Private ruling: Assessable income, capital gains tax and small business relief
Date of advice: 24 January 2018
Published: June 2018
Ruling period: Income year ended 30 June 2017 | Income year ended 30 June 2018
Date scheme commenced: 1 July 2016

Ruling: Q1: Will the sale proceeds or net profit from the sale of the Land be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Will Partner 1 and Partner 2 satisfy the basic conditions in subdivision 152-A of the ITAA 1997 to be eligible for the CGT concessions for small business relief in Division 152 of the ITAA 1997? | A2: Yes | Q3: Will Partner 1 be entitled to the CGT small business 15 year exemption in subdivision 152-B of the ITAA 1997? | A3: Yes | Q4: Will Partner 2 be entitled to the CGT small business concessions in subdivision 152-C of the ITAA 1997 and subdivision 152-D of the ITAA 1997? | A4: Yes

Relevant facts and circumstances: Partner 1 and Partner 2 purchased farm land as joint proprietors (tenants in common) in the early 1990s. They purchased the Land with the intention for it to be used as a farm. A Partnership was established with Partner 1 and Partner 2 each having a 50% interest in the partnership. The Land is an asset of the Partnership. The Partnership operated a business on the Land, and will continue to carry on the business until the Land is sold in the future. The business currently supplies a related business which is operated by a Company. The Partnership did not derive any other income from the Land apart from income associated with the business. Partner 1, Partner 2 and another Individual are the directors and shareholders of a company (the Trustee Company) which is the trustee of a Family Trust. The Family Trust also carries on a separate business. The Family Trust has not had any funds to make a distribution in the last four income years. Neither Partner 1, Partner 2 or the Individual carry on a business in their own right. Partner 1 wishes to retire and so Partner 1 and Partner 2 wish to sell the Land to an unrelated third party developer. The Land will be sold as broadacres and Partner 1 and Partner 2 will not enter into any development agreement or joint venture agreement with the developer who purchases the Land. Partner 2 proposes to choose to apply the retirement exemption to up to $500,000 of the capital gain that will be made on the sale of the interest in the Land. Partner 2 has not previously chosen to apply the retirement exemption.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Division 152 | Income Tax Assessment Act 1997 Subdivision 152-A | Income Tax Assessment Act 1997 Subdivision 152-B | Income Tax Assessment Act 1997 Subdivision 152-C | Income Tax Assessment Act 1997 Subdivision 152-D | Income Tax Assessment Act 1997 Section 152-320 | Income Tax Assessment Act 1997 Section 328-115 | Income Tax Assessment Act 1997 Section 328-130

Reasons for decision: Summary: The sale proceeds or net profit from the sale of the Land will not be assessable as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Profits from the sale of land can be assessable as ordinary income under section 6-5 of the ITAA 1997 as a result of carrying on a business of property development, or as a result of an isolated commercial transaction. Paragraph 13 of Taxation Ruling TR 97/11 states that the courts have held that the following indicators are relevant to whether or not a person is carrying on a business (although TR 97/11 specifically deals with carrying on a primary production business, the principles discussed in that Ruling can apply to any business): (a) does the activity have a significant commercial purpose or character? (b) does the taxpayer have more than a mere intention to engage in business? (c) is there an intention to make a profit or a genuine belief that a profit will be made? Will the activity be profitable? (d) is there repetition and regularity in the activity? i.e., how often is the activity engaged in? (e) is the activity of the same kind and carried on in a similar way to that of the ordinary trade? (f) is the activity organised in a businesslike manner? (g) what is the size or scale of the activity? (h) is the activity better described as a hobby, a form of recreation or a sporting activity? In this case, it is considered the Partnership is not carrying on a business of property development as the above indicators are not evident. Therefore, it is necessary to determine if the sale proceeds or net profit from the sale of the Land arose from an isolated commercial transaction, or whether they represent a mere realisation of a capital asset. Profits arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business ( FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693) ( Myer Emporium ). Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) considers the principles outlined in the Myer Emporium case and provides guidance in determining whether profits from isolated transactions are assessable ordinary income under section 6-5 of the ITAA 1997. According to Paragraph 1 of TR 92/3, the term isolated transactions refers to: ● those transactions outside the ordinary course of business of a taxpayer carrying on a business, and ● those transactions entered into by non business taxpayers. Paragraph 8 of the ruling explains that it is not necessary that the intention or purpose of profit-making be the sole or even the dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose. Having regard to your circumstances and the factors outlined in TR 92/3 the sale proceeds or net profit from the sale of the Land are not considered to be profits from an isolated transaction relevant to TR 92/3. The Partnership has not undertaken any activities to improve, develop or subdivide the land, which would tend to indicate a profit-making purpose. Therefore the proceeds or net profit are not ordinary income and are not included in the Partnership’s assessable income under section 6-5 of the ITAA 1997. The disposal of the Land is considered to be a mere realisation of a capital asset (which will have CGT implications for Partner 1 and Partner 2 individually as detailed below). | Summary: Partner 1 and Partner 2 will satisfy the basic conditions in subdivision 152-A of the ITAA 1997 to be eligible for the CGT concessions for small business relief in Division 152 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: To qualify for the small business CGT concessions, you must satisfy several conditions that are common to all the concessions. These are called the basic conditions. The basic conditions for the small business CGT concessions in subdivision 152-A of the ITAA 1997 (as relevant to this case) are: ● a CGT event happens in relation to a CGT asset of yours in an income year (paragraph 152-10(1)(a) of the ITAA 1997); ● the event would (apart from this Division) have resulted in the gain (paragraph 152-10(1)(b) of the ITAA 1997); ● you are a partner in a partnership that is a CGT small business entity for the income year and the CGT asset is an interest in an asset of the partnership (subparagraph 152-10(1)(c)(iii) of the ITAA 1997) and ● the CGT asset satisfies the active asset test (paragraph 152-10(1)(d) of the ITAA 1997). | Detailed Reasoning - Paragraphs 152-10(1)(a) and 152-10(1)(b) of the ITAA 1997: Under the proposed arrangement, CGT event A1 will happen if the Land is sold to an unrelated third party developer and it is expected that Partner 1 and Partner 2 will make a capital gain from this sale. Accordingly, the conditions in paragraphs 152-10(1)(a) and 152-10(1)(b) of the ITAA 1997 will be met. Subparagraph 152-10(1)(c)(iii) of the ITAA 1997- you are a partner in a partnership that is a CGT small business entity for the income year and the CGT asset is an interest in an asset of the partnership Partner 1 and Partner 2 are partners in the Partnership and the relevant CGT asset is an interest in an asset (the Land) of this partnership. It is however necessary to determine whether the Partnership is a CGT small business entity. An entity will be a CGT small business entity if it is an individual, partnership, company or trust that is carrying on a business and had an aggregated turnover of less than $2 million (subsection 152-10(1AA) and section 328-110 of the ITAA 1997). Aggregated turnover is your annual turnover plus the annual turnovers of any business entities that are your affiliates or connected with you. You can calculate your aggregated turnover using one of three methods: previous year, estimated current year or actual current year. Most businesses will only need to consider the ‘previous year’ method. You must use the same method for calculating the annual turnover of your business and any affiliates or connected entities. In the current circumstances, it is therefore necessary to determine if the Partnership and its affiliates and business entities connected with it had an aggregated turnover of less than $2 million. | Detailed Reasoning - Who is an affiliate of the Partnership?: An affiliate is defined in section 328-130 of the ITAA 1997 and for the purposes of this case, means an individual or company that, in relation to their business affairs, acts or could reasonably be expected to act: ● in accordance with the Partnership’s directions or wishes, or ● in concert with the Partnership. Trusts, partnerships and superannuation funds cannot be affiliates and so the Family Trust is not an affiliate of the Partnership. For the purposes of section 328-130 of the ITAA 1997, an individual or company will only be an affiliate if that individual or company carries on a business. Therefore as neither Partner 1, Partner 2 nor the Individual carry on a business in their own right they are not affiliates of the Partnership. Further, as the Trustee Company does not carry on business in its own right it is not an affiliate of the Partnership. It is noted that section 152-47 of the ITAA 1997 is not relevant to this case. | Detailed Reasoning - Is an entity connected with the Partnership?: The meaning of connected with an entity is defined in section 328-125 of the ITAA 1997. An entity is connected with another entity if: ● either entity controls the other entity, or ● both entities are controlled by the same third party entity. Direct control of an entity other than a discretionary trust According to subsection 328-125(2) of the ITAA 1997, an entity controls another entity if it or its affiliates (or all of them together): ● beneficially owns or has the right to acquire beneficial ownership of, interests in the other entity that give the right to receive at least 40% (the control percentage) of: ● any distribution of income or capital by the other entity, or ● if the other entity is a partnership, the net income of the partnership, or ● if the other entity is a company, beneficially owns, or has the right to acquire beneficial ownership of, equity interests in the company that give at least 40% of the voting power in the company. Direct control of a discretionary trust There are two ways an entity may control a discretionary trust. One is by controlling the trustee (subsection 328-125(3) of the ITAA 1997) and the other by a beneficiary (subsection 328-125(4) of the ITAA 1997). An entity controls a discretionary trust if the trustee either acts, or might reasonably be expected to act, in accordance with the directions or wishes of the entity or the entity’s affiliates, or both the entity and its affiliates (subsection 328-125(3) of the ITAA 1997). As stated in the ‘ Advanced guide to capital gains tax concessions for small business’ , all the circumstances of the case need to be considered in determining whether you satisfy this test, for example, the mere presence in the trust deed of a requirement that the trustee should have no regard to such directions or wishes would not be sufficient. Some factors which might be considered include: ● The way in which the trustee has acted in the past. ● The relationship between the trustee and the entity or its affiliates, and the relationship the trustee has with both the entity and its affiliates. ● The amount of any property or services transferred to the trust by the entity or its affiliates, or by both the entity and its affiliates. ● Any arrangement or understanding between the entity and any person who has benefited under the trust in the past. This entity may control a discretionary trust in addition to any beneficiary with control as described below. Taking into consideration the requirements outlined above, in the case at hand, the following relationships have been established: ● Both Partner 1 and Partner 2 are connected with the Partnership; ● The Company is connected with the Partnership; ● The Trustee Company is not connected with the Partnership; ● The Family Trust is not connected with the Partnership. Both Partner 1 and Partner 2 are connected with the Partnership because each has a right to receive at least 40% of the net income of the Partnership. Partner 2 controls the Company due to having at least 40% of the voting power of the Company. Partner 2 also controls the Partnership and therefore the Company is connected with the Partnership. The Trustee Company has three equal shareholders and directors and no one director has influence over the other directors. Therefore the Trustee Company and the Family Trust are not connected with the Partnership. In summary, the Partnership has no affiliates and the only business entity connected with it is the Company. Based on the information provided in this case, the Partnership will be a CGT small business entity because the total of the Partnership’s annual turnover plus the Company’s annual turnover for the income year prior to the CGT event occurring is less than $2 million (sections 328-110(1)(b)(i) and 328-115 of the ITAA 1997). Given that this requirement has been satisfied, the Partnership is a partnership that is a CGT small business entity pursuant to subparagraph 152(10)(1)(c)(iii) of the ITAA 1997 and therefore this basic condition for relief will be met. Active asset test The active asset test is contained in section 152-35 of the ITAA 1997. The active asset test is satisfied 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 test period detailed below, 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 7.5 years during the test period. The test period is from when the asset is acquired until the CGT event. If the business ceases within the 12 months before the CGT event (or such longer time as the Commissioner allows) the relevant period is from the acquisition until the business ceases. A CGT asset is an active asset if it is owned by you and is used or held ready for use in a business carried on (whether alone or in partnership) by you, your affiliate, you spouse or child, or an entity connected with you. Paragraph 152-40(4)(e) of the ITAA 1997 states, however, that an asset whose main use in the course of carrying on the business is to derive rent it cannot be an active asset unless the main use for deriving rent was only temporary. It is accepted that the main use of the Land was for the business carried on by the Partnership (which as previously noted is connected with Partner 1 and Partner 2). Accordingly, the Land is an active asset during the time it has been owned by Partner 1 and Partner 2 and for the requisite period. Accordingly, the active asset test will be met. Based on the above analysis, Partner 1 and Partner 2 will satisfy the basic conditions in subdivision 152-A of the ITAA 1997 to be eligible for the CGT concessions for small business relief in Division 152 of the ITAA 1997. | Summary: Partner 1 will be entitled to the CGT small business 15 year exemption in subdivision 152-B of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: To be eligible for the small business 15 year exemption in subdivision 152-B of the ITAA 1997, you must satisfy the basic conditions and two further conditions: ● you continuously owned the CGT asset for the 15-year period ending just before the CGT event happened; and ● you are at least 55 years old at that time and the event happened in connection with your retirement Whether a CGT event happens in connection with an individual’s retirement depends on the particular circumstances of each case. There would need to be at least a significant reduction in the number of hours the individual works or a significant change in the nature of their present activities to be regarded as a retirement. However, it is not necessary for there to be a permanent and everlasting retirement from the workforce. From the information supplied, Partner 1 will be over 55 years of age at the time of the disposal of the Land, and it is Partner 1’s intention to use the funds from the sale of the Land to fund their retirement which will occur following the sale of the Land. Accordingly, Partner 1 will be entitled to the small business 15 year exemption and can entirely disregard the capital gain on the sale of the Land. | Summary: Partner 2 will be entitled to the CGT small business concessions in subdivision 152-C of the ITAA 1997 and subdivision 152-D of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Subdivision 152-C Small business 50% reduction. Subdivision 152-C of the ITAA 1997 relates to the small business 50% reduction. A capital gain is reduced by 50%, if the basic conditions in subdivision 152-A of the ITAA 1997 are satisfied. As Partner 2 has satisfied all the conditions in subdivision 152-A of the ITAA 1997, they can apply the small business 50% reduction. Subdivision 152-D Small business retirement exemption Subdivision 152-D of the ITAA 1997 provides that if you are an individual, you can choose to disregard all or part of a capital gain if: ● You satisfy the basic conditions. ● You keep a written record of the amount you chose to disregard (the CGT exempt amount), and ● If you are under 55 years old just before you choose to use the retirement exemption, you make a personal contribution equal to the exempt amount to a complying superannuation fund or retirement savings account (RSA). You must make the contribution: ● When you make the choice to use the retirement exemption, or when you receive the proceeds (whichever is later), or ● When you make the choice to use the retirement exemption if the relevant event is CGT event J2, J5 or J6. There is an individual lifetime CGT Retirement Exemption limit of $500,000 (section 152-320 of the ITAA 1997). Under the proposed arrangement, Partner 2 will choose to apply the retirement exemption to up to $500,000 of the capital gain that will be made on the sale of the interest in the Land. Partner 2 has not previously chosen to apply the retirement exemption. If Partner 2 chooses to apply the retirement exemption, as they are under 55 years of age they must immediately on the later of receipt of the sale proceeds or making the choice contribute the relevant exempt amount into a complying superannuation fund. Provided Partner 2 complies with these conditions they will be entitled to the small business retirement exemption under subdivision 152-D of the ITAA 1997.