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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

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Edited version of your private ruling

Authorisation Number: 1012417737963

Ruling

Subject: Capital gains tax

Question 1

Are the shares held by the taxpayer in the company active assets under section 152-40 of the Income Tax Assessment Act 1997 (ITAA 1997) and therefore subject to the small business CGT concessions in Division 152 of the ITAA 1997 in respect of the sale on a 10% interest in the company?

Answer

Yes

Question 2

If the taxpayer sold 10% shares in the company for a negotiated arms length consideration, would the disposal of the remaining 90% of the shares in the company at the same time to a non-arms length party for a consideration of an extrapolated amount represent market value for the purpose of the market value substitution rule under section 116-30 of the ITAA 1997, given that CGT event A1 under section 104-10 of the ITAA 1997 occurs in respect of the non-arms length sale?

Answer

No

This ruling applies for the following periods:

1 July 2012 - 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

The taxpayer owns 100% shares in the company.

The company was incorporated in 2002 in Australia.

The taxpayer owned the shares in the company from 2003 to 2012 (financial years).

The net assets of the company and the taxpayer are less than $6 million and the maximum net asset value test is satisfied.

The taxpayer has negotiated a sale of 10% of the company on an arms-length basis to an existing employee.

A valuation of the company at 30 June 2012 was undertaken and an adjusted balance sheet was provided which includes the market value of the assets

Using the adjusted balance sheet, the shares were assessed as active assets for 7 out of the 10 years of ownership.

An advance was provided to a buying and bidding company. The reason for the advance was to procure work under a larger umbrella.

The valuation was undertaken using the following methodologies:

Under the capitalisation of future maintainable earnings methodology a valuation range was provided.

According to the arms length negotiated sale price methodology, the value of the remaining 90% of shares was directly extrapolated from the sale of 10% of shares (by multiplying the sale price by 9).

In the valuation it was considered that the arms length negotiated value was the most appropriate methodology as it was within the calculated range of values and represents what the market is prepared to pay.

The ATO engaged the Australian Valuation Office (AVO) to review the valuation report provided by the applicant.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-15

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 subsection 152-40(1)

Income Tax Assessment Act 1997 subsection 152-40(4)

Income Tax Assessment Act 1997 subsection 152-40(3)

Income Tax Assessment Act 1997 Section 152-60

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 subsection 116-30(2)

Income Tax Assessment Act 1997 section 995-1

Tax Administration Act 1953 section 359-40

Reasons for decision

Question 1

To qualify for the small business CGT concessions in Division 152 of the ITAA 1997, an entity must satisfy several conditions that are common to all the concessions. These are called the 'basic conditions' in section 152-10 of the ITAA 1997.

Basic conditions

Section 152-10 of the ITAA 1997 provides that to qualify for any of the small business concessions there are basic conditions that must be satisfied.

The CGT asset must be an active asset

If the asset is a share in a company or an interest in a trust, one of these additional basic conditions must be satisfied just before the CGT event:

There must be a CGT concession stakeholder in the company or trust, or

the entity that owns the share or interest must satisfy have a small business participation percentage in the entity of at least 90%.

Net value of the CGT assets

An entity will satisfy the maximum net asset value test under section 152-15 of the ITAA 1997 if, just before the CGT event that results in the capital gain, the net value of the CGT assets of the entity and the following entities does not exceed $6 million:

any entities connected with you; and

your affiliates and any entities connected to your affiliates (subject to certain exclusions).

An entity is connected with another entity if either entity controls the other or both entities are controlled by the same third entity under subsection 328-125(1) of the ITAA 1997.

The information provided in the private ruling, states that the net assets of the company and those of its sole shareholder (the taxpayer) are less than $6 million. Based on this information the taxpayer will satisfy the maximum net asset value test.

Active asset test

Under section 152-35 of the ITAA 1997 the active asset test requires the capital gains tax (CGT) asset to be an active asset for:

7 years, if owned for more than 15 years, or

half of the ownership period if owned for 15 years or less

Under subsection 152-40(1) of the ITAA 1997 a CGT asset is an active asset (subject to the exclusions) if it is owned and used, or held ready for use, in the course of carrying on a business by you or your small business CGT affiliate or another entity that is connected with you under paragraph 152-40(1)(c) of the ITAA 1997. An active asset may be a tangible asset or an intangible asset.

Assets which cannot be active assets

The following assets cannot be active assets (subsection 152-40(4) of the ITAA 1997):

interests in a connected entity (other than those satisfying the 80% test)

shares in companies and interests in trusts (other than those satisfying the 80% test)

shares in widely held companies unless they are held by a CGT concession stakeholder of the company

shares in trusts that are similar to widely held companies unless they are held by a CGT concession stakeholder of the trust or other exceptions for trusts with 20 members or less apply

financial instruments, including loans, debentures, bonds, promissory notes, futures contracts, forward contracts, currency swap contracts, rights and options

an asset whose main use in the course of carrying on the business is to derive interest, an annuity, rent, royalties or foreign exchange gains. However, such an asset can still be an active asset if it is an intangible asset that has been substantially developed, altered or improved by the taxpayer so that its market value has been substantially enhanced or its main use for deriving rent was only temporary.

In this case, the taxpayer proposes to dispose 10% of shares the company. Shares are not active assets unless they satisfy the 80% test in subsection 152-40(3) of the ITAA 1997.

80% test

Under subsection 152-40(3) of the ITAA 1997 a 'share' is an active asset if:

The active asset test under section 152-35 of the ITAA 1997 requires that a share in a company must satisfy the 80% test for at least half the period of ownership (2003 - 2012), in this case the shares must pass the active asset test for 5 or more years.

The company was incorporated in Australia, and therefore the first requirement in subsection 152-40(3) of the ITAA 1997 is satisfied.

The balance sheet for years 2003 -2012 have been adjusted to take into account the market value of the assets in the company.

An asset that was not considered to be an active asset, as it fell under subsection 152-40(4) of the ITAA 1997, was an advance to a buying and bidding company. The purpose of the advance to was so the company could procure work in the area under a larger umbrella. It is considered that it is inherently connected with the business. Therefore, the advance will be included in the calculation for the purposes of subsection 152-40(3) of the ITAA 1997.

In accordance with the adjusted balance sheet provided and the inclusion of the advance, the shares are active assets as the shares pass the 80% test for more than half the period of ownership.

CGT concession stakeholder

According to section 152-5 of the ITAA 1997, the entity claiming the concession must be a CGT concession stakeholder or CGT concession stakeholders must have a small business participation percentage in the entity of at least 90%, just before the CGT event.

Section 152-60 of the ITAA 1997 states that an individual is a CGT concession stakeholder of a company or trust if the individual is:

A significant individual in the company or trust; or

A spouse of a significant individual in the company or trust, if the spouse has a small business participation percentage in the company or trust at the time that is greater than zero.

The term 'significant individual' is given its meaning in section 152-55 of the ITAA 1997 as an individual that has a small business participation percentage in the company or trust of at least 20%.

An entity's small business participation in a company is made up of its direct and indirect small business participation. Under section 152-70 of the ITAA 1997 an entity's direct small business participation percentage is the following percentage that the entity has because of holding the legal and equitable interests in shares in the company:

In this case, up until the proposed sale of 10% shares in the company, the taxpayer will hold 100% shares in the company and therefore, holds 100% of the voting power, dividends and capital distributions.

Therefore, the taxpayer is a significant individual for the purposes of section 152-55 of the ITAA 1997.

Conclusion

The shares held by the taxpayer in the company are active assets under section 152-40 of the ITAA 1997 and therefore will be subject to the small business CGT concessions in Division 152 of the ITAA 1997 in respect of the sale on a 10% interest in the company.

Question 2

The taxpayer intends to dispose the remaining 90% of shares to a non arms-length party. Given the negotiated sale of 10% of shares will be sold to an arms-length party the applicant would like confirmation that the remaining 90% of shares will have a market value that is calculated by extrapolating the negotiated arms-length transaction.

The disposal of the shares, will trigger CGT event A1. Under subsection 104-10(4) of the ITAA 1997, a capital gain will arise if the capital proceeds from the disposal are more than the asset's cost base. A capital loss is made if the capital proceeds are less than the asset's reduced cost base.

Section 116-20 of the ITAA 1997, provides the general rules regarding capital proceeds for each CGT event. The modification of these rules is provided for in sections 116-30 to 116-60 of the ITAA 1997.

Under the market value substitution rule: modification 1, subsection 116-30(2) states:

The capital proceeds from a CGT event are replaced with the market value of the CGT assets that is the subject of the event if:

Some or all of those proceeds cannot be valued; or

Those capital proceeds are more or less than the market value of the asset and:

You and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event; or

The CGT event is CGT event C2 (about cancellation, surrender and similar endings)

(The market value is worked out at the time of the event.)

Section 995-1 of the ITAA 1997 defines market value as having a meaning affected by Subdivision 960-S of the ITAA 1997. However, Subdivision 960-S at section 960-400 provides that the expression 'market value' is often used in the Act with its ordinary meaning.

The High Court case, Spencer v the Commonwealth of Australia (1907) 5 CLR 418 casts some light on the ordinary meaning of market value. In this case it was held that a valuation of land should be based on the price that a willing, but not anxious, purchaser would, as at the date in question, have had to pay to a vendor who was not unwilling, but not anxious, to sell.

In order to determine whether the extrapolated amount will represent fair market value for the purposes of the market-value substitution rule under section 116-30 of the ITAA 1997, the applicant undertook a valuation of the company's value.

The applicant's valuation report applied the Capitalisation of Future Maintainable Earnings (CFME) methodology and also applied an alternative methodology which used the arms-length negotiated sale. The adoption of the arms-length negotiated sale methodology was selected as appropriate as it is within the calculated range of values.

Under section 359-40 of the Tax Administration Act 1953 the Commissioner referred the applicant's valuation to the Australian Valuation Office (AVO) for review.

According to ATO Market Valuation for Tax Purposes, when making a valuation for unlisted shares a number of adjustments may need to be made for factors such as liquidity and degree of control. Other factors that may be taken into account include discount/premium for size, discount for non-negotiability, discount for minority interests and other firm specific risks.

The AVO's report commented that there were three specific factors that needed to be taken into account:

In agreement with the AVO report, we do not consider, under the arms length negotiated transaction methodology, that the market value of the remaining 90% of shares can be directly estimated by reference to the consideration from an actual minority share sale (10%) as it does not include a control premium.

If a parcel of shares carry with it the power to control i.e. sufficient votes to pass a special resolution, control company policy, appoint and remove directors etc, that parcel will be more valuable: Murdoch's case, per Williams J at 578; Abraham's case and Haunstrup's case:

What about shares that carry special rights of control and not necessarily a large parcel when compared to the capital issued?

If the arms-length negotiated transaction was to be used to determine the market value of the shares, a higher value would result so as to include the control premium.

Conclusion

Based on the above reasoning, we do not consider that the remaining 90% of shares has a market value that can be directly extrapolated by the arms-length negotiated sale for the purpose of the market value substitution rule under subsection 116-30(2) of the ITAA 1997.

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