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Ruling

Subject: Change in majority underlying interests

Question 1

Did the assets of the company, acquired before 20 September 1985, stop being pre-CGT assets on 19 March 1999 due to a change in majority underlying interests as described in Division 149 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer

No. As there was no change in majority underlying interests at that time the existing pre-CGT assets retain their pre-CGT status.

Question 2

If the assets of the company stopped being pre-CGT assets on 19 March 1999, what was the cost base of those assets at that time?

Answer

As it has been determined that the existing pre-CGT assets would retain their pre-CGT status when the shares in the company were sold to trustee of the unit trust, it is not necessary to consider the cost base of those assets at that time.

Relevant facts

The company was incorporated some time ago. The company was incorporated as the operating entity for an individual and their immediate family. The shareholder in the company at the date of incorporation was a family discretionary trust.

Over the years the original directors of the company had several children. All of those children were beneficiaries of the family discretionary trust.

All of the children, who are now adults, have worked in the business that is operated by the company.

Over many years the children have received distributions from the discretionary trust which distributions represent a part of the annual profits of the operating company, being the taxpayer. The family, as part of an estate planning exercise, required certainty as to entitlement with this particular taxpayer. To achieve that certainty the shares held by the family discretionary trust were sold to the corporate trustee of a unit trust. The latter trust is a fixed or unit trust with fixed entitlements as to capital and income.

The unit holders of that particular trust were a number of discretionary trusts which are controlled by the children of the directors of the company. Each of discretionary trust holds one unit in the unit trust.

Since the time that the shares in the company were sold the business has continued uninterrupted. Profits have been made annually and have been distributed annually. The pattern of distribution of profits between family and members pre and post the change from the family discretionary trust to the unit trust have not changed and the entitlements pre and post the change of shareholder have not changed.

It was well prior to the 19^th day of September 1985 decided by the parents of the children that each of the children would inherit a fixed interest in the company.

Reasons for Decision

The legislation - Division 149 of the ITAA 1997.

Division 149 of the Income Tax Assessment Act 1997 ('ITAA 1997') contains the rules which govern when an asset acquired before 20 September 1985 (a 'pre-CGT asset') is treated as having been acquired after that date. Section 149-10 of the ITAA 1997 defines what is meant by a pre-CGT asset:

A CGT asset that an entity owns is a pre-CGT asset if, and only if:

(a) the entity last acquired the asset before 20 September 1985; and

(b) the entity was not, immediately before the start of the 1998-99 income year, taken under:

(i) former subsection 160ZZS(1) of the Income Tax Assessment Act 1936; or

(ii) Subdivision C of Division 20 of former Part IIIA of that Act;to have acquired the asset on or after 20 September 1985; and

(c) the asset has not stopped being a pre-CGT asset of the entity because of this Division.'

A CGT asset acquired before 20 September 1985 remains a pre-CGT asset if the majority underlying interests in the asset have not changed since before 20 September 1985. Where a change in majority underlying interests occurs after 19 September 1985, the CGT asset is deemed to be acquired on the date the change occurred, either under Division 20 of the Income Tax Assessment Act 1936 ('ITAA 1936') (pre 1998-99 income years) or Division 149 of the ITAA 1997.

Under section 149-30 of the ITAA 1997 an asset stops being a pre-CGT asset at the earliest time when the majority underlying interests in the asset were not held by the ultimate owners who held the majority underlying interests in the asset immediately before 20 September 1985.

In other words, the Commissioner has to be satisfied that the majority underlying interests in an asset have not changed. Otherwise the asset is deemed to have been acquired at the time that the change in majority underlying interests in the asset happened.

'Majority underlying interests' is defined in subsection 149-15(1) of the ITAA 1997 as more than 50% of:

'(a) the beneficial interests that the ultimate holders hold (whether directly or indirectly) in the asset; and

(b) the beneficial interests that ultimate owners hold (whether directly or indirectly) in any income that may be derived from that asset.'

An 'ultimate owner' is defined to include an individual - refer subsection 149-15 of the ITAA 1997. Accordingly, it is necessary to trace the underlying beneficial interests in the relevant assets back to natural persons.

The expression 'beneficial interests' as used in the definition of 'majority underlying interests' is not defined. At general law a shareholder does not have any legal or equitable interest in the asset of a company. Similarly, beneficiaries in a discretionary trust do not have an interest, either individually or collectively, in the assets or the income of a trust. This situation is addressed in ATO Interpretive Decision 2003/778:

'Under ordinary legal concepts, where there is a discretionary trust deed, no beneficiary is entitled to income or capital of the trust until the trustee exercises its discretion to distribute income or to make an appointment of capital. Because the beneficiary of a discretionary trust does not hold an interest in any asset of the trust or in the ordinary income derived from the asset until the trustee's discretion is exercised, it would not be possible for a discretionary trust to satisfy the continuing majority underlying interests test set out in subsection 149-30(1) of the ITAA 1997.

Taxation Ruling IT 2340 reflects on an approach of looking through interposed entities to determine which natural persons hold the beneficial interests for the purposes of section 160ZZS of the Income Tax Assessment Act 1936 (ITAA 1936), which preceded Division 149 of the ITAA 1997, is reflected in Taxation Ruling IT 2340. Among other issues, IT 2340 deals with questions regarding the application of section 160ZZS of the ITAA 1936 'to assets held by trustees of family trusts where the trustees are vested with discretionary powers as to distributions from the trusts.'

….

Taxation Ruling IT 2340 correctly reflects the position that section 160ZZS of the ITAA 1936, by its terms, necessarily supplants normal legal concepts of interests in assets. For the purposes of section 160ZZS, a beneficiary of a discretionary trust is treated as having a beneficial interest in the trust's assets. Like wise, a shareholder is treated for the purposes of section 160ZZS of the ITAA 1936 as having a beneficial interest in the company' assets.'

Under this approach the Commissioner can 'look through' an entity to determine who are the natural persons who hold beneficial interests in assets, as stated in paragraph 2 of Income Tax Ruling IT 2340:

'The terms "underlying interest" and "majority underlying interests", on the basis of which the provision operates, have the same meanings as they have in Subdivision G of Division 3 of Part III of the Act - which deals with the income tax treatment of interest in relation to "negatively geared" investments in rental property. In both cases (and like other provisions of the Act concerned with the measurement of ownership interests) underlying interests in relation to the assets concerned mean beneficial interests held by natural persons. The clear policy of the law thus permits and requires that, for the purposes of the relevant provisions, chains of companies, partnerships and trusts are to be "looked through" in order to determine whether there has been a change in the effective interests of natural persons in the assets.'

Application to your circumstances

The family trust, which originally owned the shares in the company, was settled in 19XX. The trust is a discretionary trust. The beneficiaries named in the trust deed were the spouse and children of the trustee of the discretionary trust. By deed of variation dated 19XX the class of beneficiaries was expanded:

to enlarge the class of beneficiaries amongst who xxxxx may appoint trust property to include his children and grandchildren whether now living or who may be born hereafter prior to the Trust Fund wholly vesting in possession.'

For the purposes of Division 149 of the ITAA 1997 the individuals who held a beneficial interest in the assets of the company were the spouse, children and grandchildren of the trustee of the trust.

In 19XX unit trust was created and the shares in the company were sold to the corporate trustee of the unit trust. The units in the unit trust were held by discretionary trusts controlled by the children who were beneficiaries of the original family discretionary trust.

It is evident that the beneficiaries of the original family discretionary trust and the unit trust are essentially the same. In each case the beneficiaries are the descendents of the directors of the company.

Therefore there was no change in majority underlying interests when the shares in the company were sold to the corporate trustee of the unit trust. Consequently any pre-CGT assets held by the company retained their pre-CGT status at that time.

Question 2

As it has been determined that the existing pre-CGT assets would retain their pre-CGT status when the shares were sold to corporate trustee of the unit trust, it is not necessary to consider the cost base of those assets at that time.