Private ruling: Market value substitution rule
Date of advice: 2 April 2019
Published: June 2019
Ruling period: 1 July 2018 to 30 June 2020
Date scheme commenced: 1 July 2018

Ruling: Q1: Will the capital proceeds to the Applicant (Company A) on the proposed disposal of its shares in Company B be modified by the market value substitution rule in subsection 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No

Relevant facts and circumstances: 1. In 19XX, the Applicant (Company A) acquired X shares in Company B for $X. 2. From 20XX, Company A acquired X additional shares in Company B, increasing Company A’s shareholding in Company B to X shares. 3. The Company B shares held by Company A are held on capital account. 4. Company B has X issued and paid up shares. 5. Company B’s assets have an estimated net asset value of $X million. Company B has only paid dividends to its shareholders once since Company A acquired its shares in Company B and it is unlikely that Company B will pay dividends in the near future. 6. The majority shareholder of Company B is Individual A, who holds approximately 70% of the shares in Company B. 7. Company A holds approximately 30% of the shares in Company B (the ‘Relevant Shares’). 8. Based on the current net asset value of Company B, the Relevant Shares have an approximate net asset value of $X million. 9. Company A does not have a valuation of the market value of the Relevant Shares. Circumstances surrounding the Proposed Transaction 10. In 20XX, Individual A – as the majority shareholder of Company B – approached Company A with an offer to purchase the Relevant Shares for $X million. 11. This offer was rejected by Company A as the offer was considerably less than the net asset value of the Relevant Shares. 12. Further negotiations and offers were made by phone and email between the parties. 13. Despite further negotiations, Individual A refused to make an offer higher than $Y million (the ‘Proposed Price’), which is significantly less than the current net asset value of the Relevant Shares. 14. Company A is seriously considering selling the Relevant Shares to Individual A for the Proposed Price (the ‘Proposed Transaction’) as the offer presents an opportunity for Company A to exit from an investment that is illiquid and not generating any return. 15. While Individual A is willing to acquire the Relevant Shares and Company A may be willing to sell, neither party is anxious to enter into the Proposed Transaction. Company A is reluctant to sell the Relevant Shares for a price lower than the Relevant Shares’ net asset value. There have been further negotiations by Company A to obtain a higher sale price. 16. Company A is concerned that the market value of the Relevant Shares could be greater than the Proposed Price (the proposed amount of capital proceeds). As Company A does not have a valuation of the market value of the Relevant Shares, Company A has used a percentage of net asset value to justify that the market value of the Relevant Shares could be seen to be higher than the Proposed Price. 17. Company A has never been approached previously regarding an offer to purchase the Relevant Shares. 18. Individual A approached Company A with an offer to purchase the Relevant Shares as Company A has expressed its disappointment in the investment made in Company B, particularly in terms of the lack of distributions and it being unlikely any future dividends will be paid. 19. Company A has not previously attempted to sell the Relevant Shares to the wider public. Relationship between the parties 20. The only relationship between Individual A and Company A is that they are shareholders together in Company B. The parties are not related to each other in any way nor have they dealt with each other in other dealings. 21. There are no common interests between the parties, nor do they have any influence or control over each other. 22. Both parties are independently represented, each with their own lawyer and tax advisor, and have obtained legal advice from their advisors in connection with the Proposed Transaction.

Relevant legislative provisions: Income Tax Assessment Act 1997 Subsection 100-25(2) | Income Tax Assessment Act 1997 Section 102-20 | Income Tax Assessment Act 1997 Subsection 104-10(1) | Income Tax Assessment Act 1997 Subsection 104-10(2) | Income Tax Assessment Act 1997 Section 108-5 | Income Tax Assessment Act 1997 Subsection 116-20(1) | Income Tax Assessment Act 1997 Subsection 116-30(2) | Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision: Summary: The capital proceeds that Company A would receive upon the proposed disposal of its shares in Company B (the Relevant Shares) would not be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997. | Detailed Reasoning - Relevant law: Section 102-20 of the ITAA 1997 provides that a capital gain or capital loss results from a capital gains tax (CGT) event occurring. Subsection 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if an entity disposes of a CGT asset. A ‘disposal’, as defined in subsection 104-10(2) of the ITAA 1997, occurs when there is a change of ownership from one entity to another. A ‘CGT asset’, as provided in section 108-5 of the ITAA 1997, is: ● any kind of property, or ● a legal or equitable right that is not property. Shares in a company are an example of a CGT asset, as per subsection 100-25(2) of the ITAA 1997. CGT event A1 will be triggered when an entity sells their shares. The capital gain from such an event is the difference between the capital proceeds and the cost base of the relevant CGT asset. General rules about capital proceeds are provided in section 116-20 of the ITAA 1997. Subsection 116-20(1) of the ITAA 1997 states that the capital proceeds from a CGT event are the total of: (a) the money you have received, or are entitled to receive, in respect of the event happening; and (b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). | Detailed Reasoning - The ‘market value substitution rule’: However, there are a number of modifications to the general rules. Relevantly, the ‘market value substitution rule’ in section 116-30 of the ITAA 1997 provides that an entity is taken to have received the market value of the relevant CGT asset in certain situations. In particular, subsection 116-30(2) of the ITAA 1997 modifies the general rules by replacing the capital proceeds with the market value of the relevant CGT asset (worked out as at the time of the event) if: (a) some or all of those proceeds cannot be valued; or (b) those capital proceeds are more or less than the market value of the asset and: (i) you and the entity that acquired the asset from you did not deal with each other at arm’s length in connection with the event; or (ii) the CGT event is CGT event C2 (about cancellation, surrender and similar endings). | Detailed Reasoning - Meaning of ‘at arm’s length’: The term ‘arm’s length’, in relation to dealings, is defined in the Concise Oxford Dictionary as “with neither party controlled by the other”. Osborn's Concise Law Dictionary defines ‘at arm’s length’ as “the relationship which exists between parties who are strangers to each other, and who bear no special duty, obligation or relation to each other”. Black's Law Dictionary defines ‘arm’s length’ as “beyond the reach of personal influence or control” and adds that “[p]arties are said to deal at arm's length when each stands upon the strict letter of his rights, and conducts the business in a formal manner, without trusting the other's control or overmastering influence”. Subsection 995-1(1) of the ITAA 1997 defines 'arm’s length' as follows: …in determining whether parties deal at arm’s length , consider any connection between them and any other relevant circumstance. In ACI Operations Pty Ltd v. Berri Ltd (2005) 15 VR 312 ( ACI Operations Pty Ltd ), Dodds-Streeton J said (at [223]) that the authorities establish: ... an arm’s length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal. The market value substitution rule requires consideration to be given to the nature of the dealings between parties to a transaction and not simply their relationship. As Dodds-Streeton J explained in ACI Operations Pty Ltd at [224]-[226] (footnotes omitted): The concept of an arm’s length relationship is distinct from that of an arm’s length dealing or transaction, despite the potential overlap. Unrelated parties may collude or otherwise deal with each other in an interested way, so that neither the dealing nor the resultant transaction may properly be considered arm’s length. Where the parties are not in an arm’s length relationship, it is recognised that the inference may be drawn that they did not deal with each other at arm’s length. It may further be inferred that the resultant transaction is not arm’s length. Related parties may nevertheless, in some circumstances, demonstrate a dealing which displaces the inference based on their relationship. They may engage in the disinterested bargaining characteristic of strangers, applying independent separate wills. The circumstances of the impugned transaction may be such that, despite the parties’ connection or common interest, the interposition of some independent process (such as the sale of shares on the stock exchange) ensures that the transaction itself is arm’s length, in the sense that it could equally have been concluded by unrelated parties, consulting their own self-interest and uninfluenced by any particular association or interest in common. Whether parties have dealt at arm’s length is a question of fact that must be determined in any particular case. The law looks at not only the relationship between the parties but also the quality of the bargaining between them. An individual is said to be ‘dealing at arm’s length’ with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction. Parties are not at arm’s length where the parties are related or associated in some way so that while each party may enter a transaction with some self-interest in mind, it may also take into consideration the interests of the other party in making the agreement. Examples of such relationships are transactions between family members and related corporations. Where parties are not at arm’s length, it is still possible for the parties to deal at arm’s length in relation to a specific transaction. As stated by Davies J in Barnsdall v. Federal Commissioner of Taxation (1988) ATC 4565, 4568: The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm’s length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion. Parties will be dealing at arm’s length where they act as arm’s length parties would normally do, so that their dealing has an outcome that is the result of normal or real bargaining ( The Trustee for the Estate of the late A W Furse No 5 Will Trust v. FC of T 91 ATC 4007; (1990) 21 ATR 1123 and Granby Pty Ltd v. FC of T 95 ATC 4240; (1995) 30 ATR 400 ( Granby )). In Granby at ATC 4243; ATR 403, Lee J stated 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; ATR 403-404) 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 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. In Collis v. FC of T 96 ATC 4831; (1996) 33 ATR 438 (Collis) , the Federal Court found that the parties were not dealing at arm’s length because one party was indifferent to the allocation of the sale price for the parcel of land. This indifference was indicative of a submission of one party's will to the other party's wishes which demonstrated a lack of arm’s length dealing. The underlying principles of the case law discussed above have been summarised by McKerracher J in Healey v. FC of T [2012] FCA 269 [at 95]. In that case, in determining whether or not parties are dealing at arm's length with one another, it was held that the authorities establish the following principles: 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 91 ATC 4007 (at 4017) ( Trustee for the Estate of the late AW Furse No 5 Will Trust ); Granby Pty Ltd v. Federal Commissioner of Taxation 95 ATC 4240; (1995) 129 ALR 503 (at 507) ( Granby ); Commissioner of Taxation v. AXA Asia Pacific Holdings Ltd [2010] FCAFC 134; (2010) 189 FCR 204 (at [106]) ( AXA Asia Pacific Holdings Ltd ). 2. There is a distinction between dealing at arm’s length and an arm’s length relationship ( ACI Operations Pty Ltd (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. C ommissioner of Taxation 88 ATC 4565; (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]). | Detailed Reasoning - Application to Company A’s circumstances: In the current circumstances, the Proposed Transaction involves the sale of the Relevant Shares owned by Company A to Individual A for an amount that is less than the current net asset value of the Relevant Shares. In determining whether the capital proceeds from the Proposed Transaction will be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997, each of the elements of this provision will be examined individually. | Detailed Reasoning - Paragraph 116-30(2)(a): Paragraph 116-30(2)(a) of the ITAA 1997 is not applicable to the current circumstances as, based on the Facts, the value of the capital proceeds under the Proposed Transaction (being the amount of the Proposed Price) would be known. | Detailed Reasoning - Subparagraph 116-30(2)(b)(i): For subparagraph 116-30(2)(b)(i) of the ITAA 1997 to be satisfied: 1. the capital proceeds that Company A would receive under the Proposed Transaction must be either more or less than the market value of the Relevant Shares, and 2. Company A (the potential seller of the Relevant Shares) and Individual A (the potential acquirer of the Relevant Shares) must not have dealt with each other at arm’s length in connection with the Proposed Transaction. As per the Facts, Company A does not have a valuation of the market value of the Relevant Shares. If the second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is not satisfied, then the market value substitution rule in subsection 116-30(2) of the ITAA 1997 would not apply, regardless of whether or not the first element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 is satisfied. The second element of subparagraph 116-30(2)(b)(i) of the ITAA 1997 will now be examined. | Detailed Reasoning - Did Company A and Individual A deal with each other at arm's length?: In determining whether Company A and Individual A were dealing with each other at arm's length in connection with the Proposed Transaction, the Commissioner is required to take into account not only the relationship or connection between Company A and Individual A, but also the circumstances of the Proposed Transaction with a view to determining whether or not the parties were conducting the Proposed Transaction in a way which one would expect of parties dealing at arm’s length in such a transaction. The following factors are relevant for consideration: ● The parties to the Proposed Transaction, Company A and Individual A, are unrelated parties. ● The parties to the Proposed Transaction have not had any other dealings and do not have any connection with each other apart from being shareholders in Company B. ● There are no common interests between the parties to the Proposed Transaction, nor do they have any influence or control over each other. ● The parties to the Proposed Transaction are independently represented from a legal, financial and tax perspective. ● There has been negotiation over the price of the Relevant Shares. In particular, the parties had a mutual desire to achieve their own objectives and acted in their own interests severally and independently in the negotiation process by seeking advice from their respective lawyers and tax advisors. There was no indifference to the sale price for the Relevant Shares as evidenced by the negotiations, as well as Company A’s rejection of Individual A’s initial offer and request for a better offer (of a higher sale price). There is no evidence that the outcome of their dealings is anything other than a matter of a normal bargaining process, as discussed in Granby and Collis . ● There is also no evidence that the parties to the Proposed Transaction have entered into any prior arrangement to collude or to benefit mutual interests. ● The approach to, and dealings by, both parties and their respective representatives in respect of the Proposed Transaction demonstrates that the parties behaved in a manner in which arm's length parties would be expected to behave. Based on a consideration of the above factors/circumstances, the Commissioner considers that Company A and Individual A were dealing with each other at arm’s length in respect of the Proposed Transaction. Accordingly, subparagraph 116-30(2)(b)(i) is not satisfied. It is therefore not necessary for the purpose of this subparagraph to consider whether the capital proceeds are more or less than the market value of the Relevant Shares. | Detailed Reasoning - Subparagraph 116-30(2)(b)(ii): Subparagraph 116-30(2)(b)(ii) of the ITAA 1997 is not relevant in the current circumstances as the applicable CGT event is not CGT event C2. If the Proposed Transaction were to occur, CGT event A1 would be triggered upon the disposal by Company A of the Relevant Shares. | Detailed Reasoning - Conclusion: As both paragraphs 116-30(2)(a) and 116-30(2)(b) of the ITAA 1997 are not satisfied, the capital proceeds that Company A would receive upon the proposed disposal of its shares in Company B (the Relevant Shares) would not be modified by the market value substitution rule in subsection 116-30(2) of the ITAA 1997.