Edited version of private ruling

Authorisation Number: 1011702973663

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Ruling

Subject: Capital gains tax - small business concessions

Question 1

For the purposes of the Trust satisfying the 80% test in subsection 152-40(3) of the Income Tax Assessment Act 1997 (ITAA 1997), is cash held by the Company in bank accounts considered to be inherently connected with the business the Company carries on?

Answer

Yes.

Question 2

For the purposes of the small business entity definition in paragraph 328-110(1)(a) of the ITAA 1997, was the Trust considered to be carrying on a business in the year ended 30 June 2010?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Cash Reserves held by the Company

You state that you have been advised by the Company that the general policy for its level of cash reserves was that as a general rule, cash reserves of at least $X million should be kept. The cash retention policy was very much in line with the requirements of its significant shareholder, which is also involved in the same business activities. The Company's cash retention policy was based on their experience. It was predicated on a rough working capital requirement of at least 90 days worth of contract income values.

The Company is involved in risky projects. On the one hand there is the significant risk of unforeseen technical difficulties which can cause enormous cost blow-outs. In extreme situations, these problems can result in non-performance of the contract leading to reduced payment or even non-payment of the contract sum. With a large number of long term construction projects undertaken at any one time a significant cash reserve is held to cover creditor's progress payments in the event that these contract disputes occur.

You also state that as the Company does not own assets that can be used as security, such as land and buildings, the Company has difficulty obtaining loan funds and must rely on its own cash reserves to pay its bills.

There is the further potential, over and above, for damages claims. As the quantum of the contract sum increases, so the size of this risk increases. The Company has entered into an increasing number of contracts in excess of $Y million.

You state that the nature of the business results in the fact that, once installed, there is no possibility of any recovery. If a contract becomes in dispute, or the party with which the Company has entered into a contract defaults or goes into liquidation, the loss to the Company can be as much as the entire contract sum.

The Company directors are of the view that at any time, given the large nature of the contracts, if a dispute arose or a contactor was unable to pay, cash reserves should be available. It was considered that in addition to the working capital requirement, further cash should be held in reserve as a safeguard in the event of a large one-off loss.

In addition to the estimated 3 months working capital kept on hand, the amount was increased specifically due to the likelihood of litigation cases, which came to fruition.

You state that the incidence of the claims above support the assertion that cash reserves held by the Company were necessarily connected with the ongoing business of the Company for two reasons.

Reason 1 - Cash was required to be held to provide for these specific claims.

Reason 2 - These claims are an example of both the risk in nature of the business, the size of claims that necessarily may arise, and also provides evidence that the 90 day cash requirement is justifiable.

You state that the Company operated an operating account and a cash management account and that transfers between the two occurred regularly.

Information contained in the Company's financial report states that cash and cash equivalents in the balance sheet comprise cash at bank and in hand and short-term deposits with an original maturity of three months or less that are readily convertible to cash and which are subject to an insignificant risk of changes in value.

Trust carrying on a business

You state that a land development / construction business was being carried on by the Trust commencing prior to the end of the recent financial year.

The trustee identified the potential for real estate activities involving land development at a location in the prior year and developed a business plan in this regard. Financial forecasts based on this plan together with market projections evidence a profit-making intention.

The directors of the trustee are experienced land developers and have successfully developed many properties over the years. The estimated capital commitment required when activities are in full operation is over $Xm.

Many hours were spent reviewing the potential and negotiating the purchase of the first parcel of land which settled prior to 30 June the recent year.

A second parcel of land was acquired under offer and acceptance prior to 30 June in the recent year.

A third parcel of land is being acquired with settlement due late in the recent year.

A further parcel of land has been identified for potential acquisition, subsequent construction of dwellings, and sales. These acquisitions have not proceeded yet, mainly for market related reasons. The trustees do not wish to create a false market for land at the location, and wish to ensure the first several developments are completed successfully before committing to further acquisitions. This is considered normal commercial practice.

As discussed in the ruling request a contract was signed to construct a dwelling on one of the blocks prior to 30 June in the recent year. The construction contract was entered into between the Trust and an unrelated third party, being a business located elsewhere. This third party constructs the dwellings to agreed specifications, dismantles them and transports them to the relevant location. Once there, they are reassembled by sub-contractors employed by the Trust.

As at 30 June in the recent year the first dwelling was being constructed by the third party. The dwelling has been subsequently completed, dismantled, transported to the relevant location and is currently ready to be constructed on the second block of land. As at late in the recent year, all site works have been done and re-construction of the dwelling will start within days. It is estimated construction will be completed within 10 weeks.

A contract has been signed and the third party is currently in the process of constructing a second house which will be eventually re-constructed on either the first block or third block acquired by the Trust.

The marketing of house and dwellings to be constructed by the Trust is an evolving issue, mainly because there have been no new houses built at the location for some time.

Potential for future demand of these newly constructed houses lies in the following areas:

(a) Government housing

(b) Owner occupiers

(c) Investment opportunities

Whilst advertising has commenced and initial expressions of interest for house and land packages have been sought, the Trust wishes to ensure construction activities progress smoothly before arranging presales of developed property or dwellings. Based on interest shown to date, there is a significant upside for the business assuming the first dwellings are constructed successfully.

The acquisition of initial stock and construction of dwellings has been done on a cautious and measured basis. There have been no off-the-plan sales or finalised properties as of yet. However, you state that the activities will be carried out with repetition and regularity over an extended period.

A and B, as Directors of the trustee company, have been very active in relation to this project and B in particular has spent approximately 70% of his time since early in the recent year on these business matters. During the past few months there has been a lot of work securing planning approvals, builder's licences, and undertaking numerous meetings and correspondence with the regulatory authorities.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 199, subsection 152-40(3)

Income Tax Assessment Act 1997 paragraph 152-40(3)(b)

Income Tax Assessment Act 199, subparagraph 152-40 (3)(b)(ii)

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

Income Tax Assessment Act 1997 paragraph 152-40(4)(d)

Income Tax Assessment Act 1997 paragraph 152-40(4)(e)

Income Tax Assessment Act 1997 paragraph 328-110(1)(a)

Income Tax Assessment Act 1997 section 995-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Note, all subsequent legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Under paragraph 152-40(3)(b), a share in a company that is an Australian resident will be an active asset at a given time if, at that time, you own the share and the total of:

(i) the market values of the active assets of the company; and

(ii) the market value of any financial instruments of the company that are inherently connected with a business that the company carries on; and

(iii) any cash of the company that is inherently connected with such a business;

is 80% or more of the market value of all of the assets of the company.

For the purposes of subparagraph 152-40(3)(b)(ii) a bank account represents a contractual arrangement between the depositor and the bank. A bank account is, at law, a loan to the banker and is considered to be a financial instrument.

The expression 'inherently connected' is not defined in the legislation. However, the expression is discussed at paragraph 1.38 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No.7) Bill 2006 which introduced paragraph 152-40(3)(b)(ii).

This document states that 'inherently connected' is an alternative test for intangible assets because it will be difficult for some intangible assets to meet the requirement to be used, or held ready for use, in carrying on a business. The example considered in the Explanatory Memorandum is goodwill. Goodwill is not 'used' in a business, but is inherently connected with it. From this we can conclude that there is no new meaning to the expression nor is there a criterion to be assessed against.

Generally, a bank account (in credit) used by a taxpayer in the course of carrying on their business could reasonably be seen as being inherently connected with the taxpayer's business. However, in determining whether all of the market value of a particular bank account should be included in the numerator of the 80% test calculation we must consider whether the account contains any cash amounts which, due to their source or use, do not relate specifically to the operations of the business. These amounts may cause the taxpayer to fail the 80% test.

Application to your circumstance

Previously the cash reserves were at a level commensurate with the operating needs of the Company's business. You advise that some years ago a decision was made to increase the cash reserves of the Company to at least $X million. This decision was made in line with the requirements and experience of a significant shareholder which itself is involved in the same business. The amount was predicated on a rough working capital requirement of at least 90 days worth of contract income values.

The activities undertaken by the Company are, by nature, very high risk and can lead to significant cost blow-outs or even the non-performance of the contract and non-payment of the contract sum. With many long term projects undertaken at any one time the Company requires a significant cash reserve to cover creditor's progress payments in the event that contract disputes occur.

The Company has entered into an increasing number of contracts each of which exceeds $Y million. As there is little chance of recovering any of the materials or associated outlays involved in the project, if a contract becomes in dispute or the other party defaults or goes into liquidation the loss to the Company can be as much as the entire contract sum.

Further, you advise that the nature of the Company's business activities are such that it does not own significant assets which can be used as security against which borrowings can be obtained if needed. Instead it relies on its cash reserves.

A decision was made to further increase the cash reserves specifically in view of the likelihood of litigation cases, which came to fruition and involved payouts.

Whilst the amounts held in the financial instruments in any one financial year are quite significant when considered against the overall income and expenses of the Company, it appears that it is holding cash reserves that for the greater part (i) enable it to operate its day to day trading activities, (ii) insulate it against the very real risk of urgent costs associated with litigation, and in the event of disputes enable it to (iii) cover non-payment by debtors, and (iv) cover progress payments to creditors.

Notes from the Company's financial statements indicate that cash and cash equivalents comprise cash at bank and in hand and short-term deposits with an original maturity of three months or less that are readily convertible to cash and which are subject to an insignificant risk of changes in value.

The Company owns the relevant bank accounts and term deposits that are the subject of this question. It is apparent that a significant proportion of the funds held in these accounts relate to operating expenses and the various contingent liabilities of the Company, and that these funds are readily accessible.

Therefore, we find that these financial instruments are inherently connected with the business and are active assets for the purpose of subparagraph 152-40(3)(b)(ii) and the 80% calculation.  

Goodwill

Note, for the purposes of paragraph 152-40(3)(b), whilst goodwill may be considered an active asset of the Company we have not, in this ruling, commented on the particular goodwill valuation methodology which has been adopted in the Company accounts.

Are the shares active assets of the Trust?

Whilst we can comment on what should or should not be included in the Company's subparagraph 152-40(3)(b) calculation, including financial instruments, goodwill etc, we cannot advise whether the Trust will satisfy the broader active asset test at any particular point in time in relation to the shares because we cannot undertake the 80% calculation on the Trust or the Company's behalf. If your own investigations raise doubt in this regard, a market valuation of the Trust and/or Company assets may be required. This may be arranged via the Australian Valuation Office (AVO) or alternatively through a certified valuer.

Subsection 152-40(4) exception

We note that the financial instruments are interest bearing and paragraphs 152-40(4)(d) and 152-40(4)(e) provide, in part, that financial instruments whose main use is to derive interest cannot be active assets. However in this case we find that the main use of the financial instruments by the Company is not to derive interest but instead to be used directly in the course of the carrying on its business activities. Accordingly, none of the subsection 152-40(4) exceptions will apply.

Question 2

Subsection 6-5(1) states that your assessable income includes income according to ordinary concepts. This ordinary income includes amongst other things, income from salary and wages and business operations.

Section 8-1 allows you to claim a deduction for a loss or outgoing that is incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business to gain or produce assessable income. These deductions are limited by the exclusion of losses or outgoings that are capital, private or domestic in nature.

Carrying on a business

Section 995-1 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

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.

Taxation Ruling TR 97/11 is entitled Am I carrying on a business of primary production?. However, it is of general application with its principles not restricted to questions of whether a 'primary production' business is being carried on.

In the Commissioner's view (and as you have noted in your application), 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.

No one indicator is decisive. The indicators must be considered in combination and as a whole. Whether a 'business' is carried on depends on the large or general impression.

Likewise, the point in time at which a business has commenced is dependent upon when each of the various indicators are considered to have been satisfied, with the accumulation of these factors creating a general impression that a commitment to a business activity has been evidenced.

Application to your circumstance

In relation to the above mentioned factors, you advise that the Trust acquired two parcels of land early in the recent income year, with a third parcel settled late in the recent year and further parcels identified for potential acquisition.

Prior to 30 June in the recent year a contract was signed with a third party to construct a dwelling to agreed specifications to be dismantled, transported to the certain location and then reassembled by sub-contractors engaged by the Trust. This contract has been completed and the dwelling is currently being reassembled. The same building firm has been re-engaged and is currently in the process of constructing a second dwelling which will be placed on one of the other blocks.

The potential for development at the location was identified in a previous year. Subsequently, B and in particular A spent considerable time throughout the recent financial year researching and reviewing the potential prior to acquiring the first property.

You state that advertising commenced and initial expressions of interest were sought in the recent year. A business plan has been drafted and this outlines an intention and likelihood of profit and addresses market projections.

Up until the recent year A, on behalf of the Trust, has devoted approximately 70% of his time to this project. More recently he has been busy securing planning approvals and builders licences, and attending meetings and corresponding with the regulatory authorities.

The above activities support a significant commercial purpose together with an intention to engage in a profitable business which has been planned, organised and carried on in a businesslike manner similar to what would be expected of other property developers undertaking a similar project.

Given that activities have only just commenced, the size and scale of the business venture is only relatively small at present. However with the stated injection of $X million into the project you confirm that the size, scale, repetition and regularity of the operation are all expected to increase over time.

Whilst the acquisition and development of just one property may be viewed as an isolated transaction the second property and dwelling are solid indicators that a business is commencing.

Provided the third property is developed and subsequent properties are acquired and developed for sale, the repetition and regularity indicators will be met and a business activity evidenced.

Provided the above business plan and activities are undertaken and adhered to we consider that the acquisition and commitment to develop the second property prior to 30 June in the recent year (together with all other referenced peripheral activities) represents the point in time at which the project extended beyond an isolated transaction and a business had commenced.

It follows that for the purpose of the small business entity definition in paragraph 328-110(1)(a), the Trust was considered to be carrying on a business in the recent income year.