Edited version of private advice

Authorisation Number: 1052102358494

Date of advice: 28 March 2023

Ruling

Subject: CGT small business concessions - rental properties

Question 1

Are Individual A and Individual B an association of persons carrying on a business as partners for the purposes of section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to their co-ownership of the Properties?

Answer

Yes, their co-ownership of rental properties is a partnership at general law as the ownership amounts to the carrying on of a business.

Question 2

Are the Properties 'active assets' under section 152-40 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

1 July XXXX to 30 June XXXX

Relevant facts and circumstances

Individual A and Individual B have acquired the following 3 properties that are leased (the Properties):

•         Address, date and purchase price provided. The property was purchased to carry on a XXXX business by a Related Company. Related Company leased the premises from the Individuals. Improvements were made to the premises. The XXXX business was sold in XXXX, and the new unrelated owners now lease the premises. The lessee has exclusive possession of the premises.

•         Address, date and purchase price provided and has one tenant - XXXX, which has exclusive possession of the premises.

•         Address, date and purchase price provided. It has XX separate tenants. The tenants have exclusive possession of their premises, with shared access to amenities. It was purchased with industrial buildings on a large site as a going concern. The Individuals improved this property over time as it was badly run down.

The Properties are owned by the Individuals as joint tenants.

The Properties are all leased as long-term rentals. Some leases are 3 years and others 5 years. All have options to renew.

All rental income is paid directly by the tenants into one bank account held by the Individuals. There is no cash being collected. Tax invoices are generated using MYOB and are emailed to all tenants each month with a due date for payment.

The liabilities for rates, water and electricity are paid by the Individuals and charged out as recoverable outgoings for the tenants based on the proportional area as per their lease.

The Individuals together spend on average of XX hours per week managing the rental properties. Individual A carries out most of the general repairs and maintenance themself for all the properties. This includes gardening, landscaping, repairs to buildings, driveways, and access roads. Inspections are carried out every 6 months and on average take about an hour each. An agent is now being used for online advertising to find new tenants and the agent completes the rental application. Individual A negotiates the terms of the lease, rent and bond to be paid. A solicitor prepares the leases. Individual B manages the administrative side, which includes invoicing the tenants for rent, calculating, and reconciling outgoings, recording all income and expenses for the profit and loss and BAS using MYOB, calculating the annual rent increases as per CPI or according to the lease. Taking phone calls from tenants and finding a solution to tenant issues. The Individuals maintain a dedicated room as their office, comprising 2 desks with chairs, phone, computer, printer, filing cabinets and storage shelving fixed to one wall, for this purpose.

There is no formal partnership agreement between the Individuals.

Combined the 3 commercial properties had a turnover of $X in gross rent for the 20XX financial year, with a net rental profit of $X.

The Individuals also own vacant land at an address, which they are currently developing. They have plans drawn up for the construction of a commercial development.

The Individuals are considering selling a commercial property and wish to apply the small business CGT concessions, including the small business roll-over relief to the construction of the new commercial development.

Relevant legislative provisions

Income Tax Assessment Act 1997

section 104-198

Division 152

Subdivision 152-A

Subdivision 152-E

Subsection 152-10(1)

Paragraph 152-10(1)(a)

Paragraph 152-10(1)(b)

Subparagraph 152-10(1)(c)(i)

Subparagraph 152-10(1)(c)(ii)

Subparagraph 152-10(1)(c)(iii)

Subparagraph 152-10(1)(c)(iv)

Paragraph 152-10(1)(d)

Subsection 152-10(2)

Section 152-40

Subsection 152-40(1)

Paragraph 152-40(1)(a)

Paragraph 152-40(1)(b)

Subsection 152-40(4)

Paragraph 152-40(4)(e)

Subsection 995-1(1)

Paragraph 995-1(1)(a)

Paragraph 995-1(1)(b)

Reasons for decision

Carrying on a business of letting rental properties

'Partnership' is defined in section 995-1 of the ITAA 1997 to mean:

(a)  an association of persons (other than a company or a limited partnership) carrying on business as partners or in receipt of ordinary income or statutory income jointly; or

(b)  a limited partnership.

Relevantly, the first limb of paragraph (a) of the definition refers to 'an association of persons (other than a company or a limited partnership) carrying on business as partners'. This reflects the general law definition of a partnership, set out in the Partnership Act of each State and Territory, which is 'the relation which subsists between persons carrying on a business in common with a view of profit'. This type of partnership is referred to as a general law partnership.

In Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners, the Commissioner explains that co-ownership of rental property is a partnership for income tax purposes but is not a partnership at general law unless the ownership amounts to the carrying on of a business.

In Taxation Ruling TR 94/8 Income tax: whether business is carried on in partnership (including 'husband and wife' partnerships) the Commissioner confirms that there are no statutory rules in the income tax law for deciding whether persons are carrying on business as partners. The question of whether a partnership exists is one of fact, having regard to the:

•         Intention - the mutual assent and intention of the parties

•         Conduct:

(a)  joint ownership of business assets

(b)  registration of business name

(c)  joint business account and the power to operate it

(d)  extent to which parties are involved in the conduct of the business

(e)  extent of capital contributions

(f)  entitlements to a share of net profits

(g)  business records

(h)  trading in joint names and public recognition of the partnership

The weight to be given to these factors varies with the individual circumstances. The above list of factors is not exhaustive and no single factor is decisive, although the entitlement to a share of net profits is essential.

An important element of the definition is 'carrying on a business'. Without this, there can be no partnership at general law (see TR 93/32).

Section 995-1 of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

Paragraph 8 of Taxation Ruling TR 2003/4 (which is about whether boat charter activities generate business or investment income) states:

The receipt of income from the lease of an asset does not of itself amount to the carrying on of a business (see FC of T v. McDonald 87 ATC 4541; (1987) 18 ATR 957), but instead would generally be the passive receipt of income from property.

Paragraph 51 of Taxation Ruling TR 2003/4 states:

... Beaumont J indicated (quoting Wertman v. Minister of National Revenue 64 DTC 5158) that for a business to be carried on by owners of property, one would expect that they would be involved in providing services in addition to the process of letting property (as with a boarding house), not merely receiving payments for the tenants' occupation of the property.

These statements indicate that a person who simply owns an investment property or several investment properties, either alone or with other co-owners is usually regarded as an investor who is not carrying on a rental property business.

The issue of whether individuals are carrying on a business of letting property has been considered in a number of cases, some of which are discussed below.

In the Federal Commissioner of Taxation v. McDonald 87 ATC 4541, the court found that the taxpayer and his wife were co-owners and not partners in a business operation based on the lack of their active participation (there was little if any active participation by the taxpayer or his wife and where involvement was necessary the taxpayer and not his wife became involved) and commercial expertise (the wife lacked commercial expertise):

In the present case, a number of indications point to the conclusion that the parties were not carrying on a business, with the consequence that their relationship was that of co-ownership rather than partnership. Their investment involved little, if any, active participation from either party. This was inevitable because the respondent was apparently in full-time employment, and Mrs McDonald was fully committed at home. On the few occasions on which the owners needed to be involved, the respondent and not Mrs McDonald attended to the matter. This was not a case of the active joint participation by the parties in a business activity. Rather, it was a case of a renting out of premises without the provision of other services of the kind discussed in Wertman, supra. In my view, there was here a mere investment in property rather than a partnership in the properties or their profits. This is not, of course, to say that it is not possible for husband and wife to enter into a partnership under the general law with respect to land dealings - see, e.g. Spence v. F.C. of T.(1967) 121 C.L.R. 273.

Given the respondent's minor participation in the affair and given Mrs McDonald's apparent lack of commercial expertise and her passive role, it is, I think, more accurate to describe them as co-owners in investments rather than as partners in a business operation.

In Cripps v. FC of T 99 ATC 2428; (1999) 43 ATR 1202 (Cripps case), the taxpayer and his wife purchased as joint tenants 14 double storey townhouses in Queensland. Following renovations, the townhouses were rented out. Some two years later, the taxpayer and his wife purchased a property in rural New South Wales. This property was used initially as a holiday home but was later periodically rented out (while the taxpayer and his wife were in New Zealand in 1991 and 1992 and in Tanzania in 1997 and 1998). A further property was purchased in Sydney in 1994 for residential purposes. After a failed attempt to sell it, it was also rented out.

The Administrative Appeals Tribunal found that the taxpayer and his wife were mere passive investors and were not in the business of deriving income from rental properties.

The AAT did not accept that that the level of involvement was such that it could be distinguished from McDonalds case:

The Applicant urged me on more than one occasion to distinguish McDonald's case on the basis that the properties in the present case were greater in number than those in McDonald's case. In McDonald's case, there were two properties, whereas in this case there are (now) 16. However, it must be remembered that the West Pennant Hills house was originally the home of the Applicant and his wife and that the Budgewoi house has been, and may again be, their holiday home (and has been let, in the words of the Applicant, ''sporadically'') and furthermore that the townhouses, although comprising 14 in number, were constructed on two titles purchased at the same time. The fact that there were more individual units and that their value may have been greater than that of the two properties which were relevant in McDonald's case does not, in my view, entitle me to distinguish McDonald's case; as in McDonald's case, we are concerned with real property investments owned by a husband and wife as joint tenants, where the husband is employed on a full-time basis, and where the wife is otherwise engaged (although in this case with both home duties and her part-time job). It is possible that the Applicant had a somewhat greater involvement in the management of the properties than did the taxpayer in McDonald. But he was of necessity an absentee landlord if only because the townhouses were a long way away.

The AAT also did not accept that the number of properties in the circumstances was determinative in these circumstances:

The Applicant asked me to note in particular paragraph 5 of Taxation Ruling IT 2423 (a non-binding ruling) which is referred to in clause 17 of TR 93/32 to the effect that: ''... if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business''.

Paragraph 5 of IT 2423 suggests only that a number of properties may indicate the presence of a business; it follows of course that it will not of itself be determinative.

(e) The Applicant contended that his management of the properties was such that the decision in McDonald's case should be distinguished. But leaving aside the fact that little weight can be given to Ahern's evidence, the activities of the Applicant in Sydney (or Tanzania) in relation to properties in South-East Queensland are unlikely to have been any more involved than that of an absentee landlord, albeit a concerned and interested absentee landlord.

Taxation Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? (TR 97/11) provides the Commissioners view of the factors used to determine if a taxpayer is in business for tax purposes. Its principles are not restricted to questions of whether a primary production business is being carried on.

In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

•         whether the activity has a significant commercial purpose or character

•         whether the taxpayer has more than just an intention to engage in business

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

•         whether there is regularity and repetition of the activity

•         whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

•         whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

•         the size, scale and permanency of the activity, and

•         whether the activity is better described as a hobby, a form of recreation or sporting activity.

These factors are framed in TR 97/11 to reflect that the alternate outcome is as described in the final dot point.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' (Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case.

In the Rental Properties 2022 guide (Rental Properties guide) published by the Australian Taxation Office the Commissioner explains when the owner of one or more rental properties can be said to be carrying on a business.

Relevantly, Example 4, outlines a situation in which the owners are considered to be carrying on a rental property business:

The D'Souza's own a number of rental properties, either as joint tenants or tenants in common. They own eight houses and three apartment blocks - each block comprising six residential units - a total of 26 properties.

The D'Souza's actively manage all of the properties. They devote a significant amount of time - an average of 25 hours per week - to these activities. They undertake all financial planning and decision making in relation to the properties. They interview all prospective tenants and conduct all of the rent collection. They carry out regular property inspections and attend to all of the everyday maintenance and repairs themselves or organise for them to be done on their behalf...

The D'Souza's are carrying on a rental property business. This is demonstrated by:

•         the significant size and scale of the rental property activities;

•         the number of hours the D'Souza's spend on the activities;

•         the D'Souza's extensive personal involvement in the activities; and

•         the business-like manner in which the activities are planned, organised and carried on.

As reflected in cases and the Rental Properties Guide, the indicators with the greatest weighting are the scale or volume of operations, the repetition and regularity of the activities and the level of personal involvement in the activities.

Applying the relevant cases and indicators to this situation

Having regard to the relevant factors, the Commissioner considers that Individuals are partners carrying on a business of letting rental properties. This is demonstrated by:

•         the significant size and scale of the rental property activities

•         the number of hours Individual A and Individual B spend on the activities

•         Individual A and Individual B's extensive personal involvement in the activities, and

•         the business-like manner in which the activities are planned, organised and carried on.

Question 2

Summary

The rental property to be sold does not satisfy the active asset test because it is a CGT asset that has been used by the partnership to derive rental income for the whole period of ownership and therefore is excluded from being an active asset pursuant to paragraph 152-40(4)(e) of the ITAA 1997.

Detailed reasoning

Small business capital gains tax relief and basic conditions

Division 152 of the ITAA 1997 provides for CGT relief for small business. An entity makes a capital gain if the capital proceeds from the disposal of the asset are more than the asset's cost base.

Subsection 152-10(1) of the ITAA 1997 sets out the basic conditions for relief as follows:

(a)  a CGT event happens in relation to a CGT asset that you own in an income year;

(b)  the event would have resulted in a 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 in section 152-15;

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

                  (iv)        the conditions in subsection 152-10(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.

Additional basic conditions

Subsection 152-10(2) to subsection 152-10(4) of the ITAA 1997 provide additional conditions if the CGT asset is a share in a company or interest in a trust, which are not presently relevant.

Active asset test

Subsection 152-35(1) of the ITAA 1997 provides that a CGT asset satisfies the active asset test if:

                    (i)        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 relevant period; or

                   (ii)        (ii) 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 relevant period.

Subsection 152-35(2) of the ITAA 1997 provides that the relevant period begins when you acquired the asset and ends at the CGT event.

The term 'active asset' is defined at section 152-40 of the ITAA 1997. Subsection 152-40(1) provides that a CGT asset is an active asset at a given time if, at that time, you own it and:

•         it is used (or held ready for use) in the course of carrying on a business by you, your affiliate or an entity connected with you (paragraph 152-40(1)(a)); or

•         it is an intangible asset that is inherently connected with a business that is carried on by you, your affiliate, or an entity connected with you (paragraph 152-40(1)(b)).

However, an asset is not an active asset if it falls under one of the exceptions in subsection 152-40(4) of the ITAA 1997.

Relevantly, paragraph 152-40(4)(e) of the ITAA 1997 excludes, among other things, assets whose main use is to derive rent. Such assets are excluded even if they are used in the course of carrying on a business. If the activities carried on do not amount to the carrying on of a business, it is unnecessary to consider whether the main use of the asset is to derive rent.

In Re Jakjoy Pty Ltd and Federal Commissioner of Taxation 2013 ATC 10-328, the AAT confirmed that an asset whose main use by the taxpayer is to derive rent cannot be an 'active asset' despite its use in taxpayer's business:

51. It is the Tribunal's view that it is clear on the face of the words used in s152-40(4)(e) of the ITAA 1997 that an asset whose main use by the taxpayer is to derive rent cannot be an "active asset". That is, there is nothing ambiguous about the meaning of the words appearing in this provision. Based on the facts and evidence before the Tribunal, the main use of the Properties by Jakjoy is to derive rent. As such, the Properties are excluded from being (i.e. "cannot be") "active assets" (under s 152-40(1)(a) of the ITAA 1997) by s 152-40(4)(e) of the ITAA.

...

54. Although it is common ground that Jakjoy is carrying on a business of renting properties it does not automatically follow, based on a clear reading of the text in s 152-40, that the properties Jakjoy uses in carrying on its business are "active assets". Indeed, those properties are expressly excluded from being "active assets" by the exception in s 152-40(4)(e). Whether one agrees or disagrees with this outcome from a policy perspective is not a matter for the Tribunal in performing its review functions.

...

56. In any event, the Tribunal shares the Commissioner's view that the EM, if anything, supports the proposition that whether a particular CGT asset is an "active asset" under s 152-40 of the ITAA 1997 is to be answered by reference to the use to which the asset is put by a taxpayer and not by reference to the nature of the taxpayer's particular business. That is, as correctly submitted by the Commissioner, the EM:

23.....confirms Parliament intended that assets whose main use is to derive rental income are not to be treated as 'active assets'. Whether or not the asset is held by a taxpayer [like Jakjoy] whose business involves earning income from the renting of assets is irrelevant.

24. That is a policy decision made by Parliament. An interpretation that produced results consistent with such a policy is not [as asserted by Jakjoy] absurd or manifestly unreasonable (cf Acts Interpretation Act s. 15AB(1)(b)(ii))...

In 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? the Commissioner explains that in certain circumstances the premises used in a business of providing accommodation for reward will satisfy the active asset test in section 152-35 of the ITAA 1997 notwithstanding the exclusion in paragraph 152-40(4)(e) of the ITAA 1997 for assets whose main use is to derive rent.

It will depend on the particular circumstances of each case:

Paragraphs 21 to 25 of TD 2006/78 explain 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.

Paragraph 26 of TD 2006/78 contemplates the situation where an asset is used partly for business and partly to derive rent, and provides the following factors for determining what the main use of the asset is:

•         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.

Relevantly, Example 1, outlines a situation in which the rental property is not considered to be an active asset:

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.

In this case the property being sold is not an active asset of the partnership as the partnership is not actively utilising the property for any purpose other than deriving rent. The requirement at paragraph 152-10(1)(d) of the ITAA 1997 has not been met. Therefore, the basic conditions in subsection 152-10(1) are not met in relation to the property and as a consequence CGT small business relief is not available in relation to the sale of the property including the CGT Small business roll-over in Subdivision 152-E.