NTLG Losses and CGT Sub-committee minutes - 14 November 2007

Meeting details

Venue:	Room A - Conference Level 36 Casselden Place 2 Lonsdale St Melbourne
Date:	14 November 2007
Start:	10.35am	Finish:	2.35pm
Chair:	Margaret Haly
Contact and secretariat:	Sean Bielanowski	Contact phone:	(07) 3213 5729

Attendees

Garry Addison	Certified Practicing Accountants Australia (CPAA)
Chris Birchall	Certified Practicing Accountants Australia (CPAA) (representing Mark Morris)
John Brazzale	Certified Practicing Accountants Australia (CPAA)
Steve Cane	National Tax and Accountants Association (NTAA) (representing Nick Connell)
Susan Cantamessa	Institute of Chartered Accountants Australia (ICAA)
Lance Cunningham	National Institute of Accountants (NIA)
Michael Dirkis	Taxation Institute of Australia (TIA)
Matthew Hayes	Institute of Chartered Accountants Australia (ICAA)
Jim McMillan	Taxation Institute of Australia (TIA)
Anthony Stolarek	Institute of Chartered Accountants Australia (ICAA)
Margaret Haly (Chair)	Assistant Commissioner, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Chris Adams	Technical Leader, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Sean Bielanowski (Secretariat)	Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Deborah Boyd	Director, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Kheng Eap	Losses and Captial Gains Tax (CGT) Centre of Expertise (CoE)
Martin Keating	Senior Tax Counsel, Tax Counsel Network
Adam Kendrick	Assistant Commissioner, Capital GainsTax (CGT) and Losses Segment, Large Business
Anthony Marvello	Director, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Shelley McCann	Director, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
George Roumeliotis	Director, Losses and Capital Gains Tax (CGT) Centre of Expertise (CoE)
Linda Skinner	Consolidations Centre of Expertise (CoE)

Apologies

Nick Connell	National Tax and Accountants Association (NTAA)
Stewart Grieve	Law Council of Australia (LCA)
Paul McMahon	Treasury
Mark Morris	Certified Practicing Accountants Australia (CPAA)
David Morrison	Law Council of Australia (LCA)

^[H2]Agenda items

Disclaimer

National Tax Liaison Group (NTLG) and NTLG Sub-committee agendas, minutes and related papers are not binding on the Tax Office or any of the other bodies referred to in these papers. The Commissioner of Taxation has instituted a more open philosophy and process with the NTLG and its sub-committees. As such, minutes are published on which members accept or modify the minutes under normal meeting protocols. These minutes are also available for member associations on this basis.

1.1 Apologies, welcome and opening comments, acknowledgment of resignations and new members

Apologies:

¦ Paul McMahon - Treasury (Treasury was unable to be represented during the caretaker period).

The Chair welcomed the following new members to the sub-committee:

¦ Matthew Hayes - ICAA, and

¦ Jim McMillan - TIA.

The following visitor was welcomed:

¦ Linda Skinner - Consolidations CoE who spoke to agenda item 20.

The Chair acknowledged the retirements of Garry Addison - CPAA, and Mark Ferrier - ICAA, and thanked them for their valuable contributions to the work of the sub-committee over extended periods.

She also advised that Sean Bielanowski now provides secretariat support for the Chair and members of the sub-committee. He replaces Deb Morrison in this role.

1.2 Finalisation of previous minutes from 6 June 2007 meeting

The minutes were confirmed and finalised.

Discussion
A member raised the issue of the minutes from the last meeting being late. The Chair said that the usual practice would continue to be adopted whereby, if the minutes are going to be delayed, responses to those items with a concluded view would be dealt with out of session and members notified accordingly.

1.3 Updates of action items from previous meetings

3.1 Item 2006/11-6: Interposition of a new company between notional stakeholders and the application of Division 166

Update
This issue has been drawn to the attention of Treasury. Treasury acknowledges the issue but is not currently able to take it forward. Treasury will endeavour to do so as a part of the consultation process involving multiple share classes. The Treasury contact officer is Alex Le (02) 6263 3832 .

3.2 Item 2006/6-5: Dick Smith Case

Update
The Dick Smith case decision is relevant to the application of the CGT provisions. However, the extent of the relevance will depend on the particular circumstances of each case. For example, it is clearly relevant in the circumstances of Class Ruling CR 2007/98, where special dividends were issued in the context of a sale by a company of its assets.

Post meeting update
A Taxation Ruling is to be prepared on the tax implications of the Dick Smith case and it has been included on the rulings program.

3.3 Item 2007/6-5: Non-resident CGT rules

The definition of 'taxable Australian property' in section 855-15 Income Tax Assessment Act 1997 (ITAA 1997) includes at item 3, a CGT asset that you used at any time in carrying on a business through a permanent establishment in Australia. The question relates to whether goodwill of a business carried on through a permanent established is 'used' in carrying on that business? We note that the definition of 'active asset' in section 152-35 of the small business CGT concessions at paragraph 152-30(1)(a) also has the concept of using an asset in the course of carrying on a business but in this case the drafters saw the need to add paragraph (b) in the definition of active asset, which includes intangible assets that are inherently connected with the businesses, such as goodwill.

Could the Tax Office please confirm whether goodwill and other intangible assets would be seen as being 'used' in the context of the definition of taxable Australian property in section 855-15.

Update
It is considered that leasehold property does not come within the meaning of real property in section 855-20(a) of the ITAA 1997. While it is considered that certain CGT events pertaining to leases (events F1 to F4) are currently covered by the Division 855, CGT event A1 is not.

It is acknowledged that there are two competing views as to whether certain intangible assets can be used by a foreign resident in carrying on a business through a permanent establishment.

One view is that intangible assets, including goodwill, can be 'used' by a foreign resident in carrying on a business through a permanent establishment. Some support for this view can be found in ATO IDs 2006/17 and ATO ID 2006/181.

The other view is that certain intangible assets (such as goodwill) are, or may be a product of rather than used in a business.

The appropriate position in any particular case must be determined taking account of its facts.

The Tax Office has brought the matter to Treasury's attention.

3.4 Item 2007/6-15: Liability of a non-resident to capital gains tax

Basic rule
The rules regulating the liability of non-resident to Australian CGT were amended with effect from 12 December 2006.

From that date, non-residents are only subject to CGT in respect of 'taxable Australian property' (TAP).

The ITAA 1997 contains an exhaustive list of those assets that are TAP:

a) 'Australian real property' - this term is defined to mean:

¦ real property situated in Australia1, or

¦ a mining, quarrying or prospecting right if the minerals, petroleum or quarry materials are situated in Australia.

b) an 'indirect Australian real property interest'

c) assets used in carrying on business through a permanent establishment in Australia

d) a right or option to acquire an asset within (a), (b) or (c) above, and

e) in relation to an individual - an asset covered by a 'change of residency' election.

The concept of an 'indirect Australian real property interest' provides a look-through rule to impose CGT on gains realised by non-residents on the disposal of shares in an interposed entity (whether or not resident in Australia) if:

¦ the non-resident (and its associates) has a 10% or greater direct or indirect interest in the land holding entity, and

¦ more than 50% of the market value of the entity's assets represent Australian real property (as defined above), directly or indirectly.

Real property?
The Explanatory Memorandum that accompanied the Bill introducing this change contained the following comment relating to 'real property':

4.28 Taxable Australian real property generally refers to real property, within the ordinary meaning of that term, that is situated in Australia (schedule 4, item 2, paragraph 855-20(a)). Consistent with Australia's tax treaty practice, this meaning has been expanded to include a mining, quarrying or prospecting right (to the extent that the right is not real property), where the minerals, petroleum or quarry materials are situated in Australia (schedule 4, item 2, paragraph 855-20(b)). Although where held directly, disposals of taxable Australian real property that are depreciating assets may be disregarded if section 118-24 applies.

4.29 Where an Australian tax treaty applies to a foreign resident in relation to a CGT event, in accordance with existing practice, the definition of real property should be read in conjunction with the definition as stated in the treaty. This outcome results from the application of section 4 of the International Tax Agreements Act 1953.

Osborn's Concise Legal Dictionary defines 'real property' as follows:

'Land; things growing in or attached to land, minerals (also referred to as corporeal hereditaments); rights over land, such as easements …and profits (also referred to as incorporeal hereditaments); but not leasehold …land or beneficial interests under a trust for sale.'

Halsbury's Laws of Australia2 contains the following comment under the heading 'What is real property?':

'Real property consists of land and interests in land, including fixtures and incorporeal hereditaments. The term originated in the forms of action available through the medieval common law courts. In a 'real action', the remedy was recovery of the subject matter of the dispute itself. In practice, the only property which came within the real actions was property in land, hence property in land became known as 'real property'. In actions for recovering other forms of property, the interest holder was only able to commence an action in personam and the defendant could elect either to return the property in dispute or pay monetary compensation. An important exception to this generalisation was the leasehold estate in land, which was treated in law as personal property, or more precisely as a 'chattel real'. Today, leasehold interests are treated for most purposes as real property. The main differences between real estate and chattels real were in regard to legal remedies, the manner of devolution on death and the rights of succession on intestacy.

Personal property consists of all forms of property other than real property and is described traditionally by the term 'goods and chattels'. Civil law systems make a distinction between moveables and immovables and this distinction is applied in private international law, rather than the common law distinction between real and personal property.'

It is also noted that the CGT regime contains a specific rule to equate certain leasehold interests with ownership3.

Can the Tax Office confirm whether a leasehold interest is 'real property' for the purposes of determining whether a non resident has taxable Australian property?

Previous response
The term 'real property' is not defined in the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997.

In the context of foreign residents and whether they have taxable Australian property paragraph 4.28 of the Explanatory Memorandum to Taxation Laws Amendment (2006 Measures No. 4) Bill 2006 confirms that the ordinary meaning of the term is to be used. However, it also points out that where the foreign resident is a resident of a country with which we have an international tax treaty (DTA) the meaning of 'real property' within the DTA should be taken into account as required by section 4 of the International Tax Agreements Act 1953.

This issue is being considered by the Tax Office. The response will be advised out of session once an ATO view is established.

Update
The update to this issue is the same as given for '3.3 Item 2007/6-5: Non-resident CGT rules above.

3.5 Item 2007/6-6: Interaction of Division 855 and trust provisions

Could the Tax Office confirm that the analysis in ATO ID 2003/231 in relation to assets without the necessary connection with Australia will also apply to assets that are not taxable Australian property in Division 855?

ATO ID 2003/231 considers whether the trustee of a trust that is not a resident trust for CGT purposes is required to include a capital gain, in relation to the sale of an asset that does not have the necessary connection with Australia, in the net income of the trust calculated under section 95, ITAA 1936. In the ATO ID the Tax office concludes the following:

'No. The trustee of a trust that is not a resident trust for CGT purposes will not be required to include in the net income of the trust a capital gain from an asset that does not have the necessary connection with Australia. It is considered that section 136-0 of the ITAA 1997 overrides the requirement in section 95 of the ITAA 1936 that the net income of a trust be calculated as though the trust were a resident of Australia (which would require the inclusion of capital gains from assets that do not have the necessary connection with Australia).'

In its reasons for the decision, the ATO ID states:

'It is a general rule of statutory interpretation that where there is a conflict between general and specific provisions, the specific provision prevails.'

The term 'assets with the necessary connection with Australia' in the former Division 136 ITAA 1997 has been effectively replaced by 'taxable Australian property in Division 855'. Both these terms have the effect of limiting the assets for which non-residents can be subject to Australian CGT.

Could the Tax Office confirm that the same rationale used in ATO ID 2003/231 would apply to exclude from the section 95 net income of a trust that is not a resident trust, capital gains made in relation to assets that are not 'taxable Australian property' and therefore exempt under Division 855?

Response
The Tax Office advised that agenda items 3.5, 5, 6 and 7 are related and deal with interactions between Division 6 of Part III of the ITAA 1936, the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997, and the provisions in Division 855 of the ITAA 1997, which disregards certain capital gains and losses made by foreign residents. Upon receipt these agenda items were referred to the Trust Consultation Group, with the consent of its Chair, for consideration by that group. This will allow the issues to be considered at a systemic level. The Trust Consultation Group has not previously considered these issues.

Update
This issue was considered by the Trust Consultation Sub-group at a meeting on 18 February 2008. The outcomes have been recorded in the minutes of that meeting and the Sub-group's compendium of issues. Both are available on www.ato.gov.au by following these paths:

¦ Minutes (see issue 5 - CGT and Division 6 interaction issues):

– Trust Consolidation Sub-group minutes

¦ Issues register (see issue 12):

– Trust Consultation Sub-group issues register

1.4 CGT and losses compliance report

Losses and CGT Compliance (large business and international) update

Losses
Due to law changes resulting from the review of income tax self assessment (ROSA), the government provided additional funding for the Tax Office to increase its risk assessment and active compliance focus on revenue losses.

As a result, we have completed over 300 reviews and audits (in Large and Small and Medium Enterprises (S&ME) markets) in respect of loss cases focusing particularly on the origin of the losses. To date we have disallowed over $3.5billion in revenue losses in the large market as a result of our increased focus.

Our losses strategy aims to ensure losses generated and utilised reflect economic realities. We also review losses to ensure they meet the loss recoupment and deductibility tests, particularly as they are transferred into consolidated groups. Our current stock on hand of revenue losses is shown below:

Revenue losses carried forward by market, 2006 financial year Companies, superannuation funds, trusts and individuals
	$billion	Numbers
Large	44	1,500
S&ME	41	25,000
Micro	39	445,000
Other	2	67,000
Total	126	538,500
Note: For individuals, data reflects losses carried forward from the prior year. For all other entities, losses are those carried forward to the next year.

Consistent with the intent of ROSA we are moving to real time identification and review of high-risk loss cases to ensure they are completed within the new period of review. To aid us we have developed a number of tests that are embedded in our risk engine looking at cases where new losses have been generated and/or recouped.

What we are seeing
The issues that continue to arise are:

¦ transfer pricing (large market) - creation of significant losses

¦ errors in calculating/reconciling losses and therefore over claiming of losses (particularly in S&ME and also suspected in Micro Enterprises and Individuals [MEI] as well)

¦ incorrect transfer of losses post the introduction of the consolidations regime (S&ME and MEI)

¦ failure in meeting the deductibility tests for companies, that is the continuity of ownership test (COT) and the same business test (SBT) (Large and S&ME). For COT the issues revolve around the difficulty in determining the failure date; difficulties with tracing; and the 'same share same interest' rules

¦ for SBT there are problems gathering the facts and taxpayers taking a high level industry view of the business rather than looking at the activities carried out by the business, and

¦ recordkeeping problems (S&ME and MEI) - records of old losses not being kept to prove claims.

We are currently looking at the merits of developing a calculator to assist taxpayers in reconciling carried forward losses, recouped losses and new losses incurred.

You will note from the table above that the micro market has revenue losses of approx $39 billion comprising of approximately 445,000 taxpayers. The Tax Office is in the process of undertaking a preliminary risk assessment of this segment to quantify the level of risk that exists.

Removal of quarantining of foreign tax losses
Tax Laws Amendment (2007 Measures No. 4) Act 2007, amended the income tax law to remove the quarantining of foreign losses, which are currently segregated into four baskets of foreign income to which they relate. The commencement date for the changes will be the first income year starting on or after 1 July 2009.

Foreign losses existing at commencement date will be converted to ordinary tax losses subject to transitional rules. The converted losses will be available for deduction against domestic income over a five year period starting with the commencement year.

Period of review for trustees

Background
As a result of the ROSA changes, the Commissioner may amend the assessment of a trustee of a trust estate that is a simplified tax system (STS) taxpayer within two years after the day on which the Commissioner gave notice of the assessment (subject to some exclusions). Generally speaking, a trustee of a trust estate that is a non-STS taxpayer will fall into the four year amendment period. The period of review commences on the date the Commissioner issues a notice of assessment to a taxpayer. This rule will also apply to loss and nil liability returns which, under the new rules, will also be treated as 'assessments'.

The Commissioner doesn't currently issue notices to trustees unless there is a liability to which the trustee is assessed. This means that no period of review will commence for the various potential trustee assessments unless either the Commissioner starts issuing notices or there is a legislative change. It is estimated there are over 500,000 trustees potentially affected.

The issue
The issue in question is how to provide certainty to trustees who currently lodge tax returns, which:

¦ are non-taxable (that is, no assessment needs to be raised against the trustee generally as the income is fully distributed to presently entitled beneficiaries), or

¦ give rise to a nil assessment or various types of nil assessments to the trustee under sections 98, 99 and 99A, without requiring the Commissioner to physically issue nil assessment notices to the trustee.

If a notice of assessment is not issued, there is no commencement date for a period of review, resulting in an 'unlimited review period'.

One of our key concerns is that the Commissioner not be put in a position where he is required to issue an assessment in respect of all possible trustee nil assessments. This would create significant administrative difficulties for the Commissioner, as it is not our practice to issue such assessment notices. Compliance costs would also be increased as the Tax Office does not currently collect the required information to identify the range of nil assessments for which the trustee may potentially be liable.

Current status
This issue has been the subject of various minutes between the Tax Office and Treasury. The Tax Office obtained feedback from practitioner groups and the matter has been discussed at the NTLG. Professional bodies and the Tax Office indicated that a legislative solution is the preferred strategy.

The Tax Office wrote to Treasury outlining the position of the professional bodies and the Tax Office that both parties remain of the view that a legislative amendment is the only practical solution to providing trustees with a limited period of review. Treasury's response was that they are now amenable to legislative solutions and incorporated the issue into Treasury's broader review of unlimited amendment periods (UAP).

Administrative approach
In the meantime, the Tax Office will adopt an administrative practice not to issue an original assessment (of a positive amount) to a trustee beyond the usual review period, except where there has been fraud or evasion. That is, the Commissioner will not raise an assessment after four years (two years for a trustee of a trust estate that is an STS taxpayer) from the date of lodgment of the return. The Tax Office will communicate this approach widely through the web and other avenues, giving comfort to trustees wanting certainty for a particular income year.

CGT specific

Additional funding for the Tax Office
In October the government announced that an additional $446 million will be provided for the Tax Office over the next four years starting 1 July 2008. From a CGT perspective impacts on individuals and micro markets:

¦ development of a more client centric risk assessment approach

¦ evolving into 'real time risk assessment' by developing risk engine criteria and bring forward utilisation of third party data

¦ development of more holistic compliance strategies, such as the 'investors initiative' which will be looking at investors through a more end-to-end lense

¦ focussing our strategies more at the client level and looking at the broader behaviours and motivations rather than focus at the tax level issues, and

¦ CGT will form part of this strategy along with investment properties and share transactions.

Impacts for the S&ME and large markets
Focus on delivering more certainty in providing more responsive guidance and advice in real time on planned transactions before they happen and exploring the potential for taxpayers to engage us early on in the development of their own business strategies so that we can assess the Tax Office position on CGT consequences.

There are plans for more issue based compliance projects across both markets and the potential to see increased, targeted CGT compliance action there.

New turnover test for small business concessions
The new turnover test being introduced from 2007-08 onwards which will allow businesses to access the small business CGT concessions if their turnover is less than $2 million or they have net assets of less than $6 million.

This means that there may be some businesses that are asset rich but can still access the concessions if their turnover in a year is under $2 million, including the turnover of any affiliated/connected entities.

We are looking to do two things - monitor the revenue implications of the changes as the revenue leakage has previously been rated as minimal and secondly look to identify instances where businesses are creating artificial structures to push the boundaries and manipulate the turnover test and report them in real time.

Individuals and micro
Individuals compliance is progressing according to the compliance program and currently achieving the target to meet 6,000 cases for 2007-2008. Compliance activities have included:

¦ 6000 pre-lodgment advisory letters being sent to taxpayers who may have a CGT liability from the disposal of property, and

¦ educational letters containing marketing and education brochures relating to rental properties will be sent to new property investors prior to 30 June 2008 to raise awareness of their obligations.

MEI is focusing on disposals and gains from property, share and managed investments funds, small business concessions, trust distributions and reviewing superannuation contributions and potential for non disclosure of capital gains.

We continue to see compliance issues involving:

¦ misunderstanding of the requirements to qualify for various exemptions and rollovers such as main residence exemption, small business rollover and 15 year retirement exemption

¦ timing of when the $5 million threshold is applied for small business concessions

¦ reporting capital gains based on the settlement date instead of the contract date, and

¦ classifying and claiming a rental property as an active asset.

Small and medium enterprises
We have focussed on gathering and analysing information on various CGT topics including trust cloning, claiming pre CGT status (both K6 event and Division 149) and the use of voluntary liquidations after a major disposal. We are also continuing data matching state property data and Australian Securities and Investment Commission (ASIC) share disposal information with S&ME income tax returns to ensure disposals are being accurately returned.

Findings from compliance activities this year include:

¦ generally capital losses are being appropriately claimed. A few taxpayers have been unable to meet COT or SBT or to substantiate the origin of the loss

¦ issues around pre-CGT status of assets and the failure to recognise separate assets and allocate appropriate values to post-CGT assets. For example, the hotel industry including poker machine licenses issued in the 1990's as part of pre-CGT assets, and

¦ most taxpayers are appropriately applying rollovers and cost base uplifts. However, we continue to see restructuring to obtain tax benefits through the interaction of various provisions. Part IVA may apply and we will be increasing our focus on these types of arrangements.

Work to commence early next year includes:

¦ data matching the disposal of shares via initial public offerings

¦ ensuring transfer of assets to superannuation funds are correctly treated, and

¦ providing an integrated view of the issues impacting taxpayers when exiting their businesses for retirement.

Large market
The large market focus for the upcoming compliance year includes:

¦ assessing and treating risks relating to major transactions including corporate restructures, mergers and acquisitions and divestments

¦ ensuring the economic gains from transactions undertaken by taxpayers are appropriately reflected in net capital gains returned, and

¦ ensuring that taxpayers are not artificially constructing arrangements to avoid their obligations under the new rules for foreign residents and CGT.

Currently in the large market we have 30 audits and 26 reviews with CGT issues in progress. Issues under review include capital gains tax reduction arrangements (CGTRA's), capital versus revenue distinction, validity of capital losses and CGT issues related to exiting from a consolidated group.

During the 2006-07 financial year, the large market finalised 10 audits and 40 reviews which involved CGT issues. These included adjustments for issues such as CGTRA's, calculation of capital losses, validity of capital losses and capital versus revenue distinction.

1.5 Non-Australian sourced capital gain distributed to non-resident

This question deals with a capital gain made by a trustee of a resident trust that is distributed to a beneficiary who was a non-resident at the end of the year of income but was previously a resident at a time before the relevant CGT event for the trustee.

ATO ID 2002/903 states that the trustee of a resident trust is not assessable under paragraphs 98(3)(e) or 98(4)(d) ITAA 1936 on a capital gain arising from the sale of shares in a foreign company transacted in a foreign jurisdiction. We assume the same principle will apply to the new paragraph 98(2A)(d), which replaced paragraphs 98(3)(e) and 98(4)(d). However, paragraph 98(2A) (d) (and the old paragraphs 98(3)(e) or (8 (4)(d)) only deal with the situation where all the beneficiary's share of the net income of the trust was attributable to a period when the beneficiary was not a resident. If any part of the beneficiary's share of the net income of the trust is attributable to the period when they are a resident, paragraph 98(2A)(c) applies to assess the trustee on that part of the share of the net income of the trust.

To determine whether paragraph 98(2A)(c) or 98(2A)(d) applies to a capital gain made by a trustee we have to know whether the capital gain is attributed to a period when the beneficiary was a resident. Could the Tax Office give some guidance on what period a capital gain is attributable to?

There appears to be three possible alternatives as follows.

¦ Firstly, the most logical time for the capital gain to be attributable appears to be the period in which the CGT event occurs. Therefore, provided the capital gain does not have an Australian source and the CGT event occurs after the beneficiary ceases to be a resident there will be no amount assessable to the trustee under subsection 98(2A). This is our preferred alternative.

¦ The second alternative is the time of attribution of the capital gain is at the end of the trustee's year of income in which the CGT event occurs. This is on the basis that a capital gain is brought into the net income of the trust as a component of the 'net capital gain' of the trust. The amount of the net capital gain can only be determined at the end of the year of income and the capital gain only goes into net income at this point.

¦ The third alternative is that the capital gain is attributable to the trust's period of ownership of the CGT asset. We disagree with this alternative as it attributes the gain to a period when there is no real capital gain only the possibility of an unrealised capital gain, and there may also be times in this period where there are unrealised capital losses if the value of the asset goes below the CGT cost base. We see this as the least practical alternative as it would require the trustee to identify whether the non resident beneficiary has been a resident of Australia at any time during the trust's ownership period of the CGT asset.

Response
Agenda items 3.5, 5, 6 and 7 are related and deal with interactions between Division 6 of Part III of the ITAA 1936, the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997, and the provisions in Division 855 of the ITAA 1997, which disregards certain capital gains and losses made by foreign residents. Upon receipt these agenda items were referred to the Trust Consultation Group, with the consent of its Chair, for consideration by that group. This will allow the issues to be considered at a systemic level. The Trust Consultation Group has not previously considered these issues.

During the sub-committee meeting there was general discussion of the three alternatives highlighted in this item. Several, but not all members agreed that the first alternative was most likely, with the third being the least likely as it requires fundamental tracing which is not viable in respect of widely held securities. Members asked if this analysis could be relayed to the Trust Consultation Group to assist them in making their decision.

Update
As requested, the members' analysis was provided to the Trust Consultation Group following the sub-committee meeting. This issue was considered by the Sub-group at a meeting on 18 February 2008. The outcomes will be recorded in the minutes of that meeting and the Sub-group's compendium of issues. Both are available on www.ato.gov.au by following these paths:

¦ Minutes (see issue 5 - CGT and Division 6 interaction issues):

– Trust Consolidation Sub-group minutes

¦ Issues Register (see issue 12):

– Trust Consultation Sub-group issues register

1.6 Non-resident CGT exemption and trusts

Does the section 855-40 ITAA 1997 exemption apply where a fixed trust distributes a capital gain to a discretionary trust, which in turn distributes the capital gain to a non-resident beneficiary? Section 855-40 gives a CGT exemption for non-residents who are distributed a capital gain through a fixed trust and the capital gain is not from 'taxable Australian property' (TAP).

For example Mr X, a non-resident is an object of the XY Family trust. The XY family trust is a beneficiary of the XYZ trust (an Australian resident fixed trust). The XYZ trust makes a capital gain on an asset that is not TAP. The XY family trust has a fixed entitlement to 50% of that capital gain. The trustee of the XY family trust makes a declaration distributing all of its entitlement to the gain to Mr X (a non-resident). Is Mr X entitled to the non-resident CGT exemption in Division 855 ITAA 1997 because of section 855-40?

Section 855-40 provides exemption for a non resident where the gain is in respect of the non-resident's interest in a fixed trust and the gain is attributable to a CGT event happening to a CGT asset of the fixed trust and the asset is not TAP.

In the above example, does Mr X have an interest in the XYZ trust? Mere objects of a discretionary trust don't generally have an interest in the trust assets. However, we understand that once a trustee declares a distribution in favour of an object of the trust an interest in the relevant assets of the trust is created in the relevant beneficiary. Therefore we consider that in the above example once the Trustee of the discretionary trust makes the declaration of the distribution to Mr X he has an interest in the XYZ trust, being his interest in the distributed capital gain. In addition the capital gain that Mr X makes under section 115-215 could be seen as in respect of that interest and attributable to the CGT event happening to the non-Tap CGT asset of the XYZ trust.

On this basis we consider that a non resident beneficiary in the situation outlined in the above example would be entitled to the Division 855 exemption as a result of the operation of section 855-40.

Does the Tax Office agree with this analysis?

Response
Agenda items 3.5, 5, 6 and 7 are related and consider interactions between Division 6 of Part III of the ITAA 1936, the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997, and the provisions in Division 855 of the ITAA 1997, which disregards certain capital gains and losses made by foreign residents. Upon receipt these agenda items were referred to the Trust Consultation Group with the consent of its Chair, for consideration by that Group. This will allow the issues to be considered at a systemic level. The Trust Consultation Group has not previously considered these issues.

Update
This issue was considered by the Trust Consultation Sub-group at a meeting on 18 February 2008. The outcomes will be recorded in the minutes of that meeting and the Sub-group's compendium of issues. Both are available on www.ato.gov.au by following these paths:

¦ Minutes (see issue 5 - CGT and Division 6 interaction issues):

– Trust Consolidation Sub-group minutes

¦ Issues Register (see issue 12):

– Trust Consultation Sub-group issues register

1.7 On the assumption that the Tax Office agrees with the above analysis, how does the section 855 exemption in this case align with the treatment of the capital gain under Division 6 ITAA 1936?

This part of the question also relates to a similar question that we raised as agenda item 6.1 for the NTLG Losses and CGT Sub-committee meeting of 6 June 2007. That agenda item dealt with the CGT exemption for non-resident trusts and whether the rational in ATO ID 2003/231 applies to the Division 855 exemption. ATO ID 2003/231 says the CGT exemption in Division 136 for non-resident's capital gains on assets that do not have the necessary connection with Australia overrides the requirement in section 95 ITAA 1936 that the net income of a trust be calculated as though the trust were a resident of Australia (which would otherwise require the inclusion of capital gains from assets that do not have the necessary connection with Australia). I understand the Tax Office is still considering that issue.

In the context of the current question it appears that where the discretionary trust mentioned above (the XY family trust in the above example) is a non-resident trust the answer to the question in item 6.1 of the 6 June 2007 meeting will resolve the issue, that is, whether the Division 855 exemption for the trustee will override the requirement in section 95 to calculate the gain as if it were a resident.

However, where the discretionary trust (XY family trust in the example) is a resident trust, it appears the answer is not so straight forward. The trustee of the resident discretionary trust will not be entitled to the Division 855 exemption because it is a resident. It will therefore have no option but to calculate the net income of the trust as a resident. The question then is whether the calculation of the amount taxable to the trustee under 98(2A) and 98(3) includes the distribution of the capital gain on the non-TAP CGT asset.

Subsections 98(2A) and 98(3) assesses the trustee on the share of the net income to which a non-resident beneficiary is presently entitled and is also attributable to sources in Australia. If we assume the capital gain on the non-TAP asset has an Australian source, does the Division 855 exemption override the requirement to include Australian sourced in subsections 98(2A) and 98(3) in the assessable income of the trustee where the gain is on non-TAP assets?

If in the circumstances described above the non-resident beneficiary (Mr X) is entitled to the Division 855 exemption because of the operation of section 855-40, one could apply the same rational as applies in ATO ID 2003/231 to say the Division 855 exemption overrides the requirement in subsections 98(2A) and 98 (3) to assess the trustee on the non-TAP capital gain of the Australian resident fixed trust. This is of course dependant on the assumption that the Tax Office agrees that the rationale used in ATO ID 2003/231 can also apply to the Division 855 exemption as per agenda item 6.1 of the last sub-committee meeting.

Could the Tax Office please comment on the above analysis?

Response
Agenda items 3.5, 5, 6 and 7 are related and consider interactions between Division 6 of Part III of the ITAA 1936, the capital gains tax provisions in Parts 3-1 and 3-3 of the ITAA 1997, and the provisions in Division 855 of the ITAA 1997, which disregards certain capital gains and losses made by foreign residents. Upon receipt these agenda items were referred to the Trust Consultation Group (upon their receipt) by the Chair for consideration by that group. This will allow the issues to be considered at a systemic level. The Trust Consultation Group has not previously considered these issues.

¦ Minutes (see issue 5 - CGT and Division 6 interaction issues):

– Trust Consolidation Sub-group minutes

¦ Issues Register (see issue 12):

– Trust Consultation Sub-group issues register

1.8 Trade debt - Is there double taxation?

ATO ID 2005/211 says that the CGT cost base of a trade debt that arose from the provision of services is nil. Does this result in a capital gain on the collection of the debt? Is there double taxation as a result of the same amount being assessed as ordinary income as well as a capital gain?

For an accruals based taxpayer they are generally assessable on the issue of an invoice for services rendered (under section 6-5 ITAA 1997). The resulting trade debt is a CGT asset being the right to receive payment for the debt. There will also be a CGT event C2 on discharge of the debt, that is, when the debt is collected? If the trade debt has nil CGT cost base as per ATO ID 2005/211, and on the basis that the amount received on collection of the debt is the CGT consideration received for the CGT event C2, there will be a capital gain equal to the amount collected? This will generally be the same amount that has already been included in assessable income on issue of the invoice.

Does section 118-20 ITAA 1997 apply to reduce the capital gain to avoid double taxation?

Section 118-20 will reduce the capital gain if an amount has been included in assessable income because of the CGT event. Can the amount assessed under section 6-5 on issue of the invoice be said to be included in the taxpayer's assessable income because of the CGT event C2 on discharge of the debt. If yes, that solves the problem as the capital gain will be reduced by the amount assessable under section 6-5. If not, is there potential double taxation on essentially the same amount?

We have concerns that section 118-20 does not solve the issue because it requires the amount to be assessable because of the CGT event. The CGT event in question is CGT event C2 on discharge of the debt. However that event does not appear to be what makes the amount assessable as ordinary income. The amount has already been made assessable by the issue of the invoice some time before the CGT event.

The alternative argument, and perhaps the better argument, is the one adopted by the Tax Office in item 2.1 of the NTLG CGT Sub-committee meeting of 28 November 2001 in relation to CGT C2 event on payment of a trust beneficiary's trust distribution. In that situation the Tax Office confirmed that the correct approach is to look through the legal rights created and focus on the relevant transaction. The Tax Office stated in the minutes of that meeting:

'The legal rights incidentally created - that is the right to payment and then, on payment, the discharge and satisfaction of that right - merely facilitate the transaction. This is Consistent with the approach outlined in the Commissioner of Taxation v. Dulux Holdings Pty Ltd and Orica Ltd.'

In applying that approach to the collection of trade debts the CGT event C2 on discharge of the trade debt would be ignored as it is just facilitating the collection of the underlying amount that was assessable on issue of the invoice. Do you agree that this is the best approach? If the Tax Office agrees with this approach we suggest that ATO ID 2005/211 be amended to include such an analysis.

Response
Given that a trade debt resulting from the provision of services is a CGT asset, will there be a CGT event C2 on discharge of the debt, that is, when the debt is collected?

CGT event C2 happens when a creditor's trade debt, being an intangible asset, is discharged or satisfied.

If the trade debt resulting from the provision of services has a nil CGT cost base as per ATO ID 2005/211 will there be a capital gain equal to the amount collected upon CGT event C2 happening?

If the trade debt has a nil cost base, CGT event C2 will result in a capital gain equal to the amount of the capital proceeds. Note that ATO ID 2005/211 stated that the first element of the cost base of a trade debt that arises from the provision of services is nil.

Is the amount received on collection of the debt taken to be consideration received for the CGT event C2?

The amount received on discharge of the debt is included in the capital proceeds from CGT event C2 happening.

Does section 118-20 apply to reduce the capital gain to avoid double taxation, specifically considering whether the amount assessed under section 6-5 on issue of the invoice can be said to be included in the creditor's assessable income because of CGT event C2 on discharge of the debt (under subsection 118-20(1))?

Subsection 118-20(1A) extends the application of subsection 118-20(1) to an amount that under a provision (other than Part 3-1) is included in assessable income (for example, under section 6-5) in relation to a CGT asset (for example, a debt owed to a provider of services) as if it were so included because of the CGT event (for example, CGT event C2) referred to in subsection 118-20(1) if the amount (for example, amount received on collection of a debt) would also be taken into account in working out the amount of a capital gain. Accordingly, the anti-overlap provisions of section 118-20 will apply to prevent double taxation in respect of the discharge or satisfaction of a trade debt. Treasury has previously advised the Tax Office that the application of subsection 118-20(1A) in this type of scenario does not raise policy concerns.

Will the Tax Office accept an alternative argument adopted by the office in item 2.1 of the NTLG CGT Sub-committee meeting of 28 November 2001 in relation to CGT event C2 on payment of a trust beneficiary's trust distribution to look through the legal rights created and focus on the relevant transaction?

The Tax Office considers the issue of potential double taxation is resolved by the application of the anti-overlap provisions under section 118-20. As such, there is no need to consider an extension of the approach taken in item 2.1 of the NTLG Losses and CGT Sub-committee meeting of 28 November 2001. A member asked if this view would be confirmed by the Tax Office - for example via a Tax Determination. The Tax Office advised that current thinking was that an ATO ID was the appropriate product but that further consideration would be given to this issue when preparation of a product began.

A further issue was raised as to the impact of consolidations (section 705-75(2) reduction for intra-group liabilities); for example, where the debtor and creditor are in the same consolidated group and the debt was in existence when the debtor joined the consolidated group. If the creditor's trade debt has no cost base (as per ATO ID 2005/211), subsection 705-75(2) would appear to reduce the amount included in 'step 2' of the debtor's allocable cost amount (ACA) calculation to nil. This issue was referred to the NTLG Consolidations Sub-group for their consideration.

A member asked if the same application could apply to a trust distribution. The Tax Office advised that a trust distribution raised different issues (such as the issues raised in considering agenda item 2.1 of the sub-committee meeting of 28 November 2001) and needed to be considered in that different context.

Update
The proposed ATO ID referred to during the meeting has been drafted and will be published shortly.

The issue referred to the NTLG Consolidations Sub-group was raised at their meeting on 21 November 2007 and is under consideration.

1.9 Affiliates and the active asset test

The new definition of 'affiliate' has replaced the previous definition of 'small business CGT affiliate' in the CGT small business provisions. Under the new definition of affiliate in section 328-130, a person's spouse or child under 18 are not automatically considered to be affiliates as was the case in the old definition of 'small business CGT affiliate'. The change in the definition means, in order for a spouse or child under 18 to be an affiliate they will have to be seen as acting in accord with the 'your' wishes or in concert with you, in relation to the affairs of the spouse's or child's business. The new definition also requires the affiliate to be carrying on business, which was not a requirement for the definition of 'small business CGT affiliate'.

The removal of spouse and child under 18 from the definition of 'affiliate' will make it easier for taxpayers to pass the $6 million net assets test as the assets of those persons may no longer be included in the $6 million threshold. However, it could cause problems for the active asset definition where, for example, an asset is owned by an individual and rented or leased to an entity controlled by their spouse.

An asset is an active asset where it is used in the business of the taxpayer or in the business of an affiliate of the taxpayer or connected entity of the taxpayer. A connected entity includes an entity that is controlled by the taxpayer and/or their affiliates (or under the old law 'small business CGT affiliate'). Under the old law, with the definition of small business CGT affiliate, an asset owned by an individual and used in the business of an entity that was controlled by the individual's spouse of child under 18 would be an active asset even though the individual had nothing to do with the business. It appears this is not the case under the new law.

Although, under the new law, section 152-40 (1A) deems a taxpayer's spouse or child under 18 to be an affiliate of the taxpayer for the active asset test where the asset is used in a business conducted by the spouse or child under 18, this concession does not extend to situations where the business is conducted by a company or trust that is controlled by the taxpayer's spouse or child under 18.

To clarify here is an example: A husband (the spouse) controls a company that is carrying on a business in premises that are owned by his wife (the taxpayer). The wife sells the premises and makes a capital gain. The premises would probably have been an active asset for the wife under the previous law because the premises are being used in the business of an entity controlled by the wife's 'small business CGT affiliate' (her husband). However, under the new law the husband will not be the wife's affiliate because he is not automatically taken to be an affiliate and he can't be an affiliate by acting in accord his wife's wishes or in concert with her because he is not personally carrying on the business; the company is the one carrying on the business. Therefore the company is not controlled by an affiliate of the wife.

Under the new law the premises could still be an active asset of the wife if the company itself was an affiliate of the wife, but this will only be where it could reasonably be expected that the company acts in accord with the wife's wishes or in concert with her in relation to the company's business. Where the wife's only involvement in the affairs of the company is being the company's landlord, is that enough to show that the company acts in accord with her wishes or in concert with her in relation to the company's business?

If being landlord is not sufficient what is sufficient involvement with the company's business? What if the wife was also an employee of the company? Does it matter what level of employee she is? Is there a starting point where the company starts to be seen as acting in concert with the wife, for example, cleaner, secretary, manager, or director? If the wife in this case can't get the CGT small business concessions it means there are now situations where assets that were active assets before the change to the law will not be active assets after the change to the law. Could the Tax Office comment on whether this was the policy intent of the change in the law?

Response
The Tax Office agrees with the analysis concerning the new definition of 'affiliate' and its impact on the active asset test. There was discussion as to who may be an affiliate under the new definition, with particular focus on spouses. The Tax Office advised that whether an entity is an affiliate will depend on all the facts and circumstances of each particular case. As noted in the question raised in the agenda item, the new definition does not automatically include a spouse or child under 18 and requires that the affiliate itself must be carrying on a business.

With respect to the operation of the active asset test, new subsection 152-40(1A) effectively deems use of an asset in a business by a spouse or child under 18 to be used in a business by an affiliate. This allows satisfaction of the definition of active asset in subsection 152-40(1) and therefore covers one of the situations affected by the change in the affiliate definition. However, as noted, there is no provision that covers the situation where the asset is used in a business conducted by a company or trust controlled by a spouse or a child not yet 18.

The Tax Office has brought the matter to Treasury's attention.

Whether, in the example provided, the company could be an affiliate of the wife is a question of fact dependant on all the circumstances of the case. However, the Tax Office considers it is unlikely in the circumstances outlined that the company would be an affiliate of the wife. Tenant/landlord, employer/employee, director/company (and the like) relationships are not the type, of themselves, generally considered to involve affiliate relationships.

Tax Determination TD 2006/79 discusses the affiliate concept and specifically deals with the relationship between the controller of an entity and the entity itself. The Determination also contains tenant/landlord examples.

1.10 Connected entities not carrying on business

Another problem may arise in using the CGT small business concessions in regard to an asset that is owned by a 'connected entity' that is not carrying on business but provides that asset to another entity which uses it in its business. The problem arises when the owner of the asset is expecting to rely on the $2 million turnover test to qualify for the CGT small business concessions.

The alignment of the small business threshold definitions is seen as allowing entities that are asset rich but income poor to use the CGT small business concessions, that is, they do not pass the $6 million net asset test but do pass the $2 million turnover test. However, to qualify under the $2 million turnover test the owner of the asset must be a 'small business entity' (SBE) under section 328-110. To be a SBE the owner of the asset must carry on business. This would not be a problem if the asset owner passed the $6 million asset test as there is no requirement for it to carry on business in that case. Does this mean there is a difference in the treatment for the CGT small business concessions where the taxpayer is relying on the $2 million turnover test as compared to those that pass the $6 million net asset test?

Here is an example to illustrate the point: Farm land that is valued in excess of $6 million is owned by Mr and Mrs Brown. They rent the farm land to a unit trust that they control. The unit trust carries on a farming business on the land. The aggregate turnover for Mr and Mrs Brown and the unit trust is less than $2 million. Therefore, even though the $6 million asset threshold test is failed, the unit trust qualifies as a SBE because it passes the $2 million turnover test and would be entitled to the CGT small business concessions. However, if Mr and Mrs Brown sell the farm land they would not be entitled to the CGT small business concessions as they are not an SBE as they are not carrying on a business; whereas if Mr and Mrs Brown passed the $6 million net asset test they probably would be entitled to the CGT small business concessions as they would not then be required to carry on business.

If this is correct there will be many small businesses (particularly farmers) with similar structures as per the example, who may have thought their farm land would become eligible to the CGT small business concessions after the introduction of the $2 million turnover test, but who will be surprised to find they are not so entitled. Could the Tax Office comment on whether it was the policy intent of the change to the law to distinguish between entities that qualify under the $2 million turnover test and those that qualify under the $6 million net asset test?

Response
The Tax Office agrees with the analysis set out concerning the small business entity $2 million turnover test. To be a small business entity, an entity must carry on business and satisfy the relevant turnover test. If an entity does not carry on business it cannot be a small business entity. Therefore, if an asset is owned by a non-operating entity and used in the business of a connected entity, the non-operating entity will not be a small business entity and hence will not be able to access the small business CGT concessions via the $2 million turnover test, even if the connected entity's business turnover is less than $2 million.

In this situation, the non-operating entity will need to rely on satisfying the $6 million maximum net asset value test.

The Tax Office has brought the matter to Treasury's attention.

During discussion on this item, the Tax Office referred to the previous government's announcement of a proposed amendment to the tax law that would address this issue (see the announcement by the former Minister for Revenue and Assistant Treasurer enhancing small business capital gains tax concessions of 22 October 2007). The proposed amendment would allow a taxpayer who owns a CGT asset that is used in a business by an affiliate or a connected entity of the taxpayer to access the small business CGT concessions through the $2 million aggregate turnover test.

1.11 Small business participation percentage

There are a number of situations in the CGT small business concessions that require a 'significant individual' (section 152-55) or CGT concession stakeholder (section 152-60). Both these require you to look at the small business participation percentage. The small business participation percentage is designed to trace interests through interposed entities. Where an individual has a small business participation percentage of greater than 20% in a company or trust they are a 'significant individual' in the company or trust. The definition of small business participation percentage on section 152-70 for a fixed trust uses the smallest percentage of the rights to income or the rights to capital of the trust.

Where an individual has direct or indirect interests of at least 20% in both the income and capital of a fixed trust we would have thought the small business participation percentage mechanism would identify the individual as a significant individual of the fixed trust. However, this does not appear to be the case where the individual has to trace one or both of their income and/or capital entitlements through different entities.

Section 152-75 requires the indirect small business participation percentage of a holding entity to be the sum of the intermediate entity's direct and indirect small business participation percentage in the test entity. If an interposed entity has only income or capital rights in a fixed trust does this mean it has a nil small business participation percentage in the fixed trust because section 152-70 gives the small business participation percentage as the lesser of the income and capital rights? If each of the interposed entities have nil small business participation percentage does this mean the holding entity will also have nil small business participation percentage even though they in fact have underlying rights to at least 20% of both the income and capital of the trust through different interposed entities.

An example to illustrate this point is an individual Mr A holds 100% of the capital rights in the ABC trust. Mr A also holds 100% of the shares in Bco. Bco holds 100% of the income rights in the ABC trust. It is obvious that Mr A has 100% of the underlying interests in both income and capital of the trust. However, it appears that he has nil direct small business participation percentage in the ABC trust because he only has direct income rights and no direct capital distribution rights. It appears he also does not have indirect small business participation percentage because when you trace the indirect participation percentage through Bco it also has a nil small business participation percentage because it only has capital rights. Does this mean Mr A would not be a significant individual of the ABC trust?

Is the correct analysis and if it is does it mean there is a flaw in the participation percentage mechanism?

Response
The Tax Office advised that it agreed with the analysis as set out in the example provided. That is, Mr A is not a significant individual of the ABC trust because his small business participation percentage in the trust is 0%. This is because Mr A's direct small business participation percentage in ABC trust is 0% and his indirect small business participation percentage in ABC trust is also 0% (due to Bco's direct small business participation percentage in ABC trust being 0%).

If an entity has only income or capital rights in a fixed trust but not both its direct small business participation percentage in the trust will be zero. This aspect is unchanged from the previous law (which required entitlement to at least 50% of the income and capital of the trust - see former subsection 152-55(2)).

The result highlighted in the example (that Mr A has a small business participation percentage in the trust of 0% despite effectively holding directly or indirectly 100% of both the income and capital rights in the trust) occurs because the small business participation percentage calculations do not provide for the adding of income or capital interests which are held through different entities in determining direct interests (which is the basis for all the calculations).

During discussion of this item one member stated that this issue was commonly raised in practice and an ongoing concern. The Tax Office advised that further details of frequency with which the issue came up and of actual cases would assist in finding a solution.

The Tax Office said that it would bring the matter to Treasury's attention for their consideration.

Update
Treasury has been advised of this issue.

1.12 Taxation Ruling TR2007/D10 and earnouts

In TR 2007/D10, the Tax Office expresses a view that neither section 110-45(3) nor section 116-50 apply to the purchaser and vendor respectively in a reverse earnout situation. Does the Tax Office have a view on the circumstances in which those sections are likely to apply?

Response
There was considerable discussion of this issue at the meeting. The Tax Office explained that the core issue outlined in TR 2007/D10 was that an earnout right was separate and distinct from the sale contract and should not be looked through (paragraph 14 of the draft TR). The Tax Office again confirmed that payments made in satisfaction of earnout rights under a reverse earnout arrangement do not constitute repayments of the purchase price of the underlying asset. This is because any payments in relation to a standard earnout arrangement or a reverse earnout arrangement are made in respect of the earnout right and not the acquisition of the underlying asset.

In determining when the relevant CGT event C2 happens, the contract for the sale of the original asset for an earnout right is not a 'contract that results in the asset ending' under paragraph 104-25(2)(a) of the ITAA 1997. Accordingly, the time of the CGT event is when the right ends.

If the separate nature of an earnout right is accepted, there will be no scope for double taxation.

A member asked whether the rights can be sold as a separate asset. This was answered in the affirmative. It was accepted that an earnout arrangement is very much part of the overall sale contract for the underlying asset and the TR does not seek to advise the contrary. However, the taxation ruling views the actual playing out or satisfaction of the earnout right is something which is distinct from the disposal or acquisition of the underlying asset and thus warrants separate recognition for the purposes of the CGT provisions. A connection was made between earnout rights and annuities as opposed to other categories of financial arrangement such as instalment warrants in Telstra 3.

A member raised the issue that an earnout could be two cash payments, but the TR explains the situation as one cash payment and therefore does not go far enough in its analysis.

As this agenda item raised more questions than could be answered at the meeting, it was advised that any further comment be directed to the ruling contact officer through the formal Public Rulings consultation process. Consultation on TR 2007/D10 is ongoing and the authoring team will take the comments of the sub-committee members into account in formulating its recommendations as to the changes that should be made in the course of finalising the Ruling.

Update
The issue was also raised with the Consolidation Sub-group.

The Tax Office held a meeting with industry representatives on TR 2007/D10 on 30 April 2008 at which various issues arising from the Ruling were canvassed. It was agreed at that meeting that the attendees (including a number of professional bodies) would provide a further, coordinated submission on the various matters discussed. It is expected that the submission will raise a number of interpretative issues and will provide a single consolidated document that can be addressed at the Ruling Panel meeting in July 2008.

1.13 TR 2007/D10 and earnouts - treatment of a consolidated group acquiring a subsidiary member - ACA step 1 or black hole deduction?

TR 2007/D10 deals with the CGT position on earn-out payments. It tangentially expresses a view in relation to tax consolidated groups making acquisitions of members where earnout payment obligations arise. There is a view expressed in the draft ruling (paragraph 25 and footnote 4) that:

'In the context of consolidated groups, such a payment is not therefore considered to be 'money paid, or required to be paid, in respect of acquiring a membership interest' for the purposes of subparagraph 705-65(5B)(a)(i). Rather, the creation of the earnout right is property given in respect of that acquisition.'

This view may be problematic for a buyer of shares/membership interests in an entity that becomes a subsidiary member of a consolidated group, for the purpose of calculating the ACA step 1 amount for that entity (cost base of membership interests).

This position adopted in the draft ruling is that earnout rights created by a buyer should be recognised as the giving of property by the buyer in respect of the acquisition of the underlying asset. If any amounts are ultimately payable in the future, this should be treated as the discharge of obligations under the earnout right and not as part of the cost of the underlying asset (shares).

This approach seems to conflict with/frustrate the specific amendment made to ACA step 1 (contained in section 705-65(5B)) whereby the actual payments made under contingent deferred payment arrangements should be taken into account for ACA purposes.

The potential consequences of the Tax Office approach are as follows:

¦ include market value (MV) of the earn out right granted in ACA step 1 (assume MV is $1 million due to uncertainty with contingences), and

¦ buyer actually pays $5 million under the earnout agreement (the additional $4 million is not included in the ACA).

If there is no recognition for the earnout obligation for consolidation purposes at the entry date of the subsidiary, is it intended that a black hole deduction would be available under section 40-880 in respect of amounts paid to discharge the obligation under an earn out right, if that expenditure does not form part of the cost base of a CGT asset, and the exclusion in section 40-880(9)(b)(ii) return of a debt interest does not apply? Otherwise, the ATO view would create an inappropriate black hole for consolidated groups.

Recognising that this is still a draft ruling it would be useful to discuss it at the meeting.

If the taxation ruling will lead to an 'earnouts acquisition black hole', this will raise issues about a prospective application date for the ruling and other issues.

Response
Consolidations cost-setting rules

Subsection 705-65(5B) ensures that step 1 of the ACA calculation for the cost of membership interests reflects money and property given after joining time that is in respect of acquiring the membership interest (italics added).

The Tax Office's preliminary, though considered, view is that a payment made to discharge an earnout obligation is not in respect of the acquisition of the relevant membership interest. Instead, it relates to the discharge of an obligation under a financial arrangement that is separate and distinct from the sale contract from which it originated. However, the reasoning in the draft taxation ruling does not preclude the possibility that, in different factual circumstances, a post-joining payment might properly be characterised as part of the buyer's cost base for the membership interests in the joining entity.

The authoring team is aware of the apparent tension between the view expressed in the draft taxation ruling and the stated purpose of subsection 705-65(5B). This may well be a consequence of the fact that the CGT rules are drafted on general law considerations whereas the consolidation rules were drafted based on commercial considerations.

Blackhole expenditure
The availability of a deduction under section 40-880 for amounts paid to discharge earnout obligations is outside the intended scope of TR 2007/D10. However, comments on this and other interaction issues arising from the draft taxation ruling will be taken into account in the course of the official consultation process.

Update
The issue was also raised with the Consolidation Sub-group.

1.14 How does the deeming rule in section 152-120 apply where a unit trust sells an active asset (held for at least 15 years), where the units are owned by a discretionary trust which has incurred tax losses in any one of those 15 years?

This is illustrated in the following example:

Facts
A unit trust sells an active asset which it has owned for at least 15 years.

100% of the units in the unit trust have always been held by a discretionary trust established for the benefit of the A family.

In each of the first 10 years of the ownership period, the discretionary trust made distributions of income 50/50 to Mr and Mrs A.

However, for the last five years, the discretionary trust has incurred losses, so no distributions were made in those years.

Can the sale of the active asset qualify for the small business 15 year exemption (the exemption)?

Analysis
The exemption will only apply if the unit trust had a 'significant individual' for a total of at least 15 years during the ownership period: section 152-110(1)(c).

The term 'significant individual' is defined in section 152-55 by reference to a 'small business participation percentage' (SBPP) of at least 20% in the unit trust.

That requirement will only be satisfied if either Mr or Mrs A have the required 'indirect SBPP' in the unit trust, which (under section 152-75) is measured by reference to their 'direct SBPP' in the discretionary trust.

This raises a potential problem on the present facts, as the existence of the losses means that neither Mr nor Mrs A had a direct SBPP in the discretionary trust (for the purposes of section 152-70) in any of the loss years.

Section 152-120 was presumably intended to address that issue, but there is an argument that it only applies where the discretionary trust is the taxpayer claiming the exemption (which is not the case here).

Even if section 152-120 can apply here, it is unclear whether it fixes the problem, as merely deeming that Mr and Mrs A are significant individuals in the discretionary trust does not give them a direct SBPP in the discretionary trust which can then be used to determine their indirect SBPP in the unit trust. Can the Commissioner confirm his views on that matter?

Response
Revised Question

For the purposes of determining whether a test entity had a significant individual for at least 15 years (to qualify for the 15 year exemption), can the deeming rule in section 152-120 apply in determining a holding entity's small business participation percentage in the test entity if there is an interposed discretionary trust with tax losses?

No. The deeming rule in section 152-120 does not apply in determining an entity's small business participation percentage.

Section 152-120 deems a discretionary trust to have a significant individual during a year where no distributions were made and the trust had a tax loss or no taxable income. This effectively relaxes in certain situations the requirement to have a significant individual for at least 15 years for the purposes of the 15 year exemption (paragraph 152-110(1) (c)).

The recent amendments allow for the indirect tracing of a significant individual through the small business participation percentage calculation. However, section 152-120 does not deem any other entity (such as the unit trust in the above example) to have a significant individual. In addition, although section 152-120 deems a discretionary trust to have a significant individual in certain circumstances it does not deem the trust to have a direct small business participation percentage of at least 20% (or any other amount) which could then feed into the small business participation percentage calculation of the other entity.

Accordingly, section 152-120 does not apply in indirect situations.

The Tax Office will bring this issue to Treasury's attention.

Update
Treasury has been advised of this issue.

1.15 Small Business CGT concessions section 152-20 - liabilities in relation to assets

The net value of CGT assets taken into account for the $6 million net asset threshold is reduced by the value of liabilities that are related to the CGT assets included in the threshold (section 152-20(1)(a)). Our question is: can liabilities incurred in acquiring the shares or units in a connected entity be used to reduce the net asset value of the CGT assets?

To illustrate this issue here is an example:

Mr A owns 50% of the shares in ABC Pty Ltd, that is, it is an entity connected with Mr A. Mr A's only relevant CGT assets are the shares he owns in ABC Pty Ltd and they have a value of $5 million. ABC Pty Ltd has net assets to the value of $10 million. Mr A obtained a loan of $4 million to purchase his shares in ABC Pty Ltd.

As ABC Pty Ltd is an entity connected with Mr A its $10 million net assets will be included in Mr A's maximum net asset value test as per section 152-15(b).

To prevent double counting Mr A's shares in ABC Pty Ltd will be disregarded when calculating the net value of his CGT assets as per section 152-20(2)(a). However does this provision also have the effect of disregarding the $4 million liability that Mr A incurred in acquiring the shares? This loan is obviously in relation to the purchase of the shares but if the shares are disregarded in working out the net value of Mr A's CGT assets can the loan be included to reduce Mr A's net value of CGT assets to negative $4 million?

If the $4 million liability is disregarded Mr A would not pass the $6 million net asset threshold because the net assets of his connected entity (ABC Pty Ltd) would be $10 million.

However, we submit that the $4 million liability can be taken into account in these circumstances. Although section 152-20(2(a) results in Mr A's shares being disregarded for the net asset test, there is no provision that specifically exclude the liabilities in relation to these assets. Therefore, in this example, the net value of Mr A's CGT assets taken into account should be negative $4 million. This would then be offset against the $10 million net assets of his connected entity resulting in total net value of CGT assets for the purposes of section 152-15 being $6 million, thus passing the net CGT asset value test.

Could the Tax Office please comment on this analysis?

Response
Liabilities incurred in acquiring interests in a connected entity are not taken into account in determining the net value of the CGT assets of the interest holder or the connected entity.

Although paragraph 152-20(2) (a) does not itself disregard related liabilities, the combined effect of paragraph 152-20(2) (a) and subsection 152-20(1) is that liabilities that are related to excluded assets are themselves excluded. That is, for liabilities to be taken into account under subsection 152-20(1) they must be related to assets that are included in the net value of the CGT assets calculation and are not excluded under subsection 152-20(2).

Interests in a connected entity are excluded because the assets of a connected entity are also included in the calculation - this avoids double counting. In effect, assets represented by the excluded interests are still included in the net asset calculation.

The Tax Office will bring this aspect to Treasury's attention.

Update
Treasury has been advised of this issue.

1.16 Small Business Concessions - active asset definition

A CGT asset is an active asset if it is used in the course of carrying on a business by you or by your affiliate or an entity connected with you (section 152-40(1)). There does not appear to be a requirement for the business to be used 100% in the relevant business. For example if only part of a taxpayer's land was used in their business the whole of the land would qualify as an active asset (subject to any other exclusion such as main use to derive rent). Does this also apply where part of the property is being used by someone else who is not an affiliate or connected entity?

For example a property is owned as tenants in common by three discretionary trusts. These discretionary trusts provide the property for use by three doctors as their practice rooms, the doctors are not in partnership. Each of the doctors is respectively connected to one of the discretionary trusts. The property that is owned by the trusts is being used by entities connected with each of them individually but not as a whole. That is, in relation to each discretionary trust only 1/3 of the property is being used in the business of their connected entities. Does this affect the eligibility for the discretionary trust's interest in the property to be an active asset?

Response
Revised question

Is there a requirement for an asset to be used wholly in the relevant business to qualify as an active asset and if not is this also the case where the asset is partly used by someone who is not an affiliate or connected entity of the taxpayer?

There is no requirement for an asset to be used wholly in the course of carrying on a business for it to qualify as an active asset. If an asset is only used partly in the relevant business, the asset may still qualify as an active asset (subject to any exclusion such as main use to derive rent). This is the case regardless of whether the asset is used partly in the taxpayer's business or in the business of a connected entity or an affiliate.

If an asset is used partly in a relevant business and partly by someone who is not an affiliate or a connected entity of the taxpayer, this of itself will not stop the asset may nonetheless be an active asset. However, if the asset is rented to the unrelated entity which is partly using the asset it is necessary to determine whether the main use of the asset is to derive rent. If so, the asset will not be an active asset (paragraph 152-40(4)(e)).

In the particular example provided each discretionary trust, as a tenant in common, has a separate interest in the whole asset, which is being used one-third in the business of a connected entity and two-thirds in the businesses of unrelated entities. Accordingly, each discretionary trust's asset, being its separate interest in the whole asset, is being used one-third in the business of a connected entity and two-thirds in the business of unrelated entities. As discussed above, this of itself will not stop the discretionary trust's interest in the whole asset from being an active asset. If, however, the discretionary trusts rent the rooms to the doctors, it will be necessary to determine if the main use is to derive rent.

1.17 Can a company or trust satisfy subsection 152-325(1) if the payment made direct to the CGT concession stakeholder is in breach of its constitution or trust deed?

Background
In the NTLG Losses and CGT Sub-committee minutes for the 6 June 2007 meeting, at agenda item 16.6, the ATO have advised that for a payment to satisfy subsection 152-325(1) it must be made direct to the stakeholder.

If the stakeholder does not have a direct interest in the company or trust (that is, as a shareholder or beneficiary) and is not an employee, the making of a direct payment to the stakeholder may be in breach of the company's constitution or in breach of the deed under which the trust is governed.

Relevance of issue
Anecdotal evidence suggests that companies and trusts will make a direct payment to the stakeholder in order to ensure the requirements for the capital gain to be disregarded under the retirement exemption are satisfied, notwithstanding that the payment is in breach of its constitution or deed.

NTAA view
Whilst we are in no way encouraging or condoning payments made in breach of a company's constitution or a trust's deed, we believe the payment in these circumstances will constitute a payment to the stakeholder for the purposes of subsection 152-325(1).

We hold the same view where the company or trust is required to make the payment by contributing it to superannuation in respect of the stakeholder under 55. Refer subsection 152-325(7).

We seek the Tax Office's confirmation or otherwise of this view.

Response
As noted at the last sub-committee meeting (June 2007, agenda item 16.6), direct payments to concession stakeholders are necessary for the purposes of section 152-325. There is nothing in the income law that sanctions any breach of the paying entity's constituent document.

There was discussion around what constitutes a payment in various circumstances, for example:

¦ whether a 'payment' (for example, a passing of cash) might not be a payment because of an entity's constitution

¦ what the implications might be if it is not a payment, and

¦ what is necessary for a payment to be a direct payment.

Whether a payment made direct to an indirect concession stakeholder that is in breach of the paying entity's constituent document is still nevertheless a payment that satisfies subsection 152-325(1) will depend on the particular circumstances.

1.18 Application of section 109 to payments made by private companies to CGT concession stakeholders under the retirement exemption

Background
From 1 July 2007, a company or trust is no longer required to make a payment in the form of an eligible termination payment (ETP) to a CGT concession stakeholder as part of accessing the retirement exemption. Any payment (regardless of its form) will suffice. Refer subsection 152-325(1). Prior to this date the payment was either specifically required to be an ETP or was deemed to be an ETP.

This means the legislation does not require the payment to be made in any particular form, that is, it could be paid as an employment termination payment, salary (for example, bonus) or as a dividend.

Where the payment is an employment termination payment or salary (that is, where the stakeholder is an employee) it is potentially subject to section 109. The consequence of section 109 being applied to all or part of the payment is that part of the payment is of a type referred to in section 82-135 of the ITAA 1997 (refer to paragraph 82-135(h)) and due to the operation of subsection 152-352(3A) the payment will not be a payment for the purposes of subsection 152-325(1) and the retirement exemption does not apply.

Payments made prior to 1 July 2007 were potentially subject to section 109 in the same way although there was no equivalent to subsection 152-325(3A).

Relevance of issue
From 1 July 2007, any payment made by a private company may attract the operation of section 109. To the extent that section 109 is applied, this has the effect of denying the private company from applying the retirement exemption which means the capital gain is assessable to the company and the payment is assessable to the stakeholder.

Discussion
This is clearly nonsense. There is no obvious reason why private companies should not be able to apply the retirement exemption with certainty. Private companies should be able to access the retirement exemption on the same footing as other entities such as unit trusts and discretionary trusts.

The NTAA seeks the Tax Office's view on the following:

1. Does a payment (whether a dividend or otherwise) by a private company to a stakeholder who is also an employee potentially attract the operation of section 109?

2. Can section 109 potentially apply where the payment is made by a private company by way of a contribution to a superannuation fund as required by subsection 152-325(7)?

3. If the answer to 1 and/or 2 above is yes, is the Tax Office aware of any policy intent that this outcome was intended? If the legislator has a specific mischief in mind by making the payment potentially subject to section 109 is the Tax Office able to provide practical examples of when section 109 would be applied to payments to employee stakeholders? That is, by way of response to this item and/or the advanced guide to the small business CGT concessions, taxation rulings or interpretative decisions (ATO IDS).

It is hard to imagine that this mischief (whatever it may be) would apply to the vast majority of private companies seeking to apply the retirement exemption. It is these companies that need to be certain in the knowledge that they can apply the retirement exemption on the same footing as other entities.

The NTAA is of the view that there is an urgent need for the market place to be provided with certainty that the retirement exemption is available to a private company in the absence of the existence of the mischief referred to above.

Response
A payment made by a private company to a stakeholder who is also an employee, including a payment made by way of a contribution to a superannuation fund as required by subsection 152-325(7), may attract the operation of section 109 of the ITAA 1936.

For a company to choose the retirement exemption it must make a payment to a CGT concession stakeholder in accordance with section 152-325. If the CGT concession stakeholder to whom the payment is made is an employee of the company, the payment must not be of a kind mentioned in section 82-135 (subsection 152-325(3A)). Paragraph 82-135(h) refers to a payment that is deemed to be a dividend under the Act. A payment will be deemed to be a dividend if it satisfies the requirements in section 109.

The retirement exemption is therefore not available to the extent that a payment made by a company to a CGT concession stakeholder is deemed to be a dividend under section 109.

The government explicitly expressed its intention that section 109 should be able to apply in retirement exemption situations in rejecting the Board of Taxation's recommendation for an amendment to ensure the deemed dividend provisions did not apply to retirement exemption amounts. The Treasurer's press release gave the following explanation for not adopting that recommendation:

'The safeguarding nature of the deemed dividend provisions should not be potentially undermined by reason of a CGT exemption'.

The intention that section 109 can apply in these situations is also highlighted in paragraph 1.64 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No 7) Act 2007.

Some guidance on the operation of section 109 in a retirement exemption context is set out in ATO ID 2003/743. General guidance on the operation of section 109 is also set out in Taxation Ruling IT 2621. Taxpayers are able to seek guidance on the application of these products to their particular cases through the private ruling process.

1.19 Draft Taxation Ruling TR 2007/D7 wash sales and Part IVA consequences, particularly relating to CGT

This draft ruling, which is in the rulings panel process and is thus not in a final form, raises significant issues in relation to CGT.

The draft ruling considers the application of Part IVA to 'wash sales' which include situations where a taxpayer owning an asset which has an unrealised loss, sells the asset to crystallise the loss and then subsequently repurchases the same or another similar asset.

As the professions have noted, the ruling seems to be influenced in part by the CuminsCase, where a taxpayer sold a particular asset, apparently to realise a loss, from one trust to another trust apparently having the same beneficiaries and entitlements. The draft ruling contains an example where a particular quoted share is essentially crossed in the market on a concurrent and contingent basis but also suggests that Part IVA would apply where an asset is sold on the market and is repurchased 24 hours later without any risk reduction or linking of the two transactions.

We would like to discuss why the Tax Office is unable to proceed with its previous ruling on wash sales in Taxation Ruling IT 2643 (withdrawn on 11 July 2007) and Taxation Determination TD 2004/13 (which is currently still in force but difficult to reconcile with the draft ruling), that a transfer to a relative (IT 2643) or a declaration of trust (TD 2004/13) over shares in a company that was in voluntary administration should not, as a general rule, attract the application of Part IVA where certain circumstances arise.

Response
Taxation Ruling IT 2643 Income tax: sale of shares in companies in liquidation, receivership ('wash sales'), was withdrawn in consultation with the Tax Office General Anti-avoidance Rules (GAAR) Panel.

Factors behind the decision to withdraw the ruling include the following:

¦ IT 2643 contains an unsatisfactory analysis of where Part IVA does or doesn't apply and could be viewed as potentially misleading

¦ the scope of the arrangements to which the ruling applies is not clear, and

¦ recognition that the introduction of CGT event G3 enables shareholders to claim a loss if a liquidator or administrator provides the relevant declaration.

The decision to publish a taxation ruling on the application of Part IVA to 'wash sale' arrangements was precipitated partly by:

¦ the litigation in Cumins

¦ an internal review of Part IVA products undertaken during the development of PS LA 2005/24 - Application of GAAR, and

¦ discussions at the NTLG meeting of 3 December 2004, where some stakeholders regarded IT 2643 as indicating that the Tax Office would not generally apply Part IVA to wash sale arrangements.

The Tax Office acknowledges that TR 2007/D7 does not directly deal with Taxation Determination TD 2004/13 Income tax: capital gains: can CGT event E1 in section 104-55 of the ITAA 1997 happen to a shareholder in a company in voluntary administration under Part 5.3A of the Corporations Act 2001 who declares a trust over their shares. This is an issue that we are currently considering.

In particular, the Tax Office is reviewing the conclusion in TD 2004/13 (that the declaration of trust is effective in view of section 437F of the Corporations Act 2001) and has sought the advice of Counsel in this regard.

Following the receipt of Counsel's advice the Tax Office will consider its position as to TD 2004/13 and TR 2007/D7.

Update
TR 2007/D7 was finalised and released as TR 2008/1 on 16 January 2008. The ruling does not specifically deal with TD 2004/13. The Tax Office is yet to receive Counsel's advice in respect of the application of TD 2004/13; as a consequence the Tax Office has not finalised its review.

1.20 Tax consolidation - CGT straddle contracts

The 2007 Budget announcement of CGT amendments to apply in respect of CGT straddle contracts by consolidated groups (in particular where a consolidated group is entering or leaving a tax consolidated group while at the same time having sold or acquired a CGT asset) are to apply to transactions from Budget night 2007.

This means that the position prior to that commencement time is governed by the current law. The professions understand that a detailed Tax Office paper was to issue in relation to the CGT treatment under the current CGT legislation for consolidated groups. That paper would appear to be necessary to enable resolution of relevant income tax returns.

Is a paper to issue from the Tax Office? Can this paper or position be discussed with the Losses and CGT Sub-committee?

Response
( Note: The response on this item was provided by a representative of the Consolidations CoE).

First, it should be noted that the proposed changes announced in the 2007 Budget will apply to CGT events that happen under contracts entered into after 8 May 2007.

The Tax Office advised the sub-committee in June 2007 that it was consulting on Draft Taxation Determination TD 2005/D27. We invited members to raise any concerns they had with the proposed finalisation of the ruling, as well as any issues or concerns in relation to the related consolidation issue of relevant assets, for discussion at the June 2007 meeting of the NTLG Consolidation Sub-group.

At the June 2007 meeting of the NTLG Consolidation Sub-group, the Tax Office advised that Draft TD 2005/D27 will be re-released as a draft for comment along with draft taxation determinations which will address associated issues in identifying the relevant asset. There will be some limited consultation conducted with members of the NTLG Consolidation Sub-group prior to the release of the draft determinations.

There are no plans to issue a discussion paper.

These issues are likely to be raised at the next meeting of the NTLG Consolidation Sub-committee scheduled for 21 November 2007. Members of this sub-committee were again invited to raise with their representative on the NTLG Consolidation Sub-committee any particular issues or scenarios they would like considered.

Update
This issue was on the agenda of the NTLG Consolidation Sub-group meeting held on 21 November 2007. A paper setting out the draft views being considered by the Tax Office on the CGT and related tax cost setting issues that arise under straddle contracts was circulated to members of that sub-group for comment on 21 December 2007. The Tax Office received a number of comments in late February and is considering these further.

1.21 Does a capital gain included in a beneficiary's assessable income under paragraph 97(1)(a) of the ITAA 1936 cease to be so included due to the operation of subsection 115-215(6) of the ITAA 1997?

Background
Where a beneficiary is presently entitled to a trust capital gain, this amount is generally included in the beneficiary's assessable income under paragraph 97(1)(a) of the ITAA 1936. The beneficiary is also taken to have an extra capital gain due to the operation of subsections 115-215(2) and (3) of the ITAA 1997.

To ensure the beneficiary is not taxed on the same capital gain twice, subsection 115-215(6) states that the beneficiary:

'can deduct for the income year the part (if any) of the trust amount that is attributable to the trust estate's net capital gain mentioned in subsection 102-5(1)'

The above wording indicates that the section 97 capital gain is still included in the beneficiary's assessable income notwithstanding there is an allowable deduction for this same amount.

Relevance of issue
There are many legislative provisions that require a taxpayer's assessable income to be determined. As such a beneficiary needs to know whether the paragraph 97(1)(a) capital gain still forms part of their assessable income.

NTAA view
Nothing in the wording of subsection 115-215(6) appears to override the effect of paragraph 97(1)(a) which is to include the capital gain in the beneficiary's assessable income.

We seek the Tax Office's confirmation or otherwise of whether they also have the same view.

Response
We agree that the availability of a deduction under subsection 115-215(6) of the ITAA 1997 for an amount of trust net income that is attributable to the trust's net capital gain does not mean that the amount is not otherwise included in the assessable income of the beneficiary under Division 6 of Part III of the ITAA 1936. This view was adopted in TR 2006/14 (about life and remainder interests). Paragraph 84 of that ruling provides:

'the fact that an amount equal to the amount included in assessable income under section 97 of the ITAA 1936 is deducted from the remainder owner's assessable income for the purposes of applying the rules in subdivision 115-C does not prevent the anti-overlap rule in section 118-20 from applying.

(subsection 118-20(1) relevantly requires that a non-CGT provision include an amount in assessable income or exempt income).'

It is not clear whether there are any direct consequences in terms of qualifying for benefits or offsets that are generally calculated by reference to a person's taxable income. Members of the sub-committee were asked to advise of any situation where this is not the case.

1.22 Change of unit trust deed to account for NSW land tax changes - is there a resettlement?

Section 3A of the NSW Land Tax Management Act has recently been changed to clarify the definition of 'fixed trust' to account for the decision in CPT Custodian Pty Ltd. Subsection 3A(3B) was inserted to give the criteria for a trust to be considered to be a fixed trust to be on where the beneficiaries of the trust:

¦ are presently entitled to the income of the trust, subject only to payment of proper expenses by and of the trustee relating to administration of the trust, and

¦ are presently entitled to the capital of the trust, and may require the trustee to wind up the trust and distribute the trust property or proceeds of the trust property.

Many unit trust deeds do not currently comply with these requirements, particularly the second requirement for the beneficiaries to be presently entitled to the capital of the trust and therefore the trustees are considering amendments to the trust deeds to comply with these requirements. Our question is will these changes to the trust deeds result in a resettlement of the trust?

We appreciate that, as with most issues to do with trusts, the answer will depend on the wording of the particular trust deed, however we would appreciate some guidance on the issue. To assist in this regard here is a description of the income and capital rights of a generic trust.

¦ Single class of units issued to more than one unit holder.

¦ Trustee holds the trust fund for the benefit of the unit holders, with the unit holders beneficially entitled to the entirety of the trust fund but no unit holder or combination of unit holder shall be entitled to any particular asset in the trust fund nor can they be entitled to require the trustee to transfer any trust fund assets to the unit holders.

¦ Unit holders entitled to distribution of all trust income unless the trustee determines to accumulate all or any part of the trust income for the benefit of the unit holders.

If the trust deed were amended to comply with the 'fixed trust' eligibility requirements in section 3A of the NSW Land Tax Management Act, would there be a resettlement of the trust?

We envisage that the required amendment to the trust deed would amend or delete the limitation on unit holders to entitlement to trust assets and allow the unit holders to require the trustee to transfer the assets to the unit holders as a whole. There would also be a change to the power to accumulate income, either to delete the power to accumulate or provided that the power to accumulate be subject to the consent of the unit holders.

We have looked at the Tax Office's document 'Creation of a new trust - Statement of Principles August 2001' and we note example 5.5.4 indicates that a change to a unit trust deed to allow accumulation of income will not generally result in the resettlement of the trust. Therefore we submit the deletion or restriction on the power to accumulate income should also not create a resettlement of the trust.

In relation to the changes that would give the unit holders' present entitlement to the trust capital and so on, we consider this does not fundamentally change the trust relationship. The trustee will still be holding the trust funds for the benefit of the same beneficiaries. Before the change to the trust deed the unit holders would be entitled to the capital of the trust on termination of the trust, the change to the trust deed just brings this entitlement forward by allowing the beneficiaries to require the trustee to transfer the assets to them. In other words it changes the timing of the beneficiaries' entitlement to the trust capital but does not change the essential nature of their interests in the trust.

Response
The Trust Consultation Group has not considered the NSW land tax changes. The Tax Office invited members of the Trust Consultation Group, at its meeting of 28 November 2006, to advise whether members thought the NSW land tax changes warranted consideration by the group. No feedback was provided.

Absent a review by the Trust Consultation Group involving a consideration of a cross-section of specific cases, the Tax Office is unable to provide general assurances as to the possible tax consequences of amending trust deeds to access the NSW land tax concessions. The correct tax treatment will depend on the particular facts and circumstances of the trust and the nature of the proposed amendments. This will require a careful consideration of all relevant terms of the trust deed and of the nature and purpose of the trust in question. Guidance about resettlement issues may be found in the Tax Office publication 'Creation of a new trust - Statement of Principles August 2001'.

Taxpayers wishing to obtain formal advice on the tax implications of related amendments to trust deeds may wish to approach the Tax Office for a private ruling.

1.23 Draft submissions to NTLG re: small business CGT concessions

A. Introduction

Division 152 of the ITAA 1997 ('Div 152') contains various small business CGT concessions. Significant amendments were made to the concessions with effect from 1 July 2006. As a result of those amendments the scope of the concessions has increased significantly.

Two areas in which the scope of the concessions has been increased are:

¦ the availability of the small business retirement exemption (subdivision 1 52-D) as relief for a capital gain made by a company or unit trust where the CGT concession stakeholders are not direct shareholders or unitholders of the entity, and

¦ the availability of the small business rollover (subdivision 1 52-E) where no replacement asset is ever acquired.

In applying the amended rules, various technical anomalies have become apparent as set out below.

B. Small business retirement exemption

Before 1 July 2006
Before the 1 July 2006 amendments, the small business retirement exemption was only available as relief for a capital gain made by a company or unit trust where an individual directly owned at least 50% of the shares or units. This was because of the requirement that the entity satisfy the controlling individual test. That test in turn required there to be an individual who owned at least 50% of the shares or units in the entity (called a controlling individual).

If the retirement exemption was available, the entity was required to make an eligible termination payment in respect of its 'CGT concession stakeholders' - that is, the controlling individual and her/his spouse. In order to be an ETP, the payment must have been made in connection with the termination of employment of an individual.

Therefore it can be seen that before 1 July 2006, in order for the retirement exemption to be available as relief for a capital gain made by an entity:

¦ the CGT concession stakeholder must have been an employee of the entity, and

¦ the payment must have been made directly by the entity to the employee, in consequence of the termination of employment.

From 1 July 2006
From 1 July 2006 the scope of the small business retirement exemption was increased. The definition of 'CGT concession stakeholder' was changed to mean a 'significant individual' and her/his spouse. To be a 'significant individual' in a company or unit trust, an individual was required to have a 20% (rather than 50%) ownership interest in the entity. Critically, that 20% interest could now be met via shares or units held indirectly, via one or more interposed entities.

The requirement for the payment to be made in connection with termination of employment was also removed. Instead, the payment requirement is stated as follows (section 52-325(1)):

…company or trust must make a payment to at least one of its CGT concession stakeholders…

It is this requirement that the entity make a payment 'to' its CGT concession stakeholder that causes difficulty.

Section 152-325(1) appears to require the entity to make the payment directly to its CGT concession stakeholder. This emerges from the wording of

section 152-125(1)(b) (regarding the 15 year exemption), which refers to payments made by an entity to its CGT concession stakeholder 'directly or indirectly through one or more interposed entities'. The fact that section 152-325(1) does not refer to indirect payments suggests that the retirement exemption requires the payment to be made directly from the entity to the individual.

Under the rules from 1 July 2006:

¦ it is possible for an individual to be a CGT concession stakeholder even if she/he does not own shares/units in the entity. For example, the shares/units could be owned by a discretionary trust of which the individual is a beneficiary, and

¦ there is no practical requirement for the individual to be an employee of the entity.

In other words, it is possible for an individual to be a CGT concession stakeholder in relation to an entity even if the person has no direct legal connection with the entity. In such circumstances, there will therefore be no legal basis for the entity to make a payment directly to the individual, as is required to access the small business retirement exemption.

Whilst the amendments of 1 July 2006 enabled indirect ownership to be used to qualify an individual as a CGT concession stakeholder, the payment requirement in section 152-325(1) has not been updated to allow indirect payments. This has the effect of placing taxpayers in a situation where the availability of the small business retirement exemption is predicated on a company or trust making a payment which it will often not be legally permitted to make.

Proposed solution
Section 152-325(1) should be amended to provide that the payment may be made by the company to its CGT concession stakeholder 'directly or indirectly through one or more interposed entities'.

This amendment would be consistent with the scheme of the small business concessions, which uses effective economic ownership as the basis for an individual being a CGT concession stakeholder.

Further amendments
As a consequential amendment, section 292-100(8)(b) (regarding the CGT cap) should also be amended to reflect that a payment under section 152-325(l) maybe made to the individual directly or indirectly.

Similarly, section 292-100(4)(b) (regarding the 15 year exemption and the CGT cap) should also be amended so that a payment under section 152-125(1)(b) may be made to the individual directly or indirectly.

C. Small business rollover

Before 1 July 2006
Before the 1 July 2006 amendments, the small business rollover could only be claimed if the requisite replacement asset was acquired within a period ending two years after the original CGT event.

From 1 July 2006
From 1 July 2006, the small business rollover can be claimed where no replacement asset is ever acquired. The rollover may be chosen at any time, provided the basic conditions for small business relief in subdivision 152-A are satisfied for the original capital gain.

If no replacement asset is acquired within the two year period, CGT event J5 happens. The time of CGT event J5 is two years after the original CGT event.

Intention that retirement exemption can apply to CGT event J5
When CGT event J5 happens in relation to a taxpayer, the legislative intent is that the resulting capital gain may be reduced by applying the retirement exemption. Evidence as to this intent is as follows:

Section 152-12(4)
Section 152-12(4) states as follows (regarding the scope and application of Division 152):

¦ Subdivisions 152-B and 152-C do not apply to CGT events J2, J5 and J6. In addition, subdivision 152-E does not apply to CGT events J5 and J6.

It is implicit from this section that subdivision 152-D (the retirement exemption) does apply to CGT event J5.

Section 152-325(1)
Section 152-325 sets out conditions that a non-individual taxpayer must satisfy' in order to apply the retirement exemption. One of those conditions is in section 152-325(1) as follows:

¦ a company or trust must make a payment to at least one of its CGT concession stakeholders if:

– the company or trust makes a choice under this subdivision to disregard a capital gain from CGT event J2, J5 or J6, or

– the company or trust receives an amount of capital proceeds from a CGT event for which it makes a choice under this subdivision.

Again, the reference to CGT event J5 this clearly contemplates that the retirement exemption is able to be utilised to reduce a capital gain arising from that CGT event.

Explanatory Memorandum
CGT event J5 was inserted into the ITAA 1997 pursuant to the Tax Laws Amendment (2006 Measures No. 7) Bill 2006. The Explanatory Memorandum to that bill stated as follows (at paragraph 1.71):

It is not necessary to receive actual capital proceeds in order to access the retirement exemption - the retirement exemption is available where a capital gain is made when an active asset is gifted and the market value substitution rule has applied or where CGT event J2, J5 or J6 happens. This is achieved by repealing subsections 152-310(3) and 325(4).

This expressly states the intention that the retirement exemption can apply to a capital gain arising under CGT event J5.

Difficulty in applying retirement exemption to CGT event J5
Difficulties arise when one attempts to apply the subdivision 152-D retirement exemption to a capital gain from CGT event J5. To apply the retirement exemption it is necessary that the basic conditions for small business relief in subdivision 152-A are satisfied 'for that capital gain' (subsection 152-305(1)(a) and 152-305(2)(a)).

The basic conditions for relief include:

4. 'that a CGT event happens in relation to a CGT asset of yours in an income year (section 152-1O(1)(a)):

– for present purposes, the relevant CGT event is CGT event J5

– can it be said that CGT event J5 happens 'in relation to a CGT asset?' CGT event J5 happens because no asset has been acquired by a taxpayer. Must it then follow that the relevant asset is the asset that gave rise to the original capital gain (to which rollover relief applied?) This is unclear, and

– which is the 'income year' in which the CGT event happens? CGT event J5 happens two income years after the original CGT event.

5. 'you are a small business entity for the income year' or 'you satisfy the maximum net asset value test' (section 152-1O(1)(c)):

– it is odd that the taxpayer would have to be a small business entity two years after the original CGT event. In many cases the taxpayer will have sold its business (giving rise to the original capital gain), therefore it will not be a small business entity.

– similarly, it is odd that the taxpayer would have to satisfy the maximum net asset value test two years after the original CGT event, and

– the policy intent is clearly that the retirement exemption should be available for CGT event J5. CGT event J5 is effectively the crystallisation of a rolled over gain where no replacement asset is acquired. Therefore from a policy perspective it would be more appropriate to test both small business entity status and the maximum net asset value test as at the time of the original CGT event, not two years afterwards.

6. 'the CGT asset satisfies the active asset test' (section 152-1O(d)):

– we have already established that the CGT asset must be the asset that gave rise to the original capital gain. However it appears that this provision requires the active asset test to be satisfied in relation to that asset two years after the original CGT event (that is, when it has already been sold). This makes no sense, and

– instead, the relevant question should be whether the asset satisfied the active asset test at the time of the original CGT event.

It can be seen that trying to apply the basic conditions for small business relief to CGT event J5 causes many problems. As a result, there will be great difficulty for taxpayers to ever apply the retirement exemption to a capital gain from CGT event J5.

This is inconsistent with the policy of simplification and likely to impose unnecessary cost burdens on taxpayers.

At the root of the problem is that the circumstances that should be tested are those that existed at the time of the original CGT event. However under the current provisions, CGT event J5 happens two years later therefore that is when the basic conditions for relief are tested.

Proposed solution
Where a taxpayer wishes to apply the subdivision 1 52-D retirement exemption to a capital gain from CGT event J5, the requirement that the basic conditions for small business relief must be satisfied (that is, (subsection 152-305(l)(a) and 152-305(2)(a)) should not apply.

In effect, the basic conditions should be tested as at the time of the original CGT event. Given that the taxpayer has already satisfied them and applied the small business rollover, that test will always be satisfied, therefore there is no requirement to carry out the test.

There is precedent for this in the Commissioner's previous approach to CGT event J2. In ATO ID 2004/240, the Commissioner took the position that a capital gain under CGT event J2, 'has the characteristics of the deferred capital gain'. This comment was made in addressing the question of whether there were physical capital proceeds (as opposed to deemed capital proceeds) received under CGT event J2. The answer was that if there were physical capital proceeds under the original CGT event, then the same should be assumed for CGT event J2.

CGT event J5 is conceptually the same as CGT event J2 - it is the result of the conditions for ongoing rollover relief ceasing to apply. Consequently the same approach should apply - that is, the capital gain from CGT event J5 'has the same characteristics' as the original capital gain. This should include the characteristic of satisfying the basic conditions for small business relief. Accordingly it should not be necessary to separately test those conditions two years after the original CGT event.

Response

7. Retirement exemption - direct payments to concession stakeholders

The retirement exemption requirement for direct payments to concession stakeholders (including to indirect stakeholders), was raised at the last sub-committee meeting (agenda item 16.6) and also again as a separate agenda item for this meeting (agenda item 17). As noted at the previous meeting, the Tax Office has brought the issue to Treasury's attention.

8. Retirement exemption - CGT event J5

The question of whether the retirement exemption can be chosen for capital gains made from CGT event J5 (which happens because of the non-acquisition of a replacement asset after an earlier rollover) was raised at the last sub-committee meeting (refer to June 2007 meeting agenda item 18.0).

The present drafting of Division 152 does not allow for the retirement exemption to be chosen for CGT events J5 and J6 because it is not possible for a CGT event J5 or J6 capital gain to satisfy the basic conditions in subsection 152-10(1). The Tax Office also indicated that the issue has been brought to Treasury's attention.

1.24 First home owners grant scheme (and like payments from state governments)

Could the Tax Office please confirm that payments received under the Commonwealth government's first home owners grant scheme (and like payments from state governments) will not reduce the cost base of a property for CGT purposes?

This question is relevant in cases where a property that was initially a main residence, and thus qualified for the first home owners grant scheme, subsequently becomes an investment property.

Our analysis is that these payments:

¦ are not assessable as ordinary income (which the Tax Office has confirmed in ATO ID 2001/715)

¦ are not statutory income (under, for example, section 20-20)

¦ do not give rise to any capital gain or loss due to subsection 118-37(2), and

¦ are not recouped expenditure for the purposes of subsection 110-45(3).

Response
Payments received under the first home owner grant scheme are considered to be a recoupment of the expenditure to buy or build the relevant home. The payments received are neither ordinary nor statutory income and thus are not included in the recipient's assessable income. Therefore, applying subsections 110-45(3) and 110-37(2) of the ITAA 1997, the amount of the recouped expenditure is never included in the relevant element of the cost base of the relevant CGT asset. The Tax Office will consider the publication of an ATO view product.

Update
An ATO ID is being prepared and will issue shortly.

1.25 Draft Taxation Ruling TR 2007/D10 - CGT consequences of earnout arrangements

We have a number of concerns regarding the practical operation of this draft ruling and, in particular, its application to 'reverse earnout' arrangements.

For example, in practice how is the market value of an earnout right to be determined? To paraphrase paragraph 73 of Taxation Ruling TR 96/23 dealing with the implications of a guarantee to pay a debt - it is difficult to envisage that a market value exists for an earnout right, in the sense of a value determined by an open and unrestricted market of willing (but not anxious) informed, independent buyers and sellers. Whilst technically assignable, a promise by a buyer/seller to pay an extra amount lacks the commercial character of transferability.

Turning to a 'reverse earnout' arrangement, we find it strange (to use a neutral expression) that a buyer can potentially make a capital gain from an amount that they outlaid in the first place - any adjustment should just be to the cost base of the asset acquired in our view.

Response
Market value

The relevant extract from TR 96/23 concerns the market value for CGT cost base purposes of a promise given by A (a creditor) to B (a guarantor) to lend money to C (a debtor). It is not immediately apparent to the Tax Office why statements made about a promise of this nature are relevant to the determination of the market value of an earnout right.

Further, we don't understand TR 96/23 to be stating that the absence of an 'open and unrestricted' market for an asset leads to the conclusion that the asset has no market valuation. A different conclusion may be reached where an asset, objectively valued, has no value because it confers no economic benefit on a hypothetical third-party assignee.

Subject to further consideration of these matters in the course of the official consultation process for TR 2007/D10, the Tax Office maintains that, depending on the circumstances, earnout rights confer measurable economic benefits for the 'owner' of the right and can have a substantial market value for CGT purposes.

Reverse earnouts

The comment concerning 'reverse earnouts' raises similar issues to those addressed at agenda item 12.0. The authoring team for TR 2007/D10 will escalate these views and provide a response in the course of the official consultation process for the draft taxation ruling. Subject to this process, the Tax Office does not accept the CPAA's characterisation of the tax outcome for the buyer under a reverse earnout.

1.26 Carry forward tax losses, discount capital gains and CGT event E4

Can the Tax Office please confirm that in cases like the following:

¦ no adjustment is required to the cost base of an interest in a unit trust; and

¦ no assessable capital gain can arise under CGT event E4?

Example
Trust A is a unit trust which has derived a capital gain of $500,000 that qualifies for the 12 month 50% capital gains concession - this amount is the only gain/income of the trust for the year of income.

Trust A also has $250,000 of carry forward losses (for both accounting and tax purposes).

Under section 115-100 of the ITAA 1997 the discount percentage that trust A will apply to the capital gain it has derived will be 50% - accordingly, trust A will only include a net capital gain of $250,000 in its assessable income when calculating its net income under section 95 of the ITAA 1936.

Due to the $250,000 of carry forward tax losses the net income of trust A for the income year will be Nil (that is, $250,000 of assessable income less $250,000 of allowable deductions).

Notwithstanding the fact that there is a net income of nil, the trustee of trust A distributes $250,000 to the unit holders of the trust - being the excess of the actual capital gain of $500,000 over the carry forward losses of $250,000.

Analysis
As trust A has a net income of nil, no part of the $250,000 payment from trust A will be included in the assessable income of its unit holders under section 97 of the ITAA 1936. For the purposes of section 104-70 of the ITAA 1997 therefore, the unit holders will (prima facie) have received a non-assessable payment that will:

¦ adjust the cost base of their units in trust A, and/or

¦ result in them making a capital gain under CGT event E4.

We would argue though, that in the above situation the non-assessable payment should be reduced by $250,000 under section 104-71 of the ITAA 1997. That is, there should be an adjustment to reflect the fact that what has been distributed by trust A is a capital gain to which the 50% capital gains discount has been applied.

In other words, as:

¦ a trust cannot distribute its tax losses, and

¦ the only gain/income derived by trust A during the year was a gain to which the 50% CGT discount applied.

The payment from trust A can only represent a discount capital gain and there should be no consequences for the unit holders of trust A under CGT event E4.

In support of this argument we note that if there are no carry forward tax losses in trust A and the trustee distributes all of the $500,000 capital gain derived by the trust, there will clearly be no adjustments required to the cost base of the units in trust A - that is, the non-assessable amount of $250,000 will be 'a discount capital gain excluded from the net capital gain of the trust making the payment': Item 1 of subsection 104-71(4) of the ITAA 1997.

In light of the fact that a trust cannot distribute its tax losses it would be an absurd situation if a different result arose just because a trust had losses that reduced the amount of the net capital gain which could be distributed.

Response
Section 104-71 applies to adjust the non-assessable part of a payment made by the trustee to a beneficiary under CGT event E4 where the payment includes certain CGT concession amounts. The relevant CGT concession amounts include the CGT discount.

The submission identifies issues regarding the interaction of revenue losses with non-assessable payments and the extent to which the availability of revenue losses at the trust level affects the adjustments under section 104-71.

Although on the simple facts presented it would be possible to demonstrate that the CGT concession part of the capital gain (the CGT discount) is reflected in the payment to the beneficiary, it may be more difficult to demonstrate the relevant connection in a more complex scenario. Complex ordering questions might arise where, for example the trustee has a combination of discountable and non-discountable capital gains, or the trustee has revenue income in addition to its discount capital gains.

Further consideration needs to be given to the interactions between revenue losses and trusts before we can establish an ATO view on this issue. Members were asked if they were aware of any specific cases which could be forwarded to the Tax Office as this would be of assistance in forming a view.

1.27 Application of 152-20(2) to superannuation fund assets

Subsection 152-20(2) excludes from assets that are counted towards the $6 million threshold 'a right to, or to any part of, an asset of a superannuation fund or of an approved deposit fund...'

A superannuation fund can have several different types of investments which could include units in a unit trust that holds real estate. The unit holding could be either in respect of all of the units in the unit trust or some part of the issued units in the unit trust. Such a unit holding has the potential to be connected with the taxpayer because the superannuation fund is a trust. In the case of a self managed superannuation fund, the member will probably be in a position to control the superannuation fund either because they are the trustee or entitled to more than 40% of the assets of the trust (see now the definition of connected in section 328-125 and in particular subsection 328-125(2). If the superannuation fund holds 40% or more of the issued units in the unit trust then it will be taken to control the unit trust and have to include 100% of the value of the property held by the unit trust.

(a) How will the Tax Office apply subsection 152-20(2) in these circumstances?

(b) Will the value of assets indirectly held by the superannuation fund through various structures be excluded?

Response
Subsection 328-125(1) provides that an entity is connected with another entity if either entity controls the other in a way described in section 328-125 or both entities are controlled in that way by the same third entity.

Taxation Determination TD 2006/68 expresses the view that neither the trustees nor the members of a complying superannuation fund control the fund in the way described in section 152-30 (now section 328-125, which is not relevantly different to section 152-30).

The members of a complying superannuation fund do not beneficially own, or have the right to acquire beneficial ownership of, interests carrying the right to distributions of income or capital. Further, a complying superannuation fund does not distribute income or capital as such, but rather pays benefits in the form of pensions or lump sums on the occurrence of certain events, such as retirement, death while in employment or the attainment of a stated age.

Similarly, the trustee of a complying superannuation fund does not beneficially own, or have the right to acquire beneficial ownership of, interests in the fund carrying the right to receive distributions of income or capital.

Accordingly, because members of a complying superannuation fund do not control the fund in the specified way, the members also do not control (via indirect control) any further entities that might be connected with the fund and hence the assets of those entities are not included in the members' net assets tests. It is unnecessary therefore to consider the application of subparagraph 152-20(2)(b)(iv).

1.28 Meaning of 'just before'

Background
Section 152-10 outlined the basic conditions to attract the concessions. In subsection 152-10(2), if the CGT asset is a share or a unit, then the additional basic conditions must be satisfied 'just before' the CGT event. In relation to calculating the maximum net asset value test, the taxpayer must pass the test 'just before' the CGT event. Similarly, the significant individual test in section 152-50 must be satisfied 'just before' the CGT event. The 'just before' concept is widely used throughout the concessions.

In working out the small business participation percentage (which is relevant to all of the above concepts), you have to apply their concepts outlined in the table contained in section 152-70. The opening words of section 152-70 are 'An entity holds a direct small business participation percentage at the relevant time in an entity equal to the percentage worked out using this table.' Looking at item 3 of the table in relation to discretionary trusts if the trustee makes a distribution of income or capital during the income year in which that time occurs, then you take the percentage that is distributed in that year, and if the percentages are different, then you take the lowest percentage.

From these concepts, two related questions arise.

(a) Is it correct that a discretionary trust that distributes say 30% of income and capital gains to an individual in the income year that the CGT event arises that individual will pass the relevant requirements noted above 'just before' the CGT event?

(b) If there is a tax loss or no taxable income, does the nomination allowed in section 152-42 have to occur 'just before' the CGT event or can it occur during the year of CGT event?

Response
(a) 'Just before'

Subsection 152-70(1) table item 3 is applied to work out an entity's direct small business participation percentage in a discretionary trust based on distributions to which the entity was beneficially entitled.

The percentage applies for the whole of the income year in which the relevant distributions are made. An individual who was beneficially entitled to 30% of the distributions of income and 30% of the distributions of capital from a discretionary trust during an income year will have a direct small business participation percentage (and hence a small business participation percentage) of 30% in the discretionary trust at all times during that income year. The individual will therefore be a significant individual of the trust at all times during that year and accordingly the trust will satisfy the significant individual test in section 152-50 for a CGT event that happens during that year.

If a CGT event happens during that income year to a share in a company or interest in a trust owned by the discretionary trust, the direct small business participation percentage of 30% held by the individual is taken into account in determining if the additional basic conditions in subsection 152-20(2) are satisfied.

The small business participation percentage is not relevant to the maximum net asset value test in section 152-15.

(b) Section 152-42

Section 152-42 provides that the trustee of a discretionary trust may nominate up to four beneficiaries as being controllers of the trust for an income year for which the trustee did not make a distribution of income or capital if the trust had a tax loss or no taxable income for that year. The nomination of controllers is for the purposes of determining control of, and hence connection with, the trust under section 328-125, for the purpose of determining whether an asset is an active asset via its use by a connected entity.

Section 152-42 is not relevant to determining an individual's small business participation percentage in a discretionary trust. The control/connected entity rules are different, and apply for different purposes, to the significant individual (formerly controlling individual) rules.

There is no specified time period in which the trustee of a discretionary trust must make a nomination under section 152-42. However, as the intention of section 152-42 is to enable the trustee in these circumstances to ensure a particular CGT asset is treated as an active asset for the purposes of qualifying for the small business CGT concessions, it would generally be expected the nomination would be made by the time the small business CGT concessions are chosen for a particular capital gain. These views are set out in ATO ID 2004/970 in relation to subsections 152-30(6A)-(6C) (predecessor to section 152-42).

1.29 Stakeholder's participation percentage

Section 152-42 only talks of nominating controllers, however the exempt amount under section 152-125 is only to the extent of the individual's stakeholder's participation percentage. Assume the individual has tax loss that prevents income from being distributed but has positive taxable income. Their entitlement to income in the year of the CGT event is NIL. Then you nominate that person to be a controller under section 152-42. However, their participation percentage is still nil.

Does section 152-42 allow the nomination to be up to a particular percentage or does the individual lose the concessions in that example?

Response
Revised question

Is section 152-42 (nomination of controllers) relevant to determining an individual's small business participation percentage in a discretionary trust?

No. Section 152-42 provides that the trustee of a discretionary trust may nominate up to four beneficiaries as being controllers of the trust for an income year for which the trustee did not make a distribution of income or capital if the trust had a tax loss or no taxable income for that year. The nomination of controllers is for the purposes of determining control of, and hence connection with, the trust under section 328-125, for the purpose of determining whether an asset is an active asset via its use by a connected entity.

Further observations
As noted in agenda item 14.0, section 152-120 deems (for the purposes of the 15 year exemption) a discretionary trust to have a significant individual during a year for which the trustee did not make a distribution of income and capital and the trust had a tax loss or no taxable income. However, section 152-120 does not apply in determining an entity's small business participation percentage.

In any case, regardless of the application of section 152-120 to relax, in certain situations, the requirement to have a significant individual for at least 15 years (paragraph 152-110(1)(c)), there is still the separate requirement for the company or trust to have a significant individual just before the CGT event who was either 55 or over at that time and the event happened in connection with the individual's retirement or was permanently incapacitated at that time (paragraph 152-110(1)(d)). Section 152-120 does not apply to relax the requirement in paragraph 152-110(1)(d). Therefore, if a discretionary trust does not make any distributions during the year, the relevant CGT event happens it will not have a significant individual in that year and hence will not qualify for the 15 year exemption because it won't satisfy paragraph 152-110(1)(d).

Section 152-125 limits the amount of the payment (that is disregarded) to a concession stakeholder according to the stakeholder's participation percentage, which is worked out just before the CGT event. If a trust does not have significant individual just before the CGT event and hence does not have any concession stakeholders at that time it will not satisfy paragraph 152-110(d) and hence will not qualify for the 15 year exemption. It not to the point therefore that section 152-125 would also not be satisfied.

1.30 Closing comments

Responses to agenda items that cannot be delivered via the minutes of this meeting will be advised out of session.

Meeting closed at 2:35pm.

^[H33]Next meeting

The next meeting was tentatively scheduled for Wednesday 11 June 2008 in Sydney. The date of the meeting will be confirmed once Parliamentary sitting dates are available.

Update
Members were advised on 20 December 2008 that the meeting dates for the 2008 sub-committee meetings will be Wednesday 11 June in Sydney, and Wednesday 19 November in Melbourne.

Meeting details

Venue:

Attendees

Apologies

[H2]Agenda items

Disclaimer

1.1 Apologies, welcome and opening comments, acknowledgment of resignations and new members

1.2 Finalisation of previous minutes from 6 June 2007 meeting

1.3 Updates of action items from previous meetings

3.1 Item 2006/11-6: Interposition of a new company between notional stakeholders and the application of Division 166

3.2 Item 2006/6-5: Dick Smith Case

3.3 Item 2007/6-5: Non-resident CGT rules

3.4 Item 2007/6-15: Liability of a non-resident to capital gains tax

3.5 Item 2007/6-6: Interaction of Division 855 and trust provisions

1.4 CGT and losses compliance report

Losses and CGT Compliance (large business and international) update

Period of review for trustees

CGT specific

1.5 Non-Australian sourced capital gain distributed to non-resident

1.6 Non-resident CGT exemption and trusts

1.7 On the assumption that the Tax Office agrees with the above analysis, how does the section 855 exemption in this case align with the treatment of the capital gain under Division 6 ITAA 1936?

1.8 Trade debt - Is there double taxation?

1.9 Affiliates and the active asset test

1.10 Connected entities not carrying on business

1.11 Small business participation percentage

1.12 Taxation Ruling TR2007/D10 and earnouts

1.13 TR 2007/D10 and earnouts - treatment of a consolidated group acquiring a subsidiary member - ACA step 1 or black hole deduction?

1.14 How does the deeming rule in section 152-120 apply where a unit trust sells an active asset (held for at least 15 years), where the units are owned by a discretionary trust which has incurred tax losses in any one of those 15 years?

1.15 Small Business CGT concessions section 152-20 - liabilities in relation to assets

1.16 Small Business Concessions - active asset definition

1.17 Can a company or trust satisfy subsection 152-325(1) if the payment made direct to the CGT concession stakeholder is in breach of its constitution or trust deed?

1.18 Application of section 109 to payments made by private companies to CGT concession stakeholders under the retirement exemption

1.19 Draft Taxation Ruling TR 2007/D7 wash sales and Part IVA consequences, particularly relating to CGT

1.20 Tax consolidation - CGT straddle contracts

1.21 Does a capital gain included in a beneficiary's assessable income under paragraph 97(1)(a) of the ITAA 1936 cease to be so included due to the operation of subsection 115-215(6) of the ITAA 1997?

1.22 Change of unit trust deed to account for NSW land tax changes - is there a resettlement?

1.23 Draft submissions to NTLG re: small business CGT concessions

A. Introduction

B. Small business retirement exemption

C. Small business rollover

1.24 First home owners grant scheme (and like payments from state governments)

1.25 Draft Taxation Ruling TR 2007/D10 - CGT consequences of earnout arrangements

1.26 Carry forward tax losses, discount capital gains and CGT event E4

1.27 Application of 152-20(2) to superannuation fund assets

1.28 Meaning of 'just before'

1.29 Stakeholder's participation percentage

1.30 Closing comments

[H33]Next meeting

^[H2]Agenda items

^[H33]Next meeting