Critically Analyse the Argument that Investor’s Contributions to Such Schemes are Capital or of a Capital Nature - Capital Essay Example

2 - Critically Analyse the Argument that Investor’s Contributions to Such Schemes are Capital or of a Capital Nature introduction. Critically Analyse the Argument that Investor’s Contributions to Such Schemes are Capital or of a Capital Nature and are therefore Not Deductible under Section 8 of the ITAA 1997

The deductibility of the contributions under sec 8 of the ITAA 1997 depends upon the determination of the nature of the expenses; whether they are of capital nature or of a revenue nature being a business expense. In this respect two sets of arguments can be attempted to arrive at a conclusion about the deductibility of the investors’ contributions.

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Arguments in Favour of Changes Suggested under TR 2007/D2 (Investments Not-Deductible)

The requirement of Sec 8-1 of the ITAA 1997 for the purpose of deductibility is that the amount expended should be capable of producing some assessable income by means of some business activity being carried out with the amount invested. Capital expenses or expenses in the nature of capital are specifically excluded by sec 8. As has been decided in Vincent V Commissioner of Taxation [2002] FCAFC 291 at [60][1] the investments in the agricultural Managed Investment Scheme can be categorized as capital expenditure and hence cannot be deducted.
It is also appropriate to determine the nature of the interest being acquired by the investors by becoming a member of a registered managed investment scheme, as to whether such interest represents capital or not and also whether the income derived from the investments is to be treated as income from the business carried out by the investors themselves.
For considering the capital nature of the investors’ interests, the relevant provision are chapter 5C of the Corporations Act dealing with registration and regulation of the management schemes and section  9 of the Corporations Act that defines the ‘managed investment Scheme’. While section 601 FA defines the ‘responsible entity’ Clauses (a) to (e) of Section 9 defines ‘scheme property’.

The decision in the case of Enviro Systems Renewable Resources Pty Ltd v. Australian Securities and Investments Commission [2001] SASC 11[2] is also relevant in that the concept of ‘responsible entity’ is established and the success of otherwise of the scheme is dependent on the functioning of the ‘responsible entity’ without the participants having to contribute any business skills other than investments and such investors are to be treated as passive investors.

A number of other decisions in cases like Waldron v. Auer [1977] VR 236 and ASIC v. Enterprise Solutions 2000 Pty Limited (2000) QCA 452; Crocombe v. Pine Forests of Australia Pty Ltd [2005] NSWSC 151; ASIC v. Pegasus Leveraged Options Group Pty Ltd (2002) 41 ACSR 561[3] added further dimensions to this view.

Similarly decisions in the case of Investa Properties Ltd & anor [2001] NSWSC 1089; ASIC v. Knightsbridge Managed Funds Ltd & anor [2001] WASC 339; In Southern Wine Corporation Pty Ltd (in liq) v. Frankland River Olive Co Ltd & anor [2005] WASC 236[4] determined the nature of the scheme property to be covered under section 9 of the Corporations Act.

From a consideration of the concepts of the ‘responsible entity’ and ‘scheme property’ on the basis of the legal provisions and decided cases, it evolves that “it is income in the hands of the responsible entity ‘clearly held by it as trustee’ (Southern Wine Corporation)”I.  it has further been clarified whether the pooled resources of the investors passing to the hands of the responsible entity represents scheme property; whether the property would be held by the responsible entity as trustee for the contributing investors and whether the income derived by the responsible entity from the sale of the produce is to be treated as income derived by a trustee.
From the above discussions and from the decision in the case of Puzey v. FC of T [2002] FCA 1171[5] it can be argued that it is the trustee who is carrying on the relevant business and not the individual investors and hence the income derived by the investors cannot have the character of the income from the business carried on by the investors themselves.  It can be construed that the same treatment can be extended to the scheme properties also. Thus when the investment s yield no business income assessable to tax the investments are to be treated as capital expenditure only.

The decision s in the case of Commissioner of Taxation v. Cooke [2004] FCAFC 75 and Commissioner of Taxation v. Sleight [2004] FCAFC 94[6] give rise to another concept of ‘passive investments’. In these cases it has been held that since the investors has their own businesses to carry on apart from their investments in agricultural managed investment schemes and hence cannot be considered to have carrying on any business in respect of the income derived from the investments in managed investment schemes. Hence the investments are to be considered to be of a capital nature not yielding any business income assessable under sec 8 of ITAA 1997
The contributions by the investors may also be treated as fees payable to the administrators of the scheme to conduct the business on their behalf in which case also the contributions are not eligible for any deduction.
The proper treatment of the income derived from the managed investment schemes is that the share of returns in the hands of the investors should be treated as a share of net income of a trust property assessable under Division 6 of Part III of the ITAA 1936. Hence the contributions cannot be claimed as deductible under sec 8 of the ITAA 1997. An alternative position that may be taken is to treat such income as representing ordinary income from property chargeable under sec 6-5 of the Act.
Arguments in Favour of deduction of the investments (Existing Position):

Though the decisions in the case of Commissioner of Taxation v. Cooke [2004] FCAFC 75 and Commissioner of Taxation v. Sleight [2004] FCAFC 94) and Puzey v. FC of T [2002] FCA 1171[7] contribute to the view that the investors cannot be construed to take part in the day to day business of the managed schemes, the mere factors like passive investments, lack of control in the scheme business and sharing of the net proceeds from the managed schemes as returns from the investments are not conclusive enough to disprove that the investors are running their own separate businesses in the form of managed scheme investments for the purposes of paragraph 35 of the taxation ruling TR 2000/8 on which the question of the capital nature or otherwise of the investments depends.  Hence the investors must be considered to have been running the business themselves and the deriving of business income there-from gives the investments the character of capital expenditure for the purposes of sec 8 of ITAA 1997.
If the investors are to be treated as the beneficiaries of the schemes considered as trust, then the ‘responsible entity’  as the trustee becomes only the ‘manager’ of the business, since the investors represent the primary owners of the properties with their rights of access to land by virtue of the agreements. The payments made by them then take the character of fees or provision of management services which otherwise are deductible as business expenses and cannot be treated as capital expenses. Moreover only when the management investment scheme is registered, the concept of the responsible entity holding property on trust arises.
It can be argued that the decision in the Puzey’s case that investor’s contribution as ‘plantation establishment fees’ was on capital account has a limited application and relevance to that case only and the principle cannot be generalized to colour all the investors’ contribution as capital expenditure. The decision of the court in Cooke’s case not to admit the argument that “any part of the investors’ contributions were for the acquisition of any rights of an enduring nature, so as to be capital expenditure” will add strength to this argument.
What is relevant for the consideration of the nature of the expense is the legal form of the scheme and the purpose for which the investments are made. The way in which the investments are made and the way in which the returns are shared are of no relevance for the determination of the nature of the outgoings or losses.
 

 

Conclusion:

Having considered the arguments for and against the deductibility of the investments in the managed investment scheme under sec 8 of the ITAA 1997, it can be concluded that these investments are to be treated as capital expenditure not eligible for deduction under sec 8 due to the following reasons:

The parting of the monies by investors towards contributions to the managed investment schemes is to be treated in the same lines as investments in any in shares and stocks of different companies for earning a profit and treated as capital expenses.
For treatment as revenue expenses expended for business purposes the criteria of recurrence also needs to be considered. These investments are one time expenses that have the character of capital expenses.
The arguments and settled case laws supporting the view of non-deductibility outweigh the arguments supporting the investments as deductible and hence the investments are to be held as capital expenses not deductible under sec 8 of ITAA 1997.
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3. Critically analyse the argument that investors in such schemes are ‘passive investors’ who do not carry on a business and therefore not entitled to deductions for their contributions to such schemes:

Arguments to suggest that investors are passive investors and hence the contributions are not deductible:

The arguments in favour of the proposition that the contributions made by the investors represent passive investments and hence they cannot be claimed as deductions under section 8 of the ITAA 1997 takes the following stand:

Much reliance is placed on the full federal court decision in the case of Puzey v. FC of T [2003] FCAFC 197[8] where it is held that because of the introduction of a trustee in to the scheme, the investor cannot be considered to carry on any business in connection with the agricultural income. The fact that under the management investment scheme the agricultural property is considered to be held in trust as a scheme property under the provisions of Chapter 5C of the ITAA 1997 by virtue of the established case laws, makes the investors only passive investors who do not carry on any business.
The decision in Vincent V Commissioner of Taxation [2002] FCAFC 291 at [60][9] can also be cited as supportive of passive investment where the court ruled that though money was invested by Ms. Vincent, she cannot be considered as running the business. Here although the term ‘passive investor’ was not used, she was considered so and hence the amounts were declared not deductible;
The term ‘passive investor’ was coined in the case Clowes v. FC of T (1954) 91 CLR 209; HCA 10[10]. The circumstances prevailed in the clowes case are identical to those to which the proposed changes by TR2007/D2 apply. In the circumstances described by TR 2002 D2 also the investors make a lump sum investment and wait for their shares of return from the business conducted by the organisers of the managed investment scheme. Hence the investments by the investors are to be treated as capital expenses in the light of the decision in clowe’s case.
The majority decision given in the case of Clowes was subsequently accepted by the courts in the case of Milne v. FC of T (1975-76) 133 CLR 526[11]. Similarly in the case of FC of T v. Lau (1984) 6 FCR 202[12] in view of the fact that the investor had larger controlling interest in the business as distinct from the cases of Clowes and Milne, the court accepted the distinguishing features that made the investments to be treated as capital expenditure and ruled differently. This goes to prove that there are many instances of case laws, where the different courts have recognized the character of the investments in managed investment schemes being passive investment and hence made the investments not deductible under sec 8-1 of ITAA 1997.
 

Arguments to suggest that investors are NOT passive investors and hence the contributions are deductible:

The arguments that go to suggest that the investors in the managed investment scheme are not passive investors are detailed below:

The passivity in the investment is decided by the extent to which the investor is involved in the business of the managed investment scheme. Similarly the fact that whether the investors are carrying on their business also affects the position of the investor. The Ruling TR 2007 D2 tries to substantiate the claim of passive investments by citing the decisions in the cases of Cooke and Sleight where there is the instance of the investors carrying on their own business and hence the amount of expenses were not deductible. But the circumstances of these cases cannot be equated fully to the present scenario where the investors irrespective of the fact that whether they carry on their own separate business or not must be treated as carrying on business of the scheme because of he fact that without their investments the schemes would not have been taken off at all. The investments form the basis for the ultimate questions of passivity, lack of control and sharing of the returns etc. Thus since the business of the scheme itself is dependent upon the investments the investors are naturally to be treated as running the business and hence cannot be considered as ‘passive investors’. Consequently the investments should be treated as deductible.
Conclusion:

Due to the fact that the investments form the basis for the business of the schemes it can be concluded that the contributions by the investors are to be treated as made for running their own business and should  be considered for deduction under the provisions of ITAA 1997. However mere passivity alone can not be taken as the criteria for deciding on the deductibility of the investments.

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4. Critically anslyse the proposition that even if the contributions are deductible they are subject to the prepayment rules contained in sections 82 KZME, 82 KZMF and 82 KFMG of the ITAA 1936

Section 82 KZME of the ITAA 1936 deals with the conditions of deduction of certain expenditure under some agreements. While sec 82KZMF deals with the calculation of the amounts deductible sec 82KFMZ specifies the timings for such deduction. Hence all the three sections are to be looked at as a common section as the latter two are riders of the first one. An analysis of the provisions leads the following arguments that the contributions to the investments in the agricultural managed investment schemes if deductible ARE SUBJECT TO THESE RULES:

A plain reading of the sections indicates that the sections were enacted among other things only to control the deducibility of the contributions. Hence without going in to the intricacies it can be argued that any deduction is subject to the provisions of these rules.
Subsection (3) of Section 82 KZME clearly indicates the requirements to be complied with for claiming the deductions. These requirements exactly fit in to the case of the agricultural managed investment schemes and quite obviously any investor desirous of claiming deduction would have automatically met with these requirements and hence the deduction would be subject to these rules.
Exception 5 under subsection (9) of section 82 KZME is a clear indication that the deductions on account of the contributions to the scheme must follow these rules as all such investments in order to become deductible should get the product ruling.
Section 82 KZMG subsection (4) indicates certain requirements for the eligibility of deduction. These requirements include actual expenditure incurred in connection with the agricultural activity like planting, ripping and mounding and applying fertilizers. When deductions are claimed by the Managed Investment Schemes on account of their agricultural activities they have to necessarily use the provisions of these sections and hence are subject to these rules.
The arguments to support the view that the deductions ARE NOT SUBJECT TO THESE RULES are:

It may be noted that the section 82KZMF is not the only section that deals with the deductions on account of contributions to the managed investment schemes. The deductions can be claimed under other sections like 73B, 73 BA, 73 BH or 73 Y of ITAA 1936 or section 8-1 of the ITAA 1997 depending on the circumstances of each case.  Hence it is not relevant to say that all contributions are subject to these rules.
Under section 8-1 ITAA of 1997 for the purpose of claiming deductions, the loss or expense spent should have been done to derive any business income, but not necessarily from agricultural activities. But the provision of Sections 82 KZME, 82 KZMF and 82 KZMG mainly relate to agricultural activities, Hence deductions which are otherwise eligible need not be subjected to these rules.
The various provisions of Section 82 KZME, 82 KZMF and 82 KZMG specifically mentions carrying out agricultural business and activities connected thereon in order to be eligible for deduction under these sections. But under the proposed changes the upfront deduction can be claimed even when  without showing any proof of the business being carried on in the case of forestry investments. Hence the influence of these rules doesn’t have any effect if the new ruling is effected.
Conclusion:

Though other sections are available under which the investor can claim deductions on account of the contributions made to the managed investment schemes, since the intention of the Act in enacting these sections is clearly to monitor the deductibility of such investments most of the deductions will be dealt with by these sections and hence it can be concluded that even if the contributions are deductible they are subject to the prepayment rules contained in sections 82 KZME, 82 KZMF and 82 KFMG of the ITAA 1936.

 

[1] Vincent V Commissioner of Taxation [2002] FCAFC 291 at [60] as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[2] Enviro Systems Renewable Resources Pty Ltd v. Australian Securities and Investments Commission [2001] SASC 11 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[3] Waldron v. Auer [1977] VR 236 and ASIC v. Enterprise Solutions 2000 Pty Limited (2000) QCA 452; Crocombe v. Pine Forests of Australia Pty Ltd [2005] NSWSC 151; ASIC v. Pegasus Leveraged Options Group Pty Ltd (2002) 41 ACSR 561 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[4] Investa Properties Ltd & anor [2001] NSWSC 1089; ASIC v. Knightsbridge Managed Funds Ltd & anor [2001] WASC 339; In Southern Wine Corporation Pty Ltd (in liq) v. Frankland River Olive Co Ltd & anor [2005] WASC 236 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[5] Puzey v. FC of T [2002] FCA 1171 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[6] Commissioner of Taxation v. Cooke [2004] FCAFC 75 and Commissioner of Taxation v. Sleight [2004] FCAFC 94 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[7] Commissioner of Taxation v. Cooke [2004] FCAFC 75 and Commissioner of Taxation v. Sleight [2004] FCAFC 94) and Puzey v. FC of T [2002] FCA 1171 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[8] Puzey v. FC of T [2003] FCAFC 197
[9] Vincent V Commissioner of Taxation [2002] FCAFC 291 at [60] as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[10] Clowes v. FC of T (1954) 91 CLR 209; HCA 10 all these cases as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[11] Milne v. FC of T (1975-76) 133 CLR 526 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001
[12] FC of T v. Lau (1984) 6 FCR 202 as reported in Draft Taxation Rulinf: TR 2007/D2 in Australian Taxation Office Legal Database available in http://law.ato.gov.au/atolaw/view.htm?DocID=DTR/TR2007D2/NAT/ATO/00001

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