What are the market substitution rules?
The market substitution rules are a set of provisions in the Australian capital gains tax (CGT) legislation that aim to prevent taxpayers from manipulating the capital proceeds from a CGT event. A CGT event is any transaction or occurrence that results in a capital gain or loss, such as selling an asset, receiving a gift, or transferring a property.
The market substitution rules apply when the capital proceeds from a CGT event are more or less than the market value of the asset involved, and the parties did not deal with each other at arm’s length in connection with the event. In such cases, the capital proceeds are replaced with the market value of the asset, which is determined by a hypothetical scenario of a willing but not anxious seller and buyer, both perfectly acquainted with the asset and acting independently.
The market substitution rules are designed to ensure that taxpayers pay the appropriate amount of tax on their capital gains or losses, and do not understate or overstate their proceeds by colluding with related parties or taking advantage of special circumstances.
What does it mean to deal at arm’s length?
Dealing at arm’s length means that the parties to a transaction act in their own best interests, without any influence or pressure from each other, and negotiate on a fair and reasonable basis. The opposite of dealing at arm’s length is dealing not at arm’s length, which means that the parties have a connection or relationship that affects their dealings, such as being family members, business partners, or associates.
Whether the parties deal at arm’s length or not depends on the facts and circumstances of each case and is not determined by the mere existence or absence of a connection or relationship. The key question is whether the parties acted separately and independently in forming their bargain, or whether they colluded or compromised to achieve a certain outcome.
Some indicators of dealing not at arm’s length include:
- The capital proceeds are significantly different from the market value of the asset
- The parties agree on a price without any real bargaining or negotiation
- The parties have a common interest or benefit from the transaction
- The parties are influenced or controlled by a third party
- The transaction is not commercially realistic or rational
How does the market value of an asset include special value?
The market value of an asset is the price that would be agreed upon by a willing seller and buyer in an open and competitive market, with full knowledge of the asset and its potential uses. The market value of an asset may include any special value that a particular buyer may attribute to the asset, based on their own circumstances, preferences, or expectations.
For example, a buyer may be willing to pay more for an asset if they can use it to generate synergies with their existing business, or if they can exploit a unique opportunity or advantage that the asset offers. This special value is part of the market value of the asset, as it reflects the demand and supply of the asset in the market.
The market value of an asset does not include any special value that the seller may attribute to the asset, based on their own sentimental attachment, personal enjoyment, or subjective opinion. This special value is not part of the market value of the asset, as it does not reflect the objective reality of the market.
What are some recent cases on the market substitution rules?
The market substitution rules have been the subject of several recent court cases, where taxpayers have challenged the assessments of the Commissioner of Taxation on their CGT liabilities. Two notable cases are:
- Moloney & Ors v FC of T 2024 ATC ¶10-726 [2024] AATA 1483, where the Tribunal found that although the parties were related and therefore not at arm’s length, they were nevertheless dealing at arm’s length in that they had relied on an independent valuation to arrive at a price. The Tribunal accepted the taxpayers’ valuation of the shares, which resulted in them being able to access the small business CGT concessions,
- Kilgour & Ors v FC of T 2024 ATC ¶20-919; [2024] FCA 687, where the Federal Court found that the taxpayers dealt at arm’s length with News Corp in selling their shares in an online social platform, and rejected the taxpayers’ argument that the market value of the shares was lower than the actual consideration, due to the special value that News Corp placed on the platform.
These cases illustrate the complexity and uncertainty involved in applying the market substitution rules, and the importance of obtaining professional advice and reliable valuations when dealing with CGT events.
Author: Darren O’Malley – Head of the Taxation division of Kreston Stanley Williamson
*Correct as of 29 July 2024
*Disclaimer – Kreston Stanley Williamson has produced this article to serve its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas in this article, you must seek advice about your circumstances. Liability is limited by a scheme approved under professional standards legislation.
