Private ruling: Small business entity
Date of advice: 7 October 2016
Published: December 2016
Ruling period: Year ending MMYY
Date scheme commenced: MMYY

Ruling: Q1: Is the sum of the rental income derived by both Company A and Company B, an entity connected with Company A, included in the calculation of each company's 'aggregated turnover' for the purposes of section 328-110 and subparagraph 152-10(1)(c)(i) of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes

Relevant facts and circumstances: As at MMYY Company A and Company B (the companies) owned and operated a cattle farming business. For accounting and taxation purposes the business was conducted through both entities with income and expenses declared based on the ownership of the associated farmland. In practice, the business (including the management and control) was conducted as a single entity. The business was conducted across approximately X,XXX acres of land (X,XXX in Company A and X,XXX in Company B) and turned over approximately X,XXX head of cattle each financial year (split between the 2 entities). In the XXXX income year the business employed more than 10 full time and less than 5 part time staff to work in the farming business (X full time and X part time through Company A and X full time and X part time through Company B). The shareholders of the company were actively involved in the day-to-day running of the business including repairs and maintenance to the farmland property, sale of cattle, negotiations with key customers and suppliers, managing and directing the staff's workflow and managing and implementing the breeding program of the cattle. In addition to the generation of income from the above business activities, the companies derived the following income during the XXXX income year: Company A • Rental income received from farm houses leased to employees under their employment contract with the cattle business. • Rental income received for the lease of farmland purchased in MMYY and sold in MMYY. The sale agreement involved the leasing of the property some months prior to sale. • Rental income received from the lease of a commercial building. The property was purchased in MMYY and sold in MMYY. • Rental income received from the lease of a commercial building. The property was purchased in MMYY and sold in MMYY. Company B • Rental income received from the lease of a commercial building. The property was purchased in MMYY and sold in MMYY. • Rental income received from the lease of a commercial building. The property was purchased in MMYY and sold in MMYY. • Rental income received from the lease of a residential property. The property was purchased in MMYY and is still held. An inter-entity management fee is charged between the companies to cover interest incurred on a loan in the name of Company B which was used to purchase property for both entities and is secured against property held by both entities. The residential property is managed by a third party real estate agent who is responsible for collecting rent, finding tenants, negotiating leases, ongoing maintenance and general correspondence. The commercial buildings were leased directly by the companies to unrelated third parties and the companies were responsible for the collection of rent. Rent was paid by direct debit automatically each month. Under the terms of the lease the tenants were responsible for the day-to-day maintenance and repairs to the properties. The properties were leased to long term tenants. No employees of the companies were employed to work on the properties. The invoicing and collection of rent was completed by the companies' bookkeeper. The owners of the companies were employed full-time in the farming activities and estimate that approximately X hours per annum was spent by them in relation to the rental properties with most of that being completed by the bookkeeper. In order for the companies to expand their farming operations and increase their herd size it was determined to sell the existing commercial properties and to purchase additional farming land adjacent to the existing holdings. The first property was sold in MMYY with subsequent sales occurred through to MMYY. The companies no longer own any commercial properties. In MMYY the group was restructured so that all operations are conducted through Company B. Cattle owned by Company A were sold to Company B from MMYY through MMYY. Further farmland was purchased by a connected entity from MMYY through to MMYY as part of the restructure and expansion plans. As at MMYY Company B has approximately X,XXX head of cattle and the business is conducted across X,XXX acres. For the purposes of section 328-115 of the ITAA 1997, each of Company A and Company B are entities 'connected with' the other pursuant to section 328-125 of the ITAA 1997.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Division 152 | Income Tax Assessment Act 1997 Subparagraph 152-10(1)(c)(i) | Income Tax Assessment Act 1997 Division 328 | Income Tax Assessment Act 1997 Section 328-110 | Income Tax Assessment Act 1997 Subparagraph 328-110(1)(b)(i) | Income Tax Assessment Act 1997 Subparagraph 328-110(1)(b)(ii) | Income Tax Assessment Act 1997 Subsection 328-110(3) | Income Tax Assessment Act 1997 Subsection 328-110(4) | Income Tax Assessment Act 1997 Section 328-115 | Income Tax Assessment Act 1997 Section 328-120 | Income Tax Assessment Act 1997 Subsection 328-120(1) | Income Tax Assessment Act 1997 Section 328-125 | Income Tax Assessment Act 1997 Subsection 995-1(1)

Reasons for decision: Summary: The sum of the rental income derived by both Company A and Company B should be included in the calculation of each company's aggregated turnover for the purposes of determining whether the companies were a small business entity for the YYYY income year under section 328-110 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Division 152 of the ITAA 1997 - Small business concessions An entity may be eligible to reduce or disregard a capital gain they make from a CGT event that happens in relation to a CGT asset of theirs in an income year if it is a small business entity for the income year in which the capital gain arises (subparagraph 152-10(1)(c)(i) of the ITAA 1997). Section 328-110 of the ITAA 1997 - Meaning of small business entity An entity that carries on a business in an income year will be a 'small business entity' for the income year (current year) if any one of the following tests is satisfied: • the entity carried on a business in the previous year and its aggregated turnover for the previous year was less than $2 million (subparagraph 328-110(1)(b)(i) of the ITAA 1997); • the entity's estimated aggregated turnover for the current year, worked out at the start of the current year, is likely to be less than $2 million (subparagraph 328-110(1)(b)(ii) of the ITAA 1997). However the entity cannot qualify as a small business entity under subparagraph 328-110(1)(b)(ii) of the ITAA 1997 if it carried on a business in each of the two previous income years and its aggregated turnover in each of those years was $2 million or more (subsection 328-110(3) of the ITAA 1997); or • the entity's actual aggregated turnover for the current year, worked out as at the end of the year, is less than $2 million (subsection 328-110(4) of the ITAA 1997). Section 328-115 of the ITAA 1997 - Meaning of aggregated turnover An entity's 'aggregated turnover' for an income year is defined in section 328-115 of the ITAA 1997 to be the sum of the following: (a) the entity's annual turnover for the income year; (b) the annual turnover for the income year of any entity (a relevant entity) that is connected with the entity at any time during the income year; and (c) the annual turnover for the income year of any entity (a relevant entity) that is an affiliate of the entity at any time during the income year. Section 328-120 of the ITAA 1997 - Meaning of annual turnover An entity's 'annual turnover' for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business (subsection 328-120(1) of the ITAA 1997). The term 'ordinary income' is defined in section 6-5 of the ITAA 1997 as income according to ordinary concepts. Rental income is a form of income according to ordinary concepts. An entity's annual turnover therefore includes all income according to ordinary concepts derived in the ordinary course of carrying on a business. The term 'business' is defined in subsection 995-1(1) of the ITAA 1997 to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee. 'Carrying on a business' is not defined in Division 328 of the ITAA 1997 nor is it defined elsewhere in the ITAA 1997. It therefore takes its ordinary meaning. Taxation Ruling TR 2002/11 relates to the calculation of turnover under Division 328 and considers the phrase "in the ordinary course of carrying on a business" for the purposes of that division: | Detailed Reasoning - 'in the ordinary course of carrying on a business': 66. The phrase 'in the ordinary course of carrying on a business' is not defined in Division 328 or the ITAA 1997 generally. In the absence of any defined meaning, the term must be interpreted according to its ordinary meaning and legislative context. 67. The Macquarie Dictionary (3rd ed.) defines 'ordinary' to mean: '1. such as is commonly met with; of the usual kind . . 3. customary; normal . . .7. something regular, customary or usual . . .' It defines 'course' to mean: '5. customary manner of procedure; regular or natural order of events. 6. a mode of conduct; behaviour. 7. a particular manner of proceeding . . .' These definitions emphasise that to be regarded as in the ordinary course of carrying on a business the supply needs to be of a kind that it is usual, regular or customary for the entity to make in the course of carrying on a business. 68. This accords with the interpretation given by the Courts to similar phrases in other relevant contexts. These have been viewed as describing the activities that the entity engages in on a regular day to day basis, or as part of the general flow of the business. 69. For example, in Downs Distributing Co Pty Ltd v. Associated Blue Star Stores Pty Ltd (in liq) (1948) 76 CLR 463, at 477; (1948) 22 ALJR 286, at 288, Rich J, when considering the phrase 'ordinary course of business' in section 95 of the Bankruptcy Act 1924-1933 (Cth) said: 'It means that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary business as carried on, calling for no remark and arising out of no special or particular situation.' Similarly in Bradford Roofing Industries Pty Ltd (in liq) & Companies Act, Re [1966] 1 NSWR 674 Street J, when considering a similar phrase in subsection 207(1) of The Companies Act 1961 (NSW), held at 681: 'The transaction must be one of the ordinary day-to-day business activities, having no unusual or special features.' 70. In Taylor v. White (1963-64) 110 CLR 129, Dixon CJ observed at CLR 136: 'The time honoured phrase 'in the ordinary course of business' is meant to refer to transactions regularly taking place in a sustained course of activity or some usual process naturally passing without examination.' 71. In keeping with these authorities and the ordinary meaning of the words, a supply will be made in the ordinary course of carrying on a business for the purposes of the *value of the business supplies definition in subsection 995-1(1) if the supply is of the kind regularly or customarily made by the entity in the course of carrying on its business, arising out of no special circumstance or unusual event. Ordinary income may be derived in the ordinary course of carrying on a business even if the income is not the main type of ordinary income derived by the business. The income does not need to account for a significant part of the businesses' overall receipts. It is sufficient that the ordinary income is of a kind derived regularly or customarily in the course of carrying on the business (paragraph 22 of TR 2002/11). In specific relation to the derivation of investment income in the ordinary course of carrying on a business, TR 2002/11 provides: Investment income 72. An entity will need to include investment income such as interest on invested funds or rental income in its *value of the business supplies for the relevant year if that income constitutes the value of a supply made by the entity in the ordinary course of carrying on its business. This will be a question of fact to be determined in light of the facts of the particular case. 73. If the entity is a company, this question needs to be approached bearing in mind that any exploitation by a company of its assets for the benefit of its shareholders prima facie amounts to the carrying on of a business by the company. See for example the following remarks of Lord Diplock in American Leaf Blending Co Sdn Bhd v. Director-General of Inland Revenue [1978] 3 All ER 1185 at 1189: ' . . . in the case of a company incorporated for the purpose of making profits for its shareholders any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business. Where the gainful use to which a company's property is put is letting it out for rent, their Lordships do not find it easy to envisage circumstances that are likely to arise in practice which would displace the prima facie inference that in doing so it was carrying on a business.' 74. The effect of this presumption is that where a company makes a supply giving rise to investment income such as rental or interest income, that supply can generally be presumed to be a supply made by the company in the course of carrying on a business. The value of that supply (i.e., the interest or rental income) will therefore need to be included in the company's STS group turnover. This is unless the presumption can be rebutted or it can be demonstrated that the exploitation of the asset is a supply occurring outside of the ordinary course of the company's business… Application to the present circumstances In determining whether the rental income derived by Company A and Company B in the XXXX income year constituted ordinary income derived in the ordinary course of carrying on their business, and consequently needs to be included in the calculation of their respective annual turnover for that year, the remarks of Lord Diplock in American Leaf Blending Co Sdn Bhd v. Director-General of Inland Revenue [1978] 3 All ER 1185 are relevant such that the gainful leasing of the companies' properties for rent prima facie amounts to the carrying on of a business by the companies. On balance, it is not considered that this presumption is rebutted, or that the exploitation of the properties for the benefit of the companies' shareholders in such a manner occurred outside of the ordinary course of their business. The rental income derived by Company A and Company B in the XXXX income year is an amount received as a result of activities that were usual, regular or customary for the companies to make in the course of carrying on their business. The letting out of the properties for rent constituted a sustained course of activity for the companies such that the rental income could not be said to have arisen out of a special circumstance or unusual event. The fact that the rental income was not the main type of ordinary income derived by the businesses, or that it didn't account for a significant part of the businesses' overall receipts is not determinative and does not change the above analysis. On the basis of the above, the rental income derived by Company A and Company B respectively is thus ordinary income derived by those companies in the ordinary course of carrying on their business and therefore required to be included in their respective annual turnover for that income year pursuant to section 328-120 of the ITAA 1997. As the rental income derived by Company A and Company B (each being an entity connected with the other pursuant to section 328-125 of the ITAA 1997) during the XXXX income year is required to be included in the calculation of their respective annual turnovers, the sum of that rental income will, for the purposes of establishing whether the companies were a 'small business entity' for that year under section 328-110 of the ITAA 1997, be included in their aggregated turnover for that year pursuant to section 328-115 of the ITAA 1997.