Edited version of private ruling

Authorisation Number: 1011782021573

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Ruling

Subject: Deed of settlement

Question 1

Will the distribution by the trustee of the discretionary trust be included in your assessable income in addition to the settlement sum received by you?

Advice/Answers

No.

Question 2

Should the settlement sum be allocated across your various rights, titles and interests which were transferred, relinquished or disposed of under the settlement, for the purposes of calculating the capital proceeds received for the disposal or surrender of those capital gains tax (CGT) assets?

Advice/Answers

Yes.

Question 3

Will the legal costs incurred by you be included in the cost base of your right to sue?

Advice/Answers

No.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2008

Relevant facts and circumstances

Your spouse and several other individuals operated a business.

Your spouse died several years ago.

You are the sole executor/trustee and beneficiary of your spouse's estate.

Upon your spouse's death and by virtue of their will which was accepted for probate, you acquired an uncontested interest in a number of the business entities.

One of the business entities, being a discretionary trust of which you are a beneficiary, subsequently sold several properties.

The discretionary trust resolved to distribute a share of the net capital gain from the sale of the properties to you.

A dispute between you and the other individuals arose concerning the business.

You sought various remedies, including:

· an order that your interests in the various business entities be purchased by the other individuals at a fair value or

· in the alternative, an order that the various business entities be wound up.

You, the other individuals and the various business entities subsequently signed a deed of settlement resolving all of the disputes set out above after a lengthy court ordered formal mediation of the dispute.

The key terms of the settlement were that one of the other individuals would buy all of your rights, title and interest in the business entities for which you were to be paid a settlement sum. Additionally, you acknowledged and confirmed that you had no interest in trust A and agreed not to make any further claims to an interest in trust A.

The settlement sum was to be paid in two instalments, with the titles to your interests in the entities passing upon the first payment being made.

You also released and forever discharged the individuals and the various business entities from all action, claims, demands, suits, costs, expenses and liability whatsoever arising directly or indirectly from all disputes between the parties, including those under the proceeding.

You incurred legal costs in bringing the proceedings and negotiating the settlement.

You sought an order under the proceedings that your interests in the various business entities be purchased by the individuals at a fair value.

In determining the fair value of the various business entities, each of the parties obtained an independent professional valuation. There was a large difference in the total market values of the entities determined by the valuations although the valuation percentage of each entity is similar.

At the conclusion of mediation, the parties agreed that the settlement sum would be paid to you in full settlement for your interests.

In accordance with the terms of the settlement, you were duly paid the settlement sum.

You subsequently received a letter from the trustee of the discretionary trust notifying you of the distribution. You were then advised verbally that the trustee of the discretionary trust would be treating the distribution as part of the settlement sum and thus it had been discharged in full.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 97(1)
Income Tax Assessment Act 1997 Section 116-30
Income Tax Assessment Act 1997 Subsection 116-40(1)
Taxation Administration Act 1953 Schedule 1 Section 359-40

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

Subsection 97(1) of the Income Tax Assessment Act 1936 (ITAA 1936) provides that your share of any capital gain which is part of the net income of the discretionary trust, and to which you are presently entitled, is included in your assessable income regardless of whether the share of any capital gain is actually paid to you.

The trustee of the discretionary trust made a resolution to distribute the share of the trust net capital gain to you for the income year, and you were therefore presently entitled to this share of the trust net capital gain for the income year at the time of the resolution.

Subsequent to this resolution, however, and prior to the physical receipt of the net capital gain distribution by you, you entered into the settlement under which you agreed to sell, among other things, your interest in this discretionary trust. The interest passed on payment of the first instalment of the settlement sum.

Taxation Determination TD 2001/26 provides guidance on the CGT consequences for a beneficiary of a discretionary trust who renounces their interest in the trust. TD 2001/26 states that if a beneficiary of a discretionary trust has an interest in either the assets or the income of the trust before or after the exercise of any discretion by the trustee as to the allocation of those assets or income, they can renounce their interest in the trust. A discretionary beneficiary may or may not receive any capital proceeds for renouncing their interest in the discretionary trust.

Paragraph 8 of TD 2001/26 states:

8. According to the Macquarie Dictionary in its third edition, the word 'renounce' means 'to give up or put aside voluntarily'. The word 'renounce' may be used in the sense of a disclaimer or abandonment which results in either a refusal to accept a benefit or extinguishment, without replacement, of an interest held by someone: see the High Court of Australia decision in MSP Nominees Pty Ltd & Anor v. Commissioner of Stamps (SA) (1999) 42 ATR 833; 99 ATC 4937. Re Gulbenkian's Settlements (No.2) Stephens & Anor v. Maun & Ors [1970] Ch 408 involved a valid renunciation or disclaimer of an interest in a discretionary trust by a discretionary object. The renunciation operated as an extinguishment of the interest on and from the date of renunciation.

In JW Broomhead (Vic) Pty Ltd (in Liq) v JW Broomhead Pty Ltd & Ors (1985) 9 ACLR 593 at 631 (Broomhead), a disclaimer by one beneficiary (out of four) had the consequence that the beneficiary was retrospectively disentitled to the interest declared for her benefit in the trust deed. The court noted however, that the law does not disregard the fact that until a beneficiary disclaims, they have a right to the beneficial interest.

It is clear from Broomhead and the authorities cited therein [at 630] that for a disclaimer of an interest in a trust to operate retrospectively, it must be made within a reasonable period having regard to the circumstances of the case, and in any event, before acceptance of the interest. The court noted [at 631] that:

It was basic to the decision in Hardoon v Belilios [1901] AC 118 that a beneficiary may disclaim until acceptance but not after: see also Lady Naas v Westminster Bank Limited [1940] AC 366 at 401. In the absence of positive conduct by which the donee indicates acceptance, the right to disclaim is lost because the court makes a presumption of fact or draws an inference. The presumption or inference is that by remaining silent beyond the time when he would be expected to decline the gift if not accepting it, the donee has tacitly accepted. … Inaction by the beneficiary is consistent with acceptance.

…

Inactivity over time operates in a similar evidentiary way to establish acceptance by a beneficiary. It is not simply whether a reasonable time has elapsed. … The test for whether a beneficiary is entitled to disclaim is whether in the circumstances he has accepted by words or other conduct or has remained silent for so long that the proper inference is that he has determined to accept the interest.

The issue of Deeds of Disclaimer has been considered more recently in the Full Federal Court appeal case of FC of T v Ramsden [2005] FCAFC 39 (Ramsden). In Ramsden, the principles of a beneficiary disclaiming their interest in a discretionary trust are explained at paragraph 30:

Until disclaimer, a beneficiary's entitlement to income under a trust is operative for the purposes of s97 of ITAA from the moment it arises notwithstanding that the beneficiary has no knowledge of it (FC of T v Vegners 89 ATC 5274; 91 ATC 4213 at 4215). A beneficiary may disclaim an entitlement on its coming to his or her knowledge. At law an effective disclaimer operates retrospectively, and not merely from the time of disclaimer.

In your case, the result of you entering into the settlement was the renunciation or disclaimer of your interest in the discretionary trust. You have not been paid the distribution of the net capital gain from the discretionary trust and there was no inactivity over time to establish acceptance, as the settlement deed was signed shortly after the trustee resolution.

It is considered in your circumstances that you have validly renunciated or disclaimed your interest in the discretionary trust with the resultant retrospective application, and accordingly your share of the net capital gain of the discretionary trust for the income year will not be included in your assessable income for that year. The settlement sum will be included in your assessable income for the following income year as the capital proceeds for the disposals specified in the settlement.

Question 2

Apportionment of capital proceeds

Subsection 116-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states that if you receive a payment in connection with a transaction that relates to more than one CGT event, the capital proceeds from each event are so much of the payment as is reasonably attributable to that event.

Taxation Determination TD 98/24 provides guidance on the CGT consequences if property comprises separate CGT assets. Paragraph 2 of TD 98/24 states that on a CGT event happening to the real property, that CGT event happens to each separate asset.

Paragraph 5 of TD 98/24 states that in the absence of an agreed allocation, each party needs to make their own reasonable apportionment of the capital proceeds to the separate assets. In making this apportionment, it is expected that each party would generally have regard to, and be able to justify, their reasonable apportionment based on the relevant market values of the separate assets at the time of the making of the contract.

CGT Determination Number 9 TD 9 states that there is no statutory formula to be used by taxpayers in determining the consideration for the disposal of an asset deemed to be a separate asset. It is not mandatory that taxpayers obtain an independent valuation for the purposes of apportioning the consideration received on disposal. Each taxpayer should take whatever steps are appropriate to determine the valuation of the particular asset. Taxpayer's who choose to do their own apportionments will need to be in a position to justify the estimates they make.

The valuations

Where a private ruling request requires the determination of the value of anything, the Commissioner may accept the valuation provided by the applicant

You consider that the valuation obtained by you should be accepted as a reasonable basis for apportioning the capital proceeds as this valuation:

(a) is more recent and arguably more accurate

(b) describes various flaws in the other valuation in detail and

(c) was obtained by you, whereas you have no knowledge of what instructions were received in respect to the other valuation.

You are attempting to apportion the capital proceeds of the settlement sum between each of the entities in which you have disposed of your rights, titles and interests, and you are proposing to achieve this by allocating a percentage of the market value of each entity to these capital proceeds.

In this case, as the valuation percentage of each entity is similar for the purposes of each valuation despite the large difference in the total market values of the entities, we will accept the percentages calculated from your valuation as the starting point in determining the final percentages.

We will now consider the adjustments to your valuation as proposed by you.

Value attributed to trust A

You state that your valuation percentages should exclude the value attributed to trust A, as no part of the capital proceeds was paid in respect of your interest in this entity. This was because you acknowledged in the settlement deed that you did not have any interest in this entity.

On this basis, no part of the capital proceeds would be attributable to trust A, and the appropriate percentage would be nil.

Your interest in the discretionary trust

Paragraph 3 of TD 2001/26 states that whether or not the discretionary beneficiary received capital proceeds for renouncing their interest in the discretionary trust, the beneficiary will need to determine the market value of the interest under section 116-30 of the ITAA 1997 at the time of the renunciation of the interest. A capital gain may arise if the market value exceeds the cost base of their trust interest.

Paragraph 4 of TD 2001/26 states that whether a default beneficiary's interest has any substantial value or not will need to be determined on a case by case basis depending in each case on the terms of the particular trust and its purpose, the past history of distributions made by the trustee in favour of the default beneficiary and all the other circumstances of the particular case.

In this case, there is no indication that you had an interest in either the assets or the income of the discretionary trust prior to the resolution made by the trustee. At the time of entering into the settlement, you were presently entitled to your share of the net capital gain of the discretionary trust.

It is therefore considered that, at the time of you entering into the settlement, your interest in the discretionary would have had a market value equal to the amount of the distribution to you, being the only asset or income of the discretionary trust in which you had an interest at that time.

Right to sue

Taxation Ruling TR 95/35, which considers the CGT treatment of compensation receipts, states at paragraph 4:

4. If an amount of compensation is received by a taxpayer wholly in respect of the disposal of an underlying asset, or part of an underlying asset, of the taxpayer the compensation represents consideration received on the disposal of that asset. In these circumstances, we consider that the amount is not consideration received for the disposal of any other asset, such as the right to seek compensation. Refer to Example 1 in this Ruling.

Paragraph 11 of TR 95/35 states:

11. If the amount of compensation is not received in respect of any underlying asset, the amount relates to the disposal by the taxpayer of the right to seek compensation. Accordingly, any capital gain arising on the disposal of that right is calculated using the cost base of that right. Refer to Example 8 in this Ruling.

The settlement indicates that the settlement sum was received by you wholly in respect of the disposal of your rights, titles and interests in various entities, that is, the disposal of underlying assets. No amount of the capital proceeds therefore relates to a disposal of your 'right to sue'.

Note

The apportionment taking into account the valuation percentages in the valuation obtained by you, the above comments in relation to the value attributed to trust A, your interest in the discretionary trust and any right to sue, is a suggested apportionment only and does not form part of the private ruling. You may choose to do your own apportionment provided that you can justify any estimates that are made.

Question 3

Paragraphs 173 to 175 of TR 95/35 state:

173. The underlying asset approach allows any consideration received in respect of the right to seek compensation to be attributed to the underlying asset, where the underlying asset is the most relevant asset. Certain items of expenditure incurred by the taxpayer in the course of pursuing the damages claim, or in order to remedy the damage or injury, may relate most directly to the underlying asset, or to the right to seek compensation or may relate to both assets equally.

174. In determining the cost base of the underlying asset (to calculate the capital gain or loss on disposal, or to determine whether an adjustment of the cost base is required under subsection 160ZH(11)) or of the right to seek compensation, the expenditure or outgoings incurred by the taxpayer must be allocated to the most relevant asset. That expenditure should be allocated to the asset to which it most directly relates. The capital costs of repairing the damage to the underlying asset, for example, are most directly attributable to the cost base of the underlying asset, in terms of paragraph 160ZH(1)(c) (assuming that all of the requirements of that provision are satisfied). The legal costs connected with pursuing the right to seek compensation are most directly attributable to the right, and should be included in the cost base of the right. This may mean that the taxpayer incurs a capital loss on the disposal of the right to seek compensation.

175. If the costs relate to both assets, the costs should be apportioned between the two assets on a reasonable basis. For example, the costs of obtaining professional valuations in respect of a damaged underlying asset, which are used in the course of pursuing a claim for compensation may relate equally to both assets and should be apportioned between the two assets.

In this case, the settlement indicates that the total settlement sum related to the disposal of underlying assets, and there is no indication that any part of the settlement sum consisted of a damages amount unrelated to the disposal of these underlying assets.

We would therefore consider that the legal costs relate most directly to the disposal of the underlying assets, and should be apportioned between the cost bases of these assets.