Taxing Matters: Capital Gains Tax and its Effect on Values

Capital Gains Tax

AND ITS EFFECT ON VALUES

By Grahame Young FTI, TEP

Barrister, Francis Burt Chambers

Suppose a deceased estate holds two assets having equal market values. Property A is either a pre-CGT asset or a post-CGT asset with a cost base approximately equal to the market value. Property B is a post-CGT asset with a cost base very much less than the market value. There are two equal beneficiaries and, under the Will or by agreement between them, each is to be entitled to one of the properties. If the beneficiaries were to dispose of the properties then the beneficiary taking Property A will only have a capital gain equal to any increase in value after transfer from the estate, but the beneficiary taking Property B will have a capital gain including the capital gain that accrued before the transfer from the estate.

As between the beneficiaries, the value they place on the properties will be influenced by the potential tax liability, but any purchaser will be indifferent to the taxation consequences for the seller. The question arises, what, if any, allowance is to be made for the latent capital gains tax on any subsequent disposal of property B? The question can arise in a number of contexts:

• The agreement between the parties as to who takes which property; • If there is an equalisation clause in the

Will; and • The transfer duty payable on the transfer if a beneficiary is taken to receive dutiable property having a value greater than their entitlement. The issue was considered recently by Bampton J. of the South Australian Supreme Court in Todd v Todd [2021] SASC 36, in the context of an equalisation clause intended to result in all beneficiaries receiving “an equal value of bequests” under her will. The bequests were of properties having differing market values. Two of the beneficiaries were to receive properties subject to a latent liability for capital gains tax. The executors put forward a methodology for valuing the properties by deducting the tax payable by the beneficiaries assuming the properties were sold as at the date of the deceased’s death and the beneficiaries would disclose their tax returns to enable the calculation to be made.

The two beneficiaries were prepared to accept that methodology, but also took a “value received” approach which would make allowance for the possibility of a future sale.

They argued that an allowance should be made under the equalisation clause and cited the family law decision in Rosati v Rosati [1998] FamCA 38 in which the Court held that the potential liability could be taken into account in relation to a division of property. They cited a number of other cases, but were unable to persuade the judge that they supported their contention. They also noted that in the valuation of assets and liabilities accountants, “every day of the week”,take into account future events that may or may not happen. The other beneficiary relied on the well known Spencer test to support her contention that value meant market value.

The judge accepted that there could be “truly exceptional circumstances” where “value” should notionally bring future CGT liabilities into account, but held there was no evidence to suggest such circumstances existed.

After pointing out some of the difficulties standing in the way of making an allowance she found that “value” in the equalisation clause meant market value.

While the judgment was made in relation to a particular equalisation clause, it is submitted it has wider application. In the writer’s experience, as between beneficiaries, it can be possible to agree on an allowance for the adverse tax consequence after taking into account the effect of three variables:

• The likely time the property will be retained by the beneficiary before being disposed of; • A discount rate to calculate the time value of the deferral of the liability; and • The rate of tax applicable to the gain. Resolution of the issue can be further complicated if the beneficiary has carry forward capital losses that may or may not still be available to be offset against the capital gain when realised. Any agreement usually assumes the continuation of the current capital gains tax regime and income tax rates. It is difficult, if not impossible, to forecast future tax rates or legislative changes, particularly if the property is subject to special provisions, such as the exemption for main residences or active assets of a small business that have been the focus of legislative attention from time to time.

These matters can preclude agreement being reached, in that event the fall-back is likely to be that no allowance can be made or the properties are sold. The decision in Todd suggests that a standard ‘equalisation’ clause will not be effective to take account of tax consequences. No doubt it would be possible to draft a clause that fixes, or prescribes a method to fix, the variables mentioned above so a calculation can be made of the potential liability in order to equalise the benefits received. I suggest the drafting would be difficult and that changing circumstances may mean the adjustment no longer works as intended and creates the same sort of unfairness that the provision seeks to overcome. The more recent case of Craven v Bradley [2021] VSC 344 deals with a clause that was effective, but nevertheless required the Court to construe the equalisation clause. Finally, in respect of the transfer duty regime for transfers from deceased estates contained in sections 139 and 139A of the Duties Act 2008, the decision in Todd confirms the values to be taken into account for determining whether a beneficiary has received dutiable property with a value greater than the beneficiary’s entitlement to the estate will be the market values without any adjustment for the taxation consequences for the beneficiary.

Grahame Young is a member of STEP, the Society of Trust and Estate Practitioners, a multi-disciplinary group with branches worldwide, including in Western Australia. For further information concerning STEP visit https://stepaustralia.com