Edited version of private advice

Authorisation Number: 1052202055894

Date of advice: 1 March 2024

Ruling

Subject: CGT - active asset

Question

Is the building an active asset in accordance with Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Trust

1.      The Trust was settled by deed on DDMMYYYY.

2.      The Trust was formed to purchase a property (the Property) before 20 September 1985 when Capital Gains Tax was introduced (pre-CGT).

3.      The Trust received a private ruling that issued on DDMMYYYY ruling that Division 149 of the ITAA 1997 operated to deem the pre-CGT property to be post-CGT due to changes in the majority underlying ownership of the CGT asset.

4.      There are XX units in the Trust.

5.      The original Trust unit holders were practising professionals.

6.      Distributions to each unit holder have been made annually in exact proportion to their unit holding since the commencement of the Trust.

7.      The current unit holders in the Trust and their percentage of unit holdings since DDMMYYYY are set out in the table below:

Table 1: The current unit holders in the Trust and their percentage of unit holdings since DDMMYYY are set out in Table 1:

8.      The turnover of the Trust is less than $2 million and always has been.

Partnership

9.      The Trust unit holders run a business in partnership (the Partnership).

10.   There are currently 6 partners.

11.   All of the partners in the business are professionals.

12.   All partners have an equal share in the partnership at all times.

13.   All the partners carry on their own individual professional business in addition to their partnership in the partnership.

14.   Each partner conducts their business independently of other members of the partnership. They are governed by the rules of operation set by the partnership and the lease agreement with the Trust.

15.   Each individual professional's practice pays the partnership a fee for secretarial and running expenses.

16.   Historically, not all partners in the partnership have held units in the Trust, but all Trust unit holders are partners in the partnership.

17.   All unit holders in the Trust have an equal partnership interest as soon as they commence practice.

18.   Over the years some of the professionals that have left the practice have sold their Trust units, either to existing unit holders or to the new professionals commencing practice as partners in Partnership.

19.   The Property originally purchased by the Trust in YYYY was leased to the group of professionals to run their business and rent was paid by the Partnership to the Trust.

20.   The Property was sold during 20XX financial year.

21.   The Trust made a capital gain from the sale of the Property.

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(1)

Income Tax Assessment Act 1997 paragraph 152-40(1)(a)

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)

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

Income Tax Assessment Act 1997 section 328-125

Income Tax Assessment Act 1997 section 328-130

Income Tax Assessment Act 1997 subsection 328-130(2)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

Summary

The building is not an active asset in accordance with Division 152 as the Partnership is not an affiliate of the Trust under section 328-130 and the Partnership is not connected with the Trust under section 328-125. Since the Partnership is the only entity that uses the Property other than the Trust itself, it follows that the Property is not used by an affiliate of the Trust or an entity connected with the Trust. As a result paragraph 152-40(4A)(b) has no application and the exception at paragraph 152-40(4)(e) will apply to exclude the Property from being regarded as an active asset as the main use of the Property is to derive rent. The Property is not considered to be an active asset and the small business concessions in Division 152 cannot be accessed in relation to the disposal of the Property.

Detailed reasoning

Subdivision 152-A sets out the 'basic conditions' which must be satisfied in order for small business entities to qualify for any of the CGT small business concessions to reduce their capital gain by the various concessions in Division 152.

Active assets

For the small business concessions in Division 152 to apply to reduce or disregard a capital gain, the relevant CGT asset must satisfy the active asset test in section 152-35.

Subsection 152-35(1) states that a CGT asset satisfies the active asset test if:

(a) 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

(b) 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.

For a CGT asset to be an active asset for the purposes of Subdivision 152-A, it must firstly satisfy one of the 'positive tests' in subsection 152-40(1), and then also not be excluded by one of the exceptions in subsection 152-40(4).

Under paragraph 152-40(1) a CGT asset is an active asset (subject to the exclusions) if it 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, an affiliate of yours or an entity connected with you; or

•           it is an intangible asset that is inherently connected with a business you, your affiliate or another entity that is connected with you, carries on.

Exceptions

Relevantly, paragraph 152-40(4)(e) provides that an asset whose main use by you is to derive rent cannot be an active asset (unless that main use was only temporary). That is, even if the asset is used in a business, it will not be an active asset if its main use is 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) discusses the circumstances in which a premises used in a business of providing accommodation for reward may satisfy the active asset test, notwithstanding the exclusion mentioned above.

Whether an asset's main use is to derive rent will depend upon the circumstances of each case. In accordance with paragraph 22 of TD 2006/78, the term 'rent' has been described as follows:

•           the amount payable by a lessee to a lessor for the use of the leased premises (C.H. Bailey Ltd v. Memorial Enterprises Ltd 1 All ER 1003 at 1010; United Scientific Holdings Ltd v. Burnley Borough Council 2 All ER 62 at 76, 80, 86, 93, 99)

•           a tenant's periodical payment to an owner or landlord for the use of land or premises (Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne)

•           recompense paid by a tenant to a 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, Ch 27(1) 'Landlord and tenant', paragraph 212).

If premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are considered to be rent and the premises will not be an active asset.

Use by a connected entity

If a CGT asset such as a building is leased by a taxpayer to a connected entity or affiliate for use in the connected entity or affiliates' business, in determining the main use of the asset for the purposes of paragraph 152-40(4)(e), any use of the asset by a connected or affiliate entity is treated as the taxpayer's use of the asset under paragraph 152-40(4A)(b).

Therefore, an asset leased to a connected entity for use in the connected entity's business will not, by that reason alone, be excluded by paragraph 152-40(4)(e) from being an active asset of the taxpayer.

In Taxation Determination TD 2006/63 Income tax: capital gains: is a CGT asset that is lease by a taxpayer to a connected entity for use in the connected entity's business an active asset under section 152-40 of the Income Tax Assessment Act 1997? (TD 2006/63), the Commissioner confirms that a CGT asset leased by a taxpayer to a connected entity can be an active asset of the taxpayer. This is illustrated by the example at paragraph 2 and 3:

2. Joe owns 100% of the shares in Smash Repair Co, which carries on a panel beating business. Joe and the company are therefore connected with each other. Joe also owns the business premises and leases them to the company for the conduct of its business.

3. Although Joe is wholly using the premises to derive rent, Smash Repair Co (a connected entity) is wholly using them in the course of carrying on a business. The premises are therefore not excluded under paragraph 152-40(4)(e) of the ITAA 1997 and are therefore an active asset of Joe's under subparagraph 152-40(1)(a)(iii) of the ITAA 1997.

Affiliate, or an entity that is connected

For the purposes of paragraph 152-40(4A)(b) it needs to be determined whether the Trust is connected with another entity. The rules for determining whether an entity is 'connected with' another entity are contained in section 328-125.

Connected entity

The meaning of connected with an entity is contained in section 328-125.

Subsection 328-125(1) states that an entity is connected with another entity if:

(a) one entity controls the other entity or

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

Subsection 328-125(2) states that

An entity (the first entity) controls another entity if the first entity, its affiliates, or the first entity together with its affiliates:

(a) except if the other entity is a discretionary trust - own, or have the right to acquire the ownership of, interests in the other entity that carry between them the right to receive a percentage (the control percentage) that is at least 40% of:

(i) any distribution of income by the other entity; or

(ii) if the other entity is a partnership - the net income of the partnership; or

(iii) any distribution of capital by the other entity; or

(b) ...

Affiliate

An affiliate is defined by section 328-130 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 business affairs of that individual or company.

Under subsection 328-130(1) for an entity to be an affiliate of another entity it must meet the following requirements:

•           the entity must be an individual or company

•           the entity must carry on a business and

•           the entity must act or could reasonably be expected to act, in accordance with the direction or wishes of the other entity or in concert with the entity in relation to their business affairs.

Therefore trusts, and partnerships are not capable of being an affiliate of another entity as they are not a company or individual, but they can have affiliates.

An individual partner in a partnership may be an affiliate of another entity other than in their capacity as a partner in the partnership. For this to happen, the individual must be carrying on a business in that other capacity. A partner that does not carry on a business in their own capacity is not a small business entity just by being a partner in the partnership and will not satisfy the requirement of subsection 328-130(1).

Importantly, subsection 328-130(2) provides that an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share. The business relationship of partners in a partnership is not enough to automatically be affiliates. The example in section 328-130(2) provides:

A partner in a partnership would not be an affiliate of another partner merely because the first partner acts, or could reasonably be expected to act, in accordance with the directions or wishes of the second partner, or in concert with the second partner, in relation to the affairs of the partnership.

Factors that may indicate that parties are acting in concert may include family or close personal relationships; financial relationships or dependencies; relationships created through links such as common partners, directors or shareholders; degree of consultation; and whether there is an obligation to conduct business with the other. However, none of these are decisive in themselves.

Application to your circumstances

As the Trust has owned the Property for more than 15 years, paragraph 152-35 (1)(b) applies requiring the building to be an active asset for at least 7 ½ years.

The Trust has used the Property to produce rental income by leasing it to the Partnership to use the Property to conduct a professional practice. As such, the Property would not generally fall within the definition of an active asset for the Trust. As the main use of the Property has been to derive rent, it would fall within the rental exception in paragraph 152-40(4)(e).

However, if the building owned by the Trust is used in a business that is carried on by an affiliate or an entity connected with the Trust, the building will be an active asset of the Trust. If it is established that the Trust and the Partnership are connected, paragraph 152-40(4A)(b) will apply.

The effect of that provision is that it treats any use by an affiliate or an entity that is connected with the Trust as the use of the Property by the Trust. If the provision applies, it would mean that the use of the Property by the Partnership in their business will avoid the exception in paragraph 152-40(4)(e) and the Property will satisfy the active asset test. This view is outlined in TD 2006/63, which explains that a CGT asset leased by a taxpayer to a connected entity for use in the connected entity's business is an active asset of the taxpayer under section 152-40.

The Partnership is the only entity that uses the Property in carrying on its business. Therefore for paragraph 152-40(4A)(b) to apply it must be established that the Partnership is either an affiliate of the Trust or connected with the Trust.

Partnership as Affiliate

For the Property to qualify as an active asset we need to determine whether the Property owned by the Trust is used in a business that is carried on by an affiliate or an entity connected with the Trust.

The Property is leased to the Partnership not to the individual partners. The Partnership is a partnership using the Property in the course of carrying on a business. The Partnership cannot be an affiliate of the Trust as it is not an individual or a company as required within the definition of affiliate under subsection 328-130(1).

Individual partners as Affiliates

The business relationship of partners in a partnership is not enough to automatically be affiliates as illustrated by the example in section 328-130(2) outlined above.

In this case, in addition to their role as a partner conducting a business of providing administrative and related services, each partner conducts their own separate professional business independently of other members of the partnership, governed by the rules of operation set by the partnership and the lease agreement with the Trust.

As qualified professionals practising in the field of their profession, ordinarily you would expect each practitioner to act in accordance with their own professional judgment rather than in accordance with the directions or wishes of others or in concert with others in relation to their professional business affairs.

While each partner satisfies the requirement to be carrying on a business in their own capacity, the facts do not establish that the individual partners must act or could reasonably be expected to act, in accordance with the direction or wishes of either the partnership or other partners, or in concert with the partnership or other partners in relation to their own business affairs.

As such, the individual partners are not considered affiliates of the partnership nor of each other.

Connected entities

Under subsection 328-125(1) an entity is connected with another entity if:

•           one entity controls the other entity or

•           both entities are controlled by the same third entity.

One entity controls the other entity (paragraph 328-125(1)(a))

A partnership controls a unit trust where the partnership, its affiliates, or the partnership together with its affiliates owns, or has the right to acquire, the right to receive a control percentage that is at least 40% of the distribution of income or capital in the unit trust. A unit trust controls a partnership where the unit trust, its affiliates, or the unit trust together with its affiliates owns, or has the right to acquire, the right to receive a control percentage that is at least 40% of the net income of the partnership. (paragraph 328-125(2)(a))

The Partnership does not hold units in the Trust and therefore does not have the right to any income or capital of the Trust. The Trust is not a partner and does not have a right to any net income of the Partnership.

There are currently 6 partners with equal shares in the net income of the Partnership, therefore none of the partners have the requisite control percentage of at least 40% as required under subsection 328-125(2).

Further, as discussed above, the individual partners are not affiliates of the Partnership or each other and so do not have the requisite 40% control percentage for the purposes of section 328-125.

Consequently, the Trust and the Partnership cannot satisfy the direct control requirement in paragraph 328-125(1)(a).

Both entities are controlled by the same third entity (paragraph 328-125(1)(b))

For the Trust and the Partnership to be connected with each other under paragraph 328-125(1)(b)) they would need to be controlled by the same third entity. Under the definition of control in subsection 328-125(2) the 40% requirement of the third entity includes the third entity's affiliates.

There are 2 individuals that have a control percentage in the Trust of at least 40%. However, each of these individuals holds equal shares with 5 other partners in the Partnership, so does not have the requisite 40% control percentage in the Partnership.

Since no entity controls both the Trust and the Partnership in their own right, the only means of the Trust and the Partnership being connected with each other is to include the affiliates of the third entity in determining whether the 40% control percentage has been met.

Unit holders in a trust or partners in a partnership are not automatically an affiliate merely because of a business relationship.

As concluded above the partners in the Partnership are not affiliates.

Therefore, the Partnership does not control the Trust, nor are both entities controlled by the same third entity.

Conclusion

The Partnership is not an affiliate of the Trust under section 328-130 and the Partnership is not connected with the Trust under section 328-125. Since the Partnership is the only entity that uses the Property other than the Trust itself, it follows that the Property is not used by an affiliate of the Trust or an entity connected with the Trust. As a result, paragraph 152-40(4A)(b) does not apply and the exception in paragraph 152-40(4)(e) will apply to exclude the Property from being regarded as an active asset as the main use of the Property is to derive rent. The Property is not considered to be an active asset and the small business concessions in Division 152 cannot be accessed in relation to the disposal of the Property.