Edited version of private advice

Authorisation Number: 1051762486527

Date of advice: 2 October 2020

Ruling

Subject: Can related parties deal at arm's length?

Question

1.    Which CGT event happens when you sell some shares you owned in Company A to existing shareholders/employees?

2.    Will Division 116 of Income Tax Assessment Act 1997(ITAA 1977) apply when you sell some shares in Company A to existing shareholders/employees at a price below the value determined by a valuer commissioned by you?

Answer

1.    CGT event A1 happens.

2.    No. Subsection 116-30(2) does not apply because you and the related existing shareholders/employees dealt at arm's length in connection with the CGT event.

This ruling applies for the following periods:

1 July 2020 to 30 June 2023

The scheme commences on:

1 July 2020

Relevant facts and circumstances

You owned shares in Company A which operates in the commercial building business which is cyclical and leveraged to the state of the local and national economy. One of your beneficiaries and the director of your trustee is also a shareholder, director and the company secretary of Company A.

Company A operates in the capital city of a state in Australia, does not have any offices/operations in other states, has no exclusive agencies and no strategic partnership with other companies. Company A does not export its products and services, import stocks that are not available in Australia and generally relies on local suppliers who offer trade terms for supplies.

Company A has several competitors and there are limited barriers to entry into the commercial building business by start-ups. The company has a stable workforce which meant it delivers quality products and services. Consequently, it relies on repeat business and has a stable and reliable clients base. It does not have a marketing budget and relies heavily on word of mouth or from consultants working with the clients.

You wish to sell down part of your investment and appointed a registered valuer to calculate the going concern asset value (GCAV) and market/enterprise value of the shares. The enterprise or market value of the shares is the valuation of the entire company structure including goodwill, assets and liabilities. The enterprise or market value of the shares is calculated by the following formula:

Total Enterprise value = GCAV + Other Assets -Total liabilities where GCAV is the Going concern asset value.

The valuer used the Return on investment (ROI) method to calculate GCAV using the following formula:

GCAV= (Weighted earnings before interest tax depreciation and amortisation (EBITDA))/ROI rate.

GCAV is the valuation of the business goodwill and operational assets only (usually plant, equipment, and stock). Goodwill is the difference between GCAV less the market value of property, plant and equipment.

The valuer used the standard of valuation which is 'market value' as per the Australian Taxation Office "Market Valuation for Tax Purposes' guidelines:

"The price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm's length."

The premise of the valuation is that of a 'controlling interest' in Company A. The other premises are a freely tradable minority interest and a non-marketable minority interest.

The valuation report was based on:

·   Inspection of Company A business premises;

·   Interview with the Business Managing Director;

·   Accountant prepared financial statement;

·   Management accounts, Profit and Loss and Balance Sheet;

·   All other financial information related to the income and expenses of the Company A business;

·   The seller plays a minimum role in the daily management of Company A;

·   Company A has a stable workforce employed on a full-time basis with pay rates and condition that are in line with industry standards;

·   The other directors have no active role in managing Company A;

·   The shareholders/purchasers have long term binding employment contracts with Company A;

·   The goodwill is commercial and retained through 'non-compete', 'transfer of goodwill' and 'retention of human capital agreements will be executed;

·   The earnings before interest tax depreciation and amortisation (EBITDA) were appropriately weighted;

·   Return of investment (ROI) was preferred method because it is commonly used to calculate GCAV sale of small to medium business so there is a large comparable company transactions (CCT) to determine what ROI the sales were based on; and

·   The choice of an ROI rate was based on the valuer's experience and judgment.

Other valuation methods like Industry Market Method, Discounted Cash Flow Method and Net Book Value Method were considered by the valuer. The value considered them to be inappropriate based on their experience and knowledge of the commercial building industry.

Generally, non-operational items such as sundry debts and trade creditors are not included in the market value price when ROI method is used. However, by negotiation with the valuer it was agreed that the non-operational items should be included in the market value calculation. Prior to coming to an agreement with the existing shareholders, you offered your shares in Company A to local, interstate, international companies and existing shareholders. The external parties were not interested in buying either part or the whole of your holdings. There was no offer of sale to the general public to gauge the market price due to the risk of disclosure of confidential agreement to competitors and perception of instability of ownership and management at Company A which may lead to clients taking their business to competitors.

After protracted negotiation over a lengthy period, the existing shareholders were only interested in buying part of the shares available for sale at a price which is lower than the valuer's market price and conditional on two key considerations which were:

·   satisfactory business performance going forward within period X; or

·   restructuring of certain items on Company A balance sheet within period Y.

The second condition has been met and as a consequence the value of the shares in Company A would be valued at less than the valuer originally valued them.

The proposed shareholders/purchasers have not imposed any conditions on how you dispose the remaining shares in your holding.

The other shareholders (apart from you) are prepared to accept the lower enterprise/market value offered by the purchasers.

Relevant legislative provisions

Section 102-25 of the Income Tax Assessment Act 1997

Section 104-10 of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

Subsection 116-30(2) of the Income Tax Assessment Act 1997

Section 995-1 of the Income Tax Assessment Act 1997

Reasons for decision

Question

1)    Which CGT event happens when you sell some shares in Company A to existing shareholders/employees?

2)    Will Division 116 of Income Tax Assessment Act 1997 (ITAA 1977) apply when you sell some shares in Company A to existing shareholders/employees at a price below the value determined by a valuer commissioned by you?

Answer

1)    CGT event A1 happens.

2)    No. Subsection 116-30(2) does not apply because you and the related existing shareholders/buyers dealt at arms-length in connection with the CGT event.

Detailed reasoning

CGT event A1 applies, when you sell some shares in Company A. For CGT purposes, the date of sale is when you entered into agreement to sell the shares.

Division 116 sets out the general rules on calculating capital proceeds and modifications to the general rules. Under section 116-20, the capital proceeds from a CGT event are the total of the

a)    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).

For CGT event A1, the applicable modifications to the general rule regarding capital proceeds are 1, 2, 3, 4, 5 and 6. Under modification 1, set out in section 116-30 of the ITAA 1997, the market substitution value rule will apply if the capital proceeds are more or less than the market value of the asset and you and the purchasing entities did not deal with each other at 'arm's length' (paragraph 116-30(2)(b) of the ITAA 1997). The term 'arm's length' is defined in section 995-1 of the ITAA 1997 as follows:

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

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular 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 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)).

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.

Consideration was given to the modifications when calculating the capital proceeds of your proposed share sale transaction because:

·   you and the existing shareholders/purchasers are related as shareholders and as employees of Company A; and

·   the capital proceeds are less than the market value calculated by a valuer.

It is considered that you and the purchasers dealt with each other at arm's length when they offered and you accepted a price lower than that calculated by the valuer for the following reasons:

1. The sale negotiations commenced some time ago and an agreement was reached on a sale subject to:

·         satisfactory performance by the business within Period X; or

·         a restructuring of the balance sheet within Period Y.

2. The other directors were happy to sell their shares at the lower price to the purchasers.

3. The purchasers know the strength, weaknesses, opportunities and threats to Company A.

4. There being 'no conditions' on how you disposed of the remaining shares in Company A indicate there are no potential buyers in the market.

5. The valuation method used was not the most appropriate method to determine the value of the shares because it included items from the balance sheet that are not normally included.

6. The valuer's share price favours the seller as some of the non-operational items when distributed are taxed at concessional rates,

7. The valuer's share price disadvantages the purchasers as they are entitled to some of the non-operational items and they acquire the share at a higher price.

8. International, interstate and local competitors were not interested in buying all or part of your interest.

9. Company A is a local player in the commercial building business, does not have any exclusive agencies or other strategic partnerships.

10. The risks of disclosure of confidential information to competitors and perception of ownership and management issues at Company A which may lead to the loss of customers meant there was no offer to the general public to gauge what is the market price.

The valuation method calculated a share price of $X each. The share price of $X reduced to $Y when the restructuring of the balance sheet took place. As Company A went further than the condition stipulated when the balance sheet was restructured, the share price reduced even further.

The valuation method which calculated a share price higher than what the purchasers had offered is not the appropriate for the following reasons.

1. Certain figures used by the valuer were subjective and did not allow for the gross profit peaking before the valuation period or the unique tight capital structure, number and structure of shareholder base. Some shareholders are directors and employees whilst other shareholders are managers and employees.

4. The strong balance sheet with no debt due the cyclical business environment Company A operates in and the limited barriers of entry by new start-ups.

5. The concentration of Company A's sale revenue in small but loyal customers base and the maintenance of a stable workforce.

6. The valuer assumes goodwill to be commercial rather than personal even though there were no "non- compete", "transfer of goodwill" and "retention of human capital" agreements between sellers and buyers who are known to each other.

Accordingly, it is considered that you and the proposed purchasers are dealing with each other at arm's length and the market value substitution rule in section 116-30 will not apply when calculating the capital proceeds from the sale of your shares in Company A.