Edited version of your written advice

Authorisation Number: 1013034301193

Ruling

Subject: capital gains tax consequence of an assignment of partnership interest

Question 1

Will CGT event E1 under section 104-55 of the Income Tax Assessment Act 1997 ('ITAA 1997') happen when the Partner assigns by way of declaration of trust, a beneficial interest in the Partnership to a trust?

Answer

Yes

Question 2

Will CGT event E2 under section 104-60 of the ITAA 1997 happen when the Partner assigns, by way of declaration of trust, a beneficial interest in the Partnership to a trust?

Answer

No

Question 3

Will CGT event A1 under section 104-10 of the ITAA 1997 happen when the Partner assigns, by way of declaration of trust, a beneficial interest in the Partnership to a trust?

Answer

No

Question 4

For CGT purposes, will the capital proceeds for the disposal of the Partnership interest to a trust be the nominal consideration received by the Partner for the assignment?

Answer

No

Question 5

For CGT purposes, will the capital proceeds for the Partner's disposal of the Partnership interest to a trust be the deemed market value consideration under subsection 116-30(1) of the ITAA 1997 for the CGT event?

Answer

Yes

Question 6

In calculating any CGT payable by the Partner on the disposal of the Partnership interest to a trust, are other partners in the Partnership affiliates of the Partner, as defined in section 328-130 of the ITAA 1997, for the purposes of the maximum net asset value test under section 152-15 of the ITAA 1997?

Answer

No

Question 7

If the Corporate Trustee, being a partner in the Service Entity Partnership, is an affiliate of the Partner, then are other partners of the Service Entity Partnership connected with the Corporate Trustee as defined under section 328-125 of the ITAA 1997 for the purposes of the maximum net asset value test under section 152-15 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

1 July 201X to 30 June 201Y.

The scheme commences on:

1 July 201X

Relevant facts and circumstances

You ('the Partner') are an equity partner in the Partnership which operates through a general law partnership and is part of a wider partnership group in Australia, referred to as the Partnership Group.

The Partnership Group consists of several general law partnerships located in capital cities throughout Australia. As standalone entities, each partnership has a separate Partnership Agreement that applies to its partners.

This ruling is only intended to apply to equity partners of the Partnership.

The Partnership currently has X equity partners.

Goodwill is not recognised either in the balance sheet of the Partnership or for any other purposes.

New partners become party to the Partnership Agreement by entering into an Accession Deed.

There is no entry and exit price for partners. Equity partners are allocated points by a remuneration committee and each equity partner must contribute a capital loan to the legal partnership proportionate to total points based on the debt to equity working capital requirements of the business.

Upon departure, equity partners are entitled to the remaining balance of their current account (i.e. retained earnings) and any capital loans they have contributed.

Equity partners are entitled to a share of the net profits of the Partnership in accordance with their proportionate partnership points.

The Partnership, and other partnerships within the Partnership Group, uses a partnership structure to operate its service entity, the Service Entity Partnership, which provides various services to the Partnership Group to undertake its professional services business.

The Service Administration Entity acts as the corporate agent on behalf of the Service Entity Partnership nationally. The corporate agent does not have any financial operations of its own right; it operates under a service agreement with the Service Entity Partnership.

There are approximately XY partners in the Service Entity Partnership. These partners are typically companies acting as trustees for discretionary family trusts of partners of the Partnership Group.

The Partner's associated entity, the Corporate Trustee as trustee for the Family Trust, is a partner in the Service Entity Partnership.

The Partnership is working to identify alternatives that may increase partner retention, attract new talent and reduce the risks attached to operations and partners that may otherwise inhibit the ability of the Partnership to grow.

The Partnership Agreement permits a partner to assign a portion of his or her partnership interest by way of declaration of trust ('an Everett assignment'), where specifically agreed upon by at least Y% of the partners of the Partnership by way of a vote. The Partnership Agreement also requires prior written consent of the other parties to the Agreement, which would not be granted without a declaration by the assigning partner that the Management Team Policy Guidelines will be met in their entirety.

Under the arrangement, the Partner proposes to assign up to approximately Z% of his interest in the income from the Partnership to an associated discretionary family trust ('Trust B') through an irrevocable declaration of trust (creating Trust A) whereby the Partner declares he holds up to Z% of his interest in the Partnership in trust (i.e. as trustee) for the benefit of Trust B. Trust B will be the sole beneficiary of Trust A.

Trust A will receive income from the Partnership and distribute this in full to Trust B. Trust A will undertake no other transactions.

Trust B will pay a nominal consideration of $A for the assigned partnership interest.

The assignment, by declaration of trust, will affect the assignment of all beneficial rights associated with the partnership interest, including the right to receive the share of income of the Partnership.

The Partner will continue to be legally a partner of the Partnership. The trustee of Trust B will not become a partner of the Partnership, nor will the trustee be entitled to interfere in the Partnership's business or affairs or to require any account or to inspect the books of the Partnership.

The Partner will not be the trustee of Trust B or control a corporate trustee of Trust B.

The potential beneficiaries of Trust B will be limited to family members or entities associated with the Partner and arm's length charities. While the Partner is a partner of the Partnership, he will not be a beneficiary of Trust B but may be a shareholder of a corporate beneficiary of Trust B.

Assumptions

The Partner is a capital or full equity partner of the Partnership and this response is based on the facts and arrangements pertaining to capital or full equity partners. Therefore, the questions answered in this advice are intended to only cover issues for capital or full equity partners. This advice is not intended to apply to fixed draw partners, non-equity partners or limited equity partners.

A document giving effect to the assignment will be prepared in a manner which is consistent with and provides the same legal effect as the assignments considered in Federal Commissioner of Taxation v Everett (1980) 143 CLR 440 ('Everett') and Federal Commissioner of Taxation v Galland (1986) 162 CLR 408 ('Galland').

A trust relationship will come into existence consistent with the decision in Everett.

Market valuation will be obtained from an independent accredited valuer in relation to the assigned partnership interest of the Partner. The valuer will be instructed to apply the relevant principles from the decision of the Supreme Court of Western Australia in Reynolds v Commissioner of State Taxation (WA) 86 ATC 4528 ('Reynolds'). This valuation will take into account the Commissioner's statement at paragraph 28 of Taxation Ruling IT 2540 Income Tax: Capital gains: Application to disposal of partnership assets and partnership interests.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 102-5,

Income Tax Assessment Act 1997 - Section 102-20,

Income Tax Assessment Act 1997 - Section 102-25,

Income Tax Assessment Act 1997 - Section 104-10,

Income Tax Assessment Act 1997 - Section 104-55,

Income Tax Assessment Act 1997 - Section 104-60,

Income Tax Assessment Act 1997 - Section 108-5,

Income Tax Assessment Act 1997 - Section 116-20,

Income Tax Assessment Act 1997 - Section 116-30,

Income Tax Assessment Act 1997 - Section 152-10,

Income Tax Assessment Act 1997 - Section 152-15,

Income Tax Assessment Act 1997 - Section 328-125,

Income Tax Assessment Act 1997 - Section 328-130, and

Income Tax Assessment Act 1997 - Section 995-1.

Reasons for decision

Issue 1

CGT implications of holding a portion of your partnership interest as trustee

The Commissioner considers that CGT event E1 will happen when you commence holding a portion of your interest in the Partnership as trustee for Trust B.

CGT Event E1

Section 104-55 of the ITAA 1997 provides that CGT event E1 happens if you create a trust over a CGT asset by declaration or settlement. In order for CGT event E1 to happen, two requirements must be satisfied. These are:

• you must create a trust over a CGT asset by declaration or settlement; and

• the exceptions in subsection 104-55(5) must not apply.

It is considered that the first condition will be satisfied in the present case.

No trust relationship currently exists between you and Trust B. However, you intend to commence holding a portion of your interest in the Partnership as trustee for Trust B. Accordingly, it is clear that the proposed arrangement will involve the creation of a trust.

Furthermore, it is considered that this trust would be created by declaration or settlement.

When a statute speaks of a 'declaration' of trust, it is naturally taken as referring to a declaration or instrument which is effective to create a trust by operating upon property vested in the declarant. This is what would occur in the present case when you commence holding a portion of your interest in the Partnership as trustee for Trust B. A resolution that the property is to be held on a separate trust is sufficient to amount to a declaration for the purposes of CGT event E1, even if there is no express declaration. The manifestation of an intention to create the relevant trust can be inferred from words or conduct, and no formal or technical language is required. Accordingly, it is not essential that you use words such as 'I declare myself a trustee'.

Alternatively, it is considered that a trust would be created by way of 'settlement' for the purposes of CGT event E1 in the present case, being an instrument which creates a new beneficial interest in property through the imposition of a trust.

None of the exceptions in subsection 104-55(5) apply in the present case. Accordingly, the second condition is also satisfied.

CGT Event E2

Section 104-60 provides that CGT event E2 happens if you transfer a CGT asset to an existing trust.

A distinction is to be drawn between the creation of a trust over an asset and the transfer of an asset to an existing trust: Truesdale v. Federal Commissioner of Taxation (1971) 120 CLR 353; 70 ATC 4056.

In the present case, you will commence holding your interest in the Partnership as trustee for the Trust. Whilst the Trust will exist prior to the assignment being entered into, the entering into of the assignment by declaration of trust will give rise to a new trust which was not in existence before that time. Accordingly, you will not transfer an asset to an existing trust and CGT event E2 will not happen.

CGT Event A1

Section 104-10 provides that CGT event A1 happens if you dispose of a CGT asset. Disposal is then defined in subsection 104-10(2) to have happened when there is a change of ownership from you to another entity.

Under the proposed assignment, you will retain the legal ownership and continue to be the named partner in the Partnership. Trust B will only acquire the beneficial ownership of the assigned partnership interest. Therefore, you will dispose of a part-interest in the Partnership when you commence holding it as trustee for Trust B.

However, in accordance with subsection 102-25(1) of the ITAA 1997, CGT event E1 is more specific to the situation, therefore CGT event A1 will not apply.

Capital proceeds for the disposal of your partnership interest

Subsection 104-55(3) provides the method to calculate any capital gain or loss when CGT event E1 happens to a CGT asset. It provides that:

• you make a capital gain if the capital proceeds from the creation of the trust are more than the asset's cost base; and

• you make a capital loss if the capital proceeds from the creation of the trust are less than the asset's reduced cost base.

When calculating the capital proceeds, the general rules in Division 116 need to be applied. The capital proceeds from a CGT event are the total of the amount of money a taxpayer has received, or is entitled to receive, in respect of the event happening, and the market value of any other property the taxpayer has received, or is entitled to receive, in respect of the event happening (worked out as at the time of the event - section 116-20). However, the general rules are modified by the market value substitution rules in section 116-30 where the capital proceeds received are more or less than the market value of the asset and the asset was disposed of in a non-arm's length dealing (subparagraph 116-30(2)(b)(i)).

As you are proposing to assign, by way of declaration of trust, a proportion of your partnership interest to Trust B for nominal consideration of $A, the market value substitution rule under section 116-30 needs to be considered.

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. Subsection 995-1(1) of the ITAA 1997, in respect of the term 'arm's length' states that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

Taxation Ruling IT 2540 Income Tax: Capital Gains: Application to disposals of partnership assets and partnership interests ('IT 2540') provides the Commissioner's view on the CGT consequences of entering into an Everett assignment. Paragraph 24 provides the Commissioner's view that an Everett assignment will be treated as a part disposal of the partner's interest in the assets of the partnership for CGT purposes.

The implication of this treatment was that an Everett assignment could give rise to a capital gain (or capital loss) in the hands of the assignor. As explained earlier in this ruling, the same outcome now arises under the re-written CGT provisions in Part 3-1 of the ITAA 1997. The Commissioner has stated at paragraph 25 that 'it would be very unusual for an Everett assignment to be made on an arm's length basis'. Therefore, the market value modification rule in section 116-30 will apply to determine the capital proceeds.

The case of Granby v. FC of T 95 ATC 4240 ('Granby') considered whether the cost base of certain plant and equipment for CGT purposes was the actual residual value paid or the market value at the time of purchase, in circumstances where plant and equipment was purchased at its residual value on the expiration of a lease. The question turned on whether the lessor of the plant and equipment and the taxpayer's partnership were dealing with each other at arm's length for the purposes of the CGT provisions.

In that case Lee J stated at ATC 4244 that the provision 'dealing with each other at arm's length' invited an analysis of the manner in which the parties conduct themselves in forming the transaction. The question is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs and the expression means, at least, that the parties have acted severally and independently in forming their bargain.

Further, Lee J stated at ATC 4244 that:

If the parties to the transaction are at arm's length it will follow, usually, that the parties will have dealt with each other at arm's length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be.

However this will not be the case where the parties collude to achieve a particular result, or where one of the parties submits the exercise of its will to the discretion of the other. In such a case the lack of the exercise of an independent will in the formation of the transaction would indicate a lack of real bargaining.

The way you propose to assign a proportion of your partnership interest to the Trust for $A evidences that the parties will not behave in a manner in which arm's length parties would be expected to behave. That is, in line with the Commissioner's view in paragraph 25 of IT 2540, the facts indicate that the parties will not be dealing with each other at arm's length. The amount paid by the assignee is not reflective of a normal bargaining process which was discussed in Granby and the nominal capital proceeds of $A do not reflect the value which an interest in the Partnership would expect to be valued at.

Paragraph 28 in IT 2540 provides that when determining the market value of an Everett assignment, the valuation should be in accordance with the decision in Reynolds'. Reynolds' case concerned the valuation of an assigned partnership interest on which ad valorem stamp duty was payable. Despite the other assets of the partnership being held in administration and service entities and goodwill not being recognised by the partnership, Burt CJ held:

'the assigned partnership interest was of value; its value derived from the value of the right that was attached to the partnership interest to receive a proportionate share of the future income of the partnership.'

Paragraph 28 of IT 2540 further explains that when valuing a partnership interest when entering into an Everett assignment, this will involve the determination of the price that a "hypothetical buyer" would pay for the assigned partnership interest having regard to the value of the right to the future income of the partnership which is attached to the interest.

Other partners of the Partnership as affiliates of yours

For the purposes of the maximum net asset value test set out in section 152-15, paragraph (c) of this section requires you to include in the calculation the net value of CGT assets of any affiliates of yours or entities connected with your affiliates.

The term 'affiliate' is defined by section 995-1 to have the meaning described in section 328-130.

Subsection 328-130(1) provides the criteria to be considered when assessing if an individual or a company is your affiliate. Subsection 328-130(2) then provides an exemption where an entity is not your affiliate merely because of the business relationship between you and that entity.

Furthermore an example is provided in section 328-130 in relation to partners in a partnership not being affiliates of each other by acting in concert with each other in relation to the affairs of the partnership.

As you and other partners of the Partnership share and have the common business relationship in the partnership, the exemption provided in subsection 328-130(2) is applicable to you, in relation to the affairs of the Partnership.

The Commissioner does not consider the other partners in the Partnership to be your affiliates for the purposes of section 152-15.

Other partners of the Service Entity Partnership as entities connected with the Corporate Trustee

For the purposes of the maximum net asset value test set out in section 152-15, paragraph (c) of this section requires you to include in the calculation the net value of CGT assets of any affiliates of yours or entities connected with your affiliates. Assuming the Corporate Trustee is your affiliate, it is necessary for the calculation in section 152-15 to consider if the Service Entity Partnership and its partners are entities connected with the Corporate Trustee.

The term "connected with" is defined in section 995-1 of the Act to have the meaning described in section 328-125.

Subsection 328-125(1) considers an entity is connected with another entity if either entity controls the other entity or both entities are controlled by a third entity.

As the Service Entity is a partnership, control over the partnership should be considered by reference to paragraph 328-125(2)(a).

You have stated in your private ruling request that each equity partner in the Partnership Group holds an interest in the Service Entity Partnership through their nominated associates, being a company or a company acting as trustee for a family trust.

As there are approximately X partners in the Service Entity Partnership, it is unlikely that the Corporate Trustee will have the right to at least ZZ% of any distribution of net income or capital of the Service Entity Partnership.

Therefore the Commissioner does not consider the Service Entity Partnership to be an entity connected with the Corporate Trustee for the purposes of section 152-15.

In relation to the other partners in the Service Entity Partnership, the Corporate Trustee does not receive or have the right to receive any distribution of income or capital from these entities. There is also no expectation that the other partners in the Service Entity Partnership will act in accordance with the Corporate Trustee's directions or wishes. Accordingly, the Commissioner does not consider the other partners in the Service Entity Partnership to be connected with the Corporate Trustee for the purposes of section 152-15.

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