Edited version of private advice

Authorisation Number: 1051918311908

Date of advice: 1 December 2021

Ruling

Subject: Am I a small business entity that satisfies the active asset test?

Question 1

Are you considered to be carrying on a business of leasing property?

Answer

Yes.

Question 2

Are you a small business entity under section 328-110 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 3

Are you a small business entity under subsection 152-10(1AA) of the ITAA 1997?

Answer

Yes.

Question 4

Does the warehouse meet the active asset test under section 152-35 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Person 1 (R) and Person 2 (C) are husband and wife.

R and C are directors and shareholders of Xxx Xxx Pty Ltd (you).

R owns XXX shares and C owns XXX shares.

The 20XX income year annual turnover was $XXX,XXX.

The 20XX income year's expected annual turnover is $XXX,XXX.

R and C are connected and affiliated with the following entities O Pty Ltd (O), ABD Pty Ltd (BD), R and C Fixed Unit Trust (the Trust) and RC Pty Ltd (RC).

Company O Pty Ltd

R and C are both directors and each hold X share.

The 20XX income year annual turnover was $XXX,XXX and the 20XX income year expected annual turnover is $XXX,XXX

Company BD Pty Ltd

R and C are both directors. R is the only shareholder.

The entity does not trade but receives an annual trust distribution from the Trust.

The 20XX income year annual turnover was $XX,XXX and the 20XX income year expected annual turnover is $XX,XXX.

The Trust Fixed Unit Trust

R and C are both directors and shareholders of the trustee company BD Pty Ltd.

The unit holders of this trust are:

•         Their self-managed superannuation fund X and X xxx Xxxx Superannuation Fund, which holds XX%

•         You, which holds XX%

•         BD, which holds X% and,

•         R and C, who holds X%.

The 20XX income year annual turnover was $XXX,XXX and the 20XX income year expected annual turnover is $XXX,XXX

RC Pty Ltd

RC does not trade.

R and C are the directors and hold X share each.

The 20XX income year aggregated turnover for you is below $2 million.

The 20XX income year expected aggregated turnover for you is below $2 million.

You acquired property xxx xxx (the warehouse) on XX Juxx 19XX to use for sxxxing and rxxxing xxx for your business.

When the property was first purchased, there was a building at the front of the block that was not suitable to be used for your business. You leased this building whilst constructing the warehouse.

You built the warehouse with xxx xxx and xxxx systems (facilities).

You operated a business of wholesale xxx at the FM, adjacent to the warehouse, under the business name of BD.

Construction of the warehouse took approximately one year.

Your market business company BD paid for the construction costs of the warehouse.

In 19XX, you leased the office to an unrelated business, FPBM Pty Ltd after realising the warehouse was larger than required. The office is no more than XX% and was not the main source of income.

In 20XX, you sold your market business, BD and leased the warehouse.

The property was rented from 1 Xxxber 20XX.

The estimated market value of the warehouse inclusive of its facilities is approximately $XXX,XXX to $XXX,XXX. The valuation is based on a similar building next door sold within the last xx months.

R acts as the landlord for the warehouse.

The warehouse has specific facilities such as a facilities that are specific to rxxxing and sxxxing xxxx/s. If the facilities are not operational, the tenants may experience a significant income loss.

You have a business plan to follow and adhere to, however it is not formalised. The informal business plan is used for consideration to plan the ongoing operation of the building and equipment to ensure premium rents can be charged and that the specialised equipment remain well maintained and operational.

R has used these facilities previously when using the warehouse for his own business and is experienced at fixing them.

The warehouse is not advertised in papers or online as R has been able to find tenants when required through his associates working in FM.

The tenants are obtained for xxx years with a xxx year stay option or a xxx year lease with a xxx year option. All tenants have a formal lease agreement in place and pay rent monthly.

R is the first point of contact for the tenants. He manages the lease himself and is responsible for maintenance of the building and equipment.

R is required to perform monthly safety checks for insurance purposes.

You have your own bank account, and use accounting system Xxxx for record keeping. You have employed an administrative assistant and solicitor for record keeping and maintenance of lease agreements.

R carries out repairs and maintenance on the warehouse and facilities himself, if the repair is outside his scope of experience, he arranges the relevant tradesman to assist.

The facilities require weekly maintenance of approximately X.X hours on site.

R spends approximately X hours per month to record business income and expenses. R is paid any remuneration costs by way of Director's fee annually.

Currently the annual rental income of the business is $XXX,XXX.

Sine 20XX, the warehouse has overall been a profitable business that has only experienced financial losses in the income years that large repairs of the facilities were required.

Rent is reviewed annually and may be increased by either an agreed X% or CPI annually.

R is XX years of age and a self-funded retiree.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 152-10(1AA)

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 section 328-115

Income Tax Assessment Act 1997 section 328-120

Reasons for decision

Question 1

Are you carrying on a business of leasing property?

Question 2

Are you a small business entity under section 328-110 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Question 3

Are you a small business entity under subsection 152-10(1AA) of the ITAA 1997?

Question 4

Does the warehouse meet the active asset test under section 152-35 of the ITAA 1997?

Detailed reasoning

Question 1

Carrying on a business

The term 'business' is defined to include any profession, trade employment, vocation or calling, but does not include occupation as an employee under subsection 995-1(1) of the ITAA 1997. 'Carrying on a business' is not defined in the ITAA 1997 and, therefore, takes its ordinary meaning, however Taxation Ruling TR 2019/1 Income Tax: when does a company carry on a business? outlines general principles which indicate whether a business is being carried on.

Indicators of carrying on a business

TR 2019/1 lists the relevant indicators as:

•         Whether the activity has a significant commercial purpose or character;

•         Whether the person intends to carry on a business;

•         The nature of the activities, particularly whether there is a purpose of profit;

•         Whether there is repetition and regularity of the activity;

•         Whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

•         Whether the activity is planned, organised, and carried out in a business-like manner such that it is directed at making a profit;

•         The size, scale, and permanency of the activity; and

•         Whether the activity is better described as a hobby, a form of recreation or a sporting activity.

Paragraph 39 of TR 2019/1 explains companies have been held to carry on a business where its ongoing activities are relatively limited, and its key activities consist of letting the company's premises for rent on an ongoing basis. The activities of a company that holds assets which generate ongoing returns may be limited to its ongoing management, ensuring it meets ASIC regulatory requirements, decisions (whether express or implicit) to continue holding a relatively static investment portfolio, the receipt and distribution (retention) of income and other matters of an administrative nature. While relatively limited, this level of activity is sufficient to amount to the carrying on of a business.

Whether you are carrying on a business of letting property must be determined in accordance with the principles provided in TR 2019/1.

Significant commercial purpose or character

In showing that a business is being carried on, it is important that the taxpayer can provide evidence that shows there is a significant commercial purpose or character to the activity, for example, that the activity is carried on for commercial reasons and in a commercially viable manner.

In your case, the annual rental income of the business is currently $XXX,XXX. R as the landlord is responsible for maintenance of the building and equipment inclusive of the lease, as the equipment cannot be maintained by a general property manager such as a commercial real estate agent. As R has many years of experience from operating his own business from the premises prior to leasing the premises, he knows the systems, and the best way to utilise the facilities. He is required to perform monthly safety checks for insurance purposes.

Intention to engage in business

Carrying on a business requires actual action and is not the mere idea or desire to engage in business. The extent of actions you have taken will determine whether you are carrying on a business.

In your case, R does not use a real estate agency or property manager. He finds tenants through his connections with the FM. As part of the lease agreement, R is the first point of contact for the tenants throughout the lease term and is responsible for maintenance of the building and equipment included with the lease. R is responsible for the monthly safety checks, mandated by the insurers as per his insurance policy.

Prospect of profit

In order to demonstrate your business of leasing property amounts to the carrying on of a business, you must demonstrate an intention of making a significant commercial profit.

Demonstrating the prospect of profit comprises of three elements:

•         A genuine belief that profit is attainable;

•         The intention to produce profits from the activities; and

•         That the activities are capable of producing a profit.

It is not necessary for the activities to make a profit in every year of income. You may be carrying on a business even though you are making a small profit or loss in any given year.

In your case, the current annual rental income is $XXX,XXX and you have a history of rental income. R is also remunerated for any work he completes through payment of Director fee's.

Repetition and regularity

It is often a feature of a business that similar sorts of activities are repeated on a regular basis. The repetition of activities by the same person over a period of time on a regular basis helps to determine whether there is the carrying on of a business.

In your case, the tenants pay rent to you monthly. R is regularly in attendance to address any maintenance and repair requests as well as complete the monthly inspections. Since X XXXber 20XX, the business overall has been profitable and only made financial year losses in 20XX, 20XX and 20XX when the facilities required xxx.

Activity carried on in a similar manner to that of ordinary trade

An activity is more likely to be in business when it is carried on in a manner similar to that in which other participants in the same industry carry on their activities. Lord Clyde in The Commissioners of Inland Revenue v. Livingston and Others (1927) 11 TC 538 at TC 542 said that:

'... the test, which must be used to determine whether a venture... is, or is not, "in the nature of trade", is whether the operations involved in it are of the same kind, and carried on in the same way, as those which are characteristic of ordinary trading in the line of business in which the venture was made.'

In considering this indicator the following factors might be compared with the characteristics of others engaged in the same type of business:

•         the volume of sales.

•         the types of customers the taxpayer sells his/her product to - wholesalers, retailers, the public at large, or friends or relatives - and the manner in which this marketing takes place;

•         the sort of expenses incurred by the taxpayer;

•         the amount invested in capital items;

•         previous experience of the taxpayer. A taxpayer who does not have any knowledge or experience may be expected to have sought advice from experts. However, it is recognised that a taxpayer may be a pioneer in the industry. The taxpayer may have conducted research into the activity, decided that the traditional approach is wrong. He/she may be trying to conduct the activity with a view to profit in a new but businesslike way.

In your case, you receive monthly rental income. Due to the warehouse's location and facilities, you target businesses that operate at the FM to fully utilise the warehouse operation you have. You have knowledge and experience using the facilities and has been receiving rental income since 1 Xxxber 20XX.

Planned, organised, and carried out in a business-like manner

In Newton v. Pyke (1908) 25 TLR 127 the court suggested that business should be conducted systematically. A business is characteristically carried on in a systematic and organised manner rather than on an ad hoc basis. An activity should generally conform with ordinary commercial principles to amount to the carrying on of a business.

In Ferguson v. FC of T (1979) 37 FLR 310; 79 ATC 4261; (1979) 9 ATR 873 the Full Federal Court was influenced by the systematic and organised nature of the taxpayer's activities. Fisher J said:

'... the venture as a whole had a commercial flavour, was conducted systematically and... in a business-like manner. It could not be said that there was anything haphazard or disorganised in the way in which he carried out the activity.'

In Federal Commissioner of Taxation v. JR Walker 85 ATC 4179; (1985) 16 ATR 331 Ryan J was satisfied that the taxpayer was in the business of goat breeding as he had 'organised his activities in a business-like way through the keeping of books of account'.

The weight that is attached to this indicator will depend on the facts of the situation and a taxpayer may still carry on a business despite having poor organisational skills.

In your case, you have your own bank accounts and accounting software system Xxxx that generates invoices and statements to assist in reconciling your bank account. You report business activity statements quarterly and a cash basis to keep taxation obligations up to date. You have employed an assistant to assist with the record keeping.

Size, scale, and permanency of the activity

The size or scale of the activity is not a determinative test, generally the larger the scale of the activity the more likely it will be that the taxpayer is carrying on a business, however this is not always the case and a person may carry on a business though in a small way.

In your case, you have demonstrated the size and scale of the activity that is involved by R to ensure profitability. You have a set leasing agreement for each tenant that has been prepared by a solicitor and that sets out the terms and conditions.

Hobby, recreation, or sporting activity

Money derived from the pursuit of a hobby is not regarded as income and therefore is not assessable. Often it will be the case that there is a hobby when:

•         it is evident that the taxpayer does not intend to or cannot make a profit from the activity,

•         any activity is not carried on in the same manner as a similar business,

•         the activity is carried on a small scale,

•         any produce is sold to friends and relatives and not to the public at large.

In your case, there is an informal business plan that outlines the operation of the business to ensure the building and equipment and rent continues to be operational. The lease agreements between you and the tenants are normally for X to X year terms.

Application to your circumstances

By applying the business indicators provided in TR 2019/1 to your circumstances, you are considered to be carrying on a business for the purposes of Division 328 of the ITAA 1997. The warehouse is rented out to a specific target market to ensure the facilities are appropriately used. R, a Director of the company, acts as the landlord and arranges the lease agreement for the tenant. R works on site on a regular and repetitive basis. Due to the facilities installed, R ensures the building and equipment is maintained and operational as well as performs regular inspections and safety inspections. If the facilities were not operational, there may be significant loss for the tenant which may carry on to you therefore although you may not have a formal business plan, R takes steps to ensure the profitability, repetition, and regularity of income. The business is ran similarly to other people in the same industry of leasing commercial property. You have demonstrated that you are carrying on a business of leasing property.

Question 2 and 3

Subsection 328-110(1) of the ITAA 1997, states the requirements of a small business entity for an income year as:

(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 (the previous 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

Furthermore, section 152-10(AA) of the ITAA 1997 explains you will be a small business entity to apply the small business concessions, if you are a company that is carrying on a business and has an aggregated turnover of less than $2 million.

Aggregated turnover

The term 'aggregated turnover' for an income year is defined in subsection 328-115(1) as the sum of the relevant annual turnovers listed in subsection 328-115(2), excluding any amounts covered by subsection 328-115(3).

Under subsection 328-115(2) of the ITAA 1997, the relevant annual turnovers are:

•         your annual turnover for the income year

•         the annual turnover for the income year of any entity (a relevant entity) that is connected with you at any time during the income year, and

•         the annual turnover for the income year of any entity (a relevant entity) that is an affiliate of yours at any time during the income year.

Under subsection 328-115(3) of the ITAA 1997, your aggregated turnover for an income year does not include the following amounts:

•         amounts derived in the income year by you or a relevant entity from dealings between you and the relevant entity while the relevant entity is connected with you or is your affiliate

•         amounts derived in the income year by a relevant entity from dealings between the relevant entity and another relevant entity while each relevant entity is connected with you or is your affiliate

•         amounts derived in the income year by a relevant entity while the relevant entity is not connected with you and is not your affiliate.

An entity's aggregated turnover is the same as its annual turnover if there are no other entities it is connected with or affiliated with.

Meaning of Affiliate

Section 328-130(1) of the ITAA 1997 explains the meaning of affiliate as an individual or company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of individual or company.

Application to your circumstances

You carry on business and derive rental income through the leasing of your warehouse. You are connected and affiliated with other entities; therefore, your aggregated turnover is not the same as your annual turnover under section 328-115 of the ITAA 1997 and you must include any individual or company that is your affiliate to determine your aggregated turnover.

In applying the facts and circumstances of Division 152 of the ITAA 1997 to you, through the ordinary course of carrying on a business, your annual turnover for the income year ending 30 June 20XX was under $2 million and the expected annual turnover for the 20XX income year is under $2 million.

Your aggregated turnover in the 20XX income year was under $2 million. Furthermore, you expect to derive similar amounts of income for the 20XX income year and expect to remain under the $2 million threshold.

As your aggregated and expected aggregated turnover for the 20XX and 20XX income years was and remains likely less than $2 million and you are considered to be carrying on a business of leasing property, you satisfy the requirements under section 328-110 of the ITAA 1997 to be a small business entity and further satisfy the requirements under section 152-10(1AA) of the ITAA 1997 to be a small business entity for the purposes of applying the capital gains tax small business concessions.

Question 4

Active Asset Test

Section 152-35(1) of the ITAA 1997 states that a CGT asset satisfies the active asset test if:

•         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 period owned; or

•         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 7.5 years.

Section 152-40(1) of the ITAA 1997 explains the meaning of an active asset is when you own the asset and it is used, ready to use in the course of carrying on a business that is carried on by you, your affiliate, or another connected entity.

Active Asset's main use is to derive rent

An asset whose main use is to derive rent cannot be an active asset. This is the case even if the asset is used in the course of carrying on a business.

Whether an asset's main use is to derive rent will depend on the particular circumstances of each case. The term 'rent' has been described as referring to the payments made by a tenant or lessee to a landlord or lessor for exclusive possession of the leased premises. As such, a key factor in determining whether an occupant of premises is a lessee paying rent is whether the occupier has a right to exclusive possession.

The following is considered use of the asset to derive rent, where the rent is derived from an entity that is not an affiliate or connected with the asset owner (third party) or by an entity that is an affiliated or connected with the asset owner (relevant entity).

The use of an asset to derive rent from a third party will be considered use to derive rent even if that entity uses the asset in their business. This is because the use of the asset by the asset owner is to derive rent. However, use of the asset by a relevant entity is treated as the use by the asset owner, even if the asset owner receives rent from the relevant entity for the use of that asset.

This means, if the relevant entity uses the asset, in its business, that use is treated as use by the asset owner to carry on a business and to derive interest, rent or royalties from an entity that is a third party, that use is treated as use by the asset owner to derive passive income.

Application to your circumstances

You acquired the property on XX Jxxx 19XX to construct a warehouse to use in your business company BD Pty Ltd that operated across the road. When you acquired the property there was an office at the front of the block that was not suitable to be used for your business. You leased the office whilst constructing the warehouse and therefore the office will not meet the active asset test as its main use has predominately been to derive rent.

Construction of the warehouse took approximately one year. You have held the warehouse for more than 15 years and used the warehouse as an active asset, within your business for X of those years until you decided to sell your business in 20XX. In 19XX, you rented part of the warehouse, being the front office out to another business who is not carried on by you, your affiliate, or another connected entity with you, when you realised the warehouse was too big. The office was no more than XX% of income received during the X years you operated and was not the main source of your income. Therefore, as the property was held for more than 15 years and was an active asset for more than half of that period, the warehouse satisfies the active asset test under section 152-35 of the ITAA 1997.