Edited version of private advice

Authorisation Number: 1052006706907

Date of advice: 13 July 2022

Ruling

Subject: CGT - active asset

Question

Is the Property an active asset for the purposes of the small business CGT concessions in Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 20XX

Relevant facts and circumstances

1.    Trust A is a discretionary trust established in 20XX with Taxpayer A and their spouse as trustees.

2.    Taxpayer A is the sole Appointor of Trust A.

3.    Taxpayer A and their spouse are the specified beneficiaries of Trust A.

4.    Trust A owns real property in Australia (the Property) that it acquired in 20XX.

5.    The only asset of Trust A is the Property, from which a business was carried on by Taxpayer A and, later, by Taxpayer A Pty Ltd in its capacity as trustee of Trust B. The Property was acquired for this purpose.

6.    Trust A is considering selling the Property and is likely to make a capital gain upon its sale.

7.    Trust A satisfies the maximum net asset value test as set out in section 152-15 of the ITAA 1997.

8.    The Property comprises of 5 suites known as Suite 3, Suite 4, Suite 4A, Suite 7 and Suite 10. All suites are comprised in one certificate of title.

9.    Between 20XX and the current time, Suites 3, 4, 4A and 7 have been rented to unrelated parties (i.e. parties that are neither connected with Trust A or an affiliate of Trust A).

10.  Suite 10 (the Business Premises) has been occupied by a business since 20XX in the following manner:

11.  Trust B is a discretionary trust established by deed with Taxpayer A Pty Ltd as trustee.

12.  Taxpayer A is the sole director and shareholder of Taxpayer A Pty Ltd.

13.  From 20XX, Trust B entered into an arrangement with another entity (the Group) pursuant to which Trust B carried on the business under the name of the Group (the agreement). Under the terms of the agreement, the Group provided some administration assistance however Trust B was responsible for:

•         rendering services from the Business Premises;

•         employing or engaging all employees necessary to facilitate the continuation of the business from the Business Premises; and

•         providing day-to-day ongoing management of the business.

14.  The Group is not connected with or an affiliate of Trust A in the circumstances described in sections 328-125 or 328-130 of the ITAA 1997.

15.  The Group, which leased the Business Premises from Trust A, sublet the Business Premises to Trust B. The business of Trust B occupied the entire Business Premises.

16.  Trust B made the following income distributions between 20XX and 20XX:Table 1: Income Distributions

17.  Trust B made no capital distributions during this time.

18.  The total lettable area of the Property is xxx square metres apportioned between the Suites as follows: Table 2: Lettable area of property

19.  Between the 20XX income year and the 20XX income year the rental and business income derived from the Suites was as follows: Table 3: Income derived

Relevant legislative provisions

Acts Interpretation Act 1901 section 15AB

Income Tax Assessment Act 1997 Division 152

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 section 152-40

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

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

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

Income Tax Assessment Act 1997 section 328-125

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

Income Tax Assessment Act 1997 paragraph 328-125(1)(b)

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

Income Tax Assessment Act 1997 subsection 328-125(4)

Income Tax Assessment Act 1997 section 328-130

Reasons for decision

Subsection 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 of ownership, 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 and a half years.

Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business.

However, paragraph 152-40(4)(e) of the ITAA 1997 explains that an asset whose main use is to derive rent cannot be an active asset.

Paragraph 152-40(4A)(b) of the ITAA 1997 provides that to determine the main use of an asset, treat any use by your affiliate, or an entity that is connected with you, as your use.

Connected with test

Subsection 328-125(1) of the ITAA 1997 explains that an entity is connected with another entity if:

(a)  either entity controls the other entity; or

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

Subsection 328-125(3) of the ITAA 1997 provides that an entity (the first entity) 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 first entity, its affiliates, or the first entity together with its affiliates.

Additionally, subsection 328-125(4) of the ITAA 1997 provides that an entity (the first entity) controls a discretionary trust for an income year if, for any of the four income years before that year:

(a)  the trustee of the trust paid to, or applied for the benefit of:

                               (i)        the first entity; or

                              (ii)        any of the first entity's affiliates; or

                            (iii)        the first entity and any of its affiliates;

any of the income or capital of the trust; and

(b)  the percentage (the control percentage) of the income or capital paid or applied is at least 40% of the total amount of income or capital paid or applied by the trustee for that year.

The business run out of the Business Premises was carried on via 3 different business structures between 20XX and the current time. For the purposes of this ruling, we are interested in the first 2 business structures as Trust A has not asked us to consider if the Property was an active asset from and beyond 20XX.

Trust A and Taxpayer A

Between 20XX and 20XX the business run out of the Business Premises was carried on by Taxpayer A as sole proprietor. In order for the Property to be considered an active asset of Trust A for this period, Taxpayer A must be 'connected with' or an 'affiliate' of Trust A.

The Commissioner is satisfied that Trust A is controlled by Taxpayer A in a way described under subsection 328-125(3) of the ITAA 1997 given Taxpayer A himself is one of the trustees of Trust A and can therefore be reasonably expected to act in accordance with his own directions or wishes. Accordingly, Taxpayer A was connected with Trust A for the period during which the business was carried on by Taxpayer A as sole proprietor (April 20XX to July 20XX).

Trust A and Trust B

From July 20XX to 20XX, Trust A leased the Business Premises to the Group (an unrelated entity) and the Group sublet the premises to Trust B. The business run out of the Business Premises was carried on by Trust B.

In order for the Property to be considered an active asset of Trust A for this period, Trust B must be 'connected with' Trust A.[1] Trust B and Trust A will be 'connected with' each other if both entities are controlled in a way described in section 328-125 of the ITAA 1997 by the same third entity.

Trust B made distributions to Taxpayer A in each of the 20XX to 20XX income years in excess of XX% of total distributions. The Commissioner is therefore satisfied that Trust B was controlled by Taxpayer A for that period pursuant to subsection 328-125(4) of the ITAA 1997.

As both Trust B and Trust A were controlled by the same entity (Taxpayer A) from July 20XX to 20XX, Trust B is considered an entity connected with Trust A during that period pursuant to paragraph 328-125(1)(b) of the ITAA 1997.

Main use to derive rent

Taxation Determination TD 2006/78[2] considers, amongst other issues, the situation where there is part business and part rental use of an asset. It states that an asset owned by the taxpayer and used partly for business purposes and partly to derive rent can be an active asset under section 152-40 of the ITAA 1997 where it is considered that the main use of the premises is not to derive rent. Paragraph 26 of TD 2006/78 states that:

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.

Example 5 in TD 2006/78 considers mixed use of a property as follows:

Mick owns land on which there are a number of industrial sheds. He uses one shed (45% of the land by area) to conduct a motor cycle repair business. He leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the motor cycle repair business is 80% of the total income (business plus rentals) derived from the use of the land and buildings.

In determining if the main use of the land is to derive rent, it is appropriate to consider a range of factors. In this case, a substantial (although nevertheless not a majority) proportion by area of the land is used for business purposes. As well, the business proportion of the land derives the vast majority (80%) of the total income. In all the circumstances, the Tax Office considers the main use of the land in this case is not to derive rent and accordingly the land is not excluded from being an active asset by paragraph 152-40(4)(e) of the ITAA 1997.

The Explanatory Memorandum supporting an amending Act can also be used to assist in interpreting a provision (see section 15AB of the Acts Interpretation Act 1901).

The Explanatory Memorandum to the Tax Laws Amendment (2009 Measures No. 2) Bill 2009 (the EM) makes the following statements about paragraph 152-40(4)(e) and subsection 152-40(4A) of the ITAA 1997:

2.73 The amendments remove the focus on the main use of an asset in the course of carrying on the business mentioned in subsection 152-40(1) of the ITAA 1997 and focus instead on the main use of the asset by the taxpayer. [Schedule 2, item 26, paragraph 152-40(4)(e)]

2.74 The amendments adopt an attribution approach in relation to the use of an asset by a taxpayer's affiliate or an entity connected with the taxpayer. This approach treats the use of the asset by the affiliate or the entity connected with the taxpayer as though it were the use of the taxpayer. [Schedule 2, item 27, paragraph 152-40(4A)(b)]

2.75 This attribution approach, therefore, treats any business use by the taxpayer's affiliate or an entity connected with the taxpayer as business use by the taxpayer irrespective of whether the taxpayer receives rental income from the affiliate or entity connected with the taxpayer. If the affiliate or entity connected with the taxpayer uses the asset to derive interest, rent, royalty, or foreign exchange gains from an entity that is neither an affiliate of nor connected with the taxpayer, that use is treated as the taxpayer's use. [Schedule 2, item 27, paragraph 152-40(4A)(b)]

Application to Trust A's circumstances

Trust A has owned a CGT asset (the Property) for more than 15 years and for at least 7 and a half years during Trust A's period of ownership (i.e. from 20XX to 20XX) the Property was used in the course of carrying on a business carried on by entities connected with Trust A. However, as the Property has also been used to produce rental income, we must consider whether the main use of the asset at that time was to derive rent.

Comparative areas of use of the premises

Taxpayer A and Trust B are entities connected with Trust A. Therefore, for the purposes of paragraph 152-40(4)(e) of the ITAA 1997 Taxpayer A's and Trust B's use of part of the Property is treated as Trust A's use of that part of the Property pursuant to paragraph 152-40(4A)(b) of the ITAA 1997.

Trust A has provided details of the comparative areas of the use of the Property between rent (from unrelated parties) and business. X% of the total lettable area of the Property has been used for business by entities connected with Trust A, while X% has been leased for use by unrelated entities.

Comparative levels of income derived from the different uses of the asset

As stated above, paragraph 152-40(4A)(b) of the ITAA 1997 provides that to determine the main use of an asset, any use by your affiliate, or an entity that is connected with you, is treated as your use. As such, the income derived from the business carried on by entities connected with Trust A should be considered when determining what the main use of the Property is. Furthermore, any rent paid by those connected entities is not treated as rent for the purposes of determining Trust A's main use of the Property.

Comparative levels of income derived from 20XX-20XX

From 20XX to 20XX the Business Premises was rented to Taxpayer A who operated the business as a sole proprietor.

Because Taxpayer A is connected with Trust A, Taxpayer A's use of the Property is treated as Trust A's use of the Property in accordance with paragraph 152-40(4A)(b) of the ITAA 1997. Therefore, the income earned by Taxpayer A from the business is treated as business income of Trust A for the purposes of determining the main use of the Property, regardless of the fact that Trust A received rental income from Taxpayer A.

While the rent paid by Taxpayer A to Trust A for that period is not treated as rental income received from an unrelated party, the attribution approach provided for by paragraph 152-40(4A)(b) of the ITAA 1997 does not facilitate or enable Trust A to treat the rent received from Taxpayer A as business income of Trust A and can be ignored for the purposes of determining Trust A's main use of the Property.

For the purposes of subsection 152-40(4) of the ITAA 1997, the business income derived by Taxpayer A from the business constituted the following percentage of Trust A's total income from the Property:

•         20XX - XX%

•         20XX - XX%

•         20XX - XX%

Comparative levels of income derived from 20XX-20XX

From 20XX to 20XX the Business Premises was rented to the Group, who then sublet the premises to Trust B.

Because the Group is neither connected with Trust A or its affiliate, paragraph 152-40(4A)(b) of the ITAA 1997 does not operate to treat the Group's use as Trust A's use. As such, the rent paid by the Group to Trust A is not treated as business income of Trust A for the purposes of determining the main use of the Property. Rather, the rent paid by the Group is treated the same as the rent paid to Trust A in respect of Suites 3, 4, 4A and 7.

Only the business income earned by Trust B (an entity connected with Trust A) is treated as business income of Trust A.

For the purposes of subsection 152-40(4) of the ITAA 1997, the business income derived by Trust B from the business constituted the following percentage of Trust A's total income from the Property:

•         20XX - X%

•         20XX - X%

•         20XX - X%

•         20XX - X%

•         20XX - X%

•         20XX - X%

•         20XX - X%

•         20XX - X%

Main use

Over the period during which the Property was used in the course of carrying on a business carried on by entities connected with Trust A, the majority of the Property by area (X%) was used for rental purposes (to unrelated parties), however the vast majority (between X%-X%) of the income from the Property was business income derived by connected entities.

We do not consider that the exclusion in paragraph 152-40(4)(e) of the ITAA 1997 applies in these circumstances. Therefore, the Property is an active asset and satisfies the active asset test.

[1] Pursuant to section 328-130 of the ITAA 1997, only an individual or company can be an affiliate of another entity. Therefore, as a trust, Trust B cannot be an affiliate of Trust A.

[2] 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?