Private ruling: Capital gains tax and income tax deductions
Date of advice: 23 May 2016
Published: July 2016
Ruling period: Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020
Date scheme commenced: 1 July 2015.

Ruling: Q1: Is the interest expense incurred by Company A on its borrowings to acquire the shares of Company B an allowable deduction under section 8-1 of the Income Tax Assessment Act 1997 ? | A1: Yes. | Q2: Can a roll-over under section 124-780 of the ITAA 1997 be applied in respect of the shares which you receive in Company B in exchange for your shares in Company A? | A2: Yes. | Q3: Can you acquire additional shares in Company B during the replacement asset period as replacement assets for the purposes of section 104-197 of the ITAA 1997? | A3: Yes.

Relevant facts and circumstances: You have carried on a business. Company A was later incorporated. You are the sole shareholder, director and secretary. You will be employed by Company A. The assets of Company A will be held ready for use in the course of carrying on its business. Partnership Z will incorporate a wholly owned subsidiary company (Company B) to purchase 100% of the issued shares in Company A. You will receive consideration comprising shares in Company B and cash. You will acquire more than 20% of the issued shares in Company B. Company B will obtain a loan from a third party financier for the funds required for the purchase of Company A's shares. Company B will be required to pay interest on its borrowings. It will pay that interest using the proceeds of dividends paid by Company A. Net profits remaining after payment of all expenses, interest and taxes will be available for distribution to the shareholders. It is intended that a dividend payment policy will be developed and regulated by a shareholders agreement between Partnership Z and yourself. The assets of Company B will comprise shares in Company A, a nominal amount of cash, and a nominal amount of office equipment. Together, the market value of those assets will be more than 80% of the market value of all of the assets of Company B. You are related to some of the stakeholders in Partnership Z. Despite that fact, all dealings in the proposed transactions are and will be conducted at arm's length on the basis of market values established by generally accepted valuation methodologies.

Relevant legislative provisions: Income Tax Assessment Act 1997 - Section 8-1, | Income Tax Assessment Act 1997 - Subdivision 124-M, | Income Tax Assessment Act 1997 - Section 104-197 and | Income Tax Assessment Act 1997 - Subsection 152-40(3).

Reasons for decision: Detailed Reasoning - Interest deduction: Interest is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is incurred in gaining or producing assessable income or in carrying on a business, provided those expenses are not capital, private or domestic in nature. Generally, interest on money borrowed to acquire shares will be deductible under section 8-1 of the ITAA 1997 where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, this expectation must be reasonable and not a mere theoretical possibility. There must be a prospect of dividends or other assessable income being received. In this case, interest will be incurred by Company B on funds borrowed to purchase shares in Company A from which it expects to receive dividends. You state that a dividend payment policy for the company will be developed and regulated. Consequently, the interest will be deemed to be incurred in earning assessable income and will therefore be an allowable deduction under section 8-1 of the ITAA 1997. | Detailed Reasoning - Scrip-for-scrip rollover: Generally capital gains tax (CGT) event A1 occurs if you, as an individual, dispose of a CGT asset to another entity. CGT event A1 will be triggered when you dispose of your shares in Company A to Company B. Your proceeds from this transaction will be shares in Company B in addition to a cash component. Subdivision 124-M of the ITAA 1997 provides for CGT roll-over relief when certain post-CGT interests in companies and trusts are exchanged for interests in another entity. This is known as the scrip-for-scrip rollover. Roll-over relief can only be chosen where a capital gain would have resulted from the exchange of shares under section 124-780(3) of the ITAA 1997. Roll-over relief will be available where: • a post-CGT share interest is exchanged for a share interest in another company, • the exchange is in consequence of a single arrangement that meets specified criteria, • the replacement share interest is in a specified replacement entity, and • roll-over is chosen and specific notice requirements are fulfilled. In your case, you acquired your shares in Company A after 20 September 1985. You advise that apart from this rollover, you would make a capital gain from the CGT event that happens to your shares in Company A. The exchange of your shares in Company A for shares in Company B will be in consequence of a single arrangement that will result in Company B becoming the owner of 100% of the shares in Company A. The exchange will also be one in which all owners of voting shares in Company A can participate and is one in which participation is available on the same terms for all interest holders in Company A. You advise that the parties involved will be dealing at arm's length from each other despite the fact that you are related to a number of stakeholders in Partnership Z. Nevertheless, the market value of the shares in Company B plus the cash component will be substantially the same as the market value of the Company A shares that you dispose of. The disposal of shares in Company A to receive shares in Company B therefore satisfies the above mentioned conditions and exceptions under subdivision 124-M of the ITAA 1997. However, please note that scrip-for-scrip rollover is only available for this merger to the extent that you receive Company B shares for you Company A shares. Scrip-for-scrip rollover is not available for the cash component you will receive for your Company A shares. The rollover available is therefore a partial rollover and a capital gain will be made in respect of the cash component. You intend to apply the small business rollover in Division 152 of the ITAA 1997 to defer the capital gain made in respect of the cash component. Where you choose the small business rollover, there are rollover conditions that must be satisfied by the end of the replacement asset period. This period starts one year before and ends two years after the last CGT event that occurs in the income year for which you choose the rollover, or a longer period that the Commissioner allows. You satisfy the rollover conditions where you meet all the following conditions: • you acquire one or more replacement assets as replacement assets or make a capital improvement to one or more existing assets, or both, within the replacement asset period, • the replacement asset, or the asset to which the capital improvement was made is an active asset at the end of the replacement asset period (a depreciating asset such as plant can be a replacement asset), • if the replacement asset is a share in a company or an interest in a trust, at the end of the replacement asset period: • you, or an entity connected with you, are a CGT concession stakeholder in the company or trust, or • CGT concession stakeholders in the company or trust have a small business participation percentage in the interposed entity of at least 90%. • the capital gain that is being rolled over is not more than the sum of the following: • the amount paid to acquire the replacement asset (that is, the first element of the cost base of the replacement asset) • any incidental costs incurred in acquiring the asset, which can include giving property (that is, the second element of the cost base of the replacement asset), and • the amount expended on capital improvements to one or more assets that were acquired or already owned (that is, fourth element expenditure). Subsection 152-40(3) of the ITAA 1997 states that in order for shares in a company to be considered active assets, the company must satisfy the 80% test. The test will be satisfied if 80% of the assets owned by the company are active assets (worked out by market value). You advise that all assets of Company A are used or held ready for use by it in the course of carrying on its business. Accordingly, the Company A shares can be considered active assets in accordance with subsection 152-40(3) of the ITAA 1997. In addition, the assets of Company B comprise shares in Company A, cash, and some office equipment. Together, the market value of those assets is more than 80% of the market value of all of the assets of Company B. Therefore, the shares in Company B also qualify as active assets. You advise that you will be a CGT concession stakeholder in Company B because you will hold more than 20% of the issued voting shares in Company B and will be entitled to more than 20% of its distributions. Accordingly, shares in Company B will qualify as replacement assets in accordance with 104-197 of the ITAA 1997. If meet the basic conditions for the small business concessions you will be able to defer the capital gain you make on the disposal of your Company A shares.