Edited version of private advice

Authorisation Number: 1051778131835

Date of advice: 26 November 2020

Ruling

Subject: Income tax - capital gains tax - shares - ratifying rights

Issue 1

Question 1

In accordance with subsection 104-155(1) of the Income Tax Assessment Act 1997 (ITAA 1997), will CGT event H2 be triggered for the C class shareholders in Company A when Company A ratify the rights attached to those shares?

Answer

No

Question 2

If yes, will the C class shareholders receive any capital proceeds pursuant to section 116-20 of the ITAA 1997 because of CGT event H2?

Answer

Not applicable

Question 3

Are the C class shares in Company A pre-CGT assets pursuant to section 149-10 of the ITAA 1997 for:

(a)  Individual C; or

(b)  Individual D, Individual E and Individual F?

Answer

(a)  Yes

(b)  No

Issue 2

Question 1

In accordance with subsection 104-155(1) of the Income Tax Assessment Act 1997 (ITAA 1997), will CGT event H2 be triggered for the A, B and C class shareholders in Company B when Company B ratify the rights attached to those shares and rename those shares ordinary shares?

Answer

No

Question 2

If yes, will the shareholders receive any capital proceeds pursuant to section 116-20 of the ITAA 1997 because of CGT event H2?

Answer

Not applicable

This ruling applies for the following period:

Year ending 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

Company A was incorporated on 1 January 19xx with two shareholders;

•   Individual A, holding 1 A class share; and

•   Individual B, holding 1 B class share.

Individual A and Individual B have four children:

•   Individual C;

•   Individual D;

•   Individual E; and

•   Individual F.

Clause x of the Articles of Association for Company A provides that 'shares numbered 3 to 10,000 inclusive shall be classified as ordinary shares unless otherwise decided by the Directors.'

Company A held its first general meeting on 1 February 19xx at which time the shareholders agreed to:

•   classify shares number 3 to 4,002 as C class shares; and

•   offer these shares to the trustee of the Children's Trust to hold for the benefit of Individual C, Individual D, Individual E and Individual F.

The Articles of Association do not provide any information about the rights attached to C class shares.

The minutes of 1 February 19xx do not provide any information about the rights attached to C class shares.

The Children's Trust was settled on 1 February 19xx with the transfer of the 4,000 C class shares transferred on 1 March 19xx.

Clause 4 of the trust deed of the Children's Trust provides:

Subject to the aforesaid provisions the Trustee shall hold the Trust Fund and the income thereof UPON TRUST for the said children hereinbefore named in equal shares ...

Clause 5 of the trust deed of the Children's Trust provides:

Subject to the proviso hereto each of the said children on attaining the age of twenty-five years shall be entitled to have transferred to him or her (if and to the extent to which the same are then capable of being so transferred) the investments, moneys, assets or property or an undivided or appropriated share therein representing the share and interest of such child in the Trust Fund ...

Prior to 19 September 1985, Individual C attained the age of 25 years.

After 20 September 1985, Individual D attained the age of 25 years.

After 20 September 1985, Individual E attained the age of 25 years.

After 20 September 1985, Individual F attained the age of 25 years.

On 1 July 20xx, the C class shares held within the Children's Trust were transferred to:

•   Individual C as to 1,000 C class shares;

•   Individual D as to 1,000 C class shares;

•   Individual E as to 1,000 C class shares; and

•   Individual F as to 1,000 C class shares.

Company B was incorporated on 1 January 19xx with two shareholders;

•   Individual A, holding 1 share; and

•   Individual B, holding 1 share.

Clause 4 of the Memorandum of Association provides:

The capital of the company is FIFTY THOUSAND DOLLARS ($50,000) divided into 50,000 shares of ONE DOLLAR ($1.00) each. The rights which shall attach to the shares inter se shall be such as are from time to time set out in the Articles of Association of the Company.

Clause 1 of the Articles of Association provides:

Except as hereinafter expressly provided the provisions of Table A of the Fourth Schedule to the 'Companies Act 1961' and amendments shall apply to the Company.

Clause 15 of the Articles of Association provides:

The subscribers to the Memorandum of Association shall be the first Directors and shall hold office for life or until they shall resign or become disqualified.

Clause 16 of the Articles of Association provides:

The Directors shall have the sole right to appoint other Directors up to the maximum number permitted by the Articles and any such other directors so appointed shall hold office subject to such terms and conditions as the Directors shall at that time of appointment or subsequently determined.

Clause 17 of the Articles of Association provides:

Article 71 of Table A is deleted and in lieu thereof the following new Article is inserted:

71. It shall not be necessary for a Director to hold any share in the Company.

Company B held its first general meeting on 1 February 19xx at which time the shareholders agreed to:

•   classify shares number 3 to xx,002 as C class shares; and

•   sell these shares to Company A for $xx,000.

On the form Return of Allotment of Shares dated 1 March 19xx, Company B identify the shares as follows:

•   Individual A, one ordinary Class A share;

•   Individual B, one ordinary Class B share; and

•   Company A, xx,000 ordinary Class C shares.

The Articles of Association do not provide any information about the rights attached to A, B or C class shares.

Relevant legislative provisions

Income Tax Assessment Act 1997 - subsection 104-155(1)

Income Tax Assessment Act 1997 - section 106-50

Income Tax Assessment Act 1997 - section 109-5

Income Tax Assessment Act 1997 - section 109-10

Income Tax Assessment Act 1997 - section 116-20

Income Tax Assessment Act 1997 - section 149-10

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

Income Tax Assessment Act 1997 - Part 3-1

Income Tax Assessment Act 1997 - Part 3-3

Income Tax Assessment Act 1997 - Division 19B

Issue 1

Question 1

Summary

No, ratifying the rights attached to the existing C class shares in Company A will not trigger CGT event H2 for the shareholders.

Detailed reasoning

CGT event H2

Under section 104-155(1) of the ITAA 1997, CGT event H2 happens if:

(a)  an act, transaction or event occurs in relation to a CGT asset that you own; and

(b)  the act, transaction or event does not result in an adjustment to the asset's cost base or reduced cost base.

In regards to shares, Taxation Ruling TR 94/30 CGT: implications of varying rights attaching to shares provides the Commissioner's opinion on how rights attached to shares should be treated for CGT purposes.

Nature of a share

In examining the capital gains tax (CGT) implications of any variations in the rights which are attached to shares, it is necessary to consider whether a share is one asset or whether a series of assets are contained in the bundle of rights that comprise a share. Furthermore, we need to consider whether a change in rights attaching to a share results in the creation of a new share comprised of a new bundle of rights.

The explanation which follows considers the nature of a share and then relates relevant concepts from that discussion to the statutory requirements of Part IIIA.

The precise legal nature of a share has not been made clear by the courts but some assistance can be obtained by turning to company law concepts as well as to death duty cases on the subject.

The rights of each shareholder in relation to each class of share are usually contained in the Memorandum and Articles of Association of the company. The rights attaching to a share are not ordinarily thought of as a separate piece of property.

An often-used description of a share is that it is an aliquot interest of a shareholder in a company as measured by a sum of money. (An 'aliquot' part is part of a total such that, if the total is divided by that part, there is no remainder. For example, 5 is an aliquot part of 15.) Farwell J followed this interpretation when describing the legal nature of a share in Borland's Trustee v Steele Bros & Co Ltd [1901] 1 Ch 279 at 288:

The contract contained in the articles of association is one of the original incidents of the share. A share is not a sum of money settled in the way suggested, but is an interest measured by a sum of money and made up of various rights contained in the contract, including the right to a sum of money of a more or less amount.

This description was endorsed by Williams J in the High Court decision of Archibald Howie and Others v Commissioner of Stamp Duties (NSW) (1948) 77 CLR 143 at 156. Dixon J at 152 also endorsed this approach in the following terms:

While a shareholder has not a proprietary right or interest in the assets of an incorporated company, his 'share' is after all an aliquot proportion of the company's share capital with reference to which he has certain rights.

Section 1085 of the Corporations Act 2001 defines a share as personal property which is transferable or transmissible and, subject to the articles, able to be devolved.

The nature of a share was considered in the death duty case of Re Alex Russell, deceased [1968] VR 285. McInerney J of the Supreme Court of Victoria considered the question of whether the right to convert a preference share to an ordinary share could be transferred at death. His Honour found that this right was still 'locked up' and it could not be separated out of the actual estate. Also examined was the question of whether the right to convert could be separated out from the preference shares. McInerney J commented at 299-300:

It follows that while it is correct to speak of the testator's preference shares as consisting of a bundle or congeries of rights, it is not correct to speak of a shareholder owning each of those rights as a separate piece of property, or as a separate chose in action... It is not permissible, therefore to separate out the various rights appertaining to the holder of preference shares and to treat some of those rights as 'actual estate' and others as 'notional estate'.

Accordingly, while shares are comprised of a bundle of rights, those rights are not separate pieces of property capable of being divided out and held separately.

Whether a right attaching to a share is a CGT asset

In considering the nature of a share, it has been the prevailing view of the courts that the rights attaching to shares cannot be dealt with separately from the share itself.

The Commissioner considers that these rights are not assets under the definition of 'asset' in section 160A of the ITAA 1997. The expression 'any other right' is a general provision which, under the rules of statutory interpretation, does not take precedence over a more specific provision. As a share is a chose in action, subparagraph 160A(a)(iii) takes precedence over subparagraph 160A(a)(iv) to the effect that a share itself is the asset and not its constituent rights. The concept of a share as a whole being the relevant asset is also supported by other provisions in Part IIIA: see, for example, paragraphs 160M(5)(a), 160T(1)(c) and 160T(1)(j).

Division 19B of the ITAA 1997

When considering the implications of varying rights attaching to shares, we must also consider Division 19B of the ITAA 1997. Section 160ZZR states that the object of Division 19B is to remove the CGT advantages of share value shifting arrangements. Varying rights attaching to shares is an example of how value can be shifted from one share or class of new shares for less than market value, resulting in a general dilution of the value of existing shares.

In your circumstances

The Commissioner acknowledges that you are not varying the rights attached to the C class shares, you are ratifying the rights that always existed. However, we consider the arguments are similar given that both scenarios are dealing with the rights of the shares.

Company A's Articles of Association indicate that the shares are ordinary shares. Although the resolution of 1 February 19xx classified the shares as C class shares, the resolution did not change the rights attached to those shares. Further, neither the Articles of Association nor the resolution provide different rights for C class shares. Given the Articles of Association provide different rights for A and B class shareholders, if different rights were intended, it is likely this would have been included in either the Articles of Association or the resolution. In the absence of any change, the rights attached to the shares would continue to be those of ordinary shares.

In the alternative, if ratifying the rights to the C class shares is considered a variation to the rights that previously existed, Division 19B of the ITAA 1997 must be considered.

The Commissioner does not consider ratifying or confirming the rights of the C class shares meets the threshold requirements of the value shifting provisions. Confirming these rights does not change the value of the shares, nor the value of the A and B class shares. Consequently, ratifying the rights attached to the existing C class shares will not trigger CGT event H2 for the shareholders.

Question 2

If yes, will the C class shareholders receive any capital proceeds pursuant to section 116-20 of the ITAA 1997 because of CGT event H2?

Answer

Not applicable

Question 3

Summary

The C class shares in Company A held by Individual C are pre-CGT shares.

The C class shares in CC held by Individual D, Individual E and Individual F are not pre-CGT shares.

Detailed reasoning

Pre-CGT asset

'Pre-CGT asset' is defined in the Dictionary at section 995-1(1) of the ITAA 1997 as having the meaning given by section 149-10 of the ITAA 1997. In turn, section 149-10 of the ITAA 1997 defines a pre-CGT asset as:

A CGT asset that an entity owns is a pre-CGT asset only if, and only if:

(c)   the entity last acquired the asset before 20 September 1985; and

(d)  the asset has not stopped being a pre-CGT asset because of Division 149.

In accordance with section 995-1(1) of the ITAA 1997, a CGT asset is acquired in the circumstances and at the time worked out under Division 109 of the ITAA 1997.

Section 109-5(1) of the ITAA 1997 provides that a person 'acquires' a CGT asset when they become its owner. However, the table in section 109-5(2) of the ITAA 1997 sets out specific rules for the circumstances in which, and at what time, a taxpayer acquires a CGT asset as a result of a CGT event happening.

CGT event E5

Section 104-75(1) of the ITAA 1997 provides that 'CGT event E5 happens if a beneficiary becomes absolutely entitled to a CGT asset of a trust ... as against the trustee...'

Typically, CGT event E5 might be expected to happen when a beneficiary reaches a certain age and, under the terms of the trust, becomes absolutely entitled to an asset held in trust. It may be that once the beneficiary reaches the requisite birthday their entitlement may fall short of absolute entitlement.

Time of CGT event E5

Section 104-75(2) of the ITAA 1997 provides that CGT event E5 happens 'when the beneficiary becomes absolutely entitled to the asset'. Where this is due to a beneficiary reaching a certain age, CGT event E5 might be expected to happen on the birthday of the beneficiary even though the transfer of legal title from the trustee to the beneficiary may not occur until some time later. However, if the beneficiary does not become absolutely entitled until the transfer of legal title, then CGT event E5 will not happen until that time.

Absolute entitlement

'Absolute entitlement' is not defined in either the ITAA 1936 or the ITAA 1997. The ATO issued Draft Taxation Ruling TR 2004/D25 Income tax: capital gains: meaning of the words 'absolutely entitled to a CGT asset as against the trustee of a trust' as used in Parts 3-1 and 3-3 of the Income Tax Assessment Act 1997. In paragraph 8 it states that:

The main CGT provisions to which the concept of absolute entitlement is relevant apply if a beneficiary is (or becomes) absolutely entitled to a CGT asset of the trust as against the trustee (disregarding any legal disability): see section 106-50 and CGT event E5 in section 104-75.

Paragraph 10 goes on to set out the core principle. It states that:

The core principle underpinning the concept of absolute entitlement in the CGT provisions is the ability of a beneficiary, who has a vested and indefeasible interest in the entire trust asset, to call for the asset to be transferred to them or to be transferred at their direction. This derives from the rule in Saunders v Vautier applied in the context of the CGT provisions...

Paragraph 23 considers that a beneficiary can not have absolute entitlement if more than one beneficiary has an interest in the trust. It states that:

If there is more than one beneficiary with interests in the trust asset, then it will usually not be possible for any one beneficiary to call for the asset to be transferred to them or to be transferred at their direction. This is because their entitlement is not to the entire asset.

However, paragraph 24 sets out an exception where there is more than one beneficiary with an interest. It states that:

There is, however, a particular circumstance where such a beneficiary can be considered absolutely entitled to a specific number of the trust assets for CGT purposes. This circumstance is where:

•   the assets are fungible;

•   the beneficiary is entitled against the trustee to have their interest in those assets satisfied by a distribution or allocation in their favour of a specific number of them; and

•   there is a very clear understanding on the part of all the relevant parties that the beneficiary is entitled, to the exclusion of the other beneficiaries, to that specific number of the trust's assets.

Paragraph 25 provides:

Because the assets are fungible, it does not matter that the beneficiaries cannot point to particular assets as belonging to them. It is sufficient in these circumstances that they can point to a specific number of assets as belonging to them.

This view is supported by the decision in Beck v Henley [2014] NSWCA 201. In that case, the decision of the Judge at first instance that one half of the shares in a private company should be transferred to a beneficiary who was 'absolutely and indefeasibly entitled to one half of the trust property' was upheld.

In your circumstances

The terms of the trust provide that each of the children are entitled to an equal share of the trust corpus. They are entitled to their share of the trust 'upon attaining the age of twenty-five'. The assets of the trust include the 4,000 C class shares numbered 3 to 4,003. Although the shares are separately numbered, they are fungible.

Individual C attained the age of twenty-five prior to 19 September 1986 and became absolutely entitled to their,000 C class shares in Company A. In accordance with subsection 109-5(2) of the ITAA 1997, Individual C is deemed to have acquired those shares on that date.

It is irrelevant that the shares were not transferred to Individual C until 1 July 20xx. In this regard, subsection 106-50(1) of the ITAA 1997 provides that for the purposes of Part 3-1 and Part 3-3 of the ITAA 1997 'from just after the time you become absolutely entitled to a CGT asset as against the trustee of a trust (disregarding any legal disability), the asset is treated as being your asset (instead of being an asset of the trust)'. As this was prior to 20 September 1986, these shares are pre-CGT assets.

Individual D attained the age of twenty-five after 20 September 1986 and became absolutely entitled to their 1,000 C class shares in Company A. In accordance with subsection 109-5(2) of the ITAA 1997, Individual D is deemed to have acquired those shares on that date. As this was after 19 September 1986, these shares are not pre-CGT assets.

Individual E attained the age of twenty-five after 20 September 1986 and became absolutely entitled to their 1,000 C class shares in Company A. In accordance with subsection 109-5(2) of the ITAA 1997, Individual E is deemed to have acquired those shares on that date. As this was after 19 September 1986, these shares are not pre-CGT assets.

Individual F attained the age of twenty-five after 20 September 1986 and became absolutely entitled to their 1,000 C class shares in Company A. In accordance with subsection 109-5(2) of the ITAA 1997, Individual F is deemed to have acquired those shares on that date. As this was after 19 September 1986, these shares are not pre-CGT assets.

Issue 2

Question 1

Summary

No, ratifying the rights attaching to the existing A, B and C class shares in Company B and renaming these shares ordinary shares will not trigger CGT event H2.

Detailed reasoning

There was an in-depth discussion at issue 1, question 1 regarding the nature of a share and whether a right attaching to a share is a separate CGT asset and we do not propose to repeat that information here.

In your circumstances

The Commissioner accepts that you are not varying the rights attached to the A, B and C class shares of Company B and that you are ratifying the rights that always existed. However, we consider the arguments are similar given that both scenarios are dealing with the rights of the shares.

Although the resolution of 1 February 19xx classified the shares as C class shares, the resolution did not provide any further information about the rights attached to those shares. Further, neither the Articles of Association nor the resolution provide the rights for any of the classes of shares, be they A, B or C class shares. The only evidence about the rights attached to the shares appear to be the form Return of Allotment of Shares. Despite this form dividing the shares into A, B and C class shares, it also indicated they were all ordinary shares.

The Articles of Association do give the A and B class shareholders the right to be the Directors, to hold that office for life and to appoint any further Directors. However, those rights are not attached to the holders of the shares but are given to Individual A and Individual B as they were the subscribers to the Memorandum of Association. Indeed, they retain those rights even if they do not retain the shares.

The Commissioner does not consider the rights attached to these shares have changed. Consequently, ratifying the rights attaching to the existing A, B and C class shares in Company B and renaming these shares ordinary shares will not trigger CGT event H2.

Question 2

If yes, will the shareholders receive any capital proceeds pursuant to section 116-20 of the ITAA 1997 because of CGT event H2?

Answer

Not applicable