Edited version of private advice

Authorisation Number: 1051857946627

Date of advice: 30 June 2021

Ruling

Subject: CGT - small business entity

Question

Should interest of $A derived by Company X on a term deposit during the 20XX income year be included in the calculation of its annual turnover for that year pursuant to subsection 328-120(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Relevant facts and circumstances

Company X is an Australian proprietary company which was registered in 20XX.

Of the 100 shares issued in Company X, 96 are owned by Person A and two each are owned by Person B and Person C.

Person A made an interest free loan to Company X of approximately $Ymillion during the 20XX income year. Company X placed this sum on term deposit with a bank during the same year.

As at 30 June 20XX, Company X continued to hold $Zmillion in the bank term deposit. As a consequence, Company X derived interest income in each of the 20XX, 20XX and 20XX income years. The amount of interest derived by Company X from the term deposit in the 20XX and 20XX income years respectively was $B and $A.

Company X derived no income during the 20XX and 20XX income years, other than interest.

Company X acquired property during the 20XX income year which, as at 30 June 20XX, was valued at approximately $Tmillion. That property was acquired by Company X for investment purposes, from which it derives rental income.

Gross rent received by Company X from this property during the 20XX income year was $C.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 Division 328

Income Tax Assessment Act 1997 subsection 328-110(1)

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 subsection 328-115(2)

Income Tax Assessment Act 1997 subsection 328-120(1)

Income Tax Assessment Act 1997 subsection 328-120(4)

Reasons for decision

Question

Summary

The interest amount of $A derived by Company X from its term deposit during the 20XX income year is included in the calculation of its annual turnover for that year pursuant to subsection 328-120(1) of the ITAA 1997[1].

Detailed reasoning

Division 328 provides for the meaning of a small business entity relevant for an entity to access various tax concessions available in the tax legislation. In determining whether an entity meets the criteria necessary to satisfy the definition of a small business entity, subsection 328-110(1) provides that consideration of the entity's aggregated turnover is required.

The meaning of the term 'aggregated turnover' is provided in section 328-115, which broadly is the sum of the relevant annual turnovers.[2]

Subsection 328-120(1) provides for the meaning of 'annual turnover':

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.

Consequently, in order to establish whether an entity is a small business entity it is necessary to consider what constitutes the entity's ordinary income such that its annual turnover for the relevant income year can be established.

Typically, the receipt of interest is income according to ordinary concepts (ordinary income) assessable under section 6-5. An entity's annual turnover for an income year therefore includes interest derived by the entity in the income year in the ordinary course of carrying on a business.

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

The definition of 'annual turnover' in subsection 328-120(1) 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 was ultimately enacted as the TSLABA 2007, provided the following commentary regarding the phrase 'in the ordinary course of carrying on a business':

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.

2.16 Ordinary income may be derived in the ordinary course of carrying on a business even if it is not the main type of ordinary income derived by the entity. Similarly, the income does not need to account for a significant part of the entity's overall receipts. It is sufficient that the ordinary income is of a kind derived regularly or customarily in the carrying on of a business.

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

(a)       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; or

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

While the type of ordinary income that is regularly or customarily derived in the course of carrying on a business will depend on the specific nature of the business itself, income from regular or customary activities in carrying on a business typically includes income from regular and repetitive business activities, such as selling trading stock or providing services. It can also include income from activities that are ancillary to the business, such as interest income on operating cash held at the bank (as it is expected that a business earns some interest income).

Generally, ordinary income derived in the ordinary course of carrying on a business does not include income from extraordinary activities, such as selling income producing assets.

Taxation Ruling TR 2019/1[3], at paragraph 19, refers to the presumption that companies are typically formed for the purpose of carrying on a business. In both Inland Revenue Commissioners v Westleigh Estates Co Ltd [1924] 1 KB 390 (Westleigh) and American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue [1979] AC 676; [1978] 3 WLR 985; [1978] 3 All ER 1185; [1979] 1 AC 676 (American Leaf),it was observed that where a company aims to make and has a prospect of profit, it is presumed that it intends to, and does in fact, carry on a business. In American Leaf,Diplock LJ further observed that this means any gainful use to which a company puts its assets will, on its face, amount to the carrying on of a business.

On the basis of the observations made in both Westleigh and American Leaf, the Commissioner is satisfied that Company X carries on a business and has done so since the 20XX income year when, having first deposited funds into the bank term deposit, it gainfully used an asset to make a profit.

A consideration of the relevant indicia considered by the courts in determining whether activities carried on by an entity amount to the carrying on of a business (as listed in paragraph 21 of TR 2019/1) would not rebut this presumption in the case of Company X.

The Commissioner is also satisfied that the interest derived by Company X from its bank term deposit during the 20XX income year, constituting ordinary income, was derived in that year in the ordinary course of carrying on a business. This is because:

•         since the year of Company X's incorporation (20XX), the interest has been income that has been customarily derived by it in the course of carrying on its business and, as such, has not arisen out of a special circumstance or unusual event;

•         having derived interest on a term deposit in each income year since its incorporation in 20XX, and no other form of income until the 20XX income year, the investment of funds in a term deposit, from which the interest is derived, is considered to be a normal and sustained course of activity of Company X's business; and

•         even if, in the 20XX income year, the investment in a term deposit was considered to be an activity ancillary to a business of property investment - a factor which may not be conceded given the interest income accounted for a significant part (approximately 72%) of Company X's overall receipts for the year - it was nevertheless derived by Company X in the ordinary course of carrying on a business.

Application of subsection 328-120(4)

Subsection 328-120(4) contains an adjustment to the annual turnover calculation to ensure that income derived from non-arm's length transactions is properly accounted for when determining an entity's annual turnover. It reads:

In working out an entity's *annual turnover for an income year, the amount of *ordinary income the entity *derives from any dealing with an *associate of the entity is the amount of ordinary income the entity would derive from the dealing if it were at *arm's length.

The ordinary income derived on the term deposit by Company X during the 20XX income year was derived as a consequence of a dealing between Company X and a bank. As the bank is not an associate of Company X's, subsection 328-120(4) has no application.

[1] All legislative references are to the ITAA 1997.

[2] The 'relevant annual turnovers' are listed in subsection 328-115(2).

[3] Income Tax: when does a company carry on a business?