Edited version of your written advice

Authorisation Number: 1012883903951

Date of advice: 25 September 2015

Ruling

Subject: 15 year exemption - ownership period

Question

Will entity be entitled to claim the small business capital gains tax (CGT) 15-year exemption in respect of the capital gain on disposal of a building owned by it under Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

A person owned a property.

The person sought advice from an accountant and financial adviser on selling the property to an entity.

The entity advised there was a verbal agreement in place to sell the property with this person before the title of property was transferred to the entity.

No copy of a sales contract can be found.

The property was used by the entity to carry on a business for a period of less than 7.5 years.

The property was then rented for a number years.

A small area of the property was being used as a storage area by the entity.

The area of the property used for rental purposes was substantially more than 50% of the total floor area of the property.

The entity sold the property and as a result made a capital gain.

The property was owned by the entity for more than 15 years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-10|

Income Tax Assessment Act 1997 Subsection 104-10(1)

Income Tax Assessment Act 1997 Subsection 104-10(2)

Income Tax Assessment Act 1997 Subsection 104-10(3)

Income Tax Assessment Act 1997 paragraph 104-10(3)(a)

Income Tax Assessment Act 1997 Subsection 152-10(1).

Income Tax Assessment Act 1997 Paragraph 152-35(1)(a).

Income Tax Assessment Act 1997 Paragraph 152-35(1)(b).

Income Tax Assessment Act 1997 Section 152-35.

Income Tax Assessment Act 1997 Section 152-105.

Income Tax Assessment Act 1997 Paragraph 152-40(1)(a).

Income Tax Assessment Act 1997 Subparagraph 152-40(1)(a)(i).

Reasons for decision

Transferring of the property

Capital gains tax event A1 in section 104-10 of the ITAA 1997 happens if you dispose of an asset, that is, if a change of ownership occurs from you to another entity: subsections 104-10(1) and (2).

The time of the event is when you enter into the contract for the disposal or, if there is no contract, when the change of ownership occurs: subsection 104-10(3) of the ITAA 1997.

To work out how the timing rules in CGT event A1 apply on the facts of this case, it is necessary to consider whether any sale contract either verbal or written was entered into prior to the transfer of the property to satisfy the description 'contract for the disposal' in paragraph 104-10(3)(a) of the ITAA 1997.

Meaning of 'contract for the disposal'

Subsection 160U(3) of the Income Tax Assessment Act 1936 (ITAA 1936) was rewritten in part from subsection 104-10(3) of the ITAA 1997. The words 'contract for the disposal' in paragraph 104-10(3)(a) rephrased the requirement in subsection 160U(3) that a disposal or acquisition took place 'under a contract'.

In considering the meaning of the words 'under a contract' for the purposes of subsection 160U(3) of the ITAA 1936, the Federal Court has held that the contract under which an asset is acquired or disposed of is the contract through whose operation the asset changes ownership: Elmslie v. Federal Commissioner of Taxation (1993) 46 FCR 576; (1993) 93 ATC 4964; (1993) 26 ATR 611 at FCR 592; ATC 4976; ATR 626 (Elmslie's case). The Full Federal Court in Kiwi Brands Pty Ltd v. Commissioner of Taxation (1998) 90 FCR 64; 40 ATR 477; 99 ATC 4001 at FCR 77; ATR 489 and ATC 4011 similarly identified the contract as one 'under which there was a direct connection with the disposition required by it'.

The rewritten law in paragraph 104-10(3)(a) of the ITAA 1997 refers to the time when 'you' enter into the contract for the disposal, but the better view is that it highlights the most common case (where the vendor is a party to the contract) without intending to narrow the scope of the law and to exclude other situations so long as the disposal can be said to happen under the relevant contract.

In that regard, the establishment of a mere causative link, that the disposal would not have taken place but for the existence of the contract, is not sufficient to attract the operation of the contract timing rule in subsection 160U(3) of the ITAA 1936. The contract must actually require the disposition.

In the entity's case, it argues there was verbal agreement in place to sell the property before the transfer date of the title. The timing of a contract was considered in Case 34/96, 96 ATC 374.

In Case 34/96 the AAT held that the 'time of making the contract' was the time when a legally binding and enforceable contract came into existence. However, on appeal by the taxpayer the Federal Court, in McDonald and Anor v Federal Commissioner of Taxation 98 ATC 4306, the Court held that for the purposes of sec 160U(3), there was no requirement that the contract be legally binding and enforceable; it need only have the attributes prescribed by the common law. Accordingly, a contract may be unenforceable or even illegal at the time of its making. But if the contract was carried into effect with a consequential disposition, then sec 160U(3) applies to the unenforceable contract.

The Federal Court then decided to remit the matter to the AAT. The AAT then decided, in Case 4/99, 99 ATC 144 (Case 4/99) that the first time at which a contract at common law was entered into was when written contracts were executed and exchanged.

The taxpayer appealed to the Federal Court in McDonald & Anor v. FC of T 2000 ATC 4271, on the basis that the AAT's decision that there was no pre-CGT oral contract was unreasonable. The appeal was dismissed, thus affirming the AAT decision in Case 4/99.

The taxpayer subsequently appealed to the Full Federal Court. The Court handed down its decision on 22 March 2001, and dismissed the appeal.

Further in Elmslie's case one of the issues was whether shares had been acquired under a formal sale document, or under an earlier (pre-CGT) Heads of Agreement document. The Federal Court (Wilcox J) ruled that the words -under a contract- in section 160U(3) referred to the contract that directly effected the acquisition, ie the contract through whose operation the asset changes ownership. In this case, this was the formal sale document. The Heads of Agreement document, although intended to have immediate contractual force, envisaged the acquisition of shares but was not the means by which the shares were actually acquired. In reaching this conclusion Wilcox J commented (at p 4976): 

In a particular case there may be several contracts that contemplate or require a party to acquire an asset. Those contracts may bear different dates. If subs (3) extended to all those contracts, and not just to the contract that directly got in the asset, it would provide a multiplicity of dates in respect of one asset. Unless all the dates happened to fall within the same quarter, the legislation would become unworkable in relation to the asset. It seems to me that, for the legislation to work satisfactorily, it is necessary for the courts to confine the words 'under a contract', in s160U(3), to the contract that directly effected the acquisition. It is necessary to disregard any earlier contract obliging one or both parties to the acquisition to enter into the immediately operative contract. 

In the present case, the entity argues that there was a verbal agreement in place before the title of the property was transferred. However, as noted in cases above the courts have confined the words 'under a contract' to a contract that directly effects the acquisition of an asset. This would indicate in order for a contract to exist at common law a number of elements are required. Essentially a binding contract is entered into when one party communicates an unconditional acceptance of an offer made by the other party and that a contract is in place through whose operation the asset changes ownership.

In this case seeking advice in relation to the sale of property does not constitute the existence of a common law contract. Further from the information provided whether a formal contract for the sale of the property had been made prior to the transfer of the title is unable to be determined as a sales contract has not been located. The Commissioner does not have any discretion to accept that there was a verbal agreement to sell the property before the change of ownership occurred on XX/XX/XXXX as legislation requires that a 'contract for the disposal' is required as confirmed by the courts.

Small Business Concessions

To qualify for the 15-year exemption under the capital gain tax small business concessions, the basic conditions as described in subsection 152-10(1) of the ITAA 1997 must be satisfied. One of those conditions is the active asset test under section 152-35 of the ITAA 1997.

Active asset test

Subsection 152-35(1) of the ITAA 1997 states that a CGT asset satisfies the active asset test if:

• 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 of ownership, or

• 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 and a half years.

A CGT asset is an active asset if at a given time, among other things, it is owned and used (or held ready to use) in the course of carrying on a business (paragraph 152-40(1)(a) of the ITAA 1997).

Importantly, 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.

In the entity's case, the property has been owned for a period of greater than 15 years. In considering whether the property was an active asset of the business for a period of 7.5 years we need to consider the use of the property over the period of time the property was held.

Taxation Determination TD 2006/78 considers, amongst other issues, the situation where there is part business and part rental use of an asset. It states that an asset owned by the taxpayer and used partly for business purposes and partly to derive rent can be an active asset under subsection 152-40(4) of the ITAA 1997 where it is considered that the main use of the premises is not to derive rent. In deciding if the property was mainly used to earn rent the Commissioner will consider a range of factors such as:

• the comparative areas of use of the premises (between rent and business)

• the comparative times of use of the premises (between rent and business), and

• the comparative levels of income derived from the different uses of the asset.

The period of ownership to the day before renting of the property

A review of the information provided indicates the property was used to carry on a business for a period of less than 7.5 years until the property was rented.

The period of renting the property until the disposal of the property

In the entity's case substantially more than 50% of the total floor area of the property was used to derive rent from a commercial lease with a small area of the property being used for storage.

The income derived from the property during this period was rental income from unrelated parties.

After considering a range of factors noted above such as the comparative times, area of the premises used and the levels of income we consider that the main use of the property after it was rented was to derive rent.

The entity fails the active asset test requirement that the asset must have been active for at least 7.5 years in terms of paragraph 152-35(1)(b) of the ITAA 1997. As the property is not an active asset, it does not satisfy the basic conditions for the small business CGT concessions set out in Sub-division 152-A of the ITAA 1997 and those concessions will not be available to the entity.