Issue
Will an investment in full or associate membership interests in the Board of Trade of the City of Chicago Incorporated (Chicago Board of Trade) by a public unit trust constitute an investment in a 'similar financial instrument' for the purposes of section 102M of the Income Tax Assessment Act 1936 (ITAA 1936)?
Decision
Yes. The investment will constitute an investment in a 'similar financial instrument' and will meet the definition of an 'eligible investment business' in section 102M of the ITAA 1936.
Reasons for decision
Division 6C of the ITAA 1936 treats certain trusts known as 'public trading trusts' as companies. In particular, the trustees of such trusts are taxed at the company rate and distributions to equity holders are taxed on the same basis as dividends.
A trust is a public trading trust, and therefore subject to Division 6C of the ITAA 1936 if it satisfies four requirements (section 102R of the ITAA 1936): • the trust is a public unit trust • the trust is a trading trust • either the trust is a resident unit trust or was a public trading trust of the preceding income year, that is, it was a resident in a previous year, and • the trust is not a corporate unit trust within Division 6B of the ITAA 1936.
Where these conditions are satisfied, the trust is a public trading trust and is subject to tax on its net income at the company tax rate.
A unit trust is a trading trust if it carries on a trading business or controls or is able to control, directly or indirectly, a trading business carried on by another person (section 102N of the ITAA 1936). A 'trading business' is any business that does not consist wholly of 'eligible investment business' (section 102M of the ITAA 1936).
Division 6C of the ITAA 1936 does not apply to widely held trusts where all the business of the trust relates to an 'eligible investment business'.
'Eligible investment business' is defined (section 102M of the ITAA 1936) to mean one or more of: • investment in land for rental, or • investment or trading in loans (secured or unsecured), securities, shares (including shares in a foreign hybrid company), units in a unit trust, futures contracts, forward contracts, interest rate swap contracts, currency swap contracts, forward exchange rate contracts, forward interest rate contracts, life insurance contracts, or rights or options in respect to any of these, or any similar financial instruments.
If the activities of the taxpayer consist wholly of an 'eligible investment business', then the taxpayer will not be conducting a trading business and will be excluded from the provisions of Division 6C of the ITAA 1936. Accordingly, tax will be paid by the beneficiaries upon distribution of income at their respective rates of tax applicable and not by the taxpayer at the corporate tax rate.
The Chicago Board of Trade (CBOT) is a US resident entity incorporated in the state of Delaware. CBOT is a member owned, non stock, not for profit organisation.
Both full and associate membership interests in CBOT confer rights in respect of voting, dissolution and trading privileges. Generally, full membership will confer a right to vote, a share in the proceeds from dissolution and entitlement to trade as principal or broker in all listed contracts. Associate membership confers a one-sixth right of a full membership interest in respect of voting and dissolution and entitlement to trade as principal or broker in certain prescribed listed contracts.
Returns on the investment in CBOT membership interests may be via: • the trading of membership interests via an 'over-the-counter' facility with potential for a capital gain on disposal of the membership interest, and • generation of monthly lease income by leasing of the CBOT membership interest to traders. Lease payments received from the traders for the right to trade are negotiated with the lease rates varying over time with demand for trading rights. Neither the fund nor the rulee will trade on the floor of the exchanges.
As the CBOT is a non-stock corporation, it is not possible to invest in it via a share or stock in legal form acquisition. Accordingly, the proposed investment would not fall under the 'shares in a company' part of the definition of 'eligible investment business' (subparagraph 102M(b)(iii) of the ITAA 1936). It is necessary to determine whether or not such activities will fall within the 'any similar financial instrument' part of the definition of 'eligible investment business' (subparagraph 102M(b)(xiii) of the ITAA 1936).
'Membership interest' in an entity is defined in subsection 995-1(1) of Income Tax Assessment Act 1997 (ITAA 1997) to have the meaning given by section 960-135 of the ITAA 1997. In relation to a company, section 960-130 of the ITAA 1997 lists a member as 'a member of the company or a stockholder in the company'. Section 960-135 of the ITAA 1997 equates a membership interest in an entity to an interest in the entity or a right in relation to the entity for the member of that entity.
'Shares' is defined in section 6 of the ITAA 1936 (and subsection 995-1(1) of the ITAA 1997) to mean shares (a share) in the capital of the company and includes stock.
'Company' is defined in section 6 of the ITAA 1936 (and subsection 995-1(1) of the ITAA 1997) to include all bodies or associations corporate or unincorporated, but does not include partnerships or non-entity joint ventures.
CBOT, being an incorporated entity, would fall within the definition of a company. Each membership interest investment in CBOT allows for a share in the proceeds on dissolution of the entity (company) and therefore, represents a right to a share in the capital of the entity (company).
It is arguable that a membership interest is ostensibly the same as a legal form share on the basis of entitlement to a share in the capital of a company. On this line of reasoning, an acquisition of a membership interest in CBOT would fall within the definition of 'eligible investment business' within the 'shares in a company' part of that definition (subparagraph 102M(b)(iii) of the ITAA 1936). Nevertheless, it is submitted that the better view would be to limit this legal analysis to the 'any similar financial instrument' part of the definition.
The Explanatory Memorandum to Taxation Laws Amendment Bill (No. 4) 1988 addresses what 'any similar financial instrument' actually means: The reference to 'any similar financial instruments' in subparagraph 102M(b)(xiii) is intended to obviate the need for further amendments to the term 'eligible investment business if further acceptable variants of existing financial instruments are developed. A public unit trust will therefore be able to trade or invest in new financial instruments and not be treated as a public trading trust provided that the new financial instrument invested in or traded in is similar to any of the types of financial instruments referred to in the proposed expanded definition of 'eligible investment business'.
The Explanatory Memorandum to Taxation Laws Amendment Bill (No. 4) 1985, introducing Division 6C of the ITAA 1936 mentions, inter alia, that: A unit trust will come within the scope of the proposed amendments if, at any time during a year of income, it operates a trade or business and is also a "public unit trust". Public unit trusts of the more traditional kind the business of which is to invest in land or interest in land for rental purposes, in equities or securities or a combination of these, will not be affected.
If it is considered that a membership interest in a company is not the same as a legal form share/stock in a company then, for the reasons expressed above, it can be argued that such an interest is a close equivalent or, at least, that a membership interest is an acceptable variant of or similar to an existing prescribed financial instruments (that is, legal form share or stock). Accordingly, on the basis of the comments in the Explanatory Memorandum, a membership interest acquisition in CBOT would fall within the 'any similar financial instrument' part of the definition of 'eligible investment business'. Furthermore, the acquisition of the membership interest parallels the more traditional kind of investment activity such as an investment in equities or securities. This is because the fund envisages a return on the investment by way of a gain on the realisation of the investment, or by leasing out the right to trade associated with the membership interest.
Therefore the fund will be investing in membership interests in CBOT in its capacity of a public unit trust and its investing activities fall within the requirements of section 102M of the ITAA 1936 because it is carrying on an 'eligible investment business'.