Edited version of private advice

Authorisation Number: 1051812175640

Date of advice: 30 March 2021

Ruling

Subject: Capital gains tax

Question 1

Did entity A (you) carry on a business for the years xxxx to xxxx?

Answer

Yes.

Question 2

Does property one satisfy the active asset test under Subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 3

Does property two satisfy the active asset test under Subdivision 152-A of the ITAA 1997?

Answer

No.

This ruling applies for the following periods

Years ended 30 June 19XX to 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on

April 19XX

Relevant facts

You (partnership) began offering short term accommodation in city A in the xxxx income year.

You own xx properties.

Property one was acquired in xxxx. Estimated cost base is $xxxx. Estimated value is $xxxx.

Property two was acquired in xxxx. Estimated cost base is $xxxx. Estimated value is $xxxx.

You restored property one and started your accommodation activities.

You also managed accommodation owned by your relations on a commission basis.

In xxxx, you purchased another property. Estimated cost base is $xxxx. Estimated value is $xxxx.

You started with one property, then grew to xx properties.

A related entity also owned properties.

Your net assets will not exceed $X million just before the CGT event.

Partner B worked full time as an employee during the relevant years.

Partner B was available after hours to attend to property maintenance, take accommodation bookings and other support activities.

Partner A worked at least xx hours per week on the accommodation activities, except for the period of time when employed externally. When Partner A was employed part-time externally, additional staff were employed to assist with the day-to-day tasks.

The outside employment was taken on to gain valuable experience which assisted with the future running of the accommodation activities.

You employed up to xx part time casual staff. The staff were employed to attend to the ongoing operations. All wages were accounted for in the profit and loss. You were registered for PAYG withholding, issued payment summaries to employees and paid superannuation as required.

Your associates assisted with the day to day activities and worked a combined xx hours per week. When on leave, their time was made up by paid staff.

Significant time and cost was involved in the day to day operation of the accommodation.

Tariffs were xxxx

The accommodation was available all year round.

Income from the above activities was declared as business income on the tax returns from xxxx to xxxx.

You did not enter into formal lease arrangements with guests but rather took short term bookings to occupy the premises for a short period of time.

Guests were supplied with all linen and towels, and a breakfast basket for the first morning. All cleaning was done by the employed staff.

As some of the properties were not owned by you, you paid rent to the relevant entity and then had exclusive use of the properties to be used.

Profit and loss statements have been provided.

You were motivated to start the accommodation activities because through research you had identified a niche market within the accommodation industry in the region.

You engaged qualified professional accountants and consulting services to establish detailed business plans including financial projections.

You worked to better promote and enhance the viability of your operations.

The initial business plan indicated that you would be profitable.

You had various challenges with your activities.

In xxxx, Partner A completed a course to enhance your knowledge and skills to better operate and to develop the business plan.

There was also a strong emphasis on staff development to ensure the best possible product and service to guests and continually improve their service offering. A number of activities were done to better understand the business sector and to train staff in improved services.

Partner A established working relationships with similar providers in other regions.

Your activities were a 24/7 commitment. You won awards and received great feedback.

In xxxx, the existing properties were no longer offered as short term stays but rather long term rentals involving a formal lease arrangement. Costs such as staffing and advertising were no longer required on the same scale.

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

Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Question 1

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

The Commissioner's view on whether the letting of property amounts to the carrying on of a business is found in a number of places.

The Tax Office publication Rental properties 2020 states on page 5:

A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with the other co-owners....

Most rental activities are a form of investment and do not amount to carrying on a business.

Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case, (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159). Generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual (paragraph 3 of Taxation Ruling IT 2423).

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners quotes the legal case of Federal Commissioner of Taxation v McDonald (1987) 18 ATR 957; 87 ATC 4541, where Beaumont J said at ATR p 968; ATC p 4550:

The reference to "business"... indicates a "commercial enterprise as a going concern": see Hope v Bathurst City Council (1980) 144 CLR 1 at 8; 12 ATR 231 at 236 per Mason J. Purely domestic transactions are thus excluded from the definition: see Fletcher, op cit p 28. The "business" must be "carried on". This suggests some active occupation or profession: see IRC v The Marine Steam Turbine Co Ltd (1919) 12 TC 174 per Rowlatt J at 179.'... 'On the other hand, in the case of a private individual as distinct from a company, "it may well be that the mere receipt of rents from properties that he owns raises no presumption that he is carrying on a business." see American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue (1979) AC 676 per Lord Diplock at 684.

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Normally the receipt of income from the letting of property to a tenant(s) does not amount to the carrying on of a business (Wertman v. Minister of National Revenue (1964) 64 DTC 5158; Federal Commissioner of Taxation v. McDonald (1987) 15 FCR 172;87 ATC 4541; 18 ATR 957 (McDonald's case); Cripps v. FC of T 99 ATC 2428 (Cripps' case); Case X48 90 ATC 384; (1990) 21 ATR 3389).

In Case G10 75 ATC 33 (Case G10), the taxpayer owned two properties of which six units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a seven day a week activity. The Board of Review held that the activity constituted the carrying on of a business.

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.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' (Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case, and no one indicator will be decisive (Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922).

Applying the relevant indicators to your circumstances

Significant commercial purpose

The 'significant commercial purpose or character' indicator is closely linked to the other indicators and is a generalisation drawn from the interaction of the other indicators. It is particularly linked to the size and scale of the activity, the repetition and regularity of the activity and the profit indicators.

Your activity is the renting out of short term residential accommodation. You own xx residential properties and use other properties owned by related entities for the activities. You receive income from the properties. Occupancy was not consistent over time for the short-term stays. Your business plan showed you could be profitable after a few years, however this never eventuated.

Intention of the taxpayer

The carrying on of a business is not a matter merely of intention, it is a matter of activity. It is appropriate to look at when the activities started and whether they add up to more than a mere intention to conduct a business.

Your intention was to provide short-term accommodation. Significant time and money was put into the operation. Your intention was that you would fully fund a salary of at least $xxxx per annum to Partner A.

Prospect of profits

The taxpayer's involvement in a business activity should be motivated by wanting to make a tax profit and the taxpayer's activities should be conducted in a way that facilitates this. This will require examining whether objectively there is a real prospect of making such a profit from participating in the business of the taxpayer.

You intended to make a profit, however this did not eventuate. You had high capital costs and experienced problems.

Repetition and regularity

The taxpayer's activities should involve repetition and regularity and have an air of permanence about them. With regards to letting of properties, repetition and regularity may be measured by factors such as regularity of maintenance, collecting of rent, management and advertising of the properties, insurance, dealing with tenancy agreements and inspection reports.

Partner A worked at least xx hours per week on the activities, except for the period of time when employed externally. You employed staff to help with various tasks when needed.

Activities of the same kind and carried on in a similar manner to those of the ordinary trade in that line of business

If a taxpayer carries out their activity in a manner similar to other taxpayers in the industry, it is more likely that their activity amounts to the carrying on of a business. That is, the taxpayer's operations are of the same kind and carried on in the same way as those characteristic of ordinary trading in that particular line of business (IR Commissioners v. Livingston 11 TC 538).

Generally, where the property owners grant exclusive possession of the property to the residents the relationship between the two parties is one of tenant and landlord, and the activity is more likely to be passive investment rather than a business. Similarly, activities constituting the mere maintenance of an asset and the mere collection of income do not indicate the existence of a business.

You received rental income from the use of the properties for short-term accommodation. It was identified that the development of a cohesive and structured management system was a critical element for success.

Organisation in a business-like manner, the keeping of books, records and the use of a system

The activities conducted by, or on behalf of the taxpayer, should be carried out in a systematic and organised manner. This will usually involve matters such as the keeping of appropriate business records by the taxpayer.

You kept records of income and expenses.

The size and scale of the activity

The business should be large enough to make it commercially viable. In Cripps' case, it was held that the renting of 14 two storey townhouses was not a business and in McDonald's case it was held that the letting of two units in different strata plans was also not a business.

You owned xx properties and rented xx other properties for short-term accommodation. You spent xx hours most weeks on the activities and employed staff when needed to help with maintenance, cleaning and administration duties.

Hobby or recreation

The pursuit of a hobby is not the carrying on of a business for taxation purposes.

In this case, the intention was not to carry on a hobby.

Conclusion

You had a business plan and was hoping to become profitable, however, a profit was not made in the years between xxxx and xxxx.

You managed the properties and spent much time each week on relevant activities. The gross revenue was significant. You had employees, registered for PAYG and kept records. There was regularity and repetition in your activity and efforts were made to become profitable.

After considering your specific circumstances and weighing up the relative business indicators, it is accepted that you were carrying on a business in the xxxx to xxxx income years.

Questions 2 and 3

Capital gains tax

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.

Active asset

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.

Under subsection 152-40(1) of the ITAA 1997, 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 provides some exceptions and lists some assets that cannot be active assets.

Paragraph 152-40(4)(e) of the ITAA 1997 provides that an asset whose main use is to derive rent cannot be an active asset, unless that main use 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.

Taxation Determination TD 2006/78 Income Tax: capital gains: are there any circumstances in which remises used in a business of providing accommodation for reward may satisfy the active asset test in section 152-35 of the Income Tax Assessment At 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? (TD 2006/78), outlines the circumstances when premises that provide accommodation may satisfy the active asset test. Whether an asset's main use is to derive rent will depend on the particular circumstances of each case.

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. Burley Borough Council [1977] 2 All ER 62 at 78, 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).

A key factor therefore in determining whether an occupant of premises is a lessee is whether the occupier has a right to exclusive possession (Radaich v. Smith (1959) 101 CLR 209). 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 less likely to be rent.

Relevant factors to consider in determining whether rent is derived include:

•         whether the occupier has a right to exclusive possession

•         the degree of control retained by the owner, and

•         the extent of any services provided by the owner such as room cleaning, provision of meals, supply of linen and shared amenities (Allen v. Aller (1966) 1 NSWR 572; Appah v. Parncliffe Investments Ltd [1964] 1 All ER 838 and Marchant v. Charters [1977] 3 All ER 918).

Payments are generally not rent if the following factors exist:

•         no notice is required to quit the rooms,

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

•         the owner/manager retains the right to enter the accommodation,

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

•         the owner provides services and facilities to guests 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,

•         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 accommodation do not have the right to exclusive possession of a room but rather only a right to occupy the room.

In example 4 in TD 2006/78, Linda owns a complex of six holiday apartments. The apartments are advertised collectively as a motel and are booked for periods ranging from 1 night to 1 month. The majority of bookings are from 1 to 7 nights. Linda is responsible for bookings, checking guests in and out and cleaning the apartments. She also provides clean linen and meal facilities to guests. Linda does not enter into any lease agreements with guests staying at the apartments.

In that example, the apartments are operated similar to a motel. The guests do not have exclusive possession of the apartment they are staying in but rather only a right to occupy the apartment on certain conditions. The usual length of stay by guests is very short term and room cleaning, linen and meals are also provided to guests. These facts indicate that the relationship between Linda and the guests is not that of landlord/tenant under a lease agreement. Accordingly, the income derived is not 'rent'. If Linda's activities amount to the carrying on of a business, the paragraph 152-40(4)(e) of the ITAA 1997 exclusion would not apply and the apartments would be active assets under section 152-40 of the ITAA 1997.

In Carson & Anor v FC of T [2008] AATA 156 (Carson's case), the Administrative Appeals Tribunal (AAT) considered this issue in relation to holiday rentals and stated:

In this matter, the subject asset is one unit, presumably within a group of residential units. Occupants generally stay for one or two weeks. Crockery, cutlery and linen are included but cleaning is done only after the occupants depart. I have no doubt that the occupants regard themselves as having "rented" the unit for the period of their stay and during that stay have exclusive possession. Unsurprisingly, no formal lease agreement is signed but this does not mean that there is no landlord/tenant relationship. On the facts provided, I am of the opinion that the main use of the subject property is to derive rent and, therefore, it is excluded from being an active asset under s 152-40(4) of the Act...

The AAT ruled that the main use of the property was to derive rent and therefore it was excluded from being an active asset. A key factor noted in TD 2006/78 in determining whether the paragraph 152-40(4)e) of the ITAA 1997 applied was whether the occupier had the right to exclusive possession or only a licence to occupy. Although no formal agreement was signed, there was a landlord/tenant relationship.

The issue of whether Airbnb agreements constituted a lease or a licence, and whether the Airbnb guests were given 'exclusive possession' was considered in Swan v Uecker [2016] VSC 313 (Swan v Uecker case).

The Supreme Court (the Court) held that the use of words "guest" and "licence" in the Airbnb 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.

Justice Croft held that the effect of the agreement, fully analysed, was that the Airbnb guests enjoyed a right of exclusive possession. While the Airbnb terms and conditions repeatedly used the word 'licence', Justice Croft stressed the well-established principle that the substance of an agreement prevails over its form. He held that the effect of the agreement, fully analysed, was that the Airbnb guests enjoyed a right of exclusive possession.

Accordingly, Justice Croft concluded:

I am of the opinion that the Airbnb Agreement for occupation of the whole of the Apartment is properly to be characterised as a lease...

Although every case will turn on its facts, the Court's decision clearly establishes a general principle that a short-term accommodation can be a lease, despite how the parties describe themselves.

Although your situation was different to the Swan v Uecker case and Carson's case, the principles are relevant.

You did the cleaning of the properties, however the cleaning was generally done once the guests left. You provided linen and towels and a breakfast basket for the first morning. However, no other food was provided to the guests during their stay.

It is acknowledged that you organised the bookings and advertising yourselves and your properties were not used for private purposes. However, it is considered that the relationship between you and the occupants were more properly characterised as that of landlord and tenant. Although no formal agreement was signed, we consider the occupants who stayed at the various properties would believe they had exclusive possession of the property for the duration of their stay.

The properties were all separate and were not connected to other properties owned by the owners. You weren't on the premises most of the time during the time guests were there. Guests therefore had full access to the whole property during their stay.

While the occupancy granted to your occupants were for short periods, the occupancy is not the same as those for a lodger or a hotel/motel guest as in example 4 in TD 2006/78. The possession of the property by the occupants are viewed as being the same as what would be expected of in relation to tenants of residential accommodation generally, being exclusive occupancy.

It cannot be viewed that the main use of the properties to earn rent was only of a temporary nature, but was the main use for the majority of your ownership period.

Taking into consideration all the relevant factors, it is considered that the overall arrangement of your short-term accommodation was considered to be that of a landlord/tenant relationship. As a result, it is determined that the main use of the properties was to derive rent. Therefore, the properties do not satisfy the active asset requirements found in section 152-40 of the ITAA 1997.

Consequently you will not be able to access the small business CGT concessions under Division 152 of the ITAA 1997 in relation to the capital gains made on the sale of the properties.

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).