Edited version of private advice

Authorisation Number: 1051992248048

Date of advice: 22 June 2022

Ruling

Subject: CGT - small business concessions

Question 1

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

Answer

Yes.

Question 2

Will the proposed disposal of the lease of the leased land (the Lease), satisfy the active asset test under section 152-35 of the ITAA 1997 for the purpose of the CGT small business concessions?

Answer

Yes.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 June 20XX

Relevant facts and circumstances

Individual A and Individual B (the Taxpayer's) jointly own the property including land and buildings (Property A).

Property A was inherited by the Taxpayer's in equal shares (50:50) more than XX year ago.

Property A is located on one land title.

To the rear of the land of Property A is an area used for the Taxpayer's business activity (Business X) that requires access to the rear of the land for its operations.

Business X is accessed from the street frontage by using a right of way access down the side of the adjacent lot.

Business X involves the maintenance and storage of particular equipment.

The Taxpayers are third generation proponents of the trade activity related to the maintenance of the equipment.

Business X has been operated by Company X since the Taxpayers acquired Property A.

There is a residential accommodation building (the Residence) constructed on the land located on the street frontage of the allotment.

The Residence has been rented to third parties for market rental for the duration of the Taxpayers' ownership of Property A. The Taxpayers report their share of rental income in their personal tax returns. The activity is not considered to be a property rental business. The Taxpayers do not rent out other properties.

The Taxpayers also holds a Lease over the adjacent land area (Leased Land) for use with Property A in the operation of Business X.

The Lease was inherited by the Taxpayer's. On expiry of the inherited lease, subsequent leases have been entered with the most recent for a further XX years.

A clause in the Lease restricts the activity on the Leased Land to use of the area by clients for storage of their equipment in association with the Taxpayer's Business X trade activity.

The Lease is also granted subject to the Lessee maintaining a right of access and usage over the Adjoining Land being Property A.

The following are in relation to the storage of client's equipment in the area of the Leased Land:

•         There are no written agreements, equipment is stored on a month-by-month basis by verbal agreement

•         Payments for storage is made one month in advance, with payment amounts determined by equipment size.

•         Equipment is generally stored for a period of 2-3 months.

•         All clients' equipment kept on the Leased Land is worked on by Business X or subcontractors.

•         Company X is entitled to relocate a client's equipment and has previously done so.

•         The equipment owner does not have the right to exclusive possession of any area of the Leased Land. There is no intention by the parties to grant a lease nor has a lease been granted.

There is an office in the area used by Business X in which clients can be met and administrative and management activities undertaken.

Company X often lends tools required for the equipment to clients and clients often ask the Taxpayer's for advice related to their equipment.

The Taxpayers have each held more than 40% of the ordinary shares carrying the right to exercise a control percentage that has been at least 40% of the voting power in Company X for the period they have owned Property A and held the Lease.

The Residence occupies approximately 25% of the land area of Property A. The Taxpayers have provided a detailed explanation how the remainder of the land area has been used by Company X for Business X.

Company X derives income from their use of both Property A in accompaniment with the Leased Land, each possessing features required for the conduct of Business X. The company does not derive income outside of their use of these assets.

During the period the Taxpayers have owned Property A, Company X's business income has been on average twice that of the rental income derived by the Taxpayers from the rent on the Residence.

The Taxpayers do not charge Company X for use of Property A or the Leased Land.

The Taxpayers are intending to sell Property A together with the Lease.

Company A will continue to use Property A and the Leased Land in its business until disposal.

Relevant legislative provisions

Income Tax assessment Act 1997 Section 108-5

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 152-35

Income Tax assessment Act 1997 Subsection 152-40(1)

Income Tax assessment Act 1997 Subsection 152-40(4)(e)

Income Tax assessment Act 1997 Subsection 328-125(1)

Income Tax assessment Act 1997 Paragraph 328-125(2)(b)

Reasons for decision

All subsequent legislative references are to the ITAA 1997.

Summary

Both Property A and the Leased Land interest have been owned by the Taxpayers for less than 15 years. Company X who is a connected entity of the Taxpayers, used Property A and the Leased Land in the course of its business activities for the entire period the assets have been owned by the Taxpayers. From comparative analysis of area used and income derived it has been determined that the main use of either Property A or the Leased Land was not to derive rent, so the exclusion under paragraph 152-40(4)(e) does not apply. Both Property A and the Leased Land were active assets of the Taxpayer's under paragraph 152-35(1)(b).

Detailed reasoning

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.

A CGT asset is defined in section 108-5 as any kind of property, or a legal or equitable right that is not property.

Subsection 152-40(1) of the ITAA 1997 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) of the ITAA 1997 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.

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.

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)).

In this case, both Taxpayers control Company X, each owning more than 40%of the ordinary shares carrying the right to exercise a control percentage that is at least 40% of the voting power in the company (paragraph 328-125(2)(b)). The Taxpayers are both connected to Company X under paragraph 328-125(1)(a).

Business use of Property A and 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) 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.

The CGT asset referred to in subsection 152-40(1) 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 (Eichmann and Rus v FC of T 2018 ATC 10-478 (Rus).

The Taxpayers have contended that Company X used Property A and the associated Leased Land for the conduct of its business activities related to trade X.

In applying the principles from Eichmann and Rus the Commissioner accepts that apart from the area of the land occupied by the Residence, Company X did use predominantly the whole of the remaining land and buildings in the course of carrying on the business activities of Business X.

The Lease of the Lease Land is a CGT asset under Section 108-50 as it provides the Taxpayer's with the legal right to use the Leased Land adjacent to Property A for the period of the Lease.

In this case, it is accepted that the Leased Land has been fully utilised by Company X in for the storage of equipment and carrying on other activities associated with Business X. The Leased Land are fully utilised by Company X in the course of its business activities and therefore can be an active asset of the Taxpayers.

It is necessary to consider the rental exclusion before concluding that either Property A or the Lease are active assets.

Main use to derive rent exclusion

An asset whose main use is to derive rent is excluded from being an active asset under 152-40(4)(e). Such assets are excluded even if they are used in the course of carrying on a business (paragraph 21 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? (TD 2006/78)).

TD 2006/78 also states the following in relation to determinations as to whether an assets main use is to derive rent:

22.TD 2006/78 states that 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 follows:

•        the amount payable by a tenant to a landlord for the use of the leased premises (C.H. Bailey Ltd v. Memorial Enterprises Ltd [1974] 1 All ER 1003 at 1010, United Scientific Holdings Ltd v. Burnley Borough Council [1977] 2 All ER 62 at 76, 86, 93, 99);

•        a tenant's periodical payment to an owner or landlord for the use of land or premises (The Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne); and

•        recompense paid by the tenant to the landlord for the exclusive possession of corporeal hereditaments........ The modern conception of rent is a payment which a tenant is bound by contract to make to his landlord for the use of the property let (Halsbury's Laws of England 4th Edition Reissue, Butterworths, London 1994, Vol 27(1) 'Landlord and Tenant', paragraph 212).

23. A key factor therefore in determining whether an occupant of premises is a lessee is whether the occupier has a right to exclusive possession (Radaich v. Smith (1959) 101 CLR 209; Tingari Village North Pty Ltd v. Commissioner of Taxation [2010] AATA 233 at paragraphs 44-46, 2010 ATC 10-131, 78 ATR 693 and associated Decision Impact Statement 2008/4646 & 2008/4647). If, for example, premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to be rent and the premises not an active asset. On the other hand, if the arrangement allows the person only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

...

25. Ultimately, these are questions of fact depending on all the circumstances involved. Relevant factors to consider in determining these questions (in addition to whether the occupier has a right to exclusive possession) include the degree of control retained by the owner and the extent of any services provided by the owner such as room cleaning, provision of meals, supply of linen and shared amenities (Allen v. Aller (1966) 1 NSWR 572), Appah v. Parncliffe Investments Ltd [1964] 1 All ER 838 and Marchant v. Charters [1977] 3 All ER 918).

26. If an asset is used partly for business and partly to derive rent at any given time, it will be a question of fact dependent on all the circumstances as to whether the main use of the asset at that time is to derive rent. No one single factor will necessarily be determinative, and resolving the matter is likely to involve a consideration of a range of factors such as:

•        the comparative areas of use of the premises (between deriving rent and other uses); and

•        the comparative levels of income derived from the different uses of the asset.

The Commissioner accepts your contentions that the income from fees for providing areas of the Leased Land for equipment storage should not be considered rental income. The equipment owners do not have a lease or any other arrangement providing them with exclusive possession of the areas set aside for their storage needs. Company X is entitled to move equipment to different areas if required. The verbal storage agreement with equipment owners provides for maintenance and storage only. Further, Company X offers significant services to equipment owners, including maintenance, loaning of tools for the equipment as well as providing advice related to the equipment.

For the purposes of a comparative analysis of business income derived from Property A to the income from residential rent, the Commissioner has contemplated apportioning the business income between Property A and the Leased Land. However, on consideration of the facts in this case it is evident that the generation of business income is dependent on the combined use of both Property A and the Leased Land. It is therefore appropriate that all of Company X's business income is considered derived from and attributable to both Property A and the Leased for the purpose of the comparative analysis.

On this basis, Company A's business use of Property A on the basis of land area was greater than that used by the rental residence, and also income derived was greater than that derived by the Taxpayers from residential rental.

By application of the comparative analysis of area used and income proposed by paragraph 26 of TD 2006/78, to the circumstances of this case it can be concluded that the main use by the Taxpayers for the purposes of the active asset test has not been to derive rent. Therefore, the exclusion in paragraph 152-404(e) will not apply.

Both Property A and the Lease have been owned by the Taxpayers for less than 15 years. Company X who is a connected entity of the Taxpayers, used Property A and the Leased Land in the course of its business activities (equipment maintenance and storage), for the entire period the assets have been owned by the Taxpayers. The main use of neither Property A nor the Leased Land was not to derive rent, so the exclusion under paragraph 152-40(4)(e) does not apply. Both Property A and the Lease were active assets of the Taxpayers under paragraph 152-35(1)(b).