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Overview:

Business Succession Agreements

 

Types of Agreement:

Types of Agreement

Cross Ownership:

Cross Ownership

Self Ownership:

Self Ownership

Related Party Vendors

Deemed Dividends

Risks If No Agreement

Trust Ownership:

Trust Ownership

Tax Implications

"Business Family Will"

Changing Needs

Benefits

Choice of Trustee

Super Buy/Sell

 

Drafting Issues:

Put Options

Call Options

Put and Call Options

Conditions Precedent

Put and Call Options vs. Conditions Precedent

 

Other Issues:

Pre-Agreed Purchase Price

Inadequate Insurance Proceeds

Trauma Buy/Sell Strategy

Simultaneous Deaths

 

Debt Reduction Agreement:

Debt Reduction Agreement

 

 

 

 

 

Tax Implications with respect to IGS Trust Ownership Agreement

 

ATO Ruling

Click here to read about the CGT implications of Insurance Policies (including the Trust Ownership of Policies).

IGS has submitted the Business Insurance Trust Agreement for Tax Rulings several times since 1987.

When IGS makes material improvements or changes to the body of the Agreement, it resubmits the documentation for review by the ATO.

The current Ruling was issued in December, 2001.

 

Exemption for Both Death and Non-Death Benefits

The CGT Cell of the ATO has reviewed the Business Insurance Trust Agreement used by IGS and formed the views that:

  1. the Nominated Beneficiaries of the Death Benefit under the Agreement are the 'beneficial owners' of the life policies so as to be eligible for the exemption under section 118-300; and

  2. the exemption under section 118-37 is available to any Beneficiary of a policy (as determined in accordance with the principles outlined in paragraph 1 in relation to life insurance policies) in relation to a payout of a Non-Death Benefit under that policy if the relevant injury or illness (which is the cause of the payout) is suffered personally by the Nominated Beneficiary or his or her relative (as defined in the ITAA 1997).

The Agreement therefore qualifies for an exemption with respect to both:

 

Sources of Exemption

The source of the exemption with respect to each Benefit is:

  • Section 118-300 (Death Benefits); and

  • Section 118-37 (Non-Death Benefits).

Click here to read how these provisions apply to Trust Ownership.

 

Third Party Recipients

One of the benefits of a Business Insurance Trust Agreement is that it can distribute the Insurance Proceeds directly to Third Parties both securely and tax-effectively.

In this case, there is no change to the identity of the Beneficiary or Beneficial Owner of the Policy.

The fact that there might be Multiple Recipients does not mean that there are Multiple Beneficiaries for CGT purposes.

The one Beneficary simply directs the Trustee to pay amounts to Third Parties on its behalf.

The ATO Ruling with respect to the IGS Business Insurance Trust Agreement states that:

"the payment of an amount by the trustee to a nominated recipient in accordance with a nominated beneficiary's direction, will not be the discharge or satisfaction of an asset under CGT event C2."

 

TR2004/D25

Since the issue of the ATO Ruling with respect to the IGS Agreement in 2001, the ATO has issued Draft Ruling TR2004/D25.

The Draft Ruling sets out the draft views of the ATO with respect to Absolute Entitlement Trusts under section 106-50.

This Draft Ruling was first issued in 2004 and is not likely to be finalised within the foreseeable future, because of the level of controversy with respect to its content.

Section 106-50

Superficially, section 106-50 is a very simple provision:

"If you are absolutely entitled to a CGT asset as against the trustee of a trust (disregarding any legal disability), this Part and Part 3-3 apply to an act done by the trustee in relation to the asset as if you had done it."

In effect, section 106-50 provides that a disposal of a CGT Asset by a Trustee will be treated as a disposal by the Beneficiary, if it is "Absolutely Entitled" to the CGT Asset as against the Trustee.

Purpose of Section 106-50

Theoretically, in the absence of section 106-50, there is a risk that there might be two CGT Disposals whenever a Trustee disposes of a CGT Asset:

  • a disposal of the CGT Asset to a Third Party by the Trustee; and

  • a disposal of other Trust Assets (e.g., the Sale Proceeds) to a Beneficiary by the Trustee.

The theoretical risk of a disposal at step two does not take into account the normal tax treatment of the distribution of a Capital Gain to a Beneficiary of a Trust.

However, section 106-50 makes the normal tax treatment irrelevant if the Beneficiary is an "Absolutely Entitled Beneficiary".

In effect, if the requirements of the section are satisfied, the section ignores:

  • the existence of the Trustee; and

  • the disposal of the CGT Asset by the Trustee.

It collapses the disposal down to a disposal of the CGT Asset by the Beneficiary.

By doing so, it removes any risk (if there was one) that there might be two CGT Disposals and therefore two CGT Liabilities.

Application to Insurance Policies

Section 106-50 refers to CGT Assets generally.

There is no reference in section 106-50 or the Draft Ruling to Insurance Policies, although it is accepted that it applies to Insurance Policies.

Additional Source of Exemption

Section 106-50 effectively creates a source of exemption from CGT in addition to other substantive CGT or Income Tax exemptions.

If there is already an exemption with respect to a particular type of disposal (regardless of the type of asset), then it is not necessary to rely on section 106-50.

If there is already an exemption with respect to the disposal of a particular type of CGT Asset, then it is not necessary to rely on section 106-50.

All CGT Assets

In the case of any type of asset, section 106-50 would not be relevant, if there was no CGT or Income Tax Liability, because the Beneficiary was "presently entitled" to the Capital Gain or Income of the Trust.

In other words , if a Beneficiary of a Trust is not subject to CGT or Income Tax on normal principles, it is not necessary to rely on an exemption under section 106-50.

Insurance Policies

In the case of Insurance Policies, section 106-50 effectively creates a source of exemption in addition to sections 118-300 and 118-37.

If an exemption is available to the Beneficiary of a Trust under section 118-300 or section 118-37, it is not necessary to rely on an exemption under section 106-50.

Section 118-300 Exemption for Beneficiary

Section 118-300 already grants the Beneficiary an exemption from CGT on the basis that it is the "Original Beneficial Owner" of an interest in the Policy.

Section 118-300 itself avoids the risk of two CGT liabilities.

Section 118-37 Exemption for Beneficiary

Section 118-37 grants an exemption to the Taxpayer if they receive the payment as compensation or damages for any illness or injury they suffer.

If the Taxpayer is a Beneficiary who is "presently entitled" to the Income of the Trust attributable to the Policy, then they will be exempt under section 118-37.

This is the basis upon which the ATO applies the exemption under section 118-37 to Policies held by Trusts under TD 14.

Again, section 118-37 itself avoids the risk of two CGT liabilities.

Conclusion

It is not necessary to rely on, or satisfy the requirements of, section 106-50, if another source of exemption from CGT or Income Tax applies to the payment.

 

Absolute Entitlement Trusts with Multiple Beneficiaries

It is important to recognise that TR2004/D25 does not say that Multiple Beneficiary Trusts cannot satisfy the requirements of Absolute Entitlement.

Instead, it sets out the basis upon which the ATO believes the requirements will be met.

The ATO has adopted a narrow view of what constitutes an Absolute Entitlement Trust where there are Multiple Beneficiaries.

Some competitors have argued that there is an inconsistency between the Draft Ruling and the IGS Tax Ruling in relation to Multiple Beneficiary Trusts.

Single Beneficiary Trust

Under the standard IGS Trust Agreement, there is only one Beneficial Owner with respect to each Policy.

The fact that there might be Multiple Recipients does not mean that there are Multiple Beneficiaries for CGT purposes.

The IGS Ruling and the Draft Ruling are consistent with respect to this version of the Agreement.

Multiple Beneficial Owners

In some cases, the IGS Agreement splits a Policy into separate components, each of which is beneficially owned by a different Beneficiary or Beneficial Owner.

An example of this structure is the situation where:

  • some of the Cover is beneficially owned by the Life Insured; and

  • other Cover is beneficially owned by the Trustee of a Self-Managed Superannuation Fund.

Where there are two or more Beneficial Owners under the IGS Agreement, the Agreement has been drafted so as to obtain an exemption without having to rely on section 106-50 (see the above discussion).

Instead, it relies directly on the exemptions for Trust Ownership available under sections 118-300 (Death Benefits) and 118-37 (Non-Death Benefits).

The IGS Tax Ruling did not rely on section 106-50 in order to grant the exemption where there are Multiple Beneficiaries.

It is sufficient that the Agreement qualify for an exemption under section 118-300 with respect to a Death Benefit or section 118-37 with respect to a Non-Death Benefit.

This means that it is irrelevant whether section 106-50 creates a CGT exemption with respect to Multiple Beneficiary Trusts.

Thus, there is no inconsistency between the IGS Tax Ruling and the Draft Ruling.

 

IGS Submissions with respect to TR2004/D25

IGS is actively involved in the review of TR2004/D25 and has made several submissions to the ATO with respect to the correctness of the Draft.

The Relevant "CGT Asset"

One area of criticism is that the Draft insists that the "CGT Asset" must prima facie be the whole of the physical asset.

In other words, it argues that, if the Beneficiary owns part of the asset beneficially, it is not possible to satisfy the requirements of section 106-50 with respect to that part only.

The requirements of the section must be satisfied with respect to the whole of the physical asset.

This view makes it difficult to establish "Absolute Entitlement" where other Beneficiaries have an interest in the same physical asset.

The ATO's view is contrary to the express provision of section 108-5, which states that a "CGT Asset" includes "part of, or an interest in, an Asset".

This means that the Beneficiary only has to be "Absolutely Entitled" to the CGT Asset in which it has an interest.

Because the relevant asset is the part or component in which it has a 100% interest, then it will be absolutely entitled to that part or component.

The Beneficiary would therefore be entitled to call upon the Trustee to transfer legal title to that part or component to it.

"Fungible Assets"

Notwithstanding the ATO's views on the relevant CGT Asset, the Draft permits Multiple Beneficiaries in some circumstances (e.g., where the physical assets are "fungible").

The ATO takes this to mean that:

  • the physical assets are physically divisible into separate assets or components, each of which would satisfy the relevant Beneficiary's entitlement; or

  • the Beneficiary's interest in the one asset could be adequately replaced by a replacement asset that is identical in substance.

In these cases:

  • the ATO recognises that each Beneficiary could take a separate asset or component; and

  • therefore it considers that each Beneficiary is Absolutely Entitled to that asset or component.

Physical Divisibility

The concept of "fungibility" is a relatively novel concept.

There does not seem to be any legitimate foundation for it in the wording of the section itself or in the definition of the term "CGT Asset".

However, even if the concept of "divisibility" was relevant, it is arguable that the divisibility should be or include the "legal" divisibility of the underlying physical asset.

The emphasis on "physical" fungibility does not adequately recognise that the relevant asset can be "legally" broken up into separate components, each of which could be legally or beneficially owned by a separate Beneficiary.

The ATO has to take into account the terms of the Trust Deed.

If it is the intention of the parties that the Trust constitute a "tenancy-in-common" between the different or separate Beneficiaries, then there would a clear indication that:

  • each Beneficiary is intended to have a proportionate interest in the physical asset; and

  • this proportionate interest could be transferred by the Trustee to the Beneficiary in specie in satisfaction of its separate interest.

This should be sufficient to make each Beneficiary "Absolutely Entitled" to its own CGT Asset.

Replaceability

An alternative argument applies to Insurance Policies in particular.

If two Beneficiaries each beneficially owned one-half of a $1M Policy, then there would be no substantive difference if each Beneficiary was issued a $500K Policy in substituition for their interest in the One Policy.

Thus, it is arguable that an Insurance Policy is a perfect example of a CGT Asset that is "fungible" in the sense of being able to be replaced by a similar asset.

A Trustee could satisfy the requirements of both Beneficiaries by cancelling the One Policy and taking out two separate Policies, without detriment to the interests of either Beneficiary.

Conclusion

IGS does not accept that the Draft correctly applies the current law.

However, even if the Draft is correct, IGS submits that the correct application of the ATO's own views with respect to Multiple Beneficiaries would result in a CGT exemption with respect to Insurance Proceeds payable to Multiple Beneficiaries, because an Insurance Policy is "fungible" (i.e., divisible into separate components, each of which may be owned by different or multiple Beneficiaries).

Most importantly, it is not necessary to rely on section 106-50 in order to obtain an exemption under section 118-300 or 118-37.

These sections are direct sources of exemptions for Trust Ownership of Insurance Policies.

 

Directions to Trustee

Because the Life Insured is the Beneficial Owner of the Policy, it is entitled to direct the Trustee (or Legal Owner) how to distribute the Insurance Proceeds on behalf of the Life Insured.

 

Copyright: Ian Gray Solicitor

 

 

Adviser Tip

Trust Ownership can do everything that Self-Ownership can do, but Self-Ownership can't do everything that Trust Ownership can do.

See more Adviser Tips

 

 

 

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