Edited version of private advice

Authorisation Number: 1051819802993

Date of advice: 13 April 2021

Ruling

Subject: Market value substitution rule

Question

Will the capital proceeds received by the Applicant on the disposal of a residential property located at XXX be modified by the market value substitution rule in subsection 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2021.

The scheme commences on:

1 July 2020.

Relevant facts and circumstances

Company A was incorporated in Queensland in 19XX.

Individual A and Individual B were Directors of Company A.

In April 1991 Company A acquired a residential property located at XXX (the Relevant Property).

In 20XX, Individual C and Individual D began living in a XX attached to the Relevant Property.

Individual A and Individual B resided at the Relevant Property in the main residence (as their domestic residence) until the time of their deaths.

Company A did not have a valuation of the market value of the Relevant Property however the estimated market value was between $X million and $X million.

Circumstances around the transaction

Company A and Individual C and Individual D entered into an option agreement on 15 August 20XX for $X, which granted the option to Individual C and Individual D to purchase the Relevant Property for $X million.

Individual A signed as the sole Director, as Individual B had pre-deceased Individual A, passing away in August 20XX. Individual A was XX years of age at the time.

There were no third-party witnesses to the signing of the option deed.

The option was to be exercised within XX months of the death of Individual A.

On 3 August 20XX the option was exercised by Individual C and Individual D.

Sale date was 6 November 20XX and the sale price was $X million.

Settlement date was 25 November 20XX.

Relationship between the parties

The relationship between Individual A and Individual B and Individual C and Individual D was that of acquaintance, as Individual C and Individual D had lived in the granny flat attached to the Relevant Property for approximately XX years before the option agreement was entered into.

Individual D also rented an XX from Individual B and this relationship was one of business.

The parties were not related to each other in any way by birth or marriage.

The parties shared a common interest in progressing the XX and other charitable causes.

None of the parties were independently represented or had a lawyer and/or tax adviser present at the time of the option agreement was entered into.

None of the parties sought advice as to the value of the property.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 100-25(2)

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Subsection 104-10(1)

Income Tax Assessment Act 1997 Subsection 104-10(2)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 116-20(1)

Income Tax Assessment Act 1997 Subsection 116-30(2)

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Question

Will the capital proceeds received by Company A from the disposal of the residential property located at XX (the Relevant Property), be modified by the market value substitution rule in subsection 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

The capital proceeds paid to Company A. from the disposal of the Relevant Property are to be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997.

Detailed reasoning

Relevant law

Section 102-20 of the ITAA 1997 provides that a capital gain or capital loss results from a capital gains tax (CGT) event occurring.

Subsection 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if an entity disposes of a CGT asset. A 'disposal', as defined in subsection 104-10(2) of the ITAA 1997, occurs when there is a change of ownership from one entity to another. A 'CGT asset', as provided in section 108-5 of the ITAA 1997, is:

•         any kind of property, or

•         a legal or equitable right that is not property.

CGT event A1 will be triggered when an entity sells a property. The capital gain from such an event is the difference between the capital proceeds and the cost base of the relevant CGT asset.

General rules about capital proceeds are provided in section 116-20 of the ITAA 1997. Subsection 116-20(1) of the ITAA 1997 states that 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).

The 'market value substitution rule'

However, there are a number of modifications to the general rules. Relevantly, the 'market value substitution rule' in section 116-30 of the ITAA 1997 provides that an entity is taken to have received the market value of the relevant CGT asset in certain situations.

In particular, subsection 116-30(2) of the ITAA 1997 modifies the general rules by replacing the capital proceeds with the market value of the relevant CGT asset (worked out as at the time of the event) if:

(a)  some or all of those proceeds cannot be valued; or

(b)  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; or

                          (ii)       the CGT event is CGT event C2 (about cancellation, surrender and similar endings).

Meaning of 'at arm's length'

The term 'arm's length', in relation to dealings, is defined in the Concise Oxford Dictionary as "with neither party controlled by the other". Osborn's Concise Law Dictionary defines 'at arm's length' as "the relationship which exists between parties who are strangers to each other, and who bear no special duty, obligation or relation to each other". Black's Law Dictionary defines 'arm's length' as "beyond the reach of personal influence or control" and adds that "[p]arties are said to deal at arm's length when each stands upon the strict letter of his rights, and conducts the business in a formal manner, without trusting the other's control or overmastering influence".

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 ACI Operations Pty Ltd v. Berri Ltd (2005) 15 VR 312 (ACI Operations Pty Ltd), Dodds-Streeton J said (at [223]) that the authorities establish:

... an arm's length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal.

The market value substitution rule requires consideration to be given to the nature of the dealings between parties to a transaction and not simply their relationship. As Dodds-Streeton J explained in ACI Operations Pty Ltd at [224]-[226] (footnotes omitted):

The concept of an arm's length relationship is distinct from that of an arm's length dealing or transaction, despite the potential overlap. Unrelated parties may collude or otherwise deal with each other in an interested way, so that neither the dealing nor the resultant transaction may properly be considered arm's length. Where the parties are not in an arm's length relationship, it is recognised that the inference may be drawn that they did not deal with each other at arm's length. It may further be inferred that the resultant transaction is not arm's length. Related parties may nevertheless, in some circumstances, demonstrate a dealing which displaces the inference based on their relationship. They may engage in the disinterested bargaining characteristic of strangers, applying independent separate wills. The circumstances of the impugned transaction may be such that, despite the parties' connection or common interest, the interposition of some independent process (such as the sale of shares on the stock exchange) ensures that the transaction itself is arm's length, in the sense that it could equally have been concluded by unrelated parties, consulting their own self-interest and uninfluenced by any particular association or interest in common.

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. The law looks at not only the relationship between the parties but also the quality of the bargaining between them.

An individual is said to be 'dealing at arm's length' with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction.

Parties are not at arm's length where the parties are related or associated in some way so that while each party may enter a transaction with some self-interest in mind, it may also take into consideration the interests of the other party in making the agreement. Examples of such relationships are transactions between family members and related corporations.

Where parties are not at arm's length, it is still possible for the parties to deal at arm's length in relation to a specific transaction. As stated by Davies J in Barnsdall v. Federal Commissioner of Taxation (1988) ATC 4565, 4568:

The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a 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.

Parties will be dealing at arm's length where they act as arm's length parties would normally do, so that their dealing has an outcome that is the result of normal or real bargaining (The Trustee for the Estate of the late A W Furse No 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123 and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 (Granby)).

In Granby at ATC 4243; ATR 403, Lee J stated 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; ATR 403-404) 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 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.

In Collis v. FC of T 96 ATC 4831; (1996) 33 ATR 438 (Collis), the Federal Court found that the parties were not dealing at arm's length because one party was indifferent to the allocation of the sale price for the parcel of land. This indifference was indicative of a submission of one party's will to the other party's wishes which demonstrated a lack of arm's length dealing.

The underlying principles of the case law discussed above have been summarised by McKerracher J in Healey v. FC of T [2012] FCA 269 [at 95]. In that case, in determining whether or not parties are dealing 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 91 ATC 4007 (at 4017) (Trustee for the Estate of the late AW Furse No 5 Will Trust); Granby Pty Ltd v. Federal Commissioner of Taxation 95 ATC 4240; (1995) 129 ALR 503 (at 507) (Granby); Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134; (2010) 189 FCR 204 (at [106]) (AXA Asia Pacific Holdings Ltd).

2.    There is a distinction between dealing at arm's length and an arm's length relationship (ACI Operations Pty Ltd (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).

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]).

Application to Company A's circumstances

The transaction involved the sale of the Relevant property owned by Company A to Individual C and Individual D for an amount that was less than the current market value of the Relevant Property.

In determining whether the capital proceeds from the transaction will be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997, each of the elements of this provision will be examined individually.

Paragraph 116-30(2)(a)

Paragraph 116-30(2)(a) of the ITAA 1997 is not applicable to the circumstances as, based on the facts, the value of the capital proceeds from the transaction (being the option exercise price of $X million) is known.

Subparagraph 116-30(2)(b)(i)

For subparagraph 116-30(2)(b)(i) of the ITAA 1997 to be satisfied:

1. the capital proceeds that Company A received from the transaction must be either more or less than the market value of the Relevant Property, and
2. Company A (the sellers of the Relevant Property) and Individual C and Individual D (the acquirers of the Relevant Property) must not have dealt with each other at arm's length in connection with the transaction.

As per the facts, Company A did not have a valuation of the market value of the Relevant Property at the time of signing of the option agreement. However, Company A received capital proceeds of $X million for the sale of the Relevant Property and the Relevant Property now has estimated market value was between $X million and $X million. The capital proceeds are more than the market value of the Relevant Property. Therefore, the first element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is satisfied

If the second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is not satisfied, then the market value substitution rule in subsection 116-30(2) of the ITAA 1997 would not apply, regardless of whether or not the first element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is satisfied.

The second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 will now be examined.

Did Company A. and Individual C and Individual D deal with each other at arm's length?

In determining whether Company A and Individual C and Individual D dealt with each other at arm's length in connection with the transaction, the Commissioner is required to take into account not only the relationship or connection between Company A and Individual C and Individual D, but also the circumstances of the transaction with a view to determining whether or not the parties conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction.

The following facts are relevant for consideration:

•         The parties to the transaction, Company A and Individual C and Individual D, are unrelated parties. There is no presumption that unrelated parties deal with each other at arm's length. Parties may be unrelated or at arm's length generally, yet not deal with each other at arm's length in respect of a transaction.

•         There are common interests between the parties to the transaction.

•         The parties did not act in their own interests severally and independently in the negotiation process, as they did not seek advice from lawyers and/or tax advisors.

•         The parties to the transaction were not independently represented from a legal, financial and tax perspective.

•         There has been no negotiation over the purchase price of the Relevant Property. In particular, the parties did not show that they had a mutual desire to achieve their own objectives and acted in their own interests severally and independently in the negotiation process by seeking advice from their respective lawyers, tax advisors and independent valuers. There is a significant different between the purchase price and current estimated market value of the Relevant Property. There is no real bargaining between the parties.

•         Even though market value is determined from the perspective of the seller, it is not accept in this instance, that arm's length party would sell the Relevant Property for substantially under market value.

•         The approach to, and dealings by, both parties in respect of the transaction demonstrates that the parties did not behave in a manner in which arm's length parties would be expected to behave.

Based on a consideration of the above factors/circumstances, the Commissioner considers that Company A and Individual C and Individual D did not deal with each other at arm's length in respect of the transaction.

Accordingly, subparagraph 116-30(2)(b)(i) is satisfied.

Subparagraph 116-30(2)(b)(ii)

Subparagraph 116-30(2)(b)(ii) of the ITAA 1997 is not relevant in the current circumstances as the applicable CGT event is not CGT event C2.

Conclusion

As paragraph 116-30(2)(b)(i) of the ITAA 1997 is satisfied, the capital proceeds Company A received upon the disposal of the Relevant Property would be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997.

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