Edited version of private advice

Authorisation Number: 1051674683718

Date of advice: 12 May 2020

Ruling

Subject: Small business capital gains tax concessions

Question 1

Are you entitled to the small business 15-year exemption in relation to the Property?

Answer

Yes.

Question 2

Are you entitled to the small business 15-year exemption for any capital gain in relation to compensation payable due to financial loss caused from the imposition of the Public Acquisition Overlay on the Property?

Answer

Yes.

Question 3

Are you entitled to the small business 15-year exemption for any capital gain in relation to compensation received for the compulsory acquisition by the Water Corporations of easements and land in relation to the Property?

Answer

Yes.

Question 4

Are you entitled to the small business 15-year exemption for any capital gain in relation to compensation received for any future compulsory acquisition of parts of the Property pursuant to the Public Acquisition Overlay, whether such compulsory acquisition occurs prior to or after settlement of the contract of sale of the property?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts and circumstances

You inherited the Property pursuant to your relative's Will after they passed away in 19XX.

Your relative's estate was fully administered in the following year. However, your name was not registered on the title until XX/XX/20XX because the estate lawyer failed to lodge the transfer of land documents.

Since you inherited the property, you continuously used it in carrying on your farming business until part way through the 20XX income year.

On XX/XX/20XX, an amendment to the relevant local Planning Scheme was published and part of the Property is subject to a Public Acquisition Overlay. This gave you the right to claim compensation pursuant to the relevant State Planning Act for financial loss due to the property being reserved for a public purpose.

Under the Planning Act you were required to give 60 days notice of intention to sell the Property. On XX/XX/201X your lawyer sent a notification of a proposed sale and a claim for loss for sale pursuant to the Planning Act to the Acquisitions Manager of the State roads authority.

In 20XX, Water Corporations proposed to compulsorily acquire part of the Property to construct water assets and associated infrastructure to deliver water and transfer water to other assets. This required compulsory acquisition of easements for the supply and freehold for the reserve on which the water tanks are to be constructed.

On XX/XX/20XX, you entered into a Heads of Agreement (the Heads) for the sale of the Property with the Purchaser.

The Purchaser did not pay the full deposit required under the Heads and in XX/20XX, your solicitors demanded payment. On or about XX/XX/20XX, you still had not received the full amount of the deposit from the Purchaser and so your solicitor sent a letter to the Purchaser on or about that date demanding payment and giving notice that the Heads would be rescinded if payment was not made. Payment of the remainder of the deposit was not received and on or about XX/XX/20XX, your solicitors advised the Purchaser that the Heads were rescinded.

On or about XX/XX/20XX, the Purchaser commenced proceedings in the Supreme Court to, amongst other things, seek declaratory relief that you were not entitled to rescind the Heads. The Supreme Court matter did not proceed to judgement, instead it settled at mediation. As part of that settlement, a contract of sale was entered into between the parties.

Consequently, during the 20XX income year, you executed a contract of sale for the Property (Sale Contract). The Sale Contract had terms including the following:

There was an extended settlement period.

The purchase price was paid through a deposit and instalments during the settlement period.

Terms dealing with the potential compulsory acquisition by the Water Corporations and the Public Acquisition Overlay affecting the land, include the following.

The Purchaser buys the Land in the knowledge of each of the following matters (collectively 'the Future Acquisitions'), each of which have been taken into account in determining the Price: -

(a)    The existence of the Public Acquisition Overlay affecting the Land for the XXXXX Road and its future compulsory acquisition for this purpose

(b)   The intention of the Water Corporations to acquire the following interests in the Land for the specified purposes (collectively 'the Water Infrastructure'):

(i)            Easements over the Land for access to the delivery pipeline to be constructed in the future. and

(ii)           Reserve No. 1 for the purposes of water tanks.

The proposed easements and the configuration of Reserve No. 1 are shown on the Draft Water Corporation Plans, a copy of which is attached at Annexure 1 of the Sale Contract.

Despite the Purchaser having an interest in the Land on the signing of the Sale Contract, the Vendor will, subject to the terms of the Sale Contract:-

Conduct the compensation claims (or, where applicable, the negotiations) arising from the Future Acquisitions (including the Vendor's claim for financial loss arising from the sale of the Land in the Sale Contract) and be solely entitled to the compensation or payments as the case may be, when determined and paid.

The Purchaser will not make a claim for compensation arising from the Future Acquisitions but will do all things at the Vendor's cost which are reasonably required to enable the Vendor to conduct each of the compensation claims or negotiations and to enable the interest, when acquired, to be registered on title to the Land.

The rights to conduct the compensation claims (or, where applicable, the negotiations) arising from the Future Acquisitions will not merge in the settlement of the Sale Contract and, subject to the terms of special condition X dealing with the Future Acquisitions, the Purchaser charges the land in favour of the Vendor to protect all of its interests hereunder in respect of that part of the land located within the Public Acquisition Overlay for the XXXXX road and the interests in the land required for the Water Infrastructure

Despite anything else in the Sale Contract, the Purchaser may at any time elect to request the Vendor to hold the benefit of any rights and entitlements arising out of the Future Acquisitions by the Water Corporations on trust for the Purchaser upon payment by the Purchaser to the Vendor of $X whereupon the Vendor can either agree or refuse such request at the Vendor's absolute discretion. If the Vendor agrees to such request, the Purchaser will have sole carriage of any treating, dealings, negotiations and settlements with the Water Corporations.

Part way though the 20XX income year you retired from the farming business. That is, you ceased to have anything to do with the livestock; closed all bank accounts used for running the farming business; disposed of any related plant and equipment and trading stock; and had your PAYG and GST registration cancelled by the ATO.

Your aggregated turnover for each of the 20XX, 20XX and 20XX income years was less than $XXX.

After your retirement from the farming business and before settlement takes place, your adult child now runs a farming business on the land in their own right in a similar manner as when it was run by you.

The decision to sell the Property and your planned retirement coincided with your diagnosis with serious medical conditions. The entry into the Heads and the Sale Contract was part of your retirement plan.

You were over 55 years of age when you entered into the Sale Contract.

Nothing has been done by you either prior to, or after, entry into the Sale Contract to develop the Property.

Assumption

Settlement will take place.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-105

Income Tax Assessment Act 1997 section 116-20

Reasons for decision

Question 1

Assuming settlement occurs, the capital gains tax (CGT) event in relation to the sale of the Property happened when you entered into the Sale Contract.

Based on the information provided:

• we accept that you owned the property before you were registered on the title and that you continuously owned the property for at least 15 years prior to entering into the Sale Contract;
• you were a small business entity during the 2019 income year;
• the CGT event happened in connection with your retirement; and
• you meet the active asset test as you used the property in your business for at least 7.5 years.

Consequently you meet all the requirements under section 152-105 of the Income Tax Assessment Act 1997 (ITAA 1997) to be entitled to the small business 15-year exemption in relation to the sale of the Property.

Questions 2, 3 and 4

Section 116-20 of the ITAA 1997 states that the 'capital proceeds' from a CGT event includes 'the money you have received, or are entitled to receive, in respect of the event happening'.

There are three compensation amounts you expect to receive in relation to the Property:

(A)      For the reduction in sale proceeds on the sale of the land because the land was reserved for a public purpose being the XXXXX Road through a Public Acquisition Overlay.

(B)      For the acquisitions by the Water Corporations.

(C)      For the future acquisitions of land for the XXXXX Road contemplated by the Public Acquisition Overlay.

Taxation Ruling TR 95/35 discusses the CGT implications for compensation receipts. Paragraph 70 of TR 95/35 provides that in determining the most relevant asset in respect of which the compensation has been received, it is often appropriate to adopt a 'look-through' approach to the transaction which generates the compensation receipt.

The 'look-through' approach is defined in paragraph 3 of TR 95/35 as follows:

The 'look-through' approach is the process of identifying the most relevant asset. It requires an analysis of all of the possible assets of the taxpayer in order to determine the asset to which the compensation amount is most directly related. It is also referred to in this Ruling as the underlying asset approach.

Before it was withdrawn, draft Taxation Ruling TR 2007/D10 dealt with the CGT treatment of amounts received under earnout arrangements. It was withdrawn because legislation was introduced to specifically deal with such arrangements. However, the principles that it set out provides useful guidance for the circumstances currently being considered. It stated:

A further application of the general principle set out in TR 95/35 is the 'continuum of events approach' adopted by the Commissioner in Taxation Ruling TR 1999/19. In effect, this approach provides that it is only possible to relate capital proceeds to a CGT event happening to an underlying asset when they are received in the course of the same 'continuum of events' as that CGT event.

TR 2007/D10 concluded that amounts received under earnout arrangements were not capital proceeds from the sale of the original asset because:

An earnout arrangement is not merely a mechanism by which the parties agree to set an appropriate amount of compensation for the assets delivered in the contract. The deferred payments are not, as a matter of substance, made in respect of the acquisition of those assets. They are paid in respect of a separate obligation under which the seller stands to make a financial gain depending on the economic performance of an asset which the seller has ceased to own.

That is, TR 2007/D10 concluded that the 'underlying asset' and 'continuum of events' approaches were not applicable to an amount received under an earnout arrangement because the parties have entered into a financial arrangement that is independent of the sale transaction due to the amount receivable being dependent on the performance of the asset after the sale.

The Sale Contract stipulates that you will be solely entitled to the (A), (B) and (C) compensation amounts.

This may not have been strictly necessary for (A) as the seller is entitled to this compensation for the reduction in sale proceeds on the sale of the land because of the Public Acquisition Overlay. The fact that the seller is entitled to (A) from a third party clearly distinguishes it from an earnout arrangement.

Applying the 'look-through' approach, the most relevant asset to which (A) directly relates is the Property. Also, (A) is only payable to the seller once they have suffered a financial loss, being the reduced sale proceeds on a sale, so it is clear that (A) will be received in the course of the same 'continuum of events' as the sale of the Property.

Consequently, (A) will be additional capital proceeds for the sale of the Beveridge Property.

Under the Sale Contract, you and the Purchaser have agreed that you will receive the (B) and (C) compensation amounts and this was taken into account in determining the sale price.

The amounts of (B) and (C) are not dependent on the performance of the asset after the sale so these payments can be distinguished from an earnout arrangement.

Applying the 'look-through' approach, the most relevant asset to which (B) and (C) directly relate is the Property. Also, as it is clear that you accepted a lower sale price because the Purchaser agreed that you were to receive (B) and (C), we consider that these amounts will be received in the course of the same 'continuum of events' as the sale of the Property. This is the case whether these amounts are received before or after settlement of the sale of the property.

Consequently, (B) and (C) will also be additional capital proceeds for the sale of the Property.

As you are entitled to the small business 15-year exemption in relation to the sale of the Property, this exemption will apply to the (A), (B) and (C) compensation amounts.