We have recently seen the Tax Office scrutinise the capital gains tax (CGT) treatment of unpaid present entitlements (UPEs) as part of their audit activity into high net worth individuals, particularly where UPEs have been either forgiven or assigned rather than satisfied by the trustee.
The CGT treatment of UPEs is more complex than it may first appear and requires due consideration when updating UPE arrangements for a client.
A UPE represents the right of a beneficiary to call for immediate payment of a specific amount, enforceable in equity. A UPE is therefore a chose in action and is a CGT asset under the CGT provisions.
On the creation of a UPE, capital gains tax event D1 (creation of a right) occurs.
The first element of the beneficiary’s cost base is equal to the amount paid (or required to be paid) and the market value of any property given to acquire the CGT asset.
As the UPE is a chose in action and not a debt, the beneficiary has not paid any amount (or given any property) to acquire the CGT asset.
The market value substitution rule does not assist as the operation of the rule is specifically excluded where an asset acquired for no consideration under CGT event D1.
This means the beneficiary will usually have a nil cost base for the UPE.
On the subsequent payment by the trustee to the beneficiary to satisfy the UPE, CGT event C2 (ending of an intangible CGT asset) occurs.
The capital proceeds on CGT event C2 will be the amount the beneficiary receives (or is entitled to receive) in respect of the CGT event.
As a result, at first principles the satisfaction of a UPE would appear to give rise to a taxable capital gain, by virtue of the fact the UPE does not have any cost base.
Fortunately, this disparity is addressed by the application of the ‘look-through’ approach in FCT v Dulux Holdings [2001] FCA 1344 (Dulux Decision).
The anti-overlap provisions may also be relevant, as discussed below.
Dulux Decision
The Dulux Decision (made by the Federal Court in 2001) advocated for a ‘look-through’ approach under which the legal rights which may be created are ignored in a transaction are ignored for CGT purposes if they are incidental to the ‘real’ transaction.
For instance, in the Dulux Decision, the Court held that a discharge of a chose in action (by performance of a contract) was not a disposal ‘under a contract’ for the purposes of section 160U Tax Act 1936 (now repealed).
Adopting the Federal Court’s logic, the Commissioner appears to accept that the triggering of CGT events D1 and C2 on the creation and subsequent discharge of a UPE are incidental to the ‘real’ transaction, being the distribution of income from the trust to the beneficiary.
This is the approach adopted by the Commissioner in a number of private binding rulings, such as private binding ruling 1012648073225.
This means that where an existing UPE is satisfied by the trust, no adverse taxation consequences should arise.
Anti-overlap provisions
Further assistance can be obtained in the context of the anti-overlap rules at section 118-20 Tax Act 1997.
Section 118-20(1) reads:
‘A capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in:
- your assessable income or exempt income; or
- if you are a partner in a partnership, the assessable income or exempt income of the partnership.’
These rules are designed to prevent double taxation where a taxpayer incurs a gain from a CGT event in circumstances where an equivalent amount has already been included in their taxable income.
For instance, section 118 includes the following example:
‘Example: Liz bought some land in 1990 as part of a profit-making scheme. In December 1993 she sells it.
Her profit from the sale is $40,000 and is included in her assessable income under section 6-5 (about ordinary income).
Suppose she made a capital gain from the sale of $30,000. It is reduced to zero because it does not exceed the amount included [in her income].’
The provisions operate by reducing the capital gain from the CGT event by an amount equal to the income they had already derived.
In the context of UPEs, the anti-overlap provisions are particularly relevant when the assignment of the UPE results in a capital gain for the beneficiary.
As flagged in the analysis above, this may arise where the UPE has a nil cost base and the satisfaction of the UPE triggers CGT event C2, with a taxable capital gain arising for the amount of the capital proceeds.
As the initial trust distribution will usually have resulted in taxable income for the beneficiary, section 118-20 operates to reduce any capital gain the beneficiary derives on the assignment of the UPE by the amount of the assessable income from the initial distribution.
In circumstances where the entire trust income received by the beneficiary was taxable, the anti-overlap provisions should operate to eliminate the capital gain entirely.
If, however there was a difference between the trust income and taxable income (for instance, where the trust distributed non-assessable capital to the beneficiary), then a shortfall may still arise for the beneficiary after the operation of the anti-overlap provisions.
As a result, the preferred approach is usually to rely on the ‘look-through’ approach under Dulux Decision when possible when dealing with UPEs, rather than relying on the anti-overlap provision.
For further information, please contact Patrick Ellwood on 0400 503 111 or patrick@cloverlaw.com.au.
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