Edited version of private advice

Authorisation Number: 1052324499769

Date of advice: 18 December 2024

Ruling

Subject: Look-through approach, calculation of capital gains

Question 1

Will the Commissioner accept that the 'look-through' approach applies on payment of the Tax Equalisation Payments to disregard the application of CGT event C2 to the disposal of the Person X Rights?

Answer 1

No.

Question 2

If the answer to Question 1 is no, will the Commissioner accept that the disposal of the Person X Rights will not give rise to a capital gain in Person X's hands?

Answer 2

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on

X/XX/20XX

Relevant facts and circumstances

1.            Company X is owned in equal shares (Company X Shares) as follows:

(a)                Person X holds X D class X% non-cumulative redeemable preferences shares and one X% non-cumulative preference share (Person X Shares), and

(b)                Person Y holds X C class X% non-cumulative redeemable preferences shares and one X% non-cumulative preference share (Person Y Shares).

2.            In relation to the Company X Shares:

(a)                the Person X Shares were acquired after 19 September 1985 (post-CGT assets), and

(b)                the Person Y Shares were acquired pre-19 September 1985 (pre-CGT assets).

3.            Company X is the head entity of a tax consolidated group (Group X).

4.            Group X is currently in Liquidation.

5.            Group X was established prior to 1985 by the parents of Person X and Person Y, being the late Person A and the late Person B.

6.            Person A managed Group X until 20XX, when Person B took over management. Person B withdrew from management of the Group in 20XX as was suffering from a health condition.

7.            Following Person A's death on X/XX/20XX, a dispute arose between Person X and Person Y as to Person X's ongoing role in the business of Group X.

8.            A consequence of the dispute was that on X/XX/20XX, the Court made orders by consent (Month A Orders) for the sale of assets and winding up of Group X (Sale and Liquidation).

9.            While the Month A Orders were made by consent, there were various ongoing matters of dispute which prolonged the Sale and Liquidation.

10.         The Group X was wound up pursuant to a members' voluntary liquidation on X/XX/20XX with the Liquidator

11.         Person B and Company X were parties to a Share Option Agreement dated X/XX/20XX (Option Agreement). Under the Option Agreement, Person B was granted options (Options) which, if exercised, would bring about the allotment of 10 'E' Class X% redeemable preference shares in Company X to them. The Options were to be exercised by X/XX/20XX (Option Expiry Date) or they would lapse. If the options lapsed, Company X was to be wound up within X months.

12.         Person B, Person Y and Person X entered into a separate agreement in 19XX (19XX Agreement) in relation to the Options.

13.         Clause 3 of the 19XX Agreement states:

3.1          The Liquidator has retained further amounts that will also be paid in the same manner and for the same purpose as set out in the preceding paragraph to ensure there is equalisation pursuant to the terms of an agreement entered into in 19XX. The circumstances of that agreement are set out below. Person X and Person Y agree that if Person B has not exercised the Options in accordance with their terms before the Options Exercise Date, then, unless Person B otherwise directs, Person X and Person Y will procure that the Company is wound up and, no later than X months after the Options Exercise Date, each will make such gifts to each other and to Person B so that Person Y, Person X and Person B receive, after payment of any capital gains tax assessable in any of their hands on amounts received pursuant to the winding up, an amount equal to one third of the net assets of the Company on the winding up.

3.2          Person X and Person Y undertake to make provision in their wills so that their beneficiaries will only be entitled to the respective person's share in the Company if they adopt the undertaking in this agreement as if made by the relevant testator.

14.         An explanatory statement was prepared to assist the parties in understanding their rights and obligations arising under the Option Agreement and 19XX Agreement (Explanatory Statement).

15.         Relevantly, the Explanatory Statement states that the purpose of the Option Agreement and 19XX Agreement was to ensure that:

3.3          Person B has certainty of their financial position after the death of the deceased, recognising that the family assets are all owned by Company X. The proposal is that they receive one third of the value of Company X.

3.4          The proceeds [of the winding up] will be divided equally amongst Person X, Person Y and Person B Peel so that each receives the same amount, after each has paid applicable tax on the receipts. This will require gifts from Person Y Peel and, possibly to a lesser extent, Person X Peel.

16.         On X/XX/20XX, Person X and Person Y, in their personal capacities and as joint powers of attorney for Person B, entered into an agreement not to exercise the Options on behalf of Person B (Option Exercise Deed). The Option Exercise Deed stated:

3.5          for the avoidance of doubt, clause 3.1 of the 19XX Agreement would now be read as follows:

3.6          Person X and Person Y agree that if Person B has not exercised the Options in accordance with their terms before the Option Exercise Date, then, unless Person B otherwise directs, Person X and Person Y will procure that the Company is wound up as soon as practicable after the sale of the Group X assets in accordance with the Orders made by the Court and, in any event no later than X months after the Options Exercise Date, and each will make such gifts to each other and to Person B so that Person Y, Person X and Person B receive, after payment of any capital gains tax assessable in any of their hands on amounts received pursuant to the winding up, an amount equal to one third of the net assets of the Company on the winding up.

3.7          The terms of the Explanatory Statement and the 19XX Agreement otherwise remained the same.

17.         On X/XX/20XX, Person X and Person Y made a joint application in a Court as joint powers of attorney for Person B seeking orders that they would be justified in not exercising the Options granted under the Option Agreement on Person B's behalf to ensure the directors of Group X had sufficient time to facilitate the Sale required by the Month A Orders.

18.         On X/XX/20XX, the Court made the orders sought by Person X and Person Y which had the effect of requiring the Sale and Liquidation required by the Month A Orders be completed by no later than X/XX/20XX (Month B Orders).

19.         Person B died on X/XX/20XX, and under the terms of the will, Person Y and Person X were appointed joint executors of Person B's estate (Estate). Aside from some small specific bequests, Person Y and Person X are the sole and equal beneficiaries under Person B's will.

20.         On X/XX/20XX, the Court made orders (with the consent of Person X and Person Y) appointing administrators of the Estate. The administrators received the grant of Letters of Administration in respect of the Estate on X/XX/20XX.

21.         Pursuant to the 19XX Agreement and the Option Exercise Deed (collectively, the Agreements), as Person Y's Company X shares are pre-CGT assets and Person X's Company X shares are post-CGT assets, required Person Y to pay an amount to Person X equal to half of Person X's income tax liability arising from the liquidation of Company X (Tax Equalisation Payments).

22.         The Liquidator has made several distributions from Company X to the shareholders. The source of funds comprising these distributions were sourced from pre-CGT profits:

(a)                on X/XX/20XX, Person X and Person Y both received from the Liquidator a distribution in the amount of $XX (Initial Liquidator's Distribution) all of which was sourced from Group X's available pre-CGT reserves.

(b)                on:

(i)            X/XX/20XX, Person X and Person Y both received from the Liquidator a further distribution in the amount of $XX all of which was sourced from Group X's available pre-CGT reserves, and

(ii)           X/XX/20XX, Person X and Person Y both received from the Liquidator a further distribution in the amount of $XX all of which was sourced from Group X's available pre-CGT reserves.

(c)                on X/XX/20XX, Person X and Person Y both received from the Liquidator a further distribution in the amount of $XX all of which was sourced from the Group X's available pre-CGT reserves. Both of these amounts (a total of $XX) were paid directly to the Australian Taxation Office (ATO) on account of Person X's taxation liability. Person Y's $XX payment directed to Person X's account is a Tax Equalisation Payment made pursuant to the Agreements.

(d)                the Liquidator has retained further amounts that will also be paid in the same manner and for the same purpose as set out at (c) above.

23.         The $XX payment relates to net capital gains realised by Person X in relation to the liquidation distributions made during the 20XX and 20XX income years.

Assumptions

24.         Person X and Person Y's obligation to pay one-third of the net assets to Person B ceases upon Person B's death.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(4)

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 section 103-10

Income Tax Assessment Act 1997 section 103-15

Income Tax Assessment Act 1997 108-5

Income Tax Assessment Act 1997 section104-35

Income Tax Assessment Act 1997 subsection 104-35(5)

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 paragraph 104-25(1)(b)

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 subsection 116-20(1)

Does IVA apply to this private ruling?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Issue 1 - Look through approach to disregard CGT event C2

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

Question 1

Will the Commissioner accept that the 'look-through' approach applies on payment of the Tax Equalisation Payments to disregard the application of CGT event C2 to the disposal of the Person X Rights?

Summary

The Commissioner will not accept a 'look-through' approach to disregard the application of CGT event C2 in relation to the Person X Rights.

Detailed Reasoning

1.            Section 6-5 includes in the assessable income of an Australian resident, ordinary income derived from sources in or out of Australia, during the income year.

2.            In working out whether you have derived an amount of ordinary income, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct. This principle is also referred to as 'constructive receipt'.[1]

3.            A similar rule is available in respect of the capital gains tax (CGT) provisions set out in Part 3-1. Section 103-10 states:

(1) This Part and Part 3-3 apply to you as if you had received money or other property if it has been applied for your benefit (including by discharging all or part of a debt you owe) or as you direct.

(2) Those Parts apply to you as if you are entitled to receive money or other property:

(a) if you are entitled to have it so applied; or

(b) if:

(i) you will not receive it until a later time; or

(ii) the money is payable by instalments.

4.            Subsection 108-5(1) states a CGT asset includes any kind of property, or a legal or equitable right that is not property.

5.            The creation of the Person X Rights would fall within the definition of a CGT asset, as it is a legal or contractual right.

6.            Person X acquired the Person X Rights under the Agreements in consideration for Person Y and Person X agreeing to pay Person B one-third of the net assets of Company X, and Person Y in effect, agreeing to pay Person X and Person B the Tax Equalisation Payments. Person X and Person Y's obligation to pay one-third of the net assets to Person B under the Agreements ceased upon Person B's death. This will result in a variation to the Person X Rights, with Person X and Person Y no longer required to give an amount to Person B, leaving only Person Y being required to pay Person X the Tax Equalisation Payments.

7.            CGT event D1 occurs under section 104-35, when you create a contractual right or other legal or equitable right in another entity. Where an entity acquires an asset as a result of CGT event D1 happening, the asset is considered to be when acquired when the contract is entered into, or if none, when the right is granted. However, CGT event D1 does not happen 'if the right requires you to do something that is another CGT event that happens to you.'[2]

8.            CGT event D1 does not happen to Person X as the Person X Rights requires their to do something that results in CGT event C2 to happen.

9.            CGT event C2 happens if your ownership of an intangible asset ends because the asset expires, or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.[3] The time this event happens is when the contract that results in the asset ending is entered into, or if there is no contract - when the asset ends.[4]

10.         Chapter 11 of the Replacement Explanatory Memorandum to the Taxation Laws Amendment Act (No.4) 1992 states:

Not all things often referred to as "rights" will be assets for CGT purposes. To be an asset, a right must be recognised and protected by law - a court of law or equity will assist in enforcing it.

11.         Where a CGT asset is the right to performance of an executory contract, the courts have found that performance of the contract will result in CGT event C2 to happen. As stated in paragraph 19, 23, 24 and 25 of Taxation Determination TD 2008/22 Income tax: capital gains: does CGT event C2 happen as a result of the satisfaction of an investor's rights under a Deferred Purchase Agreement warrant, an investment product offered by financial institutions, by the delivery of the Delivery Assets?

19. consistent with the decision of the High Court of Australia in FC of T v. Orica Limited (formerly ICI Australia Limited) (1998) 194 CLR 500; 39 ATR 66; 98 ATC 4494. In that case, the Court held unanimously that the right to performance of an executory contract (in that case, an 'in substance' debt defeasance arrangement) was an asset for CGT purposes. It was further held that the asset was realised for CGT purposes when the other party gave performance of its obligations.

...

23. The Commissioner accepts as a general principle the CGT provisions address what is the most relevant transaction to be considered. This principle has found its application in the recognition by the Commissioner, in appropriate circumstances, of an 'underlying asset' or 'look through' approach under which it is sometimes appropriate to regard the capital proceeds as being in respect of an 'underlying asset' rather than a more proximate 'right' to payment (see for example Taxation TR 95/35, concerning the CGT treatment of compensation receipts).

24. The underlying asset approach gives effect to the broader principle that the CGT provisions are applied in a manner consistent with 'the reality of the matter' (see Zim Properties v. Proctor (Inspector of Taxes) (1984) 129 Sol Jo 68; 58 TC 371 and Taxation Ruling TR 95/35 at paragraphs 71 to 73).

25. Consistent with the underlying asset approach, it is considered generally to be the case that where, under a contract for the purchase of an asset, the purchaser incidentally acquires and disposes of a right to the transfer of the asset, and the acquisition and disposal of that right merely facilitates the acquisition of the asset, it is proper to look at the overall transaction as the mere acquisition of a CGT asset.

Application to your circumstances

12.         Person X received an amount of $XX from Person Y in respect of the Tax Equalisation Payments they were required to pay pursuant to entering into the Agreements that created the Person X Rights. This amount was directly applied to Person X's running balance taxation liability account with the ATO. In other words, these amounts were dealt with on Person X's behalf by Person Y per the directions directly arising from the Agreements as entered into and agreed between them.

13.         You contend it would be appropriate to apply the 'look-through' approach to the payment of the Tax Equalisation Payments because the discharge of the Person X Rights is merely facilitating the real transaction, being the Gift.

14.         You submit that the ATO has confirmed its view in relation to the application of the CGT provisions due to the following:

(a)                as a general principle the CGT provisions address what is the most relevant transaction to be considered

(b)                in determining what the most relevant asset or transaction is, it is often appropriate to adopt a 'look-through' approach to the transaction or arrangement

(c)                it is sometimes appropriate to regard the capital proceeds as being in respect of an 'underlying asset' rather than a more proximate 'right' to payment, and

(d)                in the case of an unpaid present entitlement to income of a trust, on payment of that income, the Commissioner's position has been that it is appropriate to look through the legal rights incidentally created and discharged/satisfied when they are merely facilitating the real transaction, being the distribution of income from a trust to a beneficiary.

15.         It is your view that it would be appropriate to apply the 'look-through' approach to the payment of the Tax Equalisation Payments because the discharge of the Person X Rights is merely facilitating the real transaction, being a gift from Person Y to Person X (Gift).

Not a 'gift'

16.         The term 'gift' is not defined in either of the Income Tax Assessment Acts. In Taxation Ruling TR 2005/13 Income tax: tax deductible gifts - what is a gift? (TR 2005/13) the following is stated:

13.          Rather than attempting a definition of gift, the courts have described a gift as having the following characteristics and features:

•                    there is a transfer of the beneficial interest in property;

•                    the transfer is made voluntarily;

•                    the transfer arises by way of benefaction; and

•                    no material benefit or advantage is received by the giver by way of return.

14.          In doing so, the courts have recognised that the criteria may not be absolute and may involve a matter of degree.

17.         Per paragraph 32 of Taxation Ruling IT 2674 Income tax: gifts to missionaries, ministers of religion and other church workers - are the gifts income?, genuine gifts received for personal reasons are generally not assessable to the recipient.

18.         The Tax Equalisation Payments cannot be categorised as gifts because the requirement for a gift was mandated by the Agreements. The primary purpose of Person Y being required to make Tax Equalisation Payments to Person X is to facilitate a mechanism for ensuring equal receipts after the payment of tax being received by Person X and Person Y. It is considered that had Person Y not made the Tax Equalisation Payments, Person X could have or would have been likely to assert their rights under the Agreements to obtain these amounts, that is, could have sued Person Y to ensure these payments were made.

19.         This does not satisfy the requirement that a gift must be voluntarily provided, as outlined at paragraph 13 of TR 2005/13.

20.         Furthermore, the Commissioner's position outlined in Commissioner of Taxation v Dulux Holdings Pty Ltd & Ors [2001] FCA 1344, considers that it may be appropriate to look through the legal rights incidentally created and discharged/satisfied when they are merely facilitating a real transaction.

21.         However, the Person X Rights which provided the right receive the Tax Equalisation Payments from Person Y is a specific and significant benefit owing to Person X arising out of the historical negotiations underpinning the Agreements. Consequently, a 'look-through' approach to treat the proceeds received pursuant to the Person X Rights as a gift is not permissible.

Tax Equalisation Payment - amounts dealt with on your behalf

22.         The Agreements specify that Person X's net receipts from Company X (whether through the mechanism of a 'gift' or otherwise) must be equal to those payable by Person Y after determining the tax payable from the capital gain made by Person X from the ending of thier Company X shares.

23.         As Person Y is not taxed on these amounts but Person X is, the Agreements require that Person X's tax liability is grossed-up by the amounts of their liability for any CGT amounts. In other words, the difference in the amounts received by Person Y and Person X from Company X, is solely attributable to the tax consequences arising from the capital gains made to bring Person X's Company X shares to an end.

24.         As a result, all the amounts properly receivable by their under the Agreements must form part of Person X's assessable income, including amounts applied for their benefit on their behalf (for the purpose of subsection 6-5(4), or section 103-10), such as the Tax Equalisation Payments. A disparity would arise from directing the Tax Equalisation Payments to the ATO which produces a tax credit against Person X's tax liabilities, but not reporting it in assessable income has the effect of reducing the tax paid on other assessable income thereby producing an excess refund or reduction of tax payable.

25.         This is consistent with other aspects of the tax law which include gross amounts (that is, inclusive of tax components) in assessable income, for example, franking credits or PAYG amounts withheld from Salary and Wages.

26.         Hence, a look-through approach is also inappropriate for the reason the Tax Equalisation Payments represent a critical portion (being the tax component dealt with for Person X's benefit on their behalf) of the Liquidation Payments, on which Person X must be properly assessed.

Conclusion

27.         As noted above, the Tax Equalisation Payments are:

(a)          not a gift, being a performance right which is clearly non-voluntary (to Person Y) in nature, and

(b)          amounts to which Person X has constructive receipt, being dealt on Person X's behalf via a direct payment to Person X's account with the ATO.

28.         Hence, the Commissioner will not accept a 'look-through' approach to disregard CGT event C2 (or any other more applicable CGT event) of the type sought in your private ruling application. Person X will need to include the Tax Equalisation Payments in their assessable income.

Issue 2 - Calculation of capital gains from CGT event C2

Question 2

If the answer to Question 1 is 'No', will the Commissioner accept that the disposal of the Person X Rights will not give rise to a capital gain in Person X's hands?

Summary

The Commissioner will not accept that the disposal of the Person X Rights will not give rise to a capital gain in Person X's hands.

Detailed Reasoning

29.         Where CGT event C2 happens, you make a capital gain where the capital proceeds from the ending are more than the asset's cost base.[5]

30.         Subsection 116-20(1) states:

The capital proceeds from a *CGT event is 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).

31.         Under section 104-25, a capital gain under CGT event C2 occurs when the contact ending the asset is entered into or, if none, when the asset ends. A capital gain will arise where the capital proceeds from the ending are more than the asset's cost base.

32.         There are 5 elements to the cost base of a CGT asset under section 110-25. Under subsection 110-25(2), the first element of a CGT asset's cost base includes:

(a)          the money you paid, or are required to pay in respect of acquiring it; and

(b)          the market value of any property you gave, or are required to give, in respect of acquiring it (worked out as at the time of the acquisition).

33.         Under section 103-15 money or property provided will be included in the cost base, notwithstanding that you do not have to pay or give it until a later time.

Application to your circumstances

34.         The Person X Rights arose on entering into the 19XX Agreement, and subsequently varied on entering into the Option Exercise Deed and on Person B's passing along with their Executors choosing not to exercise the Option.

35.         What forms part of the cost base of the Person X Rights will depend on what amounts Person X paid towards the creation of the rights, e.g. if they contributed towards the drafting of the Agreements and any legal advice that led to the creation of the rights. Whilst Person X originally agreed to pay Person B one-third of the net assets of Company X, the Person X Rights were varied when the Executors of Person B's Estate decided not to exercise the Options. Therefore, the amount Person X was required to pay was no longer payable and is unable to form part of the first element of the cost base under subsection 110-25(2).

36.         As noted in Dingwall, K. v Commissioner of Taxation [1995] FCA 431, with respect to the predecessor to subsection 110-25(2):

in its use of the word "required", means that there is a requirement for either an actual payment or, at least, a present obligation to pay a sum certain at some future date. It is not enough that an amount might become payable in the future upon the happening of some contingency. Unless a call is made the unpaid amount and, therefore, the requirement to pay, will never "ripen" into a present obligation to pay either presently or in the future. For these reasons, I have concluded that the taxpayer did not have, at any relevant time, a requirement to pay any sum on account of uncalled capital or unpaid premiums.

37.         In these circumstances, the amount Person X may have expected to originally pay in order to acquire these rights pursuant to the Agreements do not form part of the cost base for the Person X Rights or any other asset. The payment of this amount was at all times subject to a contingency, and ultimately there was no consideration, or resources expended by Person X to obtain these rights.

38.         As such the Commissioner, does not accept that the cost base of the Person X Rights will exceed the proceeds derived in relation to the CGT event.

Conclusion

39.         The Commissioner will not accept that the Person X Rights will not be subject to a taxable capital gain.

[1] Subsection 6-5(4)

[2] Subsection 104-35(5)

[3] Subsection 104-25(1)

[4] Subsection 104-25(2)

[5] Subsection 104-25(3)