CGT Event E4: Tax timing adjustments and the potential for double taxation

Practitioners should be familiar and mindful of the potential application of CGT event E4 when dealing with unit trusts. This is especially the case  where payments are made to unitholders in respect of their unitholdings, and some or all of those payments are not included in the unitholders’ assessable income (the “non-assessable part”). If CGT event E4 happens, and subject to certain exclusions or adjustments to the non-assessable part of the payment, the cost base of the units will be adjusted downwards (but not below nil). If there is any balance remaining after the cost base reduction process, the non-assessable part of the payment is assessable to the unitholder as a capital gain.

There is a misconception that CGT event E4 can only happen to corpus distributions or capital payments since such amounts are generally not included in the assessable income of a unitholder. However, tax timing adjustments are also a variable that could trigger CGT event E4 if the adjustment gives rise to an anomaly between what is available for distribution for trust law purposes (distributable income) and the amount assessed as section 95 net income (i.e., taxable income). Examples of tax adjustments which could cause a difference between distributable income and taxable income include accrued expenses, where a deduction for the expenditure occurs in a later income year, Division 43 capital works deductions, instant asset write-off/previous temporary full expensing claims where the asset is depreciated over time for accounting purposes, the tax-free component of capital gains etc.

In some instances and depending on the timing of the payment of distributable income this could cause a unitholder from being potentially taxed twice on the same amount of income – once under section 97 ITAA 1936, and also as a CGT event E4 capital gain.

Potential for double taxation

Below is a simple example to illustrate this point.

In Year 1 ABC Unit Trust, a trading trust, generates business revenue of $100,000 and expenses of $20,000 (of which $10,000 relates to accrued annual leave entitlement, paid in Year 2). After payment of operating expenses the unit trust has $90,000 cash in the bank. As annual leave entitlements are only deductible when paid, the taxable income of the trust is higher than its distributable income by $10,000.

In Year 2 ABC Unit Trust generates the same level of business revenue and incurs the same level of other expenses (but this time there is no need to accrue for annual leave). After paying the expenses as well as the annual leave accrued in Year 1, the unit trust has $80,000 cash in the bank (in addition to the $90,000 cash from Year 1). The annual leave having already been accrued is not expensed again for accounting purposes. However, the annual leave entitlement is now deductible for tax purposes, so the distributable income in Year 2 is higher than its taxable income.

ABC Unit Trust’s trust deed defines income of the trust estate as being based on general accounting principles. Bob, the sole unitholder is made presently entitled to the distributable income of the trust in both Year 1 and Year 2. Pursuant to section 97 ITAA 1936, Bob is liable for tax on the whole of the trust taxable income for each of those years. Also, in Year 2 ABC Unit Trust distributes $90,000 to Bob as a partial discharge of the UPE it owes Bob.

Does the $90,000 payment in Year 2 cause CGT event E4 to happen?

The table shows that in Year 2, distributable income exceeded taxable income with the result that Bob will be assessed on $80,000 of the payment with $10,000 of this being the non-assessable part. The table also shows that the non-assessable component of the payment was previously included in Bob’s assessable income in Year 1. So, the logical inference is that all of the $90,000 payment in Year 2 would have been included in Bob’s assessable income (whether in the year of payment or the previous year).

So, if the non-assessable part of a payment could reasonably be traced to funds sourced from amounts previously taxed, then, arguably, CGT event E4 should not happen when the payment of the $90,000 occurs in Year 2.

The ATO adopts a similar view in private binding ruling PBR 1012974011502 (date of advice: 24 February 2016). The Commissioner concluded in that PBR where the amounts later distributed can be found to be sourced from funds that were previously taxed, then CGT event E4 will not happen. This is because the payment representing the expenses has been included in the unitholders’ assessable income in the previous years.

It is not clear whether the position adopted in that PBR is a commonly held view. Based on the “official” position in ATO ID 2012/63 (which had a similar fact pattern) the ATO considered that the fact that a taxpayer was assessed on an amount of net income in a prior year is not relevant to the question of whether CGT event E4 happens in an income year. The explanation provided seems to suggest that the CGT event E4 assessment should be by reference to whether or not the payment is included in the assessable income of the unitholder in the year that it is paid.

If ATO ID 2012/63 is the correct interpretation of the law, then there could be a potential for double taxation. Based on the above example Bob is assessed on the $10,000 in Year 1 pursuant to section 97 ITAA 1936, and the same amount is assessed in Bob’s hands again in Year 2 as an event E4 capital gain when it is paid to him (assuming the cost base of Bob’s unit in ABC Unit Trust is $1).

Possible remedies 

Based on the above example a possible solution to reduce the risk of double taxation is for ABC Unit Trust to pay out the $90,000 cash in Year 1 (when taxable income is higher than distributable income). Where applicable Bob could on lend the $10,000 back to the trust on a need basis. Another possible solution (if the trust deed allows) is for ABC Unit Trust to equate its distributable income to equal taxable income in Year 1 (where the tax timing adjustments result in taxable income being higher than distributable income). In this circumstance, it may be worth considering whether the accounts should be prepared on a section 95 basis so that they show the net income of the trust under its deed. As usual nothing is simple in tax, so when making trust distributions practitioners should plan around CGT event E4 by taking into account tax timing adjustments.

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