Capital gains everywhere in settlement of actions

Senior Member Lindsay of the Administrative Appeals Tribunal (the “AAT”) has held in AAT Case [2005] AATA 72, Re G Cassegrain & Co Pty Ltd and C of T that a $9.5 million settlement payment made to the taxpayer, a family company, was assessable as a capital gain. The case raises some intricate and fundamental issues of the operation of the CGT in the context of settlement of actions. 

Facts

The main facts may be summarised as follows:

• The taxpayer was a family company called G Cassegrain & Co Pty Ltd (“GCC”). The father and sons of the family controlled the company.
• GCC operated, inter alia, a winery in the Hastings district of New South Wales.
• In May 1987, GCC and CSIRO had discussions on the possible application of a soil improvement technology that CSIRO had been developing (known as slotting), to land that GCC proposed to develop for vineyards. In July 1987, GCC and CSIRO entered into a written agreement for the conduct of research and development concerning slotting and associated activities.
• Claude Cassegrain, one of the sons of the family became concerned that CSIRO was not giving proper recognition to contributions that had been made to the joint venture between GCC and CSIRO.
• GCC sued CSIRO for breach of its obligations under their agreement and in 1993 a settlement was reached with CSIRO agreeing to pay $9.5 million under a Deed of Settlement which as is normal was expressed to cover all possible liabilities to each other of the parties to the deed. GCC and Claude Cassegrain were parties to the Deed and the settlement amount was to be paid to them jointly or at their direction. The amount was in fact paid to GCC. During the settlement negotiations the possibility of an action for defamation by Claude was raised but was not mentioned in the Deed. Prior to the execution of the Deed, GCC resolved that $4.25million was in respect of personal damages payable to Claude. CSIRO refused to include this apportionment in the Deed but insisted that Claude be a party to it. The Deed did effect some apportionment as it allocated specific amounts totalling some $650,000 to various matters such as certain technologies developed in the joint venture and machinery.
• GCC’s return for the 1994 income year disclosed only $5.25 million of the settlement sum as assessable income. The Commissioner of Taxation (the “Commissioner”) issued an amended assessment that the entire settlement amount was ordinary income and/or consideration in respect of the disposal of an asset giving rise to a capital gain.
• The taxpayer objected to the assessment and was unsuccessful. The taxpayer appealed to the AAT.

Issues

The question before the AAT was whether the Commissioner’s assessment to include the entire settlement payment of $9.5 million as a capital gain to the GCC in terms of s160M(3)(b) (which effectively treats a release of GCC’s rights as a disposal of the right) of the Income Tax Assessment Act 1936 (Cth) (the “1936 Act”) as consideration received for the surrender of rights was correct. In this regard, it should be noted that the GCC and the Commissioner had agreed that the settlement sum was not ordinary income in character.

GCC argued that a portion of the payment was an exempt defamation payment under s.160ZB of the 1936 Act or that GCC and Claude had received the payment jointly in respect of the disposal of their jointly owned property (in which event the $9.5m settlement amount would be evenly divided between them rather than $4.25m to Claude and $5.25M to GCC).

Decision

The AAT held that the entire $9.5 million was assessable as a capital gain to GCC. The alternative grounds upon which they based this finding were that the:

• compensation was not received jointly in respect of jointly owned property;
• the agreement in the resolution of GCC to apportion part of the settlement payment to Claude for defamation was a ‘sham;’ and
• assuming that the apportionment was legally effective, s160M(6) would apply to the agreement between GCC and Claude in the resolution to apportion the settlement in the amount of $4.25m allocated to Claude.

The reasoning for each of these grounds is discussed in detail respectively below.

Reasoning

Joint property

The taxpayer submitted that, as a result of the agreement to apportion the settlement sum, GCC and Claude jointly received the amount of $9.5 million. As such, it was argued that the joint receipt did not result in a capital gain accruing to each party in respect of the entire joint sum because the effect of s160ZN(1)(a) of the 1936 Act is to allow the joint consideration to be divided equally between the joint recipients. That is, it was argued that both GCC and Claude received half. The taxpayer submitted that this argument conformed with the analysis by Beaumont J in FCT v. McDonald 87 ATC 4541 (“McDonald”).

It was noted by the AAT that the decision in McDonald turned on the nature of the definition of partnership under s6 of the 1936 Act. In that case, Beaumont J had found that there was a receipt of income jointly from investment properties. There was a derivation of income and incurrence of loss by a tax law partnership. The AAT considered that the amount received by GCC and Claude Cassegrain was not a receipt of income and McDonald was distinguished on that basis.

The AAT applied property law to negative the application of s160ZN on the basis that:

“in circumstances where persons make unequal contributions to the acquisition of an asset, there being no presumption of advancement, a resulting trust is presumed for them as tenants in common in proportion to the value of their contributions”.

Although the AAT did not expressly say so, it seems s160ZN did not apply because the result was a tenancy in common not joint ownership. There was no real evidence establishing the existence or value of a defamation claim by Claude (in fact no such action was ever commenced). Therefore, the AAT held that it was reasonable to attribute the entire $9.5 million of the disposal consideration to the share of the rights given up by GCC pursuant to s160ZD(4). In this regard, s160ZD(4) provides that:

“Where any consideration paid or given in respect of a transaction relates in part only to the disposal of a particular asset, so much of that consideration as may reasonably be attributed to the disposal of the asset shall be taken to relate to the disposal of the asset.”

The cost base of these rights was held to be nil given that the acquisition costs were either not capital in nature or would be double counted. That is, GCC had claimed deductions for most of its expenses incurred in the joint venture. Therefore, a capital gain of $9.5 million accrued to GCC under s160Z.  

Sham

The Commissioner contended that the purported agreement in the resolution of GCC was a sham. In this regard, a sham is:

“…an expression which has a well-understood legal meaning. It refers to steps which take the form of a legally effective transaction but which the parties intend should not have the apparent, or any, legal consequences (Equuscorp Pty Ltd and Anor v. Glengallan Investments Pty Ltd (2004) 211 ALR 101 at 111)”.

The Commissioner adopted and relied on the findings in Davies J’s judgments in Cassegrain v. Cassegrain [1998] 811 FCA (“Cassegrain case”) which was an oppression suit brought by some of Claude’s family against him. Davies J gave a declaration in that case that Claude, in treating the $4.25 million loan account with GCC as his entitlement to be drawn down at will, was oppressive of and unfairly prejudicial to the members of GCC.

In response to the Commissioner’s contention, the taxpayer argued that the judgment of Davies J (noted above) did not support an argument based on sham. It was submitted that Davies J would have declared a trust in respect of the $4.25 million.

The AAT held that the agreement was a sham. The main findings of the AAT in supporting its conclusion, at paragraph 46, are as follows:

• the resolution was not intended to confer on Claude beneficial entitlement to the sum of $4.25 million. Rather the intention was to maximise the after tax amount of the settlement sum. Both Claude and his father were aware of GCC’s “delicate position” with its bank. The bank was threatening receivership. The intention of the father and Claude was to reduce the level of tax on the settlement sum, so that as much as possible would be available to be paid to its bank;
• the evidence showed that Claude considered GCC to be his “alter ego” and treated GCC’s interest in the joint venture as more or less held in trust for Claude to do as he wished. As such, at the time of the agreement to make the apportionment, the AAT considered that there was no true independent bargaining between him and his father. That is, the AAT considered that the parties intended to exploit the tax advantage available to damages for defamation or other personal injury;
• there was no real relationship between the amounts agreed and any reasonable entitlement of GCC and Claude respectively; and  
• that in the Cassegrain case, Davies J had found that the family members did not regard the $4.25 million as Claude’s, despite the outward appearance of it in the letter dated 6 July 1993 which purported to divide the $9.5 million settlement between GCC and Claude.

Capital gain under s160M(6)

As an alternative to the sham argument above and assuming that the resolution of GCC was legally binding, the AAT found that s160M(6) of the 1936 Act would apply to the agreement to apportion the amount between GCC and Claude. In this regard, s160M(6) provides that:

(6) Subject to this Part (other than subsection (7) of this section), if:

(a) a person creates an asset that is not a form of corporeal property; and

(b) on its creation, the asset is vested in another person;

then subsections (6A) and (6B) apply.

 (6A) If subsection (6) applies:

(a) the person creating the asset is taken to have acquired, and to have commenced to own, the asset at the time applicable under subparagraph 160U (6)(a) (ii) or (b) (ii); and

(b) the person creating the asset is later taken to have disposed of the asset to the other person mentioned in paragraph (6) (b) of this section at the time applicable under subparagraph 160U (6) (a) (iii) or (b) (iii); and

(c) the person so taken to dispose of the asset is taken not to have paid or given any consideration, or incurred any costs or expenditure, referred to in any of paragraphs 160ZH (1) (a) to (d) (inclusive), (2) (a) to (d) (inclusive) and (3) (a) to (d) (inclusive) in respect of the asset; and

(d) paragraph 160ZD (2) (a) does not apply to that disposal of the asset.

In relation to the application of the above section, the AAT held that:

• section 160M(6)(a) was satisfied as CSIRO was prepared to pay $9.5 million to GCC, but Claude had to be a party to any settlement. The apportionment agreement vested an incorporeal asset in Claude (i.e. his entitlement to $4.25 million of the $9.5 million settlement sum); and
• section 160M(6)(b) was satisfied as GCC created an asset (as defined under s160A) that vested (as defined under s160M(6D) in Claude, enforceable against GCC, for payment of $4.25 million of the total $9.5 million. 

Accordingly, s160M(6A) deemed GCC to have disposed of the created asset at the time that it vested in Claude. The cost base of the asset for GCC was nil (see s160M(6A)(c)).

In relation to s160M(6A)(d) concerning the consideration for the disposal of the asset vested in Claude, the AAT held that Claude and his father were not acting at arm’s length in connection with the apportionment agreement. In this regard, the AAT referred to Hill J in A.W Furse No 5 Will Trust v. Commissioner of Taxation 91 ATC 4007 in determining whether persons are dealing with each other at arm’s length. Hill J stated, at 4014-5, that:

“What is required in determining whether 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.”

The AAT held that the context of their dealing was such that there was no independent bargaining positions on the part of GCC and Claude. The AAT considered that on balance, the evidence showed that Claude and his father were acting in concert and not at arm’s length (paragraph 53). Therefore, GCC was deemed to have received the market value of the right (i.e. $4.25 million). As such, a capital gain of $4.25 million accrued to GCC on disposal of the created asset vested in Claude.

Discussion

Joint property

On the argument about joint ownership, the AAT reasoning means that s160ZN (now s108-7 of the Income Tax Assessment Act 1997 (the “1997 Act”)) will often not apply where it otherwise seems to. While as the AAT noted it would be an absurd result here to accept that half of the settlement amount belonged to Claude, the use of a resulting trust to reach that result means that consideration also needs to be given to the CGT treatment of trusts which is a very thorny issue. The AAT conveniently ignores this problem.

Of greater difficulty is the comment that double counting requires that deductible costs be excluded from the cost base of GCC’s assets because they had been deducted. At the relevant time, there were no double counting rules for the first element of the cost base (these were introduced in 1997) so it is not clear why this should be so. Further it is not made clear in the decision what the relevant assets of GCC are that have been disposed of.

In Ruling TR 95/35, the Commissioner makes three important points relevant to the current case. First, a distinction is drawn between amounts arising under settlements in relation to underlying assets and amounts arising in relation to the right to sue. If the amount received relates in whole or part to the former, then those assets are treated as disposed of and their cost base will be used in calculating the amount of the gain. Secondly, if there are several assets in question, then the Commissioner will usually accept the apportionment adopted by the parties. Thirdly, if there is a potential CGT exemption (eg in relation to defamation actions), the Commissioner will only accept that the exemption is attracted if an amount is allocated to the exempt situation by the parties and consideration in respect of the disposal is allocated to those assets.

Applying those principles here, the parties did allocate some of the proceeds to specific items. As those items arose through considerable expenditures on the part of GCC (albeit that they were deducted), a capital loss may have arisen on those assets. So far as the rest of the settlement amount was concerned, it would be allocated to the right to sue and as no amount was allocated in the agreement to defamation it would all effectively be a capital gain (as there would be little or no cost base in the right to sue).

The analysis in the case generally seems to be based on the right to sue so that the subtlety of the analysis in TR 95/35 (which is not mentioned in the decision) is not canvassed.

Sham

There was considerable evidence to support the sham finding arising out of the corporate litigation involving GCC that occurred several years before. Normally it is difficult for the Commissioner to find this kind of evidence concerning private discussions within families which means that the sham argument usually fails.

Capital gain under s160M(6)

The finding that there was a capital gain under s160M(6) is expressed in the alternative. It is apparently an alternative to the sham argument and the decision does not make clear how it relates to the first finding that GCC made a capital gain under the Deed of Settlement through s160M(3)(b). As the Commissioner was only seeking tax on the $9.5m settlement once, the issue of potential double taxation was not expressly dealt with. Section 160M(6) is applied after other disposal events in the 1936 Act (likewise Event D1 in the 1997 Act) which at first sight seems to be the answer to the potential double tax problem. However, on closer examination the Tribunal seems to have found that the s160M(6) gain arose under the “side agreement” between GCC and Claude. The s160M(3)(b) gain arose under the Deed of Settlement which is a different transaction so that its application does not seem to exclude s160M(6).

Accordingly the reasoning of the AAT is of concern. Under the 1997 Act it would seem that there would be no deemed market value capital proceeds. The reasoning for this conclusion is that capital proceeds is defined to cover money or property received. No money or property was received by GCC in relation to the side agreement and accordingly the market value substitution rules need to be examined. As no proceeds were received the non-arm’s length rule in s116-30(2)(b) (equivalent to the 1936 Act rule applied by the AAT) does not apply as it requires that there be capital proceeds. Nor does the rule in s116-30(1) apply because it is not applicable to CGT Event D1 under s116-30(3). It is considered that the same result should follow under the 1936 Act.