Edited version of your written advice

Authorisation Number: 1012918935743

Date of advice: 27 November 2015

Ruling

Subject: Capital gains tax: Transfer of dwelling/redemption of units

This ruling applies to the beneficiaries of the trust and to the trustee and to any future trustees, for as long as the ruling remains current.

Question 1

Will capital gains tax (CGT) event A1 in section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to the Unit Trust when it transfers a greater than 50% interest in the property to a unit holder as consideration for the redemption of their units in the Unit Trust?

Answer

Yes.

Question 2

Will the the Super Fund be assessable under section 97 of the Income Tax Assessment Act 1936 (ITAA 1936) in respect of the capital gain made by the Unit Trust?

Answer

Yes.

Question 3

Where the Super Fund is assessable in respect of any capital gain made by the Unit Trust, does this give rise to non-arm's length income (NALI) in accordance with section 295-550 of the ITAA 1997?

Answer

No.

Question 4

Will Part IVA of the ITAA 1936 apply to the Super Fund in respect of this arrangement?

No.

This ruling applies for the following period(s)

1 July 2015 to 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents, or relevant parts of them, as the case may be, form part of and are to be read with this description. The relevant documents or parts of documents incorporated into this description of the arrangement are:

(a)   The application for private ruling together with all other documents, information and views attached to that application; and

(b)   Email provided, together with all of the attachments provided with that email including the trust deed of the Unit Trust.

The Unit Trust was established in the 1990s.

The trustees of the Unit Trust are Individual A and their spouse.

The Unit Trust owns a residential property, consisting of a dwelling on a block of land that is less than 2 hectares in area (the property). The property was acquired after 20 September 1985.

The unit holders of the Unit Trust are Individual A and the trustee of a self-managed super fund (the Super Fund).

There are a number of units in the Unit Trust. Individual A holds greater than 50% of the units and the Super Fund holds the remaining units. This structure was set up pursuant to professional advice received at the time the property was acquired.

The members of the Super Fund at all relevant times have been Individual A and their spouse.

The tenants of the property at all relevant times have been Individual A and their spouse. Individual A and their spouse as tenants have paid on a regular basis an arm's length amount of rent to the Unit Trust as the landlord. The Unit Trust then distributes on a regular basis the net income of the Unit Trust to the unit holders pursuant to the terms of the deed of the Unit Trust.

The property has at all relevant times been the main residence of Individual A and their spouse.

Individual A and their spouse now wish to simplify their tax affairs and acquire an ownership interest in their main residence, and as such propose to undertake the following course of action.

Stage 1:

In the 20XX income year, the Unit Trust will redeem Individual A's units in the Unit Trust for their market value. Rather than the Unit Trust redeeming the units for cash, it will redeem the units for an in-specie transfer of a tenancy in common interest in the property. This interest will be equal to the value of Alan's units, i.e. greater than 50% of the total value of the property.

Individual A would then have a greater than 50% tenancy in common interest in the property and the Unit Trust would own the rest of the property.

Individual A and their spouse as tenants will then pay a percentage of the market value of the rent to the Unit Trust. The payments of rent will be made in respect of the percentage tenancy in common interest that will be held by the Unit Trust. The greater than 50% interest of the property that Individual A will own will not be income generating.

It is anticipated that the Unit Trust will make a capital gain from the disposal of a greater than 50% interest in the property to Individual A, and that Individual A will make a capital gain from the redemption of his units in the Unit Trust.

The trust deed of the Unit Trust does not give the trustees the power to make any unitholder 'specifically entitled' to capital gains, as defined in section 115-228 ITAA 1997.

At the end of the 20XX income year, the Super Fund will be the sole unit holder and, as such, will be presently entitled to all the net income of the Unit Trust, which will include the capital gain from the disposal of the interest in the property.

Stage 2:

It is proposed that, following the redemption of Individual A's units, they will transfer half of their interest in the property to their spouse. At a later time, the property will be sold to an unrelated entity. That is, Individual A and their spouse together with the Unit Trust will sell their respective interests in the property to an unrelated entity.

The sale is anticipated to happen sometime in the next 10 years. The dwelling will be Individual A and their spouse's main residence throughout the period in which they hold an ownership interest in the property. During their ownership period, they will not use the property to produce any assessable income.

Relevant legislative provisions

Section 97 of the Income Tax Assessment Act 1936

Section 104-10 of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

Section 118-20 of the Income Tax Assessment Act 1997

Section 118-110 of the Income Tax Assessment Act 1997

Section 295-550 of the Income Tax Assessment Act 1997

Section 995-1 of the Income Tax Assessment Act 1997

Subdivision 115-C of the Income Tax Assessment Act 1997

Anti-avoidance rules

Part IVA of the Income Tax Assessment Act 1936

Assumption

The following assumptions have been made in the provision of this advice:

• The Super Fund acquired its fixed entitlement to the income of the Unit Trust for an amount equal to its market value

• All prior transactions which have resulted in the derivation of income by the Super Fund as beneficiary of the Unit Trust have been conducted at arm's length values

• All transactions in relation to Stage 1 of the scheme the redemption of units and transfer of an interest in the property held by the Unit Trust in satisfaction of the redemption will be conducted at arm's length values.

Reasons for decision

CGT event A1 and CGT event C2

When a beneficiary redeems their units in a unit trust for an in-specie transfer of property from the unit trust's assets, there are consequences for both the trustee and the unit holders of the unit trust.

CGT event A1 in section 104-10 of the ITAA 1997 happens if the trustee of a trust disposes of a CGT asset of the trust via an in-specie transfer to a beneficiary to redeem a beneficiary's interest in the trust. The trustee will make a capital gain if the capital proceeds are more than the cost base of the asset at the time it is disposed of.

In addition, CGT event C2 in section 104-25 of the ITAA 1997 happens to the unit holder upon redemption of their units. The unit holder will make a capital gain if the capital proceeds from the redemption are more than the cost base of the unit in the unit trust.

In this case the Unit Trust will make a capital gain under CGT event A1 upon the in-specie transfer of a proportion of the property to Individual A. Individual A will make a capital gain under CGT event C2 as a result of the redemption of the units in the Unit Trust.

Section 97 of the ITAA 1936

Section 97 of the ITAA 1936 provides that a taxpayer who is not under a legal disability and who is presently entitled to a share of the income of a trust estate must include in their assessable income that share of the net income of the trust.

Paragraph 97(1)(a) of the ITAA 1936 provides that the assessable income of a presently entitled beneficiary who is not under a legal disability comprises:

• so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident of Australia, whatever the source of the income, and

• so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia.

From the 2010-11 income year, Subdivision 115-C of the ITAA 1997 modifies the rules for trusts with net capital gains. Where permitted by the trust deed, the capital gains of a trust can be effectively streamed to beneficiaries for tax purposes, by making them 'specifically entitled' to those gains. Generally, a beneficiary will be considered specifically entitled to an amount of a capital gain if the beneficiary has received (or can reasonably be expected to receive) an amount referable to that gain.

A beneficiary specifically entitled to a capital gain will generally be assessed in respect of that gain, regardless of whether the benefit they receive or are expected to receive is income or capital of the trust. That is, unlike the law that applied prior to the amendments, under the new trust provisions, a beneficiary may be assessed based on a specific entitlement to a capital gain of the trust, even though they do not have a present entitlement to income of the trust estate.

Capital gains to which no beneficiary is specifically entitled will be allocated proportionately to beneficiaries based on their present entitlement to income of the trust estate (excluding amounts to which any entity is specifically entitled). This proportion is known as the beneficiary's 'adjusted Division 6 percentage'. If there is some income to which no beneficiary is entitled (apart from capital gains and/or franked distributions to which any entity is specifically entitled) the trustee may be assessed under section 99 or 99A of the ITAA 1936.

In this case, at the end of the relevant income year (the 20XX income year) the only unit holder will be the Super Fund. Individual A will no longer be a unit holder as his units will have been redeemed.

Therefore, in addition to Individual A making a capital gain in relation to the redemption of their units, the Unit Trust will make a capital gain from the disposal of an interest in the property. As a result, an amount will be included in the Super Fund's assessable income under section 97 of the ITAA 1936 in respect of the capital gain made by the Unit Trust.

Anti-overlap rule

The anti-overlap rule in section 118-20 of the ITAA 1997 provides that a capital gain you make from a CGT event is reduced if, because of the event, a provision (other than a CGT provision) includes an amount in your assessable income.

Section 118-20 of the ITAA 1997 does not apply to Individual A because no amount is included in their assessable income by a provision outside of the CGT provisions because of the CGT event C2 that happens to their units.

Section 118-20 also does not apply to the Unit Trust for the same reason. That is, no amount is included in the Unit Trust's assessable income by a provision outside of the CGT provisions because of the CGT event A1 that happens to the property. Accordingly, the capital gain made by the Unit Trust will be included in the Super Fund's assessable income under section 97 of the ITAA 1936.

Non-arm's length income

According to subsection 995-1(1) of the ITAA 1997, the phrase 'non-arm's length income' has the meaning given by section 295-550 of the ITAA 1997.

There are various subsections in section 295-550 of the ITAA 1997 under which amounts of ordinary income or statutory income of a complying superannuation fund are non-arm's length income of that fund. Subsections 295-550(4) and (5) of the ITAA 1997 specifically apply to such amounts derived as a beneficiary of a trust.

Subsection 295-550(4) of the ITAA 1997 provides that income derived by the entity as a beneficiary of a trust, other than because of holding a fixed entitlement to the income, is non-arm's length income of the entity.

Subsection 295-550(5) of the ITAA 1997 provides that other income derived by the entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust is non-arm's length income of the entity if:

(a) the entity acquired the entitlement under a scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at arm's length; and

(b) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length.

Income derived as a beneficiary of a trust

Subsections 295-550(4) and (5) of the ITAA 1997 are relevant to the present case in relation to amounts of ordinary or statutory income included in the assessable income of the Super Fund that are sourced from the Super Fund's entitlement as the beneficiary of the Unit Trust. Such amounts are, for the purposes of those subsections, 'income derived by the [fund] as a beneficiary of a trust': Allen v Federal Commissioner of Taxation (2011) 195 FCR 416; SCCASP Holdings Pty Ltd v Federal Commissioner of Taxation (2013) 211 FCR 332.

The income which is the subject of the ruling application is specifically the share of any net capital gain which the Unit Trust might make as a result of Stage 1 of the scheme.

The question as posed in the ruling application limits our consideration to only a part of the income which might be derived by the Super Fund as beneficiary of the Unit Trust. However subsections 295-550(4) and 295-550(5) of the ITAA 1997 apply in relation to the total amount of income which has been derived as a beneficiary of a trust and included in a fund's assessable income.

Accordingly consideration of NALI has been limited to a consideration of whether the implementation of Stage 1 of the scheme as outlined, in isolation, might result in the income derived by the fund as beneficiary of the Unit Trust being considered NALI.

Fixed entitlement to income derived as a beneficiary of a trust

In paragraph 102 of Taxation Ruling TR 2006/7 Income tax: special income derived by a complying superannuation fund, complying approved deposit fund or pooled superannuation trust in relation to a year of income (TR 2006/7), the Commissioner sets out his view that a complying superannuation fund has a fixed entitlement to a trust distribution 'if the entity's entitlement to the distribution does not depend upon the exercise of the trustee's or any other person's discretion'. Although that ruling is primarily concerned with section 273 of the Income Tax Assessment Act 1936 (ITAA 1936), it is also taken to be a ruling about section 295-550 of the ITAA 1997 to the extent that it addresses issues in section 295-550 that are the same as were in section 273: see paragraphs 1A and 1C of that ruling.

The Explanation section of TR 2006/7 expands on the meaning of fixed entitlement, and in particular:

208. Having regard to the statutory context, it is considered that the composite expression 'income derived....by virtue of a fixed entitlement to the income' is designed to test whether an amount of trust income that had been included in the assessable income of a superannuation entity under subsection 97(1) was included because the entity had an interest in the income of the trust that was, at the very least, vested in interest, if not in possession, immediately before the amount was derived by the trustee.

209. To have an interest in the income of a trust estate, a person must have a right with respect to the income of the trust that is susceptible to measurement; a right merely to be considered as a potential recipient of income is not sufficient. An interest in the income of a trust estate will be vested in interest if it is bound to take effect in possession at some time and is not contingent upon any event occurring that may or may not take place. In contrast to a vested interest, a contingent interest will be one which gives no right at all unless or until some future event happens such as the exercise of a discretion by the trustee or some other person.

In this case, the facts indicate that currently the Super Fund is one of two unit holders in the Unit Trust and owns less than 50% of the units issued in the Unit Trust. After the other unit holder redeems their units in the Unit Trust, the Super Fund will be the sole unit holder.

Clause 16.1 of the trust deed of the Unit Trust states that the trustee of the Unit Trust shall hold the net income of the trust in each accounting period in trust for the unit holders in proportion to the number of units held by them on the last day of that accounting period.

Clause 16.4 allows the trustee, with the consent of the unit holders, to accumulate all or part of the net income of the trust, and such accumulation will be dealt with as an accretion to the trust fund.

Clause 17.1 states that on and from the termination day, the trustee shall hold the trust fund for the unit holders in proportion to the number of units held by them at the commencement of that day.

It is clear from the Unit Trust deed that the Super Fund has a vested interest in the income of that trust, and its entitlement to income does not depend upon the exercise of any person's discretion. Accordingly, it is considered that the Super Fund derives income as a beneficiary of the Unit Trust through the holding of a fixed entitlement to the income of that trust.

Therefore, it is subsection 295-550(5), rather than subsection 295-550(4), of the ITAA 1997 that is the relevant provision in this case.

Subsection 295-550(5)

Paragraphs 295-550(5)(a) and (b) of the ITAA 1997 contain conditions that must be met for income derived by an entity as a beneficiary of a trust through holding a fixed entitlement to the income of the trust to be non-arm's length income of the entity:

(a) the entity acquired the entitlement under a scheme, or the income was derived under a scheme, the parties to which were not dealing with each other at arm's length; and

(b) the amount of the income is more than the amount that the entity might have been expected to derive if those parties had been dealing with each other at arm's length.

Scheme

The term 'scheme' is defined in subsection 995-1(1) of the ITAA 1997 to mean:

(a) any arrangement; or

(b) any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.

The term 'arrangement' is also defined in subsection 995-1(1) of the ITAA 1997 to mean 'any arrangement, agreement, understanding, promise or undertaking, whether expressed or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings'.

Paragraph 111 of TR 2006/7 states that 'to acquire a fixed entitlement to the income of a trust or to derive income from a trust will involve an arrangement'.

The scheme proposed by the applicant by which the Super Fund will derive a share of the net capital gain made by the Unit Trust in Stage 1 includes the following steps:

• The issuing of units in the Unit Trust to the Super Fund on the establishment of the trust;

• The issuing of units in the Unit Trust to Individual A on the establishment of the Unit Trust;

• The acquisition of a residential rental property by the trustee of the Unit Trust

• The redemption at market value of the units in the Unit Trust held by Individual A

• In satisfaction of the redemption, the transfer by the Unit Trust of a tenants in common interest in the residential property held by the Unit Trust that is equal to the market value of Individual A's units

• The operation of trust law and the trust deed to make the Super Fund presently entitled to a share of the net income of the Unit Trust

Parties to scheme not dealing at arm's length

The definition of 'arm's length' in subsection 995-1(1) of the ITAA 1997 provides that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstances.

In Federal Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204 at 213 Dowsett J summarised propositions which emerge from the numerous cases in which the expression 'not dealing with each other at arm's length' or similar expressions have been considered, as follows:

• in determining whether parties have dealt with each other at arm's length in a particular transaction, one may have regard to the relationship between them;

• one must also examine the circumstances of the transaction and the context in which it occurred;

• one should do so with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction;

• relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal;

• where the parties are not in an arm's length relationship, one may infer that they did not deal with each other at arm's length, and that the resultant transaction is not at arm's length;

• however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship;

• unrelated parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm's length.

It is clear that the parties in this case are not in an arm's length relationship. Individual A and their spouse are the trustees and members of the Super Fund, and also the trustees of the Unit Trust. Individual A and the Super Fund are currently the two unit holders of the Unit Trust.

However a non-arm's length relationship between parties does not necessarily mean that the parties cannot deal at arm's length in relation to a particular scheme.

Will the parties to the scheme be dealing with each at arm's length in relation to the scheme

Clause 26.1 of the trust deed of the Unit Trust authorises the trustee to redeem units and cancel units at the request of the unit holder. It further allows the trustee to transfer such of the assets of the trust as consideration for such redemption, provided that the value of the transfer does not exceed the value of the allotment price of a unit which would be determined if any allotment was made on that date pursuant to clause 22.

Clause 22 sets out the rules to be followed by the trustee in using additional units in the Unit Trust, including rules around determining the issue price of such units.

Provided the transactions undertaken as part of the scheme are conducted at market value and in accordance with the terms of the trust deed of the Unit Trust, it would be considered that the parties to the scheme will have dealt with each other at arm's length in relation to the scheme.

Accordingly, it is considered that the entering into of the scheme as outlined above would not, on its own, give rise to the income derived by the Super Fund as a beneficiary of the Unit Trust being considered NALI.

NOTE: This does not preclude subsection 295-550(5) of the ITAA 1997 from applying in relation to the income derived by the Super Fund as beneficiary of the Unit Trust due to any other dealings which may not be conducted at arm's length.

Paragraph 154 of TR 2006/7 states that the words of the section indicate that once the conditions are met and an amount is characterised as special income (NALI), that characterisation applies to the entire amount.

In other words, if the conditions in subsection 295-550(5) of the ITAA 1997 are met in relation to either the acquisition of the Fund's fixed entitlement or the derivation of any other income, it is the entire amount of the income derived by the Fund as beneficiary of the Unit Trust that would be considered NALI.

Part IVA

Part IVA of the ITAA 1936 may apply to a transaction if it is determined that there is:

a) a tax benefit; and

b) the sole or dominant purpose of entering into the transaction or scheme was to obtain a tax benefit.

In the Super Fund's case, the scheme consists solely of the disposal by the Unit Trust of an interest in the property for its market value. The Unit Trust will make a capital gain from this transaction, which will flow through to the Super Fund as sole unit holder of the Unit Trust. The outcome of the transaction for the Super Fund will be that it will be presently entitled to the capital gain resulting from the disposal of an asset by the Unit Trust for its market value.

No tax benefit arises to the Super Fund from this transaction as compared to any reasonable alternative postulate or counterfactual. Accordingly, Part IVA will have no application.