Edited version of private ruling

Authorisation Number: 1011831587146

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Ruling

Subject: Capital gains tax - majority underlying interests - discretionary trust and compensation payments

Issue 1

The status of pre-CGT assets

Question 1

Has there been a change in the majority underlying ownership of the pre-CGT assets held by the company in accordance with section 149-30 of the Income Tax Assessment Act 1997 (ITAA 1997) since immediately before 20 September 1985?

Answer: Yes

Question 2

Will the Commissioner exercise his discretion under subsection 149-30(2) of the ITAA 1997 so that the shares in the company currently owned by the trust do not stop being pre-CGT assets under section 149-10 of the ITAA1997?

Answer: Yes

Issue 2

The CGT status of compensation payments received for settlement.

Question 1

Is a settlement payment for compensation that has been received by the company assessable under section 102-5 of the ITAA1997 as a capital gain?

Answer: Yes

This ruling applies for the following period:

The 2010-11 income year

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The company was incorporated before 19 September 1985.

Its shareholding has not changed since 19 September 1985.

The shareholders of the company are:

· an individual A

· another individual B

· a discretionary trust - the majority shareholder

Company A is the trustee of the discretionary trust.

The directors of company C are:

· an individual A

· another individual B

The shareholders of company C are:

· an individual A

· another individual B

The primary beneficiaries of the Discretionary Trust are:

· an individual A and spouse

· another individual B and spouse

The general beneficiaries of the discretionary trust include:

· the primary beneficiaries

· relatives of the primary beneficiaries and others

Company C, as trustee of the Discretionary Trust, has unfettered discretion as to the distribution of the Trust income to the Trust's primary and general beneficiaries.

The company commenced business during the before 19 September 1985.

Assets of the company include pre-CGT assets.

On learning that another unrelated company D was in the process of registering a Trade Mark the company initiated legal action to oppose unrelated company D registering the Trade Mark. Subsequent to the action, a settlement was reached whereby the company would withdraw its opposition to the registration of the Trade Mark by unrelated company D and also amend its own Trade Mark. A settlement amount was received.

Relevant legislative provisions

Income Tax Assessment Act 1997 Part 3-1,

Income Tax Assessment Act 1997 Part 3-3,

Income Tax Assessment Act 1997 Sub-section 6-5(1),

Income Tax Assessment Act 1997 Section 6-10,

Income Tax Assessment Act 1997 Section 10-5,

Income Tax Assessment Act 1997 Section 102-5,

Income Tax Assessment Act 1997 Section 102-20,

Income Tax Assessment Act 1997 Section 104-25,

Income Tax Assessment Act 1997 Sub-section 104-(3),

Income Tax Assessment Act 1997 Section 108-5,

Income Tax Assessment Act 1997 Section 115-25(1),

Income Tax Assessment Act 1997 Paragraph 116-20(1)(a),

Income Tax Assessment Act 1997 Division 149,

Income Tax Assessment Act 1997 Section 149-10,

Income Tax Assessment Act 1997 Section 149-15,

Income Tax Assessment Act 1997 Section 149-30 and

Income Tax Assessment Act 1997 Sub-section 149-30(2).

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 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 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 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

Summary

The Commissioner will exercise his discretion under subsection 149-30(2) of the ITAA 1997 so that the assets of the company do not stop being pre-CGT assets under section 149-10 of the ITAA1997.

Detailed reasoning

Exercise of discretion regarding majority underlying interests

Under section 149-10 of the ITAA 1997, the assets that the company owns, are pre-CGT assets if, and only if, the company acquired the assets before 20 September 1985, and those assets have not stopped being pre-CGT assets of the company through the operation of Division 149 of the ITAA 1997.

The principal section which discusses when an asset of a non-public entity such as the company ceases to be a pre-CGT asset is section 149-30 of the ITAA 1997.

Section 149-30 of the ITAA 1997 discusses majority underlying ownership. Section 149-30 of the ITAA explains that the asset stops being a pre-CGT asset when the majority underlying interests in the asset were not had by ultimate owners who had majority underlying interests in the asset immediately before 20 September 1985.

Section 149-30 of the ITAA 1997 also states that if the Commissioner is satisfied that at all times on and after 20 September 1985 the majority underlying interests in the asset were had by ultimate owners who had majority underlying interests in the asset immediately before that day, then subsection 149-30(1) of the ITAA 1997 applies if that were in fact the case.

Section 149-30 refers to the following concepts:

· majority underlying interests

· underlying interest

· ultimate owner.

These concepts are defined in section 149-15 of the ITAA 1997.

Majority underlying interests in a CGT asset consist of more than 50% of the beneficial interests that ultimate owners have (whether directly or indirectly) in the asset and more than 50% of the beneficial interests that ultimate owners have (whether directly or indirectly) in any ordinary income that may be derived from the asset.

An underlying interest in a CGT asset is a beneficial interest that an ultimate owner has (whether directly or indirectly) in the asset or in any ordinary income that may be derived from the asset.

An ultimate owner is an individual or a company.

The terms 'underlying interest' and 'majority underlying interests' are discussed in paragraph 2 of Income Tax Ruling IT 2340 (which deals with section 160ZZS of the Income Tax Assessment Act 1936 (ITAA1936) the predecessor of Division 149 of the ITAA 1997) when it states that:

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, whether directly or through one or more interposed companies, partnerships or trusts. 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.

At all times since 19 September 1985, the shares in the company have been owned as follows:

· an individual A

· another individual B

· a discretionary trust - the majority shareholder

All distributions of income of the trust have been made to individual members A and B, or on occasion, to the company (in which the shareholders are A, B and the discretionary trust), in accordance with the trust deed.

A beneficiary in a discretionary trust, such as the Discretionary Trust, could not be said to have a beneficial interest in the income or assets of the trust, in the light of cases such as Gartside v IRC [1968] AC 553 and Re Weir's Settlement MacPherson & anor v. IRC [1970] 1 All ER 297.

However, paragraphs 5, 6, and 7 of Income Tax Ruling IT 2340 discusses what happens in respect of non-fixed family trusts when it states:

5. In relation to what are generally referred to as discretionary trusts, i.e., family trusts, the trustees of which have discretionary powers as to the distribution of trust income or property to beneficiaries, in considering the question of whether majority underlying interests have been maintained in the assets of the trust it will be relevant to take into account the way in which the discretionary powers of the trustees are in fact exercised. 

6. Where a trustee continues to administer a trust for the benefit of members of a particular family, for example, it will not bring section 160ZZS into application merely because distributions to family members who are beneficiaries are made in such amounts and to such of those beneficiaries as the trustee determines in the exercise of his discretion. 

7. In such a case the Commissioner would, in terms of sub-section 160ZZS(1), find it reasonable to assume that for all practical purposes the majority underlying interests in the trust assets have not changed. That is consistent with the role of the section to close potential avenues for avoidance of tax in cases where there is a substantial change in underlying ownership of assets and the legislative guidance contained in Subdivision G of Division 3 of Part III of the Act. On that basis, trust assets acquired by the trustee before 20 September 1985 would remain outside the scope of the capital gains and losses provisions of the Act.

In view of the above comments in Income Tax Ruling IT 2340, and providing that there is no change to the beneficiaries of the Discretionary Trust as per the Trust Deed, then the Commissioner is satisfied that the majority underlying interests in the assets of the company have not changed and that the assets of the company, which were acquired prior to 20 September 1985, will remain pre-CGT assets. As such, sub-section 14-30(2) of the ITAA 1997 applies and the assets currently held by the company will retain their pre-CGT status.

Issue 2

Summary

The settlement payment for compensation that has been received by the company is a capital gain and included in assessable income under section 102-5 of the ITAA 1997.

Detailed reasoning

Ordinary Income

Your assessable income includes income according to ordinary concepts (subsection 6-5(1) ITAA 1997).

For income tax purposes, a compensation amount generally bears the character of that which it intends to replace (F of CT v Dixon (1952) 86 CLR 540). A compensation receipt will be of an income nature where it replaces a revenue item and capital in nature where it replaces capital items.

Where compensation is received in settlement of an unliquidated claim covering both income and capital elements the whole amount will be treated as capital where it cannot be dissected into an income component and a capital component (Taxation Determination 93/58, McLaurin v. FC of T (1961) 104 CLR 381;(1961) 8 AITR 180; Allsop v. FC of T (1965) 113 CLR 341; (1965) 9 AITR 724).

In your case, the lump sum you received was calculated on the basis of the income and the capital losses that you suffered as a result of withdrawing your opposition to an unrelated company D registering their trade mark and amending your own trade mark in order to allow un related company D to register their trade mark.

As no portion of the payment can be identified or quantified as replacing an income item the entire compensation payment is capital and is not assessable as ordinary income under section 6-5(1) of the ITAA 1997.

Capital Gains

Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income also includes statutory income amounts that are not ordinary income but are included in assessable income by another provision.

Section 10-5 of the ITAA 1997 lists those provisions about assessable income. The most relevant section in relation to your compensation settlement payment is section 102-5 of the ITAA 1997, which deals with capital gains.

Section 102-5 of the ITAA 1997 provides that a taxpayer's assessable income includes the amount of any capital gains. Section 102-20 of the ITAA 1997 provides that a capital gain is made only if a Capital Gains Tax (CGT) event happens. A CGT event is generally something that happens in relation to a CGT asset. The most common CGT event occurs when a CGT asset is disposed of.

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property or a legal or equitable right that is not property. The wide definition of asset in section 108-5 of the ITAA 1997 would include the right to seek compensation. This is reinforced by Taxation Ruling TR 95/35 when it states:

The right to seek compensation is the right of action arising at law or in equity and vesting the taxpayer on the occurrence of any breach of contract, personal injury or other compensable damage or injury. A right to seek compensation is an asset for the purposes of the capital gains tax provisions.

The compensation settlement payment that you have received is for a final settlement. The CGT asset to which your compensation settlement payment relates is the right to seek compensation.

According to section 104-25 of the ITAA 1997, CGT event C2 occurs in relation to a right to seek compensation. You will make a capital gain if the capital proceeds from the ending of your right to seek compensation are more than the cost base of the asset (subsection 104-25(3) of the ITAA 1997).

The capital proceeds from the CGT event is the total of the money you receive in respect of the event happening (paragraph 116-20(1)(a) of the ITAA 1997).

Taxation Ruling TR 95/35 provides guidance on the calculation of the cost base of the right to seek compensation. Generally, the cost base is its acquisition cost plus any incidental costs. In your case, you did not pay anything to acquire the right to seek compensation. However, incidental costs would include the legal fees and charges associated or connected with any legal action taken to obtain the compensation settlement payment.

Therefore, a capital gain will be made if the amount of the compensation settlement payment exceeds the incidental costs associated with receiving the payment. The net capital gain will form part of your assessable income in the year in which it is received.

Further issues for you to consider

Section 115-25(1) of the ITAA 1997 provides that a discount capital gain may apply if the CGT asset was acquired at least 12 months before the CGT event that resulted in the capital gain.