Edited version of your written advice

Authorisation Number: 1051405700575

Date of advice: 1 August 2018

Ruling

Subject: Sale of shares in pre-CGT business

Question 1

Are the shares held by the Unit Trust (UT) in X Pty Ltd (X) pre-capital gains tax (CGT) assets by virtue of the roll-over election made pursuant to the former section 160ZZN of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 2

Will any capital gain or loss arising as a result of CGT event A1 happening in relation to the sale of the shares in X by the UT be disregarded under section 104-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 3

Is the whole of the business goodwill owned by X an asset that was acquired before 20 September 1985?

Answer

Yes

Question 4

Will CGT event K6 happen under section 104-230 of the ITAA 1997 in relation to the proposed sale of the shares in X?

Answer

No

Question 5

Will CGT event E4 be disregarded under section 104-70 of the ITAA 1997 in relation to the proposed distribution by the UT to its beneficiaries of the proceeds received from the sale of the shares in X?

Answer

Yes

This ruling applies for the following period(s)

Income years ending 30 June 2018 and 30 June 2019

The scheme commences on

1 July 2017

Relevant facts and circumstances

History of ownership

The business was initially conducted by family members for a number of years prior to 20 September 1985. The business was transferred to the UT, following its establishment in 198Y. In 199Y the business was transferred to X (a company wholly owned by UT) which has conducted the business since that time. The family members have continued to run and control the business.

Initial structure

The Y Family Trust (YFT), of which ABC Pty Ltd is trustee, is a discretionary trust that was established in 198Y.

The Z Family Trust (ZFT), of which CDE Pty Ltd is trustee, is a discretionary trust that was established in 198Y.

The UT, of which EFG Pty Ltd is trustee, is a unit trust that was established in 198Y.

All of the units in the UT are held equally by YFT and ZFT, and have been held since the establishment of the UT.

Transfer of business in 199Y

In 199Y, the UT entered into an agreement with X for the transfer of the business. The terms of the agreement were such that:

● The UT agreed to sell the goodwill of the business conducted by it to X; and

● The UT agreed to hire to X the plant and equipment used in the conduct of the business. Stock on hand at the time of the transfer remained owned by the UT.

In effect, only the goodwill of the business was transferred to X, with the tangible assets necessary for it to conduct the business being made available by hire.

As consideration for the transfer of the goodwill, X agreed to issue a number of fully paid ordinary $1 shares to UT, an amount equal to the market value of the goodwill of the business.

The UT elected for a roll-over under former subsection 160ZZN(4) of the ITAA 1936 in respect of the sale of the goodwill to X. A copy of this election has been provided with this Ruling application.

Settlement for the transfer of goodwill was effected on 30 June 199Y.

Current ownership

X has remained the owner of the business and goodwill, which has continued to be operated by X and its subsidiaries.

The shares in X have remained in the ownership of the UT, no further shares have been issued by X.

YFT and ZFT have each maintained their equal share of the units in the HUT.

Distributions of income from the YFT and the ZFT have only ever been made to the family members.

Division 149 of the ITAA 1997 has not applied to deem any pre-CGT assets of X to be acquired after 19 September 1985.

Nature of the business prior to 20 September 1985

The applicant has provided extensive details of the business activities, processes and customers, from the commencement of business to 19 September 1985.

Nature of the business after 19 September 1985

X has continued to grow its business and expand its product range with a continued focus on quality, vertical integration and product development.

The applicant has provided extensive details of the business activities, processes and customers from 20 September 1985 to the present day.

Importantly, the same activities and processes continue to be utilised, albeit with some changes for technology, and the customer base remains largely from the same industry as from the commencement of the business.

Subsidiaries

X has a number of subsidiary companies overseas. Extensive details were provided with the ruling application. Each subsidiary interacts directly with X in Australia and is controlled and monitored by X.

Acquired businesses

X acquired the physical assets of two small businesses:

Both acquisitions were immediately subsumed into the business operations, and no separately identifiable goodwill of either remains.

Other matters

The business has been controlled by its directors since its inception.

The trading name and logo has been used continually since its inception, in a largely unchanged form.

The core customer base has remained from the same industry. Organic growth has seen the number of those customers increase since 1985.

The activities and processes have remained, although there have been technological improvements.

A further activity was undertaken by X in the mid-2000s, but this production ceased in 201Y.

A number of brochures, both current and historical, of the business have been provided.

Proposed sale of shares in X Pty Ltd

The UT is in negotiations with a potential purchaser for the sale of the shares in X. The principal terms of the proposed sale are as follows:

● The sale price of the X shares will be based on an enterprise value for the business of $Z million. This value has been determined on a debt free basis and assumes a level of net working capital equal to the 12 month normalised average monthly net working capital of the business as at Completion.

● The properties owned by X and its subsidiaries are excluded from the sale at the request of the potential purchaser.

These properties are significant post-CGT assets and will be disposed of by X prior to the sale, with resultant CGT liability to be paid. These properties will be sold by X to entities controlled by the family members.

Accordingly, the following adjustments will be made to the enterprise value of the business to determine the purchase price for the shares in X:

● Reduce the enterprise value by the amount of the debt (including lease liabilities) of the business group

● Increase the share price by the value of the properties owned directly and indirectly by the group

● Increase/decrease the share price by the excess/deficiency of the net working capital at Completion compared to the 12 month normalised average monthly net working capital.

Following receipt of the consideration for the sale of the shares, the UT will distribute the amounts received to its unitholders in equal proportions.

Value of assets

For the purposes of calculating whether CGT event K6 applies, the value of the relevant assets was determined by X as follows:

● Cash and receivables

These are valued at face value

● Plant and equipment

It is considered by X that the book value of these items is an appropriate proxy for their market value. The value of the business principally derives from the quality and product development processes employed in the business – the items of plant and equipment used have been updated for technological advances but continue to be used within those established practices.

A number of items of plant and equipment have been modified and are so specialised to the business’ activities and processes that they have no value, or only scrap value, outside of the business.

● Subsidiaries and goodwill

The subsidiaries of X are wholly dependent on X for their operations.

The principal factor in the success of the business is its reputation with its customers for quality and timeliness. Without this, the subsidiaries would have little asset value (other than tangible assets) that a third party would be willing to purchase separately from X’s business.

It is considered that the subsidiaries do not have any valuable goodwill, nor do they have any long term contracts or other intangible assets to which a value can be attributed. Accordingly, the market value of the shares in these subsidiaries is equal to no more than the net book value of the respective company.

X considers that the only valuable goodwill within the group is the goodwill of the business conducted by X – that is, the value of the goodwill inherent in the offer for the purchase of the business reflects the value of the goodwill owned by X.

A copy of the balance sheet values of each entity in the group as at a certain date in 2018 has been provided to the Commissioner along with the CGT event K6 calculations.

The data shows that the market value of post CGT property is approx. 55% of the overall value of X.

There will be no change to values before the final date of sale that will vary this percent significantly.

Relevant legislative provisions

Section 160ZZN of the ITAA 1936

Section 104-10 of the ITAA 1997

Section 104-70 of the ITAA 1997

Section 104-230 of the ITAA 1997

Reasons for decision

Question 1

Former section 160ZZN of the ITAA 1936 provided CGT roll-over relief for assets transferred to a wholly-owned company. Subsection 160ZZN(4) of the ITAA 1936 applied to transfers by trustees, and provided the following:

Where -

(a) one of the following subparagraphs applies: (i) a taxpayer in the capacity of a trustee of a trust estate that is a resident trust estate or of a unit trust that is a resident unit trust disposes of an asset (in this section also called a ``roll-over asset'' ) of the trust estate or of the unit trust to a company that is a resident of Australia; (ii) … …
(b) subject to subsection (5A), the consideration in respect of the disposal consists only of non-redeemable shares in the company;
(ba) the market value of the shares is substantially the same as the market value of the roll-over asset, reduced, if the company assumes in connection with the disposal a liability or liabilities in respect of the roll-over asset, by the amount of the liability or the total of the amounts of the liabilities;
(c) immediately after the disposal the taxpayer owns all the shares in the company and holds those shares upon the same trust as the taxpayer held the roll-over asset that was disposed of to the company;
(ca) the roll-over asset is not trading stock of the company immediately after its acquisition by the company;
(cb) …
(d) the taxpayer has, by notice in writing given to the Commissioner on or before the date of lodgment of the return of income of the taxpayer for the year of income in which the disposal took place, or within such further period as the Commissioner allows, elected that this subsection is to apply in respect of the disposal,

this Part (other than this section) does not apply in respect of the disposal and -

(e) if the roll-over asset was acquired by the taxpayer in the capacity of a trustee of the trust concerned before 20 September 1985 - the company shall be deemed, for the purposes of this Part, to have acquired the roll-over asset before that date; or (f) …

Where these requirements have been satisfied, former subsection 160ZZN(7) of the ITAA 1936 prescribes that if the asset was acquired prior to 20 September 1985, then the consideration received for that asset will also be deemed to have been acquired before that date.

In this case, on 30 June 199Y, the UT, a resident unit trust, disposed of an asset (the goodwill of the business) to X, a company resident in Australia. The consideration in respect of the disposal was full paid $1 ordinary, non-redeemable shares in X, equal to the market value of the goodwill acquired.

Immediately after the disposal, the UT owned all the shares in X and held them in the same trust that had previously held the goodwill. A copy of the rollover election was made in 199Y and provided to the Commissioner.

The asset (the goodwill of the business that was disposed of in the transfer) was acquired by the UT before 20 September 1985 (this is discussed further at Question 3 below). As a consequence, the shares in X that were consideration paid for the disposal of the goodwill are also deemed to have been acquired before 20 September 1985.

Question 2

Section 104-10 of the ITAA 1997 provides that CGT event A1 happens if you dispose of a CGT asset. However, subsection 104-10(5) of the ITAA 1997 provides that any capital gain or capital loss is disregarded if you acquired the asset before 20 September 1985.

In this case, the UT is disposing of a CGT asset, its shares in X, and therefore CGT event A1 will occur. As a consequence of the roll-over considered in Question 1 above, UT’s shares in X are deemed to have been acquired prior to 20 September 1985.

However, in certain circumstances you can make a capital gain if you dispose of shares in a company that you acquired before September 1985 (this is discussed further at Question 4 below).

Therefore, in this case, any capital gain or loss on the disposal of the X shares by the UT will be disregarded under subsection 104-10(5) of the ITAA 1997.

Question 3

Taxation ruling TR 1999/16 Income tax: capital gains: goodwill of a business (TR 1999/16) discusses when goodwill is considered to be acquired. Taxation Ruling TR 1999/16 states at paragraph 17:

The whole of the goodwill of a business that commenced before 20 September 1985 remains the same single pre-CGT asset (subject to Division 149 - about when an asset stops being a pre-CGT asset...) provided the same business continues to be carried on. This is so even though:

(a) the sources of the goodwill of a business may vary during the life of the business; or

(b) there are fluctuations in goodwill during the life of the business.

TR 1999/16 also recognises at paragraph 18 that a business or the sources of its goodwill may change so much that it can no longer be said to be the same business.

Whether the same business is being carried on is a question of fact and degree that ultimately depends on the circumstances of each particular case.

Paragraph 21 of TR 1999/16 provides that the business does not need to be identical from its acquisition to its disposal. If the essential nature or character of the business is not changed, the business remains the same business for the CGT goodwill provisions. A business owner may expand or contract activities, or change the way in which a business is carried on, without ceasing to carry on the same business provided the business retains its essential nature or character. Organic growth, expansion or diversification of a business does not of itself cause it to be a new business, providing the business retains its essential nature or character.

Paragraph 24 of TR 1999/16 provides the same business is not being carried on if

(a) through a planned or systematic process of change within a reasonable period of time, a business changes its essential nature or character; or

(b) there is a sudden and dramatic change in the business brought about by either the acquisition or the shedding of activities on a considerable scale.

Additionally, TR 1999/16 states at paragraph 25 that the goodwill is a composite asset. That is, the whole of the goodwill of a business will either be a pre-CGT goodwill or post-CGT goodwill. It cannot be split into a pre-CGT and a post-CGT portion.

Paragraphs 60 to 62 of TR 1999/16 discuss whether new goodwill is acquired when an existing business either expands, or commences a new business. Where a new business operation is merely the expansion of an existing business, any goodwill built up will be an expansion of the existing goodwill of the business. On the other hand, if the new business activity is a new business, the goodwill attaching to that business activity will be a new separate asset to the goodwill of the existing business.

Paragraph 62 of TR 1999/16 provides the following factors that should be taken into account in determining whether there is merely an expansion of an existing activity or there is a new business activity commenced:

• nature of the new business operation or activity;

• types of customers that the business operation or activity attracts;

• extent to which the business operation or activity:

• is subject to the same integrated management and control as the existing business

• is treated for banking and accounting purposes as an extension of the existing business or as a separate business

• uses one or more different trading names

• is related to or dependent on the exiting business in a practical, economic or commercial sense.

Paragraphs 91 – 95 of TR 1999/16 consider the factors to take into account in considering whether a business has changed to such an extent that it is no longer the same business. Factors include:

● the nature or character of the business;

● its location and size;

● the extent of changes in the assets and resources;

● the activities of the business; and

● the way in which the business is structured, carried on, managed and controlled.

The above factors will now be considered in relation to the circumstances.

Since the commencement of the business, the trading name and logo has been used continually in a largely unchanged form. The business has remained based in the same region, and has added a number of facilities around the same location, as well as expanding with some overseas locations through necessity. The business structure, management and control of the business have remained unchanged, with the family members in control of all aspects of it.

The main business activities have remained unchanged. There has been significant expansion of the business, but this has occurred gradually over the many years the business has been operating.

New activities have complemented or added to the core business. As a result of the reputation of the business, some of the business expansion has come about as a result of requests from their customers. Growth has seen the number of those customers expand over time.

After considering the above factors of TR 1999/16 alongside the circumstances of the business over time, the Commissioner is satisfied that the essential nature or character of the business has not changed as a result of any activities or changes introduced since September 1985. Growth and expansion has occurred, along with some changes in processes and technology, but these have happened naturally as a result of the business growth over a long period of time. The business has remained as the same business for the CGT goodwill provisions and therefore all of the goodwill is considered to be a pre-CGT asset.

Question 4

In accordance with section 104-230 of the ITAA 1997:

(1) CGT event K6 happens if:

(a) you own shares in a company or an interest in a trust you acquired before 20 September 1985; and

(b) CGT event A1, C2, E1, E2, E3, E5, E6, E7, E8, J1, or K3 happens in relation to the shares or interest; and

(c) there is no roll-over for the other CGT event; and

(d) the applicable requirement in subsection (2) is satisfied.

(2) Just before the other event happened:

(a) The market value of property of the company or trust (that is not its trading stock) that was acquired on or after 20 September 1985; or

(b) The market value of interests the company or trust owned through interposed companies or trusts in property (except trading stock) that was acquired on or after 20 September 1985;

must be at least 75% of the net value of the company or trust.

Taxation ruling TR 2004/18 Income tax: capital gains: application of CGT event K6 (about pre-CGT shares and pre-CGT trust interests) in section 104-230 of the Income Tax Assessment Act 1997 states that the term 'property' for the purposes of CGT event K6 has its ordinary meaning, and will include goodwill.

In this situation, the UT owns shares in X, which were acquired before 20 September 1985, and CGT event A1 will be happen once they are sold, and there is no roll-over for this event. Therefore, the first 3 requirements in subsection 104-230(1) of the ITAA 1997 are satisfied.

It is therefore now necessary to consider whether the market value of the property of X that was acquired on or after 20 September 1985 is at least 75% of the net value of the company.

It was determined in question 3 above that the goodwill of X is a pre-CGT asset, and therefore will not be included in the calculation of property acquired after 19 September 1985 for the purposes of CGT event K6.

As per the information provided, the market value of X’s relevant post-CGT property is anticipated to be approx. 55% of the net value of X at the time of CGT event A1.

From the information provided, the value of X’s interest in its subsidiaries represents approximately 32% of the net value of X.

Accordingly, the requirements of paragraphs 104-230(2)(a) and (b) are not satisfied, and therefore CGT event K6 will not happen.

Question 5

Subsection 104-70(1) of the ITAA 1997 provides that CGT event E4 happens if:

(a) the trustee of a trust makes a payment to you in respect of your unit or your interest in the trust …; and

(b) some or all of the payment (the non-assessable part) is not included in your assessable income.

Subsection 104-70(1) of the ITAA 1997 further provides that event E4 is disregarded if you acquired the unit or interest before 20 September 1985.

In this case UT will be making non-assessable payments to its unitholders, as a result of the sale proceeds arising from the sale of its shares in X.

However, both the YFT and the ZFT acquired their units in UT prior to 20 September 1985. Therefore, as the interests in the units are pre-CGT, CGT event E4 will be disregarded.