Private ruling: CGT Event D2 and market value substitution
Published: July 2012
Ruling period: Period 1 July 2011 to 31 December 2014
Date scheme commenced: 1 July 2011

Ruling: Q1: Does CGT event D2 in section 104-40 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to the taxpayer if an eligible employee acquires a put option and a share under the Employee Share Scheme? | A1: Yes. CGT event D2 in section 104-40 of the ITAA 1997 happens to the taxpayer when the put option is granted to the eligible employee as it is a separate asset from the shares that the employee acquires under the scheme. | Q2: Does the market value substitution rule in paragraph 116-30(2)(b) of the ITAA 1997 apply in determining the capital proceeds received by the taxpayer from the grant of the put option for the purposes of calculating its capital gain or capital loss under subsection 104-40(3) of the ITAA 1997? | A2: No. The market value substitution rule in paragraph 116-30(2)(b) of the ITAA 1997 will not apply to substitute the capital proceeds that the taxpayer received from the grant of an option in the event that the market value of the put option is greater than, or less than, the price paid. This is because the parties were dealing with each other at arm's length in connection with the grant of the put option.


Relevant legislative provisions: Income Tax Assessment Act 1997 section 104-40 | section 108-5 | section 116-20 | Section 116-30 | Paragraph 116-30(2)(b) | Subsection 995-1 | Income Tax Assessment Act 1936 Former subsection 26AAA(4) | Subsection 102AG(3) | Former section 160ZH(9)(c)

Reasons for decision: Detailed Reasoning - Question 1:: All legislative references are to the ITAA 1997 unless otherwise stated. CGT event D2 CGT event D2 happens if you grant an option to another entity: subsection 104-40(1). The time of the event is when you grant the option: subsection 104-40(2). You make a capital gain if the capital proceeds from the grant of the option are more than the expenditure you incurred to grant it. You make a capital loss if those proceeds are less: subsection 104-40(3). The term 'option' is not defined in the Act. In Federal Commissioner of Taxation v. Guy (1996) 67 FCR 68; 96 ATC 4520; (1996) 32 ATR 601, the Federal Court considered that, in the context of the CGT provisions, the word 'option' suggests 'a right in one party unilaterally to require another party to enter a new set of jural relations or to extend or continue an existing jural relationship.' Put and call options are one of the most common examples. A 'put option' gives the grantee a right, but not an obligation, to sell an asset within a specified time and usually for a predetermined price, and the grantor the obligation to buy the asset if the grantee exercises the option. Section 104-40 does not apply to certain options identified in subsections 104-40(6) and 104-40(7). Relevantly, subsection 104-40(6) ensures that the provisions do not apply to an option granted by a company to acquire a CGT asset that is shares in the company . | Detailed Reasoning - Whether the put option is a separate CGT asset?: Under section 108-5 of the ITAA 1997, a CGT asset is any kind of property, or a legal or equitable right that is not property. Shares and options are listed as separate examples of CGT assets in Note 1 of the provision. The current arrangement involves Company A issuing an invitation to eligible employees to apply for shares and a put option. When an eligible employee's application is accepted by Company A, the employee will acquire equitable rights in the shares that the company has allocated to be held on trust for their benefit, as well as rights consisting of the put option. Whilst these rights are acquired as part of the one arrangement (i.e. an employee cannot acquire the rights in the shares but not the put option, or vice versa), and the contractual rights and obligations of each party are provided for in the Scheme Rules, each set of rights is a CGT asset in its own right. The following factors support this conclusion: Acquisition : in addition to the different acquisition costs for the shares and the put option price each asset is acquired from a different entity - the rights represented by the put option are granted by the taxpayer, whilst Company A arranges for the trustee of the ESS to acquire the shares that are to be held for the benefit of the employee. Ownership : Upon accepting an employee's application, the trustee of the ESS is instructed by Company A to acquire /subscribe for the shares and to hold them on trust for the benefit of the employee in accordance with the terms of the trust deed. However, the trustee is not issued with the put option - it is granted to the employee who may then deal with the option in accordance with the Scheme Rules and Deed Poll. Dealing with the asset : The put option and shares have their own set of terms and conditions and they are each capable of being dealt with separately. An employee can exercise the put option for the taxpayer to acquire some or all of the shares allocated to it under the scheme. Upon exercising the option, the employee's rights come to an end. However, this will not necessarily bring an end to all of the shares that the employee acquired under the scheme - i.e. the employee, in exercising the option, could retain some of the shares. Similarly, a put option will expire upon Company A being admitted to the official list of a stock exchange, whereas the shares will convert into ordinary shares. The put option is therefore severable from the shares (or the employee's beneficial interest in the share) and is a separate CGT asset. As the taxpayer is the grantor of the put option and the exclusions in subsections 104-40(6) and 104-40(7) do not apply (that is, the option is not to acquire shares in the taxpayer and is not related to a personal use asset or a collectable), CGT event D2 happens to the taxpayer upon the grant of each put option. | Detailed Reasoning - Question 2:: The capital proceeds from a CGT event is the total of the money you received, or are entitled to receive, in respect of the event and the market value of any other property you have received, or are entitled to receive, in respect of the event happening, worked out at the time of the event (section 116-20 of the ITAA 1997). However, the market value substitution rule in section 116-30 of the ITAA 1997 will apply to substitute the capital proceeds from a CGT event with the market value of the CGT asset (worked out at the time of the event) if the proceeds are more or less than the asset's market value and you did not deal at arm's length with another entity in connection with that event: subsection 116-30(2) of the ITAA 1997. In this case, the taxpayer receives payment for the grant of each put option. This will be the capital proceeds from CGT event D2 happening upon the grant of each option - even if it is more or less than the options' market value at the time of the grant - provided the taxpayer and the employee were dealing at arm's length in respect of the grant of the put option. The question of whether parties dealt with each other at arm's length in respect of a particular dealing, and the market value of an asset, is one of fact in each case. And this question is not decided by asking whether the parties were at 'arm's length' to each other. Subsection 995-1(1) of the ITAA 1997 provides: · 'Arm's length : in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstance'. The need to look beyond the nature of parties' relationship in considering whether they have dealt at arm's length is also highlighted in a number of cases. In Re Hains (deceased) ; Barnsdall v. FC of T, 88 ATC 4565; (1988) 19 ATR 1352, Davies J considered that the expression 'not dealing with each other at arm's length' referred to in subsection 26AAA(4) differed from the expression 'not at arm's length' used in Australian Trade Commission v WA Meat Exports (1987) 7 AAR 248. At 176, Davies J observed that: (the) term should not be read as if the words "dealing with" were not present. The Commissioner is required to be satisfied not merely of a connection between a taxpayer and the 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. In The Trustee for the Estate of the late AW Furse No 5 Will Trust v. FC of T (1991) ATC 4007; 21 ATR 1123 Hill J, in relation to the expression "not dealing with each other at arm's length" in subsection 102AG(3) of the ITAA 1936 , said what is required in respect of whether parties dealt with each other at arms length in a particular dealing is an assessment of whether they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining. In the context of the CGT market value substitution rules, further guidance is provided in Granby Pty Ltd v Federal Commissioner of Taxation (1995) 129 ALR 503 which concerned the calculation of a cost base for capital gains tax purposes. Former section 160ZH(9)(c) of the ITAA 1936 provided that, in determining the cost base, certain consequences would follow if the consideration paid by the taxpayer was less than the market value of the asset at the time of the acquisition, and the taxpayer and the person from whom it had acquired the asset were not dealing with each other at arm's length in connection with the acquisition. At 506, Lee J said: The expression 'dealing with each other at arm's length' involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction. What is asked is whether the parties behaved in the manner in which parties at arm's length would be expected to behave in conducting their affairs. Of course, it is relevant to that inquiry to determine the nature of the relationship between the parties, for if the parties are not parties at arm's length the inference may be drawn that they did not deal with each other at arm's length. His Honour then observed (at 506-507) that whatever else the expression might mean, it at least meant that the parties to a transaction had acted "severally and independently in forming their bargain". His Honour continued: That is not to say, however, that parties at arm's length will be dealing with each at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the dictation of the other, perhaps, to promote the interests of the other. The Commissioner is therefore required to consider, not only the relationship or connection between the taxpayer and an eligible employee, but also the circumstances of the transaction with a view to determining whether or not the parties have conducted the transaction in a way which one would expect of parties dealing at arm's length in such a transaction. The connection between the parties in this transaction arises from the asset that is the subject of the put option. That is, the grantor of the put option, the taxpayer, has ownership interests in Company A and the employees of the Company A group are eligible to acquire shares in Company A under the scheme - the shares being the subject of the option. Whilst Company A and the taxpayer may be seen to be negotiating from a position of strength (insofar as they have set the terms of the ESS), this does not, of itself, indicate an absence of real bargaining between the parties. First, one would reasonably expect the company to determine the terms and conditions of the employee share scheme as this seems to be the general practice (at least with non-management schemes). Second, the scheme is voluntary - employees do not have to accept the offer, and those who choose not to participate in the scheme can do so without risk of any adverse consequences for their future employment and remuneration. Further, in deciding whether or not to accept the offer to participate in the ESS, an eligible employee acts independently of Company A and the taxpayer, and also of any other eligible employees. An employee's decision on whether or not it is in their interest to enter into the transaction, including the acquisition of the put option, is based on their own personal circumstances. In addition, the invitation letter recommends that eligible employees obtain their own independent advice in relation to tax and any other matters in connection with the offer. This is reinforced in the application form which requires the employee to acknowledge and agree that they have had the opportunity to obtain independent advice in relation to tax and any other matters and are satisfied as to the consequences of their participation in the scheme. Importantly, the terms and conditions relating to the grant and exercise of the option also apply equally to all employees who have accepted the invitation to participate. The purchase price payable by the taxpayer to acquire the shares upon the exercise of the put option are stipulated in the Deed Poll and is calculated in accordance with a specified formula that has regard to the profitability and commercial position of Company A. Having regard to the factors above - particularly the independence of each employee's decision to participate in the scheme and, that the terms of the put option (both its acquisition, exercise and ending) applies equally to all participants, the Commissioner accepts that the parties have dealt with each other at arm's length in relation to the grant of the put option. The market value substitution rules in paragraph 116-30(2)(b) therefore will not apply to substitute the capital proceeds received by the taxpayer from the grant of the option in the event that the put option has a market value that is greater than, or less than, the price paid.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Relevant facts: Company A has established the Employee Share Scheme (ESS) to assist in the reward, attraction, retention and motivation of its employees and those of its subsidiaries. It is proposed that the ESS, together with another share trust, will hold no more than 25% of the issued shares in Company A. The remaining 75% of the shares in Company A are held by the taxpayer, an Australian resident subsidiary that is indirectly wholly owned by a foreign parent company. | As part of the ESS, Company A issues an invitation to eligible employees to acquire shares in Company A under the scheme and a put option. There is no limit to the number of invitations that the company may issue to eligible employees. The invitation letter recommends that employees obtain independent advice on tax and any other matters in connection with the offer. | Participation in the ESS is not compulsory. Eligible employees who choose not to participate in the scheme can do so without jeopardising their future employment and remuneration prospects. | An employee who wishes to accept the offer must submit an application form setting out the number of shares they wish to apply for and include cash or cheque for an amount payable to the taxpayer as consideration for the grant of the option. The price of the put option was determined by the taxpayer. The employee is required to pay a small consideration to acquire shares. Company A then has discretion to accept or reject the employee's application. | In submitting an application to accept the offer, the employee agrees to be bound by the Terms set out in the Invitation, the Scheme Rules, and the Amended and Restated Shareholders Deed Poll (the Deed Poll). The Deed Poll sets out, among other things, the terms and conditions of the put option which can be summarised briefly as: | · the taxpayer grants the put option to the scheme participants to require the taxpayer to purchase some or all of the shares allocated to the employee under the scheme. This is subject to any amendments made to the deed to provide for the restructure of the put option such that Company A is taken to be the 'grantor'. | An employee may only exercise the option if the managers have consented in writing to the exercise of their option. Managers may withhold their consent where a process has been initiated that may result in a liquidity event. | The Deed Poll specifies the time periods and performance benchmarks imposed as conditions of exercising an option. | The purchase price payable by the taxpayer to acquire the shares depends on the circumstances of its exercise. In most cases, the price is calculated using the formula in Clause 17.4 of the Deed Poll (which makes reference to the audited earnings before interest, tax, depreciation and amortisation of the company and its subsidiaries). | The put option expires upon Company A being admitted to the official list of a stock exchange following an IPO of the company and is of no further force or effect. | The terms of the shares are specified in Company A's Constitution. Aside from limited dividend rights, the shares carry the same rights as ordinary shares. The shares will automatically convert to ordinary shares in Company A upon a liquidity event occurring (eg, winding up, IPO). | The terms on which the shares are held on trust for employees who have applied to participate in the ESS are prescribed in the relevant trust deed. | Copies of the Scheme Rules, Trust Deed, Amended and Restated Shareholders Deed Poll and offer documents were provided.