Edited version of your private ruling

Authorisation Number: 1012490303365

Ruling

Subject: CGT Small Business 15-Year Exemption

Question

Are the taxpayers eligible for the small business 15-year exemption under section 152-105 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following periods:

Income year ending 30 June 2013

The scheme commences on:

January 1987

Relevant facts and circumstances

In 19XX, the taxpayers purchased a property. At the time, the only structures on the property were a small house and sheds.

In 20XX, the taxpayers sold the property.

During the time that the taxpayers owned the property, it was used for various purposes as follows:

· a market garden principally operated by taxpayer A;

· a market garden business operated by taxpayers child A;

· business premises operated by taxpayers child B;

· the leasing of part of the property to a third party for use as a farm;

· the residential renting out of the house in the property;

· the principal residence of the taxpayers' Y sons; and

· the grazing of livestock in winter for personal consumption by the taxpayers.

The taxpayers provided a table which provides a summary of each use of the land and the amount of area used as at 30 July 20XX.

In 20XX, the city council approached the taxpayers to compulsorily acquire an area of the property. The area subject to the compulsory acquisition encompassed a portion of the area leased out to the third party for farming purposes. The compulsory acquisition was settled in 20XX.

Use of Land for Market Gardening

Shortly after the taxpayers purchased the property, they applied to have the land re-zoned to urban farmland so they can operate a market garden on a portion of the property.

In 19XX, the property was classified by the city council as urban farmland. A copy of the approval was provided.

In 19XX, the taxpayers harvested their first crop.

The taxpayers continued to trade until they ceased operations for the following reasons:

· when the taxpayers purchased the property, it was not reticulated and the taxpayers did not have the funds required to install reticulation on the land. This meant that the taxpayers were restricted to cultivating crops on the pasture areas comprising a portion of natural wetlands.

· to improve their chances of succeeding in their business venture, the taxpayers also selected crops which were not dependent on a reticulated water supply.

· between the periods that the taxpayers commenced their business, the pasture area of the land gradually dried out and reduced the area that the taxpayers could effectively cultivate.

· the taxpayers attempted to compensate for this problem by applying for a license to draw groundwater for commercial use.

· in 19XX, a ground water well licence was issued which allowed the taxpayers to take water from the ground. This was sufficient to supply a manual reticulation system that the taxpayers installed to cultivate a portion of the land. The introduction of the reticulation allowed for other crops to be planted. The installation of the reticulation and the ploughing and fertilisation of this new area was made physically possible by the efforts and involvement of one of the taxpayers' children.

· after some time, the natural wetland area had reduced and the taxpayers decided to discontinue their business as, even with the reticulated area, the total area that they could cultivate was too small to generate a commercial profit.

· the taxpayers' decision was based on their child's decision to start their own market garden business on the property which they had helped the taxpayers with since 19XX. The taxpayers, considering their age at the time, did not believe that they were up to the strain of making the improvements to the land necessary to combat the drying conditions and were happy to let child A undertake the task.

In 20XX income years, the taxpayers recommenced their market business operation on the property while their child was applying to the government agency for an increase in the license to draw groundwater from the property.

The planting of crops this year also included other crops on a smaller scale.

The taxpayers ceased the business after they harvested the crops planted in 20XX because their child had obtained the increase to the water license and was intending to plant their own crops in the land in the next season. However, the quality of the produce was affected due to the drying conditions in the wetlands.

The taxpayers provided a table which sets out, year-by-year, the area of the property used by the taxpayers in their market garden.

Used for Purposes other than Market Gardening

At some point, child A operated their market garden business on the property, but eventually relocated their business to another site.

The taxpayers did not charge their child rent.

The taxpayers' only involvement in the business was to provide their child with a loan which they used to purchase equipment to start their business and to provide occasional manual labour in their business.

After some time, child B operated a business on the property but relocated their business to another site.

The taxpayers did not charge their child rent.

The taxpayers' only involvement in the business was to advance them a loan which they used to purchase equipment to start the business.

Lease to a third party

The taxpayers granted a lease over an area of the property to a neighbour which was used as a farm using water drawn from the tenant's property under the tenant's own water license after which the lease arrangement eventually ended.

The taxpayers agreed to grant the lease to their neighbour for the following reasons:

· the taxpayers did not have sufficient water at the time to cultivate that area for their market garden business. Therefore, there was no practical opportunity cost or competition for use of the land and the taxpayers believed that the lease would be beneficial so that the land was not sitting idle.

· the taxpayers were not inclined to expend the capital required to make the area suitable for cultivation because this part of the property will be compulsorily acquired by the city council in a few years time.

· of the total area leased to the third party for farming, a portion of it was not able to be used for cultivation because it was too appropriate. That part of the leased area was used by the tenant as a turning area for the tenant's irrigation machinery.

The taxpayers had argued that the rent that they charged the tenant for the area of land used for the farming was less than market value because the taxpayers took the view that this was the best price that they could charge the tenant because they were the only person able to make commercial use of the area as no one other than a neighbour would have access to the water necessary to cultivate the land on a commercial basis.

Also, the tenant was required to spend considerable time and money on the leased area to make it suitable for use in his farming business (e.g. removing fences, clearing the land and improving soil quality) without a contribution from the taxpayers

The taxpayers provided a table which details, year-by-year, the use of the land as a leased farm and the income that the taxpayers have derived from the rental activity.

Dwelling House - Rental & Principal Residence

When the taxpayers purchased the property, they acquired the property subject to a lease over a small house on the property. The house and the part of the property set aside for domestic use for this house occupied approximately 0.XX acres on the property.

The vendor of the rented out the small house to a third party but was not documented.

The taxpayers indicated that they originally intended to construct a new house to use as their new residence on the property. This plan was subsequently abandoned when the city council indicated that they intended to use the land and could not give any clear guidance as to the location of the new use for the land.

The existing lease arrangement continued until a new tenant took over the lease of the house.

In 19XX, the taxpayers evicted the new tenant from the house.

On different occasions, the taxpayers' children used the house as their principal residence but did not pay rent.

Livestock Grazing for Domestic Purposes

The taxpayers grazed a small number of livestock which were raised purely for personal consumption by the taxpayers and the taxpayers' family on the pasture area in winter between the crops and in the dried parts of the wetlands areas which were no longer capable of sustaining crops.

Asset Value Test

The taxpayer's assets were under $6 million.

In Connection with the Taxpayers' Retirement

The taxpayers have not commenced or resumed any business activity on the property since their market garden business last closed.

The taxpayers are both over the age of 55 years and have both retired from employment.

Further Information

The taxpayers applied for permits required to use the property as a market garden, including changing the zoning for the land to urban farmland, obtaining a diesel fuel certificate for agricultural vehicles and purchasing shares in a cooperative society to obtain trade discounts.

The amount of produce grown has always exceeded the taxpayers' domestic needs. At its highest, the taxpayers produced an estimated X tonnes of crop A, Y tonnes of crop B and Z tonnes of crop C in a single season.

The taxpayers have provided the following tables:

· the annual market garden expenses;

· the estimated volume of produce on an annual basis

· the comparative areas of the different uses of the land on an annual basis

· the net income derived from each use of the land

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-105

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

Summary

After considering all of the relative business indicators and objective facts surrounding the case, it is considered that that the taxpayers are not carrying on a business of primary production.

Therefore, the taxpayers are not eligible to claim the small business 15-year exemption under section 152-105 of the ITAA 1997.

Detailed reasoning

Definition of primary production

Section 152-105 of the ITAA 1997 provides that an individual can disregard any capital gain arising from a CGT event if all of the following conditions are satisfied:

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

(b) you continuously owned the asset for the 15-year period ending just before the CGT event;

(c) if the CGT asset is a share in a company or an interest in a trust- 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 you owned the CGT asset.

(d) either:

(i) you are 55 or over at the time of the CGT event and the event happens in connection with your retirement; or

(ii) you are permanently incapacitated at the time of the CGT event.

Subsection 152-35(1) of the ITAA 1997 provides the basic conditions for a CGT asset to satisfy the active asset test as follows:

(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 7½ years during the period specified in subsection (2).

Subsection 152-40(1) of the ITAA 1997 provides that a CGT asset is an active asset at a time if, at that time you own the asset; and

(a) it is used or held ready for use in the course of carrying on a business by you, your affiliate or another entity that is connected with you; or

(b) it is an intangible asset that is inherently connected with a business you carry on.

Subsection 995-1(1) of the ITAA 1997 provides the definition of primary production business as that of carrying on a business of cultivating or propagating plants, fungi or their products or parts (including seeds, spores, bulbs and similar things), in any physical environment.

A person is carrying on a business of primary production for the purposes of the ITAA 1997 if this person satisfies the definition of primary production business as provided for by subsection 995-1(1) of the ITAA 1997, and the activity amounts to the carrying on of a business.

Subsection 995-1(1) of the ITAA 1997 defines business to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee. However, this definition simply states what activities may be included in a business. It does not provide any guidance for determining whether the nature, extent and manner of undertaking those activities amount to the carrying on of a business. For this purpose it is necessary to turn to case law.

The court cases provide a number of indicators that are relevant to determining whether primary production activities constitute the carrying on of a business. These indicators are set out below. The indicators are no different, in principle, from the indicators as to whether activities in any other area constitute the carrying on of a business.

Some indicators of carrying on a business of primary production

The courts have held that the following indicators are relevant and provide general guidance in determining whether a business of primary production is or is not being carried on:

· 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 repetition and regularity of the activity;

· 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;

· whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at 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 a sporting activity.

Significant commercial purpose or character

The phrase significant commercial purpose is referred to by Walsh J in Thomas v. FC of T 72 ATC 4094; (1972) 3 ATR 165, (refer to paragraph 81) and discussed further by Gibbs CJ and Stephen J in Hope. 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 activity (refer to paragraphs 77 to 85), the repetition and regularity of activity (refer to paragraphs 55 to 62) and the profit indicators (refer to paragraphs 47 to 54). A way of establishing that there is a significant commercial purpose or character is to compare the activities with those of a taxpayer who is carrying on a similar activity that is a business. Any knowledge, previous experience or skill of the taxpayer in the activity, and any advice taken by the taxpayer in the conduct of the business should also be considered but are not necessarily determinative: see Thomas. In that case, Walsh J found that the taxpayer's activities in growing macadamia nut trees and avocado pear trees amounted to the carrying on of a business. The court was influenced by the scale of the activity, and the taxpayer's expectation of an ongoing financial return. Consideration should also be given to whether the taxpayer is a pioneer in the activity or has developed a new method of undertaking the activity, whether successful or not.

The intention of the taxpayer

The intention of the taxpayer in engaging in the activity is a relevant indicator: see Thomas. However, a mere intention to carry on a business is not enough. There must be activity. Brennan J in Inglis v. FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497 said that:

'The carrying on of a business is not a matter merely of intention. It is a matter of activity. …At the end of the day, the extent of activity determines whether the business is being carried on. That is a question of fact and degree."

Prospect of profit

We consider this to be a very important indicator. In Hope at CLR 8-9; ATC 4390; ATR 236, Mason J indicated that the carrying on of a business is usually such that the activities are:

'... engaged in for the purpose of profit on a continuous and repetitive basis.'

In Smith v. Anderson (1880) 15 Ch D 247 at 258, Jessell MR said that:

'... anything which occupies the time and attention and labour of a man for the purpose of profit is business.'

In Case H11 76 ATC 59 at 61; 20 CTBR (NS) Case 65 at 603, the Chairman of Board of Review No 1 said:

'In determining whether a business is being carried on it is, in my view, proper to consider, as one of the elements, whether the activities under consideration could ever result in a profit ...'

We believe it is important that the taxpayer is able to show how the activity can make a profit. Stronger evidence of an intention to make a profit occurs when the taxpayer has conducted research into his/her proposed activity, consulted experts or received advice on the running of the activity and the profitability of it before setting up the business. This was the situation in FC of T v. JR Walker 85 ATC 4179; (1985) 16 ATR 331. However, it is not necessary for the primary production activities to make a profit in every year of income in order to classify the activities as a business of primary production. Thus, a taxpayer may be carrying on a business of primary production even though he/she is making a small profit or a loss in any given year of income.

The situation may arise where a taxpayer is carrying on a business and has an intention to make a profit but the objective evidence is such that a profit is unlikely to be made in the short term. Bowen CJ and Franki J in Ferguson at ATC 4264; ATR 876 stated that '... an immediate purpose of profit-making in a particular income year does not appear to be essential ...'. Thus, where short term losses are expected it may be that a business is nevertheless being carried on: see Tweddle v. FC of T (1942) 7 ATD 186; (1942) 2 AITR 360.

Where an activity is carried on and the objective evidence is that it is unlikely a profit will ever be made, this fact in itself does not necessarily mean that a business is not being carried on, if the taxpayer believes that the activity will become profitable. As Walsh J said in Thomas at ATC 4100; ATR 171:

'It is not in doubt that he made mistakes. But many persons carry on a business for the competent conduct of which they have not previously acquired much knowledge or experience.'

See also Tweddle's case at ATD 190; AITR 364. Taxpayers need to show that the other indicators of business are present in sufficient strength to outweigh any objective view that the activity may be inherently unprofitable. A number of Board of Review and Administrative Appeals Tribunal decisions show that a taxpayer in this situation bears a heavy onus: see Case M50 80 ATC 349; 24 CTBR (NS) Case 24; Case K9 78 ATC 98; 22 CTBR (NS) Case 29; Case L16 79 ATC 84; 23 CTBR (NS) Case 20 and Case L22 79 ATC 106; 23 CTBR (NS) Case 25.

Repetition and regularity

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'. Similarly, in JR Walker the court held that there was repetition and regularity in the taxpayer's activities directed to the breeding of high quality Angora goats and to keeping up with the latest information on Angora goats.

Is the activity of the same kind and carried on in a manner that is characteristic of the industry?

An activity is more likely to be a business when it is carried on in a manner similar to that in which other participants in the same industry carry on their activities. Lord Clyde in IR Commissioners v. Livingston at TC 542 said that:

'... the test, which must be used to determine whether a venture ... is, or is not, "in the nature of trade", is whether the operations involved in it are of the same kind, and carried on in the same way, as those which are characteristic of ordinary trading in the line of business in which the venture was made.'

Organisation in a businesslike manner and the use of system

In Newton v. Pyke the court suggested that business should be conducted systematically. A business is characteristically carried on in a systematic and organised manner rather than on an ad hoc basis. An activity should generally conform with ordinary commercial principles to amount to the carrying on of a business.

In Ferguson the Full Federal Court was influenced by the systematic and organised nature of the taxpayer's activities. Fisher J said at FLR 324-325; ATC 4271; ATR 884:

'... the venture as a whole had a commercial flavour, was conducted systematically and, ... in a business like manner. It could not be said that there was anything haphazard or disorganised in the way in which he carried out the activity.'

In JR Walker Ryan J was satisfied, at ATC 4182; ATR 335, that the taxpayer was in the business of goat breeding as he had 'organised his activities in a business-like way through the keeping of books of account'.

Size or scale of the activity

The larger the scale of the activity the more likely it will be that the taxpayer is carrying on a business of primary production. However, this is not always the case. The size or scale of the activity is not a determinative test, and a person may carry on a business though in a small way (Thomas at ATC 4099; ATR 171).

For example, the case of JR Walker involved five Angora goats, two of which died. Whilst the scale was small, the court held that a goat breeding business was being carried on because there was a profit making purpose and repetition and regularity in the taxpayer's activities. Research, based on authenticated sources, showed that a profit could be made from the significant capital allocated to breeding stock.

In JR Walker, Ryan J said at ATC 4182; ATR 334:

'... the respondent's activities had the purpose of profit making. ... There was also repetition and regularity in his activities. ... The activities of the taxpayer were limited but ... he maintained communications with the expert and he tried to make himself informed about market conditions through membership of the Angora Breed Society and reading publications ... He organised his activities in a business-like way through the keeping of books of account ...'

The scale of the activities may be small but still result in more produce than is required for the taxpayer's own domestic needs. Where this is so and there is also intent to profit from the activities and a reasonable expectation of doing so, a business may be carried on despite the scale.

Similarly, in Thomas at ATC 4099; ATR 171 Walsh J in the High Court said:

'But a man may carry on a business although he does so in a small way. In my opinion the appellant's activities in growing the trees ought not to be found to have been carried on merely for recreation or as a hobby. I leave out of account the pine trees, the growing of which did not have, I think, a significant commercial purpose or character. But the appellant in planting the avocado pear trees and the macadamia nut trees set out to grow them on a scale that was much greater than was required to satisfy his own domestic needs and he expected upon reasonable grounds that their produce would have a ready market and would yield, if the trees became established, a financial return which would be of a significant amount, with relatively small outlay of time and money, and that this return would continue for a very long time.'

Hobby or recreation

The pursuit of a hobby is not the carrying on of a business for taxation purposes. Money derived from the pursuit of a hobby is not regarded as income and therefore is not assessable. As was said in Ferguson at ATC 4265; ATR 877:

'... if what he is doing is more properly described as the pursuit of a hobby or recreation or an addiction to a sport, he will not be held to be carrying on a business, even though his operations are fairly substantial.' (emphasis added)

Conclusion

The taxpayers purchased the land and applied to have the land re-zoned to urban farmland so they can operate a market garden. When the taxpayers purchased the land, it was not reticulated and the taxpayers did not have the funds required to install reticulation. This meant that the taxpayers were restricted to cultivating crops on the pasture areas comprising the X acres of natural wetlands which gradually dried out and reduced the area that the taxpayers could effectively cultivate, resulting in crops not being produced in a commercial scale.

The taxpayers did not draw up a business plan. They did not conduct initial research on the activity to confirm that profits can be expected based on the market prospects, the expected level of production and the running costs of the business using authenticated source of material to assist them. They failed to investigate properly the capital requirements of the venture and did not have a plan that shows how that capital will be obtained and used. They did not initially obtain soil and water analyses of the land to ascertain whether it will be suitable for growing crops on a commercial basis.

After considering all of the relative business indicators and objective facts surrounding the case, it is considered that that the taxpayers are not carrying on a business of primary production.

Therefore, the taxpayers are not eligible to claim the small business 15-year exemption under section 152-105 of the ITAA 1997.