CGT Event D1 and C2

The CGT event occurs at the time the taxpayer enters into the contract, or when the right is otherwise created.  

The taxpayer will make a capital gain if the capital proceeds from creating the right exceed the sum of incidental costs incurred. The taxpayer will make a capital loss if the capital proceeds are less than incidental costs.  

Remember that incidental costs includes the costs incurred in order to create and supply the relevant right. For example, the costs of engaging a lawyer to draft the contract which brings the relevant right into existence. The costs may not offset capital proceeds if there is reimbursement to the grantor by the grantee or another party.  

Note that the market value substitution rule may apply to calculate capital proceeds if the actual capital proceeds are more or less than market value and the taxpayer and the relevant entity fail to deal at arm’s length in connection to the event. Refer to section 116-30 of the ITAA 1997 for further details on the operation of the market value substitution rule. However, a key quirk with CGT event D1 (as distinct from most other CGT events) is that the market value substitution rule will not apply if actual capital proceeds are nil. Remember that capital proceeds can include the value of non monetary consideration (e.g. the value of chattels provided as consideration instead of money).  

CGT event D1 should not happen in the following circumstances:  

• The taxpayer created the right by borrowing money or obtaining credit from another entity; or  
• The right requires the taxpayer to do something that causes another CGT event to happen for the taxpayer (for example, if parties enter into an unconditional contract for the sale of land, this creates contractual rights for either party to enforce the transaction. However, because the transaction falls within the scope of CGT event A1, CGT event A1 will apply instead of CGT event D1); or   
• A company issues or allots equity interests or non equity shares in the company; or  
• The trustee of a unit trust issues units in the trust; or  
• A company grants an option to acquire equity interests, non equity shares or debentures in the company; or  
• The trustee of a unit trust grants an option to acquire units or debentures in the trust; or  
• The taxpayer created the right by creating in another entity a right to receive an exploration benefit under a farm in farm out arrangement.  

Note that CGT event D1 will not apply if another CGT event is applicable (with the exception of CGT event H2). The tax law is designed to prioritise the application of other CGT events with precedence over CGT event D1 and CGT event H2.  

It is also important to remember that the CGT regime (generally) will effectively only apply if an amount subject to a CGT event is not included in the taxpayer’s assessable income or exempt income (per the anti overlap provisions). Specifically, section 118-20(1) of the ITAA 1997 provides:  

‘…A capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in: (a) your assessable income or exempt income…in relation to a CGT asset as if it were so included because of the CGT event referred to in that subsection if the amount would also be taken into account in working out the amount of a capital gain you make…’  

What this is essentially saying is that any section of the tax law has a competing jurisdiction to deal with the amount included in the capital gain calculation e.g. section 6-5 of the ITAA 1997 or another specific provision (aside from section 40-880 which is a provision of last resort) then that section will take priority in treating that amount instead of the CGT regime.  

As stated above, CGT event D1 is given the lowest priority compared with other CGT events (except CGT event H2). Therefore, a close assessment needs to be made of all possible CGT events as these will apply with priority.   

That said, common examples of instances where CGT event D1 occurs include:  

• The grant of an easement.  
• The grant of a profit à prendre. 
• The grant of a licence over an asset.  
• The grant of a right to use a trademark.  
• The grant of a right to reside.  
• Where parties agree to vary a contract and the variation does not cause the disposal of rights.  
• Where a taxpayer agrees to assign a right which has not come into existence at the time of agreement.  
• Where a taxpayer agrees not to compete with another person or entity for a specified period or in respect of a specified location.  
• Where a taxpayer agrees to enter into an exclusive trade tie agreement with another person or entity.  
• Where a taxpayer grants management rights over property. 
• Where a taxpayer withdraws an objection to a proposed land development (provided amounts received for the withdrawal do not relate to permanent damage or a reduction in value of land caused by the development, see Tax Determination 1999/80 and Taxation Ruling 95/35 for further details).   
• Where a taxpayer agrees to market a particular product. 

Some of these common examples are addressed in below headings:  

Grant of an easement   

The grant of an easement by a taxpayer grantor to the grantee is a trigger for CGT event D1. This is because the grant involves the creation of rights in another entity in respect of an underlying asset. There is also no disposal of any part of the underlying asset. Therefore, another CGT event, such as CGT event A1, would not apply. 

The view of the ATO expressed in Taxation Ruling 97/3 is that CGT event D1 does not happen if an easement is created by operation of law. This could include an easement granted to a public utility provider to enable access to power lines, water lines or sewerage areas.   

The capital gain under CGT event D1 in respect of the grant of an easement is calculated as the capital proceeds from the grant (e.g.  any consideration paid for the easement, or the market value of the right if the market value substitution rules apply) less incidental costs (e.g. legal fees to draft the easement agreement).  

Licence  

The grant of a licence by a taxpayer grantor to a grantee is a trigger for CGT event D1. Note that a licence is distinct from a lease in that a licence does not offer a right of exclusive possession. CGT event F1 or F2 (not CGT event D1) will tend to apply in respect of the grant of a lease.  

The capital gain under CGT event D1 in respect of the grant of a licence is calculated as the capital proceeds from the grant (e.g.  any consideration paid for the licence, or the market value of the right if the market value substitution rules apply) less incidental costs (e.g. legal fees to draft the licence agreement).  

Restrictive covenant  

The entry into an agreement for a restrictive covenant is a trigger for CGT event D1.  

A restrictive covenant / agreement is commonly entered into between parties on the sale of a business. The purchaser often wants to prevent the vendor and / or its associated individuals from competing with the acquired business. Note the right to enforce the restrictive covenant is a CGT asset created and vested in the purchaser. 

The view of the ATO expressed in Taxation Ruling 1999/16 is that if the vendor and purchaser act on arm’s length terms and do not make a specific allocation of sale proceeds towards the restrictive covenant, then none of sale proceeds need to be allocated to the restrictive covenant. Instead, sale proceeds potentially related to the restrictive covenant will be treated as relating to the disposal of goodwill (a separate CGT asset). The logic here is that the purpose of a restrictive covenant is usually to protect of the goodwill of the business being acquired. Therefore, for CGT purpose (i.e. for the purpose of calculating a capital gain or capital loss from CGT event D1) none of the sale proceeds will be attributed to the grant of the restrictive covenant meaning a capital gain should not occur. However, (assuming the parties act at arm’s length) if part of the sale proceeds are distinctly allocated to the grant of the restrictive covenant, then the allocation will be acknowledged by the ATO and those capital proceeds will be used to calculate the capital gain under CGT event D1. The entity that obtains the contractual right (the purchaser) in another entity (the vendor) makes the capital gain. Remember that the capital gain is calculated as capital proceeds from creating the right less incidental costs related to the event.  

The CGT event happens to the taxpayer who obtains the right in the other entity. Generally, this will be the party that grants the right (i.e. the grantor) in exchange for consideration. 

Note the following further quirks about CGT event D1:  

• The CGT main residence exemption is not available to disregard a capital gain in respect of the taxpayer’s main residence which flows from CGT event D1 happening.  
• If a creation of rights occurs in respect of a pre CGT asset (i.e. an asset acquired prior to 20 September 1985) and triggers CGT event D1, the relevant capital gain or capital loss will not be disregarded despite the underlying asset being inherently CGT exempt.  
• If there is a capital gain made which flows from CGT event D1, that capital gain is not eligible for the 50% CGT discount (1/3 discount for superannuation funds). However, the taxpayer may be eligible for a discount under the small business CGT concessions. To be eligible under the small business CGT concessions, the created right that triggers CGT event D1 must be linked with a CGT asset owed by the taxpayer that satisfies the active asset test. The standard basic conditions must also be satisfied (i.e. the maximum net asset value test or the small business entity test) as set out in Division 152 of the ITAA 1997. 
• If a creation of rights occurs in respect of an CGT asset, the cost base of that underlying CGT asset must not be used to calculate the capital gain or loss that flows from CGT event D1 happening.