Edited version of private advice

Authorisation Number: 1052190852669

Date of advice: 10 November 2023

Ruling

Subject: CGT - market value substitution

Question

Can I use an apportionment of the sale price based on market value for each property to work out my capital gain on the disposal of my two units.

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2022

The scheme commenced on:

Year ended 30 June 2022

Relevant facts and circumstances

1.    A sold the following units in 2022 under separate contracts for sale:

•         unit B, at address at a contract price of $X

•         unit C, at address at a contract price of $X

2.    Unit B and unit C are adjacent reflecting a premium price for each unit. The combined sale price for both units was 2 times $X.

3.    A inherited the unit B property prior to 20 September 1985.

4.    A purchased the unit C property after 20 September 1985 for $Y.

5.    A resided in unit C with her family for a number of years until they moved out to live in another property. From around March 200V unit C was rented out to third parties and A began receiving rental income from it.

6.    A subsequent valuation report has been obtained by A that provides that unit B and unit C were valued individually as follows:

•         The market value of unit B as at the date of sale was $X plus Z.

•         The market value of unit 16 as at the date of sale was $X less Y.

7.    There is a difference in size and amenity between the units, with unit B being the larger unit.

8.    A originally requested that the sale of the two units be dealt with in a single contract given that A was selling them together.

9.    A's real estate agent and conveyancer both told her that it did not matter if the properties were sold under separate contracts or one contract, and that if they were sold under two contracts, the split of the proceeds between the two contracts did not matter.

10.  A relied on the advice of the real estate agent and conveyancer and agreed to sell the properties under separate contracts and didn't think about how to split the sale proceeds between the two properties.

11.  When the properties were sold in June 2022 the agreed price for both units of 2 times $X was split equally between the two contracts.

Relevant legislative provisions

Section 104-10 Income Tax Assessment Act 1997

Section 116-20 Income Tax Assessment Act 1997

Section 116-30 Income Tax Assessment Act 1997

Reasons for decision

Capital gains tax (CGT) is the tax any entity pays on profits from disposing of assets including investments, such as property and shares. If an entity disposes of assets (generally when the entity stops being the owner of an asset) a CGT event may be triggered. This is when an entity will need to report capital gains and capital losses in their income tax return.

The sale of the units will result in CGT event A1 for each unit. Section 104-10(4) and (5) ITAA 1997 provide that:

(4) You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

(5) A capital gain or capital loss you make is disregarded if:

(a) you acquired the asset before 20 September 1985;

Section 116-20 ITAA 1997 provides, in respect of CGT event A1:

1) The capital proceeds from a CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

In this case the money received for each unit, being the agreed contract price of $X will be the capital proceeds of the CGT event.

The CGT provisions do provide for the use of a market value in some circumstances. Under s116-30 ITAA 1997, the 'market value substitution rule modification':

(2) The capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if:

(a) some or all of those proceeds cannot be valued; or

(b) those capital proceeds are more or less than the market value of the asset and:

(i) 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; or

(ii) the CGT event is CGT event C2 (about cancellation, surrender and similar endings).

(The market value is worked out as at the time of the event.)

In the present case it would be necessary to show both that the capital proceeds are more or less than the market value, and that the parties did not deal with each other at arm's length.

On the facts in this case, the purchaser and the vendor were unrelated parties and agreed on a price and a pricing structure for each unit that was the subject of a genuine and arm's length bargain between the parties.

In addition, whilst it is possible that, sold individually, the units may have had a different value, that is not what has occurred in this case. There was an agreement to sell both the properties and the value of each property was dependent on the sale of the other property. In this case, the bargain struck between the arm's length parties would be expected to be reflected in the price for each unit notwithstanding that this price may deviate from a theoretical value for an individual value.

It is also worth noting that the capital proceeds in this case, being the price for each unit, is also the price that is relevant for other regulatory and taxation matters including determining the cost base for the purchaser and the relevant transfer duty on the sale.

The ATO has provided guidance of general relevance to this matter in TD 98/24[1] in relation to the second modification rule. TD 98/24 outlines how the ATO will generally view prices reached by parties acting at 'arm's length'.

2. On a CGT event happening to the real property, that CGT event happens to each separate asset comprising the property and a separate capital gain or loss calculation is necessary for each CGT asset. The capital proceeds from each CGT event are so much of the overall capital proceeds as is reasonably attributable to that event (subsection 116-40(1)).

3. If the property is disposed of under a contract and parties dealing with each other at arm's length allocate the overall capital proceeds to the separate assets in the contract, we will accept the allocation for the purpose of subsection 116-40(1).

4. We will accept a later agreement, between the parties in paragraph 3, that allocates the capital proceeds if this was not done in the original contract.

There are circumstances where unrelated parties may be considered to be acting otherwise than at arm's length, however the facts of this case would not extend to reaching a view that the unrelated vendor and purchaser were acting other than at arm's length. The issue is discussed extensively in Commissioner of Taxation v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 where Edmonds and Gordon JJ, in the majority stated:

"In the end, what must be borne steadily in mind is that any assessment of whether parties were dealing at arm's length is a question of fact and that question of fact is resolved by "an assessment [of] 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":

Having regard to circumstances where unrelated parties were not acting at arm's length, it was noted by Lee J in Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503:

" That is not to say, however, that parties at arm's length will be dealing with each 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. "

Conclusion

CGT event A1 happened when A disposed of unit B and the capital proceeds is the money A received in respect of the event happening. Similarly, CGT event A1 also happened when A disposed of unit C and the capital proceeds is the money A received in respect of the event happening.

As A and the purchaser dealt with each other at arm's length the market value substitution rules will not apply and the capital proceeds from the CGT event are not replaced with the market value of the asset. Whilst there are circumstances where unrelated parties may be found to have acted otherwise than at arm's length, the facts and circumstances in this case would not extend to a finding that A and the purchaser were not acting at arm's length.

[1] TD 98/24 Income tax: capital gains: what are the CGT consequences of a CGT event happening to post-CGT real property if the property comprises separate CGT assets under Subdivision 108-D in Part 3-1 of the Income Tax Assessment Act 1997 (the 1997 Act) or if the property is sold with depreciable assets?