Edited version of your written advice

Authorisation Number: 1051434904718

Date of advice: 28 September 2018

Ruling

Subject: Small Business Capital Gains Tax Concessions.

Question 1

Does the decision by a partnership to treat the property as trading stock result in CGT event K4 to occur under section 104-220 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Does the property fall within the meaning of an active asset in section 152-40 of the ITAA 1997?

Answer

No.

Question 3

Does each of the partners in the partnership satisfy the maximum net asset value test contained in the section 152-15 of the ITAA 1997?

Answer

It is not necessary for the Commissioner to answer this question, as a basic condition to claim relief under Division 152 of the ITAA 1997 has not been satisfied, i.e. the property is not considered to be an active asset.

Question 4

Is the capital gain arising as a result of the CGT event eligible to be reduced under the small business CGT concessions contained in Subdivisions 152-C and 152-E of the ITAA 1997?

Answer

No, as a basic condition to claim relief under Division 152 of the ITAA 1997 has not been satisfied.

This ruling applies for the following period:

Year ending 30 June 2016

The scheme commences on:

1 July 2015

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.

1. A, B, and C are ‘partners’ in a partnership. Any reference to ‘you’ in this document refers to each individual partner respectively.

2. The partnership acquired a property in 2009.

3. The partnership does not carry on a business.

4. The property was primarily used to derive rental income.

5. During part of the ownership period the property was used to provide a business premises for a company associated with the partnership.

6. The property was rented to the company at market value.

7. The partners each have an interest in the company through discretionary trusts they are beneficiaries of.

8. Each of the partner’s discretionary trust holds an equal one third shareholding in the company.

9. The partners are the only directors of the company.

10. In 2015 the partners elected to treat the property as trading stock. A valuation of the property was undertaken by a licenced valuer.

11. No one shareholder controls a majority of the voting rights in the company.

12. The company has historically paid a dividend to its shareholders.

13. Meetings are held regularly with directors and senior employees of the company.

14. Each director of the company is a working director.

15. There is a Shareholder/Partnership Agreement that governs the relationship of the shareholders and partners of the partnership.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 104

Income Tax Assessment Act 1997 Section 104-220

Income Tax Assessment Act 1997 Subdivision 108-A

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 108-5(1)

Income Tax Assessment Act 1997 Subsection 108-5(2)

Income Tax Assessment Act 1997 Subdivision 70-B

Income Tax Assessment Act 1997 Section 70-30

Income Tax Assessment Act 1997 Subsection 70-30(1)

Income Tax Assessment Act 1997 Paragraph 70-30(1)(a)

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 Section 152-10

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

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Section 152-25

Income Tax Assessment Act 1997 Subsection 152-25(1) I

Income Tax Assessment Act 1997 Subsection 152-25(2)

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Subsection 152-40(1)

Income Tax Assessment Act 1997 Subdivision 152-C

Income Tax Assessment Act 1997 Subdivision 152-D

Income Tax Assessment Act 1997 Subdivision 152-E

Income Tax Assessment Act 1997 Division 328

Income Tax Assessment Act 1997 Section 328-125

Income Tax Assessment Act 1997 Subsection 328-125(1)

Income Tax Assessment Act 1997 Subsection 328-125(2)

Income Tax Assessment Act 1997 Section 328-130

Income Tax Assessment Act 1997 Subsection 328-130(1)

Income Tax Assessment Act 1997 Subsection 328-130(2)

Reasons for decision

These reasons for decision accompany the Notice of private ruling for the individual partners of the partnership.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Detailed reasoning

Question 1

Does the decision by a partnership to treat the property as trading stock result in CGT event K4 to occur under section 104-220 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

As the property is a CGT asset, CGT event K4 happened when the partners elected to treat the property as trading stock under paragraph 70-30(1)(a).

Detailed reasoning

Section 108-5 defines a ‘CGT asset’ to include any kind of property, including an interest in an asset. The property would therefore fall within the definition of a CGT asset.

CGT event K4 happens if you start holding as trading stock a CGT asset you already own and you elect under paragraph 70-30(1)(a) to be treated as having sold the asset for its market value.

As the partnership started to hold the property as trading stock and the partners elected to treat the property as trading stock under paragraph 70-30(1)(a), CGT event K4 occurred at this time.

Question 2

Does the property fall within the meaning of an active asset in section 152-40 of the ITAA 1997?

Summary

The property would not fall within the meaning of an active asset, as the property was not used, or held ready for use, either by you, your affiliate, or another entity that is connected with you.

Detailed reasoning

A CGT asset is an active asset if you own the asset 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:

(a) you, or

(b) your affiliate, or

(c) another entity that is connected with you.

The partnership does not carry on a business and only derives rental income from the property. Therefore, for the property to be an active asset, it would need to be used, or held ready for use, in the course of carrying on a business by you, your affiliate or another entity connected with you.

The property was rented to the company who used it as their business premises and it is accepted that the company is conducting a business. It therefore needs to be determined whether the company is your affiliate or an entity connected with you.

Connected entity test

The meaning of ‘connected with’ an entity is described in subsection 328-125(1) as:

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.

Each partner respectively controls their discretionary trust and each discretionary trust holds an equal ownership interest in the company. As a company is involved, the relevant test that needs to be satisfied is contained in subsection 328-125(2), that 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.

The partners do not hold any shares in the company, as it is their respective discretionary trust that each holds an equal interest. As none of the discretionary trusts hold 40% or more of the shares in the company, none of the partners is a connected entity of the company.

Affiliate test

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, 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.

The following is an example of when an individual or a company is NOT your affiliate:

A partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could reasonably be expected to act, in accordance with the directions or wishes of the second partner, or in concert with the second partner, in relation to the affairs of the partnership.

Directors of the same company, or the company and a director of that company, would be in a similar position.

You contend that the company is an affiliate of each of the partners, and it must act, or be reasonably expected to act, in accordance with the directions or wishes of each partner, or in concert with each partner, in relation to the affairs of the company’s business.

Although no one partner controls a majority of voting rights in the company (either directly or indirectly), each partner contends that the company is their affiliate. Any control the partners may have over the company would be in their capacity as a director of that company, rather than as a partner in the partnership.

‘Direction or wishes’

You contend that the company is an affiliate of each partner, as it acted in accordance with the directions or wishes of each partner in relation to the affairs of the business.

It is our view that the partners are merely conducting their duties as a director of the company and as part of a normal way of doing business.

The reasons provided to support your affiliate argument come about merely because of the business relationship agreed to between the directors and would therefore fall within the exclusion in subsection 328-130(2) and the example noted in section 328-130.

We also disagree that the powers and duties exercised or carried out by each director for the company are ‘additional factors’ which negates the application of subsection 328-125(2).

Further support for our view is obtained from Re Taxpayer and FC of T [2010] AATA 445 at paragraph 52 (Re Taxpayer) where Deputy President Hack stated:

The Commissioner accepts that holding the office of director is not sufficient to give rise to the inference that the director acts at the direction of the company or in concert with it. The concession is hardly novel; the reality is that the company acts at the direction of its directors.

In Re Taxpayer, the son director was one of two directors of the applicant company and, through his company Relatedco 2, a 15% shareholder in the applicant. The Commissioner originally determined that the son director was a ‘small business affiliate’ of the applicant (under the former section 152-25) and that the son director would answer that description if he acted, or could reasonably be expected to act, in accordance with the wishes or directions of the applicant, or in concert with it. In addition to his capacity as a director of the applicant, the son director was also the duty manager who had primary responsibility for the day to day management of the hotel side of the business while his parents concentrated their endeavours on the motel side. The son was also the company’s nominee for the purposes of liquor licensing laws and was guarantor of the company’s liabilities under the Gaming Machine Act 1991 (Qld). Although paragraph 152-25(1)(b) is a former affiliate provision, it does have similar wording to subsection 328-130(1).

Deputy President PE Hack held that the facts fell well short of finding that the son director was an affiliate of the company and stated (at paragraph 54):

The acts of the son director … are explicable on the basis of the son director’s position as a director or as an employee (or both) of the applicant. That is to say, it was his conduct qua director of the applicant, not conduct of his in his own right or in his capacity as director of other entities. Moreover, there is no objective or purpose common to both, the object or purpose that underlies the conduct is that of the applicant. The son’s director’s conduct is directed to that objective or purpose but it is not his objective or purpose. Were the matter to be tested in the way that the Commissioner suggests, every employee would be regarded as a small business CGT affiliate of the employer. (Emphasis added).

On the current facts, we accept that each director plays a major role in the day to day running of the business of the company and make decisions independent of one another. However, in our view the directors are merely conducting their duties as a director of the company and would therefore fall under the exception in subsection 328-125(2). It should be noted that Re Taxpayer was affirmed in Re Excellar Pty Ltd v FC of T 98 ATR 965 and while the case was later appealed (as FC of T v Byrne Hotels Qld Pty Ltd 196 FCR 524), the judgment on the affiliate issue was not subject to the appeal.

‘In concert’

You also contend that the company acts ‘in concert’ with each partner in relation to the affairs of the company’s business. In support of this contention the following was referred to:

● Excellar Pty Ltd v FC of T [2015] AATA 282 to support that an entity should be viewed as acting in concert with one another where it and the other entity act together in pursuit of a common purpose or goal in relation to the affairs of the business of the individual or company.

● Stephens v Federal Commissioner of Taxation [2008] AATA 176 supports the company acted ‘in concert’ with each individual partner.

● the company has historically paid dividends to its shareholders (who are trusts connected to the partners).

● dividends were used by the partners to facilitate the purchase of the property with a primary purpose to make it available for the company and secure ongoing use to suitable premises.

● while the company paid market rent to the partnership, should there have been cash flow restraints on the company, payment of rent would be delayed until the company was in a better financial position.

● there was no formal lease or rental agreement between the partners and the company evidencing that the company is solely beholden to the desires of the partners in respect of the affairs of its business.

The term ‘in concert with’ was stated in Re Taxpayer 79 ATR 510 at 525, which quoted Finkelstein J in Papua New Guinea Dockyard Ltd v Adams (2005) 215 ALR 742 at 746:

Many of the important cases that discuss the meaning of “acting in concert” are helpfully collected by Barrett J in Bateman v Newhaven Park Stud Ltd (2004) 49 ACSR 597. These cases show that a person, A, will be acting in concert with another person B, if A engages in conduct (act or omission) in consequence of an agreement or understanding between A and B and the conduct is in pursuance of an objective or purpose which is common to both. It is not as is sometimes suggested necessary to show that the common objective or purpose “has some pejorative element [such as] to circumvent the letter, or perhaps even the spirit, of some other statutory obligation or requirement.”

We do not agree that the company acted ‘in concert’ with each partner in relation to the affairs of the company’s business for the reasons set out below.

You have stated the company has historically paid substantial dividends to its shareholders (that are the partners’ discretionary trusts) with distributions to the partners who then used these funds to help fund the acquisition of the property.

However, the records for each partner discretionary trust for a number of consecutive years show the dividends received from the company were not distributed to the partners, but to various associated entities.

We do not agree that dividend payments are evidence of ‘acting in concert’ with the company and there is no evidence that the dividend payments were contingent or made for the stated purpose.

We are also of the view that the mere rental relationship between the partnership and the company is not evidence of the company acting ‘in concert’ with the partners, especially when the company was paying market value rent to the partnership. Whilst reference was made that if the company had ‘cash flow constraints’, payment of rent would be delayed until the company was in a better financial position, we consider such arrangements a normal commercial arrangement, with outstanding rental payments usually recorded as a loan to the defaulter, not as parties acting in concert with one another.

The partners’ said there was no lease or formal rental agreement between the company and argued that ‘it is evident that the company is solely beholden to the desires of the partners in respect of the affairs of its business.’

We do not agree with this contention in relation to each partner. As previously discussed, no one individual partner/director controls the company so that it would be ‘beholden’ to the desires of each partner. Indeed, the Shareholder/Partnership Agreement evidences that no one partner was intended to have such power over the company.

Reference was made to Stephens v FC of T [2008] AATA 176 as support that the company acted ‘in concert’ with each partner. In Stephens, seven family trusts (owned by partners or people associated with the legal practice) owned a premises that was leased to a legal practice. One of the family trusts (that was controlled by one of the partners of the legal practice and his wife) alleged that the rental relationship helped prove that the legal practice was its affiliate. Apart from noting that the legal practice had different parties controlling it from the family trust, the AAT stated that despite having a landlord tenant relationship, there was ‘insufficient evidence’ to determine that the legal practice and one of the family trust landlords had a common purpose or object to deem them to be affiliates for the purposes of the former affiliate provision in section 152-25.

The partners allege their facts are different to Stephens, as they control (along with their associate trust entities) the company as opposed to Stephens where it was held that the controlling minds of the family trust were not the same as the controlling entities of the legal practice. The partners then allege this supports their affiliate argument.

We do not see the relevance of Stephens. Firstly, as mentioned above, no one individual partner/director is the controller of the company. Just because the partners are collectively the controlling minds of the company does not mean, that this, by itself is sufficient to deem the company to be acting ‘in concert’ with each partner. As discussed above, we do not accept that the company by simply renting a property on normal commercial terms, is sufficient to deem that it and the partners are acting in concert together as an objective or purpose common to both, in relation to the company’s business (as required under subsection 328-130(1)).

It should also be noted that the Stephens case was based on interpreting the former affiliate provision in section 152-25, which had quite different wording to the current affiliate provision in section 328-130. While the former paragraph 152-25(1)(b) is drafted on similar wording to subsection 328-130(1), the former subsection 152-25(2) (which excludes an entity being an affiliate) was drafted differently to subsection 328-130(2).

The exclusion provision in the former subsection 152-25(2) stated:

Another partner in a partnership in which you are a partner is not your small business CGT affiliate only because the partner acts, or could reasonably be expected to act, in concert with you in relation to the affairs of the partnership.

However, the exclusion provision in subsection 328-130(2) states:

However, 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.

The exclusion provision in subsection 328-130(2) is wider than the former subsection 152-25(2) (which was limited to excluding only partners from being affiliates). Subsection 328-30(2) states clearly that just because parties have a business relationship does not necessarily mean that the entities are affiliates for the purposes of section 328-130.

For the reasons explained above, we are of the view that the factors referred to by the partners to contend that the company acts ‘in concert’ with them, does not pass the affiliate test in subsection 328-130(1).

We are also of the view that all the factors referred to by the partners (i.e. the company paying dividends to each of the partners discretionary trusts and being a tenant to the partners on normal commercial terms) would also come within the exclusion provision in subsection 328-130(2), as merely being part of the ‘nature of the business relationship’ between the company and each of the partners.

Accordingly, the company is not your affiliate for the purposes of section 328-130.

Question 3

Does each of the partners in the partnership satisfy the maximum net asset value test contained in the section 152-15 of the ITAA 1997?

Summary

It is not necessary for the Commissioner to answer this question, as a basic condition to be able to claim relief under Division 152 of the ITAA 1997 has not been satisfied, i.e. the property is not considered to be an active asset.

Detailed reasoning

Section 152-10 lists a number of basic conditions that are to be satisfied before a capital gain you make may be reduced or disregarded under Division 152. As it is our view that the property did not fall within the meaning of an active asset means that one of the basic conditions in section 152-10 has not been met. Hence, it not necessary to consider whether one of the other basic conditions has been satisfied.

Question 4

Is the capital gain arising as a result of the CGT event eligible to be reduced under the small business CGT concessions contained in Subdivisions 152-C and 152-E of the ITAA 1997?

Summary

As a basic condition has not been satisfied you are not eligible to claim relief under Division 152 for the capital gain made from the sale of the property.

Detailed reasoning

Section 152-10 lists a number of basic conditions that are to be satisfied before a capital gain you make may be reduced or disregarded under Division 152. As it is our view that the property did not fall within the meaning of an active asset means that one of the basic conditions in section 152-10 has not been met. Hence, it not necessary to consider whether the capital gain made from the sale of the property is eligible to be reduced under Subdivisions 152-C and 152-E.