Tax Brief 21 December 2004 New ATO Views on Absolute Entitlement Background It has taken just under 20 years, but the Australian Taxation Office [ ATO ] has finally released a Draft Ruling outlining its interpretation of one of the pivotal concepts in the capital gains tax [ CGT ] rules for trusts. The Draft Ruling, TR 2004/D25, released on 15 December, outlines the ATO s views on the meaning of the words absolutely entitled. This term determines whether a capital gain or capital loss is reported by the beneficiary directly, or whether the gain or loss is reported in the return of the trust. This phrase is not drawn from existing trust law but was appropriated from UK tax law by the drafter of the CGT provisions for the Income Tax Assessment Act 1936 and now the Income Tax Assessment Act 1997 [ ITAA 1997 ]. Because it is not a term with an established meaning in equity, the term has always been somewhat ambiguous and contentious. Moreover, to date there have been no Australian court decisions analysing and applying the term as it is used in the ITAA 1997. The Draft Ruling goes some way to clarifying the meaning of the term, but leaves several issues unresolved and contains surprises that put in doubt a few existing practices. The CGT rules divide trusts into six groups at various places and for different purposes. In general terms, the six groups that are drawn in the ITAA 1997 are: 1 unit trusts; 2 trusts with fixed interests where the beneficiaries are absolutely entitled to trust assets; 3 trusts with fixed interests, but where the beneficiaries are not absolutely entitled to the trust assets; 4 discretionary trusts; 5 superannuation funds; and 6 deceased estates. The Draft Ruling is directed primarily to drawing the boundary between group 2 and group 3. It does not purport to apply to unit trusts, and says that for various reasons, superannuation funds are also excluded from its scope. Curiously, having excluded these trusts from the scope of the Draft Ruling, the ATO cannot
resist discussing the position of unitholders and members of superannuation funds at various places. Commercially, the Ruling will be significant for trustees and investors in 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; some types of wholesale investment trusts that are not denominated as unit trusts; instalment warrant arrangements; trusts used in leveraged lease arrangements, securitisations and joint venture arrangements; and bare trusts. Unhappily, the tone and examples in the Draft Ruling suggest the ATO considered its main audience to be individuals and deceased estates. Much of the Draft Ruling appears to have been drafted without its commercial ramifications kept firmly in mind. Draft Ruling 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. The emphasis is clearly on whether or not a beneficiary can call for a particular asset. Having chosen this idea as the core concept, the rest of the Draft Ruling then attempts to apply it in a variety of circumstances. 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. The fact that this distinction is emphasised in the Draft Ruling is important it puts in doubt a view expressed in the literature that the beneficiary of a bare trust is an example of a beneficiary who is absolutely entitled. 2 New ATO Views on Absolute Entitlement
A bare trust is usually understood as a trust under which the trustee does not have active duties to perform: the focus of the concept is on the extent of the obligations imposed on the trustee. 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 also notes that what matters is whether the beneficiary could call for the asset not whether it has and takes the view that explicit provisions in the Trust Deed which preclude a beneficiary from calling for an asset will be ineffective for CGT purposes if they are ineffective for trust law purposes. This will have commercial significance. Many arrangements are intentionally structured as an express trust by executing a Trust Deed or other document. The existence of the trust may, however, need to be ignored for CGT purposes even though the trust will remain in existence for other purposes. It is also conceivable that a trust which was recognised when created will disappear for CGT purposes because circumstances subsequently arise that would entitle the beneficiary to call for the asset. 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. Hence, 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. Examples in the Draft Ruling take the view that two adult beneficiaries who could call for a trust asset to be distributed to them jointly, will not be absolutely entitled to the asset. Multiple Beneficiaries, Multiple Trust Assets Where the trust comprises several assets, the Draft Ruling takes a different view. The Draft Ruling says that where there are multiple beneficiaries each with a vested and indefeasible interest in trust assets, and the trust comprises several identical assets, each beneficiary can be treated as absolutely entitled to a specific number of trust assets if: The assets are fungible. The Draft Ruling says assets will be fungible if a beneficiary would be indifferent about which asset they would receive. The Draft Ruling suggests that shares in listed companies would likely be fungible; land would never be fungible. 3 New ATO Views on Absolute Entitlement
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. The text of the Draft Ruling does not state clearly and unequivocally whether each beneficiary in such a case must be treated as absolutely entitled; it says rather that they can be considered absolutely entitled Other parts of the Draft Ruling suggest that once the conditions are met, the beneficiary must be treated as absolutely entitled. However, the Draft Ruling also says that, where the trust instrument does not specify individual assets and attribute them to particular beneficiaries, the trustee must create a contemporaneous written record of the number [of assets] held for each beneficiary and where there is no such record, absolute entitlement is not established. Again, this will have commercial significance for example when trust assets are added or 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. Other Examples The Draft Ruling also contains a number of other examples, which are not fully developed in the text, of instances in which a beneficiary will or will not be absolutely entitled to an asset: 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 an 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.) 4 New ATO Views on Absolute Entitlement
Comments If released unamended, this Draft Ruling will have important commercial ramifications for trustees and investors in fixed trusts that are not unit trusts. The view which automatically equates a bare trust to absolute entitlement will no longer be sustainable. The possibility that express trusts may appear and disappear as circumstances change will have to be carefully watched. The circumstances where the Commissioner will (or might) insist that beneficiaries of trusts with multiple beneficiaries are absolutely entitled will need to be monitored. Access to exemptions and rollovers which depend upon a beneficiary owning an asset (rather than an interest in a trust which owns the asset) may be restricted. The Draft Ruling is clearly not the last word on this topic, even though it is 35 pages long. It does not deal some of the thornier issues that arise in this territory. It does not address when an arrangement will give rise to an agency, a power or nomination, rather than a trust. Some arrangements which are not trusts at law are treated as trusts for tax purposes because of the extended definition in the ITAA 1936, but by no means all. The Draft Ruling does not attempt to deal with this classification issue. It assumes the existence of a trust for tax purposes. Nor does it identify when arrangements with multiple beneficiaries and classes of assets will give rise to multiple trusts, rather than a single trust (either with or without beneficiaries who are absolutely entitled). This issue will be important for many custodians and nominees who will routinely acquire multiple assets and hold them for disparate groups of beneficiaries. The Draft Ruling assumes the existence of a single trust for tax purposes. We understand that there are ongoing discussions between industry groups and the ATO about this topic which, together with the outcome of the submissions arising from this Draft Ruling, probably mean we have not yet reached a firm resolution of this issue. This is clearly a difficult and contentious topic and many issues of special relevance to business are not well handled in the Draft Ruling. Greenwoods & Freehills are proposing to make a formal submission to the ATO on legal aspects of the Draft Ruling. Clients affected by the Draft Ruling may wish to consider lodging their own submission or contacting us to have their views included. 5 New ATO Views on Absolute Entitlement
For further information, please contact Sydney Andrew Mills Andrew.Mills@gf.com.au +61 2 9225 5966 Jacinta Oner Jacinta.Oner@gf.com.au +61 2 9225 5985 G&F document ID 510039501_15.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN 60 003 146 852) www.gf.com.au Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph +61 2 9225 5955, Fax +61 2 9221 6516 Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph +61 3 9288 1881 Fax +61 3 9288 1828 Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph +61 8 9211 7770 Fax +61 8 9211 7755 6 New ATO Views on Absolute Entitlement