Tuesday, May 20, 2014

Taxation consequences of testamentary trust distributions - Part II



Again for those that do not otherwise have easy access to the Weekly Tax Bulletin, Part II of the article by fellow View Legal Director Patrick Ellwood and I is extracted below.

Part I of this article (at 2014 WTB 19 [658]) considered a number of specific aspects of the transfer of assets under a deceased estate testamentary trust. Part II of the article now considers:
  • distributions from testamentary trusts to beneficiaries;
  • the proposed changes to CGT event K3; and
  • the proposed changes where an intended beneficiary dies.

Distributions from testamentary trusts


In 2003, the ATO released PS LA 2003/12, which states that its purpose is to inform ATO staff that the Commissioner will not depart from the long-standing administrative practice of treating the trustee of a testamentary trust in the same way as a legal personal representative (LPR) is treated for the purposes of Div 128 of the ITAA 1997.

In the 2011-12 and 2012-13 Federal Budgets, it was proposed that the current ATO practice set out in PS LA 2003/12 of allowing a testamentary trust to distribute an asset of a deceased person without a capital gains tax (CGT) taxing point occurring would be codified.

While draft legislation to effect the change was prepared, the Federal Government announced that it was reviewing the progress of a large number of unenacted legislative announcements and ultimately confirmed on 14 December 2013 that the amendments would not be implemented - see 2013 WTB 53 [2270] and also 2014 WTB 12 [399].

As set out at 2014 WTB 16 [561], the ATO recently republished PS LA 2003/12 confirming that it intends to continue to consider itself bound by it. Despite the ATO apparently acknowledging that the Government will not proceed with any legislative changes, some amount of confusion has been caused by the ATO stating in updates on its website that it will "accept tax returns as lodged during the period up until the proposed law change is passed by Parliament". Those comments are contained in the ATO update entitled "Refinements to the income tax law in relation to deceased estates" (dated 22 April 2014). It is assumed these comments are simply an oversight by the ATO and that PS LA 2003/12 (as amended) will continue to be applied indefinitely into the future.

The position therefore appears to remain that there is exemption roll-over from CGT covering the "transfer" of assets from the LPR to the trustee of the testamentary trust in the first instance and the subsequent transfer by the trustee to an eventual beneficiary of the testamentary trust. The subsequent transfer may either involve a capital distribution being made by the trustee of the trust to a beneficiary during the lifetime of the trust, or a payment of capital upon vesting of the trust.

The result of PS LA 2003/12 is that, on the subsequent disposal of a CGT asset from a testamentary trust trustee to a beneficiary of the testamentary trust:
  • any capital gain or loss that the testamentary trust trustee makes is disregarded under s 128-15(3); and
  • the beneficiary will be taken to have acquired the CGT assets of the deceased at the date of the deceased's death (rather than on the date they were distributed by the LPR) and the first element of the cost base and reduced cost base for the beneficiary will be:
    • for pre-CGT assets in the hands of the deceased - the market value of the asset on the day the deceased died; and
    • for post-CGT assets in the hands of the deceased - the deceased's cost base (or reduced cost base) at the date of their death.

Ultimately under PS LA 2003/12, Div 128 (in particular ss 128(2), (3) and (4)) effectively applies twice:
  • initially, when the LPR is the "LPR" for the purposes of Div 128 and the testamentary trust trustee is the "beneficiary"; and
  • subsequently, when the testamentary trust trustee is treated as an "LPR" for the purposes of Div 128 and the beneficiaries of the testamentary trust are treated as the "beneficiaries".

CGT event K3


The ATO has indicated that the position in PS LA 2003/12 is subject to CGT event K3, which covers assets passing to tax-advantaged entities.

CGT event K3 operates to ensure that, where assets pass to concessionally taxed entities from a deceased estate, a capital gain or loss is recognised in the deceased's final tax return. This prevents assets with embedded capital gains from avoiding capital gains when they are later disposed of by the concessionally taxed entity. CGT event K3 has, in the past, been avoided by ensuring an asset does not pass to a concessionally taxed entity until after the deceased's standard amendment period (generally 4 years after the assessment) has expired.

As part of the 2011-12 Budget measures, it was announced that amendments would be made to ensure that where CGT event K3 happened outside of the deceased's standard amendment period, a CGT liability still arose in the deceased's tax return. It was proposed this could be achieved by excluding CGT event K3 from the standard amendment period.

In particular, the CGT event would have been deemed to happen to the relevant entity that passed the asset to the concessionally taxed entity (rather than with the beneficiary), avoiding the need to amend the deceased's tax return. This change would have allowed the entity to which CGT event K3 applied to be able to utilise its realised capital losses against CGT event K3, instead of the deceased utilising their capital losses against their capital gain from CGT event K3.

The change would have been consistent with how Div 128 operates under PS LA 2003/12 where an LPR or testamentary trust trustee sells an asset to a third party, rather than passing the asset to the intended beneficiary of the estate.

However, as with other proposed changes mentioned below, the announced changes to CGT event K3 were abandoned in late 2013.

Where an intended beneficiary dies before administration is completed


The Federal Government released a proposal paper "Minor amendments to the capital gains tax law" in June 2012 which specifically addressed the circumstance where an intended beneficiary dies before administration of an estate is completed. Generally, in that situation, s 128-15 provides a CGT roll-over provided that the asset passes from the first deceased's LPR to the beneficiary's LPR.

However, no CGT roll-over exists where the asset passes (ultimately) from the first deceased's LPR via the second deceased's LPR to the trustee of a testamentary trust or a beneficiary of the intended beneficiary's (ie the second deceased) estate because the asset was not one which the intended beneficiary owned when they died.

The former Labor Federal Government proposed to introduce measures to allow the intended beneficiary's LPR to access the roll-over where the intended beneficiary died before an asset that the first deceased owned passed to them, regardless of whether it passed first to a testamentary trust trustee. Again, however, the Coalition Government confirmed the amendments would not be implemented.

Arguably, PS LA 2003/12 can be relied on to provide relief in this type of situation.


Image credit: Alan Cleaver cc