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Ruling

Subject: Grant of Life Estate

Question 1

Whether the X Unit Trust was required to include a net capital gain under section 102-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in its net income as a result of CGT event E2, A1 or D1 happening in respect of the grant by it of a life interest in the Property to Taxpayer A and Taxpayer B?

Advice/Answers

Yes, CGT event A1 happens.

Question 2

If the answer is yes, whether Taxpayer A was presently entitled to the whole capital gain?

Advice/Answers

Yes, Taxpayer A was presently entitled to the whole capital gain.

Question 3

If the answer to question 2 is no, whether Y Unit Trust was presently entitled to the whole net income of the X Family Trust?

Advice/Answers

Not required to answer.

Question 4

If the answer to question 2 is no, whether C Trust and/or D Trust were presently entitled (proportionately) to the net income of the Y Unit Trust?

Advice/Answers

Not required to answer.

Question 5

If the answer to question 2 is no, whether Taxpayer A was presently entitled to the net income of the C Trust and/or the D Trust?

Advice/Answers

Not required to answer.

Question 6

Whether CGT event E4 of the ITAA 1997 happened to Taxpayer A and Taxpayer B in respect of the grant to them of the life interest in the Property by the X Unit Trust?

Advice/Answers

No

Relevant facts

Taxpayer A and Taxpayer B are individual taxpayers.

The X Unit Trust is the registered proprietor of the Property.

Company Y executed a "deed of variation" which sought to ensure (by confirmation and variation) that the trustee was empowered to grant a life interest in respect of tangible property of the trust.

Taxpayer A and Taxpayer B applied for and issued one ordinary unit in the X Unit Trust.

The then sole unit holder Company X consented to the issue of the two units.

Company X, Company Y, Taxpayer A and Taxpayer B entered into a deed of grant of life estate. The deed of grant of life estate recited that it wishes to grant to Taxpayer A and Taxpayer B jointly and to each of them a life estate in the land described as the Property.

The deed of grant of life estate provided that the grant was an estate in the land for their joint lives and for the life of each of them.

An earlier deed of variation to the deed inserted a number of new and significant clauses, including descriptions of how the trust income will be distributed.
In the year in question:

a) The X Unit Trust distributed all its income of the trust to Taxpayer A;

b) The X Family Trust distributed all its income to Company C, in its capacity as trustee for the C Trust and to Taxpayer B;

c) C Trust distributed all its income to Company C, in its capacity as trustee for the C Trust and to Company D, in its capacity as trustee for the D Trust; and

d) Both the C Trust and D Trust distributed all their income to Taxpayer A.

Reasons for decision

Question 1

Summary

CGT event A1 happens, therefore the X Unit Trust is required to include a net capital gain in its net income in respect of the grant by it of a life interest in the Property to Taxpayer A and Taxpayer B.

Detailed reasoning

Whether the interest is a life interest

Taxation Ruling TR 2006/14 deals with the capital gains tax consequences of creating life interests in property. The term 'life interest' means an interest in an estate for life in real property not held on trust.

The owner of the life interest is distinguished from the owner of the CGT asset. The owner of the trust assets is the trustee who holds the assets for the benefit of the life interest. Whereas the life interest owner is an entity who owns a life interest.

Company X, Company Y, Taxpayer A and Taxpayer B entered into a deed of grant of life estate. The deed recited Company Y is the registered proprietor of an estate in fee simple in the land and that it wishes to grant to Taxpayer A and Taxpayer B jointly and to each of them a life estate in the Property.

Therefore, a life interest has been granted to Taxpayer A and Taxpayer B and the life interest is jointly owned by Taxpayer A and Taxpayer B.

The distinction between equitable interests and legal interests is important because each type of interest is treated differently for CGT purposes.

Equitable life interests

The creation of equitable life interests involves the creation of a trust over an original asset. CGT event E1 happens if a taxpayer creates a trust over a CGT asset by declaration or settlement (subsection 104-55(1) of the ITAA 1997). The event happens if the trust was created between living persons or under the will of a deceased person.

Similarly, CGT event E2 happens if a taxpayer transfers a CGT asset to an existing trust (subsection 104-60(1) of the ITAA 1997). In particular, if an asset is transferred to an existing trust to be held for the benefit of a life interest CGT event E2 happens (paragraph 16 of TR 2006/14).

In the present case, the creation of the life interest did not involve the creation of a trust over an original asset. Further, the life interest was not transferred to the X Unit Trust (the existing trust) on the creation of the life interest. The existing trust already held the Property, therefore when the life interest was created (a separate asset), CGT event E1 did not happen. Similarly E2 did not happen because the asset was not transferred to an existing trust to be held for the benefit of life interest.

It is therefore necessary to consider whether the life interest is a legal life interest, or alternatively the creation of the life interest is a mere equitable right.

The creation of a life interest can be compared to a mere personal right to occupy a property for life. A right of occupancy does not carry with it a right to any income from the property. The distinction is important because different CGT consequences arise depending on whether a life interest or right to occupy is created. CGT event D1 happens if the taxpayer creates a contractual right or other legal or equitable right in another entity (subsection 104-35(1) of the ITAA 1997).

It is considered that, Taxpayer A and Taxpayer B have been granted a right to use and occupy the property (that is, they have the rights to rents and profits). This granting of the life estate is therefore considered to be more than a mere personal right to occupy a property for life and accordingly CGT event D1 does not apply.

Legal life interests

Paragraph 85 of TR 2006/14 provides that, bringing a legal life interest into existence involves a disposal of part of an existing CGT asset in a similar way to the disposal of a percentage interest in it. The part of the original asset that is not disposed of to the life interest owner is the legal remainder interest.

Paragraph 192 of TR 2006/14 provides that, legal life and remainder interests are carved out of the existing fee simple and legal life and remainder interests represent the entire freehold interest in the land. Importantly, it is considered that by creating a life interest, the original owner is actually disposing of part of the freehold interest in the land in a similar way to the disposal of a percentage interest in the property.

Therefore, the creation of the legal life interest involves a disposal of a CGT asset.

CGT event A1 in section 104-10 of the ITAA 1997 will happen when the original owner disposes of a life interest to another person. That is, there is a change of ownership of part of the original asset (a freehold interest in land) from the original owner to the life interest owner.

In present circumstances there was a disposal or transfer by the original owner (the X Unit Trust) of the legal life interest in the Property to Taxpayer A and Taxpayer B.

The life interest owners acquire their respective interests at the time CGT event A1 happens to the original owner (subsection 109-5(2) of the ITAA 1997).

If no money or property was given to acquire the interest, or the life interest owner did not deal at arm's length with the original owner in relation to the acquisition of the interest and the total market value of money or property given was not the same as the market value of the interest, its first element of the cost base and reduced cost base is its market value at the time of acquisition (section 112-20 of the ITAA 1997).

Further, if no money or property was given to acquire the interest, or the life interest owner did not deal at arm's length with the original owner, the original owner is taken to have received an amount equal to the market value of the life interest at the time they transferred it to Taxpayer A and Taxpayer B (subsection 116-30(1) of the ITAA 1997).

The original owners cost base attributable to the life interest is determined in accordance with the apportionment rules in subsections 112-30(2) and (3) of the ITAA 1997.

As such, Taxpayer A and Taxpayer B acquire their life interest for an amount equal to its market value at the time of the transfer.

In conclusion, it is considered that a legal life interest was created on the granting of the life interest and CGT event A1 happened to the X Unit Trust in respect of the grant by it of life interest in the property to Taxpayer A and Taxpayer B. As a result, the X Unit Trust was required to include a net capital gain in its net income of the trust.

Question 2

Summary

Taxpayer A is presently entitled to the whole capital gain and section 99A of the ITAA 1936 does not apply to assess the trustee on the additional net income referable to the capital gain of the trust estate.

Detailed reasoning

Division 6 of the ITAA 1936 governs the tax treatment of the income of a trust, including trustees and beneficiaries of a trust.

Section 95 of the ITAA 1936 defines the expression "net income", in relation to a trust estate, to mean the total assessable income of the trust estate calculated under the Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions (except certain defined deductions).

Net income of a trust is also referred to as "section 95" income or the taxable income of the trust. However, it is important to appreciate the distinction between income according to trust law and income according to tax law.

Distributable income of a trust depends on the income of the trust according to trust law (including the trust deed) rather than income according to tax law.

Broadly if a resident beneficiary is presently entitled to a share of the income of a trust estate and is not subject to a legal disability then the beneficiary is assessed on the relevant proportion of the trusts net income.

Section 97 of the ITAA 1936 states that where a beneficiary is presently entitled to a share of the income of a trust estate, the assessable income of the beneficiary includes the beneficiary's share of the net income of the trust estate. (This is the proportionate approach, where after first establishing that the beneficiary is presently entitled to the trust distribution, the entire share of the net income of the trust to which the beneficiary is entitled is assessed to the beneficiary.)

Present entitlement can arise in the following situations:

At General Law: 

There is no definition of the term 'presently entitled' in the ITAA 1936 or the ITAA 1997. It is therefore necessary to establish the meaning which has been given to the term by the courts. The principal cases on the concept of present entitlement are the High Court decisions in FC of T v. Whiting (1943) 68 CLR 99 (Whiting) and Taylor v. FC of T (1970) 119 CLR 444 (Taylor). The principles in Taylor's case are also dealt with in Income Tax Ruling IT 319.

In Whiting's case at page 215: a beneficiary is presently entitled only when he is entitled to immediate payment of a share of the income of a trust estate.

In Taylor's case, Kitto J set down 3 tests in respect of present entitlement:

· It was legally available for distribution;

· As to the whole of it, the beneficiary had an absolute vested beneficial interest in possession; and

· But for the legal disability from giving a discharge he would have succeeded in an action to recover it from the trustee.

The main principles emerging from Whiting's and Taylor's case are:

· The income must be legally available for distribution to the beneficiary. It does not matter whether the amount of income has not been exactly ascertained. Therefore, the fact that you are not in a position to know exactly what is available to distribute to a beneficiary does not alter the fact that in a legal sense, a beneficiary can still demand payment and be presently entitled;  

· The beneficiary must have an indefeasible, absolutely vested, beneficial interest in possession in the trust income. That is, the interest must not be contingent which means that the beneficiary must have the right to demand immediate payment (or would have had the right to demand payment had they not been under a legal disability). An interest is said to be defeasible where it can be brought to an end and indefeasible where it cannot.

Further, the principles concerning the meaning of present entitlement from Whiting and Taylor were applied by the Full High Court in FC of T v Totledge Pty Ltd 82 ATC 4168, when it said:

... the preferable construction of sec. 97(1) is to treat the requirement of present entitlement to a share of the income of the trust estate as not being concerned with distinctions between gross income as derived and 'surplus income' after payment of costs, expenses and outgoings but as referring to a present vested right to demand and receive payment of the whole or part of what has been received by the trustee as income and, retaining that character in his hands, is legally available to be distributed to those entitled to it as beneficiaries under the trusts to the relevant trust estate.  Such a right to demand and receive payment represents a present entitlement to receive a share of what retains its character as income of the trust estate regardless of whether upon closer analysis, it can be seen to reflect a beneficial interest in gross income as derived or whether it represents no more than, for example, the right of an annuitant to be paid a particular amount from surplus or net income.  Examination of the decided cases in which reference has been made to sec. 97(1) supports this approach.

At the heart of the concept of present entitlement lies the immediate present right of a beneficiary to demand and receive payment of the income of the trust estate or a share of it. The leading High Court authority, Harmer & Ors v FC of T 91 (Harmer), expressed the tests as follows at ATC 5004:

The parties are agreed that the cases establish that a beneficiary is ``presently entitled'' to a share of the income of a trust estate if, but only if:

(a)     the beneficiary has an interest in the income which is both vested in interest and vested in possession; and

(b)     the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.'

The judgment went on to say that the question of whether any one or more of the claimants were presently entitled must be answered as at the time when the interest was derived, that is to say, during the tax years.

Further, Hill J in Dwight v FCT [1992] Federal Court adopted the view in Harmer, in regards to when a beneficiary will be presently entitled to income.

At Income Tax Law: 

· Subsection 95A(1) of the ITAA 1936 provides that, where a beneficiary of a trust estate is presently entitled to any income of the trust estate, the beneficiary is to be taken to continue to be presently entitled to that income notwithstanding that the income is paid to, or applied for the benefit of, the beneficiary.

· Subsection 95A(2) of the ITAA 1936 provides that, where a beneficiary has a vested and indefeasible interest in any of the income of the trust estate but is not presently entitled to that income, the beneficiary is deemed to be presently entitled to that income.

· Section 101 of the ITAA 1936 applies where a trustee has a discretion to pay of apply the income of a trust for the benefit of specified beneficiaries. A beneficiary in whose favour the trustee exercise this discretion shall be deemed to be presently entitled to the income so paid or applied.

Section 99A of the ITAA 1936 provides broadly that where there is an amount of net income to which no beneficiary is presently entitled then the trustee is liable to pay tax on that amount. The rate of tax payable as a result of the application of section 99A of the ITAA 1936 is prescribed in subsection 12(9) of the Income Tax Rates Act 1986.

In particular subsection 99A(4A) of the ITAA 1936 provides:

Where there is a part of the net income of a resident trust estate:

a) that is not included in the assessable income of a beneficiary of the trust estate in pursuance of section 97;

b) in respect of which the trustee is not assessed and is not liable to pay tax in pursuance of section 98; and

c) that does not represent income to which a beneficiary is presently entitled that is attributable to a period when the beneficiary was not a resident and is also attributable to sources out of Australia;

the trustee shall be assessed and is liable to pay tax on that part of the net income of the trust estate at the rate declared by the Parliament for the purposes of this section. 

Therefore, in order for this section 99A of the ITAA 1936 to operate there must be some part of the net income of a trust estate that is not included:

a) in the assessable income of a beneficiary pursuant to section 97; or

b) subject to the non resident provisions of subsections 98(3) and (4) of the ITAA 1936.

More simply, if all net income is included in the assessable income of beneficiaries then there is no part to be assessed to the trustee to be taxed under section 99A of the ITAA 1936.

In particular, Taxation Determination TD 94/72 discusses the issue of when a unit trust distribution should be included in your assessable income:

1. A distribution by the trustee of a unit trust is included in the assessable income of a unitholder in the year of income in which the unitholder is presently entitled to a share of the income of the unit trust, rather than the year in which the distribution is received by the unitholder.

2. …

3. Accordingly, a unitholder must include in assessable income for a particular year of income, the share of net trust income to which the unitholder is entitled in that year of income...

In the present case, consideration must be had to the trust deed, any variations to the trust deed and any resolutions that were made in regard to the year of income in question.

By a deed of variation, the X Unit Trust deed was amended with the consent of the then sole unit holder.

It is considered that the insertion of the clauses under the deed of variation for X Unit Trust had the effect of changing the nature of the trust from a fixed to a discretionary trust.

It is considered that the discretionary power provided to the trustee has been exercised in favour of Taxpayer A in the income year, as all of the assessable income was distributed to Taxpayer A, rather than a distribution in proportion to the unit holdings. The Clauses in the deed of variation appear to allow the trustee to do this.

In relation to the question of present entitlement it is considered that the trustee has the power to distribute to any unit holder on any basis and at the expense of other unit holders.

This raises a question whether, upon X Unit Trust deriving a capital gain in the year, that capital gain would have passed to Taxpayer A with the income distributed to them, as evidenced in the statement of distribution. The tax return of the X Unit Trust for the year shows, under the statement of distribution, that the whole net income of the trust was distributed to Taxpayer A.

It is considered that any capital gain realised in the year would have been distributed in the same manner as the other net income or the trust so that the whole capital gain would therefore be included in the assessable income of Taxpayer A.

Similarly, the application of the proportionate approach established in FCT v Bamford [2010] HCA 10, would see Taxpayer A receiving the additional distribution in the same percentage as their "share" of income of the trust estate available for distribution. That is, their share of the original distribution expressed as a percentage is 100%, so under this method they would receive 100% of any addition to the income of the trust estate. Practically, this achieves the same outcome as the trustee's ability to apply income or capital of the trust fund to one or more of the unit holders in such proportions as the trustee determined at its sole and unfettered discretion provided for by the clauses in the deed of variation.

It is considered that the Clauses in the deed of variation would act to ensure that all income would be assessable in the hands of a presently entitled beneficiary. As a result, section 99A of the ITAA 1936 does not apply because there was no part of the net income of the X Unit Trust that was not included in the assessable income of a beneficiary in the year. That is, Taxpayer A had a vested indefeasible interest in possession in any capital gain referable to the grant of life interest by the trust.

In conclusion, based on the principles discussed above, Taxpayer A was presently entitled beneficiary to the additional net income referable to the capital gain of the trust estate, and section 99A of the ITAA 1936 does not apply to assess the trustee on the additional net income referable to the capital gain of the trust estate.

Questions 3 to 5

Not required to answer.

Question 6

Summary

CGT event E4 does not happen to Taxpayer A and Taxpayer B in relation to the relevant grant of the life interest.

Detailed reasoning
CGT Event E4 occurs when a trustee makes a payment to a beneficiary in respect of their unit or their interest in the trust.  In paragraph 1 of the Taxation Determination TD 2003/28 the Commissioner explains that CGT event E4 under section 104-70 of the ITAA 1997 does not happen if a non-assessable payment is made by a trustee of a discretionary trust to a member of the class of beneficiaries of the trust who is an object of a power of appointment vested in the trustee ('a discretionary beneficiary'').

This is because a discretionary beneficiary does not hold an "interest ... in the trust'' of the nature or character referred to in section104-70 of the ITAA 1997; and any payment made to a discretionary beneficiary is not an amount paid to the discretionary beneficiary "in respect of'' the interest that the discretionary beneficiary holds in the trust (namely, a right of due administration of the trust, including a right to have his or her interest protected by a court of equity, and a right to be considered by the trustee as a potential recipient of trust income or corpus).

It is considered that the deed of variation for the X Unit Trust has the effect of changing the nature of the trust from a fixed to a discretionary trust.

Therefore, CGT Event E4 does not apply to an interest that a discretionary beneficiary has in a discretionary trust as it is of a different nature from the type of interest in a trust referred to in subsection 104-70(1) of the ITAA 1997.

Further, CGT event E4 does not happen where the payment to the taxpayer arises because one of the CGT events listed in paragraph 104-70(1)(a) of the ITAA 1997 happens in relation to the taxpayer's unit or interest in the unit. As it has been determined that CGT event A1 happens to the trust, CGT E4 does not happen.

As such, CGT event E4 did not happen to Taxpayer A and Taxpayer B in relation to the relevant grant of the life interest.