Edited version of your written advice

Authorisation Number: 1013082234936

Date of advice: 2 September 2016

Ruling

Subject: Capital gains tax consequence of an assignment of partnership interest

Question 1

Does CGT event E1 apply in respect of the assignment of the portion of the Rulee's interest in the Partnership (Assigned Interest) to the Assignee (Assignment)?

Answer

Yes

Question 2

Is the time of the CGT event E1 the effective time of the Assignment (being the time when the trust over the partnership interest is created corresponding to the time when the assignment under the Deed of Assignment takes effect, in accordance with subsection 104-55(2) of the Income Tax Assessment Act 1997 (ITAA 1997))?

Answer

Yes

Question 3

For the purpose of determining the capital proceeds in respect of the CGT event E1, does the Commissioner accept that the market value of the Assigned Interest is the market value determined in accordance with subsection 116-30(2) of the ITAA 1997 (i.e. market value substitution rule: modification 1, applying where there are nominal capital proceeds) at the time of the Assignment?

Answer

Yes

Question 4

If the Assignor's interest in the Partnership has been held for at least 12 months before the effective time of the Assignment, will the 50% CGT discount apply in accordance with Division 115 of the ITAA 1997 to the capital gain?

Answer

Yes

Question 5

Are the other partners in the Partnership affiliates of the Rulee as defined under section 328-130 of the ITAA 1997 for the purposes of the maximum net asset value test under section 152-15 of the ITAA 1997?

Answer

No

Question 6

Are the Partnership, the Service Trust regarded as entities connected with the Rulee (or connected with the Rulee's affiliates) as defined under section 328-125 of the ITAA 1997 for the purposes of the maximum net asset value test under section 152-15 of the ITAA 1997?

Answer

No

Question 7

Does the Commissioner agree that the basic conditions for small business relief in Subdivision 152-A of the ITAA 1997 are satisfied such that the small business 50% reduction provided by Subdivision 152-C of the ITAA 1997 would apply to any capital gain?

Answer

Yes

Question 8

Does the Commissioner agree that the Assignment will not result in any amount being included in the assessable income of the Rulee on revenue account (i.e. rather than as a capital gain included in assessable income in accordance with section 102-5 of the ITAA 1997)?

Answer

Yes

Question 9

Does the Commissioner agree that the share of the income of the Partnership which has been effectively assigned under the Assignment will not be required to be included in the Rulee's assessable income in the income year of the Assignment or in later income years (and that in the income year of Assignment no daily apportionment is required)?

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 Rulee is a 'fixed draw' partner in the Partnership.

The Partnership is a large partnership and carries on a business of providing professional services, primarily in Australia with some services provided overseas.

The Partnership is a 'no goodwill' partnership. This means that incoming partners are not required to pay any amount in relation to goodwill being acquired and exiting partners are not entitled to receive any payment in recognition of goodwill. Express recognition of this is set out in the Partnership Agreement.

The Partnership has an income year end of 30 June for legal and tax purposes.

Under the Partnership Agreement, partners are admitted to the Partnership in accordance with the terms of the 90% resolution authorising such admission.

Entitlements to participate in net income of the Partnership can be based on:

(a) a fixed draw, whereby the partners concerned receive a fixed dollar amount of net income of the Partnership as a priority entitlement (to unit partners), and pro rata reduced if there is insufficient net income to cover all fixed draws; and

(b) units, whereby partners receive a portion of the net income of the Partnership after all priority entitlements have been accounted for equal to the number of units each holds divided by the total number of units then existing.

A bonus scheme is in place to reward high performing partners with an additional share of net income which is a priority entitlement.

A partner's entitlement to income can vary from time to time with potential movements in the number of units or moving from, fixed draw to units or vice versa.

The Partnership Agreement currently permits a partner to assign a share of their interest in the partnership if such assignment is approved by the Board of the Partnership. An assignment would not affect the continuation of the Partnership.

During the 12 month period leading up to the Assignment it is likely that a comparatively small number of partners will retire from the Partnership, and a comparatively small number of new partners will become members of the Partnership. This is consistent with the 'ebb and flow' of the Partnership and the nature of its business.

The Partnership has various partners and employees, who have authority to make decisions that bind the Partnership - the most senior being the Chief Executive. The Partnership Board has residual decision making power where a relevant authority has not been given to a partner or employee by the Partnership Agreement. Board members are also authorised, via a form of power of attorney, to execute deeds on behalf of the Partnership. Some partners, including those partners on the Partnership Board, have administrative responsibilities within the Partnership.

The partners do not contribute capital to the Partnership as such. However, partners in the Partnership generally contribute a loan to the Partnership.

Retirement from the Partnership:

A partner may retire from the Partnership by giving not less than 6 months' notice in writing. Where a partner wishes to retire with less than 6 months' notice, approval must be given by the Board.

Service Trust:

The Partnership engages a service trust that provides various services to the Partnership to undertake its professional services business (the Service Trust). The Service Trust is a discretionary trust and the potential beneficiaries of it include partners or their relevant associates.

The Service Trust operates as a separate business from the Rulee and the Partnership. The Service Trust is paid a service fee by the Partnership, the basis of which has been approved by the ATO. The trustee of the Service Trust is the Trustee Company, which has a board separate to the Board of the Partnership.

As a partner of the Partnership, the Rulee or their relevant associate is a potential beneficiary of the Service Trust. Whilst the Rulee may recommend to the Trustee Company that it consider making a distribution to the Rulee or a relevant associate of the Rulee, the Trustee has discretion whether to act on that.

Generally, the trustee of the Service Trust distributes income as follows:

(a) for partners on fixed draws, generally a percentage of their fixed draw amount is set for the relevant financial year and paid out (to them or relevant associates), and

(b) for partners on units, the balance of net income is paid out (to them or relevant associates) based on the number of units each partner holds divided by the total number of units then existing (noting the comments above about retirees during the relevant financial year).

Having regard to the number of partners in the Partnership and the Rulee's interest in the Partnership, it would not be the case that at least 40% of the income or capital of the Service Trust is distributed to the Rulee (including any of the Rulee's affiliates).

The proposed Assignment:

The Rulee is seriously contemplating an assignment of a portion of his interest in the 'Property' as defined in the Deed of Assignment (Assigned Interest) to the Assignee for nominal consideration of $10 (ie the Assignment) by way of a deed to be executed by both the Rulee (as Assignor) and the trustee of the Family Trust (as Assignee).

The 'Property' is defined in the Deed of Assignment to be:

'Property is the interest of the Assignor in the Partnership whilst the Assignor is a 'Partner' in the Partnership at law, including the Assignor's right to receive the share of the profits of the Partnership to which the Assignor would but for this deed have been entitled.'

The Assignment will be irrevocable.

If the Assignment occurs, it will take effect between 1 July 201X and 30 September 201X.

The Assignee will not become a partner of the Partnership as a result of the Assignment.

The Assigned Portion of the partnership interest which is being assigned, i.e. the Assigned Portion of the 'Property' as defined in the Deed of Assignment.

The loans contributed by partners to the Partnership do not form part of their interest in the Partnership (rather they are a separate loan receivable) and accordingly, the loan receivable does not form part of the Property referred to in the Deed of Assignment and hence does not form part of the Assigned Interest.

The Deed of Assignment will provide that the assigned portion equals a fixed percentage, which can be assumed to be between X% and Y%.

The Assignee:

The Assignee may be either, an individual, a company or a discretionary trust established for the benefit of the Rulee's family (Family Trust). While the Rulee is a partner of the Partnership, the Rulee will not be the trustee of the Family Trust. Apart from potential charitable beneficiaries, the potential beneficiaries of the Family Trust will be limited to the Rulee and family members or entities associated with the Rulee and family members. However, the class of beneficiaries of the Family Trust for a relevant income year excludes persons whom if they received a distribution from the Family Trust would cause the Partnership to breach any professional regulation.

The trustee of the Family Trust may be a company, and the Rulee may legally and beneficially own all the shares in that company and be one of the directors, or the sole director, of that company. The Rulee may be the appointor of the Family Trust.

The Rulee has been a member of the Partnership for more than 12 months prior to the time the Assignment takes effect.

Commercial reasons for the Assignment:

The commercial reasons for the Assignment are predominantly for family asset protection and/or wealth creation. As a partner in the Partnership (whether a unit partner or a fixed draw partner), the partner is jointly and severally liable personally for the actions and debts of the Partnership. Whilst the Partnership maintains a professional indemnity insurance policy (PI Policy), there is a limit per claim and the PI Policy contains certain exclusions together with a deductible per claim which the Partnership must bear. Each partner takes the risk that the PI Policy will not respond to a claim due to the relevant circumstances or that the insurers do not fund a claim -although neither outcome is regarded as being a likely outcome.

Importantly, from an asset protection perspective, the Assignment will have the effect of reducing new assets (being the relevant share of net income) which come to the Rulee personally from when the Assignment becomes effective.

Assumptions

(1) The Assignee (i.e. the Family Trust) is in existence as at the date the Deed of Assignment is executed and prior to the Assignment taking effect.

(2) For the purpose of Question 7 of the Questions and issues for the ruling, the Rulee satisfies the maximum net asset value test contained in section 152-15 of the ITAA 1997.

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,

Income Tax Assessment Act 1997 - Section 152-10,

Income Tax Assessment Act 1997 - Section 152-15,

Income Tax Assessment Act 1997 - Section 328-125,

Income Tax Assessment Act 1997 - Section 328-130, and

Income Tax Assessment Act 1997 - Section 995-1.

Reasons for decision

Question 1

CGT implications of the Rulee holding a portion of their partnership interest on trust

CGT Event E1

The Commissioner considers that CGT event E1 will happen when the Rulee (as a consequence of the assignment) commences holding a portion of the Rulee's interest in the Partnership on trust for the Family Trust.

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.

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 the Rulee commences holding a portion of the Rulee's interest in the Partnership on trust for the Family Trust. An assignment that has the effect that property is held on 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 the Rulee uses words such as 'I declare myself a trustee'.

In the present case, no trust relationship currently exists between the Rulee and the Family Trust. However, the effect of any assignment is that the Rulee will thereafter hold a portion of the Rulee's interest in the Partnership on trust for the Family Trust. By entering into the proposed arrangement, the Rulee will manifest an intention to create a trust over the Assigned Interest.

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

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, the Rulee will commence holding the Assigned Interest on trust for the Family Trust, which will exist prior to the assignment being entered into. However, the effect of entering into the assignment is to 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, the Rulee will retain the legal ownership and continue to be the named partner in the Partnership. The Family Trust will only acquire beneficial ownership of the Assigned Interest. Therefore, the Rulee will dispose of a part-interest in the Partnership when the Rulee commences holding it as Trustee for the Family Trust.

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

Time of CGT Event E1

Subsection 104-55(2) provides that the time of the event is when the trust over the asset is created.

A trust is created over a portion of the Rulee's partnership interest when the Rulee enters into an effective assignment of that interest to the Family Trust.

Accordingly, CGT event E1 will occur when the assignment under the Deed of Assignment takes effect.

Question 3

Capital proceeds for the disposal of your partnership interest

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)).

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 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.

Taxation Ruling IT 2540 Income Tax: Capital Gains: Application to disposals of partnership assets and partnership interest ('IT 2540') 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'.

As the Rulee proposes to assign their partnership interest to the Family Trust for nominal consideration of $10, this is evidence 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 dealing with each other at arm's length. The amount paid by the assignee is not reflective of a normal bargaining process which was discussed in Granby and nominal capital proceeds do not reflect the value which an interest in the Partnership would be expected to be valued at. The market value substitution rule under section 116-30 needs to be considered to determine the capital proceeds.

Paragraph 28 of 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.

In this regard, the market value of the Assigned Interest will be determined in accordance with the methodology agreed with the ATO by way of administrative response, in line with the principles in Reynolds' case.

Question 4

On the basis that the Rulee has been a member of the Partnership for at least 12 months prior to the time of the Deed of Assignment takes effect, the 50% CGT discount applies to any capital gain arising as a result of the Assignment pursuant to Subdivision 115-A of the ITAA 1997.

Question 5

Other partners of the Partnership as affiliates

For the purposes of the maximum net asset value test set out in section 152-15 of the ITAA 1997, paragraph (c) of this section requires the Rulee to include in the calculation the net value of CGT assets of any affiliates of the Rulee or entities connected with affiliates of the Rulee.

The term 'affiliate' is defined by section 995-1 to have the meaning described in section 328-130.

Subsection 328-130(1) provides the criteria to be considered when assessing if an individual or a company is your affiliate. Subsection 328-130(2) then provides an exemption where an entity is not your affiliate merely because of the business relationship between you and that entity.

As the Rulee and other partners of the Partnership share and have the common business relationship in the partnership, the exemption provided in subsection 328-130(2) is applicable to the Rulee, in relation to the affairs of the Partnership.

Furthermore it is clear from the example provided in section 328-130 that a partner in a partnership would not be an affiliate of another partner merely because one partner acts in accordance with the directions or wishes of another partner, or in concert with the other partner, in relation to the affairs of the partnership.

Accordingly, the Commissioner does not consider the other partners in the Partnership to be affiliates of the Rulee for the purposes of section 152-15.

Question 6

The Partnership and the Service Trust as entities connected with the Rulee

To access the small business relief CGT concession, you must satisfy the basic conditions under section 152-10. In the present case the applicable provision, in subparagraph 152-10(1)(c)(ii), requires that you satisfy the maximum net asset value test set out in section 152-15. Paragraph 152-15(c) requires you to include in the calculation the net value of CGT assets of any affiliates of yours or entities connected with your affiliates.

It is necessary for the calculation in section 152-15 to consider if the Partnership and the Service Trust are entities connected with the Rulee.

The term "connected with" is defined in section 995-1 of the ITAA 1997 to have the meaning described in section 328-125.

Subsection 328-125(1) considers an entity is connected with another entity if either entity controls the other entity or both entities are controlled by a third entity.

As the Partnership is not a discretionary trust, subsection 328-125(2) provides that the Rulee and their affiliates control the Partnership if they own, or have the right to acquire the ownership of, interests in the Partnership that carry between them the right to receive at least 40% of the net income of the partnership. As the other partners of the Partnership are not considered to be affiliates of the Rulee as discussed above, the Rulee's interest in the Partnership alone will not amount to an entitlement to at least 40% of the net income of the Partnership. As such, the Commissioner does not consider the Partnership to be connected with the Rulee.

As the Service Trust is a discretionary trust, control over the trust should be considered by reference to subsections 328-125(3) and (4).

In your submission, you state that the Partnership engages the Service Trust to provide various services to the Partnership and that the partners or their associates are potential beneficiaries of the Service Trust.

The Service Trust operates as a separate business from the Rulee and the Partnership. The trustee of the Service Trust has a board separate to the Board of the Partnership.

As a potential beneficiary of the Service Trust, the Rulee may recommend to the trustee of the Service Trust (as the case may be) that it consider making a distribution to the Rulee or a relevant associate of his. However, the Trustee has discretion whether to act on that. Therefore, it could not be said that the Rulee controls the trust under subsection 328-125(3) as the trustee of the Service Trust does not act in accordance with the directions of the Rulee.

Generally, the trustee of the Service Trust distributes income as follows:

(a) for partners on fixed draws, generally a percentage of their fixed draw amount is set for the relevant financial year and paid out (to them or relevant associates), and

(b) for partners on units, the balance of net income is paid out (to them or relevant associates) based on the number of units each partner holds divided by the total number of units then existing (noting the comments above about retirees during the relevant financial year).

Having regard to the number of partners in the Partnership to whom the trustee of the Service Trust distributes income, it is unlikely that 40% of the income or capital of the Service Trust will be distributed to the Rulee. As such, the Rulee is not considered to control the Service Trust under subsection 328-125(4).

Accordingly, the Commissioner does not regard the Service Trust as being entity connected with the Rulee or his affiliates for the purpose of the maximum net asset value test in section 152-15.

Question 7

Basic small business relief - small business 50% reduction (Subdivision 152-A)

A key requirement of the basic conditions contained in section 152-10 of the ITAA 1997 is paragraph (d) of that section, which requires that the CGT asset satisfies the 'active asset test' contained in section 152-35 of the ITAA 1997.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business.

Subsection 152-35(1) of the ITAA 1997 states that a CGT asset satisfies the active asset test if:

• you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the period of ownership, or

• you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 and a half years.

Subsection 152-40(1) of the ITAA 1997 provides that an asset is an active asset if the asset is an intangible asset you own and is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or an entity connected with you.

In your case, your interest in the Partnership is an intangible asset. It was through this interest that you carried on a business in partnership with others. Your interest in the Partnership is inseparable from the business (and therefore inherently connected with the business) that you carried on. As such, the interest is considered an active asset.

As your partnership interest was necessarily employed as an active asset throughout the whole period that you held it, the active asset test is satisfied.

The Commissioner accepts where the 'maximum net asset value test' is satisfied having regard to Assumption (2) of this ruling and hence the responses to questions (5) and (6), that the basic conditions in Subdivision 152-A of the ITAA 1997 are satisfied. Therefore the capital gain remaining after applying the method statement in subsection 102-5(1) of the ITAA 1997 is reduced by 50% (refer to subsection 152-205 of the ITAA 1997 and Subdivision 152-A of the ITAA 1997).

15 year rule - CGT exemption (Subdivision 152-B)

For completeness, it should also be noted that the 15 year rule exemption does not apply because the Rulee has also not retired and is not permanently incapacitated - refer to section 152-215 and paragraph 152-105(d) of the ITAA 1997.

Question 8

The characterisation of proceeds received from assigning a portion of your partnership interest

The Commissioner agrees that the proceeds from an assignment of a portion of the Rulee's interest in the partnership will not result in an amount being included in the assessable income of the Rulee on revenue account, other than by way of a capital gain as statutory income in accordance with section 102-5 of the ITAA 1997.

Question 9

Income tax consequences following the Assignment

The Commissioner agrees that the share of the income of the Partnership which has been effectively assigned to the Family Trust will not be required to be included in the Rulee's assessable income in the income year of the Assignment or in later income years, while the Assignment is effective. From the time the Assignment takes effect, each beneficiary of the Family Trust, who receives a distribution from the Family Trust in respect of the share of the income to which the Assigned interest relates, will be required to account for their share of that income.

Furthermore, the Commissioner agrees that, in the income year of the Assignment, no daily apportionment is required, consistent with the principles set out in the cases of Everett and Galland.