Edited version of private advice

Authorisation Number: 1051610253109

Date of advice: 2 December 2019

Ruling

Subject: Capital gains and income tax

Question 1

Is the market value of the right to royalties included in the capital proceeds for the sale of the asset?

Answer

No.

Question 2

Can the trust utilise the small business 15-year exemption to disregard the capital gain that will arise in the year ending 30 June 2020 when it disposes of the asset?

Answer

Yes.

Question 3

Will the royalties that will be received in future years be included in assessable income in each income year in which they are derived?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 2020

The scheme commences on:

1 July 2018

Relevant facts and circumstances

The trust is a discretionary trust.

In 20XX the trust purchased an asset which it has used to carry on in its business for the entire period of ownership.

The trust has continuously owned the asset for more than 15 years.

In the income year before the CGT event, the trust's aggregated turnover was less than $2 million.

For some of the income years during the period the asset has been owned, the trust made distributions of which individual N received at least 20%.

For the other income years during the period the asset has been owned, the trust had no net income or had a tax loss and did not make any distributions.

The trust proposes to sell the asset to entity Z for a certain price.

The trust will enter into a Royalty Deed with entity Z.

Individual N is over the age of 55 and has been intending to retire for the last few years; however, there have not been sufficient funds to facilitate their retirement. The sale of the asset will provide for their retirement and any continued business activities involving the trust or related entities will be undertaken by a younger family member. The younger family member has in recent years taken on more and more of the day to day responsibilities of carrying on the trust's business.

Assumptions

We have been advised that the following events will take place and this private ruling is made on the basis that these events do in fact happen:

·        The sale of the asset and the Royalty Deed will be executed in the 2019-20 income year.

·        Individual N will retire shortly after the sale of the asset.

·        For the 2019-20 income year, the trust will make distributions of income and capital with all of those distributions being made to individual N and their spouse on a 50/50 basis.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 15-20

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 Section 152-110

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 116-20

Income Tax Assessment Act 1997 Section 328-110

Reasons for decision

All of the legislative references that follow are to the Income Tax Assessment Act 1997.

Question 1

The sale of the asset will result in CGT event A1 happening to the trust and the execution of the Royalty Deed will result in CGT event D1 happening to entity Z.

We consider that the capital proceeds for the A1 event under section 116-20 is the price stipulated in the sale agreement.

Question 2

Section 152-10 contains the basic conditions you must satisfy to be eligible for the small business CGT concessions. These conditions are:

(a)      a CGT event happens in relation to a CGT asset in an income year.

(b)      the event would (if not for the small business CGT concessions) have resulted in a 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 in section 152-15

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

(iv)            the conditions in subsection 152-10(1A) or (1B) are satisfied in relation to the CGT asset in the income year.

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

Under sections 152-10(1AA) and 328-110, a CGT small business entity for an income year includes an entity that carries on a business in that income year and had an aggregated turnover in the previous income year of less than $2 million.

Section 152-40 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business.

Section 152-35 explains that an asset satisfies the active asset test if you have owned the asset for more than 15 years and it was an active asset for a total of at least 7 ½ years from the time when you acquired the asset until the CGT event. The period in which the asset is an active asset does not need to be continuous.

In the present case, based on the information provided, the trust will meet conditions a), b), c) and d) as:

·        The trust will sell the asset in the 2019-20 income year.

·        This CGT event will result in a capital gain.

·        The trust carries on a business in the 2019-20 income year and had an aggregated turnover of less than $2 million in the previous income year.

·        For more than 7 ½ years the trust used the asset in a business that it carried on.

Therefore, the basic conditions for access to the small business CGT concessions will be satisfied.

15-year exemption

Section 152-110 provides that a trust can disregard any capital gain made on the disposal of an asset if all of the following conditions are satisfied:

(a)   you satisfy the basic conditions

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

(c)   you had a significant individual for a total of at least 15 years of the whole period of ownership (even if the 15 years was not continuous and it was not always the same significant individual), and

(d)   the individual who was a significant individual just before the CGT event was:

·        at least 55 years old at that time and the event happened in connection with their retirement, or

·        permanently incapacitated at that time.

Section 152-55 explains that an individual is a significant individual in a trust if the individual has a small business participation percentage in the trust of at least 20%. The 20% can be made up of direct and indirect percentages.

A company or trust satisfies the significant individual test if it had at least one significant individual just before the CGT event. The small business 15-year exemption further requires a company or trust to have a significant individual for periods totalling at least 15 of the years of ownership of the CGT asset.

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

a)     the entity'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) explains that an entity's direct small business participation percentage in a trust, where entities do not have entitlements to all the income and capital of the trust, and the trust makes a distribution of income or capital, is the percentage of:

• distributions of income that the entity is beneficially entitled to during the income year, or
• distributions of capital that the entity is beneficially entitled to during the income year, or
• if two different percentages apply, then the smaller of the two.

Ordinarily, if the trust did not make a distribution of income or capital during the income year it will not have a significant individual during that income year. However, amendments were made to section 152-70 to allow an entity another method to work out their small business participation percentage in a discretionary trust for an income year if the trustee of the trust:

• did not make a distribution of income or capital during the income year, and
• had no net income or had a tax loss for the income year.

Then, the entity's direct small business participation percentage at the relevant time is worked out using the percentage of the distributions the entity was beneficially entitled to in the CGT event year (paragraph 152-70(5)(a)).

Importantly, a distribution by the trustee during the CGT event year of some or all of the capital gain made from the CGT event is a distribution for the purpose of assigning a small business participation percentage in that income year to the objects of the trust (paragraph 152-70(5)(a)). Trust law would determine whether the distribution is a distribution of income or capital.

In the present case, we have been advised that all of the trust's distributions of income and capital for the 2019-20 income year will be made to individual N and their spouse on a 50/50 basis. Consequently, both individual N and their spouse will be significant individuals of the trust for that year as they each will have a small business participation percentage in the trust of more than 20%.

For some of the income years during the period the asset has been owned, the trust made distributions of which individual N received at least 20% and therefore the trust had a significant individual in these income years.

For the other income years during the period the asset has been owned, the trust had no net income or had a tax loss and did not make any distributions. However, using the method provided by paragraph 152-70(5)(a), the trust will have a significant individual in these other income years as it has a significant individual in the CGT event year.

The trust will meet all the necessary conditions to be eligible to disregard any capital gain made on the sale of the asset under section 152-110 as it:

• satisfies the basic conditions
• has owned the asset for over 15 years
• had a significant individual for at least 15 years of its ownership period, and
• will have a significant individual (individual N) who is over 55 at the time of the CGT event and the CGT event will happen in connection with their retirement.

Distributions of the exemption amount

If a capital gain made by a trust is disregarded under the small business 15-year exemption, any distributions made by the trust of that exempt amount to a CGT concession stakeholder (a significant individual is a CGT concession stakeholder) is:

·        not included in the assessable income of the CGT concession stakeholder, and

·        not deductible to the trust

if certain conditions are satisfied.

The conditions are:

·        the trust must make a payment within two years after the relevant CGT event that resulted in the capital gain or, in appropriate circumstances, such further time as allowed by us

·        the payment must be made to an individual who was a CGT concession stakeholder of the trust just before the CGT event, and

·        the total payments made to each CGT concession stakeholder must not exceed an amount determined by multiplying the CGT concession stakeholder's participation percentage by the exempt amount.

The CGT concession stakeholder's participation percentage for a trust where entities do not have entitlements to all the income or capital of the trust, is the amount (expressed as a percentage) worked out using the formula 100 ÷ N (where N is the number of CGT concession stakeholders of the trust just before the CGT event).

Question 3

Royalties are specifically included in assessable income under section 15-20 if they are not assessable as ordinary income under section 6-5.

It is arguable whether the amounts that the trust will receive under the Royalty Deed meet the definition of a 'royalty'.

In any case, it is considered that these amounts would be assessable under section 6-5 as ordinary income. They are not considered to be capital in nature as they are not instalments of a set capital sum.

The amounts will be included in assessable income under section 6-5 in the income year that they are derived.

CGT event C2 also happens when each 'royalty' payment is received with the capital proceeds for the event being the 'royalty' payment received and the cost base being a portion of the cost base of the right to receive 'royalties'. As the 'royalty' payment is included in assessable income under section 6-5 the anti-overlap provision section 118-20 will apply to reduce any yearly capital gain under CGT event C2 to nil.