Capital gains tax: The impact of insolvency appointments on CGT

How capital gains tax (CGT) is dealt with in insolvency can be complex and the technicalities are best left to tax accountants. This factsheet outlines the basics of how CGT is treated under the legislation.

Overview
One of the roles of an insolvency practitioner is realising the assets owned by an insolvent person. The sale of some assets can create a liability under the capital gains tax (CGT) legislation. Insolvency practitioners are concerned with CGT to a limited extent.

There are three main issues with CGT and insolvent estates:

  1. When do capital gains occur is an insolvency administration?
  2. What happens to capital losses available at the date of the appointment?
  3. What are the tax implications on a holding company when a solvent wholly-owned subsidiary is wound up?

These issues are discussed in more detail below.

  1. When do capital gains occur is an insolvency administration?

The Income Tax Assessment Act 1997 (ITAA) includes provisions that deal with insolvent estates and capital gains that relate to bankruptcy, liquidation, or a secured creditor taking action under a security.

The provisions state that any actions or realisations that lead to a CGT liability are deemed to have been done by the company, bankrupt or debtor, and not by the insolvency practitioner.

The insolvency practitioner starts the process by looking at the ‘vesting’ or otherwise of the asset. Section 104.10 of the ITAA states that the vesting of assets in a bankruptcy or liquidation, or the providing or redeeming of a security, is not a disposal of a CGT asset and the beneficial owner (the estate) does not change.

Income Tax Assessment Act 1997 – section 104.10
Disposal of a CGT asset: CGT event A1

(7) CGT event A1 does not happen if the disposal of the asset was done:

(a) to provide or redeem a security; or

(b) because of the vesting of the asset in a trustee under the Bankruptcy Act 1966 or under a similar foreign law; or

(c) because of the vesting of the asset in a liquidator of a company, or the holder of a similar office under a foreign law.

Bankruptcy
Section 106.30 of the ITAA confirms, in relation to CGT, “the vesting of the individual’s CGT assets in the trustee under the Bankruptcy Act 1966or under a similar foreign law is ignored”. The provisions related to bankruptcy are:

Income Tax Assessment Act 1997 – section 106.30
Effect of bankruptcy

(1) For the purposes of this Part and Part 3-3, the vesting of the individual’s CGT assets in the trustee under the Bankruptcy Act 1966 or under a similar foreign law is ignored.

(2) This Part and Part 3-3 apply to an act done in relation to a CGT asset of an individual in these circumstances as if it had been done by the individual:

(a) as a result of the bankruptcy of the individual by the Official Trustee in Bankruptcy or a registered trustee, or the holder of a similar office under a foreign law;

(b) by a trustee under a personal insolvency agreement made under Part X of the Bankruptcy Act 1966, or under a similar instrument under a foreign law;

(c) by a trustee as a result of an arrangement with creditors under that Act or a foreign law.

This section has two effects on bankruptcy and CGT.

First, the vesting of property in the trustee is not deemed an asset disposal, so no CGT liability is automatically created from the vesting of assets. Second, any acts of the trustee under a bankruptcy, section 73 arrangement or Part X personal insolvency agreement (Part 10 of the Bankruptcy Act) that give rise to a CGT liability are deemed to have been done by the individual (i.e. the bankrupt or debtor) and not the trustee.

Secured creditors
Section 106.60 of the ITAA deems that if people holding or appointed under security documents take actions that accrue a capital gain, these actions are actually done by the entity that gave the security, not the entity that exercises the security. This extends to a controller appointed to assist a mortgagee in exercising a security.

It is important to note that exercising a security, or appointing a receiver or agent, does not change the asset ownership and does not accrue a CGT liability—as asset ownership does not change. Usually, controllers of property only act as agents for the owner of the assets, with powers to sell under the security. The only change is the security holder’s right to actually sell the asset on behalf of the debtor. Only the asset disposal (e.g. a sale) can create a CGT liability.

External administration summary
The appointment of a liquidator, trustee, controller, or the vesting of property and the exercising of a security, does not create a deemed acquisition or disposal of a CGT asset. Without the sale of the asset (disposal), a CGT liability will not accrue to any party.

  1. What happens to capital losses available at the date of the appointment?
    The procedure for calculating an individual’s capital gains for tax purposes is set out in section 102.5 of the ITAA.

Two events can eliminate past CGT losses:

  1. An individual is not entitled to bring forward any capital losses from prior years into a year in which they became bankrupt, or were released from their debts. The provision applies twice, once when the person is made bankrupt, and at discharge—which is usually three years later—when they are released.
  2. An individual is not entitled to bring forward any capital losses into a year in which they are released from their debts under a law relating to bankruptcy. Discharge from such debts occurs at the end of bankruptcy, or at the end of a Part X or section 73 arrangement.

Under section 102.5 of the ITAA, any capital losses accrued before the bankruptcy or insolvency administration are lost at the end of that administration.

The timing of either becoming a bankrupt and/or the release from debts (usually at the end of a bankruptcy or the agreement) may need to be considered by the bankrupt.

A bankruptcy annulment eliminates the bankruptcy. Annulments obtained by payment of debts (through section 153 of the Bankruptcy Act) or through the court will reinstate capital losses, as there is no bankruptcy and no release of debts: they are paid. Annulments obtained through section 73 proposals still provide a release from debts, and therefore any CGT losses will be lost.

  1. What are the tax implications on a holding company when a solvent wholly-owned subsidiary is wound up?
    The first thing to note is that the subsidiary being wound up must be solvent. The ITAA gives specific tax relief for a holding company that receives an asset (i.e. a roll-over of an asset) from the liquidator of a subsidiary under a members’ voluntary winding up. This relief may only be a CGT reduction, not a full exemption.

This is partially because the liquidated company is solvent and the company will pay the ATO all outstanding tax liabilities—therefore no release of debts. Under section 126.85, CGT relief only applies if the roll-over of the asset was transferred due to the cancellation of the shareholding in the 100%-owned subsidiary that is being wound up. Effectively, the holding company receives the asset in consideration for the cancellation of the shares.

Income Tax Assessment Act 1997 – section 126.85
Effect of roll-over on certain liquidations

(1) A capital gain a company (the holding company) makes because shares in its 100% subsidiary are cancelled (an example of CGT event C2: see section 104.25) on the liquidation of the subsidiary is reduced if the conditions in subsection (2) are satisfied. The reduction is worked out under subsection (3).

Because post-CGT shares in its 100% owned subsidiary are cancelled upon the liquidation of the subsidiary, the capital gain that a holding company makes from the roll-over of the asset is reduced if certain conditions are satisfied. Those conditions are:

  • There must be a roll-over of at least one ‘CGT asset’ (i.e. acquired on or after 20 September 1985) and the asset must be disposed of (transferred) by the subsidiary to the holding company in the course of its liquidation.
  • The disposal must either be part of the liquidator’s distribution in the course of the liquidation, or have occurred within 18 months of the dissolution of the subsidiary (if they are part of an interim distribution).
  • The liquidated company must be a 100% owned subsidiary from the time of the disposal until the cancellation of the shares.
  • The market value of the asset must comprise at least part of the capital proceeds for the cancellation of the shares.
  • One or more of the shares that were cancelled must have been acquired by the holding company on or after 20 September 1985 (i.e. they must be post-CGT shares).

The procedure to calculate this relief is outlined in section 126.85 of the ITAA. To summarise the position:

Income Tax Assessment Act 1997 – section 126.85
Effect of roll-over on certain liquidations

(3) The reduction of the capital gain is worked out in this way.

Method statement
Step 1. Work out (disregarding this section) the sum of the capital gains and the sum of the capital losses the holding company would make on the cancellation of its shares in the subsidiary.

Step 2. Work out (disregarding this Subdivision):

(a) The sum of the capital gains the subsidiary would make on the disposal of its CGT roll-over assets to the holding company; and

(b) The sum of the capital losses it would make except for Subdivision 170-D on the disposal of its CGT assets to the holding company; in the course of the liquidation assuming the capital proceeds were the assets’ market values at the time of the disposal.

Step 3. If, after subtracting the sum of the capital losses from the sum of the capital gains, there is an overall capital gain from step 1 and an overall capital gain from step 2, then continue. Otherwise there is no adjustment.

Step 4. Express the number of post-CGT shares as a fraction of the total number of shares the holding company owned in the subsidiary.

Step 5. Multiply the overall capital gain from Step 2 by the fraction from Step 4.

Step 6. Reduce the overall capital gain from Step 1 by the amount from Step 5. The result is the capital gain the holding company makes from the cancellation of its shares in the subsidiary.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Last Updated: 3.11.207