Edited version of private advice

Authorisation Number: 1051604832674

Date of advice: 5 November 2019

Ruling

Subject: CGT - small business concessions - basic conditions - am I in business?

Question 1

Was the trust carrying on a business in the year ended 30 June 2019, for the purposes of paragraph 328-110(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997).

Answer

No

Question 2

Was the trust carrying on a business in the year ended 30 June 2018, for the purposes of subparagraph 328-110(1)(b)(i) of the ITAA 1997?

Answer

No

Question 3

Was the trust a CGT small business entity for the year ended 30 June 2019, in accordance with subsection 152-10(1AA) of the ITAA 1997?

Answer

No

Question 4

Do the trust's shares in Holding Co Pty Ltd satisfy the active asset test in accordance with paragraph 152-10(1)(d) of the ITAA 1997?

Answer

Yes

Question 5

If the answers to questions 1, 2, 3 and 4 are yes, has the trust satisfied the requirements for relief under subsection 152-10(1) of the ITAA 1997?

Answer

No

Question 6

Does the trust satisfy the modified active asset test in paragraph 152-10(2)(a) of the ITAA 1997?

Answer

Yes

Question 7

Does the trust satisfy the requirements under subparagraph 152-10(2)(d)(ii) of the ITAA 1997?

Answer

Yes

Question 8

If the answers to 1, 2, 6 and 7 are yes, has the trust satisfied all the additional basic conditions under subsection 152-10(2) of the ITAA 1997?

Answer

No

Question 9

If the answers to question 5 and 8 are yes, has the trust satisfied the basic conditions for relief under subdivision 152-A of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2019

The scheme commences on:

1 July 2018

Relevant facts and circumstances

The trustee company is the trustee for the trust which is a discretionary trust that was established on XX July 20XX.

The directors of the trustee company are X and Y.

The primary beneficiaries of the trust are X and Y and their children and remoter issue of each of them.

From establishment to XX March 20XX, the trust carried on a business in partnership with an unrelated third party (the partner). The partnership developed a software product. Management Co Pty Ltd was incorporated with the trust and the partner holding 50% of the shares each.

Management Co Pty Ltd was the management company of the partnership from establishment to XX March 20XX.

On XX March 20XX the partnership restructured its business with a view to raise external funding.

New entities were created within the group as wholly owned subsidiaries of Holding Co Pty Ltd. Assets were transferred within the group. The trust and the partner exchanged their shares in Management Co Pty Ltd for shares in Holding Co Pty Ltd.

Immediately after the restructure, Holding Co Pty Ltd issued additional ordinary shares to an unrelated third party (the investor) for $X. The following is the resultant shareholding after the issue of additional ordinary shares:

·   XX% - the trust

·   XX% - the partner

·   XX% - the investor

In May 20XX, Holding Co Pty Ltd undertook another share capital raise, diluting the trust's shareholding to XX%.

The 20XX-XX consolidated turnover for Holding Co Pty Ltd and its wholly owned subsidiaries was $X.

All assets of Holding Co Pty Ltd and its wholly owned subsidiaries are either active assets held and used in the course of the entities' respective business activities or cash or financial instruments inherently connected with the business carried on. This has been the case for the entire period of ownership.

The intellectual property held by Holding Co Pty Ltd and its wholly owned subsidiaries is inherently connected with the business of those entities.

Holding Co Pty Ltd and its wholly owned subsidiaries do not satisfy the maximum net asset value test.

The trust did not carry on any business between XX March 20XX and November 20XX.

In November 20XX the trust was engaged by Holding Co Pty Ltd to provide 'consulting services'.

The engagement was evidenced by a written agreement.

Under the agreement, the trust:

·   has the ability to subcontract/delegate work;

·   can quote either an hourly rate or per item amount when invoicing for work performed under the agreement;

·   bares all costs for equipment, tools and other assets required to complete the work;

·   is responsible for any commercial risks and the cost of rectifying any defective work;

·   has control of the way work is performed; and

·   provides a required level of independence from Holding Co Pty Ltd.

The trust engaged Y to test, check and provide external validation for the software owned by Holding Co Pty Ltd.

Holding Co Pty Ltd engaged a number of other independent external contractors to perform validation testing, in addition to the trust.

Holding Co Pty Ltd provided the trust with a laptop. The cost of the laptop ($X) was deducted directly from an invoice. There have been no other expenses incurred in the completion of the work under the engagement.

The trust was notified on XX December 20XX that its services would no longer be required from XX January 20XX.

The trust does not provide consultancy services to any other clients.

The trust made distributions for the years ended 30 June 20XX and 30 June 20XX to the following beneficiaries in the following proportions:

·   Y - X%

·   X - X%

On XX November 20XX a share sale agreement to sell 100% of the shares in Holding Co Pty Ltd was entered into.

On XX January 20XX, the share sale agreement was completed and settled.

The trust disposed of its shareholding in Holding Co Pty Ltd for US$X (which is approximately AUD$X) which is to be received in equal thirds as:

·   Cash on settlement;

·   Script; and

·   Cash receivable in future, subject to an earn-out arrangement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-110

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

Income Tax Assessment Act 1997 section 995-1

Income Tax Assessment Act 1997 subsection 152-35(1)

Income Tax Assessment Act 1997 subsection 152-35(2)

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

Income Tax Assessment Act 1997 subsection 152-10(2)

Income Tax Assessment Act 1997 subsection 152-10(2A)

Income Tax Assessment Act 1997 paragraph 152-10(2)(a)

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 subsection 152-10(2B)

Income Tax Assessment Act 1997 section 152-55

Income Tax Assessment Act 1997 section 152-70

Income Tax Assessment Act 1997 subsection 152-75(1)

Income Tax Assessment Act 1997 section 152-65

Reasons for decision

Small business entity

To be eligible for small business entity concessions, you first need to work out if you are a CGT small business entity in an income year.

Section 328-110 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you will be 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.

Subsection 152-10(1AA) of the ITAA 1997 adjusts section 328-110 regarding when an entity will be considered a CGT small business entity. Section 152-10(1AA) states:

You are a 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.

Business is defined in section 995-1 of the ITAA 1997 to be 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

Taxation Ruling TR 97/11 provides the indicators established by the courts that need to be considered when determining whether a business is being carried on. It should be noted that TR 97/11 specifically deals with carrying on a business of primary production but the indicators established can be equally applied to most other activities. Paragraph 13 of TR 97/11 states that the following indicators are relevant:

·   Whether your activity has a significant commercial purpose or character.

·   Whether you have more than just an intention to engage in business.

·   Whether you have a purpose of profit as well as a prospect of profit from the activity.

·   Whether there is repetition and regularity of your activity.

·   Whether your activity is of the same kind and carried on in a similar manner to businesses in your industry.

·   Whether your activity is planned, organised and carried on in a businesslike manner.

·   The size, scale and permanency of your activity.

·   Whether your activity is better described as a hobby, recreation or sporting activity.

Paragraph 15 of TR 97/11 states that no one indicator is decisive (Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922). In addition, paragraph 16 of TR 97/11 states that the indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the general impression gainedfrom looking at all the indicators (Martin v. Federal Commissioner of Taxation (1953) 90 CLR 470 at 474; 5 AITR 548 at 551).

Whether the activities conducted in the validation testing for the software amounts to the carrying on of a business is a question of fact and degree.

In this case, the trust was engaged by Holding Co Pty Ltd to provide consulting services involving validation testing of the software. A number of other consultants were also engaged by Holding Co Pty Ltd to provide similar validation testing services on the software.

There is no indication of permanency of the trust's activities as the trust had one client and testing was limited to one software program. The activity could not be said to be carried out in a businesslike manner. The trust incurred one expense throughout the entire period, namely the laptop. The trust engaged Y to conduct the testing, yet there is no evidence of any contractor or employee expenses incurred within the trust for the services that Y provided. Y received distributions in the years ended 30 June 20XX and 30 June 20XX from the trust in the capacity of beneficiary, not in the capacity as a contractor or employee of the trust. There is insufficient repetition or regularity to the activity. The trust had one client, a related entity, to whom it provided this service and there appears to be no intention of providing similar services to other clients.

Although there are some elements of the activity that indicate the trust could potentially carry on a business, such as the testing activities completed, these activities are not conducted on a sufficient scale to be considered carrying on a business.

After considering the specific circumstances, it is considered that the trust's activities do not amount to the carrying on of a business and accordingly, the trust is not a CGT small business entity for the year ended 30 June 2019.

Active asset test

A CGT asset will satisfy the active asset test if:

·   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 ½ years during the test period; or

·   you owned the asset for less than 15 years and the asset was an active asset of yours for at least half of the test period. (subsection 152-35(1) of the ITAA 1997).

The test period begins when you acquired the asset and ends at the time of the CGT event (subsection 152-35(2) of the ITAA 1997).

A share in a company that is an Australian resident is an active asset at a given time if, at that time, the total of:

·   the market values of the active assets of the company

·   the market value of any financial instruments of the company that are inherently connected with a business that the company carries on, and

·   any cash of the company that is inherently connected with such a business,

is 80% or more of the market value of all of the assets of the company (subsection 152-40(3) of the ITAA 1997).

In this case, a CGT event occurred in relation to the disposal of the trust's shares in Holding Co Pty Ltd, which resulted in a capital gain. As more than 80% of the assets of the company are active assets or cash and financial instruments inherently connected with the business of the company, the shares are considered active assets and have been active assets for more than half of the period, therefore satisfying the active asset test.

Additional basic conditions for shares in a company

For CGT events happening on or after 8 February 2018, subsection 152-10(2) of the ITAA 1997 states:

The following additional basic conditions must be satisfied if the *CGT asset is a *share in a company, or an interest in a trust, (the object entity):

(a) the CGT asset would still satisfy the active asset test (see section 152-35) if the assumptions in subsection (2A) were made;

(b) if you do not satisfy the maximum net asset value test (see section 152-15) - you are carrying on a *business just before the *CGT event;

(c) either:

(i) the object entity would be a *CGT small business entity for the income year; or

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

if the following assumptions were made:

(iii) the only CGT assets or *annual turnovers considered were those of the object entity, each affiliate of the object entity, and each entity controlled by the object entity in a way described in section 328-125;

(iv) each reference in section 328-125 to 40% were a reference to 20%;

(v) no determination under subsection 328-125(6) were in force;

(d) just before the CGT event, either:

(i) you are a *CGT concession stakeholder in the object entity; or

(ii) CGT concession stakeholders in the object entity together have a *small business participation percentage in you of at least 90%.

*Note: As the Commissioner has determined that the trust is not carrying on a business, paragraph 152-10(2)(b) of the ITAA 1997 cannot be satisfied. However, for completeness we have considered the requirements under paragraphs 152-10(2)(a) and (d) of the ITAA 1997 below.

Assumptions in subsection 152-10(2A)

Subsection 152-10(2A) of the ITAA 1997 states:

For the purposes of paragraph 152-10(2)(a), in working out whether subsection 152-40(3) applies at a given time (the test time) assume that:

(a) an asset of a company or trust is covered by neither:

(i) subparagraph 152-40(3)(b)(ii) (about financial instruments); nor

(ii) subparagraph 152-40(3)(b)(iii) (about cash);

if the company or trust acquired that asset for a purpose that included assisting an entity to otherwise satisfy paragraph 152-10(2)(a) of this section; and

(b) paragraph 152-40(3)(b) does not cover an asset that:

(i) is a share in a company, or an interest in a trust, (the later entity); and

(ii) is held at the test time by the object entity directly or indirectly (through one or more interposed entities); and

(c) subparagraph 152-40(3)(b)(i) also covers each asset that:

(i) is held at the test time by a later entity covered by subsection (2B); and

(ii) is, for that later entity, an asset of a kind referred to in subparagraph 152-40(3)(b)(i), (ii) or (iii), as modified by paragraphs (a) and (b) of this subsection; and

(d) subject to paragraph (b) of this subsection, all of the assets of the object entity at the test time included all of the assets of each later entity at the test time; and

(e) for the purposes of paragraph 152-40(3)(b), the *market value at the test time of an asset held by a later entity were the product of:

(i) the asset ' s market value, apart from this paragraph, at the test time; and

(ii) the object entity's *small business participation percentage in the later entity at the test time.

The active asset test in section 152-40 of the ITAA 1997 provides that 80% or more of the assets in the entity must be active assets for the test to be satisfied.

Paragraph 152-10(2A)(a) of the ITAA 1997

Paragraph 152-10(2A)(a) of the ITAA 1997 provides that cash or financial instruments must be inherently connected to the business of the object entity. It also excludes any cash or financial instruments that are acquired or held for a purpose that includes assisting the object entity to satisfy the new additional basic conditions.

The cash and financial instruments held by Holding Co Pty Ltd have all been held for the purpose of carrying on business and as such these assets would be considered inherently connected with the business being carried on.

Paragraphs 152-10(2A)(b) - (e) of the ITAA 1997

The effect of paragraphs 152-10(2A)(b) - (e) of the ITAA 1997 is that any shares in companies or interest in trusts held by the object entity (Holding Co Pty Ltd) in later entities are not active assets for the purpose of satisfying the modified active asset test. Instead the object entity's small business participation percentage of the assets of those later entities will be relevant to the active asset test, to the extent that those later entities satisfy the conditions in subsection 152-10(2B) of the ITAA 1997.

Paragraph 152-10(2A)(c) provides that the assets of later entities must be taken into account in determining whether the object entity satisfies the modified active asset test if subsection 152-10(2B) applies to those later entities.

Subsection 152-10(2B) provides that for the purposes of paragraph 152-10(2A)(c), this subsection covers a later entity if:

(a) at the test time:

(i) your small business participation percentage in the later entity is at least 20%; or

(ii) you are a CGT concession stakeholder of the later entity; and

(b) either:

(i) the later entity would be a CGT small business entity for the income year that includes the test time; or

(ii) the later entity would satisfy the maximum net asset value test (see section 152-15) for a notional CGT event taken to have happened at the test time;

If the following assumptions were made:

(iii) the only CGT assets or annual turnovers considered were those of the later entity and of the entities referred to in subparagraph (2)(c)(ii);

(iv) each reference in section 328-125 to 40% were a reference to 20%;

(v) no determination under subsection 328-125(6) were in force.

Your small business participation percentage in a later entity is the sum of your direct small business participation percentage and indirect small business participation percentage.

In this case, between XX March 20XX to May 20XX, the trust owned X% of shares in Holding Co Pty Ltd, then between May 20XX to XX January 20XX the trust's shareholding was XX%.

From XX March 20XX to X January 20XX, Holding Co Pty Ltd owned 100% of its subsidiaries (later entities).

As such, the trust had a small business participation percentage in the later entities of at least 20% as required under subparagraph 152-10(2B)(a)(i) of the ITAA 1997 between XX March 20XX to XX January 20XX.

The later entities do not satisfy the maximum net asset value test and therefore we need to determine if the later entities would be CGT small business entities for the year ended 30 June 2019 (as per subparagraph 152-10(2B)(b)(i)).

The later entities were all carrying on businesses.

Therefore the later entities are carrying on business and have turnover of less than $2 million, satisfying subsection 152-10(2B) of the ITAA 1997. As such, under paragraph152-10(2A)(e) of the ITAA 1997 all the later entities' assets must be taken into account when considering whether Holding Co Pty Ltd satisfies the modified active asset test.

Paragraph 152-10(2A)(e) of the ITAA 1997 provides that the market value of the later entities' assets to be taken into account is worked out by multiplying the asset's market value by the small business participation percentage of the object entity (Holding Co Pty Ltd). Holding Co Pty Ltd has a 100% small business participation percentage in the later entities and therefore 100% of the assets would be taken into account when considering whether Holding Co Pty Ltd satisfies the modified active asset test.

All assets held by Holding Co Pty Ltd, including the assets held by the later entities, are assets that have been used in the business or are cash and financial instruments that are inherently connected with the business being carried on. Therefore the active asset test is satisfied and so is the modified active asset test under paragraph 152-10(2)(a) of the ITAA 1997.

CGT concession stakeholder

Subsection 152-10(2)(d) of the ITAA 1997 advises that just before the CGT event

(i)   you are a *CGT concession stakeholder in the object entity; or

(ii) CGT concession stakeholders in the object entity together have a *small business participation percentage in you of at least 90%.

Section 152-60 of the ITAA 1997 states:

An individual is a CGT concession stakeholder of acompany or a trust at a time if, the individual is:

(a)       a *significant individual in the company or trust; or

(b)       a spouse of a significant individual in the company or trust, if the spouse has a *small business percentage in the company or trust at that time is greater than zero.

As the trust holds the shares and not an individual subparagraph 152-10(2)(d)(i) of the ITAA 1997 does not apply. To determine whether the trust passes the basic condition in subparagraph 152-10(2)(d)(ii) of the ITAA 1997 it has to be determined if there is a CGT concession stakeholder of DoseMe Holdings Pty Ltd that has a small business participation percentage in the trust of at least 90%.

Section 152-55 of the ITAA 1997 states:

An individual is a significant individual in a company or a trust at a time if, at that time, the individual has a *small business participation percentage in the company or trust of at least 20%.

An individual's small business participation percentage is worked out in accordance with section 152-65 of the ITAA 1997 and is the sum of the individual's direct and indirect small business participation percentage.

An individual's direct small business participation percentage in a company is the least of the following percentages:

(a)       the percentage of 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.

Section 152-70 of the ITAA 1997 describes the direct small business participation percentage. As the trust owned X% of shares in Holding Co Pty Ltd was entitled to any dividends that they may pay, the trust has a small business percentage in Holding Co Pty Ltd of X%.

Y received a X% distribution of the trust income and X received a distribution of X% of the trust income in the 20XX income year.

Under subsection 152-70(1) of the ITAA 1997 table at item (3), Y and X have a direct small business participation percentage in the trust in the 20XX income year of X% and X% respectively.

However, to determine if there is a significant individual in Holding Co Pty Ltd the indirect small business participation percentage needs to be determined.

Subsection 152-75(1) of the ITAA 1997 states that to work out the indirect small business participation percentage that an entity (the holding entity) holds at a particular time in another entity (the test entity) by multiplying:

(a)       the holding entity's *direct small business participation percentage (if any) in another entity (the intermediate entity) at that time; by

(b)       the sum of:

(i)         the intermediate entity's direct small business participation percentage (if any) in the test entity at that time; and

(ii)        the intermediate entity's indirect small business participation percentage (if any) in the test entity at that time (as worked out under one or more other applications of this section).

Y has a small business participation percentage of X% in the trust. The trust has a small business percentage in Holding Co of X%. To determine Sarah's indirect small business percentage these two amounts are multiplied. Y has an indirect small business percentage of XX%.

Y is a significant individual of Holding Co Pty Ltd. Accordingly, the requirements of subparagraph 152-10(2)(d)(ii) of the ITAA 1997 have been met.

Conclusion

The trust satisfies the active asset test, the modified active asset test and has a CGT concession stakeholder at the time of the CGT event, however it is not a CGT small business entity and therefore the trust does not satisfy the basic conditions to apply the CGT small business concessions.