Edited version of private advice

Authorisation Number: 1051900497517

Date of advice: 23 September 2021

Ruling

Subject: Propagation

Question 1

Is the manner in which the capital gain or capital loss calculated by the taxpayer by nominating the specific parcel of shares disposed of from the taxpayer's tax propagated portfolio using the propagation system (the System) acceptable in determining the net capital gains or losses of the taxpayer for the purposes of sections 102-5 and 102-10 of the Income Tax Assessment Act 1997 (ITAA 1997) for an income year?

Answer

Yes

Question 2

If the answer to Question 1 is yes, will the System satisfy the requirements of subsection 121-20(1) of the ITAA 1997?

Answer

Yes

Question 3

Will Part IVA of the Income Tax Assessment Act 1936 apply to the System utilised by the taxpayer?

Answer

No

This ruling applies for the following period:

A number of income years

The scheme commenced during:

An income year

Relevant facts and circumstances

The taxpayer is a complying superannuation fund.

The taxpayer is managed by a trustee company (the Trustee).

The taxpayer does not have any sub-funds within the meaning of section 69A of the Superannuation Industry (Supervision) Act 1993.

The taxpayer uses the 'unsegregated current pension assets method' under section 295-390 of the Income Tax Assessment Act 1997 in calculating its exempt current pension income for Australian income tax purposes.

The taxpayer offers its members a range of investment options across various asset classes.

The taxpayer consists of two pools of assets, one pool of which its Custodian is custodian of while the other pool is for its self-managed option product for its members. The Custodian is not the custodian for the self-managed option assets and does not have the data of these assets.

The Custodian

The taxpayer had previously engaged another custodian (Former Custodian) to provide custodial and investment administration services in relation to its assets.

The taxpayer subsequently changed its custodian and implemented relevant processes to ensure the integrity of the data that was transferred from the Former Custodian to the Custodian.

For the equity portfolios, the Custodian holds all shares as nominee for the taxpayer and settles all trades for which it is instructed to by the investment managers.

When the Custodian receives instructions to settle a trade from an investment manager, its role is to:

•         be responsible for recording the sale in its records on behalf of the Trustee

•         select which parcel of shares is to be disposed of. This is because the Custodian keeps the records relating to the buying and selling of shares on behalf of the Trustee

•         allocate specific share parcels to be disposed of in accordance with the methodology determined by the taxpayer

•         maintain the taxpayer's accounting and tax records and calculations, so that it can assist the Trustee in meeting its tax and regulatory obligations.

Investment managers

To manage its assets, the taxpayer engages Australian and international investment managers. Each investment manager is responsible for a specific amount of the taxpayer's assets.

The role of the investment manager is to:

•         maintain a portfolio of assets on behalf of the Trustee within the guidelines set out in the investment management agreement, which sets out certain criteria such as limits of exposure to a single asset

•         use the funds allocated to it by the Trustee to make investment decisions

•         instruct a broker to sell (when an investment manager decides to sell some of the Trustee's shares)

•         act as an agent of the Trustee, such that it can instruct the broker to make the sale using the Custodian's account to settle the transaction

•         make the decision as to what securities to buy, hold or sell, and in what quantities, and instruct the Custodian to carry out its decisions.

The investment manager does not buy, hold or sell the shares. Nor does it select which parcel of shares is to be sold. Instead, the investment manager instructs the broker to sell a certain number of a type of shares from the Custodian's account.

Capital gain tax (CGT) parcel selection process

The taxpayer's CGT parcel selection process has been based on a propagated parcel selection methodology agreed upon with its Former Custodian.

Following the change in custodian, the Trustee also instructed the Custodian to apply a parcel selection process based on a propagated parcel selection methodology (the System).

The System provided by the Custodian is described as follows:

•         Data of share acquisitions and disposals are entered into portfolios established for each investment manager (sub-portfolio) and processed at this level.

•         The tax propagated portfolio is created by the Custodian for selected equity portfolios as instructed by the Trustee. Any share acquisition and disposal data is automatically replicated in the tax propagated portfolio. The tax propagated portfolio level reflects the actual ownership level of all the parcels of shares held by the taxpayer. Parcels held by the tax propagated portfolio may be different to the underlying sub-portfolios.

•         The System allows for parcel selection to occur across the tax propagated portfolio using a "maximise loss" tax inventory method. All parcels for a security held by all portfolios allocated to the tax propagated portfolio are available to be selected.

•         The method of selecting the nominated parcel of shares subject to the CGT event is automated within the System.

•         All parcels created in the underlying portfolios are replicated in the tax propagated portfolio as are all transactions. Any transactions for which tax cost is to be used (such as for a sale transaction) will determine that cost using the tax parcels selected using the inventory methodology at the relevant level (tax propagated portfolio or sub-portfolio).

•         Where an investment manager sells a parcel of shares, parcel selection occurs at the sub-portfolio level, and also at the tax propagated portfolio level in respect of fungible assets, i.e. identical in all aspects.

•         The identification and selection of the parcel of shares for propagation is contemporaneous with the actual disposal transaction.

•         Once a parcel of shares has been selected as the nominated parcel of shares, that selection is final. Therefore, once selected for disposal, that parcel is no longer active for future application.

•         On a tax propagated portfolio basis, the maximise loss method prioritises parcels of shares that generate the smallest gain or largest loss on disposal.

•         The Custodian utilises multiple sub-custodians across its international investment portfolio, but only one sub-custodian is utilised in each market that the taxpayer is invested in.

•         Propagation does not occur across assets held by the Custodian and its sub-custodians or between separate sub-custodians.

•         Calculations of capital gains and losses at the tax propagated portfolio level will be reported to the taxpayer for the purpose of supporting its income tax return records.

The Custodian's system is consistent with the propagated parcel selection methodology previously applied by the Former Custodian.

Assets identified for disposal under the System are also the assets identified for non-regulatory or accounting purposes by the taxpayer, i.e. assets identified as disposed of for tax are the same assets identified as being disposed of for accounting purposes regardless of variance in tax and accounting cost bases.

Assets in the equity portfolios held in custody in Australia and in an overseas jurisdiction are registered in the name of the Custodian's related party.

International equities

Foreign listed securities are held via the Custodian's various sub-custodians. Although the Custodian has multiple sub-custodians in some jurisdictions, equities issued or listed in a specific country will be held by the same sub-custodian for that country.

Whilst the taxpayer holds dual-listed securities on different exchanges, the securities of two different exchanges would be treated as different assets, which can be individually distinguished, for propagation purposes under the System via separate security identification codes for each stock exchange. As such, the System does not allow for propagation to occur between different exchanges for dual-listed securities.

Record keeping

The Custodian's system is designed at the individual investment manager level to record the:

•         date that an investment manager entered into a contract to buy or dispose of a parcel of assets (that is, a parcel of identical shares)

•         name and security identifier (for example, SEDOL) of the assets acquired.

•         type and class of asset (for example, ordinary shares)

•         number of assets (for example, the number of shares in the parcel) that have been acquired or disposed

•         cost elements of the parcel of shares including any incidental costs (for example, brokerage), in the case of an acquisition

•         reduced cost base when a tax deferred distribution is received. For schemes under the Attributed Managed Investment Trust regime the cost base increase or decrease per annual Attribution Managed Investment Trust Member Annual statement will also be recognised

•         frozen indexed cost base where relevant

•         impact of corporate actions including bonus issues, return of capital, share splits, takeovers, etc.

•         proceeds received and any incidental costs incurred (for example, brokerage) in the case of a disposal

•         notional nominated parcel of assets that was subject to the CGT event

•         remaining balance of the parcel where it has been partially disposed.

In addition, the Custodian's system allocates a system generated unique transaction ID number. The purchase and sale transaction IDs are unique at the sub-portfolio level across all of the taxpayer's transactions. The purchase and sale transaction IDs in the sub-portfolios will also be replicated in the propagated portfolio.

For purchases and sales of assets in foreign currency in the sub-portfolios and propagated portfolio, the purchase cost will be converted to Australian dollars at the contract purchase date exchange rate and the sale proceeds will be converted at contract sale date exchange rate.

The same information listed above at paragraphs 22, 23 and 24 is replicated in the tax propagated portfolio.

The Custodian performs accounting to tax reconciliations (from net operating income per the Trial Balance to taxable income) independently for each sub-portfolio and the tax propagated portfolio. Separate reconciliations of the units and market values of equity securities are performed between the propagated portfolio and the sum of the sub-portfolios, to ensure consistency between them.

Records are kept electronically and the Custodian's systems meet the record keeping requirements set out in paragraphs 7 and 8 of Taxation Ruling TR 2018/2 Income Tax: record keeping - electronic records with respect to:

•         protection from manipulation or alteration

•         record retention

•         document retrieval, system documentation, encryption keys, convertibility into standard data formatting and identifiability

•         accessibility.

Rationale for utilising the System

The System provides the taxpayer with access to information it needs to make more informed decisions to identify the shares disposed of for CGT purposes.

Relevant legislative provisions

Section 102-5 of the Income Tax Assessment Act 1997

Section 102-10 of the Income Tax Assessment Act 1997

Subsection 121-20(1) of the Income Tax Assessment Act 1997

Part IVA of the Income Tax Assessment Act 1936

Subsection 177A(1) of the Income Tax Assessment Act 1936

Subsection 177A(5) of the Income Tax Assessment Act 1936

Subsection 177C(1) of the Income Tax Assessment Act 1936

Subsection 177CB(2) of the Income Tax Assessment Act 1936

Subsection 177CB(3) of the Income Tax Assessment Act 1936

Subsection 177D(1) of the Income Tax Assessment Act 1936

Subsection 177D(2) of the Income Tax Assessment Act 1936

Subsection 177F(1) of the Income Tax Assessment Act 1936

Reasons for decision

Question 1

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified.

The taxpayer's assessable income includes any net capital gain made by the taxpayer in the income year pursuant to section 102-5.

For CGT purposes, where a disposal of a CGT asset (e.g. a parcel of shares) occurs, a capital gain or loss for most CGT events is worked out in accordance with section 100-45. Where the shares disposed can be individually distinguished, a capital gain or loss can be determined by reference to the capital proceeds, cost base and the acquisition date of the shares.

Where the disposal of shares form part of a holding of identical shares which are acquired over time, it may not always be possible to distinguish or identify the particular shares that have been disposed of. In these situations, the taxpayer will need to decide which particular shares are being disposed of.

For CGT purposes, the Commissioner will accept the taxpayer's selection of the identity of shares that have been disposed of. CGT Determination TD 33 Capital Gains: How do you identify individual shares within a holding of identical shares?, paragraphs 3 and 4 provide:

3. In these circumstances, the taxpayer will need to decide which particular shares are being disposed of. Taxpayers in this situation will need to keep adequate records of the transaction so that the decision can be supported should the income tax return be subject to Tax Office scrutiny at a later date.

4. In the past, where unidentifiable shares have been disposed of, the Commissioner has accepted 'first-in first-out' as a reasonable basis of identification. For CGT purposes, the Commissioner will also accept the taxpayer's selection of the identity of shares disposed of.

Under the 'taxpayer's selection of the identity of shares' method, a taxpayer must keep detailed records of the shares sold and this must be used in determining any capital gain or loss.

The Custodian maintains the accounting and tax records to enable the taxpayer to determine its capital gain or loss. Under the System, all relevant information is recorded at both the sub-portfolio and tax propagated portfolio levels. The information in the tax propagated portfolio reflects the actual ownership of all the parcels of shares held by the taxpayer.

When the Custodian receives instructions to settle a trade from an investment manager, the System applies the maximise loss method to select a parcel of identical shares at the time of disposal from the tax propagated portfolio.

On the basis that the taxpayer maintains sufficient records to specifically identify the shares that have been disposed of, the Commissioner accepts the taxpayer's selection of specific shares, that is, a nominated parcel of shares, for the CGT event, from the tax propagated portfolio under the propagated system in order to determine the taxpayer's net capital gain or loss for the purposes of sections 102-5 and 105-10 for an income year.

Question 2

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified.

Section 121-20 provides that records that must be kept to determine the capital gain or a capital loss from a CGT event.

Subsection 121-20(1) provides that:

You must keep records of every act, transaction, event or circumstance that can reasonably be expected to be relevant to working out whether you have made a capital gain or capital loss from a CGT event. (It does not matter whether the CGT event has already happened or may happen in the future.)

Section 121-20 also specifies that records that are relevant to determine the taxpayer's capital gain or loss are records that:

•         identify the date on which the assets are bought or sold

•         identify the price at which the assets are purchased and sold

•         record the details of every act, transaction, event or circumstance that is relevant to work out the capital gain or capital loss from a CGT event, and

•         are in English or readily accessible and convertible into English.

Further, section 121-25 provides that a taxpayer must retain such records to substantiate the taxpayer's capital gain or loss.

Where electronic records are kept, Taxation Ruling TR 2018/2 Income tax: record keeping - electronic records provides at paragraph 22:

Advances in technology (including the internet) have meant that many taxpayers who carry on a business now process and keep their records electronically rather than through a paper based system. This includes encrypted records. The Tax Office requires that records, whether kept on paper or electronically, must be kept accurately so as to enable that person's tax liability to be readily ascertained. The records must be in a form which Tax Office staff can access and understand in order to ascertain that person's taxation liability.

Based on the information provided of the System's record keeping capabilities, it is considered that the Trustee will have sufficient records to enable it to specifically identify the relevant shares disposed of from the taxpayer and to determine the capital gains and losses generated by the taxpayer in respect of the disposal of the shares.

Accordingly, the Commissioner confirms that the records the taxpayer states are maintained by the System, as described in the Facts, satisfy the requirements of subsection 121-20(1).

Question 3

All legislative references are to the Income Tax Assessment Act 1936 unless otherwise specified.

Part IVA is the general anti-avoidance provision which allows the Commissioner the discretion to cancel a 'tax benefit' that has been obtained, or would, but for section 177F, be obtained by a taxpayer in connection with a scheme to which Part IVA applies.

In order for Part IVA to apply, the following requirements must be satisfied:

•         there is a scheme to which Part IVA applies

•         a tax benefit was or would (but for subsection 177F(1)) have been obtained

•         the identified tax benefit was or would have been obtained in connection with the identified scheme, and

•         the person who entered into or carried out the identified scheme (or any part of the scheme) did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit.

Scheme

A 'scheme' is broadly defined in subsection 177A(1) and can be a series of steps taken together or a single step (refer to Commissioner of Taxation v Hart [2004] HCA 26).

The taxpayer's implementation and its utilisation of the System will constitute a scheme (the Scheme) for the purposes of subsection 177A(1).

Tax benefit

Having established the existence of a scheme, Part IVA will only apply if it is determined that a tax benefit was or would have been obtained in connection with that scheme.

Subsection 177C(1) identifies a number of tax benefits, including but not limited to:

•         an amount not being included in the taxpayer's assessable income

•         a deduction being allowable to the taxpayer

•         a capital loss being incurred by the taxpayer, and

•         a foreign tax credit being allowable to the taxpayer.

Section 177CB- the basis for identifying tax benefits

For schemes entered into on or after 16 November 2012, section 177CB provides the framework for deciding under section 177C whether any tax benefits would have occurred, or might reasonably be expected to have occurred, if the scheme had not been entered into or carried out, which is referred to as the tax effects.

The 'would have' (annihilation approach) and 'might reasonably be expected to' (reconstruction approach) limbs of subsection 177C(1) are separate and distinct bases upon which the existence of a tax effect can be demonstrated (refer paragraph 1.44 of Explanatory Memorandum to Tax Laws Amendment (Countering Tax Avoidance and Multinational Profit Shifting) Bill 2013 (the EM)).

The annihilation approach

Subsection 177CB(2) confirms that a decision that a tax effect would have occurred if the scheme had not been entered into or carried out must be based on a postulate that comprises only the events or circumstances that actually happened or existed (other than those that form part of the scheme) (the annihilation approach). In considering such a postulate, the scheme must be assumed never to have happened. That is, it is annihilated, deleted or extinguished to determine the tax effects based on the remaining events or circumstances.

The annihilation approach would typically apply where the scheme in question does not produce any material non-tax results or consequences for the taxpayer (refer paragraph 1.82 of the EM).

The reconstruction approach

Subsection 177CB(3) explains that a decision that a tax effect might reasonably be expected to have occurred if the scheme had not been entered into or carried out must be based on a postulate that is a reasonable alternative to entering into or carrying out the scheme (the reconstruction approach).

In determining whether such a postulate is a reasonable alternative, particular regard must be had to the substance of the scheme and any result or consequence for the taxpayer that is or would be achieved by the scheme. Any results in relation to the operation of the Act (as defined) that would be achieved by the postulate for any person (whether or not a party to the scheme) must be disregarded.

As a result of the Scheme, the taxpayer will have an enhanced capability to select parcels of shares from the entire tax propagated portfolio rather than from individual underlying sub-portfolios which would be the case if the System was not utilised, resulting in a more favourable tax outcome than that which may have been achieved under the alternative postulate. As such, it is likely that the following tax benefits to the taxpayer would arise under the Scheme:

•         a reduced amount of capital gains included in its assessable income

•         increased capital losses, or

•         increased discount capital gains.

Based on the above analysis, it is concluded that under the reconstruction approach, a tax benefit will be obtained in connection with the Scheme resulting from the use of the System.

Schemes to which Part IVA applies

Subsection 177D(1) provides that Part IVA applies to a scheme in connection with which the taxpayer has obtained a tax benefit if, having regard to the matters in subsection 177D(2), it would be concluded that a person (who need not be the taxpayer) who entered into or carried out the scheme (or any part of it), did so for the purpose of enabling the taxpayer to obtain a tax benefit.[1]

Subsection 177A(5) makes it clear that the 'purpose' includes the dominant purposes where there are two or more purposes - the 'dominant' purposes being the 'ruling, prevailing or most influential purpose': The Commissioner of Taxation of the Commonwealth of Australia v Spotless Services Ltd & Anor [1995] FCA 958.

Conclusion

Having regard to the relevant factors in subsection 177D(2), it is concluded that the Scheme was not entered into for the dominant purpose of obtaining a tax benefit in connection with the Scheme.

Accordingly, the Commissioner confirms that Part IVA will not apply to the System utilised by the taxpayer.

[1] Paragraph 79 of Practice Statement Law Administration PS LA 2005/24 Application of the General Anti-Avoidance Rules.