Edited version of private advice

Authorisation Number: 1051638479618

Date of advice: 20 February 2020

Ruling

Subject: CGT small business concessions

Question

Is the Trust eligible to apply the 50% Reduction in Subdivision 152-C and the Retirement Exemption in Subdivision 152-D of the ITAA 1997 to a taxable capital gain made on the sale of shares?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2018

The scheme commences on:

1 July 2017

Relevant facts and circumstances

1.     The taxpayer is a discretionary trust (the Trust) established on DD MM 20XX by deed.

2.       Mr X was settlor and Mr A is the trustee.

3.       The taxpayer held 100% of the issued shares in Company A since the establishment of the company in 20XX.

4.       Company A had two wholly owned subsidiaries comprising the Group:

-  Company B; and

-  Company C;

5.       On DD MM 20ZZ the taxpayer signed an agreement to sell all of the shares in Company A to an unrelated party.

6.       Mr A was the sole director of Company A, Company B and Company C.

7.       The Group developed software and technology for the finance industry.

8.       The two founders, Mr A and Mr B, developed the business model for the Group.

9.       All core intellectual property related to business secrets, processes and know-how vested in and was developed and owned in Company A.

10.    The purpose of Company A was to actively grow a global business with headquarters in Australia with an intention to establish subsidiaries in multiple locations. Company A played an active role in the administration of the affairs of the subsidiary companies.

11.    All key decisions for the Group were made by Company A through the 2 founders, with Mr C involved from 20YY bringing industry knowledge in relation to overseas markets.

12.    The intention was to establish a presence in overseas markets by Company A incorporating entities in each of those jurisdictions to establish and expand the business in each of the markets. The entities would report to Company A.

13.    The business successfully expanded overseas prior to the share sale.

14.    The marketing activities conducted by Company A brought the Group to the attention of the unrelated party who made an offer to acquire the shares.

15.    Company B was set up by Company A to be the local Australian and Country A trading entity.

16.    Company C was set up to hold the intellectual property relating to the mechanics of the software which will allow it to replicate the actual software platform. It was intended that as businesses were developed in other markets, Company C would license the use of the intellectual property to the relevant trading entities in those markets.

17.    The structure was intended to facilitate effective corporate governance for each of the local operating entities, while at the same time quarantining trading risks to those local entities.

18.    There has been a CGT event in relation to the shares held in Company A by the taxpayer that has resulted in a taxable capital gain.

19.    The taxpayer is not a CGT small business entity as it does not carry on a business.

20.    The taxpayer does not satisfy the $6 million net asset test. You consider that Goodwill in the business has a market value of at least $19 million.

21.    Company A is a CGT small business entity as the aggregated turnover of Company A, Company B and Company C was less than $2 million.

22.    All distributions from the taxpayer in the 20ZZ financial year have been made to CGT concession stakeholders.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-10

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

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

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

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

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

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

Income Tax Assessment Act 1997 subsection 152-40(4)

Reasons for decision

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

QUESTION:

SUMMARY

The capital gain made by the Trust on the disposal of the shares it held in Company A cannot be reduced or disregarded under Division 152 of the ITAA 1997 because the basic conditions for relief in section 152-10 have not been satisfied in the 2018 income year.

DETAILED REASONING

Basic conditions for small business concessions

To qualify for any of the CGT small business concessions, an entity must satisfy several conditions that are common to all the concessions, known as the basic conditions. The basic conditions are contained in subdivision 152-A.

According to subsection 152-10(1):

A capital gain (except a capital gain from CGT event K7) you make may be reduced or disregarded under this Division if the following basic conditions are satisfied for the gain:

(a)   a CGT event happened in relation to a CGT asset of your 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 small business entity for the income year;

(ii)              you satisfy the maximum net asset value test;

(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;

(iv)            the conditions mentioned in subsection (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.

Basic condition 152-10(1)(a)

Shares are CGT assets as defined in section 108. In 20ZZ, the Trust disposed of its shareholding in Company A. As a result of the disposal, CGT event A1 under section 104-10 happened to each of the shares. The condition in paragraph (a) is satisfied.

Basic condition 152-10(1)(b)

A capital gain resulted from a CGT event and as such, this condition is satisfied.

Basic condition 152-10(1)(c)

Paragraph 152-10(1)(c) states that at least one of the requirements listed at subparagraphs (i) to (iv) must apply. The first three requirements do not apply as:

(i)               the Trust is not a CGT small business entity

(ii)              the Trust does not satisfy the maximum net asset value test

(iii)            the Trust is not a partner in a partnership.

This leaves 152-10(1)(c)(iv) to be considered. For 152-10(1)(c)(iv) to apply the conditions mentioned in subsection 152-10(1A) or (1B) must be satisfied in relation to the CGT asset in the income year. Subsection 152-10(1B) is not relevant in this case. Subsection 152-10(1A) is discussed below.

Passively held assets

The conditions in subsection 152-10(1A) are satisfied 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.

Paragraph 152-10(1A)(a)

The term 'small business entity' is defined in section 328-110. It requires the entity to carry on a business and have aggregated turnover below $10 million. The definition of CGT small business entity is contained in subsection 152-10(1AA), and requires that the entity be a small business entity with aggregated turnover below $2 million.

The aggregated turnover of Company A, Company B and Company C is below $2 million. So provided Company A is carrying on a business it will qualify as a CGT small business entity.

Taxation Ruling TR 2019/1 Income tax: when does a company carry on a business? (TR 2019/1) sets out the Commissioner's view on when a company is carrying on a business within the meaning of section 328-110 of the ITAA 1997. The operation of TR 2019/1 is limited to the determination of whether a business is being carried on in a general sense for the purposes of determining whether it is a small business entity under 328-110 of the ITAA 1997 and section 23 of the Income Tax Rates Act 1986. Paragraph 39 states that while there is a need for activity to determine the company is carrying on a business, there are a number of cases where the court has held the company is carrying on a business, including:

...'where its ongoing activities are relatively limited and its key activities consist of...holding shares in subsidiary companies which are engaged in trading'.

It is accepted that Company A is regarded as carrying on a business for the purposes of section 328-110, so Company A was a CGT small business entity in the 2018 income year.

The final element of paragraph 152-10(1A)(a) is to determine whether the holding company is connected with the trust.

The rules for determining whether an entity is 'connected with' another entity are contained in section 328-125. The Trust owns 100% of the issued shares in Company A. On the basis of the information provided, the Trust would have a control percentage of 100% in Company A. As such, Company A would be regarded as being connected with the Trust per subsection 328-125(2). (It is also noted that the trust is connected with the trading companies (applying the indirect control rule in subsection 328-125(7)) and the holding company is connected with the trading companies).

As the Trust is connected with the holding company that is a CGT small business entity, the requirements of paragraph 152-10(1A)(a) are satisfied.

Paragraph 152-10(1A)(b)

The Trust does not carry on a business in the income year. Paragraph 152-10(1A)(b) is satisfied.

Paragraph 152-10(1A)(c)

The Trust does not carry on a business in partnership. Paragraph 152-10(1A)(c) is not relevant.

Paragraph 152-10(1A)(d)

Paragraph152-10(1A)(d) provides:

(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.

For the purposes of statutory construction section 15AA of the Acts Interpretation Act 1901 provides the following:

In interpreting a provision of an Act, the interpretation that would best achieve the purpose or object of the Act (whether or not that purpose or object is expressly stated in the Act) is to be preferred to each other interpretation.

In Project Blue Sky Inc v Australian Broadcasting Authority [1998] HCA 28 at 69, McHugh, Gummow, Kirby and Hayne JJ said:

The primary object of statutory construction is to construe the relevant provision so that it is consistent with the language and purpose of all the provision of the statue. The meaning of the provision must be determined "by reference to the language of the instrument viewed as a whole."

Paragraph 152-10(1A)(d) refers to subparagraphs 152-40(1)(a)(ii),(iii) and paragraph 152-40(1)(b), the reference is to the business being carried on by the entity referred to in each of those paragraphs/subparagraphs to draw the connection between the asset which has been disposed and the entity carrying on the business. Relevant to paragraph 152-10(1A)(d), paragraph 2.20 of the Explanatory Memorandum to the Tax Laws Amendment (2009 Measures no. 2) Bill 2009 ('EM') states:

... This access to the small business CGT concessions requires a taxpayer's affiliate or entity connected with the taxpayer to be a small business entity in the income year. The access also requires the small business entity to be the entity that carries on the business at a time in the income year referred to in subparagraph 152-40(1)(a)(ii) in its proposed new form, or new subparagraph 152-40(1)(a)(iii), or paragraph 152-40(1)(b) in its proposed new form in relation to the CGT asset. This link is necessary to prevent access to the concessions in a situation where a taxpayer's affiliate or entity connected with the taxpayer is a small business entity but the asset is used by an affiliate or entity connected with the taxpayer that is not a small business entity.

The reference in s152-10(1A)(d) to section 152-40 draws the connection between the business being carried on by the affiliate or connected entity by reference to the requirements of section 152-40 and is not intended to equate to a requirement that the CGT asset in question satisfies the active asset test. The determination of whether the CGT asset is an active asset is separate to this requirement and is another of the basic conditions contained in section 152-10.

The phrase 'in relation to'

The phrase 'in relation to' is undefined in the legislation, however the Macquarie Dictionary definition of 'relation' is '...an existing connection; a particular way of being related: the relation between cause and effect.'

Hill J discussed the words 'in relation to' in the Full Federal Court decision in First Provincial Building Society Ltd v Commissioner of Taxation (1995) 56 FCR 320 (First Provincial), a case that considered the scope of s 26(g) of the Income Tax Assessment Act 1936 (Cth) relating to bounties or subsidies "received in or in relation to the carrying on of a business". Hill J said at 4155:

The words ''in relation to'' are words of wide import. They are capable of referring to any relationship between two subject matters, in the present case the receipt of the bounty or subsidy, on the one hand, and the carrying on of the business, on the other: cf

O'Grady v The Northern Queensland Company Limited (1989-1990) 169 CLR 356 at 364-365 per Brennan J and at 376 per McHugh J. As McHugh J (at 376) points out, the degree of connection will be ''a matter of judgment on the facts of each case''. If the relationship were a merely remote one, para. (g) would have no operation. What is necessary, at the least, in the present context is that there be a real connection. But the existence of the alternative first limb of the paragraph makes it clear that the relationship need not be direct, it may also be indirect.

The phrase 'carries on the business'

In First Provincial, Hill Jconsidered the meaning of the phrase 'carrying on of the business'at 4154 as follows:

The expression "carrying on of the business" looks, in my opinion, to the activities of that business which are directed towards the gaining or producing of assessable income, rather than merely to the business itself.

In this case, the relevant CGT asset is the bundle of shares in Company A held by the Trust. The test is whether there is a direct or indirect connection between the shares in Company A and the business activities which are directed towards the gaining or producing of assessable income of Company A. For this requirement, it is not relevant that Company A carries on the business as a company and that it needs shares to exist.

The shares the Trust holds in Company A do not contribute in any way to the income producing activities of Company A. The Trust's shares are an equity interest separate from any business activities carried on by Company A. The shares give the Trust rights to the income of Company A, rather than contributing to the income of Company A.

There is no direct or indirect connection between the shares in Company A and the business activities which are directed towards the gaining or producing of assessable income of Company A. Consequently, the Trust does not satisfy all of the conditions in subsection 152-10(1A) as the business carried on by Company A is not in relation to the shares disposed of by the trust as required by paragraph 152-10(1A)(d). The requirement contained in subparagraph 152-10(1)(c)(iv) does not apply.

Basic condition 152-10(1)(d)

Paragraph 152-10(1)(d) requires the CGT asset which has been disposed of to satisfy the active asset test in section 152-35, which includes requirements in relation to the period of ownership of the CGT asset and the period the CGT asset has been active.

Active asset test

The active asset test is satisfied 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 test period detailed below, 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 7.5 years during the test period.

The test period:

·  begins when you acquired the asset, and

·  ends at the earlier of:

˗        the CGT event, and

˗        when the business ceased, if the business in question ceased in the 12 months before the CGT event (or such longer time as the Commissioner allows).

The Trust held the shares since the time Company A was incorporated, so the requirement in section 152-35 will be satisfied if the shares are active assets.

The meaning of an active asset is set out in section 152-40. Where the assets being disposed of are shares in a company, the definition of an active asset is modified, so that even if it was possible for the assets to be active assets as defined in subsection 152-40(1), the exception in subsection 152-40(4) applies and they cannot be active assets unless the requirements of subsection 152-40(3) are met.

Subsection 152-40(1) states:

152-40 (1) A * CGT asset is an active asset at a time 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 you; or

(b) if the asset is an intangible asset-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.

As stated earlier, the shares the Trust holds in Company A do not contribute in any way to the income producing activities of Company A. Consequently, the shares in Company A are not used in the course of carrying on the holding company business and are not inherently connected with the business being carried on by Company A. However, subsection 152-40(4) provides an alternate requirement for shares.

Subsection 152-40(4) states interests in an entity connected with you and other certain entities cannot be active assets other than shares and interests covered by subsection 152-40(3).

Subsection 152-40(3) states:

A *CGT asset is also an active asset at a given time if, at that time, you own it and:

In determining whether the 80% test is satisfied, the market value of active assets in the relevant company is added to the market value of financial instruments and any cash inherently connected to the relevant company's business to determine whether the total amount represents 80% or more of the market value of all the assets of the relevant entities. If it does, paragraph (b) is satisfied.

This requires a determination of the market value of each asset held by Company A, consideration of whether each of those assets would be active assets as defined, the market value of any financial instruments which are inherently connected with the business carried on by Company A and the amount of cash inherently connected with the business of Company A. The market value of Company A's active assets and inherently connected assets must then be 80% or more of the market value of all the assets of Company A.

The main assets of the holding company are the shares in the trading companies. To determine if the 80% rule is satisfied in relation to the shares held by the Trust in the holding company, it needs to be determined whether the shares held by the holding company in each of trading companies are themselves active assets.

Taxation Determination TD 2006/65 Income tax: capital gains: small business concessions: can a share in a company or an interest in a trust qualify as an active asset under subsection 152-40(3) of the Income Tax Assessment Act 1997 if the company or trust owns interests in another entity that satisfies the '80% test'? (TD 2006/65) explains the 'layered' approach to applying 152-40(3)). Once again 152-40(4)(a) requires consideration of 152-40(3) in isolation to determine whether the shares in the trading companies can be active assets of the holding company. This is illustrated in the Example 1 of TD 2006/65 as follows:

Example 1

2. Ben owns all the shares in Holding Co which, in turn, owns all the shares in Operating Co (both are resident companies ). The only assets of Holding Co are the shares in Operating Co and all of Operating Co's assets are active assets.

3. As Operating Co satisfies the 80 % test, the shares owned by Holding Co in Operating Co are active assets. As those shares are the only assets owned by Holding Co, Holding Co also satisfies the 80 % test and therefore the shares owned by Ben in Holding Co are also active assets.

In this case, the test in 152-40(3) needs to be applied to the shares held by the Trust in Company A. Given the assets of Company A includes shares in its subsidiaries, the active asset test must be applied to the shares of each subsidiary which requires consideration of the assets held by each of the subsidiaries to determine if the 80% test is satisfied.

Goodwill

Goodwill held by the Group is an intangible asset inherently connected with the business, so the goodwill is an active asset of the trading companies.

Intellectual property

Intellectual property held by the Group is an intangible asset inherently connected with the business carried on by the company, and therefore an active asset of the trading companies.

It is reasonable to conclude that the value attributed to the shares by the buyer approximates the market values of the assets of the Group such that the market value requirement in

subsection 152-40(3) is satisfied. Consequently, the shares held by the Trust satisfy the condition in paragraph 152-10(1)(d).

CONCLUSION

The Trust must satisfy all the basic conditions in subsection 152-10(1). The basic conditions in paragraphs 152-10(1)(a), (b) and (d) are satisfied.

Paragraph 152-10(1)(c) states that at least one of the requirements listed in the subparagraphs must apply. The requirements do not apply as:

(i)               the Trust is not a CGT small business entity

(ii)             the Trust does not satisfy the maximum net asset value test

(iii)            the Trust is not a partner in a partnership.

(iv)            the conditions in subsection 152-10(1A) are not satisfied.

As the none of the requirements in paragraph 152-10(1)(c) apply, the Trust does not satisfy all the basic conditions for relief in subsection 152-10(1). Therefore the Trust cannot apply the CGT small business concessions in Division 152 to reduce or disregard the capital gain made on the disposal of its shares in Company A.