JOINT SUBMISSION BY. Draft Taxation Ruling TR 2004/D25

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1 JOINT SUBMISSION BY Institute of Chartered Accountants in Australia, CPA Australia, National Institute of Accountants, Taxation Institute of Australia, Taxpayers Australia 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 Date: 3 March 2005 The professional bodies welcome the opportunity to comment on the Draft Taxation Ruling, TR 2004/D25 (the Draft Ruling ). SUMMARY In general terms, it is our submission that the Draft Ruling should not released in final form until some aspects of the text are reviewed and its commercial ramifications more clearly carefully addressed. It seems likely that when the commercial ramifications of the Draft Ruling are more carefully considered, some of the views expressed in the Draft Ruling ought to be revised. Commercially, the Ruling will be extremely significant for trustees and investors in fixed trusts that are not unit trusts. Common examples would include: wrap accounts offered to retail investors in the funds management industry; many arrangements put in place by custodians, nominees and responsible entities; wholesale investment trusts that are not denominated as unit trusts; instalment warrant arrangements; trusts used in leveraged lease arrangements; trusts used as securitisations vehicles; and joint ventures structured using a trust. KEY POINTS OF THE SUBMISSION The Draft Ruling says its core principle is the proposition that to be absolutely entitled, the beneficiary must have, a vested and indefeasible interest in the entire trust asset, to call for the relevant asset to be transferred to them or to be transferred at their direction The relevant test of absolute entitlement is not whether the trust is a bare trust [para 10]. 1. Our submission is that the definition of absolute entitlement has taken the wrong approach by using the rule in Saunders v. Vautier. The Draft Ruling has chosen the wrong core principle and much of the text which is driven from the core principle is therefore flawed. 2. There is no existing jurisprudence in either Australian tax or Australian equity law which interprets the term absolutely entitled or a cognate term. Consequently, there is no

2 Australian law which requires that this test be adopted as the definition of absolute entitlement. The ATO is therefore choosing among a range of possible meanings. 3. Using the proposed definition defeats sound tax policy. The tax policy question should be is there a single entity (or group of entities) who have a sufficient ownership interest in the CGT asset that the existence of the trust can be and should be effectively ignored? 4. The answer to that question will be yes when (a) (b) there is an existing identified and discrete group of beneficiaries all of whom must enjoy the entire benefits of the asset. In contrast, the answer will be no, for example, when the group is not exhaustively identified in the Trust Deed as in the case of a discretionary trust, when the benefit can be directed by the trustee among beneficiaries, or when some of the benefit might not flow to the beneficiaries, such as when the Trustee has a power to accumulate. 5. Where these two conditions are met, the beneficiary should be treated as deriving any capital gain made in respect of the asset, entitled to the benefit of any capital loss realised, entitled to any CGT exemption or concession, treated as the owner of the asset for other purposes, and so on. 6. To use the language of equity, the definition of absolute entitlement that should be used for CGT purposes is, is there an individual or group with a vested and indefeasible interest in the entire trust asset? Once that is the case, it should not matter whether they can also call for the relevant asset to be transferred to them or to be transferred at their direction. 7. At the very least, even if the ATO does not agree with conclusions in paragraphs 3 6, the Draft Ruling has to be amended to allow for the joint beneficiaries of a bare trust to be absolutely entitled. 1 Absolutely entitled v. a bare trust The Draft Ruling goes to some pains to try to draw a distinction between absolutely entitled and the existence of a bare trust [paras 33 50]. It says that a vested and indefeasible interest in the entire trust asset, to call for the relevant asset to be transferred to them or to be transferred at their direction The relevant test of absolute entitlement is not whether the trust is a bare trust [para 10]. The Draft Ruling acknowledges that a beneficiary under a bare trust may be absolutely entitled, but says the two ideas are not identical and the test for CGT is whether the beneficiary can call for the asset or direct its transfer, rather than whether the trustee has duties to perform. The Draft Ruling thus disagrees with the view commonly taken in practice that the beneficiary of a bare trust is a paradigm example of a beneficiary who is absolutely entitled as against the trustee. The Draft Ruling takes this position because, for unstated reasons, defining absolutely entitled as synonymous with a bare trust is not appropriate, produces a slightly different emphasis and would distort the result [para 36]. The Draft Ruling insists that two tests should be met when one is all that is needed. Insisting that a beneficiary can call for the relevant asset to be transferred to them or at their direction, is both unnecessary and the cause of most of the difficulties that the Draft Ruling encounters. It is also the cause of the commercial problems that the Draft Ruling will create. For example, in paragraphs 108 ff. the Draft Ruling insists that two beneficiaries cannot be absolutely entitled to a single asset because, were one of them to call for their interest to be distributed, this would prejudice the other. The difficulty arises, and arises only, from insisting on the test that the

3 beneficiary could call for the asset. It is the wrong test. The real test should be, are the two beneficiaries the exclusive and inexorable owners of the entire capital gain that the trustee makes? If the answer is yes, the two beneficiaries should be liable to the CGT or entitled to any capital loss. The current approach of the Draft Ruling will change current commercial practice. For example, it will change the assumed treatment currently adopted by joint ventures structured via trusts. It is not uncommon for a joint venture to be structured using a bare trust (rather than a company) to hold business assets on behalf of the joint venturers. The trustee of such a trust will hold assets say, a the freehold estate for land on which mining operations are conducted on behalf of all the joint venturers as a bare trustee. If the freehold is sold it would ordinarily be thought that the tax consequences are reported directly in the returns of the joint venturers in proportion to their interests in the venture. The same problem would arise for trusts used in leveraged lease arrangements. It is not uncommon for a leveraged lease to be structured using a bare trustee to hold the asset on behalf of investors. As a matter of tax policy, the proper treatment of the joint venturers or the lessors under the leveraged lease is that the arrangement should be transparent for tax purposes the beneficiaries own all of the income and gain, there can be no accumulation or diversion, and there is no income or gain unaccounted for. This result would be reached if the test is whether the beneficiaries have vested and indefeasible interest in the trust asset. It will not be reached if the test is whether the beneficiaries can call for distribution of their share of a single asset to them. Our submission is that the definition of absolute entitlement is much more akin to the idea of a bare trust than the current text of the Draft Ruling proposes. That is because the proper test should be whether there a single entity (or group of entities) who have a vested and indefeasible interest in the entire trust asset. Beneficiaries of a bare trust have such an interest and so: We agree with the conclusion in paragraph 39 of the Draft Ruling that a beneficiary can be absolutely entitled in circumstances where the trust is not a bare trust the existence of a bare trust is sufficient; it is not necessary. But we disagree with the conclusion in paragraph 40 that the existence of a bare trust is not always consistent with absolute entitlement. The only example of this situation given in the Draft Ruling is where there are multiple beneficiaries of the bare trust. Given our view that multiple beneficiaries can be absolutely entitled, we disagree. 2 Exclusively entitled to a trust asset The Draft Ruling takes an approach which equates absolute entitlement with exclusive entitlement that is, one beneficiary must be entitled to the entire asset. The Draft Ruling says, Generally, a beneficiary will not be absolutely entitled to a trust asset if one or more other beneficiaries also have an interest in it. So, as we noted above, if there are multiple beneficiaries and the trust consists of a single asset, the Draft Ruling takes the view that none of them can be absolutely entitled to the asset. This conflicts with current commercial practice and will lead to curious outcomes. Consider for example, an instalment warrant structure. It typically involves a security trust where a share or other security is held by a trustee until the price is paid or the securities forfeited [see for example PR 2004/91, PR 2004/93]. The position taken in the Draft Ruling will lead to very odd outcomes:

4 If the trust allows joint applications, and most arrangements would, an application from a single beneficiary would mean the beneficiary was absolutely entitled to the underlying asset, but an application from two beneficiaries would not. If one of the two beneficiaries sold its interest in the instalment warrant to the other, the single beneficiary would now be absolutely entitled. If a single beneficiary sold a half-interest in the instalment warrant to the other, neither beneficiary would be absolutely entitled to the trust asset. 3 Multiple beneficiaries, multiple trust assets Where the trust comprises several assets, the Draft Ruling says that each beneficiary can be treated as absolutely entitled to a specific number of trust assets if: The assets are fungible; The beneficiary could insist that the trustee distribute a specific number of assets to the beneficiary in satisfaction of the beneficiary s interest in the trust; and There is a very clear understanding that a beneficiary is entitled to a discrete number of assets to the exclusion of the other beneficiaries. (Paragraphs in the Explanation portion of the Draft Ruling then re-interpret this to insist on a particular form of record-keeping.) Again, this will have commercial significance when trust assets are changed under a power to sell and reinvest. Assets that may not have been fungible when acquired may be sold and replaced by assets that are, and of course the reverse may occur. Consider for example a simple bonus issue: A and B are equal beneficiaries of a fixed trust. They have vested and indefeasible interests. The trust assets consist of 100 shares in AMP Ltd. A and B can be absolutely entitled. AMP makes a 1 for 20 bonus issue. The trust assets now comprise 105 shares. It is not clear from the Draft Ruling what follows. The possibilities are: o neither A nor B can now be absolutely entitled to any of the shares o A and B are each absolutely entitled to the original 50 and no beneficiary is absolutely entitled to the 5 additional shares o A and B are each entitled to 52 and no beneficiary is absolutely entitled to one additional share. The trustee sells the 105 AMP shares and buys 67 NAB shares. Again, it is not clear from the Draft Ruling what follows, but it would seem that neither A nor B can now be absolutely entitled to any of the new shares. (Example 5 appears to confirm this view.) NAB performs a share split by cancelling all shares on issue and issuing twice the number of shares. Again, it is not clear from the Draft Ruling what follows, but it now seems to be the case that A and B are absolutely entitled again! These results are clearly unsatisfactory and derive from having chosen the wrong test. The proper treatment in these examples is that the two beneficiaries should be liable to any CGT

5 consequences arising from the transactions because they (and only they) do and must enjoy all of the benefit of the capital gain. The Draft Ruling attempts (but only in the Explanation part of the Draft Ruling) to make it a requirement of absolute entitlement that the trustee keep its records in a way which allocates individual assets to individual beneficiaries [para ]. This failure to keep records in a particular way appears to be the basis for the conclusion in Example 9 that no beneficiary is absolutely entitled. There is no basis in the statute for insisting on this requirement about record keeping. 4 Impact on CGT exemptions, discount, concessions etc The Draft Ruling will also by implication limit exemptions, concessions and rollovers which depend upon a beneficiary owning an asset, rather than owning an interest in a trust which owns the asset. In doing so, it is likely that the Draft Ruling will now conflict with, and be more restricted than, current ATO views. One example is the Taxation Determination on the benefit of the CGT exemption for a taxpayer s principal residence. The ATO currently takes the view in TD 58 that where a bare trust exists (within subsection 160V(1)), an exemption may be available to the beneficiary if a dwelling is sold by the trustee of a family trust. The TD allows the benefit of the main residence exemption to flow through the bare trust. Under the text of the Draft Ruling, the benefit of the main residence exemption could not pass if the main residence is owned by the trustee of the bare trust but for two people, rather than one, as neither beneficiary could call for the trustee to deliver the property to it exclusively. Again, the problem derives from having chosen the wrong test. Another example will arise where insurance policies are held on bare trust for more than party. It would now appear that payments under such policies will have to be accounted for in a trust return. The Draft Ruling also puts in doubt access to exemptions such as s where the payments have now to be seen as flowing through a trust. Similar problems will arise for other exemptions and concessions for example, the CGT discount in Division 115, other exemptions in Division 118, and the rollovers in Division 124, 125 and 126 where the taxpayer is (say) one of two beneficiaries of a bare trust with a single asset. 5 Other issues We agree with the views in the Draft Ruling that: A beneficiary can be absolutely entitled to an asset, even though the beneficiary holds its interest as the trustee of another trust; Consequently, absolute entitlement can be followed through a chain of trusts provided that each beneficiary holding their interest as trustee is absolutely entitled; The fact that there is a mortgage or charge over the trust property will not prevent a beneficiary being absolutely entitled to an asset; The existence of the trustee s right of indemnity out of trust property will not prevent a beneficiary being absolutely entitled to an asset; and The fact that the beneficiary is under a legal disability will not prevent the beneficiary being absolutely entitled to an asset. (This is stipulated in the ITAA 1997.)

6 The scope of the final Ruling should be confined so as to exclude superannuation funds and unit trusts. 6 Conclusion and examples We have argued above that the proper tax policy question should be: is there a single entity (or group of entities) who have a sufficient ownership interest in the CGT asset that the existence of the trust can be and should be effectively ignored? The definition of absolutely entitled should be so conceived so that it describes this situation. We have argued that a better formulation is whether there is a fixed group of beneficiaries with vested and indefeasible interests in the asset. This part of the submission gives examples of this test. Our test would reach the same conclusion for Examples 1, 2, 6 and 7 in the Draft Ruling. But for Example 3, in our view, Marie and Clare should be viewed as absolutely entitled to the trust assets. There is no reason to quarantine a loss made on the sale of the holiday unit for example were it to be sold for a loss. Nor is there any reason to deny the benefit of s , if the shares are shares in a PDF. We note that in Example 1, there is a statement that CGT Event E5 would apply to afteracquired property held in a deceased estate to which a beneficiary subsequently became absolutely entitled. This part of the Example requires so much clarification that it might be better omitted. Obvious questions arise: are the after-acquired assets ones which would be regarded as forming part of the estate of the deceased say, a fresh shares issue made upon the cancellation of shares held at death; if not, how is it that the estate is acquiring additional shares? The Draft Ruling also ventures upon the apparent drafting problem of s it refers to a trust to which Division 128 applies which is an inaccurate and unhelpful description of the effect of Division 128 which prescribes tax outcomes when a CGT asset passes to a beneficiary. Also, the Draft Ruling must put in some doubt the validity of the conclusions expressed in TD 1993/36 about the treatment of after-acquired property where there are multiple beneficiaries. Similarly, Example 12 in the Draft Ruling is, in our view, wrong and contrary to current practice. In our view, if there is: a bare trust for a single beneficiary, the beneficiary should be treated as absolutely entitled to the trust assets; a bare trust for two or more beneficiaries, each beneficiaries should be treated as absolutely entitled to their proportionate share of trust assets; a fixed trust for a single beneficiary, where the trustee has active duties of management but no power to appoint or accumulate income or gains, the beneficiary should be treated as absolutely entitled to the trust assets; a fixed trust for two or more beneficiaries, where the trustee has active duties of management but no power to appoint or accumulate income or gains, the beneficiaries should be treated as absolutely entitled to their share of trust assets; a trust where the trustee has a discretion to appoint or accumulate some or all income or gains, no beneficiary is absolutely entitled.