Owners of a business (including family businesses) can plan for the proper succession of their business on the death or disablement of an owner or controller by entering into “buy/sell” agreements. This typically involves granting call and put options to each other that allow, or require, the owners to buy out the interest of another business partner where they die or are unable to work due to illness or disablement. They also usually involve the taking out of life insurance, or the assignment of existing policies, to provide finance for this purpose.
Such an agreement has the following benefits:
- Enables the remaining business owners to retain full control of a business if a fellow owner dies or is unable to continue working due to illness or disablement
- Enables the departing owner (or their beneficiaries) to sell their share of the business for an agreed price, and
- Enables the business to continue operating with little disruption when the unexpected happens.
The focus of this article is around the exact capital gains tax (CGT) consequences of entering into and executing such an agreement.
Setting the scene
Unfortunately, the CGT implications are not entirely straight-forward (and obviously depend on the exact nature of the legal rights and obligations created under the agreement). However, the following example may provide some broad but useful guidance.
Their advisor suggests they enter into a “buy/sell” agreement which will enable (and require) them to buy out the other’s interest in the business in the event of the death or disablement of either of them for its market value at that time. This is achieved by each party granting call and put options to the other (which also bind their estates).
The advisor also suggests that they each take out a death and disability insurance policy on the other owner in order to finance the purchase of the other’s interest in the business should death/serious illness/disablement occur. The relevant terms of the arrangement are:
- the options can only be exercised by either party on the “death” or “disablement” of one or the other (as defined)
- on the exercise of the options, the relevant party’s ownership interest (the exiting owner) will be sold to the other party for its market value at that time (i.e. the “exercise price”), and
- each party will take out sufficient “death and disability” insurance on the other party for the purposes of funding the buy-out.
Note that the owner of a call option (i.e. the grantee) can exercise it to require the grantor to dispose to the grantee the underlying asset that is the subject of the option (in this case, his ownership interest). On the other hand, the owner of a put option (the grantor) can exercise it to require the grantor to acquire from the grantee the underlying asset that is subject of the option.
CGT event D2 – grant of an option?
In normal circumstances, the initial grant of an option (either a call or put option) will create an immediate capital gain for the grantor under CGT event D2 (granting an option). This would be calculated by reference to the capital proceeds received for granting the option and its cost base (usually just legal fees). Furthermore, the capital proceeds in this case would be the market value of the corresponding option they receive in exchange – which may be hard to determine in the circumstances, and which could even be nil (see later).
However, fortunately for Wilbur and Orville, the ATO takes the view that the death or injury of an owner under a buy/sell agreement is considered to be a “condition precedent” to the options coming into existence. As a result, the respective options do not come to be owned by Wilbur or Orville until this event is met (and cannot therefore be exercised) until the condition precedent (e.g. death) is met. Therefore, there are no immediate CGT consequences on granting the options.
Returning to the earlier example as it happens, a couple of years later, Wilbur fails his medical test for flying due to a serious vision problem. Accordingly, Orville exercises his call option to buy out Wilbur’s interest in the business. (But if worse came to worst, Wilbur could have exercised his put option to force Orville to buy out his interest).
Professional valuers are then engaged who value the business at between $1.3m and $1.5m – and Orville and Wilbur agree on a buyout “market value” price of $1.4m
At the same time, Orville makes a claim on the ”death and injury” insurance policy he took out on his brother – and after some wrangling as to whether the vision problem qualified for the payout, the insurance company agrees to make a payout of the sum insured of $1m. (Note: get the terms of such insurance policies ironed-out from the start!)
From a CGT point of view, now that the condition precedent to the options have been met, the options are “enlivened” and CGT event D2 is triggered.
This, in turn, will mean that Wilbur, as the grantor of the call option will be considered to have made a capital gain at that time under CGT event D2 by reference to the “capital proceeds” received and the “incidental costs” incurred in granting the option (e.g. legal fees incurred).
Once the option is exercised, the option transaction is, in effect, “merged” with the transaction requiring Wilbur to dispose of his interest in the business to Orville for its market value. As a result, any capital gain from CGT event D2 that Wilbur makes is now ignored.
However, it will still be necessary to work out the market value of the option that Orville granted Wilbur at the time it was enlivened. This is because the capital proceeds received by Wilbur for the disposal of his share of the business will be the exercise price (i.e. the market value of the interest at that time) plus the capital proceeds Wilbur received from granting the option. The following example from Div 134 of the Income Tax Assessment Act explains this rule.
Steven obtains an option to buy a yacht (for $75,000) from Tom. Steven pays $5,000 for the option. Steven exercises the option. The first element of his cost base for the yacht includes the expenditure he incurred for the option. So, the first element of his cost base and reduced cost base for the yacht is: $75,000 + $5000 = $80,000.
In this case it is important to remember that capital proceeds include the market value of property received for a CGT event.
So, what is the market value of the corresponding call option received by Wilbur in exchange for granting the call option to Orville?
It is arguable that it may be nil because at the time it comes into existence it is only useable by Wilbur and Orville – and not transferable to a third party in any way. In short, it is a non-transferable asset whose market value cannot be determined because of this.
However, the market value capital proceeds rule in the Income Tax Assessment Act provides that they apply where “some or all of those proceeds cannot be valued”. Furthermore, perhaps their market value may be ascertainable by asking what one party would be prepared to pay to the other to bring the options to an end after they were enlivened?
(Note that the extensive material on the ATO website regarding market value may help in this regard or even a private binding ruling from the ATO. And, of course, the services of a professional can always be sought.)
But let’s assume they have a market value of $50,000 at the time they are “enlivened”. Therefore, the capital proceeds in this case equal $750,000 (i.e. 50% of the agreed market value of the business at the time the option are exercised, plus $50,000 (being the amount paid for the option – or its market value).
Importantly, any capital gain made by Wilbur may be reduced to 50% CGT discount (subject to eligibility) and, presumably the CGT small business concessions (SBCs) as well (subject to eligibility). (Note also the CGT SBCs would also be available to Wilbur’s estate if relevant).
On the other hand, from Orville’s point of view (the grantee of the option), he would be taken to have acquired the business interest for a cost base of the exercise price plus any amount paid for acquiring the option. .
Finally, the acquisition of the other owner’s interest in the business will take place pursuant to CGT event A1 under the relevant contract of disposal that is then entered into. But in this regard, note that if an option agreement is considered legally to be a “conditional contract”, it would be possible to argue that the CGT asset is acquired by the grantee at the time the original option agreement was entered into on the basis that it is a “conditional” contract (there is High Court authority for this: see Laybutt v Amoco Australia Pty Ltd (1974) 132 CLR 57).
Note that the same principles would apply where a disabled owner or the executor of the estate of a deceased owner exercises his or her right under the relevant “put option” to require the other owner/s to buy-out his or her interest.
Regarding the use of insurance to finance the buyout, the receipt of proceeds under such an insurance policy will not be assessable as income but rather would be treated as a non-assessable receipt.
In relation to the CGT treatment of such proceeds, the proceeds would be regarded as “capital proceeds” in respect of the insurance policy, and not in relation to the disposal of the owner’s business interest. However, they would be exempt from CGT in the hands of an owner who took out the policy on the basis that he or she is the “original beneficial owner” of the policy.
It should also be noted that if the policy combines life cover with a trauma or total and permanent disability cover, the amount will be exempt as “compensation for a wrong, injury or illness.
The exact legal nature of a “buy-sell” agreement may operate in a more complex way than the above. However, these are the type of CGT issues that will arise and will need to be considered.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.