Tax Tip 299: CGT Trap if Leaving Shares on Death to a Non-Resident Beneficiary

There is a CGT trap for young players whose shares pass to non-residents upon their death.

The issue is CGT event K3 is triggered.

Generally, assets of the deceased pass on death to an executor/administrator then to the beneficiary under the will or intestacy laws without any CGT event being triggered. Any capital gains are only payable when the beneficiary sells the asset they have inherited.

For shares this is generally the case, but there is a difference where the shares pass to a tax non-resident. The estate will be taxed – actually the deceased will be taxed in his or her final tax return. This is the case even though the shares may not actually be sold. Having an unexpected tax bill can affect gifts made to other resident beneficiaries too. Depending on the wording of the will their shares of the inheritance could be reduced.


Example

Homer is an Australian tax resident. He draws up his will so that the main residence passes to his son Bart, the investment property to his daughter Maggie and his shares to his daughter Lisa. All are tax residents of Australia. He does it this way because the kids are all over 18 and this is what they wanted.

10 years pass. Lisa marries a woman from Uganda and goes and lives in Tehran, Iran where she works on a Uranium processing facility.

Homer suddenly dies, choking on a pork chop. His last words were ‘****, I never got around to updating my will’.

6 months later the executor transfers assets. Bart gets the main residence – no CGT issues. Maggie gets the investment property – no CGT issues until she sells. Lisa will get the shares, but the executor realises there is a tax issue. The cost base of the shares is $500,000 and the value as of the date of death is $1,500,000. That is a $1mil capital gain.

Homer will need to pay the tax. It will depend on how the will is worded as to whose share this comes out of, but in this case Lisa wears it.

There is no 50% CGT discount available to non-residents. So that is a $1mil capital gain, all subject to tax.


A simple way to avoid this is to leave the shares to the trustee of a Testamentary Discretionary Trust and structure it so the trust remains a tax resident of Australia.

 

Are these potential things the testator or executor can do:
1) Write the will so that it allows shares of estate assets by value, so that the non resident beneficiaries get the assets that do not trigger K3.
2) Realise capital gains in the estate over 3 years.
3) Realise capital gains over multiple years prior to death.

 

depending on the wording of the will there could be an adjustment clause which allows gifts to be moved around and the executor could be allowed to sell shares over 3 years - but the better way may be a testamentary discretionary trust to receive the gifts and this trust be a resident.
I will write about this in my next tip

 

Its a issue tax advisers need to exercise care with. CGT event K3 is a CGT event for Homer, not the deceased estate and is a matter for the date of death return. K3 effectively treats it as if Homer had disposed of the shares at the moment when he was happily chewing on his pork chop. TD 2004/3 raise issues with when the asset "passes" and can alter some outcome if the trustee has some notional capacity to restructure the assets being passed to a beneficiary rather than all beneficiaries being absolutely entitled at death for later distribution on the estate being finalised.

There can also be indirect interest problems when shares in a entity holds taxable Australian property. These shares wont be impacted by K3.

Definately one for tax advice if a non-resident is made entitled to assets in a will. A will which engineers a tax avoidance concern falls under Part IVA. TR 2003/3 generally applies however to a complex scheme and not a basic will. But could

 

My understanding is that only Taxable Australian Property is exempt from triggering K3.

So does that mean that if you wanted to gift non-resident children cash, while you're still alive, that cash gift would end up triggering K3?

 

Does K3 apply when you are still alive?

 

CGT events are best understood reading the table in the law. K3 is na event on the death of the asset owner if the beneficial owner is "tax advantaged". Thats it. It cant be triggred while alive. However a different CGT event may apply if you gifted shares to a non-resident for example. Or commenced to hold them on trust for that person. etc

 

That's great to know, thanks.

Do you mean a CGT event that's applicable in the non-resident's country?

I am setting up TTs for my children and appointing a resident child as trustee of all TTs to avoid triggering K3. But I also want to gift my children some cash (while I'm alive) -I'm pleased to hear K3 won't be an issue with that at least.

 

no

 

No. CGT event K3 defines that on death of the owner if the beneficiary is a non-resident and the deceased's will makes them entitled to a CGT asset that CGT event (K3) occurs. This taxes the non-resident at market value as a "deemed disposal" where for a tax resident the beneficiary inherits the asset's costbase and CGT is deferred until they later sell the asset. The country they are from is irrelevant if they are not a tax resident on the date of death. The sole test is whether the beneficiary is not a tax resident ON the date of death.

A TT will bypass the event as the beneficiary is not entitled to an asset. However if the tax residency issues concerning the TT arent considered it can still occur. For example a non-resident trustee or a non-resident trust. But these are different CGT events. You dont want the trustee of a TT to be a tax non-resident at the time of death.

 

That makes sense, thank you.

The trustee of the TT will definitely be a resident. Can a non-resident beneficiary of a TT (with a resident trustee) trigger K3? I think I read somewhere that non-resident beneficiaries can still trigger it.

 

A non-resident beneficiary of a TT wont meet the tests for K3 as they dont "inherit" under the will.. Also K3 doesnt apply to real property interests owned by the deceased.

s128-20 defines when an asset passes under K3. An asset “passes to a beneficiary” in an estate if the beneficiary becomes the owner of the asset under the will or under any other of the criteria in section 128-20. Importantly, a CGT asset does not pass to a beneficiary if the beneficiary becomes the owner of the asset because the legal personal representative (that is, the executor) transfers it under a power of sale rather than inheritance. K3 also doesnt apply to survivorship for real property for a joint asset. It also doesnt matter whether that asset is transferred directly or by a executor.

A TT interest is not a inheritance of a CGT asset. Instead the beneficiary has a beneficial entitlement based on the deed and other matters incl the trustee discretion etc. eg They may get income from the assets but dont inherit the assets.

 

And that raises the quandry many estates may face. Real property inheritances comes with a CGT issue where there is no discount for a non-resident beneficiary and K3 does much the same. HOWEVER, if the will was to contemplate the trustee disposing of the shares and property and making the non-resident inherit cash then there may be no concern.

Where a beneficiary may cease to be a tax resident its important to consider any inheritance. One asset they could inherit without a major tax concern can be some elements of super or assets not subject to CGT. The will should be drafted to provide the executor with maximum flexibility including potentially deferring the taxing issue.

 

Thank you, that's very helpful.

If we set up a TT with a resident trustee, and both a resident and non-resident as beneficiaries, my understanding is that the Oz resident would just pay tax in their own tax return, and the foreign beneficiary would have tax withheld by the trust and then they would receive the income net of tax. Then the trust would pay the tax when it lodges a tax return. Is that right?

 

The testamentary trust would help avoid CGT event K3 being triggered, but if the trustee makes a non-resident presently entitled to the income the will have to pay the non-resident tax rates, or the trustee pay it on their behalf.

 

Wouldn't the frequency of these resident/non-resident issues be significantly reduced by the proposed new residency rules?
For example person A is a tax resident of both Australia and country B according to the domestic legislation of each country. The DTA resolves which country can tax what and by how much. However in the above scenario when a beneficiary is living abroad but still a tax resident of Australia, they would pay resident tax rates, get the CGT discount, use franking credits and not trigger K3?
All it will take is for an Australian citizen/PR to be in Australia for 45 days in a tax year once every 3 years to maintain tax residency.

 

Yes it could but that won't work for everyone.

 

shouldnt the executor have considered the overall tax position for the parties and maybe not transferred the shares to a non resident ?

maybe lisa could sue them ?

 

They can only do that if they have the power. Some people leave no discretion such as Homer saying "I leave 1/3 of my shares to each of my children"

 

I didn't even know we had this option -neither my accountant nor my lawyer have mentioned it. Thanks, I will look into it -it could work for us.