Edited version of your written advice

Authorisation Number: 1051196396889

Date of advice: 8 March 2017

Ruling

Subject: Capital gains tax

Question 1

Did a capital gains event happen at the time you surrendered your life interest?

Answer 1

Yes

Question 2

Will the market value substitution rules in section 116-30 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to deem the capital proceeds from any CGT event arising under the arrangement?

Answer 2

Yes

This ruling applies for the following period(s)

Financial year ending 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

You were the spouse of the Testator at the date of their death. The Testator's will gave their residuary estate to the Trustees to hold on Trust.

The terms of the Trust provided:

a) the beneficiaries of the Trust were you and the Testator's children;

b) that the property that you and the Testator resided in at the time of the Testator's death was to be held for your use, occupation, enjoyment and benefit; and

c) the balance of the capital of the Trust was to be divided equally between the Testator's two children.

At the time of the Testator's death, you and the Testator resided at a property (Property). On completion of the administration of the estate, the Trustees held the Testator's interest in the Property as capital of the Trust.

You continued to reside at the Property after the Testator's death before renting the property out for income producing purposes. You did not treat the Property as your main residence when it was rented out.

You obtained an actuarial valuation of your life interest.

You made a proposal to the Trustees and the Testator's children proposing a sale of the Property. The proposed arrangement was designed to ensure that you were not out of pocket as a result of a sale to allow all parties to benefit from the proposal. You did not seek payment or compensation under the proposed arrangement for the actuarial value of your rights.

The proposal was formalised in a “Deed of Family Arrangement” (Deed) between you, the Testator's children and the Trustees. The Deed facilitated the sale of the Property and the winding-up of the Trust. Relevantly, the Deed provided that:

a) the sale proceeds first be applied on settlement to pay for the costs of the sale and conveyance;

b) a “Reserve” of the proceeds be applied as follows:

i. pay your costs of investigating, negotiating, documenting the Deed of Family Arrangement;

ii. pay any tax incurred by you as a consequence of the ending of your rights as beneficiary of the Trust; and

iii. the balance to be paid to the Trustees to pay any Trust tax and to divide the remaining funds between the Testator's children as a final distribution of the Trust.

Prior to entering into the Deed, each party obtained separate legal advice.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

CGT event A1 happened upon entering the contract of sale for the Property and the surrender of your life interest. As you did not receive any capital proceeds for the transaction and you were not dealing at arm's length in the transaction, the market value substitution rule will apply.

Detailed Reasoning

Surrender of Life Interest

Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you can make a capital gain or a capital loss if and only if a CGT event happens to a CGT asset. A CGT asset can be a life interest and a CGT event can be the creation or termination of that life interest.

Paragraph 66 of Taxation Ruling 2006/14 Income tax: capital gains tax: consequences of creating life and remainder interests in property and of later events affecting those interests states:

If a life interest or remainder owner surrenders or releases their interest, CGT event A1 (in section 104-10 of the ITAA 1997) rather than CGT event C2 (in section 104-25 of the ITAA 1997) happens. The Commissioner considers that CGT event A1 is the applicable event, as there is a change of ownership of the interest from one party to the other, rather than a mere ending of it.

You make a capital gain if the capital proceeds from the surrender are more than the assets cost base. Alternatively, you make a capital loss if the capital proceeds from the surrender are less than the reduced cost base.

Application to your circumstances

In your case, you had a lifetime right to the use, occupation, enjoyment and benefit of the Property held in trust and you also received income from renting out the Property. This can be contrasted with a mere personal right of residence whereby the beneficiary is not entitled to let the property by virtue of his or her estate and to receive the rents and profits from the property.

The trust was created from the will of your deceased spouse and the will names their children as the remainder beneficiaries who would receive the benefit of the property on your death or surrender of the interest.

It is therefore considered that you had an equitable life interest, being an interest in a trust. Upon entering into the contract of sale for the Property, you surrendered your life interest and CGT event A1 happens.

Capital Proceeds - Market Value Substitution Rule

Section 116-30 of the ITAA 1997 operates so that you are taken to have received the market value of the CGT asset in certain situations.

On the surrender of a life interest, the life interest owner is taken to have received the market value of the interest if:

a) no capital proceeds are received for the surrender, or

b) some or all of the capital proceeds from a CGT event cannot be valued; or

c) the capital proceeds are more or less than the market value of the asset and the parties engaged in a non-arm's length dealing in connection with the CGT event; or

d) the capital proceeds are more or less than the market value of the asset and the CGT event is a C2 event.

Section 116-20 of the ITAA 1997 provides that capital proceeds from a CGT event are the total of:

a) the money you have received, or are entitled to receive, in respect of the event happening; and

b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

Section 995-1 defines 'arm's length' as:

in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. The law looks at not only the relationship between the parties but also the quality of the bargaining between them.

An individual is said to be dealing at arm's length with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction.

Parties are not at arm's length where the parties are related or associated in some way so that while each party may enter a transaction with some self interest in mind, it may also take into consideration the interests of the other party in making the agreement. Examples of such relationships are transactions between family members and related corporations.

Where parties are not at arm's length it is still possible for the parties to deal at arm's length in relation to a specific transaction. As stated by Davies J. in Barnsdall v Federal Commissioner of Taxation (1988) ATC 4565, 4568:

“The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion.”

Parties will be dealing at arm's length where they act as arm's length parties would normally do, so that their dealing has an outcome that is the result of normal bargaining (The Trustee for the Estate of the late A W Furse No 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123 and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 (Granby)).

In Granby at ATC 4243; ATR 403 Lee J stated that the provision 'dealing with each other at arm's length' invited an analysis of the manner in which the parties conduct themselves in forming the transaction. The question is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs and the expression means, at least, that the parties have acted severally and independently in forming their bargain.

Further, Lee J stated (at ATC 4244; ATR 403-404) that:

“If the parties to the transaction are at arm's length it will follow, usually, that the parties will have dealt with each other at arm's length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be.”

However this will not be the case where the parties collude to achieve a particular result, or where one of the parties submits the exercise of its will to the discretion of the other. In such a case the lack of the exercise of an independent will in the formation of the transaction would indicate a lack of real bargaining.

In Collis v. FC of T 96 ATC 4831; (1996) 33 ATR 438 (Collis) the Federal Court found that the parties were not dealing at arm's length because one party was indifferent to the allocation of the sale price for the parcel of land. This indifference was indicative of a submission of one party's will to the other party's wishes which demonstrated a lack of arm's length dealing.

Application to your circumstances

As part of the Deed, you receive funds from the Reserve, which the Trust would pay to you. These funds reimburse your expenses including costs of investigating, negotiating, documenting the Deed and any amount of tax payable by you.

You did not receive payment under the Deed for the actuarial value of your rights under the will. Amounts you receive from the Reserve are not paid to you in connection with the CGT event - the surrender or your life interest. We do not consider that you received capital proceeds for the surrender of your life interest. The market value substitution rule under subsection 116-30(1) of the ITAA 1997 applies for you to use the asset's 'market value' when calculating the capital proceeds for the purposes of working out the capital gain.

Whether the parties engaged in arm's length dealings in connection with the CGT event is considered in circumstances when there are capital proceeds. Although above we discuss there are no capital proceeds, we have still considered whether you were at arm's length in your dealings with the remainder beneficiaries.

The transaction was with a related party, being your spouse's children. Each party obtained separate legal advice prior to the finalised Deed. However, the structure and implementation of the arrangement, under the Deed, between you and your spouse's children, demonstrates that the parties did not behave in the manner in which arm's length parties would be expected to behave.

After receiving an actuarial valuation in respect of your life interest, you did not seek payment or compensation for the actuarial value. Amounts paid or reimbursed to you by the Trustee were designed to ensure you were not out of pocket as a result of a sale, not as compensation for the surrender of your life interest. It is not a price which reflects the outcome of a normal bargaining process as discussed in Granby and Collis.

In your case, even if the parties were at arm's length, the parties did not deal with each other at arm's length.