In light of the announced measures, MITs will be seriously evaluating the merits of the MIT capital account treatment election to ascertain whether it would provide any greater assurance compared to their current position (in particular we note the carve-out of trading stock from the MIT capital account treatment rules).
However, entities other than MITs will no doubt also be examining the current treatment of their gains and losses. Even before the changes announced in the 2009-2010 Federal Budget, the relevance of the income / capital distinction was receiving considerable attention in light of the global financial crisis. While in a booming market, holding shares on capital account is attractive because of the potential to access the discount CGT regime and CGT rollovers (eg scrip for scrip), in a bear market characterised by losses, holding investments on revenue account provides taxpayers with the potential to treat investment losses as deductible against all other income. For many taxpayers, the treatment of their gains and losses will be fairly clear, however for those whose tax positions are less obvious, it would be expected that a position which purports to gives rise to deductible revenue losses will be closely scrutinised by the ATO in the event of an audit.
The introduction of CGT in 1985 has meant that irrespective of characterisation, transactions will have tax consequences which need to be considered. However, real differences in outcomes for taxpayers have progressively crept into the law as a result of policy changes and concessions. The most notable being the CGT discount and more recently, the exemption from CGT on gains derived by non-residents except where the gain arises in respect of Taxable Australian Property (eg, real property or land-rich companies). Although the introduction of the Taxation of Financial Arrangements (TOFA) regime (applicable from 1 July 2010 unless adopted earlier) has represented a further eroding the income and capital distinction for gains and losses on financial arrangements, the character of a gain or loss will be of continued relevance where a taxpayer does not need to apply the TOFA provisions because of specific carve-outs and does not make an election to apply TOFA, or where a pre-TOFA arrangement is "grandfathered" under transitional rules.
The income / capital distinction in a nutshell
Case law over the years suggests that characterisation of an item will be dependant on whether it is a receipt or an outgoing:
- for a receipt – the enquiry is focussed on the circumstance in which the receipt is derived. For example, gains in the ordinary course of carrying on a business will generally be a receipt of an income nature. Gains from isolated transactions could also be of an income nature where the transaction was entered into by the taxpayer with the intention or purpose of making a profit or gain1
- for an outgoing – the enquiry is focussed on the advantage secured by the outgoing. This will require consideration of: 1) the character of the advantage sought to be obtained by the outgoing and its lasting qualities; 2) the manner in which it is to be used, relied upon or enjoyed; and 3) the means adopted to obtain it.2 For example, expenditure which goes to the establishment of the profit-yielding structure (eg, purchase of a factory) would be of a capital nature whereas expenditure incurred to run the factory (eg, salary, wages, electricity etc) would be of a revenue nature.
Areas where the income / capital distinction is still relevant
Below we have outlined some areas where the income / capital distinction will continue to be relevant:
- the assessability of gains or profits where they represent "income according to ordinary concepts" (section 6-5 of the Income Tax Assessment Act 1997 (ITAA97))
- whether a gain derived by a non-resident is exempt from capital gains tax where the asset is not "taxable Australian Property" (broadly land, interests in land and land-rich entities). If the gain is "income" according to ordinary concepts with an Australian source, then this will be taxable to the non-resident except where a double tax agreement operates to limit Australia's taxing rights. This is especially relevant to residents of countries with which Australia has no double tax agreement
- eligibility for "Discount Capital Gains" treatment where an asset is held for at least 12 months before the CGT event. Broadly, this concession entitles individuals and trusts to include only 50% of a capital gain in their assessable income and superannuation funds to a 66 2/3% reduction of the relevant capital gain
- whether a loss or outgoing is on revenue account and therefore able to be offset in current and future income years against all income of the taxpayer or whether it is a capital loss and only able to be offset against capital gains (sections 8-1, 36-15, 36-17 and 102-5 of the ITAA1997)
- in the context of an acquisition by tax consolidated group, it is important to understand whether assets held by the acquired company are held on revenue or capital account because, under the tax cost setting rules, the new cost base in assets held on revenue account cannot exceed the greater of its market value or the tax cost to the entity which is joining the tax consolidated group.
Difficulties in applying the income / capital distinction
The main area of difficulty appears to remain the characterisation of gains and losses on investments. It cannot be said that there is any "bright-line" to distinguish whether a gain will be on revenue or capital account. Judicial pronouncement provides the only guide to the issue, and provides a variety of different considerations and principles to navigate.
The issue is of utmost importance to collective investment vehicles, both foreign and Australian based. For example, the characterisation of a gain on capital account will mean a reduction to the amount required to be included in assessable income (in the case of Australian trusts and LICs; or for non-resident vehicles, the characterisation may go to determining whether any tax is payable in Australia at all).
The ATO view in Taxation Ruling TR 2005/23 is based on the Commissioner of Taxation's interpretation of the cases of London Australia and Myer Emporium. The Commissioner's view is succinctly summarised in paragraph 9 of TR 2005/23 which states:
"If on the facts the disposals of investments by a listed investment company are undertaken as part of carrying on a business of investment, the gains or losses on such disposals of investments will be on revenue account. That is, such gains will be income according to ordinary concepts and such losses will be deductible on revenue account.... On the other hand, where the disposal of investments amounts to no more than a mere realisation or change of investments, that is, the disposals have not been made as part of a business of investment, the gains or losses will be on capital account. ..."
The Commissioner suggests that the following criteria point to a holding on capital account:
- the taxpayer's investment policy does not envisage an "exit point"
- there is a low average annual turnover of assets
- sales are infrequent
- profit on sale represents a small percentage of total income
- the fund has a significant percentage of aged stocks.
While the Board of Taxation has made some interim recommendations to which the Government has responded, it will be interesting to see what other developments (eg tax rulings, specific legislative amendments etc) arise for collective investment vehicles which do not meet the requirements to make the election for MIT capital account treatment or do not otherwise benefit from deemed CGT treatment in respect of gains and losses.
Managing Characterisation Issues
While the MIT rules referred to earlier in this tax update provide welcome concessions for eligible MITs, taxpayers in general should be mindful of tue capital / revenue characterisation prior to entering into the arrangements which require that characterisation. Processes which could assist in this regard and other relevant considerations include:
- documenting evidence such as intent and business decisions which supports the adopted treatment. For example documenting the taxpayer's overall investment strategy
- if there is a portfolio of investments, it is important to document the intention with respect to each investment, to ensure that there is sufficient certainty that the intention for one investment is not imputed to the remaining investments in a portfolio
- in a co-investment arrangement, understanding and distinguishing different strategies and investment intentions adopted by co-investors
- if necessary preparation of a "reasonably arguable position paper" which supports the position adopted
- keeping track of the continued characterisation of investments – eg if there are changes in the nature of the holding of a particular investment, tax adjustments will need to be made to income tax returns (a typical example is where a capital asset becomes trading stock)
- understanding how the likely characterisation interacts with the current and expected loss profile. For example, revenue losses may be used to offset capital gains but capital losses cannot be used to offset revenue gains
- consequences under accounting standards of adopting a particular tax position (eg US FIN 48 disclosure requirements).