Private ruling: Whether the market value substitution rule applies to determine the cost base of shares.
Date of advice: 20 November 2015
Published: February 2016
Ruling period: 1 July 2015 to 30 June 2016
Date scheme commenced: When the relevant shares were acquired

Ruling: Q1: Can the Trustee for the Trust use the market value (at the time of acquisition) as the first element of the cost base and reduced cost base of the shares in the Company it acquired from the sibling of the controller of the Trustee and beneficiary of the Trust pursuant to section 112-20 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No

Relevant facts and circumstances: The Trustee is a company that is controlled by the beneficiary of the Trust. The Trustee acquired the relevant shares in the Company from a sibling of the beneficiary. The Company was originally founded and operated by the parents of the beneficiary and their sibling. The shares in the company were held by the parents and the siblings. The beneficiary of the Trust later became significantly involved in the operation and management of the Company, eventually being solely responsible for running the business of the Company when their parents were no longer able to do so. The circumstances surrounding the relevant transaction The sibling approached the beneficiary in order to sell their shares. Due to their financial affairs at the time they considered it necessary and desirable to sell their shares which meant that the sibling was a somewhat anxious seller. The Trustee purchased the shares given the significant and continued involvement in the Company of the beneficiary. The Trustee was of the view that the Company had long term capital growth due to the land it held and agreed to purchase the shares for this reason. Several negotiations took place between the Trustee and the sibling. This ensured that appropriate documentation was in place to give effect to the sales. Various options were discussed including the Company selling its land holdings and being wound up or the land held by the Company being valued and the shares being sold accordingly. The parties had no regard to the market value of the shares at the time the sales were negotiated. The share transactions involved approximately half of the sibling's shareholdings. The amount offered by the Trustee was on the basis of what it believed it could reasonably afford at that time. The beneficiary was also of the view that the Trust should not be required to pay market value for the shares as the beneficiary was the one that was interested or involved in the Company. Although the beneficiary had capacity to borrow, they believed that the risk associated with borrowing to purchase the shares was high due to the shares being illiquid and because the land held by the Company had proved difficult to sell in the past. The parties reached their agreement in writing and each party bought independent wills to the negotiations. The purchase price paid by the Trustee for the shares acquired from the sibling was considerably less than the market value of the shares at the time they were acquired.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 110-25 | Income Tax Assessment Act 1997 Section 110-55 | Income Tax Assessment Act 1997 Section 112-15 | Income Tax Assessment Act 1997 Section 112-20 | Income Tax Assessment Act 1997 Section 995-1

Reasons for decision: Summary: Under the general cost base and reduced cost base rules in Division 110 of Part III of the ITAA 1997, the first element of the cost base and reduced cost base of a CGT asset is the sum of the amount paid (or required to be paid) and the market value of property given (or required to be given) in respect of acquiring it: subsections 110-25(2) and 110-55(2) of the ITAA 1997. The general rules may be modified by Division 112 of the ITAA 1997. Section 112-15 of the ITAA 1997 provides that if a cost base modification replaces an element of the cost base of a CGT asset with an amount, the capital gains tax provisions in Part 3-1 and 3-3 of the ITAA 1997 apply to a taxpayer as if they had paid that amount. The market value substitution rule in section 112-20 of the ITAA 1997 applies in three situations one of which is where the taxpayer did not deal at arm's length with the other entity in connection with the acquisition of a CGT asset: paragraph 112-20(1)(c) of the ITAA 1997. If the market value substitution rule applies, the first element of the cost base or reduced cost base of the CGT asset that is acquired from the other entity is its market value at the time of acquisition: subsection 112-20(1) of the ITAA 1997. There are some situations in which the market value substitution rule does not apply: subsection 112-20(3) of the ITAA 1997. However, these do not apply to the Trustee's acquisition of the relevant shares. | Detailed Reasoning - Was the dealing at arm's length?: Subsection 995-1(1) of the ITAA 1997, in respect of the term 'arm's length' states that in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance. The relevant principles established by the authorities are set out in Healey v Commissioner of Taxation [2012] FCA 269 at 95: 1. Whether the parties dealt at arm's length is a question of fact: Trustee for the Estate of the late AW Furse No 5 Will Trust v Commissioner of Taxation (1990) 91 ATC 4007 (at 4017); Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503 (at 507); Commissioner of Taxation v AXA Asia Pacific Holdings L td (2010) 189 FCR 204 (at [106]). 2. There is a distinction between dealing at arm's length and an arm's length relationship: ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (at [224]). Whether the parties did not deal at arm's length is not to be decided by answering whether the parties were not in an arm's length relationship. The fact that the parties are themselves not at arm's length does not mean that they have not, in respect of a particular dealing, dealt with each other at arm's length: Re Hains; Barnsdall v Commissioner of Taxation (1988) 81 ALR 173 (at 177); Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4014-4015). 3. Whether the parties dealt at arm's length involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction: Granby (at 506). 4. At 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]). 5. 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). 6. 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]). The beneficiary of the Trustee and their sibling are not at arm's length. However, they have behaved in a manner which indicated that there was real bargaining between them. Specifically, the parties obtained legal advice from solicitors and applied their independent wills to the transactions. There was a process of negotiation to reach an agreement where the parties considered various options other than selling the shares, including winding up the Company. In the end, the sibling was prepared to accept a price less than market value from the Trustee as a result of a combination of factors including that they were anxious sellers, they may benefit in the future from continued share ownership and there was a limit to the funds that the Trustee and beneficiary had available to acquire their shares. Under the circumstances, we have concluded that the transaction was at arm's length and paragraph 112-20(1)(c) is not satisfied. As such, the Trustee cannot use the market value of the shares as the cost base.