Edited version of private ruling

Authorisation Number: 1011736627356

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Ruling

Subject: Capital gains tax - life and remainder interests

First proposed transaction

Question 1

Will the net income of the trust include a capital gain from CGT event E6 under section 104-80 of the Income Tax Assessment Act 1997 (ITAA 1997) when the trustees transfer the legal life interest to Q?

Answer

Yes.

Question 2

Will the net income of the trust include a capital gain from CGT event E7 under section 104-85 of the ITAA 1997 when the trustees transfer the legal remainder interest to Q's children

Answer

Yes.

Question 3

If the trustees are assessed under Division 6 of the Income Tax Assessment Act 1936 (ITAA 1936), will the Commissioner exercise the discretion under subsection 99A(2) that section 99A does not apply?

Answer

Yes.

Second proposed transaction

Question 1

Will the net income of the trust include a capital gain under CGT event A1 from the disposal of the property to Tess?

Answer

No, the applicable event is CGT event E5.

Question 2

If the trustees are assessed under Division 6 of the ITAA 1936, will the Commissioner exercise the discretion under subsection 99A(2) that section 99A does not apply?

Answer

Yes.

This ruling applies for the following period<s>:

2010-11 financial year

2011-12 financial year

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The rulees are the trustees of a testamentary trust, which was set up under the will of a deceased person, to hold an asset for certain life and remainder beneficiaries.

The life beneficiaries 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 will be distributed among the remainder beneficiaries.

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

One of the beneficiaries (beneficiary X) would like to acquire the property for its market value. The rulees are considering two alternative methods to achieve this.

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 in the property, and beneficiary X will purchase the property for arm's length consideration. The proceeds will be distributed to the beneficiaries.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 95,

Income Tax Assessment Act 1936 Section 97,

Income Tax Assessment Act 1997 Section 104-80,

Income Tax Assessment Act 1997 Subsection 104-80(5),

Income Tax Assessment Act 1997 Section 118-20,

Income Tax Assessment Act 1997 Section 116-30,

Income Tax Assessment Act 1997 Section 110-25,

Income Tax Assessment Act 1997 Paragraph 110-25(2)(b),

Income Tax Assessment Act 1997 Subsection 112-20(2),

Income Tax Assessment Act 1997 Section 104-10,

Income Tax Assessment Act 1997 Section 104-75,

Income Tax Rates Act 1986 Subsection 12(9) and

Income Tax Rates Act 1986 Part 1 of Schedule 10.

First proposed transaction

Transfer of legal life interest

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, and that CGT event A1 happens.

The transfer for an asset to a life interest owner is discussed in TR 2006/14 at paragraphs 52 to 58. The principles of these paragraphs have been applied below to the rulees' circumstances.

We consider that CGT event E6 is the more specific event and not CGT event A1, because the transfer will be made to existing beneficiaries.

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 a trustee in satisfaction of their right to receive income from the trust.

The trustees will make a capital gain from CGT event E6 if the market value of the legal life interests is more than its cost base: subsection 104-80(3) of the ITAA 1997.

Paragraph 11 of TR 2006/14 states that the creation of equitable life and remainder interests involves the creation of a trust over an original asset.

Paragraph 18 of TR 2006/14 states that if the trust is created as a result of the death of an individual, the trustee acquires the asset at the date of death of the deceased.

The trustee's acquisition cost is determined under subsection 128-15(4) of the ITAA 1997, which provides that for a pre-CGT asset of a deceased person, the first element of the cost base for the trustee is the market value of the asset on the date of death.

Subsections 112-30(2 and (3) of the ITAA 1997 contain the apportionment rules for the cost base of an asset that was part of another asset. Paragraph 89 of TR 2006/14 confirms that the following formula is used to work out the cost base of the legal life interest:

cost base of asset x capital proceeds from CGT event

capital proceeds from CGT event +

market value of the remaining part of the asset

Paragraph 93 of TR 2006/14 contains the Commissioner's view that although the trustees may be disposing of both parts of the asset (both the legal life interest and the legal remainder interest), the disposal of the legal life interest must precede that of the remainder interest. Therefore at the instant that the life interest is disposed of, the remainder is undisposed and therefore a CGT event has happened to part of the asset but not to all of it.

Transfer of legal remainder interest

The granting of legal life and remainder interests is discussed in paragraphs 85 to 94 of TR 2006/14. In summary the Commissioner's view is that CGT event A1 happens if an original owner of real property disposes of a legal life interest to another person.

TR 2006/14 in paragraphs 59 to 65, states that where a trustee distributes an asset to a remainder owner in satisfaction of their interest in the trust capital, CGT event E7 happens under section 104-85 of the ITAA 1997.

The trustee makes a capital gain if the market value of the asset at the time of the disposal is more than its cost base. The cost base apportionment rules in subsections 112-30(2 and (3) of the ITAA 1997 will apply to the asset of the trust.

Commissioners Discretion

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.

Sections 99 and 99A of the ITAA 1936 apply to assess a trustee on income to which no beneficiary is presently entitled or income which is retained or accumulated by the trustee. In considering these sections, we must first consider section 99A.

 Section 99A of the ITAA 1936 applies in relation to all trusts unless:

· the trust resulted from a will; subparagraph 99A(2)(a)(i)

· the trust is bankrupt estate; paragraphs 99A(2)(b) and (c)

· the trust is a trust that consists of property referred to in paragraph 102AG(2)(c) of the ITAA 1936

· and the Commissioner forms the opinion that it would be unreasonable to apply section 99A in such circumstances.

 The applicable rate of tax under section 99A of the ITAA 1936 is set in subsection 12(9) of the Income Tax Rates Act 1986 (ITRA 1986) at 47%, which is imposed from the first dollar of taxable income.

Subsection 99A(2) of the ITAA 1936 outlines the circumstances when the Commissioner may apply his discretion for Section 99A not to apply. The relevant part of subsection 99A(2) states that the discretion may be exercised where a trust estate resulted from a will, a codicil or an order of a court that varied or modified the provisions of a will or a codicil. The discretion is exercised where the Commissioner is of the opinion that it would be unreasonable for Section 99A to apply.

Consequently, the favourable exercise of the Commissioner's discretion under subsection 99A(2) of the ITAA 1936 means the highest rate of income tax does not apply to trust estates resulting from a will, codicil, etc. These include both the estate of a deceased person and testamentary trusts established pursuant to the terms of a will.

Rates of Tax

The rates of tax for trustees assessed under section 99 are found in subsection 12(6) of the ITRA 1986 which directs attention to Schedule 10 of that Act. Part 1 of Schedule 10 of the ITRA 1986 identifies two classes of trustees for the purpose of determining the rates of tax that are to apply.

 In the first class are trustees who are liable to be assessed under section 99 of the ITAA 1936 in respect of resident trust estates of a deceased person where the income is derived in the year of death of the deceased or in any one of the following two years. These trustees are liable to pay tax at the rates applicable to resident individuals.

The second class of trustees identified in Part 1 of Schedule 10 of the ITRA 1986 comprises trustees liable to be assessed under section 99 of the ITAA 1936 in respect of income of a resident trust estate, other than the estate of a person who died fewer than three years before the end of the income year.

These trustees are liable to tax at the rates specified for resident individuals except that they have a reduced tax free threshold. For example in the 2009-10 financial year the rates applicable for a trustee of a testamentary trust where the Commissioner had exercised the discretion under section 99A(2) of the ITAA 1936 were:

Second proposed transaction

Disposal of property to a Trustee

Under alternative transaction number two, it is proposed that all of the beneficiaries give up their equitable interests in the trust, in consideration for this beneficiary X will pay market value of the asset.

The will provides for the trustees to have certain discretionary powers including the power to sell or distribute assets.

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 (the right to use occupy and enjoy the property) can only be defeated by a certain event.

Consequently, if the interest owners transferred their interests to beneficiary X, that beneficiary would become the owner of all of the life interests and the remainder interests.

In that situation, CGT event E5 under section 104-75 of the ITAA 1997 would happen if beneficiary X is considered to be absolutely entitled to the trust asset.

The Commissioner's preliminary but considered view of absolute entitlement is contained in Draft Taxation Ruling TR 2004/D25 Income tax: capital gains: meaning of the words 'absolutely entitled to a CGT asset as against the trustee of a trust' as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997.

Paragraph 10 of TR 2004/D25 states:

'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.'

Paragraph 20 states:

'The most straight forward application of the 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.'

And at paragraph 22:

'Such a beneficiary will be absolutely entitled to that asset as against the trustee for the purposes of the CGT provisions if the beneficiary can (ignoring any legal disability) terminate the trust in respect of that asset by directing the trustee to transfer the asset to them or to transfer it at their direction.'

As a result of the other beneficiaries disposing of their equitable interests in the trust beneficiary X would then hold all of the interests in the trust. The interests of beneficiary X could not be defeated, and beneficiary X would be absolutely entitled to the trust asset. Under section 104-75 of the ITAA 1997, CGT event E5 will happen at the time that beneficiary X becomes absolutely entitled to the asset.

In accordance with subsection 104-75(3) of the ITAA 1997, the trustees will make a capital gain if the market value of the property is more than its cost base. As discussed previously, the trustees cost base is its market value at the date of the deceased's death.

The resulting capital gain made by the trustee from CGT event E5 would be included in the notional taxable income of the trust. As discussed previously, this would be income to which no beneficiary would be presently entitled.

Commissioner's discretion

As the capital gain made by CGT event E5 happening to the property, is [tax] net income to which no beneficiary is presently entitled, this income would be assessed to the trustees under section 99A of the ITAA 1936, unless the Commissioner considers it unreasonable for section 99A to apply.

In accordance with the explanation given previously, as the trust created in consequence of the deceased's will, the discretion under subsection 99A(2) of the ITAA36 is exercised to assess the income of the trust in accordance with Section 99 of the ITAA 1936.