Edited version of private advice

Authorisation Number: 1052128807152

Date of advice: 13 June 2023

Ruling

Subject: Early stage innovation company bare trust arrangement

Question

Will you retain the ability to apply the modified capital gains tax (CGT) treatment under section 360-50 of the Income Tax Assessment Act (ITAA 1997) for shares held in the Company after they are transferred to a bare trust?

Answer

No.

This ruling applies for the following period

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

1.            The Company has been considered an early stage innovation company (ESIC) since incorporation through to 30 June 20XX.

2.            You were previously issued shares in the Company and claimed the ESIC tax offset available in accordance with section 360-25 of the ITAA 1997 in your income tax returns for the 20XX and 20XX income years.

3.            You are among a contingent of minority shareholders.

4.            The Company is seeking to transfer all shares held by minority shareholders into a separate bare trust/nominee structure for each shareholder.

5.            The transfer of minority shareholder shares will ensure that the Company is not required to alter its structure as per section 113 of the Corporations Act 2001.

6.            There will be a corporate trustee (nominee) for the bare trust.

7.            The arrangement is governed by the bare trust deed and a Nominee Agreement.

8.            The Nominee Agreement does not eliminate the trustee's rights of indemnity out of the trust's assets.

Relevant legislative provisions

Income Tax Assessment Act 1997, Subsection 104-55(1)

Income Tax Assessment Act 1997, Subsection 104-55(2)

Income Tax Assessment Act 1997, Subsection 104-55(4)

Income Tax Assessment Act 1997, Subsection 104-55(5)

Income Tax Assessment Act 1997, Subdivision 360-A

Income Tax Assessment Act 1997, Section 360-25

Income Tax Assessment Act 1997, Section 360-50

Income Tax Assessment Act 1997, Subsection 360-50(1)

Income Tax Assessment Act 1997, Subsection 360-50(2)

Income Tax Assessment Act 1997, Subsection 360-50(3)

Income Tax Assessment Act 1997, Subsection 360-50(4)

Income Tax Assessment Act 1997, Subsection 360-50(5)

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question

Will you retain the ability to apply modified CGT treatment under section 360-50 for shares held in the Company after they are transferred to a bare trust?

Summary

The trustee of the proposed bare trust has rights of indemnity out of trust assets (the shares in the Company). You are therefore not absolutely entitled to the shares once the bare trust is created over them. The proposed transfer of your shares in the Company into a bare trust will result in CGT event E1 happening. You will be entitled to the modified CGT treatment under section 360-50 at that point in time but will not retain the ability to utilise the modified CGT treatment again for the relevant parcels of shares.

Detailed reasoning

1.            Section 360-50 provides for modified CGT treatment if the issuing of a share to an entity gives rise to an entitlement to a tax offset under Subdivision 360-A.[1]

2.            An entity that acquires shares in a qualifying ESIC will be taken to hold these shares on capital account.[2]

3.            The specific CGT consequence arising for these shares depends on:

•         when the relevant CGT event happens, and

•         whether the investor entity realises a capital gain or a capital loss from that event.

4.            An entity that has continuously held a qualifying share for less than 10 years must disregard any capital loss it makes from any CGT event happening in relation to the share.[3]

5.            An entity that has continuously held a qualifying share for between 12 months and less than 10 years may disregard any capital gain it makes from any CGT event happening in relation to the share.[4]

6.            An investor that has continuously held a qualifying share for at least ten years will receive a market value, as determined on the ten year anniversary date, as the first element of the cost base and reduced cost base of the share. This ensures that any incremental gains (or losses) in value after 10 years will be taxable.[5]

Application to your circumstances

7.            You were issued shares in the Company and claimed the ESIC tax offset available in accordance with section 360-25. Consequently, the modified CGT treatment will apply to you in relation to these shares, in accordance with section 360-50.

8.            The Company is planning to transfer your shares into a bare trust for the purpose of remaining a proprietary company according to the Corporations Act 2001. That is, a bare trust will be settled under the terms of the Nominee Agreement and bare trust deed, with your shares transferred into the bare trust.

9.            Subsection 104-55(1) provides that CGT event E1 happens when a trust is created over a CGT asset by declaration or settlement. Pursuant to subsection 104-55(2), the event happens at the point in time the trust over the asset is created.

10.          Clearly, the execution of a trust deed that explicitly makes a declaration of trust or effects a settlement of trust property will result in CGT event E1 happening.

11.          In your case, CGT event E1 will occur when your shares in the Company are transferred to the bare trust.

12.          There is an exception contained at subsection 104-55(5) which states:

CGT event E1 does not happen if you are the sole beneficiary of the trust and:

(a) you are absolutely entitled to the asset as against the trustee (disregarding any legal disability); and

(b) the trust is not a unit trust.

13.          In your case, your bare trust will not be a unit trust. Further, you advised that the arrangement will be structured such that the trustee will be the trustee of separate trusts for each of the minority shareholders. That is, you will be the sole beneficiary of your bare trust.

14.          The Commissioner does not consider that you are absolutely entitled to the assets of the trust (the shares) as against the trustee. This is because the Agreement does not fully eliminate the trustee's right of indemnity from the trust assets.

15.          The concept of absolute entitlement implies that the beneficiary has an immediate and unconditional right to the assets or income of the trust without any competing claims or rights. However, when the trustee has a right to indemnity, it creates a competing interest in the trust assets, and the beneficiary's entitlement becomes conditional upon the trustee's indemnity claim being satisfied. In this situation, the beneficiary's claim to the trust asset is not absolute.

16.          Consequently, you cannot be said to be absolutely entitled to the trust assets due to the trustee's rights of indemnity out of trust assets (the shares) which has not been eliminated from the proposed Nominee Agreement. As a result, the exception in paragraph 104-55(5)(b) will not be satisfied.

17.          Further, since you are not absolutely entitled to the trust assets (the shares) as against the trustee, the deeming provision at subsection 106-50(1) - that treats trust assets as being the assets of beneficiaries when they are absolutely entitled as against the trustee - has no application. Consequently, when the shares in the Company are transferred into the bare trust, you no longer hold these assets. Since it is a requirement of the modified CGT treatment that the entity has continuously held the shares since their issue,[6] you will no longer satisfy this requirement from this point in time.

18.          As the exception provided at subsection 104-55(5) does not apply, and you are not absolutely entitled to the shares as against the trustee, CGT event E1 will occur when your shares in the Company are transferred to the bare trust. The modified CGT treatment available to you under section 360-50 will be crystallised at this point in time.

Conclusion

19.          You will not be absolutely entitled to the shares once the bare trust is created over them, as the trustee's rights of indemnity out of trust assets has not been eliminated. The proposed transfer of your shares in the Company into a bare trust will therefore trigger CGT event E1. Since the modified CGT treatment under section 360-50 is crystallised when any CGT event happens,[7] you will be entitled to this modified CGT treatment at that point in time. You will not retain the ability to utilise the modified CGT treatment again for the relevant parcels of shares.

Note

If you are the trustee of the trust and no beneficiary is absolutely entitled to the asset as against you (disregarding any legal disability), the first element of the asset's cost base and reduced cost base in your hands is its market value when the trust is created.[8]

[1] Subsection 360-50(1).

[2] Subsection 360-50(2).

[3] Subsection 360-50(3).

[4] Subsection 360-50(4).

[5] Subsection 360-50(5).

[6] Subsections 360-50(3), (4) and (5).

[7] Subsections 360-50(3) and (4).

[8] Subsection 104-55(4)