Edited version of private ruling

Authorisation Number: 1011734699796

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Ruling

Subject: Capital gains tax - life and remainder interests

Transaction 1

Question 1

Will the rulees be presently entitled, under section 97 of the Income Tax Assessment Act 1936 (ITAA 1936), to their share of net income as defined in section 95 of the ITAA 1936 by reference to the cash distribution?

Answer

No

Question 2

In accordance with section 104-80 of the Income Tax Assessment Act 1997 (ITAA 1997), will CGT event E6 happen when the rulees give up their equitable life interest in the property in exchange for a legal life interest?

Advice/Answers

Yes.

Question 3

Will the anti-overlap rule at section 118-20 of the ITAA 1997 operate so that the rulees will not be assessed on both the capital gain they make personally and the capital gain distributed to them from the trust?

Advice/Answers

The rule in section 118-20 of the ITAA 1997 has no application in this instance.

Question 4

Will the market value substitution rule apply to form the first element of the cost base of the legal life interest?

Advice/Answers

No.

Transaction 2

Question 1

Will the rulees be presently entitled to a share in any capital gain derived by the trust from the disposal of the property?

Advice/Answers

No.

Question 2

Will CGT event E6 happen when the rulees give up their equitable life interests?

Advice/Answers

No, CGT event A1 will happen.

Question 3

Will the market value substitution rule under section 116-30 of the ITAA 1997 apply to the proceeds received by the rulees from giving up their life interests?

Advice/Answers

Yes, if the capital proceeds are more or less than the market value of their existing interest.

Question 4

Will the anti-overlap rule at section 118-20 of the ITAA 1997 operate so that the rulees will not be assessed on both the capital gain they make personally and the capital gain distributed to them from the trust?

Advice/Answers

The rule in section 118-20 of the ITAA 1997 has no application in this instance.

This ruling applies for the following periods:

2010-11 financial year

2011-12 financial year

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The rulees hold equitable life interests in a testamentary trust, set up under the will of a deceased person, to hold an asset for the benefit of certain life and remainder beneficiaries.

The rulees have the use and enjoyment of the property, and are responsible for expenses, until the happening of a certain event. At that time, the asset is to be sold for its market value and the proceeds to be distributed among the remainder beneficiaries.

The asset has not been used to derive income. The trust has not derived any income from any source.

Beneficiary X would now like to acquire ownership of the property. There are two methods for achieving this that are being seriously considered.

Under the first method, it is proposed that the beneficiaries would exchange their equitable life and remainder interests in consideration for a legal life and remainder interests. Subsequently the legal life interests and the legal remainder interests would simultaneously be sold to beneficiary X for market value consideration.

Under the second method it is proposed that the beneficiaries will surrender their respective equitable interests and beneficiary X will acquire the property for market value consideration. The proceeds will be distributed to the beneficiaries.

First proposed transaction

Present entitlement to the trust capital gain

It is proposed that the trustees that will dispose of the property, by granting legal life and remainder interests to the beneficiaries.

Paragraph 85 of TR 2006/14 explains that bringing a legal life interest into existence involves a disposal of part of a CGT asset in a similar way to the disposal of a percentage interest in it.

This transaction is discussed in TR 2006/14 at paragraphs 52 to 58. The principles of these paragraphs have been applied below to the rulees' circumstances.

Under section 104-80 of the ITAA 1997, CGT event E6 will happen if the trustees dispose of a CGT asset (the legal life interests) to Bob and Ailsa in satisfaction of their right to receive income from the trust.

The trustees will make a capital gain if the market value of the legal life interests is more than its cost base: subsection 104-80(3) of the ITAA 1997.

The notional taxable income of the trust under section 95 of the ITAA 1936 will include a capital gain from CGT event E6.

Under section 97 of the ITAA 1936, a beneficiary who is presently entitled to a share of the 'income of the trust estate' is assessed on 'that share' of the trust's notional taxable income worked out under section 95. That notional taxable income is referred to as the 'net income' of the trust estate, but to avoid confusion in this ruling it is referred to as the '[tax] net income'.

The meaning of the expressions 'income of the trust estate' and 'share' were considered by the High Court in its decision in Commissioner of Taxation v. Phillip Bamford & Ors; Phillip Bamford & Anor v. Commissioner of Taxation (Bamford ) [2010] HCA 10.

Following the decision it is clear that 'income of the trust estate' takes its meaning from trust law such that, if the deed permits, capital receipts of a period can be treated as income for that period. It is also clear that a beneficiary's share of the income of the trust estate available for distribution (that is, of the trust's 'distributable income') is converted to a percentage and the beneficiary is assessed on that same percentage of the trust's [tax] net income.

In this case, the will does not specifically permit capital receipts to be treated as income. In addition, as the trust has never derived income from the property, and it is not anticipated that the property would be employed to derive assessable income, then there will be no distributable income of the trust.

Consequently, although the [tax] net income of the trust will include the capital gain from CGT event E6, if there is no distributable income, then it follows that there can be no beneficiary that can be presently entitled to the [tax] net income for that period.

Surrender of equitable interest

Under section 104-80 of the ITAA 1997 CGT event E6 will happen if the trustees dispose of a trust asset to the beneficiaries in satisfaction of their right to receive income (the equitable interest).

Unlike the case for a capital gain for CGT event E7, the capital gain or loss under CGT event E6 is not able to be disregarded merely because the interest was acquired for no expenditure.

The note to subsection 104-80(5) of the ITAA 1997 explains that if the beneficiary did not pay anything for the right (the equitable interest), the market value substitution rule does not apply for the first element of the cost base.

The other elements of the cost base of the right would be calculated in accordance with section 110-25 of the ITAA 1997.

CGT event E6 contains an exception for a trust to which Division 128 of the ITAA 1997 applies. Division 128 applies to the passing of an asset from a deceased individual's legal personal representative to a beneficiary in the estate, during the administration of the estate. However in this case, the administration of the deceased estate was completed (in regards to this asset) after probate was granted and the property was transferred to the trustees in accordance with the instructions contained in the will. Consequently this exception will not apply.

Cost base of legal life interest

The granting of the legal life interest is a disposal of an asset by the trustees, as there is a change of ownership of part of the original asset from the trustees to the legal life interest owner.

However, under paragraph 110-25(2)(b) of the ITAA 1997, the first element of the cost base includes the market value of any property given. The market value of the equitable right that was given up will therefore become the first element of the cost base of the legal life interest

Second proposed transaction

CGT event

Under alternative transaction number two, it is proposed that the beneficiaries will surrender their equitable interests in the trust in consideration for market value of the asset to be paid by beneficiary X.

It is proposed that the consideration will be distributed among all of the beneficiaries.

The will provides for the trustees to have certain discretionary powers, including the power to sell of distribute assets in specie.

We consider that unless the beneficiaries surrender their interests, the trustees would be required to acquire a replacement asset to be held on trust. This is because the interests of the equitable life interest owners can only be defeated by a certain event.

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

As the parties, the market value substitution rule in section 116-30 of the ITAA 1997 will apply only if the capital proceeds received from beneficiary X are less than the market value of the equitable right at the time of the event.

Consequently, if the interest owners transferred their interests in the trust, beneficiary X, would become the owner of the trust interests. In that situation, beneficiary X would be considered to be absolutely entitled to the trust asset and CGT event E5 would happen under section 104-75 of the ITAA 1997.

The resulting capital gain made by the trustee from CGT event E5 would be included in the [tax] net income of the trust however there is no beneficiary that would be presently entitled to this income. Following from the decision in Bamford, this capital gain is [tax] net income to which no beneficiary would be presently entitled, as previously discussed. This income would therefore be assessed to the trustees.