Edited version of your written advice

Authorisation Number: 1013121372522

Date of advice: 9 November 2016

Ruling

Subject: Capital gains tax

Question 1

Are the applicants affiliates of each other or of the Company, under section 328-130 or 152-47(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

If the applicants are affiliates of each other do they exclude the shares held by their affiliate because of section 152-20(3) of the ITAA 1997?

Answer

Not applicable. The applicants are not affiliates of each other

Question 3

Are the applicants' conditional rights to acquire shares in the Company from other shareholders included when determining if they are 'connected' with the Company under subsection 328-125(2)(b) of the ITAA 1997?

Answer

No

Question 4

Do earn out rights fall under the definition of 118-565 of the ITAA 1997, to qualify for the look-through treatment?

Answer

Yes

This ruling applies for the following periods:

Years ending 30 June 201X to 20XX

The scheme commences on:

1 July 201X

Relevant facts and circumstances

In late 20XX, the Company was incorporated with Applicant 1 and Applicant 2 as administrators with an X0% shareholding of one ordinary share each. Applicant 1 and Applicant 2 are family members.

The main business activity is described as consultancy The business locations are in various states. The Company owned all assets used in the business.

In late 20XX, the original Company shares were split into a total of 100 shares - Applicant 1 and Applicant 2 held X0 ordinary shares each.

In early 20XX:

● Individual 1 became an Administrator.

● A shareholder's deed was executed between Individual 1, Individual 1's nominated entity, Applicant 1, Applicant 2 and the Company. It was agreed X0% interest will be acquired by Individual 1's nominated entity in two tranches.

● X0% interest in the Company was transferred to Individual 1's nominated entity - X% each from Applicant 1 and Applicant 2.

● Pursuant to the shareholder's deed:

● a call option to acquire the remaining X0%

● a put option to sell back the shares

● Applicant 1 and Applicant 2 can exercise a call option to acquire the shares in the event Individual 1's contractor agreement was terminated (Termination Call Option). This Independent Contract Agreement with the Company is effective DD MM YY.

In early-mid 20XX a relevant document was signed between Applicant 1, Applicant 2 and Public Company, showing the proposed sale of 100% Company shares to Public Company.

In early-mid 20XX:

● X0% interest in the Company was transferred to Individual 2's nominated entity - X% each from Applicant 1 and Applicant 2.

● A Shareholders' Deed between Applicant 1, Applicant 2, Individual 1, Individual 1's nominated entity, Individual 2 and Individual 2's nominated entity was executed.

● Pursuant to the shareholder's deed:

● a put option to sell back the shares

● Applicant 1 and Applicant 2 can exercise a call option to acquire the shares in the event Individual 2's employment was terminated (Termination Call Option). The revised contract of employment with the Company is effective early-mid 20XX.

In mid 20XX, a X0% interest in the Company was transferred to Individual 1's nominated entity - X% each from Applicant 1 and Applicant 2.

In mid 20XX, 100% shares in the Company were acquired and transferred to Public Company. A Share Sale and Purchase Agreement were executed, including the following:

● Earn Out Period: means, as the case requires, the FY16, FY17 or FY18 and Earn Out Periods means all of them.

● Purchase Price and the Earn Out Amounts

● Determination of Earn Out Amounts: Calculation involving the EBITDA (earnings before interest, tax, depreciation and amortisation).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-130

Income Tax Assessment Act 1997 section 152-47

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 Subsection 118-565(1)

Reasons for decision

Each applicant has to determine whether they are affiliates of each other and/or of the Company.

Affiliate

An affiliate is defined by section 328-130 of the Income Tax Assessment Act 1997 (ITAA 1997) as being an individual or company who acts or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the individual or company.

Relevant factors that may support a finding that a person acts in such a manner include:

● the existence of a close family relationship between the parties;

● the lack of any formal agreement or formal relationship between the parties dictating how the parties are to act in relation to each other;

● the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements or legal or fiduciary obligations; and

● the actions of the parties.

Whether a person is acting in concert with another is essentially a question of fact. The term 'acting in concert' involves at least an understanding between the parties as to a common purpose or object.

A person is not your affiliate merely because of the nature of a business relationship you and the entity share. For example, companies are not affiliates of their administrators and vice versa, merely because of the positions held. Administrators of the same company are also not affiliates merely because one administrators acts, or could reasonably be expected to act, in accordance with the directions or wishes of another administrator, or in concert with another administrator, in relation to the affairs of the company. This is confirmed in the example in section 328-130 of the ITAA 1997.

Whether family members may be an affiliate is provided under section 152-47 of the ITAA 1997.

In this case, the business relationship between each applicant, does not demonstrate they are affiliates of each other or of the Company.

Entity 'connected with' you

The applicants' private ruling has requested whether conditional rights created under shareholder deeds with the Company's shareholders are included to connect them to the Company.

Subsection 328-125(1) of the ITAA 1997 explains that an entity is connected with another entity if:

a) either entity controls the other entity in a way described in this section; or

b) both entities are controlled in a way described in this section by the same third entity.

Subsection 328-125(2) of the ITAA 1997 provides that an entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates: if the other entity is a company - beneficially owns, or has the right to acquire beneficial ownership of, equity interests in the company that give at least X0% of the voting power in the company.

In this case, when the completion of sale occurs, each applicant holds less than X0% each of the interests in the Company. The shareholder deeds' conditional rights, in particular, the Termination Call Options, between the applicants and remaining shareholders has not created a beneficial interest or right to acquire a beneficial interest in the Company. The remaining shareholders have ownership interests in the Company.

The applicant's conditional rights to acquire shares will not be included when determining the control percentage to connect either of them with the Company.

Look through earn out rights

The sale of the Company's shares to Public Company includes earn out rights. The applicants have requested a private ruling on whether they would be look through earn out rights under subsection 118-565(1) of the ITAA 1997.

Look through capital gains tax treatment for earn out rights applies to look through earn out rights created on or after 24 April 2015. A right is a look through earn out right under subsection 118-565(1) if all of the following are satisfied:

(a) the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created

(b) the right is created under an arrangement that involves a disposal of a CGT asset

(c) the disposal causes CGT event A1 to happen

(d) just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset

(e) all of the financial benefits that can be provided under the right are to be provided within a period ending no later than five years after the end of the income year in which the CGT event happens

(f) those financial benefits are contingent on the economic performance of the CGT asset or a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate

(g) the value of those financial benefits reasonably relates to that economic performance, and

(h) the parties to the arrangement deal with each other at arm's length in making the arrangement.

In this case, the earn out right was created by arm's length parties the Company and Public Company after DD MM YY therefore look through treatment is applicable. The right was created from the shale sale of the Company (CGT Event A1). Applicant 1 and Applicant 2's shareholdings will be active assets. The earn out periods are within the required five year period and earn out amounts will be determined based on economic performance.

The earn out right satisfies all of the above requirements under subsection 118-565(1) to support look through capital gains treatment.