Edited version of private advice

Authorisation Number: 1052058356891

Date of advice: 5 December 2022

Ruling

Subject: Capital gains tax

Question 1

Can Trust A disregard the capital gain made when CGT event D2 happened in the 20XX income year and instead treat the Call Option Fee received as a forfeited deposit that forms part of the capital proceeds for CGT event A1 which happened when the Property was sold in the 20YY income year?

Answer

No.

Question 2

If Trust A cannot disregard the CGT event D2 capital gain in the 20XX income year, can the small business CGT concessions be applied to the gain where the relevant conditions in section 152-10 of the Income Tax Assessment Act 1997 are met?

Answer

Yes.

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20YY

Relevant facts and circumstances

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997), unless otherwise specified.

1.             Trust A is a resident trust for CGT purposes under section 995-1(1).

2.             Trust A owned a commercial property (Property).

3.             The Property was at all times used in a business carried on by an entity that is connected with Trust A.

4.             During the income year ended 30 June 20XX, Trust A entered into an Option Deed with Trust B.

5.             Under the Option Deed, Trust A (the Grantor) granted a call option to Trust B (the Grantee) to purchase the Property and Trust B granted a put option to Trust A to sell the Property.

6.             The Option Deed specified that the Call Option constitutes an irrevocable offer.

7.             A contract for the sale and purchase of land (Contract) was annexed to the Option Deed and, if executed upon exercise of the Call Option or Put Option, the Contract required a deposit to be paid.

8.             The Option Deed stated that if the Call Option was not exercised by the Grantee within the Call Option Period or the Put Option was not exercised by the Grantor within the Put Option Period, then the Call Option Fee would be immediately forfeited to the Grantor.

9.             As neither the Call Option nor the Put Option was exercised within the relevant Option Period, the Call Option Fee was immediately forfeited to Trust A under the relevant provision of the Option Deed and the Contract annexed to the Option Deed was not executed.

10.          In March 20YY, Trust A entered into a contract for the sale and purchase of the Property with Trust C.

11.          Trust C and Trust B are not associated parties.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 104-40

Income Tax Assessment Act 1997 section 104-150

Income Tax Assessment Act 1997 section 152-10

Reasons for decision

Question 1

Can Trust A disregard the capital gain made when CGT event D2 happened in the 20XX income year and instead treat the Call Option Fee received as a forfeited deposit that forms part of the capital proceeds for CGT event A1 which happened when the Property was sold in the 20YY income year?

Summary

No. Trust A cannot disregard CGT event D2 in the 20XX income year and treat the Call Option Fee as a forfeited deposit forming part of the capital proceeds for CGT event A1 in the 20YY income year.

Detailed reasoning

1.             A capital gain or capital loss can only be made if a CGT event happens. The gain or loss is made at the time of the event (section 102-20).

CGT event D2

2.             Section 104-40 provides:

(1) CGT event D2 happens if you grant an option to an entity, or renew or extend an option you had granted.

Note: Some options are not covered: see subsections (6) and (7).

(2) The time of the event is when you grant, renew or extend the option.

(3) You make a capital gain if the * capital proceeds from the grant, renewal or extension of the option are more than the expenditure you incurred to grant, renew or extend it. You make a capital loss if those capital proceeds are less.

(4) The expenditure can include giving property: see section 103-5. However, it does not include an amount you have received as * recoupment of it and that is not included in your assessable income, or an amount to the extent that you have deducted or can deduct it.

Exceptions

(5) A * capital gain or * capital loss you make from the grant, renewal or extension of the option is disregarded if the option is exercised.

Note 1: Section 134-1 sets out the consequences of an option being exercised.

Note 2: A capital gain or capital loss you made for the 1997-98 income year or an earlier income year under former Part IIIA of the Income Tax Assessment Act 1936 is also disregarded where the option is exercised in the 1998-99 income year or a later one: see section 104-40 of the Income Tax (Transitional Provisions) Act 1997.

(6) This section does not apply to an option granted, renewed or extended by a company or the trustee of a unit trust to * acquire a * CGT asset that is:

(a) * shares in the company or units in the unit trust; or

(b) debentures of the company or unit trust.

Note: Section 104-30 deals with this situation.

(7) Nor does it apply to an option relating to a * personal use asset or a * collectable.

3.             CGT event D2 happened in the income year ending 30 June 20XX when the Option Deed was entered into and the Call Option was granted by Trust A to Trust B.

4.             The capital proceeds from the grant of the Call Option was the Call Option Fee.

5.             Under subsection 104-40(3), Trust A will make a capital gain if the capital proceeds from the grant of the Call Option are more than the expenditure that Trust A incurred to grant the Call Option. Trust A will make a capital loss if those proceeds are less.

6.             Subsection 104-40(5) provides that a capital gain or loss made from the grant of the option is disregarded if the option is exercised.

7.             In this case, as neither the Call Option or Put Option was exercised, the exception in subsection 104-40(5) does not apply.

8.             The option was not granted for the acquisition of shares or debentures in Trust A, so the exception in subsection 104-40(6) does not apply.

9.             The Property is not a personal use asset or a collectable and therefore the exception in subsection 104-40(7) does not apply.

10.          Accordingly, any capital gain made by Trust A as a result of CGT event D2 happening on the grant of the Call Option cannot be disregarded and any capital gain or loss arising from the grant of the Call Option is to be taken into account in the 20XX income tax year.

Can the Call Option Fee be treated as a forfeited deposit and form part of the capital proceeds for CGT event A1?

11.          To determine whether the Call Option Fee can be treated as a forfeited amount that forms part of the capital proceeds of a subsequent CGT event A1, it needs to be established that CGT event H1 happened.

CGT event H1

12.          Section 104-150 provides:

(1) CGT event H1 happens if a deposit paid to you is forfeited because a prospective sale or other transaction does not proceed.

The payment can include giving property: see section 103-5.

Example: You decide to sell land. Before entering into a contract of sale, the prospective purchaser pays you a 2 month holding deposit of $1,000.

The negotiations fail and the deposit is forfeited.

(1A) The amount of the deposit is reduced by any part of the deposit that is:

(a) repaid by you; or

(b) compensation you paid that can reasonably be regarded as a repayment of all or part of the deposit.

The payment can include giving property: see section 103-5.

(1B) However, the deposit is not reduced by any part of the payment that you can deduct.

(2) The time of the event is when the deposit is forfeited.

(3) You make a capital gain if the deposit is more than the expenditure you incur in connection with the prospective sale or other transaction. You make a capital loss if the deposit is less.

(4) The expenditure can include giving property: see section 103-5. However, it does not include an amount you have received as * recoupment of it and that is not included in your assessable income.

Example: To continue the example: if you gave a lawyer wine worth $400 in connection with the prospective sale, you make a capital gain of:

$1,000 - $400 = $600

13.          As set out in section 104-150, for CGT event H1 to happen, there must be a forfeited deposit because a prospective sale or other transaction does not proceed.

Was there a prospective sale or other transaction that did not proceed?

14.          For capital gains tax (CGT) purposes, the Commissioner's view in relation to assets acquired on exercise of an option is that the time of acquisition of the underlying asset is the date that the option is exercised and the actual contract of sale and purchase is entered into.[1] This supports the view that an option deed and a contract of sale and purchase are separate contracts, and that the actual contract of sale and purchase is the relevant agreement under which the asset is acquired.

15.          The decision in RE Van and Federal Commissioner of Taxation 51 ATR 1153 (Van) reached the same conclusion. In Van's case, the taxpayer was issued with options to subscribe for shares in a company. The taxpayer exercised the options to subscribe for a number of shares which the taxpayer later sold. The taxpayer claimed that the date of the acquisition of the shares was the date of the contract for the acquisition of the options and that he was therefore entitled to the 50% CGT discount as he had held the shares for 12 months prior to their sale. In determining when the contract for the acquisition of the shares was entered into, the Tribunal held that the contract referred to in section 109-10, item 2 was the contract under which the shares were acquired, and not the contract that entitled the taxpayer to enter such a contract of acquisition. Accordingly, the shares were acquired on the dates when the taxpayer gave notice of the exercise of the option to request allotment of the shares, with the result that on the facts, the shares sold were not acquired more than 12 months prior to the date of their sale.

16.          The Option Deed entered into between Trust A and Trust B provided the parties with the option to enter into a contract to acquire/sell the Property. For the parties to enter into that contract of sale, the parties had to take certain steps as set out in the Option Deed to exercise the relevant option within the stipulated period, otherwise the option would be deemed to have lapsed and no contract of sale would be executed.

17.          Annexure D to the Option Deed contains the Contract which would be executed if the Call Option or the Put Option were exercised.

18.          In this case, as neither Trust A nor Trust B chose to exercise the Call Option or the Put Option, the Contract was never executed. As such, there was never a 'prospective sale or transaction that did not proceed' as contemplated under subsection 104-150(1).

Was there a deposit?

19.          Deposit is not defined in either the Income Tax Assessment Act 1936 or the ITAA 1997 and therefore takes its ordinary meaning.

20.          The ordinary meaning of deposit as defined in the Macquarie Dictionary includes 'to give as security or in part payment'.

21.          With respect to a contract for the sale and purchase of land in Byron Bay in New South Wales, the High Court in Brien v Dwyer (1978) 141 CLR 378 defined a deposit as follows:

"The deposit is an 'earnest to bind the bargain' (Howe v. Smith (1884) 27 Ch D 89, at p 101), or, as Lord Macnaghten said in Soper v. Arnold (1889) 14 App Cas 429, at p 435, 'a guarantee that the purchaser means business'. It cannot so function if payment can be made within a reasonable time after the signing of the contract. No rational vendor would subject himself to the trouble of giving a notice to pay the deposit and the risk of court determination of what is a reasonable time at the very inception of the contract. It must be remembered that on the exchange of contracts the purchaser acquires an equitable interest in the land, and this of itself has a constraining effect upon the vendor. What he can do with his land is materially limited from the moment of exchange."

22.          In Taxation Ruling TR 1999/19 Income tax capital gains: treatment of forfeited deposits, the above definition of deposit is adopted in relation to a contract for the sale and purchase of land at paragraph 35:

35. Contracts for the sale of real estate normally provide for the payment of a deposit (usually 10%, although other amounts may be agreed), payable at the time of entering into the contract and the balance of the purchase price being payable on completion or by instalments. The deposit paid by a purchaser under a binding contract for sale serves several purposes. It is an earnest given to bind the bargain; it is a guarantee that the purchaser means business; and, on completion, it becomes part payment of the purchase price (see Howe v. Smith [1884] 27 Ch D 89 at 101; Brien v. Dwyer and Another (1978) 141 CLR 378 at 392).

23.          The Option Deed makes it clear that the Call Option Fee is to be paid as consideration for the grant of the Call Option and that the deposit for the sale and purchase of the Property will be the deposit paid under the Contract.

24.          As the Contract was never executed, no deposit was paid.

Conclusion

25.          As the Contract was never executed, there was no prospective sale or other transaction that did not proceed in relation to the Property and no deposit was paid and forfeited under the Contract.

26.          Accordingly, there was no CGT event H1 in the 20XX income year.

Continuum of events

27.          As no CGT event H1 happened, there being no forfeiture of a deposit under a prospective sale or other transaction that did not proceed in relation to the Property, the question of whether a 'continuum of events' existed to enable a forfeited deposit to be taken into account as part of the capital proceeds on the later sale of the Property to Trust C, does not arise.

28.          This is because, as set out in TR 1999/19, for a 'continuum of events' to exist, there must be an earlier contract to sell the underlying asset, forfeiture of a deposit and a later bona fide disposal of the underlying asset.

29.          Paragraph 16 of TR 1999/19 provides:

What is a 'continuum of events' which constitutes a disposal of an underlying asset? For a relevant 'continuum of events' to exist, there must be an earlier contract to sell the underlying asset, forfeiture of a deposit and a later bona fide disposal of the underlying asset. It is also necessary, in our view, for continuous and reasonable attempts to be made to resell the underlying asset (for example, real estate) after the earlier contract has fallen through, which end in this later disposal of the real estate. Refer to Examples 5 and 6 in this Ruling.

30.          As explained above, this is not the situation here, because the Contract was never executed and no deposit was paid and forfeited under the Contract.

31.          As such, there is no forfeited deposit from an earlier contract of sale which can form part of the capital proceeds on the sale of the Property to Trust C in the 20YY income year.

Conclusion

32.          CGT event D2 happened on entering the Option Deed and any capital gain cannot be disregarded because none of the exceptions contained in section 104-40 apply. The capital gain made is to be taken into account in the 20XX income year.

33.          CGT event H1 did not happen because there has not been a forfeiture of a deposit under a prospective sale or other transaction that did not proceed in relation to the Property.

34.          The Call Option Fee received by Trust A cannot be treated as part of the capital proceeds for CGT event A1 on the later disposal of the Property to Trust C in the 20YY income year.

Question 2

If Trust A cannot disregard the CGT event D2 capital gain in the 20XX income year, can the small business CGT concessions be applied to the gain where the relevant conditions in section 152-10 of the Income Tax Assessment Act 1997 are met?

Summary

Yes. If the basic conditions under section 152-10 of the ITAA 1997 are satisfied, Trust A may be eligible to reduce the gain resulting from CGT event D2 using the small business CGT concessions.

Detailed reasoning

1.             Division 152 provides CGT relief for small businesses where the basic conditions for relief are met. The 4 available small business concessions are:

(a)  the 15-year exemption (in Subdivision 152-B);

(b)  the 50% reduction (in Subdivision 152-C);

(c)   the retirement concession (in Subdivision 152-D);

(d)  the roll-over (in Subdivision 152-E).

2.             To qualify for small business CGT relief, an entity must satisfy the basic conditions for relief set out in Subdivision 152-A.

3.             One of the basic conditions that must be satisfied is that a CGT event happens in relation to a CGT asset of the taxpayer in an income year (paragraph 152-10(1)(a)).

4.             In ATO Interpretative Decision ATO ID 2011/45 CGT small business concessions: basic conditions - CGT event happening in relation to a CGT asset - granting an option, the Commissioner's view is that if CGT event D2 happens, that event can be said to happen 'in relation to' the underlying asset over which the option has been granted, and accordingly paragraph 152-10(1)(a) can be satisfied.

5.             In this case, the gain made from CGT event D2 happened 'in relation to' the Property (the underlying asset). Therefore, the gain may be reduced by applying the small business CGT concessions if the other relevant conditions in section 152-10 are satisfied.

[1] ATO ID 2003/128, TD 16, See also VAN v FC of T 2002 ATC 2325.