NTLG CGT Sub-committee minutes - 28 November 2001

Meeting details

Meeting date: 28 November 2001
Meeting location: Melbourne

Next meeting: Wednesday 12 June 2002, in Sydney

Previous meeting: Wednesday 13 June 2001, in Sydney

Participants

Australian Taxation Office (ATO)

Professional bodies

Apologies

Ms Deborah Boyd

Mr Glenn Davies

Mr Alec Stasi

Ms Linda Skinner

Mr Frank Wilson

Mr John Burge (chair)

Ms Hoa Do (secretary)

Mr Jon Kirkwood, Institute of Chartered Accountants of Australia (ICAA)

Mr Anthony Stolarek, ICAA

Mr David Cominos, Taxation Institute of Australia (TIA)

Mr John Brazzale, Certified Practising Accountants (CPA) Australia, Taxpayers Australia

Mr Ken Spence, TIA

Mr Lance Cunningham, National Institute of Accountants (NIA)

Ms Annamaria Carey, Law Council of Australia (LCA)

Mr Gary Addison, CPA Australia

Mr Robert Warnock, National Tax and Accountants Association (NTAA)

Mr Chris Evans, CPA Australia

Mr Sam Sorbello, ATO

Ms Freya Marsden, Department of Treasury

[H2]Opening and other comments

Mr Burge (ATO) opened the meeting and welcomed everyone.

¦ Minutes of previous meeting - The minutes for the previous meeting, held on 12 June 2001 in Sydney, were confirmed and are available on the ATO website at: http//www.ato.gov.au/content.asp?doc=/content/Businesses/16627.htm

¦ It was observed that Mr Daryl Murphy (Senior Tax Counsel, ATO) has announced his retirement, effective February 2002. The subcommittee acknowledged, and expressed its gratitude for, Mr Murphy's important and significant contribution to its work over many years. The subcommittee also wished him a prosperous and very happy retirement.

 

[H3]Agenda items

1.1 Updates

Number & Sponsor

Issue

Outcome

1.1

Update of action items from 13 June 2001 subcommittee meeting

¦ Agenda item 1.1: ATO to forward copy of finalised minutes of the subcommittee meeting of 13 June 2001 to the Board of Taxation to assist in its review of these types of forums.

Done.

¦ Agenda item 2.5: Subject to ATO priorities, ATO to issue taxation determination on issue of capital contributions without additional issue of scrip and entitlements to cost base or increase in cost base.

Draft Taxation Determination TD 2001/D11 released on 7 November 2001. (See also discussion at agenda item 9.)

¦ Agenda item 3.4: Losses and tracing to satisfy the same ownership test in subsection 165-12(6) - ATO to report at the next meeting of the subcommittee.

ATO confirmed that the 'alternative test' did not apply on the facts provided. Such a result revealed a possible anomaly in view of the existence of the saving rule, but whether a legislative change was required was a matter for the Government.

1.2 Discretionary trusts

Number & Sponsor

Issue

Outcome

2.1 NIA

Right to distribution in a discretionary trust results in possible double taxation by virtue of the application of capital gains tax (CGT) events D1 (creating rights) and C2 (cancellation, surrender etc.)

The NIA submitted that where a trustee of a discretionary trust exercises the discretion to distribute trust income or capital to a beneficiary, it would be appropriate to 'look through' the legal rights created in the beneficiary and to focus on the relevant transaction (that is, the distribution of the assessable or non-assessable amount).

The ATO confirmed that this was the correct approach. The legal rights incidentally created - that is, the right to payment and then, on payment, the discharge and satisfaction of that right - merely facilitate the transaction. This is consistent with the approach outlined in Commissioner of Taxation v. Dulux Holdings Pty Ltd & Orica Ltd [2001] FCA 1344 (the second Orica case).

2.2 TIA

Renunciation of interests in a discretionary trust - TD 2001/26.

The TIA raised the following issues:

(a) Note 3 of Taxation Determination TD 2001/26 states that the ordering rule in section 102-25 has the effect that CGT event C2 (cancellation, surrender, etc.), rather than CGT event H2 (capital payments), applies where a beneficiary receives money or other consideration because of the renunciation of their interest. Does this affect the conclusions in Taxation Determination TD 97/15 that CGT event E4 (section 104-70) does not apply to a non-assessable payment to a discretionary trust beneficiary. Does this also affect the conclusions in draft Taxation Determination TD 1999/D67 that the interest of a default beneficiary in a discretionary trust is not an interest to which section 104-70 applies?

ATO Response: There is no change from the conclusions reached in Taxation Determination TD 97/15 and Taxation Determination TD 1999/D67.

(b) Has the ATO considered the arguments raised in Flynn & Krever in Death and Taxes at page 15-050, in relation to whether renunciation or disclaimer voids the gift absolutely or whether they are effective prospectively?

ATO response: The arguments in Flynn & Krever were considered, as were other relevant authorities. The conclusion reached is set out in the taxation determination (TD) - that renunciation operates prospectively. The concept of renunciation covers both a disclaimer and a surrender of entitlement after receiving some benefit from the interest.

(c) Does the ATO accept in the context of Taxation Determination TD 2001/26 (i) that 'renunciation' can occur beyond the 'pure form' indicated; and (ii) that Taxation Determination TD 2001/26 simply assumes an outcome in respect of renunciation?

ATO response : The ATO does accept that renunciation can occur both before and after a distribution is made to a beneficiary. The ATO is aware of two cases where the beneficiaries renounced their interests after receiving a distribution. The court distinguished between a disclaimer (where the beneficiary was treated as if they had not, in fact, acquired an interest) and a renunciation (where the termination of the interest occurred at the time of the renunciation).

It is a question of law as to whether the wording of a renunciation is effective to renounce an interest and the ATO cannot set, or even recommend, the wording.

The determination merely states the consequences of a valid renunciation.

1.3 Issues surrounding CGT event C2

Number & Sponsor

Issue

Outcome

3.1 Issue referred from National Tax Liaison Group (NTLG) (CPA Australia)

Orica litigation

CPA Australia raised issues about the Orica litigation.

(a) Given developments in the law since the first Orica case and the recent decision of the full Federal Court in the second Orica case, will the ATO be issuing a public ruling to clarify the law in this area?

ATO response : There are no current plans to issue a taxation determination or a public ruling, as there have been very few private ruling requests which raise these issues.

A taxpayer with an issue about a 'rights' asset may request a private ruling. Each case depends on its facts, and the private ruling requests received to date have not elicited general principles suitable for incorporation in a public ruling.

(b) Would the ATO please advise the professional bodies of its policy in relation to issuing rulings when there is a case before the court or tribunal on a tax matter?

The professional associations were invited to comment on this issue. They thought that the ATO should issue an appropriate statement (generally not a legally binding ruling) to raise public awareness of the issues being litigated and the ATO's initial position. The professional associations accepted that any such document would need to be a 'living document' and that the ATO's position may change as litigation progresses.

The ATO noted difficulties with circulating, tracking and timing the release of such documents, and with the length of time that they can be in circulation. In particular, where the litigation continues and the ATO view changes, further consideration may need to be given to the position of taxpayers who relied on any preliminary view and are adversely affected when a final position is determined. It was accepted, however, that in limited cases the ATO may choose to make some public comment.

Action item: The subcommittee to report back to the NTLG on its discussion on both aspects of this agenda item, as the issues have wider implications than those for CGT. Issue to be raised with the Assistant Commissioner responsible for rulings.

Later developments: The subcommittee reported back to the NTLG for its meeting held on 6 December 2001.

The second aspect has been brought to the attention of the Assistant Commissioner responsible for rulings, Mr Tom Meredith. Mr Meredith has advised that it is not the usual practice for the ATO to issue public rulings when there is litigation before a court or tribunal on a tax matter. Until the outcome of a particular case is known, the ATO administers the law on the basis of the view being argued for by the Commissioner in the case, including where there is an adverse decision of a court or tribunal against which the Commissioner has appealed.

If, during the course of any litigation, a taxpayer seeks a private ruling on the issue being litigated, the private ruling would be issued in accordance with the view being argued by the Commissioner. This is consistent with the approach taken for the issue of assessments, when a matter is being litigated before a court or tribunal.

3.2 NTAA

Instalment sales: payment made more than 12 months after sale of business

The NTAA raised the following issue:

Take an example of a business being sold for up-front consideration and 50% of the average profits each year over the next three years. Is a capital gain eligible for the CGT discount if a payment giving rise to the capital gain is made at least 12 months after the sale of the business? Also, is any capital gain eligible for the CGT small business concessions?

Does the decision in Orica affect this analysis? Under Taxation Ruling TR 93/15 (capital gains tax consequences of consideration comprising a lump sum, plus a right to a contingent and unascertainable amount), an asset (being the right) is created at the time of the contract. If the final consideration is greater than the cost base of the right, there is a capital gain. In Orica, the date of the contract is the relevant date of disposal for the 12 months requirement. Is the right to the contingent, unascertainable payments an active asset forthe small business concessions?

The ATO stated that the small business concessions are available for the sale of the business originally and the outcome of sale is a new asset (the right). That new asset does not qualify for the small business concessions as it is not an active asset. The CGT discount is available. The right arises at the date of contract, and there is a part satisfaction of it each time a payment is received.

The professional bodies asked whether Taxation Ruling TR 93/15 applies to fixed amounts to be received in the future .

The ATO stated that the total amounts receivable would be treated as capital proceeds (subsection 116-20(1)).

The professional bodies then commented that the approach taken for instalment sales is based on Marren v. Ingles [1980] 3 All ER 95 and that it is difficult to argue from a technical perspective with that outcome. However, the professional bodies said that this raises a fundamental policy problem and that the current tax system does not cope well with these types of sales. The right has to be valued and partial dispositions of it dealt with as the payments are made. More fundamentally, it is inappropriate that taxpayers be taxed up-front on amounts they are yet to receive. The ATO noted these observations.

3.3 LCA

Mutual release of obligations.

The LCA said that if there is a mutual release of obligations, a capital gain may arise where the rights are valuable. How can a reasonable cost base be attributed? Can a set-off approach be used if the parties agree to the figures, with only the party making a gain needing to disclose it in their income tax return? The United Kingdom has sought to resolve this issue with an extra-statutory concession, which states that whatever is received from damages or compensation claims is treated as relating to an underlying asset where there is one (consistent with thetreatment in Taxation Ruling TR 93/35) and exempt if there is no underlying asset (which is not the treatment in Taxation Ruling TR 95/35). Is there a possibility of this problem being fixed by a similar concession?

The ATO acknowledged that capital gains can arise in such circumstances because the rights released have value. There is not likely to be a problem where the mutual release of obligations is incidental to another transaction. In other cases, there is no statutory basis for disregarding any capital gain arising from the release. Extra-statutory concessions are not a feature of Australian taxation law. The suggested set-off approach is not supported by legislation.

The professional associations said that an important issue for these arrangements is the valuation of the rights. The ATO said that, consistent with the approach taken in Taxation Determinations TD 9 and 10, it would generally accept the taxpayer's valuations of the right provided they are based on reasonably supportable data. The taxpayer is not obliged to retain a professional valuer.

3.4 ICAA

Orica: subsection 104-25(2) (timing of CGT event C2)

The ICAA asked whether, in light of the recent Orica decision, section 104-25 (CGT event C2) accurately reflects the provisions of the Income Tax Assessment Act 1936 (ITAA 1936). Does the ATO propose to promulgate a view in this regard?

The ATO said that the equivalent provisions in the ITAA 1936 were subsections 160U(3) and (4). In the second Orica case, the Full Federal Court stated that there was a discharge of the asset under subsection 160U(4) (the equivalent in the ITAA 1997 being paragraph 104-25(2)(b)) where there is no contract under which the disposal occurs (or that results in the asset ending). The time of the deemed disposal / CGT event is when the asset ends. Their honours' comments support the view that there is no difference in legal effect between the ITAA 1936 and ITAA 1997. This was intended: there is no statement in the explanatory material signalling any change. Therefore, having regard to section 1-3 of the ITAA 1997 and to section 15AC of the Acts Interpretation Act 1901, the ATO considers that a court would reach the same conclusion under the ITAA 1997 as reached under the ITAA 1936.

The ATO does not intend to promulgate this view other than through the release of these minutes. It considers the law to be sufficiently clear on this point.

1.4 Small business CGT concessions

Number & Sponsor

Issue

Outcome

4.1 NTAA

Goodwill as an active asset

The NTAA asked whether goodwill can be an active asset of an entity if used in carrying on business by a connected entity. For example, an individual owns a business including goodwill. The individual licenses the business (including goodwill) to a trust that is connected with the individual. When the individual sells the business (including goodwill), is the goodwill an active asset?

The NTAA pointed out that under paragraph 152-40(1)(c) it is specifically stated that an active asset includes an asset which is used or held ready for use, in the course of carrying on a business by either your small business affiliate or another entity that is connected with you. However, paragraph 152-40(1)(b) refers to 'an intangible asset that is inherently connected with a business that you carry on (for example, goodwill or the benefit of a restrictive covenant)'. Does the fact that intangible assets are specifically dealt with in paragraph 152-40(1)(b) indicate that this is an exclusive code for all intangible assets and that the taxpayer cannot apply paragraph 152-40(1)(c) to the intangible asset in question?

The ATO stated that paragraph 152-40(1)(b) was inserted to remove any doubts arising under paragraph 152-40(1)(a) that a taxpayer can 'use' only physical assets in the course of carrying on the business. The purpose and effect of paragraph 152-40(1)(b) is to extend (not impliedly limit) paragraph 152-40(1)(a). Paragraph 152-40(1)(c) in turn supplements both paragraphs (a) and (b).

It is not clear in the example who owns the goodwill and the legal effect of the granting of the licence. There may be two businesses involved. The answer depends on the precise facts.

4.2 NTAA

Meaning of 'in connection with retirement' in Subdivision 152-D

The NTAA asked how broadly the ATO interprets the phrase 'in connection with the individual's retirement' in paragraph 152-110(1)(d) and the similar phrase in paragraph 152-105(d). In particular can the ATO please provide guidelines as to what an individual must do to satisfy the conditions?

The ATO stated that in framing the provisions for the 15 year retirement exemption, various definitions of 'retirement' in tax and superannuation law were examined. These were too restrictive for this purpose, and it was decided not to include a definition to ensure that the law applied flexibly and appropriately.

Attachment A gives examples of the way the law is likely to be administered for the purposes of the small business CGT concessions. These are provided only as a guide. The ATO proposes to include these, or similar, examples in the next edition of its booklet about the CGT small business concessions.

4.3 NTAA

Small business roll-over under Sub-division 152-E - replacement asset conditions

The NTAA asked whether a flaw exists in the small business rollover so that an extension of time granted under subsection 152-420(3) is ineffective unless the replacement asset is active when acquired.

Example: A CGT event happens on 28 November 2001 in relation to an original asset for which the taxpayer wants to choose the rollover. This is the last event in the 2001-02 income year for which the rollover will be chosen.

The taxpayer wishes to choose business premises as a replacement asset but the business premises are not acquired until 10 December 2003 (the date of making the contract). Settlement does not take place until 10 February 2004, at which time the replacement asset is used in the relevant business.

If the Commissioner grants an extension of time under subsection 152-420(3) to 10 December 2003, it seems that the replacement business premises will still not qualify as a replacement asset.

To qualify as a replacement asset the asset must be an active asset when acquired, or by the end of two years after the relevant CGT event - see subsection 152-420(4). In this example, as the two year period has expired, the asset must be an active asset when acquired. As the date of acquisition for CGT purposes is the date of making the contract (see section 109-5) and as the replacement asset is not active until settlement, the condition is not satisfied. Although the Commissioner has a discretion to extend the time limit under subsection 152-420(1), he or she does not have a discretion to extend the time limit under subsection 152-420(4).

The ATO acknowledged that in some cases it may be difficult to satisfy the requirements. It will consider this issue further.

4.4 NTAA

Maximum net asset value test and discretionary trusts

The NTAA said that from a practical perspective most discretionary trusts cannot satisfy the maximum net asset value test as a result of subsection 152-30(5)).

Example: If the trustee of a discretionary trust has a complete and unfettered discretion to distribute as much income as it likes to one or more of the objects of the trust, each one of those objects will have a control percentage of 100% as a result of subsection 152-30(5). This means every object of the discretionary trust will be connected with the discretionary trust and therefore the net value of each object's CGT assets must be taken into account in determining whether the discretionary trust satisfies the maximum net asset value test.

In a typical discretionary trust deed the objects include a wide range of relatives of the principals behind the trust as well as many other entities, including charities. The practical effect of the sub-section is that the $5 million threshold will often be exceeded.

If the ATO agrees that in these circumstances a discretionary trust will not satisfy the maximum net asset value test, does the ATO agree that if the discretionary trust deed is amended to limit each object's entitlement to income and capital to less than 40% this problem will be overcome? Would such an amendment give rise to any CGT implications (refer to the Commissioner's August 2001 Statement of Principles on the creation of a new trust)? Would the Commissioner apply Part IVA if such an amendment was made?

The ATO agreed that there may be difficulties satisfying the provisions. Any amendment to a trust deed may raise trust resettlement issues and the ATO noted that this type of restructuring may attract the general anti-avoidance provisions of Part IVA of the ITAA 1936.

The professional associations asked whether this issue was encompassed in the Board of Taxation's review of entity taxation. The ATO members of the subcommittee were not aware of this issue being considered in that context.

The professional bodies asked if it was possible to apply a pattern of distribution test . The ATO stated that there was no statutory authority to do that and that any administrative solution would need to be reconcilable with what Parliament had enacted.

The ATO also stated that it expected auditors would take a practical approach within the law.

4.5 NTAA

Subdivision 152-D (small business retirement exemption) and the payment of eligible termination payments

The NTAA asked several questions that essentially concerned the eligible termination payment (ETP) provisions.

The ATO stated that the CGT rules complement the ETP rules. Before the CGT rules can apply, the payment must be classified as an ETP. These issues raise questions of ETP policy and interpretation. The ATO undertook to include responses in these minutes. The questions and ATO responses, which have been provided by its Superannuation Business Line, are set out below. These responses are necessarily general and depend on the particular facts. A taxpayer can request a legally binding private ruling in relation to particular cases.

Will the requirements of subsection 152-325(7) be satisfied in the following circumstances:

The Bloggs Family Trust wishes to obtain the retirement exemption in Subdivision 152-D. It sells the asset in October 2001 and receives payment at settlement in November 2001. The trust makes the relevant choice on 14 February 2003 when it lodges its 2002 tax return. Assume all other relevant conditions are satisfied, the CGT exempt amount is $50,000 and Fred (aged 49) is a CGT concession stakeholder.

ATO response: Subsection 152-325(7) would be satisfied if the ETP rollover requirements are satisfied.

Will subsection 152-325(7) be satisfied if:

(a) the trust pays a $50,000 ETP to Fred on 15 February 2003 and on 16 February 2003 Fred pays $50,000 into his complying superannuation fund (being the roll-over fund)? Arguably yes because subsection 152-325(1) requires a $50,000 ETP to be made to Fred. Subsection (7) then requires an amount equal to $50,000 to be rolled-over. Also under paragraph 27A(12)(a) of the ITAA 1936 the requirement is that a payment be made to a complying superannuation fund immediately after the ETP is made?

ATO response : Generally, the requirements would not be satisfied as the amount is to be paid directly to Fred's complying superannuation fund. However, if the conditions of Taxation Determination TD 96/36 are satisfied, such a transaction would be acceptable.

(b) the trust pays the $50,000 directly to the complying superannuation fund without paying it to Fred first? Taxation Determination TD 96/36 indicates yes, but subsection 152-325(7) indicates the ETP must be paid to Fred before the rollover is made?

ATO response: Yes, making the payment directly to the rollover fund satisfies the requirements of subsection 152-325(7) and of the ETP provisions as explained in Taxation Determination TD 96/36.

(c) the same as (a) except Fred transfers a property worth $50,000 or more to the complying superannuation fund in lieu of paying cash to satisfy the roll-over requirement? Assume the transfer of the property does not breach the SIS Act. Does the use of the term 'amount' in subsection 152-325(7) allow non-cash payments to be made?

ATO response: No, this transaction would not satisfy the requirements. The property has come from Fred and is not the ETP. The ETP is the $50,000 and it cannot be paid to Fred on the understanding that he substitute something for the $50,000 that will be transferred into the fund. Therefore, the transfer of the property cannot be treated as a rollover. It would be treated as an undeducted contribution if the transaction was permitted under the Superannuation Industry (Supervision) Act 1993.

(d) the trust lends $50,000 (being part of the sale proceeds) to Fred in December 2001 and then pays the ETP to Fred on 15 February 2003 by journal entry. For example:

Dr ETP expense $50,000
Cr Loan account - Fred $50,000

Fred then pays $50,000 into his complying superannuation fund on 16 February 2003 to satisfy the roll-over requirement.

ATO response: No, this transaction would not satisfy the requirements. The loan to Fred in December 2001 results in the money being used for an intervening purpose. Fred is able to make use of the funds gained from selling the asset before funds are paid into the complying superannuation fund. Taxation Determination TD 96/36 requires that, for an ETP to qualify for rollover relief, it must be immediately paid to a complying superannuation fund. Paragraph 2 of Taxation Determination TD 96/36 specifically excludes any payment where the funds are otherwise put to an intervening purpose. As Fred has use of the funds before their payment into the complying superannuation fund, the funds have been put to an intervening purpose. Therefore, example (d) does not satisfy the rollover requirements in subsection 27A(12) of the Income Tax Assessment Act 1936.

4.6 ICAA

Maximum net asset value test and the types of liabilities that may be taken into account.

The ICAA raised the following issue:

Section 152-20 limits the liabilities which may be subtracted from the market value of assets in determining whether the $5 million net asset value test is passed to 'liabilities relating to those assets'.

Clarification of what this term means would be of assistance in generally applying the CGT small business concession provisions. In particular, clarification is sought concerning the treatment of general liabilities such as bank overdrafts and liabilities under bill facilities, or general loans for working capital.

The ATO stated that non-contingent liabilities relating to a particular asset or to the assets of the business more generally (such as a bank overdraft) may be taken into account. The test under section 160ZZN of the ITAA 1936 applied in a different context. Provisions for income tax, for example, do not qualify as a non-contingent liability.

4.7 ICAA

Inability for chains of entities to gain access to the small business concessions

The ICAA said that chains of entities cannot gain access to the small business tax concessions for disposals of entities in a chain of entities due to the restrictive application of the controlling individual test in section 152-50. The CGT small business concessions appear to be drafted on the assumption that a small business is operated by either an individual directly or by individuals that control a single closely held entity that operates that small business (see subsection 152-10(2) - controlling individual and CGT concession stakeholder tests must be passed if the CGT asset is a share in a company or an interest in a trust). It does not contemplate that there will be a structure where there are interposed entities between the individual and the entity that owns the business assets.

(a) Are there mechanisms whereby the concessions can apply to non-individual holders that dispose of companies or trusts?

(b) Given the proposals to adopt a consolidation regime, is it being considered whether the small business tax concessions should subsequently be amended to result in this test being able to be passed by a consolidated group for the disposal of entities outside of the group?

The ATO stated that the provisions were drafted on the basis that the benefits of the small business concessions should apply to individuals or partnerships, operating a business directly or through a directly controlled entity.

The ATO confirmed that there are no provisions which allow the small business 50% reduction amounts to be passed through tax-free to other entities. However, the 15 year exemption allows the exempt amount to pass through to the concession stakeholders. If this were to be extended to the small business 50% reduction amounts, it would represent a basic change in dividend and trust distribution policy. This would be a matter for the Government.

The professional bodies asked for the policy rationale for not requiring cost base reductions for payments representing the CGT discount by trustees to unitholders and others with trust interests, but requiring them for similar payments representing the small business 50% reduction.

The ATO stated that the CGT discount was introduced to reward patient investment and that the Government had decided to provide that concession whether the taxpayer invests directly or indirectly. The small business concessions on the other hand are intended to allow the operator to re-invest the proceeds of sale back into the business or to provide for retirement. Allowing the proceeds to pass out tax-free outside of retirement would be inconsistent with this policy.

The professional bodies noted that in many cases a small business operator would carry on a business through a trust and the business will be disposed of entirely. The small business operator would then take on another different business. The provisions should, the professional bodies submitted, provide a 'look-through' mechanism to determine what the proceeds are to be used for. The ATO noted these observations.

1.5 CGT discount

Number & Sponsor

Issue

Outcome

5.1 NIA

Call options and the 12 month rule for CGT discount

The NIA raised the following issue:

A question was put at the CGT Subcommittee meeting in June 2000 regarding whether section 115-40 applies to put options so that, if the option was granted within 12 months of acquisition, the taxpayer would not be entitled to the CGT discount. The answer indicated that the section would apply to options but the answer was not clear whether it was referring only to put options or all options. Could the ATO clarify that the section would not apply to call options where the option gives the purchaser the right to require the vendor to sell the asset? It appears that call options should not be affected by section 115-40 as the ability to require the sale of the property is with the purchaser not the vendor.

The ATO are also requested to refer to the recent draft ruling TR 2001/D12 in which a distinction was made between put and call options in the context of whether they constitute a contingent entitlement to acquire a CFC or FIF. In the context of that draft ruling the issue was whether the 'purchaser' has a contingent right to purchase the interests in the CFC or FIF and the draft ruling determined that a call option would generally result in a contingent entitlement to acquire and that generally a put option would not. This draft ruling is looking at the position from the purchaser's position. However, when applying the rationale in that draft ruling to the context of section 115-40 the treatment has to be turned around because the relevant taxpayer in section 115-40 is the 'vendor'.

As the call option does not give the vendor the ability to require the purchaser to purchase the asset the vendor has no control over whether the sale will or will not go ahead and therefore does not give the vendor any ability to manipulate their entitlement to the CGT discount.

The ATO stated that section 115-40 is intended to apply in circumstances where put or call options have been used. Section 115-40 is an essential integrity provision intended to have effect beyond legally binding contracts. Legally binding contracts would already give effect to a disposal under the normal timing rules.

The availability of the CGT discount is limited to where there is essentially unfettered ownership of the asset for at least 12 months. The CGT discount should only be accessible where the taxpayer is exposed to both 'up-side' and 'down-side' risks during the period of ownership. The 12-month minimum period is relatively generous; for example, in the United States the required period is 18 months before the taxpayer is eligible for the capped individual CGT rate.

Draft Taxation Ruling TR 2001/D12 applies in a different context - the focus of the draft ruling is on whether or not the seller has an absolute entitlement to acquire the asset (see paragraphs 22 to 29 of the draft ruling). The draft ruling also focuses on the entity that holds the asset to which the CGT event happens.

The ATO also indicated that in relation to converting preference shares, conversion may be merely a feature of the asset acquired (a share) and not involve 'a CGT event occurring under an agreement' in terms of section 115-40.

1.6 Treatment of payment received for termination of lease

Number & Sponsor

Issue

Outcome

6.1 TIA

Does CGT event C2 or H2 apply to a capital payment received for the termination of a lease?

The TIA raised the following issue:

A lessor receives a payment from a lessee for termination of a lease. Assume the payment is not income under ordinary concepts, but is to be dealt with under the CGT regime. Does this gain qualify for the CGT discount?

If the lessor is an individual or trust (and has held the lease for at least 12 months), the resulting gain would be eligible for the CGT discount if it arises under CGT event C2 (but not if it arises under CGT event H2): subsection 115-25(3).

The distinction between assessment under C2 or H2 will often have been largely academic in the past. However, the distinction has become more than academic with the introduction of the discount gains regime.

The ATO said it had already stated its view on the matter in Taxation Ruling TR 1999/18 (see in particular paragraph 14, and paragraphs 51 to 54). Such a receipt of a lessor is assessable under CGT event H2 (about receipts for events relating to CGT assets) in section 104-155 of the 1997 Act. This is because the surrender of a lease is an act, transaction or event that occurs in relation to a CGT asset that the lessor owns. The relevant CGT asset is the land of the lessor. The lessor's reversionary interest in the land changes to an unencumbered freehold. In property law, the benefits of ownership of land accrue to the owner because of that ownership.

The professional bodies queried the position taken in the ruling, noting that Kennedy's case was relied on for the proposition advanced, but that case was not directly on point because it involved a payment by the lessor to the lessee. Here, there was a payment by the lessee to the lessor, and its true character was arguably to have the lessor relinquish its rights under the lease, and at the same time the freehold would become unencumbered. The consensus of the bodies was that their concerns, being in relation to an issued ruling, should be brought to the attention of the ATO's Rulings Unit. The ATO agreed to do this.

Action item: The concerns raised are to be drawn to the attention of the ATO's Taxation Rulings Unit.

1.7 Scrip for scrip rollover

Number & Sponsor

Issue

Outcome

7.1 NIA

CGT discount and scrip for scrip exchanges: pre-CGT shares

The NIA raised the following issue:

If an individual or trust taxpayer has post-CGT shares, they can use the scrip for scrip rollover and then if within 12 months they dispose of the new shares they can obtain the CGT discount on the disposal (provided it is within 12 months of the purchase of the original shares). However, if the same taxpayer had pre-CGT shares, the scrip for scrip rules do not apply (there is no tax on the disposal), but in this case the disposal of the new shares within 12 months of the scrip for scrip exchange will not be eligible for the CGT discount. Does the ATO recognise the inequity in this situation and is there any likelihood that there will be amendments to rectify the situation?

The ATO stated that the treatment of pre-CGT shares in a scrip for scrip exchange reflects a deliberate policy position. The Government (consistent with a Ralph Report recommendation) decided that the scrip for scrip rollover should not preserve pre-CGT status. The rationale for the rollover arose from the cash-flow difficulties of meeting a tax liability at the time of a takeover and this is not an issue in relation to pre-CGT assets. The Government also decided that the post-CGT replacement shares for pre-CGT original shares should have a market value cost base.

The policy underpinning the CGT discount requires the owner to hold the asset for at least 12 months with any potential for an increase in value of the asset being subject to the CGT rules. Comparable treatment arises with inherited assets (subsection 115-30(1), table items 3 to 6). If a pre-CGT asset of the deceased passes to a beneficiary, the CGT discount clock is reset at death.

The professional bodies asked whether the market value cost base given to the post-CGT shares that replaced the pre-CGT original shares was central to the resetting of the CGT discount clock. Was this in acknowledgment of the fact that it is important not to confer a 'double taxation benefit' of having a market value cost base, but having the CGT discount clock begin from acquisition of the pre-CGT original shares? The ATO confirmed that this was important to the policy thinking.

The professional bodies suggested that a solution to concerns about this 'double benefit' could be to allow the exchanging taxpayer to choose to apply either market value cost base or the cost base of the pre-CGT original shares. Only if they chose a market value cost base should they not be entitled to take into account the pre-CGT period of ownership for qualifying for the CGT discount. The ATO noted these observations.

7.2 NIA

Scrip for scrip on unit trust interests and requirement for unitholders to have an indefeasible interest in the income and capital of the trust.

The NIA raised the following issue:

The scrip for scrip roll-over for units in a unit trust require the unit holders have a vested and indefeasible interest to a share of all the income and capital of the trust (see paragraph 124-781(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997), the definition of fixed entitlement in section 995-1 of the 1997 Act and section 272-5 of Schedule 2F of the 1936 Act).

However, if the unit holders have the right to amend the deed or the trustee has a right of indemnity from the income or capital of the trust, it may be arguable that the unit holders do not have an indefeasible interest in the income and capital of the trust. If this was the correct interpretation most unit trusts would not be entitled to use the scrip for scrip roll-over. What is the ATO's reaction to this?

ATO Response

Paragraph 124-781(1)(b) of the ITAA 1997 provides that one of the conditions for scrip for scrip roll-over on the exchange of a unit or an interest in a trust is that entities have fixed entitlements to all of the income and capital of the original entity and the acquiring entity.

The meaning of fixed entitlement is determined by reference to 272-5 of Schedule 2F to the Income Tax Assessment Act 1936. This section provides that where a beneficiary has a vested and indefeasible interest in a share of the income or capital of a trust that they will be considered to have a fixed entitlement.

The words 'vested' and 'indefeasible' are to be given their ordinary trust law meaning ( see for example FC of T v. Harmer & Ors 90 ATC 4672 (1990) 24 FCR 237; Dwight v. Federal Commissioner of Taxation (1992) 37 FCR 178; (1992) 107 ALR 407; 92 ATC 4192; 23 ATR 236; and Walsh Bay Developments Pty Ltd & Anor v. FC of T 95 ATC 4378.

Whether particular entities have vested and indefeasible interests for the purposes of section 272-5 can only be determined on a case by case basis, after having regard to all of the terms and conditions of the relevant trust instrument. Consequently, it is not possible to provide a final answer to the question raised. However, clearly the existence of a clause of the trust deed giving unit holders the right to amend either the trust deed of the original entity and/or the trust deed of the acquiring entity is an important factor in determining this question.

This will also be the case where a trustee has power to amend the trust deed.

Additionally, where such power to amend the trust deed exists, the issue of whether the exercise of such power would result in a resettlement of the relevant trust may also require consideration.

Where a trustee of a unit trust incurs a liability in pursuance of carrying out the duties under the trust, and is not in breach of trust, a trustee will generally be entitled to be indemnified against those liabilities from the trust assets. In effect, the trustee in such a situation has a charge or lien over those assets (see Vacuum Oil Company Proprietary Limited v. Wiltshire (1945) 72 CLR 319; and Octavo Investments Proprietary Limited v. Knight & Anor (1979) CLR 319). In such a situation, the right of the trustee to be indemnified, of itself, will not mean that the unitholders do not have fixed entitlements to the income and capital of the trust (Dwight v. F C of T).

7.3 LCA

What does 'original interest holder' mean in the context of a scrip for scrip rollover?

The LCA raised the following issue:

The definition of original interest holder is in section 124-780. This provides that 'there is a roll-over if...an entity (the original interest holder) exchanges ...a share (the entity's original interest) in a company (the original entity) for a share (the holder's replacement interest) in another company'.

Officers of the ATO have suggested that an entity may be an original interest holder whether or not it exchanges an original interest for a replacement interest. This is not tenable in the light of the definition.

Under the definition, an entity is not an original interest holder unless it exchanges a share for another share. If it does not exchange a share, it is not an original interest holder - it is merely an entity. It is only if it fulfils the conditions of the paragraph that it becomes the original interest holder to which the paragraph refers.

A consequence of the ATO's interpretation of the definition of original interest holder would be that if the acquiring entity holds even one share out of a million in the original entity, all other shareholders are deemed to be common stakeholder, and, subject to section 124-782 (unless there are 300 or more members), the 80% test becomes irrelevant. Was this the intent of the provisions?

The ATO stated that the purpose and effect of the provisions are to refer to all holders of interests in the original entity at the commencement of the arrangement irrespective of whether they in fact exchange any interests under the arrangement. This is not a definition as such but rather a drafting technique (a 'tag') used to identify which entity is being referred to. The 'tag' needs to be read in context. The neighbouring provisions of subsections 124-783(2) and (4) clearly contemplate an original interest holder not being an entity that is in fact exchanging interests.

1.8 Taxation of assets of deceased non-resident

Number & Sponsor

Issue

Outcome

8.1 NIA

Possibility for double taxation where a non-resident leaves an asset without the necessary connection to Australia to a resident beneficiary or legal personal representative.

The NIA raised the following issue:

A resident taxpayer holds a post-CGT asset without the necessary connection with Australia and the taxpayer ceases to be a resident, and under section 104-160 CGT Event I1 occurs at the time residency ceased (the taxpayer does not elect for section 104-165 to apply). The taxable capital gain is the notional capital gain on the post CGT shares. If the taxpayer then dies, the shares are deemed to be acquired by the legal personal representative or the beneficiary for a cost equal to the cost base of the deceased as per section 128-15. When the legal personal representative or beneficiary sells the asset they will be taxed again on the same gain that was taxed to the deceased.

For example, if the deceased bought the asset for $1 and the market value at the time residency ceased was $5, then they would pay tax on $4. However, when the asset devolved to the legal personal representative (LPR) or beneficiary on death of the taxpayer, they acquire the asset with a cost base of $1. Accordingly, if the LPR or beneficiary sells the shares for $10, the estate or beneficiary will be taxed on $9. Accordingly, there is double taxation on the $4 that has already been taxed to the deceased on ceasing residency. Can the ATO give any commitment to recommend technical amendments to rectify this double taxation?

The ATO agreed with the analysis presented. There was no provision to cause a restatement in the cost base and reduced cost base to market value. This would occur if the taxpayer again became a resident, but not if the taxpayer died and the asset passed to a resident legal personal representative or beneficiary. The ATO noted that double losses, as well as double gains, could be the result of the operation of the law. The ATO also observed that as a practical matter, these outcomes could be avoided if the choice were made under section 104-165 not to have a taxing point when the individual ceased to be a resident.

1.9 Expenditure reflected in the state or nature of an asset

Number & Sponsor

Issue

Outcome

9.1 TIA & ICAA

Comments about TD 2001/D11

The TIA and the ICAA both raised for discussion draft Taxation Determination TD 2001/D11.

The ATO said that draft Taxation Determination TD 2001/D11 had been issued at the request of the subcommittee on a matter where the ATO has had a long-standing practice. The draft determination dealt with the general question as to whether the 'value' of an asset was part of its nature for the purposes of the fourth element of cost base of an asset. It also dealt with, by way of example, a contribution of capital to a company without an issue of shares in exchange. The ATO said its preliminary, but considered, view was that such a capital contribution was illustrative of the general proposition advanced in the draft determination. The ATO also indicated that, in respect of the general question posed, it had formed a preliminary, but considered, view that 'value' was not part of the state or nature of the asset as a matter of statutory construction. Views expressed in the Court of Sessions in Aberdeen Construction Group Ltd v. Commissioners of Inland Revenue (1978) 52 TC 281 (the Aberdeen Construction case) were considered to be supportive of that interpretation.

Lengthy discussion then ensued. The professional bodies questioned the extent to which reliance was placed in the draft determination on the Aberdeen Construction case. That case dealt with a matter far removed from an additional capital contribution by a shareholder. The bodies said that, even on its facts, the case does not support the approach taken in the determination because the United Kingdom provisions on which it was decided is materially different from the provision in the Australian context. In any event, they asserted that it should not be relied on because the comments in the Court of Session were merely judicial dicta and the case was appealed to, and ultimately resolved in, the House of Lords on another point.

The professional bodies thought that the heading to the determination should be changed to deal with a much tighter fact situation - the example in the draft TD reflects the real issue but the heading does not. Also the draft is relatively silent on whether there was a practical problem with this approach given the changes to the Corporations Law in recent years (ie, allowing shareholders to contribute further capital without the additional issue of scrip, as had been the case in the United States for some time). The professional bodies asserted that ,without such a statement, the determination would not have the necessary context.

On the value point, the professional bodies said that accounting standards support the view that the ATO's approach to 'state or nature' is incorrect. The accounting standards talk about the reflection of the economic value of the asset. There is a difference between the fluctuation in price for a listed share and the increase in the value of a share due to the injection of additional funds. It is within the nature of a share that that share can be buttressed by further contributions. There is support for the position that an increase in value can affect the state of an asset. The professional bodies said anomalies arise where a company in financial difficulties receives an injection of capital which is used to trade out of its difficulties. Once the company is viable again, and it decides to return the capital, there would be CGT consequences (either a cost base reduction or a capital gain arising) where the original injection of capital was not taken into account in the cost base of the shares.

The professional bodies said that the ATO has a responsibility to advise the Government as to the implications of the draft determination, especially the fact that the taxation law is now inconsistent with its corporations legislation. The bodies argued in particular that if the view taken in the draft determination were finalised, it would have very serious implications for offshore investment, particularly for United States entities, whether by Australian residents directly or via subsidiaries. The effect of the ATO's view was likely to have a major impact in respect of the CFC provisions.

Mr Spence (TIA) circulated a set of draft comments and indicated that a final version would be forthcoming.

The professional bodies asked that the draft TD be referred to the Public Rulings Panel for their consideration. This was agreed to.

1.10 Continuity of ownership test for pre-CGT business assets

Number & Sponsor

Issue

Outcome

10.1 ICAA

Continuity of ownership test and growth of family

The ICAA raised the following issue:

In applying IT 2340, what is meant by 'one family' and by 'a new family'? What changes to the composition of the family (for example, births, deaths, marriages, divorces, and adoptions) affect this issue? What factors does the Commissioner take into account so that he or she can be satisfied or think it reasonable to assume that the majority underlying interests test has been met?

The ATO stated that the issues like these arise occasionally, but the propositions in Taxation Ruling IT 2340 seem to be generally accepted. Thus, no comprehensive administrative policy has been developed on these issues. What constitutes a member of a particular 'family' will require consideration of the facts of particular cases. The ATO considers that what is contemplated is narrower that a 'relative' (eg. a distant relative would not normally be thought to qualify), but equally , the concept of 'family' is not intended to be limited to the 'nuclear' family (ie, father, mother and children). What is often described as an 'extended' family (ie, including grandparents, children, grandchildren and their spouses) would ordinarily qualify as a 'family' for these purposes. Also, if distributions are made to post-19 September 1985 additions to a family (for example, the birth of new family members and new persons joining a family through marriage), the 'family' distribution criteria would ordinarily still be satisfied.

10.2 ICAA

Compliance requirements for the continuity of ownership test

The ICAA asked:

Are there any guidelines or instructions as to the ATO expectations of the documentation taxpayers should hold to show majority underlying interests have been maintained under Division 149?

The ATO stated that there are no published guidelines. The onus is on taxpayers to demonstrate that majority underlying interests have been maintained, and entities should keep records sufficient to satisfy that requirement.

10.3 ICAA

Distributions to charities and application of the continuity of ownership test

The ICAA asked:

If a family trust makes significant distributions to charities such that the ability to point to greater than 50% continuity was prima facie impaired, would the ATO exclude the charitable distributions from the majority underlying interest test determination?

The ATO said that, again, although the issue has arisen on occasions, it has not arisen sufficiently frequently to have required development of a detailed administrative policy. Private rulings should be sought in cases where the issue is likely to affect the outcomes under Division 149. In practice, the answer might depend on whether the charity can be an ultimate owner. Regard would need to be had to its constituent documents. If the charity is not an ultimate owner, section 149-15 appears to support the view that it should be disregarded in the tracing process.

1.11 CGT asset register

Number & Sponsor

Issue

Outcome

11.1 ICAA

What are the requirements for the keeping of records in relation to the CGT asset register?

The TIA raised the following issue:

A requirement of keeping a CGT assets register is that the source document from which the information has been transferred must be retained for five years after the entry to the register is certified. How can a taxpayer prove that a document had been retained for five years if it is destroyed after the five year period has elapsed?

The ATO stated that the requirement to keep documentation for five years after entry to the register is directed to ensuring that the taxpayer is able to produce the records on request within five years of making the entry. After the five year period for the retention of records ends, the taxpayer does not need to prove that the records were kept for that five year period.

[H15]Conclusion

Mr Burge (ATO) thanked everyone for their hard work in preparing for the meeting, and for their participation.

Mr Spence (TIA) on behalf of the professional bodies expressed their appreciation for the work put into the answers to the submitted agenda items and commended the subcommittee as being a worthwhile forum.

The next meeting of the subcommittee will be held on Wednesday, 12 June 2002 in Sydney.

Attachment A: Agenda item 4.2

[H17]Examples on the issue of what is 'in connection with the individual's retirement' for the CGT small business 15 year exemption

The following example is indicative of where there would be a 'retirement' for the 15 year exemption:

1. A small business operator, aged 55 or more, sells their business and under the terms of sale agrees to be employed by the new owner for a few hours each week for two years. The sale of the business would be in connection with the small business operator's retirement. The operator has permanently or indefinitely ceased their activity of being self employed and has commenced gainful employment on a much reduced scale with another party, although still performing similar activities.

On the other hand, the following example is indicative of where a CGT event wouldnot be 'in connection with retirement':

2. A small business operator and spouse are both pharmacists, both over 55 and carry on business through two pharmacies. They sell one (and make a capital gain) and accordingly reduce their working hours from 60 hours per week each to 45 and 35 hours per week respectively. It is true that there has been some change to their present activities in terms of hours worked and location. However, there has not been a significant reduction in the number of hours or a significant change in the nature of their activities and therefore on this basis there has been no 'retirement'.

If, on the other hand, one spouse reduces their hours to nil and stops working there would be a significant reduction in the number of hours (ie, to nil) that that spouse was engaged in the business activities. The sale would be in connection with the retirement of that spouse.

The words 'in connection with' in the phrase 'in connection with retirement' can apply even if the CGT event occurs at some time before retirement. These cases all the more turn on their own particular facts but could include the following type of example:

3. A small business operator, aged 55 or more, sells some business assets as part of a wind down in business activity ahead of selling the business. Within a short period (say, six months) they sell the business and end their present activities. If it can be shown that the earlier CGT event was integral to a plan to cease their activities and retire, the CGT event may be accepted as happening in connection with retirement.

Similarly, the words 'in connection with' can also apply where the CGT event occurs sometime after the act of retirement. It is considered that the word 'retirement' may refer to both the act of retirement and the continuing state of retirement. Again, this type of case would turn on its own particular facts and would need to be considered on a case by case basis but could include the following type of example:

4. A small business operator 'retires' and the children take over the running of the business. Soon afterwards (say, within six months), some business assets are sold and a capital gain is made. There may be several reasons that prompted the sale of the assets. If there is no relevant connection with the small business operator's business, the small business concessions would not be available. If it can be shown that the reason for disposal of the equipment is connected to retirement and the later sale is integral to the small business operator's retirement plan, the sale may be accepted as happening in connection with retirement.


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