Edited version of private advice

Authorisation Number: 1052204271738

Date of advice: 19 December 2023

Ruling

Subject: Trust distributions - deed of family arrangement

Question 1

Will CGT Event E5 in section 104-75 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to the Trustee and each of Individual A and Individual B upon distribution of the properties from the Testamentary trust X under the proposed Deed of family arrangement?

Answer

Yes.

Question 2

Will each of Individual A and Individual B be specifically entitled to the capital gain made by the Trustee of Testamentary trust X under section 115-228 of the ITAA 1997 because of the occurrence of CGT Event E5 happening under the proposed Deed of family arrangement?

Answer

Yes.

Question 3

Will a capital gain arise to each of Individual A and Individual B upon the ending of their capital interests in Testamentary trust Y?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Individual X had a spouse, Individual Y.

Individual X and Individual Y had a number of children who were born before 1985.

One of the children of Individual X and Individual Y had two children (Individual A and Individual B) who were born after 1985.

Individual X died before 1985.

The will of Individual X provided that the trustees had full power to vary, transpose, sell and re-invest any investments held by the trust fund.

The will of Individual X provided that:

•         the spouse of Individual X was to receive the net annual income of the trust fund during their lifetime

•         after the death of the spouse, the net annual income was to be paid to the children of Individual X during their lifetimes

•         after the death of the last surviving child, the remaining trust funds were to be divided equally between and grandchildren of Individual X.

The estate of Individual X (Testamentary trust X) currently comprises of two residential properties, listed shares and securities all acquired after 1985, and cash.

Individual Y died after 1985.

The will of Individual Y provided that the trustees had full power to vary, transpose, sell and re-invest any investments held by the trust fund.

The will of Individual Y provided that:

•         the net annual income of the trust fund was to be paid to the children of Individual Y during their lifetimes

•         after the death of the last surviving child, the remaining trust funds were to be divided equally between and grandchildren of Individual Y.

The estate of Individual Y (Testamentary trust Y) comprises of listed shares and securities all acquired after 1985, and cash.

In connection and agreement with the relevant beneficiaries, the trustees of the testamentary trusts are proposing to dispose of the trust assets to eligible beneficiaries in order to vest and wind up each of the trusts.

Adraft deed of family arrangement (Deed) has been prepared to document how the trustees propose to vest and distribute the assets of the trusts with the agreement of the beneficiaries.

The assets and net income of the trusts will be distributed to the beneficiaries in full satisfaction of all claims or rights which they had, now have or may hereafter have against the trust estates.

Under the Deed:

•         the children of Individual X and Individual Y will receive shares, securities and cash from both trusts which will end their income rights in both trusts

•         the grandchildren of Individual X and Individual Y (Individual A and Individual B) will receive a residential property each from Testamentary trust X (and nothing from Testamentary trust Y) which will end their capital interests in both trusts.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 95(1)

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 104-75

Income Tax Assessment Act 1997 section 104-85

Income Tax Assessment Act 1997 Subdivision 115-C

Income Tax Assessment Act 1997 section 115-215

Income Tax Assessment Act 1997 section 115-228

Income Tax Assessment Act 1997 subsection 116-30(1)

Reasons for decision

Question 1

Summary

CGT Event E5 will happen to the Trustee and each of Individual A and Individual B upon distribution of the properties from Testamentary trust X under the proposed Deed of family arrangement.

Detailed reasoning

CGT event E7

CGT event E7 in section 104-85 of the ITAA 1997 happens if the trustee of a trust (except a unit trust or a trust to which Division 128 applies) disposes of a CGT asset of the trust to a beneficiary in satisfaction of the beneficiary's interest, or part of it, in the trust capital.

The trustee makes a capital gain if the market value of the asset (at the time of the event) is more than its cost base. The trustee makes a capital loss if that market value is less than the asset's reduced cost base.

A capital gain or capital loss the beneficiary makes is disregarded if the beneficiary acquired the CGT asset that is the interest (except by way of an assignment from another entity) for no expenditure (subsection 104-85(6)).

Taxation Ruling TR 2018/6 Income tax: trust vesting - consequences of a trust vesting (TR 2018/6) states that following a trust vesting, CGT event E7 may happen (for example, upon actual distribution of CGT assets to beneficiaries), but it will not happen to the extent the beneficiaries are already absolutely entitled to the CGT assets as against the trustee.

CGT event E5

CGT event E5 in section 104-75 of the ITAA 1997 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. The time of the event is when the beneficiary becomes absolutely entitled to the asset.

The trustee makes a capital gain if the market value of the asset (at the time of the event) is more than its cost base. The trustee makes a capital loss if that market value is less than the asset's reduced cost base.

The beneficiary 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.

A capital gain or capital loss the beneficiary makes is disregarded if the beneficiary acquired the CGT asset that is the interest (except by way of an assignment from another entity) for no expenditure (subsection 104-75(6)).

A capital gain or loss from CGT event E5 happening to a trustee of a trust is taken into account in working out the trustee's net capital gain or loss. A net capital gain is included in the net income of the trust in accordance with subsection 95(1) of the ITAA 1936 and taxed in accordance with Subdivision 115-C of the ITAA 1997 (paragraph 45 of Taxation Ruling TR 2006/14 Income tax: capital gains tax: consequences of creating life and remainder interests in property and of later events affecting those interests (TR 2016/14)).

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 Commissioner's view on what is meant by absolute entitlement.

The main CGT provisions to which the concept of absolute entitlement is relevant apply if a beneficiary is (or becomes) absolutely entitled to a CGT asset of the trust as against the trustee (disregarding any legal disability): see section 106-50 and CGT event E5 in section 104-75 of the ITAA 1997 (paragraph 8 of TR 2004/D25).

The provisions apply separately to each beneficiary and asset of the trust. They require absolute entitlement to the whole of a CGT asset of the trust. While a beneficiary's interest in the trust, or in the trust property, may also be a CGT asset as that term is defined in section 108-5 of the ITAA 1997, neither is the CGT asset to which the relevant provisions refer (paragraph 9 of TR 2004/D25).

The core principle underpinning the concept of absolute entitlement is the ability of the beneficiary, who has a vested and indefeasible interest in the entire trust asset, to call for the asset to be transferred at their discretion.

A beneficiary has all the interests in a trust asset if no other beneficiary has an interest in the asset (even if the trust has other beneficiaries). 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 terminate the trust in respect of that asset by directing the trustee to transfer the asset to them or to transfer it at their direction.

Further, TR 2018/6 confirms that on a trust's vesting date, the interests in the property of the trust become vested in interest and possession.

Application to your circumstances

In this case, under the proposed Deed of arrangement, Individual A and Individual B will each receive an in-specie distribution of a specifically identified property from Individual X's estate.

Consequently, on the date the Deed is entered into by the trustees and beneficiaries, the trust will vest and each of Individual A and Individual B will have a vested and indefeasible interest in the respective properties described in the Deed.

Therefore, each of Individual A and Individual B will be absolutely entitled to the respective CGT assets of the trust as against the trustee as they will individually be able to terminate the trust in respect of that asset by directing the trustee to transfer the asset to them.

Therefore, in the case of the trustee of Individual X's estate, CGT event E5 will happen on the date the Deed is entered into and the Trustee will make a capital gain or loss at that time.

In the case of the beneficiaries, each of Individual A and Individual B will make a capital gain or loss from CGT event E5 happening; however, the gain or loss will be disregarded as the beneficiaries acquired the CGT asset that is the interest for no expenditure.

Question 2

Summary

Each of Individual A and Individual B will be specifically entitled to the capital gain made by the Trustee of Individual X's estate under section 115-228 of the ITAA 1997 because of the occurrence of CGT Event E5 happening under the proposed Deed of family arrangement.

Detailed reasoning

As mentioned above, a capital gain or loss from CGT event E5 happening to a trustee of a trust is taken into account in working out the trustee's net capital gain or loss. A net capital gain is included in the net income of the trust in accordance with subsection 95(1) of the ITAA 1936 and taxed in accordance with Subdivision 115-C of the ITAA 1997.

The capital gains tax streaming provisions in Subdivision 115-C of the ITAA 1997 (which operate in respect of the 2010-11 and later income years following substantial amendments made to the Subdivision) ensure, among other things, that a beneficiary of a trust who is made 'specifically entitled' to a capital gain made by the trustee will be assessed on it, rather than the gain being assessed proportionately to the beneficiaries entitled to trust income.

Section 115-215 of the ITAA 1997 ensures that the appropriate amounts of the trust estate's net income attributable to the trust estate's capital gains are treated as a beneficiary's capital gains when assessing the beneficiary, so:

a)  the beneficiary can apply capital losses against gains; and

b)  the beneficiary can apply the appropriate discount percentage (if any) to gains.

Section 115-228 of the ITAA 1997 sets out when a beneficiary will be regarded as specifically entitled to a trust capital gain (either in whole or in part). To be specifically entitled to the whole gain, the following requirements have to be met:

•         the beneficiary must have received, or can reasonably expect to receive, in accordance with the terms of the trust, all of the financial benefit referable to the capital gain (paragraphs (a) and (b) of the definition of 'share of net financial benefit' in subsection 115-228(1) of the ITAA 1997).

•         the financial benefit must be recorded, again in accordance with the terms of the trust, in the accounts or records of the trust in its character as referable to the capital gain (paragraph (c) of the definition).

In respect to the above, ATO ID 2013/33 states that where a trustee of a trust makes a capital gain by reason of CGT event E5, the beneficiary can be specifically entitled to the gain if the above requirements are met.

As to the first requirement, the ATO ID explains that the Explanatory Memorandum to the Bill that on enactment introduced section 115-228 of the ITAA 1997 stated:

2.59 [W]hether a beneficiary can be specifically entitled to a capital gain or franked distribution is a question of fact. For example, when a beneficiary becomes absolutely entitled to a trust asset, it may be reasonable to expect the beneficiary will receive the net financial benefit referable to the deemed (trust) capital gain from CGT event E5.

As to the second requirement, the Explanatory Memorandum stated:

2.63 The accounts or records of the trust would include the trust deed itself, statements of resolution or distribution statements, including schedules or notes attached to, or intended to be read with them. However, a record merely for tax purposes is not sufficient.

Application to your circumstances

In this case, as CGT event E5 will happen to the Trustee of Testamentary trust X on entering into the proposed Deed, a net capital gain will be included in the net income of the trust in accordance with subsection 95(1) of the ITAA 1936 and taxed in accordance with section 115-215 of the ITAA 1997.

Further, the terms of the proposed Deed meet the description of a record of the trust in which is recorded the financial benefit that each of Individual A and Individual B is expected to receive in its character as a benefit referable to the capital gain; that is, the Deed records Individual A and Individual B's absolute entitlement to the respective properties.

It follows that the absolutely entitled beneficiaries, Individual A and Individual B, will be regarded as specifically entitled to the capital gain that will arise from CGT event E5 happening to the properties. It also follows that no portion of the gain will be assessed to any other beneficiaries of Individual X's estate.

Question 3

Summary

No capital gain will arise to either Individual A or Individual B upon the ending of their capital interests in Testamentary trust Y.

Detailed reasoning

CGT event C2

CGT event C2 in section 104-25 of the ITAA 1997 happens if your ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.

The time of the event is when you enter into the contract that results in the asset ending, or if there is no contract, the event happens when the asset ends.

Cost base and capital proceeds

The first element of the cost base and reduced cost base of an equitable life or remainder interest is the sum of any money and the market value of any property given to acquire it (subsection 110-25(2)).

If, as is generally the case, no money or property is given to acquire an equitable life or remainder interest, section 112-20 of the ITAA 1997 provides that the first element of the cost base and reduced cost base of the interest is its market value at the time it was acquired (paragraphs 25 and 26 of TR 2006/14).

Where no capital proceeds are received for CGT event C2, the market value substitution rule in subsection 116-30(1) of the ITAA 1997 applies to determine the amount of capital proceeds from the event. The market value is worked out at the time of the event.

Application to your circumstances

In this case, Individual A and Individual B are the remainder beneficiaries in respect to the capital of Individual Y's testamentary trust (and also Individual X's testamentary trust).

Under the proposed Deed, Individual A and Individual B will surrender or release their respective interests in the capital of Individual Y's testamentary trust for no consideration from the trustee.

However, they will each receive a residential property from the trustee of Individual X's testamentary trust in full satisfaction of their capital interests in both trusts, and both trusts will be wound up following the distribution of all the assets of the trusts to the relevant beneficiaries.

Consequently, CGT event C2 will happen to each of Individual A and Individual B at the time their right to receive a capital distribution from Individual Y's testamentary trust ends.

The cost base of the capital interests of each of Individual A and Individual B in Individual Y's testamentary trust is the value of the interests when they were acquired on the date of Individual Y's death.

In respect to the capital proceeds received on CGT event C2 happening, it is noted that under the proposed Deed, the children of Individual X and Individual Y will receive the residual CGT assets and cash held in Individual Y's testamentary trust and CGT events E6 and C2 will happen on receipt of those distributions. As such, Individual X and Individual Y are required to calculate the relevant capital gain or loss using the actual capital proceeds received from their respective distributions from Individual Y's testamentary trust.

Consequently, it is accepted that the market value of the capital proceeds in respect of CGT event C2 happening to each of Individual A and Individual B will be nil. Therefore, no capital gain will arise to either of Individual A or Individual B upon the ending of their remainderman interests in Individual Y's testamentary trust.