Edited version of your private ruling

Authorisation Number: 1012454414672

Ruling

Subject: Income Tax: Capital Gains Tax: Earnout Arrangements

Question 1

Will the CGT cost base of X Pty Ltd's shares in Y Pty Ltd include the market value of the farm land as at the date of X Pty Ltd's acquisition of the shares in Y Pty Ltd pursuant to paragraph 110-25(2)(b) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the CGT cost base of X Pty Ltd's shares in Z Pty Ltd include the market value of the farm land as at the date of X Pty Ltd's acquisition of the shares in Z Pty Ltd pursuant to paragraph 110-25(2)(b) of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods

Financial year ended 30 June 20XX

Financial year ended 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A Pty Ltd entered a Settlement Deed for it or its nominee to acquire shares in various companies, including Y Pty Ltd, from several parties ('the vendors').

X Pty Ltd was appointed nominee by A Pty Ltd to undertake this transaction. Completion of this contract would have resulted in X Pty Ltd acquiring and holding a certain percentage of the shares in Y Pty Ltd.

In negotiating the purchase price for the shares in Y Pty Ltd, the purchaser and vendors could not agree on the value of land owned by one of Y Pty Ltd's subsidiaries. Given the inability to agree this value, the parties agreed the purchase price for the shares in Y Pty Ltd to be the total of the cash component and the land component, as set out in the Settlement Deed.

The Settlement Deed provided for the purchaser to procure the sale of the land to a third party on arms length commercial terms as soon as practicable, taking into account any issues in relation to the suitability for sale, with each vendor and the purchaser having a right of first and last refusal to purchase this land on the same terms as offered by the third party.

In broad terms, net proceeds is the total proceeds after deducting tax and all actual costs incurred in relation to the land from the date of the deed.

If the land is not sold by the 15th anniversary of completion under the Settlement Deed, X Pty Ltd is required to obtain an independent valuation of the land at that time and put the property to the market at a 15% discount to this value, in order to ensure realisation of this asset.

Prior to completion date a dispute arose between the parties and the vendors sought court approval to rescind the Settlement Deed.

As a result of the dispute with the vendors, X Pty Ltd entered into separate negotiations with one of the vendors to acquire their interests in the target companies, including Y Pty Ltd.

These negotiations led to X Pty Ltd into a Sale and Purchase Agreement with the vendor to acquire 100% of the shares in Z Pty Ltd, which held vendors shares in Y Pty Ltd and other target companies..

The Sale and Purchase Agreement comprised a cash component plus any amount payable from the sale of land.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 109-5

Income Tax Assessment Act 1997 subsection 109-5(1)

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 section 110-55

Income Tax Assessment Act 1997 subsection 110-55(2)

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Summary

The cost base of X Pty Ltd's shares in Y Pty Ltd include the market value of the land pursuant to the Settlement Deed as at the date of agreement under paragraph 110-25(2)(b) of the ITAA 1997.

Similarly, the cost base of X Pty Ltd shares in Z Pty Ltd giving the indirect shareholding in Y Pty Ltd include the market value of the land, pursuant to the Sale and Purchase Agreement as at the date of agreement under paragraph 110-25(2)(b) of the ITAA 1997.

Detailed Reasoning

Date of acquisition

Division 109 of the ITAA 1997 sets out when you are taken to have acquired an asset for CGT purposes. In general, you acquire a CGT asset when you become its owner or when the disposal contract is entered into for the disposal of the asset; subsection 109-5(1) of the ITAA 1997.

Cost base

Under the general cost base and reduced cost base rules, the first element of the cost base and reduced cost base of an asset is the sum of the amount paid (or required to be paid) and the market value of property given (or required to be given) in respect of acquiring it under subsections 110-25(2) and 110-55(2) of the ITAA 1997.

Further paragraph 83 of the Taxation Ruling TR 2008/5 (TR 2008/5) states that:

83. When a cost of a CGT asset includes giving property, as it does in the second, third, fourth and fifth elements of cost base, for CGT purposes the market value of the property given is to be used in working out the amount of the payment, cost or expenditure constituted by giving the property (section 103-5). So costs under the second and third elements of cost base, and expenditure under the fourth and fifth elements, are the market value of the property given for those purposes, and if the property given is shares in the giver that means the market value of the shares. The market value rule is explicit in the first element of cost base, without reference to section 103-5. Where current accounting standards apply, the CGT asset acquired is likely to be shown in the accounts at its fair market value rather than according to the value of the shares issued for it. This does not alter the cost of the CGT asset, which remains the market value of the share, not the market value of the asset, should those market values differ.

In this case X Pty Ltd and the vendors agreed that the purchase price for the shares in Y Pty Ltd to be the total of the cash component and the market value of the land.

As a result of a dispute which arose between the parties before the completion date of the Settlement deed, X Pty Ltd signed a Sale Purchase agreement with one of the vendors to acquire 100% of the shares in Z Pty Ltd.

The purchase price as per the Sale and Purchase Agreement comprised a cash component plus any amount payable from the sale of land..

Accordingly, X Pty Ltd gave property to the vendors, being the right to the market value of the property will be included in the cost base of the X Pty Ltd's shares in Y Pty Ltd as at the date of Settlement Deed with Y Pty Ltd's shares giving the indirect shareholding in Z Pty Ltd as at the date of the Sale Purchase Agreement.

Earnout arrangement

Earnout right is a right to an amount calculated by reference to earnings generated by the asset for a defined period following the sale. It is to be distinguished from a right to a sum in respect of that sale which is certain as to the amount.

Draft Taxation Ruling TR 2007/D10 (TR 2007/D10) rule on the tax treatment of 'earn out arrangement' where on the sale of the business/asset some part of the agreed price is contingent on future economic performance that includes the creation of an earn out right. The earn out rights are assets for capital gains tax purposes acquired by the seller and the cost base of the rights is their market value.

The tax treatment in relation to the buyer under an earnout arrangement is explained at paragraphs 24 to 26 of the draft ruling TR 2007/D10 as follows:  

24. The creation of an earnout right in the seller under a contract of sale is the giving of property by the buyer for the purposes of the cost base rules in the CGT provisions. Accordingly, under subsection 110-25(2), when a buyer acquires a CGT asset in exchange for the granting of an earnout right, the first element of the buyer's cost base of the asset includes the market value of the right (worked out at the time of acquisition).  

25. A buyer who has created an earnout right is not required to pay 'money' for the purposes of the cost base rules. Further, any money later paid pursuant to the earnout arrangement is not paid to acquire the original asset, but is paid to discharge the buyer's obligation under the earnout arrangement. 

26. Under paragraph 104-35(5)(a), in creating the earnout right the buyer is considered to be 'borrowing money or obtaining credit' from the seller. Accordingly, CGT event D1 does not happen as a result of the creation of an earnout right in the seller.

Further, paragraphs 137 - 141 of TR 2007/D10 explain the payment of an amount in satisfaction of an earnout right has no CGT implications for the payer.

Accordingly, the cost base of X Pty Ltd's shares in Y Pty Ltd include the market value of the land pursuant to the Settlement Deed as at the date of agreement under paragraph 110-25(2)(b) of the ITAA 1997.

Similarly, the cost base of X Pty Ltd shares in Z Pty Ltd giving the indirect shareholding in Y Pty Ltd include the market value of the land, pursuant to the Sale and Purchase Agreement as at the date of agreement under paragraph 110-25(2)(b) of the ITAA 1997.