Edited version of private advice

Authorisation Number: 1051595599979

Date of advice: 29 October 2019

Ruling

Subject: Capital gains tax - small business concessions - active asset

Question 1

Is the Property an active asset under section 152-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Does the Property pass the active asset test in section 152-35 of the ITAA 1997?

Answer

No.

This ruling applies for the following period

Income year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

Person A (the Trustee), is the appointer and trustee of the Trust, which is a discretionary trust.

The Trustee entered a contract to purchase the Property for the Trust after 20 September 1985.

The Property includes a car park and underneath storage on the ground level, and four office spaces of equal space located upstairs. The Property is under one Strata Title.

The Trust actively manages the leasing of the offices in the Property. No real estate agent is used in relation to organising the leasing of the offices and the Trust negotiates the leases, manages conflicts, organises repairs and cleaning, sends invoices, and collects payments.

The tenants were charged for their share of the overhead expenses, and could be relocated to other offices depending on the availability of office space.

The majority of leases for the office spaces were short-term.

From 20XX Company XYZ operated its business from the Property and did not operate their activities from any other premises from 20XX to 20XX.

Person A and their spouse, Person B, each hold 50% shares in Company XYZ entitling them to voting rights. Persons A and B are the directors of Company XYZ which they both actively manage and draw salaries from its business. Due to the nature of the relationship between all of the parties, Company XYZ is a connected entity to the Trustee.

It is estimated that the land area of the Property was used as follows from 20XX to 20XX, excluding common areas and car park:

·         Company XYZ used 2X% to 4X% area of the Property; and

·         6X% to 7X% was used for rental purposes.

The floor area of the Property used by Company XYZ varied on a year-to-year basis from 2X% to 4X% as follows:

·         up to 20XX, Company XYZ used half the office spaces with the other half of the office spaces being used by external tenants; and

·         from 20XX additional external tenants leased the office spaces reducing Company XYZ's occupancy to only one office, using the other offices when there were any vacancies.

It is estimated that income derived from Company XYZ's business activities in relation to the use of the Property, excluding rentals from related party, from 20XX to 20XX are as follows:

·         7X% used by Company XYZ calculated using weighted average over the years, with the following income estimated to have been derived by Company XYZ from the use of the Property during those years (excluding rental income from a related party) as follows:

-                   2006 - 8X%

-                   2007 - 7X%

-                   2008 - 7X%

-                   2009 - 6X%

-                   2010 - 7X%

-                   2011 - 6X%

-                   2012 - 6X%

-                   2013 - 7X%

-                   2014 - 8X%

-                   2015 - 6X%

-                   2016 - 6X%

-                   2017 - 5X%

·         3X% from rental purposes (weighted average).

The following total income amounts were recorded by Company XYZ in its assessments:

The following rental expense amounts were recorded by Company XYZ in its assessments:

You have provided the following rental expense amounts as being incurred by Company XYZ:

The following gross rent amounts were recorded by the Trust in its assessments:

A contract for the sale of the Property was entered into more than 10 years after it was purchased.

A capital gain has been made on the sale of the Property.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Reasons for decision

Active Asset - the law

The small business concessions only apply where the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997.

This test requires that the asset has to be an active asset for at least half the overall period of ownership. However, that overall period is subject to a cap of 15 years.

The term active asset is defined in subparagraph 152-40(1)(a)(i) of the ITAA 1997 and requires the asset to have been used, or held ready for use, in the course of carrying on a business by you either alone or in partnership. However, 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 unless the main use for deriving rent was only temporary.

In determining the main use of an asset for the purposes of paragraph 152-40(4)(e) of the ITAA 1997, any use of the asset by a connected entity is treated as your use of the asset (paragraph 152-40(4A)(b)). Therefore, an asset leased to a connected entity for use in the connected entity's business will not, by that reason alone, be excluded by paragraph 152-40(4)(e) of the ITAA 1997 from being an active asset.

Application to the Trust's situation

The business use by Company XYZ (as a connected entity to the Trustee) will be sufficient to meet the conditions of subsection 152-40(1) of the ITAA 1997 unless the Property is mainly used by the Trust to derive rent.

The real issue in this situation is whether the Property falls under the exception contained in paragraph 152-40(4)(e) of the ITAA 1997.

As a characterisation question, the use of the Property by Company XYZ for business purposes is also considered to be business use by the Trust by paragraph 152-40(4A)(b) of the ITAA 1997 (See also Taxation Determination TD 2006/63).

But, the Trust is deriving rent from Company XYZ and from external tenants, being unrelated parties. Therefore, values must be attributed to both to determine whether the Property was mainly used to derive rent.

Taxation Determination TD 2006/78 considers the active asset test and the main use to derive rent concept. Paragraph 26 of TD 2006/78 states that:

If an asset is used partly for business and partly to derive rent at any given time, it will be a question of fact depended on all the circumstances as to whether the main use of the asset at that time is to derive rent. No one single factor will necessarily be determinative, and resolving the matter is likely to involve a consideration of a range of factors such as:

·         the comparative areas of use of the premises (between deriving rent and other uses); and

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

Example 5 in TD 2006/78 considers mixed use of a property as follows:

Mick owns land on which there are a number of industrial sheds. He uses one shed (45% of the land by area) to conduct a motor cycle repair business. He leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the motor cycle repair business is 80% of the total income (business plus rentals) derives from the use of the land and buildings.

In determining if the main use of the land is to derive rent, it is appropriate to consider a range of factors. In this case, a substantial (although nevertheless not a majority) proportion by area of the land is used for business purposes. As well, the business proportion of the land derives the vast majority (80%) of the total income. In all the circumstances, the Tax Office considers the main use of the land in this case is not to derive rent and accordingly the land is not excluded from being an active asset by paragraph 152-40(4)(e) of the ITAA 1997.

The Explanatory Memorandum supporting an amending Act can also be used to assist in interpreting a provision (see section 15AB of the Acts Interpretation Act 1901).

The Explanatory Memorandum to the Tax Laws Amendment (2009 Measures No. 2) Bill 2009 makes the following statements about paragraph 152-40(4)(e) and subsection 152-40(4A) of the ITAA 1997:

2.73 The amendments remove the focus on the main use of an asset in the course of carrying on the business mentioned in subsection 152-40(1) of the ITAA 1997 and focus instead on the main use of the asset by the taxpayer. [Schedule 2, item 26, paragraph 152-40(4)(e)]

2.74 The amendments adopt an attribution approach in relation to the use of an asset by a taxpayer's affiliate or an entity connected with the taxpayer. This approach treats the use of the asset by the affiliate or the entity connected with the taxpayer as though it were the use of the taxpayer. [Schedule 2, item 27, paragraph 152-40(4A)(b)]

2.75 This attribution approach, therefore, treats any business use by the taxpayer's affiliate or an entity connected with the taxpayer as business use by the taxpayer irrespective of whether the taxpayer receives rental income from the affiliate or entity connected with the taxpayer. If the affiliate or entity connected with the taxpayer uses the asset to derive interest, rent, royalty, or foreign exchange gains from an entity that is neither an affiliate of nor connected with the taxpayer, that use is treated as the taxpayer's use. [Schedule 2, item 27, paragraph 152-40(4A)(b)]

2.76 The amendments exclude any personal use of an asset by the taxpayer who owns the asset and any personal use by an individual who is the taxpayer's affiliate from the determination of the main use of the asset. In the affiliate case, this is achieved by treating the affiliate's personal use of the asset as the taxpayer's use.[Schedule 2, item 27, paragraphs 152-40(4A)(a) and (b)]

Example 2.12

Further to Example 2.8: The amendments ensure that the determination of the main use of Kiki's property takes into account the 90 per cent rental use to Lost Dog Pty Ltd, which neither is Kiki's affiliate nor is connected with her.

The amendments treat Beaglehole Pty Ltd's use of that part of the property rented to it as Kiki's use because Beaglehole Pty Ltd is connected with Kiki. Because Beaglehole Pty Ltd uses that part of the property as its business premises, Kiki is treated as using that part as business premises. This means that the rent Beaglehole Pty Ltd pays to Kiki is not treated as rent for the purposes of determining Kiki's main use of the property.

Kiki's main use of the property is to derive rent, because 90 per cent of the revenue she derives from the property is rent received from Lost Dog Pty Ltd.

Therefore, Kiki's property is not an active asset in these circumstances for the purpose of section 152-40 in its proposed new form.

Area based analysis

Company XYZ is a connected entity to the Trust. Therefore, Company XYZ's use of the floor area is viewed as the Trust's use of the floor area.

Based on the information provided Company XYZ used half of the office spaces in the Property up to 20XX, which had then been reduced to one office space from 20XX to 20XX, being less than 30% of the Property. It had used other office spaces when they were vacant estimated to be a year-to-year basis from 2X% to 4X%.

A breakdown of the percentage of Property's floor space used by Company XYZ for each income year was not provided.

While Company XYZ used additional office space/s when they were vacant from 20XX, no information has been provided to support what percentage of the Property had been used by Company XYZ, the period/s Company XYZ had used the additional office space/s, that the usage was anything more than temporary, or that the offices had ceased being available for rent during the period/s of use by Company XYZ.

As the maximum use of the floor space used by Company XYZ is stated as being 4X% of the floor space of the Property in any income year, it is viewed that the majority of the use of the floor area of the Property was not used by Company XYZ, but by the external tenants who leased the office spaces, being between 6X% to 7X% of the floor area.

Therefore, it is viewed that the Trust's business use of the Property is 2X% to 4X%. The remaining 6X% to 7X% of the floor area was used by external tenants, being unrelated tenants.

It is viewed that the floor area of the Property used by Company XYZ is less than the majority of the floor area, quite often as low as 2X%. Therefore, the income earned by the Trust in relation the various uses of the Property becomes a more important factor.

Income based analysis

Reference has been made to TD 2006/78 and that 'when trying to determine the main use of an asset you look at the comparative areas of use of the property and comparative income levels'.

As outlined in both Example 5 in TD 2006/78 and the 'Kiki example' in the EM, it is the income earned from the owner's perspective in relation to the various uses of the relevant property that is taken into consideration when determining the comparative income levels.

You argued that all of the income earned by Company XYZ should count toward the income based attribution citing the inclusion of the business income in Example 5 of TD 2006/78 as provided above (the Mick example). However, the facts in this case can be distinguished from those in the Mick example.

In the Mick example the comparative areas of use of the land (being 45% for business use which was viewed as Mick's use of the land and 55% rented to unrelated parties) were inconclusive as to the main used of the land and were largely ignored. Therefore, it was appropriate to only consider the comparative levels of income derived from the different uses of the land by Mick as the owner of the land. The majority, being 80% of Mick's total income, which consisted of income from both the business and rental activities, was derived in relation the portion of the portion of the land used for the business activities.

To the extent we are applying the Mick example to this case, we are looking at the Trust's income earned in relation to its activities, being the leasing of the Property to both Company XYZ and the external tenants. While the use of the Property by Company XYZ is viewed as the Trust's use of the Property, the percentage of the Trust's rental income earned from Company XYZ is not the majority of income earned by the Trust from the Property.

The main point is that the Mick example only considers the income earned by the owner of the property from the property. The gross business income is included because Mick carried on the business. The Kiki example from the EM considers the matter where it is an affiliate that conducts the business from the property. Both examples are consistent in only using the income earned by the owner of the property.

The income earned by Company XYZ in relation to its business activities has been provided to support that the majority of the income received in relation to the Property was not received from the rental of the Property. However Company XYZ's business income is not the income that is taken into consideration when determining the comparative income levels. It is the Trust's income earned in relation to the Property from all sources that is taken into consideration as supported in TD 2006/78 and the EM.

In this case, Company XYZ's rental expenses as recorded in its assessments, and as provided with this ruling, are insufficient to support that the majority of the rental income earned by the Trust in relation to the Property was as a result of Company XYZ's use of the Property. Additionally, nothing has been provided to support that the majority of the income earned by the Trust was not earned in relation to the leasing of the office spaces to the external tenants.

Note: Company XYZ's business income would be taken into consideration when determining whether the aggregated turnover test would be met.

Conclusion

Based on the information and documentation provided it is viewed that the majority of the floor area was used by external tenants and not by Company XYZ, and the majority of the income was earned by the Trust from the leasing of the office spaces to the external tenants.

Accordingly, the Property is excluded from being an active asset and will therefore not meet the active asset test to enable the small business CGT concessions to be applied to disregard any capital gain made on the sale of the Property.