Private ruling: Capital gains
Date of advice: 2 February 2018
Published: June 2018


Relevant facts and circumstances: 1. The Company carries on business. 2. The Company has issued a number of ordinary shares, a portion of which are held by The Trustee. 3. The Company wanted to secure the services of employees and agreed that employees would be selected to participate in an Employee Incentive Scheme aimed at retaining the benefit of the services of these selected employees of The Company. 4. The terms agreed to in the Employee Incentive Scheme were as follows: a. Each selected employee (or the employee’s nominated entity) would be entitled to acquire a specified percentage of the shareholding in The Company upon the selected employee completing a minimum term of employment with The Company. b. Those shares in The Company would come from The Trustee’s shareholding. c. The Trustee would transfer those shares to the employee (or to the employee’s nominated entity) for a purchase price of $1 per share. The employee (or the employee’s nominated entity) would not pay anything more for those shares. d. Shortly before the transfer of shares pursuant to an exercise of the right to acquire the shares, a dividend would be paid out of The Company to clear out any retained earnings so that the selected senior employees of The Company would not participate in the profits (or losses) of The Company arising prior to the share transfer but rather only participate in the future profits (or losses) of The Company arising after the share transfer. e. The right to acquire the shares could not be disposed of by the employee other than by exercising the right to acquire the shares. f. The right to acquire the shares could not be exercised by the employee until the employee had agreed to be bound by the terms of the Employee Incentive Scheme. g. The right to acquire the shares must be exercised by the employee within a reasonable period of time after the employee has completed the minimum term of employment with The Company. 5. The Employee Incentive Scheme has been successful in attracting and incentivising the selected employees and retaining their services. 6. During the income year the employees exercised their right to acquire their respective shares from the Trustee for $1 per share. 7. None of the selected employees or their nominated transferee is a beneficiary of The Trustee. 8. At any time during the relevant period, the market value of a share in The Company was greater than $1 per share. Question 1: Summary 1. The transfer of shares in The Company by The Trustee to selected employees of Company A will result in CGT event A1 happening pursuant to section 104-10 of the ITAA 1997 because the transfer of shares constitutes a disposal of a CGT asset. Detailed reasoning 2. The shares in The Company are CGT assets pursuant to section 108.5 of the ITAA 1997. 3. Section 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if you dispose of a CGT asset. 4. Section 104-10(2) of the ITAA 1997 provides that you dispose of a CGT asset if a change of ownership occurs from you to another entity. 5. The transfer of shares in The Company by The Trustee to selected employees of The Company will result in a change of ownership in those shares occurring from The Trustee to another entity. 6. Accordingly, the transfer of shares in The Company by The Trustee to selected employees of The Company will result in CGT event A1 happening pursuant to section 104-10 of the ITAA 1997. Question 2: Summary 7. As the dealings were at arm’s length, subparagraph 116-30(2)(b)(i) of the ITAA 1997 will not apply to substitute the market value of the shares in The Company as the capital proceeds for the disposal of the shares. Detailed Reasoning 8. Each of the nominated transferees will pay $1 per share to the trustee of The Trustee. 9. Section 116-5 of the ITAA 1997 provides that section 116-20 of the ITAA 1997 sets out the general rules about capital proceeds. It applies to CGT event A1. 10. Section 116-20 of the ITAA 1997 provides 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). 11. Section 116-25 of the ITAA 1997 provides a table of modifications to the general rules. Modifications 1, 2, 3, 4, 5 and 6 can apply to CGT event A1. 12. In this case, The Trustee will receive an amount of $1 per share for the disposal of shares in The Company, which is less than the market value of those shares. 13. Modification 1, the market value substitution rule, contained in section 116-30(2) of the ITAA 1997 may apply if there are proceeds from the disposal of a CGT asset the subject of CGT event A1. 14. Section 116-30(2)(b)(i) provides that the capital proceeds are replaced with the market value of the CGT asset if those capital proceeds are more or less than the market value of the asset and 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. 15. In this case, for the reasons that follow, the Commissioner is satisfied that the parties are dealing at arm’s length, so that the market value substitution rule does not apply. Law 16. There are several relevant provisions of law emerging from the cases which are summarised at paragraph 26 of the judgment of Justice Dowsett in Commissioner of Taxation v AXA Pacific Holdings Ltd [2010] FCAFC 134 as follows: (a) in determining whether parties have dealt with each other at arm’s length in a particular transaction, one may have regard to the relationship between them; (b) one must also examine the circumstances of the transaction and the context in which it occurred; (c) one should do so 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; (d) relevant factors which may emerge include existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which might enable either party to influence or control the other, or induce either party to serve a common interest and so modify the terms on which strangers would deal; (e) where the parties are not in an arm’s length relationship, one may infer that they did not deal with each other at arm’s length, and that the resultant transaction is not at arm’s length; (f) however related the parties may, in some circumstances, so conduct a dealing as to displace any inference based on the relationship; (g) un-related parties may, on occasions, deal with each other in such a way that the resultant transaction may not properly be considered to be at arm’s length. 17. The above indicated that the test to be applied is: “Have the parties conducted the transaction in a way which one would expect of parties dealing at arm’s length in such a transaction?” 18. The matter was expanded upon by Justice McKerracher in Healy v Commissioner of Taxation [2012] FAC 269 at paragraph 95 as follows: 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]). Employee Incentive Arrangement 19. The Employee Incentive Arrangement was part of a wider transaction whereby it was agreed to establish a new business. 20. The Employee Incentive Arrangement was designed to attract, incentivise and retain the benefit of the services of selected employees of The Company and thereby contribute to the ongoing success of the newly established business. 21. Prima facie, the selected employees have an arm’s length relationship with The Company. 22. The bargain with the selected senior employees was essentially an incentive to perform well and stay with the business for a minimum term. After this minimum term, the selected senior employees would receive a portion of the shares in The Company, paying $1 per share. 23. The bargain (regarding the price of the shares to be paid to the employees) was initially struck when the value of the shares was nominal and then applied to all of the selected senior employees, as a means to attract, incentivise and retain the benefit of the service of those employees. 24. The bargain makes commercial sense as the parties planned to build up the business of The Company from nothing. 25. In this case, each of the parties acted in their own interest, severally and independently in the arrangements. The terms of the Employee Incentive Arrangement were agreed on the basis of the mutual desire of the parties to achieve their own objectives of growing and obtaining an ownership interest in a successful business. 26. The consideration paid to exercise the rights and acquire the subsequent shares was that agreed to in the bargain which was made in the ordinary course of business. 27. There is no evidence that the outcome of the dealings is anything other than a matter of real bargaining. Thus, the dealings were at arm’s length and subparagraph 116-30(2)(b)(i) of the ITAA 1997 does not apply to substitute the market value for the capital proceeds from the disposal of the shares. Question 3: Summary 28. The transfer of shares in The Company by The Trustee to the selected employees of The Company will not be a distribution pursuant to section 272-45 or section 272-60 of Schedule 2F of the Income Tax Assessment Act 1936 (“ITAA 1936”). Detailed Reasoning 29. The provisions about family trust distributions tax are found in Division 271 of Schedule 2F of the ITAA 1936. 30. Broadly speaking, where a valid family trust election is made, any distribution made by the family trust to a person outside the relevant family group may be subject to family trust distributions tax (“FTDT”). Section 272-45 31. Section 272-45 of Schedule 2F of the ITAA 1936 gives the meaning of the term “distributes” in relation to trusts as follows: 272-45 Trust distribution to beneficiary A trust distributes income or capital of the trust to a person if it: (a) pays or credits the income or capital in the form of money to the person; or (b) transfers the income or capital in the form of property to the person; or (c) reinvests or otherwise deals with the income or capital on behalf of the person or in accordance with the directions of the person; or (d) applies the income or capital for the benefit of the person; in the person’s capacity as a beneficiary of the trust. 32. For section 272-45 to be satisfied, income or capital of The Trustee must be transferred to the selected employees in their capacity as beneficiaries of The Trustee. As they were never beneficiaries of The Trustee, section 272-45 is not satisfied and the transfer of shares is not a distribution for the purposes of Schedule 2F. Section 272-60 33. Section 272-60 of Schedule 2F of the ITAA 1936 also provides other situations which will be considered to be a distribution to a person in circumstances not covered by section 272-45, 272-50 and 272-55. This extended meaning of the term “distributes” is as follows: 272-60 Other distributions of income and capital (1) A company, partnership or trust (an entity) also distributes income or capital to a person in circumstances not covered by section 272-45, 272-50 or 272-55 if it: (a) pays (including by way of a loan) or credits money of the entity to the person, or reinvests such money for the person; or (b) transfers property of the entity to, or allows use of property of the entity by, the person; or (c) deals with money or property of the entity for or on behalf of the person or as the person directs; or (d) applies money or property of the entity for the benefit of the person; or (e) extinguishes, forgives, releases or waives a debt or other liability owned by the person to the entity. Limit on distributions (2) However, subsection (1) only applies if, and to the extent that: (a) the amount paid, credited, reinvested or applied, the value of the property transferred, or the value of the other thing done; exceeds: (b) the amount or value of any consideration given in return. 34. The ATO has recently issued a binding determination relevant to the application of section 272-60, namely TD 2017/20. 35. TD 2017/20 confirms that a person who is not a beneficiary of a trust is capable of receiving a distribution to the extent that the value of the benefit exceeds any broad consideration given in return. 36. For section 272-60 to be satisfied, income or capital of The Trustee must be transferred to the selected employees. However, this only applies if, and to the extent that, the value of the shares transferred exceeds the amount or value of any consideration given in return. 37. In determining this, the Commissioner acknowledges in TD 2017/20 at paragraph [20] that a distribution will not occur in practice where a transaction occurs on arm’s length terms, and as part of ordinary business dealings. 38. As discussed in Question 2 above, the Commissioner accepts that the dealings were at arm’s length. 39. The sale of shares forms part of the ordinary business dealings of The Trustee. 40. Therefore, section 272-60 is not satisfied and the transfer of shares is not a distribution for the purposes of Schedule 2F.