Some losses won’t wash away a tax liability

A recent Federal Court decision should make advisors think twice if they are planning on crystallising a capital loss before 30 June to assist in managing the tax liability of clients with realised capital gains.

Typically, this sort of planning involves selling an asset that has fallen in value so that the capital loss can be set off against capital gains, resulting in a lower net gain, and thus a lower tax liability.

Back in 2008 the ATO issued TR 2008/1. This ruling addresses situations where a loss-making sale occurs in a way where the taxpayer, and their related entities, don’t genuinely lose an economic exposure to the asset being sold. This can occur where the asset is sold to a related party. The ATO calls such transactions a ‘wash sale’. It gives a number of examples of wash sales, including:

• “the taxpayer disposes of, or deals with, the asset and at the same time, or within a short period after, acquires the same or substantially the same asset;
• shortly prior to, or at the time of, disposing of, or dealing with, the asset the taxpayer acquires the same, or substantially the same, asset;

…

• the taxpayer disposes of, or deals with the asset to a company which the taxpayer is a member of, or to a trustee of a trust the taxpayer is a beneficiary, or an object of, and the taxpayer controls, or influences the company, or trustee, or is the trustee or appointor;
• the taxpayer disposes of, or deals with the asset to a company which the taxpayer controls, or has influence over but is not a member of, or to a trustee of a trust which the taxpayer controls, or has influence over, or is the trustee, or appointor of, but is not a beneficiary, or an object of. The financial benefits of the asset are not distributed to the members, or beneficiaries/objects, but rather the company or trustee disposes of the asset to the taxpayer, or enters into arrangements to provide the financial benefits of the asset to the taxpayer;
• the taxpayer disposes of the asset, or otherwise deals with the asset in circumstances where there is a significant overlap in the individuals who had direct, or indirect interests in the asset before, and after the disposal or dealing. For example, the asset is transferred from one wholly owned company to another, or between two trusts with the same trustee and class of beneficiaries, or objects;”

The ruling goes on to say that the Commissioner may make a determination to apply Part IVA to cancel the tax benefit of any wash sale loss.

In the recent case of Merchant v C of T 2024 FCA 498, such a determination was put to the test. The facts are lengthy, there were other significant tax issues considered which this article does not cover and the decision goes through the evidence in detail. In summary, a trust was looking to sell a business company to a third party, and expected to (and did) make a significant capital gain. The taxation consequences of this gain was one of many matters that was considered, and there was a genuine consideration of whether the business (rather than the company) was to be sold, whether related party debt was to be forgiven or repaid, as well as there being multiple unrelated parties vying to be the purchaser. As part of this discussion, the taxpayer’s investment advisor stated in an email (names redacted):

[Tax Agent] have modelled it and the way to go would be a share purchase by [buyer] of [target company] shares and not an asset purchase.

By doing that and by transferring some of your high cost base BBG shares – remember some of the BBG shares have a $7 cost base from one of the capital raisings and other ones have a $2 cost base etc. – from [your trust] to your Super Fund you will get a good “loss” on paper so they reckon there will be zero tax payable on a lump sum payment which is very good.

BBG was Billabong Limited, a listed company, with a then current share price of well under $1 per share, so on the cost base values noted in the above email, any sale of the BBG shares would crystallise a capital loss for the relevant trust. As the email states, the idea to sell the shares originated with the tax agent. This strategy was implemented, with the super fund buying shares in BBG from the trust, resulting in the trust having significantly higher capital losses to offset against any capital gain which might later be made on the sale of the shares it owned in the target company to the third party purchaser.

There were other tax issues at play, including the tax implications should various loans owed by the target company be forgiven before the sale occurred. This forgiveness occurred as part of the cash-free, debt-free share sale agreement, and which caused an increase in the value of the target company, thus increasing the capital gain made by the relevant trust (although we do note that the debt forgiveness was expected to have a tax benefit which was also a factor). The possible tax outcomes for the sale of shares in the target company were calculated to determine the quantum of capital loss required to be crystallised if the BBG share sale transaction was to occur. From that it could be determined how many BBG shares were to be sold by the relevant trust to the super fund, as well as what funds the super fund required in order to be able to complete the purchase.

Ultimately, the shares in the target company were sold, and a significant capital gain was made by the trust. The $56.5m capital losses realised from the earlier sale of the BBG shares by the trust to the related super fund were applied to reduce the $85m capital gain made by the trust on the sale of the target company shares.

The Court found that the earlier sale of BBG shares to the super fund was undertaken for the purpose of generating the capital loss of $56.5m, and that Part IVA applied to prevent that loss from being applied against the capital gain. The Court specifically noted that the fact that the BBG shares could have been sold on the open market (but were not) showed that a deliberate choice had been made to maintain the same level of economic ownership of BBG shares via them being sold to the super fund.

The clear implication for taxpayers from the wash sale aspect of the above Court decision is that there is a risk that any capital loss made on selling a CGT asset to a related party will be more at risk of the loss being denied if there are grounds for the Commissioner to say that the loss was realised with a tax motive. This case shows that Part IVA can apply to situations where there is no real reduction in ownership of the asset across a closely held group even though a specific taxpayer has realised a loss. As always, the burden is on the taxpayer to prove that the timing of the transaction clearly occurs for other reasons.

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