Private ruling: CGT - water licence - cost base - small business concessions
Published: November 2011
Ruling period: 1 July 2010 to 30 June 2011.
Date scheme commenced: 1 July 2010.

Ruling: Q1: Does the water licence have a cost base? | A1:  | Q2: How is the cost base of the water licence calculated? | A2:  | Q3: Are you eligible for the 50% capital gains tax (CGT) discount on the disposal of the water licence? | A3:  | Q4: Is the water licence an active asset of yours? | A4:  | Q5: Are you able to apply the Small business CGT concessions to reduce the capital gains made on the disposal of the water licence? | A5: 

Relevant facts and circumstances: Your parent acquired farming property before 1985. You inherited a share of the property. You inherited a further share when your mother died after 1985. The land was situated on a river and a few years ago, under a new Government initiative; the Government changed the rules regarding water right entitlements in that they allowed the water licences to be separated from the land and be treated as a totally separate asset. This enabled other parties to buy the water rights from the land owners. The land has always been used to carry on a business of farming activities, firstly by your parent and more recently by family members. You are employed by family members as a farm hand. You work on average 60 hours per week and you are paid wages based on the relevant award. During the period that you have co-owned the property you have paid for running costs of the property and improvements and your proportional share of the Shire and water rates. You have also had to co-sign and guarantee all bank loans relating to the property. You have been actively involved on a day to day basis with the overall management of the property as it is in your interests to do so. You have in consultation with the other co-owners formulated a land management program including property improvement. You have been involved in some decisions concerning the application of water, the repair of channels and pipelines and the management, sale and aggregation of stock. A portion of the water rights have been sold. You expect to sell further water rights in the future.

Relevant legislative provisions: Income Tax Assessment Act 1997 subsection 112-25(3) | Income Tax Assessment Act 1997 Division 115 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 subsection 112-25(2) | Income Tax Assessment Act 1997 paragraph 108-5(1)(b) | Income Tax Assessment Act 1997 section 112-25 | Income Tax Assessment Act 1997 section 115-100 | Income Tax Assessment Act 1997 paragraph 152-40(1)(a) | Income Tax Assessment Act 1997 section 328-130 | Income Tax Assessment Act 1997 subsection 152-10(1) | Income Tax Assessment Act 1997 Division 152 | Income Tax Assessment Act 1997 section 152-10 | Income Tax Assessment Act 1997 section 152-35

Reasons for decision: Detailed Reasoning - Water Rights: Water rights, such as licences and water allocations are CGT assets as defined in section 108-5 of the ITAA 1997. They are legal rights existing by the terms of the prevailing State legislation and therefore satisfy the definition. Where a water right has been acquired after 19 September 1985 any disposal of that right will have CGT consequences. The capital gain on each disposal will equal the excess of the consideration over the cost base. A water entitlement is separated from the land If the separation of a water entitlement is a result of a change in the relevant State legislation, the owner of the land will have two CGT assets, being the land and the water entitlement. More than one water entitlement could be separated from the land. No CGT event happens on this splitting of a CGT asset into two or more assets. A person who acquires assets as a beneficiary of a deceased estate When a person dies there is a change of ownership of the deceased's CGT assets. If a person acquires an asset as a beneficiary, the cost base of the asset is either: · if the asset was acquired by the deceased pre-CGT, the market value of the asset on the day the person died, or · if the asset was acquired by the deceased post-CGT, the cost base of the asset on the day the person died. Where land was acquired after 20 September 1985 but before a water entitlement was separated from the land You acquired a share in the property when your parent died. As your parent acquired the land before 20 September 1985, your cost base for the property is the value of your share of the property on the day your parent died. Under the government initiative, water rights were separated from the land. When this happened you acquired separate water licences for your share of the property. When an original asset is divided into two assets without any change in beneficial ownership, subsection 112-25(2) of the ITAA 1997 provides that the splitting is not a CGT event. Thus the water licence is taken to have been acquired when the land was acquired. When an asset is split into two or more assets, the cost base and reduced cost base of each new asset is worked out under the method statement in subsection 112-25(3) of the ITAA 1997. Under the method statement, each element of the original assets cost base or reduced cost base is apportioned in a reasonable way to each new asset. Thus for the land acquired after 20 September 1985 but before separation of water entitlement, the original cost base of the land at the time of acquisition (value of the land on the day your parent died) is apportioned to the land and the water licence. As outlined in Taxation Determination TD 97/3, the Commissioner will accept any reasonable method of apportioning costs between assets. Where land was acquired on or after 20 September 1985 and after a water entitlement was separated from the land Under the government initiative, the water right was separated from the land. Where land was acquired after this time, the water licence acquired with the land was a separate CGT asset under paragraph 108-5(1)(b) of the ITAA 1997 notwithstanding that the licence and the land were acquired as an inheritance. For any portion of the land that your mother acquired before 20 September 1985 the water licence and the land have cost bases that were the market value at the date of death of your mother. For any portion of the land that your mother acquired after 20 September 1985 the water licence and the land have cost bases that were the cost bases to your mother at the date of death of your mother. Cost bases of relevant split assets: 'reasonable apportionment' The cost base of the relevant asset that emerges after the change in the form of the original asset is determined by section 112-25(3) of the ITAA 1997. Each element of the cost base or reduced cost base of the relevant asset must be determined. Then these elements must be apportioned 'in a reasonable way' between the assets that result from the split or change. 'Reasonable' can have a number of meanings. Taxation Determination TD 97/3 provides guidance on what the ATO considers to be reasonable: In determining, for the purposes of section 112-25 of the ITAA 1997, the extent to which it is reasonable to attribute each element of the cost base and reduced cost base of the original land to the corresponding element of the cost base and reduced cost base of each new asset, we would accept any approach that is appropriate in the circumstances of the particular case, for example, on an area basis or relative market value basis. 50% discount Where a CGT event A1 occurs, a discount is available on the capital gain where the following conditions in Division 115 of the ITAA 1997 are met: 1. The capital gain is made by an individual 2. The CGT event occurred after 11.45am on 21 September 1999 3. The cost base has not been indexed. 4. The asset must have been acquired at least 12 months before the CGT event. There are special rules about the time of acquisition contained in section 115-30 of the ITAA 1997. The table in section 115-30 of the ITAA 1997 sets out the acquisition date in cases where you acquire an asset as a beneficiary and that asset was either a pre-CGT asset or a post-CGT asset. Where these conditions are met, the capital gain is reduced by 50% for individuals (section 115-100 of the ITAA 1997). Small business CGT concessions Subsection 152-10(1) of the ITAA 1997sets out some basic conditions for the CGT small business concession provisions. If the basic conditions are satisfied, then a small business entity may be able to reduce its capital gains using the small business concessions in Division 152 of the ITAA 1997. The basic conditions in section 152-10 to be satisfied for the gain include: (d) the CGT asset satisfies the active asset test in section 152-35. | Detailed Reasoning - Active asset: Under paragraph 152-40(1)(a) of the ITAA 1997, a CGT asset is an active asset at that time, you own the asset and it is used, or held ready for use, in the course of carrying on a business that is carried on by you; or your affiliate; or another entity that is connected with you. Therefore, the land will be an active asset if you, your affiliate or an entity connected with you uses the land in the course of carrying on a business. You do not use the land in carrying on a business. Family members use the land in carrying on a business and the land will only be an active asset if the family members are your affiliates. | Detailed Reasoning - Affiliates: An affiliate is defined by section 328-130 of the ITAA 1997 as being an individual or company who acts or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the individual or company. Relevant factors that may support a finding that a person acts in such a manner include: · the existence of a close family relationship between the parties · the lack of any formal agreement or formal relationship between the parties dictating how the parties are to act in relation to each other · the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements or legal or fiduciary obligations, and · the actions of the parties. Generally, another entity would not be acting in concert with you if they: · have different employees · have different business premises · have separate bank accounts · do not consult you on business matters, and · conduct their business affairs independently in all regards. | Detailed Reasoning - Application to your circumstances: You are the co-owner of some land that you have inherited. Your family members carry on a farming business on the land. You are employed as a farm hand and paid award rates. Whilst we accept that there is a family relationship in that a business is carried on by family members, the fact that you are an employee would indicate that you are not an affiliate because there is a formal arrangement, that is, you are paid award rates. The day to day tasks that you carry out are done so because you are an employee and not because you are an affiliate. You also have paid for running costs of the property and improvements and your proportional share of the Shire and water rates and had to co-sign and guarantee all bank loans relating to the property. This is consistent with your activities as a co-owner and does not indicate a business relationship. Your portion of the land and water rights are not considered to be active assets of yours. As the land and the water rights are not active assets you are not able to apply the Small business CGT concessions to the gain on the sale of the water rights.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Answer: When an asset is split into two or more assets, the cost base and reduced cost base of each new asset is worked out under the method statement in subsection 112-25(3) of the Income Tax Assessment Act 1997 (ITAA 1997). | Answer: Yes, if all of the conditions in Division 115 of the ITAA 1997 are met. | Does Part IVA apply to this ruling?: Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. | If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply. | For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.