Edited version of private ruling

Authorisation Number: 1011651688884

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Ruling

Subject: CGT - Disposal of Life Interest

Question 1

Will capital gains tax (CGT) apply on the transfer of the taxpayer's life interest in a property to the children of the taxpayer as detailed in the deed of family arrangement?

Answer

Yes

This ruling applies for the following period

Income year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

The taxpayer is the widow of their deceased spouse who died a number of years ago. They are the sole named executrix and trustee of the will.

Probate was granted to the trustee.

The taxpayer and the deceased have a number of children.

By virtue of the will, the taxpayer has a life interest in their spouse's residuary estate subject to the right of any of the children from their marriage to reside with them in the principal residence. On their death, the residuary estate passes to the children or such of them as are alive upon their death and if any of them predeceased them, then the predeceased child's' children take the share of the residuary estate that their parent would have taken.

The residuary estate comprises some personal assets and includes three separate pieces of real estate, namely:

· the principal residence;

· the rental property; and

· the unit.

The taxpayer's child from a previous marriage, was raised and maintained by both the taxpayer and the deceased as if a child of their marriage, but was not named as a beneficiary in the will.

One of the children and their spouse are currently occupying the unit.

The taxpayer and their children considered the will to be unfair in that the taxpayer was only left with life interest and omitting the child from the previous marriage as a beneficiary. They reached a family arrangement and a deed of family arrangement (the deed) was placed into effect a number of years ago to rearrange the estate as follows:

· the taxpayer will retain the absolute ownership of the personal assets.

· the taxpayer will have absolute ownership of the principal residence and the triplets relinquishes their interest (present or contingent) to the property;

· the taxpayer relinquishes their life interest in the rental property and transfers one undivided moiety to one child and the other moity to the child and their spouse as joint tenants to the intent that they shall hold that property absolutely.

· the taxpayer will retain their life interest in the unit and their child and one of the children relinquishes themselves and any of their children the remainder interests to the property in favour of the child from a previous marriage receiving one undivided moiety and the other child an undivided moiety.

After remarrying, the taxpayer has decided to give up their life interest in the unit, as they are now a pensioner and can no longer look after it, for no financial payment and transfer it to their children, the remainder owners of the unit pursuant to the deed of family arrangement.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 100-45

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-10(2)

Income Tax Assessment Act 1997 Subsection 104-10(3)

Income Tax Assessment Act 1997 Subsection 104-10(4)

Income Tax Assessment Act 1997 Section 112-20

Reasons for decision

Summary

Capital gains tax will apply on the transfer of the life interest to the taxpayer's children.

Detailed reasoning

You make a capital gain or a capital loss if and only if a capital gains tax (CGT) event happens to a CGT asset.

CGT event A1 happens if you dispose of a CGT asset: section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997).

A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997).

An interest in a CGT asset is also a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity (subsection 104-10(2) of the ITAA 1997).

The time of the event is when you enter into the contract for the disposal or if no contract, when the change of ownership occurs (subsection 104-10(3) of the ITAA 1997).

You will make a capital gain if the capital proceeds of the assets at the time of the disposal or transfer is more than their cost base and conversely you will make a capital loss if the capital proceeds is less than the reduced cost bases of the assets (subsection 104-10(4) of the ITAA 1997).

Taxation Ruling TR 2006/14 deals with the capital gains tax consequences of creating and later dealings in life and remainder interests in property.

Life interest and remainder interest are terms used to distinguish the interest that an entity has as either a beneficiary of a trust (equitable interest) or, less commonly, as the owner of a freehold estate in land (legal interest).

As a result of your spouse's death, the residuary estate created three separate interests in three real estate properties:

· your interest as a life tenant;

· the three children's interest in the remainder; and

· the children's interest of those three children, in the remainder.

However, as your children from a previous marriage was omitted from this will, a deed of family arrangement was put into place to rearrange the estate.

Pursuant to the deed, you have an absolute ownership of the personal asset and residential property, and a lifetime interest in the unit held in trust. The child from a previous marriage and one of your other children were named as the remainder beneficiaries who will receive the benefit of the unit on your death.

It is therefore considered that you have an equitable life interest, being an interest in a trust.

For CGT purposes, these separate interests in the property are assets in their own right.

Surrender of Life Interest

Paragraph 66 of TR 2006/14 states that, when a life interest owner surrenders or releases their interest in a deceased estate, a CGT event A1 happens (section 104-10 of the ITAA 1997). This is because there is a change of ownership of the interest from one party to another, rather than a mere ending of it.

Paragraphs 68, 69 and 70 further advice that if the surrender is made for no capital proceeds, then section 116-30 of the ITAA 1997, the market substitution rule, will operate to determine the amount of capital proceed that the remainder beneficiaries have paid to acquire the life interest. On the other hand, if the capital proceeds paid are more or less than the market value, and the parties did not deal at arms length, the market value substitution will apply.

In this case, you want to transfer your life interest in the unit to the remainder beneficiaries as you are now a pensioner and can no longer take care of it. By transferring your life interest, CGT event A1 will occur as you are disposing of an asset, being an equitable interest in a trust to the remainder beneficiaries. As the remainder beneficiaries are related to you and no consideration will be received, the transaction will not be at arms length.

Therefore, you will be deemed as having been paid the capital proceeds at the market value for the life interest by the remainder beneficiaries at the time of transfer.

Note: A life interest is generally measured by the life of the life interest owner and the market value of a life interest may be obtained from a qualified valuer (for example, a qualified actuary).

Capital gains tax calculation

The net capital gain applicable for this CGT event is the difference between the cost base and the capital proceeds. If the capital proceeds is more than the cost base, then you have made a capital gain. Alternatively, if the capital proceeds is less than the reduced cost base, then you have made a capital loss: section 100-45 of the ITAA 1997.

The cost base is made up of five elements. Section 110-25 of the ITAA 1997 list the elements as follows:

1. The first element is the total of the money paid or required to pay in acquiring the CGT asset (subsection 110-25(2) of the ITAA 1997)

2. The second element is the incidental costs of acquiring the asset or costs in relation to the CGT event, such as valuation cost (subsection 110-25(3) of the ITAA 1997)

3. The third element consists of capital and non-capital costs incurred in connection with the ownership of a CGT asset. Specifically, subsection 110-25(4) of the ITAA 1997states that the third element is the costs of owning the CGT asset you incurred (but only if you acquired the asset after 20 August 1991) (subsection 110-25(4)). These costs include:

(a) interest on money you borrowed to acquire the asset; and

(b) cost of maintaining, repairing or insuring it; and

(c) rates or land tax, if the asset is land; and

(d) interest on money you borrowed to refinance the money you borrowed to acquire the asset; and

(e) interest on money you borrowed to finance the capital expenditure you incurred to increase the asset's value.

4. The fourth element under subsection 110-25(5) of the ITAA 1997 is capital expenditure you incurred for

(a) the purpose or the expected effect of which is to increase or preserve the asset's value; or

(b) that relates to installing or moving the asset.

5. The fifth element includes capital expenditure you incur to preserve or defend your title or rights to the asset (subsection 110-25(6) of the ITAA 1997).

TR 2006/14 states at paragraphs 25 and 26 that the first element of the cost base and reduced cost base of an equitable life interest is the sum of any money and the market value of any property given to acquire it (subsection 110-25(2) of the ITAA 1997). In addition, if as is generally the case, no money or property is given to acquire an equitable life interest, section 112-20 of the ITAA 1997 provides that the first element of the cost base and reduced cost base of the interest is its market value at the time it was acquired.

In this case, you acquired an asset, your life interest in the trust, at the time when the testamentary trust was created, that is, at probate date.

Therefore, to determine the cost base or reduced cost base, the first element will be the market value of your life interest in the unit on the date of administration of the deceased's will and any incidental costs in relation to the CGT event.

The capital proceeds for the CGT event is the market value of your life interest in the unit on the date of transfer of your life interest to your children, that is, the date of written agreement.

As you have owned the life interest for more than 12 months, and you acquired the life interest prior to 19 September 1999, you can choose either the indexation or the 50% CGT discount method for individuals to calculate your net capital gain.

(For further information, please refer to Guide to Capital Gains Tax 2009-10 and TR 2006/14: Income tax: capital gains tax: consequences of creating life and remainder interests in property and of later events affecting those interests which can be viewed from our website.

Note: This private ruling is provided for the rulee and does not take into consideration the CGT implications for any other parties.