Edited version of private advice

Authorisation Number: 1051802593572

Date of advice: 26 February 2021

Ruling

Subject: CGT - market value substitution rule

Question

Will the first element of your cost base (or reduced cost base) of the Class B shares in Company A you acquired from Offshore Company B in MMYY be equal to their market value at that time in accordance with paragraph 112-20(1)(c) of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 20YY

The scheme commences on:

DDMMYY

Relevant facts and circumstances

You are a shareholder in Company A.

Company A is an Australian proprietary limited company, registered under the Corporations Act 2001 (Cth).

Company A has the following shares on issue:

(a)      X Class A Shares, with a paid-up capital value of AUD$X; and

(b)      X Class B Preferred Shares, with a paid-up capital value of AUD$X.

Under the company constitution for Company A:

(a)       the Class A Shares are ordinary shares in the capital of the company under the Corporations Act; and

(b)       the Class B Preferred Shares are preference shares with tights prescribed under Schedule 1of the Constitution, including:

(i)    the right to receive notice of, attend and vote at general meetings equally with Class A shareholders;

(ii)   the right to vote on an as-converted-to Class A Shares basis;

(iii)  the right to receive dividends on an as-converted-to Class A Shares basis;

(iv) the right to convert into Class A Shares as specified in Schedule 1;

(v)   the right to proceeds from liquidation as specified in Schedule 1; and

(vi) the requirement of written consent or affirmative vote of majority of then outstanding Class B Preferred Shares separately as a class with respect to matters listed in Schedule 1,including the liquidation or winding-up of the company, and issue of further equity interest with tights on par, or senior to, the Class B Preferred Shares.

You are one of XX shareholders of Company A which hold Class A shares.

Prior to October 2020, all Class B Preferred Shares were held by Offshore Company B.

Offshore Company B also held X convertible notes which were issued by deed poll dated DDMMYY, with a face value of USD$X per note.

WRL Agreement and Transfer of shares

In MM YY Company A entered negotiations with Offshore Company B and its affiliate with respect to a waiver, release and licence agreement (WRL Agreement).

Pursuant to the WRL Agreement:

(a)       Offshore Company B agreed to acquire an exclusive licence with respect to the intellectual property of Company A; and

(b)       Company A granted certain waivers and releases with respect to the employees and business operations of Company A.

As part of the commercial negotiations in respect of the WRL Agreement, the offer made by the affiliate took into account the value of the business operated by Company A, reduced by the value of the interest that Offshore Company B held in Company A (via its Class B Preferred Shares and convertible notes).

As a result, in arriving at the consideration payable under the WRL Agreement, the value of the business was reduced by USD$X (relating to the value of the Class B Preferred Shares and the convertible notes held by Offshore Company B).

During negotiations, the proposal contemplated that the convertible notes held by Offshore Company B would be cancelled or terminated and its Class B Preferred Shares 'contributed' to Company A. However, as part of the negotiations, it became clear that the Class B Preferred Shares could not be 'contributed' to Company A under Australian law, as might otherwise be contemplated in other jurisdictions.

Consequently, it was agreed that in order to give effect to the transaction contemplated by the WRL Agreement, the Class B Preferred Shares would be transferred to the holders of Class A Shares in proportion to their existing shareholding, for a total consideration of USD$X.

Company A and Offshore Company B executed the WRL Agreement on DDMMYY on this basis.

On or about DDMMYY (following execution of the WRL Agreement), each of the Class B Preferred Shares was transferred to the holders of Class A Shares for total consideration of USD$X.

The convertible notes were ultimately cancelled in accordance with the terms of the WRL Agreement.

You hold your shares in Company A on capital account.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-55

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Summary

Section 112-20 of the Income Tax Assessment Act 1997 (ITAA 1197)?will apply to modify the first element of your cost base or reduced cost base of the Class B shares in Company A you acquired from Offshore Company B to equal the market value of those shares.

Detailed reasoning

Subsection 110-25(1) of the ITAA 1997 provides that the cost base of a CGT asset consists of 5 elements.

Subsection 110-25(2) of the ITAA 1997 provides that the first element of a CGT asset is the total of:

(a)       the money you paid, or are required to pay, in respect of acquiring it; and

(b)       the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

The first element of the reduced cost base of a CGT asset's reduced cost base is the same as that for the cost base (subsection 110-55(2) of the ITAA 1997).

However, paragraph 112-20(1)(c) of the ITAA 1997 provides that 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 you did not deal at arm's length with the other entity in connection with the acquisition.

Despite paragraph 112-20(1)(c) of the ITAA 1997, subsection 112-20(2) states that, if you did not deal at arm's length with the other entity and your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening; the market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition).

Further, subsection 112-20(3) of the ITAA 1997 sets out some situations in which the market value substitution rule does not apply.

Subsection 995-1(1) of the ITAA 1997 defines 'arm's length' as follows:

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

In Healey v. Commissioner of Taxation [2012] FCA 269, in determining whether parties deal at arm's length with one another, it was held that the authorities establish the following principles:

1. Whether the parties dealt at arm's length is a question of fact: Trustee for the Estate of the late AW Furse No 5 Will Trust v Commissioner of Taxation (1990) 91 ATC 4007 (at 4017); Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503 (at 507); Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204 (at [106])

2.    There is a distinction between dealing at arm's length and an arm's length relationship: ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (at [224]). Whether the parties did not deal at arm's length is not to be decided by answering whether the parties were not in an arm's length relationship. The fact that the parties are themselves not at arm's length does not mean that they have not, in respect of a particular dealing, dealt with each other at arm's length: Re Hains; Barnsdall v Commissioner of Taxation 88 ATC 4565; (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015)

3.    Whether the parties dealt at arm's length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction: Granby (at 506)

4.    At issue is whether the parties have acted separately and independently in forming their bargain: Granby (at 507); ACI Operations Pty Ltd (at [226])(did the parties apply "independent separate wills"); AXA Pacific Holdings Ltd (at [105]). There should be an assessment of whether the parties dealt with each other as arm's length parties would be expected to behave so that the outcome is a matter of real bargaining: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506 and 507); AXA Pacific Holdings Ltd (at [105])

5.    It is relevant to consider the nature of any relationship between the parties: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506); and

6.    If the parties are not at arm's length the inference may be drawn that they did not deal with each other at arm's length: Granby (at 506); ACI Operations Pty Ltd (at [225]).

Based on the facts provided, it is considered that you did not deal at arm's length with Offshore Company B in connection with your acquisition of the Class B shares in Company A for the following reasons:

•                 You and Offshore Company B's had ownership of shares in Company A in common but Offshore Company B had sole ownership of the Class B Preferred Shares prior to the arrangement and no Class A shares. Ownership of shares in the same entity infers you and Offshore Company B were not at arm's length, despite the different classes of shares indicating you had different rights and so may not have had mutual duties or been induced to serve a common interest. On that basis, the relationship between you and Offshore Company B may have been considered as being at arm's length.

•                 The arrangement was effectively a takeover of Company A s future business operations by Offshore Company B and its affiliate. The value placed on that business is therefore reflected in the value of Offshore Company B's interest in Company A (the Class B shares and convertible notes). On the face of it, it appears to be an arm's length deal. However to transfer those shares valued at over $W.Xm for USD$1 strongly indicates the transaction was not at arm's length.

•                 The transfer of shares was required as part of the WRL Agreement between Offshore Company B and Company A resulting in Company A losing a significant amount of its business. The share acquisition was a part of that whole agreement and not an open market trading of the shares at arm's length. Offshore Company B would not have disposed of the shares outside of the WRL Agreement.

•                 The pre-existing commercial relationship between Company A and Offshore Company B could indicate future dealings between the two may not be at arm's length as can be influenced by current and previous dealings.

•                 The transfer of Class B shares was not a part of the initial negotiations but became a means of the agreement being met when gifting the shares to Company A was not allowable. All parties were indifferent as to the transfer of Class B shares. It was a means to an end.

Accordingly, paragraph 112-20(1)(c) of the ITAA 1997 will apply and the first element of your cost base or reduced cost base of the Class B shares in Company A you acquired from Offshore Company B is the market value of those shares at the time of acquisition.

Subsection 112-20(2) of the ITAA 1997 will not apply as the transaction involved Offshore Company B disposing of its interest in Company A to you and CGT event A1 subsequently happening for Offshore Company B under section 104-10.

Further, the exceptions to the market value substitution rule in subsection 112-20(3) of the ITAA 1997 do not apply.

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