Edited version of your written advice

Authorisation Number: 1051203569696

Date of advice: 16 March 2017

Ruling

Subject: Small business relief - 15 year exemption

Date of Advice: 16 March 2017

Question 1

Will the four basic conditions contained in section 152-10 of the ITAA 1997 be satisfied in respect of the transfer of your ownership interest in partnership property?

Answer

Yes.

Question 2

On the basis that the answer to question 1 is yes, will the 15-year exemption as provided for by section 152-105 of the ITAA 1997 apply to disregard the capital gain in respect of the transfer of your ownership interest in the partnership property?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 2017

The scheme commences on:

This scheme has commenced.

Relevant facts and circumstances

1. You are a farmer. You operate a number of farming businesses.

2. You operate a farming business in partnership with your former spouse and your adult child (“the Family Partnership”).

3. The Family Partnership owns the Property. The Family Partnership also owns a minority portion of the trading stock located on the Property.

4. Your ownership interest in the Property was acquired more than 15 years ago.

5. You also operate a farming business in partnership with your former spouse (“the Second Partnership”). The Second Partnership owns real property interests, trading stock and depreciable plant and equipment.

6. Your other interests include trading stock and real property interests.

7. The Property has been used by you in carrying on an active business for at least 7 ½ years, both by you personally, by the Family Partnership and by the Second Partnership.

8. Significant destocking of the trading stock owned by the Family Partnership, and owned by affiliated and connected entities (collectively known as the Family Group), took place between 1 July 20XX and 30 June 20ZZ.

9. The farming business at the Property is run as one by your child with input from yourself in respect of decision making and from your former spouse in terms of management and accounting.

10. You are over 55 years old.

11. You child will purchase the ownership interest of yourself and your former spouse in the Property for consideration that is below market value.

12. You and your former spouse will use the funds received from your child to retire bank debt associated with the Property in full.

13. You will dispose of your ownership interests in depreciable plant and equipment located on the Property.

14. You will dispose of or lease your interests in other properties.

15. You will enter into an agreement with your child to manage your interests in the Property trading stock, and meet all operating costs in respect of the trading stock, for a management fee from proceeds from the sale of the trading stock.

16. The selling or leasing of these interests is anticipated to provide you with either capital proceeds or a steady income stream to support your retirement living needs.

17. As a result of the selling and leasing of these interests, and the management agreement with your child, you will be reducing your work hours from approximately 70 hours per week to approximately 5 hours per week.

Relevant legislative provisions

Income Tax Assessment Act 1997 (ITAA 1997) section 152-10

ITAA 1997 section 152-105

ITAA 1997 section 108-5

ITAA 1997 section 100-45

ITAA 1997 section 116-20

ITAA 1997 subsection 116-30(2)

ITAA 1997 subsection 328-110(4)

ITAA 1997 section 328-115

ITAA 1997 subsection 328-120(1)

ITAA 1997 section 328-125

ITAA 1997 section 328-130

ITAA 1997 section 152-35

ITAA 1997 section 152-40

Reasons for decision

Summary

The four basic conditions contained in section 152-10 of the ITAA 1997 will be satisfied in respect of the transfer of your ownership interest in partnership property.

The 15 year exemption as provided for by section 152-105 of the ITAA 1997 will apply to disregard the capital gain in respect of the transfer of your ownership interest in the partnership property, as the property was owned by you for more than 15 years before the CGT event, at the time of which you were aged 55 or over, and which happened in relation to your retirement.

Detailed reasoning

Section 152-10 of the ITAA 1997 provides that an individual can reduce or disregard a capital gain arising from a capital gains tax (CGT) event if basic conditions are satisfied. Subsection 152-10(1) states:

1) A * capital gain (except a capital gain from * CGT event K7) you make may be reduced or disregarded under this Division if the following basic conditions are satisfied for the gain:

a) a * CGT event happens in relation to a * CGT asset of yours in an income year;

…

b) the event would (apart from this Division) have resulted in the gain;

c) at least one of the following applies:

(i) you are a * small business entity for the income year;

(ii) you satisfy the maximum net asset value test (see section 152-15);

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership;

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

Note:       For determining whether an entity is a small business entity, see Subdivision 328-C (as affected by sections 152-48 and 152-78).

d) the CGT asset satisfies the active asset test (see section 152- 35).

Basic Condition 1 - CGT Event

Under subsection 108-5(2)(a), an interest in real property is a CGT asset, with Note 1 to section 108-5 confirming that land is a CGT asset. As such, your interest in the Property is a CGT asset. CGT event A1 will happen upon disposal of your interest in the Property to your child, in the year that the contract for the disposal is executed.

As such, condition 1 under subsection 152-10(1)(a) will be satisfied, with CGT event A1 happening in relation to the CGT asset of your interest in the Property.

Basic Condition 2 - Capital Gain

To decide whether the CGT event would have resulted in a capital gain but for the exemption, and as such whether condition 2 under subsection 152-10(1)(b) will be satisfied, the cost base of the CGT asset must be subtracted from the capital proceeds from the CGT event, as per the method statement for calculating a capital gain or loss at section 100-45. Accordingly, the capital proceeds from the CGT event must be determined.

Section 116-20 sets out the General rules about capital proceeds, with subsection (1) stating:

(1) The capital proceeds from a * CGT event are the total of:

(a) the money you have received, or are entitled to receive, in respect of the event happening; and

(b) the * market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

The market value substitution rule modifies this general rule, with subsection 116-30(2) providing, where there are capital proceeds:

(2) The * capital proceeds from a * CGT event are replaced with the * market value of the * CGT asset that is the subject of the event if:

(a) some or all of those proceeds cannot be valued; or

(b) those capital proceeds are more or less than the market value of the asset and:

(i) you and the entity that * acquired the asset from you did not deal with each other at * arm's length in connection with the event

In Trustee for the Estate of the Late AW Furse No 5 Will Trust v FCT (1990) 91 ATC 4007, (Furse) Hill J stated at 4015 (as affirmed at [15] and [105] in Commissioner of Taxation v AXA Asia Pacific Holdings Ltd [2010] FCAFC 134 (AXA Asia Pacific)):

What is required in determining whether parties dealt with each other in respect of a particular dealing at arm's length is an assessment whether in respect of that dealing they dealt with each other as arm's length parties would normally do, so that the outcome of their dealing is a matter of real bargaining.

In ACI Operations Pty Ltd v Berri Ltd (2005) 15 VR 312 (ACI Operations), Dodds-Streeton J said at [223] (as affirmed at [23] in AXA Asia Pacific) that the authorities establish:

... an arm's length relationship is that of strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets, or identity of interests which present a capacity in either party to influence or control the other, or an inducement to serve that common interest, which might operate to modify the terms on which strangers would deal.

McKerracher J held at [95] in Healey v Commissioner of Taxation [2012] FCA 269 (Healey FCA) (as affirmed at [97] in Healey v Commissioner of Taxation [2012] FCAFC 194), that:

5. It is relevant to consider the nature of any relationship between the parties: Trustee for the Estate of the late AW Furse No 5 Will Trust (at 4015); Granby (at 506).

6. If the parties are not at arm's length the inference may be drawn that they did not deal with each other at arm's length: Granby (at 506); ACI Operations Pty Ltd (at [225]).

The difference between the approximate market value of your ownership interest in the Property, and the amount that you would receive from your child for the disposal of your ownership interest, suggests that the outcome of the dealing between you, your former spouse and your child, for the disposal of yours and your former spouse's interests in the Property to your child, is not a matter of real bargaining, as per Hill J in Furse. The parties, as business partners, co-owners and family members, are not in fact at arm's length, which leads to an inference that they did not deal at arm's length, as per McKerracher J in Healey FCA. The fact that the non-arm's length parties arrived at a sum for the disposal of an interest that is significantly less than the market value of the interest indicates that the dealing is not one of “strangers, or parties who are unaffected by existing mutual duties, liabilities, obligations, cross-ownership of assets”, as per Dodds-Streeton J in ACI Operations.

As such, the dealing between you and your child for the disposal of your ownership interest in the Property to your child will not have been at arm's length. Therefore, under subsection 116-30(2), the capital proceeds will be substituted by the market value of the CGT asset.

By subtracting your approximate cost base from the substituted capital proceeds, a capital gain of for the disposal of your ownership interest in the Property to your child is arrived at, satisfying basic condition 2 under paragraph 152-10(1)(b).

Basic Condition 3 - Small Business Entity

You will satisfy paragraph 152-10(1)(c)(iii) if:

1. you are a partner in a partnership; and

2. the CGT asset is an interest in an asset of the partnership; and

3. the partnership is a small business entity for the income year.

You are a partner in the Family Partnership (“the Family Partnership”). Your ownership interest in the Property, being the CGT asset, is an asset of the Family Partnership. As such, the first two of the three elements of paragraph 152-10(1)(c)(iii) are satisfied.

On the basis that the Family Partnership owns a minority of the trading stock on the Property, owns the Property and owns plant and equipment utilised on the Property for its farming business operations during the year ended 30 June 2017, it is carrying on a business during the year ended 30 June 2017.

Subsection 328-110(4) gives the following definition of 'small business entity':

You are also a small business entity for an income year (the current year ) if:

(a) you carry on a * business in the current year; and

(b) your * aggregated turnover for the current year, worked out as at the end of that year, is less than $2 million.

Section 328-115 of the ITAA 1997 gives the following definition of 'aggregated turnover':

(1) Your aggregated turnover for an income year is the sum of the relevant annual turnovers (see subsection (2)) excluding any amounts covered by subsection (3).

Note: For small business CGT relief purposes, additional entities may be treated as being connected with you or your affiliate under sections 152-48 and 152-78.

(2) The relevant annual turnovers are:

(a) your * annual turnover for the income year; and

(b) the annual turnover for the income year of any entity (a relevant entity ) that is * connected with you at any time during the income year; and

(c) the annual turnover for the income year of any entity (a relevant entity ) that is an * affiliate of yours at any time during the income year.

(3) Your aggregated turnover for an income year does not include the following amounts:

(a) amounts * derived in the income year by you or a relevant entity from dealings between you and the relevant entity while the relevant entity is * connected with you or is your * affiliate;

(b) amounts derived in the income year by a relevant entity from dealings between the relevant entity and another relevant entity while each relevant entity is connected with you or is your affiliate;

(c) amounts derived in the income year by a relevant entity while the relevant entity is not connected with you and is not your affiliate.

It is assumed that the aggregated turnover for the Family Partnership for the 2017 income year, as worked out at 30 June 2017, will be less than $2 million. The aggregated turnover of the Family Partnership for the year ending 30 June 20XX, before the destocking in the period of 1 July 20XX to 30 June 20ZZ, is taken as indicative of the aggregate turnover of a period of standard commercial activity. The aggregate turnovers for the years ending 30 June 20YY and 30 June 20ZZ were significantly higher, largely due to significant destocking of the trading stock owned by the Family Group during the period from 1 July 20XX to 30 June 20ZZ. As a result of this destocking, it is expected that there will be significantly reduced trading stock sales by the Family Group in the year ended 30 June 2017, as compared to the aggregate turnover of the year ended 30 June 20XX, with a projected aggregated turnover for the Family Partnership of less than $2 million.

As such, the Family Partnership will be a small business entity for the 2017 income year under subsection 328-110(4).

You will therefore be a partner in a partnership that is a small business entity for the income year and the CGT asset, the Property, is an interest in an asset of the partnership, satisfying paragraph 152-10(1)(c)(iii).

Basic condition 4 - Active Asset

Your ownership interest in the Property will satisfy basic condition 4 contained in paragraph 152-10(1)(d) provided the active asset test contained in section 152-35 is satisfied.

Section 152-35 states:

(1) A * CGT asset satisfies the active asset test if:

(a) you have owned the asset for 15 years or less and the asset was an * active asset of yours for a total of at least half of the period specified in subsection (2); or

(b) you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7 1 / 2 years during the period specified in subsection (2).

(2) The period:

(a) begins when you * acquired the asset; and

(b) ends at the earlier of:

(i) the * CGT event; and

(ii) if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows--the cessation of the business.

Section 152-40 states, in relation to tangible assets:

(1) A * CGT asset is an active asset at a time if, at that time:

(a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a * business that is carried on (whether alone or in partnership) by:

(i) you; or

(ii) your * affiliate; or

(iii) another entity that is * connected with you…

You have held an ownership interest in the Property for more than 15 years.

The Property has been used in carrying on an active business for at least 7 ½ years by you, both alone in your business, and in partnership in the Family Partnership business and in the Second Partnership business, for at least 7 ½ years

Your ownership interest in the Property will therefore be an active asset, satisfying basic condition 4 under paragraph 152-10(1)(d).

15-Year Exemption

Section 152-105 of ITAA 1997 relevantly states:

If you are an individual, you can disregard any * capital gain arising from a * CGT event if all of the following conditions are satisfied:

(a) the basic conditions in Subdivision 152-A are satisfied for the gain;

(b) you continuously owned the * CGT asset for the 15-year period ending just before the CGT event;

Note: Section 152- 115 allows for continuation of the period if there is an involuntary disposal of the asset.

(c) if the CGT asset is a * share in a company or an interest in a trust--the company or trust had a * significant individual for a total of at least 15 years (even if the 15 years was not continuous and it was not always the same significant individual) during which you owned the CGT asset;

(d) either:

(i) you are 55 or over at the time of the CGT event and the event happens in connection with your retirement; or

(ii) you are permanently incapacitated at the time of the CGT event.

The four basic conditions in section 152-10 will be satisfied for the gain made upon disposal of your interest in the Property to your child (as outlined in relation to Question 1 above), satisfying paragraph 152-105(a).

The ownership interests in the property will have been continuously held by you for more than 15 years, satisfying paragraph 152-105(b).

Paragraph 152-105(c) does not apply to your interest in the Property.

You are over 55 years old, satisfying the first element of paragraph 152-105(d)(i).

In connection with retirement

Whether a CGT event happens in connection with an individual's retirement depends on the particular circumstances of each case.

There is no definition of retirement for the small business CGT concessions. Accordingly the ordinary meaning of withdrawal from office, business or active life should apply.

Paragraph 1.68 of the Explanatory Memorandum to the New Business Tax System (Capital Gains Tax) Bill 1999 outlines the following comments about the requirement to be permanently incapacitated or retiring:

One of the requirements of this concession for an individual small business taxpayer is that they must be either permanent incapacitated at the time of the CGT event, or at least 55 years old and using the capital proceeds for their retirement.

The legislation does not define what is meant by the phrase 'in connection with a taxpayer's retirement', nor does it give any indication of the degree of retirement required in order to take advantage of this concession.

The ATO publication Capital gains tax concessions for small business 2016 notes on the page 'Conditions you must meet' in the section relating to 'Small business 15-year exemption':

whether a CGT event happens in connection with an individual's retirement depends on the particular circumstances of each case. There would need to be at least a significant reduction in the number of hours the individual works or a significant change in the nature of their present activities to be regarded as retirement. However, it is not necessary for there to be a permanent and everlasting retirement from the workforce.

The guide also provides that “a CGT event may be 'in connection with your retirement' even if it occurs at some time before retirement.”

Example 3 on the page 'Conditions you must meet' contrasts two scenarios to illustrate what is meant by 'retirement':

A small business operator and spouse are both pharmacists, are both over 55 years old and carry on business through two pharmacies. They sell one (and make a capital gain) and, accordingly reduce their working hours from 60 hours a week each to 45 and 35 hours a week respectively. There has been some change to their present activities in terms of hours worked and location - but there has not been a significant reduction in the number of hours worked or a significant change in the nature of their activities; therefore, there has been no 'retirement'.

If, on the other hand, one spouse reduced their hours to nil (stopped working), there would be a significant reduction in the number of hours that spouse was engaged in the business activities. Therefore the sale would be in connection with the retirement of that spouse.

The above guidance indicates that whether the proposed transfer of your ownership interest in the Property to your child is 'in connection with your retirement' will depend at least in part on whether there will be a significant reduction in the number of hours worked by you or a significant change in the nature of your present business activities.

As a result of your completed and planned disposals and leases of your interests in real property, trading stock and other assets, and the management agreement with your child, you will hold significantly less assets, will no longer have debt associated with the Property, and will be reducing your work hours from approximately 70 hours per week to approximately 5 hours per week. There will be a significant change in the nature of your activities from the active management of a business, to the management of several passive income streams. This changed activity can therefore be considered a 'retirement'.

Your ownership interest in the Property will be disposed of in connection with the above disposals and leases of assets, and change in activities. Therefore this particular disposal of your interest in the Property will be 'in connection with your retirement', satisfying the second element of paragraph 152-105(d)(i).

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