Division 149 ruling: Win for discretionary trusts selling pre-capital gains tax (CGT) assets

A family discretionary trust has won a tax case confirming the disposal of shares in a company acquired before capital gains tax (CGT) was introduced, remains exempt from CGT. This exemption applies despite the trustee appointing a new company beneficiary that was controlled by a person who, under the trust deed, was specifically excluded from being a beneficiary of the family trust.

Capital gains made on assets acquired before 20 September 1985 are generally exempt from CGT (‘pre-CGT assets’). However, there are some situations where pre-CGT assets can be deemed to be acquired on or after 20 September 1985 (‘post-CGT assets’) and therefore can become subject to CGT. One of these situations is under Division 149 of the Income Tax Assessment Act 1997 (ITAA 1997), where pre-CGT assets are owned by a company or trust and the majority of the ultimate owners of the company shares or interests in the trust change compared to before 20 September 1985.

This case provides new guidance on determining when Division 149 applies to change the pre-CGT status of assets to post-CGT and how to interpret income tax (IT) ruling IT 2340.

Business activities and structure

In 1979, the taxpayer and Husband founded a business operated by X Pty Ltd as trustee of the Settlement Trust.

In June 1988, Alpha Pty Ltd (‘Alpha’) was incorporated and X Pty Ltd, as trustee for the Settlement Trust, acquired Alpha’s shares. In July 1988, the business operated by X Pty Ltd as trustee was transferred to Alpha Pty Ltd.

The business maintained its pre-CGT status when it was acquired by Alpha in 1988, as the business was rolled over by X Pty Ltd (as trustee) to a wholly owned company (Alpha), under a 160ZZN rollover (what is now referred to as a Sub-division 122-A rollover). That is, the shares in Alpha acquired by the Trustee were deemed to have been acquired before 20 September 1985, and maintained their pre-CGT status.

Beneficiaries

There were two types of beneficiaries defined by the Trust Deed (Clause 1(c)):

• Those listed in the Schedule being the taxpayer and family members of the taxpayer and her husband (but not the husband) and a charitable trust.
• Those appointed by the nominator in writing before the vesting date, excluding the nominator himself (i.e. Husband).

Beneficiary changes

Additional discretionary beneficiaries were appointed to the Settlement Trust during the 2009 to 2010 years, all being family members and related entities of the taxpayer and her husband.

On 10 June 2011, Beta Pty Ltd (Beta) was appointed a beneficiary, with the sole shareholder being Delta Pty Ltd (Delta) as trustee of the Delta Trust. The taxpayer and her husband were the shareholders and directors of Delta and the directors of Beta.

The Delta Trust was a hybrid discretionary trust. The unit holders were the taxpayer and Husband. Other discretionary beneficiaries included family members and related entities. The taxpayer and Husband controlled the distributions of Delta Trust.

Distributions and sale of Alpha

Between 2009 to 2019 Alpha paid approximately $24,094,000 in dividends to the Settlement Trust. The Settlement Trust distributed between 44 per cent and 75 per cent of those dividend amounts to Beta in the relevant years. On average, approximately 63 per cent of those dividends over the years went to Beta.

Beta Pty Ltd distributed most of the income it received from the Settlement Trust to the Delta Trust, which then distributed the income to its beneficiaries at the discretion of the trustee. The Husband received a portion of these distributed dividends, but never 50 per cent or more in any income year. In summary, the Husband received either 0 per cent or between 15 per cent and 39 per cent of the distributed dividends (or 19 per cent across all the 2009 to 2019 income years). Other family members/entities received approximately 81 per cent.

That is, since Beta’s appointment in 2011, the Husband never received or was entitled to 50 per cent or more of income comprising the Alpha dividends.

On 19 July 2019, the Trustee sold Alpha shares to an unrelated third party for over $100 million. This triggered CGT Event A1 under section 104-10 of the ITAA 1997.

In the 2020 income year, the Settlement Trust distributed the whole of the trust income of $64.4 million to the taxpayer. This distribution was directly linked to the proceeds from the Alpha share sale.

Assessment and proceedings

The Commissioner assessed the taxpayer on the $64.4 million capital gain on the basis that the appointment of Beta as a beneficiary in June 2011 caused the “majority underlying interests” in the shares in Alpha to cease being a pre-CGT asset under Division 149.

The issue in dispute was whether the taxpayer could disregard the capital gain made by the trust from the sale of the Alpha shares (which it distributed to her) on the basis that the shares were pre-CGT assets. This involved close consideration of Division 149.

Division 149

The key tax provision for the resolution of the case focused on Division 149. Division 149 outlines when a CGT asset ceased being a pre‑CGT asset. Pursuant to section 149‑30, an asset stops being a pre‑CGT asset at the earliest time when “majority underlying interests” in the asset were not had by “ultimate owners” who had those interests immediately before 20 September 1985.

Notably, section 149‑30(2) provides the Commissioner with a discretion to assume that a pre-CGT asset has maintained its pre-CGT status. The key effect of section 149-30(2) is that the asset retains its pre-CGT status if the Commissioner reasonably assumes that the majority underlying ownership has not changed. This is an exception to the general rule under subsection 149-30(1) whereby an asset loses its pre-CGT status if the majority underlying ownership changes after 20 September 1985.

Sections 149‑15(4) and 149-15(5) provide rules to verify how an “ultimate owner” can be treated as having an indirect beneficial interest in an asset held by another entity, such as a company or a trust. Essentially, this is through a tracing mechanism to ascertain a hypothetical scenario to trace beneficial ownership through interposed entities to the "ultimate owners," generally individuals.

Taxpayer’s argument

The taxpayer’s arguments were multifaceted and included the following:

• The pre-CGT status of the trust's underlying assets had been maintained and did not become post-CGT assets under Division 149. In particular, the taxpayer considered the $64 million distribution received from a family trust was not subject to CGT because it was referable to the sale of shares that were pre-CGT assets (the Alpha shares). The trust distribution came from a capital gain the trust made from the sale of shares in Alpha, which were acquired before 20 September 1985. Therefore, because the underlying asset (the shares) was a pre-CGT asset, the capital gain, and the distribution referable to it, should be disregarded for CGT purposes

• The relevant discretionary trust had passed the continuous ownership test meaning that there had not been a change of 50 per cent or more of its ultimate owners. The continuous ownership test for discretionary trusts had not been triggered by changes in control or appointments of new beneficiaries. It was specifically noted that while the taxpayer's Husband had the power to nominate additional beneficiaries, he himself was excluded
• No beneficiary of the Settlement Trust, being a discretionary trust, had a direct beneficial interest in the Alpha Shares or in the trust's capital/income. The taxpayer emphasised historical legal authority that the object of a discretionary trust has no legal or beneficial interest in the income or capital of a trust. Accordingly, in the case of a discretionary trust, the requisite continuity of “majority underlying interests” as per Division 149 could not be established. Moreover, the mere appointment of a discretionary object could not result in any change in “majority underlying interests”
• The taxpayer accepted that subdivision 149-B was capable of being applied to assets of discretionary trusts. However, this meant that the statutory purpose could only be achieved by applying the Commissioner’s discretion in a manner that addresses the possible harshness that might ensue, including for pre-CGT assets of discretionary trusts, effectively providing for the grandfathering of those assets. The taxpayer submitted that the construction of the provisions of Subdivision 149-B which best gives effect to its purpose should be preferred. The taxpayer considered her construction of Division 149 was consistent with “IT 2340 Income tax: capital gains: deemed acquisition of assets by a taxpayer after 19 September 1985 where a change occurs in the underlying ownership of assets acquired by the taxpayer on or before that date”. Notably, IT 2340 provided that:
  • “In relation to what are generally referred to as discretionary trusts, i.e., family trusts, the trustees of which have discretionary powers as to the distribution of trust income or property to beneficiaries, in considering the question of whether majority underlying interests have been maintained in the assets of the trust, it will be relevant to take into account the way in which the discretionary powers of the trustees are in fact exercised.” [paragraph 5].

Commissioner’s argument

The Commissioner considered Division 149 extinguished the pre-CGT status of the shares in 2011 when Beta was added to the trust’s class of beneficiaries. The Commissioner argued that this resulted in a change of majority underlying interests held in the asset compared to those held just before 20 September 1985.

Broadly, the Commissioner’s position was that adding Beta to the class of discretionary beneficiaries of the Settlement Trust on 10 June 2011 altered the majority underlying interests in the Alpha shares because the Husband was not previously a direct or indirect beneficiary of the Settlement Trust. Accordingly, the shares ceased being a pre‑CGT asset from that date. More specifically, the addition of Beta to the class of beneficiaries activated Division 149, resulting in a change of majority underlying interest in the Alpha shares and the loss of their pre-CGT status, pursuant to Division 149.

In particular, the Commissioner’s contentions focused on the fact that the Husband of the taxpayer could possibly be able to benefit from the shares in Alpha, indirectly through the insertion of the Beta and the Delta Trust when Beta was appointed as beneficiary of the Trust. Accordingly, the Alpha shares ceased being pre-CGT assets on that date.

The Commissioner also considered he was not bound by IT 2340 since it preceded the commencement of the formal rulings’ regime on 1 July 1992. Nor was it intended to be an exhaustive description of the operation of the legislation.

Decision

The Tribunal found for the taxpayer and allowed the objection against her assessment. That is, the Tribunal held that the shares in Alpha acquired by the Settlement Trust (being a discretionary family trust) before 20 September 1985 continued to be treated as pre-CGT assets up until their sale in the 2020 income year.

The Tribunal was satisfied that at all times on and after 20 September 1985 and before 10 June 2011, majority underlying interests in the Alpha Shares were had by ultimate owners who had majority underlying interests in the Alpha Shares immediately before that day for the purposes of subsection 149-30(2). Consequently, the Alpha Shares continued to retain their pre-CGT status, and the assessment issued to the taxpayer was excessive.

The Tribunal outlined that Division 149 requires tracing the ‘beneficial interests’ in the asset and the income derived from it directly or indirectly through companies, trusts and partnerships to its ultimate individual owners.

The Tribunal considered that adding Beta as a discretionary object did not automatically change majority underlying interests. It only created a possibility of benefit. Therefore, subsection 149-30(1) did not apply in this context.

In so finding, the Tribunal rejected the Commissioner’s argument that Beta’s appointment caused a change in majority underlying interests. Nor was there any evidence of the original family group being replaced.

The Tribunal considered section 149-30(2) to be an entirely concessional provision as evident from its statutory context and language and, therefore, it “should be construed beneficially”. The statutory context makes clear that subsection 149-30(2) applies as an exception to subsection 149-30(1), which may prima facie apply. The fact that subsection 149-30(1) is extraordinarily difficult to apply in certain circumstances, including with respect to discretionary trusts, informs the “beneficial” interpretation of subsection 149-30(2).

Ultimately, the Tribunal concluded the appointment of Beta in 2011 did not break continuity of majority underlying interests. The Alpha shares remained a pre‑CGT asset and the capital gain on the 2020 disposal was disregarded.

Conclusion

The ART was satisfied that under section 149-30(2) it could reasonably assume that from 20 September 1985 to 10 June 2011, the majority underlying interests in Alpha shares were held by the same ultimate owners. Therefore, Alpha shares retained pre-CGT status, making the assessment excessive.

While the ART did not advocate a strict pattern of distributions test, it reviewed the history of distributions and noted that the taxpayer’s Husband did not indirectly receive more than 50 per cent of the dividends from Alpha shares in the period from 2011 to 2020 or in any single year. The addition in 2011 of Beta (through which the husband could benefit) as a beneficiary of the trust did not cause a change in the majority underlying interests held in the Alpha shares.

The case is also interesting in that it upheld the relevance of historical Taxation Rulings, notably IT 2340 where relevant. Particularly when those antecedent rulings referred to historical provisions, which have been rewritten and updated to reflect their conversion into the ITAA 1997.

How BDO can help

Should you have any questions regarding how the outcome of this case may impact your organisation, please contact your BDO tax adviser for further guidance, or visit our tax services page to see how we can help.