Edited version of your written advice

Authorisation Number: 1012940966418

Date of advice: 11 March 2016

Ruling

Subject: Capital gains

Did CGT event A1 occur on the date the right to request shares was created pursuant to section 104-10 in relation to the disposal of shares in the Operating Company from the Holding Entity to the Receiving Entity?

Answer

No. CGT event A1 occurred in relation to the disposal of the shares on the Actual Transfer Date (ATD).

Question 2

Will subparagraph 116-30(2)(b)(i) apply to substitute the market value as the capital proceeds from the disposal of the shares?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

New business venture - oral agreements and understandings

Individual A wished to start up a business and took the following actions:

• Individual A approached Individual B with the proposal for a new business.

• A company, the Operating Company was registered by another individual (Registering Individual) as sole shareholder and sole director. This individual ran this company at the time with Individual A and another individual.

• The understanding was that the Operating Company was being held by the Registering Individual for Individual A and would be transferred to Individual A at a time of Individual A's choosing.

• Individual A would support the Operating Company by arranging finance and premises for the Operating Company and mentoring Individual B to operate and grow the business of the Operating Company with the benefit of Individual A' business connections and industry experience.

• Individual A would arrange a loan facility through an associated company (the Finance Company).

• Individual B would operate the Operating Company as a working managing director at a reduced salary rate until the Finance Company had been repaid. He/she would not be required to put in any money or provide any personal guarantees to support the business.

• All of the shareholding in the Operating Company would initially be transferred from the Registering Individual to Individual B or their nominated entity but a portion would then be transferred to Individual A, or his/her nominated entity, at a time of his choosing.

• Any tax payable on the transfer of shares from Individual B to Individual A, or his/her nominated entity, to achieve the desired shareholding would be funded by money from the Operating Company.

• Individual A would fully back the new business and cover Individual B for any liabilities arising from the arrangements for the new business, including paying any tax payable on the shareholding should there be insufficient funding in the Operating Company and indemnifying Individual B in the event of particular third party claims made.

• A draft option agreement was drawn up providing for Individual B to grant an option to purchase shares in the Operating Company to the Receiving Entity for a set price at a time of their choosing up to a set expiry date. During the period between March 2011 and September 2011, the draft option agreement was revised pursuant to discussions between Individual A and Individual B through their legal representatives. The option agreements ultimately were not signed due to outstanding issues in relation to the shareholders agreement.

• Despite the option agreements not being signed, Individual B's understanding was the share transfer would still be completed at some stage when Individual A was no longer subject to a non-compete clause they had with a previous business.

• Individual B commenced working in the business. The expenditure of the business was being funded by the Finance Company although the loan agreement with the Finance Company had not been signed at that stage. The Registering Individual continued to sign documents on behalf of the Operating Company as director and shareholder although he/she had ceased being involved in operating the business.

• To give effect to the oral agreements:

• The Registering Individual transferred their ordinary shares in the Operating Company to the Holding Entity and resigned as director and public officer of the Operating Company.

• the Holding Entity applied for the allotment of, paid for and received the remaining ordinary shares in the Operating Company.

• Individual B consented to appointment as director.

• Individual B signed the loan agreement and a fixed and floating charge between the Operating Company and the Finance Company associated with Individual A.

• The Finance Company also signed a Deed of Indemnity agreeing to indemnify Individual B in the event of any claims made arising from Individual B's involvement in the setting up of the Operating Company.

• Further discussions were held confirming the earlier agreement and considering how the remaining shares would be dealt with. However, nothing was done about transferring the shares from the Holding Entity to the Receiving Entity.

• The matter of the transfer of the shares was delayed as the parties did not consider it urgent because the parties relied on the oral agreement and their subsequent conduct in accordance with the oral agreement.

• At a time before Actual Transfer Date, the Operating Company had repaid all of the finance from the Finance Company. Consequently, Individual B's salary increased to a level approximating a market rate.

Individual B is the sole director for the Holding Entity and Individual A is the sole director for the Receiving Entity.

Written agreement

A Deed of Confirmation and Indemnity (the Agreement) was executed on the actual transfer date (ATD) between the Holding Entity, the Receiving Entity, Individual B and Individual A, which affirmed the earlier oral agreement (oral agreement) on the Earlier Date (ED). The ED is when the Holding Entity acquired all of the issued shares in the Operating Company. The Agreement also provided for indemnity arrangements concerning any potential tax liability with respect to the transfer of the shares in the Operating Company to the Receiving Entity.

The Agreement recites that the terms orally agreed by the ED included that the Holding Entity would acquire all of the shareholding in the Operating Company. The Holding Entity would transfer a portion of these shares (the shares) to the Receiving Entity (Individual A's nominated entity) for a set price per share at a time of Individual A's choosing.

On the ATD, Individual A chose to have the shares transferred to the Receiving Entity and a share transfer form was completed, payment was made and the register was updated to show that the Receiving Entity now held the shares formerly held by the Holding Entity. The market value of the shares at this time did not equal the purchase price.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-25

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-35

Income Tax Assessment Act 1997 section 104-40

Income Tax Assessment Act 1997 section 116-5

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-25

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 116-65

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The transfer of the shares in the Operating Company from the Holding Entity to the Receiving Entity results in CGT event A1. The time of the CGT event is the ATD and not the ED.

Detailed reasoning

Section 102-25 establishes the order of application of CGT events. In particular, subsection (1) of that section provides that you work out if a CGT event (except CGT events D1 and H2) happens to your situation. If more than one event can happen, the one you use is the one that is most specific to your situation.

When the shares held by the Holding Entity were transferred to the Receiving Entity, the relevant CGT event that happened in relation to the shares was CGT event A1, which happens where there is a disposal of a CGT asset. Subsection 104-10(2) provides that a CGT asset is disposed of if there is a change of beneficial ownership. The change of beneficial ownership occurred on the ATD when the shares were transferred to the Receiving Entity.

Subsection 104-10(3) provides that the time of the CGT event is

(a) when you enter the contract for disposal; or

(b) if there is no contract - when the change of ownership occurs.

The Commissioner does not consider that the oral agreement constituted a contract for the disposal of shares. The Commissioner further considers that there was never any intention for the contract to be a disposal contract for the shares as no actions demonstrate this intention. There was an option agreement drafted but never finalised which supports that the intent of the parties was to give Individual A the right or option to acquire the shares at a future time of his choosing for a nominal amount, rather than a contract of disposal.

The arrangements have been designed to enable Individual A to obtain the shares at a time when he/she is no longer subject to a covenant not to compete. Thus, it seems unreasonable that the contract date for disposal of the shares would be on the ED.

The actions of the relevant parties also support the conclusion that an option or right was acquired. These rights were given to Individual A in exchange for his/her prior and ongoing involvement in the business of the Operating Company. Individual A had the option to buy or not, regardless of his/her intentions to exercise the right or not at the time it was granted. Thus, Individual A was not definitively committed to the future purchase of the shares. If the business had failed before Individual A exercised his/her right, it is unlikely that he/she would then exercise his/her right. Therefore, Individual A received an option or a right to acquire shares pursuant to the oral agreement on the ED.

The oral agreement gave rise to an option (CGT event D2 pursuant to subsection 104-40(1)) or contractual right (CGT event D1 pursuant to subsection 104-35(1)), which gave Individual A the right to have the shares transferred to him/her or his/her nominee at a time of his/her choosing. However, CGT event D1 does not happen to the Holding Entity pursuant to subparagraph 104-35(5)(b) as the right requires the Holding Entity to do something that is another CGT event, namely CGT event A1 upon the disposal of shares. The capital gain or loss made from the grant of an option under CGT event D2 is disregarded pursuant to paragraph 104-40(5) as the option was exercised.

The rights were exercised and the relevant contract (share transfer form) was signed on the ATD and this is the date that of acquisition of the underlying shares.

This decision is supported by the judgement in Van v FC of T 2002 ATC 2325 (Van), which concerned an option but is equivalently applicable to rights. In that case, the taxpayer argued that the date of acquisition of the shares acquired on exercise of the option was the date the option was granted. After considering a number of authorities on the nature of an option, the Tribunal member concluded in that case:

• the option was an offer together with a contract to keep the offer open;

• only the 'contract that directly affected the acquisition of the shares' can be taken as the contract for acquisition of the share. Prior to this date there was no contract to acquire shares only an irrevocable offer.

The reasoning in relation to the acquisition date of the share for the option holder is equally applicable to the disposal date of the share for the holder or issuer of the share.

Further, consistency between the date of disposal and the date of acquisition maintains the integrity of the capital gains tax provisions.

In this case, the relevant contract for the disposal of the shares was the share transfer form, which was signed on the ATD. Prior to this date, Individual A merely held an irrevocable offer to have shares transferred to him/her or his/her nominated entity for a set price per share if he/she chose to request the transfer. Thus, the time of disposal pursuant to subparagraph 104-10(3)(a), is the ATD, being the date the contract for disposal was entered.

Question 2

Summary

As the dealings were at arm's length, subparagraph 116-30(2)(b)(i) does not apply to substitute the market value for the capital proceeds from the disposal of the shares..

Detailed reasoning

Section 116-5 provides that:

Section 116-20 sets out the general rules about capital proceeds. They are relevant to each CGT event that is listed in the table in section 116-25.

Paragraph 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).

Section 116-25 provides a table of modifications to the general rules. Section 116-25 relevantly provides for CGT event A1 that modifications 1, 2, 3, 4, 5 and 6 can apply and that there are special rules for disposals due to option exercise under section 116-65.

Section 116-65 applies when a disposal of a CGT asset occurs due to the exercise of an option. It provides that the capital proceeds from the disposal include any payment you received from granting the option.

In this case, the Holding Entity did not receive anything from the granting of the option or right. The grant was part of the wider arrangement agreed to by the relevant parties.

Modification 1, the market value substitution rule, contained in section 116-30 provides that you are taken to have received the market value of the CGT asset in question as valued at the time of the event:

1. if you received no capital proceeds from the CGT event (subsection 116-30(1)).

2. if some or all of the proceeds cannot be valued (paragraph 116-30(2)(a)).

3. if the value of the capital proceeds are not equivalent to the market value of the asset and

a. the dealing was not at arm's length (subparagraph 116-30(2)(b)(i)), or

b. the CGT event is CGT event C2 (subparagraph 116-30(2)(b)(ii)).

An amount was received for the shares' disposal, a CGT A1 event, which was not equivalent to the market value of the shares. Thus where the dealing was not at arm's length, subparagraph 116-30(2)(b)(i) will apply. In this aspect the Commissioner considers that the parties were dealing at arm's length for the following reasons.

Subsection 995-1(1) provides that 'in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstances.'

The transfer of shares was made pursuant to the exercise of an option or right to purchase the shares. The arrangement was part of a wider transaction whereby Individual A and Individual B agreed to establish a new business. The arrangements were enable Individual A to obtain the shares at a time when he/she is no longer subject to a non-compete clause of his/her prior employment and to ensure the shares were not subsequently acquired at a higher value.

Paragraph 107 of the judgement by Edmonds J and Gordon J in Federal Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd provides that:

… there is no presumption that parties at arm's length dealt with each other at arm's length:
Hains 81 ALR 173 and Furse 21 ATR 1123 at 1132. Parties may be at arm's length generally yet not deal with each other at arm's length in respect of a particular matter: Re RAL and Federal Commissioner of Taxation (2002) 50 ATR 1076 at [45]-[51]. So, for example, even where parties to a transaction are at arm's length, they will not "be dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the discretion of the other, perhaps, to promote the interests of the other": Granby 129 ALR 503 at 507.

Edmonds and Gordon reiterate at paragraph 113 that the transaction will be at arm's length where:

…the parties were acting in their own interests, or were acting 'severally and independently in forming their bargain': Granby 129 ALR 503 at 507. …

In Granby 95 ATC 4243:

As Hill J. stated in Furse at 4015, determination of the manner in which parties not at arm's length have dealt with each other requires ``an assessment 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''.

In this case, both parties acted in their own interests, severally and independently in the arrangements. The terms of the Agreement were drawn up by a mutual desire of the parties to achieve their own objectives of running and owning a successful business. There is no evidence that the outcome of their dealings is anything other than a matter of real bargaining. Thus the dealings were at arm's length and subparagraph 116-30(2)(b)(i) does not apply to substitute the market value for the capital proceeds from the disposal of the shares.