Edited version of private advice

Authorisation Number: 1051730449807

Date of advice: 3 August 2020

Ruling

Subject: Application of market substitution rule to capital proceeds

Question

Will section 116-30(2)(b)(i) of ITAA 1997 apply so that the money received from the sale of entity A shares by the trustee for B Trust, arising from the exercise of call and put options exercised over a period of several years, will be substituted with the market value of the entity A shares, where the money received from the sale of the entity A shares and the market value of the entity A shares at the time of each sale is different?

Answer

No

This ruling applies for the following periods:

1 July 20XX to 30 June 20XZ

The scheme commences on:

Date of entering into Options Agreement.

Relevant facts and circumstances

Entity A carries on a business of building and construction (the Business).

The directors of entity A are Individual G (G), Individual H (H), Individual J (J), Individual K (K), and Individual L (L). All the directors are actively involved in the Business. G, H and J have been directors of entity A since incorporation and have been involved in the Business for many years.

All shares in entity A (entity A Shares) are held by entity B as trustee for Trust C.

The directors of entity B are G, H and J.

Trust C was established by deed of settlement and is a discretionary trust.

The specified beneficiaries of Trust C are G, H and J.

Entity D carries on a business of building construction.

The directors of Entity D are K, L, Individual M (M) and Individual N (N). The shares in Entity D are held equally by trustees of discretionary trusts controlled by K, L, M and N respectively.

K, L, M and N are the children of G, H and J. G, H and J have other children who are not involved in the Business.

G, H and J worked in the XYZ family businesses and in time took over the operation of the family business interests.

K, L, M and N became involved in the Business and have also pursued their own independent business interests through Entity B and its subsidiary entities.

G, H and J are elderly whilst K, L and M are young adults.

G, H and J want to exit from entity A and the Business by reducing their involvement over a period of time and want certainty as to the capital proceeds that they will receive through Trust C from the sale of the entity A shares, especially given the volatile nature of the building industry. At the same time they want as much flexibility as possible as to the terms of the exit from entity A and the Business.

K, L, M and N want to acquire all the entity A shares (via entity D) but cannot afford to do so in one tranche and would like the ability to acquire the entity A shares over a period of time with certainty as to the amount that they will have to pay.

A terms contract for the sale of the entity A shares is not acceptable to entity B as trustee for Trust C as the risks of default on payment for the entity A shares is too great, and entity D is unable to make sufficient payments up-front, under a terms contract, so that entity B as trustee for Trust C can meet its capital gains tax liability on the sale of the entity A shares.

The Business and the entity shares have an estimated value of $XXX (based on a preliminary valuation) on the basis that the only asset of entity A is the Business. The value of the Business and the entity A shares will be confirmed by a formal independent valuation with the appointed valuer being instructed that the valuation be in accordance with the Commissioner of Taxation's publication "Market Valuation for Tax Purposes" (Independent Valuation).

Certainty of the capital proceeds amount is important to G, H and J, as these capital proceeds are essential to their retirement planning and estate planning. It is also essential that the capital proceeds reflect the market value of the entity A shares as not all the children of G, H and J will be involved in acquiring the entity A shares and G H and J do not want to give the children acquiring the entity A shares an unfair advantage or benefit.

As the capital proceeds from the sale of the entity A shares will occur over time, G, H and J want to maintain control over the Business whilst they are still involved in it and there are unpaid capital proceeds from the entity A shares.

G, H and J believe that they will be able to maximise their capital proceeds by entity B as trustee for Trust C selling the entity A shares to entity D, because K, L, M and N work in the Business, are aware of its strengths and weaknesses and the sale of the entity A shares are akin to a sale of a business to key employees of the business. Further, it is expected that such a transaction will avoid transaction costs and costs of preparing for an expensive due diligence process.

Options Agreement

Entity B as trustee for Trust C and entity D have agreed to enter into an option agreement (Option Agreement) on the terms set out below and the price of the entity A shares that can be acquired under the Option Agreement will be equal to the market value of the entity A shares when the Option Agreement is entered into (as determined under the Independent Valuation). Entity B as trustee for Trust C and entity D will be obtaining separate independent legal and financial advice from professionals instructed by each of them on the benefits and risks associated with the Options Agreement, the commercial terms of the sale of the entity A shares and implications for each of them under the proposed transaction.

A share split will occur for the shares held in entity A by Entity B as trustee for Trust C before the Options Agreement is entered.

The key terms of the proposed Option Agreement will be:

(a)  Entity B as trustee for Trust C will grant entity D options to acquire all of the entity A shares (Call Options);

(b)  Entity D will grant Entity B as trustee for Trust C options to sell all of the entity A shares to entity D (Put Options);

(c)   There will be XX Call Options and XX Put Options, of which one Call Option and one Put Option may be exercised each year;

(d)  Each Call Option will entitle entity B to acquire XX% of the entity A shares for a price equal to XX% of the Current Value and each Put Option will entitle Entity B as trustee for Trust C to sell XX% of the entity A shares for a price equal to XX% of the Current Value. The purchase price for each XX% parcel of entity A shares acquired by entity D will be payable at the time of exercise of the relevant Option or otherwise at completion of the sale and purchase of the relevant entity A shares;

(e)  Each party will pay an option fee of $XXXX.

(f)    The first Call Option may be exercised by entity D during the period 1 July - 31 July (Call Option Period) occurring immediately after the Options Agreement is executed and the first Put Option can be exercised by Entity B as trustee for Trust C during the period 1 August to

(g)  31 August (Put Option Period) immediately after the Option Agreement is executed. The remaining nine (Call Options and Put Options can be exercised during each successive July (Call Options) and August (Put Options);

(h)  Each of the Call Options and Put Options will be granted for an option fee to be agreed by the parties.

If any of the Call Options are not exercised in the applicable Call Option Period or any of the Put Options are not exercised in the applicable Put Option Period, the relevant option or options will lapse.

At the end of the options period, entity D will own some or all of the entity A shares. If entity D does not own all of the entity A shares (Remaining Shares) upon the conclusion of the final Put Option Period, within the expiry of six months from the end of the final Put Option Period, Entity B as trustee for Trust C will have a Put Option to require entity D to acquire the Remaining Shares at their market value at that time.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 subsection 104-10(3)

Income Tax Assessment Act 1997 subsection 104(4)

Income Tax Assessment Act 1997 section 116-5

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-25

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 subsection 116-30(1)

Income Tax Assessment Act 1997 paragraph 116-30(2)(a)

Income Tax Assessment Act 1997 subparagraph 116-30(2)(b)(i)

Income Tax Assessment Act 1997 subparagraph 116-30(2)(b)(ii)

Income Tax Assessment Act 1997 section 116-65

Income Tax Assessment Act 1997 subsection 116-65(1)

Income Tax Assessment Act 1997 subsection 116-65(2)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Summary

No, the market substitution rule under subparagraph 116-30(2)(b)(i) of the ITAA 1997 will not apply so that the money received from the sale of entity A shares by the trustee for B Trust, arising from the exercise of call and put options exercised over a several year period, will be substituted with the market value of the entity A shares, where the money received from the sale of the entity A shares and the market value of the entity A shares at the time of each sale is different as Entity B as trustee for Trust C and entity D will be considered to be dealing with each other at arm's length in connection with the sale and purchase of the entity A shares.

Detailed reasoning

Capital gains tax provisions

The sale of shares as result of the exercise of a put or call option will trigger CGT event A1 under section 104-10 of the ITAA 1997. The time of this CGT event will be determined under subsection 104-10(3) of the ITAA 1997.

Capital Gain on CGT event A1 is determined under subsection 104(4) which states:

104-10(4)

You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those proceeds are less than the asset's reduced cost base.

Capital Proceeds

Section 116-5 of the ITAA 1997 provides that section 116-20 of the ITAA 1997 sets out the general rules about capital proceeds. It applies to CGT event A1.

Section 116-20 of the ITAA 1997 provides that the capital proceeds from a CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

Section 116-25 of the ITAA 1997 provides a table of modifications to the general rules. Modifications 1, 2, 3, 4, 5 and 6 can apply to CGT event A1.

Modification 1, the market value substitution rule, contained in paragraph 116-30(2)(b) of the ITAA 1997 will apply relevantly if there are proceeds from the disposal of a CGT asset the subject of CGT event A1 and:

(b) those capital proceeds are more or less than the market value of the asset and:

(i) you and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event; or

(ii) the CGT event is CGT event C2 (about cancellation, surrender and similar endings).

Section 116-65 of the ITAA 1997 applies specifically to the disposal of an asset the subject to an Option. Section 116-65 states:

SECTION 116-65 Disposal etc. of a CGT asset the subject of an option

116-65(1)

This section applies if:

(a) you granted, renewed or extended an option to create (including grant or issue) or *dispose of a *CGT asset; and

(b) another entity exercises the option; and

(c) because of the exercise of the option, you create (including grant or issue) or dispose of the CGT asset.

116-65(2)

The *capital proceeds from the creation (including grant or issue) or disposal include any payment you received for granting, renewing or extending the option.

Therefore, to determine if the market substitution rule under subparagraph 116-30(2)(b)(i) applies to the proceeds from the proposed sale of shares pursuant to the exercise of put or call options over time, we need to determine if you and the entity that will acquire the asset from you, deal with each other at arm's length in connection with the event.

Meaning of 'at arm's length'

The term 'arm's length', in relation to dealings, is defined in the Concise Oxford Dictionary as "with neither party controlled by the other". Osborn's Concise Law Dictionary defines 'at arm's length' as "the relationship which exists between parties who are strangers to each other, and who bear no special duty, obligation or relation to each other". Black's Law Dictionary defines 'arm's length' as "beyond the reach of personal influence or control" and adds that "parties are said to deal at arm's length when each stands upon the strict letter of his rights, and conducts the business in a formal manner, without trusting the other's control or overmastering influence".

Subsection 995-1(1) of the ITAA 1997 defines 'arm's length' as follows:

...in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

In ACI Operations Pty Ltd v. Berri Ltd (2005) 15 VR 312 (ACI Operations Pty Ltd), Dodds-Streeton J said (at [223]) that the authorities establish:

... an arm's length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal.

The market value substitution rule requires consideration to be given to the nature of the dealings between parties to a transaction and not simply their relationship. As Dodds-Streeton J explained in ACI Operations Pty Ltd at [224]-[226] (footnotes omitted):

The concept of an arm's length relationship is distinct from that of an arm's length dealing or transaction, despite the potential overlap. Unrelated parties may collude or otherwise deal with each other in an interested way, so that neither the dealing nor the resultant transaction may properly be considered arm's length. Where the parties are not in an arm's length relationship, it is recognised that the inference may be drawn that they did not deal with each other at arm's length. It may further be inferred that the resultant transaction is not arm's length. Related parties may nevertheless, in some circumstances, demonstrate a dealing which displaces the inference based on their relationship. They may engage in the disinterested bargaining characteristic of strangers, applying independent separate wills. The circumstances of the impugned transaction may be such that, despite the parties' connection or common interest, the interposition of some independent process (such as the sale of shares on the stock exchange) ensures that the transaction itself is arm's length, in the sense that it could equally have been concluded by unrelated parties, consulting their own self-interest and uninfluenced by any particular association or interest in common.

Whether parties have dealt at arm's length is a question of fact that must be determined in each individual case. The law looks at not only the relationship between the parties but also the quality of the bargaining between them.

An individual is said to be 'dealing at arm's length' with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction.

Parties are not at arm's length where the parties are related or associated in some way so that while each party may enter a transaction with some self-interest in mind, it may also take into consideration the interests of the other party in making the agreement. Examples of such relationships are transactions between family members and related corporations.

Where parties are not at arm's length, it is still possible for the parties to deal at arm's length in relation to a specific transaction. As stated by Davies J in Barnsdall v. Federal Commissioner of Taxation (1988) ATC 4565, 4568:

The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion.

Parties will be dealing at arm's length where they act as arm's length parties would normally do, so that their dealing has an outcome that is the result of normal or real bargaining (The Trustee for the Estate of the late A W Furse No 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123 and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 (Granby)).

In Trustee for the Estate of AW Furse No 5 Will Trust v. FC of T at 21 ATR 1132 Hill J held:

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each othr as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining.

In Granby at ATC 4243; ATR 403, Lee J stated 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; ATR 403-404) 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 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.

In Collis v. FC of T 96 ATC 4831; (1996) 33 ATR 438 (Collis), the Federal Court found that the parties were not dealing at arm's length because one party was indifferent to the allocation of the sale price for the parcel of land. This indifference was indicative of a submission of one party's will to the other party's wishes which demonstrated a lack of arm's length dealing.

The underlying principles of the case law discussed above have been summarised by McKerracher J in Healey v. FC of T [2012] FCA 269 [at 95] (Healey's case). In that case, in determining whether or not parties were dealing at arm's length with one another, it was held that the authorities establish the following principles:

1. Whether the parties dealt at arm's length is a question of fact: Trustee for the Estate of the late AW Furse No 5 Will Trust v. Commissioner of Taxation 91 ATC 4007 (at 4017) (Trustee for the Estate of the late AW Furse No 5 Will Trust); Granby Pty Ltd v. Federal Commissioner of Taxation 95 ATC 4240; (1995) 129 ALR 503 (at 507) (Granby); Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134; (2010) 189 FCR 204 (at [106]) (AXA Asia Pacific Holdings Ltd).

2. There is a distinction between dealing at arm's length and an arm's length relationship (ACI Operations Pty Ltd (at [224])). Whether the parties did not deal at arm's length is not to be decided by answering whether the parties were not in an arm's length relationship. The fact that the parties are themselves not at arm's length does not mean that they have not, in respect of a particular dealing, dealt with each other at arm's length: Re Hains; Barnsdall v. Commissioner of Taxation 88 ATC 4565; (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015).

3. Whether the parties dealt at arm's length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction: Granby (at 506).

4. At issue is whether the parties have acted separately and independently in forming their bargain: Granby (at 507); ACI Operations Pty Ltd (at [226]) (did the parties apply 'independent separate wills'); AXA Pacific Holdings Ltd (at [105]). There should be an assessment of whether the parties dealt with each other as arm's length parties would be expected to behave so that the outcome is a matter of real bargaining: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506 and 507); AXA Pacific Holdings Ltd (at [105]).

5. It is relevant to consider the nature of any relationship between the parties: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506).

6. If the parties are not at arm's length the inference may be drawn that they did not deal with each other at arm's length: Granby (at 506); ACI Operations Pty Ltd (at [225]).

Application of the Law to your circumstances.

The disposal of each parcel of entity A shares by Entity B as trustee for Trust C to entity D pursuant to the exercise of either the Call options or the Put Options will give rise to CGT event A1 under subsection 104-10(1) of the ITAA 1997.

The time of each CGT event will occur on the date that the Call option is exercised in the Call Option Period or the Put Option is exercised in the Put Option Period under subsection 104-10(3) of the ITAA 1997.

The Capital Proceeds under section 116-20 will be the money to be paid by entity D to Entity B as trustee for Trust C arising from the disposal of each parcel of entity A shares equal to XX% of the Current Value (as determined by the Independent Valuation prior to the proposed Option Agreement being entered into), plus the amount paid for granting the option (option fee) of $XXXX per Option under section 116-65 of the ITAA 1997.

The capital proceeds determined pursuant to subsection 116-20(1) of the ITAA 1997 may be modified by the market substitution rule (Modification 1) in section 116-30 of the ITAA 1997. Subsection 116-30(1) will not apply as there will be capital proceeds for the sale of entity A shares, being the money to be paid by entity D to Entity B as trustee for Trust C for each parcel of the entity A shares they acquire.

Subsection 116-30(2) states:

The capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if:

(a)  Some or all of those proceeds cannot be valued; or

(b)  Those capital proceeds are more or less than the market value of the asset and:

                                    (i)        You and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event; or

                                   (ii)        The CGT event is CGT event C2 (about cancellation, surrender and similar endings)

(The market value is worked out as at the time of the event.)

Paragraph 116-30(2)(a) will not apply as each parcel of entity A shares will be acquired for monetary consideration which can be valued.

Subparagraph 116-30(2)(b)(ii) will also not apply as the disposal of entity A shares gives rise to CGT event A1 and not CGT event C2.

Therefore, we need to determine if the parties to the proposed Options Agreement will be dealing with each other at arm's length in arriving at the terms of the Options Agreement. We will base our consideration on the indicia from case law outlined above from Healey's case.

1. Whether the parties dealt at arm's length is a question of fact:

2. There is a distinction between dealing at arm's length and an arm's length relationship. Whether the parties did not deal at arm's length is not to be decided by answering whether the parties were not in an arm's length relationship. The fact that the parties are themselves not at arm's length does not mean that they have not, in respect of a particular dealing, dealt with each other at arm's length:

3. Whether the parties dealt at arm's length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction.

4. At issue is whether the parties have acted separately and independently in forming their bargain: There should be an assessment of whether the parties dealt with each other as arm's length parties would be expected to behave so that the outcome is a matter of real bargaining.

5. It is relevant to consider the nature of any relationship between the parties.

6. If the parties are not at arm's length the inference may be drawn that they did not deal with each other at arm's length.

Relevant facts that have been presented are:

(a)  G, H and J want to exit from the business over time, given their ages

(b)  K, L, M and N, who all work in the Business, want to acquire the Business and combine it with their business interests and have the flexibility to run the Business as they see fit;

(c)   K, L, M and N do not have the resources to acquire all the entity A shares at one time and as a terms contract is not viable for G, H and J, they consider the Options Agreement will give them the certainty they require;

(d)  G, H and J will ensure the Entity B as trustee for Trust C will enter into the Options Agreement voluntarily after taking independent advice and ensuring that their requirements are met. In particular their requirements about:

                            (i)        Certainty of the quantum of their capital proceeds;

                           (ii)        Control over the disposal of the entity A shares;

                          (iii)        Control over the Business for as long as Entity B as trustee for Trust C holds entity A shares; and

                          (iv)        The capital proceeds meeting their retirement and estate planning requirements.

(e)  K, L, M and N will ensure that entity D will enter into the Options Agreement voluntarily after taking independent legal advice and ensuring their requirements are met. In particular, their requirements about:

                            (i)        Certainty to the capital expenditure required to acquire the entity A shares;

                           (ii)        Their ability to acquire all the entity A shares with certainty so they can plan accordingly;

                          (iii)        The funding for the purchase of the entity A shares over time can be dealt with taking into account their financial resources.

(f)    The discussions between the parties have been undertaken in the context of the parties considering their own respective interests and have been a matter of real bargaining representing the inter-generational transfer of a business in a manner that arm's length parties such as employer and employees would undertake.

(g)  It is accepted that G, H and J have had to ensure their exit from the Business has been negotiated on an arm's length basis because they are very conscious that they need to provide for their other children and do not want to give or be perceived to give K, L, M and N any preferential treatment. They will need the funds to meet their retirement needs and to make sure that all their children are dealt with equally.

(h)  The proposed Options Agreement is not contrived or unusual but rather it reflects an ordinary commercial transaction, particularly in a family or business succession context. The value of the shares acquired as a result of the Options Agreement will be arrived at by Independent Valuation based upon the market value of the entity A shares at the time the parties enter into the Options Agreement.

(i)    Neither Entity B as trustee for Trust C, entity D or the respective individuals is acting in a unilateral manner so that the will of the party is subject to direction; or a party submits to the will of another party.

(j)    Each of the parties is acting independently taking into account its interests and has arrived at their position voluntarily.

The question of application of the market substitution rule in regard to the exercise of a Put Option has been considered in ATO Interpretative Decision ATO ID 2009/68 Income Tax Capital Gains Tax: cost base modification of CGT asset acquired from exercise of put option. Whilst this ATO ID was in regard to a cost base modification, its reasoning is relevant. The basis for the conclusion reached in the ATO ID, i.e. the reason for not applying the market substitution rule, was that the terms of the exercise were agreed upon at the time of the granting of the option in accordance with market value conditions.

In this case, both parties acted in their own interests, severally and independently in the arrangements. The terms of the Agreement were drawn up by a mutual desire of the parties to achieve their own objectives of running and owning a successful business. There is no evidence that the outcome of their dealings is anything other than a matter of real bargaining.

Therefore, as the terms of the Options Agreement will be agreed at the time of entering into the Agreement at market value and the dealings will be considered at arm's length, then subparagraph 116-30(2)(b)(i) does not apply to substitute the market value for the capital proceeds from the disposal of the shares.