Edited version of your written advice

Authorisation Number: 1012999712713

Date of advice: 19 April 2016

Ruling

Subject: Capital gains tax on assignment of partnership interest

Question 1

Will CGT event E1 under section 104-55 of the Income Tax Assessment Act 1997 (ITAA 1997) happen when you assign, by way of declaration of trust, a beneficial interest in the partnership to a family discretionary trust?

Answer

Yes

Question 2

Assuming CGT event E1 happens, will the capital proceeds for the disposal of your partnership interest to a family discretionary trust be the deemed market value consideration under subsection 116-30(1) of the ITAA 1997 for the CGT event which will equal an amount determined by an independent qualified valuer?

Answer

Yes

Question 3

Following the assignment of your beneficial interest in the partnership, will the Commissioner continue to administer the acquisition and disposal of the partnership interests arising from the ordinary "ebb and flow" of partners in the partnership, in a manner consistent with the principles in Taxation Ruling IT 2540 such that the deemed market value of the partnership interests will be equal to the consideration paid, being nil?

Answer

Yes

This ruling applies for the following periods:

1 July 201X to 30 June 201Y.

The scheme commences on:

1 July 201X

Relevant facts and circumstances

The Partnership is a professional services firm whose principal entity is a general partnership. You ('the Partner') are an equity partner in the Partnership.

The Partnership is a "no-goodwill" partnership. Goodwill is not recognised in either the balance sheet of the Partnership nor for any other purpose. Consequently, when new partners are admitted to the Partnership, they do not make any payment to existing partners to acquire any goodwill, nor are they entitled to receive any consideration for the disposal of any goodwill when they retire or otherwise exit from the Partnership.

The Service Trust is a fixed trust that provides various services (e.g. procurement of office premises, recruitment of employees, etc.) to the Partnership to undertake its professional services business. The potential beneficiaries of the Service Trust are the partners of the Partnership and/or nominated associates of the partners.

The Partnership pays arm's length service fees to the Service Trust.

It is the intention of the Partnership to allow each equity partner to assign a portion of his or her partnership interest. By grant of approval by the Board in accordance with the Terms of Partnership, the Partner will be provided the opportunity to assign up to approximately X% of her interest in the Partnership to a trustee of a family discretionary trust.

The assignment of the partnership interest will occur by declaration of trust, which will effect the assignment of all the beneficial rights, not legal rights, associated with the partnership interest, including the right to receive an appropriate share of profits of the partnership to which the family discretionary trust will be entitled.

The declaration of trust by the Partner will create a trust ('Trust A') of which the Partner will be trustee. The beneficiary of Trust A will be the trustee of the family discretionary trust ('Trust B'). Trust B will be a pre-existing trust established by a person other than the Partner or a potential beneficiary of Trust B and will have a trustee other than the Partner.

The potential beneficiaries of Trust B will be limited to family members or entities associated with the Partner. The Partner will not be a beneficiary of Trust B, while she is a partner of the Partnership. The Partner may be a shareholder of a corporate beneficiary of Trust B.

The declaration of trust will be irrevocable.

Trust B will pay nominal consideration ($100) for the assigned partnership interest.

The Partner will continue to be legally the partner in the Partnership. The trustee of Trust B will not become a member of the Partnership nor will the trustee of Trust B be entitled to interfere in the Partnership's business or affairs or to inspect the books of the Partnership.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 102-5,

Income Tax Assessment Act 1997 - Section 102-20,

Income Tax Assessment Act 1997 - Section 102-25,

Income Tax Assessment Act 1997 - Section 104-10,

Income Tax Assessment Act 1997 - Section 104-55,

Income Tax Assessment Act 1997 - Section 104-60,

Income Tax Assessment Act 1997 - Section 108-5,

Income Tax Assessment Act 1997 - Section 116-20,

Income Tax Assessment Act 1997 - Section 116-30, and

Income Tax Assessment Act 1997 - Section 995-1.

Reasons for decision

Issue 1

Question 1

Section 108-5 of the ITAA 1997 provides the definition of CGT asset.

In your circumstance, your interests in each of the assets of the Partnership are CGT assets, according to paragraph 108-5(2)(c). Furthermore, any interest you may have in the partnership that was not covered by paragraph (c) is also a CGT asset according to paragraph 108-5(2)(d).

Subsection 102-5(1) of ITAA 1997 then states that your assessable income includes your net capital gain (if any) for the income year. This subsection also provides the method statement of working out the net capital gain for the income year by reference to capital gains and capital losses that you made during that income year.

Section 102-20 then states that you can make capital gain or capital loss if and only if a CGT event happens.

Section 102-25 requires you to consider which CGT event happens to your situation.

In the present case you will commence to hold a portion of your interest in the Partnership as a trustee, in a manner consistent with the assignment considered in Federal Commissioner of Taxation v Everett (1980) 143 CLR 440 (Everett).

CGT Event E1

The Commissioner considers that CGT event E1 will happen when you commence holding a portion of your interest in the Partnership as trustee for Trust B.

Section 104-55 of the ITAA 1997 provides that CGT event E1 happens if you create a trust over a CGT asset by declaration or settlement. In order for CGT event E1 to happen, two requirements must be satisfied. These are:

• you must create a trust over a CGT asset by declaration or settlement; and

• the exceptions in subsection 104-55(5) must not apply.

None of the exceptions in subsection 104-55(5) apply in the present case. Accordingly, the second condition is satisfied.

Further, it is considered that the first condition is satisfied in the present case.

No trust relationship currently exists between you and Trust B. However, you intend to commence holding a portion of your interest in the Partnership as trustee for Trust B. Accordingly, it is clear that the proposed arrangement will involve the creation of a trust.

Furthermore, it is considered that this trust would be created by declaration or settlement.

When a statute speaks of a 'declaration' of trust, it is naturally taken as referring to a declaration or instrument which is effective to create a trust by operating upon property vested in the declarant. This is what would occur in the present case when you commence holding a portion of your interest in the Partnership as trustee for Trust B. A resolution that property is to be held on a separate trust is sufficient to amount to a declaration for the purposes of CGT event E1, even if there is no express declaration. The manifestation of an intention to create the relevant trust can be inferred from words or conduct, and no formal or technical language is required. Accordingly, it is not essential that you use words such as 'I declare myself a trustee'.

Alternatively it is considered that a trust would be created by way of 'settlement' for the purposes of CGT event E1 in the present case, being an instrument which creates a new beneficial interest in property through the imposition of a trust.

CGT Event E2

Section 104-60 provides that CGT event E2 happens if you transfer a CGT asset to an existing trust.

A distinction is to be drawn between the creation of a trust over an asset and the transfer of an asset to an existing trust: Truesdale v. Federal Commissioner of Taxation (1971) 120 CLR 353; 70 ATC 4056.

In the present case, you will commence holding your interest in the partnership as trustee for the Trust. Whilst the Trust will exist prior to the assignment being entered into, the entering into the assignment by declaration of trust will give rise to a new trust which was not in existence before that time. Accordingly, you will not transfer an asset to an existing trust and CGT event E2 will not happen.

CGT Event A1

Section 104-10 provides that CGT event A1 happens if you dispose of a CGT asset. Disposal is then defined in subsection 104-10(2) to have happened when there is a change of ownership from you to another entity.

Under the proposed assignment, you will retain the legal ownership and continue to be the named partner in the Partnership. Trust B will only acquire the beneficial ownership of the assigned partnership interest. Therefore, you will dispose of a part-interest in the Partnership when you commence holding it as Trustee for Trust B.

However, in accordance with subsection 102-25(1) of the ITAA 1997, CGT event E1 is more specific to the situation, therefore CGT event A1 will not apply.

Question 2

Subsection 104-55(3) provides the method to calculate any capital gain or loss when CGT event E1 happens to a CGT asset. It provides that:

• you make a capital gain if the capital proceeds from the creation of the trust are more than the asset's cost base; and

• you make a capital loss if the capital proceeds from the creation of the trust are less than the asset's reduced cost base.

When calculating the capital proceeds, the general rules in Division 116 need to be applied. The capital proceeds from a CGT event are the total of the amount of money a taxpayer has received, or is entitled to receive, in respect of the event happening, and the market value of any other property the taxpayer has received, or is entitled to receive, in respect of the event happening (worked out as at the time of the event - section 116-20). However, the general rules are modified by the market value substitution rules in section 116-30 where the capital proceeds received are more or less than the market value of the asset and the asset was disposed of in a non-arm's length dealing (subparagraph 116-30(2)(b)(i)).

As you are proposing to assign, by way of declaration of trust, a proportion of your partnership interest to the Trust for nominal consideration of $100, the market value substitution rule under section 116-30 needs to be considered.

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.

Taxation Ruling IT 2540 Income Tax: Capital Gains: Application to disposals of partnership assets and partnership interests ('IT 2540') addresses the disposal and acquisition of partnership interests in the context of 'no goodwill' partnerships where partners neither pay nor receive anything on entry into or exit from the partnership. At paragraphs 13 and 14, the Commissioner accepts that:

13. For large partnerships, which can have memberships numbering in the hundreds (for example, some major legal and accountancy partnerships) the situation is potentially more complex. In some cases, the potential problems are overcome because the ownership of the assets used by the partnership is vested in a service company or trust. In other cases, it will generally be accepted, provided the evidence reasonably supports the conclusion that the partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest in the partnership will be used for Part IIIA purposes in determining the cost base or disposal proceeds of the interests in the partnership assets that the partnership interest represents. This will mean that if, for example, the partnership arrangement is such that no amount is payable for the acquisition or disposal of goodwill, it will be accepted for the purposes of Part IIIA that the value of the goodwill is nil. This treatment will also apply to partners of smaller partnerships who deal with each other at arm's length, where those dealings take place in an ordinary commercial context.

14. In the case of large professional partnerships, where the partners' dealings with each other are at arm's length, it will only be where consideration is paid by a partner on entering the partnership or where a partner receives a payment on leaving the partnership that Part IIIA will have any practical effect. Where consideration is neither paid by a person on entering the partnership, nor received on retirement from the partnership, the partner will not realise a capital gain or incur a capital loss on the disposal of particular assets. However, as noted above, the admission or retirement of a partner may affect the proportionate ownership of the partnership assets by the individual partners and therefore may affect the extent of a continuing partner's interest in the partnership. This would be relevant in the event of a subsequent disposal of the partnership assets for consideration, or where consideration is paid to a partner on retirement from the partnership. [emphasis added]

However, this treatment is only applicable to the retirement or admission of a partner out of or into the partnership. As explained in Everett's case, an assignment does not constitute the assignee a partner or pass to him the powers of management, administration and inspection of books and accounts which repose in the assignor as a partner. Therefore, the administrative treatment provided in IT 2540 is not applicable to you.

IT 2540 also provides the Commissioner's view on the CGT consequences of entering into an Everett assignment. Paragraph 24 provides the Commissioner's view that an Everett assignment will be treated as a part disposal of the partner's interest in the assets of the partnership for CGT purposes.

The implication of this treatment was that an Everett assignment could give rise to a capital gain (or capital loss) in the hands of the assignor. As explained earlier in this ruling, the same outcome now arises under the re-written CGT provisions in Part 3-1 of the ITAA 1997. The Commissioner has stated at paragraph 25 that 'it would be very unusual for an Everett assignment to be made on an arm's length basis'. Therefore, the market value modification rule in section 116-30 will apply to determine the capital proceeds.

The case of Granby v. FC of T 95 ATC 4240 considered whether the cost base of certain plant and equipment for CGT purposes was the actual residual value paid or the market value at the time of purchase, in circumstances where plant and equipment was purchased at its residual value on the expiration of a lease. The question turned on whether the lessor of the plant and equipment and the taxpayer's partnership were dealing with each other at arm's length for the purposes of the CGT provisions.

In that case Lee J stated at ATC 4244 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 that:

If the parties to the transaction are at arm's length it will follow, usually, that the parties will have dealt with each other at arm's 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.

The way that you propose to assign a proportion of your partnership interest to the Trust for a nominal amount of $100 evidences that the parties will not behave in a manner in which arm's length parties would be expected to behave. That is, in line with the Commissioner's view in paragraph 25 of IT 2540, the facts indicate that the parties will not be acting at arm's length. The amount paid by the assignee is not reflective of a normal bargaining process which was discussed in Granby and the nominal capital proceeds do not reflect the true value which an interest in the Partnership would be valued at.

Paragraph 28 in IT 2540 provides that when determining the market value of an Everett assignment, the valuation should be in accordance with the decision in Reynolds v. Commissioner of State Taxation (WA) (Reynolds' case). Reynolds' case concerned the valuation of an assigned partnership interest on which ad valorem stamp duty was payable. Despite the other assets of the partnership being held in administration and service entities and goodwill not being recognised by the partnership, Burt CJ held:

'the assigned partnership interest was of value; its value derived from the value of the right that was attached to the partnership interest to receive a proportionate share of the future income of the partnership.'

Paragraph 28 of IT 2540 further explains that when valuing a partnership interest when entering into an Everett assignment, this will involve the determination of the price that a "hypothetical buyer" would pay for the assigned partnership interest having regard to the value of the right to the future income of the partnership which is attached to the interest.

Question 3

In Taxation Ruling IT 2540, the Commissioner has stated, at paragraph 13, that:

… it will generally be accepted, provided the evidence reasonably supports the conclusions, that the partners are dealing with each other at arm's length. Any consideration paid or received on the acquisition or disposal of an interest in the partnership will be used for Part IIIA purposes in determining the cost base or disposal proceeds of the interest in the partnership assets that the partnership interest represents.

In your circumstance, the Commissioner accepts that, at retirement or admission of a partner in the Partnership, the partners in the partnership are dealing with each other at arm's length. The Commissioner accepts that your arrangement meets the relevant requirements under IT 2540 and will apply the administrative treatment provided in IT 2540 to the ordinary "ebb and flow" of partners into and out of the partnership (i.e. on the admission to, or retirement from, the partnership of any of the other partners).

The Commissioner will accept that the market value of the consideration paid on acquisition of the partnership interest will be nil, and likewise, the consideration received on disposal of the partnership interest will also be nil.