Edited version of private advice

Authorisation Number: 1052162507482

Date of advice: 29 August 2023

Ruling

Subject: Discount capital gain

Question:

Is the gain from the sale of the properties assessable solely as a discount capital gain pursuant to sections 102-5, 104-10 and Division 115 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer:

Yes

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

The Scheme commences on:

DD MM YYYY

RELEVANT FACTS AND CIRCUMSTANCES

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect, and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background Information

1.      The entity was established on DD MM YYYY.

2.      The entity is part of the wider ZZZ Group of entities (ZZZ).

3.      The key principals in ZZZ are Z1 and Z2.

4.      The business activities of ZZZ broadly include:

•           The operation of particular entities

•           Long term real estate investments, held for deriving rental income

•           Long term shareholdings, held for deriving dividend income

•           Minor primary production activities

5.      A ZZZ entity, AAA, undertakes the activities of identification of sites for potential new operations, negotiating lease terms with potential landlords, and financing operation fit outs.

6.      ZZZ now has companies (as opposed to trusts) operating its operations.

Initial business strategy of ZZZ

7.      After spending time working internationally, Z1 started ZZZ in circa YYYY with Z3.

8.      The business strategy and activities of ZZZ initially involved:

•           the acquisition of pre-existing freehold going concern operations and the ongoing operation of those operations, predominantly located regionally (for example outside of major metropolitan operations);

•           the acquisition of poorly performing leasehold operations which showed potential for upside through a refurbishment and updated operational methodology.

9.      Over time, the business strategy morphed to focus more on acquiring greenfield sites in AAA and BBB for the establishment of freehold going concern operations.

10.   With the passage of time, ZZZ was finding the capital requirements for this business strategy were challenging to manage.

11.   Whilst it was ZZZ's business strategy to retain and operate particular operations, given some delays in operation construction and regular cost overruns, the relatively short debt amortisation period imposed by the bank resulted in ZZZ undertaking isolated sales of other mature operations so as to have spare capital to enable bank debt to be retired.

Restructure / Repositioning in circa YYYY / YYYY

12.   During the course of YYYY, the business relationship between Z1 and Z3 became fractured, including in relation to integrity issues and misuse of funds.

13.   Bank A (ZZZ's lender at the time) was aware of the relationship breakdown and as a result moved ZZZ into Bank A's 'Lending Services' section which essentially meant Bank A was desirous of ZZZ repaying all debt and no longer borrowing from Bank A.

14.   In MM YYYY, Bank A required ZZZZ to sign a letter that brought forward repayment of all debt owing to Bank A to DD MM YYYY. This was earlier than the previous term and stemmed from Bank A being unwilling to bank ZZZ as a result of the breakdown in relationship between Z1 and Z3.

15.   In early YYYY, Z1 commenced litigation against Z3 for reasons relating to the misuse of funds and breach of director duties. Over the next few months, the parties then negotiated Z3's exit from the ZZZ business.

16.   The terms of Z3's exit were finally agreed in MM YYYY, but there was a very short window to fund Z3's exit and Bank A's repayment by DD MM YYYY. Funding for both Z3's exit and repayment of the Bank A debt required a substantial amount of capital, which was provided on a short-term basis by Bank B, given Z1's relationship with the Bank B, but on the following conditions:

•           A personal guarantee was provided by Z1; and

•           The debt would need to be repaid by DD MM YYYY.

17.   As a result, in the second half of YYYY, ZZZ sold xx operations to release capital to repay bank finance. Without the sale, the bank finance could not have been repaid or refinanced. In addition, the sale facilitated an exit out of a large number of older regional operations, which by this time represented ZZZ's former business strategy.

18.   The operations were sold as a package deal to one purchaser.

Current strategy

19.   At about the same time, the entity was established to be the new operation owner and operator for ZZZ.

20.   After the transaction outlined paragraph 18 above, ZZZ altered their business model to have a preference for no longer acquiring existing operations for refurbishment.

21.   Acquiring existing operations was found to have been both too capital and time intensive and generally had an inferior outcome for ZZZ when compared to the less capital-intensive approach of establishing new leasehold operations.

22.   ZZZ's preference became to identify potential new sites, solely within inner and outer ring metro which met ZZZ's location principles and enter agreements for lease with developer landlords.

23.   Such an approach substantially reduced the capital investment required by ZZZ, as they were only funding operation fit out costs and working capital requirements during the initial operating period, as opposed to acquisition and development cost of a wider site, given the sites are often located in in prominent locations.

24.   During the early stages of the YYYY financial year, Z1 informed Z3 that it was his preference to move ownership of all operations from the entity to a new corporate structure within ZZZ.

Overview of the transaction in question

25.   In late YYYY, the entity entered into a Heads of Agreement with Company A to sell xx operations.

26.   Pursuant to executing the Heads of Agreement, the entity entered into individual binding sales agreements with Company A to sell xx childcare operations on DD MM YYYY.

27.   The sales agreements also contained clauses whereby Company A may pay an earnout amount to the entity subject to certain performance hurdles and other conditions being met.

Events leading up to the sale transactions

28.   In MM YYYY, Company C, an entity within ZZZZ, entered into a contract to acquire real estate at XXX for $xxx.

29.   At the time of entering the contract, ZZZ's financiers had the following securities in place:

•           A guarantee and indemnity from Z1 and Z2 for $xxx; and

•           A mortgage over real estate owned by Z2.

30.   Additionally, ZZZ had also fully drawn all existing bank finance facilities and their financier had indicated that ZZZ was at their borrowing capacity.

31.   Given these restrictions, and the inability to borrow additional funds from ZZZ's financer, a decision was made to sell xx of the entity's operations to free up capital to assist with the purchase of XXX.

32.   The sale was structured this way to facilitate a potential sale, for the reasons outlined above, so in early MM YYYY, Z1 contacted a consultant who specialised in brokering operation sales / acquisitions.

33.   Discussions were held between Z1 and the consultant regarding the potential sale of x of the XXX operations.

34.   Z1 outlined to the consultant that these operations were the ones ZZZ would be prepared to sell from a business perspective to assist with its purchase of XXX.

35.   The consultant requested ZZZ's financial accounts, KPI and occupancy data for all operations for context.

36.   On DD MM YYYY, Company A responded with a significant unsolicited offer to buy xx operations - which in context was an offer for all mature operations owned by ZZZ.

37.   The offer was further negotiated and improved from the entity's perspective, with final sales documentation being signed on DD MM YYYY.

38.   The transaction was completed in MM YYYY.

Which operations were sold

39.   In total, xx operations were sold. Details outlining which operations were sold, their period of ownership / operation and the sale price have been provided.

40.   The total sales proceeds for all operations was $xxx. The sales agreements also included an earnout arrangement.

41.   As of DD MM YYYY, the time period for the earnout arrangement had not elapsed.

42.   In addition to the above, further operations were subject to stand alone put and call options to sell, should certain occupancy hurdles be met. The exercise price of these options is $xxx for each operation.

43.   As of DD MM YYYY, the conditions allowing the exercise of either of the put and call options had not been met.

Events subsequent to the sale

44.   As the entity's sale of the operations was completed in MM YYYY, this allowed sufficient capital to be freed up to reduce bank debt and finance the XXX acquisition.

45.   Prior to settlement of the XXX contract, the contract was rescinded.

46.   In MM YYYY, a new contract for the same parcel of real estate was entered into by Z2's father and Z2 for $xxx.

47.   The new XXX contract was completed in MM YYYY. The original XXX contract had a completion timeframe of xx months. Sale of the operations allowed for an earlier completion of the XXX purchase in line with the wishes of the beneficiary of the entity.

48.   As noted above, but for the request and requirements of Z1 and Z2 in relation to the XXX settlement, no operation would have been sold.

Information provided

49.   You have provided a number of documents containing detailed information in relation to the entity's ruling application, including:

•           Private Binding Ruling ('PBR') Application, dated DD MM YYYY

50.   We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

Assumption(s)

Not applicable.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Division 115-A

Further issues for you to consider

Not applicable.

REASONS FOR DECISION

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

SUMMARY

The gain from the sale of the operations is assessable solely as a discount capital gain pursuant to sections 102-5, 104-10 and Division 115 of the Income Tax Assessment Act 1997.

DETAILED REASONING

Legislative provisions

51.   Section 102-5 of the ITAA 1997 outlines operative provisions that assessable income includes net capital gain. Further subsection 102-5(1) outlines that assessable income includes net capital gain (if any) for the income year and provides instructions of how to work out the amount of net capital gain.

52.   Section 104-10 of the ITAA 1997 outlines the disposal of CGT assets. Specifically, subsection 104-10(1) provides that CGT Event A1 happens if you dispose of a CGT asset. Paragraph 104-10(3)(a) further states that the time of the event is when you enter into the contract for the disposal.

53.   Section 108-5 of the ITAA 1997 outlines what are CGT assets. They are defined as any kind of property or a legal or equitable right that is not property. Paragraph 108-5(2)(b) further confirms that goodwill or an interest in it are also CGT assets.

54.   Division 115-A of the ITAA 1997 outlines the meaning of discount capital gains. The Division states that a discount capital gain remaining after the application of any capital losses and net capital losses from previous income years is reduced by the discount percentage when working out the net capital gain.

55.   Section 115-5 of the ITAA 1997 outlines that a discount capital gain is a capital gain that meets the requirements of sections 115-10, 115-15, 115-20 and 115-25.

56.   Section 115-10 of the ITAA 1997 provides that to be a discount capital gain, the capital gain must be made by:

(a)    an individual; or

(b)    a complying superannuation entity; or

(c)    a trust; or

(d)    a life insurance company in relation to a discount capital gain from a CGT event in respect of a CGT asset that is a complying superannuation asset.

57.   Section 115-15 of the ITAA 1997 provides that to be a discount capital gain, the capital gain must result from a CGT event happening after 11.45 am (by legal time in the Australian Capital Territory) on 21 September 1999.

58.   Section 115-20 of the ITAA 1997 provides that a discount capital gain must not have an indexed cost base. Further, subsection 115-20(1) provides that to be a discount capital gain, the capital gain must have been worked out, as follows:

(a)    using a cost base that has been calculated without reference to indexation at any time; or

(b)    for a capital gain that arose under CGT event K7 - using the cost of the depreciating asset concerned.

59.   Section 115-25 of the ITAA 1997 provides that to be a discount capital gain, the capital gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event.

Relevant Case law

60.   In Greig v Commissioner of Taxation [2020] FCAFC 25 at p. 94, Derrington J notes;

As the Commissioner submitted, in Ransley v Deputy Commissioner of Taxation [2018] FCA 1796, Deputy President Jagot J (exercising this Court's and the Tribunal's jurisdictions concurrently), assayed a number of authorities predating the High Court's decision in Myer Emporium, together with some subsequent ones. Her Honour's careful examination makes it unnecessary to repeat that exercise. It suffices to observe that those cases identify that, in order for the gains made on the sale of an asset to be treated as assessable income, the gains must be income within the "ordinary uses and concepts of mankind" in that they arise in what is truly the carrying on, or carrying out, of a business: Federal Commissioner of Taxation v Whitfords Beach Pty Ltd [1982] HCA 8; (1982) 150 CLR 355 (Whitfords Beach) at 360-361. Gains made are not ordinary income where what is done is the mere realisation or change of an investment or an enhancement of value by realisation: Californian Copper Syndicate v Harris, 166. Prima facie, the accretion to the capital value of a security between purchase and realisation is a capital gain: Colonial Mutual Life Assurance Society Ltd v Federal Commissioner of Taxation [1946] HCA 60; (1946) 73 CLR 604 at 614.

61.   Lord Justice Clerk made a distinction between a 'mere realisation or change in investment' and 'an act done in what is truly the carrying on, or carrying out, of a business' in Californian Copper Syndicate v. Harris (Inspector of Taxes) (1904) 5 TC 159, with the following statement at 166:

"Is the sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?"

62.   The dicta of the Lord Justice Clerk in Californian Copper was quoted with approval by three out of the four High Court judges in Whitfords Beach Pty Ltd v FC of T 82 ATC 4031, Gibbs CJ saying (at p 4034):

"When the owner of an investment chooses to realize it, and obtains a greater price for it than he paid to acquire it, the enhanced price will not be income within ordinary usages and concepts, unless, to use the words of the Lord Justice Clerk in Californian Copper... 'what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business'."

63.   Further, in Commissioner of Taxation (Cth) v Myer Emporium Limited (1987) 163 CLR 199 at 213:

[O]ver the years this Court, as well as the Privy Council, has accepted that profits derived in a business operation or commercial transaction carrying out any profit-making scheme are income, whereas the proceeds of a mere realization or change of investment or from an enhancement of capital are not income.

The proposition that a mere realization or change of investment is not income requires some elaboration. First, the emphasis is on the adjective "mere" (Whitfords Beach, at p.383). Secondly, profits made on a realization or change of investments may constitute income if the investments were initially acquired as part of a business with the intention or purpose that they be realised subsequently in order to capture the profit arising from their expected increase in value - see the discussion by Gibbs J in London Australia, at pp.116-118. It is one thing if the decision to sell an asset is taken after its acquisition, there having been no intention or purpose at the time of acquisition of acquiring for the purpose of profit-making by sale. Then, if the asset be not a revenue asset on other grounds, the profit made is capital because it proceeds from a mere realization. But it is quite another thing if the decision to sell is taken by way of implementation of an intention or purpose, existing at the time of acquisition, of profit-making by sale, at least in the context of carrying on a business or carrying out a business operation or commercial transaction.

64.   Statham & Anor v. Federal Commissioner of Taxation (1988) 20 ATR 228; 16 ALD 723; 89 ATC 4070 ('Statham') clearly confirms that the taxpayer has a right to take steps to maximise the profit as part of a mere realisation of a capital asset.

65.   In Statham it was found that a mere realisation of assets had been affected even though the owners had applied themselves in an enterprising way to the realisation with the consequence that proceeds from the sale of land were not assessable income. The Full Federal Court held at 4077 that what occurred was:

".... the mere realisation, by the most advantageous means, of the asset which the owners had on their hands when they abandoned the intention of farming the subject property."

APPLICATION TO YOUR CIRCUMSTANCES

66.   We can accept that the assets were acquired with the intention to be held for long term investment purposes and to generate revenue for the business. That intention hasn't changed by the time of the sales and so the proceeds are on capital account.

67.   Whilst it is acknowledged that the sale of each of the entity's operations is a stand-alone event, for the purposes of this assessment, we consider the entity's sales of operations as being one amalgamated transaction, unless noted otherwise.

68.   Each of the contracts for sale for the xx operations included the sale of goodwill, operation fit out and plant and equipment. Therefore, each of the sales included a CGT asset for the purposes of subsection 108-5(2) of the ITAA 1997.

69.   The sale of the goodwill of each of the entity's operations is a disposal of CGT assets, which gives rise to CGT event A1.

70.   The question then remains of whether the sale of the goodwill of the operations represents a mere realisation of the capital assets.

71.   The relevant case law has, over time, drawn a distinction between the mere realisation of a capital asset and a transaction that is undertaken in carrying on a business. This distinction is a question of fact and is an objective test that requires a close examination of all relevant circumstances.

72.   The entity established the operations with the intention of holding them for the purposes of creating an enduring cash flow source from which to fund additional growth.

73.   The operations were intended to be held in the long term, as is supported by correspondence between ZZZ and their financier in both MM YYYY and MM YYYY.

74.   Cash flow projections prepared to support the MM YYYY finance submission did not anticipate any of sales of operations, nor the need to sell any.

75.   However, a previously unforeseen opportunity to acquire a new real estate asset in XXX resulted in a short-term financing issue for ZZZ and in turn the beneficiaries of the entity with a small sale of a select number of operations being a potential way to release capital to assist in funding the acquisition.

76.   ZZZ engaged a sales consultant to determine market interest for x of their lower grade operations.

77.   Whilst ZZZ did engage a sales consultant to assist with selling some operations, the brief to the sales consultant was to determine market interest for x operations only, not a bulk sale.

78.   During this process, details of ZZZ's wider operation portfolio was also shared with potential purchasers which resulted in much more wide-ranging unsolicited offer being put to ZZZ.

79.   As noted in the background facts, on DD MM YYYY, Company A put a formal offer to ZZZ to acquire xx operations for $xxx.

80.   During the course of subsequent negotiations, the sale price was amended to be:

•           Sale price for xx operations - $xxx;

•           Potential earnout payment based on performance of the xx operations;

•           Potential to sell an additional x operations for $xxx each subject to meeting agreed occupancy hurdles

81.      The realisation of the entity's operations was simply a disposal by the entity due to receiving a package offer which in its view was attractive and above market value. A package sale was not sought, nor preferred, but given the premium which was offered to buy not just higher quality operations but also those identified as having lower future growth prospects, Z1 felt it was an excellent offer.

82.      Additionally, the sale of any of the operations was only broached and considered to allow ZZZ to complete the contract for XXX. The purchase price for XXX was such that ZZZ did not need to sell all operations, but given the package sale which ensued, ZZZ was able to complete the XXX contract sooner than otherwise anticipated.

83.      Neither ZZZ nor the entity was in the business of buying / developing and subsequently selling operations for profit.

84.      Given the scale of ZZZ's operations, it was not unreasonable that from time to time they needed to either acquire / dispose of operations with limited future growth potential, so as to ensure their portfolio continued to be fit for purpose.

85.      Whenever bulk sales of operations have occurred, it was been for a reason other than simply part of normal business activities, such as:

•           To assist with funding the exit of a former business partner;

•           To free up capital to make repayments to financiers;

•           To free up capital to acquire other assets.

86.      The acquisition / establishment of the xx operations was not undertaken with the purpose of a profit-making intention by way of resale.

87.      ZZZ has a corporate and administrative function which runs the operations of the Group. In order to fund these functions, ZZZ requires a certain number of operations to be operating so as to generate the necessary cash flows to fund the corporate and administrative functions.

88.      ZZZ's cash flow forecasts were based on, and included cash flows arising from, operation operations only and not sales of operations. Additionally, ZZZ's bank finance facilities were also based on cash flows arising from operation operations only and not from sales of operations.

89.      Therefore, given the fact that the entity has disposed of the operations, and that they would seek to maximise the proceeds from the realisation of those assets, the proceeds from the sale are not profits from an undertaking or scheme or income from a business activity. The only steps undertaken to maximise the proceeds were to negotiate with one potential purchaser so as to ensure the highest possible price was achieved.

90.      As the gain on sale of the operations is a capital gain, and the entity held their interest in the operations for more than xx months (other than in the case of the XYZ operation), the gain will be a discount capital gain under section 115-5 of the ITAA 1997.

91.      Therefore, the entity can identify capital gains from a section 104-10 A1 CGT event (sale of CGT assets) and apply the discount by working through Step 3 within section 102-5 of the ITAA 1997.

CONCLUSION

The gain from the sale of the operations is assessable solely as a discount capital gain pursuant to sections 102-5, 104-10 and Division 115 of the Income Tax Assessment Act 1997.

Other references (non ATO view)

Greig v Commissioner of Taxation [2020] FCAFC 25

Californian Copper Syndicate v. Harris (Inspector of Taxes) (1904) 5 TC 159

Whitfords Beach Pty Ltd v FC of T 82 ATC 4031

Commissioner of Taxation (Cth) v Myer Emporium Limited (1987) 163 CLR 199

Statham & Anor v. Federal Commissioner of Taxation (1988) 20 ATR 228