Edited version of private advice

Authorisation Number: 1052039266070

Date of advice: 30 September 2022

Ruling

Subject: CGT - small business concessions

Question 1

Does the company satisfy the basic conditions under subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997) for accessing the capital gains tax (CGT) small business concessions?

Answer

Yes, the company satisfies the basic conditions under subdivision 152-A of the ITAA 1997.

Question 2

Can the company access the small business 50% reduction under subdivision 152-C of the ITAA 1997?

Answer

Yes, the company can access the small business 50% reduction under subdivision 152-C of the ITAA 1997.

Question 3

Can the company access the small business retirement exemption under subdivision 152-D of the ITAA 1997?

Answer

Yes, the company can access the small business retirement exemption under subdivision 152-D of the ITAA 1997.

Question 4

Will the earnout payments be considered an earnout arrangement for tax purposes with look-through treatment available under subdivision 118-I of the ITAA 1997?

Answer

Yes, the earnout payments are considered to be an earnout arrangement for tax purposes with look-through treatment available under subdivision 118-I of the ITAA 1997.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company Pty Ltd (Company) is a resident private company that operated a business. R is Company's sole director. The shareholder of Company is R's family (discretionary) trust (the Trust).

Company has previously paid dividends to the Trust which are distributed equally between beneficiaries R and R's spouse. R is over 55; R's spouse is under 55.

In the 20XX financial year, Company entered into an asset sale agreement with XXXX (Buyer). The asset sale agreement included business records; contracts and goodwill; intellectual property; and the seller's interest in the business lease (the CGT assets). Assets such as plant and equipment and trading stock (the business assets) were sold at written down market value. Company was sold as a going concern for goods and services tax (GST) purposes.

Assets excluded from the sales agreement are receivables owed to Company; motor vehicles owned by Company; a painting in the conference room; and R's laptop and mobile phone.

The sale price was $X plus saleable stock, which has a maximum value of $Y per the asset sale agreement.

Buyer paid Company a deposit, and a further deposit upon signing of the asset sale agreement.

In respect of the balance of the purchase price plus value of stock: an amount was payable as directed on the completion date of sale, and another deferred amount is payable 12 months from the completion date (deferred payment). The deferred payment will be held in escrow in R's solicitors' trust account.

Subject to whether the business reaches the profit target within 12 months of the completion date, R will be entitled to the deferred payment within 15 days of the relevant payment date. If the profit target is not reached within the first 12 months following the completion date, then the deferred payment will be reduced proportionally on a percentage basis according to the extent that the business failed to achieve the profit target.

The proceeds from the sale of Company's business will be used to fund R's retirement.

Company had a turnover of greater than $2 million in the income year of the CGT event. The net value of the CGT assets of Company and its connected and affiliated entities did not exceed $6 million just before the time of entering into the sale agreement.

R has a self managed superannuation fund (SMSF); R's spouse has their own superannuation fund, separate to R's.

R and R's spouse have each not utilised any of their $500,000 lifetime retirement exemption caps.

Relevant legislative provisions

Income Tax Assessment Act 1997 subdivision 118-I

Income Tax Assessment Act 1997 subdivision 152-A

Income Tax Assessment Act 1997 subdivision 152-C

Income Tax Assessment Act 1997 subdivision 152-D

Income Tax Assessment Act 1997 subdivision 328-C

Reasons for decision

Section 152-10 of the ITAA 1997 provides the basic conditions for access to small business relief.

Subsection 152-10(1) provides that a capital gain ... may be reduced or disregarded if the following basic conditions are satisfied:

(a)          a CGT event happens in relation to a CGT asset of yours in an income year;

(b)          the event would (apart from Division 152) have resulted in the gain;

(c)           at least one of the following applies:

(i)            you are a CGT small business entity for the income year;

(ii)           you satisfy the maximum net asset value test; ...

(d)          the CGT asset satisfies the active asset test

CGT small business entity

Subsection 152-10(1AA) provides that 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 of the ITAA 1997 to $10 million were a reference to $2 million

Maximum net asset value test

Section 152-15 of the ITAA 1997 provides that you satisfy the maximum net asset value test if, just before the CGT event, the sum of the following amounts does not exceed $6,000,000:

(a)          the net value of the CGT assets of yours;

(b)          the net value of the CGT assets of any entities connected with you;

(c)           the net value of the CGT assets of any affiliates of yours or entities connected with your affiliates (not counting any assets already counted under paragraph (b))

The meaning of "net value of the CGT assets" is provided in section 152-20 of the ITAA 1997. The net value of the CGT assets of an entity is the amount ... obtained by subtracting from the sum of the market values of those assets the sum of:

(a)          the liabilities of the entity that are related to the assets; and

(b)          the following provisions made by the entity:

(i)            provisions for annual leave;

(ii)           provisions for long service leave;

(iii)         provisions for unearned income;

(iv)         provisions for tax liabilities

Subsection 152-20(2) of the ITAA 1997 further provides that, in working out the net value of the CGT assets of an entity, certain assets are to be disregarded:

(a)          disregard shares, units or other interests (except debt) in another entity that is connected with the first-mentioned entity or with an affiliate of the first-mentioned entity, but include any liabilities related to any such shares, units or interests; and

(b)          if the entity is an individual, disregard:

(i)            assets being used solely for the personal use and enjoyment of the individual, or the individual's affiliate (except a dwelling, or an ownership interest in a dwelling, that is the individual's main residence, including any adjacent land to which the main residence exemption can extend because of section 118-120 of the ITAA 1997); and

(ii)           except for an amount included under subsection (2A), the market value of a dwelling, or an ownership interest in a dwelling, that is the individual's main residence (including any relevant adjacent land); and

(iii)         a right to, or to any part of, any allowance, annuity or capital amount payable out of a superannuation fund or an approved deposit fund; and

(iv)         a right to, or to any part of, an asset of a superannuation fund or of an approved deposit fund; and

(v)          a policy of insurance on the life of an individual.

Connected with affiliate

Section 328-125 of the ITAA 1997 provides that an entity is connected with another entity if:

(a)          either entity controls the other entity in a way described in this section; or

(b)          both entities are controlled in a way described in this section by the same third entity.

Paragraph 328-125(2)(b) of the ITAA 1997 provides that, regarding direct control of entities other than discretionary trusts, an entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates, own, or have the right to acquire the ownership of, equity interests in the company that carry between them the right to exercise, or control the exercise of, a percentage (the control percentage) that is at least 40% of the voting power in the company.

Subsections 328-125(3) and 328-125(4) of the ITAA 1997 relate to direct control of discretionary trusts. Subsection 328-125(3) of the ITAA 1997 provides that an entity (the first entity) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates, or the first entity together with its affiliates.

Subsection 328-125(4) of the ITAA 1997 provides that an entity (the first entity) controls a discretionary trust for an income year if, for any of the 4 income years before that year, paragraphs 328-125(4)(a) and 328-125(4)(b) are satisfied:

(a)          the trustee of the trust paid any of the income or capital of the trust, or applied for the benefit of:

(i)            the first entity; or

(ii)           any of the first entity's affiliates; or

(iii)         the first entity and any of its affiliates;

(b)          the percentage (the control percentage) of the income or capital paid or applied is at least 40% of the total amount of income or capital paid or applied by the trustee for that year.

In respect of indirect control on an entity, and interposed entities, subsection 328-125(7) of the ITAA 1997 provides that section 328-125 applies to an entity (the first entity) that directly controls another entity (the second entity) as if the first entity also controlled any other entity that is directly, or indirectly by any other application or applications of this section, controlled by the second entity.

Section 328-130 of the ITAA 1997 provides that an individual or a company is an affiliate of yours if the individual or company 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 business of the individual or company. However, an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.

Active asset test; meaning of active asset

Section 152-35 provides that 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 period specified in subsection (2); 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 7 ½ years during the period specified in subsection (2).

Subsection 152-35(2) of the ITAA 1997 provides that the period:

(a)          begins when you acquired the asset; and

(b)          ends at the earlier of:

(i)            the CGT event; and

(ii)           if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows - the cessation of the business

Section 152-40 of the ITAA 1997 provides that a CGT asset is an active asset at a time if, at that time:

(a)          you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership) by:

(i)            you; or

(ii)           your affiliate; or

(iii)         another entity that is connected with you; or

(b)          if the asset is an intangible asset - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you.

Small business 50% reduction

Section 152-205 of the ITAA 1997 provides that you get the small business 50% reduction if the basic conditions in Subdivision 152-A of the ITAA 1997 are satisfied for the gain.

Section 152-215 of the ITAA 1997 provides that the 15-year exemption has priority over the small business 50% reduction. The 15-year exemption cannot be accessed by Inkerman as the CGT assets were not owned for a 15-year period, per section 152-110 of the ITAA 1997.

Small business retirement exemption

Subsection 152-305(2) of the ITAA 1997 provides that a company ... can choose to disregard all or part of a capital gain if:

(a)          the basic conditions in Subdivision 152-A are satisfied for the capital gain; and

(b)          the entity satisfies the significant individual test in section 152-50; and

(c)          the company or trust conditions in section 152-325 are satisfied.

Per subsection 152-315(3), the amount chosen to be disregarded is the CGT exempt amount.

Significant individual; small business participation percentage

Section 152-50 of the ITAA 1997 provides that an entity satisfies the significant individual test if the entity had at least one significant individual just before the CGT event. Section 152-55 provides that an individual is a significant individual in a company or trust at a time if, at that time, the individual has a small business participation percentage in the company or trust of at least 20%.

Section 152-65 of the ITAA 1997 provides that an entity's small business participation percentage in another entity at a time is the percentage that is the sum of:

(a)          the entity's direct small business participation percentage in the other entity at that time; and

(b)          the entity's indirect small business participation percentage in the other entity at that time.

Section 152-60 of the ITAA 1997 provides that an individual is a CGT concession stakeholder of a company or trust at a time if the individual is:

(a)          a significant individual in the company; or

(b)          a spouse of a significant individual in the company or trust, if the spouse has a small business participation percentage in the company or trust at that time that is greater than zero.

Direct and indirect small business participation percentages are worked out under sections 152-70 and 152-75 of the ITAA 1997 respectively.

Subsection 152-75(1) of the ITAA 1997 provides that you can work out the indirect small business participation percentage that an entity (the holding entity) holds at a particular time in another entity (the test entity) by multiplying:

(a)          the holding entity's direct small business participation percentage (if any) in another entity (the intermediate entity) at that time; by

(b)          the sum of:

(i)            the intermediate entity's direct small business participation percentage (if any) in the test entity at that time; and

(ii)           the intermediate entity's indirect small business participation percentage (if any) in the test entity at that time (as worked out under one or more other applications of this section).

Extra company or trust conditions

Section 152-325 provides further conditions to be satisfied where a company is accessing the concession and making the exempted payment.

Paragraph 152-325(1)(b) of the ITAA 1997 provides that a company ... must make a payment ... to at least one of its CGT concession stakeholders if the company ... receives an amount of capital proceeds from a CGT event for which it makes a choice under Subdivision 152-D. Subsection 152-325(2) provides that if the company ... receives the capital proceeds from the CGT event in instalments, subsection (1) applies to each instalment in succession (up to the relevant CGT exempt amount, as prescribed by section 152-315).

Subsection 152-325(2A) of the ITAA 1997 provides that, for the purposes of (but without limiting) subsection (2), the company ... is treated as receiving the capital proceeds in instalments if:

(a)          the CGT event happened because the company ... disposed of the CGT asset; and

(b)          the capital proceeds from the disposal are increased by one or more financial benefits that the company ... receives under a look-through earnout right.

Paragraph 152-325(4)(b) of the ITAA 1997 provides that the payment must be made by the later of: 7 days after the company ... makes the choice; and 7 days after the company ... receives an amount of capital proceeds from the CGT event.

Subsection 152-325(7) of the ITAA 1997 provides that if a CGT concession stakeholder is under 55 just before a relevant payment is made to them:

(a)          the company ... must make the payment to the CGT concession stakeholder by contributing it for the stakeholder to a complying superannuation fund or an RSA in respect of the stakeholder; and

(b)          the company ... must notify the trustee of the fund or the RSA provider at the time the contribution is made that the contribution is made in accordance with this section.

Section 152-315(4) of the ITAA 1997 provides that the CGT exempt amount must be specified in writing; subsection 152-325(3) provides that if a payment is made to more than one CGT concession stakeholder, the amount of each such payment is to be worked out by reference to each individual's percentage (worked out under subsection 152-315(5)) of the relevant CGT exempt amount.

Subsection 152-320(1) of ITAA 1997 provides that an individual's CGT retirement exemption limit at a time is $500,000 reduced by the CGT exempt amounts of CGT assets specified in choices previously made by, or for, the individual under Subdivision 152-D. Subsection 152-320(2) provides that if the individual was one of at least 2 CGT concession stakeholders of a company ... and the company ... made a choice for the individual, only the individual' s percentage (worked out under subsection 152-315(5)) of the assets' CGT exempt amounts is taken into account under subsection 152-320(1) for that choice.

Earnout arrangements

The provisions relating to look-through earnout rights are in subdivision 118-I of the ITAA 1997. Subsection 118-565(1) provides that a look-through earnout right is a right for which the following conditions are met:

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

(b)          the right is created under an arrangement that involves the disposal of a CGT asset;

(c)          the disposal causes CGT event A1 to happen;

(d)          just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset;

(e)          all of the financial benefits that can be provided under the right are to be provided over a period ending no later than 5 years after the end of the income year in which the CGT event happens;

(f)           those financial benefits are contingent on the economic performance of:

(i)            the CGT asset; or

(ii)           a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate;

(g)          the value of those financial benefits reasonably relates to that economic performance;

(h)          the parties to the arrangement deal with each other at arm' s length in making the arrangement.

Application to your circumstances

CGT event A1 will happen as a result of the disposal of Company's CGT assets to Buyer; and but for the application of the CGT small business concessions, it would have resulted in a capital gain.

Company's turnover in the year of the CGT event exceeds $2 million, therefore subsection 152-10(1AA) and subparagraph 152-10(1)(c)(i) of the ITAA 1997 are not satisfied. However, Company satisfies the maximum net asset value test in section 152-15 of the ITAA 1997, because Company and its connected and affiliated entities did not hold more than $6 million in net assets just before the CGT event.

R and R's spouse are connected with Company. R and R's spouse have control over the Trust as they receive 50% equal distributions as beneficiaries and have influence over the trustee such that the trustee acts in accordance with the directions of R. The Trust has ownership and control of Company; accordingly, R and R's spouse have indirect ownership of Company.

The CGT assets included in the sales agreement were owned by Company and used in the course of carrying on its business. The CGT assets include intangible assets (such as goodwill and intellectual property) which were owned by Company and inherently connected with its business. The CGT assets were used in Company's business for at least half the period of ownership. Therefore, the CGT assets satisfy the active asset test and accordingly, Company satisfies the basic conditions for access to the CGT small business concessions.

Company can access the small business 50% reduction.

The Trust makes 50% distributions to R and R's spouse. The Trust directly owns 100% of Company. R and R's spouse each have small business participation percentages in Company of over 20% and therefore they both satisfy the significant individual test.

Accordingly, Company can access the small business retirement exemption. Company will document its decisions appropriately and in line with the requirements in subdivision 152-D of the ITAA 1997; payments made will occur in line with the requirements in paragraph 152-325(4)(b).

As R is over 55, they can receive the exempt amount directly. R's spouse is under 55 and will have to contribute the exempt amount directly to their superannuation fund. Neither R nor R's spouse have used any of their retirement exemption cap and therefore they each have $500,000 to utilise after the small business 50% reduction has been applied.

The earnout payments to Company are reliant upon a comparison of current year profit against profit in the year prior to the asset sale, meaning that the future financial benefits were not easily attainable at the time of the sale agreement of the CGT assets, which, as discussed above, are considered to be active assets. The earnout payment is subject to the economic performance of the business in the year after the sale is completed, per the sales agreement.

The last payment will be 12 months from the completion date of the sale, which is less than 5 years after the end of the income year in which the CGT event happened. The deferred payment is dependent on the business achieving an annual profit in comparison to the prior 12 months before settlement occurs.

Company and Buyer dealt with each other at arm's length.

At the time the deferred payment is received it will be considered proceeds in relation to the CGT event corresponding to the asset sale. Company's income tax return for the year ended 30 June 20XX will be amended to include these additional proceeds for the CGT event.

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