Capital gains tax: cost base - UK inheritance tax

Can the payment of inheritance tax under the Inheritance Tax Act (UK) (1984) , in respect of shares transferred to a taxpayer prior to the death of the transferor, be included in the cost base or reduced cost base of the shares under Division 110 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The payment of inheritance tax cannot be included as part of the cost base or reduced cost base of the shares because it does not fall within any of the elements of cost base (section 110-25 of the ITAA 1997) or reduced cost base (section 110-55 of the ITAA 1997).

In the 2001 income year, the taxpayer (an Australian resident) received a gift from their parent (a UK resident) of ordinary shares in a UK private company. The taxpayer's parent died in the 2003 income year.

As the taxpayer's parent died within seven years of making the gift, the taxpayer became liable to pay an amount of inheritance tax under the Inheritance Tax Act (UK) (1984) . The tax was calculated on the basis of the value of the shares on the day they were gifted.

The taxpayer sold the shares in the 2004 income year.

The taxpayer will make a capital gain if the capital proceeds received on the sale of the shares exceeds their cost base. They will make a capital loss if the capital proceeds are less than the share's reduced cost base.

The cost base and reduced cost base each consist of five elements (sections 110-25 and 110-55 of the ITAA 1997). The elements of reduced cost base of a CGT asset are the same as those for cost base except for the third element (subsection 110-55(2)).

The first element of cost base and reduced cost base is the total of the money paid, or required to be paid, and the market value of the property given, or required to be given, in respect of the acquisition of the asset (subsection 110-25(2) of the ITAA 1997).

Even if the payment of inheritance tax might otherwise form part of the first element of the cost base or reduced cost base of an asset, there is no direct connection between the payment of the tax and the acquisition of the shares in this case. The taxpayer was already the legal owner of the shares before the tax became due and payable and therefore the payment of the tax cannot be considered to be a cost of their acquisition.

The second element of cost base and reduced cost base is the incidental costs that the taxpayer incurs in acquiring the CGT asset or which relate to a CGT event that happens in relation to the CGT asset (subsection 110-25(3) of the ITAA 1997).

Section 110-35 of the ITAA 1997 sets out the five types of incidental costs. Inheritance tax is not one of the five types. Even if it were, it has not been incurred in acquiring the shares (because the taxpayer already owned them) and it is not in relation to a CGT event (because the only other CGT that happened was as a result of the disposal of the shares and the tax does not relate to that event).

The third element of cost base is the non-capital costs of ownership (subsection 110-25(4) of the ITAA 1997). Inheritance tax is not a non-capital or recurring cost of ownership.

The third element of reduced cost base is any amount that is assessable because of a balancing adjustment for the asset or that would be assessable if certain balancing adjustment relief were not available (subsection 110-55(3) of the ITAA 1997). In this case there is no amount assessable or relief provided because of the balancing adjustment provisions.

The fourth element of cost base and reduced cost base is capital expenditure incurred to increase the asset's value and which is reflected in the state or nature of the asset at the time of the CGT event (subsection 110-25(5) of the ITAA 1997). In this case, the payment of the inheritance tax did not increase the value of the shares nor is it reflected in the state or nature of the shares at the time they were sold.

The fifth element of cost base or reduced cost base is capital expenditure incurred to establish, preserve or defend the title to the asset, or a right over the asset (subsection 110-25(6) of the ITAA 1997). It is considered that the fifth element encompasses capital expenditure incurred because title to the asset, or a right over it, is subject to dispute or challenge.

In this case, the taxpayer's title to the shares was not in dispute. The taxpayer was already the rightful owner of the shares and nobody else could establish a better claim to the shares. On that basis, the payment of the tax is not included in fifth element.

Accordingly, the payment of inheritance tax cannot be included under any of the five elements of the cost base or reduced cost base of the shares acquired by the taxpayer prior to the deceased's death.