House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 3 Capital gains of testamentary trusts

Outline of chapter

3.1 Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to allow a trustee of a resident testamentary trust to choose to be assessed on capital gains of the trust. The capital gains would otherwise be assessed to an income beneficiary (or to the trustee on behalf of such a beneficiary) who, under the terms of the trust, would not receive the benefit of the capital gains.

Context of amendments

3.2 Under the current income tax laws an income beneficiary who is entitled to a share of a trust's income is generally assessed on a similar share of the trust's net (or taxable) income. If the net income includes capital gains, the income beneficiary may be assessed on those capital gains even if, under the terms of the trust, they are not entitled to benefit from the capital gains.

3.3 These amendments will allow the trustee of a resident testamentary trust to choose to be assessed on the capital gains which would otherwise be assessed to an income beneficiary (or the trustee on their behalf).

3.4 The trustee will be able to make the choice if, under the terms of the trust, the income beneficiary cannot benefit from the capital gains.

3.5 These amendments will ensure that, if the choice is made, tax is in effect borne by the capital beneficiaries of the trust who will ultimately benefit from the capital gains.

Summary of new law

3.6 These amendments amend Subdivision 115-C of the ITAA 1997 to allow a trustee of a resident testamentary trust to make a choice that has the effect that the trustee, rather than an income beneficiary, will be assessed on capital gains of the trust.

Comparison of key features of new law and current law

Detailed explanation of new law

3.7 A trust is not a separate taxable entity: either the trustee or the beneficiaries (or a combination of the trustee and the beneficiaries) will be assessed on the 'net income of the trust' (ie, the trust's taxable income).

3.8 If a beneficiary of a trust is presently entitled to a share of the trust income, the beneficiary, and not the trustee, will generally be assessed on that share of the trust's net income.

3.9 Where the net income includes capital gains, the income beneficiary may be inappropriately assessed on an amount from which they will never benefit.

Example 3.1

Assume that Mr Brown's will provides for his assets to be held on trust for Philip, for life with the remainder to Lynette (ie, Lynette will receive the assets on Philip's death).

The trust income for a particular income year is $60,000 interest. Philip is presently entitled to this amount. The net income of the trust is $90,000, which comprises the $60,000 interest income and a net capital gain of $30,000.

Under the current law because Philip is presently entitled to all of the trust income he would be assessed on the entire trust net income including the $30,000 net capital gain. That outcome is inappropriate because, under the terms of the Brown trust, Philip cannot benefit from the $30,000.

3.10 These amendments will allow the trustee of a resident testamentary trust to choose that the capital gains, which would otherwise be assessed to an income beneficiary, are not so assessed. [Schedule 3, item 2, paragraph 115-230(1)(a )]

3.11 In certain circumstances the trustee may be assessed on behalf of an income beneficiary under section 98 of the Income Tax Assessment Act 1936 (ITAA 1936). In these circumstances, these amendments will also allow the trustee to make a choice that they will not be assessed on the capital gains on behalf of the income beneficiary. [Schedule 3, item 2, paragraph 115-230(1)(b )]

Example 3.2

Assume the same facts as in Example 3.1. The trustee of the Brown trust could choose that Philip is not to be assessed on the capital gains that would otherwise be assessed to him. The consequences of making this choice are discussed in paragraphs 3.23 to 3.26.

Trusts for which a choice can be made

3.12 A trustee will only be able to make a choice under these amendments for a trust that resulted from:

•

a will;

•

a codicil;

•

an order of a court that varied or modified the provisions of a will or a codicil;

•

an intestacy; or

•

an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate.

[Schedule 3, item 2, paragraph 115-230(2)(a )]

3.13 In addition, the trust must also be a 'resident trust estate' (as defined for the purposes of Division 6 of Part III of the ITAA 1936) for the income year in respect of which a choice is made. [Schedule 3, item 2, paragraph 115-230(2)(b )]

3.14 A trust is a resident trust estate in relation to an income year if:

•

a trustee of the trust estate was a resident at any time during the year of income; or

•

the central management and control of the trust estate was in Australia at any time during the income year.

Example 3.3

Nigel (a resident of Australia at all relevant times) is the trustee of a trust estate set up under the terms of a will. The trust will be a resident trust estate because Nigel, the trustee, is a resident. Nigel may be able to make a choice under these provisions.

Example 3.4

Christine (a resident of Australia at all relevant times) declared that she held certain property on trust for her children, for life. Although the trust is a resident trust estate, Christine cannot make a choice under these provisions because the trust was created during her life and not as a result of her will etc.

Example 3.5

Peter's will establishes a trust for his wife for life with the remainder to his children. Nathan, one of his sons, is the trustee of the trust. When Peter died his wife and children resided in Australia.

Nathan subsequently becomes a resident of the United Kingdom. Nathan will be able to make a choice under these provisions in respect of the income year in which he ceases to be an Australian resident. Even though Nathan was a resident for only part of the year, the trust will be a resident trust estate for the whole of that income year.

Nathan will not be able to make a choice for any later income year throughout which he resides in the United Kingdom (assuming that the central management and control of the trust is not in Australia).

Circumstances in which a choice can be made

3.15 The trustee can make a choice in relation to a beneficiary who:

•

does not have a vested and indefeasible interest in trust property representing the gain under the terms of the trust; and

•

has not been paid, or had applied to them, the benefit of that property. [Schedule 3, item 2, subsection 115-230(3 )]

Example 3.6

Marcia is entitled to all the income of a resident testamentary trust for the duration of her life. Under the terms of the trust deed, the trust would be wound up on her death and the corpus distributed to Trevor.

Whilst Marcia is alive, the trustee disposes of some shares in the trust and makes a capital gain. As Marcia is not entitled under the terms of the trust to receive the proceeds from the disposal of the shares, Marcia would not have a vested and indefeasible interest in trust property representing the gain.

Example 3.7

The Jones trust is a resident testamentary trust. Timothy is the sole beneficiary of the trust. However the deed provides that if Timothy dies before he attains the age of 25 years the trust property is to be held for various charities.

The trustee disposes of an investment property and makes a capital gain. The proceeds from the sale are accumulated.

The trustee can make a choice because Timothy (who is currently 23) has a defeasible interest in the corpus of the trust at the time of the trustee making the choice (ie, his interest will be defeated if he dies before turning 25). Timothy does not have a vested and indefeasible interest in the trust property representing the gain from the sale of the property.

3.16 The trustee chooses on a beneficiary-by-beneficiary basis. That is, the trustee may make a choice in respect of one beneficiary but not another. Where an income beneficiary would not pay tax on the gain (eg, if the income beneficiary is an exempt entity), the trustee may decide not to make a choice.

3.17 The trustee cannot make a choice that an income beneficiary is assessed on some of the capital gains of the trust, but not others, that would otherwise be assessed to the income beneficiary. If the trustee makes a choice, the choice must relate to all the capital gains that would otherwise be assessed to the income beneficiary.

Example 3.8

Assume that Sarah is the only income beneficiary of a resident testamentary trust which has made a net capital gain of $50,000. Under the terms of the trust deed, the trust would be wound up on Sarah's death and the corpus distributed to Kate. The $50,000 net capital gain comprises a $30,000 capital gain from the sale of real estate and a $20,000 capital gain from the sale of shares.

If the trustee does not make a choice under these amendments then the $50,000 net capital gain is assessed to Sarah under section 97 of the ITAA 1936.

The trustee cannot make a choice that Sarah is assessed only on the capital gain from the sale of the real estate. The choice must relate to all the capital gains that would otherwise be assessed to her (ie, the capital gains from both the real estate and the shares).

How choice is to be made

3.18 There is no specific requirement as to the form a choice must take nor must the choice be provided to the Australian Taxation Office (ATO). Evidence of the choice having been made should be available if requested by the ATO. Evidence may include:

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trustee minutes;

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trustee working papers;

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tax agent working papers;

•

specific written advice (including electronic) to the beneficiary that the choice was made; or

•

beneficiary's distribution statement.

Example 3.9

Assume that the trustee of a resident testamentary trust makes a choice that subsection 115-230(4) applies in respect of a beneficiary, Mark. The choice is evidenced by a trustee minute which provides that the trustee has chosen to be assessed in respect of $20,000 being Mark's share of the trust capital gains.

Subsequently, the trust net income is increased as a result of an inclusion of an additional capital gain - Mark's share of which is $5,000.

The choice that the trustee made in respect of Mark is not invalidated by the later increase in his share of trust capital gains. Because the trustee's choice can only be made in respect of all of the capital gains for a beneficiary, the minute is taken as evidence of the making of the choice for Mark - it does not matter that the beneficiary's share may change.

3.19 In making a choice, the trustee should take into account their fiduciary duties to both the income beneficiaries and capital beneficiaries of the trust.

3.20 The trustee is required to make any choice within two months from the end of the income year to which the choice relates. A two-month deadline is consistent with the Commissioner of Taxation's (Commissioner's) administrative practice in other areas of the tax law. [Schedule 3, item 2, paragraph 115-230(5)(a )]

3.21 However, the Commissioner may allow further time for the trustee to make a choice in special circumstances. Special circumstances would not extend to the trustee wishing to defer making a choice until the income beneficiary or the trustee lodges their tax return. [Schedule 3, item 2, paragraph 115-230(5)(b )]

3.22 Section 103-25 of the ITAA 1997 is a provision about making choices for the purposes of the capital gains tax (CGT) provisions in Parts 3-1 and 3-3 of the ITAA 1997. It provides that generally a choice must be made by the time a taxpayer lodges their income tax return. Given that the choice in these amendments is required to be made within two months from the end of the income year (or within further time as allowed by the Commissioner), it is appropriate that this choice is excluded from section 103-25 of the ITAA 1997. [Schedule 3, item 1, paragraph 103-25(3)(aa )]

Consequences if the trustee makes a choice

3.23 If the trustee makes a choice in regards to an income beneficiary then the income beneficiary is not assessed on that amount under section 97, 98A or 100 of the ITAA 1936. [Schedule 3, item 2, paragraph 115-230(4)(a )]

3.24 If the trustee would otherwise be assessed on behalf of the income beneficiary, then a choice by the trustee (in their capacity as trustee) will mean that the gain is not assessed to the trustee under section 98 of the ITAA 1936. [Schedule 3, item 2, paragraph 115-230(4)(b )]

3.25 If the trustee makes a choice that the income beneficiary (or the trustee on their behalf) is not assessed on the capital gains then, as a consequence, the trustee will be assessed on those gains. This assessment to the trustee will be made under either section 99 or section 99A of the ITAA 1936 as appropriate. [Schedule 3, item 2, subsection 115-230(4 )]

3.26 These amendments do not modify the Commissioner's discretion to apply either section 99 or section 99A of the ITAA 1936 to the trustee.

Example 3.10

Assume that the Oakroad trust is a resident trust, set up under the terms of Ms Oakroad's will. It has two income beneficiaries, Richard and Kaye, each entitled to 50 per cent of the trust income for their lives. The remainder is held on trust for various charities.

For a particular income year the trust has income of $10,000. Richard is presently entitled to 50 per cent of that income. Kaye is aged 15. Apart from her legal disability (ie, being under 18 years of age), she also would be presently entitled to 50 per cent of the income of the trust. The net income of the trust for an income year is $40,000. This comprises interest income of $10,000 and a net capital gain of $30,000.

The following examples detail the consequences of a trustee's choice on the assumption that the Commissioner exercises their discretion to allow the trustee to be assessed under section 99 of the ITAA 1936.

If the Commissioner did not exercise that discretion, references in the examples to section 99 of the ITAA 1936 should be read as section 99A of the ITAA 1936. If the trustee was assessed under section 99A of the ITAA 1936, then the trustee would be required to reverse the application of the CGT discount in working out the trust's net capital gain.

Example 3.11

The trustee does not make a choice. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $20,000; and

•

the trustee is assessed, on behalf of Kaye, under subsection 98(1) of the ITAA 1936 on $20,000.

Example 3.12

The trustee makes a choice that both Richard and Kaye are not to be assessed on the capital gains of the trust. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $5,000;

•

the trustee is assessed, on behalf of Kaye, under subsection 98(1) of the ITAA 1936 on $5,000; and

•

the trustee is assessed under section 99 of the ITAA 1936, in their capacity as trustee, on $30,000.

Example 3.13

The trustee makes a choice that they (as trustee for Kaye) are not to be assessed on the capital gain. The trustee does not make a choice in relation to Richard. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $20,000;

•

the trustee is assessed under subsection 98(1) of the ITAA 1936, on behalf of Kaye, on $5,000; and

•

the trustee is assessed under section 99 of the ITAA 1936, in their capacity as trustee, on $15,000.

Application and transitional provisions

3.27 These amendments will commence on Royal Assent.

3.28 These amendments will apply to the 2005-06 and later income years [Schedule 3, item 3, subsection (1 )]. A trustee can make a choice in respect of capital gains included in the trust's net income for the 2005-06 and later income years.

Period for making a choice: 2005-06 income year

3.29 The application and transitional rules contain an exception to the general rule in subsection 115-230(5) that a trustee must make a choice within two months after the end of an income year. The exception is that, regardless of when Royal Assent is received, a trustee can make a choice for the 2005-06 income year within two years of these amendments receiving Royal Assent. In special circumstances the Commissioner may provide further time for the trustee to make a choice. [Schedule 3, item 3, subsection (2 )]

Period for making a choice: 2006-07 income year

3.30 Further, if these amendments do not receive Royal Assent until the 2007-08 income year, then a choice for the 2006-07 income year may also be made within two years of these amendments receiving Royal Assent (or within further time allowed by the Commissioner in special circumstances). [Schedule 3, item 3, subsection (3 )]

3.31 If these amendments receive Royal Assent during the 2006-07 income year, then a trustee will only have until 31 August 2007 to make a choice for the 2006-07 income year unless the Commissioner exercises their discretion under paragraph 115-230(5)(b).

The period for amending an assessment to give effect to a choice

3.32 If the trustee makes a choice under these amendments for the 2005-06 income year (and the 2006-07 income year, if the amendments do not receive Royal Assent until the 2007-08 income year) after a beneficiary, or trustee on their behalf, has received an assessment from the ATO (that related to the capital gains in respect of which the trustee choice is made), then the taxpayer may apply to amend their assessment within two years of these amendments receiving Royal Assent. [Schedule 3, item 4, paragraphs (a) and (b )]

3.33 If a taxpayer has a longer period to amend their assessment under section 170 of the ITAA 1936, then they may apply to amend their assessment within this longer time period. [Schedule 3, item 4]

3.34 There may be circumstances when a trustee makes a choice towards the end of this two year period and so an income beneficiary may not be able to apply to amend their assessment within the time limits provided for in these amendments.

3.35 Subsection 14ZW(2) of the Taxation Administration Act 1953 (TAA 1953) allows a person to lodge an out of time objection with a written request to the Commissioner that the objection be treated as if it were lodged within time. Section 14ZX of the TAA 1953 requires the Commissioner to consider whether to agree to the taxpayer's request.

3.36 When deciding whether or not to agree to the taxpayer's request for an objection out of time under these transitional provisions, the Commissioner should have regard to when the trustee made a choice under these transitional arrangements, and in particular whether it was made towards the end of this two year period.