Edited version of private advice

Authorisation Number: 1052258333610

Date of advice: 9 August 2024

Ruling

Subject: CGT - small business concessions

Question 1

Was the property an active asset of the Trust under section 152-40 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the Trust eligible to obtain the capital gains tax (CGT) small business roll-over on the disposal of the property under Subdivision 152-E of the 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

The Trust purchased a business in partnership.

In 20XX the Company purchased the partner's share of the business and operated the business at the site in partnership with the Trust.

In July 20XX the Trust purchased the Property.

For a period of 3 years from July 20XX until July 20XX the Property was used to conduct the business.

In July 20XX the business was sold to an unrelated third party.

From 20XX the Trust received rent for the property under a commercial agreement with the unrelated third party until the property was sold.

The tenants, who were unrelated third parties, paid market value rent with annual increases subject to a commercial agreement.

The main use of the Property from 20XX was to derive rent.

The Trust sold the property in December 20XX.

The total period of ownership of the property was XX years and X months.

The Trust satisfies the $6 million Maximum Net Asset Value Test.

The Trust spent time carrying on activities by conducting and organising maintenance on the site.

The Company and an individual are affiliates of the Trust.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 152-A

Income Tax Assessment Act 1997 section 152-10

Income Tax Assessment Act 1997 section 152-35

Income Tax Assessment Act 1997 section 152-40

Income Tax Assessment Act 1997 Subdivision 152-E

Reasons for decision

Question 1 and 2

Summary

The Property was not an active asset for the requisite period in section 152-35 as the exception in paragraph 152-40(4)(e) applies to exclude the Property for the period its main use was to derive rent. As a result, the Trust does not satisfy the basic conditions for CGT small business relief in subsection 152-10(1) and in turn the CGT small business rollover in Subdivision 152-E is not available in relation to the sale of the Property.

Detailed reasoning

To qualify for the CGT small business concessions including the small business roll-over relief under Subdivision 152-E, you must satisfy several conditions that are common to all the concessions.

Section 152-10 contains the basic conditions you must satisfy to be eligible for the small business CGT concessions. These conditions are:

(a) a CGT event happens in relation to a CGT asset 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 CGT 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 CGT small business entity for the income year and the CGT asset is an asset of the partnership;

(iv) you do not carry on a business, but your CGT asset is used in a business carried on by a small business entity that is your affiliate or an entity connected with you;

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

To be eligible to apply the small business CGT concessions you must satisfy all 4 of the basic conditions above.

You disposed of the Property that resulted in CGT event A1 and where that resulted in a capital gain the first 2 basic conditions in paragraphs 152-10(1)(a) and (b) will be met.

Of the 2 basic conditions remaining, the condition in paragraph 152-10(1)(c) requires that at least one of the requirements in subparagraphs 152-10(1)(c)(i) to 152-10(1)(c)(iv) applies.

One of these requirements in subparagraph 152-10(1)(c)(ii) is met if you satisfy the maximum net asset value test in section 152-15.

Maximum Net Asset Value Test

Section 152-15 states:

You satisfy the maximum net asset value test if, just before the *CGT event, the sum of the following amounts does not exceed $6,000,000:

(a) the *net value of the CGT assets of yours;

(b) the net value of the CGT assets of any entities *connected with you;

(c) the net value of the CGT assets of any *affiliates of yours or entities connected with your affiliates (not counting any assets already counted under paragraph (b)).

You have indicated that the net value of the CGT assets is less than $6 million and you pass the maximum net asset value (MNAV) test which satisfies the third basic condition in paragraph 152-10(1)(c).

Active asset test

The final basic condition is for the CGT asset to satisfy the active asset test in section 152-35.

Subsection 152-35(1) states:

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 relevant period; 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 ½ years during the relevant period.

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

The term 'active asset' is defined at section 152-40. 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)).

The combined effect of sections 152-35 and 152-40 is that the asset will meet the active asset test if the asset was used, or held ready for use, in the course of carrying on a business by you, a connected entity or affiliate for at least half of the time period it was owned.

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

Relevantly, paragraph 152-40(4)(e) 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.

Carrying on a business

Taxation Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? (TR 97/11) provides the Commissioner's 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.

Taxation Ruling 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. Also, a factor or factors may not be relevant for a particular case, for example, whether an activity would be better described as a hobby, sport or recreational activity is not relevant in the present case.

Whether the letting of property activities amount to the carrying on of a business will depend on the circumstances of each case. 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. This is because of the limited scope of the rental property activities and the limited degree to which an owner actively participates in rental property activities. A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations.

In Cripps v. FC of T 99 ATC 2428; (1999) 43 ATR 1202, the taxpayer and his wife purchased, as joint tenants, 14 townhouses which they rented out. They also purchased a property which was used initially as a holiday home but was later periodically rented out. A further property was purchased 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. They rejected the taxpayer's argument that he had greater involvement with his 16 properties.

In 11 CTBR (OS) Case 24, the taxpayer's income included rents from 3 properties. The taxpayer employed a manager and an accountant - he was principally a letting clerk with authority to refuse tenants. He collected and banked rents, attended to repairs and supervised them, and controlled the caretaker and cleaners. He kept books in connection with rents and repairs, and rates and other outgoings. The taxpayer said he personally carried out the principal part of the management of his rent-producing properties and directed policy, attended to the financial arrangements and made decisions regarding repairs. The taxpayer claimed that he was carrying on a business. In holding that he was not carrying on a business, a majority of the members of the Board of Review said:

It is obvious that some measure of supervision and management must ordinarily be exercised by a property owner who lets offices... and if that does not amount to the carrying on of a business, the fact that he employs others to assist him, either in the letting of the properties or in the preparation of the accounts relating to his rents and outgoings, will not make any difference. For the foregoing reasons we are unable to uphold the claim that the taxpayer is engaged in a 'business as property owner'.

On the other hand, Case G10 75 ATC 33 (Case G10), the taxpayer owned 2 properties of which 6 units were let as holiday flats for short term rental. The taxpayer, with assistance from his wife, managed and maintained the flats. Services included providing furniture, blankets, crockery, cutlery, pots and pans, hiring linen and laundering of blankets and bedspreads. The taxpayer also showed visiting inquirers over the premises, attended to the cleaning of the flats on a daily basis, mowing and trimming of lawns, and various other repairs and maintenance. The taxpayer's task in managing the flats was a 7-day a week activity. The Board of Review held that the activity constituted the carrying on of a business. In reaching that conclusion, the Board found:

It was clearly established in evidence that the money received by the taxpayer from the occupants of the flats was not solely a payment for the right to rent a flat for a certain period.

Active Asset's main use 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 notwithstanding the exclusion in paragraph 152-40(4)(e) for assets whose main use is to derive rent.

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 of the asset.

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.

Application to our circumstances

In your case, the Trust has owned the Property for XX years and X months. For the 3-year period between 20XX and 20XX it was used in a business that the Trust ran in partnership. From the time the business was sold in 20XX, until the Property was sold in 20XX, the Property was used to derive rent from an unrelated third party.

The Trust owned only the one commercial property from which it derived rental income, which is not considered to be large scale. Also, the property was rented out under a long-term lease to a third-party tenant who had exclusive possession. They paid market value rent with annual increases subject to the commercial agreement.

After weighing up the relative business indicators and the facts provided, the activities that were conducted by the Trust are better described as letting a commercial property to receive a stream of rental income. The income is not derived from the services the Trust provided, but from the letting of the property. It is therefore concluded that the main use of the Property has been to derive rent and the Trust is not considered to have been carrying on a business.

In conclusion, for the 3-year period between 20XX and 20XX the Property was used in a business that the Trust ran in partnership. From the time the business was sold in 20XX, until the Property was sold in 20XX, the Property was only used to derive rent from an unrelated third party. The exception in paragraph 152-40(4)(e) applies to exclude the property as an active asset as it was not used for any other purpose than deriving rent for an 11-year period until its sale in 20XX. Therefore, it was not an active asset as it was only an active asset for a period of 3 years and not 7 ½ years as required by the active asset test under section 152-35.

As the Property did not satisfy the active asset test, the requirement at paragraph 152-10(1)(d) has not been met. Therefore, the basic conditions in subsection 152-10(1) are not met, and in turn the 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.