Edited version of private advice

Authorisation Number: 1051524623673

Date of advice: 10 June 2019

Ruling

Subject: Capital gains tax

Question 1

Is entity A a small business entity for Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997) purposes, such that entity A can potentially claim the small business capital gains tax concessions?

Answer

Yes.

Question 2

Is entity A's initial ownership in the property an active asset under sections 152-35 and 152-40 of the ITAA 1997?

Answer

Yes.

Question 3

Is the entity A's additional ownership in the property an active asset under sections 152-35 and 152-40 of the ITAA 1997?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts

Entity A originally owned farmland in partnership. Entity A had a part interest in the partnership. The land was subdivided into separate titles/lots when entity A first acquired its initial and part interest.

The partnership acquired the land more than 15 years ago. The partnership carried on a primary production business for more than ten years. Entity A had its initial ownership interest in the land for more than 15 years. The original business ended a few years ago.

The partnership was making losses from the original business and decided to convert to running a business consisting of licensing plots of the land to farmers for irrigation farming.

The new arrangement includes the provision of some services.

There is an office on one of the lots which entity A uses as a central management and services office.

A few years ago, entity A acquired the remaining portion of the land from the other partners. From that point on, entity A owned 100% of the land.

During the 20XX-XX income year entity A sold one of the lots (the property).

Under entity A's arrangement, entity A provides services and the co-ordination of various common infrastructure amongst the different farmers.

Entity A has extensive relevant farming knowledge.

On average, entity A provides xx hours input each week in relation to the farmer's farming business. Entity A accessed the property at least once a week.

Entity A's aim is to ensure that farmers carry out their farming businesses in a profitable sustainable manner such that the soil quality and water supply of the farm is maintained appropriately, so that the farming activities of one farmer does not adversely impinge on the farming activities of another farmer.

You have provided all the licence agreements that have been entered into with respect to the lot that has been sold and a licence agreement dated XX/XX/XXXX for another part of the property as an additional sample of an agreement. These documents form part of and are to be read with this description of the facts of the arrangement.

Entity A engages a worker to assist with the maintenance of infrastructure and mowing.

Entity A engages casual contractors to deal with maintenance problems relating to plumbing, electrical and irrigation infrastructure issues.

Entity A also engages contractors on an as required basis, usually several times a year to maintain roads and access infrastructure, dam walls and spillways, manmade structures such as cuttings, embankments and bridges and farm infrastructure generally.

Entity A's aggregated turnover in the 20XX-XX income year was below $X million.

Entity A does not satisfy the maximum net asset value test in the 20XX-XX income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Reasons for decision

Summary

Small business entity

Taking into account all the circumstances of this case, including the amount of activity required to maintain and manage the common areas, infrastructure and facilities of the farmland, it is accepted that entity A is carrying on a business.

As the aggregated turnover of entity A was below $2 million, it is regarded as a small business entity for the 2017-18 income year.

Active asset

Due to the exclusion provided by paragraph 152-40(4)(e) of the Income Tax Assessment Act 1997 (ITAA 1997) an asset used in a business will not be an active asset if its main use is to derive rent.

For example, a taxpayer may own and manage a large number of rental properties and be considered to be carrying on a business in relation to the rental properties. However, the properties would not be active assets due to the rental exclusion in paragraph 152-40(4)(e) of the ITAA 1997.

The Supreme Court of Victoria in Swan v. Uecker [2016] VSC 313; 50 VR 74(Swan v. Uecker) stated that just because an agreement referred to a licence rather than a lease did not mean that there was not possession by the occupant and consequently a lease. It is the substance of the agreement rather than the form that is determinative.

The courts have regard to the surrounding circumstances when determining whether the occupant has exclusive possession and therefore a lease. For example, McTiernan J in Radaich v. Smith (1959) 101 CLR 209 (Radaich v. Smith) stated that a business of a milk bar could only be carried on in reasonable convenience by persons having exclusive possession of the premises and therefore held that the agreement was in substance a lease even though the document used terminology like 'licence' rather than 'lease', 'lessor' and 'lessee'.

Taking into account all the circumstances in this case, including the fact that a farming business could only be carried on in reasonable convenience by an occupant with exclusive possession, it is considered that the 'licensees' had exclusive possession and were in substance lessees. Consequently, the additional ownership share in the land that entity A only provided to lessees is excluded from being an active asset by the rental exclusion.

Entity A's original ownership share in the land was previously used by entity A in its own business for more than X.X years and therefore meets the active asset test.

Detailed reasoning

The capital gains tax (CGT) provisions provide some small business relief in Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997).

Basic conditions

To qualify for the small business CGT concessions, the basic conditions as contained in subdivision 152-A of the ITAA 1997 must be satisfied.

The basic conditions are:

·         A CGT event happens in relation to a CGT asset of yours in an income year,

·         The event would have resulted in a gain,

·         The CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997, and

·         At least one of the following applies;

·         you are a small business entity for the income year,

·         you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997,

·         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, or

·         you do not carry on a business, but your CGT asset is used in a business carried on by a small business entity that is your affiliate or an entity connected with you.

Small business entity

You are a small business entity for a year if you carry on a business in the current year and one or both of the following apply:

1) you carried on a business in the previous year and your aggregated turnover for the previous year was less than $2 million

2) your aggregated turnover for the current year is likely to be less than $2 million

Entity A's aggregated turnover for the 2017-18 income year was less than $2 million. We therefore need to consider if entity A was carrying on a business in the 2017-18 income year.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? outlines some factors that indicate whether or not a business of primary production is being carried on. These factors equally apply to other types of businesses. No individual factor is determinative, but should be weighed up in conjunction with the other factors.

In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

·         whether the activity has a significant commercial purpose or character,

·         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 regularity and repetition of the activity,

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

·         whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit,

·         the size, scale and permanency of the activity, and

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

Whilst it is not free from doubt, after weighing up the relative business indicators and objective facts surrounding this case, including the amount of activity required to maintain and manage the common areas, infrastructure and facilities of the farmland, it is accepted that entity A is carrying on a business for taxation purposes.

As the aggregated turnover of entity A was below $2 million, entity A is regarded as a small business entity for the 20XX-XX income year.

Active asset test

As outlined in subdivision 152-A of the ITAA 1997, the CGT asset must satisfy the active asset test.

Under subsection 152-35(1) of the ITAA 1997, a CGT asset will satisfy 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 test period, 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 7½ years during the test period.

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

Subsection 152-40(4) of the ITAA 1997 lists CGT assets that cannot be active assets. Under paragraph 152-40(4)(e) of the ITAA 1997, an asset whose main use is to derive rent cannot be an active asset unless the main use for deriving rent was only temporary.

That is, even if the asset is used in a business it will not be an active asset if its main use is to derive rent. For example, a taxpayer may own and manage a large number of rental properties and be considered to be carrying on a business in relation to the rental properties. However, the properties would not be active assets due to the rental exclusion in paragraph 152-40(4)(e) of the ITAA 1997.

The land in question in this case has in recent years been used by unrelated farmers under licence agreements to earn assessable income. Before that, it was used by entity A to carry on its own primary production business.

Entity A has owned its original ownership share in the land for more than XX years and used it to carry on its own primary production business for more than X years. Therefore, the entity A's original ownership share in the land is an active asset under section 152-35 of the ITAA 1997.

To determine whether entity A's additional ownership share in the land is an active asset needs further consideration.

Taxation Determination TD 2006/78 Income tax: capital gains: are there any circumstances in which the premises used in a business of providing accommodation for reward may satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 notwithstanding the exclusion in paragraph 152-40(4)(e) of the Income Tax Assessment Act 1997 for assets whose main use is to derive rent? provides guidance to assist in determining whether particular receipts constitute 'rent' for the purpose of paragraph 152-40(4)(e) of the ITAA 1997.

As outlined in paragraph 22 of TD 2006/78, the term 'rent' has been described as follows:

·         the amount payable by a tenant to a landlord for the use of the leased premises (C.H. Bailey Ltd v. Memorial Enterprises Ltd [1974] 1 All ER 1003 at 1010, United Scientific Holdings Ltd v. Burnley Borough Council [1977] 2 All ER 62 at 76, 86, 93, 99);

·         a tenant's periodical payment to an owner or landlord for the use of land or premises (The Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne); and

·         recompense paid by the tenant to the landlord for the exclusive possession of corporeal hereditaments........ The modern conception of rent is a payment which a tenant is bound by contract to make to his landlord for the use of the property let (Halsbury's Laws of England 4th Edition Reissue, Butterworths, London 1994, Vol 27(1) 'Landlord and Tenant', paragraph 212).

As highlighted at paragraph 23 of TD 2006/78, if premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to be rent and the premises not an active asset. On the other hand, if the arrangement allows the person only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

Whether a payment is rent depends on the particular circumstances and facts of each case.

The key factor in determining whether they are receiving rent is whether the person occupying the property has exclusive possession (Radaich v. Smith). Other factors that are relevant include:

·         the degree of control retained by the owner

·         extent of any services provided by the owner

However, the fact that services are provided by the owner does not necessarily mean that the owner is not receiving rent. For example, the landowner and tenant of a residential rental property may come to an agreement that as part of the leasing of the property, the landowner will arrange for the regular mowing of the property and the maintenance of the pool. The fact that these services are provided by the landowner does not mean that the payments they receive from the tenant for the use of the property are not rent.

A person occupying a property will not have exclusive possession where that person was not given rights to that particular property but rather property of that type or standard, for example, an occupant of a motel or hotel room where they are given the right to occupy a room of a certain type or standard rather than that specific room in particular.

Payments are generally not rent if the following factors exist:

·         no notice is required to quit the premises,

·         there are rules requiring visitors to leave the premises by a certain time,

·         the owner/manager retains the right to enter the premises,

·         the owner pays for all utilities (gas, electricity, water),

·         the owner provides services and facilities to guests; for boarding houses services such as room cleaning and general maintenance, linen and towels and common areas such as a TV/lounge room, kitchen, bathrooms, laundry and a recreation area are included,

·         the average length of stay is relatively short,

·         the owner/manager retains a significant degree of control over the premises through being on the premises most of the time,

·         the arrangements entered into indicate that those staying in the premises do not have the right to exclusive possession of a room but rather only a right to occupy the room.

A boarding house scenario is provided in example 3 in TD 2006/78. In this example David owns an 8 bedroom property which he operates as a boarding house. He lives on the premises. Boarders enter into arrangements to occupy single rooms with the average length of stay being 4-6 weeks and no notice is required to quit the rooms. David retains the right to enter the rooms and there are rules requiring visitors to leave the premises by a certain time. David pays for all utilities and provides services including room cleaning and general maintenance, linen and towels and common areas such as TV/lounge room, kitchen, bathrooms, laundry and a recreation area. David retains a significant degree of control over the premises. Those staying in the boarding house do not have the right to exclusive possession of a room but rather only a right to occupy the room. These circumstances indicate that the relationship between David and those staying at the boarding house is not that of a landlord/tenant under a lease agreement and is not regarded as rent.

The issue of whether an arrangement is a licence or lease was addressed in the case of Swan v. Uecker where the Supreme Court of Victoria (the Court) stated that just because an accommodation agreement referred to a licence rather than a lease, it did not mean that there was not possession by the occupant and therefore a lease.

The Court referred to several Supreme Court and High Court decisions regarding exclusive possession and how it is determined. Significantly, the Court held that determining whether a tenancy is created requires an '"objective" assessment of the facts. To determine the "true nature of the grant" a court must look not only at the terms of the agreement, but also the "surrounding circumstances".

The Court held that the use of the words "licence" in the agreement did not prevent the arrangement from being characterised as a lease. The Court held that "self-serving subjective statements" could not be used to "escape the legal consequences of one relationship by professing that it is another". The Court held that it was not bound by such "labels" and it could look at the surrounding circumstances to determine the substance (as opposed to the form) of the arrangement.

Although every case will turn on its facts, the Court's decision clearly establishes a general principle that an agreement concerning the use of a property can be a lease, despite the "labels" used in the agreement.

The test of exclusive possession determines whether a deed is a lease or not. A lease does not become a licence because the parties employ that terminology; likewise, a licence does not become a lease because the parties employ that term. That is, the terminology used is not determinative, rather "it is the substance of the deed that matters" (Facchini v. Bryson (1952) 1 T.L.R., Denning L.J. at pp. 1389, 1390).

Indeed, it is clear from such cases as Radaich v. Smith that members of the High Court did look at the surrounding circumstances, such as the fact that a milk bar business could only be carried on in reasonable convenience by persons having exclusive possession, when considering whether or not there was a lease or licence created by the document before them in that case.

As highlighted in Radich v. Smith, the retention of a limited right by a landlord to enter the premises is not inconsistent with the grant of exclusive possession. While a landlord may reserve the right to enter the premises to enforce conditions of the accommodation agreement, or to evict residents who have breached the conditions, or for repairs, this alone does not invalidate the general possession by a resident of the premises. Radich v. Smith established the principle that where the leasee needs possession for the purpose of the contract, possession will be granted, regardless of the wording of the contract. That is, the characterisation of the fee paid to occupy premises is dependent upon the intention of the parties upon entering the transaction; the rights will depend on what was agreed to.

Application to the present circumstances

In this case, the agreements between entity A and the licensees state that nothing contained in the agreement shall be construed so as to imply any right of exclusive possession by the licensee of the property or the equipment and the licensee acknowledges the right of entity A to access for the purposes of inspection and use of the property and equipment by entity A for any purpose not inconsistent with the requirements of the licensee in the permitted use of the property and the equipment.

Although it is stated that the licensees do not have exclusive possession of the land that they have the 'licence' to use, it remains that the farmer is not generally required to move from that land during the agreement. The fact that entity A has the right to enter the farms is not a significant and decisive factor.

Managing and maintaining the infrastructure and mowing the common areas are activities generally belonging to all property owners. It is acknowledged that entity A manages the use of chemicals and monitors the soil and water quality as well as attends monthly meetings with the farmers, however such activities do not compare to those of the boarding house example 3 in TD 2006/78. Entity A does not provide the same repetition of regular services throughout the agreement term. While it is acknowledged that entity A provides some services to the farmers, these services and control it retains over the farming businesses is not considered to be on the same scale as the above example.

Other services such as choosing the farmers, providing guidance on crop selection and marketing, are not required regularly each week and are not ongoing throughout the agreement period. It is acknowledged that entity A provides services such as advice to assist the farmers, however this is not determinative.

The activities of managing the agreements do not amount to entity A having a direct involvement in the farming activities and the farmer's day to day operations. The profits of the farming business belong to the farmers and entity A is not regarded as a share farmer as discussed in TD 95/62.

Taking into consideration all the relevant factors including the length of the agreements and the services provided, it is considered that the overall arrangement is considered to be that of a landlord/tenant relationship. It is considered that the services provided and the degree of control exercised by entity A is not sufficiently significant. Relevant factors that were considered included the following:

·         the time spent each week in relation to the particular land under the agreement is not sufficient to conclude that significant services are being regularly provided to the farmers,

·         entity A is not on the land occupied by the farmers for most of the time,

·         the farmer bears all costs relating to their farming and pays for their electricity and other supplies of fuel, energy, lubricants or consumables supplied,

·         the term for each agreement varies from one year to five years and is not a relatively short term such as 4-6 weeks,

·         a substantial amount of notice (X months) is required to terminate the agreement,

·         entity A is not involved in the day to day farming activities, and

·         entity A does not have a significant degree of control over the farmers' operations.

It is also noted that although a clause is included purporting to deny exclusive possession, each agreement specifies a particular part of the land that the occupant is entitled to use. That is, each agreement gives the 'licensee' rights with respect to a particular plot of land rather than specifically stating that the 'licencee' only has a general right to use an area of land of say X hectares with the 'licensor' retaining the right to move the 'licencee' to another plot of land of the same size.

As in Radich v. Smith, the most significant factor that points to exclusive possession is that the occupants would not be able to reasonably carry on their businesses if they did not have exclusive possession. That is, the farmers would not expect that the landowner could at any time make them move from the land that they are currently farming to a different plot of land.

It is considered that the arrangement with the farmers is properly characterised as a lease rather than as a licence. As a result, entity A is regarded as a landlord and the payments received under the terms of the arrangement are rent.

Consequently, the additional ownership share in the land that entity A only provided to lessees is excluded from being an active asset by the rental exclusion. Therefore entity A will not be able to access the small business CGT concessions under Division 152 of the ITAA 1997 in relation to the capital gains relating to the additional ownership share in the land.

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