Edited version of private advice

Authorisation Number: 1051989576344

Date of advice: 15 June 2022

Ruling

Subject: CGT small business concessions - active asset test

Question

Does the Property satisfy the active asset test for the purpose of the capital gains tax (CGT) small business concessions under section 152-35 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

Financial year ending 30 June 20XX

Financial year ending 30 June 20YY

The scheme commences on:

1 July 20ZZ

Relevant facts and circumstances

The Trust was settled by Trust Deed with Individual A as Trustee (Trust A). Individual A and Individual B are beneficiaries of Trust A.

The Taxpayer acquired a property of approximately 50 hectares (the Property) on one title of land.

The Property includes a residential property that has been rented to Individual A and B at market rental since acquisition.

The remainder of the land area (approximately 98% of the total area) (the Leased Land) has been leased to Company A since acquisition.

Individual A has held 50% of the shares in Company A carrying the right to exercise more than 40% of the voting power during the period Trust A has owned the Property.

Company A carries on a construction business.

There was a substantial shed on the Leased Land at acquisition. A second, more substantial shed with a large concrete pad and surrounding hard stand areas was constructed. The sheds have been used by Company A to:

•         store machinery used in the construction business

•         store farm equipment

•         service equipment and vehicles

•         carry out occasional fabrication work related to the construction business.

Additional improvements have also been made to the Leased land for primary production purposes including a hay shed, fencing upgrades and additional water storage facilities have been installed.

Company A has carried on primary production activities on the Leased Land. You have stated that the objective of the primary production operation was to diversify the income sources to support the family when Individual A fully retires from the building industry.

Company A's income in the last four financial year has predominantly been from its construction activities. Its Primary production activities contributed between $10,000 and $30,000 of income each financial year since 20AA-BB.

More than three quarters of the Leased Land had been designated for grazing. You have stated that this designated grazing land has a stock carrying capacity of more than S0 breeders, not including their prodgeny, replacement stock and male breeder.

You have provided stock trading information since the acquisition of the Property. Company A purchased more than T0 head initially in the 201A-1B financial year at a total cost of more than $X per head. Company A has traded stock each year since this time.

Company A currently holds livestock with an approximate value of $AA,000.

The planting of Crop B occurred in the 20ZZ and 20YY calendar years. F000 kg was harvested from the initial crop with sales of $G,000 ($RR/kg) to be reported in the 20ZZ-YY financial year.

The initial planting of Crop C in the 20XX calendar year was written off due to disease. The 20ZZ Crop C planting to be harvested in 20YY will be used for replanting. The 20YY planting of Crop C is anticipated to produce S0 tonnes in 20AA. The expected sale price of Crop C is $TT per/kg.

You have stated that Company C has not shown a profit on its farming operations to date due to the immediate deductibility of capital expenditure and the fact that the company is expanding its livestock and cropping activities.

You have provided projected profit and loss information for the primary production activity that shows an initial profit expected in the 20AA-BB financial year, based on approximately $WW0,000 worth of sales. Based on the projected information, but for depreciation expenditure, the primary production activity will be profitable in the current financial year.

Livestock sales are affected either through sale yards or private sale to other primary producers. The Crops are sold through an agent.

Company A has obtained the necessary licenses required to trade livestock in their state.

Individual A had experience in primary production prior to this venture, having been in partnership with their parent in a mixed farming operation until the age of approximately 30.

An agronomist was engaged soon after the Property was acquired to do soil testing and prescribe fertilisation and soil improvement program. Company A subsequently carried out amelioration of the soils using fertiliser, lime and microbial soil supplements on the basis of the agronomist's advice.

The quality of the existing pasture was assessed by the agronomist and it was concluded that to achieve optimum output from the land that a pasture renewal program should be implemented. To date, seeding of approximately G0% of the pasture has been undertaken with the intention that all grassland will have its pasture renewed.

Company A has undertaken capital expenditure on the primary production activity including the following:

•         The construction of a water reticulation system.

•         The replacement of a significant amount fencing and stock yards on the property.

•         The purchase of a tractor and ancillary equipment.

•         Fodder storage.

Detailed livestock records are maintained, and those records include a full history of each animal on the farm from their birth through to the time that they depart the property.

Detailed cropping records are maintained in which soil preparation, planting, growing and harvesting of the crops are recorded.

You have provided the full financial records for Company A for the period Trust A has owned the Property. These include divisional profit and loss statements for the primary production activity.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 paragraph 152-10(1)(d)

Income Tax Assessment Act 1997 section 152-15

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 subsection 152-35(1)

Income Tax Assessment Act 1997 paragraph 152-35(1)(a)

Income Tax Assessment Act 1997 subsection 152-35(2)

Income Tax Assessment Act 1997 subsection 152-40(1)

Income Tax Assessment Act 1997 paragraph 152-40(4)(e)

Income Tax Assessment Act 1997 subsection 152-40(4A)

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 subsection 328-125(1)

Income Tax Assessment Act 1997 paragraph 328-125(2)(b)

Income Tax Assessment Act 1997 subsection 328-125(3)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

All subsequent legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997).

Summary

The Leased Land has been used in the course of the construction and primary production business activities of Company A, a connected entity of Trust A for more than half of the ownership period of less than 15 years. The rental exclusion does not apply as the main use of the Property is not to derive rent. The Property is therefore an active asset of Trust A under section 152-35.

Detailed reasoning

The active asset test

Subdivision 152-A sets out the 'basic conditions' which must be satisfied in order for entities to qualify for any of the CGT small business concessions under Division 152 to reduce or disregard a capital gain they make. One of the basic conditions, at paragraph 152-10(1)(d), is that the CGT asset (in respect of which the CGT event resulting in the capital gain happened), satisfies the active asset test in section 152-35.

Subsection 152-35(1) provides that:

A CGT asset satisfies 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 period specified in subsection (2); 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 period specified in subsection (2).

Subsection 152-35(2) states that the period:

(a)  begins when you acquired the asset; and

(b)  ends at the earlier of:

(i)    the CGT event; and

(ii)   if the relevant business ceased to be carried on in the 12 months before that time or any longer period that the Commissioner allows - the cessation of the business.

Subsection 152-40(1) details that a CGT asset is an active asset of an entity 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 the entity, its affiliate, or another connected entity.

Paragraph 152-40(4)(e) excludes, among other things, assets whose main use is to derive rent (unless such use was only temporary). Such assets are excluded even if they are used in the course of carrying on a business of renting the assets.

However, subsection 152-40(4A) provides that any use of the asset by a connected entity is treated as the taxpayer's use of the asset for the purposes of paragraph 152-40(4)(e). This means if the connected entity uses the asset to carry on its business the asset can still qualify as the taxpayer's active asset even if rent is charged to the connected entity for its use (Taxation Determination TD 2006/63 Income tax: capital gains: is a CGT asset that is leased by a taxpayer to a connected entity for use in the connected entity's business an active asset under section 152-40 of the Income Tax Assessment Act 1997?).

Connected entity

Under subsection 328-125(1) an entity is connected with another entity if:

(a)  one entity controls the other entity or

(b)  both entities are controlled by the same third entity.

Subsection 328-125(3) provides that an individual controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the individual, their affiliates, or the individual together with their affiliates.

A company is controlled by an individual owner where the individual or the individual together with their affiliates carry between them the right to exercise a control percentage that is at least 40% of the voting power in the company (paragraph 328-125(2)(b)).

During the period Trust A has owned the Property, Individual A has been the Trustee of Trust A and it is accepted that they control this trust under 328-125(3). Individual A also controlled Company A for the same period by way of their 50% share ownership (328-125(2)). As Individual A controls both the Trust A and Company A, the two entities are connected under paragraph 328-125(1)(b).

Business use of the Leased Land

Subsection 152-40(1) 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) and in the proceedings that had led up to that decision.

In Eichmann, 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, subsection 152-40(1) requires the asset to be used "in the course of carrying on a business," encompassing, necessarily, a fairly wide range of activities.

In Eichmann, 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.

In the present case, Company A a connected entity of the Trust A used the land for two distinct activities being their construction and primary production activities. On the basis of the size, scale and profitability, there appears little doubt that Company A's construction activity amounts to a business. Further that they use the large shed and surrounding hard stand in the course of carrying on their construction business activities. The question remains as to whether the primary production use of the remainder and majority of the Leased Land could reasonably considered as part of their business activities.

Carrying on the business of primary production

Whether a taxpayer is carrying on a business must be determined on the basis of the facts of each particular case. There is no statutory definition or test of 'carrying on a business', other than the exclusion that a business does not include the occupation as an employee (subsection 995-1(1) of the ITAA 1997).

Taxation Ruling TR 97/11: Am I carrying on a business of primary production? (TR 2019/11), provides guidance of the indicators that are relevant to determine whether or not a person is carrying on a business. The courts have held that the following indicators are relevant:

•         whether the activity has a significant commercial purpose or character (this indicator comprises many aspects of the other indicators);

•         whether the taxpayer has more than just an intention to engage in business;

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

•         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 on in a businesslike 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.

Whether a business is being carried on depends on the 'large or general impression gained' (Martin v FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators of carrying on a business, and no one indicator will be decisive (Evans v FC of T 89 ATC 4540; (1989) 20 ATR 922.

Applying the principles in TR 97/11 to Company A's primary production activity, as follows:

•         Significant commercial purpose of character

­   Individual A has relevant primary production experience and Company A has utilised the services of agronomist for the soil analysis and crop performance.

­   The size of the activity is sufficient for a commercial enterprise with production of livestock and produce far in excess of the personal needs of the controlling minds.

­   There is a clear intention to make a profit, with projections indicating that this will occur in the 20XX-YY, but for accelerated depreciation provisions this likely would have occurred in the current financial year.

•         Intention of the Taxpayer

­   You have stated that the intention of objective of the primary production operation is to diversify the income sources to support the family when Individual A retires from the building industry.

­   Company A has made significant investment in farm assets and trading stock including the purchase of more than T0 head of stock in the 201A-1B financial year.

•         Prospect of profit

­   The projected profit and loss information for Company A's primary production activity which provides for a profit of more than $S0,000 in the 202C-2D financial year from $RR0,000 sales.

•         Repetition and regularity

­   Company A has engaged in the repetition and regularity of activities in order to produce commercial quantity and quality of stock and crops for sale.

•         Organisation in a business-like manner and the use of a system

­   Due the statutory imposed requirements on companies, Company A must conduct its operations and activities in a methodical and business-like manner.

­   Detailed livestock records are maintained, and those records include a full history of each animal on the farm from their birth through to the time that they depart the Property.

­   Detailed cropping records are maintained in which soil preparation, planting, growing and harvesting of the crops are recorded.

­   You have provided the full financial records of Company A for the period Trust A has owned the Property. Divisional profit and loss statements kept for the primary production activity.

On broad view of the indicia provided by TR 97/11, it is reasonable to conclude that Company A's primary production on the land amounted to a business activity. The Commissioner is satisfied that the Leased Land was fully utilised by Company A for the period beginning with the purchase of more than 40 stock in the 2017-18 financial year. This being a period of at least 29 Months up until the private ruling application date, for the purposes of the active asset test period specified in subsection 152-35(2).

Use of the Property as a whole

In determining whether for the purposes of 152-40, 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 (Eichmann and Rus v FC of T 2018 ATC 10-478 (Rus).

It is acknowledged that the definition of active asset does not require exclusive use of the asset for business purposes. However, in Rus only a small portion of land was used in carrying on a business the land was held not to be an active asset.

In Rus, 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. Only the shed and a home office in the couple's main residence was used in the running of the business, however, the majority of the business activities were conducted off site.

On review the AAT confirmed the Commissioners decision that having regard to the nature of the CGT asset, the nature of the company's business and the relationship between the CGT asset and that business, it could not be said that the CGT asset was used in the course of carrying on the company's business, therefore the property was not an active asset.

As previously discussed, Company A is considered to have used the entirety of the Leased Land in carrying on their business. This differentiates this case from Rus in terms of the relationship between the CGT asset and the nature of the business carried on.

Exclusion where the main use is to derive rent

Where the asset is used partly for business purposes and partly to derive rent it may still qualify as an active asset depending on what its "main use" was. This will be a question of fact involving a comparative analysis of the areas of use for rental and other purposes and/or the levels of income derived from the different uses as considered in example 5 of Taxation Determination TD 2006/78 Income tax: capital gains: are there any circumstances in which the premises used in a business of providing accommodation for reward may satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 notwithstanding the exclusion in paragraph 152-40(4)(e) of the Income Tax Assessment Act 1997 for assets whose main use is to derive rent?

The business income generated by Company A from the Property has been predominately from stock sales. The amount for stock sales in the last three financial years reported being slightly more on average then the rental income generated from the residence.

The area of the Property used by Company A for its business purposes constitutes the majority (98%) of the total land area.

On the basis of the comparative analysis of income and land area, it can be concluded that the main use of the property is not to derive rent and the exclusion in paragraph 152-40(4)(e) does not apply.

Conclusion

As Trust A has owned the Property for less than 15 years, paragraph 152-35(1)(a) applies requiring the land to be an active asset for at least half the ownership period.

Company A is a connected entity of the Trust A. The Leased Land has been fully used in the course of carrying on Company A's business for a period more than half the ownership period. The active asset test is passed as at the time of the private ruling application as long as the exclusions do not apply.

The main use of the Property is for Company A's business activity and not to derive rent so the rental income exclusion in paragraph 152-40(4)(e) does not apply. The Property is an active asset of Trust A under 152-35.

The Property will remain an active asset of the Trust A while Company A remains a connected entity and continues to fully utilise the Leased Land for its business activities.