Private ruling: Sale of shares and CGT event K6
Date of advice: 14 September 2018
Published: November 2018
Ruling period: Year ended 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Whether CGT event K6 under subsection 104-230(1) of the Income Tax Assessment Act 1997 (ITAA 1997) happened to Entity A and B? | A1: Yes. All the necessary requirements of subsection 104-230(1) of the ITAA 1997 were satisfied and none of the exceptions applied. The direct test in paragraph 104-230(2)(a) of the ITAA 1997 was also satisfied. | Q2: If CGT event K6 happened, whether the approach referred in the ruling application is a reasonable attribution of the capital proceeds and in accordance with subsection 104-230(6) of the ITAA 1997? | A2: No. The calculation proposed in the ruling application results in an amount that is less than would be expected under a reasonable attribution.

Relevant facts and circumstances: Company X Company X was incorporated on XX/XX/19XX. The initial share capital of Company X consisted of two ordinary shares, held by two different individuals. On XX/XX/19XX, Entity A and B each acquired one ordinary share in Company X, and became the sole shareholders of Company X. In or around May 19XX, Company X commenced carrying on a business. On XX/XX/19XX, Entity A and B each subscribed for a further 500 ordinary shares in Company X. On XX/XX/19XX, minority shareholders were introduced into Company X. Company X undertook a re-organisation in 20XX. Company X’s subsidiaries assumed all business activities that were previously carried on by Company X. Company X acted solely as a holding company. On XX/XX/20XX, Company X converted the existing ordinary shares it had on issue into 11 classes of shares. The existing shares were neither cancelled nor redeemed, and Company X’s share capital was not altered. All the classes of shares carried the same voting and capital rights. Following the conversion, there were also some further changes to the shareholdings. The particulars were provided. On XX/XX/20XX, each of the existing issued shares of Company X was subdivided into ten shares of $0.10 each. The existing shares were neither cancelled nor redeemed. Company X’s share capital was not altered. The issued capital of Company X as noted in the Financial Statement for the year ended 30 June 20XX was provided. Company Y Company Y was a wholly owned subsidiary of Company X. It was incorporated on XX/XX/19XX, operating a different business. However, it did not commence carrying on a business until 19XX. The initial share capital of Company Y consisted of 2 ordinary shares, held by two different individuals. Within one month of Company Y’s incorporation, the shareholders of Company Y became: ● Company Z as bare trustee for Company X (1 ordinary share); and ● Company ABC (1 ordinary share). On and around May 19XX, Company Z was removed as bare trustee and legal title was transferred to Company X. On XX/XX/19XX, Company ABC sold its share in Company Y to Entity A. Entity A held this share on bare trust for Company X. In mid-19XX, Entity A and B considered Entity C was a key person to further grow Company Y’s business, and proposed to issue him a 30% equity interest in Company Y. Thus, as a preliminary step on XX/XX/19XX, Company Y issued a further five ordinary shares to Company X at $1 per share. Following that transaction, Company Y beneficially held all seven shares in Company Y. On XX/XX/19XX, Entity C acquired 3 newly issued ordinary shares in Company Y, plus a share premium of $100 per share. In late 20XX, Entity A and B decided to re-organise the Company X group, so that going forward, Company X would act as the holding company of the group, and all business activity would be carried on through Company X’s subsidiaries (i.e. Company Y and other subsidiaries). Between 19XX and 20XX, the businesses of Company X and Y ran ‘in tandem’. Each company ran separate operations and had separate systems. Accordingly, on or around XX/XX/20XX, Company X acquired 3 Company Y shares from Entity C. In consideration, Company X issued 243 ordinary shares to Entity C. On that date, Company X owned 100 percent of Company Y. On or around XX/XX/20XX, Company Y acquired the business carried on by Company X. There was no written agreement regarding this restructure. On XX/XX/20XX, Company Y issued 30,000 ‘Class A’ shares to Company X (paid to $1 per share). The terms to the Class A shares were: ● A right to a dividend if Company Y declares a dividend on the Class A shares; ● Limited capital rights (limited to the issue price, i.e. $1 per share); ● No voting rights. Company XYZ and Company NZ Company X has two other subsidiaries, namely: ● Company XYZ ● Company NZ Company XYZ was incorporated on XX/XX/20XX. It was set up to deal with a particular customer. Company Y owns all the shares in Company XYZ. Company NZ operates a freight forwarding and customs clearance business in New Zealand. On XX/XX/20XX, Company X acquired 94,050 ordinary shares in Company NZ. This equated to a 55% shareholding in Company NZ. Share Sale Agreement Under a Share Sale Agreement dated XX/XX/ 20XX, the shareholders of Company X sold all of their shares in Company X to Company A for a purchase price of $?. Entity A and B were entitled to $? of the total, in consideration for their respective Company X shares. At the date of the agreement, Entity A and B held the following shares: Shareholder No of shares Entity A 1250 Class A shares 1250 Class B shares 1010 Class C shares (230 are post-CGT shares) Entity B 1250 Class A shares 1250 Class B shares 1010 Class C shares (220 are post-CGT shares) At the time of the sale of Company X, the assets of Company Y represented approximately 90% of the value of the Company X group. Under the Share Sale Agreement, the shareholders of Company X agreed that Company X would acquire the remaining 45% of the shares in Company NZ (which it did not already hold), prior to completion of the sale to Company A. Under a separate NZ Share Sale Agreement dated XX/XX/20XX, Company X agreed to acquire the remaining shares in Company NZ for $?. The commercial reasons for the NZ Share Sale Agreement were provided. The A shares of Company Y were valued at its face value (i.e. $1 per share). No dividends were ever declared in respect of the Class A shares. The purpose of issuing the Class A shares was simply to comply with share capital rules imposed by the industry. The assets held by Company X’s subsidiaries (i.e. Company Y, Company XYZ and Company NZ) and their valuations were provided.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 104-230(1) | Income Tax Assessment Act 1997 Subsection 104-230(2) | Income Tax Assessment Act 1997 Subsection 104-230(6) | Income Tax Assessment Act 1997 Subsection 104-230(9) | Income Tax Assessment Act 1997 Subsection 126-60(3) | Income Tax Assessment Act 1936 paragraph 160M(5)(a) | Income Tax Assessment Act 1936 Subsection 160ZH(12) | Income Tax Assessment Act 1936 Subsection 160ZH(13) | Income Tax Assessment Act 1936 Subsection 160ZH(14)

Reasons for decision: Summary: CGT event K6 under subsection 104-230(1) of the ITAA 1997 happened to Entity A and B when CGT event A1 occurred in relation to their pre-CGT shares in Company X. All the necessary requirements of subsection 104-230(1) of the ITAA 1997 were satisfied and none of the exceptions applied. The direct test in paragraph 104-230(2)(a) of the ITAA 1997 was also satisfied. | Detailed Reasoning - Detailed reasoning: Company A paid $? for all of the issued shares in Company X under the agreement dated XX/XX/20XX. Entity A and B were entitled to $? of the total, in consideration for their respective Company X shares. At the date of the agreement, Entity A held 1250 Class A shares, 1250 Class B shares and 1240 Class C shares in Company X. At the same time, Entity B held 1250 Class D shares, 1250 Class E shares and 1230 Class F shares in Company X. The Commissioner accepts that the conversion of Company X shares into different classes on XX/02/2004 was done with regard to the Commissioner’s guidance in Taxation Ruling TR 94/30. The conversion gave the directors the discretion to pay different dividends to different classes of shareholders, but there is no dividend priority given to any class of share in the Constitution. There is no basis to differentiate the classes of shares held by Entity A and B as at XX/XX/20XX, under the Constitution of Company X. It is reasonable to attribute the total consideration received by Entity A and B equally across their 7470 shares. Entity A was entitled to $? of the total and Entity B was entitled to $? of the total. Subject to any selling cost, Entity A would have a $? total capital gain on the disposal of his 230 post-CGT Class C shares, and Entity B would have a total capital gain of $? on the disposal of her 220 post-CGT Class F shares. Entity A’s share of the total proceeds attributable to his pre-CGT interests in Company X was $? and Entity B’s share of the total proceeds attributable to her pre-CGT interests in Company X was $?. Entity A and B both disposed of pre-CGT interests in Company X on XX/XX/20XX, satisfying paragraphs 104-230(1)(a) and (b) of the ITAA 1997. Entity A and B disposed of their Company X shares for cash consideration only. As such, there is no roll-over relief in respect of the A1 event that happened on the execution of the contract and paragraph 104-230(1)(c) of the ITAA 1997 is satisfied. | Detailed Reasoning - The Company Y share issue in July 19XX: The PBR Application submitted that 2 ½ of the Company Y shares issued on XX/07/19XX should be treated as being acquired prior to 20 September 1985. This position is based on the allotment of those shares being treated as a share split, rather than the issue of new shares. The result would be that 3 ½ of those shares would be treated as being acquired pre-CGT and that the direct test in paragraph 104-230(2)(a) of the ITAA 1997 would not be satisfied. The Commissioner first issued guidance on the CGT consequences of a share split in Draft Taxation Determination TD 94/D81. TD 94/D81 was replaced by TD 95/30 on 22 June 1995. At the time, subsections 160ZH(12) to (14) of the Income Tax Assessment Act 1936 (ITAA 1936) addressed the cost base implications of an asset being divided into two or more assets. Taxation Determination TD 2000/10 also rewrites and replaces Taxation Determination TD 95/30. There is no material change in TD 2000/10 to the views expressed in TD 95/30 apart from updating it with the rewritten income tax law in the 1997 Act and with recent Corporations Law changes. TD 2000/10 and TD 95/30 list 3 relevant factors for determining whether a transaction is a share split. Those factors are: ● the original shares are not cancelled or redeemed in terms of the Corporations Law; ● there is no change in the total amount allocated to the share capital of the company; and ● the proportion of equity owned by each shareholder in the share capital account is maintained. In this case, the original shares were not cancelled or redeemed, and Company X owned 100% of the issued shares in Company Y before and after the allotment (from 2 of 2 before to 7 of 7 after). However, the arrangement resulted in 5 additional shares being issued for an issue price of $1 each and the paid-up capital of Company Y being increased by $5. In terms of the factors described in TD 2000/10 and TD 95/30, the factor in subparagraph 1(b) was not satisfied. TD 2000/10 applies both before and after its date of issue. It did not change an existing ATO view. We first published our considered opinion in TD 94/D81, but the expectation is that if we had been asked to rule on the issue prior to the publication of TD 94/D81 then we would have done so on the same basis. While the application argues that the Commissioner had not published guidance on this issue prior to July 19XX and that the arrangement should be treated as a split, the arrangement would not meet the requirements of subsection 160ZH(12) of the ITAA 1936. The value of the new shares in Company Y was not, in whole or in part, derived from the original shares in this instance. While subsection 160ZH(12) of the ITAA 1936 is specifically interested in how the cost base of an asset is calculated, that issue has implications for the acquisition date of an asset. TD 7 dealt with the subdivision of pre-CGT land and concluded the subdivided land would maintain its pre-CGT acquisition date. However, outside of an existing asset being divided into two or more assets the normal acquisition rules apply. In this instance paragraph 160M(5)(a) of the ITAA 1936 would have deemed the new shares to be acquired for CGT purposes on the date they were issued or allotted. The 5 shares issued on XX/XX/19XX were not issued as part of a share split. As a result, they do not have a pre-CGT acquisition date. This means that 9 out of the 10 ordinary shares that Company X held in Company Y as at XX/XX/20XX were acquired post-CGT. This includes the 3 Company Y shares that Company X acquired from Entity C on XX/XX/20XX. In coming to this conclusion, the Commissioner accepts that Company Z held 1 ordinary share in Company Y as bare trustee for Company X prior to 20 September 1985. | Detailed Reasoning - The direct test: Just before CGT event A1 event that happened to the Company X shares owned by Entity A and B on XX/XX/20XX, the only assets owned by Company X were shares in Company Y and Company NZ. Company X acquired all of its shares in Company NZ post-CGT and more than 90% of its shares in Company Y post-CGT (being 9/10 ordinary shares and 30,000/30,000 Class A shares). Therefore, more than 90% of the assets held by Company X (at the relevant time on XX/XX/20XX) were post-CGT assets and the direct test in paragraph 104-230(2)(a) of the ITAA 1997 was satisfied. It is not necessary to identify the net value of Company X at this point because more than 90% of the total market value of all property owned by Company X was in property acquired after 20 September 1985. On this basis, the market value of the post-CGT property has to be more than 75% of the net value of the company. The exception in subsection 104-230(9) of the ITAA 1997 does not apply in this case because Company X was not listed on a stock exchange in Australia or in a foreign country at the relevant times. Therefore, CGT event K6 happened on XX/XX/20XX when Entity A and B contracted to sell their Company X shares to Company A. Entity A and B are required to calculate any gain on the disposal of their Company X shares in accordance with subsection 104-230(6) of the ITAA 1997. Having determined that the direct test in paragraph 104-230(2)(a) was satisfied, it is not necessary to determine whether the indirect test in paragraph 104-230(2)(b) was also satisfied in order to answer the questions posed in the application. | Summary: The calculation proposed in the PBR Application results in an amount that is less than would be expected under a reasonable attribution in accordance with subsection 104-230(6) of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Paragraph 105 of Taxation Ruling TR 2004/18 recognises that a shareholder can have two capital gains under CGT event K6, by the application of both the direct and indirect tests. The view expressed in the TR 2004/18 is that one test is not any more relevant or specific than the other test. Where two capital gains are calculated, it is appropriate to disregard the lesser capital gain to avoid a double application of the provision. Subsection 104-230(6) of the ITAA 1997 states that: You make a capital gain equal to that part of the capital proceeds from the share or interest that is reasonably attributable to the amount by which the market value of the property referred to in subsection (2) is more than the sum of the cost bases of that property. Subsection 104-230(2) of the ITAA 1997 states that: Just before the other event happened: (a) the market value of property of the company or trust (that is not its trading stock) that was acquired on or after 20 September 1985; or (b) the market value of interests the company or trust owned through interposed companies or trusts in property (except trading stock) that was acquired on or after 20 September 1985; must be at least 75% of the net value of the company or trust. The relevant property for the purposes of subsection 104-230(6) of the ITAA 1997 will depend on which paragraph of subsection 104-230(2) of the ITAA 1997 is satisfied (paragraph 22 of TR 2004/18). The Commissioner provides a two-step calculation in paragraphs 27-33 of TR 2004/18 as a starting point for determining what might be a reasonable attribution of the capital proceeds for the purposes of CGT event K6. The first step of the calculation is to determine how much of the capital proceeds actually relate to the post-CGT property. At paragraph 29 of TR 2004/18: Step 1 amount = Capital proceeds x Market value of post-CGT property Market value of all property In this case, the relevant values are presented as: $? x $? = $? or $? each $? The capital proceeds are those related to the XXX pre-CGT shares held by Entity A and B, as identified in Question 1 above. Those are the proceeds that relate to the K6 event. The remaining proceeds received by Entity A and B relate to their XX post-CGT shares in Company X and are only relevant to calculating their respective capital gains under CGT event A1. The market value of the post-CGT property of Company X is the market value of the shares that Company X acquired on or after 20 September 1985. The market value of all property of Company X is the market value of the pre-CGT and post-CGT property of Company X that was acquired just before CGT event A1 happened to the Company X shares of Entity A and B on XX/XX/20XX. Based on the information provided, Company X acquired XXX shares in Company NZ prior to the A1 event that happened to the Company X shares of Entity A and B on XX/XX/20XX. Company X then acquired a further XXX shares in Company NZ prior to the completion of the contract dated XX/XX/20XX for the disposal of the Company X shares by Entity A and B. The agreement between Company A and the shareholders of Company X refers to Company NZ being a 55% subsidiary of Company X at the time of the agreement and a 100% subsidiary at the completion date. The Share Sale Agreement refers to the ‘NZ agreement’ occurring at the same date to the Share Sale Agreement. The acquisition time of the XXX shares in Company NZ appears to be contemporaneous with CGT event A1 that happened to the Company X shares of Entity A and B, (there is no indication that the acquisition time of those shares was earlier than the relevant A1 event). The second step of the two-step process is at paragraph 32 of TR 2004/18: Step 2 amount = Step 1 amount x Market value excess Market value of post-CGT property Where ‘market value excess’ is the excess of the market value of property taken into account under subsection 104-230(6) of the ITAA 1997 over the sum of the cost bases of that property. In this case, the relevant numbers are approximately: $? x $? * = $? or $ x each $? *This figure is based on the submission in the PBR Application. The Commissioner has not verified the accuracy of the value. Company X acquired 3 Company Y shares from Entity C in December 2002 in exchange for 243 ordinary Company X shares. Those 3 shares are treated as having a cost base of $1 each in the application. The amount calculated should be considered as a maximum and it should be recognised that the actual amount may be lower. It is also submitted that just prior to the A1 event happening on XX/XX/20XX, Company X had no assets or liabilities other than the shares it held in lower tier companies. It is considered that an unmodified application of the two-step approach for single tier structures will result in a reasonable attribution of the capital proceeds to the market value excess on the post-CGT property in Company X. This is because, Company X, when viewed in isolation, is akin to a single tier structure. There are no other assets for the proceeds to be allocated against and there are no liabilities in Company X that impact upon the value of the assets of Company X. Any other allocation would require the Commissioner to ignore the fact that the shares acquired by Company X in Company Y on XX/XX/19XX were post-CGT shares, or it would require the Commissioner to allocate a disproportionately higher amount to the pre-CGT share than to the post-CGT shares. The 10 ordinary shares that Company X held in Company Y were fungible assets. That is, each individual share was economically equivalent to the other nine shares. They each gave their holder the same entitlement to income, capital and voting rights in Company Y. An entity purchasing those shares would not value one above the others. From a CGT perspective, the Commissioner would treat each of those shares as having the same market value. In terms of allocating the capital proceeds against those shares, the tax attributes of the shares in the hands of the shareholder is not a relevant consideration. The tax attributes only become relevant in calculating whether a capital gain or loss arises, after a reasonable allocation of the capital proceeds. The calculation provided in the PBR Application does not result in a reasonable attribution of the capital proceeds because it treats some of the post-CGT shares as being pre-CGT shares and it is based on an average of two attribution calculations looking at different layers of assets. Subject to potential cost base adjustments, as previously noted, a reasonable attribution under the direct test results in Entity A and B each having a total capital gain under CGT event K6 of approximately $ x . This amount, subject to such adjustments, is the minimum that should be declared. The $ x will be the result if the indirect test is satisfied and the resulting total capital gain is less than $ x (in which case the lower capital gain will be disregarded). However, if the indirect test is satisfied and the total capital gain is more than $ x then the total capital gain under the direct test will be disregarded and the higher amount will be included.