Edited version of private advice

Authorisation Number: 1051790473858

Date of advice: 15 December 2020

Ruling

Subject: Capital gains tax

Question 1

Does Capital Gains Tax (CGT) event B1 occur when Company Y began to conduct the business?

Answer

No

Question 2

Does CGT event A1 occur when contract of sale between Company X and Company Y is executed?

Answer

Yes

Question 3

Do earn out rights created under the contract of sale fall under the definition of 118-565 of the Income Tax Assessment Act 1997, to qualify for the look-through treatment?

Answer

Yes

Question 4

Is Company X a CGT small business entity in the 20XX income year?

Answer

Yes

Question 5

Where the earnout payments are not considered by the Commissioner to be look through earnout rights in Question 3 and the taxpayer is eligible to apply the 15 year exemption in Subdivision 152-B will the Commissioner allow an extension of time under subsection 152-125(4) to allow the company to make the payments required by paragraph 152-125(1)(b)?

Answer:

Not applicable -the earnout payments are look through earnout rights.

This ruling applies for the following periods:

Years ending 30 June 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Company X was formed in 19XX. The shareholders are Individual A and Individual B who each own more than 40% of the ordinary shares.

Both shareholders are over the age of 55.

Neither shareholder conducts a business in their own name.

Company X operates a business licencing software to customers in an industry and has been operating the business since 20XX.

Company X's turnover for the 20XX income year did not exceed $XXXX. In the 20XX income year the turnover was approximately $XXX,XXX.

Company X informally agreed to allow unrelated party, Company Y, to operate the business from XX February 20XX. Company Y conducted the business without input from Company X's directors and shareholders.

On XX June 20XX a contract of sale was executed between Company X and Company Y to sell Company X's business and assets for the following consideration:

•         XX% of the issued shares in Company Y; and

•         Earnout payments as shown in the table below:

Company X and Company Y agreed that if the average annual gross profit of the business for the two income years immediately preceding the date that any amount is due for payment is less than $XXXX, the amount of earnout payment may be reduced on a pro rata basis by Company Y.

Company Z

Individual A holds less than 40% of the ordinary shares in Company Z

The Shareholders' agreement for Company Z does not provide for Individual A's ownership interests to carry at least 40% of the voting power of Company Z.

Relevant legislative provisions

Section 104-15 of the Income Tax Assessment Act 1997

Section 104-10 of the Income Tax Assessment Act 1997

Subdivision 152A of the Income Tax Assessment Act 1997

Section 328-110 of the Income Tax Assessment Act 1997

Section 328-125 of the Income Tax Assessment Act 1997

Subsection 118-565(1) of the Income Tax Assessment Act 1997

Reasons for Decision

Disposal of business

In this case, a contract of sale was entered into on XX June 20XX to sell Company Y's business. Prior to the contract being executed, an informal agreement was arranged in February 20XX for the purchaser to begin business operations. For the disposal of the business, we have considered which is the most relevant CGT event to apply, CGT event A1 or CGT event B1?

CGT event B1 happens if you enter into an agreement with another entity under which:

•         the right to the use and enjoyment of a CGT asset you own passes to another entity; and

•         title in the asset will or may pass to the other entity at or before the end of the agreement: subsection 104-15(1) of the ITAA 1997.

Per ATO ID 2005/216 Income Tax Capital gains tax: CGT event B1: right to use property before title passes in order for CGT event B1 to happen the relevant agreement must be one under which title will or may pass at the end of a specific period or on the occurrence of a specific event. CGT event B1 will not happen if, under a loose family arrangement, title to an asset may pass at an unspecified time in the future.

In this case, an informal agreement to allow the transition of the business was implemented in February 20XX. The purchaser did not consequently have full use and enjoyment of the business under this arrangement. Therefore, CGT event B1 did not happen on the effective date.

CGT event A1 happens when there is a disposal of a CGT asset with the timing of the event being when the contract was entered into. CGT event A1 happened when the contract was entered into on XX June 20XX for the disposal of Company X's business/relevant assets.

Look through earn out rights

The sale of Company X's business to Company Y includes earn out rights. The application has requested a private ruling on whether they would be look through earn out rights under subsection 118-565(1) of the ITAA 1997.

Look through capital gains tax treatment for earn out rights applies to look through earn out rights

created on or after 24 April 2015. A right is a look through earn out right under subsection 118-

565(1) if all of the following are satisfied:

(a) the right is a right to future financial benefits that are not reasonably ascertainable at the time the right is created

(b) the right is created under an arrangement that involves a disposal of a CGT asset

(c) the disposal causes CGT event A1 to happen

(d) just before the CGT event, the CGT asset was an active asset of the entity who disposed of the asset

(e) all of the financial benefits that can be provided under the right are to be provided within a period ending no later than five years after the end of the income year in which the CGT event happens

(f) those financial benefits are contingent on the economic performance of the CGT asset or a business for which it is reasonably expected that the CGT asset will be an active asset for the period to which those financial benefits relate

(g) the value of those financial benefits reasonably relates to that economic performance, and

(h) the parties to the arrangement deal with each other at arm's length in making the arrangement.

In this case, the earn out right was created by arm's length after 24 April 2015 therefore look through treatment is applicable. The right was created from the contract of sale of Company X's business (CGT Event A1). The business being sold is an active asset. The earn out periods are within the required five year period and earn out amounts will be determined based on economic performance.

The earn out right satisfies all of the above requirements under subsection 118-565(1) to support look through capital gains treatment

Basic conditions for small business concessions

To qualify for any of the capital gains tax (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 of the ITAA 1997.

According to subsection 152-10(1) of the ITAA 1997:

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 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 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.

Your application has requested consideration of the basic condition, 'CGT small business entity for an income year'.

CGT small business entity

The definition of CGT small business entity is contained in subsection 152-10(1AA) of the ITAA 1997 and requires that the entity be a small business entity with aggregated turnover below $2 million. The definition of aggregate turnover is contained in subsection 328-155 of the ITAA 1997 as the sum of the relevant annual turnovers.

Carrying on a Business

It is accepted Company X operated a business licencing software in the year ended 30 June 20XX and is carrying on a business for the purposes of section 328-110 of the ITAA 1997.

Aggregate Turnover

The aggregated turnover of Company X and relevant entities must be below $2 million as per subsection 152-10(1AA) of the ITAA 1997 to satisfy the definition of a CGT small business entity.

For the year ended 30 June 20XX, you have provided that the aggregated turnover is less than $2 million.

Connected entity test

To demonstrate that entities are connected, you must be able to show that

a) Either entity controls the other entity in a way described in 328 -125(1) of the ITAA 1997; or

b) Both entities are controlled in a way described in this section by the same third entity.

Subsection 328-125(2) of the ITAA 1997 provides an entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates:

(a) except if the other entity is a discretionary trust - own, or have the right to acquire the ownership of, interests in the other entity that carry between them the right to receive a percentage (the control percentage) that is at least 40% of:

(i) any distribution of income by the other entity; or

(ii) if the other entity is a partnership - the net income of the partnership; or

(iii) any distribution of capital by the other entity; or View history reference

(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.

For the purpose of this ruling Individual A and B both with more than 40% ownership in Company X demonstrates they are connected, therefore we have considered whether other ownership interests they hold would also be connected to Company X, particularly, Company Z.

As Individual A holds less than 40% ownership interest in Company Z that test is not relevant. Additionally, the alternative test in subparagraph 328-125(2)(b) is not relevant to connect the entities because Individual A's ordinary shareholdings does not provide at least 40% of the voting power.

Therefore, it is accepted the aggregated turnover of Company X is as provided and below $2 million such that it is a CGT small business entity for the purpose of satisfying the basic conditions in the year ended 30 June 20XX.