Tax Summary 2012 & Chapter 16: Investments. Your plain English guide to tax. This document is an edited extract from:

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1 2012 & 2013 Tax Summary Your plain English guide to tax This document is an edited extract from: Chapter 16: Investments This book is copyright. Apart from fair dealing for the purposes of private study, research, criticism or review as permitted under the Copyright Act, no part may be reproduced, stored in a retrieval system, or transmitted in any form by any means electronic, mechanical, photocopying, recording or otherwise without written permission. The Copyright is owned exclusively by Taxpayers Australia Inc. (ABN: ) All information provided in this publication is of a general nature only and is not personal financial or investment advice. It does not take into account your particular objectives and circumstances. No person should act on the basis of this information without first obtaining and following the advice of a suitably qualified professional advisor. To the fullest extent permitted by law, no person involved in producing, distributing or providing the information in this publication (including Taxpayers Australia Incorporated, each of its directors, councillors, employees and contractors and the editors or authors of the information) will be liable in any way for any loss or damage suffered by any person through the use of or access to this information. Taxpayers Australia Inc, 1405 Burke Road Kew East Victoria 3102 Telephone: (03) or Fax: (03) info@taxpayer.com.au Web:

2 Investments Investors must consider a range of tax laws dealing with income, assets and deductions. This chapter is designed to provide a general summary of the relevant tax issues that should be considered when investing in various asset categories. Revenue or capital Investment returns are typically assessable either on revenue or capital account. The distinction between revenue and capital is not always clear and characterisation of a receipt will ultimately depend on the circumstances which apply to a the taxpayer. The distinction between an income and capital receipt has been likened to the fruit and the tree, where the capital amount is the tree and the fruit being the return of income from the capital. Generally an income receipt is regarded as an amount that is regular, recurrent or periodic and income tax applies to a net amount of income. A good example is dividend returns from a shareholding. However, it is not always clear whether an amount should be treated as income or capital. What may appear to be a capital gain for example may in fact be classified more correctly as income where the taxpayer had a clear view to a profit-making venture. Often this distinction can be determined by the period of ownership - generally the longer an asset is held the more likely the return on disposal, for example, is of a capital nature. Furthermore, where the amount is a capital return, the investor may have access to the CGT discount provisions which provide a better tax result than should the amount be fully taxed as assessable income. Similarly the treatment of an outgoing is important to determine whether an immediate deduction is allowable or whether the outgoing forms part of the cost base of a CGT asset. The deduction for a capital outgoing is generally deferred until the sale of the asset. Should the return be less than the original outgoing, a capital loss arises that is quarantined and can only be offset against a current or future year capital gain. Matters to be consider when deciding whether an outgoing is revenue or capital in nature include: the character of the advantage sought by the outgoing the advantage sought by the taxpayer, and how the advantage comes about, eg. recurrent payments (refer Sun Newspapers Case). Generally, those holding investment products fall into two categories - traders and longer term investors. Traders Generally, where the holder of an investment product carries on activities for the purpose of earning income from buying and selling investments, that holder will be in the business of trading. Generally, a trader: holds investment products as trading stock includes gross receipts from the sale of investment products as income expenses incurred in relation to trading activities are allowable as a deduction when incurred, and investment returns such as interest, dividends and distributions are included in assessable income. NOTE: Where the holder of an investment product enters into an isolated transaction with a profit making intention, they will not be in the business of trading. However, any net profit from the transaction will be assessable on revenue account. See TR 92/3 for further guidance on whether profits from isolated transactions are income. Longer term investors Where investments are held with the intention of earning regular income from those investments, that investor is generally not carrying on a business. The investor generally: does not include gross receipts from the sale of investments as income. However, any net profit is subject to CGT capital losses from the sale of investments cannot be offset against income from other sources except current or future capital gains expenses incurred in relation to buying and selling investments are not allowable as a deduction when incurred, but are taken into account in determining the amount of any capital gain or loss, and investment returns such as interest, dividends and distributions are included in assessable income. Phone:

3 NOTE: In determining whether the holder of an investment product is a trader or a longer term investor, the intention, frequency and volume of the taxpayer s investing activities must be considered. Additional guidance on this issue is contained in the Decision Impact Statement (DIS) of The Taxpayer and Commissioner of Taxation 2011 ATC NOTE: Tax determination TD 2011/21 considers the factors which may be relevant in deciding whether gains and losses from the disposal of securities would be on capital or revenue account for the trustee of a trust. Investment earnings Assessable investment income includes both ordinary and statutory income. Investment income earnings including dividends and interest, are typical receipts that are considered ordinary income. Franking credits, net capital gains and net trust distributions are statutory income. Australian resident taxpayers include investment earnings from both Australia and foreign sources in their assessable income under s6-5(2). However, from 1 July 2006, Australian resident taxpayers who satisfy the requirements of a temporary resident do not include in their assessable income investment income from foreign sources (see ). Non-resident taxpayers generally only include Australian sourced investment income in their assessable income. Ordinary or statutory income Ordinary income is typically income that is regular, periodic or recurrent (FTC v Dixon (1952) 86 CLR 540). Returns on property such as interest, rent or dividends are considered ordinary income. Statutory income is income that is not ordinary income but is recognised because of a provision of the tax law (Refer 6-10(2) ITAA97). While not an exhaustive list, the following table shows some of the taxing provisions for ordinary and statutory income from investments: Income item Interest Rent Dividend Imputation credit LIC dividend Forestry managed investment schemes returns Yields traditional securities Distributions trusts Capital gains Provision s6-1 ITAA97 s6-1 ITAA97 s44 ITAA97 s ITAA97 s ITAA97 Division 394 ITAA97 s26bb ITAA36 s97 ITAA36 Capital Gains Tax (CGT) is essentially a tax on the realisation of certain assets acquired (or deemed to be acquired) after 19 September 1985, where the realisation is not in the course of carrying on a business or a profit making venture. The assets to which CGT applies are indicated at and would include shares, units in a unit trust, rights, options, investment properties, and business goodwill. A capital gain is generally the sale proceeds (or market value of certain transactions) less their cost base (see ). There are certain concessions which may reduce the taxable amount of a capital gain such as a 50% discount for individuals and trusts (11.165) and concessions for certain active business assets (the latter not usually including rental properties or other passive investment assets) of eligible taxpayers (11.525). There are specific exemptions such as a taxpayer's main residence, many motor vehicles, some types of collectable, personal use assets, and compensation payments for certain forms of personal injury. It should be noted that some types of transaction involving assets which might otherwise be covered by CGT may be instead taxed as income (eg. property bought and sold in a development business or profit-making arrangement) (see from ). Generally, investors are subject to the CGT provisions on the disposal of investment assets, unless carrying on a business or the investment is sold as a profit making undertaking. Expenses incurred in relation to buying and selling investments are included in that asset s cost base. Phone:

4 Typical investment products Typical investment products In examining the tax treatment of returns on or dealings in investments, it is first necessary to examine different types of investment products. The basic investment products include cash, shares and managed investments and property. Listed below is a description of the more common investment products and tax issues faced by investors in those products. Investment property is discussed in Chapter 17. For the purposes of this analysis, we will assume that the relevant investors are not in the business of trading in investment products. Cash and fixed interest investments Interest bearing accounts are the most basic of the investment products and represent a form of lending by the investor in return for an interest payment. The deposit may take the form of either direct or indirect lending. Direct lending generally includes interest bearing deposits with a financial institution, debentures, unsecured notes, bank bills or government and corporate bonds. Indirect lending generally occurs through managed funds such as cash management trusts, bond trusts and mortgage trusts. Note: Division 974 of ITAA97 provides guidelines as to whether a particular investment is classed as debt or equity. The provisions outline tests that provide the definition of equity and debt interests. This may impact whether a return paid on the investment may be frankable and non-deductible to the payer (like a dividend) or may be deductible to the payer and not frankable (like interest). See Tax issues facing investors in cash and fixed interest investments Interest income Interest income is typically recognised on a receipts basis and is assessable to the taxpayer in the year the interest is received. Typically, interest is received on bank deposits and from savings accounts as well as on term deposits. For the tax treatment of interest from a cash managed trust, see Trust distributions at Discounted or deferred interest securities Not all investment returns are based solely on the regular payment of interest. Some debt securities instead defer income to a future period. The yield on such discounted or deferred interest securities may be taxed on an accrual basis under Division 16E Part III of the ITAA36. Effectively, Division 16E taxes the return on discount and deferred interest securities issued after 16 December 1984 on an accruals basis where tax would otherwise be deferred to a future period. The division alters the timing of income and deductions. Note that Division 16E does not apply to a qualifying security held as trading stock. To be subject to these rules, qualifying securities must have ALL of the following attributes: the security has a term of greater than one year (or a term beyond one year is anticipated) there is either no interest payable, or if there is, it is at intervals of greater than one year, and apart from periodic interest paid, the investor receives (including the maturity payout) more than the initial investment and that extra amount is more than 1.5% pa of the initial investment. Division 16E only applies if the eligible return of all amounts from the borrower (excluding any periodical interest) exceeds (or is likely to exceed) the amount determined by the following formula: Total payments over term (other than interest) including return of capital x term of deposit x 1.5% EXAMPLE: A security is purchased for $1,000 with an indexed value at maturity of $1,500 in six years and interest at 3% pa. Eligible return ($1,500 less $1,000)... $500 Formula amount ($1,500 x 6 years x 1.5%)... $135 The security is a qualifying security because the eligible return of $500 exceeds the yardstick amount determined by the formula ($135). Taxing of yield interest Regardless of when interest is received by the investor, tax is payable each income year on an accrual basis. The amount taxed is each year s increase in value. In simple terms, the increase in value is measured at six monthly intervals counted back from the maturity date. 800 Taxpayers Australia Inc 2012 & 2013

5 Typical investment products Gains and losses on discounted or deferred interest securities Gains (or losses) on these securities (if acquired after 19 September 1985) are assessed under CGT rules (see from ). This assumes that the taxpayer is a non-business investor. NOTE: The tax implications of a security that meets the definition of a 'traditional security' are discussed at Discounted or deferred interest securities from 1 July 2010 (or 1 July 2009 by election) Note that Division 230 of ITAA97 will provide the tax treatment for most of the gains and losses on discounted and deferred interest securities that are acquired or issued on or after 1 July 2010, or 1 July 2009 should the taxpayer so elect, that would otherwise have been taxed under Division 16E (refer TOFA 3 and 4). First home saver accounts From 1 October 2008, an individual can invest through a 'first home saver account' to save for the purchase of their first home through a combination of government contributions and concessional tax rates. Certain financial institutions, including banks and credit unions offer these products. Generally, the funds can only be used to buy or build the person's first home. Holders of such accounts receive a government contribution based on that person's personal contributions to the account during an income year. The government contribution is 17% of personal contributions up to a maximum amount of $935 ( income year). To receive the contribution, the holder must lodge an income tax return and the account provider must report personal contributions to the tax office. Earnings on the accounts are taxed at 15% and the tax is paid by the account provider. To be eligible to open a first home saver account, an individual person must: be aged over 18 and under 65 years have a tax file number not have previously owned a home in Australia that has been their main residence, and not have previously had a first home saver account. The account cannot be held as a joint account. The holder of the account: must make personal contributions of at least $1,000 for each of four financial years before being able to withdraw the savings (not necessarily consecutive years), and can make contributions to the account up to a maximum cap of $85,000 ( income year) over the life of the account. Other persons can make contributions on the holder s behalf. However, contributions cannot be made from pretaxed salary. NOTE: A change to the law which was enacted on 25 May 2011 will enable a first home saver account holder to transfer funds from their account into an approved mortgage where the holder acquires a home before the end of the four year period. Australian shares Many investors hold shares in Australian companies. The return on shares is in the form of a dividend, although some investors trade in shares or buy and sell share parcels with a profit making intention. As mentioned above, Division 974 of ITAA97 provides guidelines as to whether a particular investment in a company is classed as debt or equity. This may impact whether a return paid on the investment may be frankable and non-deductible to the payer (like a dividend) or may be deductible to the payer and not frankable (like interest). See Tax issues facing shareholders Dividends These are taxable distributions by companies to shareholders, whether in money or shares or other property. Generally, dividends are sourced from retained profits (including some profits on sale of capital assets). Some distributions are excluded, for example where another provision of the tax law expressly deals with the distribution, such as s23aj, s23ai, s23ak and s128d ITAA36. Franked dividends and franking offsets Dividends may be franked by a company. This means the dividend can carry a tax credit (known as the franking offset) which may be utilised by certain taxpayers to offset tax on the dividend (and/or other income). An investor in Phone:

6 Typical investment products a company who is a 'qualified person' who receives a franked dividend will add the franking credit to the amount of the dividend, include the total as assessable income and then claim a tax offset for the franking credit (this method is known as 'gross-up and offset'). This means that the franking credit is included as assessable income. If the investor is a resident individual and has franking credits for the income year which exceed their total tax payable, a refund may be available for the excess (note that in limited circumstances, certain entities also qualify for the refund). While Australian taxpayers are generally entitled to the franking credit offset, there are anti-avoidance rules which may prevent the taxpayer from using the franking credit as a tax offset. One such measure is the 'holding period rule' which applies to each shareholding (or unitholding when franking credits are received indirectly through a trust). The holding period rule varies depending on whether the relevant shares are ordinary shares or preference shares. The rule requires that ordinary shares must be held at risk to market forces (increasing or decreasing the share value) for at least 45 days (plus days of acquisition and disposal). The rule requires that preference shares must be held at risk for at least 90 days (plus days of acquisition and disposal). The holding period rule operates on a last-in-first-out basis so that a shareholder will be deemed for the purpose of applying the holding period rule to have disposed of their most recently acquired shares first. An exception to the holding period applies to individual taxpayers where the total franking credits received from all sources during the year are $5,000 or less (the 'small shareholder exemption'). See and Such individuals include the franking credit in assessable income and are eligible to claim the franking credit tax offset. Where a taxpayer is ineligible to claim a franking credit offset as a result of the holding period rule, there is no need to 'gross up' the dividend. This means that the franking credit disallowed is not included in the taxpayers assessable income. Note that while franking credits are typically attached to franked dividends, trust distributions can also carry franking credits (see ). For the tax treatment of foreign income from an investment in a foreign company, see Chapter 21. Note: Non-resident shareholders will be subject to the withholding tax provisions on any unfranked portion of the dividend (see and ). Dividend reinvestment plans Shareholders often have the option of reinvesting their dividends in the acquisition of more shares. For tax purposes, the dividend must still be included in assessable income as if the shareholder had received dividends in cash, and used the cash to acquire additional shares. For CGT purposes, the amount of the dividend applied to acquire the shares forms part of the cost base (excluding the imputation credit). Sales and purchases of shares Where the shares are not trading stock or part of a profit-making undertaking, gains on the disposal of shares may be subject to CGT (see Chapter 11) and in this instance their cost is not deductible but forms part of the cost base of the shares. From 1 July 2007, Division 315 disregards a capital gain or loss incurred by a private health policy holder where shares or rights to acquire shares (generally in the demutualised private health insurer) are received by policy holders on demutualisation. The investor will receive a market value cost base for those shares or rights. Any subsequent disposal of those shares may then be subject to CGT. Where the shares are trading stock or part of a profit-making undertaking, proceeds on the disposal of shares are included in assessable income. Taxpayers who are share traders may claim a deduction for shares disposed of each year in the course of trading. Those engaged in a profit making undertaking are taxed on the net gain. Note that special rules apply to shares issued under an employee share scheme (see ). Further, changes have been made to the tax laws dealing with the issue of employee shares and options which were announced in the May 2009 Federal Budget. These amendments started to apply from 1 July Is the taxpayer carrying on a business of share-trading? A taxpayer may successfully argue that a business exists and recognise profits and losses on share trading on a revenue basis. Rather than acquiring shares to obtain an income stream in the form of dividends, a share-trader seeks to obtain a profit through the purchase and sale of shares. Whether a person is a share trader has been considered in a number of cases (Shields v DFCT 99 ATC 2037, Case X86, Case W8, Case X31). The following factors are considered relevant in determining whether a share-trading business exists (refer ID 2001/745 and ID 2001/746): Taxpayers Australia Inc 2012 & 2013

7 Typical investment products Share trader The nature of the activities and whether they have the purpose of profit-making The complexity and magnitude of the undertaking and intention to engage in trade regularly, routinely or systematically Operating in a business-like manner and the degree of sophistication involved Whether any profit/loss is regarded as arising from a discernible pattern of trading The volume of the taxpayer s operations and the amount of capital employed Repetition and regularity in the buying and selling of shares Turnover Whether the taxpayer is operating to a plan, setting budgets and targets, keeping records Maintenance of an office Accounting for the share transactions on a gross receipts basis Whether the taxpayer is engaged in another fulltime profession Investor Shares typically held for longer terms The taxpayer predominantly relies on professional advice to make investment decisions Limited time spent on the activity The method of operation is simple No trading plan developed No contingency plan in place to absorb market downturns Inability to source funding required for continuing the activity for an indefinite period Limited record-keeping No home office maintained Income derived from share-trading activities is revenue in nature and assessed to taxation as ordinary income under s6-5, while losses are deductible under s8-1. Share traders apply the trading stock rules in Division 70 to shares purchased and sold (see ). NOTE: For those investment products(shares) held by traders as trading stock or revenue assets on hand at end of the year, the relevant price method is contained in TR 96/4. Profits derived by non-resident share-traders whose trading involves Australian entities may be assessable under subsection 6-5(3). Regardless of whether a non-resident investor maintains an Australian office or staff, if the contracts for the purchase or sale of shares are concluded in Australia, the income will be considered Australian source income (ID 2004/904). However, the profits derived by a non-resident investor on capital account can be disregard for Australian tax purposes, unless the CGT even relates to an asset that is taxable Australian property (see ) Trading stock versus capital asset Investment products may be held as trading stock by a taxpayer carrying on a business of share trading or options trading. However, whether a particular parcel should be treated as trading stock must be determined on a case by case basis. Generally, the tax issues facing share traders versus passive investors are summarised below. How share transactions are taxed Transaction Share trader Shareholder (passive investor) Gain on disposal Sale on trading account Capital gain Loss on disposal Sale on trading account Capital loss Share buy-backs Sale on trading account Capital gain or loss/usually a dividend component Dividends received Share acquisition Assessable income When received but may be accounted for when derived (ie. when dividend is declared) Purchases on trading account Allowable deduction Assessable income When received Capital cost No immediate deduction allowed Phone:

8 Typical investment products How share transactions are taxed (cont) Broker fees GST on broker fees Share investment course pre-ownership Share investment course post-ownership Technical books Share trading software Interest on margin loan Prepaid interest Bank charges on margin loan Costs to establish loan Purchases Allowable deduction Financial supply Reduced input tax credits If business commenced then allowable deduction, however nexus must be established Professional development Allowable deduction Professional development Allowable deduction Business expense Allowable deduction (if not an establishment cost) Interest expense Allowable deduction incurred to obtain assessable income Deduction up to 12 months if s82kzm satisfied Bank fees Allowable deduction Borrowing costs Allowable deduction available over five years Capital cost No immediate deduction Capital cost No immediate deduction No reduced input tax credits as no enterprise Capital cost No immediate deduction Investment expenses Allowable deduction Investment expenses Allowable deduction Investment expenses Allowable deduction Investment expenses Allowable deduction Deduction up to 12 months if s82kzm satisfied Investment expenses Allowable deduction Investment expenses Allowable deduction available over five years Issue of rights or options An investor who holds shares may be issued with rights or options to acquire additional shares at a specified price (call options) or rights or options to sell their existing shares back to the company involved (put options). In the High Court decision in FCT v McNeil (2007) 64 ATR 431, the market value of rights to sell shares back to the company issued to the taxpayer were held to be assessable income. This put into doubt the treatment of call options often issued by companies seeking to raise capital. The Tax Laws Amendment (2008 Measures No.3) Act 2008 amended the law to ensure that such call options issued by companies to investor shareholders to raise capital are dealt with under the CGT provisions. See , and Note that special rules apply to rights or options issued under an employee option plan (see ). Exercise of rights or options The tax implications of exercising rights or options to buy or sell investments are dealt with at Expiry of rights or options Generally, as there are no capital proceeds received on the expiry of shares or rights, a capital loss will be triggered (CGT event C2). See Bonus shares Bonus shares are additional shares received by a shareholder for an existing holding of shares in a company. Generally from 1 July 1998, the paid-up value of bonus shares issued is not assessable as a dividend unless part of the dividend was paid in cash as part of a dividend reinvestment plan or otherwise represented a capitalisation of profits. For CGT purposes, the bonus shares are taken to have been acquired at the time that the original shares were acquired. The cost base and the reduced cost base of the original shares are apportioned over both the original parcel of shares and the bonus shares to provide the cost base of the bonus shares. This means that the cost base and reduced cost base of the original shares is reduced accordingly. Where the original shares are pre-cgt assets, any capital gain or loss on a subsequent sale of the bonus shares is disregarded. Taxpayers Australia Inc 2012 & 2013

9 Typical investment products Generally, where the bonus shares are assessable as a dividend, the shares are taken to have been acquired for CGT purposes at the time that the shares were issued. The amount of the dividend forms part of the cost base. This is regardless of whether the original shares were pre or post-cgt shares. Note that bonus shares may be franked when assessable as a dividend. Share buy-backs A share buy-back is an arrangement where a company makes an offer to shareholders to buy back some or all of their shares in the company. Note: The Board of Taxation completed a review of the tax treatment of share buy backs in May 2009 and recommended changes to the Government. An off-market buy-back is where the company buys back shares directly from the shareholder rather than buying them through the Australian Securities Exchange. Most share buy-back arrangements will constitute an off-market buy-back for tax purposes. A shareholder participating in the buy-back arrangement will be taken, for CGT purposes, to have disposed of their shares when the company accepts their application. Where the share purchase price under the buy-back arrangement exceeds the amount debited to the share capital account, the excess is taken to be a dividend. The balance is the capital component. The deemed dividend can be franked except to the extent that the purchase price exceed the market value of the share. For tax purposes, shareholders will be treated as disposing of their shares for the capital component plus the amount (if any) by which the tax value (see below) exceeds the buy-back price. This effectively means that a market value substitution rule applies. The ordinary CGT rules apply to an on-market buy-back of shares. The consideration received is the purchase price of the shares. No amount of the purchase price is a deemed dividend. Tax implications of an off-market share buy back - dividend component of the buy back price The buy-back price in an off-market share buy-back usually consists of capital component and a fully franked dividend (an unfranked dividend will only arise where the buy-back price exceeds the market value of the share). The deemed dividend is included in the individual s assessable income in the same way as an ordinary dividend. If a shareholder, whose shares are bought back, is entitled to the benefit of franking credits on the deemed dividend the shareholder will also: include the franking credit on the deemed dividend in their assessable income, and be entitled to a franking credit offset equal to the franking credit. The franking credit offset may reduce the total tax payable by the shareholder on their taxable income. If the shareholder s total tax offset exceeds the total tax payable on his or her taxable income, the shareholder, if eligible, may be entitled to a cash refund of that excess (see ). Note that non-resident shareholders will be subject to the withholding tax provisions on any unfranked portion of the dividend. Tax implications of an off-market share buy back - capital component of the buy back price This summary of the income tax implications of participating in a buy-back is limited to shareholders who hold their shares on capital account and therefore will be assessed for tax under the CGT provisions. Shareholders, who carry on a business in dealing with shares, may be assessed on their dealings on revenue account rather than under the CGT provisions. An investor participating in the buy-back will be deemed for CGT purposes to have disposed of each share for the capital proceeds component of the buyback price plus the amount (if any) by which the tax value exceeds the buy-back price. The calculation of any capital gain in respect of shares bought back will depend on when the shares were acquired. If a shareholder has held their shares for less than 12 months, any capital gain will be calculated as the excess of the deemed capital proceeds over the CGT cost base of the shares. However, where the shareholder is an individual or trust that has held their shares for at least 12 months, then: if the share was acquired at or before 11.45am (ACT time) on 21 September 1999, the shareholder may choose whether to index the cost base to 30 September 1999 or to apply the CGT discount (which reduces the gain, net of any capital losses, by 50%), and if the shares were acquired after 11.45am (ACT time) on 21 September 1999 the shareholder may apply the CGT discount in calculating any capital gain on disposal. Where the shareholder is a superannuation fund that has held their shares for at least 12 months, then: if the share was acquired at or before 11.45am (ACT time) on 21 September 1999, the fund may choose whether to index the cost base to 30 September 1999 or apply a one-third CGT discount (which reduces the gain, net of any capital losses, by one-third), and Phone:

10 Typical investment products if the shares were acquired after 11.45am (ACT time) on 21 September 1999, the fund may apply the onethird CGT discount. The CGT discount is not available to companies. Generally, the CGT cost base for the shares will be the amount the shareholder paid to acquire the shares together with certain incidental costs of acquisition, for example stamp duty and brokerage, and certain incidental costs of disposal. A capital loss for a share disposed of under the buy-back will be the excess of the reduced cost base of the share over the deemed capital proceeds. No allowance for indexation or non-capital costs is made in determining the reduced cost base of the shares for this purpose. The capital gain which arises under the buy-back may be lower than the capital gain which may have arisen under an equivalent sale of the shares on-market. This is because the capital proceeds under the buy-back are limited to the capital component of the buy back price plus the amount (if any) by which the tax value exceeds the buy-back price, rather than the price at which the shareholder would have sold their shares on-market. The lower deemed capital proceeds also means that any capital loss which may otherwise have arisen on disposal of the shares may be higher than might otherwise have arisen. A capital loss that arises from the buy-back can only be used to offset capital gains made by the shareholder. Any capital loss arising from the buy-back cannot be offset against the deemed dividend or any franking credit included in the shareholder s assessable income. For superannuation fund investors that acquired their shares before 1 July 1988, the CGT cost base may be adjusted to the market value of the shares on 30 June NOTE: As these components will vary for each shareholder, the tax implications will be unique to each participant in the buy back. Calculation of the tax value TD 2004/22 sets out the Tax Office s methodology in determining the tax value of shares bought back off-market. The determination provides that the tax value should be determined as the volume weighted average price of the shares over the last five trading days before the first announcement of the buy-back, adjusted for the movement in the S&P/ASX 200 Index. Irrespective of the actual buy-back price received by shareholders, for CGT purposes shareholders are deemed to have received an extra capital amount if the tax value exceeds the buy back price. This amount if any is added to the capital component of the buy back price for CGT purposes. Limit on availability of franking credits There are a number of anti-avoidance rules which may prevent shareholders participating in a buy-back from claiming franking credits on the deemed dividend component of the buy-back price. These rules are designed to discourage franking credit streaming and trading in franking credits. These rules may deny the benefit of franking credits to shareholders generally, or because of their particular circumstances. The 'holding period rule' and the 'small shareholders exemption' (see ) apply to dividends from share buybacks in the same way as they apply to franking credits on ordinary dividends Listed investment company investments A Listed Investment Company (LIC) is a company (or wholly owned subsidiary) that: is an Australian resident for tax purposes is listed on the Australian Securities Exchange, and 90% of the market value of its CGT assets are 'permitted investments' (including shares, units, options, financial instruments, passive investment assets, goodwill, etc). Tax issues facing investors in a LIC Investors in a LIC must declare dividends earned in the usual way (see ). However, a concession may apply where the dividends paid by a LIC include a capital gain component. The portion of the LIC dividend attributable to the capital gain component may be recognised as an income tax deduction. This allows shareholders of LICs to obtain a benefit similar to the discount on capital gains giving the investor access to the benefit that would have been available had the investor made the capital gain directly. The deduction is only available if: the dividend is paid to an individual, trust, partnership, or complying superannuation fund the shareholder is an Australian resident when the dividend was paid or a non-resident with permanent establishment in Australia, and Taxpayers Australia Inc 2012 & 2013

11 Typical investment products the dividend was paid after 1 July The deduction amount is equal to the general capital gains discount, being 50% of the LIC capital gain amount for individuals and 33 1 /3% for complying superannuation funds. The deduction is generally recorded as an interest and dividend deduction. The LIC must notify the shareholders of the capital gain component of a LIC dividend by recording the amount on the distribution statement. Example: Tom, an Australian resident, received a distribution from LIC Ltd. The distribution statement shows the distribution comprised the following components: Franked dividend $70,000 Franking credit $30,000 LIC gain amount $20,000 Tom will be entitled to an interest and dividend deduction of $10, Fixed trusts Fixed trusts provide investors with a fixed entitlement to both the income and capital of the trust. A unit trust is a type of fixed trust where the investor is the owner of a specific number of units in the trust in accordance with their investment. While investment may occur through a private fixed trust, investors are likely to be more familiar with public trusts. A public unit trust is a listed trust or has units offered to the public or has at least 50 unit-holders. A public trust may be unlisted or listed. Listed trusts will have a readily available market valuation for the units available for sale. Valuation of units in unlisted trusts will be dependent on an appraised valuation of the underlying assets. Public unit trusts that conduct a trading business are taxed at the corporate tax rate of 30%. Public trusts that conduct an investment business are generally not taxed unless the trust retains undistributed taxable income. Generally, investors receive trust distributions in proportion to the number of units held over the total issued units of the trust. Whether the distribution is assessable to a beneficiary is wholly dependent on the nature of the trust s income and the tax status of the beneficiary Managed investments A managed investment is the pooling together of monies from many investors to purchase investment assets. The investor receives an interest in the scheme, normally units in a unit trust. The number of units an investor receives is dependant on the amount invested in the scheme. Generally, a professional investment manager operates the scheme (the fund manager or 'responsible entity'). Many investors are attracted to managed investments for professional management and diversification of investments. Managed investments cover a wide variety of different investment products. Some of the more popular managed investments include: cash management trusts property trusts Australian equity trusts, and international equity trusts Tax issues facing investors in trusts Tax treatment of trust distributions Distributions from a trust are taxed on an accruals basis. This means that a beneficiary presently entitled to trust income in respect of a particular year will be assessable in respect of that income even though it is not received until after the end of that year. The cash received by the investor (beneficiary or unit holder) from a trust distribution often differs from the amount to be included in taxable income. An annual taxation summary sent to beneficiaries or investors advises of the taxable component. A trust distribution is generally made up of various types of income (for example, interest, dividends, capital gains or foreign income) and these income amounts retain their character as they flow from the trust through to the investor. This means the investor may record a portion of the distribution as a capital gain or foreign income in their income tax return and the balance as income from a trust. A trust distribution may comprise various components including: primary production income non-primary production income (includes Australian interest income, franked and unfranked dividends) capital gains foreign source income, and Phone:

12 Typical investment products tax-deferred distributions. Where a trust distribution includes a tax-deferred component, this amount is not included in the assessable income of the investor. The annual tax statement will state the tax-deferred component included in the trust distribution. While the amount is not taxable, the cost base of any units held in the trust must be reduced by the tax-deferred amount received. Receipt of the tax-deferred component therefore impacts the calculation of the capital gain or loss on units when they are eventually disposed of (see and ). Where a trust distribution includes a tax-free amount, the investor will be required to apply that amount against their cost base in the units unless the amount is to be excluded pursuant to s If the non-assessable amounts exceed the investor s cost base in the units, CGT event E4 will occur. Where a trust has earned franked income, it may pay a franked distribution to its investors. Where the investor receives a franked distribution which flows to it indirectly, the investor, if eligible, is entitled to a tax offset equal to its share of the franking credits attached to the distribution (s ITAA97). Generally, an investor will only be eligible to utilise the franking credits attached to the franked distribution if both the trustee and the investor are 'qualified persons' (see ). As the investor in this case does not directly hold shares, special 'holding period rules' are applicable. The investor must have a minimum 30% fixed interest in the trust and have held that interest for the requisite 45 days to be eligible to claim the franking credit tax offset. Note: Where the investor is merely a discretionary beneficiary, they will not have a fixed interest in the trust and therefore will be unable to satisfy the 'holding period rule'. In this case, a franking credit tax offset will only be available if: the beneficiary is an individual that satisfies the small shareholder exemption (see ) the relevant trust has made a family trust election (see 6.200), or the relevant shares were acquired by the trust before to 31 December For the tax treatment of foreign income from a trust, see Capital gains component of distribution from managed funds and trust investments Many managed funds and trusts hold CGT assets. During a tax year a CGT event may happen in relation to those assets resulting in a capital gain to the trust. Where this event occurs, an investor (unit holder or beneficiary) is likely to receive a trust distribution comprising the investor's share of that capital gain and this will be shown on the investor s tax statement issued by the trust. The capital gains component of the trust distribution retains its character as it flows from the trust through to the beneficiary. The tax treatment on such items as discounted gains, other gains, indexed gains, the CGT concession amount, and tax deferred amounts is outlined at along with the cost base reduction rules for the distribution of a non-assessable amount. Sale of units Where the units are not trading stock or sold as part of a profit-making undertaking, gains on the disposal of trust units may be subject to CGT (see Chapter 11) and in this instance their cost is not deductible but forms part of the cost base of the units. It may be necessary reduce the cost base of the units for any tax-deferred amounts received (see ). Where the units are trading stock or part of a profit-making undertaking, then the proceeds will be on revenue account. Foreign investment income Where foreign investment income (such as foreign dividends or the foreign income component of a trust distribution) is received, these amounts must be included in the assessable income of an Australian resident taxpayer. A non-resident taxpayer is not subject to tax on income from foreign sources, even if that foreign income has been received indirectly through an Australian trust. Note: Special rules may apply where an Australian resident has a substantial interest in a foreign entity by way of an accruals regime. The rules may attribute to the taxpayer a share of specified income and gains to be included in the taxpayer's assessable income. Similar rules apply where an Australian resident taxpayer has transferred property or services to a non-resident trust estate (note these rules are under review and will be subject to reform). See Foreign Income Tax Offset (FITO) Where foreign tax has been paid on the foreign income, the investor will generally receive a credit for the foreign tax paid known as a 'foreign income tax offset'. In some circumstances, there is a cap imposed on the amount of FITO available to taxpayers (see ). Prior to 1 July 2008, a 'foreign tax credit' was allowable to such taxpayers, also subject to a cap. The 'foreign tax credit' rules were replaced with the rules relating to FITOs effective 1 July Taxpayers Australia Inc 2012 & 2013

13 Typical investment products Foreign losses Prior to 1 July 2008, foreign income was recognised according to class and deductions could only be offset against the same class of income. Where a foreign loss resulted, the loss could not be deducted from Australian source assessable income. However, the loss could be carried forward to deduct from assessable foreign income of the same class derived in a later income year. Changes to the law effective from 1 July 2008 allow a foreign loss to be offset against Australian income (see ) and remove classes of foreign income (see ). Managed investment schemes Managed Investment Schemes (MISs) have been a popular structure for investments in agricultural projects. Historically, taxpayers have enjoyed beneficial tax treatment with respect to contributions to MISs, even though a return on the investment was often delayed for many years. Generally, such a scheme must be registered if it has more than 20 members or it is promoted by someone in the business of promoting investment schemes. Generally, members do not have control of the day to day operations of the scheme. Tax issues facing investors in non-forestry MISs Prior to 1 July 2008, investors in MISs were generally permitted to claim up-front general deductions for lease and management fees and debt deductions to the scheme manager on the basis that the investor was conducting a business regarding the scheme. This was regardless of the fact that the investor generally had little involvement with the activities of the scheme. The Commissioner s view prior to this time was expressed in TR 2000/8 (which dealt with afforestation schemes) and applied where: the investor had an interest in the relevant product, and the manager was conducting activities in a business-like manner on the investor's behalf. From 1 July 2008, the Tax Office reconsidered its view. As a result, it withdrew TR 2000/8 and issued its revised opinion in TR 2007/8. In this ruling, the Commissioner's revised view was that the investor s contribution to a non-forestry MIS was as a passive investor rather than the carrying on of a business. As such, the investor s contribution to non-forestry MISs would, in his opinion, generally form the first element of the cost base of a CGT asset and would not be an allowable deduction. However at this time, the Tax Office gave an undertaking to test the issue through the Courts. Note this reconsidered view did not impact forestry MISs. Special statutory provisions relating to forestry MISs were introduced with effect from 1 July The relevant test case decision, Hance v Commissioner of Taxation (2008) FCAFC 196, was handed down by the Full Federal Court on 19 December The Court held that deductions were permitted for investment in an almond growing MIS on the basis that each taxpayer participant was carrying on a business. Following this decision, TR 2007/8 was withdrawn. WARNING! See for the Commissioner s recent guidance regarding collapsed non-forestry MISs. To provide protection to investors, many scheme managers will apply to the tax office for a 'product ruling' in relation to their particular MIS. Generally, a product ruling outlines the Commissioner's opinion as to the amount allowable as a deduction under a particular scheme, as well as other tax issues pertaining to the scheme. A product ruling is a binding public ruling that investors may rely upon. However, if the scheme actually carried out is materially different from the scheme that is described in the product ruling, it is not binding on the Commissioner and may be withdrawn. Furthermore, changes to the law will impact on the ruling. An investor who is contemplating investing in a MIS should consult any relevant product ruling where the tax implications may affect the investor s decision. Note: The Commissioner makes no comment in a product ruling as to the commercial viability of the relevant MIS. Investors should seek their own financial advice with respect to this issue. Forestry managed investment schemes One type of managed investment is the forestry Managed Investment Scheme (forestry MIS). A forestry MIS is established for the purpose of establishing a plantation for the future felling and harvesting of trees. Special tax rules apply to such schemes to encourage the expansion of commercial plantation forestry in Australia through the establishment and tending of new plantations for felling. Phone:

14 Typical investment products Investors participating in a forestry MIS receive an interest in the scheme either as an initial participant (those who acquired their investment from the forestry manager of the scheme) or a secondary investor (those who acquired their investment through secondary market trading by purchasing that interest from an initial participant). Tax issues facing investors in forestry MISs Contributions to forestry MISs From 1 July 2007, Division 394 sets out the tax treatment of contributions to forestry MISs, proceeds from harvesting trees under forestry MISs and proceeds from the sale of interests in such schemes. From that time, investors do not need to prove that they are carrying on a business in order to claim a tax deduction for contributions to a forestry MIS (as was required prior to 1 July 2007). Different tax outcomes arise depending on whether the participant is an initial investor (having acquired their investment from the manager of the scheme) or a secondary investor (having purchased their investment through secondary market trading by purchasing that interest from an initial participant). Division 394 enables initial participants to claim an immediate deduction for the contribution into the scheme, provided the scheme meets the following conditions: There is a reasonable expectation that at least 70% of participant contributions will be spent on 'direct forestry expenditure' (the 70% DFE rule). Direct Forestry Expenditure (DFE) includes the costs of establishing, tending and felling trees for harvest. Specifically excluded from DFE are marketing costs, insurance, contingency funds or provisions (other than for employee entitlements), financing, lobbying, general business overheads (but not overheads directly attributable to forestry), subscriptions to industry bodies, financial planning or advisory costs including commissions, compliance fees, legal fees and auditing the 70% DFE rule is calculated using the net present value of cash flows and market values apply the trees must be established within 18 months after the year the contributions were received (an extension applies to the 18 month rule for the replanting of unsuccessful seedlings), and initial participants retain ownership of the interest for at least four years. WARNING: The four year holding period rule under Division 394 has been amended as part of the Tax Laws Amendment (2010 Measures No.1) Act 2010 (see ). The amendment ensures that no loss of deduction occurs where the investor ceases to hold the interest for reasons outside the control of the investor and where the investor could not have foreseen the circumstances. In addition, it is necessary that the plantation under the forestry MIS is established in Australia and that the scheme manager maintains the day-to-day control over the operations. Note: Even if the contribution is a prepaid amount the deduction is available in the year paid. WARNING: If an initial investor sells their interest in a forestry MIS within four years, the deductions claimed will be denied and any relevant tax returns will require amendment. The amendment may take place up to two years after the disposal effectively extending the amendment period. The upfront deduction will not apply to secondary investors who generally hold their interests as a capital asset with the purchase price forming part of the cost base of their investment. Any costs incurred by the secondary investor such as lease fees, annual management fees or costs of felling are deductible expenses. However, these deductions affect the CGT calculation in relation to that interest. Even though forestry MISs are covered by specific legislation, the manager or promoter will typically apply for a product ruling in respect of the scheme. The Commissioner will make a public ruling which applies until the completion of the first clear-fell harvest of the trees. PS LA 2008/2 outlines guidelines followed by the tax office before issuing a forestry MIS product ruling. Shareholdings in forestry companies or unitholdings in a forestry unit trust are not investments in forestry MISs. Investments of these types are capital acquisitions that fall outside the scope of Division 394. Proceeds from forestry MISs The tax treatment (under Division 394) for income relating to forestry MISs will differ for initial investors and secondary investors. The income received by an initial investor is on revenue account, typically including sale or harvest proceeds and the disposal of their interest in the scheme to a secondary investor. Income received by the secondary investor will generally be treated as a capital receipt. However, an exception is income received from the harvest of immature trees (thinning) which will be a revenue receipt for both the initial and secondary investor. Disposal of a forestry scheme interest by a secondary investor will be treated as assessable income, but only to the extent that the proceeds represent the value of (or 'match') deductions obtained for ongoing contributions Taxpayers Australia Inc 2012 & 2013

15 Typical investment products (in relation to lease fees, annual management fees or costs of felling for example). As the initial purchase of a secondary interest is on capital account for most investors (assuming the interest is held as a capital asset), the proceeds would also be capital account, only modified to the extent that some deductions have been claimed on revenue account. This means that harvest proceeds received by a secondary investor may have a revenue and a capital component. Where the sale proceeds are less than the deductions claimed, the proceeds are fully assessable. Further, the CGT rules are modified to ensure the rules apply appropriately when secondary investors return some of the proceeds received as assessable income Changes in response to collapsed MISs There has been considerable publicity regarding the collapse of the Timbercorp and Great Southern groups. Each was prominent in the promotion and operation of Managed Investment Schemes (MIS) whereby investors would, as growers, carry on forestry or non-forestry business operations with the non-forestry activities typically involving grapes, almonds or olives. Consequently, both the Commissioner and the Government have released taxation ramifications in different forms in response to the failure of such schemes. Changes for forestry MISs Tax Laws Amendment (2010 Measures No. 1) Act 2010 passed by the Parliament changes key tax rules for forestry managed investment schemes (MIS) in order to protect investors in the collapsed schemes from unintended adverse tax outcomes. Note: These amendments apply to CGT events happening on or after 1 July A transitional provision is available for taxpayers who have previously had their tax assessments amended to deny deductions but who would have been allowed the deductions if these amendments had been passed at the time. This transitional provision allows the investor s tax return to be amended for up to four years after the CGT event occurred. Before the changes, for an initial investor in a forestry MIS to claim a deduction under Division 394, the four year holding period rule requires that a CGT event does not happen in relation to the investor s forestry interest within four years after the end of the income year in which an amount is first incurred by the investor. The amendments ensure that failing the four year rule does not lead to the denial of a previously allowed deduction, where: a Capital Gains Tax (CGT) event happens because of circumstances genuinely outside the initial investor s control, and the initial investor could not have reasonably anticipated this CGT event happening, at the time they acquired the forestry interest. Situations that could be genuinely outside the initial investor s control include: the accidental death of the initial investor the interest in the scheme being compulsorily transferred, because of marriage breakdown or compulsory acquisition by a government the initial investor becoming insolvent the interest in the scheme being cancelled, because of trees being destroyed by fire, flood or drought, and the insolvency of the manager of the scheme, leading to the winding up of the scheme. NOTE: Events that could not have been anticipated are defined by the legislation as events that could not have been anticipated by a reasonable person with knowledge of the relevant circumstances. Changes for non-forestry MISs The Commissioner provided guidance to affected MIS participants with the issue of three Taxation Determinations (TDs) in relation to non-forestry MISs which deal with: TD 2010/7: when a change of responsible entity for the MIS activities occurs TD 2010/8: the impact of a termination of an MIS on deductions which have previously been allowed, and TD 2010/9: the treatment of monies received by a participant on the winding up of an MIS. Phone:

16 Specialised investment products Specialised investment products Investment products have become increasingly complex and specialised over recent decades. The following paragraphs outline a range of specialised products available in the market, including contracts for difference, stapled securities, traditional securities and warrants. Taxpayers investing in these products may require specialist investment and taxation advice. Contracts for difference A Contract For Difference (CFD) is a high-risk speculative investment from which investors make a profit or loss on the price movement of underlying financial assets without owning those assets. CFDs typically relate to shares, but are also used for share price indices, commodity prices, interest rates, currencies and futures contracts. Under such a contract, the investor takes a position that the underlying share price, for example, will or will not exceed a given price at some time in the future. The CFD holder may take a short position, a long position or both. A short position is taken where the CFD holder believes the value of the underlying assets will fall. A long position is taken where the CFD holder believes the value will increase. The investor receives or pays the difference in price of the underlying security multiplied by the number of units between the time the CFD contract opens and closes. If the investor makes a gain, the provider pays the investor an amount equal to the gain. Conversely, if the investor makes a loss, the investor pays the amount of the loss to the provider. WARNING: CFDs are leveraged instruments. This means that a CFD holder is fully exposed to price movements of the underlying instrument without having to pay the full price of that instrument. CFDs therefore have the potential to incur a larger loss than the holder s initial outlay. Tax issues for holders of CFDs In TR2005/15, the Commissioner states that income received from CFDs will be classified in accordance with the activity that produced the receipt. The Commissioner's view is that income received from CFDs should be treated as follows: a gain from CFD is assessable as ordinary income under s6-5 ITAA97, and loss is allowable as generally deduction under s8-1 ITAA97 if the transaction is entered into as an ordinary incident of carrying on a business, or in a business operation or commercial transaction for the purpose of profit making a gain from CFD is assessable on the capital account as statutory income under s15-15 ITAA97 and loss is allowable deduction under s25-40, if the CFD is entered into in carrying out a profit-making scheme or plan, and not assessable if the gain or loss arose from a gambling or recreational pursuit. Generally, a CFD would be entered into as a business transaction or profit making scheme. However, the Commissioner states in TR 2005/15 that where the CFD is not entered into with a purpose of business or profitmaking, it is likely that the purpose with which it is entered into will be as an unusual form of recreational gambling. On that basis, no capital gain or loss would arise due to the gambling exemption in s118-37(1)(c). However, the Commissioner has given an undertaking to test this issue (termed 'spread betting') through a suitable test case being placed before the Administrative Appeals Tribunal or a Court. CFD related Interests and dividends Interest is calculated on contracts that remain open at the end of each day. Holders of CFD pay interest on open buy contacts and receive interest on open sell contracts. Typically these amounts will be taxable as ordinary assessable income and an allowable deduction available for any interest paid. Other revenue amounts may arise by certain events occurring in respect of the underlying shares, such as the share goes ex-dividend, bonus shares issue, rights issues. CFD holders pay an amount equivalent to the cash dividend declared on sell contracts that were open prior to the day the underlying shares go ex-dividend. Conversely, investors receive an amount equivalent to the cash dividend declared on buy contracts that were open prior to the day the underlying shares go ex-dividend. Stapled securities A stapled security combines at least two securities, typically a company share and a trust unit, which are contractually bound together as a single entity and cannot be sold separately. While the stapled security can only be bought or sold as a single unit, the investor maintains the rights and obligations attached to each individual security. Income received may include both a dividend and a trust distribution. If the dividend is paid by an Australian company, the dividend is frankable and a franking credit offset may be available to Australian resident taxpayers. Taxpayers Australia Inc 2012 & 2013

17 Specialised investment products Where the dividend or distribution is paid from a non-australian company or trust, the amount will be treated as foreign income. Stapling of securities is not limited to companies and trusts interests. Other securities such as convertible notes and preference shares have also been traded as a stapled security. Tax issues facing investors in stapled securities Distributions on stapled securities Investors can receive at the one time separate payments for dividends and trust distributions paid on the interests in the companies and unit trusts underlying the stapled securities. These components retain their separate legal character for tax purposes and must be recorded and reported separately. The company dividend component is assessed in the tax year received whereas the trust distribution is assessed on an accruals basis in the income year it relates to. It can be quite common for a stapled security to have an underlying company dividend and trust distribution taxed in separate income years. Trust distributions may include a tax deferred component which is not subject to tax. The annual tax statement will state the tax deferred amount included in the trust distribution. This amount must be used to reduce the cost base of any units held in the trust, therefore impacting the calculation of any capital gain or loss on units on a subsequent disposal. Disposal of stapled securities Capital gains or losses on the disposal of stapled securities are treated separately for each of the underlying securities. The CGT consequences are calculated by apportioning the purchase costs and sale proceeds to each underlying company and/or trust holding. This allocation should be made on a reasonable basis. Calculating the cost base of each underlying security will include: the value of the original securities the value of any securities received via the reinvestment of income, and where applicable a reduction of the cost base for the tax-deferred component of any trust distribution received. Once this allocation has been made, the usual CGT rules will apply to the disposal of the components of a stapled security. Scrip for scrip roll-over relief may be available to allow a shareholder to disregard a capital gain where a share is disposed of as part of a corporate takeover or merger and shareholder receives a replacement share in exchange. Where shares are exchanged for stapled securities comprising shares and units, scrip for scrip rollover is only available to the extent that the shareholder receives replacement shares. Refer TA 2008/1 warning taxpayers with respect to certain stapled securities involving notes and preference shares. Traditional securities For tax purposes, a traditional security includes certain securities acquired by the taxpayer after 10 May 'Securities' for these purposes include stocks, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes, bank or financial institution deposits and secured or unsecured loans. Generally, it is required that a traditional security must not have an eligible return unless two further conditions are satisfied: the precise amount of the eligible return must be ascertainable at the time of issue, and the security must not be issued at a discount of greater than 1.5% multiplied by the number of years, including fractions of a year, of the term of the security. Further, a traditional security must not bear deferred interest and must not be capital indexed. NOTE: A unit in a property or cash management public trust is not a security. Intercompany loans where there are deposits and withdrawals fall within the definition of a security. Tax issues of holders of traditional securities Gains or losses on the disposal of traditional securities Gains and losses on the disposal of traditional securities acquired after 10 May 1989 are taxed under special rules (s26bb, s70b ITAA36). A gain made on the disposal or redemption of a traditional security is included in assessable income under s26bb in the income year in which the disposal or redemption takes place. Section 70B provides that a loss on disposal or redemption of a traditional security may be an allowable deduction in the income year in which the disposal Phone:

18 Specialised investment products or redemption takes place. Note that the issuer s gain or loss on redemption is not assessable under s26bb or deductible under s70b as these provisions only affect holders of traditional securities. When the disposal of traditional securities is for non-cash consideration (such as shares), the consideration is deemed to be the market value of the property given (s21 ITAA36). Note: Death of a traditional security holder is not a disposal of that security. A disposal occurs when the executor or beneficiary disposes of the security. Calculation of the gain or loss on traditional securities The gain or loss on disposal or redemption is calculated as the difference between any consideration received on disposal or redemption and the acquisition cost plus relevant costs of acquisition or disposal. Unlike the CGT rules, there is no indexation of the cost of the security or discount of the gain. The gain on partial disposal or redemption of the traditional security would be calculated on a proportional basis. EXAMPLE: A traditional security was acquired on 15 August 1994 for $10,000. A 50% interest was sold for $6,000 in the current year of income. $1,000 is assessable in the current year calculated as $6,000 less 50% of $10,000. Refer TA 2008/1 warning taxpayers with respect to certain stapled securities involving notes and preference shares. Removal of the taxing point on conversion or exchange of certain traditional securities Section 26BB and s70b ITAA36 will not apply when a traditional security converts or exchanges into ordinary shares where the traditional securities were issued after 7.30 pm, legal time in the Australian Capital Territory, on 14 May This means there will be no taxing point or no deduction allowable for a gain or loss when a traditional security converts or exchanges into ordinary shares. The holder of the interest that is exchanged into shares of a company acquires the shares when the exchange of the interest happens. For the purpose of the CGT discount in Subdivision 115-A ITAA97, the period of ownership of a share acquired on exchange commences when the share is acquired on exchange, not when the original security is purchased. NOTE: This does not apply where traditional securities convert or exchange into interests other than ordinary shares. EXAMPLE: A taxpayer in year 1 acquires on issue an exchangeable note for $100 which has a face value of $100. The interest is acquired on 1 July The exchangeable interest has a term of five years, subject to the holder s annual option to exchange it into one ordinary share. In each of the years the exchangeable interest is not exchanged the taxpayer will receive $5 interest income. The exchangeable note is a traditional security and is an exchangeable interest under s of the ITAA97. At the beginning of year 3, the taxpayer exchanges the interest for a share with a market value of $110. Due to the application of s26bb(5) of ITAA36, the gain of $10 is not included in the taxpayer s assessable income at the time of exchange. There will be no need to avoid double taxation occurring on the eventual sale of the share because there is no taxing point in relation to disposal of the share prior to that time. Accordingly, when working out the first element of the cost base of the share there is no need to increase the cost base by an amount that has reduced a capital gain made on the exchangeable interest. The exchange of the interest leads to the taxpayer making a capital gain (even though the capital gain is disregarded). Subsection (1) of ITAA97 does not reduce that capital gain because there is no s26bb ITAA36 amount. As a result, the first element of the cost base of the share would be $100. This is the $100 purchase price of the exchangeable interest (assuming this is the cost base of the interest at the time of conversion). The $5 interest the taxpayer receives annually on the exchangeable interest does not form part of the cost base of the share. This is because s does not reduce the capital gain by those amounts. If the taxpayer then sells the share for $120, the taxpayer will have a capital gain of $20. Note: Forgiveness or waiver of a debt is not a disposal of a traditional security for traditional security purposes (s70b(5)) (see ). A loss is not deductible when disposals or redemptions occur because of the issuer s financial difficulties. When a security was previously issued by an insolvent company, a disposal does not occur under s70(b) when a traditional security matures. A disposal only occurs when the issuer redeems the securities (via a Court approved scheme or otherwise) at a loss. A traditional security issued by a company that has gone into liquidation is not disposed of when the liquidator has made a final payment to the holder of the security or where no payments are to be made by the liquidator. Section ITAA97 operates to modify the reduced cost base of a security by any capital loss deductible under s70b. Note a loss incurred on the waiver or release of a debt classified as a traditional security does not give rise to a deduction. Taxpayers Australia Inc 2012 & 2013

19 Specialised investment products Interest derived on a traditional security Interest derived on a traditional security is assessable to the holder as ordinary income under s6-5. It is not affected by the operation of s26bb. Warrants Instalment warrants are a geared lending product offered by certain institutions which allow an investor to take an interest in underlying assets, such as listed shares. Investors pay some of the cost up-front, and take the balance of the asset price as a loan which is limited recourse (for example, if the share value falls the investor does not suffer the loss). The underlying assets are held in trust until the investor pays out the warrant or exercises an option to buy the asset at the higher of the loan balance or the current market price of the asset. The investor is entitled to receive the income from the underlying asset (eg. dividends on the shares), Alternatively, the investor may roll-over the warrant and not change the underlying asset, or do nothing in which case the asset is sold without recourse to the investor if the sale proceeds do not meet the outstanding debt. The warrant may be accessed by cash application to the issuing institution (eg. about 50% of the share price up-front), by application by certain holders of existing shares or by investors rolling over earlier instalment warrants. Tax issues faced by investors in warrants Deductibility of interest Interest under the loan component of a warrant is generally tax-deductible for amounts pre-paid for up to 12 months (non-business individual investors), provided the interest period ends by the last day of the income year following the expenditure year and the dominant purpose of the investor in entering the arrangement is to derive assessable income from the investment (eg. dividends on shares). CGT issues CGT is also relevant. The part of the purchase price which relates to purchasing the right to sell the asset back to the issuer (the put option ) can form part of the cost base of the relevant underlying asset (eg. the shares) if the option is exercised and the asset is sold back (see Chapter 11). The cost base of the underlying asset is adjusted to remove the amount of any shortfall on the loan amount which the investor does not have to repay. If the put option expires without being exercised, a capital loss is made equivalent to the option fee. The tax implications may also be different if the investor is a trader or not an Australian resident. Dealings between the investor and the institution must also be at arm s length. Financial arrangements from 1 July 2010 (or 1 July 2009 by election) There have been numerous financial products introduced to financial markets resulting in ad-hoc amendments to the tax laws in response to specific pressure after new products were introduced. However, Division 230 was included in ITAA97 by the Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 (which received Royal Assent on 26 March 2009) to ensure that the tax laws kept pace with financial innovation. The Act enacted stages 3 and 4 of the Taxation of Financial Arrangements (TOFA 3 and 4) measures. The purpose of these amendments was to provide consistent taxation treatment of financial arrangements. The law now defines a financial arrangement and sets out different methods for bringing gains and losses on financial arrangements to account for tax purposes. Most gains and losses are on revenue account under Division 230. A financial arrangement for these purposes is defined as a cash settleable right to receive, or an obligation to provide, a financial benefit which exists under an arrangement. The right or obligation will be cash settleable where the financial benefit is money or a money equivalent. Arrangements commonly coming within the definition of financial arrangement include bank deposits, bonds, convertible notes and loans. Generally, individuals are excluded from the rules, as are other entities that meet certain thresholds (that is superannuation entities or MIS with less than $100 million in assets, financial sector entities with less than $20 million aggregated turnover or other entities with: aggregated turnover of less than $100 million financial assets less than $100 million, and total assets of less than $300 million. However, where a financial arrangement is a qualifying security of more than 12 months duration, the above taxpayers will not be excluded. A premissory note with a term of greater than 12 months would be an example of an instrument which, if held by an individual or small business entity, would be subject to Division 230. Division 230 applies to financial arrangements entered into on or after 1 July 2010 (or 1 July 2009 by election). Phone:

20 Common deductions allowable to investors NOTE: Taxpayers subject to the current Division 16E rules will need to consider the new Division 230 which replaces Division 16E with respect to future qualifying securities. Common deductions allowable to investors To be deductible, a loss or outgoing must be incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining or producing assessable income. Further, the expenditure cannot be private expenditure or capital in nature. A general checklist is set out at See also (rental properties). Discussed below are some of the typical deductions issues on losses or outgoings incurred by investors. Borrowing costs Borrowing costs may be claimed on certain loans for an income-producing purpose. Typically, borrowing costs include legal expenses on preparing and filing mortgage documents, loan establishment fees, mortgage insurance, stamp duty on mortgage documents, title search and valuation fees charged by the lender, mortgage broker fees and other costs on the taking out of the loan. If the costs are greater than $100, the deduction is spread over the lesser of the term or the loan or five years. See Capital protected loans - interest and fees A capital protected borrowing is usually a limited recourse loan facility to fund the purchase of listed shares, units in a unit trust or managed fund or stapled securities. Typically, investors are protected from a fall in the price of the shares as the investor has the right to transfer the shares back to the lender for the outstanding balance on the loan. This means that should the asset value fall below the principal, a portion of the principal does not have to be repaid. Instalment warrants are a form of capital protected borrowing. Capital protected loans generally attract a fee for capital protection or a higher rate of interest. Generally, the treatment of capital protected products or borrowings is dependent upon whether the investor entered into or extended the arrangement before 9.30am on 16 April 2003, between 9.30am on 16 April 2003 and 30 June 2007, between 1 July 2007 and 7:30pm 13 May 2008 and arrangements entered into after 7:30pm 13 May See for a detailed summary of tax treatment of capital protected loans, their entering time and adjusted appropriate benchmark interest rates. important: The Tax Laws Amendment (Measures No 5) Bill 2010 amended Division 247 ITAA97 to establish a benchmark interest rate based on Reserve Bank of Australia indicator lending rates. Depreciation Certain items of equipment or other assets used to produce assessable income may be depreciated, such as the computer and software used to manage an investment portfolio. This means a gradual claim is made for these items over their effective lives or low-value pooling may be available (see ). See for listed items. Discharge of mortgage expenses The costs involved in discharging a mortgage are deductible where the mortgage was security for the repayment of money borrowed to produce assessable income. Amounts may include penalty interest for early repayment of a loan (see ). Home office expenses A portion of home office running costs can be claimed where a distinct part of a home is used for incomeproduction. The Commissioner will accept diary records covering a representative four week period as establishing a pattern of use for the entire year. As an alternative to claiming the actual costs incurred, the Commissioner also accepts a claim of 34 cents per hour ( from 1 July 2010) for heating, cooling, lighting and decline in value of furniture (see PS LA 2001/6). The decline in value of office equipment such as computers is calculated separately. Occupancy expenses (such as rent, mortgage interest, rates and insurance) cannot be claimed unless a portion of the home is set aside as a place of business. Generally, mere investors will be unable to satisfy this requirement. Interest deductions Interest may be claimed as a deduction in certain cases when the loan funds were applied to income-producing purposes. This means the loan must have been used in a genuine attempt to produce assessable income (eg. purchase of a rental property, purchase of income-producing shares or purchase of a business). Interest cannot be Taxpayers Australia Inc 2012 & 2013