Edited version of your written advice

Authorisation Number: 1051386240996

Date of advice: 20 June 2018

Ruling

Subject: Capital Gains Tax (CGT) and the small business concessions

Question 1

Will the Land Trust satisfy the basic conditions in Subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997), to be eligible for the small business CGT concessions in Division 152 of the ITAA 1997, in relation to the capital gain made on the disposal of the Land?

Answer

Yes

This ruling applies for the following periods

Income year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

The Land Trust

The Land Trust is a discretionary trust that was established by a Deed of Settlement. The trustee of the Land Trust at the time of the relevant CGT event was, and is currently, the Trustee Company. Individual A and Individual B are the directors of the Trustee Company and are also equal shareholders. The Trustee Company is an Australian resident so the Land Trust is a resident for CGT purposes.

For the past 15 years, the Trustee Company has distributed all of the Land Trust’s net income to one beneficiary, Individual A.

The Land Trust does not carry on a business, and merely derives rent from the Land and another residential property that it owns.

The Land was acquired by the Land Trust after 20 September 1985.

Following its acquisition, a business was conducted on the Land for a number of years by Individual B as a sole trader.

The Business Trust

Since July 20XX, the business on the Land has been conducted by the trustees of the Business Trust. The trustees of the Business Trust are Individual A and Individual B.

The Business Trust is a discretionary trust with a broad group of discretionary objects (including Individual A, Individual B and their associates and related entities).

Since its creation, the majority of yearly income distributions from the Business Trust have been made to the Beneficiary Trust.

The Beneficiary Trust

The Beneficiary Trust is a discretionary trust with a corporate trustee. The directors of the corporate trustee are Individual A and Individual A’s affiliate. Individual A owns 80% of the shares in the corporate trustee and the other 20% are owned by Individual A’s affiliate.

Since its creation, the yearly income distributions from the Beneficiary Trust have been made to Individual A and Individual A’s affiliate.

Sale of the Land by the trustee of the Land Trust

In the income year ended 30 June 20XX, the Trustee Company as trustee for the Land Trust entered into a sale contract to sell the Land to an unrelated, third party purchaser.

The Land Trust will make a capital gain on the sale of the Land.

Sale of assets by the trustee of the Business Trust and the cessation of business

At the same time as the sale of the Land, the trustee of the Business Trust also sold its business and assets to an unrelated, third party purchaser and thereafter ceased business.

The income/turnover actually derived by the Business Trust during the income year ended 30 June 20XX was less than $X million.

The applicant has also estimated that, in the absence of the sale of its business, the income/turnover derived by the Business Trust would have been less than $X million in the income year ended 30 June 20XX.

Individual C and Company C

Individual C owned land which was sold during the income year ended 30 June 20XX. Prior to its sale, a business was conducted on the land by Company C.

Company C sold its business during the income year ended 30 June 20XX and ceased carrying on a business at that time. The only income derived by Company C during the income year ended 30 June 20XX was interest income from the investment of the sale proceeds of its business.

Other matters

There are no other entities that carry on business that are connected with the Land Trust that need to be taken into account in determining whether the small business CGT concessions are available. This is because there are no other entities that control the Land Trust, that the Land Trust controls, or that are commonly controlled, that carry on business.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Section 328-110

Income Tax Assessment Act 1997 Section 328-120

Income Tax Assessment Act 1997 Section 328-125

Income Tax Assessment Act 1997 Section 328-130

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or DPT tax benefit in connection with an arrangement.

If Part IVA of the ITAA 1936 applies the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA of the ITAA 1936 may apply.

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Summary

The Land Trust will satisfy the basic conditions in Subdivision 152-A, to be eligible for the small business CGT concessions in Division 152, in relation to the capital gain made on the disposal of the Land.

Detailed reasoning

To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions. These are called the basic conditions. The basic conditions for the small business CGT concessions, which are set-out in section 152-10, are:

(a) a *CGT event happens in relation to a *CGT asset of yours 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 *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 152-10(1A) or 152-10(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).

In this case, the sale of the Land constituted a CGT event (A1), and the CGT event would have resulted in a capital gain, apart from the operation of Division 152. Therefore, the conditions in paragraphs 152-10(1)(a) and 152-10(1)(b) are satisfied.

In relation to the tests detailed in paragraph 152-10(1)(c), the most relevant to the current circumstances are those in subparagraphs (i), (ii) and (iv).

In this regard, it is noted that the Land Trust will not satisfy the maximum net asset value test in subparagraph 152-10(1)(c)(ii) because, just before the CGT event, the total net value of CGT assets owned by it (and its related entities) will exceed $X million.

The Land Trust will also not be a CGT small business entity in the income year ended 30 June 20XX. An entity is a CGT small business entity if it is an individual, partnership, company or trust that is carrying on a business and has an aggregated turnover of less than $X million (subsection 152-10(1AA) and section 328-110). As the Land Trust does not carry on a business, it will not satisfy this test in subparagraph 152-10(1)(c)(i).

Subparagraph 152-10(1)(c)(iv) is however satisfied if the conditions in either subsection 152-10(1A) or 152-10(1B) are met.

In the current circumstances, subsection 152-10(1A) is relevant as it specifically provides:

The conditions in this subsection are satisfied in relation to the *CGT asset in the income year if:

(a) your *affiliate, or an entity that is *connected with you, is a CGT small business entity for the income year; and

(b) you do not carry on a *business in the income year (other than in partnership); and

(c) if you carry on a business in partnership - the CGT asset is not an interest in an asset of the partnership; and

(d) in any case – the CGT small business entity referred to in paragraph (a) is the entity that, at a time in the income year, carries on the business (as referred to in subparagraph 152-40(1)(a)(ii) or (iii) or paragraph 152-40(1)(b)) in relation to the CGT asset.

In the current circumstances, to determine whether this provision is satisfied, it is necessary to consider whether the Business Trust is an affiliate, or an entity connected with the Land Trust, and whether the Business Trust is a CGT small business entity in the relevant income year i.e. the income year ended 30 June 2018.

Is the Business Trust an affiliate of the Land Trust?

An affiliate is defined in section 328-130 and for the purposes of this case, means an individual or company that, in relation to their business affairs, acts or could reasonably be expected to act:

● in accordance with another entities directions or wishes, or

● in concert with another entity.

Trusts, partnerships and superannuation funds cannot be affiliates and so the Business Trust is not an affiliate of the Land Trust.

Is the Business Trust connected with the Land Trust?

The meaning of connected with an entity is defined in section 328-125. In this regard, subsection 328-125(1) 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.

The direct ‘control’ tests, which are contained in section 328-125, differ according to whether the entity is a discretionary trust or not.

Direct control of a discretionary trust

An entity (the first entity) controls a discretionary trust for an income year if, for any of the 4 income years before that year:

(a) the trustee of the trust paid to, or applied for the benefit of:

(i) the first entity

(ii) any of the first entity’s affiliates, or

(iii) the first entity and any of its affiliates,

any of the income or capital of the trust; and

(b) the percentage (the control percentage) of the income or capital paid or applied is at least 40% of the total amount of income or capital paid or applied by the trustee for that year (subsection 328-125(4)).

Alternatively, an entity (the first entity) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates, or the first entity together with its affiliates (subsection 328-125(3)).

It is noted that, when applying the test in subsection 328-125(3), you must consider all the circumstances to work out whether you satisfy this test. For example, to prove that you had no influence over the trustee, it would not be enough for the trust deed to say the trustee must ignore your directions or wishes.

Some factors you might consider include:

● the way the trustee has acted in the past;

● the relationship between you and/or your affiliates and the trustee;

● the amount of property or services you and/or your affiliates transferred to the trust;

● any arrangement or understanding between you and any person who has benefited under the trust in the past.

Direct control of a company

Subsection 328-125(2) provides that an entity controls a company if the entity, its affiliates, or the entity together with its affiliates beneficially own:

● interests in the company that give them the right to receive at least 40% (the control percentage) of any distribution of income or capital; or

● equity interests in the company that carry between them the right to exercise at least 40% (the control percentage) of the voting power in the company.

Indirect control

Under subsection 328-125(7), an entity that directly controls a second entity is also taken to control any other entity that is directly or indirectly controlled by the second entity. That is, if A controls B and B controls C, A is also taken to control C.

Application to the current circumstances

In this case, Individual A controls the Land Trust in the income year ended 30 June 20XX as they received 100% of the distributions in the past 4 years (subsection 328-125(4)).

Under subsection 328-125(7), Individual A is also considered to control the Business Trust in the 20XX income year because Individual A controls the Beneficiary Trust under subsection 328-125(4), having received an 80% distribution in the 20XX income year, and the Beneficiary Trust in turn controls the Business Trust since it received 100% of the distributions from the Business Trust in the 20XX income year (subsections 328-125(4) and 328-125(7)).

In addition, based on the information provided, it also seems reasonable to conclude that Individual A controls the Business Trust, under subsection 328-125(3), on the basis that the trustee of this trust acts, or could reasonably be expected to act, in accordance with his directions or wishes. This is based on the following:

● Individual A is the co-trustee of the Business Trust and has been since its creation;

● Since its creation, the majority of yearly income distributions from the Business Trust, which is a key indicator on how the trustee has acted in the past, have been made to an entity connected with Individual A (the Beneficiary Trust) with these benefits in turn ultimately flowing to Individual A and Individual A’s affiliate;

● An entity that is connected with Individual A (the Land Trust) owned and leased a key asset that was used by the Business Trust in its business; and

● Individual A is a key employee of and is actively involved in the day to day running and management of the Business Trust’s business.

Therefore, as Individual A controls both the Business Trust and the Land Trust, the Business Trust is connected with the Land Trust for the purposes of section 328-125 under paragraph 328-125(1)(b) in the 2018 income year.

Is the Business Trust a CGT small business entity?

As previously noted, an entity is a CGT small business entity if it is an individual, partnership, company or trust that is carrying on a business and has an aggregated turnover of less than $X million (subsection 152-10(1AA) and section 328-110).

There are three methods that a taxpayer may use to work out if they are a CGT small business entity by satisfying the $X million aggregated turnover requirement. These methods are:

● the taxpayer carried on business in the previous year and their aggregated turnover for the previous year was less than $X million (subparagraph 328-110(1)(b)(i))- Method 1;

● the taxpayer's aggregated turnover for the year they are seeking to be a small business entity (the current year), worked out generally as at the first day of the current year, is likely to be less than $X million. However, the taxpayer cannot qualify as a small business entity under this provision if their aggregated turnover in each of the two previous years was $X million or more (subparagraph 328-110(1)(b)(ii), subsection 328-110(2) and subsection 328-110(3))- Method 2; or

● the taxpayer's aggregated turnover for the current year, worked out as at the end of the current year, is less than $X million (subsection 328-110(4)) - Method 3.

Aggregated turnover is an entity’s annual turnover plus the annual turnovers of any business entities that are its affiliates or connected with it.

An entity’s annual turnover for an income is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business (subsection 328-120(1)). It is noted that an entity’s annual turnover would generally include amounts from the sale of trading stock, fees for services provided and interest from business bank accounts but would not include GST charged on a transaction, amounts borrowed for the business and proceeds from the sale of business capital assets.

In the current circumstances, the relevant test for consideration is whether the aggregated turnover of the Business Trust for the current year, worked out as at the end of the current year, is less than $X million (subsection 328-110(4)- Method 3).

Annual turnover of the Business Trust

Based on the information provided, it is evident that the annual turnover actually derived by the Business Trust during the income year ended 30 June 20XX will be less than $X million. In this regard, it is highlighted that the most significant amount received by the Business Trust during the 20XX income year related to the proceeds from the sale of the business’ plant and equipment which would not form part of the entity’s annual turnover.

It is noted however that the Business Trust ceased business part way through the relevant income year which contributed to its reduced turnover actually received. Subsection 328-120(5) however contains a special rule which is relevant to these circumstances as it provides that if an entity starts or ceases a business part way through an income year, it will need to work out its turnover using a ‘reasonable estimate’ of what its turnover would have been if it had carried on the business for the entire income year.

While a reasonable estimate need only be an approximation, it must be based on a sound and reasoned process of estimation that has been undertaken in good faith.

The guide ‘Capital gains tax concessions for small business’ and ato.gov.au highlights the following factors, in the context of Method 2, to consider when estimating your turnover:

● your turnover in previous income years

● if you plan to reduce or increase staff in the current income year

● whether your business operating hours will increase or decrease

● if previous extraordinary sales or product lines will be available in the current income year

● whether your business will face increased competition in the current income year

● whether your business activity will increase or decrease because of changing conditions.

The applicant has provided an estimate of the turnover that the Business Trust would have been expected to derive in the 20XX income year had its business been carried on for the entire income year. This estimate is reasonable given that it takes into consideration the projected turnover from the business as well as other changes in conditions affecting its business activities and associated turnover.

Annual turnover of any affiliates of entities connected with the Business Trust

An entity’s aggregated turnover also includes the annual turnovers of any business entities that are its affiliates or connected with it. It is noted that you must use the same method to determine the annual turnover for any business entities that are its affiliates or connected with it.

Annual turnover of the Land Trust

Although the Land Trust is connected with the Business Trust it does not carry on a business, and solely derives rent from the Land and other property that it owns. Accordingly no portion of its income would constitute annual turnover or required to be included in the aggregate turnover of the Business Trust.

Annual turnover of Company C

It is arguable that Company C may be considered an affiliate of or connected with the Business Trust (and as such its annual turnover must be included in the Business Trust’s aggregate turnover). However based on the information provided by the applicant, the level of turnover derived by Company C during the 20XX income year will not cause the Business Trust’s aggregated turnover to be $X million or more in the 20XX income year.

Conclusion on whether the Business Trust is a CGT small business entity

Based on the above analysis, it is considered that the aggregated turnover of the Business Trust for the current year, worked out as at the end of the current year, is less than $X million. As a result, the Business Trust will be a CGT small business entity in the relevant income year.

Because the Business Trust is a CGT small business entity in the 2018 income year, and is connected with the Land Trust, the requirements in paragraph 152-10(1A)(a) will be met.

In the current circumstances, the other requirements (where applicable) in subsection 152-10(1A) are also met as:

● the Land Trust did not carry on a business in the 2018 income year (paragraph 152-10(1A)(b)); and

● the Business Trust is the entity that, at a time in the income year, carries on the business (as referred to in subparagraph 152-40(1)(a)(iii)- see below for further detail on this requirement) in relation to the CGT asset, the Land (paragraph 152-10(1A)(d)).

Paragraph 152-10(1)(d)- The CGT asset satisfies the active asset test

Paragraph 152-10(1)(d) states that the CGT asset must satisfy the active asset test.

A CGT asset satisfies the active asset test, in subsection 152-35(1), 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.

In the current circumstances, the Land Trust has owned the land for more than 15 years. It therefore must be an active asset for a total of at least 7 and a half years.

Under subsection 152-40(1), a CGT asset is an active asset at a time (subject to certain exceptions) 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 your or;

(b) If the asset is an intangible - 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.

Based on the information provided, it is considered that Individual A has controlled and is connected with the Land Trust, under subsection 328-125(4), based on the distributions received previously and Individual A has also controlled and is connected with the Business Trust under subsection 328-125(3) for those reasons detailed above. On this basis, it is therefore considered that, for a period of time more than 7 and a half years, the Land Trust is connected with the Business Trust under paragraph 328-125(1)(b) given that Individual A controls both the Business Trust and Land Trust.

Accordingly, the Land was an active asset of the Land Trust for a total of at least 7 and a half years as it was, during this time, used in the course of carrying on a business by the Business Trust which was connected with the Land Trust.

It is also relevant to note that none of the ‘active asset’ exceptions in section 152-40 will apply to the current circumstances. In this regard, it is highlighted that the exception in paragraph 152-40(4)(e) which excludes, among other things, assets whose main use is to derive rent (unless such use was only temporary) from being an active asset will not apply, as is the situation here, where the relevant CGT asset is leased by a taxpayer to a connected entity for use in the connected entity's business (see subsection 152-40(4A) and Taxation Determination TD 2006/63).

Therefore the requirements of paragraph 152-10(1)(d) will be met.

Conclusion - Basic conditions in Subdivision 152-A

Based on the above analysis, it is considered that the Land Trust will satisfy the basic conditions in Subdivision 152-A, to be eligible for the small business CGT concessions in Division 152, in relation to the capital gain made on the disposal of the Land.