Edited version of private ruling

Authorisation Number: 1011808033924

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Ruling

Subject: capital gains tax issues for the trust

Question 1

Is it necessary for the Trust to charge rent to the beneficiaries for living on the property?

Answer

This is an Invalid question.

Question 2

Is one of the beneficiaries considered to be 'absolutely entitled' to the asset for capital gains tax purposes?

Answer

No.

Question 3

Does the property satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 (ITAA 1997) for the small business relief in Division 152 of the ITAA 1997?

Answer

No.

Question 4

Is the trust able to claim any interest on borrowings?

Answer

No.

Question 5

If the answer to question 4 is yes, would Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply?

Answer

Not necessary to address this issue as an interest deduction is not allowable.

This ruling applies for the following periods:

The 2006-07 income year

The 2007-08 income year

The 2008-09 income year

The 2009-10 income year

The 2010-11 income year

The scheme commences on:

1 July 2006

Relevant facts and circumstances

The company is the corporate trustee of the Trust. The sole shareholder/director of the corporate trustee is the principal and one of the prime beneficiaries of the Trust (B).

The trust deed lists the following beneficiaries:

· primary beneficiaries

· an individual B

· another individual

· secondary beneficiaries

· relatives of the primary beneficiaries

· tertiary beneficiaries

· other entities

At the time the Trust commenced, Trust A was also established. All beneficiaries of Trust A are the same as the Trust.

The Trust purchased a residential property and rented it.

Later, the Trust purchased a rural property. B erected an asset on the property and proceeded to use it.

When the rural property was purchased, the Trust A commenced primary production activities. Trust A does not pay rent to the Trust.

The primary production activities are run by B who plans to run a primary production business. The activities include various types of animals and some plants.

B solely attends to feeding of the animals, cleaning of the shed and erecting fencing as necessary.

B plans to continue as they have been. B wants to 'make a go' of farming and live on the property for a long time. B has children and wants them to learn 'the way of the land' alongside B. There is a processing centre that is willing to take as many of one type of low value livestock as B can produce. B regards this livestock as being 'by far the better option for income'.

B has spent a lot of time researching farming practices on the internet and reading books.

On purchase of the rural property, other than a bank loan, all funds were provided by B. All improvements to the property have been paid for by injection of cash into the Trust by B. The bank loan for the rural property was paid out with funds of B.

B intends to build a home on the rural property. B intends to do most of the work themselves.

The trust deed also forms part of these facts.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 120AAB,

Income Tax Assessment Act 1936 Part IVA,

Income Tax Assessment Act 1997 Subsection 8-1(1),

Income Tax Assessment Act 1997 Section 108-55,

Income Tax Assessment Act 1997 Subsection 108-55(1),

Income Tax Assessment Act 1997 Part 3-1,

Income Tax Assessment Act 1997 Part 3-1,

Income Tax Assessment Act 1997 Division 152,

Income Tax Assessment Act 1997 Section 152-30,

Income Tax Assessment Act 1997 Section 152-35,

Income Tax Assessment Act 1997 Section 152-40,

Income Tax Assessment Act 1997 Subsection 152-40(1),

Income Tax Assessment Act 1997 Section 328-125 and

Income Tax Assessment Act 1997 Section 328-130.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

Summary

This is not a valid question.

Detailed reasoning

A Private Ruling is an expression of the Commissioner's opinion on the application of taxation legislation in respect of a scheme.

The question you have asked relates to the operation of the trust and not the application of taxation law. As such, the question is not valid.

Question 2

Summary

Because the prime beneficiary is an object of a discretionary trust, then they cannot be considered to be absolutely entitled to the asset for CGT purposes.

Detailed reasoning

Draft Taxation Ruling TR 2004/D25 discusses the meaning of absolutely entitled to a CGT asset as against the trustee of a trust' as used in Parts 3-1 and 3-3 of the ITAA 1997. Paragraph 13 outlines persons who cannot be absolutely entitled.

13. The following persons cannot be absolutely entitled because they do not have an interest in the trust's assets:

· an object of a discretionary trust prior to any exercise of the trustee's discretion in their favour

·   a beneficiary of a deceased estate prior to the completion of its administration.

Section 102AAB of the Income Tax Assessment Act 1936 (ITAA 1936) defines a discretionary trust estate as a trust estate where:

a) both of the following conditions are satisfied:

i) a person (who may include the trustee) is empowered (either unconditionally or on the fulfilment of a condition) to exercise any power of appointment or other discretion;

ii) the exercise of the power or discretion, or the failure to exercise the power or discretion, has the effect of determining, to any extent, either or both of the following:

A) the identities of those who may benefit under the trust;

B) how beneficiaries are to benefit, as between themselves, under the trust; or

b) one or more of the beneficiaries under the trust have a contingent or defeasible interest in some or all of the corpus or income of the trust estate; or

c) the trustee of another trust estate, being a trust estate where both of the conditions in paragraph (a) are satisfied, benefits, or is capable (whether by the exercise of a power of appointment or otherwise) of benefiting, under the first-mentioned trust estate.

The trust deed confirms that the Trust is a discretionary trust.

The primary, secondary and tertiary beneficiaries are listed in the schedule of the trust.

The assets of the trust are being held for numerous beneficiaries, not just the primary beneficiary. The primary beneficiary is merely an object of a discretionary trust whereby the trustee may, or may not, distribute in their favour.

As the Trust is a discretionary trust, as per paragraph 13 of TR 2004/D 25, an object of a discretionary trust cannot be absolutely entitled.

Question 3

Summary

The rural property is not used, or held ready for use in the course of carrying on a business. Therefore, the property is not an active asset for the small business relief provisions.

Detailed reasoning

An active asset is defined in section 152-40 of the ITAA 1997. The active asset test in section 152-30 of the ITAA 1997 is one of the basic conditions for relief under Division 152 of the ITAA 1997, Small Business Relief.

Subsection 152-40(1) of the ITAA 1997 explains that a CGT asset is an active asset at a time if, at that time you own the asset and you use it, or hold it ready for use, in the course of carrying on a business or it is used, or held ready for use, in the course of carrying on a business by your affiliate, or by another entity that is connected with you.

As the definition of 'active asset' requires a business to be carried on, it is necessary to determine if the Trust A's activities amount to a business.

The meaning of 'connected with' is in section 328-125 of the ITAA 1997, and 'affiliate' is defined in section 328-130 of the ITAA 1997. From these definitions, the Trust and Trust A are connected with each other, as they are controlled by the same third entity.

Taxation Ruling TR 97/11 discusses the issues to be considered to determine if you are carrying on a business of primary production. Paragraph 13 of TR 97/11 lists the following indicators as relevant:

· whether the taxpayer has more than just an intention to engage in business

· whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

· whether there is repetition and regularity of the activity

· whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business

· whether the activity is planned, organised and carried out in a business like manner such that it is directed at making a profit

· the size, scale and permanency of the activity

· whether the activity is better described as a hobby, a form of recreation or a sporting activity

· whether the activity has a significant commercial purpose or character; this indictor comprises many aspects of the other indicators.

Other indicators which support the main indicators include:

· whether records are kept

· whether a business plan exists

· whether there has been commercial sales of the product

· the taxpayer's knowledge or skill.

In summary, you, or an affiliate or an entity that is connected with you, must use, or hold the asset ready for use, in the course of carrying on a business.

The intention of the taxpayer

A mere intention to carry on a business is not enough. There must be activity. At the end of the day, the extent of activity determines whether the business is being carried on. That is a question of fact and degree. (Brennan J in Inglis v. FC of T 80 ATC 4001; (1979) 10 ATR 493).

This indicator is related to:

· if the activity is preparatory or preliminary

· if there is an intention to make a profit

· if the activity is better described as a hobby or recreational or sporting activity.

Expenses associated with experimental or pilot activities which do not amount to a business and do not result in any assessable income being produced are not deductible.

The intention to make a profit considers issues such as:

· a clear purpose of how you would use the land to earn money

· is it experimental?

· breeding options

· is the size and scale sufficient to constitute a business?

Prospect of profit

In Hope v. The Council of the City of Bathurst (1980) 144 CLR 1; 80 ATC 4386; (1980) 12 ATR 231, Mason J indicated that the carrying on of a business is usually such that the activities are engaged in for the purpose of profit on a continuous and repetitive basis. It is important that the taxpayer is able to show how the activity can make a profit. Stronger evidence of an intention to make a profit occurs when the taxpayer has conducted research into the proposed activity, consulted experts or received advice on the running of the activity and the profitability of it before setting up the business.

Repetition and regularity

It is often a feature of a business that similar sorts of activities are repeated on a regular basis. The repetition of activities by the same person over a period of time on a regular basis helps to determine whether a business is being carried on. The taxpayer should undertake at least the minimum activities necessary to maintain a commercial quantity and quality of product for sale.

Is the activity of the same kind and carried on in a manner that is characteristic of the industry?

The following factors can be compared with the characteristics of others engaged in the same type of business:

· the volume of sales

· the type of customers sold to eg wholesalers and retailers or family and friends, and marketing

· type of expenses incurred

· amount invested in capital items

· previous experience of the taxpayer

· comparison to a keen amateur. A keen amateur may have no knowledge or experience in the area they intend to enter into, does not seek advice or conduct research, simply starts the activity, and may have difficulty proving they are carrying on a business of primary production.

Organised in a businesslike manner and the use of system

A business is characteristically carried on in a systematic and organised manner rather than on an ad hoc basis. An activity should generally conform with ordinary commercial principles to amount to the carrying on of a business.

The weight that is attached to this indicator will depend on the facts of the situation and a taxpayer may still carry on a business of primary production despite having poor organisational skills.

Size or scale of the activity

The larger the scale of the activity the more likely it will be that the taxpayer is carrying on a business of primary production. However, this is not always the case. The size and scale of the activity is not a determinative test, and a person may carry on a business though in a small way. The smaller the scale of the activity the more important the other indicators become when deciding whether a taxpayer is carrying on a business of primary production.

Hobby or recreation

The pursuit of a hobby is not the carrying on of a business for taxation purposes. Often it will be the case that there is a hobby when:

· no intention to make a profit

· losses are incurred and there is no plan to show how a profit can be made

· isolated transaction and no repetition or regularity of sales

· the activity is not carried on in the same manner as a normal ordinary business activity

· no system to allow a profit to be produced

· the activity is small scale

· there is an intention to carry on a hobby, a recreation, or a sport rather than a business

· any produce is sold to friends and relatives and not to the public at large.

Significant commercial purpose or character

In showing that a business is being carried on, it is important that the taxpayer is able to provide evidence that shows that there is a significant commercial purpose or character to the primary production activity. That is, that the activity is carried on for commercial reasons and in a commercially viable manner. The significant commercial purpose or character indicator is closely linked to the other indicators and is a generalisation drawn form the interaction of the other indicators.

In order to show significant commercial purpose or character it may help to know if the taxpayer has:

· drawn up a business plan

· sought expert advice from authorities, farmers and agents

· obtained technical literature

· obtained soil and water analysis of the land

· established if the land is suitable for the activities

· considered whether there is a market

· investigated the capital requirements and has a plan that shows how that capital will be obtained and used

· conducted research to confirm expected level of production, running costs and that profits can be expected

· ensured that the size and scale is sufficient for a commercial enterprise

· complied with legal requirements

· an intention to make a profit.

In your case:

The Trust purchased land. Trust A commenced primary production activities on this land. The primary production activities are carried on by B. There has been no expert advice obtained, nor has B established that the land is suitable for these activities. There is no business plan.

Whether the taxpayer has more than just an intention to engage in business

B's intention was to run a primary production business. To that end, B purchased a small number of a few different types of animals and a small quantity of plants.

There were natural increases, deaths and limited sales.

The numbers of animals and plants purchased are not sufficient to establish a commercial venture. There are insufficient numbers for breeding, inbreeding would occur within a few years, and the numbers are too small to generate commercial sales.

B has stated that 'they have children and hopes that they will learn the way of the land alongside B'. This not only indicates B's own lack of knowledge, but also confirms that this is a lifestyle choice.

The activities conducted do not support more than an intention to engage in business.

Whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

You have sold X units of livestock for a few dollars each. This is your only income since primary production activities commenced. The current expectations of profit from this livestock are limited given your very small numbers of breeding stock.

There is a processing centre that is willing to take as many of one type of low value livestock as B can produce. B regards this livestock as being 'by far the better option for income'. This indicates that there is limited, or no prospects of income from the other activities.

You have incurred capital expenses.

There is no business plan to show the expectation of profit, or how the other activities are to generate income. The current expectations of profit from the low value livestock are limited given your small number of initial breeding stock.

There is no, or extremely limited income from any of the primary production activities.

Whether there is repetition and regularity of the activity

Activities should be repeated on a regular basis in order to maintain a commercial quantity and quality of product for sale.

None of your stock numbers are sufficient enough to produce a commercial quantity of product for sale.

You state that you have solely attended to the feeding of the animals, cleaning of the shed and erecting fencing as necessary. These activities would also be conducted for a 'hobby farm' and are not enough to distinguish your activities as carrying on a business.

Whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business

The volume of sales is very small. Since the primary production activities commenced, you have sold X units of one type of livestock for a few dollars each. For all other animals and plants there were no sales at all.

You advise the processing centre is willing to take as many of the one type of animal as you can produce. However, you do not confirm if this will be your only outlet, or who your previous sales were made to.

Your expenses are large capital expenses primarily associated with one type of low value livestock.

B appears to have no previous experience in primary production.

The activities are more consistent with a keen amateur, rather than carrying on a business.

Whether the activity is planned, organised and carried out in a business like manner such that it is directed at making a profit

The facts in example 11 of TR 97/11 at paragraphs 71 and 72 are similar to your own situation:

· your activities do appear to have an element of commerciality

· you appear to have conducted limited research into the activity, potential markets or the profitability of the activities

· you have one outlet for one type of animal and none for the other aspects of your primary production activities

· you appear to be engaging in these activities as a lifestyle choice for you and your children.

The size, scale and permanency of the activity

Your activities for your primary production activities include a few of each of a small number of different types of animals and some plants.

Your activities are of a very small size and scale. In considering the other factors, it does not appear that you are carrying on a primary production business.

Whether the activity is better described as a hobby, a form of recreation or a sporting activity

Considering the above factors, it is noted:

· up until recently there was no system in place to make a profit

· losses have been made for every year of operation

· sales have consisted of the sale of 10 units of one type of a small value livestock for a few dollars each. While there is an outlet for sales, no further sales have been made and this sale can therefore be viewed as an isolated transaction

· as discussed above, your primary production activities are not carried out in the same manner as a normal, ordinary business

· the size and scale of your activities are small

Your activities would be better described as a hobby or a form of recreation.

Whether the activity has a significant commercial purpose or character; this indictor comprises many aspects of the other indicators.

In considering the relevant factors it is observed that:

· you do not have a business plan

· while you have researched farming practices in books and on the internet, you have not sought expert advice from authorities, farmers etc

· you do not have a plan for capital requirements and how that capital will be used

· you have not provided your research to show your expected levels of production, running costs and your expected profits

· you have not shown that you have considered the size and scale that would be required for a commercial enterprise

This indicates that there is a lack of significant commercial purpose or character.

On consideration of all of the above factors, it is determined that you are not running a primary production business.

In order for the rural property to be an active asset under the small relief provisions, an entity that is connected with the trust, must use, or hold the asset ready for use, in the course of carrying on a business. The rural property is not used, or held ready for use in the course of carrying on a business. Therefore, the property is not an active asset for the small business relief provisions.

Question 4

Summary

You cannot claim a deduction for the interest expense, as it was not a loss or outgoing incurred for gaining or producing assessable income.

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 is the general deductions provision. It explains that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

You incurred an interest expense on the bank loan for purchase of the rural property.

Trust A conducts primary production activities on the rural property. There is no rent paid by Trust A to the Trust. Therefore the Trust is not gaining or producing assessable income. In this situation subsection 8-1(1) of the ITAA 1997 acts to prevent you from claiming a deduction for the interest expense.

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