Edited version of your written advice

Authorisation Number: 1051459828684

Date of advice: 27 November 2018

Ruling

Subject: In-specie trust distribution

Question 1

Does the in-specie distribution give rise to capital gains tax (CGT) event E5 in section 104-75 of the Income Tax Assessment Act 1997 (ITAA 1997) happening?

Answer

Yes.

Question 2

If the answer to question 1 is no, would a variation to the trust deed, to remove the operation of sale to assets to which a beneficiary is absolutely entitled, change the Commissioner’s answer in respect of question 1 to yes.

Answer

N/A, as the answer to question 1 is yes.

Question 3

If the answer to question 1 or 2 is yes, could the Z Trust make the Applicant specifically entitled and receive the full net financial benefit of the capital gain?

Answer

Yes.

Question 4

If the answer to question 3 is yes, can the Z Trust recoup its revenue losses after the application of the general 50% CGT discount, prior to the Applicant being assessed on the capital gain?

Answer

Yes

Question 5

Would the same answers from questions 1 to 4 result if the in-specie distribution was instead made to the Applicant’s spouse?

Answer

Yes.

This ruling applies for the following period(s)

Income years ended 30 June 20XX to 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The Z Trust was settled by Deed in 19XX.

Y Pty Ltd, an Australian resident company, is the trustee of the Z Trust.

The Trust Deed dated DD MM 19XX (including variations to the deed) provided with this ruling application forms part of, and is to be read into, the facts of this ruling.

The Z Trust has made a family trust election for the 20XX income year with the Applicant as the test individual.

The Applicant and the spouse are both named as specified beneficiaries of the Z Trust and therefore fall within the class of General Beneficiaries.

The Beneficiaries did not expend anything to acquire their interest in the Z Trust.

The Z Trust holds real property. It derives rental income in respect of some of those properties.

The expenses referrable to leasing the rental properties often exceed the rental income derived by the Z Trust. As a result, the Z Trust has been accruing tax losses.

The Applicant states that the relevant trust loss provisions in Schedule 2F of the ITAA 1936 are satisfied. It is unlikely that the Z trust will have any distributable income in the year in which the proposed in-specie distribution is made.

One of the properties held by the trust is the personal residence of the Applicant and his spouse. No rental income is derived in respect of this property. This property has a cost base of approximately $X and a market value of approximately $X. This property was not acquired on or before 20 September 1985.

The Z Trust had a net asset position of $X as at 30 June 20XX, mostly related to an $X capital gift reserve. The real properties are recognised at market value in the books of Z Trust. Any changes in the market value of the real properties are recorded in the asset revaluation reserve (the Reserve) in the trust’s accounts in the relevant year.

The amounts recognised in the Reserve have not been included in the calculation of the distributable income of the Z Trust in any earlier income year, nor will it be included in the year of the arrangement. Further, no beneficiary entitlements to capital of an amount equal to all or any part of the Reserve have been created in any income year.

In-specie distribution of property

The trustee proposes to exercise its power of capital advancement to transfer the residential property to the Applicant in-specie for his sole benefit in the 2019 income year.

The in-specie distribution will be made on a non-contingent basis. It will be effected by:

● a resolution, in writing, recording the trustee exercising its power of advancement in appointing the property to the Applicant; and

● executing any other relevant deeds or contracts necessary to ensure the legal and beneficial title in the property passes to the Applicant.

Relevant legislative provisions

Section 104-75 of the ITAA 1997

Subdivision 115-C of the ITAA 1997

Section 115-228 of the ITAA 1997

Section 116-20 of the ITAA 1997

Reasons for decision

Question 1

Summary

The resolution to make the in-specie distribution will give rise to CGT event E5 happening pursuant to section 104-75 of the ITAA 1997.

Detailed reasoning

Section 104-75 of the ITAA 1997 provides that CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust as against the trustee.

Draft Taxation Ruling TR 2004/D25 Income Tax: capital gains: meaning of the words ‘absolutely entitled to a CGT asset as against the trustee of a trust’ as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (TR 2004/D25) provides the Commissioner’s view on when a beneficiary may become absolutely entitled to an asset.

Paragraphs 10 and 11 of TR 2004/D25 provide:

10. The core principle underpinning the concept of absolute entitlement in the CGT provisions is the ability of a beneficiary, who has a vested and indefeasible interest in the entire trust asset, to call for the asset to be transferred to them or to be transferred at their direction. This derives from the rule in Saunders v Vautier applied in the context of the CGT provisions (see Explanation paragraphs 41 to 50). The relevant test of absolute entitlement is not whether the trust is a bare trust (see Explanation paragraphs 33 to 40).

11. Under the rule in Saunders v Vautier, the courts do not regard as effective a direction from the settlor of the trust that purports to delay the beneficiary’s full enjoyment of an asset. However, if there is some basis upon which a trustee can legitimately resist the beneficiary’s call for an asset, then the beneficiary will not be absolutely entitled as against the trustee to it.

Paragraph 13 of TR 2004/D25 states that an object of a discretionary trust cannot be absolutely entitled prior to any exercise of the trustee’s discretion in their favour. This is because they do not have an interest in the trust’s assets.

Paragraphs 73 and 74 of TR 2005/D25 describe the type of interest required in the trust asset for a beneficiary to be absolutely entitled:

73. The interest a beneficiary has in the trust asset or assets must be vested in possession and indefeasible. A trustee would only be obliged to satisfy a demand from a beneficiary with such an interest.

74. A vested interest is one that is bound to take effect in possession at some time and is not contingent upon an event occurring that may or may not take place. A beneficiary’s interest in an asset is vested in possession if they have the right to immediate possession or enjoyment of it.

The nature of the beneficiary’s interest in the asset, and whether it meets the requirements of absolute entitlement, therefore depends on the particular trust instrument.

In this case, the trustee of the Z Trust will, pursuant to its powers under the deed to advance property of the trust fund, make a resolution that the property will be distributed to the Applicant. Upon making the irrevocable resolution, the property will cease to become part of the Trust Fund (as defined in the deed) and the Applicant will have a vested and indefeasible interest in this asset.

The existence of the trustee's right of indemnity against the trust assets to meet outgoings incurred will not prevent the Applicant from being absolutely entitled to the property. See paragraph 18 of TR 2004/D25.

On the facts of this particular case, the trustee’s general powers of sale and investment would not operate to defeat the Applicant’s entitlement to the asset. The terms of the trust, and the nature of the Applicant’s interest in the property on the making of the resolution, can be distinguished from those in Kafataris and Another v Deputy Commissioner of Taxation T [2015] FCA 874 and Oswal and Others v Federal Commissioner of Taxation2013] FCA 745.

Therefore, CGT event E5 will happen upon the making of a valid resolution to appoint the property to the Applicant.

The trustee of the Z Trust will make a capital gain from CGT event E5 happening equal to the excess of the market value of the property (at the time of making the resolution) over its cost base.

As the Applicant did not expend anything to acquire his interest in the Z trust, any capital gain he would also make as a result of CGT event E5 happening will be disregarded.

Question 2

This question does not need to be addressed because the answer to Question 1 is yes.

Question 3

Summary

The Z Trust can make the Applicant specifically entitled to receive the full net financial benefit of the capital gain.

Detailed reasoning

Subdivision 115-C of the ITAA 1997 operates to ensure, among other things, that a beneficiary of a trust who is made ‘specifically entitled’ to a capital gain made by the trustee will be assessed on it (rather than the gain being assessed proportionately to the beneficiaries entitled to trust income).

Section 115-228 of the ITAA 1997 sets out when a beneficiary will be regarded as specifically entitled to a trust’s capital gain. One requirement is that the beneficiary must have received, or can reasonably expect to receive, in accordance with the terms of the trust, all of the financial benefit referable to the capital gain. Another requirement is that the financial benefit be recorded, in its character as referable to the capital gain, in the accounts or records of the trust within 2 months of the end if the income year.

The Explanatory Memorandum to the Tax Laws Amendment (2011 Measures No. 5) Bill 2011 (the EM) states:

2.59 Whether a beneficiary can be specifically entitled to a capital gain or franked distribution is a question of fact. For example, when a beneficiary becomes absolutely entitled to a trust asset, it may be reasonable to expect the beneficiary will receive the net financial benefit referable to the deemed (trust) capital gain from CGT event E5.

…

2.63 The accounts or records of the trust would include the trust deed itself, statements of resolution or distribution statements, including schedules or notes attached to, or intended to be read with them. However, a record merely for tax purposes is not sufficient.

The manner in which the Z Trust has accounted for any increases in the value of the property during the period of ownership means that no separate entitlements have been created in the other beneficiaries of the Z Trust that may be referable to the capital gain.

As discussed above in question 1, the trustee of the Z Trust will make an irrevocable resolution to transfer the property to the Applicant in exercising its powers of capital advancement. Provided this resolution is validly made and recorded within 2 months of the end of income year, the financial benefit referable to the CGT event E5 capital gain is the property itself (or the value of that asset) and the Applicant, as the absolutely entitled beneficiary, will be the only beneficiary expected to receive (and benefit) from the asset.

Therefore, the Applicant will be regarded as specifically entitled to the capital gain that arises from CGT event E5 happening to the in-specie distribution of the property.

Question 4

Summary

The amount of the Applicant’s capital gain will be reduced by the amount of the Z Trust’s carried forward losses.

Detailed reasoning

The capital gains tax streaming provisions in Subdivision 115-C of the ITAA 1997 ensure that a beneficiary of a trust who is made specifically entitled to a capital gain made by the trustee, will be assessed on it – rather than the gain being assessed proportionately to the beneficiaries entitled to trust income.

This subdivision works alongside Division 6, as modified by Division 6E, of the Income Tax Assessment Act 1936 (ITAA 1936). Division 6E applies to adjust the amounts that would otherwise be assessed to a beneficiary under Division 6 by excluding the trust’s capital gains and franked distributions. This ensures the Applicant will not be assessed twice on his share of the capital gain under both subdivision 115-C of the ITAA 1997 and Division 6 of the ITAA 1936.

The amount of the trust’s capital gain that is assessed to a beneficiary is worked out by reference to their attributable gain.

The beneficiary’s attributable gain is calculated in accordance with section 115-225 of the ITAA 1997. Generally, a beneficiary’s attributable gain is their share of the gross gain multiplied by the net capital gain of the trust. However, this is subject to the modifications in subsection 115-225(3) that cap the amount that can be treated as the attributable gain so that the total amount allocated to the beneficiary cannot exceed the trust‘s net income. This is done via a rateable reduction of the net capital gain where it is greater than the trust’s net income calculated in accordance with section 95 of the ITAA 1936.

The modifications in subsection 115-225(3) will apply as the trust’s net capital gain is greater than the trust’s net income.

The Applicant’s rateable reduction in this case would be calculated as:

(net capital gain) x (net income)

(net capital gain)

This amount is then multiplied by the Applicant’s interest in the gross capital gain (i.e. 100%) to give an attributable gain of $X

In accordance with subsection 115-215(3), the Applicant will then be required to gross up this amount for any discounts the trustee applied to the gain (in this case the 50% CGT discount). This allows the beneficiary to utilise any personal current or prior year capital losses he may have, and then apply any CGT discounts to which he is entitled to work out his own net capital gain.

Question 5

As the Applicant’s spouse is also a specified and general beneficiary of the Z Trust, the answers to Questions 1 - 4 would not change if the trustee exercised its powers under the deed to distribute the property to the Applicant’s spouse instead of to the Applicant.

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