Edited version of private advice

Authorisation Number: 1052059628638

Date of advice: 21 February 2023

Ruling

Subject: CGT - value shifting

Question

Does the change in the ownership of the company give rise to the direct value shifting rules applying under the Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) and cause CGT event K 8 to occur under section 104-250 of the ITAA 1997?

Answer

No, both section 104-250 and Division 725 of the ITAA 1997 are effective from XX October 20XX. Division 725 applies to a scheme entered into on or after XX July 20XX.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The company was incorporated in 19XX, with ordinary shares issues at $X to the shareholders. Each would hold an equal share of the company shares.

The shareholders are related parties (Person A and B are a couple, Person C and Person D are a couple. Person A and Person C are siblings.)

The company purchased a commercial property. To raise the funds, Person A and B contributed an amount that was more than half of the total contribution as the other couple could not afford to contribute half. The majority of the funds were used for the deposit of purchasing the property, the balance was kept for company operation and loan repayments etc. The company took a loan from the bank for the purchase as well.

The company did not own any other assets at the time of purchase of the property which was settled in June 19XX.

Shortly after the settlement of the property, upon determining the amount of the funds each of the shareholders had contributed, the shareholders agreed to change the ownership of the company to reflect the capital contribution.

The change in the member's ownership of the company was not updated with ASIC due to an administrative error.

The shareholders stated that the loan repayments to shareholders over the years were in accordance with the new ownership of the company. All profits and principal have been split between the couples in the new ratio. Financial Statements for the 20XX to 20XX income years were provided.

Financial Statements for earlier years are not available. The tax agent advised that all documents related to the purchase of the commercial property and agreement of the change in the ownership of the company were destroyed during a natural disaster.

The statutory declarations state the situation and what had occurred.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-250

Income Tax Assessment Act 1997 Division 725

Income Tax Assessment Act 1997 section 725-50

Income Tax Assessment Act 1997 section 725-65

Income Tax Assessment Act 1997 section 725-85

Income Tax Assessment Act 1997 section 725-245

Income Tax Assessment Act 1997 section 725-355

Reasons for decision

Question

Does the change in the ownership of the company give rise to the direct value shifting rules applying under the Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) and cause CGT event K8 to occur under section 104-250 of the ITAA 1997?

Summary

The change in ownership does not give rise to a direct value shift under Division 725 of the ITAA 1997s in this situation. Therefore, CGT event K8 under section 104-250 of the ITAA 1997 will not happen.

Detailed reasoning

Division 725 of the ITAA 1997 may apply if, under a scheme, value is shifted from equity or loan interests in a company or trust to other equity or loan interests in the same company or trust. A direct value shift may result from issuing new shares or trust units at a discount, buying back shares at less than market value or changing the voting rights attached to shares.

For there to be consequences as a result of a direct value shift under a scheme, the conditions in section 725-50 of the ITAA 1997 need to be met. These are:

•         the control test is satisfied

•         the participants in the scheme test is satisfied

•         the cause of the value shift test is satisfied

•         you are an affected owner of interests in the target entity, or

•         no exception applies.

Subsection 725-65(1) of the ITAA 1997 requires that the target entity did, under the scheme, the thing:

(a)  to which the decrease in the market value of the down interest is reasonably attributable, and

(b)  which is the issue of up interests at a discount.

An entity controls a company for value shifting purposes if the entity can exercise or control at least 50% of the voting power in the company or has the right to receive at least 50% of the dividends or distribution of capital of the company (subsection 727-355(1) of the ITAA 1997).

An entity will control a company for value shifting purposes in the circumstances set out in section 727-355 of the ITAA 1997. Broadly, the tests require that an entity, either alone or together with its associates:

•         can directly or indirectly exercise, or control the exercise of, at least 50% of the voting power in the company, or have the right to receive 50% of the dividend or capital distributions that the company may make (the '50% stake test')

•         can directly or indirectly exercise, or control the exercise of, at least 40% of the voting power in the company, or have the right to receive 40% of the dividend or capital distributions that the company may make, where no other entity in fact controls the company (the '40% stake test'), or

•         in fact controls the company (the 'actual control test').

The direct value shifting rules in Division 725 apply to direct value shifts that happen under schemes entered into on or after 1 July 2002.

Under section 104-250 of the ITAA 1997, where the direct value shifting rules apply, they can operate to either adjust the value (for example, cost base) of those equity or loan interests, or by treating the value shift as a partial realisation, which in turn may give rise to CGT event K8 generating a gain for a down interest under section 725-245.

Section 104-250 is effective from 24 October 2002, the same date as the value shifting rules in Division 725.

Person A and Person B held 50% of the company shares before the change. They held more than 50% of the company shares after the change. They control the company for value shifting purposes under section 727-355 of the ITAA 1997. The target company is a company at some time during the scheme period. The cause of the value shift as per section 725-65 of the ITAA 1997 and the controlling entity test under section 725-355 of the ITAA 1997 are satisfied. The value shift is not likely to be reversed.

In this instance, on the basis of the information provided in the private ruling request and the information in the statutory declarations of the shareholders, it is accepted that the shareholder's ownership of the company actually changed upon the shareholders' agreement in 19XX.

As the scheme was entered into before 1 July 2002, before Division 725 and section 104-250 of the ITAA 1997 were in effect, Division 725 and section 104-250 do not apply.