House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 2 - Capital gains tax treatment of water entitlements and termination fees

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to provide a capital gains tax (CGT) roll-over for taxpayers who replace an entitlement to water with one or more different entitlements.

2.2 This Schedule will also allow taxpayers to include any termination fees they incur in relation to an asset in the asset's cost base.

2.3 All references to legislative provisions in this chapter are references to the ITAA 1997 unless otherwise stated.

Context of amendments

2.4 Irrigators may own an entitlement to water directly in the form of a statutory licence or they may own it indirectly in the form of a right against a third party such as an irrigation infrastructure operator (an operator).

•

In these latter situations, the operator typically owns an entitlement to water in the form of a statutory licence.

•

The irrigator typically owns a membership interest in the operator (such as shares) which gives them an entitlement to water in the form of a legal or equitable right against the operator. This entitlement may also include a right to have the operator deliver the water.

2.5 The Water Market Rules 2009 (Water Market Rules), made under the Water Act 2007 (Water Act), have the purpose of freeing up the trade of water entitlements within the Murray-Darling Basin. The rules do this by ensuring that operator policies or administrative requirements do not represent a barrier to trade. The Water Market Rules came into effect on 23 June 2009 with a transitional period to 31 December 2009. The Water Market Rules state that operators must not prevent or unreasonably delay the transformation or trade from 1 January 2010.

2.6 Transformation is the process by which an irrigator permanently changes (transforms) their right to water against an operator into a statutory licence held by an entity other than the operator. In most cases, it will be the individual irrigator who will own the statutory licence. The Water Market Rules refer to an irrigator's right to water against an operator as being the irrigator's irrigation right. Consequently, it is the irrigator's irrigation right that is transformed.

2.7 Operators may also have to undertake pre-transformation transactions to facilitate the transformation process and ensure member irrigators are treated equitably.

CGT water entitlement roll-over

2.8 In the absence of specific CGT relief, the transformation process is likely to trigger immediate CGT consequences for the irrigator and may trigger CGT consequences for the operator. This is because the irrigator's entitlement to water against the operator ends and part of the operator's statutory licence is cancelled. Depending on how the operator is structured, the transactions may also trigger CGT consequences for other member irrigators. This is likely to be the case if the operator is a partnership and the member irrigators own their water entitlements as joint tenants.

2.9 Subdivision 124-C provides an automatic CGT roll-over on the cancellation of a taxpayer's statutory licence if another statutory licence replaces it. However, this roll-over is not available when either the original entitlement to water or the replacement entitlement does not take the form of a statutory licence. An irrigator's right against an operator is not a statutory licence.

Example 2.1

Water Drip Ltd (Water Drip) is an operator within the Murray-Darling Basin that owns a statutory licence with a 200 megalitre (ML) entitlement to water. There are 200 shares in Water Drip that each contain an entitlement to have up to 1 ML of water delivered. Bob owns 10 shares in Water Drip and so is entitled to delivery of up to a total of 10 ML of water.

•

Bob has a total entitlement to 10 ML of water in the form of legal rights against Water Drip. (This entitlement is not a statutory licence.)

•

For the purposes of the Water Market Rules, Bob's entitlement to 10 ML of water is an irrigation right against Water Drip.

•

Should Bob choose to transform his 10 ML entitlement to water against Water Drip into a statutory licence and a separate delivery entitlement then, in the absence of this roll-over, the following CGT consequences would typically arise:

•

Bob triggers a CGT taxing point when his 10 ML entitlement to water against Water Drip ends (typically CGT event C2); and

•

Water Drip triggers a CGT taxing point when part of its statutory licence is cancelled and reissued to Bob (typically CGT event C2).

2.10 This roll-over will therefore facilitate transformation arrangements.

2.11 While the Water Market Rules apply only to the water resources of the Murray-Darling Basin, this roll-over applies more widely. This will also facilitate other forms of water entitlement restructuring without immediate CGT consequences. Consequently, the concept of an entitlement to water for the purposes of this roll-over needs to be wider than the terminology of the Water Market Rules.

Including termination fees in an asset's cost base

2.12 The CGT rules allow for the recognition of a taxpayer's costs of acquiring, owning and disposing of an asset when calculating a capital gain or capital loss on the asset. The rules do this by including these costs in the asset's cost base and reduced cost base.

2.13 The current CGT provisions allow some incidental costs of owning an asset to be included in the asset's cost base. However, these incidental costs do not include termination fees.

2.14 Although this cost base change applies to all CGT assets, it will have particular importance for irrigators who choose to sell a newly transformed water entitlement and end their delivery entitlement with their operator. This is because operators may charge the irrigator a termination fee when the irrigator terminates their delivery entitlement. The Water Charge (Termination Fees) Rules 2009 (Water Charge Rules) apply to termination fees in relation to water resources in the Murray-Darling Basin.

2.15 These rules do not modify the treatment of termination fees in the hands of the entity that receives the fee.

Summary of new law

2.16 Part 1 of Schedule 2 amends the ITAA 1997 by inserting Subdivision 124-R. This Subdivision provides a CGT roll-over for taxpayers who replace a water entitlement with one or more different water entitlements (including by transformation). It also provides a roll-over when a taxpayer owns a number of water entitlements and there is a reduction in the number of entitlements but not in the value of the total entitlement.

2.17 The concept of a water entitlement broadly encompasses any legal or equitable right relating to water, including its delivery.

2.18 Subdivision 124-R also provides a roll-over for consequential transactions arising as a direct result of this replacement.

2.19 Part 2 of Schedule 2 amends Division 110 of the ITAA 1997 by allowing taxpayers to include any termination fees they incur in relation to an asset in the second element of the asset's cost base and reduced cost base as an incidental cost.

Comparison of key features of new law and current law

Detailed explanation of new law

Water entitlement roll-overs

2.20 There are two types of water entitlement roll-over.

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The first applies if a taxpayer replaces a water entitlement with one or more new water entitlements (replacement roll-over). This roll-over may also apply when a taxpayer replaces multiple water entitlements. Paragraphs 2.29 to 2.60 provide further information about this roll-over.

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The second applies if a taxpayer has a total water entitlement made up of individual entitlements and their ownership of some of those entitlements ends but the total market value of the remaining entitlements remains the same as the total market value of the original entitlements (reduction roll-over). Paragraphs 2.61 to 2.77 provide further information about this roll-over.

2.21 Transactions that qualify for the replacement roll-over may also have CGT consequences for other taxpayers. There is also a roll-over for these consequences if they happen as a direct result of a transaction that qualifies for the replacement roll-over (variation roll-over). Paragraphs 2.78 to 2.83 provide further information about this roll-over.

What is a water entitlement?

2.22 For the purpose of these roll-overs, a water entitlement is any legal or equitable right that relates to water. This could include groundwater. There is no restriction in the form that an entitlement may take. [Schedule 2, item 6, subsection 124-1105(4)]

2.23 For example, a water entitlement could take the form of a contractual right against a third party, such as an operator. Alternatively, it could take the form of a statutory licence against a state or territory government. A share in a company would also be a water entitlement, if it has rights attaching to it that relate to water. Similarly an interest in a trust or a partnership interest would also be a water entitlement if the interest has attached rights relating to water.

2.24 For example, the following rights relate to water:

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a right to receive water;

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a right to take water from a water resource;

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a right to have water delivered; or

•

a right to deliver water.

[Schedule 2, item 6, subsection 124-1105(4)]

2.25 A right to take water from a water resource, such as a water allocation, would be a water entitlement. A water use licence would also be a water entitlement.

2.26 A separate identifiable right relating to the conveyance of water, such as a conveyance licence, would also be a water entitlement.

2.27 There are three key rights in the Water Act that relate to water and are relevant for transformation. These are:

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a water access right;

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a water delivery right; and

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an irrigation right.

For the purposes of these roll-overs, an asset that is such a right, or consists of such a right, will be a water entitlement.

Example 2.2

The Wet Water Company Ltd (Wet Water) is an operator. It has 200 shares on issue. Each share consists of a bundle of rights, including the right to vote at Wet Water's annual general meeting, receive dividends from the company and the right to receive up to two ML of water and have it delivered by Wet Water.

Wally owns 20 shares in Wet Water. Each of Wally's shares is a water entitlement.

Wet Water owns a statutory entitlement to take up to 450 ML of water from the Wet Creek. As this entitlement allows Wet Water to take water from a water resource (Wet Creek), it is a water entitlement.

Example 2.3

Jack and Jill form a partnership to jointly construct a well and take water from it. Each interest in the partnership includes the right to take 20 ML of water each year.

Each of Jack's and Jill's interest in the partnership is an entitlement to water.

Example 2.4

The Rainy Day Trust (Rainy Day) is an operator that owns a 300 gigalitre (GL) statutory licence. Rebecca has an equitable interest in Rainy Day which entitles her to delivery of up to 100 GL of water.

Rebecca's interest in the trust is an entitlement to water.

If Rebecca held a right to have her water delivered that was separate from her interest in the trust entitling her to 100 GL of water, she would own two separate water entitlements.

2.28 In some circumstances, a taxpayer may only be entitled to own a contractual water entitlement against another entity if they also own a membership interest in that entity, such as a share. The membership interest may or may not relate to water. However, even if it does not, it will still be a water entitlement if it is a prerequisite for owning a water entitlement. [Schedule 2, item 6, subsection 124-1105(4)]

Replacement of water entitlements

2.29 Two alternative replacement roll-overs are available when a taxpayer replaces a water entitlement with one or more water entitlements:

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The default replacement roll-over operates on a single asset basis (single entitlement roll-over). This roll-over applies when a taxpayer replaces a single water entitlement with one or more different water entitlements [Schedule 2, item 6, subsection 124-1105(1)] .

•

However, taxpayers may have more than one water entitlement, each of which is replaced in the one transaction. In these situations, the taxpayer may choose an alternative replacement roll-over that operates on a multiple asset basis (multiple entitlement roll-over). This roll-over applies when a taxpayer replaces more than one water entitlement with one or more different water entitlements [Schedule 2, item 6, subsection 124-1105(2)] .

2.30 The two alternative replacement roll-overs accommodate the different ways taxpayers may structure their arrangements.

2.31 Specifically, providing the multiple entitlement roll-over on an optional basis allows taxpayers to deal separately with part of a water entitlement that is not replaced.

Example 2.5

Claire owns a 100 ML water entitlement which she replaces with a 95 ML water entitlement.

Claire qualifies for the single entitlement roll-over in respect of her 100 ML entitlement. She disregards any capital gain or capital loss arising from this exchange.

Alternatively, Claire could split her original 100 ML water entitlement into two separate water entitlements - a 95 ML entitlement and a 5 ML entitlement.

If Claire splits her entitlement in this way and her new 95 ML water entitlement is cancelled and replaced with a new 95 ML water entitlement, she qualifies for the single entitlement roll-over in respect of her replaced 95 ML entitlement. Consequently, Claire disregards any capital gain or capital loss arising from this exchange.

As Claire does not replace her 5 ML water entitlement with another water entitlement, this entitlement does not need to qualify for the single entitlement roll-over.

2.32 The way the taxpayer prepares their tax return is sufficient evidence of them making this choice.

2.33 A statutory licence that relates to water may qualify as a water entitlement. However, there is an existing automatic CGT roll-over within Subdivision 124-C that applies to statutory licences. A water entitlement that is a statutory licence and that qualifies for the roll-over in Subdivision 124-C will not qualify for the water entitlement roll-over. Consequently taxpayers that own a statutory licence that is also a water entitlement should first check whether they qualify for the roll-over in Subdivision 124-C before seeing if they qualify for the water entitlement roll-over. [Schedule 2, item 6, subsection 124-1105(3)]

Example 2.6

Ron owns a statutory licence to 500 ML of general security water from the Running River. This statutory licence is a water entitlement as it allows Ron to take water from a water resource.

The state government cancels Ron's statutory licence triggering CGT event C2. However, as a result of that cancellation, the state government issues Ron with a new statutory licence with an entitlement to 300 ML of high security water from the Running River.

Ron qualifies for the statutory licence roll-over. Consequently, he does not qualify for the replacement roll-over.

Example 2.7

Rapid Water Ltd (Rapid Water), an operator, owns a 20 GL bulk water entitlement which is a statutory licence. Each year, this statutory licence expires and the state government issues Rapid Water with a new statutory licence to reflect changes in water availability.

Rapid Water's 20 GL statutory licence expires and the state government issues Rapid Water with a 19 GL statutory licence.

Rapid Water qualifies for the statutory licence roll-over in relation to this exchange. Rapid Water therefore does not qualify for the replacement roll-over.

Example 2.8

Further to Example 2.7.

Rapid Water's member irrigators receive a total of up to 15 GL of water from Rapid Water. The remaining 4 GL of Rapid Water's bulk water entitlement is accounted for by conveyance losses that occur when Rapid Water delivers this water to its member irrigators.

Rapid Water wishes to separate its bulk water entitlement into two entitlements, one reflecting the amount of water its member irrigators receive and the other, the water used to deliver its members' entitlements.

Assume that the state government cancels Rapid Water's 19 GL statutory licence and issues it with a 15 GL bulk water entitlement and an additional 4 GL water entitlement to cover the conveyance losses. As these replacement entitlements are both statutory licences, Rapid Water qualifies for the statutory licence roll-over in relation to this exchange. Rapid Water therefore does not qualify for the replacement roll-over.

Qualifying transactions

Single entitlement roll-over

2.34 A taxpayer (such as an irrigator or an operator) whose ownership of one water entitlement ends will qualify for this roll-over if they acquire one or more new water entitlements as a result of their ownership of the original entitlement ending.

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A taxpayer that sells a water entitlement in exchange for a cash payment and later chooses to acquire a new water entitlement will typically not qualify for the replacement roll-over. This is because the taxpayer did not acquire the new entitlement as a result of their ownership of the original entitlement ending. Instead the acquisition of the new entitlement is an independent event.

•

However, a taxpayer who disposes of a water entitlement with the expectation of acquiring a replacement water entitlement may qualify for the replacement roll-over when they acquire the replacement entitlement. In this situation, there is a relationship between the disposal of the original entitlement and the acquisition of the replacement entitlement.

[Schedule 2, item 6, paragraphs 124-1105(1)(a) and (b)]

2.35 It does not matter how the taxpayer's ownership ends. For example, the taxpayer may dispose of their water entitlement or may have it cancelled. Similarly, it does not matter whether the replacement water entitlement is of the same nature as the original entitlement. The roll-over simply requires the taxpayer to acquire one or more water entitlements to replace the original entitlement.

2.36 If the taxpayer chooses that the multiple entitlement roll-over applies to an original water entitlement in relation to a specific transaction, then that entitlement will not also qualify for the single entitlement roll-over. However, the replacement water entitlement will be a separate asset and so may later qualify for a single entitlement roll-over or as part of a multiple entitlement roll-over. [Schedule 2, item 6, paragraph 124-1105(1)(d)]

2.37 If the taxpayer is a foreign resident for tax purposes (including a trustee of a foreign trust), then they will only qualify for this roll-over if the original water entitlement and each of the replacement water entitlements is taxable Australian property. [Schedule 2, item 6, paragraph 124-1105(1)(c)]

2.38 Paragraphs 2.42 to 2.60 set out the consequences of this roll-over applying.

Multiple entitlement roll-over

2.39 A taxpayer whose ownership of more than one water entitlement ends will qualify for this roll-over if they acquire one or more new water entitlements as a result of the ownership of the original entitlements ending and they choose to obtain this roll-over. [Schedule 2, item 6, paragraphs 124-1105(2)(a), (b) and (d)]

2.40 If the taxpayer is a foreign resident for tax purposes (including a trustee of a foreign trust), then they will only qualify for this roll-over if each of the original water entitlements and replacement water entitlement(s) is taxable Australian property. [Schedule 2, item 6, paragraph 124-1105(2)(c)]

2.41 Paragraphs 2.42 to 2.60 set out the consequences of this roll-over applying.

Roll-over consequences

Disregard capital gain or capital loss attributed to replacement entitlement(s)

2.42 If the taxpayer satisfies the conditions for this roll-over (either the single entitlement roll-over or the multiple entitlement roll-over), then they disregard any capital gains or capital losses arising from their ownership of each original water entitlement ending. [Schedule 2, item 6, section 124-1110]

Example 2.9

Andy, Ben, Courtney, Dean and Emma each own 100 Class A shares issued by Liquid Water Irrigation Ltd (Liquid Water). Liquid Water is an operator within the Murray-Darling Basin that owns a statutory licence with an 800 ML entitlement to water. Each Class A share entitles its owner to 1 ML of water, have Liquid Water deliver the water, one vote at the annual general meeting and the right to receive dividends.

Andy chooses to transform his 100 ML entitlement against Liquid Water. Consequently he exchanges each of his 100 Class A shares for a replacement 100 ML statutory licence and 100 Class B shares, each of which has the same rights as the Class A shares, except the right to 1 ML of water. As the replacement statutory licence and each Class B share relates to water, each asset is a water entitlement.

Andy qualifies for the single entitlement roll-over in relation to each of his 100 Class A shares. (Alternatively, Andy may choose to access the multiple entitlement roll-over.)

Andy disregards any capital gains and capital losses arising from this exchange.

Realise capital gain or capital loss attributed to ineligible proceeds

2.43 However, if the taxpayer receives additional proceeds that do not take the form of a replacement water entitlement or entitlements, then the taxpayer will realise a partial capital gain or capital loss in relation to these additional proceeds. These additional proceeds (ineligible proceeds) do not qualify for the replacement roll-over, as they represent a realisation of part of the original water entitlement. [Schedule 2, item 6, subsection 124-1115(1)]

2.44 In this situation the taxpayer calculates a capital gain by attributing part of the cost base of each of the original water entitlements to the ineligible proceeds they receive. The taxpayer may do this on a reasonable basis having regard to the number and market value of the replacement water entitlement(s) relative to the market value of the ineligible proceeds. [Schedule 2, item 6, subsections 124-1115(2) and (4) and paragraph 124-1115(5)(a)]

Example 2.10

Further to Example 2.9.

Assume Courtney's 100 Class A shares in Liquid Water have a cost base of $50 each. The total cost base of her shares is $5,000.

Like Andy, Courtney exchanges her 100 shares in Liquid Water for a 100 ML statutory licence. However, rather than receive 100 Class B shares, Courtney chooses to receive a cash payment of $10,000.

The 100 ML statutory licence has a market value of $90,000.

Courtney qualifies for the replacement roll-over in relation to the 100 ML statutory licence. However the cash payment is ineligible proceeds.

It would be reasonable for Courtney to calculate her capital gain as follows:

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The total market value of Courtney's proceeds from her 100 Class A shares is $100,000. That is, $90,000 for the statutory licence plus $10,000 for the cash payment.

•

Consequently, the cash payment represents 10 per cent of her capital proceeds. That is, $10,000 divided by $100,000.

•

Therefore, 10 per cent of the cost base of Courtney's Class A shares is attributable to the cash payment. That is, $5 per share.

•

The total cost base of the Class A shares that is attributable to the $10,000 cash payment is $500.

•

Assuming Courtney incurs no other costs in relation to the Class A shares, she realises a capital gain of $9,500. That is, $10,000 capital proceeds less a $500 cost base.

2.45 The taxpayer calculates a capital loss by attributing part of the reduced cost base of each of the original water entitlements to the ineligible proceeds they receive in the same way. [Schedule 2, item 6, subsections 124-1115(3) and (4) and paragraph 124-1115(5)(b)]

Replacement of pre-CGT water entitlements

2.46 If the taxpayer acquired their original water entitlement (or all of their entitlements) before 20 September 1985, then they will be taken to have acquired each of their replacement water entitlements before 20 September 1985. [Schedule 2, item 6, section 124-1125]

2.47 Assets acquired before 20 September 1985 are known as pre-CGT assets. Capital gains and capital losses realised on these assets are generally disregarded.

Example 2.11

Further to Example 2.9.

Assume Emma purchased her 100 Class A shares on 3 August 1984.

Emma exchanges her 100 Class A shares for a 100 ML statutory licence and 100 Class B shares.

As Emma's shares were acquired before 20 September 1985, she is taken to have acquired her statutory licence and each of her Class B shares before 20 September 1985.

Replacement of post-CGT water entitlements

2.48 If the taxpayer acquired their original water entitlement (or all of their entitlements) on or after 20 September 1985, then they will acquire each of their replacement water entitlements on the actual date of acquisition of those entitlements.

2.49 Assets acquired on or after 20 September 1985 are typically known as post-CGT assets.

2.50 However, for the purposes of the CGT discount, the ownership period of each of the replacement water entitlements includes the period of ownership of the original water entitlement(s) (see paragraph 2.100). [Schedule 2, item 2]

2.51 The taxpayer calculates the first element of the cost base of each replacement water entitlement on a reasonable basis having regard to:

•

the total cost bases of the original water entitlement(s);

•

the number and market value of the original entitlement(s); and

•

the number and market value of the replacement entitlement(s).

[Schedule 2, item 6, paragraphs 124-1120(1)(a) and (b) and (2)(a) to (c)]

2.52 Taxpayers should calculate the market values at the time of the relevant events. Division 116 sets out various principles for calculating these market values in different circumstances. [Schedule 2, item 6, subsection 124-1120(4)]

2.53 However, there is no need for the taxpayer to obtain a detailed valuation from a qualified valuer as to the relevant market values. Taxpayers may choose to obtain such a valuation. However, taxpayers may alternatively choose to calculate their own valuation based on reasonably objective and supportable data.

Example 2.12

Further to Example 2.9.

Dean also chooses to exchange his 100 Class A shares for a 100 ML statutory licence and 100 Class B shares. Assume each of Dean's 100 Class A shares has a cost base of $750. The total cost base of these shares is $75,000.

It would be reasonable for Dean to calculate the cost base of his statutory licence and his 100 Class B shares as follows.

At the time of exchange, Dean's replacement 100 ML statutory licence has a market value of $100,000. Each of Dean's Class B shares has a market value of $100. (The combined market value is $10,000.)

Based on these values, Dean's statutory licence represents 90.91 per cent of the total proceeds he receives (rounded to two decimal places). This is calculated as follows:

•

The value of the total proceeds received is $110,000; that is $100,000 (for the statutory licence) plus $10,000 (for the Class B shares).

•

The value of the statutory licence relative to the total proceeds is calculated by dividing the value of the statutory licence by the total value of the proceeds; that is $100,000 divided by $110,000.

The first element of the cost base of Dean's statutory licence is $68,183 (rounded to the nearest dollar). This is calculated as follows:

•

90.91 per cent of the $75,000 total cost base of the original 100 Class A shares is $68,183.

The 100 Class B shares that Dean receives represent the other 9.09 per cent of the total proceeds. Consequently the first element of the cost base of each of these shares is $68.18. This is calculated as follows:

•

9.09 per cent of the $75,000 total cost base of the original shares is $6,817.50.

•

$6,817.50 total cost base value divided by 100 shares is $68.18 (rounded to two decimal places).

2.54 In addition, if the taxpayer has to pay an amount (including giving other property) to acquire the replacement water entitlement or entitlements, then they can include that amount in the cost base of each replacement entitlement on a reasonable basis. [Schedule 2, item 6, paragraphs 124-1120(1)(c) and (2)(d)]

Example 2.13

Further to Example 2.12.

Assume Dean had to pay a $2,000 administrative fee to acquire the statutory licence. Dean includes this fee in the cost base of his replacement statutory licence.

Assuming Dean incurs no other costs in relation to the statutory licence, it has a cost base of $70,183. That is, the first element of $68,183 plus the second element of $2,000.

2.55 The first element of the reduced cost base of each of the replacement water entitlements is calculated in the same way, taking into account:

•

the total reduced cost bases of the original water entitlement(s);

•

the number and market value of the original entitlement(s);

•

the number and market value of the replacement entitlement(s); and

•

any amount (including other property) to acquire the replacement entitlement(s).

[Schedule 2, item 6, subsections 124-1120(3) and (4)]

Replacement of pre-CGT and post-CGT water entitlements

2.56 As the single entitlement roll-over applies on an asset-by-asset basis, only taxpayers who choose to apply the multiple entitlement roll-over will have a combination of pre-CGT and post-CGT water entitlements. [Schedule 2, item 6, subsection 124-1130(1)]

2.57 In these situations, the taxpayer calculates how many of the replacement water entitlement(s) will be taken to have been acquired prior to 20 September 1985 (pre-CGT) on a reasonable basis having regard to:

•

the number and market value of the original water entitlements; and

•

the number and market value of the replacement entitlement(s).

[Schedule 2, item 6, subsection 124-1130(2)]

Example 2.14

Further to Example 2.9.

Ben purchased 25 of his Class A shares in Liquid Water in 1984 and the remaining 75 Class A shares in 2000. The cost base of each of the post-CGT shares is $800.

Ben exchanges his 100 Class A shares for a 100 ML statutory licence and 100 Class B shares. At the time of this exchange, each of Ben's Class A shares has a market value of $1,000.

Ben's replacement 100 ML statutory licence has a market value of $90,000. Each of Ben's Class B shares has a market value of $100. (The combined market value is $10,000.)

Ben is taken to have acquired two statutory licences - one pre-CGT and the other post-CGT.

Reflecting the number and market value of his pre-CGT Class A shares, it would be reasonable for Ben to be taken to have acquired a 25 ML pre-CGT statutory licence and a 75 ML post-CGT statutory licence.

Similarly, Ben will be taken to have acquired 25 of his Class B shares pre-CGT.

2.58 The taxpayer then calculates the first element of the cost base of each replacement post-CGT water entitlement on a reasonable basis having regard to:

•

the total cost bases of the original post-CGT water entitlement(s); and

•

the number and market value of the replacement post-CGT entitlement(s).

[Schedule 2, item 6, paragraphs 124-1130(3)(a) and (b)]

Example 2.15

Further to Example 2.14.

It would be reasonable for Ben to calculate the first element of the cost base of his 75 ML (post-CGT) statutory licence as follows:

•

The total market value of all his replacement post-CGT water entitlements is $75,000. Of this, his 75 ML statutory licence has a market value of $67,500 and each of his 75 post-CGT Class B shares has a market value of $100 (and a combined market value of $7,500).

•

Consequently, his 75 ML represents 90 per cent of his total post-CGT proceeds. That is, $67,500 divided by $75,000.

•

Therefore, Ben apportions 90 per cent of the total cost base of his post-CGT Class A shares to the 75 ML statutory licence. The total cost base of his post-CGT Class A shares is $60,000. That is, 75 shares multiplied by an $800 cost base.

•

The first element of the cost base of Ben's 75 ML statutory licence is $54,000. That is, 90 per cent of $60,000.

It would be reasonable for Ben to calculate the first element of the cost base of each of his post-CGT Class B shares as follows:

•

Ben's post-CGT Class B shares represent 10 per cent of his total post-CGT proceeds.

•

Therefore, Ben apportions 10 per cent of the total cost base of his post-CGT Class A shares to the 75 Class B shares. The total cost base of his post-CGT Class A shares is $60,000.

•

The total cost base of the 75 Class B shares is $6,000.

•

The first element of the cost base of each of Ben's 75 Class B shares is $80. That is, a $6,000 total cost base divided by 75 shares.

2.59 In addition, if the taxpayer has to pay an amount (including giving other property) to acquire the replacement water entitlement(s), then they can include that amount in the cost base of the replacement entitlement on a reasonable basis. [Schedule 2, item 6, paragraph 124-1130(3)(c)]

2.60 The taxpayer calculates the first element of the reduced cost base of the replacement post-CGT water entitlement in the same way. [Schedule 2, item 6, subsection 124-1130(4)]

Reduction in water entitlements

2.61 A taxpayer may own a number of individual water entitlements that together form their total entitlement to water. This entitlement may include a conveyance loss component that the taxpayer never receives. Conveyance losses represent the water lost in the operator's network due to factors such as evaporation and seepage. There may be changes to the taxpayer's individual water entitlements to effectively remove this conveyance component that have no effect on the total amount of water the taxpayer is entitled to receive.

2.62 Although the taxpayer's remaining water entitlements effectively replace the taxpayer's original water entitlements, these transactions will not qualify for the replacement roll-over if the taxpayer does not acquire a replacement water entitlement. The reduction roll-over addresses this scenario.

2.63 This roll-over does not provide specific consequences for taxpayers who acquired all of their original water entitlements before 20 September 1985, as capital gains and capital losses realised on these assets are generally disregarded.

Qualifying transactions

2.64 A taxpayer who owns more than one water entitlement will qualify for the reduction roll-over if, under a single arrangement:

•

their ownership of at least one of the original water entitlements ends but they retain at least one of the original entitlements; and

•

the total market value of all the original entitlements is substantially the same as the retained entitlements.

[Schedule 2, item 6, section 124-1135]

2.65 Paragraphs 2.69 to 2.77 set out the consequences of this roll-over applying.

2.66 If there is a close nexus between particular elements of a broader transaction, then those elements form part of the same arrangement. Interrelated and interdependent transactions typically form a single arrangement. Typically transactions will be interrelated if they happen as part of achieving a broader objective. Alternatively, transactions will typically be interdependent if they are contingent on other transactions happening.

2.67 If the taxpayer is entitled to receive the same total amount of water following this reduction, then theoretically the sum of the remaining water entitlements' market values should be equal to the sum of the original water entitlements' market values. However, the substantially the same market value test recognises that there may be small changes in value simply arising as a result of the changes. It also allows for rounding and other small adjustments.

2.68 More significant changes in value will result in the taxpayer failing this test.

Example 2.16

River Irrigation Ltd (River Irrigation) is an operator that owns a statutory licence with a 100 GL entitlement to water. River Irrigation has 100 member irrigators, each with a contractual right to water. The size of this entitlement depends on the number of shares they own in River Irrigation. Each share in River Irrigation entitles its owner to 1 ML of water.

However, each member's contractual right to water includes a conveyance component of 20 per cent. Consequently, each member only receives up to 80 per cent of their contractual entitlement.

Julie, a member of River Irrigation, owns 500 shares (that she acquired in 1994) and consequently has a 500 ML entitlement to water. However, due to the conveyance component Julie only ever receives up to 400 ML of water.

River Irrigation reorganises its affairs and cancels 20 per cent of each member's shares on a pro-rata basis. River Irrigation, with the agreement of its member irrigators, also cancels each member irrigator's contractual right and reissues a new contractual right without a conveyance component. (This cancellation and reissue of the contractual rights qualifies for the replacement water entitlement roll-over.) These transactions ensure that each member's contractual entitlement and shareholding accurately reflects the amount of water they receive.

Julie is one of River Irrigation's member irrigators. Julie has her total water entitlement reduced to 400 ML through the cancellation of 100 shares. However, as Julie continues to receive the same amount of water, the total market value of Julie's original water entitlements is the same as her retained water entitlements.

Roll-over consequences

Disregard capital gain or capital loss attributed to retained entitlement

2.69 If the taxpayer satisfies the conditions for this roll-over, then they disregard any capital gains or capital losses arising from their ownership of the original water entitlement or entitlements ending. [Schedule 2, item 6, section 124-1140]

Example 2.17

Further to Example 2.16.

Julie disregards any capital gains or capital losses arising from the cancellation of her 100 shares.

Retained post-CGT entitlements

2.70 If the taxpayer acquired all of their original water entitlements on or after 20 September 1985, then they will have the following consequences for the cost base of their retained water entitlements.

2.71 The taxpayer calculates the first element of the cost base of each retained water entitlement on a reasonable basis having regard to:

•

the total cost bases of the original water entitlement(s);

•

the number and market value of the original entitlement(s); and

•

the number and market value of the retained entitlement(s).

[Schedule 2, item 6, subsections 124-1145(1) and (2)]

Example 2.18

Further to Example 2.17.

Each of Julie's 500 shares has a cost base of $500. Her total cost base is $250,000.

At the time of the cancellation, each of her shares has the same market value of $8,000.

It would be reasonable for Julie to calculate the first element of the cost base of each of her 400 retained entitlements by apportioning the total cost base of $250,000 over the 400 shares.

That is, $250,000 divided by 400 shares equals $625. As the total market value of the retained entitlements has not changed, Julie need only apportion the total cost base between her retained shares according to the number of shares.

The first element of the cost base of each of Julie's retained shares is $625.

2.72 Taxpayers need to calculate the market values at the time of the relevant events and, as noted in paragraph 2.52 according to the principles set out in Division 116. [Schedule 2, item 6, subsection 124-1145(4)]

2.73 The taxpayer calculates the reduced cost base of each retained water entitlement in the same way. [Schedule 2, item 6, subsection 124-1145(3)]

Retained pre-CGT and post-CGT entitlements

2.74 A taxpayer may have acquired some of their original water entitlements before 20 September 1985 and the remainder of their entitlements on or after 20 September 1985. [Schedule 2, item 6, subsection 124-1150(1)]

2.75 In these situations, the taxpayer calculates how many of the retained water entitlement(s) will be taken to have been acquired prior to 20 September 1985 (pre-CGT) on a reasonable basis having regard to:

•

the number and market value of the original water entitlements; and

•

the number and market value of the retained entitlement(s).

[Schedule 2, item 6, subsection 124-1150(2)]

2.76 The taxpayer then calculates the first element of the cost base of each retained post-CGT water entitlement on a reasonable basis having regard to:

•

the total cost bases of the original post-CGT water entitlement(s); and

•

the number and market value of the retained post-CGT entitlement(s).

[Schedule 2, item 6, subsection 124-1150(3)]

2.77 The taxpayer calculates the first element of the reduced cost base of each retained post-CGT water entitlement in the same way. [Schedule 2, item 6, subsection 124-1150(4)]

Consequential variations to other CGT assets

2.78 Transactions that qualify for the replacement roll-over may have consequential effects on other taxpayers. For example, one member of an operator may transform their water entitlements against their operator and this can affect the water entitlements of the operator and other members.

Qualifying transactions

2.79 A taxpayer that has a CGT event happen to any asset they own as a direct result of circumstances that qualify for the replacement roll-over will qualify for the variation roll-over when they continue to own the asset. [Schedule 2, item 6, section 124-1155]

Example 2.19

Further to Example 2.9.

Andy exchanges each of his 100 Class A shares in Liquid Water for a replacement 100 ML statutory licence and 100 Class B shares. As a result, Liquid Water's 800 ML statutory licence is reduced to 700 ML and it cancels Andy's 100 Class A shares.

This reduction arises as a direct result of Andy transforming his entitlement, an exchange that qualifies for the replacement entitlement roll-over.

As Liquid Water continues to own its statutory licence, it qualifies for the variation roll-over in respect of this reduction.

Roll-over consequences

Disregard capital gain or capital loss attributed to the retained asset

2.80 If the taxpayer satisfies the conditions for this roll-over, then they disregard any capital gains or capital losses arising from the CGT event happening. [Schedule 2, item 6, section 124-1160]

Example 2.20

Further to Example 2.19.

As Liquid Water does not receive any other proceeds, it disregards any capital gains or capital losses arising from this reduction.

Realise capital gain or capital loss attributed to ineligible proceeds

2.81 However, if the taxpayer receives proceeds other than their retained asset (ineligible proceeds), then they will realise a partial capital gain or capital loss in relation to those proceeds. [Schedule 2, item 6, subsection 124-1165(1)]

2.82 In this situation the taxpayer calculates a capital gain by attributing part of the cost base of the original asset to the ineligible proceeds they receive. The taxpayer may do this on a reasonable basis having regard to the market value of the retained asset relative to the market value of the ineligible proceeds. [Schedule 2, item 6, subsections 124-1165(2) and (4)]

2.83 The taxpayer calculates a capital loss by attributing part of the reduced cost base of the original asset to the ineligible proceeds they receive in the same way. [Schedule 2, item 6, subsections 124-1165(3) and (4)]

Termination fees

2.84 Typically, termination fees (and exit fees) are contractual fees imposed by one party on the other as a result of the second party breaking the contract.

2.85 An asset's cost base and reduced cost base consist of five elements. The second element consists of specific incidental costs that a taxpayer incurs in relation to the asset. These incidental costs are set out in section 110-35.

2.86 A taxpayer that incurs a termination or a similar fee (such as an exit fee) as a direct result of their ownership of an asset ending includes that fee in the second element of the asset's cost base and reduced cost base as an incidental cost. [Schedule 2, item 200]

Example 2.21

Linda enters a contract with Gold Property Development Ltd (Gold) to build a residential investment property for $500,000.

The contract provides that if Linda does not arrange the necessary approvals so that Gold can commence building within four months of signing the contract, the contract will be terminated and Linda must pay Gold a termination fee equal to 2 per cent of the contract price.

Six months later, Linda has still not arranged the necessary approvals. Her contract with Gold is terminated and she pays Gold a termination fee of $10,000 in accordance with the terms of the contract.

Linda includes the amount of the termination fee in the second element of the cost base and reduced cost base of the contract as an incidental cost.

2.87 The party that imposes a termination fee may impose that fee by withholding part of the proceeds due to the other party. In this situation the taxpayer that has to pay the termination fee cannot reduce their capital proceeds by the amount of the withheld fee.

2.88 In the context of the irrigation industry, a termination fee is typically any fee or charge payable to an operator for either terminating access or surrendering a water delivery right. The Water Charge Rules provide further information about these fees.

Example 2.22

Further to Example 2.12.

Dean sells his statutory licence to an irrigator outside Liquid Water's irrigation district and elects to terminate his access to Liquid Water's irrigation network, through the cancellation of his 100 Class B shares.

Liquid Water charges Dean a $5,000 termination fee to cancel his shares.

Dean includes the $5,000 fee in the cost base and reduced cost base of the shares as an incidental cost on a pro-rata basis. That is, $50 per share.

The first element of the cost base and reduced cost base of each share is $68.18. Assuming Dean incurs no other costs in relation to these shares, the second element of the cost base and reduced cost base is $50.

The cost base and reduced cost base of each share is $118.18.

2.89 Irrigators may choose to transform an irrigation right and subsequently trade their water entitlement and terminate their delivery entitlement. These subsequent transactions may occur at different times.

2.90 Should an irrigator wish to offset a capital gain they realise on the sale of their water entitlement with a capital loss they realise on their delivery entitlement, then they may wish to ensure that these transactions occur in the same income year. This is because taxpayers can offset existing and future capital gains with any realised capital losses. However, taxpayers cannot carry back capital losses to prior income years.

Application and transitional provisions

2.91 Part 1 applies to CGT events that happen in the 2005-06 and later income years. [Schedule 2, item 300]

2.92 However, once the amending legislation receives Royal Assent, taxpayers can choose not to obtain the roll-over if the relevant transactions qualifying for the roll-over happen in the period from the 2005-06 income year to the day that the amendments receive Royal Assent. [Schedule 2, subitems 305(1) and (2)]

2.93 If a taxpayer chooses not to obtain the roll-over, then they can make this choice within 12 months of the amendments receiving Royal Assent or within the time period set out in section 170 of the Income Tax Assessment Act 1936 (ITAA 1936). [Schedule 2, subitem 305(3)]

2.94 A taxpayer may choose not to obtain the roll-over in situations when they realise a capital loss from the relevant transactions.

2.95 Part 2 applies to CGT events happening on or after 1 July 2008. [Schedule 2, item 310]

2.96 However, once the amending legislation receives Royal Assent, taxpayers can choose not to include a termination or similar fee in the asset's cost base and reduced cost base if the relevant event happens in the period from 1 July 2008 to the day that the amendments receive Royal Assent. [Schedule 2, subitem 315(1)]

2.97 If a taxpayer chooses not to include the fee in the asset's cost base, then they can make this choice within 12 months of the amending legislation receiving Royal Assent or within the time period set out in section 170 of the ITAA 1936. [Schedule 2, subitem 315(2)]

Consequential amendments

2.98 A number of consequential amendments will be made to the ITAA 1997 to reflect the availability of the water entitlement roll-over in Subdivision 124-R.

2.99 References to this roll-over will be added to Subdivision 112-B. Subdivision 112-B lists situations when the general cost base and reduced cost base rules are modified. [Schedule 2, item 1]

2.100 A reference to the water entitlement roll-overs will be added to the table of replacement asset roll-overs in section 112-115. This ensures that the ownership period of a replacement water entitlement includes the period of ownership of the original entitlement for the purposes of the CGT discount. [Schedule 2, item 2]

2.101 References to Subdivision 124-R will be added to Division 124. [Schedule 2, items 3 to 5]

2.102 The definition of a 'water entitlement' will be inserted into section 995. [Schedule 2, item 7]