Edited version of private ruling

Authorisation Number: 1011737375079

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Ruling

Subject: Capital gains tax - life and remainder interests

Transaction 1

Question 1

Will the rulees make a capital gain from CGT event E7 under section 104-85 of the Income Tax Assessment Act 1997 (ITAA 1997) when the trustees transfer the legal remainder interests to them?

Answer

Yes.

Question 2

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 from the capital gain made on the disposal of their equitable remainder interests?

Answer

No

This ruling applies for the following periods:

2010-11 financial year

2011-12 financial year

The scheme commences on:

1 July 2010

Transaction 2

Question 1

Will either CGT event C2 or CGT event A1 happen when the rulees give up their equitable remainder interests?

Answer

CGT event A1 will happen.

Question 2

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 remainder interests?

Answer

No.

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?

Answer

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

Under the will of a deceased individual, a trust was created to hold an asset for the benefit of life and remainder beneficiaries. The rulees are the remainder beneficiaries.

The life interest beneficiaries have the use and enjoyment of the property, and are responsible for expenses until the happening of a certain event.

When that event occurs the property is to be sold for its market value and the proceeds of the sale distributed to the rulees.

The property has not been used to derive income.

One of the beneficiaries (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 dispose of their equitable interest 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 all of the beneficiaries.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 97,

Income Tax Assessment Act 1936 Section 95,

Income Tax Assessment Act 1997 Subsection 104-80(3,

Income Tax Assessment Act 1997 Section 104-85,

Income Tax Assessment Act 1997 Paragraph 104-85(6)(a,

Income Tax Assessment Act 1997 Section 116-30 and

Income Tax Assessment Act 1997 Section 104-10.

Summary

First proposed transaction

Surrender of equitable interest

Under this proposal, the rulees will dispose of their equitable interests in the trust in consideration for a proportionate 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.

This is a disposal of part of the original asset, and the disposal of the remainder interest is a separate event that cannot occur until after the disposal of the life interest. This is because the law cannot recognise a remainder without the corresponding life interest.

However TR 2006/14 in paragraphs 59 to 65, also 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.

It is therefore possible that either CGT event A1 or CGT event E7 may happen. In this instance, we consider that the more appropriate event is CGT event E7, because the asset (the legal remainder interest) is being transferred to existing beneficiaries.

The rulees are able to disregard any capital gain or loss they make from CGT event E7 as they acquired their interest for no expenditure, and it was not acquired by way of assignment (paragraph 104-85(6)(a) of the ITAA 1997).

Present entitlement

Under subsection 104-80(3) CGT event E7 also has consequences for the trustee of the trust. The trustee makes a capital gain if the market value of the asset (the legal remainder interest) is more than its cost base. As the exclusion in paragraph 104­85(6)(a) of the ITAA 1997 only applies to the beneficiaries, the trustee is not able to disregard this capital gain.

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 E7, 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.

It follows that the rulees would not be presently entitled to any of the capital gain forming part of the [tax] net income in the year that the CGT event happens.

Second proposed transaction

Under alternative transaction number two, it is proposed that the ownership in the property would be transferred to beneficiary X in exchange for market value consideration. However, while trustees are the registered legal owner of the property, they actually are holding the property as trustees of the testamentary trust set up under the will. That is, trustees would be acting in their capacity as trustees and not in their own personal capacities in this disposal transaction, and beneficiary X would then acquire the sole ownership of the property in his/her personal capacity.

It is proposed that the consideration paid by beneficiary X will be distributed among all of the beneficiaries, including the rulees (remainder owners).

The will provides for the trustees to have limited discretionary powers, including to sell or 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 life interest owners (the right to use occupy and enjoy the property) can only be defeated by a specified 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 we consider that the parties are not dealing at arms length, the market value substitution rule in section 116-30 of the ITAA 1997 will apply only if the capital proceeds are less than the market value of the equitable right at the time of the event.

Where all of the interest owners transfer their interests to beneficiary X, that beneficiary would become the owner of all of the life interests and the remainder 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 none of the rulees 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.