CAPITAL GAINS TAX ISSUES WITH TRUSTS

Transcription

1 CAPITAL GAINS TAX ISSUES WITH TRUSTS Date: 1 April 2001 Articles No: PARTA00901 Subject: Capital Gains Tax Issues with Trusts Author(s): Christopher J Batten Chris Balalovski (Ed.) Pages: 6 References: Division 43 and sections , , , , , and Income Tax Assessment Act 1997, Divisions 10C and 10D and section 160ZZS Income Tax Assessment Act 1936, IT 2340, IT 2466, TR 92/13, TD 40, TD 92/149, TD 93/239, TD 97/15 and TD 1999/D67. Comments: The increased use of trusts, for both investment and business purposes, means that practitioners should be well aware of the capital gains tax implications at both the trust level as well as for the beneficiaries. The use of unit trusts for superannuation funds & property development structures, and the use of hybrid discretionary trusts for investment assets, has become widespread. As trusts become an increasingly popular structure to own assets for both business and investment purposes, it is crucial that the capital gains tax (CGT) implications and tax planning opportunities be particularly considered. For example, the flexible nature of trusts, including class, hybrid discretionary, hybrid unit and variations of fixed trusts, provides for unlimited planning opportunities, such as the ability to stream certain income, including capital gains, to certain beneficiaries. The five main CGT issues for trusts that will be addressed here include: - the return of non-assessable capital (s Income Tax Assessment Act 1997 (ITAA 1997)); - a change in the majority underlying interest of the trust (s ITAA 1997); - the 75% of net value rule (s ITAA 1997); - the issue and redemption of units (Taxation Determination TD 40); and - the streaming of income and capital gains (IT 2466 and TR 92/13). RETURN OF NON-ASSESSABLE CAPITAL The income of a trust retains its character when it is distributed to beneficiaries. Section ITAA 1997 provides that CGT event E4 occurs with the payment of amounts from the trust that are non-assessable to the beneficiaries. When such payments are made in under-capitalised trusts, the effect of the provision is to make such amounts assessable to those beneficiaries. Non-assessable amounts include the general CGT 50% discount, the concession relating to disposals of active business assets by small business under s ITAA 1997 and CGT indexation amounts. However, for the purposes of s , Division 43 ITAA 1997 and certain Division 10C and 10D ITAA 1936 allowances for capital works are not included. Section will apply where all of the following are satisfied: PARTA00901 Page 1

2 (a) a beneficiary has an interest or unit in a trust; (b) the trustee pays an amount to the beneficiary; (c) the amount is paid in respect of the interest or unit in the trust; (d) the amount is not assessable income in the beneficiary s hands; (e) the beneficiary acquired their interest or unit after 19 September 1985; and (f) the payment is not in respect of a disposal of the beneficiary s interest or unit. If all of the above are satisfied, then s will have the following consequences, as outlined in diagram 1: for CGT purposes, the cost-base of the beneficiary s interest or unit is reduced by the non-assessable amount; and if the non-assessable amount exceeds the cost-base of the interest or unit, then a capital gain equal to the excess will accrue to the beneficiary. Diagram 1 The Smith Property Unit Trust Trustee Distributions of non-assessable amounts of $1000 are made to each unitholder Unitholder 1 Unitholder 2 Unitholder 1 Unitholder 2 Original cost-base $2000 $500 s distribution $1000 $1000 Adjusted cost-base $1000 Nil Capital gain N/A $500 Importantly, s does not apply to beneficiaries of discretionary trusts - Taxation Determination TD 97/15, nor to default beneficiaries of discretionary trusts - Draft Determination TD 1999/D67. On 22 March 2001, the Treasurer issued a Press Release generally dealing with tax reform, which indicated the Government s intention to legislate for a change to the outcome discussed above, PARTA00901 Page 2

3 thereby ensuring that the general 50% CGT discount will be able to be passed on to beneficiaries with fixed interests in trusts. In particular, the Treasurer said that: For beneficiaries with fixed interests in a trust, from 1 July 2001 cost-base adjustments will not be required for distributions from the 50% CGT discount, but an adjustment will need to be made on receipt of distributions of non-assessable amounts associated with building allowances. MAJORITY UNDERLYING INTEREST Where the majority underlying interest in a trust changes, then s ITAA 1997 has the effect of deeming that any asset of the trust that was acquired pre-cgt loses that status, and that such an asset is also deemed to have been acquired by the trust for consideration equal to its market value at the date of that change. Paragraph 4 of Income Tax Ruling IT 2340 (dealing with s.160zzs ITAA 1936, which was the earlier equivalent of s ) states that: Where an asset is deemed by s.160zzs to have been acquired after 19 September 1985, the asset will be taken to have been acquired on the date on which the continuity of beneficial ownership in the asset of more than 50% ceases to be maintained. The cost base for the purposes of determining future capital gains and losses on realisation of such an asset will be the market value of the asset on the date on which the asset is taken to have been acquired by the application of s.160zzs. Assuming that immediately prior to 20 September 1985 the underlying interests in the ABC unit trust were as follows: Mr A - 85% Mr B - 15% and that after that date there is a change in those interests, so that they are as follows: Mr A - 5% Mr B - 75% Mrs C - 20% In this case, there is no application of s , since A and B between them continue to hold the majority interest. If however, the change in the underlying interests was as follows: Mr A - 5% Mr B - 10% Mrs C - 85% then there would be a change in majority underlying interest triggering s PARTA00901 Page 3

4 SECTION & THE 75% RULE Section ITAA 1997 has the effect of making the disposal of pre-cgt interests in a trust subject to tax. It applies if, at the time of disposing of those pre-cgt interests, the market value of the post-cgt assets of the trust is 75% or more of the net value of the trust. The capital gain accruing to the beneficiary that disposes of their pre-cgt interests, in these circumstances, is equal to that part of the capital proceeds from the disposal which is reasonably attributable to the amount by which the market value of the post-cgt trust property exceeds the sum of the cost-bases of that property. Paragraph 2 of Taxation Determination TD 92/149 provides that the calculation of the capital gain in these circumstances is determined in accordance with the following formula: Interest disposed of by the taxpayer in the underlying property of the company, x Notional Capital Gain expressed as a percentage Where: Notional Capital Gain = [value of underlying property - indexed cost-bases of that property] References should also be made to Taxation Determination TD 93/239 regarding the market value substitution rule. In calculating the value of post-cgt assets, trading stock is not included, whereas both cash and trade debts are. ISSUE & REDEMPTION OF UNITS Item 3 of s ITAA 1997 provides that a person acquires a CGT asset when a trustee of a unit trust issues units to them. Section ITAA 1997, however, states that CGT event D1 occurs if a taxpayer creates a legal or equitable right in another entity, except where the trustee of a unit trust issues units in the trust, ie. there will not be a disposal by the trustee in these circumstances. Further, s ITAA 1997 provides that the redemption of units in a unit trust will trigger CGT event C2, ie. the unitholder will have disposed of their interest at that time. Reproduced below is the Commissioner s interpretation of the consequences of the issue and redemption of units in a unit trust, outlined in Taxation Determination TD 40 which refers to the relevant provisions of the ITAA 1936: TD 40 Capital Gains: What is the treatment where units in a unit trust are issued or redeemed by the trustee? 1. The treatment differs for the unitholders and the unit trust as follows: UNITHOLDERS Issue of units - units issued to a unitholder are an acquisition by virtue of paragraph 160M(5)(aa). Redemption of units - the redemption of units would constitute a disposal by virtue of paragraph 160M(3)(b). Any proprietary or equitable interest conferred by the units would be extinguished at the time of redemption, thereby effectively extinguishing the units. UNIT TRUST Issue of units - units issued in a unit trust are not a disposal by virtue of paragraph 160M(5)(aa). PARTA00901 Page 4

5 Redemption of units - there is no acquisition of units in a unit trust by the trustee as the units are extinguished when redeemed. Care must be taken as to the rights attaching to units whose redemption constitutes a disposal by virtue of CGT event C2 under s In particular, as illustrated in diagram 2, if income units (under which the unitholder has no rights to capital and/or capital growth) are redeemed, then it could be argued that no capital gain would accrue to the unitholder. The calculation of the redemption value usually contained in the trust deed or unit certificate would govern whether any capital gain is made and, therefore, careful attention to any redemption clauses, even for income units, is required. Diagram 2 The Smith Property Unit Trust Trustee Unitholder Unitholder Income Unitholder Unitholder may be entitled to income only. Capital Unitholder Unitholder may be entitled to capital. STREAMING OF INCOME & CAPITAL GAINS As stated earlier, the income of a trust retains its character when it is distributed to beneficiaries. Streaming is the distribution of different types of income and capital gains to certain beneficiaries, in order to reduce the overall incidence of tax. In Income Tax Ruling IT 2466 and Taxation Ruling TR 92/13, the Commissioner has indicated that he accepts streaming with both unit and discretionary trusts. The advantages of streaming include: 1/ Capital gains to beneficiaries who can apply capital losses against them; 2/ Capital gains to beneficiaries on low marginal tax rates; 3/ Capital gains from collectibles to beneficiaries who can apply capital losses from collectibles against them; 4/ Interest income to non-resident beneficiaries to make use of the 10% withholding tax rate; PARTA00901 Page 5

6 5/ Royalties to non-resident beneficiaries to make use of lower withholding tax rates; 6/ Unfranked dividends to non-resident beneficiaries to make use of lower withholding tax rates; 7/ Trading income, dividends, etc. to beneficiaries on low marginal rates of tax or who have carry-forward income losses; and 8/ Foreign source income to non-resident beneficiaries so that no tax is payable. Two important points, in this regard, are that each class of income should be recorded separately in the books of account, and that the trustees resolution to distribute should show the income distributed to particular beneficiaries by type. Diagram 3 outlines the possibilities with streaming and important attention needs to be directed towards the capital gains distributions. Diagram 3 Franked Dividends Interest Capital Gain Trading Income Foreign Source Income GRISWALD FAMILY TRUST Income Amount Franked Dividends $ Interest $ Capital Gain $ Trading Income $ Foreign Source Income $ Clarke receives the trading income, as he is a resident with a prior year loss of $ and, therefore, will pay no tax. Helga, a non-resident, will receive the interest and, therefore, only be subject to 10% withholding tax. Julie and Louise would receive the franked dividends, as they have low levels of other income and prior year losses. Ellen (Clarke s wife), who has no other income, will receive the capital gain and, therefore, not be subject to tax if the CGT 50% discount is available to her. Hank, also a nonresident, will receive the foreign source income and, therefore, will pay no tax in Australia. COPYRIGHT. This publication is copyright. Apart from any fair dealing for the purposes of study, research, criticism, review or as otherwise permitted under the Copyright Act, no part of it may be reproduced by any process without the express permission of InvestorOne Pty Limited DISCLAIMER. No person should rely on the contents of this publication without first obtaining advice from a qualified professional person. This publication is sold on the terms and understanding that (1) the authors, consultants and editors are not responsible for the results of any actions taken on the basis of information in this publication, nor for any error in or omission from this publication; and (2) the publisher is not engaged in rendering legal, accounting, professional or other advice or services. The publisher, and the authors, consultants and editors, expressly disclaim all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this publication. Without limiting the generality of the above no author, consultant or editor shall have any responsibility for any act or omission of any other author, consultant or editor. PARTA00901 Page 6