Edited version of your private ruling

Authorisation Number: 1012557133149

Ruling

Subject: Division 7A and Unpaid Present Entitlements

Question 1

If Z Company as trustee of the Z Trust releases the Y UPE subsisting in its favour to Person 1 (as trustee of the Y subtrust), and the X UPE subsisting in its favour to Person 2 (as trustee of the X subtrust), thereby relinquishing its rights and interests in the respective subtrusts, will Division 7A of the ITAA 1936 deem a dividend to have been paid to:

· Person 1 either in his personal capacity or in their capacity as trustee of the Y sub-trust;

· Person 2 either in his personal capacity or in their capacity as trustee of the X sub-trust;

· Y Company either in its own capacity or as trustee for the Y Trust; and / or

· A Company either in its own capacity or as trustee for the A Trust?

Answer

No.

Question 2

Does Part IVA of the ITAA 1936 apply to the proposal?

Answer

No

Question 3

3(a). If the trustee of Z Trust releases the Y UPE, do the discount capital gain provisions in section 115-25(3) of ITAA 1997 apply first before the anti-overlap rule in section 118-20 of ITAA 1997, so that if the market value of the Y UPE discounted by 50% is less than the amounts historically assessed to the trustee of Z Trust in relation to those Y UPE, there would be no assessable capital gain to the trustee of Z Trust upon release of the Y UPE?

3(b) If the trustee of Z Trust released the X UPE, do the discount capital gain provisions in section 115-25(3) of ITAA 1997 apply first before the anti-overlap rule in section 118-20 of ITAA 1997, so that if the market value of the X UPE discounted by 50% is less than the amounts historically assessed to the trustee of Z Trust in relation to those X UPE, there would be no assessable capital gain to the trustee of Z Trust upon release of the X UPE?

Answer

No

Question 4

If Z Company as trustee of the Z Trust releases the Y UPE subsisting in its favour to Person 1 (as trustee of the Y subtrust), and the X UPE subsisting in its favour to Person 2 (as trustee of the X subtrust), thereby relinquishing its rights and interests in the respective subtrusts, will an amount of ordinary income be derived for the purposes of section 6-5 of the ITAA 1997 by:

Person 1 either in their personal capacity or in their capacity as trustee of the Y sub-trust; and / or

Person 2 in their personal capacity or in their capacity as trustee of the X sub-trust;

Answer

No

Question 5

Is the release of a UPE forgiveness of a debt for the purposes of Division 7A?

Answer

No

Question 6

Will a change in the trustee of the sub-trusts trigger CGT Events A1, E1 or E2?

Answer

No

This ruling applies for the following periods:

1 July 2013 to 30 June 2015

The scheme commences on:

1 July 2013.

Relevant facts and circumstances

1) The parties involved in this arrangement are:

- Ultimate Controller (UC);

- Person 1;

- Person 2;

- Person 3;

- X Company atf the X Trust ('the X Trust');

- Y Company atf Y Trust ('the Y Trust');

- Z Company atf the Z Trust;

- V Company.

2) In this ruling:

- the X UPE means the unpaid present entitlement subsisting in favour of Z Company atf the Z Trust by reason of income of the X Trust having been appointed in favour of Z Company in its trustee capacity prior to 2003.

- the X subtrust means the subtrust of the X Trust that arose for the benefit of Z Company atf the Z Trust by reason of income of the X Trust having been appointed in favour of Z Company in its trustee capacity. It is proposed that Person 2 will replace X as trustee of the subtrust.

- the Y UPE means the unpaid present entitlement subsisting in favour of Z Company atf the Z Trust by reason of income of the Y Trust having been appointed in favour of Z Company in its trustee capacity prior to 2003.

- the Y subtrust means the subtrust of the Y Trust that arose for the benefit of Z Company atf the Z Trust by reason of income of the Y Trust having been appointed in favour of Z Company in its trustee capacity. It is proposed that Person 1 will replace Y Company as trustee of the subtrust.

3) Ultimate Controller, founder of the Group, currently owns the shares in two private companies Y Company and X Company. Y Company is corporate trustee of the Y Trust; X of the X Trust

4) Ultimate Controller wishes to split the group into three subgroups of roughly equal size one of which is to pass to each of the Persons 1, 2 and 3 after UC dies.

5) Under the succession plan it is intended that Person 1 will ultimately take over control of Y Trust, and Person 2 will ultimately take over control of X Trust. Person 3 will assume control of the Z Trust.

6) In order to give effect to the split, various unpaid present entitlements subsisting within the group need to be eliminated. In particular, the X UPE and the Y UPE (both being UPEs subsisting in favour Z Company as trustee for the Z Trust) need to be eliminated.

7) The X UPE arose as a result of income appointments made by the trustee of the X Trust in favour of Z Company in its trustee capacity prior to 2003 that were left unpaid. The income was in turn appointed by Z Company as trustee in favour of Z Company, a corporate beneficiary of the Z Trust. The appointment in favour of Z Company was likewise left as an unpaid present entitlement in favour of the company. Z Company paid tax with respect to its share of the income of the Z Trust flowing from the X Trust at the corporate rate.

8) Likewise the Y UPE arose as a result of income appointments made by the trustee of the Y Trust in favour of Z Company in its trustee capacity prior to 2003 that were left unpaid. Once again the income was in turn appointed by Z Company as trustee in favour of Z Company with the appointment being left as an unpaid present entitlement. As with income flowing from the X Trust, Z Company paid tax with respect to its share of the income of the Z Trust flowing from the X Trust at the corporate rate.

9) The UPEs that arose in favour of Z Company as beneficiary of the Z Trust still subsist. These UPEs will continue to subsist after the proposed arrangement described below is implemented.

10) The respective trust deeds of the Y Trust and X Trust each authorise part of the trust fund to be held by a trustee that is different to the trustee holding assets subject to other trusts created under the deed.

11) Each deed also empowers the Appointor of the trust to remove any trustee of any trusts created under the terms of the trust deed and to appoint any new or additional trustee in their place.

12) With a view to eliminating the X and Y UPEs in the context of implementing the succession plan it is proposed that the following occur (in the order described in paras 29-32 below).

13) Neither the X Trust deed nor the Y Trust deed currently permits a beneficiary to be appointed as trustee of any trusts created under the deed. It is proposed to vary both deeds pursuant to a plenary variation power contained in the deed to remove this prohibition.

14) Once varied, the Appointor of the Y Trust will cause Y Company to resign as trustee of the Y subtrust and be replaced with Person 1. It is intended that Y Company would otherwise remain trustee of Y Trust.

15) Similarly, once varied the Appointor of the X Trust will cause X to resign as trustee of the X subtrust and be replaced with Person 2. It is intended that X would otherwise remain trustee of X Trust.

16) Once Persons 1 and 2 have been appointed as the trustees of the Y subtrust and the X subtrust respectively, Z Company as trustee of the Z Trust will release the Y and X UPEs in favour respectively of Persons 1 and 2 with the intent of thereby relinquishing its rights and interests in the respective subtrusts,

Relevant legislative provisions

Income Tax Assessment Act 1936:

109C(3)(c)

109XA

109XB

109XF

177C

177D

318(1)(a)

Income Tax Assessment Act 1997

6-5

102-5(1)

104-10(1)

104-55(1)

104-60(1)

110-25(2)

112-20

115-25(3)

116-30

118-20

960-100(2)

Reasons for decision

Issue 1

Question 1

If Z Company as trustee of the Z Trust releases the Y UPE subsisting in its favour to Person 1 (as trustee of the Y subtrust), and the X UPE subsisting in its favour to Person 2 (as trustee of the X subtrust), thereby relinquishing its rights and interests in the respective subtrusts, will Division 7A of the ITAA 1936 deem a dividend to have been paid to:

· Person 1 either in their personal capacity or in his capacity as trustee of the Y sub-trust;

· Person 2 either in their personal capacity or in his capacity as trustee of the A sub-trust;

· Y Company either in its own capacity or as trustee for the Y Trust; and / or

· A either in its own capacity or as trustee for the X Trust?

Summary

Division 7A of the ITAA 1936 does not apply to any of the transactions proposed to be undertaken under the current proposed scheme.

Detailed reasoning

Division 7A of the ITAA 1936 applies to entities as defined in section 960-100 of the ITAA 1997.

For the purposes of Division 7A of the ITAA 1936, the trustee of a trust is a different entity from the legal person who acts in that capacity (subsections 960-100(2), (3) and (4) of the ITAA 1997).

The transactions proposed to be undertaken involve release by a trustee beneficiary (i.e., the trustee of the Z Trust) of their beneficial interests in two trusts (namely the X and Y subtrusts) to their respective trustee. There is no transaction to which Subdivision B of Division 7A of the ITAA 1936 applies (i.e., no payment, loan or debt forgiven by a private company).

Subdivision EA of Division 7A of the ITAA 1936 applies to certain payments, loans and debts forgive by trustees.

As a general proposition, the release by a beneficiary of their equitable right to demand payment of an amount pursuant to a subsisting UPE is not a debt forgiveness for the purposes of Division 7A of the ITAA 1936 (i.e., section 109F and Subdivision EA of Division 7A of the ITAA 1936). This follows from the proposition that, in the basic case (i.e. in circumstances where a UPE has not been converted into a loan), a UPE is not a debt for the purposes of Division 7A of the ITAA 1936 (Taxation Ruling TR 2010/3).

Further, because the release does not involve an amount being repayable or ultimately payable to the releasing beneficiary (i.e., there is no expectation of repayment on the part of the beneficiary), the release by a beneficiary of their equitable right does not involve the making of a loan within the definition in section 109D(3) of the ITAA 1936. The release is, therefore, not a loan for the purposes of Subdivision EA of Division 7A of the ITAA 1936.

Subdivision EA of Division 7A of the ITAA 1936 only applies to payments that are made to discharge or reduce a present entitlement of the shareholder or associate recipient that is attributable to an amount that is an unrealised gain (paragraph 109XA(1)(b) of the ITAA 1936). As these preconditions to the operation of the Subdivision would not be met in relation to the proposed arrangement, the releases will not be payments to which Subdivision EA of Division 7A of the ITAA 1936 applies.

Issue 2

Question 1

Does Part IVA of the ITAA 1936 apply to the proposal?

Summary

No. Part IVA does not apply to this arrangement as there is no tax benefit.

Detailed reasoning

Part IVA will not apply as it cannot be concluded that a party to the arrangement entered into it with sole or dominant purpose objectively ascertained of enabling a relevant taxpayer to obtain a tax benefit.

Issue 3

Question 1

3(a). If the trustee of Z Trust releases the Y UPE, do the discount capital gain provisions in section 115-25(3) of ITAA 1997 apply first, before the anti-overlap rule in section 118-20 of ITAA 1997, so that if the market value of the Y UPE discounted by 50% is less than the amounts historically assessed to the trustee of Z Trust in relation to those Y UPE, there would be no assessable capital gain to the trustee of Z Trust upon release of the Y UPE?

3(b) If the trustee of Z Trust released the X UPE, do the discount capital gain provisions in section 115-25(3) of ITAA 1997 apply first, before the anti-overlap rule in section 118-20 of ITAA 1997, so that if the market value of the X UPE discounted by 50% is less than the amounts historically assessed to the trustee of Z Trust in relation to those X UPE, there would be no assessable capital gain to the trustee of Z Trust upon release of the X UPE?

Summary

The discount provisions do not apply prior to the anti-overlap rule in section 118-20 of ITAA 1997.

Detailed reasoning

We have previously provided the following advice to you:

1. A waiver is a voluntary release and consequently an effective waiver of a UPE will trigger CGT event C2.

2. CGT event C2 should not be ignored when a UPE is waived and any resultant capital gain should be brought to account by the beneficiary.

Cost Base

3. In most cases, the cost base of a UPE will be nil. However, the cost base will need to be determined on a case by case basis and after an analysis of the circumstances and the trust deed that lead to the beneficiary becoming presently entitled.

4. Subsection 110-25(2) of the ITAA 1997 defines the first element of the cost base to be the money paid (or required to be paid) or the market value of any property given (or required to be given) in acquiring the CGT asset. As the beneficiary never has any legal right to payment of the amount of the UPE against the trustee (such as a debt), the amount of the UPE cannot be said to have been paid or given (or required to be paid or given) to the trustee, by the beneficiary, to acquire the equitable right to demand and receive payment.

5. The market value substitution rule contained in section 112-20 of the ITAA 1997 will not apply because the exclusion contained in Item 1 of the table in subsection 112-20(3) of the ITAA 1997 will apply.

Capital Proceeds

6. As a waiver is a release without consideration, section 116-30 of the ITAA 1997 will apply to substitute the market value of the UPE at the time of waiver to be the capital proceeds received as a result of CGT event C2 occurring. The market value of the UPE at the time of the CGT event will be at least the amount of the UPE. However, where the funds representing the UPE have been used by the trustee to administer the principal trust and invest in fungible or composite assets, the determination of the market value of the UPE must incorporate the value of any tracing rights in respect of those assets.

Thus in the proposed arrangement CGT Event C2 will occur and there will need to be a calculation of any capital gain or loss. Your question relates to the ordering of steps in the calculation of this amount; in particular whether the discount provisions will apply prior to the operation of subsection 118-20(1) of the ITAA 1997 which reduces a capital gain to the extent that the relevant amount is elsewhere brought to tax.

It is important to note at this point that 'capital gain' and net capital gain' are both defined terms.

Subsection 118-20(1) of the ITAA 1997 states that a capital gain you make from a CGT Event is reduced if, because of the event a provision of this Act (outside of this Part) includes an amount (for any income year) in your assessable income.

Subsection 102-5(1) of the ITAA 1997 explains how to work out your net capital gain and outlines a 5 step process to follow. Step 1 states that you need to reduce the capital gains you made during the income year by the capital losses (if any) you made during the income year.

The use of the words net capital gain and capital gain in these two provisions make the ordering clear. Step 1 is the first step in working out the net capital gain which will be included in your assessable income and it clearly requires the prior ascertainment of capital gains. In order to do this if there are to be any reductions to your capital gain under section118-20 of the ITAA 1997 then you use that provision first.

Once you have used subsection 118-20 (1) to work out your capital gain you can then move to subsection 102-5(1) of the ITAA 1997 and using the capital gain figure proceed to work out your net capital gain.

Whether this will result in a capital gain in the proposed arrangement will need to be worked out at the time following this calculation process.

Issue 4

Question 1

If Z Company as trustee of the Z Trust releases the Y UPE subsisting in its favour to Person 1 (as trustee of the Y subtrust), and the X UPE subsisting in its favour to Person 2 (as trustee of the X subtrust), thereby relinquishing its rights and interests in the respective subtrusts, will an amount of ordinary income be derived for the purposes of section 6-5 of the ITAA 1997 by:

Person 1 either in their personal capacity or in his capacity as trustee of the Y sub-trust; and / or

Person 2 in their personal capacity or in his capacity as trustee of the A sub-trust;

Summary

The scheme being ruled upon will not result in amounts being assessed as ordinary income to Persons 1 or 2.

Detailed reasoning

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident for taxation purposes, includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources.

Subsection 6-5(4) of the ITAA 1997 states that a taxpayer derives an amount of ordinary income when the amount is:

· received by the taxpayer; or

· dealt with in any way on the taxpayer's behalf or as the taxpayer directs.

ATO Interpretative Decision: ATO ID 2003/42 Income Tax Trust income - assessability of employer contributions to an Income Protection and Portable Sickness Benefit Fund (ATO ID 2003/42) stated that whether an amount comes within section 6-5 of the ITAA 1997 depends on whether it represents income according to ordinary concepts. The ATOID cited Scott v. Federal Commissioner of Taxation (1966) 10 AITR 367; (1966) 117 CLR 514; (1966) 14 ATD 286 as follows:

Windeyer J stated that:

'Whether or not a particular receipt is income depends upon its quality in the hands of the recipient.'

It went on to say:

In G.P. International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; (1990) 21 ATR 1; 90 ATC 4413 the High Court considered the following factors were important in determining the nature of a receipt:

'To determine whether a receipt is of an income or a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.'

ATO Interpretative Decision: ATO ID 2002/824: Income Tax Assessability of refund of capital contribution towards obtaining electricity discussed relevant factors in determining whether a payment is ordinary income as said that they include:

· whether the payment is the product of any employment, services rendered, or any business;

· whether the payment is expected and relied upon;

· the character of the payment in the hands of the recipient;

· whether the payment is received as a lump sum or periodically; and

· the motive of the person making the payment, although this is rarely decisive by itself.

A one-off payment, that was expected but not relied upon, and not related to work performed or an interest in property does not have the characteristics of ordinary income but is rather a capital receipt in the taxpayer's hands.

ATO Interpretative Decision: ATO ID 2009/112: Income Tax Capital Gains Tax: beneficiary's share of trust net income includes trust capital gain - deduction for beneficiary's contribution to a complying superannuation fund stated as follows:

Statutory income is an amount that is not ordinary income but is included in assessable income by a provision about assessable income - for example, section 97 of the Income Tax Assessment Act 1936 (ITAA 1936). That section provides that a taxpayer who is not under a legal disability and who is presently entitled to a share of the income of a trust estate must include in their assessable income that share of the net income of the trust calculated under section 95 of the ITAA 1936.

The facts in this ATO ID were that the individual was presently entitled to 50% of the income of a trust and thus had $100,000 of statutory income under section 97 of the ITAA 1936 (that is, 50% of the trust net income).

Where, as in this ATO ID, a trust's net income includes a net capital gain, Subdivision 115-C of the ITAA 1997 treats a beneficiary's share of the net income attributable to that gain as a capital gain which the beneficiary must include in the calculation of their own net capital gain.

The net capital gain is statutory income and included in the individual's assessable income under section 102-5 of the ITAA 1997. Thus it would not be included as an amount of ordinary income under section 6-5 of the ITAA 1997.

In applying these principles to the facts of the scheme to which this ruling applies any release by a beneficiary of a trustee's obligation to make a payment in respect of the unpaid present entitlements is not the product of any employment or services rendered or any business. Any gains that may be made by the rulees in relation to the release would not be expected, relied upon or be periodical.

As can be seen in the answers to the CGT question above any amounts will be statutory income if anything and thus will not also be classed as ordinary income.

Issue 5

Question 1

Is the release of a UPE forgiveness of a debt for the purposes of Division 7A?

Summary

No. A release of a UPE is not forgiveness of a debt for the purposes of Division 7A.

Detailed reasoning

Under subsection 109F(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity at the end of the private company's year of income if all or part of a debt the entity owed the private company is forgiven in that year and either:

(a) the amount is forgiven when the entity is a shareholder in the private company, or an associate of such a shareholder; or

(b) a reasonable person would conclude (having regard to all the circumstances) that the amount is forgiven because the entity has been such a shareholder or associate at some time.

Taxation Ruling TR 2010/3 Income Tax: Division 7A loans: trust entitlements states in part:

34. When a beneficiary is presently entitled to an amount from a trust estate, it has an equitable right to that amount. That is, the beneficiary has rights in equity and not, without more, as a result of any debtor-creditor relationship

Whilst the rights arising from a present entitlement can, in some circumstances, become, or crystallise into an equitable debt (for example, upon calling for payment of that entitlement), the right that arises on the creation of a present entitlement is not a debt (See for example Euroasian Holdings Pty Ltd v. Ron Diamond Plumbing Pty Ltd (In Liquidation) [1996] FCA 1262 at [14] and McCarthy J in Commissioner of Inland Revenue v. Ward 69 ATC 6050 at 6071; (1969) 1 ATR 287 at 313).

Because it is not a debt, section 109F of the ITAA 1936 has no application with respect to the release of an unpaid present entitlement.

Issue 6

Question 1

Will a change in the trustee of the sub-trusts trigger CGT Events A1, E1 or E2?

Summary

No CGT Event will happen merely because Person 1 replaces Y Company as trustee of the X 3 subtrust and Person 2 replaces X as trustee of the X 2 subtrust.

Detailed reasoning

CGT Event A1 happens if you dispose of a CGT asset (subsection 104-10(1) of the ITAA 1997)

You dispose of a CGT asset if a change of ownership occurs from you to another entity whether because of some act or event or by operation of law. However, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner (subsection 104-10(1) of the ITAA 1997).

Note:

A change in the trustee of a trust does not constitute a change in the entity that is the trustee of the trust (see subsection 960-100(2) of the ITAA 1936. This means that CGT event A1 will not happen merely because of a change in the trustee.

The mere change of trustee of trust will not trigger CGT event E1 (note to subsection 104-55(1) of the ITAA 1997).

The mere change of trustee of trust will not trigger CGT event E2 (note to subsection 104-60(1) of the ITAA 1997).

Tax Office position from month year.

The Commissioner now accepts that continuity of trust is a function of whether the trust continues in existence under trust law in contradistinction to having terminated.

However, a CGT event will occur if the change:

a) causes the existing trust to terminate and a new trust to arise for trust law purposes; or

b) results in a particular asset being subject to a separate charter of rights and obligations such as to give rise to the conclusion that that asset has been settled on terms of a different trust.

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