Edited version of private advice

Authorisation number: 1052341294902

Date of advice: 11 December 2024

Ruling

Subject: CGT - cost base market value substitution

Question

Does section 112-20 of the Income Tax Assessment Act 1997 apply to substitute the cost base with the market value of the business acquired by Company X on DD MM 20YY?

Answer

Yes, section 112-20 of the Income Tax Assessment Act 1997 will apply to substitute the cost base of the business acquired by Company X on DD MM 20YY with its market value.

This ruling applies for the following periods:

Income year ended 31 March 20XX

The scheme commenced on:

31 March 20XX

Relevant facts and circumstances

Company X is a resident private company. Its director is Person A, and it is wholly owned by Trust Y. It was registered in State A on DD MM 20YY. It was incorporated to hold assets from a planned acquisition between Person A and their parents.

Trust Y is a resident discretionary trust. Person A is the trustee of the trust. Person A's children are its specified beneficiaries and Person A is its general beneficiary.

Trust Z is a resident discretionary trust controlled by Person A's parents. Trust Z operated a successful wholesale business (the Business).

The Business was sold to Company X for $X,XXX,XXX. This figure was based on the value of the Business's assets as set out in the purchase deed dated DD MM 20YY (Purchase Deed).

As consideration, Company X incurred a vendor loan of $XXX,XXX. The remaining amount of $XX,XXX,XXX was given as a gift. Company X repaid the vendor loan a number of months after the transaction was completed.

Assumption

The values given for the Business's assets in the Purchase Deed accurately reflects their market value for the purposes of applying section 112-20 of the Income Tax Assessment Act 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 section 995-1

Does Part IVA apply to this private ruling?

No, Part IVA does not apply to this Ruling.

Reasons for decision

Cost base of a CGT asset

A CGT asset is defined under subsection 108-5(1) as follows:

(1)           A CGT asset is:

(a)            any kind of property; or

(b)            a legal or equitable right that is not property.

(c)            an interest in an asset of a partnership; (d) an interest in a partnership that is not covered by paragraph (c).

Section 110-25 relevantly sets out general rules about working out the cost base of a CGT asset:

(1)           The cost base of a CGT asset consists of 5 elements.

(2)           The first element is the total of:

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

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

Section 112-20 modifies the first element of a CGT asset's cost base in certain situations:

(1)           The first element of your cost base and reduced cost base of a CGT asset you acquire from another entity is its market value (at the time of acquisition) if:

(a)            you did not incur expenditure to acquire it, except where your acquisition of the asset resulted from:

(i)             CGT event D1 happening; or

(ii)             another entity doing something that did not constitute a CGT event happening; or

(b)            some or all of the expenditure you incurred to acquire it cannot be valued; or

(c)            you did not deal at arm's length with the other entity in connection with the acquisition.

The expenditure can include giving property: see section 103-5.

(2)           Despite paragraph (1)(c), if:

(a)            you did not deal at arm's length with the other entity; and

(b)            your acquisition of the CGT asset resulted from another entity doing something that did not constitute a CGT event happening; the market value is substituted only if what you paid to acquire the CGT asset was more than its market value (at the time of acquisition).

The term 'arm's length' is defined in section 995-1 as follows:

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

In Healey v FC of T (2012) FCA 269, the Court summarised the principles for determining whether parties were dealing at arm's length as follows:

•                     Determine whether the parties were dealing at arm's length by considering the facts and circumstances: Trustee for the Estate of the late AW Furse No 5 Will Trust v Commissioner of Taxation 91 ATC 4007 (at

4017); Granby Pty Ltd v Federal Commissioner of Taxation 95 ATC 4240; (1995) 129 ALR 503 (at 507); Commissioner of Taxation v AXA Asia Pacific Holdings Ltd 2010 ATC ¶20-224; (2010) 189 FCR 204 (at

[106]).

•                     The parties should not be presumed to be dealing at an arm's length simply because they have an arm's length relationship: ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (at [224]). Conversely, the fact

that the parties are themselves not at arm's length does not mean that they have not dealt with each other at arm's length: Re Hain's; Barnsdall v Commissioner of Taxation 88 ATC 4565; (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015).

•                     The issue of whether parties dealt at arm's length in a particular transaction requires analysing the manner in which they conducted themselves in forming that transaction: Granby Pty Ltd v Federal Commissioner of Taxation 95 ATC 4240; (1995) 129 ALR 503.

•                     The issue is whether the parties have acted separately and independently in forming their bargain: Granby (at 507); ACI Operations Pty Ltd (at [226]) (did the parties apply "independent separate wills"); AXA Pacific Holdings Ltd (at [105]). There should be an assessment of whether the parties dealt with each other as arm's length parties would be expected to behave so that the outcome is a matter of real bargaining: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506 and 507); AXA Pacific Holdings Ltd (at [105]).

•                     It is relevant to consider the nature of any relationship between the parties: Trustee for the Estate of the

late AW Furse No 5 Will Trust (at 4015); Granby (at 506).

•                     If the parties are not at arm's length the inference may be drawn that they did not deal with each other at

arm's length: Granby (at 506); ACI Operations Pty Ltd (at [225]).

Application to facts

The Purchase Deed sets out all the assets Company X acquired when purchasing the Business. All the assets are property and therefore CGT assets in accordance with paragraph 108-5(1)(a).

Ordinarily, the first element of the Business cost base would have been $XXX,XXX, as Company X incurred a vendor loan which it was required to pay: paragraph 110-25(2)(a). As the remaining amount of $X,XXX,XXX effectively represented a discount, it would not have been included in the cost base of the Business's assets.

However, the market value substitution rule under section 1120-25 is relevant, given the nature of the relationship between Company X and Trust Z.

Company X and Trust Y did not deal at arm's length when the Business was sold for the following reasons:

•                     As Company X is controlled by Person A and Trust Z was controlled by Person A's parents, it can be

inferred that they were not dealing at arm's length.

•                     The significant discount between the market value of the business and the loan incurred by Company X, and the very description of the discount as a gift, indicates that the parties were not dealing at an arm's length.

Accordingly, the main condition in paragraph 112-20(c) is satisfied, as Person A did not deal with their parents at arm's length when they sold the Business to Company X. The exception under subsection 11225(2) does not apply, because CGT Event A1 would have happened when Trust Y sold the Business: see section 104-10 which deals with CGT Event A1 and the disposal of an asset.

Therefore, section 112-20 will apply to substitute the first element of the Business's cost base with its market value when Company X acquired it.