Edited version of your private ruling

Authorisation Number: 1012571342042

Ruling

Subject: Sale of property below market value with conditions

Questions and Answers:

1. Will your proposed disposal of property ('your Disposal'), below its market value, partly gifted, with the conditions that the recipient ('the Recipient') pay your capital gains tax (CGT) and give you the first right to purchase part A of a newly constructed building ('Level 1'), constitute you and the Recipient dealing with each other at arm's length?

No.

2. If you and the Recipient do not deal with each other at arm's length in connection with your Disposal, will your sale price (i.e., capital proceeds) be the market value of your property, worked out as at the time of the event?

Yes.

3. If the Recipient pays your CGT liability in connection with your Disposal, will this payment of tax be a component of your sale price?

No. This is because the market value will constitute your capital proceeds rather than any actual money or property you receive or are entitled to receive.

4. If a condition of your Disposal is to have the Recipient pay your stamp duty on your purchase of part A of the building, will this payment of stamp duty be a component of your sale price?

No. This is because the market value will constitute your capital proceeds rather than any actual money or property you receive or are entitled to receive.

5. If a condition of your purchase of part A of the building is for the Recipient to pay your stamp duty on that purchase, will this payment of stamp duty constitute capital proceeds for the ending of your contractual right to have your stamp duty paid and thus be a taxable capital gain to you?

Yes.

6. Will payment by you to the Recipient of the full purchase price for part A of the building, prior to completion of the project, constitute a loan to the Recipient?

No.

7. If another entity takes out an option to purchase part A upon completion, are you liable to pay CGT on: (a) the payment for the option price received; and (b) upon the exercise of the option, when the remaining is received?

Yes. However, if the option is exercised, the initial capital gain from granting the option is later disregarded and included in the final capital proceeds received from the exercising of the option.

This ruling applies for the following periods:

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

Relevant facts and circumstances

You own a post-CGT property, which you propose to provide to an entity for much less than its market value. Your sale price is estimated to be the same as the purchase price of part A of a multi-story building the entity proposes to construct on your property, which you plan to purchase after its construction.

As part of the conditions of your Disposal, the entity will pay your tax payable on your Disposal and also give you the first right to purchase part A.

The entity will also pay your stamp duty if you purchase part A.

You are also proposing to grant various options for another entity to purchase part A from you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 116-50

Income Tax Assessment Act 1997 Section 104-40

Income Tax Assessment Act 1997 Section 134-1

Reasons for decision

Summary

You and the Recipient will not be dealing at arm's length because you are not giving an unconditional gift, because the Recipient is not paying market value for your property and because the Recipient is providing you with benefits that would not normally be received in a commercial dealing, such as payment of your CGT.

Since you will be receiving less than the market value for your Disposal (and not dealing at arm's length), subsection 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997) will deem your Disposal as occurring at the property's market value, worked out as at the time of the event .

As your Disposal will occur at market value, the actual money and property you receive for your Disposal (such as, the money, the right to purchase part A and your CGT paid for you) will not form part of the capital proceeds of the relevant CGT event.

If the condition the Recipient pay your stamp duty (on your purchase of part A) is included as an obligation in your Disposal contract with the Recipient, it will have no direct tax implications for you.

However, if the condition the Recipient pay your stamp duty is included as an obligation in your purchase contract for part A, it will result in capital gains tax payable by you. This is because the payment of your stamp duty will constitute capital proceeds received by you for the ending of your contractual right to have your stamp duty paid (CGT event C2).

A 'loan' is something provided on condition of it being returned. If the market value substitution rule does not apply, payment by you to the Recipient of the full purchase price of part A prior to completion of the project will simply constitute part of your CGT cost base and will not constitute a loan to the Recipient.

Detailed reasoning

Questions 1, 2 & 3

As a general rule, subsection 116-20(1) of the ITAA 1997 states the capital proceeds from a CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

However, section 116-30 of the ITAA 1997 contains modifications to the above general rule.

Subsection 116-30(1) of the ITAA 1997 provides if you receive no capital proceeds from a CGT event, you are taken to have received the market value of the CGT asset that is the subject of the event. (The market value is worked out as at the time of the event.)

Subsection 116-30(2) of the ITAA 1997 provides, if there are capital proceeds, the capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if:

(a) those capital proceeds are more or less than the market value of the asset and:

(i) 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…[Emphasis added]

About the term 'arm's length', section 995-1 of the ITAA 1997 states:

…in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

The phrase 'deal at arm's length' does not explicitly refer to the respective parties of a transaction having no connection with each other. Instead, the phrase 'deal at arm's length' also includes the manner in which respective parties deal with each other.

In the Federal Court of Australia case of Collis v. Federal Commissioner of Taxation 96 ATC 4831 (Collis), at 96 ATC 4836, it was said:

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining.

In the Federal Court of Australia case of Trustee for the Estate of the late A.W. Furse No. 5 Will Trust v Federal Commissioner of Taxation 91 ATC 4007, his Honour said (at p. 4015):

The first of the two issues is not to be decided solely by asking whether the parties to the relevant agreement were at arm's length to each other. The emphasis in the subsection is rather upon whether those parties, in relation to the agreement, dealt with each other at arm's length. The fact that the parties are themselves not at arm's length does not mean that they may not, in respect of a particular dealing, deal with each other at arm's length. This is not to say that the relationship between the parties is irrelevant to the issue to be determined under the subsection. The distinction was pointed out by Davies J in connection with the similar words…in Re Hains (dec'd); Barnsdall v FCT (1988) 19 ATR 1352 at 1355; 88 ATC 4565 at 4568, in a passage, which with respect, I agree:

….the expression 'not dealing with each other at arm's length'. That term should not be read as if the words `dealing with' were not present. The Commissioner is required to be satisfied not merely of a connection between a taxpayer and the person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion. [Emphasis added]

As an example of the Commissioner's view about the term "arm's length", paragraphs 2.1 and 2.4 of Taxation Ruling TR 97/20, which is about arm's length transfer pricing methodologies for international dealings, state:

Conceptually, the arm's length principle requires a calculation of the taxable income that might reasonably be expected if the parties were dealing at arm's length with one another. It does this by contrasting the choices made and the outcomes achieved by the taxpayer with those that would have resulted from the interaction of the forces of supply and demand in a comparable open market, or from negotiating among comparable independent parties in more complex settings. In effect, this uses the open market results or the behaviour of the independent parties dealing at arm's length with each other as a benchmark.

Implicit in the arm's length principle is the notion that independent parties who are dealing at arm's length would each compare the options realistically available to them, and seek to maximise the overall value of their respective entities from the economic resources available to or obtainable by them...

In respect to gift made to a Deductible Gift Recipient (DGR), the phrase "non-arms' length arrangement" was used in ATO Interpretative Decision ATO ID 2002/678, as a reference to where a giver gains a materially beneficial advantage.

Division 30 of the ITAA 1997 outlines the guidelines for the deductibility of gifts and donations. Subsection 78A(2) of the Income Tax Assessment Act 1936 lists circumstances whereby a deduction is not allowable under Division 30 of the ITAA 1997. These include, where:

…the amount or value of the benefit derived by the fund, authority, institution or person as a consequence of the gift is, will be, or may reasonably be expected to be, less than the amount or value at the time when the gift was made of the property comprising the gift;

…the donor or an associate of the donor has obtained, will obtain or may reasonably be expected to obtain any benefit, advantage, right or privilege other than the benefit of any deduction transfer, any property, to any person or incurs, becomes liable to incur, or may reasonably be expected to incur or to become liable to incur, any other detriment, disadvantage, liability or obligation;

Thus, paragraph 40, in Taxation Ruling TR 2005/13, which explains tax deductible gifts, states:

The giver may still be regarded as having received a material benefit in a case where the value of the benefit to the giver is less than the value of the property transferred. In these circumstances it is not accepted that the value of the benefit received can be notionally deducted from the value of the property transferred and the net balance claimed as a gift. No part of the property transferred is considered a gift.

In your case, your gifting of property will not be at arm's length because, as a giver, you will gain a materially beneficial advantage in respect to gift, namely, the payment of your capital gains tax and the receipt of the right to purchase part A of the newly constructed building. In other words, in the sphere of giving you and the recipient will not be dealing with each other as parties would normally do because your gift is not an unconditional gift.

Also, in general, as specified in the case of Collis, an assessment of your dealings with the Recipient finds a conclusion that you are not dealing with each other as arm's length parties would normally do, since the Recipient is not paying market value for a property and since the Recipient is providing you with benefits that would not normally be received in such a dealing, such as payment of your capital gains tax.

It follows subsection 116-30(2) of the ITAA 1997 will apply to your disposal of property since: (i) you will be receiving capital proceeds (which include a right of purchase and payment of your CGT) that are less than the market value of the asset and (ii) you and the entity that acquired the asset from you will not deal with each other at arm's length in connection with the event.

As your capital proceeds will be the market value of the property, the actual money and property you receive for your Disposal (such as, the money, the right to purchase part A and your CGT paid for you.) will not form part of the capital proceeds of the relevant CGT event. This is because, as stated in subsection 116-30(2) of the ITAA 1997, the capital proceeds will be the market value rather than the actual capital proceeds received.

Questions 4 & 5

Section 108-5 of the ITAA 1997 states a CGT asset is: (a) any kind of property; or (b) a legal or equitable right that is not property.

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited; or

(e) if the asset is an option - being exercised; or

You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Section 110-25 of the ITAA 1997 sets out the five elements that make up the cost base of an asset for CGT purposes. Section 110-35 of the ITAA 1997 lists a number of incidental costs that may be included in the cost base of a CGT asset, of which stamp duty or other similar duty is listed.

(a) any part of them that you repay; or

(b) any compensation you pay that can reasonably be regarded as a repayment of part of them.

However, the capital proceeds are not reduced by any part of the payment that you can deduct.

For example, you sell a block of land for $50,000 (the capital proceeds). The purchaser later finds out that you misrepresented a term in the contract. The purchaser sues you and the court orders you to pay $10,000 in damages to the purchaser. The capital proceeds are reduced by $10,000.

In your case, the payment of stamp duty by the Recipient will result in you and the Recipient not dealing at arm's length since such an arrangement is not an ordinary commercial arrangement that would be expected in the market place. Further, if a condition of your Disposal to the Recipient is they pay your stamp duty on your purchase of part A, this payment of stamp duty will form part your capital proceeds in your Disposal. However, following the reasoning provided for Questions 1, 2 & 3, the payment of your stamp duty will not be a component of your sale price and will have no tax implications for you, because your sale price will be determined by the market value substitution rule, in subsection 116-30(2) of the ITAA 1997.

However, if, alternately, a condition of your purchase of part A is the Recipient pay your stamp duty on that purchase, this condition will be a separate CGT asset, namely, a right you can enforce against the Recipient to obligate the Recipient to pay your stamp duty. Such a payment of stamp duty by the Recipient will not form part of your CGT cost base for Level 1 under sections 110-25 and 35 of the ITAA 1997 (since you, personally, will not incur it) and will not be capital proceeds repaid by the Recipient under section 116-50 of the ITAA 1997 (since it will not represent a repayment of capital proceeds).

In effect, this payment of stamp duty will constitute capital proceeds under section 104-25 of the ITAA 1997, for the ending of your contractual right to have your stamp duty paid, and thus will be a taxable capital gain to you.

In summary, if the condition the Recipient pay your stamp duty is included as an obligation in your Disposal contract with the Recipient, it will have no direct tax implications for you. However, if the condition the Recipient pay your stamp duty is included as an obligation in your purchase contract of part A from the Recipient, it will have direct tax implications for you, namely, capital gains tax payable by you.

Section 112-20 of the ITAA 1997 is about the market value substitution rule in relation to your CGT cost base. It states:

The first element of your cost base and reduced cost base of a CGT asset you acquire from another entity is its market value (at the time of acquisition) if:

(a) you did not incur expenditure to acquire it, except where your acquisition of the asset resulted from:

(i) CGT event D1 happening; or

(ii) another entity doing something that did not constitute a CGT event happening; or

(b) some or all of the expenditure you incurred to acquire it cannot be valued; or

(c) you did not deal at arm's length with the other entity in connection with the acquisition.

The definition of the term 'loan' found in The Macquarie Dictionary Online, 2009, 5th edition, includes:

…the act of lending; a grant of the use of something temporarily: the loan of a book.

…something lent or provided on condition of being returned, especially a sum of money lent at interest.

In your case, ordinarily (that is, if the market value substitution rule in section 112-20 of the ITAA 1997 does not apply), payment by you to the Recipient of the full purchase price of part A prior to completion of the project will simply constitute part of your CGT cost base and will not constitute a loan to the Recipient. It will not constitute a loan to the Recipient simply because the payment will not be something lent or provided on condition of it being returned. Instead, payment by you to the Recipient of the full purchase price of part A will be money you paid in respect of acquiring a CGT asset, namely, the newly constructed part A.

Question 7

The Tax Office internet publication Guide to capital gains tax 2013 explains the CGT rules in respect to granting and exercising an option in relation to real estate, as follows:

CGT event D2 happens if you grant an option to a person or an entity, or renew or extend an option that you had granted.

The amount of your capital gain or capital loss from CGT event D2 is the difference between what you receive for granting the right and any expenditure you incurred on it. The CGT discount does not apply to CGT event D2.

Example: You were approached by Colleen, who was interested in buying your land. On 30 June 2012, you granted her an option to purchase your land within 12 months for $200,000. Colleen pays you $10,000 for the grant of the option. You incur legal fees of $500. You made a capital gain in the 2011-12 income year of $9,500.

Exercise of an option

If the option you granted is later exercised, you ignore any capital gain or capital loss you made from the grant, renewal or extension. You may have to amend your income tax assessment for an earlier income year.

Similarly, any capital gain or capital loss that the grantee would otherwise make from the exercise of the option is disregarded.

The effect of the exercise of an option depends on whether the option was a 'call option' or a 'put option'. A call option is one that binds the grantor to dispose of an asset. A put option binds the grantor to acquire an asset.

Example: On 1 February 2013, Colleen exercised the option you granted her. You disregard the capital gain that you made in 2011-12 income year and you request an amendment of your income tax assessment to exclude that amount. The $10,000 you received for the grant of the option is considered to be part of the capital proceeds for the sale of your property in the 2012-13 income year. Your capital gain or capital loss from the property is the difference between its cost base/reduced cost base and $210,000.

Subsection 104-40(2) of the ITAA 1997 states the time of the event is when you grant, renew or extend the option.

In your case, if, party B takes out an option to purchase part A upon completion, you will be liable to pay (undiscounted) capital gains tax on the receipt of the option price received. If the option is later exercised, the capital gain from granting the option will be later disregarded (by amending your relevant tax return) but later included in the final capital proceeds upon completion of the sale of part A.

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