Private ruling: Income vs capital
Date of advice: 4 October 2018
Published: November 2018
Ruling period: Year ending 30 June 20XX
Date scheme commenced: 1 June 20XX

Ruling: Q1: Does Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the Rights? | A1: No | Q2: Will the Rights be capital assets under section 108-5 of the ITAA 1997? | A2: Yes | Q3: Will the amount/s received upon the cancellation of the Rights be capital proceeds under section 116-20 of the ITAA 1997? | A3: No. The amount/s will be ordinary income under section 6-5. | Q4: When will the Amount be derived by the Taxpayer? | A4: They will be derived pursuant to section 6-5(4) at the earlier of when the amount/s are received or dealt with by them or on their behalf.

Relevant facts and circumstances: 1. The Company is a private Australian resident company. 2. The Parent Company owns all the shares in the Company. 3. The Company has issued rights (the Rights) to an employee (the Taxpayer). 4. The Rights effectively give the Taxpayer a right to share in the earnings of the Company (the earned amount). The rights have no connection to the shares of the Company and no rights over the beneficial ownership of the shares of the Company. 5. The Taxpayer has been granted varying amounts of rights from 20XX to 20XY. 6. Since 20XY the undistributed earned amounts were frozen and placed into an interest bearing account. The funds will remain there and accrue interest until such time that the Taxpayer exercises their rights to receive payment of the undistributed amounts. 7. The Rights become exercisable upon some triggering event, which has not yet occurred. One such event, which automatically triggers exercise, is the sale of majority ownership of the Company. If this occurs, payment is made as soon as practical thereafter. 8. The Rights cannot be sold, assigned, bequested or otherwise transferred. 9. The Parent Company is considering the sale or restructure of the Company. As part of this restructure the Taxpayer will, for the exercise and/or cancellation of the Rights, receive: a. payment of the undistributed earned amounts up to 1 January 20XY, and b. due to the Plan being frozen since 1 January 20XY, an amount (the Amount) for undistributed unearned awards plus interest accrued.

Relevant legislative provisions: Income Tax Assessment Act 1997 Division 83A | Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 83A-10 | Income Tax Assessment Act 1997 section 104-25(1) | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 section 116-20 | Income Tax Assessment Act 1997 section 116-20 | Income Tax Assessment Act 1997 section 116-40

Reasons for decision: Summary: Summary 10. Division 83A of the ITAA 1997 does not apply to the Rights as they are not ESS interests. Detailed reasoning 11. Division 83A applies to ESS interests (see paragraphs 83A-20 and 83A-105(1)). 12. Paragraph 83A-10(1) states: An ESS interest, in a company, is a beneficial interest in: (a) a *share in the company; or (b) a right to acquire a beneficial interest in a share in the company. 13. As the Rights are not beneficial interests in shares, nor beneficial interests in rights to acquire beneficial interests in shares, they are not ESS interests. Thus, Division 83A does not apply to them. Summary 14. The Rights are CGT assets pursuant to section 108-5. Detailed reasoning 15. Section 108-5 of the ITAA 1997 relevantly states: (1) A CGT asset is: (a) any kind of property; or (b) a legal or equitable right that is not property. … Note 1: Examples of CGT assets are: … • a right to enforce a contractual obligation; … 16. The Rights represent an entitlement of a legal or equitable right that is not property and that are rights under a contractual obligation. Thus, the Rights are CGT assets pursuant to section 108-5. Summary 17. The Amount will not be capital proceeds under section 116-20 as they represent deferred remuneration in the hands of the Taxpayer. The Amount will be included in their assessable income as ordinary income in accordance with section 6-5 of the ITAA 1997. Detailed reasoning 18. The Taxpayer contends that the Amount will be paid in consideration for the cancellation of the Rights, resulting in CGT event C2 under section 104-25(1), thus making the paid amounts capital proceeds under section 116-20. 19. Subsection 116-40(2) relevantly provides that: If you receive a payment in connection with a transaction that relates to one *CGT event and something else, the capital proceeds from the event are so much of the payment as is reasonably attributable to the event. 20. An amount paid to compensate for loss generally acquires the character of that for which it is substituted ( Federal Commissioner of Taxation v. Dixon (1952) 86 CLR 540; (1952) 5 ATR 443; (1952) 10 ATD 82) ( Dixon) . 21. Blank v. Commissioner of Taxation [2016] HCA 42; 2016 ATC 20-587 ( Blank ) concerns whether an amount paid to a taxpayer was ordinary income under section 6-5. In this case the taxpayer participated in a profit participation arrangement. This arrangement essentially involved setting aside a share of profits for the taxpayer each year. These amounts were then paid out to him at a future triggering event, in this case their termination of employment. The taxpayer unsuccessfully argued that the amount was from the proceeds of a capital asset. The Commissioner of Taxation successfully argued in the first instance and on appeal to the Full Federal Court, and on appeal to the High Court that the amount paid was deferred compensation for the taxpayer’s employment and assessable as ordinary income upon receipt. Any "rights" the taxpayer had were "merely executory" and were neither vested nor accrued. The conclusion that there was no derivation of any income by the taxpayer as a result of the "associated rights" was fortified by the fact that none of those so-called "associated rights" could be turned to pecuniary account. 22. The Taxpayer’s case is analogous to Blank as: ● the scheme under which Rights are offered is a profit participation arrangement. ● the Rights issued were solely for the purposes of calculating the amount of deferred compensation. ● the Rights cannot be turned to pecuniary account until a triggering event occurs. 23. The Amount is compensation for the loss of the unearned amounts, which would form part of the Taxpayer’s remuneration. In accordance with Dixon the amount paid will take on the character of the unearned amounts i.e. it will be remuneration assessable as ordinary income under section 6-5. Thus, under subsection 116-40(2) the whole of the Amount is reasonably attributable to remuneration for services provided and not the capital proceeds from the cancellation of the Rights. Summary 24. Pursuant to subsection 6-5(4), the Amount received will be assessable in the income year during which the earlier of the following occurs: ● the amount is paid to the Taxpayer (actual receipt) ● the amount is dealt with on the Taxpayer’s behalf or as he directs (constructive receipt). Detailed reasoning 25. Under section 6-5(4), ordinary income is assessable at the time it is derived. Paragraph 8 of TR 98/1 explains that this will be the sooner of when the amount is actually paid over or dealt with on the taxpayer’s behalf or as they direct. 26. Abbot v. Philbin [1961] AC 352 (Abbot) is authority for the proposition that an option granted by an employer to an employee that is unconditional and can be exercised at any time, is able to be turned to pecuniary account and is therefore assessable income to the employee during the year of income in which the option was granted. 27. This case is distinguishable from Abbot on the basis that the Taxpayer’s rights are conditional; they can only be exercised after some triggering event. 28. The Full Federal Court in F.C. of T. v. Cooke and Sherden 80 ATC 4140 stated: If a taxpayer receives a benefit which cannot be turned to pecuniary account, he has not received income as that term is understood according to ordinary concepts and usages. 29. Thus, Rights are not assessable income to the employee in the income year in which they were granted as they are not able to be turned to pecuniary account. 30. Accordingly, when a right held by an employee can be turned to pecuniary account, it will be assessable income to the employee in that income year. 31. Thus, pursuant to subsection 6-5(4), and consistent with the legal principles above, the Amount will become assessable to the Taxpayer at the earlier: ● when it is paid to them, or ● dealt with on their behalf or as they direct (this includes when the Amount is made available to them).

Reasons for decision: All references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.