What is CGT event K3?
CGT event K3 addresses a situation where a taxpayer becomes deceased and a CGT asset that taxpayer owned passes to a beneficiary of the deceased estate, whereby the beneficiary is either:
- An exempt entity, or
- The trustee of a complying superannuation entity, or
- A foreign resident.
The rules which address CGT event K3 are contained in section 104-215 of the Income Tax Assessment Act of 1997.
Essentially, what this CGT event is trying to achieve is to prevent CGT assets from exiting the CGT system without any tax consequence.
For example, take Bob who acquired a CGT asset in 2010 for $100,000. Bob becomes deceased in 2023 and the CGT asset has a market value of $500,000 at this time. If a CGT asset of Bob’s estate is distributed to an exempt entity (i.e. any entity that does not pay income tax), and that exempt entity receives and sells the CGT asset for $500,000, the asset purchased by Bob is never subjected to income tax. That is, the capital gain on the asset has escaped the income tax net.
CGT event K3 therefore seeks to impose a tax consequence at the time of disposal to ensure any unrealised gain which accrues to the deceased on a CGT asset will not be exempt when a CGT event happens to that asset in the hands of the beneficiary.
The basic tax rule for assets passing to a beneficiary of a deceased estate
CGT event K3 somewhat contradicts the basic tax rule for assets passing to beneficiaries of a deceased estate. The basic rule articulated in Division 128-10 and Division 128-15 of the ITAA 1997 is that any capital gain flowing from the event of death of a taxpayer should be disregarded. This means there is no capital gain where the deceased’s asset vest in the trustee of the estate nor when the trustee of the estate distributes assets to beneficiaries of the estate (with exceptions). From the perspective of the beneficiary, this means there is usually no immediate CGT related tax liability from inheriting the asset. However, the inherited asset cost base will be equivalent to the cost base of that asset to the deceased (i.e. when the deceased originally acquired the asset). In this way, the unrealised capital gain from the time of the deceased’s acquisition until death is not really tax free. Rather, the tax on this unrealised gain (plus or minus any appreciation or depreciation at the point the beneficiary realises the asset) is part of the capital gain or loss to be recognised by the beneficiary when a CGT eventually happens to the asset.
For example, take CC who acquires a CGT for $100,000. CC becomes deceased and according to her will, the CGT asset is distributed in specie to her husband David. The market value of the asset at the time of death is $300,000. However, there is no capital gain or loss to be recognised by the trustee of the estate due to operation of Division 128 of the ITAA 1997. When David acquires the asset, he must record a cost base equivalent to CC’s cost base in the asset. This is $100,000. Therefore, if David sells the CGT asset for $500,000, his capital gain is $400,000 ($500,000 capital proceeds $100,000 inherited cost base) not $200,000 ($500,000 capital proceeds $300,000 market value of asset acquired by David at the time of death).
What time does the event occur?
CGT event K3 occurs just before the death of the deceased taxpayer. That is, the deceased will be treated as though they disposed of the asset to the beneficiary just prior to death.
How to calculate the capital gain or loss?
There is a capital gain if the market value of the asset on the date of death (capital proceeds) exceeds the deceased’s cost base of the asset.
There is a capital loss if the market value is exceeded by the reduced cost base of the asset.
Who does the CGT event occur to?
The CGT event occurs to the deceased taxpayer as represented by the trustee of the deceased estate. The trustee of the deceased estate must include any net capital gain in the date of death tax return. Remember that a date of death return refers to the tax return that must be lodged on behalf of the deceased for the period starting on 1 July of the income year of death to the date of death.
For example, if CC dies on 31 December 2023, the date of death return would relate to the period from 1 July 2023 (the start of the income year of death) to 31 December 2023 (the date of death).
The legal personal representative/trustee of the deceased estate will be responsible for lodging the date of death return.
Remember that accrued capital losses of the deceased may be applied against any capital gain in calculating the net capital gain recognised on the date of death return.
Exempt entity
As mentioned, the tax advantaged status of an exempt entity is the reason CGT event K3 applies.
An exempt entity is defined in section 995-1 of the ITAA 1997 as follows:
‘…An entity all of whose ordinary income and statutory income is exempt from income tax because of this Act or because of another Commonwealth law…’
Section 11-5 of the ITAA 1997 lists entities of such kind. This includes certain charities, educational institutions, community service societies, and public authorities. Division 50 of the ITAA 1997 addresses the concept of tax exempt entities and sets out the requirements that must be satisfied for the exemption to be available.
The trustee of a complying superannuation entity
CGT event K3 applies to CGT assets which pass to the trustee of a complying superannuation fund. Although superannuation funds are not strictly tax exempt, it is likely that the rate of tax imposed on the happening of a CGT event within the fund is minimal. This is because the rate of tax imposed on capital gains is 15% on capital in accumulation phase and 0% on capital in pension phase.
The CGT discount is also available to further reduce capital gains on assets held for at least 12 months. However, the discount percentage is 1/3 (not ½).
Therefore, CGT event K3 exists to prevent CGT assets being subject to low (or no) tax within the tax advantaged superannuation environment.
A foreign resident
CGT event K3 will apply if the deceased taxpayer was a tax resident and the asset which passes to the beneficiary was not Taxable Australian Property.
Remember that Taxable Australian property includes Australian real property (and other assets), as defined in Division 855 of the ITAA 1997.
CGT event K3 only applies if the asset is not Taxable Australian Property because Taxable Australian Property will still be subject to CGT in the hands of foreign resident. Therefore, there is no escape from the scope of Australian income tax when the foreign resident realises that CGT asset (or where another applicable CGT event occurs).
Note that by the term foreign resident we refer to a person or entity that is not a resident of Australia for taxation purposes.
As addressed below, there are number of complications which may arise in respect of the CGT event K3 and deceased estate distributions to foreign residents. This includes the need to determine tax status at the appropriate time. This is not necessarily the time of death or the time the asset is legally transmitted or transferred to the relevant beneficiary.
Because of the complications presented by CGT event K3, a Will maker may prefer drafting a Will which enables the trustee of the deceased estate to distribute cash (instead of a in specie property distribution) or property that is Taxable Australian Property to a foreign resident beneficiary. This will enable the trustee to make distributions in such a way so as to avoid the application of CGT event K3. Alternatively, the CGT asset may be passed to the trustee of a resident testamentary trust for the benefit of the foreign resident. The transfer from an executor to testamentary trust will not trigger CGT event K3 or any other CGT consequence per the ATO approach expressed in Practice Statement LA 2003/12. This PS LA concerns the scope of Division 128 to prevent CGT outcomes on death. However, there are a number of separate tax and other matters which should be thoroughly considered before a testamentary trust is established to hold property for the benefit of a non resident beneficiary.
What is the CGT consequence for the tax advantaged entity when CGT event K3 applies?
The tax advantaged entity which receives the CGT asset from the deceased estate will be considered to have acquired the CGT asset at the time of death (not the time of receipt of the asset).
The cost base of the CGT asset is its market value at the time of death. Therefore, any capital gain will be the based on the extent to which the market value of the asset at the time of death are exceeded by the capital proceeds received once a CGT event occurs to the asset (e.g. when the beneficiary sells the asset)
Pre CGT asset
If a CGT asset was acquired by the deceased prior to 20 September 1985, any capital gain or capital loss under CGT event K3 is disregarded.
Instances where a capital gain or loss from CGT event K3 may be disregarded
If a CGT asset passes to a beneficiary in the form of a philanthropic testamentary gift, the capital gain or loss under CGT event K3 may be disregarded. The rules for eligibility to disregard capital gains or losses are contained in section 118-60. These rules are broadly similar to the standard rules governing the deductibility of gifts made during the lifetime of a taxpayer.
Specifically, section 118-60 provides:
‘…A capital gain or capital loss made from a testamentary gift of property that would have been deductible under section 30-15 if it had not been a testamentary gift is disregarded…’
However, note the caveat in subsection 118-60(4) which provides that if a gift is later acquired for less than market value by the deceased persons estate or a person who is an associate of the deceased, then:
‘the cost base…of the property in the hands of the estate or the deceased’s associate [that acquires the gift from the beneficiary] is worked out under section 128-15 as if the property had passed in the estate to the estate or the deceased’s associate.’
The main residence exemption is available to disregard a capital gain under CGT under K3 which results from the deceased’s main residence passing to a tax advantaged entity. However, the eligibility criteria in section 118-110 of the ITAA 1997 must be satisfied.
Furthermore, the main residence exemption can apply to disregard a capital gain when the trustee of the deceased estate or beneficiary disposes of the main residence. However, the requirements of section 118-195 must be satisfied. This includes:
- that the dwelling was the deceased’s main residence (as a question of fact) just before death, and
- that the dwelling was not being used for producing assessable income, and
- that the ownership interests ends within 2 years of the deceased’s death, or within a longer period allowed by the Commissioner. That means that the property supporting the main residence must be sold within 2 years of the death of the deceased.
Note there are different rules that apply if the deceased acquired the main residence before 20 September 1985.
CGT event K3 and the CGT concessions
The CGT discount and small business CGT concessions will generally be available if the basic eligibility criteria are satisfied. In respect of the CGT discount, this includes that the asset is held for at least 12 months preceding the date of death. In respect of the small business CGT concessions: that the asset is an active asset in a business of the taxpayer and either the MNAV or small business entity test is satisfied.
Note that the 15 year exemption under the small business CGT concessions may be available to entirely eliminate a capital gain on certain active assets held continually for a period of 15 years. However, there is modified eligibility criteria in the event of death. Note that the required period of continual ownership is not necessary severed in the event of death.
Problems with CGT event K3
There are a number of challenging and problematic aspects to the operation of CGT event K3. Some of these problems are explored below.
Problem 1
If a CGT asset is distributed which is not Taxable Australian Property, CGT event K3 only applies if a beneficiary is a non resident at the time the CGT asset passes to the beneficiary. The intended timing inferred by the term passes is somewhat unclear.
In Taxation Determination 2004/3, the ATO view expresses the view that a CGT asset bequeathed to a beneficiary on settlement of an entitlement under a Will will pass at the time the estate debts are discharged (assuming the executor has no discretion regarding distribution). This is the time the beneficiary becomes absolutely entitled to the CGT asset, not the time the CGT asset is transmitted or transferred to the beneficiary nor the time of death.
This problem presented is that certain beneficiaries may be a resident or non resident at the time of death or at the time of transfer of the CGT asset, but that status may be different at the time the asset passes.
Problem 2
CGT event K3 will only apply in respect of an indirect Australian real property interest if the share or trust interest is Taxable Australian Property at the time the asset passes to the beneficiary. The status of a CGT asset as Taxable Australian Property part way through an income year may be practically difficult to determine. This is because the tests related to determining if there is an indirect Australian real property interest tend to rely on information which is gathered at the end of an income year, not part way through an income at the time CGT event K3 requires the assessment to be made.
Problem 3
The legal personal representative of the deceased estate is responsible for discharging tax liabilities using estate assets. The problem presented by CGT event K3 is that there is an inherit mismatch between the party which receives economic benefits and the parties that bear the tax liability. Specifically, where K3 occurs the beneficiary of the estate receives the CGT asset from the estate (i.e. the economic benefit) but it is the estate that bears the tax burden which results from CGT event K3. This tax liability diminishes the remainder of the estate available to distribution (if any) to other beneficiaries (ultimately at their expense). Note that the Will of the deceased may be drafted to require the foreign beneficiary to compensate the estate for the tax liability which results from CGT event K3. Alternatively, the Will may address the tax liability by ensuring an equalising payment is made to resident beneficiaries.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.