CGT Event E3

 

What is CGT Event E3?

CGT Event E3 is when a trust (not a unit trust) which holds a CGT asset is converted to a unit trust. And just before the conversion, a beneficiary under the trust was absolutely entitled to the asset as against the trustee.

The rules dealing with CGT Event E3 are primarily contained in section 104-65 of the Income Tax Assessment Act 1997 (ITAA).

Context

There are many reasons why a non-unit trust (such as a discretionary trust) might sought to be converted into a unit trust. For instance, in the case of a discretionary trust, there may be reluctance to continue with trustee discretion. The preference may be to provide the beneficiaries with fixed units to dictate their interest in trust property and their proportionate right to distributions from the trust.

It’s also worth noting that the conversion of a non-unit trust to a unit trust has the potential of constituting a change to the original trust that causes a re-settlement under trust law. In brief terms, a re-settlement is where there is a change to a trust that causes it to end and a new separate trust to commence. A re-settlement is likely to trigger another CGT event such as CGT event E1 or event E2. CGT event E1 happens if a taxpayer creates a trust over a CGT asset by way of declaration or settlement. CGT event E2 happens when a taxpayer transfers a CGT asset to an existing trust. If two or more CGT events end up applying (e.g. event E3 and event E1), the CGT event most specific to the situation will have priority application (per section 102-25 ITAA).

Absolute entitlement

A key aspect to CGT Event E3 is that just before the conversion event, a beneficiary was absolutely entitled to the asset as against the trustee. The phrase ‘just before’ makes it clear that any absolute entitlement established on conversion will not be relevant to invoke event E3.

The first thing to note here is that in determining if a beneficiary is absolutely entitled to the asset, you should disregard any legal disability the beneficiary was under just before the conversion event.

In TR 2004/D25, the ATO addresses the meaning of absolutely entitled. A beneficiary will tend to be absolutely entitled to a particular trust asset if they have the ability to call for its transfer to them or at their direction. The right to make this call is grounded in the beneficiary having a vested and indefeasible interest in the entire trust asset i.e. a legally recognised interest that cannot be defeated. The most common examples of absolute entitlement are observed in trusts with a single beneficiary. Note, a beneficiary will tend not be absolutely entitled to a CGT asset if the trustee has a legal basis to legitimately resist a call for the asset.

Units trusts and non-unit trusts

Another key aspect to CGT Event E3 is that a non-unit trust is converted into a unit trust.

A non-unit trust is obviously any trust aside from a unit trust. This can include discretionary trusts along with fixed trusts which are not unit trusts. Note, fixed trusts and unit trusts are not one and the same. A unit trust is generally considered a form of fixed trust. However, as side note, bear in mind that it is possible that a unit trust does not classify as a form of fixed trust under the trust loss provisions because of the way fixed trust is defined under those rules.

Unit trust is not defined in the legislation but is understood as a trust where beneficiaries are provided with a number of defined units in the trust property. The unitholders who subscribe for their units are generally entitled to receive income and capital distributions from the trust in proportion to their unitholding. Take the example of the ABC Trust which has 2 unitholders. Each unitholder subscribes to 10 units of a total 20 units. The unitholders will each be entitled to receive 50% of income and capital distributions. The terms of the converted trust will need to be assessed to confirm the trust has become a unit trust for the purposes of CGT Event E3. For example, the trust deed needs to specify that the trust property has been divided into units.

Although not binding, there is extensive comment from the ATO in Private Ruing 1052077248394 on the definition of a unit trust and the conversion of non-unit trusts to unit trusts. There are a number of other private rulings where the ATO has been asked to decide whether a particular trust had the qualities to be a non-unit trust that converted to a unit trust.

When does CGT Event E3 occur?

CGT Event E3 occurs when the trust is converted to a unit trust.

How to calculate CGT Event E3 capital gain or capital loss

The beneficiary makes a capital gain if (and to the extent that) the market value of the underlying CGT asset exceeds the asset’s cost base at the time of conversion.

Conversely, the beneficiary makes a capital loss if (and to the extent that) the market value of the underlying CGT asset is less than asset’s reduced cost base.

Note, it is the beneficiary who is culpable for the capital gain under CGT Event E3 and not the trustee of the trust which is being converted.

Exceptions

A capital gain or capital loss made by the beneficiary under CGT Event E3 is disregarded if the underlying CGT asset was acquired prior to 20 September 1985 (i.e. pre-CGT).

CGT discounts and concessions

The general CGT discount (Division 115 ITAA) and the small business CGT concessions (Division 152 ITAA) may be available to discount or eliminate a capital gain under CGT Event E3 so long as eligibility conditions are satisfied.

The main residence exemption (Subdivision 118-B ITAA) is not available to disregard a capital gain or loss which arises under CGT Event E3.

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.