Edited version of private advice

Authorisation Number: 1051634024657

Date of advice: 21 February 2020

Ruling

Subject: CGT - small business concessions - 15 year and Div 7A - deemed dividend

Question 1

Do you satisfy the basic conditions to apply the small business capital gains tax concessions?

Answer

Yes

Question 2

Do you satisfy the conditions to apply the 15 year exemption to the capital gain made on the disposal of the property?

Answer

No

Question 3

Will vendor financing be considered a deemed dividend under Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) at the time of entering into the 'Division 7A Loan Agreement'?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 2020

Year ending 30 June 2021

The scheme commences on:

1 July 2019

Relevant facts and circumstances

Company A was incorporated in 19XX with C and D as Directors holding half of the shares in the company each.

Company A acquired a property (the property) after 20 September 1985.

The property is the only asset of the company and the company's only activity is that of leasing the property.

Company B was incorporated in 19XX with C as the sole shareholder.

Company B operates a business.

The property was leased to Company B and was used in their business since incorporation.

C disposed of their shares in Company B to Company X, Company Y and Company Z as equal shareholders in 20XX.

The sole shareholders of Company X, Company Y and Company Z are E, F and G respectively.

E, F and G are the children of C and D.

The property continued to be leased to and used in the business of Company B after the change of shareholders in 20XX.

C and D worked in the business of Company B on a full-time basis until the change of shareholders in 20XX.

C and D had many years of experience in the business and the industry, they were consulted by E, F and G (the new management of Company B) regularly during the years immediately following the change of shareholders in 20XX.

Some of the matters consulted on include:

·        large commercial projects in terms of costings, labour required and possible budgets:

·        tenders - their input was sought on large tenders:

·        significant machinery purchases; and

·        strategic decisions in relation to the business

As time went on and as the management of Company B acquired more experience, the level of consultation with C and D has decreased to ad hoc.

C and D have now ceased involvement in the business of Company B.

C and D are both over 55 years old.

Proposed disposal of the property

It is your intention to dispose of the property from Company A to an asset protective trust structure to be controlled by C and D's children.

A discretionary family trust (the trust) will be established with C and D and their children as principle beneficiaries.

Company A will dispose of the property to the trust at market value (purchase price).

The purchase price will be funded by way of a vendor financing loan.

The proposed vendor financing loan agreement (Division 7A Loan Agreement) between Company A and the trust contains the following provisions:

3. The borrower must repay in full each individual constituent loan (see subsection 109E(3) of the Income Tax Assessment Act 1936 (ITAA 1936)) forming part of an amalgamated loan, see subsection 109E(3) of the ITAA 1936, within 7 years from the time each constituent loan is advanced or otherwise paid to the borrower.

4. Despite the preceding condition, if the loan is secured in accordance with paragraph 109N(3)(a) of the ITAA 1936 then the borrower must repay, in full, each constituent loan forming part of an amalgamated loan within 25 years from the time each secured constituent loan is advanced or otherwise paid to the borrower.

5. The borrower must pay interest to the company on the amalgamated loan at the benchmark interest rate in accordance with subsection 109N(2) of the ITAA 1936.

6. The borrower must repay to the company such sum in compliance with the minimum yearly repayment requirements contained in subsection 109E(6) of the ITAA 1936 to the extent necessary to ensure that the loan is not deemed to be a dividend under Division 7A of the ITAA 1936, however the borrower may repay any greater sum in the borrower's sole discretion.

Following the disposal of the property, Company A will be liquidated.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 subsection 152-10(1AA)

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

Income Tax Assessment Act 1997 section 152-55

Income Tax Assessment Act 1997 section 152-60

Income Tax Assessment Act 1997 section 152-110

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 section 328-130

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

Income Tax Assessment Act 1997 section 955-1

Income Tax Assessment Act 1936 section 109D

Income Tax Assessment Act 1936 subsection 109N(2)

Income Tax Assessment Act 1936 subsection 109N(3)

Income Tax Assessment Act 1997 Division 7A

Reasons for decision

Summary

The company is considered a small business entity for the income year and has an aggregated turnover of less than $2 million. The property satisfies the active asset test and therefore the company has met the basic conditions to apply the small business CGT concessions.

Although there may be a reduction in C and D's ad hoc activities and/or hours of upon the disposal of the property, it is not considered to be a substantial reduction and therefore the disposal of the property is not considered to be in connection with C and D's retirement. As such you do not meet the requirements to apply the CGT small business concessions 15 year exemption.

As long as the loan agreement is made under writing, the benchmark interest rate is applied to the loan and that the maximum term for the loan does not exceed either 7 years, or 25 years where 100% of the value of the loan is secured by a mortgage over the property registered in accordance with the law of the relevant State or Territory, then the loan would not be considered to be a Div 7A deemed dividend

Detailed reasoning

Basic conditions

To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions. These are called the basic conditions.

A capital gain that you make may be reduced or disregarded under Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997) if the following basic conditions are satisfied:

·        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

Subsection 152-10(1AA) states:

You are a 'CGT small business entity' for an income year if:

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

(b)         you would be a small business entity for the income year if each reference in section 328-110 to $10 million were a reference to $2 million.

Subsection 328-110(1) states:

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

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

(b)         one or both of the following applies:'

(i)           you carried on a business in the income year (the previous year) before the current year and your *aggregated turnover for the previous year was less than $10 million; and

(ii)         your aggregated turnover for the current year is likely to be less than $10 million.

Business is defined in section 995-1 of the ITAA 1997 to be 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

Taxation Ruling TR 2019/1 provides guidance on when a company is considered to be carrying on a business. Example 3 provides an example of a company that owns a commercial property, which it rents to a third party at a market rate on normal commercial terms. The company provides no other services in relation to the property and conducts no other activities. The company is considered to be carrying on a business.

Aggregated turnover is calculated in accordance with sections 328-110 and 328-115 of the ITAA 1997. Aggregated turnover includes your annual turnover and the annual turnover of any entity connected with you or is your affiliate.

Affiliates

An affiliate is defined by section 328-130 of the ITAA 1997 as being an individual or company who acts or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the individual or company. Relevant factors that may support a finding that a person acts in such a manner include:

·        the existence of a close family relationship between the parties;

·        the lack of any formal agreement or formal relationship between the parties dictating how the parties are to act in relation to each other;

·        the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements or legal or fiduciary obligations; and

·        the actions of the parties.

Whether a person is acting in concert with another is essentially a question of fact. The term 'acting in concert' involves at least an understanding between the parties as to a common purpose or object.

Connected entity

An entity is connected with another entity if either entity controls the other entity, or both entities are controlled by the same third entity. Under subsection 328-125(2) of the ITAA 1997, an entity controls a partnership company or trust (except a discretionary trust) if it:

·        beneficially owns or has the right to acquire beneficial ownership of, interest in the other entity that give the right to receive at least 40% of any distribution of income or capital by the other entity, or

·        if the other entity is a company, beneficially owns, or has the right to acquire beneficial ownership of, equity interests in the company that give at least 40% of the voting power in the company.

Active asset test

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.

The test period begins when you acquire 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 152-40(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.

Application to your circumstances

In your case, the Company A intends to dispose of the property which will result in a capital gain.

There is the existence of a close family relationship between C and D and E, F and G. Initially, at the time immediately after the change in shareholders in 20XX, there was a reliance on C and D's input into the operational and strategic decisions of Company B. As time progressed, the degree of consultation reduced to adhoc and now C and D have ceased their involvement in the business of Company B. It is considered that as the reliance on C and D's input into the business decisions of Company B have reduced and now ceased, they would not be considered affiliates.

C and D also are not considered connected entities as they hold no right to the income or voting power in Company B. Therefore there is no requirement to include the annual turnover of Company B in the calculation of Company A's aggregated turnover.

Company A is considered a small business entity for the income year and has an aggregated turnover of less than $2 million.

The property was acquired by Company A in 19XX and has been held for more than 15 years. The property was used in the business of Company B, which from incorporation until 20XX was a connected entity of the company due to C's 100% holding in Company B. Therefore the property will satisfy the active asset test.

As such Company A has met the basic conditions to apply the small business CGT concessions.

15 year exemption

Section 152-110 of the ITAA 1997 provides a small business 15-year exemption for companies and trusts. Under this section, a company or trust can disregard the capital gain from the disposal of a CGT asset if:

(a)      the company or trust satisfies the basic conditions in Subdivision 152-A of the ITAA 1997 for the small business CGT concessions,

(b)      the company or trust continuously owned the CGT asset for the 15-year period ending just before the CGT event happened,

(c)      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 the entity owned the CGT asset, and

(d)      an individual who was a significant individual of the entity just before the CGT event was either:

˗   at least 55 years old at that time and the event happened in connection with their retirement or

˗   permanently incapacitated at that time.

Significant individual

As per section 152-60 of the ITAA 1997 an individual is a CGT concession stakeholder of a company if they are a significant individual or the spouse of a significant individual, where the spouse has a small business participation percentage in the company at that time that is greater than zero.

Under section 152-55 of the ITAA 1997 an individual is a significant individual in a company or trust if they have a small business participation percentage in the company or trust of at least 20%. This 20% can be made up of direct and indirect percentages.

An entity's direct small business participation percentage in a company is the percentage of:

·        voting power that the entity is entitled to exercise

·        any dividend payment that the entity is entitled to receive

·        any capital distribution that the entity is entitled to receive, or

·        if they are different, the smallest of the three definitions above.

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 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 a retirement.

Application to your circumstances

In your case, Company A meets the basic conditions for the small business CGT concessions and has owned the property for more than 15 years.

It is considered that Company A had a significant individual for a total of at least 15 years and that both C and D will be significant individuals of the company just before the disposal of the property.

Both C and D are over 55 years at the time of disposal of the property.

In order for a CGT event to happen in connection with retirement 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 a retirement.

C and D ceased their full-time employment in 20XX, upon the transfer of C's shareholding in Company B to the companies controlled by E, F and G. During the period immediately following the change of shareholder in 20XX, C and D were regularly consulted by E, F and G (the new management of Company B) on the operational and strategic decisions of Company B. This consultation reduced to ad hoc as the management of Company B gained experience.

There was a substantial reduction in the activities and hours worked by C and D at the time of the change in shareholders in Company B in 20XX, as they ceased full-time employment. However this significant reduction did not occur in relation to the disposal of the property XX years later.

After the disposal of the property, you intend to liquidate the company and therefore C and D will cease in their role as directors and will also cease undertaking the activities that had previously been required in relation to the lease of the property to Company B.

Although there may be a reduction in C and D's activities and/or hours of upon the disposal of the property now, it is not considered to be a substantial reduction as the activities and/or hours in the years following the shareholder change in 20XX has been on an ad hoc basis.

In order for a CGT event to be in connection with retirement there needs to be at least a significant reduction in the number of hours that you work or a significant change in the nature of your present activities to be regarded as a retirement. In this case there hasn't been a significant reduction in hours or change of activities. Therefore the disposal of the property is not considered to be in connection with C and D's retirement. As such you do not meet the requirements to apply the CGT small business concessions 15 year exemption.

Proposed vendor financing loan

A loan made by a private company to a shareholder of the company or to an associate of the shareholder may, by virtue of section 109D of the Income Tax Assessment Act 1936 (ITAA 1936), be a Division 7A deemed dividend.

Subsection 109D(1) of the ITAA 1936 does not apply to a loan if an exclusion in Subdivision D of the ITAA 1936 applies. Section 109N of the ITAA 1936 provides the following criteria for where a loan is not treated as dividends:

A private company that makes a loan to an entity in one of the private company's years of income is not taken under section 109D to pay a dividend at the end of the year of income because of the loan if, before the lodgement day for the year of income:

(a) the agreement that the loan was made under is in writing; and

(b) the rate of interest payable on the loan for years of income after the year in which the loan is made equals or exceeds the benchmark interest rate for the year; and

(c) the term of the loan does not exceed the term (the maximum term) for that kind of load worked out under subsection (3).

The benchmark interest rate for the year of income is the Indicator Lending Rates - Bank variable housing loans interest rate last published by the Reserve Bank of Australia before the start of the year of income. However, the benchmark interest rate is the rate worked out under the regulations, if they provide for working it out (Subsection 109N(2) of the ITAA 1936).

Subsection 109N(3) of the ITAA 1936 states:

The maximum term is:

(a) 25 years for a loan if:

(i) 100% of the value of the loan is secured by a mortgage over real property that has been registered in accordance with a law of a State or Territory; and

(ii) when the loan is first made, the market value of the real property (less the amounts of any other liabilities secured over that property in priority to the loan) is at least 110% of the amount of the loan; and

(b) 7 years for any other loan.

Application to your circumstances

Company A is a private company and the trust will be an associate of Company A as C and D will be beneficiaries of the trust. The proposed loan agreement (Division 7A Loan Agreement) between Company A and the trust contains provisions that incorporate the conditions required under section 109N of the ITAA 1936 for the loan to not be treated as a deemed divided.

As long as the loan agreement is made in writing, the benchmark interest rate is applied to the loan and the maximum term for the loan does not exceed either 7 years, or 25 years (where 100% of the value of the loan is secured by a mortgage over the property registered in accordance with the law of the relevant State or Territory), then the loan would not be considered to be a Div 7A deemed dividend at the time of entering the agreement.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).