Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 3 - CGT event E4
Outline of chapter
3.1 A payment by the trustee to a beneficiary of a trust, that is not assessable income of the beneficiary, may reduce the cost base of the beneficiarys unit or interest in the trust. The amendments in Schedule 3 to this bill replace sections 104-70 (CGT event E4), 104-71 and 104-72 of the ITAA 1997, prevent CGT event E4 applying to payments out of the CGT discount, and correct the treatment of certain capital gains passing through a chain of trusts. Amendments dealing with payments of non-assessable amounts associated with building allowances and minor amendments are also made.
Context of reform
3.2 In Treasurers Press Release No. 16 of 22 March 2001 the Government announced that CGT event E4 will not apply to a payment of the CGT discount amount made on or after 1 July 2001 to a beneficiary with units or interests in a trust. The Government also announced that CGT event E4 will apply to payments associated with building allowances made on or after 1 July 2001. Details of the transitional rules for chains of trusts were announced in Assistant Treasurers Press Release No. 33 of 31 July 2001.
3.3 Schedule 3 to this bill gives effect to the Government announcements.
3.4 Payments of CGT discount amounts that pass through one or more trusts before being paid to the beneficiary at the end of the chain of trust, can have inappropriate tax consequences through the application of CGT event E4 for trusts in the chain and for the end beneficiary.
3.5 Schedule 3 addresses the chain of trusts deficiencies in CGT event E4 and also makes amendments that will improve the operation of CGT event E4 by clarifying the provision and ensuring that it has the intended effect.
Summary of new law
3.6 The main amendments to CGT event E4 will:
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- enable a payment of the CGT discount amount to be made by the trustee to a beneficiary on or after 1 July 2001 without triggering CGT event E4; and
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- treat a payment associated with building allowances made by the trustee to a beneficiary on or after 1 July 2001 as a non-assessable amount to which CGT event E4 applies.
3.7 The amendments correct deficiencies in the application of CGT event E4 where a payment of a CGT discount amount flows through a chain of trusts. Minor amendments also clarify certain aspects of the application of CGT event E4.
3.8 The amendments relating to the chain of trust corrections include a transitional measure and will apply to payments made after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999. The remaining amendments apply to payments made on or after 1 July 2001.
| New law | Current law |
|---|---|
| CGT event E4 no longer applies to a payment of a CGT discount amount made by the trustee on or after 1 July 2001 to a beneficiary with a unit or interest in a trust. | CGT event E4 may apply to a payment of a CGT discount amount made by a trustee to a beneficiary with a unit or interest in a trust. |
| A payment associated with building allowances made on or after 1 July 2001 is a non-assessable part to which CGT event E4 applies. | Subsection 104-70(7) excludes a payment associated with building allowances from the non-assessable part to which CGT event E4 applies. |
| New subsection 104-71(4) ensures that CGT event E4 does not apply if the non-assessable part is attributable to a CGT discount amount and is paid to the trustee of a trust. Adjustments to the cost base of interests in the trust are not required. | Section 104-72 disregards a CGT event E4 capital gain made by the trustee of a fixed trust where a payment out of a CGT discount amount flows through a chain of trusts. Adjustments to the cost base of interests in the trust are still required. |
| Technical corrections ensure CGT event E4 operates as intended and clarify its operation. |
Detailed explanation of new law
Overview of the cost base adjustment rules
3.9 Section 104-70 (CGT event E4) of the ITAA 1997 reduces the cost base of a unit or interest in a trust if the trustee pays a non-assessable amount to a beneficiary of the trust. If the payment is more than the beneficiarys cost base, the beneficiary makes a capital gain. If the beneficiary has owned the unit or interest in the trust for at least 12 months, the beneficiary may claim the CGT discount on this capital gain.
3.10 CGT event E4 applies to non-assessable amounts which include CGT concession amounts. The following payments are CGT concession amounts:
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- the CGT discount;
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- frozen indexation; and
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- the small business 50% reduction.
3.11 The amendments remove the requirement to apply CGT event E4 to a CGT discount amount paid:
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- on or after 1 July 2001; and/or
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- before 1 July 2001 to a beneficiary that is the trustee of a trust in a chain of trusts.
3.12 The amendments ensure that CGT event E4 applies to an amount associated with building allowances paid on or after 1 July 2001.
3.13 A payment of other CGT concession amounts continues to be dealt with under CGT event E4.
Treatment of a payment to a beneficiary of a CGT discount amount
3.14 Under the current law, a payment of a CGT discount amount to a beneficiary to which CGT event E4 applies can have the effect of reducing the benefit of the CGT discount allowed in the trust.
3.15 These amendments recognise that a person investing through a managed fund should receive a similar CGT outcome to that of a person investing directly. This is achieved by reducing the non-assessable part to which CGT event E4 applies by the amount of the CGT discount allowed to the trustee that is paid to a beneficiary. [Schedule 3, item 1, subsection 104-71(4), item 1 in the table]
Example 3.1
On 15 August 2001, Sam received a payment of $100 from the Rowley Unit Trust. The trustee advised Sam that this amount comprised $50 from a discount capital gain included in the net income of the trust and $50 from the CGT discount allowed.
In applying CGT event E4 to the payment, Sam first reduces the $100 payment by $50, being the amount of the net income assessed to him under section 97 of the ITAA 1936. Sam then reduces the remaining $50 balance by a further $50, being the amount that represents the CGT discount allowed to the trustee. Sams non-assessable part is nil. CGT event E4 does not apply to reduce the cost base of Sams units in the trust nor does he make a CGT event E4 capital gain.
3.16 Other amounts can also reduce the non-assessable part. This may happen if other CGT concessions are applied to a capital gain made by a trust.
Treatment of a payment to a beneficiary of other CGT concession amounts
3.17 CGT event E4 continues to apply to a payment to a beneficiary of other CGT concession amounts. With the modification to CGT event E4 for a payment of a CGT discount amount, new rules are required to reduce the non-assessable part where other amounts are paid.
3.18 Adjustments are required where CGT concessions allowed to a beneficiary are less than those allowed to the trustee. This may happen if:
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- capital losses are applied to the capital gain of the trust or a beneficiary; or
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- a beneficiary is not entitled to claim the full benefit of the CGT discount claimed by the trustee.
[Schedule 3, item 1, subsection 104-71(4), items 2 to 7 in the table]
Example 3.2
On 15 August 2001, Chris received a payment of $600 from the Adams Family Unit Trust. The trustee advised Chris that this amount comprised $150 that was included in the net income of the trust after claiming the 50% CGT discount and the small business 50% reduction. Also included in the payment was $300 from the CGT discount and $150 from the small business 50% reduction allowed against that capital gain.
In applying CGT event E4 to the payment, Chris first reduces the $600 payment by $150, being the amount of the net income assessed to him under section 97. Chris then reduces the remaining $450 balance by a further $300, being the amount that represents the CGT discount allowed against the capital gain made by the trust. Chriss non-assessable part is $150, which represents the amount of the small business 50% reduction that Chris was allowed when applying the rules in Subdivision 115-C of the ITAA 1997.
Assuming the cost base of Chriss units in the trust is nil, Chris makes a capital gain of $150 under CGT event E4. If Chris has owned his units in the trust for at least 12 months, the 50% CGT discount reduces this capital gain to $75.
3.19 As capital losses are offset against capital gains before certain CGT concessions are applied, the extent to which the non-assessable part is adjusted for capital losses applied depends on:
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- the type of entity receiving the payment - different entities are eligible for different CGT discount percentages; and
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- the combination of CGT concessions applied.
3.20 If a payment of the CGT discount amount passes through 2 or more trusts before being paid to the beneficiary at the end of the chain of trusts, cost base adjustments under CGT event E4 may be made to each of the trustees units or interests in the chain. A definition of a chain of trusts is provided. [Schedule 3, item 1, subsection 104-71(5)]
3.21 This inappropriate outcome is removed by reducing the non-assessable part by the amount of the CGT discount allowed against a capital gain made by a trust that is paid to the trustee of another trust. [Schedule 3, item 1, subsection 104-71(4), item 1 in the table]
3.22 CGT event E4 may still apply to a payment of other tax deferred amounts to each trustee in a chain of trusts. However, a payment of the small business 50% reduction amount will not generate a capital gain under CGT event E4. [Schedule 3, item 1, section 104-72]
Effect a capital loss applied by a trustee against a capital gain has on a non-assessable part for a beneficiary
3.23 If the trustee making a payment of a CGT concession amount applied a capital loss or net capital loss against the capital gain before applying the CGT concession, a further reduction may be made to the non-assessable part of the beneficiary. The amount of this reduction is that proportion of the loss reflected in the payment to the beneficiary. This reduction may also be made if a capital loss or net capital loss was applied against a concessionally treated capital gain by another trustee in a chain of trusts. In determining whether a capital loss is reflected in a payment to a beneficiary in a chain of trusts, a capital loss claimed by a trustee higher in the chain of trusts may be taken into account. [Schedule 3, item 1, subsection 104-71(4), item 7 in the table]
Example 3.3
In the 2000-2001 income year, the Ready Capital Unit Trust made a capital gain of $1,800. The trust also made a capital loss of $500. After offsetting the capital loss, the trustee applied the CGT discount to the balance of the gain ($1,300) resulting in the trust having a net capital gain of $650. Nahid, a beneficiary of the trust, was presently entitled to all the trust income.
On 10 September 2001, the trustee paid Nahid $1,800. The trustee advised Nahid that this amount comprised $650 CGT discount, $650 net income and $500 that represented the capital loss applied by the trustee against the capital gain.
In applying CGT event E4 to the payment, Nahid reduces the $1,800 payment by the following amounts:
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- $650, being the amount of the capital gain included in the net income assessed to her under section 97 of the ITAA 1936 (paragraph 104-70(1)(b));
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- $650, being the amount that represents the CGT discount allowed against the capital gain made by the trust (item 1 in the table in subsection 104-71(4)); and
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- $500, being the amount of the loss applied against the capital gain made by the trust and reflected in the payment to Nahid (item 7 in the table in subsection 104-71(4)).
The result for Nahid is the non-assessable part is nil [$1,800 - ($650 + $650 + $500)].
Payments associated with the building allowance
3.24 Currently, paragraph 104-70(7)(a) excludes from the non-assessable part a payment of an amount that is attributable to deductions allowed under Division 43 of the ITAA 1997. This Division deals with deductions for capital works which covers buildings, structural improvements and environment protection earthworks.
3.25 These amendments, in repealing paragraph 104-70(7)(a) for payments made on or after 1 July 2001, recognise that it is now appropriate that cost base adjustments be made for payments of these deduction amounts so as to:
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- treat investors in trusts on a broadly equivalent basis to direct investors; and
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- remove the ability to generate losses (or to reduce capital gains) on trust interests where recognition for the diminished value of the asset has already been provided.
[Schedule 3, item 1, subsection 104-71(3)]
| What the provision does | What the amendment will do |
|---|---|
| Subsection 104-70(2) - describes the situations where a payment is disregarded in the calculation of the non-assessable part. | Correct the numbering of paragraphs that are now included in new subsection 104-71(1). [Schedule 3, item 1, paragraphs 104-71(1)(d) and (e)] |
| Subsection 104-70(2) - describes the situations where a payment is disregarded in the calculation of the non-assessable part. | Ensure there are no tax consequences for a payment of the small business 15-year exemption amount. This supports the rules in section 152-125 of the ITAA 1997 that such a payment is not subject to tax. [Schedule 3, item 1, paragraph 104-71(1)(g)] |
| CGT event E4 - identifies different types of payments a trustee may make to a beneficiary. | Adopt consistent terminology. [Schedule 3, item 1, subsection 104-70(1), notes 1 and 2] |
| Subsection 104-70(1) - provides that CGT event E4 applies to the non-assessable part of a payment. | Clarify that beneficiaries do not inappropriately receive a double tax benefit in calculating the non-assessable part because of the application of Subdivision 115-C. [Schedule 3, item 1, subsection 104-70(1)] |
| Subsection 104-70(1) - provides that CGT event E4 applies to a payment received in respect of your unit or interest in a trust. | Clarify the treatment of a payment to a beneficiary received after the beneficiary stops owning their interest in the trust. Such a payment forms part of the capital proceeds of the CGT event relating to the ending of ownership of the interest in the trust. [Schedule 3, item 1, subsection 104-70(1), note 3] |
Application and transitional provisions
3.26 As a transitional measure, CGT event E4 does not apply to a payment of a CGT discount amount to the trustee of another trust, that is not a complying superannuation entity. [Schedule 3, item 4]
3.27 The transitional provision applies to payments made by a trustee on or after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 and before 1 July 2001. The remaining amendments made by Schedule 3 apply to payments made by a trustee on or after 1 July 2001. [Schedule 3, item 5]
Consequential amendments
3.28 A minor change is made to the integrity rules for the CGT discount. Section 115-60 provided that to the extent a distribution is from a discount capital gain, section 115-45 will not prevent a CGT event E4 capital gain from being a discount capital gain. As the payment of a CGT discount amount no longer triggers a capital gain, section 115-60 is not necessary and is repealed [Schedule 3, item 2] . The definition of a chain of trusts is added [Schedule 3, item 3] .
Regulation impact statement
3.29 The policy objective is to ensure that persons making passive investments through managed funds receive a similar CGT outcome to persons investing directly. This will assist investors to access the benefits of portfolio diversification without adverse tax consequences.
3.30 This measure will provide broadly comparative tax treatment between direct and indirect investors by modifying the application of CGT event E4 for certain payments made by trustees to beneficiaries of trusts.
3.31 For beneficiaries owning interests in trusts to which CGT event E4 applies, where payments are made to those beneficiaries that can trigger this event, the only effective option was the one adopted in this bill. It reflects that the manner in which CGT event E4 currently operates is the source of impediment to the comparative tax treatment of persons investing indirectly through managed funds.
3.32 The amendments made to CGT event E4 ensure:
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- this event will not apply to payments of CGT discount amounts to beneficiaries;
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- inappropriate outcomes in the application of this event will not happen to CGT discount amounts passing through a chain of trusts to end beneficiaries; and
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- this event will apply to payments of non-assessable amounts associated with building allowances.
3.33 Minor amendments will enhance the understanding and operation of CGT event E4.
3.34 The proposed amendments will mainly affect persons investing in managed funds. Industry estimates that managed funds make investments on behalf of over 9 million Australians. By providing appropriate tax treatment for indirect investments, more taxpayers may invest in managed funds. Beneficiaries of other trusts owning interests of a type to which CGT event E4 applies may also be affected.
3.35 Currently, there are over 3,200 managed funds in Australia. The proposed amendments will also affect compliance costs incurred by the managed funds industry. The level of investments in managed funds is likely to increase.
3.36 The proposed amendments will also impact on the ATO who will administer the revised rules for CGT event E4.
3.37 Investors in managed funds receiving payments of CGT discount amounts will benefit from the proposal as they will not be required to make cost base adjustments to their interests in the trusts. Investors in managed funds receiving payments associated with building allowances will now be required to make cost base adjustments to their interests in the trusts.
3.38 There will be a minimal increase in compliance costs for investors as they will receive all relevant information from the fund. The exact compliance cost for the investor cannot be reliably quantified because they will use a variety of means to familiarise themselves with the new law. Some investors will rely on the information sent to them by the fund, whilst others will obtain further information from either the ATO or their tax advisers.
3.39 The current substantiation rules will apply so there will be no increase in record keeping costs for investors.
3.40 As each managed fund may have different systems in place for account and record keeping purposes, a reliable quantification of the compliance costs cannot be obtained. Examples of the types of costs that will be incurred by the managed funds include:
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- changing their systems to identify the appropriate components of payments to members that will enable members to fulfil their tax obligations;
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- providing members with information on the new law; and
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- ensuring that their record keeping systems are updated to show the components paid to members.
3.41 The proposed amendments do not require a change to any of the existing ATO systems for administering the CGT regime. However, they will require changes to the material prepared for taxpayers and tax practitioners for education about the revised rules for CGT event E4. As the ATO booklets and information pamphlets are updated each year, these changes will be folded into that process. Therefore, there should be minimal costs to administration in this respect.
3.42 The ATO will also incur costs in relation to training staff members on the new rules. In the short term there is likely to be an increase in the requests for provision of advice on the revised rules. This training will be done internally as part of ongoing ATO training, and therefore costs in relation to this aspect of administration would also be minimal.
3.43 The financial impact in modifying the operation of CGT event E4 for payments of CGT discount is included in the estimates for providing Concessions for capital gains by individuals and some other entities in the general outline of the explanatory memorandum to the New Business Tax System (Integrity and Other Measures) Act 1999 .
3.44 The proposed amendment to require cost base adjustments for payments associated with building allowances will result in a gain to revenue of $5 million in 2002-2003, rising to $40 million per annum after 10 years.
3.45 There may be some expansion in the level of investment in the managed fund industry.
3.46 Taxation will not be an impediment to how an investor may choose to invest because one of the major differences in the taxation treatment between direct investment and indirect investment is now removed.
3.47 The ATO and Treasury consulted with peak bodies representing the investment, finance and property industries. Draft legislation was also released to those representatives for their comment. The amendments have industry support.
Conclusion and recommended option
3.48 The proposed amendments will provide a comparative tax outcome for persons investing directly and indirectly through managed funds. The compliance costs associated with this change in the law will be minimal for the investor. Depending on the systems in place at the managed funds level, there may be some higher compliance costs associated with this change. However, the increased investment in managed funds will outweigh this short term increased cost.
3.49 Therefore, the net benefit of this change provides for increased levels of investment and diversification of investment for Australian investors.