Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Wayne Swan MP)Chapter 3 - Capital gains tax market value substitution rule for interests in certain companies and trusts
Outline of chapter
3.1 Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that the market value substitution rule does not apply where capital gains tax (CGT) event C2 occurs in relation to a share in a widely held company or a unit in a widely held unit trust. The terms widely held company and widely held unit trust are based on the principles in the CGT scrip for scrip roll-over provisions.
Context of amendments
3.2 Division 116 of the ITAA 1997 deals with general rules for capital proceeds from a CGT event. One of the modifications to the general rules is the market value substitution rule in section 116-30. This rule applies where a CGT event occurs and:
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- there are no capital proceeds; or
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- there are capital proceeds but either those proceeds cannot be valued or the proceeds are more or less than the market value and:
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- the parties were not dealing with each other at arm's length in connection with the event; or
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- the CGT event is CGT event C2 (about cancellation, surrender and similar endings).
3.3 The market value substitution rule is designed to prevent taxpayers from reducing capital gains or increasing capital losses by manipulating the capital proceeds associated with a CGT event. This would generally occur where parties are not dealing with each other at arm's length.
3.4 In relation to other CGT events, provided that the parties are dealing with each other at arm's length, the market value substitution rule in section 116-30 will not apply, even if the capital proceeds are more or less than the market value.
3.5 There is currently no equivalent 'arm's length dealing test' in relation to CGT event C2. In other words, the market value substitution rule will automatically apply in relation to a C2 event where the capital proceeds are more or less than the market value, regardless of whether the parties are dealing with each other at arm's length. This can result in a taxpayer being subject to CGT on an unrealised gain or being denied some or all of a capital loss even though all parties are dealing with each other at arm's length and there is no tax manipulation present.
3.6 These amendments will ensure that the market value substitution rule does not apply where CGT event C2 occurs in relation to a share in a widely held company or a unit in a widely held unit trust, as it is assumed that in these cases the parties are dealing with each other at arm's length.
3.7 These amendments will facilitate arrangements where widely held companies or unit trusts, as part of their ongoing capital management strategy, cancel shares or units and agree with their shareholders or unit holders on a cancellation price in advance of the cancellation taking place. Setting a cancellation price in advance provides certainty for management and shareholders or unit holders on the cost or return from the capital reduction.
Summary of new law
3.8 This Schedule amends the ITAA 1997 by inserting subsection 116-30(2B) and section 116-35. These provisions will ensure that the market value substitution rule in subsection 116-30(2) does not apply where CGT event C2 occurs in relation to interests in companies and unit trusts that have at least 300 members or unit holders and that do not have concentrated ownership.
Comparison of key features of new law and current law
| New law | Current law |
|---|---|
| The market value substitution rule in subsection 116-30(2) will not apply where CGT event C2 occurs in relation to a share in a company or a unit in a unit trust where that company or trust has at least 300 members or unit holders and that do not have concentrated ownership. | The market value substitution rule applies where CGT event C2 occurs and the capital proceeds from the event are more or less than the market value of the asset. |
Detailed explanation of new law
3.9 The market value substitution rule in subsection 116-30(2) will no longer apply where CGT event C2 occurs in relation to a share in a company that has at least 300 members or a unit in a unit trust that has at least 300 unit holders, provided that neither the company nor the trust:
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- has concentrated ownership; or
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- satisfies subsection 116-35(5) about the possible variation of rights.
3.10 It is assumed that a company or unit trust that has at least 300 members or unit holders and that does not have concentrated ownership will be dealing at arm's length with its members.
Concentrated ownership
3.11 A company will have concentrated ownership if an individual owns, or up to 20 individuals own between them, directly or indirectly (through one or more interposed entities) and for their own benefit, shares in the company carrying:
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- fixed entitlements to at least 75 per cent of the company's income or at least 75 per cent of the company's capital; or
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- at least 75 per cent of the voting power in the company.
3.12 A unit trust will have concentrated ownership if an individual owns, or up to 20 individuals own between them, directly or indirectly (through one or more interposed entities) and for their own benefit, units in the trust:
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- carrying fixed entitlements to at least 75 per cent of the trust's income or at least 75 per cent of the trust's capital; or
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- carrying at least 75 per cent of the voting power of the trust, if unit holders of the trust have a right to vote in respect of the activities of the trust.
Possible variation of rights
3.13 Where the constituent documents of a company or unit trust allow the rights attaching to the interests in that entity to be varied or abrogated in such a way as to create a concentration of ownership, the company or trust will be deemed to have a concentration of ownership. This is the case even if the rights are not actually varied or abrogated. [Schedule 3, item 2, subsection 116-35(5)]
3.14 Where this rule (as described in paragraph 3.13) applies the market value substitution rule will operate as normal.
Example 3.1
Sue owns 100 shares in Company A, a company listed on the Australian Securities Exchange (ie, it has more than 300 members). Company A decides to cancel some of its shares as part of its ongoing capital management strategy. The shareholders agree to a cancellation price of $2 per share on 1 July 2008 (the average closing price of Company A's shares on the securities exchange for the previous quarter). The shares are cancelled on 30 October 2008, at which time the share price had increased to $2.50. Sue receives $200 for her shares on the same day (100 × $2).
The time of CGT event C2 is either when Sue enters into the contract that results in the asset ending or, if there is no contract, when the asset ends. In this case, as there is no contract, the timing of CGT event C2 is when the share is cancelled (30 October 2008).
Prior to these amendments, the market value substitution rule in section 116-30 would have resulted in Sue having to substitute the market value of the shares ($2.50) for the actual proceeds received ($2) when calculating her capital gain on the cancellation of her shares. This is because the CGT event is a C2 event and the capital proceeds were less than the market value of the asset at the time of the event. This resulted in Sue being subject to CGT on an unrealised gain, despite the fact that she was dealing with the company at arm's length.
Assume that Company A does not have concentrated ownership and its constituent documents do not allow for the rights of the shares to be varied or abrogated to allow concentrated ownership.
As a result of these amendments, Sue will calculate her capital gain or loss based on her actual proceeds, not the market value of the shares. This aligns with the general principle of CGT that taxpayers should only be subject to CGT on realised gains or allowed to deduct realised losses.
individual
3.15 For the purposes of determining whether a company or trust has a concentrated ownership under subsections 116-35(3) and (4), the following are taken to be single individuals:
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- an individual;
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- the individual's associates; or
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- nominees of either the individuals or of the individual's associates.
[Schedule 3, item 2, subsection 116-35(6)]
Application and transitional provisions
3.16 These amendments will commence on Royal Assent.
3.17 These amendments will apply to CGT events that happen in the 2006-07 income year and later income years. [Schedule 3, item 3]