Private ruling: Capital gains tax implications of an assignment of partnership interest
Date of advice: 11 September 2017
Published: January 2018
Ruling period: 1 July 201X to 30 June 201Y.
Date scheme commenced: 1 July 201X

Ruling: Q1: Will CGT event E1 under section 104-55 of the Income Tax Assessment Act 1997 (ITAA 1997) happen when you assign, by way of declaration of trust, a beneficial interest in the partnership to the trustee of a family discretionary trust? | A1: Yes. | Q2: Assuming CGT event E1 happens, for CGT purposes, will the capital proceeds for the disposal of your partnership interest to the trustee of a family discretionary trust be the deemed market value consideration under subsection 116-30(1) of the ITAA 1997 for the CGT event which will equal an amount determined by an independent qualified valuer? | A2: Yes.

Relevant facts and circumstances: The Partnership is a professional services firm currently comprising Equity Partners and Fixed Profit Partners. You (‘the Partner’) are an Equity Partner. The Partnership is a “no-goodwill partnership”. That is, goodwill is not recognised in either the balance sheet of the Partnership nor for any other purpose. Consequently, when new partners are admitted to the Partnership, they do not make any payment to existing partners to acquire any goodwill, nor are they entitled to receive any consideration for the disposal of any goodwill when they retire or otherwise exit from the Partnership. The Service Trust is a discretionary trust that provides various administrative and support services to the Partnership to undertake its professional services business. The potential beneficiaries of the Service Trust are the partners of the Partnership and/or nominated associates of the partners. The Partnership pays arm’s length service fees to the Service Trust. It is the intention of the firm to allow each Equity Partner of the Partnership to assign a portion of his or her partnership interest in the Partnership by way of declaration of trust. By grant of approval by the Board in accordance with the Partnership Deed, the Partner will be provided with the opportunity to assign approximately X% of their interest in their share of the Partnership to the trustee of a family discretionary trust. The assignment would be of a beneficial, not legal, interest in the Partnership and by way of declaration of trust. The declaration of trust would create a trust (‘Trust A’), for which the Partner would serve as trustee, the beneficiary of which would be the trustee of a family discretionary trust (‘Trust B’). The declaration of trust will be irrevocable. Trust B would be established by a person other than the Partner who creates Trust A and Trust B would be established for the benefit of the Partner’s family and associates. Trust B will have a trustee other than the Partner. The Partner will not be a beneficiary of Trust B but may be a shareholder of a corporate beneficiary of Trust B. Trust B will be in existence prior to the assignment of the Partnership interest. Trust B will pay nominal consideration of $Z for the assigned partnership interest. The Partner will continue to be legally a partner of the Partnership. The trustee of Trust B will not become a partner of the Partnership nor will the trustee of Trust B be entitled to interfere in the Partnership’s business or affairs or to require any accounts or to inspect the books of the firm.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 section 102-25 | Income Tax Assessment Act 1997 section 104-10 | Income Tax Assessment Act 1997 section 104-55 | Income Tax Assessment Act 1997 section 104-60 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 section 116-20 | Income Tax Assessment Act 1997 section 116-30 | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Summary: Subsection 108-5(2) defines the interest in the Partnership assets as a CGT asset. As such, according to section 104-55, CGT event E1 occurs when Trust A is created over a CGT asset by declaration or settlement. | Detailed Reasoning - Detailed reasoning: Section 108-5 provides the definition of CGT asset. In your circumstance your interests in each of the assets of the Partnership are CGT assets, according to paragraph 108-5(2)(c). Furthermore, any interest you may have in the Partnership that was not covered by paragraph (c) is also a separate CGT asset according to paragraph 108-5(2)(d). Section 102-20 states that you can make a capital gain or loss if and only if a CGT event happens. Section 102-25 requires you to consider which CGT event happens to your situation. In the present case, you will commence to hold approximately X% of your interest in the Partnership as a trustee, in a manner consistent with the assignment accepted in Federal Commissioner of Taxation v Everett (1980) 143 CLR 440 (“ Everett ”). | Detailed Reasoning - CGT Event E1: Subsection 104-55(1) provides that CGT event E1 happens if you create a trust over a CGT asset by declaration or settlement. Subsection 104-55(2) provides that the timing of the event occurs when the trust is created. In order for CGT event E1 to happen, two requirements must be satisfied. These are: ● you must create a trust over a CGT asset by declaration or settlement; and ● the exceptions in subsection 104-55(5) must not apply. No trust relationship currently exists between you and Trust B. However, you intend to commence holding a portion of your interest in the Partnership as trustee for the benefit of Trust B. Accordingly, it is clear that the proposed arrangement will involve the creation of a trust, Trust A. Furthermore, it is considered that this trust would be created by declaration or settlement. When a statute speaks of a ‘declaration’ of trust, it is naturally taken as referring to a declaration or instrument which is effective to create a trust by operating upon property vested in the declarant. This is what would occur in the present case when you commence holding a portion of your interest in the Partnership on trust for the benefit of Trust B. A resolution that the Partnership interest is to be held on a trust is sufficient to amount to a declaration for the purposes of CGT event E1, even if there is no express declaration. The manifestation of an intention to create the relevant trust can be inferred from words or conduct, and no formal or technical language is required. Accordingly, it is not essential that you use words such as ‘I declare myself a trustee’. Alternatively, it is considered that a trust would be created by way of ‘settlement’ for the purposes of CGT event E1 in the present case, being an instrument which creates a new beneficial interest in property through the imposition of a trust. It is considered that the first requirement for CGT event E1 will be satisfied in the present case. The exception in subsection 104-55(5) does not apply in the present case as the Partner is not the sole beneficiary of the trust. Accordingly, the second condition is also satisfied. Given this, the commissioner considers that CGT event E1 will happen when you commence holding a portion of your interest in the Partnership as trustee for the benefit of Trust B. For completeness, the occurrence of CGT events E2 and A1 will be discussed below. | Detailed Reasoning - CGT Event E2: Subsection 104-60 provides that CGT event E2 happens if you transfer a CGT asset to an existing trust. You will commence holding your interest in the Partnership on trust for the benefit of Trust B. Whilst Trust B will exist prior to the assignment of the interest, the assignment itself will give rise to a new trust, Trust A, which was not in existence before that time. As such, you will not transfer an asset to an existing trust and CGT even E2 will not happen. | Detailed Reasoning - CGT Event A1: Subsection 104-10(1) provides that the CGT event A1 happens where you dispose of a CGT asset. Disposal is then defined in subsection 104-10(2) to have happened when there is a change of ownership in a CGT asset from you to another entity. Under the proposed assignment, you will retain the legal ownership and continue to be named Partner in the Partnership. Trust B will only acquire the beneficial ownership of the assigned interest in the Partnership. Therefore, you will dispose of a part-interest in the Partnership when you commence holding it as trustee for the benefit of Trust B. However, in accordance with subsection 102-25(1) of the ITAA 1997, CGT event E1 is more specific to the situation, therefore CGT event A1 will not apply. | Summary: Due to the proposed transaction not occurring at arm’s length, the market value substitution rule under subsection 116-30(1) applies to value the capital proceeds of the disposal at the deemed market value consideration to be determined by an independent qualified valuer. | Detailed Reasoning - Detailed reasoning: Subsection 104-55(3) provides the method to calculate any capital gain or loss when CGT event E1 happens to a CGT asset. It provides that: ● you make a capital gain if the capital proceeds from the creation of the trust are more than the asset’s cost base; and ● you make a capital loss if the capital proceeds from the creation of the trust are less than the asset’s reduced cost base. When calculating the capital proceeds, the general rules in Division 116 need to be applied. The capital proceeds from a CGT event are the total of the amount of money a taxpayer has received or is entitled to receive, in respect of the event happening, and the market value of any other property the taxpayer has received, or is entitled to receive, in respect of the event happening (worked out as at the time of the event – section 116-20). However, the general rules are modified by the market value substitution rules in section 116-30 where the capital proceeds received are more or less than the market value of the asset and the asset was disposed of in a non-arm’s length dealing (subparagraph 116-30(2)(b)(i)). As you are proposing to assign, by way declaration of trust, a proportion of your beneficial interest in the Partnership to Trust B for nominal consideration, the market value substitution rule under section 116-30 needs to be considered. Whether parties have dealt at arm's length is a question of fact that must be determined in any particular case. 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. Taxation Ruling IT 2540: Income Tax: Capital Gains: Application to disposals of partnership assets and partnership interests (“IT 2540 ” ) provides the Commissioner’s view on the CGT consequences of entering into an Everett assignment. Paragraph 24 provides the Commissioner’s view that an Everett assignment will be treated as a part disposal of the partner’s interest in the assets of the partnership for CGT purposes. The implication of this treatment was that an Everett assignment could give rise to a capital gain (or capital loss) in the hands of the assignor. As explained earlier in this ruling, the same outcome now arises under the re-written CGT provisions in Part 3-1 of the ITAA 1997 . The Commissioner has stated at paragraph 25 of IT 2540 that ‘it would be very unusual for an Everett assignment to be made on an arm’s length basis’. Therefore, the market value modification rule in section 116-30 will apply to determine the capital proceeds. The case of Granby v. FC of T 95 ATC 4240 (‘ Granby ’) considered whether the cost base of certain plant and equipment for CGT purposes was the actual residual value paid or the market value at the time of purchase, in circumstances where plant and equipment was purchased at its residual value on the expiration of a lease. The question turned on whether the lessor of the plant and equipment and the taxpayer’s partnership were dealing with each other at arm’s length for the purposes of the CGT provisions. In that case Lee J stated at ATC 4244 that the provision 'dealing with each other at arm's length' invited an analysis of the manner in which the parties conduct themselves in forming the transaction. The question is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs and the expression means, at least, that the parties have acted severally and independently in forming their bargain. Further, Lee J stated at ATC 4244 that: If the parties to the transaction are at arm's length it will follow, usually, that the parties will have dealt with each other at arm's length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be. However this will not be the case where the parties collude to achieve a particular result, or where one of the parties submits the exercise of its will to the discretion of the other. In such a case the lack of the exercise of an independent will in the formation of the transaction would indicate a lack of real bargaining. The way you propose to assign part of your beneficial interest in the Partnership to Trust B for $Z suggests that the parties will not behave in a manner arm’s length parties would be expected to behave. This would be in line with the Commissioner’s view in IT 2540 in that the facts at present indicate that the parties will not be dealing with each other at arm’s length. The amount paid by the assignee is not reflective of a normal bargaining process which was discussed in Granby and the nominal capital proceeds of $Z do not reflect the value which an interest in the Partnership would be expected to be valued at. Paragraph 28 in IT 2540 provides that when determining the market value of an Everett assignment, the valuation should be in accordance with the decision in Reynolds . This case concerned the valuation of an assigned partnership interest on which ad valorem stamp duty was payable. Despite the other assets of the partnership being held in administration and service entities and goodwill not being recognised by the partnership, Burt CJ held: ‘the assigned partnership interest was of value; its value derived from the value of the right that was attached to the partnership interest to receive a proportionate share of the future income of the partnership.’ Paragraph 28 of IT 2540 further explains that when valuing a partnership interest when entering into an Everett assignment, this will involve the determination of the price that a "hypothetical buyer" would pay for the assigned partnership interest having regard to the value of the right to the future income of the partnership which is attached to the interest.

Reasons for decision: All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified.