Having recently celebrated the 40th anniversary of the introduction of Capital Gains Tax (CGT), it still surprises us how many pre-CGT assets remain held by family groups.
When CGT was introduced, a key part of the legislation was the grandfathering of assets that were already held on the 19 September 1985.
However, as we move into the next phase of family succession and control, the CGT status of many family assets need to be considered in greater detail.
As an integrity measure to ensure taxpayers were not able to unreasonably benefit from an assets pre-CGT status, two specific provisions were enacted to treat the disposal of what was otherwise a pre-CGT asset into a taxable capital gain.
Those provisions are Division 149 and CGT Event K6 of the Income Tax Assessment Act 1997.
Division 149
Division 149 only applies when a pre-CGT asset is held in a company or a trust. The Division states:
The 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 *majority underlying interests in the asset immediately before 20 September 1985.
A majority underlying interest is taken to be a more than 50% beneficial interest in the pre-CGT asset and the income to be derived from that asset. This will require a tracing of the ownership of the entity immediately prior to 20 September 1985 and throughout its subsequent ownership period.
Where a change in ownership interests triggers a change of 50% or more, then the majority underlying interests will have changed and at that point the Division is enacted to “deem” the pre-CGT asset to have been re-acquired by the entity, as a post-CGT asset at that time and at its market value at that time.
Without careful consideration of the transfer or allotment of shares and/or units in an entity that holds a pre-CGT asset, that asset could inadvertently become a post-CGT asset.
When you are considering the succession of family entities that hold pre-CGT assets, a review of the potential impact of Division 149 not only in regard to what is proposed, but more so what has already occurred in the years since September 1985 is crucial.
Careful consideration is required when any of the following have occurred:
- The issue or redemption of Class shares or units that enable discretionary income distributions;
- Pre-CGT assets held by a Discretionary Trust where the distribution pattern to beneficiaries has changed over the years;
- Share or unit transfers because of death or marriage breakdown;
- Share splitting or the issue of bonus shares; and
- The use of CGT rollovers.
CGT Event K6
CGT Event K6 was introduced to stop taxpayers being able to take advantage of selling their pre-CGT interests in an entity tax free, albeit that the entity holds substantial post-CGT assets.
Its application is quite complicated and seeks to deem part of the sale proceeds of a pre-CGT share or unit as a taxable capital gain based on a proportionate share of the capital gain that relates to the post CGT asset held by that entity.
Unlike Division 149, another CGT Event needs to occur before CGT Event K6 is enacted, most commonly the sale of a share or a unit. When a pre-CGT share or unit is disposed of, advisers need to check whether CGT Event K6 could apply and to do so requires a valuation of the post CGT assets held by that entity.
The key condition for CGT Event K6 to apply is the 75% test.
Under this test, just before the shares or units are disposed of, the market value of the post-CGT assets of the entity (excluding trading stock) must be 75% or more of the net market value of the entity.
Given it has been over 40 years since CGT was introduced, it would not be unusual for pre-CGT companies and unit trusts to have accumulated substantial post-CGT assets that may be close to or over the 75% threshold.
Indeed, we have worked with a number of families in respect to their succession plans and have identified that CGT Event K6 will be enacted upon a sale or disposal of pre-CGT shares or units, much to the surprise of the family members.
There is some planning that can be done to mitigate the K6 gain and indeed the calculation process does enable what is termed “a reasonable attribution” of the unrealised gain, however there is no escaping the complexity of determining this amount when for many families their expectation was that the transfer would be tax free.
If you need any assistance in reviewing your client’s pre-CGT asset status, please contact Ross or Sean.