ATO ID 2009/68: Capital Gains Tax: cost base modification of CGT asset acquired from exercise of put option
Date of decision: 26 June 2009
Year of income: Year ended 30 June 2005
Business line: Public Groups and International

Issue
Does the market value substitution rule in subsection 112-20(1) of the Income Tax Assessment Act 1997 (ITAA 1997) apply to amounts paid by the grantor upon the exercise of a put option where the grantor and grantee are members of the same wholly-owned entity group and the exercise price paid by the grantor of the put option is more than the asset's market value at the time of the exercise?

Decision
No. The market value substitution rule in subsection 112-20(1) of the ITAA 1997 will not apply to amounts paid by the grantor upon the exercise of a put option where the terms of the exercise was in accordance with the market value conditions at the time of granting the put option.

Facts
The taxpayer (grantor) grants a put option, in relation to a capital gains tax (CGT) asset, to a grantee. The grantor and the grantee are members of the same wholly-owned entity group. Upon the grant of the put option, the terms of the exercise are in accordance with market value conditions. The put option is exercised. At the time of the exercise of the put option, the amount paid to exercise the put option is greater than the market value of the CGT asset.

Reasons for decision
Summary: On granting of an option, CGT event D2, in section 104-40 of the ITAA 1997, happens. You make a capital gain if the capital proceeds from the grant are more than the expenditure you incurred to grant it. You make a capital loss if those capital proceeds are less than the expenditure you incurred to grant it (subsection 104-40(3) of the ITAA 1997). If the option is exercised, the capital gain or capital loss you make from the grant is disregarded (subsection 104-40(5) of the ITAA 1997). Section 134-1 of the ITAA 1997 sets out the consequences of an option being exercised and treats the grant of the option and the transaction that supports the exercise of that option as a single transaction - being, in this case, the acquisition, by the grantor, of the CGT asset that is the subject of the option. The first element of the grantor's cost base and reduced cost base for the asset acquired is any amount paid to exercise the option reduced by any payment received by the grantor for granting the option (item 2 of the table in subsection 134-1(1) of the ITAA 1997). Generally, the terms of the exercise of an option are struck at the time of its granting. In this case, the terms of the exercise are struck accordingly and in accordance with market value conditions. For options, both grantor and grantee are subject to the market whether, if and when the option is exercised, the market value of the asset, the subject of the option, is higher, lower or equal to, the exercise price. In regards to a put option, only the grantee is at liberty, if and when, to initiate the exercise of the option. Accordingly, in this case, when invoking the notion of the 'single transaction' in section 134-1 of the ITAA 1997, coupled with the fact that the grantor of the option has no control over the market value of the asset the subject of the option when the option is exercised, the market value substitution rule in subsection 112-20(1) of the ITAA 1997 will not apply to the amount referred to as 'any amount paid to exercise the option' in item 2 of the table in subsection 134-1(1) of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1997 section 104-40 subsection 104-40(3) subsection 104-40(5) subsection 112-20(1) section 134-1 subsection 134-1(1)
Subject references: Capital gains tax CGT cost base CGT cost base modification market value substitution rule CGT events D1-D3 - bringing into existence a CGT asset Put options