Tag Archives: Capital gains tax

The capital gains tax main residence exemption, affordable housing and caps

CGT beginnings

With wage and salary earners taxable on virtually every dollar they earn from their work, sources from the Asprey Report (1975) through to the tax summit of 1985 identified the lack of a capital gains tax as a tax regressive unfairness in the Australian income tax system which then relied on a narrower tax base. Before the CGT, gains on investments made by their owners escaped income tax and allowed already wealthier people to step up their wealth untaxed where less wealthy typically working people who paid their taxes could not.

Still it would have been near unthinkable for the Hawke Keating government of 1985 to have introduced the capital gains tax, which then was a partisan political and controversial proposal, into the Australian income tax system without CGT relief on the family home following the tax summit.

In those days a greater proportion of working people and middle Australia owned their own homes. So the exemption now legislated as the CGT main residence (MR) exemption in Division 118 of the Income Tax Assessment Act (ITAA) 1997, then not thought especially regressive, was a political price the government then had to pay to have a constituency-supported capital gains tax in the Australian income tax mix at all.

The uncontained housing tax exemption

But the breadth of the CGT MR exemption has made the CGT MR exemption itself regressive.

The CGT MR exemption is unlimited and especially generous when compared to CGT relief given in other countries.

The CGT MR exemption has these characteristics:

  • generally, where there is no income-earning use of a home and a taxpayer is or is taken to have occupied the home as their main residence while he or she has owned it, any capital gain on the home is fully exempted from the Australian CGT;
  • there is no qualifying length of ownership period to wait before the CGT MR exemption can be applied to exempt CGT on sale of an Australian home – the owner can live there for a month, rent the property out for five years, go overseas, come back and sell the (former) home and claim the full exemption – see section 118-145 of the ITAA 1997; and
  • a taxpayer can turnover any number of homes and keep claiming the exemption from CGT on every successive capital gain. In other words there are no limits on the amount of, or numbers of tax free step ups in, wealth a taxpayer can achieve with no taxation by selling each of their successive and possibly more expensive homes.

This has made Australian home ownership an incomparably attractive investment for tax reasons. This frustrates wider social housing objectives such as opportunity and ability for the populace to securely house themselves when they cannot afford to compete in the housing market especially as long term renting in Australia is not so secure either.

Sources of unaffordable housing

The CGT MR exemption has indisputably contributed to unaffordible housing both as a tax shelter, as a driver of demand for real estate and as an improver of the financial case to own an expensive home. To what extent is not for a tax lawyer, who is no econometrician, to judge. The CGT MR exemption may not even be the greatest contributor to unaffordable housing in Australia. Housing markets around the world are elevated due to the abundance of money injected into major economies by quantitative easing. But in Australia add:

  • dark money laundered through Australian real estate attributable to persisting slack regulation of money flows into Australia, including continuing failure by government to commence the 2007 AML/CTF measures to expand the range of oversight of AUSTRAC to non-financial businesses and professions including the legal, accounting and real estate professions: see my 2017 blog – Sluggish anti-money laundering reform in Australia https://wp.me/p6T4vg-6J and The Lucky Laundry by Nathan Lynch https://cutt.ly/JCwVAyK;
  • housing financialisation; and
  • light and regressive taxation of housing in Australia;

to the reasons why Australian residential property prices have reached the unaffordable levels they have.

The wrong culprit

Light taxation has been widely canvassed in the media as a contributor to unaffordable housing but journalists and commentators frequently focus on the 50% CGT discount for investors and negative gearing as the tax system causes of unaffordable housing unfortunately ignoring the CGT MR exemption or even the various land tax exemptions that Australian state and territory governments extend which shelter owner-occupied homes from state taxation too.

The 50% CGT discount was an inexplicable 1999 adjustment to sound original design of the CGT in 1986. It replaced the indexation of cost (base) which was to ensure an investor paid tax only on a real capital gain after adjusting for inflation but at ordinary income tax rates so the CGT could work fairly and progressively as designed. The 50% CGT discount instead effectively and regressively reduced the income tax rate on investment capital gains made by property investors, as it turned out, during a period of negligible inflation which the 50% discount was meant to overtly but more crudely counter. Now inflation is back so a nuanced policy response may be to scrap the 50% CGT discount and to revert back to the 1986 indexation of cost which should never have been altered in the first place.

In contrast to the CGT MR exemption, the 50% CGT discount has a waiting period, 12 months – see section 115-25 of the ITAA 1997, which is not much, and is limited to 50% as a highest discount to individuals. Like the CGT MR exemption, availability is not limited or capped to those who qualify and this is a boon to investors in the property market although major investors and developers need to be tax wary that their property investment activity is not treated by the Commissioner of Taxation as a business of profit-making by sale with the consequences that:

  • proceeds of sale of investment in housing become taxable as ordinary income;
  • thus CGT relief, such as the 50% CGT discount, is unavailable – see section 118-20 of the Income Tax Assessment Act (ITAA) 1997; and
  • their activities become an enterprise where they must charge the goods and services tax (GST) to buyers for reasons set out in Miscellaneous Taxation Ruling MT 2006/1.

Tax relief saving for a home?

The CGT MR exemption is of no benefit to someone who is saving for a home, but does not have a home yet, whom one would think would be the focus of a real and progressive tax exemption to house. Capital gains made on investments by someone saving for a home are not exempt from tax, and get no better than the 50% CGT discount I have maligned in this post, which is odd when it is understood the tax system gives already housed wealthier citizens, who may turnover a series of homes of increasing value and for increasing gains, full tax relief on each gain made on their homes through the CGT MR exemption.

For the CGT MR exemption to be fairer, and to discourage home buyers from taking on higher mortgages to get into the housing market where ruin may be more likely than gain, could the CGT MR exemption extend to capital gains made by persons who are saving for a home or who are yet to own home on portfolio assets set aside to buy a home they hold in the interim? Clearly the former First Home Saver’s Account scheme, which was an utter failure and repealed in 2014, was not ambitious enough and was a false move to help those accumulating what they need to buy a home.

A cap on the CGT main residence exemption?

A limit or cap could be put on the CGT MR exemption that a taxpayer can use to exempt capital gains on his or her home during their lifetime. This would take heat out of the housing market.

An arguably generous lifetime cap of $A 1 million would still bring in substantial additional CGT revenue that could fund social and universal housing and reduce the CGT MR exemption rort by those who take large or multiple full exemptions on their turnover of increasingly expensive homes. The CGT system already uses a lifetime limit in the small business CGT retirement exemption rules in Subdivision 152-D of the ITAA 1997 and caps now limit contributions that can be put into tax concessional superannuation on tax fairness and equity grounds.

A home turnover limitation?

In many countries in Europe a holding period of less than five years can cause capital gains on assets including the family home to be taxable. Tax relief cuts in where an asset is held for longer. Are their approaches something Australia should also consider when looking at tax exemptions and concessions for housing?

Challenge

There is no doubt changes that really improve Australian housing affordability and address inequitable and fiscally disastrous untethered tax exemptions will be politically fraught especially when there are so many interests vested in the present tax system who may lose with change. In the bigger picture lightly taxed property gains and unquarantined negative gearing deductions can be seen as scourges when proper taxation, orthodox monetary policy and extended oversight of criminal money flows could be used to re-balance the housing investment market with the social housing needs of Australia’s citizens.

Foreign income tax offsets and discount capital gains – the Burton effect

HalfDollar

Non-residents* no longer have entitlement to the 50% capital gains tax discount (the Discount) on their Australian capital gains, save grandfathering, but the inverse isn’t true: Residents* can apply the Discount to foreign capital gains that meet the requirements of the Discount in their Australian tax.

The CGT discount

Obtaining the Discount principally requires:

  • the entity who made the gain being an individual either directly or as the beneficiary of a trust [50% discount] or a superannuation fund [33⅓% discount] : section 115-100 of the Income Tax Assessment Act [ITAA] 1997). That is the entity is not a company. Companies are ineligible for the Discount;
  • the CGT asset on which the gain is made was held for at least twelve months: section 115-25; and
  • the gain made is not otherwise treated income under the ITAA 1997. So where a gain is both assessable income and a capital gain under the ITAA 1997 the gain is not taxed as a capital gain and so the Discount cannot apply too: section 118-20.

How taxation of foreign income works

Broadly foreign capital gains are included in the Australian assessable income of a resident just as domestic capital gains are. Resident taxpayers are taxed on income from all worldwide sources: sections 6-5 and 6-10. Notable exceptions are foreign income of companies from:

  • their foreign branches with an permanent establishment in those foreign places: section 23AH of the ITAA 1936; and
  • foreign subsidiaries of Australian resident companies or where a company has non-portfolio (at least 10%) holding in a foreign company: section 768-5 of the ITAA 1997.

Foreign income, including of capital gains, of a resident is separately taxed (or exempted) under Australian tax rules even where the foreign income has been, or is to be, taxed under a foreign regime. To address the prospect of double (foreign and domestic) taxation of foreign income a foreign income tax offset (FITO) is available: Division 770 of the ITAA 1997. Australian tax on foreign income can be offset by a FITO for the foreign tax a resident taxpayer has paid, as a non-resident typically but dual tax residence is possible, in the foreign place the foreign income came from.

Double tax and double tax treaties

Australia has double (bilateral) tax treaties with many countries including all large countries and major trading partners which:

  • mutually allow source taxation of income of non-residents of each country (jurisdiction) at tax rates lower than both non-treaty rates and domestic rates on some forms of foreign income – this reduces foreign tax and, consequently the FITO needed to offset that foreign tax; and
  • provide a structure to alter domestic tax law, if need be, to prevent situations where taxpayers will be taxed in both places (double tax) on the same income.

The tax treaties reserve rights to a treaty partner to tax real estate where a taxpayer is resident in the other jurisdiction and taxation of capital gains made on the realisation of real estate, unlike typically interest, dividends and royalties, is not capped at lower rates in the treaties. Broadly this means Australian residents, as non-resident taxpayers, pay foreign capital gains taxes at rates comparable to, or even higher than, the taxes locals pay on capital gains made on foreign real estate.

It follows that foreign capital gains tax can be significant. Can this foreign tax payment be used as a FITO to offset the CGT on an Australian Discount capital gain? The FITO available to offset Discount capital gains on real estate and other investments was considered by the Full Federal Court in Burton v Commissioner of Taxation [2019] FCAFC 141.

Burton v Commissioner of Taxation

In Burton v Commissioner of Taxation it was found that 50% only of US tax paid on a capital gain made on US investments by an Australian resident individual taxpayer was offsettable against the individual’s Australian tax as a FITO.

The reason for this finding is technical but can be understood as follows:

In essence a FITO under section 770-10 of the ITAA 1997 is strictly confined to foreign income that is subject to foreign tax. Under the Discount regime in Division 115 and under section 102-5 of the ITAA 1997 only the net capital gain after applying the Discount, which is 50% in the case of a resident individual, is included in assessable income. It follows that a component of a capital gain taxed as a foreign capital gain is not taxed in Australia where the capital gain is a discount capital gain under Division 115. That is a Discount capital gain to an Australian resident individual taxable on their worldwide income that arises from a capital gain made in the US is made up of:

  • 50% that is taxed in the US which is included in Australia assessable income as net capital gain; and
  • 50% that is taxed in the US but which is not included in assessable income in Australia viz. it is exempt from tax in Australia.

The Full Federal Court confirmed that a FITO is only available in relation to the first of these 50% categories. Logan J. stated at paragraphs 84 and 86:

84. Read in context, the text of s 770-10 is, in my view, fatal to the success of the alternative foundation of Mr Burton’s appeal, grounds 1 to 4 of which challenge the correctness of the conclusion adverse to him reached by the learned primary judge in relation to the allowance of foreign tax offsets under s 770-10 of the 1997 Act. An amount of foreign tax paid only counts towards a tax offset if it was paid “in respect of an amount that is all or part of an amount included in your assessable income for the year”.

….

86. Section 770-10 looks to “an amount that is all or part of an amount included in your assessable income for the year”. The term “assessable income” is defined in s 995-1 of the 1997 Act, which is not the same as “income” as understood for the purposes of the Convention. As defined in the 1997 Act, assessable income includes “ordinary income” (s 6-5) and, materially, what is termed “statutory income” (s 6-10). One form of statutory income included in assessable income is a net capital gain included pursuant to s 102-5(1) of the 1997 Act. As a matter of ordinary language flowing from the text of s 770-10 and, in turn, s 102-5(1), it is only the net capital gain which is, in each instance, included in Mr Burton’s assessable income. Regard to ss 6-5, 6-10 and 102-5 highlights that the phraseology “included in your assessable income” is pervasive in the 1997 Act. There is no contextual warrant for construing “included in” as extending to an amount which is used for computation of an amount that is included in assessable income. The learned primary judge (at [113] – [114]) reached just such a conclusion. That conclusion was correct, for the reasons given by his Honour.

Burton v Commissioner of Taxation [2019] FCAFC 141 at paras. 84 and 86

Repercussions

This outcome is quirky and is entirely due to the laboured statutory drafting of the CGT provisions which is in part consequence of laudable efforts to rewrite and improve the Australian legislation with the advent of the ITAA 1997. If, instead, the taxation of discount capital gains had been governed by a rate set in less intelligible and obscure fine print in the Income Tax Rates Act 1986 as say 50% of the rate otherwise applicable, with that net rate to apply to the whole capital gain; then the whole of the US tax paid on the capital gain could have been offsettable as a FITO. In other words a half of the FITO would not have been lost to Mr. Burton due to the clash of legislative style with treaty terms.

But that is not the case. Accordingly Australian residents with Discount capital gains which are foreign capital gains need to ensure FITO claims in their Australian income tax return reduce the foreign tax claimed by the discount percentage to ensure no FITOs are claimed for the non-assessable/exempt component of the foreign capital gain that technically arises under the Australian CGT legislation.

*In this post resident and non-resident respectively mean resident and non-resident for tax purposes: see “resident of Australia” defined in sub-section 6(1) of the ITAA 1936.

Keeping the CGT main residence exemption when working from home

home

Only a partial exemption from capital gains tax (CGT) is available to the extent a main residence is used for an income-producing use: section 118-190 of the Income Tax Assessment Act (ITAA) 1997.

As the CGT main residence exemption is, or can be, so valuable – there is often no bigger tax break to an individual in their lifetime; an individual working in their business or their employment from a home they own will be looking to preserve the full CGT main residence exemption (MRE) where they can.

Setting the scene

For most taxpayers opportunity to claim the full CGT MRE will be straight forward. The Australian Taxation Office (ATO) website

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

re-assures a home owner simply working from home from a desk, chair and a computer that a full CGT MRE will be available where the ATO states:

Generally, when you sell your home CGT doesn’t apply. However, if you used any part of your home for business purposes, you may have to pay CGT. CGT won’t apply if any of the following occurred with your home-based business:

– You operated your business from a rented home.

– You didn’t have an area specifically set aside for your business activities.

– You operated your business through a company or trust.

You only have to pay CGT for periods when you used your home for your business.

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

But the ATO’s page isn’t the whole story. The ATO’s first dot point is so obvious that it shouldn’t be in the list but is helpful to any renters that may happen on to this page of course. The ATO’s second dot point is reassuring especially as all that is physically needed by many workers working from home is that chair, desk and computer. This derives from the distinction between homes with a place of business and those not with a place of business and how they are treated for the CGT MRE considered later in this blog. The third dot point is partly right. What about, though, where a related company or trust, which is a separate entity to an individual owning his or her home:

  • pays rent to the owner for the use of the home?; or
  • meets or helps meet the expenses of the owner of the home?

Separate entity – related company or trust

Let’s say Fred owns his own home and Fred has a related company from which Fred conducts his business from home. If the company rents a room in the home then the CGT MRE is reduced to a partial CGT exemption when Fred sells his home as:

  • Fred has earned rental income from the company, a separate legal entity; and
  • Fred will either have deducted, or could have deducted, interest on money borrowed put to the home, if any – see paragraph 118-190(1)(c) and sub-section 118-190(2);

as section 118-190 then applies.

Don’t charge rent

If Fred is the sole owner of his company then an obvious first measure of tax planning to ensure Fred keeps the full CGT MRE is for Fred not to charge rent to the company.

But where Fred charges no rent to the company this has implications for expenses like heating and cooling and other expenses Fred incurs, and has no rent to cover, when the company occupies his home for no charge and carries on its business from there remembering:

  • Fred is not entitled to deduction for the expenses of his company which is a separate entity to him and which are essentially private to him; and
  • the company is not entitled to a deduction for expenses for which Fred, rather than the company, is responsible even where the company pays those expenses (without considering fringe benefits tax implications where Fred is also an employee of the company as well as a shareholder).

Can the company instead reimburse Fred, sustain deductions for the expenses of the home it meets as business expenses and not disturb the CGT MRE position of Fred?

Legalities – a licence!

Firstly the company is, as stated, a separate legal entity to Fred. To clarify its basis for using Fred’s home, the company and Fred should document what the company can do at his home.

Secondly a document between Fred and the company under which the company can enter and use Fred’s home to run its business without paying rent to Fred is likely not a lease. It is a licence to enter the home granted by Fred and to do the things at the home which Fred allows the company to do under the licence.

Thirdly the licence terms can specify and delimit the home expenses of Fred which the company will reimburse to Fred.

Running expenses vs. occupancy expenses

The Commissioner of Taxation’s Taxation Ruling TR 93/30 Income tax: deductions for home office expenses explains two significant dichotomies:

Firstly TR 93/30 distinguishes between running expenses, being the costs of living at a home, and occupancy expenses which are the costs of owning a home. These examples are given:

Occupancy expenses –  relating to ownership or use of a home which are not affected by the taxpayer’s income earning activities (i.e., occupancy expenses). These include rent, mortgage interest, municipal and water rates, land taxes and house insurance premiums.

Running expenses – relating to the use of facilities within the home. These include electricity charges for heating/cooling, lighting, cleaning costs, depreciation, leasing charges and the cost of repairs on items of furniture and furnishings in the office.

Paragraph 6 of TR 93/30

Secondly, from the tax cases on the issue, TR 93/30 draws a distinction between an area of a home to be treated as a place of business and an area of a home which is not to be so treated. This ties back to the ATO observation in the second dot point on Home-based business and CGT implications about a part of a home specifically set aside for business activities.

Safe harbour for a full CGT MRE

To my mind a CGT MRE safe harbour for Fred would be for the licence:

  • to allow Fred reimbursement by the company for running expenses related to the use of the home by the company for business purposes; and
  • to preclude reimbursement by the company for occupancy expenses;

to Fred. Then the ATO would have no reason to treat payments by the company to Fred or payments by the company to meet expenses of the home on Fred’s behalf as either rent or as contributions to Fred’s occupancy expenses so that the CGT MRE of Fred then diminishes to a partial exemption where these payments do not exceed the applicable running expenses that Fred can recover under the licence.

On the other hand a reimbursement of occupancy expenses to Fred is an indicator to the ATO that Fred is allowing a physical part of the home itself, whether or not that part is a place of business or not based on the indicators of a place of business described in TR 93/30 (see below), to be used by the company in its business to earn income and a notional apportionment between use as a main residence and income earning leading to a diminished partial CGT MRE under section 118-195 might then follow.

Sole trader or partnership

Where the owner of the home is a sole trader, or where the owners of the home are carrying on a business in partnership, then the issue of licence to enter and use the home and reimbursement of home expenses to owners as separate entities won’t arise.

In those cases closely abiding by TR 93/30 can give home owners working from home safe harbour from a partial CGT MRE so long as:

1. the home has no place of business viz like:

the area is clearly identifiable as a place of business;

the area is not readily suitable or adaptable for use for private or domestic purposes in association with the home generally;

the area is used exclusively or almost exclusively for carrying on a business; or

the area is used regularly for visits of clients or customers.

from paragraph 5 of TR 93/30. A home-based doctor’s surgery is given as an example of a place of business in paragraph 4 of TR 93/30.

2. tax deduction claims by the sole trader or partnership are constrained to running expenses and occupancy expenses are excluded from those tax deduction claims.

ZBFF v. C. of T. – AAT finds no loophole at the heart of capital gains tax

… must be one of Wilde’s …

OscarWilde

Oscar Wilde’s quip “no good deed goes unpunished” opened Deputy President McCabe’s decision in the 2 February 2021 Administrative Appeals Tribunal (AAT) case of ZBFF v. Commissioner of Taxation [2021] AATA 275. It prefaced his introduction to the matter at hand in ZBFF: whether a good deed will go untaxed. ZBFF is an insight into the possibility of loophole, or lack of symmetry between assessable proceeds and tax allowable costs, at the heart of the capital gains tax (CGT) provisions of the Income Tax Assessment Act (ITAA) 1997. Lawyers for the taxpayer endeavoured to find what turned out to be elusive before this AAT.

A good deed for an old friend going through a divorce

The good deed for an old friend, whom the AAT referred to by the pseudonym of Mr. Green, was done by the taxpayer (the appellant), a wealthy businessman, who was willing and able to help out Mr. Green on his divorce in 2006. Rather than see Mr. Green lose his home in a divorce settlement, the taxpayer arranged for the taxpayer’s family trust (TFT):

  1. to purchase Mr. Green’s home from Mr. Green for its (2006) value; and
  2. to allow Mr. Green a right of occupancy so he could continue to occupy the home after the TFT’s purchase.

2016 sale of the home for a profit

The TFT sold the home in 2016 and the net proceeds of sale, being the sale price less the TFT’s cost of acquisition and its holding costs, were all paid over to Mr. Green.

The taxpayer and the TFT took nothing and sought to take nothing for their beneficence to Mr. Green.

Mr. Green not taxed on his windfall?

The decision doesn’t say as much, as the case did not concern Mr. Green’s affairs, but it might be presumed that Mr. Green wasn’t taxable or taxed on the proceeds of the 2016 sale (the Net Proceeds) paid over by the TFT to Mr. Green: going untaxed by virtue of the good deed:

Why might Mr. Green escape tax on the Net Proceeds he received? Mr. Green had no property interest or CGT asset in the home from 2006, and it would seem (presumption again) that the Commissioner sought not to assess Mr. Green on a capital gain based on the Net Proceeds he received from the TFT from the standpoint of either or both of CGT event D1 or CGT event H2 occurring. If there had been a capital gain the CGT main residence exemption could not have been applied by Mr. Green in the absence of his ownership interest in the home made out under section 118-130 of the ITAA 1997 from that time.

Instead the taxpayer, as the beneficiary of the TFT entitled, was assessed on an assessable capital gain on the 2016 sale.

In the dispute over this assessment of the taxpayer before the AAT the taxpayer was required to establish the terms of the arrangement with Mr. Green:

  1. which was only partly in writing, having been put to writing sometime after the arrangement was entered into, and otherwise oral; and
  2. the terms of which were contested by the Commissioner.

The AAT accepted that there was an agreement between the taxpayer and Mr. Green as contended for by the taxpayer.

Downside of leaving Mr. Green without rights to the Net Proceeds

Still the absence of a clear term in the arrangement as to what the TFT would do with the Net Proceeds (if any), after already paying the purchase price to Mr. Green back in 2006, a term that may enable the Commissioner to tax Mr. Green on his receipt of the gain; prejudiced the taxpayer who was left with a hard road to establish that the taxpayer, as a beneficiary of the TFT, wasn’t taxable on the Net Proceeds to the TFT unreduced.

The evidence before the AAT was that Mr. Green was willing to let the TFT retain the profits on a later sale, viz. retain the Net Proceeds, but, in the event in 2016, the TFT opted not to retain them. It could be inferred that the payment over of the Net Proceeds to Mr. Green following the sale in due course was a gift to Mr. Green of an amount the TFT was otherwise entitled to keep.

The hard road

Still the taxpayer contended before the AAT that the payment of the Net Proceeds to Mr. Green was a cost to the TFT which:

  • increased the TFT’s cost base of the home;
  • reduced the capital proceeds to the TFT from the 2016 sale; and/or
  • caused the TFT to make an off-setting capital loss;

or, alternatively was a cost to which a deduction under section 40-880 of the ITAA 1997 could be applied by the TFT.

The taxpayer asserted that the payment of the Net Proceeds was fifth element expenditure “to preserve or defend your ownership of, or rights to” the CGT asset which could be included in the CGT asset’s cost base in accord with sub-section 110-25(6) of the ITAA 1997. A difficulty for the taxpayer with his fifth element argument was that the danger identified, supposedly necessitating that the TFT defend its title to the CGT asset, was the equitable interest in the CGT asset Mr. Green might have or assert under his arrangement/agreement with the taxpayer. The AAT rejected this argument as the taxpayer could not establish any interest in the home that Mr. Green might plausibly have.

The AAT disposed of the taxpayer’s other technical arguments that somehow the payment of the Net Proceeds should be allowed to/offset by the TFT to reduce the net capital gain. Some arguments of the taxpayer relied on the taxpayer’s questionable position, given the context of the good deed, that the taxpayer was dealing with Mr. Green at arm’s length.

The arm’s length obstacle

The AAT preferred the Commissioner’s contention that the parties were not dealing at arm’s length, with paragraph 112-20(1)(c) of the ITAA 1997 applicable to include market value, rather than amounts actually paid to Mr. Green, in the TFT’s cost base of the home.

The taxpayer’s contention that section 40-880 applied failed as the taxpayer could not establish, from evidence put to the AAT, that the TFT was carrying on a business and that there was any nexus between the payment of the Net Proceeds and that business.

Symmetry prevails

The taxpayer was hopeful for a mismatch or lack of symmetry between:

  1. those provisions relating to CGT events in the ITAA 1997 that bring capital proceeds into net capital gains and into assessable income in section 102-5 of the ITAA 1997 and then to tax that presumably did not apply to Mr. Green’s receipt of the Net Proceeds on the one hand; and
  2. the provisions which would reduce the assessable capital gain to the TFT on the other hand;

in pursuit of a reduction in the amount of the Net Proceeds assessable to him as a net capital gain by the amount of the TFT’s payment of the Net Proceeds.

According to the AAT in ZBFF the symmetry holds. The payment of the Net Proceeds by the TFT was indistinguishable from a gift by the TFT to Mr. Green in the tax law analysis. Mr. Green may not have been assessable on the gain reflected by the Net Proceeds but the taxpayer/TFT was.

Will the taxpayer, a wealthy businessman who can afford to appeal, appeal to the Full Federal Court?

Determining the AAT fee on a tax appeal to the AAT

The applicable fees to appeal

Unless a taxpayer is disadvantaged and qualifies for a concessional $100 fee – see our blog post: Small business now has its own dedicated taxation division of the AAT at https://wp.me/p6T4vg-dx, fees for review of the Commissioner of Taxation’s decisions reviewable by the AAT are now:

  • $952 for review by the Taxation & Commercial Division; and
  • $511 for for review by the Small Business Taxation Division (SBTD).

These fees have gone up since our blog post in March 2019.

Who can appeal to the SBDT?

As explained in our earlier blog post, appeal to the SBTD is available where the appellant is a small business entity under section 328-110 of the Income Tax Assessment Act (ITAA) (C’th) 1997.  A small business entity is an entity (see section 960-100 of the ITAA 1997) carrying on business with an aggregated turnover of less than $10 million in an income year.

Multiple decisions – single fee on an applicant

Where the appeal is against more than one decision that relates to the appellant, the AAT can allow appeals to be dealt with together so only one fee applies. For instance, if a taxpayer is appealing against decisions to disallow a series of objections against multiple assessments of tax across multiple tax periods then the AAT can apply a single fee.

The AAT also allows for a single fee to be imposed on an “organisation” rather than separately on each of the members of the organisation applying to appeal.

Partnership CGT SBDT appeal

We have a client seeking review of objections against multiple assessments of income tax in the SBTD. The client is a partnership under State law (viz. a general law partnership carrying on business) and is a section 328-110 small business entity eligible to appeal to the SBTD.

The appeal concerns decisions by the Commissioner to disallow objections by the partners against income tax assessments seeking reduction in amounts included as assessable net capital gains to the partners in a series of income years.

Net capital gains made on partnership assets are assessed as income to the partners individually in a partnership. That is capital gains on partnership assets are not included in partnership income nor are they included in a partnership’s income tax return.

Soon after the introduction of capital gains tax (CGT) in September 1985 to include capital gains in assessable income it became apparent that it was impractical to assess partnership capital gains as partnership income to partnerships. Not only is a partnership not a legal owner of partnership property, and thus not apparent as the entity against which to assess a gain on a CGT asset, partnership property is often not owned by partners in the same names or proportions as partners share in the income and losses of the partnership.

Should a single fee have applied to the partnership?

The treatment of a partnership as an entity for some purposes, but not for others, can be confusing. It is via the small business entity regime that our client, a partnership, qualifies as a small business entity and this also impacts how the capital gains on partnership assets in dispute are assessed to the partners. The partnership is an “organisation”. Should a single fee apply to appeals by all of the partners of the partnership relating to the partnership asset CGT issues which are in common to all of the partners?

For the moment the AAT Registry say no. The AAT Registry has sought the $511 fee from each of the partners and has raised the appeals as separate cases (at odds with how the Australian Taxation Office dealt with binding private ruling applications and objections from the client in substance). The AAT Registry have raised the prospect that partners can seek to have their cases combined into one case and can seek a refund of the further instances of the $511 fee at a later point in the proceedings.

If the client is successful in obtaining a refund of the additional $511 fees we will update this story with a comment below.

Offshoring of non-resident capital gains – the India experience of Vodafone and Cairn Energy

LotsOfRupees

Two Indian tax cases that have now largely run their course illustrate difficulties faced by countries determined to tax major economic activity in their own territory by non-residents.

India stands out as a rare jurisdiction determined to tax major foreign investors that greatly gain from economic activity there.

The cases show how difficult it can be to prevent profit shifting to tax havens, such as the Cayman Islands which features in each of the cases considered in this blog. The Cayman Islands is a haven of financial secrecy with no direct resident taxation of companies that can attain Cayman resident status.

The Indian cases have comparable facts and have followed a similar course:

Vodafone

In 2007 Vodafone Group PLC (British) sought to re-organise its nationwide telecommunications business in India. So Vodafone International Holdings BV (VIHBV) acquired the share capital of a Cayman Islands holding company from Hutchison Telecommunication International Ltd giving Vodafone Group PLC 67% control of Hutch Essar, an Indian joint venture company that owned the business’s Indian telecommunications licences.

A “crore” is 107. The Indian Income Tax Department sought to tax VIHBV on a capital gain of around Rs 12,000 crore with penalties on the transfer of telecommunications licences, the capital assets of the Indian business, re-organised between non-residents.

Cairn

In 2006-7 Cairn Energy PLC (British) re-organised the largest privately owned oil and gas business in India by transferring its shares in Cairn India Holdings, a Cayman Islands company to Cairn India, an Indian company.

In 2011 Cairn India merged with Vedanta Resources, another Indian mining conglomerate. The Indian Income Tax Department sought to tax a capital gain of around Rs 24,500 crore on these transfers of the capital assets of the Cairn India business.

Source taxation

The capital gains reflected growth and the increase in value in Indian-based business assets. India sought to subject these Indian-based gains to taxation based on their source in India.

Vodafone contested their assessment and was successful before the Supreme Court of India. The Supreme Court found that the Indian Tax Department couldn’t tax VIHBV, a non-resident, on gains it realised in the Vodafone re-organisation as there was no relevant capital asset of VIHBV of, or facilitation of a look-through to a capital asset in, the Indian Income-tax Act 1961 in its pre-amendment version.

Following that loss in the Supreme Court the Indian government amended the Income-tax Act 1961 with the Finance Act 2012 to retrospectively target indirect gains made by non-residents on realisation of Indian capital assets. Section 9(1)(i) of the Income-tax Act 1961, with retrospective effect from 1961, treats income in the nature of capital gains from the direct or indirect transfers of Indian capital assets between non-residents as Indian-sourced income.

The retrospectivity was justified as a “clarification” of how the Indian tax law is to apply but the impact of the amendment suggest this government descriptor was euphemistic.

Comparison with Australian tax on indirect gains on non-residents’ assets

There is no comparable between Section 9(1)(i) of the Income-tax Act 1961 of India and the Australian and most other taxation systems where source taxation of gains on moveable assets made by non-residents is generally not pursued unless the non-resident has a direct interest in an asset used in a local business permanent establishment.

Australia has conformed with OECD model treaty conventions, and so most Australian treaties are based on, or are comparable to the OECD model convention which provides:

4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State.

Article 13(4) of the OECD model convention

This substantially confines when Australia and these other places will tax non-residents on their disposals of shares in companies. That is the source country only taxes gains on shares of a non-resident who is resident of the other treaty state where shares reflect immovable interests such as in real estate, mines, forests, fisheries etc.

The rationale of the confinement, as I understand it, is to avoid double and multiple taxation arising when countries tax dealings by non-residents outside of, or with no connection to, their own country especially understanding the country where a person is resident is expected to tax the person on their worldwide income. But the confinement in Article 13(4) and the like excludes the right to tax indirect gains enjoyed by non-residents on movable property that does have a true connection with the country such as the movable business property in India of Vodafone and Cairn owned by Cayman Islands companies.

So these treaties don’t concede rights to countries to tax a non-resident to gains on shares reflecting growth in capital assets used in a local business realised indirectly through a sale of company shares of the non-resident. Instead that right to tax is ceded to the treaty partner where the owner of the shares is tax resident in that other country.

Comparison with taxes on business profits under OECD-like treaties

This is in contrast to business profits with a source in, say, Australia where Australia has first right to tax non-residents under OECD model-like articles when a non-resident, though tax resident in the other treaty country, has a permanent establishment in Australia.

In other words Australia, like many other countries but unlike India, generally does not pursue source income taxation of gains on Australian assets of non-residents made outside of a business permanent establishment. Capital gains on Australian assets realised by non-residents, and not just treaty partner residents, that are not Taxable Australian Property (I capitalise this defined term in the Income Tax Assessment Act (ITAA) 1997) are not subjected to the Australian CGT regime under Division 855 of the ITAA 1997 though capital gains of non-residents made on Taxable Australian Property which extends to:

  1. immovable real estate, mines, etc. and interests in them – see section 855-25 of the ITAA 1997: that is, indirect interests in these too are Taxable Australian Property, and options to acquire them; and
  2. assets that are business assets used in permanent establishment though:
    • inclusion of permanent establishment business assets in Taxable Australian Property can be subject to treaty constraints; and
    • indirect interests in business assets used in permanent establishment are not included in Taxable Australian Property;

(see the table in section 855-15 of the ITAA 1997;)

are subject to Australian CGT.

The limits on non-residents relying on treaty protection to resist Australian tax on indirect capital gains are also evident in Australia in Resource Capital Fund IV LP v Commissioner of Taxation [2019] FCAFC 51 which again featured the Cayman Islands. The Full Federal Court found that a Cayman Islands limited partnership with U.S. resident limited partners could not invoke Article 13 in the Australia USA Double Tax Treaty to prevent Australia taxing capital gains on sales of shares in a limited partnership (treated as a company under Australian tax law) which held interests in immovable mining assets in Australia.

Australian opportunities for non-residents and tax havens

Where Australian shares or other business assets aren’t or don’t reflect interests in immovable property or direct interests in permanent establishment assets (other than Taxable Australian Assets in Australia’s case) then Australia and other OECD member states generally don’t look to tax non-residents on gains on them say by imposing withholding taxes to assure collection from non-residents.

It follows that these countries give non-residents based in low-tax jurisdictions, or non-residents who structure their holdings through tax havens, much opportunity to invest in movable Australian assets including brands, digital assets, designs, licences, other intellectual property and goodwill on a virtual CGT free basis.

It is known that the rather extreme minimal or zero tax outcomes these non-residents can access by offshoring their interests are a principal driver of “private equity” opportunities where restructure into, or using, either genuine or contrived non-resident ownership is a common feature.

Desirable destinations for foreign investment

Australia and other OECD nations supposedly encourage and compete for foreign investment by their light touch of capital gains on moveable property connected to local business which non-residents can realise their interests in offshore. Patent boxes, conduit foreign income exemptions, CGT participation exemptions come to mind as light touches on non-residents onshore.

Clearly, and rather dramatically, the Indian government is not so willing to give up the huge tax revenue at stake although there is awareness in India about the impact of their policy of pursuing non-residents for taxes on India-generated capital gains on India as a desirable destination for foreign investment.

The retrospectivity stumbling block

India also tried to introduce General Anti Abuse Rules (GAAR) in 2012 to retrospectively attack the Vodafone and Cairn arrangements however India was not able to implement their GAAR until 2018-19.

The retrospective elements of Section 9(1)(i) of the Income-tax Act 1961 and the proposed GAAR are controversial and the retrospective application of Section 9(1)(i) by the Indian Tax Department, especially with the imposition of penalty, now appears to be its stumbling block in its pursuit of Vodafone and Cairn.

Both Vodafone and Cairn have lately been able to rely on international treaties (not tax treaties) to resist Indian taxation under the retrospective law on the basis that imposition of the retrospective law was unfair and inequitable.

Treaty arbitration

India and the Netherlands entered into a Bilateral Investment Treaty in 1995. In the Vodafone case VIHBV obtained an order against the Indian government for violation of the treaty at the Permanent Court of Arbitration (The Hague, Singapore seat) as the tax, interest and penalties assessed to VIHBV under retrospective legislation violated the fair and equitable treatment of Dutch investment required under the treaty. Simply stated VIHBV was held to account against a tax law that was not in place at the time it undertook Vodafone India re-organisation and when VIHBV would have returned its income in India.

In December 2020, three months after the Vodafone arbitration, Cairn obtained a similar arbitrated order under a similar Bilateral Investment Treaty between the UK and India.

The Indian government can still pursue rights under these treaties to appeal to the High Court in Singapore however they will be aware that this court will be reluctant to disturb Permanent Court of Arbitration findings. Nevertheless it is surprising that both arbitrations treated the Vodafone investment as Dutch and the Cairn investment as British respectively even though the investments in India in both cases were by Cayman Islands entities presumably outside of the coverage of these bilateral investment treaties.

Conclusion

It seems clear enough that countries with the will and fortitude to do so, like India, can impose tax laws which bring gains on offshore holdings of non-residents which indirectly reflect or look through to gains on onshore capital assets used in local businesses to local tax. However these countries will be pitted against powerful interests willing to structure through tax havens and keen to resist taxes relying on any weakness in the imposition of their tax collecting law.

In that context legislation that takes effect retrospectively, even where effective under local law, is a serious flaw in the international treaty domain. Further, like in the Vodafone and Cairn cases, these countries may find tax pursuit of non-residents stymied by:

  1. treaty commitments;
  2. international norms largely set and dominated by the OECD nations; and
  3. reputational risk that the country does not welcome foreign investment;

with tax havens like the Cayman Islands and others ever ready to facilitate offshore realisation of gains effectively tax free for their clients.

Aggregating for dual $6m MNAV tests following 2018 small business CGT concession integrity changes – with the aid of chess!

ChessPieces

Those seeking the small business capital gains tax (CGT) concessions in the 2018 and later income years need to be wary of modified small business CGT concession integrity rules which apply from 8 February 2018 by virtue of Schedule 2 of the Treasury Laws Amendment (Tax Integrity and Other Measures) Act 2018 (TIOMA).

The small business CGT concessions in Division 152 of the Income Tax Assessment Act (ITAA) 1997 may look straight forward but there are subtle complications within the misnamed “basic” conditions for the relief which can be matrixlike. The small business CGT concessions are generous so perhaps it is right that rules to protect their integrity, as ramped up by the TIOMA, are more complicated than the rules that ordinarily impose a CGT liability on sales of small business related CGT assets.

Share or interest sales need to meet additional basic conditions

For CGT events involving sales of shares in companies or interests in trusts “additional” basic conditions have commenced with the TIOMA. The additional basic conditions go further than what I describe here. In this post I wish to focus on the significance of the dual $6m maximum net asset value tests that the TIOMA initiates. So in the below considerations I am going to assume that the other basic conditions for the small business CGT concessions, including the additional basic conditions, such as the dual active asset test, which also needs to be considered following the introduction of the TIOMA, will be met.

The dual MNAV and SBE tests

The dual $6m maximum net asset value (MNAV) tests are alternative tests with the similarly dual small business entity ($2m aggregated turnover) (SBE) tests which apply where the small business CGT relief is sought on a sale of shares in a company or an interest in a trust. The dual MNAV tests and SBE tests separately test both the taxpayer (“you”) and the object entity which is the relevant company or trust in which the shares are or interest is held by the taxpayer as the case may be. To obtain relief under the basic conditions, and under the additional basic conditions set out in sub-section 152-10 as revised by the TIOMA, the dual tests must be separately satisfied to obtain any small business CGT concession relief:

Taxpayer must satisfy AND Object entity must satisfy
MNAV test or SBE test   Modified MNAV test or SBE test and carried on business up to day of sale

When the object entity MNAV test becomes vital

In practice, there is a significant slew of sales of shares or trust interests where the object entity won’t satisfy the SBE test because of:

  • an aggregated annual turnover of the object entity of more than $2 million; or
  • alternatively, the object entity may satisfy that SBE test but paragraph 152-10(2)(a) may apply because the object entity ceased to carry on its business some time before the sale.

In those cases the object entity also needs to satisfy the MNAV test even where the taxpayer has separately satisfied either of the MNAV test or the SBE test or both.

Satisfaction of the MNAV test by the object entity may thus be vital to the availability of the small business CGT concessions to a taxpayer selling shares or a trust interest. Where the object entity, let us say a private company with multiple owners, is worth more than $6m overall, this may well be a problem for minority owners who otherwise are:

  • on or over the 20% significant individual/CGT stakeholder threshold; or
  • with net asset value (NAV) under $6m who sell their shares looking for the small business CGT concessions.

The Explanatory Memorandum with the TIOMA gives the following example:

Example 2.4: Investment in large business

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year. Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019 CGT assets exceeds $100 million throughout this period. On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

MNAV test complexities

Like the SBE test with aggregated turnover of the taxpayer, affiliates and their connected entities, compliance with the MNAV test relies on, or more specifically NAV (net asset value) must stay under the relevant $6m limit after, aggregation.

Before aggregation is considered there is a flip side: the exclusions from the MNAV test: The substantial exclusions are confined to individual taxpayers viz. interests in an individual’s main residence, personal use assets, superannuation and insurance: section 152-20 of the ITAA 1997. The other exclusions in this section are largely to prevent accounting anomalies with:

  • accounting provisions; and
  • the double counting of the value of an asset indirectly held in an entity and the value of the stake in the entity including the asset, representing the same value, in NAV.

Liabilities are also excluded from NAV where they relate to assets so the MNAV test can be a maximum net asset value test.

The value of assets that are not excluded are tallied in NAV when applying the MNAV test. Then aggregation must be done. Just like with the complexity of small business CGT concessions integrity more generally, MNAV tests and sometimes qualification for the concessions, involve a hierarchy of constructs which, for the purposes of illustration, can be loosely compared to the pieces on a chessboard one’s opponent in chess may hold:


Chess piece: King

Div 152 construct: The taxpayer

Comment: If the King falls, it’s game over. If either NAV of the taxpayer or (modified) NAV of the object entity exceeds $6m in each required MNAV test the basic condition is failed unless there is a pathway to compliance through the SBE test as described above.

Chess piece: Queen

Div 152 construct: An affiliate

Comment: Although an affiliate is not the taxpayer (or object entity), the NAV of the affiliate also counts/aggregates to the taxpayer (or object entity) when applying the MNAV test to the taxpayer (or object entity), in all directions including NAV aggregated from connected (and Oconnected in the case of an object entity – see below) entities of the affiliate.

Chess piece: Bishop

Div 152 construct: Connected entities

Comment: The whole of the NAV of the connected entity (excluding the exclusions described above) counts in the MNAV test. So if a taxpayer, or an affiliate, has a stake of 50% in a connected entity X, all (100%) of X’s net value is aggregated to the taxpayer’s NAV (including NAV relating to the stake in X of minority stakeholders unrelated to the taxpayer or affiliate). If Y is a connected entity of X then aggregate all (100%) of Y’s net value to the taxpayer’s NAV too.

Chess piece: Knight

Div 152 construct: Oconnected entities

Comment: The Oconnected entity (my terminology – I thought of using “controlled entity” which is in contrast to a connected entity which can either control or be controlled by the other entity it is connected to. But controlled entity is misleading for, as we shall see, only a 20% stake, hardly control in any sense, is needed to trigger this link) is a new construct introduced with the additional basic conditions in the TIOMA relating to the object entity.

The NAV of a Oconnected entity is aggregated to the NAV of the object entity but it is look through forward to aggregate and not look through back too (unlike “controlled by the other entity” which can connect too to a connected entity). An example is needed to explain constructs here: So if O, an object entity controls Q an Oconnected entity, due to a 20% or greater stake in Q, and P is another unrelated stakeholder in Q; the value of Q owned by P is included in the NAV of Q aggregated to O (see the outcome of that in the below Example 2.5 drawn from the Explanatory Memorandum) but the NAV of P and its connected entities is excluded from the NAV of O (if they are not separately affiliated/connected to O).

In chess the Knight moves in a weird way so the Knight is the allegory chosen here!

Chess piece: Pawn

Div 152 construct: Asset or investment of the above

Comment: A pawn generally moves one space in chess. $1 in value of an asset or investment owned by a taxpayer or object entity, which is not excluded, counts $1 to the NAV of the taxpayer or an object entity.  $1 in value of an asset or investment owned by affiliates, connected entities and Oconnected entities, which are not excluded, count $1 to the affiliate, connected entity and Oconnected entity, as the case may be, but if that NAV is in an affiliate, a connected entity or a Oconnected entity of the taxpayer or object entity in applying the dual tests, the whole NAV of the relevant entity is aggregated to the taxpayer/object entity, not its proportionate NAV based on percentage stake. i.e. A percentage stake is only used for an interest in an entity where the entity the interest is held in is not an affiliate, connected entity or, in the case of the object entity MNAV test, an Oconnected entity.

I don’t play chess and I accept my chess analogy with the workings of the MNAV tests is far from perfect. My endeavour is to make this consideration of the hierarchical workings of the MNAV tests a little more comprehendible and so, perhaps, if you are still reading by this point I have succeeded? If the comparison with chess conveys:

  • that counts of over $6m by either of the taxpayer NAV or the object entity NAV will generally mean failure of a basic condition for the Division 152 CGT relief so can lead to loss of the game; and
  • that high value pieces accelerate aggregation of NAV to the $6m limit. That is they can move more than one space: every $1 of a stake a taxpayer (or object entity) in a connected entity (or Oconnected entity), and affiliates and their connected entities without needing any stake in the affiliate of the taxpayer (or object entity) will generally aggregate more than $1 to NAV as the value of others’ stakes in these entities will count to the NAV attributed to the taxpayer (or object entity) too.

The modified MNAV test of the object entity & the modified Oconnected entity

The NAV for controlled entities of an object entity is different due to sub-paras 152-10(2)(c)(iii), (iv) & (v) in the TIOMA:

The threshold between unrelated entity, counted simply as an asset or investment (pawn) to NAV and connected entity (bishop) consistent with other tests of control in the ITAA 1936 and the ITAA 1997 is 40% with a discretion given to the Commissioner where:

  • there is 40% or over and under a 50% stake; and
  • it can be established to the Commissioner that some other entity controls the entity that would otherwise be the connected entity.

In practice this means expect the Commissioner to de-connect A from connection with X if A owned 48% of X and B (unconnected to A) owned 52% of X.

When applying the object entity MNAV test, sub-paras 152-10(2)(c)(iii), (iv) & (v) have operation so that the threshold is lowered to a 20% stake in the other entity. That is enough “control” to make the other entity, otherwise an asset or investment, an Oconnected entity (knight). This is apparent from another example in the Explanatory Memorandum with the TIOMA:

Example 2.5: Indirect investment in large business

Tien owns 20 per cent of the shares in Investment Co, a company that carries on an investment business. Investment Co is a CGT small business entity (according to the general rules) for the 2020-21 income year. Investment Co holds 20 per cent of Van Co, a transport company. Van’s assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year. On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition. For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van.

As stated in the table above there is no look through back so in a case where an object entity has a stake of 21% of X, the NAV in entities connected to X by virtue of the remaining 79% stakes in X are excluded from the object entity NAV although the NAV of the assets of  X, including that relating to the other stakeholders, counts to the object entity NAV.

The discretionary capital distribution – it’s a CGT free gift!

giftAnnual income distributions by family discretionary trusts (FDTs) are routine for trustees for apparent Australian income tax reasons but trustees of FDTs can be reluctant to distribute trust capital. What would be the reason for that reluctance? Why don’t trustees of FDTs make capital distributions more often?

The trust deed

The regime in a FDT deed typically centres on distribution of capital on the vesting of the FDT. However even older and archaic FDT deeds usually expressly allow for interim distribution of capital, that is, distribution of trust capital before the FDT vests and winds up. Interim distribution of capital to beneficiaries, rather than holding it for them until the vesting day, is often conditional on the distribution being for the “maintenance education advancement in life or benefit” either for infant  beneficiaries or for beneficiaries generally – see Fischer v Nemeske Pty. Ltd. [2016] HCA 11: a condition which, in ordinary family dealings, can readily be met.

Purpose of a FDT

A FDT is, in its essence, an arrangement to benefit family members. A FDT can be seen as a pool set aside to gift to family members. But is a distribution to a family beneficiary from a FDT treated the same for tax as a family gift to a family member?

It is useful to think about differences between a FDT and other types of entities before answering that:

Difference to a proprietary company

A proprietary company has the legal status of a separate person and the release of company capital to a shareholder of a company is subject to a number of corporations law and tax technicalities. A company can have wide objects but giving its value away to other persons would not usually be one of them. Under tax rules the enrichment of a shareholder’s family member from a company’s capital is likely dividend income assessable to income tax either directly or as a “payment” under section 109C of the Income Tax Assessment Act 1936.

Difference to a unit trust

A trustee of a genuine unit trust would generally be required to make capital distributions in equal proportions based on the unit holdings of unit holders. If capital distributions from a unit trust are feasible the capital gains tax (CGT) rules can discourage the trustee from making these distributions before vesting.  CGT event E4 applies to distributions of capital of a unit trust which are not in connection with the disposal of the units to reduce the cost base of the unit holder by the amount of the distribution and, to the extent the cost base doesn’t cover the amount of the distribution, the excess is a capital gain assessable to unit holders.

How CGT applies to distributions of capital by FDTs

CGT event E4 does not apply to non-assessable capital distributions from a FDT. In Taxation Determination TD 2003/28 Income tax: capital gains: does CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 happen if the trustee of a discretionary trust makes a non-assessable payment to: (a) a mere object; or (b) a default beneficiary? the Commissioner of Taxation confirms his longstanding view and practice, since the introduction of CGT in 1986, that CGT event E4 does not happen if a trustee of a discretionary trust makes a non-assessable payment to a mere object. That is, a mere discretionary beneficiary where the entitlement to the payment arose because the trustee exercised its discretion in the beneficiary’s favour and the interest was not acquired by the beneficiary for consideration or by way of assignment.

The CGT similarity of FDT cash distributions and cash gifts

The enrichment of a family beneficiary of a FDT by an interim distribution of the capital of a FDT is not, of itself, subject to CGT based on TD 2003/28 i.e. there is no CGT on a distribution of cash to a beneficiary from the capital of a FDT. If there is a distribution of a CGT asset from the capital of a FDT to a beneficiary that is a different story. CGT events E5 and E7 can apply to subject the realisation of the CGT asset by the FDT to a family beneficiary to CGT (see sub-sections 104-75(3) and 104-85(3) respectively of the Income Tax Assessment Act 1997 which visits the CGT event on the the trustee of the trust – sub-sections 104-75(6) and 104-85(6) generally enable the beneficiary of a FDT to disregard a capital gain or capital loss under either of these CGT events where the beneficiary acquired the asset within the trust without incurring expenditure viz. on a capital distribution by the trustee the beneficiary is treated only as the acquirer of the asset for CGT purposes).

But there is no fundamental difference between a distribution of a CGT asset from the capital of a FDT, and the CGT events that apply to it, and how a family gift of a CGT asset by an individual is treated for CGT. That is, a gift of cash is CGT free and a gift in the form of property that is a CGT asset is subjected to CGT: not because of the gift but because a CGT asset is being realised and the CGT regime brings gains in value on a CGT asset to tax on a change of ownership.

So cash distributions of capital by a FDT, where permissible under a trust deed of a FDT, can generally occur, either with income year end income distributions or at other times during the currency of a FDT, without income tax consequences.

However there is a problematic exception:

Small business CGT concessions participation percentage

Under item 2 in the table in section 152-70 of the Income Tax Assessment Act 1997 the “small business participation percentage” of a beneficiary of a FDT is the smaller of the percentages of the beneficiary’s entitlement to income and the beneficiary’s entitlement to capital in an income year if both income distributions and capital distributions are made in that year. Generally beneficiaries are better off qualifying for a sufficient small business participation percentage to qualify for the concessions if no distribution of capital, or no divergent distribution of capital (bearing in mind that a capital gain on an active asset distributed by a FDT is likely to have a capital component), has been made in the income year the relevant capital gain has been made in to some other beneficiary.

So if a capital gain arises to a FDT in an income year which can attract the small business CGT concessions in Division 152 of that Act, then a distribution of the income in that income year substantially to family member A, including entitlement to a capital gain, may not count or count sufficiently in the measurement of small business participation percentage where a cash distribution of capital has been made to family member B and not family member A who is left with a “smaller” participation percentage. It could be that family member A may thus not qualify as a significant individual or as a CGT concession stakeholder without the sufficient interest in capital distributions of the FDT in the relevant income year in which the capital gain was made.

So a trustee of FDT needs to be wary of cash distributions of capital from a FDT and, indeed, the streaming of capital gains where there has been a capital gain that can attract the small business CGT concessions to ensure that the desired beneficiaries have sufficient entitlements to capital that can attract the concessions. If the small business CGT concessions participation percentage is not in issue a cash distribution from from the capital of a FDT to a beneficiary can be a tax benign.

Bringing trusts to a timely ending

MovingOnEnding a trust is straight forward, isn’t it? Vest all interests in the trust in beneficiaries and make the right accounting entries and the trust is terminated? Not quite.

That word “vest”. What does it mean? Vest is a technical legal term. Broadly it means to imbue with ownership of property. So, when a trust ends and the property of the trust vests, the beneficiaries of the trust succeed the trustee of the trust as entitled to the property in the trust.

But not all trusts end that way. For instance a unit trust or an unpaid present entitlement may already be vested in a beneficiary or beneficiaries. Clearly something other than vesting is needed to bring trusts of that type to an end. In those cases property that has already vested in beneficiaries may need to be paid to or put in the possession of the beneficiaries too for the trust to end.

Ending is all in the timing

In most states and territories of Australia trusts must vest within a statutory perpetuity period, typically 80 years. From this point this post relates to jurisdictions where a statutory perpetuity period applies.

Trusts that are fully vested, such as bare trusts, fixed trusts, some sorts of unit trusts and “indefinitely continuing” superannuation funds may continue for longer than the perpetuity period. A discretionary trust must vest no later than the perpetuity period, that is, discretions to distribute all income and capital of the trust must be taken and sunset once the time for vesting has been reached otherwise it will be too late and the formula for distribution for “takers-in-default” set out in the trust deed will apply to the property then left in the trust. The divesting of those interests, which are then held by the trustee outright for those beneficiaries, by payment over to, or at the direction of, the beneficiaries, can happen later after the expiry of the perpetuity period.

Bringing forward the ending of a trust

The trust deed should also set out how the time for vesting can be brought forward from the expiry of the perpetuity period. That time of expiry will usually be the “default” time for vesting, or a time just before it, (the last vesting time) in a well-crafted discretionary trust deed.

An objective of winding up a trust is to satisfy all parties with interests, in the wider sense,  in the trust, including creditors, trustees, beneficiaries and the Commissioner of Taxation.

Failure to address these interests of the parties interested, or the trust deed requirements and formalities for the bring forward of the time of vesting, can mean that the trust, or its aftermath, will remain a matter in contention or dispute which is diametrically not what a trustee will want to occur following their effort to bring the trust to an end. A trustee can face difficulty in the converse case too where a trust is inadvertently brought to an end prematurely. In other words trustees can face problems where a trust has a mistimed ending either way. A trust may go on longer than planned or it may be inadvertently brought to an end before the trust should end. An example of the latter is to be found in trust deeds which set an inexplicably early time for vesting many years prior to the expiry of the perpetuity period.

Ending by depletion and merger

Depletion and merger are two other ways a trust may be brought to an end even where the intent of the trustee and beneficiaries is, and the trust deed may suggest that, the trust is to go on for longer.

Depletion is where the trustee no longer holds property on trust. If trust property is depleted and the trustee acquires more property on trust, the arrangement is treated as a new and separate trust. A “resettlement” occurs as well as likely confusion about which trust is which. Hence the device of a “settled sum” for a discretionary trust, which remains as trust property, to ensure continuity of the (original) trust even where the trust is in deficiency and has no other identifiable property.

Merger also brings a trust to an end in an untimely and premature way. Merger occurs where the trustee and the beneficiary are or become the same person. In the case of a merger the trust obligation of the trustee under the terms of the trust is no longer owed to the beneficiary so the trust does not continue.

Merger and SMSFs with individual trustees

Merger can be an interesting issue in the case of a self managed superannuation fund with individual trustees. There is no merger while the fund has two trustees: Trustee A has trust obligations to member B and trustee B has trust obligations to member A. However if a trustee/member dies and the surviving sole trustee is also the sole member of the fund with a fully vested beneficiary account of the entirety of the fund, the fund likely merges. It follows that the fund is no longer a trust. The Commissioner of Taxation has not addressed how the doctrine of merger may apply in these cases, and, as I understand it, the Commissioner treats a fund in this situation as continuing on as a matter of administrative convenience. If the Commissioner’s approach, which may be tantamount to a recognition of a self managed superannuation fund that is not a trust, came before the courts, it is unclear how it might be explained or permitted.

Some starting points

Trusts that require winding up usually commence by and are governed by a trust deed. I am not writing here of testamentary trusts. A trust deed will usually state the requirements to wind up the trust including how the time of vesting must be brought forward. A trust deed may also provide for other things which complicate vesting or winding up, or both. The trust deed may require that a party’s consent is required before either can happen. There may be other forerunner steps which haven’t been taken which must be taken before the trust can vest under the deed. A grasp of the design or method of the trust provisions in the trust deed will build confidence that all requirements for a winding up raised in a trust deed have been identified and addressed.

If the accounts of the trust have been correctly prepared then the current balance sheet, in particular, gives a list of activity to be addressed before the trust can be wound up. For a company liquidation, liabilities need to be satisfied with the balance of assets (property) distributed to owners. Trusts are no different. The more assets have been converted to cash and liabilities have been met the simpler the contemporary balance sheet and the winding up will be.

Tax planning

The conversion of assets to cash can give rise to taxable capital gains and assessable balancing charges but the alternative, their distribution to beneficiaries on a winding up inevitably does so too. It is generally simpler or more tax effective, or both, if these CGT events are contemporaneous with the trust coming to an end.  In the cases of a fixed trust or a unit trust CGT event E4 can occur where a non-assessable part of a capital gain is distributed to a beneficiary when the interest of the beneficiary in the capital of the trust persists.

Errors frustrate the ending

Correct accounting in the trust will follow correct treatment of interests, assets or liabilities in the trust by the trustee. But correct treatment of interests, assets or liabilities doesn’t always happen. Notable examples where correct treatment doesn’t happen include:

  • the elimination of entitlements of family beneficiaries in the course of a winding up. Trustees of discretionary trusts distribute trust income to family members on lower tax rates (A) which remains unpaid and which is treated in the accounts of the trust as an unpaid present entitlement under terms in the trust deed. On winding up the distribution may revert to or may be paid to the principals of the family (B) instead without explanation. That suggests that the present entitlement of beneficiaries to former income of the trust was a sham or misunderstood with potential tax liability for the trustee;
  • distribution in the course of a winding up to individuals where the trust holds money or property sourced from a private company to which Division 7A of the Income Tax Assessment Act 1936 applies. This may be inconsistent with repayment of the money or property to the relevant company and could trigger a “deemed dividend” tax liability; and
  • backdating and forgiveness of loans – it can be tempting for a trustee to purge debts to related parties in the accounts of a trust but the purge is unlikely to be legally effective. A more nuanced treatment, which actually addresses the nature of the original transaction, is more likely to be accepted.

The Commissioner of Taxation investigates, audits and challenges trusts and the parties involved in these kinds of errors including after a winding up.

Conclusion

The affairs of trusts vary greatly and some have deeply intransigent issues. Getting a trust ready to wind up, and executing that wind up at a custom desired point in time may pose a number of challenges which should be considered and addressed in the process. The legal, accounting, business and practical attributes of the trust and possible errors should be considered through the due diligence process so that a non-contentious consignment of the trust to history can be effectively documented.

Can I have the real estate in my SMSF?

Real estate can be provided in kind to a member as a superannuation benefit. Prohibitions can apply to acquisitions of real estate from members but this prohibition does not apply going the other way. That is: from a fund to a member on a payment out of the fund as a superannuation benefit.

Still a condition of release needs to be met before a superannuation benefit is provided by a SMSF. Let us say that the fund is in pension mode and the member is over the age of sixty-five so a condition of release is met for a benefit to come from the member’s superannuation balance in the fund to the member.

Difficulties providing a real estate benefit from a SMSF in an income stream

A SMSF in pension mode must face these difficulties before releasing a benefit in the form of real estate:

  • the Australian Taxation Office (ATO), if not the superannuation laws unequivocally, require that a pension (a superannuation income stream) benefit must be paid in money and not in kind;
  • the benefit can take the SMSF out of pension mode, where the income of the SMSF is tax exempt on its earnings; and in to accumulation mode, where the fund is taxable at 15% on its earnings; depending on how the commutation of pension is done. This could inadvertently cause the capital gain, the SMSF makes on the disposal of the real estate as a benefit, to be taxable to the SMSF; and
  • the SMSF may not have paid a minimum annual pension payment for the year as required by the superannuation income stream regulations.

Partial commutation solution

A partial commutation of a pension is a work around for these difficulties. A partial commutation of a pension is a commutation of less than the member’s pension balance in the fund as a lump sum. That is the member needs to have remaining member pension balance after the commutation. The ATO has indicated that a partial commutation:

Doing it

There are a number of traps to implementing this solution:

  • The governing rules of the SMSF must allow for partial commutations of pensions, the trustee must have a power under the governing rules to pay benefits in kind and the pension arrangements or agreement with the member must reflect this.
  • The member needs to trigger the partial commutation and the benefit in kind in accordance with the pension arrangements or agreement.
  • The trustee of the SMSF must value the real estate to ascertain the amount of the lump sum benefit being paid to debit to the member’s account.
  • The member getting the real estate benefit must have a sufficient member account balance remaining after the debit to treat the satisfaction of the benefit in kind as a partial commutation of the pension.
  • The fund and conveyancing documentation needs to be prepared on an arms length basis as required under superannuation law.

Although there is no capital gains tax if the fund remains exempt from tax in pension mode, other taxes and duties on a transfer of real estate can still apply.

For instance:

  • GST can apply to the transfer of commercial premises or new residential premises from a SMSF where the fund is registered or is required to be registered for GST.
  • Stamp duty liabilities vary significantly from state to state. Victoria has concessions on the transfer of dutiable property to a beneficiary of a trust. In New South Wales there is generally no relief from full ad valorem duty. A concession which applies in New South Wales on the transfer of dutiable property to a superannuation fund as a contribution does not apply to a transfer out the other way as a benefit.

Thus, to recap our disclaimer, partial commutation of a pension to provide real estate from a SMSF should be considered case by case and specific advice should be taken in relation to the above general comments.