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Edited version of private ruling
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Ruling
Subject: Assessability of the net income of estate and capital gains tax event K3
Issue 1
Question
Are the residual beneficiaries assessable in regards to the net income of the trust estate under section 97 of the Income Tax Assessment Act 1936 (ITAA 1936)?
Advice/Answers
Yes
Issue 2
Question 1
Will capital gains tax (CGT) event K3 in section 104-215 of the Income Tax Assessment Act 1997 (ITAA 1997) occur where the trustees sell the shares held in the residue of the trust estate and distribute the cash to the residual beneficiaries?
Advice/Answers
No
Question 2
Will any resulting capital gains from the sale of the shares, which is included in the trust estate's net income, be assessable to the trustees under section 99A of the ITAA 1936?
Advice/Answers
No
Question 3
Will CGT event K3 in section 104-215 of the ITAA 1997 occur where the trustees decide to transfer the shares to the residual beneficiaries?
Advice/Answers
Yes
Relevant facts
The deceased passed away on a certain date after September 1985.
The trustees have paid funeral and testamentary expenses and debts of the estate.
The trustees have distributed all bequests and legacies according to the will but are yet to distribute the residue. The residue of the estate is disposed of by a certain clause in the will.
This clause identified the residual beneficiaries which are both income tax exempt entities and are under no legal disability.
The trustees have identified the residue of the estate as comprising shares in Australian companies and cash. The trustees expect that an additional amount of cash, being excessive provision for income tax, will be included in the residue.
Payments of dividends have been made to the trustees.
Income is not defined for the purposes of the trust estate (either expressly or by implication and the trustee does not have the authority to determine what is income) and so takes its ordinary meaning.
The Trustees have made a resolution at a certain date that the estate was then fully administered and that the residue of the estate is being held on trust for the residual beneficiaries in equal shares. They have made a substantial cash distribution to the residual beneficiaries pursuant to that resolution.
Relevant legislative provisions
Income Tax Assessment Act 1936 Section 95
Income Tax Assessment Act 1936 Section 97
Income Tax Assessment Act 1936 Section 99A
Income Tax Assessment Act 1997 Section 104-215
Income Tax Assessment Act 1997 Section 128-20
Reasons for decision
Issue 1 Question 1
In general, under section 97 of the ITAA 1936, a beneficiary presently entitled to a share of the income of a trust estate, who is not under a legal disability, will include their share of the net income of the trust estate in their own income tax return.
Otherwise, where no beneficiary is presently entitled to some or all of the net income of the trust estate, the trustee will be assessable for the trust income under sections 99 and 99A of the ITAA 1936.
A beneficiary will be presently entitled to the income of a trust estate if:
the beneficiary has an indefeasible, absolutely vested, beneficial interest in possession in trust law income; and
the beneficiary has a present legal right to demand and receive payment of the trust law income (or would but for a legal disability).
As a special provision, where a beneficiary has a vested and indefeasible interest in income of a trust estate but does not have a present legal right to demand and receive payment of that trust income, subsection 95A(2) of the ITAA 1936 deems the beneficiary to be presently entitled to that income of the trust estate.
The Commissioner's view on present entitlement during the stages of administration of deceased estates is found in Taxation Ruling No. IT 2622. In a deceased estate, whether a beneficiary is presently entitled to a share of the trust income depends on:
The stage reached in the administration of the deceased estate.
The terms of the deceased's will or codicil, trust law and principles enunciated and orders made by the Courts.
Whether any discretionary payments have been made to the beneficiary by the executor or trustee.
Beneficiaries cannot enjoy present entitlement to income derived by a deceased estate during the administration of the estate. Income earned by the estate in years before the administration of the estate is complete is considered income of the executors and not income of the beneficiaries. In the High Court of Australia case of Federal Commissioner of Taxation v. Whiting (1943) 68 CLR 199; 7 ATD 179, the court held:
.... until an estate has been fully administered by payment or provision for the payment of funeral and testamentary expenses, death duties, debts, annuities and legacies and the amount of the residue thereby ascertained, the income of the residuary estate is the income of the executors and not of the residuary beneficiaries.
Where the administration of a deceased estate is completed during the course of an income year, the longstanding practice of the ATO is to raise assessments on the basis that beneficiaries who are not under any legal disability should bear tax under section 97 of the ITAA 1936 on their shares of the net income of the estate for that year to which they are presently entitled.
In your situation, the estate was fully administered on a certain date, when the residual of the trust estate was ascertained. Further, based on the information provided with your private ruling application, the Commissioner is satisfied the residual beneficiaries are presently entitled to the net income of the trust estate (including capital gains) for a certain period. Accordingly, the trustees of the estate will not be assessable on the net income of the trust estate for those years.
Issue 2 Question 1
Division 128 of the ITAA 1997 provides that when a person dies, a capital gain or capital loss from a Capital Gains Tax (CGT) event happening to a CGT asset the person owned just before death is disregarded (section 128-10 of the ITAA 1997).
Where the asset devolves to the legal personal representative (the executors of the estate) or passes to a beneficiary of the deceased estate the legal personal representative or beneficiary is taken to have acquired the asset on the day the person died. Any capital gain or capital loss the legal personal representative makes if the asset passes from the legal personal representative to the beneficiary is disregarded under subsection 128-15(3) of the ITAA 1997.
The provisions in Division 128 do not apply if the CGT assets pass to a beneficiary who is an exempt entity (i.e. an entity whose income is exempt from income tax). In these circumstances, section 104-215 of the ITAA 1997 applies and CGT event K3 happens.
However, as the trustees of the estate will be selling the assets and then distributing the proceeds to the residual beneficiaries, CGT event K3 cannot happen, as the assets owned by the deceased just before death never pass to the beneficiaries.
CGT Event A1
The disposal of assets by the trustees of an estate constitutes a CGT event A1 and any capital gain made on the disposal of the assets must, therefore, form part of the net income of the deceased estate (sections 104-10 of the ITAA 1997 and section 95 of the ITAA 1936).
The time of CGT event A1 occurring is when you enter into the contract for the disposal of the asset. Therefore any capital gain or capital loss is not included in the date of death tax return, as is the case if the asset is passed to a tax exempt entity and CGT event K3 applies, but in the estate return for the year of income in which the contract was for sale entered into (subsection 104-10(3) of the ITAA 1997)
The estate will make a capital gain if the capital proceeds received from the disposal of the assets exceed their cost base. The estate makes a capital loss if the capital proceeds received from the disposal of the assets is less than their cost base.
Subsection 128-15(4) of the ITAA 1997 contains the cost base rules in respect of CGT assets that devolve to the trustees of the estate. It provides, amongst other things, that:
if the asset was acquired by the deceased pre-20 September 1985, the legal personal representative is taken to have acquired it for its market value at the date of death (subsection 128-15(4) Item 4 of the ITAA 1997); and
if the asset was acquired by the deceased on or post-20 September 1985, the legal personal representative is taken to have acquired it for its cost base at the date of death (subsection 128-15(4) Item 1 of the ITAA 1997).
Therefore, the trustees will be taken to have acquired the shares on the date of death. The net capital gain arising from the sale of assets is required to be included in the net income of the estate (section 95 of the ITAA 1936 and section 102-5 of the ITAA 1997).
For the 50% discount and indexation purposes, the twelve month period is calculated from the time the deceased acquired the asset, not from the date of their death according to Item 3 in subsection 115-30(1) of the ITAA 1997.
Issue 2 Question 2
Under section 99A of the ITAA 1936, the trustee of an estate is assessed on that part of the net income of the trust estate that is not included in the assessable income of a beneficiary pursuant to section 97 of the ITAA 1936.
Section 97 of the ITAA 1936 provides that a resident beneficiary shall include in their assessable income all the income of a trust estate to which they are presently entitled.
In this case, the beneficiaries are presently entitled to all of the income of the trust estate so they should be assessed on the entire net income of the trust (including the capital gains).
If an exempt entity is covered by section 50-5 of the ITAA 1997, section 50-1 of the ITAA 1997 applies to exempt the ordinary and statutory income (that is, assessable income) of that entity from income tax.
As all of the trust income (including capital gains) is first included in assessable income of the beneficiaries under section 97 of the ITAA 1936, before becoming exempt income by virtue of section 50-1 of the ITAA 1997, there is no part of the income of the trust estate to which section 99A of the ITAA 1936 will apply.
Issue 2 Question 3
When a person dies, any capital gain or loss made by them in respect of a CGT asset they owner just before dying is disregarded, unless CGT event K3 applies (section 128-10 and 104-215 of the ITAA 1997).
Section 104-215(1) of the ITAA 1997 states that CGT event K3 happens if you die and a CGT asset you owned just before dying passes to a beneficiary in your estate who (when the asset passes):
· Is an exempt entity ;or
· Is the trustee of a complying superannuation entity; or
· Is a foreign resident.
The word passes is defined in section 995-1(1) of the ITAA 1997 as when a CGT passes to a beneficiary in an individual's estate in the way described in section 128-20 of the ITAA 1997.
Section 128-20(1) of the ITAA 1997 states that a CGT asset passes to a beneficiary in your estate if the beneficiary becomes the owner of the asset;
· under your will, that will as varied by a court order; or
· by operation of an intestacy law, or such a law as varied by a court order; or
· because it is appropriated to the beneficiary by your legal personal representative in satisfaction of a pecuniary legacy or some other interest or share in your estate; or
· under a deed of arrangement if:
· the beneficiary entered into the deed to settle a claim to participate in the distribution of your estate; and
· any consideration given by the beneficiary for the asset consisted only of the variation or waiver of a claim to one or more other CGT assets that formed part of your estate.
(It does not matter whether the asset is transmitted directly to the beneficiary or is transferred to the beneficiary by your legal personal representative).
To determine whether the CGT assets (shares) in the estate will pass to the residual beneficiaries under the will; it is necessary to determine whether the residual beneficiaries are absolutely entitled to the assets.
Draft Taxation Ruling TR 2004/D25 provides the Commissioner's view on the meaning of the words "absolutely entitled to a CGT asset as against the trustee of a trust' as used in the CGT provisions. 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 (1841) 4 BEAV 115 48 ER 282 applied in the context of the CGT provisions. If there is no basis upon which a trustee can legitimately delay the beneficiaries call for an asset, then the beneficiaries will be absolutely entitled to the asset. In this case, the will does not provide the trustee any legitimate reason to delay the beneficiaries' full enjoyment of the assets if they call for them.
If, as in this instance, there is more than one beneficiary with interests in the trust asset, then it will usually not be possible for any one beneficiary to call for the asset to be transferred to them or to be transferred at their direction. This is because their entitlement is not to the entire asset. There is, however, a particular circumstance where such a beneficiary can be considered absolutely entitled to a specific number of the trust assets for CGT purposes as explained in paragraphs 84 to 88 of TR 2004/D25.
A beneficiary with a vested and indefeasible interest in trust assets where one or more others also have an interest in those assets will nonetheless be considered absolutely entitled to a specific number of the trust's assets if the three factors listed below are also present.
First, the assets must be fungible, at least to the extent to which a person would reasonably be expected to be indifferent to the replacement of any one asset with another. Assets are fungible if they are of the same type such as shares.
Secondly, it must be the case that equity would permit the beneficiary to have their interest in all those assets satisfied by a distribution or allocation in their favour of a specific number of them.
Thirdly, there must be a very clear understanding on the part of all the relevant parties that the beneficiary is entitled, to the exclusion of the other beneficiaries, to a specific number of the trust's assets.
In this case, the trust assets to be transferred are shares and are considered to be fungible as they are of a similar type. Based on the information provided in your private ruling application the Commissioner is satisfied that equity would permit the residual beneficiaries to have their interest in all those assets being satisfied by the allocation in their favour of a specific number of them. In addition, it is clear that the residual assets of the estate are to be allocated in equal shares, thereby each beneficiary being entitled to a specific number of the trust's assets although it is impossible to say exactly which ones. Because the assets are fungible it does not matter that the beneficiaries cannot point to particular assets as belonging to them. It is sufficient that they can point to a specific number of assets as belonging to them, even though it is impossible to say exactly which ones.
As all the above factors are present, the residual beneficiaries are considered absolutely entitled to the trust's assets for CGT purposes.
You have argued that the residual beneficiaries have no absolute entitlement to the shares in the residue of the estate stating that as explained in Pagels v. MacDonald (1936) 54 CLR 519 at 528-529;
"…The natural construction of the word divide, together with the reference to the equality of shares is a direction to distribute proceeds."
You have stated that in considering the above information in Pagels v. MacDonald that the will directs the trustees to sell the shares in the residue of the estate. In Pagels v. MacDonald, the will stated that the assets were to be equally divided amongst the residual beneficiaries. In this case, Clause 8 of the will does not specify the word divide, although it does refer to the residual assets being held for the residual beneficiaries in equal shares. This being so, in the case of Pagels v. MacDonald, they were dealing with real property, where the seven residual beneficiaries were not absolutely entitled to the asset. In this situation the CGT assets being shares are considered to be fungible, and as previously explained meet the criteria under TD 2004/D25 for the residual beneficiaries to be absolutely entitled to the assets as against the trustee of the trust.
When the trustees transfer the shares to the residual beneficiaries then the assets are considered to have passed to the beneficiaries under the will. Therefore, CGT event K3 will happen as the CGT assets the deceased owned just before dying will pass to the residual beneficiaries in your estate who are exempt entities when the asset passes.