Edited version of private advice

Authorisation Number: 1051870766785

Date of advice: 3 August 2021

Ruling

Subject: CGT - active asset test

Question 1

Is the whole property (the property) regarded as an active asset under subdivision 152-A of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the back office on the property regarded as an active asset under subdivision 152-A of the ITAA 1997?

Answer

No.

Question 3

Is entity A entitled to the small business 15-year exemption for the back office or any part of the property?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20XX

The scheme commenced on

1 July 20XX

Relevant facts

On xxxx, entity A acquired a property (the property) for approximately $xxxx.

The property contains a single storey split level house at the front and a separate office located at the rear of the property.

On xxxx, the house became the main residence of entity B and entity C and continued to be their main residence until the disposal in the xxxx income year.

Entity B and C did not pay rent to entity A after entity A acquired the property.

From xxxx, the office was leased to entity D for use as its principal office.

The office is xxxx square metres. The total size of the property is xxxx square metres.

Entity D carries on a business. All report writing and other work is undertaken by entity B from the company's principal office located at the rear of the property. Entity B has been actively involved in the business since it commenced. Entity E is an employee.

Entity D occupies 100% of the room in the back office and uses the office for approximately xx hrs per week.

Clients rarely attend the back office. No business signage is on the property.

The company does not visit customers on their premises.

Entity B is xx years old.

Entity B and C have been equal shareholders and directors of entity D since xxxx.

Entity B and C are also the primary beneficiaries of entity A as well as equal shareholders and directors of its trustee company.

Entity B is also the sole appointor of entity A.

Entity B and C have equally received any income and/or capital distributions from entity A since it was established on xxxx.

The income to be distributed by entity A will be distributed xx% to entity B and the remaining xx% to entity C and if capital was also distributed in an income year, this was distributed equally between the individuals.

Since xxxx, each of entity B and C were in receipt of at least xx% of income and xx% of capital if capital was also distributed from entity A.

The property is currently worth approximately $xxxx and the sale proceeds will help fund entity B and C's retirement.

The property was sold in the 2020-21 income year.

The net value of the Trust, measured at market value, when aggregated with the net asset value, also measured at market value, of any entities connected with or affiliates of the Trust is less than $6 million just before the property sale.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 Section 152-10

Income Tax Assessment Act 1997 Section 152-35

Income Tax Assessment Act 1997 Section 152-40

Income Tax Assessment Act 1997 Subdivision 152-B

Detailed reasoning

The capital gains tax (CGT) provisions provide some small business relief in Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997).

Basic conditions

To qualify for the small business CGT concessions, the basic conditions as contained in subdivision 152-A of the ITAA 1997 must be satisfied.

The basic conditions for relief in section 152-10 of the ITAA 1997 are:

•         A CGT event happens in relation to a CGT asset of yours in an income year,

•         The event would have resulted in a gain (apart from Division 152),

•         The CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997, and

•         At least one of the following applies;

-       you are a small business entity for the income year,

-       you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997,

-       you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an interest in an asset of the partnership, or

-       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.

Active asset test

As outlined in subdivision 152-A of the ITAA 1997, the CGT asset must satisfy the active asset test.

Under subsection 152-35(1) of the ITAA 1997, a CGT asset will satisfy the active asset test if:

(a)  you have owned the asset for 15 years or less and the asset was an active asset of yours for a total of at least half of the test period, or

(b)  you have owned the asset for more than 15 years and the asset was an active asset of yours for a total of at least 7½ years during the test period.

Subsection 152-40(1) of the ITAA 1997 provides that a CGT asset is an active asset at a time if it is used, or held ready for use, in the course of carrying on a business that is carried on by you, or your affiliate, or another entity that is connected with you.

Subsection 152-40(4) of the ITAA 1997 lists CGT assets that cannot be active assets. Under paragraph 152-40(4)(e) of the ITAA 1997, an asset whose main use is to derive rent cannot be an active asset unless the main use for deriving rent was only temporary.

As stated in subsection 152-40(4A) of the ITAA 1997, for the purposes of paragraph 152-40(4)(e) of the ITAA 1997, in determining the main use of an asset:

(a)  disregard any personal use or enjoyment of the asset by you; and

(b)  treat any use by your affiliate, or an entity that is connected with you, as your use.

In determining if a property is an active asset it is necessary to determine whether, as a whole, it can be considered to be used in carrying on a business.

It is acknowledged that the definition of active asset does not require exclusive use of the asset for business purposes. However, in Rus v FC of T 2018 ATC 10-478 (Rus case), where only a small portion of land was used in carrying on a business the land was held not to be an active asset.

In the Rus case, the taxpayer and her husband purchased a 16 hectare property in June 1987. A small part of the land (1.6 hectares) contained two houses and a shed. One house was the couple's main residence while the other was the main residence of the couple's two adult children (who did not pay rent).

From the property the couple carried on a plastering/housing construction business, which was a small business entity in the 2015/16 income year and expected to remain so in the 2016/17 year. Only the shed and a home office in the couple's main residence was used in the running of the business. The home office was manned by two full-time staff, however, the majority of the business activities were conducted off site.

Even after review, it was still found that the property was not regarded as an active asset under section 152-40 of the ITAA 1997. That is, the whole of the land was not an active asset when only a very small part of it had been used in carrying on a business.

Subsection 152-40(1) of the ITAA 1997 requires the asset to be used "in the course of carrying on a business". That phrase was discussed at length in the Full Federal Court decision of Eichmann v FC of T 2020 ATC 20-762; [2020] FCAFC 155 (Eichmann's case) and in the proceedings that had led up to that decision. In Eichmann's case, the taxpayer, who carried on a business of building, bricklaying and paving, purchased land next door to his family home and used it to store work tools, equipment and materials. The land had sheds, high walls and a gate to secure the property. Work vehicles and trailers were parked on the property, and tools and items were collected from there on a daily basis. The full court held that the secure storage of the tools and materials of the taxpayer's business on a daily basis was very much part of the course of the carrying on of that business. In so holding, the court unanimously overturned the decision of Derrington J (2019 ATC 20-728; [2019] FCA 2155) and the view that, in order for an asset to be used "in" the course of carrying on a business, it was necessary for the use to have a direct functional relevance to the carrying on of the normal day-to-day activities of the business that were directed to the gaining or production of assessable income. As highlighted in Eichmann's case, subsection 152-40(1) of the ITAA 1997 requires the asset to be used "in the course of carrying on a business," encompassing, necessarily, a fairly wide range of activities.

In Eichmann's case, the Applicant did not hold any part of the land for use as a main residence and his use of the land was not trivial or insignificant. Furthermore, no reference is made to any part of the land being used for other activities.

The CGT asset referred to in section 152-10 of the ITAA 1997 refers to the whole property. In determining whether a CGT asset has been 'used in the course of carrying on a business', the courts have stated that it must be established that the whole, or predominately the whole, of the asset has been so used (Rus case and Eichmann's case).

In entity A's case, the whole of the land is not used by the business as in Eichmann's case. It cannot be said that entity D carries on the business activities in relation to the xxxx square metres of land, which is the CGT asset. That is, the business activities did not operate on most of the property.

In Eichmann's case, the extent of the use of the land was far from minimal, or incidental to the carrying on of the business. This cannot be said in entity A's circumstances. A minimal part of the land used by entity D for its business activities is insufficient to establish that the property was used or held ready for use in the course of carrying on a business.

The principles of Eichmann's case cannot be applied to entity A's circumstances. Entity A's situation is more like that in the Rus case.

In entity A's case, a substantial and majority proportion by area of the land is used for private purposes as a main residence by entity B and C. Less than xx% of the property is used for entity D's business purposes.

The use of the small portion of the property for business purposes does not convert the whole property to being an active asset. That is, entity D cannot be said to be carrying on a business in relation to the CGT asset. Therefore, it cannot be said that the property is used in the course of carrying on a business.

As in the Rus case, the nature of the business did not call for any greater level of activity on the land other than the use of a very small proportion of it. Nor did the existence of the residence contribute to the conduct of the business activities of the company. The nature of entity A's CGT asset is a residential property, with its main use being a place of residence.

The active asset test does not apply to a part of an asset. That is, if the CGT asset, that is the whole property, is not an active asset, then no part of the CGT asset can be regarded as an active asset.

In entity A's circumstances, we do not consider that the whole property and parcel of land comprising the CGT asset was used in carrying on the business. Therefore, the back office is not regarded as an active asset under subdivision 152-A of the ITAA 1997.

As the active asset test is not satisfied, the basic conditions under subdivision 152-A of the ITAA 1997 are not met. Therefore, the small business 15- year exemption under subdivision 152-B of the ITAA 1997 or any other concession under Division 152 of the ITAA 1997 is not available to entity A on the sale of the property. It follows that no part of the capital gain can be disregarded under Division 152 of the ITAA 1997.