Edited version of private advice

Authorisation Number: 1051804799925

Date of advice: 15 February 2021

Ruling

Subject: Small business capital gains tax concessions - active asset

Question

Does the farming land held by the Trustee qualify as an active asset for the purposes of the Small Business Capital Gains Tax concessions?

Answer

Yes.

This ruling applies for the following period

1 July 20XX to 30 June 20XX

The scheme commenced on

17 April 20XX

Relevant facts and circumstances

19XX Farming Land was purchased in joint names.

Primary production farming operation was run on the Farming Land by a partnership. Rent for use of the Farming Land was paid to the joint owners.

In 20XX one of the owners died. The other owner inherited other half share in the Farming Land under a will therefore owning 100% ownership of the Farming Land.

Between 20XX and 20XX the farming operation was run in partnership between a related company and the surviving owner of the Farming Land. Rent for the use of the land was paid to the surviving owner.

In 20XX the owner died.

From 20XX onwards the farming operation was run in partnership between a related entity and a new partner related to the owners of the Farming Land. Rent was paid to the estate of deceased Farm Land owner.

In 20XX the Farming Land was sold by the Estate. The farming operation continues to operate by the partnership on the Farming Land.

Throughout the history of the farming operations, the related company has held a 75% interest in all farming partnerships and the other partner (which changed over time) a 25% interest.

Prior to the death of the Farm Land owner in 20XX this person was the majority shareholder in the company. Following the death of the Farm Land owner, shares in the company are held by the Estate. The Estate is the majority shareholder in the company.

Net assets of the Estate exceed $XXX.

Turnover of the partnership for the year ended 30^th June 20XX was approximately $XX.

The company has no business turnover other than the interest in the partnership.

Turnover of the Estate for the year ended 30^th June 20XX was $XX being rent received for use of the Farming Land.

The Estate is not in any partnership with any entity.

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(1AA)

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

Reasons for decision

Detailed Reasoning

Summary

The condition in subsection 152-10(1A)(a) the Income Tax Assessment Act 1997 (ITAA 1997) is satisfied such that a connected entity of the taxpayer is a CGT small business entity in the income year ended 30 June 2020.

The interest in the Farming Land acquired in 2004 satisfies the active asset test in section 152-35 ITAA 1997 and is an active asset for the purposes of section 152-40.

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 for relief are contained in section 152-10 of the ITAA 1997:

(a)    a CGT event happened 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 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)(c)(iv)

For 152-10(1)(d) 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.

Conditions in subsection 152-10(1A)

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)

To satisfy the condition in paragraph 152-10(1A)(a) it needs to be determined if an affiliate, or an entity that is connected with you is a CGT small business entity. This is considered below:

Affiliate, or an entity that is connected

Paragraph 152-10(1A)(a) requires us to determine whether you are connected with another entity. The rules for determining whether an entity is 'connected with' another entity is contained in section 328-125.

Affiliate

An affiliate is defined by section 328-130 of the ITAA 1997 as being an individual or company who acts or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the business affairs of that individual or company.

Importantly, subsection 328-130(2) of the ITAA 1997 provides that an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share. For example, a partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could reasonably be 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.

In your case, the farming operation was carried on by continuing partners acts in accordance with the Estate who is also the majority shareholder in a private company that is the controlling partner in the partnership. The current partnership continues to run the farming operation.

Therefore, they act in accordance with the directions in relation to the business affairs of the Estate and are considered your affiliates for the purposes of the small business entity test.

An entity 'connected with' you

Subsection 328-125(1) of the ITAA 1997 provides that an entity is "connected with" another entity if, either entity controls the other entity, or both entities are controlled by the same third entity.

Paragraph 328-125(2)(b) of the ITAA 1997 provides that in the case of a company, an entity will be 'connected with' the company if the first entity, its affiliates, or the first entity together with its affiliates: beneficially own, or have the right to acquire the beneficial ownership of, equity interests in the company that carry between them the right to exercise, or control the exercise of at least 40% of the voting power in the company.

You have stated that the Estate is connected to the partnership for the purposes of section 328-125. The Estate is the majority shareholder of the 75% interest partner with the other partner 25% interest in farming operations. As the Estate has the controls the partnership through the majority ownership of the shares in the entity that is the controlling partner. Accordingly, the partnership and company that is the controlling partner of the farming operation are considered entities that are 'connected with' you for the purposes of the small business entity test.

CGT small business entity

The term 'small business entity' is defined in section 328-110.

Subsection 328-110(1) of the ITAA 1997 provides that you are a small business entity for an income 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 before the current year and your aggregated turnover for the previous year was less than $10 million;

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

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 for the relevant year and/or the previous year.

Section 328-115 of the ITAA 1997 explains that your aggregated turnover is your annual turnover plus the annual turnovers of any business entities that are your affiliates or that are 'connected with' you. The definition of aggregated turnover is contained in subsection 328-155 of the ITAA 1997 as the sum of the relevant annual turnovers. The relevant annual turnovers are outlined in subsection 328-155(2) and excludes any amounts covered by subsection 328-155(3).

Annual Turnover

The meaning of 'annual turnover' is provided in section 328-120 of the ITAA 1997. Subsection 328-120(1) states:

An entity's annual turnover for an income year is the total *ordinary income that the entity *derives in the income year in the ordinary course of carrying on a *business.

The term 'ordinary income' is defined in section 6-5 of the ITAA 1997 as income according to ordinary concepts.

An entity's annual turnover therefore includes all income according to ordinary concepts derived in the ordinary course of carrying on a business.

'In the ordinary course of carrying on a business' is not defined in ITAA 1997. The term therefore takes its ordinary meaning.

In Doutch v FC of T [2016] FCAFC 166, which was an appeal against the decision of the AAT in respect of small business entity concessions, the Full Federal Court confirmed the following reasoning provided by the Tribunal:

70 The phrase "in the ordinary course of carrying on a business", as it appears in s 328-120(1) of the ITAA 1997, is not defined in the ITAA 1997 and it is necessary to construe those words. In engaging in the exercise of statutory construction, the Court is to consider the text of the statute in context. The High Court in Commissioner of Taxation v Consolidated Media Holdings Ltd (2012) 250 CLR 503 observed as follows at [39]:

"This Court has stated on many occasions that the task of statutory construction must begin with a consideration of the [statutory] text" [Alcan (NT) Alumina Pty Ltd v Commissioner of Territory Revenue [2009] HCA 41; (2009) 239 CLR 27 at 46 [47]]. So must the task of statutory construction end. The statutory text must be considered in its context. That context includes legislative history and extrinsic materials. Understanding context has utility if, and in so far as, it assists in fixing the meaning of the statutory text. Legislative history and extrinsic materials cannot displace the meaning of the statutory text. Nor is their examination an end in itself.

71 The extrinsic materials to which the High Court referred includes an explanatory memorandum.

72 The definition of "annual turnover" in s 328-120(1) of the ITAA 1997 was inserted into the ITAA 1997 by Tax Laws Amendment (Small Business) Act 2007 (TLASBA 2007). The "Explanatory Memorandum" to the Tax Laws Amendment (Small Business) Bill 2007 (EM), which Bill was ultimately enacted as the TSLABA 2007, commencing from the 2008 income year, states:

What does 'in the ordinary course of carrying on a business' mean?

2.15 In general, income is derived in the ordinary course of carrying on a business if the income is of a kind that is regularly or customarily derived by the entity in the course of carrying on its business, arising out of no special circumstance or event. Similarly, the income is derived in the ordinary course of carrying on a business if the income although not regularly derived, is a direct result of the normal activities of the business.

Thus, according to the EM, income is derived in the ordinary course of carrying on a business where:

(e)  the income is of a kind that is regularly or customarily derived by an entity in the course of carrying on its business, arising out of no special circumstance or unusual event; and

(f)    the income, although not regularly derived, is derived as a direct result of the normal activities of the business.

Aggregate Turnover

The aggregated turnover of the partnership and other relevant entities (i.e. the Estate and associated affiliated companies) must be below $2 million as per subsection 152-10(1AA) to satisfy the definition of a CGT small business entity.

For the year ended 30 June 2020, the aggregated turnover of the Estate and affiliates satisfies subsection 152-10(1AA).

Small Business CGT Concessions

Maximum net asset value test

As per section 152-15 of the ITAA 1997, the maximum net asset value test is satisfied if, just before the CGT event the sum of the following does not exceed $6m:

•         The net market value of your CGT assets

•         The net market value of CGT assets of an entity connected with you; and

•         The net market value of CGT assets of an entity that is a CGT affiliate of yours that are used in carrying on a business with you or another entity connected with you.

In your case, your net assets exceed $XXX.

Active asset test

The active asset test is contained in section 152-35 of the Income Tax Assessment Act 1997 (ITAA 1997) and is satisfied if:

•         you have owned the asset for XX 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 XX 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;

•         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).

Section 152-40 of the ITAA 1997 provides that a CGT asset is an active asset if it is owned by you and is used or held ready for use in a business carried on (whether alone or in partnership) by you, your affiliate, your spouse or child, or an entity connected with you.

However, paragraph 152-40(4)(e) of the ITAA 1997 provides that an asset whose main use is to derive rent cannot be an active asset. Paragraph 152-40(4A)(b) of the ITAA 1997 provides that to determine the main use of an asset, treat any use by your affiliate, or an entity that is connected with you, as your use. Personal use of the asset by you or your affiliate is ignored in determining its main use.

An active asset must be used or ready for use in a business you, an affiliate or a connected entity carry on. If you are involved in a farming business, the farm will be classed as an active asset.

You acquired half of the Farming Land prior to 20 September 1985 when capital gains tax was introduced and as a pre-CGT asset is exempt from capital gain tax. You acquired the other half of the Farming Land through inheritance via a will, after the owner died on 10 December 20XX. You are taken to have acquired that half of the property for the purposes of the capital gains tax provisions at the date of death for the market value of the property at that time.

As you have owned that interest in the property for more than XX years, the property will need to have been active for at least 7.5 years during this period.

A CGT asset is an active asset if it is owned by you and is used or held ready for use in a business carried on (whether alone or in partnership) by you, your affiliate, your spouse or child, or an entity connected with you.

Farming operations XXX were initially run on the Farming Land by a partnership between an affiliated company and your spouse. After the death of your spouse, a new partnership between the company and your child ensued. Rent for the land was paid to you. Upon your death, a partnership between the company and your child formed. It follows that the land was an active asset as it was used in a business carried on by the partnership which was controlled by an affiliated company which was majority owned by the deceased and now the Estate.

The land has been an active asset for more than XX years of the period that you owned it and will pass the active asset test under section 152-35 of the ITAA 1997.

Conclusion

The interest in the Farming Land that the deceased inherited is an active asset for the purposes of 152-35 of the ITAA 1997. You have also satisfied other basic conditions of the small business concessions set out in section 152-10 of the ITAA 1997 as the requirements of section 152-10(1A) are met, in that your affiliate, the partnership is a CGT small business entity.