Edited version of your written advice

Authorisation Number: 1012823564563

Date of advice: 15 July 2015

Ruling

Subject: Income tax - Capital gains tax - Cost base and reduced cost base

Question

Does the market value substitution rule under paragraph 112-20(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) apply in working out the first element of the cost base and reduced cost base of the consolidated property?

Answer

Yes

This ruling applies for the following period:

1 July 2014 to 30 June 2015

The scheme commences on:

The scheme has commenced

Relevant facts and circumstances

Company A

The applicant is a company (Company A).

Company A operates on a not for profit basis, in that the income and property of Company A:

• can only be applied for the sole purpose of promoting and achieving the objects of Company A

Company B

The directors of Company B were founding directors of Company A.

Company B and Company A were related parties, and presented themselves to the community and the broader Australian public as a unified body.

The Consolidated Property

During 19X0s, Company B purchased 3 properties in one street in Australia (Company B properties).

From the 19X0s to the 19Y0s, there were other parcels of land situated in above mentioned street that Company A paid for (Company A properties).

Although Company A properties were funded by Company A, due to the special relationship that existed, the properties were all purchased in the name of Company B.

From 19Z0s to 20XX, Company B granted various leases for both Company B properties and Company A properties to Company A. In 200X, Company A agreed to pre-pay 5 years rent in advance to assist with Company B's cash flow requirements.

Company A operated its business and carried on its activities from these properties (i.e. from both Company B properties and Company A properties).

Ultimately, all of Company B's properties and Company A's properties were consolidated into one folio identifier (the consolidated property).

In 20YY a dispute arose between Company A and Company B relating to the proprietary rights of the consolidated property. Company A claimed that the title to the property should to be transferred to it, on the basis that Company B was, due to the special relationship, acting only as trustee for Company A in relation to Company A properties.

A Statement of Claim (the Statement of Claim) was filed with the Supreme Court in 20YY. A copy of the Statement of Claim is provided, which forms part of the description of the facts in this case. In the Statement of Claim Company A claimed that Company B was holding Company A properties on trust for Company A, and therefore, the title should be amended to recognise Company A as the registered proprietor of the properties.

In 20XX, Company A made an offer of settlement to Company B. The settlement offer provided for the parties to enter into a put/call option for the sale of the consolidated property for $X. The terms of the sale contract was detailed in the settlement agreement. Particularly, it provided that the purchase price of the consolidated property was $X.

Furthermore, as part of the settlement agreement, if the option was exercised the parties must also enter into other separate agreements which included an accommodation services deed for the supply of accommodation to Company B.

Also, if the option deed was exercised and a contract of sale entered into, judgement would be entered for the defendants (Company B was the main defendant) in the proceeding, and Company A would release the defendants from all claims.

In 20XX, Company B accepted the settlement offer, and the letter became the settlement agreement. A copy of the settlement agreement is provided, which forms part of the description of the facts in this case.

In 20XX, the option was exercised, and the contract for the sale of the consolidated property for $X was entered into.

Company A advised that the price of $X was not an arm's length price and that the consolidated property would not have been sold to a non-related party for this price. This price was agreed to because of the special relationship and long history of non-arm's length dealings between Company A and Company B. Further, this price was also conditional on a number of things, including that Company A would not take any further action in relation to the Statement of Claim, and that Company A would enter into an accommodation services deed with Company B.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Division 110

Income Tax Assessment Act 1997 Subdivision 112-A

Income Tax Assessment Act 1997 Section 112-20

Income Tax Assessment Act 1997 Subsection 112-20(1)

Income Tax Assessment Act 1997 Paragraph 112-20(1)(c)

Income Tax Assessment Act 1997 Subsection 112-20(2)

Income Tax Assessment Act 1997 Subsection 112-20(3)

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

Reasons for decision

Summary

The market value substitution rule under paragraph 112-20(1)(c) of the ITAA 1997 applies in working out the first element of the cost base and reduced cost base of the consolidated property.

Detailed reasoning

The consolidated property is a CGT asset of Company A under section 108-5 of the ITAA 1997.

The general rules for working out the cost base and reduced cost base of a CGT asset are in Division 110 of the ITAA 1997. They may be modified by the rules in Subdivision 112-A of the ITAA 1997 (and, in some cases, by other rules in the Income Tax Assessment Acts).

Section 112-20 of the ITAA 1997 contains the market value substitution rule. That is, the first element of the cost base and reduced cost base of a CGT asset will be taken to be the market value of the asset in certain circumstances, rather than the actual amount of consideration. Specifically, paragraph 112-20(1)(c) provides that the first element of the cost base and reduced cost base of the CGT asset you acquire from another entity is its market value (at the time of acquisition) if you did not deal at arm's length with the other entity in connection with the acquisition.

In this case the terms for the sale of the consolidated property (i.e. the sale contract) was agreed as part of the settlement for the proceeding between Company A and Company B. The settlement agreement was entered into in 20XX with these principal conditions:

• The parties could enter into an option deed over the sale of the consolidated property for the price of $X. The terms of the sale contract, including special conditions, were all specified in the settlement agreement;

• If the option deed was to be exercised and a contract of sale entered into, Company A was required to enter into an accommodation services deed with Company B; and

• If the option deed was to be exercised and a contract of sale entered into, judgement would be entered for the defendants (Company B was the main defendant) in the proceeding, and Company A would release the defendants from all claims.

The contract for the sale of the consolidated property was then entered into in 20XX, pursuant to the exercise of the option deed.

Therefore, the question to be determined is whether paragraph 112-20(1)(c) of the ITAA 1997 applies to the above circumstances, that is whether Company B dealt with Company A at arm's length in relation to the sale of the consolidated property. Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case.

Subsection 995-1(1) of the ITAA 1997 provides a definition for the term 'arm's length'. It states that 'in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance'. Furthermore, the fact that parties to an agreement are related does not of itself require the conclusion that parties are not dealing at arm's length in relation to a particular transaction.

In Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 (AXA Case), Justice Dowsett summarised, at paragraph 26, the 'arm's length' principle as follows:

• in determining whether parties have dealt with each other at arm's length in a particular transaction, one may have regard to the relationship between them;

• one must also examine the circumstances of the transaction and the context in which it occurred;

• one should do so with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction;

• relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal;

• where the parties are not in an arm's length relationship, one may infer that they did not deal with each other at arm's length, and that the resultant transaction is not at arm's length;

• however related parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship;

• un-related parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm's length.

In the AXA Case Edmonds and Gordon JJ further stated, at paragraph 105, that:

Any assessment of whether parties were dealing at arm's length involves "an assessment [of] whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining" …

Therefore, in applying the arm's length principle we should consider the relationship between Company A and Company B, and the relevant circumstances relating to the sale of the consolidated property.

The facts in this case support the conclusion that Company A and Company B do not, have an arm's length relationship. This is because:

• Company A was formed with the same directors of Company B;

• Since 19V0, Company A's executives which approved the financial contributions have always included persons who were directors of Company B;

• Company A and Company B presented themselves to the community and the broader Australian public as a unified body;

• Company A and Company B were related by common control and had historically conducted transactions relating to the consolidated property in a non-arm's length manner. In particular:

• Company A properties acquired over the years were funded by Company A, but due to the special relationship that existed, the properties were purchased in the name of Company B;

• Company A properties and Company B properties were consolidated onto one folio identifier; and

• Company A agreed to pre-pay 5 years rent in advance to assist with Company B's cash flow requirements.

However, the question is not answered solely by asking whether the parties were at arm's length to each other. The emphasis is on whether those parties dealt with each other at arm's length in relation to the sale of the consolidated property. This principle was also applied in Healey v. Federal Commissioner of Taxation [2012] FCAFC 194; (2012) ATC 20-365, where it was held that in determining whether a particular dealing was at arm's length, finding that the transacting parties were not at arm's length was not the end of the inquiry but the start of it.

In this case we consider Company A and Company B did not deal with each other at arm's length in connection with the acquisition of the consolidated property.

Firstly, the fact that the consideration of $X was not an arm's length consideration does not of itself mean that the parties to the agreement are not dealing with each other at arm's length. However, the facts prove that the real bargaining of this transaction relates primarily to the settlement of the proceeding between Company A and Company B.

Therefore, in negotiating the $X purchase price and other terms of the sale contract, the parties would have considered other legal rights and obligations, and act together to achieve a particular result. The terms of the option to acquire the consolidated property would not have been negotiated under regular market conditions, and the parties would not have conducted this transaction in a way which one expects of parties dealing at arm's length in such a transaction.

It is clear from the settlement agreement that there are also additional conditions to the contract of sale that must be satisfied. For instance, once the sale contract was entered into, the parties agreed that judgement would be entered for the defendants (Company B was the main defendant) in the proceeding and Company A would release the defendants from all other claims.

Accordingly, based on the circumstances of the sale transaction and the context in which it occurred, we find Company A did not deal at arm's length with Company B in connection with the acquisition.

Therefore, the Commissioner considers paragraph 112-20(1)(c) of the ITAA 1997 applies in this case, such that the first element of the cost base and reduced cost base of the consolidated property is the market value.