Edited version of your written advice

Authorisation Number: 1051300275402

Date of advice: 2 November 2017

Ruling

Subject: X Pty Ltd

Question 1

Please confirm the basic conditions for the small business CGT relief under Subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997) are satisfied.

Answer

Yes

Question 2

Please confirm the conditions for the small business 50% active asset reduction under Subdivision 152-C ITAA 1997 are satisfied.

Answer

Yes

Question 3

Please confirm the conditions for the small business retirement exemption under Subdivision 152-D ITAA 1997 are satisfied.

Answer

Yes

Question 4

Please confirm the earn out payments will be considered an “earn out arrangement” for tax purposes with look through treatment available under Subdivision 118-I ITAA 1997?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 2018

The scheme commences on:

DDMMYY

Relevant facts and circumstances

● X Pty Ltd (X), previously Y Pty Ltd, was incorporated on DDMMYY.

● X is an Australian relevant agency that established itself successfully marketing for brands targeted at women.

● There are two owners being A and B whom both had been with the business since it was first incorporated.

● A’s date of birth is XXXX which makes them less than 55 years of age at the time of the CGT event.

● B’s date of birth is XXXX which makes them greater than 55 years of age at the time of the CGT event.

● On DDMMYY, both B and A held 24 shares in X each at $1 per share.

● On November 201X, a share split was performed resulting in B and A each holding 240 shares in X each at 10 cents per share.

● On March 201Y, B and A each sold 10% of the company to an external party (equivalent to 24 shares each to an external party for $XXX,XXX).

● At that time, A and B utilised $XX,000 each of their lifetime retirement allowance cap. Therefore they each have $XXX,000 remaining.

● B however was over 55 years old and applied the retirement exemption but did not make contributions to a superannuation fund.

● X did a selective share buy-back for the 48 shares for $XX,000 and then cancelled those shares.

● Presently, both A and B hold 192 shares each in X.

● Z Ltd (Z) is a global marketing agency that has been in business since 186X.

● As part of B and A extracting value from the business they set up in X and Z wanting to acquire the specialist skills and market focus built up by X, X entered into an agreement on XXXX to sell the assets of its business to Z which according to the Sale Agreement (provided) are comprised of:

● Business records;

● Contracts;

● Goodwill;

● Seller intellectual property; and

● All other assets owned or used by X in connection with the business.

● The following assets are excluded from the business sale according to the draft asset sale agreement:

● cash deposits with banks and other financial institutions or on hand;

● original records and data relating to the Business which the Seller is obliged by law to retain;

● any tangible asset not expressly identified in a provision in this Agreement; and

● the receivables owing to X.

● Business records, contracts, goodwill and seller intellectual property are the main assets sold in the asset sale agreement, with other assets (such as plant and equipment) being sold at written down market value.

● The proceeds from sale are as follows:

● X paid $XXX,000 upfront known as the “Completion payment”;

● Following the initial payment, Z will make the First, Second and Third payment which is calculated at 45% of the Direct Annual Contribution for the period between 1 September 2017 to 31 August 2018, 1 September 2018 to 31 August 2019 and 1 September 2019 to 31 August 2020 respectively, less the completion payment not fully recovered against the payments.

● The first, second and third payment amounts in the Sale Agreements are classed as “earnout payments” in the Sale Agreement.

● The Direct Annual Contribution is calculated as the Gross Revenue from the transferred clients less:

● third party supplier and out of pocket expenses relating to these clients;

● employee liabilities and any Z employee or new employee performing services for the transferred clients plus on-costs.

● The total payment received under the agreement shall not exceed $3,000,000.

● The net value of the CGT assets of X and the net asset values of any “connected entities” and “affiliates” does not exceed $6 million just before the time of entering into the Sale Agreement.

● X changed its name to T Pty Ltd on XXXX.

● The draft aggregated turnover of X for the income year ending 30 June 2017 is $X.XXX million (Its aggregated turnover for the income year ending 30 June 2016 is $X.X million.)

● You have provided a calculation of the Maximum Net Asset Value for X and its affiliates and connected entities just before the time of entering into the Sale Agreement as at XXXX, of $X,XXX,XXX.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 118-565,

Income Tax Assessment Act 1997 Section 152-10,

Income Tax Assessment Act 1997 Section 152-15,

Income Tax Assessment Act 1997 Section 152-35,

Income Tax Assessment Act 1997 Section 152-40,

Income Tax Assessment Act 1997 Section 152-50,

Income Tax Assessment Act 1997 Section 152-55,

Income Tax Assessment Act 1997 Section 152-205,

Income Tax Assessment Act 1997 Section 152-305, and

Income Tax Assessment Act 1997 Section 152-325.

Reasons for decision

Question 1

Summary

The basic conditions for the small business relief under Subdivision 152-A are satisfied.

Detailed reasoning

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Basic conditions

Under section 152-10, the basic conditions that a taxpayer must satisfy before being entitled to any of the concessions (with additional conditions applying for some of the specific concessions) are:

● A CGT event happens in relation to a CGT asset of the taxpayer in an income year;

● The CGT event would have resulted in a capital gain but for the small business CGT concessions;

● At least one of the following applies:

i. The taxpayer is a small business entity for the income year under subsection 152-10(1AA); or

ii. The taxpayer satisfies the maximum net asset value (MNAV) test under section 152-15.

● The CGT asset that gives rise to the gain satisfies the active asset test under section 152-35.

Small business entity

A taxpayer will be a CGT small business entity under subsection 152-10(1AA) where:

● The taxpayer carries on a business in the current income year; and

● Its’ aggregated (the entity’s turnover and the turnover of its connected entities or affiliates) turnover for the previous income year was less than $2 million or the aggregated turnover for the current income year is less than $2 million.

MNAV test

A taxpayer will satisfy the MNAV test under section 152-15 where just before the relevant CGT event happens, the sum of the net value of the CGT assets of the taxpayer, and the net asset values of any “connected entities” and “affiliates” do not exceed $6 million.

The net asset value of an entity is derived by subtracting from the sum of the market value of the CGT assets held by the entity the following amounts:

● The liabilities of the entity that are related to the assets; and

● The provisions for annual leave, long service leave, unearned income and tax liabilities made by the entity.

An “affiliate” is an individual or company that could reasonably be expected to act in accordance with your directions or wishes or in concert with you, in relation to the affairs of their business. Furthermore, an individual or company will not be considered an “affiliate” merely because of the nature of the business relationship that they share.

An entity will be “connected” with the taxpayer where one entity including its affiliates controls the other entity, or where each is controlled by a third party. Generally, an entity “controls” where its’ voting, income and capital distribution rights in the taxpayer are 40% or more.

B and A control X so they will be connected with the company.

Active asset test

Under section 152-35, a taxpayer satisfied the active asset test if:

● It has 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 test period detailed below; or

● It has owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7.5 years during the test period.

The test period begins when the taxpayer acquires the asset (when the business commenced) and ends at the time of the CGT event (being 23 August 2017 when the business asset sale agreement was signed). (The provision for the test period ending when the business ceased is not relevant here.)

Under section 152-40, a CGT asset is an active asset if it is owned by the taxpayer and is:

● Used or held ready for use in a business carried on by you, your affiliate or an entity connected with you; or

● An intangible asset, for example goodwill, that is inherently connected with a business carried on by you, your affiliate or an entity connected with you.

X’s circumstances

● CGT event A1 has happened as a result of the disposal of its business and assets to Z;

● This CGT event would have resulted in a capital gain but for the CGT small business concessions;

● X is not a small business entity as its aggregated turnover is over $2 million. However, based on the calculation you have provided, we are satisfied that X will satisfy the MNAV test as at XXXX when the business asset sale agreement was signed.

● X satisfies the active asset test. The assets of the business, such as the business records and client contracts, were owned and used in the course of the business that X carries on. In addition, the goodwill and seller intellectual property constitute intangible CGT assets inherently linked with the business X carries on. These assets are active assets on this basis. Furthermore, X has owned the assets as active assets for the relevant time period.

In X’s case, the basic conditions for the small business relief under Subdivision 152 are satisfied.

Question 2

Summary

The conditions for the small business 50% active asset reduction under Subdivision 152-C are satisfied, as X meets all the basic conditions for the small business relief under Subdivision 152-A.

Detailed reasoning

Section 152-205 provides that the small business 50% active asset reduction applies if the basic conditions for Subdivision 152-A are satisfied for the gain. As X meets all the basic conditions for the small business relief under Subdivision 152-A, the conditions for the small business 50% reduction are satisfied.

Question 3

Summary

In X’s case, the conditions for the small business retirement exemption under Subdivision 152-D are satisfied.

Detailed reasoning

Conditions

Under subsection 152-305(2) and section 152-325, a company or trust can choose to disregard all or part of a capital gain up to a lifetime maximum of $500,000 if:

● It satisfies the basic conditions for the small business CGT relief under Subdivision 152-A;

● It satisfies the significant individual test (section 152-50);

● A written record is kept of the amount it chooses to disregard (the exempt amount) and, if there is more than one CGT concession stakeholder, each stakeholder’s percentage of the exempt amount;

● It makes a payment to the CGT concession stakeholders worked out by reference to each individual’s percentage of the exempt amount within seven days after it chooses to disregard the capital gain; and

● If an individual who uses the exemption is under 55 just before receiving the payment, the amount must be paid to a complying superannuation fund (subsection 152-325(7)). If the individual is over 55 they can receive the payment directly.

Significant individual test

An entity will satisfy the significant individual test where the entity had at least one significant individual just before the CGT event (section 152-50). An individual will be a significant individual in a company if the individual has a small business participation percentage of at least 20% just before the CGT event (section 152-55).

CGT concession stakeholder

An individual is a CGT concession stakeholder of a company or trust if the individual is a significant individual in the company or trust.

X’s circumstances

● X satisfies the basic conditions for the small business CGT relief under Subdivision 152-A;

● X satisfies the significant individual test. As both B and A own 50% each of X they will be significant individuals of X.

● X will keep a written record of the amount it chooses to disregard, and as there are two CGT concession stakeholders, B and A, their percentage of the exempt amount;

● Payments will be made to B and A within seven days after X chooses to disregard the gain;

● As B is over 55 they can receive the payment directly. However, A will need to contribute the profit directly to their superannuation fund as they are under 55 years of age.

In X’s case, the conditions for the small business retirement exemption under Subdivision 152-D are satisfied.

We note that B and A have previously applied $XX,000 each towards the small business retirement limit of $500,000. Therefore, they have $XXX,000 further each to utilise after the 50% active asset reduction has been applied.

Question 4

Summary

All the conditions for look through treatment of the X earnout amounts have been satisfied under Subdivision 118-I.

Detailed reasoning

Conditions

Subdivision 118-I contains measures for the “look through” treatment of certain earn out arrangements which allows them to be attributed to the original asset disposal rather than being treated as a separate CGT event. Under these rules the value of the earnout is not brought to account for tax purposes until such time as the proceeds are received by the taxpayer.

Under section 118-565, Look-through CGT treatment applies to “look-through earnout rights” if:

● The right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created;

● The right is created under an arrangement involving the disposal of a CGT asset;

● The disposal causes CGT event A1 to happen;

● Just before the CGT event, the CGT asset was an active asset of the entity that disposed of the asset;

● All of the financial benefits under the right are to be provided over a period ending no later than five years after the end of the income year in which the CGT event happens;

● The financial benefits must be contingent on the economic performance of the CGT asset or a business for which it is expected that the CGT asset must be an active for the period to which those financial benefits relate;

● The value of those financial benefits reasonably relates to that economic performance; and

● The parties to the arrangement deal with each other at arm’s length in making the arrangement.

X’s circumstances

● As the X earnout payments is based on “45% of the Direct Annual Contribution” which relies on gross revenue from transferred clients during a given future income year, we consider it is reasonable to conclude that the earnout right is a right to future financial benefits that will not be easily ascertainable at the time the asset sale arrangement is signed. This is particularly the case given in a services business, there is no certainty that existing customers will continue to remain as clients in future years.

● The earn out right is created under an arrangement that involves the disposal of a CGT asset as it is connected with the sale of the business and assets so that Z can continue to operate the X business post acquisition.

● The disposal of the business and assets causes CGT event A1 to happen.

● Just before the sale of the business and assets, the assets were active assets of X as the assets listed in the sale agreement are all business assets.

● The last payment will be latest August 20XX (March 20XY if a resignation occurs), which is not later than 5 years after the end of the 30 June 2017/18 income year in which the sale of the business happens.

● The earnout payments are subject to the performance of transferred clients which the underlying assets in the asset sale agreement specifically support.

● The yearly payments are subject to the economic performance of the sold assets as per the asset sale agreement.

● X and Z are dealing at arm’s length.

All the conditions for look through treatment of the X earnout amounts have been satisfied under Subdivision 118-I.

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