Kilgour V Commissioner Of Taxation [2024] FCA 687: Regrettably On Arm's Length Terms

Summary

There is an age-old adage that "bad facts make bad law", which in the world of tax jurisprudence has proven to be the case time and time again. However, every so often, from a particular and curious set of facts can emerge principles that help clarify an otherwise confusing and often contradictory set of judicial principles. In Kilgour v Commissioner of Taxation [2024] FCA 687¹, an attempt to "reverse Uno" the market value substitution rule, whilst backfiring on the taxpayer applicants (Applicants), has clarified the meaning of "market value" for tax purposes and the facts and circumstances in which parties can be acting at arm's length in relation to a particular transaction.

In an unusual fact pattern, it was the Applicants who argued that the market value substitution rule should apply to reduce the capital proceeds received on the sale of their business, on the basis that the parties were not dealing at arm's length and the buyer had overpaid. The Applicants argued that "special value" attributed to the sale by the buyer should not be included in the capital proceeds.

The Federal Court of Australia (FCA) determined that:

• The parties, pursuant to a Share Sale Agreement dated 4 October 2016 (Share Sale Agreement), dealt with each other at arm's length in connection with the share sale, even though there were some existing connections between the parties and "internal champions" within the buyer who supported the sale.
  
• The market value substitution rule in subsection 116-30(2) of the Income Tax Assessment Act 1997 (ITAA 1997) therefore did not apply to substitute the capital proceeds received by the Applicants with the (contended, and lower) "market value" of the shares as a result of the share sale.
  
• The term "market value" for tax purposes was interpreted broadly to include amounts representing "special value" or "synergistic value" which were specific to a particular willing purchaser (significantly, Logan J's observations on this point are at odds with the Commissioner's approach in the Market valuation for tax purposes guidelines², which explicitly indicate that such "special value" should be excluded from market valuations for tax purposes).

In Brief

The FCA's analysis considered the operation of section 116-30(2) of the ITAA 1997 and whether the purchaser (News Corp) and various sellers dealt with each other at arm's length in connection with the disposal of the shares in an online betting company, Punters Paradise Pty Ltd (Punters).

The Commissioner submitted that the parties dealt with each other at arm's length in connection with the share sale such that the capital proceeds received (being approximately $31 million) should be respected and not substituted with a lower figure.

In agreeing with the Commissioner's arguments, Logan J concluded:

• There was "real bargaining" between the parties and their interactions and negotiations indicated that they were dealing at arm's length with eachother such that the market value substitution rule had no application. In particular, the purchase price and terms of the acquisition and the decision to acquire the shares were ultimately decisions made by the News Corp's head office in the US, in order to further the group's strategic commercial interests. Even if individuals from the News Corp Australia group were "internally championing" the share sale and the sale price was arguably more than another purchaser may have been willing to pay, this did not imply that the parties were not dealing with each other at arm's length. In particular, Logan J at paragraph 95 stated:

• Even though the Applicants submitted that News Corp had ascribed "special value" to the Punters shares (which they argued was in excess of the market value of the shares) the FCA considered that the market value of the shares could include any such "special value", or "synergistic value" attributed by a purchaser.
  
• Logan J's judgment highlights that certain aspects of the Commissioner's Market valuation for tax purposes guidelines³ (which includes references to the International Valuation Standards Council conceptual framework⁴) were inconsistent with generally accepted principles of market valuation. Notably, Logan J concluded that it was "contrary to over-whelming authority" to exclude from the market value analysis "special value" to a particular purchaser – also known as "synergistic benefits".

Case Facts

Prior to the execution of the Share Sale Agreement, Punters was an online social platform which allowed users to exchange racing tips.

As of 4 October 2016, Punters had 120,000 ordinary shares on issue, owned by the Applicants and various family trusts associated with them. All 120,000 shares in Punters were sold to News Corp pursuant to the Share Sale Agreement between News Corp and the vendor shareholders for total consideration of $31,057,722.

News Corp is part of an Australian Group of companies that includes News Corp Australia Pty Ltd and News Pty Ltd, of which the ultimate holding company is News Corporation. News Corporation is incorporated in the United States of America and has its principal office is in New York.

In bringing the case, the Applicants challenged the inclusion of the capital gain in their assessable income in the 2017 income year, arguing that the market value substitution rule in section 116-30(2) of ITAA 1997 should apply to reduce the capital proceeds received on the basis that the parties did not deal with each other at arm's length in connection with the share sale. The Applicants contended that certain members of News Corp acted as "internal champions" to promote the share sale, and that the consideration received included a component attributable to "special value" (above that of the market value of the shares) that was only applicable to News Corp as a specific purchaser due to the synergistic benefits it could obtain upon acquiring Punters. As such, the Applicants submitted that News Corp paid a price in excess of the real "market value" of the shares in Punters.

Arm's Length Dealings and "internal championing"

Whilst it was not contentious that News Corp and the Applicants were at arm's length from one another, the relevant question was whether the parties dealt with each other at arm's length in brokering the share sale.

Whilst the FCA agreed there were examples of "internal championing" within the News Corp group in relation to the share sale and existing connections between the parties, the FCA maintained that no disposal of an asset ever occurs in the absence of an interested buyer.

The FCA also concluded that the decision to purchase the shares was made in News Corp's head office in New York, following significant internal analysis within the News Corp group of companies of the worth of the shares and perceived synergetic benefits of the acquisition. The share acquisition was a corporate group-level, strategic decision and the role of New's Corp's head office was not merely rubber-stamping an investment analysis conducted by individuals employed by Australian News Corp subsidiaries (some of whom may have been personally supportive of the acquisition).

Significantly, the FCA considered that in the context of section 116-30 of the ITAA 1997, the fact that the capital proceeds are more or less than the market value of an asset does not mean that the parties to the transaction are not dealing with each other at arm's length. Instead, that a purchase price is more or less than the market value of an asset may (or may not) indicate that the dealing is not at arm's length. However, the FCA concluded that having regard to the contemporaneous correspondence, negotiations and transaction documents surrounding the sale (which included two non-binding indicative offers from New Corp, eight drafts of the Share Sale Agreement, and various conversations between representatives of the parties) the parties were dealing at arm's length, even though the price ultimately paid by News Corp may have been more than another purchaser would have been willing to pay due to the unique circumstances of the purchaser.

Logan J considered that the fact that News Corp's ultimate price for the Punters shares aligned the vendor shareholders' initial expectations as to price (reflecting, broadly, 10 x EBITDA of the business), internal deliberations within News Corp's Australian subsidiaries had already identified $30 million as an enterprise value for Punters, based on their own EBITDA assessment. The fact that these two figures aligned did not necessarily indicate collusion, or that the parties were not dealing at arm's length.

"Special Value"

Although not strictly necessary to consider (given Logan J's conclusion that the parties were dealing at arm's length such that the market value substitution rule had no application) the judgment includes some significant and insightful observations about the meaning of "market value" for tax purposes.

In particular, the Applicants submitted that News Corp had attributed "special value" to Punters, which was in excess of the "market value" of the shares. The FCA considered expert evidence from several valuation specialists, as well as the Commissioner's guidelines in the Market valuation for tax purposes publication and concluded that the "special value" formed part of the market value of the Punters shares. The FCA also confirmed that, contrary to the Commissioner's view in the Market valuation for tax purposes guidelines, "market value" can include the special or synergistic value ascribed to an asset by a particular willing buyer.

Two of the four Applicants have since appealed to the Full Federal Court against the decision (which at the time of this article is yet to be heard).

A&M's Key Observations

• The decision confirms that while a price which is either above or below "market value" may suggest that the parties may not be dealing with each other at arm's length, the agreed price (and capital proceeds, in this case) must be respected unless it can be definitively established that the parties are not acting at arm's length. That is, proof that a disposal was not "fair", or not at market value, is not sufficient to show that the dealing in connection with the disposal was not at arm's length.
  
• As is common in M&A bidding wars, potential buyers may value an asset differently depending on their expected synergistic benefits. Accordingly, market value is often better indicated by the price a potential buyer is willing to pay, which may be different from an external valuation.
  
• Regard should be had to the specific facts and circumstances surrounding a transaction (as in this case, the internal analysis as to terms and price undertaken by the parties, as well as documented negotiations between and discussions of representatives of the parties) to determine whether the parties are dealing at arm's length. In this case, the existence of a documented decision making process on News Corp's side as to the acquisition and proposed pricing, two non-binding indicative offers, and the negotiations of lawyers in drafting the Share Sale Agreement all pointed towards the parties dealing with each other at arm's length, despite an existing relationship between the parties.
  
• Kilgour's broad interpretation of the definition of "arm's length" highlights that parties can be dealing with each other at arm's length in connection with the disposal of an asset in the absence of multiple interested buyers, where "internal championing" occurs and where a price paid by a buyer may be more than other willing but not anxious buyers might be prepared to pay (including because of "special value" that an asset has to that particular buyer).
  
• Logan J's observations on "special value" directly – and expressly - contradict those made by the Commissioner in the Market valuation for tax purposes guidelines, concluding that it was not appropriate to exclude from "market value" any "special value" to a particular willing purchaser in this case. It remains to be seen whether the Commissioner will make any changes to the general expectations on market valuation for tax purposes as set out in the Commissioner's market valuation guidelines.
  
• The inclusion of "special value" or "synergistic value" in the market value of a CGT asset by a specific purchaser can be an important consideration when determining what is the market value for tax purposes more broadly. This includes when calculating gains and losses on the disposal of CGT assets under CGT event A1 contained in subsection 104-10(4) of the ITAA 1997, as well as other CGT events where the market value substitution rule can apply for both residents and non-residents. The impacts of this are far reaching and can also impact the quantum of non-income based taxes such as land tax and duties on certain asset disposals. For example, in the context of non-residents, "market value" is relevant when applying the principal asset test contained in section 855-30 of the ITAA 1997 and if these values should reflect amounts representing "special value'". Similarly, consideration should be given to the determination of "market value" in subsection 104-160(4) of the ITAA 1997 upon CGT event I1 happening when an individual or company stops being an Australian resident.
  
• Further, Australia's transfer pricing rules contained in Division 815 of the ITAA 1997 require the actual conditions arising from the commercial or financial relations between entities to be compared to the arm's length conditions that might reasonably be expected to have operated given comparable commercial or financial relations under similar circumstances. Noting that Australia's transfer pricing rules apply equally to associated entities as they do unrelated entities, the decision in Kilgour, although relating to dealings between two Australian resident unassociated parties, provides guidance on interpreting arm's length conditions, specifically the criteria of whether a dealing is at arm's length. Evidence of the above factors will be relevant to understanding the commercial and financial relations that exist between entities and how this could be applied when comparing arm's length conditions in comparable circumstances for the purposes of Australia's transfer pricing rules as well as in transactions involving the disposal of CGT assets by both residents and non-residents.
  
• Other areas of Australia's income tax law also rely on the concept of what is "arm's length" and therefore the decision in Kilgour is likely to have practical impact beyond the capital gains tax provisions it considered. Relevant areas which may be impacted include the trading stock rules in Division 70 of the ITAA 1997, Taxation of Financial Arrangement rules in Division 230 of the ITAA 1997 and the foreign currency rules in Division 770 of the ITAA 1997. In particular, the managed investment trust and superannuation rules consider the concept of "non-arms length income" in respect of which the Commissioner has previously adopted an expansive view of what constitutes non-arm's length income, particularly in the superannuation context.

Footnotes

1. Kilgour v Commissioner of Taxation [2024] FCA 687: Kilgour v Commissioner of Taxation [2024] FCA 687 (26 June 2024) (austlii.edu.au)

2. Market valuation for tax purposes: Market valuation for tax purposes | Legal database (ato.gov.au)

3. Ibid.

4. See for example, International Valuations Standards Council (2021) International Valuation Standards, Page Bros, Norwich (IVS), p22.

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