Edited version of your written advice

Authorisation Number: 1051231251241

Date of advice: 6 June 2017

Ruling

Subject: Capital gains tax consequences of an assignment of partnership interest

Question 1

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

Answer

Yes.

Question 2

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

Answer

No.

Question 3

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

Answer

No.

Question 4

Will the capital proceeds for the Partner’s disposal of the Partnership interest to a trust be the deemed market value consideration under section 116-30(1) of the ITAA 1997 for the CGT event?

Answer

Yes.

Question 5

In calculating any CGT payable by the Partner on the disposal of the Partnership interest to a trust, is an interest in the Partnership an active asset pursuant to section 152-40 of the ITAA 1997?

Answer

Yes.

Question 6

In calculating any CGT payable by the Partner on the disposal of the Partnership interest to a trust, is the Service Trust an entity connected with the Partner as defined in section 328-125 of the ITAA 1997 for the purposes of the maximum net asset value test in section 152-15 of the ITAA 1997?

Answer

No.

Question 7

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

Answer

No.

This ruling applies for the following periods:

Income year ending 30 June 2017;

Income year ending 30 June 2018.

The scheme commences on:

1 July 2016

Relevant facts and circumstances

You ('the Partner’) are an equity partner in a general law partnership ('the Partnership’).

The Partnership uses a discretionary trust, ('the Service Trust’), which provides various services to the Partnership to undertake its professional services business.

The potential beneficiaries of the Service Trust are the equity partners of the Partnership and/or nominated associates of the equity partners.

The Partnership pays arm's length service fees to the Service Trust.

The Partnership operates as a 'no-goodwill' partnership in accordance with the Articles of Partnership. For the purposes of the Partnership accounts or valuing Partnership assets, goodwill has no value. New partners, when admitted to the Partnership, do not make any payment to existing partners to acquire any goodwill. The partners are also not entitled to receive any consideration for the disposal of goodwill when they retire or otherwise exit from the Partnership.

Partners make a fixed capital contribution to the Partnership on their admission. The partners are not entitled to interest on their contribution to fixed capital. On retirement from the Partnership, the partners’ fixed capital calculated as at the retirement date, will be returned to them.

The Partnership appoints a Board of Partners ('the Board’), who are responsible for the day to day management of the Partnership. However, the Board consults the partners on numerous matters. Election to the Board takes place by each equity partner voting (one vote each) and the Board is voted on and determined each year in September. The Board also has the power to appoint an Executive Chair and Managing Partner to lead and manage the firm.

The Board has been considering options to improve the Partner’s asset protection planning. The Articles of Partnership permits a partner to assign a portion of their partnership interest, with the consent of the Board.

Under the arrangement, the Partner proposes to assign up to approximately A% of his interest in 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 A% of his interest in the Partnership as trustee of Trust A for the benefit of Trust B (i.e. an Everett Assignment).

Trust B will be the sole beneficiary of Trust A.

Trust A will receive income from the Partnership and distribute 100% of this income to Trust B. No further transactions will be undertaken by Trust A.

Trust B will pay a nominal consideration of $1 for the assigned Partnership interest.

The Everett Assignment 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 member of the Partnership, nor will the trustee of Trust B have any interference or influence in the Partnership’s business or affairs or require any account or to inspect the books of the Partnership.

The Partner will not be the trustee of Trust B. The potential beneficiaries of Trust B will be in accordance with the relevant terms of the trust deed, but will generally be limited to family members or entities associated with the Partner, and arm’s length charities.

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 152-40,

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.

Relevant CGT event on 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 in trust for the benefit of 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 of Trust A for the benefit of 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 in trust for the benefit of 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 of the ITAA 1997 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 in trust for the benefit of Trust B. Whilst Trust B 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 (i.e. Trust A) 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 of the ITAA 1997 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 of Trust A.

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) of the ITAA 1997 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 of the ITAA 1997 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 $1, 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 of IT 2540 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 Trust B for $1 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 $1 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.

Partnership interest as an active asset

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset’. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with’ you, in the course of carrying on a business.

Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you.

In your case, your interest in the partnership is an intangible asset. It was through this interest that you carried on a business in partnership with others. Your interest in the partnership is inseparable from the business (and therefore inherently connected with the business) that you carried on. As such, your partnership interest is considered an active asset.

The Service Trust as an entity connected with you

To be able to access the small business relief CGT concession in Division 152 of the ITAA 1997, you must satisfy the basic conditions set out in section 152-10. Subparagraph 152-10(1)(c)(ii) refers to the maximum net asset value test in section 152-15.

Paragraph 152-15(b) requires you to consider, for the purpose of the maximum net asset value test, not only the net value of CGT assets of yours but also any entities connected to you.

The question that was raised in your request for a private ruling is whether the Service Trust is an entity connected with you or not.

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 Trust is a discretionary trust, control of the trust should be considered with reference to subsections 328-125(3), (4) and (5).

The Service Trust operates as a separate commercial business. The Service Trust provides services to the Partnership to conduct its professional service business. The Service Trust is then paid an arm’s length service fee by the Partnership.

As a partner of the Partnership, you and/or your nominated associates are potential beneficiaries of the Service Trust. While you may recommend to the trustee of the Service Trust distribution be directed to your associates, the Trustee has absolute discretion over distribution of the trust’s income.

Therefore it is accepted that the Service Trust does not act, or could reasonably be expected to act, in accordance with your directions or wishes as described in subsection 328-125(3).

As the Partnership has a total of X partners, it is unlikely that there will be any income year in which you and your associates will receive at least 40% of the income or capital of the Service Trust.

Therefore, the Commissioner does not consider the Service Trust to be an entity connected with you for the purposes of section 152-15.

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 of the ITAA 1997.

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 in 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.

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