Edited version of private advice

Authorisation Number: 1052005662306

Date of advice: 28 July 2022

Ruling

Subject: Division 7A and capital gains tax

Question

Will the in-specie distribution of the Property by the Trustee of the Family Trust to Beneficiary A result in an amount included as a deemed dividend in Beneficiary A's assessable income under Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Question

Does the in-specie distribution give rise to capital gains tax (CGT) event E5 in section 104-75 of the Income Tax Assessment Act 1997 (ITAA 1997) happening?

Answer

Yes. CGT Event E5 would apply in preference to CGT Event A1 (i.e. if CGT Event E5 does not apply, CGT Event A1 will apply). The in-specie distribution of the Property will trigger a CGT event E5, resulting in a capital gain for the Trustee.

This ruling applies for the following periods:

Year ended 30 June 20xx and 30 June 20xx

Relevant facts and circumstances

The Family Trust holds a property (the Property).

The Trustee is planning to transfer the Property to Beneficiary A by way of an in-specie distribution.

The Trustee proposes to exercise its power of to terminate part of the trust fund and transfer the property in specie.

The in-specie distribution will be made on a non-contingent basis. It will be effected by:

•         A resolution, in writing, recording the Trustee exercising its power of terminating part of the rust and appointing the Property to the beneficiary and

•         Executing any other relevant deeds or contracts necessary to ensure the legal and beneficial title in the Property passes to Beneficiary A

The terms of the trust deed allow the Property to be transferred to the specified beneficiary by way of in-specie distribution.

In addition to the Property, the Trustee also owns other assets and investments which have a market value greater than their cost base.

The Property is not connected or linked to the other assets held by the Trustee.

The only asset being distributed in-specie will be the Property, including fixtures and fittings.

The in-specie distribution of the Property will result in a capital gain.

The transfer of the asset is not in satisfaction of the beneficiary's right to income or capital from the trust.

The capital gain will be distribution to the beneficiaries at the end of income year along with other net income of the Trust.

The Trust currently has two pre-16 December 2019 unpaid present entitlements (UPE) owing to two private companies.

Both of these UPEs have been quarantined since 16 December 2009, with no repayments being made nor interest accruing.

Both UPEs are recorded as pre-16 December 2009 UPEs in the financial records.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 109XA

Income Tax Assessment Act 1936 Section 109XB

Income Tax Assessment Act 1997 Subsection 108-2

Income Tax Assessment Act 1997 Subsection 102-20

Income Tax Assessment Act 1997 Subsection 102-25

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Subsection 104-75

Reasons for decision

Question 1:

Will the in-specie distribution of the Property from the Trustee of the Family Trust to Beneficiary A result in an amount included as a deemed dividend in Beneficiary A's assessable income under Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936)?

Detailed reasoning

Division 7A of the ITAA 1936 contains a number of provisions that can result in deemed unfranked dividend arising for recipients of certain advances from a private company.

The sections relevant to this ruling application are contained in subdivision EA of Division 7A of the ITAA 1936.

Subdivision EA of Division 7A contains the rules for determining whether a shareholder of a private company (or an associate of the shareholder) will, by virtue of Division 7A, be treated as having received an assessable dividend as a result of obtaining a financial benefit in the form of a loan, payment or a forgiven debt through a trust.

Section 109XA sets out the conditions where certain payments made by trustees, including transfers of property, are treated as deemed dividends in accordance with section 109XB.

Subsection 109XA(1) provides:

Payments. Section 109XB applies if:

(a) a trustee makes a payment to a shareholder or an associate of a shareholder of a private company (except a shareholder or associate that is a company) (the actual transaction); and

(b) the payment is a discharge of or a reduction in a present entitlement of the shareholder or associate that is wholly or partly attributable to an amount that is an unrealised gain; and

(c) either:

(i) the company is presently entitled to an amount from the net income of the trust estate at the time the actual transaction takes place, and the whole of that amount has not been paid to the company before the earlier of the due date for lodgement and the date of lodgement of the trustees return of income for the trust for the year of income of the trust in which the actual transaction takes place; or

(ii) the company becomes presently entitled to an amount from the net income of the trust estate after the actual transaction takes place, but before the earlier of the due date for lodgement and the date of lodgement of the trustees return of income for the trust for the year of income of the trust in which the actual transaction takes place, and the whole of the amount has not been paid to the company before the earlier of those dates.

A 'payment' for the purposes of Division 7A is defined in subsection 109C(3) and includes a transfer of property to the shareholder, or an associate of the shareholder.

A present entitlement will be attributable to an amount that is an unrealised gain, within the meaning of paragraph109XA(1)(b), where the trust deed empowers the trustee to declare present entitlement to an amount representing the unrealised gain, and the trustee has declared present entitlement to that amount.

There is no definition of the term 'present entitlement' in the ITAA 1936 or the Income Tax Assessment Act 1997 (ITAA 1997); therefore, it is necessary to establish its ordinary meaning given by the courts. The principal cases concerning the concept of present entitlement are the High Court decisions of FC of T v. Whiting (1943) 68 CLR 99 and Taylor v. FC of T (1970) 119 CLR 444.

The main principles that emerged from these cases are:

•         The income must be legally available for distribution to the beneficiary. It does not matter whether the amount of income has been precisely ascertained.

•         The beneficiary must have an indefeasible, absolutely vested, beneficial interest in possession in the trust income. That is, the interest must not be contingent; the beneficiary must have the right to demand immediate payment (or would have had the right to demand payment had they not been under a legal disability).

Unrealised gain is defined in subsection 109XA(7) and provides:

Unrealised gain, in relation to a trust estate and an actual payment, means any unrealised gain, whether of a capital or income nature, but does not include an unrealised gain to the extent that it has been or would be included in the assessable income of the trust, apart from this Division, for:

(a) a year of income before the year in which the actual payment was made;

(b) the year of income in which the actual payment was made; or

(c) the year of income following the year in which the actual payment was made.

Further, the Explanatory Memorandum to the Tax Laws Amendment (2004 Measures No. 1) Bill 2004 provides at paragraph 8.13:

....the term 'unrealised gain' is intended to apply very broadly. It is defined to mean any unrealised gain whether of a capital or income nature. For the purposes of these rules, realisation will be taken to have occurred when a gain converts into a recoverable debt.

Application of subsection 109XA(1)

The rules in 109XA(1) are only applicable to payments that are wholly or partly attributable to an amount that is an unrealised gain.

Specifically, paragraph 109XA(1)(b) requires that the payment by the trustee to the shareholder (or associate of the shareholder) be one that discharges or reduces the present entitlement of the shareholder, and the present entitlement arose from amounts attributable to unrealised gains.

Based on the facts provided, the distribution of the Property is a realisation of that asset, its distribution is not within the meaning of "unrealised gain" as set out in subsection 109XA(7) of the ITAA 1936 and therefore the criteria in subsection 109XA(1)(b) of the ITAA 1936 is not met.

Therefore, subsection 109XA(1) of the ITAA 1936 has no application and the transfer of the Property to Beneficiary A by the Trustee of the Family Trust will not be treated as a deemed dividend under section 109XA.

Question 2

Does the in-specie distribution give rise to capital gains tax (CGT) event E5 in section 104-75 of the Income Tax Assessment Act 1997 (ITAA 1997) happening?

Summary

The resolution to make the in-specie distribution will give rise to CGT event E7 happening pursuant to section 104-75 of the ITAA 1997.

Detailed reasoning

Section 102-20 of the ITAA 1997 provides that a capital gain or capital loss is made if a CGT event happens to a CGT asset.

The Property is a CGT asset (section 108-5 of the ITAA 1997).

CGT Event A1

Under subsection 104-10(1) of the ITAA 1997, CGT event A1 happens if you dispose of a CGT asset.

Under subsection 104-10(2) of the ITAA 1997, you dispose of a CGT asset when a change of ownership occurs from you to another entity. Relevantly, a change of ownership does not occur if you stop being the legal owner of the asset but continue to be its beneficial owner.

In this case, the legal title of the Property is not held for an absolutely entitled beneficiary and is being transferred to that beneficiary.

Beneficiaries of a discretionary trust do not have any interest, either individually or collectively, in the property or income of a trust estate. ATO Interpretive Decision 2003/778 confirms that 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: it is for the trustee to determine, firstly, whether such beneficiaries will benefit at all under the terms of the trust and, secondly, to what extent the beneficiaries will benefit. Such beneficiaries have no more than a right to have the trust duly administered. This right does not constitute beneficial ownership. (See Gartside and Another v. Inland Revenue Commissioners [1968] 1 All ER 121 and Re Weir's Settlement MacPherson and Another v. Inland Revenue Commissioners [1970] 1 All ER 297).

CGT Event A1 may apply where a CGT asset is transferred by a trustee to a beneficiary, as that transfer will be a disposal of an asset for CGT purposes.

The effect of CGT Event A1 happening is that you make a capital gain if the capital proceeds from the disposal are more than the asset's costs base or a capital loss if those capital proceeds are less than the asset's reduced cost base (subsection 104-10(5) of the ITAA 1997).

The time of the event is when you enter into the contract for the disposal, or, if there is no contract, when the change occurs (subsection 104-10(3) of the ITAA 1997). In this case, the transfer arises as a consequence of an exercise of a power of appointment. Consequently, the time of the event for the purposes of CGT Event A1 will be determined with reference to when the exercise of a power of appointment in favour of the beneficiary results in a change of ownership.

CGT Event E5

Section 104-75 of the ITAA 1997 provides that CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust as against the trustee.

As discussed above, a beneficiary of a discretionary trust does not have any interest in the trust assets except to the extent that the trustee exercises a discretion in favour of that beneficiary.

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)sets out the Commissioner's view on when a beneficiary may become absolutely entitled to an asset.

Paragraphs 10 and 11 of TR 2004/D25 provide:

10. 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. This derives from the rule in Saunders v Vautier applied in the context of the CGT provisions (see Explanation paragraphs 41 to 50). The relevant test of absolute entitlement is not whether the trust is a bare trust (see Explanation paragraphs 33 to 40).

11. Under the rule in Saunders v Vautier, the courts do not regard as effective a direction from the settlor of the trust that purports to delay the beneficiary's full enjoyment of an asset. However, 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 it.

Paragraph 13 of TR 2004/D25 states that an object of a discretionary trust cannot be absolutely entitled prior to any exercise of the trustee's discretion in their favour. This is because they do not have an interest in the trust's assets.

Paragraphs 73 and 74 of TR 2005/D25 describe the type of interest required in the trust asset for a beneficiary to be absolutely entitled:

73. The interest a beneficiary has in the trust asset or assets must be vested in possession and indefeasible. A trustee would only be obliged to satisfy a demand from a beneficiary with such an interest.

74. A vested interest is one that is bound to take effect in possession at some time and is not contingent upon an event occurring that may or may not take place. A beneficiary's interest in an asset is vested in possession if they have the right to immediate possession or enjoyment of it.

The nature of the beneficiary's interest in the asset, and whether it meets the requirements of absolute entitlement, therefore depends on the particular trust instrument.

In this case, the trustee of the Family Trust will, pursuant to its powers under the deed to advance property of the trust fund, make a resolution that the Property will be distributed to Beneficiary A. Upon making the irrevocable resolution, the Property will cease to become part of the trust fund (as defined in the deed) and Beneficiary A will have a vested and indefeasible interest in this asset.

The existence of the trustee's right of indemnity against the trust assets to meet outgoings incurred will not prevent Beneficiary A from being absolutely entitled to the property (see paragraph 18 of TR 2004/D25).

In this case, the trustee's powers under the trust deed would not operate to defeat Beneficiary A's entitlement to the asset. The terms of the trust, and the nature of Beneficiary A's interest in the property on the making of the resolution, can be distinguished from those in Kafataris and Another v Deputy Commissioner of Taxation T [2015] FCA 874 and Oswal and Others v Federal Commissioner of Taxation2013] FCA 745.

Therefore, CGT event E5 will happen upon the making of a valid resolution to appoint the property to Beneficiary A.

The Trustee will make a capital gain from CGT event E5 happening equal to the excess of the market value of the Property (at the time of making the resolution) over its cost base.

As Beneficiary A did not expend anything to acquire her interest in the trust, any capital gain she would also make as a result of CGT event E5 happening will be disregarded.

Multiple CGT events

Section 102-25 of the ITAA 1997 provides that where more than one event can apply, the one you use is the one that is the most specific to your situation.

In either case, the trustee is assessed on the asset being disposed of by way of a change in ownership of the asset for the purposes of CGT Event A1, and the beneficiary becoming absolutely entitled to the asset for the purposes of CGT Event E5. However, where an interest in a trust was not acquired for expenditure or by way of assignment, any gain under CGT Event E5 is to be disregarded. As such, in the case of a beneficiary becoming absolutely entitled to an asset, CGT Event E5 would apply in preference to CGT Event A1.