Edited version of private advice

Authorisation Number: 1052097060274

Date of advice: 27 April 2023

Ruling

Subject: CGT - small business concessions

Question

Does the property satisfy the active asset test, and can the capital gain from the sale of the property therefore be disregarded under the small business 15 year exemption?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Partners A and B (you) ran a small business in partnership. Your business was buying industrial land, subdividing, building industrial sheds, and the leasing out of sheds that you retained ownership of; and selling others. You did not carry on any other business, other than your partnership's business.

You ran your small business from the mid-19XXs. You purchased the property in the late 19XXs and held it together as joint tenants. You used the property in your small business from its acquisition up to its disposal. You ceased business in the 20XX calendar year due to you both retiring.

Partner A held a Queensland Building and Construction Commission licence until 20XX, when it was cancelled for retirement reasons. Partner A built the industrial sheds on the property in the 19XXs and early 20XXs. They were the builder, site manager, project manager and then maintenance manager for the property. The long-term maintenance and upgrading of the sheds was their full time work from the mid-19XXs, and part time since the mid-20XXs. Partner B has worked part time in the business and their duties included managing administration, maintaining records (including records of tenants, disbursements and rental receipts), producing rental invoices and invoicing tenants for rentals, managing collection and banking of rental receipts, and body corporate administration. Further activities included maintaining tenant records and managing tenant disputes. There was no office set up on the property, and none of the administrative activities were carried out at the property.

Partner A managed informal occupant lease arrangements until this task was transferred to an agent in the late 20XXs. There were no formal lease agreements in place during the time Partner A managed these. Generally the formal agreements would be for one year, with options to extend; extensions could be granted informally and could be longer, for example 2 to 3 years or more. One occupant was there for over 20 years and used multiple sheds over time and there was no lease in place with this occupant. Some of the sheds were used for storage in a general sense (for example, storing vehicles overnight, storing clothing for months at a time, or storing machinery parts) and some sheds were used for other activities undertaken by the occupants, for example, welding.

Partner A undertook most of the repairs and maintenance of the property (apart from specialised trades) which was full-time work. This work included tasks such as repairing concrete and gardens, underground pipes, and fittings and fixtures within the sheds. This was also required to meet insurance obligations.

The income derived from the property has been reported as rental income in both of your income tax returns. Evidence of a 'shared rental property - distribution' statement was provided which showed 50% of the 'net rent' being reported by Partner A and the remaining 50% by Partner B.

You pay tenant outgoings in respect of the property; that is, water, rates, and insurance.

You continuously owned the property for at least 15 years until the property was sold in 20XX.

You used the property in your partnership's business for at least 7 and a half years, until your business ceased due to retirement, and you sold the property. The partnership's turnover was under $X million.

A CGT event occurred when the property was sold, which resulted in a capital gain.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 152

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 section 152-35

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 subparagraph 152-40(4)(e)(ii)

Reasons for decision

Sections 152-35 and 152-40 of the ITAA 1997 discuss the 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 is from when the asset is acquired until the CGT event. If the business ceases within the 12 months before the CGT event (or such longer time as the Commissioner allows) the relevant period is from acquisition until the business ceases.

A CGT asset is an active asset if it is owned by you and is used or held ready for use in a business carried on (whether alone or in partnership) by you, your affiliate, your spouse or child, or an entity connected with you.

The meaning of "active asset" is discussed in section 152-40 of the ITAA 1997. Exceptions (that is, exclusions) to active assets are discussed in subsection 152-40(4). Paragraph 152-40(4)(e) provides that an asset cannot be an active asset where its main use by you is to derive interest, an annuity, rent, royalties or foreign exchange gains unless:

(i)    the asset is an intangible asset and has been substantially developed, altered or improved by you so that its market value has been substantially enhanced; or

(ii)   its main use for deriving rent was only temporary.

Such assets are excluded even if they are used in the course of carrying on a business. Therefore, the critical issue is whether the main use of the property was to derive rent. If the main use of the property was to derive rent, the property is excluded from being an active asset, even if the property was used in the course of carrying on a business.

Main use to derive rent

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) provides guidance on whether an asset's main use is to derive rent.

Paragraph 22 of TD 2006/78 explains 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).

TD 2006/78 provides examples that illustrate "main use" and "mixed use" at paragraphs 2 to 3, and 15 to 16 respectively.

Example 1: rental properties

2. Commercial Property Co owns 5 commercial rental properties. The properties have been leased for several years under formal lease agreements to various commercial tenants which have used them for office and warehouse purposes. The terms of the leases have ranged from 1 year to 3 years with a 3 year option and provide for exclusive possession. The company has not engaged a real estate agent to act on its behalf and manages the leasing of the properties itself.

3. In this situation, the company has derived rental income from the leasing of a number of properties. Accordingly, the main (only) use of the properties is to derive rent and they are therefore excluded from being active assets under paragraph 152-40(4)(e) of the ITAA 1997 regardless of whether the activities constitute the carrying on of a business.

Example 5: mixed use

15. 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.

16. 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.

You advised that some of the sheds were used for storage in a general sense (for example, storing property overnight, or for months at a time or other indeterminate periods) but this is distinct from a supply of storage sheds where other services would ordinarily be provided, such as security and moving services. Some sheds were used for other activities undertaken by your tenants.

You advised that although the property maintenance activities were undertaken on the property, no other activity (such as administration, bookwork, etc.) was undertaken on the property. This further demonstrates that the main use of the property was to derive rent from shed tenants, and not to derive income from other sources or activities. Therefore, your circumstances are not consistent with Example 5 of TD 2006/78.

Paragraphs 23 to 25 of TD 2006/78 provide some factors which indicate that an asset is being used to derive rent. These factors include whether the occupier of a premises has right to exclusive possession; how much control is retained by the owners of the premises; and the extent of services provided by the owner such as room cleaning, provision of meals, supply of linen, and shared amenities.

TD 2006/78 provides another example at paragraphs 4 to 7 that illustrates "extent of services provided":

Example 2: commercial storage

4. Christine carries on a business of providing commercial storage space. The storage facility comprises 50 storage sheds which are available for hire for periods of 1 week to 2 years or more. Christine provides office facilities and 24 hour on-site security. She also provides various items of equipment for sale or loan to clients such as trolleys, cardboard boxes, brooms, tape, pens, locks, bolt cutters, torches and shelves. A cleaning service is also provided and charged for.

5. Christine enters into a storage agreement with each client. The agreements provide that in certain circumstances she can relocate the client to another space or enter the space without consent and that the client cannot assign the rights under the agreement.

6. The arrangements entered into in this situation indicate that the users of the storage sheds do not have the right to exclusive possession but rather only the right to enter and use the sheds for certain purposes. Some of the arrangements entered into were short term and a range of services were provided to the users. There was also no intention by the parties to grant a lease.

7. Having regard to all the circumstances, the Tax Office considers a tenant/landlord relationship does not exist between the parties in this example and therefore the amounts received are not rent. Accordingly, the storage facility is not excluded by paragraph 152-40(4)(e) of the ITAA 1997 and is therefore an active asset.

You provided details of maintenance activities and described these as services provided to shed tenants. However, the Commissioner considers that these activities are better described as maintaining and preserving the value of your capital assets. This contrasts with the extent of services provided in Example 2 of TD 2006/78.

Other activities detailed, such as building, leasing, compliance etc. are also considered to be ordinary activities undertaken by a property owner, as opposed to extensive services provided to tenants or occupants. Although you retained some degree of control of the sheds, and incurred costs in relation to the maintenance and running expenses of the sheds, this is not considered sufficient to determine that the payments made by the shed occupants were not rent. Your circumstances are different to those of a commercial storage shed supplier which provide additional services to clients rather than activities normally undertaken to maintain capital assets in good condition and preserve value.

Notwithstanding paragraph 6 of TD 2006/78 which states that "a key factor therefore in determining whether an occupant of premises is a lessee is whether the occupier has a right to exclusive possession", this is not the sole determinative factor of whether receipts are considered to be rent or not. As noted in paragraph 1, it will depend on the particular circumstances of each case; paragraph 25 also states that ultimately, these are questions of fact depending on all the circumstances involved. Each factor and particular circumstance in each case must be considered on balance.

Conclusion

Returning to paragraph 152-40(4)(e) of the ITAA 1997: in your circumstances, your asset (the property) was not intangible and its main use for deriving rent was not only temporary. You had both long-term and shorter-term occupants in place. You advised that you historically had no formal lease agreements in place, but you engaged an agent in the late 20XXs to generate formal lease agreements with occupants on your behalf.

Your activities are better described as leasing commercial property to receive rental income for substantial periods and obtaining the benefit of any capital growth in the future arising from the length of your ownership period of the property. The payments you received from the shed occupants are considered to have been rent. Accordingly, the main use of the sheds is considered to have been to derive rent, and therefore the sheds and the property are excluded from being active assets under paragraph 152-40(4)(e) of the ITAA 1997.

As the property does not satisfy the active asset test, the capital gain from the sale of the property cannot be disregarded under the small business 15 year exemption.