Edited version of private advice

Authorisation Number: 1052060695276

Date of advice: 23 November 2022

Ruling

Subject: CGT - capital proceeds and active asset test

Question 1

Should the capital proceeds received from the sale of Property A and Property B be apportioned based on the market values of each property, under section 116-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

If the answer to question 1 is no, will the capital proceeds received from the sale of Property A and from the sale of Property B be modified by the market value substitution rule in section 116-30 of the ITAA 1997?

Answer

Yes.

Question 3

Did Property B satisfy the active asset test under section 152-35 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Property History and Values

The Trust purchased two adjacent properties, Property A and Property B in 20XX. This transaction involved two separate contracts, one for each property.

Property A was used as a residence for controllers of the Trust who were also managers of the business on Property B.

The Trust sold Property A and Property B on the same date in the year ended 30 June 20XX.

There were two separate contracts relating to the sale, one relating to Property A and one relating to Property B. The sale contracts were conditional on both contracts proceeding.

The buyer of Property A was Buyer 1. The buyer of Property B was Buyer 2.

The buyers required the total value of both contracts to be apportioned equally between the contracts (50/50).

The Trust did not question the apportionment made between contracts, and did not seek professional advice, but accepted the required apportionment of the buyers as they viewed the sale as one transaction.

An official valuation report valued Property A at $X and Property B at $X. This valuation report was provided to the buyer as part of the due diligence.

Business Operations

The Trust operated an accommodation business on Property B, and Property B was used in this business throughout the whole ownership period.

Guests were able to book directly over the phone, through the business website or through other travel websites.

The facilities provided to guests included:

•         Kitchens

•         Bathrooms

•         Laundries with washing machines and dryers

•         Activity facilities

•         Internet.

The Trust employed a number of staff to operate the business.

The business provided accommodation to short term guests and long-term guests.

The long-term guests sign lease agreements. An example of a lease agreement was provided with this ruling application.

During the year ended 30 June 20XX, the land area used to provide accommodation to short term guests was approximately 70% and the area used to provide accommodation to long-term guests was approximately 30%.

During the year ended 30 June 20XX the Trust derived approximately 25% of its accommodation income from long-term guests and 75% from short term guests.

The income amounts and land usage apportionments for the year ended 30 June 20XX are indicative of the Trust's use of the property through its ownership period.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 section 116-40

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Reasons for decision

Question 1

Summary

The apportionment rule in section 116-40 of the ITAA 1997 cannot be used to modify the capital proceeds received on the sale of Property A and Property B with reference to the market value of each property.

Detailed reasoning

Section 116-40 contains the apportionment rule. Subsection 116-40(1) provides that if you receive a payment in connection with a transaction that relates to more than one CGT event, the capital proceeds from each event are so much of the payment as is reasonably attributable to that event.

In this case, two CGT events did occur, the disposal of Property A and the disposal of Property B. However, these two CGT events were not part of the same transaction, as required by the rule. The two CGT events happened under two separate contracts, with two separate buyers. This means that there were two separate transactions for the purposes of section 116-40 of the ITAA 1997.

Therefore, the proposed use of the apportionment rule to modify the capital proceeds for each property, by apportioning the total payment received under both contracts between each property in accordance with market value, is not available.

Question 2

Summary

The capital proceeds from the sale of Property A and the capital proceeds from the sale of Property B are both modified by the market value substitution rule in section 116-30 of the ITAA 1997.

Detailed reasoning

Section 116-30 contains the market value substitution rule. Subsection 116-30(2) provides that the capital proceeds from a CGT event are replaced with the market value of the relevant CGT asset if:

•         the capital proceeds are more or less than the market value of the asset, and

•         you and the entity that acquired the asset from you did not deal with each other at arm's length in connection with the event.

In this case, we must consider each CGT event separately to determine whether the market value substitution rule will apply.

Dealing at arm's length

The term 'arm's length', in relation to dealings, is defined in the Concise Oxford Dictionary as "with neither party controlled by the other". Osborn's Concise Law Dictionary defines 'at arm's length' as "the relationship which exists between parties who are strangers to each other, and who bear no special duty, obligation or relation to each other". Black's Law Dictionary defines 'arm's length' as "beyond the reach of personal influence or control" and adds that "[p]arties are said to deal at arm's length when each stands upon the strict letter of his rights, and conducts the business in a formal manner, without trusting the other's control or overmastering influence".

Subsection 995-1(1) of the ITAA 1997 defines 'arm's length' as follows:

...in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance.

In ACI Operations Pty Ltd v. Berri Ltd (2005) 15 VR 312 (ACI Operations), Dodds-Streeton J said (at [223]) that the authorities establish:

... an arm's length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal.

The market value substitution rule requires consideration to be given to the nature of the dealings between parties to a transaction and not simply their relationship. As Dodds-Streeton J explained in ACI Operations (footnotes omitted):

The concept of an arm's length relationship is distinct from that of an arm's length dealing or transaction, despite the potential overlap. Unrelated parties may collude or otherwise deal with each other in an interested way, so that neither the dealing nor the resultant transaction may properly be considered arm's length.

And in Granby v FC of T 95 ATC 4240 (Granby), the judge stated:

The expression "dealing with each other at arm's length" involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction. What is asked is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs. Of course, it is relevant to that inquiry to determine the nature of the relationship between the parties, for if the parties are not parties at arm's length the inference may be drawn that they did not deal with each other at arm's length. [...] That is not to say, however, that parties at arm's length will be dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the dictation of the other, perhaps, to promote the interests of the other.

Further guidance for considering the nature of the dealings between parties can be found in The Trustee for the Estate of the Late AW Furse No 5 Will Trust v FC of T 91 ATC 4007, where it was stated:

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining.

And in Collis v FC of T 96 ATC 4831 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.

Application to your circumstances

The first CGT event was the disposal of Property A. Under the contract, the Trust received $X, which are the capital proceeds. However, the market value of this property was $X. Thus, the capital proceeds are more than the market value of the property.

The entity that acquired Property A from the Trust was Buyer 1. We consider the Trust and this entity to be arm's length parties. This means that we must consider the surrounding circumstances to determine whether the nature of the dealing between these arm's length parties was characteristic of an arm's length dealing.

The second CGT event is the disposal of Property B. Under the contract, the Trust received $X, which are the capital proceeds. However, the market value was $X. Thus, the capital proceeds are less than the market value of the property.

The entity that acquired Property B from the Trust was Buyer 2. We consider the Trust and this entity to be arm's length parties. This means that we must consider the surrounding circumstances to determine whether the nature of the dealing between these arm's length parties was characteristic of an arm's length dealing.

The buyers made it a condition of purchasing the properties, that the contract price for each would be 50% of the total consideration paid for both properties, rather than reflective of the values of each property.

The Trust did not question this apportionment condition, nor did it obtain professional advice. Rather the Trust accepted the condition on face value, believing that if it was not accepted the sale would not go through for either property. This shows a level of indifference to the apportionment between the contracts, and the price placed in each individual contract. There was no real bargaining as to the contract price for each property, and the deal was achieved in a manner outside of how arm's length parties might be expected to behave.

The Trust did not know why the buyers required the contract prices to be apportioned as they did, however we consider that as this apportionment was not necessarily in the interests of the Trust, and it was likely in the interests of the buyer/s. In this sense, the Trust submitted the exercise its will to the dictation of the buyer for each contract, and this, in part, promoted the interests of the buyers.

Conclusion

Therefore, although the connection between the Trust and Buyer 1 and the connection between Trust and Buyer 2 were at arm's length, a consideration of the other relevant circumstances surrounding the disposal of the properties reveals that the parties were not dealing with each other at arm's length.

As a result, the market value substation rule will apply to modify the capital proceeds from each separate CGT event. The capital proceeds should be replaced with the actual market value of each property as at the time of disposal.

Question 3

Summary

Property B satisfies the active asset test because it was a CGT asset used by the Trust in the course of carrying on a business, for the whole period of ownership.

Detailed reasoning

Under subsection 152-35(1) the active asset test will be satisfied if:

a)     You have owned the asset for 15 years of less and the asset was an active asset of yours for a total of at least half of the test period detailed below; or

b)     You have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 ½ years during the test period detailed below.

The test period:

a)     begins when you acquired the asset, and

b)     ends at the earlier of:

i)              the CGT event, and

ii)             when the business ceased, if the business ceased in the 12 months before the CGT event

A CGT asset is an active asset if you own the asset and it is used, or held ready for use, in the course of carrying on a business that is carried on by you, your affiliate, or another entity that is connected with you (subsection 152-40(1) of the ITAA 1997).

However, an asset is not an active asset if it falls under one of the exceptions in subsection 152-40(4) of the ITAA 1997. Specifically, paragraph 152-40(4)(e) provides that an asset whose main use is to derive rent cannot be an active asset.

Taxation Determination TD 2006/78 provides guidance on the circumstances in which a premises used to provide accommodation for reward may satisfy the active asset test, notwithstanding the exclusion in paragraph 152-40(4)(e).

Paragraphs 21 to 25 of TD 2006/78 explain factors which indicate that an asset is being used to derive rent. These factors include, whether the occupier of a premises has right to exclusive possession, how much control is retained by the owners of the premises, and the extent of services provided by the owner such as room cleaning, provision of meals, supply of linen, and shared amenities.

Paragraph 26 of TD 2006/78 contemplates the situation where an asset is used partly for business and partly to derive rent, and provides the following factors for determining what the main use of the asset is:

•           the comparative areas of use of the premises (between deriving rent and other uses); and

•           the comparative levels of income derived from the different uses.

Example 5 in paragraphs 15 and 16 of TD 2006/78 demonstrates an application of these factors. Example 5 is replicated below:

Example 5: mixed use

15. Mick owns land on which there are a number of industrial sheds. He uses one shed (45% of the land by area) to conduct a motor cycle repair business. He leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the motor cycle repair business is 80% of the total income (business plus rentals) derived from the use of the land and buildings.

16. In determining if the main use of the land is to derive rent, it is appropriate to consider a range of factors. In this case, a substantial (although nevertheless not a majority) proportion by area of the land is used for business purposes. As well, the business proportion of the land derives the vast majority (80%) of the total income. In all the circumstances, the Tax Office considers the main use of the land in this case is not to derive rent and accordingly the land is not excluded from being an active asset by paragraph 152-40(4)(e) of the ITAA 1997.

Application to your circumstances

In this case, Property B is a mixed use asset.

The terms of the lease agreements made with the long-term guests indicate that the part of Property B occupied by the long-term guests is used to derive rent.

However, the nature of the services and amenities provided to the short-term guests, and the activities undertaken by the Trust to facilitate the short-term guests, indicate the carrying on of a business.

Accordingly, the comparative areas used, and levels of income derived from both the short-term and long-term guests must be considered to determine what the main use of Property B was.

As the short-term accommodation options provided at the caravan park bring in the majority of the income from accommodation and take up the majority of the land area of Property B, we consider that the main use of Property B was for carrying on the business. And therefore, the main use was not to derive rent.

As Property B was used to carry on the activities outlined above for the whole period of ownership, Property B satisfies the active asset test.