Edited version of your written advice

Authorisation Number: 1012917397872

Date of advice: 11 December 2015

Ruling

Subject: CGT small business concessions

Questions and Answers:

1. Will the trustee of the Trust be entitled to disregard the capital gain on the sale of shares in the Company under section 152-110 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes

2. Will payments made to the beneficiary by the trustee of the Trust of the capital gain on the sale of shares in the Company be able to be tax-free, if paid in accordance with the participation percentage set out in subsection 152-125(2) of the ITAA 1997 and if paid within the timeframe set out in paragraph 152-125(1)(b) of the ITAA 1997?

Yes

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commenced in:

1 July 2014

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.

The Trust is one of the shareholders of the Company.

The Company is an Australian private company that has carried on business for over 20 years and is not part of a consolidated group.

The beneficiary of the Trust has been an employee and director of the Company.

The Trust had an interest in the Company of more than 20%.

The Trust held its ordinary shares in the Company for over 20 years.

The Trust sold its shares in the Company and made a capital gain.

The beneficiary and their spouse were entitled to all of the income of the Trust and also to any capital of the Trust distributed during the year of the sale of the shares by the Trust.

The beneficiary and the Trust both satisfy the maximum net asset value test in section 152-15 of the ITAA 1997.

The Trust has had a significant individual for more than 15 years as the beneficiary or their spouse was entitled to at least 20% of the income from the Trust.

At the time of the sale of the shares the beneficiary was a significant individual over the age of 55.

The beneficiary received the majority of the distributions of income from the Trust and their spouse received over zero percent of the distributions in the year of sale.

Payments made to the beneficiary from the Trust of the capital gain on the sale of shares in the Company in the year of sale will be paid in accordance with the participation percentages set out in subsection 152-125(2) of the ITAA 1997. The payments will be paid within the timeframe set out in paragraph 152-125(1)(b) of the ITAA 1997.

The beneficiary progressively reduced their working hours for the Company until the sale and then completely ceased employment with the Company.

The beneficiary resigned as managing director and director shortly after the sale.

The following documents of the Company form part of the ruling:

• Profit and loss statements for several years

• Balance sheets for several years.

The Company has various forms of cash assets. The balance of cash assets increased between the time the business commenced and the time of sale of the shares.

An explanation has been provided as to how the cash in its various forms has been used to run the business.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 Subdivision 152-B

Income Tax Assessment Act 1997 Subsection 152-40(3)

Income Tax Assessment Act 1997 Section 152-55

Income Tax Assessment Act 1997 Section 152-60

Income Tax Assessment Act 1997 Section 152-65

Income Tax Assessment Act 1997 Section 152-70

Income Tax Assessment Act 1997 Section 152-110

Income Tax Assessment Act 1997 Section 152-120

Income Tax Assessment Act 1997 Section 152-125

Income Tax Assessment Act 1997 Paragraph 152-125(1)(b)

Income Tax Assessment Act 1997 Subsection 152-125(2)

Reasons for decision

Under section 152-125 of the Income Tax Assessment Act 1997 (ITAA 1997) certain payments to the capital gains tax (CGT) concession stakeholders of a company or trust are not included in the taxable income of the CGT concession stakeholder up to certain limits. To obtain an exemption under section 152-125 of the ITAA 1997, one of a number of conditions must be satisfied. Of those is the requirement that a capital gain of a company or trust was disregarded under section 152-110 of the ITAA 1997.

In order to determine whether the beneficiary of the Trust, can exclude from their assessable income the capital gain that is distributed by the Trust, it has to be established if the Trust is eligible to apply the small business CGT concessions set out in Division 152 of the ITAA 1997, in this case the 15 year exemption for companies and trusts under section 152-110 of the ITAA 1997.

A. The Trust

Under section 152-110 of the ITAA 1997 an entity that is a company or a trust can disregard any capital gain arising from a CGT event if all of the following conditions are satisfied:

1. the basic conditions in subdivision 152-A of the ITAA 1997 are satisfied;

2. the entity continuously owned the CGT asset for the 15 year period ending just before the CGT event;

3. the entity 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 the entity owned the CGT asset;

4. an individual who was a significant individual of the company or trust just before the CGT event either:

• was 55 or over at that time and the event happened in connection with the individual's retirement; or

• was permanently incapacitated at that time

Condition 1 - Basic conditions in subdivision 152-A of the ITAA 1997

According to subsection 152-10(1) of the ITAA 1997:

A capital gain (except a capital gain from CGT event K7) you make may be reduced or disregarded under this Division if the following basic conditions are satisfied for the gain:

(a) a CGT event happened in relation to a CGT asset of your in an income year;

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

(c) at least one of the following applies:

i. you are a small business entity for the income year;

ii. you satisfy the maximum net asset value test;

iii. you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership;

(d) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

We need to consider each of these conditions in relation to the Trust.

Paragraphs (a) and (b)

The asset in question constitutes the shares in the Company. Shares are CGT assets and the sale of shares is a CGT event A1. Paragraphs (a) and (b) are satisfied as the Trust sold its shareholding in the Company and made a capital gain.

Paragraph (c)

Section 152-15 is the maximum net asset value test which a taxpayer will satisfy if the net value of their assets and those of connected entities does not exceed six million dollars. Both the beneficiary and the Trust meet this test.

Paragraph (d) - Active asset test

The shares held by the Trust in the Company must satisfy the active assets test in paragraph 152-10(1)(d) of the ITAA 1997.

Shares are not active assets unless they satisfy the 80% test in subsection 152-40(3) of the ITAA 1997.

Under paragraph 152-40(3)(b) of the ITAA 1997 a 'share' is an active asset if:

a)   the company is an Australian resident at that time; and

  b)   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 businessis 80% or more of the market value of all assets of the company.

The active asset test under section 152-35 of the ITAA 1997 requires that a share in a company must satisfy the 80% test for at least 7½ years where a share has been held for more than 15 years. This is known as the 80% rule.

The ATO publication Capital Gains Tax Concessions for Small Business 2015 states that cash and financial instruments are not active assets, but they count towards the satisfaction of the 80% test provided they are inherently connected with the business. Inherent connection necessarily requires something more than just some form of connection between the financial instrument and the business.

For the purposes of subparagraph 152-40(3)(b)(ii) of the ITAA 1997 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 subparagraph 152-40(3)(b)(ii) into the ITAA 1997.

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 circumstances

The Company is an Australian private company and thus the first part of the active asset test where a share is the asset is satisfied. We now need to consider if the 80% test is satisfied.

The Company has various forms of cash assets. The balance of cash assets rose a lot between the time the business commenced and the time of sale of the shares.

An explanation has been provided as to how the cash in its various forms has been used to run the business.

The Commissioner is satisfied that the cash accounts were inherently connected with the business such that for at least 7½ years the cash used for the business and the other active assets were 80% or more of the market value of all of the assets of the Company. As the 80% rule is satisfied, the active asset test is met.

Conclusion - basic conditions in subdivision 152-A of the ITAA 1997

The Trust satisfies the basic conditions for small business relief under subsection 152-10(1) of the ITAA 1997 and can be summarised as follows:

• CGT event A1 happened on the sale of the shares in the Company

• The event resulted in a capital gain

• The Trust satisfies the maximum net asset value test

• The shares in the Company satisfy the active asset test.

Accordingly the basic conditions in subdivision 152-A of the ITAA 1997 are met.

Condition 2 - Ownership of asset by entity for 15 years continuously ending just before the CGT event

The Trust was one of the shareholders of the Company which has been carrying on business for over 20 years. The Trust owned shares in the Company for over 20 years until the sale of the shares. Thus the Trust owned the asset in question (shares) for at least 15 years continuously ending just before the sale thus satisfies the condition of continuous ownership of the shares for 15 years just before the CGT event.

Condition 3 Entity had a significant individual for a total of at least 15 years (even if not continuously for 15 years)l

Under section 152-55 of the ITAA 1997 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 in the company or trust of at least 20%.

Under subsection 152-10(2) of the ITAA 1997 where the CGT asset is a share in a company or an interest in a trust, one of these additional basic conditions must be met just before the CGT event: 

• the taxpayer claiming the concession must be a CGT concession stakeholder in the company or trust: or

• CGT concession stakeholders in the company or trust together have a small business participation percentage in the interposed entity of at least 90% (the 90% test). 

Under section 152-60 of the ITAA 1997 a CGT concession stakeholder of a company or trust is: 

• a significant individual of the company or trust: or

• 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 greater than zero.

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

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

• the entity's indirect small business participation percentage in the other entity at that time.

An entity's direct small business participation percentage in a company is the percentage of:

• voting power that the entity is entitled to exercise, or

• any dividend payment that the entity is entitled to receive, or

• any capital distribution that the entity is entitled to receive

An entity's direct small business participation percentage in a trust, where entities have entitlements to all the income and capital of the trust, is the percentage of:

• the income of the trust that the entity is beneficially entitled to receive, or

• the capital of the trust that the entity is beneficially entitled to receive.

An entity's direct small business participation percentage in a trust, where entities do not have entitlements to all the income and capital of the trust, and the trust makes a distribution of income or capital, is the percentage of:

• distributions of income that the entity is beneficially entitled to during the income year, or

• distributions of capital that the entity is beneficially entitled to during the income year.

Applying the calculation for indirect participation, the beneficiary received the majority of the distributions of income and the distributions of capital, if any, from the Trust in the year of sale of the shares by the Company. Thus the beneficiary is a significant individual of the Company as they have an indirect participation percentage calculated as follows:

Participation % in Trust x participation % of Trust in the Company = greater than 20%

Participation percentages are calculated ignoring redeemable shares under subsection 152-70(2) of the ITAA 1997. Thus all ordinary shareholders in the Company are taken to have a direct small business participation percentage of at least 20%.

The Trust must satisfy the basic conditions in paragraph 152-10(2)(b) of the ITAA 1997 requiring that CGT concessional stakeholders of the Company hold participation percentages in the Trust of at least 90%.

The beneficiary will be a significant individual of the Trust in the financial year when the sale took place. As the beneficiary and their spouse are income beneficiaries of the Trust, they will both be CGT concession stakeholders of:

• the Trust as the beneficiary is entitled to 20% or more of the income, and if capital is distributed, 20% or more of the capital of the Trust and their spouse is entitled to more than 0% of the income of the Trust; and

• The Company as the beneficiary will be entitled to at least x% of the income of the Trust giving the beneficiary the necessary indirect participation percentage in the Company of at least 20%.

In addition, the 90% test is met as the beneficiary and their spouse have a combined interest in the Trust of over 90% as the beneficiary and their spouse received all the income from the Trust in the year of sale

Condition 4 - Significant individual 55 years or over just before the CGT event

The beneficiary is a significant individual and was aged 55 years at the time of the CGT event, being the sale of the shares in the Company. We are satisfied that the CGT event was related to the beneficiary's retirement as the beneficiary progressively reduced their working hours for the Company until the sale and then completely ceased employment with the Company. In addition, the beneficiary resigned as managing director and director shortly after the sale.

Summary - 15 year exemption

As the Trust satisfies all the conditions in section 152-110 of the ITAA 1997, the trustee is entitled to disregard the capital gain on the sale of shares in the Company under the 15 year exemption small business concession.

B. Implications for beneficiary of the Trust

Section 152-125 of the ITAA 1997 deals with the tax consequences for distribution of the exempt amount by a company or a trust. When a company or trust distributes an exempt amount, as disregarded under section 152-110 of the ITAA 1997, to individuals, they would be able to disregard tax on the amount under certain conditions.

The conditions are:

(a) The company or trust must make the payment within two years after the CGT event that resulted in the capital gain (paragraph 152-125(1)(b) of the ITAA 1997)

(b) The payment must be made to an individual who was a CGT concession stakeholder of the company or trust just before the CGT event (paragraph 152-125(1)(b) of the ITAA 1997), and

(c) The total payments made to each CGT concession stakeholder must not exceed an amount determined by multiplying the CGT concession stakeholder's participation percentage by the exempt amount (subsection 152-125(2) of the ITAA 1997).

The stakeholder's participation percentage for a company is worked out under subsection 152-70(1) of the ITAA 1997.

In this case, the payments which the beneficiary receives of the capital gain from the sale of the shares in the Company will be paid within the required time frame as per paragraph 152-125(1)(b) of the ITAA 1997. Secondly, the beneficiary was a CGT concession stakeholder of the Trust just before the CGT event. And thirdly, the total payments made to the beneficiary will not exceed an amount determined by multiplying their stakeholder's participation percentage by the exempt amount.

Accordingly, payments made to the beneficiary by the Trust of the capital gain on the sale of shares in the Company will be tax-free.