Edited version of private advice

Authorisation Number: 1051848021924

Date of advice: 5 July 2021

Ruling

Subject: Market value substitution rule in respect to CGT event E5 happening

Question

Will the Commissioner confirm that pursuant to the operation of section 112-20 of the Income Tax Assessment Act 1997 (ITAA 1997), the first element of the cost base or reduced cost base of shares that are CGT assets immediately after the vesting of the Trust is equal to the market value of the shares at the time of the vesting?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company Pty Ltd is the Trustee of a discretionary trust (the Trust). Person X is a director of the corporate trustee.

By a Deed of Appointment, the Trustee appointed person X as a primary beneficiary of the Trust.

The assets of the Trust included shares which were acquired by the Trustee before 20 September 1985.

By a Deed of Variation, the Trustee appointed person X as the sole beneficiary of the Trust and sought to transfer all of the assets of the Trust, including the shares, to the sole beneficiary by a Vesting Deed.

By a Vesting Deed:

a)    the Trustee sought to transfer the Trust Fund to the Beneficiary in accordance with the Trust Deed;

b)    Person X agreed to accept transfer of the Trust Fund.

The shares and other assets of the Trust Fund were transferred from the Trust to Person X, on the agreed date and the Trust was vested on this date. No consideration was paid by Person X in respect of the acquisition of the assets, including the shares.

Relevant legislative provisions

Income Tax Assessment Act 1997, section 103-5

Income Tax Assessment Act 1997, section 104-75

Income Tax Assessment Act 1997, section 106-50

Income Tax Assessment Act 1997, section 108-5

Income Tax Assessment Act 1997, section 112-20

Income Tax Assessment Act 1997, subsection 112-20(1)

Income Tax Assessment Act 1997, paragraph 112-20(1)(a)

Income Tax Assessment Act 1997, paragraph 112-20(1)(c)

Income Tax Assessment Act 1997, subsection 112-20(2)

Income Tax Assessment Act 1997, subsection 112-20(2)

Reasons for decision

CGT Event E5

Section 104-75 states:

1)      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).

2)      The time of the event is when the beneficiary becomes absolutely entitled to the asset.

Shares are CGT asset for the purpose of section 104-75.[1]

Section 106-50 provides that when a beneficiary becomes absolutely entitled to an asset, the asset is no longer treated as being an asset of the trust but as the beneficiary's asset.

Meaning of 'absolutely entitled as against the trustee'

An absolutely entitled beneficiary is generally treated as the relevant taxpayer in respect of an asset for the purpose of the CGT provisions.[2] However, the term 'absolutely entitled' is not defined in the ITAA 1997.

The Commissioner's view about the meaning of the term is contained in 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).

According to TR 2004/D25, the core principle underpinning the concept of absolute entitlement in the CGT provisions 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.[3]

Where a beneficiary is a sole beneficiary (even if the trust has other beneficiaries), TR 2004/D25 states the beneficiary has all the interests in the assets of the trust if no other beneficiary has an interest in the asset. Such a beneficiary will be absolutely entitled to that asset as against the trustee for the purposes of the CGT provisions if the beneficiary can (ignoring any legal disability) terminate the trust in respect of that asset by directing the trustee to transfer the asset to them or to transfer it at their.[4]

A sole beneficiary's interest in the assets of the trust will in most cases (and barring any legal impediment) be vested in possession and indefeasible by virtue of the totality of the beneficial interest in the assets.

However, because an object of a discretionary trust does not have an interest in the trust assets, they cannot be considered absolutely entitled to any of the trust assets prior to the exercise of the trustee's discretion in their favour.

In the present case, the Trustee determined to appoint Person X as the sole beneficiary of the Trust Fund with a view to the entire Trust Fund being transferred to the sole Beneficiary on the vesting date.

The Trustee and Person X then entered into a Vesting Deed, according to which:

(a) the Trustee undertook and agreed to transfer the entire Trust Fund, including the shares to Person X; and

(b) Person X agreed to accept the transfer of the Trust Fund.

Section 106-50 provides that when a beneficiary becomes absolutely entitled to an asset, the asset is no longer treated as being an asset of the trust but as the beneficiary's asset.

Person X became absolutely entitled as against the Trustee to each and every asset of the Trust Fund (including the shares) upon the vesting of the Trust pursuant to the Vesting Deed. Person X was not subject to any legal impediment and is taken to have a right to immediate possession of the assets upon the vesting of the Trust. Therefore, Person X is taken to have acquired the shares at the time of vesting for the purpose of section 104-75.

Market value substitution rule

The market value substitution rule provides that where a taxpayer acquires a CGT asset from another entity, the first element of the cost base or reduced cost base of the CGT asset is the market value of the asset at the time of acquisition in the three situations set out in section 112-20(1).

a)    the taxpayer did not incur expenditure to acquire it, except where your acquisition of the asset resulted from:

b)    CGT event D1 happening; or

c)    another entity doing something that did not constitute a CGT event happening; or

d)    some or all of the expenditure incurred by the taxpayer to acquire it cannot be valued; or

e)    the taxpayer and the person from whom the taxpayer acquired the asset did not deal at arm's length in connection with the acquisition.

The expenditure can include giving property: see section 103-5.

In the present case, Person X did not incur any expenditure in acquiring the shares from the Trustee. Therefore, pursuant to paragraph 112-20(1)(a), the first element of Person X's cost base (or reduced cost base) for the shares will be the market value at the time that Person X became absolutely entitled to the Trust Fund.

Conclusion

It is considered that the effect of the vesting of the Trust is that Person X becomes absolutely entitled as against the Trustee to the assets of the Trust on the vesting date. Person X acquires the shares on that day. Therefore, paragraph 112-20(1)(a) applies and the first element of the cost base or reduced cost base of the shares to Person X is equal to their market value at the time the assets of the Trust Fund vested in Person X.

[1] Note 1 to Section 108-5.

[2] Section 106-50.

[3] Paragraph 10 of TR 2004/D25.

[4] Paragraph 21 and 22 of TR 2004/D25.