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Focus: Tax - Public Trading Trusts – August 2008

Proposed simplification of Division 6

In brief: In a welcome move, the Federal Government has released draft amendments to Division 6C of the Income Tax Assessment Act 1936 and called for final submissions by 14 August 2008. Partner Charles Armitage (view CV) and Senior Associate Thomas McAuliffe look at what the proposed amendments mean.

How does it affect you?

  • The proposed amendments will provide some welcome relief from the 'sudden death' nature of the public trading trust rules and remove uncertainty around the permissibility of certain common group transactions, such as the provision of cross guarantees.
  • Of particular relevance to property trusts are the broadening of the concept of 'investments in land' and the introduction of a safe harbour rule in relation to whether an investment is 'primarily for the purpose' of deriving rent.
  • A general de minimis safe harbour is also proposed to reduce the likelihood of inadvertent minor breaches of the public trading trust rules triggering company taxation for a unit trust.

Background

Groups that hold income producing assets through unit trust structures will be well acquainted with the public trading trust rules in Division 6C of the Income Tax Assessment Act 1936 (Cth). Those rules, if triggered by any 'trading' activities undertaken by a trust (even if inadvertently and only for a short period), deny the trust its 'flow through' tax treatment for the whole of the relevant year of income by subjecting it to tax as a company. In order to avoid that outcome, trustees of unit trusts (which would include the Responsible Entity of a managed fund) need to be vigilant in ensuring that the business of the trust consists only of investments covered by the definition of 'eligible investment business' in Division 6C.

Division 6C exists to ensure that any public unit trust carrying on an active trading business will be taxed in the same way as a company. This is considered necessary because trusts often have certain taxation advantages over companies (eg they may have the ability to distribute tax preferred income and provide access to the capital gains tax discount to beneficiaries in respect of trust assets). It is therefore felt that businesses conducted through unit trust structures would enjoy a competitive advantage if they were permitted to compete directly with companies in carrying on active trading businesses.

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Call for change

Unlike some other jurisdictions, Australia does not have separate tax regimes for managed funds and real estate investment trusts (REITs). In February 2008, the Federal Government announced that it had asked the Board of Taxation to examine options for a managed investments tax regime in Australia, including the potential for a specific tax regime for REITs. That announcement indicated that Treasury would, in consultation with industry, consider the best way to streamline and simplify the operation of Division 6C as an interim step while the Board of Taxation undertakes its deliberations in relation to a specific tax regime for managed investment trusts and REITs. This interim measure is intended to address industry concerns that the public trading trust rules are overly restrictive and unduly impede commercial practice, especially in respect of public unit trusts that focus on real estate investments. A draft of the proposed amendments to provide this interim relief (based on consultations with industry since February 2008) was released on 23 July 2008, with final comments invited by 14 August 2008.

The following discussion is based on the draft legislation. Depending on the final comments made by interested parties, when a Bill is introduced into the parliament (expected to happen in the Spring 2008 sittings) it may differ in some respects to the discussion below. Also, at this stage, no Explanatory Memorandum (EM) has been released on the proposed legislation. When that happens (ie, when the Bill containing the amendments is introduced into the Parliament) the EM may provide more details on how the proposed amendments are intended to operate. Accordingly, developments in this area will need to be monitored over the coming months.

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Extended concept of 'investments in land'

The limb of the definition of 'eligible investment business' that is most relevant to property trusts will continue to be 'investing in land for the purpose, or primarily for the purpose, of deriving rent'. However, the definition of 'land' will be extended to include fixtures on land. Also, the concept of 'investing in land' will be broadened to include investments in chattels that are:

  • incidental to and relevant to the renting of land; and
  • customarily supplied or provided in connection with the renting of land; and
  • ancillary to the ownership and use of land.

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Safe harbour rule for investments in land

In addition to extending the concept of 'investing in land', a safe harbour rule is proposed to address the inevitable uncertainty surrounding whether an investment in land is 'primarily for the purpose' of deriving rent (our emphasis). A public unit trust will be taken to be investing in land for the purpose, or primarily for the purpose, of deriving rent during a year of income, if:

  • each of the trust's investments in land is for purposes (other than the purpose of trading) that include a purpose of deriving rent; and
  • at least 75 per cent of the gross revenue from those investments for the year of income (on a whole of trust basis) consists of rent (except 'excluded rent'); and
  • the remaining gross non-rental revenue of 25 per cent or less does not include any revenue from the trust carrying on a trading activity on a commercial basis on the land or any 'excluded rent'.

The requirement that the remaining gross non-rental revenue of 25 per cent or less does not include any revenue from the trust carrying on a trading activity on a commercial basis on the land would appear to be directed at preventing active business income derived from one investment in land being sheltered by rental investment income derived from another investment in land by applying the safe harbour on a 'whole of trust' basis.

The concept of 'excluded rent' is employed as an anti-avoidance measure and is directed at amounts that are described by the parties as 'rent' but which are:

  • calculated by reference to turnover or level of activity under a non-arm's length arrangement; or
  • calculated by reference to the profits or net receipts (before payment of that rent) of an entity that uses any of the land under an arrangement that would result in those profits or receipts being transferred to another party to the arrangement.

As a result, the concept of excluded rent is intended to catch arrangements that include payments that are referred to as rent, but which do not, in substance, represent a passive investment return for the right to use the land.

Furthermore, in working out gross revenues for these purposes, payments for the provision of services that:

  • are incidental to and relevant to the renting of land; and
  • are ancillary to the ownership and use of the land; and
  • are not incidental to trading,

will be taken to be rent derived from the land.

Any capital gains or losses realised from the disposal of land will be excluded from the calculation of gross revenues for the purposes of applying the safe harbour allowance of 25 per cent of non-rental, non-trading income from investments in land.

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Investments in financial arrangements

Apart from investing in land for the purpose of deriving rent, the other main category of eligible investment business that a trust is confined to conducting is investing or trading in debt instruments, shares in a company (which it is proposed will include shares in a foreign hybrid company, being United States limited liability companies that are treated as partnerships for tax purposes and United Kingdom limited liability partnerships), units in a unit trust and certain derivatives. It is proposed to amend the definition of 'eligible investment business' to include investing in other financial instruments that arise under financial arrangements (as defined in the forthcoming legislation dealing with the taxation of financial arrangements) other than the following:

  • certain leasing and property arrangements;
  • certain interests in partnerships or trusts;
  • a right or obligation under a general insurance policy;
  • a right or obligation under a guarantee or indemnity, unless the financial arrangement is one where the guarantee or indemnity relates to a hedging arrangement or is given in relation to a financial arrangement (thereby permitting the granting of cross guarantees by members of a property group, for example);
  • financial rights or obligations arising from a person's membership of a superannuation or pension scheme; and
  • financial rights or obligations arising under retirement village arrangements.

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General de minimis safe harbour

A safe harbour allowance of 2 per cent of the gross revenue of a trust has also been proposed to reduce the likelihood of inadvertent minor breaches of the public trading trust rules triggering company taxation for a trust. Provided that not more than 2 per cent of the gross revenues of the trust (on a whole of trust basis) for the relevant year of income is income from things other than eligible investment business, the trust will not be taken to carry on a trading business. However, this safe harbour will not apply if the trust actually derives income from carrying on a trading business on a commercial basis.

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Transitional rules

It is proposed that the new rules will apply to the income year in which they receive Royal Assent and later income years. Therefore, if the new rules are enacted prior to 1 July 2009, the new rules will apply to the current income year ending on 30 June 2009. However, for their first year of application, a trustee of a unit trust can elect out of the safe harbour rules (if, for some reason, corporate tax treatment is desired).

If you have any questions on these changes or would like assistance in making a submission, feel free to contact any of the partners listed below.

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For further information, please contact:

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