Edited version of private advice

Authorisation Number: 1051779145362

Date of advice: 18 November 2020

Ruling

Subject: CGT - small business concessions - basic conditions

Question

Do you satisfy the basic conditions to apply the small business capital gains tax (CGT) concessions?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You and your spouse jointly acquired Property A on XX/XX/20XX.

Company 1 Pty Ltd (Company 1) was incorporated on XX/XX/20XX with you and your spouse as equal shareholders, holding XX ordinary shares each.

Company 1 ran a business in Location 1 from incorporation until XX/XX/20XX, at which time existing stock was transferred to Company 2 Pty Ltd (Company 2). You and your spouse are equal shareholders of Company 2.

Property A was used by Company 1 in their business from acquisition until XX/XX/20XX, at which time business ceased.

Company 1 was deregistered on XX/XX/20XX.

You derived rent from Company 1 for the period in which Property A was used in Company 1's business.

After Company 1 ceased trading, Property A was leased to a third party until its sale.

The Property was sold on XX/XX/20XX, with settlement occurring on XX/XX/20XX, which resulted in a capital gain.

You and your spouse jointly held X properties (including Property A) holding equal interests in each property.

The total Net Market Value of the X properties as at XX/XX/20XX, was more than $XXX.

The total gross rental income for the X properties in the 20XX income year was less than $XXX.

Most of the properties have been leased out on periodic leases of at least X months duration.

You manage the properties personally, collecting rents, engaging tradespeople for repairs and maintenance and arranging for cleaning of the properties when required.

You use real estate agents intermittently to assist in the collection of rental income and tenant management. You advertise through rental agencies as well as through advertisements you place yourself.

You do not provide any additional services in relation to any of the X properties.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-15

Income Tax Assessment Act 1997 section 152-20

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

All the legislative references that follow are to the Income Tax Assessment Act 1997 unless indicated otherwise.

Summary

You disposed of Property A triggering CGT event A1, which resulted in a capital gain. You satisfy the active asset test; however, you were not a CGT small business entity in the income year of the CGT event nor do you satisfy the maximum net asset value test. Therefore, you do not meet the conditions to apply the small business CGT concessions to the sale of Property A.

Detailed reasoning

To qualify for the CGT small business concessions, you must satisfy several conditions that are common to all the concessions.

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 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 in section 152-15

(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 asset of the partnership or

(iv)          you do not carry on a business, but your CGT asset is used in a business carried on by a small business entity that is your affiliate or an entity connected with you.

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

To be eligible to apply the small business CGT concessions you must satisfy all four of the basic conditions above.

You disposed of Property A (CGT event A1) which resulted in a capital gain; therefore, the first two basic conditions are met. To satisfy the basic conditions you must meet the remaining two basic conditions.

CGT Small Business Entity

Subsection 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.

Subsection 328-110(1) states:

You are a small business entity for an income year (the current 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; and

(ii)   your aggregated turnover for the current year is likely to be less than $10 million.

Both you and your spouse are shareholders in Company 2, which does carry on a business; however, the company is a separate legal entity and the fact that it carries on a business does not mean that you carry on that business.

It is therefore necessary to consider whether you and your spouse were carrying on a business of letting properties in the year of the CGT event.

Taxation Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? (TR 97/11) provides the Commissioner's view of the factors used to determine if a taxpayer is in business for tax purposes. Its principles are not restricted to questions of whether a primary production business is being carried on.

In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

•         whether the activity has a significant commercial purpose or character

•         whether the taxpayer has more than just an intention to engage in business

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

•         whether there is regularity and repetition of the activity

•         whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

•         whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

•         the size, scale and permanency of the activity, and

•         whether the activity is better described as a hobby, a form of recreation or sporting activity.

Taxation Ruling TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' (Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884).

However, the weighting to be given to each indicator may vary from case to case. Also, a factor or factors may not be relevant for a particular case, for example, whether an activity would be better described as a hobby, sport or recreational activity is not relevant in the present case.

Whether the letting of property activities amount to the carrying on of a business will depend on the circumstances of each case. A person, who simply owns an investment property or several investment properties, either alone or with other co-owners, is usually regarded as an investor who is not carrying on a rental property business. This is because of the limited scope of the rental property activities and the limited degree to which an owner actively participates in rental property activities. A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations.

In Cripps v. FC of T 99 ATC 2428; (1999) 43 ATR 1202, the taxpayer and his wife purchased, as joint tenants, 14 townhouses which they rented out. They also purchased a property which was used initially as a holiday home but was later periodically rented out. A further property was purchased for residential purposes. After a failed attempt to sell it, it was also rented out. The Administrative Appeals Tribunal found that the taxpayer and his wife were mere passive investors and were not in the business of deriving income from rental properties. They rejected the taxpayer's argument that he had greater involvement with his 16 properties.

In 11 CTBR (OS) Case 24, the taxpayer's income included rents from three properties. The taxpayer employed a manager and an accountant - he was principally a letting clerk with authority to refuse tenants. He collected and banked rents, attended to repairs and supervised them, and controlled the caretaker and cleaners. He kept books in connection with rents and repairs, and rates and other outgoings. The taxpayer said he personally carried out the principal part of the management of his rent-producing properties and directed policy, attended to the financial arrangements and made decisions regarding repairs. The taxpayer claimed that he was carrying on a business. In holding that he was not carrying on a business, a majority of the members of the Board of Review said:

It is obvious that some measure of supervision and management must ordinarily be exercised by a property owner who lets offices... and if that does not amount to the carrying on of a business, the fact that he employs others to assist him, either in the letting of the properties or in the preparation of the accounts relating to his rents and outgoings, will not make any difference. For the foregoing reasons we are unable to uphold the claim that the taxpayer is engaged in a 'business as property owner'.

On the other hand, Case G10 75 ATC 33 (Case G10), the taxpayer owned two properties of which six units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a seven day a week activity. The Board of Review held that the activity constituted the carrying on of a business. In reaching that conclusion, the Board found:

It was clearly established in evidence that the money received by the taxpayer from the occupants of the flats was not solely a payment for the right to rent a flat for a certain period.

In your case, you and your spouse owned X rental properties from which you derived rental income, which is not considered to be large scale. Also, most of the properties were usually leased out for periods of six months or more, with advertising and tenanting activity being carried out when required.

You conducted occasional management activities and performed maintenance as required by tenants.

You did not provide additional services to your tenants outside of those required from a property owner renting out their properties.

After weighing up the relative business indicators and the facts provided, it is the Commissioner's view that you and your spouse's rental property activities are better described as letting residential properties to receive a stream of rental income. The income is not derived from the services you provide, but from the letting of the properties. Therefore, it is the Commissioner's view that you and your spouse have not been carrying on a business of letting properties.

Consequently, you and your spouse were not a CGT small business entity in the year of the CGT event.

Maximum Net Asset Value Test

To determine whether you pass the third basic condition in paragraph 152-10(1)(c) it has to be determined if you pass the maximum net asset value (MNAV) test.

Section 152-15 states:

You satisfy the maximum net asset value test if, just before the *CGT event, the sum of the following amounts does not exceed $6,000,000:

(a)  the *net value of the CGT assets of yours;

(b)  the net value of the CGT assets of any entities *connected with you;

(c)   the net value of the CGT assets of any *affiliates of yours or entities connected with your affiliates (not counting any assets already counted under paragraph (b)).

Subsection 328-125(1) provides that an entity is connected with another entity if one of the entities controls the other entity, or if the two entities are controlled by the same third entity.

Paragraph 328-125(2)(a) contains a general direct control test which applies to all entities, except discretionary trusts, and is based on a 'control percentage' of at least 40% of any distribution of income or capital of the entity.

The term entity is defined in section 960-100 as including a partnership. The term partnership is defined in subsection 995-1(1) as:

(a) an association of persons (other than a company or limited partnership) carrying on business as partners or in receipt of ordinary income or statutory income jointly.

The first limb of paragraph (a) of the above definition of partnership refers to 'an association of persons (other than a company or limited partnership) carrying on business as partners'and therefore reflects the general law definition of partnership. The second limb of paragraph (a) which includes as a partnership entities which are in receipt of ordinary income or statutory income jointly refers to a tax law partnership.

It is the Commissioner's opinion that co-owners who receive rental income jointly from a rental property they own, would fall within the second limb of paragraph (a) and therefore be a tax law partnership.

In your case, you and your spouse were co-owners in X rental properties (including Property A that was sold), each holding a 50% interest. You jointly received ordinary income from these properties and therefore fall within the second limb of paragraph (a) and are considered to be a tax law partnership.

As you have a more than 40% control percentage in the tax law partnership, you will be required to include the entire net market value of the jointly held properties in your individual MNAV calculation.

You contend that the sale proceeds from the sale of Property A exceeded the actual market value due to an anxious buyer and that the property should therefore have a market value of approximately $X million which was the value provided by an experienced valuer at the time. However, you have provided no evidence to support your contention.

The Commissioner generally considers the sale price of an asset to be its market value. In each particular case, however, all the relevant facts and circumstances are taken into account to determine the most appropriate methodology for calculating market value. To suggest a different market value will require a justification for looking beyond the evidence of the value suggested by the transaction (Miley v. FCT [2019] AATA 5540). The Commissioner does not consider, in the absence of any further evidence, that a different market value should be assigned to Property A. The Commissioner considers that the market value of Property A was its sale price.

As the net market value of these X jointly held properties was more than $XXX dollars, you do not satisfy the MNAV test.

Active asset test

The final basic condition is for the CGT asset to satisfy the active asset test in section 152-35.

The combined effect of sections 152-35 and 152-40 is that the asset will meet the active asset test if the asset was used, or held ready for use, in the course of carrying on a business by a connected entity or affiliate for at least half of the time period it was owned.

You owned Property A for approximately XX years and it was used in the business of an entity that was connected with you (Company 1) for more than half the period of your ownership. Therefore, Property A will satisfy the active asset test.

Conclusion

You disposed of Property A triggering CGT event A1, which resulted in a capital gain. You satisfy the active asset test; however, you were not a CGT small business entity in the 20XX-XX income year nor do you do not satisfy the MNAV test. Therefore, you do not meet the conditions to apply the small business CGT concessions to the sale of Property A.