Edited version of private advice

Authorisation Number: 1051544482383

Date of advice: 24 July 2019

Ruling

Subject: Non-commercial losses, capital gains tax, small business concessions and the timing of a real estate event

Question 1

Can youapply your deferred non-commercial losses balance to the capital gain from the sale of a property which occurred in the 20XX-XX financial year?

Answer

No

Question 2

Can you remove a portion of the business expenses included in the deferred non-commercial losses balance and include these amounts in the cost base calculation of the property sold in the 20XX-XX financial year?

Answer

No

Question 3

Does the property satisfy the small business concessions active asset test?

Answer

Yes

Question 4

Is the capital gain from the sale of the property attributable to the 20XX-XX financial year?

Answer

Yes

This ruling applies for the following period:

Years ended 30 June 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You satisfy the income requirement set out in subsection 35-10(2E) of the ITAA 1997.

You purchased a property (the property) in mth/20XX for $X.

The property was used in your business for the entire ownership period.

Your business activity which was run on the property has previously made losses which have been deferred under the non-commercial loss rules, as you have not meet one of the four tests. The deferred non-commercial losses balance was $X at the end of the 20XX-XX financial year.

Included in the deferred non-commercial losses balance are expenses consisting of borrowing costs of $X, bank charges of $X, interest on the loan for the farming land of $X and rates of $5X. None of the expenses were included in the cost base of the property.

You experienced a work place injury which resulted in you experiencing financial hardship. As a result you decided to sell the property.

In the 20XX-XX financial year a contract was signed for the sale of the property, with settlement occurring the 20XX-X financial year.

The property was sold for $X resulting in a capital gain of $X.

Your tax agent has included the capital gain in the 20XX tax return.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 35-10(1),

Income Tax Assessment Act 1997 subsection 35-10(2E),

Income Tax Assessment Act 1997 paragraph 35-55(1)(a),

Income Tax Assessment Act 1997 Division 110,

Income Tax Assessment Act 1997 Section 112-20,

Income Tax Assessment Act 1997 subsection 110-25(2),

Income Tax Assessment Act 1997 subsection 110-25(3),

Income Tax Assessment Act 1997 subsection 110-25(4),

Income Tax Assessment Act 1997 subsection 110-25(5),

Income Tax Assessment Act 1997 subsection 110-25(6),

Income Tax Assessment Act 1997 subdivision 152-A,

Income Tax Assessment Act 1997 subsection 152-35,

Income Tax Assessment Act 1997 subsection 152-35(2),

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

Income Tax Assessment Act 1997 subsection 152-40(4).

Reasons for decision

Question 1

The object of Division 35 of the Income Tax Assessment Act 1997 (ITAA 1997) is to act as an integrity measure. One of the ways it achieves this is by preventing losses from non-commercial activities that are carried on as businesses by individuals (alone or in partnership) being offset against other assessable income in the income year the loss is incurred.

The loss deferral rule in subsection 35-10(2) of the ITAA 1997 will not apply to the individual undertaking that activity for an income year if the relevant business activity:

(a) satisfies at least one of the tests, and for the 2009-10 and later income years, the individual in question meets the income requirement; or

(b) comes within the Exception; or

(c) has a favourable exercise of the Commissioner's discretion.

The individual will be able to deduct the excess deductions against other assessable income where the rule does not apply.

In some cases an individual taxpayer's circumstances may change leaving issues about their ability to deduct the full extent of any loss made. Any amount deferred under subsection 35-10(2) of the ITAA 1997 will only be deductible in a subsequent year if the business activity that gave rise to this amount, or one 'of a similar kind', is carried on in that subsequent year. If the activity, or one 'of a similar kind', is never carried on again, the entitlement to deduct the amount will be lost.

For your circumstances, you cannot apply your deferred non-commercial losses to reduce your assessable income (which includes the capital gain) as you do not meet these requirements. The losses will remain as deferred losses until your business activity or an activity of a similar kind in a later financial year.

Question 2

Division 110 of the ITAA 1997 defines the rules for cost base and reduced cost base of a CGT asset.

The cost base of a CGT asset consists of 5 elements, namely:

1. acquisition costs;

2. incidental costs;

3. non-capital costs of ownership;

4. capital expenditure to increase value; and

5. capital expenditure to establish, preserve or defend title to or a right over an asset.

All of the elements can include giving property. If that is the case, section 103-5 of the ITAA 1997 requires the market value of the property to be used to work out the cost.

Note: expenses that may form part of elements 2-5 of the cost base will only form part of the cost base if incurred by the owner of the CGT asset.

First Element: Acquisition costs

Under subsection 110-25(2) of the ITAA 1997, this element is the total of any money the taxpayer paid or is required to pay in respect of acquiring the asset and the market value of any property that the taxpayer gave or is required to give in respect of acquiring it.

Section 112-20 of the ITAA 1997 replaces the first element of the cost base with the market value of the asset at the time of acquisition if you did not incur any expenditure to acquire the asset.

Hence the market value of the property at the time of transfer to you in March 1988 will be the first element of your cost base.

Second Element: Incidental costs

Under subsection 110-25(3) of the ITAA 1997, incidental costs cover both incidental costs incurred to acquire the CGT asset and those that relate to the CGT event (e.g. disposal of the asset).

Incidental costs may include transfer costs, stamp duty, advertising or costs associated with the services of a valuer, accountant or legal adviser (section 110-35 of the ITAA 1997).

You do not include such costs if you acquired the asset before 21 August 1991. Nor do you include them if you:

·         have claimed a tax deduction for them in any income year, or

·         omitted to claim a deduction but can still claim it because the period for amending the relevant income tax assessment has not expired

Third Element: Non-capital costs of ownership

Under subsection 110-25(4) of the ITAA 1997, non-capital costs of ownership of a CGT asset include, but are not limited to, interest on money borrowed to acquire the asset or to refinance such a borrowing, interest on money borrowed to finance capital improvements to the asset, repairs and maintenance, insurance premiums, rates and land tax (where the asset held is land).

Non-capital costs of ownership are only included in the cost base if the CGT asset was acquired by the taxpayer after 20 August 1991. They are not subject to indexation and are not included in the cost base of collectables or personal use assets. They do not enter into the calculation of losses.

You do not include such costs if you acquired the asset before 21 August 1991. Nor do you include them if you:

·         have claimed a tax deduction for them in any income year, or

·         omitted to claim a deduction but can still claim it because the period for amending the relevant income tax assessment has not expired

Fourth Element: Capital expenditure to increase value

Under subsection 110-25(5) of the ITAA 1997, capital expenditure incurred by a taxpayer to increase an asset's value (e.g. expenditure on improvements) is included in the cost base, provided it is reflected in the state or nature of the asset at the time of the CGT event.

The proviso means that the costs of an improvement that is subsequently removed from the asset prior to disposal cannot be included in the asset's cost base.

Fifth Element: Capital expenditure to establish or defend title to or a right over an asset

Subsection 110-25(6) of the ITAA 1997 states that capital expenditure incurred by a taxpayer to establish, preserve or defend the taxpayer's title to the asset or a right over the asset is included in the cost base.

In your circumstances, the borrowing costs, bank charges, interest and rates fall under the Third Element of the cost base. However these costs are not able to be included in the assets cost base which would reduce the capital gain, as these costs were able to be deducted in the previous years (to the extent that they did not exceed the business income). The only time that these costs could be included in the calculation of the capital gain is if you could not claim a deduction for them because you didn't use the property to produce assessable income - for example it was vacant land or your main residence.

Additionally subsection 35-10(2) of the ITAA 1997 provides that:

If the amounts attributable to the business activity for that income year that you could otherwise deduct under this Act for that year exceed your assessable income (if any) from the business activity for that year, or your share of it, this Act applies to you as if the excess:

(a) were not incurred in that income year; and

(b) were an amount attributable to the activity that you can deduct from assessable income from the activity for the next income year in which the activity is carried on.

Subsection 110-25(4) of the ITAA 1997, Third Element expenditure, relates only to the relevant costs you 'incurred'.

The remaining portion of these expenses that did exceed your business income in relevant years were deferred at the time of the CGT event. In accordance with subsection 35-10(2) of the ITAA 1997 it is determined that they would not have been 'incurred' in the year that the CGT event occurred and cannot be included in the cost base.

Question 3

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 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 152-35 of the ITAA 1997).

The test period begins when you acquired the asset and ends at the earlier of the CGT event and if the relevant business ceased to be carried on in the 12 months before that time - the cessation of the business (subsection 152-35(2) of the ITAA 1997).

For a CGT asset to be an active asset it must firstly satisfy one of the requirements in subsection 152-40(1) of the ITAA 1997, and then also not be excluded by one of the exceptions in subsection 152-40(4) of the ITAA 1997.

A CGT asset is an active asset (subject to the exclusions) if it is owned and used or held ready for use in the course of carrying on a business that is carried on by you, your affiliate or another entity that is connected with you (paragraph 152-40(1)(a) of the ITAA 1997).

However, an asset whose main use in the course of carrying on the business is to derive rent cannot be an active asset (unless that main use was only temporary) (paragraph 152-40(4)(e) of the ITAA 1997). That is, even if the asset is used in a business it will not be an active asset if its main use in the business is to derive rent.

In determining the main use of an asset for the purposes of paragraph 152-40(4)(e) of the ITAA 1997, any use of the asset by a connected entity is treated as your use of the asset (paragraph 152-40(4A)(b) of the ITAA 1997). Therefore, an asset leased to a connected entity for use in the connected entity's business will not, by that reason alone, be excluded by paragraph 152-40(4)(e) of the ITAA 1997 from being an active asset.

In your case the basic conditions contained in Subdivision 152-A of the ITAA 1997 were satisfied because:

·         a CGT event occurred when you disposed of the property

·         the event resulted in a gain

·         you are a CGT small business entity

·         you owned the property for 15 years or less and the property was used in the business for at least half of the ownership period.

Question 4

When you sell or otherwise dispose of real estate, the time of the event (when you make a capital gain or loss) is usually:

·         when you enter into the contract (generally the date on the contract), not when you settle - the fact that a contract is subject to a condition, such as finance approval, generally doesn't affect this date

·         when the change of ownership occurs if there is no contract (such as when a property passes to a beneficiary), or

·         if the real estate is compulsorily acquired - the earliest of:

-        when you receive compensation from the acquiring entity

-        when the entity became the property's owner

-        when the entity enters the property under a power of compulsory acquisition or takes possession under that power.

Paragraph 3 of Taxation Determination TD 94/89: In what year of income is a taxpayer required for tax purposes to include a capital gain or loss in relation to land disposed of under a contract which is made in one year of income, but which is settled in a later year of income states that a taxpayer is not required to include any capital gain or loss in the appropriate year until an actual change of ownership occurs, being settlement. If settlement occurs after you've lodged your tax return and been assessed for the relevant income year, you'll have to request an amendment.

Income tax assessments that are amended to include an amount of omitted income may give rise to interest on the shortfall amount. However TD 94/89 paragraph 5 provides that where the amendment is made within a reasonable time the discretion to remit the interest is likely to be exercised. It is generally accepted that within a period of one month following settlement would be reasonable.

In this case, the capital gain is attributable to the 20XX-XX financial year, as the contract was signed in this year. However the capital gain does not need to be included in the 20XX tax return until the settlement occurs, which was in the 20XX-XX financial year. Your tax agent has correctly included the capital gain in the 20XX tax return.

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