Edited version of your written advice

Authorisation Number: 1051395407556

Date of advice: 6 July 2018

Ruling

Subject: CGT implications on the conversion of a hybrid trust to a unit trust

Question 1

Will the proposed conversion of the Trust from a hybrid unit trust to a unit trust trigger CGT event E1 pursuant to section 104-55 of the Income Tax Assessment Act 1997 (‘ITAA 1997’)?

Answer

No

Question 2

Will the proposed conversion of the Trust from a hybrid unit trust to a unit trust trigger CGT event E2 pursuant to section 104-60 ITAA 1997?

Answer

No

Question 3

Will the proposed conversion of the Trust from a hybrid unit trust to a unit trust trigger CGT event E3 pursuant to section 104-65 ITAA 1997?

Answer

No

Question 4

Will the proposed conversion of the Trust from a hybrid unit trust to a unit trust trigger CGT event E5 pursuant to section 104-75 ITAA 1997?

Answer

No

Question 5

Will the proposed conversion of the Trust from a hybrid unit trust to a unit trust trigger any of CGT event E4 (section 104-70 of the ITAA 1997), CGT event E6 (section 104-80 of the ITAA 1997), CGT event E7 (section 104-85 of the ITAA 1997) or CGT event E8 (section 104-90 of the ITAA 1997)?

Answer

No

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Background

1. The XXX Unit Trust (‘Trust’) is a hybrid unit trust and was settled by a Trust Deed dated in 20XX.

2. XXX Pty Ltd is the Trustee for the XXX Unit Trust (‘Trustee’).

3. The Trust owns business premises currently funded by a bank loan. A business is operated by YYY Pty Ltd who pays rent to the Trust at market value.

4. Both the Trust and YYY Pty Ltd have the same unitholding / shareholding structure, in which AAA Pty Ltd ATF AAA Family Trust owns X units / shares, and BBB Pty Ltd ATF BBB Family Trust owns X units / shares.

Relevant Clauses of the Trust Deed

5. Clause X defines the beneficiaries, as follows:

● A sole unit holder;

● A joint unit holder who is the first-named of the joint unit holders in the Register;

● Any charity; and

● Any person defined by this deed as a beneficiary by reason of a relationship with a sole unit holder or a first-named joint unit holder.

A sole or first-named joint unit holder is called an ‘effective unit holder’ and a ‘unit holder’ is defined in the deed as an ‘effective unit holder’ and any person with whom the effective unit holder owns a unit jointly.

6. Clauses X to X define the beneficiaries by relationship with an effective unit holder who is an individual, a trustee, or a company not acting as a trustee. Essentially, they include:

● relatives of the individual unit holder;

● the trustees (in that capacity) of any trust or settlement, a corporation or a legal entity under which the above relatives have an interest (or holds a share as relevant) (for individual unit holder);

● the beneficiaries of the trust or settlement (for trustee unit holder);

● the company, and its directors and shareholders; and relatives of the above directors and shareholders (for corporate unit holder)

● any person who hold a unit jointly with the effective unit holder;

7. The relatives include the parents, brothers, sisters, spouses, children and grandchildren, and the spouse, children and grandchildren of those brothers, sisters, children and grandchildren.

8. Clause X gives the right to effective unit holders to exclude a beneficiary by relationship by notifying the trustee (except for a joint unit holder).

9. Clause X provides that an effective unit holder together with all persons defined by this deed as beneficiaries by reason of their relationship and any charity form a separate class of beneficiaries. Clause X also provides that neither the settlor nor the trustee can be a beneficiary of the Trust.

10. Clause X provides that a beneficiary has no beneficial interest in any part of the trust fund or its income.

11. Clauses X to X deal with distribution of income or capital. Broadly, the trust deed confers powers to the trustee to invest the trust fund at its discretion, and to distribute the income and capital of the trust among the beneficiaries. Normally the trustee is required to distribute the income or capital to the beneficiaries of each class in proportion to their unit holdings by reference to whom the classes are defined. However the trustee may determine to make an income distribution otherwise than in proportion to the number of units held by a unit holder, by providing written notice about the proposed distribution to all the unit holders.

12. Clause X deals with amendment power of the trustee. It states that if unit holders holding 60% of the units in the trust fund resolve or consent to amend this deed in a specified way, then the trustee must execute a deed to amend this deed to incorporate the required amendments. However, it specifically excludes the following situations:

● The amendment will favour, benefit, or result in a benefit to, the trustee

● The amendment fails to benefit all classes of beneficiary equally in proportion to the unit holdings of the effective unit holders.

13. Clause X provides that the trustee may not vary the deed in a way that causes any part of the trust fund to vest after the vesting day.

The Proposed Scheme

14. The Trustee, with the consent of the unit holders, is proposing to vary the terms of the deed to remove the discretionary distribution powers of the trustee in order to make all future distributions of income and capital fixed in accordance with the units on issue.

15. The Trustee states that this will present the possibility of the trust becoming a member of a possible tax consolidated group at some point in the future.

Proposed Deed of Variation

16. It is proposed to execute a Deed of Variation pursuant to clause X of the Trust Deed. The Trustee provided a proposed Deed of Variation which contains a number of amendments to the clauses in the trust deed consistent with the above objective.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 Section 104-55,

Income Tax Assessment Act 1997 Section 104-60,

Income Tax Assessment Act 1997 Section 104-65,

Income Tax Assessment Act 1997 Section 104-70,

Income Tax Assessment Act 1997 Section 104-75,

Income Tax Assessment Act 1997 Section 104-80,

Income Tax Assessment Act 1997 Section 104-85, and

Income Tax Assessment Act 1997 Section 104-90,

Reasons for decision

All references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Question 1

Summary

The proposed conversion of the Trust from a hybrid unit trust to a unit trust will not trigger CGT event E1 pursuant to section 104-55.

Detailed reasoning

Subsection 104-55(1) provides that CGT event E1 happens if a trust is created over a CGT asset by declaration or settlement. Section 104-60 provides that CGT event E2 happens if you transfer a CGT asset to an existing trust.

Taxation Determination TD 2012/21 Income tax: does CGT event E1 or E2 in sections 104-55 or 104-60 of the Income Tax Assessment Act 1997 happen if the terms of a trust are changed pursuant to a valid exercise of a power contained within the trust's constituent document, or varied with the approval of a relevant court? (TD 2012/21) expresses the view that neither CGT event E1 nor CGT event E2 happens if the terms of the trust are changed pursuant to a valid exercise of a power contained within the trust’s constituent document; or varied with the approval of a relevant court unless:

● the change causes the existing trust to terminate and a new trust to arise for trust law purposes; or

● the effect of the change or court approved variation is such as to lead to a particular asset being subject to a separate charter of rights and obligations such as to give rise to the conclusion that that asset has been settled on terms of a different trust.

This Taxation Determination (TD 2012/21) was issued following the decision in Federal Commissioner of Taxation v. Clark and Anor [2011] FCAFC 5; 2011 ATC 20-236; (2011) 79 ATR 550 (Clark) and the High Court's refusal to grant the Commissioner leave to appeal that decision. The explanation to TD 2012/2 explains the Commissioner’s view as follows:

21. …….assuming there is some continuity of property and membership of the trust, an amendment to the trust that is made in proper exercise of a power of amendment contained under the deed will not have the result of terminating the trust, irrespective of the extent of the amendments so made so long as the amendments are properly supported by the power.

24. Even though Clark and Commercial Nominees were decided in the context of whether changes in a continuing trust were sufficient to treat that trust as a different taxpayer for the purpose of applying relevant losses, the ATO accepts the principles set out in these cases have broader application. Relevantly, the principles established by those cases are also relevant to the question of the circumstances in which CGT event E1 or E2 may happen as a result of changes being made to the terms of an existing trust pursuant to a valid exercise of a power in the deed (including a power to amend). In light of those principles, the ATO accepts that a change in the terms of the trust pursuant to exercise of an existing power (including an amendment to the deed of a trust), or court approved variation, will not result in a termination of the trust and, therefore, subject to the observation in paragraph 27 below, will not result in CGT event E1 happening.

…………….

26. Whether a purported change to a trust in exercise of a power under the deed is properly supported by the power is to be determined in accordance with principles of trust law having regard to the scope of the power properly construed. Relevant to this question will be whether the deed itself explicitly specifies conditions (including procedural conditions) that need to be satisfied for the exercise of the power to be effective.

27. Even in instances where a pre-existing trust does not terminate, it may be the case that assets held originally as part of the trust property commence to be held under a separate charter of obligations as a result of a change to the terms of the trust - whether by exercise of a power under the deed (including a power to amend) or court approved variation - such as to lead to the conclusion that those assets are now held on terms of a distinct (that is, different) trust.

Taxation Determination TD 2012/21 further explains that the scope of the relevant power is determined by the construction of the words of the trust deed, the surrounding context and any relevant admissible evidence. Where a trustee is found not to have power to vary the trust in the manner contended, such invalid amendments, being of no effect, would not of themselves result in CGT events E1 or E2 happening.

Application to your circumstances

The proposed amendments to convert the hybrid trust to a unit trust will not terminate the Trust for trust law purposes, as it does not impact on the continuity of the trust, as set out in Clark. Furthermore, the proposed amendment will not lead to a particular asset being subject to a separate charter of rights and obligations such as to give rise to the conclusion that that asset has been settled on terms of a different trust.

Therefore, the proposed amendments will not trigger the happening of CGT event E1 under section 104-55 or CGT event E2 under section 104-60.

Question 2

Summary

The proposed conversion of the Trust from a hybrid unit trust to a unit trust will not trigger CGT event E2 pursuant to section 104-60.

Detailed reasoning

Refer to reasoning in question 1.

Question 3

Summary

The proposed conversion of the Trust from a hybrid unit trust to a unit trust will not trigger CGT event E3 pursuant to section 104-65.

Detailed reasoning

Pursuant to subsection 104-65(1) of the ITAA 1997, CGT event E3 happens if a trust (that is not a unit trust) over a CGT asset is converted into a unit trust, and just before the conversion, a beneficiary under the trust was absolutely entitled to the asset as against the trustee (disregarding any legal disability the beneficiary is under). The time of the event is when the trust is converted.

Paragraphs 90 to 93 of Draft 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 the view that joint and multiple beneficiaries cannot be absolutely entitled to the asset of the trust (of which the trustee is the owner) unless it is a fungible asset, for example shares in the same company and with the same characteristics.

Relevantly:

90. Where more than one beneficiary has an interest in the trust assets, absolute entitlement can only be established if the assets are fungible.

91. If the assets are not fungible, but more than one beneficiary has an interest in them, then that is the clearest possible indication that, under the terms of the trust, individual beneficiaries are not entitled to particular assets to the exclusion of others. That is, if each asset is unique, but the trust does not clearly set out which beneficiary is to get which asset, this indicates an intention that each beneficiary is in fact to have an interest in each of the assets.

92. In those circumstances, absolute entitlement cannot be established, unless all parties (that is, the trustee and the beneficiaries) agree that a particular asset or assets be set aside for each beneficiary to the exclusion of the others…

Therefore, in the present case, it cannot be said that a beneficiary of the Trust is absolutely entitled to any CGT asset as against the Trustee, hence CGT event E3 under subsection 104-65(1) of the ITAA 1997 does not happen.

Question 4

Summary

The proposed conversion of the Trust from a hybrid unit trust to a unit trust will not trigger CGT event E5 pursuant to section 104-75.

Detailed reasoning

CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust (except a unit trust or a trust to which Division 128 applies), as against the trustee despite any legal disability of the beneficiary (subsection 104-75(1)).

As explained above, no beneficiary of the Trust can be said to be absolutely entitled to any CGT asset of the Trust (of which the Trustee is the owner). In addition, the exception for a unit trust will apply as the Trust becomes a unit trust at the point of conversion.

Therefore, CGT event E5 does not happen when the Trust is converted to a unit trust.

Question 5

Summary

The proposed conversion of the Trust from a hybrid unit trust to a unit trust will not trigger any of CGT event E4 (section 104-70), CGT event E6 (section 104-80), CGT event E7 (section 104-85) or CGT event E8 (section 104-90)

Detailed reasoning

CGT event E4 happens if the Trustee makes a payment to a beneficiary in respect of their interest in the trust and some or all of the payment is not included in the beneficiary’s assessable income (section 104-70).

In this case, CGT event E4 does not happen because the Trustee does not make a payment to a beneficiary in respect of their interest in the trust.

CGT event E6 (section 104-80 of the ITAA 1997), CGT event E7 (section 104-85) and CGT event E8 (section 104-90) are not relevant and do not happen.