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Ruling

Subject: Capital Gains Tax - CGT event K3

Question 1

Does CGT Event K3 in section 104-215 of the Income Tax Assessment Act 1997 ('ITAA 1997') happen if assets, owned by a deceased person at the date of their death, pass to a trust established under their will which is not an exempt entity, and under the terms of the trust, the assets are to be held in the trust in perpetuity with the trust income to be applied for public charitable purposes?

Answer

No. If, at the time the assets of the estate pass, the beneficiary is not a tax-advantaged entity a CGT event K3 does not occur.

Question 2

Will CGT Event K3, or any other CGT event, happen if the testamentary trust is endorsed as an income tax exempt fund effective from the date of commencement of the trust?

Answer

Yes. A CGT event K3 will occur if the trust is endorsed as an income tax exempt fund effective from the date of its commencement.

Question 3

Would Part IVA of the Income Tax Assessment Act 1936 ('ITAA 1936') operate to deny this course of action?

Answer

The application of Part IVA of the ITAA 1936 to this scheme has not been considered.

Facts

The deceased died in July 2008. Probate was granted in November 2008. The estate has not yet applied for a tax file number (TFN) or an Australian Business Number (ABN). It is intended that a TFN and ABN will be obtained after this ruling issues.

Under the deceased's will, the residue of their estate is to be held by their executors and trustees on trust (in perpetuity) to apply the income from the trust for public charitable purposes.

The testamentary trust will not seek initial endorsement by the Australian Taxation Office under Subdivision 50-A of the ITAA 1997 as an income tax exempt fund.

It is contended that the assets pass to the testamentary trust beneficiary at the time the estate administration is concluded. Accordingly, CGT event K3 will not apply as the assets have not passed to a tax-advantaged beneficiary.

The trust will then seek income tax exempt fund endorsement on the basis that it is a non-charitable fund established by will solely for the purpose of providing money, property or benefits to income tax exempt deductible gift recipients (DGRs).

Reasons for decision

Question 1

CGT event K3

A CGT event K3 happens when an asset passes to a tax-advantaged entity. Subsection 104-215(1) of the ITAA 1997 states:

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.

…

A CGT event K3 happens if a CGT asset owned by a deceased person just before they died passes to a beneficiary in their estate that is an exempt entity when the asset passes. The time of the event is just before the deceased died which means that any resulting capital gain or loss is accounted for in the final income tax return lodged on behalf of the deceased.

An exempt entity is an entity whose ordinary and statutory income is exempt because of Division 50 of the ITAA 1997. A fund for public charitable purposes will only be exempt if it is endorsed as such by the ATO - refer Division 426 of Schedule 1 to the Taxation Administration Act 1953 (TAA).

When does an asset pass to a beneficiary?

Subsection 128-20(1) of the ITAA 1997 sets out the circumstances in which an asset is taken to have passed to a beneficiary:

A CGT asset passes to a beneficiary in your estate if the beneficiary becomes the owner of the asset:

under your will, or that will as varied by a court order…..

An asset will pass to the beneficiary of a deceased estate when the beneficiary becomes absolutely entitled to the asset as against the estate's trustee (whether or not the asset is later transmitted or transferred to the beneficiary). Taxation Ruling IT 2622 describes the process in more detail:

2. On the death of a taxpayer, the property of the deceased taxpayer passes to his or her estate, legal control over which is exercised by an executor or administrator. The executor or administrator, in effect, steps into the shoes of the deceased and winds up the deceased's personal affairs. An executor of a deceased person who leaves a will must obtain probate of the will. This is the official proving of the will and provides the executor with the authority to deal with the estate. When probate has been granted, the executor is free to call up the deceased's assets and liabilities, and pay the debts, funeral and testamentary expenses. After all these matters have been attended to, the executor distributes the property of the deceased to the beneficiaries of the estate.

3. A fiduciary obligation is assumed by the executor or administrator, on the death of the taxpayer, in favour of the beneficiaries of the estate. At that time, beneficiaries of the estate have no interest in the assets of the estate, although they do have a beneficial right to see that the estate is properly administered.

4. Even though a will may provide beneficiaries with absolute and indefeasible interests in the capital or income of an estate, under State laws those interests cannot crystallise until probate has been granted.

A beneficiary does not have any interest in any assets of a deceased estate until the administration of the estate is complete: see FC of T v. Whiting (1943) 68 CLR 199; 7 ATD 179.

Therefore the Trust in the present case will become entitled to the assets of the Estate only after the Estate has been fully administered.

Will a CGT event K3 happen in this case?

A CGT event K3 will happen if, at the time the assets of the Estate pass, the trust fund is a tax exempt entity. If the trust fund has not been endorsed as a tax exempt entity, then a CGT event K3 will not occur.

Question 2

What is an 'exempt entity'?

Subsection 995-1(1) of the ITAA 1997 defines an exempt entity as an entity whose ordinary and statutory income is exempt because of Division 50 of the ITAA 1997. A trust for public charitable purposes will only be exempt if it is endorsed as such by the ATO.

Division 426 of Schedule 1 to the TAA sets out the process by which an entity may be endorsed as a tax exempt entity. If the Commissioner gives written notice to an applicant that its application for endorsement has been approved, the endorsement has effect from the date specified by the Commissioner. The legislation states that the date specified may be any date, including a date before the application for endorsement was lodged and a date before the applicant has an ABN (subsections 426-30(1) and (2) of Schedule 1 to the TAA).

Paragraph 39 of Taxation Ruling TR 2000/11 also makes it clear that endorsement as an income tax exempt entity has effect from a date specified by the Commissioner and that this date may be earlier than the time the endorsement is made.

Neither the ITAA 1997 nor the TAA prescribe if, or when, an eligible entity must apply for endorsement as an income tax-exempt entity. The Explanatory Memorandum to the Tax Laws Amendment (2004 Measures No. 1) Act 2004 makes the following statement about endorsement of charities:

10.17 While endorsement is beneficial to charities (and public benevolent institutions and health promotion charities) as it allows them to access certain taxation concessions, it is possible that some entities may be entitled, but not wish to be endorsed. The requirement that an entity apply for endorsement preserves the right of the entity not to be endorsed if they so choose.

The effect of endorsement

Paragraph 104-215(1)(a) of the ITAA 1997 requires an entity to be an exempt entity 'when the asset passes' for CGT event K3 to be triggered.

Under section 426-30 of the TAA endorsement of a tax exempt entity has effect from the date specified by the Commissioner.

Under subsection 426-30(2) of the TAA 'the date specified may be any date (including a date before the application for endorsement was made…)'. This section would therefore allow the Commissioner to grant endorsement of an entity's tax exempt status to take effect on or before the date an asset passed to the entity from an estate.

The Explanatory Memorandum to the Income Tax Amendment (Capital Gains) Bill 1986 states that the former section 160Y of the ITAA 1936 (which section 104-215 replaced) '…applies where an asset passes in the administration of the estate of a deceased person to a tax-exempt person or body.' and that the asset is taken to have been disposed of immediately before the death of the person. It further states that 'Sub-section 160Y(1) defines a person to be a tax-exempt person for the purposes of the section if a relevant excepting provision… applies to the person in relation to the year of income.'

The former section 160Y of the ITAA1936 applied where the beneficiary was 'a tax-exempt person in relation to the year of income' (subparagraph 160Y(2)(c)(i)) and subsection 160Y(1) provided that 'A person is a tax-exempt person in relation to the year of income for the purposes of this section if the person is a person whose income of the year of income is exempt from tax by virtue of a relevant exempting provision.'

Although it is not clear in which year the status of the beneficiary was to be determined (if the asset passed in a different year to the death), the wording of the previous section does more clearly lend itself to the view that it is the entity's status in the year of income which is the determinative factor in the application of the provision and that that status would be determined strictly by the application of the exempting provisions. Under the wording of the legislation at that time the trustee of a deceased estate was also at risk that the tax liability of the deceased will be increased after the completion of administration of an estate by virtue of an estate asset passing to a tax-exempt or tax-advantaged beneficiary.

The policy behind the former section 160Y was interpreted by B M Nolan, then Second Commissioner of Taxation, in Capital Gains Tax, October 1986, (Vol 21 No 4) p 215 at 216:

There is an exception to these general rules [s 160X's rules] when an asset is bequeathed to an income tax-exempt body. The asset is taken to have been disposed of for its market value immediately before death and any capital gains tax liability of the estate will be calculated on that footing. The general provision that death is not to constitute the disposal of an asset, and that capital gains tax liability is only determined at the time of actual disposal, is departed from in these cases on policy grounds. If that were not done such assets would be completely outside the capital gains tax base as the tax exempt body is not liable for tax on any gain accruing during its period of ownership. The effective result is to limit capital gains tax to gains accrued to the date of death in these cases.

At the core of the CGT provisions is the concept that gains and losses that are taken to occur at one point in time can be affected by events that occur later in time. For instance the timing of events such as A1 may be governed by the entry into a contract for disposal but the gain or loss realised from the event may be affected by events which occur years later such as non-receipt of the capital proceeds. The fact that there are many exceptions to the period of review provisions for assessments (in subsection 170(10AA) of the ITAA 1936) allowing amendments to give effect to the CGT provisions further demonstrates that the intrinsic nature of the operation of many CGT provisions requires that the gains and losses realised by an entity can be altered over time.

In some CGT events there is a disparity between when the circumstances giving rise to a CGT event occur, and the time at which the gain or loss arises. CGT event K3 is a prime example of such a provision where the realisation of a gain or loss is taken to have occurred (just before you die) before the events happen which trigger it (your death and the administration of the CGT assets in your estate).

The concept of whether an entity is an exempt entity is also a concept which is inherently flexible in time as the Commissioner can endorse an entity's exempt status from any date including before the entity's application (section 426-30 of the TAA).

To give effect to the Commissioner's ability to grant endorsement in this way, the phrase 'when the asset passes' should not be taken as a strict point in time test which would require an entity to have already been endorsed at that time. Rather the words should be read to allow later events such as the endorsement of an entity's exempt status (with effect at the time the asset passed) to trigger the operation of CGT event K3.

For example, where the beneficiary of a testamentary trust is not an exempt entity they will be subject to CGT if a CGT event subsequently occurs in relation to the asset (or other tax consequences). An exempt entity will not be subject to tax if a CGT event subsequently occurs in relation to the asset. On this basis it is reasonable to assume that the intent of subsection 104-215(1) of the ITAA 1997 is to ensure that CGT is applied to an asset before it is transferred to an exempt entity. If the date of endorsement specified by the Commissioner is on or before the date that the asset passes then a CGT event K3 will be triggered.

In practice, endorsement of an entity as an income tax exempt entity will always occur retrospectively. As it is the Commissioner's policy to endorse an eligible entity from the time the entity comes into existence and meets the requirements for endorsement, a CGT event K3 will occur as assets will pass to a tax exempt entity.

Can a CGT event, other than K3, apply in this instance?

The CGT legislation recognises that more than one CGT event may apply in some circumstances.

Subsection 102-25(1) of the ITAA 1997 states:

Work out if a CGT event (except CGT events D1 and H2) happens to your situation. If more than one event can happen, the one you use is the one that is the most specific to your situation.

In this case, when an asset passes from the deceased estate to the testamentary trust, a CGT event A1 would occur. This is because there is a change in the beneficial and legal ownership of the asset.

However, in this instance, CGT event K3 is the most appropriate CGT event as it more accurately describes the situation - the passing of an asset(s) from a deceased estate to an income tax exempt entity.

Question 3

In view of our response to question 2, we have not considered the application of Part IVA of the ITAA 1936 to this scheme.