Edited version of private advice

Authorisation Number: 1051648528666

Date of advice: 18 March 2020

Ruling

Subject: Basic conditions for small business concessions - active asset test

Question

Will The Company satisfy the basic conditions to be eligible for the small business concessions under Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following period

Year ended 30 June 2020

The scheme commences on

1 July 2019

Relevant facts and circumstances

1.            The directors of Company A both own 50% of the shares.

2.            One of the directors of Company A (Director A) is also a director in Company B.

3.            Director A owns 33.33% of the shares in Company B.

4.            The other director of Company B (Director A) owns 66.66% of the shares in Company B.

5.            Company B was established several decades ago and is in the business of manufacturing.

6.            Company B initially leased land to carry on its business. Sometime later an adjacent property (the Property) became available and was purchased by Company A. The Property had one shed on it at this time.

7.            Company B rents the Property from Company A for the purpose of carrying on its business.

8.            As the business of Company B grew, it was decided by the directors to build more sheds on the Property to accommodate the increasing number of products that Company B wanted to manufacture. The sheds house manufacturing plant and equipment and are considered to be factories.

9.            The factories are paid for and built by Company A, which leases them to Company B. As the number of factories increased over time, the lease payments from Company B have risen accordingly.

10.          Company B does not own any real property from which it carries on its business.

11.          Neither Director A, Director B, Company A nor Company B conduct any other business external to what is described above.

12.          Apart from renting the Property to Company B, Company A has no other involvement in the business of Company B.

13.          Whilst Director B owns 66.66% of the shares in Company B, all decisions relating to Company B's business are made equally between the directors.

14.          Director A personally guarantees 50% of the debts of Company B notwithstanding Director A's shareholding amounts to 33.33%.

15.          The following information has been provided in relation to how the directors conduct the running of Company B's business. Both the directors:

·                     are liable for an overdraft amount and all other outstanding debt associated with the business

·                     personally guarantee equipment

·                     equally share the financial burden of the business despite the difference in shareholdings

·                     consult on all business matters

·                     discuss future direction of the business, and

·                     conduct two financial and operational meetings per month.

16.          Company A is proposing to sell the Property. It is intended to only be sold to a buyer prepared to enter into a leasing arrangement with Company B to allow Company B to continue its operations.

17.          The applicant has stated that the maximum net asset value test in section 152-15 of the ITAA 1997 has been passed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Subsection 104-10(1)

Income Tax Assessment Act 1997 Subsection 104-10(2)

Income Tax Assessment Act 1997 Subsection 104-10(3)

Income Tax Assessment Act 1997 Subsection 104-10(4)

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Section 152-10

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

Income Tax Assessment Act 1997 Paragraph 152-10(1)(a)

Income Tax Assessment Act 1997 Paragraph 152-10(1)(b)

Income Tax Assessment Act 1997 Paragraph 152-10(1)(c)(ii)

Income Tax Assessment Act 1997 Paragraph 152-10(1)(d)

Income Tax Assessment Act 1997 Section 152-15

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Paragraph 152-40(4)(e)

Income Tax Assessment Act 1997 Paragraph 152-40(4A)

Income Tax Assessment Act 1997 Paragraph 152-40(4A)(b)

Income Tax Assessment Act 1997 Section 328-125

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

Income Tax Assessment Act 1997 Paragraph 328-125(1)(a)

Income Tax Assessment Act 1997 Paragraph 328-125(1)(b)

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

Income Tax Assessment Act 1997 Paragraph 328-125(2)(b)

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

Question

Will Company A satisfy the basic conditions to be eligible for the small business concessions under Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Summary

Company A is not entitled to access the small business concessions to reduce or disregard a capital gain in accordance with Division 152. The basic conditions for relief will not been met since the Property, which Company A is intending to dispose of, is not an active asset.

The exception at paragraph 152-40(4)(e), which excludes CGT assets from being active assets if their main use is to derive rent, applies to the Property, since Company A uses the Property to derive rent from Company B. Company B's use of the Property in carrying on its business is unable to be treated as Company A's use of the Property as per paragraph 152-40(4A), since Company B is not an affiliate of, or connected with, Company A.

Consequently, the main use of the Property is to derive rent. As such, the Property is not considered to be an active asset and the small business concessions in Division 152 cannot be accessed in relation to the disposal of the Property.

Detailed reasoning

1.    You make a capital gain or capital loss if a CGT event happens to a CGT asset. Property is considered to be a CGT asset.

2.    CGT event A1 happens if you dispose of your ownership interest in a CGT asset.

3.    As Company A is proposing to dispose of the Property, CGT event A1 will happen at the time the contract is entered into or when the change of ownership happens You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base.

Basic conditions for relief

1.            Division 152 provides CGT concessions that allow eligible taxpayers to disregard or defer some or all of a capital gain arising from the disposal of an active asset used in a small business, provided certain conditions (the basic conditions) are met. Subsection 152-10(1) sets out the basic conditions to be satisfied before a taxpayer can access the CGT concessions.

2.            Subsection 152-10(1) states:

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 happens in relation to a *CGT asset of yours 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 *CGT 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 CGT small business entity for the income year and the CGT asset is an interest in 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 (see section 152-35).

3.            If Company A does sell the Property, CGT event A1 will happen. This will result in the first condition in paragraph 152-10(1)(a) being satisfied.

4.            If a capital gain is made from disposing of the Property, the second condition in paragraph 152-10(1)(b) will be satisfied.

5.            The applicant has stated that the maximum net asset value test will be met, therefore the third condition in paragraph 152-10(1)(c)(ii) () will be satisfied.

6.            Therefore, it needs to be determined if the final condition in paragraph 152-10(1)(d) will be met. In other words, the active asset test in section 152-35 must be passed.

Active asset test

7.            The meaning of active asset is set out in section 152-40. Of relevance to Company A are the exceptions in subsection 152-40(4), in particular paragraph 152-40(4)(e), which states:

However, the following *CGT assets cannot be active assets:

...

(e)  an asset whose main use by you is to *derive interest, an annuity, rent, royalties or foreign exchange gains unless:

(i)           the asset is an intangible asset and has been substantially developed, altered or improved by you so that its *market value has been substantially enhanced; or

(ii)           its main use for deriving rent was only temporary.

8.            Company A has used the Property for many years to derive rental income from Company B. Company A has not used the land for any other purpose.

9.            Taxation Determination TD 2006/78 examines the circumstances where premises used in a business of providing accommodation for reward satisfy the active asset test. Whether an asset's main use is to derive rent will depend on the particular circumstances of each case. The term 'rent' has been described as follows:

·                     the amount payable by a tenant to a landlord for the use of the leased premises

·                     a tenant's periodical payment to an owner or landlord for the use of land or premises, and

·                     recompense paid by the tenant to the landlord for the exclusive possession of corporeal hereditaments.

10.          A key factor is to determine whether an occupant of premises is a lessee is whether the occupier has a right of exclusive possession. If, for example, premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to be rent and the premises not an active asset. On the other hand, if the arrangement allows the person only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

11.          Whilst TD 2006/78 focusses on the provision of accommodation services, example 2 relates to a commercial storage facility:

4. Christine carries on a business of providing commercial storage space. The storage facility comprises 50 storage shed which are available for hire for periods of 1 week to 2 years or more. Christine provides office facilities and 24 hour on-site security. She also provides various items of equipment for sale or loan to clients such as trolleys, cardboard boxes, brooms, tape, pens, locks, bolt cutes, torches and shelves. A cleaning service is also provided and charged for.

5. Christine enters into a storage agreement with each client. The agreements provide that in certain circumstances she can relocate the client to another space or entered the space without consent and that the client cannot assign the rights under the agreement.

6. The arrangements entered into in this situation indicate that that the users of the storage shed do not have the right to exclusive possession but rather only the right to enter and use the sheds for certain purposes. Some of the arrangements entered into were short term and a range of services were provided to the users. There was also no intention by the parties to grant a lease.

7. Having regard to all the circumstances, the Tax Office considers a tenant/landlord relationship does not exist between the parties in this example and therefore the amounts received are not rent. Accordingly, the storage facility is not excluded by paragraph 152-40(4)(e) of the ITAA 1997 and therefore is an active asset.

12.          In Company A's situation, we consider the Property's main use is to derive rent and can be distinguished from example 2 in TD 2006/78. Company A does not provide any significant services to Company B. The arrangement is long term, with payment amounts being periodically reviewed. Company B has exclusive possession of the Property and the arrangement is in the nature of a tenant/landlord relationship.

13.          Accordingly the amounts received by Company A from the Property constitute rent.

14.          Therefore, the Property would generally not fall within the definition of an active asset, as it falls within the exclusion in paragraph 152-40(4)(e).

15.          However, in determining the main use of an asset (for the purposes of paragraph

16.          152-40(4)(e)) paragraph 152-40(4A)(b) states:

treat any use by your *affiliate, or an entity that is *connected with you, as your use.

17.          The effect of this provision is that any affiliate or entity connected with Company A that uses the Property as an active asset, may allow Company A to avoid the exception at paragraph 152-40(4)(e) and pass the active asset test. This view is outlined in Taxation Determination TD 2006/63, which explains that a CGT asset leased by a taxpayer to a connected entity for use in the connected entity's business is an active asset of the taxpayer under section 152-40.

18.          Company B is the only entity that uses the Property. Company B uses the Property in the carrying on of its business. Therefore for paragraph 152-40(4A)(b) to apply, it must be established that Company B is either an affiliate of Company A, or connected with Company B.

Affiliates

19.          The meaning of affiliate is set out at section 328-130. Subsection 328-130(1) provides that 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. The test is applied in relation to the affairs of the business generally, not merely in relation to the CGT asset.

20.          Therefore for Company B to be an affiliate of Company A it must be shown that Company B acts, or could reasonably be expected to act, in accordance with Company A's directions or wishes, or in concert with Company A, in relation to the affairs of the business of Company B. A mere rental relationship between the companies is not sufficient to describe Company B as acting in accordance with the Company A's directions in the carrying on of its business.

21.          Factors that may indicate that parties are acting in concert may include: family or close personal relationships; financial relationships or dependencies; relationships created through links such as common partners, directors or shareholders; degree of consultation; and whether there is an obligation to conduct business with the other.[1] However, none of these is decisive in itself.

22.          As to whether Company B is acting 'in concert' with Company A, the decision in Stephens v FC of T 2008 ATC 10-008 (Stephens' case) provides guidance on what this means. Fice M cites Finkelstein J in Papua New Guinea dockyard Ltd v Adams and Ors (2005) 215 ALR 742 at 746 in stating that an entity will be acting in concert with another if, in consequence of an agreement between the entities, the conduct is in pursuit of an objective or purpose which is common to both.

23.          Apart from renting the Property to Company B, Company A has no other involvement in the business of Company B. Therefore there is no conduct in pursuit of an objective or purpose which is common to both companies. Consequently, Company B is not considered to be acting in concert with Company A in relation to the affairs of the business of Company B.

24.          Moreover, subsection 328-130(2) explains that an individual or company is not considered an affiliate merely because of the nature of the business relationship you and the individual or company share. Therefore, just because Director A is a director of Company A and Company B will not make him an affiliate of either company, or make the companies an affiliate of each other, merely due to Director A's business relationship with each company.

25.          Since Company B does not act in accordance with Company A's directions or wishes, nor in concert with Company A, in the running of its business, Company B is not an affiliate of Company A under section 328-130.

Connected entities

26.          The term 'connected with' is defined in section 328-125. Subsection 328-125(1) states that 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.

27.          Subsection 328-125(2) sets out what is meant by direct control of an entity other than a discretionary trust. Where the other entity is a company, paragraph 328-125(2)(b) relevantly states:

An entity (the first entity) controls another entity if the first entity, its *affiliates, or the first entity together with its affiliates:

(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.

28.          Therefore, for Company A to be connected entity with Company B:

·                     Company A, together with its affiliates, must own 40% of the equity interests in Company B, or

·                     Company A must be controlled by an entity that also controls Company B, whereby control is determined by the entity, together with its affiliates, owning 40% of the equity interests.

Paragraph 328-125(1)(a)

29.          Company A does not hold equity interests in Company B and therefore has no voting power in Company B. To pass the test at paragraph 328-125(1)(a) Company A would therefore need to rely on its affiliates having equity interests in Company B of at least 40%. The only entity with such interests in Company B is Director B, with 66.66% of the share ownership.

30.          Director B does not conduct any business in his/her own right. Consequently it cannot be said that Director B is acting in accordance with Company A's directions or wishes, or in concert with Company A, in relation to the affairs of his/her business. Therefore, Director B cannot be an affiliate of Company A in accordance with section 328-130.

31.          Therefore, Company A, nor any of its affiliates, have direct control of Company B as required by paragraph 328-125(2)(b).

32.          As Company A does not have any subsidiary, subsection 328-125(7) cannot apply.

33.          Therefore, the condition in paragraph 328-125(1)(a) is not met.

Paragraph 328-125(1)(b)

34.          For Company A and Company B to be connected with each other in accordance with paragraph 328-125(1)(b), they would need to be controlled by the same third entity. As per the definition of 'control' at subsection 328-125(2), the 40% requirement of the third entity includes the third entity's affiliates.

35.          The only entity with a control percentage in Company B of at least 40% is Director B, with 66.66% of the shares. However, Director B holds no shares in Company A. Director B therefore does not control both Company B and Company A, in his/her own right.

36.          Director A holds 50% of the shares in Company A and therefore controls Company A. Director A owns 33.33% of the shares in Company B. As Director A does not have at least 40% of the voting power in Company B, Director A could not be said to control Company B. Therefore, Director A does not control both Company B and Company A in his/her own right.

37.          Since no entity controls both Company A and Company B in their own right, the only means of Company A and Company B being connected with each other is to include the affiliates of the third entity in determining whether the 40% control percentage has been met.

38.          Director A, owning 50% of the shares, controls Company A. Although Director A's shareholding in Company B is below 40%, if it can be established that Director B and Director A are affiliates, then Director A together with Director A's affiliates would have a control percentage in both companies exceeding 40%. Both Company A and Company B would be controlled by the same third entity and therefore be connected with each other.

39.          Subsection 328-130(2) provides that an individual or company is not automatically an affiliate merely because of a business relationship and includes the following example:

A partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could be reasonably 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 and trustees of the same trust, or the company and a director of that company would be in a similar position.

40.          In line with the above, Director A and Director B are not automatically affiliates by virtue of both being directors of Company B. As per the meaning of affiliates at subsection

41.          328-130(1) the following requirements must be met for an entity to qualify as the entity's affiliate:

·                     the entity must be an individual or company

·                     the entity must carry on a business, and

·                     in relation to its business affairs, the entity must act, or could reasonably be expected to act according to the direction or wishes of the entity or in concert with the entity.

42.          It follows that an individual or a company can only be an affiliate of another entity if the individual or company is carrying on a business. Accordingly, if an individual or a company is not carrying on a business, the individual or company could not be an affiliate of another entity.

43.          Neither Director A nor Director B carries on a business. Although they are directors and shareholders of Company B, it is Company B itself that is carrying on the business, rather than the directors in their capacity as directors. Since neither Director A nor Director B carry on a business, they cannot be considered affiliates under section 328-130.

44.          There is no entity that, together with its affiliates, has a control percentage of at least 40% in both Company A and Company B. As a result, Company A and Company B are not connected with each other in accordance with paragraph 328-125(1)(b).

Conclusion

45.          Company B is not an affiliate of Company A under section 328-130 and Company B is not connected with Company A under section 328-125. Since Company B is the only entity that uses the Property other than Company A itself, it follows that the Property is not used by an affiliate of Company A or an entity connected with Company A. As a result paragraph

46.          152-40(4A)(b) has no application, meaning that the exception at paragraph

47.          152-40(4)(e) will apply to exclude the Property from being regarded as an active asset.

48.          Since the Property is not an active asset, the requirement at paragraph 152-10(1)(d) has not been met. Company A therefore will not satisfy the basic conditions for relief in subsection 152-10(1).