Private ruling: apital gains tax concessions for small business
Published: May 2014
Ruling period: Year ending 30 June 2014
Date scheme commenced: 1 July 2013

Ruling: Q1: Is property A considered an active asset for the purposes of the capital gains tax (CGT) concessions for small business? | A1: Yes | Q2: Is property B considered an active asset for the purposes of the CGT concessions for small business? | A2: Yes | Q3: Do you satisfy the basic conditions necessary to access the CGT concessions for small business? | A3: Yes | Q4: Do you satisfy the basic conditions necessary to access the small business 50% active asset reduction and the small business rollover exemption in relation to the disposal of properties A and B? | A4: Yes | Q5: Do you satisfy the significant individual test for the purposes of accessing the 15-year exemption concession and the retirement exemption? | A5: No | Q6: Do you satisfy the necessary conditions to be eligible for the 15-year exemption concession on the disposal of property A? | A6: No | Q7: Will any payment made to X or Y, resulting from the expected disregarded capital gain under the 15 year exemption in relation to the disposal of A, be non-assessable non-exempt income in the hands of X or Y? | A7: Not applicable | Q8: Do you satisfy the necessary conditions to be eligible for the retirement exemption on the disposal of property B? | A8: No

Relevant facts and circumstances: The A Trust is a unit trust which has the following units on issue: • 'A' class units owned by the Z Trust which is a discretionary trust • 'B' class units owned by the X Fund The 'B' class units entitle the unit holders to 'Net preferential income' of the trust, which equals the FBT benchmark interest rate at the time of the distribution plus x% of the amount invested by the 'B' class unit holder (i.e. return of capital). This is akin to a fixed return. On redemption, the amount returned will equal the paid up amount initially contributed by the holders of the 'B' class units. The 'A' class units entitle the unit holders to the 'Net residual income' which is essentially the income which is left over after the net preferential income has been paid to the 'B' class unit holders, subject to the trustee determining that this income should not be accumulated or retained. This includes both ordinary and statutory income. The Trust Deed provides that; The "A" class units shall entitle the holders thereof to the following rights: (i) such rights in relation to income and corpus as are set out in respect of them in clause A1 (about income arising prior to termination date), clause A2 (about income arising on or after termination date) and clause A3 (about corpus) of this deed The "B" class units shall entitle the holders thereof to the following rights: (i) such rights in relation to income as are set out in respect of them in clause A1 of this deed The A Trust wholly owns the following properties: • Property A • Property C • Property B The A Group consists of various entities consisting of companies, unit trusts, discretionary trusts and superannuation funds which are essentially owned directly or indirectly by X and Y. The primary trading business entity of the group is D. Property A was purchased in the 1990's and is used solely in the business of D. You state that approximately X% of the total property area of Property B is used by D in their business. The remaining Y% of the area of the property is rented to an unrelated party. Approximately Z% of the income from the property is rental income from the unrelated party with the remainder from D. You have stated that the rent charged to D is not at market rates and has not changed throughout the ownership of the property. Property C was purchased in the 1990's and is wholly rented to an unrelated party. The properties will be disposed of in the relevant financial year. You expect to make a capital gain on the disposal of Property C, however, you expect to disregard the capital gain on the remaining two properties. You state that A's only income consists of rental income. However, it is not carrying on a rental property business. You state that the other connected entities of D's only income consists of rental income, investment income, interest income and trust distributions and that none of these connected entities are carrying on a business. You state that the aggregated turnover of D and its affiliates and connected entities is under $2 million for the 20XX financial year. You state that the aggregated turnover for the year ended 30 June 20YY (based on draft financial statements) is below $1.5 million. Further, you state that, based on management forecasts, the aggregated turnover for the year ended 30 June 20ZZ should be less than $2 million. X and Y will both be aged over 55 in the 2013-14 financial year. You state that neither X nor Y have previously utilised the lifetime CGT retirement exemption limit of $500,000.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 152-10 | Income Tax Assessment Act 1997 Section 152-15 | Income Tax Assessment Act 1997 Section 152-35 | Income Tax Assessment Act 1997 Section 104-10 | Income Tax Assessment Act 1997 Section 328-125 | Income Tax Assessment Act 1997 Section 328-110 | Income Tax Assessment Act 1997 Section 328-115 | Income Tax Assessment Act 1997 Section 328-120 | Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 152-40 | Income Tax Assessment Act 1997 Section 152-60 | Income Tax Assessment Act 1997 Section 152-55 | Income Tax Assessment Act 1997 Section 152-65 | Income Tax Assessment Act 1997 Section 152-70 | Income Tax Assessment Act 1997 Section 152-75 | Income Tax Assessment Act 1997 Section 152-110 | Income Tax Assessment Act 1997 Section 152-305 | Income Tax Assessment Act 1997 Section 152-410 | Income Tax Assessment Act 1997 Section 152-415 | Income Tax Assessment Act 1997 Section 115-10 | Income Tax Assessment Act 1997 Section 115-100 | Income Tax Assessment Act 1997 Section 115-25

Reasons for decision: Detailed Reasoning - Small business CGT concession eligibility: Section 152-10 of the Income Tax Assessment Act 1997 (ITAA 1997) 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 the gain (c) at least one of the following applies: (i) you are a small business entity for the income year (ii) you satisfy the maximum net asset value test in section 152-15 of the ITAA 1997 (iii) you are a partner in a partnership that is a small business entity for the income year and the CGT asset is an asset of the partnership or (iv) the conditions in subsection 152-10(1A) or (1B) of the ITAA 1997 are satisfied in relation to the CGT asset in the income year. (a) the CGT asset satisfies the active asset test in section 152-35 of the ITAA 1997. Section 104-10 of the ITAA 1997 provides that CGT event A1 occurs when your ownership in a CGT asset (eg. land or buildings) is transferred to another entity. You intend to dispose of three properties to another entity and the event is expected to result in a capital gain. Accordingly, you satisfy conditions (a) and (b) of the basic conditions, therefore, it only needs to be determined whether you satisfy one of the scenarios in condition (c) and whether the properties satisfy the active asset test (condition (d)). | Detailed Reasoning - An entity that is 'connected with' you: Subsection 328-125(1) of the ITAA 1997 explains that an entity is connected with another entity if: a) either entity controls the other entity in a way described in this section; or b) both entities are controlled in a way described in this section by the same third entity. Subsection 328-125(2) of the ITAA 1997 provides that an entity (the first entity) controls another entity (other than a discretionary trust) if the first entity, its affiliates, or the first entity together with its affiliates: a) beneficially owns, or have the right to acquire the 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 b) 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. Subsection 328-125(3) of the ITAA 1997 explains that an entity (the first entity) controls a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the first entity, its affiliates, or the first entity together with its affiliates. Subsection 328-125(4) of the ITAA 1997 provides that an entity (the first entity) controls a discretionary trust for an income year if, for any of the 4 income years before that year: a) the trustee of the trust paid to, or applied for the benefit of: i. the first entity; or ii. any of the first entity's affiliates; or iii. the first entity and any of its affiliates; any of the income or capital of the trust; and b) the percentage (the control percentage) of the income or capital paid or applied is at least 40% of the total amount of income or capital paid or applied by the trustee for that year. Subsection 328-125(7) states that the section applies to an entity (the first entity) that directly controls another entity (the second entity) as if the first entity also controlled any other entity that is directly, or indirectly by any other application or applications of this section, controlled by the second entity. As the CGT event will occur in the 2013-14 financial year, the 4 income years prior to the CGT event year will include the 2012-13, 2011-12, 2010-11 and 2009-10. You have stated that the financials for the 2012-13 income year have not yet been completed so we are unable to use 2012-13 financial year as an indication of distributions made to any beneficiaries. Z Trust, a discretionary trust, is an "A" class unit holder in A. A is a unit trust that is not a discretionary trust. The trust deed of A provides that the "A" class unit holders have 100% of the entitlement to the corpus of the trust. Therefore they have the right to receive at least 40% of any distribution of capital by A and they will be entities connected with each other. D received 100% of the distributions from Z Trust in the 2009-10, 2010-11 and 2011-12 financial years, therefore D is taken to directly control Z Trust and they will be entities connected with each other. As D is taken to directly control Z Trust and Z Trust is taken to directly control A, D is taken to indirectly control A and they will be entities connected with each other. | Detailed Reasoning - Is D a small business entity?: Section 328-110 of the ITAA 1997 provides that you will be a small business entity if you are an individual, partnership, company or trust that: • is carrying on a business, and • has an aggregated turnover of less than $2 million. What is aggregated turnover? Section 328-115 of the ITAA 1997 explains that aggregated turnover is your annual turnover plus the annual turnovers of any business entities that are your affiliates or that are connected with you. There are aggregation rules help you determine whether you need to include the annual turnover of another business entity (a relevant entity) when calculating your aggregated turnover. A relevant entity is an entity that is your affiliate or is connected with you. If your aggregated turnover for the previous income year was less than $2 million, you will be a small business entity for the current year. If your estimated aggregated turnover for the current year is less than $2 million, you will be a small business entity for the current year. However, you can estimate your turnover only if your aggregated turnover for one of the two previous income years was less than $2 million. What is annual turnover? Section 328-120(1) of the ITAA 1997 provides that 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. Ordinary income is defined in subsection 6-5(1) of the ITAA 1997 as income according to ordinary concepts. The definition of "annual turnover" looks solely at the entity's business turnover. The turnover does not take into account any other types of ordinary income such as salary and wages, rental income or interest income (unrelated to the business). Nor does the definition include statutory income, such as capital gains and trust distributions. The expression "in the ordinary course of carrying on a business" is not defined in the Assessment Act and therefore takes its ordinary meaning. Whether a business is being carried on for income tax purposes is a question of fact and degree, determined objectively on the specific circumstances of the case by weighing the various indices identified by the courts. Generally, income is derived in the ordinary course of carrying on a business in the following circumstances: a) the income is of a kind that is regularly or customarily derived by an entity in the course of carrying on its business, arising out of no special circumstance or unusual event; and b) the income, although not regularly derived, is derived as a direct result of the normal activities of the business. An entity can derive ordinary income in the ordinary course of carrying on a business even if the income is not the entity's main type of ordinary income. In your case, you provided turnover figures for entities connected with D. In order to calculate the aggregated turnover for D, the following income amounts will be disregarded as the income is not ordinary income that the connected entities derive in the ordinary course of carrying on a business; passive rental income, investment income, interest income and trust distributions. However, income derived from connected entities that are carrying on a business need to be included in the calculation. Accordingly, the aggregated turnover for D for the 2011-12 financial year total is under $2 million and therefore D will be a small business entity in the 2011-12 financial year. As D is considered a small business entity in the 2011-12 financial year and you estimate that the aggregated turnover for 2012-13 will be under $1.5 million (and under $2 million for the 2013-14 financial year), D will be considered a small business entity in the CGT event year (that is, the 2013-14 financial year). Therefore, you satisfy condition (c) of the basic conditions, in that the conditions in subsection 152-10(1A) of the ITAA 1997 are satisfied. | Detailed Reasoning - Active asset test: Section 152-40 of the ITAA 1997 provides the meaning of 'active asset'. A CGT asset will be an active asset at a time if, at that time, you own the asset and the asset was used or held ready for use by you, an affiliate of yours, or by another entity that is 'connected with' you, in the course of carrying on a business. However, subsection 152-40(4) explains that an asset whose main use is to derive rent cannot be an active asset. Paragraph 152-40(4A)(b) of the ITAA 1997 provides that to determine the main use of an asset, treat any use by your affiliate, or an entity that is connected with you, as your use. Subsection 152-35(1) of the ITAA 1997 states that 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 period of ownership, 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 and a half years. Taxation Determination TD 2006/78 considers, amongst other issues, the situation where there is part business and part rental use of an asset. It states that an asset owned by the taxpayer and used partly for business purposes and partly to derive rent can be an active asset under section 152-40 of the ITAA 1997 where it is considered that the main use of the premises is not to derive rent. In deciding if the property was mainly used to earn rent the Commissioner will consider a range of factors such as: • the comparative areas of use of the premises (between rent and business) • the comparative levels of income derived from the different uses of the asset. Property A You state that 100% of the total floor area of the property is used by D in the course of carrying on their business. As D is an entity that is 'connected with' you, its use of the asset is treated as your use. Therefore, the main use of the property is to earn business income and not to derive rent and accordingly the property will be an active asset. Property C You state that the property has been rented solely to an unrelated entity. Therefore as the property's main use is to derive rent it cannot be an active asset. Property B You state that approximately X% of the total floor area of the property is used by D the course of carrying on their business. Rental income figures provided show that on average approximately Y% of the rental income earned from the property (for your ownership period) is from. Therefore, it is considered that the main use of the property is not to derive rent and accordingly, the property will be an active asset. As both Property A and Property C are considered active assets, you satisfy the basic conditions necessary to access the CGT concessions for small business. You are therefore automatically entitled to the 50% active asset reduction concession. However, those conditions are not satisfied for Property C. | Detailed Reasoning - CGT concession stakeholder and the significant individual test: Section 152-60 of the ITAA 1997 provides that an individual is a CGT concession stakeholder of a company or trust at a time if the individual is a significant individual in the company or trust, or the spouse of a significant individual where the spouse has a small business participation percentage in the company or trust at that time that is greater than zero. Section 152-55 of the ITAA 1997 explains that an individual is a significant individual in a company or trust if the individual has a small business participation percentage in the trust of at least 20%. The 20% can be made up of direct and indirect percentages. A company or trust satisfies the significant individual test if it had at least one significant individual just before the CGT event. Section 152-65 of the ITAA 1997 provides that an entity's small business participation percentage in another entity at a time is the percentage that is the sum of: a) the entity's direct small business participation percentage in the other entity at that time; and b) the entity's indirect small business participation percentage in the other entity at that time. Subsection 152-70(1) of the ITAA 1997 explains that an entity's direct small business participation percentage in a trust, where entities do not have entitlements to all the income and capital of the trust, and the trust makes a distribution of income or capital, is the percentage of: • distributions of income that the entity is beneficially entitled to during the income year, or • distributions of capital that the entity is beneficially entitled to during the income year. or, if 2 different percentages are applicable, the smaller. However, an entity's direct small business participation percentage in a trust, where entities have entitlements to all the income and capital of the trust, is the percentage of: • any distribution of income that the trustee may make to which the entity would be beneficially entitled; or • the percentage of any distribution of capital that the trustee may make to which the entity would be beneficially entitled; or, if they are different, the smaller. Subsection 152-75(1) of the ITAA 1997 states that you work out the indirect small business participation percentage that an entity (the holding entity) holds at a particular time in another entity (the test entity) by multiplying: (a) the holding entity's direct small business participation percentage (if any) in another entity (the intermediate entity) at that time; by (b) the sum of: i. the intermediate entity's direct small business participation percentage (if any) in the test entity at that time; and ii. the intermediate entity's indirect small business participation percentage (if any) in the test entity at that time (as worked out under one or more other applications of this section). When testing an intermediate entity's indirect small business participation percentage in another entity, the intermediate entity becomes the holding entity. In your case, you are a unit trust with two classes of unit holders, 'A' and 'B'. The Trust Deed provides that the 'A' class unit holders have entitlements to income and corpus of the trust whereas the 'B' class unit holders have entitlements to income. The 'B' Class unit holders are entitled to a specified return (based on the income of the trust and the units held). The 'A' class unit holders are entitled to any income remaining after the 'B' class unit holders have been paid (subject to the trustee determining that the remaining income should not be accumulated or retained). Therefore, we consider that there are entities, being the 'A' and 'B' class unit holders, that have entitlements to all the income and capital of the trust. With the 'B' class unit holders having entitlements to the income (being a specifically calculated return) with any remaining income to the 'A' class unit holders and, the 'A' class unit holders having entitlements to 100% of corpus. Importantly, the significant individual test relates to distributions that a trustee may make. Consequently, for trusts where entities have all the entitlements to income and capital, the test would not be failed if there is no distribution during a year (which could occur where there is no income or, it has been accumulated). We do not consider that the ability of the trustee to accumulate income necessarily defeats each unit holder's entitlement to income and/or capital of the trust. Accordingly, while the 'A' class unit holders have entitlements to 100% of the capital of the trust, they do not have a set entitlement to any income of the trust (indeed the amount could be nil in any year). As such, the 'A' class unit holder's entitlement to income would be 0%. On this basis, the 'A' class unit holder, Z Trust, will have a direct small business participation percentage in A of 0%, being the smaller of their entitlement to income or capital of the trust. As Z Trust does not have a direct small business participation percentage in A, neither X nor Y can, based on the information provided, be significant individuals nor CGT concessions stakeholders in A as neither individual can surpass the required 20% small business participation percentage. | Detailed Reasoning - Small business 15-year exemption: The small business 15-year exemption takes priority over the other small business concessions and the CGT discount. If the small business 15-year exemption applies, you entirely disregard the capital gain so there is no need to apply any further concessions. Further, you do not reduce the capital gain by any capital losses before you apply the 15-year exemption concession. Subsection 152-110 of the ITAA 1997 provides that an entity that is a company or trust can disregard any capital gain arising from a CGT event if all of the following conditions are satisfied: a) the basic conditions are satisfied for the gain; b) the entity continuously owned the CGT asset for the 15-year period ending just before the CGT event; c) the entity had a significant individual for a total of at least 15 years (even if the 15 years was not continuous and it was not always the same significant individual) during which the entity owned the CGT asset; d) an individual who was a significant individual of the company or trust just before the CGT event either: i. was 55 or over at that time and the event happened in connection with the individual's retirement; or ii. was permanently incapacitated at that time. If a capital gain made by a company or trust is disregarded under the small business 15-year exemption, or would have been except that the capital gain was disregarded anyway because the relevant CGT asset was acquired before 20 September 1985, any distributions made by the company or trust of that exempt amount to a CGT concession stakeholder is: • not included in the assessable income of the CGT concession stakeholder, and • not deductible to the company or trust if certain conditions are satisfied. The conditions are: • the company or trust must make a payment within two years after the CGT event that resulted in the capital gain or, in appropriate circumstances, such further time as allowed by the Commissioner • the payment must be made to an individual who was a CGT concession stakeholder of the company or trust just before the CGT event, and • the total payments made to each CGT concession stakeholder must not exceed an amount determined by multiplying the CGT concession stakeholder's control percentage by the exempt amount. In your case: • you satisfy the basic conditions • you have owned Property A for over 15 years • you have not had a significant individual for at least 15 years of the ownership period of the asset Accordingly, you do not satisfy the necessary conditions to be eligible for the small business 15-year exemption concession on the disposal of Property A. | Detailed Reasoning - Small business retirement exemption: You may choose to disregard all or part of a capital gain under the small business retirement exemption if you satisfy certain conditions. Subsection 152-305(2) of the ITAA 1997 provides that a company or a trust can choose to disregard all or part of a capital gain if: • you satisfy the basic conditions • you satisfy the significant individual test • you keep a written record of the amount you choose to disregard (the exempt amount) and, if there are more than one CGT concession stakeholders, each stakeholder's percentage of the exempt amount (one may be nil, but together they must add up to 100%) • you make a payment to at least one of your CGT concession stakeholders worked out by reference to each individual's percentage of the exempt amount • the payment is equal to the exempt amount or the amount of capital proceeds, whichever is less, and • where you receive the capital proceeds in instalments, you make a payment to a CGT concession stakeholder for each instalment in succession (up to the asset's CGT exempt amount). If a CGT concession stakeholder is under 55 years old just before receiving a payment, an amount equal to that payment must be immediately paid to a complying superannuation fund or RSA on their behalf. The company or trust must notify the trustee of the fund or the RSA at the time of the contribution that the contribution is being made in accordance with the requirements of the retirement exemption. The amount of the capital gain that you choose to disregard (that is, the CGT exempt amount) must not exceed your 'CGT retirement exemption limit' or, in the case of a company or trust, the CGT retirement exemption limit of each CGT concession stakeholder receiving a payment. An individual's lifetime CGT retirement exemption limit is $500,000, reduced by any previous CGT exempt amounts the individual has disregarded under the retirement exemption. In your case, you satisfy the basic conditions but you do not satisfy the significant individual test. Accordingly, you do not satisfy the necessary conditions to be eligible for the small business retirement exemption concession on the disposal of Property B. | Detailed Reasoning - Small business rollover concession: Section 152-410 of the ITAA 1997 provides that you can choose to obtain a roll-over under this Subdivision for a capital gain if the basic conditions in Subdivision 152-A of the ITAA 1997 (being the basic conditions to access the small business concessions) are satisfied for the gain. Section 152-415 of the ITAA 1997 explains that if you choose the roll-over, you can choose to disregard all or part of each capital gain to which this Subdivision applies. There are rollover conditions that must be satisfied by the end of the replacement asset period. This period starts one year before and ends two years after the last CGT event that occurs in the income year for which you choose the roll over. If the rollover conditions are not met within the replacement asset period, the gain will become assessable. You satisfy the rollover conditions where you meet all the following conditions: • you acquire one or more CGT assets as replacement assets or make a capital improvement to one or more existing assets, or both, within the replacement asset period • the replacement asset, or the asset to which the capital improvement was made, is an active asset at the end of the replacement asset period (a depreciating asset such as plant can be a replacement asset) • if the replacement asset is a share in a company or an interest in a trust, at the end of the replacement asset period: • you, or an entity connected with you, are a CGT concession stakeholder in the company or trust, or • CGT concession stakeholders in the company or trust have a small business participation percentage in the interposed entity of at least 90% • the capital gain that is being rolled over is not more than the sum of the following • the amount paid to acquire the replacement asset (that is, the first element of the cost base of the replacement asset) • any incidental costs incurred in acquiring that asset, which can include giving property (that is, the second element of the cost base of the replacement asset), and • the amount expended on capital improvements to one or more assets that were acquired or already owned (that is, fourth element expenditure). In your case, as you satisfy the basic conditions you will be eligible for the small business roll-over concession. | Detailed Reasoning - 50% CGT discount: Section 115-10 of the ITAA 1997 provides that a discount capital gain can be made by a trust. A 50% discount (section 115-100 of the ITAA 1997) may be applied to a discount capital gain realised by a trust where the asset that gave rise to the capital gain has been owned for a period of at least 12 months prior to the CGT event (section 115-25 of the ITAA 1997). In your case, you owned Properties A, B and C for longer than 12 months, accordingly, you will be entitled to apply the 50% discount to any capital gain made on the sale of the properties.