Edited version of private advice

Authorisation Number: 1051696256784

Date of advice: 13 July 2020

Ruling

Subject: Capital gains tax event on changing from partnership to company

Question 1

If a company already exists, in which shares are held 50/50 by two siblings (in their own names) and a partnership asset is similarly held (each sibling holds 7% of the partnership asset directly, and an additional 43% each through two bare trusts which were established as part of the administration of the estate of their late parent) are the requirements of s122-135 (partners must own all of the shares in the company just after the trigger event) satisfied if the additional shares are issued by the company to the siblings (but not the bare trustees)?

Answer

Yes, to the extent the full interest of the partners in the partnership must own all the shares in the company just after the time of the trigger event. The composition of the partnership must pass onto the company.

Question 2

Where the partners (either as two individuals or as two individuals and two bare trusts) are eligible to, and do, make a choice under s122-150 to disregard the capital gain on the disposal of the partnership asset to the company, will Part IV A apply?

Answer

Yes, depending on the reasons for your transfer as well as if the assets from the bare trust are being fully transferred to the company.

This ruling applies for the following periods:

01 July 2019 - 30 June 2020

The scheme commences on:

01 July 2019

Relevant facts and circumstances

You advised that:

1. You, XXXX have a partnership. The partnership constitutes of XXXX, XXXX and XXXX Pty Ltd (as bare trustee for each of two trusts, one for the benefit of XXXX and the other for the benefit of XXXX X that owns real property at XXXX.
2. The real property is subject to a commercial lease with XXXX, the initial term of which expires in XXXX after which there is the option for three renewals of seven years each.
3. The XXXX is a 'bare trust' for the benefit of XXXX and the XXXX is a 'bare trust' for the benefit of XXXX.
4. XXXX beneficially holds 50% of the property (7% directly and 43% through a bare trust) and XXXX holds 50% of the property (7% directly and 43% through a separate bare trust).
5. The XXXX property was previously owned as to XX by XXXX and 86% by yourselves through two specific bare trusts, both of which have XXXX acting as the bare trustee.
6. Upon late XXXX death, the 14% of the property previously owned by XXX was transferred to you both.
7. XXXX (a family investment company), was fully owned by your late parent XXXX and was transferred to yourselves upon death.
8. The partnership holds as assets both the 'real property at XXXX' and a 'chose in action' (being the lease to XXXX).
9. In addition to the 'property at XXXX' and the consequential 'chose in action' which was partly inherited by yourselves from the estate of your late parent, you also inherited shares in the family investment company. The shares in XXXX are now owned with XXXX 50% and XXXX.
10. After your late parent XXXX passed away, the majority of their assets were distributed directly to yourselves. However, it had been late XXXX and your intention to retain the property in XXXX and the XXXX as a legacy for the respective families, including late XXXX grandchildren.
11. You advised that while it was initially contemplated to merely transfer the real property from the partnership to XXXX, the transaction costs in the order of XXXX to XXXX and significant additional conveyance and legal costs were of sufficient quantum to encourage you to consider alternative options.
12. While you considered various alternative postulates, the strategy chosen is to have the partnership grant a 'concurrent lease' to the wholly owned company. This you advise would achieve the following benefits:

a). Administration - having the revenue derived by a company which, while owned in the same proportions as the partnership property, can appoint independent, legally and financially literate directors to administer its affairs which will, it is believed, result in the assets being managed on a more professional and effective basis. The XXXX Constitution is considered the most simple and cost-effective tool to guide decision making.

b). Wealth accretion - it is anticipated that by accumulating the income in a corporate entity, with independent director representation, the legacy assets will be able to be managed on a more effective basis. Rather than requiring each partner to make partnership contributions to the partnership to fund maintenance and growth, the company will be in a position (with the equity holders) to retain profits as is appropriate for maintenance and re-investment purposes.

c). Management expertise - a 'legacy asset' investment strategy will be agreed to by the shareholders. The board, with independent director representation, will have responsibility for managing the assets in accordance with the agreed investment strategy for the benefit of future generations.

d). Legacy intent - having the future rental income accumulate in the company will result in improved asset protection for the company, and each of the equity holders. External to the 'legacy assets' to which this re-structure is directed, both XXXX and XXXX have been involved in business activities which have attributed risk. Even though their shares in XXXX will be at risk, while the lease remains current, and is held by the company, the value of the underlying asset will be better protected by being held in a corporate entity as a result of the involvement of independent directors, and the other shareholder, having influence over the operation of the company, and the allocation of its assets.

e).Asset protection - by transferring the 'chose in action' or granting a 'concurrent lease' to XXXX, the potential value of the XXXX property to acquirers or creditors will be compromised throughout the period that the 'chose in action' is owned or the 'concurrent lease' held by XXXX. This will assist in achieving the desired asset protection strategy in respect of retaining the XXXX property for future of XXXX generations.

f). Working capital - the requirement to retain assets, in the absence of a declaration to pay a dividend, will enable the legacy assets to be maintained, administered and accumulated on a more efficient basis.

g). Debt reduction - XXXX currently has loans owed to related parties. The earnings of the company over the past few years have not been sufficient to meaningfully reduce the debts. As the assets in XXXX are intended to be 'legacy assets' for XXXX grandchildren, it is considered that by transferring the right to future rental income to XXXX, the debts will be able to be repaid, and the intention to retain assets for legacy purposes will be better able to be achieved.

13. You further advised that you as the partners in a partnership may choose to obtain roll-over relief if a trigger event happens to a CGT asset of the partners.
14. The trigger event will involve each partner disposing of his/her interest in an asset of the partnership to a company and creating an asset in that company. The granting of the 'concurrent lease' will entitle XXXX to collect future rent from the tenant of the XXXX property. This represents the disposal by each partner of an interest in an asset of the partnership, and the creation of an asset in the company. The benefit of a 'concurrent lease' is that it can be entered into for a period which will extend beyond the initial lease expiry date of XXXX.
15. The benefit of the 'concurrent lease' extending beyond XXXX will be that the future income streams of the XXXX property will be afforded an improved level of commercial efficiency, improve the decision making and working capital retention processes, and enable more effective maintenance and improvement of the property. The potential disadvantages may include that the value of the property will be adversely impacted and the XXXX property will be less suitable to be used as security for future borrowings (if required) by the partners.

Your request is in respect of a proposed transaction involving the granting by the partnership of a concurrent lease to XXXX. You have set out the following considerations of the eight factors required to be considered under s177D of ITAA1936. You consider that it would be objectively concluded that the scheme is not for the sole or dominant purpose of obtaining a tax benefit.

       First factor- the manner in which the scheme was entered into or carried out - the purpose of the re-structure is to achieve improved management processes in respect of the XXXX property, and legacy outcomes for the grandchildren of late XXXX. The scheme is being considered to achieve the legacy outcome in the most cost (including tax) effective way, but the scheme is to provide management processes for the property and legacy outcomes for the benefit of late XXXX children and grandchildren. The over-riding purpose of the scheme is to achieve improved legacy outcomes for the children and grandchildren of late XXXX, and also to achieve a more aligned working relationship between XXXX and XXXX, with the assistance of an independent, legally and financially literate board member.

       Second factor- the form and substance of the scheme - the assets existed as at the date of late XXXX death. The substance of the scheme is to retain them in the most secure and effective manner for the beneficiaries of the estate. The proposed re-structure is the simple and cost-effective way by which a legacy asset can be transferred to a more appropriate entity. It is considered that the operation of subdivision 122-120 (ITAA1997) will enable the arrangement to be simply implemented.

       Third factor- the time at which the scheme was entered into and the length of the period during which the scheme was carried out - the timing has been determined by the process of administering late XXXX estate, and the fact that the initial lease is coming up for renewal in XXXX. The structure is anticipated to continue on a medium to long term basis. The timing of the scheme/re-structure is not governed in any way by seeking to achieve a tax deduction for any amounts immediately prior to the end of a financial year.

       Fourth factor- the result achieved by the scheme under the income tax law if Part IV A did not apply - the result if the scheme is implemented and Part IV A does not apply will be that the rental income derived from the property will be taxed at the corporate rate of 30%, rather than the individual rate of the adult partners. Additionally, the income will be derived in an entity which has an independent, legally and financially literate director who will encourage the retention of earnings for future property maintenance and improvements While this does represent a timing advantage, it is considered that the advantage is acceptable on the following bases:

       Such an occurrence is contemplated by subdivision 122-120; and

       The beneficiaries will be consistent with the legacy outcome intended to be achieved by XXXX.

       In the event that the rollover is not implemented, the partnership will continue to derive rent and the accumulation of assets in accordance with late XXXX estate planning purposes will continue to be impeded by the differing philosophies of the existing partners, and the more difficult operational environment of a partnership.

       Fifth factor- any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result from the scheme- the financial position of the existing partners will change only to the extent that additional assets will be accumulated in a corporate entity, enabling profits to be retained for property maintenance and improvement, and be more easily managed for the legacy benefit of late XXXX grandchildren. By having an independent director on the board of the corporate entity, it is anticipated that the performance in relation to the derivation of rental income, retention of working capital and investment decision making processes will be improved. It is anticipated that these factors will result in improved family harmony, and subsequent legacy benefits.

       Sixth factor- any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, that has resulted, will result, or may reasonably be expected to result, from the scheme - the existing partners have loans on foot to the acquiring company. The loans will be able to be repaid using rental funds collected. This does not change the financial position of the partners, as they will be swapping one asset for another asset. The benefit of the loans being retired is consistent with the legacy intent of the intended arrangement. Particularly, it is intended that XXXX will be retained to accumulate assets for the benefit of late XXXX children and grandchildren, and the restructure will enable this to be achieved in the most harmonious and effective manner.

       Seventh factor- any other consequences for the relevant taxpayer, or for any person referred to in matter 6 (above) of the scheme having been entered into or carried out - we have not identified any consequences additional to those as outlined in this application.

       Eighth factor- the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to at the 'sixth factor' - the existing partners are siblings. They have differing investment philosophies, and spending habits. Using the roll over options available in subdivision 122 will assist them in having an independent director assist with maintenance and accumulation of legacy assets for themselves and their children.

Relevant legislative provisions

Income Tax Assessment Act 1997, Div 122

Income Tax Assessment Act 1997, Div 40

Income Tax Assessment Act 1936, Section 177

Income Tax Assessment Act 1997, Section 106

Income Tax Assessment Act 1997, Section 108

Reasons for Decision

Summary

Capital Gains Tax event on changing from partnership to company.

Detailed reasoning

Div 122 of ITTA1997 covers the sale of CGT assets from an entity to a company. With regard to the circumstances that involve a partnership, Div 122-B ITAA 1997 provides for CGT relief where the partnership transfers CGT assets to a company subject to meeting specific conditions.

The CGT provisions reflect in many respects the general law as it applies to a partnership and treats a partner as having a separate interest in the partnership assets (s108-5 ITAA 1997) and this is reinforced by section 106-5ITAA 1997 which provides:

(1) Any *capital gain or *capital loss from a *CGT event happening in relation to a partnership or one of its *CGT assets is made by the partners individually. Each partner's gain or loss is calculated by reference to the partnership agreement, or partnership law if there is no agreement.

Section 122-130 ITAA 1997 specifies the rollover conditions on what the partners receive for the trigger event. The consideration the partners receive must be only:

       shares in the company; or

       for a disposal of their interests in a CGT asset, or in all the assets of a business, to the company (a disposal case)-shares in the company and the company undertaking to discharge one or more liabilities in respect of their interests.

       the shares cannot be redeemable shares.

       the market value of the shares each partner receives for the trigger event happening must be substantially the same as:

       for a disposal case--the market value of the interests in the asset or assets the partner disposed of, less any liabilities the company undertakes to discharge in respect of the interests in the asset or assets (as appropriate);

       for another trigger event (a creation case) --the market value of what would have been the partner's interest in the * CGT asset created in the company (the created asset) if it were an asset of the partnership.

       In working out if the requirement is satisfied, if the market value of the shares is different to what it would otherwise be only because of the possibility of liabilities attached to the assets, disregard the difference.

The company may have to pay income tax if an amount is included in its assessable income because of a CGT event happening to an asset a partner disposed of. The market value of the shares will reflect these contingent liabilities. The consequences of the rollover need to be considered from the perspective of the shareholder transferor and the company transferee.

The taxation consequences for the partners when choosing the rollover relief is dependent on the nature of the asset and the acquisition date of the asset (i.e. whether the asset is a pre-CGT asset). The effect of the roll-over relief provision is to defer the balancing adjustment until the next balancing adjustment event for which there is no roll-over relief and to allow the transferee to claim deductions for the depreciating asset which has been transferred as if the asset continued to be held by the transferor. However, importantly, the rollover is dependent on all of the assets being transferred pursuant to the Subdivision 122-B ITAA 1997 rollover.

The trigger event must involve each partner disposing of his/her interest in an asset of the partnership to a company and creating an asset in that company. In exchange for the transfer of their interests in the assets, the shareholders receive shares in the transferee company. s122-135(1) of ITAA 1997 states that the partners must own all the shares in the company just after the time of the trigger event.

Furthermore, s122-135(2) states that each partner must own the shares the partner received for the trigger event happening in the same capacity that the partner:

(a) owned the partner's interests in the assets that the company now owns; or

(b) participated in the creation of the asset in the company.

If a partner's interests were owned as trustee, the partner must receive shares as trustee.

Pursuant to s122-135(7), for a partner who is a trustee of a trust at the time of the trigger event, either:

(a) at that time, the trust must be a resident trust for CGT purposes and the company must be an Australian resident; or

(b) both of the following requirements must be satisfied:

(i) each CGT asset must be a CGT asset of the trust that is taxable Australian property at that time; and

(ii) the shares in the company mentioned in subsection 122-130(1) must be taxable Australian property just after that time.

Section 122-80 of ITAA 1997provides that if all of the interests disposed of are post-CGT interests, the first element of the cost base/reduced cost base (as appropriate) of each share received by the partner on the roll-over is the sum of:

       the market values of the partner's interests in any precluded assets, that is assets subject to Division 40 ITAA 1997, trading stock (division 70); and

       the cost bases/reduced cost bases (as appropriate) of the partner's interests in the other assets, less any liabilities the company undertakes to discharge in respect of all those interests divided by the number of the partner's shares.

Section 122-200(1) ITAA 1997 specifies that there are these consequences for the company in a disposal case if the partners choose to obtain a roll-over. They are relevant for interests in each CGT asset (except a precluded asset) that the partners disposed of to the company.

Section 122-200(2) provides that if all of the partners' interests in an asset were acquired on or after 20 September 1985:

(a)  the first element of the asset's *cost base (in the hands of the company) is the sum of the cost bases of the partners' interests in the asset when it was disposed of; and

(b)  the first element of the asset's *reduced cost base (in the hands of the company) is the sum of the reduced cost bases of the partners' interests in the asset when it was disposed of.

Where a depreciable asset is included (a precluded asset) and the rollover provisions are applicable, the Division 40 ITAA 1997 implications are provided by section 40-345 ITAA 1997:

(a)  s40-345(1) states s 40-285 does not apply to the *balancing adjustment event for the transferor.

(b)  s40-345(2) provides that the transferee can deduct the decline in value of the depreciating asset using the same method and effective life (or remaining effective life if that method is the prime cost method) that the transferor was using.

That is:

(i)            The transferor has no revenue gain pursuant to Division 40 ITAA 1997;

(ii)           The transferor has no CGT gain pursuant to Subdivision 122 ITAA 1997; and

(iii)          The transferee company inherits the written down value of the transferor for the purposes of the company's future Division 40 ITAA 1997 deductions.

In accordance with Taxation Ruling 2496, a presently existing right to future income from property is a 'chose in action' which is assignable at law. The acquisition of the rental property is the assignment for consideration of rights to rental income under the existing lease of property. The legal principles that govern the transfer of rights apply to proprietary rights, including choses in action. The presently existing right to future income from property, in this case the rent under an existing lease is a chose in action which is assignable in law or in equity (per Mason J. in Booth v FC of T 87 ATC 5100 at 5102; 19 ATR 514 at 517).

Furthermore, in respect to Part IV, we consider the recent decision of Track and Ors v Commissioner of Taxation [2015] AATA 45 (Track's Case) is a timely reminder of the serious impact that Part IVA of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) can have on restructures.

The central thrust of Part IVA ITAA 1936 is to strike down "blatant, artificial or contrived arrangements" but not to "cast unnecessary inhibitions on normal commercial transactions by which taxpayers legitimately take advantage of opportunities available for the arrangement of their affairs". In applying Part IVA ITAA 1936 it has to be demonstrated the commercial viability of the scheme, as compared to a reasonable alternative, is dependent on the tax outcome. Furthermore, where aspects of the scheme are not capable of commercial explanation it may constitute a scheme.

Section 177CB ITAA 1936 now provides greater scope for the Commissioner to establish a tax benefit by assessing the "alternative postulate" and deciding what would have or might reasonably be expected to have happened if the scheme had not been entered into or carried out. There are three general elements to the operation of Part IVA ITAA 1936:

(a) Was there a "scheme"? (s177A(a) ITAA 1936) - which, given the broad definition, is almost satisfied in any circumstances that Part IVA ITAA 1936 is raised.

(b) Was there a "tax benefit"? (s177CB ITAA 1936) - generally speaking, the Commissioner must compare his "alternative postulate" with the substance of what actually took place from the taxpayer's point of view.

(c) Was there a dominant purpose to obtain a tax benefit? (s177D (2) ITAA 1936) - the pertinent question is - did anyone connected with the scheme have a dominant purpose of obtaining a tax benefit? The eight factors in s177D (2) ITAA 1936 must be considered in respect of this limb. The first three consider the contrivance and artifice of the scheme. The balance of factors considers the achievements of the scheme or the consequences - aiming to tease out whether the value of the scheme from an objective viewpoint is more or less than the tax value.

Section 177CB ITAA36 further provides the Commissioners' ability to determine the two alternate bases upon which a tax benefit could be identified:

       the 'annihilation' approach (a comparison of the tax outcomes of the scheme against those of an alternate postulate which removes the scheme in its entirety), and

       the 'reconstruction' approach (a comparison of the tax outcomes of the scheme against those of an alternate postulate involving a substituted set of arrangements), and

Furthermore, PSLA 2005/24 now provides guidance on the Commissioner's view regarding the permissible means by which Part IVA may apply to schemes involving the interaction of tax consolidation. These views reflect the Commissioner's position following the separate findings of the Federal Court in CoT v Macquarie Bank Limited [2013] FCAFC 13 and Channel Pastoral Holdings Pty Ltd v CoT [2015] FCAFC 57. The complex and somewhat opposing decisions reached in these cases, PSLA 2005/24 now provides that, in the Commissioner's view, he is at large in his ability to issue both Part IVA determinations and corresponding assessments to an individual company, notwithstanding that it may be a subsidiary member of a consolidated group and would not have been a subsidiary member under his alternate postulate upon which the tax benefit is based.

It is important to note that a successful defence to Part IVA will still fundamentally turn on the taxpayer's ability to provide cogent evidence about their objective purpose in entering into this arrangement. Remember that a subjective assessment of why a taxpayer entered into a scheme is not relevant. The purpose is determined by a universal consideration of the eight factors in s177D (2) ITAA 1936.

As stipulated in s177C (2)a reference to the obtaining of a tax benefit by a taxpayer in connection with a scheme shall be read as not including a reference to:

(a) the assessable income of the taxpayer of a year of income not including an amount that would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out where:

(i) the non-inclusion of the amount in the assessable income of the taxpayer is attributable to the making of a declaration, agreement, election, selection or choice, the giving of a notice or the exercise of an option (expressly provided for by this Act or the Income Tax Assessment Act 1997) by any person, except one under Subdivision 126-B, 170-B or 960-D of the Income Tax Assessment Act 1997; and

(ii) the scheme was not entered into or carried out by any person for the purpose of creating any circumstance or state of affairs the existence of which is necessary to enable the declaration, agreement, election, selection, choice, notice or option to be made, given or exercised, as the case may be; or

However, section 177C (2) under Part IVA does not apply to a tax benefit which is "attributable to the making" of a choice expressly provided by the Act. To that extent Part IVA will not apply merely because a choice has been made to consolidate. However, there are two important qualifications to that exclusion. The first qualification is the need for the relevant tax benefit to be "attributable" to the making of the choice and the second qualification is that the relevant scheme was not entered into or carried out "for the purpose of creating any circumstances or state of affairs the existence of which is necessary to enable" the choice to be made.

Application to your circumstances

Subdivision 122 of ITAA 1997 sets out when the partners in a partnership can obtain roll-over relief on transferring a CGT asset to a company. It also deals with the creation of the CGT asset in the company.

The partners in a partnership may choose to obtain roll-over relief if a trigger event happens to a CGT asset of the partners (s122-125). The table in s122-125 includes as 'trigger events' both D1 (create a contractual right in the company) and F1 (grant a lease to the company or renew or extend a lease). From your statements we understand that the granting of a concurrent lease by the partnership to the company will give rise to CGT event F1.

The trigger event will involve each partner disposing of his/her interest in an asset of the partnership to a company and creating an asset in that company. In respect of s122-135 the extent the full interest of the partners in the partnership must own all the shares in the company just after the time of the trigger event. The shares in the acquiring company must be held in the same proportion as the partnership asset was held prior to the trigger event. As you have stated that while there will be no value shift as XXXX is currently owned 50/50 by yourselves, the 'chose in action' is owned by yourselves with a portion held by XXXX as bare trustee.

At the trigger event, the composition of the partnership must pass onto the company as held at the time of the event. If the partnership includes individuals or bare trusts the composition must pass on to the company. As you are transferring the 'chose in action' / lease to the company, you must also consider what the value/ new cost base would be at transfer. What the three seven-year lease options are valued at and if the value of the lease remaining, that is the value in the partnership financial statements is what will be transferred.

Furthermore, for the consequences of Part IV, it is important to note that a successful defence to Part IVA will still fundamentally turn on the taxpayer's ability to provide cogent evidence about their objective purpose in entering into this arrangement. Remember that a subjective assessment of whya taxpayer entered into a scheme is not relevant. The purpose is determined by a universal consideration of the eight factors in s177D (2) ITAA 1936. From your submission it is believed that while there would likely be tax savings (rather than the partners being taxed at marginal rates), the assignment of the lease to the company structure is more business driven than tax driven. The factors you have listed is primarily asset protection and the ability of the siblings to appoint outside directors/ management to maintain the business and income stream. The new arrangement will likely facilitate the cascading of the financial benefits to the new generation/s as you have indicated.

However, this carve out is subject to the condition that the relevant Part IVA scheme was not entered into or carried out 'for the purpose of creating any circumstance or state of affairs the existence of which is necessary to enable the declaration agreement, election, selection, choice, notice or option to be made, given or exercised'. The question which has to be considered in a restructuring exercise is whether embarking on a 'series of transactions' with one or more steps being designed to 'set up' are able to make a further choice under the rollover provisions that would provide a basis for the Commissioner to argue that the taxpayer has embarked on a scheme entered into for the purpose of being able to exercise the subsequent choice.