Edited version of your written advice

Authorisation Number: 1012987433145

Date of advice: 30 May 2016

Ruling

Subject: Market value substitution rule

Question

Is the first element of the cost base and reduced cost base of the property its market value at the time of its acquisition rather than the amount paid for it?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2014

The scheme commences on:

1 July 2013

Relevant facts and circumstances

A relative of yours defaulted on their mortgage and their lender issued an eviction notice to them at the property. You also resided in the dwelling.

The bank did not repossess the property and the title to the property remained with your parents at all times.

Your relative initially entered into negotiations with the bank in order to refinance the property.

You and your relative subsequently realised that it would be easier to obtain finance for the property in your own name. You subsequently entered into negotiations with the bank to refinance the property.

You made an initial offer to the bank which was rejected before offering the bank a higher amount which was accepted. The bank agreed to write off your relative's remaining debt on the property if they allowed you to purchase the property off them for the amount negotiated between you and the bank. The bank would then receive the proceeds from the sale.

Your relative then had to approve the sale of the property. At any time they could have refused the sale. They also had the option of refinancing the property themselves for the same amount.

Your relative agreed to the sale and you subsequently purchased the property off them.

The bank accepted the proceeds from the sale for the total debt and released the mortgage to you. The remaining balance of the debt was written off by the bank with your relative listed as a debtor.

You have a certificate of valuation for the property assessing its market value as greater than what you purchased for it.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 102-20

Income Tax Assessment Act 1997 - Section 110-25

Income Tax Assessment Act 1997 - Section 110-55

Income Tax Assessment Act 1997 - Section 112-20

Reasons for decision

Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a capital gain or capital loss results from a CGT event occurring. The most common CGT event, A1, occurs when you dispose of a CGT asset to someone else. CGT event A1 will be triggered when you sell your property. For CGT event A1 your capital gain is the difference between your capital proceeds and the cost base of your CGT asset.

In working out your capital gain, you determine the cost base of the CGT asset involved in the CGT event. Under the general cost base and reduced cost base rules covered under subsections 110-25(2) and 110-55(2) of the ITAA 1997 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. The general rules may be modified if the market value substitution rule in section 112-20 of the ITAA 1997 applies.

The market value substitution rule generally applies where parties do not deal at arm's length in connection with the acquisition of an asset (paragraph 112-20(1)(c) of the ITAA 1997). If the market value substitution rule applies, the first element of the cost base or reduced cost base of a CGT asset that is acquired from another person is its market value at the time of acquisition.

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. In respect of the term 'arm's length' subsection 995-1(1) of the ITAA 1997 states that in determining whether parties deal at arm's length, any connection between them and any other relevant circumstance should be considered.

In addition, in Barnsdall v. FC of T (1988) ATC 4565, 4568; Davies J states:

The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion.

The Commissioner is therefore required to consider not only the relationship or connection between you and your parents, but also the circumstances of the transaction 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.

Generally, you are 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. In The Trustee for the Estate of the late AW Furse No. 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123; Hill J describes the 'real bargaining test' adopted by the courts:

What is required in determining whether the parties deal with each other in respect of a particular dealing at arm's length is 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.

Application to your circumstances

In your case, although your relative sold the property to you for below its market value, this does not of itself indicate an absence of real bargaining. This is evident in the fact that the sale price of the property was determined through your negotiations with the bank to release the mortgage. Throughout these negotiations you made an initial lower offer which was rejected before the final offer was accepted.

Although ultimately this price had to be accepted by your relative in order for the sale to proceed, it is not accepted that the reason your relative approved the sale was because of your relationship with them. This is because the bank also gave your relative the option of refinancing the property themself for same amount that it was eventually sold for. You advise that it was decided that you would purchase the property instead because you and your relative realised it would be easier for you to obtain finance for the property.

Consequently, it is not accepted that your relative was not acting in their best interest when they decided to sell the property to you for below its market value. By selling the property to you, your relative kept the home in the family and prevented it from being repossessed and sold by the bank. Moreover, the balance of their remaining debt was subsequently written off by the bank after the sale of the property.