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Money can't buy me love – February 1999

The market value substitution rule

In this issue: Tax partner Grant Cathro (view CV) examines market value substitution rules.

• Introduction
• When can the Commissioner look beyond the terms of the agreement?
• Has consideration been allocated to all relevant CGT events?
• Understanding the proper legal effect of the transaction
• Relevance of the description provided by the parties
• Sham transactions
• Part IVA
• The market value substitution rules
• Exceptions to the market value substitution rule – capital proceeds
• Cost base of a CGT asset
• Exceptions to the market value rule – cost base
• The first limb of the market value substitution rule – no consideration
• The second limb of the market value substitution rule – consideration cannot be valued
• The third limb of the market value substitution limb – parties not dealing at arm's length
• Market value
• Determining the market value of a group of assets
• Burrill's case and market value
• Failure to allocate consideration to an asset

This paper was presented at a Taxation Institute of Australia seminar in February 1999

Introduction

I have been asked to talk in this session about the market value substitution rules. There are effectively two market value substitution rules, one which applies to the capital proceeds for a CGT event and the other which applies to the cost base of an asset.

The issue which I have attempted to deal with in this paper is, however, somewhat broader than the market value substitution rule. What I would like to do is to attempt to identify those circumstances which arise in the CGT context, in which the Commissioner is not bound by the apparent terms of the bargain struck between the parties. The market value substitution rules provide one example of those circumstances, but is not the only one.

Increasingly, the Commissioner would appear to be arguing that the capital gains consequences of a transaction are not to be judged solely by the terms of any written document recording that transaction. It is not unusual for him to suggest that the terms of a written document do not truly represent what actually happened, or that he has the power to allocate the consideration between assets disposed of in a different manner to the allocation made by the parties. This may occur even where the parties are completely unrelated. This approach of the Commissioner is also reflected in rulings such as Taxation Determination TD 98/24 dealing with assets which are treated as more than one asset for CGT purposes and Taxation Ruling TR 96/24 dealing with the characterisation of payments for goodwill as a lease premium.

This approach has also been seen in arguments advanced by the Commissioner in one form or another in Krakos Investments Pty Ltd v Federal Commissioner of Taxation (1995) ATC 4369; Federal Commissioner of Taxation v Murry (1998) ATR 129, Collis v Federal Commissioner of Taxation (1996) ATC 4381 and in a non-CGT context, in Richard Walter Pty Ltd v Federal Commissioner of Taxation (1995) ATC 4440.

When can the Commissioner look beyond the terms of the agreement?

It is clear that the Commissioner does not ordinarily have the power to rewrite a bargain merely because he feels that the result effected by a transaction could equally have been obtained in a different way with different tax consequences. As Hill J. stated in Australia and New Zealand Savings Bank Limited v Federal Commissioner of Taxation (1993) ATC 4370, 4389:

'In the absence of a submission that the transaction entered into by the parties is a sham, a disguise from some other and different transaction, and in the absence of the application of the anti-avoidance provisions of Part IVA of the Act, the Court must look to see what the transaction entered into by the parties by its terms effects. That is to say, regard must be had to the legal rights which the transaction actually entered into confers. Invocation of the doctrine of substance is no assistance in this task.'

His Honour mentions two circumstances in which the treatment of the transaction is not determined solely by reference to the terms of any agreement, namely where the transaction is a sham or in the limited circumstances in which Part IVA may apply.

As most will now be aware, the market value substitution rules allow the Commissioner to substitute market value for actual consideration in a number of circumstances. Essentially, they are where either:

• there is no consideration; or
• the consideration cannot be valued; or
• the parties did not deal at arm's length.

These rules are not dissimilar to the market value rules which apply in the trading stock, depreciation and mining context.

Before turning to look at the market value rules in detail, I first want to look at other circumstances in which the CGT consequences of a transaction may not be determined by merely looking at the face of the agreement between the parties.

It may be necessary to look beyond the face of an agreement in five circumstances. They are:

• where the parties have not allocated consideration to all relevant CGT events, or in the terms of the old Income Tax Assessment Act 1936 (the 1936 Act), consideration has not been allocated to each asset disposed of;
• where the draftsmen of an agreement has misunderstood the legal effect of what is being achieved, so that the agreement fails to deal with the relevant assets;
• where the transaction is a sham;
• where Part IVA applies; or
• where the market value substitution rules apply.

In most transactions, it is a relatively simple matter to identify the assets dealt with and any dispute with the Tax Office is likely to relate to the allocation of the consideration between them, or the possible application of CGT Event D1 (the old section 160M(6)) or CGT Event H2 (the old section 160M(7)). That will not however always be the case. There may be circumstances in which it might be suggested that a written agreement does not accurately describe what has occurred.

The tax consequences of a transaction are to be determined by having regard to the legal rights which the transaction confers. Ordinarily, those rights are to be determined by looking at the terms of the written agreement. The agreement may not, however fully reflect the transaction. This may occur because the parties forgot to deal with matters in the agreement which were actually dealt with in practice, assets were transferred which were not mentioned in the agreement, or because assets were transferred by implication which were not specifically referred to in the agreement. It may also occur because the parties misunderstood the legal nature of what they were seeking to achieve when drafting the agreement, providing an inaccurate description of what they were dealing with.

Has consideration been allocated to all relevant CGT events?

It is not uncommon for agreements to be drawn up in terms which fail to allocate consideration to all relevant assets dealt with. This may arise simply because the draftsman failed to turn his mind to the issue, or assets were dealt with in practice which were not referred to in the agreement.

Where consideration has not been allocated to each asset dealt with, section 116-40 of the 1997 Act (formerly section 160ZD(4) of the 1936 Act) provides for the apportionment of consideration. That section provides:

'If you receive a payment in connection with a transaction which relates to more than one CGT event, the capital proceeds from that event are so much of the payment as is reasonably attributable to that event.'

Likewise, where one amount of consideration relates to a CGT event and something else, section 116-40(2) apportions to the CGT event so much of the consideration as is reasonable. Similar rules are provided by section 112-30 in relation to the apportionment of consideration on the acquisition of assets.

In a self-assessment environment, taxpayers will generally make an assessment of what allocation is reasonable (see Draft Ruling TD 98/24). If the Commissioner then examines the issue and does not agree, he will no doubt issue an amended assessment on a basis which he determines to be reasonable. The difficulty then for taxpayers is of course that if they want to challenge the assessment, the onus of proof is on the taxpayer to show that the Commissioner's assessment is excessive. If what the Commissioner has done is within the range of what could be regarded as reasonable, taxpayers may not find it an easy task to upset the Commissioner's allocation.

The determination of the value of an asset is a matter of fact, not a matter of law (FC of T v Westgarth [1949-1950] 81 CLR 396, 408). Any re-allocation of consideration based on the Commissioner's view of the respective values of the assets would also be a matter of fact. The AAT stands in the shoes of the Commissioner and can form its own view as to what is reasonable. However, as stated by Brennan J. in Waterford v The Commonwealth (1987) 163 CLR 54, 77 'there is no error of law in simply making a wrong finding of fact'. Accordingly, it is likely that a court could only upset the Commissioner's assessment if, as a matter of law, it was felt that the allocation is not one which could be justified on a reasonable basis (see Australian Broadcasting Tribunal v Bond [1990] 170 CLR 321 at 355-357).

What this means is that where the allocation of consideration matters (for example, where there are pre-CGT assets, assets with no cost base, or assets which receive special CGT treatment (such as goodwill)), taxpayers should give very careful thought to the allocation of consideration between different assets. Where they have done so it will be much more difficult for the Commissioner to upset that allocation, than will be the case where there has not been a proper allocation. It is important that agreements carefully identify all relevant assets dealt with and that thought is being given to the allocation of consideration to each and every asset which is capable of being transferred. Care should be taken when allocating consideration to items which might be assets within the terms of section 108-5, but are not property and as a matter of law are not capable of transfer. There is a risk that a proper analysis of the transaction may show that a payment provided for those assets is in fact a payment for a service or alternatively, is a payment to which CGT Event D1 or CGT Event H2 apply. In either of these cases, the taxpayer will not obtain the benefit of a cost base.

Understanding the proper legal effect of the transaction

From time to time, situations no doubt arise in which the application of complex legal principals means that the transaction actually has a different effect from that which appears from the face of the agreement.

A simplistic example where this occurs, is where there are in fact assets transferred which the parties perhaps deliberately attempted not to transfer. In the UK case of Eastern National Omnibus Co Limited v The Commissioners of Inland Revenue (1939) 1 KB 161, there was a sale of a coach business. The agreement provided for the transfer of vehicles, appropriate licences and premises used in a coach business. The vendor provided a covenant not to compete with the purchaser. The question which arose was whether there was in fact a transfer of goodwill of the business. The court held that there was. The purchaser had effectively been put in a position where, in all practical terms, it was conducting the business formerly conducted by the vendor and had been equipped by the agreement with the ability to do so.

Where, as in the Eastern National Omnibus case, an asset is transferred by way of implication, or in practice, assets are transferred which are simply not dealt with in the agreement, it becomes more difficult to determine how the consideration should be allocated to all relevant assets. If the contract specifically allocates consideration to each of the assets which it deals with, but fails to mention some assets, the question of allocation of the purchase price becomes more difficult. It is, perhaps, unclear whether:

• the purchase price allocated to the relevant asset should be reallocated across all assets; or
• the market value substitution rule should be applied to deem market value consideration for the assets which are not mentioned.

The difficulties arising in this situation are discussed in more detail towards the end of this paper.

In two recent cases, the Commissioner has argued that the description placed by the taxpayer upon the nature of consideration received was inaccurate. In Federal Commissioner of Taxation v Krakos Investments Pty Ltd (1996) ATC 4063, the Commissioner argued unsuccessfully that an amount allocated to goodwill was in fact a premium paid for a lease. In Federal Commissioner of Taxation v Murry (1998) ATR 129, the Commissioner argued successfully that a payment described as one for goodwill was in reality a payment for a licence which did not form part of goodwill.

In Krakos the taxpayer operated a hotel on freehold land owned by the taxpayer. The taxpayer also held a liquor licence for the hotel. The business was sold and the purchaser was granted a lease of the premises. The consideration for the business of $840,000 was apportioned as $420,000 for plant and equipment and $420,000 for goodwill. The Commissioner contended that the goodwill of a licensed hotel adhered to the premises (ie. it was really site goodwill) and accordingly the sum of $420,000 was really a premium paid for the lease and was assessable as a capital gain under section 160ZS(1) of the 1936 Act. The Full Federal Court upheld the decision of Branson J. that there was no reason to go behind the terms of the agreement.

In Murry the taxpayer owned a taxi business which consisted to two taxi licences, one taxi and shares in a taxi cooperative company. The second taxi licence was leased to an operator, who owned a taxi. The taxpayer sold the taxi licence and the shares to the purchaser for $214,000 which was apportioned as $25,000 for the shares and $189,000 for the goodwill (the value of the licence). The taxpayer claimed a 50% reduction in the capital gain on the goodwill pursuant to section 160ZZR of the 1936 Act. The Commissioner denied the reduction claiming that the amount did not really represent goodwill. The High Court held that the consideration received was not goodwill as the sale of the licence and the shares was not the sale of the business. Accordingly, the reduction for goodwill could not be claimed.

Relevance of the description provided by the parties

As both Krakos' and Murry's case demonstrate, the description or labelling of assets in an agreement will not necessarily be determinative of the true legal character of the contractual arrangements. Nonetheless the labels used by the parties may assist in determining the true legal character of the agreement provided the agreement is not considered to be a sham. As Lord Fraser said in Australian Mutual Provident Society v Chaplin (1978) 18 ALR 385, 389-90:

'where there is no reason to think that the clause is a sham, or that it is not a genuine statement of the parties' intentions, it must be given its proper weight in relation to other clauses in the agreement'.

For example, in employment contracts an express provision in a contract between parties stating that they are acting as employer and employee will be given effect to unless there is reason to believe the clause is a sham (NM Superannuation Pty Ltd v Young (1993) 113 ALR 39, 56).

Whether the parties are acting at arm's length may also be relevant to the weight given to labels. In Krakos, in finding that the goodwill apportionment should stand, Branson J. (at first instance) placed weight on the fact that the parties had dealt in an arm's length way and apportioned the consideration on that basis.

Sham transactions

In sham transactions, the document itself will be irrelevant when determining the legal rights created by the transaction. Lockhart J. in Sharrment Pty Ltd v Official Trustee in Bankruptcy (1988) 18 FCR 449, 454 defined a sham transaction as:

'something that is intended to be mistaken for something else or that is not really what purports to be. It is a spurious imitation, a counterfeit, a disguise, or a false front. It is not genuine or true, but something made in imitation of something else or made to appear to be something which it is not. It is something which is false or deceptive. '

An example of a sham transaction is provided by the decision in Richard Walter Pty Ltd v Federal Commissioner of Taxation (1996) ATC 4550. By means of a complicated company structure, fees received in relation to a pathology clinic were purported to be distributed to the taxpayer by way of a number of loans. The Commissioner contended that the loan arrangement was a sham and that it was intended at all times that the taxpayer was to receive the money without any obligation to repay it. Accordingly, the loan arrangement was to be disregarded and the money treated as income in the hands of the taxpayer. The Full Federal Court upheld the decision of Tamberlin J. which was stated as follows:

'My conclusion is that the purported "loans" were simply a false label given in order to mask the real transaction intended by the parties, which was the transfer of the beneficial ownership of the moneys to Richard Walter free of any obligation to repay. The nomination of the payments as a loan was calculated to make the true transaction appear as something it was never in truth intended to be.'

Part IVA

It appears likely that it would require some very unusual circumstances for Part IVA to apply merely because the Commissioner did not agree with the description given by the parties to particular assets or disagreed with the allocation of consideration. In most circumstances where there is any dispute about the assets dealt with or in relation to the allocation of consideration, the Commissioner's ability to rewrite the bargain will usually be dependent upon a proper analysis of the transaction (as set out above) and an application of the specific provisions dealing with the capital proceeds from a CGT event (to be discussed below).

However, as a result of the High Court decision in Commissioner of Taxation v Spotless Services Limited (1996) 186 CLR 404, it may be arguable that the Commissioner has a greater potential to apply Part IVA to transactions which have an overall commercial purpose, but are entered into in a complex, contrived or very unusual manner. Such transactions will not generally be considered to be 'shams', even if they are designed to achieve an unacceptable purpose (Sharrment at 455) but Part IVA may however now become more relevant.

The market value substitution rules

There are two groups of market value substitution rules which apply in the capital gains context. The first is in section 116-30. Where it operates it substitutes market value for the capital proceeds from a CGT event, or in the old paralance, the consideration in the respect of the disposal of an asset (former section 160ZD(2)).

The second is in section 112-20. Where it operates it substitutes market value for the first element of the cost base of the CGT asset, or in the old paralance, the amount paid or given in respect of the acquisition of an asset (former section 160ZH(9)).

Capital proceeds

Ordinarily the capital proceeds from a CGT event are (section 116-20) the total of any money and the market value of any property which is received or which the taxpayer is entitled to receive in respect of the event happening.

Capital proceeds are usually limited to money or property. An exception perhaps arising in the case of CGT event H2 where the Commissioner argues that consideration can extend beyond money or property (see the Income Tax Ruling TR 95/3). A position which is no doubt assisted by the way in which this issue is dealt with in the rewrite in section 116-20(2).

The market value substitution rule applies to substitute the market value of the CGT asset which is the subject of the event for the actual consideration where either:

• the taxpayer receives no 'capital proceeds' from the CGT event (section 116-30(1));
• some or all of the 'capital proceeds' cannot be valued;
• the 'capital proceeds' are more or less than the market value of the asset and the taxpayer and the entity that acquired the assets from the taxpayer did not deal with each other at arm's length in connection with the event; or
• the 'capital proceeds' are more or less than the market value of the asset and the CGT event is the redemption, release, abandonment, surrender, forfeiture or cancellation of the asset (section 116-30(2)).

Exceptions to the market value substitution rule – capital proceeds

There are a number of exceptions to the operation of this capital proceeds rule. Section 116-25 sets out which of the capital proceed modification rules apply to which CGT event. The market value substitution rule does not apply to the following CGT events:

The 1997 Act reflects what was clearly the position under the 1936 Act in relation to section 160M(7), namely that as the asset dealt with was a fictional asset, which was incapable of identification or valuation, the market value substitution rule could not apply to section 160M(7) (CGT event H2).

In addition, the first limb of the market value substitution rule, namely that which applies where no capital proceeds are received does not apply to:

1. CGT event D1 (former section 160M(6)) which applies if a taxpayer creates a contractual right or other legal or exorable right in another entity (this is consistent with the position in former section 160M(6A)(d));
2. two examples of CGT event C2, namely:

1. the expiry of a CGT asset the taxpayer owns; or
2. the cancellation of a statutory licence held by the taxpayer.

Cost base of a CGT asset

The cost base of an asset is generally comprised of five elements (see section 110-25). The first element is effectively the consideration given for the acquisition of the asset. As is generally the case with capital proceeds, this first element is limited to amounts of money paid or required to be paid, or the market value of property given for the acquisition. (Section 110-25(2))

The general rules in Division 110, dealing with the cost base and reduced cost base are subject to a number of modifications in Division 112. One of those modifications is the market value substitution rule. (Section 112-20)

Where the market value substitution rule applies, it substitutes the market value of an asset at the time of acquisition for the first element of the cost base and reduced base of that CGT asset. Generally it does so where either:

1. the taxpayer did not incur 'expenditure' (which includes giving property) to acquire the CGT asset; or
2. some or all of the 'expenditure' incurred to acquire the CGT asset cannot be valued; or
3. the taxpayer did not deal at arm's length with the other entity in connection with the acquisition.

Subject to the exceptions mentioned below, the first and second limbs of the market value substitution rule are of general application. The third limb, namely that which applies where the parties did not deal at arm's length with each other in connection with the acquisition, generally applies where the consideration is greater or less than market value. In limited circumstances however, this third limb only applies if the consideration given was more than the market value of the CGT assets. Those circumstances are set out in section 112-20(2) and are where:

1. the acquisition of a CGT asset resulted from CGT event D1 (the creation of a contractual right or other legal or equitable right in another entity – old section 160M(6));
2. the CGT asset is a share in a company that was issued or allotted to the taxpayer by the company; or
3. the CGT asset is a unit in a unit trust that was issued to the taxpayer by the trustee of the unit trust.

Exceptions to the market value rule – cost base

Section 112-20(3) sets out a number of exceptions to the application of all limbs of the market value rule. The exceptions are set out in the following table which is reproduced from the Act:

Exceptions to the market value substitution rule

Differences between the 1936 Act and the 1997 Act

The Tax Law Improvement Project was not intended to make any changes in the law except those referred to in the Explanatory Memorandum. However, as time goes by, there appear to be more and more unintended changes being identified. For example, section 160M(6A)(d) served to exclude the creation of contractual or other legal or equitable rights from the market value rules where no capital proceeds were received. However, section 112-20 appears to provide such an exemption for all such rights, whether they are newly created or not.

The first limb of the market value substitution rule – no consideration

Where a taxpayer acquires an asset from another entity and the taxpayer did not incur expenditure to acquire it, section 112-20 substitutes the market value of the asset at the time of acquisition, as the first element of the cost base. For these purposes, expenditure would include money or property (section 103-5), but would not include consideration which was in a form other than money or property.

Where a CGT event occurs and no capital proceeds are received, the taxpayer is taken to have received the market value of the asset the subject of the event, market value being determined at the time the event occurs (section 116-30(1)). Again, the rule applies if no money or property is received.

The second limb of the market value substitution rule – consideration cannot be valued

Where some or all of the expenditure incurred to acquire a CGT asset cannot be valued, section 112-20 substitutes the market value of the first element of the cost base of the CGT asset. It would seem that this rule only applies where the consideration which cannot be valued is either money or property. Consequently, if there is some expenditure which can be valued, and the provision of some other form of consideration which is not money or property, it would seem that neither this limb, nor the first limb, of the market value substitution rule which applies in the context of cost base would apply.

Where some or all of the capital proceeds from a CGT event cannot be valued, section 116-30 generally substitutes market value. Again, it would seem that this rule only applies where the proceeds which cannot be valued are either money or property. This conclusion arises because the reference to 'those proceeds' in section 116-30(2)(a) would appear to be a reference to capital proceeds in subsection 116-30(2). Capital proceeds in turn, generally being limited to the money received or market value of property (section 116-20(1)).

The third limb of the market value substitution limb – parties not dealing at arm's length

The expression 'dealing at arms length' was discussed by Lee J. in Granby Pty Ltd v Federal Commissioner of Taxation (1995) ATC 4240 where His Honour said:

'The expression `dealing with each other at arm's length' involves 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 arms length would be expected to behave in conducting their affairs.'

The emphasis is on whether the parties are actually acting at arm's length in relation to that particular agreement, not whether the parties are at arm's length.

The issue of whether the parties were acting in arm's length will arise in two scenarios:

1. where the parties are not at arm's length but may be acting at arm's length in relation to a particular transaction; or
2. where the parties are at arm's length but may not be dealing at arm's length in relation to a transaction or part of a transaction.

Parties not at arm's length

The essence of an arm's length relationship is that the parties are able to act independently and without duress imposed by the other party. This means that they are able to enter the transaction on the basis their own self interest. Non-arm's length relationships are generally those where the parties are related or associated in some way so that while each party may enter a transaction with some self interest in mind, it may also take into consideration the interests of the other party in making the agreement. Examples of such relationships are transactions between family members and related corporations.

The mere fact that parties are not at arm's length is not determinative of the issue. Where parties are not at arm's length it is still possible for the parties to there deal at arm's length in relation to a specific transaction. As stated by Davies J. in Barnsdall v Federal Commissioner of Taxation (1988) ATC 4565, 4568:

'The Commissioner is required to be satisfied not merely of a connection between a taxpayer and a person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arms 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.'

The test adopted by the courts in relation to this issue was described by Hill J. in Trustee for the Estate of the late A W Furse No.5 Will Trust v Federal Commissioner of Taxation (1991) ATC 4007, 4015 as a 'real bargaining test':

'What is required in determining whether the parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing 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.'

Parties at arm's length

Where parties are at arm's length, there may be instances where the parties are not dealing at arm's length in relation to a transaction or part of a transaction.

The issue of when dealings between parties at arm's length constitute non-arm's length dealings was discussed in Granby. The taxpayer acquired chattels subject to a lease by tendering their residual value under the lease to the finance company. The finance company accepted this without any negotiation or attempt to bargain a higher price, notwithstanding that the market value of the chattels may have been higher. The taxpayer argued that because there was no real bargaining between the parties, the acquisition was not at arm's length. Lee J. rejected the argument of the taxpayer and said:

'If the parties to a transaction are at arms length, it will follow, usually, that the parties will have dealt with each other at arms length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be. That is not to say, however, that parties at arm's length will be dealing with each other 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.'

Lee J. concluded that there was no evidence that the parties had colluded or that one party had accepted dictation to the exclusion of the exercise of its independent mind and that 'the lessor corporations made decisions which, they perceived, served the interests of the businesses conducted by them' and accordingly the parties had dealt at arm's length.

Unlike Barnsdall's case and Furse's case, which both dealt with situations where the parties were clearly not at arm's length, in Granby's case, the parties were at arm's length and the only question was whether they had 'dealt' at arm's length. Consequently, the court did not find it necessary to apply the 'real bargaining test'. Even although there was no evidence that there had been any real negotiation, it was enough that the parties were at arm's length, and that the financier had taken its business interests into account when following its usual practice of selling the chattels at their residual value.

In Collis v Federal Commissioner of Taxation (1996) ATC 4831 a case concerned with the old section 26AAA the Federal Court was faced with a similar question of whether the parties to an arm's length transaction had dealt in an arm's length manner. The taxpayer auctioned four blocks of land together and the purchaser bought the blocks for a total sum of $1.43m. The taxpayer asked the purchaser to sign two contracts of sale, one relating to a vacant block of land which was purchased in 1988 within twelve months of resale and one relating to the remaining three blocks of land which were purchased in 1979. The first contract had a price of $200,000 which was inserted prior to the auction, but the price for the second contract was only inserted after the auction was completed. The purchaser was only concerned with the total purchase price and was basically indifferent to the apportionment. Jenkinson J. held that while the parties had acted at arm's length in relation to the purchase of the whole property, the parties had not dealt with at arm's length in relation to the apportionment of the consideration. His Honour referred to the statement of Lee J. in Granby and stated that, as the purchaser had been indifferent to the apportionment, he had submitted the exercise of his will to the applicants' wishes in acceding to their request to apportionment of the consideration in that way.

On the basis of these decisions, it would seem that where the parties are at arm's length, there is a presumption that the parties dealt at arm's length unless is can be shown either that the parties colluded to achieve a particular result or one of the parties has had its will dictated to by the other party, especially if this was done to promote the interests of that other party.

Market value

The Income Tax Assessment Act contains no definition of market value. The most widely accepted definition of market value can be found in the High Court decision of Spencer v The Commonwealth (1987) 5 CLR 418. The High Court held that in assessing the value of land, the basis of valuation should be the price that a willing purchaser would pay to a vendor not unwilling, but not anxious to sell. Isaacs J said (at 441):

'To arrive at the value of the land at that date, we have, as I conceive, to suppose it sold then, not be means of a forced sale, but by voluntary bargaining between the plaintiff and a purchaser, willing to trade, but neither of them so anxious to do so that he would overlook any ordinary business considerations.'

A similar test was also adopted by the High Court in Abrahams v Federal Commissioner of Taxation (1945) 70 CLR 23, 29-30 where Williams J. said the market value of shares was:

'the price which a willing but not anxious vendor could reasonably expect to obtain and a hypothetical willing but not anxious purchaser could reasonably expect to have to pay for the shares if the vendor and purchaser had got together and agreed on a price in friendly negotiation, the basis of the bargaining being that the purchaser would be entitled to be registered as the owner of the shares but when registered would hold them subject to the provisions of the memorandum and articles of association of the company, including any restrictions on transfer which they might contain.'

The extent to which the potential uses of an asset may influence the proper determination of the market value of that asset were canvassed in Collis' case. It would seem that particularly in the case of land 'the special adaptability of land for a specific purpose is an element in value', although 'it is essential to the existence of a market value that there be some continuing demand for land for that purpose' (see Hustler's Pty Ltd v The Valuer-General (1967) 14 L.G.R.A. 269, referred to in Collis at 4841).

In Taxation Determination TD 10, the Commissioner stated that where the 'market value' of an asset needs to be determined for CGT purposes, taxpayers can choose to:

1. Obtain a detailed valuation from a qualified valuer; or
2. Compute their own valuation based on reasonably objective and supportable data.

Determining the market value of a group of assets

An asset will often have a different value when it is sold in conjunction with another asset. For example, the value of two adjoining properties when sold together may be higher than if they were sold separately. This raises the issue of which value is to be used, and if it is the increased value, how is to be determined.

1. stand alone value or value added value

In Collis, the taxpayer argued that each block of land should be valued on a stand alone basis. In support of this view the taxpayer referred to High Court authority which, on its face, appears quite persuasive.

In Commissioner of Succession Duties (South Australia) v Executor Trustee and Agency Company of South Australia Limited & Ors (1947) 74 CLR 358 a deceased estate held a number of shares in a company. A large number of shares in this company were held by an associated company. The deceased also held a life-governor's share in the associated company which gave the estate the right to three-quarters of the votes in the associated company. The High Court held that, for the purposes of assessing probate duty, in valuing the shares in the first company, the life-governor's share in the associated company should not be taken into consideration, notwithstanding the voting rights attached to it. Latham CJ, Rich and Williams JJ made the following statement:

'One asset to be valued is the shares held by the deceased in D. Clifford Theatres Ltd. The share held by the deceased in Clifford's Investments Ltd is a share in a different company and therefore a separate asset. It is no more permissible to amalgamate the two lots of shares than it would be to amalgamate two separate parcels of land for the purpose of giving additional value to each.'

Jenkinson J rejected this argument and distinguished the above statement on the grounds that the High Court was referring to 'separate' parcels of land, not 'adjoining' parcels and concluded:

'when adjoining parcels of land are, on the date as at which one of them is to be valued, available for purchase under a single contract, (or under inter-dependent and collateral contracts) the value of that one lot may be, in law, ascertained by reference to what a willing purchaser would offer for all the parcels, who had the purpose of putting the whole of the land to a specific use, provided that there was at that date a demand for land for that use in the vicinity of the land to be valued.'

It is not entirely surprising that in a context where two assets are actually dealt with together, the court should base the market value on the potential which they have together. In a sense, this is no different from taking into account the potential use to which land might be put in determining its value.

It seems unlikely that market value would be determined looking at the combined value of two or more assets, in circumstances where one asset is dealt with on its own. Interesting questions will no doubt arise for public companies in determining the market value of pre-CGT assets later this year. There would appear to be a lot to be said for the view that if a prudent hypothetical vendor would dispose of the assets together, in order to obtain the most favourable price, without undue expenditure of time and effort, the assets ought to be valued on that basis.

2. Determining the value added value

In Collis, the taxpayer's valuer contended that the amended market value for the vacant block should have been determined by an apportionment of the sale price on the basis of the percentage increase of the combined value of the lots if they had both been sold individually (ie, $200,000 and $936,000) as compared to the auction price of $1.43m. This would have resulted in a 25.9% increase which increased the market value of the recently acquired vacant block to $251,800.

The Tribunal rejected this method and apportioned the sale price by way of averaging the auction price per square foot and applying the price to the respective areas of each lot. Jenkinson J found that the Tribunal made no error in law in applying the second method of valuation.

Interestingly, the approach taken differs from that which appears to be taken by the revenue in the United Kingdom (see Inland Revenue Tax Bulletin issue 24) where it has been indicated that where the value of a number of assets is to be undertaken collectively and produces a total valuation in excess of the value of the assets valued separately:

'The apportionment is to be made on a just and reasonable basis, and so must reflect the value of each of the assets. Commonly, this will require an apportionment of the total value in proportion to the value of each asset'.

Burrill's case and market value

In Burrill v FC of T (1996) ATC 4629 the taxpayer held deposits in Pyramid Building Society when an administrator was appointed. The Victorian Government offered depositors payment of the remaining 75% of deposits (25% had already been paid by the State Bank of Victoria) in consideration of the issue of a bond which carried the right to receive payment over instalments of four years. The difference between the face value and the market value of the bonds at the time they were issued to the taxpayer was $80,891. The taxpayer claimed the difference as a deduction pursuant to section 70B of the 1936 Act as a loss on the disposal of the deposits (as traditional securities) to the State Government. The Full Federal Court held that no deduction was available because any loss was to be calculated on the face value of the bonds, not their market value. Accordingly, the taxpayer suffered no loss on the disposal as he received in exchange a promise to pay the face value of the bonds, albeit by instalments over four years. As stated by the Court:

'It is a fundamental principle of Australian income tax law that rights to receive money and obligations to pay money are taken into account in calculating income and outgoings, gains and losses, at their nominal value.'

The implication of this decision is that where there is deferred consideration, even though the real value of the consideration has been effectively reduced, the Act looks at the money received or to be received. Accordingly, it is the face value which is relevant. The situation may of course be different if an existing chose in action is assigned as consideration for a CGT asset.

The taxpayer also argued that the issue of bonds was not 'cash' but was consideration in kind, and accordingly the bonds should be valued at their market value in line with section 21(1). The Full Court rejected this argument on the grounds that the bonds were a promise to pay money. The Full Court expressly distinguished the bonds from shares:

'Shares are not, and do not involve a promise to pay money, they do not find expression in case or sound in money. When shares are consideration for another's promise, they are as much a consideration in kind as a bag of wheat or a horse.'

Applying this view to the CGT context, if redeemable preference shares are issued there may be an issue as to whether the value of the shares for CGT purposes is the face value of the shares or some lesser amount such as the market value at the time of the issue. If the lesser amount is deemed to apply, there is potential for a capital gain on redemption, even though there is no gain when looking at the nominal value of the shares.

For example, one million redeemable preference shares which carry no fixed or cumulative dividend entitlement, with a redemption value of $100.00 are issued as consideration for the sale of certain assets. The consideration received is shares and not money (or a promise to pay money as in Burrill), so section 116-20 would appear to deem that the consideration received is not the redemption value of the shares ($100.00 per share), but the market value of the shares (which is likely to be less). On the redemption of the shares, although the shareholder will only receive the face value of the share, he may make a capital gain.

It should be noted that the share value shifting rules will not apply to the above situation as the shares have not been issued at below market value.

Failure to allocate consideration to an asset

To return to the example provided earlier in this paper, what happens when an asset is transferred by way of implication, or assets are transferred which are simply not dealt with in the agreement?

Where a contract provides a global amount of consideration for the sale of a number of assets, but does not allocate that consideration, it is clear that section 116-40 will allow the consideration to be apportioned for the purposes of determining the vendor's gain, on a reasonable basis. The question which arises, however, is whether it is necessarily the case that section 116-40 will apply, allowing the consideration to be allocated on a reasonable basis where consideration is actually allocated by the parties to specific assets, but some assets have no consideration allocated to them.

Two United Kingdom cases consider situations in which taxpayers who owned shares in a company, had lent the company money and later sold the shares while agreeing to accept a reduced amount from the company in satisfaction of the debt owing to them. The question which arose in each case, was whether the consideration in the contract received from the purchaser, was simply consideration for the sale of the shares, or was consideration for the sale of the shares and the agreement to dispose of the vendor's loan for a reduced repayment from the company. It should be noted that for some reason, it would seem that in the UK the vendor would not have been entitled to claim a loss on the disposal of the loan.

In one case, Aberdeen Construction Group Limited v Inland Revenue Commissioners (1978) 1 All ER 962, the House of Lords held that the consideration was paid not only for the transfer of shares, but also for the waiver of the loan. In the other case, E.V. Booth (Holdings) Limited v Buckwell [1980] STC 578, the High Court of Justice held that on a true construction of the contract, the parties had expressly allocated the consideration to the disposal of the shares, and that the parties could not subsequently seek to reallocate the consideration for tax purposes.

The distinction between these two cases would appear to lie in the precise terms of the agreement reached between the parties. In one case (Aberdeen Construction), it was felt that the consideration did relate to more than one asset, and that apportionment was required under the UK equivalent of section 116-40. In the other case, a construction of the contract did not lead to that conclusion.

The difficulty which will arise in the Australian context where there are assets transferred, to which no consideration is allocated, is that either:

• on the construction of the contract, it must be seen that the consideration allocated was in fact consideration for all relevant assets, so that where necessary the consideration is to be apportioned under section 116-40; or
• the conclusion is likely to follow that no capital proceeds (in the form of money or property) have been received from the CGT event occurring in relation to the relevant CGT asset, with the consequence that the market value substitution rule will apply to that asset.

There is obviously a very great difference between these two outcomes. In the former, the consideration agreed between the parties would merely be reallocated across the relevant assets where necessary. In the latter, the consideration would effectively be increased by the market value of the asset to which no consideration had been allocated. In practice, I suspect that it would be a rare situation in which parties who had dealt at arm's length will be found not to have intended that consideration in an agreement was to relate to all relevant assets. Consequently, at least where parties were dealing at arm's length, one would expect that where necessary the appropriate course would be to reallocate the consideration across all relevant assets where necessary, rather than apply the market value substitution rule.

For further information, please contact:

• Grant CathroPartner, Melbourne
  Ph: +61 3 9613 8644
  Grant.Cathro@aar.com.au
• Charles ArmitagePartner, Sydney
  Ph: +61 2 9230 4756
  Charles.Armitage@aar.com.au