Edited version of your written advice

Authorisation Number: 1012745259803

Ruling

Subject: CGT Event A1 - disposal of a CGT asset

CGT capital proceeds modification market value substitution rule

Question 1

Is the time at which the Agreement gave rise to the disposal of the shares by Entity A (within the meaning of section 104-10(3) of the ITAA 1997), the date (Date B) on which the Agreement became valid and effective upon the satisfaction of the last condition precedent of the Agreement?

Answer

Yes

Question 2

Will the market value substitution rule in section 116-30(2) of the ITAA 1997 apply to replace the Purchase Price for the transfer of the Shares set out in the Agreement with its market value as at Date B in determining the capital proceeds used for calculating the CGT consequences of the disposal of the Shares by Entity A?

Answer

Yes

This ruling applies for the following periods:

A particular income year

The scheme commences on:

A particular income year

Relevant facts and circumstances

The description of the scheme is based on information provided by Entity A in the following documents, which are to be read in conjunction with the facts as set out below:

• Entity A's application for a private binding ruling;

• Agreement of Entity S;

• Supplementary Agreement to the Agreement of Entity S (the Supplementary Agreement I);

• Supplementary Agreement II to the Agreement of Entity S (the Supplementary Agreement II);

• Approval documentation from the a foreign jurisdiction regulator with respect to the transaction;

• Approval letter from an Australian regulator in regard to the transaction; and,

• An independent market valuation report which provides the market valuation of Entity A's shareholding in Entity S (the Entity S shares) as at Date B.

The Head Co

The Head Co is a foreign Head Co and the Head Co Group is a supplier of products and services in the foreign country.

The Head Co indirectly controls the following entities:

• Entity A wholly owned Australian subsidiary in the Head Co Group.

• Entity B, a foreign listed company.

•

• Entity C wholly owned subsidiary of Entity B, formed for the purpose of undertaking the transaction.

The transaction

The Head Co acquired 100% of the share capital of Entity S, a producer in Australia, through Entity A, at a particular date by way of an off-market takeover bid.

Entity A subsequently transferred 100% of its Entity B shares to Entity C on Date B.

Relevant clauses of the Agreement

On a particular date (Date A), Entity A and Entity B (the Parties) executed the Agreement documenting the parties' intention to transfer the Entity S shares and the relevant terms and conditions.

A clause of the Agreement required the Parties to complete the transaction after a certain number of days of the conditions provided for by another clause.

Another clause set out the nature of the conditions including internal review, record keeping requirements and regulatory approval.

A separate clause emphasised that this Agreement was governed by the relevant laws of the foreign jurisdiction.

Entity S shares

Entity A obtained an independent market valuation report which confirms that the market valuation of the Entity S shares as at Date B was between a particular range with the median of AUD XXX.

Key dates

On Date A, Entity A and Entity B executed the Agreement documenting the parties' intention to transfer the shares in Entity S and the related terms and conditions.

As contemplated by a clause of the Agreement, the parties executed Supplementary Agreement I on a particular date stipulating a purchase price of XXX in foreign currency.

An Australian regulator approved the transfer on a particular date.

Approval of the non-public offering scheme by a foreign regulator was satisfied on Date B.

In accordance with a clause, the parties executed Supplementary Agreement II confirming the assignment of Entity B's rights and obligations under the Agreement to Entity C.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Question 1

Is the time at which the Agreement gave rise to the disposal of the shares by Entity A (within the meaning of section 104-10(3) of the ITAA 1997), the date (Date B) on which the Agreement became valid and effective upon the satisfaction of the last condition precedent of the Agreement?

Summary

The time at which the Agreement gave rise to the disposal of the Entity S Shares by Entity A (within the meaning of section 104-10(3) of the ITAA 1997) Date B, is the date on which the Agreement became valid and effective upon the satisfaction of the last condition precedent of the Agreement.

Detailed reasoning

Section 104-10(1) states:

CGT event A1 happens if you dispose of a CGT asset.

Section 104-10(3) sets out the rules pertaining to CGT event A1, which is the disposal of a CGT asset. The time of CGT event A1 is set out at 104-10(3), which states:

The time of the event is:

(a) When you enter into the contract for the disposal.

Pursuant to subsection 104-10(1), CGT event A1 took place when Entity A disposed of the Entity S shares to Entity C.

Pursuant to subsection 104-10(3), the meaning of the phrase 'entered into' is not defined in the legislation. However, under the general law, the time when a contract is entered into is the time when the contract comes into existence. The existence of a contract occurs when a binding contract is formed upon the establishment of an agreement between parties (in the form of an offer and acceptance of that offer) where consideration passes, or will pass, from one party to another and the parties intend to be legally bound by this agreement.

It is recognised that there may be matters that affect the formation of a contract; namely, where there are conditions precedent to the formation of the contract. Paragraph 5 of Taxation Determination TD 2002/4 provides that the non-fulfilment of a condition precedent to the formation of a contract prevents a binding contract from coming into existence. This can be contrasted with a condition precedent to the obligation of a party to perform their part of the contract - a binding contract exists which creates rights capable of enforcement, though the obligation of a party to perform their part of the contract depends on fulfilment of that condition.

ATO ID 2004/668 discusses the term 'enter into' under subsection 104-10(3) in the context of a buy-sell agreement, where there was a condition precedent to the formation of the agreement. The ATO ID 2004/668 provides that the language used to describe this particular condition evidenced the parties' intentions not to be bound by the agreement from the date it was signed. Hence, no agreement was entered into for the purposes of CGT event A1 until the condition was satisfied.

For the purposes of paragraph 104-10(3)(a), a contract is taken to have been 'entered into' when the contract for the disposal of an asset has been executed and is binding on the parties to the contract. If the conditions of the contract are conditions precedent to the formation of the contract, then the parties are taken to not have 'entered into' the contract until the condition has been satisfied.

In the present case, the conditions of the Agreement are conditions precedent to the formation of the Agreement for the following reasons:

• The language of the Agreement shows the parties' intentions not to be bound by the Agreement until a particular condition is satisfied;

• The inability of the parties to waive the conditions of the Agreement; and,

• The effect that the foreign law has on the conditions stipulated in the Agreement.

The language of the Agreement indicates that the parties did not intend to be bound at the time of execution

The preference of the courts is to construe a contract as containing conditions precedent to performance, as opposed to formation. This is based on Perri v Coolangatta Investments Pty Ltd (1982) 149 CLR 537, where Mason J (although dissenting in the ultimate conclusion) stated at 552:

Generally speaking the court will tend to favour that construction which leads to the conclusion that a particular stipulation is a condition precedent to performance as against that which leads to the conclusion that the stipulation is a condition precedent to the formation or existence of a contract. In most cases it is artificial to say, in the face of the details settled upon by the parties, that there is no binding contract unless the event in question happens. Instead, it is appropriate in conformity with the mutual intention of the parties to say that there is a binding contract which makes the stipulated event a condition precedent to the duty of one party, or perhaps of both parties, to perform. For these reasons the condition will not be construed as a condition precedent to the formation of a contract unless the contract read as a whole plainly compels this conclusion. [emphasis added]

It is clear from the words of Mason J that the language of a contract is critical when determining whether a condition in the contract is intended by the parties to be a condition precedent to formation or performance of the contract.

In this case, an examination of the opening words of a clause of the Agreement indicates prima facie that the conditions precedent listed in this clause are conditions precedent to the implementation of the transfer of the Entity S shares (which would make it a condition precedent to the performance of the contract rather than the formation of the contract). A sub-clause of the Agreement specifically requires the satisfaction of all conditions listed in another clause.

There are sub-clauses in the Agreement which require the non-public offering scheme to be approved by foreign jurisdiction regulators.

In the present case this regulatory approval must be sought as Entity A (as a major subsidiary of the Head Co) transfers a stake in Entity S shares that will result in the weakening of the Head Co's shareholding status.

Hence, the only way that Entity A and Entity C could satisfy the foreign regulators was to ensure that no binding contract was on foot before the relevant approvals were sought. If Entity A and Entity C were unable to obtain the requisite foreign regulatory approvals, the sale of the Entity S shares could not have happened.

When the relevant provisions of the Agreement are considered in light of the foreign regulators orders, the logical proposition is that the Agreement, being the contract for the transfer of the Entity S shares, would not have been in existence at the time of its execution on Date A, as the requisite approvals from foreign authorities for the transfer had not yet been obtained at that time.

There is authority for the proposition that where a condition is of critical importance, it will be construed as a condition precedent to the formation of the contract, and no binding contract will exist until the critical condition has been met. In George v. Roach (1942) 67 CLR 253, a named valuer under a contract for the sale of a newsagency refused to value the business, and consequently an appropriate purchase price could not be established.

In coming to the conclusion that having the valuer value the newsagency was a condition precedent to the formation of the contract, Rich J stated (at 261):

It was the essence of the bargain that the price mentioned in clause d [that the newspaper agency shall be purchased at the value placed upon the newspaper agency by the named valuer] should be fixed in accordance with the agreement. In ascertaining the price the valuer agreed upon by the parties would be guided by the profits as he estimated them. In the circumstances the condition precedent not having been fulfilled there was "no existing contract" until the price was ascertained. [emphasis added]

Further, Starke J stated (at 263):

There is no doubt that the provision for a valuation of the newspaper agency is an essential term of the agreement. And it is equally clear that in the case of an agreement to sell at a price to be fixed by some valuer the agreement is not enforceable unless the price has been so fixed; the agreement to sell is made subject to a condition precedent that the price shall be so fixed, and unless the condition be performed the agreement is not effective…

The critical nature of obtaining foreign regulatory approval for the sale of Entity S shares supports the proposition that the conditions in the relevant clause are conditions precedent to the formation of the Agreement. Various foreign legal and administrative instruments have emphasised that without the requisite foreign regulatory approval, overseas investment activities such as the transfer of Entity S shares cannot proceed. Each of the conditions in a relevant clause of the Agreement is, as Starke J stated in George v. Roach, 'an essential term of the agreement'.

The language of the Agreement is relevant to establishing the intention of the parties. A relevant clause of the Agreement provides that the transaction itself (the transfer of the Entity S shares) will only be implemented once the Agreement becomes 'effective' upon satisfaction of all conditions in another relevant clause of the Agreement, one of which is obtaining relevant foreign regulatory approval. Also, this clause of the Agreement specifies that the Agreement only 'comes into effect' upon satisfaction of the conditions in the relevant clause of the Agreement, which evidences that the parties did not intend for the Agreement to be binding on either party until the relevant authority approvals had been obtained. Accordingly, the language of the Agreement indicates that the parties' intentions were that the conditions in the relevant clause of the Agreement were conditions precedent to the formation of the Agreement.

It is further noted that, a relevant clause of Supplementary Agreement II to the Agreement, states that both parties "agree that the Agreement came into effect on Date B." This is the date when the last of the conditions in the relevant clause of the Agreement was satisfied.

Conditions under the Agreement cannot be waived

It is likely that, if a contract can progress or be enforced without a condition being satisfied, the contract is already in existence and is valid and binding on the parties, and it will follow that the condition is a condition precedent to performance of some obligations under the contract, as opposed to the contract's formation. The condition discussed in Perri v Coolangatta, which was held to be a condition precedent to the performance of the contract, was a condition that the parties could waive.

In Scott v. Rania [1996] NZLR 527, McCarthy J (who formed part of the majority of the New Zealand Court of Appeal in that case) stated at paragraph 535 in obiter that "with a condition subsequent [meaning a condition precedent to the performance of a contract] it may be easier to find waiver or election." By inference, where the contract does not provide for, or the general law does not allow for the waiver of the condition, it is more likely to be construed as a condition precedent to formation of the contract.

In this case, there are no clauses under the Agreement or in the Supplementary Agreements that provides either party the right to waive the conditions in the relevant clauses of the Agreement. The non-fulfilment of any of these conditions, including obtaining approval from foreign regulatory authorities, would have prevented the transfer of the Entity S shares from occurring. Furthermore, the foreign law does not contemplate the waiver by a party to a contract of the type of conditions in the relevant clauses of the Agreement. This lends weight to the proposition that these conditions were conditions precedent to the formation of the Agreement as opposed to its performance.

As approvals from foreign authorities are conditions precedent to the formation of the Agreement, the Agreement is taken to not have been in existence, and the parties to the contract could not have 'entered into' the Agreement, until those approvals were obtained.

The effect of the law of the foreign jurisdiction

As mentioned above, 'entering into' a contract for the purposes of paragraph 104-10(3)(a) requires the execution of a binding contract. Generally, Australian common law principles on contracts are relevant in identifying when a binding contract has been entered into for the purposes of CGT event A1.

However, in this case, a clause of the Agreement specifies that the law governing the Agreement is to be the law of the foreign jurisdiction. Hence, the time at which the Agreement is found to be binding on the parties under the foreign law will determine when the Agreement was entered into for the purposes of paragraph 104-10(3)(a).

In the relevant foreign law on contracts, there are articles relating to a contract's execution and effectiveness, respectively, under the foreign law.

Under the foreign law, the Agreement is executed upon the signing of the Agreement by the two parties. However, another article provides that the requisite foreign government approvals defer the effectiveness of the Agreement until all of the approvals have been granted.

Further, the effect of another article is that, despite a legally executed contract being in place, without obtaining relevant approvals from foreign regulatory authorities, there would be a violation of the relevant foreign laws and administrative regulations. Therefore, in accordance with the foreign law, despite the Agreement being executed prior to the satisfaction of all of the conditions, there is no binding contract in existence at the date of execution. Rather, the Agreement only became binding on both parties when the Foreign laws and administrative regulations were satisfied; that is, upon obtaining the requisite approvals from foreign regulatory authorities.

Accordingly, as paragraph 104-10(3)(a) effectively specifies that 'entered into' refers to the time a contract is taken to exist and is binding on the parties to the contract, the Agreement will be taken to have been entered into at the date the last of the requisite approvals from foreign authorities was obtained, when the Agreement became binding on both parties under the foreign law. This was Date B.

Counter-arguments

There are arguments which can be made to support the conclusion that the conditions in a clause of the Agreement are conditions precedent to the performance of the contract. Those counter-arguments primarily hinge on the wording of certain articles the foreign law on contracts, which indicates that there is a distinction between the execution of a contract (which is, under Australia common law, the default time at which a contract is entered into and the contract becoming effective.

As there are different translated versions available a certain degree of caution is necessary in adopting this approach.

There is also some uncertainty about the scope of invalidity under an article. Under Australian common law, a contract may be invalid - meaning illegal or unenforceable - but still exists for the purposes of a CGT event A1. This was endorsed by the Federal Court in McDonald v Commissioner of Taxation (1998) 80 FCR 248 at 250. However under foreign law, article invalidity may have a more fundamental effect.

In view of this uncertainty and for the other reasons detailed above, on the balance of probabilities, it is reasonable for the Commissioner to rule that the time of CGT event A1 is when the last of the conditions in a clause of the Agreement was satisfied on Date B.

Question 2

Will the market value substitution rule in section 116-30(2) of the ITAA 1997 apply to replace the Purchase Price for the transfer of the Shares set out in the Agreement with its market value as at Date B in determining the capital proceeds used for calculating the CGT consequences of the disposal of the Shares by Entity A?

Summary

The market value substitution rule in section 116-30(2) of the ITAA 1997 will apply to replace the Purchase Price for the transfer of the Entity S shares set out in the Agreement with its market value as at Date B in determining the capital proceeds used for calculating the CGT consequences of the disposal of the Entity S shares by Entity A.

Detailed reasoning

Section 116-20 sets out the general rules about capital proceeds. Section 116-20(1) states:

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).

There are a number of modifications to the general rule. The market value modification rule relevantly states at section 116-30(2):

The capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event it:

(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.

The total consideration (that is, the capital proceeds) paid to Entity A for the acquisition of the Entity S shares was AUDXXX. This amount is greater than the market value of the Entity S shares which, in the market valuation report obtained by the applicant, valued the shares at another AUD amount as at Date B. Hence, the first condition in paragraph 116-30(2)(b) is satisfied.

The term 'arm's length' is defined in section 995-1(1) as:

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

The second condition, pertaining to 'arm's length' has been considered on the relevant factors to consider when deciding whether two parties are dealing with each other at arm's length.

Firstly, an assessment is required as to whether, in that dealing, the parties were acting in a way arm's length parties would normally do, so that the outcome of the dealing is a matter of real bargaining (per Trustee for the Estate of AW Furse No 5 Will FCT 91 ATC). Hence, it is necessary to examine the nature of the particular dealing between the two parties (per Re Hains; Barnsdall v FCT (1988) 81 ALR 173).

Granby Pty Ltd v FCT 95 ATC 4240 provides that, in ascertaining whether parties are dealing with each other at arm's length, an inquiry into whether parties to a transaction have acted severally and independently in forming their bargain is required. This will depend on the facts of each case.

Although relevant, the nature of the relationship between the two parties alone is not determinative of whether the two parties were dealing at arm's length. There may be transactions between related parties to which they apply independent separate wills, such that the transaction could have equally been concluded by unrelated parties consulting their own self-interest (per ACI Operations Pty Ltd v Berri Ltd [2005] VSC 201 at 226). Conversely, parties that are at arm's length will not be considered dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or where one party exercises its will over the other (per Scott v Rania [1966] NZLR 527).

In this case, it is unlikely that Entity A and Entity C have an arm's length relationship; they are commonly owned (whether directly or indirectly) by the Head Co. As the ultimate head entity, the Head Co had sufficient influence over Entity A and Entity B. Hence, it cannot be said that Entity A and Entity C were acting severally and independently in forming the transfer of the Entity S shares; they were merely acting in accordance with the Head Co's wishes.

Further, the purchase price for the Entity S shares was not a matter of negotiation between Entity A and Entity C, but an amount unilaterally determined by the Head Co. No negotiation on the purchase price was conducted between Entity A and Entity C - Entity A was advised to apply the purchase price predetermined by the Head Co. This indifference to the purchase price by both parties to the Agreement demonstrates the absence of independent wills in the transfer of the Entity S shares, and supports the view that Entity A and Entity C did not deal with each other at arm's length in relation to the disposal of the Entity S shares.