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Ruling

Subject: Small Business CGT Concessions

Question 1:

Is the rental income derived by any of Taxpayer A, Taxpayer B and Company A, annual turnover for the purposes of section 328-120 of the Income Tax Assessment Act 1997 (ITAA 1997)? That is, do any them carry on a rental property business or some other form of business involving property, such as trading in properties?

Answer:

No

Question 2:

If the answer to Question 1 is no, is any part of Taxpayer A, Taxpayer B and Taxpayer C's ordinary income included in Company B's aggregated turnover pursuant to section 328-115 of the ITAA 1997?

Answer:

No

This ruling applies for the following period

01 July 2011 to 30 June 2013

The scheme commenced on

1 July 2011

Relevant facts and circumstances

Taxpayer A is the sole director and majority shareholder of Company B.

Taxpayer B is a minority shareholder in Company B. Taxpayer B is also a bookkeeper for the business and works part time in that role.

Company B currently operates a real estate sales business.

Company B is proposing to apply the Small Business CGT Concessions in Division 152 of the ITAA 1997, in determining its net capital gain from the sale of one or more of its Businesses.

Taxpayer A, Taxpayer B and the Company A (the Owners) own a number of investment properties, both residential and commercial premises. These properties are leased to third party tenants for market rates of rent.

Taxpayer A has an interest in ten Rental Properties, one of which is owned jointly with taxpayers' spouse. Taxpayer B (50% each) and another jointly with the Company A (50% each). One property is co-owned by Taxpayer A and an unrelated party, as to 50% each.

As well as owning one property jointly with Taxpayer A, Taxpayer B has an interest in two other Rental Properties. One is owned by Taxpayer B alone and the other is owned by her jointly.

Taxpayer A is the sole director and shareholder of Company A. Company A has an interest in nine Rental Properties. One Rental Property is owned jointly with Taxpayer A.

The Rental Properties have been acquired by each of the Owners over a period of time, with the view to retaining them long term for rental investment. None of the Owners have acquired the Rental Properties with the intention of selling them short term at a profit. The majority of the Rental Properties have been bought from third party vendors when the opportunity to buy them had arisen.

The Owners did not sell any of Rental Properties in the 2012 financial year, nor do they intend to in the near future. In the past five years, only one property has been sold by Taxpayer B.

None of Taxpayer A, Taxpayer B and Company A manages the leasing of the Rental Properties. They also do not personally carry out any maintenance, upkeep or repairs to the Rental Properties.

The Rental Properties are all fully managed by third party management staff of Company B. Company B undertakes the "day to day" attendances to the Rental Properties such as collection of rent, property inspections, liaising with tenants effecting repairs, maintenance and upkeep where required and negotiating of lease terms,

Company B charges Taxpayer A, Taxpayer B and Company A management fees in respect of the Rental Properties owned by each plus letting fees. Company B charges similar rates in respect of the properties it manages for other arm's length clients.

Management of the Rental Properties is performed by long term professionally trained and experienced employees of Company B upon an arm's length basis. Neither Taxpayer A nor Taxpayer B, as employees of Company B, undertakes these activities on behalf of Company B.

Company B also advertises for and sources tenants for the Rental Properties on behalf of Taxpayer A, Taxpayer B and Company A. This work is carried out by appropriately qualified employees of Company B. Taxpayer A and Taxpayer B do not engage in any of these activities in respect of the Rental Properties.

Taxpayer A and Taxpayer B spend no material time in relation to the Rental Properties.

The income derived from the Rental Properties is not the only income derived by Taxpayer A and Taxpayer B. Significant income is derived by each of them as employees of Company A.

The income derived by Company A from its Rental Properties is its main source of income.

The Rental Property investment activities of the Owners are not undertaken pursuant to a written business plan. The Rental Properties have been acquired over time on an ad-hoc basis. The Owners do not have an established or structured plan as to when and in what manner further properties should be acquired.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 328-110

Income Tax Assessment Act 1997 Section 328-115

Income Tax Assessment Act 1997 Section 328-120

Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision

Question 1:

Division 328 of the ITAA 1997 - Small Business Entity

An entity may be eligible to use the Small Business CGT Concessions to reduce a capital gain if it is a small business entity for the income year in which the capital gain arises (subparagraph 152-10(1)(c)(i) of the ITAA 1997).

An entity that carries on a business in an income year will be a small business entity for the income year (current year) if any one of the following tests is satisfied:

The entity carried on business in the previous year and its aggregated turnover for the previous year was less than $2 million (subparagraph 328-110(1)(b)(i) of the ITAA 1997);

The entity's estimated aggregated turnover for the current year, worked out at the start of the current year, is likely to be less than $2 million. However the entity cannot qualify as a small business entity under this provision if their aggregated turnover in each of the two previous years was $2 million or more (subparagraph 328-110(1)(b)(ii) and subsection 328-110(3) of the ITAA 1997); or

The entity's actual aggregated turnover for the current year, worked out as
at the end of the year, is less than $2 million (subsection 328-110(4) of the ITAA 1997).

Meaning of Aggregated Turnover

An entity's aggregated turnover is defined in section 328-115 of the ITAA 1997 to be the sum of the following:

· The entity's annual turnover for the income year;

· The annual turnover for the income year of any entity (a relevant entity) that is connected with the entity at any time during the income year; and

· The annual turnover for the income year of any entity (a relevant entity) that is an affiliate of the entity at any time during the income year.

Meaning of Annual Turnover

An entity's annual turnover for an income year is the total ordinary income that the entity derives in an income year in the ordinary course of carrying on a business (subsection 328-120(1) of the ITAA 1997).

The term 'ordinary income' is defined in section 6-5 of the ITAA 1997 as income according to ordinary concepts. Rental income is a form of income according to ordinary concepts. An entity's annual turnover therefore includes all income according to ordinary concepts derived in the ordinary course of carrying on a business.

The term 'business' is defined in subsection 995-1(1) of the ITAA 1997 to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee. 'Carrying on a business' is not defined in Division 328 of the ITAA 1997 nor is it defined elsewhere in the ITAA 1997. It therefore takes its ordinary meaning. This approach is confirmed in the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Act 2007, which introduced the small business $2 million turnover test and as an alternative to the Maximum Net Assets Value $6 million test. At paragraph 2.14, it is stated:

The phrase 'in the ordinary course of carrying on a business' is not defined in income tax law. It must therefore be interpreted according to its ordinary meaning.

Implicit from the analysis above, is that for an entity to have an annual turnover it must be carrying on a business.

As per subsection 328-115(2) of the ITAA 1997, Company B must also include the annual turnovers of entities connected or affiliated with Company B when calculating its turnover.

The Applicant has stated that Taxpayer A and Company A are each connected entities of Company B for the 2012 year. They have also stated that Taxpayer B may be an affiliate of Company B if she is carrying on a business or a connected entity of Company B if Taxpayer A is carrying on a business. Accordingly, it must be determined whether any of these entities are carrying on a business, such as a rental property business, or some other form of business involving property. If they are not carrying on a business their rental income does not need to be included as 'annual turnover' in Company B's aggregated turnover.

The Commissioners view on whether an entity is carrying on of a business is found in a number of places.

Taxation Ruling TR 97/11, (TR 97/11) which is about whether a taxpayer is carrying on a business, states the question of whether a person is carrying on a business is determined by the facts in each individual case. This is done by considering the following indicators that have been used in court cases:

· the nature of the activities, particularly whether they have the potential of profit making;

· the repetition and regularity of the activities;

· organisation in a business-like manner, including whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business and the keeping of books or records;

· the volume of the operations; and

· the amount of capital employed.

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' from looking at all the indicators. The weighting to be given to each indicator may vary from case to case.

In Taxation Ruling TR 93/32, (TR 93/32) which is about rental property and division of net income or loss between co-owners, the indicator of repetition and regularity of the activities is mentioned in quotes from Federal Commissioner of Taxation v McDonald (1987) 18 ATR 957; 87 ATC 4541, where Beaumont J said at ATR p 968; ATC p 4550 and at ATR page 969; ATC page 4552:

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.

Paragraph 55 of TR 97/11 considers the indicator of repetition and regularity activities:

It is often a feature of a business that similar sorts of activities are repeated on a regular basis. The repetition of activities by the same person over a period of time on a regular basis helps to determine whether there is the 'carrying on' of a business. For example, in Hope the 'transactions were entered into on a continuous and repetitive basis', such that the taxpayer's activities 'manifested the essential characteristics required of a business'.

Regarding the indicator of the scale of operations, Taxation Ruling No. IT 2423, (IT 2423) which is about whether rental income constitutes proceeds of business (for withholding tax purposes), states:

A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations. An individual who derives income from the rent of one or two residential properties would not normally be thought of as carrying on a business. On the other hand if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business.

In respect to the present facts, the following indicators have been considered by the Commissioners as to whether the activities of the Owners (both alone and as co-owners), in respect of their Rental Properties, amount to carrying on a business.

The Owners outsource the advertising for and sourcing of tenants to Company B. As the property manager, Company B actively manages the properties on behalf of the Owners, carrying out property inspections, attending to lease negotiation and enforcement issues where necessary and collecting rents. Company B is clearly not independent of the Owners. However, the services provided by Company B are not carried out personally by Taxpayer A or Taxpayer B. They are performed by experienced professional management employees of Company B, unrelated to Taxpayer A and Taxpayer B, on commercial terms. Furthermore, Company B charges the Owners management fees at commercial rates to undertake these services as if they were an arm's length landlord.

It is stated that Taxpayer A and Taxpayer B devote no material time towards owning and managing their Rental Properties. Taxpayer A and Taxpayer B's main source of income for is from their roles as director/employee and equity owners of Company B. They are not reliant on the rental income generated from the Rental Properties.

Size and scale

Taxpayer B derives rental income from the leasing of three residential properties, two of which are co-owned. It is considered that the size of Taxpayer B's activities is relatively small. The Commissioner, in IT 2432, notes that an individual who derives income from renting one or two residential properties would not normally be thought of as carrying on a business.

Company A holds a larger property portfolio. However, the size and scale of operations is only one factor relevant to the carrying on of a rental property business.

Taxpayer A owns a significant number of properties (alone and as a co-owner). As with Company A, the factors of active personal participation and, repetition and regularity is lacking in Taxpayer A's case.

Significant commercial activity

It is considered that the owners have significant knowledge, previous experience and skill in the property industry. The fact that Taxpayer A has successfully operated a similar business may establish that there is a significant commercial purpose in the rental property activities.

At paragraph 30 of TR 97/11 the Commissioner provides a list of factors which are indicative of a significant commercial activity. Many of these factors overlap with the indicators of a business as noted at paragraph 18 of TR 97/11.

In the present case, the Owners have not drawn up a business plan in respect of their rental property activities. The Rental Properties have not been acquired pursuant to an established plan or on a systematic basis. The Rental Properties have been acquired on an ad hoc basis when a viable opportunity presents itself.

Detailed investigations or cost/benefit projections are not systematically or otherwise undertaken or considered by the Owners when acquiring investment real estate. This lack of formal system and organisation indicates that the Owners' activities of passively owning and leasing properties falls far short of a rental property business or a business of trading in properties.

It is considered that a pivotal feature of a rental property business is that the taxpayer is actively involved in leasing and managing the rental properties. In the present case, the Owner's activities lack the factors of active participation, personal involvement, and, repetition and regularity.

Intention of the Taxpayer

The Applicant has stated that the Owners' intentions in purchasing and leasing the Rental Properties long term, is to build wealth over the long term and ultimately provide a steady income stream for Taxpayer A and Taxpayer B's eventual retirement. The Owners have not sold any Rental Properties in the current or last financial year, and only Taxpayer B has sold a property in the last five years, indicating an intention to own the Rental Properties long term.

Manner of conduct of activity

Where an activity is carried on in a similar manner to that of ordinary trade, this may indicate that a business is being carried on: see paragraph 63 of TR 97/11.

In the present case, there is significant capital investment, an intention to make a long term net rental return, ownership of a number of properties either alone or as co-owners and sourcing viable rental properties

Conclusion on business

Based on the facts provided, the Commissioner considers that the Owners are not carrying on a business of rental properties.

The majority of factors identified in TR 97/11 indicate that the rental property activities of the Owners (i.e. in owning and leasing the Rental Properties) do not constitute a business. The activities lack the degree of repetition, personal involvement and regularity as well as the organisation and system that would normally be found in the activities of a taxpayer who is carrying on a rental property business. The Owners have not drawn up or intend to draw up a business plan and do not acquire new properties in accordance with an established goal, plan or system. The activities are generally carried out on an ad hoc basis and the properties have been acquired over a long term basis.

Question 2:

Conclusion on Company B's aggregated turnover

As it has been determined that none of Taxpayer A, Taxpayer B or Company A are carrying on a rental property business or any other form of business such as trading in properties, the rental income derived by these entities is passive investment income and does not constitute the carrying on of a business.

The rental income derived by Taxpayer A, Taxpayer B and Company A is therefore not ordinary income derived in the ordinary course of carrying on a business within the meaning of section 328-120 of the ITAA 1997.

Accordingly, the gross rental income of each of Taxpayer A, Taxpayer B and Company A is not required to be included in Company B's aggregated turnover pursuant to section 328-115 of the ITAA 1997 in respect of the years ending 30 June 2012 or 30 June 2013.