Edited version of your written advice

Authorisation Number: 1013023620109

Date of advice: 26 May 2016

Ruling

Subject: Capital Gains Tax

Question:

Will the capital gain or capital loss on the discharge of the Policy under the Agreement be disregarded under section 118-300 of the Income Tax Assessment Act 1997?

Answer:

Yes

This ruling applies for the following period

Year ending 30 June 20YY

The scheme commenced on

1 July 20XX

Relevant facts

The deceased Person D (along with others) was a principal in a business carried on by the Entity C entities which include the Entity C Unit Trust and the Entity C Pty Ltd (the Entity C company).

The late Person D held one share in the Entity C company. Company A (as trustee for the Person D Family Trust) held one unit in the Entity C Unit Trust. The share and the unit are stapled together and referred to as 'Equity' in the business.

Similarly, each of the other principals, and their respective company have 'Equity' in the business in the form of stapled shares and units.

The late Person D and Company A together with the other principals in the business and their respective company are parties to a put and call option agreement (the Agreement).

Under the Agreement the principals agreed to buy and sell their equity in the business in the event a principal dies (or exits the business by choice). One principal had sold out of their 'Equity' in the business and a purchaser had acquired the equity related to that principal and adopted the terms of the Agreement.

Clause 2 of the Agreement provides that:

(a) each principal in the Business will hold a policy of life insurance (the Policy) against their death (subclause 2.1); and

(b) each Policy will provide a nominated cover of a nominated amount as an estimate of the market value of the principal's equity (subclause 2.3).

Clause 4 of the Agreement provides that the terminating owner grants to the continuing owners a call option to require the terminating owner to sell their equity in the business for the purchase price as set out in Clause 9 of the Agreement.

Clause 5 of the Agreement provides that the continuing owners grant to the terminating owner a put option to require the continuing owners to purchase the equity of the business for the purchase price as set out in Clause 9 of the Agreement.

Clause 6 of the Agreement provides that each principal received $X (a nominal amount) from the others of them in consideration for the grant of the options pursuant to Clauses 4 and 5 of the Agreement.

Clause 9 of the Agreement provides that the purchase price for the Equity (the exercise price of the option) is the greater of:

(1) The amount obtained by multiplying the number of shares included in the relevant shares and units by $X (floor price); or

(2) Their market value determined in accordance with Clause 8.1 less the amount of the sum assured nominated by the Trustee for the relevant Policy for the life of the principal to which the terminating owner is related as at the date of death of that principal (reduced value price).

Clause 8.1 of the Agreement provides that the Market Value of each Share and Unit is to be determined by the Independent Accountant by applying the principles described in Schedule 2.

Schedule 2 Market value - Valuation Principles provides:

(1) The Market Value of a Unit if to be calculated by the Independent Accountant having regard to:

(a) The value of all assets comprised in the Entity C Unit trust;

(b) The amount of all liabilities of the Entity C Unit Trust (including all contingent liabilities and latent taxation liabilities which would arise if the Business was disposed of at that date;

(c) Any special rights, restrictions or conditions relating to the Entitlement of the Unit to share in the income and capital of the Entity C Trust or to a distribution of capital on winding up of the Trust;

(d) Any other rights, restrictions or conditions attaching to or affecting the Unit

(e) The likely net capital gains to be derived ….

(f) Any other circumstances considered relevant by the Independent accountant

(2) The market value of a share is $X.

A policy was taken out by the late Person D in accordance with the Agreement over their life. The life cover sum insured for this policy was $Y. The policy document stated that the proceeds payable in a lump sum on death would not be taxed in the hands of the beneficiary. The policy document showed Person D as the policy owner but it did not state the name of the beneficiary.

This original policy was replaced by another policy. The life cover sum for this policy was $Z. This amount is index linked in which the benefit is automatically increased by W% or the indexation factor, whichever is greater, every year the policy is in force.

The replacement policy document showed the insurance name as 'Leading Life' and the type of policy was described as 'Insurance - Death only'. The Schedule in the policy document showed Person B as the nominated beneficiary with 100% of the sum insured with the late Person D as the policy owner.

Clause 3 of the Agreement provides that during the term of the Agreement the Entity C Unit Trust must pay all premiums relating to the insurance policy. If the Unit Trust defaults in paying a premium, any principal may pay that premium so as to maintain the policy in force and effect. The amount paid by a principal will be a 'debt' due to the principal from the Unit Trust.

Clause 3 of the Agreement was never acted upon. The premiums were funded by the principals as the insured parties under each policy and the premiums were charged to the loan account Entity C Unit Trust maintained for the principals of the business.

The Entity C Unit Trust bore the cost of premiums relating to the insurance policy as part of a separate agreement with the respective unit holders. However the Unit Trust did not claim deductions for the premiums as these expenses were treated as non-deductible life insurance expenditure.

The cost base of the share held by the late Person D in the Entity C company was $X and the cost base of the unit held by Company A in the Entity C Unit Trust was $V.

Person D died in December 20XX. The directors and shareholders of Company A immediately before the date of Person D's death were Person D and Person B.

Person B received a payout under the insurance policy of $U. The market value of the Equity in the business was $T at the time of the exercise of the option under the Agreement.

The valuation of $T was obtained in approximately two years prior to the option being exercised.

The insurance payout amount received by Person B represented the amount that Person D's life was insured for under the replacement policy. When dealing with the insurer, the Trustee of the Entity C Unit Trust estimated the market value for the purpose of nominating an insurance amount under the policy but did not commission a valuation.

Clause 10 of the Agreement states:

10. Dealings between Shareholders and Unitholders pursuant to the Agreement

10.1 The Shareholders and Unitholders acknowledge that in relation to any sale or purchase of Shares and Units resulting from the exercise of a Put Option or a Call Option, the parties will not be dealing with each other at arm's length for the purposes of section 160ZD(2) or section 160ZH(9) for the purposes of the Income Tax Assessment Act.

10.2 The Shareholders and Unitholders acknowledge that:

(1) as at the date of exercise of the Put Option or the Call Option, the Market Value of the Relevant Shares and Units will be the amount calculated in accordance with clause 8.1;

(2) the Terminating Owner will be deemed to have received the Market Value of the Relevant Shares and Units for the purposes of calculating its exposure to capital gains tax on the disposal of those Shares and Units; and

(3) the Continuing Owners will be deemed to have paid for the Relevant Shares and Units an amount equal to their Market Value calculated in accordance with clause 8.1 for the purposes of calculating the cost base, the indexed cost base or the reduced cost base of those Shares and Units to them.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-25.

Income Tax Assessment Act 1997 section 118-300

Income Tax Assessment Act 1997 subsection 118-300(1A)

Reasons for decision

Summary

Person B acquired their interest in the replacement policy for no consideration, accordingly section 118-300 of the Income Tax Assessment Act 1997 (ITAA 1997) will apply and any capital gain or capital loss will be disregarded

Detailed reasons

Proceeds on the discharge of the Policy

Where a life insurance policy is discharged or satisfied CGT event C2 (section 104-25 of the ITAA 1997) happens.

Section 118-300 of the ITAA 1997 excludes from the application of CGT provisions certain capital gains or capital losses relating to the taxpayer's interests under insurance policies, in specified circumstances.

A capital gain or loss from a relevant CGT event happening in relation to a taxpayer's interest in rights under a policy of insurance on the life of an individual or an annuity instrument is disregarded if:

• the taxpayer is the original owner of the policy or instrument (other than the trustee of a complying superannuation fund);

• the taxpayer acquired the interest in the policy or instrument for no consideration; or

• the taxpayer is the trustee of a complying superannuation entity for the income year in which the CGT event happened.

Under subsection 118-300(1A) where a trustee then makes a payment to a beneficiary in respect of the policy or instrument, any capital gain or capital loss made by the beneficiary is also disregarded. This exemption also applies where a payment of the proceeds of a life insurance policy is made by an executor of a deceased estate to a beneficiary.

Under the original policy, the sum insured would be paid to the policy owner and Person D was the policy owner. Under the replacement policy Person D was the policy owner and Person B was the named beneficiary of the policy, with the sum insured being paid to the named beneficiary. Therefore, Person B acquired their interest in the ING policy for no consideration, accordingly section 118-300 of the ITAA 1997 will apply and any capital gain or capital loss made will be disregarded.

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