Edited version of your written advice

Authorisation Number: 1012878815700

Date of advice: 16 September 2015

Ruling

Subject: Capital Gains Tax

Questions and Answers

1. Will Capital Gains Tax (CGT) event B1 happen when you enter into a standard residential tenancy agreement and grant a call option on the same property?

No

2. Will CGT event D2 happen on the granting of the option?

Yes

3. If the option is exercised, will CGT event A1 happen?

Yes

4. Will CGT event F1 happen when you enter into a standard residential tenancy agreement?

Yes

5. Will the Commissioner apply Part IVA to deny any tax benefit obtained as a result of the arrangement?

No

This ruling applies for the following period

Year ending 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

A residential property was acquired after September 1985.

The property has been rented to third party tenants until recently.

The property was in need of significant repair for this period as the tenants have not maintained the property in pristine condition.

You intend to:

Enter into a standard residential tenancy agreement with a related individual. There will be no lease premium payable by the lessee and rent will be payable at the market rate. The tenancy agreement will end on the happening of specified events, including an agreement in writing between the lessor and the lessee, or after three years, unless the lessor and lessee agree to extend it.

Separately to this, you will grant a call option to the individual, with an exercise price of the market value of the property at the time of granting the option. The lessee will pay for the option, and this will be deducted from the exercise price if the option is exercised. Rent is to be up to date, and will not be deducted from the exercise price. Exercise of the option will constitute a binding contract for sale of the property, to be settled within eight weeks. The option can be exercised in favour of a third party. If not exercised, the option will expire after three years.

Assumptions

None.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 104-40

Income Tax Assessment Act 1997 Section 104-110

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 116-65

Income Tax Assessment Act 1997 Section 134-1

Income Tax Assessment Act 1936 Part IVA

Reasons for decision

Summary

CGT event B1 will not happen when you enter into a standard residential tenancy agreement and grant a call option on the same property.

CGT event D2 will happen when the option is granted, the capital gain or capital loss is disregarded if the option is exercised.

CGT event A1 will happen when the option is exercised. The capital proceeds will include any payment received for granting the option.

CGT event F1 will happen when the lease is granted

The market value substitution rule may apply.

Part IVA will not apply

Detailed reasoning

CGT event B1 - use and enjoyment before title passes

Section 104-15 of the ITAA 1997 discusses CGT event B1, which occurs if a taxpayer enters into an agreement under which the right to the use and enjoyment of a CGT asset passes to another entity, and title of the asset will, or may, pass to the other entity at, or before the end of, the agreement.

CGT event B1 may happen when the agreement for the use and enjoyment of an asset is for a specified period, after which the title of the property passes to the other entity. CGT B1 would not occur when the title of an asset may pass to the other entity at an unspecified time in the future.

The time of the CGT event B1 is when the other entity first obtains the use and enjoyment of the asset.

If this event happens, and is the most relevant event, then no other CGT events happen as a result of entering into the lease and option agreement.

Is there one agreement or two?

While the lease agreement allows the potential purchaser to use and enjoy the rental property, the lease does not include any right to acquire the property.  In this context, Taxation Determination TD 1999/78 is relevant.  It states (in part)

…If under the agreement which provides the right to the use and enjoyment title will or may pass at the end of the agreement, CGT event B1 is triggered and you make a capital gain or capital loss when the other entity first obtains the use and enjoyment of your asset. (emphasis added)

In Example 2, a party is granted a lease over a parcel of land and the lease agreement also contains a right of first refusal for the acquisition of the land if the lessor decides to sell. In this case, CGT event B1 does not apply because the lease agreement is not regarded as being one where title will or may pass at the end of the agreement. The lessor is merely allowing the lessee the right to acquire the property if the lessor decides to sell.

By contrast, in Example 3, a taxpayer owns a boat and another party is interested in buying the boat.  A hire agreement is entered into and as part of that agreement, the owner agrees to offset the hire fees paid over the hire period should the hirer agree to buy the boat.  In this scenario, it is clear the agreement entered into whereby the hirer has a right to use and enjoy the boat and under that agreement, title would or might pass when the hire agreement ends and as such, CGT event B1 would apply.

In addition, Taxation Ruling IT 28 considers when an arrangement, purporting to be a lease agreement, should be treated as a sale agreement (that is, a hire purchase agreement). This ruling focusses on the deductibility of payments for the 'lease' of plant and equipment where the lessee gains title to the asset for no, or minimal, payment. It takes the view that in some instances, we would view two separate contracts as being one agreement for the sale of the assets, and therefore the 'lease' payments would not be deductible. Relevant considerations are that possession will remain with and title will pass to the 'lessee' and gives indicative residual values for the assets, based on the length of the 'lease agreement.

In this case, the tenancy agreement and the option are two discrete, independent agreements. There is nothing that compels the lessee to purchase the property. The exercise price is set at the time of granting the option - none of the rent paid will be taken as prepayment of the exercise price for the purchase of the property. The expiration of the option does not affect the lessee's right to continue leasing the property.

As such, CGT event B1 does not happen.

Granting an option

Section 104-40 of the ITAA 1997 states that a CGT event D2 occurs when an option is granted, renewed or extended. The legislation does not give a definition of 'option'. In Federal Commissioner of Taxation v. Guy (1996) 67 FCR 68; 96 ATC 4520; (1996) 32 ATR 601, the Federal Court defined option to mean:

The word 'option' itself suggests a right in one party to unilaterally require another party to enter a new set of jural relations or to extend or continue an existing jural relationship. Put and call options, options to purchase and options to renew leases are, perhaps, the most common illustrations.

A 'call option' gives a person the right to acquire an asset from the person granting the right at some specified time and usually at a predetermined price.

If an option agreement is subject to a condition, an issue arises whether the condition is a condition precedent to its formation or whether it is a condition precedent to performance of the contract. In the first case, the contract does not come into existence until the condition is met. In the second case, the condition does not prevent the creation of the contract - non-fulfilment of the condition merely entitles a party to terminate the contract: see Perri v. Coolangatta Investments Pty Ltd (1982) 149 CLR 537.

You make a capital gain if the capital proceeds from the grant are more than the expenditure incurred in granting the option. You make a capital loss if the capital proceeds are less than the expenditure.

The capital gain or capital loss from the granting of an option is disregarded if the option is exercised.

Exercising the option - disposal of property

If the option is exercised then the subject of the option, the CGT asset, will be disposed of by the grantor, so that CGT event A1 will happen.

When the option is exercised a legally binding contract to buy and sell the property will be created and the date of disposal of the CGT asset will be the date that the option is exercised.

Generally the capital proceeds from a CGT event is the total of the money and the market value of any other property you have received or are entitled to receive in respect of the CGT event happening. However, where you dispose of a CGT asset because another entity exercised an option you granted in relation to the asset, the capital proceeds you receive from the disposal includes any payment you received for granting the option (section 116-65 of the ITAA 1997).

Granting a lease

Section 104-110 of the ITAA 1997 states that a CGT event F1 happens if a lessor grants, renews or extends a lease. When granting a lease, the time of the event is when the lease contract is entered into, or if there is no contract when the lease starts.

Market value substitution

The market value substitution rule applies to CGT events A1 and D2 and takes effect if:

• There are no capital proceeds;

• Some or all of the proceeds cannot be valued; or

• You did not deal at arm's length with another entity in connection with the event and the capital proceeds are more or less than the assets market value.

The market value substitution rule, broadly, is when the proceeds are replaced with the market value of the asset worked out at the time of the event.

An individual is said to be dealing at arm's length with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction. The law looks at not only the relationship between the parties but also the quality of the bargaining between them.

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, in respect of the term arm's length states that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance. The CCH Macquarie Concise Dictionary of Modern Law, 1988, CCH Australia Ltd/Macquarie Library Pty Ltd, Sydney defines the expression at arm's length as meaning that the parties to the transaction are not connected in such a way as to bring into question the ability of one to act independently of the other.

It is not sufficient that the parties may be at arm's length, they must deal with each other at arm's length, that is, as arm's length parties would normally do, so that their dealing has an outcome that is the result of normal bargaining (The Trustee for the Estate of the late A W Furse No 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123 and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 (Granby)).

In Granby at ATC 4243; ATR 403 Lee J stated that the provision dealing with each other at arm's length invited an analysis of the manner in which the parties conduct themselves in forming the transaction. The question is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs and the expression means, at least, that the parties have acted severally and independently in forming their bargain.

Further, Lee J stated (at ATC 4244; ATR 403-404) that:

If the parties to the transaction are at arms length it will follow, usually, that the parties will have dealt with each other at arms length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be.

However this will not be the case where the parties collude to achieve a particular result, or where one of the parties submits the exercise of its will to the discretion of the other. In such a case the lack of the exercise of an independent will in the formation of the transaction would indicate a lack of real bargaining.

Application of Part IVA

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance provision that can apply in certain circumstances. Part IVA gives the Commissioner the power to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

In broad terms, Part IVA will apply where the following requirements are satisfied:

• there is a scheme (see section 177A);

• a taxpayer has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme (see section 177C); and

• the dominant purpose of a person who entered into or carried out the scheme, or any part of the scheme, was to enable the relevant taxpayer to obtain a tax benefit in connection with the scheme, or to enable the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (paragraph 177D(b)).

It is determined that Part IVA would not apply to the proposed transactions.