Edited version of your written advice

Authorisation Number: 1051376342174

Date of advice: 25 May 2018

Ruling

Subject: Small business 15-year exemption

Question

Is company X entitled to disregard a capital gain arising from the sale of the business asset under the small business 15-year exemption in section 152-110 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Income Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Background

Company X currently runs a small business.

Individual A currently holds 65% of the issued shares of the company X, which were all allotted at the time of incorporation more than 15 years ago. He has also been a director since incorporation.

Individual B currently holds 35% of the issued shares in company X and she is also a director of the company X.

The constitution of company X provides that the holders of ordinary shares shall be entitled to one vote per share; receive a distribution of surplus assets upon winding up and dividend distributions.

The income of company X was less than $2 million in the 20XX income year.

Individual’s A and B each own 50% of the ordinary shares in four other private companies. Two of these companies currently carry on a business but only commenced trading on 1 July 20XX, and the other two companies do not carry on a business.

Proposed transaction

A business asset of company X is proposed to be sold to an unrelated third party purchaser. A business broker has been appointed to conduct this sale.

Once the sale is complete, it is intended that company X will be wound up.

The business asset being sold is an intangible asset that is integral to the business being carried on by company X. This is the CGT asset of company X which is the subject of this ruling.

The prospective purchaser has identified other ancillary assets of company X to be included in the sale contract. These other assets have not been ascribed any value as they cannot operate in isolation of or to the business asset.

No assets included in the sale agreement have been depreciated by company X, including the business asset.

The business asset has been used, or held ready for use, in the course of carrying on the business of company X for the entire time it has been owned.

It is expected that the cost base of all the assets to be sold under the business sale is either nil, or a nominal amount.

Retirement

Individuals A and B will both be aged over 55 years at the time of the business asset sale.

The sale of the business asset will trigger the commencement of Individual A’s retirement. Once the sale of the business asset is complete, individual A will cease all involvement in company X.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 subsection 152-10(1)

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 section 152-55

Income Tax Assessment Act 1997 section 152-65

Income Tax Assessment Act 1997 section 152-70

Income Tax Assessment Act 1997 subsection 152-110(1)

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 section 328-120

Reasons for decision

Detailed reasoning

The rules covering the small business 15-year exemption are contained in Subdivision 152-B of ITAA 1997. Under this exemption, a CGT small business can disregard a capital gain arising from a CGT asset that it has owned for at least 15 years if certain conditions are met.

Section 152-110 of the ITAA 1997 provides for the small business 15-year exemption for companies and trusts. One of the requirements that must be met under that provision is that the basic conditions in Subdivision 152-A must be satisfied for the gain.

Section 152-10 of the ITAA 1997 provides that the basic conditions for the small business concessions are as follows:

(a) a *CGT event happens in relation to a *CGT asset of yours in an income year;

[This condition does not apply in the case of CGT event D1.]

(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 *CGT small business entity for the income year;

(ii) you satisfy the maximum net asset value test (see section 152-15);

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

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

(d) the CGT asset satisfies the active asset test (see section 152-35).

Basic condition (a) - A CGT event happens in relation to a CGT asset of yours in an income year

A CGT asset is defined in subsection 108-5(1) of the ITAA 1997 as any kind of property or a legal or equitable right that is not property.

Subsection 108-5(2) of the ITAA 1997 provides that to avoid doubt, these are CGT assets:

(a) part of, or an interest in, an asset referred to in subsection (1);

(b) goodwill or an interest in it;

(c) an interest in an asset of a partnership;

(d) an interest in a partnership that is not covered by paragraph (c).

The asset that is being sold under the business asset sale is an intangible asset that is integral to the business being carried on by the company (the CGT asset).

This asset is a CGT asset as per the definition in section 108-5 of the ITAA 1997. This is the CGT asset that is relevant for the purposes of paragraph 152-10(1)(a) of the ITAA 1997.

Subsection 104-10(1) of the ITAA 1997 provides that CGT event A1 happens if you dispose of a CGT asset. You dispose of a CGT asset if a change of ownership occurs from you to another entity, whether because of some act or event or by operation of law.

As the CGT asset is being disposed of, then this will be a disposal of a CGT asset pursuant to subsection 104-10(1) of the ITAA 1997 and CGT event A1 will occur.

Consequently, the requirement of paragraph 152-10(1)(a) of the ITAA 1997 is satisfied in respect of the sale of the CGT asset.

Basic condition (b) - The event would have resulted in the gain

Section 104-10 of the ITAA 1997 outlines the requirements and consequences of CGT event A1. Subsection 104-10(4) of the ITAA 1997 provides that you make a capital gain if the capital proceeds from the disposal are more than the asset's cost base.

As defined in paragraph 116-20(1)(a) of the ITAA 1997, the capital proceeds from a CGT event includes the money you have received or are entitled receive in respect of the event happening.

Company X will receive an amount of money from the disposal of the CGT asset at the time of the business asset sale.

This will be the capital proceeds received from the disposal of the CGT asset under section 116-20 of the ITAA 1997.

The cost base of the CGT asset pursuant to Subdivision 110-A of the ITAA 1997 is a nominal amount. Consequently, it is expected that company X will make a capital gain upon the sale of the CGT asset.

Consequently, the requirement of paragraph 152-10(1)(b) of the ITAA 1997 is satisfied in respect of the sale of the CGT asset.

Basic condition (c) - at least one of the following applies:

(i) you are a CGT small business entity for the income year

Subsection 152-10(1AA) of the ITAA 1997 provides that you are CGT small business entity for an income year if:

(a) you are a *small business entity for the income year; and

(b) you would be a small business entity for the income year if each reference in section 328-110 to $10 million were a reference to $2 million.

Section 328-110 of the ITAA 1997 provides that you are a small business entity for an income year if:

(a) you carry on a *business in the current year; and

(b) one or both of the following applies:

(i) you carried on a business in the income year (the previous year) before the current year and your *aggregated turnover for the previous year was less than $10 million;

(ii) your aggregated turnover for the current year is likely to be less than $10 million.

The term ‘business’ is defined in section 995-1 of the ITAA 1997 to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

Company X is carrying on a business so this satisfies the requirement of paragraph 328-110(a) of the ITAA 1997.

As per the requirements of subsection 152-40(1AA) of the ITAA 1997 and paragraph 328-110(b)(i) it has to be determined if the company’s aggregated turnover for the previous income year was less than $2 million. As the business asset sale is expected to occur in the 20XX income year, then the test year is the 20XX income year.

Aggregated turnover for an income year is defined in section 328-115(1) of the ITAA 1997 as the sum of the relevant turnovers in subsection 328-115(2) excluding any amounts covered by subsection 328-115(3).

The relevant turnovers are defined in subsection 328-115(2) of the ITAA 1997 as:

(a) your *annual turnover for the income year; and

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

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

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

Section 328-120 of the ITAA 1997 provides that certain exclusions and special rules apply in calculating the annual turnover under subsection 328-120(1) of the ITAA 1997. These exclusions and special rules do not apply in this situation.

To determine the aggregate turnover pursuant to subsection 328-115(1) of the ITAA 1997, it first must be determined if any entities are connected with, or are affiliates of the company.

Subsection 328-125(1) of the ITAA 1997 provides that an entity is connected with another entity if:

(a) Either entity controls the other entity in a way described in this section; or

(b) Both entities are controlled in a way described in this section by the same third entity.

There are different control tests in section 328-125 of the ITAA 1997 that apply depending on what type of entity is being tested.

The ‘direct control test’ in subsection 328-125(2) of the ITAA 1997 will apply in this situation to determine if the company is connected with any other entities. Subsection 328-125(2) of the ITAA 1997 states:

An entity (the first entity) controls another entity if the first entity, its *affiliates, or the first entity together with its affiliates:

(a) except if the other entity is a discretionary trust - own, or have the right to acquire the ownership of, interests in the other entity that carry between them the right to receive a percentage (the control percentage) that is at least 40% of:

(i) any distribution of income by the other entity; or

(ii) if the other entity is a partnership - the net income of the partnership; or

(iii) any distribution of capital by the other entity; or

(b) if the other entity is a company - own, or have the right to acquire the ownership of, *equity interests in the company that carry between them the right to exercise, or control the exercise of, a percentage (the control percentage) that is at least 40% of the voting power in the company.

Individual A holds 65% of the shares in company X. These are ordinary shares that carry the right to vote, and the right to a distribution of income and capital. As this is more than the required 40%, it can be concluded that Individual A is connected with the company.

Individual B only holds 35% of the issued shares in company X. Therefore Individual B on her own is not connected with company X. However, subsection 328-125(2) states that an entity can also be a connected with an entity if the first entity together with its affiliates holds more than 40% of the voting power, rights to capital or income of the company. In other words, if Individual A is an affiliate of Individual B, then she will also be connected with company X as together they would have the right to more than 40% of the voting power and entitlements to capital and income of company X.

Subsection 328-130(1) of the ITAA 1997 provides that an individual or a company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of the individual or company.

However, subsection 328-130(2) of the ITAA 1997 provides that an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.

Broadly, acting ‘in concert with you’ in relation to business affairs means there is a substantial degree of dependence on, or connection with the taxpayer.

To determine whether Individual A is Individual B’s affiliate, subsection 328-130(1) of the ITAA 1997 requires Individual A to act, or could reasonably be expected to act, in accordance with the directions or wishes, or in concert with Individual B, in relation to the affairs of Individual A’s business.

Individual A does not carry on a business in his own right.

Individual A is not an affiliate of Individual B and consequently Individual B is not connected with company X.

Subsection 328-125(1)(b) of the ITAA 1997 also provides that an entity is connected with another entity if both entities are controlled in a way described in this section by the same third entity. As it been established that Individual A is connected with company X, any other entities that Individual A is also connected with will also be connected with company X.

Individual A holds 50% of all the ordinary shares issued four private companies. These are ordinary shares that carry the right to vote, the right to a distribution of income or capital. Therefore Individual A controls these companies as per the definition in subsection 328-125(2) of the ITAA 1997 and consequently these entities are connected with company X pursuant to subsection 328-125(1).

Subsection 328-115(2) of the ITAA 1997 also includes in the annual turnover for the income year of any entity that is an affiliate of yours at any time during the income year.

As we have already concluded that Individual A is connected with company X, subsection 328-115(2) of the ITAA 1997 requires us to establish whether Individual B is an affiliate of company X.

As per the definition of affiliate in subsection 328-130(1) of the ITAA 1997, Individual B is an affiliate of company X if she acts in accordance with the directions or wishes of company X in relation to the affairs of her business. Individual B does not carry on a business in her own right.

Individual B is not an affiliate of company X.

As mentioned above, the definition of annual turnover in section 328-120 of the ITAA 1997 includes the income an entity derives in the income year in the ordinary course of carrying on a business.

Individual A does not have an annual turnover as defined by section 328-120 of the ITAA 1997 which would be included in the aggregated turnover of company X.

Two of the four private companies that are connected with company X did not have any turnover in the 2017 income year. The remaining two private companies that are connected with the company do not carry on a business or have any turnover to be included under 328-120 of the ITAA 1997.

Consequently the aggregated turnover of company X will only include the annual turnover of the company itself. Company X’s ordinary income in carrying on a business was less than $2 million for the 20XX income year.

As it has already been established that company X carries on a business, it will be a CGT small business entity as defined in subsection 152-10(1AA) of the ITAA 1997 in the 20XX income year. This in turn satisfies paragraph 152-10(1)(c) of the ITAA 1997.

As a result, the remaining subparagraphs of paragraph 152-10(1)(c) of the ITAA 1997 are not required to be considered.

Basic condition (d) - the CGT asset satisfies the active asset test

Pursuant to subsection 152-35(1) of the ITAA 1997, a CGT asset satisfies the active asset test if:

(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 152-35(2) of the ITAA 1997 provides that the period:

(a) begins when you *acquired the asset; and

(b) ends at the earlier of:

(i) the *CGT event; and

(ii) if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows - the cessation of the business.

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

(a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a *business that is carried on (whether alone or in partnership) by:

(i) you; or

(ii) your *affiliate; or

(iii) another entity that is *connected with you; or

(b) if the asset is an intangible asset - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you.

Subsection 152-35(2) of the ITAA 1997 provides that the period begins when you acquired the asset and ends at the earlier

(i) the *CGT event; and

(ii) if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows - the cessation of the business.

Certain assets are, however, excluded from being active assets under subsection 152-40(4) of the ITAA 1997. None of these exclusions apply in this situation.

To determine if the active test in section 152-35 of the ITAA 1997 is satisfied, it first has to be determined if the CGT asset is an active asset.

The CGT asset has been used by company X in the course of carrying on its business. It has owned the asset for more than 15 years and the asset has been used for more than seven and half years in carrying on this business.

Consequently, the CGT asset will satisfy the active asset test in section 152-35 of the ITAA 1997.

Subdivision 152-B – Small business 15-year exemption

Subsection 152-110(1) of the ITAA 1997 provides that a company 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) the entity continuously owned the *CGT asset for the 15-year period ending just before the CGT event;

Note: Section 152-115 allows for continuation of the period if there is an involuntary disposal of the asset.

(c) 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;

(d) an individual who was a significant individual of the company or trust just before the CGT event either:

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

(ii) was permanently incapacitated at that time.

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

As per the discussion provided above, the basic conditions in Subdivision 152-A of the ITAA 1997 are satisfied for the gain.

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

Company X will have continuously held the CGT asset for more than 15 years ending just before the CGT event A1 happening.

Consequently, the requirement of paragraph 152-110(1)(b) of the ITAA 1997 is satisfied in respect of the sale of the CGT asset.

(c) 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;

Section 152-55 of the ITAA 1997 provides that an individual is a significant individual in a company at a time, if at that time the individual has a small business participation percentage in the company of at least 20%.

Section 152-65 of the ITAA 1997 provides that an individual's small business participation percentage in another entity at a time is the percentage that is the sum of

(a) the individual's direct small business participation percentage in the other entity at that time; and

(b) the entity’s indirect small business participation percentage in the other entity at that time.

Subsection 152-70(1) of the ITAA 1997 provides that an entity’s direct small business participation percentage in a company is the percentage that the entity has from the holding of the legal and equitable interests in the company's shares, as determined by:

(a) the percentage of the voting power in the company; or

(b) the percentage of any dividend that the company may pay; or

(c) the percentage of any distribution of capital that the company may make.

If these amounts are different, the smallest amount is used.

Section 152-75 of the ITAA 1997 provides that an entity’s indirect small business participation percentage in a company is calculated by multiplying together the entity’s direct participation percentage in an interposed entity, and the interposed entity’s total participation percentage (both direct and indirect) in the company.

Individual A currently holds 65% of the shares in company X, which are ordinary shares. The constitution of the company provides that the holders of ordinary shares shall be entitled to one vote per share; receive a distribution of surplus assets upon winding up and dividend distributions.

As the shares that Individual A holds entitles him to more than 20% of the voting rights, capital surplus and dividend distributions, then Individual A is a significant individual of company X. Individual A has continuously held the ordinary shares for more than 15 years.

Consequently, the requirement of paragraph 152-110(1)(c) of the ITAA 1997 is satisfied.

For completeness, it is recognised that Individual B is also a significant individual of company X as she currently holds more than 20% of the ordinary shares.

(d) an individual who was a significant individual of the company or trust just before the CGT event either:

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

(ii) was permanently incapacitated at that time.

As identified above, Individual A is a significant individual of the company as defined by section 152-55 of the ITAA 1997.

It is not expected that Individual A will be permanently incapacitated at the time of the CGT event. Therefore subparagraph 152-110(1)(d)(ii) of the ITAA 1997 will not apply and consideration must be had to subparagraph 152-110(1)(d)(i).

Individual A will be 55 or over at the time of the CGT event so therefore it must be established whether the CGT the event being the business sale, happens in connection with Individual A’s retirement.

The Guide to Capital Gains Tax 2017 on the page ‘Conditions you must meet' in the section relating to ‘Small business 15-year exemption’ provides the following guidance on when a CGT event happen in connection with retirement:

Whether a CGT event happens in connection with an individual's retirement depends on the particular circumstances of each case. There would need to be at least a significant reduction in the number of hours the individual works or a significant change in the nature of their present activities to be regarded as a retirement. However, it isn't necessary for there to be a permanent and everlasting retirement from the workforce.

Individual A has stated that the sale of the business will trigger his retirement. Individual A currently has an active role in the business, and this role will cease upon his retirement.

Consequently, the requirement of paragraph 152-110(1)(d) of the ITAA 1997 is satisfied.

As all the conditions of section 152-110 of the ITAA 1997 have been satisfied, company X is entitled to disregard the capital gain arising from the sale of the CGT asset under the small business 15-year exemption in Subdivision 152-B of the ITAA 1997.