Edited version of private advice

Authorisation Number: 1012648073225

Ruling

Subject: Unpaid present entitlements and assignment of debts

Question 1

Will a CGT event happen for the taxpayers if the trustee of Trust A pays an unpaid present entitlement held by a beneficiary of Trust A?

Answer

Yes, but it is appropriate to look through CGT Event C2 (and any capital gain resulting) as the rights incidentally created and discharged merely facilitate the distribution of income from a trustee to a beneficiary.

Question 2

Will the trustee of Trust A have a 'net forgiven amount' for the purposes of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997) if a beneficiary of Trust A assigns a debt owed to it by the Trustee.

Answer

No

Question 3

Will a beneficiary realise a capital gain on assigning a debt owed to it by the Trustee?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commences on:

1 July 2013

Relevant facts and circumstances

Trust A

Trust A was settled under deed.

The Specified Beneficiaries of Trust A are the children of Z.

The General Beneficiaries of Trust A include the children of the Specified Beneficiaries.

The General Beneficiaries of Trust A also includes the trustee of an Eligible Trust. An Eligible Trust means any trust under which a beneficiary or General Beneficiary has any interest. Trust B is a General Beneficiary of Trust A.

Since Trust A was settled the trustee has appointed amounts of income and capital to the beneficiaries of Trust A in accordance with the Trust deed.

Old Loans

As at 30 June 2013 Trust A had current liabilities including loans made by the beneficiaries of the Trust A to the trustee (collectively, the Old Loans) which arose by:

(a) The trustee appointing an amount of trust income or capital to the relevant beneficiary of Trust A;

(b) The relevant beneficiary loaning an amount equal to the income or capital so appointed back to the Trustee thus effecting a payment of that amount by way of set-off.

The Old Loans arose prior to 30 June 2007.

The Old Loans are non-interest bearing, repayable at call and non-secured.

Some of the Old Loans were made prior to 20 September 1985 and remain outstanding as at that date.

The applicant has advised that the reductions in the original Loan amount comprise the sum of: (a) the payments made by the trustee to the relevant taxpayer and (b) the sum of other reductions in the original Loan amount resulting from transactions such as the assignment or gifting of part of the original Loan amount to another family member who was, typically, another beneficiary

Unpaid Present Entitlements

As at 30 June 2013 Trust A had current liabilities relating to unpaid present entitlements, being amounts of trust income and capital appointed to the beneficiaries of Trust A that remain unpaid as at the date the private ruling application was lodged (Beneficiary UPEs).

The applicant has advised that the reductions in the original UPE amounts comprise the sum of: (a) the payments made by the trustee to the relevant taxpayer and (b) the sum of other reductions in the original UPE amount resulting from transactions such as the assignment or gifting of part of the original UPE amount to another family member who was, typically, another beneficiary

Trust B

Trust B was settled under deed.

The trust fund of Trust B is held in portions for various classes of beneficiaries each of which portions constitute a separate trust estate, as follows:

The proposed arrangement

The Trustee and each beneficiary of Trust A are seriously considering undertaking an arrangement:

(a) To convert each of the Beneficiary UPEs into a loan that will be owed by the Trustee to the relevant beneficiary of Trust A(collectively, the New Loans) by:

i. The Trustee paying, by way of set-off, each Beneficiary UPE to the relevant beneficiary of Trust A; and

ii. Each beneficiary of Trust A agreeing to loan to the Trustee the amount paid;

(b) The New Loans will be non-interest bearing, prepayable at call and no-secured.

(c) To assign the New Loans to the trustee of Trust B for no consideration and on non-arm's length terms as per the draft deed of assignment; and

(d) To assign the Old Loans to the trustee of Trust B for no consideration and on non-arm's length terms as per the draft deed of assignment.

The applicant advised that the Trustee of Trust A has been, at all times, and will continue to be solvent and capable of paying its debts as and when they fall due.

The applicant advised that the funds it received under the Old Loans were used by Trust A to acquire income producing real property and the New Loans arise so that the trustee can discharge the UPEs without disposing of any assets, and on this basis if interest was payable by Trust A under the loans it would have been deductible.

Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) has not been considered by the Commissioner in making this ruling. Where there are beneficiaries of the Trusts which are private companies, you will need to consider the application of Division 7A of the ITAA 1936.

Relevant legislative provisions

Income Tax Assessment Act 1997, subsection 102-25(1)

Income Tax Assessment Act 1997, subsection 104-10(1)

Income Tax Assessment Act 1997, subsection 104-25(1)

Income Tax Assessment Act 1997, subsection 104-35(1)

Income Tax Assessment Act 1997, subsection 104-60(1)

Income Tax Assessment Act 1997, subsection 104-60(2)

Income Tax Assessment Act 1997, subsection 104-60(3)

Income Tax Assessment Act 1997, subsection 104-65(6)

Income Tax Assessment Act 1997, subsection 108-5(1)

Income Tax Assessment Act 1997, subsection 110-25(2)

Income Tax Assessment Act 1997, subsection 110-45(3)

Income Tax Assessment Act 1997, subsection 116-30(1)

Income Tax Assessment Act 1997, section 245-10

Income Tax Assessment Act 1997, paragraph 245-10(a)

Income Tax Assessment Act 1997, paragraph 245-10(b)

Income Tax Assessment Act 1997, paragraph 245-10(c)

Income Tax Assessment Act 1997, paragraph 245-35(a)

Income Tax Assessment Act 1997, paragraph 245-35(b)

Income Tax Assessment Act 1997, section 245-36

Income Tax Assessment Act 1997, paragraph 245-36(a)

Income Tax Assessment Act 1997, paragraph 245-36(b)

Income Tax Assessment Act 1997, subsection 245-55(1)

Income Tax Assessment Act 1997, section 245-61

Income Tax Assessment Act 1997, section 245-65

Income Tax Assessment Act 1997, subsection 245-65(1)

Income Tax Assessment Act 1997, subsection 245-75(1)

Income Tax Assessment Act 1997, subsection 245-75(2)

Reasons for decision

Question 1

Legislative References are to the Income Tax Assessment Act (ITAA 1997) unless otherwise specified.

Subsection 108-5(1) defines a "CGT asset" as being any kind of property or a legal or equitable right that is not property.

A UPE is an equitable right that is proprietary in nature in the hands of a beneficiary that is presently entitled (see paragraph 34 of Taxation Ruling TR 2010/3 Income tax: Division 7A loans: trust entitlements). It therefore satisfies the definition of "CGT asset" in subsection 108-5(1).

CGT event D1 occurs when a contractual, legal or equitable right is created. CGT event C2 occurs when an intangible CGT asset comes to an end.

A beneficiary can become presently entitled to a share of the income of a trust estate pursuant to a term of the trust deed or by the exercise by a trustee of a power under a trust deed.

As a UPE is a CGT asset that comes into existence when a beneficiary of a trust becomes presently entitled to a share of the income of a trust estate, CGT event D1 occurs at either the time as specified under the relevant term or terms of the trust deed which confer present entitlement or when a valid trust resolution is made to apply a share of the income of the trust for the benefit of a beneficiary.

Similarly, as a UPE is satisfied or discharged, and ends, when the amount of a beneficiary's present entitlement is paid to them, CGT event C2 occurs at the time of payment.

In this case the payment of each Beneficiary UPE is by way of set-off in circumstances where each UPE is converted to a loan to the Trustee of Trust A as described in the facts.

However, consistent with the approach outlined in Commissioner of Taxation v Dulux Holdings Pty Ltd & Ors [2001] FCA 1344, (the Dulux case), the Commissioner's position has been that it is appropriate to look through the legal rights incidentally created and discharged/satisfied when they are merely facilitating the real transaction, being the distribution of income from a trust to a beneficiary.

There appears to be no valid reason for departing from that position in this case where each UPE is discharged/satisfied by way of payment, albeit by way of set-off.

This position prevents any issues of double taxation of trust distributions and although an alternative position could be to instead rely on the anti-overlap provisions in section 118-20, the current position is a more practical approach to the issue.

Accordingly, it is appropriate to look through CGT event C2 (and any capital gain that may result) as the rights incidentally discharged/satisfied merely facilitate the distribution of income from a trustee to a beneficiary.

Question 2

The commercial debt forgiveness provisions are found in Division 245 and apply to debts forgiven in the 2010-2011 income year and later income years.

For the commercial debt forgiveness rules to apply there must be a forgiveness of a commercial debt. The term 'debt' is not defined so the ordinary meaning of 'debt' applies to Division 245. The Explanatory Memorandum to the Tax Law Amendment (Transfer of Provisions) Bill 2010 states that the ordinary meaning of "debt" requires an obligation to do something which is enforceable.

Section 245-10 stipulates that a debt will be a 'commercial debt' if:

• the whole or any part of interest, or of an amount in the nature of interest, paid or payable by you in respect of the debt has been deducted, or can be deducted, by you (paragraph 245-10(a)); or

• interest, or an amount in the nature of interest, is not payable by you in respect of the debt but, had interest or such an amount been payable, the whole or any part of the interest or amount could have been deducted by you (paragraph 245-10(b)); or

• interest or an amount mentioned in paragraph (a) or (b) could have been deducted by you apart from the operation of a provision of this Act (other than paragraphs 8-1(2)(a), (b) and (c)) that has the effect of preventing a deduction (paragraph 245-10(c)).

A debt is forgiven if and when the debtor's obligation to repay the debt is released, waived, or otherwise extinguished other than by repaying the debt in full (paragraph 245-35(a)), or the period within which the creditor is entitled to sue for recovery of the debt ends, because of operation of statute of limitation, without the debt having been paid (paragraph 245-35(b)).

If a debt is assigned, it will be forgiven for the purposes of Division 245 if section 245-36 is satisfied. Section 245-36 prescribes that a debt will be forgiven if and when the creditor assigns the right to receive payment to another entity (the new creditor) the following conditions are met:

• the new creditor is the debtor's associate; or the assignment occurred under an arrangement to which the new creditor and debtor were parties (paragraph 245-36 (a)); and

• the right to receive payment of the debt was not acquired by the new creditor in the ordinary course of trading on a market or exchange (paragraph 245-36(b)).

In this case, interest is not payable under either the Old Loans or the proposed New Loans. The Commissioner accepts the applicant's submission that if interest were payable, the whole or part of the interest could have been deducted. Accordingly, the debts under the Old Loans and the proposed New Loans are commercial debts under section 245-10.

Under the proposed arrangement in this case, the debts under either the Old Loans or the proposed New Loans owing by Trust A to the relevant beneficiaries will be assigned in writing by the relevant beneficiaries to Trust B as the new creditor. Trust B is a beneficiary of Trust A. Trust B and the trustee of Trust A are associates (see subsection 318(3) of the Income Tax Assessment Act 1936 (ITAA 1936)). Also, the right to receive payment of the debt was not acquired by Trust B in the ordinary course of trading on a market or exchange.

The Commissioner is satisfied that section 245-36 of the ITAA 1997 applies to make the assignment of the debts under the Old Loans and the proposed New Loans to Trust B a forgiveness of those debts owing by Trust A to the relevant beneficiaries.

The next step is to work out the net forgiven amount that will be applied against the deductible amounts of Trust A as required by Division 245.

Subsection 245-55(1) sets out the general rule for working out the value of a debt:

245-55(1)

The value of your debt at the time (the forgiveness time) when it is *forgiven is the amount that would have been its *market value (considered as an asset of the creditor) at the forgiveness time, assuming that:

(a) when you incurred the debt, you were able to pay all your debts (including that one) as and when they fell due; and

(b) your capacity to pay the debt is the same at the forgiveness time as when you incurred it.

The Commissioner accepts the applicant's advice that the Trustee was solvent at the time that the Loan was incurred; and the Trustee's capacity to repay the Loan at the time it will be forgiven is the same as at the time the Loan was incurred.

In these circumstances, subsection 245-55(1) applies and the value of the debts is the market value of each of the Old Loans and the proposed New Loans at the time they are assigned.

The term 'market value' is not defined in any general provision in the tax legislation. As a result, 'market value' usually takes the ordinary meaning unless specifically defined or qualified in a particular provision. The ATO Guide: market valuation for tax purposes (www.ato.gov.au/content/00161737.htm) considers the ordinary meanings of the term 'market value' from various sources including Judicial interpretation, and such as the definition as adopted by business valuers in Australia:

The price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller at arm's length.

The Commissioner accepts the applicant's submission that the market value of each debt is the principal amount payable by the Trustee at the time the Loans were assigned.

On the facts provided, there is no evidence that Trust B intends to forgive the debts. However, you are requested to note that if the debts assigned to Trust B are later forgiven by Trust B the value of the debts when they are later forgiven is worked out under section 245-61.

The next step is to determine if an amount is to be offset against the value of the debt under section 245-65. Specifically, Item 5 of table to subsection 245-65(1) will apply in this case.

Item 5 of the table to subsection 245-65(1) stipulates that where the debt is assigned under section 245-36 and the debt is not a moneylending debt and the creditor and the new creditor were not dealing with each other at arm's length, the amount which is offset against the value of a debt is the market value of the debt at the time of the assignment.

In this case, the terms of the Old Loans and the New Loans are interest free, repayable on call and non-secured which do not carry the indicia of the terms that would be expected of loans taken out in the course of a moneylending business. The beneficiaries (the creditors) intend to assign their interests in the Old Loans and New Loans to the trustee of Trust B (new creditor) for the consideration of 'natural love and affection' which is not dealing at arm's length. The Commissioner accepts the applicant's submissions that the Old and New Loans are not moneylending debts and the beneficiaries and the trustee of Trust B are not dealing with each other at arm's length.

In these circumstances, pursuant to an application of section 245-65 the value of the debts will be offset by the market value of the debts at the time of the assignment. As set out above the Commissioner accepts that the market value of the debts at the time of their assignment is the principal amount payable by the Trustee of Trust A at the time of the assignment.

The final step is to work out the gross forgiven amount.

In this case, where section 245-65 applies, the gross forgiven amount is the excess amount of the value of the debt (when it was forgiven) which exceeds the amount offset under section 245-65 (subsection 245-75(1)).

If the value of the debt when it was forgiven is equal to or less than the amount offset there is no gross forgiven amount in respect of the debt and subdivisions 245-D to 245-F do not apply in respect of the debt (subsection 245-75(2)).

In the circumstances of this case the value of the debt (section 245-55) is equal to the amount of offset (section 245-65) and therefore there is no gross forgiven amount. It follows that subdivisions 345-D and 245-F (about how to work out the net forgiven amount of a debt and how to treat it) do not apply.

Question 3

Detailed reasoning

CGT assets

A CGT asset is any kind of property or a legal or equitable right that is not property (Subsection 108-5(1)). The note to section 108-5 includes 'debts owed to you' as CGT assets.

In this case each debt under the Old Loans and proposed New Loans owed to each of the beneficiaries as set out in the facts are CGT assets in the hands of relevant each beneficiary.

CGT event

The general rule is that a capital gain or loss only arises if a CGT event happens.

CGT event A1 happens if you dispose of a CGT Asset (see subsection 104-10(1)).

CGT event E2 happens if you transfer a CGT asset to an existing trust (see subsection 104-60(1)). The time of the event is when the asset is transferred (see subsection 104-60(2)).

The legislation does not define the term 'transfer'. McKerracher J in Healey v FCT FCA 269 (Healey) held that the term 'transfer' in s 104-60(1) of ITAA 1997 was a word of wide import whose meaning was not limited to conveyance by way of gift or settlement but included a conveyance by way of sale.

If more than one event can happen, the one you use is the one that is the most specific to your situation (see subsection 102-25(1)).

The legislation does not provide guidance as to how the 'most specific' CGT event is worked out.

McKerracher J in Healey held that CGT event E2 (transfer of an asset to a trust) was more appropriate than CGT event A1 (disposal of an asset) in respect of a transfer of shares where the parties were not at arm's length¹.

ATO ID 2003/559 considers the disposal of land to a trust and whether CGT event A1 or CGT event E2 happened in circumstances where the vendor sold the land at arm's length and neither the taxpayer nor their associates had any connection with the purchaser which was the trustee of a trust. The decision states:

On its face, CGT event E2 happens whenever an asset is transferred to a trust and is therefore the applicable event in this case. However, it is considered that CGT event A1 (rather than CGT event E2) is the most specific event where, as in this case, as asset is transferred to another party and the transferor is indifferent as to the identify of that party. That is, CGT event A1 is the most specific event were the parties are completely unconnected and are dealing with each other at arm's length.

…

On the other hand, CGT event E2 will be the most specific event if, for example, an asset is transferred to a trust of which the transferor or an associate is a beneficiary or object.

In this case, the beneficiaries will assign the debts owed by them by Trust A under the Old Loans and the proposed New Loans to the trustee of Trust B. It is considered that at the time of the assignment CGT event E2 and CGT event A1 can happen.

The beneficiaries are beneficiaries of both Trust A and Trust B. It is clear that the beneficiaries are connected to Trust B. In addition the beneficiaries will assign the debts for natural love and affection.

In the circumstances of this case where the parties are connected and are not dealing at arm's length, the most specific CGT event is CGT event E2 and not CGT event A1.

CGT event E2 will happen when the beneficiaries assign the Old Loans and the proposed New Loans to the trustee of Trust B.

Capital gain

The next step is to work out whether there is a capital gain or a capital loss to each of the beneficiaries on assignment of their Old Loans and proposed New Loans.

Subsection 104-60(3) prescribes that you make a capital gain if the capital proceeds from the transfer are more than the asset's cost base and you make a capital loss if those capital proceeds are less than the asset's reduced cost base.

However, a capital gain or capital loss you make from CGT event E2 happening is disregarded if you acquired the asset before 20 September 1985 (see subsection 104-65(6)).

In this case the applicant has advised that an amount of the Old Loans arose prior to 20 September 1985. The beneficiaries who have assigned this amount of Old Loans which arose prior to 20 September 1985 will disregard any capita gain or capital loss arising from the assignment of those Old Loans.

For all other beneficiaries the cost base of the Old Loans and proposed New Loans and the capital proceeds need to be determined.

Capital proceeds

Subsection 116-30(1) applies where no capital proceeds are received in respect of a CGT event. In such a case, the taxpayer is taken to have received the market value of the CGT asset that is the subject of the event. The market value is worked out at the time of the event.

Tax Determination TD 2 Capital Gains: what are the CGT consequences for the lender (Creditor) when a debt is waived? refers to repealed CGT provisions. However, it still provides guidance. Paragraph 2 of TD 2 states:

If the lender receives no consideration for the disposal of the debt, the lender is taken to have received an amount equal to the market value of the debt at the time of the disposal… the market value of the debt at the time of the disposal is worked out as though the debt was not waived and was never intended to be waived.

As set out in the reasoning for the previous question, the Commissioner accepts that the market value of each Old Loan and proposed New Loan is the amount of the principal payable at the time of the assignment by the relevant beneficiary of the loan to the trustee of Trust B.

Cost base

Section 110-25 sets out the five elements of the cost base of a CGT asset. The first element of cost is the money you paid, or are required to pay, in respect of acquiring a CGT asset and the market value of any other property you gave, or are required to give in respect of acquired the asset (subsection 110-25(2)).

TD 2 states at paragraph 3:

Generally, the cost base of the debt to the lender is the amount of the loan.

However, pursuant to subsection 110-45(3) expenditure does not form part of any element of the cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

The applicant has advised that only the first element of cost base, being the amount of money paid in order to acquire a CGT asset is relevant in these circumstances.

In this case, the first element of cost of each of the Old Loans is the original loan amount (being the first column in the first table in the facts) less any repayments made (being the second column in the first table in the facts). That is, the first element of cost of each of the Old Loans is the amount of unpaid principal at the time of the assignment of the loan to the trustee of Trust B (being the last column in the first table in the facts).

The proposed arrangement involves each Current UPE amount being converted to a New Loan by way of set off, and soon after each New Loan is assigned by the relevant beneficiary to the trustee of Trust B. In these circumstances, the Commissioner accepts that the first element of cost in respect of each proposed New Loan is the relevant current UPE amount (being the last column in the second table in the facts). If any repayments are made between, the time the New Loan is created and the time that it is assigned, those repayments are recoupments which reduce the first element of cost base.

¹ The case was appealed to the Full Federal Court in Healey v FCT [2012] FCAFC 194 but the issue of which of CGT event E2 and CGT event A1 was the 'most specific' CGT event was not considered by the Full Federal Court.