Edited version of private advice

Authorisation Number: 1052327646979

Date of advice: 21 January 2025

Ruling

Subject: CGT - deceased estate

Question 1

Will the sale of the replacement property by the partnership be subject to capital gains tax (CGT) pursuant to section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Original Property was purchased by the Deceased before the introduction of CGT on 20 September 1985 (pre-CGT).

The Original Property was the principal place of residence of the Deceased until they passed away pre-CGT.

Under the terms of the will a testamentary trust (Trust) was created over the entire Estate including the Original Property.

The Deceased's children were the executors of the estate and the trustees of the Trust.

The children were recorded on the Certificate of Title of the Original Property as tenants in common.

The will granted the Deceased's spouse a life estate with the Original Property to pass to child 1.

The will stipulated that the residuary estate was held on trust for the deceased's spouse until their passing.

On the passing of the spouse, the remaining assets would either go to child 2 absolutely if the value of the residual estate did not exceed the value of the Original Property (as determined by the most recent Valuer General's valuation). Otherwise, the Trust was required to realise and convert the residuary estate into money and the balance divided in such a way that the value of the entire estate, (taking into account the value of the Original Property) would be shared equally between the children.

In MMYYYY (post-CGT) the spouse had a medical event and from then on resided in a nursing home for care.

On DDMMYYYY (post-CGT) the state government compulsorily acquired the Original Property.

In MMYYYY a replacement property was acquired by the Trust.

The replacement asset rollover relief under section 160ZZK of the Income Tax Assessment Act 1936 (the predecessor to Subdivision 124-B) was applied as the conditions for the rollover were satisfied.

On DDMMYYY the spouse passed away.

On DDMMYYYY all the assets of the Trust were transferred into a partnership between the children.

On DDMMYYYY a contract for the sale of the Replacement Property was entered into, and settlement occurred on DDMMYYYY.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 160X

Income Tax Assessment Act 1936 section 160Y

Income Tax Assessment Act 1936 section 160ZZK

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-85

Income Tax Assessment Act 1997 Subdivision 106-A

Income Tax Assessment Act 1997 section 106-5

Income Tax Assessment Act 1997 section 106-50

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 Division 115

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 Division 128

Income Tax Assessment Act 1997 section 128-15

Income Tax Assessment Act 1997 section 128-20

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Question 1

Summary

CGT event A1 happened when the partnership sold the Replacement Property in 20XX. A capital gain will be made if the capital proceeds from the event are more than the asset's cost base. As the Replacement Property was acquired post CGT and after the death of the deceased, any capital gain or capital loss from the CGT event made by the individual partners cannot be disregarded under either subsection 104-10(5) or Division 128 and must be included in the partner's individual income tax return.

Each partner holds an indivisible beneficial interest in the underlying assets of the partnership as tenants in common in equal shares, giving them a right to 50% of the proceeds from the sale of the Replacement Property. The market value substitution rule applies so that the cost base of the Replacement Property for each partner will be 50% of the market value calculated at the time of the CGT E7 event on 1 July 19XX (when the Trust transferred all the assets to the beneficiaries).

As each partner held the CGT asset for longer than 12 months, there is a 50% discount capital gain available when working out their net capital gain.

Detailed reasoning

Capital gains tax

CGT is the tax you pay on any capital gain you make. Section 102-20 states that a capital gain or capital loss is made only if a CGT event happens to a CGT asset that you own. All assets acquired since CGT started (20 September 1985) are subject to CGT unless specifically excluded.

A CGT asset is defined in section 108-5 as any kind of property, or a legal or equitable right that is not property. Under subsection 108-5(2) CGT assets includes part of or an interest in an asset. Note 1 to subsection 108-5(2) gives examples of CGT assets that includes land and buildings. The Replacement Property is a CGT asset.

CGT events are transactions that may result in a capital gain or capital loss. Division 104 sets out the CGT events that can happen to a CGT asset. Each CGT event prescribes specific conditions about when they happen.

Section 104-10 provides that CGT event A1 happens if you dispose of a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

As a consequence of a CGT event A1 you make a capital gain if the capital proceeds from the disposal are more than the assets cost base or conversely you make a capital loss if the capital proceeds are less than the assets reduced cost base.

The cost base of a CGT asset is generally what it cost you to buy it, plus other costs you incur to hold and dispose of it (section 110-25). In some situations, the cost base is the market value of the property at a specified time, plus other costs.

Capital proceeds are defined as the total of the money you have received or are entitled to receive and the market value of any other property you have received or are entitled to receive (section 116-20).

50% Discount Capital Gain

Where a capital gain arises a CGT discount may be available under Division 115. You can reduce your capital gain by 50%, if you owned the asset for at least 12 months and you are an Australian resident for tax purposes.

Exception to CGT

An exception to CGT applies to disregard a capital gain or capital loss if the asset was acquired before 20 September 1985 when CGT was introduced (pre-CGT).

For an A1 event subsection 104-10(5) provides that a capital gain or capital loss will be disregarded if the asset was acquired before 20 September 1985.

Effect of death

Division 128 (and its predecessors, former sections 160X and 160Y of the Income Tax Assessment Act 1936 that were operational prior to 1997) modifies the application of the CGT provisions when an individual dies.

The general rule is a capital gain or loss that arises when an asset passes from a legal personal representative to a beneficiary of a deceased person is disregarded (subsection 128-15(3)).

However, the CGT exemption only applies to assets owned by the deceased just before dying (section 128-15).

Testamentary trust

A testamentary trust is established when under the terms of the will an equitable life and remainder interest is created over the estate.

A testamentary trust functions in a similar way to a discretionary family trust with the provisions of the will operating like a trust deed.

In certain circumstances the Commissioner treats the trustee of a testamentary trust in the same way he treats a legal personal representative in relation to the passing of an asset owned by a deceased person to the beneficiaries (Law Administration Practice Statement PS LA 2003/12 Capital gains tax treatment of the trustee of a testamentary trust).

Ownership - Testamentary Trust

A CGT event in relation to an asset of a trust happens to the trustee on behalf of the trust unless a beneficiary is absolutely entitled to the asset. Where a beneficiary is absolutely entitled to a CGT asset as against the trustee, section 106-50 states that any act done in relation to the CGT asset by the trustee will be treated as if the act was done by the absolutely entitled 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 (Draft TR 2004/D25) discusses the concept of 'absolute entitlement' and states, at paragraph 10, that:

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.

Draft TR 2004/D25 discusses the circumstances in which a beneficiary of a trust is considered to be absolutely entitled to a CGT asset of a trust as against its trustee.

Paragraph 23 of TR 2004/D25 provides that if there is more than one beneficiary with interests in a trust asset, then it will usually not be possible for any one beneficiary to call for the asset to be transferred to them or to be transferred at their direction. This is the case where there are multiple beneficiaries with successive interests, such as a life tenant and a remainder interest holder as neither beneficiary can demand satisfaction of their share of the trust estate and therefore would not have legal ownership of the asset.

Equitable and life remainder interests

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 interest (TR 2006/14) discusses the capital gains tax consequences of creating life and remainder interests in property.

The Ruling explains that a 'life interest' and 'remainder interest' are terms to describe the interest that an entity has as a beneficiary of a trust. A life interest is generally measured by the life of the life interest owner that ends on their death. The remainder owner is entitled to an interest which vests in possession only when the prior life interest ends.

Paragraphs 187 and 188 of TR 2006/14 set out the nature of the equitable interest as follows:

187.       ...where there is no absolutely entitled beneficiary, a trustee who holds assets for the benefit of life interest and remainder owners is, for CGT purposes the relevant owner of the trust assets.

188.       The beneficiaries each have separate CGT assets (their trust interest) - the equitable life and reminder interests. The CGT events in Subdivision 104-E apply to those interest and apply in priority to more general events such as event A1 or C2 that could also apply....

Subsection 109-5(1) provides that equitable remainder interests are acquired when they commence to be owned. A remainder owner is taken to have acquired their equitable remainder interest (trust interest) when the trust was created. In this case the equitable remainder interest in the trust was acquired pre-CGT when the testamentary trust was created under the terms of the will.

During the life of the life interest owner, the equitable remainder interest is a distinct CGT asset separate from the underlying estate assets in the trust owned by the trustee.

A Legal Personal Representative will be treated as having acquired the original assets out of which life and remainder interest have been created, at the date of the deceased's death.

A remainder beneficiary under a will whose right to the assets is not subject to any contingency other than the death of the life beneficiary has a vested interest in the bequeathed assets but does not acquire possession of those assets until the death of the life beneficiary. A beneficiary who obtains a remainder interest in assets of a deceased estate under a will is also treated as acquiring those assets at the date of death of the deceased, not at the date of death of the life tenant (paragraph 126 of TR 2006/14).

However, as Division 128 only applies to the passing of an asset originally owned by a deceased individual just before dying, it means that the rules in Division 128 generally do not apply to life and remainder interests as those interests are newly created out of the estate, not CGT assets owned by the deceased at the time of death (TR 2006/14).

Ownership - Partnership

For tax purposes, a partnership arises in circumstances where there is 'an association of persons... in receipt of *ordinary income or *statutory income jointly' (paragraph 995-1(1)(a)).

A partnership does not own assets for CGT purposes. A partnership asset is owned by the partners in the proportion to which they have agreed. If a CGT event happens to a partnership during the income year, or the partnership received a share of a capital gain from a trust, each partner must include their share of the capital gain or capital loss on their own tax return.

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners (TR 93/32) examines the taxation position of co-owners whose activities do not amount to the carrying on of a business. It provides:

3.             The income/loss from the [co-owned] rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

Further, in relation to CGT:

42.          Any capital gain or loss should also be apportioned on the same basis as the rental income or loss.

Taxation Ruling IT 2540 Income tax: capital gains: application to disposals of partnership assets and partnership interests (IT 2540) discusses the application of capital gains and capital losses to disposals of partnership assets. It provides that under general law a partnership is not a separate legal entity distinct from the individual partners who comprise the partnership. Accordingly, the partnership does not own property in its own right; title to the partnership assets is legally vested in the partners, even though an individual partner may have no separate title to specific partnership assets. This view accords with the opinion expressed by the majority (Barwick CJ., Stephen, Mason and Wilson JJ.) of the Full High Court of Australia in F.C.T. v. Everett (1980) 143 CLR 440 at page 446:

Although a partner has no title to specific property owned by the partnership, he has a beneficial interest in the partnership assets, indeed in each and every asset of the partnership.

In specie distribution of the Replacement property - CGT event E7

CGT event E7 in section 104-85 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 timing of the event is when the disposal occurs.

CGT events E5 to E8 in sections 104-75 to 104-100 contain an exception for trusts 'to which Division 128 applies'. If the exception applies, it is not necessary to consider whether any other CGT event happened.

In the context of CGT event E7, the Division 128 exception will apply if, as part of the administration of a deceased estate, an asset the deceased owned when they died passes to a beneficiary in accordance with section 128-20. This means the exception will not apply unless:

(a)           the event involves an asset that the deceased owned when they died; and

(b)           the asset passes to a beneficiary of the estate in accordance with the rules in section 128-20 for the transmission of an asset through an estate.

Division 128 does not apply to a CGT asset acquired after the deceased died (see paragraph 79 TR 2006/14).

The trustee makes a capital gain if the market value of the asset (at the time of the disposal) is more than its cost base. It makes a capital loss if that market value is less than the asset's reduced cost base (subsection 104-85(3)).

The beneficiary makes a capital gain if the market value of the asset (at the time of the disposal) is more than the cost base of the right, or the part of it. The beneficiary makes a capital loss if that market value is less than the reduced cost base of the right or part (subsection 104-85(5)).

A capital gain or capital loss the trustee makes is disregarded if it acquired the asset before 20 September 1985 (subsection 104-85(4)).

A capital gain or capital loss the beneficiary makes is disregarded if they acquired the CGT asset that is the remainder interest right, before 20 September 1985 (subsection 104-85(6)).

Disposal of a Partnership asset

Subdivision 106-A sets out how the CGT provisions apply to partnerships. Under subsection 106-5(1), any capital gain or capital loss from a CGT event happening in relation to a partnership or one of its CGT assets is made by the partners individually. Each partner's gain or loss is calculated by reference to the partnership agreement, or partnership law if there is no agreement. Subsection 106-5(2) further provides that each partner has a separate cost base and reduced cost base for the partner's interest in each CGT asset of the partnership.

IT 2540 provides that where there is a disposal of a partnership asset to a third party, each of the partners disposes of their fractional interest in the asset.

Given that each partner owns a proportion of each CGT asset, the individual partners calculate a capital gain or capital loss based on their share of the asset.

Individual partners make a capital gain from a CGT event if their share of the capital proceeds from the disposal are more than the assets cost base, or conversely, they will make a capital loss if the capital proceeds are less than the assets reduced cost base.

They need to calculate their capital gain or capital loss on their 50% share of the partnership asset and include any capital gain in their individual tax return.

Application to your circumstances

The Deceased died, before 20 September 1985 when CGT was introduced. At that time under the terms of the will a testamentary trust was created over the estate, with the children appointed as trustees. The legal title of the property was transferred to them in their capacity as trustees. Their names were recorded on the Certificate of Title of the Original Property as tenants in common.

Separately to their role as trustee, child 1, in their personal capacity, also held an equitable remainder interest in the Original Property, which was also subject to a life interest in favour of the spouse. Child 1's beneficial interest as an individual was separate and distinct from their legal ownership as trustee of the testamentary trust.

Similarly, child 2 in their personal capacity held an equitable remainder interest in the residuary estate, subject to the life interest of the spouse (and any remainder interest child 1 held in the residuary estate). Their legal ownership of the Original Property was also in their capacity as trustee.

For the life of the life interest holder, child 1 only held a right to their remainder interest in the Original Property, but not the underlying property. Child 2 too had a remainder interest in the residuary of the estate, but not the underlying property. The remainder interest held by each beneficiary was itself a CGT asset acquired pre-CGT.

As these events took place before the introduction of CGT there were no CGT consequences.

The Original Property was compulsorily acquired by the Australian government agency post-CGT. The subsequent purchase of the Replacement Property by the trustees, introduced a new CGT asset into the Trust that was not owned by the Deceased just before dying. This meant that Division 128 (and its predecessors) and the possible concessional treatment in PS LA 2003/12 did not apply to the Replacement Property.

The replacement asset rollover relief in section 160ZZK of the Income Tax Assessment Act 1936 (ITAA 1936) was applied so that for the Trust, the Replacement Property purchased post-CGT retained the pre-CGT acquisition date of the Original Property.

In specie distribution

The trustees of the Trust distributed the Replacement Property to the remainder owners in satisfaction of their interest in the trust capital when the spouse, as life interest owner, died. No beneficiary was absolutely entitled to the Replacement Property under the will as the will did not make any provision specifically in relation to the Replacement Property.

The Division 128 CGT modifications did not apply, as the Replacement Property was only introduced into the Trust in 19XX and therefore was not an asset owned by the deceased prior to dying.

The distribution by the Trust to the remainder interest owners triggered a CGT event E7 when the trustee of the Trust disposed of the replacement property to the partnership (at the direction of the beneficiaries), in satisfaction of their interest, or part of it, in the trust capital (section 104-85).[1]

CGT event E7, as the most specific CGT event, applied on 1 July 19XX when the disposal occurred.

An asset was acquired by a trust beneficiary at the time of that CGT event.

CGT event E7 had consequences for both the trustee and the remainder owners as follows:

•                     Trustee

As a result of the replacement asset rollover in section 160ZZK of the ITAA 1936 the trustees of the Trust were taken to have acquired the Replacement Property pre-CGT allowing the Trust to disregard any capital gain or capital loss under the exception in subsection 104-85(4).

•                     Beneficiaries

For the beneficiaries, as their right to the capital (the remainder interest) was acquired when the testamentary trust was created, before 20 September 1985, the exception in paragraph 104-85(6)(b) applied to disregard a capital gain or loss made from CGT event E7.

As the distribution by the Trust happened simultaneously with the introduction of the Replacement Property to the partnership, the practical effect of these transactions was that when the partners sold the property in 20XX, their share of the market value of the property in July 19XX formed their cost base.

Disposal of Partnership asset

When the Trust distributed the Replacement Property to the children they became co-owners of the property in receipt of ordinary income jointly, and therefore a partnership for tax purposes (paragraph 995-1(1)(a)).

Since a partnership does not own assets for CGT purposes, as tenants in common, each partner had a 50% interest in the Replacement Property.

The sale of the Replacement Property to a third party triggered a CGT A1 event when the partners entered a contract of sale in 20XX.

The partners are taken under subsection 104-85(2)) to have acquired the Replacement Property on 1 July 19XX on its transfer to the partnership. Any capital gain cannot be disregarded under subsection 104-10(5) as the partners acquired the property after CGT was introduced, with Division 128 having no application to a new CGT asset introduced to the estate after the deceased died.

As each partner owns a proportion of each CGT asset in the partnership, the individual partners calculate a capital gain or capital loss on their share of the asset. Each individual partner will make a capital gain if their share of the capital proceeds from the disposal are more than their share of the assets cost base or conversely, they will make a capital loss if the capital proceeds are less than the assets reduced cost base.

Under subsection 116-20(1) each partner will be taken to have received 50% of the capital proceeds on disposal of the property in the 20XX.

As the partners did not incur expenditure to acquire the Replacement Property the market value substitution rule in subsection 112-20(1) operates so that the cost base for each partner will be 50% of the market value of the Replacement Property at the time it was acquired by the partnership in 19XX.

The individual partners will need to calculate their capital gain or capital loss based on their 50% share of the partnership asset and include any capital gain in their individual income tax return.

50% Discount Capital Gain

As each partner has held the CGT asset for longer than 12 months, under Division 115 there is a 50% discount capital gain available when working out their net capital gain.

Conclusion

CGT event A1 happened when the partnership sold the Replacement Property in 20XX. A capital gain will be made if the capital proceeds from the event are more than the asset's cost base. As the Replacement Property was acquired post CGT and after the death of the deceased, any capital gain or capital loss from the CGT event made by the individual partners cannot be disregarded under either subsection 104-10(5) or Division 128 and must be included in the partner's individual income tax return.

Each partner holds an indivisible beneficial interest in the underlying assets of the partnership as tenants in common in equal shares, giving them a right to 50% of the proceeds from the sale of the Replacement Property. The market value substitution rule applies so that the cost base of the Replacement Property for each partner will be 50% of the market value calculated at the time of the CGT E7 event on 1 July 19XX (when the Trust transferred all the assets to the beneficiaries).

As each partner held the CGT asset for longer than 12 months, there is a 50% discount capital gain available when working out their net capital gain.

[1] Although the children were recorded on the Certificate of Title as tenants in common in their capacity as Trustees, their beneficial interest in the Replacement Property was defined by the terms of the will. We have not analysed the terms of the will to determine the childrens's beneficial interest percentage as this has no practical bearing on the outcome of the 20XX sale of the Replacement Property.

We accept that where either the children's beneficial interest in the Replacement Property as conferred under the will, was greater than a 50% interest, the introduction of the Replacement Property into the partnership resulted in the disposal of that part of the individual's beneficial interest that was greater than 50%, to the other partner who in turn was taken to have acquired their proportionate interest at that time. A separate CGT event A1 would have been triggered by any such disposals.