if trading stock (see [5 220]) and reduced cost base if intellectual property: see [14 090]. The value is worked out at the end of the income year or, if the business activity ceases during the year, at the time of cessation or any earlier disposal of the asset. If real property or an asset is used partly in carrying on the business activity and partly for other purposes, the value is apportioned for these purposes (ie tests 3 and 4): s 35-50. If the taxpayer carries on a business activity in partnership with an entity, only that part which is attributable to the interests of the individuals in the partnership is taken into account for the purposes of the assessable income, real property and other assets tests: s 35-25. Assets used in © 2017 THOMSON REUTERS

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the business activity that are not partnership assets are ignored. The Commissioner’s views on the use of real property or assets on a ‘‘continuing basis’’ are set out in Ruling TR 2001/14.

[8 630] Pre-business and post-business capital expenditure Certain pre-business and post-business capital expenditure (‘‘blackhole expenditure’’) may be deducted over 5 income years (s 40-880 ITAA 1997): see [10 1150]. The non-commercial loss provisions will apply to such expenditure in certain circumstances. An individual taxpayer will not be able to deduct under s 40-880 pre-business capital expenditure, in relation to a business activity the taxpayer proposes to carry on (either alone or in partnership), for an income year before the one in which the business activity starts to be carried on: s 35-10(2B)(a). However, such expenditure is deemed to be attributable to the business activity in the income year the activity starts to be carried on and is deductible in that income year subject to the non-commercial rules in Div 35: s 35-10(2C). Thus, in the income year a business activity starts to be carried on, a loss (including the deductible pre-business capital expenditure) from the business activity can only be offset against other income if one of the 4 commerciality tests discussed at [8 620] is satisfied, the Commissioner has exercised the discretion not to apply the rules (see [8 640]) or the business activity is a primary production or professional arts business and the income from other sources was less than $40,000: see [8 610]. The loss may be carried forward in accordance with the rules discussed above. Similarly, an individual taxpayer cannot deduct under s 40-880 pre-business capital expenditure, in relation to a business activity another entity (that is not an individual) proposes to carry on (either alone or in partnership), for an income year before the one in which the business activity starts to be carried on: s 35-10(2B)(b). However, the expenditure is deductible in the year the business activity starts to be carried on by the other entity: s 35-10(2D). Post-business capital expenditure, in relation to a business activity an individual taxpayer used to carry on (whether alone or in partnership), will not be deductible under s 40-880 unless the non-commercial loss rules are satisfied for the income year in which the business activity ceased to be carried on or an earlier income year: s 35-10(2A). In other words, the expenditure will not be deductible unless one of the 4 commerciality tests discussed at [8 620] was satisfied, the Commissioner exercised the discretion not to apply the rules (see [8 640]) or the business activity was a primary production or professional arts business and the income from other sources was less than $40,000: see [8 610]. [8 640]

Commissioner’s discretion not to apply non-commercial loss rules The Commissioner has a discretion not to apply the non-commercial loss rules for one or more income years (and thus a loss from a business activity could be offset against other assessable income) in certain circumstances where the relevant business activity has started to be carried on: s 35-55. The Commissioner may exercise the discretion if it would be unreasonable to apply the non-commercial loss rules because: • the business activity was or will be affected by special circumstances outside the taxpayer’s control (see below); • if a taxpayer satisfies the income requirement (ie adjusted taxable income does not exceed $250,000: see [8 600]), the nature of the business activity is such that it will not satisfy the commerciality tests during the income year(s) in question but the activity is objectively expected to make a profit, or pass one of the commerciality tests, within a commercially viable period (for the industry concerned); or • if a taxpayer does not satisfy the income requirement, the nature of the business activity is such that it has not, and will not, produce a tax profit for the year in question and there is an objective expectation that it will make a tax profit within a commercially viable period (for the industry concerned).

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[8 640]

The exercise of the discretion is to be based on an assessment of the facts of each case, having regard to the language of the section and the policy and context of the non-commercial loss rules: Ruling TR 2007/6. Note that the discretion can be exercised at any time in respect of an income year or years in the period until the activity is expected to produce a profit or pass one of the commerciality tests, as appropriate.

Special circumstances Special circumstances are those that are unusual, uncommon or exceptional, which are sufficiently different to distinguish them from the circumstances that occur in the normal course of conducting a business activity: see Ruling TR 2007/6. It is important that the special circumstances are outside the taxpayer’s control. Ordinary economic, weather or market fluctuations that might reasonably be predicted to affect the business activity are not special circumstances. Examples of special circumstances are drought, flood, bushfire or some other natural disaster (eg a cyclone, hailstorm or tsunami: see Ruling TR 2007/6): s 35-55(1)(a). Other situations that may constitute special circumstances, depending on the facts, include oil spills, chemical spray drifts, explosions, disturbances to energy supplies, government restrictions and illnesses affecting key personnel: Ruling TR 2007/6. The non-payment of amounts owing by clients is not a special circumstance: Re Delandro and FCT (2006) 64 ATR 1129. In Re Delacy and FCT (2006) 62 ATR 1053, it was the inherent nature of an olive growing business (320 trees could not be expected to generate $20,000 assessable income) and not drought that prevented the taxpayer satisfying the assessable income test in the early years of the business (independent evidence showed there is generally a 5-year lead time from planting to the first commercial harvest). Similarly, in Re Hall and FCT (2006) 64 ATR 1001, there was no evidence of special circumstances (the case also concerned an olive growing scheme). In contrast, in Re Bentivoglio and FCT [2014] AATA 620, a variety of special circumstances affecting the olive growing scheme in question were shown to exist, namely infestations of the olive trees by the olive lace bug, prolonged drought, the destruction of olive trees by a grass fire and the serious illness of the taxpayer’s wife (extraordinary challenges facing the olive oil industry, such as a glut of olives and low prices were not considered to be special circumstances). In Re Farnan and FCT (2005) 58 ATR 1350, the closure of a school where a driving instructor gave presentations did not amount to special circumstances. The Commissioner considers that if the operators of the business activity fail for no adequate reason to adopt certain practices commonly used in their industry to prevent or reduce the effects of certain circumstances, such as pests or diseases, then that may point to the circumstances being within their control: Ruling TR 2007/6. Similarly, the acquisition of a poorly run but promising business activity would generally be considered to be within the control of the business operator and as such would not, by itself, constitute special circumstances, even though the actions of the former operator may have been outside the control of the current operator. Ruling TR 2007/6 states that for individuals who do not satisfy the income requirement, the factors that must be satisfied before deciding whether to exercise the special circumstances limb of the discretion are that: • the business activity is affected by special circumstances such that it is unable to produce a tax profit; • the business activity either satisfies at least one of the tests or is affected by special circumstances such that it is unable to satisfy any of the tests; and • the special circumstances affecting the business activity are outside the control of the operators of the business activity.

Nature of business activity The Commissioner cannot exercise his discretion under s 35-55 on the basis of the nature of the particular business activity unless the taxpayer has started to carry on the activity © 2017 THOMSON REUTERS

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(broadly this requires the taxpayer to have acquired the minimum level of business assets to allow that business activity to be carried on and have actually commenced business operations): Ruling TR 2001/14. In FCT v Eskandari (2004) 54 ATR 695, the court considered that the failure to meet the commerciality tests must be a result of some inherent feature that the taxpayer’s business activity has in common with business activities of that type and not a result of the way in which the taxpayer carries on the business. Taxpayers who might benefit from the exercise of this discretion include those in the grape-growing and plantation industries (ie where there is a lead time between the activity commencing and the production of assessable income). See also AAT Case [2011] AATA 779 (2011) 85 ATR 612 where the taxpayer was unsuccessful in challenging the Commissioner’s failure to exercise his discretion. It was held the losses were due to managerial choices rather than resulting from the nature of the activity itself, in that case rearing beef cattle. Similarly, in AAT Case [2013] AATA 3 (2013) 87 ATR 355, the taxpayer unsuccessfully challenged the Commissioner’s failure to exercise his discretion in the context of a winery business. In Re Hefner and FCT (2013) 95 ATR 130, the taxpayer failed to establish that 8 years of anticipated losses from a cattle stud were because of the nature of the business. The evidence showed that a stud should be profitable within 5 years and that it was the high level of debt that would prevent a profit being made for at least 8 years. Debt levels were also significant in Re Heaney and FCT (2013) 96 ATR 150, where the taxpayer sought a favourable exercise of the Commissioner’s discretion on the basis of special circumstances including drought and that the business was in a start up period. The AAT decided that, given the taxpayer’s debt levels, it was not clear that he would have been profitable even in the absence of the suggested special circumstances. In determining what is a ‘‘commercially viable period’’ for the industry concerned, the Commissioner will allow a tolerance of at least one year beyond the income year otherwise identified from the relevant material as the end of that period: Ruling TR 2007/6. In Re Hall and FCT (2006) 64 ATR 1001, it was held that there was no objective expectation that the activity would meet the assessable income test or generate a net profit within a commercially viable period. The Tax Office states that an application for the Commissioner to exercise his discretion should be accompanied by supporting evidence from independent sources (eg industry bodies, trade or professional associations, industry specialists, government agencies, tertiary institutions, banks and business advisers).

Pre-business capital expenditure The Commissioner can also exercise the discretion under s 35-55 to allow an individual taxpayer to deduct pre-business capital expenditure (under s 40-880 ITAA 1997: see [10 1150]) if it would be unreasonable to defer the deduction (by applying s 35-10(2B): see [8 630]) because special circumstances outside the taxpayer’s control (see above) prevented the particular business activity from being carried on: s 30-55(2).

COMMERCIAL DEBT FORGIVENESS [8 700] Commercial debt forgiveness – adjustments Under the commercial debt forgiveness provisions (in Div 245 ITAA 1997), if the taxpayer is released from a debt (other than in accordance with written agreements or arrangements entered into on or before 27 June 1996, not being the transaction giving rise to the original debt) the amount forgiven is deducted from certain of the debtor’s current and future tax deductions. If more than one debt is forgiven in a year, the sum of the amounts forgiven is treated as a single forgiven amount. 264

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[8 700]

The commercial debt forgiveness rules apply to a debt if interest (or an amount in the nature of interest) payable on the debt is deductible. Accrued but unpaid interest is treated as being a separate debt. In FCT v Tasman Group Services Pty Ltd (2009) 74 ATR 739, the Full Federal Court confirmed that a debt still exists if the time for payment is postponed or deferred. In that case, the Court rejected an argument that the loans giving rise to the relevant debts were unenforceable because the creditor would have breached covenants to the debtor and the debtor’s bank if it had sought to enforce the loans. Note that Div 245 does not apply to a debt whose waiver constitutes a fringe benefit (see [58 410]).

Where Div 245 operates A commercial debt is one where interest payable is deductible, or would be deductible if interest were payable (eg see the Tasman Group Services case), but for certain statutory restrictions. Debts affected include all commercial debts, including investments that are securities and equity for debt swaps. A non-equity share issued by a company (see [31 280]) is deemed to be a commercial debt owed by the company to the shareholder. A debt owed to the Commonwealth that arose under a taxation law (eg a PAYG withholding debt) is not a commercial debt. A debt is forgiven if the debtor’s obligation to pay the debt ‘‘is released or waived, or is otherwise extinguished’’. Waiver may be by conduct and the expression ‘‘or otherwise extinguished’’ would cover an agreement, enforceable in equity, not to set up the cause of action in debt (see the Tasman Group Services case). Extinguishment of a debt also includes the discharge, repurchase, redemption, defeasance or parking of the debt. Payment of a commercial debt by a guarantor, pursuant to a pre-existing guarantee, does not constitute the forgiveness of a debt provided the guarantor is subrogated to the rights formerly held by the creditor in relation to the debt so that the debt is now enforceable by the guarantor: Determination TD 2004/17. However, a subsequent forgiveness of the debt owed to the guarantor as a result of the subrogation of the former creditor’s rights may attract the operation of Div 245 as this amount can still be recovered from the debtor. Division 245 does not apply if the forgiveness of a debt is effected under an Act relating to bankruptcy or by will, or if the debt is forgiven for reasons of natural love and affection. Effect of operation If Div 245 operates, the net forgiven amount of the debt reduces, in order: prior year revenue losses, prior year net capital losses, undeducted balances of other expenditure being carried forward for deduction (including depreciable assets) and the CGT cost base of other assets held by the taxpayer. The net forgiven amount of the debt (as calculated under Subdiv 245-D) is the gross forgiven amount of the debt reduced by certain amounts that, as a result of the forgiveness of the debt, will be taken into account in arriving at the debtor’s taxable income. Those amounts include any amount that has been, or will be, included (other than under Div 245) in the debtor’s assessable income and any amount by which the cost base of any of the debtor’s CGT assets has been, or will be, reduced: s 245-85. There must be a causal connection between the forgiveness of the debt and, for example, any amount being included in assessable income: see ATO ID 2014/33. The gross forgiven amount is worked out (under Subdiv 245-C) by deducting any consideration in respect of the forgiveness from the notional value of the debt (special rules apply for a non-recourse debt and for a debt that has been parked). Thus, if no consideration is given, the gross forgiven amount is the notional value of the debt. In working out the notional value, it is assumed that the debtor’s capacity to pay the debt at the time when it was forgiven is the same as the debtor’s capacity to pay the debt at the time when it was incurred. In the Tasman Group Services case, the Court said that capacity to pay is not assessed on a going concern basis and agreed with the Commissioner that ‘‘one assumes a liquidation and the realisable value of the assets on an orderly realisation’’. The forgiven amount is applied against the debtor’s net capital losses in respect of all years before the forgiveness year of income, rather than just the immediately preceding year of income. © 2017 THOMSON REUTERS

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If the amount of the debt forgiven is not fully utilised against the first 2 classes mentioned, the taxpayer has a choice of which of the undeducted balances of other expenditure being carried forward is to be reduced, unless the balance of the amount forgiven is so great as to necessitate adjustments against all items. If adjustments are made with respect to depreciable assets, the cost of the asset or its depreciated value is reduced, depending on whether it is being depreciated under the prime cost or diminishing value method respectively: see [10 500]. EXAMPLE [8 700.10] $ 100,000 40,000 60,000

Loss carried forward Amount of debt forgiveness in current year Loss available for deduction in current year

The special provisions that apply to company groups are discussed at [20 660].

STATUTORY LIMITATIONS [8 750]

Limitations on deductibility

Deductions under s 8-1(1) ITAA 1997 may be limited by other provisions of the ITAA 1997 or ITAA 1936: s 8-5(2). The more common provisions limiting deductions are listed below, together with the most relevant paragraph number. The existence of a provision limiting a deduction does not imply that the particular outgoing is necessarily deductible under s 8-1. Section (ITAA 1997 unless otherwise indicated) Divs 28 and 900

25-5 25-50 26-5 26-10 26-20

26-30, 26-45, 26-50, Div 32 26-35 26-52, 26-53, 26-54

26-55

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Topic Work expenses, car expenses and business travel expenses may not be deductible if substantiation requirements are not complied with: see [9 100]-[9 250], [9 1450]-[9 1500] Income tax, penalty tax, franking additional tax, franking deficit tax, PAYG instalments and PAYG withholding amounts not deductible: see [9 410] Limitation on deductions for pensions, gratuities and retiring allowances paid to employees or former employees: see [9 1210] Penalties and amounts (eg fines) imposed on conviction for an offence not deductible: see [9 990] Limitations on deductions in respect of leave: see [8 320] and [9 1230] Student contributions under the Higher Education Support Act 2003, a payment to reduce a HELP or financial supplement debt, a payment to reduce a liability to the overseas debtors repayment levy and a payment to reduce a debt under the Trade Support Loans Scheme not deductible, except where paid by an employer in circumstances where the expenditure amounts to the provision of a fringe benefit: see [9 970] Limitations on deductions for travel, leisure facilities and entertainment: see [9 070], [9 500]-[9 580] Limitation on deductions for payments to relatives (see [9 550]) and related entities: see [9 1050] Bribes to public officials, including foreign public officials, and expenditure relating to certain illegal activities not deductible: see [9 1000] and [9 1010] Certain categories of deduction cannot produce or increase a tax loss: see [8 500] © 2017 THOMSON REUTERS

DEDUCTIONS – GENERAL PRINCIPLES Section (ITAA 1997 unless otherwise indicated) 26-90 26-95 26-97

[8 750]

Topic Superannuation supervisory levy not deductible: see [9 410] Superannuation guarantee charge not deductible: see [9 410] Loss or outgoing not deductible to the extent it is funded by a NDIS amount: see [9 1060]

26-98

Division 293 tax and a debt account discharge liability not deductible: see [39 325] 26-100 SRWUIP expenditure not deductible if the matching SRWUIP payment is, or is reasonably expected to be, non-assessable non-exempt income: see [27 310] Div 34 Limitations on deductions for non-compulsory corporate uniforms: see [9 310] Div 35 Limitations on deductions for losses from non-commercial business activities: see [8 600] Div 85 Limitations on deductions an individual can claim against personal services income: see [6 120] 86-60 to 86-70 Limitations on a personal services entity’s deductions: see [6 140] Div 245 Deduction for losses and certain other amounts reduced where a commercial debt is forgiven: see [8 700] Div 250 Depreciation and certain deductions for capital investment not available where asset put to tax preferred use under leasing arrangement: see [33 100] Div 820 Thin capitalisation provisions limit debt deductions: see Chapter 38 82KZL to 82KZO ITAA Limitations on deductions for prepaid expenses: see [8 350]-[8 400] 1936

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INTRODUCTION Overview ......................................................................................................................... [9 010] Checklist of deductible expenditure ............................................................................... [9 020] Checklist of non-deductible expenditure ........................................................................ [9 030] TRAVEL EXPENSES Travel expenses ............................................................................................................... [9 Car expenses .................................................................................................................... [9 Travel expenses if accompanied by a relative ............................................................... [9 Employee car parking expenses ..................................................................................... [9

050] 060] 070] 080]

CAR EXPENSES – STATUTORY METHODS Statutory methods of claiming car expenses .................................................................. [9 100] Method 1 – cents-per-kilometre ...................................................................................... [9 110] Method 2 – log book ...................................................................................................... [9 140] Comparison of methods – example ................................................................................ [9 150] Switching methods .......................................................................................................... [9 160] Exceptions – alternative to statutory methods ............................................................... [9 170] Substantiation of car expenses ........................................................................................ [9 180] Records – retention ......................................................................................................... [9 190] TRAVEL EXPENSES – SUBSTANTIATION Substantiation of travel expenses ................................................................................... [9 Employees with travel allowances ................................................................................. [9 Employees with award transport payments .................................................................... [9 Employee work travel not covered by allowance or award .......................................... [9 Business travel expenses ................................................................................................. [9 Travel records .................................................................................................................. [9

200] 210] 220] 230] 240] 250]

PRIVATE EXPENDITURE Food and drink ................................................................................................................ Clothing ........................................................................................................................... Accommodation .............................................................................................................. Other private expenditure ...............................................................................................

300] 310] 320] 330]

[9 [9 [9 [9

TAX ADVICE AND COMPLIANCE COSTS Tax-related expenses that are deductible ........................................................................ [9 350] Exclusions and restrictions ............................................................................................. [9 360] Partnerships, trusts and deceased estates ....................................................................... [9 370] TAXES AND OTHER GOVERNMENT CHARGES Deductible taxes and charges ......................................................................................... [9 Non-deductible taxes ....................................................................................................... [9 GST .................................................................................................................................. [9 Rates and land tax – clubs and associations .................................................................. [9

400] 410] 420] 430]

INTEREST AND OTHER BORROWING EXPENSES Interest ............................................................................................................................. [9 450] Restrictions on deducting interest .................................................................................. [9 460] Borrowing expenses ........................................................................................................ [9 470] ENTERTAINMENT Entertainment expenses ................................................................................................... [9 Meal entertainment or corporate box – election ............................................................ [9 Allowable entertainment expenses ................................................................................. [9 Parties and presents for employees ................................................................................ [9 Seminars .......................................................................................................................... [9 Relatives’ allowances ...................................................................................................... [9 268

500] 510] 520] 530] 540] 550]

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Leisure facilities .............................................................................................................. [9 560] Deductions for boating activities .................................................................................... [9 570] Club fees .......................................................................................................................... [9 580]

REPAIRS Repairs ............................................................................................................................. Replacement of part or whole ........................................................................................ Improvements .................................................................................................................. Initial repairs ...................................................................................................................

[9 [9 [9 [9

600] 610] 620] 630]

LEGAL AND RELATED EXPENSES Legal expenses – general ................................................................................................ [9 Professional persons and employees .............................................................................. [9 Lease and mortgage documents ...................................................................................... [9 Capital expenditure to terminate lease or licence .......................................................... [9

650] 660] 670] 680]

BAD DEBTS Bad debts ......................................................................................................................... [9 Debt must be bad ............................................................................................................ [9 Prior inclusion in assessable income .............................................................................. [9 Moneylending business ................................................................................................... [9 Restrictions – other provisions ....................................................................................... [9 Debt-for-equity swaps ..................................................................................................... [9

700] 710] 720] 730] 740] 750]

GIFTS AND DONATIONS Gifts and donations – introduction ................................................................................. [9 What qualifies as a gift? ................................................................................................. [9 Deductible amount .......................................................................................................... [9 Gifts of trading stock ...................................................................................................... [9 Spreading deduction over 5 years .................................................................................. [9 Fundraising events and auctions ..................................................................................... [9 Eligible funds, authorities and institutions ..................................................................... [9 Ancillary funds ................................................................................................................ [9 Endorsement of gift recipient ......................................................................................... [9 Cultural and heritage gifts .............................................................................................. [9 Conservation covenants .................................................................................................. [9 Political contributions ..................................................................................................... [9 Anti-avoidance measures ................................................................................................ [9

800] 810] 820] 830] 840] 850] 860] 870] 880] 890] 900] 910] 920]

MISCELLANEOUS Insurance premiums ........................................................................................................ [9 950] Self-education expenses .................................................................................................. [9 960] Higher education contributions ....................................................................................... [9 970] Home office ..................................................................................................................... [9 980] Penalties ........................................................................................................................... [9 990] Bribes to public officials ............................................................................................... [9 1000] Expenditure related to indictable offences ................................................................... [9 1010] Expenses incurred in deriving capital gains ................................................................ [9 1020] Election expenses .......................................................................................................... [9 1030] Loss from profit-making plan ....................................................................................... [9 1040] Payments to related entities and maintenance payments ............................................. [9 1050] NDIS amounts ............................................................................................................... [9 1060] EMPLOYEES Employee deductions – general .................................................................................... Travel expenses ............................................................................................................. Relocation expenses ...................................................................................................... Costs relating to employment contracts ....................................................................... Expenses that are reimbursed ....................................................................................... Miscellaneous ................................................................................................................

[9 1100] [9 1110] [9 1120] [9 1130] [9 1140] [9 1160]

BUSINESSES AND PROFESSIONALS Cost of employment ...................................................................................................... [9 1200] © 2017 THOMSON REUTERS

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[9 010]

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Pensions, gratuities and retiring allowances ................................................................ [9 Contributions to employee benefit funds ..................................................................... [9 Accrued leave transfer payments .................................................................................. [9 Work-in-progress payments .......................................................................................... [9 Professionals .................................................................................................................. [9 Business and professional subscriptions ...................................................................... [9 Losses by theft .............................................................................................................. [9 Non-cash business benefits ........................................................................................... [9 Miscellaneous ................................................................................................................ [9

1210] 1220] 1230] 1240] 1250] 1260] 1270] 1280] 1290]

INVESTORS Investment related expenditure ..................................................................................... [9 Investment schemes ...................................................................................................... [9 Share transactions .......................................................................................................... [9 Landlords ....................................................................................................................... [9 Negative gearing ........................................................................................................... [9

1350] 1360] 1370] 1380] 1390]

SUBSTANTIATION – GENERAL Substantiation requirements – overview ...................................................................... [9 Documentary evidence .................................................................................................. [9 Exclusion – small or undocumentable expenses .......................................................... [9 Exclusion – small total and laundry expenses ............................................................. [9 Commissioner’s discretion to waive substantiation requirements ............................... [9 Records .......................................................................................................................... [9

1450] 1460] 1470] 1480] 1490] 1500]

INTRODUCTION [9 010] Overview A taxpayer’s taxable income is calculated by deducting allowable deductions from assessable income: see [1 100]. The core provisions for allowable deductions are contained in Div 8 ITAA 1997. Division 8 separates allowable deductions into ‘‘general’’ and ‘‘specific’’ deductions. Section 8-1 governs ‘‘general’’ deductions, which are losses or outgoings that have a relevant connection with income or business activities and which are not excluded on the ground that they are of a capital, private or domestic nature. The general principles governing the operation of s 8-1 are discussed in Chapter 8. A ‘‘specific’’ deduction is simply a deduction which is allowable under another provision beside s 8-1: s 8-5. If the same amount gives rise to a deduction under more than one provision, a double deduction is not available and the taxpayer must claim the deduction under the provision that is most appropriate: s 8-10. This chapter addresses particular categories of allowable deductions which are relevant to a variety of taxpayers, including business taxpayers, salary and wage earners and investors. The deductions covered are both ‘‘general’’ and ‘‘specific’’ within the meaning of those terms in Division 8. The chapter firstly considers the deductibility of specific items of expenditure that are not generally associated with a particular category of taxpayer. These include: • car and travel expenses, including the rules about substantiating such expenses: see [9 050]-[9 250]; • common categories of expenditure that are more likely to be private or domestic in nature, eg expenditure on meals, clothing and accommodation: see [9 300]-[9 330]; • tax advice and compliance costs: see [9 350]-[9 370]; 270

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[9 020]

• income tax, GST and other taxes and government charges: see [9 400]-[9 430]; • interest and other borrowing expenses: see [9 450]-[9 470]; • entertainment and leisure expenses: see [9 500]-[9 580]; • expenditure on repairs and improvements: see [9 600]-[9 630]; • legal expenses: see [9 650]-[9 680]; • bad debts: see [9 700]-[9 750]; • gifts and donations: see [9 800]-[9 920]; and • various miscellaneous items, including insurance premiums, self-education expenses and home office expenses: see [9 950]-[9 1050]. The chapter then looks at 4 categories of taxpayer and considers various items of expenditure that are particularly relevant to each category. The categories are: • employees: see [9 1100]-[9 1160]; • employers: see [9 1200]-[9 1290]; • professionals: see [9 1250]; and • investors, including landlords: see [9 1350]-[9 1390]. Finally, the chapter looks at the general substantiation rules for work-related and business expenditure: see [9 1450]-[9 1500]. Checklists of deductible and non-deductible types of expenditure are set out at [9 020] and [9 030]. The checklists are a guide only.

[9 020] Checklist of deductible expenditure A checklist of items of expenditure that are generally deductible is set out below. The checklist is designed to facilitate access to commentary on the most common items and does not cover every item of deductible expenditure. References are to the first or most relevant numbered paragraph in the text where commentary on the particular item is located. The fact that an item appears in the checklist does not necessarily indicate that the item is automatically deductible. The text should be consulted for full details. Item Academics — general Accrued leave transfer payment Apartments – write-off Bad debts Balancing adjustment Blackhole expenses Bonuses – employer Books Borrowing expenses Buildings – write-off Business expenses Business related expenses Business Tax Break Capital allowances Capital protected products – part Capital works Car expenses © 2017 THOMSON REUTERS

Para [9 1250] [9 1230] [10 1570] [9 700] [10 850] [10 1150] [9 1200] [9 960] [9 470] [10 1460] [8 060] [10 1150] [10 020] [10 020] [32 610] [10 1450] [9 060]

Carbon sink forests Clothing – cleaning and repairs Clothing – special Clubs Commission – employer Commission – landlord Computer hardware Computer software Conferences – professionals Conservation covenants Copyright Council rates Debt returns Depreciating asset – balancing adjustment Depreciating asset – UCA Depreciating asset – small business

[11 620] [9 310] [9 310] [9 430] [9 1200] [9 1380] [10 1220] [10 1220] [9 1250] [9 900] [10 150] [9 400] [31 260] [10 850] [10 020] [25 160]

271

[9 020] DEDUCTIONS – SPECIFIC ITEMS Designs Donations to DGRs Election expenses Employees – general Employers – general Entertainment – some Environmental impact assessments Environmental protection activities Exchange losses Farm management deposits Fencing assets Fodder storage assets Forestry investment Forestry roads Forex realisation loss Fringe benefits tax General interest change Gifts to DGRs Grapevines Home office Hotels – write-off Horticultural plants Industrial buildings – write off Insurance premiums – some Intellectual property Interest – general Interest – business Interest – investment loans Interest – line of credit facilities Interest – linked loans Interest – negative gearing Interest – split loans Interest on underpaid tax Investment fees – some Investors – general Journals Landcare operations Landlords – general Land tax Laundry expenses Lease document preparation Lease surrender payments – some Lease termination payments – some Leave payments – employer Legal expenses Library – professional Licence termination payments – some

272

[10 150] [9 800] [9 1030] [9 1100] [9 1200] [9 500] [10 1050] [11 610] [32 250] [27 600] [27 335] [27 330] [11 600] [29 150] [32 270] [9 400] [9 450] [9 800] [27 330] [9 980] [10 1570] [27 320] [10 1560] [9 950] [10 150] [9 450] [9 450] [9 470] [32 605] [32 605] [9 1390] [32 605] [9 350] [9 1350] [9 1350] [9 960] [27 340] [9 1380] [9 400] [9 1480] [9 670] [9 1380] [9 680] [9 1200] [9 650] [9 1250] [9 680]

Live stock Local government rates Losses – general Losses – prior year (general) Losses – prior year (company) Losses – theft Losses – traditional securities Magazines Mains electricity connection Membership fees Mining capital expenditure Mining site rehabilitation Misappropriated amounts – some Mortgage discharge Motels – write-off Motor vehicle expenses Occupational clothing Partnership loss Patents – depreciation Pay-roll tax PD courses Petroleum resource rent tax Plant Political donations – some Post-business expenditure Power connections Pre-business expenditure Professionals – general Professional library Project expenditure Protective clothing R&D expenditure Relocation expenses – employer Repairs Retiring allowances Salaries – employer Self-education expenses Seminars Stamp duty – some Standing timber Structural improvements Subscriptions Super contribution – employer Super contribution – other Superannuation funds Tax advice Tax agent fees Tax compliance costs Tax disputes Taxes – some Tax losses – prior year (general)

[27 060] [9 400] [8 450] [8 460] [20 250] [9 1270] [32 490] [9 960] [27 350] [9 1260] [10 1070] [29 040] [9 1270] [9 670] [10 1570] [9 060] [9 310] [22 120] [10 150] [9 400] [9 960] [9 400] [10 160] [9 910] [10 1150] [27 350] [10 1150] [9 1250] [9 1250] [10 1050] [9 310] [11 020] [9 1120] [9 600] [9 1210] [9 1200] [9 960] [9 540] [9 400] [29 160] [10 1580] [9 1260] [39 100] [39 200] [41 350] [9 350] [9 350] [9 350] [9 350] [9 400] [8 460]

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DEDUCTIONS – SPECIFIC ITEMS Tax losses – prior year (company) Telephone lines Tertiary study Timber mill Tools of trade Trading stock – purchases Traditional securities Transport capital expenditure Travel Travel – business

[20 250] [27 360] [9 960] [29 150] [10 1200] [5 210] [32 450] [10 1080] [9 050] [9 050]

Travel – employees Traveller accommodation – write-off UMP support payments Uniforms – some Union dues Wages – employer Water facilities Work in progress payments Work-related items

[9 030]

[9 210] [10 1570] [9 1250] [9 310] [9 1160] [9 1200] [27 310] [9 1240] [9 1100]

[9 030] Checklist of non-deductible expenditure A checklist of items of expenditure that are generally not deductible is set out below. The checklist is designed to facilitate access to commentary on the most common items in each category and does not cover every item of non-deductible expenditure. References are to the first or most relevant numbered paragraph in the text where commentary on the particular item is located. The fact that an item appears in the checklist does not necessarily indicate that the item is always not deductible. The text should be consulted for full details. Item Betting losses Boat expenses – some Bribes to public officials Capital amounts Capital protected product – part Childminding Clothing – personal Club fees Debt account discharge liability Division 293 tax Domestic expenditure Entertainment – some Excess non-concessional contributions tax Excess transfer balance tax Financial supplement repayments Fines Food and drink FS assessment debts Gambling losses GST amounts Health insurance premiums HELP payments Hobbies Improvements Income tax Independent contractor – restrictions Indictable offence expenditure Insurance premiums – some © 2017 THOMSON REUTERS

Para [5 040] [9 570] [9 1000] [8 150] [32 610] [8 250] [9 310] [9 580] [39 325] [39 325] [8 250] [9 500] [39 420] [40 [9 [9 [9 [9 [5 [9 [9 [9 [5 [9 [9 [6

500] 970] 990] 300] 970] 040] 420] 950] 970] 030] 620] 410] 120]

[9 1010] [9 950]

Interest – income securities Interest – line of credit facilities Interest – linked loans Interest – split loans Investment fees – some Investors – some Lease surrender payments – some Leisure facilities – some Losses – capital Losses – non-commercial Mayoral election expenses Meals Medical expenses Maintenance payments NDIS amount Non-share equity returns Open learning deferred payments Parking – employee Penalties Personal services entity – some Private expenditure Provisions Reimbursed expenses – employees Related entity payments Relocation expenses – employee Repairs – initial Strike fund levies Superannuation guarantee charge

[32 620] [32 605] [32 605] [32 605] [9 1350] [9 1350] [9 1380] [9 560] [8 450] [8 600] [9 1030] [9 300] [9 330] [9 1050] [9 1060] [31 300] [9 970] [9 080] [9 990] [6 140] [8 250] [9 320] [9 1140] [9 1050] [9 1120] [9 600] [9 1160] [9 410]

273

[9 050]

DEDUCTIONS – SPECIFIC ITEMS

Superannuation supervisory levy Super contribution – employee Taxes – some Travel – relative Travel – to and from work

[9 [39 [9 [9 [9

410] 210] 410] 070] 050]

Trust loss Venture capital loss Water infrastructure improvement payments – some Work-related items – some

[23 800] [11 560] [27 310] [10 190]

TRAVEL EXPENSES [9 050] Travel expenses Travel expenses incurred in the course of the taxpayer’s work or business operations are deductible in accordance with general principles: Garrett v FCT (1982) 12 ATR 684; FCT v Genys (1987) 19 ATR 356. Travel expenses may include motor vehicle expenses (including parking fees and tolls), car rental costs, air, bus, train, ferry and taxi fares. Expenditure incurred in obtaining visas, passports and travel insurance is unlikely to be deductible: see Re Waters and FCT (2010) 80 ATR 919 and ATO ID 2002/208. Travel expenses incurred by itinerant employees (eg shearers, workers travelling to several sites or different sites each day, travelling salespersons) are dealt with in Ruling TR 95/34. An itinerant tote operator was allowed a travel deduction in Re Kerry and FCT (1998) 39 ATR 1252. Contrast Re Hill and FCT [2016] AATA 514, where the taxpayer was considered not to be an itinerant worker as he was not required to travel to different locations in the course of his employment – his employment at each workplace was separate and discrete. Travel expenses incurred in seeking a job are not deductible, nor are travel expenses incurred in acquiring tools and equipment (see ATO ID 2002/1005). Following the High Court decision in FCT v Anstis (2010) 76 ATR 735 (discussed at [9 960]), the Commissioner regards travel expenses as deductible where incurred in necessary travel to attend medical appointments to obtain medical certificates that are required as a condition of receiving workers compensation (see ATO ID 2012/73). However, medical expenses incurred by way of rehabilitation are private in nature and thus not deductible. Travel expenses incurred by an accompanying relative are deductible in very limited circumstances: see [9 070]. Accommodation costs incurred when an employee is required to live away from home for relatively short periods of time are likely to be deductible, particularly if the employee receives an allowance to cover the additional costs of working away from home (see below): RTA of NSW v FCT (1993) 26 ATR 76 at 92; Determination TD 93/230. If the allowance qualifies as a living-away-from-home allowance (LAFHA) for FBT purposes (see [58 550]), expenses will not be deductible against the allowance: see [9 210]. Accommodation and meals on business trips away from home are also deductible, but not entertainment expenses, unless they are incurred by an employer in circumstances that amount to the provision of a fringe benefit: see [9 1200]. The requirement for individuals and partnerships that include an individual to substantiate travel expenses (to be eligible for a deduction) is discussed at [9 100]-[9 250] and [9 1450]-[9 1500]. The fact that a taxpayer receives a travel allowance has no effect on the deductibility of expenses incurred against that allowance: Determination TD 93/174. However, provided the allowance received is less than the reasonable amount as determined by the Commissioner (see [9 210]), it may not be necessary to show the amount of the allowance on the taxpayer’s tax return (Ruling TR 2004/6). Travel between 2 places of employment Expenses incurred in travelling between 2 places where the taxpayer engages in assessable income-earning activities (including if the taxpayer carries on a business) are deductible under s 25-100 ITAA 1997. A deduction is not available under s 25-100 if the 274

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[9 050]

taxpayer resides at one of the workplaces. However, it seems that this is not intended to deny a deduction under s 8-1 for travel expenses if the taxpayer is considered to have a base at home, eg if bulky equipment is transported (see the cases discussed below). A deduction is also not available if, at the time of the travel, the taxpayer’s assessable income-earning activities have ceased at the first workplace (arguably, this must mean permanently ceased). If a business is being carried on at one of the workplaces and the non-commercial loss rules in Div 35 ITAA 1997 apply to that business activity (see [8 600]), the deduction under s 25-100 will have to be apportioned on a fair and reasonable basis (an equal split is likely, unless the particular circumstances dictate otherwise): Determination TD 2006/61.

Overseas travel One area of regular dispute between taxpayers and the Commissioner is in connection with overseas travelling expenses. The Commissioner looks with some doubt upon the costs incurred in connection with travel overseas, particularly if the employee is accompanied by her or his spouse: s 26-30 (see [9 070]). An employee, however, seeking to bring herself or himself up-to-date in her or his own particular area of expertise is entitled to a deduction in respect of travelling expenses (see also cases noted at [9 960]). A teacher on an exchange program to Canada was allowed a proportion (75%) of his travel costs in AAT Case 4374 (1988) 19 ATR 3552, while the Tax Office allowed a taxpayer on a work exchange program in the UK a deduction for the airfares (see ATO ID 2001/329). In contrast, in Re Mandikos and FCT (2001) 48 ATR 1077, a dentist was not allowed a deduction for motor vehicle expenses incurred while undertaking post-graduate studies at an American university. Travel insurance costs and the cost of obtaining a passport are not deductible (see ATO ID 2001/615).

Travel between home and work Expenses incurred in travelling between home and work are generally not deductible: Lunney v FCT (1958) 100 CLR 478; FCT v Payne (2001) 46 ATR 228 at 232. Such expenses are generally not incurred in the course of gaining assessable income and are also of a private or domestic nature. There are, however, some exceptions. Certain persons such as professional footballers and musicians have been held to have a base at their home and, consequently, from the moment they leave that home they are engaged in connection with their work and are entitled to a deduction for the travel costs incurred: Ballesty v FCT (1977) 7 ATR 411; Determination TD 96/42. A deduction may be allowable in circumstances where transporting bulky equipment by vehicle is a necessary part of the job: FCT v Vogt (1975) 5 ATR 274; Ruling IT 112. Examples include: • an aircraft engineer: AAT Case 13,206, Re Byrne and FCT (1998) 39 ATR 1244, Re Crestani and FCT (1998) 40 ATR 1037; • a doctor who used his car to carry equipment and files between hospitals: AAT Case 9235 (1994) 27 ATR 1127; and • a dentist who used his car to transport patient files and dental supplies and equipment to a second surgery 70 km from his main surgery: Re Scott and FCT (2002) 51 ATR 1122. Private Ruling Authorisation Number 1012872119301 is an example of where the taxpayer’s protective equipment (boots, hard hat and work) was not considered to be bulky enough for the ‘‘bulky equipment’’ exception to apply. The cost of using a vehicle to transport tools to and from work may not be deductible if secure storage facilities are provided at work: Re Brandon and FCT (2010) 79 ATR 712, Re Ford and FCT [2014] AATA 361 and Re Reany [2016] AATA 672. © 2017 THOMSON REUTERS

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Employees who work in remote locations on a ‘‘fly-in fly-out’’ basis may be entitled to a deduction for the cost of flying to and from the remote location. This was the conclusion reached in John Holland Group Pty Ltd v FCT (2015) 232 FCR 59 as, from the time employees checked in at Perth Airport, they were considered to be travelling in the course of their employment. It was significant that the employees’ contracts required them to travel to remote places. (The case actually concerned the application of the ‘‘otherwise deductible’’ rule for FBT purposes: see [58 960].)

[9 060] Car expenses Car expenses incurred by an individual or a partnership that includes an individual are subject to special provisions that provide alternative methods of claiming deductions (subject to substantiation): see [9 100]-[9 190]. Note that not all motor vehicles are cars for these purposes. Note that the cost of an extended warranty is on revenue account and is therefore deductible to the extent the vehicle is used for income producing purposes (although the deduction will be spread over the period of the extended warranty in accordance with the prepayment rules discussed at [8 370] and [8 380]: see Private Ruling Authorisation No 1011585972191. If a car is made available to an employee by her or his employer, the employer is liable for FBT if the vehicle is used privately, or is made available for private use, including travel from home to the place of employment: see [58 020]. In such a case, the cost of providing the vehicle is deductible to the employer, but s 51AF ITAA 1936 denies the employee a deduction for any car expenses they incur. See Determination TD 93/96 for an example of the possible FBT liability of a company employer for private expenditure as an expense payment fringe benefit. Note that the cost of obtaining or renewing a driver’s licence is not deductible: see Ruling TR 95/9 (paras 97-99) and Determination TD 93/108. [9 070] Travel expenses if accompanied by a relative If a person is accompanied during business travel by a relative, the relative’s expenses are not deductible: s 26-30(1). This prohibition is not restricted to situations where an employee is accompanied by a relative, but also includes where a company director, office-holder (for PAYG withholding purposes: see [50 030]) or religious practitioner (as a member of a religious institution) is accompanied by a relative: s 26-30(4) and (6). However, there is an exception (ie a deduction will not be denied) if the relative is an employee and undertakes work separate to the main person or incidental to that person’s work, unless it can be concluded that the relative would not have accompanied the person but for their relationship: s 26-30(2). The prohibition will not apply if the expenditure amounts to the provision of a fringe benefit: s 26-30(3). See [9 550] for the definition of a ‘‘relative’’. [9 080] Employee car parking expenses An employee who might otherwise be allowed a deduction for car parking expenses cannot deduct those expenses if, basically, the car is parked at or in the vicinity of the employee’s primary place of employment for more than 4 daylight hours and the car was used (on the day in question) for travel from home to work: s 51AGA. It makes no difference if the parking was related to business use of the car. A ‘‘car’’ has the same meaning as for FBT purposes: see [58 020]. This prohibition does not apply to parking facilities provided to an employee entitled under State or Territory law to the use of a disabled person’s parking space (a valid disabled person’s parking permit must be displayed on the car): reg 8 ITA (1936 Act) Reg. The 4-hour period must occur between 7 am and 7 pm and periods of fewer than 4 hours in a day must be added together to see whether the total has been exceeded. It should be noted that s 51AGA does not of itself authorise a deduction for car parking expenses outside 276

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[9 100]

those hours (ie between 7 pm and 7 am the next day). Whether such expenses are deductible would depend on ordinary principles: see [8 050] and [9 080].

CAR EXPENSES – STATUTORY METHODS [9 100] Statutory methods of claiming car expenses Division 28 ITAA 1997 contains 2 alternative statutory methods for working out deductions for ‘‘car expenses’’ incurred by individuals and partnerships that contain an individual: ss 28-10, 28-15. These statutory methods cannot be used by a company or any other taxpayer that is not an individual or a partnership containing an individual: s 28-10(3). The statutory methods are the cents-per-kilometre and log book methods: see the table below. Two other statutory methods were available before the 2015-16 income year – the 12% of original value and the one-third of actual expenses methods – but these have been discontinued. For details of those discontinued methods, see the Australian Tax Handbook 2015 at [9 120] and [9 130]. Car expenses A ‘‘car expense’’ is defined in s 28-13 as an expense to do with a car, including operating costs (eg fuel, oil, repairs, registration fees and insurance premiums) and the decline in value (ie depreciation). (See below for the definition of a ‘‘car’’.) Interest paid on a loan used to purchase a car will qualify as a ‘‘car expense’’. Expenses for travel outside Australia and taxi fares and similar expenses are specifically excluded. Parking fees and bridge tolls are not ‘‘car expenses’’ and are subject to the general work-related expense substantiation rules (discussed at [9 1450] and following): AAT Case 7273 (1991) 22 ATR 3402. In using the rules, the scope of the phrase ‘‘car expense’’ and the type of motor vehicle involved must always be considered. Only the owner or lessee of a vehicle may claim car expenses using either of the statutory methods: s 28-12(1). In Re Scott and FCT (2002) 51 ATR 1080, the AAT said that ownership connotes ‘‘possession … which no one is at liberty to interfere with’’ or a ‘‘right to immediate possession’’, at least when some arrangement with another person ends. The Tax Office has said on its website that a person who is not the registered owner of a car will be allowed to claim car expenses if he or she is effectively the owner or lessee of the car under a family arrangement and pays all the expenses (eg if the car is a birthday present). The lessee of a luxury car may be taken to be its owner: see [6 410]. In certain circumstances (eg under a hire purchase agreement), the notional buyer of property is taken to be its owner: see [33 090]. Cars covered by statutory methods The statutory methods of working out deductions for car expenses apply to ‘‘cars’’. A ‘‘car’’ is any motor-powered road vehicle (including a 4-wheel drive vehicle) that is designed to carry a load of less than 1 tonne and fewer than 9 passengers: see the definitions of ‘‘car’’ and ‘‘motor vehicle’’ in s 995-1. This means that panel vans and utility trucks (and other road vehicles) that are designed to carry a load of more than 1 tonne and/or more than 8 passengers are not ‘‘cars’’ for these purposes. The statutory methods of working out deductions for car expenses are not available for taxis taken on hire and vehicles taken on short term hire (unless there is substantial continuity of hire of the vehicle): s 28-165. Statutory methods Method (eligibility) Cents-per-kilometre

Calculation of deduction Base Factor Business km × Rate per km (cents)

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Substantiation

Reference

No

[9 110]

277

[9 110] DEDUCTIONS – SPECIFIC ITEMS Method (eligibility) (no restrictions) Log book (car must have been ‘‘held’’)

Calculation of deduction Base Factor (first 5,000 km only) Car expenses ($) × Business use (%) (eg fuel/tyres/service)

Substantiation

Reference

Yes + log book + odometer records (fuel/oil – no need for written evidence as odometer records kept)

[9 140]

Full substantiation of car expenses (subject to some specific modifications: see [9 180]) is only required if the log book method is used. The log book and odometer records must be kept in the prescribed manner with records being made of business trips. Eligibility to use a particular method depends on the number of business kilometres travelled in the income year. ‘‘Business kilometres’’ are the kilometres the car travelled during the income year in the course of (a) producing the taxpayer’s assessable income, or (b) travel between the taxpayer’s workplaces: ss 28-25(3), 28-50(2), 28-75(2), 28-90(4). Business kilometres include the kilometres travelled to consult with a tax agent (if the tax agent’s fees are deductible under s 25-5: see [9 350]): see ATO ID 2010/195. Using different methods for different vehicles and switching between methods for different income years is possible: see [9 160].

[9 110] Method 1 – cents-per-kilometre A taxpayer who selects the cents-per-kilometre method (in (Subdiv 28-C) calculates a deduction for car expenses by applying the formula (s 28-25(1)): Business km travelled in year × Rate of cents/kilometre

See [9 100] for the definition of ‘‘business kilometre’’. There is no formal method for calculating the number of business kilometres. Instead, the taxpayer must make a reasonable estimate: s 28-25(3). The ‘‘rate of cents/kilometre’’ is set by the Commissioner by legislative instrument (s 28-25(4)), irrespective of the car’s engine capacity. The rate for 2016-17 is 66 cents per kilometre (see item 46, Sch 1 Tax and Superannuation Laws Amendment (2015 Measures No 5) Act 2015 and Legislative Instrument F2016L01157, dated 1 July 2016). The cents-per-kilometre method can only be used for the first 5,000 business kilometres travelled. If more than 5,000 business kilometres are travelled, the method may still be used, but all business kilometres in excess of 5,000 are ignored in calculating the deduction: s 28-25(2). If this method is used for claiming a deduction, special rules in Div 40 apply for determining any balancing amount on disposal for depreciation purposes: see [10 1010].

[9 140] Method 2 – log book The log book method (in Subdiv 28-F) may only be used if the car was owned by or leased to the taxpayer for income-producing purposes during the whole or part of the income year: ss 28-90(6) and 28-95. However, use does not have to be solely for such purposes. Note that the lessee of a luxury car may be taken to be its owner (see [6 410]) and that, in certain circumstances (eg under a hire purchase agreement), the notional buyer of property is taken to be its owner: see [33 090]. To calculate a deduction under this method, the amount of each car expense is multiplied by the business use percentage. The ‘‘business use percentage’’ is the number of business kilometres travelled during the period the car was owned or leased during the income year, expressed as a percentage of the total kilometres travelled during that period: s 28-90(3). See [9 100] for the definitions of ‘‘car expense’’ and ‘‘business kilometre’’. If the cost of a car exceeds the ‘‘luxury car’’ limit ($57,581 for 2016-17: see [10 1300]), the full amount of the 278

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[9 140]

interest incurred on a loan to purchase the car may still qualify as a ‘‘car expense’’ for the purposes of the log book method. If the taxpayer is registered for GST, input tax credits should be disregarded in calculating the amount of the car expenses. As with the cents-per-kilometre method, business kilometres are determined by making a reasonable estimate. However, for the log book method, the reasonable estimate must take into account all relevant matters including log books, odometer records, variations in the pattern of use of the car and any changes in the number of cars used for income-producing purposes during the year: s 28-90(5). Under the log book method, in addition to documenting expenses under the general car expense substantiation provisions (see [9 180]), log book records and odometer records must be maintained: s 28-100.

What is a log book? A log book is a document in which an entry is recorded in respect of each business journey during the applicable log book period (see below) undertaken in the course of producing assessable income showing (s 28-125(2)): • the date the journey began and ended; • odometer readings at the start and end of the journey; • the number of kilometres travelled; • the purpose of the journey – simply writing ‘‘meeting’’ or ‘‘business’’ is seemingly insufficient (see Re Turner and DCT (1999) 42 ATR 1131 and Re Latif and FCT (2008) 73 ATR 443). If 2 or more consecutive business journeys are made in the car on the same day, they may be recorded as a single journey: s 28-125(3). The log book itself must also record (s 28-125(4)): (a) when the log book period (see below) begins and ends; (b) odometer readings at the start and end of the period; (c) total kilometres travelled during the period; (d) total business kilometres travelled on recorded journeys during the period; and (e) business percentage of travel during the period (ie (d) divided by (c) expressed as a percentage). Each entry must be made in English as soon as possible after the start or end of the journey, as appropriate. SAMPLE LOG BOOK Vehicle registration no: ......................................................................................................................... Period covered by log book: from:............................................... to:.................................................. Odometer readings for period: start:............................................ end:............................................... Odometer readings per Date of travel journey start end start end Kilometres travelled Reason for journey Total km for period: ...................................................................... km Total business km.................................................... km: ............................................................

%

For a case where the AAT was not satisfied that all the journeys recorded took place within the log book period or the relevant year and that the business kilometres stated in the log book were accurate, see Re Ovens and FCT (2009) 75 ATR 479. © 2017 THOMSON REUTERS

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What are odometer records? Odometer records are documents that record for the period for which a car was owned or leased for use in income-producing purposes during an income year (s 28-140): • the odometer reading at the start and end of the period; • the car’s make, model, registration number and engine capacity; • the make, model, registration number and engine capacity of any nominated replacement car and the odometer reading of both cars as at the end of the nominated replacement day. Entries for odometer readings must be made in English as soon as possible after the start and end of the relevant period (or as soon as possible after the end of the replacement day if a replacement occurs): s 28-140(2). Entries for the other details must be made in English before lodgment of the return to which the claim relates: s 28-140(4). The Commissioner has a discretion to allow a late entry in both cases: s 28-140(5). A sample odometer record that would satisfy these requirements is shown below. SAMPLE ODOMETER RECORD Vehicle registration no: ........ Make: ..................... Model: ....................... Engine capacity: ............ Replacement vehicle Make: ..................... Model: ....................... Engine capacity: ............ registration no: ..................... Odometer reading at start of year/period: ............................................................................................ Odometer reading at end of year/period: ............................................................................................. Odometer reading of replacement vehicle at start of year/period:....................................................... Odometer reading of replacement vehicle at end of year/period:........................................................ Estimated business use: ........................................................ km ............................................... %

Fuel and oil expenses A taxpayer can use either of 2 ways to work out fuel and oil expenses: (i) by using fuel and oil receipts if they have been kept; or (ii) by making a reasonable estimate based on odometer records: s 900-15(2). If using odometer records, a reasonable estimate of average fuel costs and average fuel consumption can be determined in most cases by reference to ABS figures on average retail prices and the Australian Fuel Consumption Guide: see Determination TD 97/19. Time period to be covered by log book For the first year in which car expenses are claimed under the log book method, a log book must be kept for a continuous 12-week period of the taxpayer’s choosing (or a longer period if desired). This period may overlap the start or end of the income year, as long as it includes part of the year. If a car is held for less than 12 weeks, the log book must cover that entire period. If the log book method is used for more than one car (not being replacement vehicles) for the same year, the same period must be used for each car: s 28-120(3). After establishing the extent of business use during the log book period, the taxpayer must use that information to estimate the number of business kilometres and business proportion of car expenses for the full year. However, variations in patterns of use must still be considered in making the estimate. These estimates must be recorded in writing before lodgment of the relevant income tax return, although the Commissioner has a discretion to allow more time: s 28-100(4). The established percentage must still be reasonable given any variation in use and the number of cars used during the year in question. When is a new log book required? Log books are required (s 28-115): • for the first year the method is used for a particular car (other than a nominated replacement); 280

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[9 160]

• after 5 years (ie the log book year and 4 subsequent years without a log book); • if required by the Commissioner by notice before a year commences; • if additional cars (other than nominated replacements only) are acquired for which the log book method is chosen; or • at the taxpayer’s option, eg to establish a higher business percentage.

Replacement cars A taxpayer may nominate a car as replacing an existing car from a specified date. The nomination must be recorded in writing before lodging the return for the year in which the replacement takes effect, although the Commissioner may extend that time: s 28-130. From the specified date, the replacement car is treated as the original car having been continuously owned and log books kept for the original vehicle need not be replaced: ss 28-130 and 28-115(5). [9 150] Comparison of methods – example The following example illustrates the deductions allowable under the 2 alternative methods for calculating deductible car expenses. Amounts are rounded to the nearest dollar. EXAMPLE [9 150.10] The taxpayer owns a car (engine capacity 2600 cc), the cost of which is totally financed by a loan at 13% interest. For decline in value (ie depreciation) purposes, the taxpayer uses the Commissioner’s effective life of 8 years for a car (see [106 030]). In the year in question, the taxpayer travels 36,000 km, of which 23,400 km is for business purposes. Total kilometres Percentage business use Annual costs: Interest on loan Decline in value/depreciation (prime cost) Registration and insurance Repairs and maintenance Petrol (10 litres/100 km @ say 140c per litre)

36,000 km 65% $4,550 4,375 2,300 900 5,040 $17,165

Deduction allowable: 1 Cents-per-kilometre method 2 Log book method:

23,400 (business km) 36,000 (total km)

5,000 × 66c

=

$3,300

× $17,165

=

$11,157

In this example, the log book method provides a substantially larger deduction.

[9 160] Switching methods The taxpayer is not bound to use the same method every year. For example, in Year 1 the log book method may be preferred for a particular car, while in Year 2 the taxpayer may wish to use the cents-per-kilometre method for that car. If the taxpayer has more than one car, different methods may be used within the same year for each car: s 28-20(3). If a taxpayer takes advantage of this option by switching methods, it will be necessary to keep log book records for a minimum continuous period of 12 weeks unless the log book method has been used within the preceding 4 years. © 2017 THOMSON REUTERS

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A taxpayer may also retrospectively change the method for a particular car for a year if, for example, on audit the Commissioner reduces the deduction claimed under the log book method because expenses or business use were overstated and the cents-per-kilometre method gives a better result: s 28-20(3).

[9 170]

Exceptions – alternative to statutory methods

In certain situations (specified in Subdiv 28-J), a taxpayer is not required to use either of the statutory methods discussed at [9 100]-[9 140]. Instead, the taxpayer can calculate deductions under the normal principles governing deductions, in particular s 8-1 ITAA 1997 (discussed in Chapter 8) and Div 40 ITAA 1997 (capital allowances: discussed in Chapter 10). This option is also available to recipients of certain PAYG withholding payments, such as company directors, office holders and religious practitioners, and to the recipients of payments for retirement or because of the termination of employment: s 28-185 Type of car Any type Any type Any type

Exempt circumstances The car is provided for the exclusive use of employees and/or their relatives and any of them was entitled to use it for private purposes. The car is hired or leased in the course of carrying on a business of hiring or leasing cars. During the period when a taxpayer owned or leased a car for use in producing assessable income:

When circumstances must be satisfied Whenever car used in the year Whenever car used in the year Whenever car used in the year

• it was used principally for that purpose; and • it was unregistered. Any type Panel van Utility truck Taxi Any road vehicle designed to carry a load of less than one tonne, but not a vehicle designed principally to carry passengers

The car was part of the trading stock of a business of Whenever car selling cars carried on by a taxpayer and he or she used used in the year it in the course of that business. A taxpayer used the car only: Whenever car used in the year (a) for travel in the course of producing her or his assessable income; and/or (b) for travel that is incidental to (a); and/or (c) for travel between her or his residence and where the car is used in the course of producing assessable income; and/or (d) by giving it to someone else for travel by them between their residence and where the car is used for the purpose in (a); and/or (e) for private travel by the taxpayer or someone else that was minor, infrequent and irregular.

Any type Any type

Any type

282

The car is unregistered and a taxpayer uses it principally Whenever car in producing assessable income. used in period held. (a) The car is trading stock of a taxpayer’s business of selling cars; and

(a) At some time in year

(b) the taxpayer did not use the car.

(b) At any time in year

The expense is to do with repairs or other work on the car and the taxpayer incurred it in her or his business of doing repairs or other work on cars.

Any time

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[9 200]

Incurring of both award transport payment and other car expenses If a taxpayer uses the exception from substantiation for travel expenses governed by an award transport payment (see [9 220]), the taxpayer does not have to use either of the statutory methods to calculate deductions for car expenses that are part of such travel expenses: s 28-180. However, if the taxpayer also incurs other car expenses not covered by the award payment, the taxpayer can either: • use a modified form of the cents-per-kilometre or log book method for those other car expenses. Kilometres travelled that are governed by the award transport payment exception are excluded: s 900-250(3). In addition, if the log book method is used to calculate a deduction for partially exempt car expenses, the method applies to the whole of the car expense without excluding the exempt part: s 900-250(5); or • elect not to use the award transport payment exception for all expenses (including car expenses) to which the exception would otherwise apply (s 900-250) and then adopt either of the 2 statutory methods in the ordinary manner for all car expenses incurred.

[9 180] Substantiation of car expenses No substantiation is required if the cents-per-kilometre method of deducting car expenses is used. Under the log book method, all car expenses require written evidence to support the deduction: s 900-70(1). The rules as to substantiation by written/documentary evidence are discussed at [9 1450] and following. Practice Statement PS LA 2005/7 contains guidelines for Tax Office staff as to what documentary or other evidence will normally be accepted as sufficient evidence to substantiate an individual taxpayer’s claim for deductible car expenses that relate to non-business and non-investment income. [9 190] Records – retention If written evidence of expenses is required, the retention period is that applicable under the general substantiation requirements: see [9 1500]. Log books are required to be retained for a period of 5 years from the later of the due date or actual date of lodgment of the return for the last year for which the log book is relied upon in estimating the business use percentage: s 28-150. This period may be extended if there is a dispute relating to a deduction worked out using the business percentage that the log book is designed to support, in the same manner as may occur under the general substantiation retention requirements. If log books are not retained, a deduction is not available for any amount calculated using the business percentage that the log book is required to support and amended assessments may be issued: s 28-150(4). Odometer records must be kept for the same period as any log book maintained for a year, but if a log book is not kept, the same retention rules as apply to general written evidence apply to the odometer records: s 28-155.

TRAVEL EXPENSES – SUBSTANTIATION [9 200] Substantiation of travel expenses The substantiation treatment for travel expenses varies according to the identity of the person incurring the expense (eg whether an employee), what it relates to, the manner of payment and/or any employment arrangements for such expenses. As a result, travel expenses need to be categorised in order to determine whether substantiation is required and, if so, the form it must take. There are 2 broad categories of travel expenses: employee travel expenses, which are generally work expenses, and business travel expenses (ie travel expenses incurred in © 2017 THOMSON REUTERS

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producing assessable income that is not salary or wages): see [9 1460]. Travel expenses include food and accommodation that is part of the travel. An employee travel expense must be substantiated in accordance with the general work expense rules discussed at [9 1460]. However, substantiation may not be required if the travel expense is incurred by an employee who is covered by a travel allowance or a pre-30 October 1986 industrial instrument: see [9 210] and [9 220]. A business travel expense must be substantiated in accordance with the general work expense rules discussed at [9 1450] and following, although if the expense is for fuel or oil the taxpayer may keep odometer records instead (see [9 180]): s 900-80. If the travel involves the taxpayer being away from their ordinary residence for 6 or more nights in a row, the taxpayer must keep certain travel records (see [9 250]). There are special rules for international flight crew: see [9 250]. Food and drink expenses that do not form part of travel expenses must be substantiated in accordance with the general work expense rules discussed at [9 1450] and following, unless covered by an overtime meal allowance (see [9 300]). In general, the record-keeping requirements for wage and salary earners (except those with travel allowances or award transport payments) and business taxpayers for both domestic and overseas travel is: • 1−5 nights away from home – written evidence; • 6+ nights away from home – written evidence plus travel diary (see [9 250]).

[9 210] Employees with travel allowances For employees with a travel allowance, substantiation is not required if the travel expenses satisfy certain criteria. This applies to both domestic and international travel allowances, but with some differences. Note that the receipt of a travel allowance does not necessarily mean that the recipient is entitled to a deduction or that any related expenditure is deductible. The expenditure must actually be incurred and it must be incurred for income-producing purposes, in accordance with general principles. A travel allowance is defined as an allowance paid by an employer to cover expenses for accommodation, food or drink, or expenses incidental to the travel, incurred by an employee for travel away from the employee’s ordinary residence (within or outside Australia) in the course of her or his employment duties: s 900-30(3). A camping allowance that is paid to a taxpayer for short periods of travel (less than 22 days) is considered to be a travel allowance: Determination TD 93/230. In Re Fardell and FCT (2011) 85 ATR 812, an allowance paid to a truck driver pursuant to an enterprise agreement was not considered to be a travel allowance as the driver was not required to sleep away from home. The allowance was categorised as a ‘‘loading’’ paid to drivers to travel long distances. Accordingly, the driver did not incur ‘‘travel allowance expenses’’ and thus the exemption from substantiation did not apply. A similar decision was reached in Re Fox and FCT (2013) 94 ATR 953, where an incentive to attract employees to work in a more remote location (also described as a ‘‘rental allowance’’) was not a travel allowance. However in Re Gleeson and FCT [2013] AATA 920, the taxpayer successfully argued that he received a travel allowance and was allowed a deduction for unsubstantiated travel expenses. A travel allowance expense is defined as a loss or outgoing incurred for travel that is covered by a travel allowance: s 900-30(2). The expense must be for accommodation, food or drink or must be incidental to the travel. In Hancox v FCT (2013) 95 ATR 574 (on appeal), an allowance was considered to be a living-away-from-home allowance (LAFHA) and not a travel allowance. As a result, deductions were not allowable against the allowance since LAFHAs are taxable to the employer under the FBT rules discussed at [58 550]. 284

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[9 210]

Domestic travel allowance expenses An employee can deduct a travel allowance expense for travel in Australia without documentary evidence (written or travel records) if the Commissioner considers the total amount claimed is reasonable: s 900-50. Each year, the Commissioner publishes daily rates (based on Australian Public Service rates) of travel allowance expenses considered to be reasonable (ie claims up to the amounts specified are reasonable). The reasonable amounts for 2016-17 (published in Determination TD 2016/13) are set out at [104 180]. Separate reasonable meal expense rates for employee truck drivers are set out at [104 160]. These amounts vary depending on the taxable income of the taxpayer. Allowances received by an employee must be shown in her or his tax return. This does not apply, however, to a bona fide overtime meal or travel allowance that does not exceed the reasonable amount (as specified by the Commissioner), is fully expended on deductible expenses and is not shown on the employee’s payment summary: see Ruling TR 2004/6. If the allowance is not shown in the return, there is no corresponding deduction for the expenditure. The ruling also states that: • if the allowance is greater than the reasonable amount, it must be shown as assessable income in the return but an unsubstantiated deduction may be claimed for an amount not greater than the reasonable amount; • if the deduction claimed is less than the allowance received, the taxpayer must show the allowance as assessable income in the return and claim only the amount of the deductible expenses incurred; and • if the deduction claimed is more than the reasonable amount, the whole amount must be substantiated and not just the excess over the reasonable amount. If the deduction claimed is less than the reasonable amount specified, substantiation is not required: Re Macintosh and FCT (2001) 47 ATR 1242. Part-day travel allowances (if the employee does not sleep away from home) are not covered by these reasonable travel allowance rules. Accordingly, the allowance should be shown as assessable income in the employee’s tax return and the corresponding claim for travel expenses is subject to the normal substantiation requirements: Ruling TR 2004/6.

Primary travel costs and other fares The actual payment of the primary travel cost (eg airfares) is not part of the travel allowance expense and, if incurred by an employee, must be substantiated in accordance with the general work expense rules discussed at [9 1450] and following. However, the employer would usually pay the primary fares directly and give the employee an allowance to cover other costs. Primary travel costs would not be incidental to the travel within the ordinary meaning of that term, and thus not within the definitions of travel allowance or travel allowance expense. Further, the amounts allocated to incidental costs in the Commissioner’s annual rulings on reasonable amounts covered by travel allowances seem to presume that primary travel costs are not covered. Although s 900-30(6) makes it clear that taxi fares or similar expenses are treated as work expenses (and thus must be substantiated unless falling within an exclusion), any incidental side trips (eg taxi, tram or bus trips between locations within the city being visited) are likely to be expenses incidental to the travel. The larger air or coach travel costs from the place of ordinary residence to the intended destination would represent the actual travel to which other costs must be incidental. Car expenses are subject to their own special rules: see [9 100]-[9 190]. © 2017 THOMSON REUTERS

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Overseas travel allowance expenses The rules that apply to domestic travel allowance expenses, to determine whether substantiation is required, also apply to overseas travel allowance expenses, but with 2 differences (s 900-55(1)): • the exception does not extend to accommodation expenses which must still be substantiated by written evidence: s 900-55(1); and • travel records, where otherwise applicable (see [9 250]), must still be maintained: s 900-55(3). The reasonable amounts for overseas travel allowance expenses for 2016-17 (published in Determination TD 2016/13) are set out at [104 190].

[9 220] Employees with award transport payments Claims by employees for expenses incurred against transport allowances or reimbursements, not exceeding the amount set by or determined in accordance with an industrial instrument (eg an award or agreement) in place on 29 October 1986, do not require substantiation by either written evidence or travel records: s 900-45 and Subdiv 900-I. Such expenses do not count towards the $300 limit for total work expenses, which can be claimed without substantiation: ss 900-35(3) and 900-245. Taxpayers wishing to claim a deduction in excess of the set amount will be required to substantiate their entire claim, not just the excess. This is true regardless of whether or not the applicable award has increased since 29 October 1986, unless the increase was built into the award as at that date, eg a percentage rate rather than amount or a clause allowing for indexation: s 900-235. While car expenses are included in the expenses that may be covered by this exception from substantiation, if a taxpayer also incurs car expenses not covered by an award transport payment, special rules apply: see [9 170]. [9 230] Employee work travel not covered by allowance or award Travel expenses incurred by employees if no allowance is paid, or which are not covered by an award transport payment, have to be substantiated in accordance with the general work expense rules discussed at [9 1450] and following. Whether or not substantiation of expenses is required, travel records (eg a travel diary) must be kept if the expenses claimed are for travel that involves the employee in travel away from home for 6 or more consecutive nights. Such travel may be within Australia or overseas: s 900-20. The requirements of a travel diary are discussed at [9 250]. [9 240] Business travel expenses A business travel expense (ie incurred in producing assessable income that is not salary or wages) must be substantiated in accordance with the general work expense rules discussed at [9 1450] and following. In addition, a travel diary is required if the travel involves an absence from home for 6 or more consecutive nights (see [9 250]). If the travel does not involve an overnight stay it is not business travel for substantiation purposes. A travel allowance expense (see [9 210]) cannot be a business travel expense: s 900-95(4). [9 250] Travel records If the travel involves the taxpayer being away from their ordinary residence for 6 or more consecutive nights, the taxpayer must maintain travel records in the form of a diary or other document: ss 900-20, 900-85. The requirement to keep travel records is a separate requirement to obtaining written evidence of travel expenses. The purpose of the travel records is to show which of the taxpayer’s activities were undertaken in the course of producing assessable income, so that an appropriate allocation can be made between deductible and non-deductible expenses: s 900-145. 286

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[9 300]

An activity is recorded by specifying in a diary or similar document (s 900-150): • the nature of the activity; • the day and approximate time it began; • the duration of the activity; and • where it occurred. Each activity must be recorded in English before, or as soon as possible after, it ends: s 900-150(2). If it is not recorded, it cannot be taken into account in working out the extent to which an expense incurred in relation to the travel is deductible: s 900-155. While only income-producing activities have to be recorded, apportionment is often easier if all activities are recorded.

International flight crew Members of international flight crews are exempt from keeping travel records if a travel allowance is received for travel that is principally outside Australia and the amount claimed does not exceed the amount of that allowance: s 900-65. The general exclusion from the written evidence requirements that applies in respect of overseas travel allowance expenses also applies: see [9 210].

PRIVATE EXPENDITURE [9 300] Food and drink Expenditure on food and drink is generally of a private or domestic nature and therefore not deductible under s 8-1. In FCT v Cooper (1991) 21 ATR 1616, a majority of the Full Federal Court held that the cost of additional food and drink consumed by a professional footballer on the instructions of his coach was not incurred in gaining or producing assessable income and therefore was not deductible. In AAT Case 10,666 (1996) 31 ATR 1349, a long-distance truck driver was denied a deduction for the cost of meals taken while on the road because they were of a private nature. The situation may be different if an employee is required to travel and sleep away from home (and receives a travel allowance to cover the cost of food and drink: see [9 210]) or receives an overtime meal allowance: see below. Meal costs of business people while on travel away from home, or as part of seminar registration fees, are usually deductible (provided the entertainment rules discussed at [9 500] and following are not breached): see ATO ID 2002/807. Overtime meal allowances Expenses on food or drink covered by a meal allowance (‘‘meal allowance expenses’’) are treated as ‘‘work expenses’’ for substantiation purposes (see [9 1460]). However, a meal allowance expense does not have to be substantiated if the meal allowance relates to overtime, is paid under an industrial instrument and is reasonable in amount: ss 900-30(5), 900-60. An ‘‘industrial instrument’’ is a Commonwealth, State or Territory law or an award, determination or industrial agreement made under such a law: s 995-1. The reasonable amount for 2016-17 is $29.40 (see Determination TD 2016/13). Note that a meal allowance expense must still satisfy the requirements of s 8-1 for it to be deductible. A deduction is not allowed if overtime is not actually worked or if an amount for overtime meals is folded-in as part of normal salary or wages, eg under a workplace agreement: Ruling TR 2004/6 (para 51). A claim that exceeds a reasonable amount, or relates to a meal allowance that does not fulfil the above criteria, must be substantiated as a ‘‘work expense’’ (see [9 1450] and © 2017 THOMSON REUTERS

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[9 310]

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following): s 900-30(4) and (5). Expenses that relate to meal allowances that are part of travel allowances are covered by those provisions (see [9 210]) and by not the meal allowance provisions: s 900-30(5).

[9 310]

Clothing

In most cases, expenditure on clothing is of a private or domestic nature. Nevertheless, if the clothing can be readily distinguished from normal day to day clothing and the necessity to wear such clothing can be specifically related to the taxpayer’s occupation, a deduction may be allowed. Expenditure on normal clothing may also be deductible, if the nature of the taxpayer’s occupation is such that it causes excessive wear and tear, damage or usage. Ruling TR 97/12 sets out the Tax Office’s views on the deductibility of expenditure on clothing.

Conventional clothing The cost of conventional clothing is usually not deductible as it is not distinguishable from normal day to day clothing that is worn outside work. If an employee is required to wear conventional clothing bearing the employer’s brand name, it remains conventional clothing (and thus the cost will generally not be deductible): Ruling TR 97/12. The cost of conventional clothing may be deductible if peculiar and unavoidable conditions in the taxpayer’s occupation cause the taxpayer to incur additional expense beyond that incurred by other persons. In FCT v Edwards (1994) 28 ATR 87, the Full Federal Court allowed the personal secretary to the wife of the Governor of Queensland a deduction for additional expenditure on clothing over and above the average of previous years. This was because her employment required attendance upon her employer at all public engagements and she was often required to change attire several times a day. In Ruling TR 94/22, the Commissioner identifies circumstances where the application of the principles in Edwards will lead to expenditure on conventional clothing being deductible, even if the clothing does not qualify as occupational clothing. In Mansfield v FCT (1995) 31 ATR 367, a flight attendant was allowed a deduction for shoes worn as part of a uniform, in particular because they were required to be at least half a size larger than for ordinary use and were subject to regular scuffing (ie abnormal wear and tear). She was also allowed a deduction for hosiery because it was part of her uniform and because the restricted cabin conditions meant greater snagging than usual (this abnormal wear and tear was used to justify the claimed level of expenditure, ie abnormal usage). Conventional clothing worn by police officers when on undercover duty may be deductible if it is of a kind the officer doesn’t normally wear: Ruling TR 94/22. In AAT Case 63 (1987) 18 ATR 3443, a sales manager for a footwear retailer was required to purchase and wear for display purposes a wide variety of expensive shoes. She was allowed a deduction for the difference between her actual expenditure and what she would otherwise have spent on shoes (ie the additional amount).

Occupational clothing Occupational clothing distinguishes a person as having a particular type of employment. Examples include a chef’s outfit, a nurse’s uniform, a pilot’s uniform, barristers’ and judges’ robes. In order to be deductible, occupational clothing need not be a uniform (see below) as such. For example, navy or white coloured stockings worn by a nurse as part of a uniform that necessitates purchases of abnormal quantities may qualify whereas flesh-coloured stockings are less likely to qualify: Ruling TR 95/15 (as amended by the Addendum) and Ruling TR 96/16. The Commissioner has also released a series of rulings dealing with an extensive range of deductions for specific occupations which generally contain guidance on the deductibility of clothing (see [9 1100]). 288

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[9 310]

Uniforms A prime example of clothing that will often qualify for deductibility is a uniform. However, the clothing must still be of a type not normally worn by persons in their non-employment activities. Examples include uniforms worn by police officers, ambulance officers, fire fighters and airline pilots. The mere fact that the employer requires a certain colour to be worn, such as blue dresses or white shirts, or certain types of clothing, such as suits, will not be sufficient to qualify for a deduction (eg AAT Re AX03B and FCT (2002) 51 ATR 1213). To qualify, the clothing should be tailor-made as a uniform, eg with precise uniformity of style and design and/or with a corporate identifier such as a logo, that is to be worn only while on official duty. The Commissioner’s views on what is required to constitute a corporate wardrobe or corporate uniform are set out in Determination TD 1999/62 (and Ruling TR 97/12). Non-compulsory corporate uniforms or wardrobes Additional restrictions (in Div 34 ITAA 1997) apply to the deductibility of non-compulsory corporate or other employer uniforms or wardrobes. The general principles governing the deductibility of expenditure under s 8-1 still need to be satisfied. Division 34 denies a deduction for items of clothing that, when considered as a set, distinctively identify the wearer as a person associated, directly or indirectly, with the person’s employer or associates of the employer except in 2 circumstances: • there is an express policy, which is consistently enforced, requiring all employees of the same class to wear such clothing; or • if not compulsory, the set of designs have been entered by the employer on the Register of Approved Occupational Clothing (the latest guidelines are the Approved Occupational Clothing Guidelines 2006). Protective clothing and occupation-specific clothing, such as traditional nurses’ uniforms and chefs’ chequered pants, are excluded from this restriction by s 34-10(3). If the clothing is not a distinctive set identifying the taxpayer with the employer, and the taxpayer is not relying on that criterion to obtain a deduction, the Div 34 restriction cannot prevent a s 8-1 deduction.

Protective clothing Expenditure on protective clothing that relates specifically to the occupational tasks performed by the taxpayer, and would not normally be worn on a day to day basis in normal life, is deductible. Examples include protective work boots, aprons worn by chefs, protective helmets worn by construction workers, special glasses worn by operators of video display units for protection from glare and overalls worn by tradesmen. The deductibility of expenditure on protective clothing, such as overalls and aprons, worn to prevent damage or soiling of the taxpayer’s ordinary clothing (rather than to protect against illness or injury) is considered in Ruling TR 97/12. The test case of Morris v FCT (2002) 50 ATR 104 established that sun-protection products (eg sunscreens, sunglasses and sunhats) used by outdoor workers are deductible if the job requires the person to work in the sun for all or part of the day. Following this decision, the Commissioner released Ruling TR 2003/16, which deals with the deductibility of expenses incurred by taxpayers in protecting themselves from the risk of illness or injury in the course of carrying out their income-earning activities. Other protective items that qualify for a deduction are: • anti-glare glasses worn by pilots and flight engineers: Ruling TR 95/19; and • sunglasses worn by a motorcycle police officer that had additional safety features relevant to that particular occupation: AAT Case 9254 (1994) 27 ATR 1233. © 2017 THOMSON REUTERS

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Cleaning and repairs If the cost of clothing is deductible in any of the circumstances considered at above, the taxpayer will also be able to obtain a deduction for cleaning and repair costs (see Ruling TR 97/12, para 95). Even if the cost of clothing is not deductible, cleaning and repair costs may be deductible if conditions peculiar to the taxpayer’s occupation result in excessive cleaning or repairs. In all other circumstances, cleaning and repair costs for clothing worn at work are not deductible as they are private in nature. [9 320] Accommodation The cost of accommodation is typically private in nature and thus not deductible: eg FCT v Charlton (1984) 15 ATR 711 and Re Fox and FCT (2013) 94 ATR 953, where accommodation expenses incurred because the taxpayers chose to live some distance from their workplace were not deductible. However, the cost of accommodation may be deductible if the taxpayer is required by her or his employer to live away from home for relatively short periods at a time: see [9 050]. For an example, see ATO ID 2002/427. Accommodation expenses incurred on a business trip are generally deductible: see [9 050]. In Re Scott and FCT (2002) 51 ATR 1122, the taxpayer claimed deductions for outgoings, including interest on a loan, in respect of a house he bought from his parents who remained in the house and paid rent. The taxpayer also moved in. The AAT characterised the arrangement as a private one, not least because the taxpayer consumed rental payments in the form of groceries and cooking and perhaps other domestic services, and denied the deductions. In Re Tabone and FCT (2006) 62 ATR 1210, interest on a loan used to acquire units in a unit trust which constructed the taxpayer’s home was not deductible. [9 330] Other private expenditure Medical expenses are generally of a private nature and thus not deductible: eg Re VBI and FCT (2005) 59 ATR 1197 (acute care nurse not entitled to a deduction for costs of seeing a psychologist). The cost of a vaccination to protect against infectious diseases in the work place is considered to be of a private nature (see Ruling TR 95/8), unless the disease being vaccinated against is restricted to persons working in a particular industry. For example, in ATO ID 2002/775, a sole trader who was regularly exposed to cattle that may be infected with Q fever, which is a recognised occupational hazard within the cattle industry, was allowed a deduction for the cost of a vaccination against Q fever. Expenses incurred in keeping fit (eg gym memberships) are generally considered to be of a private nature, unless strenuous physical activity is an essential and regular element of performing the employee’s duties, eg a police academy physical training instructor (Determination TD 93/114 and Ruling TR 94/20), a member of the SAS (Ruling TR 95/17) and a circus trapeze artist (Ruling TR 95/20). Applying the same principles, a professional sportsperson ought to be entitled to a deduction for gymnasium fees. The costs of a weight loss programme are considered to be of a private nature: Determination TD 93/112.

TAX ADVICE AND COMPLIANCE COSTS [9 350] Tax-related expenses that are deductible A wide range of deductions for tax advice and compliance costs is available under s 25-5, including preparation of income tax returns. Section 25-5(1) provides a deduction for expenditure (other than capital expenditure: see [9 360]) to the extent that it is incurred by the taxpayer for: • managing the taxpayer’s tax affairs (see below); • complying with an obligation imposed on the taxpayer by a law of the Commonwealth, insofar as that obligation relates to the tax affairs of any ‘‘entity’’ (as defined in s 960-100, which includes individuals) – this is not limited to obtaining advice; 290

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[9 350]

• the general interest charge (GIC) and the shortfall interest charge (SIC). If the GIC applicable to an RBA deficit debt is deducted, the corresponding GIC on tax debts allocated to the RBA is not deductible: s 25-5(7). Note that if the GIC or SIC is refunded to a taxpayer, the refunded amount may be assessable: see [6 580]; • a penalty under Subdiv 162-D GST Act (a GST instalment shortfall penalty); • obtaining a valuation from the Commissioner for the purposes of the deductible gift recipient (DGR) provisions: see [9 820]; or • obtaining a valuation from the Commissioner in relation to a deduction for entering into a conservation covenant: see [9 900]. In accordance with general principles, the deduction is available in the income year in which the expenditure is incurred (see [8 300]-[8 330] for when expenditure is ‘‘incurred’’). The GIC and SIC are considered to be deductible in the income year the relevant notice of assessment or amended assessment issues: see [8 310].

Managing tax affairs As noted above, a deduction is available under s 25-5 for expenses incurred in managing one’s own ‘‘tax affairs’’ and also for complying with a legal obligation relating to another’s ‘‘tax affairs’’. The term ‘‘tax affairs’’ means affairs relating to tax, while ‘‘tax’’ means income tax as assessed under the ITAA 1997 or ITAA 1936, whether imposed by the Income Tax Act 1986 or any other Act (note that mining withholding tax and withholding tax generally do not qualify as ‘‘income tax’’): s 995-1. What constitutes managing tax affairs is not spelt out in s 25-5. However, it should include: • preparing income tax returns: Bartlett v FCT; Falcetta v FCT (2003) 54 ATR 261 (upheld on appeal in Falcetta v FCT; FCT v Bartlett (2004) 56 ATR 59). The cost of preparing a foreign tax return would not be deductible; • preparing objections and answering Tax Office queries in relation to income tax; • attending to Tax Office audit requirements; • preparing documents requesting extensions of time etc; • obtaining valuations required under income tax laws, eg for consolidation purposes; • creating and maintaining records as required by the income tax laws. This would include obtaining copies of lost or destroyed documents: see [9 1500]; • obtaining legal advice on any of the above matters; • making applications to the AAT or appealing to a court; • conducting hearings before the AAT or a court; • tax planning advice; and • attending to ancillary matters and secondary taxes imposed under various Acts but assessed under the ITAA 1997, such as obligations relating to PAYG withholding amounts (including under a directors’ penalty notice (see [50 360]): ATO ID 2004/831), PAYG instalments, interest on overpayments, franking deficit tax, penalties, the GIC and the SIC (see Bartlett and Falcetta, where deductions were allowed for fees incurred by company directors in complying with the companies’ group tax and prescribed payments obligations – upheld on appeal in Falcetta v FCT; FCT v Bartlett (2004) 56 ATR 59). However, apart from the GIC, the SIC and penalties under Subdiv 162-D GST Act, the taxes and penalties themselves are not deductible: see [9 360]. © 2017 THOMSON REUTERS

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Consequently, the costs relating to those activities (eg fees paid to tax agents, solicitors and barristers and AAT and court fees) should be deductible under s 25-5 unless they are of a capital nature. Note that fees for income tax advice are not deductible unless the advice is provided by a registered tax agent or a legal practitioner: s 25-5(2)(e) (see [9 360]). In Re Harvey and FCT (2008) 72 ATR 541, the taxpayer was denied a deduction for an amount paid to his tax adviser as the taxpayer was unable to apportion the amount between those services which were for managing his tax affairs and those which were not. Travel costs may be deductible under s 25-5 if they are incurred in order to obtain an item allowable under that provision, such as preparing an income tax return: Determination TD 94/92. The Tax Office considers that the costs of a tax return preparation course incurred by a salary or wage earner with investment income are deductible: ATO ID 2003/955. In certain circumstances, the Tax Office will allow a deduction for a contribution to a fighting fund set up to fund litigation, negotiate a settlement or otherwise manage an income tax dispute arising from an investment or scheme: see Determination TD 2002/1. The fighting fund must be a properly administered trust fund. Any amount recouped from the trustee will be assessable under s 20-30: see [6 580].

Use of property The use of property in managing the taxpayer’s income tax affairs or in complying with tax obligations, while not generally itself deductible under s 25-5 because the cost of the property is capital, can give rise to deductions under other provisions because it is deemed by s 25-5(5) to be a use for the purpose of producing assessable income. This allows deductions such as for depreciation on computers used to prepare income tax returns, depreciation on buildings used to accommodate employees solely engaged in managing and administering income tax affairs and borrowing costs in acquiring property so used – but not the cost of the property itself, which is capital expenditure. Section 25-5(5) does not apply, however, if another provision of the ITAA 1997 or ITAA 1936 expressly states that a particular use of property is not taken to be for the purpose of producing assessable income: s 25-5(6). Tax advice Amounts paid for professional advice concerning taxation laws other than income tax (eg FBT and GST) are not deductible under s 25-5 (eg Drummond v FCT (2005) 60 ATR 356), but may be deductible under s 8-1 without the restrictions imposed by s 25-5 (see Jezareed Pty Ltd v FCT (1989) 20 ATR 683 and ATO ID 2002/814). As to whether the GST component of a tax agent’s/adviser’s fee is deductible, see [9 420]. Obligations relating to other taxpayers As noted above, the costs of complying with obligations relating to the tax affairs (as defined – see above) of any other taxpayer are deductible. Obligations to which this applies include obligations under the PAYG withholding system (see Chapter 50), the PAYG instalments system (see Chapter 53) and providing information or documents (eg under a s 264 notice) about another’s income tax affairs. Providing advice to a company director in relation to the preparation of company tax returns would also be covered, but not advice in relation to the liquidation of the company (at least before the issue of a director’s penalty notice) or the incorporation of a new company: see Bartlett and Falcetta (upheld on appeal in Falcetta v FCT; FCT v Bartlett (2004) 56 ATR 59). Assessable recoupments The assessable recoupment provisions Subdiv 20-A ITAA 1997 can operate in respect of the reimbursement or recoupment of expenses for which a deduction has been obtained under s 25-5: s 20-30(1), item 1.3; see also [6 580]. [9 360] Exclusions and restrictions Section 25-5 imposes a number of exclusions or restrictions on deductions allowable under the section. 292

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[9 370]

Capital expenditure Section 25-5(4) excludes capital expenditure. This would prevent a deduction, for example, for the cost of a computer used to prepare tax returns. However, it would not prevent a deduction for depreciation for the use of the computer: see [9 350]. Expenditure is not to be taken to be capital expenditure merely because the income tax affairs concerned relate to matters of a capital nature: s 25-5(4). Thus, a deduction is allowable for advice concerning the application of the CGT provisions to assets of the taxpayer or for the cost of disputing whether expenditure associated with the establishment of a new business is deductible. Certain ‘‘blackhole’’ capital expenditure is deductible over 5 years under s 40-880, although certain start-up expenses incurred by a small business entity are immediately deductible (applicable from the 2015-16 income year): see [10 1150]. Offence-related matters and penalties Section 25-5(2)(d) specifically excludes expenditure on matters relating to the commission or possible commission of an offence against an Australian (ie Commonwealth, State or Territory) or foreign law. This would include both the investigation and any proceedings in respect of the offence. Penalties (other than under Subdiv 162-D GST Act) are also not deductible: s 26-5 (see [9 990]). Tax collection Section 25-5(2)(c) excludes a deduction for expenditure for borrowing money, such as interest or borrowing expenses, in obtaining finance to pay either the taxes themselves or amounts withheld or payable under the PAYG system, eg PAYG instalments. This restriction extends to the fee charged by the Tax Office for using a credit card to pay a personal income tax debt: see ATO ID 2010/160. However, a business taxpayer will be allowed a deduction under s 8-1 ITAA 1997 for interest on loan funds used to pay income tax (ATO ID 2006/269): see [9 450]. Income tax and other taxes and charges that come within the extended definition of ‘‘tax’’ in s 995-1 are not deductible: see [9 410]. Other taxes and charges may be deductible: see [9 400]. Tax advice Section 25-5(2)(e) prevents fees or commission for advice concerning the operation of a law relating to taxation from being deductible under s 25-5 unless the advice is provided by a recognised tax adviser. A ‘‘recognised tax adviser’’ is defined in s 995-1 to mean a registered tax agent (see [56 030]) or a legal practitioner. Interestingly, s 25-5(2)(e) refers to advice about the ‘‘operation of a Commonwealth law relating to taxation’’. That expression would seem to encompass all Commonwealth taxes, yet a deduction is only available under s 25-5(1) for advice about income tax. Section 25-5(2) does not, however, prevent a deduction for the salaries of in-house tax advisers employed by the taxpayer who may not fall within one of the above categories, as such payments are not fees or commission. Other restrictions or exclusions Other provisions of the ITAA 1997 that would expressly prevent or limit the availability of a deduction for the expenditure under s 8-1, except the restrictions in that section itself, operate in the same manner to prevent or limit a deduction under s 25-5: s 25-5(3). For example, the entertainment expenses restrictions of s 32-5 would operate in relation to meals provided at tax planning seminars or business lunches held to discuss tax-related matters. [9 370] Partnerships, trusts and deceased estates For the purposes of claiming a deduction under s 25-5, the income tax affairs of a taxpayer include matters relating to the determination of the net income of a partnership or trust. Thus, expenditure incurred by a partnership or a trustee for a tax-related matter in © 2017 THOMSON REUTERS

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connection with the partnership or trust is deductible in calculating the net income of the partnership or partnership loss, or in calculating the net income of the trust estate. Section 25-5(8) deals with the situation where a taxpayer dies during an income year and the trustee of the deceased taxpayer’s estate incurs expenditure that would have been deductible to the taxpayer under s 25-5 if incurred in her or his lifetime. That expenditure is deductible in the return of the taxpayer for the period up to the date of death. In relation to returns of the estate itself for any period following death, deductions available under s 25-5 will be taken into account in calculating the net income of the trust estate.

TAXES AND OTHER GOVERNMENT CHARGES [9 400] Deductible taxes and charges Taxes other than income tax are generally deductible under s 8-1, provided there is a sufficient connection to the taxpayer’s income-producing activities and they are not of a capital or private nature. Taxes that are deductible include fringe benefits tax, pay-roll tax and land tax. Local government rates are deductible under s 8-1, to the extent the relevant property is used for income-producing purposes. The deductibility of rates and land tax paid by clubs or associations subject to the mutuality principle is governed by s 25-75: see [9 430]. Stamp duty is deductible if the transaction in respect of which it is imposed is not of a capital or private nature, or if it falls within one of the sections specifically relating to legal expenses and documents: see [9 670]. Government taxes and charges incurred in relation to the establishment of a small business entity or its operating structure are deductible as from the 2015-16 income year: see [10 1150]. PRRT Payments of petroleum resource rent tax (PRRT) and instalments of PRRT are deductible: s 40-750 (note the restriction if an asset is being put to a tax preferred use and Div 250 applies: see [33 100]). Any refund of PRRT is correspondingly assessable income: see [6 580]. Instalments of PRRT are deductible for income tax purposes in the income year in which they are paid (rather than after a final assessment of PRRT). Other payments of PRRT are also deductible in the income year in which they are paid. [9 410] Non-deductible taxes Income tax itself is not deductible (s 25-5(2)(a)), although an offset may be available for foreign income tax: see [34 200]. Other taxes and charges that come within the extended definition of ‘‘tax’’ in s 995-1 are also not deductible: s 25-5(2)(a). They include penalty tax, franking additional tax, franking deficit tax, deficit deferral tax and withholding tax (note that the general interest charge and shortfall interest charge are deductible). If interest payments to a non-resident lender are grossed-up to take account of the withholding tax, the grossed-up amount is not a payment in the nature of interest (see [35 350]) and is therefore not deductible. Amounts withheld or payable under the PAYG system (discussed in Chapter 50 and Chapter 51) are also not deductible: s 25-5(2)(b). There are specific prohibitions on the deductibility of the following amounts: the late lodgment amount of the superannuation supervisory levy (s 26-90); the superannuation guarantee charge (s 26-95); Div 293 tax and any debt account discharge liability (s 26-98); excess contributions tax (pre-1 July 2013: former s 26-75); excess concessional contributions charge (from 1 July 2013: s 26-74); excess non-concessional contributions tax (s 26-75); excess transfer balance tax (from 1 July 2017: s 26-99); the former superannuation contributions surcharge (s 26-60); and tax imposed under the Franchise Fees Windfall Tax (Imposition) Act 1997 (s 26-15) or the Commonwealth Places Windfall Tax (Imposition) Act 294

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[9 430]

1998 (s 26-17). The following are also not deductible: contributions used to offset the superannuation guarantee charge (see [39 100]); payments to reduce tertiary education or Trade Support Loan debts (see [9 970]); and payments to reduce a liability to the overseas debtors repayment levy (see [9 970]): ss 26-20, 290-95. Unit shortfall charges imposed under the Clean Energy legislation are not deductible: s 26-18. This provision has been repealed as a consequence of the repeal of the Clean Energy legislation (with effect from 1 July 2014).

[9 420] GST Division 27 ITAA 1997 sets out the effect of the GST on income tax deductions. The GST and GST-related terms used below are discussed in Chapter 60. The following GST amounts are not deductible: • amounts corresponding to input tax credits to which a taxpayer is entitled: s 27-5; • any decreasing adjustments: s 27-5; • if the GST transitional provisions operate to make GST payable on an outgoing incurred before 1 July 2000 (ie if a creditable acquisition occurs on or after that date), an amount equal to the input tax credit relating to that outgoing: s 27-30; and • GST payments: s 27-15(1). However, if an importation is not a creditable importation, or is only partly creditable, the GST paid on the importation, or on that part of the GST that is not matched by an input tax credit, is deductible (provided the criteria in s 8-1 for deductibility are satisfied: see Chapter 8): s 27-15(3). Wine equalisation tax and luxury car tax included in a net amount for GST purposes are also deductible provided the criteria for deductibility are satisfied: s 27-15(2). An increasing adjustment is deductible provided the adjustment does not relate to an increased use of the relevant item for private or domestic purposes: s 27-10(1) and 27-10(2). An increasing adjustment on cessation of an entity’s GST registration is deductible provided the asset to which the adjustment relates is held, immediately after the registration is cancelled, for the purpose of producing assessable income: s 27-10(3). A deduction is not allowed if the registration is cancelled because the entity is not carrying on an enterprise. In calculating the amount of a deduction, the GST components of amounts that form part of that calculation are excluded: s 27-20. Thus, GST payable is excluded from amounts received or receivable and amounts corresponding to input tax credits are excluded from amounts paid or payable. As a result, there is no basis on which to apportion a deduction relating to income derived from a taxable supply: see Determination TD 2005/35. In the case of a GST group or GST joint venture, the representative member’s or joint venture operator’s entitlement (as appropriate) to an input tax credit is to be treated, for the purposes of Div 27, as if each group member or participant in the joint venture (as appropriate) that made the acquisition or importation were entitled to the credit: s 27-25. The provisions discussed above do not apply to assets that have been depreciated (whether under Div 40: see Chapter 10) or (Div 328: see [25 100] and following): s 27-35. Subdivision 27-B (ss 27-80 to 27-110) applies instead: see [10 480], [10 810], [10 800] and [27 370].

[9 430] Rates and land tax – clubs and associations A club or association deriving mutual income (referred to in s 25-75 as ‘‘mutual receipts’’) is entitled to a deduction for annually assessed rates and State or Territory land tax payable in respect of premises it uses for the purpose of producing the mutual receipts, or in carrying on a business for that purpose, despite the fact that mutual income is not assessable income: s 25-75(1). Annually assessed rates and land tax payable in respect of premises used in producing amounts that are deemed by s 59-35 to be non-assessable non-exempt income © 2017 THOMSON REUTERS

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(amounts of ordinary income that would be mutual receipts but for the fact that the entity’s constituent document prevents the entity from making distributions to its members) are also deductible. The mutuality principle is discussed at [7 420]. The outcome is that mutual income is effectively treated as if it were assessable income for the purposes of determining the deductibility of rates and land tax. Hence, provided the premises are used only for producing mutual income or assessable income (eg from non-members), the rates and land tax are deductible in full against any assessable income without the need for apportionment between mutual and assessable uses: s 25-75(2). If the premises are used for a purpose other than producing mutual receipts, carrying on a business for that purpose or producing assessable income, an apportionment is required so that the deduction is denied to the extent of the use for that other purpose: s 25-75(3). Note that s 25-75 provides an exclusive code for the deductibility of rates and land tax in respect of premises used for mutual income purposes, as a club or association to which it applies is prevented from seeking a deduction under s 8-1: s 25-75(4).

INTEREST AND OTHER BORROWING EXPENSES [9 450] Interest Subject to the debt/equity rules (discussed in Chapter 31), interest is deductible if it satisfies the requirements of s 8-1. The mere fact that a taxpayer makes a large payment to somebody and labels it as interest will not be conclusive as to its categorisation; the real nature of the payment must be looked at so as to determine whether it really is interest. See, for example FCT v BHP Co Ltd (2000) 45 ATR 507 (discussed at [8 150]). Primary test – use of the borrowed funds The deductibility of interest is determined by looking at the purpose of the loan and the use to which the loan is put, although often the purpose and use will coincide: Ure v FCT (1981) 11 ATR 484; Fletcher v FCT (1991) 22 ATR 613 (discussed at [9 1390]). In ascertaining how borrowed moneys have been applied, a ‘‘rigid tracing’’ of the funds is not always necessary: see FCT v Roberts; FCT v Smith (1992) 23 ATR 494. In Ure’s case, the taxpayer borrowed moneys at ordinary commercial rates of interest and on-lent them at a 1% interest rate to his wife and a family company. The Federal Court found that the moneys were borrowed for 2 purposes, only one of which was to produce assessable interest income. The second purpose was to benefit the taxpayer and his family through the trust and by the provision of accommodation. Accordingly, the interest had to be apportioned and only that portion of the interest that was equivalent in amount to the interest income earned was deductible. Any security that has been given for the loan is irrelevant. Thus, if a loan is used to purchase assets of an income-producing business, to defray business expenses or to purchase property from which income is to be derived, the interest paid on the loan is deductible regardless of the security given to obtain the loan. Even if the security is a mortgage over the taxpayer’s home, the interest is still deductible. On the other hand, if a loan is used to purchase a property to be used for non-income producing purposes, eg the taxpayer’s home, the interest is not deductible, even if the loan is secured over income-producing assets. In FCT v Janmor Nominees Pty Ltd (1987) 19 ATR 254, a family trust borrowed money to acquire a home that it leased to the head of the family at a commercial rent. The Full Federal Court held that the interest was deductible (a residence acquired in this way will not qualify for the CGT principal place of residence exemption). In contrast, the Tax Office considers that interest incurred under a home loan unit trust arrangement is not deductible: Ruling TR 2002/18. Under such an arrangement, a taxpayer borrows money to invest in a unit 296

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trust. The trustee purchases a residential property which is leased to the taxpayer. The Tax Office distinguishes this situation from Janmor as the individual, not the trustee, claims interest deductions. In any event, even if the interest under a home loan unit trust arrangement were deductible, the Tax Office considers that Pt IVA would apply: see [42 280]. The same conclusion (as in Ruling TR 2002/18) was reached in Re Tabone and FCT (2006) 62 ATR 1210, where interest on a loan used to invest in a unit trust which owned and constructed the taxpayer’s family home was not deductible. Note also Taxpayer Alert TA 2009/20, which warns taxpayers about a scheme purporting to generate interest deductions through refinancing a home loan. Interest incurred on a loan used to acquire investments (eg shares) will be deductible if it is expected that assessable income (eg dividends) will be derived from the investment: see Ruling IT 2606 and FCT v Total Holdings (Australia) Pty Limited (1979) 9 ATR 885 (discussed at [9 1390]). In Spassked Pty Ltd v FCT (2003) 54 ATR 546, however, the Full Federal Court held that interest incurred by a holding entity on borrowings used to invest in shares in a subsidiary was not deductible because the requirements of the general deduction provision were not satisfied. The very substantial disproportion between the dividend income (approximately $44m) and the interest expense (approximately $888m) and the objective circumstances of the case showed that the expense was neither incurred in gaining or producing dividend income nor necessarily incurred in carrying on a business for the purpose of doing so. The case turned heavily on the facts. The decision was essentially confirmed in respect of different income years in IEL Finance Ltd v FCT (2010) 79 ATR 820. The taxpayer was successful in FCT v Ashwick (Qld) No 127 Pty Ltd (2011) 82 ATR 481 (Full Federal Court) when the concept of purpose was considered in the context of intra group loan arrangements. In Forrest v FCT (2010) 78 ATR 417, the Full Federal Court held that if interest was incurred on a loan used to acquire units in a unit trust, the issue of deductibility was determined by considering whether there was an expectation of distributions from the trust and not whether the taxpayer was presently entitled to the income of the trust in terms of Div 6 of Pt III ITAA 1936. Interest incurred on a loan used to purchase options to acquire shares will not be deductible as options have no entitlement to dividends: see ATO ID 2009/71. The Commissioner will allow a deduction for interest on a loan taken out to pay premiums under a keyman insurance policy, to the extent that the premiums are deductible: see [9 950]. See also AAT Case 13,481, Re Rydell Australia Pty Ltd and FCT (1998) 40 ATR 1197, where the beneficiary of a trust that derived income from a unit trust was allowed a deduction for interest on a loan used to finance premiums under keyman policies on the directors of the unit trust. Financing costs in respect of employer contributions to provide benefits for employees or their dependants are generally deductible, but not if made to a non-complying superannuation fund (see also Re The Magazine Company and FCT (2004) 58 ATR 1001). In Ruling IT 2582, the Commissioner states that interest on funds borrowed by a business taxpayer to pay income tax is deductible (see also ATO ID 2006/269). However, if a partner in a partnership borrows money to pay her or his own income tax, the interest is not deductible: Determination TD 2000/24 (see also [22 190]). Ruling TR 95/25 sets out revised Tax Office views on interest deductibility in the light of the replacement of funds used in the business test from FCT v Roberts; FCT v Smith (1992) 23 ATR 494 and deals separately with companies, individuals and partnerships. In relation to companies, it is stated that interest will be deductible if the borrowed funds are used to pay a dividend from profits arising from assessable income-producing activities or to buy back shares. © 2017 THOMSON REUTERS

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Interest incurred by a foreign bank on borrowings that fund the bank’s general reserve liquid assets, managed and controlled for use outside Australia, is not deductible: see ATO ID 2012/92. The Tax Office’s views on loan interest offset arrangements are set out in Ruling TR 93/6: see [6 260].

Contemporaneity In Steele v DCT (1999) 41 ATR 139, interest on a loan used to purchase a property to carry out a motel development was held by a majority of the High Court to be deductible, even though the property never became income-producing. Accordingly, Steele is authority for the proposition that interest incurred before any assessable income is derived is deductible, provided there is a sufficient nexus between the payment of interest and the earning of any potential future income. The interest was not incurred ‘‘too soon’’ and it did not matter that no assessable income was ever generated. See also [8 070] and [8 080]. Ruling TR 2004/4 states that interest incurred in a period before the derivation of relevant assessable income will be ‘‘incurred in gaining or producing the assessable income’’ (and thus deductible) if: • the interest is not preliminary to the income-earning activities and is not a prelude to those activities; • the period of interest outgoings before the derivation of relevant assessable income is not so long, taking into account the kind of income-earning activities involved, that the necessary connection between outgoings and assessable income is lost; • the interest is incurred with one end in view, the gaining or producing of assessable income, and is not private or domestic; and • continuing efforts are undertaken in pursuit of that end. Ruling TR 2004/4 also states that if interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income-earning activities have ceased, the outgoing will still have been incurred in gaining or producing assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period. This requires a judgment about the nexus between the outgoing and the income-earning activities. See also [8 090].

Apportionment If a loan is used for both assessable income-producing and non-income-producing purposes, the interest will have to be apportioned between the deductible and non-deductible amounts in accordance with general principles: see [8 040]. Interest incurred in deriving non-assessable non-exempt income is not deductible under s 8-1: see [8 020] and Ruling TR 2005/11. Ruling IT 2661 deals with apportionment of interest where money is borrowed to fund the purchase of an asset, part of which is used for a business purpose and part of which is used for a non-business purpose. [9 460] Restrictions on deducting interest There are a number of specific provisions in the ITAA 1997 and ITAA 1936 that may affect the deductibility of interest payments. For example, there are restrictions under ss 26-80 and 26-85 on deducting interest on loans to finance employee superannuation contributions and certain insurance premiums (see [9 470]) and s 26-35 ITAA 1997 may restrict the deduction for interest paid to a related entity (see [9 1050]). There are also restrictions on deducting interest on certain deferred interest securities (see [32 410]) . The thin capitalisation provisions may deny interest deductions in respect of cross-border transactions (see Chapter 38). Sections 82KJ, 82KK and 82KL ITAA 1936 may operate to defer or deny a deduction for interest paid: see [43 020] and following). Finally, the general anti-avoidance 298

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[9 470]

provisions of Pt IVA ITAA 1936 (discussed in Chapter 42) may apply to deny interest deductions under a scheme that was entered into for the dominant purpose of obtaining a tax benefit (eg the application of Pt IVA to linked or split loans is considered at [32 605]).

Interest as a capital outgoing The High Court in Steele v DCT (1999) 41 ATR 139 considered whether the interest incurred in that case was capital (as held by the Full Federal Court). The High Court held that it was not capital being a recurrent payment to secure the use of loan funds for a limited term. That the loan is for the acquisition of a capital asset does not mean that the interest is capital. In FCT v R & D Holdings Pty Ltd (2007) 67 ATR 790, the Federal Court confirmed that unpaid interest on a loan used to acquire an income-producing property was deductible even though it was capitalised each income year. In determining whether an outgoing is of a capital nature, the accounting treatment that the taxpayer adopts will not be decisive of its nature for tax purposes. Hence, the fact that a company chooses to capitalise interest as part of the cost of an asset purchased with borrowed funds does not mean that the interest expense will be regarded as being of a capital nature for tax purposes. However, in Macquarie Finance Ltd v FCT (2005) 61 ATR 1, the Full Federal Court confirmed that interest paid on stapled income securities was not deductible because it was an outgoing of a capital nature connected with the cost of a permanent injection of capital rather than the cost of income-producing borrowing. Similarly, In St George Bank Limited v FCT (2009) 73 ATR 148, the Full Federal Court decided that, having regard to the commercial context and legal structure used, the advantage sought by the payment of interest to an overseas subsidiary was the maintenance of a capital structure for the long term benefit of the taxpayer. In both cases, therefore, the interest payments at issue were held to be capital by reference to the overarching purpose of the banks to add to their equity capital. In coming to this conclusion, the courts departed from the perhaps more traditional approach which emphasizes an objective derivation of assessable income. [9 470] Borrowing expenses Expenditure incurred by the taxpayer in borrowing money is deductible under s 25-25, to the extent that the borrowed money is used for the purpose of producing assessable income. This is a year-by-year test, allowing for changes in the use of the borrowed funds, rather than a test applied only at the time of borrowing. Section 25-25 is concerned with the cost of borrowing, as distinct from the interest on the loan, which is a cost of the use of the money and thus deductible under s 8-1: see [9 450]. Guarantee fees payable on an annual basis during the term of the relevant loans were held to be deductible under the predecessor to s 25-25 (s 67 ITAA 1936): Ure v FCT (1981) 11 ATR 484. See also Re The Company and FCT (1999) 42 ATR 1181. Borrowing expenses include procuration fees, legal costs, search, valuation, survey and registration fees, fees paid for guaranteeing an overdraft, commission paid to brokers and other expenses incurred in raising money by the issue of debentures and the like. The payment of a life insurance premium is not a borrowing expense: AAT Case 6917 (1991) 22 ATR 3157. Although a fee charged by the Tax Office for using a credit card to pay a personal income tax debt may be expenditure incurred in borrowing money, the borrowed moneys are not used to produce assessable income and therefore the fee is not deductible under s 25-25: see ATO ID 2010/161. For a case where interest and borrowing expenses were held to be deductible under the general deduction provision (now s 8-1) where shares were acquired by a company as agent, see McGuiness v FCT (1991) 23 ATR 75. If a parent company incurs expenditure for borrowing money and on-lends part of those borrowings to a subsidiary, the subsidiary cannot claim a deduction under s 25-25 for a proportion of the borrowing expenses passed on to it by the parent company as the subsidiary does not incur the expenditure (see ATO ID 2009/51). © 2017 THOMSON REUTERS

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Calculating the deduction The deduction in respect of the total expenditure is spread over the period of the loan as specified in the original loan contract, unless that period exceeds 5 years from the date the money was borrowed or the loan is repaid early: s 25-25(5). If the period exceeds 5 years, the deduction is spread over 5 years, being 5 actual years from the date of borrowing. This may in fact mean deductions over 6 income years. For example, if $1,000 were incurred in borrowing money for a period of 7 years from 30 December 2012, the borrower would be entitled to a deduction of $100 in the 2012-13 income year, $200 each year for the next 4 income years and $100 in 2017-18. If the loan is repaid early, any unused deductions are brought forward to the year of repayment (s 25-25(5)(b)) and step 2 of the method statement in s 25-25(4) for calculating the maximum deduction for an income year – step 2 requires the period of the loan to be determined as at the end of the income year. If the total expenditure on all deductible borrowing expenses incurred in an income year (including the income-producing portion of loans used partly for income-producing purposes, but not including unused deductions from previous years) does not exceed $100, the full amount is deductible in the year in which it is incurred without the necessity of apportioning the claim over the period of the loan: s 25-25(6). The deduction for expenditure incurred in borrowing money used only partly for the purpose of producing assessable income is calculated in the same manner as for money used solely for income-producing purposes, but is then reduced by the proportion of non-income-producing use within the income year: s 25-25(3). Deductibility may be restricted or denied under Div 250 in relation to certain leasing and similar arrangements (see [33 100]), under s 82KL in relation to expenditure recoupment schemes (see [43 020]) or under the commercial debt forgiveness provisions (see [8 700]). Borrowings to pay superannuation contributions and life insurance premiums Financing costs connected with superannuation contributions are only deductible if the contributions are deductible under Subdiv 290-B ITAA 1997 (see [39 100]): s 26-80. A financing cost is expenditure that relates to obtaining finance to make the contribution and includes interest and borrowing expenses. Borrowing costs, including interest, associated with a loan to pay a life insurance premium are only deductible if the entire premium represents the risk component and any amount payable under the policy is assessable income of the recipient: s 67AAA, s 26-85.

ENTERTAINMENT [9 500] Entertainment expenses Division 32 ITAA 1997 contains the rules governing the deduction of entertainment expenses. The general rule is that, except in very limited circumstances, entertainment expenses are not deductible: s 32-5. Even if a deduction is not denied under Div 32, the requirements of s 8-1 must still be satisfied. Entertainment is defined as entertainment by way of food, drink or recreation, or accommodation or travel to do with providing such entertainment: s 32-10. Entertainment is taken to be provided even if business discussions or transactions occur: s 32-10(2). Entertainment expenditure incurred in providing a taxable fringe benefit is deductible: s 32-20. However, if the benefit is an exempt fringe benefit, the entertainment expenses are not deductible. If the taxable value of the benefit is reduced under s 63A FBTAA (where an employee is reimbursed entertainment expenditure incurred in respect of a third party who is not an associate of the employee: see [58 480]), the amount of the reduction is not deductible: s 32-20. Similarly, if the employer elects (under s 37AA, s 37CA or 152B FBTAA) to use the 300

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[9 500]

50/50 split method or the 12-week register method to determine the taxable value of the benefit (see [58 620]), the deduction is reduced proportionately: ss 51AEA to 51AEC ITAA 1936.

Provision and use of property Division 32 in Pt 2-5 also denies a deduction (eg for depreciation) in respect of property to the extent that it is used in providing entertainment: s 32-15. The provision of items such as bottled spirits, TV sets, VCRs, computers, swimming pools and gardening equipment does not generally constitute the provision of entertainment: Determination TD 94/55. The costs of corporate boxes are primarily non-deductible entertainment expenses, except where fringe benefits: Determination TD 92/162 (see [9 510] for the elective deduction method). However, to the extent that advertising signs are provided, a pro-rata deduction will be allowed, generally 5% in the absence of evidence to the contrary. Provision of food and drink Ruling TR 97/17 summarises the Tax Office’s views on the application of the ITAA 1936, ITAA 1997 and FBT legislation to entertainment by way of food and drink. The ruling considers entertainment to have been provided only when the food and drink confers entertainment on the recipient. This requires an objective analysis of all the circumstances surrounding the provision of food and drink. The Tax Office considers the following factors to be relevant. 1. What type of food and drink is being provided – morning and afternoon teas and light meals are generally not considered to constitute entertainment, nor does a cup of tea or coffee (see Private Ruling Authorisation No 38556). However, as light meals become more elaborate they are considered to take on more of the characteristics of entertainment. The reason is that the more elaborate a meal, the greater the likelihood that entertainment arises from its consumption. 2. When that food and drink is being provided – food and drink provided during work time, during overtime or while an employee is travelling is considered less likely to have the character of entertainment. 3. Where the food and drink is being provided – food and drink provided on the employer’s business premises or at the employee’s usual place of work is less likely to have the character of entertainment. However, the provision of food and drink in a function room, hotel, restaurant, cafe, coffee shop or consumed with other forms of entertainment is more likely to have the character of entertainment, because it is less likely to have a work-related purpose. 4. Why the food and drink is being provided – food and drink provided for the purposes of refreshment and sustenance are not generally considered to have the character of entertainment, whereas food and drink provided in a social situation where the purpose of the function is for employees to enjoy themselves will have the character of entertainment. The ‘‘purpose’’ is to be determined objectively and not by the subjective purpose of the person providing the food and drink: see FCT v Amway of Australia Ltd (2004) 57 ATR 339 at 357. While none of these factors are individually determinative, Items 1 and 4 are the most important. The word ‘‘entertainment’’ seemingly has its dictionary meaning of ‘‘to hold the attention of agreeably, divert, amuse’’ and ‘‘to receive as a guest, especially at one’s table, show hospitality’’: see Amway at 357. An element of entertainment is required before the provision of food and drink becomes an ‘‘entertainment meal’’, which arises when the food and drink provided has the character of entertainment such as business lunches and drinks, dinners, cocktail parties and staff social functions. The meal is often substantial, may be consumed as part of a social gathering or may be consumed with other forms of entertainment. In Amway, it was held that, having regard to the locale at which the food and © 2017 THOMSON REUTERS

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drink were provided and the inferred cost and quality, this constituted entertainment. However, the Amway case concerned s 51AE ITAA 1936 (the predecessor to Div 32) which had an exception in s 51AE(5) allowing Amway a deduction for the food and drink (except the gala dinner). As this exception was not rewritten in Div 32, the Amway decision may have limited application. The provision of morning and afternoon teas for employees (and their associates) and light ‘‘working lunch’’ meals would not amount to entertainment for Div 32 purposes. Similarly, the provision of a basic meal to enable an employee to complete a working day or food and drink consumed in the course of work-related travel (whether the employee eats alone or with others) does not have the character of entertainment. However, this would not apply if other factors are present (eg there is a floor show). On this basis, the meal of a restaurant reviewer and the ticket of a theatre critic (if work-related) would not have the character of entertainment as it is part of their working environment (and therefore the cost would be deductible). The provision of accommodation and travel ‘‘to do with providing entertainment by way of food, drink or recreation’’ is also Div 32 entertainment: s 32-10(1). In the Amway case, it was held that the seminars were a serious business event and that the travel and accommodation were provided to bring Amway distributors to the event and were not ‘‘in connection with’’ or ‘‘for the purposes of facilitating’’ (the relevant phrases in s 51AE(3)) the provision of food, drink or recreation (and, therefore, the costs were deductible). It is uncertain whether the phrase ‘‘to do with’’ (in s 32-10(1)) has a different meaning to ‘‘in connection with’’ (in s 51AE). However, s 32-10(2) provides that the taxpayer is taken to provide entertainment even if business discussions or transactions take place.

Summary of Tax Office views – consequences of provision of food and drink The table below summarises the Commissioner’s views, as expressed in Ruling TR 97/17 (and the Addendum to the Ruling), on the taxation result (income tax and FBT) of common situations involving the provision of food and/or drink. Circumstances in which food and drink Is provided entertainment conferred? Consumed by employees on employer’s business premises: • social function Ent • in-house dining facility: not Ent/Non-ent party, etc • in-house dining facility: party, Ent etc • morning or afternoon Non-ent teas/light lunches Consumed by associates on employer’s business premises: • social function Ent • in-house dining facility: not Ent/Non-ent1 party, etc • in-house dining facility: party, Ent etc • morning or afternoon Non-ent1 teas/light lunches Consumed by clients on employer’s business premises: • social function Ent • in-house dining facility: not Ent/Non-ent party, etc

302

Exempt body FBT

Taxable employer FBT Tax deduction

Yes No

No No

No Yes

Yes

No

No

No

No

Yes

Yes Yes

Yes Yes

Yes Yes

Yes

Yes

No

Yes

Yes

Yes

No No

No No

No No2/Yes

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Circumstances in which food and drink Is provided entertainment conferred? • in-house dining facility: party, Ent etc • morning or afternoon Non-ent teas/light lunches Consumed off employer’s premises at social function or business lunch by: • employees Ent • clients Ent • associates Ent Alcohol: • employee travelling: wine Non-ent accompanies evening meal • at conclusion of continuing Non-ent professional development (CPD) seminar with finger foods Consumed by employees while travelling: • travels and dines alone Non-ent • 2 or more employees travel Non-ent and dine together • travels with client and dine Non-ent together • travels with client and dine together except employer pays for all meals: – employee’s meal Non-ent – client’s meal Non-ent • dines with client travelling Non-ent separately • dines with employee not travelling: – travelling employee’s Non-ent meal only provided – all meals provided by employer: – nonEnt travelling employee – travelling Non-ent employee • dines with client not travelling: – employee’s meal only Non-ent provided – both meals provided: – employee’s Non-ent meal – client’s meal Ent Employees dining with other employees of either same employer or associate of employer: • employee entertains other Ent employee and subsequently reimbursed by employer © 2017 THOMSON REUTERS

Exempt body FBT

[9 500]

Taxable employer FBT Tax deduction

No

No

No

No

No

Yes

Yes No Yes

Yes No Yes

Yes No Yes

No

No

Yes

No

No

Yes

No No

No No

Yes Yes

No

No

Yes

No No No

No No No

Yes Yes Yes

No

No

Yes

Yes

Yes

Yes

No

No

Yes

No

No

Yes

No

No

Yes

No

No

No

Yes

Yes

Yes

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Circumstances in which food and drink Is provided entertainment conferred? • employee entertains employee of associated company and subsequently reimbursed: – employee’s employer Ent (expense payment) – employer’s associate Ent (property benefit) Meal consumed by employees while attending seminar: • provided incidental to eligible Ent/Non-ent seminar not held on employer’s premises • light breakfast provided at Non-ent CPD seminar that is not eligible seminar • light refreshments (including Non-ent moderate amount of alcohol) provided immediately after CPD seminar that is not eligible seminar Consumed by employees at Ent promotions function not held on employer’s premises and open to general public Meals provided under arrangement: • employer aware of and consents to employee being taken to dinner by client: – employee Ent – client Ent Use of corporate credit card if Ent employees dine together at restaurant and meal paid for with credit card Hotel discount cards: • employee who holds restaurant discount card entertains client: – employee: 50% total Ent discounted price – client: 50% total Ent discounted price • employee uses card to entertain 4 clients and cardholder’s meal cost reduced by 25% for each additional person: – employee: cost Ent reduced to nil – client Ent Accompanying spouses: • with employee travelling on business and employer pays for all meals: – employee Non-ent – spouse Ent

304

Exempt body FBT

Taxable employer FBT Tax deduction

Yes

Yes

Yes

Yes

Yes

Yes

No

No

Yes

No

No

Yes

No

No

Yes

Yes

Yes

Yes

Yes No Yes

Yes No Yes

Yes No Yes

Yes

Yes

Yes

No

No

No

No

No

No

No

No

No

No Yes

No Yes

Yes Yes

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[9 520]

Exempt body Taxable employer Circumstances in which food and drink Is FBT FBT Tax provided entertainment deduction conferred? Tax-exempt bodies: • entertainment meal provided Ent Yes N/A N/A to employees on employer’s premises • meals provided to employees Ent/Non-ent No N/A N/A in in-house dining facility • provision of Non-ent No N/A N/A non-entertainment meal to employees 1 Considered to be reportable fringe benefits (see [59 200]): Addendum to Ruling TR 97/17. 2 If entertainment is conferred, the employer has the option under s 32-70 of claiming a deduction for the cost of the meal and including $30 in assessable income: see [9 520].

[9 510] Meal entertainment or corporate box – election If a taxpayer has elected for FBT purposes to use the 50/50 split method (see [58 620]), a deduction equal to the cost of 50% of meal entertainment expenses incurred during the income year is allowable: s 51AEA(1) ITAA 1936. ‘‘Meal entertainment’’ is defined as the provision of: • entertainment by way of food and drink; • accommodation or travel in connection with or for the purpose of facilitating entertainment by way of food or drink; or • payment or reimbursement of expenses incurred in providing something covered by either of the above. Alternatively, if a taxpayer has elected to use the 12-week register method for the purposes of calculating meal entertainment expenses subject to FBT (see [58 620]) a deduction for meal entertainment expenses calculated in accordance with the following formula is available: s 51AEB(1) and (2). Total deductions for register meal entertainment × 100% of total meal entertainment expenses Total register meal entertainment expenses

Corporate boxes If an employer has elected to apply the 50/50 split method to corporate box leasing or hiring expenses, a deduction equal to 50% of these expenses is allowable: s 51AEC. [9 520] Allowable entertainment expenses Division 32 Pt 2-5 does not apply to the kinds of entertainment expenses listed below (ss 32-25 to 32-50) and therefore the expenditure in question may be deductible under s 8-1: see [9 420] as to the deductibility of any GST amounts. 1. Expenditure on entertainment by a taxpayer who carries on a business of providing entertainment is deductible: s 32-40. Examples are restaurants and theatres. 2. Expenditure incurred in providing entertainment in the form of promotional giveaways is deductible, provided that it is made available on a non-discriminatory basis to the public at large and is incurred for the purpose of promoting or advertising the business or products of the taxpayer: s 32-45. 3. Expenditure incurred in promoting or advertising to the general public goods or services that are provided by the taxpayer’s business, and the expenditure is incurred in providing or exhibiting those goods or services to the public at large, eg shopping mall exhibitions, is deductible: s 32-45. © 2017 THOMSON REUTERS

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4. The provision of entertainment in the course of promoting or advertising to the public a business carried on either by the taxpayer or by a third party, or in advertising and promoting goods or services provided by a business carried on by the taxpayer or another person is deductible: s 32-45. The expenditure must be incurred in providing benefits to all persons including ordinary members of the public on a non-discriminatory basis, eg free passes provided by a theatre. 5. Expenditure incurred in the form of an entertaining allowance paid to an employee if that allowance is assessable income to the employee concerned: s 32-30 (Item 1.8); but see also [9 550]. Note that an amount may be withheld under the PAYG system: see [50 030]. 6. Expenditure incurred in providing food or drink on ordinary working days to employees and other individuals at an in-house dining facility on the business premises of the taxpayer is deductible unless provided at a party, reception or other social function (see [9 530]): s 32-30 (Items 1.1, 1.3). For these purposes, ‘‘employees’’ include direct employees and employees of related companies, ie subsidiaries, parent companies or associated subsidiaries, provided there is 100% common ownership: s 32-85. Company directors are employees for this purpose: s 32-80. Under s 32-70, if food and drink are provided to a non-employee at an in-house dining facility, an amount of $30 per person must be included in assessable income. Alternatively, an election may be made to exclude from deduction the proportion of expenditure incurred for the cost of food or drink for non-employees. Expenditure on morning and afternoon teas and light meals provided to employees, associates and visitors to the taxpayer’s premises is deductible, provided no alcohol is supplied: Ruling IT 2675. While the provision of alcohol will usually denote entertainment, there may be situations where it may be incidental to a larger event or work-related activity of an employee. The 4 tests discussed at [9 500] are relevant. The table in [9 500] provides 2 examples where the provision of alcohol would not be a disqualifying factor: see Ruling TR 97/17. Board rooms and meeting rooms with attached kitchen facilities are not considered to fall within the definition of an ‘‘in-house dining facility’’ (s 32-55) and therefore the costs of providing substantial meals to employees in these facilities will not be deductible (unless another exception in Div 32 applies). 7. In certain circumstances, expenditure on food or drink at a seminar that lasts for not less than 4 hours (excluding meal and other rest breaks) is deductible: s 32-35 (see [9 540]). 8. Expenditure incurred on the provision of in-house recreational facilities for employees (including company directors: s 32-80) is deductible, provided the facility is not for accommodation or dining and drinking (unless the food or drink is provided by a vending machine): s 32-30 (Item 1.5). 9. Expenditure incurred on the provision of food and drink to an employee under the provisions of an industrial agreement relating to overtime is deductible: s 32-30 (Item 1.4). However, the provision of food or drink by mutual agreement between employer and employee in respect of overtime does not qualify for deduction. 10. Expenditure incurred by employees on food and drink in connection with overtime worked is deductible, provided they receive an allowance under an industrial instrument (see [9 300]) to buy the food and drink: s 32-50. 306

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[9 540]

11. Expenditure on entertainment incurred by an employee of a business that provides entertainment, where the expenditure is incurred as part of their work duties, is deductible: s 32-40. 12. Expenditure on entertainment incurred by a taxpayer in providing free entertainment to the sick, disabled, poor or otherwise disadvantaged members of the public is deductible: s 32-50. 13. Section 32-30 (Items 1.6 and 1.7) excludes from the prohibition on deductibility certain meal and food or drink fringe benefits that are either totally exempt or given concessional treatment under the FBTAA 1986. This is a drafting measure to exclude these benefits from FBT and retain their deductibility under the ITAA 1997. However, these provisions also need to be read in conjunction with s 32-20, which excludes other fringe benefits that are liable to fringe benefits tax from the prohibition on deductibility: see [9 500] and [9 510] in relation to some benefits subject to concessional FBT treatment for which partial deductions are allowable. 14. As noted at [9 500], expenditure incurred in providing entertainment by way of a taxable fringe benefit is deductible (although the amount of the deduction is reduced in certain circumstances): s 32-20.

[9 530] Parties and presents for employees The exclusion for food and drink provided to employees in in-house dining facilities does not apply to food or drink supplied at parties, receptions or other social functions for employees in those facilities. In most cases, however, food or drink provided to the employees as part of a Christmas party or other social function would constitute a fringe benefit and therefore would not be subject to the restriction on deductibility under the entertainment provisions. This is subject to any FBT exemptions, for example the minor benefits exemption (see [57 250]). Presents If a small Christmas present, such as whisky, wine or a food hamper from an employer to an employee, constitutes the provision of entertainment by way of food, drink or recreation (as defined in Div 32 Pt 2-5) the cost will not be deductible unless it constitutes a fringe benefit. However, it is likely that such a small Christmas present will not constitute the provision of entertainment: see Ruling TR 2007/12. Other presents that would be considered to be the provision of entertainment, regardless of where they are enjoyed, include holidays, tickets to sporting events, the theatre or cinema and restaurant functions. Staff Christmas functions constitute entertainment and their cost will only be deductible if they constitute employer-provided fringe benefits, which in most cases they will: see above. [9 540] Seminars The Div 32 restriction on claiming a deduction for entertainment expenses does not apply to food, drink, accommodation and travel that is reasonably incidental for attendance at a seminar (including by the taxpayer) of not less than 4 hours duration (excluding meal and other rest breaks): ss 32-35 and 32-65. In this context, ‘‘seminar’’ includes a conference, convention, lecture, training session (although see below) and question and answer session: s 32-65(1). A deduction will be denied, however, if the seminar is a business meeting, ie if the main purpose of the meeting is to provide information about, or to discuss, the taxpayer’s business or prospective business: s 32-65(3). In Amway of Australia v FCT (No 2) (2003) 54 ATR 480, it was held that Amway’s Australian Leadership Seminar was essentially a business meeting within the terms of the corresponding provision in the ITAA 1936 (s 51AE) as ‘‘a seminar, even according to the extended definition, requires a certain focus, formality and structure’’. The decision was upheld on appeal in FCT v Amway of Australia Ltd (2004) 57 ATR 339. © 2017 THOMSON REUTERS

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A deduction will also be denied if the main purpose of the seminar is to promote or advertise a business, or prospective business, and/or its goods or services or to provide entertainment at, or in connection with, the seminar: s 32-35. Training meetings (ie to train the taxpayer’s employees) and policy meetings relevant to the internal management of the taxpayer’s business are not business meetings for these purposes, provided they are conducted on the premises of another person whose business includes organising or hosting seminars: s 32-65(3). The seminar exception may apply in such a case.

[9 550] Relatives’ allowances A deduction may be allowable for an entertainment allowance paid to an employee (or a company director: s 32-80) if the allowance is assessable income of the employee: see [9 520]. This exception does not apply, however, if the employee to whom the allowance is paid is a relative of another employee and the allowance is paid because the relative provides, or facilitates providing, entertainment connected with the other employee’s employment and the employer expects the relative to do so. A ‘‘relative’’ is defined in s 995-1 as: (a) the taxpayer’s spouse – this includes a de facto spouse (whether of the same or opposite sex) and another individual with whom the taxpayer is in a relationship that is registered under a relevant State or Territory law; (b) a parent, grandparent, brother, sister, uncle, aunt, nephew, niece, lineal descendant (eg child and grandchild) or adopted child of the taxpayer or of the taxpayer’s spouse – note that a ‘‘child’’ also includes someone who is the product of a relationship the taxpayer has or had as a couple with another individual (including a same sex partner). However, someone cannot be the product of a relationship unless he or she is the biological child of at least one of the individuals in the relationship or was born to a woman in the relationship; or (c) the spouse (see above) of any person referred to in (b). Note also that s 960-255 ITAA 1997, which provides non-discriminatory rules for determining when certain family relationships are recognised (including same sex relationships), may affect the meaning of ‘‘relative’’ for these purposes (eg step-brothers and step-sisters may qualify as relatives).

[9 560] Leisure facilities Section 26-50(1) generally denies a deduction for expenditure on leisure facilities. A ‘‘leisure facility’’ is defined in s 26-50(2) as land, a building or part of a building or other structure used (or held for use) for holidays or recreation (‘‘recreation’’ includes amusement, sport or similar leisure-time pursuits: s 995-1). A leisure facility may include holiday cottages, tennis courts, a swimming pool, gymnasium, golf course and playground. The section extends to direct fees or costs payable, plus all associated costs including those related to the use, operation, maintenance or repair of such an asset. For example, otherwise deductible outgoings such as rates and service charges are not deductible. The section covers not only payments by way of membership of clubs or ownership of assets, but also payments in respect of ‘‘rights to use’’ a leisure facility. Note that a deduction is available for expenditure incurred in providing a fringe benefit: s 26-50(8). Excepted facilities A deduction for a leisure facility is not denied if (s 26-50(3)): • the leisure facility is held for sale by the taxpayer in the ordinary course of a business of selling leisure facilities; 308

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• the taxpayer uses the leisure facility (or holds it for use) mainly as part of a business of providing leisure facilities for payment or mainly for earning rent, lease premiums or licence fees – this would cover a public golf course, tennis courts, a commercial swimming pool or a bowling alley; or • the leisure facility is used, or held for use, mainly for employees or for the care of employees’ children. This exception does not apply (and therefore s 26-50 will deny a deduction) if the taxpayer is a company and the leisure facility is provided mainly for use by the shareholders and/or directors or for the care of their children. If any of the excepting situations for a leisure facility apply for only part of the income year, s 26-50(1) denies a deduction for part of the expenditure: s 26-50(4). In these circumstances, a ‘‘reasonable amount’’ is deductible, ie the expenses must be apportioned to reflect the business and non-business use of the leisure facility. For example, if a leisure facility is hired out to paying customers for 9 consecutive months of the year, but is used by employees for the remaining 3 months, s 26-50(1) will deny a deduction for expenditure associated with those 3 months. Comments on the issue of apportionment in Ruling TR 2003/4 (paras 36-40), which deals with boat hire arrangements, are also relevant in the context of leisure facilities.

Anti-avoidance provision Section 26-50(7) contains an anti-avoidance provision to prevent a taxpayer rearranging matters to take advantage of the relief afforded by s 26-50(3) or (5). Those subsections will not apply (and therefore s 26-50 will operate to deny a deduction) if the taxpayer enters into a scheme to take advantage of an excepting situation, and the Commissioner considers that the taxpayer would not have entered into or carried out the scheme but for the relief provided by s 26-50(3) or (5). A ‘‘scheme’’ includes an arrangement, plan, course of conduct or proposal: s 995-1. [9 570] Deductions for boating activities The deductions related to income-earning activities associated with the use of boats are capped, in an income year, at the level of income earned from the boating activities: s 26-47. The taxpayer can carry forward any excess deductions and set them off against income from the boating activities in later years (ie the excess is quarantined). The quarantined amount is modified for taxpayers who: • have boating capital gains – a quarantined amount that is to be carried forward to a future income year is first used to reduce a boating capital gain a taxpayer has for the year (see also s 118-80): s 26-47(5). In essence, capital gains from boats are treated as if they were income from boating activities; • have profits from a boating business in an income year – after the profit has been reduced by any boating capital gains, a taxpayer can deduct any remaining quarantined amount up to the amount of that profit, and reduce the remaining quarantined amount accordingly: s 26-47(6), (7). Any current year deductions are deducted first before deducting the quarantined amount; • derive exempt income from boating – after it has been reduced by any boating capital gains or boating business profits, any remaining quarantined amount that is to be carried forward to a future income year is reduced by the amount of any exempt income derived in the current year that has not already been offset against carry-forward amounts from Div 35 (non-commercial losses: see [8 600]) or Div 36 (general tax losses: see [8 450]) ITAA 1997: s 26-47(8); or • become bankrupt – a quarantined amount arising before the bankruptcy cannot be deducted afterwards: s 26-47(9). This includes any quarantined amounts generated in the income year that the taxpayer is declared bankrupt. © 2017 THOMSON REUTERS

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If a taxpayer holds and operate several boats that are subject to the quarantining rules, the taxpayer can claim the total deductions relating to all the boats up to the amount of the total income from all the boats. In effect, taxpayers can offset deductions relating to one boat against income from another boat. The quarantining rules do not apply if a boat is held as trading stock, is used or held mainly in a business of letting it on hire (see below) or transporting the public or goods for payment, or is used for a purpose that is essential to the efficient conduct of a business (eg a fishing boat): s 26-47(3). In Re Peerless Marine Pty Ltd and FCT (2006) 63 ATR 1303, the construction of a prototype catamaran was held to be essential to the efficient conduct of the taxpayer’s boat building business as the evidence established that the sale of luxury vessels was largely dependent on customers being able to see a fully functioning prototype. The opposite conclusion was reached in Re Sinclair and FCT (2000) 47 ATR 1001, where a boat was principally used as the taxpayer’s residence, and QT2000/29 v Commissioner of Taxation; Case 6/2001 (2001) 48 ATR 1176, where an accounting and secretarial services business was operated from a boat. The quarantining rules also do not apply to amounts claimed as a deduction that are incurred in providing fringe benefits: s 26-47(4).

Boat hire activities Whether a taxpayer is carrying on a business of letting a boat on hire is determined in accordance with the principles discussed at [5 020]. Relevant factors would include whether there is a significant commercial purpose or character and an expectation to make a profit (a profit need not be made every year). The Tax Office’s views on this topic are set out in Ruling TR 2003/4. The taxpayers in Re Phippen and FCT (2005) 60 ATR 1271 and Ell v FCT (2006) 61 ATR 661 were unable to show that they were carrying on a business. For a contrasting decision which turned on its facts, see Re VCK and FCT (2006) 64 ATR 1273. In Lee Group Charters Pty Ltd v FCT [2016] FCA 322, the Federal Court decided that the taxpayer was carrying on a boat hire business involving super yachts. One relevant factor was that commercial charter fees were charged when the person controlling the taxpayer company and his family used one of the yachts. The Tax Office considers that a boat owner who merely provides (eg leases) a boat to a boat hirer or charter operator for use in the latter’s business, and who does not actively participate in that business, is unlikely to be carrying on a business (although there are circumstances where that may amount to the carrying on of a business for a company if not for an individual): see Ruling TR 2003/4. If, on the other hand, the boat owner actively participates in the charter business and shares the risks and rewards, he or she is more likely to be carrying on a business. Whether letting a boat on charter amounts to a business will generally depend on the level of support services provided (eg customer inquiry and booking services, issuing accounts and processing payments, pre-charter briefing including training and providing access to jetties with electric power, hot and cold water, waste disposal facilities and fuelling facilities): see Ruling TR 2003/4. [9 580] Club fees Expenditure associated with recreational clubs, such as nomination fees, annual subscriptions or levies, are not deductible, whether incurred for oneself or another person: s 26-45(1). However, a deduction is not denied for expenditure incurred by an employer in providing a fringe benefit: s 26-45(3). A ‘‘recreational club’’ is a company established or carried on mainly to provide drinking, dining, recreational or entertainment facilities for members: s 26-45(2). A distinction should be drawn between such clubs and those that primarily provide business-related facilities. For example, there is a specific FBT exemption for payment of airport lounge memberships since 310

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it is accepted that such facilities are designed primarily for business purposes. Section 26-45 should also not operate to deny a deduction as an airport lounge club principally provides business facilities and any hospitality such as food, drink or recreation is merely incidental to its primary function. Annual fees for airport lounge membership for use by employees, where the membership is provided because of the employment relationship, are considered to be deductible under s 8-1: Determination TD 2016/15. Clubs regularly conducting horse or dog race meetings attracting extensive public patronage on courses owned or controlled by them are not ‘‘clubs’’ for the purposes of s 26-45: Ruling IT 332. However, any deduction for membership fees would have to satisfy s 8-1, which would be rare.

REPAIRS [9 600] Repairs Expenditure incurred by the taxpayer for repairs to premises, part of premises or a depreciating asset (including plant) held or used by the taxpayer solely for the purpose of producing assessable income is deductible: s 25-10(1). Actual ownership of the repaired property etc is not necessary. The word ‘‘repair’’ is not defined in the ITAA 1997 and therefore bears its ordinary meaning of restoration by renewal or replacement of subsidiary parts of a whole. Thus, the essential question is whether the particular work is the renewal or replacement of defective parts (a repair) or the renewal or replacement of substantially the whole (an improvement): Lurcott v Wakely & Wheeler [1911] 1 KB 905 at 924. If the relevant premises or assets are held or used only partly for income-producing purposes, expenditure on repairs is only deductible to the extent that it is reasonable in the circumstances: s 25-10(2). The Tax Office interprets this, in most cases, as requiring an apportionment based on the proportion of use for income-producing purposes: Ruling TR 97/23, paras 79 and 151-161 (this is a comprehensive ruling on deductions for repairs). Apportionment in relation to a home office is considered in Ruling TR 93/30, paras 32-35. The requirement that the premises (or asset) be held or used for income-producing purposes means that the cost of removing fixtures and fittings from leased premises, if the lease requires the lessee to return the premises to their original condition at the end of the lease, is not deductible under s 25-10: see ATO ID 2003/843. However, expenditure incurred after the cessation of a business may be deductible under s 8-1, in accordance with general principles: see Ruling TR 97/23, para 74, and [8 090]. Capital expenditure is not deductible: s 25-10(3). The question of whether expenditure was really incurred ‘‘for repairs’’ or amounts to capital expenditure has arisen mainly in 3 areas: • the distinction between replacement of a subsidiary part and replacement of an entirety: see [9 610]; • the distinction between a repair and an improvement: see [9 620]; and • expenditure on recently acquired property (ie initial repairs): see [9 630]. Non-deductible capital expenditure (eg because the work constitutes an improvement or initial repairs) may form part of the cost base of an asset for CGT purposes: see Determination TD 98/19 and [14 060]. Alternatively, if the expenditure relates to the acquisition of a depreciating asset (eg plant), it may form part of the cost of the asset for the purposes of Div 40 (capital allowances): see [10 360]. See AAT Case 4472 (1988) 19 ATR 3647 for an example of capital expenditure relating to depreciable plant (a pump) and not constituting deductible repair costs. © 2017 THOMSON REUTERS

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Payment for failing to repair leased premises A lessee who has failed to comply with an obligation in a lease to repair leased premises and is required to pay an amount to the lessor because of this failure can claim a deduction for the amount paid: s 25-15. It is a condition for obtaining the deduction that the lessee must be using, or must have used, the premises for the purpose of producing assessable income. The amount paid is a deduction in the year in which it is paid: Peyton v FCT (1963) 109 CLR 315. [9 610] Replacement of part or whole Whether work constitutes the replacement of a whole item or just part of an item is a question of fact and degree, essentially turning on whether the item in question is a discrete item or merely part of a larger item. In Lindsay v FCT (1960) 12 ATD 197; (1961) 12 ATD 505, the taxpayer was a member of a partnership that carried on a business of ship repairing in premises that included 2 slipways, one of which was constructed mainly of timber. The timber was replaced with concrete because timber was unavailable and the resultant slipway was longer than the old one, but the increased length produced no greater efficiency. During the course of the work, substantially the whole of the slipway had been demolished and replaced. The High Court held that the work did not constitute repairs, being the replacement of the slipway, which was an entirety in its own right and not a subsidiary part of anything else. In Rhodesia Railways Ltd v Income Tax Collector (Bechuanaland) [1933] AC 362, the cost of replacing rails and sleepers over 53 km of a railway line and of sleepers over a further 64 km, where the total length of the line was 630 km, was held to be deductible. The railway line as a whole was the relevant entirety and the work merely restored the track to normal condition. Similarly, in Samuel Jones & Co (Devondale) Ltd v IRC (1951) 32 TC 513 the replacement of a chimney of exceptional height in factory premises was held to be deductible, being a subsidiary part of the entirety. [9 620] Improvements It is vital to distinguish between restoration of the item of property in question to its former condition (deductible) and improvement of the item (capital and thus not deductible). In FCT v Western Suburbs Cinemas Ltd (1952) 9 ATD 452, the ceiling in the taxpayer’s theatre was in disrepair and it was decided to replace it with a better ceiling, using different materials, costing about 5 times more than simply repairing it. The court, in holding the expenditure was not deductible, considered the relevant factors to be the replacement of the entire ceiling, the difference in kind, as well as in degree, of the operation from the type of repairs properly allowed in working expenses and the considerable advantages over the old ceiling including the reduction in the likelihood of repairs in the future. The mere fact that different materials from those replaced are used will not of itself cause the work to be classified as an improvement, particularly in circumstances where the previous materials are no longer in current use. Once again, the question is one of degree. If the change is merely incidental to the operation of repair, the deduction will be allowed. When the wooden piles of a wharf were encased in concrete to prevent further deterioration by marine organisms in BP Oil Refinery (Bulwer Island) Ltd v FCT (1992) 23 ATR 65, it was held that the work did not have the effect of restoring something lost or damaged, whether function or substance or some other quality or characteristic. Instead it was held that the work added something: both the substance by which the piles were encased and the capacity of the piles to avoid deterioration. The work was therefore an improvement rather than a repair: see also Ruling TR 97/23, paras 44-52. [9 630] Initial repairs If an item of property is in need of repair at the time of acquisition by a taxpayer, the cost of such repairs is not deductible to that taxpayer: Law Shipping Co v IRC (1923) 12 TC 621 and W Thomas & Co Pty Ltd v FCT (1965) 115 CLR 58. This is known as the initial 312

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repairs doctrine. The cost of putting the premises into order suitable for use is part of the capital cost of acquisition, not a cost of its maintenance. To be deductible, the necessity for repair must have arisen from the operation of the person making the claim, not that of some previous owner. Ruling TR 97/23 states that it is immaterial whether at the time of acquisition the taxpayer was aware of the condition of the property, including its need for repair. It is also immaterial whether the purchase price (or lease rentals) reflected the need for repairs. Initial repair expenses can be apportioned under s 25-10 to allow a deduction to the extent to which the repair work remedies defects, damage or deterioration arising from the taxpayer’s holding, etc, of the property for income producing purposes after it is acquired: see Ruling TR 97/23.

LEGAL AND RELATED EXPENSES [9 650] Legal expenses – general In accordance with general principles, legal expenses are deductible under s 8-1 if incurred in gaining or producing assessable income, or if necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income (see Chapter 8). In general, the cases establish that if the advantage that is sought to be gained by incurring the legal expenses is of a revenue nature, the expenses will also be of a revenue nature and if the advantage that is sought to be gained is of a capital nature, the expenses will also be of a capital nature. The success or failure of legal proceedings has no bearing on the deductibility of expenses incurred in those proceedings. Note that certain legal (or legal related) expenses – eg for obtaining tax advice, preparing certain leases and discharging certain mortgages – are specifically deductible under various provisions of the ITAA 1997: see [9 350], [9 470] and [9 670]-[9 680]. Legal expenses incurred in defending legal title to existing assets or eliminating competition are generally non-deductible capital expenditure. In John Fairfax & Sons Pty Ltd v FCT (1959) 101 CLR 30, the taxpayer acquired a substantial shareholding in another newspaper company and incurred legal expenses in defending its title to the shares. The High Court held that the expenses were not deductible because they were capital outgoings. In Broken Hill Theatres Pty Ltd v FCT (1952) 85 CLR 423, the High Court held that legal expenses incurred by a cinema proprietor in attempting to restrict the entry of more competitors were capital expenses. Similarly, in Sunraysia Broadcasters Pty Ltd v FCT (1991) 22 ATR 115, expenses incurred by an AM radio station in obtaining a supplementary FM licence, primarily to forestall competition, were not deductible as they were incurred in protecting the business enterprise itself (see also Smithkline Beecham Laboratories (Australia) Ltd v FCT (1993) 26 ATR 260). Two High Court cases that are difficult to reconcile with Broken Hill Theatres should be noted: Hallstroms Pty Ltd v FCT (1946) 72 CLR 634, where legal expenses incurred in successfully opposing an extension of a patent were held to be deductible (this decision was not viewed with any approval in Broken Hill Theatres); and FCT v Duro Travel Goods Pty Ltd (1953) 87 CLR 524, where legal expenses incurred in protecting the taxpayer’s interest in its exclusive trademark were also held to be deductible. FCT v Consolidated Fertilizers Ltd (1991) 22 ATR 281 also seems to be difficult to reconcile with Broken Hill Theatres. In that case, a majority of the Full Federal Court allowed a deduction for expenditure incurred in litigation to prevent the disclosure of confidential information, and thereby protect valuable trade secrets. The majority held that the acquisition and development of valuable trade secrets led directly to the requirement that the taxpayer be prepared to protect that knowledge in the ordinary course of the conduct of its business. In reaching this conclusion, the majority drew a distinction between expenditure incurred for the purpose of preserving and protecting a business as such (non-deductible) and expenditure which the nature of the particular business (in that case, a fertiliser and pesticide manufacturer) may require as part of the prudent management of the business (deductible). © 2017 THOMSON REUTERS

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Legal expenses incurred in defending the taxpayer’s business methods are deductible. In FCT v Snowden & Willson Pty Ltd (1958) 99 CLR 431, the taxpayer was in the business of speculative building and had incurred legal expenses to appear before a Royal Commission to defend its business methods. The expenses were held to be deductible because they were necessarily incurred, as the taxpayer had to defend itself in order to maintain and continue its business in the same volume as before. In Re Pech and FCT (2001) 47 ATR 1215, legal expenses incurred in defending a right to have used a trademark in the past were held to be deductible, ie the expenses related to the way the taxpayers had conducted their business and not to the preservation of an asset. In Magna Alloys & Research Pty Ltd v FCT (1980) 11 ATR 276, legal expenses incurred by a company in defending its directors and managers against conspiracy charges (involving the payment of secret commissions to employees of purchasers of the taxpayers’ products) were held to be deductible. Similarly, in AAT Case 11,608 (1997) 34 ATR 1230, legal expenses incurred in defending criminal charges against an employee following an altercation in refusing entry of an intoxicated person to a nightclub were also deductible. The AAT considered that maintaining pleasant premises and removing drunk or abusive persons was part and parcel of such a business. In contrast, legal expenses incurred in challenging an ASIC banning order prohibiting the taxpayer from providing financial services for 5 years and in defending criminal charges for alleged insider trading were not deductible in AAT Case [2013] AATA 783; (2013) 97 ATR 680. The AAT considered that the essential character of the expenditure was to enable the taxpayer to re-enter the regulated stockbroking/financial services industry. The fact that he was not employed in the industry when the expenses were incurred was a relevant factor. Note that certain legal costs that are capital in nature (termed ‘‘blackhole expenditure’’ – eg costs incurred in establishing a business structure, in ceasing to operate a business or in relation to a takeover offer) may be deductible over 5 years under s 40-880, although certain start-up expenses incurred by a small business entity are immediately deductible (applicable from the 2015-16 income year): see [10 1150].

[9 660] Professional persons and employees Legal expenses incurred by a professional person in protecting their right to practise have been held not to be deductible as the taxpayer was seeking to protect a structural asset: AAT Case 6258 (1990) 21 ATR 3721, where a medical practitioner was defending charges brought against him at a Medical Disciplinary Tribunal inquiry (and thus defending registration as a medical practitioner); and AAT Case 4596 (1988) 19 ATR 3859, where a solicitor was defending certain allegations (concerning his trust account) before the Statutory Committee of the Law Society of New South Wales. See also ATO ID 2004/367 (expenses incurred in relation to disciplinary proceedings arising out of criminal convictions not connected to the taxpayer’s professional activities considered to be not deductible). In Putnin v FCT (1991) 21 ATR 1245, expenses incurred by an accountant in defending fraud charges were held to be deductible (see also Elberg v FCT (1998) 38 ATR 623 noted below). In FCT v Day (2008) 70 ATR 14, the High Court held that legal expenses incurred by a public servant in relation to charges under the Public Service Act 1922 (Cth) of having failed to fulfil his duty as an officer were deductible under s 8-1. The Court said that the consequences to the taxpayer of internal disciplinary proceedings, in relation the continuation or termination of his employment, formed part of what was productive of his assessable income as a public servant. Accordingly, the ‘‘occasion’’ of the legal expenses (see [8 050]) was to be found in his position as a public servant and therefore the expenses were deductible. Legal expenses incurred in seeking compensation for loss of employment, such as in an action for wrongful dismissal or loss of office, are capital in nature even if the amount awarded is calculated by reference to unpaid salary or lost income: Scott v FCT (NSW) (1935) 35 SR (NSW) 215; Ruling TR 2012/8 (paras 20 and 23). A redundancy payment is capital in nature as it is compensation for the loss of employment (or for loss of the expectation of 314

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continuity of service). Accordingly, legal expenses incurred in establishing that an employee’s dismissal was by reason of redundancy should be capital in nature. Legal expenses incurred in obtaining a release from a contract of employment in order to take up a position with a different employer are capital in nature: see ATO ID 2002/213. In contrast, legal expenses incurred in recovering unpaid wages or other contractual entitlements are deductible, even if the employment has been terminated: Romanin v FCT (2008) 73 ATR 760; TR 2012/8 (para 13); ATO ID 2004/659. In Romanin, where the taxpayer brought proceedings for payment of 12 months’ pay in lieu of notice of termination of employment, the legal expenses were of a revenue nature (and thus deductible) because the taxpayer was contractually entitled to that amount. Legal expenses incurred to obtain compensation for the loss of salary and wage income, rather than for the loss of income earning capacity, are deductible (see ATO ID 2002/193), as are legal expenses incurred to recover unused annual and long service leave from an ex-employer: see ATO ID 2002/391. In Re Museth and FCT (2006) 62 ATR 1243, a former policeman was denied a deduction for legal expenses incurred in obtaining a new contract of employment with the NSW Police Force, having been earlier dismissed from the Force. Had he been reinstated, rather than re-employed, the expenses may have been deductible. For the deductibility of expenses incurred in preparing and administering employment agreements, see [9 1100] (employees) and [9 1200] (employers).

[9 670] Lease and mortgage documents Expenditure incurred by the taxpayer in preparing, registering or stamping a lease (or an assignment or surrender of a lease) of property is deductible if the property has been, or will be, used by the taxpayer solely for the purpose of producing assessable income: s 25-20(1). Deductible expenditure would include legal fees incurred in preparing the lease and stamp duty. If the property has been, or will be, used only partly for the purpose of producing assessable income, an apportionment is required so that the expenditure is deductible only to the extent that it has been or will be so used: s 25-20(2). Note that it is the actual use of the property and not the intended future use that is relevant: see ATO ID 2012/36. Discharge of mortgage If a taxpayer has mortgaged property as security for a loan used solely for the purpose of producing assessable income, the expenses of discharging that mortgage are deductible: s 25-30(1). Similarly, if property itself has been purchased solely for the purpose of producing assessable income, the cost of discharging a mortgage given in connection with the purchase is deductible: s 25-30(2). However, payments of principal or interest are not deductible under either provision: s 25-30(4). The deductibility of interest is discussed at [9 450]. If the property or money was only used partly for the purpose of producing assessable income, the deduction is limited to an apportionment based on the extent that the property or money was used for assessable income-producing purposes: s 25-30(3). A deduction may not be allowable under s 25-30 if the expenditure incurred is part of a tax avoidance agreement: ss 82KH to 82KL (see [43 020]). [9 680] Capital expenditure to terminate lease or licence A deduction (over a 5-year period) is available for capital expenditure incurred in terminating a lease or licence, if the expenditure is incurred in carrying on a business or in connection with ceasing to carry on a business: s 25-110(1). A licence includes an authority, permit or quota. The deduction is not allowed until the lease or licence is actually terminated. The taxpayer can deduct 20% of the capital expenditure in the year in which the lease or licence is terminated and in each of the next 4 years: s 25-110(2). A market value substitution rule applies, to prevent deductions for inflated lease and licence termination payments. Thus, if the expenditure is incurred under an arrangement and the taxpayer did not deal at arm’s © 2017 THOMSON REUTERS

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length with at least one other party to the arrangement, market value will be substituted for the actual expenditure (if that is greater than market value): s 25-110(4). The concept of dealing at arm’s length is discussed at [5 260] and ‘‘market value’’ is discussed at [3 210]. A deduction is not allowed for expenditure incurred in terminating a ‘‘finance lease’’: s 25-110(3). Accounting Standard AASB 117 defines a finance lease as ‘‘a lease that transfers substantially all the risks and rewards incidental to ownership of an asset’’. A deduction is also denied if, after the lease or licence is terminated, the taxpayer or an associate enters into another lease or licence with the same party (or an associate of that party) and the other lease is of the same kind as the original lease or licence: s 25-110(5). According to the Explanatory Memorandum to the legislation inserting s 25-110 (the Tax Laws Amendment (2006 Measures No 1) Act 2006), ‘‘of the same kind’’ refers to a lease or licence agreement in which the term and/or cost of the payments associated with the lease or licence do not vary significantly, and it cannot be demonstrated that there is a need to have a new lease or licence. Similarly, a deduction is denied for capital expenditure incurred to terminate a lease or licence for the granting of another lease or licence in relation to the asset that was the subject of the original lease or licence: s 25-110(6).

BAD DEBTS [9 700] Bad debts A deduction is allowable under s 25-35(1) for a debt (or part of a debt) that is written off as a bad debt in the income year, provided: • the amount owed, except in the case of a moneylending business, was included as assessable income of the taxpayer in the current or a former income year: see [9 720]; or • the debt is in respect of money lent in the ordinary course of a business of lending money by a taxpayer who carries on that business: see [9 730]. The other conditions that must be satisfied before a bad debt may be deducted under s 25-35(1) are as follows: • there must be a debt in existence at the time of writing off: see below; • the debt must be bad: see [9 710]; and • the debt must be written off as bad during the income year in which the deduction is claimed: see [9 710]. For a comprehensive general ruling on the former equivalent of s 25-35(1) (s 63 ITAA 1936), see Ruling TR 92/18. Special rules in Subdiv 709-D ITAA 1997 deal with the ability of members of a consolidated group to claim deductions for bad debts: see [24 570]. Note also that, in certain circumstances, a deduction for a loss in relation to a ‘‘Division 230 financial arrangement’’ (under the TOFA measures discussed at [32 050] and following) is to be treated as a deduction of a bad debt. If a bad debt is not deductible under s 25-35, it may be deductible under s 8-1. It has been held that a bad debt incurred in the course of making loans to employees, where that was a regular part of the taxpayer’s business activities, was a loss incurred in the course of carrying on business for the purpose of producing assessable income and was therefore deductible under s 51(1) (corresponding to s 8-1): Case 80 (1968) 14 CTBR(NS) 80. In FCT v Marshall and Brougham Pty Ltd (1987) 18 ATR 859, an unrecoverable debt owed to a construction company was held to be deductible under s 51(1). An investment in 316

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[9 710]

the short-term money market was considered an integral part of the whole business carried on by the taxpayer in its management of the affairs of the group. It was not a separate enterprise or separate use of capital assets of its own. The loss sustained on such investments was therefore on revenue account and deductible under s 51(1). The deduction would not have been allowable under s 25-35(1) because the amount had not been returned as assessable income of the taxpayer and the investment of surplus funds on the short-term money market did not constitute ‘‘carrying on the business of lending money’’.

Partial write-offs Section 25-35(1) applies to the write-off of part of a debt in exactly the same manner as it applies to the write-off of a full debt and subject to the same conditions. The one debt may, over a period, be subject to several partial write-offs. Debt must exist A debt is money that the taxpayer is presently entitled to receive: GE Crane Sales Pty Ltd v FCT (1971) 2 ATR 692. In that case, the debts had been assigned to the taxpayer as part of a factoring operation by equitable assignments. The High Court held that they answered the description of a debt, even though due in equity only, because they could be garnisheed or would have been sufficient to justify bankruptcy proceedings or a winding-up petition for their enforcement. However, because a sum of money had been accepted in full settlement of a debt for a larger amount, the creditor’s right to recover the balance had been voluntarily extinguished. The debt was no longer in existence, so the creditor was not entitled to write off the balance as a bad debt. Note that the debt/equity rules in Div 974 (discussed in Chapter 31) are not relevant in determining whether a debt exists for the purposes of s 25-35. Write-off of debt – form and timing No particular form of book entry is required to write off a bad debt, or indeed any book entry at all. There must be some written particulars that indicate that the creditor has treated the debt as bad: Case 33 (1941) 10 CTBR 33 and AAT Case 2 (1986) 18 ATR 3006. The written particulars must be recorded during the year in respect of which the claim for a deduction is made. It is not sufficient that the written particulars be ‘‘related back’’ to the income year in question: Point v FCT (1970) 1 ATR 577. [9 710] Debt must be bad In order to qualify for a deduction under s 25-35, the taxpayer merely has to write off a debt as ‘‘bad’’ and satisfy the other requirements of the section. Section 63, however, contained an additional requirement that the debt be a ‘‘bad debt’’ on an objective basis. This is not in s 25-35. Therefore, on a literal reading of s 25-35, the taxpayer merely has to write off the debt as bad, irrespective of whether it was in fact bad. However, no intended change to the law to this effect was identified in the Explanatory Memorandum to the Tax Law Improvement Bill 1996, which introduced s 25-35. The Explanatory Memorandum appears to implicitly assume that there is still a requirement that the debt be bad. This would appear to be an instance where the general interpretive provision in relation to the tax law rewrite, s 1-3 (see [1 270]), could be used to maintain the former interpretation and require that the debt must be objectively bad. Whether a debt is bad is a question of fact: Dinshaw v Bombay Commissioner of Taxes (1934) 50 TLR 527. What is required is a bona fide conclusion that the debt was bad to the extent that it was written off: Case 26 (1945) 11 CTBR 26; see also AAT Case 5543 (1989) 21 ATR 3111 and AAT Case 8779 (1993) 26 ATR 1228 (where reference is made to the commercial judgment required and the fact that action to recover an unpaid debt does not necessarily reflect on the bona fides of treating the debt as bad). Factors that the Tax Office may examine on audit in determining whether a debt has been appropriately treated as bad include the age of the debt, recovery attempts and whether they © 2017 THOMSON REUTERS

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are continuing, whether there is continuing trading with the former debtor and, if so, whether the trading terms have been changed such as to cash on delivery, whether payment arrangements have been entered into and whether any payments have been received since declaring the debt bad and the bad debt policy of the business. An assessable recoupment arises under s 20-20 (see [6 580]) if the taxpayer writes off a debt as bad prematurely and subsequently receives any amount on account of the debt in respect of which the taxpayer has been allowed a deduction under s 8-1 (s 20-30(1), Item 1.1) or s 25-35: s 20-30(1), Item 1.4.

[9 720] Prior inclusion in assessable income Unless a moneylending business is involved, the amount owing that forms the debt must have been included at some time in the assessable income of the taxpayer claiming the deduction (eg ATO ID 2001/301). This will happen where, for example, an entity includes an amount in assessable income on selling trading stock even if the entity has not actually received the sales proceeds, eg because the entity is an accruals taxpayer (see [3 270]). If the sale proceeds are never received and the debt is later written off as bad, the requirement (for deductibility) about prior inclusion in assessable income is satisfied. A taxpayer who properly lodges returns on a cash rather than an accruals basis (see [3 270]), could not claim a deduction under s 25-35 because the amount would not have been included in assessable income. If a business is sold, including the book debts, the purchaser could not claim a deduction for debts that prove to be bad because those debts would not have been returned as assessable income by the purchaser. In Re Pope and FCT [2014] AATA 532, a trust distribution credited to an account in the books of the trust in the taxpayer’s name was treated as a loan by the trust deed and not as an unpaid present entitlement (UPE). Accordingly, the debt written off was different in character to the income included in the taxpayer’s assessable income and a deduction under s 25-35 was not available. A beneficiary of a trust cannot claim a deduction under s 25-35 for a UPE that is written off, as the UPE will not have been brought to account as assessable income: Determination TD 2016/19. [9 730] Moneylending business As noted at [9 700], a taxpayer that carries on a moneylending business is allowed a deduction for a bad debt (that is written off) in respect of a loan made by the taxpayer in the ordinary course of its moneylending business. A taxpayer carrying on a moneylending business would normally be able to justify a deduction under s 25-35(1)(a) for the writing off of interest accrued and could also write off a loss of principal, which would then be deductible under s 25-35(1)(b). The Federal Court in FCT v National Commercial Banking Co of Australia Ltd (1983) 15 ATR 21 allowed a deduction for both principal and interest under the predecessor to s 25-35(1)(b), where the interest accrued had been credited to a suspended interest account because receipt had already been considered doubtful and never returned as assessable income. The interest was a constituent of the debt, which was ‘‘in respect of money lent in the ordinary course’’ of the bank’s moneylending business. The terms of s 25-35(1)(b) should be read separately from s 25-35(1)(a). Whether a taxpayer is carrying on a moneylending business is a question of fact (the concept of ‘‘carrying on a business’’ is considered at [5 020]). Whether or not the taxpayer is a registered money-lender is not a decisive factor and moneylending need not be the only or principal business of the taxpayer (but it must be more than ancillary or incidental to its primary business): see, for example, Fairway Estates Pty Ltd v FCT (1970) 1 ATR 726; FCT v Marshall and Brougham Pty Ltd (1987) 18 ATR 859 at 866; and Ruling TR 92/18, paras 42-46. Ruling TR 92/18 also considers the meaning of ‘‘in respect of money lent’’ and whether a taxpayer must be carrying on a moneylending business both when the loan is made 318

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[9 740]

and when the debt is written off – the Tax Office accepts that, on balance, a taxpayer does not have to be carrying on a moneylending business at the time the debt is written off. The Full Federal Court held in BHP Billiton Finance Ltd v FCT (2009) 72 ATR 746 that a company which was the financier for the BHP Billiton Group was carrying on a moneylending business and that loans made to 2 group companies in relation to particular mining projects were made in the ordinary course of that business. Consequently, the company was entitled to a deduction for a total of $2bn written off as bad debts. This decision was upheld by the Full Federal Court in FCT v BHP Billiton Finance Ltd (2010) 76 ATR 472. Similarly, in Ashwick (Qld) No 127 Pty Ltd & Ors v FCT (2009) 77 ATR 92, 2 companies within the Foster’s group that provided finance to other members of the group were each carrying on a moneylending business (even though it was not a profitable business for the one company). This decision was upheld on appeal in FCT v Ashwick (Qld) No 127 Pty Ltd & Ors (2011) 82 ATR 481. Ruling TR 94/32 deals with the denial of a deduction in respect of interest not included as assessable income on an accruals basis because a loan has been classified as a non-accrual loan.

Purchased debts Section 25-35(2) specifically provides that a moneylender who acquires a debt from another moneylender may claim as a deduction any amount written off as bad, but only up to the cost paid for the debt. For example, if a debt of $100 was purchased for $85, only $85 could be claimed as a bad debt write-off. If not for this specific provision, such a deduction would not be allowable under s 25-35(1)(b) (although s 8-1 would possibly be available) as the moneylender who now owns the debt had not actually lent the money. If only part of such a debt is written off as bad, the limit on the deductible amount at any time is the amount by which the cost paid for the debt exceeds so much of the amount of the debt acquired as has not yet been written off as bad: s 25-35(3) and 25-35(4). All this means is that if the moneylender still thinks part of the debt is recoverable, that part is regarded as part of the cost that the moneylender paid and therefore is not deductible until thought unrecoverable, as opposed to regarding it as the discount portion for which the moneylender did not pay. For example, if a debt of $100 was purchased for $85 and only $15 is regarded as recoverable, although in its books the moneylender would write off $85, only $70 is deductible at that time. If the $15 becomes unrecoverable at a later time, the moneylender could then deduct that $15. In order to qualify for a bad debt write-off under these provisions, a purchased debt must have been acquired in the ordinary course of the moneylender’s business of lending money. Thus, debts acquired through a takeover of one moneylender by another would not appear to qualify. Bad debts attributable to certain foreign branches Section 63D ITAA 1936 denies an allowable deduction under s 8-1 or s 25-35 in respect of bad debts written off by a foreign branch of a moneylender if income from the loan will not be assessable to the taxpayer because of the operation of the s 23AH exemption in respect of profits of foreign branches (see [34 120]). If only some of the income derived from such a debt is assessable, an apportionment is made of the deduction that would otherwise be allowed. [9 740] Restrictions – other provisions Bad debt deductions otherwise available under s 25-35 may be eliminated, reduced or effectively reversed under a number of other provisions: s 25-35(5). A company may not be able to deduct a bad debt unless it satisfies certain continuity of ownership or same business tests (there is an alternative test for companies held by non-fixed trusts): see [20 650]. As an anti-avoidance measure, a company cannot claim a deduction for a debt incurred and written off as bad on the last day of the income year: s 165-120(3). If a © 2017 THOMSON REUTERS

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debtor and creditor are part of a company group that has not consolidated, deductions may be forgone to an extent by agreement under the commercial debt forgiveness provisions: see [20 660]. The bad debt rules for consolidated groups are considered at [24 570]. A deduction may also be denied if the company fails to give certain information requested by the Commissioner about certain foreign resident trusts with interests in the company: see [20 350]. Under the trust loss rules in Sch 2F ITAA 1936 (see [23 800] and following), certain trusts cannot deduct a bad debt if there has been a change in ownership or control or an abnormal trading in their units. Limits exist on the extent to which bad debts that relate to lease payments under luxury car leases (see [6 410]) can be written off: s 25-35(4A) to (4C). The maximum amount deductible in an income year is the finance charge reduced by amounts deducted or deductible as bad debts (ie under s 25-35 or s 63) in an earlier income year.

[9 750] Debt-for-equity swaps Deductions are available under s 63E for losses incurred if a debt is extinguished as part of a debt-for-equity swap. A debt-for-equity swap occurs where a creditor discharges, releases or otherwise extinguishes a debtor company’s debt in return for shares or units in the debtor company: s 63E(1). The prerequisites for the deduction are as follows: • there must be a debt owed to the creditor by either a company or a trust that is either a trading trust within the meaning of s 102N or a public unit trust within the meaning of s 102P (for convenience referred to here as a qualifying trust); • there must be an agreement under which a creditor extinguishes the whole or part of a debt owed to the creditor by a debtor company or qualifying trust in return for an issue of shares (other than redeemable preference shares) in the debtor company or units in the qualifying trust; • the extinguishment of the debt and the issue of the shares or units must occur contemporaneously; and • either the debt has been included in the creditor’s assessable income or the debt is in respect of money lent by the creditor in the ordinary course of a moneylending business. In the first case, if the non-moneylender extinguishes a debt that includes an amount that has previously been included in assessable income (eg interest) as well as non-assessable principal, the only part of the debt subject to s 63E is the part that has been included in assessable income. It is not necessary for the debt or part of the debt that is swapped to be a bad debt, ie a deduction may be available under s 63E that would not have been available under s 25-35: see [9 700]. Companies and trusts are subject to the same restrictions on debt-for-equity swap deductions as apply in relation to bad debt deductions: see [9 740]. Deductions under s 63E are subject to the rules in s 63D about bad debts that are attributable to foreign branches of a moneylender: see [9 730]. The deductible ‘‘swap loss’’ is the amount by which the (face) amount of the debt exceeds the value of the equity (‘‘equity value’’) received. The value of the equity (shares or units) is the greater of its market value (see [3 210]) and its value in the books of the creditor: s 63E(2) and 63E(3). The deduction is allowable in the income year in which the shares or units are issued in return for the debt that is extinguished and no amount is deductible under s 8-1 or s 25-35. The receipt of shares or units under the swap will trigger the application of the assessable recoupment provisions in Subdiv 20-A ITAA 1997 and the amount required to be included in assessable income is the amount of the ‘‘equity value’’ under s 63E(2)(a): s 63E(3)(c). 320

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[9 800]

On any later disposal, cancellation or redemption of the shares or units, depending on whether the ‘‘consideration received or receivable’’ is greater or less than the equity value, an amount may be assessable or deductible as applicable: s 63E(4).

Limit on swap loss deductions Under s 63F a swap loss deduction allowable under s 63E is reduced to the extent that a deduction has previously been allowed under one of the other provisions of the ITAA 1936 (s 51, s 63 or s 63E) or the ITAA 1997 (s 8-1 or s 25-35) in relation to the debt. The object of s 63F is to ensure that the total of the net deductions allowed in respect of the debt under those sections less any assessable recoveries falling within s 63(3) or s 25 ITAA 1936 or s 6-5 or Subdiv 20-A ITAA 1997, should equal (ie not exceed) the initial amount of the debt owing less the total of the equity value and any other payments received in discharging the debt.

GIFTS AND DONATIONS [9 800] Gifts and donations – introduction Gifts and donations valued at $2 or more (whether cash or property) are deductible under s 30-15 ITAA 1997 if the rules in Div 30 are satisfied. Organisations eligible to receive a tax deductible gift are known as ‘‘deductible gift recipients’’ (DGRs). DGRs are either listed by name in the ITAA 1997 or regulations; or otherwise fall within one of the general categories set out in the legislation and are endorsed by the Commissioner: see [9 860]. The regulatory system for the not-for-profit sector is administered by the Australian Charities and Not-for-profits Commission (ACNC). One of the ACNC’s roles is to register organisations as charities. The Tax Office continues to be responsible for deciding eligibility for the tax concessions. ‘‘In Australia’’ special conditions A DGR must be ‘‘in Australia’’ (s 30-15) which generally means that it must be established and operated in Australia (see Ruling TR 2003/5). The purposes and beneficiaries of a DGR do not have to be in Australia, unless specifically required to do so by the law (eg a necessitous circumstances fund). Draft legislation will require a DGR not only to be established in Australia, but also to operate solely in Australia and pursue its purposes solely in Australia: proposed s 30-18(1). The proposed ‘‘solely in Australia’’ requirement means a DGR must have its control, activities and assets in Australia and also its beneficiaries. A DGR would not fail to satisfy the proposed ‘‘in Australia’’ special conditions if its overseas activities are merely incidental to its activities in Australia or are minor in extent and importance relative to its Australian activities: proposed s 30-18(2). In order to undertake more significant overseas activities, a DGR would need to be a developing country relief fund under the Overseas Aid Gift Deductibility Scheme: proposed ss 30-18(6) and 30-80 (see [9 860]). Certain organisations need only be established in Australia and need not satisfy the other proposed ‘‘in Australia’’ special conditions. These would include a fund, authority or institution established and maintained solely for the purpose of providing money for scholarships, bursaries or prizes to which s 30-37 applies, entities on the Register of Environmental Organisations (see [9 860]) if the Environment Secretary makes a determination to that effect and prescribed medical research institutions: proposed ss 30-18(8) and 30-19 ITAA 1997. These new rules are intended to apply to determine whether an entity is, or remains, a DGR from the day after the legislation receives assent. However, if a DGR would be required to amend its constituent documents to comply with the new rules, the application of the new rules in relation to that DGR would be deferred for 12 months. © 2017 THOMSON REUTERS

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Written evidence of gift A gift or donation is not deductible under Div 30 unless the taxpayer has written evidence of the gift or donation: s 900-110(1). However, documentary evidence is not required if the gift does not exceed $10 (and the total of all deductible amounts not exceeding $10 (ie not only deductible gifts) does not exceed $200 for the income year) or it would be unreasonable to expect the taxpayer to have obtained documentary evidence: s 900-125. An example would be a ‘‘bucket donation’’ of less than $10 to a DGR. See further [9 1450]-[9 1470]. A receipt for a gift must show the name and ABN (if any) of the recipient DGR and the fact that the receipt is for a gift: s 30-228. If this requirement is contravened by an endorsed DGR, its endorsement may be revoked under s 30-170. If the gift is made through a workplace-giving program, confirmation by the employer to the employee that the gift has been made (eg on a PAYG payment summary) is sufficient evidence of the gift: Practice Statement PS LA 2002/15. [9 810] What qualifies as a gift? In order to constitute a ‘‘gift’’ for the purposes of Div 30, a donation (whether of money or property) has the following characteristics (see Ruling TR 2005/13): • there is a transfer of the beneficial interest in property; • the transfer is made voluntarily; • the transfer arises by way of benefaction. Conferring benefaction means that the DGR is advantaged in a material sense, to the extent of the property transferred to it, without any countervailing material detriment arising from the terms of the transfer. Benefaction need not be the sole motivation. Thus, the desire to obtain a tax deduction for a donation does not, by itself, disqualify the donation from being a gift for these purposes: FCT v Coppleson (1981) 12 ATR 358; and • no material benefit or advantage is received by the giver by way of return (eg a donation related to the provision of a box at a sporting event will not be deductible). According to Ruling TR 2005/13, the giver may still be regarded as having received a material benefit if the value of the benefit to the giver is less than the value of the property transferred. In these circumstances it is not accepted that the value of the benefit received can be notionally deducted from the value of the property transferred and the net balance claimed as a gift. No part of the property transferred is a gift. However, the cost of attending a fundraising event or the amount bid at a charity auction may be deductible: see [9 850]. According to Ruling TR 2005/13, a transfer is not made voluntarily if the giver is offered a choice of making a purported gift to the DGR where: • the choice is offered as an alternative to discharging or reducing the giver’s contractual obligation to the DGR or an associate of the DGR; and • the choice, once exercised, has the effect of discharging or reducing the giver’s contractual obligation owed to the DGR or its associate (as appropriate). For example, a donation to a school building fund (see [9 860] is not a deductible ‘‘gift’’ if made in return for a reduction in school fees payable by the donor for her or his child/children: FCT v McPhail (1968) 117 CLR 111. See also Determination TD 2004/7. In Klopper v DCT (1997) 34 ATR 650, a donation to the Australian Sports Aid Foundation was not deductible because the taxpayer, a yachtsman, received a benefit of reduced funding he would have otherwise had to make. See also s 78A (which still operates as a yet-to-be-rewritten anti-avoidance provision), discussed at [9 920].

[9 820] Deductible amount If the gift or donation consists of money, the deductible amount is the amount given by the taxpayer: s 30-15. The gift or donation must be at least $2. 322

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[9 830]

Gifts of property If the gift consists of property purchased by the taxpayer during the 12 months before making the gift, the deductible amount is the lesser of market value (excluding any GST component: see [3 210]) on the day the gift is made and the purchase price (s 30-15), although different valuation rules apply to gifts under the Cultural Gifts Program or to National Trust bodies: see [9 890]. The value of the property must be at least $2. A deduction is also available under s 30-15 for property purchased by the taxpayer more than 12 months before making the gift or given or bequeathed to the taxpayer (irrespective of the length of the period between the taxpayer acquiring the property and the date of the gift to the fund, etc) but only if the property is valued by the Commissioner at more than $5,000. If a property is valued at $5,000 or less, a deduction is only available under s 30-15 if it was purchased by the taxpayer within 12 months before making the gift (or making the contribution if the property is a contribution for the right to attend a fundraising event). The deductible amount in the circumstances specified above is the value of the property as determined by the Commissioner. The taxpayer must obtain the valuation on a form approved by the Commissioner and lodged with the General Manager, Australian Valuation Office. Fees for obtaining a valuation are deductible: see [9 350]. If the gift consists of publicly listed shares held by the taxpayer for at least 12 months and valued at $5,000 or less, the deductible amount is the market value of the shares on the day of the gift. There is no need to approach the Commissioner for a valuation if the market value exceeds $5,000.00. If the gift is of property that is jointly owned by 2 or more entities, each owner is entitled to a deduction that is reasonable having regard to their interest in the property (eg if jointly owned by 2 entities in equal shares, each will be entitled to a deduction equal to 50% of the relevant amount (generally the lesser of the market value on the day the gift is made and the purchase price): s 30-225. Conditional gift If a gift of property is made on terms and conditions imposed by the donor, the value of the gift, to ascertain the deduction to which the donor is entitled, is determined in the same manner as described above, but is then reduced by an amount that is reasonable in the circumstances: s 30-220. In determining the reasonable amount, regard must be had to the effect on the GST-inclusive value of the gift on the terms and conditions imposed. The terms and conditions that will cause this provision to be invoked are ones that do not give the donee immediate custody and control of the property, an unconditional right to retain custody and control in perpetuity and an immediate, indefeasible and unencumbered legal and equitable title to the property. In considering whether there are any onerous conditions, the question of whether they are the subject of formal or informal arrangements or are legally enforceable is irrelevant. [9 830] Gifts of trading stock In certain circumstances, a deduction is available under s 30-15 for a gift of trading stock valued at $2 or more, subject to any applicable special conditions being met. Trading stock may be donated if the recipient is an organisation or fund covered by Item 1 or Item 2 in the table in s 30-15: see [9 860]. A testamentary gift is not deductible. A testamentary gift is a gift made of, by or in a will: s 30-15(2) (see also ATO ID 2003/173). If the trading stock was purchased during the 12 months before the gift was made, the amount deductible is the lesser of market value (excluding any GST component: see [3 210]) on the day the gift is made or the purchase price. However, if the gift is a disposal outside the ordinary course of business, and none of the special elections in Subdiv 385-E has been made, the amount deductible is the market value (excluding any GST component) on the day © 2017 THOMSON REUTERS

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the gift is made (this would correspond to the amount brought to account under s 70-90: see [5 400]). In the latter case, there is no requirement that the trading stock be purchased during the 12-month period before making the gift.

[9 840] Spreading deduction over 5 years Generally, a deduction is available in the year which the gift is made. However, gifts of money, and gifts of property valued by the Commissioner at more than $5,000, to a fund, authority or institution covered by Item 1 or Item 2 of the table in s 30-15 (see [9 860]), or a gift that is covered by Item 4, Item 5 or Item 6 of the table in s 30-15 (see [9 890]), may be spread over a period of up to 5 income years: Subdiv 30-DB (ss 30-246 to 30-249D). Entering into a conservation covenant (see [9 900]) also qualifies. The taxpayer must make a written election specifying the period (the current income year and up to 4 of the immediately following years) over which the deduction is to be spread: s 30-248. The taxpayer must also specify the percentage (if any) to be deducted in each year. The election must be made before lodging the income tax return for the year in which the gift is made or covenant entered into, as appropriate. The percentages may be varied prospectively, ie only in respect of years for which a return has not been lodged. If the gift is property, the election (and any variation) must be in a form approved by, and must be given to, the Environment Secretary, Heritage Secretary or Arts Secretary, as appropriate: ss 30-249A to 30-249C. If the gift is cash, the election (and any variation) must be in a form approved by the Commissioner: s 30-248(5). EXAMPLE [9 840.10] In November 2016 Linda gives the National Gallery a Norman Lindsay painting valued at $120,000. She elects to spread the deduction over 5 years. Linda must make an election specifying the percentages to be deducted in 2016-17 and each of the next 4 income years, and send a copy to the Arts Secretary, before lodging her return for 2016-17.

[9 850]

Fundraising events and auctions

An individual (not a company) is entitled to a deduction for: • contributions of cash or property over $150 in return for the right to attend or participate in a one-off fund-raising event held in Australia (eg a ticket to a charity ball, dinner or performance) reduced by the GST inclusive market value of the right to participate. It does not matter whether the donor or another individual attends the event. An individual may claim a deduction for a maximum of 2 contributions in respect of the one fundraising event; and • contributions of cash or property over $150 for the acquisition of goods or services at a one-off fundraising auction conducted in Australia (eg buying an autographed football or cricket bat, airline tickets, a holiday or dinner at a restaurant) reduced by the GST inclusive market value of the goods and services purchased. The GST-inclusive market value of the right to attend or participate in the fundraising event or of any goods or services purchased at auction must not exceed the lesser of 20% of the amount of the contribution and $150, eg if the ticket costs $300 and its GST-inclusive market value is $50, that market value does not exceed 20% of $300. If property is contributed and it was purchased during the 12 months before making the contribution, the market value of the property on the day the contribution is made and the amount paid for the property, whichever is the lesser, must exceed $150. If the property was not purchased within that 12-month period and it is valued by the Commissioner at more than $5,000 (see [9 840]), the GST-inclusive market value (on the day the contribution is made) of the right to attend or participate in the fundraising event must not exceed $150. 324

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[9 860]

If the DGR issues a receipt for a contribution, the receipt must specify the name and ABN (if any) of the DGR, the nature of the receipt and the amount of the contribution or, if property is contributed, the GST-inclusive market value (on the day the contribution was made) of the right to attend or participate in the fundraising event or of the goods and services acquired at the fundraising auction, as appropriate: s 30-228(2), 30-228(4). In working out the GST-inclusive value of the right to attend or participate in a fundraising event, or the GST-inclusive market value of the goods or services acquired at auction, anything that would prevent or restrict conversion of the right to money is disregarded: s 30-15(4), 30-15(5) and s 30-228(3), 30-228(5). Assessing the market value of a benefit involves making a reasonable estimate of what might be paid for the benefit in an open market in an arm’s length transaction (see [3 210]).

[9 860]

Eligible funds, authorities and institutions

List of DGRs Deductible gifts and donations may be made to a fund, authority or institution that has DGR status. Some of the more significant categories are discussed below (this is not an exhaustive list). Several of the categories require that the body qualifies as a charity (eg health promotion charities, harm prevention charities and disaster relief funds). Whether an organisation is a charity for income tax purposes is considered at [7 360]. Whether an organisation has DGR status may be checked at http://www.abn.business.gov.au/ DGRListing.aspx. PBIs Gifts to a public benevolent institution (PBI) in Australia that is endorsed by the Commissioner are deductible: s 30-45(1) Item 4.1.1, s 30-17. The term ‘‘public benevolent institution’’ is not defined in the ITAA 1997 or ITAA 1936. In Perpetual Trustee Co Ltd v FCT (1931) 45 CLR 224, Starke J at 232 described a PBI as ‘‘an institution organized for the relief of poverty, sickness, destitution, or helplessness’’. Ruling TR 2003/5 states that a PBI is a non-profit institution organised for the direct relief of such poverty, sickness, suffering, distress, misfortune, disability, destitution, or helplessness as arouses compassion in the community. However, in FCT v Hunger Project Australia (2014) 221 FCR 302, the Full Federal Court held that a PBI was not required to dispense aid directly and that an organisation could qualify as a PBI even if it did not engage directly in charitable activities and was, instead, primarily engaged in fund raising activities for charitable purposes. In reaching this conclusion, the Court relied somewhat on the High Court’s decision in FCT v Word Investments Ltd (2008) 70 ATR 225 (see [7 430]). In light of the Hunger Project decision, the Commissioner may have to reconsider his views in Ruling TR 2003/5, including the view that an organisation that merely manages property and makes distributions to other organisations is not a PBI. An institution is considered to be an establishment, organisation or association, instituted for the promotion of some object, especially one of public or general utility: see Ruling TR 2011/4. An institution may be constituted in different ways including as a corporation, unincorporated association or trust, although an institution involves more than the mere incorporation of an organisation. In Douglas v FCT (1997) 36 ATR 532, the Federal Court held that a trustee of a meeting hall, to be used for meetings of certain religious affiliations and other bodies acceptable to the trustee, was a mere trust and not an institution. Trustees whose only function is the management of a trust fund consistent with the terms of a trust deed will not qualify as an institution: Ruling TR 2011/4. An organisation controlled and operated by one person, or by family members and/or friends, cannot be an institution: eg, Re Home Health Pty Ltd and FCT (2013) 93 ATR 464. The term ‘‘public’’ in PBI refers to ‘‘a substantial, appreciable, extensive or sufficient section of the community’’. In Trustees of the Indigenous Barristers’ Trust v FCT (2002) 51 ATR 495, the Federal Court considered that a trust established to help indigenous persons © 2017 THOMSON REUTERS

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become barristers in NSW satisfied the ‘‘public’’ requirement of a PBI, even though in the short-term there may have been few likely to seek assistance. The ACNC has released a draft Commissioner’s Interpretation Statement on the meaning of PBI.

Necessitous circumstances funds A deduction is available for gifts made to a public fund established and maintained for the purpose of relieving the necessitous circumstances of one or more individuals who are in Australia and which is endorsed by the Commissioner: s 30-45 Item 4.1.3, s 30-17. According to the Tax Office, ‘‘necessitous circumstances’’ is a relative term, having regard to a person’s particular circumstances including income, assets, liabilities and responsibilities: Ruling TR 2000/9. A person is in necessitous circumstances if her or his financial circumstances are insufficient to obtain all that is necessary for a modest standard of living in the Australian community. A strong indicator of this would be if a person’s level of income is such that he or she is eligible to receive income tested government benefits. In Ballarat Trustees Executors and Agency Co Ltd v FCT (1950) 80 CLR 350, Kitto J (at 355) said that ‘‘necessitous circumstances’’ refers to an ‘‘inability to afford what may fairly be regarded as necessities for persons living in Australia’’, distinguishing such necessities from things that are merely desirable advantages. Persons who were unable to afford the fees charged by a private hospital, but who enjoyed a modestly comfortable existence, were considered not to be in necessitous circumstances. In Trustees of the Indigenous Barristers’ Trust v FCT (2002) 51 ATR 495, the Federal Court favoured a broad and beneficial interpretation of the section, commenting (at 518-519) that the relief of necessitous circumstances ‘‘is not confined to the relief of poverty in a strict sense’’. In that case, the court held that a trust established to help indigenous persons become barristers in NSW was a public fund established for the relief of persons in necessitous circumstances. Central to the decision was the proposition, supported by the evidence, that an ‘‘indigenous person with virtually no assets and with all the social disadvantages … needs help in order to break free of the poverty trap’’ (at 519). The Tax Office considers that if services go beyond the distribution of money or goods, the organisation is more likely to be an institution than a fund (in which case it may be a PBI: Ruling TR 2000/9. Indirect distributions of money to another fund are acceptable to the Tax Office, provided the money is used to relieve persons in necessitous circumstances. Developing country relief funds Gifts to developing country relief funds covered by s 30-80 Item 9.1.1 are deductible (the Overseas Aid Gift Deduction Scheme) if, when the gift is made, a declaration (published in the Gazette) that the fund is a relief fund is in force (the fund must also be a public fund): s 30-85(1), (2). The fund itself must be established and administered in Australia. The Treasurer may revoke a declaration if satisfied that the fund or organisation no longer meets the relevant requirements: s 30-85(4). For these purposes, an organisation is only an ‘‘approved organisation’’, and a country is only a developing country, if the Foreign Affairs Minister makes a declaration to that effect: s 30-85(2) and (5). Guidelines for organisations seeking to have a fund admitted to the Overseas Aid Gift Deduction Scheme are contained in Ruling TR 95/2. Further information on the Overseas Aid Gift Deduction scheme is available at http://dfat.gov.au/aid/who-we-work-with/ngos/Pages/tax-deductibility.aspx. Health promotion charities Gifts to a registered health promotion charity (ie an institution whose principal activity is to promote the prevention or the control of diseases in human beings) are deductible if the charity is endorsed by the Commissioner: s 30-20, Item 1.1.6, s 30-17. The ACNC has published an interpretation statement (CIS 2015/01) which provides guidance on health promotion charity status. In Re Healthy Cities Illawarra Inc and FCT (2006) 63 ATR 1165, 326

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the AAT decided that the taxpayer, which was part of the Healthy Cities program, was not a health promotion charity as it could not be said that its principal activity was to promote the prevention or control of disease. In reaching this conclusion, the AAT drew a distinction between ‘‘disease’’ and ‘‘injury’’.

Harm prevention charities Funds on the Register of Harm Prevention Charities kept under Subdiv 30-EA have DGR status: s 30-45, Item 4.1.4. A harm prevention charity is a registered charity whose principal activity is to promote the prevention or control of behaviour that is harmful or abusive to humans (including emotional, sexual, physical or substance abuse, suicide and self harm): ss 30-288, 30-289, 995-1. A registered harm prevention charity must be endorsed as exempt from income tax under Subdiv 50-B (see [7 360]), must maintain a public fund and must not act as a mere conduit for donations to other organisations or persons: ss 30-289, 30-289A. Organisations are entered on the Register by direction of the Treasurer and the Families Minister: s 30-289B. See also the Register of Harm Prevention Charitable Institutions Guidelines 2014, available on the Department of Social Services website at https:// www.dss.gov.au. Environmental organisations Item 6.1.1 (in s 30-55) confers DGR status on funds that, at the time of the gift, are on the Register of Environmental Organisations kept under Subdiv 30-E. Organisations are entered on the Register following approval by the Environment Secretary and the Treasurer: s 30-280. Organisations whose principal purpose is to do with the protection and enhancement of the natural environment or the provision of information or education, or the carrying on of research, about the natural environment may be considered for entry on the Register: s 30-265. The Register is available on the Department of the Environment and Energy’s website at http://www.environment.gov.au. Various environmental organisations specified in s 30-55 (eg National Parks Associations and National Trust bodies) also have DGR status. Cultural organisations Funds on the Register of Cultural Organisations kept under Subdiv 30-F have DGR status: s 30-100, Item 12.1.1. The Register is available on the Department of Communications and the Arts website at https://www.communications.gov.au. Organisations that have a primary cultural purpose, are non-profit distributing and maintain a public fund for donations may be considered for inclusion on the Register: s 30-300. Public libraries, museums and art galleries The Tax Office’s views on what is a public library, public museum and public art gallery for the purposes of Items 12.1.2 to 12.1.4 (in s 30-100) are set out in Ruling TR 2000/10. A library at a public educational institution (school, college or university) is generally accepted as a ‘‘public library’’ for these purposes. School building funds Gifts to a school or college building fund are deductible if the fund, or the entity that legally owns the fund or the government body constituted by the persons who control the fund, is endorsed under Subdiv 30-BA (s 30-17) and the fund satisfies the requirements of Item 2.1.10 in s 30-25. The requirements of Item 2.1.10 are that: • the fund must be a public fund established and maintained solely for the acquisition, construction or maintenance of a school building; • the building for which the fund is established and maintained must be used, or it must be intended that it will be used, as a school by a government, a public authority or a non-profit society or association as described in Item 2.1.10; and © 2017 THOMSON REUTERS

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• the fund must be registered under the Australian Charities and Not-for-profits Commission Act 2012 or not be an ‘‘ACNC type of entity’’ (see ATO ID 2013/60 to ATO ID 2013/62). The Commissioner’s views on these requirements are set out in Ruling TR 2013/2.

Disaster relief funds Item 4.1.5 (in s 30-45) confers DGR status on a public fund (which is a registered charity) that is established and maintained (including by a PBI) solely to provide money for the relief (including assistance to re-establish a community) of people in Australia who are in distress as a result of a disaster. Item 9.1.2 (in s 30-80) similarly confers DGR status on a public fund established and maintained by a PBI solely to provide money for the relief (including assistance to re-establish a community) of people in a developed overseas country who are in distress as a result of a disaster. An event is only a disaster for these purposes if it gives rise to a declaration of a state of emergency by the relevant State or Territory Minister, or if it is declared by the relevant Federal, State or Territory Minister to be a disaster or, in the case of an overseas event, it is recognised by the Foreign Affairs Minister as a disaster. An event may only be declared to be, or recognised as, a disaster if it developed rapidly and it resulted in the death, serious injury or other physical suffering of a large number of people, or in widespread damage to property or the natural environment: ss 30-45A, 30-46, 30-86. Animal welfare DGR status is conferred under Item 4.1.6 of s 30-45 on a registered charity where the principal activity of the organisation is providing short term direct care to animals or in rehabilitating orphaned sick or injured animals. The requirements of this category were considered in Sea Shepherd Australia Ltd v FCT (2013) 92 ATR 836, where a majority of the Full Federal Court concluded that Item 4.1.6 requires an organisation to directly provide treatment or accommodation. Sea Shepherd did not satisfy this requirement because its activities were directed at Japanese whaling ships. Note that the High Court refused to grant Sea Shepherd special leave to appeal against that decision. [9 870] Ancillary funds Ancillary funds operate as conduit mechanisms which allow funds to be contributed on a tax deductible basis before the funds are distributed to eligible recipients. Ancillary funds may be either public or private. Public funds Under Item 2 of the table in s 30-15, a deduction is available for gifts (of $2 or more) to a public fund established and maintained under a will or trust instrument solely for: (i) the purpose of providing money, property or other benefits to or for any of the funds, authorities or institutions covered by the tables in Subdiv 30-B ITAA 1997 (see [9 860]), ie they must be endorsed (see [9 880]) or listed by name, and for any purposes mentioned in the tables; or (ii) the establishment of any such funds, authorities or institutions. These public funds are known as ‘‘public ancillary funds’’. A fund is a ‘‘public’’ fund if the promoters or founders intend the public to contribute to the fund, the public (or a significant part of it) does in fact contribute to the fund and the public participates in the administration of the fund: see Bray v FCT (1978) 8 ATR 569. The regulatory framework for public ancillary funds (in Subdiv 426-D in Sch 1 TAA) is similar to that for private ancillary funds (see below). The principles for establishing and operating the funds are contained in the Public Ancillary Fund Guidelines 2011 (as amended), which also govern matters such as trustee constitution, minimum distributions and investment limitations. All trustees of public ancillary funds have to be corporate trustees (this does not apply to public ancillary funds with non-corporate trustees as at 1 January 2012). In addition to a comprehensive administrative penalty regime, the Commissioner has the power to either 328

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suspend or remove corporate trustees that don’t comply with the Guidelines (this does not apply to funds with non-corporate trustees until such time as a fund replaces the non-corporate trustees with a corporate trustee). Practice Statement PS LA 2014/1 contains guidance on how penalties for failure to comply with the Public Ancillary Fund Guidelines will be administered.

Private ancillary funds A deduction is also available under Item 2 of the table in s 30-15 for a gift to a private ancillary fund (PAF). An example of a PAF is a foundation established by an employer to facilitate deductible employee contributions. Those contributions will then be distributed across a range of DGR’s as determined by the foundation trustees. The Private Ancillary Fund Guidelines 2009 (as amended) set out rules for establishing, operating and winding up a PAF. A PAF must be a valid trust and a not-for-profit entity, set up and run solely to benefit other DGRS, and it must operate solely in Australia (although this does not prohibit the fund from distributing to DGRs that operate outside Australia). At least one of the individuals involved in the decision-making of a PAF must be an individual with a degree of responsibility to the Australian community as a whole, but cannot be a founder, a donor to the fund who has contributed more than $10,000 or an associate of a founder or such a donor. The guidelines impose restrictions on investments, for example, trustees are generally prohibited from entering into uncommercial transactions and from providing benefits to related parties. In addition, the trustee must prepare and maintain a current investment strategy. The guidelines also require a PAF to distribute each financial year (but not the year in which it is established) a minimum of 5% of the market value of its net assets (as at the end of the previous financial year) if its expenses are met from outside. If the expenses are paid out of the PAF’s assets or income, it must distribute the greater of $11,000 (or the balance of the fund if less than $11,000) or 5%. A PAF cannot provide money to another ancillary fund except in the winding up phase. Other matters covered by the guidelines include valuations, records, accounts, financial statements and audits. Practice Statement PS LA 2014/1 contains guidance on how penalties for failure to comply with the Private Ancillary Fund Guidelines will be administered. [9 880] Endorsement of gift recipient A gift to a fund, authority or institution is not deductible unless the fund etc is specifically named in the legislation (primarily Subdiv 30-B) as entitled to receive tax deductible gifts or is endorsed by the Commissioner as a DGR (under Subdiv 30-BA), or is owned or controlled by an entity or government entity that is endorsed by the Commissioner: s 30-17. The general categories of organisation that need to be endorsed as a DGR include public benevolent institutions, public universities, school building funds, public hospitals and necessitous circumstances funds. Private ancillary funds are also required to be endorsed. Note that the Australiana Fund (see [9 890]) need not be endorsed. An entity is entitled to be endorsed as a DGR if it satisfies the conditions in s 30-125. An endorsed DGR must maintain a gift fund except where an organisation is seeking DGR endorsement for a fund, authority or institution that it operates and the organisation is already endorsed as a DGR as a whole: s 30-130. An endorsed DGR can consolidate multiple gift funds into one gift fund provided the fund does not receive any other money or property. The gift fund must be maintained and used for the principal purpose of the entity and all gifts and contributions must be made or credited to the gift fund. The provisions governing applications for endorsement are located in Pt 5-35 in Sch 1 TAA (ss 426-1 to 426-65). If an entity is endorsed, a statement to that effect will be included in the Australian Business Register (see [55 210]): s 426-65. The Commissioner is entitled to revoke the endorsement of a DGR on a retrospective basis where it does not satisfy the requirements for the relevant endorsement: see Re Cancer and Bowel Research Association (2013) 93 ATR 394 (on appeal). © 2017 THOMSON REUTERS

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Cultural and heritage gifts

Gifts of property, other than an estate or interest in land, a building or part of a building, under the Cultural Gifts Program are deductible if the conditions in Item 4 of the table in s 30-15 are satisfied. The Cultural Gifts Program consists of gifts to the Australiana Fund, a public library, a public museum, a public art gallery, or an institution comprising 2 or more of such bodies, or Artbank (see Ruling TR 2000/10). The conditions in Item 4 are as follows: • the value of the gift must be $2 or more; • it must not be a testamentary gift (see [9 830] for definition of ‘‘testamentary gift’’); • the property must be given to and accepted by one of the bodies mentioned for inclusion in the collection(s) maintained or being established by that body; • the body must be in Australia – if a body is established in Australia and makes its collection permanently available to the public in Australia, the Tax Office accepts that it is ‘‘in Australia’’: Ruling TR 2000/10; and • the valuation requirements set out in Subdiv 30-C ITAA 1997 must be satisfied. That is the essential requirement is that at least 2 written valuations of the donated property by approved valuers must be obtained (unless it is a gift where the Commissioner’s valuation will be required) stating an opinion of the GST-inclusive market value. An approved valuer is a valuer approved in writing by the Secretary to the Department of Communications and the Arts as a valuer of a particular kind of property: s 30-210.

Gifts to National Trust bodies Deductions are allowable under Item 6 of the table in s 30-15 for gifts of property with a value of $2 or more made to various National Trust bodies specified in Item 6. The gift must be of a place included in the Register of the National Estate kept under the Australian Heritage Council Act 2003 or of a place included in the National Heritage List, or the Commonwealth Heritage List, under the Environment Protection and Biodiversity Conservation Act 1999. In addition, the gift must be accepted for preservation by the body concerned. The gift must not be a testamentary gift and the valuation requirements in Subdiv 30-C must be satisfied. In certain circumstances, a gift of property to one of the National Trust bodies may be spread over 5 years: see [9 840].

Deductible amount The deductible value of a gift of property under the Cultural Gifts Program or to one of the National Trust bodies is determined in accordance with ss 30-215 and 30-220. There are 3 broad sets of circumstances to which different rules apply. • If the gift of property is made by a person who would have realised assessable income had the property been sold and the gift does not give rise to assessable income to the donor (meaning that it must not be trading stock or a revenue asset), such as certain gifts by artists or dealers, the deduction is limited to the amount paid for the property (if it was purchased) or alternatively the cost of creating or producing the property (equal to the amount deductible on a sale): s 30-215(3), Items 1 and 2. • If the gift is of property acquired for the purpose of making the gift or subject to an arrangement that it would be given away, or of property acquired (otherwise than by inheriting it) within the 12 months immediately preceding the gift, the deduction is restricted to the amount paid for the property or the GST-inclusive market value (see [3 210]) of the property (per the average of the valuations provided they fairly represent that value) at the date of the gift, whichever is less: s 30-215(3), Item 3. 330

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• In any other case, the deductible value is either the average of the written valuations, provided they fairly represent the GST-inclusive market value (see [3 210]) of the property at the date of the gift or, if not, that market value: s 30-215(2) and 30-215(3), Item 4. The GST-inclusive market value is reduced by 1/11 if the taxpayer would be entitled to an input tax credit if the taxpayer had acquired the property at the time of making the gift and the acquisition was for a creditable purpose: s 30-15(3) and 30-215(4). Note that a deduction for a gift under the Cultural Gifts Program or to one of the National Trust bodies may be spread over a period of up to 5 years: see [9 840].

[9 900] Conservation covenants A taxpayer who enters into a conservation covenant over land the taxpayer owns is entitled to a deduction if certain conditions are satisfied: s 31-5(1). A conservation covenant over land is a permanent covenant that restricts or prohibits certain activities on the land that could degrade the environmental value of the land and is approved in writing by, or is entered into under a program approved in writing by, the Environment Minister: s 31-5(5). In addition, the covenant must be registered on the title to the land if registration is possible. The conditions that must be satisfied are as follows (s 31-5(2)). • The covenant must be perpetual (it does not matter if a State or Territory Minister has a power to rescind it). • The taxpayer must not receive any money, property or other material benefit for entering into the covenant. • The market value of the land (see [3 210]) must decrease as a result of entering into the covenant – the decrease in value must be more than $5,000 unless the taxpayer had entered into a contract to acquire the land not more than 12 months before entering into the covenant. • The covenant must have been entered into with: – a government (ie the Commonwealth, a State, a Territory or a local governing body) or a Commonwealth, State or Territory authority; or – a fund, authority or institution that is either covered by an item in any of the tables in Subdiv 30-B (see [9 860]), and which satisfies any relevant conditions, or is an ancillary public fund or a private ancillary fund (see [9 870]): s 31-10(1). If the fund is not specifically listed in Subdiv 30-B, it must also be in Australia and either be endorsed by the Tax Office (see [9 880]) or be a private ancillary fund: s 31-10(2).

Deductible amount The deductible amount is the amount by which the decrease in the market value of the land (by comparing its market value just before and just after entering into the covenant) is attributable to entering into the covenant: s 31-5(3). Market value excludes any input tax credits attributable to the asset (ie it is GST-exclusive): see [3 210]. The deduction can be spread over 5 years under Subdiv 30-DB: see [9 840]. The change in the market value of the land must be valued by the Commissioner: s 31-15. For this purpose application is made to the General Manager, Australian Valuation Office on the approved form. [9 910] Political contributions A political contribution or gift (of $2 or more) is only deductible if made by an individual otherwise than in the course of carrying on a business: ss 26-22, 30-242(3A). Thus, a company, trust or other entity cannot claim a deduction; nor can an individual who makes the contribution in the course of carrying on a business. © 2017 THOMSON REUTERS

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A contribution or gift is deductible if made to (s 30-242(1)): • a political party registered under the Commonwealth Electoral Act 1918, or under equivalent State or Territory legislation; • an independent member of an Australian Parliament (see s 30-245); or • an independent candidate for a Commonwealth, State or Territory election. The maximum amount deductible in an income year is $1,500: s 30-243. There are separate $1,500 thresholds for donations to political parties and donations to independents (ie in the one income year, a taxpayer may separately deduct up to $1,500 for donations to parties and up to $1,500 for donations to independents). If an individual ceases to be an independent member because a Parliament, House of Parliament or Legislative Assembly is dissolved or has reached its maximum duration, or the member comes up for election, contributions or gifts to that member will continue to be tax deductible if made before the candidates for the resulting election are declared or otherwise publicly announced: s 30-243. An individual does not start being an independent candidate until the candidates for the election are declared or otherwise publicly announced by an authorised entity: s 30-244(2). An individual stops being an independent candidate when the result of the election is declared or otherwise publicly announced by an authorised entity: s 30-244(3). Section 30-244(4) deals with the situation where an election wholly fails. An employee of a political party or a member of a Parliament or local council may be allowed a deduction under s 8-1 for a contribution or gift if it is incurred in deriving assessable employment income or assessable salary, allowances, etc received as a member of a Parliament (eg the party membership fee an MP or employee of the party is required to pay): s 26-22(2).

[9 920] Anti-avoidance measures Section 78A denies a deduction for gifts if arrangements are in place which compromise the bona fides of the gift. The section applies if, by reason of the making or receipt of the gift or any scheme or arrangement associated with the gift: • the amount or value of the benefit derived by the DGR as a consequence of the gift is, or will be, or may reasonably be expected to be, diminished subsequent to the receipt of the gift: s 78A(2)(a); • another fund, authority or institution (other than the recipient DGR) makes, or becomes liable to make, or may reasonably be expected to make a payment, or transfer property to any person or incur any other detriment, disadvantage, liability or obligation: s 78A(2)(b); • the donor or an associate of the donor obtains, or will obtain, or may reasonably be expected to obtain any benefit, advantage, right or privilege apart from the benefit of a tax saving associated with the gift deduction: s 78A(2)(c). Thus, a payment of money to an eligible ‘‘umbrella’’ organisation under a ‘‘preferred donation arrangement’’ is not a tax-deductible gift if the donor taxpayer or an associate obtains a collateral benefit: Ruling TR 2005/13; or • the recipient DGR or another fund, authority or institution acquires property, directly or indirectly, from the donor or an associate of the donor: s 78A(2)(d). Section 78A applies to purported gifts if there is considerably reduced benefaction in fact conferred upon the recipient DGR arising from the transfer of the property, or if the benefit of the transfer was obtained by the recipient DGR, another (associated) fund, authority or institution bears obligations as a result of the transfer. It also applies if the benefit associated with the transfer of the property is returned either wholly or in part to the donor or an associate of the donor. 332

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MISCELLANEOUS [9 950] Insurance premiums Insurance premiums are deductible under s 8-1, in accordance with general principles, if they have the necessary connection with earning assessable income or are necessarily incurred in carrying on a business for the purpose of earning assessable income. Self-employed persons and employees are entitled to deductions for premiums paid under income protection and/or disability insurance policies: FCT v Smith (1981) 11 ATR 538 and ATO ID 2010/178. If the policy also provides benefits of a capital nature (eg for death or loss of a limb), the premiums will have to be apportioned between the income and capital components. If the premiums cannot be apportioned, the Tax Office will generally treat the whole premium as non-deductible. In any event, the premiums will not be deductible if they are part of a tax avoidance arrangement: see Ruling IT 2460. Premiums payable on savings investment, endowment and life insurance policies are generally on capital account and therefore not deductible. Health insurance premiums are not deductible as they are of a private nature, even if private health insurance has to be taken out in order to obtain a visa to work in Australia: see Re Thambiannan and FCT [2016] AATA 1004. The Tax Office considers that trauma insurance premiums are not deductible if the policy provides capital benefits, but may be deductible if paid by an employer, the policy advances the employer’s business and the employer is both the policyholder and the beneficiary under the policy: see Determinations TD 95/41 and TD 95/42. Professional indemnity insurance premiums are deductible: see Ruling TR 95/9. In FCT v Adler (1981) 12 ATR 608, a company director was allowed a deduction for liability insurance relating to his position as a director, on the basis that he was carrying on business as a director (he had a number of directorships). Premiums paid by a business for workers compensation insurance are deductible. The Commissioner allows a business a deduction for premiums for fire, theft, public liability, loss of profits and motor vehicle insurance, even though the insurance may cover capital assets or losses. In Australian National Hotels Ltd v FCT (1987) 19 ATR 417, a hotel operator was allowed a deduction for premiums for insurance against foreign exchange losses that may arise in relation to an offshore loan. Premiums for ‘‘keyman’’ insurance will be deductible if the policy was taken out to protect revenue items: see Carapark Holdings Ltd v FCT (1967) 115 CLR 653 and Ruling IT 155. However if the policy is taken out to protect against a capital loss (eg to pay a sum to the key employee’s estate on her or his death), the premiums will not be deductible. An apportionment of the premiums may be required. A deduction for a ‘‘key employee’’ insurance bond was disallowed in Gandy Timbers Pty Ltd v FCT (1995) 30 ATR 232 as the arrangement was unrelated to the business interests of the taxpayer. No part of any premiums paid by an employer under a ‘‘split purpose’’ insurance arrangement is deductible: see Determination TD 94/40. The Tax Office’s views on ‘‘split dollar’’ insurance arrangements are set out in Ruling IT 2434.

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Self-education expenses

Self-education expenses are generally deductible if there is a sufficient connection with the taxpayer’s income-producing activities (subject to the limitation in s 82A, discussed below). The leading cases (eg FCT v Finn (1961) 106 CLR 60, FCT v Hatchett (1971) 2 ATR 557 and FCT v Studdert (1991) 22 ATR 762) establish that expenses incurred in maintaining or improving the taxpayer’s skills and knowledge in her or his present occupation should be deductible, particularly if they are likely to lead to a pay increase. However, self-education expenses incurred before commencing an occupation or to obtain a new occupation are unlikely to be deductible. These principles are discussed in more detail below. © 2017 THOMSON REUTERS

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The Tax Office’s views on the deductibility of self-education expenses are set out in Ruling TR 98/9. Note that the amount of a deduction may be limited by s 82A ITAA 1936 (see below).

Tertiary studies before commencing employment The costs of university studies or similar courses undertaken before commencing any occupation or employment are generally not deductible: FCT v Maddalena (1971) 2 ATR 541. They are not incurred in gaining or producing assessable income and are also regarded as a capital cost of equipping the person for employment. See, for example, Re Southwell-Keely and FCT (2008) 73 ATR 239, where a taxpayer could not deduct the costs of a hotel management course, even though employed in the hospitality industry, as the course was considered to be relevant to the getting of work in the future. See also Re Amuthalan and FCT [2008] AATA 818 (taxpayer denied a deduction for a patisserie course which was considered to have an insufficient connection to his employment as a baker’s assistant).

Tertiary studies while in employment The cost of courses undertaken concurrently with the performance of any employment or occupation, such as part-time studies at night, is deductible provided the requisite nexus to the earning of assessable income can be established. The nexus may exist either because the courses provide information to keep the taxpayer up-to-date with developments in her or his occupation, enable the employment tasks to be carried out more effectively or are likely to lead to increased pay, eg through promotion (although actual promotion is not necessary). A leading case is FCT v Highfield (1982) 13 ATR 426, where a dentist was allowed a deduction for the cost of obtaining a specialist degree overseas. See also Re Davis and FCT (2000) 44 ATR 1109 (costs of Bachelor of Social Science (Human Services) incurred by a Health Insurance Commission claims review officer deductible), Re Maclean and FCT (2001) 48 ATR 1160 (costs of Masters course in adult education incurred by a nurse deductible), Re Mandikos and FCT (2001) 48 ATR 1077 (certain expenditure incurred by a dentist while undertaking a post-graduate course at an American university not deductible: see also [9 050]) and Re Ting and FCT [2015] AATA 166 (costs of financial accounting and marketing courses incurred by secondary college teacher not deductible). In Re Thomas and FCT [2015] AATA 687, the taxpayer was denied a deduction for 2 fee instalments in relation to an MBA course in Paris which were due for payment after the taxpayer was made redundant. On the facts, the taxpayer was not definitively committed to pay the fees at the time his employment ceased and therefore the expenditure was not ‘‘incurred’’ before his employment ended. The AAT commented, however, that the fees would have been deductible if the taxpayer had incurred the liability while still employed. (The question of when expenditure is incurred for deduction purposes is discussed at [8 300] and following.) In Re Lenten and FCT (2008) 71 ATR 862, a teacher was allowed a deduction for overseas travel expenses as the AAT was satisfied that the purpose of the travel was to enhance his promotional opportunities within the school where he was employed (see also the ATO Decision Impact Statement). Similarly, in Re Sanchez and FCT (2008) 73 ATR 650, a sales consultant in a travel agency was allowed a deduction for overseas travel expenses on the basis that he undertook the trips to gain and update the knowledge and skills he needed to improve his work performance and productivity. If a taxpayer is entitled to deduct self-education expenses incurred in respect of a course of higher education, any student services and amenities fee charged by the higher education provider is also deductible (see ATO ID 2012/65). In FCT v Anstis (2010) 76 ATR 735, the High Court held that a full-time student in receipt of the Youth Allowance was allowed a deduction for various self-education expenses (eg a student administration fee, books and depreciation on a computer) as they were considered to be incurred in deriving the Youth Allowance, which was assessable income. 334

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[9 960]

However, s 26-19 ITAA 1997 effectively disallows deductions against taxable government assistance payments that are eligible for a rebateable benefit (see [19 520] for the definition of a ‘‘rebateable benefit’’). Child-minding expenses incurred while the taxpayer undertakes a higher degree connected to their employment are not deductible as they lack the relevant connection to gaining or producing assessable income: Jayatilake v FCT (1991) 22 ATR 125. Similarly, costs associated with attending the taxpayer’s graduation ceremony are not deductible: Re Berrett and FCT (1999) 41 ATR 1262. The cost of tertiary studies will not be deductible if the studies are undertaken so that the taxpayer can pursue a new career or obtain new employment: eg FCT v Roberts (1992) 24 ATR 479, where a mining engineer was refused a deduction for the costs of obtaining an MBA in the USA. The taxpayer in Highfield may well have been denied a deduction if the specialist degree had been obtained so that he could pursue a career in that specialist field (the purpose of obtaining the degree was to use the knowledge in his general practice). A student who, during university or college holidays, undertakes casual employment in their field of study is unlikely to qualify for a deduction for the cost of the university or college course: see Ruling TR 98/9 para [57] and Re Cheung and FCT (2008) 71 ATR 335. In Cheung, it did not matter that the taxpayer’s course required her to undertake 2 semesters of industry employment. Higher education contributions such as HECS-HELP payments and FEE-HELP payments are not deductible: see [9 970]. However, course fees imposed by institutions themselves are deductible if there is a sufficient connection with income-producing activities. The Commissioner’s attitude to meal expenses incurred by part-time students while attending university or colleges is explained in Ruling TR 98/9.

Books, technical and trade journals Books, technical and trade journals that assist employees or self-employed persons to improve their knowledge in fields related to their occupations are deductible. Books should be depreciated as part of a professional library under Div 40 (see Chapter 10), although an annual edition should qualify for an outright deduction under s 8-1. The depreciation provisions also allow for an immediate 100% deduction in certain cases: see [10 530]. Technical and trade journals and magazines are deductible under s 8-1. Seminars and professional development courses The costs of attending seminars and professional development courses related to the taxpayer’s occupation are deductible under s 8-1. Allowable costs will include registration fees, travel costs and, if interstate travel or residential courses are involved, accommodation and meal costs. Costs attributable to certain seminars of less than 4 hours’ duration may be excluded from deductibility if the entertainment expenses provisions are breached: see [9 540]. See also Determination TD 93/195 and Re Chaudri and FCT (1999) 42 ATR 1001, where an academic’s meal expenses while undertaking research work on a sabbatical in India were classified as self-education expenses and allowed as a deduction. Study tour costs were held to be deductible in Finn (State government architect’s overseas study tour) and Griffın v FCT (1986) 18 ATR 23 (a railway electrical engineer went to Europe to inspect railway electrification systems). The cost of an overseas trip will have to be apportioned if the taxpayer also takes the opportunity to have a holiday while overseas. In Re Applicant and FCT (2009) 75 ATR 761, a postgraduate studying overseas was denied a deduction for accommodation and telephone expenses as they were held to have been incurred in establishing a new home where he was studying and thus were of a private nature. Deductions for the costs of flying lessons were allowed in Studdert (a flight engineer) and FCT v Wilkinson (1983) 14 ATR 218 (an air traffic controller). In Re Naglost and FCT (2001) 49 ATR 1028, a logistician in the Royal Australian Air Force was allowed a deduction © 2017 THOMSON REUTERS

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for expenses incurred in attending a course designed to enhance leadership, management and decision-making skills. Similarly, expenses incurred in attending a personal development course will be deductible if the taxpayer can demonstrate a link, not only to skills and knowledge in general, but also to her or his current duties: ATO ID 2003/84 and ATO ID 2003/614.

Home study costs The costs of a home study will be deductible if the expenses relating to the relevant course of study are deductible (because there is a direct connection with the taxpayer’s income-producing activities): eg Re Lyons and FCT (1999) 42 ATR 1106. The relevant room (or rooms) must be set aside as an identifiable study. For the type of expenses that may be deductible and how to calculate them, see [9 980] (home office expenses).

Section 82A limitation – prescribed courses of education A limitation on deductibility exists under s 82A ITAA 1936 in respect of deductions that would otherwise be allowable under s 8-1 if the self-education expenses are necessarily incurred for or in connection with a course of education provided by a school, college, university or other place of education and undertaken by the taxpayer for the purpose of gaining qualifications for use in the carrying on of a profession, business or trade or in the course of any employment. In those circumstances, only the excess over $250 may be deductible. The net amount of self-education expenses basically means the total of relevant expenses reduced by any non-assessable educational assistance or reimbursements received. Relevant expenses are those that are necessarily incurred in connection with the course of education, whether or not they are deductible under s 8-1. Thus, for example, child-minding fees may be taken into account: Ruling TR 98/9. Certain payments are excluded, in particular student contributions under the Higher Education Support Act 2003. Payments in respect of, or in the reduction or discharge of, any indebtedness under the Trade Support Loans Scheme or any liability to the overseas debtors repayment levy (see [19 910]) are also excluded. Depreciation (eg on a computer) is not allowed as it is not an expense as such. However, having established the maximum amount (ie the net amount of self-education expenses over $250), only expenses that are deductible under s 8-1 may actually be claimed (up to the maximum amount). Expenditure incurred by candidates for admission to the Institute of Chartered Accountants may be an allowable deduction without regard to the $250 exclusion, as that body is not a place of education: see Case 97 (1980) 23 CTBR(NS).

[9 970]

Higher education contributions

The following higher education-related payments are not deductible (s 26-20(1)): • a student contribution to a higher education provider; • a payment to reduce a HELP debt (ie a HECS-HELP, FEE-HELP, OS-HELP or VET FEE-HELP debt: see [19 900]) or a financial supplement debt (see [19 910]), irrespective of how the payment is made (ie whether or not through the tax system); • a payment to reduce a liability to the overseas debtors repayment levy (see [19 910]); and • a payment to reduce a debt under the Trade Support Loans Scheme. However, if any such contributions and payments are made by a person’s employer (or associate of the employer), giving rise to a fringe benefit, the expenditure may be deductible to the entity making the payment (ie s 26-20(1) does not deny a deduction in such a case): s 26-20(2). 336

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[9 990]

[9 980] Home office Expenditure in the nature of occupancy costs (contrast operating expenditure) related to a person’s home is not deductible unless it can be established that a specific part of the home has been set aside as a place of business (eg a separate surgery set up in a doctor’s home). Only if a home office has this character of a place of business will expenses of an ownership or occupancy nature be deductible: see, eg Swinford v FCT (1984) 15 ATR 1154. Cases where claims for home office expenses were rejected include Re Taxpayer and FCT (2007) 67 ATR 275, Re Russell and FCT (2013) 96 ATR 422 and Re Schlottmann and FCT (2013) 96 ATR 946. Note that the CGT principal residence exemption may be partially lost if the property contains a home office: see [15 440]. This character of a place of business may extend, in limited circumstances, to taxpayers who have no other main place of business or employment (eg rural sales managers, telecommuters), provided there is a requirement inherent in the nature of the taxpayer’s activity that the taxpayer needs a place of business, the taxpayer’s circumstances are such that no alternative place of business is available and the taxpayer must work from home and the area of the home is used almost exclusively for income-producing purposes: Ruling TR 93/30. Deductible home office expenses include electricity charges for heating/cooling and lighting, rent, interest on a mortgage, cleaning costs, depreciation (eg for floor coverings, curtains, desks and chairs) and the cost of repairing furniture and furnishings: Ruling TR 93/30. The deduction for rent or mortgage interest and council rates is usually calculated on the basis of the proportion of the floor area of the premises occupied by the taxpayer as a home office (or home study); see, for example, Re HWZG and FCT [2016] AATA 1017. See [9 1460] for the Tax Office’s views on substantiating home office ‘‘running expenses’’ and how much may be claimed in certain circumstances. In Re Ogden and FCT [2014] AATA 385, a sales commission agent was allowed deductions for only 11.7% of certain occupancy costs (eg mortgage interest, heating, lighting, cleaning, insurance and council rates) on the basis that only 11.7% of his house and garage was identifiable as a home office. In a later case involving the same taxpayer but different income years, the AAT found that only 1.8% of the family home was used as an office: Re Ogden and FCT [2016] AATA 32. Home office as convenience A deduction will not be allowed if a taxpayer merely uses part of their home as a convenient place in which to undertake work. In such a case, any relevant expenditure is related to the property’s primary function as a home, even if a room is set aside exclusively for purposes associated with earning assessable income. Evidence that, for example, the taxpayer’s employer expects her or him to work at home or make some work-related calls will help establish an entitlement to a deduction. In Thomas v FCT (1972) 3 ATR 165, for example, the High Court found that expenditure claimed as a deduction by a barrister in respect of his home was of a private or domestic nature, notwithstanding the fact that a room had been set aside for the purpose of allowing the taxpayer to undertake his professional work. Similar decisions were given by the High Court in Handley v FCT (1981) 11 ATR 644 and FCT v Forsyth (1981) 11 ATR 657. A claim to deduct home office expenses was also rejected in Re Bradshaw and DCT (1999) 41 ATR 1195 (the claim may have succeeded if the taxpayer had been operating a consultancy from home, rather than doing work for his employer) and Re Ovens and FCT (2009) 75 ATR 479. [9 990] Penalties Section 26-5 prohibits a deduction for penalties imposed under any Australian or foreign law (except for penalties under Subdiv 162-D of the GST Act where varied instalment amounts are too low: see [60 400]). This is a very wide provision and covers fines imposed in criminal proceedings, eg a prosecution under the TAA or Criminal Code and administrative penalties imposed in relation to civil matters, eg tax-related penalties under Pt 4-25 in Sch 1 © 2017 THOMSON REUTERS

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TAA and penalties imposed on directors under Div 269 in Sch 1 TAA in relation to unremitted amounts (see also ATO ID 2001/221). However, it does not cover penalties imposed by an employer for breaches of a sporting code of conduct: see ATO ID 2003/1087. The GIC and the SIC are not penalties and are specifically deductible under s 25-5: see [9 350]. Section 26-5 also prohibits a deduction for any amount ordered to be paid by a court upon conviction for an offence against any Australian or foreign law (an Australian law is a Commonwealth, State or Territory law: s 995-1). In [2000] AATA 625 (2000) 45 ATR 1019, it was decided that an amount forfeited under the Proceeds of Crime Act 1987 was not an amount ordered ‘‘to be paid’’ by a court and therefore the predecessor to s 26-5 (s 51(4) ITAA 1936) did not apply. However, the AAT decided that the amount was not deductible under general principles.

[9 1000] Bribes to public officials Sections 26-52 and 26-53 deny a deduction for bribes made to Australian public officials and foreign public officials. An Australian public official is an employee of an Australian government agency (ie the Commonwealth, a State or a Territory or a Commonwealth, State or Territory authority) or of a local governing body. A ‘‘foreign public official’’ is widely defined (by reference to the definition in s 70.1 of the Criminal Code) to include: an employee or official of a foreign government body or a public international organisation; an individual who performs work under a contract for a foreign government body or public international organisation; an individual who is otherwise in the service of a foreign government body (including a member of a military or police force) or a public international organisation; a member of the executive, judiciary or magistracy of a foreign country; and an individual who is an authorised intermediary of a foreign public official or who holds himself or herself out to be the authorised intermediary of a foreign public official. A taxpayer is regarded as having made a bribe to a public official (Australian or foreign) to the extent that (ss 26-52(2) and 26-53(2)): • an amount is incurred in providing, or promising to provide, a benefit to another person or in causing such a benefit or promise to be provided to another person; • the benefit is not legitimately due to that person; and • the amount is incurred with the intention of influencing a public official (who need not be the recipient of the bribe) in the exercise of the official’s duties, in order to obtain or retain business or any advantage in the conduct of business that is not legitimately due to the taxpayer or another person. In determining whether an amount is a bribe to a foreign public official, it is irrelevant whether business or a business advantage was actually obtained or retained: s 26-52(2A). In determining if a benefit is not legitimately due to a public official, or if a business advantage is not legitimately due to the taxpayer or another person, the following factors are disregarded (s 26-52(6) and (7) and s 26-53(3) and (4)): • the fact that the benefit or advantage may be, or may be perceived to be, customary; • the value of the benefit or advantage; and • any official tolerance of the benefit or advantage. That is, even if it is customary to bribe a public official, no deduction is allowed. In addition, in determining if a benefit is not legitimately due to a foreign public official, the fact that the benefit may be, or may be perceived to be, necessary or required is to be disregarded (in addition to the fact that it may be, or may be perceived to be, customary). An amount is not a bribe to a foreign public official if, assuming the benefit had been provided, and all related acts had been done, in the foreign public official’s country, a written law of that country would have required or permitted the provision of the benefit: s 26-52(3). 338

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[9 1020]

Facilitation payments to foreign public officials are not treated as bribes if the value of the benefit is minor: s 26-52(4) (there is no equivalent provision relating to Australian public officials). Facilitation payments are payments incurred for the sole or dominant purpose of securing or expediting the performance of a ‘‘routine government action’’ of a minor nature which includes the following (s 26-52(5)): • granting a permit, licence or other official document that qualifies a person to do business in a foreign country; • processing government papers such as a visa or work permit; • providing police protection, or mail collection or delivery; • providing telecommunications services, power or water; • loading or unloading cargo; and • protecting perishable products, or commodities, from deterioration. However, a payment is not a facilitation payment if the government action involves or encourages a decision about: • whether to award new business; • whether to continue existing business with a particular person; or • the terms of new business or existing business. Further, an amount is not a bribe to a foreign public official if no person would be guilty of an offence against the law of the foreign public official’s country if the benefit were provided, and all related acts were done, in that country: s 26-52(3). The Tax Office has released guidelines helping tax officers identify how a taxpayer may be concealing bribe transactions and advising on record keeping and audit techniques if bribery is suspected.

[9 1010] Expenditure related to indictable offences Section 26-54 denies deductions for losses and outgoings to the extent that they are incurred in furtherance of, or directly in relation to, a physical element of an offence (against Australian law) in respect of which the taxpayer has been convicted of an indictable offence (ie offences that are punishable by imprisonment for at least one year). Activities comprising the physical element of an offence are the conduct, result of conduct or circumstances in which the conduct results or occurs. Deductions are denied for all expenditure if the activities are wholly illegal, such as drug dealing or people smuggling. For example, dealing in illegal drugs (buying and selling and associated activities) is an offence in its own right, not just acquiring illegal drugs, though that in itself is an offence. On the other hand, there may be cases where the taxpayer is undertaking a lawful business but is convicted of an illegal activity while carrying out that business. In these cases, the deductions are only denied if the expenditure directly relates to entering into and carrying out the actual illegal activity. Expenditure that is incurred in undertaking the underlying lawful activity and that would have been incurred regardless of the illegal activity continues to be deductible. This is because the expenditure cannot be said to further or be directly related to the illegal activity. The Commissioner has up to 4 years after the taxpayer is convicted of an indictable offence to issue an amended assessment. [9 1020] Expenses incurred in deriving capital gains Section 51AAA ITAA 1936 disallows a deduction for expenditure that would otherwise have been allowable under various provisions of the ITAA 1997 (eg s 8-1, Div 25, Div 30, Div 36, Subdivs 40-F to 40-G and Div 230) if the only reason for allowing the deduction is © 2017 THOMSON REUTERS

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because a net capital gain is included in assessable income under s 102-5 (see [14 360]). For example, if an investment portfolio is managed with the sole aim of generating capital gains, the cost of subscriptions to share market information services and investment journals is not deductible by virtue of s 51AAA: Determination TD 2004/1. Such amounts may, however, form part of the cost base of an asset for CGT purposes: see [14 040]. As explained in Ruling IT 2589, s 51AAA was enacted to ensure that expenses incurred in relation to an asset may be taken into account only to ascertain the net capital gain arising on disposal of the asset. Section 51AAA does not deny a deduction if the expenditure is incurred to earn assessable income. For example, a repair to a rental property would still be deductible under s 25-10 as the property is used to produce assessable rental income: see [9 600]. The fact that the property might also produce an assessable capital gain when sold would not affect the availability of the deduction.

[9 1030] Election expenses Expenditure incurred in contesting an election for membership of the Commonwealth Parliament, or the Parliament of a State or the ACT or Northern Territory Legislative Assembly, is deductible, whether the candidate is successful or unsuccessful: s 25-60. The deduction under s 25-60 is not limited to expenditure incurred only after the formal writ calling the election has been issued, but includes earlier expenditure, at least from the time that a candidate has been pre-selected: FCT v Wilcox (1982) 13 ATR 395. However, legal expenses incurred in defending a challenge to the taxpayer’s pre-selection as a candidate in a State election were held not to be deductible under s 25-60 in Re Flegg and FCT (2007) 66 ATR 862. Certain expenditure incurred by members of Parliament during their period of office is deductible under s 8-1: see Ruling TR 1999/10. A person seeking election to a local government body may claim a deduction of up to $1,000 for election expenses: s 25-65. If the expenditure is incurred over 2 years, the deduction in the second year is limited to $1,000 less the expenditure claimed as a deduction in the first year. Any reimbursed expenditure is included in assessable income (but the assessed recoupment is disregarded in applying the $1,000 limit and an additional amount may be deductible). Expenses incurred in a mayoral election contest were not deductible in Vance v FCT (2004) 60 ATR 188. Expenditure on entertainment is not an allowable deduction under either s 25-60 or s 25-65 unless incurred in providing entertainment to the public generally: ss 25-70. However, expenditure on meals during the course of travelling on a campaign is deductible unless incurred in the course of entertaining a third party. See Ruling IT 2258 for the Tax Office’s views on the deductibility of election expenses. [9 1040] Loss from profit-making plan Section 25-40 provides a deduction for a loss in circumstances where a profit would have been assessable under s 15-15 (profit-making plans: see [3 120]); eg, see Ruling TR 2005/15 which deals with the tax consequences of entering into financial contracts for differences. However, as noted at [3 120], s 15-15 has a very limited operation and Section 25-40 has a correspondingly limited operation. A taxpayer is not entitled to a deduction under Section 25-40 in relation to conduct that involves mere investment in an undertaking conducted by others: Clowes v FCT (1954) 91 CLR 209 at 217-218 and Offıcial Receiver in Bankruptcy v FCT (Fox’s Case) (1956) 96 CLR 370 at 387 (both cases concerned the ITAA 1936 equivalent to s 25-40). A loss is not deductible under s 25-40 insofar as it arises in respect of property unless the Commissioner was notified that the property was acquired for profit-making purposes at or before lodgment of the taxpayer’s tax return for the year in which the property was acquired (or the first subsequent year that the taxpayer was required to lodge a tax return if not required to do so in the year of acquisition). An exception applies if the Commissioner is nevertheless satisfied that the property was acquired for profit-making purposes. 340

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[9 1050]

[9 1060]

Payments to related entities and maintenance payments

Payments to related entities are deductible only to the extent to which, in the Commissioner’s opinion, they are reasonable in amount. Any amount in excess of a reasonable amount is not deductible (and is neither assessable income nor exempt income of the related entity): s 26-35. If the amount paid to the related entity is equivalent to an arm’s length payment, the whole payment will be considered to be a reasonable amount: see ATO ID 2006/239. If the Commissioner disallows part of a payment, the taxpayer must establish that, having regard to the services rendered or other relevant circumstances, the Commissioner’s opinion was wrong: see Stewart v FCT (1973) 3 ATR 603, where the High Court considered whether the wages paid by various medical practitioners to their spouses were reasonable under s 65 ITAA 1936 (the predecessor to s 26-35). It seems that the Commissioner may take into consideration factors other than whether the amounts paid were excessive, eg whether there should be a reasonable correlation between the taxpayer’s duties and what was being paid as wages. In Re Jones and FCT (2003) 52 ATR 1063, the AAT found that the wages paid by a professional engineer to his wife for administrative duties were reasonable. There is an exception if a private company is a member of a partnership. The company’s share of the amount disallowed as a deduction to the partnership is deemed to be a dividend paid to the related entity by the company: s 65(1B).

Related entities – definition The following are related entities for these purposes: s 26-35(2) and (3). (1) In the case of an individual taxpayer: (a) a relative of the taxpayer; or (b) a partnership in which a relative of the taxpayer is a partner. (2) In the case of a partnership: (a) a relative of a partner in the partnership; (b) a second partnership in which a relative of a partner in the first partnership is a partner; (c) a person who, at some time during the year, was a shareholder or a director of a private company which was a partner in the partnership or a relative of a person who was a director or a shareholder; or (d) a person who is, or who has a relative who is, a beneficiary of a trust the trustee of which (in her or his capacity as trustee) is a partner in the partnership. See [9 550] for the definition of ‘‘relative’’.

Maintenance payments Maintenance payments are not deductible to the payer: s 26-40 (although they are also of a private or domestic nature).

[9 1060]

NDIS amounts

A participant in the National Disability Insurance Scheme (NDIS) launch cannot deduct a loss or outgoing to the extent it is funded (including funded by way of reimbursement) by an NDIS amount the participant derives under the NDIS: s 26-97. A NDIS amount is an amount paid under the NDIS in respect of reasonable and necessary supports funded under a participant’s plan. © 2017 THOMSON REUTERS

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EMPLOYEES [9 1100] Employee deductions – general Expenditure incurred by an employee in the course of her or his employment is generally deductible under the first limb of s 8-1: see [8 050]. More specific details on deductions that may be available to employees are covered in separate paragraphs, in particular: car and travel expenses (see [9 050] and following), expenditure on clothing (see [9 310]), self-education expenses (see [9 960]), home office expenses (see [9 980]) and tools of trade (see [10 1200]). Readers should also refer to the checklists at [9 020] and [9 030]. If an employer provides benefits to or on behalf of an employee under an effective salary sacrifice agreement, the benefits are non-assessable non-exempt income of the employee under s 23L ITAA 1936: see [4 050]. This means that any expenditure incurred in deriving that income is not deductible by virtue of s 8-1(2) ITAA 1997: see [8 020]. The fact that an employer directs an employee to incur expenditure does not necessarily make the expenditure deductible: FCT v Cooper (1991) 21 ATR 1616 and Ruling TR 97/12 Conversely, Ruling IT 2198 states that voluntary expenditure by an employee – if there is no requirement imposed by the employer – may still be allowable as a deduction. It will be sufficient if the subject of the claim is something that might ordinarily be expected to occur in carrying out the duties of employment. Substantiation In addition to fulfilling the criteria necessary to obtain a deduction under s 8-1(1), the employee may also need to prove that the expenditure has been incurred as required under the substantiation provisions in order to maintain entitlement to the deduction to employment related expenses. The general substantiation provisions are discussed at [9 1450] and following. Occupation-based rulings The Tax Office has released a series of rulings and determinations dealing with deductible and non-deductible work-related expense items for specific occupations. The rulings are not limited to s 8-1 deductions although that is, of course, the section under which most deductions fall for consideration. The occupations covered to date are as follows. Occupation Airline employee Australian Defence Force member Building worker Cadet officer Civil marriage celebrants Cleaner Factory worker Hairdresser Hospitality worker Itinerant employee

[9 1110]

Ruling TR 95/19 TR 95/17

Occupation Journalist – employee Lawyer – employee

Ruling TR 98/14 TR 95/9

TR 95/22 TD 1999/63 IT 2409 TR 95/8 TR 95/12 TR 95/16 TR 95/11 TR 95/34

MP Nurse Performing artist Police officer Real estate industry employee Shop assistant Teacher Truck driver – employee

TR TR TR TR TR TR TR TR

1999/10 95/15 95/20 95/13 98/6 95/10 95/14 95/18

Travel expenses

Travel expenses incurred in the course of employment activities are deductible in accordance with general principles. However, the costs of travelling between home and work are mostly not deductible. The deductibility of travel expenses is considered at [9 050] and the substantiation rules are considered at [9 200]-[9 250]. There are special rules for working out deductions for ‘‘car expenses’’. These are considered at [9 100]-[9 190]. 342

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[9 1130]

[9 1120] Relocation expenses Relocation expenses may be incurred if an employee has to travel to a new location to take up a new job, or if an employee is transferred by her or his existing employer to a different branch or office. The expenses may include travel costs of the employee and her or his family in reaching the new location, removal expenses of furniture and personal effects and storage and temporary accommodation costs. Payments by employee The general rule is that relocation expenses of an employee are not incurred in earning the assessable income of the employee, but are a prerequisite to the earning of that assessable income in the same manner as travel expenses to and from work: see [9 050]; see also Rulings IT 2406, IT 2481 and IT 2614. Relocation expenses are therefore generally not deductible to the employee, regardless of whether the employee is commencing a new job or being transferred by the same employer. There has been the odd case where an employee has been successful in obtaining a deduction for a transfer within an existing employment, but this is the exception rather than the rule: see, for example, AAT Tribunal Case 9 (1986) 18 ATR 3043 and the comments of Spender J on appeal in Noume v FCT (1988) 19 ATR 970. The Commissioner does not accept this decision: Ruling IT 2481. Payments or reimbursements by employer If the employer pays the expenses directly, a deduction is allowable to the employer under s 8-1 as part of normal remuneration costs associated with employees. Section 26-30 (see [9 070]) will not operate to deny any part of the deduction, even though the employer may also pay for the employee’s family: Ruling IT 2566. The same situation applies if the employer reimburses the employee rather than pays the expenses directly. The employer is generally not subject to FBT on any direct payments or reimbursements due to a number of specific exemptions that exist: see [57 200]. Reimbursements are generally not assessable income of the employee. The fact that a payment is a reimbursement rather than an allowance may often be evidenced by a requirement that the employee vouch the expenditure: Ruling IT 2614. Payments by way of indemnity for loss or damage caused to household effects in the course of a relocation are treated in the same manner as reimbursements. Allowances If an allowance is paid to an employee (including under an industrial award) instead of a reimbursement, it is treated as assessable income of the employee under s 6-5 or s 15-2 (see [4 030]) and any offsetting deductions for expenditure incurred with the allowance are denied as being essentially of a private nature: Ruling IT 2614. Allowances are deductible to the employer. Tax instalment deductions must be made from allowances and they must be included on the employee’s payment summary: see [50 030]. For the difference between an allowance and a reimbursement, see [58 450]. [9 1130] Costs relating to employment contracts Costs associated with renegotiating or renewing employment agreements are generally deductible: Ruling TR 2000/5. This includes the costs of changing the conditions of an existing employment agreement with the same employer, providing the existing agreement allows for changes. Costs incurred in obtaining new employment, including the costs of negotiating and drawing up a contract of employment with the new employer, are not deductible: FCT v Maddalena (1971) 2 ATR 541; Ruling TR 2000/5. This was confirmed in Spriggs and Riddell v FCT (2009) 72 ATR 148. Costs associated with the settlement of disputes arising out of an existing employment agreement, including the cost of representation, are deductible: Ruling TR 2000/5. Legal expenses incurred by an employee to prevent the termination of her or his contract of © 2017 THOMSON REUTERS

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employment may be deductible if the termination is sought to be based on her or his conduct as an employee: FCT v Rowe (1995) 31 ATR 392; Schokker v FCT (1999) 42 ATR 257.

[9 1140] Expenses that are reimbursed Expenses incurred by an employee are not deductible by the employee to the extent that they are reimbursed and constitute a fringe benefit: s 51AH ITAA 1936. The reimbursement is not included in assessable income: s 23L ITAA 1936. However, if the reimbursement by the employer would have been the same even if the employee’s expense had not been incurred in producing assessable income (ie there is no direct relationship between the reimbursement and the business component of the reimbursed expenditure), the deduction allowable to the employee is calculated on the basis that would apply if the employee had incurred expenditure equal to the net amount incurred (ie the expenditure actually incurred reduced by the reimbursement). This is a complementary measure to the manner in which the fringe benefit is calculated (ie reduced) where amounts would be only partially deductible if fully borne by the employee, ie they contain both a business and private component (the ‘‘otherwise deductible’’ rule). This is explained in more detail at [58 960]. Note that s 51AH does not prevent a deduction for the decline in value of a depreciating asset that is subject to FBT: s 51AH(3). For example, if an employee acquires a computer for $3,000, the employer reimburses part of this cost and the employee works out the decline in value on the full cost (ie $3,000), neither the cost of the computer nor the decline in value deduction is reduced by the reimbursement (the FBT consequences of such an arrangement are discussed at [58 450] and following). Section 51AJ ITAA 1936 ensures that an employee is not entitled to a deduction for a contribution to a fringe benefit to the extent that the payment is, in effect, a payment for the private element of the benefit. This applies to contributions towards a loan, property, board, airline transport or residual fringe benefit. [9 1160] Miscellaneous Annual trade union membership fees, but not joining fees, are deductible under s 8-1: Ruling TR 2000/7. Joining fees are deductible under s 25-55, but that section limits the amount of the deduction to $42 a year (see [9 1260]). Annual membership fees are also deductible under s 25-55, but it is clearly preferable to claim a deduction under s 8-1. A contribution to a strike fund is not deductible: see Ruling TR 2002/7. A prescribed fee paid to the Industrial Registrar in lieu of trade union or employee association fees is deductible under s 8-1 if the taxpayer would be entitled to a deduction if the fee was paid to the appropriate union or association: Determination TD 2000/17. The cost of applying for a visa to work in Australia is not deductible under s 8-1: see ATO ID 2002/208. A credit card payment fee paid by a salary or wage earner for using a credit card to pay their personal income tax debt is not deductible: see ATO ID 2010/159. Determination TD 2004/26 discusses a salary sacrifice arrangement under which an employee leases a residence to their employer for market rent, which then leases it back to the employee who pays ‘‘rent’’ by way of salary sacrifice. The Tax Office states that expenditure incurred by the employee in relation to the property is not deductible: Determination TD 2004/26.

BUSINESSES AND PROFESSIONALS [9 1200] Cost of employment Salaries, wages, allowances, commission and bonuses paid to an employee as part of a remuneration package are allowable deductions to the employer under s 8-1. The essential 344

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[9 1210]

character of the expenditure is of a revenue nature and it is not necessary to dissect the expenditure should the employee spend a proportion of time on capital projects of the employer. Expenditure incurred in providing fringe benefits to employees (and associates of employees) is also deductible in accordance with general principles – and many provisions of the income tax law which deny a deduction for particular types of expenditure specify that the provision does not apply to deny a deduction for expenditure incurred in providing a fringe benefit. Note that an employer will not get a deduction for salary, wages, allowances, commission and bonuses paid to a foreign resident worker participating in the Seasonal Labour Mobility Program, to the extent that the employer fails to withhold Seasonal Labour Mobility Program withholding tax (see [50 030]) or fails to pay the withholding tax to the Commissioner (applicable from 1 July 2012): s 26-25A. Expenditure incurred by an employer in implementing and administering an employee share scheme (ESS) are deductible under s 8-1 (this should be the case whether or not the scheme complies with the provisions of Div 83A ITAA 1997): see ATO ID 2014/42. Division 83A specifically allows for certain other deductions in connection with an ESS scheme that complies with that Division: see [4 230]. Employer contributions to the trustee of an employee share trust to enable the trustee to subscribe for or acquire shares in the company may also be deductible: see Private Ruling Authorisation Number 1011345829099. Draft Ruling TR 2014/D1 discusses when a deduction will be available to employers for contributions to employee remuneration trusts. Contributions will generally be deductible where they are intended to be applied to remunerate employees within a ‘‘relatively short period of time’’. (The Tax Office has indicated that it will issue a revised draft ruling.) Salary and wages paid to a person appointed as managing director of a subsidiary are an allowable deduction to the employer: Robinson v Scott Bader Co Ltd [1980] 2 All ER 780. Joining fees or annual fees paid for a ‘‘consumer loyalty program’’ are considered to be deductible only when paid by an employer as a cost of employing a person, or if they form part of a business activity: Determination TD 1999/35. In ATO ID 2002/776, an employer in the cattle industry was allowed a deduction for the costs of vaccinating employees against Q fever, which is a recognised occupational hazard within that industry. (In ATO ID 2002/775, a sole trader who was regularly exposed to cattle that may have been infected with Q fever was also allowed a deduction for the vaccination.)

Recruitment costs Employers seeking to recruit employees are entitled to a deduction for any costs incurred, including advertising and agency fees. Any travelling expenses incurred to obtain the services of a prospective employee located in another area are deductible: see [9 050]. The costs of drawing up employment agreements for existing employees and new employees of an existing business, as well as costs incurred in settling disputes arising out of employment agreements, are deductible: Ruling TR 2000/5. However, costs incurred by an employer in drawing up employment agreements for a new business are not an allowable deduction.

[9 1210]

Pensions, gratuities and retiring allowances

A deduction is allowed under s 25-50 for pensions, gratuities or retiring allowances paid to persons who are or have been employees, or to dependants of employees or former employees, and which are not otherwise deductible. The deduction is available only to the extent to which the payment is made in good faith in consideration of the past services of the employee in any business carried on by the taxpayer for income-producing purposes. © 2017 THOMSON REUTERS

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In some instances, such as where the business has incurred a loss, retirement payments may also be deductible under s 8-1. The advantage of a deduction under s 8-1 is that it is not subject to the restriction in s 26-55 limiting the amount that may be deducted if it would produce or increase a tax loss: see [8 500]. The deduction under s 8-1 is available only if the employer can prove that the payment was made in the future interests of its business. A retiring allowance paid voluntarily to a business manager who had become incapacitated by age and ill health and been replaced by a younger person was not deductible because it was not incurred for the production of assessable income, but simply from feelings of gratitude: Union Trustee Co of Australia Ltd v FCT (1935) 53 CLR 263. Similarly, there may be no deduction under s 8-1 on the ground that the allowance was an incentive to encourage persons of outstanding ability to join the board of directors, if the allowance was primarily paid as a reward for the past services of the outgoing director: Telecasters North Queensland Ltd v FCT (1989) 20 ATR 637. On the other hand, an allowance paid to a newspaper editor who was unwilling to retire voluntarily, in order to procure his retirement, was deductible in Maryborough Newspaper Co Ltd v FCT (1929) 43 CLR 450. The directors and shareholders agreed that it was important in the interest of the profitability of the business that the editor should retire with a fair allowance. The factors relevant to whether a payment has been made in good faith in consideration of past services are considered in Ruling IT 2152. In Risby Forest Industries Pty Ltd v FCT (1988) 19 ATR 1663, it was held that satisfaction of the payment in good faith in consideration of past services criterion is separate from the opinion that might be formed under s 109 (which limits the deduction for remuneration etc paid to a shareholder in or director of a private company or to an associate of such a person: see [21 360]). Once the elements of s 25-50 have been met, the relevant payment qualifies as a deduction. Section 109 may then operate to deny the deduction, but the application of s 109, which does not specify the criteria governing the Commissioner’s discretion under that section, is not confined to s 25-50. Even so, there may be a degree of overlap in some cases between the factors relevant under both provisions.

[9 1220] Contributions to employee benefit funds There have been several cases concerning the availability of deductions for superannuation contributions and other benefits, that involved controlling interest superannuation funds and employee benefit trusts. In each case the contributions have either been held to be of a capital nature or, if on revenue account, to be subject to Pt IVA ITAA 1936. In Essenbourne Pty Ltd v FCT (2002) 51 ATR 629, the taxpayer made a contribution out of surplus profits to an employee incentive trust. The only employees granted units in the trust were the sons of the family which controlled the taxpayer and, therefore, they were the only employees to whom a benefit could be given. The Federal Court held that the contribution was not referable to the conduct of the taxpayer’s income-producing business. The advantage or benefit sought to be secured by the taxpayer was the improvement of the position of the principals of the business and, as such, the contribution was of a capital nature and not deductible. The opposite conclusion was reached in Spotlight Stores Pty Ltd & Anor v FCT (2004) 55 ATR 745, where a $15m contribution to a trust fund designed to pay staff bonuses was of a revenue nature, as the contribution was in substitution for annual contributions it would otherwise have had to make over the ensuring years. However, although the contribution was prima facie deductible under s 8-1, Pt IVA applied to deny the deduction: see also [42 250]. Employer contributions to the trustee of an employee share trust to enable the trustee to subscribe for or acquire shares in the company were considered to be deductible in Private Ruling Authorisation Number 1011345829099: see [9 1200]. Division 83A ITAA 1997 provides for certain specific deductions in connection with an employee share scheme which complies with that Division: see [4 230]. 346

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[9 1250]

[9 1230] Accrued leave transfer payments The restriction on deductibility in respect of accrued leave in s 26-10 (see [8 320]) does not apply to an accrued leave transfer payment as defined in s 26-10(2). Basically, such payments are normally made from a former employer to a new employer in industries where employees regularly transfer (although the definition is not restricted to such industries) and represent payments of leave entitlements accrued with the former employer or other preceding employers. However, to be deductible, the payment must be made under or to facilitate implementation of a Commonwealth, State or Territory law or an industrial award or agreement in force under such a law. There is a corresponding provision (s 15-5) ensuring that such a payment is assessable to the recipient.

[9 1240]

Work-in-progress payments

An amount paid in respect of work-in-progress is deductible under s 25-95(1). The receipt of a work-in-progress payment is assessable: s 15-50. As work-in-progress payments commonly arise in the context of professional partnerships, these provisions are discussed in the Partnerships chapter at [22 220].

[9 1250]

Professionals

A taxpayer engaged in professional practice is entitled to claim as deductions all those expenses normally associated with the conduct of such a practice, including travelling expenses, wages, rents, etc. As to the deductibility of insurance premiums, see [9 950]. An employee of a professional partnership who travels overseas to an associated firm to expand her or his knowledge of that profession is entitled to a deduction for the expenses incurred: FCT v Kropp (1976) 6 ATR 655. Conference and seminar fees are deductible (eg AAT Case 13,585, Re Robbins v Insolvency and Trustee Service Australia (1998) 43 ATR 1262), although there are restrictions on deducting associated entertainment expenses (see [9 500] and following) and the travel costs may have to be apportioned: see [8 040].

Professional library In Munby v Furlong [1977] 2 All ER 953, a lawyer’s library was separated into 3 categories: • a set of law reports purchased when commencing practice – non-deductible capital expenditure (although subject to depreciation; • textbooks – non-deductible capital expenditure (although subject to depreciation; • periodicals, such as law reports published at regular intervals and paid for by annual subscription (including the cost of binding them) – deductible. The same rules apply to an academic’s library. In Case 104 (1953) 3 CTBR(NS) 104, a board of review held that an academic was entitled to depreciate his library at a greater rate than normal because he always had to have current editions of the texts he prescribed. The depreciation provisions are discussed in Chapter 10.

Negligence actions A professional taxpayer faced with the prospect of suspension by the governing body of the particular profession is entitled to claim as a deduction the expenses associated with resistance to that proposal. Further, a professional taxpayer resisting an action for negligence is entitled to a deduction for the costs incurred, irrespective of whether the defence is successful. A tax agent required to pay costs incurred by a client due to the negligence of the agent is entitled to deduct those costs. © 2017 THOMSON REUTERS

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Sabbatical leave Expenses associated with sabbatical leave are deductible to the extent that they are not reimbursed by the educational body or some other person: Case 31 (1956) 6 CTBR(NS) 31. See also Re Chaudri and FCT (1999) 42 ATR 1001, where an academic undertaking research work in India while on a sabbatical was allowed a deduction for his reasonable meal costs. The expenses of the family of such a person travelling with her or him during sabbatical leave are not, however, deductible: Case 96 (1967) 13 CTBR(NS) 96. Doctors – UMP support payments United Medical Protection Limited Support payments (payable under the Medical Indemnity Act 2002) paid by medical practitioners are deductible under s 25-105 ITAA 1997 (but only if not deductible under s 8-1). [9 1260] Business and professional subscriptions Membership subscriptions paid to trade, business or professional associations are deductible under s 25-55. The section covers professional associations of, for example, accountants, architects and engineers and business associations (as well as trade unions for employees). The maximum deduction is $42 per income year in respect of each association to which a taxpayer belongs. Section 25-55 is concessional in nature. Accordingly, if the subscription is deductible under s 8-1 without the need to resort to s 25-55, ie if the essential character of the expense relates to earning assessable income and is not of a capital nature, the full amount is deductible without regard to the $42 limit: Determination TD 1999/45 and Ruling TR 2000/7. Subscriptions to unions and professional associations are generally considered to be deductible under s 8-1: Ruling TR 2000/7. However, the Tax Office considers that joining fees are capital in nature and therefore not deductible. Pensioners or self-funded retirees may not be able to obtain s 8-1 deductions for subscriptions to representative associations, but may seek a deduction under s 25-55: Ruling TR 2000/7. If a retired taxpayer wishes to retain membership of her or his professional association, but can no longer obtain a s 8-1 deduction because income-producing activities have ceased, a deduction for up to $42 may be available under s 25-55. Whether a subscription is deductible immediately or has to be spread over the membership period generally depends on the amount of the subscription and when it is taken out: ss 82KZL to 82KZO (discussed at [8 350]-[8 390]). [9 1270] Losses by theft A loss incurred by a taxpayer through theft, embezzlement, larceny, defalcation or misappropriation of money by an employee or agent (other than a person employed solely for private purposes) is deductible in the income year in which the loss is discovered, provided the money is or has been included in the taxpayer’s assessable income: s 25-45. Note that the loss need not occur in the same income year as that in which the income is derived. The term ‘‘money’’ encompasses cheques and other negotiable instruments: Lean v FCT (2010) 75 ATR 213 at [32]. The words ‘‘defalcation or misappropriation’’ refer to fraudulent acts and not to acts that are merely negligent or inadvertent: EHL Burgess Pty Ltd v FCT (1988) 19 ATR 1407 at 1411. A deduction is available under s 25-45 only if the misappropriated money can be characterised as the same money that was included in assessable income: see Lean at [20]. This will not be the case if, for example, the money is applied towards expenses, is used to pay off a debt or is invested. In Lean, an investment advisor misappropriated the proceeds from the sale of shares (ie capital gains included in the taxpayer’s assessable income) after the proceeds were transferred on the taxpayer’s instructions to the advisor. This meant that the money that was misappropriated was not the same as the money that was included in the taxpayer’s assessable income (and therefore s 25-45 did not apply). 348

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[9 1290]

In Re Shail Superannuation Fund and FCT (2011) 86 ATR 339, a deduction was not allowed under s 25-45 in relation to funds misappropriated by a trustee, on the grounds that the misappropriation was not by an employee or agent and there was no evidence of awareness by the taxpayer of the loss (this decision is on appeal). If the taxpayer is a company, the misappropriation must have been done by someone other than the directors acting together in the interests of the shareholders: EHL Burgess. Note that if money is stolen from a business taxpayer, a deduction may be available under s 8-1 (see Charles Moore & Co (WA) Pty Limited v FCT (1956) 95 CLR 344, noted at [8 030]).

Theft if balancing adjustment event Section 25-47 ITAA 1997 allows a deduction for amounts (or non-cash benefits) misappropriated (in the 2007-08 or a later income year) by an employee or agent that are included in the termination value of a depreciating asset. The deduction is available if a balancing adjustment event occurs for a depreciating asset held by the taxpayer (eg the asset is sold, lost or destroyed: see [10 850]) and the taxpayer’s agent or employee misappropriates (whether by theft, embezzlement or otherwise) all or part of an amount relating to the balancing adjustment event: s 25-47(1). If the depreciating asset was used for a non-taxable purpose, the deduction must be reduced by the same proportion as the balancing adjustment is reduced under s 40-290 (to reasonably reflect the extent to which the asset was used for the non-taxable purpose: see [10 870]: s 25-47(4). The deduction under s 25-47 is available in the income year in which the amount is misappropriated: s 25-47(3). If the misappropriation is discovered after the taxpayer lodges their income tax return for that year, there is a 4-year period (starting immediately after the misappropriation is discovered) for amending the assessment. Any subsequent recoupment of the misappropriated amount will have to be included in the taxpayer’s assessable income in the income year when it is recouped under s 20-30(1) ITAA 1997: see [6 580]. [9 1280] Non-cash business benefits Section 51AK ensures non-deductibility of non-cash business benefits provided to induce business taxpayers to purchase items of plant or equipment. The section also extends to practices relating to agreements for services. Section 51AK ensures that if a benefit is received as a result of business expenditure, an amount attributable to the private benefit is not deductible or does not form part of the unit of property cost for depreciation purposes. EXAMPLE [9 1280.10] A taxpayer purchases a computer for business purposes for a total expenditure of $5,000 and also receives from the supplier a watch worth $200 for private use by the taxpayer. The $200 is taken to be expenditure incurred in respect of the watch and is not deductible. For depreciation purposes the cost of the computer is $4,800.

[9 1290] Miscellaneous Other expenses commonly incurred by a business or professional person that may be deductible include car and other travel expenses (see [9 050] and following), interest payments (see [9 450]), rental expenses (for an office or other business premises), entertainment expenses in limited circumstances (see [9 500] and following), repairs (see [9 600]), legal expenses (see [9 650]), insurance premiums (see [9 950])), self-education expenses (see [9 960]), home office expenses (see [9 980]) and paying an employee’s relocation expenses (see [9 1120]). The cost of a gift to a client may be deductible if the gift is characterised as being made for the purpose of producing future assessable income: Determination TD 2016/14. © 2017 THOMSON REUTERS

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The costs of running and maintaining a website are deductible where the website is used in a business or other income-producing activities (see Draft Ruling TR 2016/D1 and the Tax Office document ‘‘Claiming website costs’’).

Commercial websites Ruling TR 2016/3 considers the deductibility of expenditure on a commercial website. If the expenditure is incurred in acquiring or developing a commercial website for a new or existing business, it is of a capital nature (which may be treated as ‘‘in-house software’’: see [10 790]). Periodic operating, registration, web hosting and licensing fees are considered to be revenue expenses, as is expenditure on an ‘‘off-the-shelf’’ software product that is licensed periodically (otherwise an “off-the-shelf” software product may be ‘‘in-house software’’). The costs of running and maintaining a commercial website (ie where the website is used in a business or other income-producing activity) are deductible. Modifications to a website have the character of maintenance if they do not add significant new functionality or materially expand existing functionality.

INVESTORS [9 1350] Investment related expenditure Investors, whether or not carrying on business as an investor, are ordinarily entitled to a deduction, in accordance with general principles, for outgoings related to income earned from the investment (whether a person is carrying on a business is considered at [5 020]). An obvious example is interest on borrowings used for the investment: see [9 450]. Recurrent management fees and accounting and audit fees are also generally deductible. The fact that the fees are paid in advance does not of itself preclude a deduction (eg Lau v FCT (1984) 15 ATR 932), although the prepayment provisions in ss 82KZMA to 82KZO ITAA 1936 may apply to spread the deduction over the period for which the services are to be provided: see [8 350]-[8 400]. Fees paid for ongoing investment advice will ordinarily be deductible: see ATO ID 2004/139. However, whether fees for initial investment advice are deductible is contentious. Investment advice may not be deductible if it relates to initial financial planning or establishing an initial investment portfolio, rather than continuing advice for a taxpayer who already derives significant income from investments: Determination TD 95/60. However, it is arguable that although an entry fee is part of the capital cost of obtaining a particular product, fees for investment advice are fees for a service that should be of a revenue nature as there is no sufficient relationship to particular capital products. The prerequisite or preliminary expenditure test may, however, be more of a problem to overcome if investments do not already exist. Losses incurred by a sharetrader are deductible in accordance with general principles: see [9 1370]. [9 1360] Investment schemes Cases concerning ‘‘tax effective’’ investment schemes show that the deductibility of expenditure incurred in relation to such schemes depends on the particular circumstances, especially an analysis of the agreement under which the relevant fees are paid (typically the management agreement, but also the loan agreement when considering the deductibility of interest payments). In Howland-Rose v FCT (2002) 49 ATR 206 (the ‘‘Budplan case’’), the relevant expenditure was not deductible as it related wholly to research and development (in a tea-tree oil project) and was therefore neither relevant nor incidental to the production of assessable income. In Vincent v FCT (2002) 51 ATR 18, the Full Federal Court held that expenditure incurred in relation to a cattle breeding scheme, under which the taxpayer leased 3 cows, was on capital account. The expenditure was essentially for the cows to be produced under the 350

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[9 1360]

scheme and not for the services necessary to produce the cows. Since the taxpayer was not carrying on a business, the expenditure was not deductible. In contrast, in Puzey v FCT (2003) 53 ATR 614, the Full Federal Court held that, but for the application of Pt IVA, expenses incurred in investing in a sandalwood plantation project would have been deductible under s 8-1. Further, at least until the project was restructured with the result that the taxpayer became a mere investor, his involvement was such that he was carrying on a business and the expenditure was incurred in operating the business. The finding in Puzey that the taxpayer was initially carrying on a business contrasts with the finding in the Vincent case. However, the taxpayer in Vincent was a mere investor who was not involved in the operation of the project. See also Guest v FCT (2007) 65 ATR 815, where interest on a loan used to invest in a blueberry growing project was deductible (discussed further at [8 090]). In FCT v Cooke (2004) 55 ATR 183, fees incurred in investing in a ‘‘guaranteed return’’ project for growing and exporting native flowers were held to be deductible as the purpose of the investment was to provide an income stream for the taxpayer’s retirement. It was also held that Pt IVA did not apply and therefore the expenditure was deductible. In FCT v Sleight (2004) 55 ATR 555, the Full Federal Court found that certain expenses incurred by the taxpayer in connection with his investment in a ‘‘tax effective’’ investment scheme were prima facie deductible as he was carrying on a business. However, in contrast to the decision in Cooke, the Full Court held that Pt IVA applied to deny the deductions: see [42 230]. Other cases where Pt IVA applied to deny deductions in relation to investment schemes are also mentioned at [42 230]. In Hance & Anor v FCT (2008) 74 ATR 644, which was a test case, the Full Federal Court held that investors in an almond managed investment scheme would be carrying on a business on their respective lots with the purpose of producing almonds for sale at a profit. The court considered that the continuation of the operation over an extended period of time, the repetitive nature of the work involved in farming each lot (to be paid for on a regular basis) and the return in the form of almond crops (to be received from year to year) all suggested an ongoing business. Other aspects of the scheme, which allowed for pooling and for the easy ascertainment of a grower’s entitlement on sale, reflected a commercially sensible mechanism. The fact that the investors would not have control over the way in which their lots would be farmed was merely an incident of their grouping for management purposes. In a Decision Impact Statement issued in February 2009, the Tax Office commented that the retention of ownership by individual members of the produce of the scheme was of critical importance in the court reaching its decision and that that feature will need to be present before a similar conclusion can be reached in relation to other investment schemes. In 5 related cases involving a mining investment scheme, the AAT denied deductions for prepaid interest and management fees, on the grounds that the outgoings were not directed at deriving assessable income: The Taxpayer v FCT (2007) 67 ATR 344. Relevant earlier investment cases include Clowes v FCT (1954) 91 CLR 209 and Milne v FCT (1976) 5 ATR 785, which concerned investments in forestry bonds (held to be a casual investment of capital), and Lau v FCT (1984) 15 ATR 932, which concerned growing pine trees with a view to the subsequent sale of timber (rental payments for the lease of the land held to be on revenue account). The Court in Lau distinguished Clowes and Milne on the basis that the taxpayer in Lau leased a specific area of land and had an identifiable interest in specific trees and the management services were performed on behalf of the taxpayer. In Merchant v FCT (1999) 41 ATR 116, the Federal Court rejected the Commissioner’s contention that the management fees in that case should be apportioned between revenue and capital account. © 2017 THOMSON REUTERS

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Tax Office rulings The Tax Office’s views on the deductibility of initial lease and management fees incurred in relation to so-called ‘‘tax effective’’ investment schemes, eg afforestation schemes, have changed over time (eg see Ruling TR 2000/8 and Ruling TR 2007/8, both of which have been withdrawn). The Commissioner accepts that investments in managed investment schemes similar to the one considered in Hance are generally deductible, including after the scheme is wound up (see Determination TD 2010/8). However, it is likely that the Commissioner will still challenge schemes (in particular under Pt IVA) that involve features such as non-recourse or round-robin funding (which were not present in Hance), in accordance with the views expressed in Ruling TR 2000/8, or if there is evidence that the taxpayer intends, at the time of entering into the scheme, to exit the scheme once tax savings have been obtained (see also Determination TD 2010/8). It may be advisable to invest only in a ‘‘tax effective’’ investment scheme for which a product ruling has been issued. A product ruling is a form of binding public ruling and sets out the taxation consequences of investing in a particular scheme (see [45 120]). However, a product ruling is only binding to the extent the arrangement is implemented as proposed in the application for the ruling. The ruling does not guarantee the viability of a project, whether charges are reasonable or represent industry norms or whether projected returns will be achieved or are reasonably based. [9 1370] Share transactions Unless the taxpayer is a sharetrader, ie is engaged in a business of share trading, shares acquired after 19 September 1985 are CGT assets and any losses made on disposal are dealt with under the CGT provisions: see Chapter 12 to Chapter 18. Shares acquired before 20 September 1985 are pre-CGT assets (unless that status is lost) and any losses made on disposal may be deductible under s 25-40 ITAA 1997. If the taxpayer is a sharetrader, the acquisition of the shares is an acquisition of trading stock and the law applicable to trading stock operates to allow the taxpayer a deduction of the cost of acquisition, with the necessary disclosure of trading stock-on-hand at the end of the income year if it is carried over into the next year. Whether a person is a sharetrader is a question of fact to be determined in all the circumstances (the concept of carrying on a business is considered at [5 020]). In FCT v Shields (1999) 42 ATR 504, the taxpayer was held to be a sharetrader even though his activities lasted for only a month. A mere speculator is not a sharetrader: see Williams (AC) v FCT (1972) 3 ATR 236. In Re Applicant and FCT (2004) 58 ATR 1059, the AAT found that the taxpayer was not a sharetrader primarily because there was no discernible pattern of sharetrading and because of the ‘‘passive’’ nature of his involvement. Moreover, the AAT said he had simply taken discrete decisions to invest in shares on the advice of an overseas investment house in the expectation of making a premium gain, which was more akin to being a speculator. Section 52A ITAA 1936 is an anti avoidance rule which applies to the acquisition of shares and other securities as trading stock. It authorises the Commissioner to determine whether the consideration paid to acquire choses in action that include shares and other securities has been influenced by factors other than those normally applicable to their purchase and sale. If the section applies, the cost to determine the base upon which the taxable income will be calculated is that amount that the Commissioner determines under the section. In the case of bonus shares, the cost is the amount included in the assessable income of the taxpayer acquiring such bonus shares. If no amount is included in the assessable income of the taxpayer (ie the bonus shares are issued out of a share premium account), the cost to determine any taxation liability is that part of the original cost of the shares that gave rise to the right to receive the bonus shares, ie the cost of the original shares is apportioned between the original shares and the bonus shares. 352

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[9 1380]

[9 1380] Landlords The following are the most common deductions allowable (under s 8-1 or some other section) to landlords deriving rental income from tenanted properties: • council rates, water rates, land tax: s 8-1: see [9 400]; • building, fire, burglary, public liability, loss of profits, insurance premiums: s 8-1: see [9 950]; • interest on money borrowed to acquire or renovate the income-producing property: see [9 450]. If a property acquired for income-producing purposes ceases to be used for income-producing purposes, the interest ceases to be deductible. If a property originally acquired as a domestic residence is subsequently let to tenants, interest paid during the period it is tenanted is deductible: s 8-1. If the property and mortgage are in different names, in general it is the property owner who is entitled to the deductions. In Re Ormiston and FCT (2005) 60 ATR 1277, the taxpayer was entitled to a deduction for interest on a loan taken out to renovate a rental property even though it was never in fact rented out; • borrowing expenses, including guarantee fees, search fees, valuation fees, survey and registration fees, etc (pro-rated over prescribed periods): s 25-25: see [9 470]; • management fees paid to real estate agents for managing tenanted properties (but see ATO ID 2009/9) and commission paid for the collection of assessable rental income: s 8-1; • the cost of advertising for tenants: s 8-1; • the cost of non-capital repairs and regular maintenance costs: ss 8-1 and 25-10: see [9 600]; • furniture and furnishings owned by the landlord if the property is let furnished, eg carpets, blinds, hot water service and light fittings, are depreciating assets and a deduction is available for the decline in value (see Chapter 10), although an outright deduction may be available depending on the cost: see [10 530]. Costs of a quantity surveyor’s depreciation report would be deductible; • expenses of discharging a mortgage, lease preparation costs, etc, provided they are not reimbursed by the tenant: ss 25-20 and 25-30: see [9 670]; • travel costs to inspect the property, repairs, etc: s 8-1: see [9 050]; • bank charges on accounts specifically maintained to receive rental income or provide for maintenance disbursements: s 8-1; • specific telephone call charges in dealing with estate agents, tenants, plumbers, etc: s 8-1; • building write-off deductions but subject to restrictions: see [10 1450] and following; and • head rental payable by the landlord if he or she is a lessee rather than the owner and is sub-leasing the property to another rent-paying tenant: s 8-1. Body corporate fees and charges paid to an administration fund or a general purpose sinking fund, to cover the cost of day-to-day administration and general maintenance and repair of common property, are generally deductible: see the Tax Office publication Rental properties (NAT 1729). However, a special contribution levied by the body corporate for particular capital expenditure is not deductible: see the Tax Office publication Rental properties (NAT 1729) and AAT Case 5306 (1989) 20 ATR 3927. © 2017 THOMSON REUTERS

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Outgoings in respect of an empty rental property will only be deductible if the property is available for rent and there are active and bona fide attempts to let the property: eg Re Fogarty and FCT (2007) 67 ATR 264, Re Bonaccordo and FCT (2009) 75 ATR 735 and AAT Case [2012] AATA 174 (2012) 87 ATR 937. This means that outgoings will not be deductible for any period during which the landlord does not actively seek to find a tenant (eg by listing the property with a real estate agent, advertising the property in newspapers and/or on the internet and erecting ‘‘for lease’’ signs). Similarly, if a rental property (eg a holiday home) is occupied from time to time by its owner, allowable deductions will have to be apportioned. Whether the apportionment is based solely on the actual number of days the property is let at a commercial rent, or whether the number of days the property is available for letting at a commercial rent are also taken into account, depends on the particular circumstances: see Ruling IT 2167, paras 20-26. If the tenant is a boarder in the taxpayer’s house rather than the tenant of a separate property, a proportion of heating, lighting, etc costs paid by the landlord may be deductible. An acceptable basis of apportionment is the floor area or number of rooms occupied by the tenant in relation to the total area of the house or number of rooms. If the tenant pays for room and board, the costs of the tenant’s meals are deductible: s 8-1. If a co-owner of a property rents it to another co-owner on commercial terms, the former can deduct their share of the (deductible) outgoings in respect of the property: see withdrawn ATO ID 2010/193. Expenses may not be deductible if the particular arrangement is on non-commercial terms (eg if the landlord lets the property to a family member for little or no rent). In Re Bocaz and FCT (2012) 91 ATR 468, it was decided that an arrangement under which properties were rented to the taxpayer’s ex-husband and one of her sons (who was also a co-owner of the properties) were on commercial terms.

Lease surrender payments Ruling TR 2005/6 considers whether a lease surrender payment made by a lessor is deductible. In accordance with general principles, the payment will be a non-deductible capital outgoing if the lessor does not carry on a business of granting and surrendering leases and the payment is a ‘‘once and for all’’ payment to obtain a permanent advantage, namely the surrender of the lease (as in Kennedy Holdings & Property Management Pty Ltd v FCT (1992) 24 ATR 321). It does not matter that the lessor makes the payment in order to re-let the property at a higher rental and so derive more assessable income. However, if a lessor carries on a business that involves granting and surrendering leases as a normal incident of it, or that involves incurring recurrent outlays to obtain lease surrenders as part of the constant demand of its business which have to be met out of circulating capital, the lease surrender payments would be a revenue rather than a capital outgoing. [9 1390] Negative gearing Negative gearing is the term used to describe the situation where the income derived from an investment (usually a rental property) is less than the various deductible outgoings (principally interest but, in the case of a rental property, also rates, land tax, agent’s fees and repair costs). This produces a tax ‘‘loss’’ which can be offset against other income (eg salary and wages income). This strategy can be tax effective even if no income is being earned, provided relevant expenses are deductible: see [8 070]. In some cases, the deductible amount may be limited so as not to exceed the assessable income that is earned. The principal case in this regard is Fletcher v FCT (1991) 22 ATR 613, where the taxpayers entered into an annuity scheme, which in the first 10 years would generate interest deductions greatly in excess of assessable income but which in the last 5 years would generate substantial assessable income. However, the scheme effectively allowed for the investors to default without penalty, thereby avoiding the adverse tax consequences of the last 5 years. The High Court said that if the relevant assessable income is less than the outgoing (or if there is no relevant assessable income), it may be necessary to 354

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[9 1450]

consider the taxpayer’s (subjective) purpose in incurring the outgoing (and also the purpose of the taxpayer’s advisers). If the disproportion between the outgoing and the relevant assessable income was essentially to be explained by reference to the pursuit of some other objective (referred to a ‘‘colourable purpose’’), it would be necessary to apportion the outgoing. It was held on the facts that the scheme was not intended and expected to run its full course, ie 15 years. Accordingly, the interest deductions were limited each year to the amount of the assessable income generated by the scheme. The Tax Office’s views on Fletcher are set out in Ruling TR 95/33. See also Ure v FCT (1981) 11 ATR 484, discussed at [9 450]. In Madigan v FCT (1996) 33 ATR 164 a portion of expenses in relation to a rental property was denied because the below-market rent was due to the private relationship between the landlord and the tenant (even though the expenses were primarily repairs and maintenance, the same reasoning would apply had the expenses included interest payments). These cases may not have an overly wide application in the corporate sphere. In a business context, the mere fact that the interest or any other income received from the investment of borrowed funds is less than the interest expense on those borrowed funds will not be a decisive factor in determining the purpose for which the funds were borrowed and will not automatically disqualify the taxpayer from obtaining a full deduction. Even if it is accepted that there is a second purpose in addition to the production of any specific income, that second purpose may itself be within the general business of the company in a wider sense and thus not be disqualified as being of a private, domestic or capital nature. This is exemplified by FCT v Total Holdings (Aust) Pty Ltd (1979) 9 ATR 885. The taxpayer in that case borrowed moneys and on-lent them interest-free to its subsidiary. Nevertheless, the court found that the purpose of doing this was to render the subsidiary profitable as soon as commercially possible, with the result that the opportunities for the taxpayer to derive income from its subsidiary would be improved. Accordingly, the interest paid by the taxpayer on the borrowed funds was deductible in full (see also Ruling IT 2606). For a contrasting decision, see Spassked Pty Ltd v FCT (2003) 54 ATR 546, noted at [9 450].

SUBSTANTIATION – GENERAL [9 1450] Substantiation requirements – overview There are specific rules in Div 900 ITAA 1997 specifying the written evidence that an individual or a partnership that contains an individual must obtain to substantiate deductible work-related and business travel expenses. If the taxpayer does not obtain the required evidence, the expense is not deductible even if it satisfies all the requirements of s 8-1 (ie it was incurred in producing assessable income and was not expenditure of a capital or private nature): ss 900-15(1), 900-80(1). Note that specific rules for working out deductions for car expenses incurred by an individual of a partnership containing an individual are contained in Div 28 ITAA 1997 (see [9 100] and following). Of course, irrespective of the specific substantiation rules, it is prudent for a taxpayer to keep receipts and other relevant documents to show that a particular expense was incurred because the onus is on the taxpayer to prove that an assessment is excessive (see [46 120]). Note that, in completing a tax return, the taxpayer must sign a declaration that they have the necessary receipts and/or other records – or expect to obtain the necessary written evidence within a reasonable time of lodging the return – to support any claims for deductions. The substantiation requirements apply to the recipients and payers of the following payments subject to the PAYG withholding system (discussed in Chapter 50): salary, wages, bonuses and commissions paid to employees; payments to company directors and office holders; return to work payments; superannuation benefits and annuities; payments for © 2017 THOMSON REUTERS

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retirement or because of termination of employment; unused leave payments; annuities; benefit and compensation payments; and payments to religious practitioners : s 900-12. Local government councillors are not required to substantiate expenses incurred in performing council duties unless the council has passed a unanimous resolution that the councillors’ remuneration be subject to the PAYG withholding system: s 446-5 Sch 1 TAA. The following table summarises the Div 900 substantiation requirements and any exclusions (ie if substantiation is not required). Type of expense Work

Substantiation requirements Written evidence Travel records Business travel Written evidence Travel records Car

Main reference [9 1460]

Small amounts (up to $10 per item) Small total ($300 or less) Laundry ($150 or less) Travel allowance – domestic Travel allowance – overseas Award transport payment Overtime meal allowance Non-overnight travel

[9 1460] [9 1460] [9 250]

Exclusion – category

See separate table at [9 100]

Main reference [9 1470] [9 [9 [9 [9 [9 [9 [9

1480] 1480] 210] 210] 220] 300] 240]

-

Importantly, the Commissioner has a discretion in certain circumstances to overlook non-compliance with the substantiation requirements: see [9 1490].

[9 1460]

Documentary evidence

Work and business travel expenses A work expense is a loss or outgoing incurred by the taxpayer in producing salary or wages or another withholding payment specified in s 900-12, such as a payment to a company director or office holder, superannuation benefits and a compensation payment (see [9 1450]): s 900-30. Work expenses include expenses covered by a travel or meal allowance (see [9 200] and following), the decline in value of property owned by the taxpayer and used to produce their salary or wages and expenses incurred in travelling between 2 places of work that are deductible under s 900-30 (see [9 050]): s 900-30(7). A business travel expense is a travel expense incurred in producing assessable income that is not salary or wages (and thus is not a work expense): s 900-95(1). A travel expense is an expense incurred for travel (within or outside Australia) that involves the taxpayer being away from their ordinary residence for at least one night: s 900-95(2). Thus, if the travel does not involve an overnight stay it is not business travel for substantiation purposes. A travel allowance expense (see [9 210]) cannot be a business travel expense: s 900-95(4). A motor vehicle expense is neither a work expense nor a business travel expense, unless it is a taxi fare or similar expense or it is incurred in respect of travel outside Australia: ss 900-30(6), 900-95(5). A work expense and a business travel expense must be substantiated by a document (eg a receipt) from the supplier of the relevant goods or services that sets out (s 900-115): • the name or business name of the supplier; • the amount of the expense (expressed in the currency in which it was incurred); • the nature of the goods or services; • the date the expense was incurred; and • the date on which the document is made out. 356

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[9 1460]

In certain cases, travel records must also be kept: see [9 250]. Slightly different rules apply to a depreciating asset expense (see below). If the document does not specify the nature of the goods or services, the taxpayer may add those details before lodging their income tax return for the year in question: s 900-115(3)(b). In addition, if the document does not show the date the expense was incurred, supporting evidence of that date, such as a bank statement or other reasonable, independent evidence, may be used: s 900-115(3)(a). The Tax Office will also accept documents (or combinations of documents) containing similar information to what is required on a traditional paper receipt including: online banking and credit card statements; online, email, electronically-stored and photocopied receipts; and BPAY reference numbers combined with bank statements or tax invoices: Ruling IT 2482; Practice Statement PS LA 2005/7. The document used to satisfy the substantiation requirements must be in English, unless the expense was incurred in a foreign country, in which case it may be in a language of that country: s 900-115(4). Practice Statement PS LA 2005/7 contains guidelines for Tax Office tax officers as to what documentary or other evidence will normally be accepted as sufficient evidence to substantiate an individual taxpayer’s claim for deductible work expenses that relate to non-business and non-investment income. The Tax Office may also verify at source (eg during an audit) any document provided by a taxpayer regardless of whether it satisfies the legislation.

Exceptions Written evidence may not be required for the following: • small or undocumentable expenses (see [9 1470]); • small expenses totalling less than $300 (see [9 1480]); • laundry expenses (see [9 1480]); and • certain travel and meal expenses covered by a travel or meal allowance (see [9 200] and following). Note also that the Commissioner has a discretion to allow a deduction if the substantiation requirements have not been satisfied: see [9 1490].

Depreciating asset expenses A depreciating asset expense is effectively the decline in value (depreciation) that a taxpayer can claim for a depreciating asset they own and which they use in producing their salary or wages (eg a computer which the taxpayer owns and uses partly for work purposes). A depreciating asset expense must be substantiated by obtaining a document from the supplier of the asset that evidences the original acquisition of the asset and sets out (s 900-120): • the name or business name of the supplier; • the cost of the asset to the taxpayer; • the nature of the asset; • the date the taxpayer acquired the asset; and • the date on which the document is made out. If the document does not specify the nature of the goods or services, the taxpayer may add those details before lodging their income tax return for the year in which they first claim a deduction for the decline in value of the asset: ss 900-120(3). © 2017 THOMSON REUTERS

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There are rules in Subdiv 900-H which may provide relief from the substantiation requirements if the required document is not obtained before, or within a reasonable time, of lodging the relevant income tax return (see below), eg if the taxpayer only decided to use the asset for producing salary or wages some years after acquiring it: s 900-120(4). The document must be in English unless the asset was imported, in which case the document can be in a language of the country from which the asset was originally exported: s 900-120(5).

Home office expenses Individual taxpayers claiming home office expenses must be able to establish the connection between the use of the home office and their work or business (see [9 980]), in addition to proving that the expenses have been incurred. Practice Statement PS LA 2001/6 contains guidelines on how to calculate and substantiate home office expenses. ‘‘Running expenses’’ (eg for gas and electricity) can be apportioned for business use or can be deducted at the rate of 45 cents per hour. Supplier records can be used to apportion expenses, otherwise the taxpayer should maintain a record of use (eg in diary) over a 4-week representative period which can then be applied to the full year. Similar ‘‘rules’’ apply to mobile phone, home phone and internet expenses. For example, an itemised bill can be used to determine the percentage of work use over a 4-week representative period. If the taxpayer has a bundled plan, the work use for each service over a 4-week representative period needs to be identified. If work use is incidental and the taxpayer is not claiming a deduction of more than $50 in total, he or she can claim a deduction based on the following rates: • $0.25 for work calls made from a landline; • $0.75 for work calls made from a mobile phone; and • $0.10 for text messages sent from a mobile phone. A reasonable basis to apportion internet use would be to work out the amount of data downloaded for work as a percentage of the total data downloaded by all members of the taxpayer’s household.

When to obtain evidence There is no time limit on obtaining written evidence of an expense, but the taxpayer is generally not entitled to a deduction for the expense until the evidence is obtained: s 900-110(1). However, the taxpayer may claim a deduction if they expect to get written evidence of the expense within a reasonable time of lodging their income tax return (if the evidence is not obtained within a reasonable time, the deduction ceases to be allowable and the assessment (if made) will be amended): s 900-110(2). [9 1470] Exclusion – small or undocumentable expenses In 2 situations, small or undocumentable expenses (that are deductible) do not require written evidence: • expenses that individually do not exceed $10 (eg the cost of newspapers and ‘‘bucket donations’’ to a deductible gift recipient) if the total of such items does not exceed $200 for the income year: s 900-125; or • if the Commissioner considers that it would be unreasonable to expect the taxpayer to have obtained documentary evidence of the expense, eg because the nature of the expense means it would be too difficult: s 900-130. However, in both these situations, the taxpayer must record (in English) the following details in a document (s 900-125(3) – (4)): 358

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• the name of the supplier (not required in the case of a depreciating asset); • the amount of the expense (in the currency used) or, in the case of a depreciating asset, the amount of the decline in value; • the nature of the goods, services or asset, as appropriate; • the date of the expense (not required in the case of a depreciating asset); and • the date the document or record is made and, in the case of a depreciating asset, who made it. The record must be created as soon as possible after the expense is incurred or, in the case of a depreciating asset, as soon as possible after the last day of the income year. If the record is not created, a deduction may be disallowed for failing to properly substantiate the expense.

[9 1480] Exclusion – small total and laundry expenses If a taxpayer’s total claim for work expenses (including laundry expenses, but excluding expenses covered by a travel or meal allowance) is less than $300, written evidence is not required: s 900-35. The $300 limit is a strict dollar limit test and, if the $300 limit is exceeded, full documentary evidence must be provided for the entire amount claimed (and not just the excess). Laundry expenses, while included in the $300 work expenses total, may qualify for an additional concession: see below. Laundry expenses A laundry expense is defined as a work expense (ie incurred in producing assessable income) for washing, drying or ironing work clothing (which clothing will qualify is considered at [9 310]). This does not include dry cleaning (which may still qualify under the $300 general concessional limit discussed above. However, if the expense is incurred in earning exempt income, it is not deductible (eg laundry of ADF uniforms: see Ruling TR 98/5). The following table shows the substantiation required for laundry expenses: s 900-40. Laundry expenses Total of work-related expenses Up to $150 Any amount More than $150 Less than $300 More than $150

More than $300

Substantiation of laundry expenses No substantiation No substantiation (as less than $300 in work expenses) Required (but see below)

If the taxpayer does not keep written evidence of their laundry expenses or does their own washing, the Commissioner will allow a claim of $1 per load (including drying and ironing) if only work-related clothes are being washed, and 50 cents per load if both private and work-related clothes are being washed (see Ruling TR 1998/5 and item D3 of the Individual Tax Return Instructions). The taxpayer should keep details of the number of washes done during the year and what type of clothes (work related, private or both) were included in each wash.

[9 1490]

Commissioner’s discretion to waive substantiation requirements

If the nature and quality of the available evidence satisfies the Commissioner that the taxpayer incurred the expense and a deduction is allowable, substantiation may be waived: s 900-195. Ruling TR 97/24 sets out the circumstances in which this discretion is likely to be exercised. If the taxpayer makes a bona fide attempt to comply with the substantiation requirements and there is some other supporting documentation available, the discretion is more likely to be exercised. It will not be exercised solely on unsupported statements by the taxpayer. See also Practice Statement PS LA 2005/7. © 2017 THOMSON REUTERS

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The AAT has also shown a willingness to exercise the discretion if other evidence was available: eg AAT Case 10,666 (1996) 31 ATR 1349 and Re Chaudri and FCT (1999) 42 ATR 1001, where the taxpayers kept detailed diaries and Re Scott and FCT (2002) 51 ATR 1080, where a cheque stub recording details of the purchase of a depreciating asset was accepted. However, the discretion will not be exercised if there is doubt that the expenditure has been incurred: eg [2000] AATA 844 (2000) 45 ATR 1110. In AAT Case 5501 (1989) 21 ATR 3037 (which concerned the original discretion in s 82KZAA ITAA 1936), the discretion was not exercised as relevant diary entries were not signed as required. Substantiation does not apply if the taxpayer had a reasonable expectation that it would not be required: s 900-200. This may be, for example, where work expenses are normally less than $300 but exceed $300 because of unforeseen circumstances, or where a depreciable asset is acquired initially for private use but is later converted to income-producing purposes (see Ruling TR 97/24). Reliance on advice from the Tax Office may also justify nonsubstantiation. However, ignorance of the substantiation rules does not attract the operation of this concession.

[9 1500] Records All documents supporting deductions must be kept for 5 years from the due date or actual date of lodgment of the return for the year to which the expense relates, whichever is the later: ss 900-25, 900-75, 900-90 and 900-165. If an objection, a review or appeal arising from an objection, or a request for an amendment of an assessment, is outstanding when the 5-year period ends, records must be kept until the matter is resolved: s 900-170. See [9 190] for requirements to retain car log book and odometer records. Substantiation documents must be produced if required by the Commissioner by written notice (giving at least 28 days notice): s 900-175. The documents must include a supporting schedule cross-referencing and summarising the particulars of the documentary evidence; foreign currency expenses must be expressed in Australian currency: s 900-180(2). Failure to produce this evidence may result in the deduction being disallowed and the relevant assessment being amended (and interest and penalties may be imposed if there is a shortfall of tax: see Chapter 55). Note that there is no specific requirement to keep the records in Australia. Lost or destroyed records If a document has been lost or destroyed and the taxpayer has a complete copy, the copy is treated as an original from the date of loss or destruction: s 900-205. If the taxpayer does not have such a copy, but the Commissioner is satisfied that all reasonable precautions have been taken to prevent their loss or destruction, the following rules apply: • if the document was a travel diary, log book or evidence other than the written evidence required by Subdiv 900-E, the taxpayer does not have to replace it and the deduction remains available: s 900-205(3); • if the document was written evidence, the taxpayer must try to obtain a substitute that meets all the criteria of the original (eg a supplier’s invoice copy). Provided a reasonable attempt to obtain the substitute is made, the deduction is not affected, whether or not a substitute is actually obtained. However, if it is reasonably possible to obtain a substitute and none is obtained, the deduction may not be available: s 900-205(4) to (7). The Tax Office accepts that fees charged by a bank in replacing lost or destroyed documents are deductible. Ruling TR 97/24 states that the relief will not be granted if documents are lost or destroyed due to the taxpayer’s carelessness or recklessness (eg AAT Re AX03B and FCT (2002) 51 ATR 1213).

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10

DEPRECIATION INTRODUCTION Overview ....................................................................................................................... [10 010] UCA system – overview ............................................................................................... [10 020] What is depreciation? .................................................................................................... [10 030] BASIC RULES Deduction for decline in value ..................................................................................... [10 Reduction of deduction ................................................................................................. [10 Taxable purpose ............................................................................................................ [10 When a depreciating asset starts to decline in value ................................................... [10 Making a choice ............................................................................................................ [10

050] 060] 070] 080] 090]

DEPRECIATING ASSETS What assets can be depreciated? .................................................................................. [10 Definition of plant relevant ........................................................................................... [10 Examples of depreciating assets ................................................................................... [10 Fixtures and improvements ........................................................................................... [10 Assets excluded from Div 40 ....................................................................................... [10

150] 160] 170] 180] 190]

HOLDING DEPRECIATING ASSETS Who is a holder? ........................................................................................................... [10 Jointly held assets ......................................................................................................... [10 Extension or renewal of right ....................................................................................... [10 Ceasing to be holder ..................................................................................................... [10 Splitting assets ............................................................................................................... [10 Merging assets ............................................................................................................... [10

250] 260] 270] 280] 290] 300]

COST Basis of a decline in value – cost ................................................................................ [10 First element of cost (cost of acquisition etc) ............................................................. [10 Amounts paid or taken to have been paid to hold asset ............................................. [10 Second element of cost (costs after acquisition etc) ................................................... [10 Apportionment of cost .................................................................................................. [10 Cost of split assets ........................................................................................................ [10 Cost of merged assets ................................................................................................... [10 Types of expenditure forming part of cost ................................................................... [10 Assets acquired from tax-exempt entities .................................................................... [10

350] 360] 370] 380] 390] 400] 410] 420] 430]

ADJUSTMENT OF COST No double deduction ..................................................................................................... Roll-over relief for involuntary disposal ...................................................................... Commercial debt forgiveness ....................................................................................... Effect of GST on cost ...................................................................................................

[10 [10 [10 [10

450] 460] 470] 480]

WORKING OUT AMOUNT OF DECLINE IN VALUE Methods of calculating decline in value – prime cost or diminishing value ............. [10 Choice of method .......................................................................................................... [10 Where choice not available .......................................................................................... [10 Modification of prime cost method .............................................................................. [10 Outright deduction for cost of assets ........................................................................... [10 Adjustable value ............................................................................................................ [10 Opening adjustable value .............................................................................................. [10 In-house software .......................................................................................................... [10

500] 505] 510] 520] 530] 540] 550] 560]

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PRO RATA DECLINE IN VALUE AND DEDUCTION Year of acquisition/disposal .......................................................................................... [10 600] Asset used partly for non-taxable purpose ................................................................... [10 610] EFFECTIVE LIFE Determining effective life ............................................................................................. [10 Self-assessing effective life ........................................................................................... [10 Using Commissioner’s effective life determination ..................................................... [10 Assets with capped effective life .................................................................................. [10 Assets acquired from associates ................................................................................... [10 Holder of asset changes but user remains the same .................................................... [10 Intellectual property and other intangible assets .......................................................... [10 Recalculating effective life ........................................................................................... [10

650] 660] 670] 680] 690] 700] 710] 730]

POOLING Pooling – overview ....................................................................................................... [10 Pooling of low-cost and low-value assets .................................................................... [10 Calculating decline in value of assets in low-value pool ............................................ [10 Sale or scrapping of assets in low-value pool ............................................................. [10 Pooling of software development expenditure ............................................................. [10 Deduction for pooled software expenditure ................................................................. [10 Effect of GST on pooled assets .................................................................................... [10

750] 760] 770] 780] 790] 800] 810]

DISPOSAL OF DEPRECIATING ASSETS Balancing adjustments .................................................................................................. [10 850] CGT consequences ........................................................................................................ [10 860] Deductible amount ........................................................................................................ [10 870] Assessable amount ........................................................................................................ [10 880] Termination value .......................................................................................................... [10 890] Effect of GST ................................................................................................................ [10 900] In-house software not allocated to software pool ........................................................ [10 920] Assets that qualify for R&D concession ...................................................................... [10 930] Automatic roll-over relief ............................................................................................. [10 940] Optional roll-over relief ................................................................................................ [10 950] Consequences of roll-over relief .................................................................................. [10 960] Involuntary disposals – adjustment of other assets ..................................................... [10 970] Non-arm’s length disposals .......................................................................................... [10 980] Change of ownership or interests ............................................................................... [10 1000] Car – statutory substantiation methods used .............................................................. [10 1010] Disposal of leases and leased plant ............................................................................ [10 1020] Limited recourse debt ................................................................................................. [10 1030] PROJECT POOLS Project pools and project amounts ............................................................................. [10 1050] Mining and transport capital expenditure .................................................................. [10 1060] Mining capital expenditure ......................................................................................... [10 1070] Transport capital expenditure ..................................................................................... [10 1080] Calculating project pool deduction ............................................................................. [10 1090] Assessable amounts ..................................................................................................... [10 1100] BUSINESS RELATED COSTS Deduction for other business expenses ...................................................................... [10 1150] Types of deductible expenditure ................................................................................. [10 1160] PARTICULAR ASSETS Tools of trade .............................................................................................................. [10 Assets installed on Crown land or leased land .......................................................... [10 Computer software ...................................................................................................... [10 Datacasting transmitter licences ................................................................................. [10 Telecommunications cables, IRUs and site access rights .......................................... [10 Primary producers ....................................................................................................... [10 Mining, quarrying or prospecting rights and information ......................................... [10 362

1200] 1210] 1220] 1230] 1240] 1260] 1270]

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MOTOR VEHICLES Car limit ...................................................................................................................... [10 1300] Cars acquired at discount ............................................................................................ [10 1310] Disposal of car ............................................................................................................ [10 1320]

BUILDINGS AND STRUCTURAL IMPROVEMENTS OUTLINE Overview of Div 43 .................................................................................................... [10 1450] BASIC RULES Deduction for capital works ....................................................................................... [10 Deduction rates ............................................................................................................ [10 Lessees and quasi-ownership right holders ................................................................ [10 Ownership during part of year and part-ownership ................................................... [10 Disposal and purchase ................................................................................................ [10 Construction expenditure ............................................................................................ [10

1460] 1470] 1480] 1490] 1500] 1510]

SPECIFIC TYPES OF BUILDINGS AND STRUCTURES Industrial buildings – post-26 February 1992 ............................................................ Traveller accommodation – hotels and apartment buildings ..................................... Income-producing structural improvements ............................................................... Environment protection buildings and earthworks ....................................................

[10 [10 [10 [10

1560] 1570] 1580] 1590]

MISCELLANEOUS RULES Demolition or destruction ........................................................................................... [10 Temporary cessation of use ........................................................................................ [10 Part use and change of use ......................................................................................... [10 Record-keeping ............................................................................................................ [10

1620] 1630] 1640] 1650]

DEPRECIATION INTRODUCTION [10 010] Overview A loss or outgoing of capital, or of a capital nature, is expressly not deductible under s 8-1: see [8 020]. Whether a loss or outgoing is of capital, or of a capital nature, is discussed at [8 150] and following. However, the income tax legislation has long allowed a deduction for capital expenditure on depreciating assets (ie depreciation). This chapter considers the rules governing deductions for depreciation or, to use the language of the ITAA 1997, capital allowances. The principal rules for capital allowances – called the Uniform Capital Allowances (UCA) system – are contained in Div 40 ITAA 1997. The UCA system applies to all taxpayers except small business entities that choose to use special rules in Subdiv 328-D: see [25 100] and following. The principal UCA topics discussed in this chapter are: • the basic rules: see [10 050]-[10 090]; • what is a depreciating asset: see [10 150]-[10 190]; • who is the holder of a depreciating asset (the entity entitled to the deduction): see [10 250]-[10 300]; © 2017 THOMSON REUTERS

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• the cost of a depreciating asset (the basis for working out the amount of the deduction): see [10 350]-[10 480]; • the methods (prime cost and diminishing value) for working out the decline in value of a depreciating asset (the deductible amount): see [10 500]-[10 610]; • the effective life of a depreciating asset (this determines the rate at which a depreciating asset declines in value): see [10 650]-[10 730]; • the pooling rules, ie the rules that allow certain depreciating assets to be pooled (eg low cost assets and in-house software): see [10 750]-[10 810]; and • balancing adjustments, ie the rules that apply when a depreciating asset is sold, scrapped or no longer used: see [10 850]-[10 1030]. Other UCA system topics discussed in the chapter are: • project pools (for mining and transport capital expenditure): see [10 1050]-[10 1100]; • business capital expenditure not otherwise deductible under the UCA (‘‘blackhole expenditure’’): see [10 1150]-[10 1160]; and • special rules for particular assets (eg motor vehicles, tools of trade, computer software and mining, quarrying or prospecting rights and information): see [10 1200]-[10 1270]. The chapter also discusses the rules (in Div 43 ITAA 1997) governing deductions for capital works expenditure (on certain buildings and structural improvements): see [10 1450]-[10 1650].

[10 020] UCA system – overview In broad terms, the UCA system – which was enacted by the New Business Tax System (Capital Allowances) Act 2001 (‘‘the Capital Allowances Act’’) – allows a taxpayer who holds (as distinct from owns) a depreciating asset a deduction for the decline in the value of the asset during an income year (in certain circumstances the UCA recognises the economic owner as the entity entitled to the deduction). The decline in value of an asset is based on its effective life (either self-assessed or as determined by the Commissioner, although some assets have a capped effective life). If several entities hold an asset, each may be entitled to write off their own cost in relation to the asset. A depreciating asset starts to decline in value when the asset is first used for any purpose. A taxpayer can use either the prime cost or the diminishing value method to calculate the decline in value of a depreciating asset. The deduction is reduced to the extent that the asset is used for a non-taxable purpose. The deduction is also reduced in other circumstances (eg in the case of leisure facilities and boats). Generally, a balancing adjustment event happens on the disposal of a depreciating asset to determine whether it has been over- or under-depreciated. If the asset has been ‘‘over-depreciated’’ the recouped depreciation is assessable to the taxpayer, whereas if the asset has been ‘‘under-depreciated’’ the ‘‘under-depreciation’’ is deductible. Assets costing less than $1,000 and assets that have been written down to less than $1,000 can be pooled and a deduction allowed for the decline in value of the pool (based on an effective life of 4 years). In-house software development expenditure may be allocated to a separate pool. Assets costing $300 or less that are used primarily to produce non-business income can be written off immediately. Certain capital expenditure associated with projects or incurred in connection with primary production or the mining industry is also deductible under the UCA system, as is certain ‘‘blackhole expenditure’’. 364

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The UCA system started on 1 July 2001. Transitional provisions in the TPA ensured that taxpayers who were deducting amounts for depreciation before 1 July 2001 continued to deduct those amounts under the UCA system. The transitional provisions transferred existing assets (pre-1 July 2001 assets) into the UCA system while preserving a taxpayer’s existing entitlements to deductions in relation to their capital expenditure (eg see ATO ID 2003/615).

Proposed amendments shelved Various technical amendments announced in the 2009-10 Budget will not proceed (see the then Assistant Treasurer’s media release, 14 December 2013). For details of the proposed amendments, see [10 100] of the Australian Tax Handbook 2013. Taxpayers who in good faith prepared income tax returns on the basis of those proposed amendments are protected: see [47 190]. [10 030] What is depreciation? Depreciation is not a term used in Div 40. However, the concept of ‘‘decline in value’’ as used in Div 40 conveys the same meaning as depreciation – the decline in the value of the asset over the life of the asset due to the wear and tear associated with its use. This is equivalent to the well understood accounting, business and commercial concept of depreciation. However, tax depreciation rates and accounting depreciation rates do not necessarily correspond, eg where Div 40 specifically allows the cost of an asset to be fully written off in the year of acquisition as a concession.

BASIC RULES [10 050] Deduction for decline in value A deduction is allowed under Subdiv 40-B for the yearly decline in the value of a depreciating asset (as worked out by the rules in Div 40): s 40-25(1). However, the amount of the deduction is reduced in certain circumstances (eg if the asset is used partly for a non-taxable purpose: see [10 070]). The deduction is also reduced for certain types of depreciating asset: see [10 060]. An outright deduction is effectively available for certain depreciating assets costing less than $300: see [10 530]. To be entitled to a deduction for the decline in value of a depreciating asset, the taxpayer must hold the asset during the year in question: s 40-25(1). Anyone who is the holder of the asset at any time during the year qualifies for a deduction. The amount of the deduction will reflect the number of days during the year that the taxpayer holds the asset. The concept of ‘‘holding’’ a depreciating asset is considered at [10 250]-[10 300]. Special rules in Subdiv 328-D apply to small business entities that choose to use those rules: see [25 100] and following. In particular, an outright deduction is available for an asset costing less than $20,000 that is first acquired (and first used or installed ready for use) between 7.30 pm on 12 May 2015 AEST and 30 June 2017. [10 060] Reduction of deduction The deduction for the decline in the value of a depreciating asset is reduced if: • the asset is used, or installed ready for use, for a non-taxable purpose (ie a purpose other than a taxable purpose); and/or • the asset is a leisure facility or a boat.

Non-taxable purpose Taxpayers who use depreciating assets, or install them ready for use, for a purpose other than a taxable purpose have to reduce the amount of the depreciation deduction by that part of the asset’s decline in value that is attributable to the non-taxable use: s 40-25(2). No method © 2017 THOMSON REUTERS

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of apportioning the deduction is prescribed and therefore the taxpayer may use any method that reasonably apportions the deduction to reflect the non-taxable and taxable usage. For example, if a truck is used for 70% business and 30% private purposes, a deduction is available for 70% of the decline in value. See also Example [10 060.10]. The meaning of taxable purpose is considered at [10 070].

Leisure facilities If the depreciating asset is a leisure facility, the deduction for the decline in value is further reduced if it is used, or installed ready for use, for a taxable purpose and (s 40-25(3) and (4)): • its use does not constitute a fringe benefit for FBT purposes; or • it is not used, or held for use, mainly in the course of the taxpayer’s business of providing leisure facilities, for producing assessable income (eg rent or licence fees), for the taxpayer’s employees to use or for the care of employees’ children (these are the uses mentioned in s 26-50(3)(b)): see [9 560]. If the taxpayer is a company, the employees referred to cannot be shareholders and directors of the company. Thus, if the use of the leisure facility constitutes a fringe benefit or if the leisure facility is mainly used, or held for use, for one of the uses mentioned in s 26-50(3)(b), the decline in value deduction is not reduced (unless, where relevant, employees are shareholders or directors of the employer company, in which case the deduction will be further reduced). See [9 560] for the definition of a ‘‘leisure facility’’. EXAMPLE [10 060.10] Andy owns a tennis court which he uses for his private enjoyment. The statutory decline in the value of the tennis court for the year is $1,000. Three months into the financial year, Andy starts using the tennis court for his tennis coaching business. For about 4 months its use does not constitute a fringe benefit. Andy is prima facie entitled to a deduction of $1,000 for the decline in value of the tennis court. As he does not use the tennis court for income-producing purposes for 3 months, the deduction is reduced by 3/12 × $1,000 (ie $250). The reduced deduction of $750 is further reduced by 4/9 × $750 (ie $333), because for 4 months when the tennis court is used for income-producing purposes, it does not constitute a fringe benefit (assuming it is not used or held for use as mentioned in s 26-50(5)(b)). $ Prima facie deduction 1,000 Reduction for non-taxable use (250) Further reduction (333) Deduction 417 Since no deduction is available for 7 out of the 12 months, an alternative way to work out the reduction is to multiply $1,000 by 7/12 (= $583). Thus the deduction is $1,000 – $583 = $417.

Exception: low-value pools The reduction rules do not apply to depreciating assets that have been allocated to a low-value pool because the amount allocated to the pool is reduced instead (s 40-25(5)): see [10 760]. [10 070] Taxable purpose The term ‘‘taxable purpose’’ is broader than income-producing purpose. A depreciating asset is used, or installed ready for use, for a taxable purpose if it is used for the purpose of (s 40-25(7)): 366

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[10 080]

• producing assessable income: see [8 050]. A parcel of land held as an investment (ie which makes a capital gain upon realisation) is not being used to gain or produce assessable income and therefore is not being used for a taxable purpose: see ATO ID 2005/157. Examples of a taxable purpose include ATO ID 2002/1083 (leasing of depreciating assets held by a partnership) and withdrawn ATO ID 2003/125 (caravan used by the taxpayer as accommodation while travelling in the course of her or his business). Examples of no taxable purpose include ATO ID 2008/55 (use of depreciating assets in hobby of prospecting) and ATO ID 2009/137 (indirect use of depreciating asset to make a statutory capital gain). Using a depreciating asset to produce mutual income (which is not assessable: see [7 420]) is not a taxable purpose; • exploration or prospecting: see [29 030]; • mining site rehabilitation: see [29 040]; or • environmental protection activities: see [11 610]. Ordinarily, the ‘‘purpose’’ for which an asset is used will be determined by reference to the use to which the asset is put (although the taxpayer’s subjective purpose is not always irrelevant): see Pettigrew v FCT (1990) 20 ATR 1833 at 1850. A depreciating asset may be used by a taxpayer for the purpose of producing assessable income even though it does not of itself generate assessable income: eg Quarries Ltd v FCT (1961) 106 CLR 310 (portable sleeping units for the taxpayer’s employees were used for the purpose of producing assessable income and therefore depreciable); and FCT v Reef Networks Pty Ltd (2003) 54 ATR 509. In Reef Networks, the taxpayer constructed and owned a fibre optic cable consisting of 12 strands. It granted a licence to Optus to use 8 of the 12 strands and granted the owner of the corridor in which the cable was installed the exclusive right to use the other 4 strands. The Full Federal Court agreed with Hely J that the whole cable was used for the purpose of producing assessable income and not just 8/12 of the cable, as contended by the Commissioner in a private ruling (the parties accepted that the cable was a single depreciable asset). In ATO ID 2004/958, where the taxpayer granted to a partnership consisting of the taxpayer and another entity the exclusive use of assets, to enable each partner to access a service that they used wholly in carrying on their business for the purpose of producing assessable income, the Tax Office confirmed that the taxpayer used the assets wholly for a taxable purpose. See also ATO ID 2007/69, where attempting to secure licence agreements for the use of a patent constituted the use of the patent for a taxable purpose. Note that, to the extent a taxpayer uses property in gaining or producing a rebatable benefit (as defined for beneficiary rebate purposes: see [19 520]), the use of the property will be taken not to be for the purpose of producing assessable income: s 26-19(2). If a depreciating asset is used in a specific project, the taxpayer can continue to claim a deduction for the decline in value of the asset after the project is completed if they continue to hold and use the asset for a taxable purpose: Determination TD 2006/33. If a depreciating asset is put to a tax preferred use for the purposes of Div 250 and the apportionment rule in s 250-150 applies (see [33 100]), the taxpayer is taken not to be using the asset for a taxable purpose to the extent of the disallowed capital allowance percentage: s 40-25(8).

[10 080] When a depreciating asset starts to decline in value A depreciating asset starts to decline in value when the holder first uses it, or has it installed ready for use, for any purpose (called the ‘‘start time’’): s 40-60(1), (2). It is irrelevant that the asset is used for a non-taxable purpose. This means that a taxpayer is theoretically required to calculate the decline in value even though the asset is initially used for private purposes and no deduction is allowable. As to the start time of a depreciating asset held by a transition entity (under Div 58), see [10 430]. © 2017 THOMSON REUTERS

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An asset that cannot be installed only begins to decline in value when it is actually used. In the context of Div 40, the Tax Office considers that the use of a depreciating asset requires the employment of the asset in such a way that it can reasonably be expected to decline in value through and over the time of that use: see ATO ID 2006/151 and ATO ID 2007/116. For a tangible depreciating asset, physical employment or operation of the asset would generally be expected for an asset to be considered to be “used”: see ATO ID 2006/151. For an intangible depreciating asset, employment of the asset may not be physical and the asset may be considered to be “used” in the context of passive use: see ATO ID 2007/116. An asset is not installed ready for use (and does not start to decline in value) unless it is held in reserve (see the definition of ‘‘installed ready for use’’ in s 995-1). The Commissioner considers that the expression ‘‘held in reserve’’ means to ‘‘keep back or save for future use in the present income-producing operations’’ (ie it refers only to future use in existing business operations): Determination TD 2007/5. Thus, if business operations have not commenced, a tangible depreciating asset cannot start to decline in value. Similarly, if a depreciating asset is acquired solely for the purpose of its resale (eg where a leased car used in business operations is acquired by the lessee and then immediately sold to an unrelated party), it will not be ‘‘used’’ or ‘‘held ready for use’’ (see withdrawn ATO ID 2003/552). In AAT Case 9465 (1994) 28 ATR 1144, a claim for depreciation of a racing car during the course of its construction was denied as the vehicle was neither ‘‘used’’ nor ‘‘held ready for use’’. In ATO ID 2010/171, trailers acquired to undertake a particular haulage contract were not installed ready for use as they were not registered. Another example where depreciating assets were neither used nor installed ready for use is ATO ID 2006/151. In ATO ID 2007/116, mining, quarrying and prospecting rights were considered to be ‘‘used’’ for Div 40 purposes where the taxpayer made them available, in accordance with legal obligations, to another entity to use. The start time of an open pit mine site improvement is considered to be the time when it becomes necessary to use the pit to further its own construction or to extract mineralised rock: Ruling TR 2012/7. If a taxpayer stops using a depreciating asset, or having it installed ready for use, for any purpose and never expects to use it or have it installed ready for use again, there is a balancing adjustment event: see [10 850]. However, if the taxpayer starts using the asset again it has another start time (and thus starts to decline in value again): s 40-60(3).

[10 090] Making a choice Any choices available to a taxpayer under Div 40 must be made by the day the taxpayer lodges its income tax return for the income year to which the choice relates: s 40-130(1). The Commissioner may grant an extension of time. Once a choice is made, it will apply to that income year and all future income years, except in the case of a recalculation of the effective life of a depreciating asset (see [10 730]): s 40-130(2), (3).

DEPRECIATING ASSETS [10 150] What assets can be depreciated? Division 40 allows a deduction for the decline in the value of a ‘‘depreciating asset’’. A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the period it is used: s 40-30. See also [10 160] and [10 170]. Payment of an amount is not of itself an asset: eg ATO ID 2004/721. The 2 essential criteria for a depreciating asset are that it must have a limited effective life and be reasonably expected to lose its overall value by the end of its effective life. An asset that may hold its value, or even increase it for a time, can still be a depreciating asset if it is expected that its overall value will decline by the end of its effective life. The 368

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Commissioner clearly accepts that any asset for which an effective life has been determined is capable of being a depreciating asset (the Tax Office has also published on its website a number of relevant Interpretative Decisions, although see [45 320] for the dangers of seeking to rely on an ID). Intangible assets are not depreciating assets unless they are specifically listed. The following intangible assets are listed in s 40-30(2) as depreciating assets: • mining, quarrying or prospecting rights: see [10 1270]; • mining, quarrying or prospecting information; • in-house software: see [10 790]; • items of intellectual property – defined in s 995-1 as the rights held (under a Commonwealth or foreign law) as the patentee or licensee of a patent, or as the owner or licensee of copyright or a registered design. Intellectual property includes rights under a foreign law in respect of a licence to exploit a patented invention (see ATO ID 2006/169), copyright in medical records (Primary Health Care Ltd v FCT (2010) 76 ATR 749) and copyright in a film, but does not include a trademark (see ATO ID 2004/858); • spectrum licences; • datacasting transmitter licences: see [10 1230]; • an indefeasible right to use (IRU) an international telecommunications submarine cable system and an indefeasible right to use a domestic telecommunications cable system: see [10 1240]; and • telecommunications site access rights: see [10 1240].

Composite asset v individual components If a depreciating asset itself is made up of a number of different parts, it is necessary to decide whether the composite item is itself a depreciating asset or whether its components are separate depreciating assets. This is a question of fact and degree which can only be determined by considering all the relevant circumstances of the particular case: s 40-30(4). According to Ruling TR 94/11 and ATO ID 2009/130, something will be considered to be a separate item (rather than a number of separate items) if it has one or more of the following characteristics: it is an entity entire in itself, capable of being separately identified and having a separate function; it is functionally complete in itself (although it does not have to be self-contained or used in isolation); if when attached to another unit of property having its own independent function, it varies the performance of that unit; and it performs a definable, identifiable function. An open pit mine site improvement is considered to be a single depreciating asset: see Ruling TR 2012/7. In ATO ID 2011/2, the components of a cable system were not considered to be separate depreciating assets. Note that, in Mitsui & Co (Australia) Ltd v FCT (2012) 90 ATR 171, the Full Federal Court suggested that s 40-30(4) cannot apply to the types of intangible assets that are taken to be depreciating assets by virtue of s 40-30(2) (see above). The Mitsui case is considered at [10 1270]. [10 160] Definition of plant relevant Although the term ‘‘plant’’ is not used in Div 40, the legislature intended that depreciating assets include items that were considered to be plant under the previous depreciation regimes. Plant is the apparatus used to carry on a business, the goods and chattels (fixed or movable) that are kept for permanent employment in the business (and not the trading stock): per Lindley LJ in Yarmouth v France (1887) 19 QBD 647. Plant should be © 2017 THOMSON REUTERS

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distinguished from structures which provide the general setting in which the business is conducted (but see below). Whether an item is ‘‘plant’’ is primarily one of fact and degree: Carpentaria Transport Pty Ltd v FCT (1990) 21 ATR 513 at 515 (see also Ruling TR 2004/16).

Integral function v convenient setting In identifying what constitutes plant (or a depreciating asset), the courts have adopted a ‘‘functional test’’, based on the function that the item performs in the taxpayer’s business. The courts have drawn a distinction between items that fulfil an integral function in the business, which constitute plant, and items that merely provide a ‘‘convenient setting’’ for the business, which do not constitute plant. Buildings and structural improvements Capital works, eg buildings, structural improvements, extensions and alterations, generally do not qualify for a deduction under Div 40: s 40-45. This will be the case if they can be written off under Div 43: see [10 1460] and following. Obvious examples are factories, office blocks, hotels and residential flats, which merely provide a ‘‘convenient setting’’ for the taxpayer’s business operations (see also Ruling TR 2004/16, dealing with residential rental premises, which is noted at [10 180]). However, if capital works constitute plant, Div 43 will not apply (s 43-70) and Div 40 will apply instead (if the capital works constitute a depreciating asset) (see s 45-40 for the definition of ‘‘plant’’). A rockwall enclosing an area of the seabed adjacent to an existing area of reclaimed port land, which was used by the taxpayer in providing port facilities for shipping vessels, was not considered to be plant in ATO ID 2007/160 (and therefore Div 43 applied instead). A particular structure may qualify as plant if it does more than provide a ‘‘convenient setting’’ for the taxpayer’s business operations. For example, a building will be regarded as forming an integral part of plant, wholly or partly, if the relevant structure of the building was erected for the specific purpose of supporting plant installed in that part of the building and special building materials were used in the construction of that part of the structure. In Wangaratta Woollen Mills Ltd v FCT (1969) 1 ATR 329, it was held that the taxpayer’s dye-house was plant because of its function in the taxpayer’s process of manufacturing worsted yarn by dyeing and spinning. McTiernan J concluded that it was ‘‘in the nature of a tool’’ in the taxpayer’s trade and did ‘‘play a part’’ itself in the taxpayer’s manufacturing process. See also Quarries Ltd v FCT (1961) 106 CLR 310, noted at [10 170]. However, Mahoney J in Macquarie Worsteds Pty Ltd v FCT (1974) 4 ATR 334 pointed out that it is not enough simply to find that the property performs some function in enabling the taxpayer’s operations to be carried on. The question is whether the function performed by the property is so related, or has such a special relationship, to the taxpayer’s operations that it warrants being held to be plant. A structure which merely provides shelter for workers or equipment is not plant: Broken Hill Pty Ltd v FCT (1969) 1 ATR 40 at 263. In ATO ID 2005/21, a set down area allowing the taxpayer to park specialised equipment and a concrete wash down pad were considered to be depreciating assets. Whether portable accommodation, movable structures, walls, floors, ceilings, doors and fittings qualify as depreciable assets is considered at [10 170]. [10 170] Examples of depreciating assets The examples listed below are provided as a guide only. The Tax Office has also published on its website a number of relevant Interpretative Decisions (although see [45 320]). The following items have been held by the courts and Tribunals to constitute plant (and will therefore be depreciating assets): a drydock for ships; dockside transit silos; lasts used in the manufacture of shoes; a specially designed structure for the storage and loading of mineral sands; a specially designed chimney stack; a concrete mixer; the hot water system in 370

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[10 170]

a hotel/motel complex; a caravan used by a logging contractor at a forest base camp; and books of an enduring kind in the library of a professional (see also [9 1250]). In ATO ID 2004/271, a breakwater and associated infrastructure were considered to be separate depreciating assets; and in ATO ID 2004/612, a global positioning system (GPS) device was considered to be a depreciating asset separate from the car in which it was installed. In ATO ID 2007/119, an aircraft engine and airframe, to which the engine may be attached, were considered to be separate depreciating assets on the basis of the particular engine rotation arrangement. A bus is considered to be a composite item and the tyres are not separate assets: see ATO ID 2007/88. In ATO ID 2002/751, an entire photovoltaic solar system was considered to be a depreciating asset. The following items have been held not to constitute plant: insulating window screens; the residence of an architect used for display purposes; sinks, baths, toilets, shelves, electrical distribution gear, gas and telephone installations and a security system considered to have become part of the structure of rented properties; a parquetry floor; a swimming pool and spa that were part of an apartment complex; the tarmac surface of a parking area in a shopping centre; a service pit for diesel locomotives that performed nothing more than a ‘‘convenient stand’’ for the service work; and electrical wiring, trunking and electrical conduits. The Tax Office considers that a bowling green constructed from natural materials is not a depreciating asset: ATO ID 2003/820. Lift installations (Ruling IT 47 (withdrawn)), lifts, escalators, air-conditioning plant and equipment and sprinkler systems are plant, but a lift well that forms part of the building structure is not plant. Ruling TR 2007/9 considers when an item used to create a particular atmosphere or ambience for a cafe, restaurant, licensed club, hotel, motel or retail shopping business constitutes an item of plant.

Machinery Under s 45-40, the meaning of ‘‘plant’’ includes ‘‘machinery’’. Machines are certainly depreciating assets as they have a limited life and can be reasonably expected to decline in value over the time they are used. In Carpentaria Transport Pty Ltd v FCT (1990) 21 ATR 513, the Federal Court held that machinery is depreciable whether or not it forms an integral part of a building or is part of the setting in which the business is carried on. ‘‘Machinery’’ was held to have a meaning and effect additional to that of the word ‘‘plant’’. The Tax Office considers that the ordinary meaning of ‘‘machinery’’ includes devices such as computers and microprocessors, as well as stoves, cooktops, ovens and hot water services: Ruling TR 2004/16. However, according to that ruling, the ordinary meaning of ‘‘machinery’’ does not include anything that is merely a reservoir or conduit, such as ducting, piping or wiring, although connected with something that is machinery. In other words, if the ducting, piping or wiring forms part of a unit that is a machine then it is machinery, but if it is merely connected to, but not part of, a unit that is a machine then it is not machinery. Walls, floors, ceilings, doors and fittings Floors and ceilings that perform standard functions and do not contribute in any special way to the conduct of the taxpayer’s business will not qualify as depreciating assets, even if they have sound-absorbing qualities, cope with humidity or provide other incidental efficiencies: Macquarie Worsteds Pty Ltd v FCT (1974) 4 ATR 334. Movable office partitions, which provide flexibility to meet particular changed trading requirements, were held to be plant in Jarrold (Inspector of Taxes) v John Good & Sons Ltd [1963] 1 All ER 141. In other circumstances, however, they may merely form part of the setting in which the business is carried on. In Ruling IT 2130, the Commissioner ruled that a multi-storeyed demountable carpark was not plant because it formed the whole or part of the premises in which the income-producing activity was carried on. Decor, murals and light fittings have been accepted as plant due to their function in creating an ‘‘atmosphere’’ for the taxpayer’s business: CIR v Scottish & Newcastle Breweries © 2017 THOMSON REUTERS

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[10 180]

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Ltd (1982) 1 WLR 322. A wardrobe in a rented unit was depreciable because it was not built into the wall. However, built-in kitchen cupboards were fixtures and were not depreciable: AAT Case 11,655 (1997) 35 ATR 1022. The Tax Office’s views on what items in residential rental premises qualify as depreciating assets are set out in Ruling TR 2004/16.

Portable accommodation and movable structures In Quarries Ltd v FCT (1961) 106 CLR 310, the taxpayer company carried on the business of quarrying and crushing stone. Operations were frequently required to be carried out at remote places and both equipment and employees were moved between sites. The company provided portable sleeping units as on-site accommodation for employees. The units were constructed of timber and galvanised iron. They rested on the ground but were not affixed to it and could be loaded on and off transports by crane. The High Court held that the units constituted ‘‘plant or articles’’ for depreciation purposes. Taylor J noted that the sleeping units were not structures in the nature of buildings in any ordinary sense and were designed and constructed as portable or movable equipment for use in connection with the nomadic type of business which the taxpayer carried on. Determination TD 97/24 states that a caravan park or tourist park operator can only claim depreciation on caravans, mobile homes and other types of accommodation that are not fixtures on land: see [10 180]. In Benson (Inspector of Taxes) v Yard Arm Club Ltd [1979] 2 All ER 336, a ship that had been converted into a floating restaurant and was attached to a barge did not qualify as plant because the ship and the barge were merely the structure within which the business was carried on. The fact that it was a vessel rather than a building, while offering commercial attractions, made no difference in the conduct of the business. ‘‘Private’’ property Items that may commonly have a ‘‘private’’ character may nevertheless qualify for depreciation if they have a limited life and can reasonably be expected to decline in value over time. In FCT v Faichney (1972) 3 ATR 435, it was accepted that not only a desk and bookshelf but also a carpet and a curtain used in a ‘‘home office’’ qualified as ‘‘plant or articles’’. Similarly, a briefcase and, in appropriate circumstances, a wristwatch have been held to qualify for depreciation (the key issue is whether the item is used for a taxable purpose). Animals An animal may qualify as a depreciating asset, for example a racehorse (see Riddle v FCT (1952) 5 AITR 225). However, animals used as working beasts or beasts of burden in a primary production business are live stock and therefore not depreciating assets: see [27 060]. [10 180] Fixtures and improvements Improvements to land and fixtures (whether removable or not) are treated as if they are separate from the land: s 40-30(3). Otherwise they would not qualify as depreciating assets (being part of the land) since land is excluded from being such an asset. This allows the decline in the value of the improvements and fixtures to be deductible under Div 40 if they would have been depreciating assets in their own right: see also Ruling TR 2004/16. However, improvements that qualify for write off under Div 43 (which is about buildings and structural improvements), or would qualify for write off under Div 43 but for the expenditure being incurred, or the capital works being started, before a particular date or had they been used for the relevant purpose, cannot be written off under Div 40 as depreciating assets: see [10 190]. Ruling TR 2004/16 contains the Tax Office’s views on whether an item forms part of residential rental premises or is a separate depreciating asset. This is a question of fact. Relevant matters to consider include: whether the item appears visually to retain a separate identity; the degree of permanence with which it has been attached; the incompleteness of the structure without it; and the extent to which it was intended to be permanent or whether it was likely to be replaced within a relatively short period. 372

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An open pit mine site improvement is considered to be an improvement to land that meets the conditions to be a depreciating asset: see Ruling TR 2012/7. In ATO ID 2008/50, a gully dam was considered to be a depreciating asset as it was not land as such.

Lessor’s depreciating asset attached to lessee’s land If a lessor leases out a depreciating asset that becomes a fixture on another entity’s land, Div 40 contains provisions giving the lessor an entitlement to deductions for its decline in value. The lessor is a holder of a depreciating asset that is subject to a lease if the asset is fixed to land and the lessor has the right to recover the asset: s 40-40, Item 4. The lessor is not the holder unless there is a right to recover the depreciating asset from the land. The lessor ceases to be the holder when the right to remove ceases. If a leased depreciating asset is put to a tax preferred use, the lessor may be denied capital allowance deductions if Div 250 applies: see [33 100]. Note also the operation of Div 45 relating to the disposal of leased plant or an interest in leased plant: see [10 1020]. Lessee’s depreciating asset attached to lessor’s land If a lessee of land owns a depreciating asset and attaches the asset to the lessor’s land, the lessee is also considered to be the holder of the asset if the lessee has the right to remove the asset: s 40-40, Item 2. The lessee ceases to be the holder when the right to remove the asset ceases: see [10 1210]. [10 190] Assets excluded from Div 40 Certain assets are not depreciating assets (s 40-30(1)): • land; • trading stock; and • an intangible asset not specifically listed in s 40-30(2) (see [10 150]), eg a marine park permit (see ATO ID 2002/755), a trade mark (see ATO ID 2004/858), the right to have gas supplied to premises (see ATO ID 2004/721) and rights to virtual land that was part of an online role-playing game (see ATO ID 2009/28). Whether fixtures and improvements to land are depreciating assets is considered at [10 180]. The following assets are also effectively excluded from the operation of Div 40: • work-related items that are exempt from FBT under s 58X FBTAA (eg mobile phones, laptop computers, PDAs, protective equipment, briefcases and tools of trade), provided the relevant benefit is an expense payment benefit or a property benefit (see [57 260]): s 40-45(1); • capital works for which amounts are deductible under Div 43, or would be deductible under Div 43 if the capital works had been used for a relevant purpose or if their construction had not commenced before a particular day (see [10 1450] and following): s 40-45(2); • depreciating assets for which amounts were deductible under the old ITAA 1936 film concessions (former Div 10B and former Div 10BA: see [11 400]): s 40-45(5); and • cars where expenses have been substantiated using the ‘‘cents-per-kilometre’’ method (see [9 110]): s 40-55. (Before 2015-16, where car expenses were substantiated using the ‘‘12% of original value’’ method, the car was also effectively excluded from the operation of Div 40.)

Assets used for R&D purposes If a depreciating asset is used for registered R&D activities after 30 June 2011, the notional deduction provisions in Div 355 ITAA 1997 apply (the R&D offset is based on the amount of the notional deductions). In such a case, a Div 40 deduction is not available: see © 2017 THOMSON REUTERS

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[10 250]

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[11 070]. Under the pre-July 2011 rules, a depreciating asset used for R&D purposes qualified for a deduction under s 73BA and not under Div 40. For the rules that apply if a balancing adjustment event happens to an R&D depreciating asset, see [10 930].

Primary production depreciating assets Rules relating to deductions for primary production depreciating assets and capital expenditure of primary producers are contained in Subdivs 40-F, 40-G and Subdiv 40-J (discussed in Chapter 27). If a deduction in respect of a depreciating asset is available under one of those Subdivisions, a deduction is not available under the general depreciation rules: s 40-50(1).

Hire purchase arrangements Division 240 ITAA 1997 contains measures that treat hire purchase arrangements as equivalent to sale, loan and debt transactions: see [33 090].

HOLDING DEPRECIATING ASSETS [10 250] Who is a holder? A deduction is only available to an entity that holds a depreciating asset at any time during the year: s 40-25. If 2 or more entities hold the same depreciating asset, each holder is entitled to claim a capital allowance deduction calculated on the basis of the cost that they incurred in relation to that asset (see [10 350]-[10 430] for working out the cost of a depreciating asset). The following table (adapted from the table in s 40-40) identifies the circumstances under which an entity can become a holder of a depreciating asset. Essentially, the legal owner of a depreciating asset is the holder of the asset (see Item 10) unless any other item (see Items 1-9) applies. It is possible to have more than one holder in relation to a depreciating asset because a different entity can potentially qualify as a holder under different circumstances. However, an entity that has been specifically identified in column 4 of an item in the table as not holding a depreciating asset cannot be a holder under another item: s 40-40. An entity begins to hold a depreciating asset if it starts to satisfy any of the items in the table in s 40-40 in respect of the asset. Item

1.

2.

374

Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity

A luxury car in respect of which a lease has been granted

The lessee (while the lessee has the right to use the car) and not the lessor A depreciating asset fixed to land subject The owner of the to a quasi-ownership right (including any quasi-ownership extension or renewal of such a right) if right (while the right the owner of the right has a right to to remove exists – remove the asset (see ATO ID 2007/84). this is not limited to See [10 1210] for the definition of a right to remove ‘‘quasi-ownership right’’ the asset at the end of the term of the quasi-ownership right: see ATO ID 2012/9)

Entity that cannot be holder under another item in this table while this item applies The lessor

N/A

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Item

3.

4. 5.

Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity

An improvement to land (whether a fixture or not) subject to a quasi-ownership right (including any extension or renewal of such a right) made, or itself improved, by any owner of the right for the owner’s own use if the owner of the right has no right to remove the asset. For an example of where this item did not apply, see ATO ID 2005/278 A depreciating asset that is subject to a lease if the asset is fixed to land and the lessor has the right to recover the asset A right that an entity legally owns but which another entity (the economic owner) exercises or has a right to exercise immediately, if the economic owner has a right to become its legal owner and it is reasonable to expect that:

The owner of the quasi-ownership right (while it exists)

The lessor (while the right to recover exists) The economic owner and not the legal owner

[10 250]

Entity that cannot be holder under another item in this table while this item applies N/A

N/A The legal owner

(a) the economic owner will become its legal owner; or (b) it will be disposed of at the direction and for the benefit of the economic owner 6.

A depreciating asset that an entity (the The economic former holder) would, apart from this owner and not the item, hold under this table (including by former holder another application of this item) if a second entity (also the economic owner):

The former holder

(a) possesses the asset, or has the right as against the former holder to possess the asset immediately (eg see ATO ID 2007/171, ATO ID 2008/53, ATO ID 2008/54 and ATO ID 2011/71); and (b) has a right as against the former holder the exercise of which would make the economic owner the holder under any item of this table; and it is reasonable to expect that the economic owner will become its holder by exercising the right, or that the asset will be disposed of at the direction and for the benefit of the economic owner (see TR 2005/20, TR 2012/80, ATO ID 2003/998, ATO ID 2007/170 and ATO ID 2012/80) 7.

A depreciating asset that is a partnership The partnership and The individual asset (see below) – this applies to a not any particular partner general law partnership and not a tax law partner partnership (see ATO ID 2009/135)

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375

[10 250]

Item

8.

CAPITAL ALLOWANCES Identifying the holder of a depreciating asset This kind of depreciating asset Is held by this entity

Mining, quarrying or prospecting information that an entity has and that is relevant to:

The entity

Entity that cannot be holder under another item in this table while this item applies N/A

The entity

N/A

The owner, or the legal owner if there is both a legal and an equitable owner

N/A

(a) mining operations carried on, or proposed to be carried on by the entity; or (b) a business carried on by the entity that includes exploration or prospecting for minerals or quarry materials obtainable by such operations;

whether or not it is generally available 9. 10.

Other mining, quarrying or prospecting information that an entity has and that is not generally available Any depreciating asset

Section 40-40 recognises both the rights of economic and legal owners if they are not the same entity and allows these owners to deduct the decline in value of the depreciating asset. It also formalises many of the administrative practices adopted by the Tax Office in the past. Items 1, 2, 4 and 6 in the table are also considered at [33 070]. In Ruling TR 2005/20, the Tax Office states that the notional buyer under a ‘‘hire purchase’’ agreement, who is taken to be the owner of goods under Div 240 ITAA 1997 (see [33 090]), will not be the holder of the goods for the purposes of Div 40, unless it is reasonable to conclude that the notional buyer will acquire the asset, or that the asset will be disposed of at the direction, and for the benefit of, the notional buyer. If this requirement is satisfied, the notional buyer will be the holder of the asset under s 40-40, whether by reason of the direct operation of Item 6 above, or indirectly under Item 10 above. See also ATO ID 2012/80, where it was concluded that, upon entering into an arrangement for the term purchase of a depreciating asset, under which the purchaser has a right to immediate possession of the asset and a right to sell the asset to the owner (or an entity nominated by the owner) at a predetermined price at the end of the term of the arrangement, the purchaser starts to hold the asset under Item 6. Ruling TR 2005/20 also states that, for the purposes of Items 5 and 6, for it to be “reasonable to expect” something to occur, there must be a sufficiently reliable prediction that it will occur, or at least an expectation or prediction based on reasonable grounds. See also ATO ID 2010/2 concerning Item 5, and Ruling TR 2012/7 which considers who is the holder of an open pit mine site improvement (considered to be a single depreciating asset: see [10 150]). According to Ruling TR 2006/13, if the lessor in a sale and leaseback is the legal owner of the asset, the lessor holds the depreciating asset according to Item 10 above. However, the lessor may also hold the asset according to Item 4 if the asset is a fixture on someone else’s land but the lessor has the right to recover the asset. In ATO ID 2003/149, the Tax Office considered that, on the facts, Item 6 applied to arrangements involving the sale and leaseback (directly or indirectly via a sublease) of a depreciating asset subject to a call option held by the lessee or sublessee. See also [33 170]. 376

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[10 270]

EXAMPLE [10 250.10] Scenario 1 Joan (the legal owner) leases a refrigerator to Roy, who uses it in his bottle shop. Roy has the right to buy the refrigerator for a nominal sum at the end of the lease and it is reasonable to expect him to exercise that right. Roy is a holder of the refrigerator under Item 6 s 40-40 as the economic owner (he has possession of the machine, has the right to purchase it and it is reasonable to expect him to exercise that right). Normally Joan is also a holder under Item 10 (as the legal owner) but Item 6 precludes Joan from being a holder. Scenario 2 Hettie (the legal owner) leases a machine for making dog collars to Gus who has the option to purchase the machine for a nominal sum at the end of the lease. Gus uses the machine in his business and it is reasonable to expect him to exercise the option to acquire the machine. Gus subsequently grants a sublease to Amber who in turn grants a sub-sublease back to Gus. At no time does Gus lose possession of the machine. Gus is a holder of the machine under Item 6 s 40-40 as the economic owner (he has possession of the machine, has the right to purchase it and it is reasonable to expect him to exercise that right). Hettie is precluded from being a holder (even though she has legal ownership) by virtue of Item 6. Amber is also not a holder because she never had possession of the machine nor does she have any right that she could exercise which would make her a holder. Scenario 3 Peter leases a machine to Lorenzo who uses it to produce assessable income by fixing it on to his land. Peter has the right to recover the asset. He is a holder under Item 4 s 40-40. Lorenzo is also a holder under Item 10 (being the legal owner). Although there are 2 holders in relation to the same asset, they are not deducting the same cost. A holder is only entitled to deduct an amount representing the decline in value if that holder has a cost in relation to that asset.

[10 260] Jointly held assets If 2 or more entities jointly hold a depreciating asset, each co-owner treats their interest in the underlying asset as a separate depreciating asset: s 40-35. This also applies if different entities own different parts of the asset: see ATO ID 2011/1. Changes to one holder’s interest do not have to affect another holder. EXAMPLE [10 260.10] Andrew, Azra, Themis and Virginia are joint owners of a depreciating asset. Azra sells her interest in the asset to Zara. Each of the joint owners’ interest in the depreciating asset is treated as a separate asset and therefore a balancing adjustment event happens when Azra sells her interest.

Note that, in the case of a partnership (other than a tax law partnership), the asset is held by the partnership and not the partners: see [10 250]. Ruling TR 2002/19 examines arrangements involving a special purpose partnership established to acquire a licence to use intellectual property and concludes that the partnership never becomes the ‘‘holder’’ of the intellectual property.

[10 270] Extension or renewal of right The renewal or extension of a depreciating asset that is a right is taken to be a continuation of that right, so that a balancing adjustment event does not arise merely because the right terminates and is immediately followed by an extension or renewal of that right: s 40-30(5). Accordingly, the holder of a right does not cease to be a holder of that right if it © 2017 THOMSON REUTERS

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is extended or renewed. In determining the effective life of an intangible depreciating asset that is not listed in s 40-95(7) (see [10 710]), any reasonably assured extension or renewal of that term is to be taken into account. A new mining, quarrying or prospecting right will be taken to be a continuation of another mining, quarrying or prospecting right held by the taxpayer only if (s 40-30(6)): • that other right ends; and • the new right relates to the same area as the old right (or any difference in area is insignificant). For more information about mining, quarrying or prospecting rights, see [10 1270].

[10 280] Ceasing to be holder When an entity stops being a holder of a depreciating asset: • the entitlement to the deduction for the decline in the value of the asset ceases: s 40-25; and • a balancing adjustment event happens for the depreciating asset (which may result in assessable income or a deduction to the taxpayer: see [10 850]): s 40-295(1). Examples are when the asset is sold, lost or destroyed, split into 2 or more assets (see [10 290]), merged into another depreciating asset (see [10 300]) or converted to trading stock or, if the holder is an individual, he or she dies.

[10 290] Splitting assets If a depreciating asset held by a taxpayer is split into 2 or more assets, the taxpayer is deemed to have stopped holding the original asset and to have started holding the assets into which it is split: s 40-115(1). If a taxpayer stops holding part of a depreciating asset (eg selling an interest in the asset), the asset is treated as if it had been split into 2 parts, ie the part the taxpayer stops holding and the rest of the asset: s 40-115(2). This effectively means that there are now 2 new assets. EXAMPLE [10 290.10] Anicee wholly owns a printing press. She sells 10% of her interest in the press to Becky. Anicee is taken to have split the press into the 90% interest she retains and the 10% interest sold to Becky. The 90% interest retained by Anicee is taken to be a new depreciating asset that she holds and she is taken to have stopped holding the 10% interest sold to Becky.

Similarly, if a taxpayer grants or assigns an interest in an item of intellectual property, that item of intellectual property is taken to have split into the part assigned or granted and the part retained: s 40-115(3). The taxpayer is treated as ceasing to hold that part of the item that was assigned or granted and a balancing adjustment event happens in relation to that part of the item of intellectual property. The cost of split assets is considered at [10 400]. An anti-avoidance measure negates any advantage in splitting a pre-21 September 1999 asset held at the end of 30 June 2001 (and the asset qualified as plant): s 40-13 TPA. It should be noted that a balancing adjustment event does not happen just because a depreciating asset is split into 2 or more parts. It is only if the taxpayer stops holding those parts that a balancing adjustment event happens: s 40-295(3).

Replacement spectrum licences If a spectrum licence is replaced by one or more other spectrum licences, the original licence is taken to have been split into the replacement licences: s 40-120. 378

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[10 350]

[10 300] Merging assets If a depreciating asset held by a taxpayer is merged into another depreciating asset, the taxpayer is deemed to have stopped holding the original assets and started holding the merged asset: s 40-125. (See [10 410] for the cost of the merged asset.) This does not apply if the taxpayer merges a pre-21 September 1999 asset that was held by the taxpayer at the end of 30 June 2001 (and the asset qualified as plant): s 40-13 TPA. Note that a balancing adjustment event does not happen just because depreciating assets are merged. Whether the taxpayer is entitled to a deduction for the decline in value of the merged asset depends on whether the merged asset satisfies the conditions for deduction under Div 40. Issues that need to be considered are whether the merged asset can be said to still be a depreciating asset and whether the taxpayer holds the merged asset. In addition, notwithstanding the merger of the assets, it is possible that they should still be treated as separate assets: see [10 150].

COST [10 350] Basis of a decline in value – cost The basis for working out the amount of the decline in the value of a depreciating asset is the cost of the asset. The cost consists of 2 elements (s 40-175): • amounts paid, or deemed to be paid, to hold the asset (the first element of cost): s 40-180 (see [10 360]); and • amounts paid after the taxpayer began to hold the asset, that brings the asset to its present condition and location from time to time (the second element of cost): s 40-190 (see [10 380]). The cost of a depreciating asset is generally GST-exclusive, but includes any non-cash benefits that a taxpayer has provided. In the case of a sale and leaseback arrangement, it is the cost of the asset to the lessor and not to the lessee that is relevant: see Ruling TR 2006/13 (discussed at [33 170]). In certain circumstances, the cost is a particular amount attributed under the cost rules (ie deemed cost), rather than the amount actually paid, for example where a depreciating asset is split into 2 or more assets, merged with another depreciating asset or acquired under a non-arm’s length arrangement: see [10 360]. Only capital expenditure (and not revenue expenditure) can be included in the cost of a depreciating asset: s 40-220. The cost of an asset is adjusted in particular circumstances, including where: • the asset’s cost can be deducted under another provision: see [10 450]; • the cost of a car exceeds the car limit: see [10 1300]; • a car is acquired at a discount because another depreciating asset is sold at less than its market value: see [10 1310]; • the commercial debt forgiveness provisions apply: see [10 470]; or • there is a short-term forex realisation gain or loss under Subdiv 775-B: see [32 300]. If a company is entitled to the producer tax offset in respect of a film (see [11 420]), the cost of the copyright in the film (which is a depreciating asset) is reduced by the amount of the offset: s 40-45(6). Note also that, the cost of a depreciating asset is reduced by non-deductible water infrastructure improvement expenditure (see [27 310]): s 40-222. If the cost of a depreciating asset is expressed in foreign currency (eg it is purchased in the USA and paid for in US dollars), it must be translated into Australian dollars. The foreign currency translation rules in (Subdiv 960-C) are discussed at [34 060]. © 2017 THOMSON REUTERS

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Cost setting rules applicable to consolidated groups are discussed at [24 300]-[24 450]. If an employer reimburses an employee for the cost (or part of the cost) of a depreciating asset held by the employee that is subject to FBT, the employee’s deduction for the decline in value of the asset is not affected by s 51AH ITAA 1936: see [9 1140].

Impact of TOFA rules The rules for the taxation of financial arrangements (TOFA) in Div 230 ITAA 1997 contain provisions governing the interaction of Div 40 and Div 230. If a financial arrangement is used as consideration for acquiring or providing a depreciating asset, the market value of the depreciating asset must first be determined before the cost and termination value of the depreciating asset (as appropriate) can be worked out. Under s 230-505, the cost of a depreciating asset will include the market value of the depreciating asset that starts to be held. This may come about because the taxpayer might start or cease to have the financial arrangement as consideration for acquiring or holding the asset (relevant to the first element of cost), or as consideration for something acquired that goes to the second element of cost (eg, capital improvements). The TOFA rules are considered at [32 050] and following.

[10 360] First element of cost (cost of acquisition etc) The first element of cost is as follows (s 40-180(1)): • amounts that a taxpayer has paid or is taken to have paid to hold the asset: see [10 370]; • amounts specified or attributed as the first element of cost regardless of how much the taxpayer has actually paid: see below; and • an amount paid, or taken to have been paid, in relation to starting to hold a depreciating asset if that amount is directly connected with holding the asset: s 40-180(3). An example would be costs incurred in travelling to a foreign country solely for the purpose of purchasing a depreciating asset, for use in the taxpayer’s business, that is not available in Australia. See also ATO ID 2006/328 (cost of new full-scale test model includes the cost attributed to the components of an earlier test model reused in building the new test model) and ATO ID 2008/93 (capital expenditure incurred by a service provider in supplying cable and cable support equipment to another entity in order to connect their interconnection facility to the other entity’s network). The first element of cost is generally GST-exclusive: see [10 480]. The first element of cost is worked out as at the time when the taxpayer begins to hold the depreciating asset. Note that if an understatement in the first element of cost of a depreciating asset is discovered, the opening adjustable value of the asset must be recalculated for all affected income years using the correct cost of the asset: see [10 550]. The first element of cost does not include an amount that forms part of the second element of cost of another depreciating asset: s 40-180(4). The first element of cost is not reduced by any government grant received to finance the purchase of the relevant asset: see ATO ID 2003/1085. However, the first element of cost may be reduced to account for exploration benefits received under farm-in farm-out arrangements: see [10 1270].

Amounts specified as the first element cost The first step in working out the first element of cost is to determine whether s 40-180(1)(a) attributes an amount as being the first element of cost. If so, any amount that the taxpayer has paid or the value of the benefit provided is irrelevant. The table below (from 380

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[10 360]

s 40-180(2)) sets out the circumstances and the amounts attributed as the first element of cost to the taxpayer (if more than one item applies, the last item in the table prevails). Item 1. 2. 3.

4.

5.

6. 7.

8.

Amounts attributed as the first element of the cost of a depreciating asset Circumstance The first element of cost is A depreciating asset the taxpayer holds For each asset into which it is split, the is split into 2 or more assets amount worked out under s 40-205: see below. A depreciating asset or assets that the For the merged asset, the amount taxpayer holds is or are merged into worked out under s 40-210: see below. another depreciating asset A balancing adjustment event happens The termination value of the asset at the to a depreciating asset the taxpayer time of the event: see below. holds because the taxpayer stops using it for any purpose and expects never to use it again, and continues to hold it A balancing adjustment event happens The termination value of the asset at the to a depreciating asset the taxpayer time of the event: see below. holds but has not used because the taxpayer expects never to use it, and continues to hold it A partnership asset that was held, just The market value of the asset when the before it became a partnership asset, by partnership started to hold it or when one or more partners (whether or not the change referred to in s 40-295(2) any other entity was a joint holder) or a happened: see below. partnership asset to which s 40-295(2) applies There is roll-over relief under s 40-340 The adjustable value of the asset to the for a balancing adjustment event transferor just before the balancing happening to a depreciating asset adjustment event happened: see below. The taxpayer is the legal owner of a The market value of the asset when the depreciating asset that is hired under a taxpayer started to hold it: see below. hire purchase agreement and the taxpayer starts holding it because the entity to whom it is hired does not become the legal owner The taxpayer starts to hold the asset The market value of the asset when the under an arrangement and: taxpayer starts to hold it: see below. (a) there is at least one other party to the arrangement with whom the taxpayer did not deal at arm’s length; and (b) apart from this item, the first element of the asset’s cost would exceed its market value

9. 10.

11. 12.

The taxpayer starts to hold the asset under an arrangement that was private or domestic in nature (eg a gift) The Finance Minister has determined a cost for the taxpayer under s 49A, s 50A, s 50B, s 51A or s 51B Airports (Transitional) Act 1996 (ie in the context of a lease of a federal airport) Div 58 applies (this deals with assets previously owned by an exempt entity) A balancing adjustment event happens to a depreciating asset because a person dies and the asset devolves to the taxpayer as the person’s legal personal representative

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The market value of the asset when the taxpayer starts to hold it: see below. The cost so determined

The amount applicable under s 58-70(3) and (5): see [10 430] The asset’s adjustable value (see [10 540]) on the day the person died or, if the asset is allocated to a low-value pool (see [10 760]), so much of the closing pool balance for the income year in which the person died as is reasonably attributable to the asset

381

[10 360]

Item 13.

14.

CAPITAL ALLOWANCES Amounts attributed as the first element of the cost of a depreciating asset Circumstance The first element of cost is The taxpayer starts to hold a The market value of the asset when the depreciating asset because it passed to taxpayer starts to hold it reduced by any the taxpayer as beneficiary or joint capital gain that was disregarded under tenant s 128-10 or s 128-15(3), whether by the deceased or by the legal personal representative: see [17 100] and [17 110] A balancing adjustment event happens What would, apart from s 40-285(3), be to a depreciating asset the taxpayer the asset’s adjustable value on the day holds because of s 40-295(1B) (see [10 the balancing adjustment event happens 1270])

Note that market value is GST-exclusive (unless the supply of the asset cannot be a taxable supply): s 960-405. The concept of market value is considered at [3 210]. The concept of holding an asset is discussed at [10 250]-[10 300].

Commentary on Items 1-9 Item 1 deals with the situation where a depreciating asset is split into 2 or more assets. The first element of cost of each asset is the reasonable proportion of the sum of (i) the adjustable value of the original asset just before it was split and (ii) the amount the taxpayer is taken to have paid for any economic benefit involved in merging the original asset: see [10 400]. Item 2 deals with the situation where a depreciating asset is merged with another depreciating asset. The first element of cost of the merged asset is the reasonable proportion of the sum of (i) the adjustable values of the original assets just before the merger and (ii) the amount the taxpayer is taken to have paid for any economic benefit involved in merging the original asset(s): see [10 410]. Items 3 and 4 deal with the situation where a taxpayer expects not to ever use a depreciating asset for any purpose. In that situation, a balancing adjustment event happens in relation to that asset even though the taxpayer continues to hold it. The termination value for such an event is the market value of the asset at that time: see [10 890]. However, as the balancing adjustment event is triggered by an expectation rather than a real event, it is possible that the expectation will not be fulfilled. After calculating the balancing adjustment, the cost of the asset is then reset to the termination value so that if another balancing adjustment event happens to the asset, only the gain or loss since the first balancing adjustment event is recognised. It should be noted that any additional costs incurred after the first balancing adjustment event will be recognised as a second element of cost, ie costs incurred after starting to hold the asset: see [10 380]. EXAMPLE [10 360.10] Gautum Ltd owns a specialised depreciating asset. Due to a downturn in the demand for its products, the company decides to shut down that part of its business and stops using the asset. It expects never to use the asset again because it is unlikely for the demand to return. This is a balancing adjustment event and the termination value just before Gautum Ltd forms that expectation is its market value, ie $250,000. However, due to an unexpected turnaround some years later, the demand for Gautum Ltd’s products returned stronger than ever. The company reopens that part of its business and starts to use the asset again. The cost of the asset is its termination value at the time of the earlier balancing adjustment event, ie $250,000.

Item 5 deals with situations where assets are brought into a partnership by one or more of the partners and also if there is a change in the composition of a partnership. For Div 40 purposes, a partnership (rather than an individual partner) is treated as the holder of a depreciating asset. If a partnership simply buys a partnership asset, the first element of cost is 382

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[10 370]

the amount paid by the partnership to acquire it. However, if a partner contributes an asset or if there is a change in the composition of a partnership, the first element of cost for the partnership is the market value of the asset when it became the holder or when the change in composition happens (see [10 1000]), as appropriate. Item 6 deals with situations where there is a roll-over relief from a balancing adjustment event occurring in relation to transfers of depreciating assets: see [10 940]-[10 960]. If roll-over relief is available, the transferee essentially continues to deduct the decline in value of the depreciating asset using the same method and effective life as the transferor. To ensure that the transferee’s entitlement is effectively a continuation of the transferor’s entitlement, the cost of the asset to the transferee is the adjustable value of the transferor (see [10 540]) just before the transfer. Item 7 deals with depreciating assets that are the subject of a hire purchase agreement. Under s 40-40 Items 5 and 6, the economic holder (ie the hirer) is treated as the holder rather than the legal owner. If the hirer does not exercise its option to become the legal owner, the legal owner will become the holder. In this case, the first element of cost for the legal owner is the market value of the asset when it becomes the holder. Item 8 deals with non-arm’s length transactions. If the cost would otherwise (ie apart from Item 8) exceed its market value, the first element of cost is the market value. Note that if the first element of cost would have been less than its market value, there is nothing to uplift the first element of cost to its market value. In such a case, therefore, the first element of cost will be less than market value. Item 9 deals with the situation where a taxpayer starts to hold a depreciating asset under a private or domestic arrangement. The term ‘‘private or domestic’’ is taken from s 8-1. According to the Explanatory Memorandum to the Capital Allowances Act(see [10 020]), the meaning of ‘‘private or domestic’’ can be contrasted with ‘‘income earning or commercial or business’’. A transaction of a private character is said to be typically associated with the enjoyment or sharing of wealth in contrast to the creation or growth of wealth. ‘‘Domestic’’, on the other hand, is said to describe those things that are of, or pertaining to, the household. Its meaning is similar to, though less general than, ‘‘private’’: see [8 250].

[10 370] Amounts paid or taken to have been paid to hold asset If s 40-180(1)(a) does not attribute an amount to be the first element of cost to the depreciating asset (see [10 360]), amounts that a taxpayer has paid, or is taken to have paid, to hold the asset are the first element of cost: s 40-180(1)(b). The amount paid or taken to have been paid is the greater of (s 40-185(1)): • consideration given; and • amounts included in assessable income. The relevant amounts are generally GST-exclusive: see [10 480]. Consideration given by the taxpayer to hold the asset is the sum of the following (s 40-185(1)): • money paid; • a liability to pay money and an increase in the taxpayer’s liability to pay money; • non-cash benefits provided; • a liability to provide non-cash benefits and an increase in the taxpayer’s liability to provide non-cash benefits; • a reduction in the taxpayer’s right to receive money; and • a reduction in the taxpayer’s right to receive non-cash benefits. © 2017 THOMSON REUTERS

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[10 370]

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The value of a non-cash benefit is determined by its market value (market value is discussed at [3 210]). Any liability already satisfied is excluded: s 40-185(2). If a depreciating asset is given to the taxpayer by her or his employer for employment purposes and for no contribution by the taxpayer (eg the asset is not provided under a salary sacrifice arrangement), the first element of cost of the asset to the taxpayer is nil: see ATO ID 2003/384. Issuing shares is the provision of a non-cash benefit and does not constitute the payment of an amount: Burrill v FCT (1996) 33 ATR 133; Ruling TR 2008/5. Consequently, granting to the entity contributing a depreciable asset a right to be issued shares at a defined future time is not incurring a liability to pay an amount, even if the contributing entity has a discretion not to accept the shares. If shares are issued as consideration for a depreciable asset, the market value of the shares at the relevant time is the cost of the asset to the company for the purposes of Div 40. The value at which the shares are recorded in the accounts of the company is not as such the market value of the shares and is not evidence of that value: Ruling TR 2008/5. Circumstances in which an amount may be included in the assessable income of a taxpayer include: • if a business taxpayer started to hold a depreciating asset and this was a non-cash benefit: see [5 100]; and • if there is a balancing adjustment for a depreciating asset given up in order to start holding another depreciating asset. EXAMPLE [10 370.10] Rohan operates a delicatessen/cafe. He receives a coffee machine as a non-cash business benefit from Rebecca. Rohan does not provide any goods or services to Rebecca in exchange for the coffee machine. It has a market value of $2,500 and Rohan actually contributes $500. His assessable income will include the $2,000 non-cash benefit (under s 21A ITAA 1936), ie market value less the actual contribution. The first element of cost of the coffee machine is $2,500: the $2,000 included in Rohan’s assessable income plus the $500 he paid, being the amount by which the assessable income was reduced because of the payment. If Rohan borrows the $500 contribution, that $500 liability does not form part of the first element of cost because he incurs the liability to get finance and not to hold the coffee machine. Rohan also gives Tanjali a cabinet in return for a table. The cabinet has a market value of $1,900 and an adjustable value (to Tanjali) of $1,200. The table has a market value of $2,000. Rohan’s termination value for the cabinet (see [10 890]) is the market value of the table (ie $2,000). As a result of the disposal of the cabinet, a balancing adjustment of $800 is included in Rohan’s assessable income (termination value of $2,000 − adjustable value of $1,200): see [10 850]. The first element of cost of the table is the greater of: • the market value of the cabinet Rohan provided to Tanjali (non-cash benefit), ie $1,900; and • the amount included in Rohan’s assessable income under the balancing adjustment ($800) plus the adjustable value of the cabinet ($1,200), ie $2,000. The first element of cost of the table is therefore $2,000. Finally, Rohan buys a van from Malika in exchange for: • providing advice (this non-cash benefit has a market value of $1,000); • agreeing to review the advice in 6 months’ time (a market value of $500); • cancelling a debt of $2,800 owed by Malika; and • agreeing to pay Malika $26,000. The first element of cost for the van is $30,300 (the sum of all the above).

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CAPITAL ALLOWANCES [10 380] If Rohan then negotiates with Malika that, instead of reviewing his advice in 6 months’ time, he will give her a small table, the cost of the table to Malika is the market value of the advice when the liability is terminated.

See also ATO ID 2004/116 (costs of constructing a motor home) and ATO ID 2005/264 (capital expenditure incurred directly in creating the subject matter of a computer disk). Determination TD 2005/1 discusses certain copyright transfer arrangements relating to patient medical records, where the cost of the copyright is considered to be nil. Note that the cost of an extended motor vehicle warranty is on revenue account and is deductible under s 8-1: see [9 060]. It therefore does not form part of the cost of the vehicle for depreciation purposes.

[10 380] Second element of cost (costs after acquisition etc) The second element of cost consists of costs incurred after the taxpayer began holding the depreciating asset: s 40-190(1). The primary component is the amount the taxpayer is taken to have paid under s 40-185 (see [10 370]) for each economic benefit that has contributed to bringing the asset to its present condition and location from time to time since the taxpayer started to hold the asset: s 40-190(2)(a). An asset’s condition refers to its general form, state or order. The second element of cost is generally GST-exclusive: see [10 480]. According to the Explanatory Memorandum to the Capital Allowances Act (see [10 020]), economic benefits can be assets, services or some combination of both. They are the things added or used up to bring the asset to its location or condition from time to time. They need not increase the actual market value of the depreciating asset. The second element of cost includes all payments for economic benefits that are embodied in a depreciating asset and transport costs incurred in bringing the asset to its present location (eg see ATO ID 2003/514, ATO ID 2003/515, ATO ID 2003/516 and ATO ID 2009/74). Relocation costs will therefore form part of the second element of cost (eg see withdrawn ATO ID 2002/920). The second element of cost also includes expenditure incurred by the taxpayer that is reasonably attributable to a balancing adjustment event occurring for the asset (see [10 850]): s 40-190(2)(b). For example, if the taxpayer pays a contractor to demolish and remove a depreciating asset (a balancing adjustment event) so that it can be replaced with a new one, the fee paid to the contractor will form part of the second element of the cost of the old asset that was demolished (see also ATO ID 2006/275). This does not apply to a balancing adjustment event referred to in Item 6 (non-arm’s length transaction) or Item 11 in the table in s 40-300(2) (see [10 890]): s 40-190(2A). Note that demolition costs could be site preparation costs under s 40-840(2)(d) and therefore form part of the project pool: see [10 1050]. EXAMPLE [10 380.10] Winnie installs a printing press that she owns on her business premises. The labour and materials used in the installation are economic benefits that she has received and form part of the second element of cost regardless of whether the asset’s value has increased.

Amounts specified as the second element of cost The first step in working out the second element of cost is to determine whether s 40-190(3) attributes an amount as being the second element of cost. If so, any amount that the taxpayer has paid or the value of any benefit provided is irrelevant. The following table

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[10 390]

CAPITAL ALLOWANCES

sets out the circumstances and the amounts attributed as the second element of cost to the taxpayer (if more than one item applies, the last item in the table prevails). Item 1.

Amounts attributed as the second element of the cost of a depreciating asset Circumstance The second element of cost is The taxpayer receives the benefit under The market value of the benefit when an arrangement and: the taxpayer receives it (a) there is at least one other party to the arrangement with whom the taxpayer does not deal at arm’s length; and (b) apart from this item, the second element of the asset’s cost would exceed its market value

2.

The taxpayer receives the benefit under an arrangement that was private or domestic in nature

The market value of the benefit when the taxpayer receives it

The circumstances under which an amount will be specified or attributed as the second element of cost are considerably more limited than the first element of cost: see [10 360]. Essentially, there are only 2 circumstances when an amount will be specified as the second element of cost, namely non-arm’s length transactions and private or domestic transactions. Item 1 deals with non-arm’s length transactions. If the economic benefit received by the taxpayer is non-arm’s length and the second element of cost would otherwise (ie apart from Item 1) exceed the market value of the benefits received, the second element of cost is the market value (see [3 210] for market value). If the second element of cost is less than its market value, there is nothing to uplift the second element of cost to its market value. In such a case, therefore, the second element of cost will be less than market value. Item 2 deals with the situation where a taxpayer receives an economic benefit under a private or domestic arrangement. The second element of cost is the market value of the benefits received. The meaning of the term ‘‘private or domestic’’ is considered further at [10 360] in the context of Item 9 of s 40-180(2).

Amounts paid or taken to have been paid If s 40-190(3) does not specify or attribute an amount as being the second element of cost, the amounts paid or taken to have been paid by the taxpayer for the economic benefits are the second element of cost. The rules for determining the amounts paid or taken to have been paid by the taxpayer are the same as those used for the first element of cost (ie amounts paid or taken to have been paid by a taxpayer to hold a depreciating asset): see [10 370]. [10 390] Apportionment of cost If a single amount is paid for a depreciating asset and at least one other thing (whether or not a depreciating asset), a reasonable apportionment is required when working out the cost of the asset (both the first and second elements of cost): s 40-195. If the purchase contract allocates a price to each item (including the depreciating asset), the Tax Office will accept that allocation if the parties dealt with each other at arm’s length: see [5 260]. Otherwise an apportionment based on the market value of each item should be acceptable: see ATO ID 2002/818.

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[10 420]

EXAMPLE [10 390.10] Rachel buys 2 depreciating assets for $10,000. The market value of Asset 1 is $2,000 and the market value of Asset 2 is $10,000. Rachel is required to apportion the cost of the assets. It is reasonable to apportion the first element of cost on the following basis: Asset 1

$2,000 × $10,000 = $1,667 $12,000 Asset 2 $10,000 × $10,000 = $8,333 $12,000 After starting to hold the assets, Rachel decides to move both assets to another location. She incurs $1,000 in transport costs. In working out the second element of cost (assuming that the transport costs are not deductible under s 8-1), the $1,000 must be apportioned between Asset 1 and Asset 2. Under the circumstances, it is probably appropriate to apportion them on a 50/50 basis (assuming that neither asset requires special attention or treatment).

[10 400] Cost of split assets If a depreciating asset is split into 2 or more separate assets, the first element of cost of each separate asset is a reasonable proportion of the following amounts (s 40-205): • the adjustable value of the original asset just before it was split: see [10 540]; and • any amounts paid or taken to have been paid by the taxpayer (see [10 370]) for any economic benefit involved in splitting the original asset (ie any costs incurred in splitting the asset). Any further costs incurred in relation to the separate assets after the split form part of the second element of cost (assuming that the necessary conditions relating to the second element of cost are satisfied: see [10 380]).

[10 410] Cost of merged assets If a depreciating asset held by a taxpayer is merged into another depreciating asset, the first element of cost of the merged asset is a reasonable proportion of the following amounts (s 40-210): • the adjustable values of the original assets just before the merger: see [10 540]; and • any amounts paid or taken to have been paid by the taxpayer (see [10 370]) for any economic benefit involved in merging the original assets (ie any costs incurred in merging the assets). Any further costs incurred in relation to the merged asset after the merger will form part of the second element of cost (assuming that the necessary conditions relating to the second element of cost are satisfied: see [10 380]).

[10 420] Types of expenditure forming part of cost Apart from the acquisition or construction price, certain other expenditure may also form part of the first or second element of cost of a depreciating asset. Installation and other incidental costs Freight charges, import duties, sales taxes and installation charges are part of the cost of a depreciating asset (either first or second element of cost). If installation costs are incurred, care is needed to ensure that only non-structural costs are included as part of the cost of the depreciating asset. Structural alterations are not depreciable as depreciating assets if they are capital works for which a deduction can be claimed under Div 43 (see [10 150] and [10 190]) unless they can be classed as being integral to the operation of the plant itself (eg reinforced foundations to hold heavy equipment). © 2017 THOMSON REUTERS

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[10 430]

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Demolition and removal of existing assets Expenses incurred in the demolition and removal of an existing asset to make way for replacement equipment were treated as not forming part of installation costs under the previous depreciation regimes and hence not depreciable: Ruling IT 2197; see also Mount Isa Mines Ltd v FCT (1992) 24 ATR 261. Under s 40-190, these costs form part of the second element of cost of the old asset. Transport costs If a depreciating asset is moved from one site to another, the costs of removal and reinstallation form part of the second element of cost of the asset. Expenditure incurred in travelling interstate to have a vehicle (used to transport heavy and bulky equipment) modified to comply with Australian standards was accepted as forming part of the second element of cost in ATO ID 2003/514. The costs of minor rearrangements of depreciating assets within the premises are generally deductible under s 8-1. Temporary accommodation costs The Commissioner accepts that various expenses associated with the temporary accommodation of employees of a contractor engaged to construct plant form part of the cost of the plant, by analogy with installation costs: Ruling IT 2618. Reference is made to BP Refinery (Kwinana) Ltd v FCT (1961) 12 ATD 204. Such costs should therefore also form part of the first or second element of cost of a depreciating asset. [10 430] Assets acquired from tax-exempt entities Division 58 ITAA 1997 applies to depreciating assets previously held by an exempt entity that are subsequently brought into the tax system, either because the exempt entity is now a taxable entity (transition entities) or another taxable entity purchases the assets from the exempt entity. The start time of a depreciating asset held by a transition entity is effectively the time after the transition time at which the transition entity first uses the asset, or has it installed ready for use, for any purpose: see ATO ID 2006/287. The taxpayer holding the depreciating asset has a choice of using one of the following as the first element of cost of the asset: • the notional written-down value of the asset at the time it enters the tax net; or • its undeducted pre-existing audited book value at that time. The choice must be made in respect of each individual asset and is irrevocable. If the asset is on-sold to a subsequent owner, a balancing adjustment amount is included in the assessable income or deductions of the first taxable owner to reflect the special depreciation base that applies to that owner. The balancing amount also compensates for the effect on the on-sale price of the special depreciation base not applying to the purchaser. The measures are intended to ensure that if a depreciating asset of an exempt entity enters the tax net and that transfer is in connection with the acquisition of a business, the purchaser should obtain the same opening value for capital allowance purposes, irrespective of whether the transition of the asset into the tax net happens by way of entity sale or asset sale. Note that, for these purposes, exempt entities include exempt state and territory bodies (see [7 500]) and non-taxable Commonwealth entities.

ADJUSTMENT OF COST [10 450] No double deduction If a holder has already deducted an amount under the income tax legislation (excluding the UCA regime, Div 41 (Business Tax Break) and Div 328 (see [25 100])), that amount will not form part of the cost of the depreciating asset: s 40-215. Similarly, if an amount has or 388

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will be taken into account in working out an amount that the taxpayer can deduct, it will not form part of the cost of the depreciating asset. This is to prevent a double deduction for the same expenditure. This does not apply to notional deductions under the R&D rules in Div 355 ITAA 1997 because the relevant provisions (ss 355-305 and 355-520) are about deducting an R&D asset’s decline in value, not its cost: see [11 070].

[10 460] Roll-over relief for involuntary disposal If a taxpayer involuntarily disposes of a depreciating asset (eg it is lost, destroyed or compulsorily acquired), the taxpayer may choose to apply the roll-over relief to any balancing adjustment amount: s 40-365. The effect of such a choice is that the balancing adjustment amount is applied against the cost of the replacement asset(s) and is not included in assessable income. If the involuntary disposal takes place after the income year in which the replacement asset’s start time happens, the replacement asset’s opening adjustable value is also reduced by that amount, with the result that future depreciation of that asset will be less: see [10 970]. [10 470] Commercial debt forgiveness If a commercial debt is forgiven, the commercial debt forgiveness provisions in Div 245 ITAA 1997) may apply to reduce the deductible expenditure for a depreciating asset: see [8 700]. In such a case, the depreciating asset’s cost or opening adjustable value, as appropriate, is reduced by the debt forgiveness amount: s 40-90. [10 480] Effect of GST on cost The rules governing the effect of the GST on depreciating assets are contained in Subdiv 27-B. In particular, the rules deal with the situation where the holder of an asset is entitled to an input tax credit and where decreasing adjustments and increasing adjustments relate to a depreciating asset. How the rules impact on the cost of non-pooled assets is considered below. For a detailed analysis of GST, see Thomson Reuters’ Australian GST Handbook 2016-17. Entitlement to input tax credit If the holder of a depreciating asset is entitled to an input tax credit, the cost of the asset is reduced by the input tax credit: s 27-80. This applies to both the first and second element of cost to avoid double dipping on the revenue in respect of the same expenditure incurred by the taxpayer. Section 27-80 does not apply, however, if the cost is deemed to be market value because market value is defined in s 995-1 as exclusive of GST: s 27-80(3). A similar reduction in an asset’s opening adjustable value occurs if the input tax credit arises in a later income year. Decreasing adjustment If the holder of a depreciating asset has a decreasing adjustment for GST purposes (other than under Div 129 or Div 132 GST Act) that relates directly or indirectly to the asset, the asset’s cost is reduced by an amount equal to the adjustment: s 27-85. If the decreasing adjustment occurs in an income year after the one in which the asset was first used or installed for any purpose, the asset’s opening adjustable value and cost are both reduced by that adjustment: s 27-85(3). If the reduction required by s 27-80 or s 27-85 is greater than the asset’s cost or opening adjustable value (as the case may be), the excess is included in the taxpayer’s assessable income (unless an exempt entity): ss 27-80(5) and 27-85(4). If the decreasing adjustment (that relates directly or indirectly to a depreciating asset) arises under Div 129 or Div 132 GST Act, the adjustment is assessable (unless the entity is an © 2017 THOMSON REUTERS

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exempt entity): s 27-87. This does not apply if s 27-95 applies to increase the termination value of the asset because of a decreasing adjustment: see [10 900]. Generally, decreasing adjustments arise if the taxpayer has overpaid the amount of GST or has underclaimed the amount of input tax credits due to, for example, a change in creditable purpose or the cancellation of a contract.

Increasing adjustment If the holder of a depreciating asset has an increasing adjustment for GST purposes (other than under Div 129 or Div 132 GST Act) that relates directly or indirectly to the asset, the asset’s cost and opening adjustable value are increased by the adjustment: s 27-90. If the increasing adjustment arises under Div 129 or Div 132 GST Act, the adjustment is deductible (except to the extent that the activity giving rise to the adjustment is of a private or domestic nature): s 27-92. Apportionment Section 27-110 provides for a ‘‘reasonable’’ apportionment of input tax credits, decreasing adjustments and increasing adjustments if they relate to 2 or more things (and at least one of them is a depreciating asset).

WORKING OUT AMOUNT OF DECLINE IN VALUE [10 500] Methods of calculating decline in value – prime cost or diminishing value The amount of the deduction allowed under Div 40 to the holder of a depreciating asset is the yearly decline in value of the asset (see [10 050]), subject to a reduction in certain circumstances: see [10 060]. The starting point for working out the decline in value is the cost of the asset: see [10 350]-[10 480]. Once the cost has been determined, it is necessary to decide whether to use the prime cost or diminishing value method to work out the amount of the decline in value. Note that an outright deduction is effectively available for certain depreciating assets costing less than $300: see [10 530]. Under the prime cost method (or straight-line method of depreciation), the cost of the asset is allocated over the effective life of the asset evenly: s 40-75. A fixed percentage is simply applied to the cost of the asset every year in working out the amount of the decline in value. The diminishing value method, on the other hand, applies a set percentage each year to the adjustable (or written down) value, ie the value of the depreciating asset ‘‘remaining’’ after deducting the decline in value to date from its original cost: see [10 540]. See Example [10 505.10] for a comparison of the 2 methods. Prime cost method If a taxpayer uses the prime cost method, the decline in value of the asset each year is calculated using the following formula in s 40-75(1): Asset’s cost × Days held × 100% 365 Asset’s effective life

‘‘Days held’’ are the number of days (from the start time: see [10 080]) in the income year the asset is held and is used, or installed ready for use, for any purpose, taxable or non-taxable (any days on which the asset is not used, or installed ready for use, for any purpose at all are ignored). Note that “365” in the formula does not become 366 to reflect a leap year. If the taxpayer did not incur expenditure that qualifies as the second element of the asset’s cost, the amount of decline in each year (provided the asset is held for the full year) should be the same. See [10 520] for situations where the prime cost method is modified (eg if the effective life is recalculated). 390

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[10 505]

Diminishing value method – post-9 May 2006 assets If the depreciating asset is a post-9 May 2006 asset, the write-off rate is 200% rather than 150%. In other words, the formula for calculating the decline in value of a post-9 May asset if the diminishing value method is used is (s 40-72): Base value × Days held × 200% 365 Asset’s effective life

The ‘‘base value’’ is: • if it is the income year in which the asset’s start time occurs (ie when it is first used, or installed ready for use, for any purpose: see [10 080]) – the cost of the asset; or • if it is a later income year – the opening adjustable value for that year (see [10 550]) plus the second element of the asset’s cost (if any) arising in that year. ‘‘Days held’’ has the same meaning as in the prime cost formula (and ‘‘365’’ in the formula does not become 366 to reflect a leap year). The decline in value of a depreciating asset for an income year cannot be more than the base value of the asset for that year: s 40-72(3). The following are post-9 May 2006 assets: • an asset which the taxpayer starts to hold under a contract entered into on or after 10 May 2006; • an asset which the taxpayer started to construct on or after 10 May 2006; and • an asset which the taxpayer started to hold in some other way (see [10 250]) on or after 10 May 2006. Integrity measures (in s 40-72 TPA) prevented taxpayers trying to take advantage of the introduction of the 200% diminishing value rate by, for example, splitting or merging assets or substituting a post-9 May 2006 asset for an asset that is not a post-9 May 2006 asset (see [10 500] of the Australian Tax Handbook 2016 for further details).

Diminishing value method – assets that are not post-9 May 2006 assets If a taxpayer uses the diminishing value method, and the depreciating asset is not a post-9 May 2006 asset (see below), the annual decline in value is calculated using the following formula (s 40-70): Base value × Days held × 150% 365 Asset’s effective life

The terms ‘‘base value’’ and ‘‘days held’’ have the same meaning as above. Note that the decline in value of a depreciating asset for an income year cannot be more than the base value of the asset for that year: s 40-70(3).

[10 505] Choice of method The holder of a depreciating asset can choose which method to use: s 40-65. Once the choice has been made, it cannot be changed: s 40-130(2). In certain circumstances, a taxpayer does not have a choice and Div 40 prescribes the method to be used: see [10 510]. The choice of using the prime cost or diminishing value method must be made by the day the income tax return is lodged for the income year to which the choice relates: s 40-130(1). Essentially that is the income year in which the asset starts to decline in value (generally when it is first used, or installed ready for use, for any purpose: see [10 080]). The Commissioner, however, has the discretion to grant an extension of time. Under the diminishing value method, the decline in value is higher in the earlier years but gradually tapers off towards the end of the asset’s effective life. In contrast, the prime cost method provides an equal decline in value each year. This means that, in the early years, the decline in value is higher under the diminishing value method (particularly if the 200% © 2017 THOMSON REUTERS

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write-off rate is available) but, in the later years, the decline in value is higher under the prime cost method. Clearly, the appropriate method depends very much on the individual circumstances of the taxpayer. For taxpayers with heavy start-up losses and a long period of recoupment, the prime cost method may be preferable due to the deferral of earlier deductions. EXAMPLE [10 505.10] Mara acquires a machine on 1 July Year 1 for $100,000 (it is a post-9 May 2006 asset). It has an effective life of 10 years. The prime cost rate to be used is 10% (ie 100%/10). The diminishing value is 20% (ie 200%/10). Assume the base value each year (for diminishing value purposes) is simply the opening adjustable value for that year (ie no second element of cost arises during the year). Prime cost Diminishing value $ $ Cost 100,000 100,000 Year 1 depreciation 10,000 20,000 Written down value 90,000 80,000 Year 2 depreciation 10,000 16,000 Written down value 80,000 64,000 Year 3 depreciation 10,000 12,800 Written down value 70,000 51,200 Year 4 depreciation 10,000 10,240 Written down value 60,000 40,960 Year 5 depreciation 10,000 8,192 Written down value 50,000 32,768

[10 510] Where choice not available The holder of a depreciating asset does not have a choice whether to use the prime cost or diminishing value method to work out the decline in value of the asset if: • the asset is acquired from an associate – the holder must use the same method as that previously used by the associate: s 40-65(2); or • the asset is acquired from a former holder (whether an associate or not) who was using the asset and after the acquisition the former holder continues to use that asset (ie the identity of the holder changes but the end user remains the same, eg a sale and leaseback) – the new holder must use the method that the former holder was using: s 40-65(3). If the former holder did not use a method, or the holder cannot readily find out the method used by the former holder, the diminishing value method must be used: s 40-65(4). The diminishing value method is used to work out the decline in value of assets in a low-value pool: see [10 770]. The diminishing value method cannot be used to work out the decline in value of the following depreciating assets (ss 40-70(2), 40-72(2)): • in-house software; • an item of intellectual property (but not film copyright taken out on or after 1 July 2004 which is part of the UCA system: see [10 150]); • a spectrum licence; and • a datacasting transmitter licence. 392

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[10 520]

If deductions are claimed under Div 40 for a depreciating asset that later qualifies for a notional deduction under the R&D provisions in Div 355 ITAA 1997 (see [11 020] and following), or if a depreciating asset first qualifies for a notional deduction under Div 355 but is later brought into the UCA system (ie Div 40), the taxpayer must continue to use the same method (ie prime cost or diminishing value) of calculating the decline in value/notional decline in value (as appropriate): s 40-65(6), (7). A similar rule applies if a depreciating asset qualified for a deduction (or offset) under the ITAA 1936 R&D concessions (which ceased to apply as from the 2011-12 income year): s 40-67 TPA.

[10 520] Modification of prime cost method The prime cost method (see [10 500]) is modified if (s 40-75(2)): • the taxpayer recalculates the depreciating asset’s effective life; • the second element of cost (ie costs incurred in relation to the asset after the taxpayer has started holding it: see [10 380]) arises in relation to the asset and it does not arise in the same income year as the asset’s start time (ie when the asset is first used, or installed ready for use, for any purpose: see [10 080]); • the asset’s opening adjustable value is reduced under s 40-90 as a result of debt forgiveness: see [10 470]; • there is a reduction to the asset’s opening adjustable value under s 40-365(5)(b) (about involuntary disposals: see [10 970]); • the opening adjustable value of the asset is modified under s 27-80(3A), s 27-80(4), s 27-85(3) or s 27-90(3) (adjustments for GST purposes: see [10 480]); • the opening adjustable value of the asset is reduced/increased by the amount of a short-term forex realisation gain/loss: see [32 300]; or • in certain circumstances where the remaining effective life of an Australian registered eligible vessel is recalculated (after 30 June 2012): see [11 700]. In these situations, the prime cost method is modified by replacing: • the asset’s cost with the asset’s opening adjustable value for the income year in which the change happens (see [10 550]) plus the second element of cost (if any) arising in that year: s 40-75(3); and • the asset’s effective life with the asset’s remaining effective life as at the start of the year in which the change happens or, if roll-over relief applies (see [10 940]), the time the balancing adjustment event happens for the transferor (taking into account any new effective life as re-assessed by the taxpayer): see [10 650]-[10 730]. EXAMPLE [10 520.10] Angela has a business making ceiling fans. On 1 July Year 1, she acquires (and installs ready for use) a machine for $100,000. It has an effective life of 8 years. The prime cost rate to be used is 12.5% (ie 100%/8). On 1 July Year 2 (ie the income year after the start time), Angela incurs expenditure ($5,000) which qualifies as second element of cost. On 1 July Year 4, she reassesses the machine’s effective life to be 12 years instead of the original 8 years. (Cents are ignored in the calculations below.) Prime cost $ Cost 100,000 Year 1 decline $100,000 × 100%/8 (12,500) Year 2 opening adjustable value 87,500 Second element cost incurred 5,000 © 2017 THOMSON REUTERS

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[10 530]

CAPITAL ALLOWANCES Prime cost $ 92,500 (11,562) 80,938 (11,562) 69,376 (7,708) 61,668

Basis on which decline is determined Year 2 decline in value $92,500 × 100%/8 Year 3 opening adjustable value Year 3 decline in value $92,500 × 100%/8 Year 4 opening adjustable value Year 4 decline in value $69,376 × 100%/9 Year 5 opening adjustable value

The prime cost formula is also modified if the following intangible assets have been acquired from a former holder, ie as opposed to the taxpayer creating the asset (s 40-75(5)): • a patent (standard, innovation or petty); • a registered design; • a licence (except one relating to a copyright or in-house software); • a spectrum licence; and • a datacasting transmitter licence. The formula is modified for the income year in which the intangible asset is acquired and also later income years: s 40-75(6). The formula is modified so that the effective life remaining as at the start of the income year in which the asset is acquired is used. EXAMPLE [10 520.20] Virginia acquires a standard patent from Monica (the original holder) for $20,000. Monica has held that patent for exactly 4 years before selling it to Virginia. A standard patent has an effective life of 20 years: see [10 710]. The decline in value of the patent to Virginia is calculated as follows: Days held 100% Asset’s cost × × 365 Remaining effective life (ie 16 years) 100% = $20,000 × 16 = $1,250

[10 530] Outright deduction for cost of assets The decline in value of certain depreciating assets is its cost, effectively granting an outright deduction for the cost of these assets: s 40-80. Other expenditure that does not form part of the cost of a depreciating asset may also be deducted immediately under Subdiv 40-H. Low-cost assets An immediate deduction is available for a low-cost asset (ie an asset that does not exceed $300) used predominantly to produce non-business income. This is because the decline in the value of that asset is its cost: s 40-80(2). However, if the asset is part of a set of assets that the taxpayer starts to hold in the same income year and the cost of the set (including that asset) is more than $300, the asset is not a low-cost asset and the decline in its value is not its cost. This is so even if each asset individually costs less than $300. Similarly, if the total cost of an asset and any other substantially identical assets that the taxpayer starts to hold in the same income year exceeds $300, the decline in the value of the 394

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[10 540]

asset is not its cost even though it may cost less than $300 in their own right: s 40-80(2)(c) and (d). This means that the asset has to be depreciated over its effective life. An outright deduction is available for a depreciating asset that is used for exploration or prospecting (ie the decline in value of the asset is its cost) in the circumstances specified in s 40-80(1): see [10 1270].

Administrative practice – low-cost capital items For business taxpayers that are not small business entities (see [25 020]), all capital items must be written-off over their effective life under Div 40 regardless of the cost (including low-value items). In certain cases, however, the Tax Office allows an immediate deduction for low-cost capital assets. Practice Statement PS LA 2003/8 sets out 2 methods that business taxpayers can use to determine if expenditure incurred to acquire low-cost tangible assets can be deducted immediately. 1. Threshold rule – expenditure of $100 (inclusive of GST) or less incurred by a taxpayer to acquire a tangible asset in the ordinary course of carrying on a business will be assumed to be revenue in nature (for income tax purposes) and therefore deductible in the year of expenditure (see PS LA 2003/8 for examples). Because the $100 threshold includes GST, for most business taxpayers it will effectively be $90.91 as the GST component is generally not deductible: see [9 420]. 2. Sampling rule – a taxpayer with a low-value pool under Subdiv 40-E (see [10 760]) may use statistical sampling to determine the proportion of the total purchases on low-cost tangible assets (ie costing less than $1,000) that are revenue expenditure. There are 2 options available to the taxpayer to calculate the sample: (a) the first option is to extract a representative percentage sample from the eligible purchases of an income year (as a general rule, 10% of eligible purchases), and from this sample determine the percentage that is deemed to be revenue; (b) the second option allows the taxpayer to choose a sample that comprises all eligible purchases for a period (eg 2 months) in an income year that is representative of the capital and revenue purchases for the business over the course of the year. The percentage that is deemed to be revenue can be determined from this sample. The proportion established through sampling will be able to be used for up to 3 years, as long as it remains representative of the total population to which it is applied (otherwise re-sampling will be required). The $100 threshold rule can be used in the sampling process. Note that the Practice Statement does not apply to expenditure incurred in establishing a business or building up a significant stockpile of assets, nor to a variety of assets, including those held under a lease, hire purchase or similar agreement, certain assets included in an assets register, trading stock, spare parts and assets that are part of another composite asset (see paras 4 and 5).

Other expenditure An immediate deduction is available under Subdiv 40-H for expenditure on: • exploration or prospecting (with certain exceptions): see [29 030]; • rehabilitation of mining or quarrying sites: see [29 040]; • paying petroleum resource rent tax: see [29 050]; and • environmental protection activities: see [11 610]. [10 540] Adjustable value The adjustable value of a depreciating asset at a particular time is (s 40-85(1)): • if it has not yet been used or installed for any purpose – its cost; or © 2017 THOMSON REUTERS

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• if the time is in the income year in which it is first used or installed ready for use for any purpose – its cost less its decline in value up to that time; or • if the time is in a later income year – the asset’s opening adjustable value (ie depreciated value at the end of the previous income year: see [10 550]) plus any amounts included in the second element of its cost for that income year up to that time (ie any additional expenditure incurred on the asset: see [10 380]) less its decline in value for that year up to that time. Note that: • the commercial debt forgiveness provisions can reduce the opening adjustable value of an asset: see [10 470]; and • the adjustable value of a depreciating asset that is put to a tax preferred use may be modified by s 250-285: see [33 100].

[10 550] Opening adjustable value The opening adjustable value of an asset for an income year is simply the asset’s adjustable value at the end of the previous income year (the closing adjustable value): s 40-85(2). In other words, it is the depreciated value at the end of the previous income year brought forward to the current income year. The following provisions may modify the opening adjustable value of a depreciating asset: • Subdiv 27-B (GST input tax credits: see [10 480]); • s 40-90(3) (debt forgiveness: see [10 470]); • s 40-285(4) (ceasing to use a depreciating asset: see [10 850]); and • s 40-365(5)(b) (roll-over relief for involuntary disposals: see [10 970]). The opening adjustable value of a depreciating asset may also be adjusted if there is a short-term forex realisation gain or loss under Subdiv 775-B: see [32 300]. If an understatement in the first element of cost of a depreciating asset is discovered, the opening adjustable value of the asset must be recalculated for all affected income years using the correct cost of the asset, even if it is not possible to amend the assessment for an income year (or years) to reflect the recalculated decline in value of the asset because the time allowed for the amendment has expired (see [47 130]-[47 170]): see ATO ID 2008/40.

[10 560] In-house software If expenditure on in-house software has been allocated to a software development pool, Subdiv 40-E applies exclusively to determine the amount of the deduction and the decline in value of the pool: see [10 790]-[10 810].

PRO RATA DECLINE IN VALUE AND DEDUCTION [10 600] Year of acquisition/disposal The decline in value of a depreciating asset is apportioned if the taxpayer holds the asset for only part of the income year, eg in the year of acquisition and/or the year of disposal: ss 40-70 and 40-75. Note that holding a depreciating asset does not mean that the asset starts to decline in value immediately. A depreciating asset starts to decline in value when it is first used, or installed ready for use, for any purpose: see [10 080]. Therefore, if the asset only starts to decline in value some time after the taxpayer has held it, an apportionment is made from that time and not from when the taxpayer started to hold the asset. 396

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[10 650]

As the decline in value determines the amount of the deduction, an apportionment of the decline in value clearly affects the amount of the deduction.

[10 610] Asset used partly for non-taxable purpose If a depreciating asset is used both for a taxable purpose (see [10 070]) and a non-taxable purpose, the deduction otherwise allowable in respect of the decline in value of the asset must be reduced to reasonably reflect the non-taxable use: s 40-25(2). A typical example is if a motor vehicle is used partly for business purposes and partly for private or domestic purposes. Another example is if a depreciating asset is used in part to produce exempt income. It should be noted that s 40-25(2) actually apportions the amount of the deduction, whereas ss 40-70 and 40-75 (see [10 600]) apportion the amount of the decline in value (according to the number of days in the income year the asset is held). Thus, when working out the amount properly deductible, whether the decline in value needs to be apportioned should be considered before any adjustment is made under s 40-25(2) for non-taxable use. A depreciating asset can still be allocated to a low-value pool even if it is used only partly for a taxable purpose: see [10 760]. EXAMPLE [10 610.10] Maki acquires a computer on 12 July in Year 1 for $10,000. 70% of its use is to produce assessable income and 30% of its use is for private purposes. Assuming that the diminishing value method is used and the computer has an effective life of 5 years, the deductible amount for Year 1 is calculated as follows: Decline in value = $10,000 × 354 × 200% = $3,879 365 5 yrs Deductible amount = $3,879 × 70% = $2,715

EFFECTIVE LIFE [10 650] Determining effective life The effective life of a depreciating asset determines the rate at which the asset declines in value: ss 40-70 and 40-75. In essence, the cost of a depreciating asset is deducted over its effective life: s 40-20. In most cases, a taxpayer can either self-assess the effective life of a depreciating asset under s 40-105 (see [10 660]) or use the effective life determined by the Commissioner: see [10 670]. The choice is made for the income year in which the asset is first used, or installed ready for use, by the taxpayer for any purpose: s 40-95(3). The choice must be made by the day the income tax return is lodged for the income year to which the choice relates: s 40-130(1). The Commissioner, however, has the discretion to grant an extension of time. These rules also apply to second-hand depreciating assets, subject to the rules discussed at [10 690] (assets acquired from an associate) and [10 700] (holder of asset changes but user remains the same). Note that an asset’s physical life is not necessarily its effective life. If a taxpayer chooses to use the effective life determined by the Commissioner, the asset’s effective life may be capped (ie a life shorter than the effective life determined by the Commissioner may apply instead): see [10 680]. In certain circumstances, the taxpayer may recalculate the effective life of a depreciating asset: see [10 730]. © 2017 THOMSON REUTERS

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The effective life of certain intangible assets, eg intellectual property, cannot be self-assessed: see [10 710].

[10 660] Self-assessing effective life A taxpayer who chooses to self-assess the effective life of a depreciating asset must estimate how long (including fractions of a year) it can be used by an entity for a taxable purpose, for the purpose of producing exempt income or non-assessable non-exempt income or for the purpose of conducting R&D activities: s 40-105(1A). The effective life is determined when the taxpayer first uses the asset or has it installed ready for use: s 40-105(3). If the taxpayer starts to use an asset again, having previously stopped using it never expecting to use it again, the effective life is determined when the taxpayer starts using the asset again: see the definition of ‘‘start time’’ in s 40-60: see [10 080]. In determining the asset’s effective life, the taxpayer must (s 40-105(1B)): • take into account the wear and tear the taxpayer reasonably expects from the taxpayer’s expected circumstances of use of the asset; and • assume that the asset will be maintained in reasonably good order and condition. The fact that the taxpayer may, for commercial reasons, intend to dispose of the asset before the end of its useful life (eg as occurs on the trade-in of a motor vehicle) is disregarded. However, a shorter effective life must be adopted if the taxpayer concludes that the asset is likely to be scrapped, sold for scrap or abandoned before the end of what would otherwise be the effective life: s 40-105(2). In other words, s 40-105(2) allows a taxpayer to factor in obsolescence that can be reasonably predicted (eg because of experience in the particular industry). Note that if it is reasonably likely that an asset will be used for conducting R&D activities, reasons attributable to the technical risk in conducting such activities are disregarded in applying s 40-105(2). In certain circumstances, a taxpayer may choose a new effective life: see [10 730]. Otherwise, a self-assessed effective life is irrevocable: s 40-130(2). If a taxpayer self-assessed the effective life of a depreciating asset used in conducting R&D activities before the 2011-12 income year, the same effective life is used for 2011-12 and later income years (ie when the R&D concessions in Div 355 apply: see [11 020]), unless the effective life is recalculated (see [10 730]): s 40-105 TPA. Note that a taxpayer cannot self-assess the effective life of certain intangible assets, for example intellectual property: see [10 710].

[10 670] Using Commissioner’s effective life determination As an alternative to self-assessing the effective life of a depreciating asset, a taxpayer may adopt the effective life determined by the Commissioner: s 40-95(1). The effective life of many depreciating assets, as determined by the Commissioner, is set out in a series of rulings, the latest of which is Ruling TR 2016/1 (replacing Ruling TR 2015/2). The Commissioner’s determination of the effective life of a depreciating asset is based on similar assumptions that are made in self-assessing the effective life of an asset (see [10 660]): s 40-100(4)-(6). The rulings contain a non-exhaustive list of the factors the Commissioner considers to be relevant in determining the effective life of an asset. Only normal industry practice is considered. From time to time, the Commissioner revises the determination of the effective life of a depreciating asset, eg to take account of technological advances or industry practice. If this happens, the ruling is updated (see the Tax Office’s website for a list of the effective life reviews being undertaken). To provide taxpayers with certainty in the event of the Commissioner revising the determination, the taxpayer uses the determination that is in force when entering into the contract to acquire the asset, or otherwise acquiring or starting to construct it (s 40-95(2)), provided the asset is first used, or installed ready for use, for any 398

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[10 680]

purpose within 5 years. Otherwise, the taxpayer must use the determination that is in force at the start time (ie when the asset is first used or installed ready for use for any purpose: see [10 080]). If the asset is plant (see [10 160]) and it was acquired under a contract entered into, or it was otherwise acquired or its construction started, before 11.45 am on 21 September 1999 AEST, the taxpayer can rely on the determination that was in force at the relevant acquisition/construction time, regardless of whether the taxpayer uses or installs the asset ready for use within 5 years: s 40-95(2). Note that a determination made by the Commissioner can be retrospective in 2 circumstances (s 40-100(3)): • there was previously no determination in force for the particular depreciating asset; or • the new determination specifies a shorter effective life. Note also that a determination made before the 2011-12 income year in relation to an asset used for conducting R&D activities continues to apply for 2011-12 and later income years (until a new determination is made): s 40-105 TPA.

[10 680] Assets with capped effective life The effective lives of certain depreciating assets are capped under s 40-102 (ie the effective life cannot be greater than the capped life). The capped life applies if (s 40-102(2)): • the taxpayer chooses to use the Commissioner’s effective life determination (ie the taxpayer cannot self-assess the effective life): see [10 650]. Thus a taxpayer may self-assess the asset’s effective life if that provides a more appropriate effective life; • a capped life is in force at the relevant time (see below); and • the capped life is shorter than the Commissioner’s determined effective life, otherwise the determined effective life applies.

Assets that qualify for capped effective life Broadly, there are 2 categories of assets that qualify for a capped effective life. One is industry specific and the other is available generally. The following depreciating assets have a capped effective life regardless of the industry in which they are used: s 40-102(4). Item 1. 2. 3. 4. 5. 6. 7. 8. 9.

Kind of depreciating asset Aeroplane used predominantly for agricultural spraying or agricultural dusting Aeroplane to which item 1 does not apply Helicopter used predominantly for mustering, agricultural spraying or agricultural dusting Helicopter to which item 3 does not apply Bus with a gross vehicle mass of more than 3.5 tonnes Light commercial vehicle with a gross vehicle mass of 3.5 tonnes or less and designed to carry a load of one tonne or more Minibus with a gross vehicle mass of 3.5 tonnes or less and designed to carry 9 or more passengers Trailer with a gross vehicle mass of more than 4.5 tonnes Truck with a gross vehicle mass of more than 3.5 tonnes (other than a truck used in mining operations which is not of a kind that can be registered to be driven on a public road in the place in which the truck is operated)

Period 8 years 10 years 8 years 10 years 7.5 years 7.5 years 7.5 years 10 years 7.5 years

As regards the depreciating assets listed in items 5-9 above, the effective life is only capped if the start time (see [10 080]) occurs on or after 1 January 2005. ‘‘Gross vehicle mass’’ (for the purposes of Items 5-9 above) means the road weight specified by the © 2017 THOMSON REUTERS

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manufacturer of the vehicle as the maximum design weight capacity of the vehicle. If there is no such specification, the ‘‘gross vehicle mass’’ is the sum of the weight of the vehicle and the maximum load for which the vehicle was designed. The following depreciating assets have a capped life only if they are of a particular kind and used in a particular industry (s 40-102(5)). Item 1. 2. 3. 4. 5. 6.

7. 8.

Kind of depreciating asset Gas transmission asset Gas distribution asset Oil production asset (other than an electricity generation asset or an offshore platform) Gas production asset (other than an electricity generation asset or an offshore platform) Offshore platform Asset (other than an electricity generation asset) used to manufacture condensate, crude oil, domestic gas, liquid natural gas or liquid petroleum gas but not if the manufacture occurs in an oil refinery Harvester Tractor

Industry in which the asset is used Gas supply Gas supply Oil and gas extraction Oil and gas extraction Oil and gas extraction Petroleum refining

Primary production Primary production

Period 20 years 20 years 15 years 15 years 20 years 15 years

62/3 years 62/3 years

The effective life of an Australian registered eligible vessel is capped at 10 years in certain circumstances: see [11 700]. A new effective life applies when a taxpayer starts or ceases to apply the statutory capped life to a particular vessel: see [11 700].

Relevant time The capped effective life of a depreciating asset that applies is the effective life in force at the ‘‘relevant time’’: s 40-102(2)(c). This is generally the asset’s start time (ie when first used, or installed ready for use, for any purpose: see [10 080]). However, the ‘‘relevant time’’ will be the time when the taxpayer entered into a contract to acquire the asset, otherwise acquired it or started to construct it if its start time occurs within 5 years of that time and one of the following applies (s 40-102(3)(b)): • the capped life is shorter than the capped life in force at the asset’s start time; • there is no capped life in force at the asset’s start time, but there is a capped life in force at the time the taxpayer entered into the contract to acquire the asset or when construction started.

[10 690] Assets acquired from associates If a depreciating asset is acquired from an associate, s 40-95(4) effectively requires the new holder to use the effective life used by the associate. If the associate was depreciating the asset using the diminishing value method, the new holder must use the same effective life that the associate was using. If the associate was using the prime cost method, the new holder must use an effective life equal to the remaining effective life that the associate was using. It should be noted that if the taxpayer acquires from an associate a depreciating asset that has a capped effective life (see [10 680]), the taxpayer does not simply inherit the capped life. Rather, the taxpayer must decide whether the use of the asset when he or she starts to hold it satisfies the appropriate use requirements (if any) for that capped life: s 40-95(4A) to (4C). Obtaining information from associate If a taxpayer acquires a depreciating asset from an associate, the taxpayer may require the associate (by notice) to provide information about the method used by the associate to work out the decline in value of the asset and the effective life used by the associate: s 40-140(1). 400

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If the depreciating asset has a capped effective life asset (see [10 680]), the taxpayer can require the associate to provide information about the effective life that the associate would otherwise have used and the relevant time that applied to the associate (see [10 680]). The notice must be given by the taxpayer within 60 days of acquiring the asset and the associate must be allowed at least 60 days to provide the information: s 40-140(2). There is a maximum penalty of 10 penalty units for failing to comply with the notice. If the associate is a partnership, a notice may be given to any of the partners, but the obligation to comply falls upon each of the partners and may be discharged by any of them. Only one notice can be given in relation to the same depreciating asset.

[10 700] Holder of asset changes but user remains the same If there is a change in the holder of a depreciating asset but the user remains the same (or an associate of the former user now uses the asset), s 40-95(5) effectively requires the new holder to use the effective life that the former holder was using. This would apply, for example, if there is a sale and leaseback of an asset. If the former holder was using the diminishing value method, the holder who acquires the asset must use the same effective life that the former holder was using: s 40-95(5)(c). If the former holder used the prime cost method, the new holder must use an effective life equal to the remaining effective life that the former holder was using: s 40-95(5)(d). If the former holder did not use an effective life, or the new holder cannot readily find out which effective life the former holder was using, or would have used if the capped life had not applied (see [10 680]), the new holder must use an effective life determined by the Commissioner, ie the new holder cannot self-assess the asset’s effective life: s 40-95(6). This necessarily assumes that the Commissioner has a determination in force in relation to the type of depreciating asset in question. If the taxpayer acquires a depreciating asset with a capped life (see [10 680]), the taxpayer does not simply inherit the capped life. Rather, the taxpayer must decide whether the use of the asset when they start to hold it satisfies the appropriate use requirements (if any) for that capped life: see s 40-95(5A) to (5C). [10 710] Intellectual property and other intangible assets The effective life of certain intangible depreciating assets is that specified in the table in s 40-95(7) and the holder cannot choose to self-assess the effective life: s 40-105(4). Type of intangible asset Standard patent Innovation patent Petty patent Registered design Copyright (other than film copyright)

Effective life 20 years 8 years 6 years 15 years The shorter of: (a) 25 years from acquiring the copyright; or (b) the period until the copyright ends.

Effectively the maximum life of a copyright is 25 years A licence (except one relating to copyright or in-house software) A licence relating to copyright (other than film copyright)

The term of the licence The shorter of: (a) 25 years from becoming the licensee; or (b) the period until the licence ends.

Effectively the maximum life of a licence is 25 years In-house software © 2017 THOMSON REUTERS

5 years (4 years for pre-1 July 2015 software): see [10 1220].

401

[10 730]

CAPITAL ALLOWANCES

Type of intangible asset Spectrum licence Datacasting transmitter licence Telecommunications access right

Effective life The term of the licence 15 years The term of the right

Note that draft legislation issued in April 2016 (available on the Treasury website) will give taxpayers the option to depreciate the intangible assets listed above over their economic life (applicable to assets acquired on or after 1 July 2016). The effective life of an IRU (indefeasible right to use) is the effective life of the telecommunications cable over which the IRU is granted: s 40-95(9). The effective life of other intangible depreciating assets (excluding mining, quarrying and prospecting rights) cannot be longer than the term of the asset as extended by any reasonably assured extension or renewal of that term: s 40-95(8). The effective life of a mining, quarrying or prospecting right, or mining, quarrying or prospecting information, cannot be self-assessed: see further [10 1270].

[10 730] Recalculating effective life A taxpayer may recalculate the effective life of a depreciating asset (with certain exceptions) at any time after the end of the first income year for which a decline in value deduction is claimed by the taxpayer, if changed circumstances relating to the nature of the use of the asset have made the effective life inappropriate: s 40-110(1). Changed circumstances warranting a recalculation of the effective life could include: • the use of the asset by the taxpayer is more or less rigorous than expected (or anticipated by the Commissioner’s determination); • the plant will be scrapped because there is a downturn in demand for the goods or services the asset is used to produce; • legislation prevents the asset’s continued use; • changes in technology make the asset redundant; and • there is an unexpected demand, or lack of success, for a film. A taxpayer can recalculate the effective life regardless of whether it is using the Commissioner’s effective life or it has self-assessed the effective life. A taxpayer must recalculate the effective life of a depreciating asset (that is not a mining, quarrying or prospecting right) under s 40-110(2) or (3) if the cost of a depreciating asset has increased by 10% in any year and the taxpayer: • self-assessed its effective life; • used the Commissioner’s effective life (or the capped life) and the prime cost method; or • is using an effective life that its associate was using (in circumstances where the asset was acquired from an associate: s 40-95(4) to (4C)) or the former holder was using (in circumstances where the holder changes but the user remains the same: s 40-95(5) to (5C)). Section 40-110(1) and (2) also apply to a transition entity (under Div 58: see [10 430]): ATO ID 2006/288 and ATO ID 2006/289. The effective life of the following depreciating assets cannot be recalculated: • plant acquired before 1 July 2001, or the construction of which was commenced before that date: ss 40-12, 40-15 TPA; and • intangible assets (eg intellectual property and in-house software) listed in the table in s 40-95(7) (see [10 710]): s 40-110(5). 402

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[10 760]

However, draft legislation issued in April 2016 will allow the taxpayer to recalculate the effective life of an intangible asset if the effective life the taxpayer has been using is no longer accurate because of changed circumstances relating to the nature of the asset’s use. Recalculating the effective life of an intangible asset will be mandatory if the cost of the asset increases by at least 10% in a later income year or, if the taxpayer is using an effective life because of the associate or same user rule in s 40-95(4) or 40-95(5) (see above), the asset’s cost is increased by at least 10% in the same income year as the one in which the taxpayer started to hold the asset. See [10 1270] for the rules governing the recalculation of the effective life of a mining, quarrying or prospecting right, or mining, quarrying or prospecting information.

POOLING [10 750] Pooling – overview Certain depreciating assets and expenditure can be pooled, with the result that the decline in value is calculated for the pool instead of the individual assets. The pooling arrangements that are in place under Div 40 are: • low-value pools – low-cost assets and low-value assets can be allocated to a low-value pool under Subdiv 40-E; • software development pool – expenditure on in-house software can be allocated to a software development pool under Subdiv 40-E; and • certain expenditure associated with certain projects can be pooled under Subdiv 40-I: see [10 1050]-[10 1100]. Pooling arrangements were introduced in order to simplify the administrative burden associated with the need to track and calculate the decline in value for expenditure incurred on assets separately. There are special pooling rules for small business entities that choose to apply the capital allowance rules in Subdiv 328-D: see [25 120].

[10 760] Pooling of low-cost and low-value assets Taxpayers have the choice of allocating ‘‘low-cost’’ and ‘‘low-value’’ assets to a low-value pool: s 40-425. The low-value pool is then treated as a single item and its decline in value worked out using the diminishing value method as if all assets allocated to the pool had an effective life of 4 years: s 40-440. A ‘‘low-cost’’ asset is a depreciating asset (other than a horticultural plant) that costs less than $1,000: s 40-425(2). It is the cost at the end of the income year in which the taxpayer starts to use the asset, or has it installed ready for use, for a taxable purpose that is relevant in determining whether it is a low-cost asset (and not the cost when acquired), eg see ATO ID 2004/115. If a depreciating asset is jointly owned by 2 or more taxpayers, the taxpayer may allocate their particular interest in the asset to the low-value pool if the value of that interest is less than $1,000, irrespective of the cost of the asset (this is because s 40-35 effectively treats each co-owner’s interest in the asset as a separate depreciating asset: see [10 260]). An asset costing $300 or less that is used predominantly to produce non-business income and which can be immediately written off under s 40-80(2) (see [10 530]) cannot be allocated to the low-value pool. Once a choice is made to allocate a low-cost asset to a low-value pool, all low-cost assets acquired in that income year and future years must be allocated to the pool and those assets must remain in the pool once allocated: s 40-430. The choice of allocating a low-cost asset to a low-value pool is made for the income year in which the taxpayer starts to use it, or has it installed ready for use, for a taxable purpose: s 40-425(1). © 2017 THOMSON REUTERS

403

[10 770]

CAPITAL ALLOWANCES

A ‘‘low-value’’ asset is a depreciating asset (other than a horticultural plant) that has been depreciated using the diminishing value method (see [10 500]), has an opening adjustable value (see [10 550]) of less than $1,000 in an income year and is not a ‘‘low-cost’’ asset: s 40-425(5). This is because taxpayers using the diminishing value method calculate their deductions based on an ever-declining balance for each asset and, by allowing assets with a written down value of less than $1,000 to be allocated to the pool, the calculation process is simplified. An asset that has not been used for a taxable purpose can still be allocated to a low value pool: ATO ID 2006/215. Unlike low-cost assets, taxpayers can select low-value assets on an item-by-item basis as to whether or not they should be allocated to the pool. In other words, although the taxpayer may have decided to allocate a low-value asset to the pool, it does not have to allocate other low-value assets to the pool. Small business entities that choose to apply the Subdiv 328-D capital allowance rules (see [25 110]) cannot allocate a depreciating asset to a Div 40 low-value pool: s 40-425(7). A depreciating asset cannot be allocated to a low-value pool if the taxpayer is entitled to the R&D tax offset under Div 355 in respect of the asset, or if the taxpayer was entitled to a deduction under the pre-2011-12 R&D provisions in the ITAA 1936 (or would have been so entitled if it had not chosen the R&D offset): s 40-425(8) ITAA 1997 and s 40-430 TPA. Assets depreciated under the pre-1 July 2001 provisions (former Div 42) can be allocated to a low-value pool. Note the Tax Office’s administrative practice of allowing a taxpayer with a low-value pool to use statistical sampling to determine the proportion of the total purchases on low-cost tangible assets that are revenue expenditure (the ‘‘sampling rule’’): see [10 530].

[10 770] Calculating decline in value of assets in low-value pool The decline in value of a low-value pool is worked out using the diminishing value method and on the assumption that the assets allocated to that pool have an effective life of 4 years. Before allocating a depreciating asset to the low-value pool, a taxpayer must estimate the percentage of the asset’s future use for a taxable purpose (see [10 070]): s 40-435. This percentage is known as the taxable use percentage. Depreciation of a low-value pool is calculated in the following manner: ss 40-435 and 40-440. Step 1: Step 2: Step 3:

Step 4:

Take 18.75% of the taxable use percentage of the cost of each low-cost asset allocated to the pool for that year. Add to the result from step 1, 18.75% of the taxable use percentage of any current year amounts included in the second element of cost of assets already allocated to the pool in an earlier income year and low-value assets allocated to the pool in the current year. Add to the result from step 2, 37.5% of the sum of the closing pool balance for the previous income year and the taxable use percentage of the opening adjustable values of low-value assets (at the start of the income year) that were allocated to the pool for that year. See [10 550] for meaning of ‘‘opening adjustable value’’. The result from step 3 is the decline in value of the depreciating assets in the pool and is fully deductible.

Essentially the depreciation deduction for depreciating assets allocated to the low-value pool is: • 18.75% of the taxable use percentage of the total cost of low-cost assets allocated to the pool during the income year. This is half of the 4-year effective life diminishing value rate of 37.5% which recognises that assets may have been acquired and allocated to the pool throughout the income year; • 18.75% of the taxable use percentage of any additional expenditure incurred in relation to assets that are already in the pool and low-value assets allocated to the pool during the income year. Again half the normal rate is allowed in recognition that this expenditure may have been incurred throughout the income year; and 404

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[10 780]

• 37.5% of the closing pool balance for the previous income year and 37.5% of the taxable use percentage of the opening adjustable value (see [10 550]) of low-value assets allocated to the pool during the income year (depreciated at the normal 37.5% rate because these amounts are already in the pool from the start of the year, or are in relation to items that existed from the start of the year and get no other write off for the year). EXAMPLE [10 770.10] Smithers Pty Ltd has a closing (low-value) pool balance of $5,000 at the end of Year 1. On the following 2 August, Smithers acquires a table costing $800 which has a taxable use percentage of 60%. This low-cost asset is allocated to the low-value pool. At the same time, Smithers has a chair (with a taxable use percentage of 100%) that has an opening adjustable value of $900 as at the start of Year 2 using the diminishing value method. Smithers decides to allocate this low-value asset to the pool. The pool’s decline in value for Year 2 is: Asset Table (low-cost asset) allocated to the pool for Year 2 Chair (low-value asset) allocated to the pool for Year 2 Closing pool balance from Year 1 Decline in value

Calculation 18.75% × ($800 × 60%) 37.5% × $900 37.5% × $5,000

Amount $90 $338 $1,875 $2,303

The closing pool balance is the sum of (s 40-440(2)): • the closing pool balance for the previous income year; • the taxable use percentage of the costs (including the second element of cost) of low-cost assets allocated to the pool for that year; • the taxable use percentage of the opening adjustable values of any low-value assets allocated to the pool for that year as at the start of that year; and • the taxable use percentage of any amounts included in the second element of the cost for the income year of: – assets already allocated to the pool in an earlier income year; and – low-value assets allocated to the pool for the current year, less the decline in value of the depreciating assets in the pool worked out above, less the decline in value of the pool.

[10 780] Sale or scrapping of assets in low-value pool If a balancing adjustment event happens to a depreciating asset in a low-value pool, eg the asset is disposed of or destroyed or the taxpayer stops using the asset and expects never to use it again (see [10 850]), the closing pool balance (for the year in which the balancing adjustment event happens) is reduced (but not below zero) by the asset’s termination value: s 40-445(1). If there was an estimate of non-taxable use of the asset when it was allocated to the pool, the termination value is reduced by the relevant percentage of non-taxable use. Thus, for example, if the taxpayer estimated that 25% of the use of a depreciating asset costing $800 would be for private purposes and it is sold for $400, the closing pool balance is reduced by $300 ($400 × 75%). In most cases, the termination value is the amount the taxpayer receives, or is taken to have received, from the balancing adjustment event (eg the sale price if the asset is sold): see further [10 890]. If the sum of the termination values (as reduced by the relevant percentage of any non-taxable use) for the income year exceeds the closing pool balance, the excess is included in assessable income: s 40-445(2). If the sum of the termination values is less than the closing © 2017 THOMSON REUTERS

405

[10 790]

CAPITAL ALLOWANCES

pool balance (including after the taxpayer ceases to hold all the assets allocated to the pool), the taxpayer continues to work out their decline in value (eg see ATO ID 2007/117). These rules also apply to pre-CGT assets allocated to a low-value pool: see ATO ID 2003/1132. Note that the automatic roll-over relief available under s 40-340 (see [10 940]) does not apply in relation to assets allocated to a low-value pool (see ATO ID 2003/1133).

[10 790] Pooling of software development expenditure There is a pooling option under Subdiv 40-E for ‘‘in-house software’’. This is defined in s 995-1 as computer software, or a right to use computer software, that is acquired, developed or commissioned mainly for the taxpayer to use to perform the functions for which it was developed (eg writing software to support a website and acquiring a software package to enable the purchaser to build a website). In-house software is specifically listed in s 40-30(2) as a depreciating asset (unless it is trading stock). Expenditure incurred in acquiring or developing a commercial website for a new or existing business is treated as expenditure on ‘‘in-house software’’, to the extent the expenditure relates directly to the commercial website and the commercial website is mainly used by the business for interaction with customers (that is, any copyright in the website is not itself exploited for profit) (and is not deductible under some other provision): see Ruling TR 2016/3. The ruling considers that in-house software includes: • software integrated into a commercial website to enable the website owner to interact with the user (provided any independent benefit to the user is no more than incidental to the interaction); • software provided on a commercial website for installation on the user’s device to provide a user interface for interacting with the business; and • content on a website which is incidental to the website and not an asset having value separate from the website. Certain application software made available through a commercial website and member profile information and content entered onto social media is not considered to be in-house software. Software is not ‘‘in-house software’’ if expenditure on the software is deductible under any provision of the income tax legislation outside Div 40 (the UCA system) or Div 328 (small business entities: see [25 100]), eg under s 8-1. In ATO ID 2010/14, annual software licence fees were considered to be expenditure of a revenue nature and thus deductible under s 8-1. A right to use software includes a licence to use software and the acquisition of a right to use software if the licence is held by a separate entity (eg if a company’s information technology is outsourced to a service provider). If software is not in-house software, it will be depreciable under the general rules in Div 40 if it is an item of intellectual property (and thus a depreciating asset: see [10 150]).

Allocating software to a pool Subdivision 40-E contains special rules allowing a taxpayer to choose (under s 40-450) to allocate expenditure on developing or commissioning in-house software to a software development pool, rather than writing off the expenditure under the general rules in Div 40. Expenditure is only eligible to be allocated to the pool if the taxpayer intends to use the software solely for a taxable purpose: s 40-450(3). Expenditure on acquiring in-house software or a right to use in-house software cannot be allocated to a pool and is deductible under Div 40 in accordance with the general rules: see further [10 1220]. If a taxpayer chooses the pooling option, all expenditure on developing or commissioning in-house software incurred in that year and subsequent years must be pooled (the choice is irrevocable): s 40-450(2). See [10 800] for the rate at which the expenditure is deducted. 406

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CAPITAL ALLOWANCES [10 800]

There must be a separate pool for each income year for which the taxpayer incurs expenditure on in-house software: s 40-450(4). This recognises the fact that expenditure will be allocated to the pool in different years if the taxpayer has multiple software development projects on foot at any time: see Example [10 800.10]. Thus there will be a maximum of 4 pools for ‘‘pre-1 July 2015” expenditure’’ and 5 pools for ‘‘post-30 June 2015’’ expenditure (see [10 800]). The choice to allocate expenditure to a pool must be made by the day the taxpayer lodges its income tax return for the income year to which the choice relates, although the Commissioner may grant an extension of time: s 40-130(1). The choice, once made, applies to that income year and all future income years: s 40-130(2).

Moneys received in relation to pooled software Any consideration received in relation to the software on which development expenditure has been allocated to the software development pool is assessable income unless roll-over relief is available under s 40-340(3) (see [10 950]): s 40-460. [10 800] Deduction for pooled software expenditure The rate at which expenditure on developing ‘‘in-house software’’, that is allocated to a software development pool during an income year, is deductible depends on when the expenditure was incurred. If the expenditure is incurred in an income year commencing on or after 1 July 2015 (ie ‘‘post-30 June 2015’’ expenditure), the expenditure is deductible as follows (s 40-455): Income year Year 1 Year 2 Year 3 Year 4 Year 5

Deductible expenditure Nil 30% 30% 30% 10%

If the expenditure was incurred in an income year commencing before 1 July 2015 (ie ‘‘pre-1 July 2015’’ expenditure), the expenditure is deductible as follows (s 40-455): Income year Year 1 Year 2 Year 3 Year 4

Deductible expenditure Nil 40% 40% 20%

It can be seen from the table that no deduction is allowed for the income year in which the expenditure is incurred (whether ‘‘pre-1 July 2015’’ or ‘‘post-30 June 2015’’ expenditure). EXAMPLE [10 800.10] Carvalhal Pty Ltd has a 30 June balance date and chooses in June Year 1 to allocate software development expenditure (incurred after 1 July 2015) to the software development pool (years are calendar years). Date May Year 2 November Year 2 January Year 3

Project Project Cyrus Project Orange Project Cyrus & P3

Expenditure $24,000 $5,000 $2,000

The allowable deductions are: Year ended 30 June Year 2 30 June Year 3

Pool Pool 1 Pool 1 Pool 2*

© 2017 THOMSON REUTERS

Expenditure $24,000 $24,000 $7,000

Rate 0% 30% 0%

Amount $0 $7,200 $0

407

[10 810]

CAPITAL ALLOWANCES

Year ended 30 June Year 4

Pool Expenditure Rate Amount Pool 1 $24,000 30% $7,200 Pool 2 $7,000 30% $2,100 30 June Year 5 Pool 1 $24,000 30% $7,200 Pool 2 $7,000 30% $2,100 30 June Year 6 Pool 1 $24,000 10% $2,400 Pool 2 $7,000 30% $2,100 30 June Year 7 Pool 2 $7,000 10% $700 * Pool 2 comprises expenditure incurred in the income year ending 30 June Year 3 ($5,000 and $2,000).

[10 810] Effect of GST on pooled assets Subdivision 27-B deals with the interaction between Div 40 and GST. Section 27-100 in particular deals with pooled depreciating assets (including those pooled under Div 328, ie a small business pool: see [25 120]). Essentially, adjustments are required if the taxpayer is entitled to input tax credits or an increasing or decreasing adjustment occurs (directly or indirectly) in relation to a pool asset. Circumstance Pool type Can claim input Low-value pool tax credit on expenditure incurred

Consequences • If the input tax credit arises in the same income year as the acquisition (or importation) of the asset, the asset’s cost is reduced by the amount of input tax credit: s 27-100(2B). • If the input tax credit arises in a later income year than the acquisition (or importation), the closing pool balance is reduced by the amount of the input tax credit. (i) If the input tax credit arises in the same year that the asset was allocated to the pool, reduce the closing pool balance of that income year: s 27-100(3). (ii) If the input tax credit arises in an income year after the asset has been allocated to the pool, reduce the prior year’s closing pool balance (ie the year before the input tax credit arises): s 27-100(3). • The same applies to second element of cost (see [10 380]) in relation to pooled assets.

small business pool

• The opening pool balance for the income year in which the credit arises is reduced by the amount of the input tax credit: s 27-100(5). • The same applies to second element costs incurred by the taxpayer in relation to assets in the small business pool: s 27-100(6) and (7)(b).

Software development pool and project pool

408

The pool value, in the income year in which the taxpayer is entitled to claim the input tax credit, is reduced by the amount of the input tax credit: s 27-100(4).

© 2017 THOMSON REUTERS

CAPITAL ALLOWANCES [10 850] Circumstance Increasing adjustment

Pool type Low-value pool

Consequences • Increase the closing pool balance by the amount of the adjustment: s 27-100(9)(a). (i) If the adjustment arises in the same income year that the asset was allocated to the pool, increase the closing pool balance of that income year. (ii) If the adjustment arises in an income year after the asset was allocated to the pool, increase the prior year’s closing pool balance (eg the year before the adjustment arises).

small business pool

Software development pool and project pool Decreasing adjustments

All

• The opening pool balance of the adjustment year is increased by the amount of the adjustment: s 27-100(9)(b).

• The pool for the adjustment year is increased by the adjustment: s 27-100(9)(d). As per increasing adjustments, except the reverse occurs (ie reduction of the pool).

Section 27-110 provides for a ‘‘reasonable’’ apportionment of input tax credits, decreasing adjustments and increasing adjustments if they relate to 2 or more things (and at least one of them is a depreciating asset). For a detailed analysis of GST and the concepts mentioned above, see Thomson Reuters’ Australian GST Handbook 2016-17.

DISPOSAL OF DEPRECIATING ASSETS [10 850] Balancing adjustments The decline in value calculated under Div 40 is a statutory decline and there is likely to be a discrepancy between the statutory value of a depreciating asset and its actual value. The statutory value is reset to its actual value on the happening of specified events (‘‘balancing adjustment events’’) and the difference is either assessable or deductible to the holder. A balancing adjustment (either an assessable or deductible amount) must be calculated (under Subdiv 40-D) if a balancing adjustment event happens to a depreciating asset whose decline in value was worked out under Subdiv 40-B (or whose decline in value would have been worked out under Subdiv 40-B if the taxpayer has used the asset): s 40-285. Common examples of where the taxpayer would not have worked out the depreciating asset’s decline in value under Subdiv 40-B if the taxpayer had used the asset include assets to which Div 40 does not apply (eg certain pre-1 July 2001 assets) and if another Subdivision of Div 40 applies: see [10 190]. A balancing adjustment must be made if (s 40-295(1)): • a taxpayer stops holding a depreciating asset (eg the asset is sold, lost, destroyed or converted to trading stock or the taxpayer dies). An entity also stops holding an asset if it grants to another entity a licence to exploit a patent, because if an interest is granted in a patent, the asset is deemed to be split into 2 assets (under s 40-115(3)) with the holder ceasing to hold the part of the original asset that represents the interest granted (see [10 290]): see ATO ID 2006/168; • a taxpayer stops using a depreciating asset for any purpose and expects never to use it again (eg ATO ID 2006/327). An example would be if activity in one mine on a multiple mine property ceases or if a specific project comes to an end (see © 2017 THOMSON REUTERS

409

[10 860]

CAPITAL ALLOWANCES

Determination TD 2006/33). If a depreciating asset is stolen, a balancing adjustment event will only happen if the taxpayer expects never to use it again (this involves assessing the likelihood of recovering the asset in a usable condition): see ATO ID 2003/112; • a taxpayer has not used the depreciating asset (and if installed ready for use stops having it so installed) and decides never to use it (see ATO ID 2003/185 and ATO ID 2003/186). In ATO ID 2005/190, a balancing adjustment event happened where a depreciating asset failed to work from the time of purchase and attempts to repair the asset were eventually abandoned; or • there is a change in the holding of, or in the interest of entities in, the asset and one of the entities that has an interest in the asset after the change had an interest in the asset before the change (ie in a partnership situation if assets are brought into the partnership or there is a change in the composition of the partnership). An amount is included in assessable income if the termination value of a depreciating asset is more than its adjustable value just before the balancing adjustment event happens: s 40-285(1). If the termination value of the asset is less than its adjustable value, an amount is deductible: s 40-285(2). In either case, the adjustable value of the asset is then reduced to zero: s 40-285(3). However, if the balancing adjustment event happens because the taxpayer has never used the asset, or stops using the asset and never expects to use it again, the opening adjustable value of the asset for the income year in which the taxpayer uses the asset again is the asset’s termination value at the time of that event plus any second element of cost incurred later: s 40-285(4). This also applies where a balancing adjustment event happens under s 40-295(1B) in relation to a mining, quarrying or prospecting right, or mining, quarrying or prospecting information: see [10 1270]. If Subdiv 170-D applies to the balancing adjustment event, the timing of a deduction (if the termination value is less than adjustable value) is determined under that Subdivision. If a balancing adjustment arises, balancing adjustment roll-over relief may be available: see [10 940]-[10 970]. Special rules may apply if a balancing adjustment event happens to a car and any of the statutory methods for claiming car expenses have been used: see [10 1010]. For depreciating assets that are in a pool, see [10 760]–[10 810]. The tax consequences of sale and leaseback transactions are considered at [33 170]. Note that a deduction is allowed for amounts (or non-cash benefits) misappropriated by an employee or agent that are included in the termination value of a depreciating asset (applicable from 2007-08): see [9 1270].

[10 860] CGT consequences A capital gain or loss arising on the disposal of a depreciating asset is generally disregarded for CGT purposes. However, CGT event K7 happens if a balancing adjustment event happens to a depreciating asset (which the taxpayer starts to hold on or after 1 July 2001) that has been used to any extent for a non-taxable purpose. The calculation of the gain or loss is by reference to Div 40 concepts. See further [13 700]. Other CGT provisions continue to apply to all depreciating assets (whether wholly used for taxable purposes or not). For example, roll-over relief under Div 40 can still apply if CGT roll-over relief applies. CGT roll-over relief is discussed in Chapter 16. If a balancing adjustment event happens to plant acquired before 21 September 1999 or to another depreciating asset held before 1 July 2001, and an amount (the balancing adjustment) is included in assessable income, the amount is reduced to preserve the benefit of indexation, various CGT exemptions (for cars, collectables, personal-use assets and plant used to produce exempt income) and applicable pre-CGT asset rules: ss 40-285(5), 40-345 TPA. [10 870] Deductible amount As noted at [10 850], if the termination value of a depreciating asset is less than its adjustable value just before the balancing adjustment event happens, a deduction is allowable 410

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[10 870]

under s 40-285(2) in the income year in which the balancing adjustment event happens. Generally, the amount of the deduction is the difference between those 2 amounts. However, the deduction is reduced (in accordance with the formula in s 40-290(2)) to reasonably reflect the extent (if any) to which the depreciating asset was used for a non-taxable purpose (see [10 070]) during the period of ownership: s 40-290. This includes, if there has been roll-over relief for the asset under s 40-340 (see [10 940] and following), periods of ownership by the relevant previous owners: s 40-290(2). In the case of a split or merged asset (see [10 290] and [10 300]), the deduction is further reduced by an amount that reasonably reflects the extent (if any) to which the original asset was used for a non-taxable purpose (ie before the split or merger): s 40-290(3), (4). EXAMPLE [10 870.10] On 1 July Year 1, Indie Pet Foods Pty Ltd acquires for $4,000 a depreciating asset that has an effective life of 10 years. The company starts to use the asset immediately. Depreciation is calculated using the prime cost method. The company sells the asset on 30 June Year 4 for $1,500. Year ending 30 June Year 2 30 June Year 3 30 June Year 4

Depreciation (10%) $400 $400 $400

Adjustable value $3,600 $3,200 $2,800

There is a balancing adjustment event on the sale of the asset. The termination value (sale proceeds) is $1,500. Since this is less than the adjustable value, the difference of $1,300 (ie $2,800 less $1,500) is deductible.

As noted at [10 860], CGT event K7 may happen if a balancing adjustment event happens to a depreciating asset that has been used to any extent for a non-taxable purpose: see [13 700]. If the termination value is less than the adjustable value, the portion of the loss relating to the non-taxable use is treated as a capital loss. EXAMPLE [10 870.20] Assume the same facts as in Example [10 870.10] except that only 70% of the asset is used for a taxable purpose (the remaining 30% is used for private purposes). Year ending 30 June Year 2 30 June Year 3 30 June Year 4

Depreciation (10%) $400 $400 $400

Adjustable value $3,600 $3,200 $2,800

Depreciation Depreciation not deductible (70%) deductible (30%) $280 $120 $280 $120 $280 $120

There is a balancing adjustment event on the sale of the asset. Since the termination value (sale proceeds of $1,500) is less than the adjustable value, the difference of $1,300 (ie $2,800 less $1,500) would normally have been allowed as a deduction. However, as the asset was partly used for non-income-producing purposes (30%), the deduction under s 40-285 is reduced by 30%. A capital loss also arises (CGT event K7) since the asset was partly used for a non-taxable purpose. Balancing adjustment deduction (s 40-285) $910 ($2,800 − $1,500) × 70% Capital loss (CGT event K7) $750 $360 ($4,000 − $1,500) × $1,200

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411

[10 880]

CAPITAL ALLOWANCES

Section 40-290 does not apply to mining, quarrying or prospecting information and therefore the deduction does not have to be reduced just because the information was used for a non-taxable purpose: s 40-290(5). Section 40-290 also does not apply to geothermal exploration information that is started to be held on or after 1 July 2012 and before 1 July 2014. The timing of a deduction under s 40-285(2) is determined by Subdiv 170-D (dealing with transactions by a company that is a member of a linked group).

[10 880] Assessable amount An amount is included in assessable income if the termination value of a depreciating asset exceeds its adjustable value just before the balancing adjustment event happens: s 40-285(1)(b). The amount of assessable income is generally the difference between those 2 amounts. However, the assessable amount is reduced (in accordance with the formula in s 40-290(2)) to reasonably reflect the extent to which the depreciating asset was not used for a taxable purpose. In the case of a split or merged asset (see [10 290] and [10 300]), the assessable amount is further reduced by an amount that reasonably reflects the extent (if any) to which the original asset was used for a non-taxable purpose (ie before the split or merger): s 40-290(3), (4). The assessable amount is included in assessable income in the income year in which the balancing adjustment event happens. However, in certain circumstances where the balancing adjustment event happens (after 30 June 2012) in relation to an Australian registered eligible vessel, the balancing adjustment will be assessable in the second income year after the income year in which the event happens: see [11 700]. As noted at [10 860], CGT event K7 may happen if a balancing adjustment event happens to a depreciating asset that has been used to any extent for a non-taxable purpose: see [13 700]. If the termination value exceeds the adjustable value, the portion of the gain relating to the non-taxable use is treated as a capital gain. The holder may be eligible for the CGT exemptions or concessions (such as the 50% discount) if the requirements for eligibility are met: see [13 700]. Section 40-290 does not apply to mining, quarrying or prospecting information, and therefore the gain does not have to be reduced just because the information was used for non-taxable purposes: s 40-290(5). Section 40-290 also does not apply to geothermal exploration information where the start time of the asset was on or after 1 July 2012 and before 1 July 2014. See [10 930] in relation to a depreciating asset used for conducting R&D activities. [10 890] Termination value ‘‘Termination value’’ (as defined in s 40-300) generally consists of amounts that a taxpayer receives, or is taken to have received, in relation to the asset under a balancing adjustment event. This includes non-cash benefits. The most common circumstance is where a depreciating asset is sold for a specific price. In such a case, the termination value is the sale price. However, for certain balancing adjustment events, the termination value is that specified in the table contained in s 40-300(2). In that situation, the amount that the taxpayer receives as a result of the balancing adjustment event is ignored. Note that, under the TOFA rules (relating to the taxation of financial arrangements: see [32 050] and following), if a taxpayer provides a depreciating asset in consideration for the creation, acquisition or cessation of a financial arrangement, s 230-505 will generally operate so that the termination value or the amount an entity is taken to have received under the balancing adjustment event includes the market value of the depreciating asset that is disposed of or that is no longer held. 412

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CAPITAL ALLOWANCES

[10 890]

Amounts received or taken to have been received by the taxpayer If the termination value for the balancing adjustment event is not specified in the table in s 40-300(2), the amount that a taxpayer receives or is taken to have received for the asset is the termination value: s 40-300(1)(b). The amount received or taken to have been received is the greater of (s 40-305): • the consideration received; and • the sum of the amounts deducted or deductible and any amounts by which that deductible amount is reduced because of the receipt of an amount of consideration. If the qualifying expenses of the balancing adjustment event exceed the termination value of the asset, the termination value of the taxpayer’s depreciating asset is zero: see ATO ID 2004/259. Consideration received by the taxpayer is the sum of the following (s 40-305(1)): • money received; • non-cash benefits received; • the market value of the taxpayer’s liability to pay money that was terminated (the concept of market value is considered at [3 210]); • the market value of the taxpayer’s liability to provide non-cash benefits that was terminated; • any creation or increase in the taxpayer’s right to receive money; and • any creation or increase in the taxpayer’s right to receive non-cash benefits. The value of non-cash benefits is determined by their market value. Any right to receive money or non-cash benefits that has already been satisfied is excluded: s 40-305(2). The rules for working out amounts received or taken to have been received by the taxpayer under a balancing adjustment event are broadly similar to those used in working out the cost of a depreciating asset: see [10 370]. An example of an amount taken to have been received is the notional sale price when a depreciating asset is converted to trading stock: see [5 250]. In ATO ID 2006/167, an undertaking by the licensee of a patent to pay to the owner of the patent 50% of the revenue it earned from exploiting the patent was not included in the termination value of the relevant part of the patent (see also ATO ID 2006/168, noted at [10 850]).

Amounts specified as the termination value For certain balancing adjustment events, the termination value is the amount specified in the table in s 40-300, which is reproduced below. If more than one item in the table applies, the termination value is the one under the last applicable item. Note that the market value of a depreciating asset is GST-exclusive. The concept of market value is considered at [3 210]. Item 1.

2. 3.

4.

For this balancing adjustment event The taxpayer stops using a depreciating asset, or having it installed ready for use, for any purpose and expects never to use it again even though still holding it The taxpayer decides never to use a depreciating asset that the taxpayer has not used even though still holding it The taxpayer stops using in-house software for any purpose and expects never to use it again even though still holding it The taxpayer decides never to use in-house software that the taxpayer has not used even though still holding it

© 2017 THOMSON REUTERS

The termination value is The market value of the asset when the taxpayer stops using it or having it installed ready for use The market value of the asset when the taxpayer makes the decision Zero

Zero

413

[10 890] Item 5.

6.

CAPITAL ALLOWANCES For this balancing adjustment event One or more partners stop holding a depreciating asset when it becomes a partnership asset or a balancing adjustment event referred to in s 40-295(2) happens The taxpayer stops holding a depreciating asset under an arrangement and:

The termination value is The market value of the asset when the partnership starts to hold it or when the balancing adjustment event happens The market value of the asset just before the taxpayer stops holding it

(a) there is at least one other party to the arrangement with whom the taxpayer did not deal at arm’s length; and (b) apart from this item, the termination value would be less than its market value 7. 8. 9.

10.

11.

13. 14.

The taxpayer stops holding a depreciating The market value of the asset just before asset under an arrangement that was the taxpayer stops holding it private or domestic in nature (eg a gift) A depreciating asset is lost or destroyed The amount or value received or receivable under an insurance policy or otherwise for the loss or destruction The taxpayer stops holding a depreciating The asset’s adjustable value on the day asset because the taxpayer dies and the the taxpayer dies or, if the asset is asset starts being held by the legal allocated to a low-value pool, so much of personal representative the closing pool balance for the income year in which the taxpayer dies as is reasonably attributable to the asset The taxpayer stops holding a depreciating The market value of the asset on the day asset because it passes directly to a the taxpayer dies beneficiary or joint tenant when the taxpayer dies A depreciating asset for which the The amount so determined Finance Minister has determined an amount under s 52A Airports (Transitional) Act 1996 The balancing adjustment event happens Zero under s 40-295(1A): see [10 1270] The balancing adjustment event happens What would, apart from s 40-285(3), be under s 40-295(1B): see [10 1270] the asset’s adjustable value on the day the balancing adjustment event happens

If a depreciating asset is stolen, the Tax Office seems to consider that it is ‘‘lost or destroyed’’ and therefore Item 8 in the table applies: see ATO ID 2003/111. If Item 8 does not apply, Item 1 will apply provided the taxpayer expects never to use the asset again. Note that a deduction is allowed for amounts (or non-cash benefits) misappropriated by an employee or agent that are included in the termination value of a depreciating asset: see [9 1270]. Expenditure that is reasonably attributable to a balancing adjustment event is included in the second element of cost of the asset: see [10 380]. If a depreciating asset is sold with, or attached to, other assets, only that part of the price that is reasonably attributable to the depreciating asset is taken into account in calculating the termination value: s 40-310. This seems to apply even if a specific price is allocated to the asset. Note that the termination value of a depreciating asset does not include an amount that is ordinary income or statutory income: s 40-300(3). 414

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CAPITAL ALLOWANCES [10 920]

Cars – adjustment of termination value The termination value of a car is adjusted if the first element of cost exceeded the car limit or if the first element was increased because the car was acquired at a discount. For further information, see [10 1320]. Special rules may apply if the taxpayer has used any of the statutory methods for claiming car expenses: see [10 1010]. [10 900] Effect of GST The consequences (under Subdiv 27-B) when a balancing adjustment event is a taxable supply for GST purposes, or an increasing or decreasing GST adjustment relating to an asset happens after the balancing adjustment event, are set out in the following table. Circumstance Balancing adjustment event is also a taxable supply

A decreasing adjustment occurs in the same income year as the balancing adjustment event An increasing adjustment occurs in the same income year as the balancing adjustment event A decreasing adjustment occurs in a later income year An increasing adjustment occurs in a later income year

Consequences Termination value is reduced by an amount equal to the GST payable on the supply: s 27-95(1) If the termination value is deemed to be ‘‘market value’’, there is no reduction in the termination value: s 27-95(2) Termination value is increased by the amount of the decreasing adjustment: s 27-95(3) Termination value is decreased by the amount of the increasing adjustment: s 27-95(4) An amount equal to the decreasing adjustment is included in the taxpayer’s assessable income: s 27-95(5) An amount equal to the increasing adjustment is deductible: s 27-95(6)

Section 27-110 provides for a ‘‘reasonable’’ apportionment of input tax credits, decreasing adjustments and increasing adjustments if they relate to 2 or more things (and at least one of them is a depreciating asset). For a detailed analysis of GST and the concepts mentioned above, see Thomson Reuters’ Australian GST Handbook 2016-17.

[10 920] In-house software not allocated to software pool If in-house software that has not previously been allocated to a software development pool (see [10 790]) is abandoned, the expenditure incurred on the software in the current year and any previous income years may be deductible: s 40-335. The amount of the deduction is the total expenditure incurred on the software in the current year and any previous income years, less any consideration derived by the taxpayer in relation to the software or any part of it. The expenditure is only deductible to the extent that the taxpayer intended to use the software, or have it installed ready for use, for a taxable purpose (see [10 070]) when the expenditure was incurred: s 40-335(2). Specifically, the following conditions must be met before a deduction is allowable for expenditure incurred on abandoned in-house software (s 40-335(1)): • the expenditure was incurred with the intention of the taxpayer using it for a taxable purpose; • the expenditure relates to a unit of software that the taxpayer has not used or had installed ready for use; • the expenditure has not been allocated to a software development pool; and • the taxpayer has decided that it will never use the software, or have it installed ready for use. It should be noted that if the expenditure is subsequently recouped, it may be included in the taxpayer’s assessable income under Subdiv 20-A: see [6 580]. © 2017 THOMSON REUTERS

415

[10 930]

CAPITAL ALLOWANCES

[10 930] Assets that qualify for R&D concession Special rules (in s 40-292) apply if a balancing adjustment happens to a depreciating asset that is used both for conducting R&D activities (and thus qualifies for a notional deduction under Div 355 ITAA 1997: see [11 070]) and for another taxable purpose (for these purposes, conducting R&D activities is taken to be a taxable purpose). If a taxpayer is entitled to a deduction under s 40-285 (see [10 870]), the deduction is increased by half if the R&D entity’s aggregated turnover is less than $20m and by one-third in other cases. If an amount is included in a taxpayer’s assessable income under s 40-285 (see [10 880]), that amount is increased by one-third of an amount worked out under the formula in 40-292(5). The formula adjusts the amount worked out under s 40-285 so that it does not exceed the asset’s total decline in value. It then applies a factor so that the amount being clawed back reflects that proportion of the decline in value of the asset represented by total notional R&D deductions. If a balancing adjustment event happens to a depreciating asset held by an R&D partnership (see [11 040]), the deduction or assessable amount (under s 40-285) is increased by one-third of the amount worked out under the relevant formula: s 40-293. If a taxpayer claimed a deduction under former s 73BA or s 73BH in respect of a depreciating asset used for conducting R&D activities (or the taxpayer claimed the R&D tax offset under former s 73I instead), transitional provisions (in ss 40-292, 40-293 TPA) ensure that the use of the asset for the purpose of conducting R&D activities in income years before 2011-12 is treated in the same way as the use of the asset for the purpose of conducting R&D activities in 2011-12 and later income years. The deduction or assessable amount is increased by the amount worked out in accordance with the formula in s 40-292(3) or s 40-293(3). [10 940] Automatic roll-over relief Balancing adjustment roll-over relief effectively defers a balancing adjustment until the next balancing adjustment event happens: see [10 960]. The roll-over relief can be automatic (see below) or at the option of the parties: see [10 950]. Broadly, the roll-over relief is automatic if the CGT roll-over relief listed in s 40-340(1) would have been available in respect of that balancing adjustment event (for an example of automatic roll-over relief, see Determination TD 2005/1). The following conditions must be satisfied for the automatic roll-over relief to apply: • there is a balancing adjustment event because an entity disposes of a depreciating asset in an income year to another entity; • the disposal involves a CGT event; and • the conditions relating to the item in the following table are satisfied. Item 1 2

2A

416

Type of CGT roll-over Disposal of asset to wholly owned company Disposal of asset by partnership to wholly owned company

Transfer of CGT asset of a trust to a company under a trust restructure

Conditions The transferor is able to choose a roll-over under Subdiv 122-A for the CGT event: see [16 020] The transferor is a partnership, the property is partnership property and the partners are able to choose a roll-over relief under Subdiv 122-B for the disposal by the partners of the CGT assets consisting of their interests in the property: see [16 030] The transferor and transferee are able to choose a roll-over under Subdiv 124-N for the CGT event (applies to balancing adjustment events happening in 2008-09 or a later income year): see [16 240] © 2017 THOMSON REUTERS

CAPITAL ALLOWANCES [10 940] Item 3

Type of CGT roll-over Marriage breakdown

4

Disposal of asset to another member of the same wholly owned group

5

Disposal of asset from one fixed trust to another fixed trust

6

Disposal of asset as part of merger of superannuation funds

7

Disposal of asset as part of transfer to a MySuper product

8

Transfer of asset (on or after 1 July 2016) under a transaction for transfer of all assets of the transferor’s business

Conditions There is a roll-over relief under Subdiv 126-A for the CGT event: see [16 300] The transferor is able to choose a roll-over under Subdiv 126-B for the CGT event: see [16 320] The trustees of the trusts choose to obtain a roll-over under Subdiv 126-G in relation to the disposal: see [16 370] The transferor chooses a roll-over under Subdiv 310-D in relation to the disposal: see [16 380] The transferor chooses a roll-over under Subdiv 310-D in relation to the disposal: see [16 390] The transferor chooses a roll-over under Subdiv 328-G (for small business entities): see [16 500]

Automatic roll-over relief also applies where an indigenous corporation converts from a Corporations Act corporation to a Corporations (Aboriginal and Torres Strait Islander) Act 2006 corporation and there is a balancing adjustment event on disposal of a depreciating asset involving a CGT event: s 620-30. Roll-over relief is not available for the transfer of depreciating assets from a discretionary trust to a unit trust: see ATO ID 2005/202. The consequences of qualifying for roll-over relief from balancing adjustments are set out in s 40-345: see [10 960]. In applying the table above, the following are to be disregarded insofar as they relate to the depreciating asset disposed of (s 40-340(2)): • an exemption in Div 118, which contains the general exemptions from CGT (discussed in Chapter 15); • s 122-25(2) and (3), which exclude certain assets from some kinds of CGT roll-over relief: see [16 040]; and • s 124-870(5), which excludes trading stock from roll-over relief under Subdiv 124-N: see [16 240]. Roll-over relief is not available if Subdiv 170-D applies to the disposal of the depreciating asset or the change in interests in it (although Subdiv 170-D now has limited application). Note also that automatic roll-over relief does not apply if the asset disposed of was allocated to a low-value pool (see [10 780]). For roll-over relief available to small business entities that calculate their deductions for depreciating assets under Subdiv 328-D, see [25 170].

Requirement to give notice to transferee If there is automatic roll-over relief under s 40-340(1), the transferor must give a notice containing sufficient information about the transferor’s holding of the property for the transferee to work out how Div 40 applies to the transferee’s holding of the depreciating asset: s 40-360. The required information will have to include (if appropriate) the cost of the depreciating asset, the adjustable value, the opening adjustable value, the method the transferor used to calculate the decline in value (ie prime cost or diminishing value), the effective life the transferor used, the remaining effective life and the extent to which the asset was used for non-taxable purposes. © 2017 THOMSON REUTERS

417

[10 950]

CAPITAL ALLOWANCES

The notice must be given to the transferee within 6 months after the end of the transferee’s income year in which the balancing adjustment event happened, or within such further time as allowed by the Commissioner. The transferee must keep the notice until the end of 5 years after the earlier of: • the transferee disposing of the property; or • the property being lost or destroyed. The maximum penalty for failing to comply is 30 penalty units.

[10 950] Optional roll-over relief Optional roll-over relief is available in a partnership scenario if the composition of the partnership changes or if assets are brought into or taken out of the partnership: s 40-340(3). For example, if a new partner is introduced into the partnership, a balancing adjustment event happens to the existing partners because they no longer hold some of the interest in the asset. To defer any balancing adjustments, the existing partners and the new partner can jointly elect for the roll-over relief to apply. Roll-over relief is available at the option of the holders if: • there is a balancing adjustment event for a depreciating asset because of s 40-295(2) (about a change in the holding of, or interests in, the asset: see [10 1000]); and • the entity or entities that had an interest in the asset before the change and the entity or entities that have an interest in the asset after the change jointly choose the roll-over relief. It should be noted that optional roll-over relief is not available unless the original holder retains an interest in the asset after the change: s 40-295(2)(b). In addition, roll-over relief is not available if Subdiv 170-D applies to the disposal of the depreciating asset or the change in interests in it. Note that optional roll-over relief is also available to small business entities that choose to claim capital allowance deductions under Div 328: see [25 170]. Optional roll-over relief is available in certain circumstances where there is a balancing adjustment event in relation to an Australian registered eligible vessel: see [11 700].

When must choice be made? The choice must be made in writing and within 6 months after the end of the transferee’s income year in which the balancing adjustment event happened, or within such further time as allowed by the Commissioner: s 40-340(4). The choice must also contain sufficient information about the transferor’s holding of the property for the transferee to work out how Div 40 applies to the transferee’s holding of the depreciating asset. Relevant information would include (if appropriate) the cost of the depreciating asset, the adjustable value, the opening adjustable value, the method the transferor used to calculate the decline in value (ie prime cost or diminishing value), the effective life the transferor used, the remaining effective life and the extent to which the asset was used for non-taxable purposes. The transferor must keep the choice or a copy of it for 5 years after the balancing adjustment event happened. For the transferee, the choice or a copy of it must be kept until the end of 5 years after the next balancing adjustment happens for the depreciating asset: s 40-340(6) and (7). The maximum penalty for failing to comply is 30 penalty units. If a person dies before the end of the time allowed for jointly choosing the roll-over relief, the trustee of the deceased’s estate may make the choice instead: s 40-340(5). Mining arrangements: interest realignment arrangements Optional roll-over relief is available for rights acquired on or after 1 July 2001 pursuant to an interest realignment arrangement. This is an arrangement where the parties hold mining, quarrying or prospecting rights that relate to a common development project which the parties propose to undertake jointly. 418

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CAPITAL ALLOWANCES [10 970]

[10 960] Consequences of roll-over relief If roll-over relief applies (whether automatic or at the option of the parties), any balancing adjustment that would otherwise be included in the transferor’s assessable income or be deductible is ignored: s 40-345(1). Furthermore, the transferee calculates the decline in value of the depreciating asset using the same method (ie prime cost or diminishing value) and effective life that the transferor was using. If the transferor used the prime cost method, the transferee must use the remaining effective life of the asset (ie the period of effective life that is yet to elapse when the balancing adjustment event happens): s 40-345(2). In essence, roll-over relief effectively transfers the capital allowance attributes of the transferor to the transferee. The transferee ‘‘inherits’’ the profile of the depreciating asset (including its decline in value) from the transferor. Successive roll-overs are possible (including disposals more than once in a single year or if an asset that is fully written off at the time it was acquired is disposed of again), so that it will be the first transferee disposing of the depreciating asset in a non-roll-over situation who will need to account for the balancing adjustment.

Consequences for Div 45 purposes Roll-over relief also has consequences for Div 45 purposes (disposals of leases and leased plant). In essence, the transferee is taken to have done all the things that the transferor has done for Div 45 purposes including carrying on the main business of leasing assets if that was the transferor’s main business: s 40-350(1). However, these additional consequences do not apply if there is a disposal of a lease pursuant to Div 45 and the sum of the disposal benefits is at least equal to, or greater than, the market value of the plant or interest concerned: s 40-350(2): see [10 1020].

[10 970] Involuntary disposals – adjustment of other assets If an assessable balancing adjustment arises on an involuntary disposal of a depreciating asset, s 40-365 gives the taxpayer the option of offsetting the assessable balancing adjustment against the cost or the opening adjustable value of any replacement asset. This option is available to all taxpayers. A taxpayer who makes such a choice is effectively exchanging the non-inclusion of the assessable amount for a lower decline in value (and thus a lower deduction) in the future because of the lower cost or opening adjustable value. It should be noted that if the roll-over relief is elected, the cost of the replacement asset is reduced by the rolled over amount, regardless of when the involuntary disposal happens. The replacement asset’s opening adjustable value, and any amount included in the second element of cost, is also reduced if the involuntary disposal (or roll-over relief) happens after the end of the income year in which the start time (see [10 080]) for the replacement asset occurs: s 40-365(5). This offset is only available if the replacement asset qualifies for a deduction for its decline in value and is used, or installed ready for use, wholly for a taxable purpose. The replacement asset must be acquired no earlier than one year before the balancing adjustment event happens and no later than one year after the end of the income year in which the event happens (the Commissioner has the discretion to extend these time limits). If there are 2 or more items of replacement assets, the offset amounts are apportioned between those items on the basis of their cost. There is an involuntary disposal for these purposes if (s 40-365(2), (2A)): • the asset is lost or destroyed. There is also an involuntary disposal if a depreciating asset is stolen (eg ATO ID 2002/782); • the asset is compulsorily acquired by the Commonwealth or a State or Territory government (or government agency), including if the compulsory acquisition occurs after negotiations with the relevant government or government agency; © 2017 THOMSON REUTERS

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[10 980]

CAPITAL ALLOWANCES

• the asset is acquired by a non-government entity under a power of compulsory acquisition under an Australian or foreign law (apart from a law for the compulsory acquisition of minority interests under company law); • the asset is disposed of to an entity (other than a foreign government agency) after a notice was served by or on behalf of the entity inviting negotiations with a view to the entity acquiring the asset by agreement. The notice must inform the recipient that if the negotiations are unsuccessful, the asset will be compulsorily acquired by the entity (under a power of compulsory acquisition conferred by an Australian or foreign law other than a law for the compulsory acquisition of minority interests under company law); or • the asset is fixed to land which is or would be compulsorily subject to a mining lease that significantly affected, or would have significantly affected, the taxpayer’s use of the land, and it is disposed of to the lessee (which cannot be a foreign government agency). The lease needs to be in force just before the disposal. This measure does not extend to initial exploration licences or retention licences.

[10 980] Non-arm’s length disposals The termination value of a depreciating asset may be adjusted if the parties to the disposal of the asset are not dealing at arm’s length. Item 6 s 40-300(2) applies if a taxpayer sells an asset to another entity in circumstances where it would be concluded that the parties were not dealing at arm’s length and the termination value is less than market value. The consideration paid is deemed to be the market value of the asset immediately before the time of disposal. Market value is CGT-exclusive (unless the supply of the asset cannot be a taxable supply): s 960-405. The concept of market value is considered at [3 210]. [10 1000] Change of ownership or interests A balancing adjustment event happens if there is a change in the composition of a partnership or when assets are brought into or leave the partnership. Broadly, s 40-295(2) provides that a balancing adjustment event happens if: • a change occurs in the holding of, or in the interests of entities in, the asset; and • the entity that had an interest in the asset before the change has an interest in it after the change; and • the asset was a partnership asset before the change or becomes a partnership asset after the change. In other words, changes in interests in depreciating assets are treated to be a disposal by the entities that held the assets before the change to the entities holding the assets after the change. Roll-over relief against any balancing adjustment is available if all the entities before the change and all the entities after the change jointly elect: s 40-340(3): see [10 950]. While the provision applies to any change of interests of the above nature, it has particular application in the case of the formation or dissolution of a partnership. For example, if A, a partner in the firm of A and B, sold her or his share or interest in the partnership to E, s 40-295(2) treats the resultant change of interests in partnership property to be a disposal of the partnership property by A and B to B and E. Similarly, s 40-295(1) will apply if a parent takes a son or daughter into partnership or if a partnership is dissolved by one partner buying the interests of retiring partners. The effect of ss 40-295(2) and 40-300(2) Item 5 is to deem these changes in ownership to take place at full market value (GST-exclusive) in the absence of an election for balancing adjustment roll-over relief: see [10 950].

420

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CAPITAL ALLOWANCES

[10 1010]

EXAMPLE [10 1000.10] Carl and Pip are equal partners. Jackie, a new entrant, is admitted as a third partner. Jackie purchases a capital interest in the partnership of one-third overall. Carl and Pip in effect each transfer to Jackie one-third of their interest in the assets of the partnership. Carl and Pip are treated as disposing of partnership assets to Carl, Pip and Jackie. Assume that the partnership property of Carl and Pip includes depreciating assets with a cost of $10,000 and a written down value (ie adjustable value) at the date of change of $6,000. The admission agreement specifies that the total value at the date of transfer of these transferred assets is $10,000, which corresponds to the market value. Under s 40-285 the balancing adjustment of $4,000 (termination value, ie market value of $10,000 – adjustable value of $6,000) is included in the net partnership income of Carl and Pip. The decline in value of the depreciating assets to the partnership of Carl, Pip and Jackie is calculated on a cost of $10,000. If the depreciating assets are sold for a value other than $10,000, eg below the adjustable value of $6,000, the consequences for the net partnership income of Carl and Pip would be determined in accordance with s 40-300(2) Item 5, which would deem market value of $10,000 to have been received in the absence of a roll-over.

[10 1010] Car – statutory substantiation methods used There are 2 statutory methods of working out deductions for car expenses – the log book and cents-per-kilometre methods: see [9 100]-[9 140]. Two other statutory methods – the one-third of actual expenses and 12% of original value methods – ceased to be available from the 2015-16 income year. Only the log book and one-third of actual expenses methods require the decline in value of the car to be calculated. If a balancing adjustment event happens to a car and the taxpayer used a combination of methods to calculate car expense deductions, the balancing adjustment may have to be calculated by the method statement in s 40-370 instead of under s 40-285 (see Determination TD 2006/49). The table below summarises the position in relation to balancing adjustment calculations in these circumstances (note that different rules apply if the taxpayer is a small business entity which uses the Div 328 rules: see [25 160]). Importantly, although references to the one-third of actual expenses and 12% of original value methods have been removed from s 40-370, if the 12% of original value method of deducting car expenses was used in one or more income years before 2015-16 and the balancing adjustment event for the car happens during 2015-16 or a later year, the balancing adjustment will be worked out on the basis of the old rules (ie as if references to the 12% of original value method had not been removed). Method of calculating car expenses deductions Cents-per-kilometre method used every year 12% of original value method used every year (this method has been discontinued from the 2015-16 income year) One-third of actual expenses method used every year (this method has been discontinued as from the 2015-16 income year) Log book method used every year A mix between the cents-per-kilometre method and the 12% of original value method (before 2015-16) A mix between the cents-per-kilometre method and/or (before 2015-16) the 12% of original value method on the one hand and the log book method and/or (before 2015-16) the one-third of actual expenses method on the other hand © 2017 THOMSON REUTERS

Div 40 balancing adjustments No balancing adjustment (ss 40-55 and 40-370(1)(b)) No balancing adjustment (ss 40-55 and 40-370(1)(b)) Balancing adjustment under s 40-285 (with two-thirds of the balancing adjustment being apportioned away: former s 40-25(6)). Balancing adjustment under s 40-285 No balancing adjustment (ss 40-55 and 40-370(1)(b)) Balancing adjustment under s 40-370 and not s 40-285.

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[10 1010]

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Basically, the method statement in s 40-370 calculates the adjustable value at the time of disposal as if the arbitrary basis of deduction (ie the ‘‘cents-per-kilometre’’ method and (before 2015-16) the ‘‘12% of original value’’ method) had never applied. The balancing adjustment is then calculated as the termination value less the adjustable value. The difference is either assessable or deductible. However, that amount is to be reduced to the extent that the car was used for a non-taxable purpose. If the cents-per-kilometre method is used, the car is deemed to have been used for a taxable purpose to the extent of 20% only. If the 12% of original value method was used (before 2015-16), the taxable purpose use is deemed to be 331/3%. EXAMPLE [10 1010.10] Assume Nikki acquired a car on 1 July 2014 for $25,000. During the 2014-15 income year, Nikki used the car 40% for business purposes (so she uses the log book method). In the 2015-16 income year, she uses the car 60% for business purposes and continues to use the log book method. In the 2016-17 income year, business use of the car decreases significantly and Nikki therefore decides to use the cents-per-kilometre method (and therefore the business use is assumed to be 20%). She disposes of the car for $15,000 on 30 June 2017. Note that, where appropriate, amounts are rounded to the nearest dollar. Step 1: Work out the prima facie balancing adjustment amount (ie termination value less adjustable value at 30 June 2017). The adjustable value at 30 June 2017 is calculated as follows (assuming a depreciation rate of 20% using the prime cost method) – note that, in working out the adjustable value for the income year for which the cents-per-kilometre method was used to calculate car deductions (ie 2016-17), it is assumed that the decline in value was calculated on the same basis as any year(s) when those methods did not apply (ie 2014-15 and 2015-16): s 40-370(3). $ Cost of car 25,000 Depreciation for 2014-15 ($25,000 × 20%) 5,000 20,000 Depreciation for 2015-16 ($25,000 × 20%) 5,000 15,000 Depreciation for 2016-17 ($25,000 × 20%) 5,000 Adjustable value just before balancing adjustment event 10,000 The car’s termination value is $15,000. The Step 1 amount is therefore $5,000 (ie $15,000 − $10,000). Step 2: Reduce the amount in Step 1 ($5,000) by an amount that represents the extent to which the asset was used for non-taxable purposes (using the formula in s 40-290(2): see [10 870] and [10 880]). The formula is: Total reduction × Balancing adjustment amount Total decline in value The total reduction in value is calculated as follows: 2014-15 log book method

2015-16 log book method

Private use = 60%

Private use = 40%

60% × $5,000 = $3,000

40% × $5,000 = $2,000

422

2016-17 cents-per-kilometre method Private use = 80% deemed private use: s 40-370(4) 80% × $5,000 = $4,000

Total reduction

$9,000

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[10 1020]

The total decline in value is $15,000 and the balancing adjustment amount (the Step 1 amount) is $5,000. The reduction amount is therefore $3,000 (ie $9,000/$15,000 × $5,000). The Step 2 amount is therefore $2,000 (ie $5,000 – $3,000). Step 3: Multiply the Step 2 amount ($2,000) by the number of days for which the car’s decline in value was calculated using the log book method (731), ie $2,000 × 731 = $1,462,000. Step 4: Divide the Step 3 amount (ie $1,462,000) by the number of days Nikki held the car (1,096 days). $1,462,000 = $1,334 (ignoring cents) 1,096 days If the Step 4 amount is positive, it is included in assessable income. If the Step 4 amount is negative, it is deductible. $1,334 is included in Nikki’s assessable income. Steps 3 and 4 could be combined, ie $2,000 ×

[10 1020]

731 = $1,334 (ignoring cents) 1,096

Disposal of leases and leased plant

Special rules in Div 45 apply if certain leased plant, or an interest in certain leased plant, is disposed of. The rules are designed to prevent tax avoidance if leased plant (or an interest in leased plant) is disposed of to a tax loss or other tax-preferred entity after most of the benefits of the deduction for the decline in value have been claimed and the market value of the plant exceeds its written down value. For the purposes of Div 45, ‘‘plant’’ is defined (in s 45-40) to include articles, machinery, tools, rolling stock, working beasts used in a non-primary production business, fences, dams and other structural improvements on land used for agricultural or pastoral operations, certain other structural improvements used in a forestry business or in pearl culturing activities and plumbing fixtures and fittings provided mainly for employees. Structural improvements used for domestic or residential purposes are generally not ‘‘plant’’ for these purposes, unless provided for the accommodation of employees, tenants or sharefarmers (who are connected with the relevant activity). Division 45 applies if plant, or an interest in plant, is disposed of and: • the plant was a leased asset on or after 22 February 1999; • the plant has been used by the lessor primarily for leasing to others; and • the lessor has claimed deductions for the decline in value in respect of the plant. 1. If the disposal constitutes a balancing adjustment event (see [10 850]), any excess of the money consideration and the market value (see [3 210]) of other benefits obtained from disposing of the plant (or an interest in the plant) over the plant’s written down value (or relevant proportion thereof) is assessable to the lessor. 2. If the lessor disposes of rights under the lease of the plant without disposing of the plant itself, the money consideration for the disposal, plus the value of other benefits obtained as a result of the disposal, is assessable to the lessor. © 2017 THOMSON REUTERS

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3. If a partner in a partnership disposes of an interest in the partnership so as to reduce the partner’s interest in plant which the partnership has used mainly to lease to other entities, or disposes of rights or an interest under the lease, similar consequences as in 1 and 2 above follow. 4. If the relevant plant, or interest in plant, was acquired at or before 11.45 am on 21 September 1999 AEST (and is not a pre-CGT asset) and is disposed of after that time, the assessable amount is reduced to reflect indexation under the CGT provisions (frozen at 30 September 1999). This does not apply if the plant was used to produce exempt income, nor in certain cases where a capital gain or loss is disregarded under the CGT provisions (eg in the case of cars, motorcycles, valour decorations and collectables). 5. Amounts are not assessable under Div 45 if they are already directly assessable under another provision (eg as a balancing adjustment) or would be included but for a specific relieving provision (eg if roll-over relief is available). 6. If an interest in leased plant is effectively disposed of by selling more than 50% of the shares in a wholly owned leasing subsidiary that owns the plant, the leasing subsidiary is treated as having disposed of the plant and having reacquired it at market value. This means that the depreciation balancing adjustment rules will bring to tax any excess of the plant’s market value over its written down value at the deemed disposal time. This does not apply, however, if the main business of the new owners of the subsidiary is the same as the main business of the former group (and see ATO ID 2006/338 for circumstances where there is no deemed disposal and reacquisition in the context of all of the membership interests in a subsidiary member of a consolidated group being acquired by another consolidated group). 7. If more than 50% of the shares in a wholly owned subsidiary which is a partner in a leasing partnership changes hands, the subsidiary is treated as having disposed of its interest in any plant used by the partnership principally to lease to other entities. As a result, the de-grouped subsidiary becomes liable to tax on the difference between the market value of its interest in the leased plant and the proportion of its written down value attributable to that interest. This does not apply, however, if the main business of the new owners of the subsidiary is the same as the main business of the former group. 8. In either of the cases outlined in 6 and 7 above, the companies that were in the same group as the de-grouped subsidiary will become liable for the tax upon which the subsidiary was assessed, attributable to the transactions described above, if the former subsidiary does not pay the tax within 6 months of it becoming payable. This tax is imposed by the New Business Tax System (Former Subsidiary Tax Imposition) Act 1999. 9. Section 40-350 (roll-over relief: see [10 960]) is modified so that if the transferor leased out the relevant plant on or after 22 February 1999, primarily used it for leasing to others and its main business was to lease assets to others, those characteristics are attributed to the transferee. This does not apply, however, if the sum of all disposal benefits is at least equal to the market value of the plant, or interest in it, disposed of.

[10 1030] Limited recourse debt Division 243 ITAA 1997 provides for adjustments to assessable income if a taxpayer uses limited recourse debt to finance or refinance the acquisition of a depreciating asset and the arrangement is terminated before the debt is fully repaid. If the taxpayer’s capital allowance deductions exceed what would have been allowable if the capital expenditure were reduced by the amount paid, the excess is included in assessable income in the year in which the arrangement is terminated. Division 243 is considered further at [33 220]. 424

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[10 1060]

PROJECT POOLS [10 1050] Project pools and project amounts Certain expenditure associated with projects carried on by taxpayers can be pooled and written off under Subdiv 40-I on the basis of the effective life of the project. Only expenditure that qualifies as a project amount can be allocated to the project pool: s 40-830. Broadly, there are 2 types of expenditure that qualify as a project amount. The first type of expenditure consists of mining capital expenditure and transport capital expenditure: see [10 1060]. The second type of expenditure that is treated as a project amount consists of amounts for (s 40-840(2)): • creating or upgrading community infrastructure; • site preparation costs for a depreciating asset other than horticultural plants and grapevines, expenditure in draining swamp or low-lying land or expenditure in clearing land (site preparation costs include expenditure on relocating existing utilities, such as electricity lines and water pipelines: see ATO ID 2015/12); • feasibility studies for the project (see ATO ID 2003/208) and environmental assessments of the project; • information associated with the project (this does not include expenditure incurred in looking at the acquisition of a new business: see ATO ID 2003/207); • obtaining a right to intellectual property; and • ornamental trees or shrubs (see ATO ID 2009/35). The expenditure must not be deductible under another provision of the income tax legislation or form part of the cost of a depreciating asset. To qualify as a project amount, the expenditure must be directly connected with a project the taxpayer carries on for a taxable purpose (including if carrying on a business for that purpose, eg ATO ID 2007/3): see [10 070]. To satisfy the ‘‘direct connection’’ requirement, it is important to identify the particular undertaking to which the relevant expenditure belongs: see ATO ID 2012/17. Looking for an existing business to acquire is not, of itself, a project that is carried on for a taxable purpose: ATO ID 2003/206. A ‘‘project’’ for these purposes must be a plan, scheme or undertaking of some substance, ie something more substantial than an idea or speculation, and must be an activity, or set of related activities, that are distinct from any activity on which the capital expenditure which constitutes a project amount is incurred: Ruling TR 2005/4, para 21-22. For example, environmental assessments for a project must be directly connected with the project but they are not the project itself. The project must have a finite life: see ATO ID 2012/17. Ruling TR 2005/4 also emphasises that Subdiv 40-I only applies to a project that is ‘‘carried on’’ (which requires some form of continuing activity) or ‘‘proposed to be carried on’’: s 40-840(2). If project activity ceases, it is a question of fact whether the project is still being carried on or whether it has been abandoned. The holding of a passive investment would not have sufficient activity to constitute the carrying on of a project. The words ‘‘propose to carry on’’ require a commitment of some substance to the activity or activities identified as constituting the project.

[10 1060] Mining and transport capital expenditure Mining capital expenditure and transport capital expenditure incurred by a taxpayer are project amounts if the expenditure does not form part of the cost of a depreciating asset that the taxpayer holds or is taken to have held and is not deductible under another provision of the income tax legislation: s 40-840(1). In addition, the expenditure must be directly © 2017 THOMSON REUTERS

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[10 1070]

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connected with carrying on the mining operations in relation to mining capital expenditure or with the business in relation to which the transport capital expenditure is incurred (as appropriate). The inclusion of mining capital and transport capital expenditure as project amounts is intended to ensure that all mining capital expenditure and transport capital expenditure that would have been deductible under former Div 330 ITAA 1997 is now deductible under Div 40. Subdivision 40-I effectively acts as a ‘‘safety net’’ to ensure that mining and transport capital expenditure not covered by other Subdivisions of Div 40 is captured by Subdiv 40-I.

[10 1070] Mining capital expenditure Mining capital expenditure is defined in s 40-860 as capital expenditure incurred: • in carrying on mining operations (see [29 030]) and in preparing a site for those operations (eg checking the site and removing overburden); • on buildings, etc, necessary for the taxpayer to carry on those operations; • in providing, or in contributing to the cost of providing, water, light or power for use on, or access to or communications with, the site of those operations; • on buildings for use directly in connection with operating or maintaining plant that is primarily and principally for treating minerals, or quarry materials, that the taxpayer obtains by carrying on such operations; or • on buildings for use directly in connection with storing minerals or quarry materials or to facilitate minerals treatment of them. Mining capital expenditure also includes capital expenditure incurred on housing and welfare in carrying on mining operations if: • the residential accommodation is on or adjacent to the mine site for the use of employees, contractors’ employees and their dependants; • the health, education, recreation or other similar facilities and facilities for meals are on or adjacent to the mine site and are not run for profit (except facilities for meals); and • any works (including works providing for water, light, power, etc) are carried out directly in connection with the facilities covered by s 40-860. ‘‘Housing and welfare’’ is defined in s 995-1 to mean residential accommodation, health, education, recreation or similar facilities, facilities for meals and works directly connected with such accommodation facilities. In Waratah Gypsum v FCT (1965) 112 CLR 152, McTiernan J held that expenditure on houses and buildings some 9 miles from the actual mining operations were adjacent to the mine for the purposes of the equivalent provision in the ITAA 1936. The area in which the properties were located was the nearest appropriate location for that purpose. In FCT v BHP Minerals Ltd (1983) 14 ATR 389, accommodation was provided in 2 towns 50 and 60 kilometres respectively by road from the mining site. A majority of the Full Federal Court held that the location was ‘‘adjacent to’’ the mining site and that the term called for a broad approach that must have regard to the facilities available generally in the area. Mining capital expenditure does not include expenditure on (s 40-860(3)): • railway lines, roads, pipelines or other facilities for use wholly or partly for transporting minerals or quarry materials, or their products (other than facilities used for transport wholly within the site of the mining operations); • work, buildings or improvements constructed or acquired for use in connection with a port facility or other facility for ships; 426

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• an office building that is not at or adjacent to the mining site; and • housing and welfare in relation to quarrying operations. Expenditure on diverting a highway in order to maintain the life of an open cut gold mine and to gain access to other gold reserves should constitute mining capital expenditure: FCT v Pine Creek Goldfields Ltd (1999) 42 ATR 758.

[10 1080] Transport capital expenditure Transport capital expenditure is defined in s 40-865 as capital expenditure incurred in carrying on a business for a taxable purpose (effectively producing assessable income) on: • a transport facility; • obtaining a right to construct or install a transport facility on land owned or leased by another entity or in an adjacent area (within the meaning of s 6AA ITAA 1936); • paying compensation for any damage or loss caused by constructing or installing a transport facility; or • earthworks, bridges, tunnels or cuttings that are necessary for a transport facility. Transport capital expenditure also includes capital expenditure incurred by way of contribution to another entity’s capital expenditure on a transport facility or to an exempt Australian government agency’s capital expenditure on railway rolling-stock. Transport capital expenditure does not include expenditure on (s 40-865(3)): • road vehicles or ships; • railway rolling-stock; • a thing covered by the definition of housing and welfare (as defined in s 995-1); or • works for providing water, light or power, in connection with a port facility or other facility for ships; and • contributions to expenditure listed above, except a contribution to the capital expenditure of an exempt Australian government agency on railway rolling-stock. A ‘‘transport facility’’ is defined in s 40-870 as a railway, road, pipeline, port facility or other facility for ships or another facility that is used primarily and principally for the transport of minerals (see [29 030]) or quarry materials obtained by any entity in carrying on mining operations or processed minerals produced from minerals or quarry materials. For the Tax Office’s view on the meaning of ‘‘primarily and principally’’, see Determinations TD 93/52 and TD 93/53. ‘‘Processed minerals’’ are defined in s 40-875(1) to mean any of the following: materials resulting from minerals treatment of minerals or quarry materials (other than petroleum); materials resulting from sintering or calcining; pellets or other agglomerated forms of iron; and alumina and blister copper. ‘‘Minerals treatment’’ is defined in s 40-875(2) to mean cleaning, leaching, crushing, grinding, breaking, screening, grading or sizing or concentration and includes any other treatment that is applied to a mineral or to quarry materials before concentration or, in the case of minerals not requiring concentration, any treatment that would have been applied before concentration if the mineral or material had required concentration. See ATO ID 2012/100. ‘‘Minerals treatment’’ does not include sintering or calcining or producing alumina or pellets or other agglomerated forms of iron, or processing connected with such production. Transport wholly within the site of mining operations, and transport of petroleum that has been treated at a refinery or that forms part of a system of reticulation to consumers or to a particular consumer or consumers, is not a transport facility: s 40-870(2). © 2017 THOMSON REUTERS

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[10 1090]

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[10 1090] Calculating project pool deduction If a project starts to operate on or after 10 May 2006 and the project pool contains only project amounts incurred on or after that date, the deduction for expenditure allocated to the pool is (s 40-832(1)): Pool value × 200% DV project pool life

In all other cases (eg if the project started to operate before 10 May 2006 or if the pool contains project amounts incurred before that date), the write-off rate is 150%. The deduction for expenditure allocated to the pool is (s 40-830(3)): Pool value × 150% DV project pool life

The ‘‘DV project pool life’’ is the effective life of the project or its most recent recalculated effective life: ss 40-830(3), 40-832(1). The effective life of the project is worked out by estimating how long (in years and fractions of years) it will be from the time the project starts to operate until it stops operating: s 40-845. An integrity measure means that the write-off rate is 150% (and not 200%) if a pre-10 May 2006 project terminates (eg it is sold or abandoned) but the taxpayer later restarts the project in circumstances where it is reasonable to conclude that these steps were taken in order to access the higher 200% write-off rate: s 40-832 TPA. The project pool provisions do not apply if the life of the project cannot be objectively and reasonably estimated or if the project itself cannot be identified: see Ruling TR 2005/4. The taxpayer must evaluate the project pool life each year. See Ruling TR 2005/4 for the factors to be taken into account by the taxpayer in estimating the project pool life. For the income year in which a project amount is first allocated to the pool, the ‘‘pool value’’ is the total of the amounts allocated in that year: ss 40-830(3)(a), 40-832. In later income years, the pool value is the closing pool value for the previous income year plus any new amounts allocated to the pool in the current year: ss 40-830(3)(b), 40-832(1). Note that the pool value may be adjusted if there is a short-term forex realisation gain or loss under Subdiv 77-B: see [32 300]. The maximum amount deductible in an income year is the component pool value in the relevant formula for that year: ss 40-830(8); 40-832(5). However, the project pool deduction is reduced to the extent that the project does not operate for a taxable purpose (see [10 070]): s 40-835. Note that if a depreciating asset is put to a tax preferred use for the purposes of Div 250 and the apportionment rule in s 250-150 applies (see [33 100]), a deduction is not available to the extent specified under s 250-150(3). A taxpayer can begin to deduct amounts for a project pool for the first year when the project starts to operate: s 40-855. A project starts to operate when the construction or preparatory stage of the project is completed and the taxpayer starts to do things that support the relevant taxable purpose. For example, a mining project will start to operate when the taxpayer starts extraction activities. In Re Applicant and FCT (2009) 76 ATR 671, expenditure failed the taxable purpose test because the project in question was still in the experimental stage. If a project ends, the total of the closing pool value of the previous income year and any further amounts allocated to the pool in the current year are deductible: ss 40-830(4), 40-832(2). Any proceeds received by the taxpayer are assessable: see [10 1100].

[10 1100] Assessable amounts As discussed at [10 1090], an immediate deduction is available to a taxpayer when a project ends. However any proceeds on the termination of the project (eg sale proceeds) must be included in the taxpayer’s assessable income: ss 40-830(5), 40-832(3). A taxpayer must also include in assessable income any other capital amounts derived in relation to either a project amount that has been allocated to a project pool or something on which such a project 428

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CAPITAL ALLOWANCES [10 1150]

amount is expended: ss 40-830(6), 40-832(4). This ensures that all receipts in relation to pooled amounts are included in the taxpayer’s assessable income.

BUSINESS RELATED COSTS [10 1150] Deduction for other business expenses Special provisions (s 40-880 in Subdiv 40-I) provide a systematic treatment for certain business expenditure of a capital nature – sometimes termed ‘‘blackhole’’ expenses. Business related capital expenditure (see [10 1160]) is deductible under s 40-880 on a straight-line basis over 5 years if: • it is not taken into account in some way elsewhere in the income tax law (eg under Subdiv 40-B for depreciating assets); and • it is not expressly made non-deductible (other than because the expenditure is of a capital nature). The deduction under s 40-880 applies to capital expenditure incurred in relation to (s 40-880(2)): • an existing business carried on by the taxpayer; • a business that used to be carried on by any entity (‘‘post-business expenditure’’); or • a business that is proposed to be carried on by any entity (‘‘pre-business expenditure’’). This means that, in the case of a former or proposed business, a deduction may be available to an entity other than the one that carried on, or proposes to carry on, the business (although only the entity that incurs the expenditure can claim a deduction). However, if another entity carried on a former business or proposes to carry on a future business, the deduction is only available if the expenditure is incurred in connection with the particular business and with the taxpayer deriving assessable income from the business: s 40-880(4). In the case of an existing business, a deduction is only available to the entity carrying on the business (in contrast to the position where it is a former or proposed business). In the case of a proposed business, an amount is not deductible unless, having regard to any relevant circumstances, it is reasonable to conclude that the business is proposed to be carried on within a reasonable time: s 40-880(7). A business is proposed to be carried on if the taxpayer can demonstrate a commitment of some substance to commence the business and a sufficient identity about the proposed business, eg by having identified (at the time the expenditure is incurred) the business structure, the business model, the activities to be carried on and the trading name (see ATO ID 2008/107, ATO ID 2008/108 and ATO ID 2009/42). In ATO ID 2010/132, compensation paid by an individual to his employer for terminating his employment contract early, so that he could start up his own business, was not incurred in relation to a proposed business and therefore was not deductible under s 40-880. Note that, in the case of an existing business, the ‘‘business’’ is the entity’s overall business rather than a particular enterprise or undertaking, whereas in the case of a former or proposed business, the ‘‘business’’ could refer to the overall business or a business activity that is an element or aspect of the overall business: Ruling TR 2011/6. Eligibility for a deduction under s 40-880 is established as at the time the expenditure is incurred: see Ruling TR 2011/6. Expenditure is only deductible under s 40-880 to the extent that the relevant business is carried on, was carried on or is proposed to be carried on for a taxable purpose: s 40-880(3), (4). The meaning of ‘‘taxable purpose’’ is considered at [10 070]. Note that the taxable purpose test is applied to the business rather than the expenditure. © 2017 THOMSON REUTERS

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[10 1160] CAPITAL ALLOWANCES

The words ‘‘to the extent that’’ clearly imply that expenditure may be apportioned if a business is carried on for both taxable and non-taxable purposes. The Commissioner considers that the absence of the expression ‘‘to the extent that’’ in s 40-880(2) does not prevent an apportionment of expenditure which serves more than one purpose: Ruling TR 2011/6. The basis for any such apportionment must be fair and reasonable. The extent to which the taxpayer’s business will be carried on for a taxable purpose is to be determined at the time the expenditure is incurred, taking into account (in the case of an existing or proposed business) all known and predictable facts in future years: Ruling TR 2011/6. The taxable purpose test for a former business is applied to the period which reasonably reflects the taxable purpose of the former business. Generally, the Commissioner will accept that a period of 5 years before the taxpayer permanently ceased operating the business will give a reasonable reflection: Ruling TR 2011/6. If expenditure is not deductible under s 40-880, it may be possible to categorise the expenditure as a project amount under s 40-840: see [10 1050]. If a depreciating asset is put to a tax preferred use for the purposes of Div 250 and the apportionment rule in s 250-150 applies (see [33 100]), a deduction is not available to the extent specified under s 250-150(3). Note that, for individual taxpayers, the non-commercial loss provisions in Div 35 also apply so that a deduction which is otherwise available may be deferred or denied: see [8 600].

Deduction spread over 5 years If capital expenditure is deductible under s 40-880, the deduction is spread over 5 years in equal proportions (ie 20% of the expenditure each year), commencing with the year in which the expenditure is incurred: s 40-880(2). For GST adjustments in relation to a deduction under s 40-880, see [27 370]. There is no need to apportion expenditure that is incurred part-way through the year (ie the full 20% is deductible). Of course, a payment may need to be apportioned between various activities in order to determine the amount that can be written off under s 40-880 (eg see ATO ID 2005/107). If the taxpayer is wound up, the entitlement to deduct any remaining undeducted expenditure is lost for income years after the one in which the taxpayer is wound up: see ATO ID 2009/6. Immediate deduction for certain SBE start-up expenditure A small business entity (see [25 020]) is entitled to an immediate deduction for pre-business expenditure incurred after 30 June 2015 if the expenditure is (s 40-880(2A)): • a payment of government fees, taxes or charges relating to establishing a business or its operating structure (eg incorporation fees and duties on the transfer of assets) – but not if the expenditure forms part of the cost base of a CGT asset: see [10 1160]; or • the cost of advice or services relating to the structure or operation of the proposed business. A non-business taxpayer is also entitled to a deduction for the types of expenditure listed above, provided the taxpayer is not connected with, or is not an affiliate of, a business entity that is not a small business entity. For example, if an individual who is not carrying on a business pays for advice relating to the legal structure of a proposed business, the individual is entitled to a deduction for the expenditure provided he or she is not connected with, or an affiliate of, a business entity that is larger than a small business entity. See [25 050] and [25 060] respectively for the meaning of ‘‘affiliates’’ and ‘‘connected entities’’.

[10 1160] Types of deductible expenditure The types of expenditure covered by s 40-880 include those outlined below (see also the Explanatory Memorandum accompanying the Taxation Laws Amendment Act (No 5) 2002 (‘‘TLA5 2002’’), which enacted the original s 40-880). 430

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CAPITAL ALLOWANCES [10 1160]

1. Expenditure to establish a business structure, ie the legal entity (eg a company), or the legal relationship (eg a partnership or trust) that is established as the entity, that will carry on the business, eg see Determinations TD 2010/1 and TD 2011/9 (noted below). The costs of incorporating a company or creating a trust will qualify, but franchise fees and lease premiums will not. Franchise ‘‘establishment fees’’ incurred to operate a community bank have been held not to be deductible under s 40-880: Re Inglewood & Districts Community Enterprises Limited and FCT (2011) 84 ATR 688. 2. Expenditure to convert an existing business structure to a different structure. This should include expenditure incurred in varying contracts such as supply contracts to reflect that the transferee (as opposed to the transferor) is a party to them as a result of the conversion of the business structure. Costs associated with an internal reorganisation (eg if a holding company incurs expenses in selling off some part of a wholly owned subsidiary) may not be covered. 3. Expenditure to raise equity for the business through either a private placement or public issue of shares or a rights issue (but not if a company acquires shares in itself and settles them on trust for the benefit of employees). This would cover the preparation of disclosure documents such as a prospectus, a short form prospectus, a profile statement or an offer information statement for small fundraisings of $5m or less, underwriting costs, legal fees, printing costs, postal costs and advertising costs. Expenditure associated with the issue of a convertible debt instrument is not deductible under s 40-880 but may be deductible under s 25-25: see [9 470]. If that instrument is converted to shares, the conversion costs will fall within s 40-880. 4. Expenditure to defend a business against a takeover under the Corporations Act 2001. Expenditure that would be covered should include legal and accounting costs, stockbrokers’ and merchant bankers’ fees, compliance fees, and the media, printing, advertising and mailing costs in relation to documents produced for shareholders, costs of independent evaluations of the takeover offer, the salary and wages of individuals employed specifically to undertake takeover defence activities and the cost of preparing and issuing Part B statements or Part D statements. The cost of acquiring shares as a defensive manoeuvre engaged in by a company under threat of a takeover is not deductible under s 40-880 as such costs are recognised in the cost base of the shares: s 40-880(3)(f). 5. Expenditure incurred in an unsuccessful takeover attempt. 6. Expenditure incurred by a shareholder in liquidating a company that carried on a business. Capital expenditure incurred in winding up a partnership of which the taxpayer was a partner or in winding up a trust of which the taxpayer was a beneficiary is also deductible, provided the partnership or trust carried on a business: s 40-880(2). 7. Expenditure incurred in ceasing to carry on the taxpayer’s business. This should cover capital expenditure in the form of legal costs for terminating the services of employees when the taxpayer stops carrying on its business and costs associated with the removal of tenant’s fixtures and site rectification costs (although mining site rehabilitation expenditure is deductible under Subdiv 40-H (see [29 040]) and certain waste removal costs are deductible under s 40-755: see [11 610]). Pre-business expenditure such as the cost of a feasibility study and market research and post-business expenditure incurred as a consequence of the business ceasing to operate may also be deductible. For examples of expenditure considered to be deductible under s 40-880, see ATO ID 2007/87 (airfares in travelling to inspect a second-hand bus for use in a bus charter business), ATO ID 2007/91 and ATO ID 2007/92 (legal, accounting and investment banking fees incurred in effecting a demerger), ATO ID 2007/109, ATO ID 2007/111 and © 2017 THOMSON REUTERS

431

[10 1160]

CAPITAL ALLOWANCES

ATO ID 2007/112 (capital expenditure on evaluating a merger proposal, constitutional changes to facilitate the merger and implementing a scheme of arrangement), ATO ID 2009/70 (a settlement payment to finalise all claims against the taxpayer for breach of contract) and ATO ID 2009/73 (legal expenses incurred in acquiring a business). EXAMPLE [10 1160.10] Hettie The Hound Pty Ltd carries on a mobile dogwash business. The company spends $3,100 on research into the market for dog biscuits for the purpose of establishing a new business. The research indicates that such a business is unlikely to be profitable and consequently a new business is not established. However, the $3,100 is deductible over 5 years.

EXAMPLE [10 1160.20] Sandra and Paul own a small but successful coffee shop. They decide to open another coffee shop in a newly constructed shopping mall. In the income year in which they incur the expenditure, 20% of it is deductible. In the following income year, they are forced to sell the new coffee shop due to unforeseen personal circumstances. They are able to deduct the remaining 80% of the expenditure in equal proportions over the next 4 income years (commencing in the income year in which they sell the business).

Exceptions Expenditure incurred in relation to non-business activities such as a passive investment is not deductible: Ruling TR 2011/6. Similarly, occupation as an employee is generally a non-business activity. In addition, expenditure is only deductible under s 40-880 to the extent that it is not taken into account in some way elsewhere in the income tax law. More specifically, expenditure is not deductible under s 40-880 to the extent that the expenditure (s 40-880(5)): • forms part of the cost of a depreciating asset the taxpayer holds, used to hold or will hold (eg ATO ID 2009/3); • is deductible under another provision of the income tax law (eg under s 40-830 as a project amount), even if the expenditure has not yet been or can no longer be deducted; • forms part of the cost of land. This covers only the cost of acquiring land (including stamp duty and conveyance costs) and does not extend to a cost of holding or maintaining land already acquired. Expenditure incurred to acquire land where the cost of acquiring land does not form part of the cost base or reduced cost base of the land (eg if the amount is incurred to acquire the freehold title to land for someone other than the taxpayer) is not deductible: Ruling TR 2011/6; • is in relation to a lease or other legal or equitable right (eg a lease surrender payment incurred in closing down a business will not be deductible under s 40-880). However, expenditure incurred in relation to a lease or other legal or equitable right is deductible if the value of the expenditure to the taxpayer arises solely from the effect that the right has in preserving (but not enhancing) the value of goodwill: s 40-880(6). The Tax Office considers that there must be a ‘‘sufficient and relevant connection’’ between incurring the expenditure and the lease for this exception to apply: see ATO ID 2009/36 and ATO ID 2010/30. This means that if a lease does not come into existence, the expenditure will not be incurred “in relation to a lease” and the exception will not apply: see ATO ID 2010/157. 432

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[10 1160]

Ruling TR 2011/6 takes the view that the ‘‘rights’’ in question do not include all legal rights but only those similar to leases, in that they give the taxpayer a right to exploit the asset with which the right is associated, ie the right is carved out of an asset but falls short of full ownership of the asset. Examples would include profits a prendre, easements and other rights of access to land. In ATO ID 2010/30, the Tax Office said that a capital appreciation payment made by the owner of a retirement village to the lessee of a residential unit upon termination of the lease was not deductible under s 40-880; • would (apart from s 40-880) be taken into account in working out an assessable profit or deductible loss (eg in certain circumstances, expenditure may be taken into account in working out a profit arising from the carrying on or carrying out of a profit-making undertaking or plan that is included in assessable income under s 15-15: see [3 120]. Such expenditure has already been recognised through a lesser amount being included in the taxpayer’s assessable income and should not be deductible under s 40-880); • could (apart from s 40-880) be taken into account in working out the amount of a capital gain or capital loss from a CGT event (this exception applied in ATO ID 2007/89, ATO ID 2008/45 and ATO ID 2010/91, but not in ATO ID 2007/112). This exception also applied in Re Inglewood & Districts Community Enterprises Ltd in relation to franchise ‘‘establishment fees’’ incurred to operate a community bank. The Tax Office considers that this exception applies even if expenditure that could be taken into account in working out the capital gain or loss from a CGT event cannot be reflected in the taxpayer’s net capital gain for the income year, because the time allowed to amend the taxpayer’s assessment for that year has expired: see ATO ID 2010/69. Capital support payments made by a parent entity to its subsidiary are included in the cost base and reduced cost base of the parent’s investment in the subsidiary and are therefore not deductible under s 40-880: Determination TD 2014/14. Professional fees that qualify as incidental costs for CGT cost base purposes (eg for the services of a legal adviser, accountant, surveyor, valuer or broker: see [14 040]) which the head company of a consolidated group, or of an MEC group, incurs in acquiring the shares of a subsidiary before the entity joins the group, or in disposing of shares in a subsidiary to a non-group entity after the subsidiary has left the group, are not deductible under s 40-880: Determinations TD 2011/8 and TD 2011/10. However, this exception does not prevent the deduction (under s 40-880) of incidental costs which the head company of a consolidated group, or of an MEC group, incurs either in disposing of shares in a subsidiary to a non-group entity before the subsidiary leaves the group, or in acquiring shares in a subsidiary from a non-group entity after the subsidiary joins the group: Determinations TD 2010/1 and TD 2011/9; • is expressly made non-deductible by another provision of the income tax law (including if it is limited or capped) if it were not of a capital nature; • is expressly made non-deductible by another provision of the income tax law for a reason other than the expenditure being of a capital nature (eg entertainment expenses, fines and taxes). In other words, revenue expenditure that is not deductible is not made deductible simply because it is of a capital nature; • is of a private or domestic nature; or • is incurred in gaining exempt income or non-assessable non-exempt income. If a market value substitution rule applies to exclude an amount from the cost of a depreciating asset (see [10 360] and [10 380]) or from the cost base or reduced cost base of a CGT asset (see [14 160]), the excluded amount is not deductible under s 40-880: s 40-880(8). Returns of capital, including equity and debt interests, and returns on equity and debt interests are not deductible under s 40-880: s 40-880(9). This covers, for example, dividends, © 2017 THOMSON REUTERS

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[10 1200]

CAPITAL ALLOWANCES

margin calls, payments to buy back shares, trust distributions and repayments of loan principal. For examples of the application of s 40-880(9), see ATO ID 2011/78 and ATO ID 2011/79. Note that if an undivided amount of capital expenditure is incurred (eg on legal fees), the amount should be dissected as between each discrete matter in order to consider the deductibility of the expenditure: see ATO ID 2009/83.

PARTICULAR ASSETS [10 1200] Tools of trade Tools of trade, whether loose tools such as hammers and chisels or larger hand-operated power tools such as drills, are normally used for a number of years. Their cost is on capital account and therefore they must be depreciated under Div 40. However, an immediate deduction is available for tools of trade costing $300 or less that are predominantly used to produce non-business income (subject to s 40-80(2) which applies if the tools are part of a set or if other substantially identical tools are also purchased: see [10 530]). Note the Tax Office’s administrative practice of allowing an immediate deduction for certain low-cost assets, discussed at [10 530]. For special rules applying to small business entities, see [25 110]. If an immediate deduction is not available (eg the tools are used to produce business income), the tools may be allocated under Div 40 to a low-value pool (see [10 760]) if they cost less than $1,000 or their opening adjustable value (see [10 550]) is less than $1,000. Otherwise, the decline in value of the tools has to be calculated separately. Note that a set of assets, or substantially identical assets, is treated as one asset even if each asset individually costs $300 or less (s 40-80(2)): see [10 530]. Thus, for example, a set of spanners will be treated as one asset and therefore the deduction is based on the cost of the set and not the cost of each spanner (eg if the set costs more than $300, but less than $1,000, the spanners may be allocated to a low-value pool – although if the taxpayer is a small business entity, an outright deduction is available). The cost of items that are clearly expendable within an income year, such as ball point pens, pencils, nails etc, is deductible outright under s 8-1. The substantiation rules may apply to tools of trade purchased by an employee: see [9 1450] and following. Note that an employee cannot claim a deduction under Div 40 for a tool of trade provided by an employer if the provision of the benefit is an exempt expense payment or property benefit under s 58X FBTAA: see [10 190]. [10 1210] Assets installed on Crown land or leased land Item 2 of the table in s 40-40 specifies who ‘‘holds’’ a depreciating asset that is fixed to land subject to a quasi-ownership right (including any extension or renewal of that right). Item 3 of the table specifies who ‘‘holds’’ an improvement to land (whether a fixture or not) subject to a quasi-ownership right. In the situations dealt with by Items 2 and 3, the owner of the quasi-ownership right is the holder: see [10 250]. ‘‘Quasi-ownership’’ is defined broadly in s 995-1 to mean a lease over land (including a tenancy at will: see ATO ID 2009/156), an easement or any other right, power or privilege over the land or in connection with the land. A lease over Crown land is a ‘‘quasi-ownership right’’, but the quasi-ownership right need not be held from an Australian government or government agency. Sections 40-180 to 40-190 provide that, as a holder, a lessee is generally entitled to depreciate such assets based on actual cost or, if no cost is specified, based on a reasonable attribution of consideration. 434

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CAPITAL ALLOWANCES

[10 1220]

Termination of lease If a lease is terminated, expires or is surrendered and is not followed by the grant of a new lease or freehold title to the lessee, the lessee is treated as having disposed of a depreciating asset to the lessor (ie it stops holding the asset) if the right of removal ceases to exist: s 40-40, Item 2. The consideration for the disposal is the amount, if any, received by the lessee that relates to the asset disposed of: ss 40-300 and 40-305. No disposal will happen if there is still a right to remove the asset after the expiry or ending of the lease. The balancing adjustment rules in Subdiv 40-D (see [10 850]-[10 1030]) apply to determine whether the lessee has derived an assessable recoupment of previously allowed deductions for its decline in value or has incurred a deductible loss. In circumstances where the disposal of the lease is followed by the grant of a fresh lease or freehold title to the lessee, the lessee is taken to continue to own the depreciating asset provided the lessee’s right to remove the asset continues to exist: s 40-40, Item 2.

Capital gains tax Sections 124-655 and 124-660 prevent capital gains and losses from accruing in respect of depreciating assets installed on a Crown lease if a lease is terminated, but the lessee or an associate of the lessee retains an interest in the plant: see [16 210].

[10 1220]

Computer software

The treatment of computer software depends partly on whether it is ‘‘in-house software’’. In-house software is computer software, or a right to use computer software, that is acquired, developed or commissioned mainly for the taxpayer to use in performing the functions for which the software was developed: s 995-1. In-house software is specifically listed in s 40-30(2) as a depreciating asset: see [10 790]. Note that if a deduction in respect of software is available under the income tax legislation outside Div 40 (the UCA system) or Div 328 (small business entities: see [25 100]), for example under s 8-1, the software is not in-house software. Expenditure on developing or commissioning in-house software may be allocated to a software development pool: see [10 790]. If expenditure is not allocated to a pool, the software is depreciable under Div 40 in accordance with the general rules discussed earlier in this chapter. Expenditure on acquiring in-house software cannot be allocated to a software development pool and is only depreciable under the general rules. Note that if software is not in-house software, it will be depreciable under the general rules in Div 40 if it is an item of intellectual property (and thus a depreciating asset: see [10 150]). In-house software that is depreciable under the general rules (eg because it has not been allocated to a software development pool) has an effective life of 4 or 5 years, depending on the start date: s 40-95(7). Software that is first used or first installed ready for use on or after 1 July 2015 has an effective life of 5 years, otherwise the effective life is 4 years. Note that there seems to be nothing to prevent software that is not (or cannot be) allocated to a software development pool being allocated to a low-value pool: see [10 760]. If the Commissioner has not determined an effective life for computer software that is not in-house software (and which is a depreciating asset), the taxpayer must self-assess the effective life. If the relevant depreciating asset is a licence to use computer software that is not in-house software, the effective life is the term of the licence: s 40-95(7). Computer hardware may qualify as a depreciating asset, in which case it will be depreciable under Div 40 in accordance with the general rules. © 2017 THOMSON REUTERS

435

[10 1230]

CAPITAL ALLOWANCES

Software not depreciable under Div 40 In-house software that is trading stock is not a depreciating asset: s 40-30(2). Ongoing operating expenses, including expenditure on maintenance, testing, minor modifications and repairs, are not depreciable under Div 40. Instead, such expenditure is likely to be deductible under s 8-1 in accordance with general principles (discussed in Chapter 8). Abandonment of software If in-house software has never been used, or has been installed ready for use and the taxpayer decides to abandon the software, the expenditure is allowed as a deduction provided it has not been allocated to a software development pool: s 40-335. The deduction is reduced by an amount that represents the extent to which the taxpayer did not intend to use it for a taxable purpose and any amount of consideration derived in relation to the software. Expenditure of $300 or less on software is deductible outright in the year it is incurred if it has not been allocated to a software development pool and it is used predominantly for the purpose of producing non-business income: see [10 530]. Assessable income Any consideration received for pooled software is assessable: see [10 790]. [10 1230] Datacasting transmitter licences Datacasting transmitter licences are depreciating assets: s 40-30. Datacasting transmitter licences are issued under the Radiocommunications Act 1992 by the Australian Communications Authority for 10 years with a once-only renewal for a further 5 years. The holder of a datacasting transmitter licence can deduct the initial price and any incidental costs of acquiring the licence over the 15-year life of the licence. If the licence is not renewed for the additional 5 years, the taxpayer obtains an immediate write-off of the remaining cost at the end of the initial 10 years. [10 1240] Telecommunications cables, IRUs and site access rights Division 40 provides a capital allowance deduction for the cost of acquiring an indefeasible right to use (IRU) a domestic telecommunications cable system or a portion of an international telecommunications submarine cable. The cost is deductible over the effective life of the cable, as determined by the holder of the IRU. Generally, the rules are similar to those that apply to all depreciating assets. Division 40 also applies to telecommunications site access rights acquired by licensed telecommunications carriers. A telecommunications site access right is the right (except an IRU) of a carrier to share a facility, to install a facility at a particular location or on a particular structure or to enter premises for the purpose of installing or maintaining such a facility. The effective life of the right is the term of the right (the prime cost method is to be used). The expenditure on a domestic IRU or a telecommunications site access right must be incurred on or after 12 May 2004. A taxpayer cannot claim a deduction by refreshing the IRU or right on or after that date. In addition, if a taxpayer is deemed to acquire a domestic IRU or a telecommunications site access right on or after 12 May 2004 merely because of the operation of the consolidation provisions, the IRU or right is taken to have been acquired before 12 May 2004. The disposal of an IRU or telecommunications site access right is subject to the balancing adjustment provisions in Subdiv 40-D rather than the CGT provisions: see [10 850] onwards. There are special rules governing the disposal of only part of an IRU or telecommunications site access right (including before the asset begins to be depreciated). The owner of a cable system that disposes of part of the capacity in the cable is treated in the same way. There are provisions dealing with an increase in capacity of an existing IRU. 436

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CAPITAL ALLOWANCES [10 1270]

Note that if a taxpayer enters into an IRU agreement giving indefeasible rights to the use of a telecommunications cable system, the depreciating assets (such as each segment of the cable system) that are held by the taxpayer and that form the cable system are not split into 2 or more separate assets pursuant to s 40-115 (see [10 290]): ATO ID 2012/38.

[10 1260] Primary producers Subdivisions 40-F and 40-G provide capital allowances for depreciating assets that are used for primary production purposes (or, in some cases, for some other business connected with rural land). Qualifying assets include water facilities, horticultural plants, fodder storage assets, fencing assets, landcare operations, electricity connections and telephone lines. Subdivisions 40-F and 40-G are discussed at [27 300]-[27 390]. [10 1270] Mining, quarrying or prospecting rights and information Mining, quarrying or prospecting rights and mining, quarrying or prospecting information are depreciating assets that can be depreciated over their effective life (s 40-30(2)), although in certain circumstances an outright deduction may be available under s 40-80(1): see below. Mining, quarrying or prospecting rights are essentially rights to mine, quarry or prospect for resources. Such a right is defined in s 995-1 to mean any of the following: • an authority, licence, permit or right under an Australian law to mine, quarry or prospect for minerals, petroleum or quarry materials; • a lease of land that allows the lessee to mine, quarry or prospect for minerals, petroleum or quarry materials on the land; • an interest in such an authority, licence, permit, right or lease (eg see ATO ID 2010/2 and ATO ID 2010/45). This covers an interest in a mining tenement: see Ruling MT 2012/1; or • any rights that: – are in respect of buildings or other improvements (including anything covered by the definition of housing and welfare) that are on the land concerned or are used in connection with operations on it; and – are acquired with such an authority, licence, permit, right, lease or interest. However, a right in respect of anything covered by the definition of housing and welfare (see [10 1070]) in relation to a quarrying site is not a mining, quarrying or prospecting right. The definition of a ‘‘mining, quarrying or prospecting right’’ was analysed by the Full Federal Court in Mitsui & Co (Australia) Ltd v FCT (2012) 90 ATR 171 in the context of a production licence granted under the Petroleum (Submerged Lands) Act 1967. The licence conferred both a right to explore for petroleum and a right to recover petroleum. The taxpayer argued that these were separate rights, each of which comprised a “mining, quarrying or prospecting right” for the purposes of Division 40. The Full Court rejected this argument, concluding that there was but one depreciating asset, namely an interest in a right allowing exploration and recovery (thereby upholding the first instance decision in Mitsui & Co (Australia) Ltd v FCT (2011) 86 ATR 258). Whether mining, quarrying and prospecting rights were ‘‘used’’ by the taxpayer for Div 40 purposes was considered in ATO ID 2007/116. The application of s 40-80(1) is considered in ATO ID 2010/64, ATO ID 2010/65, ATO ID 2010/66 and ATO ID 2010/67. In ATO ID 2011/25, an entity contracted to provide geophysical surveying services to entities in the mining and mineral exploration industries was not considered to be carrying on a business of, or a business that included, exploration or prospecting for minerals. © 2017 THOMSON REUTERS

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[10 1270]

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Mining, quarrying or prospecting information is geological, geophysical or technical information that (a) relates to the presence, absence or extent of deposits of minerals or quarry materials in an area; or (b) is likely to help in determining the presence, absence or extent of such deposits in an area: s 40-730(8).

Immediate deduction In certain circumstances, an outright deduction is available for a depreciating asset that is used for exploration or prospecting (ie the decline in value of the asset is its cost) in the circumstances specified in s 40-80(1): see [29 030] for the definition of ‘‘exploration or prospecting’’. These circumstances are: (a) the asset is first used for exploration or prospecting for minerals, or quarry materials, obtainable by mining operations; (b) when the asset is first used by the taxpayer, it is not used for petroleum development drilling or for operations in the course of working a mining or quarrying property or petroleum field; (c) when the taxpayer first uses the asset, or has it installed ready for use, for any purpose (ie at the asset’s start time): • the taxpayer carries on mining operations; • it would be reasonable to conclude that the taxpayer proposes to carry on mining operations; and/or • the taxpayer carries on a business of, or a business that includes, exploration and prospecting for minerals or quarry materials (that are obtainable by such operations) and the expenditure on the asset is necessarily incurred in carrying on that business. (d) if the asset is a mining, quarrying or prospecting right, it was acquired from an Australian government agency or entity – this does not apply to mining rights and mining information acquired before 7.30 pm on 14 May 2013 AEST, or acquired after that time pursuant to an arrangement entered into before that time; or (e) if the asset is mining, quarrying or prospecting information, it was acquired from an Australian government agency or entity, or it was provided by a private supplier of geological data of a technical nature or it was created by the taxpayer itself, either directly or through hiring a contractor to generate the information (s 40-80(1AA)) – this does not apply to mining rights and mining information acquired before 7.30 pm on 14 May 2013 AEST, or acquired after that time pursuant to an arrangement entered into before that time. Note that expenditure incurred in improving mining, quarrying or prospecting information qualifies for an outright deduction, regardless of how the original information was acquired (applicable from 7:30 pm on 14 May 2013 AEST).

Effective life of rights and information The effective life of a mining, quarrying or prospecting right and mining, quarrying or prospecting information is generally the estimated period until the end of the life of the relevant mine, petroleum field or quarry (or proposed mine, petroleum field or quarry): s 40-95(10). If there is more than one mine or quarry, the effective life is worked out by reference to the mine or quarry that has the longest estimated life. Thus, for example, a taxpayer who acquires a mining right from a prior holder can estimate the remaining period until the end of the life of the existing or proposed mine to which the right relates, irrespective of whether the taxpayer chooses the prime cost or the diminishing value method of working out the decline in value of their mining right. 438

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CAPITAL ALLOWANCES

[10 1270]

If the only reason an immediate deduction is not available is because the requirements of (d) or (e) above are not satisfied, the effective life of the right or information is the shorter of the estimated period under s 40-95(1) and 15 years: s 40-95(10A). The period until the end of the life of an existing or proposed mine is worked out as the period over which the reserves are expected to be extracted from the mine. This period is worked out by determining the amount of the reserves, reasonably estimated by a competent person using an appropriately accepted industry practice, divided by the expected extraction rate from the mine: s 40-95(11). As well, there is no requirement for a taxpayer to undertake a yearly or periodic assessment of the effective life of their mining right. The effective life of a mining, quarrying or prospecting right or mining, quarrying or prospecting information is 15 years if the right or information does not relate to a mine or proposed mine, a petroleum field or proposed petroleum field or a quarry or proposed quarry (this does not apply to mining rights and mining information acquired before 7.30 pm on 14 May 2013 AEST, or acquired after that time pursuant to an arrangement entered into before that time): s 40-95(12). If the right ends and a new right is granted, the new right will be taken to be a continuation of the old mining, quarrying or prospecting right that the taxpayer held only if the new right relates to the same area as the old right (or the difference in area is insignificant): s 40-30(6). Otherwise it will be treated as a new right with an effective life equal to the remaining effective life of the mine, petroleum field or quarry. The taxpayer can recalculate the effective life of a mining, quarrying or prospecting right, or mining, quarrying or prospecting information, by using the method set out in ss 40-95(10) and (11) (or s 40-95(12)), if the effective life that the taxpayer has been using is no longer accurate because of changed circumstances: ss 40-110(3B), (4).

Balancing adjustments In addition to the general balancing adjustment events discussed at [10 850], there are provisions in s 40-295 that specifically relate to mining, quarrying and prospecting rights and mining, quarrying and prospecting information. If exploration has been unsuccessful and the taxpayer has not budgeted or planned to incur further expenditure in excess of the minimum expenditure required to maintain the tenement, and an immediate deduction for the right or information was not available only because the requirements in s 40-80(1)(d) or (e) were not satisfied, the taxpayer may choose for the balancing adjustment event to occur: s 40-295(1A). If the conditions that allow the taxpayer to choose to apply a s 40-295(1A) balancing adjustment event are no longer met, the taxpayer must include a clawback in their assessable income: s 40-295(1B). The amount of the clawback is dependent on the time at which the conditions for the s 40-295(1A) balancing adjustment event are no longer satisfied. The clawback amount is what the adjustable value of the mining right or mining information would have been at that time if the taxpayer had not previously applied the balancing adjustment event. Farm-in farm-out arrangements A ‘‘farm-in farm-out’’ arrangement broadly involves the exchange of an interest in a mining, quarrying or prospecting right in return for an ‘‘exploration benefit’’: see [17 345]. Where such an arrangement is entered into after 7.30 pm AEST on 14 May 2013, Subdiv 40-K provides as follows: • the termination value of the part of the interest transferred is reduced by the market value of the exploration benefit received: s 40-1105; • if the interest is ‘‘split’’ before the balancing adjustment event, the first element of the cost of the part the taxpayer stops holding is a reasonable proportion of the amount the taxpayer is taken to have paid under s 40-185 (see [10 370]) for any economic benefit involved in splitting the interest, and the first element of the cost of the retained part is the sum of the adjustable value of the entire interest just © 2017 THOMSON REUTERS

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[10 1300]

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before it was split and a reasonable proportion of the amount the taxpayer is taken to have paid under s 40-185 for any economic benefit involved in splitting the interest: s 40-1110; • the transferor’s entitlement to deduct the expense is reduced to the same extent the termination value of the original interest was reduced: s 40-1115; • if a taxpayer receives an exploration benefit under a farm-in farm-out arrangement and an amount would be included in the second element of the cost of mining, quarrying or prospecting information, that amount is not included to the extent that it is reasonably attributable to the exploration benefit: s 40-1125; • a reward received by a taxpayer for providing an exploration benefit under a farm-in farm-out arrangement, in relation to the transfer to the taxpayer of part of another entity’s interest in a mining, quarrying or prospecting right, is non-assessable non-exempt income: s 40-1130. The CGT treatment of farm-in farm-out arrangements entered into after 7.30 pm AEST on 14 May 2013 is considered at [17 345]. The application of Div 40 to farm-in farm-out arrangements entered into before 7.30 pm AEST on 14 May 2013 is considered in Ruling MT 2012/1 (immediate transfer arrangements) and Ruling MT 2012/2 (deferred transfer arrangements).

Interest realignments Division 40 has been amended to clarify the treatment of realignments of interests between joint venture partners in the minerals and petroleum industry (from 7.30pm on 14 May 2013 AEST). The measure only applies to changes of ownership within a common project (which includes combining neighbouring fields into one project and sharing expenditure in areas such as planning, research and construction of infrastructure). This reform is intended to address uncertainty for realignments, which are potentially affected by the decision to limit the immediate deduction for mining rights first used for exploration (see above). Greenfields minerals explorers The tax incentive for greenfields minerals explorers (for expenditure incurred in the 2014-15, 2015-16 and 2016-17 income years) is discussed at [29 030]. Geothermal energy Geothermal exploration rights and geothermal exploration information that a taxpayer starts to hold after 30 June 2014 are not depreciating assets. For the tax treatment of geothermal exploration rights and information that a taxpayer started to hold after 30 June 2012 and before the 2014-15 income year, see [10 1280] of the Australian Tax Handbook 2014.

MOTOR VEHICLES [10 1300] Car limit If the first element of cost (see [10 360]) of a car designed mainly for carrying passengers exceeds the ‘‘car limit’’ (sometimes referred to as the ‘‘luxury car limit’’), the first element is reduced to the car limit: s 40-230. The limit applies regardless of whether the car is new or second-hand. See [9 100] for the definition of a ‘‘car’’. The limit applies to station wagons and 4-wheel drive vehicles, as well as sedans, but not to hearses: see Determination TD 2006/39. For a taxpayer who starts to hold a car in the 2016-17 income year, the car limit is $57,581: Determination TD 2016/8. Earlier car limits are listed at [104 020]. 440

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[10 1310]

In working out if the first element of cost exceeds the car limit, the GST-exclusive value is used (see [10 480]): Determination TD 2006/40. In addition, the first element of cost is increased under s 40-225 to take account of any discount on a trade-in: see [10 1310]. The car limit does not apply to (s 40-230(2)): • cars that are fitted out for transporting disabled people in wheelchairs for profit; and • cars whose first element of cost exceeds the car limit only because of modifications to enable a person with a disability to use the car for a taxable purpose. The concession is directed at vehicles other than those used for personal transport by the driver, eg taxis or vehicles used by private hospitals. The car limit can apply if an employee, following the early termination of a novation arrangement with one employer, immediately novates the car lease to a new employer: see ATO ID 2005/197. If a car is held by one or more entities, the car limit is applied to the cost of the car and not to the cost of each entity’s interest in the car: s 40-230(4). Once the car limit is applied, s 40-35 applies to apportion the cost of the car, as reduced to the car limit, between the holders. The difference between the car limit and the actual cost of the car is not deductible under s 8-1: Australia and New Zealand Banking Group Ltd v FCT (1994) 27 ATR 559.

Previously owned cars If a previously owned car is acquired, the cost price for calculating its decline in value is the purchase price subject to the car limit in s 40-230. That limit is calculated according to the year the purchaser first started to hold the car, and not according to the year the original owner first started to hold the car: s 40-230(1). [10 1310] Cars acquired at discount Section 40-225 is an anti-avoidance provision that prevents taxpayers circumventing the car limit by offering a reduction in the price of any trade-in vehicle (or other depreciating asset), ie in exchange for a lower purchase price of the new asset. The section increases the first element of cost of a car acquired at a discount if: • it is reasonable to conclude that any portion of the discount is referable to the taxpayer or another entity selling another depreciating asset (eg a trade-in vehicle) for less than its market value; • a deduction is allowable to the taxpayer or another entity in respect of the other asset; and • the sum of the cost of the car and the relevant discount exceeds the car limit for the year in which the car is first used for any purpose. This does not apply to cars that are excluded from the car limit by s 40-230(2): see [10 1300]. EXAMPLE [10 1310.10] Morris buys a car from Austin which has a price tag of $59,000. He trades in his old car which is worth $25,000. In order to avoid the car limit, Morris agrees to reduce the price of his old car to $15,000 and Austin agrees to reduce the price of the new car to $49,000. The first element of cost of the new car is $59,000, made up of the following amounts: Amount paid Non-cash benefit Discount (s 40-225) © 2017 THOMSON REUTERS

$ 34,000 15,000 10,000

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If it were not for s 40-225, the first element of cost of the car would have been only $49,000.

Note that s 40-320 increases the termination value of the trade-in car: see [10 1320].

[10 1320] Disposal of car A car costing in excess of the relevant car limit (ie that applying for the income year in which the taxpayer first holds the car) has its decline in value calculated on the basis of that limit: see [10 1300]. Upon disposal of such a vehicle, the balancing adjustment (unless balancing adjustment roll-over relief applies: see [10 940]-[10 980]) is calculated on a proportional basis. Thus, the termination value worked out under s 40-300(1) (see [10 890]) is multiplied by (s 40-325): CL + Amounts included in the 2nd element of the car’s cost Total GST-exclusive cost of the car (ignoring the car limit)

where: “CL” is the car limit in the year in which the taxpayer first used it for any purpose. EXAMPLE [10 1320.10] Jagatheesararan purchases a car on 4 February Year 1 for $60,000 (assume no entitlement to GST input tax credits). He sells it on 5 June Year 2 for $40,000. Depreciation deductions are calculated by reference to the car limit for Year 1 (say $57,466).The rate used is the diminishing value method of 40% (see [10 500]) based on a self-assessed effective life of 5 years. (Amounts are rounded to the nearest whole dollar.) $ Depreciation to 30 June Year 1 40% × 57, 466 × 148* 9,321 365 Depreciation to 5 June Year 2 40% × 48,145 (ie 57,466 − 9,321) × 340* 17,939 365 27,260 * Pro rata deduction applies: see [10 600]. Adjustable value at date of sale ($57,466 − $27,260) = $30,206 To calculate any balancing charge on sale, the consideration received (ie termination value) is adjusted and is deemed to be the amount calculated in accordance with the formula in s 40-325: Adjusted sale price = $40,000 × $57,466 = $38,311 $60,000 As the adjusted sale price ($38,311) is more than the adjustable value of the vehicle ($30,206) as at the date of sale, the difference ($8,105) is included in Jagatheesarara’s assessable income in the year of disposal (Year 2).

Car acquired at a discount If a car is acquired at a discount and the first element of cost of the new vehicle is increased under s 40-225 by the discount portion (see [10 1310]), the termination value of the old car is also increased by the discount portion: s 40-320.

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EXAMPLE [10 1320.20] Jerry trades in a car worth $30,000 for a new car worth $50,000. However, he arranges with the dealer to buy the new car for $40,000 and accept a trade-in price of only $20,000 for the old car. Section 40-225 would apply to increase the price of the new car to $50,000 (from $40,000) for the purposes of calculating any depreciation (subject to the car limit). In addition, s 40-320 also applies to increase the trade-in price of $20,000 to $30,000 for the purpose of calculating any balancing adjustment under Subdiv 40-D.

Disposal if statutory substantiation used The rules that apply if statutory substantiation methods were used to calculate car expense deductions are explained at [10 1010]. Luxury car leases Division 242 ITAA 1997 treats luxury car leases, other than genuine short-term hire arrangements, as loan transactions for tax purposes: see [6 410]. Luxury cars are those that would exceed the car limit: see [10 1300].

BUILDINGS AND STRUCTURAL IMPROVEMENTS OUTLINE [10 1450] Overview of Div 43 Division 43 ITAA 1997 brings together the rules about deductions for income-producing buildings. The structure of Div 43 is set out in the following table. Subdivision 43-A 43-B 43-C 43-D 43-E 43-F 43-G 43-H

Title Key operative provisions Establishing the deduction base Your area and your construction expenditure Deductible uses of capital works Special rules about uses Calculation of deduction Undeducted construction expenditure Balancing deduction on destruction of capital works

Division 43 allows the capital cost of constructing capital works to be written off by the owner of the relevant property (this may include a lessee or the holder of a quasi-ownership right: see [10 1490]). The capital works must be used for income-producing purposes or, in certain cases, R&D activities: see [10 1460]. Capital works is not a defined term, but the Division recognises 3 types of capital works: • buildings, such as industrial buildings (see [10 1560]), R&D buildings (see [10 1560]) and hotels and other short-term traveller accommodation: see [10 1570]; • structural improvements: see [10 1580]; and • environmental protection buildings and earthworks: see [10 1590]. The Division also applies to extensions, alterations and improvements to buildings, etc. Division 43 applies to capital works begun in Australia after 21 August 1979 and capital works begun outside Australia after 21 August 1990: s 43-20. Division 43 also applies to © 2017 THOMSON REUTERS

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structural improvements begun after 26 February 1992. Different deduction rates apply (ie either 2.5% or 4%) depending upon when the capital works begin and the type of building or structure: see [10 1470]. Capital works are taken to begin when the first step in the construction phase starts (eg pouring foundations or sinking pilings): s 43-80. Capital works that can be written off under Div 43 are not part of the Uniform Capital Allowance (UCA) system in Div 40. On the other hand, if capital expenditure does not qualify for the Div 43 deduction, it may qualify for a deduction under Div 40, particularly Subdivision 40-I (project-related expenditure): see [10 1050]-[10 1100].

Adjustments The commercial debt forgiveness provisions can apply to the buildings and structural improvements write-off provisions in the same manner as they can apply to the capital allowances provisions in Div 40: see [10 470].

BASIC RULES [10 1460] Deduction for capital works Division 43 allows a deduction for capital expenditure incurred in constructing income producing buildings and certain structural improvements (capital works expenditure). See also [10 1560]-[10 1590]. A Div 43 deduction is allowable to the owner of the property (even if not the entity that incurred the relevant expenditure) or, in certain cases, a lessee of the property (see [10 1480]): ss 43-10, 43-15, 43-75. See also [10 1500]. More specifically, an entity must own, lease or hold a building or structure, or part of a building or structure (referred to as ‘‘the construction expenditure area’’: s 43-75): s 43-110. The building or structure must be used during the income year in question for the production of assessable income or, in certain cases, in conducting R&D activities: ss 43-140, 43-145. If the building or structure is not used for a relevant purpose for any period of time, capital works deductions are not available for that period (eg see ATO ID 2014/38), although this does not affect the taxpayer’s calculation of the undeducted construction expenditure: see [10 1500]. A property is taken to be used for a particular purpose (eg producing assessable income) if it is maintained ready for use for that purpose and has not been used for another purpose, and its use for that purpose has not been abandoned: s 43-160. A temporary cessation of use is allowed in certain circumstances: see [10 1630]. Note that pre-1 July 1997 capital works do not qualify for a deduction unless they were intended to be used for certain specified purposes upon completion. A deduction is not available until construction is complete, even if the capital works (or part of them) were used by the taxpayer before completion: s 43-30. Division 43 does not apply to buildings used for producing assessable income that are used wholly or principally for residential purposes, such as a doctor’s surgery attached to a house: s 43-170. In the case of a tax law partnership (as distinct from a common law partnership: see [22 040]), each joint owner of the capital works (and not the partnership) owns a part of the construction expenditure area for Div 43 purposes: see ATO ID 2009/134. If a property is acquired under a deferred purchase agreement, so that title to the property passes to the purchaser only on completion of payment, which may be some years after possession and use of the property by the purchaser begins, the Commissioner accepts that the purchaser is the ‘‘owner’’ of the property, for the purposes of Div 43, from the date on which possession and use begin: Addendum to Ruling IT 2254. The rate of deduction is 2.5% or 4% of the relevant construction expenditure, depending on the type of property and when construction commenced: see [10 1470]. 444

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[10 1470]

For the type of expenditure that qualifies as deductible construction expenditure, see [10 1510]. Note that if capital works are put to a tax preferred use for the purposes of Div 250 and the apportionment rule in s 250-150 applies (see [33 100]), the taxpayer will be taken not to be using the capital works for the purpose of producing assessable income or conducting R&D activities to the extent specified under s 250-150(3).

[10 1470] Deduction rates Capital expenditure incurred after 21 August 1979 on traveller accommodation is deductible at the rate of 2.5% pa. This deduction was extended to capital expenditure incurred after 19 July 1982 in respect of all buildings used for the production of assessable income, other than for residential accommodation or for exhibition or display in connection with the sale of a building. If construction commenced after 21 August 1984, the rate of deduction is 4% for both traveller accommodation and buildings used for producing assessable income. This deduction extended to all income-producing buildings, including those used for residential purposes, if construction commenced after 17 July 1985. The only exclusion is property used for exhibition or display in connection with the sale of that or any other building. If construction commenced after 15 September 1987, the deduction was reduced to 2.5% of the cost of the building. Buildings that qualified for the 4% deduction continued to enjoy that rate of deduction. The deduction (at the rate of 2.5% pa) was extended to buildings used for R&D activities if construction commenced on or after 21 November 1987. The rate of deduction was again increased to 4% for buildings used to provide short-term accommodation for travellers, and for buildings used for eligible industrial activities, that commenced to be constructed on or after 27 February 1992. The rate of deduction for structural improvements (see [10 1580]) is 2.5%. The rates of deduction are summarised in the tables below. Construction commenced before 18/7/1985 Qualifying buildings Short-term accommodation Non-residential producing

Construction commenced traveller 22/8/1979 – 21/8/1984

Deduction rate % 2.5

22/8/1984 – 17/7/1985 income- 20/7/1982 – 21/8/1984

4.0 2.5

22/8/1984 – 17/7/1985

4.0

Construction commenced 18/7/1985-26/2/1992 Qualifying buildings

Construction commenced

All income-producing1

18/7/1985 – 15/9/1987 16/9/1987 – 26/2/1992

Deduction rate % 4.0 2.52

1 Includes (a) short-term traveller accommodation; and (b) buildings used for research and development activities if construction commenced on or after 21 November 1987. 2 The 4.0% rate may still be available if certain contractual arrangements were entered into before 16 September 1987. Construction commenced on or after 27/2/1992 Qualifying buildings and Construction commenced structural improvements Short-term traveller 27/2/1992+ accommodation © 2017 THOMSON REUTERS

Deduction rate % 4.0

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Industrial buildings 27/2/1992+ Other income-producing 27/2/1992+ buildings1 Structural improvements 27/2/1992+

4.0 2.5 2.5

1 May include buildings used for research and development activities.

[10 1480] Lessees and quasi-ownership right holders An entity that leases the whole or part of a building and incurs expenditure in the construction of the building or in extensions, alterations or improvements to that building is entitled to claim Div 43 deductions: s 43-120(1) (in Subdiv 43-C). The entities concerned must have used the building for prescribed purposes after the completion of the work referred to. Division 43 also applies to a lessee who has obtained the lease of premises by assignment from an entity that immediately before that assignment was an eligible lessee entitled to a deduction under Div 43 in respect of expenditure incurred on the premises: s 43-120(2). Note that an entity that enters into the novation of a lease is not an ‘‘assignee’’ of the lease for the purposes of s 43-120(2): see ATO ID 2012/4. Section 43-120 also confirms the application of Div 43 to an entity that holds a ‘‘quasi-ownership right’’ (defined broadly in s 995-1: see [10 1210]) over land granted by an exempt Australian government agency or an exempt foreign government agency. If a lessee surrenders the lease or the lease terminates, the right for a deduction of the unrecouped balance of the eligible expenditure vests in the lessor/owner. A subsequent leasing of the property does not change this position and the new lessee is not entitled to any deduction under this Division, the right remaining with the owner. The lessee is for the purposes of the Division treated as the owner of the property and the owner is not entitled to any deduction in respect of expenditure incurred by the lessee except as outlined above on the surrender or termination of the lease. [10 1490] Ownership during part of year and part-ownership If a taxpayer is the owner of a building during part only of an income year, the deduction under Div 43 is apportioned on a time basis, ie divide by 365 the amount obtained by multiplying the deductible amount by the number of days in the income year on which the building was owned (or leased) and used by the taxpayer in a relevant manner: ss 43-210, 43-215. See Example [10 1500.10]. If the taxpayer is the owner of part only of the property that was dealt with in the prescribed manner, the deduction is apportioned on the basis of the ‘‘construction expenditure’’ that is attributable to the taxpayer’s ‘‘construction area’’. If 2 or more taxpayers own part or the whole of a building jointly (rather than owning different parts of the building as with strata titles), the apportionment will be on the basis of their proportionate ownership. [10 1500] Disposal and purchase It is important to note that Div 43, unlike the capital allowances provisions of Div 40, does not include provisions to recoup or increase deductions claimed upon sale of a building (‘‘balancing adjustments’’ in Div 40: see [10 850]). This is dealt with under the CGT provisions, by adjusting the cost base or reduced cost base of the building. There may, however, be an entitlement to an additional deduction under s 43-250 (see [10 1620]) if the building is destroyed rather than sold. Although there are no recoupments, the cost base (and reduced cost base) of an asset for CGT purposes is reduced by Div 43 deductions: see [14 080] and [14 100]. In effect, this will result in a capital gain if the building is sold for more than written down value and a capital loss if sold for less than written down value. If the profit on disposal is assessable income (under s 6-5), rather than a capital gain, any deductions claimed by the taxpayer under Div 43 446

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[10 1510]

(or under the equivalent repealed ITAA 1936 provisions) are not clawed back, ie the assessable profit is not increased by the amount of those deductions: MLC Limited v DCT (2002) 51 ATR 283. Upon sale, undeducted construction expenditure is transferred to the purchaser, regardless of the actual consideration paid by the purchaser. Broadly, the undeducted construction expenditure (as calculated under Subdiv 43-G) is the original construction expenditure less the aggregate of amounts calculated at the appropriate rate (2.5% or 4% pa) of that expenditure, from the time the capital works, or a part of it, was first used by any entity for any purpose after completion of the relevant construction. Note that the undeducted construction expenditure is not affected by any period that capital works deductions are not available to the taxpayer: see ATO ID 2014/38. In the year of sale, the deduction is apportioned between the new and previous owners under Subdiv 43-C. A building constructed by a tax exempt organisation for use for eligible incomeproducing purposes will give rise to an amount of qualifying expenditure. If the building is subsequently acquired by an entity that uses the building or part of the building for the purpose of producing assessable income, deductions would become available to that entity. Section 43-75(3) allows an entity that acquires a building from a speculative builder (which is not an associate) and all subsequent purchasers of the building to claim a deduction for the cost of construction. If a purchaser does not have details of the original cost of construction, the Commissioner will accept a building cost estimate provided by an appropriately qualified person, including a quantity surveyor: see Ruling TR 97/25. EXAMPLE [10 1500.10] Steven commences construction of a factory in 2016. Construction is completed at a cost of $1m and the building is first used for the production of assessable income on 4 January 2017. Steven’s Div 43 deduction for 2016-17 is: 50% × 2.5% × $1,000,000 = $12,500 The deduction in each of the following 39 years is 2.5% × $1,000,000 = $25,000, followed by a final half year claim. If Steven sells the building, the residual entitlement passes to the new owner, providing the building continues to be used for eligible income-producing purposes. In the year of sale, the deduction is apportioned between the vendor and the purchaser. There is no adjustment for a ‘‘balancing charge’’ in Steven’s assessable income. However, any balancing adjustment is in effect captured by the CGT provisions. Assume that Steven sells the factory on 1 July 2017 for $1.2m. The cost base of the factory for CGT purposes will be $1,000,000 – $12,500 (the deduction claimed under Div 43). This will provide a cost base of $987,500 (in effect the written down value of the factory). Therefore the capital gain is $1,200,000 − $987,500 = $212,500. On the other hand, if Steven had sold the factory for $900,000 instead, the reduced cost base of the factory would be $1,000,000 − $12,500 = $987,500. The capital loss would therefore be $987,500 − $900,000 = $87,500.

[10 1510] Construction expenditure The Div 43 deduction for capital works is 2.5% or 4% of the ‘‘construction expenditure’’ (or portion of the ‘‘construction expenditure’’). Section 43-70 simply states that ‘‘construction expenditure’’ is capital expenditure incurred in respect of the construction of capital works. The section then lists various types of expenditure that do not qualify as construction expenditure: see below. Ruling TR 97/25 states that construction expenditure includes: © 2017 THOMSON REUTERS

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• preliminary expenses such as architect fees, engineering fees, foundation excavation expenses and costs of building permits (see also ATO ID 2014/37). A consultant’s fee was deductible in ATO ID 2002/1098; • the cost of structural features that are an integral part of the income producing buildings or income producing structural improvements, such as atriums and lift wells; and • some portion of indirect costs. The Tax Office also states in Ruling TR 97/25 that, in relation to an owner/builder entitled to a Div 43 deduction, the value of the owner/builder’s contributions to the works (such as labour and expertise) and any notional profit element do not form part of construction expenditure. Other expenditure that qualifies as construction expenditure includes: • remedial painting for a newly acquired rental property which is capital in nature (ie initial repairs: see [9 630]): see ATO ID 2003/795; • expenditure incurred by the builder of a residential unit complex on an insurance policy that insures the owner of the complex against the risk of loss from the building not being completed: see ATO ID 2006/213; and • capital expenditure incurred to build temporary roads and to restore the area afterwards pursuant to a development approval for the construction of cabins (for short-term accommodation): see ATO ID 2014/37.

Costs excluded Section 43-70(2) provides that construction expenditure does not include: • expenditure on acquiring land (see ATO ID 2007/142 for the Tax Office’s views on this exclusion); • expenditure on demolishing existing structures; • expenditure on clearing, levelling, filling, draining or otherwise preparing the construction site prior to carrying out excavation works; • expenditure on landscaping (eg ATO ID 2006/235); • expenditure on plant (eg ATO ID 2010/41); • expenditure on property for which a deduction is allowable (or would be allowable if the property were used for producing assessable income) under various other provisions, including expenditure on structural improvements for use in a primary production industry, buildings for use in the storage of hay, grain or fodder, structural improvements for conserving or conveying water, forestry roads in connection with timber operations and timber mill buildings (see [29 150]), buildings subject to Subdiv 40-H (mining and quarrying: see [29 030]), expenditure on a depreciating asset that is immediately deductible under s 40-80(1) or s 40-80(1A) (exploration and prospecting: see [10 530]) and buildings subject to Subdiv 40-I (project pools); • expenditure which qualifies for a notional deduction under the Div 355 R&D provisions (see [11 070]), or would qualify if the property were used for conducting R&D activities; • expenditure which qualified for a deduction or tax offset under the former R&D provisions in the ITAA 1936: see [11 100]; • water infrastructure improvement expenditure: see [27 310]; and 448

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• expenditure that qualified for the former heritage conservation rebate. Expenditure that is revenue in nature does not qualify as construction expenditure for Div 43 purposes: eg, see ATO ID 2003/377 (expenditure by a property developer on buildings held as trading stock) and ATO ID 2005/277 (expenditure incurred in the course of carrying on a construction business). Construction expenditure is not reduced by a government grant received to finance the construction: see ATO ID 2003/1086.

Allocation of costs between building and plant Ruling TR 97/25 states that, in accordance with the decision in BP Refinery (Kwinana) Ltd v FCT (1960) 8 AITR 113, indirect costs incurred in association with the construction/alteration of a building (ie those that cannot be directly allocated to either the building itself or the plant located in the building) may be allocated between Div 42 (now Div 40: depreciation) and Div 43 in accordance with the proportion that the direct cost of plant bears to the direct cost of the building. However, the Commissioner will also consider other allocation methods provided they are based on sound accounting principles and practical considerations. Presumably the principles stated in Ruling TR 97/25 are still relevant in apportioning costs between Div 40 (which replaced Div 42) and Div 43 assets. Section 40-195 requires that costs that are reasonably attributable to the depreciating asset form part of the cost of that depreciating asset. The balance will be allocated to the building and be written off under Div 43. To the extent that it cannot be written off under Div 43, Subdiv 40-I (project-related expenditure) may apply to allow the write off (as it allows write off for certain expenditures that do not form part of the cost of a depreciating asset).

SPECIFIC TYPES OF BUILDINGS AND STRUCTURES [10 1560] Industrial buildings – post-26 February 1992 A higher deduction rate of 4% pa applies for buildings constructed after 26 February 1992 that are used wholly or mainly for ‘‘industrial activities’’. Industrial activities ‘‘Industrial activities’’ are extensively defined by s 43-150 as encompassing: • manufacturing processes; • processing of metals, petroleum, wool, meat, fish and milk; • milling of timber; • printing, publishing and engraving; • canning or bottling of foodstuffs; and • production of electricity, steam or hydraulic power for sale or use in an eligible activity. A number of other activities also qualify if undertaken in connection with an eligible industrial activity, eg packing, containerising, labelling of goods, waste disposal, cleansing of storage facilities for raw materials or finished goods, maintenance or repair of property used in such operations and storage of raw materials or finished goods at or next to the place of manufacture: s 43-150(b). Specifically excluded are activities associated with the preparation of food or drink in premises occupied in connection with hotels, restaurants and similar outlets.

Mixed usage If a building, or part of a building, is used in an eligible industrial manner, a depreciation rate of 4% applies to the portion of qualifying expenditure attributable to the building (or part of the building). For example, a taxpayer conducting both manufacturing and retailing © 2017 THOMSON REUTERS

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activities in a single building would be entitled to the higher rate in respect of the part used in manufacturing. That would require an apportionment of the qualifying expenditure in relation to the building between the 2 uses. No deduction is available for any part of a building that is not used in producing assessable income. If eligible industrial activities and other activities are conducted in the same area, the dominant activity will determine whether the higher rate will apply. For example, an upholstery business may be involved in both finishing off manufactured goods (which is an eligible industrial activity) and repair work (which is not). Unless those activities were performed in discrete areas of the workshop, the use of the workshop as a whole would be determined by the dominant activity.

R&D buildings Division 43 extends to buildings used for conducting R&D activities (see [11 050]), if construction commenced on or after 21 November 1987. To be eligible, a taxpayer or, in the case of an R&D partnership, one of the partners must be registered with AusIndustry (on behalf of Innovation Australia): s 43-35. The principal R&D tax concessions are considered in Chapter 11. [10 1570] Traveller accommodation – hotels and apartment buildings Hotel building A ‘‘hotel building’’ is a building begun after 21 August 1979 and before 18 July 1985, or after 26 February 1992, all or part of which is used wholly or mainly as a hotel, motel or guesthouse and having ‘‘at least 10 bedrooms that are used or available for use to provide short-term accommodation for travellers’’: s 43-95. Apartment building Section 43-95(2) provides that an ‘‘apartment building’’ must contain at least 10 apartments, units or flats, each of which is for use wholly or mainly to provide short-term accommodation for travellers. Special rules for hotels and apartment buildings Sections 43-175 and 43-180 set out special rules for hotels and apartment buildings. A bedroom in a hotel building or an apartment may be treated as ineligible if it is used, or is reserved for use, by the taxpayer or certain associates (eg partners in a partnership): s 43-175. Section 43-180 contains rules about a limited period of ineligible use, the taxpayer granting leases or subleases with terms exceeding 50 years, detached buildings and the provision of facilities not commonly provided in Australia in a hotel, eg a casino. The term ‘‘short-term’’ is not defined in the Division, but it is considered that any period where the obvious usage is of an itinerant nature would constitute short-term accommodation. Whether it falls within this category would be a question of fact to be determined from the individual circumstances of each case. Each unit must consist of not fewer than 10 bedrooms, but the concession can apply to an extension of fewer than this number of bedrooms provided that the total number after the extension has taken place is 10. The units must be used mainly as traveller accommodation, but temporary cessation of use due to construction of extensions, alterations or improvements or to seasonal or climatic factors is disregarded. A limited period of non-short-term traveller accommodation is also disregarded. In certain circumstances, a proportionate deduction only may be available. In determining the number of units, suites that consist of more than one bedroom are deemed to be one unit. In the case of an eligible building that contains facilities of a kind not ordinarily available in such types of accommodation in Australia, such as a casino, the costs associated with that facility do not fall within the provisions of the Division and no deduction is allowable in respect of such costs. In some instances, notably on the Barrier Reef, buildings 450

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[10 1590]

are in a complex and s 43-180(4) provides that such groups shall be taken to be one building. It will therefore be possible for an extension to be made to such a building by the construction of an independent further facility. Note the record-keeping requirements at [10 1650].

[10 1580] Income-producing structural improvements Division 43 treats certain structural improvements as if they were buildings: s 43-20(2) to (4). However, only those structural improvements commenced to be constructed after 26 February 1992 are covered by the legislation: s 43-20(2). The Division only applies to structural improvements not otherwise deductible under existing provisions, eg Subdiv 40-F (discussed in Chapter 27). While the expression ‘‘structural improvement’’ is not defined, examples of structural improvements to which the provision will apply are contained in s 43-20(3), namely sealed roads, driveways or carparks, bridges, airport runways, pipelines, lined road tunnels, retaining walls, fences, concrete or rock dams and artificial sports fields. Reclaimed land does not constitute a structural improvement: see ATO ID 2009/96. Deductions will be available for the capital cost of the original construction of the structure as well as extensions, alterations or improvements thereto. Cost for this purpose will include engineering, architecture and other design plus approval fees, permits and legal fees. Earthworks are also covered by the section and are depreciable where they are integral to the installation of the structure, eg cuttings, culverts and embankments as part of a road or foundation excavations for a bridge. On the other hand, earthworks that only affect the general enjoyment of land such as site clearing or levelling, landscaping or artificial land contouring (eg for a golf course) are excluded and the cost is not deductible under Div 43: s 43-20(4). The Tax Office considers that a bowling green constructed from natural materials (but not a bowling green constructed from synthetic materials) falls within that exclusion: see ATO ID 2003/820 and ATO ID 2003/821. [10 1590] Environment protection buildings and earthworks Division 43 covers buildings used in ‘‘environmental protection activities’’ within the meaning of s 40-755(2) to (4) ITAA 1997. Subdivision 40-H ITAA 1997 provides taxation concessions for certain kinds of expenditure on environment protection activities, if that expenditure is not deductible under any other provision: see [11 610]. Section 43-140 provides that property used for environmental protection activities or the environmental impact assessment of a project is treated as if it were used for the purpose of producing assessable income (unless expressly excluded by some other provision). The effect of this is to bring capital expenditure on buildings used for environment protection or environmental impact assessment purposes within the net of Div 43, provided that capital expenditure meets the other tests of the Division. For example, capital expenditure on constructing buildings and on extending, altering or improving buildings will be within Div 43 if the relevant buildings are used for environmental protection activities within the meaning of s 40-755(2) to (4). Broadly speaking, these are activities that are carried out in order to prevent, fight or remedy pollution of the environment by the taxpayer’s business or on the site of that business or to treat, clean up, remove or store waste produced by the taxpayer’s business or on the site of that business. In any event, the expenditure must relate to an income-producing activity carried on by the taxpayer or to a business activity carried on by a predecessor of the taxpayer. Certain kinds of earthwork constructed as a result of carrying out an environmental protection activity are effectively treated as buildings for the purposes of Div 43: s 43-20(5). This means that expenditure incurred on constructing such earthworks or on extending, altering and improving such earthworks qualifies for the concessional tax treatment under Div 43. © 2017 THOMSON REUTERS

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MISCELLANEOUS RULES [10 1620] Demolition or destruction If a building, or part of a building, is destroyed, a deduction is allowable under s 43-40 for any undeducted construction expenditure, provided the property was being used for producing assessable income immediately before the destruction. A deduction is also available if the property is not being used to produce assessable income when it is destroyed, provided it had not been used for any purpose since it was last used by the taxpayer for producing assessable income (see ATO ID 2010/35 for an example of where this condition was not satisfied, because the property in question had been used as a private residence). The deduction is allowable in respect of both voluntary destruction (demolition) and involuntary destruction (eg by fire): Ruling TR 97/25. If the building is destroyed but it has not been used exclusively for qualifying uses, s 43-250 provides that the deduction otherwise allowable is to be reduced on the basis of a reasonable apportionment by the taxpayer (eg see ATO ID 2010/36). The taxpayer’s entitlement to a deduction must take into account the consideration that he or she is entitled to receive by reason of that destruction. The consideration received, whether by way of insurance or otherwise, for the purpose of calculating the deduction to which the taxpayer is entitled is to be reduced by any demolition costs incurred in connection with the property. If consideration (relating to the building and other property) is received under an insurance policy or otherwise following the destruction of the building, the amount relating to the building is determined by the Commissioner having regard to all relevant factors. The deduction under s 43-40 is available in the income year in which the destruction happens. [10 1630] Temporary cessation of use In general, if a building or structure is not used for a relevant purposes (eg producing assessable income) for a period of time, the Div 43 deduction is not available for that period: see [10 1460]. However, a temporary cessation of use does not affect a taxpayer’s entitlement to Div 43 deductions if the reason for the temporary cessation of use is the construction of extensions, alterations or improvements or the making of repairs, or seasonal or climatic factors: s 43-165. [10 1640] Part use and change of use An apportionment is effectively required if a building is not used solely for eligible activities. In effect, the expenditure related to the eligible activities is taken to be the qualifying expenditure and the expenditure related to the non-eligible activities is excluded. For post- 26 February 1992 capital works, the amount of the deduction (4% or 2%) will depend on the income-producing use of the building. EXAMPLE [10 1640.10] A taxpayer owns a motel comprising 20 units and associated facilities in a country town. The taxpayer usually makes the entire motel available for use by travellers. Qualifying expenditure in relation to the motel is $500,000. A mining company commences exploration activities in the area and the taxpayer grants a 12-month lease of 8 of the units to the company as accommodation for its employees. The lease commences on 1 January. The taxpayer’s claim for that year would be calculated as follows.

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[10 1650]

During the period 1 July to 31 December (184 days), the entire motel was used in the prescribed manner. The deduction for that period is: $500,000 × 0.04 ×

184 = $10,082 365

For the period 1 January to 30 June (181 days, ignoring any leap year), only 8 units were used in the prescribed manner. This is less than the required minimum of 10, so the rate of deduction will reduce to 2.5%. The deduction for the period 1 January to 30 June is: 181 $500,000 × 0.025 × = $6,199 365 Deductions at the higher rate of 4% pa would become available once at least 10 of the units were used in the provision of short-term traveller accommodation.

If capital works held as trading stock when constructed cease to be held as trading stock and become eligible for a Div 43 deduction, there is a construction expenditure area (see [10 1460]): see ATO ID 2014/8.

[10 1650] Record-keeping The vendor of post-26 February 1992 capital works, in respect of which deductions have been claimed (eg under former Div 10C ITAA 1936 or Div 43 ITAA 1997), is required to provide sufficient information to enable the purchaser to work out how Div 43 will apply to them (eg by specifying the amount of qualifying expenditure and residual capital expenditure relating to the purchase): s 262A(4AF) to (4AJA) ITAA 1936. The information must be provided within 6 months after the end of the income year in which the sale happens. The provisions also specify how long the purchaser must retain the information.

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11

INVESTMENT INCENTIVES Overview ....................................................................................................................... [11 010] RESEARCH AND DEVELOPMENT Tax offset for expenditure on R&D activities .............................................................. [11 R&D tax offset rate ....................................................................................................... [11 R&D tax offset available to companies that are R&D entities ................................... [11 Eligible R&D activities ................................................................................................. [11 R&D activities – conditions ......................................................................................... [11 Notional deductions for expenditure on R&D activities ............................................. [11 Integrity, adjustment and claw back rules .................................................................... [11 Administration of the R&D tax incentive .................................................................... [11 Former ITAA 1936 tax incentive .................................................................................. [11

020] 030] 040] 050] 060] 070] 080] 090] 100]

INNOVATION COMPANIES Overview ....................................................................................................................... [11 Early stage investor offset ............................................................................................. [11 CGT concessions ........................................................................................................... [11 Shares subject to roll-over ............................................................................................ [11

200] 210] 220] 230]

AUSTRALIAN FILMS Overview of tax incentives ........................................................................................... [11 Location tax offset ......................................................................................................... [11 Producer tax offset ........................................................................................................ [11 PDV offset ..................................................................................................................... [11 Qualifying Australian production expenditure ............................................................. [11

400] 410] 420] 430] 435]

VENTURE CAPITAL INCENTIVES PDFs – introduction ...................................................................................................... [11 Taxable income and the PDF component .................................................................... [11 Distributions .................................................................................................................. [11 Losses incurred by a PDF ............................................................................................. [11 Treatment of shareholders in PDFs .............................................................................. [11 Disposal of pooled development fund shares .............................................................. [11 Venture capital entities – overview .............................................................................. [11

500] 510] 520] 530] 540] 550] 560]

ENVIRONMENTAL, URBAN AND SHIPPING INCENTIVES Investment in forestry MIS ........................................................................................... [11 Environmental protection activities .............................................................................. [11 Carbon sink forests ....................................................................................................... [11 National Rental Affordability Scheme .......................................................................... [11 Urban water tax offset ................................................................................................... [11 Significant infrastructure projects ................................................................................. [11 Shipping incentives ....................................................................................................... [11

600] 610] 620] 630] 640] 650] 700]

INVESTMENT INCENTIVES [11 010] Overview This chapter discusses specific incentives designed to encourage investment in particular activities or certain industries. The principal incentives are: 454

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[11 020]

• the research and development (R&D) incentive – eligible companies that conduct R&D activities are entitled to a tax offset under Div 355 ITAA 1997: see [11 020]-[11 100]; • film industry incentives, in particular tax offsets to encourage investment in Australian films and TV series (the location, producer and PDV offsets): see [11 400]-[11 435]; • PDF incentives – these are designed to encourage long term investment in small and medium sized Australian companies through concessionally taxed entities called pooled development funds (PDFs): see [11 500]-[11 560]; • forestry managed investment schemes – a deduction to encourage investment in certain forestry schemes: see [11 600]; • environmental protection incentives – deductions for expenditure incurred in preventing or reducing pollution and for expenditure incurred in establishing a carbon sink forest: see [11 610]-[11 620]; • the National Rental Affordability Scheme – a tax offset to encourage investment in low cost rental housing for low income earners: see [11 630]; and • various shipping incentives: see [11 700].

RESEARCH AND DEVELOPMENT [11 020] Tax offset for expenditure on R&D activities The research and development (R&D) tax incentive in Div 355 ITAA 1997 provides a tax offset to eligible companies that conduct R&D activities. The object of the offset is to encourage companies to undertake R&D activities that are likely to benefit Australia’s wider economy: s 355-5(1). Eligible R&D activities are experimental activities that are conducted in a scientific way for the purpose of generating new knowledge or information: s 355-5(2). The R&D tax offset is for expenditure on, or the decline in value of tangible depreciating assets used in, eligible R&D activities. These expenses are referred to as ‘‘notional deductions’’. A company self assesses its eligibility for the R&D tax offset. A company is generally entitled to the tax offset for an income year if it satisfies the following requirements: 1. the company is an eligible ‘‘R&D entity’’: see [11 040]; 2. experimental activities that are ‘‘R&D activities’’ (comprising ‘‘core’’ and ‘‘supporting’’ R&D activities) are conducted in the income year: see [11 050]; 3. the R&D activities are conducted by or on the company’s behalf (subject to exceptions for activities conducted for associated foreign corporations): see [11 060]; 4. the company’s notional deductions for the income year are at least $20,000 (subject to exceptions concerning research service providers and a Cooperative Research Centre): see [11 070]; and 5. the company’s R&D activities are registered with AusIndustry within 10 months of the end of the income year: see [11 090]. An ‘‘income year’’ includes a transitional substituted accounting period of less than 12 months: see ATO ID 2013/12. © 2017 THOMSON REUTERS

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Division 355 includes a number of integrity, adjustment and clawback rules: see [11 080]. The R&D tax incentive is jointly administered by the Tax Office and AusIndustry (on behalf of Innovation and Science Australia): see [11 090]. An entity which cannot claim the R&D offset may be able to claim a deduction for expenditure on R&D activities (eg under s 8-1 if of a revenue nature or under Div 40 ITAA 1997 if of a capital nature).

ITAA 1936 tax concession: pre-1 July 2011 income years The R&D tax incentive replaced the R&D tax concession for income years commencing on or after 1 July 2011: see [11 100]. Although the R&D tax incentive retains many of the features of the former R&D tax concession, it differs in some significant respects. In particular, more companies can access the offset, an R&D plan is not a pre-condition to eligibility (although more detailed information is required), the definition of ‘‘core R&D activities’’ is simpler, various supporting activities must satisfy a dominant purpose test and core technology expenditure is not eligible for special treatment. [11 030] R&D tax offset rate Division 355 provides for 2 types of tax offset (s 355-100): • a higher refundable offset for smaller companies; and • a lower non-refundable offset for larger companies and companies controlled by tax exempt entities. The amount of the offset is the relevant percentage of the R&D entity’s notional deductions (subject to a $100m expenditure cap). The concept of notional deductions is explained at [11 070].

Refundable tax offset for smaller companies A refundable tax offset is available to R&D entities with an aggregated turnover of less than $20m per annum (unless they are controlled by one or more tax exempt entities). For income years commencing on or after 1 July 2016, the offset rate is 43.5%. For earlier income years, the offset rate is 45%. ‘‘Aggregated turnover’’ is the sum of the annual turnovers of the R&D entity, connected entities and affiliates, but excluding any dealings between those entities (s 328-115): see [25 030]. In working out whether the R&D entity is controlled by exempt entities, the control test in s 328-125 (discussed at [25 060]) is applied on the basis that the ‘‘control percentage’’ is 50% (not the usual 40%). The refundable tax offset is applied after all other tax offsets, except the tax offset arising from the payment of franking deficit tax. If a taxpayer has an excess of tax offsets, it may be entitled to a refund of the R&D offset (the rules about refundable offsets are considered at [19 040]). Non-refundable for larger companies and companies controlled by exempt entities A non-refundable tax offset is available to R&D entities that do not qualify for the higher refundable offset. These are companies that have an aggregated annual turnover of $20m or more, or are majority (50%) owned or controlled by a tax exempt entity or a combination of tax exempt entities (regardless of their turnover). (See ATO ID 2013/11 for a discussion of the meaning of ‘‘combination of exempt entities’’.) For income years commencing on or after 1 July 2016, the offset rate is 38.5%. For earlier income years, the offset rate is 40%. The non-refundable offset is applied against basic tax liability, before refundable tax offsets and the tax offset that arises from paying franking deficit tax, but after all other tax 456

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[11 040]

offsets. A company can carry forward any unused offset for use in a later income year (provided the tax offset carry-forward rules in Div 65 are satisfied: see [19 050]).

$100m expenditure cap If an R&D entity’s notional deductions (see [11 070]) exceed $100m, the full R&D tax offset applies to the first $100m, while the excess is subject to a reduced tax offset rate, being the standard corporate tax rate (30% for 2016-17): s 355-100(3). Section 355-720 is designed to prevent the portion of the tax offset worked out using the corporate tax rate from being clawed back in later income years. These measures apply for income years commencing on or after 1 July 2014. [11 040]

R&D tax offset available to companies that are R&D entities

The R&D tax offset is available to the following entities (called ‘‘R&D entities’’) (s 355-35(1), (2)): • companies incorporated under Australian law; • companies incorporated under a foreign law, but which are Australian residents for tax purposes; • foreign companies that are residents of a country with a double tax agreement with Australia and carry on R&D activities through a permanent establishment in Australia; and • public trading trusts with a corporate trustee. Exempt entities (eg universities), non-incorporated entities and corporate limited partnerships are not R&D entities: s 355-35(3).

Head company of consolidated group Division 355 applies to a consolidated or MEC group as if it were a single entity. The head company registers for R&D activities performed by group members (and claims the R&D tax offset on behalf of the group). Subsidiary members cannot register for R&D activities conducted within the group. Expenditure incurred by a subsidiary on R&D activities is taken to be incurred by the head company, and R&D activities conducted for a subsidiary by a third party are taken to be conducted for the head company. There are special rules if a subsidiary that conducts R&D activities joins or leaves a consolidated group during an income year: see ss 31 to 31B of the Industry Research and Development Act 1986 (IRD Act). Other provisions clarify the history that is taken into account for the purposes of working out the aggregated turnover of the head company after a subsidiary member has joined a consolidated group or MEC group and an entity after it ceases to be a member of the group: ss 716-505, 716-510. Note that an entity joining a group will be entitled to R&D tax offsets that relate to R&D activities undertaken before the joining time provided that it is a registered R&D entity for the income year.

Partners in R&D partnership The R&D tax offset is directly available to each partner in a partnership of R&D entities (an R&D partnership: s 355-505), provided the partner is registered with AusIndustry and the other eligibility conditions are satisfied (ss 355-100 and 355-545). A partner’s proportion of various amounts (eg expenditure, turnover or recoupment) is the same as their interest in the net income or partnership loss of the R&D partnership, unless the partners have agreed to a different proportion: s 355-505(2). Various deeming rules apply to enable each partner to receive the tax offset. In particular, each partner is treated as incurring that partner’s proportion of the partnership expenditure (s 355-510) and activities conducted by the partnership are treated as conducted by each partner (s 355-515). © 2017 THOMSON REUTERS

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[11 050] Eligible R&D activities R&D activities are categorised as either ‘‘core’’ or ‘‘supporting’’ R&D activities. Activities that meet the definition of ‘‘core R&D activities’’ or ‘‘supporting R&D activities’’ can be registered. In its annual registration (see [11 090]), a company should register all activities it self-assesses to be eligible R&D activities. Core R&D activities and supporting R&D activities need to be separately identified. An application for registration of a supporting activity must refer to the core R&D activity it relates to. Although an R&D plan is not required, the main steps of each activity should be described in detail. Core R&D activities ‘‘Core R&D activities’’ are defined in s 355-25(1) as experimental activities whose outcome is not known or cannot be determined in advance, but can only be determined by applying a systematic progression of work that is based on established scientific principles and proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions. ‘‘Trial and error’’ experiments are unlikely to meet this requirement. In addition, the activity must be conducted for the purpose of generating new knowledge (including knowledge or information on creating new or improved materials, products, devices, processes or services). The AAT has said that the purpose of generating new knowledge must be more than an insubstantial purpose, but need not be the dominant or prevailing purpose: see Re JLSP and Innovation Australia [2016] AATA 23. Accordingly, in self assessing whether an activity (or set of activities) satisfies the definition of ‘‘core R&D activity’’, a company needs to consider whether: • an experiment (or set of related experiments) has taken place; • the outcome of the experiment was not known or determined in advance on the basis of current knowledge, information or experience (available in the public arena on a reasonably accessible worldwide basis at the time the activities were conducted); • the experimental activity employed the scientific method; and • the purpose of the experiment was to generate new knowledge or information. A clinical trial conducted on behalf of a pharmaceutical company to determine the safety and efficacy of a particular drug was considered to constitute a core R&D activity in Re JLSP and Innovation Australia. The Explanatory Memorandum to the Tax Laws Amendment (R&D) Bill 2010 notes that core R&D activities are part of the eligible experiment, but that not every step in the scientific method comprises experimental activities. However, ‘‘non-core’’ activities can qualify as R&D activities if they satisfy the definition of supporting R&D activities (see below). Experimental activities can satisfy the definition of core R&D activities even if they also serve a production or commercial objective. Such activities cease to be eligible once the new knowledge is generated. Taxpayer Alert TA 2015/3 advises primary producers involved in broadacre farming that the Tax Office is reviewing arrangements where a significant part (or all) of the expenditure seems to be on ‘‘business as usual’’ activities and not on R&D activities.

Excluded activities Section 355-25(2) excludes the following activities from qualifying as core R&D activities, although these activities can be claimed as supporting R&D activities if they satisfy a dominant purpose test (see below): • market research, market testing and market development; 458

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[11 050]

• sales promotion (including customer surveys); • management studies and efficiency surveys; • activities undertaken to discover and/or quantify mineral and petroleum deposits; • the commercial, legal and administrative aspects of patenting and licensing; • activities undertaken to comply with statutory requirements or standards; • activities relating to reproducing an existing product or process; • research in arts, humanities or social sciences; • developing, modifying or customising computer software for the sole or dominant purpose of internal administration of business functions by the company (or connected entities). This exclusion does not apply to in-house software of an applied nature which is an integral part of an electrical or mechanical device (eg industrial equipment or home appliances).

Supporting R&D activities ‘‘Supporting R&D activities’’ are activities that are directly related to core R&D activities and are usually required in order for the core activities to take place: s 355-30(1). However, supporting activities do not need to occur at the same time or place as the core activities. For example, core R&D may be conducted in a laboratory, while supporting R&D may take place in the production line. The following activities cannot qualify as supporting R&D activities unless they satisfy the additional requirement of being undertaken for the dominant purpose of supporting core R&D activities (s 355-30(2)): • activities that are specifically excluded from being considered as core R&D activities (ie the activities on the exclusions list in s 355-25(2): see above); and • activities that produce goods or services, or are directly related to their production. Dominant purpose means the prevailing or most influential purpose for conducting an activity. Thus, an activity with a commercial objective can qualify as a supporting R&D activity if it is undertaken for the dominant purpose of supporting core R&D activities. The Explanatory Memorandum includes 20 examples to explain and illustrate the meanings of ‘‘core’’ and ‘‘supporting’’ R&D activities, including the application of the dominant purpose test if goods are produced as part of the activities. The following example (based on Example 2.1 of the EM) illustrates a simple case where commercial production has yet to commence and there are no by-products from the R&D activities. EXAMPLE [11 050.10] Ruddturn Pty Ltd is investigating the potential for a chemical known as C23 to be added to petrol to reduce greenhouse gas emissions. The related chemistry is complex and underdeveloped, and it cannot be determined in advance whether C23 can be used in this way. The company systematically conducts documented experiments to investigate this idea. These experiments are core R&D activities because: • the idea has a scientific basis; • the company is addressing a knowledge gap that can only be resolved by applying the scientific method; and • the activities are conducted for the purposes of acquiring new knowledge. Ruddturn also conducts activities that are directly related to the core R&D activities, including researching the properties and applications of C23, preparing test batches, constructing apparatus to capture and record exhaust emissions and developing a computer model to interpret the results. These activities qualify as supporting R&D activities. Ruddturn © 2017 THOMSON REUTERS

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does not need to consider the dominant purpose test because its supporting activities are not on the core exclusions list and do not produce goods or services.

[11 060] R&D activities – conditions A company’s entitlement to the R&D tax offset is based on its ‘‘notional deductions’’ (see [11 070]) for R&D activities. R&D activities for which expenditure can produce notional deductions are activities that are conducted (s 355-210(1)): • for an R&D entity solely within Australia (see [1 130] for the definition of ‘‘Australia’’); • for a foreign corporation solely in Australia by its permanent establishment (but not for the purposes of the PE); • solely for a related foreign corporation that is a resident of a country with which Australia has a double taxation agreement; and/or • overseas in circumstances where the activities cannot be conducted in Australia and are covered by an overseas finding (see below). If the R&D activity consists of several parts, some parts may be conducted for an R&D entity solely within Australia and the other parts may be conducted for an R&D entity overseas, provided the activities are covered by an overseas finding.

R&D activities must be conducted ‘‘for’’ the R&D entity The general rule is that an R&D entity is only entitled to a tax offset for R&D activities conducted ‘‘for’’ itself (or by another entity for it), and that expenditure conducted to a significant extent for another entity is not notionally deductible: s 355-210(2). Exceptions apply if the R&D activities are conducted solely in Australia for a related foreign corporation or a body corporate carrying on business through a permanent establishment. There are strict conditions regarding when these exceptions apply: see ss 355-215, 355-220, 716-500. Determining whether an R&D activity is conducted ‘‘for’’ an R&D entity is a question of fact, tested by weighing up which entity: • effectively ‘‘owns’’ the results (eg the intellectual property or know-how) of the R&D activities; • has appropriate control over the conduct of the R&D activities; and • bears the financial risk of carrying out the R&D activities. EXAMPLE [11 060.10] Two R&D entities (Bongo and Victo) enter into a contract requiring Victo to undertake certain R&D activities. Bongo pays Victo for those services. Bongo has the complete right to control the commercial results arising from Victo’s activities. Bongo is entitled to the R&D tax offset because Victo conducts the R&D activities for Bongo’s benefit.

Overseas finding required for R&D activities conducted overseas Generally, a company may only claim a tax offset for expenditure on R&D activities that are conducted within Australia: s 355-210(1)(a). For a company to claim the offset in respect of overseas activities, it must apply to Innovation and Science Australia for a finding that the activities are eligible R&D activities: see [11 090]. Innovation and Science Australia may make a positive finding if it is satisfied that (s 28D IRD Act): 460

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[11 070]

• the overseas activities are eligible as core or supporting R&D activities. Innovation and Science Australia will be satisfied of this if the company has obtained an advance finding that the activities are eligible; • the overseas activities have a significant scientific link to core R&D activities carried on in Australia (which are registered, or reasonably likely to be conducted and registered in future); • the activities cannot be conducted within Australia due to quarantine laws, or because access is needed to facilities, expertise or equipment, a population of living things, or a geographical or geological feature not available in Australia; and • the total amount spent on the overseas activities is less than the total amount spent on Australian R&D activities (in all income years). An overseas finding is not required for minor expenditure on overseas R&D activities that are insignificant in the context of the Australian R&D activities (eg the cost of sending employees overseas to observe techniques or attend seminars).

[11 070] Notional deductions for expenditure on R&D activities An R&D entity that satisfies the eligibility criteria for the R&D tax offset (about where and for whom the R&D activities are conducted and registration: see [11 060] and [11 090]) is entitled to a tax offset (at the applicable rate: see [11 030]) if the sum of the amounts that the entity could notionally deduct under Div 355 for an income year is $20,000 or more (subject to 2 exceptions – see below). The deduction is ‘‘notional’’ because it is not an actual deduction, but is a step in calculating the entity’s tax offset entitlement. Note there is an expenditure cap of $100m: see [11 030]. An amount that is used to calculate an entity’s entitlement to the R&D tax offset cannot be deducted or offset under another provision of the income tax law: ss 355-105, 355-715. Exceptions to $20,000 expenditure threshold If an R&D entity’s notional deductions for an income year are less than the $20,000 minimum threshold, the tax offset is still available in respect of (s 355-100): • R&D activities carried on by a research service provider (a body of persons registered under the IRD Act to provide research services to R&D entities); or • monetary contributions to a Cooperative Research Centre (an organisation formed between publicly funded researchers and end users).

Eligible expenditure An R&D entity’s notional deductions generally comprise: • expenditure that is incurred on eligible, registered R&D activities during the income year: s 355-205. This is subject to the application of the prepayment rules in Subdiv H Div 3 in Pt III ITAA 1936 (see [8 350]) and a special rule for expenditure incurred to an associate (see below); • the decline in value of tangible depreciating assets (including plant) used for registered R&D activities during the income year (provided a deduction would be available under Div 40 ITAA 1997 if Div 40 applied with certain changes as outlined in s 355-310): ss 355-305, 355-310; • balancing adjustments for tangible depreciating assets used solely for R&D activities, provided the R&D entity is registered for the income year in which the balancing adjustment event occurs and could deduct the amount under s 40-285(2) (see [10 850]) if Div 40 applied as modified: s 355-315(2). If a balancing adjustment results in an additional amount being included in assessable income (to claw back excessive deductions), the additional amount is one-third of so much of the s 40-285 © 2017 THOMSON REUTERS

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amount as does not exceed the total decline in value: s 355-315(3). A partner in an R&D partnership can also obtain a notional deduction (for the relevant proportion) where a balancing adjustment event occurs in relation to a tangible depreciating asset used only to conduct R&D activities (the partner can choose to reduce the adjusted s 40-285 amount if notional deductions exceeded $100m in an earlier year or the event year): s 355-525. Note that if a depreciating asset was also used for non-R&D purposes, the balancing adjustment is worked out under s 40-292: see [10 930]. As an integrity measure, if expenditure is incurred to an associate, the notional deduction arises in the income year in which the payment is made (which may be a subsequent year to the income year in which the amount is incurred). However, there is no notional deduction if the R&D entity previously deducted the amount under the normal income tax provisions (and the company is prohibited from amending its assessment to disallow the deduction): ss 355-205(1)(b), 355-480. If an R&D entity participates in a Cooperative Research Centre (CRC), notional deductions arise when monetary contributions are made under the CRC program, rather than when such contributions are actually expended on the R&D activities: s 355-580. The normal rules apply to a non-monetary contribution to a CRC (eg a depreciating asset or the services of an employee).

Apportionment Amounts are only included as notional deductions ‘‘to the extent that’’ they are incurred on eligible, registered R&D activities: s 355-205(1). This means that expenditure with both R&D and non-R&D elements or purposes may need to be apportioned. For example, the amount claimed for the decline in value of a depreciating asset must be reduced to the extent that the asset is used for a non-R&D purpose (although a deduction may be available under Div 40 in respect of the non-R&D use of the asset if that use is for a taxable purpose: see [10 050]). The wages and superannuation contributions of employees who work part of the time on R&D activities must be apportioned. Excluded notional deductions for R&D expenditure The following expenditure is expressly excluded from eligibility for the R&D tax offset, although it may be deductible under another provision of the ITAA 1997 (eg s 8-1 or Div 43): • the cost of acquiring or constructing a building (including part of, or an extension, alteration or improvement to, a building), unless the building (or part thereof) is plant: s 355-225(1)(a); • capital expenditure included in the cost of a tangible depreciating asset for Div 40 purposes (as modified for the purpose of applying Div 355): s 355-225(1)(b); • interest payable to an entity: s 355-225(1)(c); • expenditure on acquiring core technology (unless the expenditure relates to acquiring a tangible depreciating asset): s 355-225(2). Note that Innovation and Science Australia can make a finding about whether particular technology is core technology (see [11 090]); and • expenditure that is not at risk (eg because of an indemnity or a guaranteed return under a financing arrangement): s 355-405. This exclusion does not apply to R&D activities conducted for a related foreign corporation or for a body corporate carrying on business through a permanent establishment. Determination TD 2014/15 considers when design expenditure incurred by an R&D entity is included in the first element of the cost of a tangible depreciating asset for the purposes of s 355-225(1)(b) (and therefore not able to be deducted under s 355-205). 462

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[11 080]

There is no notional deduction for the decline in value of a depreciating asset that has been pooled with other assets: see [10 750]. Conversely, a depreciating asset cannot be allocated to a low-value or small business pool if Div 355 has applied to the asset: see [10 760] and [25 120].

Notional deductions treated as actual deductions for other income tax purposes A notional deduction under Div 355 is treated as an actual deduction for the purposes of various income tax provisions, including (s 355-105): • the prepayment rules in Subdiv H of Div 3 of Pt III ITAA 1936: see [8 350]-[8 400]; • the recoupment rules in Subdiv 20-A ITAA 1997: see [6 580]; • the CGT cost base rules: see Chapter 14; • provisions that prevent amounts being deducted (eg the commercial debt forgiveness rules in Div 245 ITAA 1997 and Pt IVA ITAA 1936); and • the balancing adjustment provisions in ss 40-292 and 40-293 ITAA 1997: see [10 850]. If the prepayment rules apply to work out a notional deduction for R&D expenditure, the amount is treated as deducted under Div 355, not under the prepayment rules: s 355-110.

[11 080] Integrity, adjustment and claw back rules Division 355 includes integrity, adjustment or clawback provisions for: • expenditure incurred while not at arm’s length; • the disposal of R&D results; • group mark-ups; • the sale or supply of feedstock; and • the receipt of a government grant or reimbursement. Other integrity measures include delaying notional deductions for expenditure incurred for an associate until payment is made, and excluding expenditure that is not at risk: see [11 070].

Market value rule for non-arm’s length dealings Section 355-400 adjusts R&D expenditure incurred in a non-arm’s length transaction or a transaction with an associate, if the expenditure exceeds the market value of the R&D activity. For Div 355 purposes, the amount of expenditure is taken to be equal to its market value. Note that this market value rule is disregarded if the transfer pricing provisions (discussed in Chapter 37) apply. Amounts attributable to R&D results included in assessable income Section 355-410 requires an R&D entity to include in its assessable income amounts received or receivable (or capital gains made) in certain circumstances, including where: • the results of its R&D activities are disposed of (this may include amounts from the licensing of intellectual property payable in the future: see ATO ID 2015/5); • another entity is granted access to, or the right to use, R&D results; or • a depreciable asset used in R&D activities is disposed of. If an amount received by an R&D entity consists of payments for results from both R&D and non-R&D activities, only the amount attributable to the disposal of the results from the R&D activities is assessable under s 355-410: see ATO ID 2015/4. © 2017 THOMSON REUTERS

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Deductions are reduced to reflect mark-up within a group A company’s notional deductions must be reduced to remove any mark-ups on R&D expenditure incurred to a group entity: s 355-415. The amount notionally deducted is reduced to the extent that R&D expenditure exceeds the actual cost of the R&D goods or services to the connected entity or affiliate. Assessable amount attributable to sale or supply of feedstock Subdivision 355-H contains complex feedstock rules that include an amount in assessable income if expenditure is incurred on goods, materials or energy used during R&D activities to produce marketable products or products applied for own use. The feedstock adjustment provisions are not confined to mass production activities and do not affect the eligibility of R&D activities. The purpose of the provisions is to claw back that part of the R&D tax offset that is attributable to recouped feedstock expenditure. Certain aspects of the feedstock adjustment provisions are discussed in Ruling TR 2013/3. The feedstock adjustment is triggered when the product is sold or applied for the R&D entity’s (or a related entity’s) own use: ss 355-465(1), 355-475. The R&D entity is required to include in its assessable income one-third of the lesser of the feedback expenditure or the ‘‘feedstock revenue’’: s 355-465(2). If the feedstock output is immediately sold or applied, the feedstock revenue is its market value at that point. If further expenditure is incurred on the feedstock output between the R&D activity and the point of sale, the feedstock revenue is a proportion of the value of the product sold: s 355-470. If there are multiple feedstock outputs from an R&D activity, the feedstock adjustment applies on an output-by-output basis: s 355-465(2)(b). If a feedstock output from one R&D activity is used as an input for a subsequent R&D activity, the feedstock adjustment only applies to the output from the final R&D activity in the chain: s 355-465(3)(a). A feedstock adjustment does not arise where an R&D entity incurs expenditure on constructing a prototype which is a tangible depreciating asset, where that asset is not used in acquiring or producing any ‘‘feedstock inputs’’: see ATO ID 2012/89. EXAMPLE [11 080.10] Azra Ltd undertakes an experimental activity that produces marketable goods. The company’s notional deductions total $300,000, including $120,000 in feedstock expenditure. The goods are sold for $150,000 soon after they are produced, without any further expenditure being incurred. The company’s feedstock expenditure ($120,000) is less than its feedstock revenue ($150,000). Azra Ltd must include in its assessable income one-third of the feedstock expenditure (ie 1/3 × $120,000 = $40,000). This amount is included in the income year in which the goods are sold.

Additional tax imposed to claw back recouped R&D expenditure If an R&D entity benefits from a government recoupment (eg a grant or reimbursement) in relation to expenditure that also qualifies for the R&D tax offset, additional income tax is imposed to ‘‘claw back’’ the recouped R&D expenditure: ss 355-435, 355-450. This extra tax equals 10% of the recoupment (subject to a cap equal to the R&D part of the grant). This cap is reduced to the extent that any part of the grant is repaid. The extra income tax is payable in the income year in which the recoupment is received or receivable, regardless of whether the related tax offset benefit is used in that income year. Recoupments under the CRC program are not subject to a clawback adjustment.

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[11 090]

EXAMPLE [11 080.20] Yumi Pty Ltd, an R&D entity, receives a $500,000 government grant for expenditure on its R&D activities. Of this amount, $400,000 is notionally deductible under Div 355. Yumi Pty Ltd must pay extra tax of $40,000 (10% of $400,000) in the income year in which the grant is received.

[11 090] Administration of the R&D tax incentive The R&D tax incentive is jointly administered by the Tax Office and Innovation and Science Australia (mainly through AusIndustry). The Commissioner determines whether expenditure on, and the decline in value of depreciating assets used for, registered R&D activities qualify for the tax offset. Innovation and Science Australia manages the annual registration of R&D activities and research service providers, and has the power to make various decisions (in the form of ‘‘findings’’) about R&D activities and registration. These findings are binding on the Commissioner: s 355-705. To help determine its entitlement to the R&D tax offset, a company can apply to the Commissioner for a private ruling, and to Innovation and Science Australia for an advance finding about the nature of its activities or a finding about whether particular technology is excluded core technology (see [11 060]). The Commissioner can also request findings (on core technology and the continued eligibility of registered activities). The regulatory rules for the R&D tax incentive are contained in Pt III of the IRD Act, and regulations and decision-making principles made under that Act (in particular the Industry Research and Development Regulations 2011). Annual registration of R&D activities It is a pre-condition to claiming the R&D tax offset that a company’s R&D activities are registered with AusIndustry (on behalf of Innovation and Science Australia). If a company conducts overseas activities, an overseas finding must be obtained before applying for registration (see below). Registration takes place in the income year after the R&D activities are undertaken. Registration applications are due annually, within 10 months of the end of the company’s income year. Registration forms are available from the AusIndustry website. Innovation and Science Australia may refuse registration if the activities described in the application are not eligible R&D activities, or if the application is received after the 10-month deadline. This deadline can be extended in exceptional circumstances listed in the decision-making principles (see Re Silver Mines Ltd and Minister for Infrastructure and Regional Development [2016] AATA 707 for a case where a refusal to extend the deadline was upheld by the AAT). Innovation and Science Australia also has the power to vary or revoke a registration. Once R&D activities have been registered, the company can claim the R&D tax offset in its income tax return for the income year in which eligible R&D expenditure is incurred (by completing the R&D Tax Incentive Schedule, including quoting the registration number). R&D activities conducted in income years that commenced before 1 July 2011 need to be registered under the former R&D tax concession: see the Australian Tax Handbook 2011 at [21 030]. Advance and overseas findings Prior to applying for registration, a company can request an advance finding on the eligibility of its activities. A company may wish to obtain an advance finding if it wants confirmation that particular activities are R&D activities, or to secure financial support for conducting an R&D project. Although an advance finding is not a pre-condition to registration, Innovation and Science Australia is bound to register activities that are covered © 2017 THOMSON REUTERS

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by, and carried out consistently with, the finding. The Commissioner is also bound by the advance finding for the income year in which the application was made and the next 2 income years: s 355-705(2). A company that conducts, or intends to conduct, some of its activities overseas must obtain an overseas (advance) finding as a pre-condition to registering those activities: see [11 060]. The application for the advance finding and the overseas finding should be made together. Advance and overseas findings can be sought in relation to activities conducted in the current income year and proposed activities that are reasonably expected to be conducted in the current or next 2 income years: s 28A(2) of the IRD Act. These findings cannot be made for activities conducted in a prior income year. A company cannot rely on a finding if it carries out activities in a way that is materially different to the activities described in the finding.

Record-keeping requirements An R&D entity must keep records that sufficiently demonstrate to the Commissioner and Innovation and Science Australia that it has conducted eligible R&D activities and incurred eligible expenditure that meet all legislative requirements. Objections and reviews An R&D entity can object to an assessment, including a nil assessment, that relates to the refundable R&D tax offset: s 67-135 TPA (applicable for 2012-13); s 170 ITAA 1936 (applicable for subsequent income years). A company that is dissatisfied with the Commissioner’s objection decision has review and appeal rights under Pt IVC TAA (discussed in Chapter 48). Innovation and Science Australia’s findings and registration decisions are reviewable, first internally and then externally by the AAT. Commissioner’s amendment period The Commissioner generally has 4 years to amend an assessment to give effect to the R&D provisions (2 years for small business entities): see [47 140]. An assessment can be amended outside the standard amendment period if Innovation and Science Australia has given the Tax Office a certificate setting out a finding: s 355-710(1). An amendment that increases a company’s tax liability can be made up to 2 years after the certificate is given. There are no time limits on amending an assessment to reduce a company’s tax liability. There is also no limit on the amendment period to give effect to a decision by a court or the AAT, or an internal review under the IRD Act: s 355-710. [11 100] Former ITAA 1936 tax incentive For income years before 2011-12, Australian companies that incurred expenditure on or related to R&D may have qualified under s 73B ITAA 1936 for an accelerated deduction of up to 125% of the expenditure. The accelerated deduction rate of 125% was available only if a minimum expenditure threshold was met. An additional 50% deduction was available to certain companies that increased their R&D expenditure above their average R&D expenditure over the previous 3 years. A refundable tax offset (rebate) was available to certain companies as an alternative to claiming deductions for R&D expenditure. The ITAA 1936 R&D tax concession continues to apply and be administered in respect of R&D activities performed in income years commencing before 1 July 2011. For detailed commentary on the ITAA 1936 R&D tax concession, see Chapter 21 of the Australian Tax Handbook 2011. A number of transitional rules (in the TPA) deal with such matters as prepayments extending into the 2011-12 income year (s 355-550), undeducted core technology expenditure 466

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[11 210]

incurred before 1 July 2011 (Subdiv 355-M), intra-group mark-ups (s 355-415) and balancing adjustments if a depreciating asset was used for R&D activities under the former R&D tax concession (Subdiv 355-E).

INNOVATION COMPANIES [11 200] Overview Various concessions apply for investments in Early Stage Innovation Companies (ESICs). An investor in an ESIC is entitled to a tax offset: see [11 210]. In addition, an investor entitled to the offset may be entitled to CGT concessions in respect of shares acquired in an ESIC: see [11 220]-[11 230]. These measures apply in relation to equity interests issued on or after 1 July 2016. [11 210] Early stage investor offset A taxpayer who invests in a qualifying ESIC is entitled to a tax offset (the ESIC offset) under Subdiv 360-A ITAA 1997. The offset is non-refundable, but any unused offset can be carried forward to a later income year: see [19 050]. Qualifying investor The ESIC offset is available to all types of investors other than ‘‘widely held companies’’ and 100% subsidiaries of those companies: s 360-15. (See [20 550] for the definition of a ‘‘widely held company’’.) However, a trust or partnership is not directly entitled to the offset. Instead, the value of the offset flows through to the beneficiaries and partners. In order to qualify for the tax offset (s 360-15): • the investor must be issued with shares in the ESIC (which does not constitute an acquisition of ESS interests under an employee share scheme: see [4 150]-[4 170]); • the ESIC and the investor must not be affiliates of each other (see [25 050] for the definition of an ‘‘affiliate’’); • the investor must not hold more than 30% of the equity interests of the ESIC, including any entities ‘‘connected with’’ the ESIC, tested immediately after the time relevant equity interests are issued (see [25 060] for the definition of ‘‘connected entity’’). An investor that does not meet the requirements of the sophisticated investor test in s 708 of the Corporations Act 2001 is limited to investing a maximum of $50,000 in an income year: s 360-20. These investors are not entitled to the offset if their investment exceeds this maximum threshold.

Qualifying ESIC A company qualifies as an ESIC if it is at an early stage of its development (the early stage test) and it is developing new or significantly improved innovations with the purpose of commercialisation to generate an economic return (the innovation test). The early stage test requires the company to have been incorporated in Australia within the last 3 income years or, failing that, within the last 6 income years provided it and its 100% subsidiaries (if any) incurred total expenses of $1m or less across the last 3 income years: s 360-40(1). Alternatively, a company that has been registered in the Australian Business Register within the last 3 income years may be a qualifying ESIC. In all cases, the latest income year is the current income year. Other conditions of the early stage test are (s 360-40(1)): © 2017 THOMSON REUTERS

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• the company and its 100% subsidiaries (if any) must have incurred total expenses of $1m or less in the income year before the current year; • the company and its 100% subsidiaries (if any) must have a total assessable income of $200,000 or less in the income year before the current year; and • the company’s shares must not be listed on a stock exchange anywhere in the world. The innovation test requires the company to satisfy the 100 point innovation test in s 360-45 or be genuinely focused on developing for commercialisation one or more new, or significantly improved, products, processes, services or marketing or organisational methods and show that the business relating to that innovation has the potential for high growth, has scalability, can address a broader than local market and has competitive advantages: s 360-40(1) – (3). Regulations may specify types of activities or forms of innovation that will be excluded from being able to satisfy the innovation test. An investor that acquires shares in a company that is a qualifying ESIC at the time of issue, is not disqualified from accessing the ESIC offset in relation to those shares if the company subsequently ceases to be a qualifying ESIC. In addition, the investor is not disqualified from accessing the modified CGT treatment in relation to those shares: see [15 640]-[15 660].

Amount of offset The ESIC offset is equal to 20% of the amount the investor paid for the qualifying shares. The maximum offset that an investor and its affiliates can claim in any income year is $200,000, less the sum of any previously claimed ESIC offset(s) carried forward into the income year. If the investor is a partnership or trust, the amount of the offset is the product of (s 360-30): • the member’s share of the offset as determined by the trustee or partnership. If a member of a trust or partnership is entitled to a fixed proportion of any capital gain from investments that would result in the trust or partnership being entitled to the offset if that entity was an individual, then the member’s share of the offset must be that proportion; and • the amount of the offset that would be available to the trust or partnership were it an individual (the notional offset amount). The trustee or partnership may not determine that the members of the trust or partnership are entitled to more than 100% of the notional offset that would have been available to the trust or partnership. If a trust or partnership itself has members that are trusts or partnerships, the offset flows through those entities until it ultimately reaches an entity that is not a trust or partnership: s 360-15(2). A trustee of a trust is entitled to the offset if the trust would be entitled to the offset if it was an individual and the trustee of the trust is liable to some extent for tax in respect of the activities of the trust (under ss 98, 99 or 99A ITAA 1936 – discussed in Chapter 23): ss 360-15(3), 360-35.

[11 220] CGT concessions There are CGT concessions where an investor acquires qualifying shares in an ESIC and the investor is entitled to the ESIC tax offset: see [11 210]. The key issue is entitlement to the offset and not whether the investor has actually received the offset.

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[11 230]

EXAMPLE [11 220.10] John invests $1m in an ESIC (‘‘Innovation Co’’) that issues shares to him for his investment. In the same income year, he also invests $500,000 in another ESIC (‘‘Designer Co’’) that also issues shares to him. Because the maximum amount of the offset available in an income year cannot exceed 20% of the investment (ie $200,000) John, for example, will only be able to claim the offset in relation to the shares issued to him by Innovation Co. However, even though John is not able to claim a tax offset for the shares issued to him during the income year by Designer Co, the CGT concessions will still apply to those shares. The CGT concessions are available even if the company which issued the shares subsequently ceases to be a qualifying ESIC. Note that an investor in an ESIC is taken to hold the shares on capital account. This means that dealings with the shares will only have CGT consequences.

Shares held for less than 12 months An investor that has continuously held a qualifying share for less than 12 months will not be able to disregard any capital gains arising to that share but must disregard any capital losses. Shares held for more than 12 months and less than 10 years An investor that has continuously held a qualifying share for between 12 months and less than 10 years will be able to disregard a capital gain arising from the share. Capital losses must also be disregarded. Shares held for 10 years or more Where an investor has continuously held a qualifying share for at least 10 years, the first element of the cost base of the share will be the market value, as determined on the 10 year anniversary date. This means any incremental gains in value after 10 years will be taxable, but losses can be recognised. [11 230] Shares subject to roll-over The measures will preserve the modified treatment for qualifying shares that are subject to a CGT roll-over by preserving the original acquisition date of the qualifying shares. However, in some other cases, the measures provide a mechanism to terminate the modified treatment early. Same asset roll-overs To the extent a share otherwise qualifies for a CGT same asset roll-over (see [16 300]-[16 500]), then that asset will be taken to have been acquired by the new entity at the same time the share is initially issued by a qualifying ESIC to the original investor. Replacement asset roll-overs With some exceptions, to the extent a share otherwise qualifies for a CGT replacement asset roll-over (see [16 100]-[16 270]), then the replacement assets will be taken to have been acquired by the investor entity at the same time the shares in the qualifying ESIC are originally issued. Scrip for scrip roll-over and newly incorporated company roll-over To the extent that a share qualifies for the scrip-for-scrip roll-over under Subdiv 124-M (see [16 230]) or a newly incorporated company roll-over under Div 122 (see [16 020]-[16 060]), then the share will receive a market value as the first element of the cost base immediately before the exchange of assets under the roll-over. This will ensure that any accrued capital gains or losses in the share are not subsequently subject to CGT when the replacement asset is realised. © 2017 THOMSON REUTERS

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AUSTRALIAN FILMS [11 400] Overview of tax incentives The principal tax incentives for investment in Australian films and telemovies are 3 tax offsets (in Div 376 ITAA 1997): • the location offset – available in respect of qualifying Australian production expenditure: see [11 410]; • the producer offset – available on completion of an eligible Australian film: see [11 420]; and • the PDV offset – available in respect of expenditure incurred on in relation to the Australian post, digital and visual effects production for a film: see [11 430]. Expenditure on copyright in an Australian film is governed by Div 40 ITAA 1997 (the Uniform Capital Allowances system), which is discussed in Chapter 10. The various film tax offsets effectively replaced the long-standing incentives available under former Divs 10B and 10BA ITAA 1936 and the former Film Licensed Investment Company scheme under the (now repealed) Film Licensed Investment Company Act 2005. For further information about the former incentives, see Chapter 21 of the Australian Tax Handbook 2009. The location offset replaced the film production tax offset: see the Australian Tax Handbook 2008 at [21 420].

[11 410] Location tax offset The location tax offset (available under Subdiv 376-B ITAA 1997) applies in relation to films commencing principal photography or production of the animated image on or after 8 May 2007. The location offset is refundable (see [19 040]). The location offset is generally 16.5% of the company’s total qualifying Australian production expenditure (QAPE) on the film (see [11 435]), as determined by the Arts Minister in writing: ss 376-15, 376-30. Note that the offset rate is 15% if principal photography or production of the animated image commenced before 10 May 2011. A company is entitled to the location offset if (s 376-10): • the company’s QAPE on the film ceased being incurred in the income year. See [11 435] for which expenditure qualifies as QAPE; • the Arts Minister has granted a certificate to the applicant company (see below) – the application for a certificate must be made in accordance with the Location Offset Rules 2008 (the Rules also prescribe how a company may apply to the Film Certification Advisory Board for a non-binding provisional certificate providing guidance as to whether the film is likely to qualify for the location offset once it is completed); • the offset is claimed by the company in its income tax return for the income year in which post, digital and visual effects production work ceased; and • the company is an Australian resident company, or is a foreign resident company with a permanent establishment and an ABN. This must be the case both when the tax return is lodged and the offset is due to be credited to the company. The Arts Minister must issue a certificate (under s 376-20) if satisfied that: • the film is a qualifying film or TV series (see below); • the total of the company’s QAPE is at least $15m; • the company carried out, or made the arrangements for the carrying out of, all the activities that were necessary for making the film. 470

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[11 410]

Note that if one production company takes over a qualifying film or TV series from another production company, the latter company is taken to have incurred the expenditure that the former company incurred: s 376-180. However, expenditure incurred by the incoming company in order to take over the making of the film or TV series is disregarded for the purposes of the offset. A company used to be able to choose to disregard the remuneration (including travel and other associated costs) of one person in working out the company’s production expenditure and QAPE, but this ceased to apply from 1 July 2010. The location offset is not available if the film has been granted a certificate for the producer offset (see [11 420]) or the PDV offset (see [11 430]), a deduction was claimed in relation to intellectual property in the film under former Div 10B ITAA 1936 or the film was issued with a final certificate under former Div 10BA ITAA 1936: s 376-10.

Qualifying films and TV series A feature film or TV drama mini-series (including if produced for distribution as a video recording) is not eligible for the location offset if it is (or is substantially) a documentary (see below), an advertising program or a commercial, a discussion program, a quiz program, a panel program, a variety program (or a program of a like nature), a film of a public event, a training film or a computer game: s 376-20(2). A feature film or TV drama mini-series is not eligible for the location offset if it is a drama film forming part of a drama program series that is, or is intended to be, of a continuing nature. Game shows are also ineligible for the location offset where principal photography commences or after 29 June 2013. A TV series is eligible for the location offset if it is made up of 2 or more episodes that are produced wholly or principally for exhibition to the public on television under a single title, contain a common theme or themes and contain dramatic elements that form a narrative structure: s 376-20(3). In addition, all the episodes must be produced wholly or principally for exhibition together, for a national market or national markets. A documentary can be a TV series. Reality television is also eligible for the location (and PDV) offsets, but only as a television series. To this end, a film is considered to contain dramatic elements that form a narrative structure (without limiting the operation of the provision) if (s 376-20(4)): • the sole or dominant purpose of the film is to depict actual events, people or situations; and • the film depicts those events, people or situations in a dramatic or entertaining way, with a heavy emphasis on dramatic impact or entertainment value. In addition, computer games are specifically excluded from eligibility for the location offset. The location offset is not available for a TV series unless there is a minimum average of at least $1m of QAPE per hour: s 376-20(3). The average QAPE per hour is worked out by dividing the total QAPE for the series (as determined by the Arts Minister) by the total length of the series (measured in hours): s 376-20(6). The total QAPE must be at least $15m. See [11 435] for which expenditure qualifies as QAPE. In addition, a TV series (that is not a TV drama mini-series) must be completed within a certain timeframe (s 376-20(3)): • if the TV series is predominantly a digital animation or other animation, it must be made within a period of 36 months (excluding pre-production activities, activities associated with the production of any pilot programme and post-production activities); and • in any other case (eg a ‘‘live action’’ series) all principal photography must be completed within a period of 12 months (excluding activities associated with the production of any pilot episode). Principal photography does not include second unit photography. © 2017 THOMSON REUTERS

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Definition of “documentary” A ‘‘documentary’’ is defined as a film which is a creative treatment of actuality, having regard to matters such as the extent and purpose of any contrived situation featured in the film, the extent to which the film explores an idea or a theme and the extent to which the film has an overall narrative structure: s 376-25. The following are not a documentary: • an infotainment or lifestyle program; and • a film that presents factual information, has 2 or more discrete parts (each dealing with a different subject or a different aspect of the same subject) and does not contain an over-arching narrative structure or thesis. This definition applies in relation to films commencing principal photography on or after 1 July 2012.

[11 420] Producer tax offset The producer tax offset is available (under Subdiv 376-B ITAA 1997) for companies that produce eligible Australian films. The offset is available in relation to qualifying Australian production expenditure (QAPE) incurred on or after 1 July 2007 (see [11 435] for which expenditure qualifies as QAPE). The expenditure must be incurred by the company and not some other entity: Re Creation Ministries International Ltd and Screen Australia [2015] AATA 250. The producer offset is refundable (see [19 040]). Specifically, the producer offset is available to a company for the making of an eligible Australian film if the following conditions are met (s 376-55): • the film was completed in the income year (see s 376-55(2) for when a film is completed); • a certificate has been issued (under s 376-65) for the film by Screen Australian (or its predecessor). Rules relating to the issue of certificates are contained in the Producer Offset Rules 2007; • the offset is claimed in the income tax return for the year by the company; and • the company is an Australian resident, or is a foreign resident that has a permanent establishment in Australia and has an ABN. The producer offset is not available in similar circumstances to those where the location offset is not available (see [11 410]), including if a certificate is issued for the location offset or the PDV offset. The offset is also not available if financial assistance was received under the Producer Equity Program: s 376-55.

Eligible films A certificate will be issued (under s 376-65) by Screen Australia to the company that carried out, or made the arrangements for the carrying out of, all the activities necessary for the making of the film (thus qualifying the film for the producer offset) if the film: • is a feature film, a single episode program, a series, a season of a series or a short-form animated film – a documentary may qualify as a feature film, series or a season of a series, or a single episode program (ss 376-65(3)-(6) contain various other conditions relating to single episode programs, short-form animated films and series). Note the statutory definition of ‘‘documentary’’ at [11 410]. There is a 65 broadcast hours limit for a series; • has a significant Australian content (see below) or was made under governmental arrangement with a foreign country or an authority of a foreign country; and • if a series has a new creative concept (taking into account factors such as the title of the series and whether the series has substantially different characters, settings and production locations than any other series: s 376-70(2)). 472

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In addition, various expenditure thresholds must be satisfied (eg QAPE must be at least $500,000 if a feature film or a single episode program other than a documentary): s 376-65(6). A program which followed the efforts of a different family or household to improve household management and reduce stress through implementing advice given by an expert was considered to be a documentary in Screen Australia v EME Productions No 1 Pty Ltd (2012) 87 ATR 434. Note the statutory definition of ‘‘documentary’’ at [11 410]. The factors to be considered in determining whether a film has a significant Australian content include the subject matter of the film, the place where the film was made, the nationalities and residencies of those who took part in making the film and details of the production expenditure: s 376-70(1). Screen Australia has issued guidelines on what constitutes significant Australian content. In Re Beyond Productions Pty Ltd and Screen Australia (2011) 82 ATR 194, the AAT concluded that a TV series exploring the traditions, rituals and social mores of different cultures all over the world, which was largely filmed in Australia and mostly produced and edited by Australians, did not have a significant Australian content. This was because there were not a significant number of episodes about Australia or Australians and there was ‘‘no discernible Australian point of view or sensibility that the ordinary viewer would recognise as Australian’’. The following are not eligible for the producer offset (s 376-65(2)): • a film for exhibition as an advertising program or a commercial; • a film for exhibition as a discussion program, a quiz program, a panel program, a variety program or a program of a like nature; • a film of a public event (other than a documentary); • a training film; • a computer game; • a news or current affairs program; or • a reality program (other than a documentary). Game shows are also ineligible for the producer offset where principal photography commences on or after 29 June 2013.

Amount of offset The amount of the producer offset is (s 376-60): • if the film is a feature film – 40% of the QAPE on the film; or • if the film is not a feature film – 20% of the QAPE on the film.

[11 430] PDV offset The PDV offset is available (under Subdiv 376-B ITAA 1997) for the Australian post, digital and visual effects production for a film. It does not matter if the film was shot. The offset is available in respect of a film that commences post, digital and visual effects production on or after 1 July 2007. The PDV offset is refundable (see [19 040]). A company is entitled to the offset if (ss 376-35, 376-45): • it has incurred at least $500,000 of qualifying Australian production expenditure (QAPE) on post, digital and visual effects production work – see [11 435] for which expenditure qualifies as QAPE; • all eligible post, digital and visual effects production-related expenditure has ceased being incurred; • the Arts Minister has granted a certificate to the company for the post, digital and visual effects production for the film – the application for a certificate must be made in accordance with the PDV Offset Rules 2008 (the Rules also prescribe how a © 2017 THOMSON REUTERS

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company may apply to the Film Certification Advisory Board for a non-binding provisional certificate providing guidance as to whether the film is likely to qualify for the PDV offset once it is completed); • the offset is claimed by the company in its income tax return for the income year in which post, digital and visual effects production work ceased; and • the company is an Australian resident company, or is a foreign resident company with a permanent establishment and an ABN. This must be the case both when the tax return is lodged and the offset is credited to the company. ‘‘Post, digital and visual effects production’’ is defined as (s 376-35(2)): • the creation of audio or visual elements (other than principal photography, pick ups or the creation of physical elements such as sets, props or costumes) for the film; • the manipulation of audio or visual elements (other than pick ups or physical elements such as sets, props or costumes) for the film; and • activities that are necessarily related to the activities mentioned above. The film for which the post, digital and visual effects production work is being undertaken must be an eligible format for the location offset (see [11 410]): s 376-45(2). This means that the film must be, for example, a feature film (for distribution on any medium), telemovie, television series or miniseries. The film itself need not meet timing or expenditure criteria. The types of film that do not qualify for the location offset (see [11 410]) also do not qualify for the PDV offset – eg a documentary (see [11 410]), an advertising program or a commercial, a discussion program, a quiz program, a panel program, a variety program, a film of a public event and a training film. A game show also does not qualify for the PDV offset where principal photography commences on or after 29 June 2013. In addition, the PDV offset is not available in similar circumstances to those where the location offset is not available, including if a certificate has been issued for the location offset or the producer offset. The PDV offset is 30% of QAPE that is incurred in relation to post, digital and visual effects production for a film: s 376-40. The offset rate is 15% if post, digital and visual effects production commenced before 1 July 2011.

[11 435] Qualifying Australian production expenditure ‘‘Qualifying Australian production expenditure’’ (QAPE) on a film (for the purposes of the location, producer and PDV offsets) is production expenditure (see below) on the film to the extent to which it is incurred by the taxpayer for, or is reasonably attributable to (s 376-145): • goods and services provided in Australia (eg freight services: Determination TD 2006/3); • the use of land in Australia; or • the use of goods located in Australia at the time they are used in the making of the film. In the case of the producer offset, expenditure incurred in a foreign country which would have qualified as QAPE if incurred in Australia is also QAPE, if the film in question is made under an arrangement between the Australian government (or government body) and the foreign country (or a foreign government body): s 376-170(1). If a service is predominantly performed outside Australia and the results are embodied in goods (eg a document or computer disk) delivered in Australia, the service is not taken to be performed in Australia (and thus the expenditure may not be QAPE): s 376-160. 474

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Other expenditure that qualifies as QAPE includes (ss 376-150, 376-165, 376-170): • certain Australian development expenditure; • expenditure incurred in acquiring copyright, or a licence in relation to copyright, in a pre-existing work for use in the film if the copyright is held by an Australian resident individual or company; • expenditure incurred in producing promotional material if the copyright in the material is held by an Australian resident individual or company; • certain expenditure incurred in producing additional content; • legal costs if they relate to writers’ contracts or chain of title and other copyright issues; • a reasonable proportion of general business overheads, but only to the extent the general business overheads do not exceed the lesser of $500,000 and 2% of total production expenditure (or, in the case of the producer offset, 5% of total film expenditure); • certain travel expenditure (in the case of the producer offset, the travel can be to or within a foreign country); • certain expenditure on freighting goods to Australia (or, in the case of the producer offset, within and between countries); • in the case of the producer offset, certain expenditure incurred outside Australia for the remuneration of an Australian resident; • insurance related to making the film; • fees for audit services and legal services provided in Australia in relation to raising and servicing the financing of the film which are incurred by the company that makes, or is responsible for making, the film; and • fees for incorporation and liquidation of the company that makes or is responsible for making the film. In addition, in the case of the producer offset, the following qualify as QAPE under s 376-170(2): • expenditure incurred in Australia in respect of obtaining an independent opinion of the amount of a film’s QAPE or offset carbon emissions created during the making of the film; • certain expenditure incurred in producing Australian copyright promotional material; and • certain expenditure incurred in delivering or distributing the film. Note that a company’s production expenditure and QAPE exclude GST: s 376-185.

Exclusions There are a number of exclusions from QAPE, including (s 376-155): • expenditure incurred when the production company is neither an Australian resident company nor a foreign corporation with an ABN operating with a permanent establishment in Australia; and • the salaries and travel costs of those personnel (other than cast members) who work in Australia on the production of the film for a period shorter than 2 consecutive calendar weeks. © 2017 THOMSON REUTERS

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Production expenditure A film’s ‘‘production expenditure’’ (for the purposes of the location, producer and PDV offsets) is the expenditure incurred or reasonably attributable to actually making the film from pre-production up to the point that it is ready to be distributed, broadcast or exhibited to the general public: ss 376-125, 376-130. The production expenditure may be capital or revenue in nature and may be expenditure that gives rise to a deduction. The following types of expenditure do not qualify as production expenditure, except to the extent the expenditure qualifies as QAPE: development; copyright acquisition; general business overheads that are not incurred in relation to making the film; distribution; and deferments, profit participation, residuals (except if paid out before the film is completed) and advances: s 376-135. Financing expenditure and publicity and promotion expenditure are included in production expenditure. Expenditure setting or increasing the cost of a depreciating asset also does not qualify as production expenditure (unless incurred in acquiring copyright in, or a licence in relation to, a pre-existing work held by an Australian resident): s 376-135. However, if a company claims depreciation deductions (under Div 40) in respect of a depreciating asset that it uses in making a film, production expenditure includes the amount of the depreciation deduction to the extent it is reasonably attributable to the use of the asset in making the film: s 376-125(6). Production expenditure may be increased or reduced, as appropriate, if a balancing adjustment event occurs for the depreciating asset before the film is concluded: s 376-125(7). The Tax Office considered that various insurance premiums were not included in production expenditure (see Determination TD 2006/2), but expenditure on insurance relating to making a film may now qualify as QAPE (see above). For the purposes of the location offset, expenditure is not production expenditure if the film is a TV series that is not a feature film or a TV drama mini-series, the expenditure is reasonably attributable to the production of a pilot episode to the TV series and the expenditure would otherwise be production expenditure that was not QAPE: s 376-140. If expenditure is incurred under an arrangement between 2 or more parties who are not dealing with each other at arm’s length (see [5 260]), the expenditure will be taken to be the amount that would have been incurred if they had been dealing with each other at arm’s length: s 376-175.

VENTURE CAPITAL INCENTIVES [11 500] PDFs – introduction Pooled development funds (PDFs) raise capital and make equity investments in small and medium-sized Australian companies (total assets not greater than $50m). The actual definition of a PDF for income tax purposes is a company that was registered as a PDF as at 21 June 2007 and does not act in the capacity of a trustee: s 6(1) ITAA 1936. PDFs are taxed on their taxable income, calculated in the same way as for companies generally, but at a concessional rate: see [11 510]. They obtain franking credits for the payment of company tax and the receipt of franked distributions and are able to frank distributions paid to their shareholders. The PDF program is governed by the Pooled Development Funds Act 1992 (PDF Act) and is overseen by Innovation and Science Australia: see [11 090]. Other points to note about PDFs include: • widely-held complying superannuation funds (with a minimum of 5 members), similarly regulated overseas pension funds and limited partnerships of such funds can wholly own a PDF; 476

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[11 520]

• PDFs can buy back their own shares and return capital to their shareholders, subject to a waiting period of 2 years for a new or merged PDF; • PDFs can make loans to equity investees subject to a maximum of 20% of the PDF’s shareholders’ funds; • Innovation and Science Australia can approve the acquisition of non-transferable options in investee companies as additional investments; • Innovation and Science Australia can approve the merger of PDFs provided no cash consideration is paid as part of the merger, other than a bona fide dividend; and • Innovation and Science Australia can revoke the registration of a PDF that is not complying with any part of PDF Act. Note that a PDF cannot be a member of a consolidated group during that year: see [24 020]. Shareholders are exempt from tax on unfranked distributions. Franked distributions are also exempt from tax unless the shareholder makes an election in favour of taxation of the distributions in the manner of ordinary company distributions. PDFs are being progressively replaced by early stage venture capital limited partnerships (ESVCLPs), which provide income and capital gains tax exemptions, and flow through tax treatment, to foreign and domestic partners: see [11 560]. The PDF program closed to new applicants on 21 June 2007.

[11 510] Taxable income and the PDF component Under Div 10E of Pt III ITAA 1936 (ss 124ZM to 124ZZD), the taxable income of a PDF is divided into 2 components: the SME income component (relating to investments in small and medium enterprises) and the unregulated investment component (all other taxable income): ss 124ZU and 124ZV. The SME assessable income is calculated first; deductions may be set off first against SME income, with any excess set off against unregulated investment income. The calculation methods in Div 10E have the effect of ordering the allowable deductions applied against the different components. In calculating SME assessable income, net capital gains are assessed under Div 10E rather than under the CGT provisions, and special rules allocate assessable capital gains and deductible capital losses. For this purpose the PDF assessable income is divided into 2 classes, SME assessable income and other assessable income: s 124ZY. Capital gains in one class of SME assessable income are reduced first by capital losses in that class and then by capital losses in the other class. Prior year capital losses are deducted first from capital gains in the SME assessable income class. A concessional tax rate applies from the time the company becomes a PDF until the last income year in which it is a PDF. The general concessional rate is 25%, but a 15% rate applies to the SME income component of the PDF’s taxable income. In any income year in which an entity is not a PDF on the last day, it is taxed at the standard corporate tax rate for the whole of that income year. [11 520] Distributions The imputation system in Pt 3-6 ITAA 1997 applies to PDFs. The system is discussed in detail in Chapter 21. Distributions (eg dividends) made by a PDF are frankable. A PDF must provide a statement that indicates, among other things, the imputation credit or gross-up in relation to the distribution. The imputation credit is calculated by reference to the standard corporate tax rate (presently 30%, although note the proposals outlined at [20 030] to reduce the company tax rate). For this purpose, the special provisions of Div 10E (discussed at [11 540]) are ignored. © 2017 THOMSON REUTERS

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Franked distributions received by a PDF are treated in the same way as franked distributions received by other corporate taxpayers. That is, the PDF must gross up the dividend to include the franking credits (ie cash dividend plus imputation credits) and a tax offset is available against the tax payable: see [21 410]. A PDF is not entitled to a refund of excess franking offsets: see [21 580].

Venture capital credits Resident complying superannuation funds and ADFs, pooled superannuation trusts and like entities are entitled to a special tax offset (the venture capital franking offset) if distributions to such entities from a PDF are franked with venture capital credits (which are tax paid by the PDF that is attributable to capital gains from venture capital investments). This effectively enables such entities to receive capital gains free of tax through PDFs. The rules are contained in Div 210 ITAA 1997. Life insurance companies also qualify for the tax offset, but only to the extent that the shares on which venture capital franked distributions are paid are attributable to their superannuation business (see [30 020] for more detail on the definition of life insurance company). The tax offset is not available if the dividend is received by an eligible shareholder through a partnership or trust or, for example, the dividend is part of a dividend stripping scheme. An eligible shareholder receives a tax offset for the venture capital credits attached to a dividend, which effectively exempts from tax the underlying venture capital gain. The venture capital tax offset is equal to the venture capital credit on the distribution. A life insurance company is entitled to a proportionate tax offset, calculated as the proportion that its complying superannuation class of taxable income bears to its total income. Excess venture capital tax offsets may be refundable under s 67-25: see [19 040].

Venture capital deficit tax To prevent a PDF from over-distributing venture capital credits, a tax (venture capital deficit tax) is imposed on deficits in venture capital sub-accounts at the end of a franking year. The tax is imposed under the New Business Tax System (Venture Capital Deficit Tax) Act 2003. The amount of the tax varies depending on the relative size of the deficit and the amount of venture capital credits for that franking year. The tax is calculated at a higher rate if the deficit is greater than 10% of the PDF’s total venture capital credits.

[11 530]

Losses incurred by a PDF

The provisions relating to losses incurred by a PDF are contained in Subdiv 195-A ITAA 1997. A tax loss incurred by a PDF in an income year in which it is taxed as a PDF (and is a PDF on the last day of the income year) is deductible in a later income year only if the company is a PDF throughout the later year: s 195-5. Subject to the quarantining of PDF capital losses, losses incurred by PDFs are deductible in the same way as losses incurred by other corporate taxpayers. Thus, a PDF will incur a loss in a year if its allowable deductions, excluding any deductions for losses of earlier years, exceed the sum of its assessable and net exempt income for that year. The rules governing tax losses are discussed in Chapter 8. A PDF cannot carry back a tax loss (under the loss carry back rules) that arose in a year it ended as a PDF, unless it was a PDF throughout both the current year and the year the loss was carried back to: s 195-37. However, there is no restriction on a PDF carrying back a tax loss that arose in a year it did not end as a PDF or a tax loss that arose in the part of a year before the company became a PDF: s 195-15(5)(c). Note that the loss carry back rules have been repealed and they operated for the 2012-13 income year only: see [8 450]. 478

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[11 540]

Capital losses A net capital loss incurred by a PDF is quarantined and can only be applied against a capital gain in a later year if the company is a PDF throughout the last day of the later income year: s 195-25. Thus, a net capital loss cannot be applied against a capital gain after the company ceases to be a PDF. [11 540] Treatment of shareholders in PDFs Division 10E (ss 124ZM to 124ZZD) deals with the taxation of shareholders in PDFs. Unfranked PDF distributions An unfranked distribution or the unfranked portion of a franked distribution paid by a PDF is exempt from income tax: s 124ZM(1). Franked PDF distributions A franked PDF distribution or the franked amount of a PDF distribution received by: • a natural person or company (not in a trust capacity in either case); • a corporate unit trust; • a public trading trust; or • a superannuation entity (superannuation fund, ADF or PST), is exempt income of the particular taxpayer: s 124ZM(3), (4). Similarly, if one of those taxpayers receives a share of trust or partnership income that is attributable to franked PDF distributions (ie there is a ‘‘flow-on franking amount’’ in relation to a trust or partnership amount that is attributable to franked PDF distributions), that share of trust or partnership income is exempt income of the taxpayer: s 124ZM(3), (4). However, a shareholder or a taxpayer receiving income through a partnership or trust is able to elect to have the franked PDF distributions (or the flow-on franking amount attributable to franked PDF distributions) taxed as if they were not PDF distributions. If a taxpayer elects to prepare the tax return for the income year on the basis that the franked amount of the PDF distributions (or the flow-on franking amount attributable to franked PDF distributions) paid during the particular income year is included in the assessable income of that year, the exemption does not apply: s 124ZM(7). If a taxpayer is a partner in a partnership that incurs a partnership loss, the partnership amount attributable to the PDF flow-on franking amount is not allowable as a deduction: s 124ZM(8). However, by preparing an appropriate return, the taxpayer is entitled to elect to claim the deduction for the relevant partnership amount, ie its share of partnership loss: s 124ZM(9).

Venture capital franked distributions Venture capital franked distributions paid to eligible entities are exempt income: s 124ZM(5) and (6). Venture capital franked distributions are franked distributions that have venture capital credits attached to them: see [11 520]. PDF distributions derived by trustees If there is a trust amount or partnership amount in relation to which there is a PDF flow-on franking amount that would otherwise be assessed to a trustee: • under s 98, if the beneficiary is under a legal disability; or • under s 99A or s 99A, if no person is presently entitled to the trust income, the PDF flow-on franking amount in relation to the trust or partnership amount is not assessable to the trustee: s 124ZM(10). However, the trustee may elect to include the PDF © 2017 THOMSON REUTERS

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flow-on franking amount in the trustee’s assessable income by including the amount in the trustee’s return of trust income for the relevant income year: s 124ZM(11) and (12). If a taxpayer other than a company elects to treat as assessable income PDF distributions derived directly or indirectly through a partnership or trust, the non-corporate taxpayer is entitled to the imputation credits attributable to those distributions.

Non-assessable trust distributions Generally, if a taxpayer receives a non-assessable amount from a trust in which the taxpayer has an interest or holds units, the payment is treated as reducing the cost base of the taxpayer’s interest or units in the trust, with a possible capital gain if the non-assessable amount exceeds the relevant cost base: see [14 360]. In calculating the cost base reductions or capital gain there is excluded from the ‘‘adjusted payment’’ income that is exempt income in connection with PDF shares under s 124ZM or s 124ZN or any consideration on the disposal of PDF shares. Therefore, exempt distributions on PDF shares, for example, are not taken into account when calculating the cost base reduction or capital gain. Dividend withholding tax for PDF distributions Pooled development funds distributions exempt under s 124ZM that are paid to non-residents of Australia, whether franked or unfranked, are exempt from dividend withholding tax: s 128B(3)(ba). [11 550] Disposal of pooled development fund shares If PDF shares are acquired on revenue account, any income derived from the sale of the shares at a time when the company is a PDF is exempt from income tax: s 124ZN. Similarly, any loss incurred on the sale of the shares is not deductible. Pooled development fund shares are not trading stock for income tax purposes: s 124ZO. Therefore, profits from the disposal of PDF shares as trading stock are not assessable and losses are not deductible. In addition, the CGT provisions do not apply to the disposal of PDF shares if the company is a PDF at the time of the disposal: s 118-13 ITAA 1997. As a result, no capital gain or loss arises on the disposal of PDF shares. On the day a company ceases to be a PDF, the shares cease to be PDF shares and the holders of the shares are deemed to have disposed of the PDF shares and to have immediately re-acquired non-PDF shares for their market value on that day: s 124ZR. This applies if the shares would have been trading stock of a share trader or held on revenue account. It also applies for CGT purposes if the capital gain or loss on disposal would have been subject to CGT. [11 560] Venture capital entities – overview Non-resident partners of a venture capital limited partnership (VCLP), an early stage venture capital limited partnership (ESVCLP), an Australian venture capital fund of funds (AFOF) or a venture capital management partnership (VCMP) are entitled to certain tax concessions. These are summarised below. See [15 650] for the definitions of a VCLP, an ESVCLP, an AFOF and a VCMP. • VCLPs, ESVCLPs, AFOFs and VCMPs are treated as flow through (ie fiscally transparent) vehicles in the same way as ordinary partnerships: see [22 160]. If an entity becomes or ceases to be a VCLP, an ESVCLP, an AFOF or a VCMP, the entity’s income year is split into 2 periods: see [1 110]. • A partner’s share of any income derived from an eligible venture capital investment is exempt from income tax: see [7 470]. • A partner’s share of the profit or gain made on the disposal of an eligible venture capital investment is exempt from CGT: see [15 650]. However, the exemption does not apply to gains to which an individual venture capital manager becomes entitled (carried interests): see [13 720]. In addition, a partner is not entitled to deduct its 480

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[11 600]

share of any loss made on the disposal of an eligible venture capital investment: see [8 540]. There are rules restricting the use of losses incurred by an entity before it became a VCLP, an ESVCLP, an AFOF or a VCMP: see [8 560]. Foreign exempt superannuation funds resident in the USA, UK, Canada, France, Germany, Japan or other prescribed country (called venture capital entities) are exempt from tax on gains arising on the disposal of ‘‘venture capital equity’’ in resident investment vehicles in Australia. The relevant measures (Subdiv 118-G ITAA 1997) are discussed further at [15 660]. Offset for contributions to ESVCLPs Measures contained in the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 provide a tax offset for limited partners in ESVCLPs of up to 10% of contributions made by the partner to the ESVCLP during an income year for ESVCLPs that become unconditionally registered on or after 7 December 2015 (see [15 650]). The measures broadly apply from 1 July 2016. If the limited partner is a partnership or trust, the offset is generally available instead to the ultimate individual or corporate partners or beneficiaries. The amount of the tax offset is reduced to the extent that the amounts contributed by the partners are not, in effect, used by the ESVCLP to make eligible venture capital investments within that income year or the first 2 months after the end of that income year. The offset is non-refundable, but the taxpayer may carry forward any unused offset: see [19 050]. The measures also allow an entity in which an ESVCLP (or a VCLP or AFOF) has invested (the investee entity) to invest in other entities while remaining an eligible venture capital investment, provided that after the investment: (a) the investee entity controls the other entity; and (b) the other entity broadly satisfies the requirements to be an eligible venture capital investment.

ENVIRONMENTAL, URBAN AND SHIPPING INCENTIVES [11 600] Investment in forestry MIS A specific deduction for an investment in a forestry managed investment scheme (forestry MIS) is available under Div 394 ITAA 1997. An initial participant in a forestry MIS will receive a tax deduction of 100% of their contributions, provided the ‘‘70% DFE rule’’ is satisfied (see below): s 394-10(1). A subsequent investor is also entitled to deduct ongoing contributions (see below). Division 394 is explained in Practice Statement PS LA 2008/2. Note that expenditure may be deductible under s 8-1 if the investor is carrying on a business, in which case the prepayment rules in ss 82KZMD and 82KZMF ITAA 1936 may apply: see [8 380] and [8 390]. The conditions to be satisfied before a deduction is available for an amount paid by an investor in a forestry MIS are (ss 394-10, 394-15): • the investor must hold an interest in a forestry MIS whose purpose is for establishing and tending trees for felling only in Australia; • the investor must not have day-to-day control over the operation of the scheme; • either there must be more than one participant in the scheme, or the forestry manager (ie the entity that manages, arranges or promotes the scheme), or an associate of the forestry manager, must manage, arrange or promote similar schemes; and • the trees intended to be established in accordance with the scheme must all have been established within 18 months of the end of the income year in which the first © 2017 THOMSON REUTERS

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payment is made by an investor. Failure to plant all the trees within the 18-month period will mean that a deduction is not available under Div 394 (see Determination TD 2010/15). A deduction under Div 394 will be denied if a CGT event happens in relation to an initial participant’s interest in a forestry MIS within 4 years after the end of the income year in which they first pay an amount: s 394-10(5). A deduction will not be denied if the 4-year rule is failed because of circumstances genuinely outside the control of the investor (and the CGT event in question was not reasonably foreseeable): s 394-10(5A). Examples include insolvency of the MIS manager, the death of the investor and cancellation of an MIS interest, eg because trees were destroyed by a natural disaster (see the then Assistant Treasurer’s media release No 074, 21 October 2009). If a CGT event happens (at any time) in relation to an initial participant’s interest in a forestry MIS (other than an event that happens in respect of thinning), and a deduction under Div 394 was available (disregarding s 394-10(5)), the market value of the forestry interest (at the time of the CGT event) is treated as assessable income: s 394-25. If the initial participant retains a partial interest, the assessable amount is the decrease in the market value of the forestry interest because of the CGT event. See [3 210] for ‘‘market value’’. Note Taxpayer Alert TA 2008/11, which raises concerns about certain land impairment trust arrangements associated with a forestry MIS.

70% DFE rule A deduction under Div 394 is not available unless the 70% DFE rule is satisfied. This rule requires that, on 30 June in an income year, it is reasonable to expect on that date that the amount of direct forestry expenditure (DFE) under the scheme is equal to or greater than 70% of the amount of the payments under the scheme: s 394-35(1). The amount of DFE under the scheme is the amount of the net present value (on that 30 June) of all direct forestry expenditure under the scheme that the forestry manager has paid or will pay under the scheme (reduced by any amount that can reasonably be expected to be recouped): s 394-35(2), (6). The amount of the payments under the scheme is the net present value (at that 30 June) of all amounts that participants in the scheme have paid or will pay (reduced by any amount that can reasonably be expected to be recouped): s 394-35(3) – (6). In working out the net present value of an amount, the yield on Australian Government Treasury Bonds with the maturity closest to 10 years is used: s 394-35(7). DFE amounts may have to be apportioned to determine the extent that they are attributable to establishing, tending, felling and harvesting trees under the scheme (see Practice Statement PS LA 2008/2). Whether it is reasonable to expect that the DFE under the scheme is equal or greater than 70% of the amount of the payments under the scheme is an objective test. According to Practice Statement PS LA 2008/2, in applying the objective standard, the forestry manager is treated as having all the information that a reasonable person would require in order to make a reasonable estimate of the DFE over the term of the project. The forestry manager must have taken the steps that a reasonable person would have taken at the time to obtain sufficient information of the forestry industry and the relevant costs of carrying out the services for such a project. A market value substitution rule operates if the expenditure differs from market value and the forestry manager and at least one other party to the scheme do not deal at arm’s length in relation to the relevant transaction (the concept of dealing at arm’s length is considered at [5 260]): s 394-35(8). Direct forestry expenditure ‘‘Direct forestry expenditure’’ is defined in broad terms as (s 394-45) as: • amounts spent by the scheme manager (or an associate) under the scheme that are attributable to establishing, tending, felling and harvesting trees; and 482

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• amounts of notional expenditure reflecting the market value of land, goods and services provided by the scheme manager that are used for establishing, tending, felling and harvesting trees. Certain amounts are effectively not direct forestry expenditure, including (ss 394-40, 394-45): marketing and advertising costs, lobbying costs, insurance, borrowing costs, interest, general business overheads (but not if directly related to forestry), certain compliance costs (eg for product design and product disclosure statements), commissions for financial planners or financial advisers, stockpiling costs, certain post-harvesting transportation and handling costs, payments for processing forestry produce (eg in-field wood chipping or milling of logs), legal fees relating to excluded expenditure, stamp duty and GST (where applicable).

Subsequent investor A subsequent investor will receive a tax deduction for their ongoing contributions to a forestry MIS, subject to satisfying the 70% DFE rule: s 394-10(1). However, the acquisition costs are not deductible under Div 394 (s 394-10(3)), although if they hold the interests on revenue account as trading stock, a deduction may be available under another provision of the ITAA 1997. If the interest is held on capital account, the acquisition costs will form part of the cost base of the interest for CGT purposes. A secondary investor that subsequently disposes of a forestry scheme interest before harvest is treated as receiving assessable income to the extent the investor’s sale proceeds match the ‘‘net deductions’’. The net deductions are the total forestry scheme deductions (obtained by the investor under Div 394) less incidental forestry scheme receipts: s 394-30. However, if the sale proceeds received by a secondary investor are less than the total forestry scheme deductions for the amount of deductions obtained by the investor under Div 394 (as reduced by an amount included in assessable income as incidental forestry scheme receipts for thinnings if any) all of the proceeds are assessable income. If the interest is held on capital account, the proceeds will also be subject to a modified CGT treatment. Assessable receipts Sale or harvest proceeds received by an initial investor are included in the investor’s assessable income on revenue account. Harvest proceeds received by a secondary investor are treated in the same way. Amounts received by initial and secondary investors for thinnings are also assessable income on revenue account. Thinnings are specifically excluded from the CGT treatment for secondary investors that hold interests in a forestry scheme on capital account: s 394-30(1). Amounts received by a forestry manager (or their associate) under a forestry MIS are assessable if the entity paying the amount can deduct or has deducted the amount under s 394-10 in relation to the scheme: s 15-46 ITAA 1997. The amount is assessable only in the year for which the deduction is available to the entity paying the amount. Promoter’s reporting requirements Division 394 in Sch 1 TAA requires the forestry manager to provide certain information (in the approved form) to the Tax Office if the scheme satisfies the 70% DFE rule and the first assessable payment has been received. A statement must also be provided explaining why trees have not been established within 18 months if that is the case (see Practice Statement PS LA 2008/2). [11 610] Environmental protection activities An immediate deduction is available under s 40-755 ITAA 1997 for expenditure incurred by a taxpayer carrying on an income-producing activity for the sole or dominant purpose of carrying on environmental protection activities (the fact that a local development consent requires the taxpayer to clean up the land in question after ceasing to carry on business should not affect entitlement to a deduction: see ATO ID 2006/276). The environmental protection activities may be carried on by or for the taxpayer (this was not the case in ATO ID 2008/71). Environmental protection activities are: © 2017 THOMSON REUTERS

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• preventing, fighting or remedying pollution resulting, or likely to result, from the taxpayer’s business or on the site of that business (the taxpayer’s business can include exploration and prospecting activities); or • treating, cleaning up, removing or storing waste produced by the taxpayer’s business or on the site of that business. In ATO ID 2006/276, capital expenditure on cleaning up and removing wood residue remaining after the raw wood material had been processed through the taxpayer’s business operation was deductible. ‘‘Pollution’’ is not defined for these purposes and therefore has its ordinary meaning. According to the Explanatory Memorandum to the Taxation Laws Amendment Act (No 5) 1992 (which inserted the predecessor to s 40-755 – s 82BM ITAA 1936), ‘‘pollution’’ includes noise pollution but not visual pollution. See also ATO ID 2003/17 (deduction denied for the cost of vegetating an area to provide a visual effect and to prevent erosion). Ruling TR 2008/6 discusses when geological sequestration will be ‘‘environmental protection activities’’. Subscribing for shares in order to establish a fund to guarantee that certain remedial costs not borne by the community was not an environmental protection activity in ATO ID 2008/43. The deduction extends to expenditure incurred by the taxpayer if the taxpayer leases the site to, or licenses its use by, another entity and the pollution is caused by that entity or any other entity using the site. The deduction does not apply to expenditure on buildings, structures (including earthworks), plant, acquiring land, or a bond or security for performing environmental protection activities: s 40-760. Use of the property for environmental protection purposes listed above is taken to be use of the property for a taxable purpose: s 40-25(7). This clarifies the eligibility of expenditure on such items for periodic deductions, eg depreciation. The original cost of structural improvements, including earthworks, constructed for environmental purposes can be written off in the same way as general structural improvements (over 40 years): see [10 1460]. EXAMPLE [11 610.10] Victoday Pty Ltd purchases a swamp that was used to dump industrial waste. Expenditure on reclaiming the swamp and cleaning up the site (to build a steelworks) includes expenditure on special equipment and chemicals to neutralise the waste and remove heavy metals, reclamation plant, power and other infrastructure, wages and waste consultancy fees. The cost of equipment and consumables used for waste clean-up and infrastructure expenditure, wages and fees related to the clean-up are deductible or depreciable. However, expenditure on reclaiming the swamp is not deductible. If capital expenditure is incurred under a non-arm’s length arrangement and the expenditure exceeds market value, s 40-765 requires that the amount of expenditure taken into account is the market value (see [3 210] for a discussion of market value). Expenditure is not deductible under s 40-755 if it is deductible under another provision: s 40-760(1). In addition, if land is put to a tax preferred use for the purposes of Div 250 and the apportionment rule in s 250-150 applies (see [33 100]), a deduction is not available to the extent specified under s 250-150(3).

[11 620] Carbon sink forests A deduction is available under Subdiv 40-J ITAA 1997 for capital expenditure incurred in establishing trees in a carbon sink forest. A carbon sink forest is a forest that is established for the primary and principal purpose of sequestering carbon from the atmosphere. The carbon stored in the growing forest can then be used for greenhouse gas abatement purposes. Eligible capital expenditure is deductible over 14 years and 105 days at the rate of 7% per annum: s 40-1005. Expenditure on acquiring land to be used for establishing trees, on rights that allow access to land and on assets such as fencing, water facilities, roads and fire breaks is not 484

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[11 620]

considered to be expenditure for establishing trees and is therefore not deductible under Subdiv 40-J: see ATO ID 2009/60. Expenditure incurred in draining swamp or low-lying land or in clearing land is also not deductible under Subdiv 40-J: s 40-1020. If the parties to an arrangement are not dealing at arm’s length, the capital expenditure on which a deduction is based cannot exceed market value: s 40-1025.

Conditions to be satisfied A deduction is available under Subdiv 40-J if (ss 40-1005, 40-1010): • the taxpayer is carrying on a business. The explanatory memorandum to the relevant Bill states that this allows those businesses that wish to abate their own greenhouse gas emissions via a carbon sink forest to be eligible for the deduction; • the primary and principal purpose in establishing the trees must be carbon sequestration (ie the process by which trees absorb carbon dioxide from the atmosphere) and cannot include the purposes of felling the trees or using them in commercial horticulture; and • one of the following applies: (a) the taxpayer owns the trees and any holder of a lease, lesser interest or licence relating to the land occupied by the trees does not use the land primarily and principally for carbon sequestration purposes; (b) the trees are attached to land that the taxpayer leases (from anyone), or holds under a quasi-ownership right granted by an exempt government agency (including an exempt foreign government agency), and the lease or quasi-ownership right entitles the taxpayer to use the land for carbon sequestration (if another entity holds a lesser interest or licence relating to the land, that entity must not use the land for carbon sequestration); or (c) the taxpayer is the licensee relating to the land occupied by the trees and uses the land for carbon sequestration purposes as a result of that licence. In addition (s 40-1010(2)): • at the end of the income year, the trees (if established) must occupy a continuous land area in Australia of 0.2 hectares or more; • at the time the trees are established, it is more likely than not that they will attain a crown cover of 20% or more and reach a height of at least 2 metres; and • on 1 January 1990, the area occupied by the trees was clear of other trees that attained, or were more likely than not to attain, a crown cover of 20% or more and reached, or were more likely than not to reach, a height of 2 metres or more. The taxpayer will have to provide the Commissioner with all information necessary for a determination that s 40-1010(2) is satisfied. In addition, the establishment of the trees will have to meet the Environmental and Natural Resource Management Guidelines (as amended): s 40-1010(3), (4). The Guidelines state that: the establishment of a carbon sink forest should be based on regionally applicable best practice approaches for achieving multiple land and water environmental benefits; establishment activities should be guided by regional natural resource management plans and water sharing plans; environmental impacts at a catchment scale should be considered; establishment activities should recognise and adhere to all government regulatory requirements; and legal rights concerning carbon sequestration in carbon sink forests should be registered on the land title. If a taxpayer acquires trees in a carbon sink forest from another entity in circumstances that make the taxpayer eligible to claim the deduction, s 40-1035 ensures that that taxpayer is © 2017 THOMSON REUTERS

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given sufficient information (to work out the deduction under Subdiv 40-J) by the taxpayer who most recently deducted capital expenditure under Subdiv 40-J.

When deduction not allowed A taxpayer cannot claim a deduction for trees once they are destroyed. However, an extra deduction for any undeducted establishment expenditure is allowed for an income year if the trees are destroyed in an income year after they are established and the write-off period has not ceased: s 40-1030. The deduction is not available for expenditure on establishing trees in a carbon sink forest incurred by a managed investment scheme or a forestry managed investment scheme: s 40-1010(1). This, however, does not exclude a forestry manager entity from operating a separate business of trading in carbon offsets generated from an adjacent carbon sink forest. Note that expenditure on a landcare operation is not deductible under Subdiv 40-G (see [27 340]) if the amount is deductible under Subdiv 40-J: s 40-630(2C). [11 630] National Rental Affordability Scheme The National Rental Affordability Scheme (NRAS) is designed to encourage investment in affordable rental housing. NRAS dwellings must be rented to eligible tenants who meet the NRAS income level requirements, which are based on the tenant’s gross income. NRAS incentives receive a tax offset under Div 380 ITAA 1997. Investors also receive a contribution from the relevant State or Territory Government ($2,762.01 per dwelling in 2016-17). The contribution can also be in the form of a non-cash benefit. These payments and non-cash benefits are non-assessable non-exempt income (see [7 700]): s 380-35. This also applies if payments and benefits are received indirectly by an investor, eg from another member of an NRAS consortium. NRAS offset The following are eligible for the NRAS tax offset, provided the Secretary of the Department that administers the NRAS has issued the relevant entity an NRAS certificate: • an individual, corporate tax entity or a superannuation fund; • a party to an NRAS consortium – the NRAS certificate is issued to an approved participant, namely the entity that is complying with the NRAS legislative requirements, and not to the consortium; • the partners of a partnership and the beneficiaries of a trust; • a trustee of a trust (rather than the trust’s beneficiaries), including where the trust is a party to a non-entity joint venture, a partner of a partnership or a beneficiary of another trust which has net income and the trust to which the offset flows has no net income. Trustees assessable on net income of the trust are also entitled to a share of the offset. The NRAS offset is refundable: see [19 040]. The amount of the offset is the amount stated in the certificate, although apportionment may be required in certain cases (see below): s 380-5. The maximum offset for 2016-17 is $8,286.03 per dwelling per year for a maximum of 10 years (the maximum amount is indexed annually in line with the rents component of the CPI). If eligibility has not been established for the full 12 months, the amount of the offset is reduced proportionally. It may occur if, for example, a dwelling only becomes available for rent part way through an NRAS year or if a tenant becomes ineligible part way through an NRAS year. The amount of the offset may also be affected by such matters as withdrawal from the NRAS before the expiry of the 10-year incentive period. If the entity entitled to the offset is a party to an NRAS consortium, the amount stated in the certificate is apportioned by the NRAS rent derived by the entity from the dwelling for the 486

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[11 650]

income year and the total NRAS rent derived from the rental dwelling for the income year: s 380-10. Similarly, if an entity indirectly derives NRAS rent from a rental dwelling (as a partner of a partnership or a beneficiary of a trust), the offset will be equal to the amount stated in the certificate apportioned by the partner’s or beneficiary’s share of NRAS rent derived from the dwelling for the income year and the total NRAS rent derived from rental dwellings covered by the certificate for the income year: s 380-15, 380-25. The entity’s share of NRAS rent is a notional share and is worked out in accordance with s 380-30. Note that an approved participant of an NRAS consortium may choose to relinquish their entitlement to the offset in favour of certain other parties of the consortium. If the owner of a dwelling leases it to an NRAS consortium, which in turn subleases the dwelling, the owner of the dwelling is not considered to derive rent ‘‘under’’ the NRAS and is therefore not entitled to the offset: see ATO ID 2009/146. Entities that are not required to lodge an income tax return (eg a not-for-profit entity) can claim the offset by lodging a separate form.

Termination of NRAS The final round of the NRAS (the fifth round) has been discontinued. Incentives already allocated through the Scheme will continue to be paid for up to 10 years, as long as eligibility requirements are met and homes in the construction pipeline are built in the agreed locations according to agreed timeframes. [11 640] Urban water tax offset The refundable urban water tax offset (in Subdiv 402-W ITAA 1997) was designed to help fund large scale infrastructure projects to enable cities and towns meet future demands for water. Subdivision 402-W ITAA 1997 was repealed as from 28 June 2013 because the tax offset was not being utilised. For further information about the urban water tax offset, see [11 640] of the Australian Tax Handbook 2014. [11 650] Significant infrastructure projects Division 415 ITAA 1997 provides ‘‘tax incentives’’ for companies or fixed trusts that carry on a designated infrastructure project (DIP). Such entities are called DIP entities. The tax incentives are: • the value of a DIP entity’s unutilised tax losses is uplifted; and • tax losses may be carried forward and bad debt deductions allowed, even though the DIP entity does not satisfy the continuity of ownership and same business tests for companies or the equivalent tests for trusts. Before an entity can access the tax concessions, the relevant project must be designated as a DIP by the Infrastructure Coordinator (see the Income Tax Assessment (Infrastructure Project Designation) Rule 2013). In addition, an entity must notify the Commissioner, in the approved form, that it is a DIP entity. Notice will generally be due by the time the entity first lodges a tax return seeking to uplift a loss. Note that each DIP entity can only carry on one single DIP. These measures apply to tax losses for the 2012-13 and later income years and to debts originally incurred in those years and which later became bad debts of the entity: s 415-10 TPA. In addition, these measures only apply to projects that commence after the entity applies for designation as a DIP.

Losses uplifted The value of a DIP entity’s unutilised tax losses is uplifted by the long-term government bond rate (ie the year’s average yield for 10-year non-rebate Australian Treasury bonds). Losses are ‘‘utilised’’ when they are deducted against assessable income or exempt income and also (for these purposes) when the amount of forgiven commercial debts is applied to reduce them. © 2017 THOMSON REUTERS

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If an entity is a DIP entity only for part of an income year in which the uplift occurs, the uplift is apportioned.

Tax losses and bad debts of companies 1. The continuity of ownership test (COT) discussed at [20 320]-[20 350] is modified for DIP entities that are companies by adjusting the test period used to work out whether the company fails the COT. Instead of the period running from the start of the loss year until the end of the deduction income year, the period runs from: (i) the first time in or after the loss year that the company stops being a DIP entity; or (ii) the end of the deduction year if it has not stopped being such an entity. In either case, the period ends at the end of the deduction year. In the first case, the entity will only fail the COT if there is the necessary 50% or greater change in rights after the entity stops being a DIP entity. Changes before that time are ignored. In the second case, the test period would start and stop at the same moment, so the COT would always be passed. The modified COT in Div 166 affecting widely held and eligible Div 166 companies (companies in which more than a 50% interest is held, directly or indirectly, by widely held companies, non-profit companies, charities, or complying superannuation funds and similar entities: see [20 550]) is also adjusted. The start of the test period for these companies (if they are DIP entities) is adjusted in the same way it is adjusted for other companies that are DIP entities. 2. The period used to test whether a company that is a DIP entity passes the same business test (SBT) if it stops being a DIP entity in the deduction year is adjusted (the SBT is discussed at [20 360]-[20 370]). Instead of testing for the whole of the deduction year, a company only has to test for the part of the year that it was not a DIP entity until the end of the income year in which it seeks to utilise the loss. It needs to be carrying on the same business that it carried on just before it stops being a DIP entity if that time is later than the test time that would otherwise occur. 3. An entity that was a DIP entity when it derived the original amount does not normally have to satisfy the COT and SBT in order to deduct its bad debts for so long as it remains a DIP entity. In effect, the rules that limit a company’s capacity to deduct a bad debt are adjusted in a similar way to the way it adjusts its capacity to deduct tax losses. For the purposes of the COT, the start of the test period is delayed until the company stops being a DIP entity. If it has not stopped being such an entity, the start of the test period merges with the end of the deduction year, so that the test is passed. For the purposes of the SBT, the same business test period and test time are modified so that they cannot commence until the entity stops being a DIP entity. The same business test period and the test time have their normal application if they would not otherwise overlap with a period when the entity was a DIP entity. Note that the operation of the COT and the SBT for widely held companies and eligible Div 166 companies, which is modified for DIP entities that are deducting a tax loss (see above), is modified in the same way if they seek to deduct a bad debt. 4. The ‘‘tainted change of control’’ test discussed at [20 380] is modified so that the test is always satisfied if the entity is a DIP entity. 5. The anti-avoidance provisions concerning companies contained in Subdiv 175-A (tax benefits from unused tax losses), Subdiv 175-CA (tax benefits from unused net capital losses of earlier income years), and Subdiv 175-C (tax benefits from unused 488

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bad debt deductions) are not adjusted for DIP entities. These provisions are discussed at [20 390], [20 470] and [20 650].

Tax losses and bad debts of trusts A DIP entity that is a trust need not satisfy the ownership and control and abnormal trading tests in Sch 2F ITAA 1936 (see [23 990] and following) before deducting prior year losses and bad debts. This is achieved by making the entity an ‘‘excepted trust’’ (see [23 820]). However, if a trust stops being a DIP entity during the income year, it will need to satisfy those tests because it is not an excepted trust for the whole income year. These tests are modified in a similar way to the modifications to the tests for companies. That is, generally, the test period starts just after the entity stops being a DIP entity. The test period is not changed if it would usually start after the entity stopped being a DIP entity. Consolidated groups The head company of a consolidated group may be a DIP entity only if none of the members of the consolidated group carries on, or has ever carried on, activities that do not relate to the same DIP. This ensures that the activities carried on by a joining member before it joined the group do not stop the head company from being a DIP entity before the entity joined the group. However, consistent with the policy that the entity has only ever engaged in activities that relate to a single DIP, the head company will stop being a DIP entity from the joining time if the joining entity carried on activities that did not relate to the head company’s DIP. The head company will not stop being a DIP entity if the joining entity has only carried on activities that relate to the same DIP as the head company. [11 700]

Shipping incentives

Income tax exemption Ordinary and statutory income derived from eligible shipping activities is generally exempt from income tax: s 51-100 ITAA 1997. The shipping activities must relate to an eligible vessel (ie a vessel for which the entity has a shipping exempt income certificate for the income year in question) and take place on a certified day (ie a day covered by the shipping exempt income certificate). The requirements to be satisfied to obtain a shipping exempt income certificate are set out in the Shipping Reform (Tax Incentives) Act 2012 (‘‘Shipping Reform Act’’). Ordinary and statutory income from ‘‘incidental shipping activities’’ is not exempt if total incidental shipping income exceeds 0.25% of the total income from ‘‘core shipping activities’’ in the income year: s 51-100(2). Core shipping activities are activities directly involved in operating a vessel to carry cargo or passengers and include various listed activities: s 51-110. Incidental shipping activities are activities incidental to core shipping activities: s 51-115. Capital allowances – effective life If a taxpayer chooses to use an effective life determined by the Commissioner for an eligible vessel and the entity has been issued with a certificate under the Shipping Reform Act in respect of the vessel (a shipping certificate), the effective life is capped at 10 years (provided the relevant conditions in s 40-102 ITAA 1997 are satisfied: see [10 680]): s 40-102(4), item 10. A taxpayer cannot apply the capped effective life if income derived by the taxpayer, or an associate of the taxpayer, in relation to the vessel is exempt under s 51-100: s 40-102(4A). There is an exception to this where the owner of a vessel has obtained a shipping certificate in respect of the vessel and the operator of the vessel, other than an associate of the owner, has obtained a shipping exempt income certificate for the same vessel. In that situation, the owner can choose to apply the statutory capped life and the operator can utilise the income tax exemption. © 2017 THOMSON REUTERS

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Section 40-103 deals with the situation where a taxpayer starts or ceases to apply the statutory capped effective life. In these circumstances, a new effective life applies (the ‘‘remaining effective life’’), calculated by applying the following formula: unadjusted remaining effective life ×

alternative effective life unadjusted effective life

where: the unadjusted remaining effective life is the residual effective life just before the taxpayer starts or ceases (as appropriate) to use the capped effective life; the alternative effective life is the new effective life which is applied by the taxpayer just after the change; the unadjusted effective life is the effective life used by the taxpayer before the change.

Capital allowances – balancing adjustment If a balancing adjustment event happens in relation to a vessel (see [10 850]) and the taxpayer holds a current shipping certificate (which is not a shipping exempt income certificate), any assessable balancing adjustment (see [10 880]) will be assessed in the second income year after the one in which the balancing adjustment event occurs and not in the income year in which the event occurs: s 40-285(5). A taxpayer may choose roll-over relief under s 40-362 if: • the taxpayer holds a shipping certificate (that is not a shipping exempt income certificate) which applies to the day that the balancing adjustment event occurs; • roll-over relief under s 40-340 does not apply in respect of the original vessel (see [10 940]); and • 2 years after the day the taxpayer ceases to hold the original vessel, the taxpayer is the holder of another depreciating asset that is a vessel (the other vessel) for which roll-over relief in relation to the original vessel is chosen and for which the taxpayer has a shipping certificate (which is not a shipping exempt income certificate) that applies for the day the roll-over relief is chosen. The taxpayer can become the holder of the other vessel as early as one year before the day the taxpayer ceases to hold the original vessel and as late as 2 years after that day. If there is roll-over relief under s 40-362, the balancing adjustment is not included in the taxpayer’s assessable income under s 40-285(1) (see [10 880]): s 40-362(3). Instead, the amount by which the original vessel’s termination value (see [10 890]) exceeds the sum of the original vessel’s adjustable value just before the balancing adjustment event occurred (see [10 540]) and the cost of the other vessel is included in the taxpayer’s assessable income for the second income year after the income year in which the balancing adjustment event occurs. For these purposes, the cost of the original vessel is reduced (but not below zero) by the difference between the original vessel’s termination value and its adjustable value just before the balancing adjustment event occurred.

Seafarer offset As from 2012-13, a company is entitled to a refundable tax offset (the seafarer offset) under s 61-705 ITAA 1997 for payments made to an Australian seafarer if the company employs at least one Australian resident for a minimum of 91 qualifying days in the income year. A particular day is a qualifying day if: • on that day the individual is employed by the company, or performs work or services under a labour hire arrangement under which the company makes a withholding payment (at any time) for PAYG withholding purposes (see [50 050]); 490

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• on that day the individual works on a voyage of a vessel as master, deck officer, integrated rating, steward or engineer – the route of the vessel must include an overseas voyage (s 61-705(3) specifies when a voyage starts and ends for these purposes); and • the company, or another entity, has a current shipping certificate in respect of the vessel. The amount of the seafarer offset is 30% of the ‘‘gross payment amounts’’ (rounded up): s 61-710. The ‘‘gross payment amounts’’ are the total amount of PAYG withholding payments payable by the company in the income year to qualifying individuals (ie individuals in respect of whom the company has 91 or more qualifying days in the income year: see above). Withholding payments may be paid as salary or wages or under a labour hire arrangement (see [50 030] and [50 050]) and include salary, wages, leave pay and training allowances. The Tax and Superannuation Laws Amendment (2015 Measures No 3) Bill 2015 proposed to abolish the seafarer offset from the 2015-16 income year, but the Bill lapsed when Parliament was dissolved for the July 2016 Federal election.

Royalty withholding tax exemption Certain lease payments paid to a foreign resident are exempt from royalty withholding tax under s 128B(3)(m) ITAA 1936. The exemption applies if: • the lessee is an Australian resident company; • the vessel is not be an ‘‘excluded vessel’’ listed in s 10(4) of the Shipping Reform Act; • the vessel is leased on a bareboat basis; and • the vessel is used, or is available for use, wholly or mainly for business or commercial activities that involve shipping cargo or passengers for consideration.

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INTRODUCTION Chapter outline .............................................................................................................. [12 010] OPERATION AND STRUCTURE Overview of CGT ......................................................................................................... [12 020] Main conditions – summary ......................................................................................... [12 030] CGT events .................................................................................................................... [12 040] CGT assets .................................................................................................................... [12 050] Calculation of capital gain or loss from the event ...................................................... [12 060] Exceptions and concessions .......................................................................................... [12 070] Roll-overs ...................................................................................................................... [12 080] Calculation of net capital gain to be included in income ........................................... [12 090] Residents and foreign residents .................................................................................... [12 100] Avoidance of double taxation ....................................................................................... [12 110] Extension to Norfolk Island residents .......................................................................... [12 120] CGT ASSETS Definition ....................................................................................................................... [12 Specific inclusions and exclusions ............................................................................... [12 Personal-use assets and collectables ............................................................................. [12 Separate assets ............................................................................................................... [12 Right to sue ................................................................................................................... [12 Joint tenants ................................................................................................................... [12

150] 170] 180] 190] 200] 210]

RECORD-KEEPING Requirements ................................................................................................................. [12 250] Retention period ............................................................................................................ [12 260] Exclusions ...................................................................................................................... [12 270] LIABILITY – WHO MAKES GAIN OR LOSS? General .......................................................................................................................... [12 Partnerships ................................................................................................................... [12 Bankruptcy and liquidation ........................................................................................... [12 Absolutely entitled beneficiaries ................................................................................... [12 Security holders ............................................................................................................. [12 Managed investment trusts ........................................................................................... [12 Trustee’s choice to be assessed on capital gain ........................................................... [12

300] 310] 320] 330] 340] 350] 360]

GENERAL RULES Giving property as part of transaction ......................................................................... Entitlement to receive money or property ................................................................... Requirement to pay money or give property ............................................................... Foreign currency amounts ............................................................................................ Choices ..........................................................................................................................

400] 410] 420] 430] 440]

[12 [12 [12 [12 [12

INTRODUCTION [12 010] Chapter outline This chapter deals with the following matters: • an overview of the main features of the CGT provisions: see [12 020]-[12 110]; • the meaning of a CGT asset: see [12 150]-[12 210]; 492

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[12 040]

• CGT record-keeping requirements: see [12 250]-[12 270]; • who is liable for CGT in different situations: see [12 300]-[12 360]; • the effect of property being given as part of a transaction: see [12 400]-[12 430]; and • how a ‘‘choice’’ is made for CGT purposes: see [12 440].

OPERATION AND STRUCTURE [12 020] Overview of CGT The CGT provisions apply where a ‘‘CGT event’’ (see [12 040]) happens to a ‘‘CGT asset’’ (see [12 150]-[12 210]). The most common CGT event is the sale or disposal of a CGT asset. However, CGT events can also apply to the receipt of capital amounts independently of the sale or disposal of a CGT asset. Further, each CGT event sets out how the capital gain or loss from that event is calculated and the income year in which it arises. It should also be noted that ‘‘CGT assets’’ cover any form of property including intangible assets such as rights, options and leases. The application of CGT is subject to a range of exemptions, exceptions and concessions, including for CGT assets acquired before 20 September 1985. ‘‘Roll-over relief’’ is available in certain cases to defer the realisation of any capital gain. A ‘‘net’’ capital gain that arises to a taxpayer in an income year is included in the taxpayer’s assessable income for that year (in the same way as other assessable income). In calculating this net capital gain, current year and prior year capital losses are taken into account. Importantly, the CGT discount may also be available to reduce the assessable capital gain: see [14 390]. [12 030] Main conditions – summary In determining whether the CGT provisions apply to include a net capital gain in a taxpayer’s assessable income, it is necessary to consider the following matters: • whether a ‘‘CGT event’’ has happened (see [12 040]) to a ‘‘CGT asset’’ (see [12 050]); • whether a capital gain or capital loss has been made under the calculation rules: see [12 060]; • whether an exception or concession applies to eliminate or reduce any gain: see [12 070]; • whether a roll-over applies to defer any gain or loss: see [12 080]; and • the amount of the net capital gain to be included in assessable income: see [12 090]. It is also necessary to consider whether any cost base adjustments are required in connection with a CGT event and the application of special rules that may apply (eg in relation to CGT events and foreign residents, or on the death of a taxpayer): see [12 100]-[12 110]. Finally, there are record-keeping requirements to comply with: see [12 250]-[12 270].

[12 040] CGT events A capital gain or capital loss can only arise when a ‘‘CGT event’’ occurs. Division 104 lists the specific CGT events. In broad terms, however, a CGT event occurs when there is a change in the beneficial ownership of a CGT asset, or if a taxpayer creates a right in another entity or if a taxpayer receives a capital sum in specified circumstances. See Chapter 13 for an explanation of each CGT event. © 2017 THOMSON REUTERS

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[12 050] CGT assets Most CGT events arise as a result of a transaction occurring in relation to a CGT asset. Otherwise, if the asset is not a CGT asset, it will not be affected by the event and no capital gain or capital loss will arise. For the meaning of CGT asset, see [12 150]-[12 210]. However, in certain cases a CGT liability may arise in respect of a capital receipt per se: see [13 460]. [12 060] Calculation of capital gain or loss from the event To determine the amount of a capital gain or loss that has arisen from a CGT event, the ‘‘cost base’’ of the asset is compared with the ‘‘capital proceeds’’ from the event. The cost base includes the cost of the asset and other capital expenditures associated with the acquisition, improvement or disposal of the asset (eg legal fees). Certain non-capital costs of ownership (such as interest, insurance, repairs and rates) may also be included in the cost base of the asset if it was acquired on or after 21 August 1991. The capital proceeds are made up of the money and/or the market value of any property received, or entitled to be received, in respect of the event. Cost base and capital proceeds are discussed in Chapter 14. Note also that if a CGT asset has been held for more than 12 months, the CGT discount (or indexation if relevant) can apply to reduce the amount of the capital gain included in assessable income: see [14 390]. [12 070] Exceptions and concessions The CGT provisions contain a range of exceptions and concessions that can exempt a capital gain or exclude a particular transaction from CGT, or otherwise reduce or eliminate the capital gain to be included in assessable income. For example, capital gains or losses from certain CGT assets are ‘‘disregarded’’, including cars, the family home and pre-CGT assets (ie assets acquired before 20 September 1985). For business taxpayers, the CGT small business concessions are particularly relevant. See Chapter 15 for further details. [12 080] Roll-overs Roll-overs defer the immediate consequences from a CGT event (either automatically or at the taxpayer’s option). Roll-overs are available in a broad range of situations, including on the transfer of assets on the breakdown of a marriage or if one asset is replaced with another, such as on its loss or destruction (‘‘replacement asset roll-over’’), or if there is a change in the entity holding a CGT asset without a change in the beneficial ownership of the asset (‘‘same asset roll-over’’). Apart from disregarding any capital gain or loss that would arise from the CGT event, the effect of a roll-over is usually to place the entity who receives the asset in the same CGT position as the entity who originally owned the asset. Accordingly, if the asset being transferred was a pre-CGT asset, it will generally retain its pre-CGT status in the hands of the transferee. Similarly, if the asset was a post-CGT asset, the roll-over will generally transfer the transferor’s cost base to the transferee. Roll-overs are explained in Chapter 16. [12 090] Calculation of net capital gain to be included in income Broadly, the net capital gain to be included in a taxpayer’s assessable income is the capital gain made in a particular year as reduced (or netted off) by current year and unused prior year capital losses. Ordinary tax deductible losses are able to be offset against net capital gains (as a net capital gain is included in assessable income), but net capital losses are not available as a deduction against other assessable income (and are instead carried forward). Note also that capital losses must be applied first before the application of the CGT discount. See further [14 360]-[14 390]. The amount of a net capital gain included in a taxpayer’s assessable income, and the calculation of tax payable on the gain, is also affected by such matters as the type of taxpayer deriving the gain, when the asset was acquired and when the gain was derived. [12 100] Residents and foreign residents Residents of Australia are liable for CGT on CGT assets they own wherever the assets are situated (ie on a ‘‘worldwide basis’’), although there may be relief from double taxation if the gain is taxed in the country where it is sourced: see [18 020]. Note that there are no rules 494

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for determining the ‘‘source’’ of the capital gain for this purpose. A foreign resident, on the other hand, is only liable for Australian CGT on gains made from certain CGT assets defined as ‘‘taxable Australian property’’: see [19 700]. Note that, from 8 May 2012, foreign residents are generally not entitled to the 50% CGT discount: see [14 405].

[12 110] Avoidance of double taxation It is possible that an amount can be included in assessable income both as a capital gain and also under other provisions of the income tax legislation (eg gains from property development). To overcome the problem of double taxation, s 118-20 generally provides for capital gains to be reduced or eliminated to the extent to which other taxing provisions also include an amount in the taxpayer’s assessable or exempt income as a result of a CGT event occurring: see [14 500]. [12 120] Extension to Norfolk Island residents CGT assets acquired by Norfolk Island residents on or after 24 October 2015 are subject to the normal operation of the CGT rules if a CGT event happens to an asset on or after 1 July 2016. However, CGT assets held by Norfolk Island residents before that date will be exempt from CGT, unless an asset would not have been exempt from CGT before Norfolk Island was brought within Australia’s income tax system (ie under the law as it applied before 1 July 2016).

CGT ASSETS [12 150] Definition ‘‘CGT assets’’ are widely defined in s 108-5(1) to mean: ‘‘(a) any kind of property; or (b) a legal or equitable right that is not property’’. Meaning of property The term ‘‘property’’ takes its ordinary meaning, but the essential legal characteristic of property is that it is something that can be ‘‘owned’’ or ‘‘possessed’’, or in which an interest can be held, and which can be transferred, assigned or alienated. The term can include real and personal property, as well as intangible property in the form of choses in action, such as the rights attached to shares, debts and other equitable rights. For example, the ‘‘right to sue’’ is a CGT asset (see [12 200]). Note that legal or equitable rights that are not a form of property (eg non-assignable rights under either a personal services contract or under a restrictive covenant arrangement) and which were acquired before 26 June 1992 are not CGT assets: Note 2 to s 108-5. [12 170] Specific inclusions and exclusions Section 108-5(2) specifies that, for the avoidance of doubt, the following are CGT assets: • part of, or an interest in, ‘‘property’’ (as defined in s 108-5(1): see [12 150]); • goodwill or an interest in it (see Ruling TR 1999/16 for the meaning of ‘‘goodwill’’ and the rules that apply to its date of acquisition and cost base and also [13 050]); • an interest in an asset of a partnership; and • an interest in a partnership other than an interest in an asset of a partnership (see below). Specific examples of CGT assets include land and buildings, shares in a company, units in a unit trust, options, debts owed to the taxpayer, rights to enforce contractual obligations, foreign currency and registered emission units. Property or a right that does not have a market © 2017 THOMSON REUTERS

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value can still be a CGT asset: Determination TD 2000/34. Bitcoin is considered to be a CGT asset, including a ‘‘personal use asset’’ where appropriate (see [12 180]): Determination TD 2014/26. If a taxpayer owns an interest in a CGT asset and later acquires another interest in that asset, the new interest is a separate CGT asset with a separate date of acquisition and cost base, and does not ‘‘merge’’ with the original interest: Determination TD 2000/31. Specific examples of rights or assets that are not considered to be ‘‘CGT assets’’ include: • Australian currency used as legal tender (see Determination TD 2002/25) – except for the purposes of the ‘‘maximum net asset value’’ test in the CGT small business concessions (see [15 510]). But note that cash in a bank account is a CGT asset in the form of a debt owing to the taxpayer, ie a ‘‘chose in action’’ (see, for example, Re Excellar Pty Ltd and FCT (2015) 98 ATR 965); • ‘‘know-how’’ (see Determination TD 2000/33); • mining, quarrying or prospecting information (see ATO ID 2012/13 and [10 1270]); • a unit holder’s interest in the property of a unit trust (see Determination TD 2000/32); • a default beneficiary’s interest in a discretionary trust, unless they acquired their interest for consideration or by way of assignment (see Determination TD 2003/28); • the right to an ‘‘early repayment benefit’’ under the terms of a loan agreement: ATO ID 2006/187.

Partnerships The Commissioner’s approach to the CGT treatment of disposals of partnership assets and partnership interests is set out in Ruling IT 2540. Among other things, it states that the definition of ‘‘CGT asset’’ includes ‘‘an interest in an asset of a partnership’’ and that, because a partnership is not a legal entity that owns assets in its own right, the dissolution of a partnership that results in each partner taking their respective interests in the partnership assets will have no CGT consequences as there would not be the requisite change in the ownership of the assets. Note that Determination TD 2015/19 states that where a retiring partner receives an amount representing their individual interest in the partnership net income, that amount is assessable to the partner under s 92 ITAA 1936 and is not solely capital proceeds from a CGT event (see [22 110]) albeit, to the extent it represents capital proceeds from a CGT event, any double taxation would be eliminated by s 118-20: see [14 500]. [12 180] Personal-use assets and collectables CGT assets also include assets that are used or kept mainly for the personal use or enjoyment of a taxpayer or an associate. These are known as ‘‘personal-use assets’’ and ‘‘collectables’’. They are subject to different rules from other CGT assets (eg capital losses cannot be claimed on personal-use assets. For full details, see [14 450]-[14 470]. [12 190] Separate assets The CGT rules recognise a category of asset known as a ‘‘separate’’ CGT asset. This is essentially an asset that is considered to be ‘‘separate’’ from another asset to which it is attached or forms part of (eg certain buildings on land or a qualifying improvements to an existing asset) and is accordingly taxed as a separate asset for CGT purposes. Buildings If land was acquired by the taxpayer before 19 September 1985, any building or other structure constructed on it after 19 September 1985 is taken to be an asset separate from the land: s 108-55(2). 496

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[12 190]

A building or structure on post-CGT land will also be treated as a separate asset to the land if one of the following balancing adjustment provisions applies to the building or structure: • Subdiv 40-D ITAA 1997 (depreciating assets); • ss 355-315 or 355-525 or, for pre-2011-12 income years, former ss 73B, 73BF or 73BM ITAA 1936 (R&D). Note a rental property on post-CGT land is not a separate asset from the land under these rules. See also Determination TD 98/24 for further details on separate assets comprising land and buildings, including how capital proceeds are apportioned between the 2 assets (see [14 270]).

Adjacent land If land was acquired before 20 September 1985 and after that date the taxpayer acquired further land adjacent to the initial parcel, the adjacent land is an asset separate from the initial land. Separate asset treatment also applies if post-CGT land and adjacent pre-CGT land are consolidated into one title: s 108-65. Improvements to pre-CGT assets If an asset acquired before 20 September 1985 (ie a pre-CGT asset) has had an improvement of a capital nature made to it after 19 September 1985, the improvement will be treated as a separate asset. This can include ‘‘intangible’’ improvements to pre-CGT assets, such as rezoning approval for the subdivision of land (see CGT Determination TD 5). However, for a post-CGT improvement to a pre-CGT asset to be regarded as a ‘‘separate asset’’, the cost base to the taxpayer of the improvement needs to exceed the improvement threshold for the income year ($145,401 for 2016-17: see Determination TD 2016/12). This threshold is indexed each year: s 108-85 (see [102 050] for the thresholds since 2011-12). Additionally, the amount of the cost base of the improvement must exceed 5% of the capital proceeds in respect of the disposal of the asset to which the improvement was made: s 108-70(2) and (3). A series of improvements made to a pre-CGT asset will be grouped together for the purposes of this improvement threshold test if they are ‘‘related’’. Section 108-80 provides that the following factors are taken into account to determine whether capital improvements are ‘‘related’’: • the nature of the CGT asset to which the improvements are made; • the nature, location, size, value, quality, composition and utility of each improvement; • whether an improvement depends upon another improvement in a physical, economic, commercial or practical sense; • whether the improvements are part of an overall project; • whether the improvements are of the same kind; and • whether the improvements are made within a reasonable period of time of each other. Similar provisions apply in relation to the disposal of a capital improvement for which roll-over relief may be available if an improvement of a capital nature has been made to the actual asset and all its predecessor assets: s 108-75. Relevant assets will be either a Crown lease, a prospecting or mining entitlement, a statutory licence or a depreciating asset to which Subdiv 124-K applies: see [16 210]. © 2017 THOMSON REUTERS

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Depreciating assets A depreciating asset (see [10 150]) that is part of a building or structure is a separate CGT asset from the building or structure: s 108-60. For example, plumbing fixtures in an employee rest room in a factory constitute depreciating assets and are therefore taken to be separate CGT assets from the factory. Note that depreciating assets (including certain intangible assets) are generally exempt from CGT: see [15 080]. Apportionment of capital proceeds On the happening of CGT events to 2 or more CGT assets, the capital proceeds in respect of the disposal of the assets must be apportioned between them on a reasonable basis: s 116-40. There is no statutory formula for doing so and it is not mandatory to obtain an independent valuation for the purposes of apportioning the capital proceeds: CGT Determination TD 9. Instead, taxpayers should take whatever steps they consider appropriate to determine the valuation of the assets in question. Taxpayers who choose to do their own apportionments need to be able to justify the estimates that they make. For example, in Gerard Cassegrain & Co Pty Ltd v FCT (2007) 66 ATR 198, the Federal Court rejected an attempt to apportion capital proceeds because the entity paying the proceeds was not a party to the apportionment agreement. GST Ruling GSTR 2001/8 sets out some acceptable apportionment methods for GST purposes which should also be acceptable for CGT purposes. Note that the CGT discount (see [14 390]) would be available for a separate asset which has been held for more than 12 months (which would be measured from the time of acquisition or construction of the separate asset under the rules in Div 109). Interaction with other provisions The interaction of Subdiv 108-D with the death provisions (Div 128), the marriage breakdown provisions (Subdiv 126-A) and the main residence exemption (Subdiv 118-B) is considered in Determinations TD 96/18, TD 96/19 and TD 96/21, respectively. [12 200] Right to sue The right to sue is considered to be a CGT asset in the form of a ‘‘chose in action’’: see, for example, Gerard Cassegrain & Co Pty Ltd v FCT (2007) 66 ATR 198 and Re Coshott and FCT [2014] AATA 622. Ruling TR 95/35 sets out the Tax Office’s views on the treatment of compensation received in respect of a right to sue. If the compensation relates to the loss of, or permanent damage to, an underlying CGT asset, relevant adjustments to the cost base of the underlying asset will be required. Otherwise, the compensation will only be considered to be capital proceeds for the right to sue per se, if it is not received in relation to an underlying asset or is received as an undissected lump sum. Compensation received for personal injury is CGT exempt: see [15 100]. [12 210] Joint tenants For CGT purposes, individuals who own a CGT asset as joint tenants are treated as if they each held that interest as a tenant-in-common: s 108-7. This rule means that a change from a joint tenancy into a tenancy in common in equal shares per se will not trigger a CGT event as there is no change in beneficial ownership of the asset (see withdrawn TD 13). See also [17 130] for the rules that apply on the death of a joint tenant.

RECORD-KEEPING [12 250] Requirements Division 121 contains the CGT record-keeping obligations. Records must be kept of every act, transaction, event or circumstance that can reasonably be expected to be relevant to determining whether a taxpayer has made a capital gain or capital loss from a CGT event: s 498

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[12 310]

121-20(1). Records must be in English or, if in electronic form, must be readily accessible and convertible into English: s 121-20(2). Records must be reconstructed if they do not exist: s 121-20(5). The type of detail required in a simple case would include the date of acquisition and disposal, every element of the cost base and the capital proceeds received. For other events containing specific requirements for exemptions, exclusions or roll-over relief, other relevant details would have to be kept. In respect of events for which market values of assets are relevant, market valuations or stock exchange listed quotes (in the case of shares) should be obtained and kept. To simplify record keeping requirements, s 121-35 allows the Commissioner to accept properly certified entries in a ‘‘CGT asset register’’ as evidence of CGT records. Records can be certified by a registered tax agent or other person approved by the Commissioner. However, the register must contain all necessary information to determine the relevant gain or loss. Taxpayers may dispose of original documents 5 years after certification. The register can be kept in paper or electronic form. See also Ruling TR 2002/10 for the requirements for a CGT asset register.

[12 260] Retention period Records must generally be retained for 5 years after it becomes certain that no CGT event or further CGT event can happen to which the records could be relevant: s 121-25(2). In the case of a capital loss, records should be retained for a longer period if the statutory review period (see [47 120]) for an assessment for the income year in which the tax loss is fully deducted, or the net capital loss is fully applied, expires after the end of the 5-year period specified in s 121-25, or if a formal dispute arises in relation to the loss (see Determination TD 2007/2). The penalty for not retaining the appropriate records is 30 penalty units (see [54 020] for the value of a penalty unit). [12 270] Exclusions Records need not be retained if the Commissioner has notified the taxpayer that they need not be retained or if a company has been wound up and dissolved: s 121-25(4). Records also need not be retained if the capital gain or loss made, or which might be made in the future, in relation to a CGT event is to be disregarded: s 121-30. This exception does not apply, however, if the capital gain or loss is only disregarded because of a roll-over or under s 855-40 (about capital gains and losses of foreign residents through fixed trusts: see [18 110]): s 121-30(2).

LIABILITY – WHO MAKES GAIN OR LOSS? [12 300] General In most cases, a capital gain or capital loss is made by the person who owns the CGT asset to which the CGT event happens. However, some events happen to more than one person at the same time. These can have tax consequences for both at that time (eg CGT event E5 under which a capital gain or loss can arise to both a trustee and a beneficiary). Moreover, every CGT event indicates to whom the event happens and who will make a gain or loss. However, Div 106 applies where a capital gain or capital loss is made by someone other than the entity to which a CGT event happens: see [12 300]-[12 360]. [12 310] Partnerships Capital gains or capital losses arising from CGT events happening in relation to a partnership or a CGT asset of a partnership are taken to be made by the partners individually and not the partnership: s 106-5(1). See [22 300]-[22 330]. © 2017 THOMSON REUTERS

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[12 320] Bankruptcy and liquidation The vesting of an individual taxpayer’s assets in a trustee in bankruptcy is ignored for CGT purposes: s 106-30. This means that the bankrupt taxpayer is still treated as the owner of those assets for CGT purposes. One consequence is that no CGT event happens to the bankrupt taxpayer when the assets are vested in the trustee: see ATO ID 2006/224. Similarly, acts done by a liquidator of a company are treated for CGT purposes as if they were done by the company itself: s 106-35. Note that the vesting of assets in the trustee in bankruptcy is disregarded so that the bankrupt individual will be treated as the owner of the asset for all CGT purposes (including the ‘‘connected entity’’ test discussed at [25 060]). In FCT v Australian Building Systems Pty Ltd (in liq) [2015] HCA 48, the High Court confirmed that the obligation imposed on agents and trustees by s 254(1)(d) ITAA 1936 to retain sufficient funds to meet a potential tax liability only arises after the making of an assessment: see [49 250]. But note that s 255-100 in Sch 1 TAA allows the Commissioner to seek security for the payment of existing or future tax-related liabilities in certain situations: see [49 090]. [12 330] Absolutely entitled beneficiaries When a beneficiary becomes absolutely entitled to an asset of a trust (disregarding any legal disability), the asset is treated as an asset of the beneficiary (and not an asset of the trustee) for all CGT purposes (including the ‘‘connected entity’’ test discussed at [25 060]): s 106-50(1). Furthermore, if, apart from any legal disability, a beneficiary is absolutely entitled to a CGT asset as against the trustee of a trust, any acts done by the trustee (commonly referred to as a bare trustee) in relation to the asset are treated for CGT purposes as if they were done by the beneficiary: s 106-50(2). As a result, the beneficiary bears the CGT consequences of such acts. See Draft Ruling TR 2004/D25 for the Tax Office’s preliminary views on the meaning of ‘‘absolute entitlement’’ to a CGT asset. Note that CGT event E1 (see [13 200]) and CGT event E2 (see [13 210]) do not happen where a sole beneficiary is absolutely entitled to the relevant CGT asset as against the trustee (and the trust is not a unit trust). [12 340] Security holders Where a security holder continues to own an asset that has vested in them from a security provider, but they cease to hold a security, charge or encumbrance over that asset, the asset will be treated as having vested in the security holder at that time for all CGT purposes (including the ‘‘connected entity’’ test discussed at [25 060]): s 106-60(1). This will ensure a CGT taxing point arises as a result of the vesting, by recognising that there has been a change in ownership of the asset from the security provider to the security holder. Furthermore, if an entity or its agent that holds a security, charge or encumbrance over a CGT asset does an act in relation to the asset for the purpose of enforcing or giving effect to that security, charge or encumbrance, the act is treated for CGT purposes as if it were done by the person who provided the security: s 106-60(2). For example, if a mortgagee sells land, the mortgagor (or registered owner) will still be liable for any CGT consequences. [12 350] Managed investment trusts There are essentially 2 sets of rules for managed investment trusts (MITs). The original rules (in Div 275 ITAA 1997) apply to MITs that are not ‘‘attribution managed investment trusts’’ (AMITs): see [23 680]. If an MIT is an AMIT, a new regime (in Div 276 ITAA 1997) applies from income years starting on or after 1 July 2016 (or, by election, 1 July 2015): see [23 685]. The definition of a MIT for these purposes is now contained in Subdiv 275-A ITAA 1997: see [50 090]. 500

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Note that MITs that have not made an election in the 2010-11 or 2011-12 income years to apply the interim trust streaming provisions (discussed at [17 050]) may continue to disregard those provisions for the 2012-13 to 2016-17 income years: see [23 210].

[12 360] Trustee’s choice to be assessed on capital gain Section 115-230 allows the trustee of any resident trust (including a testamentary trust) to choose to be assessed on a capital gain made by the trust if that gain would otherwise be assessed to an income beneficiary if the relevant conditions in the section are met. However, see [17 050] for the effect of CGT trust streaming measures.

GENERAL RULES [12 400] Giving property as part of transaction Many CGT events and other provisions (eg the cost base provisions: see Chapter 13) state that a payment, cost or expenditure can include giving property. If this occurs, the market value of the property at that time is used in working out the amount of the payment, cost or expenditure: s 103-5. For example, when a company issues shares as consideration for assets, the provision of those shares is the provision of property in respect of acquiring the assets and therefore the market value of the shares is a component of the cost base of the assets (see [14 030]): Ruling TR 2008/5. [12 410] Entitlement to receive money or property A taxpayer is taken to have received money or other property for CGT purposes if it has been applied for the benefit of the taxpayer, or in accordance with the directions of the taxpayer: s 103-10(1). Such application for the benefit of a taxpayer includes the discharging of all or part of a debt owed by the taxpayer. A taxpayer is also taken to be entitled to receive money or other property for CGT purposes if it will not be received by the taxpayer until a later time or it is payable by instalments: s 103-10(2). [12 420] Requirement to pay money or give property A taxpayer is taken to be required to pay money or give other property for CGT purposes even if the taxpayer does not have to pay or give it until a later time or the money is payable by instalments: s 103-15. [12 430] Foreign currency amounts If an amount of money or the market value of property has to be taken into account at a particular time for CGT purposes but is in a foreign currency, it must be translated into the equivalent amount of Australian currency at the time of the relevant transaction (ie separately at both the time of ‘‘acquisition’’ and the ‘‘CGT event’’ transactions). See [34 050]-[34 080]. [12 440] Choices The CGT provisions give taxpayers choices in certain situations (eg the choice to take advantage of a CGT roll-over). The method for making any choice under the CGT provisions is uniform and is governed by s 103-25. In most situations, the choice must be made by the day the taxpayer lodges the tax return for the income year in which the relevant CGT event happened, unless the Commissioner allows a longer time. However, there are specific exceptions to this rule, eg see [15 580] and [16 160]. Generally, no particular form need be used or records kept in relation to making a choice. It will be evident from the way the return is prepared whether the choice has been made: s 103-25(2). However, a choice relating to the small business roll-over retirement exemption must be in writing: see [15 580]. © 2017 THOMSON REUTERS

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INTRODUCTION Overview ....................................................................................................................... [13 Nature of CGT events ................................................................................................... [13 What if more than one event applies? ......................................................................... [13 Identical assets – identifying the relevant asset ........................................................... [13

010] 020] 030] 040]

ASSET DISPOSAL OR TERMINATION CGT event A1 – disposal of CGT asset ...................................................................... [13 CGT event B1 – use and enjoyment before title passes ............................................. [13 CGT event C1 – loss or destruction ............................................................................. [13 CGT event C2 – ending of intangible asset ................................................................. [13 CGT event C3 – end of option to acquire shares, units or debentures ...................... [13

050] 060] 070] 080] 090]

RIGHT CREATION CGT event D1 – creating contractual or other rights .................................................. [13 CGT event D2 – grant, renewal or extension of option .............................................. [13 CGT event D3 – grant of right to mining income ...................................................... [13 CGT event D4 – grant of conservation covenant ........................................................ [13

150] 160] 170] 180]

TRUSTS CGT event CGT event CGT event CGT event CGT event CGT event CGT event CGT event CGT event CGT event

E1 – creating trust over asset .................................................................... [13 E2 – transfer of asset to trust .................................................................... [13 E3 – converting trust to unit trust ............................................................. [13 E4 – capital payment from trust ............................................................... [13 E5 – beneficiary becomes absolutely entitled ........................................... [13 E6 – disposal to beneficiary – to end income right ................................. [13 E7 – disposal to beneficiary – to end capital interest .............................. [13 E8 – disposal of capital interest by beneficiary ....................................... [13 E9 – creating trust over future property ................................................... [13 E10 – cost base reduction in AMIT interest ............................................. [13

200] 210] 220] 230] 240] 250] 260] 270] 280] 290]

LEASES CGT event CGT event CGT event CGT event CGT event

F1 F2 F3 F4 F5

300] 310] 320] 330] 340]

– – – – –

grant, renewal or extension of lease ................................................ [13 grant, renewal or extension of long-term lease ............................... [13 lease change – lessor’s expenditure ................................................. [13 lease change – lessee receives payment ........................................... [13 lease change – lessor receives payment ........................................... [13

SHARES CGT event G1 – capital payment to shareholder ........................................................ [13 400] CGT event G3 – liquidator or administrator declares shares or financial instruments worthless ............................................................................................................... [13 410] SPECIAL CAPITAL RECEIPTS CGT event H1 – forfeited deposit ................................................................................ [13 450] CGT event H2 – receipt for event relating to CGT asset ........................................... [13 460] CESSATION OF RESIDENCE CGT events I1 and I2 – ceasing to be resident ........................................................... [13 500] REVERSAL OF ROLL-OVERS CGT event J1 – company not in wholly owned group after roll-over ....................... CGT event J2 – small business roll-over – change in replacement asset .................. CGT event J4 – reversal of trust to company roll-over .............................................. CGT event J5 – small business roll-over – no replacement asset .............................. CGT event J6 – small business roll-over – insufficient expenditure ..........................

[13 [13 [13 [13 [13

550] 560] 570] 580] 590]

OTHER EVENTS CGT event K1 – registered emission units .................................................................. [13 640] 502

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CGT CGT CGT CGT CGT CGT CGT CGT CGT CGT CGT

event event event event event event event event event event event

[13 020]

K2 – bankrupt pays debt ........................................................................... [13 K3 – asset bequeathed to tax-advantaged entity ...................................... [13 K4 – asset becomes trading stock ............................................................. [13 K5 – special collectable losses .................................................................. [13 K6 – pre-CGT shares or trust interest ...................................................... [13 K7 – balancing adjustment events for depreciating assets ....................... [13 K8 – taxing events under direct value shifting rules ............................... [13 K9 – carried interests of venture capital managers .................................. [13 K10 – certain short-term forex realisation gains ...................................... [13 K11 – certain short-term forex realisation losses ..................................... [13 K12 – partners in foreign hybrids ............................................................. [13

650] 660] 670] 680] 690] 700] 710] 720] 730] 740] 750]

CONSOLIDATION EVENTS Background .................................................................................................................... [13 800] CGT event L1 – loss of pre-CGT status of membership interests in entity becoming subsidiary member ................................................................................................ [13 810] CGT event L2 – negative amount remaining after step 3A of the ACA on joining .... [13 820] CGT event L3 – tax cost setting amount exceeds joining ACA amount ................... [13 830] CGT event L4 – no reset cost base assets and excess of ACA on joining ................ [13 840] CGT event L5 – negative amount remaining after step 4 of the ACA for a leaving entity ...................................................................................................................... [13 850] CGT event L6 – errors in calculating the ACA .......................................................... [13 860] CGT event L7 – variation in liability – repealed ........................................................ [13 870] CGT event L8 – excess of allocable cost amount ....................................................... [13 880]

INTRODUCTION [13 010] Overview This chapter examines the CGT events which are fundamental to the operation of the CGT provisions as a capital gain or capital loss can only arise when a ‘‘CGT event’’ happens. The chapter examines the requirements and consequences of each CGT event, which are categorised into the following topical groups: • asset disposal or termination ...........................................................[13 050]-[13 090] • right creation ....................................................................................[13 150]-[13 180] • trusts .................................................................................................[13 200]-[13 280] • leases ................................................................................................[13 300]-[13 340] • shares ...............................................................................................[13 400]-[13 410] • special capital receipts ....................................................................[13 450]-[13 460] • cessation of residence .....................................................................................[13 500] • reversal of roll-overs .......................................................................[13 550]-[13 590] • other events ......................................................................................[13 640]-[13 750] • consolidation events ........................................................................[13 800]-[13 880] There is another category of CGT events relating to a ‘‘change in residence’’ which are considered in Chapter 18.

[13 020] Nature of CGT events Each CGT event deals with the following issues: how the event happens; any exceptions to the event; when the event happens; whether a capital gain or capital loss arises and how it © 2017 THOMSON REUTERS

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is calculated; and any effect the event has on the cost base of the relevant CGT asset. See Chapter 16 for ‘‘roll-overs’’ that may be available for capital gains arising under CGT events. Note that Div 109 deals with any corresponding acquisition of an asset by the other party to a CGT event (or otherwise) – which is relevant for determining, among other things, whether an asset has been held for more than 12 months for the purpose of qualifying for the CGT discount: see [14 400].

[13 030] What if more than one event applies? It is possible that more than one CGT event could apply to the same transaction. This will be relevant if, for example, the method of calculating a capital gain or loss is different under the different events. In these circumstances, the most ‘‘specific’’ event to the taxpayer’s situation is taken to apply (subject to exceptions for CGT events J2, J3, K5 and K12): s 102-25(1). Note that CGT events D1 and H2 only apply in a residual capacity if no other CGT event applies and that if they do apply, CGT event D1 takes priority over CGT event H2: s 102-25(3). For example, in Healey v FCT (2012) 91 ATR 671, the Full Federal Court upheld a decision that CGT event E2 (transfer of an asset to a trust) was more specific than CGT event A1 (disposal of asset) for the purpose of determining when a trust acquired shares under the relevant acquisition rules in Div 109 (see also [13 020]). On the other hand, in the case of the disposal of land under a standard contract of sale to a trust which is not connected with the taxpayer, CGT event A1 is the more specific event rather than CGT event E2: see ATO ID 2003/559. [13 040] Identical assets – identifying the relevant asset A CGT event may happen to assets which form part of a holding of identical assets and the assets are not able to be individually distinguished (eg shares, coins, stamps, units in a unit trust etc). In these circumstances, the Commissioner will accept either the taxpayer’s selection of the identity of the actual assets or a ‘‘first-in first-out’’ method as a reasonable basis of determining which assets have been subject to a CGT event, at the taxpayer’s choice (but the Commissioner will not accept an average cost method): see Determination TD 33. However, this approach is only available where assets disposed of or affected by a CGT event are not otherwise able to be individually identified.

ASSET DISPOSAL OR TERMINATION [13 050] CGT event A1 – disposal of CGT asset CGT event A1 happens if a taxpayer ‘‘disposes’’ of a CGT asset: s 104-10(1). Disposal Disposal happens if there is a change of ownership from the taxpayer to another entity (which can occur because of the happening of a specific act or event or by operation of law: s 104-10(2)). However, a change in the ‘‘legal’’ ownership of an asset without a change in its ‘‘beneficial’’ ownership will not constitute a disposal. This means that CGT event A1 does not apply, for example, if a taxpayer transfers legal ownership but retains the beneficial ownership of a CGT asset, or if a trustee who held the legal ownership is changed: s 104-10(2)(a) and (b). Similarly, CGT event A1 will not apply to the mere subdivision or splitting of property as there is no change in the beneficial ownership of the property: s 112-25(2) and CGT Determination 7. The most obvious CGT event A1 is the sale of an asset. However, CGT event A1 will also apply: • to the gifting of a CGT asset; 504

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• to a transfer of shares (or any CGT asset) into joint names – because a CGT asset includes an ‘‘interest in an asset’’ (see Re Murphy and FCT (2014) 98 ATR 961); • the sale of a CGT asset without the owner’s consent (see ATO ID 2010/116), but not the theft of a CGT asset as there is no change in ‘‘beneficial ownership’’ in this case; • to the compulsory acquisition of a CGT asset (subject to roll-over relief: see [16 100]); • to the transfer of ownership of the asset to the State by operation of law (see ATO ID 2009/129 and ATO ID 2002/67); and • if a trustee ceases to hold an asset on trust and commences to hold it in their own individual capacity (see ATO ID 2010/72). In relation to group companies, CGT event A1 will also happen to the head entity of a consolidated group if a subsidiary member disposes of an asset (Determination TD 2004/39), if a membership interest in a subsidiary is sold outside the group (Determination TD 2004/40) or if a subsidiary member of a group contracts to sell a CGT asset and the contract settles after the entity leaves the group (Determination TD 2008/29). Note that Forex realisation event 1 happens when an entity disposes of foreign currency or a right to it: see [32 260]. For the application of CGT event A1 to ‘‘immediate transfer farm-out arrangements’’, see Ruling MT 2012/1. Note that Bitcoin is a CGT asset and its disposal to a third party will usually give rise to CGT event A1: see TD 2014/26.

Earnout arrangements For the CGT ‘‘look-through’’ treatment of a sale of a business or business asset under an earnout arrangement, see [17 335]. Exceptions A gain or loss arising from CGT event A1 will be disregarded: • if there is a change in the legal ownership of an asset without a beneficial change in the ownership (s 104-10(2)); • for CGT assets acquired before 20 September 1985 (s 104-10(5)(a)) except where CGT event K6 applies to convert pre-CGT shares or trust interests into post-CGT assets (see [13 690]); and • if a lease was granted before, and not renewed or extended after, 19 September 1985 (s 104-10(5)). See [15 160] for an exception for capital gains and losses arising in respect of the disposal of rights under the ‘‘financial claims scheme’’.

Time of event The event happens when any contract for the disposal is entered into or, if there is no contract, when the change of ownership occurs: s 104-10(3). At common law a change of ownership occurs when the transferor has done everything necessary to effect a change of ownership: see Corin v Patton (1990) 169 CLR 540. If a contract is entered into in circumstances that involve a delay between entering into the contract and settlement, such as commonly occurs in the case of real estate sales, CGT event A1 is nevertheless taken to happen upon entering into the contract. For the CGT consequences of the forfeiture of a deposit, see [13 450]. Note that although s 170(10AA) ITAA 1936 allows the Commissioner to amend an assessment ‘‘at any time’’ to give effect to s 104-10(3), this power may only be exercised if a new fact arises after the original assessment is made which makes it necessary to give effect to the original taxing event: Metlife Insurance Ltd v FCT (2008) 70 ATR 364. © 2017 THOMSON REUTERS

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If 2 or more contracts are involved in a transaction, a judgment is required as to which of the contracts is the source of the obligation to effect the disposal: FCT v Sara Lee Household & Body Care (Australia) Pty Ltd (2000) 44 ATR 370 and McDonald v FCT (2001) 46 ATR 426. See also AAT Case [2013] AATA 76 92 ATR 652, where the AAT found that a ‘‘heads of agreement’’ arrangement was a binding contract which was conditional upon the subsequent execution of the formal contract of sale, and not simply ‘‘an agreement to agree’’. Rights acquired under an assumption of liability agreement are considered to be disposed of at the time the rights are progressively extinguished by the other party making the required payments under the agreement: Orica Ltd v FCT (2001) 46 ATR 218. Compulsory acquisitions, whether under Australian or foreign law, are taken to happen at the earliest of (s 104-10(6)): receipt of compensation from the acquiring entity; the acquiring entity becoming the asset’s owner; the acquiring entity entering the asset under the compulsory power; or the acquiring entity taking possession under the compulsory power. However, roll-over relief may be available for some compulsory acquisitions (see [16 100]) or under the CGT small business concessions in the case of a business asset (see [15 590]). In relation to goodwill acquired under a contract, if the goodwill ‘‘coalesces’’ with the existing goodwill of the taxpayer’s business and forms a part of that business already conducted, the goodwill is considered to have been acquired when the original goodwill was acquired – including pre-CGT goodwill: Ruling TR 1999/16 and ATO ID 2010/208.

Corresponding acquisition of asset The person who acquires the asset is taken to have acquired it when any contract for the disposal is entered into or, if there is no contract, when the disposing entity ceases to be the asset’s owner: s 109-5(2). However, under a compulsory acquisition, acquisition happens at the earliest of the 4 times mentioned above: s 109-5(2). There will be no acquisition if the exceptions in s 104-10(7) apply, ie where there is a disposal merely to provide or redeem a security or the vesting of assets in a trustee or liquidator on insolvency: s 109-15. Capital gain or capital loss A capital gain arises if the capital proceeds from the disposal are more than the asset’s cost base: s 104-10(4). A capital loss arises if the capital proceeds from the disposal are less than the asset’s reduced cost base: s 104-10(4). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. [13 060] CGT event B1 – use and enjoyment before title passes CGT event B1 happens if a taxpayer enters into an agreement with another entity under which the right to use and enjoy an asset owned by the taxpayer passes to the other entity before title to the asset passes, provided title to the asset will or may pass to the other entity at or before the end of the agreement: s 104-15(1). Note that in Re Confidential and FCT [2014] AATA 952, the AAT ruled that CGT event B1 only applies where a ‘‘single’’ agreement is entered into. Determination TD 1999/78 provides guidance on the meaning of ‘‘end of an agreement’’. See also Div 240 for the inclusion of amounts under hire purchase agreements in assessable income: see [33 090]. In ATO ID 2005/216, the Tax Office ruled that CGT event B1 (rather than CGT event A1) applied in relation to an agreement under which a parent bought a house for their child and child’s spouse to live in until they could obtain finance and repay the parent’s loan, at which time title to the property would be transferred to the child and the child’s spouse. Exceptions A gain or loss is disregarded for assets acquired before 20 September 1985. An exception also applies if title in the asset does not actually end up passing to the other entity when the agreement ends: s 104-15(4). 506

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Note that if title does not pass but an amount has been paid under the agreement for the use and enjoyment of the asset, it is likely that the amount would be income according to ordinary concepts (similar to rent or a royalty, depending on the nature of the asset and the terms of the agreement) and/or assessable under other CGT events (eg CGT event H2: see [13 460]).

Time of event The event happens when the other entity first obtains use and enjoyment of the asset: s 104-15(2). Corresponding acquisition of asset The person who eventually acquires the asset when title passes is taken to have acquired it when the person first obtained the use and enjoyment of it: s 109-5(2). There is no acquisition if title does not actually end up passing when the agreement ends. Capital gain or capital loss A capital gain arises if the capital proceeds from the agreement are more than the asset’s cost base: s 104-15(3). A capital loss arises if the capital proceeds from the agreement are less than the asset’s reduced cost base: s 104-15(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. [13 070] CGT event C1 – loss or destruction CGT event C1 happens if a CGT asset (or part of a CGT asset) is lost or destroyed: s 104-20(1). Determination TD 1999/79 provides guidance on the meaning of ‘‘loss or destruction’’. CGT event C1 also applies if a CGT asset is sold without the owner’s consent: ATO ID 2010/124. Exceptions An exception applies for a gain or loss for assets acquired before 20 September 1985: s 104-20(4). Note that CGT event C1 does not apply if a CGT asset (or part of it) has been merely “damaged” as opposed to destroyed: see Determination TD 1999/79. Instead, if compensation is received, cost base reductions in accordance with the Commissioner’s policy in Ruling TR 95/35 may apply: see [14 080]. Time of event Importantly, the event is taken to happen when any compensation for the loss or destruction is first received. If no compensation is received, the event happens when the loss is discovered or the destruction occurred: s 104-20(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain or capital loss A capital gain arises if the capital proceeds from the loss or destruction are more than the asset’s cost base (s 104-20(3)) or that part of the asset’s cost base in the case of a partly destroyed asset: see [14 170]. A capital loss arises if the capital proceeds from the loss or destruction are less than the asset’s reduced cost base: s 104-20(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. Note that market value capital proceeds are not imposed where no capital proceeds are received under CGT event C1. Roll-over relief under Subdiv 124-B is available for a capital gain made under CGT event C1 on the loss or destruction of an asset ([16 100]). The CGT small business concessions ([15 500]) may also be available for a gain arising under CGT event C1 if the appropriate conditions are met. [13 080] CGT event C2 – ending of intangible asset CGT event C2 happens if a taxpayer’s ownership of an intangible CGT asset ends by the asset being redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited or by the asset expiring: s 104-25(1). © 2017 THOMSON REUTERS

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Examples of where CGT event C2 can apply include: • the waiver or discharge of a debt but not the ‘‘mere writing off of a debt’’: see ATO ID 2003/125 (see also [14 260] for market value substitution rules in this case); • the cancellation or redemption of shares under corporations law; • the expiry of the lease on its extension or renewal (s 104-25(4)); • the surrender of rights by a lessor pursuant to a lease surrender payment (Ruling TR 2005/6); • renunciation by a beneficiary of their interest in a discretionary trust (Determination TD 2001/26); • closing out the position under a financial contract for differences (Ruling TR 2005/15); • extinguishing a debt when a company is deregistered (Determination TD 2000/7); • the discharge of a bankrupt borrower from bankruptcy where all provable debts are released (ATO ID 2003/215); • the discharge of contractual rights when a contract is abandoned (ATO ID 2003/828); and • the ‘‘release’’ or ‘‘discharge’’ of a right to sue on the settlement of a legal dispute (see Re Coshott and FCT [2014] AATA 622). Note that in Integrated Insurance Planning v FCT (2004) 54 ATR 722, the Federal Court held that CGT event C2 applied to the waiver of a loan received by an insurance agent on the basis that the agent’s right to have the debt waived was an intangible CGT asset in the agent’s hands that was extinguished by the waiver.

Meaning of ″expire″ For the meaning of a CGT asset ‘‘expiring’’, see TD 1999/76 which explains that the term ‘‘expiry’’ is limited to an expiry by an ‘‘effluxion or lapse of time’’ (eg when the specified time period of a lease expires). Note that this is relevant to the imposition of market value capital proceeds in the case where no capital proceeds are received on the ‘‘expiry’’ of a CGT asset: see [14 260].

Exceptions A gain or loss is disregarded for assets acquired before 20 September 1985. Likewise, if the asset is a lease, the lease must have been granted before and not renewed or extended after 19 September 1985: s 104-25(5). Exceptions also apply to: the ending of a right in relation to a marriage breakdown settlement (see [15 150]); the exercise of rights to acquire shares or units (see [17 380]); the conversion of a convertible note (or interest) into shares or units (see [17 410] and [17 420]); and the exercise of an option (see [17 220]). In addition, CGT event C2 will not apply to the ending of an ‘‘earnout right’’ (see [17 335]): s 118-575. See [15 160] for an exception for capital gains and losses arising in relation to the ending of rights under the financial claims scheme.

Time of event The event happens when any contract that results in the asset ending was entered into or, if there is no contract, when the asset ends (see, for example, Re Carberry and FCT (2011) 83 ATR 773, where cancellation of water licences occurred at the time they were replaced): s 104-25(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. 508

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Capital gain or capital loss A capital gain arises if the capital proceeds from the ending are more than the asset’s cost base: s 104-25(3). A capital loss arises if the capital proceeds from the ending are less than the asset’s reduced cost base: s 104-25(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. Note that the market value substitution rule for capital proceeds will not apply in a range of cases, eg on the ‘‘expiry’’ of a CGT asset (see above for meaning of ‘‘expiry’’) or if CGT event C2 happens in relation to a share in a widely held company or a unit in a widely held unit trust: see [14 260]. Company dissolution and cancellation of shares CGT event C2 applies to the cancellation of shares under the Corporations Act 2001 following the dissolution of a company: see Determination TD 2001/27. In this case, the capital proceeds comprise any final and interim liquidation distributions paid to shareholders, provided the company is dissolved within 18 months of the payments. Otherwise, CGT event G1 (about capital payments) would apply to the distributions: see [13 400]. Note that the capital proceeds would include any dividend component of the liquidation distribution – albeit, the anti-overlap provisions in s 118-20 (see [14 500]) will operate to reduce any double taxation arising from the taxation of the dividend under s 47(1) ITAA 1936 (see [21 150]): see Determination TD 2001/27. EXAMPLE [13 080.10] A shareholder owns 100 post-CGT shares in a company. Upon the liquidation of the company, the shares are cancelled (ie disposed of). $ $ Cost base at the time of cancellation 10,000 Liquidator’s final distribution: Amount not deemed to be a dividend 11,000 Amount deemed by s 47 to be a dividend 7,000 18,000 Capital proceeds on disposal 18,000 Notional capital gain 8,000 Reduced by the deemed dividend 7,000 Assessable capital gain 1,000

Note the capital gain of $1,000 may be eligible for the small business concessions: see [15 540]. If a liquidator’s distribution is assessable to a shareholder as a franked dividend, s 118-20 does not operate to reduce the capital gain by the amount of the franking credit and, instead, the capital gain is reduced only by the amount of the s 47(1) dividend: s 118-20(1B)(b). Note also that the availability of a franking rebate in respect of a liquidator’s distribution is subject to the restrictions relating to dividends paid out of disqualifying capital accounts. If a company is wound up and shares are cancelled, CGT event C2 happens on the date of the relevant court orders or, in the case of voluntary winding up, 3 months after the return of the final meeting is lodged (or the date specified in the court order): Determination TD 2000/7. However, CGT event G3 may apply at an earlier time if a liquidator or administrator issues a written declaration in respect of ‘‘worthless’’ shares or financial instruments: see [13 410]. © 2017 THOMSON REUTERS

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Reduction of capital gain or loss – certain companies Companies that make a capital loss from forgiveness of a commercial debt can agree to forgo the loss in certain circumstances: see [20 660]. Companies that make capital gains or losses from share cancellations on liquidation of 100% owned subsidiaries may have the relevant amounts reduced if certain roll-overs have occurred: see [16 270]. [13 090] CGT event C3 – end of option to acquire shares, units or debentures CGT event C3 happens to a company or unit trust on the ending of an option to acquire shares in a company, units in a unit trust or debentures in either, if the option was granted by the company or trust. The event happens if the option ends by way of it not being exercised by the time required or by it being cancelled, released or abandoned: s 104-30(1). Note that a CGT event does not happen on the granting of such an option: see also [13 160]. The CGT consequences of exercising an option are considered at [17 200]-[17 230]. Note CGT event C3 applies to the company or unit trust (see CGT event C2 at [13 080] for the implications for the option holder). Exceptions An exception causing a gain or loss to be disregarded applies for options granted before 20 September 1985: s 104-30(5). Time of event The event happens when the option ends: s 104-30(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain or capital loss A capital gain arises to the company or unit trust if the capital proceeds from the grant of the option are more than the expenditure incurred in granting it: s 104-30(3). A capital loss arises to the company or unit trust if the capital proceeds from the grant of the option are less than the expenditure incurred in granting it: s 104-30(3). Capital proceeds are discussed at [14 250]-[14 320]. Note that the expenditure incurred in granting the option can include giving property: see [12 400]. However, any recoupment of expenditure that is not included in assessable income must be excluded: s 104-30(4).

RIGHT CREATION [13 150] CGT event D1 – creating contractual or other rights CGT event D1 happens if a taxpayer creates a contractual right or other legal or equitable right in another entity: s 104-35(1). For example, the event happens if a taxpayer enters into a restrictive covenant agreement not to compete with a person or an entity as the taxpayer has created the right to enforce the agreement in the hands of the other party. CGT event D1 also applies, for example, to rights created under an agreement to: enter into an exclusive trade-tie agreement with another person; play sport only with a particular club; not to appear in a film made by another company; grant management rights over property; endorse the use of particular goods and services; vary a contract not amounting to a disposal of the whole or part of the rights under the contract; and create a right to reside in a property for life: Ruling TR 2006/14. CGT event D1 also happens if a taxpayer receives money or property for withdrawing an objection against a proposed land development, provided the receipt is not for permanent damage to, or reduction in value of, the land: Determination TD 1999/80.

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[13 160]

It should be noted that some of these matters could result in the taxpayer deriving ordinary income (in which case the anti-overlap rule may apply: see [14 500]) or also fall within other CGT events (which will mean that the more specific event takes precedence: see [13 030]). For example, CGT events F4 or F5 would apply to an agreement to vary a term of a lease. Note that the Commonwealth, States and Territories are ‘‘entities’’ for the purposes of CGT event D1 (Determination TD 1999/77), although a court is not (Determination TD 1999/81).

Exceptions CGT event D1 does not apply to the creation of the following rights (s 104-35(5)): • rights created through borrowing money or obtaining credit; • rights created that require the taxpayer to do something that will itself constitute a CGT event for the taxpayer (eg agreeing to dispose of an asset); • rights created by the issue or allotment of shares in a company, including non-equity shares issued on or after 1 July 2001; • rights created by the issue of units in a unit trust; • rights created by the granting of an option to acquire shares (including non-equity shares issued on or after 1 July 2001), units or debentures in the entity granting the option; • the right created in another entity to receive an ‘‘exploration benefit’’ under measures for ‘‘farm-in farm-out arrangements’’ (see [17 345]); and • the creation of an ‘‘earnout right’’ (see [17 335]): s 118-575. Note that the grant of an option is covered by CGT event D2 (see [13 160]).

Time of event The event happens when the taxpayer enters into the contract or creates the other legal or equitable right: s 104-35(2). See also Determination TD 1999/82. Corresponding acquisition of asset The person or entity who obtains the contractual or other right that has been created is taken to have acquired it when the contract is entered into or the other right is created: s 109-5(2). See also Healey v FCT (2012) 91 ATR 671, which is discussed at [13 020]. Capital gain or capital loss A capital gain arises if the capital proceeds from creating the right are more than the ‘‘incidental costs’’ that the taxpayer incurred that relate to the event: s 104-35(3). A capital loss arises if the capital proceeds from creating the right are less than the incidental costs that the taxpayer incurred that relate to the event: s 104-35(3). Note that a capital gain arising under CGT event D1 is not eligible for the CGT discount (see [14 400]): s 115-25(3). Capital proceeds are discussed at [14 250]-[14 320]. Incidental costs that relate to an event are discussed at [14 040] and would include the legal costs of creating the right. The incidental costs can include giving property: see [12 400]. However, any recoupment of costs that are not included in assessable income must be excluded, as must any amount to the extent to which it is deductible: s 104-35(4). [13 160] CGT event D2 – grant, renewal or extension of option CGT event D2 happens if a taxpayer grants an option to an entity or renews or extends an option previously granted by the taxpayer: s 104-40(1). See also [17 200]-[17 230] for a discussion of the CGT treatment of the granting and exercise of call options and put options. © 2017 THOMSON REUTERS

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Exceptions CGT event D2 does not apply in the following situations: • if the option is exercised, in which case the gain or loss is disregarded (see [17 200]-[17 230] for other consequences of exercising the option): s 104-40(5); • if an option to acquire shares in a company, units in a unit trust or debentures of either is granted, renewed or extended by the relevant company or trust: s 104-40(6); and • if the option relates to a personal-use asset or a collectable: s 104-40(7). An option granted to sell a main residence will be subject to CGT event D2 if the option is not exercised, despite a main residence being exempt from CGT: see [15 300]. Note that CGT event C3 applies if an option to acquire shares in a company, units in a unit trust or debentures of a company or unit trust is ended (provided the option was granted by the company or trust): see [13 090].

Time of event The event happens when the option is granted, renewed or extended: s 104-40(2). Corresponding acquisition of asset The person to whom the option is granted is taken to have acquired it when it is granted: s 109-5(2). Capital gain or capital loss A capital gain arises if the capital proceeds from the grant, renewal or extension of the option are more than the expenditure the taxpayer incurred to grant, renew or extend it: s 104-40(3). A capital loss arises if the capital proceeds from the grant, renewal or extension of the option are less than the expenditure the taxpayer incurred to grant, renew or extend it: s 104-40(3). Capital proceeds are discussed at [14 250]-[14 320]. The expenditure incurred to grant, renew or extend the option can include giving property: see [12 400]. However, any recoupment of the expenditure that is not included in assessable income must be excluded, as must any amount to the extent to which it is deductible: s 104-40(4). Note that the gain arising under CGT event D2 is not eligible for the CGT discount (see [14 400]): s 115-25(3)(b). [13 170] CGT event D3 – grant of right to mining income CGT event D3 deals with the granting of a right to income from mining. The event happens if a taxpayer who owns a prospecting entitlement or mining entitlement (see Chapter 29), or an interest in either, grants another entity a right to receive ordinary or statutory income from operations the entitlement permits it to carry on: s 104-45(1). There are no exceptions in relation to this event. Time of event The event happens when any contract granting the right is entered into or, if there is no contract, when the right is granted: s 104-45(2). Corresponding acquisition of asset The person to whom the right is granted is taken to have acquired it when any contract granting the right is entered into or, if there is no contract, when the right is granted: s 109-5(2). Capital gain or capital loss A capital gain arises if the capital proceeds from the grant of the right are more than the expenditure the taxpayer incurred in granting it: s 104-45(3). A capital loss arises if the capital proceeds from the grant of the right are less than the expenditure the taxpayer incurred 512

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in granting it: s 104-45(3). Capital proceeds are discussed at [14 250]-[14 320]. The expenditure incurred in granting the right can include giving property: see [12 400]. However, any recoupment of the expenditure that is not included in assessable income must be excluded, as must any amount to the extent to which it is deductible: s 104-45(4). Note that the gain arising under CGT event D3 is not eligible for the CGT discount (see [14 400]): s 115-25(3).

[13 180] CGT event D4 – grant of conservation covenant CGT event D4 applies if a ‘‘conservation covenant’’ is entered into by a landowner: s 104-47. A conservation covenant is a permanent and binding covenant, approved by the Environment Minister, that restricts current and future landowners from activities on the land that could degrade the environmental value of the land: s 31-5(5). Exceptions CGT event D4 will not apply unless the landowner receives consideration for entering into the covenant or, if no consideration is received, the landowner otherwise becomes entitled to a deduction under Div 31 for the decline in the value of the land: see [9 620]. Note that if CGT event D4 does not apply, CGT event D1 (see [13 150]) will apply instead – with the consequence that none of the concessions that apply to CGT event D4 will be available (see below). Time of event The event happens when the landowner enters into a conservation covenant: s 109-5(2). Capital gains and losses A capital gain (or loss) arises equal to the difference between the capital proceeds from granting the covenant and the cost base (or reduced cost base) of the land apportioned to the covenant: s 104-47(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. Note that a capital gain is eligible for the CGT discount (see [14 390]) and that the exemption for pre-CGT land and the small business concessions apply (see [15 500]). If the landowner receives no consideration but is entitled to a deduction under Div 31 for the decline in the market value of the land resulting from the covenant, the capital proceeds will be equal to the amount of this deduction: s 116-105. If the landowner receives consideration for granting the covenant, the capital proceeds will be the amount received. For cost base purposes, s 104-47(4) provides that the cost base (or reduced cost base) of the entire land is required to be apportioned to the covenant as follows: Cost base of land ×

Capital proceeds from entering into covenant Those capital proceeds plus market value of land just after covenant is entered into

For the purposes of calculating the gain or loss on any subsequent disposal of the land, the cost base of the entire land is reduced by the amount of the cost base apportioned to the conservation covenant: s 104-47(5).

TRUSTS [13 200] CGT event E1 – creating trust over asset CGT event E1 happens if a taxpayer creates a trust over a CGT asset by declaration or settlement: s 104-55(1). It can apply, for example, if a trust is created over shares in a company in liquidation (Determination TD 2004/13) or to an arrangement involving a trust split and the appointment of a new trustee. See also Ruling TR 2006/14 for the application of CGT event E1 to the creation of equitable life and remainder interests in property. © 2017 THOMSON REUTERS

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In Paloto Pty Ltd v Herro [2015] NSWSC 445, the NSW Supreme Court refused to extend the vesting date for a range of reasons including that, to do so in the particular circumstances, would be ‘‘tantamount to the creation of a new trust’’.

Examples In Oswal v FCT (2013) 96 ATR 68 (and Oswal v FCT [2014] FCA 812), the Federal Court held that the legal effect of the decision of a trustee of a discretionary trust to exercise a special power of ‘‘appointment’’ to make 2 beneficiaries of the trust absolutely entitled to part of the corpus of the trust triggered CGT event E1. This was despite the taxpayer arguing that the effect of the declaration was ‘‘merely’’ to establish a ‘‘separate fund of assets under the ‘umbrella’ of the [original trust]’’ (the case is on appeal to the Full Court). In Taras Nominees Pty Ltd as Trustee for the Burnley Street Trust v FCT (2015) 96 ATR 1, the Full Federal Court confirmed that CGT event E1 applied to a transaction whereby a landowner effectively transferred the land to a ‘‘joint venture trust’’ for its commercial development. The Full Court agreed that the transaction involved a ‘‘resettlement’’ when the land was transferred to the joint venture trust under the terms of the trust arrangement (even though this also required a conveyance of the land to the trust). The Full Court also found that CGT event A1 applied to the transaction because the resettlement involved a change of ownership of the land from the taxpayer to the joint venture trust by way of a disposal, but that CGT event E1 was more ‘‘specific’’: see [13 030]. Note that it may be necessary to determine whether the transfer of property to a wholly-owned company occurs via CGT event E1 or CGT event A1, as Div 122 roll-over relief (see [16 020]) will only be available for CGT event A1: see Kafataris v DCT [2015] FCA 874. Exceptions A gain or loss is disregarded for trusts created over assets acquired before 20 September 1985: s 104-55(6). Another exception applies if the taxpayer is the sole beneficiary of a trust who is absolutely entitled to the asset as against the trustee (ignoring any legal disability) and the trust is not a unit trust: s 104-55(5)(a). Determination TD 2012/21 (plus Addendum) states that CGT event E1 (or E2) does not happen if the terms of a trust are changed pursuant to a valid exercise of a power contained within the trust’s constituent document, or varied with the approval of a relevant court order unless: (a) the change causes the existing trust to terminate and a new trust to arise for trust law purposes; or (b) the effect of the change or court approved variation is such as to lead to a particular asset being subject to a separate charter of rights and obligations, such as to give rise to the conclusion that that asset has been settled on terms of a different trust. See also [23 030] for ‘‘trust resettlements’’. Note that if the trust is created under the will of a deceased person, any capital gain or loss made by the deceased from CGT event E1 happening is disregarded under s 128-10 (see [17 100]). Time of event The event happens when the trust over the asset is created: s 104-55(2). Corresponding acquisition of asset The trustee of the trust that has been created over the asset is taken to have acquired the asset when the trust is created: s 109-5(2). Capital gain or capital loss A capital gain arises if the capital proceeds from the creation are more than the asset’s cost base: s 104-55(3). A capital loss arises if the capital proceeds from the creation are less than the asset’s reduced cost base: s 104-55(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. 514

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Special cost base rule While the cost base or reduced cost base in the beneficiary’s hands is used in calculating the above capital gain or capital loss, if no beneficiary is absolutely entitled to the asset as against the trustee (ignoring any legal disability), the first element of the cost base or reduced cost base of the asset in the trustee’s hands is the asset’s market value when the trust is created: s 104-55(4). Market value is considered at [3 210]. [13 210] CGT event E2 – transfer of asset to trust CGT event E2 happens if a taxpayer transfers a CGT asset to an existing trust: s 104-60(1). See Ruling TR 2006/14 for the application of CGT event E2 to the creation of equitable life and remainder interests in property. Exceptions An exception causing a gain or loss to be disregarded applies for assets acquired before 20 September 1985: s 104-60(6). Another exception applies if the taxpayer is the sole beneficiary of a trust who is absolutely entitled to the asset as against the trustee (ignoring any legal disability) and the trust is not a unit trust: s 104-60(5)(a). If the trust is created under the will of a deceased person, any capital gain or loss made by the deceased from CGT event E2 happening is disregarded under s 128-10 (see [17 100] and Ruling TR 2006/14). See Determination TD 2012/21 (plus Addendum) for a further exception when CGT event E2 (and E1) does not apply on the alteration of the terms of a trust (discussed at [13 200]). Time of event The event happens when the asset is transferred: s 104-60(2). In Healey v FCT (2012) 91 ATR 671, the Full Federal Court confirmed that a trust had acquired shares pursuant to the acquisition rules that apply to CGT event E2 (transfer of an asset to a trust) on the date of transfer of the shares, and not pursuant to the acquisition rules that apply to CGT event A1 (disposal of asset) on the date of making the contract of disposal. As a consequence, the shares were not held for more than 12 months for the purposes of the CGT discount: see [14 400]. Corresponding acquisition of asset The trustee of the trust to which the asset has been transferred is taken to have acquired the asset when it is transferred: s 109-5(2). See also Healey v FCT (2012) 91 ATR 671, at [13 020]. Capital gain or capital loss A capital gain arises if the capital proceeds from the transfer are more than the asset’s cost base: s 104-60(3). A capital loss arises if the capital proceeds from the transfer are less than the asset’s reduced cost base: s 104-60(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. Special cost base rule While the cost base or reduced cost base in the beneficiary’s hands is used in calculating the above capital gain or capital loss, if no beneficiary is absolutely entitled to the asset as against the trustee (ignoring any legal disability), the first element of the cost base or reduced cost base of the asset in the trustee’s hands is the asset’s market value when transferred: s 104-60(4). Market value is considered at [3 210]. [13 220] CGT event E3 – converting trust to unit trust CGT event E3 deals with converting a trust to a unit trust. The event happens if a trust over a CGT asset is converted from a non-unit trust to a unit trust, provided a beneficiary of the non-unit trust was absolutely entitled to the asset as against the trustee (ignoring any legal disability) immediately before the conversion: s 104-65(1). © 2017 THOMSON REUTERS

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Exceptions The general exception causing a gain or loss to be disregarded for assets acquired by the beneficiary before 20 September 1985 applies: s 104-65(4). Time of event The event happens when the trust is converted: s 104-65(2). Corresponding acquisition of asset The asset is acquired when the non-unit trust is converted to the unit trust: s 109-5(2). Capital gain or capital loss The beneficiary makes a capital gain if the market value of the asset when the trust is converted is more than the asset’s cost base: s 104-65(3). The beneficiary makes a capital loss if the market value of the asset when the trust is converted is less than the asset’s reduced cost base: s 104-65(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 230] CGT event E4 – capital payment from trust CGT event E4 happens if a trust makes a payment to a taxpayer in respect of the taxpayer’s interest in the trust where some or all of the payment is not assessable: s 104-70(1). For example, CGT event E4 would apply to distributions of accounting income in excess of trust income and the non-assessable ‘‘small business 50% reduction’’ component of a capital gain (see Determination TD 2006/71). See also ATO ID 2012/63 for another example. However, CGT event E4 does not apply to distributions made to a beneficiary of a discretionary trust as they do not have a relevant interest in the trust. Nor would it apply to a default beneficiary of a discretionary trust unless they acquired their interest in the trust for consideration or by way of assignment: Determination TD 2003/28. Note that under the new management investment trust regime, CGT event E4 will not apply to a unit or interest in an ‘‘Attribution Managed Investment Trust’’ (see [23 685]). Payments related to a disposal, or other dealing in respect of the trust interest itself that would be covered by CGT events A1, C2, E1, E2, E6 or E7, are outside the scope of CGT event E4 (see below). Note also that a capital loss cannot arise from CGT event E4 (see below). Non-assessable payments – excluded amounts Section 104-71(1) excludes the following amounts from being a non-assessable payment that would otherwise trigger CGT event E4: • non-assessable non-exempt income, eg exempt income subject to withholding tax, income previously attributed CFC income, non-portfolio dividends from a foreign country (see [7 710]) and the exempt rights issued by a unit trust to acquire further units in the trust under s 59-40 (see [17 380]); • an amount that has been already assessed to the trustee; • attributed PSI assessable by virtue of s 86-15 ITAA 1997 (see [6 130]); • an amount that can reasonably be regarded as repayment of all or part of compensation that the beneficiary has paid to the trustee; • exempt amounts under the small business CGT 15-year exemption in s 152-125 ITAA 1997 (see [15 560]); and • an exempt distribution made to a beneficiary of CGT exempt compensation or damages received by the trustee for a wrong or injury suffered by the beneficiary in their occupation, or in relation to a wrong, injury or illness a beneficiary or their relative suffers (see [15 100]). 516

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However, ‘‘excluded non-assessable payments’’ do not include amounts for which the beneficiary can claim a deduction: s 104-71(2). Section 104-71(3) provides a further category of ‘‘excluded amounts’’, ie amounts not included in the assessable income of an entity because they are: • exempt income arising from shares in a Pooled Development Fund (PDF) under s 124ZM or s 124ZN ITAA 1936; • proceeds from a CGT event that happens in relation to shares in a company that was a PDF; and • amounts that are exempt or disregarded under the amendments to the Early Stage Venture Capital Limited Partnerships (ESVCLP) tax concessions (see [15 650]).

Excluded CGT discount amount and related adjustments Distributions of the non-assessable CGT discount component of a capital gain to an individual beneficiary are also excluded payments: s 104-71(4) and ATO ID 2010/84. Likewise, payment of the non-assessable CGT discount amount through a ‘‘chain of trusts’’ is an ‘‘excluded’’ payment. Note that because capital losses are first offset against capital gains before certain CGT concessions are applied (see [14 360]), the non-assessable part of the CGT discount may need to be adjusted for capital losses. This adjustment will depend on the type of entity receiving the payment and the combination of any CGT concessions applied: s 104-71(4) (table). This allows the full amount of capital losses offset by a beneficiary against a notional gain to be excluded from the non-assessable part of a payment to a beneficiary. The following example illustrates the operation of the adjustment rules in s 104-71(4). EXAMPLE [13 230.10] The VITW Capital Unit Trust made a capital gain of $1,800. The trust also made a capital loss of $500. After offsetting the capital loss, the trustee applied the CGT discount to the balance of the gain ($1,300) resulting in the trust having a net capital gain of $650. Ian, a beneficiary of the trust, was presently entitled to all the trust income. The trustee paid Ian $1,800, comprising the CGT discount of $650, net income of $650 and the capital loss of $500 applied by the trustee against the capital gain. In applying CGT event E4 to the payment, Ian reduces the $1,800 payment by the following amounts: • $650, being the amount of the capital gain included in the net income and assessed to him under s 97 ITAA 1936 (s 104-70(1)(b)); • $650, being the amount that represents the CGT discount allowed against the capital gain made by the trust (Item 1 in the table in s 104-71(4)); and • $500, being the amount of the loss applied against the capital gain made by the trust and reflected in the payment to Ian (Item 7 in the table in s 104-71(4)). The result for Ian is that the non-assessable part is nil (ie $1,800 − ($650 + $650 + $500)).

The example in s 104-71 also illustrates the effect of the application of a capital loss by a beneficiary to the distribution of amounts comprising the CGT discount and the small business 50% reduction. In these circumstances, the ‘‘non-assessable’’ amount distributed to the beneficiary is adjusted by the CGT discount available to the trust (Item 1 in the table) and by 25% of the capital loss available to the beneficiary (Item 3 in the table).

Exceptions Any capital gain made from CGT event E4 is disregarded if the unit or interest in the trust was acquired before 20 September 1985: s 104-70(7). © 2017 THOMSON REUTERS

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CGT event E4 does not apply to the extent that the payment is reasonably attributable to a ‘‘Listed Investment Company (LIC)’’ capital gain (see [14 390]): s 104-70(8). Nor will it apply to a payment made under the CGT small business retirement exemption: see [15 580]. CGT event E4 also does not apply to a distribution received by a non-resident beneficiary to the extent that the distribution is reasonably attributable to ordinary or statutory income from sources other than an Australian source (this exception does not apply if the trust is a corporate unit trust or a public trading trust): s 104-70(9) (see also [18 110]).

Time of event The event generally happens immediately before the end of the income year in which the trustee makes the payment: s 104-70(3)(a). However, if another CGT event happens in relation to the trust interest after the trustee has made the payment but prior to year-end, CGT event E4 happens immediately before the time of that other CGT event: s 104-70(3)(b). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain and cost base reductions A capital gain arises to the extent that the sum of the amounts of the non-assessable parts of the payments made in the income year in respect of the unit or interest exceed its cost base: s 104-70(4). If this happens, the cost base and reduced cost base of the unit or interest is reduced to nil: s 104-70(5). However, if the amount of the non-assessable parts of the payments is equal to or less than the cost base of the units or interests, then the only consequence is that the cost base is reduced by that amount. In the case of the reduced cost base, it is also reduced by that amount but without the exclusion of s 104-71(3) ‘‘excluded amounts’’ applying (ie non-assessable payments in relation to pooled development funds and infrastructure borrowings are taken into account in the cost base reduction for the reduced cost base in this case). EXAMPLE [13 230.20] Jane owns a unit in a unit trust that she bought on 1 July 2007 for $10. During the 2016-17 income year, the trustee makes 4 non-assessable payments of $0.50 per unit. If at the end of the income year Jane’s cost base for her unit would otherwise be $10, its cost base is reduced by $2, giving a new cost base of $8. If Jane sells the units (CGT event A1) in 2017-18 for more than their cost base, she will make a capital gain equal to the difference.

[13 240] CGT event E5 – beneficiary becomes absolutely entitled CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust as against the trustee (ignoring any legal disability): s 104-75(1). The event applies to both the trustee and the beneficiary. CGT event E5 does not apply if the trust is a unit trust or a trust to which Div 128 applies (deceased estates), although it will apply to a testamentary trust (eg dealings with equitable life or remainder interests): see Ruling TR 2006/14 (para 207). See also Determination TD 2004/3 (passing of an asset to an absolutely entitled beneficiary of a deceased estate – CGT event E5 does not happen) and Draft Ruling TR 2004/D25 (meaning of absolute entitlement to a CGT asset). Note that for the purposes of the CGT trust streaming rules (see [17 060]), a beneficiary can be ‘‘specifically entitled’’ to a capital gain made by a trust by virtue of CGT event E5.

Exceptions CGT event E5 does not happen to a trustee if the trustee acquired the asset before 20 September 1985 (s 104-75(4)). CGT event E5 does not happen to a beneficiary if (s 104-75(6)): 518

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• the beneficiary acquired the interest for no expenditure (even if the interest was acquired on or after 20 September 1985), provided it was not by way of assignment from another entity. Note that expenditure can include giving property: see [12 400]; • the asset to which the beneficiary becomes absolutely entitled was acquired before 20 September 1985 or if the beneficiary’s interest in the trust was acquired before that date; or • all or part of the capital gain the trustee makes from the event is disregarded because of the application of the CGT main residence exemption rules in Subdiv 118-B: see [15 300]. Note that CGT event E5 will also not apply if the trust is an employee share trust and the distribution is made as part of an employee share scheme arrangement: see [17 440].

Time of event The event happens when the beneficiary becomes absolutely entitled to the trust asset: s 104-75(2). Corresponding acquisition of asset The beneficiary is taken to have acquired the asset when the beneficiary becomes absolutely entitled to it: s 109-5(2). This is the only corresponding acquisition of an asset arising from the event, even though it applies to 2 separate assets. Capital gain or capital loss – trustee A capital gain arises to the trustee if the market value of the asset when the beneficiary becomes absolutely entitled to it is more than the asset’s cost base: s 104-75(3). A capital loss arises to the trustee if the market value of the asset when the beneficiary becomes absolutely entitled to it is less than the asset’s reduced cost base: s 104-75(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. Capital gain or capital loss – beneficiary A capital gain arises to the beneficiary if the market value of the asset when the beneficiary becomes absolutely entitled to it is more than the cost base of the beneficiary’s interest in the capital of the trust to the extent that it relates to the asset: s 104-75(5). A capital loss arises to the beneficiary if the market value of the asset when the beneficiary becomes absolutely entitled to it is less than the reduced cost base of the beneficiary’s interest in the capital of the trust to the extent that it relates to the asset: s 104-75(5). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 250] CGT event E6 – disposal to beneficiary – to end income right CGT event E6 happens if a trustee disposes of a CGT asset of a trust to a beneficiary in satisfaction of the beneficiary’s right to receive ordinary or statutory income or in satisfaction of part of that right: s 104-80(1). The event applies to both the trustee and the beneficiary. However, CGT event E6 does not apply if the trust is a unit trust or a trust to which Div 128 applies (deceased estates), although it will apply to testamentary trusts (eg dealings with equitable life or remainder interests): see Ruling TR 2006/14 (para 207). Exceptions CGT event E6 does not happen to the trustee if the trustee acquired the asset before 20 September 1985: s 104-80(4). CGT event E6 does not happen to a beneficiary if the asset that is the right to receive income was acquired before 20 September 1985: s 104-80(6). Time of event The event happens when the disposal of the asset to the beneficiary occurs: s 104-80(2). © 2017 THOMSON REUTERS

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Corresponding acquisition of asset The beneficiary is taken to have acquired the asset (disposed of to the beneficiary) when the disposal occurs: s 109-5(2). This is the only corresponding acquisition of an asset arising from the event, even though it applies to 2 separate assets. Capital gain or capital loss – trustee A capital gain arises to the trustee if the market value of the asset at the time of disposal to the beneficiary is more than the asset’s cost base: s 104-80(3). A capital loss arises to the trustee if the market value of the asset at the time of disposal to the beneficiary is less than the asset’s reduced cost base: s 104-80(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. Capital gain or capital loss – beneficiary A capital gain arises to the beneficiary if the market value of the asset at the time of disposal to the beneficiary is more than the cost base of the beneficiary’s right to receive ordinary or statutory income from the trust (or of the appropriate part of the right): s 104-80(5). A capital loss arises to the beneficiary if the market value of the asset at the time of disposal to the beneficiary is less than the reduced cost base of the beneficiary’s right to receive ordinary or statutory income from the trust (or of the appropriate part of the right): s 104-80(5). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 260] CGT event E7 – disposal to beneficiary – to end capital interest CGT event E7 happens if a trustee disposes of a CGT asset of a trust to a beneficiary in satisfaction of the beneficiary’s interest in the trust capital or in satisfaction of part of that interest: s 104-85(1). The event applies to both the trustee and the beneficiary. However, CGT event E7 does not apply if the trust is a unit trust or a trust to which Div 128 applies (deceased estates), although it will apply to testamentary trusts (eg dealings with equitable life or remainder interests): see Ruling TR 2006/14 (para 207). Exceptions CGT event E7 does not happen to the trustee if the asset was acquired by the trustee before 20 September 1985: s 104-85(4). CGT event E7 does not happen to the beneficiary if (s 104-85(6)): • the beneficiary acquired the interest for no expenditure (even if it was acquired on or after 20 September 1985), provided it was not by way of assignment from another entity. For this purpose expenditure can include giving property: see [12 400]; or • the beneficiary’s capital interest in the trust was acquired before 20 September 1985; or • all or part of the capital gain the trustee makes from the event is disregarded because of the application of the CGT main residence exemption rules in Subdiv 118-B: see [15 300].

Time of event The event happens when the disposal of the asset to the beneficiary occurs: s 104-85(2). Corresponding acquisition of asset The beneficiary is taken to have acquired the asset (disposed of by the trustee) when the disposal occurs: s 109-5(2). This is the only corresponding acquisition of an asset arising from the event, even though it applies to 2 separate assets. 520

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Capital gain or capital loss – trustee A capital gain arises to the trustee if the market value of the asset at the time of disposal to the beneficiary is more than the asset’s cost base: s 104-85(3). A capital loss arises to the trustee if the market value of the asset at the time of disposal to the beneficiary is less than the asset’s reduced cost base: s 104-85(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. Capital gain or capital loss – beneficiary A capital gain arises to the beneficiary if the market value of the asset at the time of disposal to the beneficiary is more than the cost base of the beneficiary’s interest in the trust capital (or of the appropriate part of the interest) being satisfied: s 104-85(5). A capital loss arises to the beneficiary if the market value of the asset at the time of disposal to the beneficiary is less than the reduced cost base of the beneficiary’s interest in the trust capital (or of the appropriate part of the interest) being satisfied: s 104-85(5). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 270] CGT event E8 – disposal of capital interest by beneficiary CGT event E8 happens if a beneficiary who did not give any money or property to acquire an interest in trust capital, and did not acquire it by assignment, disposes of the interest or part of it otherwise than to the trustee. However, CGT event E8 does not apply if the trust is a unit trust or a trust to which Div 128 applies (deceased estates), although it will apply to testamentary trusts: see Ruling TR 2006/14 (para 207). Exceptions CGT event E8 does not happen if the interest in the trust capital was acquired before 20 September 1985: ss 104-95(6) and 104-100(6). Note that Determination TD 2009/19 provides that CGT event E8 does not apply to a taker in default of trust capital as the taker does not have an ‘‘interest in the trust capital’’ and that only those interests which constitute a vested and indefeasible interest in a share of the trust capital fall within the scope of CGT event E8. Time of event The event happens when any contract for the disposal of the interest is entered into or, if there is no contract, when the beneficiary stops owning the interest or the appropriate part of it: s 104-90(2). Corresponding acquisition of asset The person who acquires the interest in trust capital is taken to have acquired it when any contract for the disposal of the interest is entered into or, if there is no contract, when the beneficiary stops owning the interest: s 109-5(2). Capital gain or capital loss – beneficiary has sole capital interest A capital gain arises to a beneficiary who has the sole capital interest in the trust if the capital proceeds from the disposal of the capital interest exceed the net asset amount for the trust: s 104-95(1). The net asset amount is the total (at the date of disposal) of the market value of assets of the trust acquired before 20 September 1985, the cost base of other assets and the amount of any money included in the trust capital less the liabilities of the trust at that time: s 104-95(2). The calculation is intended to isolate the accrued capital gain on those assets acquired on or after 20 September 1985. If the beneficiary disposes of part only of the interest, the calculation is performed in the same manner except that there is a pro-rating of the net asset amount on the basis of the proportion of the interest disposed of compared to the interest retained: s 104-95(3). © 2017 THOMSON REUTERS

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Note that, for the purposes of the CGT discount, if the interest in the trust capital was disposed of within 12 months of acquisition, the discount does not apply (and indexation is not available), no matter how long they have been owned by the trust: Item 1 in the table in s 115-25(2) (see [14 400]). A capital loss arises to a beneficiary who has the sole capital interest in the trust if the capital proceeds from the disposal of the capital interest are less than what is referred to as the reduced net asset amount for the trust: s 104-100(1). This is calculated in essentially the same manner as the net amount if there is a capital gain, except that the reduced cost base of post-CGT assets is used, rather than their cost base: s 104-100(2). If the beneficiary disposes of part only of the interest, pro-rating of the reduced net asset amount on the same basis as for a capital gain calculation applies: s 104-100(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. See also Taxpayer Alert TA 2009/14 which warns against creating capital losses, through default beneficiary arrangements, to offset capital gains.

Capital gain or capital loss – other beneficiaries have capital interests If the beneficiary does not have the sole interest in the trust, calculations of any capital gain (s 104-95(4) to (5)) or capital loss (s 104-100(4) to (5)) are performed in exactly the same manner as for a beneficiary who has the sole interest, except that there is a pro-rating of the net asset amount or reduced net asset amount on the basis of the proportion of the beneficiary’s interest as against total interests in the trust capital (with further pro-rating if the beneficiary only disposes of part of the beneficiary’s interest).

[13 280] CGT event E9 – creating trust over future property CGT event E9 happens if a taxpayer agrees for consideration that, when property comes into existence, he or she will hold it on trust and at the time of the agreement no potential beneficiary under the trust has a beneficial interest in the rights created by the agreement: s 104-105(1). There are no exceptions in relation to this event.

Time of event The event happens when the taxpayer makes the agreement: s 104-105(2).

Corresponding acquisition of asset The trustee of the trust that has been created over the future property is taken to have acquired that property when the agreement to create the trust is made: s 109-5(2).

Capital gain or capital loss A capital gain arises to the taxpayer if the market value the property would have had, if it had existed when the agreement was made, is more than any incidental costs that the taxpayer incurred that relate to the event: s 104-105(3). Market value is considered at [3 210]. Note that a capital gain arising under CGT event E9 is not eligible for the CGT discount (see [14 400]): s 115-25(3). A capital loss arises if the market value the property would have had, if it had existed when the agreement was made, is less than any incidental costs that the taxpayer incurred that relate to the event: s 104-105(3). Incidental costs that relate to an event are discussed at [14 040] and can include giving property: see [12 400]. However, any recoupment of the costs not included in assessable income must be excluded, as must any amount to the extent to which it is deductible: s 104-105(4). 522

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[13 300]

[13 290] CGT event E10 – cost base reduction in AMIT interest CGT event E10 (in s 104-107A) forms part of the ‘‘Attribution Managed Investment Trust’’ (AMIT) regime (see [23 685]). The event happens where there has been a reduction under s 104-107B(2) in the cost base of a unit or interest held by a member in an AMIT and the effect of the reduction is that the ‘‘AMIT cost base net amount’’ for the income year in which the reduction occurs exceeds the cost base of the unit or interest. In this case, the member will make a capital gain equal to that excess. In addition, the cost base of the unit or interest will be reduced to nil. A capital gain arising under CGT event E10 will be disregarded if the unit or interest was acquired before 20 September 1985. A capital loss cannot arise under CGT event E10. The event happens when the reduction occurs under s 104-107B. Note the cost base and reduced cost base of the membership interests will have to be adjusted by the ‘‘AMIT cost base net amount’’ at the end of each income year or, if a CGT event happens to the membership interests during an income year, just before the time of the CGT event. If the ‘‘AMIT cost base net amount’’ for the income year is a shortfall, then the cost base of the interests will be increased by the AMIT cost base net amount.

LEASES [13 300] CGT event F1 – grant, renewal or extension of lease CGT event F1 happens if a lessor grants, renews or extends a lease and, in effect, receives a ‘‘lease premium’’ for the transaction. Note that the event applies regardless of whether the property subject to the lease is a pre-CGT or post-CGT asset: s 104-110(1). Importantly, the grant, renewal or extension of the lease is not considered a part-disposal. For the meaning of ‘‘lease premium’’, see FCT v Krakos Investments Pty Ltd (1995) 32 ATR 7, where a distinction was drawn between the payment of a lease premium and goodwill. The Commissioner has confirmed in Ruling TR 96/24 that, in most cases, an amount described in an agreement as consideration for goodwill will be accepted as not being a lease premium, provided generally that the agreement is not a sham, market rentals are being charged or the parties are dealing with each other at arm’s length when allocating consideration to assets. Exception – choice The only exception to CGT event F1 is if a choice is made to apply CGT event F2 instead of CGT event F1: s 104-110(5). This choice is only available in respect of certain ‘‘long-term’’ leases (of 50 years or more) that fulfil the requirements for that event to apply: see [13 310]. The method and timing for making a choice under the CGT provisions are considered at [12 440]. Time of event For the grant of a lease, the event happens when any contract for the lease is entered into or, if there is no contract, at the start of the lease: s 104-110(2)(a). For a renewal or extension, the event happens at the start of the renewal or extension: s 104-110(2)(b). Corresponding acquisition of asset For the grant of a lease, the person to whom the lease is granted is taken to have acquired it when any contract for the lease is entered into or, if there is no contract, at the start of the lease: s 109-5(2). For a renewal or extension, the person who is granted the renewal or extension is taken to have acquired the renewed or extended lease at the start of the renewal or extension. © 2017 THOMSON REUTERS

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Capital gain or capital loss A capital gain arises to the lessor if the capital proceeds (ie the ‘‘lease premium’’) from the grant, renewal or extension of the lease are more than the expenditure the lessor incurred on the grant, renewal or extension: s 104-110(3). Note that a capital gain arising under CGT event F1 is not eligible for the CGT discount (see [14 400]): s 115-25(3). However, a capital gain under CGT event F1 is potentially eligible for the CGT small business concessions (ATO ID 2004/650): see [15 500]. A capital loss arises to the lessor if the capital proceeds from the grant, renewal or extension of the lease are less than the expenditure the lessor incurred on the grant, renewal or extension: s 104-110(3). Capital proceeds are discussed at [14 250]-[14 320]. Note that there are no deemed market value rules for capital proceeds under CGT event F1: s 116-25. The expenditure incurred on the grant, renewal or extension of the lease can include fees, commissions, remuneration for valuers, surveyors and legal advisers plus stamp duty, etc, and also includes giving property: see [14 040]. However, any recoupment of the expenditure that is not included in assessable income must be excluded, as must any amount to the extent to which it is deductible: s 104-110(4). [13 310] CGT event F2 – grant, renewal or extension of long-term lease CGT event F2 deals with the granting, renewal or extension of certain long-term leases (including a long-term sublease). This event does not apply automatically. It only applies if the lessor chooses to apply it instead of CGT event F1: see [13 300]. The method and timing for making a choice under the CGT provisions are considered at [12 440]. The event happens if a lessor grants, renews or extends a lease over land for at least 50 years, provided that at the time this occurred it was reasonable to expect it would continue for at least that period and the terms of the grant, renewal or extension applying to the lessee are substantially the same as those under which the lessor owned or leased the land: s 104-115(1). ATO ID 2003/906 discusses what is meant by the words ‘‘reasonable to expect’’. In determining if a lease is for 50 years, the period of any renewal of the lease is not taken into account: ATO ID 2007/175. Exceptions The general exception causing a gain or loss to be disregarded for land acquired by or leased to the lessor before 20 September 1985 applies. If the land was leased to the lessor and that lease has been renewed or extended, the exception still applies provided no renewal or extension has commenced after 19 September 1985: s 104-115(4). Time of event The event happens when the lessor grants the lease or, for a renewal or extension, at the start of the renewal or extension: s 104-115(2). Corresponding acquisition of asset For the grant of a long-term lease, the person to whom the lease is granted is taken to have acquired it when the lessor grants the lease: s 109-5(2). For a renewal or extension, the person who is granted the renewal or extension is taken to have acquired the renewed or extended lease at the start of the renewal or extension. Capital gain or capital loss A capital gain arises to the lessor if the capital proceeds from the event are more than the cost base of the lessor’s interest in the land: s 104-115(3). A capital loss arises to the lessor if the capital proceeds from the event are less than the reduced cost base of the lessor’s interest in the land: s 104-115(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. There is no deemed market value rule 524

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[13 330]

for proceeds under CGT event F2: s 116-25. Note that a capital gain arising under CGT event F2 is not eligible for the CGT discount (see [14 390]): s 115-25(3).

Interaction between CGT event F2 and Div 132 If, after the grant, renewal or extension of a long-term lease to which the lessor chooses to apply CGT event F2, another CGT event happens to the land or the lessor’s leasehold interest in it, then s 132-10 will apply to determine the cost base or reduced cost base attributable to the lessor’s (residual or reversionary) interest in the land by generally excluding any expenditure incurred before the happening of CGT event F2: see [17 170]. [13 320] CGT event F3 – lease change – lessor’s expenditure CGT event F3 happens if a lessor incurs expenditure in getting the lessee’s agreement to vary or waive a term of the lease: s 104-120(1). The lessor can only make a capital loss under the event as it applies to expenditure incurred by the lessor. Although the heading to the section refers to paying the lessee, the words of the section itself do not limit the expenditure to payments to the lessee. Note that there is no specific CGT ‘‘F’’ event covering the payment by either party of an amount to terminate a lease. However, s 25-110 provides a deduction over 5 years for payment by a lessor or lessee to terminate a business lease: see [9 680]. In addition, the Commissioner takes the view that CGT event C2 (see [13 080]) applies to a lease surrender payment: Ruling TR 2005/6. The Commissioner has also warned lessors of Pt IVA implications where a variation of a lease term is, in substance, a lease surrender: Ruling TR 2005/6. Exception – choice The only exception to CGT event F3 that causes the event not to apply is if a choice has been made to apply CGT event F2 to the lease: s 104-120(3). This choice is only available in respect of certain long-term leases that fulfil the requirements for that event to apply: see [13 310]. The method and timing for making a choice under the CGT provisions are considered at [12 440]. Time of event The event happens when the relevant term of the lease is varied or waived: s 104-120(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital loss A capital loss arises to the lessor equal to the amount of expenditure incurred: s 104-120(1). The expenditure incurred in getting the lessee’s agreement can include giving property: see [12 400]. [13 330] CGT event F4 – lease change – lessee receives payment CGT event F4 deals with a lessee who receives a payment for changing a lease. The event happens if a lessee receives a payment from the lessor for agreeing to vary or waive a term of the lease: s 104-125(1). The payment can include giving property: see [12 400]. It is not possible for a lessee to make a capital loss under this event as it deals only with the receipt of an amount by the lessee. The lessor’s position in respect of the payment is dealt with by CGT event F3: see [13 320]. Exception The general exception causing a gain to be disregarded for a lease granted before 20 September 1985 applies. If a lease has been renewed or extended, the exception still applies, provided no renewal or extension has commenced after 19 September 1985: s 104-125(5). Time of event The event happens when the relevant term of the lease is varied or waived: s 104-125(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. © 2017 THOMSON REUTERS

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Capital gain A capital gain arises to the lessee if the capital proceeds from the event are more than the lease’s cost base at the time of the event: s 104-125(3). Capital proceeds are discussed at [14 250]-[14 320]. Cost base and reduced cost base are discussed at [14 020]-[14 200]. Note that there is no deemed market value rule for capital proceeds under CGT event F4: s 116-25. Special cost base reductions While the lease’s cost base at the time of the event is used in calculating the above capital gain, immediately subsequent to the event there are some special modifications to the lease’s cost base relevant for future CGT events. If the lessee did make a capital gain, the lease’s cost base is reduced to nil: s 104-125(3). If the lessee did not make a capital gain because the capital proceeds from the event were less than the lease’s cost base at the time of the event, the lease’s cost base is reduced by the amount of the capital proceeds: s 104-125(4). [13 340] CGT event F5 – lease change – lessor receives payment CGT event F5 deals with a lessor who receives a payment for changing a lease. The event happens if a lessor receives a payment from the lessee for agreeing to vary or waive a term of the lease: s 104-130(1). The payment can include giving property: see [12 400]. Note that there is no specific CGT ‘‘F’’ event covering the payment by either party of an amount to terminate a lease. However, the Commissioner takes the view that CGT event C2 (see [13 080]) applies to a lease surrender payment: Ruling TR 2005/6. Note also that the Commissioner has warned lessors of Pt IVA implications where a variation of a lease term is, in substance, a lease surrender: Ruling TR 2005/6. Exception The general exception causing a gain or loss to be disregarded for a lease granted before 20 September 1985 applies. If a lease has been renewed or extended, the exception still applies, provided no renewal or extension has commenced after 19 September 1985: s 104-130(5). Time of event The event happens when the relevant term of the lease is varied or waived: s 104-130(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain or capital loss A capital gain arises to the lessor if the capital proceeds from the event are more than the expenditure the lessor incurs in relation to the variation or waiver: s 104-130(3). A capital loss arises to the lessor if the capital proceeds from the event are less than the expenditure the lessor incurs in relation to the variation or waiver: s 104-130(3). Capital proceeds are discussed at [14 250]-[14 320]. Note that there is no deemed market value rule for capital proceeds under CGT event F5: s 116-25. The expenditure incurred in relation to the variation or waiver can include giving property: see [12 400]. However, any recoupment of the expenditure that is not included in assessable income must be excluded: s 104-130(4). Note that a capital gain arising under CGT event F5 is not eligible for the CGT discount (see [14 390]): s 115-25(3).

SHARES [13 400] CGT event G1 – capital payment to shareholder CGT event G1 happens if a company makes a payment (the ‘‘non-assessable part’’) to a taxpayer in respect of a share the taxpayer owns in the company, where some or all of the payment is neither a dividend (which would be assessable under s 44 ITAA 1936: see [21 526

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[13 410]

030]) nor a deemed dividend under s 47 ITAA 1936 (see [21 250]): s 104-135(1). The payment can include giving property: see [12 400]. For example, CGT event G1 applies in relation to an interim liquidation distribution of the ‘‘exempt 50% component’’ of a capital gain if the company is not dissolved within 18 months: Determination TD 2001/14 (see also [13 080]). The payments referred to do not include payments related to a disposal (CGT event A1) or other dealing in respect of the share itself, such as cancellation (CGT event C2).

Exceptions The general exception causing a gain to be disregarded applies if the share was acquired by the taxpayer before 20 September 1985: s 104-135(5). Payments by a liquidator are disregarded for the purposes of this event if the company is dissolved within 18 months of the payment: s 104-135(6). See also Determination TD 2001/27, noted at [17 370]. CGT event G1 does not apply to bonus shares issued out of a share capital account (Subdiv 130-A applies instead: see [17 370]): Determination TD 2000/2. In addition, in working out the non-assessable part, any part of the payment that is: • non-assessable non-exempt income (see [7 700]); • repaid by the taxpayer, or is compensation paid by the taxpayer that can reasonably be regarded as a repayment of all or part of the payment; or • exempted by the small business 15-year exemption (see [15 560]), is disregarded: s 104-135(1B).

Time of event The event happens when the company makes the payment: s 104-135(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain A capital gain arises if the non-assessable part of the payment is more than the share’s cost base: s 104-135(3). Cost base and reduced cost base are discussed at [14 020]-[14 200]. It is not possible to make a capital loss in respect of this CGT event. Special cost base reductions If the shareholder did make a capital gain, the share’s cost base and reduced cost base are reduced to nil: s 104-135(3). If the shareholder did not make a capital gain because the non-assessable part of the payment was not more than the share’s cost base at the time of the payment, the share’s cost base and reduced cost base are reduced by the amount of the non-assessable part of the payment: s 104-135(4). [13 410] CGT event G3 – liquidator or administrator declares shares or financial instruments worthless CGT event G3 happens if a taxpayer owns a share in a company and a liquidator or an administrator of the company declares in writing that they have reasonable grounds to believe that there is no likelihood that shareholders in the company will receive any further distribution: s 104-145(1) (see also Determination TD 2000/52). Likewise, CGT event G3 also happens if a taxpayer owns financial instruments (eg debentures, bonds, promissory notes, rights, options) issued by, or created in relation to, a company and a liquidator or administrator declares that the instruments, or class of instruments, have no value or only negligible value. Choice CGT event G3 is not automatic and will only happen if the taxpayer chooses to apply it. If chosen, the event effectively enables a taxpayer to accelerate a capital loss that may not otherwise arise until the loss is actually realised under another CGT event at some time in the © 2017 THOMSON REUTERS

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future (eg when the company is deregistered and CGT event C2 happens: see [13 080]). The method and timing for making a choice under the CGT provisions are considered at [12 440].

Exception The general exception applies to shares or financial instruments acquired before 20 September 1985 and to revenue assets (at the time the declaration is made): s 104-145(6). The choice to trigger a capital loss is not available for employee share scheme (ESS) interests which are forfeited after the discount has been included in assessable income under Div 83A (applicable to ESS interests acquired from 1 July 2009): see [17 440] and [4 240]: s 104-145(7) and (8). A similar exception applies in relation to qualifying shares where assessability of the discount was deferred under the former ESS provisions in Div 13A of Pt III ITAA 1936: former s 104-145(7). Time of event The event happens when the liquidator or administrator makes the declaration: s 104-145(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital loss If the choice referred to above is made, a capital loss arises to the shareholder equal to the reduced cost base of the share or the financial instrument (as the case may be) as at the time of the liquidator’s or administrator’s declaration: s 104-145(3). Reduced cost base is discussed at [14 090]. It is not possible to make a capital gain in respect of this CGT event as it deals only with worthless shares. Special cost base reduction If the choice to have a capital loss arise is made, immediately subsequent to the liquidator or administrator making the declaration, the cost base and reduced cost base of the shares or financial instruments (as the case may be) are reduced to nil: s 104-145(5). This is for the purpose of calculating any capital gain or loss that may arise on a subsequent CGT event happening to the shares or financial instruments (eg if the company recovers and the shares are subject to a CGT event or the financial instruments regain value and the debt to the taxpayer is repaid).

SPECIAL CAPITAL RECEIPTS [13 450] CGT event H1 – forfeited deposit CGT event H1 happens if a deposit paid to a taxpayer is forfeited because a prospective sale or other transaction does not proceed: s 104-150(1). There are no exceptions to this event. CGT event H1 may apply if a deposit is forfeited under a contract for the sale for a post-CGT rental property (see also Brooks v FCT (2000) 44 ATR 352). However, if the forfeiture occurs ‘‘within a continuum of events constituting a later disposal’’ of the property, the deposit will form part of the capital proceeds from CGT event A1 happening to the post-CGT real estate: see Ruling TR 1999/19. On the other hand, if a deposit is forfeited under a contract for the sale of a main residence and the forfeiture occurs ‘‘within a continuum of events constituting a later disposal’’ of the dwelling, the deposit will be subject to the main residence exemption (see [15 300]): Ruling TR 1999/19 (including Addenda). Otherwise, the deposit will be caught by CGT event H1. For the entity that forfeits or loses the deposit, either CGT event C1 or C2 happens, depending on the circumstances. If CGT event C1 happens (see [13 070]), there will be a capital loss of the amount of the deposit forfeited plus incidental costs, but if CGT event C2 528

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happens there may not be a capital loss because of the application of the market value substitution rule (discussed at [14 160]): Ruling TR 1999/19 (paras 20-24).

Time of event The event happens when the deposit is forfeited: s 104-150(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital gain or capital loss A capital gain arises if the deposit is more than the expenditure the taxpayer incurred in connection with the prospective sale or other transaction: s 104-150(3). ATO ID 2003/346 confirms that a capital gain arising under CGT event H1 may qualify for the CGT small business concessions (eg in relation to the sale of farming land). A capital loss arises if the deposit is less than the expenditure the taxpayer incurred in connection with the prospective sale or other transaction: s 104-150(3). The expenditure incurred in connection with the prospective sale or other transaction can include giving property: see [12 400]. However, any recoupment of the expenditure that is not included in assessable income must be excluded: s 104-150(4). [13 460] CGT event H2 – receipt for event relating to CGT asset CGT event H2 happens if no other CGT event applies and an act, transaction or event occurs in relation to a CGT asset owned by the taxpayer that does not result in an adjustment being made to the asset’s cost base or reduced cost base: s 104-155(1). In this way, this event is designed to have a residual operation to capital receipts not covered by other CGT events: see [13 030]. However, CGT event H2 may have a limited application in view of its terms. For example, the Tax Office concluded that the event did not apply in respect of the receipt of an ex-gratia lump sum from a foreign government, as the taxpayer did not own a CGT asset in relation to which an act, transaction or event occurred (ATO ID 2002/385). On the other hand, the Tax Office decided that the event applied to a resolution by an insurer to allow a premium rebate in relation to the taxpayer’s insurance policy (see ATO ID 2006/222). See also Example 10 in Ruling TR 95/35 (in relation to the former ITAA 1936 equivalent provision). Exceptions The following acts, transactions or events will not trigger CGT event H2 (s 104-155(5)): • borrowing money or obtaining credit; • anything that requires the taxpayer to do something that will itself constitute a CGT event for the taxpayer (eg agreeing to dispose of an asset); • the issue or allotment of shares in a company, including non-equity shares issued on or after 1 July 2001; • the issue of units in a unit trust; • the granting of an option to acquire a share (including non-equity shares), unit or debenture in the entity granting the option; • the grant by a company to a taxpayer of an option to dispose of shares in the company to the company; • the grant by a unit trust of an option to acquire units or debentures in the trust; and • the issuing by a company or trust that is a member of a demerger group (see [16 270]) of new ownership interests under a demerger (see also ATO ID 2003/915).

Time of event The event happens when the relevant act, transaction or event in relation to a CGT asset owned by the taxpayer occurs: s 104-155(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. © 2017 THOMSON REUTERS

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Capital gain or capital loss A capital gain arises if the capital proceeds because of the CGT event are more than the incidental costs that the taxpayer incurred that relate to the event: s 104-155(3). A capital loss arises if the capital proceeds because of the CGT event are less than the incidental costs that the taxpayer incurred that relate to the event: s 104-155(3). Capital proceeds are discussed at [14 250]-[14 320]. Incidental costs that relate to an event are discussed at [14 040]. The incidental costs can include giving property: see [12 400]. However, any recoupment of the costs that is not included in assessable income must be excluded: s 104-155(4). Note that a capital gain arising under CGT event H2 is not eligible for the CGT discount (see [14 390]): s 115-25(3).

CESSATION OF RESIDENCE [13 500] CGT events I1 and I2 – ceasing to be resident CGT events I1 and I2 apply if an individual, company or trust ceases to be an Australian resident. These rules are discussed at [18 160] to [18 170].

REVERSAL OF ROLL-OVERS [13 550] CGT event J1 – company not in wholly owned group after roll-over CGT event J1 deals with a company ceasing to be a member of a wholly owned group after a roll-over. The event happens if there is a roll-over under Subdiv 126-B ITAA 1997 (see [16 320]) for a CGT event that happens in relation to an asset involving 2 member companies of the same wholly owned group where (s 104-175(1)–(3)): • at the time of the roll-over the recipient of the asset was a 100% subsidiary of either the transferring company or another group member; and • subsequently, while still owning the asset, the recipient stops being a 100% subsidiary of either the company that was the ultimate holding company of the group at the time of the roll-over (if there was only one roll-over within the group to which Subdiv 126-B applied) or the company that was the ultimate holding company of the group at the time of the first roll-over (if there was a series of roll-overs in relation to the asset within the group, all of which Subdiv 126-B applied to, of which this is the last). Note that CGT event J1 has become less significant because the roll-over under Subdiv 126-B ceased to apply to resident companies from 1 July 2003 in view of the introduction of the consolidation regime (discussed in Chapter 24). CGT event J1 also does not apply to companies which cease being members of a consolidated group: s 104-182. CGT event J1 generally requires the ‘‘roll-over asset’’ to be taxable Australian property both before and after the original CGT event for which a roll-over is obtained: see s 126-50(5). Otherwise, the asset need only be taxable Australian property at the time of CGT event J1. In ATO ID 2009/43, the Tax Office considers that CGT event J1 did not happen where, after the roll-over, a partnership was interposed between the ultimate holding company of the group and the subsidiary as, in the circumstances, the interposition did not cause the recipient company to cease to be a 100% subsidiary of the ultimate holding company. 530

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Exceptions An exception causing a gain or loss to be disregarded applies for roll-overs under Subdiv 126-B that result in the roll-over asset being taken to have been acquired before 20 September 1985: s 104-175(1). An exception causing the event not to apply also exists if a wholly owned sub-group within the group of which both the transferring and recipient companies of the rolled over asset were members is broken up or sold but itself remains intact: s 104-180. Further, if there has been a series of roll-overs to which Subdiv 126-B applied, all must have occurred only between companies in the sub-group: s 104-180(3). The sub-group must be sold off totally from the group for the exception to apply: s 104-180(5) and (6). Time of event The event happens when the recipient stops being a 100% subsidiary of the relevant ultimate holding company of the group (referred to as the break-up time): s 104-175(4). Corresponding acquisition of asset The recipient company is taken to have acquired the rolled-over asset at the break-up time: s 104-175(8). Capital gain or capital loss A capital gain arises to the recipient company if the roll-over asset’s market value at the break-up time is more than its cost base: s 104-175(5). A capital loss arises to the recipient company if the roll-over asset’s market value at the break-up time is less than its reduced cost base: s 104-175(5). Cost base and reduced cost base are discussed at [14 020]-[14 200]. Special cost base rule While the asset’s cost base or reduced cost base at the break-up time is used in calculating the above capital gain or capital loss, immediately subsequent to the event a revised cost base and reduced cost base (relevant for future CGT events) arise in the recipient company’s hands as a result of the new deemed acquisition (see above). In these circumstances, the first element of the cost base or reduced cost base of the roll-over asset in the recipient company’s hands (following the deemed acquisition) is the asset’s market value at the break-up time: s 104-175(9). [13 560] CGT event J2 – small business roll-over – change in replacement asset CGT event J2 reinstates a capital gain rolled over under Subdiv 152-E (small business roll-over: see [15 590]) in circumstances where a ‘‘replacement asset’’ ceases to be a replacement asset: s 104-185(1). Note also that ‘‘replacement asset’’ is not specifically defined: see [15 590]. Specifically, the event applies if a taxpayer has chosen the small business roll-over under Subdiv 152-E and has satisfied the requirements for the roll-over but, after the ‘‘replacement asset period’’ (see below), the replacement asset either: ceases to be an ‘‘active asset’’ (see [15 530]); becomes trading stock of the taxpayer; or is used solely to produce exempt or non-assessable non-exempt income (see [7 020] and [7 700]): s 104-185(2). Note CGT event J2 no longer applies if a testamentary gift is made under the Cultural Bequests Program (following the cessation of the program). CGT event J2 will also apply to replacement shares or trust interests if, after the ‘‘replacement asset period’’ either: (a) they become subject to a liquidator’s declaration under CGT event G3; (b) CGT event I1 happens to them on the taxpayer becoming a non-resident; or (c) the taxpayer or a connected entity ceases to be a CGT concession stakeholder in the company or trust or the CGT concession stakeholders cease to have a ‘‘small business participation percentage’’ of at least 90% in the taxpayer in terms of the ‘‘significant individual’’ test (see [15 550]): s 104-185(3). © 2017 THOMSON REUTERS

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[13 570]

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Replacement asset period The ‘‘replacement asset period’’ begins one year before and ends 2 years after the last CGT event in the income year for which the taxpayer obtains the roll-over, while a ‘‘replacement asset’’ includes ‘‘4th element’’ capital expenditure on an existing asset (see [14 060]): s 104-185(1)(a). The Commissioner can extend the ‘‘replacement asset period’’. It can also be extended by 12 months from the time additional capital proceeds are received under s 116-45(2) (see [14 250]): s 104-190(1) and (2). There will also be a 12-month extension if capital proceeds are increased (under s 116-60(3)) because of a recoupment of an amount misappropriated by the taxpayer’s agent or employee (see [14 310]). Exceptions CGT event J2 does not happen in the case of replacement shares or trust interests if they cease to be ‘‘active assets’’ (see [15 530]) merely because of changes in the market values of assets that were owned by the company or trust at the time the taxpayer acquired the replacement shares or interests (ie because of a failure of the ‘‘80% market value’’ test: see [15 540]): s 104-185(8). Time of event The event happens when any of these changes occur: s 104-185(4). Amount of gain If there is only one replacement asset, or if a change happens to all of the replacement assets, the capital gain is the amount that was originally rolled over. If there is more than one replacement asset and a change happens to less than all of the assets, the capital gain is the difference between (a) the amount that was originally rolled over and (b) the relevant expenditure on the remaining replacement assets: s 104-185(5). If CGT event J6 (see [13 590]) and/or CGT event J2 had previously happened in relation to the roll-over, the capital gain is the same as calculated under s 104-185(5), less the capital gain previously made under CGT event J6 and/or CGT event J2: s 104-185(6) and (7). Note that a capital gain arising under CGT event J2 is not eligible for the CGT discount (see [14 390]): s 115-25(3). A capital loss cannot arise under CGT event J2. [13 570] CGT event J4 – reversal of trust to company roll-over CGT event J4 reverses the effect of the roll-over under Subdiv 124-N (trust to company roll-over) if the trust does not cease to exist within 6 months from the transfer of the first asset to the company (as required for the roll-over): see [16 240]. The effect of the roll-over will be reversed at the trust level (in relation to trust assets disposed of to a company) and at the beneficiary level (in relation to interests in the trust that are exchanged for shares in the company): s 104-195. Exception If CGT event J4 happens in respect of an asset of the company that was taken to have been acquired before 20 September 1985, or in respect of a share owned in the company that was received in exchange for a pre-CGT interest in the trust, then there will be no capital gain or capital loss. Instead, Div 109 will apply to determine the post-CGT acquisition time for these assets: ss 124-10(5) and 124-15(7). In addition, if the trust restructuring period ends before 29 June 2002, and a trust fails to cease to exist after that date, CGT event J4 will not apply: s 104-195(8). However, for this exception to apply, the conditions that were required to be met under Subdiv 124-N must have been satisfied (apart from having made a choice to disregard the capital gain or loss). Time of event The event happens at the end of the 6-month period (or at the end of any extended period granted by the Commissioner): s 104-195(3). 532

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CGT EVENTS

[13 590]

Capital gain or capital loss If the company still owns the asset subject to the roll-over, the company will make a capital gain equal to the excess of the asset’s market value at the time the company acquired it from the trust over its cost base at that time. A capital loss will be made if the market value is less than the asset’s reduced cost base at the time the company acquired it: s 104-195(4). The shareholder will make a capital gain under CGT event J4 if the share’s market value at the time the shareholder acquired it under the trust restructure is more than the share’s cost base at that time. A capital loss is made if the share’s market value is less than the share’s reduced cost base at that time: s 104-195(6). Cost base of assets The first element of the cost base or reduced cost base of the CGT asset for the company will be the market value of the asset at the time it was acquired under the trust restructure. Likewise, the first element of the cost base or reduced cost base of the share for the shareholder will be its market value at the time it was acquired under the trust restructure: s 104-195(5) and (7). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 580] CGT event J5 – small business roll-over – no replacement asset CGT event J5 reinstates a capital gain rolled over under Subdiv 152-E (small business roll-over: see [15 590]) if by the end of the ‘‘replacement asset period’’ (see [13 560]), either: (a) the taxpayer has not acquired, or incurred ‘‘fourth element expenditure’’ (see [14 060]) on, a replacement asset; or (b) the replacement asset is not an ‘‘active asset’’ (see [15 530]): s 104-197(1) and (3). If the replacement asset is a share or trust interest, CGT event J5 will also happen if, at the end of the ‘‘replacement asset period’’, the taxpayer or a connected entity is not a ‘‘CGT concession stakeholder’’ in the company or trust or the CGT concession stakeholders cease to have a ‘‘small business participation percentage’’ of at least 90% in the taxpayer (see [15 540] and [15 550]): s 104-197(2). Time of event The event happens in the year of the event (ie at the end of the replacement asset period): s 104-197(3). Note this rule effectively allows a 2-year deferral of the capital gain rolled over under Subdiv 152-E. Capital gain The amount of the capital gain under CGT event J5 is the amount of the gain that was rolled over under Subdiv 152-E. Note that a capital gain arising under CGT event J5 is not eligible for the CGT discount (see [14 390]): s 115-25(3). A capital loss cannot arise under CGT event J5. [13 590] CGT event J6 – small business roll-over – insufficient expenditure CGT event J6 reinstates a capital gain rolled over under Subdiv 152-E small business roll-over (see [15 590]) if, by the end of the ‘‘replacement asset period’’ (see [13 560]), the total amount of expenditure incurred in either acquiring a replacement asset and/or incurring ‘‘fourth element’’ capital expenditure (see [14 060]) on an existing asset is less than the amount of the capital gain rolled over: s 104-198(1). Note that expenditure incurred on replacement assets includes any incidental costs of acquiring a CGT asset (see [14 040]). Note that there are no immediate CGT consequences if the amount of expenditure incurred on a replacement asset and/or ‘‘fourth element’’ capital expenditure on an existing asset is more than the amount of the rolled-over capital gain. This is because the purpose of CGT event J6 is to ‘‘merely’’ reinstate the capital gain rolled over under Subdiv 152-E if the conditions for it are not met: see [15 590]. Note also that ‘‘replacement asset’’ is not specifically defined: see [15 590]. © 2017 THOMSON REUTERS

533

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Time of event The event happens in the year of the event (ie at the end of the replacement asset period): s 104-198(2). Note this rule effectively allows a 2-year deferral of the capital gain rolled over under Subdiv 152-E. Capital gain The capital gain under CGT event J6 is the difference between the amount of capital gain that was rolled over under Subdiv 15-E and the amount incurred on acquiring and/or incurring expenditure on replacement assets (including incidental costs of acquiring a replacement asset): s 104-198(1)(d) and (2). That is, if the taxpayer has not acquired a replacement asset or incurred ‘‘fourth element’’ capital expenditure on an existing CGT asset by the end of the replacement asset period to cover the amount of the rolled over gain, CGT event J6 will apply to reinstate the gain to the extent of the difference between the gain rolled over and the expenditure incurred. Note that a capital gain arising under CGT event J6 is not eligible for the CGT discount (see [14 390]): s 115-25(3). A capital loss cannot arise under CGT event J6.

OTHER EVENTS [13 640] CGT event K1 – registered emission units CGT event K1 was substantially amended with effect from 1 July 2014. It now only applies when a Kyoto unit or an Australian carbon credit unit (ACCU) is transferred from the taxpayer’s ‘‘foreign account’’ (or from the taxpayer’s nominee’s ‘‘foreign account’’) to the taxpayer’s ‘‘Registry account’’ (or the taxpayer’s nominee’s ‘‘Registry account’’) and, as a result, the taxpayer starts to hold the unit as a ‘‘registered emissions unit’’. However, for the event to apply, the unit cannot be trading stock or a revenue asset of the taxpayer just before the event: s 104-205. Time of event The event happens when the entity starts to hold the unit as a registered emissions unit: s 104-205(2). Capital gain or loss The taxpayer makes a capital gain if the unit’s market value (just before it starts to hold the unit as a registered emissions unit) is more than its cost base. The taxpayer makes a capital loss if that market value is less than the reduced cost base: s 104-205(3). [13 650] CGT event K2 – bankrupt pays debt CGT event K2 reinstates part of the net capital loss previously denied under s 102-5 (because the taxpayer had become bankrupt or had been released from debts under bankruptcy law) in circumstances where part or all of that debt is repaid. The effect of the event is to allow some or all of the denied amount to be reinstated as a new capital loss in the year of payment. It is not possible to make a capital gain in respect of CGT event K2 as it applies to, in effect, reinstate previously denied capital losses. There are no exceptions in relation to this event. Time of event The event happens when the payment in respect of the debt is made: s 104-210(2). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. 534

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[13 660]

Capital loss A capital loss arises to the bankrupt taxpayer who makes the payment of the lesser of (s 104-210(3)): • the payment; • the amount of the payment that corresponds to the amount of the debt taken into account in calculating the denied loss; and • the denied loss as reduced by previously reinstated capital losses resulting from payments in respect of the debt. Any recoupment of the payment that is not included in assessable income must be excluded in calculating any capital loss: s 104-210(4).

[13 660] CGT event K3 – asset bequeathed to tax-advantaged entity CGT event K3 happens if a taxpayer dies and a CGT asset the taxpayer owned passes to a beneficiary in the taxpayer’s estate that is a “tax advantaged entity” – that is either an exempt entity, a complying superannuation entity (ie a complying superannuation fund, a complying approved deposit fund or pooled superannuation trust) or a foreign resident: s 104-215(1). See also [17 390]. Importantly, the entity must be a tax-advantaged entity at the time the asset passes. However, in the case of a foreign beneficiary, the event only happens if the deceased taxpayer was a resident and the asset is not taxable Australian property in the hands of the beneficiary (see [18 100]): s 104-215(2). Exceptions The general exception causing a gain or loss to be disregarded for assets acquired before 20 September 1985 applies: s 104-215(5). An exception also applied if the asset formed part of a testamentary gift of property under the Cultural Bequests Program (former s 118-60), but that Program has ceased to operate. A gain or loss is also disregarded if the asset is a testamentary gift of property to a gift deductible recipient: see [15 170]. Time of event The event happens immediately before death: s 104-215(3). Corresponding acquisition of asset The tax-advantaged beneficiary is taken to have acquired the asset when the taxpayer dies: s 109-5(2). Capital gain or capital loss A capital gain arises to the deceased taxpayer if the market value of the asset on the day of death is more than the asset’s cost base: s 104-215(4). A capital loss arises to the deceased taxpayer if the market value of the asset on the day of death is less than the asset’s reduced cost base: s 104-215(4). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. It is important to note that any capital gain or capital loss forms part of the tax return for the deceased taxpayer to the date of death (as the event happens immediately before death). Note also that it is necessary for the estate to have sufficient funds to meet this liability as no actual capital proceeds are received from the event – albeit, it may allow capital losses of the deceased to be used that would otherwise lapse on the deceased’s death. Note that proposed amendments that would make the entity (eg the trustee of a deceased estate) that transfers the asset to a ‘‘tax advantaged entity’’ liable to CGT in the year of transfer (and not the deceased taxpayer in his or her date of death return) will not proceed (see the Assistant Treasurer’s media release (item 63), 14 December 2013). See [47 190] for legislation providing protection to taxpayers who prepared income tax returns in good faith on the basis of the proposed amendments. © 2017 THOMSON REUTERS

535

[13 670]

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[13 670] CGT event K4 – asset becomes trading stock CGT event K4 happens if a taxpayer starts holding as trading stock a CGT asset owned by the taxpayer but not previously held as trading stock, provided the taxpayer elects ‘‘deemed sale and re-acquisition’’ at market value under s 70-30(1)(a) of the trading stock provisions (see [5 250]): s 104-220(1). In this way, the capital gain (or loss) accrued up until the time the asset becomes trading stock is accounted for, while the trading stock provisions will then capture any profit or loss arising thereafter. There is no double taxation arising from CGT event K4 and therefore relief under s 118-20 (see [14 500]) does not apply. Note that the event may be relevant for property developers (see also Taxpayer Alert TA 2014/1). Exceptions CGT event K4 does not apply to assets acquired before 20 September 1985: s 104-220(4). Nor does it apply if the taxpayer elects to treat the deemed sale and re-acquisition of the asset as trading stock for ‘‘cost’’ (instead of market value) under s 70-30(1)(a): see Note 2 to s 118-220(1). In this regard, note that capital gains or losses from trading stock are disregarded for CGT purposes (see [15 060]): s 118-25. Time of event The event happens when the taxpayer starts holding the asset as trading stock: s 104-220(2). This may be difficult to determine. (See also Determination TD 92/124 which deals with when land becomes trading stock.) Corresponding acquisition of asset There is no corresponding acquisition of an asset for CGT purposes in respect of this event (as the event only deems a re-acquisition for trading stock purposes: see [5 250]). Should the asset cease to be trading stock, s 70-110 will deem a further sale and re-acquisition at cost, re-exposing the asset to potential CGT event consequences – with its cost for CGT purposes being its market value at the time of the deemed re-acquisition: see [5 250]. Capital gain or capital loss A capital gain arises if the asset’s market value immediately prior to becoming trading stock is more than its cost base: s 104-220(3). A capital loss arises if the asset’s market value immediately prior to becoming trading stock is less than its reduced cost base: s 104-220(3). Cost base and reduced cost base are discussed at [14 020]-[14 200] and market value is considered at [3 210]. [13 680] CGT event K5 – special collectable losses CGT event K5 deals with capital losses occurring in relation to ‘‘collectables’’ (see [12 180]) in circumstances where the losses arise through falls in value of collectables held by entities in which the taxpayer holds as interests. In this case, these capital losses can be realised by the taxpayer as a result of the disposal of the interests. The effect of the event is to convert this capital loss into a capital loss on a collectable, with the result that the loss can only be offset against gains on collectables. Specifically, CGT event K5 happens where (s 104-225(1) to (4)): • a collectable owned by a company or trust falls in value; • CGT event A1, C2 or E8 happens to the shares in the company or an interest in the trust (without any roll-over); and • capital proceeds are deemed to be the market value of the shares in the company or interest in the trust under s 116-80, resulting in a capital gain or lower capital loss than would have been the case if the actual capital proceeds had been used. 536

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[13 690]

The event can also apply if the taxpayer’s shares (to which the relevant CGT event has applied in this manner) are in a company that is in the same wholly owned group as the company whose collectable has fallen in value. The effect of this event is to effectively change the nature of the corresponding fall in the value of the taxpayer’s asset (the shares or trust interest) from an ordinary capital loss (even though subsumed as part of a larger overall gain or loss calculation) to a collectable loss. There are no exceptions in relation to this event.

Time of event The event happens at the same time as CGT event A1, C2 or E8 (as appropriate) is taken to occur in relation to the shares or trust interest: s 104-225(5). Due to its nature, there is no corresponding acquisition of an asset in respect of this event. Capital loss A capital loss from a collectable arises to the taxpayer equal to the extent to which the market value of the shares or trust interest used in calculating the gain or loss under CGT event A1, C2 or E8 exceeds the actual capital proceeds from that event: s 104-225(6). See the example in s 104-225(6). Capital proceeds are discussed at [14 250]-[14 320] and market value is considered at [3 210]. In other words, the capital loss is equal to the amount by which s 116-80 caused the capital proceeds used in working out the gain or loss from CGT event A1, C2 or E8 to be increased, which would correspond to the amount by which the taxpayer’s gain or loss from that event was different to what it otherwise would have been. It is not possible to make a capital gain in respect of this CGT event as it is effectively only quarantining the taxpayer’s proportionate share of the fall in value of the collectable. [13 690] CGT event K6 – pre-CGT shares or trust interest CGT event K6 deems a taxpayer to have made a capital gain on pre-CGT shares or trust interests to which a relevant CGT event happens (see below), in circumstances where the market value of the underlying post-CGT property of the entity is 75% or more of the total value of the entity. The Commissioner’s views on the operation of all aspects of CGT event K6 are contained in Ruling TR 2004/18. Conditions The event happens if a taxpayer owns shares in a company or a trust interest acquired before 20 September 1985 to which CGT event A1, C2, E1, E2, E3, E5, E6, E7, E8, J1 or K3 happens (without a roll-over). If, immediately before that event happening, the market value of property of the company or trust acquired after 19 September 1985 (other than trading stock) or the market value of interests in such property (other than trading stock) held by the company or trust through interposed companies or trusts was at least 75% of the net value of the company or trust, the event will be triggered: s 104-230(1) and (2). ‘‘Property’’ for these purposes is not just confined to post-CGT assets, but has its ordinary meaning. However, it does not include pre-CGT assets converted to post-CGT assets by the operation of Div 149 ITAA 1997: Ruling TR 2004/18. ‘‘Net value’’ is defined in s 995-1 to mean the amount by which the sum of the market values of the assets of the entity exceeds the sum of its liabilities (market value is considered at [3 210]). However, if CGT assets were acquired or liabilities were discharged or released for a purpose that included ensuring that the 75% requirement would not be satisfied in a particular situation, the market value of those CGT assets, or the discharge or release of those liabilities, is disregarded in working out the net value of the company or trust: s 104-230(8). ‘‘Assets’’ for the purposes of this calculation means all assets, including those assets which are not subject to CGT: Ruling TR 2004/18. © 2017 THOMSON REUTERS

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Note that if a non-resident company acquires pre-CGT property from another company in the same wholly owned group and the property is not taxable Australian property (see [18 100]), in applying the net value test, that property is treated as if it were acquired by the non-resident company before 20 September 1985: s 104-230(7).

Exceptions An exception causing the event not to apply arises in respect of shares owned in a company or an interest in a unit trust that has some of its respective shares or units listed on the official list of a stock exchange, whether in Australia or overseas, at the time of the relevant other CGT event and at all times in the preceding 5 years: s 104-230(9). In the case of a unit trust the exception also applies if, instead of being listed, units were ordinarily available to the public for subscription or purchase at the relevant times. In addition, CGT event K6 does not apply to pre-CGT interests in connection with Div 125 demerger roll-over relief (see [16 270]). This is achieved by ss 104-230(9A) and (9B), which effectively provide that CGT event K6 does not apply to interests in a demerged entity when the combined period that the head entity and the demerged entity have been continuously listed on a stock exchange is at least 5 years. Note that CGT event K6 is not triggered if pre-CGT shares or trust interests of a deceased person are transferred to the trustee of the deceased estate or to a beneficiary. This is because any capital gain that may otherwise arise because of CGT event A1 happening on the transfer is disregarded by the ‘‘roll-over’’ under Div 128: see Determination TD 2006/9. Time of event The event happens at the same time as CGT events A1, C2, E1, E2, E3, E5, E6, E7, E8, J1 or K3 happen in relation to the shares or trust interest: s 104-230(5). Corresponding acquisition of asset The taxpayer who owns the shares or interest in a trust is taken to have acquired the appropriate asset at the time when the other relevant CGT event happens: s 109-5(2). Capital gain The taxpayer makes a capital gain equal to that part of the capital proceeds from the shares or interest in the trust that is ‘‘reasonably attributable’’ to the amount by which the market value of the underlying post-CGT property of the company or trust is more than the sum of the cost bases of that underlying post-CGT property: s 104-230(6). Comprehensive guidance in relation to the calculation of the gain for this CGT event is provided in Ruling TR 2004/18. Capital proceeds are discussed at [14 250]-[14 320]. It is not possible to make a capital loss in respect of this CGT event. [13 700] CGT event K7 – balancing adjustment events for depreciating assets CGT event K7 applies when a ‘‘balancing adjustment event’’ (ie a disposal or cessation of use) happens to a ‘‘depreciating asset’’ that has been used wholly or partially for non-taxable purposes: s 104-235. This includes assets used to produce ‘‘mutual’’ income. See [10 070] for the meaning of ‘‘taxable purpose’’. CGT event K7 also applies to a depreciating asset held by an entity conducting R&D activities (see [11 020]-[11 100]) if the asset was at some time used for non-taxable purposes or installed ready for use for a non-taxable purpose: s 104-235(1B). Note that a ‘‘non-taxable purpose’’ does not include R&D activities. CGT event K7 brings depreciating assets into the CGT net, but only in respect of any non-income-producing use of the asset. Otherwise, any ‘‘gain’’ or ‘‘loss’’ on a depreciating asset in respect of its income producing use is treated as a balancing adjustment under Div 40: see [10 850]. Note that there is no double taxation in these circumstances and that as a result, s 118-20 (the anti-overlap provision) does not apply (unless the profit on the sale of a depreciating asset also gives rise to income according to ordinary concepts: see [5 070]). 538

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[13 700]

Exceptions CGT event K7 will not apply: • to pre-CGT assets; • to CGT assets for which an amount can be deducted under Div 328 (for small business entities: see [25 100]-[25 170]) for the income year in which the balancing adjustment event occurred; • if there is a roll-over for a balancing adjustment event under s 40-340 (see [10 940] and [10 950]); • if the depreciating asset is covered by Subdiv 40-F or Subdiv 40-G: see [15 080]; or • if a taxpayer ceases to hold an Australian registered eligible vessel, to the extent that the vessel was used to produce exempt income under s 51-100 (see [11 700]): s 104-235(1AA).

Time of event A capital gain or loss from CGT event K7 happening to a depreciating asset arises in the same income year as any balancing adjustment calculated under Subdiv 40-D (ie when a taxpayer stops holding a depreciating asset: see [10 850]). Calculation of gain or loss A capital gain or loss under CGT event K7 is calculated by reference to Div 40 concepts (eg termination value, adjustable value), with an adjustment for non-taxable use (using a depreciating asset in conducting R&D activities is assumed to be a taxable purpose). If a balancing adjustment event happens to a depreciating asset that was used wholly for non-taxable purposes, the difference between the asset’s termination value (see [10 610]) and its cost will be a capital gain or loss. If the cost or adjustable value is equal to the termination value, there is no gain or loss. For partial non-taxable use, a capital gain will arise if the termination value is greater than its cost (pro-rated appropriately for non-taxable use): s 104-240(1). A capital loss arises in these circumstances if the termination value of the depreciating asset falls either between the cost of the depreciating asset and its adjustable value or below its adjustable value (see [10 360]). Again, an appropriate pro rata adjustment for non-taxable use is required: s 104-240(2). EXAMPLE [13 700.10] Partial non-taxable purpose – capital loss Samantha buys a depreciating asset for $1,000. Two years later Samantha sells the asset for $700. Its adjustable value at this time is $600. 30% of Samantha’s use of the asset has been for non-taxable purposes. A capital loss arises as the termination value of the depreciating asset at the time of the balancing adjustment event falls between its cost and its adjustable value. This capital loss is calculated under s 104-240(2) as follows: = (cost − termination value) × sum of reductions total decline

where: “sum of reductions” is deductions denied because of private or non-income-producing use of the asset; and “total decline” is the overall loss in value of the asset.

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[13 710]

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= ($1,000 − $700) × $120 (ie 30% × $400) $400 = $300 × 0.3 = $90 capital loss.

In the case of an asset that forms part of a low value pool, the gain or loss will be the difference between the asset’s termination value and its cost adjusted by its estimated non-taxable use at the time it was allocated to the pool: s 104-245. A gain under CGT event K7 may qualify for the CGT discount (but not the small business CGT concessions): s 115-20(1)(b). If the depreciating asset is a personal-use asset or collectable, the personal use asset and collectable rules will apply: see [12 180]. If CGT event K7 happens to a depreciating asset that is a partnership asset, the capital gain or capital loss is calculated by reference to the partnership as the holder of the depreciating asset: see [22 300]. If a balancing adjustment event occurs to plant acquired before 21 September 1999 or to another depreciating asset held before 1 July 2001, and an amount (the balancing adjustment) is included in assessable income, the amount is reduced to preserve the benefit of indexation, various CGT exemptions (for cars, collectables, personal-use assets and plant used to produce exempt income) and applicable pre-CGT asset rules: ss 40-285(5), 40-345 TPA. The rule in s 118-24 that a capital gain or loss is disregarded if a CGT event (that is also a balancing adjustment event) happens to a depreciating asset does not apply to CGT event K7: s 118-24(2). Note that partners are considered to have an interest in the capital gain or loss arising from CGT event K7: see ATO ID 2006/200.

Amount misappropriated by agent or employee Special provisions apply if an amount relating to a balancing adjustment event (as specified in Item 8 of the table to s 40-300(2) or Item 1, 3, 4 or 6 of the table in s 40-305(1): see [10 890]) in respect to a depreciating asset is misappropriated by the taxpayer’s agent or employee. In such a case, if CGT event K7 happens to the asset, the termination value of the asset is reduced by the amount misappropriated: s 104-240(3)). If any amount is later received as recoupment of the amount misappropriated, the termination value of the depreciating asset is increased by that amount: s 104-240(4). The same consequences apply if the depreciating asset is a pooled asset: s 104-245(3), (4). This rule applies to amounts misappropriated in the 2007-08 or a later income year. There is also a 4-year period for amending an assessment if the misappropriation is discovered, or a recoupment received, after the income tax return for the relevant income year is lodged: ss 104-240(5), 104-245(5). [13 710] CGT event K8 – taxing events under direct value shifting rules CGT event K8 happens if value is shifted from equity or loan interests in a company or trust (including certain interests in non-fixed trusts) under the direct value shifting rules in Div 725 ITAA 1997: see [17 700]-[17 870]. The event applies to specified ‘‘taxing events’’ that arise if there is a decrease in the market value of equity or loan interests (ie ‘‘down interests’’) under a scheme whereby another entity ‘‘controls’’ the relevant company or trust. Such taxing events will generally occur if value is shifted from a post-CGT interest to a pre-CGT interest or from a ‘‘down interest’’ to an ‘‘up interest’’ owned by another affected owner: s 725-245. The direct value shifting provisions in some cases trigger cost base adjustments instead of taxing events, eg if value is shifted between post-CGT interests held by the same owner. In these cases, CGT event K8 does not apply, but cost base adjustments still arise: see [17 870]. 540

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[13 730]

CGT event K8 does not happen if an indirect value shift arises, because indirect value shifts trigger cost base adjustments only, and not taxing events: see [17 970].

Time of event The event happens when the decrease in market value happens for the relevant interest: s 104-250(2). Exceptions A direct value shift that may trigger CGT event K8 does not arise unless the sum of the decreases in the market value of all down interests is at least $150,000: see [17 850]. Market value is considered at [3 210]. In addition, a capital gain is disregarded if the ‘‘down interest’’ is a pre-CGT asset (ie if value is shifted from pre-CGT interests to post-CGT interests): s 104-250. Capital losses It is not possible to make a capital loss in respect of CGT event K8. [13 720] CGT event K9 – ‘‘carried interests’’ of venture capital managers CGT event K9 happens in connection with the exemption from CGT for venture capital investments made by venture capital limited partnerships: see [15 650]. The event happens when an individual venture capital manager becomes entitled (directly or indirectly through a trust etc) to gains made by such investment vehicles from the sale of eligible venture capital investments (ie ‘‘carried interests’’): s 104-255. Time of event The event happens when the manager becomes entitled to receive the payment in terms of the relevant partnership agreement: s 104-255(2). Amount of gain The amount of the capital gain is equal to the capital proceeds (including the giving of any property) from the event: s 105-255(3). However, a capital loss cannot be made from the event. The CGT discount will be available if the partnership agreement under which the gain arises was entered into at least 12 months before the CGT event. [13 730] CGT event K10 – certain short-term forex realisation gains CGT event K10 captures as a capital gain certain short-term foreign currency realisation gains that would otherwise be caught under Div 775 as a revenue gain: see [32 250]. It applies if the gain is sufficiently linked to the disposal of a capital asset (excluding depreciating assets). Specifically, CGT event K10 happens if (s 104-260): • a taxpayer makes a ‘‘forex realisation gain’’ because of forex realisation event 2 (see [32 260]), ie a right to receive foreign currency ceases and a gain arises by virtue of currency exchange rate fluctuation; and • Item 1 of the table in s 775-70(1) applies (see [32 300]), ie the gain is considered ‘‘short term’’ in that the foreign currency becomes due for payment within 12 months after the realisation event occurs. CGT event K10 will automatically apply to such forex realisation gains, unless the taxpayer specifically elects for the Div 775 rules to apply: see [32 300].

Time of event The event happens when forex realisation event 2 occurs, ie when the right to receive the foreign currency ceases: s 104-260(2). Amount of gain The amount of the capital gain under CGT event K10 will be the gain worked out under forex realisation event 2 (s 104-260(3)). Broadly, this will be the excess of the amount received on the happening of that event over the forex ‘‘cost base of the right to receive © 2017 THOMSON REUTERS

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foreign currency’’ (being the amount that would be required to be paid to acquire the right), less any deductible amount: ss 775-45 and 775-85. Moreover, this must be attributable to a ‘‘currency exchange rate effect’’ (ie relevant exchange rate fluctuations: s 775-105). Note that a capital gain arising under CGT event K10 is not eligible for the CGT discount (see [14 390]): s 115-25(3). A capital loss cannot arise under CGT event K10, but instead is dealt with under CGT event K11: see [13 740].

[13 740] CGT event K11 – certain short-term forex realisation losses CGT event K11 operates in the same manner as CGT event K10 (see [13 730]), except that it captures as a capital loss certain short-term foreign currency realisation losses: s 104-265. Accordingly, CGT event K11 happens if a taxpayer makes a ‘‘forex realisation loss’’ under forex realisation event 2 (ie a right to receive foreign currency ceases) and Item 1 of the table in s 775-75(1) applies (ie the loss is considered ‘‘short-term’’). In this case, the capital loss is calculated by reference to the excess of the cost base of the right over the amount received in respect of that event: see [13 730]. The event happens when the forex realisation event happens. [13 750] CGT event K12 – partners in foreign hybrids CGT event K12 happens if a partner in a foreign hybrid makes a capital loss under s 830-50(2)(b) or s 830-50(3)(b) ITAA 1997: s 104-270(1). A foreign hybrid is either a foreign hybrid limited partnership or a foreign hybrid company (which is a CFC): see [22 440]. In essence, the event realises a capital loss in a limited partner’s hands when the carried forward capital losses available to a foreign hybrid are less than a partner’s available ‘‘loss exposure amount’’ (essentially, the maximum capital loss available to the partner under the applicable loss limitation rules in s 830-60). Amount of loss The amount of the capital loss is that difference (ie the ‘‘outstanding foreign hybrid net capital loss amount’’: s 830-70) as calculated under s 830-50(2)(b) or s 830-50(3)(b): s 104-270(3). Note that the capital loss can be used by the partner in calculating the net capital gain or loss of the limited partner in that income year. Time of event The event happens just before the end of the income year in which the capital loss under s 830-50(2)(b) or s 830-50(3)(b) occurs: s 104-270(2).

CONSOLIDATION EVENTS [13 800] Background CGT events L1 to L8 deal with the CGT consequences that may arise to the ‘‘head entity’’ under the consolidation measures (discussed in Chapter 24), including head entities of MEC groups (on the application of the ‘‘allocated cost amount’’ (ACA) calculations). These CGT events are essentially ‘‘adjustment’’ or ‘‘integrity’’ measures that operate in relation to the process of allocating cost bases to assets on the consolidation of a group. See [24 300]-[24 450] for explanation of these rules. Note that, as a general rule, the pre-CGT status of membership interests held in a joining entity is preserved on consolidation. [13 810] CGT event L1 – loss of pre-CGT status of membership interests in entity becoming subsidiary member CGT event L1 operates to recognise a capital loss in a head entity in circumstances where it may incur a greater tax liability on the sale of a revenue asset than it otherwise would have done as a result of the application of the allocable cost amount (ACA) rules: s 104-500(1). 542

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The capital loss is calculated with reference to consolidation concepts contained in Pt 3-90 ITAA 1997. This is because the concepts of capital proceeds and cost base are not relevant when determining the tax cost setting amount for an asset under the consolidation rules. The amount of the capital loss is equal to the ‘‘reduction amount’’ calculated under s 705-57: s 104-500(3). The capital loss made under CGT event L1 is spread over 5 income years, starting in the income year in which the entity becomes a subsidiary member of the consolidated group or MEC group. In each year the head entity is entitled to use up to one-fifth of the entire CGT event L1 capital loss: s 104-500(4) and (5). (In certain circumstances, there are transitional provisions that allow the capital loss to be claimed earlier.) Note that this capital loss forms part of the net capital losses for the year in which that event happens and, together with any other capital losses, will be applied in the order in which it is incurred, although the ability to use that net capital loss is spread over 5 years: s 104-500(5). The event happens just after the entity joins the group (so that the loss may be recognised by the head entity in that year): s 104-500(4) and (2).

[13 820] CGT event L2 – negative amount remaining after step 3A of the ACA on joining Before a consolidated group or MEC group forms, or an entity becomes a subsidiary member of a consolidated group or MEC group, an asset may have been rolled over to a subsidiary by either a member of the group or a foreign entity. This roll-over defers a capital gain that would otherwise be brought to account as a result of disposing of the asset. This capital gain may then be sheltered as a result of the tax cost setting process (see [24 300] and following). The operation of step 3A of the allocable cost amount (ACA) under s 705-93 cancels any effect a roll-over would have had in altering the group’s ACA: see [24 320] and [24 350]. CGT event L2 happens where an entity joins the group and the adjustment made by step 3A results in the ACA being reduced below zero. A capital gain accrues to the head company equal to the negative amount. The event happens, and the gain arises, just after the entity joins the group.

[13 830] CGT event L3 – tax cost setting amount exceeds joining ACA amount CGT event L3 happens if the head company’s cost for retained cost base assets of a joining entity (see [24 330]) exceeds the consolidated group’s or MEC group’s allocable cost amount (ACA) for the joining entity (see [24 320]). In these circumstances, the head company makes a gain equal to the excess. However, capital gains do not arise when an entity joins a consolidated group or MEC group solely because the joining entity has doubtful debts at the joining time. In this case, any capital gain will be reduced by the difference between the market value and the face value of doubtful debts held at the joining time, but not beyond nil. The event happens, and the gain accrues to the head company, just after the entity joins the group.

[13 840] CGT event L4 – no reset cost base assets and excess of ACA on joining CGT event L4 happens if an entity becomes a subsidiary member of a consolidated group or MEC group and a balance of its allocable cost amount (ACA: see [24 320]) remains ‘‘unallocated’’ against reset cost base assets (see [24 330]), eg if the joining entity is a shelf company acquired by the group and it cannot allocate any remaining ACA to goodwill. In these circumstances, a capital loss arises equal to the amount remaining after the group’s ACA is reduced by the total of the payments for retained cost base assets. © 2017 THOMSON REUTERS

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If the cost and value of the reset cost base assets of a joining entity are so small or trifling that they are de minimis, they can be ignored when determining whether a loss under CGT event L4 is available: Determination TD 2005/54. The event happens, and the capital loss accrues to the head company, just after the entity joins the group.

[13 850] CGT event L5 – negative amount remaining after step 4 of the ACA for a leaving entity By way of background, the cost of membership interests in a ‘‘leaving entity’’ is determined by working out the ‘‘old group’s’’ allocable cost amount (ACA) for the leaving entity (see [24 400]). This amount is determined in accordance with the 5 steps specified in s 711-20. Step 4 in determining the old group’s ACA is to subtract the amount of the leaving entity’s liabilities. These liabilities are those that exist ‘‘just before the leaving time’’ and not those that exist ‘‘at the leaving time’’: see Handbury Holdings Pty Ltd v FCT (2009) 77 ATR 670. CGT event L5 happens when the amount remaining after applying step 4 is negative. In this case, the head company will make a capital gain equal to the negative amount. CGT event L5 can happen if a subsidiary member of a consolidated group or MEC group is deregistered (and thus ceases to be a member of the group) and it has unsatisfied debts at the time of deregistration that would result in a negative ACA: Determination TD 2007/13 (plus Addendum). For examples of where CGT event L5 may or may not happen, see ATO ID 2006/99, ATO ID 2006/170 and ATO ID 2006/171. If a tax loss or net capital loss was transferred from the joining entity to the head company of the group at the joining time and the loss is in a bundle of losses for which the available fraction is nil (see [24 400]), s 707-415 ITAA 1997 allows the head company to choose to apply the loss to reduce the capital gain arising under CGT event L5 if: • the joining entity ceases to be a subsidiary member of the group after the joining time; and • the entity’s liabilities at the leaving time are the same as, or are reasonably connected to, the liabilities that it had at the joining time. However, the total amount of losses in the bundle of losses that can be applied to reduce any capital gain arising under CGT event L5 cannot exceed the amount of the capital gain that would be made under CGT event L5 assuming the joining entity ceased to be a member of the consolidated group just after the joining time. The event happens when the joining entity ceases to be a subsidiary member of the group.

[13 860] CGT event L6 – errors in calculating the ACA CGT event L6 happens if a taxpayer makes an error in calculating the allocable cost amount (ACA: see [24 320]). Instead of forcing the head company to amend the return for the year the error is made, ss 705-315 and 705-320 allow the head company to treat the amount of the error as either a capital gain or loss where an amendment to the earlier year’s tax return would be ‘‘unreasonable’’ (taking account of the amount of the error and the compliance costs involved): see [24 450] and Ruling TR 2007/7. (Note that the same concession applies if the settled amount of a liability differs from the amount included in step 2 of the ACA calculation.) A capital gain arises equal to the net amount by which the tax cost setting amounts are overstated, while a capital loss arises equal to the net amount by which the tax cost setting amounts are understated: s 104-525. The event happens at the start of the income year in which the Commissioner becomes aware of the error. Note that it is not the year in which the taxpayer becomes aware of the error. There is, however, an obligation on a head company to notify the Commissioner of any such error. 544

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CGT event L6 may happen where a head company retirement village operator of a consolidated group has a net overstated amount in respect of an entity that joined the group before 26 November 2014, as a consequence of the Tax Office changing its views (in an Addendum to Ruling TR 2002/14) about capital growth payments: see Practical Compliance Guideline PCG 2016/15.

[13 870] CGT event L7 – variation in liability – repealed CGT event L7 has been repealed with effect from 1 July 2002. However, it still applies to capital losses incurred under CGT event L7 before 10 February 2010. Otherwise, CGT event L7 happened where a liability that was taken into account in working out the ACA was discharged for a different amount and, had the amount been used at the joining time, the ACA would have been different. [13 880] CGT event L8 – excess of allocable cost amount Under the cost base setting rules, the allocable cost amount (ACA) remaining after deducting an amount equal to a head company’s set costs, for the retained cost base assets of an entity becoming a subsidiary member of a consolidated group or a MEC group, is allocated among the reset cost base assets (other than excluded assets): see [24 340]. There is then a proportionate allocation of the remaining ACA to each of the joining entity’s reset cost base assets in accordance with their relative market value. However, under s 705-40, the ACA that can be allocated to reset cost base assets that are held on revenue account is limited to the greater of the asset’s market or terminating value. CGT event L8 happens if there is an excess of ACA on joining that cannot be allocated to reset cost base assets after the operation of s 705-40. In these circumstances, the head company makes a capital loss equal to the excess: s 104-535. The event happens just after the entity joins the group.

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INTRODUCTION Overview ....................................................................................................................... [14 010]

COST BASE GENERAL RULES General basis rules ........................................................................................................ [14 First element – acquisition costs .................................................................................. [14 Second element – incidental costs ................................................................................ [14 Third element – costs of owning the asset .................................................................. [14 Fourth element – capital expenditure to increase or preserve value .......................... [14 Fifth element – capital expenditure to establish or defend title .................................. [14 Exclusions from cost base ............................................................................................ [14 Reduced cost base ......................................................................................................... [14 Exclusions from reduced cost base .............................................................................. [14

020] 030] 040] 050] 060] 070] 080] 090] 100]

MODIFICATIONS AND SPECIAL RULES General modifications – introduction ........................................................................... [14 Market value substitution rule and exceptions ............................................................ [14 Split, changed or merged assets ................................................................................... [14 Partial acquisitions or disposals – apportionment ........................................................ [14 Assumption of liability rule .......................................................................................... [14 Put options ..................................................................................................................... [14 Earnout arrangements .................................................................................................... [14 Share acquired in ESIC ................................................................................................ [14 Cost base reset for super $1.6m transfer balance cap ................................................. [14

150] 160] 170] 180] 190] 200] 210] 220] 230]

CAPITAL PROCEEDS Capital proceeds ............................................................................................................ [14 Market value substitution rule and exceptions ............................................................ [14 Apportionment rule ....................................................................................................... [14 Non-receipt rule ............................................................................................................ [14 Repaid rule .................................................................................................................... [14 Assumption of liability rule .......................................................................................... [14 Misappropriated amounts .............................................................................................. [14 Special rules .................................................................................................................. [14 Earnout arrangements .................................................................................................... [14

250] 260] 270] 280] 290] 300] 310] 320] 330]

CALCULATION OF GAINS AND LOSSES Introduction ................................................................................................................... Net capital gain ............................................................................................................. Net capital loss .............................................................................................................. Restriction on use of net capital losses ........................................................................ CGT discount – general ................................................................................................ CGT discount – 12-month holding rule ....................................................................... CGT discount – abolition for foreign residents ........................................................... CGT discount – anti-avoidance measures .................................................................... Rate of tax on net capital gain ..................................................................................... 546

[14 [14 [14 [14 [14 [14 [14 [14 [14

350] 360] 370] 380] 390] 400] 405] 410] 420]

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RULES FOR COLLECTABLES AND PERSONAL-USE ASSETS Collectables ................................................................................................................... [14 450] Personal-use assets ........................................................................................................ [14 460] Collectables and personal-use assets held by companies or trusts ............................. [14 470]

ANTI-OVERLAP PROVISIONS No double taxation for otherwise assessable amounts ................................................ [14 500] Interaction of TOFA rules and CGT ............................................................................ [14 510]

INTRODUCTION [14 010] Overview This chapter principally deals with the determination of the cost base or reduced cost base of a CGT asset, and the determination of the capital proceeds that need to be taken into account in calculating whether a capital gain or capital loss has arisen from a CGT event. In particular, the chapter examines the following matters related to the cost base of a CGT asset: • the elements that comprise the cost base: see [14 020]-[14 070]; • expenditure excluded from the costs base: see [14 080]; • the reduced cost base (and expenditure excluded from it): see [14 090]-[14 100]; and • modifications made to the cost base (eg the market value substitution rule) and other special rules that apply to the cost base: see [14 150]-[14 200]. The chapter also examines the following matters related to determining the capital proceeds received for a CGT event: • the general rules that apply to capital proceeds: see [14 250]; • modifications made to the general rules: see [14 260]-[14 310]; and • other special rules that apply to determining capital proceeds: see [14 320]. The ascertainment of the actual ‘‘net capital gain’’ to be included in assessable income is discussed at [14 350] to [14 420]. Other topics considered in this chapter are: • rules for collectables and personal-use assets: see [14 450]-[14 470]; • anti-overlap rules preventing double taxation: see [14 500]; and • the interaction between the TOFA rules and CGT: see [14 510].

COST BASE GENERAL RULES [14 020] General basis rules The cost base of a CGT asset consists of the following 5 elements (s 110-25(1)): • acquisition costs – the first element: see [14 030]; © 2017 THOMSON REUTERS

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• incidental costs – the second element: see [14 040]; • non-deductible costs of owning the asset – the third element: see [14 050]; • capital expenditure to increase or preserve the value of the asset, or that relates to installing or moving the asset – the fourth element: see [14 060]; and • capital expenditure to establish or defend title to or a right over the asset – the fifth element: see [14 070]. For the effect of the consolidation measures on the cost base of assets when entities consolidate, see [24 300]-[24 450]. Note also that the cost base is reduced by any relevant net input tax credit: s 103-30.

[14 030] First element – acquisition costs The first element of the cost base of a CGT asset is the ‘‘acquisition cost’’, which is the total of any money the taxpayer paid, or is required to pay, in respect of acquiring the asset and/or the market value of any property that the taxpayer gave, or is required to give, in respect of acquiring it (as worked out at the time of acquisition): ss 110-25(2). Note also the following: • the money and/or property need not be paid to the entity from whom the asset was acquired as long as it was or given in respect of the acquisition: Determination TD 2003/1; • if an amount is owed in respect of the acquisition of a CGT asset, the ‘‘set-off’’ of all or part of that liability constitutes money paid in respect of the acquisition of the asset: Determination TD 2005/52; • in the case of an acquisition paid for in instalments, the cost base includes the totality of the payments required to be made at the time of entering into the contract: Dolby v FCT (2002) 51 ATR 272; • no amount may be included for the value of a taxpayer’s own labour in constructing or creating an asset: CGT Determination TD 60; and • ‘‘initial repairs’’ that are not deductible may form part of the cost base of an asset: see also [9 630] and Determination TD 98/19. See Ruling TR 2005/6 for the cost base consequences of the receipt and payment of lease surrender amounts.

Share transactions The cost base of new shares acquired on a takeover or merger is the market value of the shares exchanged or surrendered, which is determined on the date the bidder company shares are allotted or issued or, in any other case, when they are acquired: Determination TD 2002/4. Market value is considered at [3 210]. The value at which the shares are recorded in the accounts of the company is not the market value of the shares and is not evidence of market value: Ruling TR 2008/5. (See [16 230] for the cost base of the interest acquired if scrip-for-scrip roll-over relief applies.) Note that company formation expenses do not form part of the cost base of a shareholder’s initial shares: ATO ID 2009/1. Ruling TR 2008/5 (para 84-87) sets out the Tax Office’s views on whether a ‘‘set-off’’ is available if a company issues shares for money in circumstances where there is an independent matching obligation on the company to pay money to the shareholder as a cost in relation to an asset. [14 040] Second element – incidental costs The second element of the cost base of a CGT asset is the incidental costs (as defined in s 110-35) incurred by the taxpayer in acquiring the asset, or that relate to a CGT event that happens to the asset: ss 110-25(3) and 110-55(2). Note that there are certain CGT events that 548

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require a capital gain or capital loss to be calculated by reference to incidental costs alone (namely, CGT events D1, E9 and H2: see Chapter 12). The types of incidental costs that may form part of the second element are specifically defined in s 110-35 as follows: • professional fees (see below); • costs of transfer; • stamp duty (or similar duties); • advertising or marketing costs to find a buyer or seller (eg costs incurred by the seller of a property in hiring furniture); • valuation or apportionment costs incurred for CGT purposes; • search fees relating to a CGT asset; • the cost of a conveyancing kit (or a similar cost); • borrowing expenses (eg loan application fees and mortgage discharge fees); • expenditure incurred by the head company of a consolidated group to an entity that is not a member of the group, if the expenditure reasonably relates to a CGT asset held by the head company and is incurred because of a transaction between members of a group (eg stamp duty payable if one member of the group transfers land to another member of the group); and • a termination or similar fee (eg an exit fee) incurred by a taxpayer as a direct result of their ownership of an asset ending, including where the termination fee is withheld from capital proceeds owed to the taxpayer: s 110-35(11). Note that incidental costs can include giving property: see [12 400]. These incidental costs do not form part of the cost base (or reduced cost base) of a CGT asset, nor will they satisfy the expression (relevant to CGT events D1, E9 and H2) ‘‘incidental costs … that relate to the event’’, unless they were incurred to ‘‘acquire’’ a CGT asset or ‘‘in relation to a CGT event’’. For example, the ordinary costs associated with administering a deceased estate would not be regarded as incidental expenses incurred in the acquisition of an asset of the estate by a beneficiary. Incidental costs may also form part of the cost base (or reduced cost base) of an asset if they are incurred after the CGT event, provided they still relate to that event, as there is no requirement for such costs to be incurred during the period of ownership: TD 23. For example, fees paid to a legal adviser by the seller of a business, as a result of an action for damages later brought by the purchaser over the goodwill sold, were considered to be incidental costs that ‘‘relate to a CGT event’’ (see ATO ID 2006/179). See also FCT v Byrne Hotels Qld Pty Ltd (2011) 83 ATR 261 at [15 510]. Note that the costs of subscriptions to share market information services and investment journals are not considered to be ‘‘incidental costs’’ in relation to the acquisition of shares: Determination TD 2004/1 (see also [9 1260]).

Professional fees Professional fees are specifically defined in s 110-35(2) to be remuneration for the services of a surveyor, valuer, auctioneer, accountant, broker, agent, consultant or legal adviser. Such fees must “relate to a CGT event”. However, professional fees cannot be included in the cost base if the CGT event does not happen (see ATO ID 2003/361, ATO ID 2004/150 and ATO ID 2006/179). Note that if the incidental costs are “business expenses” of a capital nature, they may qualify for deduction under the blackhole expenditure rules in s 40-880 ITAA 1997 (see [10 1150]). © 2017 THOMSON REUTERS

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Professional advice about the operation of taxation laws is only included if provided by a recognised tax adviser (see [9 360]): s 110-35(2). As a result, advice about the impact of CGT on the disposal of an asset can form part of incidental costs.

Allocation of incidental costs – multiple asset acquisition If a group of assets is acquired (eg on purchase of a business), the incidental costs are allocated to the assets acquired on a reasonable basis: s 112-30(1A). [14 050] Third element – costs of owning the asset The third element of the cost base of a CGT asset is the non-deductible costs of owning the asset (provided the asset was acquired after 20 August 1991): s 110-25(4). These costs include interest on money borrowed to acquire the asset or to refinance it, interest on money borrowed to finance capital improvements to an asset, repairs and maintenance, insurance premiums, rates and land tax: s 110-25(4). Note that the costs of owning the asset can include giving property: see [12 400]. Third element expenditure is not restricted to ‘‘non-capital’’ expenditure – the key condition is that the expenditure not be deductible. For example, in ATO ID 2007/67, travel and accommodation costs incurred in carrying out initial repairs to an investment (or a residential) property were considered to be third element expenditure (despite initial repairs costs being generally capital in nature: see [9 600]). The costs of becoming an owner of a CGT asset are not part of the costs of owning the asset. Thus, for example, borrowing expenses incurred in obtaining a loan to acquire an asset (as opposed to interest on that loan) are not third element expenditure. Instead, they are second element expenditure: see [14 040]. Note that such borrowing expenses are deductible under s 25-25 if the asset is income-producing: see [9 470]. Third element expenditure is not included in the cost base if the expenditure is a ‘‘tax benefit’’ obtained, or which but for Pt IVA ITAA 1936 would be obtained, unless a compensating adjustment is made under s 177F(3) (see [42 140]): Determination TD 2005/33. This would include the ‘‘interest’’ under the split loan arrangement struck down in FCT v Hart (2004) 55 ATR 712: see [42 130]. Note that the costs of owning the asset are not entitled to indexation if relevant: s 110-36. In addition, they are not included in the cost base of collectables or personal-use assets: ss 108-17 and 108-30. Nor do they form part of the reduced cost base of assets for the calculation of losses: see [14 090]. [14 060] Fourth element – capital expenditure to increase or preserve value The fourth element of the cost base of a CGT asset is capital expenditure incurred by the taxpayer (a) for ‘‘the purpose or the expected effect’’ of increasing or preserving the value of the asset, or (b) which relates to installing or moving the asset: s 110-25(5). The expenditure is not included in the cost base if it is deductible (see [14 080]): s 110-25(5). Note that expenditure can include giving property: see [12 400]. Examples of fourth element expenditure include capital expenditure on improvements, legal and other expenses incurred in fighting a proposed development that would adversely affect the value of the taxpayer’s property and costs incurred in unsuccessfully applying for a rezoning of land or removing a restrictive covenant from land. It can also include the effect of share capital contributions on the value of existing shares held by a taxpayer (see National Mutual Life Association of Australia v FCT (2009) 76 ATR 608). Likewise, Determination TD 2014/14 provides that ‘‘capital support payments’’ made by a parent entity to its subsidiary for the maintenance or enhancement of the capital value of the parent’s investment (direct or indirect) in the subsidiary can be included in the fourth element of the cost base of the investment (but are not deductible). See also ATO ID 2012/46 in relation to an underground power levy. 550

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However, note that capital expenditure incurred in relation to goodwill is not included in the fourth element: s 110-25(5A).

[14 070] Fifth element – capital expenditure to establish or defend title The fifth element of the cost of a CGT asset is capital expenditure incurred by the taxpayer to ‘‘establish, preserve or defend’’ their title to a CGT asset, or a right over the asset: s 110-25(6). Examples of fifth element expenditure include legal costs in confirming the validity of a will under which a taxpayer is bequeathed an asset (ATO ID 2001/729) and an amount paid by a purchaser to terminate a contract of sale in order to retain ownership of an asset: ATO ID 2008/147. In Uratoriu & Anor v FCT (2010) 80 ATR 646, it was held that legal fees incurred in a dispute over real property was fifth element capital expenditure. However, it is questionable whether fifth element expenditure includes expenditure incurred by the holder of a liquor licence or broadcasting licence opposing the grant of further licences to others since such expenditure does not relate to the holder’s licence. Capital expenditure for these purposes would also include giving property: see [12 400]. [14 080] Exclusions from cost base Sections 110-37 to 110-54 list various types of expenditures that cannot form part of the cost base. These are broadly categorised as deductible expenditure, recouped expenditure and other specific items. Deductible expenditure Expenditure that has been or can be deductible is excluded from any element of the cost base. It does not matter whether the taxpayer has claimed the deduction or not. See also Determination TD 2005/47. For CGT assets (and partnership interests) acquired after 7.30 pm on 13 May 1997, capital expenditure (eg on traveller accommodation, buildings, structural improvements, water facilities, horticultural plants, extending telephone lines and connecting mains electricity), in respect of which capital allowance deductions have been or can be claimed under Div 40 or 43 ITAA 1997, are excluded from the cost base of an asset: ss 110-45(2) and 110-55(5). This exclusion also applies to (a) expenditure incurred after 30 June 1999 on land or a building if the land or building was acquired before 7.30 pm on 13 May 1997, and the expenditure forms part of the fourth element of the cost base of the land or building (see [14 060]): s 110-45(1A); and (b) deductible capital expenditure incurred by another entity in respect of the asset, such as if the expenditure has been incurred by a previous owner (but not if the deduction is reversible by an amount being included in assessable income): s 110-45(2), (4). Likewise, if capital expenditure on a building qualified for the former heritage conservation rebate rather than a deduction, the amount that would otherwise have been deductible under various capital allowance provisions (eg Div 43: see [10 1460]) is excluded from the cost base: ss 110-45(6), 110-50(6). Note also that expenditure in respect of which the former landcare and water facility tax offset was chosen does not form part of the cost base: s 110-45(5). Practice Statement PS LA 2006/1 (GA) provides that a taxpayer is not required to reduce the cost base for capital construction expenditure in respect of an asset for which the taxpayer: (a) does not (as a question of fact) have sufficient information to determine the amount and nature of the expenditure (eg if the builder or a previous owner is unable to provide the information, although required to do so by s 262A: see [10 1650]); and (b) does not seek to deduct any amount in relation to the expenditure under Div 43 (or any other provision). Reductions under the commercial debt forgiveness provisions (see [8 700]) are also excluded from the cost base (and reduced cost base) of a CGT asset. Debt deductions © 2017 THOMSON REUTERS

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disallowed by the thin capitalisation rules in Div 820 (see Chapter 38) are also excluded from the cost base: s 110-54. However, expenditure that is deductible under Div 243 (limited recourse debt provisions: see [10 1030]) may form part of the cost base: s 110-45(2). Note that the cost base does not have to be reduced by the amount of the shortfall between a loaned amount used to acquire the asset and the market value of the CGT asset in relation to funds loaned under a limited recourse loan: see ATO ID 2013/64. Importantly, the Commissioner takes the view that if a taxpayer has omitted to claim deductions for amounts which could have been deducted at the time of the CGT event but, when the omission is discovered, can no longer be deducted because the amendment period for the deduction has expired, these amounts can be included in the cost base and the reduced cost base of the asset (eg Div 43 deductions), provided they are within the amendment period for the tax consequences of the CGT event (see [47 170]): Determination TD 2005/47.

Recouped expenditure Recouped expenditure is excluded from the cost base of an asset, except to the extent that the recoupment is included in assessable income (see [6 580]): ss 110-40(3) and 110-45(3). An example of recouped expenditure that is excluded from the cost base of an asset is compensation or damages received in respect of the asset, eg if compensation is received for damage to an asset which is not destroyed (see also Ruling TR 95/35 and [13 070]). Note that, if the recouped amount is included in assessable income (and thus is not excluded from the cost base), it seemingly does not matter that it may be included in assessable income in an income year different to the one in which the capital gain arises. Other specific exclusions For policy reasons, the following amounts are also excluded from any element of the cost base of a CGT asset (ss 110-38(1) to 110-38(7)); • losses or outgoings from illegal activities, to the extent that s 26-54 prevents a deduction for such amounts (see [9 1010]): s 110-38(1); • bribes to a public official or foreign public official: s 110-38(2); • entertainment expenses (see [9 500]): s 110-38(3); • penalties, to the extent that s 26-5 prevents a deduction for such expenditure (see [9 990]): s 110-38(4). This includes penalty interest (see Ruling TR 93/7); • losses on boats, to the extent that s 26-47 prevents a deduction for such amounts (see [9 570]): s 110-38(5); • contributions and gifts to political parties and to individuals who are members of, or candidates in an election for, the Commonwealth, a State Parliament or a local council, to the extent that s 26-22 prevents a deduction (see [9 910]): s 110-38(6); • expenditure incurred on a CGT asset (eg infrastructure improvements) by participants in the Sustainable Rural Water Use and Infrastructure Program, to the extent s 26-100 prevents it being deducted (see [27 310]): s 110-38(8); and • National Disability Insurance Scheme expenditure, to the extent that s 26-97 prevents it being deducted (see [9 1060]): s 110-38(7). Note that the cost base (and reduced cost base) is reduced by any relevant net input tax credit, regardless of when the asset was acquired: s 103-30.

[14 090] Reduced cost base The reduced cost base of a CGT asset is relevant in calculating any capital loss and consists of the following 5 elements (s 110-55(1)): • acquisition costs – the first element: see [14 030]; 552

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[14 100]

• incidental costs – the second element: see [14 040]; • assessable balancing adjustments – the third element: see below; • capital expenditure to increase or preserve the value of the asset, or that relates to installing or moving the asset – the fourth element: see [14 060]; and • capital expenditure to establish or defend title to or a right over the asset – the fifth element: see [14 070]. These elements of the reduced cost base are identical to the elements of the cost base (see [14 020]), except for the inclusion of assessable balancing adjustments (s 110-55(2)) and the exclusion of the “costs of owning” the asset: see [14 050]. Indexation (see [14 030]) does not apply to any element of the reduced cost base. Note that the reduced cost base (and cost base) is reduced by any relevant net input tax credit, regardless of when the asset was acquired: s 103-30.

Assessable balancing adjustments Although depreciating assets are generally exempt from CGT (see [15 080]), adjustments to the cost base of depreciating assets for assessable balancing adjustments are still relevant as CGT event K7 applies to a depreciating asset that has been partially or wholly used for a ‘‘non-taxable purpose’’: see [13 700]. As a result, in such a case, the third element of the reduced cost base restores expenditure which is recouped through the assessable balancing adjustment. Assessable balancing adjustments included in the reduced cost base cover not only amounts included in assessable income for any income year as a balancing adjustment on disposal of an asset (see [10 020]), but also amounts that would have been so included had the taxpayer not chosen to reduce the cost of other assets for depreciation purposes in lieu of including a balancing charge in assessable income (see [10 1320]): s 110-55(3). EXAMPLE [14 090.10] Hamdan acquires a depreciating asset for $100,000. One year’s depreciation at 20% is allowed, ie a deduction of $20,000. The property, which is used during the year for a non-taxable purpose, is sold for $90,000. The reduced cost base is $90,000, calculated as follows: $100,000 (cost) − $20,000 (depreciation deductions) + $10,000 (assessable balancing adjustment) As the sale proceeds ($90,000) equal the reduced cost base, there is no capital loss.

Note also that if Div 58 applies to an asset (ie depreciation of a depreciating asset previously owned by an exempt entity: see [10 430]), with the result that an amount has been included in the taxpayer’s assessable income because of a balancing adjustment, the reduced cost base will include any part of that amount that is deductible because of the decline in value of that asset: s 110-55(3)(a)(ii).

[14 100] Exclusions from reduced cost base Deductible expenditure is excluded from the reduced cost base of a CGT asset in the same way it is excluded from the cost base: s 110-55(4). An amount that would have been deductible if the asset had been wholly used for the purpose of producing assessable income is also excluded from the reduced cost base: s 110-55(5). The exclusion extends not only to ordinary deductible expenses, but also capital allowance under Div 40 and 43 and expenditure that qualified for the former heritage conservation rebate (as per its exclusion from the cost base: see [14 080]). © 2017 THOMSON REUTERS

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Recouped expenditure is also excluded from the reduced cost base, except to the extent that it is included in assessable income (as per its exclusion from the cost base: see [14 080]): s 110-55(6). Likewise, the amounts listed at [14 080] that are specifically excluded from the cost base by virtue of s 110-38 – eg losses or outgoings from illegal activities, penalties, bribes, entertainment expenditure, donations to political parties and National Disability Insurance Scheme expenditure – are also excluded from the reduced cost base: ss 110-55(9A) to 110-55(9H). In addition, if an asset is a share owned by a company, the reduced cost base may be reduced under s 110-55(7). This effectively reduces any capital loss that a controller of a company or an associate of the controller would otherwise incur on the disposal of any share, by the amount of any distribution made by the company that includes franking tax offsets, if the distribution or part of it is attributable to profits derived by the company before the company’s acquisition of the shares. The reduced cost base is reduced by the full or a proportionate amount of the dividend depending on the amount of the tax offset: see the formula in s 110-55(8). In FCT v Sun Alliance Investments Pty Ltd (in liq) (2005) 60 ATR 560, the High Court held that unrealised pre-merger profits of one of 2 subsidiaries attributable to a company’s share portfolio had to be taken into account in determining the reduced cost base of the company’s shares. Finally, the reduced cost base of a CGT asset is also reduced by any deductible revenue loss arising from the realisation of a CGT asset: s 110-55(9). Importantly, the deductible revenue loss must arise as a result of a CGT event that happens in relation to the asset, and therefore will generally only apply to CGT assets that are also revenue assets.

MODIFICATIONS AND SPECIAL RULES [14 150] General modifications – introduction The CGT events themselves (discussed in Chapter 13) identify any modifications required to the cost base or reduced cost base for every CGT event. Cost base adjustments are also required under special provisions (eg under Div 128 on the death of a taxpayer). These are listed in Subdiv 112-B. Section 112-97 also sets out the situations where cost base modifications are required outside the CGT provisions under other sections of the tax law. Examples include under s 70-110 ITAA 1997 when an item is no longer held as trading stock (see [5 250]), under s 26BC ITAA 1936 where a lender acquires a replacement asset (see [32 780]) and under s 412 ITAA 1936 where a CGT asset of a CFC is taken into account in calculating its attributable income etc: see [34 080]. In addition to modifications required by specific CGT events or under special topics or other provisions of the tax law, there are general modifications that apply no matter what the event or topic (subject to any special rules in the CGT event or topic that overrule the modification). These general modifications are discussed at [14 160]-[14 200]. Note that if a modification to the cost base or reduced cost base (or to an element of the cost base) is required, the CGT provisions apply as if the taxpayer had paid that amount: s 112-15. [14 160] Market value substitution rule and exceptions The market value substitution rule replaces the first element (see [14 030]) of the cost base of a CGT asset acquired from another entity with that CGT asset’s market value at the time of its acquisition in any of the following situations (s 112-20(1)): • where no expenditure was incurred to acquire the asset; or • some or all of the expenditure incurred cannot be valued; or 554

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[14 170]

• the taxpayer did not deal at arm’s length with the entity in connection with the acquisition. The expenditure can include giving property: see [12 400]. The meaning of ‘‘market value’’ is discussed at [3 210]. In determining whether parties are dealing with each other at arm’s length, it is the nature of the dealings between the parties that is relevant, and not the nature of the relationship between the parties per se. Accordingly, related parties can deal with each other at arm’s length (eg Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123), while unrelated parties may not always deal with each other in an arm’s length manner (eg Collis v FCT (1996) 33 ATR 438). See also Healey v FCT (2012) 91 ATR 671, discussed at [13 020] and [5 260]. In the case of ‘‘non-arm’s length’’ dealings where the asset is a share in a company or a unit in a unit trust that is allotted to the taxpayer by the company or trust, market value is only substituted if the payment to acquire the share or unit was more than its market value at the time of its acquisition (for allotment or issues occurring from 16 August 1989): s 112-20(2). Note taxpayers can apply to the Tax Office for a ‘‘market value’’ private ruling (see also [3 210] and [45 160]).

Exceptions In the case where the taxpayer did not pay or give anything to acquire the following assets, s 112-20(3) provides that the market value substitution rule for the cost base of an asset does not apply: • a right to receive income from a trust (except a unit trust or a trust that arises because of someone’s death), provided the taxpayer did not pay or give anything for the right and did not acquire the right by way of an assignment from another entity; • a decoration awarded for valour or brave conduct; • a contractual or other legal or equitable right resulting from CGT event D1 happening; • rights to acquire shares or options in a company or rights to acquire units or options in a unit trust if Subdiv 130-B (see [17 380]) applies to the rights; • a share in a company, or a right to acquire a share or debenture in a company, that was issued or allotted to the taxpayer by the company; • a unit in a unit trust, or a right to acquire a unit or debenture in a unit trust, that was issued to the taxpayer by the trustee of the unit trust; and • a right to dispose of a share in a company (ie a put option) that was issued by the company and was exercised by the shareholder or another person who became the owner of the right (this does not apply to rights issued before 1 July 2001).

[14 170] Split, changed or merged assets If 2 or more assets have been merged, or an asset has been divided into 2 or more assets or an asset has changed into an asset of a different nature, and there is no change in the beneficial ownership of the asset, the rules in s 112-25 apply for the purpose of calculating the cost base and reduced cost base of the changed assets. Note that no CGT event is taken to happen in any of these situations. With split or changed assets, each element of the cost base and reduced cost base of the original asset is simply apportioned in a reasonable manner to each new asset: s 112-25(3). With merged assets, each element of the original assets is simply added together to form the corresponding element of the cost base or reduced cost base of the new asset: s 112-25(4). © 2017 THOMSON REUTERS

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An example of the circumstances in which these provisions might operate is the conversion of a block of flats under one title to strata title. The appropriate cost base elements of each flat would be a proportional share of the cost base elements of the whole block at the time of conversion (but see [16 130] for roll-over relief on strata title conversions). Another example would be the subdivision of land: see Determination TD 97/3. Note also that the costs of subdivision would prima facie be allocated on a proportionate basis between the subdivided lots.

[14 180] Partial acquisitions or disposals – apportionment Section 112-30 provides that an apportionment of the cost base and reduced cost base of a CGT asset is required if: • more than one asset is acquired in a single transaction; • an asset is acquired as part of a broader transaction; or • only part of an asset is subject to a CGT event. The first 2 situations are dealt with together and require that the money paid or property given be allocated on a reasonable basis to the acquisition costs (ie the first element) of the cost base and reduced cost base of the relevant CGT asset (see [14 030]): s 112-30(1). A similar attribution applies if only part of expenditure relates to other elements of the cost base and reduced cost base of a CGT asset (eg incidental costs of acquisition): s 112-30(1A).

Partial disposals If a CGT event only happens to part of a CGT asset (eg if a storm destroys part of a CGT asset, or if part of a CGT asset is compulsorily acquired: see Determination TD 2001/9), there is an apportionment of the various elements of the cost base and reduced cost base of the whole asset: s 112-30(2). Each element of the cost base and reduced cost base is apportioned in the same proportion as the amount of the capital proceeds from the event bears to the sum of those proceeds plus the market value of that part of the asset that is not affected by the CGT event: s 112-30(3). (Market value is considered at [3 210].) This is set out in the formula in s 112-30(3)) as follows: Capital proceeds for CGT event Capital proceeds for CGT event plus market value of remaining part of asset

×

Cost base = Cost base of part to which event happened

EXAMPLE [14 180.10] Madison acquires a property for $140,000. Part of the property is subject to a CGT event and Madison receives capital proceeds of $80,000. The rest of the property which Madison still owns has a market value of $120,000. The cost base of the part disposed of is calculated as follows: 80,000 × $140,000 = $56,000 80,000 + 120,000

The remainder of the cost base is attributable to that part of the CGT asset that is not affected by the CGT event (ie the part ‘‘that remains’’): s 112-30(4). However, an amount forming part of the cost base or reduced cost base of the asset is not apportioned under this rule if, on the facts, that amount is wholly attributable to the part to which the CGT event happened or the remaining part: s 112-30(5). This may be the case if, for example, a demountable building with its owned specific cost is subject to a CGT event such as being removed from land. For the disposal of separate rights arising under the one contract, see Determination TD 93/86. 556

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[14 230]

[14 190] Assumption of liability rule If a taxpayer acquires a CGT asset that is subject to a liability, the first element of the cost base and reduced cost base (acquisition costs: see [14 030]) includes the amount of the liability assumed by the taxpayer: s 112-35. EXAMPLE [14 190.10] Roslyn acquires a block of land for $150,000. She pays $50,000 and assumes a liability for an outstanding mortgage of $100,000. The first element of Roslyn’s cost base and reduced cost base is $150,000.

[14 200] Put options The cost base of a put option (eg a right to dispose of a share in a company) that was acquired by a taxpayer as a result of CGT event D2 happening to the company (see [13 160]) is any amount included in the taxpayer’s assessable income as a result of the acquisition of the right plus any amount paid to acquire the right: s 112-37. Note that an amount will not be included in assessable income if it is exempt under s 59-40 ITAA 1997: see [17 230].

[14 210] Earnout arrangements Under ‘‘eligible’’ earnout arrangements, where a business asset is acquired by a purchaser under a ‘‘standard’’ earnout arrangement, the value of any ‘‘look-through earnout right’’ given in exchange by the purchaser can be elected to be excluded from the cost base of the asset acquired by the purchaser until such time as an amount under the earnout is actually paid by the purchaser (provided it is paid within 5 years of the income year in which the sale or disposal occurs): s 112-36(1). Likewise, the cost base will be reduced by the amount of any financial benefit that is refunded to the purchaser from the vendor under a ‘‘reverse’’ earnout arrangement. Note that any capital gain or loss relating to the creation of the earnout right in the vendor by the purchaser (pursuant to CGT event D1) is disregarded: see [13 150]. Note also that the purchaser may be able to remake any choice to apply any relevant CGT concessions: s 112-36(2). Transitional rules will preserve the income tax status of taxpayers that have reasonably and in good faith anticipated changes to the tax law in this area as a result of Government announcements. See [17 335] for further details of the CGT treatment of ‘‘eligible’’ earnout arrangements.

[14 220] Share acquired in ‘‘ESIC’’ Under the concessions for shares acquired in a ‘‘Early Stage Innovation Company’’ (ESIC), where such shares have been continuously been held for at least 10 years they will receive a market value cost base at that 10-year date: see [11 200].

[14 230] Cost base reset for super $1.6m transfer balance cap Under the superannuation measures introducing the ‘‘$1.6m transfer balance cap’’ for the retirement phase of pensions, transitional CGT arrangements apply to enable complying superannuation funds to choose to reset the cost base of assets that are reallocated or re-proportioned from the retirement phase to the accumulation phase before 1 July 2017. This ensures that CGT will not apply to unrealised capital gains that have accrued on assets that were used to support superannuation income streams up until 30 June 2017. See [41 200] for further details. © 2017 THOMSON REUTERS

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CAPITAL PROCEEDS [14 250] Capital proceeds Section 116-20(1) provides that the capital proceeds from a CGT event (if no modifications or special rules apply) is the total of: (a) money the taxpayer has received or is entitled to receive in respect of the CGT event happening; and (b) the market value of any other property the taxpayer has received or is entitled to receive in respect of the CGT event happening (market value is considered at [3 210]). The question of what the taxpayer is ‘‘entitled to receive’’ is determined by the terms of the relevant contract(s). In Re Taxpayer and FCT (2006) 62 ATR 1043, the AAT found that if there is a contingency in the contract for repayment by the vendor of part of the sale proceeds, the amount the taxpayer will be ‘‘entitled to receive’’ will be the amount originally received reduced by the amount of that repayment. Note that this differs from a reduction in capital proceeds under s 116-50 (for an amount that the taxpayer is required to repay) in that a repayment under s 116-50 occurs independently of the original contract of sale: see [14 290]. In Lend Lease Custodian Pty Ltd v DCT (2006) 65 ATR 455, the Federal Court held that the taxpayer’s right to continue to receive dividends on shares the taxpayer had sold at a discount under a ‘‘forward purchase agreement’’ did not constitute ‘‘property other than money’’ for the purposes of the ITAA 1936 equivalent of s 116-20(1) (s 160ZD(1)). This was essentially because the taxpayer was not entitled to receive that right ‘‘in respect of the CGT event happening’’, but rather because that equitable right automatically remained with the taxpayer until settlement, regardless of the arrangement between the parties. On the other hand, a ‘‘payment by direction’’ clause, whereby the purchaser was required to pay part of the capital proceeds to a party related to the vendor, did not affect the capital proceeds that the vendor was ‘‘entitled to receive’’ in terms of s 116-20: see Quality Publications Australia Pty Ltd v FCT (2012) 88 ATR 145. Note that s 116-20(5) provides that capital proceeds from a CGT event are to exclude any GST payable if the capital proceeds also constitute consideration for a taxable supply. Ruling TR 2010/4 provides that a dividend paid by a company will be included in the capital proceeds received by a shareholder who disposes of shares in the company under a contract or a Scheme of Arrangement, if the shareholder has bargained for the receipt of the dividend (whether or not in addition to other consideration) in return for the transfer of the shares. This may typically happen if the payment of the dividend is funded by the purchaser of the shares by way of lending money to the company to allow it to make the payment. Note that on the expiry, surrender or forfeiture of a lease, the capital proceeds include any amount that the lessor pays to the taxpayer as lessee for improvements to the leased property: s 116-75. [14 260] Market value substitution rule and exceptions The market value of a CGT asset is substituted as the capital proceeds for a CGT event if (s 116-30): • there are no capital proceeds; • some or all of the capital proceeds cannot be valued (see Determination TD 1999/84 for the meaning of ‘‘proceeds cannot be valued’’); or • the asset was disposed of in a non-arm’s length dealing. In determining whether parties are dealing with each other at arm’s length, it is not a matter of the relationship between the parties that is relevant but rather a matter of the nature of the dealings between the parties in the circumstances. Accordingly, related parties can deal with each other at arm’s length (eg Trustee for the Estate of the late AW Furse No 5 Will Trust v FCT (1990) 21 ATR 1123), while unrelated parties may not always deal with each other in 558

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[14 260]

an arm’s length manner. For example, in Collis v FCT (1996) 33 ATR 438, the Federal Court held that the ‘‘indifference’’ of an unrelated purchaser to the allocation of consideration to different lots of land meant that the parties were not dealing with each other at arm’s length. See also [5 260]. The market value of an asset is generally GST-exclusive: s 960-405. Market value is considered at [3 210]. Note taxpayers can apply to the Tax Office for a market value private ruling: see [45 160]. If a practitioner shareholder is leaving or joining a ‘‘no goodwill’’ incorporated professional practice, the Commissioner will accept that the shares have a market value of nil if certain conditions are satisfied. See ‘‘Administrative treatment: acquisitions and disposals of interests in ‘no goodwill’ professional partnerships, trusts and incorporated practices’’ (available on the ATO website), which replaced Determination TD 2011/26. Note that the membership interests in a subsidiary member of a consolidated group can be recognised for the purpose of applying the market value substitution rules: Determination TD 2004/41.

Exceptions The market value substitution rule does not apply if CGT event C1 (loss or destruction of a CGT asset: see [13 070]) happens and no capital proceeds are received: s 116-25, Item C1. This will be relevant, for example, on the destruction of uninsured property. Nor does the rule apply if no capital proceeds are received and CGT event C2 (end of intangible asset: see [13 080]) happens in the form of the ‘‘expiry’’ of an intangible CGT asset or the ‘‘cancellation of a statutory licence’’: s 116-30(3)(a). Note that Determination TD 1999/76 states that the term ‘‘expiry’’ of a CGT asset is limited to an expiry by way of ‘‘effluxion or lapse of time’’ (such as when the specified time period of a lease expires). In all other cases where CGT event C2 happens and the market value has to be worked out, it is done so as if the event never happened and the asset still existed. This prevents the taxpayer from claiming a capital loss by arguing that because the asset has ended it has no market value: s 116-30(3A). This would typically occur where a debt owed by a solvent debtor is forgiven or where shares are cancelled. The market value substitution rule does not apply if CGT event C2 happens in relation to a share in a widely held company or a unit in a widely held unit trust in circumstances where the capital proceeds received differ from the market value of the shares or units: s 116-30(2B). For these purposes, a ‘‘widely held’’ company or unit trust means a company or unit trust that has at least 300 members or unit holders that does not have ‘‘concentrated ownership’’. ‘‘Concentrated ownership’’ will occur if one or more individuals (up to a maximum of 20) own between them shares or units that carry fixed entitlements to at least 75% of the income or capital of the company or trust, or that carry at least 75% of the voting power in the company or trust (including if the constituent documents allow the rights attaching to the interests in the entity to be varied in such a way to create concentrated ownership): s 116-35. The market value substitution rule also does not apply if a contractual or other right is created under CGT event D1 (see [13 150]), and no capital proceeds are received: s 116-30(3). Nor does the rule apply if a share in a ‘‘no goodwill’’ incorporated professional practice is disposed of for no consideration (so that the goodwill of the company can be taken to have no value) under an arm’s length transaction for admission to, and exit from, the professional practice in the natural ‘‘ebb and flow’’ of natural person practitioner shareholders into and out of the company: Determination TD 2011/26. Note that the membership interests in a subsidiary member of a consolidated group can be recognised for the purpose of applying the market value substitution rules: Determination TD 2004/41. © 2017 THOMSON REUTERS

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Importantly, the market value of an asset is generally GST-exclusive: s 960-405. Market value is considered at [3 210].

[14 270] Apportionment rule Capital proceeds are to be apportioned on a reasonable basis if the capital proceeds relate to more than one CGT event or to a CGT event and something else: s 116-40. Note that in Gerard Cassegrain & Co Pty Ltd v FCT (2007) 66 ATR 198, the Federal Court took the view that the requirement to apportion (under the predecessor to s 116-40) applied instead of the undissected lump sum principle (discussed at [6 500]). [14 280] Non-receipt rule Capital proceeds are reduced by any amount owed that is unlikely to be received provided the taxpayer takes reasonable steps to recover it: s 116-45(1). If the taxpayer subsequently receives the unpaid amount, the capital proceeds are increased by that amount: s 116-45(2). Note that the debt for the amount owing is not considered to be a CGT asset in these circumstances: s 116-45(3). Importantly, where s 116-45 applies, s 170(10AA) of ITAA 1936 allows relevant assessments to be amended at any time for this purpose. [14 290] Repaid rule Capital proceeds are reduced by any non-deductible amount a taxpayer has to repay (eg by way of compensation): s 116-50. Contrast this ‘‘repaid rule’’ with the amount of capital proceeds that the vendor of an asset is ‘‘entitled to receive’’ under s 116-20, and which instead may be reduced under the terms of the contract that gave rise to the CGT event: see [14 250]. [14 300] Assumption of liability rule Capital proceeds from a CGT event are increased by the amount of any liability by way of security over the asset assumed by the purchaser under the contract. EXAMPLE [14 300.10] Ranjiv sells land for $400,000. He receives $300,000 from the purchaser, who also becomes liable for an outstanding mortgage of $100,000. The capital proceeds are increased to $400,000 by the purchaser’s assumption of liability for the $100,000 mortgage.

[14 310] Misappropriated amounts Capital proceeds are reduced by any amount that is misappropriated by the taxpayer’s agent or employee (whether by theft, embezzlement, larceny or otherwise): s 116-60. If all or part of the misappropriated amount is later recouped, the capital proceeds will be increased by the amount received: s 116-60(3). The debt for the amount misappropriated is deemed not to be a CGT asset: s 116-60(4). Note that there is a 4-year period for amending an assessment if the misappropriation is discovered, or a recoupment received, after the income tax return for the relevant income year is lodged: s 116-60(5). [14 320] Special rules There are a number of special rules that apply to capital proceeds. The circumstances in which they apply are set out below and the consequences are covered in the sections indicated. CGT event A1 – disposal of asset If CGT event A1 is the giving of a gift of property for which a valuation is obtained from the Commissioner under s 30-212 for income tax deduction purposes (see [9 350]), the taxpayer will be able to choose to replace the capital proceeds from the event with that valuation of the property: s 116-100. 560

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[14 350]

Company or trust owning collectable or personal-use asset If a taxpayer disposes of shares or an interest in a trust and the capital proceeds reflect a fall in the market value of collectables or personal-use assets (other than a car, motor cycle or similar vehicle) of the company or trust, the market value of the shares or interest is determined as if that fall had not occurred: s 116-80. See also [13 650] and [13 680]. Receipt of deemed dividend under s 47A The capital proceeds from a CGT event that happens to a CGT asset owned by a taxpayer are reduced if the taxpayer acquired the asset from a company or CFC that obtained roll-over relief for its disposal and, in relation to that disposal, the taxpayer or another entity received an assessable deemed dividend under s 47A ITAA 1936 (distribution by a CFC resident in an unlisted country: see [34 350]): s 116-85. CFC changes residency from unlisted to listed country The capital proceeds are adjusted if a CGT event happens to an asset that the taxpayer acquired from a CFC that held it since changing residency from an unlisted country to a listed country: s 116-95. See also [18 190]. Investments in forestry MIS If a CGT event happens in relation to an investor’s interest in a ‘‘forestry managed investment scheme’’, the proceeds are treated as ordinary income and not as a capital gain. These proceeds will either be the market value of the interest or a lesser amount measured by reference to the decline in value of the interest or deductions claimed under the scheme – depending on whether the investor is an ‘‘initial’’ investor or a ‘‘subsequent’’ investor, or whether the CGT event resulted in the entire disposal of the interest. [14 330] Earnout arrangements Under ‘‘eligible’’ earnout arrangements, where capital proceeds are received on the sale or disposal of a business asset under a ‘‘standard’’ earnout arrangement, s 116-120(1) provides that the value of any “look-through earnout right” received can be elected to be excluded from the capital proceeds. However, the capital proceeds are later increased by any future ‘‘financial benefit’’ that is received within 5 years of the income year in which the sale or disposal occurs. Likewise, the capital proceeds are reduced by any financial benefit that the vendor is required to provide or repay to the purchaser under an eligible ‘‘reverse’’ earnout right. This means that the capital gain or capital loss made by the vendor on the sale of the business will be recalculated to take account of the financial benefit. Note that any capital gain or loss relating to the ending of an earnout right (pursuant to CGT event C2) on the receipt of earnout payments will be disregarded: see [13 080]. Note also that the vendor may be able to remake any choice to apply relevant CGT concessions: s 116-120(2). Transitional rules will preserve the income tax status of taxpayers that have reasonably and in good faith anticipated changes to the tax law in this area as a result of Government announcements. See [17 335] for further details of the CGT treatment of ‘‘eligible’’ earnout arrangements.

CALCULATION OF GAINS AND LOSSES [14 350] Introduction It is necessary to determine whether a capital gain or capital loss has arisen from a CGT event, as any ‘‘net capital gain’’ for the income year is required to be included in a taxpayer’s assessable income: s 102-5(1). Every CGT event has its own rules for determining whether a © 2017 THOMSON REUTERS

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capital gain or capital loss has arisen from the event and how it is calculated by reference to the cost base (in the case of capital gains) or reduced cost base (in the case of capital losses) of the asset and the capital proceeds received. The ‘‘net capital gain’’ made in the income year is the sum of all capital gains made during the income year, reduced by any capital losses from that year and unused capital losses from previous income years: see [14 360]. The CGT discount (or indexation where relevant) may be available to reduce the amount of the net capital gain to be included in assessable income: see [14 390]. Likewise, the CGT small business concessions may apply to further reduce or eliminate an assessable capital gain: see [15 500]-[15 590].

[14 360] Net capital gain A net capital gain made by a taxpayer in the income year is included in their assessable income: s 102-5(1). This requires capital gains made during the year to be reduced by any capital losses from that year and unused capital losses from previous income years. For the treatment of capital gains made by trusts, see [17 020]-[17 090]. Calculation of a net capital gain The method statement in s 102-5(1) sets out the 5 steps required to calculate a taxpayer’s net capital gain for an income year. Step 1 – reduce the capital gains made during the income year by any capital losses made during the year. If there is more than one gain in the income year, the taxpayer can choose the order in which the gains are reduced by the capital losses. (Note: the best result will usually arise by applying capital losses first to gains that do not qualify for the CGT discount.) Step 2 – if any gains remain after applying current year capital losses, any prior year net capital losses (see [14 370]) are then applied. Again, the taxpayer can choose which gains to reduce by prior year capital losses, subject to applying the capital losses in the order in which they arose. Step 3 – the CGT discount (see [14 390]) is applied to any capital gains that remain, if relevant. Step 4 – if the taxpayer also qualifies for the CGT small business concessions (see [15 500]-[15 590]) in relation to any of the gains, they are applied to the gain that remains after applying Steps 1 to 3. (Note: if a gain qualifies for the 15-year exemption (see [15 560]), it will apply in priority to eliminate the whole gain completely, without first having to apply capital losses or the discount.) Step 5 – the amount of the capital gains remaining after Step 4 are added up to arrive at the taxpayer’s ‘‘net capital gain’’ for the income year. EXAMPLE [14 360.10] Trixie has a carried forward capital loss of $5,000 from Year 1. In Year 3, she makes a capital gain of $14,000 on shares owned for more than 12 months (a ‘‘discounted’’ capital gain) and a capital gain of $1,000 on shares owned for less than 12 months (a ‘‘non-discounted gain’’ as it does not qualify for the CGT discount). In Year 3 she also has a capital loss of $400 from the sale of shares. Using the discount method, Trixie can calculate her CGT liability as follows: Option 1 (applying capital losses to ‘‘non-discounted’’ gains first) Non-discounted capital gain Current year capital loss applied Non-discounted capital gain balance Prior year capital loss applied

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Available carry-forward loss Discounted capital gain Discounted capital gain (c/f capital loss applied) Assessable net capital gain (50% discount applied)

[14 370]

$ (4,400) 14,000 9,600 4,800

Option 2 (applying capital losses to ‘‘discounted’’ gains first) Current year capital loss applied Non-discounted capital gain balance Prior year capital loss applied Discounted capital gain (p/y capital loss applied) Discounted capital gain (50% discount applied) Non-discounted capital gain Assessable net capital gain

$ (400) 13,600 (5,000) 8,600 4,300 1,000 5,300

Accordingly, Trixie should use Option 1 to calculate her CGT liability for Year 3 (ie applying the capital loss against the ‘‘non-discounted’’ gains first).

EXAMPLE [14 360.20] In the income year, Geoffrey makes a capital gain of $5,000 from the sale of investment shares he held for 2 years and $60,000 from the sale of a small business he owned for 10 years. He also makes a capital loss of $11,000. Before applying the CGT discount to both sets of gains and the small business concessions to the $60,000 gain, Geoffrey must first reduce the gains by the capital loss. In doing so, he can choose which gains to reduce first. (In this case, it would be probably best to first apply the capital losses to the $5,000 gain, as the $60,000 gain can be reduced or eliminated by the application of the small business concessions.) In doing so, Geoffrey reduces his share investment gain to nil and his small business gain to $54,000 (ie $60,000 less the $6,000 balance of the capital loss). He then applies the 50% discount to this gain, leaving him with a net capital gain of $27,000. This, in turn, can be reduced or eliminated by the small business concessions: see [15 500] and following. If the $60,000 gain qualified for the 15-year exemption (see [15 560]), this concession would be applied to the gain without the need to apply capital losses or the discount. In this case, the capital losses of $11,000 would be applied to reduce the share investment gain of $5,000 to nil, leaving a carried forward capital loss of $6,000. Note that revenue losses can be offset against any assessable net capital gains. For the treatment of capital gains made by trusts, see [17 020]-[17 090].

[14 370] Net capital loss Section 102-10 provides that if the total of capital losses made during the income year exceeds the total of capital gains made during the year, a net capital loss equal to the amount of the excess exists for that income year. This can be summarised as: Net capital loss = Current year capital loss(es) − Current year capital gain(s)

A net capital loss incurred by a taxpayer in an income year is not an allowable deduction and cannot be offset against revenue income in calculating taxable income: s 102-10(2). Instead, it must be ‘‘quarantined’’ and carried forward to reduce or eliminate any future capital gains. Note that Taxpayer Alert TA 2009/12 warns against re-characterising capital losses on shares as revenue losses.

Application of net capital losses Each net capital loss (or part thereof) retains its identity as a net capital loss for the income year in respect of which it was originally incurred. In using net capital losses of © 2017 THOMSON REUTERS

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previous income years, the net capital losses are applied in the order in which they were made (ie earlier years first): s 102-15. A net capital loss can be applied only to the extent that it has not already been utilised: s 960-20. In any year in which all or part of any still unapplied net capital losses of previous years cannot be applied as an offset (because current year capital gains do not sufficiently exceed current year capital losses), such unapplied net capital losses are available to be carried forward into future income years for utilisation. Net capital losses are therefore carried forward indefinitely until they are applied as an offset as part of determining whether there is a net capital gain for an income year: s 102-15. However, any unused net capital losses expire on the death of a taxpayer: Determination TD 95/47. EXAMPLE [14 370.10] Jerry has the following capital gains and losses for each of the income years indicated: Year 1 – – – Year 2 – – – – Year 3 – – –

Capital gains Capital losses Net capital loss Capital gains Capital losses Net capital loss – Capital gains Capital losses Net capital gain

– –

– = = – – = = – – = =

Nil $12,000 $12,000 $20,000 $25,000 $25,000 − $20,000 $5,000 $14,000 $8,000 $14,000 − $8,000 − $6,000 (from Year 1) Nil

Net capital losses carried forward: Year 1 –

–

Year 2 –

=

$12,000 − $6,000 = $6,000 (unapplied amount) $5,000

Note: The capital losses (including the unapplied amount of $6,000 from Year 1) retain their identity as a capital loss attaching to the income year in which they were originally incurred.

[14 380] Restriction on use of net capital losses A net capital loss, or the use of capital losses, may be disregarded or is subject to special rules for certain taxpayers or in certain circumstances, as explained below. For the treatment of capital losses made by trusts, see [17 020]-[17 090].

Collectables and personal-use assets The special rules that apply to the quarantining of capital losses on ‘‘collectables’’ and the denial of capital losses on ‘‘personal-use assets’’ are explained at [12 180].

Exempt taxpayers and exempt income uses Charities, non-profit organisations and other entities whose ordinary and statutory income is exempt from income tax under Div 50 ITAA 1997 (see [7 350] and following) are not liable for CGT and, therefore, there is no use for capital losses or net capital losses. A capital loss (or capital gain) made by a taxpayer from a CGT asset that the taxpayer used solely to produce exempt income or ‘‘non-assessable non-exempt’’ income (see [7 700]) is disregarded unless the use was for producing certain excluded categories of non-assessable non-exempt income: s 118-12: see [15 040]. 564

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[14 390]

A capital loss a lessee makes from the expiry, surrender, forfeiture or assignment of a lease (except one granted for 99 years or more) is disregarded if the lessee did not use the lease solely or mainly for the purpose of producing assessable income: s 118-40.

Bankruptcy If, in an income year, a taxpayer becomes bankrupt or is released from debts under bankruptcy law or if a bankruptcy is annulled under s 74 of the Bankruptcy Act 1966, net capital losses arising in earlier income years are disregarded in determining whether a net capital gain is made in the year the bankruptcy or release occurs, or in any subsequent income year: s 102-5(2) and (3). However, if a taxpayer subsequently pays all or part of a debt that was taken into account in working out the amount of a net capital loss that was denied under the above rules, CGT event K2 will reinstate some or all of the denied amount as a new capital loss in the year such a payment is made: see [13 650]. Companies Importantly, a company’s ability to carry forward capital losses is subject to similar restrictions that apply to the carry forward of revenue losses (ie the continuity of ownership and same business tests, discussed at [20 320] and following). However, the continuity of ownership test will be considered to have been met where a shareholder dies, provided the shares are owned by either the trustee of the deceased person’s estate or a beneficiary of the estate. Note there appears to be a similar ‘‘continuity’’ requirement for trusts. For example, in FCT v Clark (2011) 79 ATR 550, the Full Federal Court confirmed that there was no ‘‘break in continuity’’ of a trust between the time it incurred an earlier capital loss and the time it made a later capital gain, for the purpose of carrying forward and offsetting the capital loss. See also [23 030]. There are also anti-avoidance provisions dealing with artificially created capital losses involving members of company groups: see [17 550]. However, under the consolidation regime the ability to transfer capital losses between group companies is limited: see [24 160] and following. Wash sales to crystallise capital losses The Commissioner’s views on the application of Pt IVA to the disposal of CGT assets in order to crystallise capital losses to offset against capital gains are found in Ruling TR 2008/1. The ruling, in effect, provides that Pt IVA will apply to any disposition of CGT assets by a taxpayer to either a related or unrelated party, in circumstances where there has been no substantive change in the commercial position of the taxpayer (and/or related entities) and where it is established (on an objective basis) that the generation of the loss was a dominant purpose for the transfer: see also [42 220]. Commercial debt forgiveness A prior year net capital loss may be reduced under the commercial debt forgiveness provisions: see [8 700]. Beneficiary entitled to foreign gain Draft Determination TD 2016/D5 states that where an amount included in a resident beneficiary’s assessable income under s 99B(1) ITAA 1936 has its origins in a capital gain from property of a foreign trust that is not ‘‘taxable Australian property’’ (see [18 100]), the beneficiary cannot use current or prior year capital losses (or the CGT discount) in relation to the amount. [14 390] CGT discount – general An assessable capital gain may be reduced by the CGT discount in Div 115: s 115-15. However, if the CGT asset in question was acquired before 11.45 am on 21 September 1999, © 2017 THOMSON REUTERS

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the taxpayer can chose to use either the CGT discount method or the indexation method (frozen as at 30 September 1999): ss 110-36, 114-5. Note also the abolition of the 50% CGT discount for foreign residents: see [14 405]. The CGT asset must have been held by the taxpayer for at least 12 months for the CGT discount method to be available: see [14 400]. If the discount method is used, current year and prior year capital losses must first be offset against capital gains before applying the discount: see s 103-5. Note that if an asset is taken to have been acquired for the indexed cost base, the indexation component is ignored for the purpose of calculating the gain eligible for the discount. Note that the non-assessable concession amount of a discount capital gain is not exempt income. As a result, deductible losses do not have to be first offset against that amount (see [8 480]): see withdrawn ATO ID 2004/120.

Rate of discount – individuals, trusts, super funds If the taxpayer is an individual or a trust (excluding a complying superannuation entity), the CGT discount method applies to include only 50% of the capital gain in assessable income: s 115-100(a). However, the discount is not available if the trustee is assessed under ss 98(3), 98(4) or 99A ITAA 1936: see Chapter 23. The CGT discount is also available to the beneficiary of a trust in respect of their share of the trust’s discounted capital gain (see below). For a superannuation fund or a life insurance company that makes a gain from a complying superannuation asset (see [30 100]), the CGT discount is 33.33% (ie 66.66% of the capital gain is included in assessable income): s 115-100(b). Note that ATO ID 2003/48 states that the 50% discount applies to a non-complying superannuation fund that is a trust. Note that for assets acquired after 31 March 1987, the discount method is likely to give the most tax effective result for individuals and trustees (depending on the size of the gain, how long the asset was held and the availability of capital losses). Companies The CGT discount is not available to companies: s 115-10. As a result, a company must include the full net capital gain in assessable income. However, companies can use the indexation method (as frozen at 30 September 1999) if the CGT asset was acquired before 11.45 am on 21 September 1999 (and held for at least 12 months): ss 114-1 to 114-10. Note that the CGT discount is available to certain shareholders in ‘‘listed investment companies’’: see below. The CGT discount is also available to life insurance companies in relation to a capital gain from a CGT event in respect of a CGT asset that is a complying superannuation asset: see [30 100]. Beneficiaries of a trust The CGT discount is also available to a beneficiary of a trust. However, beneficiaries are required to gross-up their share of the trust’s discounted capital gain by 100% for the purposes of first offsetting any personal capital losses against the gain before applying the CGT discount: see [14 360]. Further, any distribution of the tax-exempt CGT discount amount made by the trust to an individual beneficiary (including through an interposed trust) will not trigger CGT event E4: see [13 230]. See ATO ID 2010/84 for the effect of the CGT discount if the trustee of a unit trust transfers trust property to unit holders: see also [13 230]. For rules that apply to streaming capital gains from a trust to a “specified” beneficiary, see [17 050]. If the beneficiary of a resident trust is a non-resident trustee beneficiary, the trustee of the resident trust will be assessed under s 98(4) in respect of the beneficiary’s share of the net income of the trust attributable to Australian sources (see [23 450]) but the CGT discount will not be available to the trustee in this case: s 115-222. Nevertheless, the beneficiary can apply the discount on assessment (if applicable) and claim a credit for the tax paid by the trustee: see [23 150]. Where an amount included in a resident beneficiary’s assessable income under 566

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[14 400]

s 99B(1) ITAA 1936 has its origins in a capital gain from property of a foreign trust which is not ‘‘taxable Australian property’’ (see [18 100]), the beneficiary cannot use the CGT discount (or current or prior year capital losses) in relation to the amount: Draft Determination TD 2016/D5.

Shareholders in Listed Investment Companies Shareholders in Listed Investment Companies (LICs) are generally allowed to reduce the eligible capital gain component of a dividend paid to them by the CGT discount. This is achieved by classifying certain capital gains made by an LIC as an LIC capital gain and then allowing shareholders in the LIC a deduction that reflects the CGT discount the shareholder could have obtained if they had made the capital gain directly: ss 115-280, 115-285. The operation of these rules is explained in Ruling TR 2005/23. [14 400] CGT discount – 12-month holding rule To qualify for the CGT discount, a CGT asset must have been owned by the taxpayer for at least 12 months: s 115-25. The 12-month period does not include the day of acquisition and the day of disposal: Determination TD 2002/10. The 12-month holding rule means that generally capital gains made from CGT events that create an asset in another entity cannot qualify for the discount. Accordingly, the following CGT events do not qualify for the discount: CGT events D1, D2, D3, E9, F1, F2, F5, H2, J2, J5, J6 and K10: s 115-25(3). See [13 720] for the application of this rule to CGT event K9. Roll-overs In the case of assets subject to roll-overs (see Chapter 15), the general rule is that the ‘‘combined period of ownership’’ is taken into account in determining if a rolled-over asset or a replacement asset has been owned for more than 12 months: s 115-30, items 1 and 2. This rule also applies to replacement assets acquired under the small business roll-over in Subdiv 152-E: see [15 590]. However, the general rule is subject to certain modifications in the case of particular roll-overs. In the case of the Div 122 roll-over (roll-over to wholly owned company: see [16 020]-[16 060]), the shares acquired in exchange for the transfer of the asset/s to the company will be deemed to have been held for 12 months even if they are subject to a CGT event within 12 months of their acquisition: s 115-34. Note that the asset transferred to the company will not be entitled to the CGT discount as the CGT discount is not available to companies: see [14 390]. In the case of replacement asset roll-overs (see [16 100]-[16 270]), the combined period of ownership of the original asset and the replacement asset is taken into account in determining if the 12-month holding rule is satisfied for the replacement asset: s 115-30(1), Item 2. If a taxpayer acquires a replacement interest in a company or trust under a replacement asset roll-over, that replacement interest will be treated as having been held for more than 12 months if, in terms of the integrity tests in s 115-45(4) and (5) (see [14 410]), the cost bases and the net capital gains of assets of the original entity that have been owned for less than 12 months are not more than 50% of the cost bases and net capital gains of all the original entity’s assets: s 115-32. But in the case of the Subdiv 124-N roll-over (fixed trust to company: see [16 240]), the replacement share will be deemed to have been held for 12 months without having to satisfy this requirement: s 115-34. In the case of a same-asset roll-over (see [16 300]-[16 380]), the combined period of ownership of the rolled over asset in the hands of the original owner and the new owner is taken into account in determining if the 12-month holding ruling is satisfied: s 115-30(1), item 2. For replacement interests acquired under a Div 122 roll-over, see [16 050]. For replacement assets acquired under the Subdiv 124-N roll-over, see [16 230]. Deceased estates In the case of post-CGT assets acquired from a deceased estate, the time of acquisition by the beneficiary or LPR for the purposes of the 12-month holding rule is the time when the © 2017 THOMSON REUTERS

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deceased acquired the asset: s 115-30(1), items 3, 4 and 7. On the other hand, the beneficiary or LPR is considered to have acquired a pre-CGT asset of the deceased at the time of the deceased’s death: s 115-30(1), items 5 and 6.

Certain ESS interests In the case of a share that has been acquired by exercising a right that was an ESS interest subject to the start-up concession (see [4 180]), the time of acquisition for CGT discount purposes is the time at which the right was acquired, and not the time at which the share was acquired: s 115-30(1), item 9A. [14 405] CGT discount – abolition for foreign residents If an individual makes a discount capital gain from a CGT event happening after 8 May 2012, the CGT discount is not available, or is available in part only, if the individual is a foreign resident for some or all of the period from 8 May 2012 to the date the relevant CGT event happens. In those circumstances, the ‘‘discount percentage’’ applying to the discount capital gain will depend on: • whether the relevant CGT asset was held on or acquired after 8 May 2012; • if the asset was held on 8 May 2012, whether or not the individual was a resident on that date; • whether a choice is made by an individual who was a foreign resident on 8 May 2012 to use the market value approach to determine the capital gain accruing on and before that date which is entitled to the discount; and • the residency of the individual during the period that the asset was owned, in particular after 8 May 2012. The general effect of ss 115-105 and 115-115 is to adjust the amount of the discount percentage by denying the discount for that part of a gain that arose after 8 May 2012 to the extent that a taxpayer was a foreign resident after that date, but to allow the discount for any gain that accrued before 8 May 2012 by reference to its market value at that date (provided the taxpayer chooses the ‘‘market value’’ approach). The provisions also apply to temporary residents (see [2 100]) and to foreign resident beneficiaries of a trust in respect of capital gains made by a trust to which the beneficiary is entitled: s 115-110. In that regard, where a trustee is taxed under s 98 of ITAA 1936 in respect of an individual beneficiary (ie a beneficiary who is presently entitled to a share of the income of a resident trust estate but is under a legal disability: see [23 460]), the discount percentage will be worked out on the basis the individual made the gain: s 115-120. The main calculation rules are set out below. • A full CGT discount percentage will continue to apply if the CGT asset was acquired before 8 May 2012, was subject to a CGT event before that date and was owned for at least 12 months. • No CGT discount applies if the CGT asset was acquired after 8 May 2012 and was subject to a CGT event after that date and the taxpayer is a foreign resident for the whole period of ownership of the asset. • If the CGT asset was acquired before 8 May 2012, no CGT discount is available if the market value of the asset at 8 May 2012 is not obtained (unless the taxpayer was a resident after that date). • Where an asset is acquired after 8 May 2012 and the individual is a foreign resident during some or all of the period the asset is owned by the individual after that date, the discount percentage is effectively reduced to allow individuals to receive the CGT discount for the days they were a resident, and deny the CGT discount for days they were a foreign resident, under the formula in s 155-115(3). 568

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[14 410]

• For assets acquired before 9 May 2012, to the extent that the difference between the cost base of the asset and its market value as at 8 May 2012 is equal to or greater than the discount capital gain from the asset (the ‘‘excess’’), the discount percentage is 50%. (This ensures that individuals do not have a reduction in discount percentage where the value of the CGT asset has fallen between 8 May 2012 and the end of the discount testing period.) • For assets acquired before 9 May 2012, if the ‘‘excess’’ (ie to the extent to which the asset increased in value over the period to 8 May 2012) is less than the discount capital gain, then the formula in s 115-115(5) will apply. (This is intended to ensure that, if an individual chooses to use the market valuation method, the full 50% discount applies to the increase in value of the CGT asset attributed to the ownership period prior to the announcement of the measure. Any increase in the value of the CGT asset attributed to the ownership period after 8 May 2012 will be subject to a discount percentage that is determined based upon the days the individual is a resident.) Note that it is not clear how the discount percentage is calculated where a foreign resident makes a relevant ‘‘net capital gain’’ comprised of a gain from one CGT asset as reduced by capital losses from one or more CGT assets.

Change in residency Where an Australian resident becomes a foreign resident, the measures discussed above will only apply in circumstances where the assets are taxable Australian property, including where the individual has chosen to disregard any capital gains under CGT event I1 triggered by their change in residency status: see [18 160]. If a foreign resident becomes a resident, they are treated as having acquired relevant assets at the time they become a resident for CGT purposes (see [18 180]): s 855-45(3). Therefore, the 12-month holding rule for the purposes of qualifying for the CGT discount would begin from that time. However, ‘‘taxable Australian property’’ (see [18 100]) will be considered to have been acquired when it was actually acquired by the taxpayer as a resident or foreign resident. For the situation where the foreign resident has a foreign dwelling, see [15 330]. [14 410] CGT discount – anti-avoidance measures The CGT discount is not available for a gain from a CGT event that happens under an agreement which is made within 12 months of acquiring the asset: s 115-40. The Tax Office has suggested that ‘‘the use of a put or call option over an asset may, in certain circumstances, support an inference that a relevant agreement exists. One such circumstance is where an option is issued with such a high premium and low exercise price that it is evident that the parties fully intend that it will be exercised’’: see the minutes of the NTLG Losses & CGT Subcommittee meeting on 9 June 2004 and also [17 220]. As another integrity measure, s 115-45 provides that the CGT discount is not available for capital gains arising from certain CGT events happening to equity interests in a company or trust with less than 300 members unless at least one of the following conditions is satisfied: • the taxpayer (including associates) has less than 10% equity in the entity before the CGT event: s 115-45(3); • the sum of the cost base of the assets held for less than 12 months by the entity just before the CGT event is not more than 50% of the cost base of all the assets of the entity: s 115-45(4); or • the notional net capital gain made on assets held by the entity for less than 12 months just before the CGT event is not more than 50% of the notional net capital gain on all assets held by the entity at that time: s 115-45(5). © 2017 THOMSON REUTERS

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Note that s 115-45 does not apply if the company or unit trust has more than 300 members, unless the entity is subject to ‘‘concentrated ownership’’ (ie if up to 20 individuals own interests between them giving them at least 75% control of the entity in terms of voting rights, income and capital, or the variation of rights can result in this): s 115-50.

[14 420] Rate of tax on net capital gain For individuals, the net capital gain (whether calculated under the indexation or CGT discount method) is included in the taxpayer’s assessable income and taxed at the individual’s marginal tax rate. For trusts and superannuation funds, the same principle applies, except that the net capital gain is taxed at the rate applicable to the trust or superannuation fund. In the case of a company, which is not entitled to the CGT discount, the net capital gain (after indexation in the case of assets acquired before 21 September 1999) is included in the company’s taxable income and taxed at the company rate.

RULES FOR COLLECTABLES AND PERSONAL-USE ASSETS [14 450] Collectables A ‘‘collectable’’ means any of the following assets that are kept mainly for the personal use and enjoyment of the taxpayer or an associate of the taxpayer (s 108-10(2)): • artwork, jewellery, an antique, a coin or a medallion; • a rare folio, manuscript or book; • a postage stamp or first-day cover; and • an interest in, or a debt arising from, or an option or right to acquire, any such collectable. Artwork held as a long-term investment in the expectation of capital appreciation (as opposed to being held for business or profit making purposes) is a ‘‘collectable’’: ATO ID 2011/9. The Tax Office regards an ‘‘antique’’ as an object of artistic and historical significance that is at least 100 years old at the time of its disposal: Determination TD 1999/40. If a ‘‘collectable’’ (as defined) is acquired for $500 or less, any gain or loss made from the collectable is disregarded: s 118-10. (Note that any GST input tax credits are disregarded for this purpose.) However, if a collectable is acquired for more than $500, then any capital gains or losses will be subject to CGT, but any capital loss from the collectable can only be offset against capital gains from collectables (and otherwise the normal rules apply to carried forward losses or excess capital losses: see [14 370]): ss 108-10(1) and (4). Note also that capital losses from other assets can be offset against any ‘‘net’’ capital gains from collectables. To prevent exploitation of the $500 threshold, if a collectable (other than a debt, option or right) is jointly owned, a taxpayer’s interest in the collectable will still be subject to CGT if the market value (see [3 210]) of the collectable itself exceeds the $500 threshold, even though the taxpayer’s individual interest may be less: s 118-10(2). Likewise, s 108-15 prevents exploitation of the threshold by providing that if a set of collectables would normally be disposed of as a set, they will be taken to be one asset (and therefore the disposal of one part of the set will be a disposal of part of an asset). Note that in working out the cost base of a collectable, the costs of owning an asset (the third element of the cost base: see [14 050]) are disregarded: s 108-17.

[14 460] Personal-use assets A ‘‘personal use asset’’ is an asset (other than land or a building) owned by the taxpayer and used or kept primarily for the personal use or enjoyment of the taxpayer or an associate of the taxpayer: s 108-20(2). It also includes a debt owed to the taxpayer in respect of an asset 570

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[14 500]

that was formerly a personal-use asset and a debt that came to be owed to the taxpayer otherwise than in the course of a business carried on by the taxpayer or the taxpayer’s income-producing activities (eg the right of subrogation where a taxpayer guarantees a loan made to another for private purposes such as the purchase of a home, and is later called on to meet that guarantee). An option or right to acquire an asset that would be used or kept primarily for the personal use or enjoyment of the taxpayer, or his or her associates, is itself taken to be a personal-use asset. Capital gains or losses made on ‘‘personal use assets’’ are disregarded, unless the personal-use asset was acquired for more than $10,000 in which case only a capital gain can arise: s 118-10(3). Note that any GST input tax credits are included in this threshold test and that the cost base of a personal-use asset does not include the costs of ownership (see [14 050]): s 108-30, 110-25(4). To prevent exploitation of the threshold, if a set of personal-use assets would normally be disposed of as a set, they will be taken to be one asset (and therefore the disposal of part of the set will be a disposal of part of an asset): s 108-25.

[14 470] Collectables and personal-use assets held by companies or trusts If a personal-use asset or collectable is owned by a company or trust, and there is a decline in its value, then capital proceeds from a relevant CGT event (ie CGT event A1, C1 or E8) happening to a share in a company or an interest in a trust are adjusted so as not to recognise the loss attributable to this fall in market value: s 116-80. If the capital proceeds are less than the amount that would arise but for the fall in value of the personal-use asset or collectable, the capital proceeds are replaced with what the market value of the shares or trust interest would have been if there had not been a fall in value of the collectable or personal-use asset. If such an adjustment has been made, CGT event K5 (see [13 680]) can cause the taxpayer to make a capital loss from a collectable equal to the amount of the adjustment: s 104-225.

ANTI-OVERLAP PROVISIONS [14 500] No double taxation for otherwise assessable amounts Section 118-20 prevents double taxation that may arise where a transaction gives rise to both an assessable capital gain from a CGT event and an assessable amount under another provision of the tax law. In this case, if the capital gain does not exceed the amount included in assessable income, the capital gain is reduced to zero: s 118-20(2). On the other hand, if the capital gain exceeds the amount included in assessable income, only the excess is taxed as a capital gain: s 118-20(3). Note that, by virtue of the method statement in s 102-5, the application of capital losses and/or the CGT discount (if relevant) only happens to any capital gain remaining after this process (ie to any ‘‘excess’’ capital gain): see [14 360]. For example, s 118-20 applies where a taxpayer acquires a ‘‘revenue asset’’ (ie an asset acquired for resale at a profit) and later sells it, generating both an assessable capital gain and ordinary income. However, the section does not apply where a post-CGT asset becomes trading stock (such as where post-CGT land is ventured into property development). In this case, CGT event K4 (see [13 670]) will apply to capture the capital gain (or loss) that accrued on the CGT asset up to that time and thereafter any profit or loss will be accounted for under the trading stock provisions (note that capital gains or losses on trading stock are ‘‘disregarded’’: see [15 060]). Likewise, s 118-20 does not apply where the method of accounting changes from cash to accruals basis in an income year to reduce any capital gain made when a debt that arose from the provision of services in the previous income year is discharged: ATO ID 2014/1. Importantly, s 118-20 applies where the tax law treats an amount as exempt income or non-assessable non-exempt (NANE) income ‘‘under another provision of the income tax © 2017 THOMSON REUTERS

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law’’ (such as the exempt component of an ETP: see [4 300]). This ensures that such an exclusion from assessable income is treated as income to allow for the removal of double taxation in relation to the assessable CGT component of an ETP (arising from the ending of the right to the payment): s 118-20(4). Likewise, if any part of an ETP or a superannuation lump sum is included in assessable income, any applicable capital gain will be reduced by the whole of the payment: s 118-22. EXAMPLE [14 500.10] Justin is made redundant and receives a genuine redundancy payment of $130,000 (the exempt component of which is $90,000). Therefore, $40,000 of the payment is assessable as an employment termination payment (ETP). Justin also makes a capital gain of $130,000 in respect of his right to the payment. Ordinarily, the capital gain of $130,000 would only be reduced to $90,000 by the assessable ETP component of $40,000. However, as the exempt component of the ETP of $90,000 (ie the genuine redundancy component) is taken into account, the capital gain is reduced to nil by both the exempt component ($90,000) and the assessable ETP component (ie $40,000).

However, the rule that treats NANE amounts as ‘‘an assessable amount under another provision of the tax law’’ for the purposes of s 118-20 does not apply to the exemption for the market value of rights issued by companies or trusts to acquire further shares or units in the entity under s 59-40 (see [17 380]): s 118-20(4).

[14 510] Interaction of TOFA rules and CGT The TOFA (taxation of financial arrangements) rules (see [32 050] and following) provide that there will be ‘‘symmetry’’ between the cost or proceeds of a financial arrangement and the cost base or capital proceeds of the arrangement for CGT purposes, if an entity starts or ceases to have a ‘‘Division 230 financial arrangement’’ as consideration for providing or acquiring a thing: s 230-505. Further, s 118-27 provides that if Div 230 applies to a financial arrangement, the capital gain or loss that is made from the CGT asset (or from its creation or the discharge of a liability) will be disregarded if, at the time of the CGT event from which the gain or loss is made, the asset or liability is a ‘‘Division 230 financial arrangement’’: see [32 070].

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15

INTRODUCTION Overview ....................................................................................................................... [15 010] DISREGARDED GAINS AND LOSSES Cars, motorcycles and valour decorations ................................................................... [15 Collectables and personal-use assets ............................................................................ [15 Assets used to produce exempt income ....................................................................... [15 Shares in a pooled development fund .......................................................................... [15 Trading stock ................................................................................................................. [15 Other disregarded gains and losses .............................................................................. [15 Depreciating assets ........................................................................................................ [15

020] 030] 040] 050] 060] 070] 080]

EXEMPT RECEIPTS Compensation – personal injury, illness or vocational wrongs ................................... [15 100] Gambling or competition winnings .............................................................................. [15 110] Miscellaneous exemptions ............................................................................................ [15 120] EXEMPT TRANSACTIONS Marriage breakdown settlement .................................................................................... [15 Rights under financial claims scheme .......................................................................... [15 Testamentary gifts ......................................................................................................... [15 Other exempt transactions ............................................................................................ [15 Exemption for temporary residents .............................................................................. [15

150] 160] 170] 180] 190]

MAIN RESIDENCE Main residence exemption – introduction .................................................................... [15 Meaning of dwelling ..................................................................................................... [15 Ownership of dwelling .................................................................................................. [15 Ownership period .......................................................................................................... [15 Adjacent land ................................................................................................................ [15 Qualification as a main residence ................................................................................. [15 Exemption for main residence owned by Special Disability Trust ............................. [15 Moving into dwelling .................................................................................................... [15 Changing main residences ............................................................................................ [15 Absences ........................................................................................................................ [15 Building, renovation or repair ...................................................................................... [15 Destruction of dwelling ................................................................................................ [15 Spouses or dependent child with different main residences ........................................ [15 Transfer of main residence on marriage breakdown ................................................... [15 Partial exemption – failure to qualify as residence ..................................................... [15 Partial exemption – income producing use .................................................................. [15 Disposal of adjacent land separately from dwelling .................................................... [15 Abandoned contracts ..................................................................................................... [15 Exemption for dwellings acquired from a deceased estate ......................................... [15

300] 310] 320] 330] 340] 350] 355] 360] 370] 380] 390] 400] 410] 420] 430] 440] 450] 460] 470]

SMALL BUSINESS CONCESSIONS Overview ....................................................................................................................... [15 Maximum net asset value test ...................................................................................... [15 CGT small business entity test ..................................................................................... [15 Active asset test – general ............................................................................................ [15 Active assets – shares and trust interests ..................................................................... [15 The 80% active asset test ............................................................................................. [15 CGT concession stakeholder test .................................................................................. [15 15-year exemption ......................................................................................................... [15 50% reduction ............................................................................................................... [15

500] 510] 520] 530] 540] 545] 550] 560] 570]

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Retirement exemption ................................................................................................... [15 580] Roll-over concession ..................................................................................................... [15 590]

VENTURE CAPITAL Concessions for shares in ESICs .................................................................................. [15 640] Exemption for venture capital limited partnerships ..................................................... [15 650] Non-resident tax-exempt pension funds ....................................................................... [15 660] INSURANCE AND SUPERANNUATION Insurance policies .......................................................................................................... [15 700] Superannuation funds, RSAs and PSTs ....................................................................... [15 710]

INTRODUCTION [15 010] Overview This chapter examines the CGT exemptions and concessions contained in Divs 118 and 152 ITAA 1997, that is, the situations in which capital gains or capital losses from CGT events will be ‘‘disregarded’’. Broadly, these ‘‘exemptions’’ are classified into 3 main categories: • exempt assets: see [15 020]-[15 080]; • exempt receipts: see [15 100]-[15 120]; • exempt transactions: see [15 150]-[15 190]. The most significant exemptions or concessions discussed in this chapter are: • the main residence exemption (Subdiv 118-B): see [15 300]-[15 470]; and • the exemptions and other concessions available under the CGT small business provisions (Div 152): see [15 500]-[15 590]. The chapter also deals with the CGT exemption for interests in certain venture capital vehicles (see [15 650]-[15 660]) and for interests in insurance and superannuation assets (see [15 700]-[15 710]). Note that Div 118 does not contain a specific exemption for pre-CGT assets (ie assets acquired before 20 September 1985), as gains or losses from such assets are usually ‘‘disregarded’’ under the relevant CGT event itself: see Chapter 12.

DISREGARDED GAINS AND LOSSES [15 020] Cars, motorcycles and valour decorations Capital gains or losses made from cars, motor cycles and valour decorations are ‘‘disregarded’’: s 118-5. A ‘‘car’’ is defined in s 995-1 to mean any motor-powered road vehicle (including a 4-wheel drive vehicle) designed to carry a load of less than one tonne and fewer than 9 passengers, but not a motorcycle or similar vehicle. A ‘‘car’’ includes a vintage car: Determination TD 2000/35. In the case of a valour decoration, if consideration was given to acquire it, then any capital gain or loss on its disposal is not disregarded: s 118-5(b). [15 030] Collectables and personal-use assets For the special calculation rules that apply to ‘‘collectables and personal-use assets’’ (as defined): see [14 450]-[14 470]. If a ‘‘collectable’’ (as defined) is acquired for $500 or less, any gain or loss made from the collectable is disregarded: s 118-10. Likewise, capital gains or 574

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[15 060]

losses made on ‘‘personal use assets’’ are disregarded, unless the personal-use asset was acquired for more than $10,000 in which case only a capital gain can arise: s 118-10(3).

[15 040] Assets used to produce exempt income If an asset is used solely for the purpose of producing exempt income (see [7 020]) or ‘‘non-assessable non-exempt’’ income (see [7 700]), any capital gain or loss made from a CGT event happening to the asset will be disregarded: s 118-12(1). The use of the word ‘‘solely’’ indicates that use for any other purpose, whether it be for private purposes or for producing assessable income, will result in the asset not satisfying the exemption: s 118-12(1). This exemption does not apply if an asset is used to produce income that is ‘‘non-assessable non-exempt income’’ because of any of the following specific listed provisions (ITAA 1997 unless otherwise specified): • mining payments (s 59-15): see [29 100]; • amounts that would be mutual receipts but for the prohibition on distributions to members (s 59-35): see [7 420]); • disposal of trading stock outside the ordinary course of business (s 70-90(2)): see [5 400]; • income of, and payments by, a personal services entity (s 86-30 to 86-35): see [6 130]; • treatment of arrangement payments (s 240-40): see [15 180]; • dividends, royalties and interest subject to withholding tax (s 128D ITAA 1936): see [35 150]; • foreign residents – exempting conduit foreign income from Australian tax (s 802-15): see [38 180]; • foreign residents – final withholding tax on managed investment trust income (s 840-815): see [50 110]; • foreign branch profits of an Australian company (s 23AH ITAA 1936): see [34 020]; • attributed income of a CFC (s 23AI ITAA 1936): see [34 140]; • certain non-portfolio dividends from foreign companies (s 23AJ ITAA 1936): see [34 110]; • amounts paid out of attributed FIF income (s 23AK ITAA 1936): see [34 200]; • fringe benefits (s 23L(1) ITAA 1936): see [4 050]; • attributable trust income (s 99B(2A) ITAA 1936); • luxury car lease payments (s 242-40): see [6 410]; and • amounts subject to family trust distributions tax (s 271-105(3) in Sch 2F ITAA 1936): see [23 900].

[15 050] Shares in a pooled development fund A capital gain or loss made from a CGT event in relation to shares in a pooled development fund (see [11 550]) within the meaning of the Pooled Development Funds Act 1992 is disregarded: s 118-13. [15 060] Trading stock A capital gain or loss made on an asset that is trading stock (see [5 200]) at the time of the CGT event is disregarded: s 118-25. Further, if a CGT asset starts to be held as trading stock (see [5 250]), any capital gain or loss made on the conversion is disregarded provided © 2017 THOMSON REUTERS

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the taxpayer elects to treat the asset as having been disposed of for its ‘‘cost’’: 118-25(2). Otherwise, CGT event K4 will apply if the taxpayer elects for a ‘‘market value’’ disposal: see [13 670]. The trading stock exemption does not apply in relation to capital gains or losses made by complying superannuation entities on specified assets (primarily shares, units in a unit trust and land), unless held as trading stock before 7.30 pm AEST on 10 May 2011: see [41 190].

[15 070] Other disregarded gains and losses A capital gain or loss from a CGT event is disregarded in relation to the following CGT assets: • registered emission units and rights to receive Australian carbon credit units (see [13 640]): s 118-15; • carried interests (see [15 650]): s 118-21; • a financial arrangement (or part of one) to which Subdiv 250-E applies (see [33 100]): s 118-27; and • an interest in the copyright of a film if an amount is included in assessable income under s 26AG ITAA 1936 (about film proceeds) because of the CGT event: s 118-30. A capital gain or loss is also disregarded if an amount is included in assessable income where R&D results are disposed of or another entity is granted access to, or the right to use, R&D results (see [11 020]-[11 100]): s 118-35. However, note that CGT event K7 applies to assets used in conducting R&D activities to the extent that they have not been used for a taxable purpose: see [13 700]. Note also the CGT exemption for investments in eligible ‘‘start-up’’ ventures: see [11 200].

[15 080] Depreciating assets A capital gain or loss made from a CGT event that is also a balancing adjustment event (see [10 850]) that happens to a depreciating asset (see [10 150]) is disregarded if the asset was used wholly for a taxable purpose (see [10 070]) and depreciation deductions were claimed under Div 40 (discussed in Chapter 10) or Div 328 (discussed in Chapter 25): s 118-24(1). Certain intangible assets are depreciating assets, such as intellectual property (eg copyright), mining, quarrying or prospecting rights and mining, quarrying or prospecting information: see [10 150]. A capital gain or loss made from a CGT event happening to a depreciating asset that is used wholly for R&D activities (see [11 020]-[11 100]) is also exempt from CGT under s 118-24(1). If the asset was used for a mix of taxable and non-taxable purposes, the disposal will give rise to a balancing adjustment calculation and a capital gain or loss. If the asset was used only for a non-taxable purpose, there will only be a capital gain or loss. The capital gain or loss in either case is calculated under CGT event K7: see [13 700]. However, capital gains or losses arising in respect of depreciating assets affected by CGT event J2 (see [13 560]) or covered by Subdiv 40-F (water facilities, horticultural plants or grapevines) or Subdiv 40-G (landcare operations, electricity connections or telephone lines) are not disregarded and are subject to the CGT provisions: s 118-24(2). The Subdivs 40-F and 40-G concessions are discussed in Chapter 27.

EXEMPT RECEIPTS [15 100] Compensation – personal injury, illness or vocational wrongs Section 118-37(1)(a) and (b) provide that a capital gain or capital loss is disregarded from a CGT event relating directly to: 576

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[15 120]

• compensation or damages for any wrong or injury suffered by the taxpayer in his or her occupation; or • compensation or damages for any wrong, injury or illness the taxpayer or a relative suffers personally (eg damages for personal injury, defamation or negligence of a solicitor failing to institute a personal injury action). This CGT exemption also applies in respect of such compensation or damages received by a trustee on behalf of a beneficiary or their relative, or where the beneficiary subsequently receives a distribution of the compensation from the trustee. The exemption also applies to a trustee in relation to proceeds received under a policy of insurance on the life of an individual or an annuity instrument if they are the original owner of the policy or instrument, and also to a trustee of a complying superannuation entity for a policy of insurance for an individual’s illness or injury. See [15 700]. Note that compensation includes property other than money (but that the later disposal of any such property may have CGT consequences). Ruling TR 95/35 (which deals with the ITAA 1936 predecessor to s 118-37) states that the exemption is to be read widely as to whether an amount is relevant compensation or damages. The ruling states that the exemption can include an amount received in an out-of-court settlement even if liability is not admitted. It also covers the full range of employment and professional type claims, including sexual harassment, discrimination and wrongful dismissal. However, the ruling states that ‘‘compensation received by a company or trustee for any wrong or injury suffered by the company or trust does not fall within the scope of the exemption’’ (para 22). Importantly, Ruling TR 95/35 also takes the view that if an undissected lump sum compensation amount is received and it is not possible to determine or estimate the component that relates to personal injury, the exemption will not apply to any part of the compensation. See also Dibb v FCT (2004) 55 ATR 786. However, if it is possible to determine or estimate the amount from sources such as the reasoning of the court, particulars of the plaintiff’s claim or the wording of settlement offers, the undissected lump sum nature of the final receipt will not of itself prevent that proportionate amount of the payment receiving the benefit of the exemption.

[15 110]

Gambling or competition winnings

Capital gains or losses from CGT events relating directly to gambling, a game or a competition with prizes are disregarded: s 118-37(1)(c). The exemption will also apply in relation to gains or losses arising from a financial contract for differences if the contract was entered into for the purpose of recreation by gambling: Ruling TR 2005/15. Note, however, that gains or losses from gambling may be assessable under the ordinary income provisions if the taxpayer is carrying on gambling activities in a business-like manner. The exemption does not apply to a capital gain or loss made in relation to the disposal of a CGT asset obtained from gambling or from a prize. In this case, the market value substitution rules in s 112-20(1) would apply so that the cost base of the prize would be its market value at its date of acquisition. See also Ruling IT 2584.

[15 120] Miscellaneous exemptions The following receipts (of money, property and/or reimbursements) are also exempt from CGT: • an incentive, or a variation, transfer or revocation of an allocation, under the National Rental Affordability Scheme and anything of economic value provided by a State or Territory in relation to a taxpayer’s participation in the National Rental Affordability Scheme (s 118-37(1)(j), (h), (i)); © 2017 THOMSON REUTERS

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• a right or entitlement to a tax offset, a deduction or a similar benefit under an Australian or foreign law (eg a right to an urban water tax offset or a reduction in land tax), in relation to a CGT event happening from the 2009-10 income year (s 118-37(1)(h)); • amounts received under a Commonwealth, State, Territory, local government or foreign government scheme established under an enactment or an instrument of a legislative character: s 118-37(2)(a); • amounts received under the General Practice Rural Incentives Program and the Rural and Remote General Practice Program (s 118-37(2)(b)); • amounts received (s 118-37(2)(c));

under

the

Sydney

Aircraft

Noise

Insulation

Project

• amounts received under the M4/M5 Cashback Scheme (s 118-37(2)(d)); • grants received under the Unlawful Termination Assistance Scheme or the Alternative Dispute Resolution Assistance Scheme: s 118-37(2)(e); • compensation received under the firearms surrender arrangements: s 118-37(3); and • native title payments and benefits (see [7 710]): s 118-77. Note this also includes receipts from the transfer of native title rights (or the right to a native title benefit) to an Indigenous holding entity or Indigenous person, or from the creation of a trust that is an Indigenous holding entity over such rights. If a participant in the Sustainable Rural Water Use and Infrastructure Program makes a relevant choice (ss 118-37(1)(ga) and (gb)): • payments they derive under the program will be exempt from CGT (and will also be NANE income: see [7 710]); • there will be no CGT consequences for the part of a Commonwealth payment that relates to the transfer of water rights; and • to the extent that the payment is the capital proceeds for the disposal of a right to get the payment, there will be no CGT consequences for the disposal of that right.

World War II compensation payments A CGT exemption applies to Australian residents who receive payments under the German Forced Labour Compensation Programme or from the Foundation known as ‘‘Remembrance, Responsibility and Future’’ or any of its partner organisations, either personally or as a relative or eligible heir of a forced labour victim for any wrong or injury or loss of property suffered: s 118-37(4). Likewise s 118-37(5) provides a CGT exemption for payments or property received by Australian residents from a source in a foreign country in connection with a wrong, injuries, loss of property or other detriment as a result of persecution by the National Socialist regime of Germany or by any other enemy of Australia during the Second World War (including immediately before or after the war).

EXEMPT TRANSACTIONS [15 150] Marriage breakdown settlement A capital gain or loss that is made under CGT event C2 (see [13 080]) on the ending of a right that directly relates to a marriage or relationship breakdown settlement (eg rights under a pre-nupital agreement) will be disregarded under s 118-75 if the following conditions are met: 578

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[15 180]

• the capital gain or loss is made in relation to a right that directly relates to the breakdown of a marriage or de facto relationship (including same sex relationships); • at the time of the trigger event, the spouses involved are separated and there is no reasonable likelihood of cohabitation being resumed; and • the trigger event happened because of reasons directly connected with the marriage or de facto relationship breakdown. The question of whether spouses have separated is to be determined in the same way as it is in the Family Law Act 1975: see [16 300].

[15 160] Rights under financial claims scheme A CGT exemption applies in relation to certain rights arising under the Banking Act 1959 or the Insurance Act 1973 if an authorised deposit-taking institution (ADI) or a general insurance company fails. Division 2AA Pt II of the Banking Act 1959 entitles depositors in a failed ADI to be paid their deposit by APRA (up to a certain limit). Similarly, Div 3 of Pt VC of the Insurance Act 1973 entitles claimants under a general insurance policy issued by a failed insurance company to be paid the amount of the claim by APRA. Subdivision 253-A will provide that capital gains and losses arising because the taxpayer’s entitlement to receive a payment from APRA under Div 2AA of Pt II of the Banking Act 1959 is met, and arising on the resulting transfer of the taxpayer’s rights to APRA following the payment, are to be disregarded. Subdivision 322-B will provide a similar CGT exemption if a policyholder’s entitlement to receive a payment from APRA under Div 3 of Pt VC of the Insurance Act 1973 is met (and also if the policyholder’s rights are transferred to APRA). Cost base adjustments under s 112-30(3) (see [14 180]) are required if a payment is made to a holder of an ADI deposit which covers only part of the deposit. However, to ensure that there are no CGT consequences in this case, s 253-15 specifies that the cost base of the part of a deposit which is covered by the scheme will be equal to the payment under the scheme, while the cost base of the remainder of the deposit following the payment will be equal to the cost base of the deposit reduced by the amount that has been paid. Subdivisions 253-A and 322-B apply to CGT events happening, or amounts paid or applied to meet entitlements arising (as appropriate), after 17 October 2008. [15 170] Testamentary gifts Any capital gain or loss made from the following gifts is disregarded: • a testamentary gift (ie made under a will) of property under the former Cultural Bequests Program (but note that the Program no longer operates); • a testamentary gift of property that would have been deductible under s 30-15 if it had not been a testamentary gift (see [9 830]): s 118-60(1); and • a gift of property under the former Cultural Gifts Program to public libraries, museums and art galleries and Artbank (note that the Program no longer operates): former s 118-60(2). However, the exception does not apply if the gift was not a testamentary gift and the property is later acquired for less than market value by the person making the gift or an associate of that person: s 118-60(3). There is an anti-avoidance provision for testamentary gifts of property. If a testamentary gift is reacquired for less than market value (see [3 210]) by the deceased’s estate or an associate of the deceased’s estate or a person who was an associate of the deceased just before the latter died, the exception does not apply. Instead, the normal rules (in s 128-15) relating to the effect of death on CGT assets apply (see [17 100]): s 118-60(4).

[15 180] Other exempt transactions Other transactions that give rise to a capital gain or loss being disregarded are: © 2017 THOMSON REUTERS

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• a capital loss that a lessee makes from the expiry, surrender, forfeiture or assignment of a lease (except a lease granted for 99 years or more) is disregarded if the lessee did not use the lease solely or mainly for the purpose of producing assessable income: s 118-40. The CGT treatment of leases is examined at [13 300]-[13 340] (CGT events) and [17 150]-[17 180]; • any capital gain or loss on the subdivision and transfer of stratum units to the building owner at the time strata title is obtained is disregarded: s 118-42; • a capital gain or loss from the sale, transfer or assignment of rights to mine in a particular area in Australia is disregarded if exempt income for the income year is derived (because of the former s 330-60) from the sale, transfer or assignment: s 118-45. • capital gains or losses do not arise under hedging contracts (including gains or losses on currency received under such contracts) if the sole purpose of the contract was the elimination or reduction of an exposure to currency fluctuation losses under another contract or in relation to a CGT asset, being a right acquired before 20 September 1985 under another contract: s 118-55; • a capital loss made from a payment of personal services income (PSI) is disregarded if the PSI is included in the recipient entity’s assessable income under s 86-15 (see [6 130]): s 118-65. A capital loss is similarly disregarded if the payment is attributable to that PSI; • any CGT consequences for taxpayers who received shares in Tower Limited as a consequence of the demutualisation of Tower Corporation in October 1999 will generally be deferred until a CGT event happens to the shares: s 118-550; and • a capital gain or loss from assets transferred into a Special Disability Trust (SDT) for no consideration or into a trust which becomes an SDT as soon as practicable after the transfer, or where an asset passes from a deceased person’s estate to such an SDT: s 118-85.

Treatment of earnout rights The CGT treatment of earnout rights under ‘‘eligible’’ earnout arrangements is contained in Subdiv 118-I. Essentially, there will be no CGT consequences on the creation or receipt of an eligible earnout right, but subsequent financial benefits received or made will be taken into account for the purposes of calculating the ultimate capital gain made by a vendor and the cost base for the purchaser, retrospectively. See [17 335] for further details. [15 190] Exemption for temporary residents Temporary residents who are Australian residents are treated the same as foreign residents for CGT purposes: see [18 100]-[18 140]. For the meaning of ‘‘temporary resident’’, see [2 100].

MAIN RESIDENCE [15 300] Main residence exemption – introduction There is an automatic exemption (under Subdiv 118-B) for the capital gain or loss that arises when a relevant CGT event happens to a dwelling (or a taxpayer’s ownership interest in it) that qualifies as the taxpayer’s main residence. The exemption is only available for certain CGT events. The most common event is A1 (disposal of a CGT asset). Other CGT events where the main residence exemption applies are: B1, C1, C2, E1, E2, F2, I1, I2, K3, K4 and K6: s 118-110(2)(a). These events are also 580

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relevant to include as capital proceeds for main residence exemption purposes a forfeited deposit received as part of an uninterrupted sequence of transactions ending in one of those CGT events (see [15 460]): s 118-110(2)(b). CGT events E5 and E7 will also be ‘‘relevant’’ CGT events, to cater for the exemption for a main residence owned by a Special Disability Trust (see [15 355]).

[15 310] Meaning of dwelling A ‘‘dwelling’’ is defined in s 118-115 as including a unit of accommodation constituted by or contained in a building which must consist in whole, or in a substantial part, of residential accommodation. Additionally, the term ‘‘dwelling’’ includes a caravan, house boat or other mobile home, as well as any land immediately under the unit of accommodation. In Re Summers and FCT (2008) 71 ATR 279, a shed that contained a bed, mains water and a toilet was, in the circumstances, considered to be a ‘‘dwelling’’ that qualified as the taxpayer’s main residence. Note that a ‘‘dwelling’’ can include more than one unit of accommodation if the units are used together as a place of residence: see Determination TD 1999/69. [15 320] Ownership of dwelling A person is taken to have an interest in a dwelling if the person has a legal or equitable interest in the land on which the dwelling is erected, or a licence or right to occupy the dwelling: s 118-130. In the case of a flat or a home unit, this is extended to include ownership of a share in a company that owns a legal or equitable interest in the land on which the building containing the flat or home unit is erected, provided the share gives the holder a right to occupy the flat or home unit. In respect of joint owners of a dwelling, the main residence exemption applies to the interest of the joint owner or owners who actually use the dwelling as a main residence: Ruling IT 2485. The main residence exemption is only available to individuals, and not to a company or a trustee (including an individual trustee): see ATO ID 2003/163, ATO ID 2003/467 and withdrawn Determination TD 58. However, the exemption will be available to the trustee of a deceased estate (see [15 470]) or the trustee of a Special Disability Trust (see [15 355]) where relevant conditions are met.

[15 330] Ownership period For the main residence exemption to apply, the dwelling must have qualified as the taxpayer’s main residence throughout the ‘‘ownership period’’. This is the period on or after 20 September 1985 when the taxpayer had an ‘‘ownership interest’’ in the dwelling or the land on which it is built: s 118-125. A taxpayer’s ownership interest in a dwelling or land (see also [15 320]) begins and ends on settlement of the respective contracts of sale, or when a right to occupy begins and ends (if relevant). This rule also applies to a foreign dwelling owned by a foreign resident if the owner later becomes a resident of Australia: see ATO ID 2010/101.

[15 340] Adjacent land The exemption for a main residence includes any land that is adjacent to the dwelling, to the extent to which the land is used for private or domestic purposes in association with the dwelling and does not, together with the land on which the dwelling is situated, exceed 2 hectares in area: s 118-120. This will be a question of fact and degree depending on the particular circumstances: Determination TD 2000/15. A garage, store room or other structure owned by the person that forms part of building containing the flat or home unit is also eligible for exemption provided the structure is used primarily for private or domestic purposes: s 118-120(3). The land need only be close or near to the dwelling to be ‘‘adjacent’’ and it does not have to be contiguous with the land on which the dwelling is situated: Determination TD 1999/67. © 2017 THOMSON REUTERS

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If a taxpayer’s land which is used for private or domestic purposes exceeds 2 hectares, the taxpayer can select the 2 hectares which will qualify for the main residence exemption, but it must include the portion of land on which the dwelling is situated: Determination TD 1999/67. If adjacent land is not used primarily for private or domestic purposes in association with the dwelling throughout the period of ownership, a partial exemption will apply: see [15 430] and [15 440]. This may occur where part of the adjacent land is used to produce assessable income from business activities for any period of time: see Determination TD 1999/67. Note that if adjacent land (or a garage, store room or other structure that forms part of the dwelling) is disposed of separately from the rest of the dwelling, the exemption is not available in respect of that disposal (unless it was compulsorily acquired): see [15 450].

Exemption for compulsory acquisition of adjacent land The main residence exemption also applies to the compulsory acquisition of adjacent land or structures if certain conditions are met: ss 118-245, 118-250. ‘‘Compulsorily acquisition’’ is defined in the same way as for the compulsory acquisition roll-over in Subdiv 124-B (see [16 100]). The exemption also extends to the compulsory creation of an easement over adjacent land and the compulsory variation of the taxpayer’s rights in relation to adjacent land. If the adjacent land exceeds 2 hectares, the exemption will apply for a defined ‘‘maximum exempt area’’: s 118-255. If the exemption applies, there will be a reduction in the area of adjacent land entitled to exemption for future compulsory acquisitions. Only a partial exemption will apply to the extent that the dwelling was not always a main residence of the taxpayer and/or was used to produce assessable income: s 118-260. Note that the exemption is automatic. [15 350] Qualification as a main residence It is not enough that a taxpayer merely owns a dwelling. For the main residence exemption to apply, the dwelling must also qualify as a taxpayer’s main residence throughout the period of their ownership: s 118-110(1)(b). See, for example, Re Gerbic and FCT (2013) 96 ATR 451 and Re Keep and FCT (2013) 95 ATR 467. Withdrawn Determination TD 51 set out the factors the Commissioner will take into account in determining this matter (eg the length of time the dwelling has been occupied, the connection of services etc). Although the Determination has been withdrawn, the views expressed therein are still relevant as they are reflected in the Tax Office’s CGT Guide and have been confirmed by various AAT decisions (eg Re Erdelyi and FCT (2007) 66 ATR 872 and Re Summers and FCT (2008) 71 ATR 279). Note that the mere intention to occupy a dwelling as a main residence, without doing so, will not be sufficient for the exemption to apply. Further, there is no specified minimum timeframe for occupancy, although other main residence provisions such as the concession for construction, renovation or repair (see [15 390]) suggest that it can be established in as little as 3 months. See also ATO ID 2006/189 which indicates that a period less than 3 months will suffice. Note also that an overseas dwelling may qualify as a taxpayer’s main residence if the conditions for the exemption are met (see also [15 330]). [15 355] Exemption for main residence owned by Special Disability Trust The main residence exemption will apply to a dwelling owned by a Special Disability Trust (SDT) established under either the Veterans’ Entitlement Act 1986 and Social Security Act 1991, and which is used by the ‘‘principal’’ beneficiary as their main residence (for CGT events happening from the 2006-07 income year): ss 118-215 to 118-218. The exemption will apply to the extent that the principal beneficiary would have been able to claim the exemption if they owned the dwelling. A trustee of an SDT can also access all the concessions that extend the main residence exemption (see [15 360] to [15 400]), to the extent the principal beneficiary could access 582

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[15 370]

them if they owned the dwelling directly. Likewise, a trustee of an SDT will be subject to a partial main residence exemption if the dwelling fails to qualify as a main residence (see [15 430]) and/or is used to produce assessable income (see [15 440]), to the extent the principal beneficiary would have been subject to a partial exemption. However, any day that a trust is not an SDT will be treated as a ‘‘non-main residence day’’ (except for days when a trust becomes an SDT ‘‘as soon as practicable after a dwelling is acquired’’). If a trustee of an SDT inherits a dwelling from a deceased person’s estate, the trustee may be able to disregard or reduce a capital gain or loss on a later dealing with that dwelling – in terms of the extent to which the trustee can access a full or a partial exemption as if they were a trustee or a beneficiary of the deceased person’s estate (see [15 470]): s 118-218. Further, a market value cost base acquisition will apply so that when the SDT calculates any CGT liability on a later dealing with that dwelling, any use of the dwelling by the deceased will be ignored.

[15 360] Moving into dwelling This concession allows a dwelling to be treated as a taxpayer’s main residence for the period that the taxpayer does not move into it after settlement or obtaining ownership, provided the taxpayer moves into it as soon as it is ‘‘first practicable’’ to do so: s 118-135. The concession would apply where the delay in moving in is due to illness or other reasonable cause (eg where repairs to the dwelling need to be carried out or where administration of an estate was not complete: see ATO ID 2007/128). But it would not apply where a taxpayer is unable to move in because the dwelling is subject to a lease or where it is merely ‘‘inconvenient’’ to do so (see Re Chapman and FCT (2008) 71 ATR 689) or where the taxpayer is seconded to a new employment location before moving in (see Re Caller and FCT (2009) 77 ATR 975). Note that this rule also means that a partial exemption will apply (see [15 430]) if a dwelling is not moved into from the time it is ‘‘first practicable’’ to do so. In this way, the rule also acts to ‘‘punish’’ taxpayers who do not move in at that time.

[15 370]

Changing main residences

This concession allows 2 dwellings to be entitled to the main residence exemption where a new main residence is acquired before the original one is disposed of – provided the original dwelling is sold within 6 months of the acquisition of the new dwelling: s 118-140. That is, there is a maximum 6-month period where both dwellings can be treated as a main residence. However, this rule only applies if: • the original dwelling was the taxpayer’s main residence for a continuous period of at least 3 months in the 12 months before it is sold; • the original dwelling was not used for gaining or producing assessable income in any part of that 12-month period when it was not the taxpayer’s main residence; and • the new dwelling becomes the taxpayer’s main residence. Note also the following: • The absence concession (see [15 380]) can be used in respect of the original dwelling in order to meet these requirements (including, it seems, if the original dwelling is rented) as the effect of the absence concession is to continue to treat the original dwelling as the taxpayer’s main residence despite the absence from it: see Determination TD 1999/43. • If it takes longer than 6 months to sell the original dwelling, both dwellings will be treated as the taxpayer’s main residence for the 6-month period before the sale of © 2017 THOMSON REUTERS

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the original dwelling, but a partial exemption (see [15 430]) will apply to the particular dwelling that did not qualify as the taxpayer’s main residence before that 6 month period. EXAMPLE [15 370.10] Serena lived in her original home until 1 January 2017 when she moved into a new home that she had acquired. She eventually sells her original home on 1 October 2017 (ie 9 months after the acquisition of the original home). Serena can treat both homes as her main residence for the 6-month period prior to selling the original home (ie from 1 April to 1 October 2017). This means that there will be a 3-month period (ie from 1 January to 1 April 2017) when the original home will not qualify as her main residence and a partial exemption will apply under s 118-185 in relation to any capital gain or loss made on the sale of the original home by reference to this 3-month period: see [15 430].

[15 380] Absences The ‘‘absence concession’’ allows a taxpayer to treat a dwelling as her or his main residence despite being absent from it: s 118-145. However, it is subject to the following conditions: • it can only apply once the dwelling has qualified as a main residence (see [15 350]); • no other dwelling can be treated as a main residence during the period that the concession applies – except where a choice is made to use the ‘‘changing main residence’’ concession (see [15 370]): s 118-145(4). See also Determination TD 1999/43; • it applies indefinitely if the dwelling is not used for producing assessable income during the period of absence; • it applies for up to 6 years if the dwelling is used to produce assessable income (and any further period it is not so used). EXAMPLE [15 380.10] Luis purchases a property in North Adelaide and occupies it as his main residence for a period of one year. He then buys a property in Glenelg. During this time Luis lets out his North Adelaide property to tenants for a period of 6 years and then leaves it vacant for a further 4 years, before selling it. If he chooses the absence concession for the North Adelaide property, Luis will be entitled to the main residence exemption for the full 11-year period of ownership. However, he will not be entitled to the main residence exemption on the Glenelg property during this period.

Note also: • the absence from the dwelling can be for any reason; • a taxpayer need only make the choice to treat the dwelling as the main residence on the disposal of the dwelling (see [12 440] about making a choice); • if the dwelling ceases to be an individual’s main residence more than once during the ownership period, the maximum 6-year period of income-producing use can apply to each period of absence providing the dwelling again becomes her or his main residence; • the 6-year income producing period need not be continuous – intermittent periods of income-producing use during a period of absence can be aggregated to see whether the 6-year limitation is exceeded. 584

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[15 390]

If a substitute dwelling is acquired under the roll-over for compulsory acquisition, loss or destruction (see [16 100]) of an original dwelling that is entitled to the absence concession, the substitute dwelling can continue to be entitled to the absence concession even though it has not been occupied as a main residence: s 118-47. However, the substitute dwelling must be acquired or built within one year after the income year in which the original dwelling was destroyed or compulsorily acquired (or such further time as the Commissioner allows). In this case, the substitute dwelling can continue to be treated as the taxpayer’s main residence indefinitely if it is not used to produce assessable income, or up to 6 years if it is (including any period that the original dwelling was used to produce income): s 118-145(5). Note that the building concession can also be used in this case: see [15 390].

[15 390] Building, renovation or repair The ‘‘building concession’’ allows a taxpayer to treat land acquired, or a dwelling he or she has vacated, as his or her main residence during the period that the taxpayer ‘‘constructs, repairs, renovates or finishes building’’ a dwelling on the land, for a maximum period of up to 4 years: s 118-150. However, the availability of the concession is subject to the following conditions: • the dwelling must become the taxpayer’s main residence as soon as practicable after ‘‘construction, repair, renovation etc’’ (see Re Summers and FCT (2008) 71 ATR 279); and • the dwelling must remain the taxpayer’s main residence for at least 3 months (see Re Erdelyi and FCT (2007) 66 ATR 872) – but note that the absence concession (see [15 380]) may also be used to satisfy this requirement: see ATO ID 2006/185 and ATO ID 2006/189. The concession only applies for a maximum period of 4 years from the time the taxpayer acquires the land, or ceases to occupy a dwelling already on the land, until the constructed or repaired dwelling is occupied as the taxpayer’s main residence. This is subject to the Commissioner’s discretion to extend this 4-year period in limited circumstances (eg where the builder becomes bankrupt and is unable to complete the construction or where a family member has a severe illness). If it takes more than 4 years before the constructed or repaired dwelling is occupied as the taxpayer’s main residence, a partial exemption under s 118-185 will apply in respect of that ‘‘excess’’ period: see [15 430]. Further guidelines on the operation of the 4-year requirement are found in Determinations TD 2000/16 and TD 92/129. For the interaction of the building concession and dual occupancy constructions, see Determinations TD 2000/13 and TD 2000/14. Note also: • If the taxpayer chooses this concession, no other dwelling can be treated as the taxpayer’s main residence for the period (unless the changing main residence concession in s 118-140 applies: see [15 370]). • If a dwelling that is subject to the absence concession (see [15 380]) is destroyed or compulsorily acquired and land is acquired on which to build a replacement (‘‘substitute’’) dwelling, the building concession can also be used in these circumstances to preserve the effect of the absence concession in relation to the substitute dwelling: s 118-47. However, the land must be acquired within one year after the income year in which the original dwelling was destroyed or compulsorily acquired (or such further time as the Commissioner allows). A choice can be made to use the building concession directly in relation to a dwelling that is also treated as the taxpayer’s main residence under the absence concession: see ATO ID 2006/185. • An LPR or surviving spouse can also apply the concession where the taxpayer dies after construction has begun (or after entering into a contract for construction) but before construction is complete, or before satisfying the 3-month occupancy © 2017 THOMSON REUTERS

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requirement: s 118-155. In this case, the dwelling will be taken to be the taxpayer’s main residence for a maximum period of 4 years up to the taxpayer’s death (or such further time as the Commissioner allows). This will also enable access to the exemption for the disposal of a dwelling acquired from a deceased estate: see [15 470].

[15 400] Destruction of dwelling This concession allows vacant land to be treated as a taxpayer’s main residence if a dwelling that is the main residence of an individual is ‘‘accidentally’’ destroyed (eg in a bushfire or flood) and the vacant land is subsequently sold or disposed of: s 118-160. However, the following conditions must be met: • the destruction was accidental; • the dwelling was the individual’s main residence at the time of its destruction (or taken to be by way of an absence choice: see [15 380]); • no other dwelling was subsequently built on the land; and • the land was not used to produce assessable income. Note also that if a choice is made to apply the concession, no other dwelling can be treated as the taxpayer’s main residence during the period that is covered.

[15 410] Spouses or dependent child with different main residences If, during a period, a taxpayer and his or her spouse have separate dwellings as main residences, they must either choose one of them to be the main residence for both of them for that period or each nominate one of them as their main residences for that period: s 118-170(1) and 118-175. This rule does not apply if the spouse is living permanently separately and apart from the taxpayer. See [16 300] for the definition of ‘‘spouse’’. If both dwellings are nominated as main residences of each spouse, the entitlement to the main residence exemption is, in effect, split between the 2 dwellings. In the case of a dwelling nominated by the taxpayer, if the taxpayer’s interest in the dwelling does not exceed one-half of the total interests in the dwelling, the taxpayer’s interest in the dwelling is deemed to have been the main residence of the taxpayer and entitled to a full exemption: s 118-170(3). However, if the taxpayer’s interest exceeds one-half, the dwelling is deemed to have been the main residence of the taxpayer during only one-half of the period that it actually was the main residence. The rule applies likewise to the dwelling nominated by the taxpayer’s spouse: s 118-170(4). On the other hand, if the taxpayer has a dwelling as a main residence and a dependent child of the taxpayer has a different dwelling as a main residence, the taxpayer can only choose one of the dwellings as the main residence of both of them for the purposes of the exemption: s 118-175. In the situation where a taxpayer only owns one dwelling which is occupied by his or her dependent children, and the taxpayer does not live with them, that house can still be chosen as the taxpayer’s main residence under this rule (see also withdrawn ATO ID 2002/1039). A ‘‘dependent child’’ for this purpose means a child (which can be an adopted child, step-child or ex-nuptial child) under the age of 18 years who is dependent upon the taxpayer for economic support. See ATO ID 2011/77 for a discussion of the meaning of ‘‘step-child’’. A ‘‘child’’ also includes a child of the taxpayer’s spouse and a child who is the biological child of a person with whom the taxpayer has or had a relationship as a couple (including a same sex partner). [15 420] Transfer of main residence on marriage breakdown If a former spouse acquires a post-CGT dwelling from a company or trust under the marriage or relationship breakdown roll-over (see [16 300]), the dwelling is treated as having been owned by the spouse during the period that it was owned by the company or trust. As a 586

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[15 430]

result, a partial exemption (see [15 430]) will apply if a CGT event subsequently happens to the dwelling to reflect the fact that the dwelling cannot qualify as a main residence when it was owned by a company or trust – even if the spouse occupied it as his or her main residence during that time: s 118-180. EXAMPLE [15 420.10] A family trust owns the matrimonial home that it acquired in 2002. On the breakdown of the marriage in 2012, the Family Court orders that the home be transferred to the former wife who continues to reside in it as her main residence until it is sold in 2017. Under the rule in s 118-180, the former wife is considered to have owned the property from 2002 to 2017. As a result, she will be subject to a partial exemption (under s 118-185) to reflect the fact that the property was her main residence for only 5 of the 15 years of her deemed ownership.

If the marriage or relationship breakdown roll-over applies to a post-CGT dwelling transferred from one former spouse to the other, the CGT main residence exemption rules will apply to reflect the extent that the dwelling qualified as a main residence of both the transferor and transferee during their combined period of ownership of the dwelling, for the purpose of determining the transferee spouse’s eligibility for the main residence exemption: s 118-178. Further, if a dwelling that is used as a main residence from the time of its acquisition is later used to produce income and is then eligible for the roll-over on its transfer to the transferee spouse, the rule in s 118-192 for when a dwelling is first used to produce income after 20 August 1996 (see [15 440]) will apply. Accordingly, the transferee spouse will be taken to have acquired the dwelling at the time it is first used to produce income for its market value at that time, with the result that any CGT liability on its subsequent sale by the transferee spouse will be calculated by reference to this cost base and date of acquisition. This is because the transferee spouse is considered to have used the dwelling in the same way as the transferor spouse: s 118-178(2)(b). Note that the choices that may be available to a transferor spouse to treat a dwelling as his or her main residence during their ownership period (eg the absence choice: see [15 380]) are available to the transferee spouse. This may also have implications for property settlement negotiations between the parties. However, in relation to the choice for spouses with different main residences (see [15 410]), the Explanatory Memorandum to the Bill introducing s 118-178 states that, for practical reasons of negotiating a property settlement, the transferor spouse would need to make the choice before he or she transfers their interest to the transferee spouse. In this regard, it further states that a signed statement could be provided by the transferor spouse to the transferee spouse as evidence of the making of a choice.

[15 430] Partial exemption – failure to qualify as residence A partial main residence exemption will apply if the dwelling was the main residence of the taxpayer for only part of the ‘‘ownership period’’: see [15 330]. This can occur, for example, where the dwelling was first rented before it became the taxpayer’s main residence or where the building concession was chosen to apply and it took more than 4 years to construct a dwelling: see [15 390]. However, note that a dwelling will still qualify as a main residence throughout the period of ownership if any of the various concessions are chosen which allow it to be treated as a main residence during a period (eg the absence concession: see [15 380]). The partial capital gain or loss to be accounted for in these circumstances is calculated on a pro-rata basis in accordance with the following formula set out in s 118-185: CG or CL amount × © 2017 THOMSON REUTERS

Non-main residence days Days in your *ownership period

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where: “CG or CL amount” is the capital gain or capital loss you would have made from the CGT event apart from Subdiv 118-B; “non-main residence days” is the number of days in your ownership period when the dwelling was not your main residence. The ‘‘CG or CL amount’’ is calculated in the normal way as for any CGT asset. Thus, the ‘‘costs of owning the CGT asset’’, for example non-deductible mortgage interest, can be included in the cost base of a main residence if the relevant requirements are met (see [14 050]) – this may substantially lessen any partial capital gain. Note that any capital gain arising under this partial exemption may qualify for the CGT discount provided the relevant conditions are satisfied: see [14 390]. Note that the amount of a First Home Owners Grant does not form part of the expenditure included in the cost base of a home for the purposes of a partial exemption calculation: ATO ID 2010/73. [15 440] Partial exemption – income producing use If a dwelling otherwise qualifies as a main residence, but the dwelling was also used to produce assessable income, a partial exemption will apply: s 118-190(1). This may occur where a part of the residence is used as place of business (eg as a business office). This partial exemption can apply in addition to the partial exemption under s 118-185 for failing to qualify as a main residence (see [15 430]), subject to a reduction for any period of ‘‘overlap’’: see the example in s 118-190(3). A residence will only be taken to have been used to produce assessable income if, had an individual incurred interest on money borrowed to acquire the residence, this interest would have been deductible: s 118-190(1)(c). A deduction for interest for using part of a residence as place of business requires that that part of the residence have the character of a place of business: see Ruling IT 2673. As a result, a partial exemption will not apply if, for example, a room in the dwelling is merely used as a home office or to give music lessons (see also Ruling TR 93/30). The amount of the capital gain or loss will be the amount that is ‘‘reasonable’’, having regard to the extent (and period) for which the residence was used to produce assessable income: s 118-190(2). It is generally appropriate for that extent of income-producing use to be calculated on a floor area basis: Determination TD 1999/66. Note a partial exemption does not apply if the dwelling is used by someone else to produce income: Determination TD 1999/71. However, if a main residence is first used for income-producing purposes after 20 August 1996, any capital gain or loss on the disposal of the dwelling will be calculated by reference to the gain or loss that actually accrued over the period of income-producing use: s 118-192. To achieve this, the taxpayer will be taken to have acquired the dwelling for its market value at that time of first income-producing use: s 118-192(2). The rule only applies if the dwelling would have been entitled to a full main residence exemption immediately before the time of first income-producing use: s 118-192(1)(b). Note that a dwelling will not be subject to a partial exemption for income use if the absence concession (see [15 380]) is chosen under this rule. However, a partial exemption will apply if the 6-year income use under the absence concession is exceeded. This will be calculated by reference to the market value cost base at first income use and a relevant proportion of the period beyond 6 years that the dwelling then ceases to qualify as the taxpayer’s main residence, as per the partial exemption rule in s 118-185 for failing to qualify as a main residence ([15 430]). [15 450] Disposal of adjacent land separately from dwelling If land adjacent to a dwelling (including a garage, storeroom etc forming part of a home unit) is subject to a CGT event separately from the dwelling, the adjacent land does not 588

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qualify for the main residence exemption: s 118-165. This will usually occur if land adjacent to a dwelling is subdivided and sold, such as under dual occupancy arrangements: see also Determinations TD 2000/13 and TD 2000/14. A capital gain or loss in this situation is calculated on the basis that the cost base of that part of the asset that is sold is determined under the rules in s 112-25 for ‘‘split assets’’, which require the original cost base of the dwelling to be apportioned to each new subdivided lot: see [14 170]. This will include apportionment of any incidental costs of acquisition and non-deductible costs of ownership (eg mortgage interest). See Determination TD 1999/67 and ATO ID 2002/691 for the Commissioner’s views on the method of apportionment. See [15 340] for the extension of the main residence exemption to the compulsory acquisition of adjacent land where otherwise the rule in s 118-165 would prevent an exemption.

[15 460] Abandoned contracts The treatment of forfeited deposits in relation to abandoned contracts is dealt with under CGT event H1 (see [13 450]). Note that the main residence exemption is available for the amount of a forfeited deposit provided the deposit received as part of an uninterrupted sequence of transactions ending in the sale of the residence (or other relevant CGT event): s 118-110(2)(b). [15 470] Exemption for dwellings acquired from a deceased estate Special rules and concessions apply to dwellings (or interests in dwellings) that have been acquired through a deceased estate: ss 118-195 to 118-210. These rules apply regardless of whether the dwelling was a pre-CGT or post-CGT dwelling of the deceased, or whether it was the deceased’s main residence. The rules also apply if an interest in a dwelling passes to a surviving joint tenant (who is treated as having acquired the interest as a beneficiary in the deceased’s estate for the purposes of these rules: s 118-197). Full exemption Section 118-195(1) provides that a full exemption will apply on the disposal of a pre-CGT or post-CGT dwelling (or an inherited interest in the dwelling) by a trustee or beneficiary of the deceased estate in either of the following situations: 1. A post-CGT or pre-CGT dwelling is disposed of within 2 years of the deceased’s death. In the case of a post-CGT dwelling of the deceased, however, it must have been the deceased’s main residence at the date of death (or taken to have been the deceased’s main residence by way of the absence choice: see [15 380]) and was not then being used for producing assessable income. Note that the exemption will apply regardless of how the dwelling is used in that 2-year period (eg even if it was used to produce assessable income): see Determination TD 1999/70. Note also that the 2-year period is measured from the date of the deceased’s death until ‘‘settlement’’ of the contract of sale (given the meaning of ‘‘end of ownership interest’’ in s 118-130(3)), but subject to the Commissioner’s discretion to extend the 2-year period (see below). See also the Tax Office Guide to Capital Gains Tax on its website. 2. Disposal occurs after the dwelling has been occupied by defined person(s). The dwelling must be occupied as a main residence from the deceased’s death until its disposal by one or more of: (a) a surviving spouse (but not one ‘‘living permanently separately and apart from the deceased’’), (b) an individual with a right to occupy the dwelling under the deceased’s will, or (c) a beneficiary to whom the dwelling or an ownership interest in the dwelling passed (but, otherwise, a beneficiary must have a specific right to occupy the dwelling: see ATO ID 2003/109). Any delay in occupying the dwelling after the deceased’s death (eg © 2017 THOMSON REUTERS

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because of the time taken to obtain probate) is ignored in view of the concession in s 118-135 for ‘‘moving into a dwelling’’ (see [15 360] and ATO ID 2007/128). The Commissioner has a discretion to extend the 2-year period in which a dwelling can be disposed of CGT-free in circumstances such as where: ownership of the dwelling or the will is challenged; the complexity of a deceased estate delays the completion of administration of the estate; or a trustee or beneficiary is unable to attend to the deceased estate due to unforeseen circumstances. In exercising the discretion, the Commissioner will be expected to consider whether and to what extent the dwelling was used to produce assessable income and the period that the trustee or beneficiary held the ownership interest in the dwelling. The discretion will also apply to the partial exemption rules where relevant (see below). Note that the requirement in s 118-195 that the ownership interest in the dwelling disposed of by the trustee or beneficiaries of the estate be the same as the ownership interest held by the deceased means, for example, that the exemption does not apply if the deceased only had a right to occupy the dwelling: see Re the Estate of JR Cawthen (dec’d) and FCT (2008) 74 ATR 320. However, as an exception to this, the exemption rules will generally apply to the disposal by the recipient of a main residence owned by a Special Disability Trust on the death of the principal beneficiary, with effect from the 2006-07 income year: ss 118-220 to 118-227. See also [15 355]. Finally, for the purposes of s 118-195(1), a trustee of a deceased estate includes the trustee of a testamentary trust: see ATO ID 2006/34. Note that a proposal to enshrine in legislation the Tax Office practice of allowing a testamentary trust to distribute an asset of the deceased person without a CGT taxing point occurring will not proceed (see the then Assistant Treasurer’s media release (item 63), 14 December 2013). See [47 190] for legislation protecting taxpayers who in good faith prepared income tax returns on the basis of this measure.

Partial exemption If a full exemption is not available for the disposal of an inherited dwelling, a partial (or no) exemption will apply instead: s 118-200(1). However, if the dwelling was a pre-CGT dwelling or was the deceased’s main residence at the date of death and was not then being used to produce assessable income (or was taken to be under the absence concession: see [15 380]), any period during the deceased’s ownership when it did not qualify as their main residence and/or was used to produce assessable income is ignored in the partial exemption calculation (ss 118-190(4) and 118-200(4)), and the partial exemption will be calculated by reference the dwelling having been acquired for its market value at the date of the deceased’s death: s 128-15(4). On the other hand, if a post-CGT dwelling of the deceased was not the deceased’s main residence at date of death, the partial exemption calculation will take into account any period before the deceased’s death when it was not his or her main residence and also any period after the deceased’s death when it was not the main residence of a surviving spouse, a beneficiary or a person with a right to occupy (but subject to the concession if the dwelling is sold within 2 years of the deceased’s death): s 118-200(2) and (3). Importantly, the capital gain or loss subject to the partial exemption is calculated by reference to the trustee or beneficiary having acquired the inherited dwelling for a cost base as determined under the rules in s 128-15(4). Note that the same partial exemption rules will generally apply to the disposal by the recipient of a main residence owned by a Special Disability Trust on the death of the principal beneficiary, with effect from the 2006-07 income year: ss 118-220 to 118-227. See also [15 355].

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EXAMPLE [15 470.10] Ian inherits his mother’s post-CGT dwelling that was her main residence at the date of her death and was not then being used to produce assessable income. Its market value at that date was $400,000. He rents it out for 2 years and then moves in and makes it his home. He sells it 3 years later for $700,000. The capital gain is calculated as follows: 2 years (non-main residence days) 5 years (total days) = $300,000 × 0.4 = $120,000 $300,000 ×

Note (1) As the dwelling was the deceased’s main residence at her date of death and was not then used to produce income, any prior use of the dwelling by the deceased is ignored. (2) The dwelling is taken to have been acquired by Ian for its market value at the date of his mother’s death: s 128-15(4). (3) The 50% CGT discount (see [14 390]) is available as the dwelling was held for more than 12 months.

In addition, a partial exemption also applies to a dwelling of the deceased that was previously inherited by the deceased, to take account of the period that it did not qualify as a main residence under prior ownership periods before the deceased’s acquisition of the dwelling: s 118-205.

Disposal by trustee of dwelling acquired for occupation by beneficiary Special rules also apply if, under a will, the trustee of the deceased estate acquires a dwelling for occupation by a beneficiary of the estate: s 118-210. In this case, if the dwelling is transferred to the beneficiary and no money or property is received, any capital gain or loss is disregarded and the beneficiary is taken to have acquired the dwelling for the trustee’s cost base and acquisition date: s 118-210(2). If the dwelling is subsequently disposed of to a third party for consideration, no gain or loss will arise, provided the dwelling was the main residence of the beneficiary from the time it was acquired by the trustee until the time it was sold: s 118-210(3). Otherwise, a partial exemption may apply: s 118-210(4).

SMALL BUSINESS CONCESSIONS [15 500] Overview Division 152 provides 4 concessions to eliminate, reduce and/or provide a roll-over for a capital gain made on a CGT asset that has been used in a ‘‘small’’ business. These concessions are: (1) the ‘‘15-year exemption’’ (Subdiv 152-B): see [15 560]; (2) the ‘‘50% reduction’’ (Subdiv 152-C): see [15 570]; (3) the ‘‘retirement exemption’’ (Subdiv 152-D): see [15 580]; (4) the ‘‘roll-over’’ concession (Subdiv 152-E): see [15 590]. The availability of the concessions is subject to satisfying a range of ‘‘basic’’ conditions. In addition, the concessions themselves contain additional conditions that must also be met. Importantly, the concessions can be applied successively to eliminate a capital gain (but note the ‘‘15-year exemption’’ eliminates the capital gain entirely in its own right). © 2017 THOMSON REUTERS

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Note also the roll-over for small businesses owners that transfer business assets from one entity to another: see [16 500].

Basic conditions There are 2 basic conditions that must be met for a taxpayer to qualify for the small business concessions. 1. Either (a) the ‘‘maximum net asset value’’ (MNAV) test (see [15 510]) or (b) the ‘‘CGT small business entity’’ (SBE) test (see [15 520]) is satisfied or (c) where the taxpayer is a partner in a partnership that is a ‘‘small business entity’’, the CGT asset is an interest in an asset of the partnership: see [15 520]. 2. The CGT asset that gives rise to the gain must be an ‘‘active asset’’, ie generally an asset used in carrying on a business by the taxpayer or a ‘‘related’’ entity (see [15 530]). An active asset can also include shares in a company or trust interests in a trust, subject to satisfying certain conditions: see [15 540]. Note that in the case of a partner, the partner can choose to use either the test for ‘‘a partner in a partnership that is an SBE etc’’ or the ‘‘MNAV’’ test to qualify for the concessions, but not the SBE test, as a partner cannot be an SBE.

Relevant CGT events The concessions are available in respect of all CGT events that happen to an active asset (s 152-10(1)(a)) – except for gains arising under CGT event K7 (balancing adjustment event for depreciating asset) as this relates to the use of an asset for non-income producing purposes. Note the concessions are also available for gains arising under (s 152-12): (a) CGT event D2 (about granting, renewing or extending an option: see [13 160]) as the CGT event happens ‘‘in relation to’’ the underlying asset (see ATO ID 2011/45); and (b) CGT event D1 (creating contractual or other rights: see [13 150]), provided the CGT event is inherently connected with a CGT asset that satisfies the ‘‘active asset’’ test (eg it applies if a restrictive covenant is granted on the sale of business assets). However, capital gains arising under CGT events J2, J5 or J6 (see [15 590]) are not entitled to the 15-year exemption under Subdiv 152-B or the 50% reduction under Subdiv 152-C, while gains arising under CGT events J5 and J6 are not entitled to the roll-over (those events happen in certain circumstances where the roll-over was chosen): s 152-10(4).

Taxpayer includes LPR, beneficiary and surviving joint tenant The concessions are also available to the legal personal representative (LPR) or beneficiary of a deceased estate, a surviving joint tenant and the trustee of a testamentary trust provided (s 152-80): (a) the deceased would have qualified for the concessions just before her or his death; (b) the CGT event that gives rise to the gain in the hands of the LPR or beneficiary occurs within 2 years of the deceased’s death (or such further time as the Commissioner allows); and (c) the asset formed part of the estate of the deceased or came to be owned by a joint-tenant under the rule of survivorship.

Concessions available for gain under earnout arrangement The CGT small business concessions will also be available for any capital gain made on the sale of a business under an earnout arrangement under the CGT ‘‘look through’’ treatment of earnout arrangements. See [17 335] for further details. Note that prior to this CGT ‘‘look 592

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through’’ treatment, the Commissioner took the view that any gain made on an earnout right itself was not eligible for the concessions as an earnout right was not an ‘‘active asset’’ (see [15 530]).

[15 510] Maximum net asset value test The maximum net asset value (MNAV) test requires the ‘‘net value’’ of CGT assets of the following entities be less than $6m just before the CGT event (s 152-15): • the taxpayer; • ‘‘connected entities’’ (see [25 060]); and • ‘‘affiliates’’ (see [25 050]) – including connected entities of affiliates. In regard to the operation of the MNAV test, the following points should be noted. • Some assets are specifically excluded from the test (see below). • A debt owed to a taxpayer would generally be included in the test and would prima facie be brought into account at its face value (see Re Cannavo and FCT (2010) 79 ATR 756). However, whether a debt that is ‘‘statute-barred’’ from recovery would be included is uncertain. The issue was raised in Breakwell v FCT [2015] FCA 1471, but the court did not come to any particular conclusion as it held that the debt in question was not statute-barred. • In the case of a foreign resident, their worldwide CGT assets are included in the test and not just ‘‘taxable Australian property’’ (see [18 100]): ATO ID 2010/126. • Australian currency is a CGT asset for the purposes of the test only (see ATO ID 2003/166) but, in any event, moneys held in a bank account would be a chose in action which is clearly a CGT asset (see Re Excellar Pty Ltd and FCT (2015) 98 ATR 965). • In any dispute, the onus is on the taxpayer to establish that valuations are correct or at least more reasonable than the Commissioner’s valuations: see, for example, Re M & T Properties Pty Ltd and FCT (2011) 85 ATR 691. Note that a taxpayer can apply to the Tax Office for a ‘‘market value’’ private ruling: see also [3 210] and [45 160]. Note that the selling price of an asset in an arm’s length transaction is usually the ‘‘best indication’’ of its market value (see Re Excellar). Re Miley and FCT [2016] AATA 73 concerned the ‘‘market value’’ of a parcel of shares that a taxpayer sold in a private company in an arm’s length transaction (together with the other 2 shareholders’ shares in the company). The AAT decided that the market value was not the portion of the sale price allocated to the taxpayer’s 1/3 shareholding, but a lesser amount to cater for the fact that the price paid for all the shares did not reflect the fact that the market value of the taxpayer’s shares alone as a non-controlling shareholder was not the same. Central to the decision was the finding that the subject matter of the sale agreement was the entire shares in the company, but that it was only the market value of the taxpayer’s 1/3 shareholding that was subject to the MNAV test. This decision is on appeal. See [17 335] for the application of the MNAV test to the sale of a business under an earnout arrangement. See Ruling TR 2015/4 for how ‘‘unpaid present entitlements’’ of trusts are accounted for under the MNAV test.

Meaning of net value The ‘‘net value’’ of CGT assets means the amount (including negative amounts) by which the market value (not book value) of each CGT asset exceeds the liabilities that are related to the asset and various specified provisions: s 152-20(1). These ‘‘specified © 2017 THOMSON REUTERS

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provisions’’ are provisions for annual leave, long service leave, unearned income and tax liabilities: s 152-20(1)(b). See also Determination TD 2007/14. Note also liabilities would be inclusive of GST (see Re Excellar Pty Ltd). EXAMPLE [15 510.10] Valerie has CGT assets with a market value of $7m. The liabilities that relate to those assets are $1m. She has also made provisions for the income year of $300,000 for annual leave, $150,000 for unearned income and $50,000 for tax liabilities (totalling $0.5m). She therefore has a net asset value of $5.5m for that year. Valerie also owns 70% of the shares in LAE Pty Ltd (a ‘‘connected entity’’), which has CGT assets with a market value of $2m and liabilities relating to those assets of $3m, ie a negative net asset value of $1m. Therefore, as the net asset value of a taxpayer includes the value of connected entities, Valerie’s net asset value is $4.5m, ie $5.5m less the $1m negative net asset value of LAE Pty Ltd.

Various points about the meaning of the term ‘‘liabilities’’ should be noted: • It extends to legally enforceable debts due for payment and to presently existing obligations to pay a sum certain or an ascertainable sum, such as a resolution made by a trustee to make a distribution. But note that in Re Scanlon and FCT (2014) 99 ATR 687, the AAT ruled that a resolution per se made by a private company to pay eligible termination payments (ETPs) to its husband and wife directors was not a liability for the purposes of the MNAV test as, without an accompanying contractual arrangement, it did not create an enforceable right against the company (on appeal). • It would not include contingent liabilities (but see FCT v Byrne Hotels Qld Pty Ltd (2011) 83 ATR 261 below) or future obligations or expectancies (eg those under a guarantee or indemnity, unless the obligation actually arises). • It includes liabilities relating to interests in an entity connected with the taxpayer, where those interests have been disregarded to avoid double counting, eg money borrowed by the taxpayer to buy shares in a connected entity, where the net value of the shares themselves is otherwise disregarded. • In Re Track and FCT [2015] AATA 45, the AAT stated that the ‘‘liabilities’’ need to reflect the economic value of the business and that, in the ordinary course of events, the balance sheet of a business should demonstrate the economic value of a business. Importantly, there must be a ‘‘real and substantial and not remote’’ connection between the liability and a particular asset of an entity, or between a liability and the assets of the entity as a whole (eg a bank overdraft). For example, in Bell v FCT (2013) 90 ATR 7, the Full Federal Court confirmed that a loan of $2m taken out by a trust to enable it to make a distribution to the taxpayer beneficiary was not a liability that ‘‘related to’’ any asset of the trust. However, it said that the resolution to make a distribution created a liability over the assets of the trust as the trustee was required, under the terms of the resolution, to fund the resolution from capital. The Full Court also held that a $1m debit liability in a bank account of the taxpayer’s wife was not related to a credit amount in a related offset account as they were separate accounts (ie not ‘‘connected’’ or related) and that, in any event, the liability related to an excluded asset (ie a family home). Similarly, in Re Phillips and FCT (2012) 88 ATR 297, a liability incurred in respect of a loan made to a family trust that was secured by way of a mortgage over assets owned by a related entity (and not the entity whose assets were to be taken into account under the MNAV test) was not considered to be ‘‘related’’ to the assets of the trust as required. 594

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Partnership assets If the taxpayer is a partner in a partnership, and the relevant CGT event happens to partnership assets, the MNAV test does not include all the partnership assets, but only the partner’s interest in the partnership. (Note that a tax law partnership includes persons who jointly own an income producing property: see [22 040].) However, all the partnership assets will be taken into account for the purposes of the MNAV test if the partner controls the partnership in terms of the 40% distribution control test under s 328-125(2)(a)(ii) for connected entities, or to the extent that the partners are ‘‘affiliates’’ of each other under s 328-130: see [25 050] and [25 060]. Note that in Re Excellar Pty Ltd and FCT (2015) 98 ATR 965, the AAT ‘‘reluctantly’’ dismissed the argument that, on the basis that each partner was ‘‘jointly and severally’’ liable for the liabilities of the partnership, the liabilities of a 50% partner included 100% of the liabilities of the partnership. The AAT said that this approach would ‘‘distort’’ the application of the MNAV test (albeit, it appears that the AAT was mistaken in only including 50% of the value of the assets of the partnership when, as a 50% partner, the market value of all the partnership assets should have been included in the test). Excluded assets Various CGT assets are excluded from the MNAV test (s 152-20(2)): • shares, units or other interests (except debt) in an affiliate or a connected entity (to prevent double counting of the value of the underlying assets of those entities that have already have been taken into account under the test). Likewise, if an entity connected with the taxpayer is also connected with an affiliate of the taxpayer, its assets are not taken into account twice; • if the taxpayer is an individual, an asset used over its entire ownership period (ATO ID 2011/37) solely for the personal use and enjoyment of the taxpayer or her or his affiliates (ATO ID 2011/39) is excluded. See Re Altnot Pty Ltd and FCT (2013) 92 ATR 438 in which the AAT ruled that ‘‘personal use and enjoyment’’ requires a ‘‘continuity of use’’ and that, as a result, a holiday home did not qualify as ‘‘being used’’ for personal use and enjoyment as it had been used for rental purposes for much of the seven-year period before the relevant CGT event happened. An asset used ‘‘solely for personal use and enjoyment’’ does not include an interest earning personal bank account (ATO ID 2009/33), vacant land on which the taxpayer intends to construct a dwelling for private use (ATO ID 2009/34) or the personal use by others of an individual’s holiday house for which rent is paid (ATO ID 2011/41), but (if no rent is paid, the asset may still be used ‘‘solely for personal use and enjoyment’’ (ATO ID 2011/40); • the net value of a dwelling that is an individual’s main residence (see Bell v FCT (2013) 90 ATR 7 and ATO ID 2011/38), but only to the extent that it is not used for income producing purposes (as determined by the proportion of the dwelling and the period for which interest could be claimed as a deduction): s 152-20(2A); • a right to any payment from, or asset of, a superannuation fund or approved deposit fund, or a policy of insurance on the life of an individual is excluded. Note that the net value of the CGT assets of a taxpayer’s affiliate, or an entity that is connected with the affiliate, are not included in the MNAV test if they are used, or held ready for use, in the carrying on of a business by an entity that is ‘‘connected’’ with the taxpayer only because of that affiliate relationship: s 152-20(4). This would occur, for example, where the taxpayer and another party carry on a business jointly in partnership in circumstances where one party is an affiliate of the taxpayer, but where that affiliate carries on a separate and independent business. In this case, the assets of that business would not be included in the MNAV test. © 2017 THOMSON REUTERS

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EXAMPLE [15 510.20] Eloise and Sam are a married couple who sell a florist’s business that they jointly carry on. Eloise also wholly owns a company that carries on a theatrical production business. Sam has no involvement with the theatrical production business. Sam disregards the theatrical production company’s assets in working out whether he satisfies the MNAV test because, although the company is ‘‘connected’’ with him, it is so connected only because of his affiliate (Eloise).

Application of MNAV test – ‘‘just before CGT event’’ The maximum net asset value test is required to be met ‘‘just before the CGT event’’ that gives rise to the capital gain: s 152-15. Real estate agent commissions incurred on the sale of a hotel business and legal fees billed after the sale may be taken into account as a ‘‘liability’’ for the purposes of the MNAV test, even though payment is dependent on the sale being completed (ie after CGT event A1 has happened on the making of the contract of disposal): see FCT v Byrne Hotels Qld Pty Ltd (2011) 83 ATR 261. Note in this regard that Addendum 14A3 to Determination TD 2007/14 states that the ‘‘contingent liabilities’’ which are relevant for the purpose of the net asset value calculation under s 152-20 are presently existing legal or equitable obligations where the only contingency is enforcement (eg solicitor’s fees) or obligations that are technically, but not ‘‘truly’’, contingent because the contingencies are formalities or procedural matters where nothing remains to be done by the relevant party to perfect its entitlement (eg agent’s commission). [15 520] CGT small business entity test A taxpayer can also qualify for the concessions under the ‘‘CGT small business entity’’ (SBE) test in Subdiv 328-C: s 152-10(1)(c)(i). This requires: (a) the taxpayer who owns the CGT asset to be carrying on a business (subject to the exception for ‘‘passively held assets’’ – see below), and (b) the annual turnover of the taxpayer, ‘‘affiliates’’ and ‘‘connected entities’’ not to exceed $2m in the income year (note that the proposed increase in the small business entity threshold to $10m will not apply for the purposes of the CGT small business concessions: see [25 020]). See [25 020] for further details of this test. In the case of partners, this test will be met if the partnership is a SBE and the CGT asset is ‘‘an interest in an asset of the partnership’’: s 152-10(1)(c)(iii). However, a partner cannot be a SBE in their own right: s 328-110(6).

‘‘Passively held’’ assets A taxpayer can also use the SBE test for ‘‘passively held’’ assets (ie where the taxpayer does not carry on a business but an asset they own is used in a business carried on by an affiliate or a connected entity of the taxpayer): s 152-10(1A). This would occur, for example, where an asset owned by an individual taxpayer is used in a business carried on through their wholly owned company. Likewise, a partner (or partners) who owns a CGT asset that is not an interest in a partnership asset can access the small business concessions via the SBE test if the asset is made available for use in the partnership: s 152-10(1B). There are also special rules for calculating aggregated turnover for passively held assets, in addition to the basic aggregated turnover rules in Subdiv 328-C (see [25 020]). Broadly, these rules treat an entity that is an affiliate or connected entity of the owner of a passively held CGT asset as an affiliate or connected entity with the entity that uses the passively held 596

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asset in its business: s 152-48. As a result, this rule includes the turnover of all entities that are, in effect, part of the same business operation. If the CGT event that gives rise to the capital gain occurs in a later year than that in which the asset owner ceased to carry on the business, and the business is being wound up in the CGT event year, s 152-49 effectively allows access to the small business concessions by treating the entity as carrying on the business in the CGT event year and treating the CGT asset as being used in, or being inherently connected with, the business in that year. This ensures the same treatment applies to passively held assets as for other assets under s 152-35(2): see [15 530].

[15 530] Active asset test – general A CGT asset of the taxpayer is an ‘‘active asset’’ if it is used, or held ready for use, in carrying on a business by the taxpayer, an ‘‘affiliate’’ (see [25 050]) or a ‘‘connected entity’’ (see [25 060]) for the relevant period of ownership of the asset (see below): s 152-40(1)(a). For example, an active asset can include land owned by a family trust that is used by a beneficiary in their business, provided the trust and the beneficiary are ‘‘connected entities’’ or ‘‘affiliates’’. Likewise, an active asset can include an asset leased by a taxpayer to a connected entity or affiliate for use in their business. See Determination TD 2006/63. Carrying on a business Whether an entity is ‘‘carrying on a business’’ is considered at [5 020]. In Re Karapanagiotidis and FCT (2007) 68 ATR 348, the AAT decided that vacant land on which a taxpayer stored business records in containers was not an active asset on this basis. But the situation may be different if, for example, trading stock was stored on the land. See also Re Fowler and FCT [2016] AATA 416, where the late taxpayer was not considered to be carrying on a business managing units that he owned. Note that the rule in s 392-20(1) ITAA 1997, that a beneficiary who is entitled to income of a trust carrying on a primary production business is deemed to be also carrying on the business for averaging purposes, is disregarded for the purposes of the ‘‘active asset’’ test: s 152-40(2). Note also that a partner is not considered to be carrying on a business in their own right, but rather collectively with the other partners (and, as a result, a partner per se cannot be an SBE). For the meaning of ‘‘used, or held ready for use’’, see [10 080]. For example, a farm to which improvements have been made in preparation for the return of stock would be considered as being ‘‘held ready for use’’ in the taxpayer’s business. See ATO ID 2002/354, where the Tax Office ruled that assets were not being used, or held ready for use, in a business. Assets used in business of a spouse or child For the purposes of allowing greater access to the concessions, a CGT asset owned by a taxpayer (or by an entity which the taxpayer ‘‘controls’’) that is used in a business carried on by a spouse or child (under 18 years) of the taxpayer, will qualify as an active asset. This is achieved by ‘‘automatically’’ treating the spouse or child as an ‘‘affiliate’’ of the taxpayer even if they do not satisfy the specific requirements of the definition of ‘‘affiliate’’: s 152-47. Likewise, if the spouse or child ‘‘controls’’ an entity which carries on a business in which the taxpayer’s asset is used, then that entity will also be a ‘‘connected entity’’ of the taxpayer. While this rule allows greater access to the concessions, it also possibly reduces access to the concessions by requiring the net assets and turnover of such ‘‘affiliates’’ and ‘‘connected entities’’ to be included in the MNAV and SBE test, respectively. Discretionary trusts – connected entities in loss year For the purposes of the ‘‘active asset’’ test, the trustee of a discretionary trust can nominate (in writing) up to 4 beneficiaries as being ‘‘connected entities’’ to the trust in a year in which it did not make a distribution (because of tax losses or nil taxable income) for the © 2017 THOMSON REUTERS

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purpose of either the trust or beneficiary accessing the concessions: s 152-78. Note that the trust and the beneficiary, or beneficiaries, are also required to aggregate the market value of their CGT assets (for MNAV test purposes) or their turnovers (for SBE test purposes) in this case.

Intangible active assets Section 152-40(1)(b) provides that an ‘‘active asset’’ also includes intangible assets inherently connected with carrying on the business (eg goodwill and rights under a restrictive covenant) by the taxpayer, an affiliate or a connected entity. Note the following: • trade debts can also be an active asset under this test (see the Tax Office’s Advanced Guide to CGT Concessions for Small Business, which provides that where a business makes sales on credit in the normal course of its operations, the resulting trade debtors can reasonably be seen as being ‘‘inherently connected’’ with that business); • intangible assets do not include intellectual property (eg trademarks) as these are depreciating assets and capital gains and losses on such assets are generally ignored: see [15 080] and [13 700].

Period for which asset must have been an active asset The asset must have been an ‘‘active asset’’ for either (a) at least half the period of its ownership, or (b) at least 71/2 years if the asset was owned for more than 15 years: s 152-35(1). Note this ‘‘holding period’’ is measured from the time the asset was acquired until the earlier of either (a) the CGT event that gives rise to its disposal or (b) the cessation of the business, provided the asset is disposed of within 12 months of the cessation of the business (or such further time as the Commissioner allows): s 152-35(2). This advantages the taxpayer. This holding rule means that once an asset has been an active asset for the required holding period, it will retain its character as an active asset regardless of how it is used during the rest of the period of ownership. Further, the exclusion for an asset whose ‘‘main use’’ is to derive rent (see below) only applies to determine if, during any part of the period of ownership, the asset did not qualify as an active asset on the basis that its main use was to derive rent (noting also that the holding period requirement does not have to be met on a continuous basis, but can comprise one or more periods of requisite business use). The holding rule is adjusted for assets acquired under the Subdiv 124-B roll-over (assets compulsorily acquired, lost or destroyed: see [16 100]) and assets subject to the former Subdiv 124-O roll-over (financial services reform relief) to take account of the period of ownership of the original asset. Likewise, an optional extended ‘‘holding period’’ is available for assets acquired under the marriage or relationship breakdown roll-over (see [16 350]) to take into account the former spouse’s ownership of the asset: s 152-45. Specific exclusions Section 152-40(4) provides that the following assets cannot be ‘‘active assets’’: • shares and trust interests in ‘‘connected entities’’ (see [25 060]), other than those which qualify as active assets under the test in s 152-40(4)(a) (see [15 540]); • certain shares and trust interests in widely held entities: s 152-40(4)(b) and (c) (see [15 540]); • financial instruments (eg loans, debentures, promissory notes, futures contracts, currency swap contracts and a right or option over a share, security, loan, etc): s 152-40(4)(d). Note that Australian currency is not an active asset, with the result that moneylenders cannot access the small business concessions, but trade debts are not financial instruments and therefore would qualify as active assets (see withdrawn ATO ID 2002/1003); 598

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• an asset whose main use in the course of carrying on a business is to derive interest, an annuity, rent (see below), royalties or foreign exchange gains – but this exclusion does not apply if the main use of the asset for deriving rent was only ‘‘temporary’’, or if an intangible asset has been substantially developed or improved so that its market value has been substantially enhanced: s 152-40(4)(e).

Exclusion for assets used mainly to derive rent The following matters about the exclusion for an asset used mainly to derive rent should be noted. • If the asset is not used in carrying on a business, the exclusion will not apply as the asset will not qualify as an ‘‘active asset’’ in the first place (eg Re Carson and FCT (2008) 71 ATR 301, where it was ruled that no business was being carried on in relation to a holiday unit used for short-term holiday accommodation). See also Determination TD 2006/78. • Even if the taxpayer is using an asset to ‘‘carry on a business’’ of deriving rent, it will be excluded under this rule for being used ‘‘mainly to derive rent’’ (see Re Jakjoy Pty Ltd and FCT (2013) 96 ATR 185). • Whether an asset is used to derive rent will depend on the circumstances (eg in Re Tingari Village North Pty Ltd and FCT (2010) 78 ATR 693, the AAT decided that the exclusion applied to the sale of a mobile home park business as the relationship between the taxpayer and each resident was in the nature of a lease from which the taxpayer derived rent). On the other hand, a rent roll used in a real estate agency business would be considered to derive management fees and not rent and therefore would qualify as an active asset. • It is the ‘‘use’’ of the asset in the business, and not by the taxpayer who owns it, that is relevant for this purpose. As a result, for example, if a taxpayer rents an asset to a connected entity for use in its business, the asset is not excluded, unless the connected entity itself uses the asset to derive rent: see Determination TD 2006/63. • If an asset is used by the taxpayer’s affiliate or an entity connected with the taxpayer, all the uses of the asset (except for personal use by the taxpayer or an affiliate, etc) will be taken into account in determining whether the asset’s main use is to derive rent. The exclusion of an asset whose main use is to derive rent does not override the holding rule that an asset is only required to be an active asset for half the period of its ownership, or 71/2 years if it has been owned for more than 15 years. Therefore an asset can still be an active asset if for less than half the period of its ownership its ‘‘main use’’ was to derive rent while, on the other hand, it will not be an active asset if for more than half the period of its ownership its ‘‘main use’’ was to derive rent (see, for example, Re Vaughan and FCT (2011) 85 ATR 608). The following Example (taken from Determination TD 2006/78) explains the Commissioner’s approach to determining if a CGT asset is used mainly to derive rent. EXAMPLE [15 530.10] Mick owns land on which there are a number of industrial sheds. He uses one shed (45% of the land by area) to conduct a motor cycle repair business. He leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the motor cycle repair business is 80% of the total income derived from the use of the land and buildings. In determining the main use of the land at that time, it is appropriate to consider that a substantial (although nevertheless not a majority) proportion by area of the land is used for business purposes. As well, the business proportion of the land derives the vast majority (80%) of the total income. In all the circumstances, the Tax Office considers the main use of the land © 2017 THOMSON REUTERS

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in this case is not to derive rent.

[15 540] Active assets – shares and trust interests A share in a resident company or a trust interest in a resident trust (the ‘‘object’’ company or trust) can qualify as an ‘‘active asset’’ if the following 2 conditions are met: • the ‘‘80% active asset’’ test: see [15 545]; and • the ‘‘CGT concession stakeholder’’ test: see [15 550]. These conditions apply whether the shares or trust interests in the ‘‘object’’ company or trust are held by an individual or by an interposed company or trust.

[15 545] The 80% active asset test Under the ‘‘80% active asset test’’, the market value of the active assets of the company or trust carrying on the business must be 80% or more of the market value of all the assets of the company or trust. In this regard, note that this test for shares and trust interests operates ‘‘successively at each level in a chain of entities’’: see Determination TD 2006/65. This means that a share in a company or a trust interest in an interposed entity will also qualify as an active asset if the interposed entity owns shares or trust interests in the relevant company or trust that satisfy the 80% active test. Likewise, shares or trust interests held by the interposed entity in the company or trust that satisfy the 80% active asset test will also qualify as active assets. Other key things to note about this 80% active asset test include: • The 80% test will be satisfied if it is ‘‘reasonable to conclude’’ that it has been met, ie it does not need to be applied on a day-to-day basis (eg it will be met if there has been no significant change to the assets or liabilities of the entity): s 152-40(3A). Likewise, a breach of the 80% test that is only ‘‘temporary’’ will not result in the test being failed (eg if a company borrows money to pay a dividend): s 152-40(3B). • Like other active assets, shares or trust interests need only qualify as ‘‘active assets’’ for at least half the period of their ownership, or 7 1/2 years if they have been owned for 15 years or more: see [15 530]. This means, for example, that shares in a company in liquidation could be disposed of some time after the liquidation and still qualify as active assets. • Cash and financial instruments inherently connected with the business are treated as active assets in determining whether the 80% test is satisfied: s 152-40(3)(b)(ii) and (iii). Note that shares and trust interests in ‘‘widely held entities’’ (see [20 550]) are prevented from being active assets, unless the entity passes the ‘‘80% active asset’’ test and the shares or trust interests are held by ‘‘CGT concession stakeholders’’ (see [15 550]): s 152-40(4)(b). Likewise, a trust interest cannot be an active asset unless the trust passes the 80% active asset test and, in the case of trusts listed on an approved stock exchange (in Sch 5 to ITA Regs) or a trust with 50 ‘‘members’’ or more, the trust interest is owned by a CGT concession stakeholder: s 152-40(4)(c) and (5). However, this rule does not apply to a trust with 50 members or more that is a discretionary trust or to a trust in respect of which control is concentrated in 20 members or less by reference to ‘‘membership interests’’, voting interests or distributions rights of at least 75%.

[15 550] CGT concession stakeholder test For a share or trust interest to qualify as an ‘‘active asset’’, the ‘‘CGT concession stakeholder’’ test in s 152-10(2) must also be satisfied in the income year in which the capital gain arises (in addition to the 80% active asset test: see [15 540]). In this case, there are 2 scenarios to consider. 600

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1. Where shares or trust interests are owned by an individual, the individual must be a ‘‘CGT concession stakeholder’’ in the company or trust that carries on the business (as traced through any interposed companies or trusts): s 152-10(2)(a). 2. Where shares or trust interests are owned by a company or trust, these ‘‘CGT concession stakeholders’’ must also have at least a 90% ‘‘small business participation percentage’’ in the company or trust (see below): s 152-10(2)(b).

Meaning of CGT concession stakeholder A ‘‘CGT concession stakeholder’’ is defined as (a) a ‘‘significant individual’’ in the company or trust, or (b) the spouse of a significant individual in the company or trust, if the spouse has a ‘‘small business participation percentage’’ (SBPP) in the company or trust greater than zero: s 152-60. Note that in determining if a shareholder or the trust interest holder is a ‘‘significant individual’’, both their direct and indirect SBPP (see below) in the company or trust is taken into account: s 152-55. Note that the ‘‘CGT concession stakeholder’’ test ensures that the CGT small business concessions apply in respect of the shares and trust interests of those individuals (and their spouses) who, in effect, own the business being carried on by a company or trust. The test also allows up to 8 individual shareholders in a company to access the concessions. The ‘‘CGT concession stakeholder’’ is also relevant to eligibility for the 15-year exemption (see [15 560]) and the retirement exemption: see [15 580]. Direct SBPP – shares For shareholders, their ‘‘direct SBPP’’ is measured by reference to the smallest of their voting, dividend and capital distribution rights under the shares they hold in the entity (ignoring redeemable shares): s 152-70(1) and (2). That is, if a shareholder owns different percentages of these rights in a company, the SBPP will be the smallest percentage. Note that in Re Devuba Pty Ltd and FCT [2015] AATA 255, the AAT held that the fact that a CGT concession stakeholder held a dividend access share with no right to the payment of a dividend until such time as the directors resolved to make a distribution, did not mean they had the ‘‘smaller’’ interest of ‘‘zero’’ in the company. The decision was confirmed on appeal in FCT v Devuba Pty Ltd [2015] FCAFC 168, where the Court also took into account the company’s Articles of Association to find that the resolution expressly limited the company’s ability to pay a dividend to the holder of the dividend access share until the directors resolved otherwise. EXAMPLE [15 550.10] Jay has shares that entitle him to 25% of any dividend and capital distributions of ABC Pty Ltd. However, the shares do not carry any voting rights. As a result, Jay’s SBPP in ABC Pty Ltd is nil and he is not a significant individual.

Note that joint owners of shares can qualify as significant individuals on the basis of their dividend or capital distribution entitlements alone. (This overcomes concerns that a joint owner may only have a zero percentage of voting power.)

Direct SBPP – trust interests For trust interest holders who have entitlements to all the income and capital of the trust (ie a ‘‘fixed trust’’), their direct SBPP will be the actual percentage of distributions of income or capital or, if they are different, the smallest percentage. Note also that a trust, in relation to which a term of the trust deed gives the trustee the power to accumulate income or capital of the trust estate for a year of income, is capable of being a trust where entities have entitlements to all the income and capital of the trust: see ATO ID 2015/8. © 2017 THOMSON REUTERS

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For trust interest holders who do not have entitlements to all the income and capital of the trust (ie a discretionary trust), their direct SBPP will be the actual percentage of distributions of income or capital they are entitled to in an income year or, if they are different, the smallest percentage: s 152-70(1). Note that the requisite direct SBPP can be achieved by making appropriate distributions (or resolving to) by the end of the relevant year (see below). Note also that ‘‘income’’ in this context means income of the trust, determined according to the general law of trusts (see [23 300]), and does not necessarily mean income according to ordinary concepts: see ATO ID 2012/99. EXAMPLE [15 550.20] A family trust has income of $10,000 in the relevant income year. It distributes $2,000 of this income to Gus, who is a beneficiary. This means that Gus has a direct SBPP of 20% in the trust and is a significant individual. However, if the trust also distributed $10,000 of capital in the same year, of which the beneficiary received $1,000, Gus would only have an SBPP of 10% (the smaller of the 2 SBPP entitlements). In that case, Gus would not be a significant individual.

If a discretionary trust does not make a distribution of income or capital during the income year, it will not have a significant individual in that year: s 152-70(6). However, a person can be a significant individual if a relevant distribution is made in a prior year if the reason the trust made no distribution in the year of the CGT event (or immediately preceding years) is because it had a tax loss or no net income for the year(s): ss 152-70(4) and (5). This will also be relevant for satisfying the CGT concession stakeholder requirement for the purposes of the 15-year exemption (see [15 560]) and the retirement exemption (see [15 580]).

Indirect SBPP – shares and trust interests The indirect SBPP of a shareholder or a trust interest holder is calculated by multiplying their ‘‘direct SBPP’’ in an interposed entity by the interposed entity’s total SBPP (both direct and indirect) in the company or trust: s 152-75. EXAMPLE [15 550.30] Carl owns 60% of the shares in Interposed Co, which in turn owns 50% of the units in Interposed Unit trust, which in turn owns 100% of the shares in Operating Co. Carl’s indirect SBPP in Operating Co is 30%. This is calculated by multiplying his direct SBPP (60%) in Interposed Co by Interposed Co’s total SBPP (both direct and indirect) in Operating Co (50% × 100%). That is, Carl’s indirect SBPP is 60% × (50% × 100%) = 30% Carl is therefore a significant individual CGT concession stakeholder in Operating Co via his indirect greater than 20% SBPP in Operating Co.

EXAMPLE [15 550.35] Ken owns 20% of the units in Fixed Trust A that owns 90% of the shares in Company B (that carries on a business and meets the 80% active asset test). Ken’s indirect interest in Company B is 18% (ie 20% of the units in Fixed Trust A × 90% of its shares in Company B). Therefore, he does not have the requisite 20% interest in Company B. However, if he also directly owned 10% of the shares in Company B, that direct interest would also be included and he would own a 28% interest in Company B and therefore satisfy the ‘‘CGT concession stakeholder test’’.

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[15 560]

Company or trust makes gain on interest – 90% SBPP test Where the taxpayer is a company or trust that makes a capital gain on shares or trust interests it holds in another company or trust (as the case may be), then the following 2 requirements must be met (s 152-10(2)(b)): (a) there must be individuals who are ‘‘CGT concession stakeholders’’ in the company or trust that carries on the business (as traced through any interposed companies or trusts); and (b) those CGT concession stakeholders must have alone or between them at least a 90% SBPP in the company or trust that has made the capital gain on the shares or trust interests. In short, the 90% SBPP test requires 90% or more of the SBPP in the company or trust which makes the capital gain on the shares or trust interests to be directly or indirectly held by individuals who are also CGT concession stakeholders in the company or trust which carries on the business. Again note that a discretionary trust can ensure it satisfies the 90% SBPP test by making appropriate distributions in the income year in which the capital gain arises or by resolving to (including by way of making appropriate records, minutes or notes of the decision to do so). EXAMPLE [15 550.40] All of the shares in ABC Pty Ltd are held by the XYZ family trust, the beneficiaries of which include Lisa and Dean. ABC Pty Ltd carries on a business that satisfies the 80% active asset test. In the 2016-17 income year, the XYZ family trust sold all its shares in ABC Pty Ltd. In the same income year, it made distributions of 50% of its income to Lisa and 40% to Dean. The shares that the XYZ family trust sold in ABC Pty Ltd would qualify as active assets because: (a) Lisa and/or Dean are CGT concession stakeholders in ABC Pty Ltd in view of their interest of greater than 20% in ABC Pty Ltd (as traced through the XYZ family trust), ie Lisa 50% (50% × 100%) and Dean 40% (40% × 100%); and (b) between them they would have an interest in the XYZ family trust of at least 90% (in view of the 90% distributions of trust income made to them in the 2016-17 income year).

Finally, note that the ‘‘15-year exemption’’ (see [15 560]) and the ‘‘retirement exemption’’ (see [15 580]) also require the existence of a CGT concession stakeholder to whom the payment of the exempt amount can be made where a capital gain is made by a company or trust.

[15 560] 15-year exemption A taxpayer, whether an individual, company or trust, is entitled to a total exemption on a capital gain (under Subdiv 152-B) if: • the basic conditions in Subdiv 152-A are met (ie either the ‘‘maximum net asset value’’ test (see [15 510]) or the ‘‘small business entity’’ test (see [15 520]), plus the ‘‘active asset’’ test (see [15 530]) are satisfied): ss 152-105(1)(a) and 152-110(1)(a); • the asset has been continuously owned by the taxpayer for at least 15 years up to the time of the CGT event: ss 152-105(1)(b) and 152-110(1)(b); • if the CGT asset is a share or trust interest, or if the taxpayer is a company or trust, the company or trust must have had a ‘‘significant individual’’ for at least 15 years during which the share or trust interest was owned (even if the 15 years was not continuous and even if it was not the same significant individual): ss 152-105(1)(c) © 2017 THOMSON REUTERS

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and 152-110(1)(c). Note that a discretionary trust need not have a significant individual in a loss year or a nil income year (see [15 550]); and • if the taxpayer is an individual, he or she must be at least 55 years of age and the CGT event must happen in connection with the taxpayer’s retirement, or he or she must be permanently incapacitated at that time: s 152-105(1)(d). If the taxpayer is a company or trust, a person who was a significant individual just before the CGT event must satisfy those requirements: s 152-110(1)(d). Importantly, the 15-year exemption has priority over the other concessions because it provides a full exemption for the capital gain: ss 152-215, 152-330 and 152-430. In addition, the exemption is applied without first having to use prior year capital losses: see [14 370]. Note that any ordinary or statutory income derived by a company or trust from a CGT event which would give rise to the 15-year exemption is non-assessable non-exempt income of the company or trust: s 152-110(2). However, this does not apply to income derived by a company or trust from a balancing adjustment event in relation to a depreciating asset under Div 40 (the uniform capital allowance regime) or under Div 328 (small business entities).

15-year ownership requirement The active asset holding period requirement (see [15 530]) means that, although an asset is required to have been owned by the taxpayer for at least 15 years, it need only have been an active asset for a minimum of 71/2 years. The period of ownership of an active asset can be extended to take into account prior periods of ownership if there has been a roll-over because of a marriage breakdown, a compulsory acquisition or the loss or destruction of an asset, or if the ‘‘small business roll-over’’ relief applied: see [16 500]. If the asset was transferred between members of a consolidated group, the ownership period does not recommence: Determination TD 2004/44. Likewise, the period of ownership of an asset by a company is not affected by any change in the majority underlying interests in the asset under Div 149 (see [17 250]): s 152-110(1A). Meaning of ‘‘in connection with retirement’’ or ‘‘permanent incapacity’’ There is no definition of ‘‘retirement’’ for the purpose of the exemption. Accordingly, the ordinary meaning of withdrawal from office, business or active life should apply. Further, if a wide interpretation is given to the phrase ‘‘in connection with’’, the relevant CGT event does not have to occur at the same time as the retirement and could occur either in anticipation of the retirement or after retirement. Note that there does not need to be a complete withdrawal from the workforce (eg a taxpayer may stay on for a limited period to assist a new owner during a transitional period). Similarly, it may be permissible for a taxpayer who has genuinely retired from the workforce to subsequently take up another full time position or to become involved in a new business. See the Tax Office publication ‘‘Advanced guide to capital gains tax concessions for small business’’ for further details on this matter. The term ‘‘permanent incapacity’’ is also not defined in Subdiv 152-B. However, the SIS Regs define permanent incapacity in relation to a fund member who has ceased to be gainfully employed due to ill health, whether physical or mental, as being where the trustee is reasonably satisfied that the member is unlikely to ever again engage in gainful employment for which the member is reasonably qualified. Gain made by company or trust In the case of a capital gain made by a company or trust (‘‘the exempt amount’’), this amount must be distributed (in one or more payments) to a person who was a CGT concession stakeholder just before the CGT event: see [15 550]. The distribution must be made, within 2 years of the CGT event (or such further time as the Commissioner allows): s 152-125(1) and (4). Note the payment can be made through interposed entities: s 152-125(2). 604

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[15 580]

Where these conditions are met, the amount of the payment will be exempt in the recipient’s hands. In addition, it will not be treated as a dividend or frankable distribution in the case of a payment by a company: s 152-125(1) – (3). This also applies to a distribution of the gain from pre-CGT active assets held for 15 years, or where the disposal gave rise to non-assessable non-exempt income (eg the amount under the ‘‘no gain/no loss’’ rule in s 100-45): s 152-125(1)(a)(i)-(iii). Likewise, a pre-CGT capital gain that existed on an asset before the effect of Div 149 (which converts a pre-CGT asset into a post-CGT asset if there has been at least a 50% change in ownership of the entity that owns the asset) can be distributed tax-free to a CGT concession stakeholder: s 152-125(1)(a)(iv). See also [17 250]. However, the exemption only applies to the extent that the total of the payments made to the CGT concession stakeholder do not exceed the ‘‘stakeholder’s participation percentage’’ in the exempt amount, which is essentially their small business participation percentage in the company or trust (see [15 550]): s 152-125(2).

The CGT cap Superannuation contributions arising from capital proceeds that qualify for the 15-year exemption (and capital gains that qualify for the retirement exemption) are excluded from the non-concessional contributions cap up to a lifetime indexed ‘‘CGT amount’’: see [39 450]. [15 570] 50% reduction The 50% reduction in Subdiv 152-C applies automatically to a capital gain if the basic conditions contained in Subdiv 152-A are satisfied (ie either the ‘‘maximum net value asset’’ test (see [15 510]) or the ‘‘small business entity’’ test (see [15 520]), plus the ‘‘active asset’’ test (see [15 530]) are satisfied) – unless the taxpayer chooses for it not to apply: ss 152-205 and 152-220. See [12 440] for how to make a choice. If the CGT asset is a share or trust interest held by either an individual or an interposed entity, the ‘‘CGT concession stakeholder’’ requirements must also be met (see [15 530]). However, if the taxpayer claiming the 50% reduction in respect of the disposal of an asset (other than a share or a trust interest) is a company or trust, there is no requirement that it have a ‘‘significant individual’’. If the 15-year exemption applies (see [15 560]), it has priority over the 50% reduction: s 152-215. Application of the CGT discount If the gain derived by the taxpayer qualifies for the 50% CGT discount, it must be applied to the gain before the 50% reduction: s 152-205. This will require the use of existing capital losses: see step 3 in the Method Statement in s 102-5(1) (see [14 360]). The result, however, will be a 75% reduction in the assessable gain. Note that the CGT discount is not available to companies (see [14 390]). Note also that, unlike the 50% CGT discount, the 50% reduction applies notwithstanding the asset may have been held for less than 12 months. Application of other small business concessions The capital gain remaining after the 50% reduction may be further reduced by the retirement exemption (see [15 580]) and/or the small business roll-over (see [15 590]) if the gain qualifies for those concessions, and the taxpayer can choose the order in which to apply them: s 152-210(1) and (2). Application of concessions to beneficiaries of a trust The 50% reduction is also available to a beneficiary of a trust in respect of a capital gain distributed to the beneficiary if the trust was eligible for the 50% reduction: s 115-215. See [17 030] for how the assessable capital gain is calculated in this case. [15 580] Retirement exemption Under the retirement exemption in Subdiv 152-D, a taxpayer can choose to disregard all or part of a capital gain made from a CGT event. This includes capital gains reinstated under © 2017 THOMSON REUTERS

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CGT events J2, J5 or J6. The taxpayer can be an individual, a company or a trust. However, a lifetime maximum limit of $500,000 applies to amounts that qualify for the exemption: ss 152-315 and 152-320. See [12 440] for how to make a ‘‘choice’’. But note the rules that apply in relation to choosing the retirement exemption for gains made under an earnout arrangement (see [17 335]). To access the concession, the basic conditions contained in Subdiv 152-A must be met (ie the ‘‘maximum net asset value’’ test (see [15 510]) or the ‘‘small business entity’’ test (see [15 520]), plus the active asset test (see [15 530]): s 152-305(1)(a) and (2)(a). However, they do not have to be met if the gain arises from CGT event J5 (see [13 580]) or CGT event J6 (see [13 590]): s 152-305(4). Note that an executor of a deceased estate can make the choice to apply the retirement exemption if the relevant conditions are met: see ATO ID 2012/39. Any prior year losses and the CGT discount must be applied to a gain before the retirement exemption: see [14 360]. If a taxpayer qualifies for the 15-year exemption (see [15 560]), that exemption will take priority over the retirement exemption (and other concessions).

No age limit or requirement to retire There is no age limit on using the exemption, nor any requirement to retire. However, if an individual is under 55 at the time of choosing to apply the exemption, the amount chosen to be disregarded by the individual must be rolled over to a complying superannuation fund or an RSA: s 152-305(1)(b) and (c). (See below for when the roll-over must occur.) This can include a contribution by way of transferring real property to a complying super fund provided the transfer satisfies the relevant provisions of the SIS Act: see ATO ID 2010/217. The amount rolled over is not deductible (s 290-150(4)) and thus is not assessable income of the fund or RSA (see [41 190]). The same rule applies if the capital gain is made by a company or trust that chooses the exemption and is required to make a payment to a CGT concession stakeholder (see below). On the other hand, if the individual or CGT concession stakeholder is 55 or over at the time of choosing the exemption, they can take the capital gain tax free without any obligation to roll the amount over into a superannuation fund or an RSA. Note that a deduction cannot be claimed for contributions made by the taxpayer in these circumstances. Note also that superannuation contributions arising from gains that qualify for the retirement exemption (and the 15-year exemption) are excluded from the nonconcessional contributions cap up to a lifetime indexed ‘‘CGT cap amount’’: see [39 450]. CGT exempt amount If a taxpayer chooses to apply the retirement exemption, that part of the gain equal to the CGT exempt amount is disregarded: s 152-310(1). The ‘‘CGT exempt amount’’ is the amount of the gain chosen by the taxpayer to be disregarded (which must be specified in writing): s 152-315(1)-(4). The amount chosen as the CGT exempt amount cannot exceed the $500,000 CGT retirement exemption limit of the taxpayer or CGT concession stakeholder (ss 152-315(2) and 152-320), as reduced by any prior applications of the exemption (s 152-320(1)). Note also that if a taxpayer claimed the retirement exemption before 1 July 1999 under former Subdiv 118-F, any reductions in the retirement exemption limit under those provisions are carried over for the purposes of Subdiv 152-D. When roll-over must occur The roll-over must happen by the later of (a) when the choice to apply the concession is made or (b) when the proceeds are received. But if the relevant CGT event is J2, J5 or J6, the roll-over must happen by the time the choice is made. The latest time for making the choice is the date the income return is lodged for the income year in which the CGT event occurred, 606

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[15 580]

although the Commissioner can grant an extension of time (see [12 440]). If the capital proceeds are received in instalments, these provisions apply to each instalment in succession (up to the relevant CGT exempt amount): s 152-305(1A).

Application to companies and trusts If a company or trust makes the capital gain, the concession only applies where the company or trust has a ‘‘significant individual’’ and it makes a payment of the capital gain (where the gain arises from CGT events J2, J5 or J6) or the capital proceeds (where the gain arises from other CGT events) to at least one CGT concession stakeholder: ss 152-305(2) and 152-325(1). (See [15 550] for the meaning of a ‘‘CGT concession stakeholder’’.) If the capital proceeds are received in instalments, this requirement applies to each instalment in succession (up to the asset’s CGT exempt amount: see below): s 152-325(2). These payments can be made directly or indirectly through one or more interposed entities with no tax consequences for the interposed entity for payments made on or after 23 June 2009. Note that the payment will not trigger CGT event E4 (capital payment from trust: see [13 230]). As with individuals who use the exemption, there is no requirement for the CGT concession stakeholder to retire. However, if he or she is under 55 just before receiving the payment, the amount must be paid by the company or trust to a complying superannuation fund or an RSA (which must be notified of this): s 152-325(7). The payment is deemed by s 152-325(8) to be a contribution to the fund or RSA by the CGT concession stakeholder, and is excluded from being an ETP: s 82-135(fa). As a consequence, the payment is not included in the assessable income of the receiving fund or RSA: s 295-90 (see [41 190]). This allows it to form part of the ‘‘tax free component’’ of the member’s superannuation interest so that it will not be taxable to the member when paid out as a benefit: ss 307-205 and 307-210. If the stakeholder to whom the payment is made is an employee of the company or trust, the payment must not be of a kind listed in s 82-135. Note that both the stakeholder and the company or trust are denied a deduction for the payment: ss 152-310(2), 290-150(4). Importantly, with effect from 23 June 2009, such payments made by companies are excluded from being treated as ‘‘deemed dividends’’ under s 109 and Div 7A ITAA 1936: ss 152-325(10) and (11). Prior to that date, s 152-325(9) could apply to deem a payment made by a private company to a shareholder to be excessive remuneration under s 109 (see [21 260]). The amount of the payment required to be made to the CGT concession stakeholder is the lesser of (a) the capital gain or capital proceeds that accrued to the company or trust (as relevant) and (b) the CGT exempt amount (see above). This requirement can be met by making one or more payments: s 152-325(5) and (6). However, if a company or trust has more than one CGT concession stakeholder, it must choose (and specify in writing) the percentage of the CGT exempt amount that is attributable to each stakeholder and it must distribute all of the CGT exempt amount, even if to only one CGT concession stakeholder. See the Example in s 152-315(5). For gains arising under CGT events J2, J5 or J6 (see [13 560]-[13 590]), the company or trust must make the payment to the CGT concession stakeholder within 7 days of choosing the exemption. For gains arising under other CGT events, the payment must be made within 7 days of the later of the making of the choice and the receipt of the capital proceeds: s 152-325(4). Note that public entities listed in 328-125(8) (eg a company listed on an approved stock exchange) cannot use the retirement exemption: s 152-305(3). No capital proceeds received The retirement exemption is available even if the taxpayer does not receive any actual capital proceeds (ie if an asset is gifted or if the gain is reinstated under CGT event J2, J6 or J7). If that happens and an individual taxpayer is under 55, the taxpayer can only use the © 2017 THOMSON REUTERS

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retirement exemption if he or she pays an amount equal to the disregarded gain into a complying superannuation fund or an RSA. Otherwise, a payment is not required to be made to himself or herself. EXAMPLE [15 580.10] Jim, a farmer aged 51, gifts his farm to his son Ben and makes a capital gain of $150,000 from the transfer. If Jim qualifies for the retirement exemption, he must find funds of $150,000 to pay to a complying superannuation fund (or an RSA) in order to take advantage of the exemption. If he was 55 or over when choosing the exemption, he would not need to do so.

Likewise, a company or trust will be required to find funds to make a payment to at least one CGT concession stakeholder if no capital proceeds are received: s 152-325(1). However, if the stakeholder is under 55 years, the payment has to be made to a complying superannuation fund or RSA: s 152-325(7). If the capital gain arises from the gifting of the asset to a CGT concession stakeholder, this would suffice (as a ‘‘payment’’ for CGT purposes is defined to include the ‘‘giving of property’’: s 103-5). However, as the payment has to be the lesser of the capital proceeds (in this case, the market value substituted capital proceeds) or the CGT exempt amount (see s 152-325(5)), any excess of the market value capital proceeds over the CGT exempt amount may have Div 7A consequences in the case of a company (see [21 250] and following).

The CGT cap Superannuation contributions arising from an exempt amount that qualifies for the retirement exemption (and capital proceeds that qualify for the 15-year exemption) are excluded from the non-concessional contributions cap up to a lifetime indexed ‘‘CGT amount’’: see [39 450]. [15 590] Roll-over concession A taxpayer can choose to roll over all or part of a capital gain under Subdiv 152-E if the basic conditions in Subdiv 152-A are met (ie either the ‘‘maximum net value asset’’ test (see [15 510]) or the ‘‘small business entity’’ test (see [15 520]), plus the ‘‘active asset’’ test (see [15 530]) are satisfied): ss 152-410 and 152-415. If only a part of a capital gain is rolled over, a capital gain will arise in respect of the excess: s 152-415. See [12 440] for how to make a choice. But note the rules that apply in relation to choosing the roll-over concession for gains made under an earnout arrangement (see [17 335]). Note that if a taxpayer qualifies for both the Subdiv 152-E roll-over and the replacement asset roll-over under Subdiv 124-B (for assets that are compulsorily acquired, lost or destroyed: see [16 100]), the taxpayer can choose which roll-over to apply: see ATO ID 2009/147. Reinstatement of rolled over gains Importantly, a taxpayer need not acquire a replacement asset before choosing the roll-over. However, if the taxpayer does not acquire a ‘‘replacement asset’’ (see below) by the end of the ‘‘replacement asset period’’ (see below), or other replacement asset conditions are not met by that time (eg the asset is not an active asset by that time), then CGT event J5 will apply to reinstate the rolled over gain (see [13 580]). Likewise, if the taxpayer has not acquired a replacement asset or incurred ‘‘fourth element’’ capital expenditure on an existing CGT asset by the end of the replacement asset period to cover the amount of the rolled over gain, CGT event J6 will apply to reinstate the gain to the extent of the difference between the gain rolled over and the expenditure incurred: see [13 590]. 608

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On the other hand, CGT event J2 will apply to reinstate the rolled over gain if, after the end of the ‘‘replacement asset period’’, an acquired replacement asset ceases to qualify as a replacement asset (eg if it ceases to be an active asset): see [13 560]. Importantly, gains reinstated under CGT events J5 and J6 (and CGT event J2) are reinstated in the income year of that event and not in the income year that the gain originally arose. This, in effect, allows for a 2-year deferral of all or part of a capital gain entitled to the roll-over which is subsequently reinstated by CGT events J5 or J6, as there is no requirement to actually acquire a replacement asset before these CGT events are triggered. Note that gains arising under CGT events J2, J5 or J6 are not entitled to the 15-year exemption or the 50% reduction, while gains reinstated under CGT events J5 and J6 are not entitled to the Subdiv 152-E roll-over: s 152-10(4). Any prior year losses and the CGT discount are applied before the roll-over (see [14 350] and following). If the 15-year exemption under Subdiv 152-B applies (see [15 560]), it has priority over the roll-over.

Meaning of ‘‘replacement asset’’ and ‘‘replacement asset period’’ A ‘‘replacement asset’’ means a newly acquired asset and/or ‘‘fourth element’’ expenditure incurred on an existing CGT asset (in terms of the cost base rules: see [14 060]): s 104-185(1)(a). However, a replacement asset does not have to be the same category of asset, or serve the same function, as the original asset and it can also include replacement shares and trust interests (but not trading stock: s 104-185(2)(b)). It can also include an asset that is not subject to CGT (eg a car or a depreciating asset). This is because if such a replacement asset ceases to be an active asset, then the effect of CGT event J2 is to reinstate the original rolled over capital gain – albeit, if the replacement asset is a depreciating asset it will also be subject to the capital allowance provisions (and note the effect of s 118-20(5) in this case: see [14 460]). Note also that CGT event K7 (see [13 700]) may apply to the extent that a depreciating asset is used for a non-income producing purpose. The ‘‘replacement asset period’’ is the period beginning one year before, and ending 2 years after, the last CGT event in the income year for which the roll-over is available: s 104-185(1)(a). This period is extended by 12 months from the time the taxpayer later receives additional capital proceeds under the rule in s 116-45 (see [14 280]) or can be extended at the discretion of the Commissioner: s 104-190.

VENTURE CAPITAL [15 640] Concessions for shares in ESICs Various CGT concessions in Div 360 ITAA 1997 apply to shares where an investor acquires shares in a qualifying Early Stage Innovation Company (ESIC) and is entitled to the ESIC tax offset. These are discussed at [11 200]–[11 230]. [15 650] Exemption for venture capital limited partnerships Subdivision 118-F provides an exemption for capital gains made by certain limited partnership vehicles from eligible venture capital investments (thereby extending the exemption available under Subdiv 118-G: see [15 660]). For the CGT exemption to apply, both the limited partnership (including the partners comprising it) and the investment itself must satisfy a range of conditions. This includes the holding of the investment for at least 12 months: see [7 470]. The limited partnerships will also be taxed on a flow-through basis as ordinary partnerships. Limited partnerships The exemption (and flow-through taxation) is available to 4 types of limited partnerships: venture capital limited partnerships (VCLPs), early stage venture capital limited partnerships (ESVCLPs), Australian venture capital fund of funds (AFOF) and venture capital © 2017 THOMSON REUTERS

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management partnerships (VCMPs). VCLPs, ESVCLPs and AFOFs need to be registered with Innovation Australia under the Venture Capital Act 2002, both at the time of the investment and the time of the CGT event (including where conditionally registered). Among other things, VCLPs must have been formed under Australian State or Territory law, or under a law of Canada, France, Germany, Japan, the UK or US (or any other country prescribed by regulation), and must remain in existence for at least 5 years (but no more than 15 years). They must have a minimum of $10m in capital, their investments can only be eligible venture capital investments and their debt interests can only be loans to venture capital investee companies. Similarly, an AFOF must be formed in Australia with every general partner being resident in Australia and must remain in existence for at least 5 years (but no more than 20 years). Its investments must only be investments in a VCLP or venture capital investments in a company in which a VCLP already holds an investment. Its debt interests must only be loans to venture capital investee companies. A limited partnership that is a separate legal entity may register as a VCLP or AFOF.

Eligible venture capital partner Limited partners may be residents of any foreign country and general partners and VCLPs may be resident of, or established in, countries with which Australia has a DTA in force. Eligible venture capital partners need to be registered with Innovation Australia. Eligible venture capital investment An investment will qualify as an ‘‘eligible venture capital investment’’ (s 118-425) if it satisfies a range of conditions, including that the investment is ‘‘at risk’’ and involves an acquisition of shares or options in a company and that it is held for at least 12 months. The amount invested by the partnership in the company cannot exceed 30% of the partnership capital. In addition, the company must be resident in Australia when the investment is made and must have a registered company auditor as its auditor. The company can include a holding company if generally the value of its assets and those of connected entities is not more than $250m (subject to ‘‘integrity rules’’). See also amendments made by the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016. Investments in units trusts and in convertible notes that are equity interests will qualify as eligible venture capital investments: s 118-427. An investment in a unit trust will only qualify as an eligible venture capital investment if certain requirements are met, including: the investment must be at risk; the total amount of the partnership interest in the unit trust, together with its interests in any connected entities of the unit trust, cannot exceed 30% of the partnership’s committed capital; immediately before the investment is made, the unit trust must not exceed the permitted entity value of either $250m, for investments made by VCLPs, or $50m, for investments made by ESVCLPs; at the time the investment is made, the unit trust must not be listed on a stock exchange in Australia or a foreign country or, if it is listed, it must cease to be listed within 12 months of the investment being made. At the time an initial investment is made in a company or unit trust (and generally for the next 12 months), more than 50% of the persons who provide services to the company or unit trust (including employees) must perform them primarily in Australia, and more than 50% of the company’s or unit trust’s assets (by value) must be in Australia. The company’s or unit trust’s primary activity must not be in property development or land ownership, finance, insurance, construction or acquisition of certain infrastructure facilities or investments that generate interest, rents, dividends, royalties or lease payments. Some investments (up to 20% of committed capital) can be made in companies and unit trusts that are not located in Australia. Note also that measures enacted by the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 will also allow an entity, in which a VCLP, ESVCLP or AFOF has invested (the investee entity), to invest in other entities while remaining an eligible venture capital investment (see below). 610

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CGT event K9 If an individual venture capital manager of a limited partnership becomes entitled to a share of the gains made from the sale of eligible venture capital investments, CGT event K9 will occur in relation to this ‘‘carried interest’’: see [13 720]. Early stage venture capital limited partnerships To qualify as an early stage venture capital limited partnership (ESVCLP), the partnership’s committed capital must be at least $10m, but cannot exceed $100m (or $200m if registered on or after 1 July 2016: see below), an individual investment in any one company cannot exceed 30% of the ESVCLP fund’s committed capital, the total assets of the investee company cannot exceed $50m before the investment and the ESVCLP must divest itself of any holdings in the investee company once the latter’s total assets exceed $250m (although this rule has been modified: see below). The ESVCLP’s investments must be eligible venture capital investments (or would be eligible venture capital investments if the investee company or unit trust met the location in Australia and the permitted entity value requirements of the ITAA 1997). In addition, the ESVCLP must have an investment plan approved by Innovation Australia and each investment must comply with that plan. There must also be a spread of investors and investments (as opposed to a single investor or investment): see Re Elcano Capital LP and Innovation Australia (2010) 80 ATR 495. An ESVCLP will be taxed as an ordinary partnership (ie on a flow-through basis) rather than as a corporate limited partnership. Thus, the partners will be taxed on their share of the net income of the partnership. However, the amount of any loss that is deductible to a limited partner of an ESVCLP is limited to the extent of their financial exposure: s 26-68 ITAA 1997. See [7 470]. A partner’s share of a capital gain or loss from an ESVCLP that arises in relation to eligible venture capital investments will be disregarded if certain conditions are satisfied: s 118-407. However, the application of CGT event K9 to ‘‘carried interests’’ (see above) is extended to general partners of ESVCLPs. To ensure that investments made by an ESVCLP are directed at early stage venture capital activities, measures provide that a partnership can acquire pre-owned investments in an entity only if: (a) it already owns an investment in the entity, or it will also be making investments, that are not pre-owned investments in the entity at the same time; and (b) the total value of the partnership’s pre-owned investments does not exceed 20% of its committed capital. Reforms Measures enacted by the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016: • increase the cap on committed capital to $200m (applicable to the registration of existing or new partnerships as ESVCLPs on or after 1 July 2016); • remove the requirement that an ESVCLP divest an investment in an entity once the value of the entity’s assets exceeds $250m (applicable from 2016-17). However, if an ESVCLP does not dispose of an investment in an entity within 6 months after the end of an income year in which the investee’s market value exceeds $250m, then the ESVCLP will only be entitled to a partial CGT exemption. The amount exempt will be limited to the amount of the exempt capital gain that would have arisen had the investment been sold at the end of 6 months after the income year in which the $250m threshold was first exceeded; • provide a non-refundable carry-forward tax offset for limited partners in ESVCLPs of up to 10% of contributions made by the partner to the ESVCLP during an income year for ESVCLPs that become unconditionally registered on or after 7 December 2015. However, the amount of the tax offset will be reduced to the extent that the © 2017 THOMSON REUTERS

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amounts contributed by the partners are not, in effect, used by the ESVCLP to make eligible venture capital investments within that income year or the first two months after the end of that income year. If a limited partner is a partnership or trust, the offset will generally instead be available to the ultimate individual or corporate partners or beneficiaries. The measures also allow an entity in which an ESVCLP (or a VCLP or AFOF) has invested (the investee entity) to invest in other entities while remaining an eligible venture capital investment, provided that after the investment: (a) the investee entity controls the other entity; and (b) the other entity broadly satisfies the requirements to be an eligible venture capital investment. These measures generally apply from 2016-17. Finally note that the measures provide that to the extent a Managed Investment Trust (MIT) has a direct interest in a CGT asset as a result of being a limited partner in a ESVCLP (or VCLP), that asset is treated as an asset it owns for the purposes of an election it has made or may make for CGT to be the primary code in relation to the assets of the MIT: see [23 680].

[15 660] Non-resident tax-exempt pension funds Subdivision 118-G provides venture capital entities, such as US pension funds, with an exemption from tax on the disposal of venture capital equity in resident investment vehicles in Australia. To qualify for exemption, the venture capital entity must: • not be a resident of Australia (but it can have dual residency of 2 foreign jurisdictions); • be a superannuation fund for foreign residents; • be a resident of Canada, France, Germany, Japan, UK, US or some other prescribed country; • be exempt from income tax in that jurisdiction; • be registered under Pt 7A Pooled Development Funds Act 1992; and • make an eligible investment. For these purposes, an ‘‘eligible investment’’ is an investment in a resident investment vehicle, by way of venture capital equity (ie a share in a company or a unit or fixed interest in a trust) held at risk for at least 12 months. A ‘‘resident investment vehicle’’ is a company or fixed trust whose total assets do not exceed $50m at the time of the new investment (including the new investment) and which does not have property development or ownership in land as its primary activity.

INSURANCE AND SUPERANNUATION [15 700] Insurance policies Section 118-300 provides an exemption for gains or losses from the transfer (or other listed CGT event) of an interest in a general insurance policy, life insurance policy or an annuity instrument in the following circumstances. Type of policy Any insurance policy or annuity instrument

If the taxpayer is The insurer or the entity that issued the instrument A general insurance policy for property where, if The insured a CGT event happened in relation to the property, any capital gain or capital loss would be disregarded

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CGT – EXEMPTIONS AND CONCESSIONS Type of policy A life insurance policy or annuity instrument A life insurance policy or annuity instrument A life insurance policy or annuity instrument

[15 710]

If the taxpayer is The original beneficial owner of the policy or instrument An entity that acquired the interest in the policy or instrument for no consideration The trustee of: • a complying superannuation fund; • a complying approved deposit fund; or • a pooled superannuation trust, for the income year in which the CGT event happened.

A policy of insurance on the life of an individual or an annuity instrument, if the life insurance company’s liabilities under the policy or instrument are to be discharged out of complying superannuation/FSHA assets or segregated exempt assets

The life insurance company.

Note that a capital gain made by a life insurance company on the disposal of its life insurance business is not disregarded under item 1 in the above table if the capital gain relates to the consideration received by the company for the future profits component of the value of the ‘‘in force business’’ of the company: ATO ID 2006/53. However, a capital gain or capital loss that a life insurance company makes from a CGT event happening in relation to a segregated exempt asset (see [30 100]) is disregarded: s 118-315. Capital gains or capital losses that a complying superannuation entity makes from a CGT event happening in relation to a segregated current pension asset (as defined in Pt IX ITAA 1936) are likewise disregarded: s 118-320. According to the Tax Office, the expression ‘‘policy on the life of an individual’’ does not have the same meaning as ‘‘life insurance policy’’. Accordingly, that expression is not limited to life insurance policies to the extent they are within the common law meaning of that term, but includes other policies to the extent that they provide for a sum of money to be paid if an event happens that results in the death of an individual or for the payment of a ‘‘terminal illness benefit’’ (a benefit payable upon the diagnosis of an illness which will result in the death of the insured within 12 months regardless of any treatment they may receive): Determination TD 2007/4. See also Determinations TD 94/31 (including addendum) to TD 94/34 (inclusive). Amendments that apply from the 2005-06 income year provide a CGT exemption from a CGT event happening to an interest in a policy of insurance on the life of an individual or an annuity instrument for the original owner of the policy or instrument, including a trustee (except a trustee of a complying superannuation entity). There is also an exemption when the trustee makes a payment to a beneficiary in respect of the amount. The amendments also ensure that a CGT exemption applies when a CGT event happens to an interest in a policy of insurance for an individual’s illness or injury where the capital gain or loss is made by the trustee of a complying superannuation entity. They also ensure that such CGT exempt amounts are not taxed under the ordinary income tax provisions (subject to exceptions in s 295-85(3)-(4)), thereby ensuring that CGT remains the ‘‘primary code’’ for taxing such amounts. See also [15 100].

[15 710] Superannuation funds, RSAs and PSTs Capital gains and losses arising from a CGT event happening in relation to the following are disregarded (s 118-305(1)): • a right to, or to any part of, an allowance, annuity or capital amount payable out of a superannuation fund or an approved ADF; or © 2017 THOMSON REUTERS

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• a right to, or to any part of, an asset of a superannuation fund or of an ADF, except if the trustee of the fund disposes of a CGT asset (in general, trustees are assessed on net capital gains realised in relation to assets of superannuation funds and ADFs, unless specific exemptions apply: see [41 190]). Note that an act or transaction that results in the payment to a person or the transfer of an asset to a person out of the superannuation fund or approved deposit fund is deemed to constitute the disposal of the right to money or property. The exemption does not extend to entities who have acquired superannuation interests for consideration and who are not members of the relevant superannuation fund: s 118-305(2)(b). However, an exception to this rule applies if there is a payment split on the breakdown of a marriage (see [40 450] and [16 350]) and there is a resulting payment to a non-member spouse (or their legal personal representative): s 118-305(3). The disposal by a trustee of a complying superannuation fund of any asset is subject to CGT irrespective of its date of acquisition. Special rules apply to determine the cost base and reduced cost base of assets acquired before 1 July 1988: see [41 190]. A capital gain or loss made in respect of the transfer (or other CGT event) of the following is disregarded (ss 118-310, 118-350): • a right to or any part of a ‘‘retirement savings account’’ (RSA); or • a unit in a pooled superannuation trust (this exemption applies only in limited circumstances: s 118-350(2)).

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INTRODUCTION Overview ....................................................................................................................... [16 010] ROLL-OVERS TO WHOLLY OWNED COMPANY Nature of roll-over ........................................................................................................ Eligibility ....................................................................................................................... Excluded assets ............................................................................................................. Effect of roll-over – for individuals, trustees and partners ......................................... Effect of roll-over – for company ................................................................................

[16 [16 [16 [16 [16

020] 030] 040] 050] 060]

REPLACEMENT ASSET ROLL-OVERS Assets compulsorily acquired, lost or destroyed ......................................................... [16 100] Statutory licences .......................................................................................................... [16 110] Transformation of water rights ..................................................................................... [16 120] Strata title conversion ................................................................................................... [16 130] Exchange of shares in same company or units in the same unit trust ....................... [16 140] Exchange of rights or options ...................................................................................... [16 150] Exchange of units or shares for new shares – business restructures .......................... [16 160] Exchange of stapled interests for units in unit trust .................................................... [16 180] Conversion of body to incorporated company ............................................................. [16 190] Crown leases ................................................................................................................. [16 200] Depreciating assets installed on leased Crown land .................................................... [16 210] Prospecting and mining entitlements ............................................................................ [16 220] Scrip-for-scrip roll-over ................................................................................................ [16 230] Fixed trust to company ................................................................................................. [16 240] Medical defence organisation roll-over ........................................................................ [16 260] Interest realignment roll-over for mining industry ...................................................... [16 265] Demerger relief ............................................................................................................. [16 270] SAME ASSET ROLL-OVERS Marriage and relationship breakdowns ........................................................................ [16 Companies in same wholly owned group .................................................................... [16 Changes to trust deeds .................................................................................................. [16 Demutualisation and scrip-for-scrip roll-over .............................................................. [16 Small superannuation funds roll-over .......................................................................... [16 Fixed trust to fixed trust ............................................................................................... [16 Merger of superannuation funds ................................................................................... [16 Transfer of member’s accrued amounts to a MySuper product .................................. [16 Transfer of assets on winding-up of an entity ............................................................. [16 Changes to small business structures ........................................................................... [16

300] 320] 330] 340] 350] 370] 380] 390] 400] 500]

INTRODUCTION [16 010] Overview This chapter explains the types of roll-over relief that apply to disregard and/or defer a capital gain or loss where it would otherwise be inappropriate to recognise a CGT liability at that time. These types of roll-over relief are classified into 3 main categories as follows. Roll-over to wholly-owned companies This roll-over applies if an asset, or all the assets of a business, are transferred to a wholly-owned company or if certain rights are created in a wholly-owned company, and the taxpayer receives shares in the company in return. The roll-over disregards any capital gain or © 2017 THOMSON REUTERS

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loss made on the transfer or creation of the asset, while various rules set out the CGT consequences for both the taxpayer in respect of the shares received and for the company in respect of the acquisition of the asset/s: see [16 020] to [16 060].

Replacement asset roll-over This roll-over applies if a taxpayer disposes of an original asset and receives a replacement asset in exchange without there, in effect, being any beneficial change in the ownership of the asset or any underlying assets. In this case, the roll-over disregards any capital gain or loss made on the disposal of the original asset, and gives the replacement asset the same CGT characteristics as the original asset (in terms of its cost base and time of acquisition). This chapter deals the following replacement asset roll-overs: • asset compulsorily acquired, lost or destroyed: see [16 100]; • statutory licences: see [16 110]; • transformation of water rights: see [16 120]; • strata title conversion: see [16 130]; • exchange of shares in same company or units in same unit trust: see [16 140]; • exchange of rights or options: see [16 150]; • exchange of units or shares for new shares – business restructures: see [16 160]; • exchange of stapled interests for units in unit trust: see [16 180]; • conversion of body to incorporated company: see [16 190]; • crown leases: see [16 200]; • depreciating assets installed on leased Crown land: see [16 210]; • prospecting and mining entitlements: see [16 220]; • scrip-for-scrip roll-over: see [16 230]; • fixed trust to company: see [16 240]; • medical defence organisation roll-over: see [16 260]; and • demerger relief: see [16 270].

Same asset roll-over This roll-over applies if an asset is transferred or created in another entity if it would be inappropriate to recognise a capital gain or loss in the circumstances (eg on the transfer of an asset to a spouse on a marriage or relationship breakdown) or where there is no beneficial change in the ownership of the asset. This chapter deals the following same-asset roll-overs: • marriage and relationship breakdowns: see [16 300]; • companies in same wholly owned group: see [16 320]; • changes to trust deeds: see [16 330]; • demutualisation and scrip-for-scrip roll-over: see [16 340]; • small superannuation funds roll-over: see [16 350]; • fixed trust to fixed trust: see [16 370]; and • merger of superannuation funds (loss transfer): see [16 380]. 616

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[16 030]

CGT discount For the application of the CGT discount (and indexation where relevant) to assets involved in these roll-overs, see [14 390] and following.

ROLL-OVERS TO WHOLLY OWNED COMPANY [16 020] Nature of roll-over Division 122 ITAA 1997 provides roll-over relief if an asset, or all the assets of a business, are transferred by a taxpayer to a wholly-owned company or if certain contractual rights (including the grant of options and leases) are created in the company by the taxpayer. If the taxpayer is an individual or trustee, the rules in Subdiv 122-A apply. If the taxpayer is a partner, the rules in Subdiv 122-B apply. [16 030] Eligibility Individuals and trustees – Subdiv 122-A The requirements for Subdiv 122-A roll-over (for individuals or trustees) are as follows: • there must be a disposal of a CGT asset to, or the creation of a CGT asset in, the company by an individual or trustee by way of any of the following CGT events (‘‘trigger events’’): CGT event A1 (disposal of asset/s), CGT event D1 (creation of contractual or other rights), CGT event D2 (grant of option), CGT event D3 (grant of a right to income from mining) or CGT event F1 (grant, renewal or extension of lease): s 122-15; • the company must issue only non-redeemable shares in exchange for the asset, although it may assume liabilities in respect of an asset (as calculated under the rules in s 122-37): s 122-20(2). However, such liabilities must be less than the market value of the asset if a pre-CGT asset at that time, or less than the cost base of the asset if a post-CGT asset at that time: s 122-35. Note that this ‘‘share’’ requirement can also be met if the taxpayer already owns all the shares in the company and receives no other consideration (ATO ID 2004/94) or if an asset is disposed of to a company, the shareholders of which transfer all their shares to the taxpayer (withdrawn ATO ID 2004/95); • the market value of the shares must be substantially the same as the market value of the transferred asset (net of any transferred liability): s 122-20(3). This would generally be a matter of course regardless of the number or the par value of the shares issued; • immediately after the transfer the individual or trustee must beneficially own all the shares in the company and in the same capacity as they were owned or created before the event: s 122-25(1); • the company cannot be exempt from tax in the year of the disposal or creation of the asset: s 122-25(5); • the individual or trustee must choose for the roll-over relief to apply (see [12 440]); and • the transfer or creation of the asset must be (a) from a resident individual or a resident trust to an Australian resident company, or (b) of an asset that is ‘‘taxable Australian property’’ (see [18 100]) and the shares in the company must be ‘‘taxable Australian property’’ just after the trigger event. Note that if a right, option or convertible or exchangeable interest is created in the company, the asset acquired by the company on the exercise of that right, etc, must not be trading stock of the company immediately after its acquisition: s 122-25(4). © 2017 THOMSON REUTERS

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Partners – Subdiv 122-B The requirements for the Subdiv 122-B roll-over (for partners) are the same as for individuals and trustees under Subdiv 122-A, except that the relevant asset transferred to the company is the partner’s interest in a CGT asset of the partnership or all of the assets of a business carried on by the partnership. However, it should be noted that while the roll-over relief applies at a partner level in relation to a partner’s interest in a CGT asset of a partnership or all the assets of a business carried on by the partnership, all the partners must participate in the roll-over (ie they all must choose the roll-over: s 122-125, and they must own all the shares in the company in the same proportions as their interests in the relevant partnership asset (s 122-135). Note also that, in view of the definition of ‘‘partnership’’ in s 995-1, the roll-over relief would also extend to the transfer of jointly owned income-producing land. [16 040] Excluded assets The Div 122 roll-over relief does not apply to the transfer of the following assets (ss 122-25(2) and (3)): • a collectable and a personal-use asset: see [12 180]; • a decoration awarded for valour or brave conduct (except if money or property was given to acquire the award: see [15 020]); • a depreciating asset (ie a ‘‘precluded asset’’): see [15 080]; • an asset that becomes trading stock of the company just after the disposal or creation (ie a ‘‘precluded asset’’): see [15 060]; • an interest in the copyright of a film that is exempt under s 118-30 (ie a ‘‘precluded asset’’): see [15 070]; • a registered emissions unit (ie a ‘‘precluded asset’’): see [15 070]; and • an asset that becomes a registered emissions unit held by the company just after the disposal or creation (unless, in the case of the transfer of all the assets of a business, it was a registered emissions unit when it was disposed of). Note that the Div 122 roll-over will not apply to the disposal of an asset to a company whose income is exempt under Div 50 ITAA 1997 for the year in which the disposal takes place. ‘‘Prescribed dual resident’’ companies are also denied the Div 122 roll-over (see [35 060]).

[16 050] Effect of roll-over – for individuals, trustees and partners The roll-over consequences for the individual, trustee and partners will depend on if the asset was transferred to the company (disposal cases) or a relevant right etc was created in, or granted to, the company (creation cases). There will also be consequences depending on whether just one asset, or all the assets of a business, are transferred to the company and whether, in the latter case, the assets transferred are a mix of pre-CGT and post-CGT assets. Note the roll-over may also be available to partners of a ‘‘tax law partnership’’ – that is ‘‘persons in receipt of ordinary income or statutory income jointly’’ such as joint rental property owners. In Kafataris v DCT [2015] FCA 874, however, roll-over relief was not available where a jointly owned property was transferred to a wholly-owned company because the Court decided that the transfer occurred pursuant to CGT event E1 (see [13 200]) and not CGT event A1. Disposal cases The roll-over consequences for the individual, trustee and partners in disposal cases are set out below. 618

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[16 050]

1. Any capital gain or loss made on the disposal of the asset/s to the company (including a partner’s interest in a CGT asset) is disregarded: ss 122-40(1), 122-45(1), 122-150, 122-170. 2. If the asset/s disposed of to the company (including a partner’s interest in a CGT asset) were pre-CGT assets, the shares received in relation to the assets are also taken to be pre-CGT assets: ss 122-40(3), 122-55(2). However, if the transferred assets included ‘‘precluded assets’’ (see [16 040]), a proportion of the shares (as calculated by reference to the market values of the precluded assets to the market value of all the assets transferred) will be treated as post-CGT shares: see ss 122-55, 122-185. 3. If the asset/s disposed of to the company were post-CGT asset/s, the shares are taken to have been acquired for the cost base and reduced cost base of the asset at the time of its disposal (reduced by any liability assumed by the company in respect of the asset/s), and this cost base is apportioned across the number of shares: ss 122-40(2), 122-180(1). If transferred assets include ‘‘precluded assets’’ (see [16 040]), the cost base of the shares is increased by the market value of the precluded assets at the time of their transfer: ss 122-50, 122-180(1). Note that the shares are taken to have been acquired when they were actually acquired, albeit for the purposes of applying the CGT discount, a share is treated (s 115-34) as having been owned for at least 12 months even if it is disposed of within 12 months of its actual acquisition: see [14 400]. 4. If the assets disposed of to the company were a mix of pre-CGT and post-CGT assets, the number of shares taken to have been acquired pre-CGT is worked out on a proportionate basis by reference to the market value of the pre-CGT assets disposed of (together with adjustments for liabilities assumed by the company in respect of the assets): ss 122-60(1), 122-160(1), 122-190(1). The cost base and reduced cost base of the post-CGT shares is then worked out by apportioning amongst the post-CGT shares the market value of both the post-CGT assets and the precluded assets that were disposed of to the company: ss 122-60(2)-(4), 122-190(2)-(4). EXAMPLE [16 050.10] Jason transfers all the assets of his business to a wholly-owned company and in return receives 100 shares. The assets transferred are comprised of the following: • pre-CGT assets (with a market value of $20,000 at the date of transfer); • post-CGT assets (with a market value of $130,000 at the date of transfer); and • precluded assets (with a market value of $50,000 at the date of transfer). Number of pre-CGT and post-CGT shares Of the 100 shares the following percentage will be considered to be pre-CGT shares: $20,000/($20,000 + $130,000 + $50,000) = 10% Therefore, 10 shares will be considered to be pre-CGT shares, and 90 shares will be considered to be post-CGT shares. Cost base of post-shares The cost base of each post CGT share will be calculated as follows: ($130,000 + $50,000)/90 = $2,000 each

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Creation cases In creation cases, the cost base and the reduced cost base of the shares is worked out by equally apportioning the cost base and reduced cost base of the created right, option or lease (ie the incidental cost of creating the right or the expenditure incurred in granting the option or lease) among the shares: ss 122-65, 122-195. [16 060] Effect of roll-over – for company The roll-over consequences for the company will also depend on whether an asset was transferred to the company (disposal cases) or a relevant right or option etc was created in the company (creation cases). However, in creation cases, the rights etc will only be post-CGT assets in the company’s hands because of the nature of the CGT events by which they were acquired. Disposal cases Any pre-CGT asset disposed of will retain its pre-CGT status in the hands of the company: s 122-70(3). If the asset disposed of was a post-CGT asset, the company will be taken to have acquired it for its cost base and/ or reduced cost at the time of its disposal: s 122-70(2). Note that ATO ID 2014/14 states that where relevant, the cost base of pre-CGT assets acquired by a company under the Subdiv 122-A roll-over is based on an acquisition time of before 20 September 1985 and not the day the pre-CGT assets were transferred. Therefore, the cost base of the pre-CGT assets acquired by the company is the market value of the shares before 20 September 1985. Creation cases The company will be taken to have acquired the created right etc at the time of its creation for a cost base or reduced cost base equal to the incidental costs of creating the right or the expenditure incurred in granting the option or lease: ss 122-65(2), 122-75, 122-205.

REPLACEMENT ASSET ROLL-OVERS [16 100] Assets compulsorily acquired, lost or destroyed Subdivision 124-B provides roll-over relief for a capital gain (but not loss) made on the compulsory acquisition, loss or destruction of an asset (or part of an asset). The consequences of the roll-over vary depending upon whether an asset, money or a combination of both is received as compensation. The taxpayer must choose for the roll-over to apply (see [12 440]). Exclusions The roll-over does not apply if the replacement asset is: • a car, motor cycle or similar vehicle: s 124-70(2); or • a depreciating asset that is subject to Div 40 (the Uniform Capital Allowance system) or Div 328-D (capital allowances for small business entities): s 124-75(2). In addition, the replacement asset must not become a depreciating asset subject to Div 40 or Div 328-D or trading stock: ss 124-75(5), 124-80(2). Nor can the replacement asset be a registered emissions unit under the former carbon pricing scheme: ss 124-75(6) and 124-80(2). See also [15 070]. If a taxpayer qualifies for both the Subdiv 124-B roll-over and the small business roll-over in Subdiv 152-E (see [15 590]), the taxpayer can choose which roll-over to apply: see ATO ID 2009/147. Note that there is no restriction under the Subdiv 152-E roll-over on what type of asset can be a replacement asset, eg it can be a depreciating asset: see [15 590]. 620

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[16 100]

Loss or destruction ‘‘Loss or destruction’’ of a CGT asset includes both voluntary and involuntary destruction: Determination TD 1999/79. It also includes the destruction of part of a CGT asset. In practice, it may be difficult to determine the difference between the destruction of part of a CGT asset (for which the roll-over is available) and ‘‘permanent damage’’ to a CGT asset (to which the principles in Ruling TR 95/35 will instead apply to reduce the cost base of the damaged asset by the compensation received without any immediate CGT consequences: see also [12 070] and [14 080]). Note that the loss or destruction of a CGT asset will ordinarily give rise to CGT event C1 (see [13 070]) and that the time of the loss or destruction will be the same as for CGT event C1 (ie when the compensation for the loss or destruction is first received, or otherwise when the destruction occurs or the loss is discovered). This is relevant for determining the income year in which the roll-over for the loss or destruction of a CGT asset may give rise to an immediate capital gain.

Compulsory acquisition The roll-over applies to the following types of compulsory acquisitions (s 124-70(1)): • a CGT asset is compulsorily acquired by the Commonwealth, a State or Territory or an authority of the Commonwealth, a State or Territory (eg a local government body); • a CGT asset is acquired by a non-government entity under a power of compulsory acquisition under an Australian or foreign law, other than a law for the compulsory acquisition of minority interests; • a CGT asset is disposed of to an entity (other than to a foreign government agency) after a notice was served by or on behalf of the entity inviting negotiations with a view to the entity acquiring the asset by agreement (but the notice must inform the recipient that if the negotiations are unsuccessful, the asset will be compulsorily acquired by the entity under a power of compulsory acquisition conferred by an Australian or foreign law, other than a law for the compulsory acquisition of minority interests); • land (and any depreciating asset fixed to the land), which is or would be subject to a mining lease, is disposed of to the lessee (other than a foreign government agency), provided the lease is in force just before the disposal. (Note that this measure does not extend to initial exploration licences or retention licences, nor if a Crown lease is not renewed.) The asset must be taxable Australian property (see [18 100]) just before its compulsory acquisition, and any replacement asset must be taxable Australian property after it is acquired: s 124-70(4). Note that the compulsory acquisition of a CGT asset will occur under CGT event A1. The time of such an event is determined under the rules in s 104-10(6), ie when the contract of disposal is entered into or, otherwise, when the change of ownership occurs: see [13 050]. This is relevant for determining the income year when the roll-over for the compulsory acquisition of a CGT asset may also give rise to an immediate capital gain. The Commissioner’s views on the treatment of the compulsory acquisition of an easement are contained in Ruling TR 97/3, where the Commissioner appears to take the view that the roll-over in Subdiv 124-B is available on the basis that the compulsory acquisition of an easement involves the required disposal (part) or change in ownership of the land (part). However, the Commissioner appears to take the contrary view in ATO ID 2010/34: see [17 330]. © 2017 THOMSON REUTERS

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Money received If the taxpayer receives money by way of compensation, the roll-over relief is only available if the taxpayer incurs expenditure in acquiring another CGT asset (that is not a depreciating asset): s 124-75(2). Alternatively, if part of the original asset is lost or destroyed, the taxpayer must incur expenditure of a capital nature in repairing or restoring the asset: s 124-75(2). Further, at least some of the expenditure must be incurred no earlier than one year before the event happens, or no later than one year, after the end of the income year in which the event happens (or within such further time as the Commissioner allows): s 124-75(3). For calculating the cost base if only part of a CGT asset is compulsorily acquired, see TD 2001/9 and [14 170]. Replacement asset If the original asset was used, or was installed ready for use, in the taxpayer’s business, or was in the process of being installed ready for use in the taxpayer’s business, the roll-over relief is only available if the replacement asset is also used, or is installed ready for use, in the taxpayer’s business for a reasonable time after the taxpayer acquires it: s 124-75(4). Otherwise, the taxpayer must use the replacement asset (for a reasonable time after acquiring it) for the same purpose as, or for a similar purpose to, the original asset immediately before the CGT event happened. Further guidance on these requirements is found in Determinations TD 2000/41 to TD 2000/45. Note that potential use of the asset is not considered relevant: ATO ID 2003/127. Effect of roll-over – pre-CGT assets If the choice is made for the roll-over and the original asset that was lost or damaged was acquired before 20 September 1985, the replacement asset or the original asset as repaired (as appropriate) is taken to have been acquired before that date: s 124-85(3), (4). However, the pre-CGT status is only preserved if the taxpayer does not expend more than 120% of the market value of the original asset (immediately before its disposal) in acquiring a replacement asset or, if the original asset was destroyed by natural disaster, it is reasonable to treat the replacement asset as ‘‘substantially the same’’ as the original asset: 124-85(3). Effect of roll-over – post-CGT assets If the taxpayer would have made a capital gain from the compulsory acquisition, loss or destruction of a post-CGT asset, then the CGT consequences for the taxpayer will depend on whether or not the compensation received exceeds the amount of the compensation spent on acquiring a replacement asset or repairing the original asset. Also, adjustments may be required to the ‘‘cost base expenditure’’ incurred on the replacement asset or the repair for the calculation of any future CGT liability on the replacement or repaired asset. Specifically, if the compensation does exceed the expenditure on the replacement asset or repair of the original asset, one of 2 alternative results under s 124-85 will arise. Firstly, if the capital gain that would otherwise have arisen as a result of the compulsory acquisition, loss or destruction of the asset is greater than the ‘‘excess’’ of the compensation received over the expenditure incurred on the replacement asset or repair of the original asset, then the capital gain will be the amount of this ‘‘excess’’. Additionally, the cost base expenditure incurred on the replacement asset or the repair of the original asset is reduced by the amount by which the capital gain is greater than the excess of the compensation received over the expenditure on the replacement asset or the repair.

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[16 100]

EXAMPLE [16 100.10] Zhen owns an asset that has a cost base of $5000. The asset is destroyed and $20,000 compensation is received. Zhen spends $12,000 in replacing the asset. There will be a ‘‘notional’’ capital gain of $15,000 (ie $20,000 compensation less $5000 cost base). This notional capital gain of $15,000 is greater than the ‘‘excess’’ of $8,000 (ie $20,000 less $12,000). Therefore, Zhen will realise a capital gain of, $8,000 - being the amount of the ‘‘excess’’. In calculating any future capital gain or loss on the replacement asset, the cost base expenditure incurred on the replacement asset (ie $12,000) is reduced by the amount by which the notional gain (ie $15,000) is more than the ‘‘excess’’ (ie $8,000), ie $12,000 is reduced by $7,000 ($15,000 less $8,000), leaving cost base expenditure for the replacement asset of $5,000.

See also ‘‘Case 1’’ in the example accompanying s 124-85(2). Secondly, if the capital gain that would otherwise have arisen is less than or equal to the ‘‘excess’’ of the compensation received over expenditure on a replacement asset or repair of the original asset, then that ‘‘notional’’ capital gain is not reduced. EXAMPLE [16 100.20] Carol receives $2,000 compensation for damage to an asset. The cost base of the asset is $800. Carol expends $500 repairing it. There will be a notional capital gain of $1,200 (ie $2,000 less $800) and the ‘‘excess’’ will be $1500 (ie $2,000 less $500). As the notional capital gain of $1200 is less than the ‘‘excess’’ (ie $1,500), the notional capital gain is not reduced and is taxed as the actual capital gain. Therefore, in this example Carol would have an actual capital gain of $1,200. See also ‘‘Case 2’’ in the example accompanying s 124-85(2). On the other hand, if the compensation received does not exceed the expenditure incurred on the replacement asset or repair of the original asset, then no capital gain arises, but the cost base expenditure incurred on the replacement asset or repair is reduced by the amount of the capital gain that would otherwise have arisen but for the roll-over. See also ‘‘Case 3’’ in the example accompanying s 124-85(2). Further examples illustrating the operation of these rules are set out in Determination TD 93/178.

Roll-over if asset received Roll-over relief under Subdiv 124-B is also available if the taxpayer receives a replacement asset instead of money. If that happens, and roll-over relief is chosen, any capital gain made on the original asset is disregarded: s 124-90(2). If the original asset was acquired on or after 20 September 1985, the taxpayer is taken to have acquired the replacement asset for an amount equal to the cost base of the original asset: s 124-90(3). If the original asset was acquired before 20 September 1985, the replacement asset is also taken to have been acquired before that date: s 124-90(4). For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following.

Money and asset received Section 124-95 sets out the roll-over consequences if a taxpayer receives both cash and a new asset for the involuntary disposal of the original asset. It basically requires that each part of the compensation is treated separately, in accordance with the rules set out above for the receipt of money or the receipt of an asset. See also the example in s 124-95. © 2017 THOMSON REUTERS

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[16 110] Statutory licences Section 124-140 (in Subdiv 124-C) extends roll-over relief to the renewal or extension of statutory licences. A statutory licence is a licence or permit granted by a government or government authority under a statutory law of the Commonwealth, State, Territory or foreign country (and can include water licences): s 124-140(3). ‘‘Statutory licence’’ does not, however, include a lease or a prospecting right or mining right (which have their own roll-over relief: see [16 220]). For CGT events happening in the 2006-07 or a later income year, roll-over relief is available if (s 124-140(1)): • the taxpayer’s ownership of one or more statutory licences ends (ie CGT event C2 happens: see [13 080]) and, as a result, the taxpayer is issued with one or more new licences. Note that if multiple licences are involved, the original licences must end, and the new licence or licences must be issued, as part of a single arrangement; and • the new licence or licences authorise substantially similar activity as that authorised by the original licence(s). The Explanatory Memorandum to the Tax Laws Amendment (2007 Measures No 5) Act 2007 states that, in determining whether a new licence authorises substantially similar activity, it is appropriate to consider whether the skills or infrastructure required to utilise or exploit the rights granted by the original licence are also required to utilise or exploit the rights granted by the new licence. It also explains that the fact that a new licence is for a different period, or that it authorises changes in volume or quantity available for use and/or authorises changes in areas or physical locations, does not necessarily mean that the substantially similar activity test is failed. If the taxpayer is a foreign resident or the trustee of a foreign trust, the original licence(s) must be ‘‘taxable Australian property’’ just before CGT event C2 happens and the new licence(s) must be ‘‘taxable Australian property’’ (see [18 100]) just after the taxpayer acquires the licence(s): s 124-140(1A)-(1B).

Effect of roll-over Any capital gain or loss made from the original licence(s) is disregarded: s 124-145. If one new licence results from the ending of an original post-CGT licence, the cost base of the original licence becomes the first element of the cost base of the new post-CGT licence: s 124-155. If more than one licence ends, or more than one new licence is received, the cost base of each new licence must be determined on a reasonable basis. The original cost base or cost bases are allocated by reference to the number, market value and character of the original and new licences: s 124-155. See [3 210] for a discussion of market value. If the original licence or licences were acquired before 20 September 1985 (ie pre-CGT), the new licence or licences are taken to have been acquired before that date also: s 124-160. If pre-CGT and post-CGT licences end and a new licence or licences are issued, each new licence is taken to be 2 separate assets. One of these assets is treated as having been acquired before 20 September 1985 (ie pre-CGT), and the other is treated as having been acquired on or after 20 September 1985 (ie post-CGT): s 124-165. The cost base of each of those assets is determined by allocating the total of the cost bases of the original post-CGT licences between the new licences in proportion to their market values (as determined when the original licences end). For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. Partial roll-over If ‘‘ineligible proceeds’’ (eg money or other property) are received in addition to receiving a new licence or licences, s 124-150(1) provides that there is no roll-over for that part of the original licence or licences for which the ineligible proceeds are received. 624

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Instead, ss 124-150(2), (3) and (5) require that, before apportioning the cost base of the original licence or licences to the new licence or licences, the cost base of the original licence or licences is to be apportioned on a reasonable basis by reference to that part of the original licence or licences that is not eligible for roll-over. Note that, in relation to calculating the capital gain or loss on that part of the original licence for which the ineligible proceeds are received, the market value substitution rule does not apply in these circumstances: s 116-130(2A) (see [14 260]).

ASGE licences, etc Transitional provisions (ss 124-140 to 124-142 TPA) deal with the replacement of bore licences (issued under the Water Act 1912 (NSW)) by aquifer access licences (issued under the Water Management Act 2000 (NSW)) under the Achieving Sustainable Groundwater Entitlements (ASGE) programme. [16 120] Transformation of water rights Subdivision 124-R provides roll-over relief for irrigators who replace an entitlement to water with one or more different entitlements (as well as providing a roll-over for other member irrigators who may be affected). But for the roll-over CGT event C2 would happen (see [13 080]). There are 3 types of roll-over for these purposes – replacement, reduction and variation roll-over (discussed below). Note also that termination fees incurred by a taxpayer in relation to a water entitlement asset can be included in its cost base (see [14 040]): s 110-35(11). The roll-over applies automatically to CGT events that happen in the 2005-06 and later income years. However, taxpayers could choose not to obtain the roll-over if the relevant transactions qualifying for the roll-over happened in the period from the start of the 2005-06 income year to 7 December 2010. Meaning of water entitlement A water entitlement is any legal or equitable right that relates to water (or groundwater): s 124-1105(4). There is no restriction on the form that an entitlement may take and it can include: a contractual right against a third party operator; a statutory licence against a State or Territory government; a share in a company, or an interest in a trust or partnership, if the share or interest has rights attaching to it that relate to water; a water use licence; or a separate identifiable right relating to the conveyance of water. A water access right, a water delivery right and an irrigation right under the Water Act 2007 will also qualify as a water entitlement for these purposes. However, a water entitlement that is a ‘‘statutory licence’’ that qualifies for the roll-over in Subdiv 124-C (see [16 110]) will not qualify for the water entitlement roll-over: s 124-1105(3). Replacement roll-over ‘‘Replacement’’ roll-over (ss 124-1105 to 124-1130) applies if a taxpayer replaces a single water entitlement with one or more different water entitlements. It does not matter whether the replacement water entitlement is of the same nature as the original entitlement, as the taxpayer is only required to acquire one or more water entitlements to replace the original entitlement. Replacement roll-over may also apply when a taxpayer replaces multiple water entitlements with one or more different water entitlements. In this situation, the taxpayer may choose an alternative replacement roll-over that operates on a multiple asset basis. If the taxpayer satisfies the conditions for either the single entitlement or multiple entitlement roll-over, they disregard any capital gains or losses arising from their ownership of each original water entitlement ending. However, if the taxpayer receives additional proceeds that do not take the form of a replacement water entitlement/s, they will realise a partial capital gain or loss in relation to © 2017 THOMSON REUTERS

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these proceeds. This is calculated by attributing part of the cost base of each of the original water entitlements to these ineligible proceeds (on a reasonable basis having regard to the number and market value of the replacement water entitlement/s relative to the market value of the ineligible proceeds). If the taxpayer acquired their original water entitlement(s) before 20 September 1985 (ie pre-CGT), the replacement water entitlement(s) will be taken to be pre-CGT assets. If the original water entitlement(s) are post-CGT assets, the taxpayer will be taken to acquire each replacement water entitlement(s) on the actual date of acquisition of those entitlements. The taxpayer calculates the first element of the cost base of each replacement water entitlement on a reasonable basis having regard to: (a) the total cost bases of the original water entitlement(s); (b) the number and market value of the original entitlement(s); and (c) the number and market value of the replacement entitlement(s). In addition, if the taxpayer has to pay an amount (including giving other property) to acquire the replacement water entitlement(s), they can include that amount in the cost base of each replacement entitlement on a reasonable basis. Similar calculations apply if some of the original water entitlements are pre-CGT and the remainder are post-CGT.

Reduction roll-over ‘‘Reduction’’ roll-over (ss 124-1135 to 124-1150) applies if a taxpayer has a total water entitlement made up of individual entitlements and their ownership of some of those entitlements ends under the same arrangement, but the total market value of the remaining entitlements remains substantially the same as the total market value of the original entitlements. If there is a close nexus between particular elements of a broader transaction, those elements form part of the same arrangement. The taxpayer will disregard any capital gains or losses arising from their ownership of the original water entitlements ending. If all the original water entitlements are post-CGT assets, the taxpayer calculates the first element of the cost base of each retained water entitlement on a reasonable basis having regard to: (a) the total cost bases of the original water entitlement(s); (b) the number and market value of the original entitlement(s); and (c) the number and market value of the retained entitlement(s). Similar calculations apply if some of the original water entitlements are pre-CGT and the remainder are post-CGT. Variation roll-over ‘‘Variation’’ roll-over (ss 124-1155 to 124-1165) applies if the transactions that qualify for the replacement roll-over have consequential effects on other taxpayers. A taxpayer that has a CGT event happen to any asset they own as a direct result of circumstances that qualify for the replacement roll-over will qualify for the variation roll-over if they continue to own the asset. In this case, the taxpayer disregards any capital gains or losses arising from the CGT event. However, if the taxpayer receives proceeds other than their retained asset (ie ineligible proceeds), they will realise a partial capital gain or capital loss in relation to those proceeds. In this situation, the taxpayer calculates the gain or loss by attributing part of the cost base of the original asset to the ineligible proceeds they receive. The taxpayer may do this on a reasonable basis having regard to the market value of the retained asset relative to the market value of the ineligible proceeds. CGT discount For the application of the CGT discount to assets involved in a replacement-asset roll-over, see [14 390] and following. 626

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[16 140]

[16 130] Strata title conversion Subdivision 124-D provides roll-over relief if an ownership arrangement for a home unit or apartment is converted into strata title ownership. This roll-over is only available if: • persons who formerly held units under the previous ownership scheme are, immediately after the conversion, the only holders of strata title units in the building; and • the unit owners hold the same or substantially the same rights to occupy the units after the conversion as they did before. The effect of the roll-over is that the legal title to the home unit or apartment is treated for CGT purposes as if it were the same as the previous ownership interest. See Ruling TR 97/4 for further details on strata title roll-over relief. For the application of the CGT discount to assets involved in a replacement-asset roll-over, see [14 390] and following.

[16 140] Exchange of shares in same company or units in the same unit trust Subdivision 124-E provides roll-over relief if a taxpayer has had shares cancelled or redeemed in a company and has had new shares issued in substitution for the cancelled or redeemed shares, or if a taxpayer has had units cancelled or redeemed in a unit trust and new units are issued in substitution for the cancelled or redeemed units. The conditions that must be satisfied for the roll-over relief to be available in respect of shares are (s 124-240): • the company must redeem or cancel all the shares of a particular class of the company (in terms of the requirements of the Corporations Act 2001: see Determination TD 2000/10), and the taxpayer must hold shares of that class; • the taxpayer must be a resident or, if a foreign resident, the cancellation must happen to shares that are ‘‘taxable Australian property’’ (see [18 100]) and the replacement shares must also be ‘‘taxable Australian property’’ just after they are issued; • the company must issue to the taxpayer new shares in substitution for the original shares; • the market value (see [3 210]) of the new shares immediately after they were issued must not be less than the market value of the original shares immediately before the redemption or cancellation; • the total paid-up share capital of the company must be the same immediately after the new shares were issued as immediately before the redemption or cancellation; • the taxpayer must not receive any consideration other than the new shares by reason of the redemption or cancellation; and • the taxpayer must choose for the roll-over to apply (see [12 440]). Note that if a company subdivides (splits) or consolidates its share capital without cancelling or redeeming the original shares, there is no disposal and, accordingly, no Subdiv 124-E roll-over arises. Instead, a cost base adjustment under s 112-25 occurs (see [14 170]). The same requirements are to be satisfied for a roll-over in respect of the exchange of units in the same unit trust (s 124-245).

Effect of roll-over If the roll-over applies and the original shares or units were acquired by the taxpayer before 20 September 1985 (ie pre-CGT), the new shares or units are taken also to have been acquired pre-CGT. If the original shares or units were acquired after 20 September 1985, the taxpayer is taken to have acquired the new shares or units for the cost base (and reduced cost © 2017 THOMSON REUTERS

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base) of the original shares or units. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following.

[16 150] Exchange of rights or options Subdivision 124-F provides roll-over relief if rights and options to acquire shares (s 124-295), or rights and options to acquire units (s 124-300), are cancelled as a consequence of the consolidation or subdivision of the shares or units to which those rights or options related and if they are replaced with new rights or options. The requirements for the roll-over in respect of options and rights to acquire shares are (s 124-295): • the taxpayer owns rights to acquire shares or rights to acquire an option to acquire shares or owns an option to acquire shares in a company (called the ‘‘original shares’’); • the original shares are either consolidated or subdivided; • as a consequence of the consolidation or subdivision the rights or options are cancelled and the company issues to the taxpayer other rights or options relating to the newly consolidated or subdivided shares in substitution for the original rights or options; • the taxpayer must be a resident or, if a foreign resident, the cancellation must happen to rights or options that are ‘‘taxable Australian property’’ (see [18 100]) and the replacement interests must also be ‘‘taxable Australian property’’ just after they are issued; • the market value (see [3 210]) of the new rights or the new option immediately after they were issued is not less than the market value immediately before the cancellation; • the taxpayer did not receive any consideration other than the new rights or the new options in respect of the cancellation; and • the taxpayer chooses that roll-over relief applies (see [12 440]).

Effect of roll-over If the roll-over applies and the original rights or options were acquired before 20 September 1985, the taxpayer is taken to have acquired the new rights or options before that date also. If the original rights or options were acquired after 20 September 1985, the taxpayer is taken to have acquired the replacement rights or options for the cost base (and reduced cost base) of the cancelled rights or options. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. The roll-over for options and rights to acquire shares is mirrored exactly in s 124-300 in relation to rights to acquire units or options or an option to acquire units in a unit trust. [16 160] Exchange of units or shares for new shares – business restructures Division 615 provides roll-over relief for the restructure of a company’s or a unit trust’s business whereby the taxpayer ceases to own shares in the company or units in the trust and in exchange becomes the owner of new shares in another company. Note that this roll-over was formerly contained in Subdiv 124-H (Exchange of units in unit trust for shares in interposed company) and in Subdiv 124-G (Exchange of shares in company for shares in an interposed company), but has now been consolidated into one area, with the same principles applying. 628

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Requirements Broadly, the roll-over applies where under a scheme for the reorganisation or restructure of a business, a resident company is interposed between either (i) a resident company and its shareholders, or (ii) a resident unit trust and its unitholders. In addition, the shareholders or unitholders must dispose of their shares or units solely in exchange for shares in the interposed company. Note that the restructuring can be carried out either by a direct exchange of shares or units or by their redemption or cancellation in exchange for the new shares. Note the shareholders or unitholders and the interposed company must choose for the roll-over to apply. In the case of the interposed company, it must make this choice within 2 months after completion of the reorganisation or within such further time as the Commissioner allows: s 615-30. See exception to the general rule in s 103-25 about making a choice (see [12 440]). Specifically, the conditions to be satisfied are as follows (Subdiv 615-B): • the interposed company must not be acting in the capacity of a trustee; • the consideration for the disposal must consist solely of shares in the new company that are not redeemable shares; • shareholders and/or unitholders must be issued only with whole shares in the interposed company; • the interest of each shareholder in the new company immediately after ‘‘completion of the reorganisation’’ must be of the same value as their prior interest in the former company or unit trust (as determined by comparing the market value of the shareholding to the value of the shares or units previously held); • immediately after completion of the reorganisation, the new company must be the sole shareholder or unitholder in the original company or unit trust (as the case may be) and the former shareholders or unitholders must be the only shareholders in the new company; and • the taxpayer must be a resident or the original shares or units which are exchanged or redeemed must be ‘‘taxable Australian property’’ (while shares received in exchange must also be “taxable Australian property” just after they are issued): see [18 100]. Note that the roll-over will apply where a ‘‘share sale facility’’ is used for foreign held interests without the ‘‘same ownership’’ test being failed (for CGT events happening after 11 May 2010). See also the Tax Office website for details of its administrative treatment of this change. In the case of a consolidated group, it is not necessary for an interposed company, which becomes the head company of a consolidated group, to demonstrate compliance with these requirements for it to make a choice that the consolidated group is to continue in existence: see ATO ID 2007/216. However, ATO ID 2008/122 states that a new shelf company interposed between the shareholders and the head companies of 2 separate consolidated groups cannot make a choice to continue the existence of both consolidated groups as a single consolidated group because it would be contrary to the intention of the section. Ruling TR 97/18 provides further details and clarification of the requirements to be met for roll-over relief where a business undertakes a restructure or reorganisation in this manner. Note also that the Addendum to Ruling TR 97/18 states that roll-over relief is not available if more than one entity is reorganised, at least if the restructure is in the nature of a merger or amalgamation. Roll-over relief may be available, however, if the reorganisation is of entities that use the same interposed shelf company, and maintain economic interests in the underlying assets of each entity just after the reorganisation. © 2017 THOMSON REUTERS

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Trading stock and revenue assets The roll-over also applies to revenue assets and trading stock equally (in the same way it applies to shares and units held as investments), provided the replacement shares in the interposed company retain the same ‘‘tax character’’ of the original shares or units: see [5 070] and [5 445]. Further, it applies to an exchange of shares in any company, rather than only shares in consolidated groups. Roll-over relief in relation to revenue assets and trading stock applies from 10 May 2011 (subject to modifications where the relevant transaction happened between then and 8 May 2012). Effect of roll-over The effect of the roll-over is that there will be no CGT liability in respect of the disposal to the new company of the existing shares or units acquired after 19 September 1985 (or on their redemption or cancellation). Further, if the shareholder or unitholder acquired all the shares or units before 20 September 1985, the shares received in the new company will also be taken to have been acquired before 20 September 1985. If only some of a shareholder’s shares or a unitholder’s units were acquired before 20 September 1985, an equivalent proportion of the shares received in the new company will be taken to have been acquired before that date. On the other hand, for new shares taken to have been acquired on or after 20 September 1985, their cost base (and reduced cost base) will be determined by reference to the relevant cost bases of the original shares or units exchanged. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. For the interposed company, the effect of the roll-over is that a proportion of the shares in the existing company or the units in the existing unit trust may be taken to have been acquired before 20 September 1985. This will be determined by reference to the net value of the assets of the original company or unit trust that were acquired before 20 September 1985. For the remaining shares or units that are taken to have been acquired on or after 20 September 1985, the amount of any capital gain or loss when a CGT event subsequently happens to them will be determined by taking into account the relevant cost bases of assets of the company or unit trust that were acquired on or after 20 September 1985, reduced by any liabilities of the company or trust attributable to those assets. Finally, note that this is a very useful roll-over provision because it effectively provides for the possibility of restructuring a group by inserting a holding company without reliance upon either Subdiv 122-A or Subdiv 126-B. In particular, the use of Div 615 to effect the reconstruction can give rise to the preservation of a pre-CGT structure. Division 615 also contains measures to assist financial groups containing authorised deposit-taking institutions (ADIs) to restructure. Section 615-25 allows shareholders of an original company (either an ADI or an extended licensed entity member), who exchange their shares for shares in an interposed non-operating holding company, to roll over any capital gain or loss that arises from the exchange into the shares they receive in the interposed non-operating holding company. Note that roll-over relief is also available for the ‘‘demerger’’ of subsidiary entities: see [16 270]. [16 180] Exchange of stapled interests for units in unit trust Subdivision 124-Q provides a roll-over to the holders of ownership interests in stapled entities when a public unit trust is interposed between those holders and the stapled entities. The roll-over is directed at allowing stapled groups, in particular Australian Listed Property Trusts, to rearrange their stapled structures and interpose a head trust so that they are treated as a single entity for the purposes of overseas acquisitions. See also Determination TD 2011/7. Stapled entities are a group of entities that consist of 2 or more trusts, or one or more companies and one or more trusts, whose ownership interests are stapled together to form 630

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[16 180]

stapled securities. ‘‘Ownership interests’’ cover shares, trust interests, and options or the like, giving an entitlement to acquire a share or trust interest: s 125-60(1). A stapled entity is an entity in relation to stapled securities if ownership interests in the entity form part of the stapled securities: s 124-1045(2).

Eligibility The roll-over is available if (s 124-1045): • under a scheme for reorganising the affairs of the relevant stapled entities, a public unit trust is interposed between the owners of ownership interests in the entities in a stapled group (the ‘‘exchanging members’’) and the entities in the stapled group; • the stapled entities include at least one entity (ie a public trading trust or a corporate unit trust) that is taxed like a company (under Div 6B or 6C of Pt III ITAA 1936: see [23 1550]-[23 1610]) and at least one entity that is not so taxed; • if a new unit trust is interposed between the exchanging members and the stapled entities, the interposed trust must become the owner of all of the ownership interests in the stapled entities (or if the interposed trust is one of the stapled entities, the latter must become the owner of all the ownership interests in the other stapled entities); • each exchanging member must own a percentage of the ownership interests in the interposed trust that reasonably equates to the percentage of the ownership interests the member owned in the stapled entities just after the scheme is completed (the ‘‘completion time’’); • just after the completion time, each exchanging member must have the same, or as nearly as practicably the same, proportionate market value of ownership interests in the interposed trust as the member had in the stapled entities before the completion time: s 124-1050(2) and (3); and • the member must be an Australian resident at the completion time or, if the member is a foreign resident at that time, some or all of their ownership interests in the stapled entities must have been ‘‘taxable Australian property’’ (see [18 100]) just before the completion time and their ownership interests in the interposed trust must be ‘‘taxable Australian property’’ just after the completion time.

Effect of roll-over for exchanging member If a member with post-CGT interests obtains the roll-over, a capital gain or capital loss that a member makes from each of their ownership interests is disregarded: s 124-1055(1). The cost base and reduced cost base of each of the member’s ownership interests in the interposed trust is the reasonably attributable amount, having regard to the total of the cost bases of all of their ownership interests in the stapled entities and the number, market value and character of their ownership interests in the interposed trust (s 124-1055(2)). If a member acquired all of their ownership interests in the stapled entities before 20 September 1985, they are taken to have acquired all of their ownership interests in the interposed trust before that date: s 124-1055(3). If the member has both pre- and post-CGT interests in the stapled entities, some of their ownership interests in the interposed trust will also be pre-CGT interests. This is determined by reference to the number, market value and character of their ownership interests in the stapled entities and the number, market value and character of their ownership interests in the interposed trust: s 124-1055(4). The first element of the cost base and reduced cost base of each of the member’s post-CGT ownership interests in the interposed trust is an amount that is reasonable, having regard to the total of the cost bases of their post-CGT ownership interests in the stapled entities and the number, market value and character of their post-CGT ownership interests: s 124-1055(5). © 2017 THOMSON REUTERS

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Effect of roll-over for interposed trust The CGT consequences for the interposed trust are as follows (s 124-1060(1)-(3)): • the trustee is taken to have acquired some ownership interests pre-CGT if some of the stapled entity’s assets at the completion time were acquired pre-CGT; and • the number of ownership interests is the greatest possible (expressed as a percentage of all the ownership interests in the stapled entity acquired by the trustee) that does not exceed the market value of the stapled entity’s assets it acquired pre-CGT, less its liabilities. This is expressed as a percentage of the market value of the stapled entity’s assets less its liabilities. The amounts are to be worked out at the completion time. The first element of the cost base and reduced cost base of each of the trustee’s ownership interests in the stapled entity, which is not treated as having been acquired pre-CGT, is a reasonable proportion of the total cost bases (as at the completion time) of the stapled entity’s assets acquired post-CGT less its liabilities: s 124-1060(4). In applying the section, a liability that does not relate to any specific asset of a stapled entity is treated as a liability in respect of all of the assets of the stapled entity: s 124-1060(5). Further, if a liability relates to 2 or more of those assets, the liability is allocated between those assets on a reasonable basis having regard to the market value of those assets.

Foreign holders Certain foreign holders (as defined) are not treated as exchanging members for the purposes of Subdiv 124-Q. However, the roll-over is available if a foreign sale facility is used. Note that the roll-over will also apply where a share sale facility is used for foreign held interests without the ‘‘same ownership’’ test being failed (in relation to CGT events happening after 11 May 2010). See also the Tax Office website for details of its administrative treatment of this change. [16 190] Conversion of body to incorporated company Subdivision 124-I provides roll-over relief on the conversion of a body or association into a company incorporated under the Corporations Act 2001, if a taxpayer’s interest in the association is replaced by shares in the company. The roll-over applies if (s 124-520): • the only consideration for the disposal of an interest in the former association is the issue of shares in the new company; • there is no significant difference in the ownership of, or mix of ownership of, the body prior to the conversion compared to the position just after the conversion; • the taxpayer is a resident or the shares in the new company are ‘‘taxable Australian property’’ (see [18 100]); and • the taxpayer chooses for the roll-over to apply (see [12 440]). The effect of the roll-over is that there are no CGT consequences on the conversion, the pre-CGT status of membership interests are retained in respect of relevant replacement shares, while the cost base of any post-CGT membership interests is transferred to relevant replacement shares. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. The roll-over will also apply where a ‘‘share sale facility’’ is used for foreign held interests without the ‘‘same ownership’’ test being failed (in relation to CGT events happening after 11 May 2010). See also the Tax Office website for details of its administrative treatment of the change. In addition, the roll-over will also apply to entities that change incorporation to become a Corporations (Aboriginal and Torres Strait Islander) Act 2006 (CATSI Act) corporation. In 632

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[16 210]

this case, the roll-over will also cover a taxpayer’s rights associated with a body, as well as their ownership interests, and situations where a body is wound up and replaced by a new company incorporated under a different law. It will also provide for tax neutral consequences for CGT, depreciating, revenue and trading stock assets of a body where these assets are transferred to the new company. The amendments will apply to CGT events happening after 11 May 2010.

[16 200] Crown leases Subdivision 124-J provides an automatic roll-over to a holder of rights under a Crown lease over land when the lease is renewed, extended or converted to a fee simple title. The new right must relate to the same land or, if different, one of the following criteria in s 124-585 must also be satisfied: the difference in area must not be significant; the difference in market value must not be significant; the new right must have been granted to correct errors in or omissions from the original right; the new right must relate to a significantly different area of land but reasonable efforts have been made to ensure that the area was the same; or it must otherwise be reasonable for the roll-over to apply. Note that a partial roll-over is available if some of the land that is the subject of the original right is not covered by the new right: s 124-590. In this case, the cost base of the original right is adjusted to take account of any excised land: s 124-600. Effect of roll-over If the roll-over applies, the pre-CGT status of a Crown lease of land granted before 20 September 1985 is preserved. If a lease was acquired on or after 20 September 1985, the expiry or surrender of the lease is not treated as a disposal for CGT purposes but the cost base or reduced cost base of the new lease will be the same as that of the old lease. If the new Crown lease relates partly to land upon which an original Crown lease was granted prior to 20 September 1985, partly to land upon which a Crown lease was granted on or after 20 September 1985 and partly to other land, the new Crown lease is taken to comprise separate leases. In this case, the separate lease relating to land in respect of which a lease was granted before 20 September 1985 is not subject to CGT. The other leases are subject to CGT and for the purpose of determining if a capital gain accrued upon a subsequent CGT event, the taxpayer is taken to have acquired the post-19 September new Crown leases for an amount calculated by reference to the formula set out in s 124-600. Basically the cost base of the original Crown lease will be taken to be the cost base of the new one. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. [16 210] Depreciating assets installed on leased Crown land Subdivision 124-K ensures symmetry of tax treatment under the CGT provisions as applies for depreciation purposes in relation to depreciating assets installed on land leased from an Australian government agency or a foreign government agency or from certain exempt government agencies or authorities (see [10 1210]). Specifically, it applies to the disposal of a depreciable asset of which a person or entity is the quasi-owner (ie holder) under the Uniform Capital Allowance system (discussed in Chapter 10). Note that generally the disposal of a depreciating asset has no CGT consequences if the CGT event takes place after 20 September 1999 (except in relation to certain primary production depreciating assets and any non-income-producing use of assets: see CGT event K7 at [13 700]). Background The termination, expiry or surrender of a lease constitutes a disposal of the lease by the lessee for CGT purposes, including any separate assets comprising the lessee’s interest in any plant installed on the land. However, if the lease is a ‘‘Crown lease’’ or a ‘‘mining or prospecting entitlement’’ as defined for CGT purposes (see s 124-580 or s 124-710 © 2017 THOMSON REUTERS

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respectively), Subdiv 124-J (see [16 200]) or Subdiv 124-L (see [16 220]) provides automatic CGT roll-over relief if the disposal of the lease is followed by the grant to the lessee of a fresh lease or freehold title to the property. The effect of roll-over relief is to treat the termination, expiry or surrender as if it had not occurred so that no gain or loss accrues. However, assets attached to land held under quasi-ownership rights granted by exempt Australian and foreign government agencies do not come within the concepts of ‘‘Crown lease’’ (Subdiv 124-J) and ‘‘prospecting and mining entitlements’’ (Subdiv 124-L) for CGT purposes. This occurs because a quasi-ownership right for depreciation purposes broadly means a lease, easement or other right, power or privilege over land (s 995-1) granted by a government or exempt government agency, whereas for CGT purposes a Crown lease is limited to a lease granted under an Australian law (but not the common law) or a foreign law.

Effect of roll-over The purpose of Subdiv 124-K, therefore, is to provide comparable roll-over relief to the relief provided for Crown leases under Subdiv 124-J and prospecting and mining entitlements under Subdiv 124-L. Accordingly, Subdiv 124-K ensures CGT roll-over relief automatically applies to a disposal of the taxpayer’s interest (or, if a partnership, of each partner’s interest) in a depreciating asset affixed to a lease of land from an exempt government or exempt government agency, if neither Subdiv 124-J nor Subdiv 124-L applies, where the depreciation quasi-owner provisions treat the taxpayer as continuing to hold the depreciating asset for depreciation purposes because the taxpayer has received a fresh interest, either as lessee or owner, in the asset. Roll-over relief will only apply to the interest in a depreciating asset and not to the disposal of the separate asset comprising the leasehold interest in the land itself. In practice, this will mean that if the interest in the depreciating asset that was disposed of was acquired by the taxpayer before 20 September 1985, the fresh interest will be treated as being acquired before that date, preserving its pre-CGT status. In the case of a disposal of an interest in a depreciating asset acquired by a taxpayer after 19 September 1985, the fresh interest will be treated, for the purposes of calculating a capital gain or loss on its disposal, as being acquired for consideration equal to the cost base or reduced cost base of the terminated interest immediately before its disposal. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. Termination of lease followed by grant of fresh lease or freehold title to associate of lessee On the termination, expiry or surrender of a quasi-ownership right (eg lease) that is followed by the grant of a fresh interest in the land to an associate of the quasi-owner (lessee), the capital allowance provisions treat the lessee as disposing of the depreciating asset on the leased land for consideration equal to what would be its market value if the lessee owned the land, thereby denying a balancing loss on the disposal of the asset to an associate and preventing avoidance of an assessable balancing adjustment. The normal CGT rules would treat such a termination as the disposal of the assets comprising the leasehold interest in the land and in the depreciating asset, usually for no consideration, and a capital loss would be available equal to the reduced cost base, if any, of the lessee’s interest (or each partner’s interest) in the asset. This would be inappropriate because an associate has obtained an interest in the property. In this case, s 124-660 modifies the reduced cost base rules to ensure that the undeducted cost of the depreciating asset under Div 40 ITAA 1997 at the time of the termination is deducted from the reduced cost base of the taxpayer’s interest in the asset. In the case of a depreciating asset of a partnership, the portion of the undeducted cost of the asset that is attributable to the partner’s interest in the asset is excluded from the reduced cost base of the partner’s interest in the asset. Section 124-660 also ensures that no roll-over relief is available in these circumstances. 634

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[16 220]

[16 220] Prospecting and mining entitlements Subdivision 124-L provides automatic roll-over if a prospecting or mining right expires or is surrendered and is replaced by a new prospecting or mining right. However, mining and prospecting rights granted after 30 June 2001 under an Australian law are depreciating assets for the purposes of Div 40 ITAA 1997 (see [10 150]). Accordingly, the surrender or expiry of such a right is a balancing adjustment event (see [10 1270]) and thus outside the operation of the CGT provisions, including the Subdiv 124-L roll-over. For the roll-over to apply (where applicable), the new right must have been granted in any of the following ways (s 124-705): • by renewing or extending the term of the original entitlement if the renewal or extension is mainly due to having held the original entitlement; • by consolidating, or consolidating and dividing, the original entitlement; • by subdividing the original entitlement; • by converting a prospecting entitlement to a mining entitlement or a mining entitlement to a prospecting entitlement; • by excising or relinquishing a part of the land to which the original entitlement related; or • by expanding the area of that land. The new right must also relate to the same land to which the original entitlement related or, if different, one of the following criteria (s 124-715) must be satisfied: • the difference in area must not be significant; • the difference in market value must not be significant; • the new right must have been granted to correct errors in or omissions from the original right; or • it must otherwise be reasonable for the Subdivision to apply.

Effect of roll-over If the roll-over applies, any gain or loss on the expiry or surrender of the right is disregarded. However, if part of the land over which the right extends is excised and consideration is received in respect of the expiry or surrender of the original mining asset and that original mining asset was granted after 20 September 1985, there will be a part-disposal for the purposes of the CGT provisions. If the section applies and a new mining or prospecting right relates wholly to land in respect of which an original mining asset was granted prior to 20 September 1985, the new mining asset is taken to have been acquired prior to that date, ie it retains its pre-CGT status. If a new mining or prospecting right relates wholly to land in respect of which an original mining asset was granted after 20 September 1985, the new right is taken to have been acquired after that date. The taxpayer is taken to have paid or given, as consideration for the purposes of calculating a capital gain upon subsequent disposal to a third party of that new mining asset, an amount calculated in accordance with the formula set out in s 124-730(3). If a new mining or prospecting entitlement relates partly to land to which a pre-20 September 1985 original entitlement related, partly to land to which a post20 September 1985 original entitlement related and partly to other land in respect of which there was no original entitlement, then, upon the subsequent disposal of the new entitlement, there is taken to have been a disposal of separate assets, being basically divided into the pre-20 September 1985 assets and post-20 September 1985 new assets. The formula in © 2017 THOMSON REUTERS

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s 124-730 is utilised for determining the amount which is taken to have been paid or given as consideration in respect of the acquisition of the post-20 September 1985 new assets. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following.

[16 230] Scrip-for-scrip roll-over Subdivision 124-M provides roll-over relief for certain post-CGT interests in companies and trusts that are exchanged for interests in another entity. Note that a corporate limited partnership (see [22 410]) is treated as a company for the purposes of Subdiv 124-M. For the roll-over available on the ‘‘demerger’’ of a company group, see [16 270]. Eligibility The roll-over can only be chosen if a capital gain would have resulted from the exchange of the share interest: ss 124-780(3)(b). Roll-over relief is available if: • a post-CGT share interest is exchanged for a share interest in another company; • the exchange is in consequence of a ‘‘single arrangement’’ that meets specified criteria; • the ‘‘replacement share interest’’ is in a specified replacement entity; and • roll-over is chosen and specific notice requirements fulfilled. The roll-over is also similarly available in respect of trust interests (see below). See Determination TD 2004/50 for application of the roll-over where a subsidiary member of a consolidated group acquires shares in a non-consolidated company under a scrip-for-scrip arrangement. See also Ruling TR 2005/19 for the application of Pt IVA to scrip-for-scrip roll-over ‘‘schemes’’.

Post-CGT share interest and similar interest condition Post-CGT interests in shares, options, rights or similar interests can attract the roll-over relief, provided one form of interest is exchanged for a similar interest (eg the roll-over can apply to option-for-option exchanges but not share-for-option exchanges): s 124-780(1)(a)(ii). See also Determination TD 2002/22, which provides that the exchange of a fixed interest (other than a unit) in a trust for a unit in a trust will satisfy the requirements for scrip-for-scrip roll-over relief. However, relief is not available if units in a public trading trust are exchanged for shares in a company: ATO ID 2003/197. Note that the stakeholder tests apply on the basis of who owns the relevant interests in an entity, rather than who benefits from the interests (ie a look-through approach): s 124-783(6) and (7). This ensures that the tests apply to interests owned by life insurance companies, superannuation funds and trusts in the same way that they apply to interests owned by other types of entity.

Single arrangement condition The range of activities constituting an arrangement includes takeover offers and schemes of arrangement governed by the Corporations Act 2001. The arrangement must result in an entity becoming the owner of 80% or more of the specified interests in the target company. Note that a company or wholly owned group of companies can become the owner of 80% or more of the voting shares in another company even if the company or group owned 80% or more of those shares before the arrangement, provided that they owned a greater percentage after the arrangement: Determination TD 636

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2000/50. Also a company can increase the percentage of voting shares that it owns in an original entity for these purposes even if it starts out with no voting shares: Determination TD 2000/51. The arrangement must be one in which at least all owners of voting shares in the target entity can participate and that participation must be available on substantially the same terms for all owners of interests of a particular type. This condition will be satisfied if different offers are made to separate classes of members, provided the offer to each class of member is on substantially the same terms: see ATO ID 2003/177. Moreover, if one shareholder has additional or collateral rights in relation to her or his shares by virtue of a shareholders’ agreement, participation may still be on substantially the same terms: ATO ID 2004/800. Note that the issue of whether the arrangement is a ‘‘single arrangement’’ in which participation is available on substantially the same terms for all interest owners will be a question of fact, depending on such matters as whether there is more than one offer or transaction, whether aspects of the overall transaction occur contemporaneously and the objective intention of the parties to the transaction. In this regard, in FCT v Fabig (2013) 95 ATR 660, the Full Federal Court held that the requirement that ‘‘the arrangement must be one in which participation was available on substantially the same terms for all of the owners of interests’’ meant that the exchange of consideration had to take place ‘‘substantially on the same terms’’. In this case, the offer was made to the shareholders on the same terms, but the consideration for the shares was split ‘‘unevenly’’ between them under a private arrangement. However, for CGT events that happen on or after 6 January 2010, shareholders will not have to satisfy the ‘‘substantially the same participation requirements’’ in s 124-780(2)(b) and (c) and s 124-781(2)(b) and (c) under a takeover or a scheme of arrangement that meets the relevant requirements of the Corporations Act 2001.

The ‘‘replacement share’’ condition The replacement shares must be shares in the acquiring entity. However, an exception arises in the context of downstream acquisitions if the acquiring entity is a 100% subsidiary of another company in its wholly owned group and the replacement shares are shares in the ultimate holding company: s 124-780(3)(a). See also AXA Asia Pacific Holdings Ltd v FCT (2009) 77 ATR 829, where the Commissioner unsuccessfully argued that Pt IVA applied to the roll-over on the basis that a non-wholly-owned company had been inserted into an arrangement merely to qualify as an ultimate holding company for the purposes of qualifying for the roll-over. Additional conditions relating to non-widely held entities Roll-over relief applies irrespective of whether the entities are widely held. If either the entity making the takeover offer or the target entity is widely held, there is no requirement that the replacement interest must confer the same rights and obligations as the original interest. The replacement interest must be of the same broad kind as the original interest (eg ordinary shares could be exchanged for preference shares and options could be exchanged for options, but shares could not be exchanged for options). If the entities did not deal with each other at arm’s length and both entities are not widely held, or if the original interest holder, original entity and replacement entity were all members of the same commonly controlled group just before the arrangement, it is an additional condition that the replacement interest must confer the same rights and obligations as the original interest (eg ordinary shares must be exchanged for ordinary shares): s 124-780(4), (5). The second additional condition which must be satisfied in this circumstance is that the capital proceeds for the exchange must be at least substantially the same as the market value of its original interest: s 124-780(5). ATO ID 2004/498 considers when shareholders deal at arm’s length with the acquiring entity. Ruling TR 2005/19 considers certain arrangements which the Tax Office considers do not satisfy the requirements of s 124-780(4) and (5). In FCT v AXA Asia Pacific Holdings Ltd (2010) 81 ATR 180, the Commissioner unsuccessfully argued that ‘‘collusion’’ between the parties meant that the arm’s length condition had not been met (see also [42 120]). © 2017 THOMSON REUTERS

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Choice of roll-over Roll-over relief can be obtained by an original interest holder by choosing for roll-over relief to apply in respect of the exchange: s 124-780(3)(d). The original interest holder must choose to obtain the roll-over relief or, if s 124-782 applies (see below), the original interest holder and the replacement entity must jointly choose to obtain the roll-over relief: s 124-780(3)(d). See [12 440] about making a choice under the CGT provisions. If s 124-782 applies, the original interest holder must inform the replacement entity in writing of the cost base of its original interest worked out just before a CGT event happened in relation to it: s 124-780(3)(e). Replacement of trust interests The roll-over for the exchange of trust interests applies if (s 124-781(1) to (3)): • a post-CGT trust interest is exchanged for an interest in another trust; • entities have fixed entitlements to all of the income and capital of both the acquiring entity and the original entity; • the exchange is in consequence of an ‘‘arrangement’’ meeting specified criteria; • the ‘‘replacement interest’’ is in the acquiring entity or in the ultimate holding company of the acquiring entity; and • roll-over relief is chosen and specific notice requirements fulfilled. The relevant definitions and conditions are similar to those which apply in the case of the exchange of shares for shares, discussed above.

Partial roll-over – ineligible proceeds The original interest holder can obtain only a partial roll-over if the capital proceeds for its original interest include ‘‘ineligible proceeds’’, ie something other than the replacement interest (eg cash). There is no roll-over for that part of its original interest for which it received ineligible proceeds: s 124-790(1). Effect of roll-over – cost bases of interests acquired Generally, the first element of the cost base of interests acquired by an acquiring entity will be determined under the ordinary cost base rules. However, the cost base of the original interest will become the first element of the cost base of the replacement interest where the holder is either a significant stakeholder or a common stakeholder for the arrangement: s 124-782(2). This rule applies if the original interest holder, together with associates, has either (s 124-783): • a 30% or more stake in the original entity and in the entity in which the replacement interest is issued; or • together with other entities, at least an 80% holding common to both the original entity and the entity in which the replacement interest is issued (but only if both entities are not widely held). If the acquiring entity either issues equity or owes new debt to its ultimate holding company under an arrangement and the cost base of an original interest was transferred or allocated under s 124-782, then s 124-784 allocates a specific cost base to the equity issued or new debt owed, irrespective of either the cost or paid up value attributed to the new shares by the parent and the subsidiary or the amount of the new debt recorded or recognised by them, in their respective accounts. The cost base will be based on the cost base of the shares in the original entity transferred to the subsidiary under s 124-782. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. 638

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Pre-CGT interests A replacement interest acquired on exchange of a pre-CGT interest under the scrip-for-scrip roll-over does not retain its pre-CGT status. Instead, the first element of the cost base and reduced cost base of the replacement interest will be its market value just before it is acquired: s 124-800(1). Note that this cost base will be reduced to the extent that a capital gain from CGT event K6 (pre-CGT interests converted to post-CGT interest: see [13 690]) can be disregarded on the basis that the roll-over could have been chosen if the pre-CGT interest had been a post-CGT interest: s 124-800(2). Cost base of shares under corporate restructures For arrangements entered into after 13 May 2008, a market value cost base will not apply when shares and certain other interests in an entity are acquired by another entity following a scrip-for-scrip roll-over under an arrangement that is taken to be a ‘‘restructure’’: s 124-784B. An arrangement will be taken to be a restructure if, broadly, just after the arrangement was completed (the completion time) the market value of the replacement interests issued by the acquiring entity under the arrangement in exchange for qualifying interests in the original entity is more than 80% of the market value of all the shares (including options, rights and similar interests to acquire shares) issued by the replacement entity: s 124-784A. If an arrangement that qualifies for scrip for scrip roll-over is taken to be a restructure, then the cost base for the qualifying interests that the acquiring entity acquires in the original entity will reflect the cost bases of the underlying net assets of the original entity (rather than the market value of the original entity). Note that if the original entity becomes a member of a consolidated group or multiple entry consolidated group (MEC group) under the arrangement, then the head company of the group can elect to retain the tax costs of the original entity’s assets. Non-resident limitations Roll-over relief will only be available to a foreign resident if the replacement interest is ‘‘taxable Australian property’’ (see [18 100]) just after it is acquired: s 124-795(1). No roll-over relief if other roll-over available Roll-over relief is not available if roll-over relief under Div 122 of Pt 3-3 (disposal of assets to a wholly owned company: see [16 020]) or Div 615 (company reorganisation: see [16 160]) is chosen, or if the Subdiv 126-B roll-over (companies in the same wholly-owned group) is available or the capital gain would be disregarded: s 124-795. However, see Determination TD 2006/9 which confirms that, for the purposes of s 124-795(2)(a), the scrip-for-scrip ‘‘roll-over’’ will be available if the replacement asset may be subject to another roll-over, including if a provision operates in a similar manner to defer tax recognition by disregarding a capital gain or loss (eg the Div 128 ‘‘roll-over’’ on death). Additional integrity measures Integrity measures make it harder for companies and trusts to access the roll-over when they sell subsidiary companies other than as part of a genuine merger or restructure of their business. The measures apply in relation to CGT events that happen after 8 May 2012. In summary, they: • expand the ‘‘significant’’ and ‘‘common stakeholder’’ tests to include any entitlements that interest holders have to acquire additional rights (s 124-783A); • provide that a capital gain arising on the settlement of a debt owed by an acquiring entity to its parent company as part of the scrip-for-scrip acquisition is no longer disregarded (new ss 124-784, 124-784C); • extend the application of the cost base allocation rules regardless of whether the interest is issued to the group’s parent company or to another member of the group (new ss 124-784, 124-784C); and © 2017 THOMSON REUTERS

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• introduce a new condition on the availability of scrip-for-scrip roll-over relief in downstream acquisitions to apply the rules equally where the acquiring entity issues debt or equity to another member of the group (new ss 124-784, 124-784C). They also, importantly, extend the application of the scrip-for-scrip roll-over restructure provisions to trust restructures.

[16 240] Fixed trust to company Subdivision 124-N provides roll-over relief if a trust (other than a discretionary trust) disposes of all of its assets to a resident company and the beneficiaries’ interests in the trust are exchanged for shares in the company. The roll-over will be available for both the trust and its beneficiaries.

Eligibility ForTHEroll-overtoapply,thefollowingconditionsmustbemet(s124-860): • the trust must dispose of all of its assets to a company (including to a corporate trustee: ATO ID 2010/72), except assets retained to discharge debts of the trust; • CGT event E4 (capital payments for trust interests) must be capable of applying to all of the interests in the trust (thereby excluding discretionary trusts); • all the beneficiaries must own replacement shares in the company in the same proportion as they owned interests in the trust; • the market value of the beneficiaries’ interests in the trust and the market value of the shares in the company must be at least substantially the same; • the company must generally be a shelf company at the time the asset disposals commence; • the entities involved must choose to obtain the roll-over (see [12 440]). The roll-over is not available to CGT assets that are trading stock of the transferor and/or which become trading stock of a transferee: s 124-875(5). The recipient company may have or own ‘‘facilitation rights’’ (eg the right to demand transfer of the assets). If the transferee is a foreign resident, the roll-over will only be available for assets that are ‘‘taxable Australian property’’ (see [18 100]) just after their acquisition: s 124-875(6). In addition, the roll-over will still apply where a ‘‘share sale facility’’ is used for foreign held interests without the ‘‘same ownership’’ test being failed. Importantly, the trust must be wound up within 6 months from the disposal of the first asset to the company (subject to an extension of time in limited circumstances). However, the roll-over will be clawed back if the trust fails to be wound up within that time by way of reversal of the roll-over under CGT event J4 (see [13 570]). Note also that capital allowance roll-over relief (see [10 940]) will also apply in circumstances where the Subdiv 124-N roll-over relief applies.

Effect Any capital gain or loss arising from the transfer of the assets is disregarded: s 124-875(1). Pre-CGT assets retain their pre-CGT status in the hands of the transferee company (except if CGT event J4 applies to reverse the roll-over: see [13 570]): s 124-875(3), (4). The cost base and reduced cost base of post-CGT assets is transferred to the company: s 124-875(2). The former interest holder is considered to have acquired pre-CGT and post-CGT shares in the company in the same proportion as the number of pre-CGT and post-CGT assets that were transferred (except if CGT event J4 applies to reverse the roll-over): s 124-15(4) and 640

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(5). The cost base of any post-CGT share acquired under this method is the total of the cost base of post-CGT assets that were transferred divided by the number of post-CGT shares: s 124-15(6). Note that the shares acquired will be treated as having been owned for 12 months if sold within 12 months of their acquisition for the purposes of the CGT discount: see also [14 390] and following.

[16 260] Medical defence organisation roll-over Subdivision 124-P provides roll-over relief for medical defence organisations (MDOs) that are companies limited by guarantee. The relief is available where post-CGT membership interests in a company limited by guarantee are replaced with membership interests in another company limited by guarantee if both companies are medical defence organisations. The roll-over applies to CGT events happening from 14 February 2007. The arrangement must result in the new MDO becoming the sole member of the original MDO. In addition, participation in the exchange of membership interests must be on substantially the same terms for all the holders of particular interests in the original MDO. However, holders of particular interests in the original MDO are not required to be able to participate in the exchange of membership interests on the same terms as holders of different interests. If roll-over relief is chosen, the first element of the cost base of the replacement interest is the cost base of the original interest (just before the exchange of interests). The roll-over is not available to the extent that a member receives ineligible proceeds (ie anything other than a replacement interest in the new MDO, eg money) for their original interest. In such a case, the cost base of the original interest is apportioned (on a reasonable basis) to reflect the ineligible proceeds received. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. [16 265] Interest realignment roll-over for mining industry Subdivision 124-S provides roll-over relief where an interest in a mining, quarrying or prospecting right is disposed of under an ‘‘interest realignment’’ arrangement: see [17 345]. Broadly, an interest realignment arrangement occurs where parties to a joint venture exchange interests in mining, quarrying or prospecting rights to pursue a single development project, with a view to aligning the ownership of individual rights with the ownership of the overall venture. The roll-over applies to CGT events that happen after 7.30 pm AEST on 14 May 2013. [16 270] Demerger relief Division 125 provides automatic ‘‘demerger’’ roll-over relief if the head entity in a group undertakes restructuring in order to pass ownership of one or more of its subsidiary entities to shareholders of the head entity. The group can include corporate unit trusts (see [23 600]), public trading trusts (see [23 700]) and dual listed companies. Eligible head entities The head company of a consolidated group can qualify for demerger relief: Determination TD 2004/48. However, roll-over relief is not available if a discretionary trust is either the head entity of the group or a subsidiary being demerged, or if another CGT roll-over can be used. An entity will be excluded from being a member of a demerger group if the entity is a ‘‘corporation sole’’ or a ‘‘complying superannuation entity’’ (with effect to CGT events happening after 11 May 2010). This will allow an entity owned by the corporation sole or complying superannuation entity to qualify as the head entity of a demerger group. As a result, the new head entity will be able to demerge entities from the demerger group and qualify for Div 125 demerger relief. © 2017 THOMSON REUTERS

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Eligibility The key conditions (in Subdiv 125-B) for the roll-over to apply are: • at least 80% of the demerger group’s ownership interest in the demerged entity must be acquired by the shareholders of the head entity; • each owner must receive the same proportion of new interests in the demerged entity as per his or her original interests in the head entity, just before the demerger. Certain ownership interests are disregarded in working out whether this condition is satisfied, eg employee share scheme interests (see [6 200]) that are not fully paid-up: s 125-75(2) and (3). (Note that all ESS interests that would have been disregarded before the commencement of the new ESS provisions in Div 83A ITAA 1997 on 1 July 2009 (see [4 160]) continue to be disregarded); and • the total market value of each owner’s interests in the demerger entity and the head entity must not be less than the total market value of the original interests in the head entity just before the demerger (disregarding the ownership interests specified in s 125-75). Note that the roll-over will still apply where a ‘‘share sale facility’’ is used for foreign held interests without the ‘‘same ownership’’ test being failed (in relation to CGT events happening after 11 May 2010). Importantly, the relief does not apply to the extent the owners of the head entity receive something other than a new interest in the demerged entity (eg if cash is received, in addition to a new interest). However, relief is available if the shareholders of the head entity provide consideration for their new interests in the demerged entity: ATO ID 2004/455. Division 125 does not specify the method by which the demerger must occur. Rather, the measures provide for roll-over relief for any CGT event happening under the demerger. The most common methods for implementing a demerger will be by way of selective capital reduction of the shares held by the head entity, or by an issue of shares to the shareholders of the head entity followed by the cancellation of the shares held by the head entity in the demerger subsidiary (subject to stamp duty considerations).

Effect of the roll-over The effect of the roll-over is to defer the making of a capital gain or loss by the owners of the interest in the head entity for each of their affected interests: s 125-155. The cost base of the owners’ original interest is then apportioned across this interest and the new interest acquired under the demerger. Only a reasonable apportionment is required and therefore more than one method may be used (eg the relative market value method or the ‘‘parcel by parcel’’ method): Determination TD 2006/73. Owners of pre-CGT interests in the head entity can treat their new interest in the demerged entity as pre-CGT interests also. Note also that measures prevent CGT event K6 applying to convert pre-CGT interests into post-CGT interests on a demerger: see [13 690]. For the application of the CGT discount (and indexation where relevant) to assets involved in a replacement-asset roll-over, see [14 390] and following. EXAMPLE [16 270.10] Gareth acquired 500 ordinary shares (out of 50,000) in Head Groom Co for $3 per share. Head Groom Co owns 100% of the shares in Subsid Co. Head Groom Co announces that it will demerge Subsid Co by way of a capital reduction and the disposal of all its shares in Subsid Co. Provided the capital reduction is proportional and is offered to all shareholders in Head Groom Co, the proportionality requirement will be met. Under the capital reduction, $1 per share in Head Groom Co will be used to acquire Head Groom Co’s shares in Subsid Co for a price of $5 per share. The amount that Gareth is entitled to is $500 (ie 500 × $1). This equates to 100 shares in Subsid Co.

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CGT ROLL-OVERS [16 300] In order to obtain roll-over relief, the sum of the market value of Gareth’s remaining shares in Head Groom Co and new shares in Subsid Co must reasonably be expected to be not less than the market value of Gareth’s shares in Head Groom Co immediately prior to the demerger. As a result of the demerger, Gareth must recalculate the cost base of his interests in Head Groom Co and Subsid Co. Head Groom Co advises Gareth that the interests in Subsid Co account for approximately 20% of the market value of the group as a whole. The cost base of Gareth’s shares in Head Groom Co prior to the demerger was $1,500 (ignoring transaction costs). This cost base must now be spread between the new shares in Subsid Co and the remaining shares in Head Groom Co. • Cost base of shares in Subsid Co = 20% × $1,500 = $300 divided by 100 shares = $3 per share. • Cost base of shares in Head Groom Co = 80% × $1,500 = $1,200 divided by 500 shares = $2.40 per share. In these circumstances, Gareth can choose to defer the making of a capital gain or loss for CGT event G1 or the demerger dividend which arises from the capital reduction. Capital gains or capital losses made by Head Groom Co in relation to its shares in Subsid Co (generally, as a result of CGT event A1, C2, C3 or K6 being triggered) are disregarded.

Demerger dividends Dividends arising as a result of a demerger happening (a ‘‘demerger dividend’’) are neither assessable income nor exempt income (unless a scheme has been entered into for the purpose of obtaining that non-assessable dividend: see [21 030] and Practice Statement PS LA 2005/21). Otherwise, if the dividend is not a demerger dividend, the normal rules relating to assessability of dividends apply.

SAME ASSET ROLL-OVERS [16 300] Marriage and relationship breakdowns Subdivision 126-A provides roll-over relief if a CGT asset is transferred to a spouse or former spouse under either CGT event A1 or B1 in relation to the breakdown of a marriage or de-facto relationship (‘‘transfer cases’’). Likewise, the roll-over applies if a CGT asset in the form of a right, option etc is created in a spouse under CGT events D1, D2, D3 and F1 (‘‘creation cases’’): s 126-5(2), (3). The roll-over will only apply if the transfer, or creation, of the CGT asset takes place because of any of the following (s 126-5(1)): • a court order under the Family Law Act 1975, or under a relevant State or territory law or a corresponding foreign law; • a maintenance agreement approved by a court under s 87 of the Family Law Act 1975 or a corresponding agreement approved under a corresponding foreign law; • a binding financial agreement under Pt VIIIA of the Family Law Act 1975 or a corresponding binding written agreement under a corresponding foreign law; or • a Pt VIIIAB binding financial agreement between de facto spouses within the meaning of the Family Law Act 1975, or a corresponding binding written agreement under a corresponding foreign law; • an arbitration award under s 13H of the Family Law Act 1975 or a corresponding award under a State law, Territory law or foreign law; or • a binding written agreement, under a State, Territory or foreign law relating to the breakdown of relations between spouses. © 2017 THOMSON REUTERS

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If a CGT asset is transferred or created in these circumstances, the roll-over applies automatically. This means, for example, that a capital loss could only be realised on a CGT asset if it were transferred other than under the agreements set out in s 126-5(1) (see above). Note that a ‘‘spouse’’ is defined to include a de facto spouse (ie a person living with the taxpayer on a genuine domestic basis as their husband or wife), whether of the opposite or same sex, and an individual who is in a relationship (including with another individual of the same sex) that is registered under a relevant State or Territory law: s 995-1. Note also that if the CGT asset is transferred pursuant to a binding financial agreement or an arbitration award, the roll-over is only available if the spouses are separated with no reasonable likelihood of cohabitation being resumed and the transfer of the CGT asset happened for reasons directly connected with the breakdown of the marriage or de facto relationship: ss 126-5(3A), 126-25(1). The issue of whether the spouses have so separated is to be determined in the same way as for the purposes of s 48 of the Family Law Act 1975: s 126-25(2). See Determinations TD 1999/47 to TD 1999/61 for a discussion of other aspects of the roll-over.

Exclusions The roll-over is not available if the CGT asset transferred is trading stock of the transferor: ss 126-5(3)(a). Further, the roll-over does not apply if an asset is sold or transferred to someone other than a spouse: Re Kok Yong Tey and FCT (2004) 57 ATR 1359. It also does not apply if a CGT asset is transferred to the legal personal representative of a deceased former spouse pursuant to a relevant court order: see ATO ID 2008/103. Note also that cash settlements do not give rise to any CGT liabilities (see [15 150]).

Effect of roll-over Any capital gain or capital loss made from the transfer or creation of the asset is disregarded: s 126-5(4). In transfer cases, if the asset was acquired by the taxpayer before 20 September 1985, the spouse will be taken to have acquired it before that date also: s 126-5(6). If the asset was acquired on or after 20 September 1985, the first element of the asset’s cost base and reduced cost base in the hands of the transferee spouse will be its cost base at the time the transferee spouse acquired it: s 126-5(5). If the asset transferred was a personal-use asset or collectable (see [12 180]) of the taxpayer, it will retain its status as a personal-use asset or collectable in the hands of the transferee spouse: s 126-5(7). Note that if the asset transferred is a pre-CGT asset with a post-CGT improvement that is a separate asset under Subdiv 108-D (see [12 190]), the transferred asset is treated as 2 separate assets, one with a pre-CGT status and the other with a post-CGT status. As a result, the roll-over operates accordingly to the separate status of the assets: Determination TD 1996/19. In creation cases, the transferee spouse will be considered to have acquired the right, option etc for the incidental costs (see [14 040]) incurred in creating the rights or the expenditure incurred in granting them: s 126-5(8). For the application of the CGT discount (and indexation if relevant) to assets involved in a same-asset roll-over.

Transfer from company or trust The roll-over will also apply if a company or trustee transfers an asset to, or creates an asset in, the spouse pursuant to a relevant court order or agreement etc (above): s 126-15. 644

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[16 320]

However, in this case, provision is made to recalculate the cost base and reduced cost base of any post-CGT shares in or loans to the company, or interests in the trust or loans to the trustee (or underlying interests in any of those assets) held by other taxpayers (including the transferee spouse). Specifically, the cost base of the share, loan or other interest will be reduced by an amount that reasonably reflects the fall in its market value attributable to the transfer of the asset out of the company or trust, or creation of the asset in the spouse: s 126-5(3). If the share, loan or interest holder is the transferee spouse, this cost base will be increased by any amount that is included in the assessable income of the transferee spouse because of the transfer or creation of the asset: s 126-5(4). Note that if a company or trust is a CFC or a non-resident trust and a CGT event happens to the transferred or created asset in the hands of the transferee spouses, then modifications to the calculation of the capital gain or loss may need to be made under Div 7 of Pt X or Subdiv D of Div 6AA ITAA 1936: s 126-20. Importantly, Ruling TR 2014/5 provides that where an order is made under s 79 of the Family Law Act 1975 that requires a private company or a party to the matrimonial proceedings to cause the private company to pay money or transfer property to a shareholder of the private company, then the payment or transfer will be an ordinary dividend to the extent it is paid out of the private company’s profits and is ordinary income. Likewise, the Ruling provides that where a payment or transfer is made in the same circumstances to an associate of a shareholder of the private company, then the payment or transfer is a payment for the purposes of s 109C(3) of the ITAA 1936 (see [21 260]), and that s 109J will not prevent the payment from being treated as a dividend under s 109C(1): see [21 320]. In addition, where a dividend that is taken to be paid to an associate of a shareholder under s 109C is franked, that associate is treated as being a shareholder.

Interaction with other provisions For provisions relating to the interaction of the marriage breakdown roll-over relief with the main residence CGT exemption and the effect of the transfer of a dwelling from a company or trust on marriage breakdown, see [15 420]. For ‘‘superannuation split’’ roll-over for small superannuation funds in relation to marriage breakdown and pre-marriage financial arrangements, see [16 350]. [16 320] Companies in same wholly owned group With the introduction of the consolidation regime, the roll-over under Subdiv 126-B (for the transfer of assets between wholly owned group companies) was removed for transfers between resident companies (whether or not the entities form a consolidated group). This is because once a consolidated group is formed, relief applies automatically to the transfer of assets between resident group companies as a consequence of the single entity rule (see Chapter 24). Accordingly, the Subdiv 126-B roll-over will only apply to transfers between members of the same wholly-owned group if at least one of the companies is a foreign resident. As there is a ‘‘foreign resident’’ element, the asset subject to the roll-over must be ‘‘taxable Australian property’’ (see [18 100]) both before and after the trigger event: s 126-50(5). Effect of application of roll-over relief If Subdiv 126-B applies and the asset was acquired by the originating company before 20 September 1985, the recipient is also taken to have acquired the asset before that date. If the asset was acquired by the originating company on or after 20 September 1985, the recipient is taken to have acquired the asset for an amount equal to the cost base to the originator at the time of the CGT event, when calculating a capital gain, or the reduced cost base to the originator at the time the CGT event, when calculating whether the recipient incurred a capital loss. For the application of the CGT discount (and indexation where relevant) to assets involved in a same-asset roll-over, see [14 390] and following. © 2017 THOMSON REUTERS

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Note that the asset involved cannot be trading stock of the recipient company, nor a registered emissions unit under the former carbon pricing scheme: s 126-50(2) and (3), s 126-50(3A).

Member of wholly owned group A company is taken to be a member of the same wholly owned group as another company if either one of the companies was a subsidiary of the other or both were subsidiaries of the same company: s 975-500. A company is taken to be a subsidiary of another company at a particular time if at that time all the shares in the subsidiary were beneficially owned by the holding company, or by a company or companies each of which is a subsidiary of the holding company, or by the holding company and a subsidiary or subsidiaries of the holding company. If a company is a subsidiary of another company, every company that is a subsidiary of the subsidiary is also taken to be a subsidiary of the holding company. However, no person must be in a position to affect rights of the holding company or of a subsidiary of the holding company in relation to the group company subsidiary in question. A person is taken to be in a position to affect rights if that person has a right, power or option to acquire those rights or to do an act that would prevent the holder of the rights from exercising them for its own benefit. [16 330] Changes to trust deeds Subdivision 126-C provides roll-over relief if an asset is subject to a CGT event as a result of the trust deed of a complying superannuation fund or complying ADF being amended or replaced in order to comply with the SIS Act 1993, or in order to allow a complying ADF to convert to a complying superannuation fund, provided there is no change in the assets of the fund or interests of members in the fund as a consequence of the amendments. The roll-over also applies to changes to trust deeds for the purpose of having the fund approved as a ‘‘worker entitlement fund’’ under s 58PB FBTAA 1986 (see [57 270]), again provided the assets and members of the fund do not change as a result of the change to the deed: s 126-130(2). Roll-over relief is not available if ADFs merge. For the application of the CGT discount (and indexation where relevant) to assets involved in a same-asset roll-over, see [14 390] and following. Note that CGT event E2 happens when the assets of a superannuation fund are transferred to another superannuation fund under an agreement between the funds (see withdrawn ATO ID 2003/667). [16 340] Demutualisation and scrip-for-scrip roll-over Subdivision 126-E provides roll-over relief for a policyholder or member of a mutual insurance company who becomes absolutely entitled to a share held on trust, in circumstances where the trustee replaces demutualisation shares with other shares under a scrip-for-scrip roll-over. The roll-over applies (s 126-190) if, as a result of a demutualisation of a mutual insurance company: • a trustee holds shares on behalf of a policyholder/member because, for example, he or she cannot be located; • before the policyholder/member becomes absolutely entitled to the shares, the trustee exchanges those shares for new shares and chooses scrip-for-scrip roll-over; and • the policyholder/member later becomes absolutely entitled to the new shares. In these circumstances, any capital gain or loss the trustee would otherwise make is disregarded. The cost base of the new shares to the policyholder/member will equal the cost base of those shares to the trustee just before the relevant CGT event happened: s 126-195. For the application of the CGT discount (and indexation where relevant) to assets involved in a same-asset roll-over, see [14 390] and following. 646

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[16 370]

See [17 390] for CGT relief on the demutualisation of various entities, including private health insurers and friendly societies.

[16 350] Small superannuation funds roll-over Subdivision 126-D provides CGT roll-over relief if a trustee of a ‘‘small superannuation fund’’ (ie a complying superannuation fund with 4 or fewer members) transfers an asset to another superannuation fund. This will typically happen on the dissolution of a marriage or if the parties to a marriage have predetermined the splitting of superannuation interests as part of a financial agreement entered into either in contemplation of marriage or during marriage. The requirements for a roll-over under s 126-140 are: • an interest in a small superannuation fund is subject to a ‘‘payment split’’ (a term defined in the Family Law Act 1975); • the ‘‘non-member spouse’’ (as defined in the Family Law Act 1975) serves a waiver notice under s 90MZA of the Family Law Act 1975 in respect of that interest; • as a result of serving the notice, a CGT asset is transferred from a small superannuation fund to another complying superannuation fund (even if not a small fund) for the benefit of the non-member spouse. If, because of a payment split, the trustee of a small superannuation fund, to which both spouses belong, transfers a CGT asset to another SMSF, the roll-over is only available for the proportion of the CGT asset that relates to the interest subject to the payment split. It is not available for the proportion of the CGT asset that relates to the interest not subject to the payment split.

Other circumstances in which roll-over applies The roll-over applies in similar circumstances if a non-member spouse requests the trustee of a small superannuation fund to create an interest for the non-member spouse and that interest is then transferred to the trustee of another complying superannuation fund (even if not a small fund) in accordance with the SIS Regs: s 126-140(2). The roll-over also applies if all CGT assets reflecting the personal interest of either spouse (but not both) in a small superannuation fund are transferred to another complying superannuation fund, provided the spouses (or former spouses) are separated at the time of the transfer and there is no reasonable likelihood of cohabitation being resumed and the transfer happened because of reasons directly connected with the breakdown of the marriage (including a de facto marriage): s 126-140(2A) to 126-140(2D). The transfer must be made in accordance with a relevant Family Law Act 1975 award or court order, under a corresponding State, Territory or foreign law relating to de facto marriage breakdowns, a binding financial agreement under the Family Law Act 1975 or a corresponding foreign law or a binding written agreement of the type referred to at [16 300]. Note that it does not matter when the award, order or agreement was made. Finally, the roll-over will also apply to in-specie transfers between SMSFs under a binding financial agreement made between de facto partners (including same-sex partners) under Pt VIIIAB of the Family Law Act 1975 (from 1 March 2009). Effect of roll-over In each case, any capital gain or loss from the transfer of the asset is disregarded: s 126-140(3). The transfer of any pre-CGT asset will retain its pre-CGT status in the hands of the transferee: s 126-140(5). In the case of a post-CGT asset, the first element of the cost base and reduced cost base of the asset in the hands of the transferee will be its cost base at the time the transferee acquired the asset: s 126-140(4). For the application of the CGT discount to assets involved in a same-asset roll-over, see [14 390] and following. [16 370] Fixed trust to fixed trust Subdivision 126-G provides optional CGT roll-over relief for the transfer of assets between ‘‘fixed’’ trusts (for CGT events happening from 1 November 2008). The main conditions for the roll-over (ss 126-225 to 126-230) are set out below. © 2017 THOMSON REUTERS

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General requirements The roll-over applies if a trust (the ‘‘transferring trust’’) either (a) creates a ‘‘receiving’’ trust by declaration or settlement, over one or more CGT assets that include the roll-over asset; or (b) transfers the roll-over asset to an existing trust (the ‘‘receiving trust’’). In the case of a transfer of assets, the transfer can be on an asset-by-asset basis or as part of a multiple asset transfer.

Trust requirements Both the transferring and the receiving trust must be ‘‘fixed trusts’’. For these purposes, CGT event E4 (see [13 230]) must be capable of happening to all the units or interests in each of the trusts. In this regard, the roll-over will not apply if the trustee (or another entity) has the power to alter a beneficiary’s interest in the trust (excluding the trustee’s power of administration or indemnity). Note also that the terms of the 2 trusts are not required to be precisely the same (although any differences that result in a significant difference in the nature or extent of beneficiaries’ interests will prevent the roll-over applying). Subject to satisfying certain conditions, a trust that is a managed investment trust may also be eligible. Note the receiving trust must have no CGT assets, other than a small amount of cash or debt or ‘‘facilitation rights’’ (eg the right to demand transfer of the assets) just before the transfer time. Importantly, both trusts must have the same tax choices in force just after the transfer (eg the family trust election). Any conditions that apply to the original choice must apply in a corresponding way to the ‘‘mirror’’ choice. Mirror choices must be in force just after the transfer time. Finally, both trusts must choose for the roll-over to apply.

Beneficiary requirements Both trusts must have the same ‘‘direct’’ beneficiaries. It is not sufficient that the ‘‘indirect’’ or ultimate beneficiaries of both trusts are the same. Further, both trusts must have the same classes of membership interests. In addition, the total market value of each beneficiary’s interests in the transferring trust of a particular class and their interests of the matching class in the receiving trust must be substantially the same just before and just after the transfer time. This ensures that the beneficiaries have the same proportionate membership interests before and after the transfer.

Exclusions from roll-over The roll-over is not available if the receiving trust is a foreign trust for CGT purposes and the transferred asset is not taxable Australian property (see [18 100]). Nor is it available, if either trust is a corporate unit trust or a public trading trust at any time in the income year of the transfer (see [23 1500]-[23 1610]).

Consequences for the trustees If both trustees choose the roll over, any capital gain or capital loss made by the trustee of the transferring trust is disregarded: s 126-240(1). The first element of the cost base of the transferred asset in the hands of the receiving trust is equal to the cost base of the asset in the hands of the trustee of the transferring trust just before the transfer time: s 126-240(2). If the transferring trust acquired the asset pre-CGT, the trustee of the receiving trust is taken to have also acquired the asset pre-CGT: s 126-240(4). Otherwise, the receiving trust acquires the asset when the trust is created or the asset is transferred. Note that if the receiving trust has any revenue or capital losses just after the (first) transfer, they are effectively extinguished: s 126-240(3). For the application of the CGT discount (and indexation where relevant) to assets involved in a same-asset roll-over, see [14 390]. 648

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[16 380]

Consequences for beneficiaries The cost base of the beneficiary’s membership interest in both the transferring and receiving trusts is worked out under s 126-245 (general approach). Alternatively, if there is a series of roll-overs under an arrangement and a beneficiary continuously owns interests in the transferring trust over a period of time that covers multiple transfers, the beneficiary can choose to determine the cost base and acquisition date only once for those interests under s 126-250 (other approach). Under the ‘‘general’’ approach, the cost base and reduced cost base of each membership interest in the transferring trust after the transfer time is a proportion of the cost base of that interest, just before the transfer time. The proportion is what is reasonable, having regard to the market value of that interest (or a reasonable approximation of its market value) just before and just after the transfer time. The effect of the adjustment is to reduce the other elements of the cost base and reduced cost base to zero. Similarly, the cost base and reduced cost base of each membership interest in the receiving trust is an amount such that the total cost base of that interest and the cost base of the corresponding interest(s), or proportion of interest(s), in the transferring trust, just after the transfer time, reasonably approximates the total cost base of those interests just before the transfer time. Note also that beneficiaries are deemed to have acquired their interests in the receiving trust at the transfer time and that the interests will be taken to have been acquired pre-CGT if corresponding interests in the transferring trust were acquired pre-CGT. Under the ‘‘other’’ approach, the cost bases of interests in the transferring trust are based on the market value (or a reasonable approximation of market value) of those interests just before the first transfer, and just after the last transfer. Similarly, the cost bases of the corresponding interests in the receiving trust are adjusted so that the total cost base of the corresponding interests in both trusts, just after the last transfer, reasonably approximates the total cost base just before the first transfer. Those interests in the receiving trust are treated as having been acquired just after the transfer time of the last transfer in the chosen series. Note that if adjustments are made under s 126-245 or s 126-250 to the cost base and reduced cost base of the beneficiary’s membership interests, no other adjustment are made: s 126-255. For the application of the CGT discount (and indexation where relevant) to assets involved in a same-asset roll-over, see [14 390] and following. Finally, the trustee of the transferring trust must send a written notice containing certain information to each of its beneficiaries (as at the transfer time) to enable the relevant calculations to be carried out: s 126-260. The notice must be sent within 3 months of the end of the income year in which the transfer occurs, and failure to comply is a strict liability offence. Share sale facilities The roll-over will also apply where a ‘‘share sale facility’’ is used for foreign held interests without the ‘‘same ownership’’ test being failed (in relation to CGT events happening after 11 May 2010). See also the Tax Office website for details of its administrative treatment of the change. [16 380] Merger of superannuation funds Division 310 ITAA 1997 provides optional roll-over relief for the transfer of capital losses (and revenue losses) if a complying superannuation fund or a complying ADF merges with a complying superannuation fund with 5 or more members (applicable to asset transfers before 2 July 2107). This is achieved through the provision of a loss transfer and an asset roll-over. Earlier year capital losses (and tax losses) that are transferred to a receiving entity will be taken to be made by the receiving entity in the year that the losses are transferred: s 310-40. © 2017 THOMSON REUTERS

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An entity that chooses the assets roll-over under Div 310 must generally choose either a ‘‘global asset’’ approach or an ‘‘individual asset’’ approach to apply to each of the original assets that are not ‘‘revenue assets’’ (and the original assets that are revenue assets) and the corresponding received assets: s 310-50. Note also that the entity choosing the form of the roll-over may choose different forms of roll-over for its CGT assets and revenue assets. Access to both options under the asset roll-over will be available, regardless of the net capital (or revenue) position of the entity, in relation to the transferred assets. Under the ‘‘global asset approach’’, for each of the CGT assets that the transferring entity rolls over, the entity’s capital proceeds from the transfer are taken to be an amount equal to (s 310-55(1)): • the cost base of the asset just before the transfer if the transfer would otherwise result in a capital gain; or • the reduced cost base of the asset just before the transfer if the transfer would otherwise result in a capital loss. This means that neither a capital gain nor a capital loss will arise on the transfer of the CGT assets. For each CGT asset received by the receiving entity, the first element of the cost base or reduced cost base of the asset is taken to be equal to the cost base or reduced cost base of the asset just before it was transferred: s 310-55(2)-(3). Under the individual asset approach, the transferring entity may disregard all capital gains or losses it realises, or it may choose to disregard some or none of its capital gains or losses: s 310-60(1). The choice as to what gains or losses to disregard is a matter for the transferring entity. A transferring entity that chooses the individual asset approach for its CGT assets may elect to treat those assets subject to the asset roll-over as being transferred (or disposed of) to the receiving entity by treating: (a) the assets that would otherwise realise a capital gain as being transferred at their cost base; and (b) the assets that would otherwise realise a capital loss as being transferred at their reduced cost base: s 310-60(3). Furthermore, the effect of the individual asset approach is that the transferred CGT assets will have neither a capital gain nor a capital loss on their transfer. For the receiving entity, the first element of the cost base and reduced cost base of the transferred assets in its hands is taken to be equal to the cost base and the reduced cost base respectively of the asset just before its transfer (when it was still held by the transferring entity): s 310-60(4)-(5). As regards revenue assets, under the global asset approach there is no gain or loss for the transferring fund and, for each revenue asset transferred, the receiving fund is taken to have paid an amount equal to the deemed proceeds for the transferring fund: s 310-65. Under the individual asset approach, if the transferring entity derives assessable income (capital gains excluded) or incurs a tax loss from the transfer, its gross proceeds from the transfer are taken to be the amount it would need to receive so as to make neither a profit nor a loss from the transfer: s 310-70(1). The receiving entity is taken to have paid an amount for the received asset equal to the deemed proceeds of the transferring entity: s 310-70(2). This means the deemed proceeds represent the cost from which any subsequent profit or loss is calculated.

[16 390] Transfer of member’s accrued amounts to a ‘‘MySuper’’ product Division 311 ITAA 1997 ensures that a complying superannuation fund that is mandatorily required to transfer a member’s ‘‘accrued default amounts’’ to a MySuper product in another complying fund can transfer realised capital (and tax) losses to other entities, and defer an income tax liability for assets transferred to other entities, so that a liability will not arise until an ultimate disposal of the asset by the other entity. In addition, the receiving entity will be treated as having acquired the asset for the transferring entity’s cost base (and reduced cost base). A trustee of a complying superannuation fund that satisfies certain conditions in Div 311 will be able to choose to transfer a loss, choose an asset roll-over or both. The same relief will 650

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[16 400]

also be provided where the superannuation fund invests in a life insurance company or a pooled superannuation trust (PST) to support its default members. The relevant conditions are: • the transferring entity accessing the relief must be a complying superannuation fund, a life insurance company or a PST that holds the default member’s account balances; • the original superannuation fund must transfer the accrued default amounts of the member to a continuing complying fund that offers a MySuper product (pursuant to an election under s 29SAA(1)(b) or s 388 of the SIS Act) and the default member must become a member of the continuing fund when the accrued default amounts are transferred; and • the transfer must occur between 1 July 2013 and 1 July 2017. Note that where a transferring superannuation fund is eligible for relief under both Div 311 and Div 310 (see [16 380]), the fund is able to choose which provisions apply to its particular transaction. An eligible transferring entity that chooses to access the loss transfer provisions may transfer capital (and tax) losses to a receiving entity ‘‘to the extent they are reasonably attributable to the accrued default amount of the default member’’. As a result, the transferring entity will be permitted to liquidate its assets and then transfer cash and realised losses to the receiving entity: ss 311-20 and 311-35. Where a transferring entity generates losses from the realisation of assets after the default member has been transferred to another fund, these losses can also be transferred to a receiving entity to the extent that the losses are attributable to the accrued default amounts of the default member who has already been transferred. If the transferring entity transfers realised capital losses to a receiving entity, it reduces its capital losses by the transferred amount. A corresponding capital loss is taken to have been made by the receiving entity on the day the default member’ accrued default amounts are transferred. A choice under Div 311 must be made by the day the transferring entity’s income tax return is lodged for the transfer year for the entity (the Commissioner may allow further time). Division 311 applies to the income year of the superannuation fund that includes 1 July 2013 and the following income years if the accrued default amounts of a member are transferred to a MySuper product between 1 July 2013 and 1 July 2017. Note that a sunset clause provides for Div 311 to be repealed on 2 July 2019. The previous Coalition Government announced that CGT roll-over relief will also be provided to the transfer of members’ account balances from default products to MySuper products within the same super fund where the transfer is mandatorily required under the law. The roll-over will apply at the membership interest level and to the interposed entities that dispose of assets pursuant to the transfer, but will not extend to any rebalancing, which may occur after the initial transfer. Nor will it extend to the transfer of losses. The relief will apply from 29 June 2015. (See the then Assistant Treasurer’s Media Release, 29 June 2015.)

[16 400] Transfer of assets on winding-up of an entity Division 620 provides a general roll-over to defer taxation consequences where an original body is wound up and, as part of the process of changing its incorporation status, it transfers its assets to a new company, provided the ownership of the original body and new company is not significantly different. The roll-over applies to the transfer of CGT, depreciating and revenue assets and trading stock. It operates in conjunction with the roll-over in Subdiv 124-I (see [16 190]). The roll-over applies to CGT events (and other relevant disposals) happening after 11 May 2010. Note that the roll-over automatically applies if the reincorporation roll-over applies to the original body and the company (so that a capital loss cannot be generated). © 2017 THOMSON REUTERS

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Consequences for CGT assets The capital gain or loss the original body makes on the transfer of the CGT asset to the new company is disregarded: s 620-20(1)(a) and (2). Likewise, if any other CGT event happens to a CGT asset of the body because the body ceases to exist, the capital gain or loss the body makes on that CGT asset is also disregarded (eg where a lease is terminated, and CGT event C2 happens, as part of the winding up of the original body). Where an original body disposes of a post-CGT asset to the new company and the body ceases to exist, the first element of the CGT asset’s cost base (and reduced cost base) for the new company is the asset’s cost base when it was disposed of by the original body: s 620-25(1)-(3). On the other hand, if the original body acquired the asset before 20 September 1985, it will retain its pre-CGT status for the new company: s 620-25(4). Consequences for other assets The disposal of a depreciating asset to a new company will have no income tax consequences under the capital allowance provisions as the roll-over under s 40-340 for a balancing adjustment event will apply in these circumstances (see [10 940]): s 620-30(1)-(3). The disposal of an item of ‘‘trading stock’’ to the new company will likewise have tax neutral outcomes as the original entity will be taken to have sold it, and the new company bought it, for the cost of the item to the original body or, if it was trading stock at the start of the income year, the value of the item at that time: s 620-40(1)-(3). In the same way, disposals of revenue assets to the new company will be revenue neutral as the original body will be taken to have disposed of them for an amount that would result in the original body not making a profit or loss: s 620-50(1)-(2). In addition, the new company will be taken to have paid the same amount to acquire the asset that resulted in the original body not making a profit or loss, which will then use that amount as its cost to calculate any future profit or loss on a later disposal: s 620-50(3). [16 500] Changes to small business structures Subdivision 328-G provides roll-over relief for small business owners who restructure their business. The measures defer capital gains or losses that would arise from transferring business assets to another entity where there is no change in the ‘‘ultimate economic ownership’’ of the asset/s (as traced through to individuals). The measures apply to the transfer of assets occurring on or after 1 July 2016. The roll-over applies not only to the transfer of CGT assets, but also to depreciating assets, trading stock or revenue assets as part of the restructure of a small business. Note that the roll-over is in addition to the CGT roll-overs available where a sole trader or partner transfers assets to, or creates assets in, a company (see [16 020]–[16 060]). Key requirements for roll-over 1. The transfer of the asset(s) must be part of a ‘‘genuine’’ restructure of an ongoing business. This is a question of fact to be determined having regard to all the facts and circumstances. Law Companion Guideline LCG 2016/3 (plus Addendum) explains the Commissioner’s views on what is a ‘‘genuine restructure’’. It also states that the Tax Office’s attention may be attracted if the restructure is ‘‘contrived or unduly tax driven’’ or if, for example, it is considered to be ‘‘a divestment or preliminary step to facilitate the economic realisation of assets’’. 2. Both the transferor and the transferee must be a ‘‘small business entity’’ (SBE) during the income year in which the transfer occurs (see [25 020]). (Note that the proposed increase in the small business entity threshold from $2m to $10m (see [25 020]) will apply for the purposes of the Subdiv 328-G roll-over.) 3. The roll-over also applies to an asset used in a business carried on by an ‘‘affiliate’’ (see [25 050]) or a ‘‘connected entity’’ (see [25 060]) of an SBE – in which case the affiliate 652

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or connected entity must also be an SBE or, in the case of a partner being involved, the partnership must be an SBE and the transferred CGT asset must be an interest in an asset of the partnership. 4. The asset transferred must be an ‘‘active asset’’ (see [15 530]). But note the roll-over is not available for the transfer of shares or trust interests. 5. Either or both the transferor and transferee can be a discretionary trust, provided there is no material change in the ‘‘ultimate economic ownership’’ of the transferred asset. This requirement can be met in two ways: (a) if ‘‘on the facts’’ there is ‘‘no practical change’’ in the individuals who economically benefit from the assets before and after the roll-over; or (b) the rolled-over assets continue to be held for the benefit of the same family group in terms of a family trust election requirement in the ‘‘trust loss’’ rules in Sch 2F ITAA 1936 (see [23 800]). 6. The transferor and transferee must choose to apply the roll-over.

Consequences of roll-over The effect of the roll-over is that there are no CGT consequences for the transferor (or income tax consequences in the case of the transfer of depreciating assets, trading stock etc). This is achieved by the tax cost of the transferred asset being rolled over from the transferor entity to the transferee entity by way of: (a) the transferor being taken to have received an amount which would result in them making neither a gain nor a loss under the transfer; and (b) the transferee being taken to have acquired each asset for the amount that equals the transferor’s tax cost for the asset just before the transfer. Note also: (a) transferred pre-CGT assets retain their status as pre-CGT assets; (b) transferred post-CGT assets are deemed to have been acquired by the transferee at the time of the transfer – which means that the transferee has to hold the asset for 12 months to qualify for the CGT discount (see [14 390]); and (c) if the asset was transferred from a company to a shareholder, it is not subject to the deemed dividend provisions of Div 7A ITAA 1936 (see [21 250]). Where membership interests are issued in consideration for the transfer of assets, the cost base of those new membership interests is worked out based on the sum of the roll-over costs and adjustable values of the roll-over assets, less any liabilities that the transferee undertakes to discharge in respect of those assets, divided by the number of new membership interests. But note that where membership interests are issued in consideration for the transfer of a pre-CGT asset, the interests are not deemed to be pre-CGT interests. Note that as an integrity measure, a capital loss cannot arise on any subsequent disposal of either an issued or existing membership interest, unless it can be shown that the loss was not attributable to the restructure. Law Companion Guideline LCG 2016/2 explains the various consequences of applying the small business restructure roll-over.

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CGT – SPECIAL TOPICS INTRODUCTION

Overview ....................................................................................................................... [17 010]

SPECIAL TOPICS CAPITAL GAINS MADE BY A TRUST Character and classification of gains made by a trust ................................................. [17 Amount of net capital gain made by trust ................................................................... [17 Rules for specific types of trust .................................................................................... [17 Streaming capital gains ................................................................................................. [17 Gains assessed in the hands of beneficiaries ............................................................... [17 Taxation of beneficiary’s assessable capital gains under Subdiv 115-C ..................... [17 Option for resident trustee to be assessed on a capital gain ....................................... [17 Gains made by foreign residents and temporary residents .......................................... [17

020] 030] 040] 050] 060] 070] 080] 090]

DEATH Capital gain or loss at the time of death is disregarded .............................................. [17 100] Effect on the legal personal representative or beneficiary ........................................... [17 110] Asset bequeathed to tax advantaged entity .................................................................. [17 120] Special rules for joint tenants ....................................................................................... [17 130] LEASES CGT treatment ............................................................................................................... [17 Tenants’ fixtures ............................................................................................................ [17 Grant of a long-term lease ............................................................................................ [17 Acquisition by lessee of lessor’s reversionary interest ................................................ [17

150] 160] 170] 180]

OPTIONS Introduction ................................................................................................................... [17 General effect of grant of option .................................................................................. [17 Call options ................................................................................................................... [17 Put options ..................................................................................................................... [17

200] 210] 220] 230]

ASSETS CEASING TO BE PRE-CGT ASSETS When asset stops being a pre-CGT asset ..................................................................... [17 Change in majority underlying interests ...................................................................... [17 Deemed acquisition for market value .......................................................................... [17 Exceptions ..................................................................................................................... [17 Application to public entities ........................................................................................ [17 Superannuation funds .................................................................................................... [17

250] 260] 270] 280] 290] 300]

EASEMENTS Introduction ................................................................................................................... [17 310] Voluntary grant of an easement .................................................................................... [17 320] Compulsory acquisition of an easement ...................................................................... [17 330]

OTHER Look-through approach to earnout arrangements ........................................................ [17 335] Instalment warrants ....................................................................................................... [17 340] Mining: Farm-in Farm-out arrangements ..................................................................... [17 345]

COMPANIES AND UNIT TRUSTS SHARES, UNITS, RIGHTS, OPTIONS, CONVERTIBLE NOTES 654

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Overview of CGT implications for companies and shareholders ............................... [17 Bonus equities ............................................................................................................... [17 Return of capital on shares and units ........................................................................... [17 Rights and options to acquire shares and units ........................................................... [17 Demutualisation of insurance companies and other bodies ........................................ [17 Convertible interests issued by companies and unit trusts .......................................... [17 Unexercised options under convertible interests .......................................................... [17 Exchangeable interests .................................................................................................. [17 Employee share scheme interest ................................................................................... [17

350] 360] 370] 380] 390] 410] 420] 430] 440]

RECOUPMENT AND USE OF NET CAPITAL LOSSES Capital loss recoupment rules ....................................................................................... [17 Unrealised capital losses ............................................................................................... [17 Transfer of net capital losses ........................................................................................ [17 Consequential adjustments to cost bases of shares or loans ....................................... [17 Deferral of capital losses – linked group ..................................................................... [17 Artificially created capital losses – Pt IVA .................................................................. [17

500] 510] 520] 530] 540] 550]

COST BASE REDUCTIONS AFTER CHANGE IN OWNERSHIP OF A LOSS COMPANY Background .................................................................................................................... [17 600] Alteration time .............................................................................................................. [17 610] Calculation of losses ..................................................................................................... [17 620] Relevant debt and equity interests ................................................................................ [17 630] Calculation of the cost base adjustment ....................................................................... [17 640] VALUE SHIFTING Overview of value shifting ........................................................................................... [17 700] DIVISION 723 – RIGHTS OVER NON-DEPRECIATING ASSETS Overview – rights over non-depreciating assets .......................................................... [17 Associate ........................................................................................................................ [17 $50,000 exclusion ......................................................................................................... [17 Other exclusions from Div 723 .................................................................................... [17 Consequences if Div 723 applies ................................................................................. [17 Effect of a roll-over ...................................................................................................... [17

710] 720] 730] 740] 750] 760]

DIVISION 725 – DIRECT VALUE SHIFTING Conditions for direct value shifting to occur ............................................................... [17 What is a direct value shift? ......................................................................................... [17 Types of interests affected ............................................................................................ [17 Controlling entity test ................................................................................................... [17 Cause of direct value shift ............................................................................................ [17 $150,000 exclusion ....................................................................................................... [17 Reversing direct value shifts ........................................................................................ [17 Neutral direct value shifts ............................................................................................. [17 Consequences of direct value shifting .......................................................................... [17

800] 810] 820] 830] 840] 850] 860] 865] 870]

DIVISION 727 – INDIRECT VALUE SHIFTING Indirect value shifting ................................................................................................... [17 Conditions for indirect value shift ................................................................................ [17 Exclusions ...................................................................................................................... [17 Economic benefits ......................................................................................................... [17 Ultimate controller tests ................................................................................................ [17 Common ownership tests .............................................................................................. [17 Anti-overlap provisions ................................................................................................. [17 Consequences of indirect value shift ............................................................................ [17

900] 910] 920] 930] 940] 950] 960] 970]

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[17 010] Overview This chapter deals with a range of miscellaneous CGT topics for which special CGT provisions exist. The topics covered are: • the treatment of capital gains made by trusts: see [17 020]-[17 050]; • death: see [17 100]-[17 130]; • leases: see [17 150]-[17 180]; • options: see [17 200]-[17 230]; • assets ceasing to be pre-CGT assets: see [17 250]-[17 300]; and • easements: see [17 310]-[17 330]. Note that personal-use assets and collectables are dealt with at [12 180] and separate CGT assets at [12 190]. The chapter also examines the following topics that relate specifically to companies: • shares, units, rights, options, convertible notes: see [17 350]-[17 440]; • recoupment and use of net capital losses: see [17 500]-[17 550]; • cost base reductions for loss company: see [17 600]-[17 640]; and • value shifting: see [17 700]-[17 970].

SPECIAL TOPICS CAPITAL GAINS MADE BY A TRUST [17 020] Character and classification of gains made by a trust The character of a gain arising on the disposal of a trust asset – that is, the question of whether the gain is a capital gain or income – depends on the particular circumstances in which the gain is made: see Determination TD 2011/21. The discussion below relates to gains that are capital gains, applying the principles stated in TD 2011/21 and any other principles that are relevant to the characterisation of a gain as capital in nature: see [3 100]. If the trust deed classifies a capital gain as income, or a trustee acting in accordance with the terms of the trust classifies a capital gain as income, then that amount forms part of the “income of the trust estate”: FCT v Bamford (2010) 75 ATR 1. See also Draft Ruling TR 2012/D1, which sets out the Tax Office’s views on the meaning of the expression ‘‘income of the trust estate’’ and Determination TD 2012/22 (proportionate approach to the assessment of trust net income). They are considered further at [23 300] and [23 320] respectively. But note that Draft Ruling TR 2012/D1 was withdrawn from the ATO Public Rulings Program pending the outcome of the decision in Thomas v FCT [2015] FCA 968, which subsequently held that franking credits do not form part of the net ‘‘income of a trust estate’’: see [23 310]. [17 030] Amount of net capital gain made by trust In determining the amount of a capital gain that is included in the net income of a trust estate, the gain must first be reduced by any of the trust’s prior or current year capital losses (see [14 370]), then by the 50% CGT discount (if relevant: see [14 390]) and, finally, by the CGT small business 50% reduction (if applicable and/or chosen: see [15 570]). This accords with the method statement in s 102-5(1) for calculating a capital gain to be included in assessable income (see [14 360]). 656

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If a capital gain arising in a trust, net of a discount, is included in the assessable income of a beneficiary under Subdiv 115-C, the gross amount of the gain is included in determining the beneficiary’s overall capital gain, against which capital losses are applied and from which CGT discounts are subtracted: see [14 390].

Set-off of capital losses If the trust has a net capital loss for the year (see [14 370]), the capital loss is carried forward and taken into account in determining the trust’s net capital gain of the following income year. It cannot be allocated or distributed to beneficiaries. As noted above, the capital loss is deducted from capital gains of the trust before the CGT discounts are applied. In FCT v Clark (2011) 79 ATR 550, a majority of the Full Federal Court held that changes to a trust (primarily a change in the ownership of units of beneficial entitlement to the trust property and changes to the trust property itself) did not result in a break in continuity of the trust estate. As a result, capital losses incurred by the trustee before those changes occurred could be offset in calculating net capital gains arising after the changes occurred. [17 040] Rules for specific types of trust Managed investment trusts A managed investment trust (‘‘MIT’’) can elect that gains and losses on the happening of CGT events be dealt with under the CGT regime. However, the election is restricted to CGT events involving certain assets (primarily shares, units and real property). The requirements for an entity to qualify as an MIT are discussed at [50 110] and the CGT rules are explained at [23 680]. Note also the general exclusion of MITs from the capital gains streaming rules: see [17 050]. A new set of rules for certain MITs came into operation on 1 July 2016, although entities could choose to apply the rules from 1 July 2015: see [23 685]. Special disability trusts For the CGT exemptions and concessions applicable to Special Disability Trusts established under either the Veterans’ Entitlements Act 1986 or the Social Security Act 1991, including the main residence exemption, see [15 180] and [15 355]. [17 050] Streaming capital gains In the leading case of FCT v Bamford (2010) 75 ATR 1, the High Court confirmed that the proportionate approach is the correct method of determining the amount of the net income of a trust estate that is assessable in the hands of a beneficiary who is presently entitled to a share of the income of a trust estate. A consequence of the Bamford case was that a beneficiary could be assessed on a capital gain arising in a trust to which the beneficiary was not entitled under the terms of a trust. For example, if the income of a trust estate included a capital gain, and a particular beneficiary was presently entitled (in proportionate terms) to 30% of the net income, the beneficiary would be taxed on 30% of the entire net income of the trust estate, including 30% of any capital gain included in the calculation of that net income, even if under the terms of the trust a different beneficiary was entitled to 100% of the capital gain. In order to ensure that the taxation consequences of capital gains arising in trusts are aligned, as far as possible, with the way in which capital gains are in fact allocated to beneficiaries under the terms of particular trusts, specific flow-through rules have been enacted: see [17 060]. Similar rules apply to franked dividends arising in trusts: see [21 530]. It is proposed that these rules will be repealed if a new regime for taxing the income of trusts is introduced: see [23 770]. For the 2010-11 and subsequent income years, capital gains are assessed in the hands of beneficiaries or trustees under Subdiv 115-C (see below). For the rules and administrative practices that apply to earlier income years, see the Australian Tax Handbook 2011 and earlier editions. © 2017 THOMSON REUTERS

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Note that special rules apply to capital gains to which foreign resident and temporary resident beneficiaries are presently entitled: see [17 090].

Modification of Div 6 rules With effect from the 2010-11 income year, the rules in Div 6 were modified to exclude capital gains, franked dividends and franking credits from the calculation of the income of a trust estate and the net income of a trust estate and the share of the income of a trust estate to which a beneficiary is presently entitled, only for the purposes of determining whether a beneficiary or a trustee is assessed on a share of the net income of a trust estate: ss 102UWITAA 1936 to 102UY of ITAA 1936. From that time, capital gains made by a trust have been dealt with under Subdiv 115-C of ITAA 1997. For the treatment of franked dividends, see [21 530]. General scope of Subdiv 115-C Subdiv 115-C allows a capital gain (or part of a capital gain) made by a trust to be ‘‘streamed’’ to a beneficiary by making the beneficiary ‘‘specifically entitled’’ to the gain or part of the gain (including through a chain if trusts), provided this is allowed by the trust deed. If there is a capital gain or part of a capital gain to which no beneficiary is specifically entitled, and to which the trustee is not specifically entitled, that gain or part of a gain is taxable under Subdiv 115-C in the hands of beneficiaries who are presently entitled to the income of the trust estate, or, failing that, the trustee: see [17 060]. Note that where a trust has a capital gain and a revenue loss, the ‘‘attributable’’ capital gain to be distributed to the beneficiary must be ‘‘rateably reduced’’ to reflect the effect of that revenue loss (or any other assessable income): see Step 3, s 115-227. EXAMPLE [17 050.10] A trust makes a capital gain of $200,000. It is entitled to the CGT 50% discount. The trust has revenue losses of $40,000. Therefore the net income of the trust is $60,000 (ie $200,000 capital gain reduced to $100,000 by the CGT 50% discount and then reduced by $40,000 revenue losses). Assume there is one beneficiary of the trust who is presently entitled to the net income of trust. The ‘‘rateable reduction’’ of the taxable gain of the trust for the purposes of determining the amount ‘‘attributable’’ to the beneficiary is calculated as follows (Step 3, s 115-227): ‘‘net income of the trust (excluding franking credits) ÷ (net capital gain of the trust + ‘net’ franked distributions)’’ = $60,000 divided by $100,000 = 60% Therefore the ‘‘attributable’’ capital gain is 60% of $100,000 = $60,000.

See [17 070] for the taxation of ‘‘attributable’’ capital gains in a beneficiary’s hands. The application of the streaming measures in Subdiv 115-C to managed investment trusts is considered at [23 680].

[17 060] Gains assessed in the hands of beneficiaries A beneficiary is ‘‘specifically entitled’’ to a capital gain of a trust if, in accordance with the terms of a trust (including the appointment of a gain to the beneficiary by the trustee in accordance with the terms of the trust), the taxpayer has received or can reasonably be expected to receive an amount referable to the capital gain and that amount ‘‘is recorded, in its character as referable to a capital gain, in the accounts or records of the trust no later than 2 months after the end of the income year’’: s 115-228. Note also that ATO ID 2013/33 provides that a beneficiary can be ‘‘specifically entitled’’ to a capital gain made by a trust by reason of CGT event E5 happening (see [13 240]). 658

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[17 060]

The amount of the capital gain to which the beneficiary is specifically entitled is the amount of the capital gain accruing to the trust multiplied by the beneficiary’s proportionate share of the net financial benefit referable to the gain. The beneficiary’s share (say $X) of the net financial benefit referable to the capital gain is the amount referable to the gain that is received, or that can reasonably be expected to be received, by the beneficiary. The beneficiary’s proportionate share of the net financial benefit referable to the gain is that amount ($X) divided by the net financial benefit referable to the gain (say $Y). EXAMPLE [17 060.10] The VITW Trust sells Asset A for a gain of $4,000 and Asset B for a gain of $8,000. The trust also sells another asset for a capital loss of $2,000. (Assume that the amounts are the same for the purpose of determining the income of the trust estate under the general law applying to trusts and for the purpose of determining the net income of the trust under income tax law.) The trustee resolves to distribute $2,000 to Lisa, recorded as referable to the gain on Asset A after being reduced by the capital loss, and $8,000 to Jane, recorded as referable to the gain on Asset B. However, for tax purposes, the trustee applies the capital loss against the capital gain on Asset B. Therefore, the net financial benefit referable to the capital gain on Asset A is $4,000, and Lisa is only specifically entitled to half of the capital gain. The net financial benefit referable to the capital gain on Asset B is $8,000 (because the trustee did not apply any trust losses against the trust gain) and Jane is specifically entitled to all of the capital gain. [This example is adapted from an example in the Explanatory Memorandum to the Tax Laws Amendment (2011 Measures No 5) Bill 2011.]

The net financial benefit referable to the capital gain is the amount of the gain reduced by losses allocated to the gain in accordance with the terms of the trust, to the extent that such allocation is consistent with the required set-off of capital losses against capital gains in the method statement in s 102-5(1). A ‘‘financial benefit’’ is anything of economic value, including cash, property, services, the forgiveness of a debt obligation of the trust or any other accretion of value to the trust (eg a revaluation of trust assets): s 974-160. In Determination TD 2012/11, the Commissioner states that it is not necessary that the gain itself be reasonably certain, merely that if a gain arises it is reasonably certain that a share of the gain will be received by the beneficiary. For example, if a trustee enters into a contract before the end of the income year for the disposal of an asset, a beneficiary may be reasonably certain to receive an amount referable to the gain, should it arise, even if the completion of the contract is not itself reasonably certain. If the net income of a trust, including a capital gain, is less than the amount of the capital gain, an abatement calculation is required to reduce the net capital gain (under s 115-225) and the beneficiary’s accompanying share of that net financial benefit. The meaning of ‘‘receive or reasonably expect to receive’’ the ‘‘net financial benefit’’ referable to the gain does not require an ‘‘equitable tracing’’ to the trust proceeds that represent the gain. It is sufficient if the beneficiary receives, or can be expected to receive, an amount equivalent to their share of the ‘‘net financial benefit’’ (eg ‘‘half the trust gain realised on the sale of an asset’’). Note that a beneficiary cannot be specifically entitled to a ‘‘notional’’ capital gain that arises from the imposition of, for example, the market value substitution rule (see [14 260]): s 115-228(3). In such a case, the amount of specific entitlement is limited to what the (tax) capital gain would have been if the market value substitution rules did not apply. Similarly, a beneficiary cannot be specifically entitled to a ‘‘notional’’ capital gain that arises under CGT event I2 on the trust becoming a foreign resident (see [18 180]) or where the ‘‘net financial benefit’’ is zero or negative. © 2017 THOMSON REUTERS

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Subdivision 115-C ensures that gains are assessed to those beneficiaries that are made “specifically entitled” to them, regardless of whether the amounts are part of the income or capital of the trust estate. As a result, beneficiaries no longer need to have an amount of assessable income included under s 97, 98A or 100 ITAA 1936 to be treated as having a capital gain under s 115-215. This ensures that a ‘‘capital beneficiary’’ who is specifically entitled to an amount representing a capital gain of a trust is treated as having a capital gain in relation to that amount, even if the beneficiary is not presently entitled to a share of the trust income: s 115-215(3).

No streaming of tax free discount component of gain Because the beneficiary’s entitlement must be to a ‘‘net financial benefit’’, it is not possible to stream the ‘‘taxable component’’ to one beneficiary and the tax-free ‘‘discount component’’ to another. A beneficiary who is only entitled to the ‘‘taxable component’’ will generally only be specifically entitled to half of the capital gain. For example, if a beneficiary is only entitled to $500 out of a gross capital gain of $1,000 (ie the discount component), only 50% of the discounted capital gain (ie $250) can be streamed to the beneficiary. In order to distribute the whole of the taxable amount of $500 to a beneficiary, the trustee would be required to distribute the non-discount component of the capital gain as well, ie make the beneficiary entitled to the whole gain of $1,000. Gains to which no beneficiary ‘‘specifically entitled’’ Capital gains to which no beneficiary is ‘‘specifically entitled’’ will be assessed to other beneficiaries (or the trustee on their behalf) on a ‘‘proportionate’’ basis, based on the ‘‘adjusted Div 6 percentage’’. The ‘‘adjusted Div 6 percentage’’ is calculated as: (a) the beneficiary’s present entitlement to trust income excluding any capital gains (or franked dividends) to which they are specifically entitled divided by (b) the income of the trust excluding any capital gains or franked distributions to which any entity is specifically entitled: s 95(1) ITAA 1936. If the sum of beneficiaries’ adjusted Div 6 percentage is less than 100%, the difference is the trustee’s adjusted Div 6 percentage. If the income of the trust is nil, the trustee has an adjusted Div 6 percentage of 100%: s 95(1) ITAA 1936. EXAMPLE [17 060.20] The Barton Trust receives $100,000 of rental income and $70,000 of fully franked distributions. The trust has no expenses. Its income is therefore $170,000 and its taxable income is $200,000 (including the $30,000 franking credit attached to the distribution). The trust has 2 beneficiaries, Ian and Kim. The trustee of the Barton Trust, in accordance with a power under the deed, makes Ian presently and specifically entitled to $50,000 of the franked distributions and additionally entitled to so much of the remainder of the trust’s income as to make his total present entitlement equal to 50% of the income of the trust. Kim is presently entitled to 50% of the income of the trust. Ian’s Div 6 percentage is 50% as he is entitled to half of the income of the trust estate. Kim’s Div 6 percentage is likewise 50%. However, Ian’s adjusted Div 6 percentage is 29% ($85,000 – $50,000)/ ($170,000 – $50,000), being his entitlement to income (disregarding his specific entitlement to $50,000 of the distribution) divided by the adjusted income of the trust of $120,000 (disregarding the $50,000 of the income to which Ian is specifically entitled). Kim’s adjusted Div 6 percentage is 71% ($85,000/$120,000). [This example is adapted from an example in the Explanatory Memorandum to the Tax Laws Amendment (2011 Measures No 5) Bill 2011.]

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[17 070] Taxation of beneficiary’s assessable capital gains under Subdiv 115-C The tax consequences for a beneficiary to whom a trust capital gain is specifically allocated under Subdiv 115-C, or who is otherwise taken to have a trust capital gain under Div 115-C, may be summarised as follows (see ss 115-215 and 115-225): • If no discount was applied in calculating the capital gain of the trust, Div 102 (see [14 360]) applies to the beneficiary as if the beneficiary had a capital gain (an ‘‘attributable capital gain’’: see s 115-225) equal to the proportion of the capital gain included in the trust’s net income to which the beneficiary is specifically entitled, or in respect of which the beneficiary has a proportional entitlement, under Subdiv 115-C. • If the trust was entitled to either the 50% CGT discount or the small business 50% reduction, the amount that is treated as a capital gain of the beneficiary for the purpose of applying the method statement in Div 102 is doubled and, in the case that both the discount and the 50% reduction apply, the amount is quadrupled. • The beneficiary then adds capital gains accruing from other sources and then deducts its own capital losses (prior and current year) from total capital gains. • The beneficiary then applies the 50% discount and/or the 50% reduction to which the trust was entitled in calculating the net capital gain to be included in its assessable income. In FCT v Greenhatch (2012) 88 ATR 560, the Full Federal Court held that a beneficiary’s taxable income only included the 50% discounted component of a capital gain attributed to the taxpayer under Subdiv 115-C (see also ATO Decision Impact Statement on matter). This meant that more than 10% of the taxpayer’s income for the year comprised salary and wage income, and as a result no deduction was available for the taxpayer’s contribution to a superannuation fund. Note that Draft Determination TD 2016/D5 states that where an amount included in a resident beneficiary’s assessable income under s 99B(1) ITAA 1936 has its origins in a capital gain from property of a foreign trust that is not ‘‘taxable Australian property’’ (see [18 100]), the beneficiary cannot use current or prior year capital losses, or the CGT discount, in relation to the amount.

[17 080] Option for resident trustee to be assessed on a capital gain If permitted by the trust deed, a trustee of a resident trust can choose to be assessed on a gain to which no beneficiary is specifically entitled: s 115-230. In particular, it allows the trustee of a trust to pay tax on behalf of: (a) an income beneficiary who cannot benefit from the gain; or (b) a capital beneficiary who is unable to immediately benefit from the gain. Otherwise, the only way a trustee will be assessed on a gain is if: (a) no beneficiary is specifically entitled to the gain; and (b) there is a share of the net income of the trust to which no beneficiary is presently entitled (after disregarding capital gains and net franked distributions to which a beneficiary is specifically entitled) – or there is no trust income. In that case, s 115-222 specifically adds an amount to the amount assessed in the hands of the trustee under ss 99 or 99A.

[17 090] Gains made by foreign residents and temporary residents Capital gains made by a foreign resident beneficiary through a fixed trust on the disposal of assets that are not taxable Australian property are disregarded in applying the CGT rules to the beneficiary and also for the purposes of assessing the trustee: see [18 110]. In addition, because of the operation of s 855-40(3), the trustee of the fixed trust would not be liable to pay tax on the taxable income relating to the gain by way of s 115-220. © 2017 THOMSON REUTERS

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Foreign resident beneficiary – companies and trustees Where the trustee is assessed under s 98(3) on a portion of the net income of the trust estate because a foreign resident company is presently entitled to that income, the effect of any CGT discount under s 102-5(1) is reversed in calculating the amount of trust net income on which the trustee is assessed: s 115-220. The same applies where the foreign resident beneficiary is presently entitled to a share of the net income of the trust in the capacity of the trustee of another trust: s 115-222.

DEATH [17 100] Capital gain or loss at the time of death is disregarded Any gain or loss resulting from a CGT event in relation to an asset owned by the deceased person at the time of their death is disregarded: s 128-10. However, note that CGT event K3 will apply if the CGT asset passes to a beneficiary which is a ‘‘tax advantaged entity’’ (see [13 660]). [17 110] Effect on the legal personal representative or beneficiary If an asset that formed part of the estate of a deceased person passes to the legal personal representative (LPR) and then subsequently passes to a beneficiary in that estate, the asset is not considered to be subject to a CGT event on these transfers. In this way Div 128 operates as a form of CGT ‘‘roll-over’’. However, if the asset is subsequently subject to a CGT event in the hands of the beneficiary, or is disposed of by the LPR to someone other than a beneficiary of the estate (eg under a power of sale by the LPR) there will be CGT consequences for the beneficiary and LPR, respectively. Note this Div 128 ‘‘roll-over’’ also applies where an asset passes through a testamentary trust created under the deceased’s will: see Practice Statement PS LA 2003/12. Note also that the Commissioner takes the view (in Private Ruling Authorisation No 1012846046513) that CGT events A1, E1 or E2 do not happen to the variation of a ‘‘trust deed’’ (ie the will) that creates a testamentary trust. It should also be noted that the trustee of a testamentary trust can choose to be assessed on a capital gain included in the net income of the trust where a presently entitled beneficiary would otherwise be assessed in respect of the gain but would not benefit from the gain: see [12 360]. Death before 20 September 1985 In the case of a person who died before 20 September 1985, any asset that formed part of the estate that passed to the LPR or to a beneficiary in the estate is taken to have been acquired by the LPR or beneficiary at the date of the person’s death (ie before 20 September 1985), notwithstanding that it may have been transmitted to the LPR or beneficiary at any time after 20 September 1985: s 128-15(2). Death after 19 September 1985 Where an asset formed part of the estate of a deceased person who died on or after 20 September 1985, and it has ‘‘passed’’ to the LPR or to the beneficiary, the CGT consequences will depend upon whether the asset was originally acquired by the deceased before or after 20 September 1985: s 128-15(4). For the meaning of an asset ‘‘passing’’ to an LPR or beneficiary, see below. Assets acquired pre-CGT by deceased If the asset was acquired by the deceased before 20 September 1985 (where the deceased died on or after that date), the asset is taken to have been acquired by the LPR or beneficiary for a cost base equal to the market value of the asset at the date of the person’s death: 662

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[17 110]

s 128-15(2), (4) item 4. This includes a post-CGT dwelling built on pre-CGT land as such assets are not considered ‘‘separate assets’’ (see [12 190]) in the hands of an LPR or beneficiary: Determination TD 96/18. The concept of ‘‘market value’’ is discussed at [3 210].

Assets acquired post-CGT by deceased If the asset was acquired by the deceased on or after 20 September 1985, the asset is taken to have been acquired by the LPR or beneficiary for a cost base equal to the asset’s cost base or reduced cost base (as relevant) at the date of death: s 128-15(2), (4) item 1. Dwelling that was deceased main residence at death Where a dwelling that was the deceased’s main residence just before their death and was not at that time being used to produce assessable income, it will be taken to have been acquired by the LPR or beneficiary at the date of the deceased’s death for its market value at that date: s 128-15(2), (4) item 3. See also [15 170]. Foreign residents If the deceased was a foreign resident just before their death and an asset which passes to the LPR or a beneficiary was not ‘‘taxable Australian property’’ (see [18 100]) nor trading stock, the LPR or beneficiary will be taken to have acquired the asset for its market value on the date of death: s 128-15(2), (4), Item 3A. See also Determination TD 2000/6. Trading stock An asset that was trading stock of the deceased will, in the hands of the LPR or beneficiary, have a cost base equal to the amount worked out under s 70-105 ITAA 1997 (ie its market value on the date of death): s 128-15(2), (4), Item 2. Personal-use assets and collectables Where an asset was a personal-use asset or a collectable (see [12 180]) of the deceased it is taken to be a personal-use asset or collectable in the hands of the beneficiary (and LPR): s 128-15(6). This means that the rules that apply to personal use assets and collectables will apply to the disposal of such assets by the beneficiary (and LPR). CGT discount and small business concessions In terms of satisfying the 12-month ownership period for the purposes of the CGT discount (see [14 400]), s 115-30 (items 3-6) provides that an asset is considered to have been acquired by the LPR or beneficiary at: (i) the time the deceased acquired it – in the case of a post-CGT of the deceased; or (ii) at the deceased’s date of death – in the case of a pre-CGT of the deceased. Note that an LPR, a beneficiary or a surviving joint tenant may access the CGT small business concessions in relation to the disposal of an asset of the deceased in appropriate circumstance: see [15 500].

Asset ‘‘passing’’ to LPR or beneficiary A reference to an asset that formed part of the estate of a deceased person passing to the LPR is a reference to such an asset coming into the ownership of the person as the executor of the will or as the administrator of the estate of the deceased person (or as a trustee of a testamentary trust: see Practice Statement PS LA 2003/12). Section 128-20 provides that a CGT asset passes to a beneficiary of a deceased estate if the beneficiary becomes the owner of the asset as a result of any of the following: (a) under a will or a will varied by a court order; or (b) by operation of an intestacy law or such a law as varied by a court order; or © 2017 THOMSON REUTERS

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(c) because it is appropriated to the beneficiary by the LPR of the deceased in satisfaction of a pecuniary legacy or some other interest or share in the estate; or (d) under a deed of arrangement if: (i) the beneficiary entered into the deed to settle a claim to participate in the distribution of the estate; and (ii) any consideration given by the beneficiary for the asset consisted only of the variation or waiver of a claim to one or more other CGT assets that formed part of the estate. It does not matter whether the asset is transmitted directly to the beneficiary or is transferred to the beneficiary by the LPR. Determination TD 2004/3 states that an asset also passes to a beneficiary of a deceased estate on the beneficiary becoming absolutely entitled to the asset – regardless of when it is actually transferred. However, a CGT asset does not ‘‘pass’’ to a beneficiary of a deceased estate if the beneficiary becomes the owner of the asset because the LPR transfers it under a power of sale (see ATO ID 2006/34). But note that Ruling TR 2006/14 (at paras 33-37) indicates that a life tenant and remainderman dissatisfied with the terms of a will can enter into a deed of arrangement to effect a redistribution of estate assets that will qualify as the ‘‘passing of an asset’’ to a beneficiary for the purposes of the rules in Div 128, provided it is done before administration of the estate is finalised, thereby perhaps giving some ‘‘licence’’ to legitimately re-distribute estate assets.

Life and remainder interest created under a will The Tax Office views on the treatment of life and remainder interests arising from a deceased estate (and also inter vivos trusts) are set out Ruling TR 2006/14. The ruling deals with the CGT consequences of a range of transactions involving such interests, including their creation, disposal and disclaimer. The Tax Office takes the view that such interests are ‘‘created’’ interests and are not ‘‘carved out’’ of the original assets of the estate – with the result that a CGT event will apply to any dealings with them. For example, if a testamentary trust is created under a will, CGT event E1 happens when the administration of the deceased’s estate is completed, but any capital gain or loss will be disregarded by virtue of s 128-10. See the ruling for full details. In addition, a remainderman who is absolutely entitled to an asset of the deceased is considered to have acquired the asset (a) at the date of death of the deceased (despite the intervening life interest) and (b) for a cost base as determined by the relevant rules discussed above, but as adjusted if necessary for the effect of the life interest: Ruling TR 2006/14 (para 126) and (withdrawn) Determination TD 93/37 (para 2). [17 120] Asset bequeathed to tax advantaged entity See CGT event K3 (at [13 660]) for the consequences where an asset that formed part of the deceased’s estate has passed to a beneficiary who is a tax advantaged entity, ie a tax-exempt entity, a foreign resident or a complying superannuation entity. Note that the first element of the cost base of an asset bequeathed to a Special Disability Trust its market value on the day the deceased died: s 128-15(4), item 3B. See also [15 355]. [17 130] Special rules for joint tenants If a CGT asset is owned by joint tenants and one of them dies, the survivor is taken to have acquired (on the day the individual died) the deceased’s interest in the asset: s 128-50. If the deceased joint-owner originally acquired their interest after 20 September 1985, the cost base for the survivor will be equal to the cost base of the interest in the hands of the deceased immediately before their death. If the asset was acquired by the deceased before 20 September 1985, the survivor will be taken to have acquired the interest for its market value at the date of death. If there is more than one surviving joint tenant, the cost bases are apportioned accordingly. 664

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[17 160]

LEASES [17 150] CGT treatment The CGT consequences of the grant, extension, renewal or change of a lease are covered by the CGT ‘‘F’’ events (see [13 300]-[13 340]). Other CGT matters relating to leases are contained in Div 132 ITAA 1997, discussed at [17 160]-[17 180]. In addition, the Commissioner’s views on the treatment of ‘‘tenants’ fixtures’’ are explained below at [17 160]. [17 160] Tenants’ fixtures The effect of the CGT provisions upon tenants’ fixtures is the subject of a number of determinations: see CGT Determinations TD 46, TD 47 and TD 48 (in the context of the corresponding ITAA 1936 provisions) and Determination TD 98/23 (in relation to the ITAA 1997 provisions). Under real property law, in the absence of any specific provisions to the contrary, improvements affixed to land by a lessee become the property of the lessor or landowner. In these circumstances, pursuant to CGT Determination TD 48, the Commissioner will consider the lessee to have disposed of assets so affixed and the landowner to have acquired the asset at the time when they were affixed to the land. Where capital proceeds are paid for the disposal of the asset, that amount will be taken to be the proceeds on disposal by the lessee and the price paid for acquisition by the lessor. Where no capital proceeds are paid, the provisions of ss 116-30 and 112-20 may apply to deem the market value (see [3 210]) of the asset to have been paid and given (respectively) where the parties were not dealing with each other at arm’s length (see [5 260]). CGT Determination TD 48 also confirms that in these circumstances there would be no scope for the operation of s 104-25 (CGT event C2), which only has application to a disposal by a lessee at the time of expiry, forfeiture or surrender of a lease. When the lessor pays the lessee on expiry, forfeiture or surrender for capital improvements effected by the lessee to the leased property, the following consequences arise: • the payment to the lessee is treated as capital proceeds for the CGT event and gives rise to a CGT liability to the lessee or goes to reduce the capital loss that would otherwise arise: ss 104-25 and 116-75; and • the lessor’s cost base is increased: s 132-5. However, this section seems to be limited in its application to those circumstances discussed in CGT Determinations TD 46 and TD 47. According to CGT Determination TD 46, a lessee will be considered to remain the owner of fixtures attached to land where the law of the relevant State or Territory provides for ownership to remain with the lessee or where the lessee is regarded as being the owner of the assets within the terms of Ruling IT 175. There is thus no CGT event at the time the asset is affixed to the land in these circumstances. Upon the expiry, forfeiture or surrender of the lease, a disposal of the asset by the lessee and its acquisition by the lessor will occur. The date of disposal and acquisition is considered in CGT Determination TD 47 to take place at the time of change in ownership. This may be at the end of the lease itself or at some later time if the tenant fails to remove the asset in accordance with the provisions of the lease. The provisions of s 116-75 apply to any amount paid by the lessor to the lessee for such a disposal. Where no amount is paid, ss 116-30 and 112-20 may deem market value to be received and paid where the lessor and lessee are not dealing with each other at arm’s length. It should also be noted that if the lease was for a residential property, the assets affixed may be personal-use assets (see [12 180]) and, as such, Subdivs 108-C and 118-A should be considered if the cost base of the asset is more than $10,000. © 2017 THOMSON REUTERS

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[17 170] Grant of a long-term lease Section 132-10 applies where CGT event F2 happens for a lessor of land: see [13 310]. It provides that for any later CGT event that happens to the land or the lessor’s lease of it (eg a disposal of the land), the cost base and reduced cost base (including the cost base and reduced cost base of any building, part of a building, structure or improvement that is treated as a separate CGT asset under Subdiv 108-D) excludes: • any expenditure incurred before CGT event F2 happened – this is because the cost base immediately before that event (primarily the cost of acquisition) is subtracted from the capital proceeds from the grant of the long-term lease to determine whether there is a capital gain or loss under CGT event F2 (otherwise the acquisition cost would be counted twice); and • the cost of any depreciating assets for which the lessor has claimed or could have claimed depreciation. In addition, the fourth element of the cost base and reduced cost base (capital expenditure to increase the asset’s value: see [14 060]) includes any payment by the lessor to the lessee to vary or waive a term of the lease or for the surrender of the lease (reduced by any GST input tax credit to which the lessor is entitled): s 132-10(3). The expenditure or payment can include giving property, as provided by s 103-5: s 132-10(4). Note that CGT event F2 only applies in respect of a lease or sublease granted for more than 50 years on terms that are substantially the same as those applying to the owner of the underlying freehold or leasehold interest. Moreover, the provision only applies if, at the time the lease or sublease is granted, it is reasonable to expect that it will continue for at least 50 years: see ATO ID 2003/906. In measuring the 50-year period, the original term of the lease is not aggregated with the period of any renewal of the lease: ATO ID 2007/175. The choice means that where a taxpayer’s interest in land was acquired before 20 September 1985, the grant of the lease or sublease will remain outside the CGT provisions.

[17 180] Acquisition by lessee of lessor’s reversionary interest Where a lessee acquires the lessor’s reversionary interest in land, in circumstances other than those dealt with in Subdiv 124-J (Crown leases: see [16 200]), the lessee will be taken to have acquired the land at the time of the acquisition unless the lease had been granted for a term not less than 99 years. In the latter case the acquisition date for the property will be considered to be the date of acquisition of the lease. The cost of the combined interests in the land will generally be treated as the sum of the premium paid for the lease and the amount paid for the reversionary interest. However, in the case of a lease for a term less than 99 years that was acquired by the lessee before 20 September 1985, the lessee’s cost of the merged asset will be the market value of the property (see [3 210]) at the time of the acquisition of the reversion: s 132-15.

OPTIONS [17 200] Introduction Options are treated as separate assets with separate CGT implications unless the option is exercised, in which case the option transaction is ‘‘merged’’ with the underlying transaction that results in the acquisition or disposal of the asset that is the subject of the option. [17 210] General effect of grant of option Except in the case of options granted by a company over its own shares or debentures or by the trustee of a unit trust over its own units or debentures (see [17 380]), the grant, renewal or extension of an option is taken to constitute CGT event D2 at the time the grant took effect: s 104-40. As a result, the ‘‘grantor’’ of the option will make a capital gain or loss under 666

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the rules that apply to CGT event D2: see [13 160]. Note that the capital gain arising under CGT event D2 is not eligible for the CGT discount. This provision applies even where the grantor does not own the asset that is the subject of the option. The provision also applies where the grantor is bound to acquire an asset (ie a put option) which, because the option expires, the grantor never actually acquires. These rules are subject to the exception that disregards any capital gain or loss from the grant, renewal or extension of an option where the option is subsequently exercised: s 104-40(5). For further discussion in relation to call options and put options, see [17 220] and [17 230] respectively. The treatment of forfeited deposits is discussed at [13 450]. In relation to options exercised on or after 27 May 2005, the option provisions and the related capital proceeds provisions will apply to: • options for the creating, granting or issuing of assets in the same way as they apply to options for the disposal of assets and to options for the issuing of shares; and • the renewing or extending of options in the same way as they apply to the granting of options. In addition, s 134-1, which applies to options granted before 20 September 1985 binding the grantor to dispose of a CGT asset, will apply to options to create, grant or issue an asset but will not apply to options last renewed or extended on or after 20 September 1985. Section 134-1 is considered at [17 220] and [17 230]. Examples of options to which these provisions will apply are options for granting a lease or easement or for issuing units in a unit trust. For example, where a grantee exercises an option that binds the grantor to grant it a lease, they will allow for the inclusion in the CGT cost base of the lease the amount paid for the option plus any amount paid to exercise it.

[17 220] Call options Grantor’s position The grantor of a call option will be subject to CGT event D2 (see [13 160]) and therefore will be considered to have disposed of an asset (ie the call option) for the capital proceeds received for it. The grantor will make a capital gain (or loss) of the difference between these capital proceeds and the cost of granting the option (ie legal costs, etc) at the time the option is granted. However, if the option is exercised by the grantee this capital gain (or loss) is disregarded (s 104-40(5)) and the option transaction is ‘‘merged’’ with the underlying transaction. As a result, the grantor is considered to have disposed of the CGT asset that is the subject of the option (in terms of CGT event A1: see [13 050]) for an amount comprising the exercise price plus the amount received for granting the option in the first place: s 116-65. Note for the purposes of disregarding/ignoring the capital gain or loss that otherwise arises on the exercise of the option, the Commissioner has an unlimited time to amend the relevant assessment to remove the capital gain (or loss) that arose on granting the option: item 50, s 170(10AA) ITAA 1936. This disposal by the grantor happens at the time the contract for disposal was entered into under CGT event A1: s 104-10(3). For the purposes of the grantor qualifying for the CGT discount on the disposal of the asset subject to the option, the Commissioner takes the view that if the option agreement was entered into within 12 months of the grantor acquiring the asset, and the asset is disposed of as a result of the exercise of that option, then the 12-month qualifying period for the CGT discount will not be satisfied: s 115-40. However, the Commissioner’s views on this issue may not be sustainable given that the acquisition of the asset occurs under the agreement which is made when the option is exercised, not when it is granted. Aspects of the reasoning in Re VAN and FCT (2002) 51 ATR 1153 also cast some doubt on the Commissioner’s interpretation of s 115-40. See also [14 400]. © 2017 THOMSON REUTERS

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Grantee’s position From the grantee’s position (ie the person to whom the call option is granted), they have acquired an asset (ie the call option) for the consideration paid for it: s 109-5, s 110. If the option expires or is not exercised, the grantee makes a capital gain or loss under CGT event C2 (see [13 080]) equal to the difference between its cost base (ie the amount paid for the option plus legal costs) and the amount received on its expiry or termination: s 104-25(3). However, if the option is exercised by the grantee, the transaction is ‘‘merged’’, ie the grantee is considered to have acquired the CGT asset that is the subject of the option for the amount paid for the option plus the exercise price (and legal fees, etc). The asset acquired will have a cost base equal to this amount: s 134-1(1), item 1. Note that no capital gain or loss arises from the exercise of the option: s 134-1(4). Importantly, the Tax Office takes the view that, in terms of CGT event A1, the CGT asset acquired by the grantee on the exercise of the option is acquired at the time ‘‘the contract for disposal’’ is entered into. See also Re VAN and FCT (2002) 51 ATR 1153. However, in light of the High Court’s decision in Laybutt v Amoco Australia Pty Ltd (1974) 132 CLR 57, which held that an option agreement is a ‘‘conditional contract’’, it may be possible to argue that the CGT asset is acquired by the grantee at the time the option agreement is entered into (being ‘‘the contract for disposal’’ under CGT event A1). This may be relevant for the purposes of owning the asset for 12 months for CGT discount purposes: see [14 400]. [17 230] Put options Grantor’s position The grantor of a put option makes a capital gain or loss under CGT event D2 (see [13 160]) for the amount the grantee paid for the put option, less the cost to the grantor of granting the option (ie legal fees, etc): s 104-40. However, if the put option is exercised by the grantee (thereby forcing the grantor to acquire from the grantee the asset that is the subject of the option) the grantor is taken to have acquired the asset at the time the option is exercised for the exercise price, less any amount the grantor received for granting the option. That is, the cost base of the CGT asset in the grantor’s hands is reduced by the amount received for granting the option: s 134-1(1), item 2. Note that the market value substitution rule in s 112-20(1) (see [14 160]) does not apply where the exercise price paid by the grantor is more than the asset’s market value at the time of the exercise: see ATO ID 2009/68. Grantee’s position The grantee of a put option acquires an asset for a cost base of the amount paid for it plus legal fees. If the option expires or is not exercised, the grantee prima facie makes a capital loss under CGT event C2 equal to the cost base amount: s 104-25(3). Note that market value capital proceeds (see [14 260]) would not be imposed. If the option is sold, the grantee will make a capital gain or loss under CGT event A1 (disposal) by reference to the difference between its cost base and the capital proceeds received on its sale. Note that, in this case, market value capital proceeds can be imposed where appropriate. However, if the grantee exercises the option (and thereby forces the grantor to acquire from the grantee the asset that is the subject of the option), the grantee will be taken to have disposed of the asset at the time the option is exercised and its cost base in the grantee’s hands will be its original cost base plus the amount the grantee paid for the option: s 134-1(1), item 2. The capital proceeds for disposing of the asset (via CGT event A1) will be the amount received from the grantor: s 116-20. Note that no capital gain or loss arises from the exercise of the option: s 134-1(4). If a company issues ‘‘tradeable’’ put options to a shareholder, and the market value of the options is included in the shareholder’s assessable income in accordance with the High Court decision in FCT v McNeil (2007) 64 ATR 431 (as opposed to being exempt under s 59-40: see 668

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[3 050]), s 112-37 provides that the cost base of the tradeable put option is the sum of: (a) the amount included in the taxpayer’s assessable income as ordinary income as a result of acquiring it; and (b) the amount, if any, paid by the taxpayer to acquire the right.

ASSETS CEASING TO BE PRE-CGT ASSETS [17 250] When asset stops being a pre-CGT asset An asset acquired before 20 September 1985 may be deemed by Div 149 to have been acquired after that date where there is a change in the ‘‘majority underlying interests’’ in the asset on or after 20 September 1985 (see [17 270]). Typically, this will occur where the majority shareholding in a private company which owns a pre-CGT asset changes after 20 September 1985. The effect of Div 149 is that the asset will cease to be a pre-CGT asset at the earliest time that the change in ‘‘majority underlying interests’’ occurs. Further, the asset will be considered to have been acquired for its market value at that time: see [17 220]. However, if a CGT asset is treated as having been acquired post-CGT because of the operation of Div 149, the asset continues to be treated as having been acquired pre-CGT for the purposes of CGT event K6 (see [13 690]): Ruling TR 2004/18. Division 149 applies both to private and public entities, although special rules apply to public entities: see [17 290]. However, Div 149 has no direct application to partnerships as partners directly own the assets of the partnership: see Ruling IT 2540. Note that under the consolidation regime, CGT event L1 will be relevant where Div 149 previously applied to membership interests held by a subsidiary member of a group or where the interest was acquired from a ‘‘controlled entity’’: see also [13 810] and [24 440]. [17 260] Change in ‘‘majority underlying interests’’ Division 149 will apply where there is a change in ‘‘majority underling interests’’ in a pre-CGT asset owned by a company or trust. Specifically, s 149-30 provides that ‘‘an asset stops being a pre-CGT asset at the earliest time when majority underlying interests in the asset were not held by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985’’. That is, the section requires ultimate owners who held ‘‘majority underlying interests’’ in a pre-CGT asset before 20 September 1985 to retain ‘‘majority underlying interests’’ after that date, otherwise Div 149 will be triggered to convert the asset into a post-CGT asset: see [17 270]. The Commissioner has the discretion in certain circumstances to treat majority underlying interests as having been held at all times by the same ultimate owners who held such interests immediately before 20 September 1985 if reasonable to do so (see, for example, ATO ID 2011/101 and ATO ID 2011/107): s 149-30(2). For these purposes, the term ‘‘majority underlying interests’’ is defined to mean more than 50% of the beneficial interests held by ‘‘ultimate owners’’ (whether directly or indirectly through interposed companies, partnerships or trusts) in both the pre-CGT asset and in any income that may be derived from the asset: s 149-15(1), (4)-(5). Moreover, the underlying interest traces ownership back to natural persons who are the ‘‘ultimate owners’’. See also ATO ID 2010/228. For these purposes, ‘‘ultimate owner’’ means (a) an individual, (b) a company whose constitution prevents it from making a distribution to its members (see also ATO ID 2006/172 and ATO ID 2010/98), (c) the Commonwealth, State or Territory, (d) a municipal corporation, (e) a local governing body or (d) the government of a foreign country: s 149-15(3). Note that an individual may have a beneficial interest in the assets of a superannuation fund of which the individual is a member: see ATO ID 2006/219. Importantly, a change in the proportions in which majority underlying interests are held in a pre-CGT asset will not trigger Div 149: see Ruling IT 2530. © 2017 THOMSON REUTERS

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EXAMPLE [17 260.10] Immediately before 20 September 1985 the shares in X company were owned by: Virginia – 40% Themis – 9% Fiona – 37% Andrew – 14% Following a change in shareholding in 2017, the shares are now owned by: Virginia – 25% Andrew – 14% ABC Pty Ltd – 21% (ABC is 100% owned by Themis) Azra – 40% As the individuals who owned more than a 50% interest in the company before 20 September 1985 (ie Virginia, Themis and Andrew with 63% of the shares) now hold a majority of 60% of the shares after the change in shareholding, Div 149 will not be triggered.

Application to family trusts The Commissioner takes the view that where a trustee of a family trust continues to administer the trust for the benefit of members of a particular family, Div 149 will not apply merely because different distributions to family members who are beneficiaries are made in such amounts, and to such of those beneficiaries, as the trustee determines in accordance with the exercise of the trustee’s discretion: Ruling IT 2340. In this case, the Commissioner would find it reasonable to assume that for all practical purposes the majority underlying interests in the trust assets have not changed. However, the Commissioner takes the view that if by the exercise of a trustee’s discretionary powers to appoint new beneficiaries, or by amendment of the trust deed, there is in practical effect a change in the ‘‘majority underlying interests’’ in the trust assets, Div 149 will apply. Note there are a number of problems with the Commissioner’s approach in Ruling IT 2340, including that it assumes that a beneficiary of a family trust has a beneficial interest in the trust’s assets (see also AAT Case 7529 (1991) 22 ATR 3532 and ATO ID 2003/778).

[17 270] Deemed acquisition for market value Any pre-CGT assets owned by an entity will be taken to have been acquired at the time when the first change in majority underlying interests in the asset occurs: s 149-30. The cost base of the asset will be its market value (see [3 210]) at that time: s 149-35. If an asset is deemed by Div 149 to have been acquired after 19 September 1985 and is disposed of within 12 months of that deemed acquisition date, the CGT discount or indexation (see [14 400]) will not be available: Ruling IT 2666 (para 12). Note that the appropriate value to be attributed to leased equipment that is the subject of Div 149 is the market value of the lease and not the capitalised value of the underlying equipment. The market value of the lease is the amount for which the lessee could dispose of the lease in an arm’s length transaction: TD 27.

[17 280]

Exceptions

A change in ‘‘majority underling interests’’ will not be taken to have occurred as a result of an asset transferred under the marriage or relationship breakdown roll-over (see [16 300]) or on the death of a person (see also ATO ID 2003/778): s 149-30(3). In addition, the issue or redemption of preference shares will not be taken into account for Div 149 purposes if the shares are issued as part of a financing arrangement: TD 28. 670

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Note also that the operation of Div 149 will, in effect, be ignored for the purpose of allowing pre-CGT capital gains to be distributed to CGT concession stakeholders pursuant to the small business ‘‘15-year exemption’’ (see [15 540]): s 149-30(1A).

[17 290] Application to public entities A ‘‘public entity’’ (defined in s 149-50(1) to mean public companies, publicly traded unit trusts and mutual insurance organisations) is subject to a non-mandatory testing regime to determine if there has been a change in majority underlying interests in any of its pre-CGT assets: see Subdivs 149-C to 149-F. There are no consequences if a public entity fails to carry out the test as a public entity will still be subject to Div 149 if there has in fact been a change in the majority underlying interests in its pre-CGT assets. However, the test makes compliance easier. Under the test, a public entity can test whether there has been a change in majority underlying interests in its pre-CGT assets. The test is required to be done at the end of the ‘‘test day’’: s 149-55(2) and (3). The ‘‘test day’’ is every 5 years from 30 June 1999, or a day on which there has been ‘‘abnormal trading’’ in interests in the entity (ie shares in a company or units in a unit trust): s 149-55(2). ‘‘Abnormal trading’’ is defined in Subdiv 960-H: see [24 190]. The public entity must then provide written evidence to the Tax Office within 6 months of the test day: s 149-55(1). This evidence must make it ‘‘readily apparent’’ whether there has been a change in majority underlying interests between the test day and the ‘‘start date’’ (being a date chosen between 1 July 1985 and 30 June 1986 which provides a reasonable approximation of ultimate owners in pre-CGT assets): s 149-55(1A). See also Ruling TR 2004/7. Special rules in Subdiv 149-F apply to mutual insurance companies, mutual affiliate companies and demutualised entities. These essentially provide for optional simplified tracing rules for determining underlying beneficial interests is such entities, provided the Tax Office is satisfied that it is appropriate to apply the rules. [17 300] Superannuation funds Special CGT rules in Subdiv 295-B ITAA 1997 apply to the disposal of all assets of complying superannuation funds, complying approved deposit funds and pooled superannuation trusts for the purposes of Div 149. These special rules are discussed at [41 150]. Non-complying funds are subject to the normal CGT rules in an unmodified manner.

EASEMENTS [17 310] Introduction The CGT treatment of easements depends on whether the easement is granted voluntarily or whether it is compulsorily acquired by a government agency, as well as such matters as whether it was granted for consideration or no consideration and whether it arose in respect of adjacent land to a main residence. It will also be necessary to determine whether any capital gain from an easement is eligible for the CGT concessions (eg roll-over relief for compulsory acquisition). [17 320] Voluntary grant of an easement The voluntary granting of an easement will trigger CGT event D1 (see [13 150]), regardless of whether the land is a pre-CGT or a post-CGT asset. The capital gain or loss will be calculated by reference to a cost base comprising incidental costs involved in granting the easement (eg legal fees) and the capital proceeds received: s 104-35(3). The gain or loss will arise in the income year in which the landowner enters into the relevant contract or creates the right: s 104-35(2). © 2017 THOMSON REUTERS

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No capital proceeds received In the case where no capital proceeds are received for granting the easement, the market value substitution rules will not apply: see s 116-30(3)(b). This means that there will be no capital gain. A capital loss may arise to the grantor by reference to any incidental costs the grantor incurred in creating the easement. Easement over ‘‘adjacent land’’ If an easement is granted over land ‘‘adjacent’’ to a main residence, CGT event D1 will still apply and the CGT main residence exemption (see [15 300]) will not be available. This is because the exemption only applies to a relevant disposal of a main residence together with the adjacent land, and not in respect of the creation of a right over adjacent land. See also Determination TD 93/236. Availability of concessions A gain made on the grant of an easement will be eligible for the small business concessions if the easement is ‘‘inherently connected’’ with a CGT asset (ie land) that satisfies the ‘‘active asset’’ test (see [15 530]) and the other conditions for the concessions are met: ss 152-10(1), 152-12(2). However, any such gain is not eligible for the CGT discount: s 115-25(3)(a). Option to acquire an easement In the case of an option for an easement granted by a landowner, the consequences are: the grant of the option will trigger CGT event D2 (even if the land is a pre-CGT asset): s 104-40(1); the capital gain or loss arising from the event will be the difference between any amount received for granting the option and the expenditure incurred by the grantor in granting the option (eg legal fees etc): s 104-40(4); the capital gain or loss will arise in the income year in which the option is granted: s 104-40(2); and, if a capital gain arises, it will be eligible for the small business concessions (s 152-10(1)(a); see also ATO ID 2011/45), but it will not be eligible for the CGT discount (s 115-25(3)(b)). However, CGT event D2 will not happen if the option is exercised: s 104-40(5). In this case, the consequences are as follows (regardless of whether the land is a pre-CGT or a post-CGT asset): the option transaction will be ‘‘merged’’ with the grant of the easement to treat any exercise price, plus the amount given for granting the option, as the capital proceeds for CGT event D1: see Div 134; the cost base for the event will be the ‘‘incidental costs’’ incurred by the taxpayer in relation to the event: s 110-35; the capital gain or loss will arise in the income year in which the right is created: s 104-35(2); and if a capital gain arises it will be eligible for the small business concessions (ss 152-10(1) and 152-12(2)), but it will not be eligible for the CGT discount (s 115-25(3)(a)). Note that the Commissioner has unlimited time to amend an assessment for any capital gain (or loss) returned in an earlier income year arising from CGT event D2: s 170(10AA) ITAA 1936 (see [47 170]). [17 330] Compulsory acquisition of an easement The Commissioner takes the view (in Ruling TR 97/3) that CGT event C2 (and not CGT event D1) applies to the compulsory acquisition of an easement by a government authority, on the basis that the compulsory acquisition of an easement involves the surrendering or relinquishing of rights over the land and not the creation of rights over land. This is regardless of whether the acquisition may occur by way of negotiation (as an acquisition in such circumstances is ‘‘in the shadow of a compulsory acquisition’’). Availability of rollover for compulsory acquisition The Commissioner takes the view (in ATO ID 2010/34) that the roll-over under Subdiv 124-B does not apply as a compulsory acquisition of an easement does not involve a ‘‘disposal’’ of a CGT asset (as required for the roll-over under the ‘‘threshold conditions’’ in s 124-70(1)(a), (aa) and (c)). 672

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[17 335]

Ruling TR 97/3 – compensation received from public authorities Ruling TR 97/3 deals with the CGT consequences of compensation received by landowners from public authorities. It provides (in relation to the ITAA 1936 equivalent provisions) that (a) CGT event D1 applies to the voluntary grant of an easement (see para 11), and (b) CGT event C2 applies to the compulsory acquisition of easements by government authorities (see paras 4, 9 and 10) and where compensation is received for imposing limits on a taxpayer’s use of the land (see paras 12-14). However, Ruling TR 97/3 also makes the point that it is to be read in conjunction with Ruling TR 95/35 (the CGT treatment of compensation receipts). In this context, Ruling TR 97/3 states that ‘‘the compensation received by a landowner from a public authority that compulsorily acquires an easement is not excluded from’’ the ‘‘look through approach’’ in Ruling TR 95/35, and that compensation received for the grant of involuntary easements will not be ‘‘consideration received for the disposal of any other asset, such as the right to seek compensation’’ (see para 7). Compulsory acquisition of adjacent land to main residence The exemption in ss 118-240 to 118-260 for the compulsory acquisition of land adjacent to a main residence includes certain rights over adjacent land that are compulsorily acquired or varied, such as easements. See [15 340] for further details.

OTHER [17 335] Look-through approach to earnout arrangements Subdivision 118-I contains measures for the CGT ‘‘look-through’’ treatment of earnout arrangements. (The Tax Office’s comments on the administrative treatment of earnouts are available on its website.) Key features Where a business asset is sold under an ‘‘eligible’’ earnout arrangement (ie where the buyer and seller agree that subsequent financial benefits may be provided based on the future performance of the asset), the value of the ‘‘earnout right’’ need not be bought into account as capital proceeds for the vendor, or as part of the cost base to the purchaser, until such time as all and any future financial benefits are received or paid (as relevant). Nevertheless, any capital gain or loss arising to a vendor from any fixed amount received for the sale of the business asset(s) will be bought into account in the income year in which the sale or disposal occurs, with adjustments being made to the capital proceeds of the vendor for any subsequent financial benefits received and to the cost base to the purchaser for any subsequent financial benefits paid. Note that the parties can still apply the former CGT rules (contained in withdrawn Draft Ruling TR 2007/D10) by treating the earnout right as a separate CGT asset whose market value has to be determined at the time of the sale and bought into account as part of the capital proceeds to the vendor at that time, or as part of the cost base for the purchaser (Draft TR 2007/D10 was withdrawn on 7 December 2016 and does not apply to earnout arrangements created after that date). Note also this treatment will apply to an earnout arrangement that is not an ‘‘eligible’’ earnout arrangement. ‘‘Eligible’’ earnout arrangements To qualify for CGT look-through treatment under Subdiv 118-I, the arrangement must meet the following requirements (s 118-565): • the earnout right must be created under an arrangement for the sale or disposal of the business or its assets, causing CGT event A1 to happen (see [13 050]); © 2017 THOMSON REUTERS

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• the sale must be an arm’s length commercial transaction; • the assets sold must be ‘‘active assets’’ of the business just before it is sold, ie assets used in the business of the taxpayer, a connected entity or an affiliate (see [15 530]), but not include depreciating assets; • the future financial benefits provided under the right must be linked to the ‘‘economic performance’’ of the business or assets sold, and must reasonably relate to this performance and, furthermore, must not be able to be reasonably ascertained at the time the right is created (as reflected in the definition of ‘‘contingent on economic performance’’ in s 974-85); and • the financial benefits must be provided within 5 years after the end of the income year in which CGT event A1 happens (including where a party may merely be late in providing a financial benefit) – but excluding financial benefits paid under an option for the parties to extend the period over which benefits are provided or financial benefits which are provided under a new agreement. Note that an eligible look-through earnout right includes a right to receive certain financial benefits for ending a right that is an eligible earnout right, including where made by a third party (see Example [17 335.10]). The sale or disposal of an interest in an Australian resident company or trust will also qualify as an eligible earnout right if at least 80% of the value of the assets of the company or trust are active assets. In determining whether this is the case, the following requirements must be met (s 118-570): • at the time of the sale or disposal, the entity holding the share or trust interest must either (a) be a CGT concession stakeholder in relation to the company or trust, if they are an individual, or (b) have a 20% interest in the company or trust; • the company or trust must carry on a business and have carried on a business or businesses for at least one prior income year; and • for the immediately preceding income year, at least 80% of the income of the company or trust must have come from the carrying on a business or businesses and not been derived as an annuity, interest, rent, royalties or foreign exchange gains, or derived from or in relation to financial instruments. This test also applies where shares or interests that are held through interposed entities are sold. Note that this test avoids the need to value the assets of the company or trust, but instead requires an examination of how the company or trust has earned its income over the prior income year. There are no CGT consequences to the purchaser on the creation of an earnout right (under CGT event D1) or to the vendor on ending an earnout right (under CGT event C2): s 118-575.

CGT consequences of a right being a look-through earnout right From the vendor’s point of view, the value of an earnout right will not be taken into account in determining the capital proceeds on the sale of the asset. However, the value of any financial benefits subsequently received will be taken into account as capital proceeds of the vendor for the disposal: s 116-120. Likewise, the capital proceeds will be reduced by any financial benefit that the vendor is required to repay to the purchaser. See also [14 330]. From a purchaser’s point of view, the value of an earnout right provided will not form part of the cost base of the asset(s) acquired by the purchaser until any ‘‘financial benefit’’ is 674

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required to be paid to the vendor under the earnout arrangement: s 112-36. Likewise, the purchaser’s cost base will be reduced by the amount of any financial benefit that is received or refunded by the vendor. See also [14 210]. EXAMPLE [17 335.10] Anna sells her business, ABC Co, to Purple Ltd in March 2017. Under the sale arrangement, Anna receives an upfront payment of $1m at the time of sale and a right to 2 future payments in March 2018 and March 2019, each of $100,000, provided the turnover of ABC Co exceeds an agreed threshold during 2017 and 2018 respectively. At this time Anna’s capital proceeds for the sale of the business are $1m – with the right to future payments being disregarded when working out the capital proceeds. As Anna’s cost base for ABC Co is $600,000, at this time Anna has a capital gain of $400,000 as a result of the sale. ABC Co’s turnover exceeds the agreed threshold in 2017 and so Purple Ltd pays Anna a further $100,000 in March 2018. As a result of this payment, the capital proceeds for the sale of ABC Co are now $1.1m (made up of the 1m initial payment and the $100,000 payment she receives in March 2018). She has now made a capital gain of $500,000 as a result of the sale. In July 2018, Purple Ltd decides it would prefer to end the arrangement immediately. It offers to pay Anna $50,000 if she will agree to forgo her right to further payments under the look-through earnout right, and Anna agrees to this offer. This financial benefit provided to terminate the look-through earnout right is treated in the same way as the financial benefits provided under the right. As a result, Anna’s total capital proceeds for the sale are now $1.15m (made up of the $1m initial payment, the subsequent $100,000 payment under the earnout right and the $50,000 payment to end it). Anna’s final capital gain from the sale is $550,000 (capital proceeds of $1.15m less the cost base of $600,000).

Choices and timing As the CGT treatment of earnouts will result in the amount of a capital gain or loss changing as a result of financial benefits received in later years, the rules extend the period of review for relevant taxpayers to four years after the final date when financial benefits could be provided under the look through earnout right. This will include where amendments have to be made for the application of any CGT small business concession. The extension also applies to a taxpayer’s right to object where they are dissatisfied with an assessment. As a result, where the Commissioner amends a taxpayer’s assessment because of a financial benefit provided or received under an earnout right, the taxpayer may object in the same way the taxpayer may object to any other amendments to an assessment, ie within 60 days of receiving notice of the amended assessment (see [48 060]). Where the amount of a gain or loss may vary from the amount of the gain or loss identified in the year in which the initial ‘‘interim’’ gain or loss arose, taxpayers can amend a choice made previously where the choice relates to a gain or loss that can be affected by subsequent financial benefits (eg to apply the CGT small business concessions). But the decision to vary a choice must be made by the time the taxpayer is required to lodge a return for the period in which the financial benefit under the earnout right is received. But note that while the receipt of a financial benefit under an earnout right may allow the taxpayer to remake a choice and often extends the period in which a choice can be made, it does not entitle the taxpayer to undo the actions they have taken in that period. For example, if a taxpayer has made contributions to superannuation under the CGT small business retirement exemption, they cannot withdraw those contributions even if are no longer available. Note that taxpayers will not be subject to any shortfall interest charge that may otherwise arise if there is a shortfall as a consequence of financial benefits provided or received under a look-through earnout right, as long as the taxpayer requests an amendment to their relevant assessment within the period they must lodge their return for the relevant income year: s © 2017 THOMSON REUTERS

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280-100(5) of Sch 1 TAA. Likewise, the Commissioner will not be liable for interest on any overpayment of tax in the same circumstances.

‘‘Temporary’’ capital losses disregarded A capital loss arising from the disposal of an asset to which an earnout right relates will be ‘‘temporarily’’ disregarded until it becomes ‘‘reasonably certain’’: s 118-580. This prevents a taxpayer from receiving an excessive tax benefit by being able to use the ‘‘loss’’ they have originally incurred until any final financial benefits are received under the earnout right. However, once such losses become certain, they will be available from the year in which the loss was originally incurred, and not when the amount became certain. Access to CGT concessions The CGT rules for earnout arrangements are not intended to affect a vendor’s entitlement to CGT concessions. For example, in relation to accessing the CGT small business concessions, the maximum net asset value test (MNAV test: see [15 510]) will be revised so that when working out the value of an entity’s CGT assets ‘‘just before the time of a CGT event’’, taxpayers will be able to elect not to include the value of any look-through earnout right they may hold, but instead take into account any financial benefits that they may have provided or received under the look-through earnout right after that time. Note that the election to use this method may only be made once no further financial benefits can be provided under the look-through earnout right. If the value of an earnout right is chosen to be included in the capital proceeds at the time of the sale and the vendor valued it with the result that the MNAV test is passed, but then the vendor later receives earnout payments which result in the MNAV test being failed, the vendor will be subject to the shortfall interest charge (SIC) in relation to an amended assessment that increases their liability to tax as a result of this undervaluation of the earnout right. In the case where a taxpayer may not initially be in a position to elect for a concession to apply to a CGT event, or may be concerned that anticipated future financial benefits may mean that they cease to be eligible for a concession after they have taken irrevocable actions based on this concession (eg making contributions to superannuation), the taxpayer can wait until it is clear whether they will be finally eligible for the concession before making any choice. In relation to the CGT small business concessions that require things to be done or decisions to be made within a fixed period of time, the period for accessing such concessions is extended. For example, in relation to the small business roll-over, the replacement asset period (see [15 590]) will be extended until 2 years after the potential final financial benefit is received.

Date of effect Subdivision 118-I applies to all earnout arrangements entered into on or after 23 April 2015. As a transitional measure, taxpayers that have reasonably and in good faith anticipated these changes as a result of the announcement on 12 May 2010 proposing this CGT look-through treatment are protected in accordance with s 170B of ITAA 1936 (see [47 190]). However, any protection will be lost if the taxpayer makes a statement for a later income year that is not consistent with the anticipated amendments reflected in the taxpayer’s original statement.

[17 340] Instalment warrants A ‘‘look-through’’ treatment applies to certain instalment warrants and instalment receipts (ie financial products that entail borrowing on a limited recourse basis to invest in an asset, such as a share which is then held on trust during the life of the loan to provide security 676

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[17 345]

for the lender). The measures are contained in Subdiv 235-I ITAA 1997 and treat acts done by the trustee in relation to the asset as having been done by the investor. In relation to CGT, this means the underlying investment assets is deemed to be held directly by the investor, with a range of consequences, including: no CGT event will happen on payment of any final instalment by the investor; the investor’s cost base of the asset will include the upfront instalment paid by the investor (and any liability assumed by the investor under the arrangement); where the asset is sold by the trustee, CGT event A1 will happen for the investor; the investor’s cost base will include any amount paid for the granting of a put option by the lender (the capital protection component) if the put option is exercised; and the investor will be taken to have acquired the asset when the interest in the instalment warrant or receipt trust was acquired. See further [32 620]. The amendments apply to assets that vest in the trust in the 2007-08 and later income years.

[17 345] Mining: ‘‘Farm-in Farm-out’’ arrangements ‘‘Farm-in farm-out’’ arrangements broadly involve the exchange of an interest in a mining, quarrying or prospecting right in return for an ‘‘exploration benefit’’ (with the initial owner of the right known as the ‘‘farmor’’ and the person providing the exploration benefit in exchange for the right known as the ‘‘farmee’’). The CGT consequences of such arrangements are: • the capital proceeds of the CGT event will be reduced by the value of the exploration benefit received; • the cost base and reduced cost base of the entitlement will be reduced by the market value of the entitlement; • the capital proceeds of the C2 event will be reduced by the market value of any exploration benefits received; and • CGT event D1 will not happen if the right created in the other entity (the farmor) is a right to receive an exploration benefit under a FIFO arrangement. Other income tax consequences are as follows: • the first element of the cost of the right received will be reduced by the market value of the exploration benefits provided; • the termination value of the part of the right transferred will be reduced by the value of the exploration benefit received; • the adjustable value of the entire right will be allocated to the cost of the retained part when the right is split immediately before the balancing adjustment event; • the farmor’s entitlement to deduct the expense will be reduced to the same extent the termination value of the farmor’s original right was reduced; and • the receipt of the right will be non-assessable non-exempt income, to the extent the cost of the right was the farmee providing exploration benefits to the farmor. These measures apply to such ‘‘farm-in farm-out’’ arrangements entered into after 14 May 2013. The CGT and other tax consequences of ‘‘immediate transfer farm-out arrangements’’ entered into on or before 14 May 2013 are dealt with in Ruling MT 2012/1. The ruling states, among other things, that CGT event A1 happens to the farmor for the interest in the mining tenement that is transferred by the farmor to the farmee. It also states that the exemption in s 118-24(1) (see [15 080]) will apply to disregard any capital gain or loss on the transfer of the interest in the mining tenement if the decline in value of the interest in the mining tenement would be worked out under the UCA provisions in Div 40. See also Ruling MT 2012/2. © 2017 THOMSON REUTERS

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COMPANIES AND UNIT TRUSTS SHARES, UNITS, RIGHTS, OPTIONS, CONVERTIBLE NOTES [17 350] Overview of CGT implications for companies and shareholders A company is a separate legal entity and generally CGT applies to it in the same way as it applies to individuals. The only substantial differences are the provisions relating to capital losses and certain roll-over relief where the relief that is granted to a company may be different to that granted to individuals, partnerships and trusts. Use of capital losses Companies may only carry forward capital losses for offsetting against capital gains in later income years where they satisfy the tests applicable to carried-forward revenue losses contained in Subdiv 165-A (same owners and control or same business): see Subdiv 166-A (for listed public companies) and Subdiv 175-A (tax benefits from unused losses). Likewise, companies can only use current-year capital losses to offset capital gains arising in the same year in accordance with rules applying to current year revenue losses under Div 165. See [20 450]-[20 490]. The acquisition and disposal of shares is subject to the normal CGT rules. However, in addition to these rules there are a number of special provisions.

Issue or allotment of shares and rights The issue or allotment of shares in a company constitutes an acquisition of the shares by the person to whom they were issued or allotted (s 109-10) but it does not constitute a CGT event to the company: see ss 104-35(5)(c) and 104-155(5)(c). Therefore, moneys paid to subscribe for shares, whether paid-up capital or a premium on allotment, do not create a CGT liability for the company. This exception also applies to non-equity shares issued on or after 1 July 2001. For shares issued after 15 August 1989, the cost base of the shares in the hands of the shareholders will be their actual cost or, if issued in a non-arm’s length transaction, will be the lesser of their actual cost or their market value (see [3 210]): s 112-20. See [17 380] for the treatment of rights and options granted by a company or unit trust to re-acquire shares from a shareholder or units from a unit holder. Options to acquire shares or debentures The treatment of options to acquire shares or debentures in a company is somewhat similar. Where a company grants an option to acquire shares in the company or to acquire debentures of the company, the grant of the option is not taken to be a disposal of the option at the time the grant took effect (this also applies to non-equity shares issued on or after 1 July 2001): see [17 380]. If the option is exercised, the grant is not taken to have constituted a disposal of the option at any time. However, if the option expires without being exercised or is cancelled, released or abandoned, CGT event C2 (see [13 080]) will happen at the time the option expires or is cancelled, released or abandoned and the option is deemed to have been owned by the company immediately before the deemed disposal took place: see [17 380]. Any amount paid for the option or, where no amount is paid for the option or in a non-arm’s length situation (unless disposal is by mere expiry), the market value (see [3 210]) of the option may constitute a capital gain to the company (the concept of dealing at arm’s length is discussed at [5 260]). Note that the date of acquisition of shares acquired by exercising an option is considered to be the date the contract of acquisition is entered into (although this is subject to some dispute): see [17 220]. 678

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Redemption or cancellation of shares or debentures The redemption or the cancellation of a share or debenture of a company is deemed to be a disposal by the shareholder or debenture holder under CGT event C2 (see [13 080]): s 104-25. Accordingly, any amount received in respect of such a redemption or cancellation or, if no amount is received, the market value of the share or debenture at the time of redemption or cancellation will form part of the capital proceeds for the CGT event in the hands of the shareholder or debenture holder. See also [14 160] for the non-application of the market value substitution rule.

Share buybacks The share buyback provisions are found in Div 16K of Pt III ITAA 1936. The provisions are discussed at [20 700]-[20 730]. For CGT purposes the buyback is to be ignored when determining whether a capital gain or loss accrues to or is incurred by a company in respect of the buyback (or on the subsequent cancellation of the shares): s 159GZZZN. It should be noted, however, that the section does not have the effect that the buyback is to be ignored for the purposes of Div 149 (see [17 270]). See also [17 380] for the treatment of rights and options issued to effect a buy-back. From the shareholder’s point of view, an off-market purchase needs to be distinguished from an on-market purchase. Where the buyback is an on-market purchase, the whole of the purchase price is taken into account as the capital proceeds for the disposal: s 159GZZZS. For off-market share buybacks, the full buyback price is treated as capital proceeds for CGT purposes if debited against amounts standing to the credit of the purchaser’s ‘‘share capital account’’: see FCT v Consolidated Media Holdings Ltd (2012) 84 ATR 1. Otherwise, any relief from double taxation is provided by reducing the amount of the capital gain that is a dividend: ss 159GZZZP and 159GZZZQ.

Identifying shares acquired at different times Where a CGT event happens to shares which form part of a holding of identical shares and they are not able to be individually distinguished, the Commissioner will accept either the taxpayer’s selection of the identity of the assets in question or a ‘‘first-in first-out’’ method as a reasonable basis of determining which assets have been disposed of or affected by a CGT event, at the taxpayer’s choice (but not an average cost method): see Determination TD 33.

[17 360] Bonus equities Subdivision 130-A sets out the rules for modifying the cost base or reduced cost base in working out a gain or loss on the issue of a bonus share or unit (bonus equity) in satisfaction of an amount payable to an equity holder in relation to the holding of their original shares. It also determines when the equity holder is taken to acquire the bonus equity: s 130-20. Where the bonus equity is assessable, the cost base or reduced cost base of the bonus equity includes the assessable amount at the time of issue: s 130-20(2). If the bonus equity is not assessable, the cost base or reduced cost base will depend on when the original equity was acquired. Note also that s 130-20(1), as originally enacted, applies to bonus shares issued up to 1 July 1998: see ATO ID 2013/19. The following charts are included in s 130-15 to outline the application of Subdiv 130-A to determine the acquisition time and cost base of bonus equities (ie bonus shares and units).

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[17 380]

[17 370] Return of capital on shares and units The return of capital on shares and units constitutes CGT events G1 (see [13 400]) and CGT event E4 (see [13 230]), respectively. Note that this is the case to the extent that the payment is not assessable as a dividend or as an amount taken to be a dividend under s 47 ITAA 1936 (liquidator’s distribution). Further, CGT Event G1 does not apply to a bonus share issued out of a share capital account: Determination TD 2000/2. Liquidators’ distributions For the CGT treatment of distributions made by a liquidator in relation to shares, see CGT event C2 (see [13 080]) and CGT event G1 (see [13 400]). The consolidation regime applies to distributions in specie upon the liquidation of a group company. [17 380] Rights and options to acquire shares and units The treatment of rights and options granted by a company or a unit trust to acquire shares or units in the entity is discussed below. Grant of the right or option The grant of a right or option by a company or unit trust to acquire shares in that company or units in that unit trust is excluded from the operation of CGT events D1 (creating a contractual right) and D2 (granting an option): ss 104-35(5) and 104-40(6). As a result, the grant of such rights or options will not constitute a CGT event by the company or unit trust. The grant of a right or option to acquire a debenture in the company or unit trust that issued the right or option is similarly excluded and does not constitute a CGT event. Expiry of the right or option If the option subsequently ends because it is not exercised within the exercise period, or is cancelled, released or abandoned, CGT event C3 will happen: s 104-30. The company or trustee makes a capital gain if the capital proceeds from the grant of the option are more than the expenditure incurred in granting it. It makes a capital loss if those capital proceeds are less. The deemed market value capital proceeds rule (see [14 250]) does not apply in relation to CGT event C3: s 116-25. Exercise of the right or option Subdivision 130-B provides further rules in relation to rights and options to acquire shares or units or further options to acquire shares or units. Subdivision 130-B refers to rights as encompassing both rights and options. It applies where: (a) rights were acquired for no consideration and the taxpayer owns shares, units or convertible interests issued by the trust or company or by a member of the same wholly owned group of companies; or (b) rights are acquired from an entity that already owned shares, units or convertible interests of the kind referred to in (a). Note that, in respect of rights to acquire units in a unit trust, Subdiv 130-B will only apply if the rights were issued by the trustee after 28 January 1988. Where these conditions are satisfied, any capital gain or loss on the exercise of a right or option issued by a company or trust to acquire its shares or units is disregarded: s 130-40(7). The cost base of the shares, units or options acquired upon exercise of the rights is determined in accordance with the table in s 130-40(6), which broadly provides the first element of the cost base of the shares, units or options acquired upon the exercise of a right will include any amount paid to exercise the right (except to the extent that it is represented in the cost base of the right at the time of exercise): s 130-40. © 2017 THOMSON REUTERS

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Note that s 130-40(6A) amounts (referred to in the table) are, in effect, any income amounts that would have been excluded from assessable income under the anti-overlap provisions contained in s 118-20, had a capital gain on the exercise of the right been assessable, and not disregarded by s 130-40(7). Further, any amount in respect of the cost base that is deductible to the taxpayer also reduces the cost base before it is incorporated into the first element of the cost base of the share or unit: Div 110: see Chapter 14.

Grant of right to shares or units No amount is to be included in the assessable income of a shareholder or unit holder as a result of acquiring certain rights, issued by the company or unit trust, to acquire shares or units under a buy-back arrangement: s 59-40. In particular, if an entity issues to a taxpayer who owns an interest in the issuing entity such rights to acquire a relevant interest in that entity, the market value of the rights, as at the time of issue, are non-assessable non-exempt income (see [7 700]). This is provided the following conditions are satisfied (s 59-40(1)): (a) the rights must be issued to the taxpayer because of their ownership of the original interests; (b) the original interests and the rights must not be revenue assets or trading stock at the time the rights are issued; (c) the rights must not have been acquired under an employee share scheme (see [4 150]); (d) the original interests and rights must not be traditional securities (see [32 250]); and (e) the original interests must not be convertible interests. For CGT purposes, a capital gain or loss will only arise when a CGT event happens to the rights, or to the shares or units acquired as a result of the exercise of the rights. See [14 200] for how to calculate the cost base of the rights (ie the put option) in this situation. In addition, if a company or unit trust issues put options to dispose of shares or units to the company or trust, CGT event H2 will not apply (see [13 400] and [17 230]). [17 390] Demutualisation of insurance companies and other bodies Special provisions in s 121AS modify the rules that apply to the acquisition or disposal of shares and associated matters as part of the demutualisation of an insurance company. Generic rules for demutualisation of non-insurance companies Division 326 in Sch 2H ITAA 1936 contains CGT ‘‘roll-over’’ rules for the demutualisation of non-insurance companies. They apply to demutualising mutual entities, which are non-profit-making organisations which do not have a share structure (excluding mutual life organisations). Demutualisation of health insurers Division 315 ITAA 1997 provides CGT relief when a private health insurer converts, by way of demutualisation, from being a not-for-profit to a for-profit insurer. Relief for demutualisation of friendly societies Division 316 ITAA 1997 provides roll-over relief to taxpayers who receive shares in connection with the demutualisation of friendly societies that principally carry on life insurance business and that have never issued shares. [17 410] Convertible ‘‘interests’’ issued by companies and unit trusts The conversion of ‘‘interests’’ issued by companies and unit trusts into shares and units is not a disposal of the interest for CGT purposes, nor will it generally give rise to assessable amounts under s 26BB ITAA 1936 or deductible amounts under s 70B ITAA 1936: see [32 300]. Cost base of shares or units Section 130-60(1) and (1A) provides that the first element of the cost base of the shares or units acquired on the conversion of a convertible interest (regardless of whether or not the convertible interest is a traditional security) is comprised of: 682

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• the cost base of the convertible interest at the time of conversion; and • any income amounts that would have been excluded from assessable income under the anti-overlap provisions contained in s 118-20 had a capital gain on the conversion of the convertible interest been assessable, and not disregarded by s 130-60(3). By this mechanism, any capital gain realised on the newly acquired shares or units will be freed from being taxed twice on any related assessable income amounts. This standard cost base calculation also applies to the acquisition of units from the conversion of a convertible interest (excluding a traditional security) that was issued by the trustee of the unit trust after 28 January 1988. In addition, any amount in respect of the cost base that is deductible to the taxpayer will also reduce the cost base before it is incorporated into the first element of the cost base of the share or unit.

Time of acquisition rules For assessments for 1998-1999 and following years of income, shares or units acquired on the conversion of a convertible interest (or ‘‘note’’) are considered to have been acquired at the time of conversion: s 130-60(2) TPA. [17 420] Unexercised options under convertible interests The nature of a convertible note issued by a company or unit trust is such that while it is essentially a loan to the issuer of the note, it also carries with it an option, exercisable by the note holder, to convert the note into shares or units. Where the right to convert is not exercised, the issuer will be deemed to have disposed of the option under CGT event C3 at the date it lapses: s 104-30. The issuer will be subject to CGT where part of the consideration received for the issue of the convertible note can be attributed to the option to convert, for example where the company or trust is required to repay less than the full face value of the note. [17 430] Exchangeable interests Subdivision 130-E deals with ‘‘exchangeable interests’’. An ‘‘exchangeable interest’’ is a traditional security that is issued on the basis that it will or may exchange into shares in a company that is neither the issuer of the exchangeable interest nor a connected entity of the issuer (see [32 250] for the definition of a ‘‘traditional security’’). At exchange, the exchangeable interest is redeemed by the issuer or disposed of by the holder to the issuer or a connected entity of the issuer. Note that a traditional security issued before 7.30 pm on 14 May 2002 AEST, cannot be an exchangeable interest. Any capital gain or loss from the disposal or redemption of an exchangeable interest to the issuer of the interest or to a connected entity of the issuer will be disregarded: s 130-105(4). The holder of an exchangeable interest that is exchanged into shares of a company acquires the shares when the exchange happens: s 109-55, table item 11B. For the purpose of the CGT discount (see [14 400]), the period of ownership of a share acquired on exchange commences when the share is acquired, not when the exchangeable interest is purchased. The first element of the cost base of shares acquired on the disposal or redemption of an exchangeable interest will be the total of (s 130-105): • the cost base of the exchangeable interest at the time of disposal or redemption; • an amount (if any) paid for the exchange; and • an amount (if any) by which a capital gain from the exchange of the exchangeable interest has been reduced under s 118-20. © 2017 THOMSON REUTERS

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[17 440] Employee share scheme interest The concessional rules dealing with the taxation of benefits under an employee share scheme are considered at [4 150]-[4 260]. The CGT treatment of employee share scheme interests is dealt with at [4 225].

RECOUPMENT AND USE OF NET CAPITAL LOSSES [17 500] Capital loss recoupment rules Apart from the general rules as to use of net capital losses applicable to all taxpayers (see [14 370]), companies are subject to a number of additional restrictions that must be satisfied before any net capital losses can be used in the normal manner. The special tests that apply are very similar and in some cases are identical to those that apply in relation to use of revenue losses by companies: see Chapter 20. Carried forward net capital losses A net capital loss will not be able to be used as an offset against capital gains by a company in a later income year if, had it been a tax loss (ie a revenue loss), Subdiv 165-A (together with Subdiv 166-A for listed public companies) or Subdiv 175-A ITAA 1997 would have prevented the company from deducting it in that later income year: s 165-96. In other words, to be able to utilise a carried-forward net capital loss in a later year, the company must satisfy the continuity of ownership or same business tests and not breach the injected capital gain or third party tax benefit tests which apply in determining whether a carried forward revenue loss is deductible. It should be noted that from 21 September 1999 Subdiv 165-CC (together with Subdiv 166-C for listed public companies) will require the same business test to be met for the purpose of carrying forward unrealised capital losses (and unrealised revenue losses) at the time of a breach of the same ownership test. Note also that s 165-205 clarifies that, for the purpose of applying the ‘‘continuity of ownership’’ test after a shareholder dies, the shares that are beneficially owned by the deceased person at the time of death will be treated as continuing to be owned by that person, provided the shares are owned by either the trustee of the deceased person’s estate or by a beneficiary of the estate. The application of these tests is described in detail at [20 300]-[20 400]. Current year capital loss rules The current year capital loss rules, contained in Subdiv 165-CB (together with Subdiv 166-B for listed public companies) mirror the application of the current year tax loss rules in Subdiv 165-B. Subdivision 165-CB (together with Subdiv 166-B for listed public companies) requires a company to work out its net capital gain and net capital loss differently for a year in which it has not had the same majority ownership and control and does not satisfy the same business test. It is required to do this if it is required to calculate its taxable income and tax loss under the special rules for the income year of change under Subdiv 165-B or would have been so required had it incurred a notional loss in any of the relevant periods: s 165-102. The year is divided into periods according to the same rules as those that apply for working out the company’s taxable income and tax loss for the year of change: see [20 450]-[20 490]. Further details of the current year net capital loss provisions are provided at [20 470]. A company has a notional net capital gain for a period if the capital gains it makes during the period exceed its capital losses. If the capital losses exceed the capital gains, it has a notional net capital loss: ss 165-105 and 165-108. A company makes a net capital gain equal to the excess of its notional net capital gains for the year over any available net capital losses 684

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[17 520]

of earlier years: s 165-111. A company makes a net capital loss equal to the sum of its notional net capital losses for the year: s 165-114.

[17 510] Unrealised capital losses Subdivision 165-CC (together with Subdiv 166-CA for listed public companies) prevents the duplication of capital (and other) losses at both the company and shareholder level in relation to unrealised losses at the time of a substantial (ie 50% or more) change in a company’s ownership or control (ie changeover time). In this case, capital losses (or deductions) arising in respect of the later disposal of assets held at the changeover time can only be claimed by the company if it passes the same business test. Specifically, this business test will need to be applied to the amount of losses subsequently realised up to the amount of the unrealised net losses calculated by the company at changeover time. A company’s ‘‘unrealised net loss’’ for these purposes will generally be the loss that the company would make if it sold all of its assets at market value at that time. Global or individual basis of valuation In calculating the ‘‘unrealised net losses’’, companies can choose to value assets on either a ‘‘global’’ or ‘‘individual’’ basis for any changeover times occurring from 11 November 1999. The choice must be made by the time the company lodges its return for the year in which the changeover time occurred (or such later day as the Commissioner allows) or within 6 months of 24 October 2002 (for changeover times occurring before that time). Broadly, the global method requires that the total market value of all CGT assets that the company owned at the relevant time be valued using a valuation method that would ‘‘generally be regarded as appropriate’’ (together with safeguards to ensure that the unrealised net loss calculated under the global method cannot be less than it would be under the individual asset method): s 165-115E. Under the individual method, assets acquired for less than $10,000 may, at the taxpayer’s option, be excluded. However, this exclusion does not apply if the global method is chosen. Access to Subdiv 170-D losses Subdivision 165-CC may also impact on the ability of a company to access losses that have been deferred by Subdiv 170-D on assets held by the company before the changeover time. Application to consolidated groups These provisions may also apply to consolidated groups. However, the operation of Subdiv 165-CC is adjusted where it is applied to a consolidated or MEC group. This is discussed further at [24 610]. [17 520] Transfer of net capital losses Subdivision 170-B enables the transfer of net capital losses from one company in a 100% wholly owned group to another company in the same group. The provisions in this respect are almost identical to those contained in Subdiv 170-A and Div 975 ITAA 1997, which enable the transfer of income losses. However, with the introduction of the consolidation regime (see [24 010]), the loss transfer rules in Subdivs 170-A and 170-B have effectively ceased to apply except for Australian branches of foreign banks and (in relation to losses for income years starting on or after 26 June 2005 (effectively from 2005-06)) Australian branches of other financial entities that are like banks: ss 170-75 and 170-174. Where applicable, the capital loss transfer rules require that the loss company must be an Australian resident throughout the loss year and the gain company must be an Australian resident throughout the year for which the loss is to be applied. Both companies must agree that the transfer is to occur and a written agreement evidencing the transfer must be made on or before the date of lodgment of the return of income of the transferee company for the year © 2017 THOMSON REUTERS

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to which the transfer relates or within such further period as the Commissioner allows: s 170-150. See TD 2003/23 and ATO ID 2006/41 in relation to written agreements for the transfer of additional revenue and capital losses. Ruling TR 98/12 discusses the flexibility and timing of tax loss transfer agreements, although most of the provisions to which it refers have been superseded by rewritten provisions. In the BHP Billiton Direct Reduced Iron case, the Federal Court said that the Tax office had misapplied Ruling TR 98/12 in refusing to grant the taxpayer an extension of time to transfer a tax loss. The Court also said that the Tax Office had failed to take into account, among other things, the purpose of the loss transfer provisions. Shelf companies can be considered part of a group even though non-group entities owned the original shares. In effect, the acquisition of a ‘‘shelf’’ company is treated as if it were the formation of a company: s 170-130. Where a net capital loss is transferred, the gain company is taken to have made the net capital loss in the year in which it was made by the loss company: s 170-120. The gain company is required to apply the net capital loss in its year of transfer and the loss ceases to be available to the loss company: s 170-115. If the loss company has 2 or more net capital losses, they are transferable in the order in which they were made: s 170-155. The gain company is not permitted to transfer any amount of a net capital loss that has been transferred to it: s 170-160. Note that the transfer of a net capital loss in accordance with Subdiv 170-B is not subject to GST: s 110-5 GST Act.

Satisfaction of carried-forward capital loss recoupment tests Where a transfer is sought in a year subsequent to the year in which the net capital loss was incurred, for a net capital loss to be transferable the transferor must be able to satisfy the carried-forward net capital loss recoupment tests (see [17 500]) as though it was seeking to offset the net capital loss: s 170-135. The transferee will also need to be able to satisfy these tests, as the transferred net capital loss is merely deemed to be a net capital loss incurred by the transferee in the same year as it was actually incurred by the transferor (s 170-140), meaning the normal provisions will then apply to the transferee’s ability to utilise the net capital loss. Satisfaction of current year capital loss recoupment tests A net capital loss will not be able to be transferred in either the current year or a later year if in the year in which the net capital loss was incurred, the transferor is subject to the current year net capital loss restrictions of Subdiv 165-CB (together with Subdiv 166-B for listed public companies) or is in breach of the injected capital gain, injected capital loss or third party tax benefit tests of Subdiv 175-CA or Subdiv 175-CB: s 170-140. These are similar rules as apply to the transfer of revenue losses within a company group: see [20 250]. Where a transfer is sought in the same year as that in which the net capital loss was incurred, the transferee must also be able to satisfy the same tests for that year in order to be able to treat the net capital loss as a capital loss incurred by it in that year. Amount that can be transferred The amount of the net capital loss to be transferred cannot exceed (s 170-145): • the amount of the loss company’s unutilised net capital loss at the end of the application year if the loss company utilised the net capital loss to the greatest extent possible; or • the amount that the gain company can apply in the year of transfer. Before 22 February 1999, the amount of the loss which could be transferred within the company group was further limited by s 170-145. For further information, see the Australian Tax Handbook 2002 at [17 380]. 686

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[17 530]

Dual resident investment company and prescribed dual resident exclusion Losses cannot be transferred by a company that is a dual resident investment company (see [35 060]) in relation to the income year or the loss year: s 170-135(1). In addition, the loss company cannot be a prescribed dual resident (see [2 150]) during the loss year. This prohibition is similar to that in s 170-35(1), covering the transfer of revenue losses pursuant to Subdiv 170-A ITAA 1997. Note that the dual resident investment company exclusion and the prescribed dual resident exclusion are separate tests that must both be satisfied for the loss to be transferable. Subvention payments It should also be noted that a revenue loss, a net capital loss or the ability to utilise that loss is not an asset for CGT purposes. In this regard, s 170-125 deals with the tax treatment of payments made for the transfer of tax losses (subvention payments). It provides that: • the consideration is neither assessable income nor exempt income of the loss company; • the loss company does not make a capital gain because of receiving the consideration; • the gain company cannot deduct the consideration; and • the gain company does not make a capital loss because of the giving of the consideration. See Determination TD 2001/16 (noted at [17 530]) for the issue of cost base adjustments in relation to the making of subvention payments. Note that a tax benefit (in relation to the gain company) that is distributed as a dividend is not taken into account.

[17 530] Consequential adjustments to cost bases of shares or loans Subdivision 170-C operates to provide cost base adjustments to interests in the transferor and transferee of capital losses. It should be noted that the same cost base adjustment provisions apply as a result of the transfer of ordinary tax losses. The adjustments will apply to: • reduce the cost base of the direct and indirect share interests held by group companies in the company which transferred the tax loss or capital loss; • reduce the reduced cost base of direct and indirect debts owed to group companies by the company which transferred the tax loss or capital loss; • increase the cost base of the direct and indirect share interests held by group companies in the company which received the tax loss or capital loss; and • increase the reduced cost base of direct and indirect debts owed to group companies by the company which received the tax loss or capital loss. The amount of the cost base adjustments are set at a level which is appropriate having regard to: • the group company’s direct and indirect interests in the loss company or income company; • the amount of the loss transferred; • the extent to which the loss reduced the market value of the share or debt in the loss company (see [3 210] for ‘‘market value’’); • any consideration received by the loss company for the loss transferred; and © 2017 THOMSON REUTERS

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• whether, because of a dividend or dividends paid by the loss company, the consideration is no longer reflected in the market value of the share or debt when a future CGT event happens in relation to it. Where the amount of the loss transferred reflects a real loss in value of the transferor company, the cost base adjustment will generally equal the total amount of the loss transferred. If the gain company pays the loss company an amount for the loss (a subvention payment), for example equal to 34% of the loss transferred, the cost base adjustment would be equal to 66% of the loss transferred. An adjustment is still necessary if a payment equal to the tax benefit of the loss is made to the loss company: Determination TD 2001/16. The amount of any increase in the cost base cannot exceed the increase in the market value of the shares or debt that results from the transfer. For indexation purposes, the increase in value is taken to have occurred at the time the loss was transferred: Determination TD 2001/16.

[17 540] Deferral of capital losses – linked group Subdivision 170-D provides for the deferral of capital losses and deductions where there is a transfer or creation of an asset between companies in a ‘‘linked group’’ (it is less relevant with the introduction of the consolidation regime: see [24 010]). For these purposes, 2 companies will be ‘‘linked’’ to each other if one of them has a controlling stake in the other or the same entity has a direct or indirect controlling stake in each of them (in terms of exercising or controlling more than 50% of the voting power, or having the right to receive more than 50% of the dividends or capital of the company): s 170-260. The immediate consequence of Subdiv 170-D is that the capital loss or deduction incurred by the originating company will be disregarded: s 170-270. However, the capital loss or deduction will become available to be used by the originating company on the happening of a number of subsequent events: s 170-275. These generally involve the originating company, or the asset subject to the CGT event, ceasing to belong to the linked group. [17 550] Artificially created capital losses – Pt IVA The general anti-avoidance provisions of Pt IVA can apply to arrangements entered into after 28 April 1997 that are designed to artificially create CGT losses. In particular, it will apply to the creation of capital losses in the year in which they are incurred, rather than apply only to the amount of loss offset against capital gains in a particular year (see [42 120]). However, s 177C(2A) provides that where the roll-over under Subdiv 126-B (for transfer of assets between company groups) or s 170-B (for the transfer of capital losses) is chosen, Pt IVA will not apply provided the scheme consists solely of the choice for the roll-over or for the transfer of the loss: see British American Tobacco Australia Services Ltd v FCT (2010) 80 ATR 813, noted at [42 120]. See also the application of Subdiv 165-CD, discussed at [17 600].

COST BASE REDUCTIONS AFTER CHANGE IN OWNERSHIP OF A LOSS COMPANY [17 600] Background The inter-entity loss duplication rules in Subdiv 165-CD ITAA 1997 prevent the duplication of losses within groups of companies. This will occur where a company’s losses are reflected in the values of shares or debts held in that company. The rules prevent duplication of losses by reducing the reduced cost base of those equity and debt interests in the loss company. 688

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[17 620]

The inter-entity loss duplication rules will apply where the following conditions are met: • an ‘‘alteration time’’ occurs in respect of a company; • the company is a ‘‘loss company’’ at the alteration time; and • one or more entities had a ‘‘relevant equity interest’’ or ‘‘relevant debt interest’’ in the loss company immediately before the alteration time. Where these conditions are met, the reduced cost base of equity and debt interests in the loss company will be reduced reflecting the value of the loss companies’ realised and unrealised losses. The controlling entity of a loss company immediately before the alteration time must give relevant information to associates generally within 6 months of the alteration time: s 165-115ZC. Subdivision 165-CD does not address the situation where there may be reduced gains to recognise an inter-entity interest because the company has made losses. Unrealised gains in the company are not relevant because only loss attributes (ie reduced cost bases and deductions) of interests in it are reduced or adjusted. EXAMPLE [17 600.10] X Co has a 100% shareholding in Y Co, having capitalised Y Co post-CGT with $10m. X Co sells its shares to an independent buyer for $7m. This triggers the operation of the subdivision. Y Co has a realised loss of $3m (at the beginning of the income year in which the subdivision is triggered), and an unrealised loss of $1m on one asset and an unrealised gain of $1m on another. The reduced cost base of X Co shares would be reduced by $4m to $6m. The cost base of $10m is unaffected by the subdivision so no capital gain or capital loss would be made on the sale. If Y Co distributed the unrealised gain asset to X Co before the sale and sold its shares for $6m, the subdivision would again prevent duplication of the company’s losses.

Subdivision 165-CD also applies to consolidated and MEC groups. However, its operation in the case of these entities is modified so that it operates properly within the single entity concept. This is discussed further at [24 610].

[17 610] Alteration time An alteration time will occur where there is a 50% or more change in ownership of the loss company or a liquidator or administrator of the loss company declares that shares or financial instruments are worthless thereby triggering CGT event G3 (see [13 410]). In the case of an administrator, this only applies to declarations made after 21 March 2005. In addition, there will be a ‘‘notional alteration time’’ if an entity disposes of an equity or debt interest in the loss company 12 months before the alteration time. If there is a notional alteration time, the inter-entity loss duplication rules will apply to those equity or debt interests as if there had been an alteration time.

[17 620] Calculation of losses A company is a loss company at the alteration time if it has: • prior year tax losses or net capital losses; • current year tax losses or net capital losses; or • adjusted unrealised losses. In broad terms, an adjusted unrealised loss is the sum of unrealised revenue and capital losses in respect of CGT assets and unrealised trading stock losses. It should be noted that this calculation is determined on the basis of gross unrealised losses (ie it is not offset by any unrealised gains on assets held by the same entity). Sections 165-115U and 165-115ZD discuss the use of a proxy for a company’s adjusted unrealised loss at an alteration time. © 2017 THOMSON REUTERS

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Global valuation and special value shifting rule In determining the amount of a company’s adjusted unrealised loss at an alteration time, a company can choose to value assets on either a ‘‘global’’ (s 165-115U) or ‘‘individual’’ basis for any alteration times occurring from 11 November 1999. The global method of valuation for these purposes operates broadly in the same way as for Subdiv 165-CC: see [17 510]. At the same time, s 165-115ZD provides that a special value shifting rule will apply where the global method has been used and a significant equity or debt interest in that company is later realised. This is to ensure that where the unrealised gain value of a company is captured in a global asset valuation at an alteration time, and the value is later removed from the company, it will not be possible to duplicate the company’s unrealised losses at that alteration time on realisation of an equity or debt interest in the company. The rule will operate where an equity or debt interest would (but for the rule) be realised at a loss for income tax purposes and the alteration time was the latest when the equity or debt interest was a significant equity or debt interest in the company. Thus, the realised loss will not be allowed to the extent that the company has paid dividends, returned capital, or otherwise shifted value while the interest remained a significant equity or debt interest in the company. However, if it can be shown that this removal of value is not reasonably attributable to the unrealised gain value on assets acquired for at least $10,000 at the alteration time or has not given rise to a reduction to the reduced cost base of the interest, the value shifting rule will not apply. In addition, transitional rules can apply to limit the impact of the rule (for which notice must be given). [17 630] Relevant debt and equity interests An entity will have a relevant equity interest in a loss company if: • the entity has a ‘‘controlling stake’’ in the loss company; • the entity has interests that give it the right (either directly or indirectly through one or more interposed entities) to control 10% or more of the voting power of the loss company, or receive 10% or more either of any dividends or any capital distributions of the loss company; and • the equity consists of shares in the loss company or an entity with a relevant debt or equity interest in the loss company. An individual or partnership of individuals is taken never to have a relevant equity or debt interest in a company. Individuals are therefore outside the scope of these rules. An entity will have a ‘‘controlling stake’’ in a loss company if the entity and its associates are able to control more than 50% of the voting power in the company, or has the right to receive more than 50% of either the dividends or capital distributions of the company. If an entity has a controlling stake in a loss company in its own right, associates of that entity will also have a controlling stake in the loss company irrespective of whether they independently have such a stake. An entity will have a relevant debt interest in a loss company if: • the entity has a controlling stake in the loss company; and • the loss company owes the entity at least one debt of A$10,000 or more.

[17 640] Calculation of the cost base adjustment Where the conditions set out in [17 630] are satisfied, the reduced cost base of equity in the loss company or debts owed by the loss company will be reduced having regard to the loss company’s realised and unrealised losses: ss 165-115ZA and 165-115ZB. 690

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[17 700]

Formula method If the following conditions are satisfied, the formula method is applied (s 165-115ZB(2), (3)). • All the shares in the loss company are of the same class and have the same market value (see [3 210]). • The equity consists only of shares in the loss company. • The debt consists of a single debt or 2 or more debts of the same kind. Under the formula method the adjustment amount is the amount calculated by applying the following fraction to the loss company’s overall loss. No of shares constituted by the equity immediately before the alteration time

÷

Total no of shares in the loss company immediately before the alteration time

This amount is applied equally among the shares to the maximum extent possible. Any remaining amount is applied to the company’s debt or debts on a proportionate basis.

Non-formula method Where the preconditions for the formula method are not satisfied, or the formula method would produce a result which is not reasonable, the non-formula method is to be applied (eg ATO ID 2006/152). The adjustment amount worked out under the formula method is the amount that is appropriate having regard to (s 165-115ZB(6)): (a) the object of the subdivision and the other factors set out in s 165-115J; (b) the extent of the affected entity’s relevant equity or debt interests in the loss company immediately before the alteration time; (c) when, and under what circumstances, the relevant equity interests or relevant debt interests were acquired by the affected entity; (d) the loss company’s overall loss at the alteration time; (e) the extent to which that overall loss has reduced the market values of the equity or debt. To avoid doubt, if factors other than an overall loss altered the market value of the equity or debt, the extent to which the overall loss reduced that market value is taken to be the extent to which that market value would have been reduced apart from those other factors; and (f) the prevention of double counting in relation to the extent of any adjustments required under this subdivision because of any application of this subdivision to another loss company in which the affected entity has a relevant equity interest or relevant debt interest. The amount so worked out is to be applied in making reductions in an appropriate way. ATO ID 2006/152 gives an example of where the non-formula method may be appropriate.

VALUE SHIFTING [17 700] Overview of value shifting Divisions 723, 725 and 727 ITAA 1997 contain comprehensive value shifting provisions. Division 723 is concerned with direct value shifting by creating a right over an underlying asset which is not a depreciating asset. It is directed at arrangements under which a right is created over an asset in the hands of an associate (eg a licence or a lease) for less than market value to depress the value of the underlying asset. In the absence of this © 2017 THOMSON REUTERS

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anti-avoidance rule, the result would be that the asset could be realised at a lower price than would have been received if the right had not been created. Division 725 provides that value shifting arises where there is a shift in value affecting shares or a shift in value affecting interests in trusts. Furthermore, value shifting arises not only for shifts in value affecting CGT assets, but also trading stock and revenue assets under Div 725. Division 727 contains indirect value shifting provisions that are concerned with value shifted from a company, a fixed trust or a non-fixed trust to another entity, and the resulting affect on equity or loan interests in a company, fixed trust or non-fixed trust. Note that the value shifting provisions generally do not apply to value shifts between members of, or interests in, consolidated and MEC groups as a consequence of the single entity principle: see Chapter 24.

DIVISION 723 – RIGHTS OVER NON-DEPRECIATING ASSETS [17 710] Overview – rights over non-depreciating assets Division 723 applies to reduce a loss that would otherwise be realised when an asset (other than a depreciating asset) is realised at a loss, and the loss is partly or wholly attributable to the owner creating in an associate a right over the asset in circumstances where a tax liability did not arise when the right was either created or realised: s 723-1. Practically, Div 723 will apply to the grant of a lease, licence, option, covenant or other right in the hands of an associate over a non-depreciating asset for less than market value, if the CGT or other income tax provisions do not already tax that shift in value, such as under the market value substitution rule in s 116-30 ITAA 1997. [17 720] Associate The definition of an ‘‘associate’’ for the purposes of Div 723 is as provided by s 318 ITAA 1936. It is defined broadly and incorporates associates of a natural person, a company, a trustee and a partnership and, for business associates, relies heavily on whether the associates are ‘‘sufficiently influenced’’. See [4 220] for further details. [17 730] $50,000 exclusion Section 723-10 contains a de minimis test which means that Div 723 will not apply unless the consideration for the creation of the right is more than $50,000 below its market value (see [3 210]). Note that there is an anti-avoidance provision in s 723-35 which is designed to prevent multiple rights being created to take advantage of the $50,000 threshold. [17 740] Other exclusions from Div 723 There are exceptions to the application of Div 723 where the right which is created is a conservation covenant: see [13 180]. Likewise, an exception applies to a right which is created on the death of the owner under a will, codicil, a court order varying or modifying a will or codicil, as a result of total or partial intestacy, or an order of a court, varying or modifying the application of the law about intestacy. [17 750] Consequences if Div 723 applies Where Div 723 applies, a loss arising on the realisation of an underlying asset is reduced by the lesser of the shortfall on creating the right and the deficit on realisation. The shortfall on creating the right is the market value of the right (see [3 210]) less the capital proceeds. The amount of the loss is itself reduced by any gain that is made for income tax purposes for the realisation of the right before, at or within 4 years after the realisation time for the underlying asset. 692

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[17 810]

The concept of the ‘‘realisation event’’ for the right is determined under Div 977. A realisation event for a CGT asset is simply the time of a CGT event (other than CGT events E4 and G1). A realisation event for trading stock is the disposal of the item or the ending of an income year. For revenue assets, the realisation event is the disposing of, ceasing to own or otherwise realising the asset. EXAMPLE [17 750.10] Ken Pty Ltd owns land with a cost base of $15m and a market value of $20m. Ken Pty Ltd grants a lease over the land to an associate for 5 years for a premium of $1. The market value substitution rule under s 116-30 does not apply to CGT event F1: s 116-25. Rent is not payable for the entire 5-year period of the lease. The existence of the lease reduces the market value of the land from $20m to $13m. Sometime later, Ken Pty Ltd sells the land for $14m to an unrelated third party. But for the operation of Div 723, a capital loss of $1m (ie $15m – $14m) would be made. The effect of Div 723 is to reduce the capital loss of $1m by $6m, being the lesser of the shortfall on creating the lease ($7m) and the deficit on realisation ($6m). As a consequence, the capital loss is reduced to nil. (Note that a capital loss cannot be reduced below nil.)

[17 760] Effect of a roll-over Section 723-105 mirrors the effect of the rules in Div 723 where an asset that would be realised at a loss is instead subject to a replacement asset roll-over, such as under Subdiv 122-A. The effect of s 723-105 is to replicate the tax consequences that would have occurred to the underlying asset in the replacement asset.

DIVISION 725 – DIRECT VALUE SHIFTING [17 800] Conditions for direct value shifting to occur In order for a direct value shift to arise, each of the following conditions must be satisfied: • the target entity must be a company or a trust; • an entity must ‘‘control’’ the target entity during the period in which the value shifting occurs: see [17 830]; • the value shift must be caused by the target entity, the controller, an associate of the controller, or an active participant in the scheme: see [17 840]; • there must be an affected owner of a down interest, or an affected owner of an up interest, or both: see [17 810]; and • the direct value shift must not be reversed within 4 years: see [17 860]. In this regard, the main object of Div 725 (as set out in s 725-45(1)) is: (a) to prevent inappropriate losses from arising on the realisation of equity or loan interests from which value has been shifted to other equity or loan interests in the same entity; and

(b) to prevent inappropriate gains from arising on the realisation of equity or loan interests in the same entity to which the value has been shifted,

so far as those interests are owned by entities involved in the value shift.

[17 810] What is a direct value shift? A direct value shift arises if there is a decrease in the market value of equity or loan interests in a company or trust (referred to as a ‘‘down interest’’), and the decrease is reasonably attributable to one or more things done under a scheme: s 725-145. Some © 2017 THOMSON REUTERS

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examples of a direct value shift are issuing new shares or units at a discount, buying back shares, or redeeming units for less than market value, or changing the voting rights attached to shares or units. A direct value shift also requires there to be an ‘‘up interest’’, which consists of either the equity or loan interests issued at a discount, or the increase in the market value of equity or loan interests in the target entity: s 725-145(2) and (3). See [3 210] for the definition of ‘‘market value’’.

[17 820] Types of interests affected Value shifting occurs in relation to ‘‘equity or loan interests’’ in companies or trusts: s 725-50. Equity or loan interests consist of either ‘‘primary interests’’ or ‘‘secondary interests’’: s 727-520. A ‘‘primary interest’’ is an interest consisting of either a share in a company or an interest in a trust’s income or capital, or any other interest in a trust. Examples would include units in a unit trust, a fixed interest in a trust or an interest in a hybrid trust. ‘‘Secondary interests’’ such as rights or options may also be subject to the direct value shifting measures. Although the position is not free from doubt, the relevant explanatory memorandum expresses the view that a direct value shift should not arise in relation to interests in discretionary trusts because typically those interests cannot decrease or increase in market value (see [3 210] for ‘‘market value’’). A further issue of uncertainty is whether the issue of dividend access shares potentially triggers the operation of the direct value shifting measures. The better view would seem to be that such interests typically do not effect a shift in value where the rights attaching to those shares consist only of a discretionary entitlement to dividends. That is because such interests do not typically have value. [17 830] Controlling entity test A direct value shift only arises if an entity controls the target entity at some time during which the value shifting scheme occurs. There are different control tests for companies, fixed trusts and non-fixed trusts. The definition of a ‘‘fixed trust’’ and a ‘‘non-fixed trust’’ for value shifting purposes is the same as the definition used in the trust loss measures: see [20 350]. Company An entity controls a company if the entity (and its associates) has a 50% interest (either directly or indirectly through interposed entities) in either the voting power, dividends or capital distribution entitlements of the company: s 727-355(1). Control prima facie exists where there is a 40% interest, unless control exists elsewhere: s 727-355(2). A general test of control also exists in s 727-355(3) based on the common law test of control. Fixed trust An entity controls a fixed trust if the entity (and its associates) has the right (either directly or indirectly through interposed entities) to receive at least 40% of any distribution of trust income or trust capital: s 727-360(1). An entity also controls a fixed trust if the entity (or its associates) have the power to obtain the beneficial enjoyment of the trust’s capital or income, or the ability to control the application of the trust’s capital or income, or the trustee is accustomed to act in accordance with the entity’s directions, instructions or wishes, or the entity has the right to remove or appoint a trustee: s 727-360(2). Non-fixed trust An entity controls a non-fixed trust if the entity is simply an object of a discretionary trust (s 727-365(3)), or the entity is a trustee of the trust, or has the power to remove or appoint the trustee, or the trustee is accustomed to act in accordance with the entity’s directions, instructions or wishes: s 727-365(1). An entity also controls a non-fixed trust if the 694

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entity has the power to obtain the beneficial enjoyment of trust income or capital, or can control the application of trust income or capital: s 727-365(2).

[17 840] Cause of direct value shift A direct value shift only arises if the target entity, the controller, an associate of the controller, or an ‘‘active participant’’ in the scheme did something to bring about a decrease in the market value of down interests and an increase in the market value of up interests: s 725-65. These persons are collectively referred to as ‘‘affected owners’’. If the holder of an equity or loan interest is not an affected owner, they will not be affected by a value shift. The theory behind s 725-65 is that a merely passive holder of an interest will not be an ‘‘affected owner’’ and will therefore not have the value of their interest affected by a value shift. Care needs to be taken in determining who is an ‘‘affected owner’’. For example, the definition of an ‘‘active participant’’ in s 725-65(2) is very broad and applies where an entity ‘‘actively participates in’’, or ‘‘directly facilitates’’, the value shifting scheme. According to the explanatory memorandum, ‘‘active participation’’ or ‘‘direct facilitation’’ will arise where the holder of an equity or loan interest exerts their influence over the company or trustee’s decision-making process, or even abstains or fails to exercise a right of veto over a value shifting scheme: see also ATO ID 2004/210.

[17 850] $150,000 exclusion Under s 725-70, a direct value shift does not arise unless the sum of the decreases in the market value of all down interests under the same scheme is at least $150,000 (see [3 210] for ‘‘market value’’). To ensure separate schemes are not entered into to take advantage of the $150,000 threshold, s 725-70(2) contains an anti-avoidance provision.

[17 860] Reversing direct value shifts There is a rather odd provision under which a direct value shift is treated as never having occurred where it is more likely than not that a direct value shift will be reversed within 4 years: s 725-90. An example where this will occur is where a shareholder or unitholder is given special voting rights for a period of less than 4 years duration.

[17 865] Neutral direct value shifts In working out the adjustment that is required where a ‘‘neutral’’ value shift occurs (ie where the total decrease in the market value of down interests held by an entity is matched by an equal increase in the market value of up interests held by the same entity), only interests held by that entity need to be considered: s 725-220. In other cases, it is necessary to determine the value of interests held by other entities involved in the value shift in order to work out the adjustment that is required to be made to interests (as per the rules set out in [17 870]).

[17 870] Consequences of direct value shifting Not all direct value shifts result in a taxing event. As a general guide, where value is shifted between down interests and up interests of the same character, and these interests are owned by the same affected owner, cost base adjustments occur rather than a taxing event. The effect of a cost base adjustment is that the cost base of the down interest is decreased and the cost base of the up interest is increased. An example of where this will occur is where value is shifted between post-CGT interests held by a controller of a company or a trust. The © 2017 THOMSON REUTERS

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table in ss 725-250 to 725-380 (reproduced below) sets out all the circumstances under which a cost base adjustment will happen for shifts in value affecting CGT assets. Item 1

To the extent that the direct value shift is from: down interests that: (a) are owned by you; and (b) have pre-shift gains; and

To:

The decrease or uplift is worked out under:

up interests owned by you that do not give rise to a taxing event generating a gain for you on those down interests under s 725-245

• for the down interests: s 725-365; and • for the up interests: s 725-370.

(c) are post-CGT assets 2

down interests that: (a) are owned by you; and

up interests owned by you that are pre-CGT assets

• for the down interests: s 725-365; and • for the up interests: s 725-370.

(b) have pre-shift gains; and (c) are pre-CGT assets 3

down interests that: (a) are owned by you; and

up interests owned by you that are post-CGT assets

• for the down interests: s 725-365; and • for the up interests: s 725-375.

(b) have pre-shift gains; and (c) are pre-CGT assets 4

5

down interests owned by you that have pre-shift gains

down interests owned by you that have pre-shift losses

up interests owned by you that give rise to a taxing event generating a gain on those down interests under s 725-245

up interests owned by you

• for the down interests: s 725-365; and • for the up interests: s 725-375.

• for the down interests: s 725-380; and • for the up interests: s 725-375.

6 7 8 9 10

down interests owned by you that have pre-shift gains down interests owned by you that have pre-shift losses down interests owned by other affected owners down interests owned by you down interests owned by entities that are not affected owners

up interests owned by other for the down interests: affected owners s 725-365. up interests owned by other for the down interests: affected owners s 725-380. up interests owned by you up interests owned by entities that are not affected owners up interests owned by you

for the up interests: s 725-375. there are no decreases or uplifts. there are no decreases or uplifts.

Note that if an amount is included in the adjustable value of an up interest, the value will not adjust the cost base of the up interest under the direct value shifting rules (eg where a 696

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shareholder makes a payment to another shareholder for an impairment of their share rights, and such expenditure also qualifies for inclusion in the 4th element of the cost base of the paying shareholder’s shares: see [14 060]). Instead of a cost base adjustment, a taxing event will be triggered where the value shift is from: • post-CGT interests to pre-CGT interests; • a down interest owned by the taxpayer to an up interest owned by another affected owner; • a down interest (which is not trading stock or a revenue asset) to an up interest which is trading stock or a revenue asset; or • a down interest, which is either trading stock or a revenue asset to an up interest, which is of a different kind (ie a revenue asset or trading stock or CGT asset). The table in s 725-245 sets out all the circumstances in which a taxing event will occur for shifts in value affecting CGT assets. EXAMPLE [17 870.10] Carissa and Steve are post-CGT unitholders in the Harford Unit Trust. Carissa and Steve each hold one unit with a cost base of $1 per unit and a current market value of $400,000 per unit. The trustee of the Harford Unit Trust issues 2 units to Carissa’s sister, Lisa, for $1 per unit. The issue of the 2 units effects a value shift of one-half of the value of Carissa’s and Steve’s units to Lisa. Because value is shifted from one affected owner to another, a taxing event occurs.

DIVISION 727 – INDIRECT VALUE SHIFTING [17 900] Indirect value shifting In its simplest form, Div 727 is concerned with situations where a non-arm’s length dealing occurs between one entity (referred to as the ‘‘losing entity’’) and another entity (referred to as the ‘‘gaining entity’’), resulting in a reduction in the value of equity or loan interests in the losing entity. The losing entity and the gaining entity must be connected by having the same ultimate controller or, otherwise, a high level of common ownership. In other words, if there is a net shift of value between 2 related entities because of a non-arm’s length dealing, the object of Div 727 (as set out in s 727-1) is: (a) to prevent losses from arising, because of the value shift, on realisation of direct or indirect equity or loan interests in the losing entity; and

(b) within limits, to prevent gains from arising, because of the value shift, on realisation of direct or indirect equity or loan interests in the gaining entity.

However, it does so only for interests that are owned by entities involved in the value shift.

[17 910] Conditions for indirect value shift An indirect value shift requires: • the provision of ‘‘economic benefits’’ between 2 entities either on a non-arm’s length basis, or for less than market value: see [17 930]; © 2017 THOMSON REUTERS

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• a value shift from a company or trust (but not a superannuation fund), which is called a ‘‘losing entity’’, to another entity (which need not be a company or trust), which is called a ‘‘gaining entity’’; and • the losing entity and the gaining entity must have either the same ultimate controller or a high level of common ownership: see [17 940] and [17 950].

[17 920] Exclusions In many cases, the exclusions from the indirect value shifting provisions will make consideration of these measures unnecessary. The exclusions consist of the following. 1. Value shifts between members of consolidated or MEC groups, as a consequence of the single entity principle. 2. Small business entities (see [25 020]) are excluded, including where the indirect value shift happens in the 2007-08 or a later income year pursuant to a scheme entered into before the start of 2007-08 (s 727-470 TPA). 3. Entities whose net assets do not exceed the CGT small business threshold of $6m (see [15 510]) are excluded. 4. An exclusion exists for indirect value shifts which do not exceed $50,000 in value: s 727-215(1). There is an anti-avoidance provision in s 727-215(2) which is designed to prevent indirect value shifting schemes from being split to take advantage of this de minimis exclusion. 5. An exclusion exists for a value shift down a chain of entities, eg where the losing entity is a holding company and the gaining entity a subsidiary: s 727-260 6. An exclusion exists where there is a disposal of a CGT asset for not less than the greater of the asset’s cost base, its cost and its market value: s 727-220. 7. An exclusion exists where the economic benefits consist of services provided by the losing entity to the gaining entity for a price of at least the direct cost to the losing entity of providing the services: s 727-230. 8. An exclusion exists where services are provided by the gaining entity to the losing entity for no more than a commercially realistic price. The market value (see [3 210]) of the economic benefits provided by the losing entity cannot be more than the total present value of the direct costs and indirect costs of providing the service together with a commercially realistic mark-up. In the absence of a specific mark-up based on industry practice, a standard mark-up of 10% is considered acceptable: s 727-235. As a transitional measure, certain indirect value shifts involving the transition to the consolidation regime (see Chapter 24) were excluded from the operation of Div 727. These relate to the provision of services where the relevant value shifts occurred before the beginning of a losing entity’s 2003-04 income year.

[17 930] Economic benefits Indirect value shifting does not arise unless ‘‘economic benefits’’ are provided on a non-arm’s length basis, or for less than their market value. Section 727-155 contains examples of where ‘‘economic benefits’’ are provided. The provision of an economic benefit can take the form of either a payment, the provision of an asset, the performance of services, the creation of an asset, the incurrence or termination of a liability, or anything which increases the market value of an asset held by another entity. [17 940] Ultimate controller tests In order for an indirect value shift to occur, the losing entity and the gaining entity must have either the same ultimate controller or be subject to a high degree of common ownership 698

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(in the case of closely held entities). The definition of an ‘‘ultimate controller’’ is set out in detail in ss 727-350 to 727-375 and there are different tests for each type of entity.

Companies An entity controls a company if the entity, or the entity and its associates, between them can exercise, or can control the exercise of at least 50% of the voting power, dividends or capital distributions of the company (directly or indirectly through interposed entities). This test is complemented by a presumed control test in s 727-355(2) under which the threshold is reduced to 40% of voting power, dividends or distribution rights. However, where an entity has an interest of between 40% and 50% in either the voting power, dividends or distribution rights of a company, that entity will not be treated as the controller if in fact control exists elsewhere. Section 727-355(3) also contains an actual control test based on the common law test of control. Fixed trusts Section 727-360 contains the control test for a fixed trust. The definition of a ‘‘fixed trust’’ is the same as under the trust loss measures: see [20 350]. Under s 727-360(1), control exists in relation to a fixed trust if the entity, or the entity and its associates, has the right to receive (directly or indirectly through interposed entities) at least 40% of any distribution of trust income or trust capital to beneficiaries of the trust. Section 727-360(2) also contains other tests for control of a fixed trust. In effect, control will exist if an entity, or an entity and its associates, have the ability to: • obtain the beneficial enjoyment of the trust’s capital or income; or • control the application of the trust’s capital or income in any manner. Moreover, there are 2 tests of control for a fixed trust in s 727-360(2) which focus on the ability to control the trustee of the trust. So for example, if the entity, or the entity and its associates, have the ability to remove or appoint a trustee of the trust, or the trustee of the trust is accustomed, or is under an obligation (whether formally or informally) or might reasonably be expected, to act in accordance with the entity’s directions, instructions or wishes, then control exists.

Non-fixed trusts Section 727-365 sets out the control tests for non-fixed trusts. A ‘‘non-fixed trust’’ is simply a trust that is not a fixed trust: see [20 350]. An entity controls a non-fixed trust if: • the entity (or its associate) is a trustee of the trust; • the entity (or the entity and its associates) can remove or appoint the trustee, or one or more of the trustees (ie the appointor); • a trustee is accustomed to act, is under an obligation (whether formally or informally) to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of the entity or an associate of the entity, or 2 or more entities (one of which is the entity or its associate). Section 727-365(2) sets out a further test of control. Under this test, an entity (or an entity and its associates between them) controls a non-fixed trust if they have the power to obtain the beneficial enjoyment of trust income or capital, or have the ability to control the application of trust income or capital. Section 727-365(3) sets out the broadest test of control of a non-fixed trust. Under s 727-365(3) an entity controls a non-fixed trust if the entity, or any of its associates, either: • ‘‘can benefit under trust’’ otherwise than because of a fixed entitlement to a share of the income or capital of the trust; or © 2017 THOMSON REUTERS

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• have the right to receive (either directly or indirectly through interposed entities) at least 40% of any distribution of trust income, or trust capital. Although this provision is drafted in somewhat ambiguous language, the apparent intent is to treat all objects of a discretionary trust as being in a position to ‘‘control’’ the trust. This is certainly the view expressed in para 11.111 of the explanatory memorandum.

[17 950] Common ownership tests The common ownership test is an alternative test which is really only relevant if the ultimate controller test in s 727-105 is not satisfied. Under s 727-110, a value shift will arise if a losing entity and a gaining entity have less than 300 members each, and the losing entity and the gaining entity have a ‘‘commonownership nexus’’. A common-ownership nexus will exist if 80% or more of the interests in both entities (after tracing through interposed entities) is subject to common ownership. Section 727-110(2) contains a special exception to the 300 member test where up to 20 individuals between them own shares (for companies) or fixed interests (for trusts) which carry with them rights to at least 75% of the income or capital or voting power of the company or trust. Non-fixed trusts are also deemed to have less than 300 members: s 727-110(3). [17 960] Anti-overlap provisions In practice, one of the most important provisions in Div 727 is s 727-250. This provision outlines the interaction between the indirect value shifting provisions and other taxing provisions, such as CGT events E4 (see [13 230]) and CGT event G1 (see [13 400]). In essence, s 727-250 provides that an indirect value shift is disregarded if the economic benefits provided consist entirely of a distribution, or right to a distribution, by a losing entity to a gaining entity which is taken into account for tax purposes in any of the following ways. • The amount of the distribution is included in the gaining entity’s assessable income or exempt income. • The distribution results in a change to the cost base or reduced cost base of the shares or interest in the trust held by the gaining entity in the losing entity, such as under CGT event G1 or E4. • The distribution is taken into account under s 116-20 in working out the capital proceeds of a CGT event, or in working out a capital gain under either CGT event G1 or E4, or in working out whether a gain or loss arises on the realisation of primary equity interests the gaining entity held in the losing entity as revenue assets or trading stock. The practical effect of s 727-250 is that the indirect value shifting provisions do not generally arise where another taxing provision already applies. For example, a distribution by a company or trust to a shareholder or unitholder may technically cause an indirect value shift but if such a distribution is brought to tax by another provision, Div 727 will not apply.

[17 970] Consequences of indirect value shift Unlike the direct value shifting provisions, the indirect value shifting provisions do not, where they apply, trigger a taxing event. Instead, the effect of an indirect value shift is to trigger adjustments to the cost bases of interests in the losing entity and the gaining entity. There are 2 methods of making adjustments to cost bases. The first method is the adjustable value method under which an adjustment to the cost base is made at the time of the value shift. The realisation method (more commonly used) requires an adjustment to a loss only at the time the interest in the entity is realised. The realisation method applies unless a choice is made to use the adjustable value method. The choice must be made within 3 years from the time that an affected interest in a losing or gaining entity is first realised. 700

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If the realisation method is used, there are 2 further exclusions which apply: • where the value shift is less than $500,000 and it occurs more than 4 years before the affected interest is realised: s 727-610(2)(d); and • where the economic benefits provided by the losing entity to the gaining entity comprise at least 95% services. However, this exclusion is subject to several disentitling conditions, such as: – there must have been an adjustment to an amount included in an income tax return resulting in a variation of at least $100,000: s 727-705; – where an ongoing or recent service arrangement reduces the value of the losing entity by at least $100,000, subject to a sliding scale that increases up to a maximum $500,000 for primary interests with a value of greater than $10m: s 727-710; – where the aggregate of service arrangements reduces the value of a group service provider by at least $500,000: s 727-715; and – where an abnormal service arrangement reduces the value of a losing entity that is not a group service provider by at least $500,000: s 727-720. EXAMPLE [17 970.10] A group of companies is structured as follows. Bart Co is a wholly owned subsidiary of Homer Co. Lisa Co is a wholly owned subsidiary of Marge Co. Both Homer Co and Marge Co are in turn wholly owned subsidiaries of Grandpa Co. Bart Co has a commercial property with a market value of $1m which it transfers to Lisa Co for $100,000. The transfer of the property effects a value shift of $900,000 from Bart Co to Lisa Co.

Indirect value shifting is not concerned with the effect on Bart Co or Lisa Co of the shift in value. The existing market value substitution rules in s 116-25 ITAA 1997 will apply so that Bart Co is deemed to have received market value. Likewise, s 112-20 will apply to give Lisa Co a market value cost base. Indirect value shifting is concerned with the reduction in value of Homer Co’s shares in Bart Co and the corresponding increase in Marge Co’s shares in Lisa Co, with the result that a cost base adjustment will occur to reflect the reduction in value of Homer Co’s shares in Bart Co and the corresponding increase in value of Marge Co’s shares in Lisa Co. Cost base adjustments will be made under either the realisation method or the adjustment value method (if a choice is made).

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INTRODUCTION Overview ....................................................................................................................... [18 010] RESIDENTS Residents taxable on overseas assets ............................................................................ [18 020] Relief for shares in foreign companies with active assets .......................................... [18 030] FOREIGN RESIDENTS Foreign residents subject to CGT on taxable Australian property .............................. [18 100] Indirect interests in real property ................................................................................. [18 105] Trusts and managed funds ............................................................................................ [18 110] Business assets of permanent establishments .............................................................. [18 120] Foreign residents and roll-overs ................................................................................... [18 130] Temporary residents treated as foreign residents ......................................................... [18 140] CGT withholding on disposals of property by foreign residents ................................ [18 145] CHANGE OF RESIDENCE Change of residence ...................................................................................................... Individual or company ceasing to be a resident .......................................................... Trust ceasing to be a resident ....................................................................................... Individual, company or trust becoming a resident ...................................................... Controlled foreign companies become resident ...........................................................

[18 [18 [18 [18 [18

150] 160] 170] 180] 190]

DOUBLE TAX AGREEMENTS Double tax agreements and CGT – introduction ......................................................... [18 No right to tax capital gains under pre-CGT tax treaties ............................................ [18 Business profits article .................................................................................................. [18 Alienation of property article ....................................................................................... [18

250] 260] 270] 280]

INTRODUCTION [18 010] Overview This chapter examines the international aspects of CGT. In particular it explains the following: • an Australian resident’s liability for CGT on assets on a worldwide basis (plus exemptions and avoidance issues): see [18 020]-[18 030]; • a foreign resident’s liability for CGT on “taxable Australian property”, interests in fixed trusts and assets used in a permanent establishment: see [18 100]-[18 130]; • the CGT consequences of a change in residency: see [18 150]-[18 190]; and • the impact of Double Tax Agreements on Australia’s right to tax capital gains of foreign residents: see [18 250]-[18 280].

RESIDENTS [18 020] Residents taxable on overseas assets Residents of Australia for tax purposes (see [2 020]) are assessable on their worldwide capital gains. However, a foreign income tax offset may be available for any foreign tax paid 702

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on a foreign gain: see [34 200]. Capital gains made by Australian residents under the CFC provisions are also brought into account, subject to a range of exceptions and exemptions: see [34 120]. However, certain capital gains made by Australian residents on assets owned in foreign jurisdictions will be exempt from tax in Australia. These include: • gains on depreciating assets, provided the asset is used 100% for a taxable purpose and capital allowance deductions were claimed in respect of the asset: see [15 080]. Otherwise CGT event K7 applies (subject to certain exceptions) – if the asset was used partially for a taxable purpose and partially for a non-taxable purpose, the capital gain is effectively apportioned: see [13 700]; and • gains derived by an Australian resident company on an asset that is not taxable Australian property (see [18 100]) and which is used wholly or mainly for the purpose of producing foreign income in carrying on a business at or through a PE of the company in a foreign country (this exemption does not apply if the gain is from a tainted asset and is eligible designated concession income in relation to a listed country): s 23AH (see [34 120]). Note that the provisions defining ‘‘Australia’’ for tax purposes have been rewritten, although generally there were no policy changes: see [1 130]. In some cases, gains may be exempt from tax because of a double tax agreement (DTA): see [18 270].

[18 030] Relief for shares in foreign companies with active assets Under Subdiv 768-G ITAA 1997, the capital gain or loss made by an Australian company or its CFC from certain CGT events happening to shares owned in a foreign company is reduced to the extent that the foreign company has underlying ‘‘active business’’ assets. Attributable income arising from the same CGT events happening to shares owned by a CFC are also reduced on the same basis. To qualify for the reduction, a company must have held at least a 10% direct voting percentage in the foreign company for a continuous period of at least 12 months in the 2 years before the CGT event. The relevant capital gain or loss will be reduced by the ‘‘active foreign business asset percentage’’ for the foreign company. Broadly, this will be the value of active foreign business assets held by the company as a percentage of the value of all its assets. Active foreign business assets include an asset that is used by the company in the course of carrying on a business, goodwill and shares (which allows for the active foreign business asset percentage of a subsidiary of the foreign company to contribute to the percentage of its parent). However, the following are excluded: taxable Australian property (see [18 100]); assets used to generate passive investment income; financial instruments; a membership interest in a resident company or trust; life insurance policies; and cash. See also Determination TD 2008/23.

FOREIGN RESIDENTS [18 100] Foreign residents subject to CGT on ‘‘taxable Australian property’’ Under the rules in Div 855 ITAA 1997, a foreign resident is only subject to CGT in Australia on ‘‘taxable Australian property’’. More specifically, s 855-10 provides that a foreign resident (or the trustee of a foreign trust) disregards a capital gain or capital loss from a CGT event if the event happens in relation to a CGT asset that is not taxable Australian property. (Note also the CGT withholding rules for foreign residents in relation to certain property disposals in Australia: see [18 145].) © 2017 THOMSON REUTERS

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‘‘Taxable Australian property’’ is defined as (a) real property situated in Australia (which includes a leasehold interest in land: s 855-20(9) and Determination TD 2009/18) and (b) assets used in carrying on a business through a ‘‘permanent establishment’’ in Australia: ss 855-15, 855-20. Note that the meaning of ‘‘permanent establishment’’ (as defined for the purposes of s 23AH ITAA 1936: see [34 120]) now takes into account an entity’s status as a resident of a country with which Australia has an international tax agreement in determining whether it has a permanent establishment in Australia. Importantly, ‘‘taxable Australian property’’ also includes (ss 855-15, 855-20): • ‘‘indirect Australian real property interests’’ (see [18 105]); • options and rights to acquire (i) Australian real property, (ii) assets used in carrying on a business through a PE in Australia or (iii) ‘‘indirect Australian real property interests’’; • mining, quarrying or prospecting rights if the minerals, petroleum or quarry materials are situated in Australia (but not ‘‘mining information’’, which is not a CGT asset: see ATO ID 2012/13 and [12 170]); and • assets covered by CGT event I1 (ceasing to be a resident) if the taxpayer chooses to defer the CGT liability under s 104-165 (see also [18 160]) – but not options and rights to acquire such assets. The general exception contained in CGT events for assets acquired before 20 September 1985 means that foreign residents are not subject to CGT in relation to pre-CGT taxable Australian property. Likewise, other exceptions in relevant CGT events may be applicable. Note that the CGT discount is not available (or is adjusted) for foreign residents in respect of capital gains that accrue after 7.30pm AEST on 8 May 2012: see [14 390].

Relevant CGT events In determining if a CGT event happens to ‘‘taxable Australian property’’, the event will include the following CGT events that happen to the underlying CGT asset (s 855-10(2)): • CGT event D1 (creating an easement over land in Australia): see [13 150]; • CGT event D2 (granting an option over land in Australia): see [13 160]; • CGT event F1 (granting a lease over land in Australia): see [13 300]; and • CGT event J1 (company ceasing to be a member of wholly-owned group): see [13 550]. Note that a capital gain that a foreign resident beneficiary of an Australian resident non-fixed trust makes because of the operation of s 115-215(3) (see [17 060]) is not disregarded under Div 855, as the capital gain does not arise from a CGT event: see ATO ID 2007/60.

[18 105] Indirect interests in real property A foreign resident will also be subject to CGT (on an assessment basis) on the disposal of ‘‘indirect interests in Australian real property’’ held through another entity (eg a company or trust) or a chain of interposed entities if relevant conditions are met. Broadly, an ‘‘indirect Australian real property interest’’ will exist if (s 855-25(1)): (a) a foreign resident has a 10% or more interest in the ‘‘test entity’’ (the ‘‘non-portfolio interest test’’); and (b) more than 50% of the market value of the entity’s assets is attributable to Australian real property (the ‘‘principal asset’’ test). Note that rights or options over such interests are excluded: s 855-25(2). Non-portfolio test A ‘‘membership interest’’ held by a foreign resident in the test entity will pass the ‘‘non-portfolio interest test’’ if the sum of the ‘‘direct participation interests’’ held by the 704

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[18 105]

foreign resident and its ‘‘associates’’ in the test entity is 10% or more (‘‘associate’’ is defined in s 318 ITAA 1936: see [4 220]): s 960-195. If the test entity is a company (other than a company in the capacity of a trustee), the ‘‘direct participation interest’’ is the ‘‘direct control interest’’ it ‘‘holds’’ within the meaning of s 318 (see [34 370]): s 960-190(1). The non-portfolio interest test will be satisfied if the interest of the foreign resident passes the test either at the time of the CGT event or throughout a 12-month period occurring within 24 months before the CGT event: s 855-25(1)(a). If a foreign resident and their foreign resident associates cumulatively hold a direct participation interest in an Australian resident company exceeding 10% for 12 months, the test will be satisfied even if their individual holdings do not span those 12 months: ATO ID 2008/46 and ATO ID 2010/88. The non-portfolio interest test is an integrity measure to counter staggered sell-downs. (See also Taxpayer Alert TA 2008/19.)

Principal asset test The ‘‘principal asset’’ test will be satisfied if the sum of market values of the test entity’s assets that are taxable Australian real property (TARP) exceeds the market value of the test entity’s assets that are not attributable to TARP: s 855-30. Note that in FCT v Resource Capital Fund III LP (2014) 98 ATR 136, the Full Federal Court ruled that, where there were a number of TARP assets in question, the assets should be valued on the basis of ‘‘an assumed simultaneous sale of the assets to the same hypothetical purchaser, not as stand-alone separate sales’’. In FCT v AP Energy Investments Pty Ltd [2016] FCA 577, the Federal Court accepted the AAT’s valuation of ‘‘mining information’’ on the basis that it did not conflict with the Full Court’s approach in the Resource Capital case and that it was in accordance with established valuation tests. The assets of the test entity are examined to determine whether the assets are TARP or are attributable to TARP through membership interests held in other entities. TARP and non-TARP assets that are not membership interests in other entities are valued at market value: s 855-30(2). If an asset of an entity is a membership interest in another entity that is tested, it will be necessary to divide that membership interest into TARP and non-TARP by reference to the assets held in the other entity: s 855-30(3). These are valued at market value in accordance with the rules in s 855-30(4). If the other entity is not tested, the membership interest is treated as non-TARP. Note that the Tax Office considers that an ‘‘asset’’ of an entity for the purposes of the principal asset test is anything recognised in commerce and business as having economic value to the entity at the time of the relevant CGT event for which a purchaser of the entity’s membership interests would be willing to pay: see ATO ID 2012/14. EXAMPLE [18 105.10] Forco owns 100% of the shares in Austco, which owns land in Australia (TARP) valued at $1.5m and land in New Zealand (non-TARP) valued at $0.5m. As the value of the TARP is greater than the non-TARP, the shares Forco holds in Austco pass the principal asset test.

An integrity rule ensures that the value of assets acquired for a purpose that includes ensuring that the ‘‘principal asset’’ test would not be passed are to be disregarded for the purposes of the test: s 855-35(5). This would include the injection of liquid assets at the testing time to avoid passing the test. (See also Taxpayer Alert TA 2008/20.) Note also that where the assets of 2 or more entities are included in the principal asset test, the market value of new assets that are not TARP (for example, a financial asset or a new interest in a pre-existing asset of another entity) arising from an arrangement involving those entities will be disregarded. This ensures that assets cannot in effect be counted multiple times. Where the entities involved in the creation of the new non-TARP asset are members of © 2017 THOMSON REUTERS

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the same tax consolidated group, or MEC group, this rule applies to CGT events with effect from 7.30pm on 14 May 2013 AEST. For all other entities, the rule applies to CGT events happening on or after 13 May 2014. The proposal (in the 2013-14 Budget) to value mining, quarrying or prospecting information and goodwill together with the mining rights to which they relate has been deferred.

Other For the purpose of calculating any capital gain or loss, the cost base of an ‘‘indirect Australian property interest’’ that was not previously subject to Australian CGT (ie it was not previously an asset with a ‘‘necessary connection to Australia’’) will be the market value of the interest on 10 May 2005. [18 110] Trusts and managed funds The rules for taxing capital gains and losses of foreign residents that hold interests in certain fixed trusts (eg managed investment funds) are also contained in Subdiv 855-A. A capital gain made by a foreign resident in respect of their interest in a fixed trust will be disregarded under s 855-40 if (a) the gain is attributable to a CGT event happening to a CGT asset (whether of that trust or another fixed trust in which the first-mentioned trust has a direct or indirect interest) and (b) the asset is not taxable Australian property for the first-mentioned trust. Alternatively, if the CGT asset is an interest in a fixed trust, the gain will be disregarded if at least 90% (by market value) of the CGT assets of the first-mentioned trust, or at least 90% (by market value) of the underlying CGT assets if that trust has an interest (direct or indirect) in another fixed trust, are not Australian taxable property at the time of the relevant CGT event: s 855-40. CGT event I2 (trust ceasing to be a resident: see [18 160]) is considered to be a CGT event happening to a CGT asset for the purposes of s 855-40: see ATO ID 2010/102. Note that a trustee of a fixed trust is not liable to pay tax to the extent that a capital gain is disregarded for a beneficiary under s 855-40. However, the trustee of a trust is liable to pay tax on a non-resident trustee beneficiary’s share of the net income of the trust attributable to an Australian source (including any capital gain): see [23 600] and following. [18 120] Business assets of permanent establishments A foreign resident will also be subject to CGT on the assets of an Australian permanent establishment (PE) that have been used at any time in carrying on a business through that PE: s 855-35(1). This includes options and rights to acquire such assets. However, the extent of any capital gain or loss will be determined by reference to the period of its use as a business asset of the PE: s 855-35(2). For these purposes, a PE takes its meaning from s 23AH ITAA 1936. Accordingly, if a DTA applies, the definition in that DTA will apply. Otherwise, the definition of PE in s 6(1) ITAA 1936 will apply (see [35 280]). [18 130] Foreign residents and roll-overs In general, roll-over relief is also available to a foreign resident provided the relevant asset is ‘‘taxable Australian property’’ before and/or after the roll-over, as the case may be. See Chapter 16 for further details. [18 140] Temporary residents treated as foreign residents Temporary residents who are Australian residents are treated the same as foreign residents for CGT purposes: see [18 100]-[18 130]. For the meaning of ‘‘temporary resident’’, see [2 100]. (Note that ATO ID 2009/88 states that the exemption does not extend to a temporary resident acting in a trustee capacity.) In addition, the rules in s 855-45 ITAA 1997 that apply when a foreign resident becomes an Australian resident (see [18 180]) do not apply if, immediately after becoming an Australian resident, the person is a temporary resident: s 768-950. The CGT rules that apply when a temporary resident ceases to be a temporary resident and becomes an Australian resident, are discussed at [18 160]. 706

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[18 145]

[18 145] CGT withholding on disposals of property by foreign residents A 10% non-final withholding obligation is imposed (under Subdiv 14-D in Sch 1 TAA) where a certain type of Australian CGT asset is acquired from a relevant foreign resident on or after 1 July 2016. The withholding obligation is imposed on the purchaser. Relevant assets subject to this withholding obligation are (s 14-200): ‘‘taxable Australian real property’’ (TARP); an indirect Australian real property interest (where the vendor has not made a declaration that the membership interests are not indirect Australian real property interests); or an option or right to acquire such property or such an interest. The vendor is a ‘‘relevant foreign resident’’ if the purchaser knows, or has reason to believe, the vendor is a foreign resident, or in certain specified situations where the purchaser does not reasonably believe the vendor is an Australian resident (eg the vendor has an address outside Australia): s 14-210. Note that if the purchaser acquires a relevant asset from multiple vendors, the obligation to pay an amount may arise if any of the vendors is a relevant foreign resident. The withholding obligation requires the purchaser to pay 10% of the first element of the cost base (usually the purchase price) to the Commissioner less, if the asset is acquired as a result of exercising an option, any amount paid for the option (see Law Companion Guidelines LCG 2016/6 and 2016/7): s 14-200(3). The amount must be paid on or before the day the purchaser becomes the asset’s owner (usually the settlement date): s 14-200(2). Paying an amount to the Commissioner under these rules discharges the purchaser from all liability to pay that amount to the vendor (thus effectively allowing the purchaser to withhold the required amount from the purchase price): s 16-20(2) Sch 1 TAA. The foreign resident may be entitled to a credit for the amount paid to the Commissioner when an assessment is made: see [50 400]. The Commissioner has the power under s 14-235 to vary the amount to be withheld upon application by the purchaser, the vendor or an entity owed a debt by the vendor (see Law Companion Guidelines LCG 2016/5). There is no withholding obligation in any of the following situations (s 14-215): • a transaction involving TARP valued at less than $2 million (ie including residential premises, commercial property, vacant land, leasehold, easements) or certain and indirect Australian real property interests valued at less than $2 million; • a transaction that is conducted through an approved stock exchange or a crossing system (see Sch 5 to the ITR for approved stock exchanges); • an arrangement that is already subject to an existing withholding obligation; • a securities lending arrangement; or • a transaction involving vendors who are subject to formal insolvency or bankruptcy proceedings. Note that where there are multiple purchasers, the $2 million de minimis threshold applies to the market value of the sum of all of the purchasers’ interests: s 14-215(2). There is also no withholding obligation in the following circumstances: • in the case of TARP and certain indirect Australian real property interests – where the vendor obtains before settlement a clearance certificate from the Commissioner (ss 14-210(2), 14-220). If the vendor is not entitled to a clearance certificate, but believes a withholding of 10% is inappropriate, the vendor can apply for a variation; • in the case of other types of property – where the vendor has made a declaration that they are an Australian resident for income tax purposes (ss 14-210(3), 14-225); and • in the case of a membership interest (eg a share or trust interest) – where the vendor has made a declaration that the interest is not an indirect Australian real property interest (ss 14-201(3), 14-225). © 2017 THOMSON REUTERS

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Note there are administrative penalties for making a false or misleading declaration: s 14-230. The Commissioner has also registered a range of instruments dealing with withholding variations in the following situations: • ‘‘acquisitions from multiple entities’’ – to provide withholding only from foreign vendors who have not provided a clearance certificate, notice of variation, etc in respect of their interest in a relevant CGT asset when there are multiple owners (with effect from 1 July 2016); • ‘‘deceased estates and LPRs’’ – no withholding is required where, as a result of the death of an individual, the LPR is taken to have acquired, or a beneficiary obtains ownership of, the relevant CGT asset or a surviving joint tenant acquires the deceased’s joint interest in the relevant CGT asset (with effect from 7 September 2016); and • ‘‘marriage or relationship breakdowns’’ – no withholding is required where, under relevant laws relating to breakdowns of relationships between spouses, a transferee acquires ownership of a relevant CGT asset and the rollover under Subdiv 126-A (see [16 300]) applies (with effect from 26 October 2016). EXAMPLE [18 145.10] Maggie (an Australian resident), Khushi (an Australian resident) and Mia (a foreign resident) jointly own property that is TARP. Their interests are: Maggie – 50%; Khushi – 25%; and Mia – 25%. They are selling the property to Stuart for $6m. Maggie and Khushi have provided valid clearance certificates to Stuart. Stuart is required to withhold from the purchase price 10% of the amount attributable to Mia ($6m × 25%), namely $150,000 (10% × $1.5m).

Relevant variation and other forms are available on the Tax Office website.

CHANGE OF RESIDENCE [18 150] Change of residence To prevent the avoidance of CGT by changes in residence, CGT events I1 and I2 apply if a taxpayer ceases to be an Australian resident: see [18 160] and [18 170]. On the other hand, Subdiv 855-B deals with a foreign resident becoming an Australian resident, to bring their foreign assets into the Australian CGT net: see [18 180]. [18 160] Individual or company ceasing to be a resident CGT event I1 happens if an individual or company stops being an Australian resident: s 104-160(1). It will apply to all CGT assets that the taxpayer owns, except ‘‘taxable Australian real property’’ and the business assets of a permanent establishment (including options and rights to acquire such assets) as these remain subject to CGT regardless of the taxpayer’s residency status (see [18 100]): s 104-160(3). The event happens when the individual or company ceases to be a resident: s 104-160(2). Importantly, CGT event I1 will also apply to CGT assets that are indirect Australian real property interests: see [18 100]. However, an individual may elect to ignore the capital gain or capital loss consequences of the event in relation to CGT assets otherwise affected by CGT event I1, including ‘‘indirect Australian real property interests’’. In that case, each of those assets will be ‘‘deemed’’ to be taxable Australian property assets until either a CGT event happens in relation to the asset resulting in the taxpayer ceasing to own the asset or the individual again becomes an Australian resident: s 104-165(2) and (3). See [18 100]. However, the election must be made in respect of all the taxpayer’s assets that are affected by CGT event I1. 708

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[18 170]

If the non-resident again becomes a resident of Australia, those assets for which an election has been made are taken to have been acquired at their original date of acquisition and not at the time of becoming a resident (as otherwise applies under s 855-45 on becoming a resident: see [18 180]): see ATO ID 2009/148. If the individual is a resident of the US or UK when the asset is sold, there will be no Australian CGT liability as the US and UK DTAs give exclusive taxing rights to those countries in this case: see ATO ID 2006/262 and [18 250].

Exceptions CGT event I1 does not apply to: • assets acquired before 20 September 1985: s 104-160(5); • taxable Australian real property and the business assets of a permanent establishment, and options and rights over such assets (see [18 100]): s 104-160(3); and • a temporary resident (see [2 100]) who becomes a foreign resident: Note 1A to 104-160(6).

Capital gain or capital loss Capital gains or capital losses need to be worked out separately for every CGT asset owned immediately before the taxpayer ceases to be a resident: s 104-160(3). A capital gain arises in respect of relevant assets if the market value of the asset when the individual or company ceases to be a resident is more than the asset’s cost base: s 104-160(4). A capital loss arises in respect of relevant assets if the market value of the asset when the individual or company ceases to be a resident is less than the asset’s reduced cost base: s 104-160(4). Cost base and reduced cost base are discussed at [14 020]-[14 200]. Market value is considered at [3 210]. See also the Tax Office publication Market valuation for tax purposes. Temporary resident becomes Australian resident If a ‘‘temporary resident’’ (see [2 100]) ceases to be a temporary resident but remains an Australian resident, the following rules apply to each CGT asset (acquired on or after 20 September 1985) owned by that person just before he or she ceased to be a temporary resident and which is not ‘‘taxable Australian property’’ (see [18 100]) (s 768-955): • the first element of the cost base and reduced cost base of the asset is its market value at that time; • the CGT provisions apply to the asset as if the taxpayer had acquired it at the time he or she ceased to be a temporary resident. However, this rule does not apply to an employee share scheme (ESS) interest if Subdiv 83A-C applies to the interest and the ESS deferred taxing point for the interest has not yet occurred (see [4 190] and [4 225]) or if the ESS provisions about start-ups apply (see [4 180]): s 768-955(4). This applies to ESS interests acquired from 1 July 2009.

[18 170] Trust ceasing to be a resident CGT event I2 applies to trusts in the same manner that CGT event I1 applies to individuals and companies. It happens if a trust stops being a ‘‘resident trust for CGT purposes’’ (as defined in s 995-1(1)): s 104-170(1). CGT event I2 will also apply to CGT assets that are indirect Australian real property interests: see [18 100]. A unit trust is a resident trust for CGT purposes for an income year if, at any time during that income year, any property of the trust is situated in Australia or it carries on business in Australia. In addition, either the trust’s central management and control must be in Australia or Australian residents must hold more than 50% of the beneficial interests in its income or property: s 995-1(1). A non-unit trust is a resident trust for CGT purposes for an income year © 2017 THOMSON REUTERS

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if, at any time during that income year, the trustee is an Australian resident or the trust’s central management and control is in Australia: s 995-1(1). Further guidance on trusts and residency changes is provided by Determination TD 1999/83.

Exceptions CGT event I2 does apply to assets acquired before 20 September 1985 (s 104-170(5)) or to taxable Australian real property and the business assets of a permanent establishment, including options and rights to acquire such assets (see [18 120]): s 104-70(3). Time of event The event happens when the trust ceases to be a resident trust for CGT purposes: s 104-170(2). Capital gain or capital loss Capital gains or capital losses need to be worked out separately for every CGT asset owned immediately before the trust ceasing to be a resident trust for CGT purposes. A capital gain arises in respect of each relevant asset if the market value of the asset when the trust ceases to be a resident trust for CGT purposes is more than the asset’s cost base: s 104-170(4). A capital loss arises in respect of each relevant asset if the market value of the asset when the trust ceases to be a resident trust for CGT purposes is less than the asset’s reduced cost base: s 104-170(4). Cost base and reduced cost base are discussed at [14 020]-[14 200]. [18 180] Individual, company or trust becoming a resident When an individual, a company or a trust becomes a resident, they are deemed to have acquired all their assets, other than ‘‘taxable Australian property’’ (see [18 100]) and assets acquired before 20 September 1985, at the time of becoming a resident: s 855-45(3). Further, they are deemed to have acquired these assets for their market value at the time they became a resident: s 855-50. As a result, any capital gain that accrued before becoming an Australian resident is quarantined from Australian CGT. However, these rules do not apply to: • controlled foreign companies: see [18 190]; • controlled foreign trusts (in terms of s 342 ITAA 1936): s 855-50(4); • an employee share scheme (ESS) interest acquired on or after 1 July 2009 if Subdiv 83A-C applies to the interest and the ESS deferred taxing point for the interest has not yet occurred (see [4 190]) or if the ESS provisions about start-ups (see [4 180]) apply; and • if a foreign resident becomes a ‘‘temporary resident’’ (see [15 190]). See also [18 160] for the effect of ceasing to be a temporary residency. Note that the CGT discount is not available if an asset that is not ‘‘taxable Australian property’’ is sold within 12 months of the taxpayer becoming a resident: see [14 390].

[18 190] Controlled foreign companies become resident Section 855-55 deals with the situation where a controlled foreign company (CFC) or a controlled foreign trust becomes an Australian resident (see Chapter 38). In effect, it provides that the rules in s 855-45 for an individual or a company becoming a resident (see [18 180]) do not apply to a CFC that becomes a resident. Instead, there is continuity of its treatment for CGT purposes (ie the assets will be treated as having a cost base equal to the greater of its market value or its actual cost as at 30 June 1990). This provision is necessary because, unlike the situation with other foreign resident companies and trusts, CFCs are treated as residents in calculating their attributable income. This means that the CGT provisions would have applied to its assets other than ‘‘taxable 710

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[18 270]

Australian property’’ (see [18 100]) in any event. Accordingly, it is not appropriate to protect accrued capital gains from the application of CGT prior to the CFC becoming an Australian resident. Section 116-95 deals with the situation where a CFC, while not becoming an Australian resident, nevertheless changes residence from one listed country to another listed country or from an unlisted to a listed country. It is also necessary to specifically deal with the situation of resident companies and trusts that become foreign residents and are controlled foreign companies (or trusts) after the change in residence. In addition, Australian taxation of capital gains occurs on the deemed disposal of tainted assets of a CFC if that CFC ceases to be a member of a group that has previously received CGT roll-over relief in respect of the tainted asset. Note also that the CGT rules are modified in relation to calculating the attributable income of a CFC: see [34 380].

DOUBLE TAX AGREEMENTS [18 250] Double tax agreements and CGT – introduction Except for the more recently negotiated Double Tax Agreements, Australia’s older DTAs generally do not make special provision for capital gains (note that many of those older treaties are being renegotiated). However, a number of those DTAs contain articles dealing with gains from the alienation of real property and interests in land-owning companies and business profits, but the rules in the OECD Model Convention are more comprehensive (eg compare Art 13(3) of the Italian and Swiss agreements). Since the DTAs generally override the application of domestic laws, it is important to know the extent to which Australia’s DTAs apply to capital gains. [18 260] No right to tax capital gains under pre-CGT tax treaties Following the decisions of the Federal Court in Virgin Holdings SA v FCT (2008) 70 ATR 478 and Undershaft (No 1) Ltd v FCT (2009) 74 ATR 888, the Tax Office now accepts that it does not have a right under DTAs negotiated prior to 20 September 1985 to tax capital gains made by a non-resident from sources in Australia if the non-resident does not carry on business through a permanent establishment. In these circumstances, the country of residence has exclusive taxing rights over capital gains. However, the court decisions have a somewhat limited application because a number of Australia’s DTAs with significant trading partners have been renegotiated (eg the US, the UK, New Zealand and Canada DTAs) or will be renegotiated. In relation to DTAs (eg with Singapore, China and other countries) that have been negotiated since 1988, the DTAs seek to preserve Australia’s right to tax capital gains generally by the way of ‘‘sweep-up’’ provisions, which intend to overcome the problem that the business profits article (see [18 270]) denies source country taxation if the relevant capital gain is not covered by the other provisions (see for example Art 13(5) of the China DTA). [18 270] Business profits article Capital gains may be covered by the business profits articles of older DTAs. If so, and there is no permanent establishment (PE) in the source country, the source country is precluded from taxing the gains (see Ruling IT 355). Section 3(2) of the International Tax Agreements Act 1953 (InTAA) provides that the ‘‘profits’’ of a business or activity, in relation to Australian tax, must be read as a reference to the taxable income of the business or activity. As capital gains are included in ‘‘taxable income’’, there are obvious implications for the interpretation of the business profits articles, except if a specific article applies. But note, for example, in Thiel v FCT (1990) 21 ATR 531 the High Court held that a Swiss resident who derived a profit from an isolated transaction involving a sale of shares © 2017 THOMSON REUTERS

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acquired with the intention of making a profit was not subject to CGT in Australia. This was essentially because the High Court found that, having regard to the nature of the taxpayer’s activity, it would be inappropriate to regard the taxpayer’s gain as being by way of income from the alienation of capital assets within the meaning of Art 13 of the Swiss DTA. Nevertheless the actual scope of the Australian right to tax capital gains of foreign residents under domestic law is determined by the concept of ‘‘taxable Australian property’’: see [18 100].

[18 280] Alienation of property article A number of Australia’s DTAs contain a specific Article dealing with the taxation of gains from the alienation of property, including real property (eg, Art 13 of the amended UK and US DTAs). The alienation of property Article is not uniform, but typically it allows a contracting country to tax the gains from: • the alienation of real property situated in that country (for these purposes ‘‘real property’’ may be defined to include rights to explore for or exploit natural resources); • the alienation of business property (other than real property) of a permanent establishment (of a foreign resident entity) in that country; and • the disposal of interests in an entity (eg shares in a company) whose sole or principal assets are real property situated in that country, which includes where the interests are indirectly held through an interposed entity (see ‘‘Indirect alienation of property’’ below). In some DTAs, the alienation of property article does not affect a country’s laws relating to capital gains except to the extent specified in the Article. Other DTAs (eg the Norway and France agreements) provide that capital gains not otherwise covered in the Article may only be taxed in the country of which the alienator is a resident. Note that in FCT v Resource Capital Fund III LP (2014) 98 ATR 136, the Full Federal Court held that the US DTA did not apply to a limited partnership as it was not a resident of either of the Contracting States. In doing so, the Full Court likewise dismissed the finding at first instance that, for the purposes of Article 13 of the DTA, the Source State was precluded from taxing a limited partnership and was permitted only to tax the partners.

Indirect alienation of property Section 3A InTAA ensures that profits arising from the indirect alienation of real property situated in Australia by a non-resident are subject to tax in Australia. This overcomes the decision in FCT v Lamesa Holdings BV (1997) 36 ATR 589, where it was held that Art 13 of the Netherlands agreement (the ‘‘alienation of property’’ article) did not apply to profits realised by a Dutch company on the sale of shares in an Australian subsidiary. Other matters More recent alienation of property Articles in DTAs provide that an individual who, on changing countries of residence, is treated in the former country of residence as having alienated property (and who is taxed as a result) may elect to be treated (for the purposes of the tax laws of the new country of residence) as having disposed of and re-acquired the property for an amount equal to its market value (see, for example, ATO ID 2006/315). Note, however, that Art 13(6) of the US Convention provides that an individual who had made an election to defer taxation on income or gains relating to property which would be otherwise taxable in Australia upon the individual ceasing to be a resident of Australia shall, if the individual is a resident of the US, be taxable on the subsequent alienation of that property only in the US. In ATO ID 2006/262, the Commissioner decided that a former resident of Australia could rely on Art 13(6) to escape CGT on the sale of shares in an Australian company while they were a US resident, despite making an election under CGT event I1 (see [18 160]) to treat the shares as ‘‘taxable Australian property’’ (see [18 100]). 712

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19

INTRODUCTION Overview ....................................................................................................................... [19 010] TAX OFFSETS What are tax offsets? .................................................................................................... [19 Checklist of offsets ........................................................................................................ [19 Refundable tax offsets ................................................................................................... [19 Tax offset carry forward rules ...................................................................................... [19

020] 030] 040] 050]

DEPENDANT OFFSETS Introduction ................................................................................................................... [19 Dependant (invalid and carer) offset ............................................................................ [19 Amount of offset ........................................................................................................... [19 Apportionment of offset ................................................................................................ [19 Students and children – notional offset ........................................................................ [19 Sole parent – notional offset ......................................................................................... [19

100] 150] 160] 170] 180] 190]

LOW INCOME OFFSET Low income offset ........................................................................................................ [19 300] MEDICAL EXPENSES OFFSET Medical expenses offset – introduction ........................................................................ [19 Offset rate and threshold ............................................................................................... [19 Qualifying medical expenses ........................................................................................ [19 Specific categories of qualifying medical expenses .................................................... [19 Payment of medical expenses by trust estate .............................................................. [19

350] 360] 370] 380] 400]

PRIVATE HEALTH INSURANCE TAX OFFSET Private health insurance offset – introduction .............................................................. [19 450] Qualifying conditions .................................................................................................... [19 460] Amount of offset ........................................................................................................... [19 470] PENSIONERS, SOCIAL SECURITY RECIPIENTS AND MATURE AGE WORKERS Senior Australians and other pensioners ...................................................................... [19 500] Social security and educational beneficiary offset ....................................................... [19 520] ZONE AND OVERSEAS FORCES OFFSET Isolated areas – qualifications for offset ...................................................................... [19 Special areas .................................................................................................................. [19 Calculating the offset .................................................................................................... [19 Examples of zone offsets .............................................................................................. [19 Defence Force members serving overseas ................................................................... [19 Civilians serving with United Nations armed forces ................................................... [19

550] 560] 570] 580] 590] 600]

OTHER OFFSETS Arrears of income ......................................................................................................... [19 650] RATES OF TAX Resident v non-resident rates scale .............................................................................. [19 700] Tax-free threshold ......................................................................................................... [19 710] MEDICARE LEVY Introduction ................................................................................................................... [19 Levy rates and thresholds ............................................................................................. [19 Family income thresholds ............................................................................................. [19 Surcharge – liability ...................................................................................................... [19 Surcharge rate and thresholds ....................................................................................... [19 Surcharge offset ............................................................................................................. [19

750] 760] 770] 780] 790] 800]

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Exemptions .................................................................................................................... [19 810]

HIGHER EDUCATION CONTRIBUTIONS Higher education loans ................................................................................................. [19 900] Payment through the tax system .................................................................................. [19 910]

INTRODUCTION [19 010] Overview This chapter discusses a number of topics relevant to the income tax liability of individual taxpayers. These topics are: • tax offsets – the various offsets available to individual taxpayers, including the dependant (invalid and carer), low income, medical expenses, private health insurance, senior Australians and pensioners, beneficiary, zone, overseas forces and income in arrears offsets: see [19 100]-[19 650]. The rules specifying whether excess offsets are refundable or can be carried forward to a later income year are discussed at [19 040]-[19 050]. A checklist of offsets is located at [19 030]; • the rates of tax applicable to an individual, including the tax-free threshold: see [19 700]-[19 710]; • the Medicare levy and surcharge (the surcharge is payable by certain higher income earners who do not have the required private health insurance): see [19 750]-[19 810]; and • the HELP scheme, under which higher education loans are repaid through the tax system: see [19 900]-[19 910]. Superannuation related tax offsets are discussed in Chapter 39 and Chapter 40.

TAX OFFSETS [19 020] What are tax offsets? A ‘‘tax offset’’ reduces a taxpayer’s ‘‘basic income tax liability’’: see below. The term ‘‘tax offset’’ was introduced by the ITAA 1997, replacing the terms ‘‘rebate’’ and ‘‘credit’’ that are used in the ITAA 1936. This publication uses the term ‘‘offset’’ rather than ‘‘rebate’’. The tables at [100 100]-[100 150] provide a convenient summary of the amounts of many of the offsets discussed in this chapter. Entitlement to tax offsets The tax offsets discussed in this chapter are only available to resident individuals and cannot be claimed by foreign resident individuals, companies and funds. A foreign resident may be entitled to a superannuation-related tax offset: see [40 160]. See also [7 640]. If a trustee is assessed under s 98 ITAA 1936 on behalf of a resident beneficiary (see [23 500]), the trustee may be entitled to a personal tax offset in that assessment (this does not apply if the beneficiary is a company). Effect of tax offset Unlike deductions, tax offsets are not taken into account in determining taxable income. Instead, as noted above, they reduce the ‘‘basic income tax liability’’ on that taxable income: see [1 100]. Note that they generally do not reduce the Medicare levy (or surcharge). 714

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[19 030]

The amount of any tax offset to which a taxpayer is entitled is independent of the level of the taxpayer’s taxable income or marginal tax rate, although the dependant’s own taxable income (if any) may affect the amount of the offset. The low income offset (see [19 300]) and the small business offset (see [25 250]) are of a different nature to the other personal tax offsets and operate as an effective reduction in the rate of tax payable. Tax offsets are applied in the following order (s 63-10(1)): • the senior Australians and pensioner tax offset: see [19 500]; • the beneficiary tax offset: see [19 520]; • the low income tax offset: see [19 300]; • any non-refundable tax offset not specified in this list (ie the list in s 63-10(1)), eg the dependant (invalid and carer) offset (see [19 150]), the medical expenses offset (see [19 350]), the private health insurance offset (see [19 450]) and the zone offset (see [19 550]); • the foreign income tax offset (FITO: see [34 200]); • the former child care tax offset; • any unused amount of the former landcare and water facility tax offset; • the non-refundable R&D tax offset (ie calculated using the lower rate): see [11 030]; • any other tax offset that is refundable: see [19 040]; and • the franking deficit tax offset: see [21 750]. Within each category, a tax offset is applied in the order in which it arose: s 63-10(2). This is relevant if the taxpayer has carry forward tax offsets of the same category for different income years. Section 63-10(1) also specifies what happens to any unused amount of a tax offset. For example, any unused SATO or pensioner offset may be transferred to the taxpayer’s spouse, any unused refundable offset is refunded and any unused non-refundable R&D offset or landcare and water facility offset may be carried forward to a later income year. If any unused offset cannot be transferred, carried forward or refunded, the excess will be lost. Any unused FITO is applied against the taxpayer’s Medicare levy liability (if any) and then their Medicare levy (fringe benefits) surcharge liability (if any). Any remaining FITO will be lost.

[19 030] Checklist of offsets Item Aged care – some ....................... Annual leave – accrued – some .. Annuities – some ......................... Arrears of income ........................ Attendant care – some ................ Austudy ........................................ Carer ............................................ Child (notional) ............................. Concessional super contributions – excess........................................ Death benefit ............................... Defence forces – overseas .......... Dependant (invalid and carer) ...... © 2017 THOMSON REUTERS

Para [19 350] [4 420] [40 510] [19 650] [19 350] [19 520] [19 150] [19 180] [39 315] [40 350] [19 590] [19 150]

Item Disability aids – some .................. Dividends – franked ..................... Dividends – franked NZ companies .................................... Education and training payments ...................................................... Employment termination payment ...................................................... Employment termination payment – death benefit ............................. ESVCLP – contributions to .......... Film – location ............................. Film – post-production ................. Film producer ...............................

Para [19 350] [21 500] [21 440] [19 520] [4 300] [4 380] [11 [11 [11 [11

560] 410] 430] 420]

715

[19 040]

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Item Foreign income tax ...................... Greenfields mineral exploration ... Income stream death benefit ....... Innovation – early stage investors ...................................................... Invalid ........................................... Long service leave – accrued ..... Low income taxpayers ................. Medical expenses – some ........... Medicare levy surcharge ............. Newstart allowance ...................... No-TFN contributions income ...... Overseas forces ........................... Parenting payment (partnered) .... Pensions ...................................... Pensions – superannuation ......... PDV offset .................................... Primary producers – averaging ... Private health insurance .............. R&D expenditure ......................... Remote area ................................. Seafarer ....................................... Self-funded retirees .....................

Para [34 200] [29 030] [40 390] [11 200] [19 [4 [19 [19 [19 [19 [41 [19 [19 [19 [40 [11 [27 [19 [11 [19 [11 [19

150] 430] 300] 350] 800] 520] 240] 590] 520] 500] 510] 430] 520] 450] 020] 550] 700] 500]

Item Senior Australians ........................ Short-term life policies ................. Sickness allowance ..................... Small business ............................. Social security payments – some ...................................................... Sole parent (notional) .................. Special benefits ........................... Special disability trust .................. Student (notional) ........................ Super contribution – excess concessional ................................. Super contribution – spouse ........ Superannuation income stream ... Training payments ....................... Trustees ....................................... TV series ...................................... UN armed forces – civilians ........ Urban water project ..................... Venture capital ............................. Widow allowance ......................... Youth allowance ........................... Zone .............................................

Para [19 500] [6 260] [19 520] [25 250] [19 520] [19 [19 [23 [19 [39

190] 520] 460] 180] 315]

[39 610] [40 200] [19 520] [23 1350] [11 410] [19 600] [11 640] [11 530] [19 520] [19 520] [19 550]

[19 040] Refundable tax offsets Section 63-10 (item 40) ITAA 1997 allows for a refund of any tax offset that is subject to the refundable tax offset rules if the taxpayer’s offsets exceed his or her ‘‘basic income tax liability’’ for the income year: see [1 100]. The refundable amount is the excess. This means that if a taxpayer does not have to make any payment at assessment stage because sufficient tax has been collected during the income year under the PAYG withholding system, the taxpayer will still get the full benefit of any refundable tax offset that has not been used. The specified refundable tax offsets are (ss 67-23, 67-30): • the private health insurance tax offset (except where a trustee liable to be assessed under s 98 is entitled to the offset): see [19 450]; • the offset provided to the principal beneficiary of a special disability trust where the net income of the trust is also assessed to the principal beneficiary: see [23 460]; • the various film tax offsets: see [11 410]-[11 435]; • the tax offset under the National Rental Affordability Scheme: see [11 630]; • the former conservation tillage offset: see [27 240]; • the seafarer tax offset (note that the previous Coalition Government proposed to repeal the offset): see [11 700]; • the former urban water tax offset: see [11 640]; • the R&D tax offset (if calculated using the higher rate): see [11 030]; • the greenfields mineral exploration offset: see [29 030]; • franking tax offsets (see [21 500]) and venture capital franking tax offsets (see [11 520]), but subject to the limitations discussed below (there are no restrictions on individuals claiming a refund of excess franking tax offsets); 716

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[19 040]

• the offset payable to a foreign resident member of an ‘‘attribution managed investment trust’’: see [23 685]; • the tax offset available under s 713-545 where a life insurance company’s subsidiary joins a consolidated group; • the no-TFN contributions income tax offset: see [41 240]; and • the tax offset available under s 292–467 for refunded excess concessional superannuation contributions (for 2011-12 and 2012-13): see [39 320]. The following offsets are not refundable: • the low income offset: see [19 300]; • the small business tax offset: see [25 250]; • the foreign income tax offset: see [34 200]; • the excess concessional superannuation contributions tax offset: see [39 325]; • the offset for early stage investors in innovation companies: see [11 200]; and • the offset for contributions by a limited partner in an ESVCLP: see [11 560]. The proposed $100 offset for expenditure on Standard Business Reporting enabled software (see [25 010]) will also be non-refundable. The ascertainment of a taxpayer’s total tax offset refunds forms part of the assessment process: see [47 020]. In the case of a self-assessment entity such as a company (see [47 020]), the entity’s tax return is treated as a notice of its total tax offset refunds for the year. Note that any tax offsets to be refunded to a taxpayer can be used to reduce any other tax liability of the taxpayer under the rules in ss 8AAZLA to 8AAZLE TAA: see [52 050]. A refundable tax offset may attract interest under the Taxation (Interest on Overpayments and Early Payments) Act 1983: see [49 070].

Franking and venture capital offsets In the case of franking tax offsets and venture capital franking tax offsets (where applicable), a corporate tax entity (ie a company, corporate limited partnership, corporate unit trust or public trading trust) is not entitled to a refund of excess franking tax offsets and venture capital franking tax offsets unless the entity is (s 67-25(1C) to (1E)): • a life insurance company and the company’s interest in the share (or other membership interest) on which the distribution was made was not held by the company on behalf of its shareholders at any time between the start of the income year in which the distribution is made and the time when the distribution is made. Thus, franking tax offsets attributable to shares etc held on behalf of policyholders are refundable; or • an exempt institution eligible for a refund – these are certain charitable institutions and funds, deductible gift recipients and certain non-charitable prescribed private funds: see [22 360]. Complying superannuation entities are entitled to a refund of excess franking tax offsets. However, non-complying superannuation funds and non-complying ADFs are not entitled to a refund of excess franking tax offsets: s 67-25(1A). A foreign entity that carries on business in Australia at or through a permanent establishment is not entitled to a refund of excess franking tax offsets in relation to franked distributions that are attributable to the permanent establishment (if a tax treaty applies, the treaty definition of ‘‘permanent establishment’’ applies, otherwise the ordinary meaning applies: see [36 110]): s 67-25(1DA). In the case of a trust, excess franking tax offsets are not refundable where (s 67-25(1B)): © 2017 THOMSON REUTERS

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• the trustee is entitled to the offset because a franked distribution flows indirectly to the trustee (see [21 530]); and • the trustee is liable to be assessed under s 98 (beneficiary presently entitled but under a legal disability or beneficiary deemed to be presently entitled: see [23 450] and [23 460]) or s 99A (no beneficiary presently entitled: see [23 500]) in respect of a share of the net income of the trust estate that is attributable, in whole or in part, to the distribution. Otherwise, excess franking tax offsets are refundable to the trustee or the beneficiary, as appropriate: see [23 220]. Individuals who do not have to lodge a tax return can claim a refund of excess franking tax offsets by post or, in certain cases, by telephone.

[19 050] Tax offset carry forward rules In certain circumstances, a tax offset may be carried forward to reduce income tax payable in a later income year. The tax offset carry forward rules are in Div 63 and Div 65 ITAA 1997. A tax offset may be carried forward if it exceeds the amount of income tax payable by the taxpayer, after applying other tax offsets in the order specified in s 63-10: s 65-30. As at 1 January 2017, the only tax offsets that can be carried forward are (s 63-10(1)): • the franking deficit tax offset: see [21 750]; • the R&D offset (if calculated using the higher rate: see [11 030]); • the offset for early stage investors in innovation companies: see [11 200]; • the offset for limited partners in ESVCLPs: see [11 560]; and • the former landcare and water facility offset (under former Div 388). If the taxpayer has taxable income for the year, the tax offset is reduced by 30% of net exempt income (see [8 480] for the meaning of net exempt income): s 65-30. For income years commencing on or after 1 July 2015 (eg the 2016-17 income year if a 30 June balancer), the 30% rate is 28.5% if the taxpayer is a small business entity (but note the proposal to reduce the rate to 27.5% for small business entities, as from 2016-17: see [25 250]). A tax offset that is carried forward is first applied to reduce to nil any net exempt income, ie before it is applied to reduce the taxpayer’s income tax liability: s 65-35(3). Each $0.30 (or $0.285 if a small business entity) of offset reduces net exempt income by $1. A company cannot carry forward a tax offset if the company would fail the continuity of ownership and same business tests in Subdiv 165-A (see [20 320]-[20 370]) if those tests applied (and ignoring s 165-20, which is about carrying forward part of a loss: see [20 330]): s 65-40. The head company of a consolidated group can access the R&D tax offset available to an entity joining the group at the joining time: see ATO ID 2015/6. However, the head company will need to overcome the limitations in s 65-40. A taxpayer who becomes bankrupt, or who is released from debts under a law relating to bankruptcy, cannot apply (including in a later income year) a tax offset that is carried forward from an earlier year, even if the bankruptcy is annulled: s 65-50. If a taxpayer pays an amount for a debt incurred in an earlier income year (ie before the bankruptcy), so much of that amount that was taken into account in calculating the tax offset (that cannot be carried forward) is deductible (up to the maximum specified): s 65-55.

DEPENDANT OFFSETS [19 100] Introduction The only dependant offset that is now available is the dependant (invalid and carer) offset (DICTO): see [19 150]. However, notional tax offsets in respect of sole parents, children 718

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[19 150]

under 21 and students under 25 are also available for zone, overseas forces and/or overseas civilian offset purposes: see [19 180] and [19 190].

[19 150] Dependant (invalid and carer) offset A taxpayer may be entitled to the dependant (invalid and carer) offset (DICTO) under Subdiv 61-A ITAA 1997 if he or she contributed to the maintenance of an eligible dependant: s 61-10(1). An eligible dependant is (s 61-10(2)-(4)): • the taxpayer’s spouse, parent or parent-in-law, or (if aged at least 16) the taxpayer’s child, brother, sister, brother-in-law or sister-in-law, who receives a disability support pension or a special needs disability support pension under the Social Security Act 1991, or an invalidity service pension under the Veterans’ Entitlements Act 1986; or • the taxpayer’s spouse, parent or parent-in-law, who receives a carer payment or carer allowance under the Social Security Act 1991 in relation to providing care to the taxpayer’s child, brother, sister, brother-in-law or sister-in-law (who is aged at least 16); or • the taxpayer’s spouse, parent or parent-in-law, who is wholly engaged in providing care to the taxpayer’s child, brother, sister, brother-in-law or sister-in-law (who is aged at least 16), where the individual being cared for receives a disability support pension or a special needs disability support pension under the Social Security Act 1991, or an invalidity service pension under the Veterans’ Entitlements Act 1986. An eligible dependant must be an Australian resident, although if the taxpayer’s spouse or child is a foreign resident, he or she may be an eligible dependant if the taxpayer has a domicile in Australia: s 61-10(1). De facto spouses (ie individuals who live together on a genuine domestic basis in a relationship as a couple, including same sex de facto spouses) are treated in the same way as legally married spouses: see the definition of ‘‘spouse’’ in s 995-1(1) ITAA 1997. An individual (whether of the opposite or same sex) whose relationship with another individual is registered under a relevant State or Territory law is also treated as the ‘‘spouse’’ of that other individual. A taxpayer may be entitled to receive more than one amount of DICTO if he or she contributed to the maintenance of more than one eligible dependant (none of whom are the taxpayer’s spouse): s 61-10(5). There are rules covering the situation where the taxpayer has more than one spouse at any time during the income year (whether part only of the year or the whole year). The basic rule is that only the spouse with whom the taxpayer resides at any particular time can qualify as an eligible dependant during the period they reside together: s 61-15(1). For example, if the taxpayer resides with one spouse for 14 weeks in the first half of the income year and with another spouse for 20 weeks during the second half of the income year, the first spouse may qualify as an eligible dependant only during the relevant 14-week period and the second spouse may qualify as an eligible dependant only during the relevant 20-week period. This will require the amount of DICTO to be apportioned: see also [19 170]. A further rule, however, provides that if, during a period in the income year (whether part of the year or the whole year), the taxpayer resides with 2 or more individuals who are each her or his spouse, or has more than one spouse but does not reside with any of them, only one spouse can qualify as an eligible dependant for the relevant period, namely the spouse in relation to whom the taxpayer would receive the smaller or smallest amount of DICTO (including a nil amount): s 61-15(2). A taxpayer is not entitled to DICTO in respect of a spouse if, during the whole of the year, the taxpayer or their spouse is eligible for Family Tax Benefit (Part B) (without shared © 2017 THOMSON REUTERS

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care): s 61-25. If a taxpayer has a partial eligibility only for Family Tax Benefit (Part B), the amount of DICTO is apportioned: see [19 170]. A taxpayer who incorrectly claims a tax offset, or claims a greater offset than that to which he or she is entitled, may be subject to penalties (the penalty regime is discussed in Chapter 54).

Income test There is an income test which must be satisfied before a taxpayer is entitled to DICTO. The offset is not available if the taxpayer’s ‘‘adjusted taxable income for offsets’’ (ATI) for the income year, or the combined ATI of the taxpayer and her or his spouse (if the taxpayer has a spouse at any time during the income year), is more than (for 2016-17) $100,000 (ie the income limit for Family Tax Benefit (FTB) Part B): s 61-20. The spouse’s ATI is not taken into account if he or she is the eligible dependant in relation to whom the taxpayer is claiming the offset (see above). See [19 160] for how ATI is worked out. The spouse’s ATI is apportioned if he or she is the taxpayer’s spouse for part of the income year only: s 61-20(2). If the taxpayer has a different spouse during different parts of the year, the ATI of each spouse is included: s 61-20(3). [19 160] Amount of offset The maximum amount of DICTO for 2016-17 is $2,627. It is indexed annually in accordance with Subdiv 960: s 61-30. EXAMPLE [19 160.10] Carlos qualifies for DICTO in respect of his father who receives a disability support pension. The father has no adjusted taxable income (see below). For 2016-17, Carlos is entitled to the maximum DICTO of $2,627. Note that DICTO will not be available if the dependant receives her or his government invalid or carer payment (see [19 150]) for the full income year.

Reduction for dependant’s income The amount of DICTO is reduced if the dependant derives ‘‘adjusted taxable income for offsets’’ (ATI) in excess of $282: s 61-45. Where that happens, the offset otherwise allowable in respect of that dependant is reduced by $1 for every $4 by which the ATI exceeds $282. The maximum allowable dependant’s ATI for 2016-17 (ie the amount of ATI which reduces the DICTO to nil) is $10,790.

Adjusted taxable income ATI (which is defined by reference to the term ‘‘adjusted taxable income for rebates’’ in s 6 ITAA 1936) is worked out in accordance with the rules in Sch 3 to the A New Tax System (Family Assistance) Act 1999 (‘‘Family Assistance Act’’), but disregarding cl 3 (about where an individual is a member of a couple) and cl 3A (about where an individual ceases to be a member of a couple). A dependant’s ATI is effectively the sum of: • taxable income for the year; • adjusted fringe benefits total for the year (see below); • tax-free pensions and benefits for the year (see below); • foreign income for the year that is not subject to Australian tax (and which is not received as a fringe benefit); • total net investment loss for the year (see below); and 720

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[19 170]

• reportable superannuation contributions for the year, ie the sum of any reportable employer superannuation contributions and all deductible personal superannuation contributions made by the dependant (see [39 140]), less any child maintenance paid to support a child from a previous relationship. A dependant’s adjusted fringe benefits total for the year is her or his reportable fringe benefits total × 51% (for 2016-17). The dependant’s reportable fringe benefits total is the sum of each reportable fringe benefits amount (see [59 200]). From 2017-18, the gross rather than the adjusted net value of reportable fringe benefits will be used in working out a dependant’s adjusted fringe benefits total for an income year: see amendments made by Sch 15 of the Budget Savings (Omnibus) Act 2016. Tax-free pensions and benefits are any non-taxable pensions or benefits paid under the Social Security Act 1991 or the Veterans’ Entitlements Act 1986 and may include the disability support pension, carer payment, invalidity service pension, disability pension, war widow’s pension and war widower’s pension, partner service pension, Defence Force Income Support Allowance, special rate disability pension safety net payment and certain Military Rehabilitation and Compensation Commission payments. The following are not tax-free pensions and benefits: payments by way of bereavement payment, pharmaceutical allowance, rent assistance, language, literacy and numeracy supplement or remote area allowance and the tax-exempt pension supplement component (if any) of social security or veterans’ entitlement payments. An individual’s total net investment loss for the year is the sum of their net financial investment losses and their net rental property losses. A ‘‘financial investment’’ is a share in a company, an interest in a managed investment scheme (including in a forestry managed investment scheme: see [11 600]), a right or option in respect of a share or an interest in a managed investment scheme and any investment of a like nature to those already mentioned: s 995-1 ITAA 1997. EXAMPLE [19 160.20] Rebecca has an invalid husband whose ATI is $2,142. Maximum 2016-17 offset less reduction for ATI: ($2,142 – $282) ÷ 4 = $465 Allowable offset

$ 2,627 (465) 2,162

See also the Examples in [19 170]. If the taxpayer contributes to the maintenance of the dependant for only part of the income year, then only the ATI earned by the dependant during that part of the year is taken into account: s 61-45(b). See Example [19 170.20]. On the other hand, if the dependant dies, her or his ATI is annualised in accordance with the following formula contained in Sch 3 Family Assistance Act: Dependant’s ATI for income year × Number of days in income year/Number of days dependant was alive during income year. See Example [19 170.50].

[19 170] Apportionment of offset The amount of DICTO is apportioned in the following situations listed in s 61-40: • the taxpayer contributes to the maintenance of the dependant (in respect of whom an offset is claimed) for part of the income year only; © 2017 THOMSON REUTERS

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• the dependant qualifies as a dependant (for offset purposes) for part of the income year only; • the dependant dies during the income year; • the residency test (see [19 150]) is satisfied for only part of the income year. A temporary absence overseas is unlikely to result in the loss of residence status: see [2 060]; • 2 or more individuals contribute to the maintenance of the dependant during the whole or part of the income year. This can include where the dependant is in prison and the taxpayer contributes to the dependant’s maintenance, along with the relevant Corrective Services Commissioner: see AAT Tribunal Case 128 (1987) 18 ATR 3938; • the taxpayer or taxpayer’s spouse had shared care arrangements for a child for which they are receiving Family Tax Benefit (Part B) – in this case the offset is effectively apportioned (under s 61-35) between the shared care days and non-shared care days. This ensures that a taxpayer who has a partial eligibility for Family Tax Benefit (Part B) only will have a partial eligibility for DICTO; and • the taxpayer or his or her spouse (while the taxpayer’s partner) receives parental leave pay under the Paid Parental Leave Act 2010. Where an apportionment is required, the amount of the offset is the proportion which the Commissioner considers to be reasonable in the circumstances (usually determined on a time basis). EXAMPLE [19 170.10] Jane and Christian marry on 16 January 2017. Christian maintains Jane for the rest of the income year (166 days, including the wedding day). He is entitled to DICTO. There are no dependent children and Jane has no ATI. Christian is entitled to a proportionate offset (for 2016-17) of $2,627 × (166 ÷ 365) = $1,195 (rounded to the nearest dollar).

EXAMPLE [19 170.20] Larry marries on 10 November 2016 and maintains his invalid wife, Fiona, for the rest of the income year (233 days, including the wedding day). He is entitled to DICTO. There are no dependent children. From 1 July 2016 to the date of marriage, Fiona’s ATI is $3,560. From the date of marriage to 30 June 2017, her ATI is $1,970. Larry is entitled to the following proportionate offset for 2016-17 (rounded to the nearest dollar): $ Maximum offset for period 10/11 to 30/6 $2,627 × (233 ÷ 365) less reduction for ATI: ($1,970 − $282) ÷ 4 Allowable 2016-17 offset

1,677 (422) 1,255

The income earned by Fiona before the marriage ($3,560) is outside the period of the claim for the offset and therefore is not taken into account in calculating the allowable offset.

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EXAMPLE [19 170.30] Luis and Rebecca are eligible for family tax benefit Part B for their child Mila for the period from 26 January to 30 June 2017 (156 days). Luis is entitled to DICTO. The amount allowable is (rounded to the nearest dollar): 209 (ie 365 − 156) × $2,627 = $1,504 365

EXAMPLE [19 170.40] Nick and Nicki are married and care for Becky, Nick’s 8-year-old daughter from his previous marriage. Nick is the sole earner and Nicki has no separate net income. Nick is entitled to the dependant (invalid and carer) offset. Nick shares the care of Becky with his ex-wife. There is a determination under s 59 of the Family Assistance Act that Nick and Nicki’s percentage of Family Tax Benefit (FTB) from 1 July 2016 is 60%. Nick or Nicki is therefore entitled to FTB Part B at the rate of $1,911.87 (60% of the standard rate of $3,186.45). On 23 February 2017, the pattern of care arrangements changes and there is a new determination that Nick and Nicki’s percentage of FTB is 64%. The new FTB Part B rate is $2,039.33 (64% of $3,186.45). Nick’s entitlement to the offset is calculated as follows (rounded to the nearest 5 cents): Shared care period 1/7/2016-22/2/2017 (237 days)

Shared care period 23/2/2017-30/6/2017 (128 days)

Nick is therefore entitled to an offset for 2016-17 of $1,013.95 ($682.30 + $331.65).

EXAMPLE [19 170.50] Hillary maintains her invalid husband Donald from 1 July 2016 until his death on 30 December 2016 (183 days). Her ATI is $50,450 and Donald’s ATI until his death is $2,198 (including a part disability pension). Note that Donald’s ATI is annualised. Hillary is entitled to the following proportionate offset for 2016-17 (rounded to the nearest dollar): $ Maximum offset for period 1/07/16 to 30/12/16 $2,627 × (183 ÷ 365) 1,317 less reduction for ATI: ($4,384* – $282) ÷ 4 (1,026) Allowable 2016-17 offset 291

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* ATI calculated as follows: $2,198 × 365/183 = $4,384

[19 180] Students and children – notional offset Notional offsets are available in respect of dependent full-time students aged under 25 and non-student dependent children aged under 21 (under s 961-5 ITAA 1997) if the taxpayer is eligible for the zone offset (see [19 550]), the overseas forces offset (see [19 590]) or the overseas civilian offset: see [19 600]. The notional offsets are used to calculate the amount of the zone, overseas forces or overseas civilian offset. They are also relevant for the purposes of the medical expenses offset: see [19 350]. (The notional offsets were contained in former s 159J ITAA 1936, but have been rewritten in Subdiv 961-A.) To qualify for a notional offset, the taxpayer must be a resident individual who contributes to the maintenance of one of more full-time students under 25 and/or non-student children under 21 (this is not restricted to the taxpayer’s own children). If the student or child is not an Australian resident, the taxpayer must have an Australian domicile. A ‘‘child’’ includes an adopted child, a step-child or an ex-nuptial child (see ATO ID 2011/77 for a discussion of the meaning of ‘‘step-child’’): s 995-1(1) ITAA 1997. It does not include a sibling or a grandchild (unless adopted). A ‘‘child’’ also includes someone who is the product of a relationship the taxpayer has or had as a couple with another individual (including a same sex partner) – but someone cannot be the product of a relationship unless he or she is the biological child of at least one of the individuals in the relationship or was born to a woman in the relationship. A ‘‘student’’ for these purposes is an individual receiving full-time education at a school, college or university. The notional offset would therefore only be available in respect of a part-time student if he or she is under 21. The notional offset for each dependent student is $376: s 961-10(1). The notional offset for the first dependent non-student child is $376 and then $282 for each additional dependent non-student child: s 961-10(1), (2). The notional offsets are not indexed. Reduction for dependant’s ATI The amount of the notional offset is reduced by $1 for every $4 by which the dependent student or child’s ‘‘adjusted taxable income for offsets’’ (ATI) for the year exceeds $282: s 961-20. If the taxpayer does not maintain the student or child for the whole income year, only the ATI for that part of the year during which the taxpayer does maintain the student or child is taken into account. This is the same test that applies in relation to DICTO and is considered further (including the definition of ATI) at [19 160]. As a result, if a dependent student or child is being maintained for the whole income year: • the notional $376 offset (for each dependent student under 25 and the first dependent non-student child under 21) cuts out when the ATI is $1,786; and • the notional $282 offset (for any additional dependent non-student children) cuts out when the ATI is $1,410. If a dependent student or child is being maintained for part of the income year only: • the notional $376 offset (for each dependent student and the first dependent non-student child) cuts out when the ATI is $282 plus $28.92 for each week the child or student is maintained by the taxpayer; and 724

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• the notional $282 offset (for any additional dependent non-student child) cuts out when the ATI is $282 plus $21.54 for each week the child is maintained by the taxpayer.

Apportionment of offset The amount of a notional offset is reduced where (s 961-15): • the taxpayer maintains the student or child for part of the income year only; • the residency test in respect of the student or child is satisfied for part of the income year only; • 2 or more individuals contribute to the maintenance of the student or child; or • the dependant is a qualifying student or child for part of the income year only. The notional offset is reduced to an amount that the Commissioner considers is a reasonable apportionment in the circumstances (eg if the taxpayer maintains the student or child for part of the income year only, the offset is likely to be apportioned on a time basis).

[19 190] Sole parent – notional offset A notional offset is available (under s 961-55 ITAA 1997) where an unmarried person has the sole care of a dependent student aged under 25 or a dependent non-student child aged under 21, provided he or she is entitled to a notional offset under Subdiv 961-A: see [19 180]. This is called the notional sole parent offset. It is relevant for the purposes of calculating the zone offset (see [19 570]) and the overseas forces offset (see [19 590]), and for Medicare levy purposes (in relation to the family income threshold): see [19 770]. (The notional offset was contained in former s 159K ITAA 1936, but has been rewritten in Subdiv 961-B.) The maximum notional sole parent offset is $1,607 (it is not indexed): s 961-60. The offset is apportioned (usually on a time basis) if the taxpayer does not have the sole care of the dependent student or child for the whole income year: s 961-65. Although a taxpayer who has a spouse during the income year is prima facie not eligible for the notional sole parent offset (s 961-55(1)(c)), the offset will be allowed if the Commissioner considers there are special circumstances: s 961-55(2). (See [19 150] for the definition of ‘‘spouse’’.) If so, the notional offset will effectively be such amount as the Commissioner considers reasonable: s 961-65. Examples of special circumstances include where the spouse having sole care of the child or student has been deserted, or the other spouse is serving a long-term prison sentence, eg at least 12 months, or is severely intellectually disabled: Rulings IT 253 and IT 254. See also AAT Case 13,380; Re Irwin and DCT (1998) 40 ATR 1148 and AAT Case 13,505; Re Black and FCT (1998) 41 ATR 1025. Sole care ‘‘Sole care’’ is the basis for allowing the notional offset but it is not necessary that the taxpayer has the sole financial responsibility for the child, nor that the child be under her or his sole physical control. Rather, the benefit is intended for single parents who are caring for children without the aid of a spouse or housekeeper and therefore have the sole responsibility for the actual care and upbringing of the child: Ruling IT 2337. However, the decision in Sharma v FCT (1984) 15 ATR 488 would appear to be in conflict with this ruling, stating that sole financial responsibility should be the test. AAT Case 5471 (1989) 20 ATR 4164 specifically rejects the ruling and follows the sole financial responsibility test. If one parent does not have custody of the child but has significant periodic access (eg for 2 or 3 days every week or an unbroken period of 3 months), and provides for all the child’s needs during the period in which the child is in that parent’s care, both parents are considered to have sole care (and therefore the notional offset will be apportioned between the parents if all other conditions of Subdiv 961-B are satisfied): Ruling IT 254. © 2017 THOMSON REUTERS

725

[19 300]

INDIVIDUALS

LOW INCOME OFFSET [19 300] Low income offset Certain low income taxpayers are entitled to an offset under s 159N ITAA 1936. The maximum offset for 2016-17 is $445. The offset phases out at the rate of 1.5 cents for every dollar by which taxable income exceeds $37,000 (the “phase-out threshold”). This means that the offset ceases to be available once taxable income reaches $66,667 (the ‘‘phase-out limit’’): see [100 100]. The low income offset is only available to resident individuals (companies and foreign residents do not qualify): s 159H. See also [7 640]. A trustee assessed under s 98 on behalf of a qualifying beneficiary is entitled to the offset, but a trustee assessed under s 99 or s 99A is not. The low income offset is neither refundable nor transferable and cannot be carried forward to a later income year: s 63-10(1). Note that 18% of an individual’s entitlement to the low income offset is delivered through the PAYG withholding system. A resident minor or a trustee for a resident minor cannot use the low income offset to reduce the tax payable on Div 6AA income: see [26 250]. EXAMPLE [19 300.10] Mrs Bennett has a 2016-17 taxable income of $41,750 and no dependants. Her tax payable is (ignoring cents): Tax on $41,750 less low income offset: $445 − ([$41,750 − $37,000] × 1.5%) add Medicare levy ($41,750 × 2%)

$ 5,115 374 4,741 835 5,576

MEDICAL EXPENSES OFFSET [19 350] Medical expenses offset – introduction A resident taxpayer who during the income year pays ‘‘rebatable medical expenses’’ may be entitled to an offset under s 159P ITAA 1936 (commonly called the net medical expenses tax offset). See [19 370]-[19 380] for the categories of medical expenses that may qualify as rebatable medical expenses. Importantly, the offset is being phased out: see below. The offset is allowable for rebatable medical expenses incurred in respect of the following individuals (s 159P(4)): • the taxpayer; • the taxpayer’s spouse (including a de facto spouse and a same sex partner: see [19 150]); • a child of the taxpayer who is under 21; • a person in respect of whom the taxpayer is entitled to the dependant (invalid and carer) offset, or would be entitled to the offset if the income test was disregarded: see [19 150]; and 726

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[19 360]

• a dependent student under 25 or a dependent non-student child under 21, in respect of whom the taxpayer qualifies for a notional offset under Subdiv 961-A ITAA 1997: see [19 180]. Medical expenses are not rebatable unless incurred in respect of a resident taxpayer or dependant. However, there is no requirement that the medical expenses be paid in Australia and therefore medical expenses paid during an overseas trip may qualify: withdrawn ATO ID 2001/669. Health insurance contributions do not qualify as medical expenses (a separate tax offset is available in respect of such contributions: see [19 450]).

Phase out of offset The medical expenses offset will cease to be available as from the 2019-20 income year. For the 2016-17, 2017-18 and 2018-19 income years (inclusive), the medical expenses offset is only available for qualifying expenses that relate to disability aids, attendant care or aged care: see [19 370]. This rule also applied for 2013-14, 2014-15 and 2015-16, except transitional arrangements allowed certain taxpayers to claim the offset in 2013-14 and 2014-15 for all qualifying expenses in accordance with the pre-2013-14 rules: s 159P(1C). For further details about the transitional arrangements and the pre-2013-14 rules, see the Australian Tax Handbook 2015 at [19 350]. Medicare payments and other reimbursements Any amounts that the taxpayer or some other person has received, or is entitled to receive, from a government, public authority, society, association or fund (including an insurance company) do not qualify as rebatable medical expenses: s 159P(1). Thus, refunds from Medicare and health funds (including overseas funds: see ATO ID 2002/275), and amounts the taxpayer is entitled to claim from Medicare and health funds even if he or she does not make a claim (Case 57 (1969) 15 CTBR(NS) 57), reduce the rebatable amount. Reimbursements of medical expenses from an employer that is not a government, public authority, society, association or fund should not reduce the rebatable amount, but may constitute a fringe benefit. An amount paid in reimbursement of medical expenses as part of a compensation payment paid (as a result of a damages action) by a person that is not a government, public authority, society, association or fund also seemingly does not reduce the rebatable amount: see ATO ID 2003/954. Medicare benefits repaid to the Health Insurance Commission as a result of receiving a compensation payment in an out-of-court settlement would not be rebatable. [19 360] Offset rate and threshold There are different offset rates and phase-in limits, depending on the taxpayer’s ‘‘adjustable taxable income for rebates’’ (ATI), or the combined ATI of the taxpayer and her or his spouse. See [19 160] for the definition of ATI. If the taxpayer’s ATI, or the combined ATI of the taxpayer and the taxpayer’s spouse if the taxpayer has a spouse on the last day of the income year (see [19 150] for the definition of ‘‘spouse’’), is equal to or less than the appropriate Medicare levy surcharge threshold (see [19 790]), for 2016-17 the offset rate is 20% and the phase-in limit (which is indexed) is $2,299. This means that, for 2016-17, the offset is not available unless eligible net medical expenses for the year exceed $2,299. If the taxpayer’s ATI, or the combined ATI of the taxpayer and the taxpayer’s spouse if the taxpayer has a spouse on the last day of the income year (see [19 150] for the definition of ‘‘spouse’’), exceeds the appropriate Medicare levy surcharge threshold (see [19 790]), for 2016-17 the offset rate is 10% and the phase-in limit is $5,423. This means that, for 2016-17, the offset is not available unless eligible net medical expenses for the year exceed $5,423.

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727

[19 370]

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EXAMPLE [19 360.10] During 2016-17, Mr Chansiri incurs qualifying medical expenses of $11,467 in respect of his wife. He is a member of a health fund which refunded him $7,825 in total. They have 2 children. The combined ATI for the year of himself and his wife is less than $181,500 (the relevant Medicare levy surcharge threshold: see [19 790]). Net medical expenses ($11,467 − $7,825) less threshold Offset = 20% × $1,343 (ignoring cents) =

$ 3,642 2,299 1,343 268

[19 370] Qualifying medical expenses As noted at [19 350], the medical expenses offset is only available for payments for medical expenses (as defined) that relate to ( s 159P(1B)): • disability aids; • attendant care services; or • aged care services and accommodation. A disability aid is considered to be an instrument, apparatus, assistance device or any other item of property that is manufactured as, distributed as, or generally recognised to be, an aid to the function or capacity of a person with a disability. A disability aid would be considered to be an aid to function or capacity if it helps a person in performing activities of daily living or provides assistance to alleviate the effect of the disability. According to the Explanatory Memorandum to the relevant amending legislation (Act No 11 of 2014), examples of a disability aid include a wheelchair for a paraplegic and a guide dog for a blind person (both of which fall within the definition of ‘‘medical expenses’’ in s 159P(4): see [19 380]). Disability aids generally will not include ordinary household or commercial appliances. For example, if a person with a disability who is bed ridden has a particular sensitivity to heat (that is unrelated to the disability), an air conditioner would seemingly not qualify as a disability aid. See further [19 380]. Attendant care services relate to services and care provided to a person with a disability to assist with everyday living, such as the provision of personal assistance, home nursing, home maintenance and domestic services. According to the Explanatory Memorandum to Act No 11 of 2014, the cost of an attendant assisting a person who has an acquired brain injury with grooming, clothing and feeding activities would be considered to be related to ‘‘attendant care’’. Aged care expenses relate to services and accommodation provided by an approved aged care provider to a person who is a care recipient or continuing recipient within the meaning of the Aged Care Act 1997. The term ‘‘care’’ has its ordinary meaning and is consistent with the definition in the Aged Care Act 1997, wherein care means ‘‘services, or accommodation and services, provided to a person whose physical, mental or social functioning is affected to such a degree that the person cannot maintain himself or herself independently’’. The interest charged on an outstanding instalment of a lump sum accommodation bond owed by a taxpayer to an aged care facility of which he/she is a resident may qualify as a medical expense for offset purposes: see ATO ID 2006/251.

Cosmetic surgery excluded Payments to a legally qualified medical practitioner, nurse or chemist, or a public or private hospital, in respect of a cosmetic operation that is not a professional service for which 728

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[19 380]

a Medicare benefit is payable under Pt II of the Health Insurance Act 1973, are ineligible for the offset (these are called ‘‘ineligible medical expenses’’).

[19 380] Specific categories of qualifying medical expenses To qualify for the medical expenses offset, a payment must satisfy the definition of ‘‘medical expenses’’ in s 159P(4). The definition covers a wide variety of payments. However, in view of the restriction in s 159P(1B) – that qualifying medical expenses must relate to disability aids, attendant care or aged care (see [19 370]) – only some of the categories of ‘‘medical expenses’’ in s 159P(4) are still relevant. These are considered below. Payments that seemingly no longer qualify for the offset include: • payments to a medical practitioner, nurse or chemist (who is legally qualified to practise as such), or to a public or private hospital, in respect of an illness or operation; • payments in respect of dental services and artificial teeth; • payments for therapeutic treatment (eg massage, physiotherapy, chiropractic treatment and osteopathy, although massage and physiotherapy might qualify as ‘‘attendant care services’’); and • payments for eye tests. Payments for spectacles and contact lenses are unlikely to qualify for the offset other than in exceptional circumstances (where a sight problem is considered to be a disability and the particular spectacles or contact lenses can be considered to be a disability aid). Incidental expenses, such as travel and accommodation costs, should not qualify as ‘‘medical expenses’’: see Case No 63/1983 (1984) 27 CTBR(NS) 535; Case 63 (1983) 27 CTBR(NS) 63; and withdrawn ATO ID 2001/228.

Medical or surgical appliances Paragraph (f) of the definition of ‘‘medical expenses’’ in s 159P(4) includes payments in respect of a medical or surgical appliance (other than an artificial limb, artificial eye or hearing aid) provided the appliances are prescribed by a legally qualified medical practitioner. The Tax Office considers that a ‘‘medical or surgical appliance’’, which is not defined in s 159P, is an instrument, apparatus or device which is manufactured or distributed as, or generally recognised to be, an aid to the function or capacity of a person with a disability or illness: see Ruling TR 93/34. Such an appliance may therefore qualify as a ‘‘disability aid’’. The ruling also states that an appliance is an aid to function or capacity if it helps a person in performing activities of daily living. Generally, a household or commercial appliance is not considered to be a ‘‘medical or surgical appliance’’ (nor a disability aid: see [19 370]). Ruling TR 93/34 lists various items that qualify as rebatable medical or surgical appliances, including wheelchairs, crutches, car controls for the disabled, kidney dialysis machines, Maximyst machines, teletypewriters, medical wigs and surgical braces (these may also qualify as disability aids). Items that do not qualify as a rebatable medical or surgical appliance include breathing monitors, household air conditioners, cosmetic wigs, hydrotherapy pools, swimming pools, wheelchair ramps and language kits. An electrically operated chairlift installed in a home qualified as a medical appliance in Case 7 (1972) 18 CTBR (NS). In FCT v Ildes (1988) 19 ATR 952, a spa pool was not a medical appliance because it was not an aid to function or capacity. Other items that may qualify as ‘‘medical or surgical appliances’’ include a freestanding overbed frame and mobile shower commode (ATO ID 2001/154), an electric scooter (ATO ID 2003/979), a fold down ramp to provide wheelchair access to a car (ATO ID 2006/250) and a speech aid (ATO ID 2006/252). Items that may not qualify include a mattress replacement system and recline lift chair (ATO ID 2001/155) and a personal alarm monitoring service (ATO ID 2003/868). © 2017 THOMSON REUTERS

729

[19 400]

INDIVIDUALS

Artificial aids Paragraph (e) of the definition of ‘‘medical expenses’’ in s 159P(4) also includes payments in respect of an artificial limb (or part of a limb), artificial eye or hearing aid (these should qualify as disability aids). These aids need not be prescribed by a legally qualified medical practitioner. An auditory trainer used in speech therapy treatment was accepted as a hearing aid in former Ruling IT 318. The Tax Office considers that the costs incurred in transporting an artificial limb for repair do not qualify for the offset: see ATO ID 2003/171. Personal attendants Paragraph (h) of the definition of ‘‘medical expenses’’ in s 159P(4) includes payments as remuneration of a person for services rendered by her or him as an attendant to a person who is blind or is permanently confined to a bed or invalid chair. Such payments would prima facie be related to attendant care: see [19 370]. The term ‘‘attendant’’ is not defined for these purposes. However, the Tax Office considers that payments in respect of the provision of services that are solely domestic services (such as house cleaning, home and garden maintenance services) only qualify as ‘‘medical expenses’’ if the expense is capable of being characterised as a medical expense (see the notice of withdrawal for ATO ID 2007/190). Payments to a company for the provision of a carer to help a person confined to a wheelchair may qualify for the offset: see ATO ID 2002/934, citing an unreported case (AAT Case 944 (Allen M, 15 November 2001)). Guide dogs Payments for the maintenance of a dog used for the guidance or assistance of a person with a disability are rebatable, as the dog qualifies as a ‘‘disability aid’’ (see [19 370]), provided the dog has been properly trained for that purpose. This does not cover the costs of a dog used for social therapy. [19 400] Payment of medical expenses by trust estate If medical expenses are paid on behalf of a resident beneficiary by a trustee, from income of the trust, those expenses to the extent to which they are not recouped or entitled to be recouped are rebatable (s 159P(3)): • in the assessment of the trustee if the trustee is liable to be assessed under s 98; and • in the assessment of the beneficiary if the beneficiary is liable to be assessed in respect of that income. In the case of a deceased estate, the trustee is entitled to an offset equal to that to which the deceased would have been entitled.

PRIVATE HEALTH INSURANCE TAX OFFSET [19 450] Private health insurance offset – introduction A tax offset is available (under Subdiv 61-G ITAA 1997) to individual taxpayers and some trustees in respect of private health insurance premiums, including if the premiums are paid by an individual’s employer as a fringe benefit: see [19 460]. The amount of the tax offset depends on the taxpayer’s (and any spouse’s) ‘‘income for surcharge purposes’’ and whether the policy covers one or more persons aged 65 or over: see [19 470]. The offset is refundable in accordance with the rules discussed at [19 040], unless paid to a trustee (see below). The private health insurance tax offset is in addition to the medical expenses tax offset, for which private health insurance contributions do not qualify: see [19 350]. 730

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[19 460]

A private health insurer is required to provide the insured person with details about the relevant health insurance policy and the premiums paid under the policy: reg 61-220.02 ITA Regs. The information must be provided in the approved form within 14 days after the end of the relevant income year (ie before 15 July). A private health insurer may also be required to provide to the Commissioner relevant information about any person covered by a health insurance policy or who paid premiums under such a policy: s 264BB ITAA 1936

Premium reduction alternative As an alternative to the private health insurance offset, the premiums payable under the insurance policy may be reduced under Div 23 of the Private Health Insurance Act 2007. To the extent that a person’s premiums are reduced, that person will not be entitled to the private health insurance offset. A second alternative incentive in the form of a tax-exempt direct cash payment (under Div 26 of the PHI Act) is no longer available. PAYG deductions The offset is not a ‘‘prescribed offset’’ for PAYG withholding purposes (see [50 150]) and is not built into the PAYG withholding schedules. However, a taxpayer may apply for a variation of the PAYG withholding amount to take the offset into account (see [50 160]). [19 460] Qualifying conditions Eligibility for the private health insurance offset is determined by reference to the Private Health Insurance Act 2007 (PHI Act). A person qualifies for the offset if (s 61-205): • a premium, or an amount in respect of a premium, has been paid under a complying private health insurance policy (see below) in respect of a particular period (the ‘‘premium period’’). The premium can be paid by the taxpayer or another entity (eg the taxpayer’s employer as a fringe benefit: see [19 450]); • he or she is a PHIIB in respect of that premium or amount (see below); and • each person insured under the policy is an eligible person for the whole time he or she is insured during the premium period.

PHIIBs In general, all adults who are covered by a private health insurance policy will be PHIIBs (private health insurance incentive beneficiaries) for that policy. Where a policy covers a dependent child (or children) only, the parents of that child or children will be PHIIBs for the policy. However, if a policy covers a dependent child or children only, and the parents are not married at the end of the income year, the payer of the premium in respect of that policy will be the only PHIIB for the policy (provided the payer is not a dependent child). The following table (adapted from the Explanatory Memorandum to the Fairer Private Health Insurance Incentives Bill 2011) sets out which person or persons are entitled to receive the private health insurance offset, how much each person is entitled to and which person or persons will be income tested. Persons covered

Single adult

Single family

Who is eligible to claim the offset?

How much are they eligible for?

Single adult on the Whole offset policy

parent Single parent on the Whole offset policy

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Who is income tested?1 Single adult on the policy with respect to the single tier thresholds Single parent on the policy with respect to the family tier thresholds. The thresholds increase by $1,500 for each child after the first.

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[19 460]

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Persons covered

Couple/family

Who is eligible to claim the offset?

How much are they eligible for? Each is entitled to one half of the offset. Both adults on the One member of the couple may elect to receive the benefit policy on behalf of his or her spouse.

Multiple adults All adults on the policy Each is entitled to an offset (not coupled) based on their share of the policy. This is calculated by dividing the total cost of the policy by the number of adults covered. (i) Each parent is entitled to an offset based on their share of the policy. This is calculated by (i) The parents of the dividing the total cost of the children covered policy by the number of parents. One parent may elect Dependent child to receive the benefit on behalf (children) only of his or her spouse. (ii) If the parents of the children are not a couple, then the person who pays for (ii) The payer is entitled to the the policy, provided whole offset. the payer is not a dependent child

Who is income tested?1 Both adults on the policy with respect to the family tier thresholds. The thresholds increase by $1,500 for each child after the first. Each adult is income tested separately with respect to the single tier thresholds.

(i) The parents with respect to the family tier thresholds

(ii) The payer, provided the payer is not a dependent child, with respect to the family tier thresholds

1. See [19 470] for the single tier and family tier thresholds.

Complying health insurance A ‘‘complying health insurance policy’’ is defined in s 63-10 of the PHI Act as an insurance policy that meets various requirements set out in the Act and Regulations, including community rating, coverage, benefit, waiting period and portability requirements. Note that a health fund must give a policyholder, before 15 July each year, a statement containing certain information about the policy, the total of premiums paid for the previous income year and the amount of the offset: reg 61-220.01 ITA Regs.

Eligible persons As noted above, unless each person insured under the complying health insurance policy is an ‘‘eligible person’’ (or is treated as such), the premiums paid under it do not qualify for the offset. An ‘‘eligible person’’ is an Australian resident or an eligible overseas representative. Thus, unless a person is an eligible overseas representative, the offset is not available in respect of any period during which the persons covered by an appropriate health insurance policy are not Australian residents. The concept of residency is discussed in Chapter 2. ‘‘Eligible overseas representatives’’ are certain diplomatic or consular staff and their families and persons declared by the Minister to be treated as eligible persons. A taxpayer is entitled to the offset even if not covered by the policy as there is no requirement in s 61-205 that the policy must cover the person paying the premium; see also ATO ID 2002/975.

Trustees A trustee assessed under s 98 on behalf of a presently entitled beneficiary (see [23 500]) is also entitled to the private health insurance offset if the beneficiary would have been entitled to the offset: s 61-205(2). A trustee, however, is not entitled to a refund of any excess offset: see [19 040]. 732

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Employer-paid premiums It is possible to qualify for the offset if premiums, or amounts in respect of premiums, are paid by an employer as a fringe benefit: s 61-205(1). Basically, this means a fringe benefit within the meaning of the FBTAA, although an ‘‘employer’’ for these purposes includes the Commonwealth and Commonwealth authorities. Even though the employer has paid the premium, the PHIIBs are entitled to the offset. The calculation of the offset is done in exactly the same manner as if the employee had paid the premium. [19 470] Amount of offset The amount of the private health insurance offset is worked out under s 61-210 by reference to Div 22 of the Private Health Insurance Act 2007 (PHI Act). The amount depends on: • the taxpayer’s (and any spouse’s) ‘‘income for surcharge purposes’’; and • whether the policy covers one or more persons aged 65 or over. Each PHIIB (see [19 460]) is eligible to receive the offset for their share of the private health insurance incentive benefit (‘‘PHII benefit’’) in respect of the insurance policy premium or amount: s 61-210(1). However, if a couple (including same sex partners) are married (legally or de facto) on the last day of the income year, the one member of the couple may claim the offset on behalf of their partner (the choice must be made in the person’s income tax return). If so, the offset entitlement of their partner will be reduced to nil: s 61-215.

Calculation of offset There are 3 ‘‘Private Health Insurance Incentive Tiers’’ (in Div 22 PHI Act). The table below sets out the amount of the offset for 2016-17. Note that the relevant thresholds also apply for 2017-18, 2018-19, 2019-20 and 2020-21. 2016-17 Income for surcharge purposes Offset2, 3 ($)1 Singles4 Couples/ Under 65 65 – 69 70 or above families4, 5 0 – 90,000 0 – 180,000 26.791% 31.256% 35.722% 1 90,001 – 105, 180,001 – 210, 17.861% 22.326% 26.791% 000 000 2 105,001 – 140, 210,001 – 280, 8.930% 13.395% 17.861% 000 000 3 140,001+ 280,001+ 0% 0% 0% 1 ‘‘Income for surcharge purposes’’ has the same meaning as for Medicare levy surcharge purposes: see [19 780]. 2 Different offset rates apply depending on whether there is at least one person covered by the health insurance policy who is aged 65 to 69 or 70 or above. 3 It is likely that, because of the Rebate Adjustment Factor (RAF) (see the Private Health Insurance (Incentives) Rules 2012 (No 2)), the rebate percentages above will apply to premiums paid between 1 June 2016 and 31 March 2017 and that different percentages will apply to premiums paid between 1 April and 30 June 2017. If so, the premiums may need to be apportioned between the 2 periods. 4 These thresholds also apply for 2017-18, 2018-19, 2019-20 and 2020-21. 5 For families with more than one dependent child, the relevant threshold is increased by $1,500 for each child after the first. Tier

Note that the amount of the offset is reduced by the amount of any premium reduction under Div 23 of the PHI Act (see [19 450]): s 61-210(2)-(5). In addition, the offset does not apply to any increase in the premium because of the lifetime health cover rules in Div 34 of the PHI Act: s 22-15(6) PHI Act. If a premium provides cover for more than one income year, or for parts of more than one income year, it seems that the whole premium qualifies for the offset in the year in which © 2017 THOMSON REUTERS

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[19 470]

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it is paid (ie the premium is not spread across both years). This is because the ‘‘premium period’’ (see [19 460]) is not restricted to an income year (see also ATO ID 2004/713). There are provisions in the PHI Act (s 22-25) which deal with the situation where a higher rate offset is payable because a person aged 65 or over is covered by a complying health insurance policy (the ‘‘entitling person’’), but he or she ceases to be covered by the policy. If another person (other than a dependent child) was insured under the policy, the amount of the offset payable in relation to a complying health insurance policy (whether the original policy or another policy such as a renewal of the original policy) is worked out as if the entitling person were covered by that policy and were the same age as the age at which he or she ceased to be insured under the original policy. This concession does not apply, however, if a person (other than a dependent child) who was not covered under the original policy when the entitling person ceased to be covered by that policy becomes covered by the particular policy (ie the one in relation to which the offset is payable). This concession does not operate if its application would result in the amount of tax offset being less than it would otherwise have been. EXAMPLE [19 470.10] Fatoula pays health insurance premiums of $2,242 to a health fund during the income year for family hospital and ancillary cover for herself, her husband and their 2 children. Fatoula and her husband are both under 65. Income for surcharge purposes is less than $181,500. Fatoula chooses the offset on behalf of her husband. The premiums are apportioned between the periods from 1 July 2016 to 31 March 2017 (274 days) and 1 April to 30 June 2017 (91 days). Assume the offset percentage for the period from 1 April to 30 June 2017 is 26.248%. Fatoula is entitled to a private health insurance offset for 2016-17 of (ignoring cents): $2,242 × 274/365 × 26.791% = $450 + $2,242 × 91/365 × 26.248% = $146 = $596

EXAMPLE [19 470.20] On 30 January 2017, Sunil (who is under 65) pays a health insurance premium (for hospital and ancillary cover) of $2,340, which provides cover for himself and his 3 children until 29 January 2018. Income for surcharge purposes is less than $183,000. Although the premium provides cover across 2 income years, the offset for the 2016-17 income year is calculated by reference to the whole premium, ie the premium does not have to be apportioned over the 2 income years. In addition, it seems that the premium is not apportioned between the periods from 1 July 2016 to 31 March 2017 (274 days) and 1 April to 30 June 2017 (91 days): see s 22-15(5A), (5C) and (5D) PHI Act. Sunil is entitled to a private health insurance offset for 2016-17 of (ignoring cents): $2,340 × 26.791% = $626

EXAMPLE [19 470.30] Jodie and Alex are a de facto married couple. Jodie is 62 and Alex is 67. They have a couple’s complying health insurance policy, paying total premiums of $3,146. Jodie’s income for surcharge purposes is $70,000 and Alex’s is $160,000. Their combined income for surcharge purposes is $230,000, so both are tier 2 earners. The premiums are apportioned between the periods from 1 July 2016 to 31 March 2017 (274 days) and 1 April to 30 June 2017

734

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[19 500]

(91 days). Assume the offset percentage for the period from 1 April to 30 June 2017 is 12.769%. Neither chooses to claim the private health insurance offset on their partner’s behalf. Jodie and Alex are each entitled to an offset for 2016-17 of (ignoring cents): 274

/365 × 13.395% × 50% = $158 + $3,146 × 91/365 × 12.769% × 50% = $50 = $208

$3,146 ×

EXAMPLE [19 470.40] In the 2016-17 income year, Yudi pays health insurance premiums of $1,910 for hospital cover for himself and his wife Elena. Elena turns 65 on 28 November 2016 (Yudi is under 65 for the whole income year). Their combined income for surcharge purposes is less than $180,000. For the period 1 July-27 November 2016 (150 days), Yudi is entitled to the private health insurance offset at the 26.791% rate. For the period 28 November 2016-31 March 2017 (124 days), he is entitled to the offset at the 31.256% rate. Assume the offset percentage for the period from 1 April to 30 June 2017 (91 days) is 30.485%. Yudi’s offset amount for 2016-17 is (ignoring cents): $1,910 × 150/365 × 26.791% = $210 + 124

/365 × 31.256% = $202 + $1,910 × 91/365 × 30.485% = $145 Total offset = $557

$1,910 ×

PENSIONERS, SOCIAL SECURITY RECIPIENTS AND MATURE AGE WORKERS [19 500] Senior Australians and other pensioners Senior Australians and other pensioners may qualify for the senior Australians and pensioner tax offset (SAPTO) under s 160AAAA ITAA 1936. The following are eligible for SAPTO if their ‘‘rebate income’’ (see below) is less than the relevant threshold amount: • a person who, on at least one day in the income year, is qualified for the age pension under the Social Security Act 1991 and is not in gaol; • a person who, on at least one day of the income year, is eligible for a pension, allowance or benefit under the Veterans’ Entitlements Act 1986 (but not under the Veterans’ Children Education Scheme), has reached pension age and is not in gaol; and • a person whose assessable income includes a social security pension, an education entry payment, service pension, carer service pension, income support supplement or Defence Force Income Support Allowance or a DFISA-like payment and who, on at least one day in the income year, is not in gaol. Note that the Social Services Legislation Amendment (Budget Repair) Bill 2016 proposes to abolish the education entry payment from 1 January 2017. © 2017 THOMSON REUTERS

735

[19 500]

INDIVIDUALS

A person who is in gaol for the whole income year does not qualify for SAPTO. The SAPTO is similarly available to a trustee liable to be assessed under s 98 ITAA 1936 on behalf of a beneficiary who satisfies the above conditions: s 160AAAB ITAA 1936. A common situation where a trustee is assessed under s 98 ITAA 1936 is where the beneficiary is under a legal disability: see [23 460]. If a taxpayer is entitled to both SAPTO and the social security and educational beneficiary offset (see [19 520]), he or she qualifies for the higher offset and not the lower one: s 160AAA(4). If the 2 offsets are equal in amount, the taxpayer is entitled to only one of the offsets and not both. Similarly, if a beneficiary of a trust qualifies for the social security and educational beneficiary offset and the trustee qualifies for SAPTO, the beneficiary cannot claim the social security and educational beneficiary offset if the amounts of the 2 offsets are the same or if SAPTO is greater: s 160AAA(4A). However, if the social security and educational beneficiary offset is greater than SAPTO, the trustee cannot claim SAPTO. Note that SAPTO is not a refundable offset: see [19 040].

Amount of offset The amount of the offset is determined in accordance with regs 9 to 11 ITA (1936 Act) Reg. The offset is available at a different rate depending upon whether the person is single, partnered (usually married) and living together or partnered and separated (provided the parties are only unable to live together due to illness or infirmity). If a partnered pensioner receives the single rate of pension during a respite care period, that pensioner is entitled to claim the offset at the partnered and separated rate. The offset reduces by $0.125 for every dollar by which ‘‘rebate income’’ exceeds the relevant threshold amount (this varies, depending upon whether the person is single, a member of a couple who live together or a member of a couple who are separated due to illness). See below for the definition of ‘‘rebate income’’. The level of offset is generally the same for social security and service pensioners unless the number of pension paydays falling within the income year varies for each, in which case separate levels of offset are provided. The maximum amount of SAPTO is: • single – $2,230; • couple (each) – $1,602; and • couple (separated due to illness) – $2,040. The shading-out income levels (ie the ‘‘rebate income’’ levels at which SAPTO starts to phase out and at which it is reduced to nil) for 2015-16 are set out in the table at [100 130]. The relevant amounts for 2016-17 are unlikely to be known until May 2017. Any unused SAPTO may be transferred between spouses (if both are entitled to SAPTO), including where the one taxpayer is a trustee entitled to the offset under s 160AAAB, in accordance with reg 12 ITA (1936 Act) Reg.

Rebate income As noted above, the amount of SAPTO payable to a taxpayer depends on their ‘‘rebate income’’. Thus, the amount of SAPTO is reduced if rebate income exceeds the lower threshold and the SAPTO is not available if rebate income exceeds the higher threshold. ‘‘Rebate income’’ is defined in s 6(1) as the sum of: • taxable income for the year; • adjusted fringe benefits total for the year: see [19 160]; • total net investment loss for the year: see [19 160]; and 736

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[19 520]

• reportable superannuation contributions for the year, ie the sum of any reportable employer superannuation contributions and all deductible personal superannuation contributions made by the dependant: see [39 140]. If the taxpayer has a spouse (including a de facto spouse: see [19 150] for the definition of ‘‘spouse’’), the taxpayer’s ‘‘rebate income’’ is taken to be half the sum of the following amounts: her or his ‘‘rebate income’’; the spouse’s actual “rebate income” (excluding s 100 trust amounts); and any amount in respect of which a trustee of a trust estate is liable to be assessed (and pay tax) under s 98 in respect of the taxpayer’s spouse (eg if the spouse is under a legal disability: see [23 460]): s 160AAAA(4). A similar provision applies if SAPTO is claimed by a trustee liable to be assessed under s 98 (see above): s 160AAAB(5). EXAMPLE [19 500.10] A single pensioner (below age pension age) has ‘‘rebate income’’ of $38,690 (including the pension). The offset is (rounded to the nearest dollar): $2,230 − (12.5% × ($38,690 − $32,279)) = $1,429

EXAMPLE [19 500.20] A married pensioner (below age pension age) living with her or his spouse has ‘‘rebate income’’ of $31,630 (including the pension). The offset is (rounded to the nearest dollar): $1,602 − (12.5% × ($31,630 − $28,974)) = $1,270

[19 520] Social security and educational beneficiary offset A taxpayer who is a low income earner is entitled to the social security and educational beneficiary offset (‘‘beneficiary offset’’) under s 160AAA(3) ITAA 1936 if her or his assessable income includes any of the following social security payments (called ‘‘rebatable benefits’’): • a benefit under Pt 2.8A, 2.11, 2.11A, 2.12, 2.14, 2.15, 2.15A or 2.23B of the Social Security Act 1991 – ie recipients of Newstart allowance, youth allowance, sickness allowance, widow allowance, partner allowance, special benefits, Austudy payment or Disaster Recovery Allowance; • parenting payment that is PP (partnered) under the Social Security Act 1991 to the extent that it is not exempt under Div 52 ITAA 1997; • a Commonwealth education or training payment (as defined in s 52-145) except where the recipient or the individual on whose behalf the recipient receives the payment is an employee of any person who is entitled to a Commonwealth subsidy in respect of the employment – those who qualify in respect of Commonwealth education or training payments include recipients of youth allowance, Austudy payment, ABSTUDY, Assistance for Isolated Children Scheme or Veterans’ Children Education Scheme payments in respect of a period commencing when the student was at least 16 years of age and participants in a Commonwealth labour market program: see [7 270]; • wages under the Community Development Employment Projects program (from the wages component of a grant made under the program); • Cyclone Larry and Cyclone Monica income support payments (paid to farmers and small business owners); © 2017 THOMSON REUTERS

737

[19 550]

INDIVIDUALS

• interim income support payments under s 33 of the Financial Management and Accountability Act 1997; or • the Equine Workers Hardship Wage Supplement Payment. Section 160AAA is to be amended by the Treasury Laws Amendment (2016 Measures No 1) Bill 2016, so that Income Support Allowance paid to New Zealand special category visa (subclass 444) holders in Australia who have been impacted by a disaster in 2014-15 or a later income year will also be a rebatable benefit. The offset can be set off against tax payable on income from all sources and is not restricted to being offset against tax payable on the benefits received. The offset can only reduce the total tax liability for the year to zero or above; it cannot give rise to a refund if it exceeds the total tax liability. However, it can give rise to a refund of PAYG deductions. The beneficiary offset can be used by a minor to reduce the tax payable on Div 6AA income: see [26 250]. Note that a loss or outgoing is not deductible under s 8-1 ITAA 1997 to the extent it is incurred in gaining a rebatable benefit: see [9 960]. See [19 500] for the rules that apply if a taxpayer is entitled to both the beneficiary offset and SAPTO, or if a taxpayer entitled to the beneficiary offset is the beneficiary of a trust whose trustee is entitled to SAPTO.

Calculation of offset The amount of the beneficiary offset is determined under reg 13 ITA (1936 Act) Reg. It is calculated on the basis of the amount of rebatable benefit actually received during the year and is designed to offset the tax liability on that amount with no threshold at which it tapers off (see below). If the amount of the 2016-17 rebatable benefit does not exceed $37,000 (the upper threshold for the lowest marginal rate), the offset is simply 15% of the excess above $6,000 (rounded up to the nearest dollar). This may be expressed in the formula: [A − $6,000] × 0.15

where A is the amount of rebatable benefit received by the taxpayer during the income year (rounded down to the nearest dollar). If the amount of the 2016-17 rebatable benefit exceeds $37,000, the above formula is still applied in the manner indicated, but the offset is increased by 30% of the excess above $37,000 (rounded up to the nearest dollar). In other words, the formula becomes: [A − $6,000] × 0.15 + [A − $37,000] × 0.15

EXAMPLE [19 520.10] Amelia’s rebatable benefit amount is $42,000. She is entitled to an offset of: (($42,000 − $6,000) × 0.15) + (($42,000 − $37,000) × 0.15) = $5,400 + $750 = $6,150

ZONE AND OVERSEAS FORCES OFFSET [19 550] Isolated areas – qualifications for offset An offset is available under s 79A ITAA 1936 to taxpayers who live in remote areas of Australia that are collectively called the ‘‘prescribed area’’. The offset is granted because of the uncongenial climate, isolation and high cost of living in these areas. The ‘‘prescribed area’’ is divided into 2 zones: Zone A and Zone B. The geographical position of each of these zones is described in Sch 2 ITAA 1936. Areas in Zone A are 738

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INDIVIDUALS [19 550]

generally more isolated and uncongenial than areas in Zone B. Particularly isolated areas within the 2 zones are known as ‘‘special areas’’, residents of which are entitled to a higher offset. The Tax Office uses the Australian Zone List to determine whether an area is in Zone A or Zone B or in a special area (see Practice Statement PS LA 2002/6). The list is available on the Tax Office website. In AAT Case 8299 (1992) 24 ATR 1120, it was held that an offshore petroleum platform did not form part of the Australian mainland and it was not an island. Consequently, it could not be within the boundaries of Zone A as described in the legislation.

Required period of residence To qualify for the zone offset, the taxpayer is required to be a resident of Zone A or Zone B for a period of more than one-half of the relevant income year (ie at least 183 days). The primary test for establishing residence is where the taxpayer’s usual place of residence is situated. Thus, a taxpayer is a resident of a relevant area (ie Zone A, Zone B or the special area in Zone A or Zone B) if he or she has his or her usual place of residence in that area for at least 183 days in the income year: s 79A(3B)(a). Alternatively, if a taxpayer dies during the income year, he or she will have been a resident of a relevant area if he or she had his or her usual place of residence in that area when he or she died: s 79A(3B)(c). The term ‘‘usual place of residence’’ is not defined, but it may have the same meaning as for FBT purposes: see [58 550]. This means that ‘‘fly-in fly-out’’ workers who spend more than 183 days in a particular zone, but whose usual place of residence is not in that zone, will not qualify for the zone offset in relation to that zone (for income years before 2015-16 they would have qualified for the offset, as residence in a particular zone was based on the taxpayer being present in that zone). EXAMPLE [19 550.10] Barry is a mining engineer who has his usual place of residence in Broome (in Zone A). He travels to Telfer in Western Australia (in a Zone A special area) where he is employed in the mining industry. The distance between Broome and Telfer is approximately 990 km. Barry usually works 14 days at the mine and then returns to Broome for 7 days. He spends a whole day driving to Telfer and a whole day driving back to Broome. Barry can only claim the Zone A offset as his usual place of residence for at least 183 days in the income year is in Broome, which is in Zone A. Before 2015-16, Barry could have claimed the Zone A special area offset, as he was actually in Telfer for at least 183 days in the income year.

There are secondary residence tests so that a taxpayer can qualify for the zone offset in the following situations: • where the taxpayer has his or her usual place of residence in a relevant area for less than 183 days in each of the current income year and the preceding income year, the total number of such days over the 2 income years exceeds 182 and he or she was not a resident of the relevant area in the preceding income year and therefore could not claim the zone offset for that year (see Example [19 550.20]): s 79A(3B)(d); or • where he or she has his or her usual place of residence in a relevant area for less than 183 days (the first period), and that period includes the first day of the income year, and also had his or her usual place of residence in the relevant area in any of the preceding 4 income years but for not more than 182 days (and was not a resident of the relevant area in that earlier year) (the second period), provided the total number of days in the first and second periods exceeds 182 and the taxpayer had his or her usual place of residence in the relevant area continuously from the commencement of the second period until the completion of the first period (see Example [19 550.30]): s 79A(3B)(e). © 2017 THOMSON REUTERS

739

[19 560]

INDIVIDUALS

In both these situations, days where the taxpayer qualifies for the overseas forces or overseas civilian offset (see [19 590] and [19 600]) are not counted in determining if the relevant period exceeds 182 days. Generally, days in a particular period need not be continuous: s 79A(3C). Thus, in Example [19 550.20] the days taken into account in working out the total relevant period over the 2 income years need not be continuous. However, in Example [19 550.30], the relevant period of residence must be continuous. Note that a ‘‘day’’ for these purposes includes part of a day: Ruling TR 94/27, para 12. EXAMPLE [19 550.20] Wyn has her usual place of residence in Zone A from 1 March 2016 until 30 October 2016 (244 days). Because the total period exceeds 182 days, Wyn is entitled to the offset in the 2016-17 income year (but not in 2015-16 as she was not a resident in Zone A in that income year).

EXAMPLE [19 550.30] Dae-Jung has his usual place of residence in a prescribed area from 1 February 2013 to 30 September 2016. He is not entitled to any offset in the 2012-13 income year, but is entitled to claim an offset in 2016-17 (as well as in the intervening years).

The fact that a person is deemed to be a foreign resident under s 23AA ITAA 1936 (see [7 640]) does not disqualify that person from being a resident of a prescribed area for zone offset purposes: see ATO ID 2004/759.

[19 560] Special areas A ‘‘special area’’ in either zone is an area of residence that: • is, as at 1 November 1981, situated at a distance of more than 250 km by the shortest practicable surface route from the centre point of the nearest urban centre with a census population of not less than 2,500 – the starting point is the point from which measurements are normally taken or, if there is more than one such point, the principal one; or • was within a ‘‘special area’’ immediately before 19 October 1984. The Commissioner’s views on the shortest practicable surface route test, including road, water and train routes, are set out in Ruling TR 94/27. If a place of residence is within 250 km of the nearest urban centre but is adjacent to, or in close proximity to, a ‘‘special area’’ in the zone, the Commissioner may determine that the first-mentioned place is within the ‘‘special area’’. This overcomes difficulties that might arise in the case of residences that are within the 250-km test but are part of a settlement of which some of the residences are more than 250 km from the nearest urban centre. The adjacent to or close proximity test is discussed in Ruling TR 94/27. Surface route means any route other than an air route and could include a sea route, a land route or a combination of both.

Meaning of urban centre The term ‘‘urban centre’’ is defined in s 79A(4) as an area that is prescribed as an urban centre or bounded locality in the census of population and housing that was conducted by the Australian Statistician on 30 June 1981. The results of this census were published by the Australian Bureau of Statistics in documents entitled ‘‘Persons and Dwellings in Local 740

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INDIVIDUALS

[19 580]

Government Areas and Urban Centres’’. The same source is used to determine whether that urban centre has a population of more than 2,500. This census replaced the census conducted on 30 June 1976 and resulted in changes to the locations included in the zones. The Tax Office uses the Australian Zone List to determine whether a location is in a special area (see Practice Statement PS LA 2002/6). The list is available on the Tax Office website.

[19 570] Calculating the offset The standard offsets allowable for the 2016-17 income year are (s 79A(2)): • a resident of a ‘‘special area’’ in Zone A or Zone B: $1,173 + 50% of the ‘‘relevant rebate amount’’ (see Example [19 580.10]); • a resident of Zone A who is not a resident of the ‘‘special area’’ in Zone A or Zone B during any part of the income year: $338 + 50% of the ‘‘relevant rebate amount’’ (see Example [19 580.20]); • a resident of Zone B who is not a resident of Zone A or of the ‘‘special area’’ in Zone B during any part of the income year: $57 + 20% of the ‘‘relevant rebate amount’’ (see Example [19 580.30]); • in any other case: the offset is allowable on the basis of the amount considered by the Commissioner to be reasonable in the circumstances. The manner in which the Commissioner will exercise this discretion is discussed in Ruling TR 94/27. The taxpayer will be allowed the greater offset if there are alternative amounts.

Relevant rebate amount The ‘‘relevant rebate amount’’ is the sum of the offsets (if any) to which the taxpayer is entitled for the year, or would be entitled if certain disqualifying provisions were ignored: s 79A(4). The relevant offsets (for 2016-17) are: • the dependant (invalid and carer) offset: see [19 150]. Note that a taxpayer is not entitled to claim more than one amount of offset in respect of the same spouse as a component of their zone offset; • the notional child and student offsets ($376 for a full-time student under 25 and the first child under 21 who is not a full-time student and $282 for any additional child under 21 who is not a full-time student: see [19 180]); and • the notional sole parent offset ($1,607): see [19 190]. See [19 580] for examples of how the zone offset is calculated.

Reduction of offset The zone offset allowed under s 79A is reduced if a taxpayer has received any payments under the Social Security Act 1991 or the Veterans’ Entitlements Act 1986 that include a payment by way of remote area allowance. The zone offset is reduced by the amount of that remote area allowance to ensure that the total of the allowance and the offset do not exceed the maximum zone offset otherwise allowable: s 79A(2A) and (4). [19 580] Examples of zone offsets These Examples below apply for the 2016-17 income year. Note that cents are ignored in the Examples.

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741

[19 580]

INDIVIDUALS

EXAMPLE [19 580.10] ‘‘Relevant rebate amount’’ Jann is married to Stephen and has a dependent student aged 23 and 2 other dependent children aged under 21. She is entitled to the dependant (invalid and carer) offset (DICTO) in respect of Stephen, whose adjusted taxable income for rebates is nil. The ‘‘relevant rebate amount’’ is the sum of DICTO and the notional student and child offsets: see [19 570]. The ‘‘relevant rebate amount’’ is: $ DICTO ........................................................................................................................ 2,627 Student child .............................................................................................................. 376 First child under 21 .................................................................................................... 376 Second child under 21 .............................................................................................. 282 3,661

EXAMPLE [19 580.20] Resident of Zone A but not of a ‘‘special area’’ in either Zone A or Zone B Assume the same facts as in Example [19 580.10] except Jann is a resident of Zone A but not of a ‘‘special area’’ in either Zone A or Zone B. The zone offset allowable is: $ Standard offset .......................................................................................................... 338 50% of ‘‘relevant rebate amount’’ ($3,661 × 50%) ................................................... 1,830 2,168

EXAMPLE [19 580.30] Resident of special zone area – spouse has separate net income Omar is married and has 3 dependent children aged under 21. He qualifies for the dependant (invalid and carer) offset in respect of his wife, whose adjusted taxable income for rebates (ATI) is $3,250. The ‘‘relevant rebate amount’’ is the sum of DICTO and the notional child offsets. DICTO is reduced for the spouse’s ATI: see [19 160]. The ‘‘relevant rebate amount’’ is: DICTO ............................................................................................................. First child under 21 ......................................................................................... Other children under 21 ($282 × 2) ...............................................................

$ 1,885* 376 564 2,825

*$2,627 − 1/4 × ($3,250 − 282) = $1,885 Omar is a resident in a ‘‘special area’’ in Zone A or Zone B. The zone offset is: Standard offset .................................................................................................................... 50% of ‘‘relevant rebate amount’’ ($2,825 × 50%) .............................................................

742

$ 1,173 1,412 2,585

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INDIVIDUALS [19 590]

[19 590] Defence Force members serving overseas A member of the Australian Defence Force (ADF) serving in a declared locality for a period of 6 months or more during the income year is entitled to the overseas forces offset under s 79B ITAA 1936. The offset corresponds to the Zone A zone offset ([19 550]). The availability of the offset is discussed in Ruling TR 97/2. If the total period of overseas service during the income year is at least 183 days, or if the taxpayer dies at an overseas locality during the income year, the amount of the offset is (s 79B(2)(a)): $338 + 50% of the concessional rebate amount

The ‘‘concessional rebate amount’’ is worked out in the same way as the ‘‘relevant rebate amount’’ for zone offset purposes: see [19 570]. If the taxpayer serves abroad for fewer than 6 months during the income year, he or she is entitled to a proportionate offset (usually on a time basis): s 79B(2)(b). Any period of service in Zone A or Zone B (for zone offset purposes: see [19 550]) qualifies as overseas service for s 79B purposes. However, the following do not qualify as overseas service (s 79B(3A)): • operational service or eligible duty in an area prescribed under s 23AD (s 23AD exempts the pay and allowances of certain ADF members serving overseas: see [7 090]); and • periods of overseas service that qualify for a tax exemption under s 23AG (see [7 170]). The aggregate of the offsets that may be allowed under s 79B and s 79A (zone offset), or under s 79B and s 23AB (civilian serving with UN forces: see [19 600]), must not exceed (s 79B(4)): $338 + 50% of the concessional rebate amount

If the zone offset exceeds that amount, the taxpayer is not entitled to an offset under s 79B (ie he or she may only claim the zone offset): s 79B(4A). The Treasurer may, in writing, declare to the Commissioner that any particular locality outside Australia is one to which, by reason of its isolation and the uncongenial nature of service in that locality, the section will apply: s 79B(5). The Treasurer may specify the date from which, or the period for which, the section is to apply to the particular overseas locality. A list of overseas localities to which s 79B applies is available on the Tax Office website (search for ‘‘overseas forces tax offset’’). The s 79B offset is not available in relation to service: (a) as or under an attaché at an Australian Embassy or Legation in an overseas locality at a time as at which that locality was, or is deemed to have been, a specified locality for s 79B purposes: s 79B(1A); (b) in similar circumstances that have been certified by the Chief of the Defence Forces or a service chief: s 79B(1B). Assessments may be amended at any time to allow the offsets under s 79B: s 79B(5B). EXAMPLE [19 590.10] Virginia is married with 2 dependent children – one who is a full-time student aged 22 and one who is under 21 (see [19 180]) – and resides in a prescribed area for more than 6 months. She is entitled to the dependant (invalid and carer) offset (DICTO) in respect of her husband Jason, whose adjusted taxable income for rebates is nil: see [19 550]. The ‘‘concessional rebate amount’’ is (cents are ignored):

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743

[19 600]

INDIVIDUALS

DICTO ........................................................................................................................ Student child .............................................................................................................. Child under 21 ...........................................................................................................

2,627 376 376 3,379

Standard offset .......................................................................................................... 50% of concessional rebate amount (ie 50% × 3,379) .............................................

338 1,689 2,027

[19 600] Civilians serving with United Nations armed forces Special tax concessions are available under s 23AB ITAA 1936 to prescribed civilian personnel serving with armed forces under the control of the United Nations. The tax concessions include exemptions (see [7 090]) and an offset (see below). As at 1 January 2017, the relevant prescribed personnel (for s 23AB purposes) are members of the Australian Federal Police who are members of the UN peacekeeping force in Cyprus: reg 5 ITA (1936 Act) Reg. The s 23AB offset (the overseas civilian offset) is equal to the sum of $338 plus 50% of the following offsets (s 23AB(7), (7A)): • the dependant (invalid and carer) offset (DICTO): see [19 150]; and • the notional student and child offsets: see [19 180]. The full overseas civilian offset is allowable if the taxpayer’s UN service overseas exceeds half the income year or if the taxpayer dies while performing that overseas service: s 23AB(7)(a). In any other case, a proportionate offset is allowable (usually apportioned on a time basis): s 23AB(7)(b). A taxpayer’s period of service for s 23AB offset purposes includes any time spent in a zone area: see [19 550]. If a taxpayer qualifies for both the s 23AB offset and a zone offset, he or she is entitled to the greater offset: s 23AB(9) to (9B). Periods of overseas service that qualify for a tax exemption under s 23AG (see [7 170]) do not qualify as periods of service for the purposes of the overseas civilian offset: s 23AB(8). In addition, the s 23AB offset is not available to ADF members.

OTHER OFFSETS [19 650] Arrears of income An offset may be available under s 159ZRA ITAA 1936 to an individual taxpayer who receives an assessable lump sum payment that contains an amount (or amounts) that accrued in an earlier income year or years. The effect of the offset is to limit the tax payable on the arrears component of the lump sum to an amount comparable to the amount that would have been payable had the income been received in the year in which it accrued. The offset is available if the taxpayer’s assessable income for a year includes an amount of ‘‘eligible income’’ that accrued in an earlier income year and the total amount that accrued in earlier years is not less than 10% of the normal taxable income for the year of receipt, after deducting the accrued amount(s). ‘‘Normal taxable income’’ is defined in s 159ZR as the amount that would be taxable income if certain payments on termination of employment, capital gains and any above-average special professional income were excluded. Income that qualifies for the offset (ie ‘‘eligible income’’) includes salary and wages, workers compensation (see Re Edwards and FCT [2016] AATA 781) and accident 744

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INDIVIDUALS [19 650]

compensation payments. However, salary and wages only qualify to the extent to which they accrued more than 12 months before the payment date or, if paid to a person who is reinstated to duty after a period of suspension, to the extent to which they accrued during the period of suspension. Payments of amounts under the Business Services Wage Assessment Tool Payment Scheme Act 2014 may qualify as eligible income. The following are not eligible income and therefore do not qualify for the offset: insurance payments to the owner of the policy; annuities, social security and repatriation pensions and benefits (that are not tax-exempt); Commonwealth education and training payments (defined in s 6(1) in the same terms as in s 52-145 ITAA 1997: see [7 270]); interest, dividends and royalties. A payment for unused sick leave would not be ‘‘eligible income’’ as it is the entitlement to unused sick leave and not the payment itself that accrues. The offset is the amount by which the tax payable on the lump sum in the year in which it is received exceeds the notional tax on the arrears: s 159ZRB. The notional tax on the arrears is the sum of: • the additional tax that would have been payable in the 2 most recent years before the year of receipt if amounts that accrued in those years had been included in the taxable incomes of those years: s 159ZRC; and • if income accrued in years earlier than the 2 most recent years before the year of receipt, the amount calculated by multiplying the amount(s) that accrued in those earlier years by the average of the rates of tax on the income that accrued in the 2 most recent years: s 159ZRD. In calculating the average rates of tax on the arrears of the 2 most recent years, the relevant taxable income is reduced by any income received in those years that accrued in earlier years and was eligible for the offset, certain payments on termination of employment, abnormal income and capital gains. EXAMPLE [19 650.10] During the 2016-17 income year, Grace receives a lump sum of $11,640 representing arrears of salary. She derives other taxable income of $82,590 during the year, making a total taxable income of $94,230. The arrears accrued as follows: Income year 2013-14 2014-15 2015-16 2016-17

Arrears accrued $ 7,020 2,490 2,130 – 11,640

Other taxable income $ 42,930 54,260 59,740 77,980

As the accrued amount is more than 10% of Grace’s taxable income for 2016-17 (excluding the accrued amount), she is entitled to an offset under s 159ZRA. Note that in the following calculations tax excludes the Medicare levy (and cents are ignored). Notional tax amounts for recent accrual years The 2 most recent accrual years are 2014-15 and 2015-16. 2014-15

2015-16

tax on $56,750 (ie $54,260 + $2,490) Tax on $54,260 Notional tax amount tax on $61,870 (ie $59,740 + $2,130) Tax on $59,740 Notional tax amount

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$ 9,990 9,181 809 11,654 10,962 692

745

[19 700]

INDIVIDUALS

Average tax rate on recent arrears 2014-15

tax rate on arrears =

2015-16

tax rate on arrears =

809 2,490 692 2,130

= 0.325 = 0.325

Average = (0.325 + 0.325) ÷ 2 = 0.325 Notional tax amount for distant accrual year, ie 2013-14 $7,020 × 0.325 = $2,281 Notional tax on arrears $809 + $692 + $2,281 = $3,782 Calculation of offset Tax at 2016-17 rates on taxable income of $94,230 Tax on reduced taxable income of $82,590 (ie $94,230 − $11,640) Tax on arrears less notional tax on arrears Offset

$ 22,497 18,388 4,109 3,782 327

Note that if the tax on the arrears is less than the notional tax on the arrears, the taxpayer is not entitled to an offset. This can happen if the rate of tax for the income year(s) in which the arrears of income accrued is higher than the rate of tax for the income year in which the arrears are received.

RATES OF TAX [19 700] Resident v non-resident rates scale Resident individual taxpayers are generally taxed at a lower rate than foreign residents. The reasons for this are: • foreign residents do not qualify for the tax-free threshold (see [19 710]); • for 2016-17, the lowest marginal tax rate for foreign residents is 32.5%, whereas it is 19% for residents – the rate scales are set out at [100 020] (residents) and [100 030] (foreign residents); and • foreign residents do not qualify for the low income tax offset, which operates as an effective reduction in the rate of tax (see [19 300]). Note the new rules concerning working holiday makers (see below). Both residents and foreign residents are liable to pay the 2% temporary budget repair levy, which effectively increases the top rate of tax from 45% to 47% (the levy will cease to apply as from 2017-18). However, foreign residents are not liable for the Medicare levy: see [19 750]. Whether a taxpayer is an Australian resident is discussed in Chapter 2. An individual is an Australian resident (for income tax purposes) unless a foreign resident at all – times during the income year. Accordingly, if an individual is an Australian resident for part of the income year and a foreign resident for the rest of the year, the resident rates apply to all taxable income derived by that individual during the year. However, the tax-free threshold is pro-rated if there is a change of residency status: see [19 710]. Even if the taxpayer is a foreign resident during the entire income year, the resident scale still applies if he or she is entitled at any time during the year to a pension, allowance or 746

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[19 700]

benefit or compensation payable under the Veterans’ Entitlements Act 1986, the Veterans’ Entitlements (Transitional Provisions and Consequential Amendments) Act 1986 (s 4(6)), the Social Security Act 1991 or the Military Rehabilitation and Compensation Act 2004, that is assessable to Australian income tax. In those circumstances, the tax-free threshold is not apportioned unless the benefit is of a particular nature: see [19 710]. Salary, wages, allowances, commission and bonuses paid to a foreign resident who is the holder of a Special Program Visa (subclass 416), and who is an employee of an approved employer under the Seasonal Labour Mobility Program, are taxed at 15% (the foreign resident is liable to pay Seasonal Labour Mobility Program withholding tax: see [50 020]).

Working holiday makers From 1 January 2017, working holiday makers are taxed at different rates to other taxpayers. This applies to an individual who holds a Subclass 417 (working holiday) or Subclass 462 (work and holiday) visa, or a bridging visa permitting the individual to work in Australia that was granted in relation to an application for a Subclass 417 or Subclass 462 visa that has still to be determined (and the most recent visa, other than a bridging visa, held by the individual was a Subclass 417 or Subclass 462 visa): see the definition of ‘‘working holiday maker’’ in s 3A(1) Rates Act. In essence, the first $37,000 of ‘‘working holiday taxable income’’ is taxed at 15% and then the balance is taxed at the standard rates applicable to residents (Pt III of Sch 7 Rates Act): see [100 035]. ‘‘Working holiday taxable income’’ is the individual’s assessable income derived from sources in Australia while the individual is a working holiday maker, less related deductions: s 3A(2) Rates Act. This definition means that non-employment income (eg interest) derived from an Australian source while the individual is a working holiday maker constitutes ‘‘working holiday taxable income’’. The special rates apply even in the unlikely event that the working holiday maker can establish that he or she is a resident (working holiday makers are usually foreign residents: see [2 080]). In other words, a working holiday maker who is a resident is not entitled to the tax-free threshold. EXAMPLE [19 700.10] Mette is a non-resident for income tax purposes. She is a working holiday maker for the whole of the 2017-18 income year, earning $75,000 in total. Mette pays tax at the rate of 15% for the first $37,000 and 32.5% for the remaining $38,000 (total tax of $17,900).

If a person is a working holiday maker for part of an income year only and holds a different (non-working holiday) visa for the balance of that income year, the working holiday maker rates of income tax apply only to income derived during the period in which the person qualifies as a working holiday maker. EXAMPLE [19 700.20] José Luis earns $63,000 salary while a working holiday maker from 1 July 2017 to 28 February 2018. He also earns $31,000 while holding a different class of visa from 1 March 2018 to 30 June 2018. The $63,000 salary is José Luis’ working holiday taxable income and is the first part of his ordinary taxable income. He pays tax at the rate of 15% on the first $37,000 of that salary, and tax at the rate of 32.5% on the remaining $26,000. The $31,000 income earned from 1 March 2018 makes up the remaining parts of José Luis’ ordinary taxable income. He pays tax at the rate of 32.5% on $24,000 of that income (ie $87,000 – $63,000), and tax at the rate of 37% on the remaining $7,000 of that income.

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Working holiday taxable income ($) 0-37,000 37,001-63,000 ($26,000)

Other assessable income ($) 0-24,000 24,001-31,000 ($7,000)

Tax rate (%) 15 32.5

Tax rate (%) 32.5 37

Tax payable ($) 5,550 8,450

Tax payable ($) 7,800 2,590

Total assessable income = $94,000 ($63,000 + $31,000) Total tax payable = $24,390 ($5,550 + $8,450 + $7,800 + $2,590)

Note that entities which employ working holiday makers are required to register with the Tax Office: see [50 300].

[19 710] Tax-free threshold The tax-free threshold under the Rates Act refers to that portion of an individual taxpayer’s income that is subject to a zero rate of tax under the ordinary rates scale. For the 2016-17 income year, the general tax-free threshold available to Australian resident taxpayers is $18,200: see [100 020]. The tax-free threshold does not apply to foreign residents (see [100 030]) nor, from 1 January 2017, working holiday makers: see [19 700]. Whether a person is a resident of Australia for income tax purposes is discussed at [2 050]-[2 090]. Change of residency status The tax-free threshold has to be apportioned if a taxpayer becomes an Australian resident, or ceases to be an Australian resident, during the income year: s18. In such a case, only a portion of the tax-free threshold is free of tax and the remaining amount is subject to tax at the lowest marginal rate of tax (19% for 2016-17): s 20. The first $13,464 of the $18,200 tax-free threshold is available to part-year residents (and trustees if appropriate). The remaining $4,736 of the tax-free threshold is apportioned on the basis of the number of months during the income year the taxpayer is a resident. The month in which a taxpayer changes residency status is treated as a whole month of residency. In effect, therefore, the remaining $4,736 is apportioned on the basis of $394.66 for each month, or part of a month, the taxpayer is a resident. These rules (in s 18 Rates Act) apply even if there is more than one change of residency status during an income year. Pro-rating applies if a trustee is assessed under s 98 ITAA 1936 (presently entitled beneficiary under a legal disability: see [23 460]) and the relevant beneficiary is a part-year resident: s 20(2). However, pro-rating does not apply if the trustee is assessed under s 99 (no beneficiary presently entitled: see [23 500]): s 20(3). Pro-rating also applies to a taxpayer in the year he or she becomes a temporary resident: see [2 100]. Apportioning the tax-free threshold on the basis of residency may occur on more than one occasion in a person’s lifetime. No additional amount is added to the pro-rated threshold as a consequence of income derived in the period that a person is a foreign resident in the income year.

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EXAMPLE [19 710.10] Jay becomes an Australian resident on 11 February 2017. His tax-free threshold is $13,464 plus 5/12 (1/2/2017-30/6/2017) of the remaining tax-free threshold ($4,736), ie: $13,464 + (5/12 × $4,736) = $15,438 (rounded up)

EXAMPLE [19 710.20] Ivana ceases to be an Australian resident on 14 January 2017. Her tax-free threshold is $13,464 plus 7/12 (1/7/2016-31/1/2017) of the remaining tax-free threshold ($4,736), ie: $13,464 + (7/12 × $4,736) = $16,226 (rounded up)

The threshold is not pro-rated on account of residency if the taxpayer is an ‘‘eligible pensioner’’ (s 18(2)), ie a person in receipt at any time during the income year of a social security or veterans’ entitlement pension, allowance or benefit that is subject to Australian tax, other than those payable under Pt 2.11 (youth allowance), Pt 2.12 (Newstart), Pt 2.14 (sickness allowance) or Pt 2.15 (special benefits) of the Social Security Act 1991: s 16. In other words, persons in receipt of youth allowance, Newstart, sickness allowance or special benefits are not ‘‘eligible pensioners’’ and their tax-free threshold may be pro-rated on account of residency. A person in receipt of a benefit or compensation under the Military Rehabilitation and Compensation Act 2004 is also an ‘‘eligible pensioner’’.

Overseas students in Australia on short-term vocational experience Determination TD 93/223 points out that an overseas student who is in Australia for 12 months or less on work experience related to an overseas course of study, and who is not regarded as having become a resident of Australia during that period, is not entitled to any tax-free threshold.

MEDICARE LEVY [19 750] Introduction The Medicare levy is an additional 2% charge calculated by reference to the taxable income of a taxpayer. Liability for the levy is determined under Pt VIIB ITAA 1936 (ss 251R to 251Z). The levy is imposed by, and the rate determined under, the Medicare Levy Act 1986 (MLA); see [19 760] for the levy rate. The levy is payable by: • resident individuals (with certain exceptions: see [19 810]); • trustees assessed under s 98 ITAA 1936 (presently entitled resident beneficiary under a legal disability: see [23 460]) – the levy is calculated by reference to the amount of the net income of the trust in respect of which the trustee is assessed: s 251S(1) ITAA 1936, s 6(2) MLA; • trustees assessed under s 99 or s 99A ITAA 1936 (no presently entitled beneficiary) (see [23 500]), unless the trustee of a deceased estate (in which case they pay no levy): s 251S(1) ITAA 1936, s 6(3) MLA – see [101 070] for the levy rates; and • trustees of ‘‘attribution managed investment trusts’’ – the levy is calculated by reference to certain amounts in respect of which the trustee is liable to be assessed under Subdiv 276-G (see [23 685]). © 2017 THOMSON REUTERS

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Foreign residents and companies do not pay the levy. A person who is a resident for part of the year only may be liable to pay a proportionate levy (see [19 810]). Certain high income earners who do not have appropriate private health insurance may have to pay a Medicare levy surcharge (see [19 780]). A person who is not liable to pay the levy is not liable to pay the surcharge. Note that any unused foreign income tax offset may be applied against the taxpayer’s Medicare levy liability and Medicare levy (fringe benefits) surcharge liability: see [34 240].

[19 760] Levy rates and thresholds The Medicare levy is 2% of a taxpayer’s entire taxable income, including net capital gains (see [14 360]) and the portion below the tax-free threshold (see [19 710]), but excluding certain superannuation amounts (see below): s 6(1) MLA. However, there are concessions for certain low income earners. If a taxpayer’s taxable income is equal to or below the relevant low income threshold, he or she is not liable to pay the levy: s 7(1) MLA. If a taxpayer’s taxable income exceeds the relevant low income threshold amount, but does not exceed what is called the “phase-in limit”, the Medicare levy is 10% of the excess of taxable income above the low income threshold limit: s 7(2) MLA. The full levy becomes payable if a taxpayer’s taxable income exceeds the phase-in limit. The Medicare levy thresholds and rate scales for 2015-16 for single taxpayers are summarised below. The 2016-17 thresholds and rate scales are unlikely to be known until May 2017. Taxpayer Individual not entitled to SAPTO

Individual entitled to SAPTO

Taxable income $ 0 – 21,335 21,336 – 26,668 26,669 + 0 – 33,738 33,739 – 42,172 42,173 +

Levy payable $ Nil 10% of excess over 21,336 2% of entire amount Nil 10% of excess over 33,738 2% of entire amount

EXAMPLE [19 760.10] Andrew has a taxable income of $46,750 and is unmarried. His Medicare levy is $935 (ie $46,750 × 2%).

EXAMPLE [19 760.20] Bingmei has a taxable income of $22,685 and is unmarried. Her Medicare levy is $135, ie ($22,685 − $21,335) × 10%. If Bingmei was entitled to SAPTO, she would pay no levy as the relevant threshold is higher than $22,685.

Amounts excluded from taxable income If a taxpayer receives superannuation member benefits paid from a complying plan and is entitled to an offset under s 301-20(2) ITAA 1997 (see [40 160]), her or his taxable income (for Medicare levy purposes) excludes so much of the total of the taxable components included in the taxpayer’s assessable income as does not exceed the low rate cap amount for the income year ($195,000 for 2015-16: see [40 180]): s 251S(1A) ITAA 1936. 750

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[19 770] Family income thresholds Relief from the Medicare levy is provided to certain low income earners with families. The following taxpayers do not have to pay the Medicare levy if their family income is below the family income threshold (s 8(1) MLA): • a person married on the last day of the income year (unmarried or de facto couples, including same sex couples, are treated as being married to each other if they live together as a couple on a genuine domestic basis or if their relationship is registered under a relevant State or Territory law: s 251R(2) ITAA 1936). Only one relationship can be recognised during any period: s 251R(2A)); • a person entitled to the dependant (invalid and carer) offset (see [19 150]) in respect of his or her child; and • a person entitled to the notional sole parent offset: see [19 190]). ‘‘Family income’’, for Medicare levy purposes, is the taxpayer’s taxable income or, if the taxpayer is married on the last day of the income year, the sum of the taxable incomes of both the taxpayer and her or his spouse: s 8(5) MLA. A married couple who are living separate and apart are not treated as being married: s 3(3) MLA. If a taxpayer’s spouse dies during the income year (while living together) the taxpayer is treated as having been married to the deceased for the whole income year: s 3(3A) MLA. The 2015-16 ‘‘family income threshold’’ for those not entitled to SAPTO is $36,001, increased by $3,306 for each dependent full-time student under 25 and dependent non-student child under 21 in respect of whom the taxpayer or, if married, the taxpayer’s spouse is entitled to a notional offset under Subdiv 961-A: see [19 180]. If a taxpayer is unmarried on the last day of the income year, the threshold is not increased for a dependent student or child unless the taxpayer is entitled to family tax benefit for all or part of the year: s 8(6) MLA. This prevents both members of a separated couple from increasing their family income threshold on account of any dependent student or child. See [19 180] for the definitions of ‘‘student’’ and ‘‘child’’. The family income thresholds for 2015-16 are summarised below. The 2016-17 thresholds are unlikely to be known until May 2017. No of dependent children or students1

0 1 2 3 4 5 Each extra child

Those entitled to SAPTO Other taxpayers No levy payable if Full levy payable No levy payable if Full levy payable family income if family income is family income if family income is does not exceed equal to or does not exceed equal to or exceeds exceeds $ $ $ $ 46,966 58,708 36,001 45,002 50,272 62,841 39,307 49,134 53,578 66,974 42,613 53,267 56,884 71,107 45,919 57,399 60,190 75,240 49,225 61,532 63,496 79,373 52,531 65,664 +3,306 +4,133 +3,306 +4,133

1 Dependent students and children in respect of whom a notional offset under Subdiv 961-A is available: see [19 180].

If the family income is in the shading-in range (where no Medicare levy is payable and the full levy is payable), the levy otherwise payable by a taxpayer is reduced by the amount calculated in accordance with the following formula in s 8(2) MLA: A – (0.08 × (B–C))

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• B = family income • C = the relevant family income threshold If total family income is within the shading-in range, and if the combined taxable income of the taxpayer and her or his spouse is above the level at which Medicare levy would be payable individually, the reduction is shared between the 2 according to the proportion of their taxable income in relation to total family income. If the proportionate reduction available to either taxpayer exceeds the levy otherwise payable, the unused reduction amount may be utilised by the other taxpayer in addition to her or his own portion. EXAMPLE [19 770.10] Khoan has a taxable income of $47,820. Her de facto spouse James has a taxable income of $6,880. They have 4 dependent children. Khoan is not entitled to SAPTO. (Amounts are rounded to the nearest whole dollar.) • Family income (B) = $54,700 • Family income threshold (no levy payable) (C) = $49,225 Khoan’s Medicare levy liability is: • Levy otherwise payable = 2% × $47,820 = $956 • Reduction = A – (0.08 × (B – C)) – A = 2% × $49,225 = $985 – B = $54,700 – C = $49,225 • Reduction = $985 – (0.08 × ($54,700 – $49,225)) = $547 • Levy = $956 – $547 = $409 No levy is payable by James as his taxable income is below the individual income threshold.

EXAMPLE [19 770.20] Luis has a taxable income of $27,200. His spouse (Rebecca) has a taxable income of $21,900. They have 2 dependent children. Neither is entitled to SAPTO. (Amounts are rounded to the nearest whole dollar.) • Family income (B) = $49,100 • Family income threshold (C) = $42,613 • Reduction = A – (0.08 × (B – C)) – A = 2% × $42,613 = $852 – B = $49,100 – C = $42,613 Accordingly, reduction = $852 – (0.08 × ($49,100 – $42,613)) = $333 Luis’ Medicare levy liability is: • Levy otherwise payable = 2% × $27,200 = $544 • Proportion of reduction = $333 × 27,200/49,100 = $184 • Unused reduction of Rebecca (see below) = $149 − $56 = $93

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INDIVIDUALS [19 780] • Total reduction = $184 + $93 = $277 • Levy = $544 – $277 = $267 Rebecca’s Medicare levy liability is: • Levy otherwise payable = 10% × ($21,900 – $21,336) = $56 • Proportion of reduction = $333 × 21,900/49,100 = $149 • Levy = $56 – $149 = $Nil

[19 780] Surcharge – liability Certain higher income earners who do not have appropriate private health insurance may have to pay the Medicare levy surcharge in addition to the standard Medicare levy. The surcharge is imposed by the MLA and the A New Tax System (Medicare Levy Surcharge – Fringe Benefits) Act 1999 (MLS-FBA). An individual who is not liable to pay the Medicare levy is not liable to pay the surcharge. See [19 790] for the surcharge rate. The surcharge is payable if (ss 8B(1)(c), 8C(1)(c) and 8D(1)(b) MLA; ss 12(1)(b), 13(1)(b) and 14(1)(b) MLS-FBA): • a taxpayer and at least one of her or his dependants (if any) are not covered by an appropriate health insurance policy; and • the ‘‘income for surcharge purposes’’ (see below) of the taxpayer, or the ‘‘combined income for surcharge purposes’’ of the taxpayer and her or his spouse (if any), exceeds the relevant threshold for the income year. A trustee may also be liable to pay the surcharge: see below. Dependants of a taxpayer for surcharge purposes are (s 251R(3)): • her or his spouse (see [19 150]); • her or his dependent children aged under 21 (see [19 180] for the definition of ‘‘child’’); and • her or his dependent students aged at least 21 and under 25 who are receiving full-time education at a school, college or university. However, such a student is only a dependant for these purposes if the taxpayer is entitled to a notional offset under Subdiv 961-A in respect of the student (see [19 180]): s 251R(4). To qualify as a dependant, a person must be an Australian resident and the taxpayer must have contributed to her or his maintenance: s 251R(3). The taxpayer is deemed to have contributed to the maintenance of a dependant if they reside together: s 251R(6). Children not residing with the taxpayer are still dependants of the taxpayer if he or she pays child support (see ATO ID 2002/48). A married couple who are living separately and apart are not treated as being married: s 3(3) MLA, s 7(2) MLS-FBA. An ex-spouse to whom a taxpayer pays maintenance is not a ‘‘dependant’’ for surcharge purposes (Re West and FCT [2003] AATA 368). An appropriate private health insurance policy for surcharge purposes is one which provides private patient hospital cover. The policy must be a complying health insurance policy (within the meaning of the Private Health Insurance Act 2007) which covers hospital treatment: s 3(5) MLA; s 4 MLS-FBA. See [19 460] for what qualifies as a ‘‘complying health insurance policy’’. A health insurance policy is not a complying policy if it has an annual excess (not including any co-payments: see ATO ID 2010/122) of over $500 (for singles) or an excess of over $1,000 (for couples and families), unless the taxpayer has been insured continuously © 2017 THOMSON REUTERS

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under the policy since the end of 24 May 2000 and the amount of excess has not increased since then (ss 3(5), (5A) MLA, ss 4(1), (2) MLS-FBA). An overseas visitor policy with an Australian health insurance company was not considered to be a complying health insurance policy in ATO ID 2011/21. If a taxpayer has the required policy, but her or his spouse is not covered by the taxpayer’s insurance and does not have separate private patient hospital cover, both the taxpayer and the spouse are liable for the surcharge.

Income for surcharge purposes ‘‘Income for surcharge purposes’’ (as defined in s 995-1 ITAA 1997) is the sum of the following amounts: • taxable income for the income year (see below); • reportable fringe benefits total for the income year, ie the sum of any reportable fringe benefits amounts (see [59 200]); • reportable superannuation contributions for the income year (see [39 140]); and • total net investment loss for the income year (see [19 160]). Taxable income (of both the taxpayer and her or his spouse) is adjusted to add back any amount that is not assessable because family trust distribution tax was paid in relation to it (see [23 900]): s 995-1; s 3(2A) MLA; ss 15(2), 16(5) MLS-FBA. Taxable income also includes a lump sum in arrears payment that forms part of the taxpayer’s taxable income and payments for unused annual and long service leave. However, the taxable components of lump sum superannuation benefits that do not in total exceed the taxpayer’s low rate cap amount for the income year are excluded from ‘‘income for surcharge purposes’’, if the taxpayer is entitled to a tax offset under s 301-20 ITAA 1997 in respect of the taxable components (the offset is available where the taxpayer has reached their preservation age and is under 60): see [40 160].

Trustees The Medicare levy surcharge is payable (under ss 8E to 8G MLA) by a trustee who is liable to be assessed under s 98 ITAA 1936 (see [23 450] and [23 460]) in respect of the share of the net income of the trust estate to which the beneficiary is presently entitled (the ‘‘beneficiary’s trust income’’) if: • the beneficiary on behalf of whom the trustee is assessed does not have complying private health insurance; and • the beneficiary’s trust income exceeds the relevant surcharge threshold (single or family, as appropriate: see [19 790]) or, if the beneficiary is married for part or all of the income year (ie s 8D applies), the sum of the beneficiary’s trust income and her or his spouse’s income for surcharge purposes exceeds the family surcharge threshold and the beneficiary’s trust income exceeds the low income threshold for individuals not entitled to SAPTO (see [19 760]). The rate of the surcharge depends on whether the tier 1, tier 2 or tier 3 threshold applies: see [19 790]. The surcharge is apportioned if these provisions do not apply to the beneficiary for the whole year. If the beneficiary has other taxable income or is subject to s 98 through more than one trust, any amounts subject to s 98 are also included in the beneficiary’s own taxable income through s 100, meaning the surcharge is payable by the beneficiary in her or his own right. This ensures that beneficiaries cannot potentially escape the surcharge through the splitting of income. If the beneficiary’s trust income, in respect of which the trustee is assessed under s 98, does not exceed the relevant low income threshold below which no Medicare levy is payable 754

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(see [19 760] and [19 770]), the surcharge does not apply to the trustee. The surcharge is imposed on the trustee if the s 98 income exceeds the low income threshold. Note that, for surcharge purposes, any amount that is not assessable because family trust distribution tax was paid in relation to it (see [23 900]) is added back to the beneficiary’s trust income: s 3(2A) MLA.

[19 790] Surcharge rate and thresholds For the 2016-17 income year, no surcharge is payable if income for surcharge purposes (see [19 780]) is $90,000 or below (singles) or $180,000 or below (couples/families). If income for surcharge purposes is above those amounts, the Medicare levy surcharge rate is as shown in the table below. For families with more than one dependent child (or dependent student: see [19 780]), the relevant threshold is increased by $1,500 for each child after the first. The surcharge is payable on the taxpayer’s taxable income and not on her or his ‘‘income for surcharge purposes’’.

Singles1 Families1,2

Rates

2016-17 income years Tier 1 $ $ 90,001 – 0 – 90,000 105,000 180,001 – 0 – 180,000 210,000 Medicare levy surcharge 0.00% 1.00%

Tier 2 $ 105,001 – 140,000 210,001 – 280,000 1.25%

Tier 3 $ $140,001+ $280,001+ 1.50%

1 The 2016-17 surcharge thresholds also apply for 2017-18, 2018-19, 2019-20 and 2020-21. 2 Threshold increased by $1,500 for each dependent child after the first. A dependent child does not have to be a dependant for the whole income year (the increase in the threshold is not apportioned if the child is a dependant for only part of the year: see ATO ID 2005/364). A married couple who are living separately and apart are not treated as being married: s 3(3) MLA, s 7(2) MLS-FBA. If a taxpayer’s spouse dies during the income year (while living together) the taxpayer is treated as having been married to the deceased for the whole income year and the family surcharge threshold applies: s 3(3A) MLA, s 7(3) MLS-FBA. Because the surcharge is payable on the taxpayer’s taxable income and not on her or his ‘‘income for surcharge purposes’’, it is possible for someone to be liable to pay the surcharge even if her or his taxable income is below the relevant threshold. For example, if income for surcharge purposes of a single taxpayer is $100,000, he or she may be liable to pay the surcharge even if his or her taxable income is less than $90,000.

Couples – one member with low income exemption If the income for surcharge purposes of one member of a couple does not exceed the relevant individual low income Medicare levy threshold (see [19 760]), that person is not liable to pay the surcharge, even if the combined income for surcharge purposes of the couple exceeds the family tier 1 threshold (s 8D(3)(c) and 8D(4)(a) MLA; s 15(1)(c) MLS-FBA). However, if a member of a couple whose individual income for surcharge purposes is in the shading-in range for Medicare levy purposes (see [19 770]) and the combined income for surcharge purposes of the couple exceeds the family tier 1 threshold, the individual is liable to pay the surcharge in full (ss 8D(3) to (4) MLA, s 15(1) MLS-FBA). The other member of the couple is still liable to pay the surcharge. Pro-rating the surcharge The surcharge is imposed on a pro rata basis according to the number of days during the income year that the taxpayer, her or his spouse and all dependants are not covered by the required health insurance (see the formulas in ss 8B to 8G MLA and ss 12 to 16 MLS-FBA). © 2017 THOMSON REUTERS

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If a taxpayer changes her or his marital status or acquires dependants, or if the taxpayer only has a spouse for part of the income year (ss 8C to 8D MLA, s 16 MLS-FBA), the total surcharge payable is pro-rated for the period during which the taxpayer exceeds the threshold in each relevant category (provided the taxpayer is liable to pay the surcharge). See Example [19 790.30]. EXAMPLE [19 790.10] Erasmus is 35 years old, unmarried and lives alone. He takes out private patient hospital insurance for the first time, with cover commencing from 21 January Year 2. The insurance remains in force for the rest of the income year. Erasmus’ taxable income for the year ending 30 June Year 2 is $94,000, made up of $53,250 derived before 21 January Year 2 and $40,750 during the rest of the income year (this is also his ‘‘income for surcharge purposes’’ for the income year). Erasmus is not a prescribed person. The relevant surcharge threshold is $90,000 (tier 1). Erasmus is liable to pay the Medicare levy surcharge for the period 1 July Year 1 to 20 January Year 2 (204 days) as he was not covered by private patient hospital insurance for that period and his ‘‘income for surcharge purposes’’ for the year exceeds the surcharge threshold (the fact that it was less than this amount for the period not covered by the insurance is irrelevant). Erasmus’ total Medicare levy liability is (ignoring cents): Medicare levy $94,000 × 2% Medicare levy surcharge $94,000 × 1% × 204/365

$ = 1,880 = 525 2,405

EXAMPLE [19 790.20] Olivia and Ben are married with 3 children aged 9, 7 and 4. Olivia’s income for surcharge purposes for the year is $167,600. Ben’s income for surcharge purposes for the year is $19,700. They are members of the ambulance fund but do not have any other health insurance. Neither is a prescribed person. Their family threshold for 2016-17 is: $180,000 (tier 1) + [$1,500 × (3 – 1)] = $183,000. Olivia is liable to pay the Medicare levy surcharge as the combined income for surcharge purposes of herself and Ben is $187,300 ($167,600 + $19,700), which exceeds the tier 1 threshold. Her Medicare levy liability is: Medicare levy $167,600 × 2% Surcharge $167,600 × 1%

$ = 3,352 = 1,676 5,028

Ben is not liable for the Medicare levy surcharge. Although his income for surcharge purposes is the same as Olivia’s (ie the combined amounts), his own income for surcharge purposes is below the individual threshold amount for Medicare levy purposes (see [19 760]). This also means that he is not liable to pay the Medicare levy. If Ben’s income for surcharge purposes exceeded the individual threshold amount for Medicare levy purposes, he would be liable to pay the surcharge in full, as well as the standard levy.

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EXAMPLE [19 790.30] Naomi and Liev, a married couple, separate on 5 February and each stays single for the rest of the income year. They do not have the required health insurance at any time during the year. They have no dependent children but they are dependants of each other for Medicare levy surcharge purposes until they separate (see [19 770]). For the income year in question, Naomi’s income for surcharge purposes is $95,000 and Liev’s income for surcharge purposes is $63,000. In the income year they separate, Naomi and Liev use their individual income for surcharge purposes to assess their liability to pay the surcharge. However, they are taken to be a family for the period 1 July-5 February (220 days). Accordingly, the relevant family surcharge threshold for each of them for that period is $180,000 (for 2016-17). As a result, neither is liable to pay the surcharge for that period because the income for surcharge purposes of each one is less than the relevant threshold. Naomi and Liev are single for the period 6 February to 30 June and therefore the single person’s threshold of $90,000 (for 2016-17) applies for that period. As a result, only Naomi is liable to pay the surcharge because her income for surcharge purposes exceeds the relevant threshold and Liev’s does not.

[19 800] Surcharge offset If a taxpayer’s liability to pay the Medicare levy surcharge arises, or significantly increases, as a result of the taxpayer receiving an eligible lump sum payment in arrears, Subdiv 61-L ITAA 1997 provides relief in the form of a tax offset. An eligible lump sum includes a lump sum payment of ‘‘eligible income’’ included in the taxpayer’s assessable income for the current year (but only to the extent that it accrued in an earlier year) or exempt foreign employment income for the current year (but only to the extent it accrued during a period ending more than 12 months before the date on which it was paid): s 61-590. ‘‘Eligible income’’ has the same meaning as for the purposes of s 159ZR: see [19 650]. The offset is available if the taxpayer’s assessable income (or exempt foreign employment income) for the income year includes one or more eligible lump sums and the total of the lump sums is equal to at least one-eleventh of the total of (s 61-580(1)): • the taxpayer’s normal taxable income for the year (see [19 650]; • the taxpayer’s exempt foreign income for the year (ie any amounts exempts under s 23AF or s 23AG ITAA 1936: see [7 160] and [7 180]); • the taxpayer’s reportable fringe benefits total for the year (see [59 200]); • the taxpayer’s reportable superannuation contributions for the year (see [39 140]); • the taxpayer’s net investment loss for the year (see [19 160]); and • the net amount on which any family trust distribution tax for the year has been paid (see [23 900]). The amount of offset is equal to the amount of Medicare levy surcharge liability attributable to the lump sum received by the taxpayer, regardless of the taxpayer’s income in previous years (s 61-585). A married (de facto) taxpayer is also entitled to the offset if her or his liability to pay the surcharge arises because of one or more lump sums paid to her or his spouse: s 61-580(2). The offset is not refundable.

[19 810] Exemptions Those who are ‘‘prescribed persons’’ during the whole of the income year are exempt from the Medicare levy and Medicare levy surcharge: s 251T ITAA 1936. ‘‘Prescribed persons’’ are (s 251U): © 2017 THOMSON REUTERS

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• members of the Australian Defence Forces and their relatives who are entitled to free medical treatment in respect of every incapacity, disease or disabling condition; • persons entitled under the Veterans’ Entitlements Act 1986 or the Military Rehabilitation and Compensation Act 2004 to full free medical treatment of all conditions; • blind pensioners and sickness allowance recipients – a person in receipt of a disability support pension who is not blind is not a prescribed person (see ATO ID 2001/239); • persons who are not residents of Australia (for tax purposes) and residents of Norfolk Island (note the definition of Australia has been rewritten in Subdiv 960-T ITAA 1997: see [1 130]). Residents of Norfolk Island will cease to be prescribed persons from the 2016-17 income year; • members of diplomatic missions or consular posts in Australia and members of their families (if living with them), who are not Australian citizens and are not ordinarily residents of Australia (note the extended meaning of family relationship in s 960-255 ITAA 1997); and • any person who would not have been entitled to Medicare benefits in respect of service, treatment or care to which Medicare benefits under the Health Insurance Act 1973 relate. This exemption normally applies to visitors whose approved length of stay is less than 6 months. The Tax Office requires a certificate from the Medicare Levy Exemption Certification unit of Medicare Australia. To qualify as a prescribed person, the taxpayer must fulfil one of the specific criteria in the categories above (see Determination TD 92/168). If a person is a prescribed person for part of the income year only, the Medicare levy is proportionately reduced. EXAMPLE [19 810.10] Shirley has a taxable income of $26,138 and is unmarried. She is a sickness allowance recipient from 1 December to 30 June (212 days). Levy (ignoring cents) = (2% × $26,138) × 153/365 = $219 Note that Shirley would be entitled to the beneficiary offset: see [19 520]. If a person is a foreign resident (or a resident of Norfolk Island) for part of the income year only, they do not pay the levy (and surcharge) for that part of the year (but if the person has dependants, every dependant must be a prescribed person for that period (with exceptions): see below). Note that residents of Norfolk Island will generally become liable to pay the Medicare levy from the 2016-17 income year.

Prescribed persons – with dependants If a prescribed person has one or more dependants (see [19 770]), the Medicare levy and surcharge exemption only applies if every dependant is also a prescribed person: s 251U(2). However, in the following 2 situations, the dependent spouse or child (as appropriate) is taken not to be a dependant of the prescribed person and therefore the exemption still applies: • if the dependant is liable to pay the levy on her or his taxable income: s 251R(6B); or • if the prescribed person has a spouse (see [19 150]) who is liable to pay the levy and the spouse contributes to the maintenance of their dependent child: s 251R(6C). If both members of a married couple would be exempt from the levy if not for the fact that they had a dependant who was not a prescribed person, they are entitled to enter into an 758

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agreement allowing one of them to be fully exempt from paying the levy: s 251R(6D). The other member is liable for the levy at half the normal rate. The agreement, known as a family agreement, must be entered into on or before the date of lodgment of the tax return of the person who is to be exempt: s 251R(6E). The agreement must be retained for 5 years from the date of lodgment of the return or a shorter period if specified by the Commissioner: s 251R(6F). For individuals with relatively simple tax affairs, namely those described at [50 420], the retention period for the agreement is 2 years from the date issue of the notice of assessment: see the Shortened Document Retention Periods (Individuals with Simple Tax Affairs) Determination 2006. If the dependent is not a prescribed person and is not liable to pay the Medicare levy on her or his taxable income, and the prescribed person does not have a spouse liable to the levy who contributes to the maintenance of the dependant, the prescribed person is liable to pay the levy at half the normal rate: s 251U(3). Prescribed persons who receive only a half-exemption (as above) from the Medicare levy and have dependants who are not prescribed persons, are not regarded as prescribed persons for surcharge purposes and therefore are not eligible for any exemption: s 251VA, ss 13(2) and 14(2) MLS-FBA). In order to avoid the surcharge, the dependants of the prescribed person needs to be covered by appropriate private hospital cover (the actual taxpayer is deemed to have such cover: ss 8C(2) and 8D(2) MLA; ss 13(2) and 14(2) MLS-FBA).

HIGHER EDUCATION CONTRIBUTIONS [19 900] Higher education loans Students enrolled in higher education courses may have access to deferred payment arrangements through the Higher Education Loan Programme (HELP) under the Higher Education Support Act 2003 or some other student assistance scheme. The relevant schemes are HECS-HELP, FEE-HELP, OS-HELP and VET student loans (replacing VET FEE-HELP from 1 January 2017). If a student receives a loan under any of these schemes (a HELP loan), a HELP debt is recorded for the student with the Tax Office against their Tax File Number (TFN). If a student does not have a TFN, he or she must apply to the Tax Office for one (see [55 040]). HELP debts include accumulated pre-1 January 2005 HECS, OLDPS, PELS and BOTPLS debts. The loan is indexed to maintain its real value, but is otherwise interest-free. The loan repayment options are discussed at [19 910]. The PAYG withholding and PAYG instalment systems apply in relation to compulsory repayment amounts: ss 154-70 and 154-80 Higher Education Support Act 2003. For further information on HELP, see the Study Assist website (http://studyassist.gov.au/ sites/StudyAssist/). The Trade Support Loans (TSL) Scheme aims to assist apprentices in covering the personal costs of engaging in and completing apprenticeships. For further information, see https://www.australianapprenticeships.gov.au/trade-support-loans. Tax consequences HELP contributions (and payments to reduce a debt under the TSL scheme) are not tax deductible to the student (nor will payments to reduce a liability to the overseas debtors repayment levy: see [19 910]): see [9 970]. However, if the contribution is paid or reimbursed by the student’s employer by way of a fringe benefit, the employer is entitled to a deduction for the amount of the payment or reimbursement (and fringe benefits tax will be levied on the value of the benefit: see [58 450]): s 26-20 ITAA 1997. There is no GST on HELP contributions. The availability of a tax deduction for tuition fees (see [9 970]) is not affected by a student receiving assistance under a HELP scheme. © 2017 THOMSON REUTERS

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[19 910] Payment through the tax system Students who opt to pay HELP debts through the tax system are not required to make any payments if their ‘‘HELP repayment income’’ is below the minimum threshold for the year ($54,869 for 2016-17). The 2016-17 HELP repayment thresholds and rates are set out at [104 400]. Note that legislated changes to the thresholds and rates will apply from 2018-19: see [104 400]. ‘‘HELP repayment income’’ is effectively the sum of taxable income, reportable fringe benefits total (see [59 200]), net exempt foreign employment income, reportable superannuation contributions (see [39 140]) and total net investment losses: see [19 160]. EXAMPLE [19 910.10] Takumi’s taxable income for 2016-17 is $49,420. In his income tax return, he claims a net investment loss (on a rental property) of $2,250. He also has a total reportable fringe benefits amount of $3,890 and reportable superannuation contributions of $2,580. Takumi’s repayment income is: $49,420 + $2,250 + $3,890 + $2,580 = $58,140. Takumi’s compulsory repayment for 2016-17 is (ignoring cents): $58,140 × 4% = $2,325.

A taxpayer’s repayment amount may be reduced by the HECS-HELP benefit. Taxpayers are exempt from repaying their HELP debt in a particular year if they are entitled to a reduction in the Medicare levy or are exempt from the levy under s 8MLA (ie depending on personal or family income and number of dependent children and students: see [19 770]). Higher education contributions payable on assessment of taxable income are deducted from a student’s accumulated HELP debt. The unpaid balance is adjusted annually to reflect movements in the Consumer Price Index. If no payment is made for a particular year because the taxable income threshold was not reached, the debt accumulates. Higher education contributions payable on assessment are treated in the same way as income tax and normal taxation collection and recovery mechanisms apply: discussed in Chapter 49. The Commissioner is authorised to apply available PAYG instalments and other credits against a HELP debt in preference to the person’s income tax liability. Any refunds of HELP repayment credits of less than $50 may be applied against outstanding tax debts. Repayments of HELP debts are not deductible: see [9 970]. A taxpayer dissatisfied with a HELP assessment has the same objection and review rights under Pt IVC TAA (discussed in Chapter 48) as a taxpayer dissatisfied with an income tax assessment. HELP repayments may be deferred (but not written off) if: • making the repayment has caused or would cause serious hardship – this exists when the taxpayer is unable to provide food, accommodation, clothing, medical treatment, education or other necessities for her/himself, her/his family or other people for whom she/he is responsible; or • there are other special reasons that make it fair and reasonable to defer making the repayment. An application to defer should be made on the appropriate form available from the Tax Office (phone 13 28 61). Guidelines for the remission of HELP debts can be found on http://studyassist.gov.au/sites/StudyAssist/). Employees with a HELP debt must complete an employment declaration advising the employer of the debt. If the HECS repayment income is more than the minimum compulsory repayment threshold (see [104 400]), the employee will have additional amounts deducted from salary or wages through the PAYG withholding system. If a person with a HELP debt is subject to the PAYG instalments system, the debt will be taken into account when the Tax Office sets the instalment rate: see [51 090]. 760

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[19 910]

If a person with a HELP debt dies, the trustee or executor should lodge all outstanding tax returns up to the date of death. Any compulsory HELP repayment included on a notice of assessment relating to the period before the date of death must be paid from the deceased’s estate, but the remainder of the debt is cancelled.

Overseas debtors levy Foreign residents who have a HELP debt will be required to make repayments by way of a levy (called the overseas debtors repayment levy). Repayment obligations will commence from 1 July 2017 (for income earned in the 2016-17 income year). Foreign resident HELP debtors are required to register with the Tax Office through myGov and then, at the end of each financial year, submit a special return declaring all their assessed worldwide income for the year (assessed worldwide income is the sum of HELP repayment income and foreign-sourced income). If assessed worldwide income exceeds the minimum repayment income, the HELP debtor will be required to pay the overseas debtors repayment levy. The relevant provisions are contained in Subdiv 154-AA of the Higher Education Support Act 2003. Debtors going overseas for at least 183 days are required to register with the Tax Office before they leave, while those already overseas have until 1 July 2017 to register. The new arrangements apply to both new and existing debts. Voluntary repayment scheme A person with a HELP debt may make voluntary payments (eg by cheque or BPAY) to the Tax Office at any time (voluntary payments are in addition to compulsory repayments). Voluntary lump sum payments of $500 or more attract a 5% bonus – ie the voluntary payment reduces the HELP debt by the amount paid as increased by 5%. However, the 5% bonus was abolished from 1 January 2017. Financial supplement loans Loans under the former Student Financial Supplement Scheme are also repaid through the tax system. Repayments are not compulsory until 1 June in the 5th year after the loan is taken out (subject to a minimum repayment threshold), at which point the Tax Office takes over responsibility for collecting the debt (Stage 2). Voluntary repayments are permissible during Stage 2. Loans are indexed on 1 June each year. A repayment is not required if repayment income (essentially the same as ‘‘HELP repayment income’’: see above) is below the minimum repayment threshold ($54,869 for 2016-17). The Financial Supplement repayment thresholds and rates are set out at [104 410]. The HELP debt repayment exemptions and hardship provisions (see above) also apply in relation to Financial Supplement debts. A person dissatisfied with a notice of Financial Supplement repayment has objection and review rights under Pt IVC TAA (discussed in Chapter 48). Trade support loans Trade support loan (TSL) debts and accumulated TSL debts are payable through the tax system. The repayment system is similar to the HELP debt repayment system. The relevant repayment thresholds and rates are the same as under the HELP system. The 2016-17 rates and thresholds are set out at [104 400]. Rules similar to those for HELP debtors who are foreign residents (see above) will apply to foreign residents who have an accumulated TSL debt. These rules are contained in Subdiv AA of Div 4 of Pt 3-2 of the Trade Support Loans Act 2014.

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20

INTRODUCTION Overview ....................................................................................................................... [20 What is a company? ...................................................................................................... [20 Company tax system ..................................................................................................... [20 Public officer ................................................................................................................. [20

010] 020] 030] 040]

COMPANY STATUS Public and private companies – different treatment .................................................... [20 100] Private company – definition ........................................................................................ [20 110] Public company – definition ......................................................................................... [20 120] Listed or co-operative companies – additional tests .................................................... [20 130] Subsidiaries of public companies ................................................................................. [20 140] Co-operative companies ................................................................................................ [20 150] Co-operative companies – tax treatment ...................................................................... [20 160] Credit unions ................................................................................................................. [20 170] Non-profit companies and registered organisations ..................................................... [20 180] Other entities taxed as companies ................................................................................ [20 190] Strata title bodies .......................................................................................................... [20 200]

LOSSES LOSSES – GENERAL Losses and prior year losses ......................................................................................... [20 Deduction of tax losses by corporate tax entities ........................................................ [20 Capital losses ................................................................................................................. [20 Inter-entity loss multiplication ...................................................................................... [20

250] 260] 270] 280]

CARRIED FORWARD LOSSES Prior year loss deductions ............................................................................................. [20 Recoupment tests .......................................................................................................... [20 Continuity of ownership test ........................................................................................ [20 Change of ownership during year of loss .................................................................... [20 Arrangements affecting beneficial ownership of shares .............................................. [20 Special tracing rules – trusts as shareholders .............................................................. [20 Same business test ........................................................................................................ [20 Change in business before change in shareholding ..................................................... [20 Tainted change of control ............................................................................................. [20 Disallowance of losses – anti-avoidance provisions .................................................... [20 Prior year losses from bad debts .................................................................................. [20

300] 310] 320] 330] 340] 350] 360] 370] 380] 390] 400]

CURRENT YEAR LOSSES Current year losses ........................................................................................................ [20 Conversion of excess franking offsets into a tax loss ................................................. [20 Current year net capital losses ...................................................................................... [20 Notional taxable income or notional loss for separate periods ................................... [20 Partnerships and current year losses ............................................................................ [20

450] 460] 470] 480] 490]

LISTED PUBLIC COMPANIES Listed public companies – modified ownership tests .................................................. [20 When ownership is tested under Div 166 .................................................................... [20 Tracing rules .................................................................................................................. [20 Modified same share rule .............................................................................................. [20

550] 570] 580] 590]

BAD OR FORGIVEN DEBTS Bad debts – restrictions on ability to deduct ............................................................... [20 650] Commercial debt forgiveness – consequences ............................................................. [20 660] 762

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SHARE BUYBACKS AND CANCELLATIONS SHARE BUYBACK SCHEMES Introduction ................................................................................................................... [20 Off-market buybacks – shareholder treatment ............................................................. [20 On-market buybacks – shareholder treatment .............................................................. [20 On-market buybacks – company issues ....................................................................... [20

700] 710] 720] 730]

SHARE CANCELLATIONS Introduction ................................................................................................................... [20 750] Operation of Div 16J .................................................................................................... [20 760]

INTRODUCTION [20 010] Overview This chapter considers the taxation of companies and the effect of various arrangements such as share buybacks and share cancellations. The topics discussed are: • what is a ‘‘company’’ for tax purposes and what are the different types of company (eg private companies, public companies and co-operative companies): see [20 020]-[20 190]; • how current year and prior year losses of a company are treated for tax purposes: see [20 250]-[20 590]; • the rules governing bad debts and forgiven debts: see [20 650]-[20 660]; • the tax consequences of share buybacks: see [20 700]-[20 730]; and • the tax consequences of a share cancellation: see [20 750]-[20 760]. The taxation of dividends and the imputation system are discussed in Chapter 21.

[20 020] What is a company? A ‘‘company’’ for tax purposes is defined in s 995-1 ITAA 1997 as ‘‘(a) a body corporate; or (b) any other unincorporated association or body of persons; but does not include a partnership or non-entity joint venture’’. The definition in s 6(1) ITAA 1936 includes ‘‘all bodies or associations corporate or unincorporate, but does not include partnerships or non-entity joint ventures’’. A body does not necessarily have to be incorporated as a company for company law purposes in order to be a company for tax purposes. Although the terms ‘‘company’’ and ‘‘partnership’’ are mutually exclusive, corporate limited partnerships are taxed as companies. Corporate unit trusts and public trading trusts are also taxed as companies: see [20 190]. A Korean Hapja Hoesa is considered to be a company (see ATO ID 2010/27). The residence of a company is important because an Australian resident company is liable to tax on all income irrespective of source. It is also relevant to various issues such as imputation (see [21 450]), consolidation (see [24 010]) and various CGT roll-over relief concessions (see Chapter 15). The tests (in s 6(1) ITAA 1936) to determine whether a company is an Australian resident company are discussed at [3 120].

[20 030] Company tax system A company is treated as a separate taxable entity from its shareholders in the sense that a separate taxable income is calculated for the company and the company pays tax on that taxable income. © 2017 THOMSON REUTERS

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Under the consolidation regime, qualifying groups of entities are treated as a single entity for income tax purposes. This means that intragroup transactions are ignored for tax purposes. The rules for consolidated and MEC groups are contained in detail in Chapter 24.

Company tax rates Companies are subject to a flat rate of tax on the entirety of their taxable income, unlike individuals who are subject to a progressive rates scale. The standard company rate is 30%. However, with effect from the 2015-16 income year, the corporate tax rate applying to small business entities that are companies is 28.5% (a ‘‘small business entity’’ is an entity with an aggregated turnover of less than $2m: see [25 020]). These corporate rates apply whether the company is public, private, resident or non-resident. They also apply to corporate limited partnerships, corporate unit trusts and public trading trusts. Special rates apply to life insurance companies (see [101 210]), credit unions (see [20 170]) and non-profit companies (see [20 180]). Special rules apply to pooled development funds (see [11 500]). The Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 proposes to introduce a phased reduction in the corporate tax rate. As from the 2016-17 income year, the rate for companies with a turnover of less than $10m is proposed to be 27.5%. From the 2017-18 income year, the 27.5% rate is proposed to apply also to companies whose turnover is $10m or more but less than $25m. Eventually, from 2026-27, the rate is proposed to be 25% for all companies. From the information available at 1 January 2017, it seems that the proposal that is most likely to be approved by the Parliament is the reduction in the company tax rate for companies with a turnover of less than $10m. Company self-assessment and instalment payment system Company tax returns and the calculation and collection of company tax are subject to self-assessment. A company need only provide brief details of its taxable income in the annual company tax return form (Form C) and verification will be by means of a potential tax audit. See further [46 090]. Under the PAYG instalment system, instalments of income tax are generally calculated by applying an instalment rate to a company’s actual ordinary income for a period (usually quarterly, although a monthly system is being phased in over a 3-year period from 1 January 2014, commencing with very large companies). The instalment rate is provided by the Commissioner (based on the last return lodged), although the company may adopt a different instalment rate. Alternatively, the company may pay instalments as calculated by the Tax Office. Small companies may qualify as annual payers, in which case only one annual instalment is payable. The PAYG instalment system is discussed in Chapter 51. Companies are required to furnish a return of income by the day on which assessed tax is due and payable: see [46 090]. An assessment is not actually made but is deemed to have been made by the Commissioner on the date of lodgment: s 166A(2) (see [47 030]). Calculation of taxable income The taxable income of a company is calculated by applying all of the provisions of the ITAA 1997 and ITAA 1936 that determine whether amounts are assessable or deductible. However, there are also many special rules, additional tests and modifications that apply in relation to companies, especially in relation to deductions for losses of earlier income years and bad debts, current year losses and share cancellations. Other special provisions are dealt with in other chapters, eg the consolidation rules (see Chapter 24), the thin capitalisation rules (see Chapter 38), interest paid on bearer debentures (see [6 290]), special CGT rules dealing with continuity of majority underlying interests (see [17 270]-[17 290]), the disposal of shares in companies with significant post-CGT property holdings (see [13 660]) and shares, rights, options and convertible notes (see Chapter 17). The primary producer averaging provisions do not apply to companies: see [27 460]. 764

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[20 100]

Taxation of company shareholders A company deriving income is taxed on that income and then has the after-tax income available for distribution to its shareholders in the form of dividends. With the exception of co-operative companies that comply with certain rules (see [20 150]), a company does not obtain an income deduction for dividends paid to its shareholders. As shareholders also pay tax on dividends included in their assessable income, there would be double taxation of the original profits derived by the company if special rules did not exist to prevent it. The principal method of overcoming double taxation is the imputation system, discussed at [21 400] and following. [20 040] Public officer Every company carrying on business in Australia or deriving income from property in Australia has to be represented by a public officer: s 252 ITAA 1936. The company must: • appoint a public officer within 3 months of it commencing to carry on business or deriving income in Australia; • keep the office of public officer constantly filled; • notify the Commissioner in writing of the name and address for service of the public officer. There is a maximum penalty of one penalty unit for every day the company fails to comply (see [54 020] for the value of a penalty unit). A public officer must be a natural person who is at least 18, must be ordinarily resident in Australia or in a prescribed territory and must be capable of understanding the nature of her or his appointment as the public officer of the company. The public officer is answerable for all those things that a company is required to do under the income tax legislation and the TAA and is liable for the same penalties as the company: s 252(1)(f), (5). Notwithstanding the effect of s 252(1)(f), it was held in Lean v Brady (1937) 58 CLR 328 that the public officer is not personally liable for payment of the tax payable by the company. See also Reynolds v DCT (1984) 15 ATR 1073. Section 8Y TAA causes persons who are a part of the management of a corporation to be deemed to have committed a taxation offence and be punished accordingly if that corporation does or omits to do an act or thing which constitutes a taxation offence. Such a person, however, may claim a defence under s 8Y(2) that he or she did not aid, abet, counsel or procure the act or omission in question and was not in any way by actual omission directly or indirectly knowingly concerned in or party to the act or omission of the corporation (these defences are not available in relation to a prosecution under Pt 2.4 of the Criminal Code 1995).

Service of notices etc on company A notice may be given to, or a process may be served on, a company by giving the notice to, or serving the process on, the public officer of the company, or on a director or another officer of the company, including the company secretary, or on an attorney or agent of the company: ss 252(1)(e), 253. There are similar provisions about giving notices to, and serving processes, on companies for indirect tax law and superannuation guarantee purposes: see ss 444-10, 444-15 TAA, Sch 1 TAA; ss 57, 57A SGAA.

COMPANY STATUS [20 100] Public and private companies – different treatment Tax legislation distinguishes between public companies and private companies. Division 7 of Pt III ITAA 1936, in particular s 103A, provides a number of tests by which the © 2017 THOMSON REUTERS

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status of a company may be determined: see [20 110]-[20 120]. The difference between the 2 should not be confused with the concept of proprietary company in the Corporations Act 2001. The Div 7 categorisation into public companies and private companies is relevant to the power of the Commissioner to examine the circumstances under which loans are made to shareholders, or salaries or other remuneration paid to directors, shareholders or their relatives, to see if the amounts should be deemed to be dividends. In this regard, particular attention should be paid to s 26-35 (see [9 1050]) and s 109 and Div 7A ITAA 1936 (discussed in Chapter 21). The continuity of ownership test (for the purposes of carrying forward losses) is modified for listed public companies: see [20 550]-[20 590].

[20 110] Private company – definition For income tax purposes, a company is a ‘‘private company’’ if it is not a public company: s 995-1. Whether a company is a public company is discussed at [20 120] and following. This general definition of a ‘‘private company’’ must be distinguished from the special categories created by certain provisions, eg an unlisted company that does not fall within the s 104-230(7)(a) exclusion from CGT event K6 (see [13 690]) is not the same as a private company. Deemed private companies The Commissioner is authorised by s 103A(6) ITAA 1936 to treat a company that otherwise qualifies as a public company, through being either a company listed on a stock exchange or a co-operative company (see [20 120]), as a private company in relation to an income year if he considers that: • the company’s memorandum and articles of association or rules or any agreement, contract or instrument authorise the variation or abrogation of the voting or dividend rights of the company or the rights of the shareholders upon a conversion, exchange or redemption of any shares; • any contract, agreement or option or other instrument gives to a person the power to acquire shares in the company and thus alter the voting or dividend rights; or • any person has the power or the authority in relation to the voting or dividend rights to vary them at any time during the income year. Before exercising this power, the Commissioner is required to be satisfied that such variation or abrogation would cause: • a change in the voting power that results in 75% or more of the voting power being capable of being exercised by not more than 20 persons; • not less than 75% of the amount of any dividend paid or 75% of the total amount of any dividend being paid to not more than 20 persons; or • if the company did not pay a dividend during the year, not less than 75% of any dividend that would have been paid being beneficially received by not more than 20 persons.

Number of persons – deeming provisions In determining the number of persons for the purposes of s 103A, the following are treated as one person (s 103A(7)): • a person irrespective of whether he or she holds shares or not; • his or her relatives. A ‘‘relative’’ (as defined in s 995-1) includes not only parents, grandparents, children (including an adopted child), grandchildren, brothers, sisters, etc, but also a spouse and relatives of a spouse (see [9 550]); and 766

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• his or her nominees and the nominees of any of his or her relatives. A person is deemed to hold shares in a company indirectly if, in the event of the payment of a dividend on those shares, that person would, in a capacity other than a shareholder of the company, receive the whole or a part of that dividend. In applying this test, successive distributions of the relative parts of that dividend can be deemed to have been made by private companies, trusts or partnerships which are interposed between the company paying the dividend and that person: s 103(3). EXAMPLE [20 110.10] Xie is a beneficiary under the ILA trust. The trust is a member of the Victoday partnership, which owns shares in Proud Pty Ltd, which is a private company. Xie is deemed to hold shares indirectly in Proud Pty Ltd.

[20 120] Public company – definition As noted at [20 110], a private company is any company that is not a public company. Some tests as to what is a public company apply as at ‘‘the last day of the income year’’, while other tests must be met ‘‘at all times’’. Listed companies A ‘‘public company’’ includes a company whose shares, other than shares entitled to a fixed rate of dividend, whether or not participating in profits in excess of a stipulated amount, were listed for quotation on the official list of a stock exchange, whether Australian or foreign, on the last day of the income year of the company: s 103A(2)(a) and s 995-1(1). This definition must be distinguished from the definition of ‘‘listed public company’’: see [20 130]. Other public companies In addition to the broad category of public companies set out above, the following special types of company are deemed to be public companies (see s 103A(2)(b) to 103A(2)(d)): • a co-operative company; • a company that at all times since its incorporation has not been carried on for the purpose of profit or gain to its individual members. In addition, the company in the income year must be prohibited by its memorandum and articles of association or other document under which it is incorporated from making any distribution in any form to its members or to relatives of its members; • a mutual life assurance company; • a friendly society dispensary; • any body constituted by a law of the Commonwealth, of a State or of a Territory of the Commonwealth, which has been established for public purposes and does not qualify as a company within the meaning of the law of any State or Territory of the Commonwealth relating to companies (a ‘‘government body’’); • any company in which a government or a government body had a controlling interest on the last day of the income year; and • any company in which a government or a government body had a controlling interest on the last day of the income year (see ATO ID 2011/73 and ATO ID 2011/74); and © 2017 THOMSON REUTERS

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Section 103A(3A) ensures that the control that the public body has of the subsidiary is real and not illusory. For this purpose a number of tests are prescribed and, in order that the subsidiary qualifies as a public company in the relevant income year, it must meet every one of the tests. Under s 103A(3B) the Commissioner has the discretion to treat the subsidiary as a public company notwithstanding the fact that it may have breached one or other of the tests, if he is satisfied that the shares in the subsidiary were held by the public body for its own beneficial purposes and were not held for the purpose of enabling the subsidiary to be treated as a public company for income tax purposes.

Deemed public companies If a company would not otherwise be a public company, the Commissioner has the discretion to treat the company as a public company if it is reasonable to do so, even if this results in the company having to pay more income tax: ss 103A(5), (5A). The factors to be taken into account by the Commissioner in deciding whether to exercise the discretion are: • the number of persons at any time during the year who were capable of controlling the company and whether any of those persons was a public company; • the paid-up value of the capital of the company issued before the end of the income year; • the number of persons beneficially owning shares in the company; and • such other matters as the Commissioner considers relevant to the forming of his opinion. Note that the rules deeming a person and her or his relatives and nominees as one person (see [20 110]) also apply for the purposes of s 103(5), (5A). If a company satisfies all the requirements to be registered on a stock exchange but chooses for reasons unrelated to taxation not to be registered, it is likely that the Commissioner will exercise the discretion to treat the company as a public company. The company will have to request the Commissioner to exercise the discretion for each income year in which it does not meet the tests contained in s 103A(2). However, once the discretion is exercised for the first time, it will probably be sufficient in subsequent years for the company to simply state that conditions have not changed.

[20 130] Listed or co-operative companies – additional tests Although a company may otherwise satisfy the requirements of s 103A(2)(a) or (b) in relation to being a company listed on an official stock exchange or a co-operative company (see [20 120]), there are additional requirements to be met for a company to be a public company. Section 103A(3) provides that a company is not a public company if: • at any time during an income year 20 or fewer persons hold, or have the right to acquire or become the holder or holders of, shares representing 75% or more of the value of the shares in the company, other than shares entitled to a fixed rate of dividend only; • at any time 75% or more of the voting power is vested in or capable of being exercised by 20 or fewer persons; • during the income year 75% or more of any dividend or, alternatively, 75% or more of the total of dividends paid during the year was paid to 20 or fewer persons; or • a dividend was not paid during the year but the Commissioner is of the opinion that if it had been paid, 75% or more of such notional dividend would have been paid to 20 or fewer persons. 768

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[20 140]

Note that the rules deeming a person and her or his relatives or nominees as one person also apply for these purposes: see [20 110]. The tests set out above are alternative disqualifying tests and any company that is a public company under s 103A(2)(a) or (b) but does not satisfy any requirement of s 103A(3) during the income year is a private company for that income year. In determining the number of persons for the purpose of these tests, the Commissioner has indicated that the Tax Office will normally ignore a public company shareholder.

[20 140] Subsidiaries of public companies A company is treated as a subsidiary of a public company for the purposes of itself qualifying as a public company under s 103A(2)(d)(v) (see [20 120]) if it meets either the wholly owned tests in s 103A(4) (as interpreted by s 103A(4A)) or the alternative control of voting power and dividend or capital distribution tests in s 103A(4B) (as interpreted by s 103A(4C)). Both tests are, however, subject to the management and conduct of affairs tests in s 103A(4D) (as interpreted by s 103A(4E)).

Wholly owned subsidiaries Under s 103A(4) a subsidiary of a public company is a public company if, at all times during the income year, all the shares in it were owned by one or more companies, each of which was a public company, except if that company is a subsidiary, other than a wholly owned subsidiary, of a listed company or a non-profit company under s 103A(2)(c). The rights of the holding company must be such that they are at no time during the year capable of being affected in such a manner as to prevent it from exercising its rights to vote to receive dividends or to receive distributions of capital from the company whose classification is in question. Any such rights must not be capable of being changed by unilateral action of any person: s 103A(4)(c). To determine whether those rights may be affected, a person who has a right, power or option, whether under the articles and memorandum or otherwise, to acquire the rights of the holding company in its subsidiary or to do any act that would prevent the holding company from acting exclusively in its own interests is deemed to breach the required provisions, and in such circumstances the subsidiary would be deemed to be a private company. In considering whether a person has a right, power, option, agreement or instrument that will affect the rights, it is irrelevant that the power given is not enforceable by legal proceedings (s 103(5)) and any arrangement or understanding, whether formal or informal, is deemed to be an agreement (s 103(6)).

Partly owned subsidiaries If a company cannot satisfy the test of being a wholly owned subsidiary as outlined above, an alternative test relating to controlled subsidiaries may apply: see s 103A(4B). Such a subsidiary must at all times during the income year have its voting power controlled or capable of being controlled by a listed company or companies, either directly or through an interposed entity. At all times during the income year the listed company or companies must have the right to receive either directly or indirectly more than 50% of any dividend declared or any distribution of capital made. As was the case with the wholly owned subsidiary, the rights of the listed company must not be capable at any time during the income year of being affected in such a way as to prevent it from exercising those rights in its own favour and for its own exclusive benefit in regard to the receipt of dividends or the distribution of capital. No agreements must have been entered into by virtue of which a person or persons can affect the right of the listed company in connection with the subsidiary. As was the case with the position of a wholly owned subsidiary, any rights, powers or options held by third parties to affect the rights of the listed company are deemed to have been of such a nature as to affect the rights of the listed company and thus breach the requirements of the abovementioned provisions: s 103A(4C). © 2017 THOMSON REUTERS

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Commissioner’s discretion – management and conduct of affairs Notwithstanding that a company may meet the requirements of s 103A(4) or (4B) outlined above, the Commissioner may treat the company as not being a public company if it finds that the affairs of the company concerned were managed and conducted in the interests of persons other than the holding company (in the case of a wholly owned subsidiary) or without proper regard to the interests of the holding company (where the holding company has only a major shareholding): s 103A(4D). In determining this, the Tax Office is required to have regard to the matters set out in s 103A(4E). [20 150] Co-operative companies Special tax rules, contained in ss 117 to 121 ITAA 1936, apply to co-operative companies and their shareholders, which result in their tax treatment being substantially different to other companies and shareholders: see [21 160]. A ‘‘co-operative company’’ is defined by s 117 as meaning a company: (a) whose rules limit the number of shares that may be held by, or by and on behalf of, any one shareholder; (b) whose rules prohibit the quotation of the shares for sale or purchase at any stock exchange or in any other public manner whatever and includes a company that has no share capital; and (c) that in either case is established for the purpose of carrying on any business having as its primary object or objects one or more of the following: (i) the acquisition of commodities or animals for disposal or distribution among its shareholders; (ii) the acquisition of commodities or animals from its shareholders for disposal or distribution; (iii) the storage, marketing, packing or processing of commodities of its shareholders; (iv) the rendering of services to its shareholders; and (v) the obtaining of funds from its shareholders for the purpose of making loans to its shareholders to enable them to acquire land or buildings to be used for the purpose of residence or of residence and business. In Brookton Co-operative Society Ltd v FCT (1981) 11 ATR 880 the High Court held that the primary object of the company was to be determined from its activities during the relevant income year, not merely at the time of its formation. If a company has several distinct businesses, the Commissioner considers that if the primary object or objects of any of those businesses fall outside those specified in (c) above, the company will not be a co-operative company: Ruling TR 1999/14.

Exclusion However, a company is deemed not to be a co-operative in any income year in which the business done with its members is less than 90% of its total business: see s 118. In making the forgoing test, each of the above classes of business must be tested separately. For example, if a company: (a) purchases goods, etc in the open market for sale to its members; and also (b) purchases goods, etc from its members for sale in the open market, as long as not less than 90% of the total sales referred to in (a) and not less than 90% of the total purchases referred to in (b) are made during the income year with its members, the company is a co-operative company for that year. 770

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[20 170]

Other matters Credit unions are excluded from being a co-operative company and, provided the prescribed conditions are met, the interest income from member loans derived by a small credit union (but not a large or medium credit union) is exempt from tax under s 23G: see [20 170]. [20 160] Co-operative companies – tax treatment Money received by a co-operative from the activities referred to in [20 150] whether from shareholders or not, or on account of the company or its shareholders, is assessable income of the co-operative (s 119), which must obtain its relief from the deduction permitted by s 120 (see below). Generally, companies are liable to income tax on the total profits derived without any deduction in respect of dividends paid to shareholders. An exception is made in the case of a co-operative company, which is permitted a deduction under s 120(1) of so much of the assessable income as is distributed among its shareholders: • as interest or dividends on shares; or • as rebates or bonuses based on business done by shareholders with the company. A co-operative company whose primary object is the acquisition of commodities or animals from its shareholders for disposal or distribution is also entitled to a deduction of so much of its assessable income as is applied in repayment of government loans to it to enable it to acquire assets needed in carrying on its business, but only if 90% or more of the paid-up capital was held by shareholder-suppliers of the company: s 120(1)(c). Rebates or bonuses based on a shareholder’s purchases from a co-operative are not assessable to the shareholder unless the goods are purchased for resale or are goods for use in a business in respect of which a deduction is allowed in calculating the purchaser’s taxable income: s 120(2). Co-operative companies can frank dividends, but s 120(4) limits the deduction available under s 120(1) to the unfranked part of a dividend. Section 120(5) determines the extent to which the franked part of a dividend is paid from the assessable income of a co-operative.

[20 170] Credit unions A ‘‘credit union’’ is defined in s 23G(1) ITAA 1936 as a company that is an authorised deposit-taking institution for the purposes of the Banking Act 1959 and has consent under s 66 of that Act to call itself a credit union or credit society. A credit union does not include a building society. Credit unions are classified as recognised small, recognised medium and recognised large credit unions: s 6H. A partial tax exemption is available only for recognised small credit unions, although medium credit unions enjoy concessional tax rates on portions of their taxable income over a phasing-in range before large credit union status is reached. A special rate of tax applies to credit unions that provide retirement savings accounts (RSAs), but only on such accounts. Small credit unions A recognised small credit union is one that has notional taxable income (defined in s 6H(5)) for the year of less than $50,000. Income derived by a small credit union from interest paid by members in respect of loans made to those members is exempt from income tax under s 23G(2). The exemption does not extend to other forms of income such as interest from non-members, investment income, etc: Ruling IT 361. Section 23G(3) is a precautionary provision designed to prevent the use of the exemption in a manner not intended. The credit union seeking exemption must not enter into any © 2017 THOMSON REUTERS

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abnormal transactions, ie transactions not ordinarily entered into by credit unions, nor must it make excessive profits. The question of profits that are excessive is determined by reference to the performance of other credit unions in that particular income year. In determining whether transactions are abnormal, the terms and conditions of borrowing and lending of money and the investment of money plus the connection between the credit union and its members who have borrowed or made available money will be considered together with any other relevant matter. A small credit union is taxed at a rate of 30%, corresponding to the standard company tax rate. For income years commencing on or after 1 July 2015, the rate is 28.5% if the credit union is a small business entity (proposed to reduce to 27.5% from 2016-17): see [25 020] for the definition of a small business entity.

Medium and large credit unions A recognised medium credit union is one that has notional taxable income of less than $150,000. Such a credit union is taxed on the basis that tax payable must not exceed 45% of the excess taxable income over $49,999 less offsets, rebates or credits: s 23(7) Rates Act. For income years beginning on or after 1 July 2015, the 45% rate is reduced to 42.75% for recognised medium credit unions that are small business entities: see [25 020] for the definition of a small business entity. This effectively amounts to a shading-in so that at the $150,000 taxable income threshold that differentiates medium and large credit unions, tax payable becomes the same. A recognised large credit union is any other credit union. Such a credit union is taxed at a rate of 30%, corresponding to the standard company tax rate. For income years commencing on or after 1 July 2015, the rate is 28.5% if the credit union is a small business entity (proposed to reduce to 27.5% from 2016-17): see [25 020] for the definition of a small business entity. The interest exemption for small credit unions is not available for medium and large credit unions.

[20 180]

Non-profit companies and registered organisations

Non-profit companies, as defined in s 3(1) of the Rates Act, other than ‘‘registered organisations’’, are not liable to pay tax if their taxable income is $416 or less. If the taxable income of such companies exceeds $416 but does not exceed $915, the tax payable in relation to the income year is 55% of the excess over $416 less any rebate or credit. If taxable income is above $915, the entire income is taxed at the standard corporate rate (30%): s 23 Rates Act. For income years beginning on or after 1 July 2015, the $915 threshold level is reduced to $863 for non-profit companies that are small business entities: see [25 020] for the definition of a small business entity. The tax rate applying to taxable income above that level for such entities is reduced to 28.5% for income years commencing on or after 1 July 2015 (and is proposed to reduce to 27.5% as from 2016-17). In AAT Case 5544 (1989) 21 ATR 3117, it was held that a body corporate which lacked a prohibition in its constituent documents on distributions to members was not a non-profit company within the definition in s 3(1) of the Income Tax (Companies, Corporate Unit Trusts and Superannuation Funds) Act 1982. Registered organisations are certain trade unions, friendly societies and employee organisations: s 3(1) Rates Act. The majority of their income would be exempt under s 50-15: see [7 450]. The income of a friendly society derived from its life insurance business is generally subject to Div 320 ITAA 1997 and is assessed in accordance with those provisions: see [30 150]. The rates of tax applicable to the various components of taxable income of life insurance companies and friendly societies that carry on life insurance business are set out at [101 210]. 772

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[20 250]

[20 190] Other entities taxed as companies Public trading trusts are effectively taxed as companies and not taxed as trusts (Div 6C in Pt III ITAA 1936): see [23 1600]-[23 1610]. In other words, income tax is paid by the trustee upon the income derived by the trust and then tax is paid by the various unitholders on their respective distribution of that trust income. Corporate unit trusts were also effectively taxed as companies rather than as trusts, but the relevant provisions (former Div 6B in Pt III ITAA 1936) were repealed for income years commencing on or after 1 July 2016: see [23 1550]-[23 1560]. Public trading trusts are subject to the imputation provisions, as were corporate unit trusts: see [21 400]. For the relevant rates of tax, see [101 240]. Corporate limited partnerships (ie a partnership where the liability of at least one partner is limited) are also treated as companies for income tax purposes: see [22 400]-[22 440]. Note the proposal to introduce a corporate collective investment vehicle from 1 July 2017, which will allow Australian fund managers to offer investments through a company structure: see [23 680]. [20 200] Strata title bodies A strata title body is a body corporate created on the registration of a strata scheme under relevant State and Territory Acts. A Strata Scheme is an arrangement whereby a building and the land upon which it is erected is subdivided into lots and common property. The Commissioner sets out his views on the tax treatment of strata title bodies in Ruling TR 2015/3. A strata title body is a company for income tax purposes. The Commissioner has indicated that he will exercise his discretion under s 103A(5) of ITAA 1936 to treat the body as a public company in circumstances where the strata title body is in substantial compliance with its obligations under the applicable governing legislation. The Commissioner has also indicated that a strata title body will not be taxed as a non-profit company even if it includes non-profit clauses in its by-laws. Amounts of income and deductions relating to the personal property of the strata title body (eg interest and dividends earned on money invested which has been raised through levies on proprietors) will form part of the assessable income of the strata title body. Similarly, deductions relating to property held by the strata title body as its personal property, eg claims for depreciation on depreciating assets under Div 40 of ITAA 1997, will be allowable deductions to the strata title body. In contrast, income from common property will be regarded as being earned by the strata title body in its capacity as trustee and will be assessable income of individual proprietors. Other amounts, eg amounts levied on proprietors by a strata title body, may be mutual income and thus not assessable: see [7 440]. The strata title body will not be entitled to deductions under s 8-1 of ITAA 1997 in respect of common property, nor under Div 40 of ITAA 1997 and/or Div 43 of ITAA 1997.

LOSSES LOSSES – GENERAL [20 250] Losses and prior year losses The essential notion of a ‘‘tax loss’’ is the excess in a year of any allowable deductions (other than deductions for any prior year losses), over the sum of assessable income and any net exempt income. © 2017 THOMSON REUTERS

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It is necessary to distinguish between revenue losses and capital losses. For capital losses, see [20 270].

Revenue losses A ‘‘tax loss’’ is defined in s 995-1 to mean: • all revenue losses (including film losses and primary production losses) for 1997-1998 and subsequent years; or • general domestic losses, including primary production losses; or • primary production losses for 1957-1958 to 1988-1989 under s 80AA ITAA 1936. Special current year loss rules that apply to companies are discussed at [20 450] and following.

Carry forward of losses Taxpayers, including companies, are entitled to deduct tax losses incurred in one income year against assessable income derived in later years in accordance with the rules discussed at [8 450] and following. A company’s ability to carry forward losses (under s 36-17) is subject to certain restrictions designed to prevent trafficking in tax losses: see [20 300]. These restrictions were qualified by special rules that allowed the transfer of tax losses within a corporate group before the advent of the consolidation rules. Special tracing rules apply if interests are held through discretionary trusts (see [20 350]). Special rules also apply to listed public companies and their wholly owned subsidiaries: see [20 550] and following. Reduction of losses – commercial debt forgiveness If a commercial debt is forgiven, certain loss deductions and other items may be reduced by the amount forgiven: see [20 660]. Venture capital entities There are special rules for losses of pooled development funds and for venture capital limited partnerships, Australian venture capital fund of funds and venture capital management partnerships: see [8 540]. Anti-avoidance provisions Division 175 ITAA 1997 contains general anti-avoidance provisions designed to counter arrangements (eg income injection) to exploit company losses: see [20 390] and [20 470]. Subdivision 165-CD imposes cost base reductions to prevent the duplication or losses within groups of companies: see [17 600]-[17 640]. The general anti-avoidance provisions of Pt IVA may also apply to artificially created capital losses: see [20 390]. Consolidation regime As for the treatment of losses in a consolidated group under the tax consolidation regime, see Chapter 24. Group companies As a result of the introduction of the consolidation regime, the provisions governing the transfer of losses within wholly-owned groups of companies (Div 170 ITAA 1997) now only apply to Australian branches of foreign banks and Australian branches of other foreign financial entities that are like banks: ss 170-5(2A) and 170-105(2A). For details of Div 170, see the Australian Tax Handbook 2003 at [27 1150]-[27 1195]. [20 260] Deduction of tax losses by corporate tax entities A separate rule (in s 36-17) applies for the carry forward of prior year losses by a corporate tax entity (a company, corporate limited partnership, corporate unit trust or public trading trust). This separate rule was enacted to provide corporate tax entities (‘‘companies’’) 774

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with a mechanism to avoid the ‘‘wastage’’ of tax losses that could arise in the post-consolidation environment from their inability to obtain a refund for excess franking credits. The main feature of this mechanism is a company’s capacity to choose the amount of prior year losses it wishes to deduct in a later income year (subject to certain limitations). As it can choose a nil amount, a company can ignore its tax losses and pay tax to generate franking credits for its distributions. At the same time as s 36-17 was enacted, further flexibility was provided in s 36-55 by allowing companies to convert excess franking offsets into a current year loss available to be carried forward for deduction in a later year: see [20 460].

Loss deduction rules The rules for deducting a prior year tax loss (in s 36-17) are summarised below. 1. A company is required to first deduct a prior year tax loss from any net exempt income in the later income year. If there is no exempt income, the company can deduct so much of the tax loss as it chooses (subject to the loss limitation rule – see below). 2. If the company has net exempt income and its assessable income exceeds its deductions (excluding the tax loss), the tax loss is first applied against the net exempt income and the company can then deduct the chosen amount of any remaining tax loss (again subject to the loss limitation rule). 3. If the company has net exempt income and its deductions (excluding the tax loss) exceed its assessable income, the excess deductions are applied against the net exempt income and the tax loss must then be applied against any remaining net exempt income. 4. If the company has exempt income from shipping activities (ie under s 51-100: see [11 700]) for the later income year, 90% of so much of the net exempt income for the later income year as directly relates to that exempt income is to be disregarded (applicable from 2012-13): s 36-17(4A).

Loss limitation rule – excess franking offsets If a company has excess franking offsets without deducting any amount of a tax loss, then it must ‘‘choose’’ to deduct a nil amount of the tax loss: s 36-17(5)(a). Similarly, a company cannot choose an amount of tax loss that would give rise to an excess franking offset: s 36-17(5)(b). The following example adapted from the example embedded in s 36-17 illustrates how these limitation rules work. EXAMPLE [20 260.10] In the current income year, a company has: • a tax loss of $150 from a previous income year; • assessable income of $200 (a franked distribution of $70, a franking credit of $30 and $100 of income from other sources); • no allowable deductions; and • no net exempt income. The tax offset of $30 from the franking credit is not refundable under Div 67. The loss limitation rule under s 36-17(5)(a) does not apply because the company would not have excess franking offsets for that year if the tax loss were disregarded (ie the tax offset of $30 is less than the income tax that the company would pay if it did not have the tax offset and tax loss). If the company chooses to deduct the full amount of the tax loss, it would have excess franking offsets of $15. However, this breaches the loss limitation rule in s 36-17(5)(b) that precludes a loss amount choice that would give rise to an excess franking offset. © 2017 THOMSON REUTERS

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However, if the company chooses to deduct $100 of the tax loss, it would not have an excess franking offset and not be in breach of s 36-17(5)(b).

Making the loss amount choice A company’s loss amount choice must be made in the income tax return for the relevant income year. In the following circumstances (provided for in s 36-17(10) and requiring written notice to the Commissioner) a company can make this choice – or revise its initial choice – at a later time: • if the amount of the tax loss available for deduction is recalculated; • if, in the deduction year, the difference between assessable income and allowable deductions is recalculated; or • if, in the deduction year, the amount of net exempt income is recalculated.

Other loss deduction rules There are other loss deduction rules for companies that mirror those applicable to other taxpayers under s 36-15: • tax losses must be deducted in the order in which they are incurred: s 36-17(7); • once deducted a tax loss cannot give rise to another deduction: s 36-17(8); and • if a tax loss (or part of a tax loss) cannot be deducted, it can be considered for deduction in the next income year: s 36-17(9)

[20 270] Capital losses As noted at [14 380], taxpayers, including companies, are entitled to offset capital losses against capital gains and to carry forward indefinitely any net capital loss for offset against any capital gains accruing in later years: ss 102-5(1) to 102-15. The carry forward of a net capital loss by a company is subject to the same anti-loss trafficking restrictions that apply to the carry forward by companies of revenue losses: see [20 310]. A net capital loss is calculated on an annual basis and attaches to the income year in which it is incurred: s 102-10(1). Net capital losses are applied in the order in which they were made: s 102-15. If all or part of the net capital loss cannot be applied in an income year, the unapplied amount is carried forward to be applied in the next income year. A net capital loss for an income year cannot be applied in determining whether a net capital gain accrued in a later income year to the extent that the net capital loss is a tax loss, and a deduction is denied by Subdiv 165-A or 175-A ITAA 1997: ss 102-30 and 165-96. A company is not entitled to offset a capital loss against capital gains realised in the same year if it is required to calculate its taxable income and tax loss for the year under Subdiv 165-B (which imposes recoupment conditions) or Subdiv 175-CB (which imposes anti-avoidance recoupment conditions): s 165-10; see also [20 470]. The provisions of Subdivs 165-CA and 165-CB relating to the treatment of capital losses in the calculation of net capital gains contain no separate treatment or quarantining of foreign capital losses that are subject to those provisions. [20 280] Inter-entity loss multiplication Subdivision 165-CD ITAA 1997 prevents the duplicate or multiple recognition of the realised and unrealised losses of a company which has an ‘‘alteration’’ (a change in the company’s ownership or control or a declaration by a liquidator or an administrator that its shares (or other financial instruments) are effectively worthless). The measures are concerned with prohibiting the replication of a single economic loss for tax purposes. If entities are interposed between shareholders and a loss company, the 776

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[20 310]

company’s losses, which may be reflected in the value of direct or indirect interests (both shares and loans) in the company may be multiplied by the realisation of the ‘‘inter-entity’’ interests in the loss company. In broad terms, Subdiv 165-CD operates by requiring an appropriate reduction to the tax attributes of significant interests in a loss company that undergoes an alteration. Subdivision 165-CD is discussed at [17 600]-[17 640].

CARRIED FORWARD LOSSES [20 300] Prior year loss deductions The ability of a company to deduct a prior year loss is restricted, in particular by the continuity of ownership and same business tests. The general object of these restrictions is to maintain the principle that the persons who obtain the benefit of the loss deductions should, as far as practicable, be the same as the persons who owned and controlled the company during the year in which the losses were incurred. The same tests apply in relation to the carry forward of deductions for prior year revenue and capital losses and current year revenue and capital losses. Although the provisions in the ITAA 1997 relating to the recoupment of prior year revenue losses are in the main a restatement of the recoupment tests in the ITAA 1936, a significant difference is the introduction, in Div 166 ITAA 1997, of an alternative test for establishing the continuity of ownership of shares of listed public companies: see [20 550]. There were no equivalent provisions in the ITAA 1936. See [20 350] for the provisions which expressly deal with shares held by trusts: Subdiv 165-F ITAA 1997. [20 310] Recoupment tests The general principle that applies to the carry forward of prior year deductions for both revenue and capital losses, is that a company is not entitled to a deduction for a prior year tax loss if there is a failure to maintain continuity of majority beneficial ownership throughout the entirety of the loss year and the income year in which the deduction for the loss is claimed (the continuity of ownership test or COT). However, if the required continuity of ownership is not maintained, the company may still be entitled to the deduction if it satisfies a same business test (SBT), determined by reference to the business carried on by the company immediately before the change of ownership that caused the COT to be failed. The ownership test is supplemented by a change of control test, which focuses on a change in control of the voting power in the company if made for the purpose of obtaining a tax benefit (called a ‘‘tainted change of control’’). If there is a change in majority beneficial ownership or a tainted change of control, the company must satisfy the SBT for the rest of the income year in which the change occurred. The test is applied in relation to the business carried on by the company immediately before the (first) change in ownership or tainted change of control: see [20 360]. If a company is prevented from carrying forward a loss for an entire year by virtue of failing to satisfy the COT and SBT, it may nonetheless be entitled to carry forward part of a prior year loss. This will happen if, assuming the period of the loss year in which the part loss was incurred were to be treated as a whole year, the company would have been entitled to deduct the loss: s 165-20 (see also [20 330]). When a prior year tax loss deduction may be carried forward A company is entitled to deduct a tax loss if: • it satisfies the COT in s 165-12 (see [20 320]), as amplified by Subdiv 165-D (there is a modified continuity of ownership test (in Div 166) for listed public companies and the wholly owned subsidiaries of listed public companies: see [20 550]); and © 2017 THOMSON REUTERS

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• there is no tainted change of control of voting power within s 165-15 in the income year compared with the loss year. If the COT is failed, or if there is a tainted change of control of voting power, a company may still deduct a tax loss if the company satisfies the SBT in s 165-13 for the rest of the income year. For this purpose, the SBT is applied to the business carried on by the company immediately before either the change of ownership that (first) broke the continuity of majority ownership or the tainted change of control of voting power, whichever applies: ss 165-13 and 165-15(2) respectively. The detail of the same business test is contained in Subdiv 165-E: see [20 360].

Designated infrastructure projects The COT and SBT are modified in relation to companies that are designated infrastructure project (DIP) entities: see [11 650]. [20 320] Continuity of ownership test To satisfy the continuity of ownership test (COT) in s 165-12 the same persons must have: • more than 50% of the company’s voting power from the start of the loss year through to the end of the income year; and • the rights to more than 50% of the company’s dividends from the start of the loss year through to the end of the income year; and • the rights to more than 50% of the company’s capital distributions from the start of the loss year through to the end of the income year. The 3 conditions are cumulative and failure to satisfy any one of them will lead to disallowance of the loss. Special tracing rules apply if ownership interests in a company are held through discretionary trusts: see [20 350]. The detail of these ownership conditions is contained in Subdiv 165-D (ss 165-150 to 165-209). The Subdivision is structured so that it contains separate and alternative tests, comprising ‘‘primary’’ tests that deal with direct beneficial ownership, and ‘‘alternative’’ tests that deal with indirect beneficial ownership. When determining whether the ownership conditions are satisfied, the primary test for each condition is applied first, unless the prescribed alternative test for that condition is required by s 165-12(5). An alternative test for a condition must be applied if one or more other companies beneficially own shares or interests in shares in the company at the beginning of the ownership test period (ie at the start of the loss year). Tracing through entities to identify the indirect beneficial owner is generally required. However, tracing is not necessary through certain entities specified in s 165-202. These include Commonwealth, State, Territory and foreign governments, local government bodies, charities, non-profit companies, domestic or foreign superannuation funds, complying approved deposit funds, managed investment schemes and special companies. Note that the time of change in ownership of shares for these purposes may not necessarily be the same as the time of disposal of shares for CGT purposes: see ATO ID 2006/35. The rules in Div 974 ITAA 1997 which determine the classification of an interest as either debt or equity do not apply to determine ownership for these purposes.

The same share test There is a requirement that there be no substantial change in the composition of ownership within a group of continuing owners, and that majority ownership be maintained throughout the period from the loss year to the end of the claim year: s 165-12. Under the ‘‘same share’’ test, a person’s share in the company is only counted for the COT if the person holds exactly the same shares throughout the relevant period: s 165-165(1). 778

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[20 320]

Private companies must be able to demonstrate that they satisfy the primary tests. However, public companies are taken to have satisfied the primary tests if it is reasonable to assume that they have done so: s 165-165(7). Under the equivalent ITAA 1936 provisions, the Commissioner indicated that the assumption would be reasonable unless there was evidence of takeovers, unusual activity on the stock exchange or other similar activity that would cause doubt to arise: Ruling IT 2361. The alternative tests in the ITAA 1997 are taken to be satisfied if that is the case or if it is reasonable to assume that the conditions are satisfied. Companies will not fail the COT because they have multiple classes of shares on issue, or special arrangements in place to make distributions of dividends and capital returns (Subdiv 167-A). Technical breaches of the COT may otherwise occur, for example, as a result of the preferential dividend rights which may be conferred upon redeemable preference shares. A company that fails the COT because it has shares with unequal rights to dividends or capital distributions will be able to choose to reconsider the test after disregarding debt interests and secondary classes of shares. If the company continues to fail the test after disregarding debt interests and secondary classes of shares, the remaining shares will be taken to have fixed dividend and capital distribution rights for the purpose of applying the test.

Voting power For the purposes of the first ownership condition, persons have more than 50% of the voting power in the company during the ownership test period if, at all times during that period, they beneficially own shares that carry the right to exercise more than 50% of the voting power in the company: s 165-150. The alternative test relating to this condition focuses on control of voting power directly or through interposed entities. A change of beneficial ownership in shareholdings resulted in the COT being failed in Re Doug Panton Motors Pty Ltd and FCT (1999) 43 ATR 1179. If the shares of a company have different voting rights (whether because of the company’s constitution or for some other reason) then, for the purpose of applying the COT, the voting power of those shares may be tested solely by reference to the maximum number of votes that could be cast on a poll for the election of the company’s directors or on the adoption or amendment of the company’s constitution: s 167-85. Dividends For the purposes of the second ownership condition, persons have rights to more than 50% of the company’s dividends during the whole of the ownership test period if, at all times during that period, they beneficially own shares that carry the right to receive more than 50% of any dividends that the company may pay: s 165-155. Again, the alternative test looks at the right to receive dividends directly or through interposed entities. Capital distributions Persons have rights to more than 50% of the company’s capital distributions during the whole of the ownership test period if, at all times during that period, they beneficially own shares that carry the right to receive more than 50% of any distribution of capital of the company: s 165-160. Under the alternative test, reference is made to the right to receive, directly or through interposed entities, more than 50% of capital distributions. Section 165-165(1) requires that, for the purposes of the primary test for each of the ownership conditions, the same person must beneficially own exactly the same shares at all times during the ownership period. The alternative tests in the ITAA 1997 relating to dividends and capital distributions refer to ‘‘the right to receive’’ for their own benefit more than 50% of dividends and distributions of capital, whether directly or ‘‘indirectly through one or more interposed entities’’. The ITAA 1997 does not contain an equivalent of s 80A(4) ITAA 1936, which prescribed the method of determining the proportion of the rights beneficially owned by a natural person. It © 2017 THOMSON REUTERS

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required the application of the following formula to the loss company and to each interposed company: voting interest of interposed company in loss company × (voting interest of person in interposed company ÷ total voting interest in interposed company)

Although a similar calculation may be relevant to the alternative tests in ss 165-155 and 165-160, the more general wording in those sections might suggest a broader approach. For a decision concerning the former tracing provisions, see Kolotex Hosiery (Aust) Pty Ltd v FCT (1975) 5 ATR 206. In relation to companies owned by discretionary trusts, see [20 350].

Death of shareholder The death of a shareholder does not necessarily impact on the COT. Shares beneficially owned by a person who dies are taken to be still beneficially owned by that person, so long as they are owned by the trustee of the deceased’s estate or are beneficially owned by a person who receives the shares as a beneficiary of the estate: s 165-205. The deceased person is also taken to have retained all voting power, dividend entitlements and rights to capital distributions. This does not extend to non-testamentary gifts of shares. Modified test There is a modified COT (in Div 166 ITAA 1997) for listed public companies and the wholly owned subsidiaries of listed public companies. The modified test is discussed at [20 550]. [20 330] Change of ownership during year of loss A change of ownership and of business during the year of loss may prevent a company from obtaining a deduction for the whole of a tax loss for the year. Nevertheless, under s 165-20, the company is entitled to deduct part of a tax loss incurred during part of the loss year, providing it would have been entitled to deduct the tax loss if the part of the loss year were treated as the whole of the loss year for the purposes of the recoupment tests. The Commissioner has indicated in Public Information Bulletin (No 3) (see OG 4 in Thomson Reuters’ Rulings and Guidelines) that, in considering the proportion of loss applicable to a part of an income year, apportioning on a time basis will normally not be acceptable. Therefore, in order to satisfy this provision, it would be necessary to virtually produce 2 sets of accounts, one relating to that part of the income year before the change in shareholding and the other relating to the balance of the income year subsequent to that change. Reference should also be made to the treatment of revenue losses of the current year (see [20 450]) and to the treatment of current year net capital losses and current year capital losses in Subdivs 165-CA, 165-CB, 165-CC, 175-CA and 175-CB: see [20 390] and [20 470]. Revenue losses incurred in part of a year may not be able to be carried forward and set off against income derived in a later part of the year if the recoupment tests imposed by those provisions are not satisfied. [20 340] Arrangements affecting beneficial ownership of shares To deal with arrangements under which rights in relation to shares are manipulated in order to satisfy the COT, s 165-180 allows the Commissioner to treat a person as not having beneficially owned shares during the ownership test period. An example of such an arrangement is K Porter & Co Pty Ltd v FCT (1977) 8 ATR 88, where the original owners of shares (a married couple) agreed to sell their shareholding in a tax loss company, but retained sufficient shares in order to satisfy the then applicable COT threshold (under the ITAA 1936) until the losses had been absorbed. The discretion under s 165-180 is available if the arrangement relates to, affects or depends for its operation on the beneficial interest in the shares or rights carried by or relating to the shares or the exercise of those rights, and has a purpose of reducing or eliminating someone’s tax liability. In FCT v Brian Hatch Timber Co (Sales) Pty Ltd (1972) 2 ATR 658, 780

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[20 350]

Menzies J accepted that the grant of a proxy was part of a wider arrangement entered into for the purpose of preserving the tax losses of the company. These provisions are supported by additional rules, contained in ss 165-185, 165-190 and 165-207(2), to the following effect. • If the Commissioner is satisfied that shares cease to carry rights or will cease to carry rights after the ownership test period, they are treated as never having carried those rights. • Conversely, if the Commissioner is satisfied that shares started, or will or may start, to carry rights after the ownership test period, those shares will be considered to have carried those rights at all times during the income year. • The trustee of a family trust is treated as a beneficial owner of some rights: see [20 350]. The rules relating to arrangements affecting beneficial ownership contained in ss 165-180 and 165-185 to 165-190 are not applied for the purposes of determining the total voting power in the company, the total dividends the company may pay or the total distributions of capital of the company: s 165-200. The fact a company becomes externally administered or a provisional liquidator is appointed does not prevent a shareholder from beneficially owning shares, having control of voting power, or rights to dividends on capital: s 165-208(1) ITAA 1997. This section was enacted in response to FCT v Linter Textiles Australia Ltd (in liq) (2005) 59 ATR 177, where the High Court confirmed that the liquidation of a company did not affect its beneficial ownership of shares in its subsidiary, but also held that the liquidator’s appointment resulted in a loss of control by the ultimate owners of the subsidiary of the voting power in the subsidiary, in terms of (now repealed) s 80A(3) ITAA 1936. As a result, the subsidiary was unable to utilise those losses. (Note that, under the ITAA 1997, the change of control test focuses on a ‘‘tainted’’ change of control: see [20 310].)

[20 350] Special tracing rules – trusts as shareholders There are 2 concessional tracing rules which apply to company losses and debts incurred in the 1996-1997 or later income years. They are designed to extend to companies the tracing concessions that were introduced in relation to trust losses pursuant to Sch 2F ITAA 1936. The 2 concessional tracing rules are referred to as: • the family trust concession (s 165-207); and • the alternative condition, which applies to fixed trusts (Subdiv 165-F).

The family trust concession Section 165-207 provides that, if the relevant ownership interests (voting, dividends and capital) in a company are held by the trustee of a family trust, the trustee will be taken to own the interests as a single notional entity. The section also confirms that changes to the trustee will not cause the COT to fail. A ‘‘family trust’’ has the same meaning as for the purposes of the trust loss provisions, ie a trust where the trustee of the trust has made an election (a family trust election) that the trust be a family trust and the election is in effect: see [23 880]. Alternative condition (fixed trusts) The alternative condition in relation to companies in Subdiv 165-F corresponds with the same provision applicable to fixed trusts under the trust loss provisions in Sch 2F ITAA 1936 (s 266-45). Many of the Sch 2F terms are adopted. The alternative condition is available in connection with both the prior and current year loss rules and the debt deduction rules if the company satisfies the tests contained in the alternative condition. The alternative condition © 2017 THOMSON REUTERS

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can be applied if individuals do not directly or indirectly hold fixed entitlements to more than 50% of the income or capital of the company at the start of the relevant period and either of the following 2 conditions are met: • fixed entitlements to 50% or more of the income or capital of a company are held, throughout the relevant period, by a non-fixed trust or trusts (other than family trusts); or • both of the following conditions are satisfied: – all the fixed entitlements to income and capital of the company are held, directly or indirectly and throughout the relevant period, by a fixed trust or another company (the holding entity); and – a non-fixed trust or trusts (other than family trusts) hold, throughout the relevant period, fixed entitlements to a 50% or greater share of the income or capital of the holding entity. For the alternative condition to be satisfied, if the company is held directly by non-fixed trusts, there must be no change in the persons directly holding, throughout the relevant period, fixed entitlements to shares of income or capital of the company, nor any change to the percentage of their shares. If there is a holding entity interposed, this requirement applies to the holding entity. If a non-fixed trust (that is not a family trust or other excepted trust) holds, at any time in the relevant period, fixed entitlements in the company, directly or indirectly, special continuity tests are applied in the form of a 50% stake test, a control test and a pattern of distributions test (the latter is not applied to current year losses). See ss 50HA, 63AA and 63AB ITAA 1936 and ss 165-215 and 165-220 ITAA 1997. The relevant periods for meeting these conditions are as follows. Prior year losses Current year losses Prior year debts Current year debts

Relevant period All times during the loss year and the income year All times during the income year All times during the prior income year from the day the debt was incurred and at all times in the income year All times during the income year

Foreign resident trusts Provisions in the ITAA 1936 require a company to provide information in connection with foreign resident family trusts that hold interests in the company. The information is intended to enable the Commissioner to determine whether any family trust distribution tax is payable in respect of trust distributions: see [23 900]. The Commissioner may, in certain circumstances, require a company to give information about conferrals of present entitlement to, or distributions of, income or capital of non-resident family trusts that hold interests in the company or information on transactions, acts and other matters that will enable him to determine whether a non-fixed trust has satisfied the alternative condition: Div 180 ITAA 1997. If the company does not give the information, it is not able to deduct the tax loss. [20 360] Same business test If a company fails to meet the COT (see [20 320]), tax loss deductions will not be lost if the company satisfies the same business test (SBT) in ss 165-13 and 165-210 ITAA 1997. In order to apply the SBT (in respect of either prior year or current year losses), there must be a period during which the continuity of ownership conditions are satisfied (called the continuity period), which begins at the start of the loss year and ends at some time during or after the loss year due to a failure to satisfy the continuity conditions. The SBT is applied to the business that the company carried on immediately before the time (the test time) when the continuity period ends, ie when the COT is failed. If it is not practicable to determine when the COT has been failed, the default test time for the 782

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application of the SBT is the start of the loss year. If the company came into existence during the year (ie it did not exist at the start of the loss year), the default test time for applying the SBT is the end of the loss year: s 165-13(2). This means that companies will not be prevented from applying the SBT simply because they are unable to determine the precise date on which the COT was failed. Under s 165-210(1) and (2) (in Subdiv 165-E): (a) the SBT is satisfied if, throughout the same business test period (ie the whole of the income year), the company carries on the same business as it carried on immediately before the test time; and (b) the SBT is failed if, at any time during the same business test period, the company derives assessable income from: (i) a business of a kind that it did not carry on before the test time (see TelePacific Pty Ltd v FCT (2005) 58 ATR 441) (this is called the new business test); or (ii) a transaction of a kind that it had not entered into in the course of its business operations before the test time (this is called the new transactions test). In relation to the SBT, it is necessary to consider the business carried on immediately before the test time, whereas in relation to the new business and new transactions tests, reference is made to the position before the test time. In Ruling TR 1999/9, the Commissioner notes (para 36) that the word ‘‘immediately’’ in the SBT refers to the overall business being carried on at the ‘‘changeover’’ (test) time rather than to the particular activities taking place at that time as part of it. Note that the SBT applies to the business carried on both in and out of Australia: see ATO ID 2006/258. The SBT also applies in relation to current year losses under Subdiv 165-B (see [20 450]) and prior year and current year losses of listed public companies under Div 166 (see [20 550]). Note the loss recoupment rules are to be amended, with effect from 1 July 2002, to ensure that the entry history rule in the consolidation regime (see [24 020]) is to be disregarded in applying the SBT: see [24 190].

Additional expenditure If the SBT is applied to the carry forward of current year losses under Subdiv 165-B (see [20 450]) in addition to the tests contained in s 165-210(1) and (2), s 165-210(4) states that a company will also not satisfy the SBT if, at any time during the same business test period (the period during which the same business must be maintained), it incurs expenditure: • in carrying on a business of a kind that it did not carry on before the test time (when continuity of ownership ended); or • as a result of a transaction of a kind that it had not entered into in the course of its business operations before the test time. This additional expenditure test corresponds with the expenditure test in the current year loss provisions in the ITAA 1936 (s 50D(4)(b) and (6)(b)). Ruling TR 1999/9 makes no reference to the expenditure test, which was presumably introduced because of the short intervals involved with current year losses and the possibility that the assessable income tests in s 165-210(2) might not be reliable.

Continuity of business None of the tests in s 165-210 are based on the business carried on during the loss year as such. If, eg a company that carries on business as a retailer of groceries changes its business to that of a wholesaler of shoes, and subsequently there is a change in shareholding, © 2017 THOMSON REUTERS

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the question is whether the business as a wholesaler of shoes is being continued from ‘‘immediately before’’ the change in shareholding, despite the fact that the losses were incurred in the business of a retailer of groceries. If the company satisfies these tests, Subdiv 165-A does not operate to prevent the prior year losses being deductible. In Avondale Motors (Parts) Pty Ltd v FCT (1971) 2 ATR 312, Gibbs J held that a company is not carrying on the same business if its name, premises, staff, stock, plant and franchises are different to those enjoyed prior to the change in shareholding. The ‘‘same as’’ was held to import identity and not merely similarity. However, in AGC (Advances) Ltd v FCT (1975) 5 ATR 243, the Full High Court (in relation to bad debts) adopted a more liberal interpretation of what is a continuing business. Barwick CJ considered it irrelevant that a company had changed its name, changed its address or had a substantial break in the continuity of business, while Mason J considered it irrelevant that the company had a changed clientele (see also Re Australasian Feed Pty Ltd and DCT (1999) 43 ATR 1243). The fact that a change of business may be inevitable in the business carried on does not by reason of that fact justify a decision that the company continues to carry on the same business after this development has taken place. In Fielder Downs (WA) Pty Ltd v FCT (1979) 9 ATR 460, the taxpayer argued that the natural development of its business justified a decision that it carried on the same business as was carried on prior to the change in shareholding. This view was rejected. As to the effect of an investment in a partnership in lieu of a direct investment in a business of the same kind as was carried on by the partnership, see J Hammond Investments Pty Ltd v FCT (1977) 7 ATR 633. In that case Sheppard J said that the ‘‘second limb’’ of s 80E(1)(c), relating to a transaction of a kind not previously entered into in the course of the business operations, is not intended to refer to ‘‘daily transactions’’ but to ‘‘isolated’’ and ‘‘independent’’ transactions that are nevertheless within the course of business operations.

Tax Office views The Tax Office’s views on the operation of the SBT are set out in Ruling TR 1999/9. Ruling TR 1999/9 states that a company may expand or contract its activities without necessarily ceasing to carry on the same business. According to the ruling, expansion will not ordinarily cause the test to be failed if it constitutes the ‘‘organic growth’’ of the business through the adoption of new ‘‘compatible’’ operations and the business retains its identity. Similarly, it is considered that if portions of former operations are discarded ‘‘in the ordinary way’’, discontinuation of those activities will not necessarily cause the test to be failed. However, if the scale of the changes, especially over a short period, causes the essential identity of the business to be lost, the test may be failed. In relation to the new business test, Ruling TR 1999/9 adopts the view that the reference to ‘‘business’’ is a reference to each kind of enterprise or undertaking (if there is more than one) that forms part of the overall business carried on by the company at the time of the ownership change and during the year when the deduction is sought. Again, the ruling accepts a limited expansion, provided it is within the same ‘‘field of endeavour’’. Ruling TR 1999/9 states that the new transactions test, in referring to the derivation of income from a transaction of a kind not entered into in the course of the company’s business operations before the ownership change, is intended to prevent the injection of income into a loss company that has satisfied the other tests. The views expressed by Sheppard J in J Hammond Investments Pty Ltd (see above) are not accepted and it is concluded that reference must be made to all transactions entered into in the course of the company’s business operations. However, it is considered that the test will not be failed in respect of a transaction that could have been entered into ‘‘ordinarily and naturally’’ in the course of the business operations carried on by the company before the change of ownership. If a foreign resident company carries on business both inside and out of Australia, the entirety of the company’s operations and not merely the Australian business operations must be examined to determine if the SBT is met: see ATO ID 2006/258. 784

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Miscellaneous cases In DCT v Australasian Feed Pty Ltd (2000) 45 ATR 293, the Federal Court held the SBT was satisfied notwithstanding a change in customers from many to only one and the derivation of income (small amounts of rent) from a new source. In Lilyvale Hotel Pty Ltd v FCT (2009) 75 ATR 253, the Full Federal Court held that the SBT was satisfied notwithstanding there had been substantial changes to the way the taxpayer managed its hotel business. The approach taken by the court was to identify the nature of the business (which will require a focus on the revenue producing activities). How the taxpayer manages the business so identified is not relevant to the SBT. For example, it was noted that from the perspective of the hotel’s clientele there was no discernable change after the new management arrangements were instituted. In R & D Holdings Pty Ltd v DCT (2006) 64 ATR 71, the taxpayer failed the SBT as in the relevant income years it was not carrying on a business at all. Instead, the business (the management and rental of an office block) was being carried on by the mortgagee in possession, which was acting neither in a fiduciary capacity nor as agent for the taxpayer. This decision was upheld on appeal in FCT v R & D Holdings Pty Ltd (2007) 67 ATR 790. In Coal Developments (German Creek) Pty Ltd v FCT (2007) 68 ATR 869, it was held that when the taxpayer sold its interest in a coal mining joint venture to a third party, its business ceased. The activities conducted by the taxpayer after it sold its interest in the joint venture were incidents of the sale of the interest and not a continuation of the original business. This decision was upheld on appeal: Coal Developments (German Creek) Pty Ltd v FCT (2008) 71 ATR 96. Proposed amendment relating to start-ups The previous Coalition Government announced in The National Innovation and Science Agenda (released in December 2015) that the ‘‘same business test’’ will be relaxed to allow businesses to access prior year losses when they have entered into new transactions or business activities. As part of the reforms, the same business test will be replaced with a more flexible ‘‘predominantly similar business test’’. This is intended to encourage small innovative companies and start-ups to take sensible risks. The new test will apply to losses made in the 2015-16 and future income years. The current same business test will continue to apply to losses arising before 2015-16. Draft legislation to give effect to this measure was released on 6 April 2016 and is available on the Treasury website. [20 370] Change in business before change in shareholding The SBT will not be satisfied if, before the test time (see [20 360]), the company started to carry on a business not previously carried on or, in the course of its business operations, the company entered into a transaction of a kind not previously entered into for the purpose (or a purpose) of being taken to have carried on, throughout the same business test period, the same business as it carried on immediately before the test time: s 165-210(3) ITAA 1997. In a reorganisation of any company for the purpose of remedying deficiencies that have caused the losses it will often be necessary for there to be a change in business ie branches that are unprofitable may be closed down and there will be an effort to develop those parts of the business that are profitable. While this rearrangement would appear to constitute a denial of the proposition that the company is carrying on the same business, it is considered that routine business rearrangements would not cause the test to be failed: Ruling TR 1999/9, paras 91 to 95. [20 380] Tainted change of control Even if a company satisfies the COT in s 165-12 (or indeed, the SBT invoked if there is a failure to satisfy the COT) it cannot deduct a tax loss if (s 165-15(1)): • there is a change in control of the voting power in the company (whether directly or indirectly through interposed entities), which occurs during either the loss year or © 2017 THOMSON REUTERS

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the income year (or, for losses claimed in income years ending after 21 September 1999, during the ownership test period); and • a purpose for the change is to obtain a benefit or advantage under the income tax legislation. The purpose of obtaining a tax benefit ‘‘taints’’ the change of control. However, the change of control does not prevent the company from obtaining the loss deductions if the company satisfies the SBT for the whole of the income year. The SBT is applied to the business that the company carried on immediately before the time (the test time) when the change of control took place: s 165-15(2) to (3) and Subdiv 165-E ITAA 1997. For an example of where the equivalent test in the ITAA 1936 (s 80DA(1)) was applied to deny a deduction for a tax loss, see Network Acceptance Pty Ltd v FCT (1979) 9 ATR 787). The tainted change of control test is modified in relation to companies that are designated infrastructure project (DIP) entities: see [11 650].

[20 390] Disallowance of losses – anti-avoidance provisions In some cases a company may satisfy the COT, but the benefits of the deduction of a prior or current year loss might, without safeguards, be enjoyed wholly or partly by persons who were not shareholders in the year or part-year in which the loss was incurred. The safeguards, relating respectively to prior and current year revenue losses, are found in Subdivs 175-A and 175-B ITAA 1997. Subdivision 175-A (ss 175-5 to 175-15) contains 2 general provisions that apply to ‘‘tax losses’’ as defined (essentially, prior year revenue losses). Subdiv 175-B (ss 175-20 to 17535) contains 2 comparable anti-avoidance rules that apply to schemes in relation to current year revenue losses. Subdivisions 175-CA and 175-CB contain similar anti-avoidance rules relating to net capital losses of a prior year and current year capital losses: see [20 470]. The first situation deals with income injected into a company because of an available prior year or current year revenue loss. The Commissioner may disallow all or part of a tax loss if, during the income year, the company derives assessable income, some or all of which (the injected income) would not have been derived if the prior year tax loss or current year deductions had not been available: ss 175-10 and 175-20. However, the disallowed loss is not cancelled and may potentially be used in future years (ATO ID 2010/48). In the case of prior year losses, an exception applies that prevents the denial of the prior year tax loss deductions if the company fails the COT in s 165-12 but satisfies the SBT in respect of the income year: s 175-5. In addition, the income injection test, in respect of both prior and current year losses, is subject to an exception to the extent that the continuing majority shareholders, as defined, will benefit from the derivation of the injected income to an extent that the Commissioner thinks fair and reasonable having regard to their respective rights and interests in the company (eg ATO ID 2002/845 and ATO ID 2010/49): ss 175-10(2) and (3), 175-25(2) and (3). A continuing shareholder can include a family trust that is deemed to be a notional entity under s 165-207 (see [20 350]): ATO ID 2006/157. In the second situation, if a person other than the company would obtain a tax benefit in connection with a scheme relating to prior or current year losses, the Commissioner may disallow all or part of a tax loss if a person other than the company will obtain a tax benefit in connection with a scheme that would not have been entered into if the tax losses had not been available in relation to the prior or current year loss provisions: ss 175-15 and 175-30. The term ‘‘tax benefit’’ has the same meaning as in Pt IVA: see [42 120]. An exception applies if the Commissioner considers the tax benefit to be fair and reasonable, having regard to a shareholding interest of the person in the company at some time during the income year: ss 175-15(2) and 175-30(2) ITAA 1997. The meaning of a ‘‘shareholding interest’’ is set out in s 175-65. For a case involving the ITAA 1936 equivalent (s 80DA(1)(b)), see BOA Pty Ltd v FCT (1981) 12 ATR 270. The tests in ss 175-15 and 175-30 are triggered if a person other than the company will obtain a tax benefit in connection with a scheme where the losses would otherwise have been 786

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[20 450]

denied by the tests in Div 165. Under Pt IVA a person obtains a tax benefit if an amount is not included in assessable income or a deduction is allowable and either the amount would have been or might reasonably be expected to have been assessable or deductible, as the case may be, but for the scheme: see [42 120]. Arrangements that seek to gain access to available losses may also attract the ordinary operation of the general provisions of Pt IVA: CC (NSW) Pty Ltd (In Liq) v FCT (1997) 34 ATR 604; 35 ATR 316 and AAT Case 11,764 (1997) 35 ATR 1164.

[20 400] Prior year losses from bad debts Section 165-120 applies if a change in majority ownership is followed by a bad debt write-off (or cancellation of debt by a debt/equity swap), which is an allowable deduction by virtue of the s 165-126 SBT, as a result of which a tax loss deduction is created that is protected by continuity of ownership even though a change of business then occurs. In these circumstances, the loss or increase in the loss caused by the bad debt shall not be an allowable deduction, unless the company carried on the same business at all times during the income year in which the loss is claimed as it did immediately before the change of shareholding. It also is necessary, as in the SBT, that the company should not, during the later year, have derived income from a business or transaction of a kind that it did not carry on before the change in shareholding.

CURRENT YEAR LOSSES [20 450] Current year losses As with other taxpayers, companies normally calculate their taxable income for an income year in accordance with the steps in s 4-15 ITAA 1997 (see [3 020]). However, as s 4-15(2) indicates, there are situations where taxable income is worked out in a special way and this is the case with the current year revenue loss provisions in Subdiv 165-B (ss 165-23 to 165-90) ITAA 1997. A company is required to calculate its taxable income and tax loss under Subdiv 165-B if: • there is a failure to maintain majority beneficial ownership (a greater than 50% stake in the company) for the whole of the income year, ie a change in majority beneficial ownership occurs during the year; and • following the change of ownership, the company does not satisfy the same business test (SBT) for the remainder of the income year (see [20 360]): s 165-35. For this purpose, the SBT is applied to the business carried on immediately before the change of ownership: ss 165-23 and 165-30. In addition, a company must calculate its taxable income and tax loss under Subdiv 165-B if: • there is a tainted change of control ie a person begins to control or becomes able to control the voting power in the company for a purpose of obtaining a tax benefit; and • the company does not satisfy the SBT for the remainder of the income year after the tainted change of control of the company: s 165-40. One effect of these provisions is that a company does not have to apply the current year loss provisions in Subdiv 165-B if the company satisfies the SBT for the year in which there is a change in its majority beneficial ownership or a tainted change of control: ss 165-35(b) and 165-40(2). © 2017 THOMSON REUTERS

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The conditions under which a person has more than a 50% stake in a company during an ownership test period, ie has maintained majority beneficial ownership, are set out in s 165-37. To work out whether the required continuity conditions are satisfied, the same primary or alternative tests are applied as under Subdiv 165-D (see [20 320]-[20 350]): ss 165-150 to 165-207. A company is not required to calculate its taxable income under Subdiv 165-B if it does not have a notional loss for any period in the income year: s 165-50(3). In that event, the company’s taxable income is calculated in the usual way under s 4-15. In summary, a company is required to calculate its taxable income and tax loss for an income year under Subdiv 165-B if, during an income year, it: • experienced a change in majority beneficial ownership or a tainted change of control; • did not satisfy the SBT for the remainder of the income year; and • incurred a notional loss in a period of the income year, whether before or after the change in ownership or control. The term ‘‘test time’’ is used to refer to the time at which it is necessary to apply the SBT following either the failure to maintain a greater than 50% stake in the company or a tainted change of control of voting power: ss 165-35 and 165-40(3).

[20 460] Conversion of excess franking offsets into a tax loss Current year losses can give rise to excess franking tax offsets. Excess franking tax offsets are calculated as the (non-refundable) excess of franking offsets over the amount of tax the corporate tax entity is required to pay on its taxable income for the year. A corporate tax entity can convert excess franking offsets to an equivalent amount of tax losses which can be carried forward for deduction in a later year of income: s 36-55. The standard corporate tax rate (30% as at 1 January 2017) is used for the purposes of Step 2 of the method statement (see Example [20 460.10] below), even if the entity is itself taxed at a concessional rate: see ATO ID 2009/62. EXAMPLE [20 460.10] Bco has assessable income of $1,000 (a fully franked dividend of $700 and a franking credit of $300), allowable deductions of $2,000 and net exempt income of $400. Applying the method statement in s 36-55: Step 1: work out the amount that would have been the entity’s tax loss disregarding the net exempt income: $2,000 − $1,000 = $1,000 Step 2: divide the amount of excess franking offsets by the standard corporate tax rate (ie 30%): $300 ÷ 30% = $1,000 Step 3: add the results of Steps 1 and 2: $1,000 + $1,000 = $2,000 Step 4: reduce the result at Step 3 by the entity’s net exempt income: $2,000 − $400 = $1,600 Bco has a tax loss for the year of $1,600.

[20 470] Current year net capital losses As is the case with current year revenue losses, a company may be required to calculate its current year net capital gain or net capital loss in a special way if it does not satisfy the recoupment tests applicable to the income year in which a change occurs. The recoupment tests are contained in Subdivs 165-CB and 175-CB ITAA 1997. A company must work out its net capital gain or loss for the year under Subdiv 165-CB if it is required to calculate its taxable income and tax loss for the income year under Subdiv 165-B: s 165-102. Thus, the trigger for the application of Subdiv 165-CB is the 788

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requirement to calculate the taxable income and tax loss for the year under Subdiv 165-B. In effect, the recoupment tests are the same as those applicable to current year revenue losses under ss 165-25 to 165-40. In this way the tests for the maintenance of majority beneficial ownership of the company are imposed, together with the test for a tainted change of control, and, if failed, the SBT. A company must also calculate its net capital gain and net capital loss for the year under Subdiv 165-CB if it would have been required to calculate its taxable income and tax loss under Subdiv 165-B, except for the fact that it did not have a notional loss for any of the periods into which the year was divided pursuant to s 165-50(3): s 165-102(b). Thus, a company must calculate its net capital gain or loss under Subdiv 165-CB unless there are persons who had more than a 50% stake in the company during the whole of the year of income. If the same persons had more than a 50% stake for only part of the year of income, commencing from the start of the year of income, the company is not required to calculate its net capital gain or loss under Subdiv 165-CB if the company satisfies the SBT for the rest of the income year. The SBT is applied in relation to the business carried on immediately before the time (test time) when the failure to maintain more than a 50% stake occurred: s 165-40(3). A 50% stake is determined by reference to voting power, rights to dividends and capital distributions: s 165-37. These ownership tests are supplemented by a tainted change of control test. A company must also calculate its net capital gain or loss under Subdiv 165-CB if there is a tainted change of control of voting power within s 165-40 and the company does not satisfy the SBT for the rest of the year of income after the change of control has occurred. When a company is required to work out its net capital gain or loss under Subdiv 165-CB, the year of income is divided into periods and a similar treatment applies as that which applies to current year revenue losses: ss 165-105 to 165-114. A company has a notional capital gain for a period if the total of the capital gains made during the period exceeds the total of its capital losses made during that period. If total capital losses exceed capital gains, the company has a notional net capital loss: s 165-108. Overall, a company makes a net capital gain for the year equal to the amount by which notional capital gains for the year exceed any available prior year net capital losses: s 165-111. (A notional net capital loss for a period is not taken into account but is counted towards the company’s net capital loss for the year.) A company makes a net capital loss for the year equal to the total of its notional net capital losses for the year: s 165-114. If the company does not have a notional net capital loss for any of the periods in the year, Subdiv 165-CB has no further application and the company’s net capital gain for the year is calculated in the usual way: s 165-108(3). Section 165-37 (in Subdiv 165-B) sets out the tests that deal with direct ownership (the primary tests) and indirect ownership through interposed entities (the alternative tests): see ss 165-150(2), 165-155(2) and 165-160(2). The other provisions also correspondingly adapt those that apply to current year revenue losses, including the SBT in Subdiv 165-E. In addition, anti-avoidance tests corresponding with those for current year revenue losses in Subdiv 175-B are contained in Subdiv 175-CB (current year capital losses) and Subdiv 175-CA (prior year capital losses). Under Subdiv 175-CB the Commissioner may disallow some or all of a capital loss made in an income year if: • either a capital gain or a capital loss is made (an ‘‘injected capital gain’’ or ‘‘injected capital loss’’) that would not have been made but for the existence, respectively, of either capital losses or a capital gain, except where continuing shareholders benefit from either the capital gain or from some profit or advantage arising from the loss: ss 175-60 and 175-65; or © 2017 THOMSON REUTERS

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• either a person (other than the company) obtained a tax benefit from a scheme that would not have been entered into but for the capital loss or a person would obtain a tax benefit from a scheme that would not have been entered into but for a prior available capital gain in the same year, in each case except where the tax benefit is reasonable having regard to the person’s shareholding interest: s 175-70(1), (2).

[20 480] Notional taxable income or notional loss for separate periods If Subdiv 165-B applies in relation to both current year revenue losses and net capital losses, the income year is required to be divided into periods, beginning from the start of the income year and ending at either a failure to maintain a 50% stake in the company or the first instance of any tainted change of control of the company, whichever occurs earlier. For convenience, the following references will be to current year revenue losses. Section 165-25 summarises the steps for calculating taxable income for an income year under Subdiv 165-B as follows. Step 1 Step 2 Step 3

Divide the income year into periods: each change in ownership or control is a dividing point between periods. Treat each period as if it were an income year and work out the notional loss or notional taxable income for that period. Work out the taxable income for the year of the change by adding up: • each notional taxable income; and • any full year amounts (amounts of assessable income not taken into account at Step 2); and then subtracting any full year deductions (deductions not taken into account at Step 2): s 165-65.

The notional loss for a period, mentioned in step 2, is the amount by which deductions attributable to the period exceed assessable income attributable to the period: s 165-50(1). Notional taxable income for a period is the excess of a company’s assessable income attributable to a period over deductions attributable to the period: s 165-50(2). A single rule applies under which deductions in specified categories (primarily depreciation and exploration or prospecting expenditure) are attributed to periods within a year: s 165-55(2). Full year deductions (eg for bad debts, debt/equity swap losses, pensions and retiring allowances, gifts, prior year tax losses and farm management deposits) are deductions that are not attributable to a particular period: s 165-55(4). Full year amounts are amounts of assessable income derived by a company as a beneficiary of a trust, which are not reasonably attributable to a particular period: s 165-60(7). Similarly, a single rule identifies specified categories of assessable income that are attributed to periods within a year: s 165-60. A company’s tax loss for an income year is calculated as follows. Step 1 Step 2 Step 3

Calculate the total of notional losses worked out under s 165-50. Add any excess full year deductions. Excess full year deductions are the excess of allowable deductions for bad debts and certain pre-paid expenses over the sum of notional taxable income amounts and full year deductions: s 165-70(3). Deduct any net exempt income worked out under s 36-20: see [8 480].

The amount remaining is the company’s tax loss for the income year, which is called a loss year: s 165-70. If there is only one event that results in a failure to maintain a 50% stake in the company, the year is divided into 2 periods, separated by the event that causes the break in the 50% stake. If a company is subject to more than one change of beneficial ownership or tainted 790

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[20 490]

change in control of voting power, but satisfies the SBT throughout 2 or more successive periods that would otherwise be treated as separate periods, those periods may be treated as a single period: s 165-45(4). EXAMPLE [20 480.10] Assume that 3 changes of ownership and/or control have occurred in relation to a company in an income year, in which the following is ascertained for the 4 periods: Period 1: notional taxable income of $10,000 Period 2: notional loss of ($5,000) Period 3: notional taxable income of $20,000 Period 4: notional taxable income of $15,000 Assume, firstly, that, in relation to the test time at the end of period 1, the SBT is not satisfied for the rest of the income year (the same business test period). Calculation of taxable income for the year (ss 165-55 and 165-65) Add notional taxable incomes (Exclude notional loss of $5,000)

$ 10,000 20,000 15,000

Add full year amount (share of net income of trust estate: s 165-60(2)(a))

$

45,000 5,000

50,000 Subtract full year deductions, in the following order: Bad debt 1,000 Prior year tax losses 5,000 General mining deductions 2,000 Exploration expenditure deduction 2,000 10,000 Taxable income 40,000 Under s 165-70 the company’s tax loss, assuming there is no net exempt income, is the amount of the notional loss ($5,000). Since the total of the full year deductions does not exceed the total of the notional taxable incomes and the full year amounts in s 165-60, no further amount under s 165-70(3) arises. If the SBT was satisfied for the rest of the year after the test time at the end of period 1, Subdiv 165-B would not apply: ss 165-35 and 165-40(2). Also, if the company satisfies the SBT for all of what would otherwise be 2 or more successive periods, they are treated as a single period: s 165-45(4).

[20 490] Partnerships and current year losses Special rules apply if a company is a member of a partnership at any time during a period: ss 165-75 to 165-90. Firstly, as in the case of non-partners, if a company has a notional taxable income for all periods in the income year, Subdiv 165-B has no further application and the company’s taxable income for the income year is calculated in the usual way under s 4-15. A company may have a share, as a partner, of a notional net income of the partnership for a period or a share of any notional loss of the partnership for the period: s 165-75. If the company and the partnership have the same income year, the partnership’s notional loss or notional net income for the period is calculated in the same way as the notional loss or notional taxable income of the company: s 165-80. The company’s share is A/B expressed as a percentage, where: • A is the company’s interest in the partnership’s net income or loss for the income year; and • B is the amount of the partnership’s net income or partnership loss. © 2017 THOMSON REUTERS

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If the partnership and the company have different income years, the partnership’s notional net income or notional loss for a period is so much of the partnership’s net income or loss of the income year as is derived during the period: s 165-85. The company’s share of the partnership’s full year deductions is calculated in a similar manner, depending on whether the partnership and the company have the same or a different income year: s 165-90.

LISTED PUBLIC COMPANIES [20 550] Listed public companies – modified ownership tests Division 166 ITAA 1997 provides an alternative way of testing the continuity of beneficial ownership of the shares of certain widely held and eligible Div 166 companies. Entities that can use modified test in Div 166 ‘‘Widely held’’ and ‘‘eligible Div 166’’ companies for the income tax year in which they seek to deduct a tax loss can take advantage of the modified continuity of ownership test (COT) in s 166-145. Companies which do not satisfy the requirements for widely held or eligible Div 166 companies need to satisfy Div 165 (see [20 320]) to determine whether they satisfy the COT. A ‘‘widely held company’’ is a company that is listed on an approved stock exchange (see Sch 5 to the ITA Regs) or has more than 50 members: s 995-1. However, a company which satisfies the 50-member rule will not qualify as a widely held company if, at any time during the income year: (a) 20 or fewer persons hold or have the right to acquire or become the holder of shares representing 75% or more of the value of shares in the company (shares that only carry a right to a fixed rate of dividend are not counted); (b) 20 or fewer people are capable of exercising 75% or more of the voting power in the company; (c) 20 or fewer people receive 75% or more of any dividend paid by the company or, if no dividend was paid, the Commissioner believes that the 20/75% test would have been satisfied. In ATO ID 2007/106, where a widely held company was replaced by an interposed widely held company which chose roll-over relief under former Subdiv 124-G ITAA 1997 (now Div 615: see [16 160]), the interposed company was considered to be a widely held company for the whole income year. A company is an ‘‘eligible Div 166 company’’ if it is not a widely held company and more than 50% of the voting power, rights to dividends or rights to capital distributions are beneficially owned by one or more of the following entities: a widely held company, a superannuation fund, an ADF, a special company, a managed investment scheme, an entity prescribed under the tracing rule that deems entities to be beneficial owners (see [20 580]), a non-profit company or charitable institution, a charitable fund or any other kind of charitable body: s 995-1.

[20 570] When ownership is tested under Div 166 Under the COT rules in Div 165, a company must maintain the same owners continuously from the start of the loss year until the end of the income year. However, under Div 166, the test is modified so that continuity of ownership is required between the start of the test period and at the end of a later time when there has been any one of the following ‘‘corporate changes’’ as listed in s 166-175:

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(a) a takeover bid for the company (whether successful or not); (b) a court approved scheme of arrangement involving more than 50% of the company’s shares; (c) any other arrangement involving the acquisition of more than 50% of the company’s shares regulated under the Corporations Act 2001 or a foreign law; or (d) an issue of shares in the company that increases the issued capital or the number of shares by 20% or more. A corporate change also occurs if one of these events occurs in relation to another company that holds more than 50% of the voting power, dividend or capital rights in the company being tested. See ATO ID 2007/107 for a situation where a reorganisation involving a consolidated group is taken not to give rise to a corporate change.

[20 580] Tracing rules Division 166 contains a number of concessional ‘‘tracing rules’’ (in Subdiv 166-E) which are designed to avoid the need for companies to identify small ownership interests. Essentially, these rules obviate the need for tracing back through certain specified holders to the ultimate shareholders.

Direct stake of less than 10% For all registered shareholdings carrying less than 10% of voting power, the voting power is taken to be controlled by a single notional entity: s 166-225. This means it is not necessary to trace ownership interests of less than 10%. Voting power and rights to dividends and capital are dealt with separately so that if voting power, for example, is less than 10% but rights to capital are not, it is only the voting power interest which will be attributable to the single notional entity. If a registered shareholder is a nominee company there is a choice as to whether there is a tracing through to beneficial owners (which would be advantageous if the nominee held more than 10%, but the beneficial owners each held less than 10%). In that case each less than 10% stake may be attributed to a single notional entity. Of course, if the nominee itself holds less than 10% then it would not be necessary to undertake the inquiry.

Indirect stake of less than 10% An indirect stake of less than 10% is attributed to the top interposed entity: s 166-230. The top interposed entity is the entity in which the stakeholder with a less than 10% interest has a direct interest. This need not be a company. Again, voting dividend and capital rights are dealt with separately. There is a special rule in s 166-230(3) which allows for the restructuring of a top interposed entity after the start of test period so that a holding company can be inserted between the top interposed entity and less than 10% stakeholders. The new interposed company is treated as holding its stake in the tested company at all times that the old interposed company did. To qualify under s 166-230(3), all of the following conditions must be met: (a) all the shares in the old interposed entity must be acquired; (b) the shares in the new interposed entity must be of the same class as those in the old entity; (c) the shares must be non-redeemable; and (d) each shareholder must retain the same proportionate shareholding in the new interposed entity as in the old. © 2017 THOMSON REUTERS

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Widely held company stake between 10% and 50% A stake of between 10% and 50% (inclusive) held by a widely held company is attributed to the widely held company as an ultimate owner: s 166-240. This rule only applies if a company is widely held for the entirety of the income year where the ownership test time occurs. Again, voting, dividend and capital stakes are treated separately. There is also a provision like s 166-230(3) which allows for the interposition of a widely held holding company above an existing widely held company: s 166-240(4). Other tracing rules Certain entities are deemed to be beneficial owners. These entities are superannuation funds, ADFs, managed investment schemes and special companies (eg mutual insurance companies, mutual affiliate companies, trade unions and sporting clubs: s 166-245. An indirect stake held by way of bearer shares in a foreign listed company is attributed to the single notional entity if various conditions are satisfied (eg see ATO ID 2013/5): s 166-255. Bearer shares are instruments which evidence ownership of a share to a person who has in their possession the bearer share certificate. Since bearer shares are not recorded on a register it is generally not practicable for a company to trace through their ownership. An indirect stake held by a depository entity through shares in a foreign listed company is attributed to the depository entity as an ultimate owner. An example of a depository entity would be the depositary trust company in the US. These entities provide custody of share certificates and similar services. Certain foreign jurisdictions have disclosure laws which means it may not be possible for Australian companies to trace through shares held by such depository entities. In order to satisfy the test, the conditions in s 166-260 must be satisfied. Tracing if test company is ‘‘controlled’’ The tracing rules do not modify how the ownership test in s 166-145 applies to a test company if: (a) a natural person (with associates) controls more than 25% of the voting power of the test company; or (b) a company or trust (with associates) controls more than 50% of the voting power of the test company. In such cases, s 166-280 requires tracing through to the entity that has ‘‘sufficient influence’’ over the test company, ie the natural person, company or trustee with the level of voting control mentioned above. This prevents the strict operation of the tracing rules hiding significant interests in the test company.

No detrimental operation of tracing rules A testing company can disregard any of the tracing rules in ss 166-225, 166-230, 166-240, 166-245, 166-255 and 166-260 that would, as applied to a particular stake, prevent it satisfying the modified COT: s 166-275. The company must hold a reasonable belief that it would not fail the test if the tracing rule did not apply to that stake. This will allow a company to use the modified COT if it might otherwise have to choose not to use it because a tracing rule would expose a change that would cause it to fail the test. Note that a company cannot apply the concessional tracing rules in the former Subdivs 166-F and 166-G in order to form the required reasonable belief: see ATO ID 2008/14. [20 590] Modified same share rule The same share rule, which applies under the general continuity of ownership test regime in Div 165 (see [20 320]), applies in modified form in Div 166. Section 166-272 contains rules which ensure that the modified continuity of ownership test is only applicable in respect of shares or other interests held by a top interposed entity, a widely held company, an entity deemed to be a beneficial owner or a depository entity. The purpose is to ensure that a loss or deduction is not available if it has been substantially 794

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duplicated through CGT events which have happened to interests held directly or indirectly by these entities. So, for example, if a top interposed entity holds shares directly in a tested company those shares must be the same shares at each test time to be taken into account for the modified COT. In recognition of this, there is a savings provision which negates the same share rule in circumstances where there has not been a duplication of tax loss through capital gains tax events occurring in the test company: s 166-272(8) and (11).

Minimum interests rule The same share rule does not apply in respect of stakes held by a single notional entity. The rule would not make sense in this context since it would be contrary to the policy of allowing the tested company to disregard interests of less than 10%. Rather, a minimum interest rule applies which restricts the total proportion of voting power, dividend rights and capital rights attributed to the single notional entity to the proportion attributed to it at the beginning of the test period: s 166-270. In other words, if at the start of the test period the tracing rule concerning direct stakes of less than 10% attributes a certain percentage to the single notional entity it is not possible to take into account a higher percentage on the basis that those interests may have grown by the test time.

BAD OR FORGIVEN DEBTS [20 650] Bad debts – restrictions on ability to deduct Companies that seek a deduction in respect of bad debts must satisfy the continuing shareholding requirements of s 165-123 or the continuing business test of s 165-126 in Subdiv 165-C. These sections are intended to prevent tax avoidance by the acquisition of a company that has substantial amounts owing to it that are not able to be recovered and that will be written off to provide a deduction against income derived from new income-producing activities after the acquisition of the company. The effect of the provisions is that bad debts written off by a company are not deductible under s 8-1 or s 25-35 unless there has been a substantial continuity (more than 50%) of beneficial ownership of the shares in the company. Even if there has been technical compliance with the need for a continuing ownership to satisfy s 165-123, the deduction is not allowed because of the additional safeguards in Subdiv 175-C if the real control of the company has been changed, if a person other than the company will receive a benefit from a scheme based on the availability of the bad debt deduction, or if the business was conducted without proper regard to the rights of the continuing shareholders in the company. If these conditions apply and income has been channelled into the company to secure the benefit of the bad debt, a deduction will not be allowable: ss 175-80 to 175-90. If the company has carried on the same business at all times during the year in which the debt was written off as it carried on immediately before a change in beneficial ownership which prevents it from relying on the continuity of beneficial ownership test, and has not derived income of a kind that it previously had not derived, the bad debt will be allowable as a deduction under ss 165-126 and 175-80(2), even though the company may not pass the tests outlined above (in s 165-123 and Subdiv 175-C). (Compare the test in Subdiv 165-E ITAA 1997, which applies in respect of losses of prior years: see [20 360].) If it is not practicable to determine when the company failed the (COT), the same business test (SBT) will be applied at the start of the current year. If the debt was incurred before the current year or the company came into existence during the current year, the SBT is applied at the end of the day the debt was incurred: s 165-126(2). Section 165-132 is intended to prevent a company obtaining a deduction for losses incurred in prior years through writing off a bad debt: [20 400]. Section 165-132 will apply to © 2017 THOMSON REUTERS

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deny the loss if there has not been a continuity of ownership as required by s 165-123 unless the company continued to carry on the same business as required by s 165-126 during year of recoupment. The restrictions apply to part of a debt as if it were an entire debt: ss 165-120 and 165-132. If there are other companies interposed between the company seeking to write off the bad debt and the natural persons whose beneficial ownership of shares is to be taken into account, there are tracing provisions under which the interests of the natural persons are to be determined: s 165-123(5). The beneficial interests are traced in the same way as for loss companies: see [20 320].

[20 660] Commercial debt forgiveness – consequences Under the commercial debt forgiveness provisions (Div 245 ITAA 1997), if a commercial debt is forgiven, the amount forgiven will be deducted from the debtor’s future tax benefits in the following order: first against prior year revenue losses, then prior year net capital losses, undeducted balances of certain prescribed deductible expenditure and, finally, cost bases of capital assets (generally calculated by reference to the balances at year-opening). No change is made to the deductions available to a creditor for bad debts and capital losses. The general operation of these rules in relation to all taxpayers is discussed in detail at [8 700]. Debts affected include all commercial debts, including investments that are ‘‘securities’’ and equity for debt swaps. A company that issues debt dividends, which are treated like interest, will be treated as a debtor. Section 245-90 contains a special rule whereby companies under common ownership throughout the term of the relevant debt may enter into an agreement under which the commonly owned creditor company may forgo an entitlement it would otherwise have to a capital loss as a result of forgiving the debt or a deduction in the forgiveness year for a bad debt under s 8-1 or s 25-35. In these circumstances, the creditor’s capital loss or deduction is reduced by the amount forgone and a corresponding amount is deducted from the debtor company’s net forgiven amount. Whether companies are ‘‘under common ownership’’ is determined in accordance with the definition of that term in s 995-1. There are some important limitations to the circumstances when this trade-off may be made. In particular, the debtor and creditor companies must be ‘‘under common ownership’’, throughout the period from the time the debt was incurred until it is forgiven. (A similar trade-off is available for debts under s 8-1 or s 25-35.) A written agreement is required to be signed by the public officers of both companies before whichever is the earlier of the lodgment dates for both companies (although the Commissioner may grant an extension of time).

SHARE BUYBACKS AND CANCELLATIONS SHARE BUYBACK SCHEMES [20 700] Introduction The company law legislation (ss 257A to 257J of the Corporations Act 2001) allows companies to buy back their own shares. The legislation provides for the automatic cancellation of bought-back shares. Division 16K in Pt III ITAA 1936 (ss 159GZZZIA to 159GZZZS) provides for the tax consequences of share buybacks. A distinction is drawn between buybacks made in the ordinary course of trading on an official stock exchange (‘‘on-market purchases’’) and all other buybacks (‘‘off-market purchases’’): s 159GZZZK. Transactions that are ‘‘special’’ 796

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under stock exchange rules are deemed to be outside the ordinary course of trading and are treated as off-market purchases: s 159GZZZL. Notwithstanding that, in the case of off market buybacks, a portion of the buyback price might be attributable to earnings and treated as a dividend for tax purposes, it is not a dividend for company law purposes (ie under s 254W of the Corporations Act 2001). Practice Statement PS LA 2007/9 sets out the Tax Office’s views on the potential application of certain anti-avoidance provisions (eg ss 45A, 45B and 177EA ITAA 1936) to share buybacks and when it may be appropriate to issue a private ruling or a class ruling concerning the application or otherwise of those provisions. It was announced in the 2009-10 Budget that, following a period of consultation, the Board of Taxation recommendations on share buybacks would be implemented. Draft legislation proposes to give effect to the recommendations by rewriting the existing Div 16K as Div 190 ITAA 1997. The rewritten rules would deny notional losses, provide a more specific basis for the capital dividend split and address streaming to foreign residents. The rewritten rules are designed to give greater certainty, thereby avoiding the need for listed companies to seek class rulings. The changes are proposed to have effect for share buybacks undertaken after the date of assent of the amending legislation. The previous Coalition Government, however, stated that it would consult further before deciding whether to proceed with these changes (see the then Treasurer’s and Assistant Treasurer’s joint media release, 6 November 2013).

[20 710] Off-market buybacks – shareholder treatment Off-market share buybacks can give rise to deemed dividends, unlike on-market buybacks: see [20 720]. Special rules may also apply in determining the capital proceeds for CGT purposes. Deemed dividend If the amount of the purchase price exceeds the part, if any, of the purchase price that is debited to the share capital account, then the excess is taken to be a dividend paid to the seller as a shareholder out of profits of the company: s 159GZZZP(1). This causes it to be assessable under s 44. For an example, see Re Fitzgerald and FCT (2011) 85 ATR 950. The remainder of the purchase price (ie the amount debited to the share capital account) is not taken to be a dividend: s 159GZZZP(2). As to the operation of these rules (albeit under the legislation applicable in 2002 which contained in s 6D a definition of ‘‘share capital account’’, since repealed) refer to FCT v Consolidated Media Holdings Ltd (2012) 84 ATR 1 where the High Court took a broad view of what constitutes a share capital account. In Cable & Wireless Australia & Pacific Holdings BV (in liq) v FCT [2016] FCA 78, the Federal Court distinguished Consolidated Media on the basis that the purpose of the buyback was not to return capital that was surplus to its needs, but rather to facilitate the sale by the taxpayer of its shares in Optus to Singtel (this decision is on appeal): see also [35 160]. (Under the current law, the question would be decided by reference to s 975-300: see [21 070].) The dividend portion of the purchase price is taken to be a distribution paid ‘‘on the day the buy-back occurs’’: s 159GZZZP(1)(e). This is consistent with s 960-120, which provides that a distribution is made when paid or ‘‘taken to be paid’’. This need not necessarily be the date on which the purchase price is paid. The Tax Office considers the buy-back to occur on the day the buy-back contract is formed rather than on the day the purchase price is paid: see Draft Ruling TR 2016/D2. If the purchase price exceeds the market value of the shares, the full purchase price remains a deemed dividend but the excess over market value is not frankable (the concept of market value is considered at [3 210]). Disposal consideration For the purpose of calculating the ordinary income or capital gain or loss realised as a result of an off-market share buyback, the amount treated as the disposal consideration is the full purchase price for the share: s 159GZZZQ(1). © 2017 THOMSON REUTERS

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Market value rule The amount treated as the disposal consideration is subject to a deemed disposal consideration rule in relation to buybacks for below market value. The market value of the share is the amount that would have been the market value of the share at the time of the buyback on the assumption that the buyback had not been proposed or implemented: s 159GZZZQ(2)(b). If the purchase price is less than the market value of the share, the full market value is nevertheless treated as the disposal consideration for ordinary income or capital gain purposes: s 159GZZZQ(2). If the purchase price exceeds market value, no adjustment is made to the disposal consideration, nor to the calculation of the dividend component, but, as mentioned, the part of the deemed dividend that is attributable to the excess over market value is not frankable: s 202-45 (see [21 420]). See [3 210] for the definition of ‘‘market value’’. The Tax Office approved method for the calculation of market value in relation to off-market share buybacks of listed company shares is set out in Determination TD 2004/22. The market value should be determined as the volume weighted average price of the company’s shares on the ASX over the last 5 trading days before the first announcement of the buyback (which is not necessarily the formal announcement) adjusted for the percentage change in the S&P/ASX 200 index from the commencement of trading on the first announcement date to the close of trading on the day the buyback closes. See Administrative treatment: acquisitions and disposals of interests in ‘‘no goodwill’’ professional partnerships, trusts and incorporated practices on the Tax Office website for the Commissioner’s views on the market value of a share in a ‘‘no goodwill’’ incorporated professional practice where a practitioner-shareholder exits the practice. Reduction rule In order to prevent double taxation as a result of the deemed disposal consideration rules if a deemed dividend is assessable, the purchase price (increased to market value if that is required) is reduced by a ‘‘reduction amount’’: s 159GZZZQ(4). (This adjustment is made in place of any of operation of the general capital gain reduction rule in s 118-20, which is excluded by s 159GZZZP(1A).) The reduction amount is that part of any deemed dividend in connection with the buyback that is either (s 159GZZZQ(4)(b)): • included in the shareholder’s assessable income (ignoring, if it would otherwise apply, the exclusion in s 128D relating to fully franked dividends and dividend withholding tax); or • an ‘‘eligible non-capital amount’’. A deemed dividend is an eligible non-capital amount if it is not debited against a share capital account or an asset revaluation reserve, nor is attributable, directly or indirectly, to amounts transferred from any such accounts or reserves: s 159GZZZQ(5). An example of a dividend that is potentially an eligible non-capital amount is a dividend not included in assessable income pursuant to s 23AJ: • if paid out of realised operating profits, it would be an eligible non-capital amount and a reduction of the disposal consideration would be required based on the reduction amount; • conversely, if paid out of an asset revaluation reserve, it would not be an eligible non-capital amount and no reduction to the disposal consideration would be made. If a dividend is debited partly to a capital account and partly to a non-capital account, only the part debited to the latter will be an eligible non-capital amount.

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EXAMPLE [20 710.10] A natural person holds a share with a cost base (ignoring indexation) and a paid-up amount of $2. If the market value and buyback price is $6, the deemed dividend is $4 and the disposal consideration is $6. The ‘‘reduction amount’’ is the (assessable) deemed dividend of $4, resulting in a reduced disposal consideration of $2 ($6 − $4). No capital gain or loss arises. A capital gain or loss could accrue, if the relevant cost base fell below or exceeded $2. (There is no eligible non-capital amount in this example.)

[20 720] On-market buybacks – shareholder treatment In the case of on-market purchases, no part of the purchase price is treated as a dividend: s 159GZZZR. Rather, the full amount of the purchase price is treated as the consideration on sale for both ordinary income and CGT purposes: s 159GZZZS. Consequently, no question of franking credits arises. [20 730] On-market buybacks – company issues It is expressly provided in relation to all buybacks, whether on- or off-market, that there are no ordinary income, allowable deduction or CGT consequences for the company if it buys back its own shares and then cancels them. The company is treated as if neither the buyback nor the cancellation had ever occurred: s 159GZZZN. As noted, a company may frank the amount of any off-market purchase price that is treated as a dividend. In relation to on-market purchases a special statutory franking debit arises on the day of the on-market buyback: s 205-30, item 9. The amount of the franking debit is calculated by determining the notional dividend that would have been paid if the on-market purchase had been an off-market purchase. Thus, although an on-market purchase is not treated as a dividend in the hands of the shareholder, it is treated as the payment of a franked dividend as far as the company is concerned, with an appropriate statutory franking debit. EXAMPLE [20 730.10] A shareholder holds a share with a paid-up value of $1 and a market value of $2.50. The company buys the share back for $2.50. On-market purchase For the shareholder: consideration on disposal of $2.50. If the indexed cost base was $2, a capital gain of $0.50 would accrue; no amount would be a dividend. The purchase is tax neutral for the company. The company has a franking debit based on the required franking amount for a notional dividend of $1.50.

SHARE CANCELLATIONS [20 750] Introduction Division 16J (ss 159GZZZC to 159GZZZI) ITAA 1936, operates to deny any benefit accruing to a holding company or its subsidiary if the holding company cancels or reduces any of its issued share capital held by the subsidiary. The benefits to be denied can take the form of a reduction in assessable income (including capital gains) or the increase in an allowable deduction or capital loss. The provisions of Div 16J will also apply to a natural person who is an ‘‘associate’’ of a holding company that is subject to its operation. © 2017 THOMSON REUTERS

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The holding company/subsidiary company relationship for Div 16J purposes is defined by reference to the Corporations Act 2001. The purpose of the Division is to prohibit the holding company and its subsidiary from claiming what are in effect ‘‘paper losses’’ on both sides of the transaction and thereby reduce their income tax liability. Generally, no real loss will occur within a corporate group upon the cancellation of shares in the holding company. The net asset backing of the corporate group will upon such a cancellation, in most cases, remain constant. The term ‘‘cancellation’’ is defined by s 159GZZZC(1) to include a ‘‘redemption’’. Accordingly, a redemption of shares will be subject to the provisions of the Division.

[20 760] Operation of Div 16J Subsidiary company level At the subsidiary company level, Div 16J applies if a holding company cancels shares in itself that have been acquired by a company that is directly or indirectly, through interposed entities, its subsidiary and that subsidiary, upon the cancellation of the shares, is not entitled to receive or would not receive capital proceeds, or any capital proceeds it does receive are less than the market value of the shares at the time they were cancelled. The subsidiary is taken for tax purposes to have received as the consideration for the cancellation of the shares an amount equal to the market value of the shares at the time they were cancelled. The concept of market value is considered at [3 210]. Holding company level At the holding company level, an ‘‘adjustment’’ is made to any remaining interest in the shareholding of the subsidiary held by the holding company, directly or indirectly through interposed entities, to reflect the reduction in value due to the share cancellation when it ultimately disposes of the interest. The ‘‘adjustment’’ is made to ensure that any gain made on disposal is not reduced or excluded from assessable income of the holding company (including any capital gains). Also, Div 16J operates to ensure that any decrease in profit or any increase in a loss arising on disposal is not included as assessable income or not allowed as a deduction or a capital loss. The ‘‘adjustment’’ is made by reducing the acquisition cost of the interest of the subsidiary by the amount of the capital proceeds the subsidiary company is taken to have received upon cancellation. If the interest held in the subsidiary constitutes trading stock, the ‘‘adjustment’’ is made by increasing the amount of the proceeds received upon disposal by the amount the subsidiary is taken to have received upon cancellation. If the holding company holds its interest in the subsidiary through an interposed entity, the adjustment will be made by multiplying its proportionate interest by the amount of capital proceeds the subsidiary is taken to have received upon cancellation of the shares. Any natural person who is an associate of the holding company will also have similar adjustments made to her or his interest in the subsidiary held directly or indirectly through any interposed entities. EXAMPLE [20 760.10] Company A has assets of $1,000 and has issued capital of 1,000 $1 ordinary shares and no liabilities (ie a net asset backing of $1 per share). Company B has assets of $200 (consisting of $100 cash and 100 × $1 ordinary shares in Company A and no liabilities) and has issued capital of 100 $1 ordinary shares (ie a net asset backing of $2 per share). Company A purchases the total issued capital of Company B for $200. The net assets of the group would be calculated as follows:

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Company A – net assets Company B – net assets less 100 × $1 in Company A Net assets of group

[20 760]

$ 1,000 200 1,200 100 1,100

To include Company B’s shareholding in Company A would be double counting, as those shares represent the value of a one-tenth share of Company A’s assets (notwithstanding that Company B because of its shareholding is not legally entitled to those assets). If Company A were to cancel the shares that Company B owns (and receives no capital proceeds), the net assets of the group would be calculated as follows: Company A – net assets Company B – net assets Net assets of group

$ 1,000 100 1,100

Assume any disposal of the shares in Company A by Company B is subject to the CGT provisions with all of the transactions taking place within 12 months. Before the introduction of Div 16J, the CGT provisions would have the following effect. Section 160ZL would not operate to reduce the cost base of the Company A shares held by Company B, as no consideration is paid by Company A upon the cancellation of the shares. A capital loss of $100 would arise to Company B upon the cancellation of the shares of Company A. Also, when Company A ultimately disposes of its shareholding in Company B, a capital loss of $100 would also arise as the market value of the shares will decrease by $100 because of the cancellation of the shares in Company A. A ‘‘paper’’ loss of $200 would be generated within the group when in fact no real loss has resulted in the overall net assets of the group. Division 16J will apply with the effect that Company B, upon the cancellation of the shares in Company A, will be taken to receive as capital proceeds an amount equal to the market value of the shares of Company A at the time of the cancellation, ignoring the fact that the cancellation of shares in Company A has occurred. Accordingly, no capital loss will arise upon the cancellation of the shareholding of Company B in Company A. Upon the disposal of the Company B shares, Div 16J will operate to reduce the value of the cost base of Company A’s shareholding in Company B to $100 to reflect the reduction in value of that shareholding due to the cancellation of the shares in Company A.

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21

INTRODUCTION Overview ....................................................................................................................... [21 010]

DIVIDENDS DIVIDENDS – GENERAL Definition of dividend ................................................................................................... [21 020] Assessability of dividends ............................................................................................ [21 030] Who is a shareholder? .................................................................................................. [21 050] Derivation – dividends paid or credited ....................................................................... [21 060] Tainting and untainting share capital account .............................................................. [21 070] Bonus shares .................................................................................................................. [21 080] Dividend reinvestment plans ........................................................................................ [21 090] Streaming bonus shares and unfranked dividends ....................................................... [21 100] Streaming dividends and capital benefits ..................................................................... [21 110] Schemes to provide capital benefits and demerger benefits ........................................ [21 120] Determinations by the Commissioner – procedure ...................................................... [21 130] LIQUIDATOR’S DISTRIBUTIONS Deemed dividends ......................................................................................................... Meaning of income ....................................................................................................... Value of distributions in specie .................................................................................... Informal liquidations ..................................................................................................... Subsidiary company liquidations and CGT .................................................................

[21 [21 [21 [21 [21

150] 160] 170] 180] 190]

LOANS AND PAYMENTS BY PRIVATE COMPANIES Deemed dividend payments by private companies: Div 7A ....................................... [21 Private companies, shareholders and shareholders’ associates ................................... [21 Payments treated as dividends ...................................................................................... [21 Loans treated as dividends ............................................................................................ [21 Amalgamated loans treated as dividends ..................................................................... [21 Forgiven debts treated as dividends ............................................................................. [21 Payments and loans through interposed entities .......................................................... [21 Unpaid present entitlements .......................................................................................... [21 Deemed dividend limited to distributable surplus ....................................................... [21 Exclusions from Div 7A ............................................................................................... [21 Commissioner’s discretion to disregard Div 7A .......................................................... [21 Division 7A and imputation .......................................................................................... [21 Division 7A and fringe benefits tax ............................................................................. [21 Remuneration and termination payments ..................................................................... [21

250] 255] 260] 270] 280] 290] 300] 305] 310] 320] 330] 340] 350] 360]

IMPUTATION SYSTEM FRANKABLE DISTRIBUTIONS Introduction ................................................................................................................... [21 Frankable distributions .................................................................................................. [21 Unfrankable distributions .............................................................................................. [21 Bonus shares .................................................................................................................. [21 Distributions from foreign resident companies ............................................................ [21 Co-operative companies ................................................................................................ [21

400] 410] 420] 430] 440] 450]

IMPUTATION – RECIPIENT’S VIEWPOINT Resident individuals ...................................................................................................... [21 500] Company shareholders .................................................................................................. [21 510] 802

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[21 010]

Foreign residents ........................................................................................................... [21 520] Franked distributions flowing through partnerships and trusts ................................... [21 530] Trusts taxed as companies ............................................................................................ [21 540] Superannuation funds .................................................................................................... [21 550] Life insurance companies and friendly societies ......................................................... [21 560] Co-operative companies ................................................................................................ [21 570] No gross-up and offset when franked distribution is not assessable .......................... [21 580] Tax offset for refund-eligible exempt institutions ........................................................ [21 590] Flow on of franking credits under cum-dividend contracts and securities lending arrangements ......................................................................................................... [21 600] Refund of excess franking offsets ................................................................................ [21 610]

IMPUTATION – COMPANY’S VIEWPOINT Franking distributions – introduction ........................................................................... [21 Franking periods ............................................................................................................ [21 Franking account ........................................................................................................... [21 Franking a distribution .................................................................................................. [21 Franking credits ............................................................................................................. [21 Franking debits .............................................................................................................. [21 Example of franking account ........................................................................................ [21 Benchmark rule ............................................................................................................. [21 Consequences of breaching the benchmark rule .......................................................... [21 Departure from benchmark – application to Commissioner required ......................... [21 Disclosure rule – benchmark variations ....................................................................... [21 Franking taxes ............................................................................................................... [21 Distribution statements .................................................................................................. [21 Distributions on non-share equity ................................................................................ [21 Ability to frank distributions – practical considerations ............................................. [21

650] 655] 660] 670] 680] 690] 700] 710] 720] 730] 740] 750] 760] 770] 780]

INTEGRITY RULES Integrity rules – overview ............................................................................................. [21 No gross-up and credit if imputation system manipulated .......................................... [21 Dividend stripping ......................................................................................................... [21 Linked distributions ...................................................................................................... [21 Substituting tax-exempt bonus shares for franked distribution ................................... [21 Anti-streaming provisions ............................................................................................. [21 Anti-avoidance – imputation benefits ........................................................................... [21 Franking credit benefits under consolidation ............................................................... [21 The 45-day holding period rule .................................................................................... [21 Related payments rule ................................................................................................... [21 Shares held through trusts ............................................................................................ [21

800] 810] 820] 830] 840] 850] 860] 870] 880] 890] 900]

EXEMPTING ENTITIES Exempting companies and exempting accounts .......................................................... [21 950]

INTRODUCTION [21 010] Overview This chapter considers how company distributions (primarily dividends) are treated for income tax purposes. The first section of the chapter discusses the meaning of ‘‘dividend’’ and how dividends are taxed: see [21 020]-[21 060]. Related topics that are discussed include tainting and untainting share capital accounts, bonus shares, dividend reinvestment plans, streaming dividends and capital benefits: see [21 070]-[21 130]. How liquidator’s distributions are treated for tax purposes is considered at [21 150]-[21 190]. © 2017 THOMSON REUTERS

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The next topic discussed in this chapter is loans and other payments by private companies to shareholders and associates of shareholders. The most important provisions are the ‘‘Div 7A deemed dividend rules’’, which deem certain payments, loans and forgiven debts to be dividends paid to the relevant shareholder(s). These are discussed at [21 250]-[21 350]. The final topic discussed in this chapter is the most significant – the imputation system. This is designed to prevent double taxation of a company’s profits (first in the hands of the company and then in the hands of shareholders). The system operates by imputing the payment of company tax to the shareholders, who become entitled to a tax offset for the tax paid by the company. The issues discussed include: • what are frankable and unfrankable distributions: see [21 410]-[21 450]; • how imputation works from the shareholder’s viewpoint: see [21 500]-[21 610]; • how imputation works from the company’s viewpoint: see [21 650]-[21 780]; and • integrity rules to prevent manipulation of the system: see [21 800]-[21 900].

DIVIDENDS DIVIDENDS – GENERAL [21 020] Definition of ‘‘dividend’’ The definition of a ‘‘dividend’’ for income tax purposes is found in s 6 ITAA 1936, as supplemented by ss 6BA(5) and 94L: s 995-1. A ‘‘dividend’’ is defined in s 6(1) ITAA 1936 to include: (a) any distribution made by a company to any of its shareholders, whether in money or other property (eg shares); and (b) any amount credited by a company to any of its shareholders as shareholders. Although this is an inclusive definition, which allows the common law meaning to apply, the scope of these paragraphs is very broad. For example, if an order is made under s 79 of the Family Law Act 1975 that requires a private company, or a party to the matrimonial proceedings to cause the private company, to pay money or transfer property to a party to the matrimonial proceedings who is shareholder of the company, the payment of money or transfer of property is an ordinary dividend to the extent it is paid out of the company’s profits: see Ruling TR 2014/5. Note that if a company deals with a shareholder in a different capacity (ie other than as a shareholder) there is no distribution, for example, if shares in a group company are sold to a shareholder at an undervalue pursuant to a share purchase agreement (see ATO ID 2010/95). Expressly excluded from the s 6(1) definition are: (d) moneys paid or credited by a company to a shareholder or any other property distributed by a company to shareholders (not being moneys or other property to which this paragraph, by reason of subsection (4), does not apply or moneys paid or credited, or property distributed for the redemption or cancellation of a redeemable preference share), if the amount of the moneys paid or credited, or the amount of the value of the property, is debited against an amount standing to the credit of the share capital account of the company; or (e) moneys paid or credited, or property distributed, by a company for the redemption or cancellation of a redeemable preference share if: 804

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[21 020]

(i) the company gives the holder of the share a notice when it redeems or cancels the share; and (ii) the notice specifies the amount paid-up on the share immediately before the cancellation or redemption; and (iii) the amount is debited to the company’s share capital account, except to the extent that the amount of those moneys or the value of that property, as the case may be, is greater than the amount specified in the notice as the amount paid-up on the share (meaning that the amount of any such excess will fall within the ‘‘dividend’’ definition); or (f) a reversionary bonus on a policy of life-assurance.

Implications of the debt/equity rules The rules for distinguishing debt and equity interests (in Div 974 ITAA 1997) introduced the concept of a non-share equity interest. Distributions in respect of a non-share equity interest are regarded as non-share dividends except to the extent that the company making the distribution debits it against the company’s non-share capital account or the company’s share capital account: s 974-120. Section 164-20 prescribes the circumstances in which a distribution can be validly debited to the company’s non-share capital account: see [31 290]. Non-share dividends are not ‘‘dividends’’ as defined in s 6(1) and, although their income tax treatment in many respects parallels that of dividends paid over legal form equity, there are important differences, eg in relation to assessability (see [21 030]) and franking. The debt/equity rules are discussed in detail in Chapter 31. Distributions on reduction of capital ‘‘Share capital account’’ is defined as an account which the company keeps of its share capital, or any other account (whatever it is called) created on or after 1 July 1998 where the first amount credited to the account was an amount of share capital: see [21 070]. Section 995-1 ITAA 1997 and s 6(1) ITAA 1936 define ‘‘paid-up share capital’’ to mean ‘‘the amount standing to the credit of the company’s share capital account reduced by the amount (if any) that represents amounts unpaid on shares’’. ‘‘Amount paid-up’’ is defined as ‘‘the amount (if any) paid on that share’’ and ‘‘amount unpaid’’ is ‘‘the amount (if any) unpaid on that share’’. One of the purposes of the definition of ‘‘share capital account’’ is to ensure that the term does not include a ‘‘tainted’’ share capital account, except for certain specific purposes. The result is that only a share capital account that is not tainted qualifies for the para (d) exclusion from the definition of ‘‘dividend’’. Excluded from the definition of ‘‘dividend’’ in s 6(1) are amounts covered by para (d) of the definition, ie moneys paid or credited or property distributed to shareholders to the extent that an amount is debited to the company’s share capital account. This means that if a company distributes property to a resident shareholder, the amount by which the money value of the property exceeds the amount debited to the share capital account will be included in the shareholder’s assessable income as a dividend to the extent that it is paid out of profits derived by the company (except where s 45B ITAA 1936 applies: see [21 120]). The ‘‘out of profits’’ requirement will be satisfied if immediately after the distribution of property, the market value (see [3 210]) of the company’s assets exceeds the total amount of its liabilities and share capital: Ruling TR 2003/8. The exclusion under para (d) does not operate if s 6(4) applies or a redemption of redeemable preference shares is involved. Section 6(4) applies (ie a dividend will be paid) if: • a person pays or credits any money or gives property to the company and the company credits its share capital account with the amount of the money or the value of the property; and © 2017 THOMSON REUTERS

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• the company pays or credits any money or distributes property to another person and debits its share capital account with that amount of the money or the value of that property. The Tax Office considers that ‘‘retail premiums’’, which are amounts debited against a company’s share capital amount and paid to non-participating shareholders in rights issues, are assessable dividends due to the application of s 6(4): see Ruling TR 2012/1. There is a further exclusion from the definition of dividend (see para (e)) which relates to moneys paid or credited, or property distributed, for the redemption and the cancellation of redeemable preference shares.

Deemed dividends The scope of dividend treatment is extended by several provisions that deem amounts to be dividends paid to shareholders (and also to be paid out of profits) for the purpose of expressly making them assessable to the recipient: • bonus shares issued where there is a choice between dividends and shares, where s 6BA(5) applies and s 6BA(6) does not: see [21 080]; • deemed distributions by private companies to shareholders or their associates: Div 7A (see [21 250]-[21 340]); • excessive payments to associates: s 109 (see [21 360]); • off-market share buybacks: s 159GZZZP (see [20 710]); • liquidator’s distributions: s 47 (see [21 150]); • a distribution by a corporate limited partnership within s 94L: see [22 400]; • distribution by controlled foreign companies: s 47A (see [34 420]).

[21 030] Assessability of dividends The assessability of both dividends and non-share dividends is dealt with by s 44(1) ITAA 1936. The following are included in a taxpayer’s assessable income under s 44(1): (a) if the shareholder is a resident, dividends paid by the company out of profits derived by it from any source, and all non-share dividends; (b) if the shareholder is a foreign resident, dividends paid by the company out of profits derived from sources in Australia and non-share dividends derived from sources in Australia; (c) if the shareholder is a foreign resident carrying on business in Australia through a permanent establishment, dividends that are attributable to the permanent establishment and are derived by the company from sources outside Australia and non-share dividends derived from sources outside Australia. However, s 44(1) is made subject to the operation of provisions that make specific provision in relation the inclusion in, or exclusion of, dividends or non-share dividends from assessable income. For example, a franked dividend covered by para (b) is specifically excluded from assessable income under s 128D. Any distributions to proprietors of a strata title body out of profits derived by the body are assessable dividends: see Ruling TR 2015/3. As to the source of income derived by way of dividends: see DCT (NSW) v Freeman (1956) 6 AITR 225; Esquire Nominees Ltd v FCT (1972) 3 ATR 105; see also [2 210]-[2 240]. Traditionally, a dividend for corporations law purposes could only be paid out of profits. However, s 254T of the Corporations Act 2001 now provides that a company must not pay a dividend unless: 806

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[21 050]

• the company’s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; • the payment of the dividend is fair and reasonable to the company’s shareholders as a whole; and • the payment of the dividend does not materially prejudice the company’s ability to pay its creditors. Assets and liabilities are calculated in accordance with accounting standards in force at the relevant time. Where a ‘‘dividend’’ is paid for corporations law purposes otherwise than out of profits, s 44(1) would not include the dividend in the shareholder’s assessable income. Following the enactment of s 254T of the Corporations Act, s 44(1A) was inserted into the ITAA 1936 to provide that a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits for the income tax law (applicable to dividends declared on or after 28 June 2010). ‘‘Dividends’’ for the purposes of s 44(1A) is defined in s 6(1) (see [21 020]). It is therefore subject to the exclusion for amounts debited against an amount standing to the credit of the company’s share capital account. In other words, since s 44 is still based on the s 6(1) definition of ‘‘dividend’’, distributions debited to share capital will not be assessable notwithstanding the deeming effect of s 44(1A). The Commissioner has expressed the view that s 254T is not empowering – it merely prohibits the payment of a dividend in the specified circumstances. He takes the view that the company law requirement for a dividend to be paid out of profits still exists, as a dividend is defined at common law as a share of profits allocated by a company to its shareholders (see Ruling TR 2012/5). For the consequences of this for franking purposes, see [21 420].

Demerger dividends Division 125 provides ‘‘demerger’’ roll-over relief if the ‘‘head entity’’ in a group undertakes restructuring in order to pass ownership of a subsidiary to shareholders of the head entity. The dividend component of a genuine demerger (a ‘‘demerger dividend’’ as defined in s 6(1)) will not result in either assessable income or exempt income for the owners of relevant interests: s 44(4). A demerger dividend is taken not to be paid out of profits and is not assessable income or exempt income if, just after the demerger, at least 50% of the market value of CGT assets owned by the demerged entity or its demerger subsidiaries are used in the carrying on of a business: s 44(5). See also [21 120]. Listed investment company dividends Eligible shareholders in listed investment companies (LICs) are entitled to a capital gains tax discount for that part of a dividend paid to them which represents a discount capital gain: see [14 390]. Income attributable to dividends If dividend income is indirectly received by a person, as a beneficial owner of the shares (eg under a bare trust or through present entitlement to a share of trust income that consists either partly or wholly of dividends), that person is deemed to have received ‘‘income attributable to a dividend’’: s 6B. Dividends derived indirectly in this manner are not caught by s 44 because it only applies to dividends derived by a ‘‘shareholder’’ as such. [21 050] Who is a shareholder? The reference to a ‘‘shareholder’’ in s 44(1) has a particular meaning. Patcorp Investments Ltd v FCT (1976) 6 ATR 420 confirmed the general principle that entry on the share register is necessary to constitute membership of a company and that beneficial ownership of shares without registration does not make a person a shareholder. However, the © 2017 THOMSON REUTERS

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word ‘‘shareholder’’ would also include a person who is entitled as against the company to be registered and who the company is absolutely entitled to register as a member of the company. Therefore to be a shareholder, the person must be either registered or beneficially entitled to the shares and be entitled as against the company to be treated as a shareholder and to be registered as such. Under the debt/equity rules (discussed in Chapter 31), the holder of an equity interest is to be treated in the same way as a shareholder.

[21 060] Derivation – dividends ‘‘paid’’ or ‘‘credited’’ Section 44(1) refers to dividends ‘‘paid’’. The definition of ‘‘paid’’ in s 6(1) is inclusive and includes credited or distributed where it relates to dividends. This extended statutory definition does not alter or qualify the characteristic of a dividend as a debt owing by the company to the shareholder. It acts as a safeguard to ensure that a dividend is still ‘‘paid’’ for tax purposes in circumstances where it is credited (only) where the crediting cannot be revoked or rescinded: Brookton Co-operative Society Ltd v FCT (1981) 11 ATR 880. In addition to payment in cash or by bill of exchange, a dividend may be paid by an agreed set-off of liabilities, account stated or an agreement that acknowledges that the amount of the dividend is to be lent by the shareholder to the company and is to be repaid to the shareholder in accordance with the terms of that agreement: see Brookton Co-operative Society at 889 and Ruling IT 2603, para 11. A dividend can also be ‘‘paid’’ when it is credited to a third party rather than to the shareholder directly: ABB Australia Pty Ltd v FCT (2007) 66 ATR 460. A ‘‘distribution’’ commonly refers to a transfer of property other than cash or a negotiable instrument, ie an in specie distribution. It is also capable of applying to a final distribution by a liquidator, which, it has been suggested, does not give rise to a payment or credit: Webb v FCT (1922) 30 CLR 450 at 479-481; see also Ruling IT 2285. Meaning of ‘‘credited’’ The reference to the ‘‘crediting’’ of a dividend does not refer to a mere credit entry in the company’s books of account: Brookton Co-operative Society Ltd v FCT (1981) 11 ATR 880 at 889. There is a ‘‘crediting’’ within the meaning of the term if profits of the company are appropriated to satisfy or extinguish a liability of the shareholder to the company: Commissioner of Taxes (Vic) v Nicholas (1938) 59 CLR 230 at 244. It has also been held that the terms ‘‘credited’’ and ‘‘paid’’ imply the existence of a debt from the company: Webb v FCT (1922) 30 CLR 450 per Isaacs J. The declaration of an interim dividend does not create a debt owing by the company to the shareholder and it may be revoked before payment: Brookton Co-operative Society Ltd. In contrast, the declaration of a final dividend in a general meeting creates a debt and a right to payment enforceable by the shareholder. If the parties intend that a declared dividend is to be lent back by the shareholder to the company, it is necessary to ensure both that a debt due by the company in respect of the dividend has been created and that a loan by the shareholder has come into existence resulting in the discharge of the company’s liability to pay the dividend and the creation of a new liability in respect of the loan: see Re Harry Simpson & Co Pty Ltd [1966] 2 NSWR 445 and Re Associated Electronic Services Pty Ltd (in vol liq) [1965] Qd R 36. In Lonsdale Sand & Metal Pty Ltd v FCT (1998) 38 ATR 384, the Federal Court adopted a dictionary meaning of the word ‘‘credited’’ as including: ‘‘to enter upon the credit side of an account; give credit for or to; to give the benefit of such an entry to (a person, etc)’’. The court held that, in appropriate circumstances, the forgiveness of a debt could be deemed to be a dividend under s 108 ITAA 1936 (now repealed), eg if a company is owed money by a shareholder and declares a dividend but satisfies its debt to the shareholder created by the declaration of the dividend by crediting that amount against the amount owing by the shareholder. The forgiveness of a debt may now be caught by Div 7A: see [21 250]-[21 350]. 808

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The declaration of a dividend to be paid at a future date accompanied by the immediate crediting of an amount to a ‘‘dividends payable account’’ does not create an obligation enforceable prior to the payment date and, therefore, no dividend is credited to the shareholder until that date: Case 37 (1955) 5 CTBR(NS) 37. If a dividend is declared and paid by the drawing of a cheque, questions can arise as to whether it is necessary for the cheque to both leave the control of the company and be received by the shareholder for ‘‘payment’’ to have occurred.

[21 070] Tainting and untainting share capital account If a company transfers an amount to its share capital account from any other account, its share capital account is ‘‘tainted’’. An amount is not ‘‘transferred’’ in the relevant sense when the accounting entries result in the balance of both the share capital account and the other account increasing in size. For example, debiting either an asset or expense account with the corresponding credit to the share capital account will not constitute a transfer. It is only the entries made in the entity’s general ledger that are relevant, not the entries to reflect the consolidated accounting position (see ATO ID 2009/94). For an example of where accounting entries are not ‘‘transfers’’ for the purposes of the share capital tainting provisions, see ATO ID 2009/136 (conversion of convertible debentures into ordinary shares). Certain types of transfers are excluded from the tainting rules: • an amount that can be identified as share capital (s 197-10); • certain amounts that are transferred under debt/equity swaps (s 197-15); • an amount that is transferred by a non-corporations Act company to remove shares with a par value (s 197-20); • certain amounts transferred from an option premium account (s 197-25) – in ATO ID 2009/87, amounts credited as tax assets that were greater than debited tax expenses in relation to an employee share scheme were not option premiums; • certain amounts transferred in connection with the demutualisation of noninsurance, insurance, life insurance or private health insurance companies (ss 197-30 to 197-40); and • amounts transferred by a greenfields minerals explorer in connection with the creation of exploration credits (see [29 030]): s 197-42.

Share capital account A share capital account is defined in s 975-300 as: (a) an account which the company keeps of its share capital; or (b) any other account (whether or not called a share capital account), created on or after 1 July 1998, where the first amount credited to the account was an amount of share capital. If a company has more than one share capital account, the accounts are taken to be a single account. This means that the tainting of any of the share capital accounts will result in the tainting of all accounts. Alternatively, if there are 2 accounts neither of which is tainted, transfers between them may be made without tainting the share capital account. It is expressly provided that an account that is tainted is not a share capital account, other than for the purposes of: • the definition of ‘‘paid-up share capital’’; • s 44(1B), relating to the assessability of dividends; • s 159GZZZQ(5), concerning share buybacks out of certain non-capital accounts; • s 118-20(6), the CGT anti-overlap rule; • Div 197, concerning tainted share capital accounts; and • s 202-45(e), concerning unfrankable distributions. © 2017 THOMSON REUTERS

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Consequences of tainting If a company transfers a tainting amount to its share capital account, a franking debit arises in the company’s franking account immediately before the end of the franking period in which the transfer occurs: s 197-45(1). The amount of the franking debit is calculated by applying this formula in s 197-45(2): transferred amount

x

applicable franking percentage corporate tax gross-up rate

The applicable franking percentage is generally the company’s benchmark franking percentage under s 203-30: see [21 710]. However, if the percentage has not been set before the debit arises, the applicable franking percentage is 100%. The corporate tax gross-up rate is 2.3333. Note that if the proposed reductions in the company tax rate (see [20 030]) become law, the above formula will become: transferred amount

x

applicable franking percentage applicable gross-up rate

The ‘‘applicable gross-up rate’’ will be the company’s corporate tax gross-up rate for the income year in which the franking debit arises: see [21 670]. A distribution from a tainted account is taxed as a dividend in the hands of the shareholder. This occurs because a tainted share capital account is not a share capital account for the purposes of para (d) of the statutory definition of ‘‘dividend’’. The dividend is taken to be unfrankable: s 202-45. A company may ‘‘untaint’’ its share capital account by making a choice to that effect under s 197-55. The choice can be made at any time, but cannot be revoked. If an untainting choice is made, an additional franking debit arises in the company’s franking account: s 197-65. The company may also be liable to pay untainting tax in accordance with s 197-60.

[21 080] Bonus shares A company is allowed to issue bonus shares for which no consideration is payable. On the issue of bonus shares, there need not be any increase in the company’s share capital: s 254A Corporations Act 2001. If bonus shares are issued for no consideration, and they are not a dividend or deemed dividend, the cost of the original shares is spread across the original shares and the bonus shares for trading stock purposes, or for the purposes of working out the profit or loss on the disposal of any of the shares: s 6BA(3). If a bonus share is a dividend, or if a bonus share is deemed to be a dividend under the anti-streaming provisions of s 45, s 45A or s 45B (see [21 100]-[21 120]), the consideration for the acquisition of the shares for tax purposes is taken to be the amount of the dividend that is assessable: s 6BA(2). The deemed dividend treatment arises from ss 45(2) and 45C(1) – (2). For situations where a bonus share might be a dividend, see [21 430]. Under s 6BA(4), a company issues shares for no consideration if: • it credits its (share) capital account with profits in connection with the issue of shares; or • it credits its (share) capital account with the amount of a dividend and the shareholder has no choice whether to be paid the dividend or be issued with shares. In both cases the company will have a tainted share capital account: s 6(4). This provision links in with the rule in s 6BA(3) considered at [21 090]. The CGT treatment of bonus shares is considered at [17 360]. For the CGT treatment of bonus shares issued on shares held by a deceased person at the date of her or his death where the bonus shares are issued after death, see Determination TD 2000/11. 810

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[21 100]

[21 090] Dividend reinvestment plans Subject to a special rule relating to listed public companies, if bonus shares are offered and the shareholder is given a choice between receiving a dividend or an issue of shares and chooses to be issued shares, the general rules are as follows. • The dividend is taken to be ‘‘credited’’ to the shareholder (s 6BA(5)), ie the bonus shares are effectively taken to be a dividend within para (b) of the s 6(1) definition. • The dividend is taken to have been paid out of profits: s 6BA(5). • The amount of the dividend to the shareholder is taken to be consideration for the acquisition of the shares: s 6BA(2). • Assuming it is not otherwise tainted, the share capital account does not by this process become a tainted share capital account: s 6BA(5). See Determination TD 2009/4 for examples of dividend reinvestment plans that do not taint the company’s share capital account because of s 6BA(5). • A share that is taken to be a dividend under s 6BA(5) is a frankable distribution: see [21 410]. • The CGT treatment is determined under s 130-20(2). Note that the Tax Office does not consider that the words ‘‘bonus shares’’ are used in s 6BA in their legal technical sense or as a term of restriction. Rather, those words are used to describe the outcome of a situation where other shares are issued in respect of the original shares: see Determination TD 2009/4. If a listed public company offers a choice between franked distributions (other than dividends only minimally franked) and shares (eg under a bonus share plan), the treatment depends on whether or not the company credits an amount to its share capital account in connection with the share issue. If no amount is credited to the share capital account and the shareholder chooses to be issued with shares, then s 6BA(5) does not apply, with the result that s 6BA(3) applies and the acquisition consideration for the original shares is spread across both the original shares and the bonus shares in appropriate proportions: s 6BA(6). If an amount is credited to the share capital account and the shareholder chooses shares, the above rules in s 6BA(5) (with s 6BA(2) and (3)) and s 130-20(2) apply. The explanatory memorandum concludes that this means that listed public companies may continue to offer shareholders a choice between franked dividends and bonus shares. Companies other than listed public companies have no comparable provision applicable to them. In all cases it is necessary to have regard to the possible operation of the anti-avoidance provisions that can apply to the streaming of bonus shares in lieu of unfranked dividends (s 45) and the provisions applicable to the conferral of capital benefits: s 45B. If an offer is made, as mentioned above, to a pre-CGT shareholder who elects to receive bonus shares rather than a dividend, but then effectively realises the dividend by selling the shares, s 45B would apply. In addition, it is necessary to consider the possible operation of the measures designed to counter the streaming of franked dividends: see [21 850]. Ruling IT 2285 deals with dividend reinvestment plans where, instead of receiving a cheque in payment of a dividend, the amount that is otherwise payable is applied as payment for new ordinary shares in the company. It concludes that the amount of any dividend so applied is considered to be paid to the shareholder within the extended definition. Shares acquired under a dividend reinvestment plan are not considered to be bonus shares for the purposes of Subdiv 130-A ITAA 1997 (CGT rules): see DeterminationTD 2000/3. In relation to ‘‘scrip dividends’’, see Ruling IT 2603.

[21 100] Streaming bonus shares and unfranked dividends Section 45 applies if a company streams shares (other than shares to which s 6BA(5) applies) and the payment of minimally franked dividends to its shareholders so that shares are © 2017 THOMSON REUTERS

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received by some but not all shareholders and some or all of the shareholders who do not receive the shares receive minimally franked dividends: s 45(1). Under s 45A(1), s 45 applies in priority to s 45A. A dividend is minimally franked if it is unfranked or if it is franked to less than 10%: s 45(3). The effect of the exception relating to s 6BA(5) is that s 45 does not apply if the shareholder has a choice whether to be paid a dividend or be issued with shares and the shareholder chooses the shares. A choice between a more-than-minimally-franked dividend and bonus shares offered by a listed public company (a bonus share plan) under s 6BA(6) would also fall outside s 45. If s 45 applies, the value of the bonus share, when provided, is taken to be an unfranked dividend paid out of profits to the shareholder at that time. Thus, the deemed dividend will be assessable under s 44(1) or subject to dividend withholding tax under s 128B. Section 45 is self-executing. Its application does not require a determination by the Commissioner.

[21 110] Streaming dividends and capital benefits Section 45A applies if a company, in the same or different years of income, streams capital benefits and dividends in such a way that capital benefits are, or would otherwise be, received by shareholders (the ‘‘advantaged shareholders’’) who would ‘‘derive a greater benefit from the capital benefits’’ than other shareholders in the year in which the capital benefits are provided, and it is reasonable to assume that the other shareholders (the ‘‘disadvantaged shareholders’’) have received or will receive dividends. Under s 45A(2) the Commissioner may make a written determination that s 45C applies to all or part of a capital benefit. The amount determined to be a capital benefit is deemed to be an unfranked dividend paid by the company out of profits to the shareholder or relevant taxpayer at the time the capital benefit is provided. As a result, the deemed dividend will be assessable under s 44(1) or subject to dividend withholding tax under s 128B. Unlike s 45B, the Commissioner cannot make a further determination in respect of a capital benefit under s 45A to impose a franking debit on the company. A shareholder is ‘‘provided with a capital benefit’’ (s 45A(3)) if: • shares are provided (eg bonus shares); • there is a distribution of share capital (eg a return of capital or share buyback) or share premiums (if it exists); or • something that is done in relation to a share has the effect of increasing the value of that share or another share held by the shareholder (eg a change of rights attached to shares). The circumstances in which a shareholder would derive ‘‘a greater benefit from capital benefits’’ than another shareholder include, but are not limited to, the circumstances listed in s 45A(4). These circumstances, which exist in relation to the first shareholder but not in relation to the other shareholder, include: • some or all of the shares held are pre-CGT shares; • the first shareholder is a non-resident; • the first shareholder has a cost base for the relevant shares that is not substantially less (ie is equal to or greater than) the capital benefit; • the first shareholder has capital losses or income tax losses. Section 45A does not apply if it is reasonable to assume that the disadvantaged shareholders have received or will receive fully franked dividends: s 45A(5). Further, if the capital benefit is the provision of shares (eg bonus shares) and it is reasonable to assume that the disadvantaged shareholders have received or will receive partly franked dividends, the 812

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[21 120]

Commissioner may only make a determination in relation to that part of the capital benefit that the Commissioner considers relates to the unfranked part of the dividend: s 45A(6).

[21 120] Schemes to provide capital benefits and demerger benefits Section 45B applies if: • there is a scheme under which a person is provided with a capital benefit or a demerger benefit by a company; • under the scheme a taxpayer (the ‘‘relevant taxpayer’’) obtains a tax benefit; and • having regard to the list of ‘‘relevant circumstances’’ in s 45B(8) (including any of the matters listed in s 177D(2) that are to be taken into account for Pt IVA purposes: see [42 130]), it would be objectively concluded that the scheme was entered into for a purpose of enabling the relevant taxpayer to obtain a tax benefit: s 45B(2). The purpose of enabling the relevant taxpayer to obtain a tax benefit need not be the dominant purpose, but it must be more than a merely incidental purpose (if merely incidental, s 45B will not apply). The purpose of any one of the persons who entered into or carried out the scheme, or any part of the scheme, is sufficient to attract the operation of s 45B: see Practice Statement PS LA 2008/10. Relevant persons would include the company, its directors and managers, and its shareholders. See ATO ID 2006/188 and ATO ID 2006/232 for contrasting examples of whether a purpose of obtaining a tax benefit existed.

Capital benefits The provision of a capital benefit is defined in s 45B(5) as involving: • the provision of ownership interests in a company (eg bonus shares); • the distribution of share capital (eg a return of capital or share buyback) or share premium; or • something that is done in relation to an ownership interest that has the effect of increasing the value of that or some other ownership interest held by a person (eg a change of rights attached to shares). The explanatory memorandum to the legislation which enacted s 45B stated that, if a company makes a profit from a transaction (eg the disposal of business assets) and then returns capital to shareholders equal to the amount of the profit, that would suggest that the distribution of capital is a substituted dividend within s 45B. On the other hand, if a company disposed of a substantial part of its business at a profit and distributed an amount of share capital that could reasonably be regarded as the share capital invested in that part of the business, the distribution of capital would not be seen as a substituted dividend, because no amount would be attributable to profits. In the context of distributions of share capital, reference is made to a ‘‘genuine return of capital’’ being outside s 45B. It is also stated that bonus share plans offered in the ordinary course of business by publicly listed companies as an alternative to franked dividends would generally not be subject to s 45B unless the shareholder receiving the bonus shares engaged in a course of conduct that provided an equivalent to the cash dividend in a more tax-effective form (eg if a pre-CGT shareholder consistently sold the bonus shares tax-free after receiving them). A non-share distribution (see [31 290]) to an equity holder is taken to be a distribution to the equity holder of share capital to the extent to which it is a non-share capital return: s 45B(7). Thus, s 45B may apply to transactions that involve non-share capital returns: see Practice Statement PS LA 2008/10. The Commissioner may make a written determination that s 45C applies to all or part of the capital benefit (as determined under s 45C(4)), in which case the amount determined to be © 2017 THOMSON REUTERS

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a capital benefit will be an unfranked dividend paid by the company out of profits to the shareholder or relevant taxpayer at the time the capital benefit is provided: s 45C(1) and (2). As a result, the deemed dividend will be assessable under s 44(1) or subject to dividend withholding tax under s 128B. In addition, the Commissioner may also make a further determination under s 45C(3) to impose a franking debit on the company. The effect of this further determination is that a franking debit will arise equal to the amount that (if the company had paid a dividend of an amount equal to the capital benefit) would have been the amount of the maximum franking credit on the dividend.

Demerger benefits Under s 45B(4) a person is provided with a demerger benefit if, in relation to a demerger: • a company distributes money or property to the person and the distribution is not included as an assessable dividend under s 44; • a company provides the person with ownership interests in that or another company and the value of those interests is not included in the assessable income of that or another person; or • something is done in relation to an ownership interest owned by the person that has the effect of increasing the value of an ownership interest owned by the person, and that increase in value is not included in the assessable income of that or another person. If the Commissioner makes a written determination under s 45B(3) that s 45BA applies to all or part of the demerger benefit (as determined under s 45BA(2)), it will not be treated as an exempt ‘‘demerger dividend’’ in the hands of the owner of the ownership interest or the relevant taxpayer. Guidance on when and how the Tax Office will apply s 45B to demergers is set out in Practice Statement PS LA 2005/21.

[21 130] Determinations by the Commissioner – procedure If the Commissioner makes a determination under s 45A, s 45B or s 45C, he must give a copy to the company concerned. In the particular case of a s 45B demerger benefit determination, a copy must be given to the head entity of the demerger group: s 45D(1). A determination does not form part of an assessment, but may be included in a notice of assessment. Section 45D(1A) requires the company receiving a copy of a determination made under s 45A or s 45B to, in turn, provide a copy of the determination to the advantaged shareholder under a s 45A determination: see [21 110] and to the relevant taxpayer under a s 45B determination: see [21 120]. A statutory deemed notice arises under s 45D(2) if the Commissioner makes a s 45A determination and places a notice of the determination in a daily newspaper that circulates generally in each state and territory. A taxpayer dissatisfied with the determination may object against it in the manner set out in Pt IVC TAA (discussed in Chapter 48): s 45D(4).

LIQUIDATOR’S DISTRIBUTIONS [21 150] Deemed dividends Distributions made by a liquidator upon the winding up of a company are not in the nature of income for general law purposes: DCT (NSW) v Stevenson (1937) 59 CLR 80. However, s 47(1) deems certain distributions by the liquidator to be assessable in the hands of 814

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[21 160]

the shareholders of the company. These distributions are only assessable to the extent to which they represent income derived by the company (whether before or during liquidation) other than income that has been properly applied to replace a loss of paid-up capital. Such distributions are deemed by s 47(1) to be dividends paid to the shareholders by the company out of profits derived by it. If the liquidated company is a subsidiary member of a consolidated group, the single entity rule applies and the distribution (as an intra-group transaction) is disregarded for the purpose of calculating the head company’s income: see [24 020]. However, s 47 continues to affect distributions from a head company to its shareholders: see Determination TD 2007/D5. A liquidation of a company may cause the holders of post-CGT shares to realise a capital gain, subject to the operation of s 118-20, which is intended to prevent duplication between the ordinary income and CGT consequences: see [14 500]. The Full Federal Court in FCT v Brewing Investments Ltd (2000) 44 ATR 471 held that s 47 can apply to distributions on liquidation of a non-resident company which are paid out of non-Australian source income.

Capital gains tax consequences When a company goes into liquidation there is no deemed disposal of assets owned by the company. A disposal by a liquidator of the company is treated as a disposal of the asset by the company itself: see [12 320]. If a company is dissolved, the post-CGT shares held by the shareholder will be deemed to have been disposed of for CGT purposes: see [13 080]. The resulting liquidation distributions will be capital proceeds for CGT event C2, provided the company is dissolved with 18 months of the payment. Otherwise, in the case of an interim distribution by the liquidator, CGT event G1 (capital payments) will apply to the distribution: see [17 370] and Determination TD 2001/14. [21 160] Meaning of ‘‘income’’ Section 47(1A) expands the meaning of the words ‘‘income derived by a company’’ in s 47(1) to include: • any amount included in the company’s assessable income, including all deemed assessable income but excluding a net capital gain; or • the full amount of any capital gains, without indexation and without reduction by capital losses. In effect, s 47(1A)(b) requires a specific calculation of a net capital gain for the purposes of s 47 that differs from the calculation under s 100-50: see Example [21 160.10]. In determining whether income is derived by the head company of a consolidated group, the single entity rule (see [24 020]) is ignored: Draft Determination TD 2007/D5. Exempt income would appear to fall within the meaning of ‘‘income’’ in s 47(1), but non-assessable non-exempt income (see [7 700]) (eg under s 23AH) would appear to fall outside s 47(1) and (1A). Distributions will not represent ‘‘income’’, and will therefore not lead to deemed dividends, if they are paid out of: • pre-CGT capital profits (realised on pre-CGT assets); • capital gains that are required to be disregarded, ie not recognised for tax purposes. Distributions within these exceptions are not taxable as deemed dividends. However, if the shares are post-CGT shares of the shareholder, it is still necessary to consider the capital gains tax consequences. Determination TD 2001/14 states that when a liquidator distributes that part of a capital gain that is subject to a small business 50% reduction under s 152-205, it is neither income © 2017 THOMSON REUTERS

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under ordinary concepts, nor ‘‘income’’ within the extended statutory definition in s 47(1A). Therefore, it is not included as a capital gain that becomes ‘‘income’’ for s 47 purposes, and the distribution to that extent does not result in a deemed dividend. Example [21 160.10] demonstrates the operation of s 47(1A). It will be noted that for the purposes of the CGT provisions the net gain to the company is $3,500 in relation to assets A, B and C. However, for the purposes of s 47(1), pursuant to s 47(1A), the net gain is $10,000. The reason for the difference is that the indexation factor is ignored and any capital losses are similarly ignored when calculating a ‘‘net capital gain’’ for s 47 purposes under s 47(1A)(b). This method of calculation is unique to s 47 ITAA 1936. It ignores the fact that the company no longer has the funds that it has lost when selling assets for a sale price of less than the original cost price.

Asset

Reduced cost base $ 18,000 13,000 5,000

EXAMPLE [21 160.10] Cost base Capital proceeds Capital gain/loss

$ A 22,000 B N/A C 6,500 Net capital gain The gain calculated pursuant to s 47(1A) is: A 18,000 B 13,000 C 5,000 ‘‘Income’’ for purposes of s 47(1A) Example [21 160.20] illustrates the result of this provision.

$ 25,000 12,000 8,000

$ 3,000 (1,000) 1,500 3,500

25,000 12,000 8,000

7,000 – 3,000 10,000

EXAMPLE [21 160.20] Assumptions $ 1. Paid-up capital 2. Post-19 September 1985 capital gain 3. Post-19 September 1985 capital loss Accumulated profits The balance sheet of the company would then appear as: Paid-up capital Capital gain Capital loss Accumulated profits

$ 10,000 50,000 (40,000) Nil 10,000 50,000 (40,000)

10,000 Nil 20,000 Cash on hand 20,000 In this example, the liquidator had only $20,000 in assets to distribute. There is $10,000 of paid-up capital to be distributed to shareholders as well as accumulated net capital gains of $10,000. However, for the purposes of s 47(1) the income available for distribution would be $50,000 because the company will not obtain credit for the capital loss of $40,000. The method that the liquidator would probably choose to distribute the assets of the company would be to first distribute $10,000 in reduction of the paid-up capital and second, to distribute the remaining $10,000 in the form of the capital gain. The fact that s 47(1A) indicates that there is a further $40,000 of capital gain remaining in the company is then of no relevance

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[21 160]

because the company and the liquidator have no assets that can be used to satisfy this distribution.

There is some doubt about the legal basis for this preferential treatment of assets remaining in a company when distributed by a liquidator. The definition of ‘‘dividend’’ in s 6(1) permits a liquidator to make a distribution to the shareholders in the form of the repayment of moneys paid-up on a share where the amount paid or credited (or the value of property given) is debited to the share capital account without that distribution being treated as a dividend. Section 47(1) deems distribution by liquidators to be dividends to the extent only that they represent income derived by the company. It is by the extended definition in s 47(1A) that the additional capital gains are included within that definition of ‘‘income’’. The decision of the Full High Court in Archer Bros Pty Ltd v FCT (1953) 90 CLR 140 confirmed that, by an adequate method of bookkeeping, the liquidator of a company could keep accounts in the same way as the accountant of a company as a going concern in order that distributions could be made out of certain profits or funds, which would be capable of determining the assessability or otherwise of the distribution in the hands of the shareholder. This concept is illustrated in Example [21 160.20] by way of a distribution to the shareholders first from the fund of issued capital and second from the fund of capital gain reserves. In relation to ‘‘income which has been properly applied to replace a loss of paid-up capital’’ (amended in 1998 to ‘‘paid-up share capital’’) (s 47(1)), the case of Glenville Pastoral Co Pty Ltd (in liq) v FCT (1963) 109 CLR 199 indicated that while the company was still a going concern and the directors had made a definite and final decision to apply distributable profits to make good a loss of share capital, the liquidator could ignore that income so applied. Any such application of income could not be properly made after the company had ceased to trade as a going concern or when under the power of the liquidator. Given the decision in the Archer Bros and Glenville Pastoral Co cases, it would seem appropriate for a company to separately account for capital reserves that were earned on assets acquired before 20 September 1985 and assets that were acquired post-19 September 1985. This would permit a liquidator to easily distinguish between those capital funds and decide upon the tax effectiveness of the distribution that he or she makes to shareholders. The Commissioner accepts that a liquidator may rely on the Archer Bros principle in the appropriation of particular funds of profit or income in making a distribution, including an amount representing a return of share capital: see Determination TD 95/10. However, the Tax Office reserves the right, in appropriate cases, to look behind accounting entries and trace the actual source of the funds distributed. The accounts must be kept so that the liquidator can clearly identify a specific profit or fund in making a distribution and it must be clear that a specific profit or fund has been appropriated in making the distribution. The Commissioner considers that the application of the Archer Bros principle is not affected by the requirement in s 47(1A)(b) to disregard capital losses. It is recognised that the effect of capital losses may be that a notional capital gain calculated under s 47(1A)(b) cannot be distributed due to a lack of distributable funds: see Determination TD 2000/5 (which contains an example). Example [21 160.30] illustrates these points. EXAMPLE [21 160.30] Assumptions $ 1. 2. 3. 4.

Paid-up capital Pre-20 September 1985 capital gain Post-19 September 1985 capital gain Post-19 September 1985 capital loss

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$ 10,000 15,000 20,000 (15,000)

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$ 18,000

5. Accumulated profits Balance sheet Paid-up capital Pre-20 September 1985 capital gain Post-19 September 1985 capital gain Post-19 September 1985 capital loss Accumulated profits Cash on hand

10,000 15,000 20,000 (15,000)

5,000 18,000 48,000 48,000

The income of the company as calculated by reference to s 47(1A) would include the $20,000 post-19 September 1985 capital gain but without any reference to the post19 September 1985 capital loss of $15,000. The Archer Bros decision would seem to permit the liquidator to distribute first the $10,000 of paid-up capital as a non-taxable amount to shareholders, second the $15,000 of pre-20 September 1985 capital gain again as a non-taxable amount to shareholders and the balance of the funds represented by $23,000 in cash in the form of either the post-19 September 1985 capital gain or the accumulated profits. Therefore, while s 47(1), through the operation of s 47(1A), would deem that there was $38,000 of ‘‘income’’ in the company to be distributed, by using the methodology in the Archer Bros case this could be reduced to (in this example) $23,000 of assessable dividends distributed to shareholders. If the pre-20 September 1985 capital gain had been mixed with the post-19 September gain and the other accumulated profits in the one account, it may not be possible for the liquidator to distribute the same quantum of the tax-free amounts to the shareholders if the source of the funds distributed cannot be determined: see Determination TD 95/10.

[21 170] Value of distributions in specie If a company makes a distribution in liquidation to its shareholders in specie, it is the real value of the assets distributed and not the book value that determines the quantum distributed to the shareholder. The nature of the distribution would depend upon the nature of the asset concerned. If the asset is a pre-CGT asset and it is not a revenue asset of the company, the excess of its real value over its book value is not treated as an assessable distribution to the shareholders of the company. A CGT asset when distributed will give rise to a capital gain taxable to the company by reference to its market value (see [3 210]) at its time of distribution and its capital cost in the hands of the company. The shareholder will be deemed to have acquired the asset at its then market value. The capital gain derived by the company (without reference to indexation) will be included in the company’s income for the purposes of s 47(1A). It could form the basis of a frankable distribution. In an appropriate case, roll-over relief under s 126-45 could be sought for an in specie distribution by a liquidator. [21 180] Informal liquidations Sections 47(2A) and (2B) apply if the business of a company is discontinued otherwise than in the course of a winding-up of the company and, in connection with the discontinuance, money or other property of the company has been distributed to shareholders (otherwise than by the company) but not in the form of dividends. If this occurs, there is a deemed distribution to shareholders by a liquidator in the course of winding up the company: s 47(2A). However, if the company is not dissolved within 3 years after the distribution or within such further period as the Commissioner allows, s 47(2A) will not apply and the amounts distributed will be deemed to be dividends paid by the company to the shareholders out of profits derived by it: s 47(2B). It can be seen that if s 47(2A) applies, s 47(1) will treat the distribution as a dividend paid out of profits, to the extent to which it represents income derived by the company. If 818

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[21 250]

s 47(2B) applies, the whole of the distribution will be treated as assessable income regardless of the extent to which it is paid out of ‘‘income’’ derived by the company. Note that s 47(2A) and (2B) were introduced as a result of the decision of the Full High Court in FCT v Blakely (1951) 82 CLR 388.

[21 190] Subsidiary company liquidations and CGT Special provisions apply to reduce a capital gain or loss that would otherwise be realised by a parent company shareholder upon the cancellation, by liquidation, of shares held by it in a wholly owned subsidiary where an asset is distributed in specie by way of final distribution: s 126-85. However, it remains necessary to determine the effect of the roll-over on the operation of s 47.

LOANS AND PAYMENTS BY PRIVATE COMPANIES [21 250] Deemed dividend payments by private companies: Div 7A Div 7A in Pt III ITAA 1936 is designed to ensure that income is not inappropriately sheltered in closely held corporate structures at the corporate tax rate. The rules look to identify situations where those associated with closely held companies obtain the benefits of the company assets in non-assessable form, thereby escaping tax at higher individual marginal rates. It does this by deeming assessable dividends to result from certain specified dealings between private companies and their shareholders and associated persons. There are 3 situations where a private company may be taken to pay a dividend: • an amount is paid by the company to a shareholder or to an associate of a shareholder (s 109C): see [21 260]; • an amount is lent by the company to a shareholder, or to an associate of a shareholder, during an income year (s 109D): see [21 270] and [21 280]; or • the company forgives a debt owed to the company by a shareholder or an associate of a shareholder (s 109F): see [21 290]. In each case, the amount of the dividend is restricted to the company’s distributable surplus (s 109Y): see [21 310].

The exceptions to the above situations (ie where a private company is not taken to pay a dividend under Div 7A) are considered at [21 320]. In particular, in the case of a loan, a deemed dividend will not result if the loan is on commercial terms or it is fully repaid within the required time. In addition, the Commissioner has the general discretion (under s 109RB) to disregard in certain circumstances a deemed dividend that arises because of an honest mistake or an inadvertent omission: see [21 330]. © 2017 THOMSON REUTERS

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As well as deeming dividends to be paid in situations where the company and its shareholders transact directly, Div 7A contains complex rules which apply to indirect dealings: see [21 300]. Since 2009, there has been controversy as to the position where a trust makes a private company beneficiary presently entitled to income but does not pay any or all of the entitlement. This is referred to as an ‘‘unpaid present entitlement’’ (commonly UPE). There are complex rules (in Subdivs EA and EB) which deem a Div 7A dividend to be paid in these circumstances (see [21 305]). However, in practical terms, the operation of those provisions has been severely limited by the Commissioner’s approach whereby he will consider a UPE (with certain exceptions) to be a loan, leading to a direct application of Div 7A (s 109D): see [21 270]). A Div 7A deemed dividend is taken to be paid to the shareholder (or associate) as a shareholder in the private company and out of the company’s profits: s 109Z. This links the deemed dividend to s 44 ITAA 1936, making the deemed dividend assessable: see [21 030]. A Div 7A deemed dividend is an unfrankable distribution (and generally does not give rise to a franking debit): see [21 420]. In addition, the amount is not treated as a dividend for dividend withholding tax purposes: s 109ZA. In 2014, the Board of Taxation completed a post-implementation review of Div 7A, including how the rules interact with the trust income tax provisions and other income tax rules. In its final report to the Government (released in June 2015), the Board recommended that, irrespective of the business structure chosen, business accumulations should be taxed at a ‘‘business’’ tax rate. The Board also proposed a number of significant changes to Div 7A, including: • for complying loans – adopting a reform model called the amortisation model, with a single loan period of 10 years, a statutory interest rate fixed at the start of the loan and greater flexibility in repaying the principal and interest; • for UPEs – aligning their treatment with the treatment of loans for Div 7A purposes in conjunction with either the amortisation model or an interest only model. This would eliminate the need to create sub-trusts and to comply with the conditions set out in Practice Statement PS LA 2010/4: see [21 270]; • safe harbour rules for the use of private company assets; and • various self-correcting mechanisms. In the 2016-17 Budget, the Government foreshadowed amendments (from 1 July 2018) to improve the operation of Div 7A, including implementing many of the Board’s recommendations, but will first consult with stakeholders: see Budget Paper No 2, p 42.

[21 255] Private companies, shareholders and shareholders’ associates Division 7A applies to private companies, including non-resident private companies (s 109BC): see [20 110]. A corporate limited partnership is not a private company (s 94N), but the operation of Div 7A has been extended to closely held corporate limited partnerships (s 109BB). A closely held corporate limited partnership is a partnership with fewer than 50 members or a partnership where any entity has, directly or indirectly, and for the entity’s own benefit, an entitlement to at least a 75% share of the income or capital of the partnership. The provisions apply to shareholders, which include a member or stockholder (s 6(1)). Division 7A applies to non-share equity interests in the same way as it applies to shares. Holders of such interests will be treated as shareholders for the purposes of the rules (s 109BA). The rules also extend to the associates of shareholders. For these purposes an ‘‘associate’’ is broadly defined in s 318 ITAA 1936: see [4 220]. 820

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[21 260]

Division 7A will apply where the shareholder (or shareholder associate) relationship exists at the time when the payment, loan or forgiveness occurs. However, Div 7A may also be attracted where a reasonable person would conclude that the payment or loan is made, or the debt is forgiven, because there has been a shareholder (or shareholder associate) relationship at some time (see ss 109C(1)(b), 109D(1)(d) and 109F(1)(b)). The Commissioner interprets this as meaning that there must be a real and substantial reason for the payment, loan or debt forgiveness concerned, even if it is not the only reason or the main reason for the transaction: see Determination TD 2008/14.

[21 260] Payments treated as dividends An amount paid by a private company to a shareholder or an associate of a shareholder is treated as a deemed Div 7A dividend: s 109C(1). This will not apply if one of the exceptions considered at [21 320] applies. The Commissioner considers that a contribution to the trustee of an employee remuneration trust (ERT) made by an employer that is a private company will be deemed under s 109C to be a dividend (and thus will be included in the s 95 net income of the ERT (see [23 310]) to the extent of the employer’s ‘‘distributable surplus’’: see [21 310]): see Draft Ruling TR 2014/D1 (the Commissioner has indicated that the draft will be reissued). The concept of ‘‘payment’’ is a broad one and covers transactions which are perhaps beyond the normal meaning of the term. Section 109C(3) contains an extended definition of ‘‘payment’’, which includes the crediting of amounts to or on behalf of or for the benefit of an entity and the transfer of property to an entity (eg see Re Reid and FCT (2009) 75 ATR 686). In Determination TD 2015/20, the Commissioner expresses the view that the legal release by a company of its rights to an unpaid present entitlement (UPE) generally represents a credit and therefore a payment for the purposes of s 109C(3). However, there will be circumstances where the release does not confer a financial benefit, for example where the trust has lost the ability to satisfy the UPE and the beneficiary has no cause of action against the trustee in respect of the loss. Payment by direction will satisfy the requirements of s 109C, for example, a direction by the company to a debtor to pay the shareholder (see FCT v Rozman (2010) 75 ATR 782 and FCT v Rozman (No 2) (2010) 76 ATR 58). It can extend, for example, to transfers effected from a private company consequent upon a marriage breakdown (see Ruling TR 2014/5 and ATO ID 2004/461). If property is transferred, or an asset is otherwise provided, to a relevant entity, the amount that is treated as a dividend is equal to the difference between the arm’s length value of the property or right and any consideration that may have been given by the entity: s 109C(4). The concept of ‘‘payment’’ extends to the provision of an asset for use by the shareholder or the shareholder’s associate. The use may be effected under a lease, licence or other right s 109CA. Accordingly, if a shareholder uses a leisure asset (eg a boat) owned by the company, an arm’s length fee will need to be paid to avoid the application of s 109C. The use is not confined to actual use but includes availability for use. The Explanatory Memorandum to the Taxation Laws Amendment (2010 Measures No 2) Bill 2010 contains an example of where a yacht is available for a shareholder’s use because the shareholder holds the keys and stores some personal possessions, even though actual use is relatively infrequent. Care should therefore be taken to ensure there is full and unfettered access provided to the company to avoid triggering a ‘‘payment’’ valued on continued availability to the shareholder. Section 109CA is subject to several exceptions (s 109CA(4)-(7)): • minor benefits – ie benefits which, if provided to an employee, would be exempt from FBT under s 58P FBTAA: see [57 250]; • otherwise deductible payments – ie payments for which an income tax deduction would be available; © 2017 THOMSON REUTERS

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• dwellings connected with the carrying on of a business. This exception will often apply to farming businesses, but it is not limited to them; and • main residences owned by the company before 1 July 2009 – these have a grandfathered exemption (provided the company satisfies the continuity of ownership test for prior year loss purposes (see [20 320]) from 1 July 2009 until the first use of the residence). The exceptions relating to dwellings and main residences extends to any adjacent land that would be covered by the CGT main residence exemption (see [15 340]): s 109CA(8). The time of the payment is when the asset is first used with the permission of the provider, or when the shareholder or associate have a right to use the asset at a time when the provider does not have the right to use or to provide the asset for use by another: s 109CA(2). The amount of the dividend is restricted to the company’s distributable surplus (calculated under s 109Y): see [21 330].

[21 270] Loans treated as dividends A private company will also be taken (under s 109D) to pay a dividend at year-end if a loan is made by the company to an entity during the income year (the current year) that is not fully repaid by the lodgment day for the current year and either: • the entity is a shareholder or an associate of a shareholder when the loan is made; or • a reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been a shareholder or associate at some time (the Tax Office considers that ‘‘because’’ means by reason that. The reason must be a real and substantial reason for the loan concerned, even if it is not the only reason or not the main reason for the transaction: see Determination TD 2008/14). The ‘‘lodgment day’’ for these purposes is the earlier of the due date for lodgment of the company’s return for the current year and the actual lodgment date: s 109D(6). For a private company that is a subsidiary member of a consolidated group, the ‘‘lodgment day’’ is the lodgment day of the head company of the consolidated group: see Determination TD 2015/18. A private company will not be taken to have paid a dividend in these circumstances if one of the exclusions in Subdiv D applies (see below and [21 320]) or if the Commissioner exercises the discretion not to apply Div 7A (see [21 330]). Further, s 109D(4A) allows a payment by a private company to a shareholder (or an associate) to be converted into a loan before the lodgment day for the company’s tax return. The loan can be repaid (before the lodgment day) or a written loan agreement that complies with s 109N (see [21 320]) may be entered into. The amount that is treated as a Div 7A dividend is the amount of the loan that has not been repaid before the lodgment day (for loans made before the 2004-05 income year, the amount treated as a dividend was the amount of the loan that had not been repaid by the end of the year): ss 109D(1AA), (2), (6). Importantly, s 109Y limits the total amount of dividends taken to have been paid by a private company under Div 7A to the company’s distributable surplus: see [21 310]. A similar provision applies in relation to trust loans to shareholders of private companies (but applicable to loans made on or after 12 December 2002); see also [21 300]. Generally, loans in existence before 4 December 1997 will not be affected by Div 7A. However, where a loan made before 4 December 1997 is altered or varied to extend the term of the loan or increase the amount of the loan, the loan will be treated as if it were a new loan entered into on the day it is varied: s 109D(5). Under s 109D(3) a ‘‘loan’’ includes: • an advance of money; 822

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[21 270]

• a provision of credit or any other form of financial accommodation (the Commissioner’s views on this element of the definition of a ‘‘loan’’ are set out in ATO ID 2011/8); • a payment of an amount for another person if there is an obligation to repay the amount; and • a transaction that is in substance a loan. In Di Lorenzo Ceramics Pty Ltd v FCT (2007) 67 ATR 42, payments by a company to a trust that was an associate of the company’s shareholders constituted a loan, principally because they were treated as a loan in the company’s accounts. Note that if a private company makes a loan in an income year and, in the following income year (and before the relevant lodgment day) puts in place a written loan agreement which amounts to a new loan, s 109D applies to the original loan in the income year in which the original loan is made: see ATO ID 2012/60.

Unpaid present entitlements The Commissioner has indicated he will apply Div 7A where there is an unpaid present entitlement (UPE) from a trust to an associated private company. The rationale is that if a present entitlement is unpaid, it is at least a form of financial accommodation and therefore a loan as defined. If the trust is a shareholder or, as may be more common, an associate of a shareholder in the private company (see [21 255]), then there is a direct application of s 109D.

In such a situation there is no provision of cash to the shareholder or the associate. The Commissioner considers that Div 7A does not necessarily require the private use of company funds by the shareholder or an associate where a ‘‘loan’’ can be identified – it does not matter that the funds are retained within the trust structure. The mischief that the Commissioner’s approach on this issue is directed to is that by creating a present entitlement – without a payment of funds – the trustee is avoiding tax on what would otherwise be accumulated income under s 99A. © 2017 THOMSON REUTERS

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The Commissioner’s approach on this issue leaves little scope for the interposed entity rules which are specifically directed to UPE’s, in particular Subdiv EA (see [21 305]). It has been suggested that the Commissioner should rely on the specific UPE rules in Subdivs EA and EB rather than taxing under the general rules. The Commissioner’s answer to this is that the specific rules were formulated on the assumption that UPEs were held on a sub-trust for the sole benefit of the private company beneficiary – which has proven not to be true in practice. The distinction is significant, as the general rule has broader application. The specific rules in Subdivs EA and EB require a payment, loan or debt forgiveness from the trust to the shareholder of the private company or an associate. (Subdivision EA is not so much directed to strategies to reduce tax on trust accumulation – rather to the interposition of a trust to disguise the channelling of benefits to shareholders or shareholder associates – in a way which would otherwise fall outside the scope of Div 7A). There is no such requirement where s 109D is applied. The approach that the Commissioner will adopt in UPE cases is outlined in Ruling TR 2010/3, with guidance as to how that ruling will be applied in Practice Statement PS LA 2010/4. The Commissioner has indicated there are 2 types of ‘‘loans’’ which will come within Div 7A: • ‘‘Section two loans’’ – these are loans within the ordinary meaning of that term and, as such, are subject to Div 7A. These loans are not UPEs at all, since they arise in cases where the UPE is paid out and the money lent back by the private company beneficiary. In other words, these are simple loans which fall within s 109D. The Commissioner takes the position that the loan can arise from an express loan document or may be implied, such as where an amount is recorded as a loan in the financial accounts of the trust. As such, Div 7A will be applied subject to the usual criteria in such cases irrespective of when the loan was made. The Practice Statement provides for “self corrective action” which allows a taxpayer to fix the situation if a UPE (which was in existence before 16 December 2009 – see below) is incorrectly classified as a loan. However, there are stringent criteria which must be satisfied. This remedy was available until 31 December 2011. There is also the ability to take corrective action by self-assessing the exercise of the Commissioner’s discretion under s 109RB (see [21 330]) in the circumstance where the failure to comply with Div 7A is the result of an honest mistake or inadvertent omission. • ‘‘Section three loans’’ – these are subsisting UPEs which, being a ‘‘financial accommodation’’, fall within the extended definition of loan in Div 7A. A UPE will not be considered to be a section three loan if the funds representing the UPE are held on sub-trust for the sole benefit of the private company beneficiary. A sub-trust may arise by express resolution, where the trust deed expressly provides for UPEs to be held on sub-trust or where the trust deed contains words to the effect that the trustee has the power to set aside the income of the trust for the exclusive benefit of one or all of the beneficiaries. In order to evidence the sub-trust, the Practice Statement indicates there should be a separate accounting. However, to escape the application of Div 7A, it will be necessary to show that the funds in the sub-trust are held for the sole benefit of the private company beneficiary. To demonstrate this, it will be necessary to show that the funds are invested on commercial terms (the Practice Statement sets out 3 safe harbour investment options which will be accepted by the Commissioner), all benefits flow back to the private company beneficiary and that such benefits (eg the annual return on investment) are actually paid (including by way of set off) to the private company beneficiary by the lodgement day of the tax return of the main trust for the year in which the benefit arises. The Commissioner has indicated that he will not apply Div 7A to UPEs in existence before 16 December 2009. For UPEs arising between 16 December 2009 and 30 June 2010, the trustee had until 30 June 2011 to put the funds on sub-trust for the benefit of the private company beneficiary. 824

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COMPANIES – DIVIDENDS AND IMPUTATION [21 280]

If taxpayers have either ‘‘section two’’ or ‘‘section three’’ loan exposures which do not qualify for the exclusions mentioned above, then remedial action may be taken by either arranging for payment of the loan or UPE, or entering into a complying s 109N loan arrangement (see [21 320]). Note that if all UPEs in a fixed trust are mixed with the trust fund but employed by the trustee to benefit all corporate beneficiaries (by retiring trust debt) in the exact same proportion as each UPE bears to the total of all UPEs, a loan does not arise for the purposes of Div 7A: see ATO ID 2012/74.

Loans by a liquidator in a winding-up Under s 109NA, neither s 109C nor s 109D deems a dividend to be paid because of a distribution or loan made in the course of the winding-up of the company by a liquidator. However, this is subject to s 109D(1A), which treats as a dividend a loan made by the liquidator of a private company in the course of the winding-up of the company if the loan is not repaid by the end of the income year immediately following the income year in which the loan is made. Repayment may be made by an actual payment or by a set-off of the amount lent against a later liquidator’s distribution to which the shareholder is entitled. The effect of the exclusion in s 109NA is that loans by a liquidator in the course of a winding-up cannot be included in the amalgamated loan provisions discussed at [21 280].

[21 280] Amalgamated loans treated as dividends In some cases, loans may be required to be combined and treated as a single loan. A private company is taken to have made an ‘‘amalgamated loan’’ to an entity during an income year if it makes multiple loans to that entity during that year where each loan (constituent loan) has the same maximum term (within the meaning of s 109N: see [21 320]), would otherwise be treated as a deemed dividend in that year and is not fully repaid before the earlier of the due date for lodgment of the company’s return for that year and the actual lodgment date (eg ATO ID 2012/60): s 109E(3). If a private company is taken to have made an amalgamated loan with a maximum term of 7 years, and an unsecured loan is converted to a loan secured by a mortgage over real property with a maximum term of 25 years (less the period of the term already expired in the old loan), a new amalgamated loan is taken to be made in the income year prior to the income year in which the extension takes place: s 109E(3A), (3B). The basic rule is that a private company is taken to pay a dividend to an entity (at the end of the current income year) if the amalgamated loan (made in an earlier year) is not repaid at the end of the current year and the amount paid to the company during the current year in relation to the loan is less than the minimum yearly repayment worked out under s 109E(5) and (6) (although the Commissioner has the discretion under s 109Q to allow an amalgamated loan not to be treated as a dividend: see below): s 109E(1). The amount of the deemed dividend is the amount of the shortfall, ie the difference between the amount paid and the minimum yearly payment: s 109E(2). Note that the capital component of the shortfall does not reduce the ‘‘amount of the loan not repaid by the end of the previous year of income’’ in the formula in s 109E(6), when calculating the minimum yearly loan repayment for the subsequent income year: see ATO ID 2013/36. The amount of the dividend is restricted to the company’s distributable surplus (calculated under s 109Y): see [21 310]. If a dividend is deemed to be paid because there is a shortfall, and the company forgives the debt, that does not trigger an additional deemed dividend: s 109G(3A), (3B). Note that if a shortfall in a minimum yearly repayment gives rise to a deemed dividend under s 109E, a deemed dividend does not also arise under s 109D in respect of the proportion of the shortfall comprising unpaid interest: see ATO ID 2011/8. If a private company makes a loan in an income year and, in respect of the loan, in the following income year (and before the relevant lodgment day) puts in place an agreement that satisfies the criteria in s 109N (see [21 320]), the income year in which an amalgamated loan © 2017 THOMSON REUTERS

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is taken to be made is the income year in which the loan is made. The putting in place of a complying loan agreement, in respect of a loan, does not alter the date on which the loan was made: see ATO ID 2012/61. The Commissioner has the discretion under s 109Q to treat an amalgamated loan as not being a Div 7A dividend if satisfied that: • the specified minimum yearly repayment was not made because of circumstances beyond the entity’s control; and • the entity would suffer undue hardship if the loan was taken to be a deemed dividend. The Commissioner also has the discretion in certain circumstances to disregard a deemed dividend that arises because of an honest mistake or an inadvertent omission (s 109RB) and to extend the period for repayments of an amalgamated loan (s 109RD): see [21 330]. An amalgamated loan is taken not to be a dividend under s 109D in the year in which it is made: s 109P. The question is whether there is a deemed dividend under s 109E at the end of the current year in respect of an amalgamated loan made in an earlier year that is not repaid by the due date. An amalgamated loan will not be taken to be a dividend in a later income year if the repayments in relation to the loan during that year equal or exceed the minimum repayments required under s 109E. The minimum repayments are calculated in accordance with a statutory formula in s 109E(6): see Determination TD 98/22. The formula applies the current year’s benchmark interest rate to the outstanding balance on the amalgamated loan at the end of the previous year and then discounts the resulting amount by reference to the number of years remaining in the term of the loan. The current year’s benchmark interest rate is the benchmark interest rate for the income year for which the minimum yearly repayment is being calculated. The benchmark interest rate for 2016-17, relevant for loans made or deemed to have been made before 1 July 2016, is 5.40%: see Determination TD 2016/11. Earlier benchmark interest rates are set out at [101 170]. These benchmark rates only apply to companies that balance at 30 June. With certain exceptions, actual loan repayments are not taken into account if it is reasonable to assume that they are made with the intention of borrowing a similar amount from the private company later, ie where the loan is temporarily repaid: s 109R. In addition, a deemed dividend is not triggered if a private company loan becomes subordinated to another loan from another entity (such as a bank), and a private company loan is refinanced because of that subordination, provided the subordination arose because of circumstances beyond the control of the shareholder (or associate) and the parties that made the loans dealt with each other on an arm’s length basis: s 109R(5). Note Taxpayer Alert TA 2008/9. If a loan repayment is made after the end of the income year but before the company’s tax return for the first year of the loan is lodged, that payment is taken into account in determining whether the minimum yearly payment has been made in the year of the loan but not in the following income year (see ATO ID 2010/82). EXAMPLE [21 280.10] On 3 August 2015, Bharucha Pty Ltd makes a loan of $100,000 to a shareholder. The loan is made under a qualifying Div 7A loan agreement with a 7-year term. In the following income year, on 1 September 2016, the shareholder repays $20,000 to the company, before the company’s 2015-16 tax return is lodged on 16 December 2016. In working out the minimum yearly repayment for 2016-17 in accordance with the formula in s 109E(6): • the ‘‘amount of the loan not repaid by the end of the previous year of income’’ is $100,000; and • the ‘‘current year’s benchmark interest rate’’ is the rate for 2016-17 (5.40%).

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EXAMPLE [21 280.20] If the amount of an amalgamated loan is $100,000, the term of the loan is 5 years, the remaining term of the loan is also 5 years and the benchmark interest rate is (say) 8.05%, the minimum yearly repayment in the year immediately after the year in which the amalgamated loan comes into existence is calculated as follows: (100,000 × 0.0805) / (1 − ((1/(1 + 0.0805)) ^ 5)) = $25,079

When determining the minimum yearly repayment for the second or later years, a calculation is made of the opening balance that takes account of repayments during the first or a prior year. Under s 109E(7) the amount of an amalgamated loan repaid by the end of an income year is equal to the difference between the actual repayments during the year and the amount of notional interest. Notional interest is calculated by applying the benchmark interest rate for the income year to the amounts outstanding from time to time in the year. EXAMPLE [21 280.30] A private company loaned a shareholder $40,000 on 30 June 2016 under a written loan agreement that satisfies the requirements of s 109N. This was the only loan the company made to this particular shareholder in the 2015-16 year. The shareholder makes 2 repayments of $10,000 each after the company’s lodgment day. The first payment is made on 4 January 2017 and the second is made on 30 June 2017. The benchmark interest rate for 2016-17 is 5.40%. Calculations Interest (using the benchmark rate) is calculated annually in arrears by reference to the daily balance throughout the year as follows (amounts are rounded to the nearest dollar): Credit Loan balance $ $ Principal at 1/7/2016 40,000.00 Repayment at 4/1/2017 10,000.00 30,000.00 Repayment at 30/6/2017 10,000.00 20,000.00 Interest payable = (interest payable on $40,000 from 1/7/16 to 3/1/17) + (interest payable on $30,000 from 4/1/17 to 29/6/17) + (interest payable on $20,000 from 30/6/17) = (5.40% × $40,000 × 187/365) + (5.40% × $30,000 × 177/365) + (5.40% × $20,000 × 1/365) Calculations Interest is calculated annually in arrears by reference to the daily balance throughout the year as follows (rounding to the nearest dollar): Credit Loan balance $ $ = $1,107 + $786 + $3 = $1,896 Of the $20,000 repayments made during the income year, $1,896 is taken to have been applied against the interest amount and the balance ($18,104) is taken to have been applied against the loan principal. This leaves $21,896 as the amount of the loan not repaid by the end of the income year. This figure is used in working out the minimum yearly repayment for the 2017-18 income year.

[21 290] Forgiven debts treated as dividends Under s 109F a private company is taken to pay a dividend to an entity (at the end of the company’s income year) if all or part of a debt owed to the company by the entity is forgiven during the year and either: © 2017 THOMSON REUTERS

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• the amount is forgiven when the entity is a shareholder or associate of a shareholder in the private company; or • a reasonable person would conclude (having regard to all the circumstances) that the amount is forgiven because the entity has been a shareholder or associate at some time (the Tax Office considers that ‘‘because’’ means by reason that. The reason must be a real and substantial reason for the forgiveness concerned, even if it is not the only reason or not the main reason for the transaction: see Determination TD 2008/14). A debt is also taken to be forgiven (even if it has not actually been forgiven) if a reasonable person would conclude (having regard to all the circumstances) that the private company will not insist on the entity paying the debt or rely on the entity’s obligation to pay the debt: s 109F(6). If the same debt is taken to be forgiven under more than one provision, the provision that takes effect first prevails: s 109F(8). A deemed dividend may arise if a shareholder dies and the debt is forgiven during administration of the deceased’s estate (the dividend will be taken to be paid to the legal personal representative of the shareholder): see ATO ID 2012/77. Where s 109F applies, the amount forgiven will only be deemed to be a dividend to the extent of the distributable surplus, calculated under s 109Y (see [21 310]): s 109F(2). Note that, under s 109G, certain forgiven debts are not treated as deemed dividends: see [21 320] and [21 330]. If a dividend is deemed to be paid under s 109F because a debt resulting from a loan is forgiven, and the relevant private company is deemed under s 109E to pay a dividend at the end of an earlier income year in relation to that loan, the s 109F deemed dividend is reduced by the amount of the s 109E deemed dividend (but not below zero): s 109G(3A), (3B). Whether a debt is ‘‘forgiven’’ is determined in accordance with the commercial debt forgiveness provisions in Div 245 ITAA 1997 (ie ss 245-35 and 245-37, but not s 245-36 relating to debt parking): s 109F(3). In summary, a debt is forgiven when: • the debtor’s obligation to pay the debt is released, waived or otherwise extinguished: s 245-35(1); • a creditor loses its right to sue the debtor for recovery of the debt because of the operation of a State or Territory statute of limitations: s 245-35(2); • a debtor is effectively released from the obligation to pay the debt despite the existence of arrangements that continue the indebtedness for a period: s 245-35(3). See further [8 700]. A debt is not ‘‘forgiven’’ for these purposes if the forgiveness is effected by will or under an Act relating to bankruptcy, or for reasons of natural love and affection: s 245-40. In the case of debt forgiveness by ‘‘debt parking’’, s 109F(5) applies in place of s 245-35(4) and the debt is taken to be forgiven if it is assigned by the private company to another entity (the new creditor) who is either associated with the debtor entity or a party to an arrangement with the debtor entity and where a reasonable person would conclude that the new creditor will not enforce the debt. Section 109F may apply to a forgiven debt even if that debt arose before 4 December 1997. However, the Tax Office will take no active compliance action on private company and trustee loans made before the enactment of Div 7A that are deemed to be forgiven in consequence of the operation of s 109F(3), merely because the period within which the creditor is entitled to sue for recovery of the debt ends by the operation of a statute of limitations: Practice Statement PS LA 2006/2(GA).

[21 300] Payments and loans through interposed entities There are several rules which seek to ensure that Div 7A is not avoided by the use of interposed entities. In determining whether these rules apply, it is important to remember that Div 7A applies not only to payments, loans and debt forgiveness transacted directly with the 828

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shareholders of the private company, but also to such transactions entered into with their associates (a broadly defined term: see [21 255]). If the interposed entity is an associate of the private company shareholder, it may not be necessary for the Commissioner to have regard to the specific interposed entity rules as there will be a direct application of either s 109C (payments), s 109D (loans) or s 109F (debt forgiveness).

Indirect payment and loans to target entity (s 109T) The operation of Div 7A is extended by tracing provisions (in Subdiv E), which apply to payments or loans made by a private company to an interposed entity where it is reasonable to conclude that the payment or loan was made solely or mainly as part of an arrangement for the payment of a loan to an entity (the ‘‘target entity’’). If the provisions apply, the private company will be treated as having made a loan or payment directly to the target entity.

The provisions apply if an entity, or more than one entity, is interposed between the private company and the target entity: s 109T(1). NR Allsopp Holdings Pty Ltd v FCT [2016] FCAFC 87 provides an example of where the requirements of s 109T(1)(b) were satisfied. It is not material whether or not the amounts of the payments or loans are the same, or whether the time of the payment or loan from the private company to the interposed entity precedes the time of the payment or loan from the interposed entity to the target entity: s 109T(2). If an amount is paid or lent to a shareholder or associate through an interposed entity that is also a shareholder or associate of the paying company, the amount may be a deemed dividend to the interposed entity in its own right, in which case the tracing rules will not apply: s 109T(3). See ATO ID 2011/104 for an example of where s 109T(3) did not apply, and s 109T operated to treat a private company as having made a payment or loan to a shareholder or an associate of a shareholder (the target entity) in circumstances where the interposed entity was also a shareholder of the private company, and the payment made to the interposed entity was the payment of an actual dividend.

Payments and loans through interposed entities relying on guarantees (s 109U)) Section 109U is an integrity rule designed to ensure that Div 7A cannot be avoided by the interposition of a private company with a low distributable surplus, which is put in a position to make a payment or loan by the provision of a guarantee by a private company (which, had it provided that payment or loan directly, would have generated a Div 7 deemed dividend). The section applies if a loan or payment is made to a shareholder or associate by an interposed company that does not have a distributable surplus, or has a distributable surplus © 2017 THOMSON REUTERS

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less than the amount paid or lent to the shareholder or associate, and the repayment is guaranteed or secured by a company with distributable profits. The private company providing the guarantee or security for the payment or loan made by the interposed company is treated as having made the payment or loan directly to the shareholder or associate. The amount treated as paid by the private company to the shareholder is determined by the Commissioner under s 109V, taking account of the value of the consideration payable to the shareholder or associate (the target entity), adjusted for any distributable surplus in the interposed entity and any other deemed dividends: s 109U(2), (3). These are not the only matters that the Commissioner can take into account. In Determination TD 2011/16, the Commissioner indicates that behaviour before the lodgment date of the company for the year in which the payment or loan was made will be relevant. For example, matters such as the repayment of loans and compliance with s 109N will be taken into account in the exercise of the discretion.

If s 109U applies, an amount is deemed to be a dividend under s 109C: see [21 260]. The payment or loan by the interposed company will also be treated as a dividend to the extent of any distributable surplus.

Provision of guarantees to shareholders (s 109UA) Section 109UA also deals with the case where a guarantee has been provided. However, the provision has a very different objective to s 109U. While s 109U is concerned with avoidance schemes involving interposition of low distributable surplus private companies, s 109UA is more concerned with the actual provision of a payment benefit which might arise in an arm’s length transaction (eg if the interposed entity is a bank – see below). A company may be treated as having paid a dividend to the extent of any liability (other than a contingent liability) incurred by the company as a result of providing a guarantee or security for a loan made directly or indirectly to a shareholder or associate. Its operation differs from s 109U as it only operates where a liability has been triggered under the guarantee. The consequence of the section applying is that there is deemed to be a payment to an interposed entity which facilitates the operation of s 109T. Unlike s 109UA, the interposed entity is not necessarily a private company. 830

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The section contains an example where a private company guarantees a loan that a bank makes to a shareholder in the private company and the shareholder defaults on the loan. The private company is treated as though it had made a payment to the shareholder through the bank as an interposed entity. The deemed dividend arises in the income year in which the private company that provided the guarantee or security becomes liable to make a payment under the guarantee to the interposed entity. The actual amount treated as paid by the private company is determined by the Commissioner under s 109V (see below). The Commissioner has a discretion under s 109UA(3) not to apply the section in certain hardship cases. In addition, s 109UA will not apply if the shareholder (or associate) enters into a loan agreement with the private company and that loan meets the requirements of s 109N (see [21 320]).

The amount of the payment through an interposed entity The amount of a payment or loan taken to be made by a private company to the target entity through an interposed entity is determined by the Commissioner having regard to (ss 109V, 109W): • the amount of the payment or loan made by the interposed entity to the target entity; and • how much, if any, of the amount the Commissioner believes represents consideration payable to the target entity for anything (assuming it represents an arm’s length consideration). If a private company is taken to have made a loan to a target entity through an interposed entity, the amount deemed to have been lent directly by the private company to the target entity is referred to as the notional loan: s 109W(1). If the target entity repays part of the loan made by the interposed entity, the target entity is taken to have repaid a corresponding proportion of the notional loan from the private company: s 109W(3). EXAMPLE [21 300.10] Tu Pty Ltd, a private company, lends $100 to an interposed entity (Luu Pty Ltd). Luu Pty Ltd lends $150 to a shareholder of Tu Pty Ltd (Wu). The Commissioner concludes that $100 of the $150 lent by Luu Pty Ltd is the notional loan. © 2017 THOMSON REUTERS

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Wu makes a repayment of $21 to Luu Pty Ltd. $21 (repayment) ×

$100 (notional loan amount) $150 (actual amount lent)

Notional repayment = $14

A private company may be deemed to have paid a dividend to a target entity even if some or all of the amount paid or lent by the private company to an interposed entity is included in the interposed entity’s assessable income: s 109X(1)(b). However, s 109X(1) does not deny the operation of s 109K (see [21 320]) if the target entity is a company and a deemed dividend does not arise under s 109C or s 109D in respect of a deemed payment or loan arising under s 109T (see above) to a company: see Determination TD 2001/2. If a payment or loan is made by an entity interposed between a private company and a shareholder or their associate, a loan agreement may be made and put on a commercial footing between the interposed entity and the shareholder (or associate). If the loan meets the minimum interest rate and maximum term criteria in s 109N (see [21 320]), a deemed dividend will not arise: s 109X(2)-(4).

[21 305] Unpaid present entitlements The rather complex rules set out in Subdivs EA and EB are integrity rules directed to the use of interposed trusts and unpaid present entitlements (UPEs) to avoid the application of Div 7A. However these provisions are unlikely to have significant practical importance given the Commissioner’s approach of treating UPEs as loans, subject to certain exceptions (see [21 270]). Put simply, where the trust is a shareholder associate, if the UPE is regarded as the provision of financial accommodation and therefore a ‘‘loan’’ for Div 7A purposes, s 109D may apply to deem a dividend to have been paid to the trust. Hence Div 7A is attracted without the need to rely on Subdiv EA. (Importantly, in contrast to the position under Subdiv EA where the UPE is a loan, it is not necessary to show there has been a payment, loan or debt forgiveness from the trust to the private company shareholder or associate – see below.) The Commissioner has stated that where a UPE attracts s 109D, it will not be regarded as unpaid, so that Subdiv EA will not operate. It would seem, as a result of the Commissioner adopting this view as to the application of s 109D, that Subdiv EA is relegated to applying only where s 109D does not apply to the UPE, for example, where: • the trust is not associated with shareholders of the private company; • the UPE was in existence before 16 December 2009 (and hence grandfathered under Ruling TR 2010/3); or • the UPE is placed on a sub-trust for the sole benefit of the private company beneficiary.

Trust with UPE to private company (Subdiv EA) Subdivision EA (ss 109XA to 109XD) contains specific provisions to counter the practice of sheltering trust earnings in companies at the corporate tax rate, while the benefit of the funds is enjoyed by high marginal rate shareholders, or shareholders’ associates, free of tax. The rules apply if a trustee makes a payment or a loan to, or forgives a debt owed by, a non-corporate shareholder (or their associate) of a private company, in the following circumstances (s 109XA(1)): • in the case of a payment, that payment discharges or reduces a present entitlement of the shareholder or their associate to an amount that is an unrealised gain (other than an unrealised gain which has been, is or will be included in the assessable 832

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income of the trust in a prior income year, the current income year or the next income year) – this requirement will not apply if a shareholder of a corporate beneficiary of a trust (or an associate of a shareholder) receives a distribution of an amount attributable to an unrealised gain (which is subject to the application of s 109XA(1)) and all or part of that amount is subsequently loaned back to the trust; • in all cases, the private company is, or becomes, presently entitled to an amount from the net income of the trust; and • in all cases, all or part of the present entitlement remains unpaid before the earlier of the due date for lodgment and the actual date of lodgment of the trust return for the income year in which the payment or loan takes place, or the debt is forgiven (the ‘‘lodgment day’’).

A deemed dividend will not arise if the loan from the trustee is repaid or put on a commercial footing in accordance with s 109N (ie meeting the minimum interest rate and maximum term criteria: see [21 320]) before the earlier of the due date for lodgment of the company’s return for the relevant income year or the actual lodgment date. (This will not assist if the deemed dividend arises due to the direct application of s 109D since the loan from the trustee is not relevant if the UPE is itself regarded as a loan.) The forgiveness of a loan by a trustee will not give rise to a deemed dividend if the loan has previously resulted in an amount being included in the assessable income of the shareholder (or their associate) under s 109XB: s 109XD. If Subdiv EA applies, the amount of a payment, loan or forgiven debt treated as a dividend is effectively the lesser of: (a) the amount involved in the actual transaction; and (b) the UPE less any amounts previously treated as deemed dividends: ss 109XA and 109XB.

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EXAMPLE [21 305.10] A private company has an UPE to $2,000 of accounting income of a trust estate. The trustee creates an entitlement to an unrealised gain to a shareholder of the private company of $8,000. The trustee makes a payment of $4,000 towards the beneficiary’s entitlement to the unrealised gain. Subdivision EA will apply to the payment and, subject to the operation of the other rules in Div 7A, a deemed dividend of $2,000 will arise in the hands of the shareholder.

EXAMPLE [21 305.20] A private company has an UPE to $10,000 of accounting income of a trust estate that remains unpaid. The trustee creates an entitlement to a shareholder of the private company comprising $7,000 of unrealised gains and $3,000 of realised gains. The trustee then makes a payment of $5,000 towards the beneficiary’s entitlements. The trustee is permitted to determine the extent to which the payment is treated as a reduction in entitlements to realised or unrealised gains and determines that, of the $5,000 paid, the first $3,000 discharges the entitlement to the realised gain and the remaining $2,000 reduces the entitlement to the unrealised gain. Subdivision EA will apply to the payment and, subject to the operation of the other rules in Div 7A, a deemed dividend of $2,000 will arise in the hands of the shareholder.

Ruling TR 2010/3 considers the application of Subdiv EA where a private company has an UPE to an amount from the net income of a trust which is satisfied by the settling on a sub-trust of trust property for the benefit of that private company. The ruling also states that if a private company beneficiary has made a Div 7A loan in respect of a subsisting UPE, the Subdivision will have no subsequent operation in respect of that UPE. A Practice Statement (PS LA 2010/4) has been released which provides practical guidance on the administration of the ruling.

UPEs – interposed entities (Subdiv EB) Subdivision EB (ss 109XE to 109XI) is intended to ensure that if an entity is interposed between a trust making a payment or loan to a shareholder of a private company (or their associate), or between a trust and the private company that holds an UPE to an amount from the net income of the trust, the interposed entity cannot be used to circumvent the operation of Div 7A (applicable to payments and loans made on or after 1 July 2009). Sections 109XF and 109XG (payments and loans respectively) operate where the trustee transacts indirectly through one or more interposed entities with the private company shareholder or associate. The rules operate where a reasonable person would conclude, having regard to all the circumstances that the trustee made the payment or loan as part of an arrangement involving the shareholder or associate. If (as may often be the case) the interposed entity is an associate of the shareholder, it will be unnecessary to rely on Subdiv EB since Subdiv EA will apply on its face.

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Section 109XI is concerned with the interposition of a trust (or a series of trusts) between the target trust and the private company. The section requires that a reasonable person would conclude that the private company is, or became, entitled to the income from the interposed trust solely or mainly as part of an arrangement involving entitlement to an amount from the target trust. If it applies, the section deems a present entitlement from the target trust to the company and thereby facilitates the operation of Subdiv EA. Determination TD 2011/15 provides detailed guidance on the matters the Commissioner will take into account in applying the section.

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[21 310] Deemed dividend limited to distributable surplus Section 109Y restricts the amount of all deemed dividends under Div 7A to the company’s ‘‘distributable surplus’’ for that year. The amount of a Div 7A deemed dividend is proportionately reduced if the total of all Div 7A dividends taken to be paid by the private company at the end of the income year exceeds the distributable surplus of the company for that year. In these circumstances, the assessable proportion is the distributable surplus divided by the total of all Div 7A dividends paid: s 109Y. A private company’s distributable surplus for an income year is (s 109Y(2)): Net assets + Division 7A amounts − Non-commercial loans − Paid-up share value − Repayments of non-commercial loans

where: Net assets means the amount by which the company’s assets (according to its accounting records) exceeds its present legal obligations and certain accounting provisions, at the end of its year of income (see below). Division 7A amounts means the total (ignoring the operation of s 109Y) of any payments or forgiven debts the company is taken (under s 109C or s 109F) to have paid as dividends in the income year (see [21 260] and [21 290]); Non-commercial loans is the total of any deemed dividends under s 108, s 109D or s 109E taken to have been paid in earlier income years (which are shown as assets in the company’s accounting records) and (from 2009-10) any amounts included in the assessable income of shareholders, or associates of shareholders, under s 109XB (see [21 305]) as if the amounts were dividends paid in earlier income years (reduced by the total of the unfranked parts of any later dividends that have been set off under s 109ZCA: see [21 340]); Paid-up share value is the sum at year-end of the company’s paid-up capital and its share premium account, if any; and Repayments of non-commercial loans means any repayments of loans or amounts that have been deemed to be dividends under former s 108, s 109D or s 109E, including certain amounts set off against such loans but excluding amounts set off as a result of unfranked dividends or any such loan or part that has been forgiven. A private company is required to provide a written statement setting out the company’s distributable surplus for the income year and the total amount the company would be deemed under Div 7A to pay as dividends, ignoring the s 109Y limitation: s 109Y(5).

Net assets As stated above, the ‘‘net assets’’ component of the ‘‘distributable surplus’’ formula means the amount by which the value of the company’s assets (according to its accounting records) exceed its present legal obligations and certain accounting provisions. According to the Tax Office, a ‘‘present legal obligation’’ is an immediate obligation binding at law, whether payable and enforceable presently or at a future time (see Determination TD 2007/28, as amended by the Addendum which issued to reflect the decision in FCT v H (2010) 85 ATR 357). The Full Federal Court in FCT v H decided that the obligation to pay properly assessed tax and the GIC (but not penalties) is a present legal 836

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obligation at the end of the financial year in which the income is derived. Following the decision, the Commissioner released Determination TD 2012/10 which states that the amount of an unpaid PAYG instalment is a ‘‘present legal obligation’’. The Determination also states that, for a full self-assessment taxpayer, any amount due and payable under a deemed assessment (see [47 030]) is a ‘‘present legal obligation’’ for the income year to which the deemed assessment relates, even though payment is not due until the return is lodged after the end of the year. The same principle applies where there is an amended assessment, so that any tax due and payable under the amended assessment will be regarded as a ‘‘present legal obligation’’ for the year to which the amendment relates. Furthermore, in later income years, to the extent that instalments remain unpaid and amounts payable under an assessment or amended assessment remain payable at the end of the later income year, they will be present legal obligations for the purposes of the distributable surplus calculation worked out at the end of that later income year. In Re Fresta and FCT (2002) 49 ATR 1212, it was decided that the company’s provision for tax could be deducted in calculating net assets. If the Commissioner considers that the company’s accounting records significantly undervalue or overvalue its assets or provisions, the Commissioner has the discretion to substitute a value he thinks is appropriate. The Commissioner considers that, in exercising this discretion, he can take into account assets not shown in the company’s accounting records: see Determination TD 2009/5.

[21 320] Exclusions from Div 7A Each of the 3 categories of deemed dividends under Div 7A (see [21 250]) contains exclusions. These exclusions are considered below. Note also that the Commissioner has the general discretion (under s 109RB) to disregard in certain circumstances a deemed dividend that arises because of an honest mistake or an inadvertent omission: see [21 330]. Forgiven debts not treated as dividends Under s 109G, a forgiven debt will not be treated as a deemed dividend in the following circumstances: • The debt is owed by another company (other than a debt owed by a company in the capacity of trustee). • The debtor has become bankrupt or Pt X of the Bankruptcy Act 1966 applies. • The debt that is forgiven relates to a loan that is otherwise deemed to be a dividend by s 109D or former s 108 for that year or an earlier one. • The Commissioner is satisfied that: (a) the reason for the forgiveness was that payment would have caused the entity undue hardship; and (b) the entity had the capacity to pay the debt when it was incurred but lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity’s control. Note also s 109G(3A) and (3B), which are discussed at [21 290].

Payments and loans not treated as dividends Under Subdiv D, the following payments and loans between a private company and an entity are not treated as dividends under Div 7A: • repayment on an arm’s length basis of a debt owed by the private company to the entity: s 109J; © 2017 THOMSON REUTERS

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• a payment or loan by the private company to another company, other than a company in the capacity of trustee (eg see Di Lorenzo Ceramics Pty Ltd v FCT (2007) 67 ATR 42): s 109K (except where the interposed entities rules in Subdiv E apply: see [21 300]); • a payment or loan by the private company to the extent that is otherwise included in the entity’s assessable income (s 109L, eg an annual bonus); • a loan by the private company in the ordinary course of business on usual arm’s length terms: s 109M. Determination TD 2008/1 considers whether s 109M may apply if a private company provides trade credit to a shareholder (or their associate) on the usual terms it gives to parties at arm’s length and the shareholder (or associate) fails to repay the amount within the agreed payment term; • a loan meeting the criteria for minimum interest rate and maximum term under s 109N and any regulations (see below); • a distribution or loan in the course of the winding-up of the private company by a liquidator: s 109NA (see [21 270]); • a loan made for the sole purpose of enabling a shareholder or associate to acquire employee share scheme (ESS) interests to which the ESS provisions in the ITAA 1997 or ITAA 1936 apply: s 109NB; and • amalgamated loans excluded under the discretion exercised by the Commissioner under s 109Q. These exclusions, however, will not operate to prevent the deeming provisions in the interposed entity rules in Subdiv E from giving rise to deemed dividends under Subdiv B: see Determination TD 2012/12.

Loans meeting minimum rate and maximum term criteria Under s 109N, a loan by a private company will not be taken to be a dividend in an income year if each of the following criteria are satisfied before the earlier of the due date for lodgment of the company’s return for that year or the actual lodgment date. 1. The agreement that the loan is made under is in writing. When a private company makes a loan to a shareholder under a clause in the company’s constitution setting out the terms on which such loans are to be made, there is a ‘‘written agreement’’ for the loan for Div 7A purposes if the criteria outlined by Determination TD 2008/8 are satisfied. For examples of where the requirement for a written agreement was not satisfied, see Re Applicant and FCT (2009) 76 ATR 395, Re Applicant and FCT (2009) 76 ATR 413, Re Applicant and FCT (2009) 76 ATR 430, Re Applicant and FCT (2009) 76 ATR 447 (there was only a written promise to repay). 2. The interest rate on the loan for years of income after the year in which the loan is made equals or exceeds the ‘‘benchmark interest rate’’ for the year (see [21 280]). 3. Subject to any regulations, the term (the maximum term): (a) for a loan fully secured by a mortgage over real property that is registered under State or Territory law, must not exceed 25 years. (The market value of the property at the time the loan is made must be at least 110% of the loan amount: see [3 210] for ‘‘market value’’.); or (b) for all other loans, must not exceed 7 years. The maximum 7-year term applies if a mortgage is ineligible for registration under a State or Territory law (see ATO ID 2007/215). If an unsecured loan with a maximum term of 7 years is refinanced with a secured loan with a maximum term of 25 years, the maximum term of the secured loan is reduced by the 838

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expired period of the old loan: s 109N(3A), (3B). Conversely, if a secured loan with a maximum term of 25 years is refinanced with an unsecured loan, the maximum term for the unsecured loan is 7 years, reduced by the number of years (if any) by which the expired period of the old loan exceeds 18 years: s 109N(3C), (3D). Thus, the total term of the loan (in both its secured and unsecured form) will be no more than 25 years. If the loan satisfies s 109N, Div 7A does not require the borrower to pay interest or make any repayments in the income year in which the loan is first made: see Determination TD 98/22 and ATO ID 2010/206. However, if the required minimum yearly repayment is not made for a subsequent income year and the loan meets the definition of an ‘‘amalgamated loan’’, s 109E may operate to treat the shortfall in the minimum yearly repayment as a dividend: see [21 280].

[21 330] Commissioner’s discretion to disregard Div 7A Section 109RB gives the Commissioner the discretion to disregard a dividend that would otherwise be deemed to arise under Div 7A, or to allow the company to frank a deemed dividend, if the failure to satisfy Div 7A is the result of an honest mistake or inadvertent omission. The meaning of these terms is considered in Ruling TR 2010/8. The factors the Commissioner will consider in determining whether to exercise the discretion are: the circumstances that led to the relevant mistake or omission; the extent to which action had been taken and how quickly action had been taken to correct the mistake or omission; whether Div 7A had previously operated in respect of the relevant entities and in what circumstances this had occurred; and any other matters that the Commissioner considers relevant. The Commissioner may impose conditions on the exercise of discretion, eg he may require a loan agreement to be entered into that complies with s 109N (see [21 320]). Practice Statement PS LA 2011/29 provides guidance for Tax Office staff exercising the discretion. The Practice Statement describes a 2 step procedure; the first step being the identification of an honest mistake or inadvertent omission giving rise to a Div 7A deemed dividend, and the second step being the application of factors in s 109RB(3) to determine whether the discretion should be exercised. Potentially relevant matters include the sophistication of the taxpayer, corrective action (if any) taken by the taxpayer, the complexity of the Div 7A provisions at issue, and whether the taxpayer should have sought professional advice. The application of the discretion was considered in Re Building Company Owner and FCT (2012) 91 ATR 186. One situation where the discretion may be exercised is where the mistake or omission is made because a decision to consolidate has the effect of changing the lodgment day of a subsidiary private company: see Determination TD 2015/18, para 25. Section 109RD gives the Commissioner the discretion to disregard a deemed dividend that arises under s 109E (see [21 280]) where the recipient of an amalgamated loan (ie the shareholder or an associate of the shareholder) was unable to make the minimum yearly repayments because of circumstances beyond their control. The Commissioner can specify a later time by which the minimum yearly repayments must be made. [21 340] Division 7A and imputation Division 7A deemed dividends are generally unfrankable distributions: see [21 420]. However, a Div 7A dividend that is deemed to be paid because of a ‘‘family law obligation’’ (eg pursuant to a court order under the Family Law Act 1975, a maintenance agreement approved by a court under that Act or a court order relating to de facto marriage breakdowns) is not unfrankable and may be franked in accordance with s 109RC. Note also that the Commissioner has the general discretion (under s 109RB) to allow a Div 7A dividend to be franked if the dividend is deemed to arise because of an honest mistake or an inadvertent omission: see [21 330]. In some circumstances, a private company may pay a general dividend (fully or partly franked) if the dividend is used to offset an amount that has previously been treated as a © 2017 THOMSON REUTERS

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deemed dividend under Div 7A. In these circumstances, the later dividend that is set off or applied against the previous deemed dividend will not be treated as a dividend for income tax purposes, except under the franking provisions: s 109ZC. For example, a private company may pay a dividend that is applied in reduction of a loan previously made to a shareholder. To the extent that the amount applied is greater than the unfranked amount of a later dividend, the excess is treated as a dividend, ie it may be a frankable dividend: s 109ZC(2). The same rules apply if later dividends are applied by a shareholder against deemed dividends taken previously to be paid to the shareholder’s associate: s 109ZC(1A). The amount that is set off or applied under s 109ZC is treated as non-assessable, non-exempt income: s 11-55 ITAA 1997. Section 109ZCA allows a later dividend, distributed by a private company to a shareholder (or their associate), to be set off against an amount received from a trustee that has already been included in the assessable income of the shareholder (or their associate) under Subdiv EA (see [21 305]). The franking credit attached to the later dividend will still be available to shareholders if the franked dividend is used to offset an earlier amount treated as a dividend.

[21 350] Division 7A and fringe benefits tax Division 7A has a potential application to a loan or debt forgiveness, even if the loan involves an employment relationship (and would therefore also possibly give rise to a taxable fringe benefit): s 109ZB(1), (2). However, the definition of ‘‘fringe benefit’’ in s 136(1) FBTAA excludes anything done in relation to a shareholder in a private company (or associate) that results in a Div 7A deemed dividend to the shareholder (or associate). In effect, these provisions give priority to Div 7A. However, Div 7A does not apply to a payment made to a shareholder or associate in her or his capacity as an employee or associate of an employee: s 109ZB(3). Thus, payments (including the transfer of property) to a shareholder or associate in her or his capacity as an employee or associate of an employee remain subject to the FBTAA, and not Div 7A, although FBT does not apply to excluded loans that satisfy the requirements of s 109N (see [21 320]). Section 109ZB also means that superannuation contributions by a private company on behalf of a shareholder or associate who is an employee are not subject to Div 7A. [21 360] Remuneration and termination payments Section 109 ITAA 1936 deals with the situation where a private company pays or credits to an associated person an amount that is or purports to be: • remuneration for services rendered by the associated person; or • an allowance, gratuity or compensation in consequence of the retirement of the associated person from an office or employment held by the associated person in the company or upon the termination of any such office or employment. In these circumstances, so much (if any) of the amount as exceeds an amount that, in the opinion of the Commissioner is reasonable, is not deductible and is deemed, except for certain purposes, to be a dividend paid by the company to the associated person as a shareholder in the company out of profits derived by the company on the last day of the income year of the company in which the excessive payment or credit is made. An ‘‘associated person’’ is a shareholder or director (or former shareholder or director) of the company and an associate of such a shareholder or director (‘‘associate’’ has the same meaning as in s 318 ITAA 1936: see [4 220]). Section 109 reduces an otherwise allowable deduction (see WJ & F Barnes Pty Ltd v FCT (1957) 96 CLR 294) and denies a deduction for the amount that the Commissioner considers unreasonable. Although that decision concerned an earlier version of the section, it would apply equally to the current version. In Ferris v FCT (1988) 19 ATR 1705, it was held that s 109 is concerned with the payment of sums that are so high as to amount to a diversion of profits that ought to have 840

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been retained by the company and taxed as such, or distributed and taxed on their distribution as dividends. The test of reasonableness in s 109 is objective, but depends on the circumstances of the particular case upon commercial practice. One must therefore weigh factors such as the skills and worth of the director/employee against the rights of shareholders as holders of equity in the company. For other factors relevant to the question of reasonableness, see also Case 5630 (1990) 21 ATR 3168, AAT Case 9483 (1994) 28 ATR 1166, Re Applicant and FCT (2009) 76 ATR 190 and FCT v White (2010) 79 ATR 498. The reference in s 109 to amounts paid or credited specifically includes the transfer of an asset. If the Commissioner deems the payment of an amount to be a dividend, the dividend will be an unfrankable distribution: s 202-45(g) ITAA 1997. A sum deemed to be a dividend under s 109 is not subject to withholding tax.

IMPUTATION SYSTEM FRANKABLE DISTRIBUTIONS [21 400] Introduction The imputation system is designed to prevent the double taxation of the profits of a ‘‘corporate tax entity’’, first in the hands of the entity and then in the hands of the ‘‘members’’ (eg shareholders in the case of a company) when distributed to them (eg as dividends). The payment of tax by the entity is imputed to the members, who become entitled to a tax offset for the tax paid by the entity. The imputation system (in Pt 3-6 ITAA 1997) applies to ‘‘corporate tax entities’’. These are companies, corporate limited partnerships, corporate unit trusts and public trading trusts: s 960-115. In brief, the imputation system: • allows a corporate tax entity to ‘‘frank’’ a distribution – this means that the benefit of tax paid by the entity on its profits attaches to the distribution (a ‘‘franking credit’’). The entity can choose the rate of franking allocated to a distribution, subject to the benchmark rule; • requires a member (which includes a corporate member) to ‘‘gross-up’’ a franked distribution when including it in their assessable income – this adds back the tax paid by the corporate tax entity on the profits in respect of which the distribution was declared; • grants a tax offset to a member referrable to the tax paid by the corporate tax entity, with the possibility of the member obtaining a refund for excess offsets. If an individual member is on a marginal tax rate higher than the corporate tax rate for imputation purposes (30%, or 28.5% for small business entities – but note the proposed reductions in the company tax rate at [20 030]), the member effectively pays the difference on assessment by only receiving a tax offset for the lesser amount of tax paid by the entity; and • requires a corporate tax entity to maintain a franking account – franking credits and debits arise in the account. For example, paying company tax and receiving a franked distribution give rise to franking credits and paying a franked or unfranked distribution and receiving a refund of income tax give rise to franking debits. The sum of franking credits in the account dictates the extent to which distributions can be franked. © 2017 THOMSON REUTERS

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The imputation system extends to non-share dividends arising under the debt and equity rules (see Chapter 25), subject to various modifications. The extension of the imputation system through the debt and equity rules has meant that the terminology used has become non-generic, ie member rather than shareholder, distribution rather than dividend and entity rather than company. The imputation system applies in a modified manner to certain life insurance companies and registered organisations: see [30 300]. Special imputation rules for consolidated groups are discussed at [24 520].

[21 410] Frankable distributions The kinds of distributions that can be franked under the imputation system are defined in Subdiv 202-C. Essentially, all distributions are frankable with some specific exclusions: s 202-40. Non-share dividends are frankable distributions, unless unfrankable pursuant to s 202-45: s 202-40(2). However, care must be taken to comply with Div 215: see [21 770]. A ‘‘distribution’’, in respect of companies, is defined in s 960-120 as a dividend or a deemed dividend (eg under Div 7A: see [21 250] and following). A distribution is made when a dividend is paid or deemed to be paid. A dividend is (s 995-1): • a ‘‘dividend’’ as defined in s 6(1) and (4); • a bonus share that is taken to be a dividend under s 6BA(5): see [21 430]; • a distribution from limited corporate partnership under s 94L; • a liquidator’s distribution to which s 47 applies; • that part of an off-market purchase price deemed by s 159GZZZP to be a dividend; and • a distribution of FLIC concessional capital that is taken to be a dividend under s 375-872. As a ‘‘distribution’’ includes deemed dividends without exhaustively defining which provisions of the tax legislation deem distributions to be dividends, the definition can be expanded by provisions introduced outside the imputation rules. Any distributions to proprietors of a strata title body out of profits derived by the body are frankable dividends: see Ruling TR 2015/3.

[21 420] Unfrankable distributions Unfrankable distributions (listed in s 202-45) are: • distributions paid by a company that is resident in Norfolk Island out of profits from sources in that Territory; • dividend components of the purchase price on an off-market share buyback, if any, that exceeds the market value of the share: see [20 710]; • distributions in respect of a non-equity share; • non-share dividends covered by ss 215-10 and 215-15; • distributions sourced, directly or indirectly, from a company’s share capital account (but not a distribution of FLIC concessional capital that is taken to be a dividend under s 375-872). The Tax Office has expressed the view in Ruling TR 2012/5 that a company which pays a dividend authorised by s 254T of the Corporations Act (see [21 030]) would not constitute a distribution sourced indirectly from the company’s share capital account. However, a distribution (even if labelled as a dividend) that does not comply with s 254T is an unauthorised capital return that may be taxed as 842

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[21 430]

an assessable unfranked dividend (or alternatively a CGT event) depending on the particular facts. See also the approach taken in ATO ID 2010/25, which considered an indirect sourcing from share capital would arise where a company transfers an amount from its share capital account into a distributable profits reserve, and subsequently makes a distribution to shareholders that is debited against the distributable profits reserve, in circumstances where it is reasonable to conclude that the distribution represents the amount transferred from the share capital account. However, if a company reduced its share capital account by the amount of accumulated accounting losses, recorded as a debit to the share capital account, amounts paid out of its current year profits or future retained earnings subsequent to the accounting entry would not be unfrankable; • certain deemed dividends, namely: – Div 7A distributions by a private company to an associated entity, unless the Commissioner exercises his discretion to allow a Div 7A deemed dividend to be franked or the dividend is paid as a result of a family law obligation: see [21 330] and [21 340]; – s 109 excessive payments to shareholders, directors and associates: see [21 360]; – demerger dividends: see [21 030]; – distributions by a NZ franking company covered by s 220-105: see [21 440]; • amounts that are taken to be an unfranked dividend for any purpose under s 45 (streaming bonus shares and unfranked dividends) or s 45C (streaming dividends, capital benefits and demerger benefits): see [21 100]-[21 130]. A distribution made by the non-operating holding company of an ADI, following an ADI restructure, will be taken to be a dividend that is not an unfrankable distribution where (s 202-47): • the distribution is sourced, directly or indirectly, from the ADI’s profits before the restructure instrument came into force; and • the distribution would have been a frankable distribution if it had been made by the ADI prior to the ADI restructure.

[21 430] Bonus shares The position with bonus shares varies, depending whether the company has shares with a par value. Companies whose shares have no par value Bonus shares may be issued without giving rise to a distribution: see [21 080]. However, a bonus share may give rise to a distribution in the following circumstances. • If the bonus issue is made by the former indirect method of declaring a dividend and crediting the dividend to shareholders against the amount payable in respect of the bonus issue. This procedure would cause the share capital account to become tainted. • A bonus share may be deemed to be a dividend under s 45 or s 45A, the capital benefit measures. • Subject to the special rule in s 6BA(6) relating to listed public companies, bonus shares may be taken to be dividends under s 6BA(5) if the shareholder has a choice between a dividend or the bonus shares and chooses the shares: see [21 090]. A bonus share deemed to be a dividend under s 45 or s 45A is unfranked: s 45(2). Similarly, a capital benefit, in the form of shares or otherwise, under s 45B may be deemed to be unfranked: s 45C. © 2017 THOMSON REUTERS

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A bonus share deemed to be a dividend under s 6BA(5) is a ‘‘frankable distribution’’. In the case of listed public companies, if a choice is offered between franked dividends (other than dividends only minimally franked) and bonus shares, providing no amount is credited to the share capital account the bonus shares will not be deemed to be a dividend under s 6BA(5). However, if an amount is credited to the share capital account and the shareholder chooses to be issued shares, s 6BA(5) applies, with the result that a frankable dividend is deemed to have been paid.

Companies with par value shares For companies that have par value shares, bonus shares are, with one exception, distributions for tax purposes to the extent to which the paid-up value represents a capitalisation of profits. The paid-up value is fully assessable under s 44, except where the distribution would be liable to withholding tax. If a company declares a dividend then applies it to pay up the par value and premium attaching to an allotment of shares ie, broadly, an issue of shares at a premium, this is known as a ‘‘scrip dividend’’. As with cash dividends, since bonus shares are dividends under s 6(1), they fall within the definition of ‘‘frankable distribution’’ and may be franked under the imputation system. However, the same exception as for cash dividends applies, namely, that if the bonus shares are paid up by the debiting of an amount against the balance in a share premium account, the exclusion in para (d) of the definition of ‘‘dividend’’ operates and the bonus share issue will not be a distribution. Therefore, it is also not a frankable distribution and cannot be franked. This non-treatment as a dividend will not apply if s 6(4) applies. [21 440] Distributions from foreign resident companies Although dividends received from foreign resident companies may qualify as frankable distributions, such distributions cannot generally be franked (there is an exception for certain NZ companies, see below). Section 205-5 requires not only that the distribution be a frankable distribution in order to be taken to be franked, but also that the company (in which the taxpayer to whom the distribution is paid is a shareholder) must be a resident at the time of payment of the frankable distribution. This will not prevent a company that is a resident at the time of payment from franking a distribution paid out of profits that were derived at a time when it was not a resident provided that sufficient franking credits exist. Australian franking status for NZ companies The imputation rules apply to a company resident in New Zealand as if the company were an Australian resident, albeit with certain modifications. A NZ company is able to maintain an Australian franking account and to attach franking credits to dividends that it pays. Therefore, Australian shareholders of NZ companies with operations in Australia may be entitled to a tax offset reflecting Australian tax paid on Australian sourced income. Hence, a NZ company will be able to frank dividends, so that Australian shareholders receive a tax offset for the franking credits arising from Australian tax paid by the company. Similar legislation has been introduced in New Zealand which will allow an Australian company to attach NZ imputation credits to dividends it pays out of NZ sourced income. A ‘‘NZ resident’’ company can give notice to the Commissioner that it wishes to be part of the Australian imputation system. The criteria in s 220-20 which are applied to determine whether a company is an NZ resident essentially mirror the Australian residency requirements set out in s 6(1). If this choice (‘‘a NZ franking choice’’) is made, the company becomes a ‘‘NZ franking company’’. The notice must be lodged with the Commissioner at least one month before a NZ company makes any franked distributions. 844

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The choice is revokable by the company giving notice in an approved form to the Commissioner. In addition, the Commissioner is empowered to cancel a NZ franking choice, essentially in circumstances where the company does not pay its franking deficit tax or over franking tax liability by the due date or fails to provide a franking return to the Commissioner as required. This power is given to the Commissioner in recognition of the potential enforcement difficulties given that the NZ franking company is not resident in Australia. Certain payments by NZ companies will be unfrankable distributions. These include conduit tax relief additional dividends and supplementary dividends paid by NZ franking companies: s 220-105. Franking credits will arise if the company pays Australian tax or receives a franked dividend: s 220-25. A NZ franking company will also receive a franking credit for the payment of Australian dividend, interest or royalty withholding tax imposed by s 128B: s 220-205. Franking credits are available to an Australian company which receives a franked distribution from a NZ franking company that is non-assessable non-exempt income of the Australian company under s 23AI, 23AJ or 23AK: s 220-350. Special rules have been developed in the case of a wholly owned group which includes a company that is not a resident of either Australia or New Zealand. The rules provide that franking debits or credits that would otherwise arise in the franking account of the subsidiary will be transferred to the franking account of the NZ parent provided that all NZ companies and the wholly owned group have made a NZ franking choice: s 202-300.

[21 450] Co-operative companies The imputation rules governing co-operative companies allow them to choose to frank distributions sourced from current year assessable income that are made to members. Companies that do not choose to frank distributions can claim a deduction for the distributions under s 120. A co-operative company can make unfranked distributions despite having franking credits available to frank the distributions made.

IMPUTATION – RECIPIENT’S VIEWPOINT [21 500] Resident individuals When an individual receives a franked distribution (and he or she satisfies the residency requirement when the distribution is made: ss 207-65 to 207-75), there is a ‘‘gross-up’’ so that both the cash distribution and the attached franking credits are included in the individual’s assessable income: s 207-20(1). An individual satisfies the residency requirement if he or she is an Australian resident (see [2 050]) at that time: s 207-75(1). The taxpayer will be entitled to a tax offset (sometimes called a franking offset) equal to the franking credit allocated to the distribution: s 207-20(2). Any excess franking credits are refundable: see [19 040]. See Example [21 520.10]. [21 510] Company shareholders The ITAA 1997 imputation system requires companies and other corporate tax entities (see [21 400]) which receive dividends to adopt the same treatment as that which applies to individuals. The same operative provisions apply. The franking credits received cannot give rise to a refund (see [19 040]), but excess franking credits may be able to be converted into a carry forward loss (see [20 460]). See Example [21 520.10]. These rules apply to a company or corporate limited partnership that is an Australian resident when the distribution is made. In the case of a corporate unit trust and a public trading trust, the entity must be a resident unit trust for the income year in which the distribution is made: ss 207-65 to 207-75. See [2 150] for the rules determining the residency of a company, etc. © 2017 THOMSON REUTERS

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[21 520] Foreign residents Franked distributions paid to a foreign resident are generally non-assessable non-exempt income of the recipient (and not subject to withholding tax): see [35 170]. This means no tax offset is required. However, franked (and unfranked) dividends paid by an Australian company to a foreign resident shareholder carrying on business in Australia at or through a permanent establishment of the shareholder are assessable, to the extent those dividends are derived by the company from sources outside Australia: see [21 030]. In such a case, the recipient will be taken to satisfy the residency requirement (see [21 510]): s 207-75(2). Dividends paid by any company (resident or otherwise) to a foreign resident out of profits that have an Australian source are also assessable: see [21 030]. EXAMPLE [21 520.10] Wislonco pays dividends during the year ended 30 June 2017: Date Dividend Franked

Franking credits allocated $ $ 20 October 2016 3,500.00 100% 1,500.00 14 April 2017 3,500.00 80% 1,200.00 7,000.00 2,700.00 The company has 5 shareholders, all of whom hold the same number of shares. All shares issued are of the same class.

Dividend received Gross-up Assessable income Tax liability Tax offset Tax to pay/(refund)

Resident individual

Resident company

1,400.00 540.00 1,940.00 388.001 540.00 (152.00)

1,400.00 540.00 1,940.00 582.00 540.00 42.00

Non-resident individual 1,400.00

21.002 0

1 Assumes an individual rate of 20%. 2 Dividend withholding tax of 15% on unfranked amount of $140: see [35 180].

[21 530] Franked distributions flowing through partnerships and trusts The rules for the treatment of franked distributions and the allocation of franking credits when a franked distribution flows indirectly to an entity through a partnership or trust are contained in Subdiv 207-B. The Subdivision allows for streaming of franked distributions to specified beneficiaries (see below). If a trust does not make particular beneficiaries specifically entitled, the result is generally the same as under the current law. Under s 207-35, a partnership or trust is required to gross-up its assessable income by the amount of any franking credits attached to a franked distribution it receives. This grossing-up rule does not apply when the partnership or trust is a corporate tax entity or the trustee of a trust that is a complying superannuation entity. A partner, beneficiary or trustee to which a franked distribution flows indirectly includes its share of the franking credit on the distribution in its assessable income. EXAMPLE [21 530.10] The trustee of a trust receives a franked distribution of $700 (with an attached franking credit of $300). For that income year, the trust has $1,000 of assessable income from other sources. Under s 207-35 the trust’s assessable income is grossed-up to include the $300 franking credit. Therefore, the trust has a net income of $2,000 for the income year.

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COMPANIES – DIVIDENDS AND IMPUTATION [21 530] There are 3 presently entitled beneficiaries of the trust. The distribution flows indirectly to those beneficiaries. As each beneficiary is entitled to a one-third share of the net income of the trust, each beneficiary includes $333 in her or his assessable income as a one-third share of the franked distribution. The assessable income of each beneficiary also includes $100 as a share of the franking credit on the distribution.

An entity’s share of a franking credit on a franked distribution is worked out using this formula in s 207-57(2): amount of franking credit on franked distribution × [entity’s share of franked distribution ÷ amount of franked distribution]

For the purposes of this formula, the table in s 207-55 sets out how much of an ‘‘intermediary’’ (ie partnership or trustee) entity’s share of a franked distribution is treated as a ‘‘focal’’ (ie partner, beneficiary or trustee) entity’s ‘‘share of the franked distribution’’. A focal entity’s share of a distribution is based on the share of the distribution of each preceding intermediary entity through which the distribution flows, starting from the intermediary entity to which the distribution is made. EXAMPLE [21 530.20] The Oldfield Partnership receives a franked distribution of $7,000 (with $3,000 franking credits attached). The partnership has 2 equal partners, Annie (an individual) and the trustee of the Ashton Trust (which has 2 equal beneficiaries, Natasha and Stephen). To determine the share of the franked distribution to which Natasha and Stephen are entitled, it is first necessary to look at the trust (as the focal entity) and determine its share (as partner) of the franked distribution received by the partnership (the intermediary entity): Item 1 in the table in s 207-55(3). As the trustee is entitled to a 50% share of the partnership’s net income, its share of the franked distribution is $3,500. Therefore, Natasha’s and Stephen’s individual share (as focal entities) of the franked distribution in relation to the trust (now tested as the intermediary entity: Item 4 in the table in s 207-55(3)) is $1,750. The trustee’s share of the franking credit on the franked distribution is equal to: $3,000 × ($3,500 ÷ $7,000) = $1,500. Natasha’s and Stephen’s share of the franking credit on the franked distribution is equal to: $3,000 × ($1,750 ÷ $7,000) = $750.

If a partner, beneficiary or trustee is the ultimate recipient of a franked distribution which flows to it indirectly, that recipient is entitled under s 207-45 to a tax offset for that income year equal to its share of the franking credit attached to the distribution. These ultimate recipients can be individuals, corporate tax entities, trustees assessable under s 98, s 99 or s 99A and trustees of superannuation funds, ADFs and PSTs. The circumstances in which a franked distribution is taken to flow indirectly to an entity are stated in s 207-50 as follows: • to a partner provided the partner has an individual interest in the partnership’s net income or loss; • to a beneficiary provided the beneficiary has a share of the trust’s net income under s 97(i)(a) or an individual interest in the trust’s net income under s 98A or s 100; • to a trustee where the trustee is liable to be assessed on a share of the trust’s net income under s 98 or all or part of the trust’s net income under s 99 or s 99A. © 2017 THOMSON REUTERS

847

[21 540]

COMPANIES – DIVIDENDS AND IMPUTATION

In all 3 cases it is also necessary for the entity’s ‘‘share of the distribution’’ to be a positive amount. It does not matter whether an entity does not receive any of the franked distribution (eg because deductions exceed the amount of the franked distribution) because s 207-55 notionally allocates a share of a distribution for franking purposes. EXAMPLE [21 530.30] A trustee receives a franked distribution of $3,500 (with $1,500 franking credits attached). The trust has deductions of $5,500 that relate to the distribution. The trustee derives other assessable income of $5,000. The net income of the trust is $4,500. The trustee has 3 equal beneficiaries to which the $4,500 is distributed. The franked distribution is taken into account in determining the net income of the trustee and, as such, each beneficiary’s share of the franked distribution is $500, even though they did not receive any of the franked distribution because the trustee’s deductions exceeded the amount of the franked distribution.

Streaming of franked distributions Streaming refers to the practice of allocating franked dividend distributions to particular beneficiaries. Streaming of franked distributions is governed by interim measures, which are intended to apply while the government undertakes a broader review of the taxation of trust income. The interim measures introduced: • the concept of ‘‘specifically entitled’’, which will be the mechanism by which capital gains and franked dividends may be streamed to beneficiaries; and • anti-avoidance measures to prevent inappropriate use of exempt beneficiaries (such as charities) to shelter taxable income of a trust. Under these measures, franked dividends may be streamed if the trust deed allows a trustee to do so. In order to effectively stream a franked dividend to a particular beneficiary, that beneficiary must be made ‘‘specifically entitled’’ to the franked dividend. A beneficiary is ‘‘specifically entitled’’ only if the following requirements are met in accordance with the trust deed (s 207-58): (a) the beneficiary has received, or can be reasonably expected to receive, an amount from the trust; (b) the amount is referable to the capital gain or the franked distribution (net of certain amounts including losses and relevant expenses); and (c) the amount of the franked distribution and the particular beneficiary to whom it has been distributed is recorded in the accounts or records of the trust no later than the end of the income year. If a beneficiary is not specifically entitled to a franked dividend, the franked dividend should generally be allocated to all beneficiaries on a proportionate basis: see [23 320].

[21 540] Trusts taxed as companies Divisions 6B and 6C in Pt III ITAA 1936 effectively treat ‘‘corporate unit trusts’’ and ‘‘public trading trusts’’ as if they were companies: see [23 1550]-[23 1600]. Corporate unit trusts and public trading trusts also fall within the definition of ‘‘corporate tax entity’’ in s 960-115 (see [21 400] and are therefore generally required to conform to the imputation rules as if they were companies. A ‘‘unit trust dividend’’ paid by either of these entities is a distribution for imputation purposes: s 960-120(1), Items 3, 43, 4. Note that Div 6B relating to corporate unit trusts has been repealed for income years starting on or after 1 July 2016 (subject to certain transitional rules): see [23 1550]. 848

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COMPANIES – DIVIDENDS AND IMPUTATION

[21 580]

[21 550] Superannuation funds Superannuation funds receive full tax offsets (which can be offset against the fund’s tax liability) notwithstanding that part of the fund’s franked distribution income may be exempt. Excess offsets are refundable: see [19 040]. Section 207-110 ensures that superannuation funds will receive offsets for franking credits on franked distributions irrespective of the fact that they may be exempt under s 295-385, s 295-390 or s 295-400 (which provide alternative methods to exempt a percentage of the ‘‘normal assessable income’’ of a complying superannuation fund that is attributable to the liability of the fund to pay current pensions). [21 560] Life insurance companies and friendly societies Surplus tax offsets from the taxation at 15% of distributions received as part of a life insurance company’s superannuation business may be used to reduce the company’s overall tax burden. Excess offsets are refundable: see [19 040]. The taxation of life insurers is discussed in Chapter 30. Registered organisations (ie registered trade unions, friendly societies and associations of employees) are also entitled to tax offsets in respect of distributions. A life insurance company is entitled to a tax offset for the franked distributions derived from assets included in its insurance funds or, in the case of a registered organisation, for the franked distributions derived by the organisation: s 207-110. A life insurance company is required to include a franking credit in its assessable income, and is eligible for a tax offset where s 320-37(1)(a) (segregated exempt assets) and s 320-37(1)(d) (income bonds) apply to the distribution received. In all other cases, an offset is denied. In these cases, the franking credit is not included in the income of the recipient. In the case of a friendly society, income attributable to income bonds, funeral plans and scholarship plans that is exempt (see [30 020]) gives rise to a tax offset: s 207-110.

[21 570] Co-operative companies The imputation rules apply to co-operative companies in the same way as they do to other companies, subject to a number of modifications (see Div 218 ITAA 1997). All distributions made by a co-operative company that are covered by s 120(1)(a) or (b) ITAA 1936 are treated as distributions for imputation purposes: see [20 160].

[21 580] No gross-up and offset when franked distribution is not assessable When an entity is a direct recipient of a franked distribution that is exempt income or non-assessable non-exempt income (‘‘exempt’’ income) in its hands (eg a non-resident), the franking credit on the distribution is not included in the entity’s assessable income and the entity is not entitled to a tax offset: s 207-90(1). If only part of the franked distribution is exempt income, the franked distribution is reduced by the exempt part and the offset is reduced proportionately: s 207-90(2). If an entity receives a franked distribution indirectly through a partnership or trust that is exempt income in the entity’s hands, its assessable income is adjusted as follows under s 207-95(1) to (4) to remove its share of the franking credit (and there is no tax offset entitlement): • a partner can deduct an amount equivalent to the partner’s share of the franking credit: see [21 530]; • a beneficiary can deduct an amount equal to the lesser of its share of the franked distribution (see [21 530]) and its share of the franking credit; and © 2017 THOMSON REUTERS

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[21 590]

COMPANIES – DIVIDENDS AND IMPUTATION

• a trustee’s share of the franked distribution is reduced by the lesser of that share and the trustee’s share of the franking credit on the distribution. EXAMPLE [21 580.10] The Wihavno Trust receives a franked distribution of $21,000 (with $9,000 franking credits attached). The trust has 2 equal beneficiaries, Kirk and a company (Kopco). The distribution is non-assessable non-exempt income in Kopco’s hands. To remove its share of the franking credit, Kopco is allowed a deduction equal to that share, ie $4,500. Kopco has no entitlement to a tax offset.

If only part of the franked distribution is exempt income in the hands of an entity receiving a franked distribution, the relevant deduction/reduction amount is calculated in a modified form using the formula in s 207-95(5).

Exceptions to non-application of gross-up and offset There are 3 circumstances dealt with in Subdiv 207-E under which an entity in receipt of a franked distribution that is exempt income in its hands is not subject to the rules in s 207-90 or s 207-95: • the distribution is exempt income of a complying superannuation entity: see [21 550]; • the distribution is exempt income of a life insurance company: see [21 560]; or • the entity is a refund eligible tax-exempt institution: see [21 590].

[21 590] Tax offset for refund-eligible exempt institutions Certain categories of tax-exempt institutions that are listed as being ‘‘eligible for a refund’’ under s 207-115 have an entitlement under s 207-110 to a tax offset in relation to the franking credit on their franked distributions so they can claim a refund of excess franking credits under Div 67 (the refundable tax offset rules in Div 67 are discussed at [19 040]). When a franked distribution is made directly to a refund-eligible exempt institution, the institution is entitled to a tax offset equal to the franking credit on the distribution. When a franked distribution flows indirectly to such an institution, it will be entitled to a tax offset provided it did not flow indirectly to the institution either as a partner or through another exempt institution with the same refund status. The exempt institutions that are ‘‘eligible for a refund’’ are (s 207-115): (a) registered charities that are endorsed as being exempt from income tax: see [7 360]; (b) an entity endorsed as a deductible gift recipient under s 30-120(a): see [9 880]; (c) an entity listed as a deductible gift recipient under Subdiv 30-B (see [9 800]) that has an ABN; (d) a public fund for which there is in force a declaration by the Treasurer that the fund is a relief fund for the people of a particular country under s 30-85(2): see [9 860]; and (e) an entity that is prescribed in the regulations as being eligible for a refund. An entity in categories (a), (b) or (c) must also satisfy a residency requirement in s 207-117, ie at all times during the year in which the distribution is made it must have a physical presence in Australia and incur its expenditure and pursue its objectives principally in Australia. The Future Fund is also an exempt institution eligible for a refund: s 31 Future Fund Act 2006. 850

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COMPANIES – DIVIDENDS AND IMPUTATION

[21 650]

A tax-exempt institution’s entitlement to a tax offset under s 207-110 is subject to anti-avoidance rules designed to combat schemes devised to exploit the exempt status of the institution: ss 207-119 to 207-136.

[21 600] Flow on of franking credits under cum-dividend contracts and securities lending arrangements Division 216 deals with 2 situations in which a distribution made to a member of a corporate tax entity is treated as having been made to someone else: when interests are sold under a cum-dividend contract or a franked distribution is received by a borrower under a ‘‘securities lending arrangement’’: see [32 780]. The cum-dividend rules in s 216-5 are triggered when, at the time a franked distribution is made, the member has entered into a contract in the ordinary course of stockmarket trading to sell the membership interest and pay the distribution to the buyer. In such a case, the distribution and any attached franking credit is treated as having been paid to the buyer (as a member) and not to the member. A similar rule applies under s 216-10 so that distribution made to a member who is a borrower under a securities lending arrangement will be taken to have been paid instead to the lender (as a member) under that arrangement. Subdivision 216-B (ss 216-20 to 216-30) makes provision for the various statements that must be given (in the approved form) by the various parties to these types of transaction. [21 610] Refund of excess franking offsets Refunds are available under Div 67 for excess franking offsets which arise where the amount of a franking offset exceeds tax payable. This applies to individuals, beneficiaries, trustees assessed on a resident beneficiary’s share of trust income, complying superannuation funds and ADFs, life insurance companies, friendly societies, PSTs (those generally entitled to franking offsets), taxpayers entitled to venture capital franking offsets and tax-exempt registered charities and gift deductible organisations. See further [19 040]. In recognition of this, companies are able to choose not to claim a prior year loss if any excess franking offsets would otherwise be ‘‘wasted’’: see [20 260]. In addition, if current year losses give rise to excess franking offsets, a company can convert the excess franking offsets to current year losses: see [20 460]. Companies (other than life insurance companies) are not entitled to a refund. Registered organisations and gift-deductible charities, which are tax-exempt, are given a hypothetical entitlement to the franking offset, or they would not be entitled to a refund. The trustee of a trust and a beneficiary of that trust cannot claim a refund of the same excess imputation credits. If the trustee is assessed under s 98, the beneficiary and not the trustee is entitled to the refund of any excess franking offsets; if a trustee is assessed under s 99, the trustee is eligible for the refund. A foreign resident that carries on business in Australia at or through a permanent establishment is not entitled to a refund of excess franking offsets in relation to franked distributions that are attributable to the permanent establishment: see [19 040].

IMPUTATION – COMPANY’S VIEWPOINT [21 650] Franking distributions – introduction Franking a distribution is the method by which the company tax is imputed to its members. A distribution may be franked if it is: made by a franking entity that is resident when the distribution is made, is a frankable distribution and the entity allocates franking credits to the distribution. © 2017 THOMSON REUTERS

851

[21 655]

COMPANIES – DIVIDENDS AND IMPUTATION

A ‘‘franking entity’’ is a corporate tax entity that is not acting as the trustee of a trust. A mutual life insurance company is not a franking entity. Franking a distribution is discussed at [21 670] and franking credits are discussed at [21 680].

[21 655] Franking periods The franking period of a private company is the same as the income year: s 203-45. For other companies the franking periods are set out below: s 203-40. Length of income year Less than 6 months 6 to 12 months 12 months Greater than 12 months

Number of franking periods 1 2 2 3 or more

Length of franking period(s) Income year 6 months + remainder 6 months + 6 months 6 months + 6 months + remainder

Together, these periods make up the franking year. These periods are a key element in the operation of the benchmark rule, which is discussed at [21 710]. EXAMPLE [21 655.10] Vazquez Limited is an unlisted public company. It was set up on 1 June 2016, and its income year is 12 months. Assume that Vazquez Limited lodges a single tax return for the 2016-17 income year. This means that the company has an income year of 13 months. The 3 franking periods and their respective lengths are illustrated below. -XQH

1RY

0D\

-XQH

[21 660] Franking account The rules for the operation of franking accounts are contained in Div 205. Every entity that is (or has ever been) a corporate tax entity (see [21 400]) has a franking account.. A franking account is a rolling balance account, so the balance of the account rolls from one income year to the next. For an example of movements in a franking account, see [21 700]. A franking account is not required to form part of a company’s ledger accounts or financial statements. However, a franking surplus held by a company at year-end constitutes an ‘‘asset’’ that will be of interest to its shareholders. Generally, shareholders would be particularly interested to look at the company’s accounts to determine its ability to pass on franked distributions. Franking assessments The Commissioner may make an assessment of a corporate tax entity’s franking account balance at the end of the income year (a franking assessment), giving the entity notice of that assessment as soon as practicable after making the assessment: s 214-60(1), (2). A corporate tax entity’s first franking account for the year is deemed to be a franking assessment: s 214-65. If a franking account return is not required (see [46 120]), the Commissioner has 3 years (from the later of when the income tax return was lodged or required to be lodged) to make an assessment: s 214-60(1A). A corporate tax entity dissatisfied with an assessment may object against it in accordance with Pt IVC TAA (see Chapter 49): s 214-80. 852

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[21 680]

[21 670] Franking a distribution For a distribution to be franked it must (s 202-5): • be a frankable distribution: see [21 410]; • be paid by a ‘‘franking entity’’ (see [21 650]) that satisfies the residency requirement when the distribution is made: see below; and • have franking credits allocated in compliance with the ‘‘benchmark rule’’: see [21 710]. In addition, the franking entity must provide to the recipient a distribution statement. The amount of franking credits is the amount stipulated on the distribution statement: s 202-60(1). A franking entity satisfies the residency requirement if the entity is an Australian tax resident according to ordinary principles: s 202-20. For a company, this will be satisfied if the company was incorporated in Australia or it carries on a business in Australia and its central management and control is in Australia: see [2 150]. Corporate limited partnerships, corporate unit trusts and public trading trusts must also satisfy the general definition of residency. The maximum franking credits that can allocated to a distribution is the amount of the frankable distribution multiplied by a factor worked out by dividing one by the corporate tax gross-up rate: s 202-60. As the standard corporate tax rate is 30%, the ‘‘corporate tax gross-up rate’’ is 70%/30%, ie 2.3333 (see the definition of ‘‘corporate tax gross-up rate’’ in s 995-1). This means that the multiplication factor for working out the maximum franking credits is 1/2.333. EXAMPLE [21 670.10] Bertone Pty Ltd has after-tax profits of $7,000 available for distribution. It decides to pay $3,500 of this after-tax profit (ie a frankable distribution) to its shareholders. The maximum franking credit that the company can attach to this distribution is calculated as follows: $3,500 × 1/ 2.3333 = $1,500

For small business entities that benefit from the reduced corporate tax rate (28.5%), the franking credit cap is nevertheless set at the standard corporate tax rate (30%). If the proposed reductions in the company tax rate (see [20 030]) become law, the maximum franking credits that can be allocated to a distribution will be worked out by multiplying the amount of the distribution by 1/applicable gross-up rate. The ‘‘applicable gross-up rate’’ is defined as the corporate tax gross-up rate for the income year in which the distribution is made. The ‘‘corporate tax gross-up rate’’ is defined as 100% – corporate tax rate / corporate tax rate. The corporate tax rate of the distributing entity is worked out on the assumption that the entity’s aggregated turnover for the income year is equal to its aggregated turnover for the previous income year. This is to address the problem that the entity may not know is actual applicable income tax rate until it prepares its income tax return following the conclusion of the income year (see para 1.71 of the Explanatory Memorandum to the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016).

[21 680] Franking credits Generally, a franking credit will arise on the payment of tax or receipt of franked dividends. The maximum franking credit for a distribution is equivalent to the maximum amount of income tax that the entity making the distribution could have paid, at the standard corporate tax rate (30%), on the profits underlying the distribution: s 202-55. Franking credits for PAYG instalment payments and corporate income tax only arise if the entity is a ‘‘franking entity’’ (see [21 650]) and satisfies the ‘‘residency requirement’’ in s 205-25. © 2017 THOMSON REUTERS

853

[21 680]

COMPANIES – DIVIDENDS AND IMPUTATION

In order to satisfy the residency requirement, a company or corporate limited partnership must be an Australian resident for more than half of the income year, or if in existence for less than half of the income year, at all times while the entity exists. An entity that qualifies as a corporate unit trust or a public trading trust automatically satisfies the residency requirement. A franking credit arises in the circumstances set out in the table below (s 205-15). Item 1

2

3

4

If: A credit of: the entity pays a PAYG that part of the instalment payment that is attributable to the period during which the entity was a franking entity (less any reduction under s 205-15(4): see below) the entity pays income that part of the tax payment that is attributable to the period during which the entity was a franking entity (less any reduction under s 205-15(4): see below) a franked distribution is the franking credit on made to the entity; and the distribution the entity is entitled to a tax offset because of the distribution under Div 207 • a franked distribution flows indirectly to the entity through a partnership or the trustee of a trust; and

the entity’s share of the franking credit on the distribution

Arises: on the day on which the payment is made (see ATO ID 2004/836)

on the day on which the payment is made

on the day on which the distribution is made (note s 960-120 defines ‘‘made’’ as including ‘‘taken to have been made’’) at the end of the income year of the last partnership or trust interposed between the entity and the corporate tax entity that made the distribution

• the entity is entitled to a tax offset because of the distribution under Div 207 5

6

7

the entity incurs a liability to pay franking deficit tax under s 205-45 or s 205-50 a franking credit arises under s 316-275 because a friendly society (or a wholly-owned subsidiary) receives a refund of income tax a franking credit arises under s 418-55(1) in relation to an exploration credit (see [29 030])

the amount of the liability

immediately after the liability is incurred

the amount of the debit at the same time as specified in the franking debit s 316-275(3) arises

the amount of the franking credit specified in s 418-55(2)

at the same time the exploration credit is issued

If the above criteria are satisfied, a franking credit will only arise to the extent the entity is a franking entity and the residency requirements are met. If an entity is not a franking 854

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COMPANIES – DIVIDENDS AND IMPUTATION [21 690]

entity for the entire period to which the PAYG instalment relates, or entire year that the income tax relates, the franking credit will be reduced on an attribution basis. Despite Items 1 or 2 above, no franking credit arises on that part of a payment that is attributable to a payment of income tax in relation to an RSA component: s 205-15(3). In addition, a franking credit must be reduced (but not below zero) in accordance with the method statement in s 205-15(4) where a refund of income tax is attributable to the refundable R&D tax offset under Div 355 ITAA 1997 (discussed at [11 020] and following). In effect, a franking credit will not arise until the deferred franking debits (see [21 690]) are recovered. Franking credits cannot arise from a voluntary payment of tax. Section 205-20 ensures that a PAYG instalment or income tax is paid for franking account purposes only when a liability arises to make such a payment and the payment is made to satisfy that liability, or a credit or a RBA surplus is applied to that liability. Note that if the Commissioner allocates a payment to the taxpayer’s running balance account, which records the primary tax debts notified on an activity statement in accordance with the policy in Practice Statement PS LA 2011/20 (see [52 050]), and the payment does not fully satisfy a PAYG instalment liability, franking credits will not arise in relation to the PAYG instalment amount that remains outstanding (see Practice Statement PS LA 2001/13). Generally, a company does not pay income tax which will generate franking credits until after the end of the first income year during which it derives taxable income. If a company pays a franked distribution during that year, it will incur a franking deficit liability. While there will be a matching franking deficit tax offset, it will be reduced by 30%. To remove this disincentive for a private company to pay a franked distribution in its first profitable income year, the reduction is not imposed if the conditions in s 205-70(5) are satisfied: see [21 750].

Franking credits for franked dividends received The other major source of franking credits for many companies will be the receipt of franked dividends from other companies, subsidiaries in particular. This concept is simple – the franking credit attaching to a franked dividend flows unimpeded through a chain of companies.

[21 690] Franking debits The circumstances in which a franking debit will arise and the timing of that debit are set out in the table below (s 205-30). Note that there is no Item 8 (it was repealed) and that Items 10-12, which deal with friendly societies and their subsidiaries, have not been reproduced. Item 1 2

If: A debit of: a franking entity makes the amount of franking a franked distribution credits allocated to the distribution an entity receives a the amount of refund refund of income tax (attributable for any (s 205-35 sets out the period the entity was circumstances when not a franking entity) an entity receives a refund of income tax – it does not include where there is a refund of a film tax offset: see ATO ID 2015/16)

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Arises when: the distribution is made

• the entity receives the refund; or • the Commissioner applies a credit, or an RBA surplus, against a liability or liabilities of the entity, and this represents a return to the entity of an amount paid or applied to satisfy the entity’s liability to pay income tax

855

[21 690]

COMPANIES – DIVIDENDS AND IMPUTATION Item 2A

3

4 5

If: a non-resident franking entity with a franking account in surplus receives a tax offset refund an entity makes an underfranked distribution

an entity ceases to be a franking entity an entity makes a linked distribution

6

an entity issues tax-exempt bonus shares instead of making a distribution

7

Commissioner determines a franking debit should arise because the entity is streaming imputation benefits to members most able to benefit the transfer of an amount into a company’s share capital account ‘‘taints’’ the account in terms of Div 197

7A

7B

9

A debit of: that part of the refund attributable to the period the entity was a franking entity, but limited to the surplus the franking percentage that is less than the entity’s benchmark franking percentage for the relevant franking period. an amount equal to the franking surplus an amount equal to the franking debit if the entity had made a distribution with franking credits equal to its benchmark an amount equal to the franking debit if the entity had made a distribution with franking credits equal to its benchmark the amount specified in the determination

transferred amount × 30/70 × benchmark franking percentage (‘‘BFP’’) (see [22 070]) (assuming the applicable corporate tax rate is 30%) a company chooses to excess amount arising untaint its share capital if BFP for untainting account period > BFP for tainting period: s 197-65(3) a company buys back equal to the debit that a share on-market would have arisen if the buyback was off-market and distribution were franked at benchmark franking percentage (or 100% if no benchmark)

Arises when: the refund is received

the distribution is made

the entity ceases to be a franking entity the linked distribution is made

the shares are issued

the determination is given

immediately before the end of franking period in which transfer is made

immediately before end of franking period in which choice is made the interest is purchased

Despite Item 2 above, no franking debit arises on that part of a refund that is attributable to a payment of income tax in relation to an RSA component: s 205-30(2)(a). Similarly, no franking debit arises on that part of a refund of income tax that is attributable to the refundable R&D tax offset under Div 355 ITAA 1997 (discussed at [11 020] and following) – the franking debit is effectively deferred: s 205-30(2).

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[21 710]

[21 700] Example of franking account Reproduced below is an example of entries in a franking account (the example assumes a corporate tax rate for imputation purposes of 30%). Debit $ 1 Jul 2016 28 Jul 2016

20 Sep 2016

28 Oct 2016

28 Feb 2017

6 Apr 2017

28 Apr 2017

16 Jun 2017

30 Jun 2017

Opening balance Payment final instalment of 2015-16 tax of $35,000 Fully franked dividend of $140,000 received (credit = $140,000 × 30 ÷ 70) Payment first instalment of 2016-17 tax of $43,000 Payment second instalment of 2016-17 tax of $45,000 Refund on 2015-16 assessment of $28,000 Payment third instalment of 2016-17 tax $48,000 Payment fully franked dividend of $450,000 (debit = $450,000 × 30 ÷ 70) Closing balance (equals opening balance on 1 July 2017)

Credit $ 35,000

Balance $ 46,000 81,000

60,000

141,000

43,000

184,000

45,000

229,000

28,000

201,000

48,000

192,857

249,000

56,143

56,143

[21 710] Benchmark rule Under the ITAA 1936 franking rules, companies were required to frank a distribution to the maximum extent possible having regard to the company’s franking account surplus and future dividend commitments at the time of the payment. The ITAA 1997 imputation regime allows franking entities to choose the rate of franking allocated to the distributions (expressed as a percentage of the maximum franking credits available), provided that such percentage does not exceed 100%. To ensure the uniformity of franking of the distributions for each and every recipient and to prevent franking credit streaming, a benchmark rule was introduced. The benchmark rule provides that all frankable distributions made by an entity during a franking period (see [21 655]) must be franked to the same percentage – the benchmark franking percentage: ss 203-5, 203-25. The benchmark franking percentage is the same as the franking percentage for the first frankable distribution made by the entity within the relevant franking period: s 203-30. The franking percentage is worked out under s 203-35 and cannot exceed 100%. For public companies this means that distributions within a six-month period must be franked carefully. For private companies the period is generally 12 months. However, significant inter-period differences need to be disclosed: see [21 740]. © 2017 THOMSON REUTERS

857

[21 720]

COMPANIES – DIVIDENDS AND IMPUTATION

If all distributions made by the entity are unfrankable distributions, the entity does not have a benchmark franking percentage for the franking period. If, on the other hand, the entity makes a frankable distribution, but decides not to frank it, the benchmark franking percentage is 0%. EXAMPLE [21 710.10] Bartemis Pty Ltd makes an unfrankable distribution of $100 and then a further frankable distribution of $500 which it franks at 50%. Both distributions occur in the same franking period. Under the benchmark rule the benchmark franking percentage of Bartemis Pty Ltd for the franking period is 50%. This means that a frankable distribution of $500 would have $107 of franking credits attached to it, which is half of the maximum franking credits available (0.5 × 500 × 30/70), assuming that the applicable corporate tax rate for imputation purposes is 30%.

With the exception of some listed public companies and their wholly owned subsidiaries, the benchmark rule applies to all franking entities. Section 203-20 lists criteria which must be satisfied by a listed public company in order to be exempt from the operation of the benchmark rule. The exemption is available to a listed public company or its wholly owned subsidiary if: • the company cannot make a distribution on a membership interest without also making a distribution (under the same resolution) to all other membership interests; and • the company cannot frank a distribution without franking distributions on all membership interests. Section 203-20(2) gives the following examples of circumstances that will satisfy the above requirements. • A company has a single class of membership interests. • A company’s constitution prevents the company from making a distribution only in respect of certain membership interests or franking a class of membership interests in excess of other classes. Interests that are ‘‘debt interests’’ under the debt equity rules (see Chapter 25) will not constitute a membership interest: ss 960-130 and 960-135. However, non-share equity interests will be subject to the benchmark rule (ATO ID 2010/53).

[21 720] Consequences of breaching the benchmark rule If an entity to which the benchmark rule applies franks a distribution in breach of the benchmark rule (by either over-franking or underfranking the distribution), the entity will be subject to a penalty (in the form of over-franking tax or a franking debit) under s 203-50. The recipient of the distribution will still be able to get the benefit of the franking credits attached to the distribution. The s 203-50 penalty is calculated by reference to the difference between the actual franking credits allocated to the distribution and credits allowed under the benchmark rule (the franking percentage differential). The Commissioner may make a determination under s 203-55 permitting the entity to use a franking percentage which is different from its benchmark franking percentage: see [21 730]. The formula for calculating the over-franking tax or a franking debit is as follows: franking % differential × amount of frankable distribution × [standard corporate tax rate ÷ (100% − standard corporate tax rate)]

The standard corporate tax rate is 30%. 858

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COMPANIES – DIVIDENDS AND IMPUTATION [21 730]

If the proposed reductions in the company tax rate (see [20 030]) become law, the formula will be: Amount of the frankable distribution

x

Franking % differential Applicable gross-up rate

The applicable gross-up rate means the corporate tax gross-up rate for the income year in which the distribution is made. The corporate tax gross-up rate is defined as 100% – corporate tax rate / corporate tax rate. If the actual franking credits allocated to the distribution exceed the credits allowed under the benchmark rule, an entity will be liable to pay overfranking tax (imposed by New Business Tax System (Over-franking Tax) Act 2002). Unlike franking deficit tax, which effectively amounts to prepayment of income tax, the over-franking tax does not give rise to a franking credit in the franking account, and cannot be offset against future tax instalments. If a company miscalculates the amount of credits required to meet the benchmark rule in a subsequent distribution and therefore has insufficient credits available, the rule will still apply. EXAMPLE [21 720.10] Assuming the same facts as in Example [21 710.10], Bartemis Pty Ltd makes its third distribution in the same franking period of $300 and fully franks it. The franking differential is 50% (100% − 50%). The amount of over-franking tax is $64 (50% × 300 × 30/70).

If the actual franking credits allocated to the distribution fall short of the amount of credits required under the benchmark rule, a penalty franking debit will arise in the entity’s franking account. The penalty debit is in addition to the debit that already arises from payment of the distribution and is equal to the extra franking credit that should have been allocated to the distribution according to the benchmark rule. This effectively cancels out the unused credit, which means that the credit that ought to have been allocated to the distribution is wasted. If, at the end of an income year, the franking account of the entity shows a deficit (franking debits exceed franking credits), the entity will be liable to pay franking deficit tax, which could later be offset against income tax: see [21 750]. EXAMPLE [21 720.20] If, instead of fully franking the $300 distribution, Bartemis Pty Ltd franks it to 20%, the franking % differential is 30% (50% − 20%). The penalty franking debit is $39 (30% × 300 × 30 /70).

[21 730] Departure from benchmark – application to Commissioner required A franking entity may apply to the Commissioner in writing, either before or after a distribution is made, for permission to depart from the benchmark rule: s 203-55. A distribution that is franked in accordance with the Commissioner’s permission to depart from the benchmark rule is taken to comply with the benchmark rule. If permission is obtained, the rate set by the Commissioner may be used instead of the benchmark rate. The power to permit a departure from a benchmark percentage will be exercised by the Commissioner only in extraordinary circumstances. Generally, the circumstances justifying a departure would need to be unforeseeable and beyond the control of the entity, its members and controllers. A change in ownership of an entity would rarely amount to extraordinary circumstances sufficient to warrant a departure from a benchmarking percentage. The factors that the Commissioner must consider in deciding on an application are (s 203-55(3)): © 2017 THOMSON REUTERS

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• the entity’s reasons for wanting to depart from the benchmark rule; • the extent of the departure; • whether the entity has previously sought the exercise of the Commissioner’s power to permit the departure; • whether a member of the entity will receive franking benefits in preference to other members of the entity as a result of the departure; and • any other material that the Commissioner considers relevant. EXAMPLE [21 730.10] Boyden Pty Ltd has 4 shareholders. On 31 July it paid a franked distribution of $350 to each of its shareholders. The franking credit allocated to each of these distributions was intended to be $150, that is, they were all intended to be fully franked distributions. Distribution statements issued to all 4 shareholders however, because of a transposition error one of the shareholders’ distribution statements showed that franking credits of only $105 were allocated to the distribution, making the distribution partly franked. In this situation, Boyden Pty Ltd could apply to the Commissioner to allow it to change the franking credit allocated on this shareholder’s distribution by amending its distribution statement. In making this application, Boyden Pty Ltd must include all information relevant to the matters that must be considered by the Commissioner.

[21 740] Disclosure rule – benchmark variations An entity may be required to notify the Commissioner in writing if the benchmark franking percentage for a franking period differs from the benchmark franking percentage for the most recent franking period in which a frankable distribution was made: s 204-70. Notification is required if the benchmark percentage differs by more than the amount worked out under s 204-70: s 204-75. This amount is 20 percentage points multiplied by the number of franking periods since the last frankable distribution was made, up to and including the current franking period. EXAMPLE [21 740.10] Ting Ting Pty Ltd has: • a benchmark franking percentage of 0% in Year 1; • no benchmark franking percentage in Year 2 (no frankable distributions); • a benchmark franking percentage of 30% in Year 3. The benchmark percentage of Ting Ting Pty Ltd in Year 3 has not varied by more than 40 percentage points (2 × 20%), hence it has no obligation to disclose.

The purpose of this disclosure rule is to assist the Commissioner in identifying cases where the anti-streaming rules (see [21 850]) may apply. Variations between benchmark franking percentages from period to period may indicate that franking credits are being streamed. Note that this disclosure rule does not apply to an entity to which the benchmark rule does not apply. The Commissioner may request the franking entity to (s 204-80): • provide reasons for setting the significantly varied benchmark franking percentage; • provide the franking percentage for all frankable distributions made in the current and last relevant franking period; 860

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[21 750]

• provide details of any other benefits given to the entity’s members, either by the entity or an associate of the entity, which took place from the beginning of the period in which the last frankable distribution was made to the end of the current period; • advise whether any of the entity’s members have derived, or will derive, a greater benefit from the imputation credits than another member of the entity as a result of the variation in the benchmark franking percentage period; and • provide any other information required by the Commissioner.

[21 750] Franking taxes As noted at [21 720], a corporate tax entity will incur: (a) ‘‘over-franking tax’’ if the franking percentage for a distribution exceeds the benchmark percentage; or (b) a franking debit if the franking percentage is less than the benchmark rate (this debit is in addition to the debit that arises in the account on payment of the distribution).

Franking deficit tax A corporate tax entity will be liable to pay franking deficit tax if its franking account is in deficit at the end of an income year: s 205-45(2). The amount of tax payable is the amount of the entity’s franking deficit at that time. s 5 New Business Tax System (Franking Deficit Tax) Act 2002. Franking deficit tax can be offset against the entity’s income tax: s 205-70(1), (3). If the company has a franking deficit at the end of the year which is more than 10% of all the franking credits that arose during the year, the company’s franking deficit tax tax offset will be reduced by 30%: s 205-70(2). EXAMPLE [21 750.10] Victoday Pty Ltd has a $5,000 franking deficit at the end of the income year. In the year, there were a total of $20,000 of franking credits to the company’s franking account. The company has a franking deficit tax liability for $5,000. Since the amount of the franking deficit is more than 10% of the total franking credits, the company loses the entitlement to offset 30% of the amount of the franking deficit tax (ie 30% of $5,000 being $1,500) against its tax payable.

However, only franking deficit tax attributable to Item 1, 3, 5 or 6 in the table in s 205-30 (see [21 690]) is taken into account to determine whether the 30% reduction applies: s 205-70(8). If an entity has franking debits that arise under one or more of Item 1, 3, 5 or 6 in the table in s 205-30, all franking debits that arise under Item 2 in that table will also be taken into account to determine whether the 30% reduction applies. The Commissioner has the discretion to disregard the 30% reduction if, following an application by the entity in the approved form, the Commissioner determines, in writing, that the franking debits that caused the franking deficit arose due to events that were outside the entity’s control: s 205-70(6), (7). For example, if a company pays a fully franked dividend part way through an income year in the reasonable expectation that future quarterly PAYG instalment payments in the year will be sufficient to ensure that there will not be a deficit in the franking account at the end of the year, but an unexpected downturn in business results in the company’s future quarterly PAYG instalment payments being less than expected, the discretion may be exercised.

No FDT offset reduction in private company’s first taxable year The 30% FDT tax offset reduction, where a private company’s FDT liability is more than 10% of its franking credits for the income year, does not apply in the first income year in which the company has an income tax liability: s 205-70(5). This concession is designed to © 2017 THOMSON REUTERS

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enable a private company to make franked distributions in its first taxable year (ie before it would have franking credits attributable to the payment of tax) without incurring the penalty that a reduction in its FDT tax offset would represent. The reduction is not applied if the following conditions are satisfied: (a) if the company did not have the FDT offset (but retained its entitlement to all other tax offsets), it would be liable to tax in the relevant year; (b) the company had no income tax liability in any previous income year; and (c) the tax liability under para (a) is at least 90% of company’s franking account deficit at the end of the relevant year, ie the company’s freedom to frank without penalty is constrained by having to maintain a close alignment between the franking credits it allocates and the tax liability it incurs. EXAMPLE [21 750.20] Panthaco is a private company that commenced business during the 2014-15 income year. During the 2016-17 income year, the company derives taxable income of $100,000 in respect of which it would expect to have an income tax liability of $30,000. This is the first year in which the company has had an income tax liability. During the year, the company makes a franked distribution of $70,000. This gives rise to a franking debit of $30,000 and a franking account deficit at year end. This results in the company having a FDT liability of $30,000 for the year. Under the normal application of the FDT offset calculation rules, Panthaco’s FDT amount ($30,000) would be reduced by 30% to $21,000 because its FDT liability was more than 10% of its franking credits (it had no franking credits). However, as 2016-17 is the company’s first taxable year and its tax liability for the income year ($30,000) is at least 90% of its franking account deficit, the 30% reduction in Panthaco’s FDT offset will not apply.

Deficit deferral tax Unlike the former arrangements, the ITAA 1997 imputation regime does not separately impose a ‘‘deficit deferral tax’’. Instead, as disincentive to overpay tax to avoid franking deficit tax, s 205-50 will treat a refund of tax for an income year as having been paid at the end of that income year if: (a) the refund is paid within 3 months of the end of that year; and (b) the franking account would have been in deficit (or the deficit would have been greater) if the refund had been received in that income year. This will result in a recalculation of franking deficit tax.

[21 760] Distribution statements An entity that is not a private company for the income year in which a distribution is made, must give a distribution statement on or before the day on which the distribution is made: s 202-75. See ATO ID 2006/330 for circumstances where a public company may issue a valid distribution statement after a frankable distribution is paid. On the other hand, a private company has up to 4 months after the end of the income year in which a distribution is made to give a distribution statement (and the Commissioner has the discretion to allow more time): s 202-75. It is intended that this flexibility will effectively allow private companies to retrospectively frank a distribution. However, in practice, most private companies will seek to determine the franking percentage at the time the distribution is made.

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[21 770]

EXAMPLE [21 760.10] Savcor Pty Ltd is a private company with 5 shareholders. It prepares its income tax return on a 30 June basis. During the income year it makes distributions totalling $7,000. However, in preparing its income tax return for the year, Savcor Pty Ltd establishes that, on the last day of the income year (ie 30 June), it had a surplus balance in its franking account of $6,000. This surplus was the result of carrying forward the franking account balance from the previous franking year and by paying its PAYG instalment liabilities during the income year in question. On 1 October next, Savcor Pty Ltd issues distribution statements to its 5 shareholders which state, among other things, that each shareholder received a frankable distribution of $1,400 together with franking credits of $600 (that is, the distribution was fully franked).

The franking percentage is the extent to which a frankable distribution has been franked. It is expressed as a percentage of the frankable distribution, rather than the whole of the distribution. Thus in the circumstances where a distribution contains both a frankable and unfrankable element, the franking percentage may be 100% even if only part of the total distribution is frankable.

[21 770] Distributions on non-share equity It is a convenient generalisation when describing the debt/equity rules in Div 974 to say that certain debts are treated as equity for tax purposes. So returns on non-share equity are not deductible: s 26-26 ITAA 1997. However, while many of the implications of non-share equity are akin to shares, there are important differences. The legislation distinguishes the definition of non-share dividend from that of dividend, ie a ‘‘non-share dividend’’ is not a ‘‘dividend’’ as defined. This is a key definitional issue which allows the treatment of non-share dividends to diverge from the tax treatment of dividends. The debt and equity rules are discussed in detail in Chapter 31. Treatment of distributions on non-share equity as non-share dividends rather than non-share capital returns Under s 974-120(2) a non-share distribution is not a non-share dividend to the extent to which the company debits the distribution against either the company’s non-share capital account or the company’s share capital account. The flexibility to make a distribution which is respected as a return of capital is less than that allowed by a company in respect of legal form shares. The company may only validly debit the non-share capital account if the distribution is in consideration of the surrender, cancellation or redemption of a non-share equity interest in the company or the distribution is made in connection with and is equal to, a reduction in market value (see [3 210]) of a non-share equity interest in the company. Non-share dividends are assessable notwithstanding the absence of profit The debt/equity rules resulted in s 44(1) ITAA 1936 being amended. This section relevantly provides that the assessable income of a shareholder in a company includes all non-share dividends paid to the shareholder by the company or if the shareholder is a non-resident non-share dividends paid to the shareholder by the company to the extent to which they are derived from sources in Australia. This puts real pressure on the capital return issue discussed above. If a company gets the capital return wrong so that it is treated as a non-share dividend, then the result is automatic assessability under s 44(1). Franking non-share dividends Non-share dividends are not frankable unless profits are available: see s 215-15. The critical term here is ‘‘available franking profits’’. Broadly, these are available profits after taking into account claims on those profits referable to certain dividends and non-share dividends. © 2017 THOMSON REUTERS

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The purpose behind the rules is to counter the potential for the streaming of franking credits in circumstances where there is no such opportunity under current law because a relevant company has no profits.

[21 780] Ability to frank distributions – practical considerations Companies should be aware that their ability to frank distributions may be directly influenced by: • the automatic loss of a potential franking account surplus if a distribution is franked in contravention of the benchmark rule and the operation of the franking deficit taxes (FDT) and the franking additional tax (FAT); • the amount of foreign tax paid in respect of foreign-sourced income; • the extent to which the company is able to avail itself of tax concessions; • the operation of the ‘‘capital benefit’’ streaming restrictions in ss 45 to 45D and both the specific anti-streaming provisions, and the general anti-streaming provision, s 177EA or • future obligations to make payments in respect of non-share membership interests.

Reserves and franking account levels The extent to which a corporate entity can pay franked distributions is dependent upon the level of its franking accounts. The franking account surplus at any given time will indicate to the corporate entity the amount of fully franked distributions that it can pay. Ordinarily, should the corporate entity wish to pay distributions in excess of the franking surplus, then a percentage of the distributions will be unfranked. Consequently, should the corporate entity decide to pay distributions out of reserves pre-imputation then the shareholders will be subject to tax in respect of those distributions. Differences between tax and accounting income must always be taken into account. Absence of tax profits generally results in the unavailability of franking credits. EXAMPLE [21 780.10] 1 July Capital profit reserve

$ Asset revaluation reserve

55,000

Accumulated profits Franking surplus Company has net trading income of $210,000.

20,000 Nil

Revenue reserve

Allowable deductions are: • Depreciation allowed on income-producing buildings: $400,000 × 2½% = $10,000 • Depreciation allowed on depreciating assets: $75,000 In addition, the company sold a capital asset (acquired for a cost of $60,000), the details being as follows. Capital proceeds 120,000 Cost base 80,000 Taxable capital gain 40,000 The company’s position is as follows: Accounting profit: $270,000 ($210,000 + $60,000) Taxable income: $165,000 [($210,000 + $40,000) − ($10,000 + $75,000)]

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[21 800]

Company tax payable on $165,000 (at the 30% rate) would be $49,500 resulting, upon assessment, in a franking credit of $49,500. Take the situation where the company wished to pay the following cash dividends. 1. $70,000 2. $115,500 3. $270,000 4. $310,000 The percentage to which the distributions would be franked are as follows. 1. 100% (ie fully franked) – a surplus of $19,500 would remain in the franking account. 2. 100% – however, the franking account balance would be nil. 3. 43% – here the accounting profit has been distributed; however, due to the tax concessions the tax has been reduced limiting the credit that may be passed on to the shareholder. 4. 37% – here the company has distributed accounting profit and $40,000 from its capital reserves. As the reserves were not subject to tax at the rate of 30% and such dividends are taxable distributions, the company’s ability to frank the distribution has been further reduced. If the shareholder was on the highest marginal rate, he or she would therefore be subject to tax on the unfranked component of the distributions received. Effectively, the benefit the company receives in respect of tax concessions has increased the shareholder’s liability.

INTEGRITY RULES [21 800] Integrity rules – overview A number of measures have been introduced to maintain the integrity of the imputation system. Several of the measures apply by reference to repealed sections of the ITAA 1936, but are intended to be re-enacted in the ITAA 1997: • the consequences of manipulating the imputation system. These are set out in Subdiv 207-F. This sets out the consequences where various specified integrity rules are applied, ie there is no gross-up of the entity’s assessable income and any tax offset to which the entity would have otherwise been entitled as a result of the distribution is denied: see [21 810]. • dividend stripping rules: see [21 820]; • rules relating to the ‘‘linked distributions’’ rules: see [21 830]; • substituting tax exempt bonus shares for franked dividends: see [21 840]; • anti-streaming provisions designed to ensure that franking benefits are not streamed to members who are in a position to derive a greater benefit from franking credits than other members: see [21 850]; • Pt IVA which has been extended to include imputation benefits: see [21 860]; • the 45-day holding period and related payment rules which are directed at franking credit trading: see [21 880] and [21 890]; and • rules to prevent franking credit benefit trading in a consolidation environment: see [21 870]. © 2017 THOMSON REUTERS

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The 45-day holding period and related payment rules are still found in the ITAA 1936 and have not yet been rewritten in the ITAA 1997. Although the ITAA 1936 imputation provisions have been repealed, the Tax Office considers that the 45-day holding period and related payment rules have been ‘‘imported’’ into the ITAA 1997 regime via the anti-manipulation rule in s 207-145(1)(a) (discussed at [21 810]): see Determination TD 2007/11. Note that the Government rejected a proposal to rewrite the relevant ITAA 1936 provisions into the ITAA 1997 (see the then Assistant Treasurer’s media release (item 75), 14 December 2013).

Dividend washing A specific integrity rule (s 207-157) addresses certain dividend washing transactions (from 1 July 2013). The transaction of concern involves the sale of shares ex dividend and the purchase of the same company’s shares cum dividend, thereby obtaining a double entitlement to franking credits. (The Australian Securities Exchange allows this special cum dividend market for 2 days after a share goes ex dividend.) The rule is activated during the period between the dividend date and the record date of a membership interest, where a membership interest is disposed of on an ex dividend basis and a substantially identical membership interest is acquired cum-dividend. In such a case, the rule denies franking benefits in respect of the newly acquired shares. In addition, the Tax Office has stated that it will seek to apply s 177EA (discussed at [21 860]) to such arrangements, at least where they are in place before 1 July 2013: see Determination TD 2014/10.

[21 810] No gross-up and credit if imputation system manipulated The general rule in s 207-20 under which taxpayers apply a ‘‘gross-up and credit’’ treatment on the receipt of a franked distribution does not apply if the imputation system has been ‘‘manipulated’’ in the circumstances described in Subdiv 207-F. Subdivision 207-F applies if: • the entity is not a ‘‘qualified person’’ for the purposes of holding period rules under the ITAA 1936 imputation regime (s 207-145(1)(a)), eg Determination TD 2003/32 regarding scrip loan and call option arrangements. Specific holding rules for the ITAA 1997 imputation regime have not yet been enacted. Notwithstanding this, the intention is that the ITAA 1936 holding period rules (see [21 880] and [21 890]) continue to apply: see Determination TD 2007/11 and [21 880]; • the Commissioner has made a determination under s 204-30(3)(c) that, as a result of the streaming of distributions, the recipient is not entitled to an imputation benefit: see [21 850]; • the distribution is part of a dividend stripping operation: see [21 820]; or • the Commissioner has made a franking credit benefit determination under s 177EA(5)(b): see [21 860]. For an entity that receives a distribution directly, the effect of Subdiv 207-F is that the distribution will not be grossed up and the entity will not be entitled to a tax offset. Whether or not a corporate recipient will be entitled to a credit to its franking account will depend on satisfying the particular requirements for a credit. In the particular case of a determination being made under s 177EA(5)(b), the gross-up and tax offset is calculated by the following formula: [(franked distribution – specified part) ÷ franked distribution] × franking credit

In the case of a distribution that flows indirectly, adjustments will be made to the assessable income of the interposed trust or partnership to achieve a similar outcome as for direct distributions. 866

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[21 830]

[21 820] Dividend stripping Division 207 contains a number of specific provisions that are designed to prevent companies and individuals from gaining any benefit from franking credits that are received as part of a dividend stripping operation. Dividend stripping is generally considered to be an arrangement whereby a company purchases shares in another company that has accumulated profits, the newly acquired company declares dividends to the new parent company, which then sells the shares in the newly acquired company after, as will be apparent, effectively stripping that company of accumulated profits and consequently its assets to the extent of its profits. It is suggested in certain circumstances that the sale step is unnecessary, the language ‘‘a scheme having substantially the effect of a scheme by way of or in the nature of a dividend stripping’’ is used as in s 177E. Provisions dealing with dividend stripping are designed to support the benchmark rule and: • prevent companies involved in dividend stripping operations from receiving franking credits in respect of franked dividends paid as part of the dividend stripping operation; • prevent resident individuals and certain trustees from receiving the benefit of any franking credits attached to franked distributions that are paid as part of a dividend stripping operation. Section 207-155 provides that a distribution is to be regarded as being paid as part of a dividend stripping operation if the payment of that dividend arose out of or was made in the course of a scheme that: • was by way of or in the nature of dividend stripping; • had substantially the effect of a scheme by way of or in the nature of dividend stripping. ‘‘Scheme’’ is defined in s 995-1 and has the same meaning as that contained in s 177A: see [42 100]. Dividend stripping has not been meaningfully defined, although the loose definition provided in s 207-155 parallels that contained in s 177E(1): see Ruling IT 2627 for guidelines regarding the application of s 177E to dividend stripping arrangements (particularly note para 35); see also Determination TD 95/37. The meaning of ‘‘dividend stripping’’ in s 177E was discussed by the High Court in FCT v Consolidated Press Holdings Ltd; CPH Property Pty Ltd v FCT (2001) 47 ATR 229. Section 177E is considered at [42 330]. Sections 207-145 and 207-150 provide that if a distribution is made as part of a dividend stripping operation, no gross-up amount will be included in assessable income. Thus, there will be no entitlement to a tax offset. See Draft Ruling TR 2014/D1 for situations where s 207-150 may apply in the context of an employee remuneration trust (the Commissioner has indicated the draft will be reissued).

[21 830] Linked distributions A ‘‘linked distribution’’ occurs where another entity pays an unfranked or partly franked distribution (s 204-15(1)) to a member in place of the payment or proposed payment by an entity of a franked distribution to a member of the entity. In this category, it is only necessary that the unfranked ‘‘linked distribution’’ be paid to a member in lieu of the payment by an entity of a franked distribution to its member, ie any member, including an interposed entity. If the linked distribution provisions apply, the entity with the highest benchmark franking percentage will incur a penalty franking debit: s 204-15(2). This debt arises on the day © 2017 THOMSON REUTERS

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distribution is made and is equal to the amount that would have arisen if the distribution had been made at the relevant entity’s benchmark franking percentage. If the relevant entity does not have a benchmark franking percentage, the entity is deemed to have a percentage of 100% if the linked distribution has a franking percentage of less that 50%. If the franking percentage of the linked distribution is equal to or greater than 50%, the benchmark franking percentage is deemed to be nil. Examples are stapled stock arrangements and dividend access schemes, under which another company may pay dividends to a shareholder or any other person or entity on the shareholder’s behalf who receives that dividend instead of a franked dividend from the company that established the arrangement. This may be of benefit if foreign resident shareholders in an Australian resident company are permitted to receive unfranked dividends paid by a foreign subsidiary or an offshore associated company of the Australian company. In such a case, the resident company (the debit company) pays or proposes to pay franked dividends (substituted dividends) to its resident shareholders, but other shareholders have their dividend entitlements satisfied under a streaming arrangement, whereby an unfranked or partly franked dividend (a linked dividend) is paid by a foreign subsidiary or an offshore associated company (a linked company). The linked dividend may be paid to a shareholder in the shareholder’s own right or the shareholder may be acting as a trustee for or as a representative of other shareholders.

[21 840] Substituting tax-exempt bonus shares for franked distribution The second category of distribution streaming arrangement occurs if an entity issues ‘‘tax-exempt bonus shares’’ instead of paying a franked distribution to the member. Essentially, to satisfy the definition of a tax-exempt bonus share, the amount or value of the share must be debited to a capital account, the paid-up value of the share must not be a dividend and the share must be issued either as a bonus share or in satisfaction of a dividend on shares already held within s 6BA(1). If there is a streaming arrangement within this category, a franking debit arises on the day the bonus shares are issued: s 204-25(3). The amount of the franking debit is the amount that would have arisen if the issuing entity had paid the substituted distribution instead of issuing the bonus shares. [21 850] Anti-streaming provisions Specific anti-streaming rule The specific anti-streaming rule in Subdiv 204-D ITAA 1997 applies if an entity streams the payment of distributions, or streams the payment of distributions and the giving of other benefits to its members in a way that benefits one group of favoured members who would, in the income year in which the distributions are paid, derive a greater benefit from franking credits than other members, where another group of members (disadvantaged members) will receive fewer or no franking credit benefits. Imputation benefits Under s 204-30(6) a member will receive an imputation benefit if in relation to the receipt of a franked distribution: • a franking credit arises in the member’s franking account as a result of the receipt of the franked distribution; • an imputation credit is included in its assessable income under s 207-35 as a result of the franked distribution; • the member is entitled to an exemption from dividend withholding tax under s 128B(3)(ga) in respect of the distribution because it is franked; or • the member is entitled to a tax offset as a result of the distribution. 868

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Other benefits In addition to applying if a corporate entity streams the payment of franked distributions to some members and unfranked distributions to others, Subdiv 204-D applies if a corporate entity streams the payment of franked distributions to some members and provides ‘‘other benefits’’ to other members. Examples of other benefits include (s 204-30(2)): • the issue of bonus shares in the company; • the return of paid-up share capital; • the forgiveness of a debt; and • the making of a payment of any kind, including the giving of property, whether made by the corporate entity or another person. The making of a payment on behalf of the member will include, for example, circumstances where a shareholder receives in lieu of a franked dividend a benefit in the form of the payment of superannuation contributions by the company on behalf of the shareholder. Also, the streaming of other benefits will include circumstances where, for example, a company pays a franked distribution to a particular member and that member passes on a related amount to another member (without the franking credits).

Greater benefits from franking credits In determining whether a member would derive a greater benefit from franking credits regard will be given to (s 204-30(8)): • the residence of the other member (ie because a non-resident cannot fully use franking credits); • whether the amount of tax payable on the distribution would be less than the tax offset to which the other member would be entitled; • if the other member is a corporate entity, whether it would be unable to pay a franked distribution to its members because it has insufficient profits; and • if the other member is a corporate entity, whether it would not be entitled to franking credits or would be less able to use franking credits than other companies. ATO ID 2005/31 discusses a case where an Australian resident company pays franked dividends to its A-class shareholder to the exclusion of its ordinary shareholder. The Tax Office concluded that the company did not direct distributions in such a manner as to confer greater benefits from franking upon a member that is able to derive a greater benefit from franking credits to the exclusion of a member that is unable to do so.

Commissioner’s determination If the specific anti-streaming rule applies, the Commissioner may make a determination under s 204-30(3) that either: • the corporate entity will incur a franking debit in respect of each distribution or other benefit paid or given to a disadvantaged member; or • no franking credit benefit is to arise in respect of any distribution paid to an advantaged member. The Commissioner is required to serve notice of the determination in writing on the taxpayer to which it relates. If the determination applies to a dividend paid by a listed public company, the Commissioner may publish the notice in an Australian national newspaper and it is then deemed to have been served on the day it is published: s 204-50(3). A notice is subject to the objection and appeal provisions of Pt IVC of the Taxation Administration Act © 2017 THOMSON REUTERS

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1953 (discussed in Chapter 49). A determination does not form part of an assessment (although the notice may be included in a notice of assessment or served separately).

Calculation of additional franking debit If the streaming involves the payment of distributions only, under s 204-40(1) the additional franking debit is equal to the difference between: • the franking credit (if any) of the distribution; and • the amount worked out by multiplying the distribution by the highest percentage at which a distribution to a favoured member is franked; • if the specified distribution has not been franked the amount of the distribution multiplied by the highest franking percentage at which a distribution to a favoured member is franked; or • if the specified distribution is unfrankable, the amount of the distribution multiplied by the highest franking percentage at which a distribution to a favoured member is franked; or • if the specified benefit is the issue of bonus shares from a share premium account the amount debited to the share premium account in respect of the bonus shares multiplied by the highest franking percentage at which a distribution to a favoured member is franked; or • if some other benefit is specified the value of the benefit multiplied by the highest franking percentage at which a distribution to a favoured member is franked.

Denial of franking credit benefits If the Commissioner determines that no franking credit benefit is to arise in respect of any streamed distributions paid to members, the determination has effect according to its terms: s 204-30(3). As a result: • no franking credits will arise upon the receipt of franked distributions; • no imputation benefits will apply to the receipt of franked distributions.

[21 860] Anti-avoidance – imputation benefits The general anti-avoidance rules in s 177EA apply to schemes that seek to provide a taxpayer with an imputation benefit. The preconditions for the application of s 177EA are: • a scheme for a disposition of shares or an interest in shares in a company; • a frankable dividend or a distribution has been paid, is payable or expected to be payable in respect of the shares or interest in shares; • the dividend or distribution was or is expected to be franked and, but for the section, the shareholder would receive or could reasonably be expected to receive imputation benefits from the dividend or distribution; and • having regard to the relevant circumstances of the scheme, it would be concluded that a person entered into the scheme or any part of the scheme for a purpose (whether or not the dominant purpose but not including an incidental purpose) of enabling a taxpayer to obtain an imputation benefit: s 177EA(3). The rules in s 177EA apply to non-share equity interests (under the debt/equity rules: see Chapter 31): s 177EA(12). Thus, the rules extend to equity holders (in the same way they apply to shareholders) and to non-share dividends (in the same way they apply to dividends). The rules also apply to issues of certain kinds of ‘‘dollar value’’ convertible notes that are non-share equity interests (see Ruling TR 2009/3, which is discussed at [31 320]). 870

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[21 860]

The rules in s 177EA were successfully applied by the Commissioner in Electricity Supply Industry Superannuation (Qld) Ltd v FCT (2003) 53 ATR 120, but not in Mills v FCT (2012) 83 ATR 514 (see below). The rules also applied to a scheme in the nature of dividend washing in The Trustees of the WT & A Norman Superannuation Fund and FCT [2015] AATA 914, although there are now specific rules targeting dividend washing: see [21 800]. The Government will introduce measures to prevent the distribution of franking credits where a distribution to shareholders is funded by particular capital raising activities (as identified in Taxpayer Alert TA 2015/2): see the 2016-17 Mid-Year Economic and Fiscal Outlook (MYEFO). The measures will apply to special distributions (made after 12:00pm AEDT on 19 December 2016) to the extent they are funded directly or indirectly by capital raising activities which result in the issue of new equity interests. Examples include an underwritten dividend reinvestment plan, a placement or an underwritten rights issue. Where such arrangements are entered into, the corporate entity will be prevented from attaching franking credits to shareholder distributions.

Scheme for the disposition of shares or an interest in shares The definition of ‘‘scheme’’ in s 177A(1) includes any agreement, arrangement, understanding, promise or undertaking (whether express or implied and whether legally enforceable or not) and any plan, proposal, course of action or course of conduct: see [42 100]. An example of a scheme for the disposition of shares, or an interest in shares, is the issue of a dividend access share or an interest in a discretionary trust, for the purpose of streaming franking credits to a particular shareholder or beneficiary. Another example is a securities lending arrangement under which a shareholder who cannot fully use franking credits (eg a foreign resident) ‘‘lends’’ shares to a taxpayer over a dividend period so that the dividend and attached franking credits are paid to the ‘‘borrower’’. A scheme for the disposition of shares or interest in shares includes de facto sales or dispositions: s 177EA(14). There does not need to be a legal disposition of shares or an interest in shares. According to the explanatory memorandum there will be a disposition for the purposes of the rule if a taxpayer transfers the right to receive income from shares to another taxpayer and that other taxpayer assumes the risks of share price fluctuation, even if there is no change in the legal ownership of the shares. The mere acquisition of shares or units in a unit trust if the shares or units are to be held at risk in the ordinary way will not, in the absence of further features, attract the rule, even though the shares or units are expected to pay franked dividends or distributions: s 177EA(4).

Meaning of imputation benefit The definition of an ‘‘imputation benefit’’ in s 177EA(16) corresponds with the definition of imputation benefit in s 204-30(6): see [21 850]. Similarly, the meaning of a ‘‘greater benefit from franking credits’’ in s 177EA(18) corresponds with the definition in s 204-30(8).

Incidental purpose According to the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 3) 1998 (TLAB3 1998), a purpose is an incidental purpose ‘‘when it occurs fortuitously or in subordinate conjunction with another purpose, or merely follows another purpose as its natural incident’’. By way of example, it is stated that when a taxpayer holds shares in the ordinary way to obtain the benefit of any increase in their share price and the dividend income flowing from the shares, a franking credit benefit is generally no more than a natural incident of holding the shares and is therefore an incidental purpose. In the Mills case, the High Court said that a purpose can be incidental even where it is central to the design of a scheme if that design is directed to the achievement of another purpose. The court also observed that possible alternatives may be considered (ie a ‘‘counterfactual’’ analysis) to assist in determining whether the required “purpose” exists. In © 2017 THOMSON REUTERS

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Mills the main purpose of a bank issuing hybrid securities was to raise Tier 1 capital – the purpose of enabling holders of the security to obtain franking credits was merely incidental. For an example of an arrangement under which the Commissioner regards obtaining an imputation benefit as being more than an ‘‘incidental’’ purpose, see Determination TD 2003/32 which deals with scrip loan and call option arrangements.

Relevant circumstances The test of purpose is objective: Mills v FCT. The question is whether it could be concluded that a person who entered into or carried out the scheme under which the disposition of shares occurs did so for the purpose of obtaining a tax advantage relating to franking credits. In determining the purpose of the scheme, the purpose of one of the persons who entered into or carried out the scheme (whether or not that person is the person receiving the franking credit benefit) will be sufficient to attract the rule. In deciding this question, regard must be given to the terms of the disposition and the relevant circumstances of the scheme: s 177EA(3)(e). The relevant circumstances include 8 listed factors plus any of the matters listed in s 177D(2) that are to be taken into account for Pt IVA purposes (see [42 130]): s 177EA(17). These relevant circumstances include: • the length of time for which the shares were held and the extent to which the person receiving a dividend is exposed to the risks and opportunities of holding shares or having an interest in shares, or another person is so exposed; • the tax profiles of the parties to the scheme, ie the extent to which the franking credits might provide a benefit or be wasted. The items relating to the meaning of a greater benefit from franking credits in s 177EA(19) are also relevant; • the extent to which the consideration paid by or to the relevant taxpayer (including interest calculated on loan) represents the value of franking; • associated deductions or capital losses; • whether a distribution is sourced, directly or indirectly, from unrealised or untaxed profits, and whether a distribution is equivalent to interest or an amount in the nature of interest. Other relevant factors borrowed from s 177D(2) would include whether the parties to the scheme are acting at arm’s length and whether fair value is paid or provided under the scheme. Whether dealings are in the ordinary course of business or are conducted on or off market may also be relevant.

Commissioner’s determination If both the company and the person receiving the dividend are parties to the scheme, the Commissioner has a choice as to whether to debit the company’s franking account or deny the imputation benefit to the relevant taxpayer: s 177EA(5). According to the Explanatory Memorandum to TLAB3 1998, if there are numerous shareholders it will generally be appropriate to debit the company’s franking account. However, in some cases (eg if the company has very substantial surplus credits), posting debits to the company’s franking account will not effectively counteract the scheme and thus it will be more appropriate to deny the shareholders the franking credit benefit directly. The amount of the debit to the franking account is the amount the Commissioner considers reasonable in the circumstances, not being an amount larger than the debit to the franking account occasioned by the payment of the dividend: s 177EA(10)(b). Adjustments in relation to imputation credits A beneficiary or partner is not entitled to imputation credit benefits from a trust or partnership distribution in respect of which a determination to deny imputation credit benefits is made. However, as the imputation credit is included in the assessable income of the trust or 872

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partnership, the beneficiary’s or partner’s share in the net income of the trust or partnership would, but for a consequential amendment, be inappropriately increased. Accordingly, a trust or partnership amount that is included in a taxpayer’s assessable income, in respect of which a determination to deny franking credit benefits has been made, is deductible.

[21 870] Franking credit benefits under consolidation Section 177EB was enacted as a consolidation-related integrity measure to prevent a head entity from acquiring a subsidiary to circumvent the franking credit trading scheme rules in s 177EA; see also [24 520]. Section 177EB applies if there is a scheme to dispose of a membership interest in an entity (the ‘‘joining entity’’) and, as a result of that disposition, the joining entity becomes a subsidiary of a consolidated group and a franking credit arises in the account of the head entity. If, having regard to the relevant circumstances of the scheme, it would be concluded that a person entered into or carried out the scheme for a purpose of enabling the head entity to access the credit, the Commissioner may disallow the credit. Like the operation of s 177EA the mere acquisition of shares or units in a unit trust if the shares or units are to be held at risk will not, in the absence of further features, attract the operation of s 177EB, even though the shares or units are expected to pay franked dividends or distributions. The factors listed in s 177EB(1) that will influence the Commissioner to apply s 177EB are modelled on those in s 177EA (see [21 860]) and include: • the extent and duration of the risk of loss and the opportunity to profit or gain that the parties to the scheme bear from holding the membership interest and whether the risks or opportunities have varied; • whether the head company or person holding the membership interest in the head company will, in the year the subsidiary joins the group or in any later year, derive a greater interest from the franking credits than a person who held an interest in the subsidiary before it joined the group; • the extent to which the subsidiary is able to pay a franked dividend or distribution immediately before joining the group; • whether the consideration relating to the scheme was calculated with reference to the franking credit benefits to be received by the head company; and • the period for which the head company held a membership interest in the subsidiary. The application of s 177EB includes exempting credits arising in the exempting account of the head entity.

[21 880] The 45-day holding period rule The 45-day holding period and the related payments rules (see [21 890]) are intended to counter arrangements that seek to provide franking credits to persons who were not effectively the owners of the shares that generated the benefits or were owners only very briefly. To be entitled to a franking credit in relation to a dividend, a taxpayer must be a ‘‘qualified person’’ in relation to the dividend: s 160APHO. Generally, to be a qualified person in relation to a dividend, a taxpayer must satisfy both the holding period rule, or a modification of it, and the related payments rule: see [21 890]. Special rules apply to beneficiaries of trusts: see [21 900]. Note that these rules in the ITAA 1936 have not yet been re-enacted in the ITAA 1997 imputation regime but the Tax Office stated (somewhat belatedly) in Determination TD 2007/11 that the ITAA 1936 rules have ongoing application as a result of being ‘‘imported’’ into the ITAA 1997 regime via the anti-manipulation rule in s 207-145(1)(a) (discussed at [21 810]): see [21 800]. © 2017 THOMSON REUTERS

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At-risk requirement The holding period rule is a once-and-for-all test. Once a taxpayer has satisfied the 45-day holding period (90 days for certain preference shares) and is a qualified person in relation to a dividend or distribution paid on the shares or interest held, the taxpayer is taken to be a qualified person in relation to future dividends or distributions (even if a risk reduction strategy is adopted after the qualification period). The taxpayer is not required to hold shares or an interest in shares for more than 45 days before a dividend is paid to be a qualified person in relation to that dividend; days after the dividend is paid can also be counted (although they must be within the qualifying period explained below). The primary qualification period for the holding period rule is the period commencing on the day after the day the taxpayer acquires the shares or interest and ending on the 45th day (or 90th day for certain preference shares) after the day on which the shares or interest become ex-dividend. A share or interest becomes ex-dividend on the day after the last day on which the shares or interest can be acquired so as to become entitled to the dividend or distribution on the shares or interest (ie the day after the day books are closed): s 160APHE. Relevant definitions of a ‘‘share’’, an ‘‘interest’’ in a share and the ‘‘holding’’ of a share are provided by ss 160APHD, 160APHG and 160APHH. In determining whether a taxpayer has held particular shares or interests for the required period, regard is had not only to the particular shares or interests (the ‘‘primary securities’’), but also to whether a disposal of ‘‘related securities’’ by the taxpayer, an associate of the taxpayer or if the taxpayer is a company, another company in the same wholly owned group has occurred. If such a disposal has been made, the taxpayer may be taken to have disposed of (and immediately re-acquired) the primary securities. Therefore, the scope of the definition of ‘‘related securities’’ in s 160APHI, including ‘‘substantially identical’’ securities, is quite important. (A disposal within a wholly owned group is excluded from the rule that requires rebated securities held by connected persons to constitute a group of securities: s 160APHI(5).) Broadly, the holding period rule is applied on a ‘‘last-in-first-out’’ basis (LIFO) in respect of all related securities held by connected persons: s 160APHI(4). See ATO ID 2011/96 for the Tax Office’s views on whether shares held by a connected company that fail the holding period rule from the perspective of the connected company constitute related securities for the purposes of the LIFO rule. Materially diminished risk In determining whether the holding period requirements are satisfied for the prescribed minimum period, no account is taken of any days on which the taxpayer has ‘‘materially diminished risks of loss or opportunities for gain’’ in respect of the shares or interest: s 160APHO(3). The exclusion of these days does not break the continuity of the period for which the shares or interests are held. Subject to any regulations that may be introduced, a taxpayer is taken to have materially diminished the risks of loss or opportunities for gain with respect to shares or interests if the ‘‘net position’’ of the taxpayer results in the taxpayer having less than 30% of the risks and opportunities relating to the shares or interests: s 160APHM(2). A ‘‘position’’ in relation to shares or an interest is anything that has a ‘‘delta’’ in relation to the shares or interest: s 160APHJ(2). A delta is a financial calculation that measures the relative change in the price of the shares or interest and the price of a related hedging arrangement such as an option or other derivative. A derivative with a positive delta indicates that its price is expected to rise or fall as the price of the underlying securities rises or falls, while a negative delta indicates an inverse movement. Note that if an entity leaves a consolidated group taking with it shares previously held by the head company, the exit history rule (see [24 020]) will deem the trustee of the unit trust to 874

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have inherited the head company’s net position, or delta, in relation to the shares, as if the entity had been the holder of the shares on each of the days held by the head company: see ATO ID 2006/254. The taxpayer’s net position is worked out by reference to any ‘‘long’’ or ‘‘short’’ positions under s 160APHJ. A short position in relation to shares is a position that has a negative delta in relation to those shares, such as a short sale, a sold future, a sold call option, a bought put option and a sold share index future: s 160APHJ(3). A long position in relation to shares is a position that has a positive delta in relation to those shares, such as a share purchase, a bought future, a bought call option, a sold put option and a bought share index future: s 160APHJ(4). If the net effect of any long or short positions is a delta of less than 0.3, there are materially diminished risks of loss or opportunities for gain, ie the taxpayer is exposed to less than 30% of the risks or opportunities. In ATO ID 2012/24, the methodology adopted by a fund to determine its net position in respect of particular shares – essentially deconstructing the SPI 200 Futures contracts into their open (short) component stock positions – was considered to be acceptable. If an option in relation to a share is granted to or by a party other than the issuer of the share, the option will constitute a position for the purposes of s 160APHJ(2), whether the option is granted as part of the issue terms of the share (that is, it is ‘‘embedded’’ in the share) or is granted under a separate transaction: see Determination TD 2007/29. If s 160APHJ(4) were read as disregarding third party options provided they arise at the time of issue of the relevant equity interest, that would create an unwarranted distinction between options created after issue of an equity interest and options created at the time of issue. If a taxpayer takes a position in relation to shares or an interest, provided the taxpayer continues to hold the shares or interest and does not enter into any other positions, the delta of the position remains the delta of the position on the day on which the shares were acquired or the position was entered into, whichever is the later (even if the delta actually changes after that time): s 160APHJ(9).

Shares held through trusts and partnerships Specific measures apply if shares are held through trusts and partnerships, including widely held trusts, non-widely held trusts (including discretionary trusts), employee share trusts, bare trusts and superannuation funds. These are discussed at [21 900].

Institutional investors Certain taxpayers may elect to be treated as qualified persons and therefore satisfy the holding period requirements by a different, formula-based method. The eligible taxpayers, subject to any regulations, include: listed widely held trusts, unlisted very widely held trusts, life assurance companies, general insurance companies, friendly societies, health insurance funds, trustees of complying superannuation funds and ADFs other than excluded funds and pooled superannuation trusts (PSTs): s 160APHR(1). Broadly, the election involves the application of a franking credit or rebate ceiling to shares or interests managed as a discrete fund. Subject to any regulations, the ceiling amount in relation to a fund is a particular notional total credit amount of expected franking credits, increased by 20%. A calculation is required of the expected franked dividend yield of a benchmark portfolio of shares: see [101 160]. The standard benchmark portfolio of shares is a portfolio of shares comprising the All Ordinaries Index published by the Australian Stock Exchange equal in value to the average weekly net equity exposure of the fund for the income year: s 160AQZH. The net equity exposure of the fund for a year is the overall exposure of the fund to risk-based positions taken in relation to the fund on an average weekly basis. Alternative benchmark portfolios may be prescribed by regulation. If an election is made, a ceiling is imposed on the franking credits and franking rebates to which the taxpayer is entitled: ss 160AQZE, 160AQZF and 160AQZG. Any excess over the maximum potential rebate is deductible: s 160AQZF(6) (second occurring). © 2017 THOMSON REUTERS

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Small shareholder exemption Individual shareholders may qualify for the small shareholder exemption under the holding period rule. If the sum of the offsets to which the taxpayer would be entitled does not exceed $5,000, the taxpayer will be regarded as a qualified person for the purposes of the holding period rules: s 160APHT. The exemption does not apply in relation to a dividend if the related payments rule applies to the dividend. Shares issued in connection with a winding up Effectively, a person will ordinarily be a qualified person in respect of any shares issued (and not disposed of to a third party) that are cancelled in the course of a winding-up where a dividend is paid on the shares: s 160APHQ. Application to entities leaving a consolidated group In order to determine whether an entity leaving a consolidated group is a qualified person with respect to the shares it takes with it, the ‘‘exit history’’ rule (see [24 020]) will deem the leaving entity to have acquired the shares at the time acquired by the head company and to have entered into the net position in relation to the shares as entered into by the head company: see ATO ID 2006/254. Consequences of not being a qualified person If the holding period rule is not met (or the taxpayer is not a qualified person), the taxpayer is denied the franking credit and therefore the franking rebate on the dividend or distribution. [21 890] Related payments rule As noted at [21 880], a taxpayer must be a ‘‘qualified person’’ to be entitled to a franking credit in respect of a dividend. To be a qualified person, a taxpayer must satisfy the related payments rule in addition to the 45-day holding period rule discussed at [21 880]. Although the related payments rule is applied by reference to the repealed provisions of the ITAA 1936, the Tax Office stated (somewhat belatedly) in Determination TD 2007/11 that the ITAA 1936 rules have ongoing application as a result of being ‘‘imported’’ into the ITAA 1997 regime via the anti-manipulation rule in s 207-145(1)(a) (discussed at [21 810]): see [21 800]. The related payments rule is not a once-and-for-all requirement. Even if the at-risk requirements (see [21 880]) are satisfied in respect of one qualification period around the payment of a dividend or distribution in respect of shares or interests held, the requirements continue to apply to future dividends or distributions paid in respect of the shares or interests if the taxpayer is obliged to make a related payment in respect of those future dividends or distributions. The secondary qualification period, for the related payments rule, is the period commencing on the 45th day before and ending on the 45th day after the day on which the shares or interest become ex-dividend (90th day in each case for preference shares). A taxpayer will not satisfy the related payments rule if the taxpayer effectively has no interest in the relevant dividend, or in the relevant distribution paid on an interest in a share, because of an obligation to make a related payment to another party with respect to positions in property that are substantially similar or related to the shares or interest. The related payments rule will apply to the scrip loan fee involved in the scrip loan and call option arrangements dealt with in Determination TD 2003/32, because the taxpayer is obliged to pass the benefit of the dividend to the lender via the dividend offset. A taxpayer or associate is taken to have made a related payment if the taxpayer or associate is under an obligation to or may reasonably be expected to pass the benefit of a dividend or distribution to other persons: s 160APHN(2). Examples of transactions that may be related payments are contained in s 160APHN(3). If the benefit of the dividend or distribution remains with the taxpayer, there will not be a related payment eg merely because the dividend is credited to the taxpayer’s bank account. 876

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[21 900]

An example of where there is not a related payment is ATO ID 2005/93 (a notional payment made in connection with an SPI Futures contract not a related payment where there was not a sufficiently close correlation between the physical shares in the portfolio (or any part) and the shares reflected in the SPI). A related payment includes a notional crediting of an amount calculated by reference to the amount of a dividend or distribution: s 160APHN(6). According to the explanatory memorandum, this means, for example, that if the holders of an endowment warrant have their obligations under the warrant reduced by the amount of dividends received by the issuing institution (the price payable on completion of the warrant is reduced), the inclusion of the dividend amounts in the calculation of the amount payable is a related payment. Several other examples of related payments are mentioned in the explanatory memorandum. The distribution by a trustee of a dividend to a presently entitled beneficiary of the trust does not, in itself, constitute the making of a related payment in respect of the dividend: s 160APHN(5). The related payments rule will be relevant if a company is being purchased and a dividend is paid to its shareholders which leads to a reduction in the consideration paid by the purchaser. Several class rulings have addressed this situation, including CR 2007/53, CR 2009/44 and CR 2009/46. However, the related payments rule will not apply if the sale of a wholly owned subsidiary takes place and, within 6 months of the contract to sell, a dividend is paid by the subsidiary to the vendor and the sale price is reduced by the amount of the dividend, providing it is reasonable to assume that the dividend is attributable to profits of the subsidiary while it was owned by the vendor: s 160APHNA. The implication is that the reduction of a sale price by reason of a dividend paid in circumstances outside the section could be a related payment.

[21 900] Shares held through trusts There are measures to prevent franking credit trading schemes under which taxpayers access franking credit benefits through trusts, without being exposed to the risks and opportunities associated with membership interest ownership. Taxpayers who hold membership interests under a trust, other than a family trust (as defined in the trust loss provisions: see [23 850]) or deceased estate, are required to have sufficient interest in the corpus of the trust to expose them to at least 30% of the risks of loss or opportunities for gain in respect of the membership interests included in the trust estate. The aim is to place risk reduction arrangements using trusts in the same position as risk reduction arrangements using derivatives. This ensures that the holding period and related payments rules are not circumvented by the use of discretionary trusts or other trust arrangements that do not expose beneficiaries to the risks and opportunities of share ownership. Note that the small shareholder exemption applies to natural person beneficiaries who have a total franking account credit entitlement of $5,000 or less: see [21 880]. This modification of the holding period rule applies to distributions in respect of shares, or interests in shares, acquired after 3 pm on 31 December 1997 by trusts other than widely held public sharetrading trusts (as defined in the trust loss provisions: see [23 970]) and to distributions in respect of shares or interests in shares held by widely held public sharetrading trusts established after 3 pm on 31 December 1997. Note that if the trustee of a discretionary trust chooses CGT roll-over relief under Subdiv 122-A to deem the acquisition date of newly issued shares to be pre-20 September 1985, the new shares are not deemed to have been acquired before 20 September 1985 for the purposes of these imputation rules: see ATO ID 2006/31. Under the general requirements of the holding period rule, a taxpayer must both be a ‘‘qualified person’’ and hold the shares or interest in shares at risk for the minimum ‘‘qualification period’’ (the 45 or 90 days). In the case of a trust or partner distribution consisting wholly or partly of dividend income (including an amount attributable to a © 2017 THOMSON REUTERS

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dividend), generally the trustee or partner must be a qualified person and, in addition, the beneficiary or partner must be at risk for a prescribed period during the qualification period in respect of the taxpayer’s interest in the membership interest from which the dividend income is derived (ss 160APHK and 160APHL). However, a beneficiary of a widely held trust need only be at risk in respect of the interest in the trust during the qualification period around the trust distribution date or must not make a related payment in relation to the distribution as a whole: s 160APHP. The beneficiaries of a trust, including potential beneficiaries of a discretionary trust, are taken to acquire, hold or dispose of a membership interest when the trustee acquires, holds or disposes of the interest: s 160APHG(3). Similarly, an interest in shares is acquired upon becoming a beneficiary or potential beneficiary if the trust estate already includes shares or an interest in shares: s 160APHG(4). A modification of these rules applies to a ‘‘widely held trust’’, as defined in s 160APHD. The rules relating to a partnership holding and a partner’s interest in shares are determined under s 160APHK, under which the beneficiary is required to satisfy the holding period rule with respect to the beneficiary’s interest in the trust as a whole, rather than in relation to the specific shares held from time to time by the trustee (which may be bought and sold during the period in which the interest is held by the beneficiary): s 160APHG(6) to (8). The interest of a beneficiary in each share (or interest in a share) held by a non-widely held trust is the beneficiary’s share in the income from that share, expressed as a proportion of the total dividend income received by the trust in relation to the share: s 160APHL(5). In determining whether a beneficiary is sufficiently at risk in relation to an interest in shares, in addition to the distinction between widely and non-widely held trusts, specific categories of non-widely held trusts are recognised. Family trusts, deceased estates and employee share scheme trusts are separated from all other non-widely held trusts. The effect of deemed long and short positions under s 160APHL(7) and (10) relating to shares held is that unless a beneficiary has a fixed interest constituted by a vested and indefeasible interest in the corpus of the trust or an exception applies, a beneficiary in a non-widely held trust will typically have a net position of zero, ie not be sufficiently at risk, meaning that franking credits will not pass through the trust (eg see ATO ID 2002/122). This will inevitably be the case for discretionary trusts, unless an exception, such as the family trust or small shareholder exception, applies. Note that if a beneficiary does not have a vested and indefeasible interest in the corpus of the trust, s 160APHL(14) allows the Commissioner to treat the interest as being vested and indefeasible (eg see ATO ID 2014/10). The rules require any position of the trustee of a non-widely held trust in relation to trust shares to be imputed to the beneficiary to the extent that it relates to the beneficiary’s interest in the shares (s 160APHL(8), (9)), and a beneficiary with a fixed interest (vested and indefeasible) will have a long position, but not otherwise: s 160APHL(10). If a family trust election has been made (see [23 880]), there is no deemed short position under s 160APHL(10), meaning that in the absence of any positions of the trustee that reduce risk, the only position of the beneficiary would normally be a deemed long position under s 160APHL(7). Accordingly, franking benefits can pass through to the beneficiaries. Widely held trusts are subject to different rules, because the beneficiary’s interest in shares for these trusts is taken to be the beneficiary’s share of dividend income, on a proportional basis, from all shares (or interests in shares) held by the trustee in respect of which the beneficiary receives a distribution, not specific shares (or interests): s 160APHL(2), (4), (6). EXAMPLE [21 900.10] The trustee of a non-widely held trust that is not a family trust (or deceased estate or employee share scheme trust) holds 2,000 shares. A beneficiary is entitled to half the dividends from those shares. The beneficiary’s interest in those shares is 50% of the trustee’s holding, ie 1,000 shares. The deemed long position under s 160APHL(7) is offset by a deemed matching short position under s 160APHL(10), leaving the beneficiary with a long position to the extent that the beneficiary has a fixed interest as defined in s 160APHL(11).

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[21 950]

If the beneficiary has a fixed interest of 30% or more in the 1,000 shares (the equivalent of 300 shares), the beneficiary will be sufficiently at risk (not have a materially diminished risk) in respect of the interest in the shares. However, if the beneficiary has a lesser fixed interest or no fixed interest (as in the case of a discretionary trust), the beneficiary would not be sufficiently at risk (have a materially diminished risk) and a tax offset would be denied.

As with the other exclusions, under s 160APHL(10) no deemed short position arises for an ‘‘employee share scheme security’’, as defined in s 160APHD, to offset the long position created by s 160APHL(7) and thus these securities will satisfy the at-risk requirement.

Bare trusts An exception to the ‘‘qualified person’’ requirement applies if there is a single beneficiary who is absolutely entitled to the shares held by a nominee/bare trustee. In these circumstances Div 1A applies as if the shares or interests are held directly by the beneficiary: s 160APHH(6)(c). Special rules apply if the trust ceases to be a bare trust, with different treatment depending on whether it becomes a non-widely held trust or a widely held trust: s 160APHH(7). Special provisions for institutional taxpayers A special set of rules applies to certain low-risk taxpayers, such as superannuation funds, that would incur high compliance costs in meeting the holding period rule. The eligible taxpayers include listed widely held trusts, unlisted very widely held trusts, life assurance companies, ADFs and PSTs: s 160APHR(1). These taxpayers are able to elect to use another rule that sets a ceiling on franking based on an appropriate benchmark with respect to shares (or interests) managed as a discrete fund; this ceiling then applies instead of the holding period rule. The maximum franking benefits and the benchmark portfolio of shares are prescribed by Subdiv BA of Div 7: ss 160AQZD to 160AQZH. The All Ordinaries Index is prescribed by s 160AQZH(1), but may be set by regulation. Other details of the rules may also be specified by the regulations: see [21 880].

EXEMPTING ENTITIES [21 950] Exempting companies and exempting accounts Broadly, Div 208 ITAA 1997 contains anti-avoidance measures intended to prevent franking credit trading by exempting entities and former exempting entities. Exempting entities are entities that are effectively owned by foreign residents or tax-exempt entities, while former exempting entities are entities that have ceased to be so owned: ss 208-5, 208-10 and 208-50. Effective ownership is determined by reference to the membership interests held at risk (‘‘accountable membership interests’’) and interests in membership interests held at risk (‘‘accountable partial interests’’): ss 208-25 and 208-35. An entity is not taken to be a former exempting entity by ceasing to be an exempting entity within 12 months of becoming an exempting entity: s 208-50(2). The test in s 208-25 is based on the direct or indirect holding of 95% or more of accountable membership interests or accountable partial interests by one or more of the prescribed persons, ie foreign residents or tax exempt entities: s 208-40. The rules ‘‘look through’’ to ultimate ownership. This approach is extended to New Zealand companies which will be looked through to find ultimate ownership in order to give affect to Trans-Tasman imputation arrangements: see [21 440]. In Hastie Group Ltd v FCT (2008) 79 ATR 390, the Full Federal Court decided that the head company of a consolidated group was a former exempting entity under s 208-50. The relevant franking credits were accumulated during a period of less than 12 months when the head company was effectively owned by non-residents. © 2017 THOMSON REUTERS

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An exempting entity franks a distribution in effectively the same way as an ordinary franking entity, by applying franking credits to frankable distributions (see [21 670]): s 208-60. The only effective difference between ordinary franking entities and exempting entities is that franked distributions made by exempting entities confer limited benefits on the recipients. In particular, Australian tax residents are not entitled to a tax offset or a franking credit as a result of a distribution. Foreign resident recipients of a distribution are exempt from withholding tax (see [35 150]) to the extent of franked distributions made by exempting entities. The rules in Div 208 do not apply where distributions are made to certain franking entities or where employees receive distributions in connection with certain employee share schemes: Subdiv 208-G. When an entity ceases to be an exempting entity, ie becomes a former exempting entity, the balance in its franking account is transferred into a new account, known as an ‘‘exempting account’’, thereby quarantining that balance: Item 1 in ss 208-145 and 208-115. The exempting account operates in the same way as a franking account, except that entities frank their distributions with ‘‘exempting credits’’ instead of the ‘‘franking credits’’. The use of ‘‘exempting credits’’ in an exempting account is restricted to distributions made to certain individuals, exempting entities, former exempting entities, and employees acquiring shares, or stapled securities treated as qualifying shares, under certain employee share schemes: Subdiv 208-H. A new franking account is established to record the entity’s normal franking debits and credits after the entity ceases to be an exempting entity. There is no restriction on who can benefit from franking credits from this account. When a former exempting entity makes a franked distribution in a given franking period, it must first frank the distribution by allocating franking credits to the distribution from its franking account, having regard to the entity’s benchmark for that franking period. For discussion of the benchmark rule, see [21 710]. The exempting credits from the exempting account may then be attached to the part of the distribution which remains unfranked. If a former exempting entity allocates an exempting credit to a distribution, it must frank all subsequent frankable distributions in the remainder of the franking period with an exempting credit to the same extent as its first distribution: s 208-90. If the entity does not, distributions made within the franking period with an exempting credit attached are taken not to have been franked with an exempting credit. The amount of the exempting credit on a distribution is as stated in the distribution statement: s 208-70(1). The sum of the franking credit and the exempting credit must not exceed the maximum franking credit for the distribution. If they do, the amount of the exempting credit on the distribution is taken to be nil: s 208-70(2). This is to ensure that the former exempting entities do not use their exempting account surpluses excessively. Note there are rules in Sch 2D ITAA 1936 that apply where an entity changes its status from tax-exempt to taxable: see [7 550].

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22

INTRODUCTION Overview ....................................................................................................................... [22 010] PARTNERSHIPS Definition of partnership ............................................................................................... [22 General law partnership ................................................................................................ [22 Tax law partnership/statutory partnership .................................................................... [22 Existence of partnership ................................................................................................ [22 Requirements of valid partnership ................................................................................ [22 Partnership tax returns .................................................................................................. [22

020] 030] 040] 050] 060] 070]

TAX TREATMENT – GENERAL Partnership net income or partnership loss .................................................................. [22 100] Distribution of partnership income or loss ................................................................... [22 110] Losses, exempt income and non-assessable non-exempt income ............................... [22 120] Commercial debt forgiveness ....................................................................................... [22 130] DEALINGS BETWEEN PARTNERS Salaries .......................................................................................................................... [22 Interest on capital .......................................................................................................... [22 Interest on external borrowings .................................................................................... [22 Interest on money lent by partner ................................................................................ [22 Interest on money borrowed by partner ....................................................................... [22 Drawings ........................................................................................................................ [22 Earnings outside the partnership .................................................................................. [22 Changes of interests in partnership property ............................................................... [22 Varying income interests of partners ............................................................................ [22 Service arrangements for professional partnerships .................................................... [22 Alienation of share of partnership income – Everett assignments .............................. [22 No goodwill partnerships .............................................................................................. [22

150] 160] 170] 180] 190] 200] 210] 220] 230] 240] 250] 260]

CAPITAL GAINS TAX CGT and partnerships – overview ................................................................................ [22 Dual assessability – CGT v other provisions ............................................................... [22 Dissolution/reconstitution of partnership ...................................................................... [22 Disposal of partnership assets ...................................................................................... [22

300] 310] 320] 330]

ANTI-AVOIDANCE MEASURES Income splitting using nominal partners ...................................................................... [22 Lack of real and effective control and disposal ........................................................... [22 Liability for further tax ................................................................................................. [22 Primary production partnerships and s 94 ................................................................... [22

350] 360] 370] 380]

CORPORATE LIMITED PARTNERSHIPS Limited partnerships ...................................................................................................... [22 Corporate limited partnerships ...................................................................................... [22 Treatment as a company for tax purposes ................................................................... [22 Other corporate tax modifications ................................................................................ [22 Foreign hybrids ............................................................................................................. [22

400] 410] 420] 430] 440]

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INTRODUCTION [22 010] Overview This chapter summarises the tax treatment of partnerships. The general rules governing the taxation of partnerships are contained in Div 5 of Pt III ITAA 1936 (ss 90 to 94). Special rules apply to corporate limited partnerships (which are treated as companies for tax purposes: see [22 400]-[22 430]) and foreign hybrids (see [22 440]). Division 5A of Pt III ITAA 1936 (ss 94A to 94Y) contains provisions for the general taxation of certain partnerships. Tax treatment – overview Broadly, Div 5 treats each partner as having an individual interest in the net income and assets of the partnership while the partnership is not regarded as a separate entity (the ‘‘aggregate’’ approach). Specific provisions regarding capital gains and losses in Pt 3-1 ITAA 1997 have confirmed the aggregate approach. However, for some purposes, a partnership is treated as an entity independent of the partners, in particular in calculating the net partnership income (or loss). The taxation of the ordinary income of a partnership proceeds in 2 stages. 1. The net income or loss is determined by treating the partnership as a resident taxpayer, ie by adopting the separate entity premise (s 90): see [22 100]. This approach is also reflected in the requirement for the lodgment of a tax return for the partnership, although the partnership is not liable to pay tax on that return, ie the return is for information only (s 91): see [22 070]. 2. Then, the distributive shares of the partnership net income or loss are attributed to each partner (s 92): see [22 110]-[22 120]. Aggregate treatment is plainly evident in the provisions for the reporting and taxation of these distributive shares at the level of the particular partners. The rules relating to the payment and collection of tax and other administrative matters in Sch 1 TAA (including the PAYG withholding and PAYG instalments systems and the penalty provisions) generally apply to a partnership as if it were a person. However, any obligation imposed on the partnership is imposed on each partner and may be discharged by any of the partners: s 444-30(1). The partners are jointly and severally liable to pay any amount that would otherwise be payable by the partnership: s 444-30(2).

PARTNERSHIPS [22 020] Definition of ‘‘partnership’’ The definition of a ‘‘partnership’’ in s 995-1 has 3 limbs: • an association of persons (other than a company or limited partnership) carrying on business as partners (a general law partnership): see [22 030]; • an association of persons (other than a company or limited partnership) in receipt of ordinary or statutory income jointly (a ‘‘tax law partnership’’ – also called a statutory partnership): see [22 040]; or • a limited partnership: see [22 400]. It is generally accepted that the first limb of the definition imports the general law meaning of ‘‘partnership’’ expressed in State and Territory partnership legislation, while the second limb has the effect of including associations that would not be partnerships under the general law. 882

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Individuals and companies may be partners, while trustees may be partners in their capacity as trustees. Although persons under 18 are not prohibited from entering partnerships, the prevailing State or Territory laws governing the contractual capacity of minors apply. Generally a distinction should be drawn between totally invalid contracts due to the minor’s inability to comprehend the nature of the alleged agreement (eg Case 51 (1966) 13 CTBR(NS) 51) and contracts that will be binding when majority is reached, depending on affirmation or disaffirmation.

Joint ventures Although the distinction is often a fine one, a joint venture is not synonymous with a partnership: see Ryvitch v FCT (2001) 47 ATR 381 at 389. In some cases, however, the joint venturers are partners, but not if they can show that they have independent interests and are pursuing individual gain. If their association is not a partnership for tax purposes, it may be considered to be an unincorporated association that should be treated as a ‘‘company’’. However, if their interests are sufficiently distinct and they are not partners for tax purposes, they will simply be taxed as separate taxpayers. Unlike partners, joint venturers share in the product or output of the business activity and they share costs but not profits. Syndicates and unit partnerships Members of a syndicate may be a partnership for tax purposes even though the members change reasonably frequently: Tikva Investments Pty Ltd v FCT (1972) 3 ATR 458; and Sarich v FCT (1978) 9 ATR 294. Corporate limited partnerships Although limited partnerships fall within the definition of ‘‘partnership’’, corporate limited partnerships are generally taxed as companies: see [22 420]. [22 030] General law partnership A ‘‘partnership’’ is the relationship that exists between persons carrying on a business in common with a view to profit but the characteristics to determine this are primarily to be found in case law: see [5 020] for a discussion of whether an entity is ‘‘carrying on a business’’. There must be a genuine intention of the parties to act as partners taking into account all relevant circumstances including their conduct. If a relationship is in truth a partnership, giving it a different name (eg a joint venture or syndicate) will not alter that fact: Sarich v FCT (1978) 9 ATR 294. The question of whether a partnership exists is considered at [22 050]. The GST Act treats a partnership as an entity from the time that a partnership is formed. As an entity, a general law partnership can make supplies and acquisitions under the GST Act. See further [60 030]. GST Ruling GSTR 2003/13 distinguishes 2 types of dissolution of a partnership: 1. A dissolution leading to the winding up of the partnership (a general dissolution). This may come about in a number of ways (eg by mutual agreement or cessation of business). The Tax Office considers that the final distribution forms part of carrying on the partnership’s enterprise. 2. A dissolution that does not lead to the winding up of a partnership (a technical dissolution). The continuing partners and any new partner may conduct the business of the partnership without any break in its continuity. As there is no winding up of the partnership, the change in membership does not give rise to any supplies or acquisition from one partnership to another partnership.

[22 040] Tax law partnership/statutory partnership As noted at [22 020], the definition of ‘‘partnership’’ includes an association of persons (other than a company or limited partnership) in receipt of ordinary or statutory income jointly. This is known as a ‘‘tax law partnership’’ or a ‘‘statutory partnership’’. A common © 2017 THOMSON REUTERS

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example of a tax law partnership is where 2 or more persons are the joint owners of a real estate property, as joint tenants or tenants-in-common, who share the rental income. They will be partners for tax purposes, even though they may not be under the general law: eg Tikva Investments Pty Ltd v FCT (1972) 3 ATR 458; Yeung v FCT (1988) 19 ATR 1006. It has been suggested that business income will be the income only of the person who derived it and therefore not jointly received unless it can be said that the business is conducted by the ‘‘partnership’’: Case 24 (1965) 12 CTBR(NS) 24. Another expression of this idea is the proposition that joint receipt requires joint beneficial entitlement: Case 10 (1981) 25 CTBR(NS) 10. A tax law partnership between a married couple was found not to exist in Re Harbutt and FCT (2013) 87 ATR 698, where the rental property in question was in the name of one person only (the husband). Many ‘‘joint receipt’’ cases founder on the related issue concerning the existence of a partnership: see [22 050]. Even though co-owners of property may be partners for tax purposes, if they are not in fact general law partners, they will not be permitted to assert a division of profits or losses between them that requires the elements of a general law partnership for its validity: see FCT v McDonald 18 ATR 957; Re Cripps and FCT (1999) 43 ATR 1202. Ruling TR 93/32 deals with the division of net income or loss between the co-owners of rental property. For statutory partnerships, it is generally the legal interests of the parties that ultimately determine the individual interests in the partnership net income or loss. GST Ruling GSTR 2004/6 discusses the GST implications for transactions involving tax law partnerships. The Tax Office considers that the GST Act applies to tax law partnerships in broadly the same way that it applies to general law partnerships. Accordingly, a tax law partnership can be registered for GST if it carries on an enterprise, can make taxable supplies to third parties on which it incurs a GST liability and can make creditable acquisitions for which it can claim input tax credits. For GST purposes, a tax law partnership comes into existence when the constituent members form an intention to receive income jointly, ie when an association of persons carries on an activity from which income is or will be received jointly. This enables the partnership to claim input tax credits before it has received any income (subject to the normal rules). A tax law partnership comes to an end, and its GST registration must be cancelled, if: • an income producing property that is the sole source of income is disposed of; • the property of the co-owners ceases to be used for an income producing purpose; or • there is a change of persons comprising the association of persons in receipt of income jointly. (In the Commissioner’s view, a tax law partnership cannot be reconstituted.)

[22 050] Existence of partnership Whether a partnership exists is a question of fact. Because the onus of proving that an assessment is excessive lies upon the taxpayer (see [48 110]), a taxpayer alleging that there is a partnership (and consequent division of income) bears the onus of proving its existence. The Tax Office considers that the intent and conduct of the parties indicates the existence of a partnership and, in Ruling TR 94/8, outlines the following non-exhaustive factors that should be taken into account in deciding whether a partnership exists: • the mutual assent and intention of the parties; • joint ownership of business assets; • registration of a business name; • joint business account and the power to operate it; • the extent to which the parties are involved in the conduct of the business; • the extent of capital contributions; 884

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• entitlements to a share of net profits; • business records; and • trading in joint names and public recognition of the partnership. No single factor is decisive and the weight to be given to each factor varies with individual circumstances, although the entitlement to a share of net profits is essential. In domestic situations, eg involving a married couple, the conduct of each party must be examined to determine whether it is part of their ordinary domestic relationship or part of a business association. See Ruling TR 94/8 for examples. While a contributor of capital need not work actively in the partnership business to be considered a partner (Case 53 (1969) 15 CTBR(NS) 53), a loan to the proprietor of a business in return for a share of the profits may be influential (Case 71 (1953) 3 CTBR(NS) 71). The Tax Office has issued Taxpayer Alert TA 2015/4 concerning certain partnerships involving private company partners and an individual partner, which are being used to enable associates of the individual to access business profits under a tax minimisation scheme. Under the arrangements, business profits are directed through a partnership and taxed to the private company. Profits are accessed by one or more individuals without paying additional tax reflecting their higher marginal tax rate. The Tax Office suggests that such a ‘‘partnership’’ may not be a partnership at general law.

Relevance of documentation Although advisable, a written partnership agreement is not essential as the conduct of the parties may itself evidence the existence of a partnership provided there is a mutual intention to do so (eg Jolley v FCT (1989) 20 ATR 335 and AAT Case 1025 (1999) 44 ATR 1131). In the Jolley case, the AAT later decided that the existence of a joint bank account, the issue of receipts in joint names, the wife’s entitlement to half the profits and her agreement to the distribution of those profits to a family trust were sufficient evidence of a partnership despite the wife’s non-participation in the management of the business and the fact that her only investment in the business was an interest-free loan: AAT Case 5705 (1990) 21 ATR 3253. In contrast, in Palermo v Palermo (No 2) [2014] WASC 6, the lack of a partnership agreement was an important factor in light of evidence showing that the parties in question (2 brothers) intended to trade in a way ‘‘antithetical to any partnership’’. This decision was overturned on appeal as the trial judge failed to consider whether a partnership agreement could be inferred from the evidence: see Palermo v Palermo [2015] WASCA 49. According to the WA Court of Appeal, an inferred partnership agreement could exist concurrently with the corporate and trust structures put in place by the brothers. Other relevant factors evidencing the existence of a partnership include joint registration of a business name and joint interests in the business premises or property, but mere registration as a joint proprietor of the business name may not be sufficient if there is no contribution to capital, no division of profits and only routine clerical work not done on a commercial basis. In these circumstances, even the presence of a genuine intention and understanding between the parties to act as partners will not constitute a partnership where there are no visible external signs of this to outsiders: Case 10 (1981) 25 CTBR(NS) 10. Similarly, in Robinson v FCT (1986) 17 ATR 1068 and DCT v Tuza (1997) 35 ATR 32, the existence of partnership accounts and the lodgment of partnership returns evidenced a partnership by conduct. In contrast, in AAT Case 9017 (1993) 26 ATR 1388, it was held that a marine engineer was an employee despite the existence of a ‘‘partnership’’ agreement between himself, the skipper of the vessel on which he worked and other crew members. Documentation was also significant in the decisions in AAT Case 1025 (1999) 44 ATR 1131 and Re Taxpayer and FCT (2008) 73 ATR 950 that partnerships existed. In the latter case, a document recording the dissolution of the partnership was particularly significant. A lack of documentary evidence of a partnership (no partnership tax returns, no partnership agreement, representations to the bank of a company rather than a partnership) © 2017 THOMSON REUTERS

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meant that there was no partnership in AATA Case 568 (2003) 53 ATR 1017. See also Re Brown and FCT (2006) 65 ATR 172, where it was decided that a purported partnership created in connection with a prepaid service warrant arrangement was not in fact a partnership (the same conclusion reached in Determination TD 2003/9 in relation to similar arrangements). The taxpayer successfully argued in AAT Case 240 (2000) 44 ATR 1059 that a property-owning partnership existed between himself and 2 other investors, even though title to the property was held by a company they had formed. The AAT agreed with the taxpayer that the company received rental income merely as a bare trustee for the 3 investors (including the taxpayer) and incurred expenditure as agent for them. In contrast, in Ryvitch v FCT (2001) 47 ATR 381, the Federal Court rejected the taxpayer’s claim that a property development project was being carried on by a company acting in the capacity of nominee for a partnership of individuals including herself (they were the shareholders in the company). The court acknowledged that a partnership agreement may be made orally or may arise as a matter of inference from a course of dealing between the parties but this was not applicable in this case. An individual may validly enter a partnership with a company formed for the exploitation of the individual’s skills in entertainment engagements: Newstead v Frost [1980] 1 All ER 363. However, such an arrangement may be caught by the alienation of personal services income rules.

Time of commencement and dissolution Since the existence of partnership is a question of fact, a date of commencement or dissolution stated in a deed or written agreement will not be given effect for tax purposes unless the underlying facts establish the existence of partnership in conformity with the statement. Thus, a purported ‘‘back-dating’’ of commencement will be disregarded: Waddington v O’Callaghan (HM Inspector of Taxes) (1932) 16 TC 187. However, if a partnership does commence as a matter of fact before the execution of a deed, the deed may properly recite the earlier commencement date: Case 67 (1970) 15 CTBR(NS) 67. Similarly, a purported back-dating of the dissolution of a partnership will be ineffective if it is not supported by the facts. In FCT v Happ (1952) 9 ATD 447, 2 members of a 4-partner firm resigned in December but declared in writing that the dissolution was effective from the previous 30 June. The court did not accept that the partnership consisted only of the 2 continuing partners from 30 June and upheld an assessment of one of the retiring partners on his share of profits for the period from 30 June to the date he resigned. Although the assignment of a part of a partnership share does not necessarily cause a dissolution, if partners purport to back-date the commencement of an assignment that effects a dissolution, the assignment will take effect as a present assignment without retrospective effect: Rowe v FCT (1982) 13 ATR 110. If an assignment provides for the admission of a new partner(s), the existing partnership will be dissolved, despite a clause purporting to negate dissolution: FCT v Jefferies (1980) 11 ATR 429. In Anderson Group v Davies (2001) 53 NSWLR 401, it was held that the winding up of a corporate partner does not of itself dissolve the partnership, subject to any express provision in the partnership agreement. In contrast, the bankruptcy of an individual partner does dissolve the partnership under s 33(1) of the Partnership Act 1892 (NSW) (subject to the terms of the partnership agreement). [22 060] Requirements of valid partnership Like other legal relationships, a partnership agreement should be entered into before the commencement of the relationship. In particular, the agreement may assist in establishing the genuine nature of the partnership (particularly if a family arrangement) and the terms under which the partners are carrying on business. If there is a partnership agreement, it need not be provided to the Commissioner unless specifically requested. 886

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The following steps should be taken on or before the commencement of the partnership in order to evidence both the existence of a partnership and the date it commenced to exist. 1. A memorandum or partnership agreement setting out the terms and arrangements under which the partnership is to operate should be prepared. Normally this should be done by a legal practitioner instructed for the purpose. 2. The partnership should be registered under the applicable Business Names legislation (see [55 200]) if it carries on business under a name other than that of the partners. 3. The partnership should apply for a tax file number (TFN) and an Australian Business Number (ABN) if carrying on an enterprise: see [55 040] and [55 210]. If turnover exceeds $75,000 pa ($150,000 for non-profit bodies), it must register for GST: see [60 130]. If turnover is less than $75,000, it may voluntarily register for GST purposes. 4. A partnership bank account should be established and the arrangements for signing and endorsing cheques should be agreed. 5. Persons having business relations with the partnership, such as customers, suppliers, etc should be notified of the existence of the partnership. 6. Any partnership property should be transferred into the name of the partnership. 7. A set of books of account should be prepared and, in addition, a minute book obtained to record the decisions of the partnership: see Ruling TR 94/8, para 26 as to business records.

[22 070] Partnership tax returns A partnership is required to furnish a return of the income of the partnership, but the partnership itself is not liable to pay tax on such income (ie it is for information purposes only): s 91. The partnership return must disclose the final income derived by the partnership during the income year. The requirements in Div 388 in Sch 1 TAA relating to returns (see [46 200] and following) are effectively imposed on each partner, but may be discharged by one partner: s 444-30 Sch 1 TAA. Each partner is required to lodge her or his own individual return, which will show the distribution of income and losses (if any) from the partnership. Taxpayers who receive investment income jointly (eg rent, interest and/or dividends), and who are therefore partners for income tax purposes (see [22 040]), are not required to lodge a partnership return if they do not receive business partnership income: Ruling TR 93/32. Each taxpayer can show their share of the joint investment income in their individual tax returns. Partners with common accounting periods should lodge returns for the same accounting period. If partners do not have common accounting periods, an accounting period corresponding to that of the majority partner will generally be approved for the partnership, provided the others return appropriate shares of income or loss in their periods: Ruling IT 2433. Accounts may also be ascertained at some other date such as upon the dissolution of the partnership.

TAX TREATMENT – GENERAL [22 100] Partnership net income or partnership loss As noted at [22 010], Div 5 effectively treats each partner as having an individual interest in the net income (or loss) of the partnership. In working out the partners’ tax position in relation to the partnership, the starting point is to work out the net income (or loss) of the partnership. © 2017 THOMSON REUTERS

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The net income of a partnership is the assessable income of the partnership, calculated as if the partnership were a resident taxpayer, less all allowable deductions (other than prior year tax losses and personal superannuation contributions): s 90. A partnership loss arises if allowable deductions (other than prior year tax losses and personal superannuation contributions) exceed assessable income. In working out the net income (or loss), the partnership uses the appropriate method of income derivation (ie cash or accruals) at the end of the relevant accounting period when accounts are taken for this purpose: FCT v Galland (1986) 18 ATR 33. The partnership net income includes income derived by each partner in her or his capacity as a partner. In Re Baldwin and FCT (2005) 58 ATR 1245, the AAT decided that certain income was not derived by a husband and wife partnership, but by the husband in his individual capacity outside the partnership. The case underscores the importance of this distinction for tax purposes. See also Re Mews and FCT (2008) 71 ATR 887. Partners’ ‘‘salaries’’ and ‘‘interest’’ on capital contributions are not deductions in the determination of partnership net income but are part of the allocation or distribution of profits: see [22 150]. If a partnership ceases to carry on business and is terminated, it may not be possible to satisfy s 8-1 ITAA 1997 concerning the connection with gaining or producing assessable income: AAT Case 5596 (1989) 21 ATR 3154. The expenditure may even be classified as non-deductible capital expenditure or the activities of the partners may not be classified as business activities, in which case the outgoings are not taken into account: see Tanner v FCT (1990) 21 ATR 793. A partnership may only deduct ‘‘reasonable’’ amounts paid to relatives and related entities (s 26-35): see [9 1050]. If the amount claimed is excessive according to general commercial standards, the Commissioner may reduce the deduction to the partnership. As such, this would increase partnership income and there would be an increased distribution to the partners to include in their partnership income under s 92. There would also be a corresponding reduced amount of s 6-5 assessable income (the ‘‘reasonable’’ amount) for the relative or related entity. As noted above, prior year tax losses are not allowable deductions to the partnership. Instead, the necessary adjustment for the loss incurred is made in the assessments of the individual partners in the year in which the loss is incurred: s 90. If the individual partner does not have sufficient income to offset against the loss, that partner carries that loss forward. For the purposes of capital works deductions under Subdiv 43-B, a partnership is also treated as a person: s 960-100. However, deductions are apportioned for part-ownership: see [10 1490]. As for the application of the commercial debt forgiveness provisions, see [23 130]. Note that the Tax Office has released guidelines on how it will assess the Pt IVA risk applying to the allocation of profits from a professional firm carried on through a partnership, trust or company, where the income of the firm is not personal services income: see [22 110].

Elections Elections under the ITAA 1997 are made by the partnership and not by the partners. These include elections in relation to: • the method of valuing trading stock other than live stock: s 70-45; • the method of depreciation: ss 40-40 and 40-65; and • a number of primary production income-spreading elections (Subdivs 385-E, 385-F and 385-G): s 385-145. All partners must elect for s 122-125 roll-over relief: see [23 330].

[22 110] Distribution of partnership income or loss The result of ascertaining the tax position of the partnership (see [22 100]) may be: • net income available for distribution; 888

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[22 110]

• a partnership loss for allocation; • exempt income for allocation; • non-assessable non-exempt income for allocation. The allocation of net income or a partnership loss is based on each partner’s individual interests in the net income or loss and not on the distribution of partnership profits: AAT Case 1025 (1999) 44 ATR 1131. The distributive shares of the partners must be determined in accordance with s 92. The assessable income of a resident partner includes the partner’s individual interest in the (worldwide) partnership net income that is attributable to the period during which the partner is a resident: s 92(1)(a). The assessable income of a non-resident partner includes the partner’s individual interest in the net partnership income that, for the period of non-residence, is sourced in Australia: s 92(1)(b). A partner is assessable on their share of the relevant net income even if it is not distributed to the partner (eg because it is used to pay partnership debts). Corresponding provisions apply in relation to partnership losses, exempt income and non-assessable non-exempt income: see [22 120]. EXAMPLE [22 110.10] Personal exertion Partnership return: income $ Assessable income .................................................. 54,000 Allowable deductions ............................................... 16,000 Net income of partnership before deducting 38,000 partner’s salary ........................................................ Distributions: $ P Salary ............................................. 12 000 3 /5 of remainder $46,000 − $12,000 = $34,000 20,400 26,765(1) ................................................ Q Salary ............................................. Nil 2 /5 of $34,000 .................................... 13,600 11,235 38,000 P’s return: Personal assessable income ................................... Interest in partnership net income ........................... 26,765 P’s taxable income .................................................. 26,765 Q’s return: Personal assessable income ................................... Interest in partnership net income ........................... 11,235 Q’s taxable income .................................................. 11,235 (1)

Property income $ 10,000 2,000 8,000

Total $ 64,000 18,000 46,000

5,635(2)

32,400

2,365 8,000

13,600 46,000

6,000 5,635 11,635

6,000 32,400 38,400 Nil

2,365 2,365

13,600 13,600

$32,400 $32,400 × $38,000 = $26,765 (2) × $8,000 = $5,635 $46,000 $46,000

Example [22 110.10] illustrates the approach required in determining the share included in the tax returns of individual partners. It also illustrates the treatment of a salaried partner:

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[22 120]

PARTNERSHIPS

see [22 150]. In the example, the income from personal exertion and income from property of the partnership is shown separately. This is for illustrative purposes only and is not necessary for the particular example. Note that in Example [22 110.10] the partnership income retains its character. However, if the personal exertion income were income from primary production, the averaging provisions in Div 392 ITAA 1997 would apply to the individual assessments of the partners: see [27 460]. Similarly, where a partnership derives exempt income or non-assessable non-exempt income, the individual interest of the partner in that income is itself exempt income or non-assessable non-exempt income (as appropriate) in the hands of the partner: see [22 120].

Partner aged under 18 A special rate of tax (under Div 6AA in Pt III ITAA 1936) may apply where excessive partnership business income, or certain partnership investment income, is derived by a partner who is a minor (aged under 18), or where partnership income is included in the net income of a trust estate in which a minor is a beneficiary: see Chapter 26. Retiring partner Determination TD 2015/19 states that where a retiring partner receives an amount representing her or his individual interest in the partnership net income, the amount is assessable under s 92 (whenever received), even if the partner has retired by the end of the income year. Previously, in several private rulings, the Tax Office approach was to take this amount into account in determining the capital gain (or loss) from the disposal of the retiring partner’s interest. Potential application of Pt IVA to allocation of profits The Tax Office has expressed concern about schemes which are designed to ensure that the individual practitioner professionals are not directly rewarded for the services they provide to the business, or receive a reward which is substantially less than the value of those services. This is particularly the case where, for example, the level of income received by the individual, whether by way of salary, distribution of partnership or trust profit, dividend or any combination of them, does not reflect her or his contribution to the business and is not otherwise explicable by the commercial circumstances of the business. Where an individual attempts to alienate amounts of income flowing from personal exertion (as opposed to income generated by the business structure), the Tax Office has said that it may consider cancelling relevant tax benefits under Pt IVA. Tax Office guidelines consider the Pt IVA risk applying to the allocation of profits from a professional firm carried on through a partnership, trust or company, where the income of the firm is not personal services income. The guidelines also explain how professionals can assess the tax risks flowing from the use of partnerships of discretionary trusts and similar structures: see [63 285]. [22 120] Losses, exempt income and non-assessable non-exempt income A partner’s individual interest in a partnership loss (if any) incurred in the income year is an allowable deduction in the partner’s assessment: s 92(2). However, a deduction is not available where the partner’s interest in the partnership is a segregated exempt asset of a life insurance company or a segregated current pension asset of a complying superannuation fund: s 92(2A). The exempt income of a partner includes the individual interest of the partner in the exempt income of the partnership of the income year: s 92(3). This subsection is necessary because ss 36-10 and 36-15 provide that a loss shall be deemed to be incurred in any year when the deductions (except carried forward loss deductions) from the assessable income of that year exceed the sum of that income and the net exempt income of that year: see [8 450]-[8 500]. 890

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PARTNERSHIPS [22 120]

The non-assessable non-exempt income (NANE income) of a partner in a partnership includes the individual interest of the partner in the NANE income of the partnership: s 92(4). Thus, the NANE income of the partnership is apportioned between partners in the same way as assessable income and exempt income. In all cases (losses, exempt income and NANE income), the same dissection as to residency and source as applies to net partnership income occurs: see [22 110]. That is, the deductible amount is the individual partner’s interest in: • the worldwide partnership loss attributable to the period during which the partner is a resident; and • only the Australian source partnership loss attributable to any period of non-residence. EXAMPLE [22 120.10] T’s share of partnership loss (excluding partnership exempt income) ................ T’s individual net income ...................................................................................... Excess of deductions ........................................................................................... Deduct T’s share of partnership exempt income ................................................. Amount of loss to be carried forward under s 36-15(7)........................................

$ 38,000 8,000 30,000 2,000 28,000

T is entitled to a deduction of the $28,000 from assessable income of subsequent years in accordance with and subject to the limits imposed by Subdiv 36-A ITAA 1997. As the partners carry forward their share of partnership losses in their individual returns, no deduction is allowed in respect of partnership losses of previous years in calculating the net income or loss of the partnership itself: s 90.

Non-commercial losses A partner’s individual interest in a partnership loss is not an allowable deduction in the year it is incurred if the loss is a ‘‘non-commercial loss’’ under Div 35 ITAA 1997 (discussed at [8 600] and following). Where a business activity fails all 4 statutory tests in Div 35, and the Commissioner does not exercise the discretion to disregard that failure, a loss incurred in relation to that activity is deferred (or ‘‘quarantined’’) for offset against future income from that same activity. A deferred Div 35 loss can be offset against future income from other sources only in a year in which the business activity satisfies one of the 4 tests or the Commissioner’s discretion is exercised. Division 35 only applies to individuals trading as sole traders or in a general law partnership. For a partnership, each partner must independently assess her or his interest in the business activity both as a member of the partnership and as a separate individual. For example, in applying the ‘‘other assets’’ test, the assets that can be counted include the assets a partner contributes to the business activity both as an individual and as a member of a partnership. Similarly, if real property has become a partnership asset that is used in carrying on the partnership business activity, a partner who does not have legal title to the property may include the value of the property for the purposes of determining whether they satisfy the ‘‘real property’’ test: see Ruling TR 2001/14, para 63C. The application of Div 35 to business activities (particularly multiple business activities) carried on in partnership is considered in Ruling TR 2003/3. In this ruling, particular attention is also given to the calculation of assessable income in relation to the exception from the loss deferral rule for a primary production business or a professional arts business. Tax deductions for non-commercial losses of individuals with adjusted taxable income of $250,000 or more are quarantined for use only against future income from the business activity (subject to the Commissioner’s discretion not to apply the non-commercial loss rules). © 2017 THOMSON REUTERS

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[22 130]

PARTNERSHIPS

Foreign losses of a partnership There is no distinction between a foreign loss and a domestic loss for the purposes of calculating taxable income. For income years before 2008-09, however, a partnership’s foreign losses were quarantined within the partnership and were not available for distribution between the partners under s 92(2). Instead, the partnership could carry the foreign loss forward to offset against its income of later years. [22 130] Commercial debt forgiveness Under the commercial debt forgiveness provisions (see [8 600]), if a commercial debt owing by a partnership is forgiven, certain future tax deductions otherwise available to the partnership/partners may be reduced by the amount forgiven. Any reduction is first applied to the extent possible against relevant reducible amounts of the partnership. If the amount forgiven is not fully absorbed against such partnership amounts, the remaining balance is allocated to the partners, in the proportions in which they are entitled to share in the net income or losses of the partnership for the year, for offset against any reducible amounts that those partners may have. The tax deductions that are reduced are those relating, in order, to prior year losses, prior year net capital losses, undeducted balances of capital expenditure (eg depreciation) and the cost bases of capital assets. When first determining the applicable reduction when calculating the partnership net income or loss, only the third category is relevant as the other losses etc are not available to a partnership, only the partners.

DEALINGS BETWEEN PARTNERS [22 150] Salaries Both the ITAA 1936 and ITAA 1997 are silent on the treatment of a partner’s salary (also called ‘‘partnership salary’’). Under the general law (and also accounting principles), the payment of a ‘‘salary’’ to a partner is the only way of adjusting the distribution of partnership income as a person cannot contract with herself or himself (Rye v Rye [1962] 2 WLR 361) and a partnership cannot employ a partner (Ellis v Joseph Ellis & Co [1905] 1 KB 324). The ‘‘salary’’ is effectively an entitlement to an allocation of profits prior to the general distribution of income or loss (and is not a deductible outgoing in calculating the net income or loss of the partnership: see Ruling TR 2005/7). The effect is to vary the partner’s individual interest in the net income of the partnership. Example [22 150.10] illustrates the correct calculation of a partner’s distribution of partnership net income where ‘‘partnership salary’’ is not included in partnership income. The example also illustrates the incorrect calculation in these circumstances where exactly the same result would be achieved for the individual partner but a different partnership income results. See also [22 200]. EXAMPLE Correct calculation of partnership net income and distribution to partners $ Assessable income of 64,000 partnership Allowable deductions 18,000 Net income of partnership Distribution of partnership income:

892

46,000

[22 150.10] Incorrect calculation of partnership net income and distribution to partners $ Assessable income of 64,000 partnership Allowable deductions including 30,000 P’s salary of $12,000 Net income of partnership 34,000

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PARTNERSHIPS [22 170] Correct calculation of partnership net income Incorrect calculation of partnership net and distribution to partners income and distribution to partners $ $ P’s salary 12,000 Share of net income 3/5 × 20,400 $34,000 13,600 P’s assessable income includes: Q’s share of net income 2/5 × 34,000 Total distribution 46,000 Salary from partnership 12,000 Share of net income 3/5 × 20,400 $34,000 P’s s 92 partnership income 32,400 P’s assessable income 32,400

The strict rule that a ‘‘salary’’ paid to a partner from partnership funds is not an outgoing of the partnership, but forms part of the partner’s distributive share, was applied in Case 59 (1968) 14 CTBR(NS) 59 and Case 81 (1985) 28 CTBR(NS) 81. Similarly, in Re Scott and FCT (2002) 50 ATR 1235, it was held that ‘‘salaries’’ paid to partners which inflated the tax losses of the partnership were not deductible partnership expenses because, as a matter of law, partners cannot be paid salaries. Further, the payments were not authorised by the partnership agreement and the lack of bona fides in the recording of the payments and the purpose and destination of the payments would prevent reliance on Ruling IT 2218 to argue that the ‘‘salaries’’ could be treated as a deductible expense of a partnership. The Commissioner, in Ruling TR 2005/7, confirms the view that a partnership salary is not a salary in the true sense, nor is it an expense of the partnership. Accordingly, a partnership salary is not taken into account as an allowable deduction in calculating the net income or loss of the partnership. Instead, a partnership salary is taken into account in determining the recipient partner’s interest in the net income (or partnership loss) of the partnership at the end of the income year under s 92. If, in a particular year, the partnership salary drawn by a partner exceeds the partner’s interest in the available net income of the partnership, the excess is not assessable income of the partner at that time. Instead, the excess is assessable to the partner in a future income year when sufficient profits are available. The ruling also points out that an agreement by the partners to allow a partner to draw a partnership salary is a contractual agreement among the partners to vary the interests of the partners in the partnership (and thus in the partnership net income). For such an agreement to be effective for tax purposes in an income year the agreement must be entered into before the end of that income year. In AAT Case 5303 (1989) 20 ATR 3905, it was held that a decision after the end of the income year to pay a salary to a partner was too late to alter what had been derived and amounted to a redistribution of partnership income.

[22 160] Interest on capital Interest on a partner’s capital should be treated as an appropriation in the distribution of profit. As in the case of partners’ salaries, it is considered that interest on capital is a method of adjusting the individual interest of the partners in the net income of the partnership. Similarly, interest debited to a partner’s current account is not regarded as income of the partnership, nor are credit entries business outgoings of the partnership. They merely define the partner’s interest in the partnership profits: FCT v Beville (1953) 10 ATD 170. Exceptions to this rule apply where the interest is on a loan to the partnership (see [22 180]) or the interest relates to the reduction of capital by external borrowings for use in the business (see [22 170]). [22 170] Interest on external borrowings The deductibility of interest incurred by a partnership on money borrowed by the partnership for the purpose of permitting certain amounts of partnership capital to be returned © 2017 THOMSON REUTERS

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[22 180]

PARTNERSHIPS

to existing partners, so as to reduce the capital contribution required from prospective partners, was considered in FCT v Roberts; FCT v Smith (1992) 23 ATR 494. The Full Federal Court held that interest on money borrowed to repay to partners’ undrawn partnership distributions employed in the partnership business or working capital of the partnership originally borrowed from another source is deductible. The character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense. However, the provision of funds to the partners that do not constitute a repayment of funds invested in the partnership business lacks the essential connection with the income-producing activities of the partnership. Interest incurred on a borrowing for that purpose is therefore not incidental and relevant to the partnership business and is not deductible. The Full Court also held in Roberts that a new partner was entitled to a deduction for the interest expense as it was a condition of admission to the partnership to accept liability to the bank for interest payments on the borrowing. The interest liability had the necessary connection with the assessable income. The interest expense was considered similar to interest incurred by an incoming partner who borrowed from an external financier to finance the purchase from the other partners of the partnership share or where an incoming partner is financed into the partnership by the other partners and is required to pay interest to them. The Commissioner accepts that such interest is deductible, provided the capital account reduced represented funds employed in the partnership business resulting from contributions or retention of earnings as opposed to capital generated by mere book entries such as internally generated goodwill or unrealised revaluations of assets: Ruling TR 95/25. However, the provision of funds to the partners that do not constitute a repayment of funds invested in the partnership business lacks the essential connection with the income-producing activities of the partnership and, therefore, the related interest incurred is not incidental and relevant to the partnership business and is not deductible. The refinancing principle established in Roberts should be applied with caution. In AAT Case 13,135 (1998) 39 ATR 1105, a partner was disallowed a deduction for his share of interest incurred on a personal overdraft account that the taxpayer operated jointly with his spouse. The taxpayer’s argument that a necessary connection existed between the derivation of partnership income and the interest expenses was rejected because, had the taxpayer drawn down his full share of the partnership profits and used them to reduce the overdraft, the interest would not have been incurred. By only partially drawing down the profits, the partner contributed to the partnership’s working capital requirements. Interest on borrowings to pay partners their share of profit distributions is deductible as it represents the replacement of funds retained for use in the business. However, interest on borrowings to pay drawings against anticipated profits is only deductible when the drawings are set off against finally determined profit distributions: Ruling TR 95/25. The ‘‘refinancing principle’’ is considered not to apply to statutory partnerships: see also AAT Case 10,079 (1995) 30 ATR 1169.

[22 180] Interest on money lent by partner If a partner makes a loan to the partnership (as distinct from introducing capital), the interest is an allowable deduction in calculating the net income or loss of the partnership and is assessable to the partner: Leonard v FCT (1919) 26 CLR 175. If partnership funds are withdrawn and replaced by a loan from a family discretionary trustee to maintain ownership by the partners of income-earning properties, the interest is deductible: Yeung v FCT (1988) 19 ATR 1006. [22 190] Interest on money borrowed by partner Whether interest incurred by a partner on borrowings is deductible depends on how the borrowed funds are used, in accordance with the general principles discussed at [9 450]. Thus, for example, if the funds are used to acquire an income-producing asset, the interest is 894

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[22 210]

generally deductible. On the other hand, the individual expenses of an individual partner are not incurred in the carrying on of a partnership business. Thus, interest on borrowed funds used to pay a partner’s personal income tax liability is not deductible: Determination TD 2000/24. Any borrowing by the individual partner on account of income tax relates to the partner’s personal income tax obligations and lacks any direct connection with the business or income activities of the partnership.

[22 200] Drawings Drawings are those amounts withdrawn from the business by the owner(s) and are merely prepayments of the distribution of the business profits. They are not taken into account in determining the individual interests in the net income of a partnership or in a partnership loss. This is illustrated in Example [22 200.10] where the partnership concerned actually charges interest on drawings made by partners. EXAMPLE [22 200.10] Y’s account in partnership books of ‘‘Y and Z’’. $ Drawings ............................. 20,000 Capital ................................. Interest on drawings ........... 600 Interest on capital ............... Balance c/d ......................... 110,400 Salary .................................. Half-share profits ................. 131,000

$ 100,000 5,000 8,000 18,000 131,000

Assuming there is no adjustment of the profits for taxation purposes, Y’s total interest in the net income of the partnership is $30,400. Interest on capital ................................................................................................. 5,000 Salary .................................................................................................................... 8,000 Share profits ......................................................................................................... 18,000 31,000 less interest on drawings ...................................................................................... 600 30,400

From this example, Y was entitled to $12,400 (ie 5,000 + 8,000 − 600) before the calculation of the half-share in the balance of the partnership income. If it is assumed that Z received no adjustment for a salary, interest on capital or interest on drawings, then each partner receives $18,000 and the total partnership net income would have been $48,400 (ie 18,000 × 2 + 12,400). As a result, Y is entitled to $30,400 (ie 12,400 + 18,000) and Z is entitled to $18,000, a total of $48,400 between them which corresponds to the total partnership income. As such, the adjustments are merely elements in determining the total profit share. In the above example, while only $20,000 has been withdrawn, Y must include $30,400 in assessable income. Even had the drawings exceeded $30,400, this is the amount that must be included in assessable income: Case 6 (1983) 27 CTBR(NS) 6. For a case where partnership records were virtually non-existent and amounts withdrawn from the partnership account were treated as drawings, see Re Beydoun and FCT (2004) 57 ATR 1226. Note that a taxpayer is not entitled to a deduction under s 8-1 for a loss of accumulated undrawn partnership profits upon resignation from the partnership: see ATO ID 2003/483.

[22 210] Earnings outside the partnership The partnership agreement may require a partner to bring into the partnership earnings from employment or services rendered outside the partnership. If any such earnings are © 2017 THOMSON REUTERS

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[22 220]

PARTNERSHIPS

subject to an express or constructive trust in favour of the partnership, the earnings should be directly included in the partnership net income and not in the partner’s assessable income. However, if the earnings are not subject to a trust, or were not derived as agent for the partnership, the partner is beneficially entitled to the earnings and will be assessed on them and they will not be included in the partnership net income: see also Case 131 (1983) 26 CTBR(NS) 131. Whether earnings are subject to an express or constructive trust, or are derived as agent for the partnership, depends on the circumstances of the particular case. Note that if the partner is contractually bound to pass on the earnings to the partnership, he or she may be able to claim a deduction for the amount passed on: Service v FCT (2000) 44 ATR 71, although the case did not concern a partnership. For an example of where earnings were paid to the taxpayer in his own right and were not partnership income, see Re Baldwin and FCT (2005) 58 ATR 1245. Where a partner is a director of a company, the Tax Office considers that if the appointment as director is as agent for the partnership or resulted from the opportunity arising from a partnership business connection, any directors’ fees paid to the partner are received as trustee for the partnership and will therefore be included in the partnership net income and not the partner’s assessable income: Determination TD 97/2. However, if the appointment as director is unrelated to the partner’s membership of the partnership, or the partners agree that the individual partner may retain any director’s fees, the partner is beneficially entitled to those fees (irrespective of any agreement to pay the fees to the partnership): Determination TD 97/2. If so, they will be included in her or his assessable income, although a deduction may be available if they are paid to the partnership (see above). Note that Determination TD 97/2 only applies to professional partnerships (eg accounting and legal firms), but there seems to be no reason why the views expressed should not also apply to other partnerships. Although an amount should be withheld under the PAYG withholding system from directors’ fees and other earnings paid to a partner, Ruling IT 2321 and Determination TD 97/2 suggest that amounts need not be withheld if the partner receives the fees or earnings as trustee for the partnership (those rulings concerned the former PAYE system).

[22 220] Changes of interests in partnership property Work-in-progress (WIP) is the value of services performed by a firm during an income year for which the firm cannot legally demand payment (ie no recoverable debt has arisen), so that income is not derived in respect of those services in that income year. A tax deduction is available for a payment made in respect of WIP to the extent that, at the end of the income year, a recoverable debt has arisen in respect of the relevant work or the taxpayer reasonably expects a recoverable debt to arise within 12 months after making the payment: s 25-95. The remainder of the WIP payment is deductible in the following income year. A WIP payment is correspondingly assessable in the hands of the recipient: s 15-50. Where a WIP is transferred by a partnership to a company in return for shares in the company, each partner is assessable on the market value of their interest in the WIP at the date of the transfer. The CGT implications of a change in the interests in a partnership and WIP payments are considered at [22 300] and following. In FCT v Nandan (1995) 31 ATR 477, it was held that a partnership dissolution agreement that provided that the retiring partner was entitled to receive a fixed sum out of the final annual partnership profits displaced the original partnership agreement, which had provided for equal shares of profit between the 2 partners. It was held that only the fixed sum was assessable, not the 50% share that had been varied by the dissolution agreement. There are special rules in Subdiv 40-D ITAA 1997 (Uniform Capital Allowance system) dealing with changes in interests in depreciating assets, including plant. These will apply, for example, where there is a change in partners: see [10 850]. Roll-over relief in respect of depreciating assets is also available where a partnership is a small business entity: see [25 170]. There are special provisions (discussed at [5 420]) to deal with the following situations (s 70-100): 896

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[22 240]

• a sole trader who owns trading stock of a business transfers the assets to a partnership comprising the sole trader and a trustee of a discretionary trust; • the partnership of the sole trader and the trustee, in turn, transfers the assets to the trustee (see Determination TD 96/3); and • partners of a partnership that owns trading stock transfer the assets to a trustee of a unit trust in which one of the former partners holds at least 25% of the units (see Determination TD 96/4).

[22 230] Varying income interests of partners As a general rule, the net income of the partnership should be distributed according to the basic agreement between the partners for the sharing of profits and losses: Ruling IT 2316. However, individual consideration will be given to cases where it is apparent that the partnership agreement is merely a device to enable distributions to be made that are completely out of proportion to the partners’ true interests in partnership assets or their participation in the partnership business. If the variation constitutes an adjustment to the capital interests of the partners, there may be CGT implications, discussed at [22 300] and following. A retrospective variation of the partners’ interests in the net income of the partnership after the end of the income year is not effective for income tax purposes: see AAT Case 5303 (1989) 20 ATR 3905 and para 26 of Ruling TR 2005/7 (the ruling discusses the effect of an agreement to pay a salary to a partner). A prospective variation may be effective, subject to the operation of the anti-avoidance provisions of Pt IVA (discussed in Chapter 42). A variation must also comply with the relevant State or Territory Partnership Act. A partnership agreement that divided the profits of the firm between 2 partners who were empowered to distribute them between other partners was held in Jones v FCT (1963) 109 CLR 342 to be merely a mandate governing the distribution of accrued partnership profits within the operation of s 19 ITAA 1936 (the predecessor to ss 6-5(4) and 6-10(3), which deem income to be received by an entity when it is applied or dealt with on behalf of that entity: see [3 260]). [22 240] Service arrangements for professional partnerships Service arrangements are used by professional partnerships to protect assets, develop wealth independently (in, say, a family trust) and facilitate tax minimisation by income splitting. A service arrangement typically involves a trust that is controlled, or a company that is owned and/or controlled, by the taxpayer who is carrying on business, either alone or in partnership, providing a range of services to the business. These services may include staff hire and recruitment services, clerical and administrative services, providing premises and plant and/or equipment and debt collection services. The service entity provides these services at cost plus a commercial mark-up. The use of service entities was accepted as explicable on commercial grounds in FCT v Phillips (1978) 8 ATR 783. In that case, the service entity, a fixed unit trust, was effectively owned by trusts established for the benefit of the partners’ wives and family members. While the Commissioner accepts the correctness of the decision in Phillips (see Rulings IT 276 and TR 2006/2), the case is not authority for the proposition that expenditure made under a service arrangement and calculated using the particular mark-ups adopted in that case will always be deductible under s 8-1. According to Ruling TR 2006/2, whether expenditure made under a service arrangement is deductible depends on what the expenditure was calculated to achieve from a practical and business point of view. This is a question of fact. Ruling TR 2006/2 acknowledges that where the benefits conferred by a service arrangement provide an objective commercial explanation for the whole of the expenditure made under the arrangement, the expenditure will be deductible under s 8-1. However, where the benefits do not provide an objective commercial explanation for the whole of the expenditure, a broader examination of all of the circumstances surrounding the expenditure © 2017 THOMSON REUTERS

897

[22 240]

PARTNERSHIPS

will be required to determine what the expenditure was for. Depending on the particular circumstances, this may include an examination of the relationship between the taxpayer and the service entity, the manner in which the taxpayer and the service entity have dealt with each other and the taxpayer’s subjective purpose in incurring the expenditure. The ruling goes on to state that a service arrangement may not suffice to provide an objective commercial explanation for the whole of the expenditure if the service fees and charges: • are disproportionate or grossly excessive in relation to the benefits conferred by the service arrangement – according to the Tax Office, a good rule of thumb for determining whether the service fees and charges levied by a service entity are commercially realistic is to ask whether an independent person in the same circumstances would engage the service entity to provide the same or similar property or services on the same (or substantially similar) terms to those the taxpayer has entered into with the service entity; • guarantee the service entity a certain profit outcome without reasonable commercial explanation; or • generate profits in the service entity without any clear evidence that the service entity has added any value or performed any substantive functions. For example, this might occur where there is no clear separation between the service entity’s business activities and those of the taxpayer. If a broader examination is undertaken and it is determined that the expenditure under a service arrangement was, in whole or in part, incurred wholly in connection with the taxpayer’s income earning activities or business, the expenditure will be deductible. On the other hand, if it is determined that the expenditure was incurred partly or wholly in the pursuit of an independent advantage then, to that extent, based on a fair and reasonable apportionment, the expenditure will not be deductible. The ruling states that the characterisation of expenditure under a broader inquiry must always be resolved by a commonsense or practical weighing of the whole set of objects and advantages which the taxpayer sought in making the outgoing. In that context, if the expenditure is paid to a related service entity and it is grossly excessive, this would raise the presumption that the expenditure was not wholly payable for the purposes of the taxpayer’s income producing activities or business but for some other purpose. The Tax Office has also published guidelines (Your Service Entity Arrangements – NAT 13086) to help practitioners decide whether to review their service arrangements. It uses a 3-step approach: (i) identify how the service arrangement assists the taxpayer in running the business; (ii) determine whether the service fees are correctly calculated; and (iii) determine whether the arrangements are adequately documented. Service arrangements should be reviewed where the fees are disproportionate or grossly excessive in relation to the benefits conferred on the taxpayer’s business or where the taxpayer has agreed to pay service fees calculated without regard to the value of the services provided by the service entity. Other triggers are where the business being conducted by the taxpayer is not clearly separated from the business being carried on by the service entity or where there is a failure to maintain adequate records evidencing the service arrangement and its benefits to the taxpayer. The guide sets out a number of methodologies to determine if the fees have been ‘‘correctly calculated’’. Taxpayers can apply the indicative rates contained in the guide, but can also obtain comparable market prices or use the comparable profits approach. Where the indicative rates are used and the profits of the service entity do not exceed 30% of the combined profits of the professional firm and the service entity, the risk of an audit is low. The Tax Office has said that it will look at cases where service fee expenses are over $1m and represent over 50% of the gross fees or business income earned and where the net profit in the service entity (or service entities) represents more than 50% of the combined net 898

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[22 250]

profit of the entities involved (the 12-month review period does not apply in these cases). The Tax Office will also look at cases where there are serious questions as to whether the services were in fact provided by the service entity.

Application of Pt IVA In determining whether Pt IVA ITAA 1936 applies to a service arrangement, the relevant question is whether the identified scheme was entered into or carried out in the particular way for the dominant purpose of obtaining a tax benefit for a relevant taxpayer in connection with the scheme: Ruling TR 2006/2. The identification of the relevant taxpayer and the nature of the tax benefit depend on the particular facts and circumstances of each case. For example, where grossly excessive fees are charged, the scheme may simply comprise the charging of the excessive fees. The relevant purpose (of entering into the scheme) is to be predicated by reference to the objective factors set out in s 177D(2): see [42 130]. The ruling states that relevant considerations for service arrangements may include: • the manner in which the arrangement is entered into including any non-commercial aspects of the arrangement. For example, where the service fees are excessive and not negotiated in a commercial manner; • any divergence between the form (that a separate service entity is providing the services) and the substance (which in a particular case may be the taxpayer assumes all risks and operates as if there were no separate service entity). For example, there may be no clear evidence that the service entity has added any value or performed any substantive functions independently of the taxpayer, or the service entity is so highly integrated with the professional practice that it is difficult to differentiate between them; and/or • the impact of the service entity arrangements on the on-going profitability of the taxpayer relative to what other possibilities existed. For example, the arrangements may not make any business sense regarding the long term profitability of the firm. However, Pt IVA will not apply where: • the service entity arrangements make objective business sense; • the service entity actually performs its contractual duties such that there is an alignment between form and substance; • the service fees and charges are commercially realistic; and • the arrangements do not contain unusual features (eg use of loss entities as service providers). Part IVA was applied in Case Decision Summary CDS 10283, to strike down a service trust arrangement for a partnership of doctors.

[22 250] Alienation of share of partnership income – Everett assignments Prior to the release of Taxpayer Alert TA 2013/3 (on partnerships of discretionary trusts), the Commissioner accepted that the assignment of an interest in a professional partnership is effective for tax purposes if the assignment is ‘‘on all fours’’ with the High Court decisions in FCT v Everett (1980) 10 ATR 608 and FCT v Galland (1986) 18 ATR 33: see Rulings IT 2330 and IT 2501. In FCT v Everett (1980) 10 ATR 608, the taxpayer, who was a partner in a law firm, assigned to his wife, who was also a qualified legal practitioner, 6/13 of his share in the partnership, with the right to the proportionate share of partnership profits referable to it. A majority of the High Court held that the 6/13 share of the partnership profits was assessable to the taxpayer’s wife and not to the taxpayer. © 2017 THOMSON REUTERS

899

[22 250]

PARTNERSHIPS

In FCT v Galland (1986) 18 ATR 33, a father and son carried on a law firm in partnership. The son assigned 49% of his 50% interest in the partnership to a discretionary family trust. The High Court held that the assignment was effective, even though the son was a potential beneficiary of the trust and had the power to remove the trustee. Similarly, in Kelly v FCT (2013) 94 ATR 411, several partners in a law firm validly assigned a 30% ‘‘collective’’ interest in the partnership to a holding trust for the benefit of each partner’s family trust. The assignment was held to be effective in equity because the intention of the partners was clear and there was payment of consideration by the trust. On the other hand, the purported transfer of 20% of the partnership interests pursuant to a ‘‘Retirement Deed’’ was found to be ineffective as there was insufficient evidence of any transfer and no evidence of consideration provided by the trust for the assignment. Key principles arising from these various decisions include: • a partnership interest is a chose in action which is assignable in whole or in part; and • an assignee of a partnership interest does not become a partner – the assignee only acquires a right to receive the portion of the partner’s income attributable to that interest. The Tax Office has released 2 documents – Assessing the Risk: Allocation of Profits Within Professional Firms and Everett Assignments – dealing with the potential application of Pt IVA ITAA 1936 to Everett assignments entered into on or after 1 July 2015. A practitioner will need to satisfy one of the following ‘‘benchmarks’’ in order for the Tax Office to view the assignment as low risk: 1. the practitioner receives assessable income from the firm as an appropriate return for the services provided to the firm (‘‘equivalent remuneration’’); 2. at least 50% the income to which the practitioner and her or his associated entities are collectively entitled (whether directly or indirectly through interposed entities) is assessable in the hands of the practitioner (‘‘50% entitlement’’); or 3. the practitioner, and associated entities, each have an effective tax rate of 30% or higher on the income received from the firm (‘‘30% effective tax rate’’). These benchmarks are considered further at [63 285]. The Tax Office may also consider applying Pt IVA to a pre-1 July 2015 assignment where, after 30 June 2015, the practitioner fails to satisfy any of the above benchmarks following a further assignment or the exercise of a power of appointment or other discretion. However, where this occurs, the practitioner will have the opportunity to self-correct the arrangement in the following income tax year. Note that where the power to revoke the bare trust created by an Everett assignment exists in the assignment itself, or in the supporting documents, this would fall within s 102 (revocable trusts: see [23 1300]) and the assignment would be ineffective for tax purposes. The above discussion relates only to whether there has been a successful assignment so as to cause the assignee to be assessed on the assigned portion of the partnership income. However, there are also CGT considerations which effectively mean that Everett assignments may only be advantageous if the relevant interest is a pre-CGT asset. There may be implications for a partner’s deductions and share of losses as a result of Ruling IT 2608. There are also stamp duty considerations. For CGT purposes, an Everett assignment will be treated as the disposal by the assigning partner of the relevant fraction of that partner’s interest in the partnership assets, despite the fact that the assignee has only an equitable interest in the assignor’s partnership interest and legal title to partnership assets continues to vest in the partners rather than the assignee: Ruling IT 2540. Under s 110-25(2), the cost base is limited to money paid and/or the market value of any property given for the acquisition of the partnership interest. An Everett 900

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PARTNERSHIPS

[22 260]

assignment not made at arm’s length will cause the market value substitution rule in s 112-20 to apply, which will require the value of the right to future partnership income to be taken into account. Relying on s 112-20(1)(b), it has been contended that the consideration given by a partner for the partner’s interest in the partnership has a value equal to the value of that interest. The deductibility of expenses and losses after an assignment and the effect of a partnership dissolution upon the assignment are discussed in Ruling IT 2608. In Taxpayer Alert TA 2013/3, the Tax Office stated that it will be reviewing arrangements involving accountants, lawyers and other professionals operating through partnerships of discretionary trusts where an individual purports to make the trustee of a discretionary trust a partner in a firm, but fails to give legal effect to that structure or fails to account for its tax consequences. The Tax Office is concerned that, in some cases, the arrangement may be ineffective in alienating the individual’s income; may have CGT consequences for the individual which have not been correctly identified; and may involve a scheme to which Pt IVA may apply. The Tax Office is reviewing Rulings IT 2330, IT 2501 and IT 2540.

[22 260] ‘‘No goodwill’’ partnerships In a ‘‘no goodwill’’ professional practice, the practitioner entities agree that when a new practitioner entity is admitted into the practice they are not required to pay an amount which reflects a value for any goodwill of the practice. Further, when the practitioner exits the practice, they are not entitled to receive a payment which reflects a value for any goodwill of the practice. The Tax Office has published on its website guidelines explaining its administrative treatment of the acquisition and disposal of interests (practice interests) in ‘‘no goodwill’’ professional partnerships: see Administrative treatment: acquisitions and disposals of interests in ‘‘no goodwill’’ professional partnerships, trusts and incorporated practices. The administrative treatment set out in the table below will apply where the treatment corresponding to the relevant issue is adopted and the various requirements in the guidelines are satisfied. These include: • the practitioner entity must carry on or participate in the carrying on of a professional practice and be a partner in a partnership carrying on that practice; and • the dealings and relationships between the parties must satisfy a number of conditions concerning documentation and arm’s length dealings. CGT: calculation of cost bases Section 112-20 ITAA 1997 (see The market value of the practice and reduced cost bases of the [14 160]) interest at the time of acquisition practice interest is treated as being equal to the amount the taxpayer pays (including nil) in respect of the acquisition. CGT: calculation of the capital Section 116-30 ITAA 1997 (see The market value of the practice proceeds in respect of a CGT [14 260]) interest at the time of disposal is event happening to a practice treated as being equal to the interest amount the taxpayer receives (including nil) in respect of the disposal. Off-market share buyback Section 159GZZZQ(2) ITAA The market value of the practice (OMB): calculation of 1936 (see [20 710]) interest at the time of disposal is consideration in respect of an treated as being equal to the OMB of shares in an amount the taxpayer receives incorporated practice (including nil) in respect of the disposal. Employee share scheme: Section 83A-20 ITAA 1997 (see The market value of the practice calculation of a discount (if any) [4 180]) interest at the time of acquisition on the issue of shares in an is treated as being equal to the incorporated practice amount the taxpayer pays (including nil) in respect of the acquisition.

Where the administrative treatment is applied, it must be applied to all applicable tax issues set out above. In addition, the CGT treatment of assets which are exchanged for practice interests subject to the guidelines should be determined on a consistent basis. © 2017 THOMSON REUTERS

901

[22 300]

PARTNERSHIPS

CAPITAL GAINS TAX [22 300] CGT and partnerships – overview A partnership is not treated as an entity distinct from the partners, and the ITAA 1997 CGT provisions make clear what was implicit in the ITAA 1936 – that partners entering or leaving a partnership have an interest in each partnership asset: ss 106-5, 108-5(2) and Subdiv 106-A. The majority underlying interest rules in Div 149, which determine when an asset stops being a pre-CGT asset (see [17 250]), generally do not apply to partnerships (because partners directly own the assets of the partnership), although they may indirectly apply where there is a corporate partner. Section 106-5 contains the principal rules governing the application of the CGT provisions to partnerships and partners together with examples illustrating its operation. 1. The partners individually make any capital gain or loss from a CGT event happening in relation to a partnership or one of its CGT assets. Each partner’s gain or loss is calculated by reference to the partnership agreement or to partnership law if there is no agreement. 2. Each partner has a separate cost base and reduced cost base for the partner’s interest in each CGT asset of the partnership. 3. If a partner leaves a partnership, the remaining partners acquire separate CGT assets to the extent that the remaining partners acquire a share of the departing partner’s interest in a partnership asset. 4. If a new partner is admitted to a partnership: (a) the new partner acquires a share of each partnership asset; and (b) the existing partners are treated as having disposed of part of their interest in each partnership asset to the extent that the new partner has acquired it. CGT event K7 applies to disposals of depreciating assets that are partnership assets to the extent that the use of the assets is a ‘‘non-taxable’’ use: see [13 700]. Furthermore, the gain or loss will be calculated at the partnership level and then, in effect, attributed to the respective individual partners who held interests in the asset: s 106-5. See, for example, ATO ID 2006/200 which confirms that partners do not have an individual interest in a depreciating asset where CGT event K7 occurs, but instead have an interest in the capital gain or loss calculated by reference to the partnership as holder of the depreciating asset. Other CGT provisions specifically affecting partners and partnerships include: • the definition of a ‘‘CGT asset’’ (s 108-5(2)(c), (d)): see [12 150]; • the relevant taxpayer (s 106-5 and Subdiv 106-A): see [12 310]; • the cost base of a partner’s interest in a CGT asset of the partnership (ss 110-43, 110-50): see [14 080]; • the reduced cost base of a partner’s interest in a CGT asset of the partnership (s 110-60): see [14 090]; and • roll-over relief where a CGT asset is transferred to a wholly owned company (s 122-125 and Subdiv 122-B): see [16 050].

[22 310] Dual assessability – CGT v other provisions Section 118-20 applies where an assessable amount in respect of the disposal of a partnership asset is taken into account under a non-Pt 3-3 provision (excluding capital deduction recoupment provisions: see below) in determining the net income of a partnership 902

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[22 320]

or a partnership loss. The proportion of the assessable amount taken into account in determining an individual partner’s share of partnership income or loss reduces the amount of any capital gain realised by a partner on the disposal of an interest in a partnership asset. A calculation must be made of the ‘‘partner’s share’’ of the amount included in the assessable income or exempt income of the partnership (ie of the individual interest of the partner in the net partnership income or loss that is attributable to the included amount). If the amount of the capital gain does not exceed the partner’s portion of the amount included, no capital gain is taken to have accrued to the partner in respect of the disposal. A capital gain accrues to the partner only to the extent of the amount, if any, by which the capital gain exceeds the partner’s portion of the amount included. Section 118-20(5) excludes from the reduction of the capital gain of a partner amounts included in the assessable income of the partnership arising from balancing adjustments: see [14 500].

[22 320] Dissolution/reconstitution of partnership The dissolution of a partnership may be by agreement between the partners, by death or bankruptcy of a partner or by a court on the application of a partner. Reconstitution of a partnership occurs where a partner dies or retires and the partnership continues with the remaining partners, or where a new partner is admitted to the partnership. The disposal of a partnership interest is treated as the disposal of the partner’s fractional interest in each of the particular CGT assets of the partnership. The disposal consideration must be apportioned appropriately. Similarly, the acquisition of a partnership interest is treated as the acquisition of a fractional interest in each of the relevant partnership assets with a suitably apportioned cost base. A partner’s interest in partnership assets may change from time to time as the composition of the partnership changes though there may be a continuing interest component that is not reduced or changed. EXAMPLE [22 320.10] A new partner, C, joins an equal partnership of 2 members, A and B. Each of A and B is treated as having disposed to C 1/3 of their interests in post-admission partnership assets, ie 1/6 each of the total of such assets. C is treated as having acquired a 1/3 interest in all partnership assets (1/6 from each of A and B). This will be an acquisition of CGT assets by C, even if the assets were acquired by A and B before 20 September 1985. If C introduced CGT assets to the firm on a similar basis, there will be a disposal by C of 2 /3 of C’s interest, 1/3 to each of A and B. The acquisitions by A and B are of CGT assets, even if their interests in other partnership assets were acquired before 20 September 1985. The 1/3 interests of each of A and B (in the total) that they retain are not affected (though where they relate to CGT assets, there will be cost base apportionments). The same applies to the 1/3 interest retained by C in assets introduced.

Where a partnership is reconstituted (a common occurrence for large legal and accounting firms), the Tax Office treats the partnership as a continuing entity with the same ABN and TFN if there is a written agreement incorporating a provision for a change in the membership or shares of the partnership (a ‘‘continuity clause’’), notwithstanding judicial support for the view that a continuity clause is ineffective: see the minutes of the Tax Office Tax Practitioner Forum meeting on 2 November 2001 and Ruling GSTR 2003/13 (para 163). In any event, irrespective of the terms of the partnership agreement, the Tax Office will treat reconstituted partnerships with at least 20 partners as a continuing entity with the same ABN and TFN provided the change represents less than a 10% change in the beneficial interest of the partnership. The Commissioner accepts in Ruling IT 2540 that, in the case of large professional partnerships, the partners generally deal with each other at arm’s length and therefore the actual cost bases or disposal proceeds relating to interests in partnership assets will be accepted for tax purposes. This will also apply to the partners of smaller partnerships who © 2017 THOMSON REUTERS

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[22 330]

PARTNERSHIPS

deal with each other at arm’s length in an ordinary commercial context. With large professional partnerships, the admission or retirement of a partner will not have CGT consequences unless consideration is paid. However, the changes in the proportionate ownership of partnership assets by the individual partners must still be taken into account. The parties’ agreement to dissolve a partnership retrospectively was held to be ineffective for tax purposes in FCT v Happ (1952) 9 ATD 447. This is consistent with the treatment of the retrospective variation of the partners’ income interests: see [22 230]. For the Tax Office’s administrative treatment of CGT issues concerning ‘‘no goodwill’’ partnerships, see [22 260].

[22 330] Disposal of partnership assets Where there is a disposal of a partnership asset to a third party, each of the partners is regarded as having disposed of a fractional interest in the asset. Separate acquisition dates and cost bases must be determined with respect to each partner’s interest in each partnership asset. EXAMPLE [22 330.10] A partnership of 10 partners disposes of a block of land to a third party for $150,000. The block was originally purchased by all of them as equal partners for $90,000. Each partner is taken to have disposed of a 1/10 interest in the land. Where particular partners acquired their fractional interests at different times (some may have acquired their interests before 20 September 1985 and others on or after that date) and/or where partners have paid different amounts as consideration for the acquisition of their interests, separate calculations must be made with respect to each partner. Since the partners own equal interests in the land, each will be taken to have received $15,000 as capital proceeds on disposal. If the land had been acquired after 19 September 1985, each member who was a partner at the time of acquisition would have a cost base of $9,000 relating to her or his interest in the land and the capital gain would be calculated on that basis. If one of the 10 partners entered the partnership after the acquisition of the land by the other 9 and paid $12,000 for a 1/10 interest in the totality of partnership assets (1/90 of the whole from each of the original 9), that partner would have a cost base of $12,000 and would realise a capital gain of $3,000 (ignoring indexation) on the disposal. If the land had been acquired by the original 10 partners before 20 September 1985 and upon the retirement of one of the partners after 19 September 1985, the remaining 9 partners acquired an equal proportion of the retiring partner’s interest in the land for $1,300, there would be no CGT consequences for the retiring partner, but the other partners would each acquire a new post-19 September 1985 interest in the asset, ie 1/9 of the retiring partner’s 1/10 interest in the land (1/90 of the whole). On the subsequent sale of the land for $150,000, assuming no other changes, each partner would realise a capital gain (ignoring indexation) with respect to that new interest.

Transfer of assets to wholly owned company Roll-over relief is provided under Subdiv 122-B for the transfer of partnership assets to a company wholly owned by the partners. This can apply either to individual assets or all of the assets used in the business of the partnership, with certain exceptions. If the taxpayer chooses a roll-over, any capital gain or loss made from the trigger event is disregarded. Subdivision 122-B is considered further at [16 050].

ANTI-AVOIDANCE MEASURES [22 350] Income splitting using nominal partners Two provisions impose special rates of taxation to deter the inclusion of persons as partners merely as a means of splitting the income of the firm. 904

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1. Where the persons included as partners are minors, or where partnership income passes to a trustee on behalf of minors, Div 6AA in Pt III ITAA 1936 may apply: see [22 110] and Chapter 26. 2. Where the person included as a nominal partner is a natural person aged 18 or over (on the last day of the income year corresponding with the partnership’s income year) or a trustee holding the partnership interest on trust for an adult beneficiary, the deterrent is s 94: see [22 360]-[22 370]. With reference to the operation of Div 6AA, s 94 does not apply where income from the partnership is derived by partners or presently entitled beneficiaries who are aged under 18 on the last day of the income year of the person that corresponds with the partnership’s year of income. Because of the effectiveness of s 94, taxpayers rarely enter into arrangements that cause the section to be invoked. Note also the alienation of personal services income measures, discussed at [6 100] onwards.

[22 360] Lack of ‘‘real and effective control and disposal’’ Section 94 provides for a ‘‘further tax’’ to be payable where partnership income is derived by a person who is a partner in name only and who lacks ‘‘real and effective control and disposal’’ of their share of the partnership income. The latter is termed ‘‘uncontrolled partnership income’’: s 94(1) and (2). The rate of further tax to be imposed under s 94 is prescribed by the appropriate rating Act, in accordance with s 94(9), (11), (12) or (12A). Section 94 applies where: • a ‘‘share in the net income of a partnership’’, as defined in s 94(13), is included in the assessable income of a partner and includes both the partner’s individual interest in partnership net income and any income derived by the partner from the partnership otherwise than as a partner. It could include salary, interest or rent paid by a partnership to a partner; and • the partnership is ‘‘so constituted or controlled, or its operation … so conducted’’ that the partner lacked ‘‘real and effective control and disposal’’ of the relevant income from the partnership. Section 94 can only apply to income derived by a company from a partnership where it is acting in the capacity of a trustee. Section 94 provides for 3 alternative causative conditions that give rise to lack of ‘‘real and effective’’ control: • the constitution of the partnership; • the control of the partnership; and • the conduct of the operations of the partnership. Some assistance on the meaning of these conditions may be gained from Robert Coldstream Partnership v FCT (1943) 2 AITR 572. For example, in order to capitalise a professional partnership, it may be necessary for new partners to agree to contribute a sum of money from their share of each year’s income to the working capital of the partnership. Such a practice would not be considered to be within the ambit of s 94.

Trustees as partners Where a trustee is a member of a partnership and does not have the real and effective control and disposal of the share or part of the share of income due to the trust, that share or part of the share is ‘‘uncontrolled partnership income’’ and subject to s 94. If a beneficiary of a trust is presently entitled to the income of the trust and the income is subject to tax under s 97, or the income is assessed to the trustee under s 98, the rate of tax applicable to that share of income is determined in accordance with s 94 if it is derived in © 2017 THOMSON REUTERS

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[22 370] PARTNERSHIPS

whole or in part from ‘‘uncontrolled partnership income’’. The section details how to determine the proportion of uncontrolled partnership in various situations.

[22 370] Liability for further tax The ‘‘further tax’’ imposed by s 94(9), (11), (12) and (12A) ITAA 1936 effectively subjects the uncontrolled partnership income to the top personal marginal tax rate. In order to determine the net amount that is liable to further tax, the following are deducted from the amount of the s 94 income (s 94(10)): • any deductions allowable to the taxpayer that relate exclusively to s 94 income; • that proportion of any other deductions (other than apportionable deductions) allowable to the taxpayer as may appropriately be related to s 94 income; • an appropriate proportion of the taxpayer’s ‘‘apportionable deductions’’. ‘‘Apportionable deductions’’ are rates, land tax and most tax-deductible gifts (but not trading stock): see [27 470]. EXAMPLE [22 370.10] Bhakthi’s assessable income for the income year is $42,000, comprising $24,000 investment income and $18,000 partnership income over which she lacks real and effective control and disposal. She borrowed $60,000; $40,000 was used for investments purposes and the balance of $20,000 was contributed to the capital of the partnership. During the income year, Bhakthi paid $5,100 interest on the loan. She also made deductible gifts (of money) totalling $2,600 (‘‘apportionable deductions’’) and paid deductible tax-related expenses of $460 (of which $270 related to the partnership income). Her taxable income is therefore $33,840 ($42,000 – ($5,100 + $2,600 + $460)). The portion of Bhakthi’s partnership income that is subject to ‘‘further tax’’ under s 94 is worked out as follows (ignoring cents): $ Partnership income ................................................................................................ 18,000 less deductions (other than apportionable deductions) related to the partnership income (interest and tax-related expenses) $ $18,000 × $5,100 = 2,185 $42,000 + 270 Proportion of apportionable deductions relevant to partnership income: $2,600 × ($18,000 − ($2,185 + $270)) = 1,109 3,564 $33,840 + $2,600 14,436 The taxable income of the taxpayer from the partnership would be: Income subject to s 94........................................................................................ Income subject to normal rates (ie $33,840 − $14,436) ................................... Taxable income

14,436 19,404 33,840

The rate of further tax under s 94(9) is calculated using the following formula: A–B C where: “A” is 47% of the taxable income (ie $15,904); “B” is the tax payable on taxable income at the standard rates, ignoring any offsets, rebates or credits (ie tax on $33,840 at 2016-17 rates = $2,971, an average rate of 8.78%); and “C” is the number of whole dollars in the taxable income (ie $33,840).

906

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PARTNERSHIPS

[22 400]

The rate of further tax and tax payable (for 2016-17) is: Rate of additional tax

= =

Further tax under s 94(9)

=

$15,904 − $2,971 $33,840 $12,933 (average rate 38.22%) $33,840 $14,436

×

38.22%

= $5,517 = standard tax ($2,971) + further tax ($5,517) = $8,488 Note that the effect is to subject the uncontrolled partnership income of $14,436 to tax at a combined rate equal to the top personal marginal income tax rate for 2016-17 (including the 2% Temporary Budget Repair Levy but ignoring the Medicare levy) (ie 8.78% + 38.22% = 47%). However, the low-income taxpayer offset is available: see [19 300]. Total tax payable

Where a trustee is assessable under s 98 or s 99 ITAA 1936 and part of the income derived by the trust is income to which s 94 applies, the trustee is liable to pay further tax on a similar basis to that payable by individual taxpayers (see Example [22 370.10]): s 94(11) and (12).

[22 380] Primary production partnerships and s 94 Under Div 392 ITAA 1997, primary producers may be entitled to a tax offset calculated by reference to the rate of tax applicable to the average income or may have to pay extra income tax: see [27 450]. A taxpayer may have income subject to averaging that is also uncontrolled partnership income. In calculating the further tax payable under s 94, the rate of tax payable on the deemed taxable income from primary production that is uncontrolled partnership income is calculated at the rate applicable to the average income that effectively, by means of the tax offset or extra tax, is applied to the primary production income. Where a taxpayer has uncontrolled partnership income from a business of primary production and from other sources, the calculation of the further tax payable under s 94 is made in 2 stages. The tax payable on the income derived from a business of primary production is calculated by reference to the tax on the average income because that effectively is the rate of tax applicable to that income. In the case of income from other sources, the average rate is determined from the tax that would be applicable but for any rebates or credits otherwise allowable. In each case, further tax is equal to the difference between the top personal marginal tax rate and the percentage rate of tax determined, as explained. These provisions are contained in s 94(10A), (10B) and (10C). The situation where a trustee is a member of a primary production partnership in receipt of uncontrolled partnership income is dealt with in s 94(12B) and (12C).

CORPORATE LIMITED PARTNERSHIPS [22 400] Limited partnerships As noted at [22 010], the definition of ‘‘partnership’’ in s 995-1 includes a limited partnership. A ‘‘limited partnership’’ is effectively defined as a partnership where the liability of at least one of the partners is limited: s 995-1. There is no distinction between private and public limited partnerships and there is no restriction on where the limited partnership may be formed (whether in Australia or overseas). In D Marks Partnership and FCT [2016] FCAFC 86, the Full Federal Court upheld an AAT decision (Re D Marks Partnership and FCT [2015] AATA 651) that one of the taxpayers was not a partnership under the Queensland Partnership (Limited Liability) Act 1988 or © 2017 THOMSON REUTERS

907

[22 410]

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general law and therefore could not be a limited partnership. An Australian-formed unincorporated association of persons, who do not carry on a business in common with a view to profit, is not a general law partnership (see [22 030]) and therefore cannot be a corporate limited partnership: see Determination TD 2008/15. The definition of ‘‘limited partnership’’ in s 995-1 also encompasses a limited partnership incorporated as a separate legal entity and formed solely for the purpose of becoming a venture capital limited partnership (VCLP), an early stage venture capital limited partnership (ESVCLP), an Australian venture capital fund of funds (AFOF) or a venture capital management partnership (VCMP): see [22 410]. Limited partnerships may be established under specific legislation in Australia and overseas. Under the State and Territory legislation the liability of the limited partners is usually limited to their capital contribution and limited partners generally are precluded from taking any part in management of the partnership business. Typically, there must be at least one general partner who bears the unlimited liability of a conventional general law partner. Division 5A in Pt III ITAA 1936 (ss 94A to 94Y) provides for the general taxation of ‘‘corporate limited partnerships’’ as companies for all tax purposes. One important consequence of this is that the tax losses of such partnerships cannot be deducted directly by the partners. This treatment may be compared with corporate unit trusts and public trading trusts that are taxed as companies: see [23 1550]-[23 1610].

[22 410] Corporate limited partnerships Limited partnerships that may be corporate limited partnerships under s 94D are those that fall within the broad definition of a ‘‘limited partnership’’: see [22 400]. However, certain venture capital limited partnerships (see below) and foreign hybrid limited partnerships (see [22 400]) are not corporate limited partnerships. A Bermudan Exempted Limited Partnership is a corporate limited partnership (see ATO ID 2006/149); a Delaware Limited Partnership (DLP) formed under the Delaware Revised Uniform Limited Partnership Act can be a corporate limited partnership (see ATO ID 2010/9). A corporate limited partnership is treated as a continuous entity, unaffected by a change in its membership: s 94C. All references to a ‘‘partnership’’ are to be read as references to the s 6(1) (and also s 995-1) category of partnership and not to a corporate limited partnership: ss 94H and 94K. In addition, all references to a ‘‘private company’’ are to be read as not including a corporate limited partnership: s 94N. Such references occur, for example, in ss 103 to 103A, ITAA 1936 and ss 26-35, 136-25, 202-75, 203-45 and 995-1 ITAA 1997. A reference in the income tax law to a shareholder includes a reference to a partner in a corporate limited partnership (s 94Q). Along with the extended meaning of ‘‘share’’ (s 94P), ‘‘dividend’’ and ‘‘company’’ (see [22 420]), this ensures that many provisions for the taxation of companies and shareholders apply to corporate limited partnerships and their partners. Venture capital limited partnerships The following types of limited partnership are specifically excluded from the definition of a ‘‘corporate limited partnership’’ for income tax purposes (s 94D(2)): a VCLP, an ESVCLP, an AFOF and a VCMP. These types of limited partnership are recognised under Australian tax law primarily for the purpose of providing a CGT and income tax exemption for profits or gains made by such entities on the disposal of their eligible venture capital investments: see [7 470] and [15 650]. VCLPs, ESVCLPs, AFOFs and VCMPs are taxed on a flow-through basis as ordinary partnerships with special provision made in s 92(2AA) to restrict a limited partner’s loss deduction in an income year to the partner’s financial exposure to the loss. Any ‘‘excess’’ s 92(2AA) amounts may be deductible in subsequent years under s 92A, but cannot form part of a tax loss that can be carried forward under Div 36 ITAA 1997 (see [8 460]). (For the rules governing the use of losses incurred by an entity before it became a VCLP, see [8 380].) Where an entity becomes or ceases to be a VCLP, an ESVCLP, an AFOF or a VCMP, the entity’s income year is split into 2 periods according to the rules in s 18A: see [1 110]. 908

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Collective investment vehicle Note the proposal to introduce a limited partnership collective investment vehicle from 1 July 2018, to facilitate wholesale investment by large investors such as pension funds: see [23 680]. [22 420] Treatment as a ‘‘company’’ for tax purposes Corporate limited partnerships are taxed as companies through a series of modifications (made by ss 94H to 94W) to the ‘‘income tax law’’ (including provisions of the TAA insofar as they relate to the ITAA 1936, ITAA 1997 and Rates Act) as it applies to a corporate limited partnership in relation to an income year: s 94H. Broadly, all references in the income tax law to a company or to a body corporate (with certain exceptions) are to be read as including a reference to a corporate limited partnership: s 94J. The exceptions are the definitions of “dividend”, “resident” and “resident of Australia” and Div 355 ITAA 1997 (the R&D tax concession: see [11 020] and following). The treatment of corporate limited partnerships (including dividends paid by such partnerships) in respect of various international matters corresponds with the treatment of companies (including dividends paid by companies) in those areas. The areas affected are: the foreign income tax offset (FITO), controlled foreign companies (CFC) and former foreign investment fund (FIF) provisions. A corporate limited partnership is a resident for the purposes mentioned in s 94T(a) to 94T(d) if, and only if, the partnership was formed in Australia or it either carries on business in Australia or has its central management and control in Australia. A corporate limited partnership is taken to have been incorporated in the place where it was formed and under a law in force in that place: s 94U. The debt/equity rules in Div 974 ITAA 1997 apply to corporate limited partnerships in the same way they apply to companies. The debt/equity rules are discussed in Chapter 31. [22 430] Other corporate tax modifications Other special provisions apply to adopt the income tax law to corporate limited partnerships. For the purposes of the income tax law, references to a ‘‘dividend’’, or to a ‘‘dividend within the meaning of s 6’’, include a reference to a distribution made by a corporate limited partnership to a partner in the partnership, whether in money or other property. As a result, the distribution is assessable as a dividend paid out under s 44 ITAA 1936: see [21 030]. This does not apply, however, to the extent the distribution is attributable to profits or gains from a year when the partnership was not a corporate limited partnership: s 94L. Note that s 44(1A) (which provides that a dividend paid out of an amount other than profits is taken to be a dividend paid out of profits: see [21 030]) does not operate for the purposes of determining whether a payment made by a corporate limited partnership (on or after 28 June 2010) is taken to be a dividend under s 94L, thereby allowing corporate limited partnerships to effectively return capital to partners. If a corporate limited partnership pays or credits an amount to a partner in the partnership from profits or anticipated profits, the amount paid or credited will be deemed to be a dividend paid by the partnership to the partner out of profits derived by the partnership: s 94M. Assessable income of shareholders includes certain dividends paid out of profits under s 44(1); companies generally pay dividends only out of profits, as a matter of corporations law, but limited partnerships could pay dividends from other sources more readily. One view of partnership law as it applies to corporate limited partnerships suggests that their income only arises when accounts are taken despite their treatment as companies for taxation purposes. It could also be argued that profits do not arise until their amount can be finally ascertained. As corporate limited partnerships can make distributions before the taking of accounts out of anticipated profits the provision ensures that such distributions will be taken to be made out of profits. If the partnership makes a subsequent distribution of profits which includes an amount paid or credited in anticipation of profits, the Commissioner is required to take any steps that are necessary to ensure that a partner is not subject to double taxation. © 2017 THOMSON REUTERS

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This ensures that if a partner has already been taxed on a distribution when it was credited, the partner will not face tax again when the distribution is actually paid. Broadly, obligations and offences of corporate limited partnerships are taken to be those of the individual partners with certain joint and several liabilities. Treating corporate limited partnerships as companies for income tax purposes does not convert them into companies for other purposes, including criminal law, monetary claims and so on. Other special modifications relate to the liquidator of a corporate limited partnership (s 94R), the current year and prior period loss provisions in Subdivs 165-A and 165-B (s 94X) and the company collection rules (s 94Y).

[22 440] Foreign hybrids Division 830 ITAA 1997 deals with the taxation of investments in foreign hybrids. A foreign hybrid is a foreign hybrid limited partnership or a foreign hybrid company with the following essential features (ss 830-5, 830-10, 830-15): • it must be formed in a foreign country and must not be an Australian resident at any time; • it must be taxed in the relevant foreign jurisdiction as a partnership, that is, the partners or shareholders are taxed rather than the entity itself. The Commissioner considers that whether foreign income tax is imposed on the partnership or the partners for these purposes, consideration must be given to characteristics specific to the limited partnership in question where they affect its status, and/or the status of the partners, as taxpayers: Determination TD 2009/2. The determination also points out that entity may still be a foreign hybrid even if the partners or shareholders are not subject to foreign tax on the income or profits of the entity in a particular income year, eg because the entity made a loss; • it must not be taxed in another foreign country (apart from the country of formation) as a resident of that country; and • it must (at the end of a statutory accounting period that ends in the relevant income year) be a CFC with at least one attributable taxpayer (see [34 390]) having an attribution percentage greater than nil. In simple terms, this means that there must be a least one Australian taxpayer who has a direct or indirect interest of at least 10% in the limited partnership or company. If a partner in a limited partnership is not an attributable taxpayer for CFC purposes, the limited partnership is a foreign hybrid only if the partner makes an election under s 830-10(2), or had made an election under former s 485AA to exclude foreign hybrids from the operation of the repealed FIF provisions (see [34 330]) (elections made under s 485AA before its repeal continue in force). Note that a foreign resident cannot elect to treat their interest in a limited partnership as an interest in a foreign hybrid limited partnership under s 830-10(2): see Draft Determination TD 2016/D2. Examples of foreign hybrid limited partnerships include a UK limited partnership formed under the UK Limited Partnerships Act 1907 (ATO ID 2006/334), a German Kommanditgesellschaft (ATO ID 2007/47) and a US limited partnership formed under the Delaware Revised Uniform Limited Partnership Act (ATO ID 2008/80). A UK limited liability partnership incorporated under the UK Limited Liability Partnerships Act 2000 can be a foreign hybrid company (but not a foreign hybrid limited partnership): see ATO ID 2006/331 and ATO ID 2006/332 and reg 830-15.01 ITA Regs. A US limited liability company (including a single member limited liability company) can be a foreign hybrid company: see ATO ID 2006/18, ATO ID 2010/77 and ATO ID 2012/70. Foreign hybrid limited partnerships are not corporate limited partnerships for the purposes of the ITAA 1936 and ITAA 1997: s 94D(5). The taxation of foreign hybrids and interests in foreign hybrids is summarised below. 910

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1. Foreign hybrids are treated for taxation purposes as partnerships. Therefore, the normal ‘‘flow-through’’ taxation treatment under Div 5 Pt III ITAA 1936 applies, whereby tax is levied on the partners or shareholders of the hybrid rather than the hybrid itself (eg see ATO ID 2006/18). One consequence of this is that a foreign hybrid whose only members are Australian residents will not be liable to pay interest withholding tax on interest received from an Australian resident entity: see ATO ID 2012/70. 2. There are limitations on the losses of a foreign hybrid which can be deducted by a partner or shareholder of the foreign hybrid against income from other sources. The limits are based on the limited partner’s or shareholder’s contributions to the foreign hybrid. The limit is adjusted annually for additional contributions or withdrawals and for previous losses taken into account. There are similar limitations on the capital losses that are allowed to partners and shareholders in foreign hybrids. The principle that underlies this treatment is that limited partners and shareholders in a foreign hybrid should not be able to claim deductions for tax losses to which they are not exposed economically because of their limited liability. 3. Transitional rules transfer asset values from the foreign hybrid to the partners or shareholders (or vice versa) when an entity becomes or ceases to be a foreign hybrid. This value transfer does not give rise to a taxable event and is necessary to ensure coherent CGT treatment – assets of the foreign hybrid are treated for CGT purposes as assets of the partners or shareholders of the foreign hybrid, not the assets of the hybrid itself. Ruling TR 2009/6 states that where a resident taxpayer’s assessable income includes a share of the net income of a foreign hybrid (under s 92), the taxpayer is entitled to a FITO under s 770-10(1) ITAA 1997 for foreign income tax paid under the law of a foreign country in respect of that income, irrespective of whether it was the taxpayer, the foreign hybrid or some other entity which pays the foreign income tax.

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TRUSTS AND THE TAXATION OF TRUST INCOME Overview ....................................................................................................................... [23 010]

FEATURES AND TYPES OF TRUSTS Nature of a trust ............................................................................................................ [23 Creation, variation and resettlement of a trust ............................................................. [23 Trust, trust estate, trustee and beneficiary .................................................................... [23 Types of trust ................................................................................................................ [23

020] 030] 040] 050]

OVERVIEW OF TRUST INCOME-ASSESSING PROVISIONS Core provisions – outline .............................................................................................. [23 100] Special rules affecting trusts ......................................................................................... [23 110] Rates of tax ................................................................................................................... [23 120] Administrative matters .................................................................................................. [23 130] CORE TRUST INCOME-ASSESSING PROVISIONS Assessment of trust income – introduction .................................................................. [23 Application of Div 6 to a resident trust estate ............................................................ [23 Application of Div 6 to a non-resident trust ................................................................ [23 Derivation of income for the purposes of Div 6 ......................................................... [23 Trustee’s assessment and right to recover tax from the trust estate ........................... [23 Character and source of trust income .......................................................................... [23 Capital gains and losses ................................................................................................ [23 Special rules for franked distributions ......................................................................... [23 Trust losses .................................................................................................................... [23 Income allocated to exempt bodies .............................................................................. [23 Income allocated to superannuation funds, ADFs and PSTs ....................................... [23

150] 160] 170] 190] 195] 200] 210] 220] 230] 240] 250]

INCOME AND NET INCOME OF A TRUST ESTATE Income of a trust estate ................................................................................................ [23 Net income of a trust estate .......................................................................................... [23 Allocation of share of net income to beneficiary ........................................................ [23 Position where trust income exceeds net income ........................................................ [23

300] 310] 320] 330]

PRESENT ENTITLEMENT AND LEGAL DISABILITY Present entitlement: general principles ......................................................................... [23 Present entitlement: deceased estates ........................................................................... [23 Statutory clarification and extension of present entitlement ....................................... [23 Legal disability .............................................................................................................. [23

400] 410] 420] 430]

BENEFICIARY PRESENTLY ENTITLED TO TRUST INCOME Presently entitled beneficiary not under a legal disability .......................................... [23 450] Presently entitled beneficiary under a legal disability ................................................. [23 460] Beneficiary presently entitled as trustee of another trust ............................................ [23 470] NO BENEFICIARY PRESENTLY ENTITLED TO TRUST INCOME Trustee assessed ............................................................................................................ [23 500] Matters to be considered by the Commissioner .......................................................... [23 510] Income of deceased received after death ..................................................................... [23 520] TRUST INCOME NOT PREVIOUSLY TAXED Purpose and scope of s 99B ......................................................................................... [23 550] FOREIGN RESIDENT BENEFICIARIES Basic rules ..................................................................................................................... [23 600] Variations to the basic rules .......................................................................................... [23 610] Capital gains to which a foreign resident beneficiary is entitled ................................ [23 620] 912

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Interaction with the withholding tax rules ................................................................... Deemed permanent establishment and deemed source rules ...................................... Investment manager regime .......................................................................................... Refunds to foreign residents .........................................................................................

[23 [23 [23 [23

630] 650] 655] 660]

MANAGED INVESTMENT TRUSTS Special tax rules for managed investment trusts ......................................................... [23 680] New AMIT regime ........................................................................................................ [23 685] AUSTRALIAN BENEFICIARIES OF NON-RESIDENT TRUSTS Interaction of transferor trust rules with Div 6 ............................................................ [23 700] MINORS Beneficiaries who are minors ....................................................................................... [23 750] Trusts for children of the settlor ................................................................................... [23 760]

REFORM OPTIONS Options paper ................................................................................................................ [23 770]

TRUST LOSSES INTRODUCTION Trust loss recoupment – overview ............................................................................... [23 800] Summary – tests applicable .......................................................................................... [23 810] Excepted trusts .............................................................................................................. [23 820] FAMILY TRUSTS Family trusts – overview .............................................................................................. [23 Family group ................................................................................................................. [23 Family control test ........................................................................................................ [23 Family trust election ..................................................................................................... [23 Interposed entity election .............................................................................................. [23 Family trust distribution tax – primary ........................................................................ [23 Family trust distribution tax – secondary .................................................................... [23

850] 860] 870] 880] 890] 900] 910]

FIXED TRUSTS – OWNERSHIP Fixed trusts – meaning .................................................................................................. [23 950] Ordinary fixed trusts ..................................................................................................... [23 960] Widely held trusts – general ......................................................................................... [23 970] Widely held trusts – types ............................................................................................ [23 980] Fixed trusts – overview of tests ................................................................................... [23 990] 50% stake test ............................................................................................................. [23 1000] Abnormal trading ........................................................................................................ [23 1010] Same business test ...................................................................................................... [23 1020] NON-FIXED TRUSTS – OWNERSHIP/CONTROL Non-fixed trusts – meaning ........................................................................................ Non-fixed trusts – overview of tests .......................................................................... 50% stake test ............................................................................................................. Control test .................................................................................................................. Pattern of distributions test .........................................................................................

[23 [23 [23 [23 [23

1050] 1060] 1070] 1080] 1090]

CURRENT YEAR LOSS CALCULATIONS Current year loss calculations – overview ................................................................. [23 1150] Division of year into periods ...................................................................................... [23 1160] Attribution of deductions to periods ........................................................................... [23 1170] Attribution of income to periods ................................................................................ [23 1180] Notional net income or notional losses for periods ................................................... [23 1190] Net income for year – calculation .............................................................................. [23 1200] Tax loss for year – calculation ................................................................................... [23 1210] © 2017 THOMSON REUTERS

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INCOME INJECTION Income injection test – all trusts ................................................................................ [23 1250] Family trusts – modified application .......................................................................... [23 1260] Consequences of breach .............................................................................................. [23 1270]

ANTI-AVOIDANCE PROVISIONS REVOCABLE AND OTHER TRUSTS Revocable trusts .......................................................................................................... [23 1300] Trusts for children of settlor ....................................................................................... [23 1310] REIMBURSEMENT AGREEMENTS Amount taxed in hands of trustee .............................................................................. [23 1350] CONTRIVED AND NON-COMMERCIAL ARRANGEMENTS Trust arrangements under Tax Office scrutiny ........................................................... [23 1400] Arrangements involving trusts and private companies .............................................. [23 1410] Income derived and expenses incurred in connection with a tax avoidance agreement .... [23 1420] CLOSELY HELD TRUSTS Overview of Div 6D ................................................................................................... [23 What is a closely held trust? ...................................................................................... [23 Correct TB statement .................................................................................................. [23 Lodgment requirements for TB statement ................................................................. [23 Consequences if no correct TB statement made ........................................................ [23 Tax-preferred amounts ................................................................................................ [23

1450] 1460] 1470] 1480] 1490] 1500]

TRUSTS TREATED AS COMPANIES CORPORATE UNIT TRUSTS Corporate unit trusts – outline .................................................................................... [23 1550] Definition of corporate unit trust and related terms .................................................. [23 1560] PUBLIC TRADING TRUSTS Public trading trusts – outline .................................................................................... [23 1600] Definition of public trading trust ................................................................................ [23 1610]

TRUSTS AND THE TAXATION OF TRUST INCOME [23 010] Overview This chapter deals with the taxation of income derived by an entity (or entities) in the capacity of trustee (or trustees) of a trust or as a beneficiary of a trust. For the sake of convenience, this chapter refers to such income as trust income or the income of, or income derived by, a trust although, strictly speaking, a trust cannot derive income because it is a fiduciary obligation or a set of fiduciary obligations (see [23 020]) and not a legal person. A trust is included, however, in the definition of ‘‘entity’’ in s 960-100 ITAA 1997. This is significant for the purposes of applying some parts of the income tax law, for example the provisions dealing with the consolidation of corporate groups: see [23 110]. But, in general, the income tax law relating to trust income applies to a person in the capacity of trustee or beneficiary of a trust rather than applying to the trust itself. The main provisions for assessing trust income are contained in Div 6 of Pt III ITAA 1936. In general, those provisions determine not only the amount of income assessed but also whether it is taxed in the hands of a beneficiary, the trustee or both. The general Div 6 rules are modified for: 914

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• special disability trusts; • trust income in the form of franked distributions; • capital gains made by trusts; • trust income to which the dividend, interest and royalty withholding tax provisions apply; • amounts to which the investment manager regime applies; and • certain amounts derived by trustees of managed investment trusts. There are also special rules for determining the circumstances in which losses incurred by certain trusts can be set off against current year income or future income. Finally, corporate unit trusts (to 30 June 2016), public trading trusts, qualifying superannuation funds, approved deposit funds, pooled superannuation trusts, trusts forming part of a consolidated income tax group and ‘‘attribution managed investment trusts’’ (from 1 July 2016 or, by election, 1 July 2015) are covered by income tax rules outside Div 6.

Terminology: foreign resident Although the ITAA 1936 uses the term ‘‘non-resident’’ for an entity that is not a resident of Australia, the term ‘‘foreign resident’’ (the ITAA 1997 terminology) is generally used in this chapter to conform with the policy stated in [2 020]. Approach The approach taken in this chapter is: • first to consider briefly fundamental concepts of trust law that are relevant to the taxation of trust income (see [23 020]-[23 050]); • then to provide an overview of the relevant taxing provisions (see [23 100]-[23 250]); • then to explain key concepts and provisions in Div 6 in more detail (see [23 300]-[23 760]), before covering special rules regarding: – the taxation of franked distributions derived by trusts: see [23 220] (although considered in greater detail in [21 530]); – the taxation of capital gains made by a trust: see [23 210] (although considered in greater detail at [17 020]-[17 060]); – the interaction between the trust income assessing provisions and the withholding tax provisions that apply to dividends, interest and royalties paid to foreign residents: see [23 630]; – the treatment of certain other income and gains derived by foreign entities where the investment manager regime (IMR) applies: see [23 655]; – the rules applying to managed investment trusts (MITs), including elective application of the streaming rules for capital gains and franked distributions (see [23 680]), and the new regime for attribution managed investment trusts (AMITs): see [23 685]; and – restrictions on the ability to deduct prior year and current year losses in calculating the net income of the trust on which tax is payable: see [23 800]-[23 1270]. Specific anti-avoidance rules that apply to the taxation of trust income are also considered, including the special withholding rules for distributions from certain closely held trusts: see [23 1300]-[23 1500]. © 2017 THOMSON REUTERS

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The chapter then deals with income derived by a trustee of a public trading trust which is taxed in the same way as income derived by a company (and equivalent rules that applied to corporate unit trusts before their repeal with effect from 1 July 2016): see [23 1550]-[23 1610].

Reforms Substantial amendments have been made to resolve difficulties regarding the taxation of trust income, and other proposals are under consideration, as summarised below. • A Treasury consultation paper: ‘‘Modernising the taxation of trust income: options for reform’’ was released in November 2011 and is available via the Treasury website. A further discussion paper on this topic was released on 24 October 2012: see [23 770]. Draft legislation was expected in early 2013 and the new measures were expected to apply from 1 July 2014: see the then Assistant Treasurer’s media release No 080, 30 July 2012. However, as at 1 January 2017, there had been no further developments (eg no draft legislation had been released). • The Board of Taxation recommended in March 2011 that the concept of ‘‘net income of a trust estate’’ (on which presently entitled beneficiaries, and in some cases trustees, are taxed) should be better aligned with the concept of ‘‘income of a trust estate’’ (‘‘present entitlement’’ to which determines the share of the net income on which a beneficiary is taxed). The then Government decided to defer consideration of the ‘‘alignment’’ issue to the broader trust tax law review that had previously been announced: see the then Assistant Treasurer’s media release No 52, 11 April 2011. • The Board of Taxation also recommended that measures be introduced to allow capital gains and franked distributions to be streamed through trusts to particular beneficiaries. Such measures have been introduced (see [23 210] and [23 220]) but are expected to be replaced if the taxation of trust income is reformed (as discussed above). • Treasury released a discussion paper in July 2012 on ‘‘A more workable approach to fixed trusts’’. The concept of a ‘‘fixed trust’’ is of particular importance to the operation of the trust loss carry forward rules: see [23 950]. Draft legislation was expected to be released in early 2013 (see the then Assistant Treasurer’s media release No 080, 30 July 2012), but it had not been released as at 1 January 2017. However, the new rules for AMITs (see below) deem an AMIT to be a fixed trust and the Tax Office has released Draft Practical Compliance Guideline PCG 2016/D16 setting out the factors that are likely to affect the exercise of the discretion that results in a trust being treated as a fixed trust: see [23 950]. • Managed investment trust (MIT) rules were introduced to provide special tax treatment for certain widely-held trusts. These rules modify the general trust income assessing regime but do not entirely displace those rules: see [23 680]. • After a long period of consultation, legislation for an elective attribution managed investment trust (AMIT) tax regime was introduced in December 2015 and enacted in May 2016: see [23 685]. The AMIT regime applies to income years starting on or after 1 July 2016, but an MIT can elect to apply the new rules for an income year starting on or after 1 July 2015. The AMIT rules provide an alternative to the MIT rules for widely held trusts that meet certain additional tests. • An investment manager regime (IMR) was introduced to ensure that the appointment of an Australian fund manager by a widely held foreign entity did not have the effect that income and gains that would otherwise not be taxable in Australia became subject to Australian tax: see [23 655]. These rules were expanded and in some circumstances they now apply even where the foreign entity is not widely held and where no Australian fund manager is used. 916

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FEATURES AND TYPES OF TRUSTS [23 020] Nature of a trust A trust is not a legal entity or person; it is a fiduciary obligation or set of fiduciary obligations accepted by a person (known as the ‘‘trustee’’) or persons (‘‘trustees’’) in relation to property (known as the ‘‘trust property’’). Such obligations are to be exercised for the benefit of another person or persons (‘‘beneficiaries’’) or for a specified purpose. A trustee may be a natural or any other juristic person. The trustee of a trust holds a legal or equitable interest in trust property and is obliged to deal with that interest in accordance with the terms of the trust for the benefit of the beneficiary or beneficiaries, or to achieve the purpose of the trust. A trustee may be a beneficiary of the trust but may not be the sole beneficiary. If the trustee were the sole beneficiary, the trustee’s interests in the trust property would merge and the trust would cease to exist. [23 030] Creation, variation and resettlement of a trust Creation of a trust In general, an express trust is created when a person (the ‘‘settlor’’) ‘‘settles’’ the trust by transferring legal ownership of property, or a beneficial interest in property, to a trustee or trustees, subject to the obligations constituting the trust. An express trust may be created by the settlor transferring property to a trustee during his or her lifetime (an ‘‘inter vivos’’ trust) or by will upon the death of the settlor (a ‘‘testamentary trust’’ or ‘‘will trust’’). The terms of an inter vivos express trust are generally set out in a written instrument (the ‘‘trust deed’’) but may also be spoken or implied by conduct. The deposit of moneys into an account on behalf of a developer and a landowner created an express trust in Walsh Bay Developments Pty Ltd v FCT (1995) 31 ATR 15. A property syndicate that is structured to comply with the requirements of the managed investment scheme provisions of the Corporations Act 2001 is considered to be a trust: Determination TD 2005/28. Purported declarations of trust were found to be unsupported by the evidence in DCT v Haritos (2014) 99 ATR 12. In Korda & Ors v Australian Executor Trustees (SA) Ltd [2015] HCA 6, the High Court found that statements in a prospectus for a timber investment scheme did not support the contention of investors that an express trust existed, in favour of the investors, over the proceeds of disposal of the timber and land previously owned by the scheme entities. A resulting trust comes into existence where a person conveys property to another person without the intention that the person to whom the property has been conveyed is to obtain a beneficial interest in the property. In many such cases, there will be an express trust in relation to the property that has been conveyed, but if there is no express trust, or if the terms of the express trust fail, a resulting trust will arise. A constructive trust is imposed by operation of law where, in equity, it would be unconscientious for the holder of title to property to deny the claimant a beneficial interest in the property or for a person to deny that he or she is liable to account to the claimant as if he or she were an express trustee. In FCT v Sarkis (2003) 54 ATR 127, the Supreme Court of Victoria granted the Commissioner an order that the appellants, who owed considerable amounts of tax, were the beneficial owners of property under a constructive trust. The behaviour of the appellants in paying all the outgoings on the property and in borrowing against the property to effect improvements led the court to conclude that a constructive trust existed. This decision was confirmed on appeal in Sarkis v DCT (2005) 59 ATR 33. A constructive trust over stolen money was found to exist in Zobory v FCT (1995) 30 ATR 412. In Re the Employed Accountant and FCT (2012) 91 ATR 468, cheques drawn in favour of the Tax Office were deposited in the taxpayer’s bank account because, according to the taxpayer, the accounting practice’s trust account was not in order. The Tax Office assessed © 2017 THOMSON REUTERS

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the amounts deposited as income. The AAT found that the funds were received by the taxpayer on trust for the Tax Office and were therefore not income beneficially derived by the taxpayer. In contrast, in Howard v FCT (2014) 92 ATR 38, the High Court held (in 3 separate judgments all arriving at the same conclusion) that equitable compensation received by the taxpayer in satisfaction of a Supreme Court judgment was not the subject of a constructive trust in favour of a company of which the taxpayer was a director. A trust over property may also arise by operation of law or by order or declaration of a court. The laws relating to bankruptcy, for example, allow for the appointment of a trustee who becomes the legal owner of the bankrupt person’s property and is obliged to deal with that property for the benefit of the bankrupt person’s creditors.

Variations and resettlements The power to vary the terms of a trust may be found in those terms. In Andtrust v Giovanni Andreatta [2015] NSWSC 38, the Supreme Court of NSW held that the terms of the trust permitted a change to the vesting date. In Jenkins v Ellett [2007] QSC 154, the Supreme Court of Queensland held that the variation power given to the trustee did not extend to the removal of the principal, who had the power to remove and replace the trustee. Where a proposed variation is not within the terms of a trust, a court may be authorised by statute to approve the variation of a trust in certain circumstances. A useful reference to the legislative provisions of States and Territories authorising a variation to the terms of a trust may be found in Determination TD 2012/21 (see footnote 4). In Re Arthur Brady Family Trust; Re Trekmore Trading Trust [2014] QSC 244; [2015] 2 Qd R 172, the Supreme Court of Queensland made an order sought by the trustees to vary the vesting date of a trust in view of the substantial CGT and stamp duty costs that would arise if the trusts vested on the original vesting date. The court held that the amendment to the vesting date ‘‘could fairly be characterised as a transaction’’, with the result that the order was within the court’s jurisdiction under the Trusts Act 1973 (Qld). Victorian cases in which a variation in the terms of a trust was found to be a ‘‘transaction’’ which could be, and was, authorised by the court include Ballard v Attorney-General [2010] VSC 525; 30 VR 413. In contrast, in Re Dion Investments Pty Ltd [2014] NSWCA 367; (2014) 87 NSWLR 753, the New South Wales Court of Appeal upheld the primary judge’s decision that s 81 of the Trustee Act 1925 (NSW) did not permit the Court to confer upon the trustee a general power to vary the terms of the trust, as such a variation would not be a ‘‘transaction’’. In exceptional circumstances a court may exercise its inherent (extra-statutory) jurisdiction to vary the terms of a trust. In Paloto Pty Limited v Herro [2015] NSWSC 445, the plaintiff accepted that in view of the decision in Re Dion Investments, the NSW Supreme Court could not authorise an amendment to the vesting date of the trust under s 81 of the Trustee Act 1925 (NSW), but sought to invoke the inherent jurisdiction of the court to sanction the proposed variation. The court held that the imminent vesting of the trust, which would have resulted in substantial CGT and stamp duty costs, was not an ‘‘emergency’’ which allowed the court, under its inherent jurisdiction, to authorise an amendment to the vesting date of the trust. Whether changes to a trust create a new trust (a resettlement) will depend on the particular circumstances. The question of whether a trust has continued, or has ceased and has been replaced by a new trust, is particularly important where brought forward losses are available in determining the net income of the trust if it is not a new trust. Note that CGT event E1 may happen when a new trust is created: see [13 200]. Other CGT events relating to trusts (E2 to E10) are considered at [13 210]-[13 290]. In FCT v Clark (2011) 79 ATR 550, Edmonds and Gordon JJ considered that the indicia of continuity identified in FCT v Commercial Nominees of Australia Ltd (2001) 47 ATR 220 (see [41 350]) in relation to a superannuation fund apply equally for the purposes of the income tax laws governing trusts (Div 6). Edmonds and Gordon JJ went on to find that changes which the Commissioner argued had brought about a break in the continuity of the 918

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trust estate were insufficient to have had that effect. Dowsett J, dissenting, found that the trust estate ceased to exist ‘‘when the trust was effectively deprived of all assets and then re-endowed’’. The High Court refused special leave to appeal against this decision. Following this decision, the Tax Office withdrew the document – Creation of a new trust – Statement of Principles August 2001 – which set out its views on this issue. In Determination TD 2012/21, the Commissioner acknowledged that, as a result of the Full Federal Court’s decision in FCT v Clark (2011) 79 ATR 550, the approach set out in the Statement of Principles was not sustainable. The Commissioner now accepts that ‘‘continuity of trust is a function of whether the trust continues in existence under trust law in contradistinction to having terminated’’. In August 2016, the Tax Office issued an addendum to TD 2012/21 omitting a more complex interpretation of the position. In July 2016, the Tax Office added commentary headed ‘‘Trusts – concern around vesting’’ to its website. The commentary states that if the vesting date of a trust is not changed, ‘‘continuing to administer the trust in the same manner as before the vesting date does not provide a basis for saying this date has been validly extended’’. The Tax Office also said that it would publish detailed information about the tax consequences of vesting, including attempts to extend the vesting date after a trust has vested.

[23 040] ‘‘Trust’’, ‘‘trust estate’’, ‘‘trustee’’ and beneficiary Trust and trust estate The term ‘‘trust estate’’, rather than ‘‘trust’’, is used in the basic trust income-assessing provisions in the ITAA 1936. The term ‘‘trust estate’’ is not defined in the income tax legislation but seems to mean, broadly, the property that forms the subject of the trust or the source of the income that is subject to the trust. Thus, the ‘‘income of the trust estate’’ is clearly the income that arises from the property (or other source) that is the ‘‘trust estate’’.

Trustee The term ‘‘trustee’’ is defined in s 6(1) ITAA 1936 to include an executor or administrator, guardian, committee, receiver or liquidator and every person having the administration or control of income affected by any express or implied trust, or acting in a fiduciary capacity or having the possession, control or management of the income of a person under any legal or other disability. The application of this definition to persons holding moneys for the benefit of other persons in the course of legal and commercial affairs has been considered in Harmer v FCT (1991) 22 ATR 726, Dwight v FCT (1992) 23 ATR 236 and Registrar of the Accident Compensation Tribunal v FCT (1993) 26 ATR 353. An administrator appointed under Pt 5.3A of the Corporations Act 2001 is considered to be a ‘‘trustee’’ for the purposes of s 254 ITAA 1936 (see [49 250]). In Leighton v FCT (2011) 84 ATR 547, the Full Federal Court held that a foreign resident who set up share trading accounts in the names of 2 non-resident corporations, and used those accounts for trading in Australian shares, was not a trustee of a trust but was merely acting as a broker or agent in relation to the operation of those accounts. In a Decision Impact Statement on the case, the Commissioner states that once it had been concluded that the 2 non-resident companies were themselves carrying on a business of trading in shares, it followed that Mr Leighton was not a trustee in relation to the income derived from that business. In FCT v Australian Building Systems Pty Ltd (In Liq) [2015] HCA 48, the High Court held that only a trustee ‘‘in the ordinary sense’’ (and not a liquidator, despite the definition of ‘‘trustee’’ in s 6(1) ITAA 1936) is a trustee for the purposes of Div 6. However, the limitation read by the High Court into the definition of ‘‘trustee’’ for the purposes of Div 6 does not apply for the purpose of s 254: see [49 250]. That provision applies to ‘‘every agent and every trustee’’. Under the definition of trustee in s 6(1), this includes a liquidator (as confirmed by the High Court in FCT v Australian Building Systems © 2017 THOMSON REUTERS

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Pty Ltd (In Liq) [2015] HCA 48). The Tax Office considers that it also includes an administrator appointed under Pt 5.3A of the Corporations Act 2001: ATO ID 2003/506. See further [23 195].

Beneficiary The term ‘‘beneficiary’’ is not defined in the income tax legislation. The essential meaning of the term is a person who is ‘‘entitled to enforce the trustee’s obligation to administer the trust according to its terms’’: Kafataris v DCT (2008) 73 ATR 531 at [42] per Lindgren J. In Yazbek v FCT (2013) 88 ATR 792, the Federal Court applied Kafataris in concluding that a taxpayer who was an object of a discretionary trust, but was not presently entitled to any income of the trust in a particular income year, was a beneficiary of the trust in that year. This was relevant to the question of whether the Commissioner was entitled to issue an amended assessment to the taxpayer outside the 2-year amendment period that applies to taxpayers with simple tax affairs (see [47 130]). In Colonial First State Investments Ltd v FCT (2011) 81 ATR 772, the Commissioner argued that a trustee of a trust (the ‘‘Retail Fund’’) was not a beneficiary of another trust (the ‘‘Wholesale Fund’’) because the relevant units in the Wholesale Fund were held by a custodian on behalf of the trustee of the Retail Fund. The Federal Court said that the Commissioner’s conclusion ‘‘ignores equity’s concern with substance rather than form’’ and held that the trustee of the Retail Fund was a beneficiary of the Wholesale Fund despite the custodianship arrangement in relation to the units in the Wholesale Fund. [23 050] Types of trust There are many different types of trust. The general trust income-assessing provisions in Div 6 of Pt III ITAA 1936 apply to all trusts except those mentioned in [23 100] (but see the comments below on bare trusts, transparent trusts and secured purchase trusts). In addition, specific sets of rules apply to specific types of trust for specific income tax purposes. Some types of trust that are relevant to the operation of the income tax law are discussed briefly below. Bare trust, transparent trust and secured purchase trust The simplest form of trust is a bare trust. In Corumo Holdings Pty Ltd v C Itoh Ltd (1991) 24 NSWLR 370, Meagher JA at NSWLR 399 described a ‘‘bare trustee’’ for the purposes of a specific NSW statutory provision (since repealed) as ‘‘no more than a nominee or cypher, in a commonsense commercial view’’. The passage in Meagher JA’s judgment in which this description occurs was cited with approval by Sackville J in Australian Securities Commission v Bank Leumi Le-Israel (1995) 134 ALR 101 at 685. As a matter of administrative practice, a trust that meets the Tax Office’s description of a ‘‘Transparent Trust’’ is not required to lodge an income tax return unless the trustee is liable to pay tax on the net income of the trust estate under Div 6: Practice Statement PS LA 2000/2. The same concession (and proviso) applies to a ‘‘Secured Purchase Trust’’, which is described in PS LA 2000/2 as a trust ‘‘created solely to facilitate the financing or holding of publicly listed company shares or publicly listed units in a unit trust’’. It is arguable that such a trust is not a genuinely bare trust because a financier has a security interest in the trust property. See also [23 130] regarding the obligations of a series of custodians to lodge tax returns, and the comments below on ‘‘instalment trusts’’. As noted at [23 040], the Federal Court held in Colonial First State Investments Ltd v FCT (2011) 81 ATR 772 that a person (the trustee of the ‘‘Retail Fund’’) was a beneficiary of a unit trust (‘‘the Wholesale Fund’’) even though the units in the Wholesale Fund were held by a custodian for the benefit of the trustee of the retail fund. In other words, the Court looked through the custodianship arrangement in concluding that the trustee of the Retail Fund units was a beneficiary of the Wholesale Fund. In a Decision Impact Statement on this case, the Tax Office stated it accepted that ‘‘in situations with facts materially the same as those in Colonial First State, a retail fund is a 920

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beneficiary of a wholesale fund in respect of units in the wholesale fund that a custodian holds as trustee of a sub-trust for the retail fund’’. The Tax Office implied that, in other cases, it remained of the view that ‘‘assets held on trust for beneficiaries form part of the relevant trust estate, the net income of which is subject to Division 6 of Part III’’, and cited as authority for that view Harmer v FCT (see [23 040]) and Di Lorenzo Ceramics Pty Ltd v FCT (see [21 270]). Nevertheless, the Tax Office went on to state that ‘‘notwithstanding his view on this issue, the Commissioner will not generally seek to disturb the current practice [of ignoring bare trusts] while ... reform options are being considered [by the Government]. However, if the Commissioner is asked or required to state his view formally, then he will do so as he understands the law to operate (namely that Division 6 of Part III of the ITAA 1936 applies in determining who is taxed on the income of all bare trusts and in what amount – aside from cases with facts materially the same as those in Colonial First State). Examples of circumstances in which the Commissioner would be obliged to state and apply his view of the law as he understands it to operate include: the provision of a private or public ruling; putting arguments and submissions to the Tribunal or a Court in a litigation matter; and responding to issues raised at a consultation forum, such as the National Tax Liaison Group (NTLG) or one of its Sub-groups’’. The Commissioner stated that he would review this approach ‘‘in the event that amendments have not been made to the law (addressing whether Division 6 applies to bare trusts) by 1 July 2014, which was the proposed date for enactment of the reforms’’. This view was reaffirmed by the Tax Office in August 2014 in a Decision Impact Statement on the Federal Court and the Full Federal Court decisions in Howard v FCT (No 2) (2011) 86 ATR 753 and Howard v FCT (2012) 91 ATR 89. The Tax Office added that ‘‘in recognition of the continued prevalence of the practice of essentially ignoring bare trusts for most income tax purposes, and the minimal risk associated with this practice in most instances, the Commissioner proposes to maintain the approach to bare trusts that he has taken in that DIS’’. The Tax Office added that it proposed to consult with practitioners about the best way to formally restate this approach.

Instalment trust Assets owned by a trustee of an ‘‘instalment trust’’ are treated as assets of the ‘‘investor’’inthetrustformostincometaxandCGTpurposes:Subdiv235-IITAA1997.An instalment trust is a trust over assets of a specifiedk ind( sharesi nw idelyh eldcompanies, unitsinwidelyheldunittrustsandstapledsecuritiesincompaniesandtruststhatarewidely held)formingpartof1of2typesofarrangement: • an arrangement through which the investor, as the sole beneficiary of the trust, has a beneficial interest in the assets that are held in trust, where those assets are used as security for a borrowing or credit that has been provided to the investor and the investor is entitled to obtain legal ownership of the assets when the obligations relating to the borrowing or credit have been discharged; or • an investment made by a regulated superannuation fund that involves a permitted limited recourse borrowing arrangement. Although the instalment trust rules were enacted in 2015, they apply with retrospective effect to assets acquired in 2007-08 or a later income year. See further [32 620].

Fixed trust and discretionary trust The term ‘‘fixed trust’’ is defined in s 272-65 in Sch 2F ITAA 1936 for the limited purposes of the trust loss provisions: see [23 950]. Under a fixed trust, each beneficiary is entitled to a fixed or predetermined share of the income and/or capital of the trust. The fixed entitlement may be defined as a set fraction or a set amount of the income and/or capital of the trust, or the balance or part of the balance of the income or capital after taking account of the entitlements of other beneficiaries. © 2017 THOMSON REUTERS

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Under a discretionary trust, some or all of the entitlements of the beneficiaries in any particular income year are determined by the exercise of the trustee’s discretionary powers. The trust instrument may place limits on the extent of the trustee’s discretion. The discretion may include the right to add or remove beneficiaries. The term ‘‘discretionary trust’’ is not defined in the income tax law, but a beneficiary in whose favour a trustee exercises a discretion to appoint trust income is deemed to be presently entitled to the amount paid to the beneficiary or applied for the benefit of the beneficiary: s 101. This has income tax consequences for the trustee and beneficiary through the operation of the Div 6 rules. There are differences between the treatment of fixed and discretionary trusts under the capital gains tax rules. In addition, the trust loss provisions (see [23 800]-[23 1270]) apply differently to ‘‘fixed trusts’’ and ‘‘non-fixed trusts’’.

Unit trust A unit trust is a form of fixed trust (but not necessarily a ‘‘fixed trust’’ as defined in s 272-65 in Sch 2F ITAA 1936) under which the entitlement of each beneficiary to trust income and trust property is determined by the number of ‘‘units’’ owned by the beneficiary. The terms of issue of the trust units may allow units to be transferred in the same manner as shares in a company. Many investment funds adopt this structure. Certain capital gains tax provisions apply only to unit trusts. In addition, it should be noted that 2 forms of unit trust – ‘‘corporate unit trusts’’ and ‘‘public trading trusts’’ – are in some respects taxed in the same way as companies: see [23 1550]-[23 1610]. The trust loss provisions also make use of the concept of a unit trust. The term ‘‘unit trust’’ is not defined for the purposes of the CGT, trust loss, corporate unit trust or public trading trust provisions. However, the meaning of the term for the purposes of the public trading trust provisions was considered by the High Court in ElecNet (Aust) Pty Ltd v FCT [2016] HCA 51: see [23 1610]. Various kinds of unit trust are defined for the purposes of the corporate unit trust and public trading trust provisions and the trust loss provisions. Employee remuneration trust The application of the trust income assessing provisions, and other aspects of the income tax law, to an employee remuneration (or employee benefit) trust arrangement (that is not a defined type of trust for income tax purposes) is considered in Draft Ruling TR 2014/D1, although aspects of the draft ruling are under review and a revised version will be issued in due course. To the extent to which its revised position for arrangements that are taxed under the employee share scheme rules in Subdiv 83A-B or Subdiv 83A-C (see [4 150]) is less favourable than the position described in paras 40 and 77 of Class Ruling CR 2013/15, the Tax Office will apply its revised position prospectively. Types of trust defined for specific purposes Certain types of trust are defined in the income tax legislation for specific purposes, for example: • instalment trusts and fixed trusts, as noted above; • ‘‘non-resident trust estates’’ for the purposes of the general trust income-assessing provisions (see [23 700]) and the ‘‘transferor trust’’ rules discussed in Chapter 34; • ‘‘family trusts’’ and ‘‘widely held trusts’’ for the purposes of the trust loss provisions: see [23 850] and [23 970]; • ‘‘closely held trusts’’ for the purposes of ‘‘trustee beneficiary non-disclosure tax’’: see [23 1460]; • ‘‘corporate unit trusts’’ and ‘‘public trading trusts’’, which are taxed in the same way as companies (but note that the corporate unit trust rules do not apply to income years commencing on or after 1 July 2016): see [23 1550] and [23 160]; 922

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• ‘‘managed investment trusts’’ or ‘‘MITS’’ (see [23 680]), which can elect for the CGT rules to apply to gains and losses (see [12 350]) and in respect of which a special withholding tax regime applies to distributions to foreign beneficiaries: see [50 090]; • ‘‘attribution managed investment trusts’’ or ‘‘AMITs’’: see [23 685]; and • FHSA trusts as defined in the First Home Saver Accounts Act 2008 (but this regime has been discontinued): see [6 280].

Chains of trusts A chain of trusts may be created in a manner analogous to a chain of companies. In such structures, a person acting in the capacity of trustee of one trust is a beneficiary of another trust or trusts. The superior trust is sometimes referred to as the ‘‘head trust’’. In certain circumstances, the assessing rules are varied if a beneficiary holds a beneficial interest in a trust in the capacity of trustee in another trust: see [23 1450]-[23 1500].

OVERVIEW OF TRUST INCOME-ASSESSING PROVISIONS [23 100] Core provisions – outline As noted in [23 010], the main provisions dealing with the taxation of trust income are in Div 6 of ITAA 1936. Division 6 has the effect that the ‘‘net income of the trust estate’’ (comprising amounts that would be assessable if derived by an Australian resident taxpayer, less losses and outgoings relating (relevantly) to the derivation of that income) is treated as assessable income of: • the beneficiaries of the trust in some circumstances; and • the trustee in some circumstances (including some circumstances in which a beneficiary is assessed on the same income, with a credit given to the beneficiary for tax paid by the trustee). The fundamental principles to which the rules in Div 6 give effect are summarised below. Note that the meanings of the key terms ‘‘net income of the trust estate’’, ‘‘income of the trust estate’’ and ‘‘present entitlement’’ are explained in [23 300], [23 310] and [23 400]. 1. A beneficiary who is presently entitled to a share of the income of the trust estate in an income year and is a resident at the end of the income year is assessed on a corresponding share of the ‘‘net income’’ of the trust estate, excluding amounts attributable to a period of non-residence during the year and also attributable to a foreign source. 2. If a beneficiary who is presently entitled to a share of the income of a trust estate is a foreign resident at the end of the income year, the trustee and the beneficiary are both assessed on a corresponding share of the net income of the trust estate, excluding amounts attributable to a period of non-residence of the beneficiary and also attributable to a foreign source. The tax paid by the trustee on this income is deducted from the amount payable by the beneficiary. 3. A trustee of a resident trust estate is assessed on the share of the net income of the trust estate corresponding to a share of the income of the trust estate to which no beneficiary is presently entitled during the income year. 4. If a beneficiary is under a legal disability (being a minor, insane or bankrupt), amounts that would otherwise be assessable income of the beneficiary are generally assessable income of the trustee. © 2017 THOMSON REUTERS

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5. If the amount derived by a trust estate would have been assessable in the year of derivation if it had been derived by an Australian resident, but it was not assessed in Australia in the year of derivation (eg because no beneficiary was presently entitled to the income and the trust was not a resident trust estate), that income is taxable when it is distributed to a beneficiary or ‘‘applied for the benefit of’’ a beneficiary. The core Div 6 rules are outlined at [23 150] and [23 160].

Exclusions Division 6 does not apply to: • corporate unit trusts (for income years starting before 1 July 2016) and public trading trusts, which are taxed in the same way as companies: see [23 1550]-[23 1610]; • superannuation funds, approved deposit funds and pooled superannuation trusts, to which a special tax regime applies: see Chapter 41; • First Home Saver Account (FHSA) Trusts (note that the FHSA regime has been discontinued: see [6 280]); • income and capital gains of a trust which forms part of a consolidated group: see [23 110]; • ‘‘instalment trusts’’: see [23 685] and [32 620]; • income that is subject to dividend, interest or royalty withholding tax: see [23 630]; • income and capital gains of a ‘‘managed investment trust’’ to the extent that it represents amounts distributed to beneficiaries as ‘‘fund payments’’: see [23 680]; • income and capital gains of an ‘‘attribution managed investment trust’’ (‘‘AMIT’’): see [23 685]; and • income and capital gains of a trust to the extent that the ‘‘investment manager regime’’ excludes the amount from the assessable income of a beneficiary: see [23 655]. Also note that a bare trust is generally ignored for income tax purposes (that is, the beneficiary is treated as if it held the interest that the trustee holds in the trust assets), and the Tax Office does not require the trustee of a ‘‘Transparent Trust’’ or a ‘‘Secured Purchase Trust’’ to lodge income tax returns in relation to the income of the trust: see [23 050]. Special rules (in Subdiv EA of Div 7A of Pt III of the ITAA 1936) are designed to prevent a trustee sheltering trust income at the company tax rate by creating a present entitlement to a private company without payment, and then distributing the underlying cash to a shareholder of the company. In such circumstances, the company will be deemed to have paid a dividend to the shareholder. See [21 300].

Interaction of general assessing provision with Div 6 The Tax Office considers that if an insurance company holds units in managed investment trusts as part of its investment business, the distributions paid to the insurance company on those units are assessable under s 6-5 ITAA 1997 to the extent that they are not part of the net income, exempt income or non-assessable non-exempt income of the relevant trust estate: see ATO ID 2011/58. The Tax Office proposed to issue a more general public ruling on the question of whether a distribution from a trust could be assessable income under s 6-5 ITAA 1997, but this initiative has been suspended while options for reforming the taxation of trust income are considered: see [23 010]. When the attribution managed investment trust (“AMIT”) rules were introduced (see [23 685]), a consequential change was enacted to provide that an AMIT beneficiary’s ‘‘starting’’ 924

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to be entitled to an amount of trust property does not cause the beneficiary to derive ordinary income under s 6-5 or statutory income under s 6-10: s 104-107F(2) and 104-107F(3).

[23 110] Special rules affecting trusts The types of trust and trust income to which the Div 6 rules do not apply are noted at [23 100]. Other special rules applying to trusts or the trustees and/or beneficiaries of trusts are noted briefly below. Capital gains and capital losses Net capital gains made by a trustee as trustee of a trust are treated as capital gains of beneficiaries of the trust, to the extent that they are ‘‘specifically entitled’’ to those capital gains: see [17 060] and [23 210]. Net capital gains to which no beneficiary is ‘‘specifically entitled’’ are taxed in the hands of beneficiaries who are presently entitled to the income of the trust, or the trustee. Special rules take account of the CGT discount and the small business 50% reduction. In some circumstances, a trustee of an Australian resident trust estate can elect to be taxed on capital gains arising in the trust in respect of which a presently entitled beneficiary would otherwise have been taxed: see [23 210]. Note that managed investment trusts can elect for the CGT rules to apply to gains and losses: see [12 350] and [23 680]. The capital gains tax rules also apply in the following situations (CGT events) involving trusts: • the disposal of an interest in a trust; • the distribution of a non-assessable amount to a beneficiary; • the creation of a trust over a CGT asset; • the transfer of an asset to a trust; • the conversion of a trust to a unit trust; • a beneficiary becoming entitled to a trust asset; • the disposal of a CGT asset of a trust to a beneficiary to end an income right; • the disposal of a CGT asset of a trust to a beneficiary to end a capital right; • a beneficiary’s disposal of a capital interest in a trust; and • the creation of a trust over future property. These CGT events are discussed in Chapter 13. The treatment of capital gains and losses made by a trust and issues regarding the allocation of capital gains to beneficiaries are discussed at [17 020]-[17 060].

Franked distributions Franked distributions derived by a trustee as trustee of a trust are treated as having been paid to beneficiaries to the extent that those beneficiaries are ‘‘specifically entitled’’ to the dividends, and franking credits are available to those beneficiaries: see [23 220]. Franked dividends to which no beneficiary is specifically entitled, to the extent that they are part of the net income of the trust estate, are taxed in the hands of beneficiaries (who are presently entitled to the income of the trust estate) or the trustee. Foreign trusts In addition to Div 6, the ‘‘transferor trust’’ rules in Div 6AAA in Pt III ITAA 1936 apply to Australian residents who have transferred property or services to non-resident trust estates: see [34 450]-[34 490]. The ways in which the transferor trust rules interact with each other and with Div 6 are described at [23 700]. © 2017 THOMSON REUTERS

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Note that the ‘‘investment manager regime’’ (IMR) excludes certain income and capital gains of certain widely held foreign funds from being taken into account in determining the net income of the trust that is assessable in the hands of a foreign beneficiary (or a trustee in respect of the net income of a trust estate to which a foreign beneficiary is presently entitled): see [23 655].

Trust loss rules Rules restricting the circumstances in which current year and prior year losses and certain other deductions can be utilised by trusts are contained in Sch 2F ITAA 1936. These rules are explained in detail at [23 800]-[23 1270]. Trustee beneficiary statements A trustee of a ‘‘closely held trust’’ with a beneficiary who is a beneficiary in the capacity of trustee of another trust is required (under Div 6D) to provide the Commissioner with certain information about that trustee beneficiary. If an appropriate statement is not given within the required period, or an incorrect statement is given, the trustee may be liable for trustee beneficiary non-disclosure tax: see [23 1450]-[23 1500]. Note that the TFN withholding arrangements have been extended to closely held trusts. Unearned income of a minor Special rules (in Div 6AA of Pt III ITAA 1936) deal with the assessment of unearned income derived by a minor (a person under 18) directly or through a trust: see [23 750]. Anti-avoidance rules Various anti-avoidance rules applying to trusts are considered in [23 1300]-[23 1420]. The Tax Office has issued guidelines on how it will assess the risk of Pt IVA applying to arrangements involving the allocation of profits of a professional firm (including one carried on by a trust). [23 120] Rates of tax The applicable rate scale is determined by reference to whether the trustee or beneficiary is assessed and the section under which that person is assessed. The applicable rate scale also depends on whether the beneficiary is under the age of 18: see [23 750]. If a beneficiary is assessed pursuant to s 97 or s 100, the relevant share of the net income is merely aggregated with other assessable income of the beneficiary and the normal tax rates applicable to that beneficiary apply. This will not affect withholding tax arrangements for dividends, interest and royalty income distributed to foreign residents through trusts: see [23 630]. If the trustee is assessed, different rates scales (in Div 3 in Pt II of the Income Tax Rates Act 1986) apply. The relevant rate scales are set out at [101 010]-[101 060]. Example [23 120.10] illustrates how the Rates Act operates. Note that for trustee assessments under s 99 or 99A, the rate of tax for 2016-17 is 49%, incorporating the temporary budget repair levy of 2% (see [19 700]). The relevant rates are set out in Chapter 101. If the trustee of a deceased estate is assessed pursuant to s 99, the rate of tax is increased if, at the end of the income year, 3 years or more has elapsed since the death of the deceased: see [23 520]. Medicare levy A trustee’s liability to pay the Medicare levy and the Medicare levy surcharge is discussed at [19 750] and [19 780]. Tax offsets A trustee being assessed on behalf of a beneficiary under s 98 may be entitled in that assessment to the same tax offsets to which that beneficiary would be entitled. The relevant offsets include the low-income offset, but not to reduce the tax payable on a minor’s Div 6AA 926

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income (see [19 300]), the Seniors and Pensioners Tax Offset (see [19 500]) and the private health insurance offset (see [19 450]): ss 159H(1)(b) and 159N(6) ITAA 1936; s 61-205(2) ITAA 1997. A trustee being assessed on behalf of a beneficiary is not entitled to claim the dependant (invalid and carer) offset (see [19 150]). A trustee assessable under s 99 or s 99A is not entitled to these tax offsets, which is consistent with the fact that such an assessment is not in respect of any particular beneficiary. The rules as to whether the trustee or beneficiary is entitled to a refund of excess franking tax offsets (if any) are discussed at [23 220]. EXAMPLE [23 120.10] A trust created by will has net income for the year of $20,000. The testator died less than 3 years ago. The net income for the 2016-17 income year is divided as follows: Widow Son (aged 14) Accumulated until daughter (aged 10) marries, otherwise for son or his estate

50% 25% 25%

Other income of beneficiaries for the 2016-17 income year: Widow – bank interest Son (aged 14) – newspaper delivery

$13,000 $1,000

Assessments issued Widow: Assessable under s 97(1)(a)(i) on $10,000 trust income. Assessable under s 6-5 on $13,000 bank interest. Total: $23,000 taxed under general rates scale. Trustee: Assessable under s 98(1)(a) on $5,000 trust income as son is presently entitled but under legal disability. Although beneficiary is a prescribed person under Div 6AA (s 102AC(1)) the income is excepted trust income being from a will trust (s 102AG(2)(a)(i)); hence no eligible taxable income. Son: Assessable under s 100(1) on $5,000 trust income as has income from another source. Assessable under s 6-5 on $1,000 income from newspaper deliveries. Trust income is not subject to Div 6AA (see reasons for trustee above) and neither is newspaper delivery income as it is excepted assessable income being employment income (s 102AE(2)(a)); hence no eligible taxable income. Will receive credit under s 100(2) for any tax paid by trustee. Total $6,000 taxed in aggregate. Trustee: Assessable on $5,000 accumulation as no beneficiary is presently entitled to it. There is no deemed present entitlement under s 95A(2) as neither son’s nor daughter’s interests are vested and indefeasible; they are both contingent on daughter marrying. Assessment will be separate to other trustee assessment above. As it is a will trust, s 99A will not apply provided Commissioner considers it reasonable that it should not apply (s 99A(2)(a)(i)). Therefore assessed on $5,000 under s 99. Rates Act Widow:

Trustee:

Section 12(1) applies except as otherwise provided. No section provides to contrary. Leads to Sch 7. Part I of Sch 7 applies if taxpayer is a resident. Tax payable on $23,000 = $912 (the widow may be entitled to Family Tax Benefit). Section 12(1) applies except as otherwise provided. Section 12(6) does provide otherwise as trustee is being assessed under s 98. Section 13(3) will not apply as share of net income is not subject to Div 6AA.

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Section 15 is irrelevant as only applies to foreign residents. Leads to Sch 10. Part I of Sch 10 applies if beneficiary is a resident. Clause 1(a) applies. Leads to Sch 7. Tax payable on $5,000 = $Nil. Son: Section 12(1) applies except as otherwise provided. Section 13(1) will not apply as eligible taxable income under Div 6AA does not exceed $416, therefore no section provides to the contrary of s 12(1). Leads to Sch 7. Part I of Sch 7 applies if a resident. Tax payable on $6,000 = $Nil. Trustee did not pay any tax so there is no credit under s 100(2). Trustee: Section 12(1) applies except as otherwise provided. Section 12(6) does provide otherwise as trustee is being assessed under s 99. Sections 13 and 15 do not apply. Leads to Sch 10. Part I of Sch 10 applies if it is a resident trust estate. Clause 1(b) applies as deceased died less than 3 years before end of income year. Leads to Sch 7. Section 14 is also irrelevant as deceased died less than 3 years before end of income year. Tax payable on $5,000 = $Nil. Offsets and Medicare levy The widow would be entitled to the low-income offset: see [19 300]. She is not liable to the Medicare levy because her own income is below the relevant family income threshold: see [19 770]. The son would be entitled to the low-income offset, reducing the tax payable to nil. Amounts were not included in the example as the purpose of the example is to illustrate the application of the Rates Act.

[23 130] Administrative matters A trust that carries on business in Australia or derives income from property, and which does not have a resident trustee, is required to appoint a person resident in Australia as its public officer: s 252A. A public officer is not required if the trust only derives income that is subject to withholding tax under Div 11A in Pt III ITAA 1936 (primarily unfranked dividends, interest and royalties). In addition, the Commissioner may grant an exemption. The public officer must be a natural person aged 18 or more who is ordinarily resident in Australia. The appointment must be notified in writing to the Commissioner. The public officer is answerable for the doing of all things required by the ITAA 1997 or ITAA 1936 or regulations (and certain portions of the TAA) to be done by the trustee and, in the case of default, is liable to the same penalties as the trustee would be. Returns and assessments By notice in the Commonwealth Gazette (published under the authority of s 161(1)), the Commissioner requires a tax return (Form T) to be lodged each year for every trust: see [46 080]. The trust itself is not assessed to tax. Instead, as discussed later in this chapter, the trustee may be assessed on a share of the net income of the trust. A notice of assessment is not issued to a trustee unless there is a positive amount of tax payable by the trustee: see Practice Statement PS LA 2015/2. In its capacity as trustee of a trust, a trustee is a separate ‘‘entity’’ from the trust in its own right and in its capacity as a trustee of another trust: s 960-100(2) and (3). Consequently, an assessment issued to a trustee as trustee of a trust relates only to the income of that trust. A separate assessment (if required) is issued to the trustee for income derived in its own right and for the income of each trust of which it is trustee, to the extent that the income is assessable in the hands of the trustee. 928

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A notice of assessment addressed to the trust rather than the trustee will be valid, provided it is served on the trustee and it brings to the trustee’s attention that the assessment to which it relates is an assessment of the trustee to tax: FCT v Prestige Motors Pty Ltd (1994) 28 ATR 336. A trustee may object against an assessment in accordance with Pt IVC TAA (discussed in Chapter 48). The Commissioner may issue more than one assessment to the trustee. For example, he may issue an assessment under s 98 in respect of tax payable by the trustee on that part of the ‘‘net income of the trust estate’’ that corresponds to ″income of the trust estate″ to which a beneficiary under a legal disability, or a foreign resident beneficiary, is presently entitled (see [23 460] and [23 500]), and he may also issue an assessment under s 99 or 99A in respect of tax payable by the trustee on that part of the ‘‘net income of the trust estate’’ that corresponds to ‘‘income of a trust estate’’ to which no beneficiary is presently entitled (see [23 600]). In Practice Statement PS LA 2015/2, the Commissioner states that in general an original trustee assessment will not be issued more than 4 years after the relevant trust tax return is lodged or, for the 2013-14 income year, more than 2 years after lodgement of the trust tax return if the trust qualifies as a small business entity (and none of the exceptions in item 3 of the table in s 170(1) apply: see [47 130]). As noted at [23 050], a trustee of a ‘‘Transparent Trust’’ or a ‘‘Secured Purchase Trust’’ is not required to lodge an income tax return unless the trustee is liable to pay tax on the net income of the trust under Div 6: Practice Statement PS LA 2000/2. Where s 98 applies to assess a trustee on the net income of a trust estate (see [23 450]) to the extent that a foreign resident is presently entitled to Australian source income of the trust estate, the concession described in Practice Statement PS LA 200/2 does not apply. If the foreign resident beneficiary is a person acting as a trustee of another trust estate, that trustee is also liable to tax on the net income of a trust estate to the extent that a foreign resident is presently entitled to Australian source income of the trust estate (with a deduction allowed for the tax paid by the trustee of the first trust). Both trustees are required to lodge a tax return unless the Tax Office’s streamlined arrangements (as set out in a factsheet) for the lodging of trust returns by custodians (as defined in s 12-390(9), Sch 1 TAA) apply. Under these arrangements, if an Australian resident custodian which holds separate accounts relating to multiple unrelated clients of a non-resident global custodian lodges a return showing the net income to which each beneficiary under the global custodianship arrangement is presently entitled, then it will not be necessary to lodge a tax return for the separate trust estates that arise from the global custodianship arrangement. If the Commissioner considers that a trust is being used for tax avoidance purposes, he may issue alternative assessments to the beneficiaries, assessing them both in their own right without reference to the trust and as beneficiaries of the trust (although only one amount of tax may be recovered). Alternative assessments are generally valid unless issued in bad faith: see [47 060]. However, the existence of alternative assessments may be grounds for a stay of proceedings to recover outstanding tax (see [49 120]).

Substituted accounting periods A trustee can apply for permission to adopt an accounting period for a trust estate ending on a date other than 30 June each year. Practice Statement PS LA 2007/21 sets out the Tax Office’s approach to granting permission for large investment or property trusts to adopt substituted accounting periods. In general, such applications are only granted if the trust’s circumstances are ‘‘out of the ordinary run’’. The Practice Statement seems to imply that such circumstances are only likely to exist in the case of widely held trusts. See also [1 120].

Appointment of public officer if no resident trustee If any business of a trust estate is carried on in Australia or any income from property is derived by a trust estate from sources in Australia (other than income that is subject to the withholding tax rules in Div 11A), and no trustee of the trust estate is resident in Australia, a © 2017 THOMSON REUTERS

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public officer must be appointed: s 252A. Failure to appoint a public officer is a strict liability offence unless the Commissioner has granted an exemption under s 252A(3). The public officer is answerable for the doing of all things required by the ITAA 1997 or ITAA 1936 or regulations (and certain portions of the TAA) to be done by the trustee and, in the case of default, is liable to the same penalties as the trustee would be.

CORE TRUST INCOME-ASSESSING PROVISIONS [23 150] Assessment of trust income – introduction The basic trust income-assessing provisions are contained in Div 6 of Pt III ITAA 1936 (as modified by Div 6E). The meanings of key terms used in Div 6 are summarised at [23 040]. A basic methodology for applying Div 6 is set out at [23 160] and [23 170]. The assessing provisions within Div 6 are summarised in the following table. The criteria in the top rows indicate the features that must be identified in order to determine which assessing section applies. The foot of the table shows the treatment of income that is distributed in a subsequent year to that in which it was derived by the trust. The notes following the table describe in more detail the provisions that may be of relevance to the situation under consideration. In some circumstances, if a particular factual situation is excluded from the basic assessing section, the notes identify the section that deals with the excluded portions of income. Note that the table does not apply if a beneficiary is presently entitled to income in the capacity of a trustee of another trust estate or is the owner of a farm management deposit.

Person assessed

Beneficiary Trustee (on behalf of beneficiary)

Assessing criteria in year of derivation by trust Presently entitled beneficiary (resident trust estate)* No beneficiary presently entitled Resident Foreign resident Foreign source NonResident resident No legal Legal Australian Foreign Australian trust trust disability disability source** source source estate estate 976 98A7 1 97 1002 1004 1008 985 989 983

99A10 9910

Trustee

Person affected Beneficiary Notes *

930

99A11 9911

Not Not assessed assessed DISTRIBUTIONS IN A YEAR SUBSEQUENT TO DERIVATION BY TRUST Not assessed

Not assessed

Not assessed

99B12

Not assessed

99D13

99B14

The situation of a non-resident trust estate is more complicated and is not able to be adequately illustrated on the same diagram without confusing the situation for the more common resident trust estate. © 2017 THOMSON REUTERS

TRUSTS [23 160] **

1

2

3

4

5 6 7

8 9

10 11 12 13 14

Certain types of Australian source income to which a foreign resident is presently entitled through a trust are subject to withholding tax under Div 11A (see [35 150]) – these amounts are excluded from assessment under Div 6 (see [23 630]). In addition, distributions made by a managed investment trust to a foreign resident are subject to a special withholding tax regime in Subdiv 12-H Sch 1 TAA (see [50 090]) and are excluded by s 99G from assessment under Div 6. s 97(1)(a)(i) Applies to all present entitlements except a deemed s 95A(2) present entitlement for non-trustee natural persons: s 97(2)(a); or if beneficiary is a foreign resident at end of year: s 97(2)(b). Also subject to closely held trust provisions in Div 6D. s 100(1)(a) and If beneficiary is deemed presently entitled by s 95A(2) and is a s 100(1C) beneficiary in more than one trust estate or derives income from other sources or the net income includes specified types of income. s 100(2) Credit for tax paid by trustee (note 5). s 98(2)(d) Only applies if present entitlement was a deemed s 95A(2) present entitlement for non-trustee natural persons excluded from s 97 by s 97(2)(a). s 98(3)(a), (b) Applies to beneficiaries who are foreign residents at end of year but were resident for a period during the year. s 100 Only if beneficiary in more than one trust estate or has income from other sources or the net income includes specified types of income. s 100(2) Credit for tax paid by trustee (note 5). s 98(1)(a) Trustee assessed on behalf of beneficiary. s 97(1)(a)(ii) Will only apply to beneficiaries who are trustees or certain exempt bodies, excluded from s 97 by s 97(2)(b). s 98A(1) If beneficiary is presently entitled and trustee is assessed under s 98(3). Alternatively, s 22F applies if the income represents a ‘‘fund payment’’ (from a managed investment trust) from which tax has been withheld under Subdiv 12-H in Sch 1 TAA. s 98A(2) Credit or refund for tax paid by trustee (note 9). Credit may be offset against another tax debt. s 100(2) Credit for tax paid by trustee. s 98(3)(b) Applies to companies that are non-resident at end of year. s 98(4)(a) Applies to natural persons who are foreign residents at end of year. s 98(1)(b) Trustee assessed on behalf of beneficiary under legal disability. s 98(2)(e) Only applies if present entitlement was a deemed s 95A(2) present entitlement for non-trustee natural persons excluded from s 97 by s 97(2)(b). s 99A Section 99A(4), (4A), (4B) or (4C). s 99 Section 99(2), (3), (4) or (5) only if s 99A does not apply. s 99A Section 99A(4) or (4A). s 99 Section 99(2) or (3) only if s 99A does not apply. s 99B Assessed only if beneficiary is a resident at any time during year of distribution. s 99D Refund if attributable to period when beneficiary was a foreign resident. s 99B Assessed if beneficiary is a resident at any time during year of distribution.

[23 160] Application of Div 6 to a resident trust estate The following steps provide a basic procedural guide to the application of Div 6 to the net income of a resident trust estate (but not if the beneficiary is presently entitled to income in the capacity of a trustee of another trust estate). See [23 170] for an explanation of the way in which these steps are modified to apply to a non-resident trust estate. Note that Div 6 does not apply in the circumstances listed in [23 100]. © 2017 THOMSON REUTERS

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Determine net income 1. Determine the net income of the trust estate (ie assessable income less allowable deductions) under s 95: see [23 310]. Note that the net income may have to be recalculated by excluding net capital gains, net franked distributions and franking credits: see [23 210] and [23 220].

Determine present entitlement 2. Determine which beneficiaries are presently entitled, during the income year (taking account of the trust law meaning of present entitlement and the statutory clarification and extension of that concept: see [23 400]-[23 420]), to shares of the income of the trust estate as calculated for trust law purposes: see [23 300]. Note that the income of the trust estate may have to be recalculated by excluding net capital gains and net franked distributions: see [23 210] and [23 220].

Allocate net income 3. Allocate appropriate shares of the net income of the trust estate to each beneficiary and the trustee on the basis of: (a) whether the beneficiary is presently entitled to the income of the trust estate during the income year (taking account of statutory extensions of the concept of present entitlement); (b) whether the beneficiary is a resident or a foreign resident at the end of the income year; and (c) whether or not the beneficiary has legal capacity – as indicated at points 4 to 10 below. If the net income of the trust estate is greater or smaller than the income of the trust estate, the net income is allocated to beneficiaries in proportion to their present entitlement to income of the trust estate: see [23 320] and [23 330]. Note that capital gains, franked distributions and franking credits are generally excluded from assessment under Div 6 and are dealt with under Subdiv 115-C (capital gains) and Div 207 (franked distributions and franking credits) ITAA 1997: see [17 060] and [21 530].

Allocation if beneficiary resident at end of the income year 4. If a beneficiary who is a resident at the end of the income year is presently entitled to a share of the income of the trust estate during the income year, allocate a corresponding share of the net income of the trust estate, excluding any portion of that net income that is attributable to non-Australian source income derived in a period when the beneficiary was not a resident: • directly to the beneficiary if the beneficiary is not under a legal disability (s 97(1)): see [24 450]; or • to the trustee if the beneficiary is under a legal disability (s 98(1)): see [23 460]. Also exclude from any amount allocated to the beneficiary or the trustee income to which the beneficiary became presently entitled while a foreign resident, comprising: (a) income subject to withholding tax and franked distributions specifically exempt from withholding tax (see [23 630]); and (b) ‘‘conduit foreign income’’ (see [35 180]). Note that the beneficiary may be entitled to a credit for: • tax withheld under the managed investment withholding tax regime, to the extent that the tax was imposed on an amount that is included in the net income of the trust estate: see [50 400]; and • tax paid by a trustee of another trust estate under s 98(4) in respect of income that has flowed through 2 or more trusts and is included in the trust estate in which the person assessed under s 97 is a beneficiary: see [23 450]. 932

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Note the exceptions mentioned in points 5, 6 and 7 below. 5. If the beneficiary is: • statutorily deemed to be presently entitled to trust income under s 95A(2) (see [23 420]); and • a natural person; and • not a beneficiary in the capacity of a trustee of another trust; and • not the owner of a farm management deposit (see [27 610]) to whom s 97A(1) or (1A) applies, allocate the beneficiary’s share of the net income of the trust estate to the trustee under s 98(2), not to the beneficiary under s 97(1): see [23 450] (but see also point 6 below). 6. If net income is allocated to a trustee under s 98(2) in respect of a beneficiary who is: • deemed by s 95A(2) to be presently entitled to income of a trust; or • presently entitled to income of the trust but is under a legal disability, and the beneficiary: • is a beneficiary in more than one trust; or • derives income from more than one source including a share of a capital gain that is assessable under Subdiv 115-C (see [23 210]) or a share of a franked dividend that is assessable under Subdiv 207-B (see [23 220]), also allocate the same share of the net income of the trust to the beneficiary (s 100). The tax paid or payable by the trustee in respect of the allocated share of the trust net income is deducted from the income tax assessed against the beneficiary. There is no provision for a refund if the tax payable by the beneficiary is less than the tax paid by the trustee: see [23 450]-[23 460]. In addition, if a beneficiary under a legal disability is presently entitled to income of a trust estate, or a beneficiary is deemed to be entitled to a share of the income of a trust estate by s 95A(2), and the beneficiary: • is a resident at the end of the income year; and • is not a beneficiary in any other trust estate and does not derive income from any other source, s 100 applies to the beneficiary’s share of the net income of the trust estate if it includes: • income in respect of which the beneficiary would be entitled to a refund of tax offsets if it were included in the beneficiary’s assessable income (see [19 040]); or • income that has flowed through 2 or more trusts and represents an amount that was assessed in the hands of a trustee of another trust under s 98(4); or • an amount from which an entity is required to withhold an amount under the managed investment trust withholding tax regime (see [50 090]). A credit is allowed for tax assessed under s 98 or withheld under the managed investment fund withholding tax regime, to the extent that it relates to income assessed in the hands of the beneficiary under s 100. © 2017 THOMSON REUTERS

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Allocation if beneficiary not resident at the end of the income year 7. If a beneficiary who is a foreign resident at the end of the income year is presently entitled to a share of the income of the trust estate during the income year, and • is not the owner of a farm management deposit (see [27 610]) to whom s 97A or s 97A(1A) applies; and • is not an exempt body, allocate a corresponding share of the net income of the trust estate, excluding any portion of that net income that is attributable to non-Australian source income derived in a period when the beneficiary was not a resident: • to the trustee (under s 98(1) if the beneficiary is under a legal disability; under s 98(2) if the beneficiary is an individual not under a legal disability and is deemed to be presently entitled by s 95A: under s 98(4) if a beneficiary in the capacity of a trustee of another trust); and • also to the beneficiary (s 98A or s 100) and claim a credit for the tax paid by the trustee in respect of the allocated share of the trust net income, noting that if the tax payable by the beneficiary is less than the tax paid by the trustee the excess is refundable to the beneficiary: see [23 450], [23 460] and [23 600]-[23 620]. However, exclude from any amount allocated to the beneficiary and the trustee income to which the beneficiary became presently entitled while a foreign resident, comprising: (a) income subject to withholding tax and franked distributions specifically exempt from withholding tax (see [23 630]); (b) so much of the net income of a trust estate as ‘‘is represented by or reasonably attributable to’’ an amount from which an entity is required to withhold an amount under the managed investment trust withholding tax regime (see [23 680]); and (c) ‘‘conduit foreign income’’ (see [35 180]). Note also the effect of the ‘‘investment manager regime’’: see [23 655]. The amount allocated to the trustee under s 98 will also include the amount of an ‘‘attributable gain’’ that is allocated to a foreign resident beneficiary under Subdiv 115-C: see [23 210]. 8. If a beneficiary is a foreign resident at the end of the income year and is presently entitled to a share of the income of the trust estate during the income year otherwise than in the capacity of a trustee of a trust estate, and: • is the owner of a farm management deposit (see [27 610]) to whom s 97A or s 97A(1A) applies; or • is an exempt body, allocate the beneficiary’s share of the net income of the trust estate to the beneficiary under s 97, not to the trustee under s 98: see [23 450], [23 460] and [23 600]. However, do not include in the assessable income of the trustee or the beneficiary: (a) income in respect of which withholding tax is payable; or (b) income excluded from the withholding tax provisions because it is a franked dividend: see [23 630].

Allocation if beneficiary is a temporary resident 9. If steps 4 or 8 result in the allocation of foreign source income to a beneficiary who is a ‘‘temporary resident’’ at the time of derivation of the income, it will be non-assessable non-exempt income under s 768-910: see [7 110]. 934

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[23 160]

Allocate income to which no beneficiary presently entitled 10. If there is a portion of the income of the trust estate to which no beneficiary is presently entitled during the income year, allocate the corresponding proportion of the net income of the trust estate to the trustee under: • s 99A – unless falling within one of the exclusions to that section; or • s 99 – if excluded from s 99A: see [23 500]-[23 520]. Also allocate to the trustee, for assessment under s 99 or s 99A, any amount of the net income of a trust comprising a capital gain in respect of which the trustee has an ‘‘attributable capital gain’’ as determined under Subdiv 115-C: see [23 210]. Note that s 99 and s 99A do not apply to so much of the net income of a trust estate as ‘‘is represented by or reasonably attributable to’’ an amount from which an entity is required to withhold an amount under the managed investment trust withholding tax regime (see [50 090]). Also consider the effect of the special rules for assessing franked distributions and franking credits in Subdiv 207-B (see [23 220]).

Allocate exempt income 11. Allocate exempt income to the beneficiaries in the same way, except that it must first be utilised against current year or carried forward losses within the trust as part of the net income calculation before apportionment (see [8 450]-[8 480]), and must then be apportioned only to beneficiaries who are presently entitled and not under a legal disability: see [23 450]. No part is apportioned either to beneficiaries under a legal disability or to trustees.

Identify taxable distributions of untaxed income 12. If an amount previously untaxed in Australia is paid to or applied for the benefit of a beneficiary, it may be taxed in the hands of the beneficiary under s 99B: see [23 550]. 13. Note also (although this provision is not within Div 6) that when a trustee distributes an amount to a beneficiary that does not represent an amount included in the beneficiary’s assessable income, CGT event E4 occurs: s 104-70. As a result, the cost base (and reduced cost base) of the beneficiary’s interest in the trust is reduced by that amount and a capital gain arises to the extent that the amount exceeds the cost base of the beneficiary’s interest in the trust. This will not be the case, however, if the beneficiary is a foreign resident when the distribution occurs and the conditions in s 104-70(9) are satisfied. See [13 230].

Consider anti-avoidance provisions 14. If the trust is covered by a family trust election and a distribution of income or capital is made from the family trust to a person other than either the individual specified in that election or a member of that person’s family group, or a person outside the family group becomes presently entitled to income or capital of the family trust, family trust distribution tax applies: see [23 900]. 15. If present entitlement is manipulated as part of a trust stripping exercise, s 100A may apply: see [23 1350]. 16. If control of income can easily revert to the creator of a trust, or a settlor has created a trust for the benefit of a minor child of the settlor, s 102 may apply: see [23 1300] and [23 1310]. © 2017 THOMSON REUTERS

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17. If income is allocated to a foreign resident in circumstances suggesting that the reason for the allocation is to gain access to lower (or nil) rates of tax, and it is not intended that the income will be distributed to the foreign resident, the Commissioner may challenge the validity of the arrangement: see Rulings IT 2344 and IT 2466. 18. If a beneficiary is exempt from income tax, consider the effect of the anti-avoidance provisions in ss 100AA and 100AB which can result in the trustee being liable for income tax on part or all of the net income of the trust: see [23 240]. If the process outlined above results in the inclusion of any amount in the assessable income of the trustee or a minor, consideration must be given to the rate at which that income is taxed: see [23 750]-[23 760].

[23 170] Application of Div 6 to a non-resident trust The procedure outlined at [23 160] is modified as follows in applying Div 6 to the net income of a non-resident trust estate. 1. The effect of the ‘‘deemed present entitlement’’ rules in ss 96B and 96C must be considered (but only in respect of income years before the 2010-11 income year): see [23 420]. 2. The rules in ss 99 and 99A (regarding the assessment of income in the hands of the trustee if there is a portion of the income of the trust estate to which no beneficiary is presently entitled) apply only to the part of the net income of the trust estate arising from Australian sources. 3. The potential application of the ‘‘transferor trust’’ rules must also be considered: see [34 450]-[34 490]. Interactions between the transferor trust and Div 6 rules are discussed at [23 700]. 4. The trustee of a non-resident trust cannot elect that an amount representing a capital gain be assessed under s 99 or s 99A instead of being assessed in the hands of a beneficiary: see [17 080]. 5. The trust will not qualify as a ‘‘managed investment trust’’ (‘‘MIT’’). Consequently, elective capital gains treatment and the special withholding tax rules for certain payments from an MIT do not apply: see [23 680], [12 350] and [50 090]. 6. The ‘‘investment manager regime’’ (‘‘IMR’’) may exempt certain income and capital gains of the trust in determining the amount of the net income of the trust estate which is assessable in the hands of a trustee under s 98 or a foreign resident beneficiary under s 98A: see [23 655].

[23 190] Derivation of income for the purposes of Div 6 The net income of a trust is taxed in the year it is derived by the trustee of the trust, regardless of whether or not it is actually distributed to beneficiaries within that income year. It is important to note that this principle applies not only to private trusts, but also to all other trusts including cash management, equity, mortgage, property and other unit trusts unless the unit trust is treated as a company for tax purposes. Thus, even though an investor may not receive a distribution and accompanying statement until after the close of the income year, the investor’s share of the net income of the trust is included in the investor’s assessable income for the income year in which the income is derived by the trust, provided that the investor is presently entitled (see [23 300]) to the income at that time, which will depend upon the terms of the trust: Determination TD 94/72. If no beneficiary is presently entitled to the income for the income year in which it was derived by the trust, the trustee is assessed, ie assessment is not deferred until receipt by the investor. 936

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[23 200]

[23 195] Trustee’s assessment and right to recover tax from the trust estate If a trustee is assessed on an amount of trust income, the assessment must be separate and distinct from an assessment of the trustee’s own income and from any other assessment of income derived by the trustee as trustee or agent: s 254(1)(b) ITAA 1936. The trustee is ‘‘required’’ to retain, from the trust money, ‘‘an amount sufficient to pay tax which is or will become due in respect of the income, profits or gains of the trust’’: s 254(1)(d). An agent or trustee is personally liable for the tax payable, but only to the extent of any amount retained, or which should have been retained (s 254(1)(e)): see FCT v Australian Building Systems Pty Ltd (In Liq) (2015) 90 ALJR 151; [2015] HCA 48 at [64], [104] and [176]. The consequence, for a liquidator of a company who is a ‘‘trustee’’ for the purposes of s 254 because the definition of ‘‘trustee’’ in s 6(1) includes a liquidator, but is not a ‘‘trustee’’ for the purposes of Div 6 (see [23 040]), is that the liquidator is personally liable under s 254(1)(e) to pay tax assessed on the income of the company in liquidation, to the extent that the liquidator is required by s 254(1)(d) to retain an amount sufficient to pay the tax. The High Court unanimously held that the term ‘‘tax payable’’ in s 254(1) relates only to tax in respect of which an assessment has been issued. See further [49 250]. [23 200] Character and source of trust income In some circumstances, trust income assessed in the hands of a presently entitled beneficiary retains the character that the income had when derived by the trustee: Charles v FCT (1954) 90 CLR 598. In that case, the High Court considered that the trust deed conferred upon the beneficiaries ‘‘a proprietary interest in all of the property which for the time being is subject to the trust of the deed’’. For that reason, the question to be determined in that case, regarding the character of part of an amount distributed to a particular beneficiary, was to be determined ‘‘by considering the character of those moneys in the hands of the trustees before the distribution is made’’. In contrast, in CPT Custodian Pty Ltd v CSR (2005) 60 ATR 371, a Victorian land tax case, the High Court held that the terms of the trusts ‘‘did not support any direct and simple conclusion respecting proprietary interests of unit holders such as that reached in Charles’’. In essence, the Court held that the unit holders were not beneficial owners of the trust property. In reaching this conclusion, the Court distinguished Charles’ case on the basis that the trustees in that case were bound to make half-yearly distributions of the ‘‘cash produce’’ to unitholders, whereas in the CPT Custodian case (in the words of the judge at first instance, Nettle J, quoted with approval by the High Court), ‘‘the only right of the unit holder is to a proportionate share of the income of the fund for the year’’. This decision, though not concerned with the character of trust income in the hands of beneficiaries, suggests that the conclusion reached in Charles’ case as to the character of income derived by the beneficiary of the trust in that case is not universally applicable. Statutory rules dealing with the treatment of capital gains accruing to a trust and franked distributions derived by a trust are discussed at [23 210] and [23 220] respectively. The ‘‘attribution managed investment trust’’ (‘‘AMIT’’) tax regime includes a provision specifying that income ‘‘attributed’’ from an AMIT to its ‘‘members’’ has the character in the hands of the ‘‘members’’ that it had in the hands of the trustee: see [23 685]. Earlier statutory rules regarding the character and the source of income were introduced at the same time as the former foreign tax credit system, but are not confined to the operation of that system, which has since been replaced by the foreign income tax offset system (see [34 200]). These rules have the effect that: • income derived by a person has the character of dividend income if derived by that person by reason of being the beneficial owner of the share in respect of which the dividend was paid, or the person derived the income as a beneficiary of a trust estate and the income can be attributed, directly or indirectly, to a dividend: s 6B(1); © 2017 THOMSON REUTERS

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[23 210]

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• income derived by a person has the character of passive income (a category relevant to the former foreign tax credit system) or interest income if the person derived the income by reason of being beneficially entitled to an amount representing passive income or interest income (respectively), or if the person derived the income as a beneficiary of a trust estate and the income can be attributed, directly or indirectly, to passive income or interest income (respectively): s 6B(1), (1A) and (2), read with s 6B(3). For these purposes, if a person is presently entitled to income of a trust estate, the income is taken to have been derived by that person: s 6B(3). A related provision, s 6B(2A), deems income derived by a beneficiary in a trust estate to be derived from the source to which the income can be directly or indirectly attributed (source rules are discussed further in Chapter 2). The purpose of the source rule in s 6B(2A) seems to be to assign a geographical source to facilitate the application of the income tax law in cross-border contexts (see Ruling IT 2555), but its operation is not specifically confined to those contexts. See also [23 630], which discusses the application of the withholding tax rules to interest, dividends and royalties derived by a trustee, to which a foreign resident is presently entitled.

[23 210] Capital gains and losses Whether a gain or loss made on the disposal of a trust asset is on capital or revenue account depends on the particular circumstances. The Tax Office states in Determination TD 2011/21 that the mere fact that a trustee (rather than a person who is not a trustee) makes a gain or loss on an investment does not have the automatic consequence that the gain or loss is a capital gain or loss. Bamford case and introduction of capital gains streaming rules The High Court confirmed in FCT v Bamford (2010) 75 ATR 1 that, although a capital gain is not ‘‘income’’ at common law, a capital gain treated by the trustee as income available for distribution, in accordance with the terms of the trust deed, forms part of the ‘‘income of the trust estate’’ for the purposes of s 97: see [23 300]. An effect of the decision was that all beneficiaries presently entitled to a share of the income of a trust estate in a particular income year were taxable on a proportionate share of any net capital gains made by the trust in that year even if, in accordance with the trust deed, the capital gains were to be distributed to specific beneficiaries or accumulated. Following the Bamford decision, rules were introduced to allow capital gains made by trusts to be taxed in the hands of beneficiaries who are entitled to those gains. To achieve this: • the Div 6 rules were modified in specific respects to allow those rules to operate effectively in relation to the income and net income of trust estates excluding capital gains (and franked distributions: see [23 220]); and • a specific code was introduced for the taxation of capital gains made by trusts. Note that, as discussed below, these amendments do not apply automatically to managed investment trusts and entities treated in the same way as managed investment trusts for the purposes of Div 275 of ITAA 1997.

Modification of the Div 6 rules to exclude capital gains A capital gain is excluded from the income of a trust estate in determining the amount that is assessable in the hands of a beneficiary under ss 97, 98A or 100, or in respect of which the trustee is liable to pay tax under ss 98, 99 or 99A: ss 102UX(2) and 102UY(2). A corresponding adjustment is made to the share of the income of the trust estate to which the beneficiary is taken to be presently entitled: ss 102UX(4) and 102UY(4). 938

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[23 210]

A capital gain is also excluded from the net income of a trust estate in determining the amount that is assessable in the hands of a beneficiary under ss 97, 98A or 100, or in respect of which the trustee is liable to pay tax under ss 98, 99 or 99A: ss 102UX(3) and 102UY(3).

Code for the treatment of capital gains made by trusts With effect from the 2010-11 income year, specific provisions in Subdiv 115-C apply to assess capital gains made by trusts. The effect of the provisions is: • to treat capital gains accruing to trusts as arising in the hands of beneficiaries who are ‘‘specifically entitled’’ to the capital gains, even if such beneficiaries are not ‘‘presently entitled’’ to any share of the trust income; • for capital gains to which no beneficiary is specifically entitled, to allocate the capital gains to beneficiaries on a proportionate basis in accordance with their present entitlement to the income of the trust (excluding any franked distribution or capital gain to which the beneficiary is specifically entitled); and • to allocate capital gains to trustees in accordance with the principles that apply to the assessment of income in the hands of trustees under ss 98, 99 and 99A: see [23 460], [23 500] and [23 510]. Draft Determination TD 2016/D4 states that, despite the residency assumption in the definition of ‘‘net income’’ in s 95(1) (see [23 310]), if a trust is a ‘‘foreign trust for CGT purposes’’ (as defined in s 995-1) and a CGT event happens in relation to an asset of the trust that is not ‘‘taxable Australian property’’ (see [18 100]), a gain arising from the CGT event is not included in the amount that is allocated under Subdiv 115-C. However, a subsequent distribution of the gain to an Australian resident beneficiary is assessable under s 99B: see [23 550]. Before the allocation described above is done, the capital gain is reduced by capital losses available to the trust. The remaining gain (if any) is reduced by 50% under the discount capital gain rules if the asset in respect of which the CGT event occurred was owned by the trust for at least 12 months (see [14 390]), and finally by the small business 50% reduction if it applies (see [15 570]). If a gain is allocated to a beneficiary as described above, the allocated gain is grossed up to eliminate the effect of the reduction under the discount capital gains rules, the small business concessions, or both. The gain is then reduced by any capital losses available to the beneficiary before any discounts available to the beneficiary (under the discount capital gains rules and the small business concessions) are applied. The resulting gain (if any) is included in the beneficiary’s assessable income. If a capital gain is taken into account in determining the net income of a trust estate for an income year and the trust property representing all or part of that capital gain is not paid to a beneficiary within 2 months after the end of that income year, the trustee can make a choice, under s 115-230, that varies the effect of the capital gains streaming rules in Subdiv 115-C. The effect of the choice is that ss 115-215 and 115-220 will not apply to the capital gain (thereby in effect cancelling the streaming of capital gains to ‘‘specifically entitled’’ beneficiaries) and instead the trustee will be treated as being ‘‘specifically entitled’’ to the capital gain. As a result, the capital gain will be assessed in the hands of the trustee under s 99 or s 99A. The choice has to be made within 2 months after the last day of the income year, although the Commissioner may grant an extension of time. The Subdiv 115-C rules are discussed further at [17 020] and following.

Application to managed investment trusts A trustee of a managed investment trust (‘‘MIT’’) can choose that the CGT rules are to apply exclusively to some gains that might otherwise be treated as income under ordinary concepts: see [23 680]. © 2017 THOMSON REUTERS

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The capital gains streaming rules in Subdiv 115-C do not apply to ‘‘MITs’’ (and, for years prior to the 2016-17 income year, trusts taxed in the same way as MITs for the purposes of Div 275 of ITAA 1997), unless the trustee made a choice that those rules are to apply. The choice is available for the 2010-11 to 2016-17 income years and must be made in writing within 2 months after the end of the relevant income year. For further information on MITs, see [23 680].

[23 220] Special rules for franked distributions The treatment of franked distributions made by trusts was amended following the Bamford case (see [23 210] and [23 330]), which highlighted longstanding difficulties in the application of the Div 6 rules. Note that, as discussed below, these amendments do not apply automatically to managed investment trusts and entities treated in the same way as managed investment trusts for the purposes of Div 275 of ITAA 1997.

Modification of the Div 6 rules to exclude franked distributions With effect from the beginning of the 2010-11 income year, franked distributions and franking credits are specifically excluded from the income and net income of the trust estate in determining the amount that is assessable in the hands of a beneficiary under s 97, 98A or 100, or in respect of which the trustee is liable to pay tax under s 98, 99 or 99A: ss 102UX(2) and (3). A corresponding adjustment is made to the share of the income of the trust estate to which the beneficiary is taken to be presently entitled: ss 102UX(4) and 102UY(4).

Code for the treatment of franked distributions derived by trusts Specific provisions to assess franked distributions and apply dividend imputation to distributions derived by trusts are contained in Subdiv 207-B ITAA 1997: see [21 530]. The effect of Subdiv 207-B is: • to allow franked distributions and franking credits to flow through a trust to beneficiaries who are ‘‘specifically entitled’’ to franked distributions: see [21 530]; • for franked distributions to which no beneficiary is specifically entitled, to allocate the franked distribution and the associated franking credits to beneficiaries on a proportionate basis in accordance with their present entitlement to the income of the trust (excluding any amount of franked distribution or capital gain to which the beneficiary is specifically entitled); and • to allocate franked distributions and franking credits to trustees in accordance with the principles that apply to the assessment of income in the hands of trustees under ss 98, 99 and 99A: see [23 460], [23 500] and [23 510]. In Thomas v FCT [2015] FCA 968, the Federal Court held that resolutions to allocate franking credits to particular beneficiaries were not effective as the franking credits were not ‘‘income’’ under the trust deed. Furthermore, the Court concluded that the statutory regime in Subdiv 207-B does not allow franking credits (and a potential entitlement to a franking offset) to be allocated to a beneficiary separately from the franked dividends in respect of which the franking credits arose. In other words, if the conditions for the streaming of franked dividends to a beneficiary under Subdiv 207-B are satisfied (but not otherwise), the associated franking credits are treated as income of that beneficiary and that beneficiary may be entitled to a franking offset in respect of those franking credits. In Thomas v FCT [2015] FCA 1339, the Federal Court refused the taxpayer’s application to reopen the proceedings. The initial decision is on appeal, but the Full Federal Court had not handed down its decision as at 1 January 2017. 940

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[23 230]

Application to managed investment trusts The franked distribution streaming rules do not apply to managed investment trusts (‘‘MITs’’) (and, for years prior to the 2016-17 income year, trusts taxed in the same way as MITs for the purposes of Div 275 of ITAA 1997) unless the trustee made a choice those rules are to apply. The choice must be made in writing within 2 months after the end of the relevant income year and is available for the 2010-11 to 2016-17 income years: see [23 680]. Refund of franking offset For income years before s 102UX applied, if the trustee was assessed in respect of franked dividend income to which a resident beneficiary under a legal disability was presently entitled, and the beneficiary did not derive income from any other source and was not a beneficiary in any other trust, the net income to which the beneficiary was presently entitled was included in the beneficiary’s assessable income, thereby entitling the beneficiary to a refund of the excess franking tax offset (see [19 040]): s 100(1A). This provision did not apply if there was no potential refund of any excess franking tax offset. If s 100(1A) applied, s 98(1) applied simultaneously but the trustee was not able to claim a franking tax offset in respect of the franked dividend income. The beneficiary was given a credit for the tax paid or payable by the trustee: s 100(2). The same rules applied if a trustee was assessed in respect of franked dividend income to which a resident beneficiary not under a legal disability was deemed by s 95A(2) to be presently entitled. Trustees assessed under s 99 on net income in respect of which no beneficiary was presently entitled were eligible for any refunds of excess franking tax offsets: see [19 040]. The same result is now achieved through the operation of the dividend imputation provisions in Divs 200 to 220. Foreign resident beneficiary presently entitled Trust income, comprising dividends paid by an Australian resident company to which a foreign resident beneficiary is presently entitled, is subject to the withholding tax rules in precedence to the assessing rules in Div 6 or the rules in Div 207 ITAA 1997: see [23 630]. [23 230] Trust losses The rules in Div 6 do not deal with the situation where the calculation of the net income of a trust estate produces a loss for income tax purposes (ie an excess of deductions over assessable income, calculated as if the trustee were a resident taxpayer). Nothing in Div 6 or elsewhere in the income tax law allocates such a loss to the trustee or the beneficiaries: Doherty v FCT (1933) 48 CLR 1; AAT Case 8226 (1992) 24 ATR 1040 at 1044; Re AX01C and AX01D (2001) 48 ATR 1200. A loss arising in one income year is carried forward and offset in calculating the net income of the trust estate in future years, in accordance with the carry forward loss provisions of s 36-15 ITAA 1997 (see [8 460]), provided that the special conditions for the recoupment of trust losses are satisfied: see [23 800] to [23 1270]. This is subject to a limitation (in s 95) that losses of previous years that have been recouped from corpus are not deductible in calculating the net income of a trust estate in the case of life tenants and beneficiaries who have no beneficial interest in the corpus of the trust estate. This is illustrated in Example [23 230.10].

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EXAMPLE [23 230.10] Year 1 ......................................................................................... Loss Year 2 ......................................................................................... Profit Net income of trust estate for Year 2: Alternative 1. Loss to be met out of subsequent income ............................................. 2. Loss to be met out of corpus and person entitled to income is also entitled to corpus whether presently entitled or not ............................... 3. Loss to be met out of corpus and person entitled to income is life tenant only ..............................................................................................

$ 600 3,000

2,400 2,400 3,000

As regards capital losses, see [23 210]. Anti-trafficking measures – loss recoupment tests Rules designed to restrict the circumstances in which current and prior year losses (and certain other deductions) can be utilised by trusts so as to prevent trafficking in such losses are contained in Sch 2F ITAA 1936. These rules are explained in detail at [23 800]-[23 1270]. Designated infrastructure projects From the beginning of the 2012-13 income year, losses incurred by a fixed trust (see [23 950]) that is a ‘‘designated infrastructure project entity’’ will be uplifted by the long term government bond rate. In addition, the fixed trust will not be subject to the loss recoupment measures in Sch 2F ITAA 1936 while it is a ‘‘designated infrastructure project entity’’. These measures are considered at [11 650]. [23 240] Income allocated to exempt bodies A number of entities are exempt from tax under Subdiv 50-A ITAA 1997: see [7 350]-[7 460]. The bodies referred to include religious, scientific, charitable or public educational institutions, public hospitals, non-profit private hospitals, trade unions, societies or clubs established for the encouragement of music, art, science, literature or a game or sport, bodies established to promote the development of certain industries or resources and funds or trusts established for public charitable purposes. By a combination of s 97(2)(b)(ii) and (3) and s 98(3), trust income to which such bodies are presently entitled is dealt with under s 97(1), regardless of whether the present entitlement is actual or deemed (s 95A(2)) or whether the beneficiary body is a resident or a foreign resident. The trustee, therefore, is not assessed on such income. Although s 97(1) would prima facie appear to include such income in the assessable income of the exempt body, the exemption overrides the assessability otherwise imposed by s 97(1), in the same manner as it overrides assessability otherwise imposed by s 6-5 or other sections. Organisations whose income is exempt under the International Organisations (Privileges and Immunities) Act 1963 (see [7 620]) are dealt with in the same manner. Certain tax-exempt organisations (those listed in s 207-130 ITAA 1997 as being ‘‘eligible for a refund’’) are entitled to a tax offset under s 207-110 in relation to the franking credit on franked distributions received by the organisation. If the organisation is a trust and the franked distribution is received indirectly through a chain of tax-exempt trusts, only the first trust (that is ‘‘eligible for a refund’’) to receive the distribution is entitled to the offset. See further [21 590]. Two anti-avoidance provisions potentially apply if an exempt entity (other than an exempt Australian government agency) is presently entitled to a share of the income of the trust estate (unless the trust is an MIT or a trust that is treated in the same way as an MIT for the purposes of Div 275: see [50 090]): 942

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[23 300]

• if the exempt entity is not notified, within 2 months of the end of the income year, that it is presently entitled to income of the trust for that year, then it is treated as not being presently entitled to that income: s 100AA; and • if the exempt entity’s ‘‘adjusted share’’ of the income of the trust estate exceeds a prescribed benchmark percentage, the exempt entity is treated as not being presently entitled to the excess: s 100AB. The effect in both cases is that the trustee will be liable for income tax on a share of the net income of the trust estate, equal to the share (ie proportion) of the income of the trust estate to which the exempt entity is deemed not to be entitled: see [23 500].

[23 250] Income allocated to superannuation funds, ADFs and PSTs Certain trust distributions to complying superannuation funds, complying approved deposit funds and pooled superannuation trusts are treated as non-arm’s length income of the fund concerned and are taxed at the non-concessional rate of 47%: see [41 230]. Note that non-complying superannuation funds and non-complying ADFs are not eligible for refunds of excess franking tax offsets: see [19 040].

‘‘INCOME’’ AND ‘‘NET INCOME’’ OF A TRUST ESTATE [23 300] ‘‘Income of a trust estate’’ The existence or absence of a beneficiary’s present entitlement (see [23 400]) to ‘‘income of the trust estate” is used in Div 6 to determine the liability of the beneficiary or the trustee, in a particular income year, to tax on the “net income of the trust estate’’. Although the term ‘‘net income of the trust estate’’ is defined in s 95 (see [23 310]), the term ‘‘income of the trust estate’’ is not defined in the ITAA 1936 and there remains some uncertainty as to its meaning. Draft Ruling TR 2012/D1 sets out the Tax Office’s preliminary views on the meaning of ‘‘income of the trust estate’’. Following the decision in Thomas v FCT [2015] FCA 968, the Tax Office confirmed that the draft ruling still represents its preliminary, though considered, views on this issue: see below. Inclusion of certain non-income items in the income of a trust estate The High Court confirmed in FCT v Bamford (2010) 75 ATR 1 that a capital gain can form part of the income of a trust estate. In that case, the trust deed permitted the trustee to determine that a capital gain should be treated as income of the trust estate. For the 2001-02 income year, the trustee made such a determination and distributed equal shares of a capital gain to Mr and Mrs Bamford. The Commissioner argued that the capital gain, by its nature, was not ‘‘income of the trust estate’’. The High Court held that the term ‘‘income of the trust estate’’ took its meaning from ‘‘the general law of trusts, but adapted to the operation of the 1936 Act upon distinct years of income’’. The High Court noted that ‘‘income’’, under the general law of trusts, can include a capital gain. Therefore, in Bamford, the ‘‘income of the trust estate’’ included a capital gain treated by the trustee as distributable income in accordance with the terms of the trust deed. In contrast, capital gains were found not to be part of the income of a trust estate in Colonial First State Investments Ltd v FCT (2011) 81 ATR 772. The basis for this decision was that there was no provision in the constitution of the trust that permitted the trustee to treat capital gains as income of the trust estate. The Tax Office now accepts that a provision of a trust instrument, or a trustee acting in accordance with a trust instrument, may treat the whole or part of a receipt as income of a period and it will thereby constitute ‘‘income of the trust estate’’ for the purposes of s 97: see the Tax Office’s Decision Impact Statement on the Bamford case and Practice Statement PS © 2017 THOMSON REUTERS

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LA 2010/1. But the Tax Office considers that the Bamford case has not resolved ‘‘the effect of a recharacterisation clause that requires or permits a trustee to treat as capital what is otherwise received as income’’: see further below. Note that specific rules now apply to capital gains made by trusts (applicable from 2010-11): see [23 210].

Unrealised gains In its Decision Impact Statement for the Bamford case, the Tax Office states its view that Bamford has not resolved: • what constitutes a receipt or outgoing for the purposes of ascertaining a trust’s distributable income of a period; and • the extent to which accounting principles are relevant in identifying and measuring the apportionable receipts and outgoings of a trust and therefore the trust’s distributable income of a period. The words ‘‘trust’s distributable income’’ above seem to be intended to have the same meaning as ‘‘income of the trust estate’’. In Clark v Inglis (2010) 79 ATR 447, the NSW Court of Appeal held that the trustee of a trust was entitled to treat unrealised increases in the value of investments of the trust as ‘‘income’’. The case was not concerned with tax law but the Bamford case would seem to be authority for the proposition that if, for trust law purposes, an amount that is not income at common law is properly treated as income in accordance with the trust deed, then that amount is included in the determination of ‘‘the income of the trust estate’’. This would be consistent with the view set out in Draft Ruling TR 2012/D1 (which is considered in further detail below), provided that the unrealised increases in the value of investments of the trust are amounts that are capable of being appointed to beneficiaries or accumulated and are ‘‘accretions to the trust estate’’.

‘‘Recharacterisation’’: can income at common law be excluded from income of a trust? Although the Bamford case confirms that the terms of a trust deed can have the effect of including in the income of a trust estate an amount that is not income at common law, it does not necessarily confirm that the terms of a trust deed can exclude from the income of a trust estate (for example, by treating as capital) an amount that is actually income at common law. In FCT v Australia & New Zealand Savings Bank Ltd (1998) 39 ATR 419, the High Court decided that, notwithstanding provisions in a trust deed requiring portions of annuity payments received by a trustee to be treated as capital and not income, the whole of each annuity payment was ‘‘income’’ of the trust estate for the purposes of s 97(1). As noted above, the Tax Office considers that that in Bamford the High Court did not explicitly overrule the previous decision of the Court in the ANZ Savings Bank case. Consequently, in the Tax Office’s view, the Bamford case has not resolved ‘‘the effect of a recharacterisation clause that requires or permits a trustee to treat as capital what is otherwise received as income’’ and therefore continues to regard itself as bound by the decision of the High Court in the ANZ Savings Bank case (see the Decision Impact Statement for the Bamford case). Treatment of expenses and losses In Cajkusic v FCT (2006) 64 ATR 676, the Full Federal Court found that a beneficiary was not presently entitled to any ‘‘income’’ of the trust estate as the trustee had, in accordance with the terms of the trust deed, applied current year expenses and prior year losses against the income of the current year, leaving no amount which a beneficiary could require the trustee to distribute. The Tax Office has published a Decision Impact Statement stating that it does not regard this case as confirming that an amount which was in fact 944

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[23 300]

received by the trustee as income of a trust estate ceased to have the character of income as a result of being set off against current year expenses and prior year losses. Instead, the Tax Office regards the case as a decision regarding present entitlement to income, and accepts that the beneficiaries in the case were not presently entitled to any amounts. In its Decision Impact Statement on the Bamford case, the Tax Office accepts that a provision of a trust instrument, or a trustee acting in accordance with the trust instrument, may determine whether an outgoing is properly chargeable against the income of a period, in determining the ‘‘income of the trust estate’’. Note, however, that the Tax Office considers that Bamford has not resolved questions concerning what constitutes a receipt or outgoing, and the extent to which accounting principles are relevant, for the purposes of ascertaining a trust’s distributable income of a period (see above).

Provisions in trust deeds equating ‘‘income of the trust estate’’ with ‘‘net income’’ Some practitioners consider that the High Court’s decision in Bamford confirms the effectiveness of provisions in trust deeds which equate the income of the trust estate with the net income of the trust estate. In its Decision Impact Statement on the Bamford case, the Tax Office states that the effect of such provisions remains uncertain if the net income of the trust estate includes notional amounts (eg franking credits or deemed capital gains) or if the time at which income is recognised for tax purposes differs from the time at which it is recognised for trust accounting purposes. Note also the comments above regarding unrealised gains and losses, the timing of recognition of income and the treatment of expenses and losses. Most of Draft Ruling TR 2012/D1 is concerned with whether, in various situations, an income equalisation clause in a trust deed achieves its objective of ensuring that the income of a trust estate is equal to the ‘‘net income’’ of the trust estate, ie the trust’s taxable income calculated for the purposes of Div 6 (see [23 310]). The Tax Office’s conclusion on the efficacy of such a clause is summarised below. • Various amounts that are assessable but do not represent accretions to the assets of a trust estate (referred to as ‘‘notional income amounts’’) cannot be taken into account in determining the income of a trust estate, except to the extent that they are matched by amounts that are deductible but do not represent depletions of the trust estate (referred to as ‘‘notional expense amounts’’). • To the extent that total notional income amounts for an income year exceed notional expense amounts for that year, the excess notional income amounts cannot form part of the income of the trust estate for that year. The Draft Ruling provides a number of examples to illustrate the effect of the Tax Office’s conclusions.

Tax Office’s overall view In Draft Ruling TR 2012/D1, taking account of its view of issues resolved and not resolved by the Bamford case, the Tax Office concludes (at para 12) that the income of the trust estate is ‘‘the net amount of income to which a beneficiary could be made presently entitled or accumulated’’. On that basis, the Tax Office considers that the income of the trust estate for an income year cannot be more than: • the accretions to the trust estate (whether accretions of property, including cash, or value) for that year; • less such accretions which have not been allocated, pursuant to the general law of trusts (as that may be affected by the particular trust instrument), to income; and • less any depletions to the trust estate (whether depletions of property, including cash, or value) for that year which, pursuant to the general law of trusts (as that may be affected by the particular trust instrument) have been allocated as being chargeable against income. © 2017 THOMSON REUTERS

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The Tax Office has removed the finalisation of the Draft Ruling from the Public Rulings Program pending consideration of the decision in Thomas v FCT (see below). Note that the Draft Ruling, if finalised, will not apply to taxpayers who have relied on Practice Statement PS LA 2009/7 to the extent that this PS LA was more favourable.

Franked distributions, franking credits, capital gains and income subject to withholding tax Special rules affecting the determination of the income of a trust estate to which a beneficiary is presently entitled apply to capital gains (see [23 210]), franked distributions (see [23 220]) and income subject to withholding tax (see [23 630] and [23 680]). In Thomas v FCT [2015] FCA 968, the taxpayers contended that a provision in the trust deed defined franking credits to be part of the income of the trust estate which the trustee could resolve to allocate to particular beneficiaries. The Court held that, on the particular facts, the trust deed did not have that effect. This leaves open the question as to whether a differently worded trust deed might have the effect of treating franking credits as income of a trust estate. Note also that the Court found that even if the franking credits had been income of the trust estate, it would not have been possible, under Subdiv 207-B ITAA 1997, for franking credits to accrue to beneficiaries in proportions that differed from the proportions in which franked dividends paid to the trustee were taken into account in determining the income of the trust estate to which the beneficiaries were presently entitled: see [23 220]. An appeal against this decision has been heard but the Full Federal Court’s decision had not been handed down as at 1 January 2017. [23 310] Net income of a trust estate The ‘‘net income’’ of a trust estate is defined in s 95 as the total assessable income of the trust estate calculated as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions except: • deductions for farm management deposits: see [27 620]; and • 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 deduction of such losses of previous years as are required to be met out of corpus. If a deduction claimed by a trust estate is disallowed, the net income of the trust estate is increased by the amount disallowed: see for example Weyers & Ors v FCT (2006) 63 ATR 268. Note that, in calculating the net income of a trust estate, the deduction of prior year losses, and in some cases current year losses and outgoings, of the trust estate is also affected by the trust loss provisions in Sch 2F: see [23 800] and following. The net income of a property syndicate that is structured to comply with the requirements of the managed investment scheme provisions of the Corporations Act 2001 is considered in Determination TD 2005/28.

Franked distributions, capital gains and income subject to withholding tax Special rules apply to capital gains, franked distributions and income subject to withholding tax. With effect from the 2010-11 income year, capital gains and franked distributions (and the franking credits) are effectively excluded from the income and net income of a trust estate only for the purposes of calculating the amount included in the assessable income of a beneficiary of the trust estate under s 97, 98A or 100, or in respect of which the trustee is liable to pay tax under s 98, 99 or 99A: s 102UX. The treatment of trust capital gains is summarised at [23 210] and considered in more detail at [17 020]-[17 060]. The treatment of franked distributions received by a trust is summarised at [23 220] and considered in more detail at [21 530]. In relation to income subject to withholding tax, see [23 630]. 946

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IMR and MIT regimes If the IMR or MIT regime applies to a trust, certain income of the trust may be excluded from the trust’s net income for the purposes of Div 6: see [23 655] and [23 680]. Interest on certain borrowings Ruling TR 2005/12 sets out the Commissioner’s views on whether a trustee of a trust estate is entitled to a deduction when calculating the net income of the trust estate (under s 95) in respect of interest expenses incurred on funds borrowed in connection with the payment of distributions to beneficiaries. The ruling states that, in order to be deductible, the interest expenses incurred by a trustee must be sufficiently connected with the assessable income earning activity, or business, carried on by the trustee as trustee of a particular trust estate. The interest expenses will be sufficiently connected if the purpose of the borrowing, when viewed objectively, is to refinance a ‘‘returnable amount’’. Examples of money or property being considered to be a ‘‘returnable amount’’ include: • an individual has subscribed money for units in a unit trust and has a right of redemption in relation to the units, and the money is used by the trustee to purchase income producing assets; • a beneficiary has an unpaid present entitlement to some or all of the capital of a trust estate, or some or all of the net income of the trust estate, and the amount to which the beneficiary is entitled has been retained by the trustee and used in the gaining or producing of assessable income of the trust; and • a beneficiary lends an amount to the trustee who uses the money for income producing purposes (for example, by depositing it at interest in a bank). The ruling states that interest expenses will not be sufficiently connected if the objective purpose of the borrowing is merely to discharge an obligation to make a distribution. Accordingly, if a beneficiary becomes entitled to an amount that had not previously been provided to the trustee by, or on behalf of, the beneficiary, and the borrowing and distribution by the trustee is contemporaneous (or nearly so) with that entitlement coming into existence, it would be difficult to show that a sufficient connection exists. In such a case, it would ordinarily be concluded that the purpose of the borrowing was only to make the distribution. However, if the trustee is required to return a returnable amount earlier than had been expected as a result of an unforeseen change in circumstances, the interest expense may still be deductible. Internally generated goodwill or unrealised revaluations of assets are not considered to be amounts provided to the trustee by, or on behalf of, a beneficiary of the trust estate and therefore do not constitute returnable amounts. The ruling acknowledges that there may be practical difficulties in establishing that a returnable amount was used to produce assessable income, particularly if funds are mixed and a portion of the funds is used to gain exempt income, is used for private family purposes or is otherwise used in a non-income producing way.

[23 320] Allocation of share of net income to beneficiary A beneficiary who is a resident at the end of the income year is assessed under s 97 on the share of ‘‘net income of the trust estate’’ (see [23 310]) corresponding to the share of the ‘‘income of the trust estate’’ (see [23 300]) to which the beneficiary is presently entitled. The question of whether ‘‘share’’, in this context, means ‘‘proportion’’ or ‘‘amount’’ was resolved by the High Court in FCT v Bamford (2010) 75 ATR 1. In that case, the net income of a trust estate for the 1999-2000 income year, determined under s 95, exceeded the income of the trust estate, the whole of which had been appointed to 6 beneficiaries. The Commissioner sought to assess portions of the net income of the trust estate in the hands of Mr and Mrs Bamford corresponding, in percentage terms, to the portions of the income of the trust estate actually appointed to them by the trustee. In rejecting the taxpayers’ appeal and © 2017 THOMSON REUTERS

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confirming the approach adopted by the Commissioner, the Court held that the words ‘‘that share’’ in s 97 refer to a beneficiary’s proportionate or fractional entitlement to the income of a trust estate and not to a fixed amount. It follows that if beneficiaries have fixed proportionate entitlements to the income of a trust, and the income of the trust estate for a particular income year is nil so that there is no amount to which a beneficiary is presently entitled, the beneficiaries cannot be assessed on any part of the net income of the trust. This situation was considered in Cajkusic v FCT (2006) 64 ATR 676. Determination TD 2012/22 confirms the Tax Office’s view that the proportionate approach is to be applied in all cases (except where a beneficiary is ‘‘specifically entitled’’ to a capital gain or franked distribution: see below) and provides a number of examples of the application of the proportionate approach.

Capital gains, franked distributions and franking credits To facilitate streaming of capital gains, franked distributions and franking credits to specific beneficiaries, those amounts are excluded in determining the share of the net income of a trust estate that is allocated to a beneficiary under Div 6 for the 2010-11 and subsequent income years: s 102UX. The assessment of net capital gains accruing to trusts is now dealt with in Subdiv 115-C ITAA 1997 (see [17 030]-[17 090]) and the allocation of franked distributions and franking credits derived through trusts is dealt with in Subdiv 207-B ITAA 1997 (see [21 530]). Example 11 in Determination TD 2012/22 deals with a situation in which trust income includes a franked dividend. The example excludes the franked dividend from the ‘‘income of the trust estate’’ and excludes the franked dividend and franking credits from the ‘‘net income of the trust estate’’ in determining the allocation of the net income of the trust estate to beneficiaries for the purposes of Div 6. The franked dividend is allocated to beneficiaries in accordance with Subdiv 207-B. The Determination states that the allocation would be on a strictly proportional basis for income years prior to the 2010-11 income year (ie years before Subdiv 207-B applied). Allocations of income and net income: Tax Office action Taxpayer Alert TA 2016/12 sets out 4 examples of situations where an arrangement entered into by a trustee or the trustee’s exercise of a power in a trust deed, results in all of the net income of a trust being taxable in the hands of a company beneficiary and a substantially larger amount being distributed by the trustee to another beneficiary as a capital distribution. The Tax Office states that it is currently reviewing arrangements such as this and is considering the potential application of specific aspects of the tax law and the general anti-avoidance provisions in Pt IVA to these arrangements. The Tax Office has issued guidelines on how it will assess the risk of Pt IVA applying to arrangements involving the allocation of profits of a professional firm (including one carried on by a trust): see [63 285]. [23 330] Position where trust income exceeds net income If the income of a trust estate to which a beneficiary is presently entitled (and which would, in general, be distributed to the beneficiary) exceeds the share of the net income of the trust estate which is included in the beneficiary’s assessable income, the excess amount, even if distributed to the beneficiary, is not liable to taxation under s 97, s 98A or s 100. Although this view is universally accepted, a complication arises from the broad wording of s 99B. In some situations, this section has the potential to assess a distributed amount as income in the hands of the beneficiary even if it does not form part of the net income of the trust estate: see Hill J’s analysis in Traknew Holdings Ptd Ltd v FCT (1991) 21 ATR 1478 at 1492. Nevertheless, it does not seem to be the Commissioner’s practice to apply s 99B in this manner. The situation to which s 99B is really directed is explained at [23 550]. 948

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TRUSTS [23 400]

It should also be noted that although the excess of the income of a trust over the net income of the trust is not liable to taxation under Div 6, a distribution of a non-taxable amount to a beneficiary may result in a reduction in the beneficiary’s cost base (for CGT purposes) of any interest in the trust, or sometimes an assessable capital gain, by virtue of CGT event E4: see [13 230]. The Commissioner has expressed the view that in some cases the whole amount distributed to a beneficiary (including the amount in excess of the beneficiary’s share of the net income of the trust estate) is assessable under the general assessing provision: see [23 100].

‘‘PRESENT ENTITLEMENT’’ AND ‘‘LEGAL DISABILITY’’ [23 400] Present entitlement: general principles A beneficiary is ‘‘presently entitled’’ to a share of the income of the trust estate if, but only if: (a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) 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 income year and whether or not the trustee has the funds available for immediate payment: Harmer v FCT (1991) 22 ATR 726. See also: Trustees of the ID Taylor Trust v FCT (1970) 1 ATR 582, FCT v Whiting (1943) 68 CLR 199, Union Fidelity Trustee Co of Aust Ltd v FCT (1969) 1 ATR 200, FCT v Totledge (1982) 12 ATR 830 and Pearson v FCT (2006) 64 ATR 109. If the beneficiary’s interest is only contingent, the beneficiary will not be presently entitled. In Harmer v FCT, there were no beneficiaries presently entitled to interest earned on moneys held on trust by a solicitor pending court orders to resolve competing claims to the moneys. In Richardson v FCT (2001) 48 ATR 101, a taxpayer beneficiary was presently entitled to income that the trustee had resolved to distribute to him but had not distributed. In Weyers & Ors v FCT (2006) 63 ATR 268, the Federal Court found that amounts described as loans were in fact distributions of income to beneficiaries. If an appointment of income to a beneficiary is invalid and the income is not accumulated in the trust, the default beneficiary nominated in the default clause in the trust deed (if any) will be presently entitled to that income. In Cajkusic v FCT (2006) 64 ATR 676, the beneficiaries of a discretionary trust were not presently entitled to any income of the trust estate because the income of the trust estate, determined in accordance with the trust deed, was nil (in fact there was a loss). The High Court refused to grant special leave to appeal against this decision. It is often the case that the trust deed of a fixed trust makes one or more beneficiaries presently entitled to income of the trust as and when that income arises, or on particular dates during the year, without any need for a resolution by the trustee. However, if the trust deed (of a discretionary trust or a fixed trust) requires an actual resolution of the trustee to appoint or distribute income, such a resolution or other action demonstrating the appointment or distribution of income to the beneficiary is necessary to establish present entitlement: see [23 240]. In Pearson, the trustee of the J Trust (J Pty Ltd), was the holder of all of the units in 2 unit trusts. The net income of each of those unit trusts was increased as a result of amended assessments issued some years after the end of the relevant income years. J Pty Ltd was found to be presently entitled to the revised net income of one of the unit trusts for 3 earlier income years, as the trust deed of that unit trust was drafted in such a way that J Pty Ltd ‘‘had a present legal right to demand and receive payment of that income’’ (at 4358). It may be noted that although present entitlement is a concept that applies in respect of the income (not the net income) of a trust estate, the Court’s conclusion appears to be based on the view that J Pty Ltd was presently entitled to all of the income of the trust estate and consequently was assessable on all of the trust’s net income, whatever that turned out to be. © 2017 THOMSON REUTERS

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In respect of the other unit trust, however, J Pty Ltd was found not to be ‘‘presently entitled’’ to the increased amount of ‘‘net income’’ because the trust deed of that trust required the trustee to make a resolution that income be distributed and no such resolution had been passed (as the trust accounts had shown a loss for the particular income year).

Deemed present entitlement – vested and indefeasible interest In certain circumstances, s 95A(2) deems present entitlement to exist although the beneficiary is unable to demand immediate payment: see [23 420]. Legal disability does not affect present entitlement A beneficiary who is able to demand immediate payment of trust income but is under a legal disability is nevertheless presently entitled to that income. This position is regarded as actual present entitlement, not deemed present entitlement, as it arises from interpretation of the term ‘‘present entitlement’’, rather than any deeming provision of the ITAA 1936: Taylor v FCT (1970) 1 ATR 582. Application, dealing and transfer An application or dealing with income on behalf of or at the direction of the beneficiary is consistent with the beneficiary being presently entitled to the income. For example, if the trustee applies an amount of trust income in settlement of an amount owed by the beneficiary who is presently entitled to that income, the beneficiary remains presently entitled to the income even though he or she is not able to receive it in cash. This situation should be contrasted with a transfer of the right to trust income before present entitlement arises. If the terms of a trust allow a beneficiary to transfer a right to a share of the income of the trust estate to another party, that transfer will be effective for the purposes of Div 6 provided it is made before the present entitlement arises, subject to the possible operation of s 102B: see [3 170]. Knowledge and disclaimer A beneficiary can have a valid entitlement to trust income even if the beneficiary has no knowledge of it: FCT v Cornell (1946) 73 CLR 394; Vegners v FCT (1991) 21 ATR 1347. A beneficiary may disclaim her or his entitlement to trust income on becoming so aware, but must do so within a reasonable time of becoming aware of that entitlement: Vegners; FCT v Ramsden (2005) 58 ATR 485; Pearson v FCT (2005) 58 ATR 502. In Ramsden, the Full Federal Court held that 3 years was well in excess of a reasonable period within which to disclaim an entitlement as a default beneficiary to trust income. A disclaimer was also ineffective in Pearson because it was not made within a reasonable time of the taxpayer becoming aware of her entitlement to the relevant trust income (it was irrelevant that when she accepted the appointment of the trust income, she believed that the amount appointed was substantially less than the amount that was actually appointed). This issue was not considered on appeal. A disclaimer 11 months after becoming aware of the entitlement was found to be effective in Re Moignard and FCT (2014) 98 ATR 723. On appeal, the Federal Court (in FCT v Moignard [2015] FCA 143) did not consider this issue in view of its decision to refer the matter back to the AAT for redetermination. In Re TVKS and FCT [2016] AATA 1010, however, the lapse of time (almost 3 years) between becoming aware of trust distributions and disclaiming entitlement to them was a factor in the AAT’s decision that the disclaimer was ineffective. In Re Applicant and FCT (2008) 73 ATR 675, a taxpayer disclaimed entitlement to trust income shortly after becoming aware of the entitlement. The waiver was found to be ineffective because the taxpayer’s solicitor, acting as agent for the taxpayer, had been aware of the entitlement for many months before the purported waiver was made. ATO ID 2010/85 deals with a situation in which a trustee of a discretionary trust appointed part of the income of the trust estate to a beneficiary for the 2006-07 income year, 950

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but the beneficiary was not aware of the appointment until the Commissioner issued an amended assessment in 2009. Thereupon, the beneficiary immediately advised the trustee of the disclaimer. The Tax Office accepted that the beneficiary had validly disclaimed the entitlement to trust income. In contrast, the AAT held in Re Alderton and FCT [2015] AATA 807 that a taxpayer who had no knowledge of an appointment of trust income to her by a trustee of a discretionary trust, but had drawn funds from the trust by using a debit card in the name of the trust and had used the trust’s bank account for internet banking, could not validly disclaim the appointment of trust income to her when she became aware of it as she had had the use and benefit of the amount appointed to her. The AAT acknowledged that the taxpayer had been placed in a difficult position by the trustee and suggested that the taxpayer apply for remission of the administrative penalty and request the Commissioner to exercise his discretion to release her from her tax debt. To be effective, a disclaimer must constitute an absolute rejection of the whole gift. A beneficiary may get different gifts under a trust, eg a gift by particular appointment or a gift in default of an appointment of income of the trust estate (ie if a default beneficiary). A beneficiary may disclaim one gift without disclaiming the other gifts, but a disclaimer of a particular gift is not effective unless it relates to the whole subject matter of the gift. In Ramsden, the Commissioner argued unsuccessfully that for a disclaimer to be effective ‘‘the beneficiary must disclaim the entirety of the interest that has accrued to him or her in the past, or which may accrue to him or her in the future, in the income or corpus of the trust fund’’. Nevertheless, the Commissioner succeeded for a different reason. In relation to discretionary appointments of income to beneficiaries, the Full Federal Court held that each exercise of the trustee’s discretion to appoint income of the trust estate for an accounting period ‘‘results in a gift to the person in whose favour the discretion is exercised’’, and ‘‘the specified beneficiary should be entitled to accept or reject the subject matter of that gift’’. However, the appointment of each of the respondents as a default beneficiary was a separate gift that had been made by virtue of the operation of the trust deed. It was this gift that each of the respondents had purported to disclaim, but (in all but one case) the purported disclaimers applied to only one accounting year. The court held that the purported disclaimers of an entitlement as default beneficiary in relation to a single income year were incomplete as they did not relate to the whole of the gift (ie, the appointment as default beneficiary for the whole period of the trust). Consequently, those purported disclaimers were ‘‘necessarily ineffective’’. An effective disclaimer operates retrospectively, and not merely from the time of disclaimer. However, an ineffective disclaimer of an existing entitlement may operate as a prospective disclaimer: see Re Huong Thi Thu Nguyen and FCT (1999) 42 ATR 1030; Re Capershaw Pty Ltd and FCT (2004) 57 ATR 1263; and Re Maurice Hannan Nominees Pty Ltd and FCT (2004) 57 ATR 1315.

Invalidity Note that an appointment of income to a beneficiary may be invalid, and may not establish present entitlement (for example, because it breaches the rule against perpetuities). [23 410] Present entitlement: deceased estates In FCT v Whiting (1943) 68 CLR 199, it was held that if an estate was in the course of administration, the residuary beneficiaries would not become presently entitled to any income until all debts, annuities and legacies (if any) had been paid or provided for in full. Accordingly, no beneficiary is presently entitled to a share of the income for trust law purposes during the stage before administration is finalised and, therefore, the entirety of the net income for tax purposes is assessable to the trustee during that period. Ruling IT 2622 confirms the position described above except that, in the year in which administration is finalised, the Commissioner regards any presently entitled beneficiaries at the end of the year as being presently entitled to their relevant share of trust income for the full year, even if derived before the completion of administration. Nevertheless, the ruling indicates that the Commissioner will accept an apportionment if the executors and © 2017 THOMSON REUTERS

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beneficiaries can demonstrate, through the striking of accounts at the completion of administration, the actual amounts of income derived in the periods before and after the day on which the estate was fully administered. ATO ID 2004/214 records a decision that expenses incurred by a beneficiary of a testamentary trust in defending a right to income under the trust were deductible.

Capital gains Note that, in certain circumstances, a trustee can elect for undistributed net capital gains of a trust that would otherwise be assessed in the hands of beneficiaries under Subdiv 115-C to be assessed as income of the trustee: see [23 210]. Before the enactment of the capital gains streaming rules in 2011, a former version of s 115-230 allowed a similar choice to the trustee of a trust established by will or intestacy (but not to trustees of other trusts).

[23 420] Statutory clarification and extension of ‘‘present entitlement’’ Four provisions clarify or extend the concept of present entitlement. Sections 95A(1) and 101 are clarifying provisions. Sections 95A(2) and 96B extend the meaning of the term ‘‘present entitlement’’.

Section 95A(1) – present entitlement does not cease on payment Apart from the situation where a beneficiary has a right to demand immediate payment, present entitlement also includes the situation where the trustee has actually paid the income to the beneficiary: s 95A(1). In other words, for the purposes of Div 6, even though a beneficiary has actually received the income, he or she is still regarded as presently entitled to it in the year in which the present entitlement arises. It may be that this provision was intended to put beyond doubt that if the test of present entitlement is to be applied at the end of the income year (see, for example, paragraph 19 of Ruling IT 2622), the fact that the beneficiary’s entitlement to a share of the income of the trust estate has been satisfied before that time does not have the effect of rendering the beneficiary not presently entitled to income of the trust estate at the relevant time (that is, at the end of the income year).

Section 101 – discretionary trusts If the trustee of a discretionary trust exercises her or his discretion ‘‘to pay or apply income of a trust estate to or for the benefit of specified beneficiaries’’, a beneficiary in whose favour the trustee exercises that discretion is taken to be presently entitled to the portion of the income in respect of which the discretion has been so exercised: s 101. This is the case regardless of whether or not the trustee actually pays the income to the beneficiary, provided that the income has been allocated to the beneficiary under the terms of the trust. The Commissioner used to accept that a payment or application in favour of a beneficiary made by a trustee within 2 months of the close of the income year was effective for the purposes of s 101; and that a declaration or resolution made by a trustee in favour of a beneficiary within 2 months after the end of the income year would be effective as an ‘‘application’’ of a trustee’s discretion for that income year for the purposes of s 101: Rulings IT 328 and IT 329. Those 2 rulings were withdrawn on 1 September 2011. In withdrawing the rulings, the Commissioner stated that the starting point for ‘‘present entitlement’’ is the principle outlined by the High Court in Harmer v FCT (1991) 22 ATR 726 at 730, namely that a beneficiary is ‘‘presently entitled’’ to a share of the income of a trust estate if, but only if: (a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and 952

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[23 420]

(b) 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 income year and whether or not the trustee has the funds available for immediate payment. The Commissioner also referred to FCT v Totledge Pty Ltd (1982) 12 ATR 830, Trustees of the Estate Mortgage Fighting Fund v FCT (2000) 45 ATR 7, where Hill J said (at 22) that ‘‘present entitlement to the income of a trust estate must arise, if at all, at the latest by the end of the year of income’’, and Colonial First State Investments Ltd v FCT (2011) 81 ATR 772, in which Stone J held that the test of present entitlement prescribed in Harmer will be satisfied if ‘‘an entitlement arises within the relevant tax year’’. An application of trust income by a trustee in favour of beneficiaries after the end of 2 income years did not make the beneficiaries presently entitled to the income of the trust for those income years in Re Hopkins and Anor and FCT (2012) 88 ATR 633. In FCT v Moignard [2015] FCA 143, the Full Federal Court allowed the Commissioner’s appeal against an AAT decision, on the basis that the AAT had failed to consider whether the trustee had made a ‘‘determination’’, as required by the trust deed, to ‘‘pay, apply or set aside’’ the income of the trust for the benefit of a beneficiary. A ‘‘resolutions checklist’’ on the Tax Office’s website states that ‘‘all trustees who make beneficiaries entitled to trust income by way of a resolution must do so by the end of an income year (30 June). This resolution will determine who is to be assessed on the trust’s taxable income’’. The checklist goes on to state that whether the resolution must be recorded in writing will depend on the terms of the trust deed. However, a written record will provide better evidence of the resolution and avoid a later dispute (for example, with the Tax Office or with relevant beneficiaries) as to whether any resolution was made by 30 June. EXAMPLE [23 420.10] The net income of a trust estate is $13,000, to which 2 children under the age of 18, A and B, are contingently entitled. The trustees made the following advancements for the maintenance and education of the children: A, $2,500 and B, $6,000. Three assessments will be issued against the trustees. 1. In respect of A ..................................................................................... $2,500 2. In respect of B .................................................................................... $6,000 3. In respect of remainder of the trust income ....................................... $4,500

The consequences of a trustee allocating income of a discretionary trust to a beneficiary who is a minor are discussed at [23 750].

Section 95A(2) – vested and indefeasible interest but no actual present entitlement A beneficiary who has a vested and indefeasible interest in the income of a trust estate, but who is not presently entitled to that income, is deemed to be presently entitled to that income: s 95A(2). The Estate Mortgage Fighting Fund Trust case illustrates the effect of s 95A. In that case, the beneficiaries were held to be deemed to be presently entitled, pursuant to s 95A(2), to interest income derived by the trustee on the basis that the trust deed conferred a vested and indefeasible right to the income which was unaffected by provisions in the deed giving the beneficiaries the right to terminate the trust by majority vote. Having reached that conclusion, the Court found it unnecessary, in that case, to determine whether the fact that the intervention of the Court was required ‘‘before a beneficiary would be in a position to have transferred any income to which the beneficiary would otherwise be entitled’’ may have the effect that the beneficiary was not presently entitled to that income on general principles. Hill J observed in the Estate Mortgage Fighting Fund Trust case that the purpose of the introduction of s 95A(2) ‘‘remains obscure’’ and ventured the suggestion that the provision © 2017 THOMSON REUTERS

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might have been introduced ‘‘to overcome the decision in Whiting, so that a beneficiary otherwise with an absolute interest, in an unadministered estate might be treated as being presently entitled’’. It should be noted that Ruling IT 2622 does not suggest that s 95A(2) alters the conclusion arrived at in the Whiting case, that a beneficiary of a deceased estate cannot be presently entitled to the income of the estate until the estate has been fully administered. In certain circumstances, the trustee is assessed under s 98, instead of the beneficiary being assessed under s 97, on the share of the net income of the trust estate corresponding to the share of the income of the trust estate to which the beneficiary is deemed to be presently entitled under s 95A(2): see [24 330].

Sections 96B and 96C – non-resident trusts For income years before 2010-11, the question of whether a beneficiary was presently entitled to income of a non-resident trust estate was influenced by the deeming rule in s 96B. Where s 96B applied, the amount of income to which the person was deemed to be presently entitled was calculated under s 96C. The operation of ss 96B and 96C was considered in detail in Howard v FCT (No 2) (2011) 86 ATR 753. On appeal, the Full Federal Court (in Howard v FCT (2012) 91 ATR 89) did not consider the application of ss 96B and 96C because the Court found that any amount not included in the taxpayer’s assessable income under s 97 by reason of the deeming rule in s 96B was assessable under s 99B: see [23 550]. [23 430] Legal disability The term ‘‘legal disability’’, which is not defined in the income tax legislation, refers to a person who is unable to give a trustee an immediate valid discharge in respect of a distribution of trust income. Common examples include persons who are minors (a person under 18), undischarged bankrupts (in their personal capacity) and lunatics. It also includes felons. It would appear that a company in liquidation or under the control of a receiver is not under a legal disability for Div 6 purposes. Beneficiary in the capacity of a trustee of another trust A beneficiary who is presently entitled to a share of the income of a trust estate in the capacity of a trustee of another trust estate is deemed not to be under a legal disability in respect of their present entitlement to that share: s 95B. This prevents the frustration of the trust stripping provisions in s 100A by the appointment as trustee of a person who is under a legal disability. It also ensures that the closely held trust provisions of Div 6D operate as intended: see [23 1450]-[23 1500]. Beneficiary holding a farm management deposit A presently entitled beneficiary who is under a legal disability and is the owner of a farm management deposit (see [27 610]) made during the income year at a time when the beneficiary is a ‘‘primary producer’’ is treated as if he or she is not under a legal disability: Div 6D.

BENEFICIARY PRESENTLY ENTITLED TO TRUST INCOME [23 450] Presently entitled beneficiary not under a legal disability Beneficiary a resident at end of income year As noted at [23 160] and [23 170], a beneficiary who is a resident (of Australia) at the end of the income year, and who is presently entitled to a share of the income of a trust estate and is not under a legal disability, is assessed under s 97 on a corresponding share of the net income of the trust estate. However, a beneficiary who is a resident natural person, and is deemed by s 95A(2) to be presently entitled to a share of the trust income, is assessable under s 97 on the corresponding share of the net income of the trust estate only if the beneficiary is (s 97(1), (2)(a)): 954

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[23 450]

• a beneficiary in the capacity of the trustee of another trust estate; or • a beneficiary to whom s 97A(1) or s 97A(1A) applies – those sections apply to a beneficiary who is the owner of a farm management deposit (see [27 610]). If s 97 does not apply, the share of the net income of the trust estate that would otherwise be included in the assessable income of the beneficiary is assessed in the hands of the trustee under s 98(2). In those cases, the beneficiary will also be assessed on that income under s 100(1) only if the beneficiary: • is a beneficiary in more than one trust estate; or • during the income year derived income from another source; or the share of net income to which the beneficiary is presently entitled includes: • franked dividend income in respect of which the beneficiary would be entitled to a refund of tax offsets (see [19 040]) if it were included in the beneficiary’s assessable income ; or • income that has flowed through 2 or more trusts and represents an amount that was assessed in the hands of a trustee of another trust under s 98(4) (see [23 470]); or • an amount in respect of which an entity has been required to withhold an amount under the managed investment trust withholding regime (see [50 090]). Tax offsets are allowed to the beneficiary in respect of the franked dividend income; and for individuals and superannuation funds, excess tax offsets are refundable (see [19 040]). A credit is allowed for tax assessed under s 98 or withheld under the managed investment trust withholding regime to the extent that it relates to income assessed in the hands of the beneficiary under s 100. There is no provision for a refund except in relation to tax paid by a trustee in respect of income flowing through a chain of trusts.

Beneficiary temporary resident at end of income year Foreign source income to which a ‘‘temporary resident’’ (see [2 100]) is presently entitled is non-assessable non-exempt income under s 768-910: see [7 110]. Beneficiary not a resident at the end of the income year The general principle is that the trustee is assessed on a share of the net income of the trust estate corresponding to the income of the trust estate to which a person who is not a resident at the end of the income year is presently entitled, excluding income derived from non-Australian sources when the beneficiary was not a resident of Australia. The same income is also assessed in the hands of the beneficiary and a credit is available for the tax paid by the trustee. This basic principle is varied by the interaction of Div 6 with the withholding tax rules for dividends, interest and royalty income in Div 11A (see Chapter 35), the investment manager regime (see [23 655]) and the managed investment trust withholding regime (see [23 680]). The basic rules in Div 6, in relation to the share of the net income corresponding to trust income to which a beneficiary who is not under a legal disability is presently entitled, are set out below (see also [23 600]). The relevant share of the net income of the trust estate is assessed in the hands of the trustee under s 98(2) if the beneficiary is a natural person who is deemed to be presently entitled by s 95A, and is not affected by s 97A(1) or 97(1A) relating to farm management deposits. If s 98(2) does not apply, the relevant share of the net income of the trust estate is assessed in the hands of the trustee: © 2017 THOMSON REUTERS

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[23 450]

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• under s 98(3) unless the beneficiary is a beneficiary in the capacity of a trustee of another trust estate; and • under s 98(4) if the beneficiary is a beneficiary in the capacity of a trustee of another trust estate. Where s 98(3) applies, the amount of income assessed in the hands of the trustee is (s 98(2A)): • the beneficiary’s share of the net income of the trust estate that is attributable to a period (if any) when the beneficiary was a resident of Australia, plus • the beneficiary’s share of the net income of the trust estate that is attributable to a period (if any) when the beneficiary was not a resident of Australia and is also attributable to Australian sources. Where s 98(4) applies, the amount of income assessed in the hands of the trustee is the beneficiary’s share of the net income of the trust estate that is attributable to Australian sources. If the relevant assessing provision for the trustee is s 98(2), the same share of net income is assessed in the hands of the beneficiary under s 100. If the relevant share of the net income of the trust estate is assessed in the hands of the trustee under s 98(3), the same share is assessed in the hands of the beneficiary under s 98A. In addition, a beneficiary in another trust estate who is presently entitled to income of that trust estate through a chain of trusts is required to include in assessable income any income assessed in the hands of the trustee under s 98(4): s 98A(3). Income assessed in the hands of an indirect beneficiary under s 98A(3) is not assessed under s 100 in the hands of the direct beneficiary acting as a trustee of a trust estate. Credit is available for tax paid by the trustee under s 98: see [23 600]. For a discussion of the way in which the general trust income assessing rules interact with: • the withholding tax rules for dividends, interest and royalties, see [23 630]; and • the withholding tax rules for payments by managed investment trusts, see [23 680]. A capital gain that a foreign resident beneficiary in a fixed trust is taken (by s 115-215) to have made as a result of a CGT event happening to a CGT asset of a trust is exempt if, at the time of the event, the asset was not taxable Australian property of the trust (see [18 110]): s 855-40(2). The exemption does not apply if the trust is a non-fixed trust. The gain is also disregarded in determining the amount that is assessable in the hands of the trustee: s 855-40(3). The rules regarding the allocation of capital gains to beneficiaries and/or a trustee are discussed at [17 020]-[17 060].

Present entitlement and exempt or non-assessable non-exempt income The exempt income of a beneficiary who is presently entitled to a share of the income of a trust estate, and who is not under a legal disability, includes the beneficiary’s interest in the exempt income of the trust estate, except to the extent to which that exempt income is taken into account in calculating the net income of the trust estate: s 97(1)(b). The non-assessable non-exempt income (see [7 700]) of such a beneficiary similarly includes the beneficiary’s interest in the non-assessable non-exempt income of the trust estate: s 97(1)(c). The exception in relation to exempt income may be illustrated as follows.

956

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EXAMPLE [23 450.10] Assume that the results of operations for a trust estate were as follows. Also assume that all business income was assessable for tax purposes and that all expenses were allowable deductions. Business loss ................................................................................... Business profit .................................................................................. Other income (exempt for tax purposes) ......................................... Total income .....................................................................................

$ (1,000) 1,100 600 1,700

For tax purposes the position would be as follows: Year 1 Carried forward loss .........................................................................

(1,000)

Year 1 Year 2

This loss is not distributed to beneficiaries for tax purposes and remains in the trust estate. Year 2 Assessable income .................................................................... 1,100 less allowable deduction: Carried forward loss (Year 1) ................... 1,000 Offset against exempt income (s 36-15) .. 600 400 Net income of trust estate .................................................................. 700 If there were beneficiaries who were presently entitled to the entire income of the trust estate for trust law purposes, the $700 net income of the trust estate would be assessable in their hands. Note that they are not regarded as deriving any of the $600 exempt income for this year as it was fully taken into account in calculating the net income of the trust estate (by being offset against carried forward losses).

[23 460] Presently entitled beneficiary under a legal disability If a beneficiary is presently entitled to a share of the income of a resident trust estate but is under a legal disability, the trustee is assessed and liable to pay tax in respect of the corresponding share of the net income of the trust estate as if it were the income of an individual and were not subject to any deduction: s 98(1). The income is assessed separately from any other income of the trust. The meaning of ‘‘legal disability’’ is discussed at [23 430]. If a beneficiary who is a minor is indefeasibly entitled to the income of a trust estate, the net income of the trust estate is taxed in the hands of the trustee under s 98: Trustees of the ID Taylor Trust v FCT (1970) 1 ATR 582. A beneficiary under a legal disability is exempt from the TFN withholding regime for closely held trusts: see [50 080]. If the beneficiary does not derive any other income apart from her or his share of the net income of a single trust estate that has been dealt with under s 98(1), the s 98 assessment issued to the trustee will finalise the tax assessments issued in respect of such income. The trustee will have paid tax on behalf of the beneficiary and the beneficiary will have no liability. If the beneficiary has income from other sources (including capital gains and franked dividends ‘‘streamed’’ to the beneficiary: see [17 050] and [21 530]) or is a beneficiary in more than one trust estate, s 100(1) includes the same amount in the assessable income of the beneficiary (and tax paid or payable by the trustee is deducted from the tax assessed to the beneficiary: s 100(2)). This generally ensures that the total income of the beneficiary is taxed at the correct marginal rate, but there is no provision for a refund of tax paid by the trustee if it exceeds the total tax payable by the beneficiary: Case 28 (1972) 18 CTBR (NS) 28. In addition, the beneficiary’s share of the net income of the trust estate is assessed in the hands of the beneficiary if it includes: © 2017 THOMSON REUTERS

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[23 470]

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• income in respect of which the beneficiary would be entitled to a refund of tax offsets (eg the franking tax offset) if it were included in the beneficiary’s assessable income (see [19 040]): s 100(1A); • income that has flowed through 2 or more trusts and represents an amount that was assessed in the hands of a trustee of another trust under s 98(4) (see [23 450]): s 100(1B); or • an amount from which an entity is required to withhold an amount under the managed investment trust withholding regime (see [50 090]): s 100(1C). Where a beneficiary is assessed in accordance with s 100(1) or s 100(1A), the appropriate portion of the tax paid or payable by the trustee is deducted from the tax paid by the beneficiary: s 100(2). A credit is also allowed for tax assessed in the hands of the trustee under s 98 or withheld under the managed investment trust withholding regime, to the extent that it relates to income assessed in the hands of the beneficiary under s 100: s 98B and s 18-50, Sch 1 TAA.

Consequences for beneficiary in non-resident trust estate On its terms, s 98(1) applies equally to a beneficiary under a legal disability in a resident or non-resident trust estate. For income years before 2010-11, a person who had an interest in a non-resident trust estate was deemed to be presently entitled to a share of the income of the trust estate and was also deemed not to be under a legal disability: s 96B. As a result, the beneficiary’s share of the net income of the trust estate (taking account of the calculation required by s 96C) was assessed in the hands of the beneficiary under s 97 notwithstanding the beneficiary’s legal disability, unless the former FIF rules applied: see [23 700]. This had the effect of restricting the operation of s 98(1) to situations in which a beneficiary under a legal disability was entitled to income of a resident trust estate. Special disability trusts Special disability trusts are trusts set up in accordance with requirements of the law to qualify for income support: see the website of the Department of Families, Housing, Community Services and Indigenous Affairs. With effect from the 2008-09 income year, the principal beneficiary of a special disability trust is deemed to be presently entitled to all of the income of the trust estate for a particular income year: s 95AB(2). This is the case even if there is no ‘‘income of the trust estate’’: s 95AB(4). If the principal beneficiary is a resident at the end of the income year, he or she is treated as being under a legal disability: s 95AB(3). The effect is that all of the net income of the trust is taxable in the hands of the trustee under s 98(3) at the principal beneficiary’s personal income tax rate. If the principal beneficiary has income from other sources, the income which is assessed in the hands of the trustee is also assessed in the hands of the beneficiary under s 100 and the tax paid or payable by the trustee is deducted under s 100(2) from the tax assessed to the beneficiary. If the amount deducted is greater than the income tax assessed to the principal beneficiary, a refundable tax offset (see [19 040]) is payable to the principal beneficiary: s 95AB(5). The deeming rules in s 95AB were introduced to ensure that income retained in a special disability trust is not taxed in the hands of the trustee at the top personal tax rate plus Medicare levy under s 99A. [23 470] Beneficiary presently entitled as trustee of another trust The following special rules apply to a beneficiary who is presently entitled to a share of the income of a trust estate in the capacity of trustee of another trust. Firstly, if such a beneficiary is not a resident at the end of the income year, the general provision assessing trust income in the hands of a presently entitled beneficiary applies: s 97(2)(b)(ii). 958

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Secondly, if such a beneficiary is a resident at the end of the income year, income to which the beneficiary is deemed by s 95A to be presently entitled (by reason of having a vested and indefeasible interest in that income) is included in the beneficiary’s assessable income: s 97(2)(a)(iii). These provisions allow assessable income to flow from one trust to another if a beneficiary is presently entitled to income of the first trust in the capacity of trustee of another trust. Income to which a beneficiary who is a foreign resident at the end of the income year is presently entitled, or to which a beneficiary is deemed to be presently entitled under s 95A, is generally assessed in the hands of the trustee under s 98(2) or (3) unless the beneficiary is presently entitled in the capacity of a trustee of another trust. But where such a beneficiary is a foreign resident, or another trustee of the second trust is a foreign resident, then to the extent that the income is from Australian sources, it is assessed in the hands of the trustee of the first trust (s 98(4)) as well as being assessed in the hands of the beneficiary under s 97.

NO BENEFICIARY PRESENTLY ENTITLED TO TRUST INCOME [23 500] Trustee assessed If a share of: • the net income of a resident trust estate; or • the net Australian source income of a non-resident trust estate, is not assessable in the hands of any beneficiary (generally because no beneficiary is presently entitled to the income of the trust estate), that share is assessed in the hands of the trustee. This situation may arise, for example, if a trust deed or will specifies that all or part of the income of a trust estate is to be accumulated until a future event occurs, such as the coming of age of one of the beneficiaries. It is immaterial whether or not it can be ascertained who will eventually become entitled to the income. The trustee is assessed under either s 99A or s 99. These sections are interrelated and must be read together to determine which applies in any particular situation. The manner in which the sections operate is that s 99A, which imposes a higher rate of tax, applies automatically unless the trust estate is of a type specified in s 99A(2) and the Commissioner considers that it would be unreasonable for s 99A to apply in relation to the trust estate in relation to the relevant income year. The types of trust estate specified in s 99A (in respect of which the Commissioner may form an opinion that it would be unreasonable for the section to apply) are trust estates that: • have resulted from a will or intestacy; • consist of the property of a person who has become bankrupt that is vested in the Official Receiver or a registered trustee under the Bankruptcy Act 1966; • are administered under Pt XI of the Bankruptcy Act 1966; or • consist of property of a kind referred to in s 102AG(2)(c), ie property vested in a trust in the circumstances outlined in [26 150]-[26 220], such as under the terms of a life insurance policy on the death of a person, in satisfaction of a claim for damages or as the result of a family breakdown (trust income derived from the investment of such property is excepted trust income for the purposes of Div 6AA). The factors to be taken into account by the Commissioner in forming an opinion as to whether it is unreasonable that s 99A should apply are considered at [23 510]. Section 99A applies a penalty rate of tax (equivalent to the top personal marginal rate of tax: see [101 060]), whereas the rates under s 99 are more closely linked to the marginal rates © 2017 THOMSON REUTERS

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[23 500]

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that apply to individuals. The exact rate applicable under s 99 varies depending, in the case of a will trust, upon when the deceased died. If the deceased died less than 3 years before the end of the income year in question, the general tax-free threshold is available, but not if the deceased died 3 or more years before the end of the income year. The rates are set out at [101 030]. The rigidity of the 3-year time limit is exemplified by Re Trustee for the Estate of Dukes and FCT (2002) 50 ATR 1060. In that case, the deceased died on 24 June 1997 and therefore the tax-free threshold was not available for the year ended 30 June 2000 (3 years and 6 days after the date of death). EXAMPLE [23 500.10] The income of a trust estate created under a will is divisible as follows: one-third to widow; one-third to elder son who is presently entitled but is under a legal disability; one-sixth to be accumulated until younger son becomes 21; and one-sixth to be accumulated until daughter becomes 21 or marries. In the case of the latter 2 beneficiaries, their interest is contingent upon their satisfying the conditions. The net income of the trust estate is $30,000. 1. $10,000 will be included in the assessable income of the widow: s 97. 2. The trustee will be separately assessed on $10,000 in respect of the share of the elder son: s 98. 3. The trustee will be assessed on the whole of the income to which no beneficiary is presently entitled: Younger son ......................................................................................... Daughter .............................................................................................. Taxable income ....................................................................................

$5,000 $5,000 $10,000

Assuming that the Commissioner considers it unreasonable that s 99A should apply, the trustee will be assessed on $10,000 at the rates specified for an assessment under s 99: see [23 120]. For income derived during the year of death or either of the 2 subsequent years, the tax-free threshold that is available to a resident individual taxpayer will be available. For subsequent years, progressive income tax rates apply with no tax-free threshold. In Re Trustee for the Estate of Dukes and FCT (2002) 50 ATR 1060, the AAT confirmed that the trustee of a deceased estate had been correctly assessed on an amount of income derived in respect of assets of the deceased estate, as the deceased person had died more than 3 years before the end of the income year in which the income was derived. The Commissioner in this case exercised his discretion to assess the income under s 99, not s 99A. A trustee assessed under s 99 (but not s 99A) is entitled to a refund of excess franking tax offsets: see [19 040]. An Official Receiver in Bankruptcy may be assessable under the provisions of s 99: Offıcial Receiver in Bankruptcy as Trustee of Estate of William Fox (otherwise Rankin) v FCT (1956) 11 ATD 119; 6 AITR 331.

Capital gains If a capital gain is taken into account in determining the net capital gain of a resident trust estate for an income year and the trust property representing all or part of that capital gain is not paid to a beneficiary within 2 months of the end of that income year, the trustee can make a choice, under s 115-230, that varies the effect of the capital gains streaming rules in Subdiv 115-C (see [23 210]). The effect of the choice is that ss 115-215 and 115-220 will not apply to the capital gain (thereby in effect cancelling the streaming of capital gains to ‘‘specifically entitled’’ beneficiaries) and instead the trustee will be treated as being ‘‘specifically entitled’’ to the capital gain. As a result, the capital gain will be assessed in the hands of the trustee under s 99 or s 99A. 960

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[23 520]

[23 510] Matters to be considered by the Commissioner The Commissioner is required by s 99A(3) to consider the following matters in determining whether it is unreasonable that s 99A should apply to the income of a trust: (a) the circumstances in which and the conditions under which property, including money, was acquired by or lent to the trust estate, income was derived by the trust estate, benefits were conferred on the trust estate or special rights or privileges conferred on or attached to property of the trust estate, whether or not the rights or privileges granted have been exercised; and (b) whether any person who: (i) has transferred or lent money or property or conferred benefits upon the trust estate, or conferred or attached any special right or privilege or done any act either alone or in association with another person or persons that has resulted in the conferring or attaching of any special right on the property of the trust estate, whether or not the right or privilege has been exercised in connection with the trust estate; (ii) has done anything similar in connection with any other trust estate. The Commissioner is also required to consider any other matters that he considers relevant in forming his opinion: see s 99A(3)(c) and Perron v FCT (1972) 3 ATR 249. In the case of a deceased estate, the Commissioner is also required to consider the above matters as they relate to the deceased person: s 99A(3A). The Tax Office’s website contains the following statements regarding deceased estates: “First three income years For the first three tax returns, the deceased estate income to which no beneficiary is presently entitled is taxed at the general individual rates, with the benefit of the full tax-free threshold, but without the tax offsets (concessional rebates), such as the low-income tax offset. No Medicare levy is payable ... Fourth income year and later For deceased estates with prolonged administration that extend beyond the concessionally taxed period, there are special progressive trust tax rates that will apply.” A similar statement appears in the trust tax return instructions. These statements imply that, in a normal case, the Commissioner will form a view that it would be unreasonable for s 99A to apply to the income of a deceased estate. The Tax Office’s reference to special progressive rates applying from the fourth year is a reference to the unavailability of the tax-free threshold for s 99 assessments of the income of a deceased estate after the end of the third year. It does not imply that the Commissioner will consider that s 99A should apply after 3 years (as in that event a flat rate of tax would apply).

[23 520] Income of deceased received after death If the trustee of the estate of a deceased person receives any amount that would have been assessable income in the hands of the deceased person if it had been received during her or his lifetime, that amount must be included in the assessable income of the trust estate of the year in which the amount was received. Such income is deemed to be income to which no beneficiary is presently entitled: s 101A(1). A typical example is that of a medical practitioner who has prepared returns on a cash receipts basis. In the event of her or his death, outstanding fees that are collected by the trustee are assessable income of the trust estate in the year of receipt. Seemingly, this includes receipts for work that was incomplete at the date of death (work in progress): Single v FCT (1964) 110 CLR 177. As Menzies J said in that case: © 2017 THOMSON REUTERS

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[23 550]

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It does not seem to me to matter whether or not the deceased could during his lifetime have received the actual payments which the trustee of his estate received after his death. Nor does it matter that the deceased had no right to receive the payments in question during his lifetime. Amounts received by the trustee subsequent to death that represent income derived from property owned by the deceased are not assessable under this provision unless the right to the income had accrued before the date of death. An employment termination payment or a superannuation death benefit received by the trustee of the estate of a deceased person is also treated as income to which no beneficiary is presently entitled: s 101A(3). Section 101A does not apply to the following amounts received by the trustee of a deceased estate: • lump sum payments for unused annual or long service leave that would have been assessable to the deceased if received during her or his lifetime: s 101A(2); and • a farm management deposit, of which the deceased was the owner, that had become repayable (see [27 610]): s 101A(4). Moneys assessable under s 101A are included in assessments issued to the trustee under s 99 or s 99A (usually the former: see [23 500]).

TRUST INCOME NOT PREVIOUSLY TAXED [23 550] Purpose and scope of s 99B If property of a trust estate is paid to a beneficiary or applied for the benefit of a beneficiary (as described in s 96C), and the beneficiary is a resident at any time during the income year, s 99B includes that amount in the assessable income of the beneficiary, except to the extent that the amount is reduced by s 99B(2). The original rationale for the insertion of s 99B into the income tax law in 1979 was to assess an amount paid to an Australian resident beneficiary out of income from foreign sources that had been accumulated in a non-resident trust estate and would not have been taxed in Australia while the income accumulated. Before the provision was introduced, a distribution to an Australian resident beneficiary of an amount that had become trust capital as a result of a process of capitalisation of foreign source income within a non-resident trust estate was not subject to tax in Australia. Section 99B(2) reduces an amount that would otherwise by assessable under s 99B(1) by so much (if any) of the amount as represents: • a distribution in the form of corpus except if that corpus resulted from the receipt of amounts by the trustee that if received directly by a resident taxpayer would have been assessable income; • an amount that would not have been included in the assessable income of a resident taxpayer if it had been derived by the taxpayer at the time of the derivation by the trustee; • an amount that is non-assessable non-exempt income of the beneficiary because of s 802-17 (relating to conduit foreign income: see [35 180]); • an amount that has been previously assessed to the beneficiary under s 97 or to the trustee under s 98, s 99 or s 99A; • an amount that is reasonably attributable to a part of the net income of another trust in respect of which the trustee of the other trust is assessed and liable to pay tax under s 98(4); and 962

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[23 600]

• an amount that has been included in the assessable income of any taxpayer (other than a company) under s 102AAZD (the ‘‘transfer trust’’ rules; see [34 450]-[34 490]) or, if the beneficiary being assessed under s 99B is a company, an amount that has been included in the assessable income of that company under s 102AAZD. In Howard v FCT (No 2) (2011) 86 ATR 753, the taxpayer asserted that an amount distributed to him by a non-resident trust estate was a distribution of the corpus of the trust estate and was therefore a capital receipt. The Commissioner did not take issue with this assertion but said the amount was nevertheless assessable under s 99B to the extent that it was not assessable under s 97. The Court agreed, finding that when the amount that was later distributed to the taxpayer was derived by the trustee, it would have been assessable if it had been derived by an Australian resident. This decision was affirmed on appeal in Howard v FCT (2012) 91 FCA 89. The taxpayer was denied special leave to appeal to the High Court in relation to this issue, but was granted leave to appeal on a separate issue: see [23 030]. Note that the Commissioner does not apply s 99B as widely as a literal interpretation of the provision might allow: see [23 330].

Amounts applied for benefit of beneficiaries Under s 99B property is deemed to be distributed to a beneficiary of a trust estate if it is applied for her or his benefit. Under s 99C(1) a beneficiary may be deemed to have received a benefit irrespective of when it accrued and irrespective of the nature or form of the benefit. Section 99C(2) amplifies the preceding comment by referring to certain situations but does not purport to be exhaustive of the above general proposition. A beneficiary is deemed to have received a benefit if amounts have been reinvested, accumulated, capitalised or otherwise dealt with directly or indirectly for the benefit of the beneficiary. Other examples of amounts being deemed to be applied for the benefit of the beneficiary include: • situations where the property or rights held by or for the benefit of the beneficiary have been increased in value; • moneys have been received by the beneficiary irrespective of the form, if these moneys have been provided directly or indirectly out of property or money that was available to the trustee by reason of the derivation of the amount. This provision includes loans or repayments of loans; • the beneficiary has the power, either alone or in conjunction with another party or parties, to the beneficial enjoyment of any amount; and • the beneficiary has directly or indirectly assigned her or his rights to a third party or is able to control the application of an interest in an amount, whether directly or indirectly. Character of amount that is assessable under s 99B In Draft Determination TD 2016/D5, the Tax Office states that if an amount that is assessable under s 99B represents a capital gain that was not taxable in Australia in the year that it was made by the foreign trust (see [23 210]), the amount that is assessable under s 99B is not itself a capital gain that is capable of being offset against capital losses. Further charge in respect of tax payable on amounts assessed under s 99B If an amount is included in a taxpayer’s assessable income under s 99B, a further amount of tax is imposed, calculated by reference to an interest rate and the period of time between the derivation of the relevant income by the trustee and the inclusion of the amount in the assessable income of the beneficiary: s 102AAM, discussed at [34 490].

FOREIGN RESIDENT BENEFICIARIES [23 600] Basic rules A beneficiary who is a resident at the end of an income year, but who was not a resident for the whole year, and who is presently entitled to all or part of the income of a trust estate © 2017 THOMSON REUTERS

963

[23 610]

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(but not by reason of s 95A(2): see [23 420]) and is not under a legal disability, is assessed on a corresponding portion of the net income of the trust estate, excluding any income from non-Australian sources derived during the beneficiary’s period of non-residence: s 97(1). In some cases, a taxation agreement between Australia and another country may deem income in respect of which Australia has a taxing right to be income from a source in Australia for all purposes of Australian income tax law. In ATO ID 2007/166, the Tax Office confirms that the deeming of Australian source in this situation under the Australia-New Zealand taxation agreement is overridden by s 3AA(2) of the International Tax Agreements Act 1953 in considering whether a New Zealand resident is assessable on the income of a widely held unit trust. Note also the investment manager regime rules (see [23 655]) and the managed investment trust rules (see [23 680]). A beneficiary who is not a resident at the end of an income year generally cannot be assessed under s 97(1), even if the person was a resident at some stage during the income year: s 97(2)(b). If a beneficiary, who is not a resident at the end of the income year, is presently entitled to a share of the income of a trust estate (but not by reason of s 95A(2): see [23 420]) and is not under a legal disability, the corresponding share of the net income of the trust estate (excluding any income from non-Australian sources derived by the trustee during the beneficiary’s period of non-residence) is assessed in the hands of the trustee under s 98(3) (read with s 98(2A)), unless the beneficiary is presently entitled to the trust income in the capacity of a trustee of another trust, is the owner of a farm management deposit (see [27 610]) or is an exempt foreign organisation. If a beneficiary is presently entitled to trust income in the capacity of a trustee of another trust, and a trustee of the other trust is not a resident at the end of the income year, the trustee of the first trust is assessed under s 98(4) on so much of the share of the net income of the first trust as is attributable to Australian sources (but not in respect of a distribution from a managed investment trust that is subject to the withholding regime in Subdiv 12-H in Sch 1 TAA: see [50 090]). A foreign resident beneficiary can apply for a refund if it can be shown that the trustee paid Australian tax on an amount of non-Australian source net income corresponding to a share of the income of the trust estate to which the beneficiary is presently entitled: s 99D (see [23 660]). In addition, regardless of whether a refund is claimed under s 99D, the income assessed in the hands of the trustee under s 98(3) (or s 98(4)) is also assessed in the hands of the beneficiary under s 98A(1) (or s 98A(3)) but the tax thereon is reduced by the tax paid by the trustee on the same income: s 98A(2) (or s 98A(3)). If the tax paid by the trustee exceeds the amount payable by the beneficiary, the difference is payable by the Commissioner to the beneficiary (s 98A(2)(b) or s 98B(4)) but the Commissioner may offset the payment against another tax debt owed by the beneficiary: see [52 050]. A presently entitled beneficiary under a legal disability, who is a resident at the end of the income year but was not a resident for the whole year, will not be assessed under s 97(1). Instead the trustee will be assessed under s 98(1). In addition, the beneficiary’s share of the net income of the trust may be assessed under s 100 in certain circumstances, with a credit given for tax payable by the trustee in respect of that income: see [23 460].

[23 610] Variations to the basic rules The basic rules set out in [23 600] are varied in the following circumstances. 1. Dividend, interest and royalty income to which the withholding tax rules apply is dealt with under those rules (see [23 630]). 2. If the trust is an IMR entity, certain amounts are excluded from the calculation of a share of the trust’s net income that is assessable in the hands of the trustee under s 98 and a non-resident beneficiary: see [23 655]. 964

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[23 620]

3. Amounts that are subject to managed investment trust (MIT) withholding tax are non-assessable non-exempt income: see [23 680]. Note also the new regime for ‘‘attribution managed investment trusts’’: see [23 685]. 4. Neither s 97 nor s 98 applies to a share of the net income of a trust estate that corresponds with a share of the income of a trust estate to which an exempt body is presently entitled: see [23 240]. If a foreign resident beneficiary is a natural person who is deemed to be presently entitled to a share of the income of the trust estate by virtue of s 95A(2) (see [23 420]), is not under a legal disability, is not the owner of a farm management deposit and is not a beneficiary in the capacity of a trustee of another trust, the trustee is assessed under s 98(2) on the corresponding share of the net income of the trust estate that is attributable to a period when the beneficiary was not a resident and is attributable to sources in Australia. The beneficiary is not assessed under s 97(1) but will be assessed under s 100 if the circumstances for assessment under that section exist. In addition, it should be noted that: • the transferor trust rules in Div 6AAA (see [34 450]-[34 490]) potentially attribute income to a person who transferred property or services to a non-resident trust estate and was a resident at any time during the income year: s 102AAZD. Note that a ‘‘temporary resident’’ (see [2 100]), is not a resident for the purposes of s 102AAZD: s 768-970 ITAA 1997; • s 99B (in conjunction with s 99C) potentially includes previously untaxed trust income in the assessable income of a beneficiary to whom those amounts are paid or applied, if the beneficiary was a resident at any time during the income year. Note that a ‘‘temporary resident’’ is not a resident for the purposes of s 99C: s 768-975; and • specific modifications to the CGT rules and deemed source rules under double tax agreements ensure that foreign resident beneficiaries are not taxed on non-Australian source capital gains and income respectively: see [23 620].

[23 620] Capital gains to which a foreign resident beneficiary is entitled With effect from the 2010-11 income year: • Div 6E removes capital gains from the calculation of the net income of the trust estate for the purpose of determining the amount that is assessable in the hands of a beneficiary or the trustee; • the portion of a net capital gain of a trust that is assessable in the hands of a beneficiary is determined under Subdiv 115-C (see s 115-215); and • if the beneficiary is a foreign resident, s 115-220 includes the same amount assessed in the hands of the trustee under s 98. In determining the tax payable by the foreign resident beneficiary, a deduction (effectively a credit) is allowed for the tax payable by the trustee and any excess credit is refundable: s 98A(2). The foreign resident beneficiary should consider whether s 855-10 exempts the gain if the CGT event giving rise to the gain “happened” in relation to an asset that was not ‘‘taxable Australian property’’. ATO ID 2007/60 reports a decision of the Tax Office that s 855-10 did not exempt a gain attributed by s 115-215 to a foreign resident beneficiary. The same net gain is assessable in the hands of the relevant foreign resident beneficiary under s 115-215. © 2017 THOMSON REUTERS

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A capital gain that a foreign resident beneficiary in a fixed trust is taken (by s 115-215) to have made as a result of a CGT event happening to a CGT asset of a trust is exempt if, at the time of the event, the asset was not taxable Australian property of the trust (see [18 110]): s 855-40 ITAA 1997.

[23 630] Interaction with the withholding tax rules Section 128A(3) (in Div 11A) deals with the liability of a foreign resident beneficiary to pay withholding tax in respect of dividends, interest or royalties included in the income of a trust estate to which the beneficiary is presently entitled: see Chapter 35. Interaction of s 128A(3) and Div 6 The interaction of s 128A(3) and Div 6 is by no means straightforward and in each case depends on the precise terms of the trust, particularly the time at which present entitlement to trust income arises. Section 3(11) InTAA deems a beneficiary’s share of the income of a trust estate to be attributable to a permanent establishment of the beneficiary in Australia, if the income is derived from the carrying on by the trustee of a business through a permanent establishment in Australia. In GE Capital Finance Pty Ltd (as trustee for the Highland Finance Unit Trust) v FCT (2007) 66 ATR 447, the Federal Court held that s 3(11) does not apply for the purpose of determining whether the Australian withholding tax provisions apply to that income. The result in that case was that the income derived by the beneficiary was subject to the withholding tax rules and not Div 6 (see also [36 110]). The Commissioner’s view on the interaction of Div 6 and the dividend and interest withholding tax rules is set out in Ruling IT 2680. The Commissioner considers that if there is an amount of trust income comprising unfranked dividends or interest paid by an Australian resident company to which a foreign resident beneficiary is presently entitled, s 128A(3) applies to that income even if the trust has no ‘‘net income’’ for the purposes of Div 6. The converse must also be true, so that if a trustee of a trust with a foreign resident beneficiary receives unfranked dividend, interest or royalty income, but the foreign resident beneficiary is not presently entitled to that income, the income will not be subject to withholding tax and instead the Div 6 rules will apply to it. This situation may occur, for example, if unfranked dividend, interest or royalty income is paid to a trustee but, under the terms of the trust deed, the beneficiaries do not become presently entitled to income until the end of an accounting period, and there is in fact no trust ‘‘income’’ because there is an accounting loss. Although not specifically stated, Ruling IT 2680 implies that amounts that are subject to the withholding tax rules are included in the income and the net income of the trust estate. The Commissioner accepts that a foreign resident beneficiary’s share of the net income of the trust estate is excluded from assessable income by s 128D to the extent that the net income on which the foreign resident would otherwise be assessed represents income that has been subject to withholding tax (see para 46). Entitlement of resident beneficiary to credit The Commissioner accepts that if withholding tax has been deducted because unfranked dividends, interest or royalties were paid to a foreign resident trustee, and a resident beneficiary receives or is entitled to receive a trust distribution that includes all or part of such income, the beneficiary is entitled to a credit under s 18-30 in Sch 1 TAA for the withholding tax that relates to that distribution: Ruling TR 93/10. [23 650] Deemed permanent establishment and deemed source rules If a trustee derives income from carrying on a business through a permanent establishment in Australia, and a beneficiary of the trust is presently entitled to a share of that income and is a resident of a country which made a double tax agreement (DTA) with Australia before 19 August 1984, then (under s 3(11) InTAA): • the beneficiary is deemed to be carrying on business through a permanent establishment in Australia; and 966

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• the share of the income referred to above is deemed to be attributable to that permanent establishment. For beneficiaries resident in countries with which a DTA was made after 19 August 1984, the agreement itself may contain equivalent provisions (see also [36 110]). The combined effect of these rules is that a foreign beneficiary’s share of the net income of the trust, to the extent that it is derived from business activities undertaken by the trustee in Australia, is assessable income in the hands of the foreign resident beneficiary, even if the income would otherwise not be regarded as having an Australian source. The deemed Australian source provisions in tax treaties, and in ss 11(3), 11S(2) and 11ZF(2) of InTAA in relation to the DTAs with Germany, China and Taipei, have limited application if the trust is a ‘‘widely held unit trust’’ (see [23 970]) that is carrying on ‘‘funds management activities’’: s 3AA InTAA (see [36 110]). In such cases, the deemed source provisions apply only to income adjusted under the Associated Enterprises Article or the Business Profits Article in a DTA. See also ATO ID 2007/166. For foreign trusts, the investment manager regime (IMR) effectively broadens the exclusion provided by s 3AA of the TAA: see [23 655].

[23 655] Investment manager regime The investment manager regime (IMR), insofar as it relates to the taxation of trust income, was initially designed to ensure that the engagement by a foreign widely held trust of an Australian resident agent, manager (such as an investment manager) or service provider does not cause income and gains to become subject to Australian taxation in the hands of beneficiaries or the trustee, where such income and gains would not otherwise have been taxable in Australia. The rules achieve this effect but now also ensure that, even if an Australian resident agent, manager or service provider is not engaged by a foreign fund, the making of an investment by a foreign investor through the foreign fund (rather than directly) does not result in Australian income tax on certain items of income and gains that would not have been assessable in Australia if the foreign investor had made the investment directly. The rules were introduced in 3 stages. The first set of rules (generally known as ‘‘Element 1’’) applies to the 2010-11 and earlier income years (Div 842 TPA). The second set of rules (generally known as ‘‘Element 2’’) applies to the 2010-11 and later income years (Div 842 ITAA 1997). A third set of rules (generally known as ‘‘Element 3’’) was enacted in June 2015. The Element 3 rules exempt a wider range of income and gains from Australian tax and make the IMR available to a wider range of foreign entities. Some of the ‘‘Element 3’’ rules have retrospective effect from the 2011-12 income year. The Element 1 rules, described below, are not affected by the measures enacted in June 2015. The Element 2 rules were repealed in June 2015 and superseded by the Element 3 rules, which apply from the 2015-16 income year. However, some of the Element 3 rules have retrospective effect from the 2011-12 income year if the taxpayer so chooses. The Element 3 rules are therefore summarised below separately from the Element 2 rules. ‘‘Element 1’’ rules for 2010-11 and earlier income years Division 842 TPA restricts the Tax Office’s power to raise assessments in respect of certain Australian investment income of foreign managed funds for the 2010-11 and earlier income years if: • a return had not been lodged in relation to the relevant income year; • an assessment had not made before 18 December 2010 for any income year; and • the Commissioner had not given notice of an audit or compliance review by that date. In these circumstances, s 842-210 TPA instructs the Commissioner to treat the fund’s IMR income as non-assessable non-exempt income and to disregard the fund’s IMR © 2017 THOMSON REUTERS

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deductions, IMR capital gains and IMR capital losses for the income year, in assessing the trustee or a foreign resident beneficiary of the trust. Note that the legislation that introduced the ‘‘Element 3’’ rules also amended the ‘‘widely held’’ test that applies for the purposes of the ‘‘Element 1’’ rules. The new widely held requirements apply to an ‘‘IMR entity’’ rather than an ‘‘IMR foreign fund’’. The application of the new test is elective.

‘‘Element 2’’ rules for 2010-11 and later income years Note that these rules (in Subdiv 842-I) have been repealed with effect from the beginning of the 2015-16 income year. For the previous 4 income years, a taxpayer can choose to apply the Element 3 rules rather than the Element 2 rules. A foreign resident beneficiary or trustee of an ‘‘IMR foreign fund’’ is assessable under Div 6 only in respect of the relevant entity’s share of the ‘‘non-IMR net income’’ of the trust estate: s 842-215(3). An IMR foreign fund includes a trust that is not a resident trust estate under s 95(2) at any time in the income year, does not carry on a trading business in Australia (applying the test in s 102M: see [23 1610]) at any time during the income year, is widely held at all times during the income year and does not breach an ownership concentration test at any time during the income year. Note that a company or partnership may also be an ‘‘IMR foreign fund’’. The calculation of ‘‘non-IMR net income’’ excludes ‘‘IMR income’’ and related deductions. ‘‘IMR income’’ is assessable income to the extent that: • it is attributable to a return or a gain from a ‘‘financial arrangement’’ (as defined in Div 230 ITAA 1997) that is not specifically excluded; and • it would not have been assessable in Australia but for the fact that it is attributable to a permanent establishment that arises solely from the use of an Australian resident agent, manager or service provider, who habitually exercises a general authority to negotiate and conclude contracts on behalf of the IMR foreign fund. A financial arrangement is excluded (under s 842-245) if it is: • an interest in an entity in which the IMR foreign fund has a participation interest of 10% or more; • a derivative financial arrangement that relates to such an excluded interest or to taxable Australian real property or an indirect Australian real property interest; or • a financial arrangement that gives the IMR foreign fund a vote at the entity’s board of directors or the right to participate in making financial, operating or policy decisions in relation to the issuer’s operations or the right to deal with the issuer’s assets other than on a default under the financial arrangement). An ‘‘IMR capital gain’’ and an ‘‘IMR capital loss’’ is disregarded in similar circumstances.

‘‘Element 3’’ rules that apply from the 2015-16 income year (or earlier by election) The Element 2 rules in Subdiv 842-I have been replaced with Subdiv 842-I (the Element 3 rules) by the Tax and Superannuation Measures (2015 Measures No 1) Act 2015. The explanatory memorandum to the amending legislation (the Tax and Superannuation Measures (2015 Measures No 1) Act 2015) states that the rules are intended to achieve 2 broad objectives: • The first objective, through a ‘‘direct IMR concession’’, is to place foreign investors that invest in Australian assets through a foreign fund in the same income tax position in relation to gains and losses on disposal of the investment as they would typically have been had they made their share of the fund’s investment directly. 968

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• The second objective, through an ‘‘indirect IMR concession’’, is ‘‘to ensure that a foreign investor that invests through an independent Australian fund manager will be in the same position, in relation to disposal gains and losses, as if they had invested directly’’. This element of the IMR rules is a modified version of the Element 2 rules. The new IMR rules apply for the 2015-16 income year and later income years. In addition, a taxpayer may choose to apply the ‘‘indirect IMR concession’’ elements of the new rules with retrospective effect (instead of applying the Element 2 rules) from the 2011-12 income year to the 2014-15 income year. The Element 3 rules may be summarised as follows. IMR entities • The rules apply to certain types of income or gains derived by an ‘‘IMR entity’’. An ‘‘IMR entity’’ is an entity that is a foreign resident throughout the income year and is not a resident trust for CGT purposes, and does not carry on a trading business in Australia or control (directly or indirectly) a trading business in Australia at any time in the income year. As noted below, certain aspects of the IMR rules apply to an IMR entity regardless of whether or not it is a ‘‘widely held entity’’, and other aspects apply only if the IMR entity is a ‘‘widely held entity’’. • The IMR rules apply for the purposes of determining the ‘‘assessable income’’ of an entity that is a foreign resident and is not a trust or partnership: s 842-210. If the IMR entity is a partnership or trust, the general partnership income assessing rules in Div 5 of Pt III of ITAA 1936 (discussed in Chapter 22) and the trust income assessing rules operate in conjunction with the IMR rules to ensure that income and gains can be treated as non-assessable non-exempt income under the IMR regime, to the extent that they flow through to a foreign partner or beneficiary, but not to the extent that they flow through to a partner or beneficiary who is an Australian resident. It seems that income in respect of which a trustee would otherwise be assessed under s 98 would be reduced as a result of the application of the IMR rules to the relevant foreign beneficiary. Qualifying for the direct IMR concession and the indirect IMR concession • As noted above, 2 concessional tax regimes are provided: one for direct investment by an IMR entity (the ‘‘direct IMR concession’’) and one for investment by an IMR entity that has engaged an Australian fund manager (the ‘‘indirect IMR concession’’). Both concessional tax regimes can apply to the same IMR entity. In other words, the ‘‘direct investment’’ concession applies to an IMR entity whether or not it has engaged an Australian fund manager (which is somewhat confusing, as the IMR was initially introduced to deal with problems arising from the appointment of an Australian fund manager) and the ‘‘indirect IMR concession’’ applies to an IMR entity that has engaged an Australian fund manager. • Further conditions that have to be satisfied in order for an IMR entity to benefit from the rules are specified separately for the ‘‘direct IMR concession’’ and the ‘‘indirect IMR concession’’. • An IMR entity qualifies for the ‘‘direct IMR concession’’ in an income year if it is a ‘‘widely held entity’’ during the whole of the income year and it does not have a non-portfolio interest in the issuer of, or counterparty to, the IMR financial arrangement, and the returns, gains or losses are not attributable to a permanent establishment of the IMR entity in Australia. • There are 2 ways for an IMR entity to satisfy the ‘‘widely held’’ test. IMR entities automatically qualify as ‘‘widely held’’ if they are included in the list of entities specified in s 12-402(3) of Sch 1 to the TAA for the purposes of the managed © 2017 THOMSON REUTERS

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investment trust (MIT) rules: see [50 090] (except that a modified test applies for entities that fall within one of the categories set out in that section). Entities that automatically qualify as ‘‘widely held’’ include foreign life insurance companies and certain foreign superannuation funds. An IMR entity may also qualify as ‘‘widely held’’ if no member of the entity has a ‘‘participation interest’’ of 20% or more, and there are not 5 or fewer members who have a total participation interest of at least 50% in the entity. • An entity is deemed to have satisfied the ‘‘widely held’’ test in certain start-up and wind-down situations and in certain circumstances outside the control of an IMR entity. • An IMR entity qualifies for the ‘‘indirect IMR concession’’ if the IMR financial arrangement was made on the IMR entity’s behalf by an ‘‘independent Australian fund manager’’ for the IMR entity for the income year and it does not have a non-portfolio interest in the issuer of, or counterparty to, the IMR financial arrangement (or the IMR financial arrangement in respect of which a subunderwriting arrangement has been entered into) if that issuer or counterparty is an Australian resident. This expands the ‘‘conduit income’’ provisions in the Element 2 IMR regime to cover income and gains from IMR financial arrangements even if the IMR entity has a non-portfolio interest in the issuer. The requirements to qualify for the direct and indirect IMR concessions may be summarised as follows: Widely held requirement Direct IMR concession Indirect IMR concession

Yes No

Independent Australian fund manager requirement No Yes

Non-portfolio interest requirement No Yes if the issuer or counterparty is an Australian resident

Income and gains qualifying for the IMR concessions • For an IMR entity that is not a trust or partnership, and for a foreign resident who is a partner or beneficiary in an IMR entity that is a partnership or a trust, the IMR rules apply as follows: – an amount derived by that IMR entity itself (if it is not a partnership or a trust), and an amount derived by the foreign resident through an IMR entity that is a partnership or trust, is treated as non-assessable non-exempt income if it is attributable to a return or gain from an ‘‘IMR financial arrangement’’ that is a derivative financial arrangement, or from the IMR entity disposing of, ceasing to own or otherwise realising an IMR financial arrangement; – there is a corresponding denial of a deduction for a loss or outgoing attributable to an IMR financial arrangement that is a derivative financial arrangement, or from the IMR entity disposing of, ceasing to own or otherwise realising an IMR financial arrangement; and – capital gains and losses arising from the occurrence of a CGT event in relation to an IMR financial arrangement are disregarded. • An IMR financial arrangement is any financial arrangement (as defined in Div 230: see [32 070]) other than one which arises from or relates to a CGT asset that is taxable Australian real property or an indirect Australian real property interest (see [18 100] and [18 105]). A sub-underwriting arrangement is deemed to be an ‘‘IMR financial arrangement’’ (and so a fee from such an arrangement is potentially covered by the IMR rules) if it was entered into by the IMR entity ‘‘for the purpose 970

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of providing for the entity to invest or trade in a financial arrangement that is an IMR financial arrangement’’: s 815-225(2). This is relevant for the ‘‘indirect IMR concession’’ only (see s 842-215(3)). • In addition, income that relates to or arises under an IMR financial arrangement that would otherwise be assessable income, is non-assessable non-exempt income to the extent that it is deemed to have an Australian source as a result of the income being attributable to a permanent establishment of the IMR entity in Australia under an international tax agreement or under Subdiv 815-C. There is a corresponding denial of a deduction for a loss or outgoing attributable to an IMR financial arrangement, to the extent that the loss or outgoing is attributable to gaining income that is non-assessable non-exempt income under this provision. In addition, capital gains and losses arising from the occurrence of a CGT event in relation to an IMR financial arrangement are disregarded if the CGT asset would otherwise be ‘‘taxable Australian property’’ as a result of being regarded as having been used in an Australian permanent establishment, or because it is an option or right in relation to such an asset. Reduction in IMR concession • IMR tax concessions are reduced if an independent fund manager for the IMR entity, or a connected entity of that fund manager, is entitled to more than 20% of the IMR entity’s profits for that income year. However, an IMR entity can apply to the Commissioner to determine that this reduction is not to occur in certain temporary situations.

[23 660] Refunds to foreign residents Income derived by a foreign resident from sources outside Australia is not assessable, unless specifically made assessable by some provision of the income tax legislation. Resident trustees are liable for income tax upon non-Australian income, but s 99D provides a means by which foreign resident beneficiaries who are in receipt of income derived by a resident trust from non-Australian sources may obtain a refund of any tax paid by the trustee on that income. The section applies to income that has been assessed to the trustee under either s 99 or s 99A that is subsequently paid to a foreign resident beneficiary. The beneficiary may apply to the Commissioner for a refund of the amount of tax paid on the income received by her or him via the trustee. The application must be in writing and must be lodged within 60 days after the date upon which the trust income was paid to the beneficiary. The Commissioner may extend this 60-day period. The beneficiary is required to satisfy the Commissioner that he or she was not an Australian resident during the period in which the income was derived and that the income received from the trust was derived by the trust from sources outside Australia. He or she must also establish that tax was paid on the income by the trustee and that the provisions of s 100A (income derived by a beneficiary under a reimbursement agreement) (see [23 1350]) do not apply. Note that if the income represents a ‘‘fund payment’’ in respect of which tax has been withheld under Subdiv 12-H in Sch 1 TAA (see [23 680] and [50 090]), a credit is available for that amount: s 18-32 Sch 1 TAA.

MANAGED INVESTMENT TRUSTS [23 680] Special tax rules for managed investment trusts Special tax rules in Div 275 ITAA 1997 apply to a managed investment trust (‘‘MIT’’). These rules vary but do not entirely displace the operation of the Div 6 rules. © 2017 THOMSON REUTERS

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In broad terms, a trust is an MIT if (i) it has an Australian resident trustee or the central management and control of the trust is in Australia, (ii) it is a ‘‘managed investment scheme’’ for the purposes of the Corporations Act 2001, (iii) it is not a trading trust as defined in Div 6C (see [23 1610]) and does not carry on or have the ability to control a trading business and (iv) it is widely held: s 275-10 ITAA 1997. The Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 (‘‘MIT Act’’) expanded the circumstances in which an entity is an MIT. The most significant change was the inclusion of a foreign life insurance company regulated under a foreign law in the list of eligible investors in an MIT, for the purposes of the ‘‘widely held’’ test in s 12-402(3) of Sch 1 TAA (with effect from 1 July 2014) and also in the new test in s 275-20(4) ITAA 1997: see [50 090]. Amendments made by the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016 allow an entity to disregard its interests as a limited partner in a VCLP or ESVCLP in determining if it is a trading trust (or carrying on or controlling a trading business) for the purposes of eligibility to be an MIT, provided it and its associates have provided no more than 30% of the committed capital of the VCLP or ESVCLP and the MIT is not a general partner. The Tax Office’s administrative practice in relation to MITs is set out on its website. A separate tax regime for ‘‘attribution MITs’’ (or AMITs) has been enacted: see [23 685]. The AMIT rules apply on an elective basis and, if an MIT does not qualify as an AMIT or the trustee of the MIT does not make a choice that the AMIT rules are to apply, the MIT rules continue to apply to the MIT.

Capital gains A trustee of an MIT can elect under s 275-115 for the CGT rules to apply to gains and losses in relation to eligible ‘‘covered assets’’. Covered assets are shares, non-equity interests in companies, units in unit trusts, real property and rights and options to acquire or dispose of those types of asset, but Div 230 financial arrangements and debt interests are excluded. If an MIT is a partner in a partnership that owns a share in a company, the MIT’s interest in the share is not a covered asset: see ATO ID 2011/67. Note that as a result of amendments made by the Tax Laws Amendment (Tax Incentives for Innovation) Act 2016, to the extent an MIT has an interest in a CGT asset as a result of being a limited partner in a ‘‘venture capital limited partnership’’ (‘‘VCLP’’) or ‘‘early stage venture capital limited partnership’’ (‘‘ESVCLP’’) (see [15 650]), that asset is treated as an asset it owns for the purposes of an election it has made (or may make) for CGT to be the primary code in relation to the assets of the MIT. An election to apply the CGT provisions is irrevocable: s 275-115. If no election to apply the CGT rules is made, all gains and losses made by MITs in relation to covered assets other than land, interests in land and rights and options to acquire or dispose of land or an interest in land are treated as assessable income (rather than capital gains) and allowable deductions (rather than capital losses). The question of whether a gain or loss made on a disposal of land or a right or option to acquire or dispose of land is on capital or revenue account is determined in accordance with general principles. Application of streaming rules The capital gains and franked distribution streaming rules (see [23 210] and [23 220]) do not apply to MITs unless the trustee makes a choice that those rules are to apply. The choice must be made within 2 months after the end of the relevant income year and is available for the 2010-11 to 2016-17 income years: item 51(5), (6) and (7) of Sch 2 Tax Laws Amendment Act (2011 Measures No 5) Act 2011, as amended. Carried interests The term ‘‘carried interest’’ is used in the headings to Subdiv 275-C and s 275-200 but not in the text of the legislation. The term refers to a CGT asset that (s 275-200): 972

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• carries an entitlement to a distribution from an entity that is or was an MIT; and • was acquired because of the provision of services to the entity as a manager or employee of the entity (or an associate of either a manager or an employee). For this purpose, the definition of MIT is modified by removing the requirement that the trust is not a trading trust and does not control, and is not capable of controlling, a trading business: s 275-200(1A). A distribution from an MIT in relation to a carried interest (except to the extent that it represents a return of capital contributed by the taxpayer or an associate), and any gain or profit arising from a CGT event in relation to the carried interest, is included in the assessable income of the holder of the carried interest and is deemed to have an Australian source: s 275-200(2)-(4). A loss arising from a CGT event in relation to the carried interest is deductible: s 275-200(5).

Treatment of distributions to foreign residents Distributions of ‘‘fund payments’’ from a ‘‘withholding MIT’’ to foreign residents are subject to withholding tax under s 840-810 ITAA 1997. A trust is a ‘‘withholding MIT’’ in relation to an income year under s 12-383 in Sch 1 TAA if it is an ‘‘MIT’’ in relation to that year, and a substantial proportion of the investment management activities carried out in relation to the trust in respect of all of the following assets of the trust are carried out in Australia throughout the income year: (i) assets situated in Australia at any time in the income year; (ii) assets that are taxable Australian property at any time in the income year; (iii) shares, units or interests listed for quotation in the official list of an approved stock exchange in Australia at any time in the income year. Fund payments are defined in s 12-405, Sch 1 TAA as distributions of the net income of the trust estate other than distributions of dividends, interest, royalties, non-Australian source income and gains arising from assets that are not taxable Australian property. The payer is obliged to withhold the tax from fund payments under Subdiv 12-H, Sch 1 TAA. Amounts subject to withholding tax are non-assessable non-exempt income: s 840-815 ITAA 1997. The withholding tax rate for fund payments (except to the extent that they are, or are attributable to fund payments from, a ‘‘clean building managed investment trust’’) is 15% if the recipient is resident in a jurisdiction with which Australia has effective exchange of information arrangements for tax matters. If the recipient is not resident in such a jurisdiction, the withholding tax rate is 30%. A reduced withholding tax rate of 10% applies to the extent that the fund payments are from, or are attributable to, a ‘‘clean building managed investment trust’’ if the recipient is resident in a jurisdiction with which Australia has effective exchange of information arrangements for tax matters. See [50 090] for further detail.

Interaction with Div 6 As amounts that are subject to MIT withholding tax are non-assessable non-exempt income (s 840-815 ITAA 1997), these amounts are not assessed under Division 6. In addition, s 98(4) (which may otherwise assess an amount in the hands of a trustee that is a beneficiary of another trust) does not apply to an amount of net income of a trust estate if (s 99G): • it represents income to which a beneficiary is presently entitled; and • it gives rise to an amount from which an entity is required to withhold tax under Subdiv 12-H, Sch 1 TAA. © 2017 THOMSON REUTERS

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Arm’s length rules The MIT Act introduced ‘‘non-arm’s length income’’ rules (in Subdiv 275-L) to remove the incentive to shift profits to an MIT from a related party. Under these rules, if the Commissioner makes a determination that specifies an amount of non-arm’s length income for an MIT, the trustee is taxed on that amount at a rate of 30%: s 12(1) Income Tax Rates Act 1986. The Tax Office has published Law Companion Guide LCG 2015/15 explaining how it interprets and administers this provision. Collective investment vehicles In the 2016-17 Budget, the previous Coalition Government proposed to introduce special income tax regimes for two types of ‘‘collective investment vehicle’’ (CIV): • corporate CIVs – for income years commencing on or after 1 July 2017; and • limited partnership CIVs – for income years commencing on or after 1 July 2018. The Budget announcement stated that CIVs covered by the new regime would be will be required to meet similar eligibility criteria as MITs, such as being widely held and engaging in primarily passive investment. Investors in these proposed new CIVs will generally be taxed as if they had invested directly. Treasury released a consultation paper in November 2016 outlining 3 alternative proposals regarding tax policy settings for CIVs: 1 no change to existing tax policy settings; 2 a 5% Australian withholding tax rate for Australian MITs and CIVs that will be within the Asia Region Funds Passport (ARFP) when that regime commences in late 2017 (the new withholding tax rate would not apply to income that is currently exempt from withholding tax, ie franked dividends and conduit foreign income). Foreign resident investors in CIVs and MITs outside the ARFP and foreign resident investors investing directly into Australian assets would continue to be subject to existing non-resident withholding tax rates; and 3 as per B except that: • the new regime would apply to all Australian MITs and CIVs, not merely those that fall within the ARFP; • income from Australian real property and taxable Australian real property gains would not be covered by the new regime; and • the withholding tax rate may be higher than 5% (possibly 10%).

[23 685] New AMIT regime An entirely new set of elective rules for certain MITs has been enacted by the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 and supporting legislation. The new rules (in Div 276 ITAA 1997): • define an ‘‘attribution managed investment trust’’ (or ‘‘AMIT’’) as an MIT in relation to the income year, in respect of which: i. the rights to income and capital arising from the membership interests in the trust are ‘‘clearly defined’’ (as provided for by s 276-15) at all times during the income year; and ii. if the trust is an MIT only because of s 275-10(1)(b), the only members of the MIT are other MITs; and 974

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[23 685]

iii. if regulations specify any additional criteria, those criteria are satisfied; and iv. the trustee makes an irrevocable choice that the AMIT regime applies in respect of the income year, or made such a choice in respect of an earlier income year; • treat an AMITs as a fixed trust (thereby removing the uncertainty referred to at [23 950]); • provide an ‘‘attribution’’ system of taxation for income and other amounts allocated to ‘‘members’’ of an AMIT on a ‘‘fair and reasonable basis’’ in accordance with their ‘‘clearly defined interests’’, such attribution applying separately to taxable income, exempt income, non-assessable non-exempt income, tax offsets and credits; • specify that income so attributed has the character in the hands of the beneficiaries that it had in the hands of the trustee (thereby, for AMITs, resolving the issue discussed at [23 200]); • make the trustee liable to pay tax on income attributed to foreign resident beneficiaries; • allow ‘‘overs and unders’’ – that is, differences between the amounts of income that should have been allocated to beneficiaries and the amounts actually allocated – to be dealt with in the year in which they are discovered, with a gross-up to reflect a shortfall interest charge if the amounts are significant; • make the trustee of an AMIT liable to pay tax on certain amounts reflecting under-attribution of income or over-attribution of tax offsets; • provide a refundable tax offset to a beneficiary where the trustee is liable to pay tax on an amount attributed to the beneficiary (the offset is equal to the amount of tax paid by the trustee); • allow annual upward and downward cost base adjustments to the CGT cost base of a member’s interest in the AMIT, to ensure that if a member is taxed on a greater amount than is distributed, potential double taxation on the disposal of the member’s interest in the AMIT is avoided, and also that tax free distributions result in a greater potential capital gain on the disposal of an interest in an AMIT; and • provide that an amount attributed to a member of an AMIT is a ‘‘fund payment’’ for the purposes of the MIT withholding rules (see [50 090]) even if it is not paid to the member. The new rules apply to income years starting on or after 1 July 2016 (or, by election, 1 July 2015).

Tax Office rulings and guidance The Tax Office has published a number of Law Companion Guides (LCGs) explaining the way in which it administers the AMIT regime. Each of the LCGs listed below states that it is a ‘‘public ruling’’: • LCG 2015/4 – ‘‘clearly defined rights’’ (see also Practical Compliance Guideline PCG 2016/9, mentioned below); • LCG 2015/5 – choice to treat separate classes as separate AMITs; • LCG 2015/6 – character flow-through for AMITs; • LCG 2015/7 – attribution on a ‘‘fair and reasonable’’ basis; • LCG 2015/8 – the rules for working out trust components: allocation of deductions under s 276-270; © 2017 THOMSON REUTERS

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• LCG 2015/9 – trustee shortfall taxation (s 276-420); • LCG 2015/10 – administrative penalties for recklessness or intentional disregard of the tax law (s 288-115 Sch 1 TAA); • LCG 2015/11 – annual cost base adjustments for units in an AMIT and associated transitional rules; • LCG 2015/12 – dividend, interest and royalty withholding; • LCG 2015/13 – withholding in respect of ‘‘fund payments’’; • LCG 2015/14 – widely-held tests: wholly-owned entity of an Australian government agency; • LCG 2015/15 – the non-arm’s length income rule (in ss 275-605, 275-610 and 275-615 ITAA 1997); and • LCG 2016/4 – AMITs: ‘‘carry-forward trust component deficit’’. In an addendum to LCG 2015/2, the Tax Office stated that it will consider applying the general anti-avoidance rules in Pt IVA to contrived arrangements that seek to obtain tax benefits by creating separate classes that would not otherwise qualify as separate AMITs. In Practical Compliance Guideline PCG 2016/9, the Tax Office acknowledges that there was very limited time between the MIT Act taking effect and 1 July 2016, for the trust deeds of MITs to be amended to ensure that the beneficiaries of the trust hold ‘‘clearly defined interests’’ throughout the 2016-17 income year. Accordingly, for those MITs in respect of which a trustee wishes to make a choice for the MIT to be an AMIT, but where the necessary modifications to the trust deed have not been made before 1 July 2016, the Tax Office will administer the law on the basis that the relevant rights were in existence ‘‘at all times’’ in respect of the income year commencing 1 July 2016, where the relevant modifications or replacement are made on or after 1 July 2016 and no later than 31 October 2016, and: • for trust law purposes, the modifications or replacement apply from 1 July 2016; or • the modifications or replacement do not apply from 1 July 2016, but for the purpose of applying the AMIT provisions, the trustee does not exercise any powers which, had they not been modified or replaced, would have prevented the trust from satisfying the requirement that rights to income and capital are clearly defined. The Tax Office’s administrative practice in relation to MITs (including AMITs) is set out on its website.

Other amendments In addition to introducing the AMIT regime, the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 amended the trust income tax rules to: • expand the circumstances in which a trust qualifies as an MIT: see [23 680]; • abolish Div 6B of ITAA 1936 (corporate unit trusts): see [23 1550]; • amend the definition of ‘‘public unit trust’’ for the purposes of Div 6C: see [23 1610]; • introduce a ‘‘non-arm’s length income’’ rule for all MITS, including AMITs: see [23 680]; and • provide that Div 6 does not apply to a trustee or beneficiary of an AMIT. Consequently, the flow-through rules for capital gains (see [23 210]) and franked dividends (see [23 220]) also do not apply. 976

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AUSTRALIAN BENEFICIARIES OF NON-RESIDENT TRUSTS [23 700] Interaction of transferor trust rules with Div 6 The general trust rules in Div 6 (particularly s 97) and the transferor trust provisions in Div 6AAA operate in relation to the interests of resident beneficiaries in non-resident trusts. Subdivision 115-C ITAA 1997 (which deals with the capital gains of a trust) may also be relevant: see [23 210]. If an Australian resident transfers ‘‘property or services’’ to a non-resident trust estate and certain other conditions are met, the ‘‘attributable income’’ derived by the foreign resident trustee can be included in the assessable income of the ‘‘transferor’’ under Div 6AAA. Division 6AAA is discussed in detail at [34 450]-[34 490]. If both the transferor trust rules in Div 6AAA and the core trust income-assessing provisions in Div 6 apply, the amount of income assessed under the transferor trust rules is reduced by the amount assessed under Div 6: s 102AAU. If an amount of trust income that has not previously been taxed in the hands of the trustee is distributed to a beneficiary, that amount is excluded by s 99B(2)(d) or (e) from assessment under s 99B(1) if it has previously been assessed in the hands of any person under the transferor trust rules. If neither the transferor trust rules nor the Div 6 rules apply when the income arises in the trust, a subsequent payment of the income to, or application of the income for the benefit of, a beneficiary who at any time during the year of payment or application is a resident (of Australia) may result in the relevant amount being assessed to the beneficiary under s 99B: see [23 550]. In addition, an interest charge may arise under s 102AAM. For the purposes of the transferor trust rules, a ‘‘temporary resident’’ (see [2 100]) is treated as not being a resident: s 768-970.

MINORS [23 750] Beneficiaries who are minors A beneficiary who is a minor (ie under 18) is treated as being under a legal disability: see [23 430]. If such a beneficiary is presently entitled to any trust income, the trustee is assessed in the first instance under s 98 unless the trust estate is a non-resident trust estate: see [23 460]. If the beneficiary also derives income from other sources or from another trust estate, the beneficiary is also assessed pursuant to s 100: see [23 460]. If a beneficiary is under 18 at the end of the income year, trust income derived by the beneficiary is subject to Div 6AA of Pt III ITAA 1936, which in broad terms taxes ‘‘unearned income’’ of minors at a higher rate. However, Div 6AA does not apply to ‘‘excepted trust income’’. Division 6AA is discussed in Chapter 26. Children’s bank accounts Children’s bank accounts, if opened in the name of a child and/or conducted by a parent as trustee on behalf of a child, can be contentious. The Tax Office’s views on who should pay tax on any interest earned on the money in the account are set out in Ruling IT 2486 which is considered at [6 270]. [23 760] Trusts for children of the settlor If a person (the settlor): • has created a trust in respect of any income or property (including money); and © 2017 THOMSON REUTERS

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• income is, under that trust, in the income year, payable to, or accumulated for, or applicable for the benefit of, a child or children of the settlor who is/are under the age of 18 years, the Commissioner may assess the trustee to pay income tax, as explained at [23 1300], and the trustee is liable to pay the tax so assessed: see s 102(1)(b). For s 102(1)(b) to come into operation: • the income must, in the income year, be payable to or accumulated for or applicable for the benefit of the child or children; and • to deal with it otherwise is not within the trust: see Hobbs v FCT (1957) 98 CLR 151. If the child is only contingently entitled, s 102(1)(b) does not apply. A person who wishes to make a settlement in favour of her or his children usually adopts the device of having a friend or relative establish a trust with a nominal settlement. The assets of the trust are then supplemented by gifts or loans from the parents. Such a procedure avoids the application of s 102(1)(b), which is probably only effective when trusts are set up by uninformed people. In Truesdale v FCT (1970) 1 ATR 667, it was held that a person did not create a trust merely by transferring property to an existing trust, settled by some other person, with the intention that that property would be held on the same terms and conditions as existing trust property.

REFORM OPTIONS [23 770] Options paper A policy options paper for reforms to the taxation of trusts was released in October 2012 (see the then Assistant Treasurer’s media release No 122, 24 October 2012). The paper is available on the Treasury website. Although the then Government indicated that the new measures would apply as from 1 July 2014, there have been no further developments (as at 1 January 2017) since the release of the options paper. The options paper considers 2 possible models for taxing trust income that were outlined in the initial consultation paper released in November 2011: • the economic benefits model (EBM) – this model (called the ‘‘trustee assessment and deduction model’’ in the consultation paper) uses tax concepts to determine how different amounts should be dealt with for tax purposes. Broadly, the EBM would assess beneficiaries on taxable amounts distributed or allocated to them, with the trustee assessed on any remaining taxable income; and • the proportionate assessment model (PAM) – this model uses general concepts of profit to determine tax outcomes. Broadly, the PAM assesses beneficiaries on a proportionate share of the trust’s taxable income equal to their proportionate share of the ‘‘trust profit’’ of the relevant class. As currently occurs, present entitlement would be used as the basis for attributing the trust profit or class amounts to beneficiaries. It seems that the 3rd model canvassed in the consultation paper – the ‘‘patch’’ model – has been ruled out. The then Government also ruled out taxing trusts like companies. Appendix A to the options paper contains an example which demonstrates how the EBM and the PAM would apply to a discretionary trust that is carrying on a business. The example also provides a comparison with the application of the current law. For further information about EBM and PAM, see the Australian Tax Handbook 2016 at [23 770]-[23 790]. 978

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TRUST LOSSES INTRODUCTION [23 800] Trust loss recoupment – overview Special rules in Sch 2F ITAA 1936 restrict the circumstances in which prior year and current year losses of trusts can be claimed as a deduction in calculating net income. The rules are designed to prevent loss trafficking and the transfer of the tax benefit of losses to persons who did not bear the economic loss when the tax losses were incurred by the trust. The rules differ from the carried forward and current year loss tests applying to companies, reflecting the different characteristics of trusts. Scope of measures The measures apply to 2 different types of arrangements under which the tax benefit of trust losses can be transferred: • ownership or control changes; and • income injection schemes.

Categorisation of trusts For the purposes of applying the measures, 3 broad categories of trusts are identified: • fixed trusts; • non-fixed trusts; and • excepted trusts. Fixed trusts are further categorised for the purpose of applying the change in ownership or control arrangements into ordinary fixed trusts and various categories of widely held trusts: see [23 950]-[23 1020]. Non-fixed trusts include not only ordinary discretionary trusts but also unit trusts that allow for discretionary distributions between classes of unitholders: see [23 1050]. Excepted trusts, which include family trusts (as defined) and most deceased estates, are generally excluded from the measures: see [23 820]. However, there is a limited exception in relation to the application of the income injection provisions if an ‘‘outsider’’ to a family trust is involved.

Corporate unit trusts and public trading trusts The trust loss rules also apply to corporate unit trusts and public trading trusts. Bad debt deductions – similar tests The measures also apply to deduction of bad debts, and certain other debt deductions, but only from 20 August 1996. Consequences of non-compliance The consequences of a trust failing the ownership or control tests can vary depending on the category into which it falls, but in general may include: • prior year tax losses not being deductible; • bad debts (or certain debt/equity swaps) of the current or prior years not being deductible; and © 2017 THOMSON REUTERS

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• current year losses not being deductible (ie its net income and tax loss for the income year having to be calculated in a special way, the effect being to deny a deduction for the loss). If the injected income test is failed, the trust may be prevented from making use of any deductions, or full use of such deductions, in an income year.

Date of effect In general terms the measures apply, subject to transitional arrangements (including relating to trusts converting to a family trust), from 7.30 pm on 9 May 1995 AEST. However: • the pattern of distributions test only applies from 28 September 1995; • the debt deduction provisions only apply to transfers of the benefit of bad debt and other relevant deductions from 7.30 pm on 20 August 1996 AEST; and • a narrower definition of ‘‘family members’’ applies from 7.30 pm on 13 May 1997 AEST.

[23 810] Summary – tests applicable The tests that must be satisfied in order to be able to utilise trust losses (still only within the trust: see [24 200]) or debt deductions, or to fully utilise other deductions, vary depending on the type of trust and are summarised in the following table. Ownership/control tests Type of trust Fixed

Non-fixed Excepted

50% Category stake test Ordinary fixed 50% trust stake 50% Listed widely held1 stake Unlisted widely 50% stake held1 Unlisted very 50% widely held1 stake Wholesale widely 50% stake held1 50% stake2 Family trust Family Excepted (non-family trust)

Test time All times Abnormal trading Abnormal trading + year-end Abnormal trading + year-end Abnormal trading + year-end All times

Other tests or alternative tests Alternative to 50% stake test Same business test

Control test Pattern of distributions test3 trust distribution tax payable if distributions outside of family group No requirements

Income injection test Income injection Income injection Income injection Income injection Income injection Income injection Income injection4

1 All trusts in these categories must qualify as widely held unit trusts. 2 Only if certain fixed entitlements exist. 3 Not relevant for current year losses. 4 Modified application with income injection from persons or entities within family allowed.

[23 820] Excepted trusts Certain trusts are excluded from the trust loss and debt deduction tests and do not have to comply with them in order to take trust losses into account. However, the losses themselves are still only able to be utilised within the trust: see [23 230]. These trusts are referred to as excepted trusts: Sch 2F, s 272-100. They are discussed below, together with any special conditions that must be satisfied. Family trusts A trust that qualifies as a family trust (see [23 850]) will be an excepted trust. However, unlike other excepted trusts, a family trust is only excluded from the income injection test in 980

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relation to injections from family members, not outsiders. In addition, a special tax, family trust distribution tax, may be imposed if a family trust makes distributions to non-family members: see [23 900].

Deceased estates Deceased estates are granted a reasonable period for the completion of administration of the estate before the rules will apply to the trust estate. They are treated as an excepted trust during this period. The period runs from the date of death of the deceased until the end of the income year in which the fifth anniversary of death occurs. Superannuation funds, ADFs, PSTs and FHSAs Complying superannuation funds, complying approved deposit funds (ADFs), pooled superannuation trusts (PSTs) and First Home Saver Account (FHSA) trusts are excepted trusts. Non-complying superannuation funds and non-complying approved deposit funds are not excepted and must comply with the various tests. The exclusion only applies to the complying superannuation fund, complying ADF, PST or FHSA itself. Any other trusts in which they invest must still comply with the tests in order to be able to deduct their losses. Note that the FHSA regime has been discontinued: see [6 280]. Fixed unit trusts with tax exempt beneficiaries A fixed trust that is a unit trust will be an excepted trust if entitlements to all its income and capital are fixed and held, directly or indirectly, for their own benefit, by bodies that are exempt from income tax under Div 50 ITAA 1997 (see Chapter 7). Exempt bodies include state and territory bodies (see [7 500]) and untaxable Commonwealth entities. Designated infrastructure project entities A fixed trust is treated as an ‘‘excluded entity’’ if, at the particular time, it is a ‘‘designated infrastructure entity’’ under Div 415 ITAA 1997. Note that, for periods in which the trust is not a designated infrastructure project (DIP) entity, the loss recoupment rules apply in a modified way, generally to exclude the period in which the trust was a DIP entity. These measures are considered at [11 650].

FAMILY TRUSTS [23 850] Family trusts – overview A trust is a family trust for the purposes of the trust loss measures if and only if it makes a ‘‘family trust election’’. The form, timing and effect of this election are set out at [23 880]. The characteristics that a trust must possess in order to be able to make a family trust election and related aspects of the family trust provisions are outlined below and explained in more detail in the paragraphs to which reference is made. Elements of family trust arrangements There are 4 major elements of the overall scheme for dealing with family trusts: (a) a specified individual whose family group is the basis of other tests; (b) a family control test; (c) interposed entities that elect to be in the family group; and (d) restriction of trust distributions to the family group (or certain charitable, tax-exempt or similar bodies). © 2017 THOMSON REUTERS

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The first 2 elements must be satisfied to make a valid family trust election. The concept of the ‘‘family group’’ is explained at [23 860]. The ‘‘family control test’’ is explained at [23 870]. The third element is optional, but creates a wider family group without which other tests may not be passed if such entities are part of the family operating structure. Interposed entity elections and their form and timing are outlined at [23 890]. The fourth element is the key reason for allowing a family trust exception and, while not part of establishing the exception, a severe penalty is imposed if it is breached. This penalty, known as ‘‘family trust distribution tax’’, is dealt with at [23 900]-[23 910].

Extent of family trust exception Changes in ownership or control of a family trust do not have adverse consequences provided the trust is a ‘‘family trust’’ at the relevant times. However, the income injection rules still apply if persons outside the family group inject income: see [23 1260]. Income injection is allowed within the defined family group. The definition of ‘‘family group’’ includes former spouses, former widows/widowers and former step-children, thereby exempting them from family trust distribution tax. However, these individuals are ‘‘outsiders to the trust’’ for the purposes of the income injection test: see [23 1250]. [23 860] Family group The family group of the individual who has been specified in the family trust election (see [23 880]) is important as it is only this group to which distributions can be made (or present entitlements granted) without causing a liability to family trust distribution tax to arise. The family group for these purposes is defined in Sch 2F, s 272-90 and can be divided into a number of categories: • family members of the specified individual; • the family trust in respect of which the election is made; • interposed entities that have made an interposed entity election to be included in the family group (see [23 890]); • certain other 100% family-owned entities; • estates of the specified individual or family members if all are dead; • certain persons holding interests in small and medium enterprises (SMEs) that have made interposed entity elections (but note that this category was to be repealed by the Treasury Legislation Amendment (Repeal Day 2015) Bill 2016, but the Bill lapsed when Parliament was dissolved for the July 2016 Federal election); and • certain charities, other institutions covered by the gift deduction provisions or tax-exempt bodies to which distributions will be allowed. Another trust with the same individual specified in its family trust election is not an ‘‘outsider to the trust’’ and is automatically included in the first trust’s family group, without the need to make an interposed entity election.

Family members ‘‘Family’’ of the specified individual is defined in Sch 2F, s 272-95 as: • the person’s spouse; • a child, child of a child, parent, grandparent, brother, sister, nephew or niece of the person or of her or his spouse; and • the spouse of any of the above. 982

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A ‘‘spouse’’ includes a de facto spouse (including of the same sex) and an individual who is in a relationship with another individual that is registered under relevant State or Territory law (see [40 360]): s 995-1. A ‘‘child’’ includes an adopted, step- or ex-nuptial child, a child of an individual’s spouse and someone who is a child of an individual within the meaning of the Family Law Act 1975: s 995-1. See ATO ID 2011/77 for a discussion of the meaning of ‘‘step-child’’. The definition of ‘‘family’’ includes ‘‘lineal descendants’’ (including an adopted child, step-child or ex-nuptial child) of any nephew, niece or child of the specified individual or of his or her spouse (applicable from the 2007-08 income year). The definition of ‘‘family group’’ includes former spouses, former widows/widowers and former step-children, thereby exempting them from family trust distribution tax. However, these individuals are ‘‘outsiders to the trust’’ for the purposes of the income injection test: see [23 1250]. Note also that s 960-255 ITAA 1997, which provides non-discriminatory rules for determining when certain family relationships are recognised (including same sex relationships), may affect the meaning of ‘‘family’’ for these purposes (for example, a step-brother or step-sister may fall within the definition). A person does not cease to be a family member merely because of the death of any other family member. However, a person who is deceased when the trustee makes the family trust election cannot be specified as the individual whose family group is the subject of the election: see ATO ID 2014/3.

Interposed entities Interposed entities and interposed entity elections are considered at [23 890]. In relation to interposed entities that have made such elections, it should be noted that family trust distribution tax will be payable if the interposed entity gives income or capital to persons who are not members of the family group. 100% family-owned entities This category refers to entities that have fixed entitlements to all of their capital and income held by the specified individual or family members of the family trust under consideration or by other family trusts that have the same specified individual in any combination. Charities, tax-exempt bodies, gift-deductible bodies These include funds, authorities or institutions in Australia that are deductible gift recipients mentioned in items 1 or 2 of the table in s 30-15(2) (see [9 860]): Sch 2F, s 272-90(6). Also included are institutions, hospitals, trustees, societies, associations, clubs or funds whose income is exempt from tax under Div 50 (see [7 350]-[7 460]): Sch 2F, s 272-90(7). In relation to these bodies and institutions, s 78A must not prevent a deduction from being allowable (assuming a deduction was being allowed under the gift provisions). This ensures that such bodies cannot be used as a conduit to transfer the tax benefit of a family trust’s losses through the receipt of benefits in return for distributions. This last restriction does not apply in relation to all of the gift-deductible bodies and certain specified tax-exempt bodies if at the time of the distribution or present entitlement arising, all individual beneficiaries of the family trust were dead: Sch 2F, s 272-90(8). [23 870] Family control test The family control test must be passed by a trust in order to be allowed to make a family trust election: Sch 2F, s 272-80(4). It must also be passed by an interposed entity in order to be allowed to make an interposed entity election: Sch 2F, s 272-85(4). In both cases the test must be passed at the end of the income year to which the election relates. The test is set out in Sch 2F, s 272-87. It differs depending on whether it is a trust being tested or a company or partnership. © 2017 THOMSON REUTERS

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Trusts The same test applies whether the trust is making a family trust election or it is making an interposed entity election. A trust passes the family control test at a particular time if certain persons control the trust at that time. The relevant persons are limited to the individual specified in the relevant family trust election, members of that person’s family, legal or financial advisers to either or some combination of these persons: Sch 2F, s 272-87(1). The control test for this purpose is similar to that applying to non-fixed trusts: see [23 1080]. A number of control possibilities for satisfying the test exist, covering matters such as control of the application of, or beneficial enjoyment of, income or capital of the trust, control of the trustee and a majority stake in the income or capital: Sch 2F, s 272-87(2). A legal or financial adviser to a family is allowed to be part of the controlling group in satisfying the test because such an adviser might commonly act as a director of the trustee company. However, the adviser must be acting in her or his professional capacity as such, not her or his personal capacity. Any fixed entitlements in the trust beneficially owned by the adviser cannot, however, be used to satisfy the majority stake control test alternative (Sch 2F, s 272-87(2)(f)) as that alternative can only be satisfied by the specified individual and family members: Sch 2F, s 272-87(1)(b). A trust will also pass the family control test if persons in the relevant group are the only persons who, under the terms of the trust, can obtain the beneficial enjoyment of the income and capital of the trust. Control, as such, is not relevant in this regard. Companies or partnerships The family control test applies when a company or partnership wants to make an interposed entity election. A company or partnership passes the test at a particular time if certain persons beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the company or partnership. The relevant persons are limited to the individual specified in the relevant family trust election and members of that person’s family: Sch 2F, s 272-87(3). As the test only examines beneficial ownership, control influenced by a legal or financial adviser is not relevant. [23 880] Family trust election A trust becomes a family trust for the purposes of the trust loss measures if it makes a family trust election. Family trust elections are governed by Sch 2F, s 272-80. The election must specify an individual as the individual whose family group is the subject of the election: Sch 2F, s 272-80(3). A person who is deceased when the trustee makes the family trust election cannot be specified as the individual whose family group is the subject of the election: see ATO ID 2014/3. Timing and operation A family trust election applies from the start of the specified income year in respect of which it is made. The trust is then automatically a family trust for all subsequent income years: Sch 2F, s 272-80(1). A family trust election must be in writing and in the approved form, irrespective of whether a return is required to be lodged: Sch 2F, s 272-80(2). A family trust election may be made at any time in relation to an earlier income year (but generally not a year before 2004-05), provided that at all times in the period from the beginning of the specified income year until 30 June in the income year before the one during which the election is made (Sch 2F, s 272-80(4A)): • the trust passes the family control test (see [23 870]); and • the trust has made no distributions of income or capital to persons other than the individual specified in the election, or members of that individual’s family group. 984

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A family trust election must not be made if the trust does not pass the family control test at the end of the specified income year: Sch 2F, s 272-80(4). Even if the trust does pass the family control test at the end of the year, the starting time may be delayed if it does not pass that test at all times in the specified income year. The starting time will be delayed until the earliest time at which it passes that test, provided it continues to pass it for the remainder of the year from that time.

Revocation and variation of election A family trust election may be revoked unless, during the period from the start of the income year specified in the election to the end of the income year before the year in which the election is revoked, the existence of the election allowed the trust or another entity to claim deductions for losses and/or bad debts that could not otherwise have been deducted, or allowed a beneficiary to be a ‘‘qualified person’’ in relation to franked distributions received indirectly through the trust: s 272-80(6A). In the case of a fixed trust, a family trust election is revocable if some or all of the interests in the trust are disposed of to non-family members (or the persons holding them cease to be family members): s 272-80(6). In all other cases, a family trust election cannot be revoked: s 272-80(5). A family trust election may be varied once only to replace the specified individual with another specified individual, if (s 272-80(5A)): • the new specified individual was a member of the original specified individual’s family when the family trust election commenced; and • there has been no conferral of present entitlement to trust income or capital, or distribution of trust income or capital, outside the new individual’s test group during the period in which the election has been in force. The first income year to which the revocation or variation applies must start within 5 years from the start of the income year specified in the family trust election: s 272-80(6B). However, if the family trust election first applied to an income year that started more than 4 years before the start of the 2007-08 income year, the revocation or variation may first apply to the 2007-08 income year or the following year.

[23 890] Interposed entity election Family trust structures may involve other trusts, partnerships or companies being interposed between the family trust and ultimate distributions to family members. These interposed entities may, subject to certain conditions, be included in the family group. This will avoid family trust distribution tax being imposed on any present entitlements conferred on the entities or distributions made to them by the family trust. Family trust distribution tax may, however, be payable by the entity that has made an interposed entity election if it makes distributions outside the family group and in certain other circumstances: see [23 900]. No interposed entity election required Some interposed entities are automatically included in the family group. These are entities that have fixed entitlements to all of the capital and income held by the specified individual or family members of the family trust under consideration or by other family trusts that have the same specified individual, in any combination. In ATO ID 2004/876 (withdrawn), the Tax Office confirmed that a company that is wholly owned by a trustee of a family trust is automatically within the family group of the individual specified in the family trust election. In addition, as from 2007-08, 2 family trusts that have each specified the same individual in their family trust elections are within the same family group and do not need to make an interposed entity election to become members of the same family group. This ID was withdrawn because it was a restatement of the law and did not contain an interpretive decision. © 2017 THOMSON REUTERS

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Interposed entity election Other interposed entities are only included in the family group if they have made an interposed entity election. Every entity to be included must make a separate interposed entity election. Interposed entity elections are governed by Sch 2F, s 272-85. The major requirement for an entity to be allowed to make an interposed entity election is that it passes the family control test: Sch 2F, s 272-85(4). If the entity is a trust, the test is the same as used in determining whether a family trust election can be made (see [23 880]), but obviously applied to a different trust. The test is slightly different if the entity is a company or partnership. The family control test is considered at [23 870]. In ATO ID 2005/174, the Tax Office confirmed that a family trust (the X family trust) that specified individual X in its family trust election could make an interposed entity election to be included in the family group of individual Y, if X and Y were brothers. This ATO ID has been withdrawn on the basis that ‘‘it is a straight application of the law and does not contain an interpretive decision’’. In ATO ID 2013/21, the Tax Office states that an interposed entity election remains in force even if the trust in respect of which the family trust election has been made ceases to exist. As a general rule an interposed entity cannot make an interposed entity election in respect of more than one family trust. The exception is if the individual specified in the family trust elections of each family trust is the same. Timing and operation An interposed entity election has to be in writing and in the approved form, irrespective of whether a return is required to be lodged: Sch 2F, s 272-85(2). The effect of the election is that, at all times after the specified date, the entity will be included in the family group of the specified individual in the family trust election to which the interposed entity election relates. Entities may make an interposed entity election at any time in relation to an earlier income year (but generally not a year before 2004-05), provided that at all times in the period from the beginning of the specified income year until 30 June in the income year before the one in which the election is made (Sch 2F, s 272-85(4A)): • the entity passes the family control test; and • the entity has made no distributions of income or capital to persons other than the individual specified in the family trust election, or members of that individual’s family group. There is no requirement that an interposed entity election is made in the same year as the relevant family trust election; it can be a later income year. However, only distributions to the entity after the date from which the election takes effect will escape family trust distribution tax. If a partnership, company or trustee that is not required to lodge a tax return wants to make an election, it must be made within 2 months of the end of the year in which the specified starting date occurs. It must be in writing in an approved form and given to the Commissioner within that time, unless an extension is granted: Sch 2F, s 272-85(2).

Revocation of election An interposed entity election to be revoked if (s 272-85(5A)): • the election was made for an entity that was already included in the family group; or • the election relates to an entity that became part of the family group as a result of being wholly-owned by family members. The first income year to which the revocation applies must start within 5 years from the start of the income year specified in the interposed entity election or the start of the income year in which the entity became part of the family group: s 272-85(5C). However, if the 986

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interposed entity election first applied to an income year starting more than 4 years before the start of the 2007-08 income year, the revocation may first apply to the 2007-08 income year or the following year. In all other cases, an interposed entity election cannot be revoked: s 272-85(5).

[23 900] Family trust distribution tax – primary A special tax – family trust distribution tax – is imposed if the tax benefit of losses of a family trust is transferred to non-family members, contrary to the rationale for granting the family trust an exception from the trust loss recoupment measures. A family trust (ie a trust that has made a family trust election) is subject to family trust distribution tax if it confers a present entitlement on, or distributes income or capital to, persons other than the individual specified in the family trust election or members of that person’s family group: Sch 2F, ss 271-10, 271-15. Membership of a family group is discussed at [23 860]. If the individual or family group member is acting in the capacity of a trustee in receiving any distribution or becoming the subject of any present entitlement, family trust distribution tax will still apply unless the trust of which the person or entity is acting as trustee is also a member of the family group: Sch 2F, s 271-15(1)(b)(ii). A ‘‘distribution’’ of income or capital includes paying or crediting the relevant amount, transferring income or capital in the form of property, reinvesting or otherwise dealing with the relevant amount in accordance with the directions of the relevant person or applying the relevant amount for their benefit: Sch 2F, s 272-45. In one case, the Tax Office considered that the redemption of trust units for more than their market value resulted in a ‘‘distribution’’ of the excess for the purposes of family trust distribution tax: see ATO ID 2004/162. A distribution in satisfaction of a present entitlement that has already given rise to a liability to the tax is not taxed again: Sch 2F, s 271-35. The trustee is liable to pay the tax: Sch 2F, s 271-15(2)(a). If the trustee is a company, the directors of that company at the time of conferral of the present entitlement or distribution (subject to certain exclusions) are also jointly and severally liable with the trustee to pay the tax: Sch 2F, s 271-15(2)(b). The exclusions provide that a director will not be liable if it would be unreasonable to impose liability because the director did not take part in any decision in relation to the distribution or voted against it and took reasonable steps to prevent its implementation: Sch 2F, s 271-40. A distribution (or present entitlement) in respect of which family trust distribution tax is paid is excluded from the taxpayer’s assessable income (the excluded amount is non-assessable non-exempt income): Sch 2F s 271-105. If the tax is not paid in full, only a proportionate part of the distribution (or present entitlement) is excluded. One consequence of this is that expenditure incurred in deriving the excluded amount is non-deductible. The excluded amount is also not subject to withholding tax (s 128B(3)(k) ITAA 1936). Rate of tax Family trust distribution tax is payable on the amount or value of income or capital to which a non-family member is presently entitled or that is distributed to a non-family member. It is imposed by the Family Trust Distribution Tax (Primary Liability) Act 1998. The rate of tax is equal to the top personal marginal tax rate plus Medicare levy. The rate is 47% for 2016-17 (incorporating the temporary budget repair levy) and 47% for 2017-18 and later income years. Interposed entities It is possible for family members of the individual specified in the family trust election or that individual to receive distributions from the family trust through other trusts, partnerships or companies without exposing the family trust to family trust distribution tax, © 2017 THOMSON REUTERS

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provided those entities have made interposed entity elections. This is because the effect of the interposed entity election is to include the entity in the family group. Family trust distribution tax may, however, be imposed at the level of the interposed trust, partnership or company, in respect of which such an election has been made, if it confers a present entitlement on or makes a distribution to persons other than the specified individual or members of the family group: Sch 2F, ss 271-20 to 271-30. Liability is imposed on the interposed trustee, corporate trustee directors, partners, corporate partner directors, company or company directors, as the case may be. The same exclusions from liability as applied at the family trust level are available to directors of companies or of corporate trustees (see above).

Foreign residents In a number of circumstances, the Commissioner is given information-gathering powers if foreign residents are involved in the family structure to ascertain whether the trust is making distributions or conferring present entitlement other than to members of the family group: Sch 2F, ss 271-45 and 271-50. In addition to the liabilities discussed above, a family trust or interposed entity will have a primary liability to family trust distribution tax if distributions (or present entitlements) occur in relation to interposed entities, even though those entities are part of the family group, if the foreign resident aspects mentioned in these sections exist and the specified information is not given to the Commissioner upon written request: Sch 2F, s 271-55. See above for the rate of tax. Payment of tax Family trust distribution tax is due and payable: • if the conferral or distribution (giving rise to the liability to pay the tax) was made on or before the day on which the relevant family trust election or interposed entity election was made – 21 days after the day on which the election was made; • if the conferral or distribution was made after the day the relevant election was made – 21 days after the conferral or distribution day; or • if liability to pay the tax arises under Sch 2F, s 271-55 – 21 days after the end of the period allowed by the Commissioner for giving the relevant information. If any family trust distribution tax remains unpaid 60 days after it is due and payable, the general interest charge (see [54 370]) is payable on the outstanding amount from the 60th day: Sch 2F, s 271-80. The collection and recovery provisions in Pt 4-15 in Sch 1 TAA (discussed in Chapter 49) apply to the recovery of unpaid family trust distribution tax. Note that the TFN withholding provisions have been extended to cover distributions from closely held trusts and present entitlements to income of closely held trusts, including family trusts: see [50 080]. The purpose of this measure is to encourage beneficiaries to quote their tax file numbers (TFNs) to trustees of such trusts, which will in turn enable the Tax Office to use the TFN information to match amounts reported by trustees and amounts reported in beneficiaries’ tax returns.

[23 910] Family trust distribution tax – secondary If a non-resident trust is liable to pay family trust distribution tax, the liability can be effectively transferred to the connected resident family trust if the Commissioner believes that the tax cannot be collected from the trust or entity that incurred the primary liability: see Sch 2F, ss 271-60 and 271-65. The Commissioner may impose an equivalent tax liability on certain connected resident trusts or, if the trustee is a company, the directors of the company, if the primary family trust distribution tax liability of the foreign resident entity remains unpaid after becoming due and payable and the Commissioner has made a determination in writing that the amount due by the foreign resident is unlikely to be paid. 988

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[23 950]

The secondary liability may be imposed on a resident company in which a non-resident family trust that does not pay the primary liability has an interest and has benefited from the trust loss provisions only because the non-resident family trust held the interest (applicable wherever the primary liability arises).

Rate of tax The transferred liability is equal to the amount of the unpaid family trust distribution tax of the relevant foreign resident. It is imposed by the Family Trust Distribution Tax (Secondary Liability) Act 1998. Any unpaid tax attracts the general interest charge (see [54 370]) from the 60th day after it was due and payable: Sch 2F, s 271-80.

FIXED TRUSTS – OWNERSHIP [23 950] Fixed trusts – meaning A trust is a fixed trust if persons (whether natural persons, companies, trustees or the partners in a partnership) have fixed entitlements to all of the income and capital of the trust: Sch 2F, s 272-65. The Commissioner has a discretion to treat an interest as a fixed entitlement in certain circumstances: Sch 2F, s 272-5(3). Unless the Commissioner’s discretion is exercised, a beneficiary must have a vested and indefeasible interest in a share of income or capital under the trust instrument for it to qualify as a fixed entitlement: Sch 2F, s 272-5(1). In other words, there can be no discretion vested in the trustee as to who will be entitled to the income or capital or what their share will be. In Colonial First State Investments Ltd v FCT (2011) 81 ATR 772, the Federal Court found that s 601GC(1)(a) of the Corporations Act 2001, which permits the members of a registered scheme to vote to modify, repeal or replace the constitution of a unit trust by special resolution, meant that the trust was not a fixed trust. This decision clearly has adverse implications for all unit trusts to which the Corporations Act 2001 applies and means that, in many cases, trusts will have to rely on the exercise of the Commissioner’s discretion to be considered a ‘‘fixed trust’’. A trustee’s power to determine the timing of distributions does not breach this requirement. Thus, a power to accumulate income or capital is permissible, provided specified beneficiaries have a vested and indefeasible interest in the accumulated amounts that they will receive at some time in the future. In ATO ID 2006/279, the Tax Office confirmed that the residuary beneficiaries of a trust created by will, once an individual bequest had been satisfied, had fixed entitlements to all of the income and capital of the estate. The fact that units in a unit trust may be redeemable or that new units may be issued will also not breach this requirement, provided certain criteria are satisfied: Sch 2F, s 272-5(2). All requests to the Tax Office for advice in respect of persons having fixed entitlements to income and/or capital of a trust under Sch 2F s 272-5(1) and/or exercise of the discretion under Sch 2F s 272-5(3) are escalated to the Trust Technical Network and Trust Risk Manager: Practice Statement PS LA 2002/11. This includes requests for advice as to whether a trust is a fixed trust or a non-fixed trust. In determining whether to exercise his discretion under Sch 2F s 272-5(3), the Commissioner is required to take the following factors into account: • the circumstances in which a particular entitlement is capable of not vesting or being defeased; • the likelihood of the entitlement not vesting or the possible defeasance not happening; and • the nature of the trust. © 2017 THOMSON REUTERS

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Draft Practical Compliance Guideline PCG 2016/D16 provides guidance on the impact that specific features of a trust are likely to have on the Commissioner’s consideration of the factors listed above. Since the introduction of the trust loss measures in Sch 2F, the requirement of persons to have fixed entitlements to income and/or capital has also been incorporated in other tax legislation, eg the ‘‘trustee beneficiary statement’’ rules in Div 6D applying to ‘‘closely held trusts’’ (see [23 1450]), the CGT scrip-for-scrip roll-over provisions contained in Subdiv 124-M (see [16 230]) and the rules contained in s 295-550 ITAA 1997 regarding ‘‘non-arm’s length income’’ derived by superannuation funds (which replaced the ‘‘special income’’ rules previously contained in former s 273 ITAA 1936) (see [41 230]). In Re the Trustee for MH Ghali Superannuation Fund and FCT (2012) 89 ATR 963, the AAT held that a fund had a fixed entitlement to a share of the income of a unit trust so that the income derived from the unit trust was not ‘‘special income’’ under former s 273(6). It was, however, ‘‘special income’’ within another category in former s 273. The Commissioner’s views on the concept of ‘‘fixed entitlement’’ for the purpose of s 295-550 and former s 273 are set out in Ruling TR 2006/7.

Categories of fixed trusts There are 2 broad categories into which fixed trusts are divided for the purposes of the tests that determine deductibility of prior and current year losses and debt deductions. These are ordinary fixed trusts (see [23 960]) and widely held trusts: see [23 970]. Widely held trusts are further divided into 4 special categories: see [23 980]. Possible reforms A discussion paper on ‘‘A more workable approach to fixed trusts’’ was released in July 2012 (the paper is available via the Treasury website). In his Foreword, the then Assistant Treasurer said that the paper presented a number of options to address the uncertainty arising from the interpretation of the term ‘‘indefeasible’’ in the Colonial First State Investments case and ‘‘considers avenues to provide a balance between the practicalities of allowing trusts to function efficiently and maintaining the integrity of the law’’. However, as at 1 January 2017 there had been no further developments, except that attribution managed investment trusts (see [23 685]) are deemed to be fixed trusts. [23 960] Ordinary fixed trusts All fixed trusts will be ‘‘ordinary fixed trusts’’ unless they are ‘‘widely held unit trusts’’, which is an underlying requirement of all categories of widely held trust: see [23 970]. In other words, an ‘‘ordinary fixed trust’’ (a term which is not used in the legislation) is merely a shorthand way of referring to all fixed trusts other than those that fall within one of the 4 widely held trust categories described at [23 980]. The tests that apply generally to all fixed trusts in determining the deductibility of prior year or current year losses and debt deductions therefore apply to an ordinary fixed trust: see [23 990]. The modifications of these tests that apply to some types of widely held trusts are irrelevant. In particular, the 50% stake test is the only test in relation to ownership that is available for ordinary fixed trusts to pass to obtain deductions and they must pass that test (although there is one modification or alternative within that test itself available to such trusts): see [23 1000]. For an ordinary fixed trust to be able to deduct prior year losses there must therefore be continuity of majority beneficial ownership of the trust. This requirement applies on a continuous basis during the periods for which the 50% stake test is applied. Importantly, if an ordinary fixed trust fails the 50% stake test, it cannot apply the same business test (unlike widely held trusts). [23 970] Widely held trusts – general Widely held trusts are divided into 4 categories for the purposes of applying the tests that determine deductibility of prior and current year losses and debt deductions. 990

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However, when the definitions of all categories are examined (see [23 980]), it becomes apparent that, to qualify as any type of widely held trust, a trust must qualify as a ‘‘widely held unit trust’’. There are no separate tests laid down on an overall basis for trusts satisfying the description ‘‘widely held unit trust’’. There are merely separate tests for the 4 categories into which it is divided. The expression is, however, used to exclude all such trusts from the general rules applying to fixed trusts. Nevertheless, those general rules are then virtually repeated on a modified basis individually for each category of widely held trust. A summary of the general tests applicable is therefore provided on a combined basis for all fixed trusts at [23 990], with the modifications noted.

Widely held unit trust A widely held unit trust is a fixed trust that is a unit trust and that is not closely held: Sch 2F, s 272-105. Closely held – meaning A trust is closely held if 20 or fewer individuals between them hold directly or indirectly and for their own benefit 75% or more of the fixed entitlements to income or capital of the trust. However, a trust is also closely held if no individuals or individuals between them hold directly or indirectly and for their own benefit interests of that size (eg if the fixed entitlements in a unit trust are owned by a non-fixed trust). Note the closely held trust provisions of Div 6D, discussed at [23 1450]-[23 1500]. [23 980] Widely held trusts – types Fixed trusts that are widely held trusts are divided into a number of further categories in order to determine whether they can deduct prior year losses. Slightly different tests apply to each category, as discussed at [23 990]. Unlisted widely held trust An unlisted widely held trust is a widely held unit trust not listed on the stock exchange. Listed widely held trust A listed widely held trust is a widely held unit trust that is listed on the stock exchange. Unlisted very widely held trust An unlisted very widely held trust is an unlisted widely held trust with at least 1,000 unitholders if all its units carry the same rights and it engages only in qualifying activities. If it has redeemable units, they must be redeemable for a price determined on the basis of its net asset value. In ATO ID 2007/90, the Tax Office confirms that the requirement for all of the units to carry the same rights applies at all times throughout the income year. Wholesale widely held trust A wholesale widely held trust is an unlisted widely held trust (other than an unlisted very widely held trust) with 75% or more of its units held by either listed widely held trusts, unlisted very widely held trusts, complying superannuation funds, complying approved deposit funds, pooled superannuation trusts, life insurance companies or registered organisations and if all its units carry the same rights and it engages only in qualifying activities. If it has redeemable units, they must be redeemable for a price determined on the basis of its net asset value. The minimum subscription amount for units in the trust by each person to whom they have been issued must be at least $500,000. Categorisations affected by parent trust An unlisted widely held trust, unlisted very widely held trust or wholesale widely held trust whose fixed entitlements to income and capital are all held, directly or indirectly, by another trust of a higher level will take on the categorisation of that higher level trust: Sch 2F, © 2017 THOMSON REUTERS

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s 272-127. For this purpose, the level of trusts from lowest to highest is unlisted widely held trust, unlisted very widely held trust, wholesale widely held trust and listed widely held trust. The effect of s 272-127 is that there must be at least one trust (of a higher level) that owns all of the fixed entitlements of a lower level trust (whether directly or indirectly), in order for the lower level trust to be classified as a trust of the same kind as the trust of the highest level. The requirement that all of the fixed entitlements of a lower level trust must be owned by a higher level trust for the lower level trust to be accorded the status of the higher level trust was confirmed in ConnectEast Management Ltd v FCT (2009) 75 ATR 101. The Full Federal Court effectively rejected an argument that 2 or more trusts could confer their status on a collectively owned subsidiary trust (and therefore an unlisted widely held trust did not acquire the status of a listed widely held trust). The Tax Office’s views as expressed in ATO ID 2006/317 have therefore been confirmed.

[23 990] Fixed trusts – overview of tests The rules in relation to continuity of ownership that a fixed trust must satisfy to be able to deduct prior year losses, current year losses (ie calculating net income or tax loss for year in special way) or debt deductions are governed by Div 266 in Sch 2F. In broad terms, for a fixed trust to be able to deduct prior and current year losses and debt deductions, there must be a continuity of majority beneficial ownership of the trust. The test is referred to as the ‘‘50% stake test’’ and is discussed at [23 1000]. The times when it must be applied are discussed below. The precise rules vary depending upon whether the trust is an ordinary fixed trust or one of the special categories of widely held fixed trust. In particular, whether continuity needs to be tested at all times or only if there is abnormal trading or at year-end is determined by the type of trust (see below). As the aim is to ensure that tax benefits from deducting losses go to those who bore the losses (which with a fixed trust is determined by the fixed entitlements), the tests examine whether there has been a significant change in the individuals who held those fixed entitlements at the respective times. Indirect holdings by an individual can satisfy the requirements, provided they can be traced through fixed entitlements that the individual had in interposed entities with fixed entitlements in the trust. Prior year losses With most fixed trusts the tests for prior year losses apply to the income year in which the tax loss was incurred, the income year in which it is sought to claim it as a deduction and all intervening income years. The exception is an unlisted very widely held trust, in which case the period is basically the same except that it excludes any start-up period of the trust. A trust is only tested against the fixed trust tests if it was a fixed trust and not an excepted trust at all times during the above periods. To obtain a deduction for a prior year tax loss, the trust must pass the 50% stake test in respect of the above period. There is a slightly modified alternative version of this test available to an ordinary fixed trust in certain circumstances. However, a widely held trust is generally assumed to pass this test unless there has been abnormal trading. A completely alternative test, the same business test, is available to a listed widely held trust: see [23 1020]. There are no alternatives available to unlisted widely held trusts. A chart summarising the situation is located at [23 810]. Prior year losses – partial deductions If a deduction is denied under the general prior year loss deduction tests, a partial deduction may nevertheless be available. This can only happen if the change in ownership that caused the loss to be non-deductible took place in the year the loss was incurred. 992

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[23 1000]

A deduction is allowable for that part of the loss that is properly attributable to the part of the loss year occurring after the disqualifying change in ownership, provided it would have been deductible under the general prior year loss tests had that period been a full year.

Current year losses With most fixed trusts the current year loss tests apply to the full income year under consideration. However, as with prior year losses, the exception is an unlisted very widely held trust, if any start-up period of the trust is excluded. A trust is only tested against the fixed trust tests if it was a fixed trust and not an excepted trust at all times during the year (or relevant period in the case of the exception). The tests that must be satisfied to avoid having to calculate the trust’s net income and tax loss in a special way and the times at which they must be applied are for the most part identical to the prior year loss tests (see above). The only exception is that the additional end-of-year test time that applied to unlisted widely held trusts under the prior year loss provisions is not applicable, as the current year loss rules are designed to split the income year up into periods and calculate a net income or tax loss for each period, so end-of-year testing is irrelevant as the full year has expired at that time. Bad debt or debt/equity swap deductions In respect of bad debt deductions or deductions under s 63E, the relevant times at which the tests need to be applied depend on when the debt was incurred. If it was in a year before the deduction arises, the tests apply from the time the debt was incurred through to the end of the income year in which a deduction is sought. If the debt was incurred in the same year as a deduction is sought, the tests apply for that full year. The exception is again an unlisted very widely held trust, if any start-up period of the trust is excluded. A trust is only tested against the fixed trust tests if it was a fixed trust and not an excepted trust at all times during the above periods. The tests that must be satisfied to obtain a deduction are identical to the prior year loss tests. Note that these rules are modified by Subdiv 709-D in relation to a trust that used to be a member of a consolidated group and that writes off as bad a debt that used to be owed to a member of the group: see also [24 570]. [23 1000] 50% stake test A fixed trust passes the 50% stake test if the same individuals beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the income of the trust and the same individuals beneficially hold between them, directly or indirectly, fixed entitlements to more than 50% of the capital of the trust at the relevant times: Sch 2F, ss 269-50 and 269-55(1). The test is applied separately to income and capital, so the individuals used to satisfy both tests do not need to be the same. The times at which the test must be satisfied vary with the type of deduction under consideration (prior year loss, current year loss or debt deduction) and the type of fixed trust: see [23 990]. It is only holdings by individuals that can satisfy the test, but they can be held directly or indirectly, so they can be traced through an interposed company, trust or partnership. Special tracing rules exist to overcome the difficulties in tracing through certain types of entities to individuals, eg if interests are held by certain complying superannuation funds. Widely held unit trusts In order to overcome practical difficulties caused by large numbers of direct or indirect unitholders in widely held unit trusts, a special rule exists under which the 50% stake test will be passed if it is reasonable to assume that the requirements of the 50% stake test are met: Sch 2F, s 269-55(2). © 2017 THOMSON REUTERS

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As a result, it is provided that widely held unit trusts only need test for continuity of ownership when there is abnormal trading in the trust’s units, such as upon a takeover or merger. However, in addition, unlisted widely held trusts must apply the tests at the end of an income year.

Ordinary fixed trust Fixed entitlements in an ordinary fixed trust may be held by non-fixed trusts or by companies with non-fixed trusts as shareholders. A non-fixed trust directly or indirectly (through a company) holding such fixed entitlements could itself have a mixture of fixed and non-fixed entitlements to its income and capital. With non-fixed entitlements, there is no interest capable of being taken into account in applying the 50% stake test. Hence, if in tracing through the interests in an ordinary fixed trust these non-fixed entitlements amount to 50% or more of the interests in the ordinary fixed trust, eg if a discretionary trust holds the majority of the fixed entitlements in a fixed trust, the 50% stake test cannot be satisfied by the fixed trust. This puts the ordinary fixed trust in a worse position than if it were a non-fixed trust, as a non-fixed trust would have an opportunity to satisfy alternative tests (ie in this case the ordinary fixed trust is being disqualified because of the inability to count or look behind non-fixed entitlements, whereas a non-fixed trust could avoid being disqualified if, for example, the pattern of distributions test is satisfied). If the non-fixed trust is a family trust, the problem is overcome through treating a fixed entitlement held by a family trust as if it were held by an individual: see Sch 2F, s 272-30(2). An alternative test to the 50% stake test is, however, provided by Sch 2F, s 266-45 in certain circumstances to overcome this anomaly. When is the alternative available? An ordinary fixed trust can apply an alternative test to the 50% stake test if individuals do not directly or indirectly hold fixed entitlements to more than 50% of the income or capital of the ordinary fixed trust and either: (a) fixed entitlements to 50% or more of the income or capital are held by a non-fixed trust or trusts (other than family trusts); or (b) all fixed entitlements to income and capital are held, directly or indirectly, by another fixed trust or a company and a non-fixed trust or trusts (other than family trusts) hold fixed entitlements to a 50% or greater share of the income or capital of the relevant other fixed trust or company. What is the alternative? There are 2 requirements to satisfy the alternative test: • either: (i) if situation (a) applies, there must be no change in the persons directly holding fixed entitlements to shares of the income or capital of the fixed trust, nor to the percentage of their shares; or (ii) if situation (b) applies, this requirement is applied to the fixed holdings in the holding entity (ie the other fixed trust or company); and • every non-fixed trust (that is not a family trust or other excepted trust) that holds fixed entitlements in the fixed trust, directly or indirectly, must satisfy the relevant tests that would apply to non-fixed trusts if they stood in place of the loss trust: see [23 1050]-[23 1090].

[23 1010] Abnormal trading Abnormal trading is the concept used to determine the point of time at which all widely held trusts must determine whether they have passed the tests to deduct prior or current year losses or debt deductions. 994

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[23 1010]

‘‘Trading’’ for these purposes is defined to mean an issue, redemption or transfer of units in a widely held unit trust (which all widely held trusts must be: see [23 970]) or other dealing in the trust’s units: Sch 2F, s 269-10. Schedule 2F, ss 269-15 to 269-49 describe a number of different circumstances in which abnormal trading will be taken to have incurred. There is one general test and 4 specific tests.

Abnormal trading – general test Schedule 2F, s 269-15(1) sets out a general test under which all relevant factors must be taken into account to determine whether trading is abnormal, including the following 4 specified factors: • timing of the trading compared to the normal timing for trading in units of the trust; • number of units traded compared to the normal number of units traded; • any connection between the trading and any other trading in units in the trust; and • any connection between the trading and a tax loss or other deduction of the trust (such as if units are bought because the trust has prior year losses).

Suspected acquisition or merger Abnormal trading automatically occurs if the trading is part of a proposed acquisition of the trust or a proposed merger with another trust, provided the trustee knows or reasonably suspects this to be the case: Sch 2F, s 269-20. 5% of units traded in single transaction Abnormal trading automatically occurs if 5% or more of the units in the trust are traded in one transaction: Sch 2F, s 269-25. This test does not apply to a wholesale widely held trust. Suspected 5% of units traded in series of transactions Abnormal trading automatically occurs if a person and/or associates of the person have acquired and/or redeemed 5% or more of the units in the trust in 2 or more transactions, provided the trustee knows or reasonably suspects that the acquisitions or redemptions have occurred and that they would not have been made if the trust did not have a tax loss or other deduction: Sch 2F, s 269-30(1). This test does not apply to a wholesale widely held trust. The abnormal trading is taken to occur at the time of the transaction that causes the 5% limit to be exceeded: Sch 2F, s 269-30(2). 20% of units traded, issued or redeemed over 60-day period Abnormal trading automatically occurs if more than 20% of the units on issue at the end of any 60-day period were traded during that period: Sch 2F, s 269-35(1). This test does not apply to a wholesale widely held trust. Examples could include ownership changes of more than 20%, new units issued to new unitholders that amount to more than 20% of the units on issue or redemption of more than 20% of the trust’s units in a 60-day period. Any combination of trading, issuing or redemption that satisfies the 20% and 60-day rule would also be abnormal trading. The abnormal trading is taken to occur at the end of the 60-day period: Sch 2F, s 269-35(2). Wholesale widely held trusts As noted above, the last 3 tests do not apply to wholesale widely held trusts. However, a special abnormal trading test applies to such trusts, in addition to the general and suspected acquisition or merger tests. Abnormal trading in a wholesale widely held trust occurs if the trustee knows or reasonably suspects that the same persons did not hold more than 50% of the trust’s units at the beginning and end of the period: Sch 2F, s 269-40(1). © 2017 THOMSON REUTERS

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The abnormal trading is taken to occur immediately before the end of the period: Sch 2F, s 269-40(2).

Time at which trustee must have knowledge or suspicion With the tests that require the trustee to know or reasonably suspect that certain things have occurred, Sch 2F, s 269-45 clarifies when that state of mind must arise. If the suspected acquisition or merger test is being applied, it is at any time during the relevant income year. For the other tests, it is at any time during the relevant period. If there is a holding trust If a unit trust (the holding trust) holds fixed entitlements, directly or indirectly, to all the income and capital of another unit trust (the subsidiary trust), abnormal trading occurs in the subsidiary trust only when there is abnormal trading in the holding trust at the top of the chain: Sch 2F, s 269-47(3). However, a transaction that causes a trust to become or cease to be a holding trust of a subsidiary is abnormal trading in that subsidiary unless the holding trust is itself a subsidiary trust and before and after the transaction the first mentioned subsidiary trust was a subsidiary of one of the trusts of which the holding trust is a subsidiary: Sch 2F, s 269-47(2). No abnormal trading – proportionate issue of units There will be no abnormal trading if an issue of units to existing unitholders is done on a pro-rata basis that does not cause their proportionate interests in income and capital of the trust to change: Sch 2F, s 269-40. However, this exception will not prevent the suspected acquisition or merger test from applying. [23 1020] Same business test Listed widely held trusts may satisfy the same business test as an alternative if they fail the 50% stake test: Sch 2F, s 266-125(2). The same business test is only available to such trusts. This test is similar to that which applies to company carried forward losses. In broad terms it involves: • carrying on the same business as was carried on immediately before any abnormal trading in units of the trust that results in the 50% stake test being failed: Sch 2F, s 269-100(1); • not deriving assessable income from carrying on a business or entering into a transaction of a kind that the trust did not carry on or had not entered into in the course of business before that time: Sch 2F, s 269-100(3); and • not manufacturing such a situation prior to such time: Sch 2F, s 269-100(4). Because listed widely held trusts need only apply the 50% stake test when there is abnormal trading, the same business test need also only be applied at that time. The test must be satisfied for the remainder of the test period that occurs after the abnormal trading: Sch 2F, s 266-125(2)(b).

Current year losses If the test is being applied to current year losses, the second requirement above is expanded to include not incurring expenditure in carrying on a business or entering into a transaction of a kind that the trust did not carry on or had not entered into in the course of business before that time: Sch 2F, s 269-100(5). If prior year loss includes debt deduction Schedule 2F, s 266-135 provides an additional condition if a prior year loss is wholly or partly made up of a debt deduction. It applies if a debt deduction is available only because the same business test has been met. 996

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TRUSTS

[23 1060]

If the Commissioner considers that the same business test was satisfied in the test period for the debt deduction so as to secure the debt deduction, then to be able to deduct the portion of the prior year loss attributable to the debt deduction, the trust must satisfy the same business test from the time of the failure of the 50% stake test to the end of the income year in which the loss is to be deducted.

NON-FIXED TRUSTS – OWNERSHIP/CONTROL [23 1050] Non-fixed trusts – meaning A non-fixed trust is any trust that does not fulfil the requirements for treatment as a fixed trust: Sch 2F, s 272-70. As a fixed trust was required to have fixed entitlements that were vested and indefeasible to 100% of its income and capital (see [23 950]), non-fixed trusts for the purposes of the trust loss provisions are not limited to purely discretionary trusts. It is a default category that can include trusts that have both fixed and discretionary elements (often called ‘‘hybrid trusts’’) or trusts in which the interests have not yet vested or can be defeated. [23 1060] Non-fixed trusts – overview of tests The rules in relation to continuity of ownership or control that a non-fixed trust must satisfy to be able to deduct prior year losses, current year losses (ie calculating net income or tax loss for year in special way) or debt deductions are governed by Div 267 in Sch 2F. In broad terms, for a non-fixed trust to be able to deduct prior and current year losses and debt deductions, there must be continuity of control of the trust. There may also need to be continuity of majority beneficial ownership of the trust if individuals held, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the trust at some stage during the test period and there will need to be less than a 50% change in the pattern of distributions of the income or capital of the trust if relevant distributions have been made by the trust. Continuity of majority beneficial ownership is governed by the ‘‘50% stake test’’, which is described in detail at [23 1070]. The control test is dealt with at [23 1080] and the pattern of distributions test is dealt with at [23 1090]. The times when they must be applied are discussed below. Prior year losses The tests for prior year losses apply to the income year in which the tax loss was incurred, the income year in which it is sought to claim it as a deduction and all intervening income years: Sch 2F, s 267-20(1). A trust is tested against the non-fixed trust tests if it was a non-fixed trust at any time during the above periods, unless it was an excepted trust at all times: Sch 2F, s 267-20(1). To obtain a deduction for a prior year loss, the trust must pass up to 3 separate tests, of which 2 do not apply to all trusts: Sch 2F, s 267-20(2). The 3 tests are: • control test: Sch 2F, s 267-45; • 50% stake test (which will not apply if individuals never hold, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the trust in the test period): Sch 2F, s 267-40; and • pattern of distributions test (which only applies if relevant distributions have been made by the trust): Sch 2F, ss 267-30 and 267-35. © 2017 THOMSON REUTERS

997

[23 1070]

TRUSTS

Prior year losses – partial deductions If a deduction is denied because a trust does not meet either the 50% stake test or the control test of the prior year loss deduction tests, a partial deduction may nevertheless be available: Sch 2F, s 267-50(1). This can only happen if the change in ownership or control that caused the loss to be non-deductible took place in the year the loss was incurred. A deduction is allowable for that part of the loss that is properly attributable to the part of the loss year occurring after the disqualifying change in ownership or control, provided it would have been deductible under the general prior year loss tests had that period been a full year: Sch 2F, s 267-50(2). Current year losses The current year loss tests apply to the full income year under consideration. A trust is tested against the non-fixed trust tests if it was a non-fixed trust at any time during the year, unless it was an excepted trust at all times during the year: Sch 2F, s 267-60. The tests that must be satisfied to avoid having to calculate the trust’s net income and tax loss in a special way and the times at which they must be applied are identical to the control test and 50% stake test under the prior year loss tests (see above): Sch 2F, ss 267-70 and 267-75. As with the prior year loss tests, the 50% stake test will not apply if individuals never hold, directly or indirectly, fixed entitlements to more than 50% of the income or capital of the trust in the test period. Bad debt or debt/equity swap deductions In respect of bad debt deductions or deductions under s 63E, the relevant times at which the tests need to be applied depend on when the debt was incurred. If it was in a year before the deduction arises, the tests apply from the time the debt was incurred through to the end of the income year in which a deduction is sought. If the debt was incurred in the same year as a deduction is sought, the tests apply for that full year. A trust is tested against the non-fixed trust tests if it was a non-fixed trust at any time during the above periods, unless it was an excepted trust at all times: Sch 2F, ss 267-25(1) and 267-65(1). If the debt was incurred in a year before the deduction arises, the tests that must be satisfied to obtain a deduction are identical to the prior year loss tests: Sch 2F s 267-25(2). If the debt was incurred in the same year as a deduction is sought, the tests that must be satisfied to obtain a deduction are identical to the prior year loss tests: Sch 2F, s 267-65(2). Note that these rules are modified by Subdiv 709-D in relation to a trust that used to be a member of a consolidated group and that writes off as bad a debt that used to be owed to a member of the group: see also [24 570]. [23 1070] 50% stake test The 50% stake test applies if individuals beneficially have fixed entitlements (referred to as a stake) to more than 50% of the income or capital of the trust at any time (the ‘‘test time’’) in the test period: Sch 2F, s 267-40(1). If so, at all times from the time the more than 50% stake is first reached to the end of the test period, the same individuals must maintain a more than 50% stake in the income or capital, respectively, of the trust: Sch 2F, s 267-40(2). The test is applied separately to income and capital. However, unlike the 50% stake test applying to fixed trusts, it does not have to be satisfied in relation to both income and capital, unless the prerequisite of more than 50% fixed entitlements arose in respect of both. If the test applies, it only requires that the same individuals hold more than 50% on a group basis (ie between them), similar to the 50% stake test applying to fixed trusts. Commissioner’s discretion The Commissioner has a discretion to treat a non-fixed trust as having met the 50% stake test if some or all of the individuals cease to have a stake in more than 50% of the income or capital of the trust (whichever is applicable) and the Commissioner considers it fair and 998

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TRUSTS

[23 1080]

reasonable to treat the trust as having met the 50% stake test having regard to the likely way in which the trustee will exercise any discretion to distribute income or capital and to any other relevant matter: Sch 2F, s 267-40(3). This might be used, for example, if holdings only fall marginally below the 50% level but the holders are likely to be the beneficiaries who receive any discretionary distributions.

[23 1080] Control test The control test provides that no group must begin to control the trust, directly or indirectly, during the relevant test period: Sch 2F, s 267-45. Thus, while a trustee may be controlled by another person or a corporate trustee may be controlled by persons who control the company, that control must not change. What is a group? A group is either a person, a person and one or more associates or 2 or more associates of a person: Sch 2F, s 269-95(5). ‘‘Associate’’ is defined in Sch 2F, s 272-140 to have the same meaning as in s 318 ITAA 1936 (see [4 220]). Control of a non-fixed trust Sch 2F, s 269-95(1) provides that a group controls a non-fixed trust if the group: • has power, by whatever means, including a power of appointment or revocation, to obtain beneficial enjoyment, directly or indirectly, of the income or capital; • is able to control, directly or indirectly, the application of the income or capital; • is capable under a scheme of gaining the enjoyment or control referred to above; • is in a position whereby the trustee is accustomed under an obligation or might reasonably be expected to act in accordance with their directions, instructions or wishes; • is able to remove or appoint the trustee; or • acquires more than a 50% stake in the income or capital.

Controller’s death, incapacity or marriage breakdown Schedule 2F, s 269-95(2) and (3) deems there to be no change in control if a member of the controlling group has died, become incapacitated or suffered a marriage breakdown, provided: • a replacement group consisting only of members of the family of the affected controller and all other members of the original controlling group (unless themselves deceased, incapacitated or separated), if any, begins to control the trust within a prescribed time; • the replacement group only took control because of the death, incapacity or marriage breakdown; and • disregarding any deceased, incapacitated or separated individuals and the new controllers, there are no changes to the beneficiaries. The Tax Office has indicated that, if a group ceased to control a trust as a result of the death of an individual, and another group later began to control the trust, the replacement group test is satisfied even if one of the members of the replacement group was not related to the deceased person until after her or his death, provided that the requisite family relationship came into existence (in this case by marriage) before the replacement group began to control the trust: see ATO ID 2004/649. For an example of where a group does not begin to control a trust for the purposes of s 267-45 immediately after the death of the individual who was a co-director of the trustee company and the co-appointor and co-guardian of the trust, see ATO ID 2007/59. © 2017 THOMSON REUTERS

999

[23 1090]

TRUSTS

The prescribed time in which the replacement group must take control is one year from the death, incapacity or separation, unless the Commissioner grants a longer period: Sch 2F, s 269-95(2)(b). The replacement group is deemed to have controlled the trust during the times the original group controlled it until the replacement group started its actual control, with any interim control during the prescribed time by another group ignored, provided such interim control only arose because of the death, incapacity or marriage breakdown (eg control by the trustee of a deceased estate) and ceased when the replacement group began actual control: Sch 2F, s 269-95(3). Note that, from 2009-10, s 269-95(2) and (3) will also apply if there is a breakdown in the relationship of a member of the controlling group with another person (including of the same sex) with whom he or she lives on a genuine domestic basis as a couple.

Commissioner’s discretion The Commissioner has a discretion to treat a group as not controlling a trust at a particular time if, having regard to all relevant circumstances, including the identity of the beneficiaries at any time before and after the group commenced control, the Commissioner considers that course reasonable: Sch 2F, s 269-95(4). An example might be the retirement of an elderly controller if those who can benefit under the trust have not changed. [23 1090] Pattern of distributions test The pattern of distributions test only applies in relation to the deductibility of prior year losses or debt deductions (not current year losses) of a non-fixed trust: see [23 1060]. The test does not mean that distributions have to be made, only that if certain distributions are made, then the test must be passed in respect of them. It is designed to examine whether there has been an effective change in those who actually benefit under the trust, given that a non-fixed trust does not have 100% fixed and indefeasible entitlements to its income or capital. Once the pattern of distributions test has been failed in respect of a loss, the loss cannot be deducted in any future year: Sch 2F, s 267-35. When must the test be applied? The test only applies if distributions of either income or capital are made in the income year in which it is sought to deduct the loss (or within 2 months of its end) and in at least one of the 6 earlier income years: Sch 2F, s 267-30. It does not necessarily apply to all income years in this period and the years in respect of which it does apply are known as test year distributions of income (or capital): see below. What is the test? A trust passes the pattern of distributions test under Sch 2F, s 269-60 if, within 2 months of the end of the income year: • it has distributed, directly or indirectly, to the same individuals, for their own benefit, more than 50% of all test year distributions of income; and • it has distributed, directly or indirectly, to the same individuals, for their own benefit, more than 50% of all test year distributions of capital. The test is applied separately to income and capital, so the individuals used to satisfy both tests do not need to be the same.

Distributions of income or capital – meaning Distributions of income or capital are defined to include distributions in the ordinary sense, such as paying or crediting an amount or transferring property to the person, reinvesting or dealing with it on her or his behalf or at their direction or applying it for her or his benefit: Sch 2F ss 272-45 to 272-55. Distributions within an extended meaning are also 1000

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TRUSTS

[23 1090]

included, such as by distributing money or property of the entity not necessarily identified as a distribution of income or capital, including the making of loans or forgiveness of debts, to the extent to which they exceed any consideration given in return: Sch 2F, s 272-60. A company distributes an amount if it pays a dividend or non-share dividend (see [31 290]): Sch 2F, s 272-50(1). A non-share capital return (see [31 290]) is also a distribution of capital by a company: Sch 2F s 272-50(3). In ATO ID 2012/12, the writing off of trade debts by a trustee was not a ‘‘distribution’’ for the purpose of s 272-60, where the debtor was not a beneficiary of the trust and was not associated with any beneficiary of the trust. Distributions to individuals also include distributions the trustee makes through interposed entities (Sch 2F, s 272-63), which further distribute the amounts through to individuals (Sch 2F, ss 272-45 to 272-60) or in which the individual has a direct or indirect fixed entitlement to a share of the amount (Sch 2F, s 269-75).

Test year distributions of income or capital A test year distribution of income is the total of all distributions of income made by the trust in each period required to be considered (usually an income year, although including the subsequent 2 months for the year in which the deduction is sought), excluding periods that start more than 6 years before the year in which it is sought to deduct the prior year loss. The test period is determined as follows under Sch 2F, s 269-65: (i) the test period ends 2 months after the income year being examined; (ii) if the trust distributed income in a year prior to the loss year, the first relevant year is the year immediately before the loss year; (iii) if the trust did not distribute income prior to the loss year, but did distribute income in the loss year, the first relevant year is the loss year; (iv) if neither (ii) nor (iii) is satisfied (ie there was no distribution of income in a year prior to the loss year or in the loss year), the first relevant year is the first year in which the trust distributed income after the loss year; (v) the test period includes each intervening income year between the first relevant year and the year in which a deduction is being sought for the loss, but excludes any income year that starts more than 6 years before the year in which a deduction is sought for the loss. The test applies in exactly the same manner when determining test year distributions of capital: Sch 2F, s 269-65(3). If distributions prior to 9 May 1995 have to be taken into account in applying the test, a transitional rule applies to treat the members of a particular family as one individual for purposes of the test.

Percentage of a test year distribution distributed to individual The percentage of any test year distribution of income or capital distributed to an individual for any income year (including the extra 2 months if applicable) is the total income or capital distributed to the individual in that year expressed as a percentage of the total income or capital distributed by the trust for that year. If percentages for same individual vary If the trust does not distribute to each individual the same percentage of income or capital in every test year distribution, then the smallest of the percentages distributed to that individual in any of the test years is taken to be the percentage distributed to that individual for every one of those years: Sch 2F, s 269-70. For example, if there are 4 test year distributions and an individual receives 10%, 26%, 6% and 14%, the individual will be taken to receive 6% in each of the 4 years. © 2017 THOMSON REUTERS

1001

[23 1090]

TRUSTS

This rule is designed to avoid manipulations of distributions that may indicate an effective change in those benefiting, such as if the distribution in which the individual received 26% was only $1,000 but the distribution in which 6% was received was $250,000 or vice versa.

How the pattern of distributions test works Applying the above principles, if the smallest percentages for every individual who is common to every test year, when added together, exceed 50%, the pattern of distributions test is passed. If this is not the case, the test is not passed. It is not actually necessary to determine the individuals who are common to each test year as, for any individual who only receives distributions in some test years, their smallest percentage will be 0%, which will therefore apply for all test years, so they will effectively not be counted in applying the test. EXAMPLE [23 1090.10] A trust incurs a loss in Year 3 of $75,000, a loss in Year 4 of $40,000 and has a net income (before deducting any loss) of $30,000 in Year 5 (the current income year). It is therefore seeking to deduct part of its Year 3 loss against its otherwise net income in Year 5. The trust was established in Year 1 and distributed in total $16,000 in Year 1, $14,000 in Year 2, nothing in Year 3 or Year 4 and $24,000 in Year 5. All distributions are of income, not capital. Relevant test year distributions of income The fact that the trust made a distribution before the loss year means that Year 1 and Year 2 are both potentially within the test period. Both years are within 6 years of the year in which it is sought to deduct the loss but Year 2 is closer to the loss year, so it is the starting year (s 269-65(1)(b)). (Note that this would have been the case even if no distribution had been made in Year 2.) Therefore the relevant test years are Years 2 to 5 (inclusive). Of these years, the only test year distributions of income are in Year 2 and Year 5. Pattern of distributions test If the distribution percentages in each of these years was as indicated below, the test would be applied as indicated. Year 2 Year 5 Smallest percentage Carol 17% 12% 12% David 17% 10% 10% James 25% 20% 20% Luis 3% 8% 3% Grace 38% 4% 4% Mara 0% 46% 0% 49% The pattern of distributions test has been failed. Taking only the smallest percentages into account, more than 50% of distributions have not been made to the same individuals. Note how this gives a different result to the method used in relation to the 50% stake test had the above percentages been fixed entitlements under which the 5 beneficiaries other than Mara would have held more than 50% between them in the 2 years.

Tracing and incomplete distributions A trust may make a distribution to an interposed entity that is not passed through to individuals within 2 months of the end of the income year. However, for tracing purposes under the pattern of distributions test, the interposed entity will be deemed to have distributed a corresponding amount of such income or capital to any individual who beneficially holds a fixed entitlement (directly or indirectly) to a share of the undistributed amount: Sch 2F, s 269-75. 1002

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TRUSTS

[23 1160]

The corresponding amount is based on the proportionate fixed entitlement. The distribution is deemed to occur immediately before the end of 2 months after the income year. If there are no individuals who had a fixed entitlement in the interposed entity, no individuals will be taken to have been distributed any amount.

Death or marriage breakdown To prevent the pattern of distributions test being failed if potential beneficiaries have changed merely because of death or marriage breakdown, distributions that have been received by a deceased person or a person whose marriage has broken down are excluded from any test year distributions in applying the test: Sch 2F, s 269-80(1) and (2). In addition, if a deceased person beneficially had a direct or indirect fixed entitlement in the trust and that entitlement is passed to the trustee of or a beneficiary in the deceased estate, the distributions flowing to the estate or beneficiary from the fixed entitlements are also excluded: Sch 2F, s 269-80(3). Debt deductions The test applies in the same manner when debt deductions are being considered except that instead of the loss year being the focus for determining when test year distributions occur, it is the year in which the debt was incurred: Sch 2F, s 269-65(2). Anti-avoidance provision Schedule 2F, s 269-85 is an anti-avoidance provision under which the Commissioner can treat a share of a test year distribution as not having been made if an arrangement has been entered into that in some way (directly or indirectly) related to, affected or depended for its operation on the distribution or its value and that had a purpose of ensuring that the pattern of distributions test would be passed.

CURRENT YEAR LOSS CALCULATIONS [23 1150] Current year loss calculations – overview The tests that a fixed trust must meet in order to be able to use a current year loss are outlined at [23 990] and those that a non-fixed trust must meet are outlined at [23 1060]. The tests do not apply if the trust is a family trust or other excepted trust: see [23 820]. If any of the applicable tests are failed, the trust is required to work out its net income and tax loss in a special way. Basically, what happens is that: • the trust’s income year is divided into periods on the basis of when a specified event (eg change in ownership or control) occurs; • assessable income and deductions are allocated to each period, if possible, and a notional net income or notional loss is determined for each period; and • the net income (if any) and tax loss for the year as a whole are then determined, taking into account the notional net income and notional loss for each period and any income or deductions that cannot be allocated to periods. The net income resulting from this procedure will be assessable in accordance with Div 6 of Pt III ITAA 1936 and the loss may be able to be carried forward for deduction in a later income year.

[23 1160] Division of year into periods If the current year loss tests have been breached, the income year is divided into 2 or more periods. The manner in which this occurs will depend on the type of trust and the tests it has breached. Schedule 2F, Subdiv 268-B sets out the methodology. © 2017 THOMSON REUTERS

1003

[23 1170]

TRUSTS

All trusts – general For all fixed trusts, the first period starts at the start of the income year, any subsequent periods follow on one after the other and the last period ends at the end of the income year. The determination of when each period (other than the last) ends and the next period therefore begins varies for each type of trust, as indicated below. Ordinary fixed trusts If the trust is an ordinary fixed trust, each period (except the last) ends at the latest time that would result in the trust passing the 50% stake test for the whole of the period: Sch 2F, s 268-10. However, if the trust has also failed the alternative to the 50% stake test provided by Sch 2F, s 266-45, each period (except the last) may instead end the first time after the start of that period that any event that would cause that alternative test to be failed occurs (see [23 1000]): Sch 2F, s 268-15. Widely held trusts If the trust is a widely held unit trust, each period (except the last) ends at the earliest time at which there is abnormal trading in the trust’s units if the trust does not pass the 50% stake test in respect of the beginning of the period and immediately after the abnormal trading: Sch 2F, s 268-20. However, for a listed widely held trust, successive periods are treated as a single period if, throughout them, the trust passes the same business test in relation to the time immediately before the end of the first such period: Sch 2F, s 268-20(4).

Non-fixed trusts If the trust is a non-fixed trust and the 50% stake test applies (see [23 1070]) but the trust did not meet that test, each period (except the last) ends at the earlier of: • the latest time (after the test time) that would result in the same individuals having more than a 50% stake in the income or the capital, as the case may be, of the trust during the whole of the period; and • the earliest time when a group begins to control the trust (directly or indirectly): Sch 2F, s 268-25(4). For all other non-fixed trusts, each period (except the last) ends at the earliest time that a group begins to control the trust (directly or indirectly): Sch 2F, s 268-25(5).

[23 1170]

Attribution of deductions to periods

Deductions are divided by Sch 2F, s 268-35 into 3 categories for this purpose: • specified deductions that are attributed pro rata across all periods according to the length of the period; • specified full-year deductions that are not attributed to periods but are taken into account when calculating the overall net income for the year; and • all other deductions, which are attributable to periods as if each period were an income year.

Pro-rated deductions Deductions that are pro-rated according to the length of the period are identified in Sch 2F, s 268-35(2). The most common is the decline in value of a depreciating asset (depreciation), but the category includes most other deductions for expenditure if the deduction is spread over 2 or more years. 1004

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TRUSTS [23 1180]

Full-year deductions Full-year deductions that are not attributed to individual periods at all are identified in Sch 2F, s 268-35(5). An exhaustive list is provided, with some of the more common full-year deductions being bad debt, prior year loss and gift deductions. Other deductions Deductions attributed to periods as if each period were an income year are governed by Sch 2F, s 268-35(3) and will include deductions eliminated from being full-year deductions by Sch 2F, s 268-35(6). No further guidance is indicated as to how to achieve this attribution. However, basically it involves adopting normal tax accounting principles such as attributing depreciation balancing deductions on disposal to the period in which disposal occurs and, if operating on an accruals basis, attributing expenses to the period in which they were incurred. [23 1180] Attribution of income to periods Assessable income is divided by Sch 2F, s 268-40 into 6 categories for this purpose: • trust income assessed to the trust under s 97 or s 98A ITAA 1936; • specified assessable income that is attributed pro rata across all periods according to the length of the period; • double wool clip income; • deemed dividends under s 65, s 109 or Div 7A ITAA 1936; • specified full-year amounts that are not attributed to periods but are taken into account when calculating the overall net income for the year; and • all other assessable income, which is attributable to periods as if each period were an income year.

Trust income Trust income assessable under s 97 or s 98A is reasonably attributed to periods if possible (Sch 2F, s 268-40(2)), but otherwise it is dealt with as a full-year amount. Pro-rated assessable income Assessable income that is pro-rated according to the length of the period is identified in Sch 2F, s 268-40(3). It mostly involves certain types of primary production income from insurance recoveries or forced disposals that concessional provisions allow to be spread over a number of years. Double wool clips Primary production double wool clip income that has been deferred from the preceding year is attributed to the period when the wool would ordinarily have been shorn: Sch 2F, s 268-40(4). Deemed dividends Deemed dividends under s 65, s 109 or Div 7A ITAA 1936 are attributed to the period when the amount was paid or credited, whichever occurred first: Sch 2F, s 268-40(5). Full-year amounts Full-year amounts that are not attributed to individual periods at all only consist of amounts in the trust income category (see above) that could not be reasonably attributed to periods: Sch 2F, s 268-40(7). Other assessable income Assessable income attributed to periods as if each period were an income year is governed by Sch 2F, 268-40(6). No further guidance is indicated as to how to achieve this attribution. However, basically it involves adopting normal tax accounting principles for dealing with assessable income. © 2017 THOMSON REUTERS

1005

[23 1190]

TRUSTS

[23 1190] Notional net income or notional losses for periods A notional net income or notional loss has to be calculated for each period into which the income year has been divided: Sch 2F, s 268-30. This is done in the same manner as if the period were an income year. A notional loss arises if deductions attributable to a period exceed assessable income attributable to the same period: Sch 2F, s 268-30(2). If assessable income exceeds deductions, a notional net income arises: Sch 2F, s 268-30(3). If there is no notional loss in any period, the provisions have no further application and the net income of the trust is calculated for the full year in the normal manner: Sch 2F, s 268-30(4). Trusts with interests in partnerships Special supplementary rules are provided in Sch 2F, Subdiv 268-D if a trust is a partner in a partnership. In broad terms, these rules attempt to attribute a share of the partnership’s net income or tax loss to the trust for the purpose of determining the trust’s notional loss or notional net income for each period. To do this, a notional loss or notional net income of the partnership is calculated for each period into which the trust’s income year is divided as if that partnership were a trust that had to perform this task. The trust’s share of the partnership’s notional loss or notional net income calculated in this manner is effectively added to the trust’s own notional loss and notional net income for each period: Sch 2F, s 268-70. Trust and partnership with same income years If the trust and partnership have the same income year, the notional loss or notional net income of the partnership is allocated to the trust for each relevant period according to the percentage interest of the trust in the partnership’s net income or loss for the year: Sch 2F, s 268-75(3). If the partnership has no overall net income or tax loss for an income year, the trust’s share used to allocate the period amounts is a percentage that is fair and reasonable, having regard to the trust’s interest in the partnership: Sch 2F, s 268-75(4). Full-year deductions of the partnership are allocated to the trust on the same basis: Sch 2F, s 268-85(1) to (4). Trust and partnership with different income years If the trust has a different income year to the partnership, the partnership’s net income or loss (ignoring full-year deductions) is treated as a notional loss or notional net income for each period of the trust’s income year to the extent to which it was derived in those periods: Sch 2F, s 268-80(2). The trust’s share for each period is calculated according to the percentage interest of the trust in the partnership’s net income or loss for the year: Sch 2F, s 268-80(3). Full-year deductions are allocated to the trust on a basis that is fair and reasonable having regard to any relevant circumstances: Sch 2F, s 268-85(5). [23 1200] Net income for year – calculation If the current year loss provisions have been breached and the income year has had to be divided into periods, the net income of the trust for the income year is calculated in accordance with the following method under Sch 2F, s 268-45. Current year losses – net income for year

Method of calculation 1. Add together all notional net incomes for individual periods. 2. Add to the total in Step 1 any full-year amounts of income.

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[23 1250]

3. Deduct from the total in Step 2 certain specified full-year deductions (see Sch 2F, s 268-45(4)), unless they exceed the total in Step 2 (in which case, or if they equal it, the trust would not have a net income for the year). 4. Deduct from any total remaining in Step 3 any other full-year deductions (in the order in which they are listed in Sch 2F, s 268-35(5)), unless they exceed the total remaining in Step 3 (in which case, or if they equal it, the trust would not have a net income for the year). 5. Net income for the year is any amount remaining after Step 4.

[23 1210] Tax loss for year – calculation If the current year loss provisions have been breached and the income year has had to be divided into periods, the loss of the trust for the income year is calculated in accordance with the following method under Sch 2F, s 268-60. Current year losses – loss for year

Method of calculation 1. Add together all notional losses for individual periods. 2. Add to the total in Step 1 certain specified full-year deductions (Sch 2F, s 268-60(3)), but only to the extent that they exceed the total of any notional net incomes for individual periods and any full-year amounts of income. 3. Deduct from the total in Step 2 any net exempt income. 4. Loss for the year is any amount remaining after Step 3.

INCOME INJECTION [23 1250] Income injection test – all trusts The income injection test, contained in Sch 2F, Div 270, may operate to limit a trust’s capacity to make full use in the current year of prior year losses or other deductions, even though the trust has satisfied the relevant ownership or control tests discussed at [23 990] and [23 1080]. The test deals with certain schemes to take advantage of tax losses or other deductions of the trust. The schemes targeted are those under which assessable income is injected into or derived by the trust with the intention of it being sheltered from tax by the losses or other deductions and where an outsider to the trust provides a trustee, beneficiary or associate with a benefit and a return benefit is given to the outsider (or associates). The test is only breached if deriving the income or providing either of the benefits occurred wholly or partly because of the availability of the losses or deductions. The income injection test is an objective test, ie a tax-avoidance motive is not required. Excepted trusts The test does not apply to excepted trusts other than family trusts: Sch 2F, s 270-10(1)(d). As regards family trusts, the test does not apply to income injection schemes that take place wholly within a specified family group: see [23 1260]. Income injection test Schedule 2F, s 270-10(1) sets out the circumstances in which the test will be breached: (a) the trust must have an allowable deduction; © 2017 THOMSON REUTERS

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[23 1250]

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(b) there must be a scheme under which: (i) assessable income is derived by the trust; (ii) an outsider directly or indirectly provides a benefit to the trustee, a beneficiary or an associate of either; and (iii) the trustee, a beneficiary or an associate of either directly or indirectly provides a benefit to the outsider or certain associates of the outsider; and (c) it is reasonable to conclude that any (not all) of the matters mentioned at (b) occurred wholly or partly, but not merely incidentally, because of the existence of the allowable deduction mentioned in (a). The allowable deduction referred to, which must be available to the trust in the income year under consideration, can include a deduction for prior year losses. In ATO ID 2004/246 the Tax Office considered the writing off of a bad debt by a trust may be a ‘‘deduction’’ for the purposes of the income injection test, but the ATO ID has been withdrawn. In relation to benefits flowing to an outsider or certain of the outsider’s associates, if it is a family trust being subjected to the test and this return benefit is provided only to an associate who is not an outsider to the trust, the test is not breached: see the exception in Sch 2F, s 270-10(1)(b)(iii). The test therefore has no application if benefits only flow from the family trust to members of the specified family group.

Outsiders The meaning of ‘‘outsider’’ depends on whether or not the trust is a family trust. For a trust that is not a family trust, an outsider is a person other than the trustee of the trust or a person with a fixed entitlement to income or capital of the trust: Sch 2F, s 270-25(2). As to family trusts, see [23 1260]. Outsiders who cease to be outsiders If a person who was an outsider before the scheme was entered into ceases to be an outsider as part of the scheme (ie to prevent the above conditions being breached), the requirements are automatically deemed to have been breached: Sch 2F, s 270-10(2). This is designed to prevent the test being bypassed by the simple expedient of having the outsider become the trustee or take up a fixed entitlement in the trust, which would mean he or she would not be an outsider. Scheme ‘‘Scheme’’ has the same meaning as for Pt IVA purposes (Sch 2F, s 272-140): see [42 110]. In Re Eldersmede Pty Ltd and FCT (2004) 56 ATR 1179, the AAT considered that the reference to s 177A(1) necessarily imports a reference to s 177A(3), which broadens the meaning of ‘‘scheme’’ by including a ‘‘unilateral’’ scheme. The AAT further considered that the words used in the definition of ‘‘scheme’’ should be given the full extent of their ordinary meaning. An appeal against this decision was dismissed by the Full Federal Court, which also rejected an argument that failing to do something cannot constitute an element of a ‘‘scheme’’: Corporate Initiatives Pty Ltd v FCT (2005) 59 ATR 351. Benefit ‘‘Benefit’’ is widely defined in Sch 2F, s 270-20 and will include any benefit or advantage within the ordinary meaning of those expressions. In Re Eldersmede, the AAT considered that the words ‘‘benefit or advantage’’ should be read as ‘‘anything that is for the good of a person or thing or puts him, her or it in a better or more favourable position’’. The 1008

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[23 1270]

AAT also considered that the benefit need not be provided in the income year in which the scheme existed. As noted above, an appeal against this decision was dismissed in Corporate Initiatives. The definition of ‘‘benefit’’ specifically includes money, a dividend, property (whether tangible or intangible), rights or entitlements (whether or not property), services and the extinguishment, forgiveness, release or waiver of a debt or other liability. Also specifically included in the definition of ‘‘benefit’’ is the doing of anything that results in the derivation of assessable income. It would appear from the explanatory memorandum that accompanied these provisions that this was intended to catch transactions such as the transfer of some income-producing property or interest to the trust for full consideration. Although such a transfer might not normally be considered a benefit due to being for full consideration, if the trustee derives assessable income from the item transferred, it would be caught. However, it is arguable that it would be a benefit anyway, being property or a right, as the definition of ‘‘benefit’’ contains no qualifications relating to consideration. It is difficult to conceive of other circumstances to which this last-mentioned limb could apply that would not also amount to providing property, a right or an entitlement under the other limbs of the definition. Secret information that allowed the trustee to derive assessable income is perhaps a possibility, but this would also appear to be an advantage in the ordinary meaning of that expression.

[23 1260] Family trusts – modified application In relation to family trusts, the definition of outsider to the trust, in addition to excluding the same persons as for other trusts, also excludes most persons and entities that could be broadly described as within the same family group as the family trust. The effect is that income injection is allowed in family trusts without any adverse consequences provided it is only from members of this broadly defined family group (or the trustee or persons with fixed entitlements). Outsiders The specific definition of ‘‘outsider’’ for these purposes is in Sch 2F, s 270-25(1). As stated, it operates in an exclusionary fashion; however, the exclusions are not identical to the definition of ‘‘family group’’ for family trust purposes. The persons who are not outsiders to a family trust are the trustee, persons with fixed entitlements to income or capital, the specified individual in the family trust election and her or his family members (see [23 860]), a trust with the same individual specified in its family trust election and any interposed entity that had made an interposed entity election to take effect before the scheme began. In addition, a fixed trust, company or partnership in which fixed entitlements to all income and capital were beneficially held, directly or indirectly, by the specified individual in the family trust election, her or his family members or other family trusts of the specified individual at all times while the relevant scheme was being carried out will not be an outsider. [23 1270] Consequences of breach The broad effect of breaching the income injection test is that the assessable income derived as part of the scheme will be assessable in full in the year in which it is derived. This is achieved through first disallowing any deduction otherwise allowable in the income year under consideration to the extent that it relates exclusively, or may appropriately be related, to the scheme assessable income: Sch 2F, s 270-15(a). In addition, the total net income of the trust is increased to at least equal the amount of the scheme assessable income if it is less than that amount: Sch 2F, s 270-15(b). If it is already equal to or more than the scheme assessable income, it is not increased. Other deductions not related to the scheme assessable income continue to be allowable (or may be carried forward as a tax loss): Sch 2F, s 270-15(c). © 2017 THOMSON REUTERS

1009

[23 1300]

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If the deduction available to the trust (as mentioned at (a) of [23 1250]) was itself a carried forward loss, then to the extent that there is insufficient other assessable income for it to be offset against it, it continues to be available for carry forward into future years (ie it is not reduced because of the scheme assessable income or any increase in the trust net income resulting from the existence of the scheme assessable income): Sch 2F, s 270-15(d). In Re Eldersmede Pty Ltd and FCT (2004) 56 ATR 1179 the taxpayer, as trustee of the Eldersmede Unit Trust (EUT), directed income to itself as trustee of the Eldersmede Distribution Trust (EDT). The trust deed of EDT had been varied to facilitate the redirection of assessable income. The taxpayer, as trustee of EDT, then directed income to another entity (SBS) as trustee of another trust (CUT). Both of the allocations were recorded by journal entry and remained unpaid. Neither of the trustees took action to recover the allocated amounts or to require that the retained amount be reinvested on commercial terms. The AAT found that this series of events constituted a scheme under which the taxpayer, as trustee of EDT, provided a benefit to SBS and, by allowing the taxpayer to retain the use of the allocated amount, SBS provided the taxpayer and its associates with a benefit. Accordingly, the ultimate beneficiaries of CUT were assessable on additional amounts of trust income. An appeal against this decision was dismissed by the Full Federal Court, which also rejected an argument that failing to do something cannot constitute an element of a ‘‘scheme’’: Corporate Initiatives Pty Ltd v FCT (2005) 59 ATR 351.

ANTI-AVOIDANCE PROVISIONS REVOCABLE AND OTHER TRUSTS [23 1300] Revocable trusts If a person (the settlor): (a) has created a trust in respect of any income or property (including money); and (b) has power, whenever exercisable, to revoke or alter the trusts so as to acquire a beneficial interest in: (i) the income derived by the trustee during the income year; or (ii) the property producing that income; or (iii) any part of that income or property, the Commissioner may assess the trustee to pay income tax, as explained below, and the trustee is liable to pay the tax so assessed: s 102(1)(a). The amount of such tax is determined under s 102(2). It is the amount by which the tax actually payable by the settlor on her or his own taxable income is less than the tax that would have been payable by the settlor if she or he had received, in addition to any other income received by her or him, so much of the net income of the trust estate as: • is attributable to the property in which she or he has power to acquire the beneficial interest; or • represents the income, or the part of the income, in which she or he has power to acquire the beneficial interest. 1010

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[23 1350]

The net income taken into account in this calculation is reduced to the extent that it is attributable to a period when the person who created the trust was not a resident, is attributable to sources out of Australia and is also reduced by attributable income assessed under s 102AAZD (see [34 480]): s 102(2B). EXAMPLE [23 1300.10] The net income of a trust estate for the income year is $10,000, divisible in equal shares between the settlor’s wife and his daughter aged 14. The settlor has power to revoke the trusts so as to acquire a beneficial interest in the income derived by the daughter. The settlor’s individual income is $20,000. One-half of the net income of the trust estate, $5,000, will be included in the assessable income of the settlor’s wife. The settlor will be assessed in respect of his individual taxable income of $20,000. The trustee will be assessed on $5,000 as follows: $ $ Tax on $20,000 + $5,000 = $25,000 ................................................ 2,850 Add Medicare levy ................................................................ 375 3,225 less tax payable by settlor on $20,000 ................................ 2,100 Medicare levy ................................................................ 300 2,400 $825 Note that there is no specific provision that defines tax to include the low-income offset (see [19 300]), as there is with the Medicare levy (s 251R(7)). Therefore, while the settlor will remain entitled to the low-income offset, it appears it cannot be included as additional tax payable by the trustee.

If trust property is converted into other property, s 102 applies in the same way as if the trust had originally been created in respect of that other property: s 102(2A). If s 102 applies to the assessment of the income of a trust estate, or part thereof, derived in the income year, no beneficiary is to be assessed in her or his individual capacity in respect of her or his individual interest in the income or part to which s 102 has been applied. In addition, the trustee is not to be assessed in respect of that income or part otherwise than under s 102. Thus, in Example [23 1300.10] the daughter’s assessable income will not include her one-half share of the net income of the trust estate: s 102(3). A trust is irrevocable even if the settlor can bring about the disintegration of the trust estate by reason of extrinsic matters not referable to or contained in the terms of settlement: Jenkins v IRC [1944] 2 All ER 491.

[23 1310] Trusts for children of settlor Section 102 contains an anti-avoidance provision in relation to income payable to children of the settlor of a trust: see [23 760].

REIMBURSEMENT AGREEMENTS [23 1350] Amount taxed in hands of trustee Section 100A is intended to prevent what is commonly called ‘‘trust stripping’’. At its simplest, this involves arrangements whereby trust income is diverted to third parties and away from the truly intended beneficiaries. The truly intended beneficiaries, or an associate of them, in return receive what is hoped to be a non-taxable amount or benefit. Section 100A operates by deeming the actual beneficiaries not to be presently entitled to the diverted © 2017 THOMSON REUTERS

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[23 1350]

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income. As a result, the diverted income is assessed in the hands of the trustee under s 99A at the rate prescribed for that section (49% for 2016-17 and reducing to 47% from 2017-18). For s 100A to apply, there must be a ‘‘reimbursement agreement’’. This is defined in s 100A(7) as an agreement ‘‘that provides for the payment of money or the transfer of property to, or the provision of services or other benefits for, a person or persons other than the beneficiary or the beneficiary and another person or persons’’. The term ‘‘agreement’’ is widely defined in s 100A(13) to include all arrangements etc that are express or implied, enforceable or unenforceable or intended to be enforceable. The term does not include any agreement entered into in the course of ordinary family or commercial dealing. A ‘‘reimbursement agreement’’ may consist of a series of transactions and should not be viewed as a discrete transaction divorced from the context of the overall arrangement: FCT v Prestige Motors Pty Ltd (1998) 38 ATR 568 at 587-588; Raftland Pty Ltd v FCT (2006) 62 ATR 49 at 70 (upheld by the Full Federal Court in Raftland Pty Ltd v FCT (2007) 65 ATR 336 and by the High Court in Raftland Pty Ltd v FCT (2008) 68 ATR 170). An agreement that otherwise satisfies the terms of s 100A(7) is not a ‘‘reimbursement agreement’’ if no person intended that there would be a reduction, either wholly or in part, in an income tax liability for a taxpayer. This only requires that one person have the necessary ‘‘purpose’’ and does not require that all parties to the agreement should have that ‘‘purpose’’. The benefit under a reimbursement agreement can consist of the payment of money, the transfer of property (including choses in action) or an estate, interest, right or power in or over property or the provision of services. Under s 100A(10) a person is deemed to have been paid money in circumstances that, prima facie, satisfy the requirements of a reimbursement agreement if a loan is made to that person. In all cases the payment can be made either to the person beneficially or to the person as a trustee. Additionally, any agreement under which a person either abandons her or his rights to repayment of loan moneys or fails to take action to recover loan moneys is deemed to be an agreement for the payment of money. Such an agreement also includes the postponement of the repayment of any debt: s 100A(2). The ‘‘beneficiary’’ referred to in the definition of ‘‘reimbursement agreement’’ is a person presently entitled to a share of the income of a trust estate, if the entitlement to that share or to a part of that share of the income of the trust estate ‘‘arose out of a reimbursement agreement or arose by reason of an act, transaction or circumstance that occurred in connection with, or as a result of, a reimbursement agreement’’: s 100A(1). If a beneficiary would have been entitled to a share of the income of a trust estate in the absence of a reimbursement agreement, and becomes entitled to a further part of the income of the trust estate as a result of or in consequence of the reimbursement agreement, s 100A can apply to that further part of the income of the trust estate. Two arrangements involving the trustee of a motor vehicle retail business were held to be reimbursement agreements by the Full Federal Court in FCT v Prestige Motors Pty Ltd (1998) 38 ATR 568. They were not explicable as ordinary commercial dealings. For a discussion on the Commissioner’s approach to reimbursement agreements following this decision, see Practice Statement PS LA 1998/5. In Idlecroft Pty Ltd v FCT (2004) 56 ATR 699, the trustee taxpayers entered into a joint venture with the trustee of a unit trust to develop a shopping centre, appointed the trustee of the unit trust as a beneficiary of their respective trusts and made distributions to it over a number of years. The trustee of the unit trust did not pay tax on those distributions because of accumulated losses. It was accepted that s 100A would apply if the income of a trust estate was found to have been validly allocated to the trustee of the unit trust. However, the Federal Court held that the purported appointments of income to the trustee of the unit trust were not valid (except in one case). The court then found that the default beneficiaries would have been presently entitled to the income but for the operation of s 100A, and that the present entitlement of those beneficiaries ‘‘arose by reason of an act, transaction or circumstance that 1012

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[23 1410]

occurred in connection with a reimbursement agreement’’. Consequently, s 100A applied to deem the default beneficiaries not to be presently entitled to the trust income, so the income was assessable in the hands of the trustee. The court commented that Parliament intended that s 100A have a very wide scope, catching not only those present entitlements which arose out of a reimbursement agreement, but also those which arose by reason of any act, transaction or circumstance that occurred in connection with a reimbursement agreement. The Full Federal Court unanimously upheld this decision in Idlecroft Pty Ltd v FCT (2005) 60 ATR 224. In the Raftland case, the Federal Court found that the appointment of the trustee of a trust with accumulated tax losses (the E&M Unit Trust) as a beneficiary of the Raftland Trust and purported distributions by the Raftland Trust to that beneficiary were sham transactions and, as in the Idlecroft case, held that s 100A applied to deem the default beneficiaries not to be presently entitled to the trust net income. On appeal, the Full Federal Court held that the appointment of the trustee of the E&M Unit Trust as an additional beneficiary and the purported distributions to that beneficiary were not sham transactions, but that its entitlement to income of the Raftland Trust (except one distribution of rental and interest income) arose out of a reimbursement agreement. On appeal in Raftland Pty Ltd v FCT (2008) 68 ATR 170, the High Court agreed with the judge at first instance that the appointment of a beneficiary with tax losses and the purported distributions to that beneficiary were sham transactions. As a result, the purported allocations of income to the E&M Unit Trust (including that one distribution of rental and interest income) were of no effect. Instead, the income was to be allocated to the default beneficiaries in accordance with the trust deed. However, the court held that the allocation of income to the default beneficiaries arose out of a reimbursement agreement. Accordingly, applying s 100A, the default beneficiaries were not presently entitled to the net income of the trust estate, so that the net income was assessable in the hands of the trustee. In Determination TD 2005/34, the Tax Office describes a profit washing scheme using a chain of trusts and a loss company and concludes that s 100A would apply to it (the determination was updated in July 2009 to take account of the High Court’s judgment in Raftland).

CONTRIVED AND NON-COMMERCIAL ARRANGEMENTS [23 1400] Trust arrangements under Tax Office scrutiny If a taxpayer uses borrowed moneys to acquire an interest in a trust as a beneficiary, and the funds are used for an income-producing purpose, the Tax Office considers that the taxpayer’s borrowing costs will not be fully deductible if the borrowed funds are used to benefit not only the taxpayer but also other beneficiaries: Determination TD 2009/17. If a self-managed superannuation fund invests directly or indirectly in a closely-held trust and is allocated income or gains that are disproportionate to its investment, the income derived by the superannuation fund may be ‘‘non-arm’s length income’’ for the purposes of s 295-550 (see [41 230]): Taxpayer Alert TA 2008/4. Such income is taxed at a higher rate than other income of a qualifying superannuation fund.

[23 1410] Arrangements involving trusts and private companies An amount of trust income to which a private company is or has been presently entitled, but which has not been distributed to the company, may be regarded as a loan made by the company to the trust, for the purposes of the deemed dividend provisions of Div 7A ITAA 1936 (see [21 270]): Ruling TR 2010/3. In addition, specific rules in Div 7A apply to arrangements involving the interposition of a trust between a private company and its shareholders (or associates): see [21 300]. © 2017 THOMSON REUTERS

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[23 1420]

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[23 1420] Income derived and expenses incurred in connection with a ‘‘tax avoidance agreement’’ Specific anti-avoidance provisions apply to various arrangements, including arrangements involving trusts, if income is derived or an expense is incurred under or in connection with a ‘‘tax avoidance agreement’’ as defined in s 121F(1) ITAA 1936. Such an agreement is one entered into for the purpose, or for purposes that include the purpose, of ensuring that a person avoids, either wholly or in part, a liability to pay income tax that would have arisen if the agreement had not been entered into. A merely incidental tax avoidance purpose is ignored. See [43 100] for further details.

CLOSELY HELD TRUSTS [23 1450] Overview of Div 6D Section 102UA(1)) states that the main purpose of Div 6D is to ensure that the trustee of a closely held trust that has one or more trustee beneficiaries (ie a beneficiary of the trust in the capacity of trustee of another trust: s 102UD) correctly identifies the trustee beneficiaries, by giving a correct TB statement, within a specified period (the ‘‘TB statement period’’) after the end of the income year: see [23 1470]. This will allow the Commissioner to check whether the assessable income of the trustee beneficiaries includes the correct share of net income, and whether the net assets of the trustee beneficiaries reflect the receipt of tax preferred amounts. A tax-preferred amount is either (s 102UI): • an amount of income of the trust that is not included in its assessable income in working out net income; or • an amount of capital. It is a precondition of the operation of Div 6D that a share of the net income of a closely held trust is included in the assessable income of a trustee beneficiary under s 97 or there is a share of tax-preferred income to which a trustee beneficiary is presently entitled at the end of the income year. Thus, Div 6D does not apply if none of the beneficiaries is a trustee beneficiary. However, if at least one of the beneficiaries of the trust is a trustee beneficiary, the definition of ‘‘closely held trust’’ becomes critical: see [23 1460]. If the trustee of a closely held trust fails to make a correct TB statement during the TB statement period, a liability to tax is imposed on the trustee: see [23 1490].

Tax file number withholding arrangements The TFN withholding arrangements have been extended to closely held trusts: see [50 080]. However, withholding does not apply if the beneficiary of a closely held trust quotes their tax file number (TFN) to the trustee of the trust: s 202DO ITAA 1936. The purpose of this measure is to encourage beneficiaries to quote their TFN to the trustees of such trusts, which will in turn enable the Tax Office to use the TFN information to match amounts reported by trustees and amounts reported in beneficiaries’ tax returns. [23 1460] What is a closely held trust? A ‘‘closely held trust’’ is (s 102UC(1)): • a trust in respect of which, broadly, no more than 20 individuals have between them, directly or indirectly, fixed beneficial entitlements to 75% or more of the income or capital of the trust – the trustee of a discretionary trust will be treated as an individual for these purposes if holding a fixed entitlement to a share of the income or capital of the first mentioned trust and no person holds that fixed entitlement directly or indirectly through the discretionary trust: s 102UC(2); or 1014

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[23 1470]

• a discretionary trust, ie a trust that is not a fixed trust within the meaning of s 272-65 in Sch 2F (see [23 950]), and which is not an ‘‘excluded trust’’. An ‘‘excluded trust’’ is (s 102UC(4); Sch 2F, s 272-100): • a trust that is covered by a family trust election or an interposed entity election or that is a member of the family group of a family trust for the purposes of Sch 2F (see [23 860]-[23 890]); • a complying superannuation fund, a complying approved deposit fund (ADF), a pooled superannuation trust (PST) or a First Home Savers Account (FHSA) trust (note that the FHSA regime has been discontinued); • the trust of a deceased estate, until the end of the income year in which the 5th anniversary of the death occurs; • a fixed unit trust in respect of which all the capital and income of the trust is the subject of fixed entitlements held by persons all of whose income is exempt from tax under Div 50 ITAA 1997 (see [7 350]-[7 460]). Exempt bodies, for these purposes, include exempt State and Territory bodies (see [7 500]) and untaxable Commonwealth entities; and • a unit trust whose units are listed on the Australian Stock Exchange Limited. There is no exclusion for a bare trust that arises under a nominee arrangement.

[23 1470] Correct TB statement The trustee of a closely held trust must advise the Commissioner of certain details about each trustee beneficiary that is entitled to a share of the trust’s net income which includes or comprises an untaxed part, or to a share of a tax-preferred amount of the trust: s 102UG. This advice is contained in a trustee beneficiary (TB) statement (in the form approved by the Commissioner), which must be provided within the TB statement period. This is the period from the end of the income year to the time the trustee is required to lodge the trust’s return of income: s 102UH. However, an extension of time for the lodgment of UB statements may be allowed: see [23 1480]. A correct TB statement must include the following details (s 102UG(3)): • for each trustee beneficiary that is a resident at the end of the income year, their name and TFN; • for each trustee beneficiary that is a foreign resident at the end of the income year, their name and address; and • for each trustee beneficiary, the amount of the untaxed part of the share of the net income or the amount of the share of the tax-preferred amount. The trustee of a closely held trust need not report amounts to the extent that they have been taxed to the trustee of the closely held trust, or to an earlier trust in the chain, under certain other provisions of the tax law. TB statements (and UB statements) may be amended within 4 years of the due date for payment of the TB tax if made to correct an error on the original statement made by the trustee which the trustee has reasonable grounds to believe was correct, and the event leading to the need to amend the statement could not reasonably have been foreseen by the trustee: s 102UK(2A). The Commissioner can make a determination not to require statements in certain circumstances: s 102UK(1A). Pursuant to this power, the Commissioner has determined that trustees of closely held trusts with a substituted accounting period ending between 23 September 2008 and 31 December 2008 (in lieu of 30 June 2008) are not required to make © 2017 THOMSON REUTERS

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[23 1480]

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a statement for the 2007-08 income year if a share of the net income of the trust is included in the assessable income of a trustee beneficiary.

[23 1480] Lodgment requirements for TB statement Practice Statement PS LA 2001/12 clarifies the circumstances under which a trustee of a closely held trust is required to lodge a UB statement. The Practice Statement should also be relevant to the lodgment of TB statements. On that basis, trustees are required to indicate on the trust return if they are notionally required to lodge a TB statement. However, the lodgment of a TB statement is only required if the trustee has a trustee beneficiary non-disclosure tax liability for the year under consideration or the Commissioner requests a TB statement. If the Commissioner requests a TB statement, the trustee has such time as is reasonable in the circumstances (a minimum of 28 days) to comply. Practice Statement PS LA 2001/12 also provides guidelines on when the period for lodging a UB statement will be extended. These guidelines may also be relevant to the lodgment of TB statements. [23 1490] Consequences if no correct TB statement made If the trustee of the closely held trust does not make and give to the Commissioner a correct TB statement during the TB statement period (see [23 1470]), the trustee is liable to pay ‘‘trustee beneficiary non-disclosure tax’’ on the relevant untaxed part (if the trustee is a company, the trustee and the directors of the company are jointly and severally liable to pay the tax): s 102UK. A director of a corporate trustee may be excused from liability if it would be unreasonable that the director be liable for the tax, eg if the director did not participate because of illness in any decision not to make a correct TB statement or if he or she was aware of such a decision but took reasonable steps to prevent it: s 102UL. Trustee beneficiary non-disclosure tax is also payable if a share of the net income of a closely held trust is included in the assessable income of a trustee beneficiary under s 97 and the trustee of the closely held trust becomes presently entitled to an amount that is reasonably attributable to the whole or a part of the untaxed part of the share and trustee beneficiary non-disclosure tax is not payable by the trustee of the closely held trust on the untaxed part: s 102UM. In those circumstances, the trustee is liable to pay trustee beneficiary non-disclosure tax on the untaxed part (if the trustee is a company, the trustee and the directors of the company are jointly and severally liable to pay the tax). The tax is imposed by the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No 1) 2007 (where s 102UK applies) or the Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No 2) 2007 (where s 102UM applies). The rate of tax is equal to the top marginal rate plus the Medicare levy, ie 49% for 2016-17 (incorporating the temporary budget repair levy) and 47% for 2017-18 and later income years. In both the above situations where trustee beneficiary non-disclosure tax is imposed, the untaxed part is not included in the trustee beneficiary’s assessable income, except for the purposes of ss 99, 99A and 99B (see [23 500]-[23 550]) and Div 6D: ss 102UK(2)(b), 102UM(2)(b). Payment of tax Trustee beneficiary non-disclosure tax is due and payable 21 days after the end of the TB statement period or such later date as the Commissioner allows: s 102UO. If any tax remains unpaid 60 days after the due date, the general interest charge (see [54 370]) may be imposed on the unpaid amount from the 60th day: s 102UP. The Commissioner may exercise his power to remit the GIC in the circumstances set out in Practice Statement PS LA 2001/12. Trustee beneficiary non-disclosure tax is reduced by any rebates to which the trustee would be entitled in a s 99A assessment (see [24 360]) assuming the trustee was liable to pay tax under s 99A on all or part of the share of the net income: s 102UN. 1016

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Recovery of tax from trustee beneficiaries A trustee of a closely held trust may also recover TB non-disclosure tax (and penalties) from the trustee beneficiaries if the trustee has distributed the full distribution amount (ie without deduction for TB non-disclosure tax) and they have relied on information from such persons in circumstances where it was reasonable for them to do so, and have unwittingly become liable to TB non-disclosure tax if the statement is incorrect. A similar right to recovery exists if genuine attempts have been made to seek the correct explanation, but it has not been made available by the trustee beneficiaries: s 102USA. [23 1500] Tax-preferred amounts If a trustee beneficiary is presently entitled to a share of a tax-preferred amount of a closely held trust, the trustee of the closely held trust must, during the TB statement period, make and send to the Commissioner a correct TB statement: s 102UT. If the trustee fails to do so, the trustee is guilty of an offence under s 8C TAA, punishable on conviction by a fine not exceeding 20 penalty units for a first offence (see [54 020] for the value of a penalty unit). However, there is no offence if the trustee did not know all the information required to be included in the TB statement, took reasonable steps to ascertain it and included in the TB statement what information they did know.

TRUSTS TREATED AS COMPANIES CORPORATE UNIT TRUSTS [23 1550] Corporate unit trusts – outline The corporate unit trust rules in Div 6B in Pt III ITAA 1936 (ss 102D to 102L) were repealed by the Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 (‘‘MIT Act’’) for income years starting on or after 1 July 2016. For earlier income years, Div 6B included the net income of the corporate unit trust in the assessable income of the trustee of the trust (acting in that capacity): former s 102K. Note that ‘‘net income’’ for this purpose is defined in former s 102D. The relevant tax rate, for income years starting before 1 July 2016, was the corporate income tax rate (effectively 30%) or the small business company tax rate if applicable: see [25 250]. A distribution defined as a ‘‘unit trust dividend’’ in former s 102D was treated in the same way as a dividend for the purposes of the assessing and withholding tax provisions (former s 102L(11)) and also for the purposes of other provisions, such as the imputation provisions, that apply to dividends: former s 102L(22). A corporate unit trust could not be a managed investment trust for the purposes of the withholding tax regime discussed at [50 090]: former s 102L(15). Under transitional rules, payments of income tax and PAYG instalments by a corporate unit trust for an income year starting before 1 July 2016 will continue to give rise to franking credits and a corporate unit trust has until 30 June 2018 to utilise any surplus in its franking account, subject to satisfying the requirements of the imputation system: see Pt 4, Sch 5 MIT Act. [23 1560] Definition of ‘‘corporate unit trust’’ and related terms A ‘‘corporate unit trust’’ is defined in former s 102J as: • a unit trust that is an ‘‘eligible unit trust’’ in relation to the relevant income year; • the unit trust is a ‘‘public unit trust’’ in relation to that income year; and © 2017 THOMSON REUTERS

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• either the unit trust is a ‘‘resident unit trust’’ in that year or, alternatively, was a corporate unit trust in relation to a preceding income year. A ‘‘prescribed trust estate’’ is a corporate unit trust in relation to a particular income year: former s 102D. It is particularly relevant in relation to former s 102L, which modifies the application of the ITAA 1936 generally in connection with unit trusts to ensure that corporate unit trusts are treated in exactly the same way as companies, both on the receipt of income and the disposal of that income to the members of the trust.

‘‘Unit’’ A ‘‘unit’’ is defined in former s 102D as including a beneficial interest, however described, in any of the income or property of a trust estate. A unitholder is the holder of such a unit or units. A unit trust dividend is a distribution to a unitholder by the trustees of a corporate unit trust. It does not include moneys distributed when the trust estate was not a corporate unit trust, nor the repayment to unitholders of moneys paid up on a unit: former s 102D. Eligible unit trust A unit trust is an ‘‘eligible unit trust’’ if property was acquired in pursuance of an arrangement that is a ‘‘prescribed arrangement’’: former s 102F. Ownership interests in a unit trust or a company that is part of a scheme for reorganising the affairs of stapled entities referred to in Subdiv 124-Q ITAA 1997 (see [16 180]) are not property for these purposes. Under the prescribed arrangement, the unit trust must have acquired property that at some earlier time had been the property of the company or of an associate of the company: former s 102E. In the case of a prescribed arrangement involving the acquisition of a business, the business acquired by the unit trust must at some time before acquisition have been carried on by the company or an associate of the company. Note that a unit trust exiting a consolidated group does not become an eligible unit trust as a result of the exit history rule in the consolidation provisions: ATO ID 2004/875. The reason for this is that the exit history rule deems the property that the unit trust takes with it when leaving the consolidated group always to have been the property of the unit trust. Another requirement is that a shareholder in the company was, by reason of being a shareholder, granted a right to acquire units in the unit trust, or a unitholder in one unit trust was by reason of being a unitholder granted a right to acquire units in a second unit trust. In both cases, the provisions apply whether the right to acquire was granted directly or indirectly or through any interposed companies or trusts. Public unit trust ‘‘Public unit trusts’’ are defined in former s 102G in specific terms with a number of anti-avoidance provisions following the first subsection. Prima facie, a unit trust is a public unit trust in relation to an income year if any of the units in the unit trust were: • listed for quotation in the official list of a stock exchange, being in Australia or elsewhere; or • offered to the public; or • held during that relevant year by not fewer than 50 persons. If the units were offered to the public at any time during the income year but the Commissioner considers that the purpose of the offering, or one of the purposes, was to qualify the unit trust as a public unit trust under the terms of former s 102G(1)(b), the Commissioner has the power to declare that unit trust not to be a public unit trust in relation to an income year merely by reason of that offering to the public. One of the tests former in s 102G(1) for the purpose of determining whether a unit trust is a public unit trust is whether units have been offered to the public. Former s 102G(8) provides that this is deemed to have taken place when an offer is made to the public or to a 1018

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section of the public to subscribe to or purchase the units or, alternatively, an invitation is issued to the public or to a section of the public to make offers to subscribe for or purchase the units.

Resident unit trust A unit trust is a ‘‘resident unit trust’’ if it satisfies 2 conditions: former s 102H. First, property of the trust must be situated in Australia or it must carry on business in Australia. Second, the trust’s central management and control must be situated in Australia or residents must hold more than 50% of the beneficial interests in the income or property of the trust. Limited holdings of units If, at any time during the income year, up to 20 persons (maximum) hold, or have the right to acquire or become the holder of: • not less than 75% of the beneficial interest in the income of the unit trust; or • not less than 75% of the beneficial interest in the property of the unit trust, the trust is not a public unit trust for Div 6B purposes: former s 102G(3), (6). Note that a person and her or his relatives and nominees (and a relative’s nominees) count as one person for these purposes: former s 102G(11). A unit trust is also not a public unit trust for the purposes of former Div 6B if 75% or more of the moneys paid or credited by the trustee during the income year was paid or credited to not more than 20 in number: former s 102G(6). Notwithstanding a breach of the 20 persons/75% tests, the Commissioner may treat a trust as a public unit trust if appropriate: former s 102G(4), (7). ATO ID 2006/234 describes a situation in which that discretion was exercised. For these purposes, if the trustee of a trust estate holds units in a unit trust, any person who has a beneficial interest in the property of the first-mentioned trust estate is deemed to hold the units in that trust estate: former s 102G(9). The 20 persons/75% rule above (former s 102G(3)) includes the situation where there is an option to acquire or become the holder or holders of a unit or units in a unit trust, which will cause the 20/75% rule to be breached. If a person holds such a right and the Commissioner is of the opinion, having regard to the financial circumstances of that holder and to such other matters as he considers relevant, that it is not intended that the right will be exercised, he is authorised to disregard that right: former s 102G(5). In those circumstances the holder is deemed not to have the right and the question of whether the unit trust is a public unit trust proceeds by way of tests contained in former s 102G(1).

PUBLIC TRADING TRUSTS [23 1600] Public trading trusts – outline Division 6C in Pt III ITAA 1936 (ss 102M to 102T) effectively treats certain trusts known as public trading trusts as companies. In particular: • a trustee of a ‘‘corporate unit trust’’ (acting in that capacity) is assessed on the net income of the corporate unit trust at the rate declared by Parliament: s 102S; • ‘‘net income’’ for this purpose is defined in s 102M; • the relevant tax rate is the corporate income tax rate (effectively 30%) or the small business company tax rate if applicable (or, for the 2017-18 income year and subsequent income years, the rate that applies to a ‘‘base rate entity’’ if applicable): (see [25 250]); © 2017 THOMSON REUTERS

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• a distribution defined as a ‘‘unit trust dividend’’ in s 102M is treated in the same way as a dividend for the purposes of the assessing and withholding tax provisions (s 102T(12)) and also for the purposes of other provisions, such as the imputation provisions, that apply to dividends: s 102T(13); and • a public trading trust is not treated as a trust for the purposes of the general trust income assessing provisions in Div 6 and cannot be a managed investment trust for the purposes of the MIT rules discussed at [23 680], [23 685] and [50 090]: s 102T(16).

[23 1610] Definition of ‘‘public trading trust’’ A trust is a public trading trust, and therefore subject to Div 6C, if it satisfies 4 requirements (s 102R(1)): • the trust is a public unit trust; • the trust is a trading trust; • either the trust is a resident unit trust or was a public trading trust of a preceding income year; and • the trust is not a corporate unit trust within Div 6B. This requirement has no practical effect for income years starting on or after 1 July 2016 as Div 6B has been repealed for those income years: see [23 1550].

Unit trust Division 6C applies to a unit trust that is a public trading trust, but there is no definition of the term ‘‘unit trust’’ for Div 6C purposes. A ‘‘unit’’, however, is defined in s 102M to include ‘‘a beneficial interest, however described, in any of the income or property of the trust estate’’. The issue of what is a unit trust was considered in FCT v ElecNet (Aust) Pty Ltd (Trustee) [2015] FCAFC 178. A majority of the Full Federal Court (Pagone and Edelman JJ) agreed with the primary judge that the extended definition of ‘‘unit’’ in s 102M is relevant in determining whether a trust is a ‘‘unit trust’’ for the purposes of Div 6C. However, their Honours also held that there is ‘‘a necessity for something which fits a description of ‘units’ within the functional, and descriptive, notion of a unit trust’’. They decided that the existence of trustee discretions regarding the distribution of both income and capital of the trust to electrical workers meant that any interest that a worker had in the trust was not capable of being described functionally as a ‘‘unitised’’ interest, regardless of whether or not it was correct to describe the interests of the workers as a beneficial interest in the trust estate. It followed that the trust was not a ‘‘unit trust’’. Jessup J considered that the extended meaning of ‘‘unit’’ in s 102M does not apply for the purposes of determining the meaning of ‘‘unit trust’’ in Div 6C. His Honour noted that there is no indication that Div 6C uses the term ‘‘unit trust’’ in anything other than its ordinary meaning, and central to that meaning is a requirement that the interests in the trust, whatever other characteristics they might have, be divided into units (or ‘‘unitised’’). That requires the existence of an irreducible, discrete ‘‘unit’’ or a parcel of rights by reference to which those interests are held, such that every person or entity with an interest in the trust will have one or more such units. As that requirement was not met, Jessup J found that the trust was not a unit trust for the purposes of Div 6. The High Court dismissed the taxpayer’s appeal in ElecNet (Aust) Pty Ltd v FCT [2016] HCA 51, essentially for the reasons given by Jessup J in the Full Federal Court. In Re B.E.R.T. Pty Ltd as Trustee for the B.E.R.T. Fund No 2 (2013) 95 ATR 457, the AAT decided that an approved worker entitlement fund was not a ‘‘unit trust’’ for the purposes of Div 6B. There were a number of reasons for this decision, including that the 1020

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beneficial interests in the fund were not divided into discrete parcels of rights, the interest of a member in the fund was personal and was not capable of assignment and a member had no right to, or interest in, any money or assets of the fund. Jessup J in ElecNet considered that the AAT’s decision was correct. The Tax Office concluded in ATO ID 2010/57 that, if beneficiaries are entitled to shares of a beneficial interest under a trust, such as an interest in the income and capital, or in either one of these, and those entitlements are measured by reference to a fixed standard of measurement howsoever described (eg a percentage or a fraction or a fixed formula), the trust would be a ‘‘unit trust’’ for Div 6C purposes, whether or not the deed itself labels the interests ‘‘units’’. This decision does not appear to be consistent with Jessup J’s decision in ElecNet, to the extent that His Honour’s decision was based on a finding that rights in both the income and the capital of a trust (rather than the income or capital) must be fixed and ‘‘unitised’’, for the trust to be a ‘‘unit trust’’, but may be consistent with the decision of Pagone and Edelman JJ in the same case, if the beneficiaries’ interests in the trust could functionally be described as units.

Public unit trust A unit trust is a public unit trust if at any time during the income year (s 102P): • any of the units were listed for quotation in the official list of a stock exchange in Australia or elsewhere; • any of the units in the unit trust were offered to the public; or • the units in the unit trust were held by not fewer than 50 persons. One of these tests must be satisfied in a particular income year in order for the trust to be a public unit trust for that income year. The Tax Office has confirmed that the offering of units to the public in one income year does not result in the trust being a public unit trust in any subsequent income year: see the minutes of the 18 September 2012 NTLG Trust Consultation Sub-Group meeting, available on the Tax Office website. Additionally, the unit trust is a public unit trust if ‘‘exempt entities’’ (see below) hold or have the right to acquire or become the holder of units entitling the holder to not less than 20% of the income or property of the trust: A trust is also a public unit trust if not less than 20% of the money paid or credited by it was paid or credited to exempt entities or, by reason of any of the circumstances set out in s 102P(1)(c), the rights attaching to any of the units were capable of being varied or abrogated so that: • exempt entities could become the holders of units entitling them to not less than 20% of the income or property of the trust; or • not less than 20% of the total money actually paid or credited to unitholders or the money that could have been paid or credited to unitholders during an income year could have been paid or credited to exempt entities. The Tax Laws Amendment (New Tax System for Managed Investment Trusts) Act 2016 (‘‘MIT Act’’) enacted a new version of s 102MD which provides that, for the purposes of Div 6C, an exempt entity that is entitled to a refund of franking credits (such as a complying superannuation fund: see [21 610]) is treated as not being an exempt entity for the purposes of Div 6C. This ensures that such exempt entities are disregarded for the purposes of applying the 20% tracing rule summarised above. For those trusts that ceased to be public unit trusts as a result of this change, transitional rules in the MIT Act provide that payments of income tax and PAYG instalments by a public trading trust for an income year starting before 1 July 2016 will continue to give rise to franking credits and a public trading trust has until 30 June 2018 to utilise any surplus in its franking account, subject to satisfying the requirements of the imputation system: see Pt 4, Sch 5 MIT Act. There are complex provisions designed to prevent entities attaining public unit trust status while not being truly public. These are similar to the requirements under s 103A for determining whether a company is public or private: see [20 120]. © 2017 THOMSON REUTERS

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Trading trust A unit trust is a trading trust if at any time during the income year it carried on a trading business or controlled another entity that carried on a trading business: s 102N. A ‘‘trading business’’ is defined in s 102M as a business that does not consist wholly of eligible investment business. An ‘‘eligible investment business’’ is defined in s 102M as: • investing in land for the purpose, or primarily for the purpose, of deriving rent – this includes investing in fixtures on the land and movable property (ie, chattels) customarily supplied, incidental and relevant to the renting of the land and ancillary to the ownership and utilisation of the land; or • investing or trading in unsecured loans, bonds, debentures, stock or other securities, shares in a company, units in a unit trust, futures or forward contracts, interest rate or currency swap contracts, forward exchange or interest rate contracts, life insurance policies, a right or option in respect of such a loan, security, share, unit, contract or policy or any similar financial instruments (the range of permitted financial instruments has been expanded to include all financial instruments (not covered by the original definition of ‘‘eligible investment business’’) that arise under financial arrangements in the ITAA 1997, other than certain excepted arrangements (the excepted arrangements are listed in s 102MA and include a luxury car lease, hire purchase agreements and other arrangements recharacterised as a sale and loan, certain interests in trusts and partnerships, general insurance policies, certain guarantees and indemnities and superannuation and pension income). The Tax Office concluded in ATO ID 2010/128 that a public unit trust which aimed to derive part of its returns from realised gains on property investments would be investing ‘‘primarily for the purpose of deriving rent’’ and, therefore, would be conducting an ‘‘eligible investment business’’ and not a ‘‘trading business’’. Undertaking activities that are merely incidental to the public unit trust’s predominant activity/activities (which meet the ‘‘eligible investment business’’ definition) does not of itself cause the public unit trust to be considered to be a trading trust: Determination TD 98/4 and ATO ID 2003/73 and ATO ID 2008/1. An investment in full or associate membership interests in the Chicago Board of Trade is considered to constitute an investment in a ‘‘similar financial instrument’’ for the purposes of s 102M: ATO ID 2006/233. Although it is not possible to invest in ‘‘shares’’ in the Chicago Board of Trade as it is a non-stock corporation, the interests issued fall within the definition of ‘‘membership interests’’ in s 960-135, which in this case are sufficiently similar to ‘‘shares’’ to qualify as ‘‘similar financial instruments’’. In ATO ID 2008/1, equity mortgage agreements, involving the issue of a financial instrument by a homeowner to a unit trust and the subsequent redemption of that financial instrument by the homeowner, but without the unit trust acquiring any ownership interest in the property, were considered to be ‘‘securities’’ for the purposes of s 102M. A participating loan with rights to a specified share of the net sales value of specific properties, secured by mortgages over those properties, was considered not to be a loan for the purposes of s 102M, but to fall within ‘‘other securities’’: see ATO ID 2010/16 and ATO ID 2010/17. A trust that restricts its activities to investing would become a trading trust if it obtained a controlling interest in an entity that carried on a trading business. A public unit trust is not a trading trust only because it has acquired ownership interests (including a controlling interest) in, or controls, a foreign entity whose business (taking into account the businesses of entities that it controls) consists primarily of investing in land outside Australia for the purpose, or primarily for the purpose, of deriving rent or a foreign entity controlled, or able to be controlled, by such an entity: s 102N(2). In addition, a public unit trust is not a trading trust if (s 102NA): • the trust is an interposed trust in relation to a scheme for reorganising the affairs of stapled entities (as referred to in Subdiv 124-Q ITAA 1997: see [16 180]); 1022

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• a roll-over was obtained by any entity under Subdiv 124-Q; and • the trustee of the trust does not carry on a trading business or control, directly or indirectly, the affairs or operations of another entity that carries on a trading business, other than an entity (whether a company, a corporate unit trust or public trading trust) that was one of the formerly stapled entities referred to in Subdiv 124-Q or an entity controlled by one of those formerly stapled entities. The Tax Office considers that the conditions of s 102NA are not satisfied if, following a reorganisation to which s 102NA applies, a formerly stapled entity or an entity controlled by one of those entities acquires or commences a new trading business: see Determination TD 2011/7. There is a 25% safe harbour allowance for non-rental, non-trading income from investments in land. If a trust does not meet this safe harbour, it can assess whether it is investing in land for the purpose, or primarily for the purpose, of deriving rent. There is also a 2% safe harbour allowance, so that the trustee of a unit trust will not be treated as carrying on a trading business if not more than 2% of the gross revenue of the unit trust in an income year is not from eligible investment business and that income is not from carrying on a business that is not incidental and relevant to the eligible investment business.

Resident unit trust A unit trust is a resident if at any time: either property of the trust is situated in Australia or the trustee carries on business in Australia; or the central management and the control of the trust is in Australia or residents hold more than 50% of the beneficial interest in the income or the property of the trust.

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INTRODUCTION Overview ....................................................................................................................... [24 010] Core rules ...................................................................................................................... [24 020] MEMBERSHIP OF CONSOLIDATED GROUP Formation of consolidated group .................................................................................. [24 050] Election to consolidate .................................................................................................. [24 060] Multiple entry consolidated (MEC) groups ................................................................. [24 070] Formation of MEC group ............................................................................................. [24 080] Post-formation transactions affecting MEC group ....................................................... [24 090] Interposed foreign entities ............................................................................................ [24 100] Notification requirements .............................................................................................. [24 110] TREATMENT OF TAX LOSSES IN CONSOLIDATION Introduction ................................................................................................................... [24 Transfer of losses under consolidation rules – general ............................................... [24 Continuity of ownership as transfer test ...................................................................... [24 Control as transfer test .................................................................................................. [24 Same business test as transfer test ............................................................................... [24 Can transferred losses be utilised? ............................................................................... [24 Modified application of COT to MEC groups ............................................................. [24 Rules for loss bundles ................................................................................................... [24 Available fraction method ............................................................................................. [24 Calculation of available fraction .................................................................................. [24 Adjustments to available fraction ................................................................................. [24 Special loss rules ........................................................................................................... [24

150] 160] 170] 180] 190] 200] 210] 220] 230] 240] 250] 260]

ASSET TAX COST SETTING Introduction ................................................................................................................... [24 Tax cost setting on joining consolidated group ........................................................... [24 Allocable cost amount .................................................................................................. [24 Retained cost base assets .............................................................................................. [24 Reset cost base assets ................................................................................................... [24 Formation of a consolidated group .............................................................................. [24 Acquisition of consolidated group by another ............................................................. [24 Linked entities join consolidated group ....................................................................... [24 Trust joins consolidated group ..................................................................................... [24 Partner or partnership joins a consolidated group ....................................................... [24 Subsidiary member leaves group .................................................................................. [24 CGT events relating to cost setting .............................................................................. [24 MEC group cost setting and pooling rules .................................................................. [24 Importance of market valuations .................................................................................. [24 Integrity measures ......................................................................................................... [24 Errors in calculation of ACA ........................................................................................ [24

300] 310] 320] 330] 340] 350] 360] 370] 380] 390] 400] 410] 420] 430] 440] 450]

RELATIONSHIP TO OTHER TAX RULES Pre-CGT status .............................................................................................................. [24 CGT straddles ................................................................................................................ [24 Franking within consolidated groups ........................................................................... [24 CFC attribution .............................................................................................................. [24 Foreign tax offsets and losses ....................................................................................... [24 Foreign dividend accounts ............................................................................................ [24 Thin capitalisation ......................................................................................................... [24 Bad debts ....................................................................................................................... [24 Losses and the same business test ................................................................................ [24 Offshore banking units .................................................................................................. [24 Special rules applying to life insurance companies ..................................................... [24

500] 510] 520] 530] 540] 550] 560] 570] 580] 590] 600]

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Loss integrity and value shifting provisions ................................................................ [24 610] TOFA Interactions ......................................................................................................... [24 615] Consolidation and Pt IVA ............................................................................................. [24 620]

ADMINISTRATIVE RULES Liability for payment of tax ......................................................................................... [24 650] PAYG instalments ......................................................................................................... [24 660] Tax returns ..................................................................................................................... [24 670]

INTRODUCTION [24 010] Overview This chapter considers the consolidation regime in Pt 3-90 ITAA 1997. Under the consolidation regime, qualifying groups of entities are treated as single entities for income tax purposes. This means that intragroup transactions are ignored for tax purposes and there is a single return lodged on behalf of the group (the ‘‘single entity’’ rule: see [24 020]). The head company is responsible for the tax liabilities of the group after consolidation. There are special rules regarding the treatment of losses (see [24 150]-[24 260]) and the cost bases of assets (see [24 300]-[24 450]). Consolidation applies to wholly-owned groups of Australian resident entities that choose to form a consolidated group for income tax purposes (see [24 050]). Consolidation does not apply to other taxes such as FBT and GST. A choice to consolidate is irrevocable and is mandatory for all wholly-owned Australian entities in the group. The consolidation regime applies not only to companies, but also to certain other qualifying entities such as some trusts and partnerships. There are specific rules applying to: resident wholly-owned subsidiaries of foreign holding companies where there are multiple entry points into Australia (MEC groups) (see [24 070]); and groups where one or more subsidiary members are life insurance companies (see [24 600]). Note also the provisions outlined at [32 190] to ensure that the consolidation regime interacts with the TOFA rules. A package of integrity rules concerning double deductions, ‘‘churning’’ and deductible liabilities were announced in the 2013-14 Budget, to apply to arrangements entered into on or after 14 May 2014 (see the then Acting Assistant Treasurer’s media release, 13 May 2014). [24 020] Core rules Division 701 ITAA 1997 sets out the core rules of consolidation. Single entity rule If a choice to consolidate is made, subsidiary members of a group are treated as divisions or branches of the head company and not as separate income tax entities: s 701-1(1). This extends to foreign branch operations: see ATO ID 2009/161. This single entity theory underpins many of the consolidation rules. It means that any transactions undertaken by a consolidated group are regarded as being undertaken by the head company and not the separate legal entities that comprise the consolidated group. As a result, the consolidated group will: • ignore transactions such as asset sales, fee payments, dividends and so on that occur between group members; • attribute certain rights held by subsidiaries to the head company (eg voting rights relevant to s 23AJ ITAA 1936: Determination TD 2004/76); • maintain a common tax accounting period for all member entities; © 2017 THOMSON REUTERS

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• keep consolidated accounts for losses and foreign income tax offsets; • keep consolidated franking accounts; • lodge a single income tax return. The Tax Office considers that the head company may be able to claim a deduction under s 8-1 ITAA 1997 for interest paid on funds borrowed from outside the group by it or a subsidiary member to buy shares in another subsidiary member of the group: Determination TD 2006/48. In certain circumstances, the head company of a multiple entry consolidated (MEC) group may be able to claim a deduction for interest paid on funds borrowed from outside the group by it or a subsidiary member to buy shares in an existing eligible tier-1 company of the group: Determination TD 2006/47. The application of the single entity rule to intragroup debt, for example in situations of recoupment or forgiveness, is considered in ATO ID 2005/344 to ATO ID 2005/346. The single entity rule does not apply in determining whether distributions by a liquidator of a head company represent income derived by the head company for the purposes of s 47 ITAA 1936 (which deems a liquidator’s distributions to be dividends: see [21 150]): Draft Determination TD 2007/D5. Generally, the decision to consolidate will not affect the basis of income recognition of the group for income tax purposes. The only exception is where ignoring intragroup dealings impacts on the group’s method of income recognition: see Determination TD 2005/3. The Tax Office’s views on the operation of the single entity rule are contained in Ruling TR 2004/11.

Character of transaction The Tax Office considers that the character of a business carried on by a head company is not affected by the nature of activities carried on by subsidiary members. So, for example, the existence of an in-house finance company is irrelevant to the character of the head company’s activities: Determination TD 2004/37. Group generated assets If an asset is created between group members (eg a loan or a grant of a licence) the single entity rule means that the tax consequences of either the grant or any payments attributable to it (such as royalties payable on an intragroup licence) are not relevant. However, issues can arise if there is a dealing with a third party in relation to the intragroup asset. The Tax Office has commented on this issue in several Determinations. • The disposal of a debt created intragroup to a third party does not give rise to CGT event D2 since the transaction is regarded as a borrowing by the third party (Determination TD 2004/33), although Div 16E ITAA 1936 may apply (Determination TD 2004/84). • The assignment of an option granted between group members to a third party is considered to be the conferring of rights and options to the third party, hence CGT event D2 can apply (Determination TD 2004/34). • The disposal of an intragroup asset (in this case a licence) to a non-group entity can be a CGT event A1 (Determination TD 2004/35). The Tax Office has expressed the view that the single entity rule does not necessarily mean that an intragroup asset, such as a licence between subsidiary members, is not taken to exist. • Division 16E ITAA 1936 can apply if an intragroup income stream is arranged to a third party (Determination TD 2004/85). • The Full Federal Court in Channel Pastoral Holdings Pty Ltd & Anor v FCT [2015] FCAFC 57 ruled that, notwithstanding the single entity rule, a Pt IVA determination and assessment could be made against a subsidiary member of a consolidated group. 1026

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• The gross proceeds or profit on the disposal of membership interests in a subsidiary member of a consolidated group can be income according to ordinary concepts, depending on the facts of the particular case, eg if the acquisition and disposal of the membership interests is part of the ordinary business of the head company or is an isolated transaction entered into with the intention of making a profit (see [3 060] and [3 070]) (Determination TD 2006/36).

Entry history rule Everything that happened in relation to a subsidiary member of a group before it joined a consolidated group is taken to have happened to the head company: s 701-5. The ‘‘entry history rule’’ means that a head company may be entitled to deductions allowable on an amortised basis for expenses incurred by the joining entity before it became part of the consolidated group. An example of this is the deduction for borrowing expenses. Other examples are: • if a subsidiary acquires a CGT asset before the formation of a consolidated group, the head company is taken to have acquired the asset at the same time: Determinations TD 2004/43 and TD 2004/44; • the head company of a consolidated group can claim a deduction under s 8-1 for interest paid on funds borrowed before consolidation and on-lent interest-free to a subsidiary member of the consolidated group (provided the interest expense satisfies the requirements of s 8-1: see [9 450]): Determination TD 2004/36; • the head company of a consolidated group can claim a deduction under s 25-35(1) (subject to the application of s 25-35(5)) in relation to a debt that is written off as bad by a subsidiary member (see [9 700]-[9 740]), if the debt is in respect of money lent by the subsidiary in the ordinary course of its business of lending money before it became a member of the consolidated group (this does not apply to an intragroup debt): Determination TD 2005/23; • the head company is entitled to claim deductions for capital expenditure (under Subdiv 40-F) incurred by a subsidiary member of the group before the joining time: ATO ID 2007/37; • the head company is taken to have borrowed in the ordinary course of a finance business (for s 25-35(1) purposes), if a finance company subsidiary enters into a borrowing prior to the formation of a consolidated group: ATO ID 2010/100; • the head company of a consolidated group is entitled to access the non-refundable carry forward tax offsets available to the joining entity at the joining time: ATO ID 2015/6. Note the provisions (outlined at [32 190]) relating to the interaction of the consolidation regime and the TOFA rules. For the purposes of applying the same business test, the entry history rule does not operate in relation to an entity becoming a subsidiary member of a consolidated group or an MEC group: s 165-212E. This means the history of the subsidiary prior to joining need not be considered in determining whether the head company satisfies the same business test.

Exit history rule If a subsidiary member leaves a consolidated group it takes with it the history in relation to the assets and liabilities and businesses that cease to be part of the head company as a consequence of its leaving: s 701-40. The ‘‘exit history rule’’ applies for the core purpose of working out the entity’s income tax liability or loss for any period following its ceasing to be a part of the head company. Note the provisions (outlined at [32 190]) relating to the interaction of the consolidation regime and the TOFA measures. © 2017 THOMSON REUTERS

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Entry and exit history rules and choices Subdivisions 715-J and 715-K contain special rules for irrevocable elections or choices made by entities in respect of: • attribution of income in respect of controlled foreign corporations and foreign limited partnerships; • functional currency rules; • Div 230 financial arrangements; • reinsurance with non-residents; • short-term forex realisation gains and losses; • rules about disregarding certain forex realisation gains and losses; and • registered emissions units (under the carbon pricing scheme) – note that the carbon pricing scheme has been repealed from 1 July 2014: see [5 500]. Under these rules, the head company of a consolidated group will not inherit the choices (or lack of choices) made by a joining entity. Instead, all pre-joining time or pre-consolidation time choices of a joining entity will be withdrawn and the head company will be able to make a choice effective from the consolidation/joining time. Any choice made by the head company, or taken to have been made by the head company, will be disregarded for leaving entity core rule purposes. On leaving, the leaving entity will be entitled to make a choice effective from the leaving time. At consolidation, if the choices of a joining entity are inconsistent, those choices will be disregarded and the head company will be allowed to make a choice. If before the joining time, the making of an election is relevant to the group, any choices made (or no choice) by a joining entity will be disregarded and the head company will be able to make a new choice. On leaving, the leaving entity will be entitled to make a fresh choice effective from the leaving time if the head company’s choice differs from the entity’s choice before the joining time or consolidation. As regards elections attaching to certain assets, liabilities and transactions that have an ongoing effect, choices made by an entity before joining are taken (at the consolidation/ joining time) to have been made by the head company. This treatment essentially ‘‘sees through’’ consolidation and continues to apply the election to the assets, liabilities and transactions of a consolidated group as it applied before consolidation/joining. Despite this, the head company will be able to choose to have the election apply to all of its assets from the consolidation/joining time. On leaving, the leaving entity will continue to apply the election as it applied before consolidation/joining. If the choice were first made by the head company, the leaving entity will simply inherit the election status of the head company.

MEMBERSHIP OF CONSOLIDATED GROUP [24 050] Formation of consolidated group A consolidated group is formed if an election is properly made to consolidate a consolidatable group of entities. The choice to consolidate is optional. However, if a choice is made, all of the entities in the consolidatable group must be included – this is the ‘‘one in – all in’’ principle. It applies to the entities in a consolidatable group at the time that the choice is made and also to entities which may subsequently join the group. The choice is irrevocable and remains effective until the consolidated group ceases to exist. The 2 exceptions to the ‘‘one in – all in’’ rule are in the case of MEC (see [24 070]) and consolidated groups that have members that are life insurance companies. A wholly-owned 1028

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subsidiary of a life insurance company with membership interests that directly or indirectly are a mixture of complying superannuation assets, segregated exempt assets and/or ordinary assets is precluded from being a member of a consolidated group: see [24 600]. A consolidatable group consists of the head company and all subsidiary members. If an MEC group exists at the beginning of the day specified by the head company in its choice to consolidate, the group comes into existence from the beginning of that day: see Determination TD 2006/26. Similarly, if a consolidatable group comes into existence during a day, the head company can choose that day as the day on which the group is taken to be consolidated: see Determination TD 2006/74.

Head company The identity of the head company is important for several reasons. Once consolidation is chosen, under the single entity theory the entities in the corporate group are regarded as divisions of the head company. The identity of the head company will therefore dictate the tax treatment of the group as a whole. For this reason there are various rules, which seek to ensure that the head company is a corporate entity subject to the normal corporate laws, and taxed at the general corporate tax rate (30%, but note the proposal to reduce the corporate tax rate: see [20 030]). A consolidatable group requires a head company and at least one subsidiary (eg ATO ID 2008/32). It is not possible for a head company to form a consolidatable group by itself: s 703-10(2). Once formed, the consolidated group exists so long as the head company exists. This leads to the rather odd result that a consolidated group may consist of a head company solely if the subsidiary members, subsequent to formation, leave the group. Under s 703-15(2) the following conditions must be met for a head company. 1. The entity must be a company. However, certain corporate unit trusts and public trading trusts are permitted to head consolidated groups on the basis that they are taxed in the same way as companies. The rules allowing these trusts to elect to form a consolidated group are contained in Subdiv 713-C. A corporate limited partnership will meet the company requirement. 2. The company has the general corporate tax rate applied to some or all of its taxable income. 3. The company is not specifically precluded from being a member of a consolidatable group: s 703-20. 4. The company is an Australian resident and not a prescribed dual resident: see [2 030]. 5. The company is not a wholly-owned subsidiary of an entity that meets the requirements, set out in 1 to 4 above. This is to ensure that a company may not qualify as a member of more than one consolidated group. ATO ID 2003/739 confirms a consolidated group ceases to exist when the head company is deregistered as the final step in liquidation.

Subsidiary members The consolidated group consists of the subsidiary members together with the head company. Under s 703-15(2) a subsidiary member must satisfy the following conditions. 1. The entity must be a company, trust or partnership but not one which is specifically precluded from being a member of a consolidatable group: s 703-20. 2. If the entity is a company some or all of its taxable income must be taxable at a rate equal to the general corporate tax rate. 3. The entity must not be a non-profit company. © 2017 THOMSON REUTERS

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4. If the entity is a company or a trust, it must meet the Australian residence requirements (ie it is an Australian resident and not a prescribed dual resident). The single entity test is not relevant in determining whether the test is met, for example, if a company incorporated offshore carries on business in Australia as a result of carrying out intra-group activities (see ATO ID 2009/8). Further, partnerships do not need to satisfy the residence criteria. The Commissioner has confirmed that the foreign hybrid rules have effect for consolidation purposes, so that an incorporated entity treated as a partnership under those rules (see [22 440]) will not have to meet the residence requirements (see ATO ID 2009/149). 5. The entity must meet the ownership requirements as a wholly-owned subsidiary of the head company, which requires all membership interests in the subsidiary to be ‘‘beneficially owned’’ by the holding entity or one or more wholly-owned subsidiaries either alone or in combination. In the explanatory memorandum to the Tax Laws Amendment (2004 Measures No 6) Act 2005, beneficial ownership is considered as meaning the ‘‘real owner’’ of the property and, if legal and equitable ownership is divided, the ‘‘owner of the property in equity’’. Beneficial ownership is not affected by a member of a consolidated group being in liquidation or under administration. It is possible to be a subsidiary member notwithstanding that there are interposed entities: see below. ATO ID 2003/654 confirms that a subsidiary ceases to be a member of a consolidated group under s 703-15(2) when it is deregistered at the end of a voluntary deregistration process. If a company’s registration is subsequently reinstated, it is treated as having continuously satisfied the requirements in s 703-15: see Determination TD 2007/15. With certain exceptions, the tax costs of assets of a subsidiary member of a consolidated or MEC group are not set under Divs 701 and 705 if some of the membership interests in the subsidiary member are directly held by entities outside the group: Determination TD 2005/43 (and see [24 300]).

Precluded entities Under s 703-20 certain entities cannot be members of a consolidatable group. In other words these entities can be neither head companies nor subsidiary members. These precluded entities are: • an entity of any kind whose total ordinary income or statutory income is exempt under Div 50 ITAA 1997: see [7 350]-[7 480]; • certain credit companies which are recognised credit unions: see [20 170]; • a PDF: see [11 500]; and • a trust, which is a complying superannuation entity, a non-complying ADF or a non-complying superannuation fund: see [41 060]-[41 110].

Interposed entities Generally, an entity can only be a member of a consolidatable group if it is a wholly-owned subsidiary of the head company. However, it is possible for an entity to qualify as a subsidiary member notwithstanding that it is wholly or partly owned by an entity which itself does not qualify as either a head company or subsidiary member. • If the entity is held through a non-fixed trust: s 703-40. This section treats the trust as a fixed trust for the purposes of determining whether the head company wholly owns the subsidiary. • If the interposed entity acts in the capacity of nominee: s 703-45. The subsidiary can still qualify as being wholly-owned by a member of the group where the interposed entity holds the interest as a nominee for the head company or a subsidiary of the head company. 1030

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• If an authorised deposit-taking institution (ADI) issues certain preference shares: s 703-37. This section treats an ADI that issues preference shares as if it is a wholly-owned subsidiary of the holding body. The section is designed to facilitate the restructure of financial groups that contain ADIs. • Certain non-resident entities: see s 701C-30 TPA. Only groups that consolidate in the transitional period may have non-resident entities interposed between the members of the group. Also, the holding must be in place at the time the consolidated group is formed. These entities are described as transitional foreign held entities. Note that special cost setting rules apply to these entities which treat them as part of the head company rather than a separate entity (see also Determination TD 2005/44). This results in the existing tax costs of the assets of these entities being retained: see s 701C-310 TPA and Determination TD 2005/41. An Australian resident subsidiary that qualifies as a transitional foreign held entity of a consolidatable or potential MEC group must be included as a member of the consolidated group when it consolidates: Determination TD 2005/40. • Employee share schemes. In certain circumstances, employee share scheme (ESS) interests held by employees will be disregarded and will not prevent a company being treated as a wholly-owned subsidiary. In order to qualify for the exception, the ESS interests must not exceed 1% of the total equity of an entity. There are a number of additional criteria that must be met. Although similar to the requirements for a qualifying ESS under Div 83A ITAA 1997 (see [4 150]-[4 260]), the requirements are not identical (eg shares or rights do not have to be issued at a discount to their market value): s 703-35.

Interposed shelf head company The general rule is that a consolidated group ceases to exist if there is no longer an eligible head company. However, provided certain conditions are met, it is possible to interpose a company between shareholders and the company that was formerly regarded as the head company without terminating the consolidated group. In order for the deconsolidation exception to apply, the new head company must be interposed between the original company and its shareholders through a share for share exchange pursuant to which the company becomes the owner of all the shares in the original head company and the interposed company must make an irrevocable choice that the consolidated group is to continue: ss 703-65 and 703-70. The consequence of the interposition, if the election is made, is that the former head company becomes a subsidiary member of the group (s 703-70(2)) and everything that happened to the former head company will be taken to have happened instead to the interposed company as if the interposed company had been the head company from the outset: s 703-75. This is referred to in the explanatory memorandum as the ‘‘substitution rule’’ (see ATO ID 2007/106 and ATO ID 2007/107). The relevance of the debt/equity rules The debt/equity rules contained in Div 974 ITAA 1997 (discussed in Chapter 31) are relevant to the question of ownership. The ownership tests for consolidation purposes rely on the concept of ‘‘membership interests’’. An interest in an entity will not be regarded as a membership interest even if it is a share where it is treated as a debt interest under Div 974: s 960-130. However, the reverse is not true. An interest which is regarded as being an equity interest under Div 974 will not be treated as a membership interest if it is debt in legal form. So, for example a convertible note, which is a non-share equity interest under Div 974, cannot give rise to a membership interest. When beneficial ownership changes A change in beneficial ownership happens at the time a vendor ceases to be entitled, and the purchaser becomes entitled, to be registered as the holder of the shares: s 703-33. © 2017 THOMSON REUTERS

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[24 060] Election to consolidate The choice to consolidate is made by the company that is the head company of the consolidatable group on the start date for consolidation. The choice must be in writing and must be made no later than the day the group’s first consolidated income tax return is lodged (or the due lodgment day if a return were required to be lodged): s 703-50(3). If a consolidated group comes into existence on the day specified in the choice to consolidate, the head company will have to provide certain specified information (in the approved form) about the consolidated group: s 703-58. The head company must also give notice to the Commissioner in the approved form within 28 days of an entity becoming a member of a consolidated group or within 28 days of the exit of a subsidiary member from a consolidated group: s 703-60. The head company must also notify the Commissioner in the approved form, within 28 days of a group ceasing to exist. [24 070] Multiple entry consolidated (MEC) groups Companies may be eligible for relief under the group loss transfer and CGT roll-over rules, notwithstanding that there is no common Australian parent company. As discussed at [24 050] the normal membership rules for consolidated groups require a single resident head company and resident wholly-owned subsidiaries. The MEC group rules extend the ability to consolidate beyond groups that have a single resident Australian holding company. This enables these groups to work out their income tax liability as though they are a single entity: see Subdiv 719-A. MEC groups are not subject to the ‘‘one in – all in’’ rule that applies to other consolidated groups (see [24 050]). The Board of Taxation raised concerns about inconsistencies in the tax treatment for MEC groups used by multinationals and ordinary consolidated groups. As a result, proposed amendments (applicable from 1 July 2014) would ensure that MEC groups would not be able to access tax benefits not available to domestic consolidated groups (see the then Assistant Treasurer’s media release No 068, 14 May 2013). It seems that the previous Coalition Government was prepared to implement these measures (see the then Treasurer’s and Assistant Treasurer’s joint media release (item 6), 6 November 2013). Key concepts in identifying whether a MEC group exists are set out below. Top company This is a foreign resident company and must not be a wholly-owned subsidiary of another company: s 719-20. There are exceptions to this, such as where the top company is owned by an Australian resident company which is a prescribed dual resident or which is specifically excluded from being a member of a consolidated group or where no part of its taxable income would be taxable at a rate that is at least the general corporate tax rate (30%, but note the proposal to reduce the corporate tax rate: see [20 030]). Tier-1 company A tier-1 company must be a wholly-owned subsidiary of the top company: s 719-20. It must be an Australian resident and not a prescribed dual resident. A tier-1 company must have at least some of its taxable income taxed at a rate that is at least the general corporate tax rate, must not be of a type which is specifically excluded from being a member of a consolidated group (see [24 050]) and must not be a wholly-owned subsidiary of an Australian resident company. Since any tier-1 company could become the provisional head company of a MEC group, tier-1 companies must be companies as defined in s 995-1: see [24 050]. Eligible tier-1 companies A company is an eligible tier-1 company if there are no interposed entities between it and the top company: s 719-15(2). One exception is if the membership interest in the tier-1 company is held by an entity as nominee for another tier-1 company or for an entity that is a wholly-owned subsidiary of another tier-1 company. Another exception is if part of the equity 1032

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in the tier-1 company is held by employees under an employee share scheme. Only eligible tier-1 companies and their subsidiaries can become members of the MEC group. Note that it is not necessary for all the eligible tier-1 companies of a foreign-owned group to form a single MEC group: Determination TD 2005/38. This means that for any foreign-owned group with more than one eligible tier-1 company, several potential MEC groups may be formed. An Australian resident company can qualify as an eligible tier-1 company of a MEC group if a foreign resident entity is interposed between the Australian resident company and the top company of the group: Determination TD 2005/39.

Provisional head company A company is eligible to be the provisional head company of a MEC group if it is an eligible tier-1 company of the top company and no membership interests in it are beneficially owned by other members of the MEC group: s 719-65. This option remains open if the MEC group has been reduced to a single tier-1 company (see ATO ID 2007/165). Wholly-owned subsidiary The concept of a wholly-owned subsidiary is discussed at [24 050]. Similar rules dealing with entities held through non-fixed trusts and employee share schemes as discussed at [24 050] apply in relation to MEC groups: ss 719-30, 719-35. Potential MEC group The members of a potential MEC group include: (a) all Australian resident companies that are wholly-owned subsidiaries of an eligible tier-1 company of a top company from which the potential MEC group is derived; (b) all Australian resident trusts that are wholly-owned subsidiaries of an eligible tier-1 company of a top company from which the MEC group is derived; (c) all partnerships that are wholly-owned subsidiaries of an eligible tier-1 company of a top company from which the potential group is derived.

* Either Company A or Company B is eligible to be the provisional head company. The MEC group is then Eligible Tier-1 Company A, Eligible Tier-1 Company B and Wholly Owned Subsidiary C.

[24 080] Formation of MEC group A MEC group can be formed either by (s 719-5): © 2017 THOMSON REUTERS

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(a) choosing (under s 719-50) to form a MEC group. The choice must be made in writing (s 719-5(4)). As to the requirements for the written choice, see GE Capital Finance Pty Ltd v FCT (2011) 84 ATR 128, where the Federal Court held it was not necessary to specify the time for joining as that will follow from the operation of the law. This may be made by 2 or more eligible tier-1 companies jointly notifying the Commissioner of their decision to consolidate the potential MEC group derived from those eligible tier-1 companies. A MEC group can only be formed when there are at least 2 eligible tier-1 companies of the same top company. However, unlike a normal consolidated group, it is not necessary for the eligible tier-1 companies to have wholly-owned subsidiary companies to make the election. Moreover, there is no restriction on the number of MEC groups that are formed in relation to the same top company. In this way, the ‘‘one in – all in’’ rule does not apply to MEC groups (see Example [24 080.10] below); or (b) a special conversion event occurring. This describes the conversion of a consolidated group to a MEC group. The conversion will occur if there is an existing consolidated group, the head company of which is an eligible tier-1 company of a top company and there is at least one other company which becomes an eligible tier-1 company of the same top company: s 719-40 (eg see ATO ID 2006/146, ATO ID 2006/148 and ATO ID 2010/4). In order for a MEC group to form in these circumstances, the requisite notification must be given to the Commissioner. Subdivision 719-BA applies if an MEC group is created from a consolidated group. The effect of the Subdivision is to minimise the impact of the conversion for ongoing members. Certain provisions which normally would apply on cessation of a consolidated group will be ‘‘switched off’’; for example, the tax cost setting rules will not apply to the assets of the old group and therefore certain capital gains and losses will not arise, tax losses of the old group will not be tested and the new group will retain the history of the old group. EXAMPLE [24 080.10] In the group structure illustrated below, A Co and B Co may form a separate MEC group to C Co and D Co. E Co may choose not to be a part of any consolidated group. Since F Co wholly owns G Co it may choose to form a consolidated group.

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[24 090] Post-formation transactions affecting MEC group An election to form a MEC group is irrevocable, so that it is not possible to simply elect to leave the MEC group: s 719-50(2). However, an entity will fall outside the group if it is ineligible to continue to be a part of that group. This may occur if the ownership changes so that the entity is not a wholly-owned subsidiary, or if an ineligible entity is interposed in the ownership chain. An entity leaving the MEC group does not of itself cause the MEC group to cease to exist. When the entity departs the MEC group, a calculation is undertaken to assign a cost in the membership entity to the head company: see [24 420]. Cessation of MEC group There are 3 circumstances where a MEC group will cease to exist (s 719-5(7)): (a) if no eligible tier-1 companies of the top company remain. Although it is necessary to have more than one tier-1 company to form a MEC group, a MEC group can continue in existence notwithstanding only one tier-1 company remains below the top company. If this occurs, the Australian resident entities may choose to form a consolidated group (see Example [24 090.10] below); (b) the MEC group will cease to exist if the common foreign parent changes and the eligible tier-1 companies also change. This could occur if the top company itself becomes a wholly-owned subsidiary of another foreign company. A change in the top company will not of itself affect the continuity of the MEC group if the identities of the eligible tier-1 companies remain unchanged; (c) there is no longer a provisional head company for the MEC group. A MEC group can continue to exist following the failure of a provisional head company to satisfy the relevant conditions, provided another eligible tier-1 company is nominated as a replacement provisional head company within the 28-day notice period provided for in s 719-80. The Commissioner has the discretion (in s 388-55 in Sch 1 TAA) to defer the time for lodgment of the notification. EXAMPLE [24 090.10] In the structure illustrated below, if A Co were to dispose of some of its interests in B Co so that B Co no longer qualified as an eligible tier-1 company, then B Co could nonetheless form a consolidated group with C Co. A consolidated group will also cease to exist when a special conversion event happens under s 719-40 in relation to it (see [24 080]): see ATO ID 2006/145 and ATO ID 2006/147.

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The sale of a non eligible tier-1 company subsidiary to a wholly owned foreign subsidiary does not mean Subco ceases to be a member of the MEC group at any time. Provided the provisional head co so elects, Subco may continue in the MEC group – as an eligible tier-1 company (see ATO ID 2010/141).

Conversion of MEC group to consolidated group If an MEC group includes only one eligible tier-1 company and the MEC group ceases to exist only because that company ceases to be an eligible tier-1 company, a consolidated group comes into existence at that time provided the company is a head company (as defined in s 703-15: see [24 050]): s 703-55. The consolidated group will consist of that company and every entity (if any) that was a subsidiary member of the MEC group. Subdivision 719-BA (see [24 080]) will operate to ameliorate negative impacts on ongoing members from the conversion. Thus, for example, the rules which deem a continuity of ownership test failure (s 719-280) will not apply. [24 100] Interposed foreign entities The interposition of a foreign resident entity between subsidiary companies of eligible tier-1 companies does not necessarily dissolve the MEC group. The rules for interposed foreign resident entities differ according to whether the resident entity being tested is a company, a trust or a partnership. If the entity being tested is a company, it may be eligible to be a member of a MEC group formed before 1 July 2004 if it is itself owned by an interposed foreign resident entity or entities. However, a resident trust cannot become a member of a MEC group if that trust is directly owned by an interposed foreign resident entity. ATO ID 2009/44 indicates that the interposition of a partnership of foreign wholly owned subsidiaries of the top company will not cause the MEC group to dissolve. [24 110] Notification requirements The eligible tier-1 companies of a potential MEC group can jointly make a choice to form a MEC group on or after the date specified in the choice: s 719-50. The requirements are broadly similar to those for a consolidated group. The choice does not need to be given to the Commissioner, but certain information about the group will have to be provided (in the approved form): s 719-76. Once the choice is made, it is irrevocable. Neither the decision to form a MEC group nor the date it takes effect can subsequently be altered. The choice must be made in the period up to the day that the head company of the group lodges the consolidated income tax return for the commencement year. 1036

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[24 160]

TREATMENT OF TAX LOSSES IN CONSOLIDATION [24 150] Introduction A consolidated group can utilise the losses made by joining entities before the time they joined the group. However, simply allowing pre-joining time losses to be transferred into a consolidated group without limitation would result in a detriment to the revenue as losses could be deducted at a greater rate than under the general loss rules. The consolidation rules therefore restrict the benefits of tax losses in 2 ways. • The ability to transfer losses into a consolidated group is tested by applying modified versions of the continuity of ownership and same business tests to the entity seeking to transfer the losses. • The rate the transferred losses can be used is restricted by the ‘‘available fraction’’ which seeks to approximate the rate the losses could have been used by the entity on a stand-alone basis.

[24 160] Transfer of losses under consolidation rules – general If an entity wants to transfer losses to the head company of a group, it follows a 3-step process. 1. It calculates its taxable income/loss for the period up to the time it joins the group. 2. It identifies the amount of its unused carry forward losses as at the joining time. 3. It determines whether these losses satisfy the modified tests applying to consolidated groups. The losses that may be transferred are tax losses and net capital losses: s 707-110(2). When an entity (the joining entity) becomes a member of a consolidated group (the joining time), whether as head company or a subsidiary member (s 707-120(1)), its unused carry forward losses are transferred into the group provided that certain tests are satisfied at the relevant time. Broadly, these tests are modified versions of the continuity of ownership test (COT) and the same business test (SBT). These rules test whether the joining entity could have satisfied either the same ownership or same business tests throughout a notional claim year (ie 12 months ending at the joining time): see [20 310] and following for a discussion of the general loss recoupment tests. The 4 tests that apply depending on the type of entity are: • the COT; • the control test; • the SBT; or • the pattern of distribution test. If losses can be transferred into the group, these losses are deemed to have been made by the head company so the head company can use the loss, provided the head company satisfies the COT and SBT. Losses that do not satisfy either the COT or SBT cannot be used by any entity. Note that if the joining entity is also the head company of the group, the losses it generated as a single entity are transferred to itself in its capacity as head company. These rules are contained in Subdivs 707-A to 707-D. The following flowchart shows the relevant tests to be applied in determining whether a loss can be transferred from a member of a consolidated group to the head company. © 2017 THOMSON REUTERS

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[24 170] Continuity of ownership as transfer test As the trial year ends immediately after the joining time (s 707-120(2)(b)), the continuity of ownership test (COT) is satisfied if the same majority ownership of the joining entity was maintained from the start of the income year in which the loss was made until just after the joining time. The reason why the test period ends just after the joining times is to catch the ownership changes that occur as a result of consolidation itself. The trial year is generally the 12 months which ends just before the joining time. However, in certain circumstances, the trial year may be less than 12 months, eg if the entity did not exist for the whole 12 months or the entity was previously a subsidiary of another consolidated group: s 707-120(2). Under the consolidation rules, a joining entity’s loss may be transferred to the head company if those losses could have been used by the joining entity in the ‘‘trial year’’ assuming it had sufficient income or gains of the relevant type: s 707-120. EXAMPLE [24 170.10] Kalhari Co has owned 40% of Assaad Co since Year 1. In Year 3 Assaad Co incurs $10m in tax losses which are carried forward. In Year 6 Kalhari Co acquires the remaining 60% of Assaad Co, at which time the companies form a consolidated group. The COT test will not be satisfied for the trial period since there will have been a greater than 50% change in the ownership of Assaad Co in the 12-month period ending just after consolidation.

The ownership test period starts at the beginning of the year the loss was incurred which may be before or after the start of the trial year. A company satisfies the COT if, from the start of the income year in which it made the loss until immediately after the joining time, the same individuals have: • control of more than 50% of the voting power in the company; • rights to more than 50% of the company’s dividends; and • rights to more than 50% of the company’s capital distributions. See [20 320] for a detailed discussion of the COT. If the COT and tainted change in control test are met, the joining entity’s losses may be transferred to the head company. If the COT and tainted change in control test are not met, the joining entity’s losses may still be transferred if it passes the SBT. 1038

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[24 190]

The 50% stake test (see [23 1000]) for trusts operates in a similar manner. If the entity is a non-fixed trust, it must also pass the pattern of distributions test, if relevant, (see [23 1090]) and a control test: see [23 870].

[24 180] Control as transfer test The joining entity must also satisfy the ‘‘tainted change in control test’’. Broadly, this looks to control of voting power for the purpose of gaining a tax advantage. This test is also applied from the start of the income year in which the loss was made until just after the joining time. [24 190] Same business test as transfer test The same business test (SBT) (in s 165-210) when used to test the recoupment of losses compares the business that the company carried on immediately before the time when the COT is failed with the income year in which the loss is claimed. See [20 360] for a detailed explanation of the SBT. Ruling TR 2007/2 explains how the concepts which apply to the operation of the SBT for a single entity apply in the context of consolidated and MEC groups. In order to satisfy the SBT requirements that the business conducted by the head company of the group is the same throughout the SBT period and at the test time, the ruling states that it is necessary to look at the businesses carried on by all the subsidiary members of the group at these times to determine the nature of the ‘‘overall business’’ carried on by the head company. Similarly, in applying the new business and transactions tests, the head company must consider transactions carried on or entered into prior to the test time and during the SBT period by all the members of the group at these times. The ruling states that it is not necessary that a business carried on during the SBT period by an entity in the group be of a kind carried on by that same entity before the test time, provided a group member carried on the activity during the period before the test time. Also, as a result of the single entity rule, the new business test can be satisfied if the business carried on by the head company during the SBT period is of a kind carried on by any entity that is a group member during the period before the test time. Under the consolidation rules, the period during which the SBT applies is modified. SBT is tested by reference to the ‘‘trial year’’. The trial year is the year ending just before the joining time. (Contrast this with the COT test where the trial year ends just after the joining time.) This is achieved by assuming that the business carried on by the joining entity at and just after the joining time is the same as the business it carried on just before the joining time: s 707-120(3). Without the trial year concept, there might be practical difficulties in applying the SBT, since the period between when the COT was failed and the joining time would be the test period and these times are likely to coincide in the usual case where a majority of shares in a company are acquired, thus bringing that company into consolidation. The SBT differs according to the loss year: • in respect of pre-1 July 1999 losses, the SBT is applied just before the COT was first failed and the trial year: s 707-125; and • a stricter SBT test applies in respect of post-30 June 1999 losses. Broadly, the SBT is applied just before the end of the income year in which the loss was made, the income year in which the joining entity fails the COT and the trial year: s 707-125. Note that, for the purpose of applying the SBT, the entry history rule (see [24 020]) does not operate: s 165-212E. As a result, the head company of a consolidated group does not need to take into account the history of a subsidiary member prior to the time of joining the group to determine whether it can satisfy the SBT.

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EXAMPLE [24 190.10] Truong Ltd incurs a loss in the year ended 30 June Year 1. On 1 July Year 5 all the shares in Truong are acquired by the head company of an existing consolidated group. Under s 707-125 the position of the business of Truong for the year ended before 1 July Year 5 (the income year the COT was failed which overlaps the trial year) must be compared with its position at 30 June Year 1 (the end of the year the loss was made).

Listed public companies and their 100% subsidiaries The SBT as applied to listed public companies and their 100% owned subsidiaries (in Div 166) only requires the SBT to be applied when there is abnormal trading in their shares (see [20 550]-[20 590]). These tests are modified by ss 707-120(1) and 707-125(1) and (4): • in respect of pre-1 July 1999 losses, the SBT is applied just before the joining entity first fails COT as a result of testing at prescribed times, and the trial year; • for post-30 June 1999 losses testing occurs at 3 points: just before the end of the income year when the loss was made, the income year in which the joining entity first fails COT as a result of testing at prescribed times, and the trial year.

Additional test for losses previously transferred under the SBT If the SBT is satisfied, the transferred loss will be ‘‘tagged’’ as subject to the additional test if it is transferred again: s 707-135. An additional test applies to the subsequent transfer of a loss that was previously transferred because the SBT was satisfied. Under this additional test, the SBT loss may only be transferred again if the transferee carried on the same business: • just before the end of the income year in which the loss was previously transferred to it; and • during the trial year. If the SBT is met, the joining entity’s losses may be transferred to the head company. If the SBT is not satisfied, the joining entity’s losses cannot be used by any entity for any income year ending after the joining time: s 707-150.

[24 200] Can transferred losses be utilised? If an entity has transferred losses to the head company under Subdiv 707-A (including where the head company is taken to have transferred losses to itself: see [24 160]), that will not automatically entitle the head company to utilise the losses. The head company must satisfy modified versions of the loss recoupment tests in Subdiv 707-B before it can use the losses. Because a head company is taken to have made losses transferred to it in the income year in which the transfer occurred, pre-consolidation ownership changes in the original loss entity are effectively erased. In the absence of the further loss recoupment test, all transferred losses would be refreshed in the hands of the head company. That outcome is considered inappropriate if the original loss entity is a company and the loss is transferred because the COT is passed. It would allow a faster use of losses than would occur outside consolidation and would therefore place loss companies that consolidate at a considerable advantage to non-consolidated companies. A head company must satisfy the modified loss recoupment test before it can use a loss, if the losses were transferred because the COT was passed. The tests do not apply if a loss was transferred because the SBT was satisfied or if part of a tax loss is transferred under s 165-20 (see [20 330]) (Determination TD 2006/75): s 707-210(1) and (1A). In addition, the tests do not apply if both the COT and the SBT in s 165-15(2) and (3) (the ‘‘control SBT’’) 1040

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[24 200]

are passed. (This is the SBT that applies if the control test in s 165-15(1) is failed). If the control SBT is passed, the loss is categorised as an SBT loss (even though the COT was also passed): s 707-210(1A)(b). This is an interesting and perhaps unexpected result. If a loss company, on joining a group, fails the COT but passes the SBT so that losses are transferred to the head company the SBT losses are effectively ‘‘refreshed’’: s 707-210(1). The COT has been failed so there is no need to continue to monitor compliance. There is also no need to maintain the same business going forward in the loss entity. Continuing to monitor a subsidiary’s compliance with the SBT on a stand-alone basis would be contrary to the single entity theory that underpins consolidation. In contrast, if the COT is passed there is a requirement to continue to monitor continuity of ownership, using the method and assumption described below. This may mean there are circumstances where failing the COT is preferable to passing it on joining a consolidated group. The general loss recoupment tests in Subdiv 707-B are modified in 2 ways. • First, the rule that the transferred loss is taken to have been made by the head company is reversed. This treats the loss as having been made by the test company for the income year in which it was actually made: s 707-210(4)(a). If the test company and the head company are the same entity, the modification reinstates the original loss year: s 707-210(4)(b). • Second, anything that happens after the transfer time to membership interests or voting power in a subsidiary of the group at the transfer time or an entity interposed between the test company and the head company at the transfer time, and that would be relevant in determining whether the test company passed the COT, is taken not to have happened: s 707-210(4)(c). As a result, intragroup ownership/voting power changes and changes in the ownership of interposed entities are ignored in determining whether the loss can be used. It effectively only tests changes above the head company level. If the losses are subsequently transferred again to a head company of another consolidated group, the tests are again modified. After the transfer, anything that happens to membership interests or voting power in the old head company or an entity interposed between the old and new head companies, that would be relevant in determining whether the test company passed the COT, is taken not to have happened: s 707-210(4)(d). Therefore, only changes above the new head company level are taken into account. The test company is the company to which the modified loss recoupment tests are applied to determine whether the head company can use the loss. The test company is the first company to have made the loss, either because it actually made the loss or because it was an earlier head company to which the loss was transferred. However, if the loss was transferred by a company as an SBT loss, the transferor company is not the test company; the most recent head company (the transferee) is the test company: s 707-210(3). If the test company would have failed the COT, the head company is taken to have failed the COT and must satisfy the SBT if it is to use the losses it has received. The time that the head company is taken to fail the COT for the purposes of applying the SBT is the first time the test company would have failed the COT or, if Div 166 relating to listed public companies applied, just before the end of the test company’s test time (the time of abnormal trading in the test company or the end of the test company’s income year) that triggered the failure of the COT: s 707-210(5). If the test company made the loss because of a transfer from another entity, Divs 165 and 166 operate in relation to the test company as if its loss year started at the time of the transfer: ss 707-210(7) and 707-205(2).

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EXAMPLE [24 200.10] This example is adapted from Example 7.5 of the Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No 1) 2002. Head Co initially holds 80% of Loss Co. On 30 June Year 2, Head Co acquires X Co’s 20% interest in Loss Co. Head Co then chooses to form a consolidated group (comprising Head Co, Loss Co and Z Co) from 1 July Year 2. The loss year is the income year starting on 1 July Year 1 and ending on 30 June Year 2. On consolidation, Loss Co’s loss is tested to determine whether it is transferred to Head Co. (The rule that preserves the history of a COT loss does not apply to the initial transfer of a loss so it is not relevant at this point.) Assuming Head Co’s acquisition of the final 20% of Loss Co was the only change in the ultimate beneficial ownership of Loss Co since the start of the loss year, the loss is transferred to Head Co as a COT loss. In determining whether Head Co can use the loss, the rule that preserves the ownership history of a COT loss applies. Head Co can use the loss if Loss Co could have used it assuming there were no changes in Head Co’s interest in Loss Co after Loss Co joined the group. Between the time the group was formed (1 July Year 2) and the end of the loss claim year (30 June Year 4) Head Co disposed of Loss Co and, as a result, Loss Co has left the group. This is irrelevant in determining whether Head Co can use the loss, because intragroup ownership changes after the loss was transferred are ignored. However, after the group formed, A sold 40% of its interest in Head Co to B. By itself, this sale would not cause Head Co to fail the COT. But because the rule requires examination of Loss Co’s ability to claim the loss, the 20% change that occurred before consolidation (when Head Co acquired X Co’s 20% interest in Loss Co) is also relevant. When the pre-consolidation changes in Loss Co are taken into account, together with the post-consolidation changes in Head Co, it can be seen that only 48% of Loss Co’s ultimate beneficial ownership has continued from the start of the loss year until the end of the loss claim year. This means that Head Co fails the COT and so can only deduct the loss if it passes the SBT.

[24 210] Modified application of COT to MEC groups In the case of a MEC group, in determining whether the head company has passed the COT in respect of a group loss or a transferred loss other than a transferred COT loss, the ownership of the group’s top company is tested. The test is applied from the transfer time or the start of the income year for which the group loss was made. In the case of a transferred COT loss, the ownership of the transferor is tested subject to certain assumptions. The test is applied from the start of the transferor’s loss year. In applying the SBT to the new head company of a MEC group, Subdiv 719-F requires the new head company to take into account the group’s business history and not things that happened to the new head company as a single entity before it joined the group. [24 220] Rules for loss bundles There are 2 categories of carry forward losses that a group may use to reduce its income: • group losses – losses generated by the consolidated group; • transferred losses – losses generated by a joining entity (the ‘‘real loss-maker’’) before it joined a group and which it transfers to the head company of a consolidated group (the ‘‘joined group’’). The available fraction method (see [24 230]) and concessional method for the utilisation of losses apply only to transferred losses. At the time an entity transfers losses of any ‘‘sort’’ (the ‘‘initial transfer time’’), which have not been previously transferred, the losses form a ‘‘bundle’’: ss 701-1(4) and 707-315. 1042

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[24 230]

All the losses transferred by the real loss-maker form a single bundle. Losses of the following types will constitute a different ‘‘sort’’ of loss: • tax loss; • film loss; and • net capital loss. The loss bundle continues to exist if it is transferred again, provided it includes at least one loss of any sort that could be utilised or otherwise reduced by an entity: s 707-315(3). A loss ceases to be included in a bundle at the first time at which it can no longer be utilised or reduced by an entity: s 707-315(4). Group losses of a particular sort must be used before transferred losses of the same sort: ss 707-305(2) and 707-310(3)(b). This creates the prospect that some part of the transferred losses may be disallowed. The longer the loss remains unused, the greater the chance that circumstances may change so that the loss cannot be used as the COT may be failed due to changes in the ownership of the head entity: see [24 200]. The rationale for this is that under Div 170 a company can only benefit from a transferred loss after it has used the losses it has generated itself. In utilising group losses, rules ensure that if a company uses less than the available amount of group losses it cannot use transferred losses before group losses of the same kind. Also the amount of transferred losses that can be used is reduced by the amount of available franking offsets. Transferred losses are taken to have been made by a head company for the income year in which the transfer occurred: s 707-140. A transferred loss may be used in the same income year in which the head company is taken to have made it: s 707-140(2). This overrides the general rule that an entity may only deduct or apply losses from earlier income years. Losses in different bundles will have different ages if the bundles were acquired by the head company in different income years. There is no requirement that a bundle containing earlier losses must be exhausted before drawing upon a bundle containing later losses.

[24 230] Available fraction method Subdivision 707-C (ss 707-305 to 707-345) limits the use of transferred losses by a consolidated group. It contains the main method for the utilisation of transferred losses, known as the available fraction method. Subdivision 707-C of the TPA contains certain transitional concessions relating to the utilisation of losses. The value donor concession allows the available fraction for the purposes of the available fraction method to be increased in certain circumstances: see [24 260]. The concessional method is an alternative method for the utilisation of losses which is only available for groups that consolidated in the transitional period before 1 July 2004. The purpose of Subdiv 707-C is to enable the transferee to use the transferred losses for an income year only to the extent to which it has income or gains for the income year, after reduction of other losses and deductions, and to ensure that the transferred losses are used at approximately the same rate they would have been used by the joining entity had it remained outside the group: s 707-305. The consolidation rules attempt, in broad terms, to replicate the tax result under the pre-consolidation regime. Under those rules (in Div 170 ITAA 1997), if a company which had a carry forward loss has a change of ownership, it was restricted to using the carry forward loss against income which the company generated itself. In consolidation, restricting use of losses by joining entities to their stand-alone income would be contrary to the single entity core rule. The solution is the available fraction methodology. This uses market value as a proxy for income generation. In essence it looks to the market value of the joining entity and concludes that the higher the market value, the greater would have been the ability of the joining entity to use its losses on a stand-alone basis – and, accordingly, the greater is the rate of loss utilisation allowed in consolidation. © 2017 THOMSON REUTERS

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The main object of Subdiv 707-C is to limit the amount of transferred losses a head company can use by giving effect to the following principles: s 707-305(1), (3). • The head company should only be able to use transferred losses for an income year to the extent it has income or gains for the income year. • The head company should only be able to use transferred losses to the extent the entity which transferred the losses could have used them, had it not become a member of the consolidated group. To give effect to these principles, the Subdivision assumes that the income and gains of entities which transferred losses to a head company for an income year will not exceed the head company’s income or gains for an income year and that the transferor’s income or gains for the year would have equalled a fraction of the head company’s income or gains for the year: s 707-305(4). The available fraction for a bundle of losses is calculated to the nearest 3 decimal places, rounding up if the 4th decimal place is 5 or more: s 707-320. If rounding to 3 decimal places results in an available fraction of nil, the available fraction for a bundle of losses will be rounded to the first non-zero digit, rounding up if the next digit is 5 or more.

[24 240] Calculation of available fraction The amount of losses in a bundle that can be utilised by the transferee is limited by reference to an available fraction for the bundle: s 707-310(1). The application of the available fraction method can be reduced to 3 steps. 1. The group’s total income or gains for each of the categories listed in column 1 of the table in s 707-310(3) is determined according to column 2 of the table (taking into account s 707-310(3A)), then reduced by any relevant deductions including group losses and concessional losses. 2. The group’s remaining income or gains for each category are multiplied by the bundle’s available fraction and the result is taken to be the head company’s only income or gains: s 707-310(3). 3. Once the head company’s only income or gains have been determined, a notional taxable income for the head company must be determined. The amount of transferred losses of each sort from the bundle used in working out the notional taxable income is the amount of transferred losses of those sorts from the bundle that can be used by the head company when it works out its actual taxable income: s 707-310(1) and (2). Transferred losses from the relevant bundle are the only deductions to be taken into account in working out the notional taxable income (since all other deductions are taken into account in working out the category amounts): s 707-310(4) and (5). Tax losses must first be deducted against exempt income under the general loss rules. Those rules would ordinarily require the head company to use any transferred tax losses against the group’s total exempt income, rather than a fraction of it. To prevent this outcome, a special rule in s 707-340 enables a head company with exempt income to use losses against assessable income, provided that the losses have been used against exempt income to the same extent they were used under the process of determining the group’s notional taxable income (ie losses are only used against a fraction of the exempt income). The available fraction for a bundle of losses is the proportion the joining entity’s modified market value bears to the market value of the group at the initial transfer time. The available fraction is calculated according to the following formula: (s 707-320(1)): Modified market value of the real loss-maker at the initial transfer time Transferee’s adjusted market value at the initial transfer time

The transferee’s ‘‘adjusted market value at the initial transfer time’’ is the head company’s market value, ignoring its losses including any losses transferred to the transferee 1044

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at the transfer time (see ATO ID 2003/971) and franking account balance: s 707-320(1). The transferee’s adjusted market value represents the market value of the group because, owing to the single entity rule (s 701-1), the value of the head company includes the value of subsidiary members of the group (see [3 210] for ‘‘market value’’). The real loss-maker’s ‘‘modified market value’’ at the initial transfer time is its market value, assuming that (s 707-325): • it has no losses and the balance of its franking account is nil; • the subsidiary members of the group are separate entities (which overrides the single entity rule discussed at [24 020]); • its market value does not include any amounts attributable (directly or indirectly) to a membership interest in another group entity which is a corporate tax entity or transferred losses to the head company; and • the contribution to market value made by a trust (that is not a corporate tax entity or has transferred losses to the head company) is limited to the amount of the real loss-maker’s fixed entitlements to income or capital of the trust. The real loss-maker’s losses and franking account are ignored because those attributes do not enhance the entity’s income producing capacity. The interests the real loss-maker holds in other group entities are ignored because the amounts attributable to those membership interests are reflected in the market value of the other group members and should not be counted twice. To prevent entities joining a group from inflating their market values before consolidation, an increase in the value of a loss entity is excluded from its modified market value if the increase was due to (s 707-325(2)): • an injection of capital into the loss entity or its associate, or the associate of the trustee if the entity is a trust (Ruling TR 2004/9); or • a non-arm’s length transaction involving the loss entity, its associate or the associate of the trustee. These rules prevent a loss entity from inflating its market value before it joins a consolidated group in order to obtain a higher available fraction. The limitation applies to events that occur in the 4 years before the loss entity joins the group. Determination TD 2006/18 deals with how the rules apply where money is received under a publicly listed share offer. The capital injection rules do not apply if there is an injection of capital into a listed public company through a dividend reinvestment scheme, provided the entity to which the shares are issued held a share in the listed public company before the capital injection. In addition, the rules do not apply to an acquisition of shares under an employee share scheme if the scheme is eligible for the 1% threshold exemption under s 703-35 (see [24 050]): s 707-325(5). There are further exclusions from this capital injection limitation contained in the TPA. The first of these is the group waiver rule whereby the transferee can choose to waive the capital injection rule in respect of injections and transactions involving group members: s 707-328A TPA. The choice had to be made on or before 31 December 2005 and cannot be amended or revoked after that date. The single waiver rule waives the effect of the capital injection rule in respect of injections and transactions involving 2 group members and may apply if the group waiver rule cannot be satisfied: s 707-326 TPA.

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EXAMPLE [24 240.10] The following is from Example 8.10 in the Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No 1) 2002.

The Cellar Door Sales group consolidates. At the initial transfer time, the group’s market value is $10,000. Available fractions for the head company’s loss bundles are: head company: $5,000 ÷ $10,000 = 0.5 A: $3,000 ÷ $10,000 = 0.3 B: $2,000 ÷ $10,000 = 0.2

[24 250] Adjustments to available fraction To ensure that the available fraction continues to reflect the proportion of the group’s income that can be said to be generated by the real loss-maker, it will need to be adjusted if one of the following events identified in the table in s 707-320(2) occurs. • Previously transferred loss bundles are transferred for the second or subsequent time (ie to a new head company). • Previously transferred loss bundles are transferred to a new head company and, at the same time, the group also transfers group losses to the new head company. • A head company with transferred losses acquires new loss bundles. • There is an increase in market value of the group due to capital injection or non-arm’s length transaction. • The group’s available fractions total more than 1. The available fraction may be reduced or maintained as a result of an adjustment event occurring, but never increased: s 707-320(2). The available fraction may only be increased if the value donor concession applies: see [24 260]. The adjusted available fraction is worked out by multiplying the available fraction by the factor next to the relevant event in the table in s 707-320(2). If an adjustment event occurs because losses are transferred for a second or subsequent time, the old group’s available fractions are multiplied by a factor equal to the lesser of one and the following formula:

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[24 300]

market value of the old group market value of the new group

The formula adjusts the fraction to reflect the proportion that the old group’s market value bears to the value of the new group at the transfer time. The market value of the new group also includes the market value of the old group: s 707-330. See [3 210] for the definition of ‘‘market value’’.

Apportionment of transferred losses The amount of transferred losses in a bundle that can be utilised by the transferee for an income year is limited if the losses in the bundle were transferred after the start of the income year or the available fraction was adjusted during the transferee’s loss-holding period: s 707-335(1). The transferee’s loss-holding period starts at the start of the income year or, if the losses in the bundle were transferred during the income year, at the time of transfer, and ends when the income year ends or the transferee becomes a subsidiary member of a group: s 707-335(2). The transferee cannot utilise for the income year any more of the transferred losses than is reasonable having regard to the factors set out in s 707-335(3), including the number of days in the transferee’s loss holding period (ie losses can only be offset against income attributable to that period). If this rule were not available, losses transferred by an entity that joins a group on the second last day of the group’s income year could be used in reducing the group’s income for the whole of the income year. The rule ensures that the losses are only offset against income generated by the group after the transferor has become a member and that the adjusted available fraction only applies from the date of the event that triggered the adjustment. Note that this adjustment is not required for losses subject to the concessional transitional loss provisions. [24 260] Special loss rules Section 707-415 (in Subdiv 707-D) provides that if a loss has been transferred with a nil available fraction, certain adjustments are made to other provisions to avoid inequitable outcomes. In the absence of these adjustments, taxpayers could be penalised for losses which they can never take advantage of. In particular, the head company can apply the losses to: • reduce a net forgiven amount under the debt forgiveness rules (see [8 700]); • reduce a capital allowance that is adjusted under the limited recourse debt rules (see [33 200]); or • reduce the capital gain that arises under CGT event L5 when the joining entity subsequently leaves the group (see [13 750]).

ASSET TAX COST SETTING [24 300] Introduction On formation of a consolidated group, the head company retains existing tax values for its assets except for those assets that are intragroup debts and intragroup membership interests (these are not recognised for income tax purposes once the group has consolidated). Consequently, the tax cost setting process involves allocating the cost of holding or acquiring membership interests to the assets of the relevant subsidiary member. In accordance with the single entity rule, every asset that a subsidiary member brings to a consolidated group is taken to be an asset of the head company of the joined group. As the subsidiary member ceases to be recognised as a separate entity for tax purposes, the cost allocated to the assets of the subsidiary member, referred to as the tax cost, is intended to © 2017 THOMSON REUTERS

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reflect the cost to the consolidated group of holding or acquiring the subsidiary member. In effect, the cost of holding or acquiring the subsidiary member is allocated to its assets. The tax cost setting process for assets brought to a joined group is determined under Div 705. When a subsidiary member leaves a consolidated group, the above cost setting process is reversed. The cost base of the membership interests in the subsidiary member held by the consolidated group is determined according to the value of net assets of the leaving entity. The cost setting process for a leaving entity is determined under Div 711. The meaning of ‘‘asset’’ for the purposes of the cost setting rules is considered in Ruling TR 2004/13, which states that an asset is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay (see also Determination TD 2007/18 concerning revenue assets). A joining entity’s entitlement to claim a deduction for (or otherwise deal with) a tax loss may be an asset: see Determination TD 2006/56. If an element of the allocable cost amount is worked out using accounting standards or concepts, the entity must use the accounting principles and authoritative pronouncements it used to prepare its financial statements. If financial statements were not prepared, the entity must prepare a notional statement using accounting principles and authoritative pronouncements that it would use if it were required to prepare financial statements. Section 701-55 clarifies that the head company can use the tax cost setting amount of an asset for the purpose of working out the amount included in assessable income or allowed as a deduction when applying other provisions of the income tax law, eg the head company can deduct an amount under Div 40 for the decline in value of an asset (see [10 050]) for the period after the joining time: ATO ID 2011/51. In the absence of this rule, the asset’s original cost would be used for certain tax law purposes. Special rules address the position under the cost setting rules of the lessor and lessee under finance lease arrangements: s 705-56. Amendments contained in the Tax and Superannuation Laws Amendment (2014 Measures No 4) Act 2014 implement a number of recommendations of the Board of Taxation regarding aspects of the tax cost setting rules (see also the then Assistant Treasurer’s media release No 068, 14 May 2013).

[24 310] Tax cost setting on joining consolidated group Subdivision 705-A deals with the basic case in the tax cost setting process where a single entity joins an existing consolidated group. This basic position is then modified for the following circumstances: • formation of a consolidated group – Subdiv 705-B; • the head company of one consolidated group is acquired by another consolidated group – Subdiv 705-C; • other circumstances where the joining entity and other entities become members of the joined group – Subdiv 705-D; • there are errors in making tax cost-setting amount calculations – Subdiv 705-E. Ruling TR 2007/7 considers the treatment of errors the head company of a consolidated group or MEC group makes in working out the tax cost setting amounts (of reset cost base assets of an entity that becomes a subsidiary member of the group). The cost of membership interests in a subsidiary member is allocated to the assets of that subsidiary member in order to align the tax costs of the subsidiary member’s assets with the costs of its membership interests to the joined group. The assets of the subsidiary member will be classified as either retained cost base assets, reset cost base assets or excluded assets. Each of these categories is discussed further at [24 330]-[24 340]. Market valuations need to be obtained for all the assets of the joining entity (except for retained cost base assets), 1048

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[24 310]

including assets that are off balance sheet and intangible assets such as goodwill. The general rule is that assets and liabilities are not set off. However, there is an exception for linked assets and liabilities (s 705-59) which must be set off against each other under the accounting standards. This approach avoids distortion to the allocable cost calculation – particularly for financial assets. For specific issues regarding market valuations, see [24 430]. Assets that do not become assets of the head company under the single entity rule (eg intragroup assets such as loans between members of the consolidated group) still have their cost set as if the single entity rule did not apply: s 701-10(2). Without an allocation to these assets, it was considered that too much cost would be allocated to other assets, thereby causing a distortion. The tax cost setting process involves: • determining the allocable cost amount of the joining entity; • apportioning part of the allocable cost amount to the subsidiary member’s retained cost base assets; • apportioning the balance of the allocable cost amount to the subsidiary member’s reset cost base assets in proportion to their market values (subject to further adjustments for assets held on revenue account and over-depreciated assets). The CGT scrip-for-scrip roll-over provisions have been modified, for arrangements regarded as ‘‘restructures’’ (in relation to arrangements entered into after 13 May 2008). If these rules apply in the case of the target entity becoming a member of a consolidated group, the head company of a consolidated group can choose to disregard the cost setting rules (ss 715-910(3) and 715-920(3)). This means the target entity’s cost base for assets is retained under the entry history rule (s 715-915). In June 2010 legislation was enacted, with application from 1 July 2002, which allowed for the cost base of rights to future income to be reset. As originally enacted (s 701-55(5C)), the rules resulted in the retrospective amendment of assessments in order to claim deductions for losses in connection with the reset cost base of certain intangibles. However, the revenue impact of the changes turned out to be much higher than originally thought. Having regard to this background, the consolidation rules which apply to corporate acquisitions (in particular ss 701-55, 701-56, 716-405 and 716-410) were amended retrospectively (by the Tax Laws Amendment (2012 Measures No 2) Act 2012) – but with some grandfathering concessions. The new rules are segmented into 3 periods – ‘‘pre-rules’’, ‘‘interim rules’’ and ‘‘prospective rules’’. • Pre-rules (which apply to the period before 12 May 2010) – these restore the cost setting rules to those that applied before the 2010 amendments, with the effect that rights to future income other than unbilled income and consumable stores will be regarded as retained cost base assets. • Interim rules (which apply to the period between 12 May 2010 and 30 March 2011) – these are designed to protect taxpayers who acted on the basis of the 2010 legislation. The rules essentially restore the rules introduced in 2010 with certain modifications. • Prospective rules (which apply to the period after 30 March 2011) – these are designed to equate the tax position of consolidated groups to that of entities acquired outside of consolidation. In particular: – the cost setting rules are expressly restricted to CGT assets, revenue assets, depreciating assets, trading stock and Division 230 financial arrangements; – a business acquisition approach to the residual tax cost setting rule is adopted. Taking this approach means that the revenue or capital character of the assets will be determined based on the character of the assets in the hands of the head company rather than the joining entity. It is considered that this means © 2017 THOMSON REUTERS

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the acquisition of assets by the head company is likely to be on capital account. However, if there are circumstances where the asset is held on revenue account the residual cost setting rule (s 701-55(6)) will apply; and – reset tax costs for rights to future income that are work in progress or consumable stores are deductible and other rights to future income are treated as retained cost base assets. As an overriding safeguard, the amendments do not apply where a claim is covered by a private binding ruling issued before 31 March 2011 or a written advice is given by the Commissioner before 31 March 2011 based on the law as enacted in 2010. The Commissioner has issued 3 Determinations – TD 2014/22 to TD 2014/24 – which set out his views on various aspects of the application of the interim rules.

[24 320] Allocable cost amount The 8 steps for calculating the allocable cost amount (ACA) are set out in s 705-60. This amount should be calculated on the assumption that if any transactions were subject to roll-over, that roll-over did not occur. There are rules designed to avoid double counting of amounts in undertaking the ACA calculation (s 705-62).

1. Step 1 amount: the total cost of all membership interests that the consolidated group holds in the joining entity: s 705-65. This will be the greater of the market value or 1050

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the reduced cost base. However, if the market value is greater than or exceeds the cost base the latter will be taken to be the relevant cost. The step 1 amount may be adjusted if: • the reduced cost base of a membership interest is different from the cost base; • there has been an application of the value shifting or loss transfer provisions; • there have been adjustments to the reduced cost base of membership interests for rebatable dividends. For the purposes of this step, ‘‘non-membership equity interests’’ (eg convertible notes) are taken to be membership interests and contribute to the calculation of the step 1 amount. Deferred acquisition payments (eg a future payment dependent on meeting certain profit targets) may be taken into account: s 705-65(5B). This will necessitate a recalculation of the ACA as such payments, by their nature, are not due till after the joining time. In calculating the cost base for these purposes, s 110-25(2)(b) directs that it is worked out ‘‘as at the time of acquisition’’. In Financial Synergy Holdings Pty Ltd v FCT [2016] FCAFC 31, the Full Federal Court held that the time of acquisition is the date of actual acquisition and not the time of deemed acquisition (as is the case where the asset in question is the subject of a roll-over transaction). The High Court has refused to grant the Commissioner special leave to appeal against this decision. 2. Step 2 amount (add): the sum of each accounting liability of the joining entity at the joining time that, in accordance with accounting principles, can or must be recognised in the entity’s statement of financial position: s 705-70. The step 2 amount may be adjusted if (ss 705-75 to 705-85): • the head company will be entitled to claim a deduction for the liability; • a liability attaches to a particular asset and would be transferred with that asset; • the liability is owed to a member of the consolidated group; • there is a timing difference between income tax provisions and accounting standards in recognising the liability; • there are any employee membership interests in the joining entity; • there are ‘‘non membership equity interests’’ as defined in s 995-1 issued to entities outside the joined group. No adjustment needs to be made to the Step 2 amount if an accounting liability of a life insurance company is calculated under Subdiv 713-L ITAA 1997 (see [24 600]): Determination TD 2005/17. In ATO ID 2008/164, the Tax Office states that the amount of a deferred tax liability attributable to an exploration permit, measured by the head company by having regard to the $nil tax value of the asset that would arise after the joining time following the application of subsection 40-80(1) (see [10 530]), is not an amount within the ambit of s 705-70. Draft legislation has been released (the Exposure Draft: Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015) which seeks to remove a double benefit which can arise in respect of certain deductible liabilities held by a joining entity. The approach as originally announced has been modified, as announced in the © 2017 THOMSON REUTERS

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2016-17 Budget, by including the deductible liability as part of the cost setting amount, rather than requiring an income inclusion. The commencement date of this measure has been deferred to 1 July 2016. 3. Step 3 amount (add): the sum of the undistributed profits (see Determinations TD 2004/53, TD 2004/55 and TD 2004/62) of the joining entity in respect of any direct or indirect membership interests the joined group has held continuously in the joining entity, which have been taxed: s 705-90. Continuously held membership interests are membership interests of the joining entity held (directly or indirectly) by the head company from the acquisition date to the formation or joining time. A membership interest will be taken not to have been held continuously in certain situations even if there was no disposal of the membership interest, eg when the membership interest stops being a pre-CGT asset. The amount added is not reduced by profits that have recouped a loss. 3A. Step 3A: In some situations there may need to be an adjustment to the ACA for a pre-joining time roll-over from a foreign resident company or head company to a resident company that did not elect to ‘‘stick’’ with historical asset basis on formation of the consolidated group (a ‘‘spread entity’’). If this has occurred, the ACA for the joining entity is increased by the amount of the deferred roll-over loss or reduced by the amount of the deferred roll-over gain: s 705-93. If the net result is a capital gain, this will be reflected in CGT event L2: see [13 820]. 4. Step 4 amount (subtract): the sum of all the following distributions (s 705-95): • distributions by the joining entity that would reflect a net return of the cost of membership interests included in the step 1 amount; • distributions made by the joining entity out of profits before the joining time that the head company would receive directly in respect of continuously held membership interests in the joining entity. This only applies to the extent that those profits recouped losses that accrued to direct membership interests that the head company held continuously: see Determinations TD 2004/57, TD 2004/58 and TD 2004/60. 5. Step 5 amount (subtract): the sum of all carry forward losses of the joining entity that have not been utilised (provided that these losses were not taken into account in calculating the undistributed profits for the purposes of step 3): s 705-100. The carry forward losses must accrue to continuously held membership interests in the joining entity: see Determination TD 2004/59. 6. Step 6 amount (subtract): the sum of all the losses of the joining entity not accruing before the joining time and transferred to the head company: s 705-110. This result is then multiplied by the general corporate tax rate (30%) to obtain the step 6 amount (note the proposal to reduce the corporate tax rate: see [20 030]). 7. Step 7 amount (subtract): the sum of unclaimed deductions inherited by the head company for expenditure incurred by the joining entity before the formation or joining time: s 705-115. The following deductions will not change the step 7 amount: • expenditure that becomes part of, or reduces the cost of the relevant asset; • expenditure (subject to an exclusion for certain undeducted construction expenditure) that is precluded from becoming part of the cost of the asset because of s 110-40 (ie certain assets acquired before 7.30 pm on 13 May 1997 AEST): see [14 030]; • expenditure that reduced the step 3 amount. 1052

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8. Step 8 result: if the result of the calculations performed in steps 1 to 7 is positive, that amount is the ACA of the joining entity. If the result of the calculations performed in steps 1 to 7 is negative, the ACA is nil. Draft legislation (the Exposure Draft: Tax and Superannuation Laws Amendment (2015 Measures No 4) Bill 2015) proposes to amend the so called ‘‘anti-churning’’ rules, to prevent the tax costs of a joining entity’s assets being uplifted where no tax is payable by a foreign resident owner when it ceases to hold membership interests, in circumstances where there has been no change in the majority economic ownership of the joining entity for a period of at least 12 months before the joining time: proposed s 716-440.

[24 330] Retained cost base assets Once the allocable cost amount (ACA) of a joining entity has been determined, it is reduced by the sum of the tax cost setting amounts of the retained cost base assets. The amount of the reduction is apportioned to each of the retained cost base assets. Essentially, retained cost base assets have the same cost base for the head company as they had for the joining entity: s 705-25. Retained cost base asset Australian currency Cash management trust Qualifying securities (Div 16E Pt III ITAA 1936)

Entitlements to pre-paid services Complying superannuation assets and segregated exempt assets of life insurance companies Rights to future income assets (eg long term construction contracts)

Tax cost setting amount Equal to the amount of Australian currency. This amount may be reduced in the case of impaired debts: (s 705-27) Equal to the amount of Australian currency The amount of the consideration that the joining entity would need to receive if it were to dispose of the asset just before the joining time in order for no amount to be included in, or deductible from, the joining entity’s assessable income under s 159GS: see [32 400] The amount of deductions to which the head company is entitled as a result of the entry history rule in respect of the expenditure that gave rise to the entitlement The amounts calculated in accordance with ss 320-190 and 320-245 at the joining time: see [30 210] and [30 230] The amount that would be the cost base if the asset were a CGT asset just before the joining time (s 705-30(5))

The Tax Office’s views on when Australian currency is a retained cost base asset are set out in Ruling TR 2005/10 and Determination TD 2005/22. See also ATO ID 2007/40 (rights over discrete debts contained within purchased debt ledgers of the joining entity at the joining time are not prevented from being retained cost base assets). Rights to future income (such as work-in-progress and unbilled revenue) held by a joining entity are treated as retained cost base assets, provided those rights accrue to the head company. In certain circumstances, trading stock is treated as a retained cost base asset: see [24 440].

[24 340] Reset cost base assets The allocable cost amount (ACA), as reduced by the tax cost setting amounts of the retained cost base assets, is apportioned over the reset cost base assets of the joining entity according to their market values (subject to any adjustments for assets held on revenue account): s 705-35. A reset cost base asset is any asset of the joining entity that is not a retained cost base asset or an excluded asset. An asset is an excluded asset if an amount has been deducted for that asset in calculating the ACA of the joining entity. No part of the ACA is allocated to excluded assets. Determination TD 2006/57 discusses when a future tax benefit asset is an excluded asset. © 2017 THOMSON REUTERS

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Adjustments for reset cost base assets The terminating value to the joining entity of reset cost base assets is determined under s 705-30 as follows. Asset Trading stock on hand at the beginning of the joining year Live stock acquired by natural increase Other trading stock A qualifying security (Div 16E Pt III ITAA 1936) that is not trading stock A depreciating asset A CGT asset that is not trading stock, a qualifying security or a depreciating asset A registered emissions unit (under the carbon pricing scheme, although this has been repealed from 1 July 2014: see [5 500]) Any other asset (eg knowledge or information assets and future income tax benefit assets)

Terminating value The value at the joining time under Div 70: see [5 220] The cost under s 70-55: see [27 110] The expenditure incurred in acquiring the trading stock: see [5 210] The amount of the consideration that the joining entity would need to receive if it were to dispose of the asset just before the joining time in order for no amount to be included in, or deductible from, the joining entity’s assessable income under s 159GS: see [32 400]. Its adjustable value just before the joining time: see [10 540] Its cost base just before the joining time If held at the start of the income year – the value of the unit at the start of the year: see [5 500]. In all other cases – the expenditure incurred in becoming the holder of the unit. The amount that would have been its cost base just before the joining time if it were a CGT asset (see Determination TD 2006/53)

Adjustments may be made to the tax cost setting amount for reset cost base assets in certain circumstances. The adjustments are as follows. Reset cost base asset Trading stock, revenue assets, depreciating assets, registered emissions units Depreciating asset

Circumstances for adjustment

Adjustment to tax cost setting amount

The calculated tax cost setting The tax cost setting amount is amount exceeds both the market reduced to the greater of the market value and the terminating value of the value or the terminating value: asset s 705-40 (see Determination TD 2007/18) • The calculated tax cost setting The tax cost setting amount is amount exceeds the terminating reduced to the terminating value: value s 705-45 • The asset was subject to accelerated depreciation • The head company makes an election to apply s 705-45

If an adjustment is made to the tax cost setting amount of a reset cost base asset, any excess of the tax cost setting amount is redistributed to other reset cost base assets. The Tax Office has issued Taxpayer Alert TA 2005/3 in relation to the application of the tax cost setting rules to inflate the value attributable to copyright assets. Also note Ruling TR 2012/7, where the Commissioner has indicated that the entirety of a mine site improvement held by an entity joining a consolidated group will be considered a reset cost base asset.

[24 350] Formation of a consolidated group Subdivision 705-B determines the tax cost setting process for the assets of an entity if the assets of that entity become assets of the head company as the result of the formation of a consolidated group. Modifications are made to the tax cost setting rules (see [24 310]) to deal with the following circumstances. 1054

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[24 360]

Membership interests in other subsidiary members When a consolidated group forms, the tax cost setting process is applied separately to each subsidiary member. The effect is a cascading pushdown calculation. When a subsidiary member (Member 1) holds membership interests in another subsidiary member (Member 2), the membership interests in Member 2 are an asset of Member 1. The cost setting provisions are first applied to Member 1 and the cost setting amount allocated to the membership interests in Member 2, as an asset of Member 1, is used in determining the allocable cost amount (ACA) of the assets of Member 2. This process is simply reapplied from the top down, as many times as necessary. Pre-formation roll-over The step 3 amount in the tax cost setting process under Subdiv 705-A (see [24 320]) is the sum of all undistributed profits of the joining entity. If there has been a same asset roll-over between the head company and a subsidiary member under Subdiv 126-B (or the ITAA 1936 equivalent: s 160ZZO) before formation of the consolidated group (see [16 320]), the step 3 amount is adjusted to reflect the roll-over amount. If the roll-over amount resulted in a capital gain to the head company, the ACA of the subsidiary member will be decreased. Conversely, if the roll-over amount resulted in a capital loss to the head company, the ACA of the subsidiary member will be increased. Pre-formation distributions The step 4 amount in the tax cost setting process under Subdiv 705-A includes the sum of all distributions by the joining entity that reflect a net return of the cost of membership interests included in the step 1 amount. However, if the same amount has been distributed a number of times, the step 4 amount only takes account of the original distribution by a subsidiary member. Losses of subsidiary member The step 5 amount in the tax cost setting process under Subdiv 705-A is the sum of all carry forward losses of the joining entity that have not been utilised. If a subsidiary member (Member 1) holds membership interests in another subsidiary member (Member 2) that has certain tax losses, the market value of Member 1’s membership interests in Member 2 is increased by the proportion of the step 5 amount of the consolidated group’s ACA in Member 2 that is attributable to Member 1’s membership interests in Member 2. [24 360] Acquisition of consolidated group by another Subdivision 705-C modifies the tax cost setting rules in Subdiv 705-A in circumstances where one consolidated group (acquired group) is acquired by another consolidated group (acquiring group). In these circumstances the head company of the acquired group is the joining entity for the purposes of Subdiv 705-A. These modifications ensure that the tax cost setting amounts of the assets of the acquired group accurately reflect the cost of the acquired group to the acquiring group. Over-depreciated assets If a subsidiary member of the acquired group paid a rebatable dividend which reduced the tax cost setting amount of an over-depreciated asset, there will be no further reductions in that tax cost setting amount as a result of the acquisition of the acquired group by the acquiring group. Rights and options in the acquired group If the acquiring group held rights or options to acquire membership interests in the acquired group at the joining time, those rights and options will constitute membership interests for the purposes of determining the step 1 amount (see [24 320]) under Subdiv 705-A. © 2017 THOMSON REUTERS

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The step 2 amount of the tax cost setting process under Subdiv 705-A is the sum of all the accounting liabilities of the joining entity at the joining time. This amount is increased by the market value of any rights or options to acquire membership interests in a subsidiary member of the acquired group, which are held by an entity other than a member of the acquired group or the acquiring group.

[24 370] Linked entities join consolidated group Subdivision 705-D modifies the application of Subdiv 705-A in circumstances if multiple entities (linked entities) become members of a consolidated group at the same time as a result of an event that happens in relation to one of those linked entities. Subdivision 705-D deals with the acquisition by the consolidated group of an unconsolidated group of wholly-owned companies by virtue of the acquisition of the ultimate holding company. Each of the entities in the acquired wholly-owned group is referred to as a linked entity. The linked entities are treated as joining entities for the purposes of applying Subdiv 705-A. Membership interests in other linked entities When linked entities join a consolidated group, the tax cost setting process detailed in Subdiv 705-A is applied separately to each subsidiary member. When one linked entity (LE 1) holds membership interests in another linked entity (LE 2), the membership interests in LE 2 are assets of LE 1. The cost setting provisions are applied on a top down approach, first applying to LE 1. This establishes a cost setting amount for the assets of LE 1 (which includes the interest in LE 2). The cost setting amount allocated to the membership interests in LE 2, as an asset of LE 1, is used in determining the allocable cost amount (ACA) of the assets of LE 2. This process is simply reapplied from the top down, as many times as necessary. Successive distributions The step 4 amount in the tax cost setting process under Subdiv 705-A (see [24 320]) includes the sum of all distributions by the joining entity that would reflect a net return of the cost of membership interests included in the step 1 amount. However, if the same amount has been distributed a number of times, the step 4 amount only takes account of the original distribution by a linked entity. Losses of the linked entity The step 5 amount in the tax cost setting process under Subdiv 705-A is the sum of all carry forward losses of the joining entity that have not been utilised. If a linked entity (LE 1) holds membership interests in another linked entity (LE 2) that has certain tax losses, the market value of LE 1’s membership interests in LE 2 is increased by the proportion of the step 5 amount of the joined group’s ACA in LE 2 that is attributable to LE 1’s membership interests in LE 2. The value used in the allocation is the market value plus the amount of the membership interest’s pro-rated share of the loss. [24 380] Trust joins consolidated group A specific provision enables the assets of a discretionary trust to have a cost base. Otherwise the assets of the trust would have a nil cost base. This is because the interest in the trust does not have a cost base so there is nothing to push down into the trust’s assets. Division 713 modifies step 1 of the allocable cost amount (see [24 320]) to increase the cost of the membership interest by any amount settled on the trust independently of the group that could have been distributed tax free had the trust not joined the group. The increase in the step 1 amount is the lesser of: • any amount settled on the trust up to the joining time, including the market value of any property settled on the trust. The result is then reduced so that all that remains is the part that would have been paid to holders of the membership interest if the trust 1056

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had been wound up at the joining time. This amount is further reduced by any amount that would have been included in the beneficiary’s assessable income or as a capital gain or loss; and • any amount settled on the trust either directly by the head entity or by any entity that is unconnected with the group. The step 3 amount is also adjusted so that it includes any realised but undistributed profits that accrued to the group before the joining time, except if they would have produced a capital gain in accordance with CGT event E4 or if they recouped losses that accrued to the group before the joining time.

On exit If a trust exits a consolidated group there is an adjustment to the step 1 amount detailed in [24 400] to ensure that the holders of the discretionary interest in the trust do not recognise a loss. The cost setting amount of these interests is accordingly reduced to nil. [24 390] Partner or partnership joins a consolidated group The tax cost setting rules are modified by Subdiv 713-E if a partner in a partnership becomes a member of a consolidated group and also if a partnership itself becomes a member of a consolidated group (which will occur where all partners of the partnership are members of a consolidated group). If a partner becomes a member of a consolidated group but the partnership does not, it is necessary to push down the costs of the membership interests in the partner to the partner’s assets, which include its interest in the partnership assets. In order to achieve this, the partner’s individual share in the assets of the partnership are recognised for cost setting purposes, rather than the underlying assets of the partnership. This is achieved by recognising a notional asset referred in the legislation as ‘‘partnership cost setting interests’’ (s 713-210) to which the cost setting rules apply. These interests consist of an interest in the assets of a partnership or an interest in the partnership that is not an interest in the assets of the partnership. Since an underlying asset of the partnership is not a partnership cost setting interest, then resetting the cost of a partnership cost setting interest will have no effect on the tax cost of the underlying asset of the partnership. This means that assets such as trading stock or depreciating assets do not have their cost reset so that the calculation of net income or loss of the partnership is unaffected. If this were not the case then it would be possible for different partners to have to undertake separate calculations of partnership income or loss. If all the partners become a member of a consolidated group, so that the partnership itself is a member of the consolidated group, the cost setting rules are applied to the underlying assets of the partnership. It is not necessary to apply the concept of a partnership cost setting interest since there is no possibility of causing a differential calculation of partnership profit or loss as between the partners given they are all within the consolidated group: s 713-240. A partnership may cease to be a subsidiary member or a consolidated group if either the partner leaves the group or the head company disposes of some or all of its partnership cost setting interests. Subdivision 713-E modifies the normal exit rules. [24 400] Subsidiary member leaves group An entity leaves a consolidated group when it ceases to satisfy the requirements to be a subsidiary member of the group (this includes if the subsidiary is deregistered: Determination TD 2006/58). The head company of a consolidated group does not recognise the membership interests it has in a subsidiary member, but rather the cost of those membership interests is transferred to the assets of the subsidiary member. Consequently, when a subsidiary member leaves a consolidated group, the tax cost setting process undergone at the joining time must be reversed and the head company must recognise, just before the leaving time, the value of membership interests in the leaving entity. The consolidated group’s cost base in the membership interests of the leaving entity is calculated on the basis of the value of net assets of the leaving entity at the leaving time. © 2017 THOMSON REUTERS

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Division 711 sets out the rules for determining the tax cost setting amounts for membership interests in leaving entities (eg ATO ID 2006/96). These rules do not, however, apply if the member leaves the consolidated group because the head company is acquired by another consolidated group. In this case the rules in Subdiv 705-C governing the acquisition of one consolidated group by another apply: Determination TD 2006/38; see [24 360]. See also ATO ID 2006/338. The commercial debt forgiveness rules (see [8 700]), the limited recourse debt rules (see [33 200]) and CGT event L5 (see [13 850]) have been modified to ensure that, if a debt has been forgiven, the amount can be applied against losses transferred from an entity that has losses with a nil available fraction, provided the debts being forgiven are the same as or are reasonably connected with the debts held by the joining entity at the joining time.

Allocable cost amount The allocable cost amount (ACA) that a consolidated group (the old group) has in respect of a leaving entity is calculated according to the 5 steps set out in s 711-20.

1. Step 1 amount: the total of the terminating values of all the assets that the leaving entity takes with it and which the head company is taken to hold at the leaving time because the leaving entity is taken to be part of the head company: ss 711-25, 711-30. The terminating values of these assets are determined under s 705-30 (see the table at [24 340]). The determinations are made at the leaving time rather than the joining time (see Determination TD 2006/19). As to working out the tax cost of goodwill, see Determination TD 2007/27. Some future income tax benefit assets (eg attribution credits, transport infrastructure borrowing offsets and deductions for borrowing expenses) can be relevant assets of the leaving entity at the leaving time, but they would rarely have a terminating value for the purposes of step 1: Determination TD 2006/53. 2. Step 2 amount: the sum of all the deductions to which the leaving entity becomes entitled as a result of leaving the old group, except to the extent that such deductions form part of (or reduce) the cost of an asset of the leaving entity: s 711-35. 3. Step 3 amount: the sum of the market values of all the liabilities owed by members of the old group to the leaving entity at the leaving time (as to the meaning of ‘‘liability owed’’, see Determinations TD 2005/45 and TD 2005/46). In some cases, 1058

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the old group could gain an unwarranted advantage if the creation of an asset in a leaving entity (being the liability owed by a member of the group) before its leaving time would have been a CGT event but is a disregarded transaction because of the single entity rule. In these circumstances, the actual cost of the liability rather than the market value of the liability will be used to calculate the step 3 amount: s 711-40(2) and (3). 4. Step 4 amount: the sum of the accounting liabilities owed by the leaving entity: s 711-45 (see Determination TD 2005/53). If a subsidiary is deregistered, the unsatisfied debts of the subsidiary at the time of deregistration are recognised as accounting liabilities: Determination TD 2006/59. When an entity leaves a consolidated group with the same liability that was brought into the group by a joining entity, the amount taken into account for the liability must be the same as the value at the joining time. This includes liabilities owed to the old group, liabilities owed to third parties and certain membership interests such as employee share interests. If an accounting liability is also a membership interest, it is not deductible under Step 4 (see ATO ID 2009/121). The step 4 amount is adjusted in certain circumstances, including where: • the leaving entity will be entitled to claim a deduction for the liability – the liability is reduced; • a liability attaching to a particular asset is transferred with that asset – the liability is disregarded; • an accounting liability is owed to a member of the old group – the amount to be added for the liability is the market value of the corresponding asset of the member (eg Determination TD 2007/12); • there is a timing difference between income tax provisions and accounting standards in recognising the liability (eg accrued employee leave entitlements or foreign exchange gains and losses); • there is an amount received on the issue of non-membership equity interests outside the group. In Handbury Holdings Pty Limited v FCT (2009) 77 ATR 670, the Full Federal Court ruled that as part of the calculation of the step 4 amount under s 711-45(1), it was necessary to take into account liabilities of the subsidiary ‘‘just before the leaving time’’, not liabilities ‘‘at the leaving time’’. In that case, the liabilities of the subsidiary to the head company and another entity were satisfied by issuing shares in the subsidiary, resulting in the subsidiary’s exit from the consolidated group. The head company argued that, at the ‘‘leaving time’’, the subsidiary had no liabilities to be taken into account in the tax cost setting amount for the shares. The Court held otherwise, concluding that the construction that promoted the stated objects of the consolidation regime was to be preferred. However, s 711-45(1) has been amended to clarify the position prospectively, by replacing the words ‘‘at the leaving time’’ with ‘‘just before the leaving time’’. 5. Step 5 result: if the result of the calculations performed in steps 1 to 4 is positive, that amount is the ACA of the leaving entity. If the result of the calculations performed in steps 1 to 4 is negative, the ACA is nil. In addition, if the ACA result is negative, the head company will be taken to have made a capital gain equal to the absolute value of the negative result (CGT event L5: see [13 850]).

Apportionment The ACA of the leaving entity is allocated to each of the membership interests in the leaving entity by dividing the ACA by the number of membership interests in the leaving entity (for this purpose ‘‘non-membership equity interests’’, as defined in s 995-1, are © 2017 THOMSON REUTERS

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considered to be membership interests). The allocated amount is the tax cost setting amount for each membership interest and forms the cost base. If there is more than one class of membership interest in the leaving entity, the ACA of the leaving entity is first allocated among the different classes in proportion to the aggregate of the market values of each class. The allocated amount for each class is then allocated to each of the membership interests within the class by dividing the amount by the number of membership interests within the class.

[24 410] CGT events relating to cost setting There will be situations where the cost setting process results in a CGT event: • if there is a loss of pre-CGT status of membership interests in a joining entity under s 705-57, there is a reduction in the cost setting amount of assets of an entity that becomes a member of the consolidated group: CGT event L1 (see [13 810]; • if a negative amount remains after step 3A of the allocable cost amount (ACA) on joining: CGT event L2 (see [13 820]); • if the tax cost setting amount for retained cost base assets exceeds the joining ACA amount: CGT event L3 (see [13 830]); • if there are no reset cost base assets and an excess of the ACA on joining: CGT event L4 (see [13 840]); • if a negative amount remains after step 4 of the ACA for a leaving entity: CGT event L5 (see [13 850]); • if there is an error in calculating the tax cost setting amount for a joining entity’s assets: CGT event L6 (see [13 860]); and • if there is an excess of allocable cost amount on joining that cannot be allocated to reset cost base assets because of the restriction on the cost base that can be allocated to reset cost base assets held on revenue account: CGT event L8 (see [13 880]).

[24 420] MEC group cost setting and pooling rules The cost setting rules for the establishment of asset cost bases in MEC groups is based on the treatment afforded to a consolidated group but with certain modifications. Broadly, the modifications (in Subdiv 719-C) are designed to ensure that eligible tier-1 companies are treated similarly to the head company of a consolidated group. The cost setting rules are modified so each eligible tier-1 company is treated as though it were a part of the provisional head company and not a separate entity. So, for example, when an eligible tier-1 company joins a MEC group, the cost of its trading stock is not reset because the rules that reset the cost of trading stock (see [24 340]) only apply when an entity joins a group as a subsidiary member (a similar rule applies in relation to registered emissions units): see s 701-35(4), (5). Likewise, when a MEC group acquires a group and the head company of the acquired group becomes an eligible tier-1 company of the acquiring group, the assets of the members of the acquired group will not have their tax cost reset at the acquisition time. However, if: • the acquiring group is a MEC group, but the head company of the acquired group does not become an eligible tier-1 company of the acquiring group; or • the acquired group is a MEC group and the acquiring group is a consolidated group, the assets of the members of the acquired group will have their tax cost reset at the acquisition time: s 719-170. When an eligible tier-1 company leaves a MEC group, the pooling rules in Subdiv 719-K are relevant. These rules have been developed for eligible tier-1 companies and are designed to enable a tax-free transfer of assets within a MEC group without the need for value shifting adjustments at the eligible tier-1 company level. The cost base of all interests in eligible tier-1 1060

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companies is pooled just before the transaction that triggers the rule. This transaction may be either an eligible tier-1 company ceasing to be a member of the group or a CGT event happening in relation to one or more membership interests in an eligible tier-1 company. The cost base of the membership interest will be reset immediately before the time of the event based on an allocation from the pool.

[24 430] Importance of market valuations If the allocable cost amount (ACA) rather than the transitional method is chosen by a head company, the market value of assets in all member entities must be determined. Market valuations are also necessary to determine the available fraction so that the rate of write-off of losses by the consolidated group can be calculated: see [24 230]. The Tax Office has published guidelines (on its website) on how to conduct market valuations for consolidation purposes: see Market valuation for tax purposes. The guidelines set out the short-cuts that can be adopted in certain circumstances for certain categories of assets and for particular businesses. However, these short-cut methods can only be used to determine the ACA. They cannot be used to calculate the loss factor. The short-cuts that can be used are summarised as follows. Type of asset Depreciating assets (excluding intangibles) not depreciated at an accelerated rate where the individual adjustable values (see [10 540]) are 1% or less of the joining subsidiaries ACA Depreciating assets (excluding intangibles) that have been written off on an accelerated basis where the individual adjustable values are 1% or less of the joining subsidiary’s ACA Trading stock (other than live stock and growing crops) that is not a retained cost base asset Employee share scheme shares and unlisted shares

Valuation option The adjustable value can be used as the market value The adjustable value revised to discount the effect of the accelerated depreciation can be used as the market value The terminating value at the joining time can be used as the market value Existing market valuation (updated if appropriate)

Depending on the situation, a market valuation may be undertaken by: • an external qualified valuer; • an in-house qualified valuer; or • a person without formal valuation qualifications but who bases her or his calculation on reasonably objective and supportable data. Expenditure incurred in obtaining valuations for the purposes of the consolidation provisions is deductible under s 25-5 whether incurred by the head company or a subsidiary member of the group, even if consolidation does not go ahead: see Determinations TD 2003/10 and TD 2003/11. However, no deduction is available for this expenditure under s 8-1: see Ruling TR 2004/2. Taxpayers can enter into Advance Market Valuation Agreements with the Tax Office under which values are set for assets and entities for consolidation purposes. The agreement is administratively binding on the Tax Office.

[24 440] Integrity measures Adjustment to membership interests that were previously pre-CGT assets If a membership interest in an entity was previously a pre-CGT asset and the entity’s assets are trading stock, depreciating assets, revenue assets and/or registered emissions units, an adjustment may need to be made under s 705-57. This will occur if Div 149 ITAA 1997 (or the ITAA 1936 equivalent: s 160ZZS) previously applied to the pre-CGT membership interest (see [17 270]) or if the interest was acquired from a controlled entity and the tax cost setting amount under Div 705-A is greater than the asset’s terminating value: see [24 340]. The section applies to reduce the cost setting amount (but not below the terminating value of © 2017 THOMSON REUTERS

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the assets). The allocable cost amount (ACA) for the entity is calculated twice. If the difference between the 2 figures results in a capital loss, it is available to be written off over capital gains made in a 5-year period, commencing in the year the subsidiary joins the group.

Trading stock treated as retained cost base asset Normally trading stock is treated as a reset cost base asset. However, if at the time of becoming a subsidiary member of the consolidated group, the entity was a continuing majority owned entity, there will be no tax deferral if the market value of the trading stock at the time the entity joins the group is greater than the stock’s terminating value. The trading stock will instead be treated as a retained cost base asset. A ‘‘continuing majority owned entity’’ is one that is majority owned at all times from the start of 27 June 2002 until the entity becomes a member of a consolidated group (the ‘‘test period’’). These integrity measures (in s 701A-5 TPA) apply in relation to the entity if there is any person, or there are any persons, who continued to be majority owners throughout the test period. This will be the case if there has been no change in the ultimate beneficial ownership of the entity: Determination TD 2004/88 (see also ATO ID 2007/39). Internally generated assets An internally generated asset is one where more than 50% of the total amount of expenditure incurred on the asset or its construction cost is of a revenue nature and is claimed as a deduction. Section 701A-10 of the TPA ensures that 2 costs apply to these assets. First there is the cost for Div 40 purposes: see [10 350]. A separate cost is calculated if a balancing adjustment event occurs (see [10 850]) or if the asset leaves the group. The section applies if: • an asset became a depreciating asset of the head company at the time a continuing majority owned entity joined the group; • the asset was in existence at the start of 27 June 2002; and • there was a balancing adjustment event in relation to the asset and roll-over relief was claimed. These integrity measures apply in relation to the entity if there is any person, or there are any persons, who continued to be majority owners throughout the test period. This will be the case if there has been no change in the ultimate beneficial ownership of the entity: Determination TD 2004/88.

[24 450] Errors in calculation of ACA If a taxpayer makes an error in calculating the allocable cost amount (ACA), normally the assessment for the relevant year must be amended. However, if an amendment to the earlier year’s return is unreasonable, taking into account the amount of the error and the compliance costs involved in an amendment, the incorrect amount will be taken to be correct: ss 705-315, 705-320. The difference is brought to account as a capital gain or loss in the tax year the mistake is discovered as CGT event L6: see [13 860]. The Commissioner’s views on these provisions are set out in Ruling TR 2007/7.

RELATIONSHIP TO OTHER TAX RULES [24 500] Pre-CGT status One of the aspects of the consolidation regime is that no tax consequences should result from the act of consolidating. For this reason, the CGT status of assets is preserved under the regime. 1062

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Assets Under the entry history rule the pre-CGT status of assets is preserved. The pre-CGT status of assets that are brought into a consolidated group by a subsidiary member is inherited by the head company as a consequence of the entry history rule. Similarly, the exit history rule ensures that the pre-CGT status of assets that an entity takes with it when it leaves a consolidated group is inherited by that entity. However, any acquisition of membership interests in an entity holding pre-CGT status assets will still cause that pre-CGT status to be lost if the ultimate owners of the entity do not continue to hold majority underlying interests in the asset. Membership interests The pre-CGT status of membership interests in an entity joining a consolidated group is currently not preserved by the entry history rule because intragroup interests are not recognised. The preservation is achieved by working out the proportion (measured by market value) of membership interests in the joining entity that have pre-CGT status. This pre-CGT proportion is used when an entity leaves a consolidated group to work out which of its membership interests are pre-CGT assets. When an entity leaves a consolidated group, subject to integrity rules, the assets which may be treated as pre-CGT assets are worked out by multiplying the number of membership interests in the leaving entity held by members of the group by the leaving entity’s pre-CGT proportion worked out as above (see s 705-125). [24 510] CGT straddles A CGT straddle occurs if a CGT event is taken to happen at a time different to when the capital proceeds are received and, at some point after the occurrence of the CGT event, there is a change in the consolidated group. For example, if an entity enters into a contract to dispose of a CGT asset and, prior to settlement, the entity joins a consolidated group, the entity that entered into the contract is different to the entity that holds the asset at the time of settlement and receives the capital proceeds (being the head company of the consolidated group). Conversely, the situation may arise if a member of a group enters into a contract to dispose of a CGT asset and, prior to settlement, the member leaves the group. In that case, while the contract has been entered into effectively with the head company, the proceeds are received by the subsidiary company which owns the asset outside of the consolidated group. The solution is to treat the CGT event as happening at the time when the circumstances that gave rise to the CGT event first existed: s 716-860. This means that, generally in this situation, the CGT event will occur on settlement rather than as at the date of entry into the contract. [24 520] Franking within consolidated groups Under the single entity rule, only the head company of a consolidated group maintains a franking account. The franking accounts of subsidiary members of a consolidated group do not operate while in consolidation. These principles are set out in Subdiv 709-A. The Commissioner has confirmed that the single entity rule extends to a trust that is a subsidiary member of a consolidated group in a franking context. This means that when a trust receives a franked distribution, a credit will arise in the franking account of the head company of the consolidated group of which the trust is a member: see Determination TD 2014/8. Treatment on entry into consolidation If an entity becomes a subsidiary member of a consolidated group, if its franking account is in surplus at that time, it is required to debit its franking account to the extent of the surplus: s 709-60(1). An equivalent credit arises in the franking account of the head company of the consolidated group. If the joining entity’s franking account is in deficit, the joining entity is required to pay franking deficit tax as if the joining entity’s income year had ended just before the joining © 2017 THOMSON REUTERS

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time: s 709-60(2). A credit equal to the franking deficit then arises in the joining entity’s franking account. However, there is no further franking credit as a result of the franking deficit tax liability. It will be important to monitor franking accounts of joining entities to ensure that they are not in deficit at the joining time. If the joining entity has excess franking deficit tax offsets at the joining time, that excess is transferred to and retained by the head company: ss 709-185, 709-190. Special rules may apply if the joining entity is an authorised deposit-taking institution: s 202-47.

Operation of the franking account during consolidation Consistent with the single entity rule, the franking account rules apply to the head company with respect to the tax payments for the consolidated group (see Hastie Group Ltd & Ors v FCT (2008) 79 ATR 390 (noted at [21 950]) for an example of how these rules apply). If a subsidiary member of a consolidated group has a tax liability that relates to the pre-consolidation period, notwithstanding that the subsidiary may pay the tax, the franking credit arises in the franking account of the head company. Notwithstanding the general requirement that only wholly-owned subsidiaries may consolidate, subsidiaries may be in a position to pay frankable distributions to entities outside the group. This may occur in respect of employee share scheme interests and also to non-share equity interests, since these do not constitute ownership for determining whether a consolidated group exists: see [24 050]. The Commissioner considers that, in the case of non-share equity interests, one looks to the available frankable profits and non-share capital account of the subsidiary and not of the head company for determining the tax treatment of distributions (and the single entity rule is not relevant): see ATO ID 2009/64 and ATO ID 2009/65. Anti-avoidance rules are included in Pt IVA (s 177EB) which operate so that the Commissioner can deny the transfer of franking credits from a subsidiary to a head company on consolidation if a scheme exists, the dominant purpose of which is to enable a franking credit to arise in the head company’s franking account: see [21 870]. All franking credits will remain with the head company, notwithstanding that a subsidiary member subsequently leaves the group. Special franking rules for MEC groups and transitional foreign held entities The obligations under the imputation system of a member of a MEC group which is not the provisional head company are assumed by the provisional head company (eg provision of distribution statements): Determination TD 2006/21. Therefore, the provisional head company will be required to provide a distribution statement under s 202-75 in relation to each frankable distribution made by an eligible tier-1 company in the group on or after the day specified in the choice. The distribution statement must be given to the recipient(s) of the distribution. The benchmark rule will apply to the provisional head company of the MEC group, unless the foreign parent company is a listed public company that satisfies the criteria set out in s 203-20 (see [21 710]): Determination TD 2006/20. If a frankable distribution is made by a transitional foreign held entity (see [24 050]), the distribution is treated as a frankable distribution by the head company. [24 530] CFC attribution As a consequence of the single entity rule, only the head company of a consolidated group will operate an attribution account and attributed tax account for the purposes of the CFC (and former FIF) provisions. The pre-consolidation attribution and attributed tax account surpluses of a joining entity are transferred to the head company so that these surpluses may be used during consolidation. The mechanics of the transfer of these accounts is that a credit arises at the joining time, or formation time, equal to the attribution account surplus in the head company and a corresponding debit in the joining company. The head company 1064

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maintains the attribution and attributed tax accounts for each attribution account entity in which it has an interest as the head company. While in consolidation, subsidiary members will not operate the attribution accounts. These rules are contained in Subdivs 717-D and 717-E. The former foreign income fund (FIF) rules only applied to a taxpayer that had an interest in a FIF at the end of the income year. Therefore, notional accounting periods for the FIF were taken to end at the formation, joining or leaving time. The same problem does not arise in relation to controlled foreign companies (CFCs) because the CFC rules include in assessable income a share of attributable income of the CFC for the whole of the statutory accounting period that ends in the income year. If a company leaves a consolidated group, taking with it an interest in a CFC, the head company will transfer to the leaving company a proportion of the attribution surplus and attributed tax account surplus, if any, that the head company has in relation to that CFC. This rule differs from the general position in relation to other tax attributes such as losses, where the entity departing the consolidated group leaves the losses with the head company. The difference arises because the purpose of the attribution surplus and attributed tax account surplus is to avoid double tax on a subsequent distribution by the foreign entity. If an entity leaves a consolidated group owning a CFC, it will recognise subsequent distributions in its own right or as part of a subsequently joined consolidated group and therefore should retain entitlement in respect of the attribution surplus and/or attributed tax account surplus.

[24 540] Foreign tax offsets and losses If foreign income tax is paid by a member of a consolidated group, the operation of the single entity rule will mean that the foreign tax offset rules (see [34 200]) are applied to the head company: s 717-10. However, special transitional rules (in Subdiv 770-E of the TPA) govern the treatment of excess foreign income of an entity which relates to periods prior to it joining the consolidated group. Following the repeal of the foreign loss quarantining rules from 1 July 2008, special transitional rules (in Subdiv 770-B of the TPA) apply to consolidated groups in relation to foreign losses. The rules provide that losses are not freshened when a joining entity enters into consolidation. [24 550] Foreign dividend accounts The head company of a consolidated group (or the provisional head company in the case of a MEC group) can operate a single foreign dividend account (FDA) (see [35 010]) by pooling the FDA balances transferred to it at the joining time. The head company can then use the FDA surplus to pay non-residents unfranked dividends free from dividend withholding tax. An exiting entity cannot take with it any of its FDA balance: see Subdiv 717-J. [24 560] Thin capitalisation Certain amendments have been made to the thin capitalisation rules that affect the way that the rules apply to consolidated groups and MEC groups: see [38 080]. [24 570] Bad debts Special rules in Subdiv 709-D deal with the ability of members of a consolidated group to claim deductions for bad debts. Each period that an entity is owed a debt is called a ‘‘debt test period’’. For the consolidated bad debt rules to apply, the debt must have been owed to an entity that was a member of a consolidated group for one debt test period and owed to an entity (which could be the same entity) for a different debt test period while that entity was not a member of the group. The claimant entity also must have been owed the debt for one of the debt test periods and must have written off the debt. In order to be entitled to deduct a bad debt, the claimant and any entity that has for a period been owed the debt must satisfy certain conditions, which © 2017 THOMSON REUTERS

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ensure that each entity that has been owed the debt for a period between when the debt was incurred and when it is written off could have deducted the debt at the end of the holding period. The rules used to determine if a debt is deductible for each entity are those contained in ss 8-1 and 25-35 (see [9 700] and following), subject to certain modifications. Amendments made by the Tax and Superannuation Laws Amendment (2014 Measures No 4) Act 2014 clarify that, where a debt is taken to be owed by the head company of a consolidated group (because of the single entity rule), a debt test period for the head company ends when the subsidiary member of the consolidated group that is actually owed the debt leaves the group but does not join another consolidated group. The result is that the subsidiary cannot deduct the debt when it is written off as bad. For MEC groups, the continuity of ownership test (see [20 320]) is applied to the top company of the group and, if the head company is a listed public company, the same business test (see [20 360]) is applied to the head company. The modifications to the bad debt rules for consolidated groups and MEC groups also apply to determine whether consolidated groups and MEC groups can deduct swap losses (the swap loss rules are considered at [9 750]).

[24 580] Losses and the same business test For consolidation purposes, the head company of a consolidated group needs to show that the one overall business carried on by that head company throughout the same business test period was the same one overall business as carried on by the head company immediately before the appropriate test time. The single entity rule (see [24 020]) means that, when determining the one overall business carried on by the head company of a consolidated group for the purposes of s 165-210(1) (see [20 360]), it is necessary to have regard to the activities, enterprises or undertakings carried on by all those entities that were members of the consolidated group at the appropriate test time and by all entities during that part of the same business test period when they were members of the consolidated group (the activities which comprise a business carried on by an entity during any period when that entity was not a member of a consolidated group are ignored): see Ruling TR 2007/2. The ruling also states that it is not necessary that a business carried on or a transaction entered into during the same business test period by an entity in the group be of a kind carried on by that same entity before the test time. Note that the entry history rule is disregarded in applying the same business test: see [24 190]. [24 590] Offshore banking units The head company of a consolidated group will be deemed to be an offshore banking unit (OBU) if a subsidiary member of the consolidated group is gazetted as an OBU for the period the gazettal is applicable. [24 600] Special rules applying to life insurance companies There are special provisions (in Subdiv 713-L) that apply to life insurance companies. The special tax rules that apply to life insurance companies (see Chapter 30) will apply to the head company of a consolidated group if the group has one or more members that are life insurance companies. Wholly-owned subsidiaries of a life insurance company that have membership interests that are a mixture of complying superannuation assets, segregated exempt assets and/or ordinary assets are precluded from being a subsidiary member of the same consolidated group as the life insurance company. The tax cost setting rules are modified so that certain assets are specified as retained cost base assets and the value of certain policy liabilities is specified for the purposes of calculating the ACA. As a transitional measure, life insurance companies are able to rearrange assets of the group so that wholly-owned subsidiary entities can become members of the same consolidated group without attracting any immediate taxation consequences. 1066

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[24 620]

[24 610] Loss integrity and value shifting provisions Modifications are made to the loss integrity measures and the general value shifting provisions, which are discussed in detail in Chapter 17, to ensure that they operate properly with consolidated and MEC groups. In summarised form these modifications are as follows. Subdivisions 165-CC and CD Subdivision 165-CC on formation Subdivision 165-CC on exit

Subdivision 165-CD on exit Subdivisions 165-CC and 165-CD during consolidation Application of single entity rule for the purposes of Divs 723, 725 and 727 Division 727 during consolidation

Only the head company can have a changeover or alteration time. Realised and unrealised losses are taken to be in the head company. Same business testing for the trial year. If the test is failed reductions for calculating the allocable cost for membership interests or intragroup debts. Loss denial pools with tagged Subdiv 165-CC assets and Subdiv 170-D amounts. The same business testing of the head company on leaving. If the test is failed, reduce the adjustable values of assets to market, or to nil (to save compliance costs). Loss denial pool in exiting entity in some cases. Revised alteration times based on the head company’s reference times and ownership profiles. Otherwise a normal application of Subdivision. Broadly normal operation as modified by the single entity concept and loss reduction method for interests other than those in the head company or top company. The head company is the relevant entity in respect of group dealings and transactions with external parties. Broadly normal operation modified by an extended single entity concept and the loss reduction method for interests other than those in the head company or the top company of a MEC group or pooled interests.

[24 615] TOFA Interactions Special rules in Subdiv 715-F deal with aspects of the interaction between the consolidation rules and the taxation of financial arrangement (TOFA) rules in Div 230 ITAA 1997 (discussed in Chapter 32). When an entity joins a consolidated group, the accounting liabilities are taken into the consolidated group for Div 230 purposes for a deemed payment equal to the amount of the liability: s 715-375(2). Similarly, the head company is deemed to have provided payment for a financial arrangement which is an asset: s 701-55(5A). Were this approach not adopted, the head company would be able to obtain tax outcomes for gains and losses that accrued before the joining time. These rules in combination with s 230-60 ensure the gain or loss from the asset or liability is appropriately accounted for under the TOFA rules. The exit history rule is modified to allow the preservation of the TOFA rules regarding spreading and gain/loss calculations in the situation where an entity ceases to be part of a consolidated group: s 715-380. See further [32 190].

[24 620] Consolidation and Pt IVA The Tax Office has indicated that there are situations where the general anti-avoidance rules of Pt IVA may apply on the formation of a consolidated group. Part IVA may be applied if the dominant purpose of entering into the arrangement is to obtain a tax benefit, eg the ability of the head company to access tax losses of subsidiary members. In Channel Pastoral Holdings Pty Ltd v FCT [2015] FCAFC 57, the Commissioner sought to apply Pt IVA where the head company of a consolidated group could not benefit from the tax cost setting rules in circumstances where various assets of the business were sold shortly after the consolidation joining time. This matter was a special case which focussed on the interaction between Pt IVA and the consolidation regime, in particular, to whom a Pt IVA determination and the © 2017 THOMSON REUTERS

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accompanying assessment could be issued. The Full Court held that the Commissioner could issue Pt IVA determinations and accompanying assessments to the subsidiary company, notwithstanding the single entity rule.

ADMINISTRATIVE RULES [24 650] Liability for payment of tax Joint and several liability of contributing members In keeping with the single entity rule the head company is, in the first instance, liable for all group tax liabilities. However, if the head company fails to meet the tax liabilities by the time they become due and payable, in accordance with s 721-5, each of the ‘‘contributing members’’ becomes jointly and severally liable to pay the group tax liability (including GIC) along with the head company. A contributing member is a subsidiary member of the group for at least part of the period to which the group liability relates. The group liability refers to a tax related liability as defined in s 721-10. However, subsidiary members of the consolidated group remain separately liable for tax related liabilities which are referable to the non-membership period before consolidation, as well as being separately liable to other tax liabilities such as GST and FBT. The joint and several approach means that there is no apportionment of group liability to contributing members based upon the period of time they may have been in the consolidated group during the relevant period. If a contributing member is jointly and severally liable, and pays an amount with respect to that liability, a statutory right of contribution arises under s 265-45 in Sch 1 TAA against the head company and other contributing members: see [49 360]. Section 721-15 provides that a contributing member is not subject to the joint and several liability imposed by s 721-15(1)(b) if that contributing member is prohibited under Australian law from entering into an arrangement, which gives rise to joint and several liability. Ruling TR 2004/12 discusses the prohibition that applies under the ASX Market Rules and the Australian Clearing House Rules. The Tax Office’s policy in relation to the collection of income tax-related liabilities from head companies of consolidated groups, member entities and entities that have left the group is set out in PS LA 2013/5. Consequence of payment resulting from joint and several liability If a contributing member that has left a group makes a payment in discharge of a joint and several group liability, a credit will only arise in the franking account of the head company. If an amount paid towards a group debt is refunded to a contributing member, a debit will only arise in the head company’s franking account. Tax sharing agreement If the group liability is regulated in accordance with a valid tax sharing agreement (TSA), each contributing member covered by the agreement is liable for an amount of tax as determined by the agreement, rather than being jointly and severally liable: s 721-15(3). The effect of the TSA is that the contributing member is liable to pay to the Commonwealth an amount equal to the contribution amount set under the TSA for that member in relation to group liability: s 721-30(2). The liability arises just after the head company’s due time and becomes due and payable 14 days after the Commissioner gives the contributing member written notice of the liability under s 721-30(5). A TSA will commonly be relevant if an entity leaves a consolidated group, to ensure a purchaser that the entity does not have any residual tax liability relating to the group as a whole. A TSA may also be relevant if an entity remains in the group, for example, where a lender is concerned that the borrower is in a position to repay the loan on a stand-alone basis. 1068

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The requirements for a valid TSA include the following (s 721-25). 1. The agreement must exist between the head company and the contributing members immediately before the time when the head company’s liability is due and payable (thus a TSA need not exist for the whole of the period during which the liability arises). This requirement implies that it is possible to have a TSA between some, but not all, of the contributing members of a consolidated group. 2. The agreement must provide for the determination of the ‘‘contribution amount’’. 3. The contribution amounts for each of the TSA contributing members as determined under the agreement must represent a reasonable allocation of the total amount of group liability among the head company and the TSA contributing members. The question of reasonable allocation is difficult. The Commissioner has indicated what he considers to be a reasonable allocation. Presumably, one would not need to calculate the tax liabilities of contributing members on a separate entity basis, as that would obviate the benefits of entering into consolidation in the first place. 4. The agreement must not have been entered into as part of an arrangement the purpose of which was to prejudice recovery by the Commissioner of some of, or the entire amount of, the unpaid group liability from group members. The TSA is invalidated if the head company fails to comply with a notice to produce the agreement: s 721-25(3). This leads to the curious result that a departing member of the group may be at the mercy of the vendor head company in respect of the validity of its coverage under a tax sharing agreement. Former contributing members may provide the Tax Office with a TSA in certain circumstances: s 721-15(3A). There are special ‘‘clear exit’’ rules where a TSA contributing member exits the group: s 721-35. Essentially, before leaving the group, the TSA contributing member must pay to the head company (and not the Tax Office) an amount equal to its contribution amount under the TSA or, if a precise calculation cannot be made, a reasonable estimate. This will clear the contributing member of any future liabilities provided the leaving is not part of an arrangement intended to prejudice a recovery of the group liability. The Tax Office’s policy in relation to TSAs, including their form and basis of apportionment of liabilities among members, is set out in PS LA 2013/5.

[24 660] PAYG instalments Under the single entity rule, it is the head company (or provisional head company) of the consolidated group that has the liability to pay PAYG instalments: see [51 070]. [24 670] Tax returns The head company must consolidate income tax information from all members of the group to prepare and lodge a single consolidated income tax return. It is also responsible for: • reconciling available PAYG instalment credits with its income tax liability; and • making any balancing payment or refund request. As already mentioned, the notification to form a consolidated group must be lodged with the first consolidated return. A subsidiary member that is not a member of a consolidated group for the full income tax year must lodge an income tax return for that non-membership period. How penalties in the case of a shortfall amount will be administered in the case of a consolidated group is dealt with in Practice Statement PS LA 2006/15.

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INTRODUCTION Overview ....................................................................................................................... [25 010] SMALL BUSINESS ENTITIES Definition of small business entity ............................................................................... [25 Aggregated turnover and grouping rules ...................................................................... [25 Affiliates ........................................................................................................................ [25 Connected entities ......................................................................................................... [25

020] 030] 050] 060]

CAPITAL ALLOWANCE RULES Excluded depreciating assets ........................................................................................ [25 100] Outright deduction for low cost assets ......................................................................... [25 110] Depreciation of pooled assets ....................................................................................... [25 120] Estimate of taxable purpose use ................................................................................... [25 130] Adjustments for changes in use .................................................................................... [25 140] Low value pools ............................................................................................................ [25 150] Disposal of a depreciating asset ................................................................................... [25 160] Roll-over relief .............................................................................................................. [25 170] TRADING STOCK RULES Choice not to account for changes in the value of trading stock ............................... [25 200] Effect of not accounting for changes in the value of closing stock ........................... [25 210] TAX DISCOUNT RULES Tax discount for small business entities ....................................................................... [25 250]

INTRODUCTION [25 010] Overview This chapter considers certain tax concessions available to small business entities: • capital allowance concessions – an immediate deduction for depreciating assets costing less than $20,000, pooling arrangements for other depreciating assets (subject to certain exceptions) and simplified accounting for the private use of depreciating assets: see [25 100]-[25 170]; • trading stock concessions – being allowed to ignore the difference between the opening and closing value of trading stock (up to $5,000): see [25 200]-[25 210]; and • concessional tax rates – from 2015-16, the tax rate applicable to small business entities that are companies is 28.5% (rather than the standard 30% rate), while non-corporate small business entities are entitled to a tax discount in the form of a tax offset (the small business tax offset): see [25 250]. Note the proposal to reduce the 28.5% rate to 27.5% from 2016-17. The capital allowance and trading stock concessions, and the small business tax offset, are contained in Div 328 ITAA 1997. It will be apparent from a small business entity’s tax returns whether the entity has used the tax concessions (ie a small business entity does not make a specific election to use the Div 328 concessions). Other tax concessions available to small business entities are considered elsewhere in this publication including: 1070

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• the CGT small business concessions – the 15-year asset exemption, CGT 50% active asset reduction, CGT retirement exemption and CGT roll-over: see [15 500] and following; • roll-over relief for small business entities that change their legal structure, without changing the ultimate economic ownership of the relevant asset(s): see [16 500]; • an immediate deduction for certain prepaid business expenses: see [8 370]; • an immediate deduction for certain start-up expenses: see [10 1150]; • using the GDP-adjusted notional tax method to work out PAYG instalments: see [51 250]; • the FBT car parking exemption: see [57 175]; and • GST concessions – choosing to account for GST on a cash basis (see [60 120]), annual apportionment of GST input tax credits (see [60 100]) and choosing to pay GST by instalments (see [60 400]). In addition: • small business entities are excluded from having to make any adjustments under the indirect value shift rules in Div 727 ITAA 1997: see [17 900]; • the FBT exemption for work-related portable electronic devices is more generous for small business entities (as from the 2016-17 FBT year): see [57 260]; and • the standard period for amending assessments is 2 years (and not 4 years) for small business entities: see [47 130]. There are certain tax incentives for investments in small Australian companies with high-growth potential that are engaging in innovative activities: see [11 200]. It has been proposed that a small business entity with a turnover of less than $2m will be entitled to a $100 non-refundable tax offset for expenditure on Standard Business Reporting enabled software (ie software purchases or subscriptions) made in the 2017-18 financial year only: see MYEFO 2015-16, p 125.

STS taxpayers – transitional arrangements Transitional arrangements apply for any entity that, in an income year before 2007-08, was a Simplified Tax System taxpayer (STS taxpayer) and stopped carrying on any business. The entity can continue to use the pre-1 July 2007 concessions if they are winding up the business they previously carried on: s 328-111 TPA.

SMALL BUSINESS ENTITIES [25 020] Definition of small business entity The concept of a ‘‘small business entity’’ is explained in Subdiv 328-C ITAA 1997. A ‘‘small business entity’’ for the current income year is an entity that carries on a business and which (ss 328-110(1), 328-110(4)): • had an ‘‘aggregated turnover’’ of less than $2m in the previous income year; • is likely to have an ‘‘aggregated turnover’’ in the current income year of less than $2m (an objective test). This is worked out at the start of the income year or, if the entity starts to carry on a business part-way through an income year, as at the day they started to carry on a business: s 328-110(2). However, an entity will not be a small business entity if its aggregated turnover for each of the 2 income years © 2017 THOMSON REUTERS

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preceding the current year was $2m or more (unless its actual aggregated turnover for the year is less than $2m: see below): s 328-110(3); or • at the end of the current income year has an aggregated turnover, worked out at the end of the year, of less than $2m (an entity that qualifies as a small business entity under this method cannot access the concessions listed in the note to s 328-110(4)). The concept of ‘‘aggregated turnover’’ is considered at [25 030]. Note that the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 proposes to increase the $2m threshold to $10m from 1 July 2016. The increased threshold will apply for the purposes of the small business restructure roll-over relief in Subdiv 328-G (see [16 500]), but not for the purposes of accessing the CGT small business concessions in Div 152 via the CGT small business entity test (see [15 520]) – the threshold will remain at $2m for the purposes of that test. An entity is taken to be carrying on a business in an income year for the purposes of the small business entity test if (s 328-110(5)): • the entity is winding up a business it formerly carried on; and • it was a small business entity in the income year that it stopped carrying on the business. A person who is a partner in a partnership in an income year is not, in his or her capacity as a partner, a small business entity for the income year: s 328-110.

[25 030] Aggregated turnover and grouping rules An entity’s ‘‘aggregated turnover’’ is the sum of the relevant ‘‘annual turnovers’’, but excluding certain amounts: s 328-115(1). The relevant ‘‘annual turnovers’’ are the entity’s annual turnover, any connected entity’s annual turnover and any affiliate’s annual turnover. These are entities or affiliates that are connected with the entity seeking to satisfy the small business entity test (the ‘‘taxpayer entity’’) at any time during the year. See [25 050] for which entities qualify as ‘‘affiliates’’ and see [25 060] for which entities qualify as ‘‘connected entities’’. These concepts are also important in the context of the CGT small business concessions: see [15 510] and [15 520]. Three classes of ordinary income are excluded from aggregated turnover to avoid double-counting (s 328-115(3)): amounts derived from dealings between the taxpayer entity and any connected entity or affiliate; amounts derived by a connected entity or an affiliate from their dealings with each other while connected with, or an affiliate of, the taxpayer entity; and amounts derived by a connected entity or an affiliate while they are not connected with, or an affiliate of, the taxpayer entity: s 328-115(3). An entity’s annual turnover for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business: s 328-120(1). The expression “ordinary course of carrying on a business” has its ordinary meaning and refers to the “ordinary and common flow of transactions” of the particular business carried on by the entity: Doutch v FCT [2016] FCAFC 166 at [74]-[77]. It is therefore the income that is an incident of, or directly related to, the carrying on of the normal day to day activities of the particular business that is taken into account, even if that income is not regularly derived in that way. In Re PFGG and FCT [2015] AATA 972, reimbursed fuel costs constituted ordinary income derived in the ordinary course of carrying on the relevant entity’s business (oil and gas drilling) and thus were included in the entity’s annual turnover (decision upheld in Doutch). The following amounts are excluded from annual turnover (s 328-120(2) – (3)): • any GST-related amounts that are non-assessable non-exempt income under s 17-5: see [5 090]; and • any ordinary income derived from the sale of retail fuel (a retail sale requires the transfer of property in the relevant goods from the seller to the buyer: Re PFGG and FCT at [82]-[86] – this aspect of the decision was not considered on appeal in Doutch). 1072

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If an entity has a dealing with an associate that was not at arm’s length, the entity needs to include in its turnover any ordinary income that would have resulted from that dealing as if the dealing had been at arm’s length: s 328-120(4). ‘‘Associate’’ has the same meaning as in s 318 ITAA 1936: see [4 220]. If an entity carries on a business for part of the income year only, its turnover must be worked out using a reasonable estimate of what the turnover would have been if the entity had carried on a business for the whole of the income year: s 328-120(5). This also applies if an entity carries on one or more businesses for the whole of an income year and another business for only part of the same year: see ATO ID 2009/49. Regulations may be made requiring an entity’s annual turnover to be calculated in a different way, but only if it reduces the entity’s annual turnover: s 328-120(6).

[25 050] Affiliates An ‘‘affiliate’’ is an individual or company that acts, or could reasonably be expected to act, in accordance with the directions or wishes of the taxpayer, or in concert with the taxpayer, in relation to the affairs of the business of the individual or company: s 328-130(1). However, a trustee cannot be an affiliate of another entity (see the Tax Laws Amendment (2012 Measures No 6) Act 2013 (Sch 8) which removed the reference to ‘‘trustees of the same trust’’ from the examples relating to the definition of ‘‘affiliate’’), although s 328-125(3) (‘‘control or influence over a discretionary trust’’) concerning the definition of ‘‘connected entity’’ fills this gap: see [25 060]. In Re Stephens and FCT (2008) 71 ATR 306, the AAT commented that, to be an affiliate of a taxpayer, an entity must act in accordance with the taxpayer’s directions or wishes in the way it carries on its business and not just in relation to the relevant CGT asset (commercial premises in the Stephens case). The Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007, which introduced the concept of ‘‘affiliate’’, states (at para 2.36) that: the following factors may have a bearing on whether an individual or company is an affiliate of an entity: • family or close personal relationships; • financial relationships or dependencies; • relationships created through links such as common directors, partners, or shareholders; • the degree to which the entities consult with each other on business matters; or • whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity.

Note that in FCT v Altnot Pty Ltd (2014) 92 ATR 489, the Federal Court indicated that even though an individual may not have an interest in a company, nonetheless they may be ‘‘connected’’ with it (see below) if their affiliate controls the company. A spouse or a child under 18 may also be an affiliate under s 152-47 ITAA 1997 for the purposes of assets of the taxpayer the spouse or child uses in carrying on a business: see [15 520]. EXAMPLE [25 050.10] Mara and Robert, a married couple, share in the running of their household. Mara carries on a cleaning business with an aggregated turnover of $1.7m, while Robert carries on a bakery with an aggregated turnover of $1.5m. They both have separate bank accounts for their businesses and have nothing to do with each other’s business. Both businesses are run from different locations and they have their own employees. Neither Mara nor Robert control the management of the other’s business. Even though they are married, neither is an affiliate of the other. The reason is that they do not act in concert with each other in respect of their businesses and neither acts in accordance with the directions or wishes of the other.

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Note that an individual or company is not automatically an affiliate merely because of the legal nature of their business relationship: s 328-130(2). For example, co-directors or partners are not necessarily affiliates. In addition, a director is not automatically an affiliate of the company of which he or she is a director, nor would the company automatically be an affiliate of the director. In this regard, the AAT in Re Excellar Pty Ltd and FCT [2015] AATA 282 stated at [75] that the definition of ‘‘affiliate’’ requires ‘‘something more than ... those relationships that are dictated by legal requirements, fiduciary duties and the like’’. Note also that the affiliate test is a ‘‘one way’’ test in that if one entity is an affiliate of another entity, it does not mean that the other entity is an affiliate of the first entity.

[25 060] ‘‘Connected entities’’ Basic ‘‘control’’ rule An entity is connected with another entity if: (a) one of the entities ‘‘controls’’ the other entity; or (b) if the 2 entities are ‘‘controlled’’ by the same third entity, in which case all 3 entities will be connected: s 328-125(1). Control of entity other than a discretionary trust An entity ‘‘controls’’ a company or partnership if the first entity or its affiliates, or the first entity and its affiliates, between them own, or have the right to acquire the ownership of, interests in the other entity that between them give the right to receive at least 40% of any distribution of either income, the net income of the partnership (if the other entity is a partnership) or capital (eg ATO ID 2009/33): s 328-125(2)(a). An entity can also control a company if the entity alone, or together with affiliates, owns, or has the right to acquire ownership of, interests in the company with at least 40% of the voting power in the company: s 328-125(2)(b). Note that the connected entity test is now based on ownership of interests rather than beneficial ownership of interests. As a result, the small business concessions in Div 328 will apply to structures involving trusts, life insurance companies and superannuation funds in the same way as they apply to structures involving other types of entity. In addition, companies in liquidation, bankrupts, absolutely entitled beneficiaries and security providers will be treated as the owners of CGT assets for the purposes of the small business connected entity test: see [12 320]-[12 340]. Discretionary trusts An entity can control a discretionary trust in one of two ways. Firstly, an entity will control a discretionary trust if the trustee acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity, its affiliates or the first entity together with its affiliates: s 328-125(3). Whether an entity controls a discretionary trust for these purposes will depend on the particular facts and circumstances. The Commissioner takes the view that whether a trustee might reasonably be expected to act in accordance with the directions or wishes of another is determined having regard to all the circumstances of the case, including: (a) the way in which the trustee has acted in the past; (b) the amount of any property or services transferred to the trust by the entities; and (c) any arrangement or understanding between the entities and a person or persons who have benefited under the trust in the past. See also Ruling TR 2002/6. By way of example, in Re Gutteridge and FCT (2013) 96 ATR 472, the father of the person who was the sole director and shareholder of a company that acted as trustee for the family trust was found to be the person who ‘‘controlled’’ the trust within the meaning of s 328-125(3), as the trust did not act in accordance with the director’s wishes independently of the father’s wishes. Note, however, that the Tax Office’s Decision Impact Statement on this case stated that the Commissioner does not accept that the ‘‘reasonable expectation’’ test in s 328-125(3) can be substituted with an ‘‘accustomed to act’’ test in all cases. For example, 1074

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the Tax Office said that if there is no history at all of a trustee having acted on the directions of another, there may nonetheless be an expectation (reasonably founded) that they would act on the directions of that person, were such directions to be given. Note that a person who has the power to remove the trustee of a discretionary trust and appoint a new trustee does not automatically control the trust for these purposes; the issue will still be a question of fact of whether the trustee acts, or could reasonably be expected to act, in accordance with the directions or wishes of such a person and/or their affiliates: see withdrawn ATO ID 2008/139. Note also that neither the trustees nor the members of a complying superannuation fund are taken to ‘‘control’’ a fund: Determination TD 2006/68. Secondly, an entity is taken to control a discretionary trust for an income year if, for any of the 4 income years before that income year: (a) the trustee paid any income or capital of the trust to or for the benefit of the first entity, its affiliates, or the first entity and its affiliates; and (b) the amount paid or applied to the entity and/or its affiliates is at least 40% of the total amount of income or capital paid or applied by the trustee for that income year: s 328-125(4). Importantly, this may mean that many entities could be considered to control a discretionary trust on the basis of distributions made in the previous 4 years. Note that the trustee of a discretionary trust may nominate up to 4 beneficiaries as controllers of the trust for an income year in which the trustee did not make a distribution of income or capital because it had a tax loss or no net income for that year (but the nomination must be in writing and be signed by the trustee and each nominated beneficiary): s 152-78. Note also that amounts paid to, or applied for the benefit of, exempt entities (ie an entity that is exempt from income tax) and deductible gift recipients (ie entities to which donations of $2 or more are tax deductible: see [9 800]) are not relevant in determining whether these entities control discretionary trusts: s 328-125(5).

Indirect control of entity An entity can also ‘‘indirectly’’ control an entity if the entity (the first entity) directly controls a second entity, and that second entity also controls (whether directly or indirectly) a third entity. In this case, the first entity is taken to control the third entity: s 328-125(7). However, this rule will not apply if the interposed entities are any of the type of public companies, publicly traded trusts and mutual companies listed in s 328-125(8), although control of the third entity in this case may arise by other means (eg direct ownership). Commissioner’s discretion The Commissioner has a discretion to determine that one entity (and its affiliates) does not control another if the ‘‘control percentage’’ is less than 50% but greater than or equal to 40%, and the Commissioner ‘‘thinks’’ that the entity is ‘‘controlled’’ by another entity: s 328-125(6).

CAPITAL ALLOWANCE RULES [25 100] Excluded depreciating assets Subdivision 328-D contains capital allowance concessions for small business entities that choose to use the concessions (a specific election is not required: see [25 010]). The concessions consist of an outright deduction for low value assets (see [25 110]) and pooling arrangements for other depreciating assets (see [25 120]). A low value asset is an asset valued at less than $1,000 or $20,000, depending on when the asset is acquired and first used, or installed ready for use, for a taxable purpose. Certain depreciating assets are not covered by the Subdiv 328-D capital allowance rules (s 328-175): © 2017 THOMSON REUTERS

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• assets listed in s 40-45 that do not qualify for depreciation under Div 40 (see [10 190]), including capital works covered by Div 43 (see [10 1460]) (Australian films, or copyright in Australian films, for which a deduction was available under former Div 10B or Div 10BA ITAA 1936 (see [11 400]) are also excluded); • R&D depreciating assets which qualify for a notional deduction under Div 355 (see [11 070]) or which qualified for a deduction (or offset) under earlier R&D tax concessions in the ITAA 1936 (see [11 100]); • horticultural plants (including grapevines): see [27 320]; • an asset that is let or might reasonably be expected to be let ‘‘predominantly on a depreciating asset lease’’ (including a building). A ‘‘depreciating asset lease’’ is, broadly, a lease under which a right to use a depreciating asset is granted, other than a short-term hire agreement (considered to be an agreement, or series of agreements, under which the hire period does not exceed 6 months: see ATO ID 2011/72). This exclusion ensures that the benefits of the Div 328 rules cannot be transferred through leases to taxpayers that are not small business entities; • an asset allocated to low-value pool under Subdiv 40-E (see [10 760]) during an income year in which the taxpayer was not a small business entity; and • an asset allocated to a software development pool under Subdiv 40-E: see [10 790]. Capital allowances on assets that are excluded from the Div 328 capital allowances regime are calculated under Div 40 in the normal way. It should be noted that ss 85-10 and 86-60, which would otherwise prevent a ‘‘personal services entity’’ from claiming capital allowances on certain assets, do not prevent a small business entity from claiming deductions under the Div 328 rules in respect of those assets (other than cars): s 328-235. Primary producers that have depreciating assets covered by Subdiv 40-F or Subdiv 40-G can choose to use those Subdivisions or Subdiv 328-D to calculate capital allowances. The depreciating assets in question are water facilities (see [27 310]), fodder storage assets (see [27 330]), fencing assets (see [27 335]), landcare operations (see [27 340]), electricity connections (see [27 350]) and telephone lines (see [27 360]). Subdivision 40-F also applies to horticultural plants (including grapevines), but s 328-175(5) specifically excludes horticultural plants and grapevines from the Subdiv 328-D concessions. The choice (to use Subdiv 328-D or the relevant provisions of Div 40) must be made for the later of the first income year in which a taxpayer is a small business entity and the income year in which the taxpayer started to use the asset, or have it installed ready for use, for a taxable purpose: s 328-175(4).

‘‘Lock-out’’ rule If an entity chooses to stop using the Div 328 capital allowance rules, they cannot again choose to use the rules until at least 5 years after the income year in which they chose to stop using the rules: s 328-175(10). This ‘‘lock-out’’ rule does not apply for income years that end on or after 12 May 2015 but on or before 30 June 2017 (called “increased access years”): s 328-180(2) TPA. Thus, for entities that balance at 30 June, the increased access years are 2014-15, 2015-16 and 2016-17. The lock-out rule will begin to apply again from the first income year that ends after 30 June 2017. However, in determining whether the lock-out rule applies from that point, the income years preceding the increased access years are disregarded, as are the increased access years except for the last of those years: s s 328-180(3) TPA. This will mean that, for entities that balance at 30 June, although the lock-out rule applies from the 2017-18 income year, they are only required to look as far back as the 2016-17 year in determining whether the lock-out rule applies. If for some reason a small business entity opted out of the small business capital allowance provisions in the 2016-17 income year (being the last of the increased access 1076

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years), the entity would be locked out from the small business capital allowance provisions for at least 5 years. However, the lock-out rule would not apply if the small business entity had instead opted out in the 2015-16 income year, or an earlier income year, but then chose to apply the small business capital allowance provisions in the 2016-17 income year.

[25 110] Outright deduction for low cost assets Small business entities that choose to apply the Subdiv 328-D capital allowance rules are entitled to an outright deduction for the “taxable purpose proportion” of the “adjustable value” of a depreciating asset if (s 328-180(1)): • the asset is a ‘‘low cost asset’’; and • the taxpayer starts to hold the asset when the taxpayer is a small business entity. (Since an outright deduction is only available for assets acquired while the entity is a small business entity, assets already pooled in the general small business pool (see [25 120]) must remain in the pool after an entity becomes a small business entity.) The deduction is available in the income year in which the taxpayer starts to use the asset, or installs it ready for use, for a taxable purpose. A depreciating asset is a ‘‘low cost asset’’ if its cost as at the end of the income year in which the taxpayer starts to use it, or installs it ready for use, for a taxable purpose is less than the relevant threshold: s 328-180. The thresholds are as follows (s 328-180 ITAA 1997 and s 328-180(4) TPA): • for depreciating assets first acquired by the taxpayer at or after 7.30 pm on 12 May 2015 AEST (‘‘the 2015 Budget time’’) and first used, or installed ready for use, by the taxpayer for a taxable purpose at or after the 2015 Budget time and before 1 July 2017 – $20,000. The requirement that a depreciating asset to have been ‘‘first’’ acquired (by the taxpayer) after the 2015 Budget time ensures that assets previously acquired at an earlier time, temporarily disposed of and then reacquired at or after the 2015 Budget time do not qualify for the $20,000 threshold. However, a second hand depreciating asset can qualify for the $20,000 low cost asset threshold if the taxpayer first acquires it after the 2015 Budget time; • for depreciating assets first acquired on or after 1 July 2014 and before the 2015 Budget time – $1,000; • for depreciating assets acquired at or after the 2015 Budget time but first used, or installed ready for use, for a taxable purpose before the 2015 Budget time – $1,000; and • for depreciating assets acquired on or after 1 July 2017, and depreciating assets acquired before 1 July 2017 but first used, or installed ready for use, for a taxable purpose on or after that date – $1,000. See earlier editions of this publication for the relevant threshold for income years before 2014-15. In the normal case, the ‘‘adjustable value’’ of a low cost asset will be the cost of the asset. The ‘‘taxable purpose proportion’’ is (broadly) the proportion that relates to use of the asset ‘‘for a taxable purpose’’. If there is additional expenditure on a low cost asset (ie an amount is included in the second element of cost: see [10 380]) and the additional expenditure is less than the relevant threshold (ie $20,000 or $1,000), the taxable purpose proportion of that expenditure is also deductible: s 328-180(2) ITAA 1997, s 328-180(5) TPA. However, in certain circumstances where additional expenditure is incurred, the asset is allocated to the general small business pool (see [25 120]), even if the expenditure is incurred during an income year for which the taxpayer is not a small business entity or has not chosen to use the Subdiv 328-D rules (s 328-180(3), (5) ITAA 1997, s 328-180(5) TPA): © 2017 THOMSON REUTERS

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• the additional expenditure is equal to or greater than the relevant threshold; or • the taxpayer has deducted (or can deduct) an amount under s 328-180(2) for an amount previously included in the second element of the asset’s cost.

Motor vehicles In most cases, a small business entity could effectively write off the first $5,000 of the cost of a motor vehicle which the entity acquired on or after 1 July 2012 and before 1 January 2014. This concession was repealed by the Minerals Resource Rent Tax Repeal and Other Measures Act 2014. [25 120] Depreciation of pooled assets Special pooling rules apply to small business entities that choose to apply the capital allowance rules in Subdiv 328-D. The pool is called the general small business pool. Subject to certain exceptions, depreciating assets held by an entity just before, and at the start of, the first income year for which it is, or last was, a small business entity and for which it chooses to use Subdiv 328-D are automatically allocated to the pool, provided the entity has started to use the asset, or have it installed ready for use, for a taxable purpose: s 328-185(2), (3). If the entity starts to use, or have installed ready for use, a depreciating asset for a taxable purpose during an income year for which it is a small business entity and chooses to use Subdiv 328-D, the asset is allocated to the pool at the end of that year. Once a depreciating asset is allocated to the pool, it is not re-allocated, even if the entity is not a small business entity for a later income year or it does not choose to use Subdiv 328-D for that later year: s 328-185(7). The following assets are not allocated to the pool: • ‘‘low cost assets’’ subject to immediate write-off (see [25 110]): s 328-185(1); and • certain depreciating assets first used, or first held ready for use, for a taxable purpose before 1 July 2001 and which the entity chose not to add to the pool: see the Australian Tax Handbook 2015 at [25 120].

Rate of deduction The deduction for the pool for an income year is calculated using the following formula (s 328-190(1)): Opening pool balance × 30%

Depreciating assets acquired during the income year (ie which the taxpayer starts to use, or has installed ready for use, during the income year) are depreciated at half the standard rate (ie 15%): s 328-190(2). This applies regardless of when the asset was acquired during the year. Any additions to the cost of a pooled asset (ie any amounts included in the second element of the cost of the asset: see [10 380]) incurred during the year are depreciable on the same half-rate basis as for assets acquired during the year (ie at the rate of 15%): s 328-190(3), (4). A taxpayer can write off the total balance of the pool when it falls below the relevant threshold (a low value pool): see [25 150].

Opening pool balance The opening pool balance for the taxpayer’s first year as a small business entity (and which chooses to use the Subdiv 328-D capital allowance rules) comprises the sum of the taxable purpose proportions of the adjustable values of the depreciating assets allocated to the pool: s 328-195(1). The ‘‘taxable purpose proportion’’ will generally be a reasonable estimate of the business use of a depreciating asset: see [25 130]. For the adjustable value of a depreciating asset, see [10 540]. 1078

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In subsequent years, the opening pool balance is equal to the ‘‘closing pool balance’’ for the previous year, reduced or increased by any adjustment that is required where there is a change in the business percentage use of an asset (see [25 140]). The opening pool balance is also adjusted to account for GST: see [10 810]. If an entity stops being a small business entity or chooses not to use Subdiv 328-D, depreciating assets previously allocated to the pool remain in the pool. If the entity later re-qualifies as a small business entity and chooses to use Subdiv 328-D, it will allocate, to the pool, assets which have come into use, or have been installed ready for use, for a taxable purpose in the interim: s 328-195(3). The taxable purpose proportion of the adjustable value of each such asset is added to the opening pool balance for the first income year in which the entity returns to Subdiv 328-D.

Closing pool balance There is a 3 step process (in s 328-200) for calculating the closing pool balance. Step 1 – add the following amounts to the opening pool balance for the income year: • the taxable purpose proportion of the adjustable value of each depreciating asset that was first used, or installed ready for use, for a taxable purpose during the income year and allocated to the pool; and • the taxable purpose proportion of any cost addition amount incurred in the income year which relates to an asset allocated to the pool (ie any amount included in the second element of the cost of the asset: see [10 380]). The ‘‘taxable purpose proportion’’ of a depreciating asset’s adjustable value, or of any cost addition, is that part of that amount which represents the proportion estimated under s 328-205(1) or (2) (see above) or, if an adjustment was made under s 328-225 for the asset (see [25 140]), the proportion most recently applicable to the asset under that section. Step 2 – subtract the following from the Step 1 amount: • the taxable purpose proportion of the termination value of each depreciating asset allocated to the pool (see below), for which a balancing adjustment happens during the income year (see [10 890] for the definition of ‘‘termination value’’); • the deduction for the pool calculated under s 328-190(1): see above; • the deduction allowable for depreciating assets first held by the small business entity during the year, as calculated under s 328-190(2): see above; and • the deduction allowable for cost addition amounts incurred in the year, as calculated under s 328-190(3): see above. Step 3 – the result is the closing pool balance for the income year. The taxable purpose proportion of the termination value of a depreciating asset is that part of the termination value which represents the ‘‘taxable use’’ proportion estimated under s 328-205(1) or (2) (see [25 130]). If there has been more than one estimate for the asset, an average proportion over a 4-year period is calculated – the average of the proportion estimated under s 328-205(1) or (2) for the income year in which the asset was allocated to the pool and the proportion applicable to the asset for each of the next 3 income years: s 328-205(4). EXAMPLE [25 120.10] VTD Pty Ltd is a small business entity which balances at 30 June. The opening balance of its general small business pool for 2016-17 is $68,720. During the first half of the 2016-17 income year, VTD disposes of a number of depreciating assets for $35,450 in total. In December 2016, VTD acquires a new depreciating asset that has an adjustable value of $21,500 (ie not a low cost asset). The taxable purpose proportion for all assets is 100%. © 2017 THOMSON REUTERS

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The deduction allowable under s 328-190 is ($68,720 × 30%) + ($21,500 × 15%) = $23,841 ($20,616 + $3,225). The closing value of the pool is ($68,720 + $21,500) – ($35,450 + $23,841) = $30,929. That is also the opening value of the general small business pool for 2017-18.

Ceasing to be small business entity If a taxpayer ceases to be a small business entity, or chooses to stop using the Subdiv 328-D capital allowance rules, the general small business pool remains in existence and deductions and adjustments continue to be calculated for the pool under the Subdiv 328-D rules: s 328-220(1). However, depreciating assets that the taxpayer started to use or installed ready for use for a taxable purpose after ceasing to be a small business entity, or after choosing to stop using the Subdiv 328-D rules, are not allocated to the pool: s 328-220(2). Capital allowances for those assets are calculated under Div 40. If the taxpayer again qualifies as a small business entity or chooses to use the Subdiv 328-D rules, the adjustable values of those assets will be transferred to the pool if the assets are not specifically excluded from the scope of the Subdiv 328-D rules. Transitional rules If an entity stopped being an STS taxpayer before 2006-07, but they are a small business entity for 2007-08 or a later income year and choose to use the Subdiv 328-D rules, the opening pool balance of the general small business pool includes the sum of the taxable purpose proportions of the adjustable values of depreciating assets allocated to the pool for the later year: s 328-195(3) TPA. [25 130] Estimate of taxable purpose use For the first year in which a taxpayer is a small business entity or chooses to use the Subdiv 328-D capital allowance rules, the taxpayer is required to make a ‘‘reasonable estimate’’ of the proportion of the use of each depreciating asset ‘‘for a taxable purpose’’: s 328-205(1). An estimate must also be made for any asset acquired while a taxpayer is a small business entity: s 328-205(2). If another provision of the income tax legislation denies a deduction for the asset in that year, the estimate of the proportion of use of the asset for a taxable purpose is taken to be zero: s 328-230. The proportion of estimated use of the asset ‘‘for a taxable purpose’’ is used to determine the ‘‘taxable purpose proportion of a depreciating asset’s adjustable value’’ or the ‘‘taxable purpose proportion of an amount included in the second element of its cost’’ (essentially, expenditure on improving the asset). If different estimates have been made for the same asset for different years (only if there is a change of more than 10%: see [25 140]), the most recent estimate applies: s 328-205(3). As noted above, these concepts are used in calculating the amount of the cost of the asset or the cost of the improvement (as the case may be) that is added to the general small business pool balance. [25 140] Adjustments for changes in use A change in a taxpayer’s estimate of the proportion of business use of a depreciating asset can result in an adjustment under s 328-225 to the opening pool balance of the general small business pool. The aim of the adjustment is to ensure that the annual deduction for the pool is not based on a materially incorrect estimate of the proportion of the depreciating asset’s business use. An adjustment is required in any year for which a small business entity’s estimate of the proportion of business use of an asset differs by more than 10% from: • the taxpayer’s original estimate of the proportion of business use of the asset; or 1080

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[25 160]

• the taxpayer’s most recent estimate of the proportion of business use of the asset that resulted in an adjustment under s 328-225. The calculation of the adjustment is complex, but the required steps are clearly set out in s 328-225(3) and (4). No adjustment is necessary for a depreciating asset for an income year that is at least 3 income years after the year in which the asset was allocated to the general small business pool.

[25 150] Low value pools If the value of the general small business pool falls below the relevant threshold, a small business entity can claim an immediate deduction for the pool balance (provided it is greater than zero): s 328-210(1). The relevant thresholds are: • for income years ending on or after 12 May 2015 and before 1 July 2017 (ie 2014-15, 2015-16 and 2016-17 for entities that balance at 30 June) – $20,000; • for the 2014-15 income year if the entity’s 2014-15 income year ended before 12 May 2015 – $1,000; and • for income years ending after 30 June 2017 – $1,000. See earlier editions of this publication for the relevant threshold for income years before 2014-15. To determine whether the pool value satisfies this requirement, the following are added to the pool’s opening balance for the income year (s 328-210(2)): • the taxable purpose proportion of the adjustable value of pool assets that are first used, or installed ready for use, during that year and allocated to the pool; and • the taxable purpose proportion of the cost addition amounts incurred in the income year in respect of assets in the pool, and the following amount is subtracted: • the taxable purpose proportion of the termination value of pool assets to which a balancing adjustment event happened during the year (see [25 140]). If the pool balance is claimed as an immediate deduction, the closing pool balance for the income year becomes zero: s 328-210(3). EXAMPLE [25 150.10] WDA Pty Ltd is a small business entity which balances at 30 June. The opening balance of its general small business pool for 2016-17 is $29,450. During the first half of the 2016-17 income year, WDA disposes of a number of depreciating assets for $11,820 (the taxable purpose proportion of the termination value of each asset is 100%). Later in the income year WDA acquires 3 new depreciating assets, each one costing less than the low cost threshold. The closing value of the pool calculated under s 328-210 is ($29,450 – $11,820) = $17,630. Because the value of the pool adjusted in this way is under $20,000, WDA can claim an outright deduction of $17,630 in 2016-17. The opening value of the general small business pool for 2017-18 is zero.

[25 160] Disposal of a depreciating asset If a balancing adjustment event (see [10 850]) happens to an asset in the general small business pool, the taxable use proportion of the termination value of the asset is subtracted in calculating the closing value of the pool: see Step 2 in calculating the pool closing balance at © 2017 THOMSON REUTERS

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[25 120]. However, if balancing adjustment roll-over relief is chosen under s 40-340(3), that amount is not subtracted: see [25 170]. See [10 890] for the definition of ‘‘termination value’’. If, after the taxable use proportion of the asset’s termination value is subtracted from the pool value, the closing pool balance is less than zero, the amount by which that balance is less than zero is included in the entity’s assessable income: s 328-215(2)(a). Similarly, if, as a result of a balancing adjustment event, the calculation under s 328-210(2) (see [25 150]) results in a negative amount, the amount below zero is included in assessable income: s 328-215(2)(b). In such cases, the pool’s closing balance then becomes zero, rather than the negative amount. Where an asset for which a small business entity has claimed an immediate deduction (see [25 110]) is subject to a balancing adjustment event, an amount representing the termination value of the asset is included in the entity’s assessable income. If the asset was not used 100% for business purposes, the termination value is reduced accordingly: s 328-215(4). Where an entity ceases to carry on a business and disposes of all the assets in a pool which has a positive closing balance, there is no balancing adjustment deduction; the entity continues to claim annual deductions until the balance of the pool falls below the small business instant asset write-off threshold (see [25 110]), at which time the balance is deductible.

[25 170] Roll-over relief If a balancing adjustment event happens to a depreciating asset because a small business entity disposes of the asset (and the disposal is a CGT event) and the first entity has claimed deductions under Subdiv 328-D in respect of the asset, roll-over relief (under s 40-340(1)) is available in the following situations where CGT roll-over relief would be available (s 328-243(1A)): • the asset is disposed of to a wholly-owned company (Subdiv 122-A: see [16 030]); • a partnership disposes of the asset to a wholly-owned company (Subdiv 122-B: see [16 030]); • the asset is transferred as a result of a marriage breakdown (Subdiv 126-A: see [16 300]); or • the asset is transferred under a small business restructure (Subdiv 328-G: see [16 500]). The transferor and the transferee must jointly choose roll-over relief. Roll-over relief is also available under s 40-340(3) if there is partial change in the ownership of an asset held by a small business entity that is a partnership (ie as a result of a variation in the constitution of the partnership or in the interests of the partners in the partnership) and the small business entity has claimed deductions under Subdiv 328-D in respect of the asset: s 328-243(1). The entity or entities that had an interest in the asset just before the balancing adjustment event happens and the entity or entities that have an interest in the asset just after that event happens must jointly choose the roll-over relief. This means, for example, that if a sole trader enters into a partnership or a partner leaves a partnership to operate as a sole trader, roll-over relief will be available to defer any adjustment to taxable income resulting from that balancing adjustment event. Roll-over relief is not available if all the assets that were allocated to a partnership’s general small business pool are disposed of to the former partners and, just after the disposals, no former partner has an interest in each of the assets that were allocated to the pool: see ATO ID 2011/99. In all cases where roll-over relief is available, all assets that, just before the balancing adjustment event, were held by the transferor and were allocated to the general small business 1082

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pool must be held by the transferee after the balancing adjustment event happens (this means that roll-over relief must be sought for all pooled assets and not just selected ones): s 328-243(2). If roll-over relief is chosen: • the transferor does not subtract an amount in calculating the closing pool balance for the general small business pool or in working out a deduction in relation to a low value pool: s 328-245; • the deduction from the transferor’s general small business pool for the year in which the balancing adjustment event happens is split equally between the transferor and the transferee: s 328-247; • any deduction available in respect of an asset that was first used, or installed ready for use, by the transferor in the year in which the balancing adjustment event happens is split equally between the transferor and the transferee: s 328-250; • there is an equal split between the transferor and transferee of any deduction available in the year in which the balancing adjustment event happens for expenditure on an asset incurred by the transferor as a cost addition amount (ie an amount included in the second element of the cost of the asset: see [10 380]): s 328-253; • if the closing balance of the general small business pool, or the amount worked out under s 328-210(2) (see [25 150]), in the year in which the balancing adjustment event happens is less than zero, the amount included in assessable income is split equally between the transferor and the transferee: s 328-255; and • for the year in which the balancing adjustment event happens, the transferee uses the transferor’s estimate (or most recent estimate if more than one) of the taxable use under s 328-205(1) (see [25 130]). For later income years, s 328-255 (about adjustments for changes in use: see [25 140]) will operate as if the transferee had held the asset during the period that the transferor held it and estimates made by the transferor were made by the transferee: s 328-257.

TRADING STOCK RULES [25 200] Choice not to account for changes in the value of trading stock Under Subdiv 328-E, a small business entity can choose not to account for changes in the value of trading stock for an income year, if the difference between the opening value of trading stock on hand and a reasonable estimate of the GST-exclusive value of trading stock on hand at the end of the year does not exceed $5,000: s 328-285(1). When making a reasonable estimate of the value of trading stock on hand, the taxpayer may use special valuation rules, eg in relation to obsolete stock (see [5 340]) or a natural increase in live stock (see [27 110]). In addition, that taxpayer should take into account factors such as: the type of trading stock held (eg large variety versus large numbers of items); where and how it is stored (eg number of locations); whether there are material variations in the value of items of trading stock; how sales and purchases of trading stock are recorded; inventory systems used and their known accuracy; information from previous stocktakes; and any significant changes from previous income years to the type and quantity of trading stock held. Note that there is no need to make a specific election to use these trading stock concessions: see [25 010]. If these trading stock concessions are not used, the normal trading stock rules in Subdiv 70-C will apply: see [5 220] and [5 300]-[5 370]. © 2017 THOMSON REUTERS

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[25 210] Effect of not accounting for changes in the value of closing stock As is the case for all taxpayers, the value of a small business entity’s stock on hand at the beginning of the income year is the same as the value taken into account at the end of the previous income year: s 328-295(1). This rule applies regardless of whether, for the previous year, the taxpayer took account of changes in the value of trading stock. If the taxpayer’s reasonable estimate of the changes in the value of trading stock on hand between the beginning and the end of the year is less than $5,000 and the taxpayer chooses not to account for the change in value, the value of closing stock for that year is taken to be the same as the value of trading stock at the beginning of the year: s 328-295(2).

TAX DISCOUNT RULES [25 250] Tax discount for small business entities The rate of tax applicable to a small business entity that is a company has been reduced from 30% (the standard company tax rate) to 28.5%. The 28.5% rate applies for income years commencing on or after 1 July 2015. This means that the company tax rate for small business entities that balance at 30 June is: • 30% for 2014-15 and earlier years; and • 28.5% for 2015-16 and later years. However, the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 proposes to reduce the rate to 27.5% as from the 2016-17 income year (with further reductions from 1 July 2024 until 1 July 2026, when the rate is proposed to fall to 25%: see also [20 030]). The Bill also proposes to introduce the term ‘‘base rate entity’’ to describe any entity that qualifies for the lower corporate tax rate.

Small business tax offset – qualifying rules To complement the reduction in the company tax rate from 30% to 28.5%, a small business entity that is not a company is entitled to a tax discount (by way of a tax offset) under Subdiv 328-F for income years commencing on or after 1 July 2015 (ie the 2015-16 and later income years for an entity that balances at 30 June). The offset (the small business income tax offset) is available to individuals (ie sole traders) who are small business entities, individuals who are partners in a partnership that is a small business entity and individuals who are beneficiaries of a trust that is a small business entity. The offset is not available to individuals in their capacity as a trustee. An individual also qualifies for the offset if her or his assessable income has the necessary connection to a small business entity, does not give rise to a tax offset more than once for the same amount of income and is of the same character as other types of income to which the offset applies. This is designed to be flexible enough to allow for the direct and indirect consequences of an individual being a partner or beneficiary. A foreign resident may qualify for the offset and the offset can apply to the foreign business income of an Australian resident. Note that although the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 proposes to increase the aggregated turnover threshold for small business entities to $10m (see [25 020]), the threshold will be $5m for the purposes of accessing the small business income tax offset. Amount of offset The amount of the offset is equal to 5% of the income tax payable on the portion of an individual’s taxable income that is net small business income (but subject to a $1,000 cap): s 328-360. Note that the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 proposes 1084

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to increase the offset rate to 8% from the 2016-17 income year (to complement the proposed reduction in the small business company tax rate to 27.5%). The income tax payable on the portion of an individual’s taxable income that is net small business income is worked out in accordance with the following formula: Your total net small business income for the income year × Your basic income tax liability for the income year Your taxable income for the income year

An individual’s total net small business income for an income year is comprised of the net small business income he or she makes as a small business entity during the income year, together with any share of the net small business income of another entity that is a small business entity (other than a corporate tax entity) that is included in the individual’s assessable income, less any deductions that are attributable to that share (except deductions for tax-related expenses, gifts and personal superannuation contributions): s 328-360(1). If an individual has an amount included in their total net small business income as a result of the amendments discussed above, the amount is reduced by any deductions attributable to the amount to which the individual is entitled. A component amount (of total net small business income) is not reduced below zero where it is less than the deductions attributable to it. Note that the total net small business income cannot exceed the individual’s taxable income for the year. An entity’s net small business income for an income year is the sum of the entity’s assessable income minus its deductions for the year, to the extent that the assessable income relates to the entity carrying on a business and its deductions are attributable to that assessable income: s 328-365(1). Net capital gains (see [14 360]) and any personal services income not produced from conducting a personal services business (see [6 150]) are disregarded (s 328-365(1)), while deductions for tax-related expenses, gifts and personal superannuation contributions are not included in attributable deductions: s 328-370. Note that the net small business income is taken to be zero if it would otherwise be a negative amount: s 328-365(2). If an individual is under 18 on the last day of the income year and is not an ‘‘excepted person’’ for the purposes of Div 6AA ITAA 1936 (ie if he or she is a ‘‘prescribed person’’ for Div 6AA purposes: see [26 020]), total net small business income is worked out in accordance with s 328-375. It is the total amount of ‘‘business income’’ (as defined for Div 6AA purposes: see [26 080]) that the individual derives from carrying on a business as a small business entity, and from carrying on a business in a partnership that is a small business entity (if relevant), less any deductions that the individual or the partnership has, to the extent the deductions are attributable to the individual’s business income. Note that the net small business income is taken to be zero if it would otherwise be a negative amount. The total net small business income of a ‘‘prescribed person’’ cannot exceed his or her taxable income for the income year. Note that the offset is not available to a ‘‘prescribed person’’ who is a beneficiary of a trust that is a small business entity. See [1 100] for how a taxpayer’s basic income tax liability is worked out. As noted above, the maximum amount of the offset available to an individual in an income year is capped at $1,000: s 328-360(2). The $1,000 cap applies regardless of the number of small business entities that cause the taxpayer to be entitled to the offset for the particular year. EXAMPLE [25 250.10] Eloise is a small business entity. For the 2016-17 income year, her taxable income is $74,500, her basic income tax liability is $15,760 and her total net small business income is $37,250.

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Eloise’s small business income tax offset is worked out as follows: 1. Divide the total net small business income by taxable income, ie $37,250/$74,500 = 0.5. 2. Multiply the basic income tax liability by 0.5, ie $15,760 × 0.5 = $7,880. In effect, $7,880 of Eloise’s basic income tax liability is from her total net small business income. 3. Eloise’s small business tax offset is $394 ($7,880 × 5%).

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INTRODUCTION Overview ....................................................................................................................... [26 010] APPLICATION OF DIV 6AA Prescribed persons ......................................................................................................... [26 020] Excepted persons ........................................................................................................... [26 030] OPERATION OF DIV 6AA Eligible taxable income ................................................................................................ [26 050] Excepted assessable income – overview ...................................................................... [26 060] Employment income ..................................................................................................... [26 070] Business income ............................................................................................................ [26 080] Income from deceased estates ...................................................................................... [26 090] Investment of property received from legal or moral claims ...................................... [26 100] Trust income .................................................................................................................. [26 110] Partnership income ........................................................................................................ [26 120] Anti-avoidance – general .............................................................................................. [26 130] TRUST INCOME Application of Div 6AA to trust income ..................................................................... [26 Trust resulting from death of a person ......................................................................... [26 Property received indirectly as a result of death of a person ..................................... [26 Damages ........................................................................................................................ [26 Other sources ................................................................................................................. [26 Dealings not at arm’s length ........................................................................................ [26 Anti-avoidance – general .............................................................................................. [26 Discretionary trusts ....................................................................................................... [26

150] 160] 170] 180] 190] 200] 210] 220]

RATES OF TAX Rates of tax on Div 6AA income ................................................................................. [26 250]

INTRODUCTION [26 010] Overview This chapter considers the special rules designed to discourage family income splitting arrangements, whereby income is diverted to minors (ie those under 18) in order to reduce the tax payable on total family income. In effect, the special rules in Div 6AA in Pt III ITAA 1936 tax the ‘‘unearned income’’ of certain minors at the highest marginal tax rate. The rules apply to most minors (see [26 020]), but certain minors are not covered: see [26 030]. The rest of the chapter considers the operation of the rules, in particular the types of income subject to the rules (see [26 050]-[26 130]) and the application of the rules to trust income derived by a beneficiary who is a minor: see [26 150]-[26 220]. The relevant tax rates are discussed at [26 250].

APPLICATION OF DIV 6AA [26 020] Prescribed persons Division 6AA applies to ‘‘prescribed persons’’. A ‘‘prescribed person’’ is a person who is under 18 (a minor) on the last day of the income year and who is not an ‘‘excepted person’’ (see [26 030]): s 102AC(1). The income to which Div 6AA applies is known as ‘‘eligible © 2017 THOMSON REUTERS

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taxable income’’: see [26 050]. The Division applies to all income of all minors unless a specific exclusion exists (the minor might be excluded as an ‘‘excepted person’’ or the income might be excluded as ‘‘excepted assessable income’’). The categories of ‘‘excepted person’’ are considered at [26 030] and the categories of ‘‘excepted assessable income’’ are considered at [26 060]-[26 130]. The assessability or deductibility of a minor’s income is determined in the usual manner by the relevant provisions of the ITAA 1936 and ITAA 1997. Division 6AA merely identifies that portion of assessable income which is to be taxed at the special rates: see [26 250]. Division 6AA is often relevant if trust income is derived by minors, but it applies equally to various other types of ‘‘unearned income’’. Of course, the income in question must belong to the minor before Div 6AA applies. In certain circumstances, the income may in fact belong to a parent or other adult, eg if the adult provides the funds to acquire shares in the child’s name, makes all decisions concerning the shares and spends the money earned on the shares. The ownership of interest income accruing to children’s savings accounts is considered at [6 500]. A person under 18 is under a legal disability. Accordingly, if a minor is presently entitled to a share of the income of a resident trust estate, the trustee is assessed and liable to pay tax under s 98 ITAA 1936 in respect of the corresponding share of the net income of the trust estate. However, a minor’s legal disability is effectively ignored if the minor is a beneficiary in the capacity of the trustee of another trust estate or the owner of a farm management deposit (and a primary producer when the deposit is made): ITAA 1936 ss 95B, 97A. In those circumstances, the relevant share of the net income of the trust estate is generally assessed in the hands of the minor under s 97 ITAA 1936: see [26 110].

[26 030] Excepted persons Division 6AA does not apply to income derived during an income year by a minor who is an ‘‘excepted person’’ in respect of that year. The list of ‘‘excepted persons’’ includes (s 102AC(2)): • a minor engaged in a full-time occupation on the last day of the income year. However, see s 102AC(4), (6), (7) and (8), discussed below; • a minor in receipt of a disability support pension, or in respect of whom a carer allowance is payable, under the Social Security Act 1991 (SSA) in respect of a period of time during the relevant year including the last day of the income year, or is in receipt of a rehabilitation allowance under the SSA and would otherwise be entitled to an invalid pension; • a minor who the Commissioner is satisfied is, on the last day of the income year, a disabled child or a disabled adult within the meaning of Pt 2.19 SSA, a person with a continuing inability to work within the meaning of Pt 2.3 SSA or who is permanently blind (a medical certificate to that effect must be provided to the Commissioner); • a minor in respect of whom a double orphan pension was payable under the SSA, or would have been payable but for s 1003 SSA (ie if the minor receives a pension under Pt II or Pt IV of the Veterans’ Entitlements Act 1986), in respect of a period during the relevant income year including the last day of the year (although see s 102AC(3), discussed below); and • a minor who the Commissioner is satisfied suffers, on the last day of the income year, a permanent disability and, as a result, is unlikely to be able to engage in a full-time occupation (a medical certificate to that effect must be provided to the Commissioner). Section 102AC(3) to (8) provides some additional tests that must be satisfied even if a minor is prima facie within one of these categories, as well as clarifying the limits of those 1088

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categories; these subsections are discussed below. Note that if a medical certificate is required (third and fifth points above), it must be given by a legally qualified medical practitioner.

Double orphans If a minor in respect of whom a double orphan pension was payable, or would have been payable but for s 1003 SSA, was wholly or substantially dependent for support on a relative or relatives throughout the relevant period (which must include the last day of the income year), the minor is not an ‘‘excepted person’’ (and therefore Div 6AA may apply): s 102AC(3). Whether a minor is ‘‘wholly or substantially dependent’’ on a relative is a question of fact. ‘‘Substantially’’ suggests dependency to a degree greater than 50%. Although such a minor is not an ‘‘excepted person’’, income derived by the minor may be ‘‘excepted assessable income’’, eg if derived from property received from the estate of a deceased person: see [26 090]. An orphan residing with a relative is taken to have been wholly or substantially dependent for support on that relative unless the contrary is established to the satisfaction of the Commissioner, eg by establishing that the minor paid for meals, accommodation etc: s 102AC(5). Minors suffering from permanent disabilities A minor who is medically certified as suffering from a permanent disability and, as a result, is unlikely to be able to engage in a full-time occupation (see above) is not an ‘‘excepted person’’ if, during the whole of the period that he or she was suffering from this permanent disability, the person was wholly or substantially dependent for support on a relative or relatives (in which case Div 6AA may apply): s 102AC(4). See above for comment on the phrase ‘‘wholly or substantially dependent’’. As in the case of double orphans, a minor residing with a relative is taken to have been wholly or substantially dependent for support on that relative unless the contrary is established. Minors engaged in full-time occupations An ‘‘excepted person’’ includes a minor engaged in a full-time occupation on the last day of the income year: s 102AC(2)(b). The word ‘‘occupation’’ is defined in s 102AA(1) as any office, employment, trade, business, profession, vocation or calling. A course of education at an educational institution such as a school, college or university is excluded. A minor who is not in a full-time occupation on the last day of the income year will be taken to be in a full-time occupation on that day (and thus an ‘‘excepted person’’) if he or she was engaged in a full-time occupation during the income year for a minimum period of 3 months (or periods which total at least 3 months): s 102AC(6). If a minor is engaged in a full-time occupation for a period and then engages in a full-time course of education at a school, college, university or similar institution, the period of engagement in a full-time occupation is disregarded in determining whether the minor has been engaged in a full-time occupation for at least 3 months: s 102AC(7). A period of unemployment does not have the same effect. EXAMPLE [26 030.10] Zara, who is a minor, is employed full-time from 27 September 2016 to 15 February 2017. She then enrols full-time at a university but abandons the course after 2 months. Zara starts another full-time job on 29 April 2017 but leaves that job on 21 June 2017 to go travelling overseas. Although she was employed on a full-time basis for more than 3 months during the 2016-17 income year, the first period of employment is disregarded and therefore she is not engaged in a full-time occupation for at least 3 months. Accordingly, Zara is not an ‘‘excepted person’’.

Section 102AC(8) prevents minors taking advantage of the ‘‘excepted person’’ exemption if not genuinely engaged in a full-time occupation. The subsection provides that a © 2017 THOMSON REUTERS

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person will not be taken to be engaged in a full-time occupation on the last day of the income year (and thus will not be an ‘‘excepted person’’) unless the Commissioner is satisfied that, on the last day of the year, the minor intends to remain in a full-time occupation (or occupations) during the whole or a substantial part of the next succeeding income year and does not intend to engage in a full-time educational course at any time during the next succeeding income year.

OPERATION OF DIV 6AA [26 050] Eligible taxable income A minor subject to Div 6AA (ie a ‘‘prescribed person’’: see [26 020]) is liable for tax on the ‘‘eligible taxable income’’ at the rate applicable as determined by the Income Tax Rates Act 1986: see [26 250]. The ‘‘eligible taxable income’’ is determined by calculating the ‘‘eligible assessable income’’ and deducting from it the sum of: the deductions that relate specifically to that income; the deductions other than apportionable deductions that may properly be related to the ‘‘eligible assessable income’’; and the proportion of apportionable deductions that the ‘‘eligible taxable income’’ of the individual bears to the taxable income plus the apportionable deductions: s 102AD. The ‘‘eligible assessable income’’ of a minor for an income year is the amount of the minor’s assessable income for the year less the ‘‘excepted assessable income’’: s 102AE. See [26 060]-[26 130] for the meaning of ‘‘excepted assessable income’’. Note that a minor is deemed to have derived income if that amount is included in his or her assessable income under the other provisions of the ITAA 1997 or ITAA 1936. EXAMPLE [26 050.10] Andre is a minor who, in 2016-17, derives income of $4,000 from wages and $6,000 of ‘‘eligible assessable income’’. He is entitled to a deduction of $500 directly related to the ‘‘eligible assessable income’’ and to a deduction of $400, being ‘‘apportionable deductions’’. The 2016-17 tax payable is determined as follows: $ $ Eligible assessable income ......................................................... 6,000 less deduction directly related to this income .................................... 500 proportion of apportionable deductions* ..................................... 232 732 Eligible taxable income 5,268 add salary ........................................................................................... 4,000 less balance of apportionable deductions .................................. 168 3,832 Taxable income ........................................................................... 9,100 Tax payable on eligible taxable income (ignoring cents) = $5,268 × 47% = $2,475 (see [26 250] for the rates of tax). Note that the low income offset does not reduce the tax payable by a minor in these circumstances: see [26 250]. *($232) deducted from ‘‘eligible assessable income’’ calculated as follows: Eligible assessable income ($6,000) − direct deductions ($500) × $400 Taxable income ($9,100) + apportionable deductions ($400) = $5,500 × $400 $9,500 = $232

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Property Division 6AA applies to income derived by a minor from, among other things, property, but excludes income derived from the investment of property transferred to the minor in various circumstances of a socially compensatory nature (eg damages for personal injury and life insurance on the death of another person). The term ‘‘property’’ is defined in s 102AA(1) to include money, as well as real and personal property. Provisions in Div 6AA which refer to income derived from particular property include a reference to income derived from property which, in the Commissioner’s opinion, represents the first-mentioned property: s 102AA(4). This prevents Div 6AA being circumvented by substituting other property for the particular investment property (including money). [26 060] Excepted assessable income – overview ‘‘Excepted assessable income’’ is excluded from the application of the special rates of tax that apply to income derived by a minor. The categories of ‘‘excepted assessable income’’ are set out in s 102AE(2), subject to various qualifications set out in ss 102AE, 102AF and 102AG. The categories of ‘‘excepted assessable income’’ are: • employment income: see [26 070]; • business income: see [26 080]; • income from deceased estates: see [26 090]; • income from the investment of property (including money) transferred to a minor by way of, or in settlement of, a claim for damages in respect of loss of parental support or personal injury: see [26 100]; • trust income included in a minor’s assessable income under s 97 or s 100 ITAA 1936, unless Div 6AA applies to that income: see [26 110]; • partnership income: see [26 120]; • excepted trust income: see [26 160]-[26 220]; • income derived from investing winnings, which are capable of verification, from a legally organised and conducted lottery; and • income derived from investing ‘‘excepted assessable income’’, or income that would have been ‘‘excepted assessable income’’ if Div 6AA had operated in relation to the income year in which it was derived, and from investing exempt income which would have been ‘‘excepted assessable income’’ if it had been assessable income. Note the anti-avoidance provisions discussed at [26 130].

[26 070] Employment income Employment income is ‘‘excepted assessable income’’ and thus not subject to the provisions of Div 6AA: s 102AE(2)(a). ‘‘Employment income’’ is defined in s 102AF(1) as: • work and income support related withholding payments and benefits within the meaning of s 221A(1), effectively payments for work and services (eg salary and wages, return to work payments and payments under labour hire arrangements), non-cash benefits, retirement payments, ETPs, annuities, benefits and compensation payments from which amounts must be withheld under the PAYG withholding system (see [50 020]) and alienated personal services payments in respect of which payments must be made to the Commissioner (see [50 100]); • payments for services rendered or to be rendered; and • compensation, sickness or accident payments made to an individual because of the individual’s or another person’s incapacity for work and which are calculated at a periodical rate. © 2017 THOMSON REUTERS

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The exclusion of employment income from the provisions of Div 6AA where trusts are concerned is limited to income derived by the beneficiary: s 102AG(5A). The exclusion does not apply to income derived by the beneficiary from business income that consists of the provision of people for employment under service-type arrangements. Scholarships, educational allowances and educational assistance payments, but not payments under Commonwealth education or training programs, are generally tax-exempt (see [7 250]) and would not be employment income.

[26 080] Business income Business income is ‘‘excepted assessable income’’ and thus not subject to the provisions of Div 6AA: s 102AE(2)(a). ‘‘Business income’’ refers to income derived from a business carried on by the taxpayer either individually or together with another person or persons: see s 102AF(3). The Commissioner may examine the income derived by a minor from a business, whether carried on alone or in partnership with other persons under 18, and determine for these purposes the extent to which that business income is fair and reasonable having regard to (s 102AE(5)(a)): • the participation of the minor in the day-to-day activities of the business; • whether the minor had the real and effective conduct and control of the business or her or his proportion of the partnership business (s 94); • the extent to which the minor had the right to dispose of her or his proportion of the income derived by the business; • the extent to which the income of the business was derived from capital contributed by the minor, particularly having regard to the question of whether the income derived from the capital would be ‘‘excepted assessable income’’; and • such other matters as the Commissioner considers to be appropriate. For a detailed analysis of the scope of s 102AE(5), see AAT Case 50 (1987) 18 ATR 3312, AAT Case 54 (1987) 18 ATR 3348 and Ruling IT 2489. In the case of other business income such as income derived from a partnership if one or more of the other partners is over 18, the Commissioner may determine for those purposes (s 102AE(5)(b)): • a reasonable remuneration by way of salary or wages for the services that were rendered by the minor; and • the amount that is a reasonable reward for the provision of capital of the business that had been contributed by the minor and would be excepted assessable income in relation to that minor. The sum of these 2 amounts is excepted assessable income and any surplus received by the minor from the business would be eligible assessable income subject to the provisions of Div 6AA. Note that, from the 2015-16 income year, a minor who qualifies as a small business entity may be entitled to a tax offset: see [25 250].

[26 090] Income from deceased estates Income derived by a minor from property received from a deceased estate is ‘‘excepted assessable income’’ and thus not subject to the provisions of Div 6AA: s 102AE(2)(c)(i). Similarly, if a third party who has received property from a deceased estate transfers that property to the minor within 3 years of the date of death, income derived from that property is also ‘‘excepted assessable income’’, but subject to the limitation discussed below: s 102AE(2)(c)(ii). 1092

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[26 100]

Limitations on income derived from deceased estates Section 102AE(10) limits the amount of income derived from property (from a deceased estate) transferred to the minor by a third party that will qualify as excepted assessable income. This limitation does not apply if the income is derived from property received directly from a deceased estate. The ‘‘excepted assessable income’’ is limited to the amount of the income that would have been derived if the property transferred to the minor by the third party had been limited to such amount as would have been received under an intestacy of the deceased person. If the minor would not have qualified as a person to receive property from the estate of the deceased person, no part of the income qualifies as ‘‘excepted assessable income’’. If, in addition to the income from property transferred to the minor by a third party, the minor also received property directly from the estate of that deceased person, the 2 amounts of property are taken into account for the purpose of determining the amount of income that will qualify as excepted assessable income. In this instance, the income derived from property directly received by the minor from the deceased person is not affected if the property received is in excess of that which would have been received by the minor under an intestacy. It is only the property received by the minor through a third party that can be affected by this position. [26 100] Investment of property received from legal or moral claims Income derived from investing money or other property is ‘‘excepted assessable income’’ where the money or property was transferred to a minor in the following circumstances: s 102AE(2)(b): • by way of, or in satisfaction of a claim for, damages for the loss by the minor of parental support, or for personal injury to the minor, any disease suffered by the minor or for any impairment of the minor’s physical or mental condition; • under workers compensation legislation; • under any law relating to the payment of compensation in respect of criminal injuries; • directly as a result of the death of another person and under the terms of a life assurance policy; • directly as a result of the death of another person and out of a provident, benefit, superannuation or retirement fund; • by the employer of a deceased person directly as the result of the death of that person; • as the result of a family breakdown (defined in s 102AGA to include legal obligations arising not only from the breakdown of live-in relationships, but also if parentage has occurred outside of such a relationship); or • out of a public fund established and maintained exclusively for the relief of persons in necessitous circumstances. In The Trustee for the Confidential Trust and FCT (2014) 100 ATR 158, trust income distributed to 2 infant beneficiaries was not ‘‘excepted trust income’’ because it was not derived from money transferred to the minors as required by s 102AE(2)(b). Instead, the income was derived from money transferred to the trust as a result of a workers compensation claim.

Limitations with damages from out of court settlements If income is derived by a minor from the investment of moneys received as a result of a claim for damages for the loss of parental support, or personal injury or disease suffered by the minor or impairment of her or his physical or mental condition, and those damages were © 2017 THOMSON REUTERS

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not received as a result of a court order (eg an out of court settlement not incorporated in a court order), the ‘‘excepted assessable income’’ is limited to the amount the Commissioner considers to be fair and reasonable: s 102AE(9). The excess of the income over this amount is subject to the application of the special rates of tax imposed by Div 6AA.

[26 110] Trust income Trust income would prima facie form part of the eligible assessable income of a minor pursuant to s 102AE(1) in the same manner as other assessable income. While trust income included in the assessable income of a minor under s 97 or s 100 (see [23 430]) appears to be ‘‘excepted assessable income’’ (s 102AE(2)(e)), s 102AE(4) excludes from excepted assessable income any part of such trust income ‘‘to which this Division applies’’. The words ‘‘to which this Division applies’’ are then adopted by s 102AG(1), which deals with trust income: see [26 150]-[26 220]. It follows a similar pattern to s 102AE, applying to every item of trust income unless specifically excluded. The prime exclusion is for a trust estate resulting from a will. The other exclusions are similar to those that would apply under s 102AE(2) were the income derived directly by the minor rather than through a trust. The net result is that if trust income is ‘‘excepted trust income’’ for the purposes of s 102AG, it will also be ‘‘excepted assessable income’’ for the purposes of s 102AE; and if it is not ‘‘excepted trust income’’, it will be ‘‘eligible assessable income’’ under s 102AE. A similar result is achieved if the trustee is assessed under s 98, but indirectly through the Income Tax Rates Act 1986 and s 102AA(3)(b), rather than solely through the wording of Div 6AA. [26 120] Partnership income Partnership income derived from a business may be ‘‘excepted assessable income’’: see [26 080]. In the case of other partnership income, such as from the joint derivation of income from property, that income will qualify as ‘‘excepted assessable income’’ provided the income if derived separately would have qualified as ‘‘excepted assessable income’’. For example, a minor receiving moneys from the death of her or his parents would be entitled to have the income derived from the investment of those moneys treated as ‘‘excepted assessable income’’ under s 102AE(2)(c)(i). If the minor invested in that property with another person, the assessable income derived would be determined under s 92, but because it would qualify as ‘‘excepted assessable income’’ if derived as an individual, it also qualifies as ‘‘excepted assessable income’’ when derived from that partnership. If the income would not qualify as ‘‘excepted assessable income’’ if derived individually, eg a settlement was made on the individual by a living person, the income derived from the investment of that property with a third party would not qualify as ‘‘excepted assessable income’’. [26 130] Anti-avoidance – general Income does not qualify as excepted assessable income if it is derived as a result of agreements made and carried out for the purpose of defeating the application of Div 6AA by securing that assessable income will not be eligible assessable income: s 102AE(7). This does not apply if that is a merely incidental purpose: s 102AE(8). If income that would otherwise be excepted assessable income is derived in circumstances where any 2 or more parties to the derivation, or to any act or transaction directly or indirectly connected with the derivation, were not dealing at arm’s length, the excepted assessable income is only so much (if any) of the income as would have been derived if they had been dealing at arm’s length: s 102AE(6). The concept of dealing at arm’s length is considered at [5 260].

TRUST INCOME [26 150] Application of Div 6AA to trust income All income derived by the beneficiary of a trust estate who is under 18 at the end of the income year is subject to the application of Div 6AA, except that income derived by the trust 1094

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[26 180]

estate which is excepted trust income. The term ‘‘excepted trust income’’ is defined in s 102AG(2), in terms comparable to s 102AE(2), which defines ‘‘excepted assessable income’’: see [26 050]-[26 130]. Other subsections in s 102AG qualify the application of s 102AG(2) (this is similar to s 102AE). The manner in which trust income forms part of eligible assessable income and the interrelationship between ss 102AE and 102AG is discussed at [26 110]. The specific categories of ‘‘excepted trust income’’ are considered at [26 160]-[26 220].

[26 160] Trust resulting from death of a person If a trust estate arises out of a will or a codicil, or any court order varying or modifying that will or codicil, the income derived is excepted trust income and is therefore subject to the normal provisions of the ITAA 1997 or ITAA 1936 and not to the provisions of Div 6AA. If a trust arises out of an intestacy, the income of that trust received by a prescribed person (see [26 020]), whether it arises in accordance with the laws of intestacy or any variation or modification of those laws by a court, is also excluded from the application of Div 6AA. Income derived from property held by a trustee that was received through the death of a person other than under a will or the rules of intestacy will qualify as excepted trust income in certain circumstances. This applies if the property has been received from a life insurance policy, the proceeds of a provident, benefit, superannuation or retirement fund, a payment by the employer of a deceased person to a trust for the benefit of the beneficiary and/or a pension from a superannuation or provident fund: s 102AG(2). Under the terms of the trust, the minor must acquire the relevant trust property in her or his own right when the trust ends: s 102AG(2A).

[26 170] Property received indirectly as a result of death of a person If property is transferred to a trustee for the benefit of a minor and such property has been received by the transferor from a deceased estate, the income derived may qualify as ‘‘excepted trust income’’. If so, it will be excluded from the provisions of Div 6AA and be assessed under the normal provisions of the ITAA 1997 and ITAA 1936. To qualify for this concession (s 102AG(2)(d)(ii)), the property must have been transferred within 3 years of the death of the person from whom the transferor received the property. Under the terms of the trust, the minor must acquire the relevant trust property in her or his own right when the trust ends: s 102AG(2A). This particular condition was not satisfied in The Trustee for the Confidential Trust and FCT (2014) 100 ATR 158 (see also [26 100]).

Limitation on exclusion of income derived from deceased estates Section 102AG(7) limits the amount of income that qualifies as ‘‘excepted trust income’’ under s 102AG(2)(d)(ii) to the income derived from the property that would have been received by the beneficiary directly from the estate of the deceased person if that person had died intestate. If a beneficiary has received property directly from the estate of the deceased person, and also from a third party in the circumstances outlined, the values of the properties are combined. If the combined amount exceeds the amount that would have been received by the beneficiary in an intestacy, the income derived from the property representing the excess is not ‘‘excepted trust income’’. This does not apply to income from any property that the beneficiary has received directly. There can only be a reduction if the surplus represents property transferred to the beneficiary by a third party within the 3-year time limit. [26 180] Damages The income arising from the investment of property is ‘‘excepted trust income’’ in cases where property (including money) is transferred to a trustee for the benefit of a minor by way of, or in satisfaction of, a claim for damages. This applies if property is received as a result of (s 102AG(2)(c)): (a) an action arising from the loss by the beneficiary of parental support; © 2017 THOMSON REUTERS

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(b) an action for damages in respect of personal injury to the beneficiary, disease suffered by the beneficiary or any impairment of her or his mental or physical condition; (c) an action under workers compensation law; and (d) an action under criminal injuries compensation law. Under the terms of the trust, the minor must acquire the relevant trust property in her or his own right when the trust ends: s 102AG(2A). Assessable income derived by a trustee from the investment of property received in the circumstances set out in (a) or (b) above is treated in a special way if the property was transferred to the trustee other than by a court order (eg if the action was settled without court approval). The income is only ‘‘excepted trust income’’ to the extent that the Commissioner considers fair and reasonable: s 102AG(6). The fair and reasonable amount is likely to be the amount actually received if the parties are dealing with each other at arm’s length.

[26 190] Other sources ‘‘Excepted trust income’’ also includes assessable income derived from a variety of sources if property has been settled for the benefit of the beneficiary and income is distributed from such property by the intervention of third parties or in circumstances beyond the control of the beneficiary and persons related to the beneficiary. Examples of this are: (a) distributions from public funds established for the benefit of persons in necessitous circumstances and maintained exclusively for that purpose; (b) income derived from the investment of property held as a result of winnings in a legally authorised and conducted lottery if the beneficiary was the beneficial owner of the prize; and (c) moneys arising from property transferred as a result of ‘‘family breakdown’’. This term is widely defined in s 102AGA to include the situation where spouses (whether legally married or de facto, including de facto same sex spouses) cease to live together and at least one of the couple in question is the parent (including step-parent or adoptive parent) of the beneficiary or has legal custody or guardianship of the beneficiary. ‘‘Family breakdown’’ can also cover situations where the parents of the beneficiary are not living together as legally married or de facto spouses (including same sex de facto spouses) when the beneficiary is born. In relation to items (a) and (c), under the terms of the trust the minor must acquire the relevant trust property in her or his own right when the trust ends: s 102AG(2A). In relation to item (b), the fact that the beneficiary must be the beneficial owner of the prize has the same effect. Ruling TR 98/4 states that income derived from the investment of property transferred to a child maintenance trust for the benefit of the child as a result of family breakdown is ‘‘excepted trust income’’ under Div 6AA unless any of the following situations apply: (a) property is not transferred beneficially to the child; (b) the income is not derived from the investment of the property; (c) property has not been transferred as a result of family breakdown; (d) the income derived from the trust exceeds an arm’s length return on the investment; or (e) income is derived as a result of an agreement entered into by the parent to ensure that otherwise assessable income will become ‘‘excepted trust income’’. If income is derived by a trustee from property which represents an accumulation of past income, s 102AG(2)(e) treats that income as ‘‘excepted trust income’’ provided the accumulation is of: 1096

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[26 220]

(a) income that, in relation to the beneficiary concerned, was ‘‘excepted trust income’’; (b) income that, if accumulated before 1 July 1979, would have been ‘‘excepted trust income’’ if Div 6AA had been operative; and (c) exempt income that would have qualified under (a) and (b) above. The effect of s 102AG(2)(e) is to carry the exclusion from the application of Div 6AA into income derived from property that represents accumulations of income that themselves do not qualify for assessment in terms of Div 6AA.

[26 200] Dealings not at arm’s length Section 102AG(3) applies if a trust derives income that would otherwise be ‘‘excepted trust income’’ in circumstances where any 2 or more parties to the derivation, or to any act or transaction directly or indirectly connected with the derivation, were not dealing at arm’s length. In such a case, the ‘‘excepted trust income’’ is only so much of the income as would have been derived if they had been dealing at arm’s length. The excess over this amount is subject to Div 6AA if it is derived by a minor. The concept of dealing at arm’s length is considered at [5 260]. The issue of parties dealing at arm’s length was considered in AAT Case 5515 (1989) 21 ATR 3065. A trustee company held 50% of the units in a unit trust as trustee for 5 family trusts established by the deceased’s will. The unit trust was the sole unitholder in a trading trust that provided services to a firm of lawyers. The trustee company was controlled by the deceased’s daughter and son-in-law and the unit trust was controlled by the son-in-law and another person, who were both partners in the law firm. The partners arranged the firm’s affairs to diminish its profitability, to the benefit of the family interests in the service trust. The AAT determined that the various parties were not dealing with each other at arm’s length, with the result that distributions by the trustee company to the deceased’s grandchildren were not ‘‘excepted trust income’’.

[26 210] Anti-avoidance – general Income derived from the various sources referred to in s 102AG(2) does not qualify as excepted trust income if it is derived as a result of an agreement entered into for the purpose of avoiding Div 6AA (unless that is a merely incidental purpose): s 102AG(4) and (5). In these circumstances, any income derived is treated as directly assessable in accordance with the terms of the Division and of the special provisions of the Income Tax Rates Act 1986 that apply to income assessable under the Division. For an example of the operation of s 102AG(4), see AAT Case 10,321 (1995) 31 ATR 1131.

[26 220] Discretionary trusts If a trustee has a discretion to distribute income to one or more beneficiaries either specifically referred to or of a specified class, the property of the trust is deemed to have been transferred to the trust for the benefit of either the named beneficiary or the specified class: s 102AG(8). This will apply if income is derived by the trustee in 2 forms: in a form that is subject to Div 6AA and in a form that qualifies as ‘‘excepted trust income’’. A trustee may receive property as part of an inter vivos settlement and the income derived by that trust upon distribution to minors will be subject to tax in accordance with Div 6AA. If, subsequently, property is settled on that trust by a will of a deceased person, the income derived from that property, provided it satisfies the requirements of s 102AG(2)(c), will be ‘‘excepted trust income’’. A distribution of the income to the beneficiary or beneficiaries will therefore include income both subject to and not subject to Div 6AA. If there is more than one beneficiary or if the trustee does not distribute the whole of the income, the apportionment of the 2 classes of income is on a proportional basis. © 2017 THOMSON REUTERS

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RATES OF TAX [26 250] Rates of tax on Div 6AA income The 2016-17 rates of tax applicable to resident prescribed persons and trust beneficiaries in receipt of Div 6AA income (ss 13 and 36 and Schs 11 and 12 of the Income Tax Rates Act 1986) are set out at [100 040]. In effect, the first $416 of the income caught by Div 6AA is not taxed, the difference between $416 and the ‘‘resident phase-out limit’’ ($1,307 for 2016-17) is taxed at 66% and, if there is any excess over the ‘‘resident phase-out limit’’, the whole amount is taxed at the top marginal rate (47% for 2016-17). The ‘‘resident phase-out limit’’ is calculated in accordance with the formula in s 13(10) of the Rates Act. Of course, the exact rate applicable to a prescribed person depends on the amount of any assessable income not caught by Div 6AA. If a resident minor qualifies for the beneficiary offset under s 160AAA ITAA 1936 (see [19 520]), it can be used to reduce the tax payable on Div 6AA income: s 159N(5). However, a resident minor or a trustee for a resident minor cannot use the low income tax offset (see [19 300]) to reduce the tax payable on Div 6AA income: s 159N(4), (6). Note that, from the 2015-16 income year, a minor who qualifies as a small business entity may be entitled to a tax offset: see [25 250]. EXAMPLE [26 250.10] Sinead (a resident) has employment income of $20,300 and unearned income subject to Div 6AA of $3,180. Sinead’s 2016-17 tax liability is calculated as follows (ignoring cents): $ Tax on employment income of $20,300 (at standard rates) 399 Tax on Div 6AA income of $3,180 (at 47%) 1,494 1,893 Sinead can use the low income offset (maximum $445) to reduce the tax on her employment income to zero, but she cannot use the offset to reduce the tax on her unearned income. Sinead now has a net total tax liability of $1,494 (ie $1,893 – $399).

The 2016-17 tax rates applicable to foreign resident prescribed persons are set out at [100 050]. The rates of tax applicable if a trustee is assessed under s 98 are set out at [101 010] (resident beneficiary) and [101 020] (foreign resident beneficiary).

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27

INTRODUCTION Overview ....................................................................................................................... [27 010] What is a primary production business? ...................................................................... [27 020] Special provisions – primary producers ....................................................................... [27 030] TRADING STOCK Growing crops ............................................................................................................... [27 050] Live stock ...................................................................................................................... [27 060] Pooled marketing schemes ............................................................................................ [27 070] LIVE STOCK ACCOUNTING Live stock-on-hand ........................................................................................................ [27 100] Natural increase ............................................................................................................. [27 110] Live stock accounts ....................................................................................................... [27 120] Partnerships ................................................................................................................... [27 130] DISPOSAL NOT IN ORDINARY COURSE OF BUSINESS Live stock disposed of not in ordinary course of business ......................................... [27 Disposal on change of ownership or interests ............................................................. [27 Forced disposals or death of live stock ........................................................................ [27 Replacement – same species ........................................................................................ [27 Replacement – different species ................................................................................... [27 Replacement – breeding ................................................................................................ [27 Devolution on death ...................................................................................................... [27 Insurance recoveries ...................................................................................................... [27 Double wool clips ......................................................................................................... [27 Rules for elections ........................................................................................................ [27

150] 160] 170] 180] 190] 200] 210] 220] 230] 240]

CAPITAL ALLOWANCES FOR PRIMARY PRODUCERS Capital allowances – introduction ................................................................................ [27 Water facilities ............................................................................................................... [27 Horticultural plants ........................................................................................................ [27 Fodder storage assets .................................................................................................... [27 Fencing assets ................................................................................................................ [27 Landcare operations ...................................................................................................... [27 Connecting power to land ............................................................................................. [27 Telephone lines .............................................................................................................. [27 GST adjustments ........................................................................................................... [27 Partnerships ................................................................................................................... [27 Non-arm’s length transactions ...................................................................................... [27 Depreciating assets ........................................................................................................ [27

300] 310] 320] 330] 335] 340] 350] 360] 370] 380] 390] 400]

LONG-TERM AVERAGING OF TAX LIABILITY What is averaging? ........................................................................................................ [27 Who qualifies for averaging? ........................................................................................ [27 What income is subject to averaging? ......................................................................... [27 First average year .......................................................................................................... [27 Getting started on averaging ......................................................................................... [27 Years in which a loss is incurred ................................................................................. [27 How is tax calculated? .................................................................................................. [27 Tax offset ....................................................................................................................... [27 Extra income tax ........................................................................................................... [27 Beneficiary of a trust .................................................................................................... [27 Permanent reduction of income .................................................................................... [27

450] 460] 470] 480] 490] 500] 510] 520] 530] 540] 550]

FARM MANAGEMENT DEPOSITS Farm management deposits – introduction .................................................................. [27 600] What is a farm management deposit? .......................................................................... [27 610] © 2017 THOMSON REUTERS

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Tax consequences of FMDs .......................................................................................... [27 620]

INTRODUCTION [27 010] Overview This chapter discusses the special treatment given to primary producers by the income tax laws (see the summary at [27 020]). It is obviously important to identify a primary producer. The chapter therefore initially considers the factors involved in determining what is a primary production business (see [27 020]). The chapter then considers the various special rules in detail. The topics covered are: • trading stock issues, with an emphasis on live stock, growing crops, and pooled marketing schemes: see [27 050]-[27 070]; • live stock accounting, which is fundamental to the calculation of the number and cost of live stock on hand, the treatment of natural increase, stock losses and stock killed for rations. The form of live stock accounts and the way primary producer partnerships are treated for income tax purposes are also examined: see [27 100]-[27 130]; • disposals of live stock otherwise than in the ordinary course of business: see [27 150]-[27 240]; • capital allowances for expenditure on infrastructure such as water facilities, power connections and telephone lines, on landcare operations and on horticultural plants (in certain cases the relevant land need not be used for primary production): see [27 300]-[27 390]; • income averaging to counter the effects of income fluctuations that are inherent to a primary production business: see [27 450]-[27 550]; and • farm management deposits, which can be used to defer income tax liabilities: see [27 600]-[27 620].

[27 020] What is a primary production business? A ‘‘primary production business’’ is defined in s 995-1 ITAA 1997 to mean carrying on a business of: • cultivating or propagating plants, fungi or their products or parts (including seeds, spores, bulbs and similar things) in any physical environment; • maintaining animals for the purpose of selling them or their bodily produce (including natural increase); • manufacturing dairy produce from raw material that you produced; • conducting operations relating directly to taking or catching fish, turtles, dugong, bêche-de-mer, crustaceans or aquatic molluscs; • conducting operations relating directly to taking or culturing pearls or pearl shell; • planting or tending trees in a plantation or forest that are intended to be felled; • felling trees in a plantation or forest; or • transporting trees or parts of trees that are felled in a plantation or forest to the place: 1100

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[27 020]

– where they are first to be milled or processed; or – from which they are to be transported to the place where they are first to be milled or processed.

Carrying on a primary production business The taxpayer must be carrying on a primary production business to be regarded as a primary producer. What constitutes carrying on a business is often difficult to determine, particularly if the activities in which the taxpayer is engaged are small-scale, as is often the case. See [5 020] for a discussion of the meaning of ‘‘carrying on a business’’. Cases where it was decided that a primary production business was being carried on include: • farming business consistently making losses: Tweddle v FCT (1942) 180 CLR 1; • barrister carrying on a primary production business on 7.5 acres: Thomas v FCT (1972) 3 ATR 165; • naval officer who leased a few cows: Ferguson v FCT (1979) 9 ATR 873; • real estate salesman who purchased one high-priced female Angora goat for breeding purposes: FCT v Walker (1985) 16 ATR 331; and • 2 doctors involved in a financially unsuccessful sheep leasing scheme: FCT v Solling (1985) 16 ATR 753. Cases where it was decided that a primary production business was not being carried on include: • orchid growing operation did not have ‘‘significant commercial character’’: Re Crees and FCT (2001) 46 ATR 1091; • activities undertaken over a 5-year period on a 500 acre property, such as making improvements, researching various primary production activities and preparing business plans, without generating any income did not constitute carrying on a business and were merely preparatory: Nelson v FCT [2014] FCA 57 (the taxpayer’s appeal was dismissed in Nelson v FCT (2014) 100 ATR 47, largely because the appeal did not raise questions of law, and the High Court refused the taxpayer special leave to appeal); • palm tree cultivation not a business – key factors were the number of palms planted and the small potential return compared with the cost of the land and the interest incurred: Re Reiger and FCT (2002) 49 ATR 1022; and • leasing 3 cows to which fertilised eggs were transplanted from stud cattle was not carrying on a business of breeding and selling cattle: Vincent v FCT (2002) 51 ATR 18. See also some of the cases noted at [5 020] where taxpayers invested in agricultural schemes (eg vineyards and forestry plantations) and Rulings TR 2000/8 and TR 2007/8 (discussed below). For an exhaustive analysis of whether a taxpayer is carrying on a primary production business, see Ruling TR 97/11. The Commissioner considers that a landowner is engaged in a primary production business if, under a share-farming arrangement allowing another person to cultivate the land, the landowner is carrying on business in partnership or he or she is directly involved in that business with a degree of control or ongoing participation: Determination TD 95/62.

Afforestation and other agricultural schemes Commonly, under an afforestation scheme, an investor leases land upon which to grow trees and a manager is responsible for planting, maintaining and harvesting the trees and often selling the cut timber. The investor claims an immediate deduction for the lease and © 2017 THOMSON REUTERS

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management fees payable upon execution of the lease and management agreements. For schemes begun to be carried out before 1 July 2008, Ruling TR 2000/8 (withdrawn with effect from 1 July 2008) specifies the circumstances in which those fees are deductible. These include that the investor must be carrying on an afforestation business. The ruling accepts that an afforestation business will be carried on by an investor if: • the investor has an interest in specific growing trees and a right to harvest and sell timber from those trees; • the investor carries out, or a manager carries out on the investor’s behalf, afforestation activities; and • the activities have a significant commercial purpose in view of factors such as their nature, size, scale, repetition and regularity, and the manner in which those activities are conducted. An investor’s early exit from a scheme, or the use of non-recourse or limited recourse loans effected by round robin arrangements, may result in the Tax Office not accepting that the investor is carrying on a bona fide business. Ruling TR 2000/8 also applies generally to other agricultural, horticultural and viticultural investment schemes with similar characteristics to those described in the ruling. In 2007, the Tax Office revised its views and issued Ruling TR 2007/8, in which it stated that investor contributions are generally of a capital nature, because they are the capital cost of the investor’s interest in the scheme, and hence not deductible under s 8-1 ITAA 1997 (whether the investor is considered to be a beneficiary of a trust or a passive investor who is not carrying on a business). Ruling TR 2007/8 was expressed to apply only in relation to schemes begun to be carried out on and after 1 July 2008. However, following the Full Federal Court’s decision in Hance & Anor v FCT (2008) 74 ATR 644, the Commissioner has withdrawn Ruling TR 2007/8 (with effect from 11 February 2009): see further [9 1360]. Investors in certain forestry managed investment schemes are entitled to a tax deduction (under Div 394 ITAA 1997) for their contributions, provided that at least 70% of the scheme manager’s expenditure under the scheme is ‘‘direct forestry expenditure’’: see [11 600]. If an investor in an afforestation or other agricultural scheme is entitled to a deduction, the prepayment rules in ss 82KZME to 82KZMG ITAA 1936 may apportion the deduction over the expenditure year and later years: see [8 350]-[8 400]. Determination TD 2010/9 discusses whether a payment received by an investor in a non-forestry managed investment scheme upon the winding-up of the scheme, that does not involve the disposal of their interest in the scheme, is assessable income. Note that the Tax Office issues product rulings which set out the tax consequences of investing in particular investment schemes. Product rulings are binding on the Tax Office (note that they do not guarantee the viability of the particular scheme): see [45 120]. The Tax Office has also issued guidelines to tax agents in respect of taxpayers earning salary and wage income who claim primary production losses.

[27 030] Special provisions – primary producers Although primary producers are subject to the general rules relating to assessable income (see Chapter 3 to Chapter 6) and allowable deductions (see Chapter 8 to Chapter 10), primary producers (and certain other landholders) receive special concessions under the ITAA 1997. These are listed below. The capital expenditure provisions have mostly been consolidated in Div 40, which contains the general rules about the deductibility of capital expenditure under the Uniform Capital Allowance (UCA) system (see [27 300]). (1) Profits may be taxed on a concessional basis in the case of: (a) forced sales and death or destruction of live stock (ss 385-100, 385-105, 385-110 and 385-125): see [27 170]; 1102

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(b) insurance recoveries on loss of live stock or loss of trees by fire (s 385-130): see [27 220]. (2) Special provisions relate to the treatment of live stock, as distinct from other kinds of trading stock, in calculating a primary producer’s taxable income (ss 70-55 (Natural increase), 70-60 (Horse breeding stock) and Income Tax Assessment Regulations 1997 reg 70-55.01): see [27 100] and following. (3) Standing or growing crops, crop stools or trees that have been planted and tended for the purposes of sale that are included in a sale or disposal of a business or that devolve on death are treated in such a case as trading stock (ss 70-85 and 70-105): see [5 400] and following. See also [29 160] (deduction for capital cost of acquiring land carrying trees or a right to fell trees). (4) A deduction is allowable under Div 40 for the decline in value (ie depreciation) of various structural improvements on land used to carry on a primary production business: see [27 400]. (5) Capital expenditure on a water facility is deductible immediately if post-12 May 2015 expenditure, otherwise over 3 years (Subdiv 40-F): see [27 310]. (6) Post-12 May 2015 capital expenditure on fodder storage assets is deductible over 3 years (Subdiv 40-F): see [27 330]; (7) Post-12 May 2015 capital expenditure on fences is deductible immediately (Subdiv 40-F): see [27 335]; (8) Capital expenditure in establishing horticultural plants (including grapevines) is deductible over their effective life (Subdiv 40-F): see [27 320]; (9) Capital expenditure on a landcare operation for land in Australia used at the time for carrying on a primary production business is deductible immediately (Subdiv 40-G): see [27 340]. (10) Capital expenditure incurred in connecting power to land or upgrading the connection, and also for capital expenditure incurred on a telephone line on or extending to land on which a primary production business is carried on, is deductible over 10 years (Subdiv 40-G): see [27 350] and [27 360]. (11) Investments in certain forestry managed investment schemes are deductible (Div 394): see [11 600]. (12) The costs incurred in establishing a qualifying carbon sink forest are deductible at the rate of 7% per annum: see [11 620]. (13) The incomes of primary producers may be eligible for averaging tax offsets. Alternatively, complementary tax may be payable (Div 392): see [27 450] and following. (14) Deposits to the Farm Management Deposits Scheme are tax deductible with corresponding assessability when the deposits are withdrawn (Div 393): see [27 600]-[27 620].

Losses Primary production losses are dealt with under the general loss provisions (in s 36-15) which are discussed at [8 450] and following. The non-commercial loss rules in Div 35 ITAA 1997 may operate to prevent an individual offsetting a loss from a non-commercial business activity against other assessable income in the year the loss is incurred. Special concessions apply to primary producers, © 2017 THOMSON REUTERS

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however, so that a loss from a primary production business can be offset against other assessable income if non-primary production business income (excluding capital gains) is less than $40,000: see [6 020] and following.

PAYG instalments Individuals who are primary producers and who are ‘‘quarterly payers’’ under the PAYG instalment system may elect to pay only 2 instalments annually: see [51 150]. Dairy Adjustment Scheme The Tax Office’s views (in information sheets) on the tax consequences of the Dairy Structural Adjustment Program (DSAP) scheme include: • payments under a DSAP payment right are assessable subsidies; • payments under a DSAP scheme are income from primary production, but only while the dairy farm enterprise continues to be carried on; • a subsequent owner of a DSAP payment right ‘‘unit’’ has acquired an annuity; • a DSAP payment right ‘‘unit’’ is a CGT asset and therefore the disposal and acquisition of a ‘‘unit’’ has CGT consequences (the information sheets consider what the cost base of a ‘‘unit’’ is); • if a dairy farmer converts her or his entitlement to payments under a DSAP payment right to a lump sum under an arrangement with a financial institution, the lump sum is a loan and not income (nor is there a CGT event); and • interest on that loan is deductible if the loan is used to produce assessable income.

TRADING STOCK [27 050] Growing crops Growing crops still in the paddock, whether growing directly on the land or fruit on trees, do not become trading stock until the time at which they are harvested, ie when severed from the land. Once harvested, the crops or fruit are trading stock and are dealt with under the normal provisions of the ITAA 1997 applying to trading stock: see Chapter 5. However, standing or growing crops, crop stools or trees that have been planted and tended for the purpose of sale are also treated as trading stock if the crops, etc, are disposed of outside the ordinary course of business (ss 70-90 and 70-100) or are used for personal use or as a depreciating asset (s 70-115), or if the owner dies (s 70-105). Thus, for example, if standing or growing crops are sold in an unharvested state, the market value of the crops on the day of disposal is included in the taxpayer’s assessable income: s 70-90 (see [5 400]). See [3 210] for ‘‘market value’’. In Case 3 (1953) 4 CTBR (NS) 3 it was held that, to value these items, there should be deducted from the estimated gross proceeds: • the purchaser’s estimated future expenses in harvesting the crop; • the value of allowances for risks, such as fire, to be borne by the purchaser; and • the purchaser’s share of estimated profit notionally apportioned between herself or himself and the vendor. In Determination TD 96/8, the Commissioner considers that the market value of trees ventured in forestry operations at the time when they were ventured may be deducted from sale proceeds in calculating net profit. If the disposal is of trees, the relevant portion of the capital costs of acquiring the land carrying the trees or of acquiring a right to fell the trees is deductible: s 70-120. 1104

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[27 070]

[27 060] Live stock Trading stock includes live stock: s 995-1 and 70-10; see also [5 400]. Animals used as beasts of burden or working beasts are only live stock if used in a primary production business: s 995-1. In the case of a primary production business, working beasts are treated in exactly the same way as other live stock. Purchases and sales must be brought into the taxpayer’s live stock trading account together with the value of opening and closing stock of working beasts including any natural increase. A horse (or an interest in a horse) will be live stock if used in the taxpayer’s primary production business (eg horse breeding business) or if the taxpayer is in the business of actually buying and selling horses (ie a horse trader): see Ruling TR 2008/2 (discussed at [5 050]). Freshwater crayfish kept or bred on farms or in hatcheries (Ruling IT 2667) and bees kept for use in a honey production business (Determination TD 2008/26) are considered to be live stock. Birds used for display in a tourist park are not trading stock because they are working beasts in a non-primary production business (ATO ID 2009/25).

[27 070] Pooled marketing schemes Cooperative or compulsory pooled marketing and sale arrangements operate in respect of many primary products. Whether trading stock contributed to these schemes remains trading stock of the individual primary producers who contributed it, and the time at which such contributors are taken to derive sales income, usually depends upon the precise contractual arrangements under which each individual scheme operates.

Is pooled produce trading stock of the producer? The general rule is that trading stock contributed to a pool is not treated as trading stock-on-hand at the end of the income year of the individual primary producers who contributed it unless the contributor retains legal entitlement to it and it is separately identifiable. For an example, see Farnsworth v FCT (1949) 4 AITR 258, which dealt with the packing and marketing of dried fruit. The general rule is subject to any specific contractual arrangements to the contrary. Any surplus stock not contributed to the pooled scheme and held for sale by the primary producer remains as trading stock once it has attained that status: see [27 050]. Crops that have been harvested and are stored on the primary producer’s farm pending shipment to the pooled authority usually remain as trading stock of the primary producer, although this is not the case if legislation divests the grower of property in the crop once ready for sale and transfers title to a marketing board.

At what time are proceeds of pooled sales assessable to producers? Farnsworth’s case is also authority for the proposition that primary producers who contribute trading stock to a pooled sale and marketing scheme are usually only assessable on a receipts basis, although it depends on the precise contractual arrangements under which the scheme operates. Rulings – specific pooling schemes The Commissioner’s views are generally in accord with the above principles and a number of rulings and determinations have been issued on their application to specific schemes: see Ruling TR 97/9 (wool), Ruling TR 94/13 (cotton seed and cotton bales), Determination TD 94/13 (wheat industry fund refunds), Ruling TR 2001/1 (assessability of amounts from the sale of wheat and grain) and Ruling TR 2001/5 (assessability of amounts from the sale of barley, grain and other commodities). Note that Determination TD 2002/18 confirms that a deduction is available under s 8-1 for underwriting fees paid as a harvest payment with AWB Finance Limited, AWB (Australia) Limited or ABB Grain Export Limited. © 2017 THOMSON REUTERS

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LIVE STOCK ACCOUNTING [27 100] Live stock-on-hand The value of all live stock-on-hand at the beginning of the income year, and of all live stock-on-hand at the end of that year, is taken into account in ascertaining whether or not a taxpayer carrying on a primary production business has a taxable income (s 70-35(1)): see [5 220]. A deduction is thus effectively obtained for all losses by death, etc in the income year in which they occur: see [5 240]. On the other hand, a taxpayer’s assessable income is increased by the value of all natural increase on hand at the end of that year: see [27 110]. Whether a taxpayer is carrying on a business is considered at [5 020] (general principles), [5 050] (horse related activities such as training or breeding racehorses) and [27 020] (primary production business). Note that a small business entity may not have to account for changes in the value of trading stock: see [25 210]. Value at beginning of year The value of live stock to be taken into account at the beginning of the income year is the value taken into account at the end of the previous income year: s 70-40(1). Value at end of year – options The value of live stock at the end of the income year (ie the closing value) is whichever of its cost, its market selling value or its replacement value the taxpayer chooses: s 70-45. These options are considered further at [5 300]. Note that the taxpayer does not need the Commissioner’s permission to change the basis of valuation. Live stock may be valued below all the values in s 70-45 as a result of obsolescence or any other special circumstances provided the value elected is reasonable (s 70-50): see [5 340]. There are additional options for valuing horse breeding stock: see below. The value of an animal (including horse breeding stock) acquired by natural increase is considered at [27 110]. The Commissioner originally stated in Canberra Income Tax Circular Memorandum 761 that he would accept, in appropriate circumstances, a reduction of the closing value for named stud sires (eg stallions, bulls, rams) by 20% of the cost price in each of 5 years including the year of purchase. This concession relates to the reduction in market value of the sire through normal service. The continuation of this policy as a means of estimating the market selling value of named and identified stud stock was confirmed in the Explanatory Memorandum to Taxation Laws Amendment Bill (No 5) 1992 at the time of splitting former s 32 into s 32 and 32A, subject to there being no concrete evidence that the animals’ value had, in fact, been maintained or increased. It would be open to a taxpayer to establish that the reduction in market value was greater than 20%. Value at end of year – horse breeding stock The closing value for horse breeding stock is its cost, market selling value or replacement value (s 70-45). However, if the horse is at least 3 years old and was acquired by the taxpayer under a contract (and held for breeding), an alternative closing value may be adopted under s 70-60 and 70-65. Under the rules in s 70-60 and 70-65, sires can be written down at a maximum rate of 25% on a prime cost basis. Mares can be written down at a maximum rate of 331/3% on a prime cost basis, but the value cannot exceed $1 if the mare is 12 years or older. The age of a horse is measured from the 1 August immediately before it was born: s 70-60(4). Whether a taxpayer is carrying on a horse breeding business is considered in Ruling TR 2008/2 (see [5 050]). 1106

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[27 120]

[27 110] Natural increase The closing value of live stock acquired by natural increase is its cost, market selling value or replacement value (see [34 060]). However, if the animal is horse breeding stock, the valuation options under s 70-60 and 70-65 are not available as they only apply to horses that are at least 3 years old and are acquired under a contract (see [27 100]). If live stock acquired by natural increase is valued at cost, the taxpayer may choose either the actual cost of the animal or the cost prescribed by the regulations for each animal in the applicable class of live stock: s 70-55. ‘‘Actual cost’’ means the full absorption cost of bringing the animal into its current state and location. The prescribed costs are set out in reg 70-55.01 of the ITA Regs. A horse acquired by natural increase attributable to a service fee is included in the closing stock of an income year at a cost amounting to the greater of the amount worked out under s 70-55(1) (actual cost or the cost prescribed by the regulations) or that part of the service fee attributable to acquiring the horse. Service fees include fees for natural service or artificial insemination of a female horse that resulted in natural increase. If the insemination did not result in natural increase, the service fee would be an allowable deduction under s 8-1(1). Atlantic salmon bred in a land-based nursery as part of an aquaculture business become animals held as live stock for the purposes of 70-55 when they reach the ‘‘fry’’ stage of development: see ATO ID 2011/23. [27 120] Live stock accounts The following examples illustrate the foregoing provisions. EXAMPLE [27 120.10] If the taxpayer has adopted market selling value (and is not a small business entity):

Sheep account No 3,600 240 110 7,660 11,550 nil 8,200 3,350 11,550

Sales Losses (including deaths) Rations Closing stock (market value) Opening stock Purchases Natural increase Gross profit

$ 72,000 – 1,760 136,800 210,560 nil 131,200 – 131,200 79,360

EXAMPLE [27 120.20] If the taxpayer has adopted cost price and has selected $4 as the cost price of natural increase (and is not a small business entity):

Sheep account Sales Losses (including deaths) © 2017 THOMSON REUTERS

No 3,600 240

$ 72,000 –

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Rations Closing stock (cost – see below) Opening stock Purchases Natural increase

No 110 7,660 11,550 nil 8,200 3,350 11,550

$ 1,760 95,152 168,912 nil 131,200 – 131,200 37,712

No 8,200 3,350 11,550

$ 131,200 13,400 144,600

Gross profit

Method of valuing closing stock Purchase at cost Natural increase at $4 per head

Average cost per head =

144,600 = $12.52 (nearest cent) 11,550

7,600 at $12.52 = $95,152

Numbers of live stock While the numbers of natural increase and losses (including deaths) appear in the acquisitions section and the disposals section respectively, this is done merely to balance the numbers of live stock appearing in both sections of the schedule. No amount is placed opposite these 2 items as the resultant increase and decrease in values are reflected in the closing stock. Killed for rations If live stock (and other trading stock) is taken by the taxpayer for business use or for private use, the taxpayer is treated as having disposed of the trading stock at cost: s 70-110. The section does not appear to change the long-standing practice of treating live stock killed for rations, which is detailed below. The amount that appears in the disposals section of the live stock schedule will, to the extent that the sheep have been consumed by the station staff, be claimed as an allowable deduction, together with the cost of other rations supplied to those employees. The value of ration sheep and other live stock consumed by the taxpayer’s family and domestic staff is not deductible and will be charged to drawings. Live stock killed and used for rations may be valued at average cost if the taxpayer has selected cost price as the basis of valuation, but if live stock killed and used for rations can be identified, the taxpayer may return the value of rations at the identified value. Those values are opening stock average value, cost of purchases or selected value for natural increase. In Examples [27 120.10] and [27 120.20] above, it is assumed that stock killed for rations is identifiable as stock purchased during the year. It should be noted that a taxable fringe benefit will arise if a primary producer employer provides rations or other farm produce to an employee. However, there may be little or no tax liability because of the valuation procedures or the nature of the produce. Purchases and sales The total cost of purchases and the net proceeds of sales should be included in the live stock schedule. 1108

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[27 130]

Live stock-on-hand at close of income year If market selling value has been adopted, the taxpayer must include closing stock in the live stock schedule at the market selling value on the last day of the income year. If cost has been adopted, the taxpayer must include closing stock valued on that basis. The method of calculating this closing value, as illustrated in Example [27 120.20], is known as the ‘‘average cost’’ method and it is the one almost universally in use among taxpayers who have adopted cost. This is because it is usually not feasible to identify the actual cost of each individual animal, as with large numbers it is not known which are the ones that have died or been sold, which are still on hand, etc. However, if specific identification is possible (eg stud cattle), then it should be used. The ‘‘average cost’’ method is more fully illustrated in Example [27 120.30] by carrying the taxpayer’s transactions in Example [27 120.20] into the second income year. EXAMPLE [27 120.30]

Sheep account Sales Losses (including deaths) Rations Closing stock Opening stock Purchases Natural increase

No 2,700 270 100 8,880 11,950 7,600 1,500 2,850 11,950

$ 59,400 – 1,252 97,591 158,243 95,152 24,750 – 119,902 38,341

No 7,600 1,500 2,850 11,950

$ 95,152 24,750 11,400 131,302

Gross profit

Method of valuing closing stock Opening stock at average cost Purchases at cost Natural increase at $4 per head

Average cost per head =

131,302 = $10.99 (nearest cent) 11,950

8,880 at $10.99 = $97,591

In Example [27 120.30], stock killed for rations is valued at average value of opening stock (average cost at the end of the previous year), ie $12.52 per head, as in Example [27 120.20].

[27 130] Partnerships If a partnership owns live stock in a primary production business, an election to value closing stock at cost price (including the value selected for natural increase), market selling value or replacement price is made by the partnership and not by the partners individually.

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DISPOSAL NOT IN ORDINARY COURSE OF BUSINESS [27 150] Live stock disposed of not in ordinary course of business Section 70-90 applies to a taxpayer who disposes of an item of trading stock (including live stock) outside the ordinary course of a business being carried on by the taxpayer, and the item is an asset of the business. The taxpayer’s assessable income includes the market value (see [3 210]) of the item on the day of the disposal (although note s 70-90(1A) about using the Commissioner’s valuation). Any person acquiring the live stock will be deemed to have purchased it at the amount of that value: s 70-95. Standing or growing crops or crop stools and trees that have been planted and tended for the purpose of sale are also included in these provisions: s 70-85. See also [5 400]. [27 160] Disposal on change of ownership or interests The provisions of s 70-100 that are discussed in [5 420] and following have particular application if a change has occurred in the ownership of, or in the interests of persons in, live stock, as, for example, upon the formation or dissolution of or variation in a grazing partnership. The explanation in [5 420] and following of the operation of s 70-100 in relation to ordinary trading stock applies also to the operation of that provision in relation to live stock. An election under s 70-100 has no effect if (s 70-100(10)): • the trading stock stops being trading stock-on-hand of the transferor outside the course of ordinary family or commercial dealing; and • the consideration receivable by the transferor substantially exceeds what would reasonably be expected to be the consideration receivable if the market value (see [3 210]) of the item of trading stock immediately before it stops being trading stock-on-hand of the transferor were the closing value elected under s 70-100(4).

[27 170] Forced disposals or death of live stock In certain situations where a primary producer makes a profit on the forced disposal or death of live stock, Subdiv 385-E allows the primary producer to elect either to spread the tax profit over 5 years or, if the profit is mainly used for replacement stock, to defer including the tax profit in assessable income. Rules for making an election are contained in Subdiv 385-H: see [27 170]. Subdiv 385-E applies if (s 385-100(1)): • the taxpayer disposes of live stock or they die because: – land is compulsorily acquired or resumed under legislation; – a State or Territory leases land for a cattle tick eradication campaign; – pasture or fodder is destroyed by fire, drought or flood and the taxpayer will use the proceeds of the disposal or death mainly to buy replacement stock or to maintain breeding stock for the purpose of replacing the live stock – the Tax Office considers that the natural disaster and consequent destruction of pasture must be the compelling and decisive reason for the live stock disposal and the required nexus is not established if the destruction of pasture is just a background factor or an incidental or remote reason for the disposal: see ATO ID 2011/6; – the live stock is compulsorily destroyed under an Australian law for the control of a disease or it dies of such a disease (see Determination TD 98/29); or 1110

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[27 170]

– the taxpayer receives an official notification under an Australian law dealing with contamination of property; and • the taxpayer held the live stock as assets of a primary production business carried on in Australia; and • apart from Subdiv 385-E, the taxpayer’s assessable income for any income year would include the proceeds of the disposal or death. Any amount included in assessable income because of an election under Subdiv 385-E is taken to be income from carrying on a primary production business in Australia and thus allows the taxpayer to utilise the averaging provisions: s 385-155.

Profit on disposal The ‘‘tax profit on the disposal or death’’ of live stock is defined in s 385-105(3) as any amount remaining after deducting from the proceeds of the disposal or death (see below) the sum of: • in the case of live stock purchased during the year – the amount paid or payable for the live stock; and • the value of the rest of the live stock as trading stock-on-hand at the start of the income year. The ‘‘proceeds of the disposal or death’’ are the sum of the market value of the live stock or their carcasses at the time of disposal and any compensation received from a government agency for the death or destruction, or a reduction in the market value, of the live stock or their carcasses: s 385-100(2). See [3 210] for ‘‘market value’’. No deduction is made from the sale price of any natural increase bred by the taxpayer during the year that may have been sold; neither is a deduction allowed of any part of the working expenses incurred by the taxpayer during the year up to the date of sale. These expenses are allowed in full against the income of the year of sale.

Spreading tax profit over 5 years Under the first alternative (s 385-105), the primary producer may elect to spread over 5 years the tax profit on disposal or death. This is achieved by: • including in the primary producer’s assessable income for the disposal year the proceeds of disposal or death, reduced by the tax profit, and 20% of the tax profit; and • including in the primary producer’s assessable income for each of the next 4 income years 20% of the tax profit.

Deferring tax profit if replacement live stock Under the second alternative (s 385-110), the primary producer may elect to use the tax profit on disposal or death to reduce the cost of replacement live stock over a 6-year period (the disposal year and the next 5 income years), provided the primary producer will use the proceeds of disposal or death mainly to buy replacement live stock or to breed replacement stock. This is achieved by: • including in the primary producer’s assessable income for the disposal year the proceeds of disposal or death, reduced by the tax profit; • reducing the cost of replacement live stock bought in the disposal year (or any of the next 5 income years). The total of the reductions cannot exceed the tax profit; and • including in the primary producer’s assessable income for the last of the 6 years any unused tax profit (ie any tax profit that has not been used by the end of that year to reduce the cost of replacement live stock). © 2017 THOMSON REUTERS

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The ‘‘unused tax profit’’ is the tax profit on disposal or death less: (a) any amounts included in assessable income under s 385-115 for replacement live stock the primary producer breeds (see [27 200]); and (b) the amounts by which the amounts paid or payable for replacement stock is reduced under s 385-120 (the ‘‘reduction amount’’: see [27 180] and [27 190]).

Bovine tuberculosis A taxpayer may elect that any deferred profit arising if live stock are compulsorily destroyed under an Australian law for the control of bovine tuberculosis be accounted for over a 10-year period (instead of the normal 5-year period): s 385-125. [27 180] Replacement – same species Replaced stock of the same species (eg sheep replaced by sheep) is taken into account for income tax purposes at the amount paid or payable for the purchase of each replacement animal, less the reduction amount: s 385-120(1). The reduction amount is so much of the tax profit on disposal or death attributed to live stock of the species being replaced, divided by the number of animals of that species that were disposed of or died: s 385-120(2). Section 385-120(4) limits the reduction amount to the unused tax profit so that a particular purchase cannot reduce it to less than nil. These provisions do not deal with the situation where the reduction is greater than the cost of the replacement animal of the same species but, by necessary implication, the replacement cost cannot be less than nil. The excess amount is carried forward in the unused tax profit. EXAMPLE [27 180.10] Tracphil Pty Ltd, which carries on a primary production business in Australia, is required by reason of one of the specified disasters or diseases to dispose of a flock of 5,000 sheep at $10 per head. The cost of those sheep was $5 per head and therefore a profit of $25,000 is made. By making an election under s 385-120, Tracphil can, assuming that it purchases 5,000 sheep in one of the next 5 years at, say, $12 per head, reduce the cost of the new sheep to $7 per head for income tax purposes and avoid paying tax on the original profit until the new sheep are sold or disposed of. If, in the next year, 1,000 of the new sheep are sold at $15 per head, the assessable income derived from the sale is: 1,000 × ($15 − $7) = $8,000 The right to reduce the cost, and thus absorb the assessable income derived from the original disposal or death until such time as the new animals are disposed of, extends for a period of 5 years from the date of the disposal.

EXAMPLE [27 180.20] If, following the original disposal or death of the sheep referred to in Example [27 180.10], 500 sheep are purchased in the same year at $12 per head, the value of each of those new sheep is, for income tax purposes, reduced in a similar manner to $7. If in the following year 1,500 sheep are purchased at $15 per head, the value for income tax purposes of those sheep is reduced to $10. Assume further that in a subsequent year before the fifth year 3,000 sheep are purchased at $17 per head, the value of those sheep for income tax purposes is reduced to $12 per head. If, in a subsequent year the profit on the death or forced disposal (if applied in the normal manner) would exceed the amount of the profit remaining to be adjusted, the cost per head of the animals acquired in that last year is reduced proportionately: s 385-120(4).

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[27 220]

EXAMPLE [27 180.30] Assume the same set of facts as in Example [27 180.20], but in the last year 5,000 sheep are acquired at $17 per head. The value of those sheep in this case is reduced, not by $5 per head, the figure used in the previous 2 acquisitions, but by $3 per head. This amount is determined by the following formula: Unused tax profit on date of purchase of replacement animals Number of replacement animals purchased

Profit on forced sale of sheep less amounts applied in previous 2 years (2,000 sheep at $5 per head) Unused tax profit on disposal Number of stock purchased in subject year Unused tax profit on disposal Cost of each animal purchased during the year to be reduced by: $15,000 5,000

$ 25,000 10,000 15,000 5,000 15,000

$3 per head

[27 190] Replacement – different species Section 385-120(3) provides that the reduction amount for replaced stock of a different species (eg sheep replaced by cattle) is any reasonable amount at least equal to the amount worked out under s 385-120(2): see [27 180]. If the replacement stock is acquired at a price substantially in excess of the replacement cost of the species disposed of, the proportion of the profit on disposal required to reduce for taxation purposes the cost of the new animal is any reasonable amount at least equal to the amount worked out under s 385-120(2) provided that it does not exceed the cost of the new animal. If the cost of the replacement animal is not substantially in excess of the replacement cost of stock of a similar species to that disposed of, the reduction amount is the amount worked out under s 385-120(2) or the cost of the animal. [27 200] Replacement – breeding A primary producer who makes an election under s 385-110 (see [27 170]) and replaces the stock disposed of by breeding, may elect to include an amount in their assessable income of the income year in which the live stock are replaced: s 385-115. No formula is provided for determining the amount to be included and it is any amount chosen by the taxpayer. [27 210] Devolution on death The commentary in [5 450] applies also to live stock included in the assets of a business that devolve by reason of a taxpayer’s death. Thus, market value (see [3 210]) will be applied to the closing live stock in the deceased taxpayer’s return and that value will also be used as the opening value for trustees and beneficiaries: s 70-105(1) and (2). However, the legal personal representative can make an election under s 70-105(3) to include in the taxpayer’s assessable income the amount that would have been the value of the trading stock at the end of the income year ending on the date of the deceased taxpayer’s death. The election is only available if the business is carried on after the taxpayer’s death and the trading stock continues to be held as trading stock of that business: s 70-105(5). [27 220] Insurance recoveries Subdivision 385-F applies to insurance recoveries for a loss of live stock or a loss by fire of trees by a taxpayer carrying on a primary production business in Australia. Insurance recoveries are normally included in the recipient’s assessable income under s 15-30: see [5 © 2017 THOMSON REUTERS

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120]. If an insurance recovery in respect of a loss of live stock or a loss by fire of trees would otherwise be included in the taxpayer’s assessable income for an income year, the taxpayer may elect to include 20% of the insurance recovery in assessable income for that income year and 20% of the insurance recovery in assessable income for each of the next 4 income years: s 385-130. Rules as to making an election are contained in Subdiv 385-H: see [27 240].

[27 230] Double wool clips Subdivision 385-G allows a taxpayer who carries on a primary production business in Australia to defer the profit on a second wool clip if the taxpayer satisfies the following conditions: • the taxpayer’s assessable income would otherwise include the proceeds of the sale of 2 wool clips; • the sheep are shorn earlier than normal because of fire, drought or flood; • at the time the sheep were shorn, they were assets of a primary production business carried on by the taxpayer in Australia; and • the fire, drought or flood must have been in an area of Australia where the taxpayer carried on the business at that time. A taxpayer who satisfies the above conditions may make an election to include in assessable income for the next income year the profit on the earlier-than-normal wool clip: s 385-135. The profit on the earlier-than-normal wool clip is the proceeds of the sale of the wool clip that would otherwise be included in the taxpayer’s assessable income for the income year, less any expenses incurred in the income year that are directly attributable to the earlier-than-normal shearing or sale: s 385-135(4). The ‘‘proceeds of the sale of 2 wool clips’’ is defined in s 385-135(3) to mean the proceeds of the sale of the earlier-than-normal wool clip and an amount covered by one or more of: • the proceeds of the sale of another wool clip in the income year; • the proceeds of the sale of wool shorn in the previous income year that were held at the start of the income year and were taken into account at cost in working and the value of trading stock-on-hand at the end of the previous income year; and/or • an amount for wool shorn in the previous income year that is included in the taxpayer’s assessable income of the income year because of a previous election under this section.

[27 240] Rules for elections Subdivision 385-H sets out the rules that apply to all elections made under Subdiv 385-E (see [27 170]), Subdiv 385-F (see [27 220]) and Subdiv 385-G (see [27 230]). Section 385-145 385-150

385-155 385-160

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Title Partnerships and trusts – only the partnership or trustee can make the election. Time for making election – to be made before lodging a return for the last income year for which assessable income would include (apart from the election) the proceeds of the disposal or death of live stock, insurance recovery for the loss of live stock or trees or the proceeds of sale of 2 wool clips (the Commissioner may allow further time). Amounts included in assessable income because of an election or because of s 385-160 are taken to be from carrying on a primary production business in Australia. Effect of disentitling event on election – an election cannot be made after a disentitling event happens. If a disentitling event happens after an election is made, any amount deferred under an election will be included in assessable income in the income year in which the event happens. If an alternative election has been made under s 385-110 and a disentitling event happens, any unused tax profit on the disposal or death on the last day of the income year will be included in assessable income. © 2017 THOMSON REUTERS

PRIMARY PRODUCERS Section 385-163

385-165 385-170

[27 310]

Title Disentitling events – a disentitling event occurs when a taxpayer dies, becomes bankrupt or subject to insolvency laws, leaves Australia permanently or appears to the Commissioner to be about to do so or ceases to carry on the primary production business to which the election relates. Similar rules apply (as appropriate) to partnerships and trusts (eg a partner or beneficiary becomes bankrupt), including it seems a discretionary trust. The Commissioner has the discretion to ignore disentitling events covered by s 385-163(3)(c) or (d). New partnership – a new partnership can elect to be treated as the same entity as the old partnership, where it takes over the business of the old partnership and there is a 25% continuity of partnership interests. New partnership – a new partnership can elect to take advantage of an election made by the former owner of the business, provided the former owner transferred the primary production business to the partnership and they are entitled to at least 25% of the income of that partnership.

CAPITAL ALLOWANCES FOR PRIMARY PRODUCERS [27 300] Capital allowances – introduction The Uniform Capital Allowance (UCA) system in Div 40 ITAA 1997 generally allows primary producers to deduct capital expenditure on depreciating assets. In other words, primary producers are generally treated the same as other taxpayers for depreciation purposes. The UCA system is discussed in Chapter 10. However, Div 40 also contains special rules for certain assets used in connection with a primary production business. The relevant provisions are contained in Subdivs 40-F and 40-G as follows: Subdiv 40-F Water facilities Horticultural plants Grapevines Fodder storage assets Fencing assets

Subdiv 40-G Landcare operations Electricity connections Telephone lines

The period over which expenditure can be deducted varies from item to item (eg expenditure on water facilities, fencing assets and landcare operations may qualify for an immediate deduction, whereas expenditure on fodder storage assets may be deductible over 3 years). Note that the costs of establishing a qualifying carbon sink forest are deductible under Subdiv 40-J: see [11 620].

Small business entities Primary producers that are small business entities (aggregated turnover of less than $2m: see [25 020]) may qualify for the special capital allowance rules under Subdiv 328-DIncome Tax Assessment Act 1997: see [25 100] and following. If a small business entity qualifies for accelerated depreciation deductions under Subdiv 40-F or Subdiv 40-G, eg for water facilities, fodder storage assets, fencing assets or landcare operations, the entity may choose between the Subdiv 328-D rules and the Subdiv 40-F or Subdiv 40-G. Note that horticultural plants are not eligible for the Subdiv 328-D rules: see [25 100]. [27 310] Water facilities Capital expenditure incurred by a primary producer on the construction, manufacture, installation or acquisition of a water facility is deductible under Subdiv 40-F. Post-12 May 2015 expenditure is deductible in the income year in which the expenditure is incurred, whereas pre-12 May 2015 expenditure is deductible over 3 years: see below. A ‘‘water facility’’ is plant or a structural improvement, or an alteration, addition or extension to plant or a structural improvement, that is primarily and principally for the © 2017 THOMSON REUTERS

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purpose of conserving or conveying water: s 40-520(1). A ‘‘water facility’’ also includes a repair of a capital nature to such plant or structural improvements and a structural improvement, or a repair of a capital nature, or an alteration, addition or extension to a structural improvement, that is reasonably incidental to conserving or conveying water. Examples of a water facility include a dam, earth tank, underground tank, concrete tank, metal tank, tank stand, bore, well, irrigation channel (or similar improvement), pipe, pump, water tower, windmill and extensions or improvements to any of these items. An overhead sprinkler system used by the taxpayer solely for frost protection is considered to be a water facility: see ATO ID 2011/3. For issues in relation to whether expenditure is reasonably incidental to conveying or conserving water, see ATO ID 2009/30, ATO ID 2009/31 and ATO ID 2009/32. A deduction is only available if the expenditure on the water facility is incurred (s 40-525(1)): • primarily and principally for the purpose of conserving or conveying water for use in a primary production business (see [27 020]) conducted by the taxpayer on land in Australia. Thus, a deduction is not allowable to a person who owns land upon which a primary production business is carried on by some other person. However, the person carrying on a primary production business on the land is allowed a deduction, even if the person is only a lessee of the land; or • for expenditure incurred by an irrigation water provider – primarily and principally for the purpose of conserving or conveying water for use in primary production businesses conducted by other entities on land in Australia. Those entities must be supplied with water by the irrigation water provider. An ‘‘irrigation water provider’’ is defined in s 40-515(6) as an entity whose business is primarily and principally the supply (otherwise than by using a motor vehicle) of water to entities for use in primary production businesses on land in Australia (for a discussion of the meaning of ‘‘primarily and principally’’, see ATO ID 2009/4). If an entity conducts its business in 2 separate, but consecutive phases – the first being the construction of the water facilities and the second being the supply of water through the subsequent operation of the water facilities – the Commissioner will treat the entity as also carrying on a business of supplying water during the construction phase: see ATO ID 2007/35. Note that if Div 250 applies to an asset that is a water facility (ie if the asset is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), the above conditions will be taken not to be satisfied to the extent specified under s 250-150(3).

Amount of deduction Pre-12 May 2015 expenditure on a qualifying water facility is generally deductible over 3 years, whereas post-12 May 2015 expenditure on a qualifying water facility is generally deductible in the income year in which the expenditure is incurred: s 40-540. An immediate deduction is available where an entity starts to hold, or first incurs expenditure, on a qualifying water facility at or after 7:30pm on 12 May 2015 AEST. See [10 250] for a discussion of the concept of holding a depreciating asset. In all other cases, eg where expenditure on the water facility was incurred before 7.30 pm on 12 May 2015 AEST, the deduction is an amount equal to the decline in value of the water facility: s 40-515(1). A water facility starts to decline in value in the income year in which the expenditure is first incurred: s 40-530 item 1. The decline in value for that first year and the subsequent 2 years is one-third of the capital expenditure on the facility: s 40-540. In other words, the deduction is spread over 3 years in equal instalments, commencing with the year in which the expenditure is first incurred. Note that non-deductible SRWUIP expenditure (see below) will not count as capital expenditure for the purposes of s 40-515: s 40-515(3). For GST adjustments, see [27 370]. 1116

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[27 310]

See [27 380] for the position if the expenditure is incurred by a partnership. If a water facility is not used wholly for the purpose of carrying on a primary production business or for a taxable purpose, eg if it is also used for domestic purposes, the amount of the deduction that would otherwise be allowable is reduced by an amount attributable to the period when the water facility was not used in the business or for a taxable purpose (the use of the word ‘‘period’’ implies apportionment on a time basis): s 40-515(4). This does not apply, however, if the expenditure is incurred by an irrigation water provider: s 40-515(5). There are market value substitution rules (in s 40-560) that apply if parties are not dealing at arm’s length: see [27 390]. If deductible water facility expenditure is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580]. Note that Subdiv 58-B ITAA 1997 does not modify the way in which a transition entity (see [10 430]) works out the decline in value under s 40-515 of water facilities which are privatised assets at the transition time: see ATO ID 2007/36. Treasury issued exposure draft legislation in January 2016 containing amendments to ensure the law operates as intended in relation to water facilities, by correcting technical or drafting defects, removing anomalies and addressing unintended consequences.

Acquisition of water facility from another taxpayer A deduction is not available for expenditure on acquiring a water facility if any other person has deducted, or is entitled to deduct, under s 40-515 (or its predecessor, Subdiv 387-B) earlier expenditure on constructing or acquiring the water facility: s 40-555; s 40-525 TPA. Note that any alteration, addition or extension to a water facility, or a repair of a capital nature, is not the same as the facility itself: s 40-53 (see [10 190]). Thus, a taxpayer who incurs expenditure in altering, adding to or extending a water facility will not be denied a deduction for the expenditure simply because another taxpayer has deducted, or is entitled to deduct, expenditure incurred in constructing or acquiring the original facility.

Sustainable Rural Water Use and Infrastructure Program A taxpayer has the option of how to treat expenditure and receipts under the Sustainable Rural Water Use and Infrastructure Program (SRWUIP). They can elect to deduct the expenditure over 3 years under Subdiv 40-F, in which case payments under the Program are taxable in the year they are received, either as ordinary income or as a subsidy or, to the extent that the payment is deemed consideration for the supply of the surrendered water rights, capital gains. Alternatively, a taxpayer may: • treat payments under a SRWUIP program, or which are reasonably attributable to a payment under such a program, as non-assessable non-exempt income (s 59-65). If so, a deduction for expenditure that is reasonably attributable to a payment under a SRWUIP program or for a decline in value that relates to such expenditure will be denied (s 26-100); • disregard any capital gains and losses arising from the transfer of water rights under the program (see [15 120]); and • exclude the expenditure incurred under the program from the cost base of any assets acquired (see [14 080]). The choice must be made before the time the taxpayer has to lodge their income tax return for the year that they derive the first SRWUIP payment under a particular program or incur the first expense that satisfies an obligation under an arrangement entered into under the program: s 59-65. © 2017 THOMSON REUTERS

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[27 320] Horticultural plants The decline in value each year of a horticultural plant that is used for the purpose of producing assessable income in a horticulture business is deductible under Subdiv 40-F: s 40-515(1). Note that a horticultural plant does not qualify for the small business capital allowance rules in Subdiv 328-D: see [25 100]. ‘‘Horticultural plant’’ is defined in s 40-520(2) to mean a live plant or fungus that is cultivated or propagated for any of its products or parts. This includes grapevines. The taxpayer must carry on a horticulture business and either own the plant or have a lease or quasi-ownership right to the land to which the plant is attached, or hold a licence or lesser interest relating to the land: s 40-525(2). In addition, the holder of any other interest in the land must not be carrying on a horticultural business on the land. Note that if Div 250 applies to an asset that is a horticultural plant (ie if the asset is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), s 40-525(2) will be taken not to be satisfied to the extent specified under s 250-150(3). If the taxpayer is the first entity to satisfy a condition of ownership or quasi-ownership in s 40-525(2), the decline in value of a horticultural plant starts in the income year in which the first commercial season begins: s 40-530 item 2. In any other case, the decline in value begins in the later of the income year in which that condition was first satisfied and the income year in which the first commercial season starts. The amount that is deductible each year is determined on the basis of the effective life of the horticultural plant. A taxpayer may self-assess the effective life under s 40-105 or adopt the Commissioner’s determination made under s 40-100. Each year the Commissioner publishes a ruling setting out the effective lives of many depreciating assets as determined under s 40-100. The latest ruling is Ruling TR 2016/1 which applies from 1 July 2016 (replacing Ruling TR 2015/2): see [10 670]-[10 730]. If the effective life is less than 3 years, the first taxpayer to use the plant for the required purpose can deduct the expenditure in full in the year the taxpayer first uses the plant to produce assessable income: s 40-545(1). If the effective life is 3 years or more, the deduction is worked out by reference to the relevant annual write-off rate: s 40-545(2). The write-off rates and maximum write-off periods are as follows. Effective life 3 to fewer than 5 years 5 to fewer than 6 2/3 years 6 2/3 to fewer than 10 years 10 to fewer than 13 years 13 to fewer than 30 years 30 years or more

Write-off rate 40% 27% 20% 17% 13% 7%

Maximum write-off period 2 years 183 days 3 years 257 days 5 years 5 years 323 days 7 years 253 days 14 years 105 days

Note that, for horticultural plant established before 1 July 2001, the taxpayer is required to use the pre-1 July 2001 effective life. The amount deductible in an income year is calculated according to the following formula (s 40-545(2)): Establishment expenditure ×

Write-off days in income year × Write-off rate 365

The write-off days are the number of days in an income year on which the taxpayer satisfies a condition of ownership in s 40-525(2) for the horticultural plant and the plant is used, or held ready for use, for commercial horticulture. Thus, an apportionment will be required for any year in which horticultural plant is transferred to another taxpayer claiming a deduction under Subdiv 40-F (unless occurring at the start of the income year). For GST adjustments, see [27 370]. Note that the ‘‘365’’ element of the formula is constant, thus leap years are ignored. If the plants are destroyed before the end of their effective life, the taxpayer is allowed a deduction in that year for the remaining unclaimed expenditure less any proceeds, eg insurance. 1118

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[27 320]

Establishment expenditure is the capital expenditure attributable to the horticultural plant. According to the Tax Office, capital expenditure includes expenses incurred in establishing or extending a plantation up to the stage of planting horticultural plants in their long-term growing medium: Determination TD 2006/46. This would include the cost of acquiring plants or seeds, costs incurred in preparing to plant (eg the part of the cost of ploughing, top dressing, fertilising, top soil enhancement, soil analysis tests, forming up planting rows and planting site surveys that is attributable to the establishment of a horticultural plant), the cost of maintaining plants until they are ready to be planted, the cost of planting the plants or seeds, the cost of pots and potting mixtures (for potted plants), the costs incurred in grafting trees and the cost of establishing plants used for associated purposes, such as for companion planting (if those plants are not horticultural plants in their own right). The cost of purchasing land to be used for growing a horticultural plant is not establishment expenditure, as the cost is attributable to the land rather than to the establishment of the plant, and expenditure incurred in draining swamps or low-lying land or the clearing of land is specifically excluded: s 40-555(3). The cost of maintaining an established plantation is revenue in nature and therefore not establishment expenditure. A taxpayer cannot deduct more than the capital expenditure incurred on the horticultural plant: s 40-515(3). Treasury issued exposure draft legislation in January 2016 containing amendments to ensure the law operates as intended in relation to horticultural plants, by correcting technical or drafting defects, removing anomalies and addressing unintended consequences. EXAMPLE [27 320.10] Annie grows avocados for the domestic market. In February 2011 she spends $400,000 planting avocado trees. The first avocados from these trees are able to be harvested and sold commercially in March 2017. The income year in which the first commercial season starts is therefore 2016-17 and the decline in value commences in that year. The write-off days in 2016-17 are 122 (1 March to 30 June). Annie adopts the Commissioner’s determination of the effective life of the trees (20 years) and therefore the write-off rate is 13%. The decline in value for these trees is (amounts are rounded to the nearest whole dollar): 2016-17 income year Write-off days in income year Establishment expenditure × × Write-off rate 365 122 × 13% = $17,380.82 365

$400,000 × 2017-18 income year Establishment expenditure ×

Write-off days in income year × Write-off rate 365

365 × 13% = $52,000 365 Because the decline in value over the 20-year effective life of the avocado trees would exceed the $400,000 capital expenditure, the cap (in s 40-515(3)) on the amount that can be deducted will ensure that Annie cannot deduct more than the $400,000 capital expenditure incurred on the trees. $400,000 ×

There are market value substitution rules (in s 40-560) that apply if parties are not dealing at arm’s length: see [27 390]. If a plant with an effective life of 3 years or more is destroyed before the end of its maximum effective life, the balance of the undeducted expenditure (less insurance and other recoveries) is deductible: s 40-565. © 2017 THOMSON REUTERS

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If deductible expenditure for the establishment of horticultural plants is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580].

Transferring deduction The deduction for a horticultural plant can be transferred from one taxpayer to another. When a horticultural plant is acquired, the acquiring taxpayer must give the last entity entitled to claim a deduction in respect of the plant a written notice requiring that entity to provide certain information: s 40-575(1). The required information is the amount of the establishment expenditure, the effective life of the plant and the day on which it could first be used for commercial horticulture. The notice must be given within 60 days after acquiring the plant and the other entity must be given at least 60 days to provide the information: s 40-575(2). Intentionally failing or refusing to provide the information is an offence: s 40-575(3) and (5). If the relevant entity is a partnership, the notice may be given to any of the partners, but the obligation to provide the information falls on each partner although it may be discharged by any of them: s 40-575(4). Only one notice can be given to the other entity: s 40-575(6). Grapevines The Tax Laws Amendment (Wine Producer Rebate and Other Measures) Act 2004 implemented a wine equalisation tax (WET) rebate for every wine producer (including now New Zealand wine producers who export to Australia: see WET Rulings WETR 2006/1 and 2009/2). The rebate is $500,000 per annum. As part of the package, grapevines are now treated in the same way as other horticultural plants. [27 330] Fodder storage assets A deduction is available under s 40-515 for capital expenditure on fodder storage assets (as defined: see below). The deduction is spread over 3 income years (the income year in which the expenditure is first incurred and the next 2 years): ss 40-530(1), 40-548. These measures apply to assets that an entity starts to hold, or to expenditure an entity incurs, at or after 7:30 pm on 12 May 2015 AEST. See [10 250] for a discussion of the concept of ‘‘holding’’ a depreciating asset. A fodder storage asset is an asset or a structural improvement, or a repair of a capital nature, or an alteration, addition or extension, to an asset or a structural improvement, that is primarily and principally for the purpose of storing fodder: s 40-520(3). To qualify for the deduction, the expenditure must have been incurred primarily and principally for use in a primary production business conducted on land in Australia: s 40-525(3). However, the deduction is not available if any entity has deducted or is able to deduct an amount under Subdiv 40-F for any income year for earlier capital expenditure on the construction or manufacture, or a previous acquisition, of the fodder storage asset: s 40-555(4). If a fodder storage asset is not used wholly for the purpose of carrying on a primary production business or for a taxable purpose, eg if it is also used for domestic purposes, the amount of the deduction that would otherwise be allowable is reduced by an amount attributable to the period when the asset was not used in the business or for a taxable purpose (the use of the word ‘‘period’’ implies apportionment on a time basis): s 40-515(4). There are market value substitution rules (in s 40-560) that apply if parties are not dealing at arm’s length: see [27 390]. If deductible expenditure on fodder storage assets is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580]. Note that if Div 250 applies to a fodder storage asset (ie if the asset is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), s 40-525(3) will be taken not to be satisfied to the extent specified under s 250-150(3). 1120

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[27 340]

Treasury issued exposure draft legislation in January 2016 containing amendments to ensure the law operates as intended in relation to fodder storage assets, by correcting technical and drafting defects, removing anomalies and addressing unintended consequence.

[27 335] Fencing assets An immediate deduction is available under s 40-515 for capital expenditure on fencing assets (as defined: see below). The relevant expenditure is deductible in the income year in which the expenditure is first incurred: ss 40-530(1), 40-551. These measures apply to assets that an entity starts to hold, or to expenditure an entity incurs, at or after 7:30 pm on 12 May 2015 AEST. See [10 250] for a discussion of the concept of ‘‘holding’’ a depreciating asset. A fencing asset is an asset that is a structural improvement that is a fence, or a repair of a capital nature, or an alteration, addition or extension, to a fence: s 40-520(4). To qualify for the deduction, the expenditure must have been incurred primarily and principally for use in a primary production business conducted on land in Australia: s 40-525(4). However, the deduction is not available if any entity has deducted or is able to deduct an amount under Subdiv 40-Ffor any income year for earlier capital expenditure on the construction or manufacture, or a previous acquisition, of the fencing asset: s 40-555(5). If a fencing asset is not used wholly for the purpose of carrying on a primary production business or for a taxable purpose, eg if it is also used for domestic purposes, the amount of the deduction that would otherwise be allowable is reduced by an amount attributable to the period when the asset was not used in the business or for a taxable purpose (the use of the word ‘‘period’’ implies apportionment on a time basis): s 40-515(4). There are market value substitution rules (in s 40-560) that apply if parties are not dealing at arm’s length: see [27 390]. If deductible expenditure on fencing assets is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580]. Note that if Div 250 applies to a fencing asset (ie if the asset is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), s 40-525(4) will be taken not to be satisfied to the extent specified under s 250-150(3). Treasury issued exposure draft legislation in January 2016 containing amendments to ensure the law operates as intended in relation to fencing assets, by correcting technical or drafting defects, removing anomalies and addressing unintended consequences. [27 340] Landcare operations A taxpayer who carries on a primary production business on any land in Australia is entitled to an immediate deduction under Subdiv 40-G for capital expenditure incurred on a landcare operation: s 40-630(1). Expenditure on a landcare operation on rural land in Australia used for carrying on a business for producing assessable income from the use of the land is also deductible under s 40-630(1), unless the land is used for mining or quarrying operations: see [29 030]. Note that a deduction is not available under Subdiv 40-G for expenditure on a carbon sink forest that is deductible under Subdiv 40-J (see [11 620]): s 40-630(2C). A rural land irrigation water provider is entitled to a deduction under Subdiv 40-G for capital expenditure on a landcare operation for land in Australia that another entity uses at the time for carrying on a primary production business, or for rural land in Australia that another entity uses at the time for carrying on a business for producing assessable income from the use of the land (except a mining or quarrying business): s 40-630(1A). A ‘‘rural land irrigation water provider’’ is an irrigation water provider or an entity whose business is primarily and principally the supply (other than by using a motor vehicle) of water to entities for use in carrying on a business (other than a mining or quarrying business) using rural land in Australia: s 40-630(1B). If expenditure by a rural land irrigation water provider is © 2017 THOMSON REUTERS

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seemingly deductible under both Subdiv 40-F (water facilities: see [27 310]) and Subdiv 40-G, the expenditure is deductible under Subdiv 40-F. Note that if Div 250 applies to an asset that is land (ie if the land is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), the taxpayer will only be taken to be using the land for the purpose of carrying on a primary production business, or a business for the purpose of producing assessable income from the use of rural land (except a mining or quarrying business), to the extent under s 250-150(3). ‘‘Landcare operation’’ is defined in s 40-635 to mean: • erecting a fence to separate different land classes on the land in accordance with an approved management plan for the land (see below); • erecting a fence on the land primarily and principally for the purpose of excluding animals from an area affected by land degradation, to prevent or limit worsening of land degradation in the area and to help reclaim the area; • constructing a levee or similar improvement on the land; • constructing drainage works on the land primarily and principally for the purpose of controlling salinity or assisting in drainage control; • an extension, alteration, addition or repair of a capital nature to any fence, levee or similar improvement or drainage works mentioned above; • constructing a structural improvement, or a capital repair, alteration, addition or extension to a structural improvement, that is reasonably incidental to a levee or similar improvement or drainage works mentioned above – examples include a bridge constructed over a drain constructed to control salinity and a fence constructed to prevent live stock entering such a drain; • an operation primarily and principally for the purpose of eradicating or exterminating from the land animals that are pests, eradicating, exterminating or destroying plant growth detrimental to the land or preventing or fighting land degradation (except by erecting fences on the land); or • an extension of any operation described above. Expenditure on plant is not deductible under Subdiv 40-G unless it is a fence erected for one of the purposes listed above, or a dam or structural improvement used for agricultural, pastoral, forestry or pearling operations (the agricultural or pastoral operations requirement does not apply to rural land irrigation water providers). Revegetation comes under landcare: ATO ID 2004/714. A person carrying on a primary production business on the land is entitled to a deduction even if the person is only a lessee of the land. The deduction under Subdiv 40-G has to be reduced by a reasonable amount to reflect any use of the land in the relevant income year (after the expenditure was incurred) for any non-business purposes (except mining or quarrying operations): s 40-630(3). A similar provision applies to rural land irrigation water providers, except the deduction is reduced to reflect the use of the land in the year after the expenditure is incurred for a non-taxable purpose: s 40-630(4). For GST adjustments, see [27 370]. An ‘‘approved management plan’’ is defined in s 40-640. It must be prepared by an authorised officer of an Australian government agency responsible for land conservation or a farm consultant approved by the Agriculture Department: see s 40-670. Decisions refusing to approve a person as a farm consultant or revoking an approval are reviewable by the AAT: s 40-675. Expenditure that is not deductible under s 8-1 for controlling the regrowth of trees and other vegetation is potentially deductible under Subdiv 40-G, but the precise boundaries of 1122

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[27 350]

the provisions have not been defined by either the Commissioner or the courts. Section 40-635(2) makes it clear that expenditure incurred in draining swamp or low-lying land is not deductible. There are market value substitution rules (in s 40-660) that apply if parties are not dealing at arm’s length: see [27 390]. See [27 380] for the position if the expenditure is incurred by a partnership. If deductible landcare operations expenditure is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580]. Treasury issued exposure draft legislation in January 2016 containing amendments to ensure the law operates as intended in relation to landcare operations, by correcting technical or drafting defects, removing anomalies and addressing unintended consequences.

[27 350] Connecting power to land Capital expenditure incurred by a taxpayer in connecting power to land, or in upgrading the connection, is deductible under Subdiv 40-G over a 10-year write-off period if, when the expenditure is incurred, the taxpayer has an interest in the land, or is a share-farmer carrying on a business on the land: s 40-645(1). In addition, the taxpayer or another person must intend to use the electricity in carrying on a business at a time when the taxpayer has an interest in the land, or is a share-farmer carrying on a business on the land. Note that the land need not be used for primary production. A deduction is not available under Subdiv 40-G if the electricity is not used as intended within 12 months after it is first supplied as a result of the expenditure: s 40-650(1). If the deduction has already been claimed in an assessment, it can be amended to disallow the deduction: s 40-650(2). A deduction (under Subdiv 40-G) is also denied for capital expenditure incurred on connecting power to land or upgrading the connection, for expenditure in (or a contribution to the cost of) providing water, light or power for use on, access to or communication with the site of mining or quarrying operations): s 40-650(3). For GST adjustments, see [27 370]. The electricity connection or upgrading work for which a deduction may be claimed includes (s 40-655): • connecting a mains electricity cable to a metering point on the land; • providing or installing equipment designed to measure the amount of electricity supplied through a mains electricity cable to a metering point on the land, or modifying or replacing such equipment (provided the modification or replacement results from increasing the amount of electricity supplied to the land); • providing or installing equipment for use directly in connection with the supply of electricity through a mains electricity cable to a metering point on the land, or modifying or replacing such equipment (provided the modification or replacement results from increasing the amount of electricity supplied to the land); and • work to increase the amount of electricity that can be supplied through a mains electricity cable to a metering point on the land. If any of the above operations are done in the course of replacing or relocating a mains electricity cable or equipment, a deduction will only be allowed under Subdiv 40-G if done to increase the amount of electricity that can be supplied to a metering point on the land: s 40-655(2). Expenditure that is deducted or deductible under Subdiv 40-G cannot be deducted under any other provision of the income tax law: s 40-650(7) and (8). There are market value substitution rules (in s 40-660) that apply if parties are not dealing at arm’s length: see [27 390]. See [27 380] for the position if the expenditure is incurred by a partnership. © 2017 THOMSON REUTERS

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If expenditure on connecting power or upgrading the connection, that is deductible under Subdiv 40-G, is recouped or refunded, the amount recouped or refunded is included in assessable income under Subdiv 20-A: see [6 580]. EXAMPLE [27 350.10] Carlo incurs expenditure of $10,000 on a mains electricity connection in the 2013-14 income year. $5,000 of the expenditure is recouped in the 2016-17 income year. The deductions allowable under Subdiv 40-G and the amounts to be included in Carlo’s assessable income are as follows:

2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 to 2022-23

Deduction allowable $ 1,000 1,000 1,000 1,000 1,000 1,000

Recoupment assessable $ 0 0 0 4,000* 1,000 0

* Assessable recoupment in 2016-17 equals total allowable deductions for 2013-14 to 2016-17 inclusive: see [6 580]. If the recoupment had been less than $4,000, the assessable amount in 2016-17 would have been the amount recouped.

[27 360] Telephone lines A deduction is available under Subdiv 40-G over a 10-year write off period for capital expenditure incurred on a telephone line on, or on extending a telephone line to, land. A deduction is only available under Subdiv 40-G if, at the time the expenditure was incurred, the taxpayer was carrying on a primary production business on the land and either had an interest in the land or was a share-farmer carrying on a primary production business on the land: s 40-645(2). Restrictions on a taxpayer deducting capital expenditure on part of a telephone line if another entity is entitled to a deduction for the cost of that part (other than under Subdiv 40-G) are contained in s 40-650(4) to (6). Expenditure deductible under Subdiv 40-G is not deductible under any other provision of the income tax law, including the Uniform Capital Allowance system: s 40-650(7) and (8). For GST adjustments, see [27 370]. If deductible expenditure on telephone lines is recouped or refunded, the amount recouped or refunded is assessable under Subdiv 20-A: see [6 580]. See [27 380] for the position if the expenditure is incurred by a partnership.

[27 370] GST adjustments Subdivision 27-B ITAA 1997 deals with the effect of GST on the deduction under Subdiv 40-F (water facilities: see [27 310] and horticultural plants and grapevines: see [27 320]) and Subdiv 40-G (landcare operations: see [27 340]; electricity connections: see [27 350]; and telephone lines: see [27 360]). Subdivision 27-B also applies to expenditure that is deductible under Subdiv 40-H (exploration and prospecting: see [29 030]; and mining site rehabilitation: see [29 040]). Subdiv 40-I (but only in relation to ‘‘blackhole’’ expenditure: see [10 1150]) or Subdiv 40-J (carbon sink forests: see [11 620]). A taxpayer entitled to an input tax credit for expenditure that is deductible under any of those Subdivisions, must reduce the expenditure by an amount equal to the input tax credit: s 27-105(2). If there is a decreasing adjustment for GST that relates directly or indirectly to the expenditure, the amount of the decreasing adjustment is included in the taxpayer’s assessable 1124

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[27 450]

income for the income year in which the adjustment arises: s 27-105(3). On the other hand, a taxpayer is entitled to deduct an amount if there is an increasing adjustment for GST: s 27-105(4). For partnership expenditure, the input tax credit, decreasing adjustment or increasing adjustment is apportioned to each partner as described at [27 380]. Section 27-110 provides for the apportionment of input tax credits, decreasing adjustments and increasing adjustments if they relate to 2 or more things.

[27 380] Partnerships A partnership which incurs expenditure that is deductible under Subdiv 40-F or Subdiv 40-G is not entitled to a deduction in determining the net income of the partnership or the partnership loss. In these circumstances, a deduction is allowed to the individual partners with the amount of the deduction being determined by reference to the individual interests of the partners in the net income or net loss of the partnership. If, however, the partners have agreed that they are to meet the relevant expenditure in special proportions, the proportions agreed between the partners are the basis upon which the deduction is allowed: ss 40-570 and 40-665. [27 390] Non-arm’s length transactions Capital expenditure, incurred by a taxpayer under an arrangement where at least one party was not dealing at arm’s length and the amount of the expenditure is more than the market value, is subject to s 40-560 (Subdiv 40-F) and s 40-660 (Subdiv 40-G). Those sections require that the amount of expenditure taken into account is the market value (see [3 210] for ‘‘market value’’). The concept of ‘‘dealing at arm’s length’’ is discussed at [5 260]. [27 400] Depreciating assets Deductions under the Uniform Capital Allowance (UCA) system for the decline in value of depreciating assets (ie depreciation deductions) are equally available to primary producers (subject to the special rules in Subdivs 40-F and 40-G discussed at [27 300] and following). The UCA system is described in detail in Chapter 10. Note the Tax Office’s administrative practice (set out in Practice Statement PS LA 2003/8) of allowing an immediate deduction for low-cost capital assets in certain cases: see [10 530]. Section 40-30(3) provides that an improvement to land, or a fixture on land, whether or not the improvement or fixture is removable, will be treated as a separate asset (ie separate from the land) for depreciation purposes. Depreciation is not allowed in respect of improvements used for the taxpayer’s domestic or residential purposes, but is allowable on buildings provided for the accommodation of employees, tenants or share-farmers engaged in the primary production business. Depreciation is also allowed on that part of a homestead devoted exclusively to station or farming purposes as distinct from domestic purposes. If a property is owned by a private company, residential accommodation used by employees who are also shareholders in that company qualifies for depreciation under the UCA. Small business entities (aggregated turnover of less than $2m: see [25 020]) that are primary producers may qualify for the special capital allowance rules under Subdiv 328-D: see [25 100] and following. Where appropriate, a small business entity that is a primary producer may choose between the Subdiv 328-D rules and the accelerated depreciation deductions under Subdiv 40-F or Subdiv 40-G for water facilities, horticultural plants, fodder storage assets, fencing assets, landcare operations, etc: see [27 300].

LONG-TERM AVERAGING OF TAX LIABILITY [27 450] What is averaging? It is inherent to the nature of primary production activities that a primary producer’s income level may fluctuate significantly from year to year, particularly in view of natural disasters such as drought, floods or fire. © 2017 THOMSON REUTERS

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Division 392 ITAA 1997 (ss 392-1 to 392-95) is designed to relieve the burden that would otherwise be imposed on primary producers of having unreasonably high marginal tax rates apply to their taxable income in the years in which high levels of income occur, but that are not representative of the true level of their income over a longer period. (Division 392 replaced Div 16 of Pt III ITAA 1936.) This result is achieved through a formula that averages income from primary production and certain other limited amounts of income over a period not exceeding 5 years and results in an averaging adjustment of either a tax offset (rebate) or extra income tax, depending on whether the taxable income for the year is above or below the average income. This is designed to level out tax payable over a period of time as much as possible. Averaging of income applicable to primary producers is separate from, and should not be confused with, the limited averaging that is available to authors, inventors, performing artists, production associates and sportspersons (see Chapter 28). Those forms of averaging are different to primary production averaging.

[27 460] Who qualifies for averaging? The averaging rules in Div 392 only apply to an individual (and not a company) carrying on a primary production business in Australia. The application of averaging is limited to income from primary production or the averaging component. The rules apply either to allow a tax offset which reduces tax if the average income is less than the taxable income or to apply a surcharge (referred to as extra income tax) if the average income exceeds the taxable income. A primary producer may elect to opt out of the averaging rules: s 392-25. The election must be in writing and be lodged with the Commissioner by the time the income return for the relevant year is lodged. The election is irrevocable and the primary producer cannot use the averaging rules at any time after electing to opt out. However, the Tax and Superannuation Laws Amendment (2016 Measures No 2) Bill 2016 proposes to allow eligible primary producers to re-enter the averaging system after 10 income years. The basic conditions for readmission to the averaging system are: • the taxpayer opted out of the averaging system 10 or more income years ago; • the taxpayer has been carrying on a primary production business for 2 years in a row; and • the taxpayer’s basic taxable income in the first year after the end of the 10 year opt-out period is less than or equal to their basic taxable income in the later year. A primary producer who re-enters the system will be treated as a new primary producer, and will have to comply with the basic conditions for entry before admission to the income tax averaging system again. The proposed amendments are to apply from the 2016-17 income year. This means that a primary producer who opted out before the 2006-07 income year will be able to re-enter the system in 2016-17. ‘‘Primary producer’’ refers to a person who carries on in Australia a primary production business. The definition of ‘‘primary production business’’ (in s 995-1) is considered at [27 020]. A beneficiary in a trust estate that is carrying on a primary production business is generally taken to be carrying on the primary production business if the beneficiary is presently entitled to all or part of the trust income for the income year: s 392-20. There is an exception if a beneficiary is presently entitled to income of less than $1,040 from the trust estate and the Commissioner is satisfied that the interest of the beneficiary was acquired to enable the averaging provisions to apply to the beneficiary: see further [27 540]. Averaging is available to an individual taxpayer who is a partner in a partnership which carries on a primary production business: ATO ID 2003/359. The High Court in FCT v Bamford (2010) 75 ATR 1 held that a beneficiary cannot be presently entitled to a share of income of a trust if the trust has no income to distribute, 1126

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[27 470]

usually because the trust has a loss for trust law purposes. This had the effect of preventing beneficiaries applying the averaging provisions or the farm management deposits system in that year. Legislation has been enacted to reinstate the position existing before the Bamford decision, but subject to certain conditions: see [27 540] and [27 610]. Section 392-10 adopts the previous administrative practice of allowing a taxpayer, who receives primary production income from a business that has ceased, to continue applying the averaging provisions in the current year.

[27 470] What income is subject to averaging? Averaging is a method to determine the effective rate of tax applicable to an individual taxpayer deriving income from carrying on a primary production business by reference to the average income of the current year and the 4 previous income years. The averaging provisions apply to all primary production income and to a certain amount of non-primary production income explained below with reference to taxable non-primary production income in s 392-85 and averaging component in s 392-90. Distributions by WoolStock Australia Limited (the privatised Wool International) to an original wool grower who held units in Wool International are treated, for tax purposes, as primary production income, provided that person paid the relevant wool tax in the course of carrying on a business: s 21 Wool International Privatisation Act 1999. Basic taxable income ‘‘Basic taxable income’’ means the taxable income of a primary producer less any net capital gain, any death benefit termination payment assessable under s 82-65 or s 82-70 ITAA 1997, any superannuation lump sum assessable under s 302-145 ITAA 1997 and any above-average special professional income under Div 405 ITAA 1997: s 392-15(1). Basic taxable income will be nil if the taxpayer does not have a taxable income or the amount worked out under s 392-15(1) is less than nil. A loss deferred under the non-commercial loss provisions (see [8 600]) is not taken into account in calculating basic taxable income. Taxable primary production income ‘‘Taxable primary production income’’ is worked out under s 392-80(1) by comparing assessable primary production income derived from carrying on a primary production business with primary production deductions. Note that the following are considered to be assessable primary production income: • a repaid Farm Management Deposit (see [27 620]); and • dividends from shares acquired by a primary producer under a compulsory share acquisition scheme (eg shares in a growers’ co-operative): see ATO ID 2010/149. Note also that the Commissioner considers that ordinary income derived by an individual from wind farming infrastructure constructed, operated and accessed on freehold land the individual owns and uses in carrying on a business of primary production does not constitute assessable primary production income of that individual for the purposes of Div 392: Determination TD 2013/2. If assessable primary production income is larger than primary production deductions, taxable primary production income is the difference between them. If primary production deductions are larger than or equal to assessable primary production income, taxable primary production income is nil. ‘‘Primary production deductions’’ are deductible amounts that relate exclusively or reasonably to assessable primary production income. From 2010-11, ‘‘apportionable deductions’’ (rates, land tax and most tax-deductible gifts other than gifts of trading stock) are not taken into account in working out primary production deductions and are allocated entirely to ‘‘non-primary production deductions’’ (see below). For earlier income years, ‘‘apportionable deductions’’ were spread across both primary production deductions and non-primary production deductions. © 2017 THOMSON REUTERS

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Note that a loss which is deferred under the non-commercial loss provisions (see [8 600]) is not an amount that can be deducted from assessable primary production income.

Taxable non-primary production income ‘‘Taxable non-primary production income’’ is the difference between assessable non-primary production income and non-primary production deductions if the income component is larger: s 392-85(1). Assessable non-primary production income is worked out by excluding any net capital gain, any death benefit termination payment assessable under s 82-65 or s 82-70 ITAA 1997 and any superannuation lump sum assessable under s 302-145 ITAA 1997: ss 392-45(2), 392-85(2). If the non-primary production deductions are larger than (or equal to) assessable non-primary production income, taxable non-primary production income is nil: s 392-85(1). ‘‘Non-primary production deductions’’ are the difference between total deductions and primary production deductions and, from 2010-11, include all ‘‘apportionable deductions’’ (see above): s 392-85(3). Non-primary production shade-out amount The ‘‘non-primary production shade-out amount’’ is the amount of non-primary production income subject to averaging and is worked out in one of 2 ways under s 392-90(2) and (3). If taxable primary production income is more than nil, the non-primary production shade-out amount is: $10,000 − Taxable non-PP income

If taxable primary production income is nil, the non-primary production shade-out amount is: $10,000 − Taxable non-PP income − (PP deductions − Assessable PP income)

If that amount is less than nil (a negative), the non-primary production shade-out amount is nil.

Averaging component The ‘‘averaging component’’ is worked out under s 392-90(1) by applying the following table. Item

1 2 3 4

AVERAGING COMPONENT If taxable non-primary The averaging component equals: production income: For taxable primary For taxable primary production income > 0 production income = 0 is nil basic taxable income nil is more than nil but does basic taxable income basic taxable income not exceed $5,000 exceeds $5,000 but does taxable primary production non-primary production not exceed $10,000 income plus non-primary shade-out amount shade-out amount is $10,000 or more taxable primary production nil income

The following examples illustrate the above formulas. EXAMPLE [27 470.10] James has a basic taxable income of $14,000 and his taxable primary production income is $8,400. The non-primary production shade-out amount is calculated as follows. Basic taxable income less taxable primary production shade-out amount is: $14,000 − $8,400 = $5,600 As this exceeds $5,000, the non-primary production shade-out amount is: $10,000 − $5,600 = $4,400

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[27 480]

Averaging component is: $8,400 + $4,400 = $12,800 The averaging tax offset is calculated on this amount.

EXAMPLE [27 470.20] Hannah incurs a loss of $2,000 in a primary production business. Taxable income after allowing for this loss is $6,000. Because the sum of the taxpayer’s basic taxable income ($6,000) and the loss from the primary production business exceeds $5,000, the non-primary production shade-out amount is: $10,000 − ($8,000 + $2,000) = nil If the taxable income of the taxpayer had been $3,000 or less, the taxable income would have been the non-primary production shade-out amount.

[27 480] First average year For the purpose of applying averaging under Div 392, the first income year to which averaging applies is the income year in which the basic taxable income is equal to or less than the succeeding year: s 392-10(1). No year before this year will be an average year. For the first averaging calculation, a minimum of 2 years is required in which the basic taxable income of the second year must be no less than the first year. EXAMPLE [27 480.10] Assume all income is derived from primary production.

First year (primary production business commences) Second year Third year (first average year) Fourth year Fifth year Sixth year Seventh year

Taxable income $ 6,900 6,800 7,100 7,000 7,900 8,400 6,700

First year $6,900 is taxed at the rate applicable to that income. Second year The averaging provisions do not apply as the basic taxable income of the first year is greater than that of the second year. The sum of $6,800 is therefore taxed at the rate applicable to that amount. Third year (first average year) The averaging provisions first apply in the third year, as the income of the second year, $6,800, is less than that of the third year, $7,100. The average income is: ($6,800 + $7,100) ÷ 2 = $6,950. Fourth year If a taxpayer’s income has been previously averaged, the provisions of Div 392 continue to apply notwithstanding a rise or fall in the basic taxable incomes of succeeding years, except if the income tax law contains a specific provision to the contrary. The average income for the fourth year is therefore: $20,900 (ie $6,800 + $7,100 + $7,000) ÷ 3 = $6,967 Fifth year © 2017 THOMSON REUTERS

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The average income is: $28,800 (ie $6,800 + $7,100 + $7,000 + $7,900) ÷ 4 = $7,200 Sixth year The average income is now determined with reference to a full 5-year period: $37,200 (ie $6,800 + $7,100 + $7,000 + $7,900 + $8,400) ÷ 5 = $7,440 Seventh year Section 392-40 provides that averaging applies to the current year and the 4 previous income years. The second year is therefore excluded from averaging since the maximum number of average years is 5: $ 7,100 7,000 7,900 8,400 6,700 37,100 Average income = $37,100 ÷ 5 = $7,420

EXAMPLE [27 480.20] $ 6,600 6,600 7,500 20,700

First year Second year Third year

Average income = $20,700 ÷ 3 = $6,900 The sum of $7,500 is subject to tax at standard rates less a tax offset of the difference between that tax and the amount that would be payable if the tax on $7,500 was calculated at the rates applicable to a taxable income of $6,900. It will be observed that the income of the first year (being the year in which the taxpayer commenced business) is equal to or less than that of the second year and the first year is therefore the first average year. A loss is treated as a nil taxable income in calculating the average income.

[27 490] Getting started on averaging Averaging does not automatically apply when an individual commences to carry on a primary production business in Australia. The following basic conditions in s 392-10(1) must first be satisfied: • the taxpayer must be an individual; • a primary production business in Australia must be carried on for 2 or more income years in a row with the current year being the last of those years; and • for at least one of those income years, the basic taxable income must be less than or equal to the basic taxable income for the next income year. Section 392-10(2) incorporates an administrative practice of the Tax Office under the old law allowing a taxpayer who receives income from a primary production business that had ceased in an earlier year to continue to apply averaging to the current year.

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[27 510]

EXAMPLE [27 490.10] $ First year (primary production business commences) Loss (800) Second year Profit 15,000 The loss incurred in the first year is deductible from the income derived in the second year (s 36-15), the basic taxable income of which is therefore $14,200. The average table is: $ First year Nil Second year 14,200 14,200 Average income = $14,200 ÷ 2 = $7,100. The sum of $14,200 is, therefore, subject to tax at standard rates less a tax offset of the difference between the tax that would be payable on that amount and the tax payable on income of $14,200 calculated by reference to the average rate of tax (referred to in s 392-55 as the ‘‘comparison rate’’) applicable to a taxable income of $7,100.

Re-entering the system The Tax and Superannuation Laws Amendment (2016 Measures No 2) Bill 2016 proposes to allow a primary producer to re-enter the averaging system: see [27 460]. An entity that re-enters the system will effectively be treated as a new primary producer. Thus, in applying the basic conditions (see above) after the 10-year opt-out period had passed, none of the years in the opt-out period will be counted for averaging purposes: proposed s 392-10(3). [27 500] Years in which a loss is incurred If a taxpayer has a loss in a particular year, the income of that year is deemed to be nil for the purpose of calculating the average income: s 392-15(2). The income of the next year will be reduced by the amount of the loss carried forward. Thus, in practical terms, the amount of the loss that will be taken into account as the income of that year is the net amount after deducting the amount of the prior year loss. [27 510] How is tax calculated? Tax is still calculated in the first instance on the taxpayer’s actual basic taxable income at ordinary rates but, in the case of primary producers, a tax offset (or rebate) is available or extra income tax becomes payable in order to adjust tax payable at the rate of tax applicable to the average income: s 392-35. A primary producer is entitled to a tax offset if the average income is less than the taxable income, but must pay extra income tax if the average income exceeds the taxable income for a particular year. The ‘‘average income’’ of a taxpayer means the average of basic taxable incomes (see [27 470]) of the ‘‘average years’’, ie the years beginning with the first average year and ending with the current income year: see [27 480]-[27 500]. If averaging has applied for at least 4 income years in a row (including the current year), the first average year is the fourth year before the current year: s 392-40(a). However, if averaging has applied for less than 4 income years in a row (including the current year), the first average year is the last income year before those income years: s 392-40(b). Thus, the maximum number of average years is 5 and the minimum is 2 (see also s 392-10(1)). Although the non-primary production income may only partially be taken into account in determining the amount of the offset or extra income tax, the average income is determined by reference to the taxable income (subject to the exclusions mentioned) derived irrespective of the source of that income. © 2017 THOMSON REUTERS

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EXAMPLE [27 510.10]

First year Second year Third year Fourth year Fifth year (current income year)

A $ 15,000 16,000 23,000 17,000 19,000 90,000

B $ 14,000 17,000 17,000 19,000 23,000 90,000

The average income for the 5 years is $18,000 in both instances (ie $90,000 ÷ 5). Assuming that the income is derived wholly from primary production, in the current income year, A will be entitled to a tax offset on the difference between the tax payable on $19,000 at basic rates (referred to in s 392-35(4)) and the tax payable on $19,000 at the rate applicable to a taxable income of $18,000. B will be entitled to a tax offset equal to the difference between the tax payable on $23,000 at basic rates of tax and the tax payable on $23,000 calculated at the rate of tax applicable to $18,000.

Averaging for the purposes of determining the tax payable applies only with limited effect upon income derived other than from primary production. In the following examples it has been assumed that the whole of the income is derived from a primary production business. The averaging provisions provide for a rebate to the primary producer whose taxable income is greater than her or his average income. In the case of the primary producer whose taxable income is less than her or his average income, extra income tax is payable. If the average income is less than the taxable income of a year, the tax offset is determined by applying the tax rate applicable to the average income to the taxable income and apportioning the difference on the basis explained in [27 520]. EXAMPLE [27 510.20] Tumaini, who carries on a primary production business, has taxable income as shown below. Average income is determined by reference to the figures indicated. Year Taxable income Average income $ $ 1 12,000 12,000 2 14,000 13,000 3 17,000 14,333 4 13,000 14,000 5 18,000 14,800 6 22,000 16,800 7 12,000 16,400 8 25,000 18,000 There is a tax offset in years 2, 3, 5, 6 and 8. Extra income tax is payable in years 4 and 7.

Averaging tax offset or extra income tax – method of calculation The following table sets out step-by-step the method of calculating a tax offset or extra income tax under the averaging system.

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[27 520]

Averaging tax offset or extra income tax

Method of calculation 1 Calculate taxable income. 2 Calculate basic taxable income (see [27 470]): s 392-15. 3 Calculate average income: s 392-45. 4 Calculate the averaging component: s 392-90. 5 Determine tax on basic taxable income at basic rates (ie ordinary rates for residents or non-residents) and ignore offsets, credits and Medicare levy: s 392-35(1) and (5). 6 Determine tax on average income at basic rates (ignoring offsets, credits and Medicare levy): s 392-50. 7 Calculate the comparison rate (ie average rates of tax on average income) by dividing the amount in 6 by the amount in 3: s 392-55. 8 Apply comparison rate to basic taxable income by multiplying the amount in 7 by the amount in 2: s 392-35(1). 9 Work out gross averaging amount by the difference between the amount in 8 and the amount in 5: s 392-70. 10 Work out the averaging adjustment by applying the formula under s 392-75: Gross averaging amount ×

Averaging component Basic taxable income

11 If the income tax payable at the comparison rate is less than the income tax payable at basic rates, the averaging adjustment will be a tax offset (or rebate): s 392-35(2). 12 If the income tax payable at the comparison rate is more than the income tax payable at basic rates, the averaging adjustment will result in extra income tax: s 392-35(3).

Examples of the application of the above method are shown at [27 520] and [27 530].

[27 520] Tax offset A taxpayer carrying on a primary production business is entitled to a tax offset (or rebate) determined by reference to the taxpayer’s: • basic taxable income; • averaging component; and • average income. The average income is determined by reference to the basic taxable income of the previous 5 years as illustrated at [27 480]-[27 500]. The averaging component is then determined on the basis that income from non-primary production activities is made subject to the averaging concession only on a limited basis (see [27 470]). The tax offset to which a taxpayer is entitled is worked out by calculating the gross averaging amount under s 392-70 and the averaging adjustment under s 392-75 with reference to s 392-35(2). The detailed method to follow is set out at [27 510]. The following examples illustrate the application of the method at the various alternative possible levels of non-primary production income. If the average income exceeds the taxable income of a year, the tax offset is not applicable and the tax payable is increased by extra income tax: see [27 530].

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EXAMPLE [27 520.10] Nicole, who carries on a primary production business, has taxable income from that source of $22,000 for 2016-17. In addition, she has a part-time job from which $4,000 taxable income is derived. Because taxable non-primary production income is less than $5,000, it is taken into account in calculating the averaging tax offset. Assume the average income is $24,000. In determining final tax payable in this example, and in Examples [27 520.20] and [27 520.30], it is assumed that Nicole has no dependants. Medicare levy would need to be added to the final figure in each case. The tax payable is calculated as follows (cents are ignored): Tax on taxable income of $26,000 ($22,000 + $4,000) at ordinary 2016-17 rates Tax on $24,000 (average income) at ordinary 2016-17 rates Comparison rate

=

$ 1,482

=

1,102 $1,102 $24,000 1,193

Tax on taxable income ($26,000) at = comparison rate Tax offset $1,482 − $1,193 = 289 Tax payable $1,482 − $289 = 1,193 Note that the tax payable by Nicole is reduced by the low-income offset (maximum $455): see [19 300].

EXAMPLE [27 520.20] Assume that in Example [27 520.10] Nicole’s non-primary production income for 2016-17 was $7,000 but all other amounts were the same. The position is as follows (cents are ignored). Because the non-primary production income exceeds $5,000, part only is taken into account to determine the averaging tax offset. The part is equal to: $10,000 − $7,000 = $3,000

Tax on taxable income of $29,000 ($22,000 + $7,000) at ordinary 2016-17 rates Tax on $24,000 (average income) at ordinary 2016-17 rates Comparison rate Tax on taxable income ($29,000) at comparison rate Gross averaging amount $2,052 − $1,331

=

$ 2,052

=

1,102

=

1,331

=

721

$1,102 $24,000

Tax offset averaging: Averaging component ($22,000 + $3,000) Gross averaging amount × = 621 adjustment ($721) Basic taxable income ($29,000) Tax payable $2,052 − 1,431 = $621 Note that the tax payable by Nicole is reduced by the low-income offset (maximum $455): see [19 300].

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[27 530]

EXAMPLE [27 520.30] Assume that in Example [27 520.10] Nicole’s non-primary production income for 2016-17 is $13,000, ie no part of this income is to be taken into account for the purpose of determining the averaging tax offset. All the other figures in Example [27 520.10] remain the same. Tax on taxable income of $35,000 ($22,000 + $13,000) at ordinary 2016-17 rates Tax on $24,000 (average income) at ordinary 2016-17 rates Comparison rate Tax on taxable income ($35,000) at comparison rate Gross averaging amount $3,192 − $1,607

=

$ 3,192

=

1,102

=

1,607

=

1,585

$1,102 $24,000

Tax offset averaging: Averaging component ($22,000) × Gross averaging amount ($1,585) = 996 Basic taxable income ($35,000) Tax payable $3,192 − $996 = 2,196 Note that the tax payable by Nicole is reduced by the low-income offset (maximum $455): see [19 300].

[27 530] Extra income tax The examples in [27 520] illustrate the situation where the average income is less than the taxable income and, in those circumstances, a tax offset was allowed. If, however, the average income exceeds the taxable income, the rate of tax applicable to the taxable income (which is that determined as applicable to the average income) may result in a higher amount of tax than applies if the taxable income was taxed at ordinary resident rates. Under these circumstances, the primary producer is required to pay extra income tax. Determination of this amount of extra income tax is made in exactly the same way as is applicable to determining the amount of tax offset if the average income is less than the taxable income. The detailed method to follow is set out at [27 510]. Example [27 530.10] illustrates the application of this method in a situation where extra income tax is payable. EXAMPLE [27 530.10] Lister, who carries on a primary production business, has a net income from that source of $18,000 for the 2016-17 income year. In addition, he has a part-time job from which $4,000 is derived as other income. Because non-primary production income is less than $5,000, it is taken into account in calculating the averaging adjustment for Lister. Assume the average income is $28,000. The tax payable is calculated as follows: $ Tax on taxable income of $22,000 ($18,000 = 722 + $4,000) at ordinary 2016-17 rates Tax on $28,000 (average income) at = 1,862 ordinary 2016-17 rates Comparison rate $1,862 $28,000 Tax on taxable income ($22,000) at = 1,463 comparison rate Extra income tax $1,463 − $722 = 741 Tax payable = $722 + $741 = 1,463 © 2017 THOMSON REUTERS

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Note that the tax payable by Lister is reduced by the low-income offset (maximum $455): see [19 300].

[27 540] Beneficiary of a trust A beneficiary of a trust which is carrying on a primary production business may still qualify for income averaging under s 392-20 (the beneficiary is taken to be carrying on the business). A beneficiary who is presently entitled to a share of the income of the trust for the income year may qualify for averaging if that share is $1,040 or greater. However, if that share is less than $1,040, averaging is only available if the Commissioner is satisfied that the beneficiary’s interest in the trust was not acquired or granted (wholly or primarily) so that the beneficiary may qualify for averaging: s 392-20(2). A beneficiary may still qualify for averaging if the trust does not have any income (for the income year) to which a beneficiary could be presently entitled. If the trust is a fixed trust, a beneficiary may qualify for averaging if (i) the beneficiary would be presently entitled to trust income if the trust had income and (ii) the manner or extent to which each beneficiary can benefit from the trust is not capable of being significantly affected by the exercise, or non-exercise, of a power: s 392-20(3). If the trust is a non-fixed trust (eg a discretionary family trust), a beneficiary may qualify for averaging if he or she is a ‘‘chosen beneficiary’’ of the trust: s 392-20(4). The maximum number of choices that the trustee may make is the higher of the number of individuals taken to be carrying on a primary production business under s 392-20(1) in the income year immediately before the current income year and 12: s 392-25. The choice must be in writing and made before the relevant trust return is lodged (although the Commissioner may grant an extension of time). The choice cannot be varied or revoked. Beneficiaries of ‘‘corporate unit trusts’’ (see [23 1560]) or ‘‘public trading trusts’’ (see [23 1610]) that operate a primary production business cannot access the averaging provisions: s 392-20(5). [27 550] Permanent reduction of income Special provisions apply if a taxpayer establishes to the Commissioner that, owing to retirement from her or his occupation or from any other cause (but not including a change in the investment of assets from which assessable income was derived into assets from which the taxpayer derives income that is not liable to be assessed under the income tax law), her or his taxable income has been permanently reduced to an amount that is less than two-thirds of her or his average income. In these circumstances, the taxpayer is to be assessed, and the provisions of Div 392 will apply to the income subsequently derived, as if the taxpayer had never been a taxpayer before that year: s 392-95. Effectively, the taxpayer obtains a fresh start to the averaging provisions. In the case of a taxpayer seeking the benefit of s 392-95, the question of whether he or she meets the test of a permanent reduction of her or his taxable income to less than two-thirds of her or his average taxable income is determined by reference to the actual taxable income and not by reference to the average income as now determined. Consequently, s 392-95(2) provides that, in working out the permanent reduction, the taxpayer’s average income for the reduction year must be worked out on the basis that the taxpayer’s basic assessable income did not include any assessable income from sources from which the taxpayer does not usually receive assessable income. In addition, the taxpayer must disregard a reduction in basic taxable income resulting from a change of assets from which assessable income was derived into assets from which income that is not assessable was derived: s 392-95(3). For an example of an AAT decision on the ITAA 1936 provision corresponding to s 392-95 (s 155), see AAT Case 5595 (1989) 21 ATR 3149. 1136

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[27 610]

Averaging does not recommence automatically. The taxpayer must make the choice by notifying the Commissioner in writing by the date of lodgment of the return for the reduction year: s 392-95(1A).

FARM MANAGEMENT DEPOSITS [27 600] Farm management deposits – introduction The farm management deposits (FMD) scheme (in Div 393 ITAA 1997) allows primary producers (with a limited amount of non-primary production income) to claim deductions for FMDs made in the year of deposit (and reduce their PAYG instalment income accordingly). When an FMD is withdrawn, the amount of the deduction previously allowed is included in both the primary producer’s PAYG instalment income and assessable income in the repayment year. See further [27 620].

[27 610] What is a farm management deposit? A ‘‘farm management deposit’’ (FMD) IS a deposit of money made under an agreementbetweentheFMDproviderandthedepositorthatsatisfiesvariousrequirements:s 393-20(1). An ‘‘FMD provider’’ must be an ADI or an entity carrying on in Australia a banking businessor a business of taking deposits (provided the repayment of deposits is guaranteed by the Commonwealth or a State or Territory government): s 393-20(3). Pastoral agents are notfinancial institutions under the definition because they are notADIs and their deposits are not government guaranteed. The owner of an FMD is the individual making the deposit or, if thedeposit is made by a trustee on behalf of a beneficiary of the trust, the beneficiary (see below): s 393-25. If a partnership is carrying on a primary production business, each individual who is a partner is treated for FMD purposes as if he or she is carrying on thebusiness:s393-25(2). As noted above, the agreement between the FMD provider and the depositor must contain various requirements (listed in the table in s 393-35) in order for a deposit to be an FMD. The agreement may contain additional requirements that are not inconsistent with those listed. The requirements are: 1. The owner of the FMD must be an individual carrying on a primary production business in Australia when the deposit is made (ie the owner cannot be a company). 2. A deposit must not be made jointly by, or on behalf of, 2 or more individuals. 3. A beneficiary of a trust is taken to be the owner of an FMD if the deposit is made by the trustee on behalf of the beneficiary (see below). 4. The deposit must be $1,000 or more when made, unless it is the immediate reinvestment of an FMD with the same FMD provider or the extension of the term of an FMD. 5. The depositor’s rights in respect of the FMD must not be transferable. 6. The FMD must not be the subject of a charge or other encumbrance to secure an amount. 7. Amounts that would otherwise accrue as interest or other income on the deposit must not reduce the liability of the depositor to pay interest to the FMD provider in respect of loans or other debts of the depositor (eg the FMD cannot be a mortgage offset account). 8. Interest or other earnings on an FMD cannot be invested as an FMD without being first paid to the depositor. © 2017 THOMSON REUTERS

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9. The FMD must not be more than $400,000 and the total balances of all FMDs of the owner with the FMD provider must never exceed $400,000 (a person can have FMDs with multiple FMD providers, although the total amount deposited in FMDs must not exceed $400,000). 10. The FMD must be repaid if the owner dies or becomes bankrupt or the owner ceases to carry on a primary production business in Australia (and does not commence to carry on another primary production business in Australia within 120 days). 11. The minimum repayment amount is $1,000 (unless the entire FMD is being repaid). 12. The FMD provider must transfer the FMD (by electronic means) to another FMD provider if requested to do so in writing by the depositor. 13. The FMD provider must not at any time deduct from the FMD any administration or other fee that is required to be paid in respect of the FMD. If any of the requirements in 1 to 8 above are contravened, the deposit is effectively treated as not being an FMD: s 393-30. As a result, the tax advantages of FMDs will be denied. If requirement 9 is contravened, the excess amount above $400,000 is treated as not being an FMD. Amendments made by the Tax and Superannuation Laws Amendment (2016 Measures No 1) Act 2016 seek to make the FMD regime more flexible. The amendments, which apply from 2016-17: • increase the maximum amount a taxpayer can hold in FMDs to $800,000: s 393-35 (item 10 of table) • allow primary producers experiencing severe drought conditions to withdraw amounts held in deposits for less than 12 months in the income year following the deposit without affecting the income tax treatment of the FMD in the year of deposit, but subject to a rain deficiency test: s 393-17; and • allow amounts held in an FMD to reduce the interest charged on a loan or other debt relating to the primary production business of the FMD owner: s 393-37. However, an administrative penalty is payable if an FMD offset loan arrangement results in a lower amount of interest payable on a loan or other debt other than for the purposes of a primary production business of the FMD owner or a partnership in which they are a partner. The penalty is equal to 200% of the amount by which the interest was reduced: s 288-115 in Sch 1 TAA. The FMD regulations have been incorporated in the ITA Regs (new Pt 3A and Sch 1C) and TA Regs (new Pt 7A) by the Treasury Laws Amendment (2016 Measures No 3) Regulations 2016. The new regulations reflect the changes made by the 2016 Measures No 1 Act (see above). In addition, the regulations update the information requirements, including information FMD depositors must provide in application forms, information FMD providers must give to depositors and information FMD providers must give to the Agriculture Secretary.

Beneficiary as owner of FMD If a deposit is made by a trustee on behalf of a beneficiary of the trust, ss 393-25 and 393-27 contain provisions which, in certain circumstances, treat the beneficiary as the owner of the FMD.These provisions apply in a similar way as equivalent provisions (ss 392-20 and 392-22) that enable a beneficiary of a trust (that is carrying on a primary production business) to access the averaging provisions: see [27 540]. If a deposit was made by a trustee on behalf of a beneficiary who was under a legal disability (see [23 430]) at the time of the deposit, but the beneficiary is no longer under a legal disability, Div 393 applies to the beneficiary as if he or she had made the deposit: s 393-28. 1138

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[27 620]

[27 620] Tax consequences of FMDs The owner of an FMD is entitled to a tax deduction under s 393-5 ITAA 1997 (in the year the deposit is made) for the amount of the FMD, subject to a number of conditions (in addition to the conditions listed at [27 610]): • the deposit must be made when the owner is carrying on a primary production business in Australia; • if the owner stops carrying on a primary production business in Australia, he or she must start to carry on such a business again within 120 days; • the owner’s taxable non-primary production income for the income year must not be more than $100,000 – taxable non-primary production income has the same meaning as for the averaging provisions: see [27 470]; • the owner must not die or become bankrupt during the income year; • the total amounts deposited as FMDs must not exceed the owner’s taxable primary production income for the year (taxable primary production income has the same meaning as for the averaging provisions: see [27 470]); and • if a series of FMDs is made during the income year, the FMDs are deductible in the order in which they are made (until the taxable primary production limit is reached).

Repayment of FMD If an FMD is repaid in full during the income year, any unrecouped FMD deduction just before the repayment occurred is assessable to the owner: s 393-10(1). The unrecouped FMD deduction is the part of the FMD that was deductible under s 393-5 (or under the ITAA 1936 FMD provisions) and that has not been included in the owner’s assessable income: s 393-10(2); s 393-5 TPA. It may also include part of an unrecouped income equalisation deposit that was transferred to an FMD: s 393-10 TPA. If only part of an FMD is repaid, the difference between the amount of the FMD immediately before repayment and the amount of the FMD immediately after repayment is assessable: s 393-10(1). If an FMD is repaid because the owner dies, becomes bankrupt or ceases to be a primary producer for more than 120 days (see item 11 at [27 610]), the FMD is assessable when it becomes repayable, not when it is in fact repaid: s 393-10(4). If some or all of an FMD is repaid, the amount included in the owner’s assessable income under s 393-10 (see above) forms part of her or his instalment income under the PAYG instalment system (see [51 220]: s 45-120(5) Sch 1 TAA). Withholding tax will be deducted at the top individual marginal rate plus Medicare levy if the owner does not quote her or his tax file number and ABN to the financial institution holding the FMD: see [50 070]. Any part of an FMD that is repaid before the last day of the 12 months after the deposit is made is treated as never having been part of an FMD: s 393-40(1). This does not apply if an FMD (or part of an FMD) is repaid on the last day of the 12-month period (that is, on the one year anniversary date of the deposit). If the amount of an FMD is reduced to less than $1,000 within that 12-month period, the deposit is treated as never having been an FMD: s 393-40(2). In both cases, therefore, the tax advantages of being an FMD will be lost. These provisions do not apply, however, if: • the owner dies or becomes bankrupt: s 393-40(5); or • the owner ceases to carry on a primary production business in Australia and does not commence another such business within 120 days: s 393-40(5). In addition, an FMD owner affected by a prescribed natural disaster may access the whole or part of their FMD within 12 months of deposit without losing the entitlement to the deduction, (therefore the previous year’s tax return will not have to be amended to remove the deduction claimed for the deposit): s 393-40(3A). An FMD owner who accesses the whole or © 2017 THOMSON REUTERS

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part of an FMD in such circumstances is prevented from obtaining an additional deduction on a later FMD made in the income year in which the repayment is made: s 393-40(4). The transfer or reinvestment of an FMD is treated as the repayment of the FMD, unless it is immediately reinvested with the same FMD provider or the term is extended (even if other terms are varied), or it is transferred to another FMD provider at the request of the owner: s 393-15. If amounts that were a FMD have been paid to the Government as unclaimed moneys, the repayment of the FMD will be considered to occur when the moneys are repaid by the Government: s 393-30 TPA. Sections 393-55 and 393-60 ensure that there are no adverse taxation implications for the holder of an FMD arising from the financial claims scheme if the FMD is held with a failed ADI.

Consolidating FMDs The FMD provisions facilitate the consolidation of multiple FMDs into one FMD. Where 2 or more FMDs are withdrawn and immediately redeposited in a new FMD (the consolidated FMD), amounts will not be included in an individual’s assessable income for that income year as a result of the withdrawals: s 393-16. Nor will the immediate redeposit of the withdrawn amount into the consolidated FMD result in the amount being deductible. Only amounts that were part of an FMD (including a consolidated FMD) immediately prior to consolidation may be included in a consolidated FMD: s 393-16(1). Amounts from FMDs that are less than 12 months old, and amounts that did not give rise to an FMD deduction when the amount was deposited, may not be included in a consolidated FMD. A consolidated FMD is considered to be made on the same day as the most recent of the FMDs from which amounts are consolidated was made: s 393-16(4). The unrecouped FMD deduction in respect of a consolidated FMD (before any part of the FMD is repaid) is equal to the sum of the unrecouped FMD deductions in respect of the FMDs that have been consolidated just before the reinvestment occurred: s 393-16(3). As a result, all amounts withdrawn from an FMD will result in an amount being included in taxpayer’s assessable income.

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28

INTRODUCTION Overview ....................................................................................................................... [28 010] AVERAGING FOR SPECIAL PROFESSIONALS Introduction ................................................................................................................... [28 Who is eligible? ............................................................................................................ [28 Which income qualifies? ............................................................................................... [28 Artificial inflation of assessable professional income .................................................. [28 Exclusions ...................................................................................................................... [28

020] 030] 040] 050] 060]

ABOVE-AVERAGE INCOME Taxable professional income ........................................................................................ [28 100] Average taxable professional income ........................................................................... [28 110] Above-average special professional income ................................................................ [28 120] TAX PAYABLE – CALCULATION Tax payable if Div 405 applies .................................................................................... [28 150] GST and PAYG instalment options .............................................................................. [28 160]

INTRODUCTION [28 010] Overview The income of certain professionals, such as authors, sportspersons, composers and performing artists, may fluctuate widely from year to year. For example, an author might work 3 or 4 years in writing a book, receiving very little income, but in the year of publication derive a very high income. A professional sportsperson may win a number of high-prize-money tournaments in one year but be unsuccessful in the next. An actor may only perform intermittently over a few years, having to do other casual work to survive, but then be offered a highly paid role in a successful film, TV production or stage play. This chapter considers the special rules (in Div 405 ITAA 1997) which are designed to relieve the burden of having high marginal tax rates apply to taxable income in the years in which higher than normal amounts are derived, but which are not representative of the true level of a taxpayer’s income over a longer period. The Division effectively applies a form of limited averaging to this above-average income. The issues analysed in this chapter are: • who is a ‘‘special professional’’: see [28 030]; • which income qualifies for special treatment: see [28 040]-[28 060]; • how above-average special professional income is calculated: see [28 100]-[28 120]; and • how the actual tax payable is calculated: see [28 150]-[28 160].

AVERAGING FOR SPECIAL PROFESSIONALS [28 020] Introduction The categories of taxpayer who can take advantage of the averaging rules in Div 405 ITAA 1997 are authors, inventors, performing artists, production associates and sportspersons © 2017 THOMSON REUTERS

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(called ‘‘special professionals’’). The meaning of each class of special professionals is further extended by individual definition: see [28 030]. The taxable income of a special professional is divided into above-average special professional income, which is the subject of the averaging arrangements, and other income: see [28 120]. The above-average special professional income for the year is taxed in a different manner to the other income under the Income Tax Rates Act 1986: see [28 150]. Above-average special professional income is the excess of the taxable income from the relevant activities prescribed in Div 405 (the ‘‘taxable professional income’’) over the average of such income in the previous 4 years: see [28 110]. Tax at ordinary rates will be payable if there is no above-average special professional income, ie taxable professional income is equal to or less than the average taxable professional income of the previous 4 years: see [28 110]. In separately calculating taxable professional income from other taxable income, deductions for expenses incurred in earning income are allocated according to whether they are attributable to the earning of the special professional or other income: see [28 100]. A taxpayer will only be taken to have above-average special professional income for a year if he or she has a taxable professional income in excess of $2,500 in the current income year or any earlier year and is an Australian resident for all or part of the current year: see [28 110]. The taxpayer must also have been an Australian resident for all or part of an earlier year if that earlier year is being relied on to qualify. Once that qualifying event has occurred, the taxpayer will remain eligible for the operation of averaging even though his or her taxable professional income may not in subsequent years exceed $2,500. Special professionals have the option of paying 2 instalments of GST and PAYG instead of the normal quarterly payments: see [28 160]. With regard to visiting entertainers and athletes, Australia’s double tax agreements (DTAs) generally contain a special article dealing with the taxation of visiting public entertainers, which is a term normally widely defined so as to include theatre, motion picture, radio or television artists, musicians and athletes: see [36 280].

[28 030] Who is eligible? The income averaging provisions of Div 405 only apply to a ‘‘special professional’’. A ‘‘special professional’’ is defined in s 405-25(1) as the author of a literary, dramatic, musical or artistic work, the inventor of an invention, a performing artist, a production associate or a sportsperson. A number of these terms are then further defined, some in a very wide manner to include others who ordinarily might not be considered as falling within those terms. Authors and inventors An author is referred to as the author of a literary, dramatic, musical or artistic work. This is designed to incorporate the meaning of those latter words as used in the Copyright Act 1968: see note to s 405-25(1)(a). A computer programmer qualifies (Determination TD 93/65 and Re Finlayson and FCT (2002) 51 ATR 1029) as does a glass artist (ATO ID 2002/628) and a graphic designer (ATO ID 2002/856). The inventor of an invention alludes to those terms as used in the Patents Act 1990. If 2 or more persons collaborate in the authorship of a literary, dramatic, musical or artistic work or are joint inventors of an invention, each person is treated as the sole author or inventor for the purpose of applying Div 405: s 405-40. Excluded from the averaging arrangements are those persons who are no more than employees but whose activities give rise to the technical production of artistic works, literary works, dramatic works, musical works or inventions. Persons such as journalists, architectural draftspersons, graphic artists and computer programmers are among a class of persons who produce these works as an ordinary part of their employment. It is not intended that this class of person should, simply as a result of their ordinary employment tasks, qualify to have the income arising from the carrying out of those tasks taken into account for the purposes of Div 405. 1142

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SPECIAL PROFESSIONALS [28 030]

An author or inventor who engages in a scheme (as defined in s 995-1) to render services to another person will not be able to count income from those activities as assessable professional income unless 2 tests are satisfied. First, the scheme must have been entered into solely for the taxpayer to undertake the completion of one or more specified artistic works, literary works, dramatic works, musical works or the invention of one or more specified inventions. Second, the taxpayer must not have been, nor could reasonably be expected to be, rendering such services to the other person (or an associate of the person) under successive schemes of a kind that result in substantial continuity of the rendering of such services by the taxpayer (the ‘‘continuity of service’’ test): s 405-30(1). In Re Finlayson and FCT, a computer programmer employed by a software company had a small amount of special professional income (less than 1.5% of his salary and wage income). He sought to characterise his salary and wage income as assessable professional income, on the basis that each of the different products and projects on which he worked was an individual scheme for the purposes of Div 405. The AAT, however, rejected the taxpayer’s argument for a narrow interpretation of ‘‘scheme’’ and found that he had provided his services under successive schemes on a continuing basis and thus failed the ‘‘continuity of service’’ test (although the first test was satisfied).

Performing artists and production associates ‘‘Performing artists’’ are exhaustively defined as persons who perform or present either music, a play, dance, entertainment, an address, a display, a promotional activity, an exhibition or any similar activities provided they involve the exercise by the person of intellectual, artistic, musical, physical or other personal skills in the presence of an audience: s 405-25(2). In addition, performing artists also include persons who perform or appear in or on a film, tape or disc or in a television or radio broadcast, which may not necessarily be carried on in the presence of an audience: s 405-25(3). The definition of a ‘‘production associate’’ is closely associated with the definition of a ‘‘performing artist’’, being a person who provides artistic support in connection with the activities of a performing artist, such as an art director, choreographer, costume designer, director, photographic director, film editor, lighting designer, musical director, producer, production designer or set designer or persons performing similar services that are of an artistic rather than technical nature: s 405-25(4) and 405-25(5). In ATO ID 2002/959, the Tax Office accepted that an animatronics engineer provided artistic support and therefore qualified as a production associate. In ATO ID 2014/41, an individual who produced, designed, edited and scripted films and acted as the presenter in videos which were uploaded onto YouTube, was considered to be a performing artist and production associate.

Sportspersons Sportspersons are persons who compete in sporting competitions: s 405-25(6). Sporting competitions are sporting activities to the extent that human beings compete by riding or exercising other skills in relation to animals; human beings compete by driving, piloting or crewing motor vehicles, boats, aircraft or other modes of transport; human beings compete with, or compete by overcoming, natural obstacles or forces; or activities in which human beings are the sole competitors: s 405-25(7)(a). In addition, the participation in the sporting activity by each human competitor must involve primarily the exercise of physical prowess, strength or stamina, except if the person is a navigator in car rallying, a coxswain in rowing or similar competitor: s 405-25(7)(b) and 405-25(8). A professional golf caddy does not qualify for income averaging as he or she does not ‘‘compete in a sporting competition’’: ATO ID 2004/196 and AAT Case Re Davidson and FCT (2005) 60 ATR 1105. Specifically excluded from counting as assessable professional income is any assessable income derived from coaching or training sportspersons, umpiring or refereeing, administering sport, being a member of the pit crew in motor sport, being a theatrical or sports entrepreneur or owning or training animals: s 405-30(2). © 2017 THOMSON REUTERS

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[28 040] Which income qualifies? Having ascertained whether a taxpayer is a special professional eligible to use the Div 405 averaging provisions, the first step in applying those provisions is to work out the taxpayer’s ‘‘assessable professional income’’ (in accordance with s 405-20). Assessable professional income is that part of a taxpayer’s total assessable income that is derived from activities as a special professional (eg author, performing artist or sportsperson) that s 405-20 allows the taxpayer to count as such. Calculating assessable professional income is a necessary step in calculating taxable professional income (see [28 100]), which, in turn, is an element in the calculation of the above-average special professional income to which Div 405 applies: see [28 120]. Section 405-20 establishes a number of classes of assessable income that can count as being included in assessable professional income. Reward for services provided The first class is assessable income derived as a reward for services rendered in relation to the taxpayer’s activities as a special professional. Thus, only the assessable income received from the activities which make her or him a special professional will qualify as ‘‘assessable professional income’’. Remuneration received for other unrelated activities will not qualify. For example, a taxpayer may receive remuneration as a player/coach of a football team. Activities as a football player are activities as a competitor in a sporting activity in which human beings are the sole competitors and, as such, the taxpayer will satisfy the ‘‘sportsperson’’ category of ‘‘special professional’’. On the other hand, assessable income from the activity of coaching competitors in sport is expressly excluded from counting as assessable professional income. In the case of a player/coach, therefore, it is necessary to determine the extent to which the remuneration is attributable to her or his playing activities (‘‘assessable professional income’’) and the extent to which it is attributable to coaching activities (which will not be income that is taken into account for Div 405 purposes). It is irrelevant whether or not the assessable income is derived by way of consideration for the taxpayer entering into an arrangement for the rendering of services. This means that both employees (eg most footballers) and independent persons (eg tournament professional golfers and tennis players) may have the income derived from those activities qualify as assessable professional income. Prizes The second class comprises prizes given in respect of a taxpayer’s activities as a special professional. Of course, this only applies to ‘‘assessable income’’ derived by way of a prize and does not of itself make such prizes assessable income if they would not otherwise be so. Whether such amounts are assessable to sportspersons is discussed at [4 080]. Promotion, advertising, interviews and commentating The third class includes assessable income that is attributable to the taxpayer’s activities or former activities as a special professional, although the income is not derived directly from those activities. This includes endorsing or promoting goods or services, appearing or participating in an advertisement, appearing or participating in an interview, services as a commentator and similar services. A person need not be an active sportsperson, performing artist, etc to have income of this kind qualify as assessable professional income, provided that the person had once qualified as a ‘‘special professional’’ and provided that there is a sufficient nexus between those activities or former activities and the services being rendered by the taxpayer. Of course, former sportspersons (for example) may cross over into the ‘‘performing artist’’ category of ‘‘special professional’’ when they become radio or television commentators or appear or participate in television or radio advertisements or interviews. 1144

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SPECIAL PROFESSIONALS [28 100]

Royalties, assignments and licences The final 3 classes include kinds of income peculiarly derived by authors and inventors. These consist of consideration for the assignment of intellectual property rights in any literary, dramatic, musical or artistic work or invention produced by the taxpayer, granting licences to use the intellectual property rights, advances on account of royalties in respect of such a copyright or patent, prizes in respect of such a work or invention or any other amount received by the taxpayer in respect of, or in respect of the intellectual property in, any literary, dramatic, musical or artistic work or invention produced by the taxpayer. [28 050] Artificial inflation of assessable professional income Section 405-35(2) and (3) is designed to prevent the exploitation of the concessional tax treatment afforded to assessable professional income under Div 405 through entering into schemes for the receipt of assessable professional income and other assessable income, which have the effect of inflating the assessable professional income. For example, the bar manager of a football club may also be a player in the club’s team. An arrangement might be entered into purporting to pay him a much higher remuneration as a player, to increase his assessable professional income and decrease his remuneration as bar manager by a corresponding amount. Another example would be if the owner of a theatre enters into an arrangement where she appears as a performer in an activity in the theatre. The rent otherwise chargeable for the use of the theatre may, under the arrangement, be reduced by an amount equivalent to an increase in her remuneration as a performing artist. Section 405-35(2) requires the taxpayer in calculating assessable professional income to reduce or increase the amount of the assessable professional income to a reasonable amount for the activities that gave rise to assessable professional income. [28 060] Exclusions The following amounts are specifically excluded from constituting assessable professional income (s 405-30(3)): • employment termination payments and superannuation lump sums; • unused annual leave payments and unused long service leave payments; and • net capital gains. The types of assessable income that fall within the first 2 categories are subject to their own concessional taxing arrangements in the ITAA 1997 (see Chapter 40) and the exclusion of capital gains amounts is to ensure that a capital gain should be dealt with primarily under the CGT provisions and not under Div 405.

ABOVE-AVERAGE INCOME [28 100] Taxable professional income To work out the tax payable by a special professional using the Div 405 averaging provisions, it is necessary to work out the ‘‘above-average special professional income’’. The first step in this process is to work out the taxpayer’s ‘‘taxable professional income’’ in accordance with s 405-45. Taxable professional income is the taxpayer’s assessable income derived from activities related to the taxpayer’s status as a special professional (ie the ‘‘assessable professional income’’), minus certain deductions (essentially those that reasonably relate to assessable professional income and a proportion of ‘‘apportionable deductions’’). Deductions Deductions taken into account in working out taxable professional income are: • deductions that relate exclusively to the taxpayer’s assessable professional income; © 2017 THOMSON REUTERS

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• deductions that, although not exclusively related to the incurring of the taxpayer’s assessable professional income, reasonably relate to that income; and • an amount in relation to “apportionable deductions”. Deductions that relate exclusively to the taxpayer’s assessable professional income would include items such as the cost of sporting equipment used by a sportsperson. The deduction would be calculated in the normal manner under the appropriate deduction provisions of the ITAA 1997 or ITAA 1936. For example, an outright deduction under s 8-1 would be allowable for items such as golf balls, which have a very limited life. However, the deduction may be in the form of depreciation under Div 40 for other items such as a set of golf clubs that may last a number of years depending upon the level of activity of the individual sportsperson. The depreciation/capital allowance rules are discussed in Chapter 10. Deductions that might reasonably relate to the taxpayer’s assessable professional income would include expenses of a motor vehicle used partly in carrying on activities as a sportsperson and partly in carrying out other activities (business or personal) not related to the taxpayer’s activities as a special professional. An apportionment, such as on the basis of kilometres travelled on each activity, would be required. Deductions available to certain performing artists when acting in the capacity of employees, including musicians, actors, variety artists, singers, dancers and circus performers, are discussed in Ruling TR 95/20. ‘‘Apportionable deductions’’ (as defined in s 995-1) are rates, land tax and most deductible gifts (other than gifts of trading stock). The amount of apportionable deductions that is taken into account in working out taxable professional income is calculated under a formula that effectively apportions the apportionable deductions between the taxpayer’s assessable professional income and their other assessable income: see Step 2 of the method statement in s 405-45.

[28 110] Average taxable professional income Having worked out the taxpayer’s ‘‘taxable professional income’’ (see [28 100]), the next step is to work out the taxpayer’s ‘‘average taxable professional income’’ (in accordance with s 405-50). Ordinarily, average taxable professional income in an income year will be one-quarter of the sum of the taxable professional incomes for the preceding 4 years. Special rules apply, however, for calculating the average taxable professional income if any of those 4 years is one of the first 4 years in respect of which the taxpayer was an Australian resident for any part of the year and had a taxable professional income exceeding $2,500. Professional year 1 – definition Section 405-50(3) establishes the meaning of ‘‘professional year 1’’, which is relevant to calculating the average taxable professional income of a taxpayer. ‘‘Professional year 1’’ will be the first year in which the taxpayer was both an Australian resident for all or part of the year and had taxable professional income in excess of $2,500. Section 405-50(2), in conjunction with s 405-50(5), attributes special values for the average taxable professional income in that year and in each of the succeeding 3 years. If a ‘‘professional year 1’’ is established in a previous income year, that year will always be the taxpayer’s professional year 1 for the purpose of applying the averaging provisions. It makes no difference that the taxpayer may become a non-resident for a number of intervening years. Professional year 1 may also be a year more than 4 years before the commencement of either Div 405 or its predecessor, Div 16A of Pt III: AAT Case 7674 (1992) 22 ATR 3587; see also Determination TD 93/33. Calculation – first 4 years The average taxable professional income of a taxpayer for the first 4 professional years (meaning professional year 1 as defined and the 3 immediately following income years) 1146

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SPECIAL PROFESSIONALS [28 120]

differs depending upon whether the taxpayer was an Australian resident for any part of the income year immediately before professional year 1 (see s 405-50(5) and the table set out there). The majority of persons will be Australian residents for at least part of the income year immediately before professional year 1 and the calculation of their average taxable professional income depends upon the relevant income year: • for professional year 1 it is nil. Therefore, all of the taxable professional income would be above-average special professional income; • for professional year 2 the average taxable professional income is one-third of the taxpayer’s taxable professional income of professional year 1; • for professional year 3 it is one-quarter of the aggregate of the taxpayer’s taxable professional incomes of the previous 2 professional years; • for professional year 4, that is, for a taxpayer who has continuously qualified for averaging, the fourth year in which the taxpayer has received assessable professional income (having originally met the requirements necessary to constitute professional year 1 discussed above), the average taxable professional income is one-quarter of the aggregate of the taxpayer’s taxable professional incomes of the previous 3 professional years.

Calculation – subsequent years For every following income year the average taxable professional income is one-quarter of the aggregate of the taxpayer’s taxable professional incomes of the previous 4 income years: s 405-50(1). EXAMPLE [28 110.10] Assume a taxpayer, who has always been an Australian resident, has not before year 1 received more than $2,500 of taxable professional income. If the taxpayer receives the following taxable professional incomes in the 5 years commencing with year 1, the average taxable professional income for each year will be: Income year Taxable professional income Average taxable professional income $ $ Year 1 15,000 Nil Year 2 25,000 5,000 Year 3 30,000 10,000 Year 4 30,000 17,500 Year 5 40,000 25,000

[28 120] Above-average special professional income ‘‘Above-average special professional income’’ is the excess of taxable professional income (see [28 100]) over average taxable professional income (see [28 110]) of the income year: s 405-15(2). If there is no excess, there is no above-average special professional income for that year: s 405-15(1)(c). An individual’s taxable income for an income year includes above-average special professional income if (and only if) the following conditions in s 405-15 are satisfied: • the individual has been an Australian resident for all or part of the current income year; © 2017 THOMSON REUTERS

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• the individual’s taxable professional income for the current income year (see [28 100]) exceeds their average taxable professional income for that year (see [28 110]); and • either their taxable professional income for the current income year is more than $2,500 or their taxable professional income for an earlier income year was more than $2,500 and they were an Australian resident for all or part of that year. EXAMPLE [28 120.10] Using the same facts and figures as in Example [28 110.10], the following would be the above-average special professional income for each year. Income year

Year Year Year Year Year

1 2 3 4 5

Taxable professional income $ 15,000 25,000 30,000 30,000 40,000

Average taxable professional income $ Nil 5,000 10,000 17,500 25,000

Above-average income amount $ 15,000 20,000 20,000 12,500 15,000

TAX PAYABLE – CALCULATION [28 150] Tax payable if Div 405 applies A taxpayer with above-average special professional income has his or her liability calculated, pursuant to the special averaging procedure, by applying to the aggregated amount the average rate of tax that one-fifth of that amount would have borne as the ‘‘top slice’’ of the taxpayer’s taxable income: Sch 7 to the Income Tax Rates Act 1986. The amount of above-average special professional income taxed under the special averaging procedure is called the ‘‘special income component’’. If the taxpayer’s taxable income includes an employment termination payment and/or a superannuation benefit that is taxable at the highest marginal rate (see [4 330] and [40 210] respectively), those amounts are effectively disregarded in working out the special income component: see below. Total tax payable is then determined by adding this amount to tax payable on the remainder of taxable income, in the most usual situation where the special income component is only part of total taxable income (the situation is slightly different if a loss resulted from other activities so that taxable income is less than the special income component: see table below). The formula for determining the rate of tax payable is set out in the Income Tax Rates Act 1986 at cll (2) and (3) Pts I and II in Sch 7. The applicable provision depends upon whether the taxpayer is a resident or non-resident, whether the taxpayer would be entitled to family tax assistance and whether the taxpayer is also eligible for the separate averaging system that applies to primary producers. Ruling TR 92/12 explains the method of applying the formulas in the Rates Act in order to determine tax payable, although the ruling was issued before the removal of net capital gains from the averaging system. In step form the procedure (if there is no family tax assistance) may be described as follows. 1148

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Medicare levy is calculated separately in the usual manner on the entire taxable income. Step 1.

Calculate the SIC

(special income component)

2. 3.

4.

Calculate the RTI (reduced taxable income) Calculate A (ie tax payable on taxable income as reduced by the SIC) Calculate B (ie tax payable on above-average special professional income according to special averaging procedure)

Formula Above-average special professional income (called ‘‘abnormal income amount’’ in Rates Act) or Taxable income (if less than above sum) Taxable income – SIC Tax payable1 on RTI

If not primary producer (1) X = tax payable1 on: (1) RTI + (20% × SIC) (2) B = 5 × (X − A) If primary producer (1) Y = tax payable1 on: (1) average income + (20% × SIC) (2) Z = tax payable1 on average income (3) B = 5 × (Y − Z)

5.

Calculate tax payable2

A+B

1 Tax payable is calculated according to ordinary rates scale depending upon whether a resident or a foreign resident. 2 Step 5 is actually expressed as a rate of tax in the Rates Act (ie A+B C

where C = taxable income). Applying this rate to taxable income therefore gives tax payable as indicated. EXAMPLE [28 150.10] Natsuko is a professional musician. Her total taxable income in 2016-17 is $75,640. $51,860 is above-average special professional income and $23,780 represents other income. The tax payable by Natsuko for 2016-17 is (ignoring cents): $ Tax on ordinary income: Tax on $23,780 at general rates Tax on above-average special professional income: Ordinary income 23,780 Add 20% of above-average income 10,372 34,152 Tax on $34,152 at general rates Less tax on ordinary income (as above) © 2017 THOMSON REUTERS

$ 1,060

3,030 1,060

1149

[28 160]

SPECIAL PROFESSIONALS $ Multiply by 5

Total tax payable (before Medicare levy, offsets and credits): $1,060 + $9,850 Tax on $75,640 at 2016-17 general rates would be $16,130.

$ 1,970 5 9,850 10,910

More complex examples covering the situation of non-residents and primary producers are contained in Ruling TR 92/12.

If taxable income includes superannuation remainder/employment termination remainder If the taxpayer’s taxable income includes any employment termination remainder (see [4 330]) or superannuation remainder (see [40 210]), which are taxed at the highest marginal rate, the steps discussed above need to be modified. In the commentary below, the total of the superannuation remainder and employment termination remainder (if any) is called the ‘‘remainder component’’. First, if the special income component as calculated in step 1 of the above table would, when added to the remainder component of taxable income, exceed the total taxable income, the special income component is reduced by the amount of the excess. This ensures that if there is an overall loss from sources other than the special income component or remainder component, it reduces the special income component first, meaning more of the taxable income is taxed at the rate attributable to the remainder component (ie the highest marginal rate). Second, as noted above, solely for the purpose of calculating tax attributable to the special income component (step 2 (ie component B) of the above table), the special tax rate applicable to the remainder component is ignored and it is treated as ordinary taxable income. [28 160] GST and PAYG instalment options Special professionals who, in the most recent income year, have net assessable income from their profession have the option of paying 2 instalments of GST and/or PAYG instalments: s 45-134 Sch 1 TAA (see [51 150] and [60 110]). If the option is exercised, a taxpayer will be required to pay 75% of her or his annual GST liability and/or 75% of her or his annual PAYG instalment liability by the due date of the third quarter BAS (28 April). The remaining 25% will have to be paid by the due date of the fourth quarter BAS (28 July).

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NATURAL RESOURCE INDUSTRIES

29

INTRODUCTION Overview ....................................................................................................................... [29 010] MINING AND QUARRYING Introduction to mining and quarrying .......................................................................... [29 Exploration and prospecting expenditure ..................................................................... [29 Mining site rehabilitation .............................................................................................. [29 Non-arm’s length transactions, trading stock and resource rent taxes ....................... [29

020] 030] 040] 050]

INDIGENOUS LAND – COMPENSATION PAYMENTS Withholding tax – mining payments ............................................................................ [29 100] FORESTRY EXPENDITURE Forestry roads and timber mill buildings ..................................................................... [29 150] Capital costs of acquiring trees .................................................................................... [29 160]

INTRODUCTION [29 010] Overview This chapter deals with special provisions in the income tax laws about the natural resource industries. These special provisions relate to: • mining and quarrying – principally exploration and prospecting expenditure and mining site rehabilitation expenditure, but also including an incentive for greenfields minerals explorers: see [29 020]-[29 040]; • compensation payments in relation to the use of Indigenous land – a withholding tax system applies to such payments made to Indigenous associations and certain other bodies: see [29 100]; • native title benefits arising from the extinguishment or impairment of native title – such benefits fall outside the withholding tax system and are treated as non-assessable non-exempt income: see [29 100]; and • timber and forestry expenditure, in particular deductions for acquiring land carrying trees or a right to fell trees: see [29 150]-[29 160].

MINING AND QUARRYING [29 020] Introduction to mining and quarrying Subdivision 40-H ITAA 1997 contains provisions specific to the mining and quarrying industries. These provisions deal with exploration and prospecting expenditure (see [29 030]) and mining site rehabilitation expenditure: see [29 040]. Otherwise, the Uniform Capital Allowance (UCA) system in Div 40 generally applies to the mining and quarrying industries. Division 40 is discussed in detail in Chapter 10: see in particular [10 1270]. © 2017 THOMSON REUTERS

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Commercial debt forgiveness – adjustments The commercial debt forgiveness provisions can apply to carry forward capital expenditure under the mining and natural resource provisions in a similar manner to which they may apply to the UCA provisions: see [10 470] and [8 700]. Environmental expenditure Expenditure on environmental impact assessments is pooled and written off under Subdiv 40-I: see [10 1050]. Expenditure on environmental protection activities is deductible under s 40-755: see [11 610]. The deductions are not limited to taxpayers in the natural resources industries. [29 030] Exploration and prospecting expenditure Expenditure (whether on revenue or capital account) on exploration or prospecting for minerals or quarry materials, obtainable by mining operations, is deductible in full under Subdiv 40-H ITAA 1997 in the income year in which it is incurred provided the taxpayer (s 40-730(1)): • carried on mining operations, or it would be reasonable to conclude that it proposed to carry on such operations; or • carried on a business of (or a business that included) exploration and prospecting for minerals or quarry materials and the expenditure was necessarily incurred in carrying on that business. ‘‘Minerals’’ are defined to generally include petroleum: s 40-730(5). Note that if Div 250 applies to an asset that is land (ie if the land is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), the taxpayer cannot deduct expenditure incurred in relation to the land to the extent specified in s 250-150(3). ‘‘Exploration or prospecting’’, in the case of mining in general and quarrying, is defined to include geological mapping, geophysical surveys, systematic search for areas containing minerals (other than petroleum) or quarry materials, search by drilling or other means for such minerals or materials within those areas and search for ore within or near an ore body or search for quarry materials by drives, shafts, cross-cuts, winzes, rises and drilling: s 40-730(4). In the case of petroleum mining, it includes geological, geophysical and geochemical surveys and exploration drilling and appraisal drilling. Exploration and prospecting also includes studies to evaluate the economic feasibility of mining minerals or quarry materials once they have been discovered and obtaining relevant information associated with the search for, and evaluation of, areas containing minerals or quarry materials. ‘‘Mining and quarrying operations’’ means mining operations on a mining property for extracting minerals (other than petroleum) from their natural site, mining operations to obtain petroleum or quarrying operations on a quarrying property for extracting quarry materials from their natural site. In all cases, the operations must be conducted for the purpose of producing assessable income: s 40-730(7). See Esso Australia Resources Ltd v FCT (1998) 39 ATR 394 and FCT v Pine Creek Goldfields Ltd (1999) 42 ATR 758 for a discussion of these issues under the equivalent ITAA 1936 provisions. See also Goliath Portland Cement Co Ltd v CEO of Customs (2000) 45 ATR 96, and David Mitchell Ltd v CEO of Customs (2001) 46 ATR 433, where the term ‘‘mining operations’’ in the context of the diesel fuel rebate is discussed. Subdivision 40-H is considered in Draft Ruling TR 2015/D4. Draft Practical Compliance Guideline PCG 2016/D17 sets out the factors that the Tax Office will consider when assessing a taxpayer’s risk of non-compliance and therefore, how likely it is to review the taxpayer’s exploration expenditure claims. The effect of GST on expenditure that is deductible under Subdiv 40-H is considered at [27 370]. 1152

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Expenditure on development drilling for petroleum and operations in the course of working a mining property, quarrying property or petroleum field is not deductible under Subdiv 40-H: s 40-730(2). Whether activities are at the exploration or development stage is a question of fact. To the extent that expenditure on exploration or prospecting for minerals or quarry materials forms part of the cost of a depreciating asset, it is deductible under Subdiv 40-B (discussed in Chapter 10) and not under Subdiv 40-H: s 40-730(3). Such expenditure may be deductible outright under s 40-80(1): see [10 530]. Mining, quarrying and prospecting rights and mining, quarrying and prospecting information first used in exploration or prospecting are depreciating assets (unless trading stock) that can be depreciated over their effective life or, in certain circumstances, are immediately deductible: see [10 1270]. Note that an amount received for providing mining, quarrying, prospecting or geothermal information to another entity is assessable if the entity providing the information continues to hold it: s 15-40 ITAA 1997. An amount may be included in the taxpayer’s assessable income for a deduction claimed under Subdiv 40-H if the expenditure is recouped (see [6 580]) or if the expenditure was financed by limited recourse debt that has terminated: see [10 1030]. Note that draft legislation to update terminology, improve clarity, and remove potential ambiguity in some provisions of Div 40 dealing with mining exploration or prospecting was released in January 2016.

‘‘Farm-in farm-out’’ arrangements The CGT and other tax consequences of ‘‘farm-in farm-out’’ arrangements entered into after 14 May 2013 are considered at [17 345]. The tax consequences of immediate transfer farm-out arrangements entered into on or before 14 May 2013 are dealt with in Ruling MT 2012/1. Greenfields minerals explorers A tax incentive (in Div 418 ITAA 1997) is designed to encourage investment in small mineral exploration companies undertaking greenfields minerals exploration in Australia. A greenfields minerals explorer for an income year is an entity that has not carried on any mining operations during the income year or over the immediately preceding income year. Further, no mining operations may have been carried out during this period by a connected entity or an affiliate. Companies are entitled to issue exploration credits to shareholders up to an amount based on its exploration or prospecting expenditure and tax loss for the relevant year of income up to the capped amount for the particular year ($25m for 2015-16, $35m for 2016-17 and $40m for 2017-18). Eligible companies can utilise their tax losses to reduce taxable income in later years, or create exploration credits up to the capped amount to the extent the loss results from eligible exploration expenditure. Australian resident entities that are not corporate taxpayers and receive exploration credits are entitled to a tax offset equal to the exploration credits. For individuals, superannuation funds and certain trustees, this offset is refundable. Australian resident trusts and partnerships may provide their members with a share of exploration credits so that the member may obtain the offset. Australian resident life insurance companies are also entitled to a refundable offset if, had the exploration credit been a franking credit, the distribution would have been non-assessable and non-exempt income because it was derived from segregated exempt assets used to discharge exempt life policy liabilities (see [30 230]). Australian resident corporate tax entities receiving exploration credits are entitled to a franking credit equal to the amount of the exploration credit. Entities that create exploration credits in excess of their maximum exploration credit entitlement will be subject to excess exploration credit tax and, potentially, shortfall penalties in respect of that amount. A self-assessment system operates so the Commissioner is taken to © 2017 THOMSON REUTERS

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have made an assessment of an amount of excess exploration credit tax on the day the taxpayer lodges a return under s 418-160: ss 155-5, 155-15 Sch 1 TAA. These measures apply to expenditure in the 2014-15, 2015-16 and 2016-17 income years, allowing the distribution of exploration credits in the 2015-16, 2016-17 and 2017-18 income years. Note that draft legislation to update terminology, improve clarity and remove potential ambiguity in some provisions of Div 418 was released in January 2016.

Geothermal energy See [10 1270] for comment on geothermal exploration rights and geothermal exploration information. [29 040] Mining site rehabilitation Expenditure on mining site rehabilitation, whether of a capital nature or of a revenue nature, is deductible under Subdiv 40-H in the income year in which it is incurred: s 40-735(1). ‘‘Mining site rehabilitation’’ is defined in s 40-735(4) as an act of restoring or rehabilitating a site, or part of a site, to its pre-mining condition or to a reasonable approximation of it. The site must be a site on which the taxpayer carried on mining or quarrying operations or conducted exploration or prospecting or ancillary mining activities. Rehabilitation of a mining building site is also covered. In that case, the relevant pre-activity condition to which the site is to be restored is the condition it was in when buildings, improvements, or depreciating assets were first located on the site: s 40-735(6). Partly rehabilitating or restoring a site counts as mine site rehabilitation, even though there is no intention to finish the work: s 40-735(5). Whether expenditure on geological sequestration may be mining site rehabilitation expenditure is considered in Ruling TR 2008/6. Ancillary mining activities are any of the following activities (s 40-740): • preparing a site for the taxpayer to carry on eligible mining or quarrying operations; • providing water, light or power for access to or communications with a site on which the taxpayer carries on or will carry on eligible mining or quarrying operations; • treating minerals or quarrying materials obtained by the taxpayer in carrying on eligible mining or quarrying operations; • storing before or after treatment such minerals or quarry materials in relation to the operation of plant for use primarily and principally in treating such minerals or quarry materials; or • liquefying natural gas obtained from eligible mining operations carried on by the taxpayer. A mining building site is a site, or part of a site, where there are depreciating assets necessary for the carrying on of mining or quarrying operations (housing and welfare expenditure excluded): s 40-740(2). The Tax Office considers that expenditure ‘‘on’’ mining site rehabilitation means only expenditure directly associated with an act or acts of restoring or rehabilitating a mining site and therefore a payment by the vendor of a mining site to the purchaser to take over responsibility for rehabilitating the site is not deductible under Subdiv 40-H (see ATO ID 2008/72). See also Taxpayer Alert TA 2009/3, which considers certain arrangements whereby a mining company attempts to bring forward a deduction for future costs of rehabilitating a mining site. The effect of GST on expenditure deductible under Subdiv 40-H is considered at [27 370]. 1154

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Certain expenditure is specifically not deductible under Subdiv 40-H. This includes expenditure on acquiring land, an interest in land or a right, power or privilege to do with land, a bond or security (however described) for performing mining site rehabilitation and capital expenditure on housing and welfare: s 40-745. In addition, expenditure for the cost of a depreciating asset is not deductible under Subdiv 40-H (s 40-735(3)), although it will be subject to a deduction under Subdiv 40-B. Note that if Div 250 applies to an asset that is land (ie if the land is put to a tax preferred use) and the apportionment rule in s 250-150 applies (see [33 100]), the taxpayer cannot deduct expenditure incurred in relation to the land to the extent specified in s 250-150(3). An amount may be included in the taxpayer’s assessable income if deductible mining site rehabilitation expenditure is recouped (Subdiv 20-A: see [6 580]) or if the expenditure was financed by limited recourse debt that has terminated (Div 243: see [10 1030]). Note that draft legislation to update terminology, improve clarity, and remove potential ambiguity in some provisions of Div 40 dealing with mining site rehabilitation was released in January 2016.

[29 050] Non-arm’s length transactions, trading stock and resource rent taxes Mining and quarrying capital expenditure incurred by a taxpayer under an arrangement where at least one party was not dealing at arm’s length requires special considerations. The amount of expenditure