Edited version of your written advice

Authorisation Number: 1051180438334

Date of advice: 23 February 2017

Ruling

Subject: Capital gains tax consequence of an 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 the Partner assigns, by way of declaration of trust, a beneficial interest in each Partnership in the Partnership Group to a trust?

Answer

Yes.

Question 2

Will CGT event E2 under section 104-60 happen when the Partner assigns, by way of declaration of trust, a beneficial interest in each Partnership in the Partnership Group to a trust?

Answer

No.

Question 3

Will CGT event A1 under section 104-10 happen when the Partner assigns, by way of declaration of trust, a beneficial interest in each Partnership in the Partnership Group to a trust?

Answer

No.

Question 4

Assuming either CGT event E1, E2 or A1 happens, for CGT purposes, will the capital proceeds for the disposal of each partnership interest to a trust be the nominal consideration received by the Partner for the assignment?

Answer

No.

Question 5

Assuming either CGT event E1, E2 or A1 happens, for CGT purposes, will the capital proceeds for the Partner's disposal of each partnership interest to a trust be the deemed market value consideration under subsection 116-30(1) of the ITAA 1997 for the CGT event?

Answer

Yes.

Question 6

Assuming either CGT event E1, E2 or A1 happen, will the CGT event happen in relation to an active asset, for the purposes of section 152-40 of the ITAA 1997?

Answer

Yes.

Question 7

In calculating any CGT payable by the Partner on the disposal of each partnership interest to a trust, are the other partners in the Partnership affiliates of the Partner 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 8

In calculating any CGT payable by the Partner on the disposal of each partnership interest to a trust, is the Service Entity Partnership:

● an entity connected with the Partner as defined under section 328-125 of the ITAA 1997; or

● an affiliate of the Partner 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 9

If the Corporate Trustee, being a partner in the Service Entity Partnership, is an affiliate of the Partner, then are other partners of the Service Entity Partnership connected with the Corporate Trustee as defined under sections 328-125 and 328-130 of the ITAA 1997 respectively for the purposes of the maximum net asset value test under section 152-15 of the ITAA 1997?

Answer

No.

This ruling applies for the following periods:

Income year ending 30 June 2017

The scheme commences on:

1 July 2016

Relevant facts and circumstances

The national partnership consists of various general law partnerships located in capital cities.

You ('the Partner') are an equity partner in a number of these general law partnerships ('the Partnership Group'). The Partner wishes to assign a portion of their interest in the Partnership Group to an associated family discretionary trust.

As standalone entities, each partnership has a separate Partnership Agreement that applies to its partners.

This ruling is only intended to apply to equity partners of the Partnership Group.

New partners become party to the Partnership Agreement by entering into an Accession Deed.

In certain partnerships, there is no entry and exit price for new partners. Equity partners are allocated points by a remuneration committee and each equity partner must contribute a capital loan to the partnership proportionate to total points based on the debt to equity working capital requirements of the business.

Upon departure, equity partners are entitled to the remaining balance of their current account and any capital loans they have contributed.

In other partnerships, there is effectively no entry or exit price for new partners. Equity partners are allocated a percentage of the firm by a remuneration committee and the working capital is funded by way of retained earnings. New equity partners must acquire a percentage based on the value of proportionate Net Tangible Assets of the firm. The acquiring partner pays the selling down partner(s) the NTA value, but simultaneously, an equivalent amount is transferred as a book entry from the selling down partner's current account.

Goodwill is not recognised either in the balance sheet of any of the Partnerships or for any other purpose.

The Partnership Agreements of some partnerships in the Partnership Group permit a Vendor Partner to be paid an amount for goodwill upon departure. However this is upon the occurrence of a sale event (other than an admission or retirement). Entering or exiting partners only pay or receive the value of proportionate Net Tangible Assets of the partnership. The Net Tangible Asset value does not include any value attributed to goodwill.

The Partnership Group uses a partnership structure to operate its service entity, the Service Entity Partnership, that provides various services to the Partnership Group to undertake its professional services business.

The Service Administration Entity acts as the corporate agent on behalf of the Service Entity Partnership nationally. The corporate agent does not have any financial operations of its own right; it operates under a service agreement with the Service Entity Partnership.

There are approximately X partners in the Service Entity Partnership. These partners are typically companies acting as trustees for discretionary family trusts of partners of the Partnership Group. The Partner's associated entity, the Corporate Trustee, is a partner in the Service Entity Partnership.

For each of the income years ended 30 June 2013 to 30 June 2016, each partner and their nominated associates had a maximum interest of less than 10% of the income and capital of the Service Entity Partnership.

The Partnership Group is working to identify alternatives that may increase partner retention, attract new talent and reduce the risks attaching to operations and partners that may otherwise inhibit the ability of the Partnership Group to grow.

The Partnership Agreements already permit partners to assign a portion of his or her partnership interest by way of declaration of trust ('Everett assignment'), where specifically agreed upon by at least 75% of the partners of the relevant partnership by way of a vote. Prior written consent of the other parties to the Partnership Agreement, as required by a clause in the Partnership Agreement, would not be granted without a declaration that the Management Team Policy Guidelines were met in their entirety.

Under the arrangement, the Partner proposes to assign up to approximately A% of their interest in the income from each partnership in the Partnership Group to an associated discretionary family trust ('Trust B') through an irrevocable declaration of trust (in effect creating 'Trust A'), whereby the Partner declares their holds up to A% of their interest in each partnership in the Partnership Group in trust (i.e. as trustee of Trust A) for the benefit of Trust B. Trust B will be the sole beneficiary of Trust A.

Trust A will receive income from the Partnership Group and distribute this in full to Trust B. Trust A will undertake no further transactions.

Trust B will pay a nominal consideration, $1, for the assigned partnership interest.

The assignment, by declaration of trust, will effect the assignment of all beneficial rights associated with the partnership interest, including the right to receive the share of income of the partnerships.

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

The Partner will not be the trustee of Trust B, or control a corporate trustee of Trust B.

The potential beneficiaries of Trust B will be limited to family members or entities associated with the Partner and arm's length charities. While the Partner is a partner of the Partnership Group, they will not be a beneficiary of Trust B but may be a shareholder of a corporate beneficiary of Trust B.

Assumptions

Documents giving effect to the assignment will be prepared in a manner which is consistent with and which provides the same legal effect as the assignments considered in:

● Federal Commissioner of Taxation v Everett (1980) 143 CLR 440 (Everett), and

● Federal Commissioner of Taxation v Galland (1986) 162 CLR 408 (Galland)

A trust relationship will come into existence consistent with the decision in Everett.

A market valuation will be obtained from an independent accredited valuer in relation to the assigned partnership interest of the Partner. The valuer will be instructed to apply the relevant principles from the decision of the Supreme Court of Western Australia in Reynolds v Commissioner of State Taxation (WA) 86 ATC 4528 (Reynolds). This valuation will also take into account the Commissioner's statement at paragraph 28 of Taxation Ruling IT 2540 Income Tax: Capital gains: Application to disposal of partnership assets and partnership interests.

The Partner is a capital or full equity partner of the Partnership Group and this response is based on the facts and arrangements pertaining to capital or full equity partners. Therefore, the questions answered in this advice are intended to only cover issues for capital or full equity partners. This advice is not intended to apply to fixed draw partners, non-equity partners or limited equity partners.

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

Relevant CGT event on holding a portion of your partnership interest as trustee

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

CGT Event E1

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.

It is considered that the first condition will be 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 Group as trustee of Trust A for the benefit of 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 Group in trust for the benefit of Trust B. A resolution that the 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.

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

CGT Event E2

Section 104-60 of the ITAA 1997 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 Group in trust for the benefit of Trust B. Whilst Trust B will exist prior to the assignment being entered into, the entering into of the assignment by declaration of trust will give rise to a new trust (i.e. Trust A) 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 of the ITAA 1997 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 Group. 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 of Trust A.

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.

Capital proceeds for the disposal of your partnership interest

Subsection 104-55(3) of the ITAA 1997 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 of the ITAA 1997 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 Trust B for nominal consideration of $1, 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') 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 of IT 2540 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 ('Granby') 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 you propose to assign a proportion of your partnership interest to Trust B for $1 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 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 the nominal capital proceeds of $1 do not reflect the value which an interest in the Partnership would expect to 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'. 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.

Partnership interest as an active asset

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 152-40(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, your partnership interest is considered an active asset.

Other partners of the Partnership as entities connected with or affiliates of yours

For the purposes of the maximum net asset value test set out in section 152-15 of the ITAA 1997, paragraphs (b) and (c) of this section requires you to include in the calculation the net value of CGT assets of:

● any entities connected with you, and

● any affiliates of yours or entities connected with your affiliates.

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

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 a partner in the Partnership Group, you have a business relationship with the other partners and you do not control the other partners in a way described in section 382-125. The Commissioner does not consider the other partners in the Partnership Group to be entities connected with you for the purposes of section 152-15.

The term 'affiliate' is defined by section 995-1 to have the meaning described in section 328-130 of the ITAA 1997.

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.

Furthermore an example is provided in section 328-130 in relation to partners in a partnership not being affiliates of each other by acting in concert with each other in relation to the affairs of the partnership.

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

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

The Service Entity Partnership as entities connected with or affiliates of yours

For the purposes of the maximum net asset value test in section 152-15, it is also necessary to consider if the Service Entity Partnership is an entity connected with or affiliate of yours.

As the Service Entity is a partnership, control over the partnership should be considered by reference to subsection 328-125(2).

As there are X partners in the Service Entity Partnership, it is unlikely that you have or will have the right to at least 40% of any distribution of net income or capital of the Service Entity Partnership.

Therefore the Commissioner does not consider the Service Entity Partnership to be an entity connected with you for the purposes of section 152-15.

Subsection 328-130(1) provides the criteria to consider if an individual or company is an affiliate of another entity. As the Service Entity is a partnership, this section is not applicable.

The Commissioner does not consider the Service Entity Partnership to be affiliate of yours for the purposes of section 152-15.

Other partners of the Service Entity Partnership as entities connected with the Corporate Trustee

Assuming the Corporate Trustee is your affiliate, it is necessary for the purposes of the maximum net asset value test in section 152-15 to consider if the Service Entity Partnership and its partners are entities connected with the Corporate Trustee.

As the Service Entity is a partnership, control over the partnership should be considered by reference to paragraph 328-125(2)(a).

You have stated in your private ruling request that each equity partner in the Partnership Group holds an interest in the Service Entity Partnership through their nominated associates, being a company or a company acting as trustee for a family trust.

As there are approximately X partners in the Service Entity Partnership, each with less than 10% interest in the Service Entity Partnership's income and capital, it is unlikely that the Corporate Trustee has or will have the right to at least 40% of any distribution of net income or capital of the Service Entity Partnership.

Therefore the Commissioner does not consider the Service Entity Partnership to be an entity connected with the Corporate Trustee for the purposes of section 152-15.

In relation to the other partners in the Service Entity Partnership, the Corporate Trustee does not receive or have the right to receive any distribution of income or capital from these entities. There is also no expectation that the other partners in the Service Entity Partnership will act in accordance with the Corporate Trustee's directions or wishes. Accordingly, the Commissioner does not consider the other partners in the Service Entity Partnership to be connected with the Corporate Trustee for the purposes of section 152-15.