Edited version of private advice

Authorisation Number: 1052312710326

Date of advice: 11 October 2024

Ruling

Subject: Small business concessions

Question

Was xxx (the company) a base rate entity under section 23AA of the Income Tax Rates Act 1986 for the income years ended DD MM YYYY to DD MM YYYY?

Answer

No

This ruling applies for the following period:

DD MM YYYY to DD MM YYYY

The scheme commenced on:

DD MM YYYY

Relevant facts and circumstances

This private ruling is based on the facts and circumstances set out below. If your facts and circumstances are different from those set out below, this private ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Background information

The company

The company has lodged its income tax returns for the income years ended DD MM YYYY and DD MM YYYY and indicated that it was a base rate entity.

The company reported the following income in its income tax returns for the income years ended DD MM YYYY and DD MM YYYY:

Table 1: Company's assessable income during the income years ended DD MM YYYY and DD MM YYYY

In the income years ended DD MM YYYY and DD MM YYYY, the company applied the lower corporate tax rate of xxx%.

The company's usual sources of income were from:

•                     interest income from bank accounts held with a financial institution, and

•                     rental income.

The company sold the property located at xxx (property) for $xxx million in the income year ended DD MM YYYY. A net capital gain of $xxx was reported in the company's tax return for the income year ended DD MM YYYY.

The company's aggregated turnover in each of the income years ended DD MM YYYY and DD MM YYYY was less than $xxx million.

The company declared fully franked dividends to its shareholders as follows:

Table 2: Fully franked dividends declared by the company

As the company considered itself to be a base rate entity in the income years ended DD MM YYYY and DD MM YYYY, the franking percentage applied was based on the lower corporate tax rate.

The property

The property owned by the company consisted of xxx commercial shops and xxx residential units.

The shops and residential units were leased under formal lease agreements that granted tenants exclusive possession and use of the premises.

The company leased the shops and residential units directly to the tenants.

A standard lease term for the shops was xxx years with an option to renew for another xxx years. For the residential units, the minimum lease term was xxx months.

The company did not engage a property manager to manage the properties prior to the income year ended DD MM YYYY.

Since the income year ended DD MM YYYY, the company has engaged a property manager solely to assist with advertising and finding new tenants. The company's director handles all daily ongoing activities, including signing lease agreements, rent collection, and carrying out repairs and maintenance.

Rent is collected by bank transfer to the company's bank account.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 328-110

Income Tax Assessment Act 1997 section 328-115

Income Tax Rates Act 1986 section 23

Income Tax Rates Act 1986 section 23AA

Income Tax Rates Act 1986section 23AB

Further issues for you to consider

We have limited our private ruling to the questions raised in your application. There may be related issues that you should consider, including the corporate tax rate for imputation purposes under section 202-55 of the Income Tax Assessment Act 1997. We note that as the company was not a base rate entity in the income years ended DD MM YYYY and DD MM YYYY, consideration should be given to the effect on the imputation credit for the fully franked dividends declared by the company in those income years.

You may apply for another private ruling on this or any other matter.

Reasons for decision

All legislative references are to the Income Tax Rates Act 1986 unless otherwise stated.

Question:

Was the company a base rate entity under section 23AA of the Income Tax Rates Act 1986 for the income years ended DD MM YYYY and DD MM YYYY?

Summary:

For the income years ended DD MM YYYY and DD MM YYYY, the company was not a base rate entity. All the company's assessable income during these years was base rate entity passive income, comprising of rent and interest income, and a net capital gain in the income year ended DD MM YYYY.

Detailed reasoning

Base rate entity

From the income year ended 30 June 2018, a company needed to be a base rate entity, rather than a small business entity, to qualify for the lower corporate tax rate.[1]

A company will be a base rate entity for a year of income if:[2]

(a)          no more than 80% of its assessable income for the year of income is base rate entity passive income, and

(b)          its aggregated turnover for the year of income, worked out as at the end of that year, is less than $50 million commencing from the income year ended 30 June 2019.

A company's aggregated turnover is the sum of its ordinary income and the ordinary income of any entity that is connected with or an affiliate of the company, where that ordinary income is derived in the ordinary course of carrying on a business.[3]

Eligibility to be a base rate entity depends on a company's base rate entity passive income and aggregated turnover in an income year.

Base rate entity passive income

Base rate entity passive income is defined to be assessable income that is interest (or a payment in the nature of interest), royalties and rent,[4] and a net capital gain.[5]

Broadly only entities who operate as a bank or financial institution, will have interest excluded from base rate entity passive income.[6]

Law Companion Ruling 2019/5 Base rate entities and base rate passive income (LCR 2019/5) explains that:[7]

•                     Eligibility for the lower corporate tax rate depends on an entity's base rate passive income and aggregated turnover in an income year.

•                     A corporate tax entity's tax rate may change if there are fluctuations in either their base rate passive income, as a percentage of their assessable income, or their aggregated turnover.

•                     The Commissioner does not have a discretion to allow an entity to be a base rate entity in an income year, if its base rate passive income is more than 80% of its assessable income or its aggregated turnover exceeds the applicable threshold in that income year.

Interest income

Interest is not a defined term and for the purposes of base rate entity passive income means:[8]

the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to another, and that interest must be referrable to a principal.

Payments in the nature of interest must have the character of return or profit to the lender for the use of money belonging to, or owed to another.[9]Whether a payment has this character turns on its substance, no matter how it is calculated. For example, payments are not in the nature of interest if they are payable under a clause in a contract that requires a borrower to pay a lender's costs and liabilities a lender incurs to establish a loan, or under an indemnification clause to pay amounts of tax payable on interest received.[10]

Rental income

Rent is a form of assessable income that is base rate entity passive income. Rent is not a defined term and for the purposes of base rate entity passive income means:[11]

... the consideration payable by a tenant to a landlord for the exclusive possession and use of land or premises.

LCR 2019/5 explains further in respect of rent:

Consistent with the purpose of the amendment, 'rent' in paragraph 23AB(1)(d) means the consideration payable by a tenant to a landlord for the exclusive possession and use of land or premises. The Commissioner's view and examples on when consideration paid for the use of land or premises will be rent for the purpose of paragraph 23AB(1)(d) are set out in TD 2006/78. As rent takes its ordinary meaning there are no statutory income tax law exceptions that apply in contrast to the definition for interest (or payments in the nature of interest).

The term 'rent' is described as follows in TD 2006/78:[12]

•                     the amount payable by a tenant to a landlord for the use of the leased premises[13]

•                     a tenant's periodical payment to an owner or landlord for the use of land or premises,[14] 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.[15]

TD 2006/78 also states the following in relation to characterising the type of occupancy:[16]

23. A key factor therefore in determining whether an occupant of premises is a lessee is whether the occupier has a right to exclusive possession (Radaich v. Smith (1959) 101 CLR 209; Tingari Village North Pty Ltd v. Commissioner of Taxation [2010] AATA 233 at paragraphs 44-46 ...). If, for example, premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to be rent and the premises not an active asset. On the other hand, if the arrangement allows the person only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

...

25. Ultimately, these are questions of fact depending on all the circumstances involved. Relevant factors to consider in determining these questions (in addition to whether the occupier has a right to exclusive possession) include the degree of control retained by the owner and the extent of any services provided by the owner such as room cleaning, provision of meals, supply of linen and shared amenities (Allen v. Aller (1966) 1 NSWR 572), Appah v. Parncliffe Investments Ltd [1964] 1 All ER 838 and Marchant v. Charters [1977] 3 All ER 918).

Net capital gain

LCR 2019/5 provides guidance on what is a net capital gain for the purposes of base rate entity passive income.

A net capital gain for an income year is calculated using the method described in subsection 102-5(1) of the ITAA 1997.[17] Broadly, it is calculated by subtracting the total of capital losses made in the income year and carried forward net capital losses, from the total of capital gains made in an income year. This is then adjusted for any small business concessions to which the taxpayer is entitled.

Summary of changes to the company tax rate

The below tables summarise the corporate tax rate for the income years ended DD MM YYYY and DD MM YYYY:

Table 3: Changes to the corporate tax rate

Table 4: Corporate tax rate

Application to your circumstances

Income years ended DD MM YYYY and DD MM YYYY

In order for the company to be considered a base rate entity in the income years ended DD MM YYYY and DD MM YYYY, the company was required to meet the following definition:[18]

(a)          no more than 80% of its assessable income for the year of income is base rate entity passive income, and

(b)          its aggregated turnover for the year of income, worked out as at the end of that year, is less than $50 million commencing from the income year ended 30 June 2019.

The company has advised that its aggregated turnover was less than $1 million in both income years ended DD MM YYYY and DD MM YYYY.[19]

In the income years ended DD MM YYYY and DD MM YYYY, the company's assessable income comprised of rent and interest income. The company reported a net capital gain arising from the disposal of property in the income year ended DD MM YYYY.

Rent, interest income and net capital gains are all forms of assessable income considered to be base rate entity passive income as defined in section 23AB.

Rent

Rent is not a defined term for the purposes of base rate entity passive income, and so takes its ordinary legal meaning. A key factor in determining whether the income from premises constitutes rent is whether the tenant has a right to exclusive possession and use of land or premises.[20]

The company owned a property comprising of commercial and residential premises. The premises were leased under formal lease agreements to various tenants for their respective use. The terms of the commercial leases were for xxx years with a xxx year option to renew. The residential leases were for a minimum term of xxx months. The leases entitled each tenant to exclusive possession and quiet enjoyment of their respective premises.

In the income years ended DD MM YYYY and DD MM YYYY, a property manager was used for advertising and finding new tenants. All daily activities, such as managing the leasing of the premises, collecting rent, and signing lease agreements was handled by the company's director. Although the company and its directors retained a significant degree of control over the tenants by being responsible for maintenance and requiring payment of rent, the company's directors agreed to give vacant possession to a tenant on a certain date, tenants were granted exclusive possession and had the right of quiet enjoyment, and the premises were either occupied as the tenant's principal place of residence or business.

Due to the receipt of periodical payments from the tenants to the company under formal lease agreements that granted tenants exclusive possession and use of the premises,[21] the amounts paid by the tenants to the company was rent, which is a form of base rate entity passive income.[22]

Interest income

Interest is not a defined term for the purposes of base rate entity passive income, and so takes on its ordinary legal meaning as follows:[23]

Interest means 'the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal'.

Payments in the nature of interest must have the character of return or profit to the lender for the use of money belonging to, or owed to another.[24]

Subsection 23AB(2) provides for certain entities operating in the financial sector to exclude interest or payments in the nature of interest when determining the amount of their base rate entity passive income.

The interest income reported annually by the company was derived from bank accounts held with a financial institution. The bank has retained the company's cash for safekeeping. Therefore, the interest that has accrued on the accounts paid by the financial institution are considered a return on the original principal amount and is interest.[25]

The company does not operate in the financial sector and, as such, is not eligible to exclude the interest from its calculation of base rate entity passive income.

Net capital gain

A net capital gain is a form of base rate entity passive income.[26] A net capital gain essentially arises if the taxpayer's capital gains for the income year are more than the sum of its capital losses for the income year and any unapplied prior year capital losses, and adjusted for any small business concessions to which it is entitled.[27]

In calculating the net capital gain of $xxx arising from the sale of the property in the income year ended DD MM YYYY, it is expected that the company has followed the method in subsection 102-5(1) of the ITAA 1997. The company has not treated its capital gain as a discount capital gain and claimed the percentage discount against its gain.[28]

On this basis, the net capital gain reported by the company in the income year ended DD MM YYYY is a form of base rate entity passive income.[29]

Rent, interest income and net capital gains are all forms of assessable income that is base rate entity passive income as defined in section 23AB.

Hence, the company did not meet the criteria of being a base rate entity as rent and interest income (and a net capital gain in the income year ended DD MM YYYY) exceeded 80% of its assessable income in the income years ended DD MM YYYY and DD MM YYYY under paragraph 23AA(a).

Therefore, the company was not a base rate entity in the income years ended DD MM YYYY and DD MM YYYY.

[1] Subsection 23(2) as amended by Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Act 2018.

[2] Section 23AA.

[3] Subsections 328-115(1) and (2) of the ITAA 1997.

[4] Subsection 23AB(1)(d).

[5] Subsection 23AB(1)(f).

[6] Subsection 23AB(2).

[7] Paragraph 8.

[8] Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd [1998] FCA 269.

[9] Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd [1998] FCA 269.

[10] LCR 2019/5 at paragraph 12.

[11] LCR 2019/5 at Table 1 of paragraph 9.

[12] 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) at paragraph 22.

[13] 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.

[14] Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne.

[15] Halsbury's Laws of England 4^th Edition, Butterworths, London 1994, Volume 27(1) 'Landlord and Tenant', paragraph 212.

[16] Paragraph 23.

[17] Paragraph 23AB(1)(f).

[18] Section 23AA.

[19] As defined in section 328-115 of the ITAA 1997.

[20] LCR 2019/5 at Table 1 of paragraph 9.

[21] TD 2006/78 at paragraph 23.

[22] As per paragraph 23AB(1)(d).

[23] LCR 2019/5 at paragraph 11 and Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd [1998] FCA 269.

[24] LCR 2019/5 at paragraph 12.

[25] As per paragraph 23AB(1)(d).

[26] Paragraph 23AB(1)(f).

[27] Subsection 102-5(1) of the ITAA 1997.

[28] Per section 115-100 of the ITAA 1997.

[29] Per paragraph 23AB(1)(f).