Edited version of your written advice

Authorisation Number: 1051371655752

Date of advice: 14 May 2018

Ruling

Subject: Capital gains tax

Question 1

Will section 118-12 of the Income Tax Assessment Act 1997 (ITAA 1997) operate so as to disregard any capital gain or capital loss made on the sale of the property?

Answer

Yes.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Foundation has been granted income tax exemption by the ATO as a charity since 2004, and has been registered by the Australian Charities and Not-for-profits Commission (ACNC) as a registered charity since 2012.

The Foundation has been organising charitable activities for its members in City A State B since 2004 through its City A branch office (branch office).

The branch office operated under the Foundation and the Foundation financially supported the branch office prior the branch office being incorporated in 2012.

In 2007, the branch office wanted to purchase a property for use as its permanent office for servicing its members whose number in City A had grown significantly over the years.

The Foundation was established to be the organisation that supported all centres in Australia however in the early years the Foundation did not have the financial capacity to assist the establishment of the other state centres. Therefore, in 2007 when the branch office wanted to purchase a property, the Foundation did not have sufficient financial capacity to apply for a mortgage loan. The branch office therefore sought assistance from its members.

In 2007 the property was purchased under the names of two individual members of the Foundation who are the registered legal owners on the title.

The deposit for the purchase of the property was funded by the Foundation and from donations from its branch office members in City A.

The property was used as security for the mortgage loan. The two individual members of the Foundation are the mortgagors.

In 2012 the branch office was incorporated (the incorporated entity). The incorporated entity is established to undertake charitable activities.

The incorporated entity is registered as a charity by the ACNC since 2012 and it has been granted income tax exemption as a registered charity by the ATO since 2012.

The property is recognised and included in the financial statements of the incorporated entity which provide that the property is held through individuals who confirm that the incorporated entity is at all times entitled to the benefits of the property together with all the earnings, profits, gains accrued or to accrue in respect of the property.

Prior to the incorporation of the branch office, mortgage payments for the property were paid by an official representative of the Foundation on behalf of the branch office. Since the incorporation of the branch office in 2012, mortgage payments for the property have been paid by the incorporated entity. The mortgage payments have never been paid by any other person or entity besides the Foundation, branch office or incorporated entity.

Since the branch office was incorporated, all income received and expenses paid in relation to the property have been accounted for in the incorporated entity’s financial records.

The two individual members of the Foundation have never lived in the property and have always lived and maintained a residence at another address.

The two individual members of the Foundation have held the property exclusively for use by the Foundation, its branch office or the incorporated entity for charitable purposes.

The property has always been used solely for servicing the Foundation’s, branch office’s and incorporated entity’s members, and for conducting charitable activities in City A by the Foundation, its branch office and the incorporated entity. From time to time the property has been used for accommodation for the organisation’s official representatives who are conducting the charitable activities.

The incorporated entity is considering selling the property.

The incorporated entity also conducts charitable activities at another property City A.

The property will continue to be used solely to produce exempt income until the property is disposed of.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 11-5

Income Tax Assessment Act 1997 section 50-5

Income Tax Assessment Act 1997 section 102-20

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

Income Tax Assessment Act 1997 section 106-50

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 118-12

Reasons for decision

Question 1

Summary

A trust relationship exists between the legal owners of the property, the two individual members of the Foundation, and the incorporated entity, the beneficial owner of the property. The incorporated entity is therefore liable for any capital gains tax (CGT) liability in respect of the disposal of the property.

The incorporated entity has however used the property to produce its income which is exempt income. Therefore, section 118-12 of the ITAA 1997 operates so that any capital gain or loss made in respect of the disposal of the property is exempt.

Detailed reasoning

A capital gain or loss can only result if a CGT event happens (section 102-20 of the ITAA 1997). The gain or loss may however be affected by an exemption.

CGT event A1 happens if a taxpayer disposes of a CGT asset (subsection 104-10(1) of the ITAA 1997). A ‘CGT asset’ is defined in section 108-5 of the ITAA 1997 and includes any kind of property.

When considering the disposal of property and any liability in respect of CGT, the most important element in the application of the CGT provisions is ownership. Therefore, any liability in respect of CGT will depend upon the ownership of the asset.

Ownership for the purposes of CGT

In the absence of evidence to the contrary, where the asset is property, the property is considered to be owned by the people or entity registered on the title.

It is however possible for legal ownership of an asset to differ from beneficial ownership of an asset. Where beneficial ownership and legal ownership of an asset are not the same, there must be evidence that the legal owner holds the asset on trust for the beneficial owner.

Section 106-50 of the ITAA 1997 provides that where a beneficiary is absolutely entitled to an asset held by a trustee any ‘act done by the trustee in relation to the asset’ is treated as if it had been an act of the person absolutely entitled.

As a result if the act triggers a CGT event, then the beneficiary, and not the trustee, is liable for any capital gain or loss that arises in relation to the asset.

A beneficiary is absolutely entitled to an asset of a trust as against the trustee for the purposes of section 106-50 of the ITAA 1997 if the beneficiary is:

● absolutely entitled in equity to the asset and thus has a vested, indefeasible and absolute interest in the asset; and

● able to direct the trustee how to deal with the asset.

It therefore follows that where the legal and beneficial ownership of an asset are not the same, in order to establish who will be liable for any CGT consequences on the disposal of the asset, it is necessary to determine if the beneficial owner is absolutely entitled to the property as against the registered legal owners.

Absolute entitlement to a CGT asset

The phrase 'absolutely entitled to a CGT asset as against the trustee’ is not defined in the tax legislation. However, the decision in Saunders v. Vautier (1841) 4 BEAV 155, 49 ER 282 established the concept of absolute entitlement and Taxation Ruling TR 2004/D25 Income tax: capital gains: meaning of the words 'absolutely entitled to a CGT asset as against the trustee of a trust' as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997 (TR 2004/D25) provides guidelines on the application of this concept in the context of the CGT provisions.

The core principle underpinning the concept of absolute entitlement is the ability of a beneficiary, who has a vested and indefeasible interest in the entire trust asset, to call for the asset to be transferred to them or to be transferred at their direction (paragraph 10 of TR 2004/D25).

A vested interest is one that will take effect in possession at some time and is not contingent upon an event that may or may not happen. A beneficiary's interest is vested in possession if they have the right to immediate possession or enjoyment of the asset (paragraph 74 of TR 2004/D25). That is, there are no legal impediments to the beneficiary's right.

It is also necessary that the interest of a beneficiary to a CGT asset cannot be defeated by the actions of any person or the occurrence of any subsequent event. Paragraph 11 of TR 2004/D25 explains that if there is some basis upon which a trustee can legitimately resist the beneficiary's call for an asset, then the beneficiary will not be absolutely entitled as against the trustee to the asset.

The test of absolute entitlement is therefore based on whether the beneficiary has a vested and indefeasible interest in the property and is able to call for that property to be transferred. Anything that allows the registered legal owners to resist the demand for the property will mean the beneficiary does not have an absolute entitlement to that asset.

Exempt capital gains or losses

Although an amount is included in assessable income under a provision of the ITAA it may be made exempt income or non-assessable non-exempt income under another provision.

Section 118-12 of the ITAA 1997 exempts capital gains or losses from CGT assets used solely to produce exempt income or non-assessable non-exempt income.

Exempt income can be divided into two main classes:

● ordinary or statutory income of entities that are exempt no matter what kind of ordinary or statutory income they have, and

● ordinary or statutory income of a kind that is exempt.

Section 11-5 of the ITAA 1997 lists entities that are exempt no matter what kind of ordinary or statutory income they have. A ‘registered charity’ which is endorsed as exempt from income tax by the Commissioner of Taxation (item 1.1 of section 50-5 of the ITAA 1997) is listed as an exempt entity. Therefore an endorsed registered charity will not have a CGT liability in respect of disposals of its assets.

Application to your circumstances

CGT event A1 will happen to the property when it is disposed of. Any liability in respect of capital gains or losses on the disposal of the property depends upon the ownership of the property.

The two individual members of the Foundation are the legal owners of the property however the property was acquired for the Foundation’s branch office, and then the incorporated entity, as its permanent office for conducting its charitable activities.

There is no formal trust relationship established between the legal owners, the two individual members of the Foundation, and the incorporated entity. The arrangement under which the parties acquired and service the property is not documented, nor is there a trust instrument which sets out the terms and parameters governing the relationship. The arrangement was however documented in the financial statements of the incorporated entity which state that the incorporated entity was at ‘all times entitled to the benefits of the property together with all the earnings, profits, gains accrued or to accrue in respect of the property’.

Whilst there is no formal trust instrument, the arrangement exhibits the essential characteristics of a trust:

● The registered title owners, the two individual members of the Foundation, hold a legal interest in the property.

● The property is capable of being held on trust.

● The incorporated entity is the sole beneficiary of the property, a claim supported by the legal owners who declare that the intention in acquiring the property was for the property to be beneficially owned by the incorporated entity at all times and not the legal owners themselves. At the time of acquisition of the property the incorporated entity (formerly the branch office) could not obtain a loan from the bank.

● The legal owners have a personal obligation to deal with the property for the benefit of the incorporated entity. Accordingly, whilst a formal trust instrument does not exist, we acknowledge that a trust relationship exists between the legal owners of the property, the two individual members of the Foundation, and the incorporated entity, the beneficial owner of the property.

Given that a trust relationship exists in respect of the property it is necessary to determine if the incorporated entity as the beneficial owner is absolutely entitled to the property as against the legal owners of the property.

The Foundation and its branch office did not have sufficient financial capacity to obtain a bank loan by which to purchase the property in 2007. This prompted the Foundation to enter an arrangement with the two individual members of the Foundation, whereby the two individual members of the Foundation would obtain finance for the purchase of the property on behalf of the Foundation and the legal proprietary interest in the property would be registered in their names. The property however, would be held on trust by the two individual members of the Foundation exclusively for the benefit of the Foundation to conduct its charitable activities in City A through the branch office, and then by the incorporated entity upon the incorporation of the branch office. The property has always been used for this purpose.

Whilst the two individual members of the Foundation are the mortgagors, the mortgage payments have been paid by the branch office and the incorporated entity. The deposit for the acquisition of the property was funded by the Foundation and from donations made to the branch office. Mortgage payments have never been paid by any other person or entity besides the Foundation, its branch office or the incorporated entity. In addition, all income and expenses in relation to the property have been accounted for by the incorporated entity since it was incorporated.

In Dyer v. Dyer (1788) 30 ER 42 it was held that, in general, when a person paid the purchase price of a property and caused the property to be registered in the name of some other person, it was presumed that the payer intended that the registered owner held the property in trust for them. This presumption may be rebutted by evidence to the contrary. In this case no such rebuttal is apparent on the facts.

Paragraph 78 of TR 2004/D25 points out that, given the absence of any other beneficiaries, a sole beneficiary would have a beneficial interest in the entire asset. This totality of beneficial interest means a sole beneficiary satisfies the requirement that their interest in the asset be vested in possession and indefeasible if the beneficiary has the ability to terminate the trust by demanding the asset be transferred to them or to transfer it at their direction in circumstances where that entitlement cannot be defeated. This would be the case if there are no legal impediments to the beneficiary in obtaining immediate possession and enjoyment of the asset.

On the basis of information provided, the incorporated entity has a beneficial interest in the entire property and is absolutely entitled to the property. The incorporated entity’s interest is vested and indefeasible in that there are no legal impediments to its ability to demand that the two individual members of the Foundation, as the property’s legal owners and as trustees, transfer the property to it or to direct them how to otherwise deal with the property. There is no indication of anything that would allow the two individual members of the Foundation to resist the incorporated entity's demand for such a transfer, nor that they would consider taking any step to resist the demand. Consequently, when the property is disposed of section 106-50 of the ITAA 1997 will apply to treat any act done by the two individual members of the Foundation, as the legal owners and as the trustees of the property, as if it had been an act of the incorporated entity. As a result, when the property is disposed of and CGT event A1 happens, the incorporated entity will be subject to any CGT liability in respect of the disposal of the property.

Whilst a capital gain or capital loss may arise in respect of the property’s disposal the incorporated entity is endorsed by the Commissioner as a registered charity as described in item 1.1 of section 50-5 of the ITAA 1997. As a result, all of the income of the incorporated entity is exempt income.

Section 118-12 of the ITAA 1997 exempts capital gains or losses from CGT assets used solely to produce exempt income. Given that the incorporated entity has used the property to produce its income which is exempt income it will not have a liability in respect of any gains or losses made on the disposal of its assets. Therefore, any capital gain or loss made in respect of the disposal of the property will be exempt.