Edited version of private advice

Authorisation Number: 1051688616543

Date of advice: 19 June 2020

Ruling

Subject: CGT on property being a pre-CGT asset on the date of entering into the contract of sale

Question

Will the Commissioner be satisfied or think it reasonable to assume that at all times on and after 20 September 1985 and up to and including the date of the contract of sale of the property by ultimate owners who had majority underlying interests in the property immediately before that day such that Division 149 of the Income Tax Assessment Act 1997 will not stop the property being a pre-CGT asset on the date of entering into the contract of sale?

Answer

Yes

This ruling applies for the following periods:

XXXX - XXXX.

The scheme commences on:

XXXX

Relevant facts and circumstances

You advised that the residential property at XXXX and being the property contained in certificate of title XXXX was purchased jointly by your dad XXXX and his wife your mum XXXX in about XXXX.

You, XXXX and XXXX are the daughters and legal personal representatives of the deceased parents and are also now the directors and shareholders of the Trustee.

You advised that there are XXXX children of the marriage of XXXX (all now adults and one of whom is a non-resident), and that XXXX passed away in XXXX and XXXX passed away in XXXX.

In your application you stated late XXXX was a XXXX who commenced practice in XXXX and retired in about XXXX. He conducted his practice at various XXXX in XXXX and from a XXXX comprising three separate rooms on the property.

You stated that on XXXX, the XXXX was formed, with XXXX as its trustee (Trustee). On or about that date, XXXX transferred the Property to the Trust. The transfer was part of an estate planning structure. Notwithstanding the transfer of the property to the Trust, the property has all times since XXXX remained the family home of XXXX.

Your application stated that the Trust is now in the process of being wound up in conjunction with the estates of both XXXX. As part of that process, the property has been sold for XXXX under a contract of sale dated XXXX. Settlement of the sale was XXXX.The sale proceeds will result in the Trust making a substantial capital gain to the Trust in the current financial year.

The transfer of the property into the Trust formed part of an estate planning exercise advised by their solicitors and Senior Counsel in early XXXX. You advised that this step was aimed at limiting the impact of probate and estate duties in existence in XXXX at that time and also at minimising the exposure of the family home and farming properties owned by XXXX to any claims against late XXXX in his professional capacity.

You have stated in your application that the Trust deed is consistent with estate planning structuring of the time, which commonly involved preserving family capital assets in a trust structure for the benefit of children and their descendants to the exclusion of your parents, but enabling your parents to continue to enjoy income from those assets and to effectively control the use of those assets during their lifetimes.

You have also stated in your application that the Trust deed:

·         limits the capital beneficiaries to "the children and further issue" of XXXX, but excludes XXXX from any participation in capital;

·         limits the income beneficiaries to the capital beneficiaries plus XXXX;

·         other than charities (in the event of failure of the discretionary distributions provisions during the period of the Trust), or the statutory next of kin of XXXX (in the event of total failure of the Trust for any reason), does not contemplate any additional beneficiaries (other than, perhaps, in the event of an effective resettlement into a different trust fund - which has not occurred).

You advised that for reasons associated with the death duty legislation in place at the time the estate planning and structuring involved directorships of the Trustee not being held by either XXXX at the time of creation of the Trust and for a period of three years after establishment of the Trust and transfer of the properties (the directors being professional colleagues of your late dad).

You also confirmed in your application that other than for the initial three years (until XXXX), until XXXX death in XXXX, the trust was under the control of late XXXX and, since XXXX death under the control of XXXX and since XXXX death controlled by yourselves XXXX and XXXX.

You further advised that the Trustee retained two firms of solicitors during the period from creation of the Trust until the current year, XXXX until about XXXX; and XXXX since then to date. A search of all original documents held by both firms has revealed no documents effecting any capital distributions by the Trust since its creation. The only deeds of variation in existence are held by XXXX. These were two deeds which inserting additional powers of the Trustee to satisfy requirements of the Trustee's bankers.

You stated that since the creation of the Trust, there have been at least three successive firms of accountants/tax agents, including the current accountants and tax agents, XXXX. XXXX took over the Trust's accounting and taxation affairs from XXXX during the course of the financial year ending XXXX. The records of income distributions by the Trustee dating from the XXXX financial year back to the period prior to XXXX are effectively non-existent as a result of the passage of time.

You advised that attempts to obtain previous accounting and tax records from accountants and tax agents who acted for the Trustee prior to XXXX have proved unsuccessful due to retirement of practitioners and closure of practices. However, the few records that have been found in respect of the period prior to XXXX are consistent with distributions having been made only to members of the XXXX. This is also consistent with the basis on which late XXXX conducted his professional and farming activities, which was characterised by the following structural arrangements:

·         The Trust acted solely as a land-owning company in respect of the property deriving rent from late XXXX for the use of his professional rooms in the property.

You further advised that from the records carried over by XXXX from the previous accountant, the beneficiaries who were carrying forward unpaid present entitlements at XXXX arising out of prior income distributions were XXXX, XXXX, XXXX, XXXX, XXXX and XXXX. From the only record of distribution prior to XXXX that can be found (a distribution statement from the Trust's XXXX tax return), income distributions were made in the XXXX financial year to late XXXX and XXXX.

You stated that XXXX records confirm that all trust income distributions from XXXX to XXXX were made to XXXX solely. The Trust has incurred losses in all years since 20XX. You and XXXX are not aware of any documents or information which suggests that the Trust has ever made any distributions of capital or income to persons other than late XXXX, XXXX or their descendants.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 104-75

Income Tax Assessment Act 1997 section 149-10

Income Tax Assessment Act 1997 section 149-15

Income Tax Assessment Act 1997 section 149-30

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or DPT tax benefit in connection with an arrangement.

If Part IVA applies the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for Decision

Summary

Property being a pre-CGT asset on the date of entering into the contract of sale.

Detailed reasoning

The effect of CGT on income tax liability is best described in s100-10 of the Income Tax Assessment Act 1997 s100-10. as follows:

'CGT affects your income tax liability because your assessable income includes your net capital gain for the income year. Your net capital gain is the total of your capital gains for the income year, reduced by certain capital losses you have made.'

A capital gain or loss occurs only if a CGT event occurs.

If the takers on vesting become absolutely entitled as against the trustee to the CGT assets of the trust then CGT Event E5 will apply, although this is dependent on the particular interests of the takers on vesting.

S104-75(1) of ITAA97 states that a 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 (disregarding any legal disability the beneficiary is under).

Taxation Ruling TR 2018/6 outlines the view of the tax consequences when a trust vests. Whether CGT is triggered on the vesting of a trust depends on the trust deed terms. CGT event E5 is triggered when a beneficiary becomes absolutely entitled to a trust asset. When CGT event E5 occurs, the trustee makes a taxable capital gain equal to the difference between the market value of the asset and the trustee's cost base in the asset.

The concept of absolute entitlement is not settled at law. Case law suggests that it is difficult for a beneficiary to be absolutely entitled to a trust asset because the trustee's right of indemnity for trust liabilities may prevent this. Additionally, the ATO has a position that if there is more than one beneficiary entitled to a trust asset on vesting, CGT event E5 is not triggered since neither beneficiary can be considered absolutely entitled to the asset.

Beneficiaries may become absolutely entitled as against the trustee to CGT assets of the trust, upon the vesting of a trust. The Commissioner's view on this issue are explained in TR 2004/D25.

In TR 2004/D25 the Commissioner expressed the view that follows the rule established in Saunders v Vautier (1841) 49 ER 282. That is, a beneficiary who has a vested and indefeasible interest in an entire trust asset has absolute entitlement to the asset and may call for the asset to be transferred to them or to be transferred at their discretion. However, it is the general rule that unless the assets in a trust are fungible (interchangeable with one another), if there are multiple beneficiaries to a trust, an individual beneficiary cannot become absolutely entitled to a trust.

If the administration of a deceased estate is not completed in the same year as the date of death, a trust tax return for that income year does not have to be lodged if:

·         the deceased person died less than three years from before the end of that income year

·         no beneficiary is presently entitled to a share of the income of the trust estate at the end of that income year

·         the deceased estate received no income from capital gains or franked dividends

·         the net income of the trust estate under section 95 of the Income Tax Assessment Act 1936 is less than $18,200 for that income year, and

·         there are no non-resident beneficiaries of the trust estate during the income year.

A trust must keep adequate records of all expenditure which will help to correctly work out the amount of capital gain or capital loss made when a CGT event happens. A trust must keep records relating to the ownership and all the costs of acquiring and disposing of property.

Penalties can apply if the trust does not keep the records for at least five years after the relevant CGT event. If the trust uses the information from those records in a later tax return, the trust should generally keep records longer. If the trust has applied a net capital loss, the trust should generally keep records of the CGT event that resulted in the loss until the end of any period of review for the income year in which the capital loss is fully applied.

For the beneficiary in respect to s104-75(5) of the ITAA97, it makes a capital gain if the market value of the asset (at the time of the event) is more than the cost base of the beneficiary's interest in the trust capital to the extent it relates to the asset. It makes a capital loss if that market value is less than the reduced cost base of that beneficiary's interest in the trust capital to the extent it relates to the asset.

There are also exceptions to this under s104-75(6), where a capital gain or capital loss the beneficiary makes is disregarded if:

(a) the beneficiary acquired the CGT asset that is the interest (except by way of an assignment from another entity) for no expenditure; or

(b) the beneficiary acquired it before 20 September 1985; or

(c) all or part of the capital gain or capital loss the trustee makes from the CGT event is disregarded under Subdivision 118-B (about main residence).

Majority underlying interests is defined in subsection 149-15(1) as more than 50% of the beneficial interests that ultimate owners have (whether directly or indirectly) in:

·         ●the asset; and

·         ●any ordinary income that may be derived from the asset.

Subsection 149-15(2) provides that an 'underlying interest' means a beneficial interest that an ultimate owner may have in the asset or any ordinary income derived from the asset. An ultimate owner is defined to include an individual under subsection 149-15(3).

An ultimate owner indirectly has a beneficial interest in a CGT asset of another entity (that is not an ultimate owner) if they would receive for their own benefit any of the capital of the other entity if:

·         ●the other entity was to distribute any of its capital; and

·         ●the capital was then successively distributed by each entity interposed between the other entity and the ultimate owner.

Section 149-15 provides:

(1) Majority underlying interests in a *CGT asset consist of:

(a) more than 50% of the beneficial interests that *ultimate owners have (whether directly or *indirectly) in the asset; and

(b) more than 50% of the beneficial interests that *ultimate owners have (whether directly or *indirectly) in any *ordinary income that may be *derived from the asset.

(2) An underlying interest in a *CGT asset is a beneficial interest that an ultimate owner has (whether directly or *indirectly) in the asset or in any *ordinary income that may be *derived from the asset.

(3) An ultimate owner is:

(a) an individual; or

(b) a company whose *constitution prevents it from making any distribution, whether in money, property or otherwise, to its members; or

(c)...;

(4) An *ultimate owner indirectly has a beneficial interest in a *CGT asset of another entity (that is not an *ultimate owner) if he, she or it would receive for his, her or its own benefit any of the capital of the other entity if:

(a) the other entity were to distribute any of its capital; and

(b) the capital were then successively distributed by each entity interposed between the other entity and the ultimate owner.

(5) An *ultimate owner indirectly has a beneficial interest in *ordinary income that may be *derived from a *CGT asset of another entity (that is not an *ultimate owner) if he, she or it would receive for his, her or its own benefit any of a *dividend or income if:

(a) the other entity were to pay that dividend, or otherwise distribute that income; and

(b) the dividend or income were then successively paid or distributed by each entity interposed between the other entity and the ultimate owner.

Relevant to the current circumstances, Taxation Ruling IT 2340 (IT 2340) discusses the terms underlying interest and majority underlying interest, and former section 160ZZS of the Income Tax Assessment Act 1936 (since replaced by section 149-30). Paragraph 2 of IT 2340 advocates a look through approach in relation to chains of companies, partnerships and trusts in order to determine whether there has been a change in the effective interests of natural persons in the assets.

Where a CGT asset is held by the trustee of a discretionary trust, the CGT asset is not beneficially owned by any persons. This creates difficulties when assessing whether the majority underlying beneficial interest in an asset is maintained. IT 2340 however sets out the Commissioner's approach in respect of 'looking through' discretionary family trusts to determine whether majority underlying interests have been maintained in the assets of the trust, as follows:

·         In relation to what are generally referred to as discretionary trusts, i.e. family trusts, the trustees of which have discretionary powers as to the distribution of trust income or property to beneficiaries, in considering the question of whether majority underlying interests have been maintained in the assets of the trust it will be relevant to take into account the way in which the discretionary powers of the trustees are in fact exercised.

·         Where a trustee continues to administer a trust for the benefit of members of a particular family, for example, it will not bring section 160ZZS into application merely because distributions to members who are beneficiaries are made in such amounts and to such of those beneficiaries as the trustee determines in the exercise of his discretion.

·         In such a case the Commissioner would, in terms of subsection 160ZZS(1), find it reasonable to assume that for all practical purposes the majority underlying interests in the trust assets have not changed That is consistent with the role of the section to close potential avenues for avoidance of tax in cases where there is a substantial change in underlying ownership of assets and the legislative guidance contained in Subdivision G of Division 3 of Part III of the Act. On that basis, trust assets acquired by the trustee before 20 September 1985 would remain outside the scope of the capital gains and losses provisions of the Act.

The expression 'beneficial interests' as used in the definition of 'majority underlying interests' is not defined. At general law, a shareholder does not have any legal or equitable interest in the asset of a company. Similarly, beneficiaries in a discretionary trust do not have an interest, either individually or collectively, in the assets or the income of a trust. This situation is addressed in ATO Interpretive Decision 2003/778:

'Under ordinary legal concepts, where there is a discretionary trust deed, no beneficiary is entitled to income or capital of the trust until the trustee exercises its discretion to distribute income or to make an appointment of capital. Because the beneficiary of a discretionary trust does not hold an interest in any asset of the trust or in the ordinary income derived from the asset until the trustee's discretion is exercised, it would not be possible for a discretionary trust to satisfy the continuing majority underlying interests test set out in subsection 149-30(1) of the ITAA 1997.

Taxation Ruling IT 2340 reflects on an approach of looking through interposed entities to determine which natural persons hold the beneficial interests for the purposes of section 160ZZS of the Income Tax Assessment Act 1936 (ITAA 1936), which preceded Division 149 of the ITAA 1997. Among other issues, IT 2340 deals with questions regarding the application of section 160ZZS of the ITAA 1936 'to assets held by trustees of family trusts where the trustees are vested with discretionary powers as to distributions from the trusts.'

Application to your circumstances

You did attempt to locate records for the Trust prior to XXXX, but both the tax agents have closed their services or retired. However, the few records that have been found in respect of the period prior to XXXX are consistent with distributions having been made only to members of the XXXX. Since XXXX any distributions if made were to the members of the XXXX as well.

Having regard to the relevant provisions of the trust deed of the XXXX and all of the available evidence as set out in the facts provided by you, it is reasonable to conclude that the Trust Fund is a discretionary family trust that has at all times over all periods since its establishment been administered for the exclusive benefit of members of the family of late XXXX and XXXX. The provisions of the Trust deed and the particular facts and circumstances reasonably assume that at all relevant times the Trustee has continued to administer the Trust for benefit of the family of late XXXX and XXXX.

The Trust deed also states that it limits:

·         the capital beneficiaries to "the children and further issue" of XXXX and expressly exclude XXXX from any capital distributions;

·         the income beneficiaries to the capital beneficiaries plus XXXX;

·         other than charities (in the event of failure of the discretionary distributions provisions during the period of the Trust), and statutory next of kin of XXXX (in the event of total failure of the Trust for any reason), do not contemplate the inclusion of any additional beneficiaries (other than, perhaps, in the event of an effective resettlement into a different trust fund - which has not occurred).

Therefore, in the period from the establishment of the Trust until the present time, the narrowness of the definition of beneficiaries would not have permitted any beneficial entitlements to income or capital to flow from the Trust to anyone other than late XXXX, XXXX, their children and future descendants. As stated by you, you have no knowledge of any distributions to anyone apart from the family of the XXXX family. If there were any purported distributions made by the Trustee in any year of income to persons other than XXXX, XXXX, their children or other descendants or capital to persons other than the descendants of late XXXX and XXXX, such distributions would have been invalid and would have conveyed no entitlements to any beneficial interests.

Furthermore, the majority underlying interests of ultimate owners in the asset before 20 September 1985 remained unchanged after that date and at the time of a CGT event happening. Consequently, in accordance with IT 2340 it should be reasonable to make an assumption for the purposes of s149-30(2) and s149-30(1) that it has not stopped the property at XXXX being a pre-CGT asset on the date of entering into the contract of sale of the property.