Edited version of private ruling

Authorisation Number: 1011574246326

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Ruling

Subject: CGT calculation methodology and application of Part IVA

Issue 1

Question 1

Does the tax parcel optimisation (TPO) methodology adopted by the taxpayer satisfy the requirements for calculating the taxpayer's net capital gains and net capital losses under sections 102-5 and 102-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Issue 1

Question 2

Does the TPO methodology adopted by the taxpayer satisfy the record keeping obligations under section 121-20 of the ITAA 1997?

Answer

Yes.

Issue 2

Question 1

Will Part IVA of the Income Tax Assessment Act 1936 (ITAA 196) not apply to the scheme?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commenced on:

1 July 2010

Relevant facts and circumstances

A complying superannuation fund (the fund) as defined under subsection 995-1(1) of the ITAA 1997, utilises a single pool of assets (the portfolio) and unitised structure to provide investment choice options for non-defined benefit accumulation and pension members and investments designated for defined benefit members (both non-pension and pension) of the fund.

The portfolio consists of investments in different securities, which in relation to shares and units (securities) are divided into separate sub-portfolios according to variable investment mandates. Each sub-portfolio is not a separate legal entity.

Each sub-portfolio is managed by an investment manager which determines the securities to buy, sell and hold and is authorised to enter into transactions in the name of the custodian of the fund, subject to restrictions agreed with the trustee of the fund.

The trustee has a custody agreement (custody agreement) with the custodian. The custodian meets the definition of a 'custodian' under subsection 995-1(1) of the ITAA 1997 as it holds interests in each security of the fund's sub-portfolios for the absolute benefit of the trustee of the fund.

Subject to the custody agreement and instructions from the trustee, the custodian is authorised to:

· open and maintain bank accounts and securities accounts

· separate sub-accounts in respect of investment managers or foreign currencies in the records of the custodian

· enter into all types of foreign exchange transactions on behalf of the fund

· appoint sub-custodians or use any securities system

· seek and act upon legal, professional and other advice

· prepare, complete, execute (in markets where market regulations or market practices permit), lodge or file on behalf of the trustee any documents in connection with the performance of the services under the custody agreement, including the endorsement of any cheques, drafts, notes, bills or other instruments, and

· provide various other custodial services, including accounting and taxation reporting and services.

The trustee will instruct the custodian to activate its TPO system upgrade in respect of the fund's portfolio.

TPO will be adopted to calculate the fund's overall tax position in accordance with the capital gains tax (CGT) provisions contained in Part 3-1 of the ITAA 1997 when a CGT event occurs unless either or both of the following apply:

(a) the CGT event is attributable to currency exchange rate fluctuations as mentioned under paragraph 295-85(3)(a) of the ITAA 1997

(b) the security is listed in paragraph 295-85(3)(b).

The TPO methodology will create a notional consolidated portfolio (the 'propagated portfolio') which encompasses the information of all securities from all sub-portfolios to calculate capital gains and losses, whilst still being able to identify separate tax parcels.

When an investment manager initiates a disposal of a security on behalf of the fund, the custodian will select for disposal a security from the propagated portfolio as determined by applying one of the following methods that enhances the after tax returns and cash flows of fund members and pensioners:

· first in first out (FIFO) - selection according to the earliest acquisition date;

· loss maximisation - selection that will result in the highest tax loss or lowest capital gain (after taking into account the CGT discount); or

· profit maximisation - selection that will generate the highest tax profit or the lowest tax loss (after taking into account the CGT discount).

The TPO system will replace the fund's current system which confines the selection of securities to the sub-portfolio of the investment manager initiating the disposal.

Under the TPO system, the custodian will record the same information as the current system, including the:

· date of the contract to buy or dispose of a parcel of securities

· name and security identifier

· type and class of asset

· number of assets that have been acquired or disposed

· cost elements of the parcel of assets including any cost base adjustments

· reduced cost base (including any cost base adjustments)

· proceeds received for the sale (including any sale costs), and

· subsequent capital gain or loss (adjusted for discounting if necessary).

The custodian will also provide a summary report disclosing the aggregate of all capital gains and losses realised for the income year and the fund's overall net capital gain or loss.

The TPO system will retain records electronically and will satisfy the record keeping requirements set out in Taxation Ruling TR 2005/9 with respect to:

· record retention

· data security and integrity

· system documentation

· retaining archival copies, and

· accessibility.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Subsection 177A(1)

Income Tax Assessment Act 1936 Subsection 177C(1)

Income Tax Assessment Act 1936 Subsection 177C(4)

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1936 Section 177F

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Section 100-45

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 102-10

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 121-20

Income Tax Assessment Act 1997 Section 121-25

Income Tax Assessment Act 1997 Section 295-85

Income Tax Assessment Act 1997 Subsection 995-1(1)

Further issues to be considered

This ruling does not provide the Commissioner's view on matters outside the application including:

· whether the fund or its trustee is the beneficial owner of the assets under custodianship or management by different entities; and

· the revenue or capital characterisation of the gain and loss on disposal of the relevant assets.

Reasons for decision

Issue 1

The provisions relating to the taxation of complying superannuation funds are contained in Division 295 of the ITAA 1997. Section 295-85 of the ITAA 1997 makes the CGT rules the primary code for determining the tax treatment of the gains or losses generated on the disposal of an asset by a complying superannuation fund.

Paragraph 295-85(2)(a) of the ITAA 1997 modifies the normal CGT rules so that a CGT event happening to a CGT asset of the fund is not affected by the following provisions:

· section 6-5 of the ITAA 1997 (ordinary income),

· section 8-1 of the ITAA 1997 (amounts you can deduct), and

· sections 15-15 and 25-40 of the ITAA 1997 (profit-making undertakings or plans);

An exception to this treatment is contained in paragraph 295-85(3)(b) of the ITAA 1997 for certain CGT assets of the fund.

As the fund's assets to which the propagated method will apply do not fall within one of the exceptions listed under paragraph 295-85(3)(b) of the ITAA 1997, pursuant to ATO Interpretative Decision ATO ID 2010/7, the CGT provisions will be the only provisions to apply.

Pursuant to the capital gains and losses provisions in Part 3-1 of the ITAA 1997, as the securities that make up the portfolio of the fund constitute company shares and units in unit trusts, they are CGT assets under section 108-5 of the ITAA 1997 (also refer to Note 1 to section 108-5).

The disposal of the securities by the custodian as instructed by the fund will be a CGT event that gives rise to either a net capital gain or loss. To calculate the net capital gain in accordance with section 102-5 of the ITAA 1997 or net capital loss in accordance with section 102-10 of the ITAA 1997, the capital gain or loss for each CGT event must be determined.

For CGT purposes, a capital gain or loss for most CGT events (for example, disposal of a parcel of securities) is calculated in accordance with section 100-45 of the ITAA 1997. Where the CGT assets can be individually distinguished, capital gains or losses can be determined by reference to the capital proceeds, cost base and the acquisition date of the particular CGT asset.

However, when the disposal of the CGT assets form part of a holding of identical assets which are acquired over time, it may not always be possible to distinguish or identify the particular assets that have been disposed of. In these circumstances, the taxpayer will need to decide which particular assets are being disposed of.

Paragraph 3 of CGT Determination Number 33 (TD 33) states the Commissioner's view of this situation:

Taxpayers in this situation need to keep adequate records of the transaction so that the decisions can be supported should the income tax return be subject to Tax Office scrutiny at a later date.

Paragraph 4 of TD 33 further states that:

In the past, where unidentifiable shares have been disposed of, the Commissioner has accepted the 'first-in first-out' as a reasonable basis of identification. For CGT purposes, the Commissioner will also accept the taxpayer's selection of the identity of shares disposed of.

Paragraph 5 of TD 33 and the Addendum to TD 33 (that is, TD 33A) excludes average cost as an acceptable method, except in very limited circumstances.

Hence, TD 33 allows the taxpayer to select the identity of shares they wish to nominate as having disposed of where the shares cannot be individually distinguished, provided the taxpayer maintains sufficient records of the transaction.

The note to TD 33 confirms that the Determination applies to the disposal of assets other than shares which form part of a holding of identical assets where the assets are not able to be individually distinguished, for example, units in a unit trust.

Accordingly, when an investment manager initiates a disposal of securities that form part of a holding of identical securities that cannot be individually distinguished, the propagated method can be used to calculate the net capital gains or losses under sections 102-5 and 102-10 of the ITAA 1997, provided the fund maintains sufficient records of the transaction.

Record keeping requirements

Section 121-20 of the ITAA 1997 provides the record keeping requirements for calculating capital gains or losses from a CGT event. Subsection 121-20(1) of the ITAA 1997 states:

You must keep records of every act, transaction, event or circumstance that can reasonably be expected to be relevant to working out whether you have made a capital gain or capital loss from a CGT event. (It does not matter whether the CGT event has already happened or may happen in the future.)

Example 1 under this subsection provides that the relevant records for working out a capital gain or loss upon the disposal of a CGT asset are that which identify:

· the acquisition date;

· the date the asset is disposed of;

· each element of the cost base and reduced cost base and the effect of indexation on those elements; and

· the capital proceeds.

The additional requirements set out in subsections 121-20(2) to 121-20(5) of the ITAA 1997 must also be met, including that the records must be readily accessible and convertible into English.

Section 121-25 of the ITAA 1997 states that records required under section 121-20 of the ITAA 1997 must be retained for at least five years provided that it can reasonably be expected that the records are not necessary for other CGT events or future CGT events.

Where electronic records are kept, paragraph 22 of TR 2005/9 provides the following:

Advances in technology (including the internet) have meant that many taxpayers who carry on a business now process and keep their records electronically rather than through a paper based system. This includes encrypted records. The Tax Office requires that records, whether kept on paper or electronically, must be kept accurately so as to enable that person's tax liability to be readily ascertained. The records must be in a form which Tax Office staff can access and understand in order to ascertain that person's taxation liability.

Taxation Ruling TR 96/4 addresses the question of how to value shares that cannot be individually identified by reference in relation to taxpayers who acquire shares as revenue assets. Further, paragraph 2 of TR 96/4 states that the ruling does not apply to taxpayers who acquired shares as capital assets.

Nevertheless, TR 96/4 provides guidance on what records should be kept for the purpose of identifying shares. In this respect, it is considered that the key records that a taxpayer needs to maintain for CGT purposes with respect to the identical shares must include (but are not limited to) the following:

· the specific code of each buy or sell transaction

· the date, CGT cost base and reduced cost base, quantity, name of the company, type and class of shares acquired by the taxpayer (that is, the tax attributes)

· the date, quantity, name and capital proceeds of the shares sold

· incidental costs incurred in acquiring or disposing the shares

· the calculation of capital gain or loss

· the balance of shares remaining in a particular trade and the tax attributes of those shares

· any adjustments required under taxation law, and

· data security and inbuilt system audit trails.

It is considered that the records maintained by the propagated method on behalf of the fund will satisfy the requirements of section 121-20 of the ITAA 1997 as:

· the adoption of the propagated method will not change the reporting capabilities of the custodian and the custodian will continue to record the same information as under the current system

· the custodian will have sufficient records to enable it to specifically identify the securities that have been disposed (at the propagated portfolio level) and calculate the gain or loss in respect of the disposal of the securities

· the custodian's records will satisfy the requirements under TR 94/6, and

· the system meets the record keeping requirements set out in TR 2005/9 with respect to:

- record retention

- data security and integrity

- system documentation

- retaining archival copies, and

- accessibility.

Issue 2

Part IVA of the ITAA 1936 (Part IVA) is the general anti-avoidance provision which allows the Commissioner the discretion to cancel a 'tax benefit' that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained by a taxpayer in connection with a scheme to which Part IVA applies.

Pursuant to Practice Statement PS LA 2005/24, Part IVA applies when the following elements are satisfied:

· there is a 'scheme' as defined in subsection 177A(1) of the ITAA 1936;

· a 'tax benefit' as defined in subsection 177C(1) of the ITAA 1936 was or would have been obtained in connection with the scheme; and

· after consideration of a number of factors specified in section 177D of the ITAA 1936, it is concluded that the scheme was entered or is entered into for the dominant purpose of obtaining the tax benefit.

The scheme

Subsection 177A(1) of the ITAA 1936 widely defines a scheme as:

(a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and

(b) any scheme, plan, proposal, action, course of action or course of conduct.

Federal Commissioner of Taxation v Hart [2004] HCA 26; 55 ATR 712 per Gummow and Hayne JJ:

This definition is very broad. It encompasses not only a series of steps which together can be said to constitute a 'scheme' or a 'plan' but also (by its reference to 'action' in the singular) the taking of but one step.

In the present case, the broad definition of 'scheme' would encompass the adoption of the propagated method upgrade as described in the facts of this ruling as it is an arrangement which calculates capital gains and losses at the propagated portfolio level to determine the fund's overall CGT position.

The tax benefit

Subsection 177C(1) of the ITAA 1936 provides that the following tax benefit may be obtained by a taxpayer in connection with a scheme:

(a) an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out; or

(b) a deduction being allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out; or

(ba) a capital loss being incurred by the taxpayer during a year of income where the whole or a part of that capital loss would not have been, or might reasonably be expected not to have been, incurred by the taxpayer during the year of income if the scheme had not been entered into or carried out; or

(bb) a foreign income tax offset being allowable to the taxpayer where the whole or a part of that foreign income tax offset would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer if the scheme had not been entered into or carried out;…

Subsection 177C(4) of the ITAA 1936 provides:

To avoid doubt, paragraph (1)(a) applies to a scheme if:

(a) an amount of income is not included in the assessable income of the taxpayer of a year of income; and

(b) an amount would have been included, or might reasonably be expected to have been included, in the assessable income if the scheme had not been entered into or carried out; and

(c) instead, the taxpayer or any other taxpayer makes a discount capital gain (within the meaning of the Income Tax Assessment Act 1997) for that or any other year of income.

In ascertaining whether there has been a tax benefit, regard must be had to the position of what 'might reasonably be expected' to have occurred 'if the scheme had not been entered into or carried out'.

In Peabody v. FC of T 92 ATC 4585 the High Court said, at [4671]:

A reasonable expectation requires more than a possibility. It involves a predication as to events which would have taken place if the relevant scheme had not been entered into or carried out and the predication must be sufficiently reliable for it to be regarded as reasonable.

In the arrangement, the reasonable expectation is that if the scheme is not entered into, the fund would continue to select the parcel of securities for disposal from the sub-portfolio of the investment manager initiating the disposal. Subsequently the CGT position for the fund will be determined by aggregating all the individual gains or losses calculated within each sub-portfolio.

After the scheme is entered into, the custodian will have an enhanced capacity to select the parcels from the entire propagated portfolio rather than from the individual sub-portfolios. The trustee expects that the scheme will increase the after tax returns and cashflows of the members and pensioners of the fund by obtaining tax benefits in the form of:

· reduced amount of capital gains included in assessable income for a year of income; or

· capital losses being incurred rather than capital gains being derived for a year of income; or

· discount capital gains rather than non-discount capital gains being derived for a year of income.

Dominant purpose of the scheme

For Part IVA to apply to the scheme, it must have been entered into for the dominant purpose of obtaining the tax benefit. To determine whether a taxpayer entered into the scheme with the sole or dominant purpose of obtaining a tax benefit, it is necessary to consider the eight factors in section 177D of the ITAA 1936. The test is whether, having regard to:

(i) the manner in which the scheme was entered into or carried out;

(ii) the form and substance of the scheme;

(iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out;

(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme;

(v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme;

(vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme;

(vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out; and

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi),

it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme.

(i) The manner in which the scheme was entered into or carried out.

In FCT v. Spotless Services Ltd 96 ATC 5201, the joint judgement of the High Court noted that 'manner' and 'entered into' are not to be given any restricted meaning and stated that 'manner' includes consideration of the way in which and method or procedure by which the particular scheme in question was established.

Historically limited software capabilities and constraints meant that the fund was unfairly disadvantaged when calculating its capital gains and losses as the calculation upon disposal of a security could only be performed at a sub-portfolio level. The applicant has stated that the propagated method is a legitimate service offered through a system upgrade that will enable the selection of specific parcels of securities for disposal in accordance with TD 33.

The purpose for adopting the propagated method is to achieve the fund's commercial objective of enhancing the after tax returns and cash flows of the members and pensioners of the fund.

(ii) The form and the substance of the scheme

Where the same security is held across different portfolios, the propagated method essentially enables the fund to use the 'selection of the identity of shares disposed of' method provided for in TD 33, at a propagated portfolio level.

The substance of the arrangement is that the arrangement will typically have the effect of potentially decreasing capital gains, or of deferring capital gains to later periods, by enabling selection of parcels of shares with more favourable cost base attributes.

(iii) The time at which the scheme was entered into and the length of the period during which the scheme was carried out

The fund will enter into the arrangement in the relevant income year. There is no artificiality or contrivance in relation to the implementation date of the scheme.

(iv) The result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme

The relevant result sought by the scheme would be to select the parcels which give the best CGT outcome, mainly by deferring the recognition of a net capital gain, or reducing the fund's net capital gain, or deriving a discount capital gain.

Provided the scheme occurs in accordance with TD 33, a correct tax outcome will result, notwithstanding that it will be one which is more beneficial to the taxpayer than under their former practice.

(v) Any change in the financial position of the relevant taxpayer's financial position

The trustee expects that the arrangement could result in a reduced tax payable by the fund.

(vi) Any change in the financial position of other person

The trustee expects that the members will have increased after tax returns as a result of the implementation of the propagated method.

(vii) any other consequence for the relevant taxpayer, or any person referred to in subparagraph (vi), of the scheme having been entered into or carried out

No other consequences have been identified by the trustee.

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi).

The trustee has a fiduciary obligation to act in the best interest of fund members and pensioners.

Conclusion:

Having regard to the relevant factors specified in section 177D of the ITAA 1936, it is concluded that the scheme will not be entered into for the sole or dominant purpose of obtaining a tax benefit in connection with the scheme.

This leads to the conclusion that any tax benefit arising from the scheme will not be one to which Part IVA applies.

Accordingly, the Commissioner confirms that Part IVA will not apply to the proposed arrangement.

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