Edited version of private advice

Authorisation Number: 1051869794197

Date of advice: 19 July 2021

Ruling

Subject: Capital gains tax

Question

Is Entity A entitled to use the market value as the first element of the cost base or reduced cost base under section 112-20 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the Entity B's assets acquired as part of an amalgamation?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XA

Relevant facts and circumstances

Entity A is a registered club under the Registered Clubs Act 1976 and holds a Liquor Licence under the Liquor Act 2007.

Entity A is a public company limited by guarantee. Its principal activity is the conduct and promotion of licensed social and sporting clubs and the provision of sporting and recreation facilities to members.

The ordinary income (and corresponding expenses) of Entity A is subject to the principle of mutuality.

Amalgamation between Entity A and Entity B in 20XA

Entity B considered an amalgamation as it was determined that Entity B could not best serve members interests without support from an amalgamation partner. An amalgamation would be a solution to secure Entity B's future following years of declining performance and cash reserves which could have led to its closure.

Entity B called for 'Expressions of Interests' from other registered clubs within a 50 kilometres radius of Entity B interested in exploring an amalgamation in 20XA. Entity B's major objectives for the amalgamation were to ensure the financial viability of their club for their members.

Entity B subsequently selected Entity A as its amalgamation partner in an attempt to improve its performance and help restore the club 'to its brighter past'.

On 10 XXX 20XA, the Board of Entity A signed a Memorandum of Understanding for an amalgamation with Entity B.

The application for legislated approval was approved with the Independent Liquor and Gaming Authority and a new entity, Entity C was established.

The amalgamation involved Entity A taking over two entities, including:

•         Entity D, a company setup to run the sporting operations at Entity B with very limited assets.

•         Entity B which owned premises and related substantial assets.

On 1 XXXX 20XA, Entity A completed the amalgamation with Entity B. The amalgamation between the two entities resulted in the transfer of ownership to Entity A. The amalgamation deal involved Entity A acquiring Entity B for a nominal amount of $1, and with this it assumed to take over all Entity B's historic and current assets and liabilities. The nominal consideration was based on Entity B's attempt to continue its survival.

With regard to $1 nominal amount, additional information was provided. Based on this information and as far as Entity A's knowledge, there was never any discussion about Entity B receiving any consideration for the sale of assets. The $1 consideration was inserted into the Sale Contract as a nominal amount to allow the execution of the legal process.

Balance sheet and valuation of assets prior to amalgamation was provided in respect of Entity B

You have stated that the consideration paid was not an arm's length price. The assets would not have been sold for a nominal value if this was not for the amalgamation and the members aim to secure Entity B's future. The club had exhausted its options and required the help of an amalgamation partner to avoid a closure and job losses.

As part of the commitment post amalgamation, Entity A agreed to inject capital of approximately $X, XXX,XXX (post amalgamation) into Entity C. This commitment was met and by XX XXX 20XX. $X,XXX,XXX had been spent on working capital including hiring new staff and delivering new projects that Entity B was unable to carry out due to lack of funds (including purchases of new equipment and replacing old equipment into Entity C).

On XX XXX 20XA, Entity B's balance sheet displayed a $XXX,XXX loan creditor balance (post amalgamation). You have stated it is your belief that this debt was subsequently forgiven by Entity A.

De-Amalgamation between Entity A and Entity B in 20XX

Entity E) is a registered club under the Registered Clubs Act and holds a Liquor Licence under the Liquor Act 2007.

On XX XXXX 20XB, Entity A submitted an expression of interest to Entity E with respect of an amalgamation of its Entity C premises that is occupied by Entity C. Following negotiations, Entity E selected Entity A as its preferred amalgamation partner.

Under the Sales Purchase Agreement, Entity A sold 100% of Entity C to Entity E. Under the Contract for Sale of Land, Entity A disposed of Entity C Land to Entity E for a consideration of $XXX,XXX.

In addition to the sale of land, other assets (not including real property/land) were also sold to Entity E under an Asset Transfer Agreement for a consideration of $X,XXX,XXX.

The following information has been supplied and their contents form part of these facts:

•         Appendix 1 - Private Ruling application form (tax professionals);

•         Appendix 2 - Section C, Question 7: Facts describing the scheme or circumstance;

•         Appendix 4 - Copy of the Entity B Amalgamation Deed;

•         Appendix 5 - Current Constitution of Entity A;

•         Appendix 6 - Annual Reports for the relevant recent years;

•         Client emails 1, 2 and 3 dated XX XXX 20XX including all attachments; and

•         Client email dated XX XXX 20XX.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 110-25(2)

Income Tax Assessment Act 1997 subsection 110-55(2)

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 subsection 112-20(1)

Income Tax Assessment Act 1997 paragraph 112-20(1)(c)

Income Tax Assessment Act 1997 subsection 112-20(2)

Income Tax Assessment Act 1997 subsection 112-20(3)

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

Liquor Act 2007

Registered Clubs Act 1976

Reasons for decision

Summary

Entity A is able to use the market value at the time of acquisition of the Entity B assets as the first element of the cost base or reduced cost base under the market value substitution rule in section 112-20 of the ITAA 1997.

Detailed reasoning

Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997).

Subsection 110-25(1) provides that the cost base of a CGT asset consists of 5 elements.

Subsection 110-25(2) provides that the first element of a CGT asset is the total of:

(a) the money you paid, or are required to pay, in respect of acquiring it; and

(b) the market value of any other property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

The first element of the reduced cost base of a CGT asset's reduced cost base is the same as that for the cost base under subsection 110-55(2).

However, paragraph 112-20(1)(c) provides that the first element of your cost base and reduced cost base of a CGT asset you acquire from another entity is its market value (at the time of acquisition) if you did not deal at arm's length with the other entity in connection with the acquisition.

Despite paragraph 112-20(1)(c), subsection 112-20(2) states that, if you did not deal at arm's length with the other entity and your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening; the market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition).

Further, subsection 112-20(3) sets out some situations in which the market value substitution rule does not apply.

In this case, Entity A acquired the assets of the Entity B in return for the following:

•         Assume all existing financial Liabilities of Entity B.

•         Provide employment offers to all existing Entity B employees and recognise continued service for the provisions of leave.

•         Preserve the sporting facilities at the premises.

•         A commitment of $X,XXX,XXX to upgrade and renovate the Entity B premises and facilities.

•         A commitment of $XXX,XXX to the Sporting Fund for expenditure and priority investments in the relevant sport.

•         A commitment for Bonus investment in the sport if sufficient Financial Performance measures were achieved.

The 'MOU Agreement' between Entity A and Entity B does not address any value to be attributed to the assets acquired as a result of the amalgamation.

Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. Subsection 995-1(1), in respect of the term 'arm's length', states that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

The Legal Dictionary.com defines an 'arm's length transaction' as transactions wherein the buyers and sellers to the transaction have no prior relationship with each other. Arm's length transactions ensure that each party is acting in his own self-interest, and that neither party is being pressured by the other party to go ahead with the transaction. This also reassures any potential third parties to the transaction that no collusion exists between the buyer and the seller.

Because of the nature of the entities involved in the transaction (that is, not for profit entities which are companies with no share value) and the absence of 'direction' provided with relation to the valuation of assets transferred as a result of the amalgamation, it is necessary to determine whether paragraph 112-20(1)(c) applied to the above circumstances. Even given the parties were 'arm's length parties', the entities may not have been considered to be dealing at 'arm's length' in that transaction.

It is not sufficient that the parties may be at arm's length, they must deal with each other at arm's length, that is, 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 (Furse) and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 (Granby).

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 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 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.

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 Federal Court found at 4835 - 4836:

On the evidence before it, particularly that of A, the Tribunal was of the view that, whilst the sale and purchase of the whole of the property at public auction was an arm's length dealing, the contract of sale of 1343 M Road did not result from the applicants and Mr B dealing with each other at arm's length. From the clear evidence of A, no negotiating or bargaining took place in relation to the price to be paid for that particular block of land. The purchase price was typed on the contract prior to the auction. Mr B was simply requested to sign two contracts for the total purchase price. The price for 1343 M Road was determined in advance by the applicants without waiting for a determination of the market value of the whole of the land at auction or without knowledge of what that might be. The question is not whether the parties were at arm's length but whether they were dealing with each other at arm's length.

The way in which the arrangement between Entity A and Entity B was structured and implemented evidences that the parties did not behave in the manner in which arm's length parties would be expected to behave, that is, the facts indicate that the parties did not deal with each other at arm's length. There was no "dealing" on the price to be payable on the acquisition and no mention of price included in the amalgamation brief, expression of interest or MOU supplied.

The amounts paid for the liabilities of Entity B were substantially under the market value of the assets acquired and the parties were aware of this. It is not a 'sale' price which reflects the outcome of a normal bargaining process as discussed in Granby and Collis and the asset values included in the list of assets before amalgamation indicate that the 'sale' price did not reflect the price at which the assets were valued. Entity A acquired Entity B (which at the time had gross assets of $X,XXX,XXX per the balance sheet) for a nominal sum of $1.

As it is considered that Entity A did not deal with Entity B at arm's length in connection with the acquisition of Entity B' assets, paragraph 112-20(1)(c) will apply. Subsections 112-20(2) and (3) do not apply in this case.

Entity A can, therefore, use the market value at the time of acquisition of the Entity B assets acquired as part of the amalgamation as the first element of the cost base of the assets under the market value substitution rule in section 112-20.