how to maximise cgt cost bases

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How to Maximise CGT Cost Bases

by Gordon Thring, Coopers & Lybrand

Released March 1998

1.0 Overview

The "cost base" of an asset forms a fundamental step in determining whether a taxpayer has derived a capitalgain or incurred a capital loss following the disposal of an asset. In its simplest form a taxable gain is calculatedas the difference between the amount you receive upon disposal ("disposal consideration") and the cost to you ofthe asset ("cost base"), indexed for inflation. Similarly a capital loss is calculated as the difference between theamount you paid ("cost base") and the amount you receive upon disposal ("disposal consideration").

In determining the amount of a capital gain or capital loss, section 160Z of the Income Tax Assessment Act1936 ("the 1936 Act") requires the taxpayer to compare the consideration received on the disposal of an assetwith the asset's cost base. Generally, a capital gain will arise where the disposal consideration exceeds the "costbase" (or "indexed cost base" where the asset was held for greater than 12 months). Alternatively, a capital losswill arise where the "reduced cost base" exceeds the disposal consideration.

1.1 Cost base: components

For CGT purposes an asset's cost generally comprises of expenditure incurred at the time of acquisition,throughout the period of ownership and at the time of disposal.

Section 160ZH(1) of the 1936 Act defines the term "cost base" as the sum of the following components:

(a) the amount of any consideration in respect of the acquisition of the asset;

(b) the amount of the incidental costs to the taxpayer of the acquisition of the asset;

(ba) the amount of the noncapital costs to the taxpayer of the of ownership of the asset (exceptwhere the asset is a personal use asset of the taxpayer);

(c) the amount of any expenditure of a capital nature incurred by the taxpayer to the extent towhich it was incurred for the purpose of enhancing the value of the asset and is reflected in the stateor nature of the asset at the time of disposal of the asset;

(d) the amount of any expenditure of a capital nature incurred by the taxpayer to the extent towhich it was incurred in establishing, preserving or defending the taxpayer's title to, or a right over,the asset; and

(e) the amount of the incidental costs to the taxpayer of the disposal of the asset.

Note that section 160ZH does not require the relevant expenditure to be capital expenditure (though often it willbe).

Each of the above components are considered below.

(i) Acquisition consideration

Commonly, the principal component of an asset's cost base is "the consideration in respect of the acquisition ofan asset", ie the acquisition consideration. Section 160ZH(4) of the Act defines this component as comprising of:

any amount or amounts of monies which the taxpayer has paid or is required to pay in respect of theacquisition of the asset; and/orthe market value of any property which the taxpayer has given or is required to give in respect of theacquisition of the asset.

It should first be noted that "consideration" for CGT purposes is not the contract law "consideration". It is anarrower concept of "money" or "property". In this respect "a contractual promise", which is contract lawconsideration is unlikely to be "property", and hence consideration for section 160ZH purposes see TaxationRuling TR 95/3, para 104 to 108.By virtue of section 160ZK(4), where a taxpayer is required to pay money or give



property, it includes a requirement to pay money or give property immediately or at a future date and in the caseof money, either in a lump sum or by instalments. Accordingly, the acquisition consideration will include allamounts payable in respect of the acquisition of the asset, without any discount for the time value of money. Thismatter is considered in further detail under the heading Timing of acquisition.

An issue also arises in relation to the requirement that the taxpayer has given or is required to give property. Forinstance is the issue of shares by the purchaser company to the vendor in exchange for assets the "giving" ofproperty, even though the shares were never owned by the purchaser? Similarly is the forgiveness of a debt owedby the vendor to the purchaser a "giving" of property when the property is being extinguished? Does it matter if adebt is first created and then satisfied by the share issue or debt forgiveness?

Where a taxpayer acquires an asset which is subject to a security (eg a mortgage), section 160S(2) of the Actrequires that the full amount of the liability assumed form part of the consideration for the acquisition of the assetby that person. For example, where a person acquires an asset for $100,000, and also assumes a liability of$50,000 (eg a mortgage), the total acquisition consideration would be $150,000.

Where an asset is constructed or created by the taxpayer the Commissioner, in Taxation Determination TD 60, isof the opinion that no amount can be imputed for the value of the owner's labour.

Acquisition consideration deemed market value

In certain instances the acquisition consideration will be deemed, under section 160ZH(9), to equal the marketvalue of that asset, being where :

(a) There is no consideration

Section 160ZH(9)(a) states that in determining the cost base of an asset, a taxpayer will be deemed to have paidor given consideration equal to the market value of the asset if the taxpayer acquires the asset from anotherperson and does not pay or give any consideration in respect of the acquisition.

There is some doubt as to whether a covenant or undertaking provided by the person in respect of the acquisitionof an asset would amount to consideration. We understand however that the ATO are of the opinion that the term"consideration", in the context of section 160ZH(9)(a), should be limited to "money and other property", and assuch would not extend to include a covenant or undertaking.

(b) The consideration cannot be valued

In determining the cost base of an asset, under section 160ZH(9)(b) a taxpayer will be deemed to have paid orgiven consideration equal to the market value of the asset, if the whole or part of the consideration "cannot bevalued". However, it is felt that it will only be in extremely rare cases that a court would hold that property cannotbe valued. Situations where valuation is not possible may include promises of future services or recognition of pastservices (assuming these are property).

(c) The consideration is excessive or inadequate and the parties are not acting at arms length

Section 160ZH(9)(c) states that a taxpayer will be deemed to have paid or given consideration equal to the marketvalue of the asset if :

the consideration paid or given in respect of the acquisition is greater or (if it is a disposal by anotherperson) less than the market value of the asset at the time of acquisition.the taxpayer and the vendor were not dealing with each other at arm's length in connection with theacquisition.

The pivotal question to be considered in determining whether market value will be deemed under section 160ZH(9)(c) is whether the parties were acting with each other at arm's length in connection with the acquisition.

In Granby v FCT ATC 4240, Lee J of the Federal Court stated (at p 4243) that "the operation of sec 160ZH(9)(c)does not depend on the consideration paid or given being greater, or less, than market value alone. It is necessaryto show that the transaction under which the consideration is paid or given was not conducted by parties dealingwith each other at arm's length''.

It is important to remember that there are two requirements in section 160ZH(9)(c) nonmarket valueconsideration given and nonarms length dealing in relation to the asset disposal. In practice some people



assume that an acquisition at a clearly nonmarket value automatically triggers section 160ZH(9)(c) (and thedisposal consideration equivalent section 160ZD2(c)). This is not the case. A donation of property to a charity is asimple example. Clearly the property was disposed of at less than market value. Despite this it is felt that theparties (the charity and the donor) would normally be considered to be dealing at arms length in relation to thedisposal (ie the donation).

The other point to recognise is that section 160ZH(9)(c) requires that there is non arms length dealing in relationto the acquisition of the asset. Hence, a deal involving several transactions may, from a overall perspective be atarms length with the total consideration between the parties equal to market value, however section 160ZH(9) maystill apply if one part of the deal involves an acquisition of an asset for consideration which is not equal to marketvalue. This may arise where another part of the overall deal is also not at market value, thus "balancing" the totalconsideration at market value (ie. a "collateral transaction").

Barnsdall v FCT 88 ATC 4565 confirms the proposition that nonarm's length parties may nevertheless be dealingwith each other at arm's length in connection with an acquisition. Although the onus would be on the purchaser toestablish that the dealings were at arm's length, particularly if it were not at market value. Correspondingly, thefact that the parties' normal relationship is at arm's length does not mean that they were dealing with other atarm's length in connection with a particular acquisition.

The Commissioner, in Taxation Determination TD 12, considers that where a leased asset is purchased by thelessee at its residual value, the lessor and lessee will generally be dealing with each other at arm's length inconnection with the acquisition. This was the view taken by the Federal Court in Granby's case.

(ii) Incidental costs of acquisition and disposal

Incidental costs incurred by the taxpayer in connection with the acquisition and/or disposal of the asset areincluded in the asset's cost base. The term "incidental costs" is exhaustively (and restrictively) defined by the Actas being :

(a) fees, commission or remuneration for the professional services of a surveyor, valuer,auctioneer, accountant, broker, agent, consultant or legal adviser;

(b) costs of transfer, including stamp duty or other similar duty;

(c) costs of advertising to find a seller or buyer; or

(d) costs in relation to the making of any valuation or apportionment for CGT purposes;

However, "incidental costs" do not include amounts which have been allowed or are allowable as a deduction tothe taxpayer.

The Commissioner, in Taxation Determination TD 23, states that expenditure incurred subsequent to the disposalof an asset may qualify as "incidental costs" of the disposal and be included in the cost base of the asset.

Expenditure incurred in relation to taxation advice provided by a professional tax adviser in relation to theacquisition or disposal of an asset is an "incidental costs", however only to the extent that it was incurred after 1July 1989.

(iii) Noncapital costs of ownership

An asset's cost base (excluding personal use assets) includes certain costs of ownership, provided they are notcapital in nature. These "noncapital costs of ownership" are defined as being:

interest incurred on a loan taken out to finance the acquisition of the asset;expenditure on repairs to, or maintenance of, the asset;premiums to insure the asset; andrates or land tax (where applicable).

Notwithstanding the fact that interest incurred on a loan taken out to finance the acquisition of an asset is eligible,the Commissioner in Taxation Determination 93/1 excludes any related borrowing costs.

The "noncapital costs of ownership" do not include amounts which have been allowed or are allowable as adeduction to the taxpayer. Generally, where the asset is used for income producing activities, expenditure suchas interest, insurance premiums, repairs and rates are likely to be deductible, and as such will not be included in



the cost base.

Note that although "noncapital costs of ownership" are included in the indexed cost base, they are notthemselves indexed. Further, these costs are not included in the reduced cost base and as such are not takeninto account in calculating a capital loss.

The difficulty with this provision has been highlighted by the decision in Steele v FC of T 97 ATC 4239 ("Steele'scase"). In certain situations interest and other costs of ownership such as repairs, rates and taxes may not bedeductible because (amongst other factors) they are of a capital nature (as in Steele's case; Wharf Properties Ltdv Commr of IR (Hong Kong) 97 ATC 4225). Such expenses are therefore not only nondeductible, but also because they are capital strictly speaking, cannot be taken into account in determining the cost base under sec160ZH(6A).

(iv) Enhancement Expenditure

Expenditure of a capital nature which is incurred by the taxpayer for the purpose of enhancing the value of theasset and is reflected in the state or nature of the asset at the time of disposal of the asset is also included in thecost base of an asset.

In relation to the first condition, there is considerable uncertainty as to how the reference to "purpose" should beinterpreted. The preferable view would be that it is the result desired to be achieved which should be considered.That is, if the result to be achieved by the expenditure is an enhancement in value then it forms part of the costbase of the asset irrespective of the motives for incurring the expenditure. Although in many instances it will beclear whether the requisite purpose exists, this will not always be the case.

In relation to the second condition, the expenditure must be reflected in the state or nature of the asset, and not inits value. Therefore, expenditure incurred on an improvement which, notwithstanding the taxpayer's intentions, hasin fact resulted in a decline in the asset's value, may nevertheless be included in the cost base where thatimprovement is reflected in the state or nature of the asset.

On the other hand, where expenditure is no longer reflected in the state or nature of the asset, that expenditurewould not be included in the asset's cost base. For instance a expenditure incurred in repairing a building wouldnot qualify for inclusion in the asset's cost base where subsequent repairs have erased the physical effects of theearlier expenditure.

One area in which there is uncertainty as to whether they amount to enhancement expenditure is demolitionexpenditure. For instance expenditure incurred in demolishing a building to allow for the construction of a newbuilding may not satisfy the requisite purpose as it may not be clear whether the purpose of the demolition was toenhance the value of the asset (rather it was to enable the construction of a new building). Further, following theconstruction of the new building a question arises whether the demolition costs represent an enhancementreflected in the nature of the asset on disposal. However, where land is simply cleared of an existing building andis sold in the cleared state, it may be possible to argue that the purpose of the demolition costs was to enhancethe value of the land and that the demolition costs do represent an enhancement in the state of the land.

(v) Expenditure relating to establishing, preserving or defending title

Expenditure of a capital nature incurred by the taxpayer to the extent to which it was incurred in establishing,preserving or defending the taxpayer's title to, or a right over, the asset will be included in the cost base of theasset.

Typically, expenditure which would qualify within this heading would be legal costs incurred in "establishing,preserving or defending" the taxpayer's title. For instance, in Broken Hill Theatres Pty Limited v FCT (1952) 85CLR 423 legal costs incurred by a motion picture operator in opposing a potential competitor's application for alicence were considered to be of a capital nature and may have fallen within this category.

1.2 Types of cost base

In calculating a capital gain or loss, the CGT provisions refer to three types of cost base, being:

ordinary cost base which is generally used to calculate a capital gain where the taxpayer disposes of theasset within 12 months of acquisition;indexed cost base which is generally used to calculate a capital gain where the taxpayer disposes of theasset 12 months or more after the date of acquisition; and



reduced cost base which is used to calculate a capital loss.

In calculating the indexed cost base of an asset, each of the elements discussed above (other than noncapitalcosts of ownership) may be indexed by the indexation factor. The indexation factor is determined in accordancewith the following formula (rounded to three decimal places):

CPI Index number for the quarter of year

in which asset disposed of

CPI Index number for the quarter of year

in which liability to pay consideration arise

or expenditure incurred

The reduced cost base is basically the cost base of the asset, with the following adjustments :

noncapital costs of ownership are not to be included;the cost base is reduced by :amounts that have been allowed or are allowable (or would be allowable but for apportionment undersection 61), as a deduction to the taxpayer in respect of any year of income; andamounts that are included in the taxpayer's assessable income on disposal (eg depreciation balancingcharge).

1.3 Record keeping requirements

Section 160ZZU of the 1936 Act requires a person who has, at any time after 19 September 1985, owned anasset to keep such records as are necessary to enable the ready ascertainment of:

the date on which the asset was acquired;any amount that would, on the disposal of the asset, form part of the cost base of the asset; andwhere the asset has been disposed of, the date of the disposal and the consideration in respect of thedisposal.

Generally, such records must be retained for a period of five years after the date of disposal. The penalty for failureto comply with this section is $3,000.

The record keeping requirements contained in section 160ZZU will not apply to certain "excepted assets" beingassets to which the CGT provisions "did not" or "would not apply". However, the record keeping requirements aretermed in such a way that they may apply to assets which at present are exempt from CGT. For instance acompany holding pre CGT assets may have those assets deemed to be post CGT assets by the operation ofsection 160ZZS. In such a case the record keeping requirements would apply to that asset, possiblyretrospectively.

Given that a taxpayer has the onus to prove that an assessment is excessive, pursuant to section 14ZZK ofthe Taxation Administration Act, the record keeping requirements in section 160ZZU would seem largely irrelevantand in many cases inadequate. For instance, a taxpayer may be required to substantiate the cost base of anasset more than five years after the date the asset was disposed of. For example, a disposal may result in acapital loss which is carried forward and offset against capital gains derived many years after the original disposal.

Taxation Laws Amendment Bill (No 7) 1997

Taxation Laws Amendment Bill (No 7) 1997, which was introduced to Parliament in December 1997, containsamendments to CGT record keeping requirements. The Bill will allow taxpayers to use an asset register instead ofsource documents for CGT recordkeeping purposes. The amendments will apply to all assets, whether acquiredbefore or after the commencement of the new rules. The measure will only apply to entries made in asset registerthat has been "certified" on or after 1 January 1998.

1.4 Cost base : why is maximising it important?

The asset's cost base forms a pivotal consideration in determining whether a taxpayer has derived a capital gainor incurred a capital loss on the disposal of an asset. Section 160Z of the 1936 Act requires that a taxpayer, incalculating a capital gain or loss on disposal, compare the consideration received with the asset's cost base.



Obviously by maximising the cost base of an asset the taxpayer should be able to effectively minimise anypotential capital gain on disposal, or alternatively maximise the availability of capital losses.

The following strategies could be adopted by a taxpayer in order to maximise the cost base:

the taxpayer needs to ensure that all amounts allowed under section 160ZH are included in the cost base.In this regard the taxpayer should maintain sufficient records of the acquisition consideration and allowableexpenditure;the taxpayer should be aware of the impact of situations which may erode the cost base, such as thetransfer of capital losses between group companies;transactions need to be structured effectively, with particular regard had to the funding mix (debt v equity)and the choice of investment vehicle;amounts payable.

These strategies are considered throughout the paper and in particular under the heading "Tax Planning".

2.0 Implication of Steele's case

The decision of the Full Federal Court, in Steele v FCT 96 ATC 4131 ("Steele's case"), raises serious doubts overthe deductibility of holding and interest costs incurred prior to a property becoming income producing.

Steele's case (and other similar cases such as Temelli and Wharf Properties) have implications for determiningthe cost base of an asset. Prior to Steele's case it was generally accepted that interest expenditure would benoncapital and therefore would, if denied deductibility, fall within the "noncapital cost of ownership" category andbe included in an asset's cost base. Steele's case, however, suggests that interest may in certain circumstancesbe capital in nature and therefore, not only denied a deduction but also excluded from the asset's cost base.

Steele's case involved a taxpayer who on 18 December 1980 acquired a tract of rural land using borrowed fundswith the stated intention of developing a motel and townhouse complex. Various works were undertaken by thetaxpayer in pursuance of the development project including obtaining plumbing and engineering reports andnegotiating with architects and a construction company. In early 1982 the taxpayer sold a half interest in the landto the construction company, entering into a joint venture agreement with the construction company in relation tothe development of the motel and townhouse complex.

The joint venture arrangements did not run smoothly, and despite the taxpayer's original intention and the worksundertaken, the land was finally sold without any development proceeding. During the seven years of ownershipthe taxpayer used the land for agistment producing minor income. The taxpayer claimed a deduction for interestincurred on the funds borrowed to acquire the land.

The majority of the Full Federal court in Steele's case denied the taxpayer a deduction for interest on the basisthat the interest was incurred on capital account. Their Honours concluded that the character of the advantagesought by the taxpayer in making payments of interest was the creation of a capital asset, and notwithstandingthe fact that the interest was a recurrent expense, it was of a capital nature. Their Honours said:

"When Dixon J, in the often cited passage in The Texas Company at ATD 356; CLR 468469,spoke of the way the Australian system treats interest on money borrowed to secure capital, he wasspeak ing in the context of current incomegaining activities. He regarded interest payments as partof "the recurrent expenditure which must be incurred to obtain the use of the money", and as likeother regular outgoings of the business incurred to obtain the use of capital assets, such as rent orhire. If the matter be looked at in this context, and in this way, as Bowen CJ and Burchett J pointedout in the passage cited from Australian National Hotels, interest payments may be seen to secureno enduring advantage. Like rent, they secure merely the use of the capital itself, or of premisesrepresenting it, from day to day. But interest paid in relation to the acquisition or creation of acapital asset, which is later to be utilised in incomegaining activities, is in an entirely differentposition. It is paid so that, when the time comes, an enduring asset (in this case, a motel complex)will be available for use in the intended activity. The fact that, while the capital asset is beingcreated, the payments of interest are recurrent is not enough to change this conclusion. Thosepayments are not part of the recurrent operations of any existing business activity."

If a taxpayer is to be denied an interest deduction in respect of interest on borrowings used to acquire aninvestment it might be expected that the interest would form part of the cost base for capital gains tax purposes.However, in light of the decision in Steele's case the disallowed interest is unlikely to form part of the asset costbase.



By reference to section 160ZH(1), the interest expense does not appear to fall into any of the defined categoriesforming part of the cost base. Typically nondeductible interest expenditure would be included in an asset's costbase under section 160ZH(2)(ba). This section was introduced in 1991 to specifically include within an asset'scost base nondeductible interest on a loan taken out to finance the acquisition of an asset. However, interestwhich is of a capital nature will not be within section 160ZH(2)(ba) and therefore will not be eligible for inclusion inthe cost base. This is because section 160ZH(2)(ba) refers to noncapital costs. Therefore the only possibilitywould be section 160ZH(1)(c) which refers to expenditure of a capital nature, but requires its purpose to enhancethe value of the asset. In the case of interest expense, it probably does not enhance the value of the underlyingland.

The scope of the doubts raised by Steele's case are not clear. Applying the reasoning contained inSteele's case itis possible that a deduction for interest could be denied even where the taxpayer carries on a continuing businessif the asset is not currently employed in an incomeproducing activity. An example would be costs incurred inrelation to the extension or construction of buildings for use as part of manufacturing or warehousing operations.

The Commissioner of Taxation released a Draft Taxation Ruling TR 97/D18 in October 1997 which seeks toaddress the issues arising out of Steele's case. At this stage however, the Commissioner's views are onlypreliminary as the taxpayer in Steele's case has sought special leave to appeal to the High Court.

The Commissioner states that should interest, incurred in the circumstances in Steele's case, be ultimatelyconsidered capital in nature (contrary to the view expressed in the ruling), such interest would not form part of thecost base under section 160ZH. The Commissioner however acknowledges that section 160ZH(1)(ba) rests on theassumption that interest is inherently a noncapital expense.

However, the Commissioner takes the view that interest cannot be at the same time a loss or outgoing incurred ingaining assessable income and capital in nature. Therefore, where interest expenditure has satisfied the positivelimbs of the deductibility test, it will not be denied a deduction on the basis that it is an affair of capital.

Therefore, in light of the Commissioner's view that interest expenditure will rarely be capital, the Commissionerhas adopted a concessional approach to determining whether interest expenditure should form part of an asset'scost base. This is reflected by the following extract from TR 97/D18:

"In the meantime, nondeductible interest that would otherwise have been included in the cost baseof an asset because of the operation of paragraph 160ZH(1)(ba) and subsection 160ZH(6A) maycontinue to be so included until it is finally decided whether such interest is capital in nature."

This position may change once the issues in Steele's case have been finalised (ie special leave to appeal to theHigh Court is refused or the High Court hears the appeal). Should the Federal Court decision stand or be affirmedby the High Court, then not only would the interest expenditure be nondeductible, but may also be ineligible forinclusion in the cost base of the asset.

3.0 Indexation : Timing of acquisition / expenditure

Where an asset has been held for a period of more than 12 months, leaving aside the circumstances where acapital loss is incurred, it is necessary to index the cost base for the purposes of calculating a capital gain. Theindexed cost base of an asset is generally calculated by multiplying the various components of the cost base bythe indexation factor. The indexation factor is determined in accordance with the following formula (rounded tothree decimal places):

CPI Index number for the quarter of year in which asset disposed of

CPI Index number for the quarter of year in which liability to pay consideration arise or expenditure incurred

Note that the noncapital costs of ownership, whilst included in the cost base, are not indexed.

A number of strategies can be adopted to ensure that the benefits of indexation are maximised, thus ensuring thata capital gain arising on disposal of an asset is minimised. Broadly, these strategies include:

where possible assets should be held for more than 12 months, thus allowing the taxpayer to take intoaccount indexation in calculating a capital gain;the disposal of an asset should, where possible, be delayed from one quarter to the next, which in a periodof inflation, will result in a greater indexed cost base;acquiring an asset, or incurring expenditure eligible (which is eligible for inclusion in the cost base), should



be brought forward to an earlier quarter thus resulting in indexation applying from an earlier time.

Section 160ZJ of the 1936 Act provides that indexation begins in the quarter of year in which the "liability to pay orgive the consideration arose" or "the costs or expenditure were incurred".

In determining when costs or expenditure is "incurred" the body of case law relevant to section 51(1) may bereferred to. For an amount to have been incurred, it is not necessary for an actual disbursement to have beenmade. If, in the relevant year, the taxpayer is definitively committed, or has completely subjected itself in a legalsense, to the expenditure, it will be incurred (James Flood(1953) 88 CLR 492). Less clear is determining when the"liability to pay consideration arose".

Generally where the consideration is paid by instalment the liability will typically arise at the time of the initialcontract. This is further supported by section 160K(4), which has the effect that where a person is required to paymoney or give property, it includes a person being required to pay money or give property immediately or at afuture date and, in the case of money, either in a lump sum or by instalments. Accordingly, if an asset is acquiredby way of instalments, the asset will have a cost base of the aggregate of the amount of the instalments withoutany discount for the time value of money. Indexation will apply to the whole of the purchase price from the date ofthe contract, notwithstanding that some, or indeed all, of the purchase price remains unpaid.

Where a taxpayer is deemed to have paid or given market value consideration under section 160ZH(9), theconsideration is treated by section 160K(6) as having been paid or given at the time when the asset was acquiredand indexation of the consideration is determined accordingly.

The Commissioner has issued a number of rulings regarding when indexation should begin, including thefollowing:

where an asset is acquired for a lump sum plus an obligation to pay a contingent and unascertainableamount the Commissioner considers that, although the cost base includes any later payment made if andwhen the contingent obligation becomes an actual obligation, indexation of the later payment onlycommences in the quarter in which such payment is made (Taxation Ruling TR 93/15);where the liability to pay the consideration for an asset that is subject to vendor finance arises at the timeof the acquisition of the asset, the indexation factor is to be calculated for the whole of the considerationfrom that time even though, under the finance arrangements, part of the consideration is not actually paiduntil some time in the future (Taxation Ruling IT 2362);where a taxpayer enters into a set fee construction contract which provides for payment by instalmentscorresponding to the value of work done by the builder as per an architect's certificate, each progresspayment is indexed from the quarter in which the architect's certificate in relation to that payment issues(Taxation Determination TD 19);in an "off the plan" purchase, both the amount of the deposit and the balance of the purchase considerationare indexed from the time the liability to pay the respective amounts is incurred. Examples of "off the plan"purchases are where the owner of the land has not completed all capital works required before building cancommence such as finalisation of boundaries, roads and telephone and electricity connections, or wherean apartment block is in the course of construction (Taxation Determination TD 18).

Specific rules govern the indexation of consideration where the taxpayer acquired an asset, after 15 August 1989,as a result of the doing by a person of an act that did not constitute a "disposal" of the asset. For instance, therules may apply where shares are acquired by issue or allotment or units in a unit trust are acquired by issue bythe trustee. The Full Federal Court in Allina Pty Ltd v FCT 91 ATC 4195 held that the issue of rights over sharesdid not amount to a "disposal" of an asset.

These rules apply as follows:

where consideration has been paid or given, indexation begins from the date that the liability to pay or givethe consideration arose;where consideration is paid or given at a later date, that consideration is indexed from the time the relevantconsideration was paid or given;where consideration is not in fact paid or given, that consideration is not indexed.

For example, a company issues 10,000 $2.00 shares on 31 December 1996, of which 50 cents per share ispayable on issue. A further call of $1.00 per share is payable for each share on 31 December 1997. Indexationwould apply as follows :

50 cents indexation would begin from the December 1996 quarter;



$1.00 indexation would begin from the December 1997 quarter;the remaining 50 cents is not indexed.

These rules apply not only to deferred consideration payable by the person who first acquired the asset but alsoto any subsequent person who acquires the asset where liability for deferred consideration payable to the personwho did the act that resulted in the acquisition of the asset by the first person is assumed by that subsequentperson.

4.0 Erosion (Reduction) of the Cost Base of CGT Assets

The 1936 Act contains provisions which operates to erode (reduce) the cost base of CGT assets in certaincircumstances. These include :

(a) the transfer of capital losses between group companies;

(b) the transfer of a CGT asset between group companies;

(c) a share value shifting arrangement;

(d) the forgiveness of a commercial debt;

(e) the disposal of a CGT asset for less than its cost base;

(f) the reduction or return of capital of shares in a company or units or interests in a trust; and

(g) recouped expenditure.

Each of these will be dealt with in turn below:

(a) By Capital Loss Transfers

In certain specified instances, a company, which incurs a capital loss and which is also part of a group ofcompanies, may transfer a capital loss to another group company. When this occurs, that is where a groupcompany (being the loss company) transfers a capital loss to another group company (being the gain company),then the cost base of certain CGT assets may be reduced.

These CGT assets are shares held by any parent company and debt held by any creditor related company. Thisobviously includes shares held by the parent company and debt held by the creditor company directly in the losscompany. However, indirect interests may also be affected. For example, shares and debt investments not madedirectly into the loss company but made via another group company and then invested into the loss company maybe affected. The CGT provisions provide that the parent company must be a group company in relation to the losscompany and must hold postCGT shares in another group company. The creditor company is also required to bea group company and have made a postCGT loan to another group company. Accordingly, all intragroupshareholdings and loans could potentially be affected and their cost base adjusted by capital loss transfers.

The CGT provisions operate to adjust the cost base of these CGT assets "by such amount as is appropriate"having regard to subvention payments made and to the direct and indirect interests of the parent company andcreditor company in the loss company. This provision is generally understood to mean that the cost base of theseCGT assets are reduced to the extent of the capital loss transferred out after taking into account any subventionpayments, which are payments made for the transfer of the capital loss. For example, where the subventionpayments equal the full after tax value of the capital losses transferred then no cost base adjustments should berequired.

An appropriate basis for allocating the cost base reduction adjustment may be something other than a proratabasis across the entire intragroup share and debt investment in the loss company. The corporate group may beable to allocate the reduction adjustment entirely to the cost base of the shares. This could be justified on thebasis that the intragroup debt does not represent an capital investment in the company but is only a short termdebt or a trade debt etc.

There is a limit as to the amount by which the cost base of these CGT asset can be reduced that is, it can onlybe reduced to $Nil. This is as a result of the CGT provisions operating to limit the amount of capital losses thatcan be transferred out to the sum of the unindexed cost base of all shares and any debt held by a group companyin the loss company. For example, where the parent holding company holds all the shares and debt in asubsidiary company with a cost base of $100, any capital losses of the subsidiary can only be transferred to the


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extent of $100.

By way of an aside, in order to utilise any capital loss that exceeds this limit it would be necessary to recapitalisethe transferor company by way of a capital or debt injection. However, this potentially leaves a significantunrealised CGT exposure in the hands of the parent and creditor companies. If these shares or debt interestswere ever sold or redeemed a significant capital gain may arise.

Interestingly, an upward adjustment "by such amount as is appropriate" is required to the cost base of certainCGT assets, being the shares held by any parent company and debt held by any creditor company having regardtheir direct and indirect interests in the gain company. This compensatory adjustment serves to uplift the costbase of the shares and any debt held in the gain company, thus operating to maximise its cost base and avoiddouble taxation arising upon disposal of the shares as a result of the acquisition of the asset increasing theunderlying value of the gain company. Further, the cost base increase may not be restricted to the amount of thecost base decrease. Rather, the cost base increase is not to exceed the increase in market value of the shares ordebt that results from the capital loss being taken to have been incurred by the gain company. Accordingly, all ofthe indirect interests of the parent and creditor companies in the gain company may be adjusted upwards takinginto account the impact of the loss transfer.

However, the restriction in the amount of capital loss that can be transferred out does not apply where it is beingtransferred out of a parent company down to its subsidiary company, that is the parent company, is the losscompany.

By way of example, suppose that parent company holds 100% of the shares in loss company with has a costbase of $100. The parent also holds 100% of the shares in gain company with a cost base of $100. Assume thatthere is no debt. In the 1997 year, the loss company incurred a capital loss of $20, while the gain companyincurred a capital gain of $20. The loss company transfers the capital loss to the gain company to offset thecapital gain. The loss company is restricted to the transfer of $100 as this is the cost base of the shares held init. The loss company is therefore not restricted in transferring the $20 capital loss to the gain company. The costbase of the shares held by the parent company in the loss company is reduced by the amount of the transfer, thatis the new cost base is $80. The cost base of the shares held by the parent company in the gain company isincreased by the amount of the transfer, that is the new cost base is $120. However, where parent company wasthe loss company there would be no restriction on the amount of capital losses that could be transferred to itsubsidiary gain company and further there would be no adjustments to the cost bases of the investments in eitherthe parent or gain companies.

(b) By way of Transfers of Assets between Group Companies

Another instance where a the cost base of an investment (shares or debt) in a company may be affected is wherethere is a transfer of an asset to another company. Pursuant to Division 19A of the CGT provisions, an adjustmentto the cost base of the shares in the transferor company is only required where:

(a) the company transfers a preCGT asset for consideration less than the market value of thatasset; or

(b) the company transfers a postCGT asset for consideration less than both its market value andits indexed cost base.

Both companies must also share 100% common ownership, which includes being group companies and alsoincludes being wholly owned by the same natural person.

The adjustment is intended to prevent an asset strip, that is to prevent company groups from claiming capitallosses where no real economic loss has occurred.

By way of example, Holding Pty Ltd holds 100% of the shares in X Pty Ltd and Y Pty Ltd both with cost bases of$100. X and Y each have an asset which cost $100 and has a current market value of $100. X transfers its assetto Y for no consideration. As there is no consideration, X would be deemed to have given consideration equal tomarket value, ie $100. X therefore has no capital gain or loss. If no cost base adjustment was required, then whenHolding Pty Ltd subsequently disposed of X it realises a capital loss of $100 on the disposal of the shares (ie the$100 cost base less $Nil consideration based on market value). An unrealised capital gain is also sitting in Y ofthe equivalent amount. Accordingly, Holding Pty Ltd would be able to realise a capital loss now and defer therealisation of a capital gain until some time in the future. However, the CGT provisions would operate to adjust thecost base of the shares in X in this instance down to $nil. As a result Holding Pty Ltd is not be able to realise anycapital loss on the transfer of the asset from X to Y.



(c) By way of a Share Value Shifting Arrangement

The cost base of shares may be adjusted where Division 19B of the CGT provision applies as a result of enteringinto a share value shifting arrangement. This may occur where the value of the original share has been "shifted" tosome other shares. As a result the provisions may operate to deem the cost base of the shares to be reduced.

Division 19B only operates where all of the following conditions are satisfied:

(a) value is shifted away from shares (A shift in value of other assets, eg debt, is not affected.);

(b) the shares are postCGT shares;

(c) the shares were held by a controller (or associate) of the company;

(d) there are shares which simultaneously increase in value;

(e) the shares to which the value is shifted are also shares of that company;

(f) the increased value shares are also held by the controller (or associates); and

(g) there is a material decrease in the value shifted out of the original shares.

Where these conditions are met then the cost base of the original share is reduced to reflect the shift. However,where the increased value share is a postCGT share, there is also a compensating increase in the cost base ofthe increased value share, so as to avoid double taxation. Where the increase and decrease value shares are heldby different parties there may also be a deemed disposal and capital gain.

(d) By way of a Forgiveness of a Commercial Debt

Where a commercial debt forgiveness is deemed to occur by virtue of the Debt Forgiveness provisions, then theremay be a forgiven amount which may reduce the cost bases of CGT assets held by the debtor company. This willoccur where a forgiven amount is required to be offset and there are insufficient prior revenue losses, prior capitallosses, and undeducted capital expenditures (for example depreciable cost bases of assets) to fully offset theforgiven amount. In this case the remainder of the forgiven amount will be applied against any cost bases (beingthe indexed cost base, reduced cost base or cost base as is appropriate) of CGT assets held by the debtorcompany.

However, where the commercial debt is an intragroup debt between a creditor company and debtor companyunder common ownership, then these companies may enter into an agreement so that the creditor forgoes itsentitlement to claim a capital loss to the extent of the provisional net forgiven amount.

(e) Where the Asset is Disposed Of for Less that its Cost Base

Subsection 160ZH(3) of the CGT provisions also operates to reduce the cost base of a CGT asset where it isdisposed of for less than its cost base for the purpose of calculating if any potential capital loss arises. The effectof this provision is to reduce the capital loss realised upon disposal of a CGT asset.

The cost base of the CGT asset is reduced by the amount of any expenditure to the extent it was allowed or isallowable as deduction. For example, deductions for depreciation will reduce the cost base to the extent of theallowable deductions. However, certain expenditure which is clawed back into assessable income as a result ofthe disposal will be included in the reduced cost base. For example, depreciation balancing charges will beincluded in the reduced cost base of the CGT asset.

Further, where there is a disposal of a CGT asset being a share, a rebateable dividend adjustment may be madeto reduce the cost base for the purposes of determining the reduced cost base. A rebateable dividend adjustmentarises where:

(a) under an arrangement, the company makes a distribution to a shareholder;

(b) whole or part of the distribution could reasonably be taken to be attributable to preacquisitionprofits, ie profits derived by the company before the shareholder acquired its share.

(c) the shareholder is entitled to a dividend rebate pursuant to sections 46 or 46A in respect ofthe dividend component of the distribution.



(d) the shareholder is a controller (or associate) of the company at any time during the period inwhich the arrangement is made or carried out.

(f) By way of reductions or return of capital

In the case of postCGT shares, where there is a reduction of capital the cost base of the shares is effectivelyreduced. That is, where a company distributes an amount that is neither a dividend nor for the shares' disposal,then the CGT provisions operate to deem a disposal and reacquisition of the shares at the reduced cost base.

The CGT provisions also operate similarly to reduce the cost base of an return of capital on a unit in a unit trust oran interest in a trust.

(g) Recouped expenditure

In determining the cost base, indexed cost base or reduced cost base of an asset section 160ZH(11) providesthat "account shall not be taken" of consideration in respect of which the taxpayer is to be recouped. No"account" presumably means it is to be ignored completely (ie. deemed never to have been paid).

"Recouped" normally means that you are reimbursed outside the original transaction. However, the ATO take theview that section 160ZH(11) covers the refund of a purchase price of an asset under the terms of the sale contract.However it may not cover the suing for damages by way of refund of the purchase price due to the asset notperforming to expectations.

5.0 Any TLIP Changes in relation to Cost Base

The Tax Law Improvement Project ("TLIP") is a government initiative to rewrite and replace the 1936 Act overseveral years. The aim of the project is to restructure, renumber and rewrite the income tax law so that it can bemore easily understood by those who need to read it. The project does not aim to reform the tax system or reviewtax policy (but inevitably disputes have arisen as to whether the rewritten law has merely restated the old law, orhas inadvertently changed it).

The rewritten CGT provisions were released during 1997 in Exposure Drafts 10 and 11. The Bill introducing thesechanges is currently before the Parliament and has not yet been passed. Some of the broad changes to the CGTprovisions include:

(a) Sections 160ZH(1) and (4), which relate to monetary and property consideration for acquisitioncosts have been consolidated into a single section. This should be a structural change rather than asubstantive change.

(b) The new CGT provisions use the term "CGT event". This is used to cover disposals of assets.This is relevant to the cost base for purposes of determining incidental costs. Incidental costs willbe included in the cost base of an asset to the extent they relate to the "CGT event".

(c) Non capital costs of ownership that can be included in the cost base have been broadened toinclude interest on money borrowed to refinance the original acquisition borrowings and interest onmoney borrowed to finance capital expenditure incurred to increase the asset's value.

(d) The CGT provisions relating to the determination of cost base are to be tabulated so thattaxpayers can readily identify which modifications apply.

Some of the more substantive changes to be introduced by Exposure Drafts 10 and 11 which impact upon thecalculation of cost base include:

(a) The requirements on beneficiaries to make cost base adjustments to trust interests each timethey receive nonassessable payments will be eased to require only a single annual reduction.

Further, the law will expressly state that payments in kind are to be treated in the same way asmoney payments, which is in accordance with current administrative arrangements. Under theexisting law, when a trustee pays an amount to a beneficiary, the cost base of the trust interest isreduced by the amount of the payment. Although the expression "pays an amount" clearly coversmoney payments, the position is less clear if it is a payment in kind.

(b) The law will expressly state that payments in kind by a company to a shareholder are treatedin the same way as money payments. Under the existing law, where a company pays an amount to



a shareholder, the cost base of shares is reduced.

(c) A building or capital improvement will be treated as a separate CGT asset only if it is of a kindsubject to a balancing adjustment on its disposal, loss or destruction. This will simplify calculationand recordkeeping requirements.

At present, improvements on land, such as buildings or capital improvements, that qualify for anincome tax deduction are treated as separate assets. This means that the CGT provisions causetaxpayers to apportion sale proceeds between land and individual improvements whereas this is notrequired for other purposes.

(d) Trading stock which is inherited by a deceased's estate or beneficiary at will have a cost baseequal to its market value. At present, an estate or beneficiary acquires trading stock that wasacquired by the deceased on or after 20</`>September 1985 at the deceased's cost base (reducedor indexed, if relevant), even though the deceased's final taxation return accounts for it at marketvalue and that amount is treated as income.

(e) The cost base of an asset transferred from one entity to another, which is subject to rolloverrelief, will be entitled to indexation where the combined period of ownership by both the transferorand transferee is at least 12 months. Correspondingly, if rollover relief applies to an entity thatreplaces a CGT asset with another asset, the 12month period will begin from when the originalasset (rather than the replacement asset) was acquired.

At present, the transferee must own the asset for at least 12 months to get indexation irrespectiveof how long the transferor owned it. For a replacement asset rollover, the 12month period begins atacquisition of the replacement asset (rather than the original asset).

6.0 Any Other Recent Changes 1997 Federal Budget changes to cost base

The Federal Government announced changes to the cost base provisions in the May 1997 budget. The changesare aimed at adjusting the cost base of an asset where deductions were allowed or are allowable and the existingcost base reduction rules did not apply.

As discussed above the cost base of an asset is defined in sec 160ZH(1) as the sum of the consideration inrespect of acquisition, noncapital costs of ownership, capital expenditure to enhance value or defend the assetand incidental costs of acquisition and disposal. Incidental costs and noncapital costs, to the extent that anamount has been (or is) allowable as a deduction to the taxpayer, are excluded from the cost base. The existinglaw does not however prevent an amount of consideration in respect of the acquisition of an asset or expenditurein respect of the asset from being included in the cost base where that amount is also allowable as a deduction.

The current position in relation to cost base and indexed cost base is to be contrasted with that of the reducedcost base, which is calculated by reducing the cost base by amounts which were allowed as deductions to thetaxpayer. The proposed changes will require that a similar reduction be made to the calculation of the cost base(and indexed cost base) for the purpose of calculating a capital gain. In other words, included in the cost base isexpenditure only to the extent that deductions are not allowable in respect of that expenditure.

One area where this change may be of particular relevance is in relation to the Division 10D building allowancewhich previously did not impact on the cost base of property. For instance, a building is acquired on 1 July 1999for consideration of $1 million. The building writeoff is calculated at 2.5% per year (ie $25,000 per year).Assuming the building is sold on 30 June 2001, and that the indexed cost base at this date is equal to $1.1million. The amendments introduced by the Bill will reduce the indexed cost base by $50,000 to $1.05 million,being the building allowance deductions claimed over the 2 years.

These changes were introduced into Parliament in Taxation Laws Amendment Bill (No 6) 1997. As a concessionalmeasure these changes will not apply to assets acquired before 7.30pm on 13 May 1997. Further, as atransitional measure where the underlying asset is land or building acquired before 7.30pm on 13 May 1997 thenthese measures will not apply to expenditure incurred before 1 July 1999 even though this expenditure mayconstitute the deemed acquisition of a separate asset.

The cost base changes contained in Taxation Laws Amendment Bill (No 6) 1997 do not impact upon section160ZM of the 1936 Act, which operates to reduce the cost base of a taxpayer's interest in a trust upon receipt of anonassessable distribution.



7.0 Tax Planning

As discussed above the tax planning focus should be on the maximisation of the cost base for CGT purposes.

Often, the cost base of an asset can be maximised by simply ensuring that all the amounts of expenditurecovered in section 160ZH that can be included in the cost base are identified and included in respect of theacquisition of an asset. For example, all incidental costs to the acquisition should be identified.

Further keeping an CGT asset register for each asset will assist in determining the relevant cost base by listingthe costs of acquisition, the date of acquisition, as well as capital expenditure incurred while holding the assetwhich enhanced the value of the asset or preserved the taxpayers right over the asset etc. This should ensure thatno relevant expenditure, for example, expenditure on capital works and legal costs in defending title to the assetare not overlooked.

In respects of the disposal of a parcel of shares, TD 33 (capital assets) and TR 95/D12 (revenue assets) acceptthe use of a "nomination" or "specific ID" method in calculating the realised gain or loss on disposal for taxpurposes. Accordingly, where a parcel of shares exist, one should ensure that systems are adequate to calculatethe resulting gain or loss on a basis other than FIFO. This would allow the taxpayer a choice in calculating thecost base.

Where a composite asset purchase is made, it may be desirable to allocate the consideration paid in order tomaximise the cost base of one of those assets rather than the other. If this is the case, then specifying the valuein the purchase contract or obtaining an independent valuation may be required.

Effective structuring of transactions is an effective means of ensuring that an asset's cost base is maximised andany potential CGT liability is minimised. The following matters should be considered:

The choice of funding of an acquisition, by way of either debt or equity in a structure such as a company orfixed trust, may impact upon the cost base and ultimately the amount of any taxable gain realised ondisposal of the investment.

Generally, from a CGT perspective, equity, as opposed to debt (particularly interest free debt), is the preferredmeans of funding an acquisition. Essentially, making a loan to a company or trust wastes any indexation shelterwhich would have been available had the investment been made by way of equity in the structure. A gain in thevalue of a share in a company or unit in a unit trust, if assessable under Pt IIIA, will obtain the benefit of anyindexation of the asset cost base.

Alternatively where debt is being used for funding it should go into the structure at the highest possible level,preferably direct to the ultimate investor. If debt funding is put in at lower levels there will be an erosion of costbase and hence indexation at the investor level.

The choice of investment vehicle may also impact upon the cost base and any ultimate capital gain ondisposal. Generally companies are not preferred for property investments.

Further, using a discretionary trust rather than a unit trust could avoid a CGT liability being crystallised wherethere is a return of capital on the trust. The CGT provisions operate to reduce the cost base of an interest in atrust and once the cost base is reduced to $Nil, an assessable capital gain may arise. However, under adiscretionary trust a beneficiary is not legally regarded as having an interest in the trust and this problem isovercome.

"amounts payable"

Alternatives to an outright disposal could be considered where, for example, an asset has a minimal cost base,eg mining rights or research and development results. It may be possible to create a lease or licence over theoriginal asset rather than dispose of the original assets and crystallise a significant capital gain.

The taxpayer should also be aware of the existence of specific CGT provisions which, when triggered, will deemthat an asset was acquired for no consideration. Broadly these provisions may be triggered either where a personcreates an intangible asset, which immediately vests in another person and where a person who owns an assetreceives consideration for a transaction in relation to that asset and further none of the other CGT provisions applyto the transaction.

On the other hand, the CGT provisions may operate to deem a market value cost base even where no



consideration or inadequate consideration is paid. The deeming rules apply where:

(a) no consideration is paid in respect of an acquisition that also constituted a disposal by thedisposer;

(b) the whole or part of the consideration cannot be valued; and

(c) where the parties were not dealing with each other at arms length and the consideration paidin respect of an acquisition that also constituted a disposal by the disposer is inadequate.

Lastly, as discussed earlier the timing of the acquisition and disposal of an assets can ensure that the benefitsfrom indexation applying to the cost base are maximised. This will be especially relevant in periods where inflationis high. For example, by acquiring the asset in an earlier quarter, holding the asset for at least 12 months anddisposing of the asset in a later quarter.

STUDY POINTS

1. If you do not pay anything for an asset, do you miss out on a cost base? If not, how is it determined?2. To maximise the cost base of an asset, it is important to include all incidental costs of acquisition and

disposal. What are they?3. In what situations can interest costs be included in an asset's cost base?4. What circumstances may potentially erode an asset's cost base?5. In structuring transactions, how does the funding mix affect an asset's cost base?6. In periods of high inflation, what steps can be taken to maximise the benefits of indexation applying to an

asset's cost base?

how to maximise cgt cost bases

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