Edited version of private advice

Authorisation Number: 1052000290953

Date of advice: 22 July 2022

Ruling

Subject: Meaning of active asset - inherently connected

Question

Is the balance of funds held by the company in the account inherently connected with the business carried on by the company pursuant to sub-paragraphs 152-40(3)(b)(ii) and 152-40(3)(b)(iii) of the Income Tax Assessment Act 1997 (ITAA 1997) and hence an active asset of the company for each of the years in question?

Answer

Yes, when you dispose of your share in a company or interest in a trust, any amount held in a bank account, that is inherently connected with the business, is classified as a financial instrument in accordance with sub-paragraph 152-40(3)(b)(ii) of the ITAA 1997. It is classified as an active asset in an income tax year when applying the 80% test. If you hold physical Australian denominated cash, this amount can also be classified as an active asset in accordance with sub-paragraph 152-40(3)(b)(iii) of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

In a prior income year, Person A (A) and Person B (B) established a company (the Company).

The Company has ordinary shares. Half of the ordinary shares are held by A and the remaining half are held by B.

Both A and B have been approached to sell their shares in the Company.

In the relevant income year, the Company commenced trading and has operated an active business.

The Company runs its accounts at levels less than that required to maintain the working capital of the business on a day to day basis.

The Company's deposits are made to the account (account) from the subsequent account regularly for the primary purpose of use within the business as and when the need arises. Additional working capital is sourced from the account regularly.

A summary of the transactions in and out of the account.

The level of funds held in the account at the end of each income year is less than what is required from a working capital perspective.

From the commencement there have been more withdrawals in number from the account back to the subsequent business account than deposits to it, showing that the account is in fact an active part of the business capital requirements.

The company runs its main business account in a consistent way and the funds are transferred between accounts regularly but that the business account is left with no working capital such that transfers back to the business account are required on a regular basis to meet the day to day running costs of the company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 section 328-125

Reasons for decision

Detailed reasoning

Meaning of Active Asset

Paragraph 152-40(4)(b) of the ITAA 1997 explains that generally shares in a company are not active assets, other than the shares listed in subsection 152-40(3) of the ITAA 1997. Paragraph 152-40(4)(d) of the ITAA 1997 also explains financial instruments, such as bank accounts, loans, debentures, bonds, futures and other contracts and share option cannot be active assets.

Subsection 152-40(3) of the ITAA 1997 explains that a CGT asset is an active asset when you own the asset and it is used or ready to use in the course of carrying on a business, or at a given time if, at that time, you own it and:

a)    it is either a share in a company that is an Australian resident at the time or an interest in a trust that is a resident trust for CGT purposes for the income year in which that time occurs and:

b)    the total of:

c)    (i) the market values of the active assets of the company; and

d)    (ii) the market value of any financial instruments of the company that are inherently connected with a business that the company carries on; and

e)    (iii) any cash of the company that is inherently connected with such business;

is 80% or more of the market value of all the assets of the company.

This means a share in a company is an active asset if the company itself has active assets and inherently connected financial instruments and cash with a market value of at least 80% of the market value of all its assets. Cash and financial instruments are not active assets, but they count towards the satisfaction of the 80% test provided they are inherently connected with the business.

Paragraph 152-40(3)(b) of the ITAA 1997 states a share in a company is an active asset at a time if the share or interest fails to meet the requirements under subsection (3) at that time and the failure is of a temporary nature only.

Inherent Connection

The term 'inherently connected' is not defined in the Income Tax Assessment Act 1936 (ITAA 1936) or the ITAA 1997. Paragraph 328-125(1)(b) of the ITAA 1997 provides that an entity is connected with another entity if both entities are controlled in a way described in this section by the same third party. Inherent connection necessarily requires something more than just some form of connection between the financial instrument and the business. A thing might be regarded as inherently connected to a business when it is a permanent or characteristic attribute of the business. Where a business is holding excess funds arising from a temporary spike in trading activity or the sale of a business asset, the excess funds might also reasonably be regarded as inherently connected with the business. A financial instrument must be inherently connected with the business that the owner of the financial instrument carries on, rather than any business a related entity carries on.

Application to your circumstances

When you dispose of a share(s) in a company or an interest in a trust, subsection 152-40(3) of the ITAA 1997 allows you to apply the modified active asset test (also referred to as the '80% test') to your circumstances. You satisfy the 80% test when the sum of the market value of the company or trust's active assets are 80% or more of the market value of all of the company and trust's assets.

A bank account is classified as a 'financial instrument' for active asset purposes. Paragraph 152-40(4)(d) of the ITAA 1997 states financial instruments are not active assets. However, to calculate the 80% test, subparagraph 152-40(3)(b)(ii) allows for financial instruments to be included in the sum of active assets. Therefore, the balance of cash held by the company in the account is inherently connected with the Company and can be used towards the calculation of the 80% test to satisfy the meaning of the active asset test pursuant to sub-paragraphs 152-40(3)(b)(ii) of the ITAA 1997, classified as a financial instrument.

Australian denominated cash is not a CGT asset in accordance with section 108-5 of the ITAA 1997 and supported by Taxation Determination TD 2002/25: Income tax: capital gains: is Australian currency a CGT asset under section 108-5 of the Income Tax Assessment Act 1997 (ITAA 1997) if it is used as a legal tender to facilitate a transaction? However, when the 80% test is being applied, subparagraph 152-40(3)(b)(iii) allows cash to be included as a part of the sum of the active assets at a point in time. Therefore, when you hold physical cash, if the cash is inherently connected with the Company, it can be included into the calculation of the 80% test to satisfy the meaning of the active asset test pursuant to subsection 152-40(3) of the ITAA 1997.

Further issues for consideration

This ruling has not fully considered your eligibility for the active asset test in section 152-35 of the ITAA 1997. You should ensure that you satisfy the application of cash and financial instruments as part of the modified active asset test when working out the application of the basic conditions to apply the small business concessions under subsection 152-10(2) of the ITAA 1997. More information is available on our website www.ato.gov.au, in the search field input keywords 'small business CGT concessions' or webpage reference 'QC 22655'.