Edited version of private advice

Authorisation Number: 1052117941752

Date of advice: 29 May 2023

Ruling

Subject: Capital gains tax

Question 1

Will the proposed amendment to the trust deed converting the trust from a discretionary trust into a unit trust give rise to CGT event E1 in section 104-55 or CGT event E2 in section 104-60 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Will the proposed amendment to the trust deed give rise to a CGT event E3in section 104-65 of the ITAA 1997?

Answer

No.

Question 3

Will the market value substitution rule under section 112-20 of the ITAA 1997 apply so that the cost base of each unitholders' proportionate interest in the unit trust will be in proportion to the market value?

Answer

No.

This ruling applies for the following period:

year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The trust is a discretionary trust that was constituted by a deed (the trust deed).

The trustee wishes to amend the trust deed in order to satisfy the criteria of a fixed trust under section 3A(3B) of the Land Tax Management Act NSW 1956.

The trustee proposes to:

•         To amend the trust deed in accordance with the Deed of Amendment so that the trust is a unit trust for NSW land tax purposes

•         Issue units in the unit trust to beneficiaries.

No assets are being transferred when the amendments are made.

No unpaid present entitlements will exist at the time to Deed of Amendment is signed.

Clause X of the trust deed provides "... the Trustee may at any time by deed or instrument in writing or by written or oral resolution add to, alter, vary, modify, delete or otherwise amend any provision of this Deed in such manner as it may in its absolute discretion decides...".

Under Clause Y of the trust deed, the Trustee has the discretionary powers to determine the proportion or amount of the income to be distributed to the beneficiaries.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection104-55(1)

Income Tax Assessment Act 1997 Subsection104-60(1)

Income Tax Assessment Act 1997 Subsection104-65(1)

Income Tax Assessment Act 1997 Section112-20

Reasons for decision

Question 1

Will the proposed amendment to the trust deed give rise to CGT events E1 in section 104-55 or CGT event E2 in section 104-60 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

No. The continuity in the membership, operation and property of the Trust would be maintained following the execution of the proposed amendments to the trust deed pursuant to a valid exercise of the power of the trustee under the trust deed. Accordingly, neither CGT event E1 nor CGT event E2 will happen.

Detailed reasoning

CGT event E1 happens if a trust is created over a CGT asset by declaration or settlement (subsection 104-55(1) of the ITAA 1997).

CGT event E2 happens if a CGT asset is transferred to an existing trust (subsection 104-60(1) of the ITAA 1997).

Taxation Determination TD 2012/21 Income tax: does CGT event E1 or E2 in sections 104-55 or 104-60 of the Income Tax Assessment Act 1997 expresses the view that CGT event E1 or CGT event E2 does not happen if the terms of the trust are changed pursuant to a valid exercise of a power contained within the trust's constituent document; or varied with the approval of a relevant court unless:

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

•         the effect of the change or court approved variation is such as to lead to a particular asset being subject to separate charter of rights and obligations such as to give rise to the conclusion that the asset has been settled on terms of a different trust.

TD 2012/21 explains at paragraph 24 that:

... the ATO accepts that a change in the terms of the trust pursuant to exercise of an existing power (including an amendment to the deed of a trust), or court approved variation, will not result in a termination of the trust and, therefore, subject to the observation in paragraph 27 below, will not result in CGT event E1 happening.

Where an asset is instead transferred to an existing trust, CGT event E2 will be the relevant event - subsection 104-60(1).

Paragraphs 26 and 27 further states that:

26. Whether a purported change to a trust in exercise of a power under the deed is properly supported by the power is to be determined in accordance with principles of trust law having regard to the scope of the power properly construed. Relevant to this question will be whether the deed itself explicitly specifies conditions (including procedural conditions) that need to be satisfied for the exercise of the power to be effective.

27. Even in instances where a pre-existing trust does not terminate, it may be the case that assets held originally as part of the trust property commence to be held under a separate charter of obligations as a result of a change to the terms of the trust - whether by exercise of a power under the deed (including a power to amend) or court approved variation - such as to lead to the conclusion that those assets are now held on terms of a distinct (that is, different) trust.

In this case the proposed amendment to the trust deed is a valid exercise of the trustee's power.

Further, the asset of the Trust will continue in the unit trust for the benefit of the beneficiaries.

Application to your circumstances

The proposed changes to the trust deed are considered to fall within the scope of the trustee's power of amendment provided for under the relevant clause of the trust deed. In addition, the proposed amendments are not considered to fall within the specific restrictions on the powers of variation set out in the trust deed. Accordingly, execution of the proposed Deed of Amendment is considered a valid exercise of the trustee's powers of amendment.

As the proposed amendments are within the trustee's powers contained in the trust deed, the Commissioner considers that, following the execution of the proposed Deed of Amendment to amend the terms of the trust deed, there will be continuity:

•         of the Trust property

•         in the membership of the Trust (apart from the exclusion of various potential beneficiaries under the trust deed), and

•         in the operation of the Trust.

As the continuity in the membership, operation and property of the Trust would be maintained following the execution of the proposed amendments to the trust deed pursuant to a valid exercise of the power of the trustee under the trust deed, such amendments would not result in a termination of the Trust.

Therefore, the proposed Deed of Amendment to amend the trust deed will not cause either CGT event E1 or CGT event E2 to happen.

Question 2

Will the proposed amendment to the trust deed give rise to CGT event E3 in section 104-65 of the ITAA 1997?

Summary

No. CGT event E3 happens when a trust with an absolutely entitled beneficiary converts into a unit trust. While the proposed amendment will convert a discretionary trust into a unit trust, no beneficiary will be absolutely entitled to trust assets just before the conversion.

Detailed reasoning

CGT event E3 happens if a trust over a CGT asset is converted to a unit trust and just before the conversion, a beneficiary was absolutely entitled to the asset as against the trustee (subsection 104-65(1) of the ATAA 1997).

Draft Taxation Ruling TR 2004/D25 sets out the Commissioner's view on when a beneficiary may become absolutely entitled to an asset.

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. The most straight forward application of this core principle is one where a single beneficiary has all the interests in the trust asset. Generally, a beneficiary will not be absolutely entitled to a trust asset if one or more other beneficiaries also have an interest in it.

Beneficiaries of a discretionary trust do not have any interest, either individually or collectively, in the property or income of a trust estate. Where there is a discretionary trust deed, no beneficiary is entitled to income or capital of the trust until the trustee exercises its discretion to distribute income or to make an appointment of capital: it is for the trustee to determine, firstly, whether such beneficiaries will benefit at all under the terms of the trust and, secondly, to what extent the beneficiaries will benefit. Such beneficiaries have no more than a right to have the trust duly administered.

Application to your circumstances

In this case, under the current trust deed, none of the beneficiaries are absolutely entitled to any of the assets of the trust.

Therefore, CGT event E3 will not happen on the Trust's conversion to a unit trust.

Question 3

Will the market value substitution rule under section 112-20 of the ITAA 1997 apply so that the cost base of each unitholders' proportionate interest in the unit trust will be in proportion to the market value?

Summary

No.

Detailed reasoning

Section 102-20 of the ITAA 1997 provides that a capital gain or capital loss results from a capital gains tax (CGT) event occurring.

Subsection 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if an entity disposes of a CGT asset. A 'disposal', as defined in subsection 104-10(2) of the ITAA 1997, occurs when there is a change of ownership from one entity to another. A 'CGT asset', as provided in section 108-5 of the ITAA 1997, is:

•         Any kind of property, or

•         A legal or equitable right that is not property.

CGT event A1 will be triggered when an entity sells a property. The capital gain from such an event is the difference between the capital proceeds and the cost base of the relevant CGT asset.

General rules about cost base are provided in section 110-25 of the ITAA 1997. The cost base of a CGT asset consists of five elements (subsection 110-25(1).

The first element is the total of:

(a)  the money you paid, or are required to pay, in respect of acquiring it; and

(b)  the market value of any other property you gave, or are required to give, in respect of acquiring the asset.

Market value substitution rule

There are a number of modifications to the general rules about cost base. The market valuesubstitution rule in subsection 112-20(1) of the ITAA 1997 modifies the general rule by replacing the first element of the cost base and reduced cost base of a CGT asset acquired from another entity with its market value (at the time of acquisition) where:

(a)  You did not incur expenditure to acquire it, except where your acquisition of the asset resulted from:

(i)      CGT event D1 happening; or

(ii)     Another entity doing something that did not constitute a CGT event happening; or

(b)  Some or all of the expenditure you incurred to acquire it cannot be valued; or

(c)   You did not deal at arm's length with the other entity in connection with the acquisition.

However, despite paragraph 112-20(1)(c), subsection 112-20(2) states that

a)    if you did not deal at arm's length with the other entity; and

b)    your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening:

the market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition).

Section 112-20(1) requires the "dealing" to be at arm's length, not for the parties to "be" at arm's length. Therefore, the mere fact that the parties' normal relationship is not at arm's length does not mean that they were not dealing with each other at arm's length in connection with a particular acquisition.

Subsection 995-1(1) of the ITAA 1997 defines 'arm's length' as follows:

...in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

In Healey v. Commissioner of Taxation [2012] FCA 269, in determining whether parties deal at arm's length with one another, it was held that the authorities establish the following principles:

1. Whether the parties dealt at arm's length is a question of fact: Trustee for the Estate of the late AW Furse No 5 Will Trust v Commissioner of Taxation (1990) 91 ATC 4007 (at 4017); Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503 (at 507); Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204 (at [106])
2. There is a distinction between dealing at arm's length and an arm's length relationship: ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (at [224]). Whether the parties did not deal at arm's length is not to be decided by answering whether the parties were not in an arm's length relationship. The fact that the parties are themselves not at arm's length does not mean that they have not, in respect of a particular dealing, dealt with each other at arm's length: Re Hains; Barnsdall v Commissioner of Taxation 88 ATC 4565; (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015)
3. Whether the parties dealt at arm's length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction: Granby (at 506)
4. At issue is whether the parties have acted separately and independently in forming their bargain: Granby (at 507); ACI Operations Pty Ltd (at [226])(did the parties apply "independent separate wills"); AXA Pacific Holdings Ltd (at [105]). There should be an assessment of whether the parties dealt with each other as arm's length parties would be expected to behave so that the outcome is a matter of real bargaining: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506 and 507); AXA Pacific Holdings Ltd (at [105])
5. It is relevant to consider the nature of any relationship between the parties: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506); and
6. If the parties are not at arm's length the inference may be drawn that they did not deal with each other at arm's length: Granby (at 506); ACI Operations Pty Ltd (at [225]).

Application to your circumstances

Having regard to paragraph 112-20(1)(c), the acquisition of the units in the proposed unit trust would be considered as not dealing at arm's length considering that the unit price is below the market value. The acquisition of the units is the result of the amendment to the trust deed converting the discretionary trust to a unit trust. Under subsection 112-20(2), where non-arm's length acquisition of an asset resulted from another entity doing something that did not constitute a CGT event happening, the market value of the CGT asset at the time of acquisition isonly substituted if what was paid to acquire the asset is more than that market value. In this case the market value substitution rule will not apply as the amount paid to acquire the CGT asset (units) would not be more than its market value (at the time of acquisition).

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