Eligible investment business: loan - Division 6C of the Income Tax Assessment Act 1936

Whether a participating loan provided by a managed investment scheme (MIS) is a 'loan' for the purposes of the definition of 'eligible investment business' in subparagraph 102M(b)(i) of Division 6C of the Income Tax Assessment Act 1936 (ITAA 1936).

No, the participating loan is not a 'loan' for the purposes of the definition of 'eligible investment business' in subparagraph 102M(b)(i) of the ITAA 1936.

Investors will subscribe for units in a unit trust which is also a MIS for the purposes of section 9 of the Corporations Act 2001 . The MIS will use the subscription monies, together with external borrowings, to provide what is called a participating loan to an unrelated entity (entity X).

Entity X will use the funding provided by the MIS under the participating loan to acquire a number of new residential properties which will be rented to tenants at arm's length. The funding provided by the MIS under the participating loan will represent a percentage of the cost to be incurred by entity X in acquiring all residential properties.

The participating loan provided by the MIS to entity X will have the following features: • it will not bear any interest • no periodic repayments will be required to be made by entity X • it will have a term of ten years • at the end of this term, entity X will be required to pay the MIS the amount due and payable under the participating loan agreement. The amount due and payable will be equal to 80% of the 'adjusted net sales value' of all the residential properties. This amount will be secured by mortgages held by the MIS over the residential properties, and • the amount payable by entity X under the participating loan agreement will be secured by mortgages held by the MIS over the residential properties

The concept of 'adjusted net sales value' is a defined term under the participating loan agreement and represents an agreed valuation of all the residential properties at the end of this term. Under the participating loan agreement, the 'adjusted net sales value' will be determined on the basis that all properties are fully and properly maintained during the ten year term.

Subparagraph 102M(b)(i) of the ITAA 1936 provides:

In this Division, unless the contrary intention appears: ' eligible investment business' means one or more of: (a) ...; or (b) investing or trading in any or all of the following: (i) secured or unsecured loans (including deposits with a bank or other financial institution); (ii) ... ; (iii) ... ; (xiii) any similar financial instruments; or (c) .........

The word 'loan' is not a defined term in Division 6C of the ITAA 1936. Accordingly, the question of whether the participating loan is properly characterised as a loan will need to be determined by reference to its ordinary meaning.

The Macquarie Dictionary , 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW defines 'loan' as follows: ...something lent or furnished on condition of being returned, especially a sum of money lent at interest

Butterworths Concise Australian Legal Dictionary , 2004, 3rd edn, LexisNexis, NSW defines a 'loan' as: An advance of money; the provision of credit; the payment of an amount on behalf or at the request of a person where there is an obligation to repay the amount; or a transaction which in substance affects a loan of money.

Judicial decisions suggest a similar interpretation. The decision in Inland Revenue Commissioners v. Rowntree and Co. Ltd [1948] 1 All ER 482 provides that for a facility to be characterised as a loan there must exist the legal relation of lender and borrower which gives rise to a loan of money in return for which there is a promise to repay.

In Re Securitibank Ltd (No.2 ) [1978] 2 NZLR 136, Richardson J stated at 167 that: ... the essence of a loan of money is payment of a sum on condition that at some future time an equivalent amount will be repaid.

Sackville and Lehane JJ in Federal Commissioner of Taxation v. Radilo Enterprises Pty Ltd (1997) 72 FCR 300; (1997) 34 ATR 635; (1997) 97 ATC 4151 noted that: a loan involves an obligation on the borrower to repay the sum borrowed.

The Commissioner is of the opinion that the above definitions and case law provides the following understanding of the ordinary meaning of the word 'loan' for the purposes of subparagraph 102M(b)(i) of the ITAA 1936 and is succinctly expressed by the definition of 'loan' found in Joseph, C 1989, Chitty on Contracts , 26th edn, Sweet & Maxwell, London (at page 3574): A contract of loan of money is a contract whereby one person lends or agrees to lend a sum of money to another, in consideration of a promise express or implied to repay that sum on demand, or at a fixed or determinable future time, or conditionally upon an event which is bound to happen, with or without interest.

Under the arrangement, the MIS will provide entity X with the participating loan to assist with entity X's acquisition of residential properties, whereby entity X will be required to pay the MIS the amount due and payable under the participating loan agreement at the end of a ten year term. The amount due and payable will be equal to 80% of the 'adjusted net sales value' of all the residential properties.

The concept of 'adjusted net sales value' is a defined term under the participating loan agreement and represents an agreed valuation of all the residential properties at the end of this term. Under the participating loan agreement, the 'adjusted net sales value' will be determined on the basis that all properties are fully and properly maintained during the ten year term.

Due to the possible favourable or unfavourable movements in the 'adjusted net sales value' of a property over the term of a loan, the amount ultimately paid by entity X to the MIS under the participating loan agreement may be greater than or less than the amount initially provided by the MIS to entity X.

More importantly, the amount ultimately paid by entity X to the MIS under the participating loan agreement is not calculated by any reference to the amount of what is initially provided by the MIS to entity X.

Therefore, under the terms of the participating loan agreement there is no repayment to the MIS by entity X of a sum borrowed. Accordingly, in these circumstances there is no loan within the meaning of subparagraph 102M(b)(i) of the ITAA 1936 of the definition of 'eligible investment business' within section 102M of the ITAA 1936.