Structuring contracts and capital gains tax

It seems that wherever you turn in Australian commercial transactions you are faced with a state or federal tax. Capital Gains Tax (CGT) applies to a capital gain which is made upon a disposal of a CGT Asset, subject to specific exceptions and exemptions. CGT forms part of income tax and is not considered a separate tax. A capital loss cannot be claimed against income but can be used to reduce a capital gain in the same income year. If capital losses exceed capital gains in an income year, they can generally be carried forward and deducted against capital gains in future years.

What is a CGT Asset?

Under section 108-5 of the Income Tax Assessment Act 1997 (Cth) a CGT Asset is defined as:

any kind of property;
a legal or equitable right that is not property;
part of, or an interest in, an asset referred to in (a) and (b);
goodwill or an interest in it;
an interest in an asset of a partnership;
an interest in a partnership that is not covered by (e).

Examples of CGT Assets

Examples of CGT Assets, according to section 108-5, are:

land and buildings;
shares in a company and units in a unit trust;
options;
debts owed to you;
a right to enforce a contractual obligation;
foreign currency.

Generally, a CGT Asset is acquired when a third party becomes the owner of it, as per section 109-5.

Examples of what is not a CGT Asset

Examples of assets which are generally exempt are:

a main residence;
a car (designed to carry a load of less than one tonne and fewer than nine (9) passengers);
pre-CGT Assets (assets acquired before 20 September 1985);
personal use items acquired for less than $10,000, and some collectables;
depreciating assets used solely for taxable purposes, and trading stock;
a decoration awarded for valour or brave conduct;
winnings or losses from gambling, a game or a competition with prizes; and
compensation or damages received for any wrong or injury suffered.

CGT Events

A summary of over fifty (50) CGT Events that may result in a capital gain or capital loss is set out in section 104-5 of ITAA97. Some of the more common CGT Events include:

disposing of a CGT Asset (CGT A1 Event);
loss or destruction of a CGT Asset;
creating contractual or other rights (CGT D1 Event);
beneficiary becoming entitled to a trust asset;
granting a lease; and
granting an option (CGT D2 Event)

Disposing of CGT Asset – CGT A1 Event

Under section 104-10(1) a CGT A1 Event happens if the first entity disposes of a CGT Asset. An entity “disposes of” a CGT Asset under section 104-10(2) when it relinquishes ownership to another entity, whether because of some act or event, or by operation of law. An entity does not “dispose of” a CGT Asset if it merely ceases to be the legal owner but continues to be the beneficial owner, or if the disposal contract falls through before completion.

Other considerations which must be assessed include:

time of event – see section 104-10(3); and
working out the capital gain or capital loss – see sections 104-10(4), 116-20, 110-25, 110-35, 110-55.

Creating contractual or other rights – CGT D1 Event

Under section 104-35(1) a CGT D1 Event happens if the first entity creates a contractual right or other legal or equitable right in another entity. For example, entering into a contract to not operate a similar business in a stated geographical area in exchange for $X consideration.

Pursuant to section 104-35(5), a CGT D1 Event does not occur if:

the first entity created the right by borrowing money or obtaining credit from another entity;
the right requires the first entity to do something that is another CGT Event that happens to the first entity;
a company issues or allots equity interests or non-equity shares in the company;
the trustee of a unit trust issues units in the trust;
a company grants an option to acquire equity interests, non-equity shares or debentures in the company; or
the trustee of a unit trust grants an option to acquire units or debentures in the trust.

Other considerations which must be assessed include:

time of event – see section 104-35(2); and
working out the capital gain or capital loss – see sections 104-35(3), 104-35(4) and 20-25.

Granting an option – CGT D2 Event

Under section 104-40(1) a CGT D2 Event happens if the first entity grants an option to the second entity, or renews or extends an option that has already been granted. Other considerations which must be assessed include:

time of event – see section 104-40(2);
working out the capital gain or capital loss – see section 104-40; and
the effect of an option on the costs base and reduced cost base – see section 134-1.

Record keeping for CGT

Penalties apply if adequate records are not kept for at least five (5) years after a CGT Event. Records must be in English and must show:

the nature of the transaction, event or circumstances;
the date it happened;
the parties to the transaction; and
how the transaction, event or circumstances are relevant to working out the capital gain or capital loss.

Records can include:

receipts of purchase or transfer;
details of interest on money borrowed relating to this asset;
records of agent, accountant, legal and advertising costs;
receipts for insurance costs, rates and land taxes;
any market valuations;
receipts for the cost of maintenance, repairs and modifications; and
accounts showing brokerage fees on shares.

What the above shows is that care must be taken in any commercial transaction to ensure that the proposed transaction structure does not trigger any unwanted capital gains tax issues.

Links and further references

Legislation

Income Tax Assessment Act 1936 (Cth)

Income Tax Assessment Act 1997 (Cth)

Further information about capital gains tax law

If you need further information about structuring a transaction so as to comply with the rules regarding capital gains tax, contact us for a confidential and obligation-free discussion:

Malcolm Burrows B.Bus.,MBA.,LL.B.,LL.M.,MQLS.
Legal Practice Director
T: +61 7 3221 0013 (preferred)
M: +61 419 726 535
E: mburrows@dundaslawyers.com.au

Disclaimer

This article contains general commentary only. You should not rely on the commentary as legal advice. Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.