Edited version of private advice

Authorisation Number: 1051911760454

Date of advice: 25 October 2021

Ruling

Subject: Proposed restructure of on-going small business

Question 1

Will the proposed transaction be part of a genuine restructure of an ongoing business for the purpose of paragraph 328-430(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Will the proposed transaction result in the ultimate economic ownership of assets being maintained for the purposes of paragraph 328-430(1)(c) of the ITAA 1997?

Answer

Yes

This ruling applies for the following period(s)

Year ending 30 June 20XX.

The scheme commences on

Date from when proposed transaction occurs.

Relevant facts and circumstances

A Pty Ltd (A) is an Australian resident private company, operating a business of accounting and taxation services.

A is a registered tax agent and a practice entity registered with Chartered Accountants Australia and New Zealand ("CAANZ").

A's shareholder details currently are as follows:

Each of the above-mentioned shareholders are discretionary trusts with companies acting as trustees. All trusts have made a family trust election (FTE) prior to the proposed transaction. Details of FTE's were provided with details of date lodged and specified individuals.

A's aggregated turnover for the 2021 income year was less than $10 million. The company's retained profits on 30 June 2021 were provided.

A's franking account balance on 30 June 20XB was $XX, XXX.

All relevant individuals and/or entities are Australian residents.

Proposed Transaction

A is proposing to restructure the business to a partnership (the Partnership).

This will involve the company transferring the business to the shareholders jointly, such that the shareholders commence operating the business in partnership.

The Partnership will not be a corporate limited partnership for the purposes of Division 5A of the Income Tax Assessment Act 1936 (ITAA 1936).

All key personnel and business assets will transfer to the Partnership. After the restructure has taken place, the Partnership will operate the business indefinitely. Each current shareholder will have a proportionate interest in the Partnership that is exactly the same as their current ownership interest in A.

You have advised that the restructure will proceed with the following steps:

•         A will firstly pay a dividend equal to 100% of its retained earnings (up to the date of the restructure) to its shareholders based on their relevant shareholding percentages. The dividend will be franked to the maximum extent possible based on the available franking credits in A's franking account; and

•         subsequently, the business assets will be transferred to the Partnership under the Subdivision 328-G of the ITAA 1997 roll-over; and A will be wound-up (deregistered) after all assets and liabilities had been dealt with.

Therefore, the following will occur:

• all pre-restructure retained profits will be paid to the existing shareholders as fully taxable dividends prior to the restructure, in exactly the same manner as they would if the business continued to operate through the company; and

•         the company's only remaining assets will be business assets, which will be transferred to the partnership for use in the ongoing conduct of the accountancy business.

None of the trust deeds of the five discretionary trusts will be amended (including in relation to the schedule of discretionary objects of each trust) in conjunction with the restructure.

The following reasons for the restructure were provided with the application:

Risk profile and change in nature of business

A company was chosen as the appropriate entity to operate the business due to the nature of the business being conducted at the time.

In prior income years, in addition to operating an accounting and taxation services business, A also was the holder of a limited Australian Financial Services License ("AFSL") and was a registered Self-Managed Superannuation Fund ("SMSF") auditor.

The changing landscape associated with these licenses and registrations, together with the spiralling costs, risks, and compliance burdens, led the directors to cancel the AFSL and SMSF auditor registrations with effect from 1 July 20XB. These roles are now outsourced to external professionals.

The outsourcing of the financial advice and auditing functions means that the business activities have been consolidated and simplified to accounting and taxation services from 1 July 20XB. This means that the risk profile associated with the A business has reduced substantially from 1 July 20XB.

The ownership group no longer feel that the additional asset protection (potentially) afforded by the corporate structure is necessary. The risk associated with the current business activities can be adequately dealt with by professional indemnity insurance, public liability insurance, strong internal quality assurance systems and the professional standards liability capping scheme provided by CAANZ.

The additional costs and administrative burden of the company structure now outweigh the benefits gained from the corporate structure.

Administrative aspects of admitting new partners

It is highly likely that new 'partners' will be admitted to the business in the coming years. These admissions will be in line with the budgeted expectations for growth in client numbers, revenue and improving the productivity levels within the business.

The ownership group considers a partnership to be a more appropriate structure for admitting new owners to the business. The practical and administrative aspects of admitting partners to a partnership is simpler and more flexible than admitting shareholders and directors to a company.

Financing the admission of new partners

A partnership structure provides more flexibility for financing the admission of new partners to the business. In most cases, incoming partners will be required to secure their own external finance when buying-in to the business.

However, in some cases, the ownership group may want to assist with funding the buy-in of someone who is otherwise unable to secure their own funding. Given the problems in recruiting and retaining talented staff, it is in the long-term interest of the business to be able to secure the admission of 'up-and-coming star performers' who may not have the financial resources to obtain funding from the bank to finance their entry to the business.

The existing company structure does not allow the business to assist a new partner with financing their buy-in. This is because:

• Part 2J.3 of the Corporations Act 2001 prohibits a company from providing financial assistance to someone to buy shares in itself; and

•         Loans from the company to a shareholder would be subject to the restrictive terms of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936).

In contrast, under a partnership structure, the business has complete flexibility in deciding whether to assist an incoming partner with their buy-in and, if so, the terms under which the finance will be provided.

A partnership structure provides more opportunities and flexibility in growing the business and securing key personnel in the long-term.

Inequities between ownership and risk

The nature of a corporate structure is such that the directors of the company are exposed to certain risks of the business. In contrast, the company's shareholders are generally not exposed to any risk.

For various reasons over time (some financial, some commercial, some simply legacy matters), there have been occasions where the company has had a smaller number of directors than shareholders. For example, the company may have had 5 shareholders but only 2 directors. This meant that certain participants (i.e., directors) were bearing a disproportionate level of risk, particularly where the financing for the business required director guarantees.

The ownership group have decided that they no longer want to have a 'tiered' ownership structure in the business, or even offer the possibility of a tiered ownership structure. It has been decided that, if a person wants to be an 'owner' of the business, they will be subject to both the risks and rewards of the business.

This is simplified under a partnership structure where all partners are jointly and severally liable for the risks associated with the business. Under a partnership structure, it will be no longer necessary to consider and negotiate the different levels of risk and involvement in the business (e.g., shareholder v director); in the partnership structure all equity participants will be equally committed to the business and liable for the business risks.

Administrative burden under the Corporations Act 2001

The Corporations Act 2001, as administered by the Australian Securities and Investments Commission ("ASIC"), imposes strict and inflexible obligations on corporations and their directors and shareholders.

The ownership group want to be able to enter into 'partnership' agreements that represent their intended business relationships and accurately reflect the commercial nature of their dealings, without the limitation of being bound by the Corporations Act 2001 and the terms of the relevant company constitution. This is not possible with a company but will be possible under a partnership structure.

By transitioning to a partnership structure, the business owners will no longer be bound by the strict and inflexible administrative burdens as imposed by the Corporations Act 2001 and ASIC. The administrative obligations will henceforth be determined by the Partnership agreement.

Compliance costs

The business will benefit from a small reduction in compliance costs by moving away from a company structure (e.g., annual ASIC fees, reduced administrative costs, etc.).

Additional information was provided in your email dated X XXXX 20XB. The enclosed information including details of FTE's lodged by the five discretionary trusts, form part of these facts.

Relevant legislative provisions

Corporations Act 2001 Part 2J.3

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Schedule 2F

Income Tax Assessment Act 1936 section 272-70 of Schedule 2F

Income Tax Assessment Act 1936 section 272-75 of Schedule 2F

Income Tax Assessment Act 1936 section 272-90 of Schedule 2F

Income Tax Assessment Act 1997 Subdivision 328-G

Income Tax Assessment Act 1997 section 328-430

Income Tax Assessment Act 1997 paragraph 328-430(1)(a)

Income Tax Assessment Act 1997 paragraph 328-430(1)(c)

Income Tax Assessment Act 1997 section 328-435

Income Tax Assessment Act 1997 section 328-440

Income Tax Assessment Act 1997 subparagraph 328-440(a)(i)

Income Tax Assessment Act 1997 subparagraph 328-440(a)(ii)

Income Tax Assessment Act 1997 paragraph 328-440(b)

Income Tax Assessment Act 1997 paragraph 328-440(c)

Reasons for decision

Note: All references in this Ruling are to the ITAA 1997 unless otherwise stated

Issue 1

Question 1

The proposed restructure is considered to be part of a genuine restructure of an ongoing business for the purposes of paragraph 328-430(1)(a) of the ITAA 1997.

Detailed reasoning

The meaning of 'genuine restructure of an on-going business' for the purposes of section 328-430 is explained in LCR 2016/3 Law Companion Rulings: Small Business Restructure Roll-over: genuine restructure of an ongoing business and related matters.

Paragraphs 4-11 of LCR 2016/3 states the following as what a genuine restructure is:

Genuine restructure

4. The SBRR can apply to transactions that are, or are part of, a 'genuine restructure of an ongoing business'.2

5. Whether a transaction is or is part of a 'genuine restructure of an ongoing business' is a question of fact that is determined having regard to all of the circumstances surrounding the restructure.

6. A 'genuine restructure of an ongoing business' is one that could be reasonably expected to deliver benefits to small business owners in respect of their efficient conduct of the business. It can encompass a restructure of the way in which business assets are held where that structure is likely to have been adopted had the business owners obtained appropriate professional advice when setting up the business. However, it is a composite phrase emphasising that the SBRR is not available to small business owners who are restructuring in the course of winding down or realising their ownership interests.

7. The following features indicate that a transaction is, or is part of, a 'genuine restructure of an ongoing business':

•         It is a bona fide commercial arrangement undertaken in a real and honest sense to

- facilitate growth, innovation and diversification

- adapt to changed conditions, or

- reduce administrative burdens, compliance costs and/or cash flow impediments.

•         It is authentically restructuring the way in which the business is conducted as opposed to a 'divestment' or preliminary step to facilitate the economic realisation of assets.

•         The economic ownership of the business and its restructured assets is maintained.

•         The small business owners continue to operate the business through a different legal structure. For example, there is:

- continued use of the transferred assets as active assets of the business

- continuity of employment of key personnel, and

- continuity of production, supplies, sales or services.

•         It results in a structure likely to have been adopted had the small business owners obtained appropriate professional advice when setting up the business.

8. The Commissioner acknowledges that tax considerations are factors that can be taken into account under a genuine small business restructure. For example, a sole trader subject to the highest marginal rate moving to a company structure to access the lower corporate tax rate.

9. However, this is not without limits. There are concerns where the restructure is contrived or unduly tax driven in the sense that it achieves a tax outcome that does not reflect the economic reality or creates an outcome that would, but for the SBRR, ordinarily attract other integrity measures in the law. For example, a restructure directed at eliminating an impending or existing tax liability, would indicate that a restructure is not a 'genuine restructure of an ongoing business'.

10. Other factors which tend to indicate that a restructure is not a 'genuine restructure of an ongoing business' include:

•         where the restructure is a preliminary step to facilitate the economic realisation of assets, or takes place in the course of a winding down to transfer wealth between generations

•         where the restructure effects an extraction of wealth from the assets of the business (including accumulated profits) for personal investment or consumption or otherwise designed for use outside of the business

•         where artificial losses are created or there is a bringing forward of their recognition

•         the restructure effects a permanent non-recognition of gain or the creation of artificial timing advantages, and/or

•         there are other tax outcomes that do not reflect economic reality.

11. The SBRR contemplates restructures to or from more than one entity. Accordingly, there may be circumstances where not all business assets that are necessary for the continued operation of an 'ongoing business' are transferred. For example, small business owners may decide to transfer plant and equipment to a new entity but leave real property in the original entity. On its own, this is not a factor that is inconsistent with the conclusion that a restructure is a 'genuine restructure of an ongoing business'.

(i) Is the arrangement a bona fide commercial arrangement undertaken in a real and honest sense to facilitate growth, innovation and reduce administrative burdens?

The partnership structure is more flexible and practical structure to operate the business in the long-term. The relationships between the partners can be determined by a commercially structured partnership agreement, that is not restricted by the terms of the Corporations Act 2001.

The partnership structure provides greater opportunity to introduce new business partners and, thus, grow the business long-term, because the business will be able to assist with financing the buy-in of partners who cannot secure their own external loans. This is seen as a key objective in securing up-and-coming personnel and is not possible in a company structure.

The business environment in which A operates has changed over time. A partnership is a lower-cost structure that is more suitable now that the business has less risk, having relinquished its AFSL and SMSF audit registrations.

Accordingly, the proposed restructure will be a bona fide commercial arrangement undertaken to facilitate growth and reduce administrative burdens.

(ii) Is the arrangement authentically restructuring the way in which the business is conducted as opposed to a 'divestment' or preliminary step to facilitate the economic realisation of assets?

The proposed restructure will be undertaken primarily to create a more appropriate business structure to conduct the business. You have also specified that the business will continue to be operated in broadly the same manner and utilising the same business assets and key personnel following the proposed restructure. Further, it will not be a preliminary step to facilitate the winding down or realising of ownership interests in A. Instead, the proposed restructure is expected to deliver benefits to the business going forward. You have also advised that all retained profits will be paid out as dividends to existing shareholders of A prior to the restructure. Therefore, there will be no divestment or economic realisation of assets post the proposed restructure.

The arrangement is considered to be authentically restructuring the way in which the current business is conducted.

(iii) Is Ultimate economic ownership maintained?

Yes, See discussion under question 2.

(iv) Do the small business owners continue to operate the business through a different legal structure?

Although the business will be operated under the new Partnership owned by the discretionary trusts, the same ultimate business owners (i.e. the five discretionary trusts) will continue to manage and operate the business in the same manner. It will have the same management and key staff performing the same tasks. The business assets and business property will be used in the same manner.

(v) Is it reasonable to conclude that the proposed restructure will result in a structure likely to have been adopted had the small business owners obtained appropriate professional advice when setting up the business?

The business has ceased to perform the high-risk activities that were provided in prior income years (AFSL and SMSF audit). The additional asset protection characteristics of a company structure are no longer necessary.

The business has arrangements in place to adequately address business risk and liability (including insurance and the liability capping scheme).

Had the business been established today, without the provision of AFSL and SMSF audit services, it is likely the owners would have elected to use a partnership structure.

Partnerships are the most commonly adopted structure for operating a professional services business due to their flexibility and administrative simplicity. It is reasonable to conclude based upon the facts available that the proposed restructure will result in a structure likely to have been adopted if appropriate professional advice had been obtained at the time of setting up the accounting business.

Additionally, it is not considered that the proposed transaction is predominantly tax-driven. The restructure will not result in any non-recognition of gains or artificial timing advantages. Under the CGT roll-over, the cost base of the transferred assets is retained as the cost base of the assets in the new entity. If the business is sold in the future, or a partner disposes of their interest in the business, the same tax cost base will be used to calculate the capital gain.

The timing of the CGT event will be the same regardless. The beneficiaries will be from the same Family Group (as per the meaning of that term in section 272-90 of Schedule 2F to the ITAA 1936) and it cannot be concluded that any tax driven reasons are driving the proposed restructure.

Conclusion

Therefore, based on the reasons above the proposed restructure is considered to be part of a genuine restructure of an ongoing business for the purposes of paragraph 328-430(1)(a) of the ITAA 1997.

Note: we have not considered whether the proposed transaction would satisfy the safe harbour rule to determine if the proposed restructure transaction is part of a genuine restructure under section 328-435. Responding to this request would necessitate making assumptions about future events. Regardless, if the conditions of the section are satisfied in the three years subsequent to the proposed transaction then the safe harbour rule under section 328-435 could have application to make the transaction a part of a genuine restructure of an on-going business.

Question 2

Summary

The proposed restructure will result in the ultimate economic ownership of the assets being maintained for the purposes of paragraph 328-430(1)(c) and section 328-440 of the ITAA 1997.

Detailed reasoning

Ultimate Economic Ownership

Subdivision 328-G provides tax-neutral consequences for a small business entity that restructures the ownership of the assets of the business, without changing the ultimate economic ownership of the assets.

Ultimate economic ownership - discretionary trusts

For the restructure roll-over provided for by Subdivision 328-G to be available, there is a requirement that the restructure does not have the effect of materially changing which individual has, or which individuals have, the ultimate economic ownership of the business assets (paragraph 328-430(1)(c)).

Where ownership passes to or from a discretionary trust, this requirement would generally not be able to be met.

However, section 328-440 contains an alternative ultimate economic ownership test for discretionary trusts. It states:

Section 328-440 Ultimate economic ownership - discretionary trusts

For the purposes of paragraph 328-430(1)(c), a transaction does not have the effect of changing the ultimate economic ownership of an asset, or any individual's share of that ultimate economic ownership, if:

(a)  either or both of the following applies:

(i)    just before the transaction took effect, the asset was included in the property of a non-fixed trust that was a family trust; or

(ii)   just after the transaction takes effect, the asset is included in the property of a non-fixed trust that is a family trust; and

(b)  every individual who, just before the transfer took effect, had the ultimate economic ownership of the asset was a member of the family group (within the meaning of Schedule 2F to the Income Tax Assessment Act 1936) relating to the trust or trusts referred to above; and

(c)   every individual who, just after the transfer takes effect, has the ultimate economic ownership of the asset is a member of that family group.

The Commissioner's interpretation of the alternative test is provided in LCR 2016/3. Firstly, it states that a transfer of assets from or to a discretionary trust will generally not meet the requirements for ultimate economic ownership on their facts. Therefore, where it is not possible to demonstrate that ultimate economic ownership of the assets has been maintained, an alternative ultimate economic ownership test is available.

The alternative test is available when assets are included in the property of a

non-fixed trust that is a family trust (i.e. a non-fixed trust for which there is a family trust election in force.

(a)(i) Will the asset be included in the property of a non-fixed trust that was a family trust just before the proposed transaction takes place?

The shares in A (which owns the Business assets) are owned by the trustees of five non-fixed trusts that are each family trusts (for the purposes of sections 272-70 and 272-75 of Schedule 2F to the ITAA 1936). The Business Assets are, and will be, owned by these five discretionary trusts immediately before the proposed transaction takes place. Therefore, subparagraph 328-440(a)(i) will be satisfied.

(a)(ii) Will the asset be included in the property of a non-fixed trust that was a family trust just after the proposed transaction takes place?

This condition is satisfied if, just after the restructure happens, the asset is included in the property of a non-fixed trust that is a family trust.

All partners in the partnership will be discretionary trusts, which are non-fixed trusts. Each of the trusts will have made an FTE (as detailed in facts), and thus they will be family trusts.

Under the proposed restructure, each of the discretionary trust shareholders will become the owners of a proportionate interest in each of the assets of the business (in partnership with the other discretionary trust partners).

This satisfies the requirements of subparagraph 328-440(a)(ii).

(b) Will every individual who, just before the proposed transfer takes effect, has the ultimate economic ownership of the asset, be a member of the family group (within the meaning of Schedule 2F to the Income Tax Assessment Act 1936) relating to the trust or trusts referred to above?

You have provided evidence that the five discretionary trusts have each lodged FTE's and have disclosed the specified individuals as per the facts. The condition under paragraph 328-440(b) is therefore satisfied.

(c) Will every individual who, just after the transfer takes effect, has the ultimate economic ownership of the asset, be a member of that family group?

None of the trust deeds of the five discretionary trusts will be amended (including in relation to the schedule of discretionary objects of each trust) in conjunction with the restructure.

The condition under paragraph 328-440(c) of the ITAA 1997 will be satisfied because, after the restructure is completed, proportionate interests in the business assets will be held by the five discretionary trusts that have made FTEs.

Conclusion

Therefore, following the transfer every individual that will have ultimate economic ownership of the assets after the transfer is a member of the same family group. As the ultimate economic ownership requirements will be satisfied under section 328-440 of the ITAA 1997, paragraph 328-430(1)(c) will also be satisfied.