Edited version of your private ruling

Authorisation Number: 1012450070252

Ruling

Subject: CGT - Proposed disposal of a portion of a partnership interest to related party

Question 1

Under the proposed restructure, will section 116-30 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to change the taxable value on disposal of part of your partnership interest to a related party?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commences on:

The date of issue of this private ruling.

Relevant facts and circumstances

· You are an 'equity partner' in the Partnership and are proposing to dispose of 70% of your partnership interest to a related trust (the Trust) for asset protection purposes.

· You will be the Trustee of the Trust.

· Potential beneficiaries of the Trust would be your associated individuals and entities.

· The Partnership Agreement states:

'A partner shall be admitted as an equity partner upon the payment to the existing equity partners of the first amount calculated by reference to [y] hereof.'

· The Partnership Agreement states:

'Each Equity Partner, including a new Equity Partner, shall be entitled to receive a share of the Partnership capital and partnership property and will share in any partnership loss in proportion to their allocated percentage share.'

· The Partnership Agreement states:

An Equity Partner who is allocated Shares or additional Shares shall in compliance with paragraph [x] pay an amount for the Share being acquired by that person, calculated as the proportional share of the net asset backing of the Partnership in each preceding year including:-

§ debtors and client outlays;

§ work-in-progress at net realisable value;

§ plant and equipment;

§ deposits, prepayments etc;

§ any other assets used in the business;

§ all bank liabilities;

§ all current creditors; and

§ goodwill (if any) recognised in the balance sheet;

but excluding:-

§ artwork if this is not recognised in the balance sheet.

A Partner whose share is reduced shall be paid by the other Partners an amount calculated by reference to paragraph [y]

· No value for goodwill is recognised in the balance sheet of the Partnership.

· The partners consider the Partnership to be a 'no goodwill' practice.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 116-20

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

Income Tax Assessment Act 1997 section 116-30

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

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 995-1

Question 1

Summary

As you and the Trust would not be dealing with each other at arm's length in connection with the proposed transaction, and the concessional treatment in Taxation Ruling IT 2540 does not apply, the market value of the CGT asset sold (including an amount for goodwill) would be substituted for the capital proceeds amount received.

Detailed reasoning

Under the general rules provided in section 116-20 of the Income Tax Assessment Act 1997 (ITAA 1997), 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 (subsection 116-20(1) of the ITAA 1997).

Subsection 116-30(2) of the ITAA 1997, however, modifies the general rules replacing the capital proceeds with the market value of the 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).

In Taxation Determination TD 1999/84 the Commissioner considers situations where capital proceeds cannot be valued, and explains that it is not sufficient that a valuation is merely difficult, costly or inconvenient - if it is at all possible to value the capital proceeds, the valuation should be done.

CGT assets

Section 108-5 of the ITAA 1997 states that a CGT asset is:

§ any kind of property, or

§ a legal or equitable right that is not property.

The section specifically recognises that an interest in an asset of a partnership, and any other interests in a partnership are CGT assets.

Taxation Ruling TR 1999/16 discusses goodwill of a business and explains that for the purposes of section 108-5 (ITAA 1997), goodwill takes the legal definition as explained by the High Court in FC of T v. Murry 98 ATC 4585; (1998) 39 ATR 129 rather than its accounting and business definitions (paragraph 9). The ruling explains that:

'… goodwill is the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it… It is an indivisible item of property that is legally distinct from the sources from which it emanates. It is something that attaches to a business and is inseparable from the conduct of a business. It cannot be dealt with separately from the business with which it is associated' (TR 1999/16 paragraph 12).

Goodwill exists in connection with the conduct of a business, even though it may not necessarily appear in the financial statements of the business (TR 1999/16 paragraph 15).

As such, where a business is being carried on in partnership, the goodwill is intangible property of the business. The partners' interests in the partnership assets include an interest in the business goodwill equal to their interest in the partnership, whether or not the goodwill is recognised on the financial statements of the business.

Dealing at arm's length

Section 995-1 of the ITAA 1997 provides that in determining whether parties deal at arm's length, any connection between them and any other relevant circumstance must be considered'.

The Butterworths Concise Australian Legal Dictionary, 2004, 3^rd edn, LexisNexis, NSW defines an 'arms length transaction' as:

'a transaction in which the parties act severally and independently in forming the bargain and in which neither of the parties has the ability to exert personal influence or control over the other.'

Whether or not parties are dealing with each other at arm's length has been used in various legislative contexts and considered in many courts. The authorities established the following principles (Healey v Commissioner of Taxation 2012 ATC 20-309; [2012] FCA269, at 95):

§ Whether or not parties are dealing with each other at arm's length is a question of fact that must be determined in any particular case: Trustee for the Estate of the late AW Furse No 5 Will Trust v Cmr of Taxation (1990) 91 ATC 4007 (Furse), (at 4017); Granby Pty Ltd v FCT (1995) 129 ALR 503 (Granby), (at 507); Commissioner of Taxation v AXA Asia Pacific Holdings Ltd (2010) 189 FCR 204 (AXA Pacific Holdings Ltd), (at [106]).

§ 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 (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 Cmr of Taxation (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015).

§ 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).

§ 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 do, so that the outcome is a matter of real bargaining: Furse (at 4015); Granby (at 506 and 507); AXA Pacific Holdings Ltd (at [105]).

§ It is relevant to consider the nature of any relationship between the parties: Furse (at 4015); Granby (at 506).

§ 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]).

If more than one item of property is transferred as part of one transaction and one of the parties is indifferent to the apportionment of consideration between the various items of property, the parties are considered not to be dealing with each other at arm's length because the acceding party has submitted the exercise of its will to the wishes of the other party (Collis v. FC of T 96 ATC 4831; (1996) 33 ATR 438).

Taxation Ruling IT 2540 discusses the application of the CGT provisions to disposals of partners' interests in partnerships, and states that in certain circumstances the Commissioner will accept that partners are dealing with each other at arm's length provided the evidence reasonable supports that conclusion. Paragraphs 12-13 of IT 2540 state:

12. In cases where the number of partners in a partnership is small, the cost base and acquisition date of a relevant partner's interests in the partnership assets should be able to be determined without undue difficulty.

13. For large partnerships, which can have memberships numbering in the hundreds (for example, some major legal and accountancy partnerships) the situation is potentially more complex. In some cases, the potential problems are overcome because the ownership of the assets used by the partnership is vested in a service company or trust. In other cases, it will generally be accepted, provided the evidence reasonably supports the conclusion, that the partners are dealing with each other at arm's length… This treatment will also apply to partners of smaller partnerships who deal with each other at arm's length, where those dealings take place in an ordinary commercial context.

Taxation Determination 2011/26 (paragraph 17) clarifies when the treatment in IT 2540 applies and states:

17. IT 2540 was released in 1989 at a time when some professions were restricted by rules imposed by State legislation and their State regulatory bodies to practise either as a sole trader or a partnership of natural persons. As such, the approach provided in IT 2540 only applied to acquisitions and disposals of partnership interest by natural person practitioners. This aspect of IT 2540 is also limited to dealings that occur during the normal 'ebb and flow' of natural person partners into and out of a partnership and does not apply to restructures …

Under the proposed arrangement, the money you are entitled to receive in respect of the disposal of your partnership interest is established in clauses [y] and [z] of the Partnership Agreement. As no goodwill is recognised on the balance sheet of the Partnership, the payment received on disposal would not include an amount for goodwill. However, for the purposes of the CGT provisions, goodwill is a CGT asset. It can be bought and sold and has value whether or not that value appears in the financial statements of the business.

As the payment you would receive in respects of the disposal would not include an amount for part of the CGT assets being sold, it would not reflect the full market value of the asset - the capital proceeds (under the general rules) would be less than the market value of the CGT asset. Consideration must be had to whether or not the proposed transaction would be at arm's length.

As discussed in IT 2540 and TD 2011/26, the Commissioner will accept disposal transactions between natural person partners are 'at arm's length'. However, as the proposed disposal is:

· between you and a non-individual entity,

· is a restructure of your interests to achieve your asset protection objectives, and

· is not a disposal in the normal commercial ebb and flow of partners into and out of the partnership,

the concession in IT 2540 does not apply. The proposed arrangement does not show:

§ evidence that you and the Trust are acting separately and independently in the dealing,

§ evidence of real bargaining of the terms of the dealing, or

§ 'independent purpose' of the Trust in entering into the proposed arrangement.

Conclusion

You and the Trust would not be dealing with each other at arm's length in connection with the proposed transaction and the concessional treatment in IT 2540 would not apply.

Therefore, subsection 116-30(2) of the ITAA 1997 would apply to the proposed transaction, and the market value of the CGT asset sold (including an amount for goodwill) would be substituted for the capital proceeds amount received.

Further issues for you to consider

In Supreme Court of Western Australia in Reynolds v. Commissioner of State Taxation (WA) 86 ATC 4528, 17 ATR 987 Burt, CJ provides an acceptable method for valuation of the goodwill of a business.