Edited version of private advice

Authorisation Number: 1052008838562

Date of advice: 29 July 2022

Ruling

Subject: CGT - small business concessions

Question 1

Do you meet the basic conditions under section 152-10 of the Income Tax Assessment Act 1997 (ITAA 1997) to apply the small business capital gains tax (CGT) concessions?

Answer

Yes.

Question 2

Do you satisfy the conditions for the small business 50% reduction in Subdivision 152-C of the ITAA 1997 and the small business retirement exemption in Subdivision 152-D of the ITAA 1997 in relation to the post CGT property?

Answer

Yes.

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You are a founding director and shareholder of a company (the Company). You held less than 40% of the shares in the Company.

The Company has developed a novel process for a certain industry over a number of years.

The Company carries on the business of developing and commercialising the IP and patent rights in relation to certain technologies.

The Company derives revenue from the granting of licenses to third parties including:

•         User licences for commercial use of the intellectual property;

•         Site based testing and piloting licenses to undertake testing and piloting using the intellectual property;

•         Certified laboratory partner agreements to use the Intellectual property in undertaking test work and piloting for companies.

The Company received a purchase offer which the directors have accepted.

The business was carried on up until the date of sale by the current directors.

There were other directors of the Company prior to the sale.

Based on the 20XX financial statements the Company will meet the $XM aggregated turnover test and the $XM MNAV test. The Company sold the entire business including its intellectual capital (ie the process) to the new buyer.

The Company has been in existence for more than 7.5 years at the time of sale.

You were over 55 years of age on the sale date.

Your only other asset as a portion of your home (valued at $XX0,000) which was used as a rental property for some years but has been your primary residence for over 15 years.

The main asset of the Company is intellectual property which makes up over 90% of its assets.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 104-10

Income Tax Assessment Act 1997 section 108

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-15

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

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

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

Income Tax Assessment Act 1997 subsection 152-40(3)

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 section 328-130

Income Tax Assessment Act 1997 section 152-205

Income Tax Assessment Act 1997 section 152-305

Reasons for decision

Summary

The capital gain you made on the disposal of the shares held in the Company can be reduced under Division 152 because the basic conditions for relief in section 152-10 have been satisfied in the 20XX income year.

Detailed reasoning

Note: Unless otherwise stated, all legislative references below are to the Income Tax Assessment Act 1997.

Basic conditions for small business concessions

To qualify for any of the CGT small business concessions, an entity must satisfy several conditions that are common to all the concessions, known as the basic conditions. The basic conditions are contained in subdivision 152-A.

According to subsection 152-10(1):

A capital gain (except a capital gain from CGT event K7) you make may be reduced or disregarded under this Division if the following basic conditions are satisfied for the gain:

(a) a CGT event happened in relation to a CGT asset of your in an income year;

(b) the event would (apart from this Division) have resulted in the gain;

(c) at least one of the following applies:

(i) you are a small business entity for the income year;

(ii) you satisfy the maximum net asset value test;

(iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership;

(iv) the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;

(d) the CGT asset satisfies the active asset test in section 152-35.

Basic condition 152-10(1)(a)

Shares are CGT assets as defined in section 108. In 20XX, you disposed of your shareholding in THE COMPANY. As a result of the disposal, CGT event A1 under section 104-10 happened to each of the shares. The condition in paragraph (a) is satisfied.

Basic condition 152-10(1)(b)

A capital gain resulted from this CGT event and as such, this condition is satisfied.

Basic condition 152-10(1)(c)

Paragraph 152-10(1)(c) states that at least one of the requirements listed at subparagraphs (i) to (iv) must apply. The first and third requirements do not apply as:

(i)      You are not a CGT small business entity

(ii)     ...

(iii)    You are not a partner in a partnership.

(iv)    ...

This leaves 152-10(1)(c)(ii) and 152-10(1)(c)(iv) to be considered.

For 152-10(1)(c)(ii) to apply, you must satisfy the maximum net asset value (MNAV) test as outlined in section 152-15. The MNAV test is satisfied if, just before the CGT event, the sum of the net value of the CGT assets owned by:

(a) you

(b) any entities connected with you, and

(c) any affiliates of you or entities connected with such affiliates,

does not exceed $6 million.

The net value of your CGT assets is under $AA0,000 being a portion of your primary residence which is valued at $AA0,000 and which was used as an investment property between 200C and 200D.

Net assets of entities connected with you

Section 328-125 provides 'control' tests which govern when an entity will be deemed to be 'connected with' another entity.

Subsection 328-125(1) states:

An entity is connected with another entity if:

(a) either entity controls the other in a way described in this section; or

(b) both entities are controlled in a way described in this section by the same third entity.

In relation to companies, the relevant control test is set out in paragraph 328-125(2)(a) as follows:

An entity (the first entity) 'controls' another entity if the first entity, its affiliates, or the first entity together with its affiliates own or have the right to acquire 40% of the other entity's:

i. income distribution

ii. capital distribution, or

iii. if the entity is a company - 40% of its voting rights.

As your shareholding in the Company is under 40%, your entitlement to income and capital from the Company and your voting rights in the Company is under 40%. Therefore you are not considered to control the Company and therefore the Company is not considered 'connected to' you for the purposes of the MNAV test.

Net assets of your affiliates

An affiliate is defined by subsection 328-130(1) as being an individual or company who 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 individual or company.

However, subsection 328-130(2) states that an individual is not your affiliate merely because of the nature of the business relationship you and the individual share.

Whether a person is acting in concert with another is essentially a question of fact. The term 'acting in concert' involves at least an understanding between the parties as to a common purpose or object.

According to paragraph 2.36 of the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Bill 2007 which introduced the definition of affiliate into the tax law, the following factors may have a bearing on whether an individual or company is an affiliate of an entity:

•         Family or close personal relationships.

•         Financial relationships or dependencies.

•         Relationships created through links such as common directors, partners, or shareholders.

•         The degree to which the entities consult with each other on business matters; or

•         Whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity.

In FC of T v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344 the full High Court, in considering the meaning of the phrase 'might reasonably be expected' as it appears in section 177C of the ITAA 1936, held that '[a] reasonable expectation requires more than a possibility'. In the High Court's view the phrase involves a prediction that must be sufficiently reliable for it to be regarded as reasonable.

It is considered that the Company is not your affiliate. There is no reasonable expectation that you could influence the Company given there are other directors and given your minority shareholding, without other director(s)/shareholder(s) agreeing with you.

MNAV conclusion

Since the Company is not considered connected to you, nor your affiliate, and there are no other relevant entities at the time of your share sale, subparagraph 152-10(1)(c)(ii) is satisfied as you meet the MNAV test as your net asset value is under $X million.

Since subparagraph 152-10(1)(c)(ii) is satisfied, we do not need to consider subparagraph 152-10(1)(c)(iv).

Basic condition 152-10(1)(d)

Paragraph 152-10(1)(d) requires the CGT asset which has been disposed of to satisfy the active asset test in section 152-35, which includes requirements in relation to the period of ownership of the CGT asset and the period the CGT asset has been active.

Active asset test

The active asset test is satisfied 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 test period detailed below, 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 during the test period.

The test period:

•         begins when you acquired the asset, and

•         ends at the earlier of:

˗ the CGT event, and

˗ when the business ceased, if the business in question ceased in the 12 months before the CGT event (or such longer time as the Commissioner allows).

You held the shares since the time the Company was incorporated, so the requirement in section 152-35 will be satisfied if the shares are active assets.

The meaning of an active asset is set out in section 152-40. Where the assets being disposed of are shares in a company, the definition of an active asset is modified, so that even if it was possible for the assets to be active assets as defined in subsection 152-40(1), the exception in subsection 152-40(4) applies and they cannot be active assets unless the requirements of subsection 152-40(3) are met.

Subsection 152-40(1) states:

152-40 (1) A CGT asset is an active asset at a time if, at that time:

(a) you own the asset (whether the asset is tangible or intangible) and it is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership) by:

(i) you; or

(ii) your affiliate; or

(iii) another entity that is connected with you; or

(b) if the asset is an intangible asset - you own it and it is inherently connected with a business that is carried on (whether alone or in partnership) by you, your affiliate, or another entity that is connected with you.

The shares you held in the Company did not contribute in any way to the income producing activities of the Company. Your shares are an equity interest separate from any business activities carried on by the Company. The shares give you rights to the income of the Company, rather than contributing to the income of the Company. Consequently, the shares in the Company are not used in the course of carrying on the business and are not inherently connected with the business being carried on by the Company. However, subsection 152-40(4) provides an alternate requirement for shares.

Subsection 152-40(4) states interests in an entity connected with you and other certain entities cannot be active assets other than shares and interests covered by subsection 152-40(3).

Subsection 152-40(3) states:

A CGT asset is also an active asset 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 that 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:

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

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

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

is 80% or more of the market value of all of the assets of the company or trust. (the 80% test).

In determining whether the 80% test is satisfied, the market value of active assets in the relevant company is added to the market value of financial instruments and any cash inherently connected to the relevant company's business to determine whether the total amount represents 80% or more of the market value of all the assets of the relevant entities. If it does, paragraph (b) is satisfied.

This requires a determination of the market value of each asset held by the Company, consideration of whether each of those assets would be active assets as defined, the market value of any financial instruments which are inherently connected with the business carried on by the Company and the amount of cash inherently connected with the business of the Company. The market value of the Company's active assets and inherently connected assets must then be 80% or more of the market value of all the assets of the Company.

The main assets of the Company are intellectual property. To determine if the 80% rule is satisfied in relation to the shares held by you in the Company, it needs to be determined whether these assets are themselves active assets.

The intellectual property assets held by the Company are intangible asset inherently connected with the business carried on by the Company, and therefore an active asset of the Company. the Company carries on a business of developing and commercialising such intellectual property and patent rights in relation to such novel process technologies. It derives revenue from the granting of licences to third parties to use such intellectual property; site based testing and piloting licences using such the intellectual property; and from certified laboratory partner agreements to use the Intellectual property in undertaking test work and piloting for companies.

The 20XX financial statements for the Company indicate the intellectual property make up over 90% of the total assets of the Company indicating you pass the modified active asset test based on the book value of the company at 30 June 20XX.

Given the amount the buyer paid for the Company, it is reasonable to conclude that the value attributed to the shares by the buyer approximates the market values of the assets of the Company and that the extra paid over the book value of the company's assets represents goodwill or further intellectual property of the Company. Goodwill, like the intellectual property in this case, is an intangible asset inherently connected with the business and so is an active asset of the Company.

Either way it is considered you pass the modified active asset test. Consequently, the shares held by you satisfy the condition in paragraph 152-10(1)(d).

Additional basic conditions for small business concessions

Subsection 152-10(2) of the ITAA 1997 provides additional basic conditions to be satisfied for the disposal of CGT assets that are shares in a company. In your case:

(a) the shares in the Company would still satisfy the active asset test if modified by the assumptions in subsection (2A);

(b) if you do not satisfy the MNAV test - you are carrying on a business just before the CGT event;

(c) the Company satisfies either:

(i) a modified CGT SBE test; or

(ii) a modified MNAV test; and

(d) just before the sale of the shares, you are a CGT concession stakeholders in the Company.

Paragraph 152-10(2)(a) of the ITAA 1997 - the modified active asset test

The assumptions in subsection 152-10(2A) of the ITAA 1997 require modifications to the active asset test as follows:

•         Paragraph (a) excludes financial instruments and cash that are inherently connected with the business if they were acquired for a purpose that included assisting the Company to satisfy the modified active asset test, and

•         The effect of paragraphs (b) - (e) is that any shares in companies or interest in trusts held by the object entity (the Company) in later entities are not active assets for the purpose of satisfying the modified active asset test. Instead the object entity's small business participation percentage of the assets of those later entities will be relevant to the active asset test, to the extent that those later entities satisfy the conditions in subsection 152-10(2B).

Paragraph 152-10(2A)(c) provides that the assets of later entities must be taken into account in determining whether the object entity satisfies the modified active asset test if subsection 152-10(2B) applies to those later entities

In respect of paragraph 152-10(2A)(a) of the ITAA 1997, the Commissioner is satisfied that none of the assets of the Company were acquired for a purpose that included assisting the Company to satisfy the modified active asset test.

The Company has a small direct shareholding in listed companies (MV $X00,000). The additional assumption in paragraph 152-10(2A)(b) applies to exclude these shares from the active asset test. They are excluded as the test is modified to capture the underlying assets of these listed companies.

As such, the shares satisfy the modified active asset test and paragraph 152-10(2)(a) of the ITAA 1997 is satisfied.

Paragraph 152-10(2)(b) of the ITAA 1997

As discussed previously, you satisfied the MNAV test so the additional basic condition in paragraph 152-10(2)(b) does not apply.

Paragraph 152-10(2)(c) of the ITAA 1997 - the modified CGT SBE test or MNAV test

Subsection 152-10(2)(c) of the ITAA 1997 modifies the CGT SBE test and the MNAV test by requiring that the following assumptions are made:

•         the only CGT assets or annual turnovers considered were those of the object entity, each affiliate of the object entity, and each entity controlled by the object entity in a way described in section 328-125;

•         each reference in section 328- 125 to 40% were a reference to 20%;

•         no determination under subsection 328-125(6) were in force;

Applying these modifications, only the CGT assets and annual turnovers of you and the Company are relevant, as:

•         you are not affiliates of, or connected with, each other,

•         you do not control any other entities, and

•         no determinations have been made under subsection 328-125(6) of the ITAA 1997 for either entity.

Based on the information provided, as the MNAVs of you and the Company are under $6,000,000, you both satisfy the modified MNAV test. As such, paragraph 152-10(2)(c) of the ITAA 1997 is satisfied for the shares.

Paragraph 152-10(2)(d) of the ITAA 1997 - Ownership percentage of CGT concessions stakeholders

According to section 152-60 of the ITAA 1997, an individual is a CGT concession stakeholder in a company at a time if the individual is a significant individual in the company at that time.

Section 152-55 of ITAA1997 defines a 'significant individual' in a company at a time is an individual who has a SBPP in the company of at least 20% at that time. An entity's SBPP in another entity at a time is the sum of the entity's direct and indirect SBPP's in the other entity at that time (section 152-65 of the ITAA 1997).

An entity's direct SBPP in a company, from item 1 of the table in subsection 152-70(1) of the ITAA 1997, is:

'the percentage of:

(a) the voting power in the company;

(b) any dividend that the company may pay; or

(c) any distribution of capital that the company may make,

that the entity has because of holding the legal and equitable interests in the company's shares.'

If an entity has more than one of the rights in (a) to (c) above, and the relevant percentages are different, the smaller or smallest percentage is the entity's SBPP in relation to the company.

An entity's indirect SBPP in a company is the entity's direct SBPP in an interposed entity multiplied by the interposed entity's total SBPP (both direct and indirect) in the company (subsection 152-75(1) of the ITAA 1997).

Are you a significant individual of the Company (the test entity)?

You held more than 20% of the shares on issue in the Company and, because of this, held more than 20% of the rights to voting, dividends and capital distributions. As such, just before the CGT event, you had a direct SBPP in the Company of more than 20% under item 1 of the table in subsection 152-70(1) of the ITAA 1997.

You did not hold an indirect SBPP in the Company as you did not hold any additional shares in the Company through a related interposed entity.

As your direct SBPP in the Company was greater than 20% you were a significant individual, and CGT concession stakeholder of the Company.

As you were a CGT concession stakeholder in the Company, paragraph 152-10(2)(d) of the ITAA 1997 is satisfied.

The additional basic conditions in subsection 152-10(2) of the ITAA 1997 are satisfied in relation to the sale of your shares in the Company.

CONCLUSION

You must satisfy all the basic conditions in subsection 152-10(1). The basic conditions in paragraphs 152-10(1)(a), (b), (c) and (d) are satisfied.

Since you satisfy all the basic conditions for relief in subsection 152-10(1), you can therefore apply the CGT small business concessions in Division 152 to reduce the capital gain made on the disposal of your shares in the Company.

Active asset reduction

To apply the small business 50% active asset reduction, you need to satisfy only the basic conditions. There are no further requirements. Since you satisfy the basic conditions as outlined above, you are eligible to apply the small business 50% reduction contained in section 152-205 of ITAA 1997.

Small business retirement exemption

As you are an individual and over 55 years of age, under subsection 152-305(1) there is no requirement that a contribution be made to a superannuation fund in order for you to meet the requirements of the CGT small business retirement exemption. As you meet the basic conditions as outlined above, there are no further requirements and you are eligible to apply the small business retirement exemption contained in section 152-305 of ITAA 1997.