Private ruling: Small Business Concessions – active asset test – main use to derive rent
Date of advice: 9 October 2018
Published: December 2018
Ruling period: Between 1 July 2016 and 30 June 2017 (“the Relevant Period”)
Date scheme commenced: 1 July 2008

Ruling: Q1: Does the property satisfy the active asset test in section 152-35 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Is the property excluded from being an active asset by paragraph 152-40(4)(e) of the ITAA 1997? | A2: Yes.

Relevant facts and circumstances: You purchased the property which consisted of two units on a date in 199X from two related parties. The two units are on a single title and have been for the entire time you owned them. Unit 1 is X% of the total size of the property. During the Relevant Period it had it had X bedrooms, a living room, kitchen, dining area, laundry, one bathroom and one toilet. Unit 2 is X % of the total size of the property. Unit 1 has been a registered rooming house from a date in 200X. Prior to that date it was used as a residential rental property. Unit 2 has always been a residential rental property, apart from 201W to 201X, when it was used as a rooming house. The accommodation arrangements for Unit 1 of the property were as follows: ● the operations of the premises were registered with the relevant authorities, including the state government, and listed on a public register as a rooming house; ● the house was fully furnished and all essentials other than linen were provided; ● common areas comprised of a lounge room, self-contained kitchen, dining area, laundry, toilet and a bathroom; ● sufficient car parking was available for each room; ● there was no written lease agreement between you and the residents; ● residents were able to stay on a day to day basis; ● the length of stay varied between residents from a week to one year; ● each room had an individual key; ● you were liable to pay all the utility bills; ● residents had no control over the common areas; - a related party visited the property every two days to check on things and could be contacted by phone between visits; ● you did not provide meals to the residents; ● the establishment of the premises was planned. You budgeted income and expenses and sought to maximise profits. There was a cash book to record income and expenses, guest ledgers and bank accounts were maintained; and ● you advertised for prospective residents in local newspapers and the rooming house register. You did not use a real estate agent to find occupants. There was no resident caretaker or on-site supervisor of the premises. You provided the following services to the residents: ● Fortnightly cleaning – provided by a contractor; and ● Fortnightly gardening – provided by a related party. The following is your estimate of the time spent managing the premises: ● Gardening - 2 hours per fortnight ● Checking in on residents - ½ hour per week ● Maintenance - 2 hours per fortnight ● Collecting rent - 1 hour per week ● Maintaining financial records - 1 hour per fortnight ● Collating and paying bills - 2 hours per fortnight Estimated time spent managing the premises was five hours per week. You reported the income from Unit 1 as rental income in your tax returns. The income you received from Unit 1 from 200X to 201Y was $XXX,000. You sold the whole Property on a date in 201Y.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 104-10 | Income Tax Assessment Act 1997 section 152-35 | Income Tax Assessment Act 1997 paragraph 152-40(4)(e) | Income Tax Assessment Act 1997 section 152-55 | Income Tax Assessment Act 1997 section 152-110 | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Detailed Reasoning - Active asset test: The active asset test is contained in section 152-35 of the ITAA 1997 and is satisfied if 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. 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, your spouse or child or an entity connected with you. Therefore, the first question that needs to be considered is whether the property has been used or held ready for use in any business. Taxation Ruling TR 97/11 outlines the important factors that are considered in determining if an activity was a business for tax purposes. The factors include: ● whether the activity has a significant commercial purpose or character ● whether there is more than just an intention to engage in business ● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity ● whether there is regularity and repetition of the activity ● whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business ● whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit ● the size and scale and permanency of the activity No one indicator is decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the general impression gained from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour'. Taxation Ruling IT 2423 Withholding tax: whether rental income constitutes proceeds of business - permanent establishment- deduction for interest, states that the conclusion that an individual is carrying on a business of letting property depends largely upon the scale of operations. An individual deriving income from the rent of one or two residential properties would not normally be thought of as carrying on a business. The issue of whether the owner of one or several properties, in providing accommodation, is carrying on a business has arisen in a number of cases. Taxation Ruling TR 93/32 Income tax: rental property- division of net income or loss between co-owners, states that as a general proposition, it is more accurate to describe the owners of rental property as … owners in investment rather than … in a business operation.' In Commissioner v. McDonald (1987) 15 FCR 172; 18 ATR 957; 87 ATC 4541 ( McDonald's case ), the Federal Court considered that for a business to be carried on by owners of property, one would expect that they would be involved in providing services in addition to the process of letting property (as with a hotel or motel), not merely receiving payments for the tenants occupation of the property. In Carson & Anor v. FC of T AAT 156 (Carson's case) the taxpayers owned one property jointly which was used to provide short term tourist accommodation, usually for stays of about a week to two weeks. It was stated that whether a business is being carried on, is a question of fact and an objective consideration of the extent of the applicant's activities relating to the property. Appointing a real estate agent to arrange rentals and minor repairs, spending one week every six months servicing the property and providing brochures relating to the property as required are all activities with all the earmarks of maintaining and deriving income from an investment rather than the carrying on of a business. Similarly, activities such as financing the property, dealing with rating authorities and body corporate are no more than any investor in real estate would do. Application to your circumstances In accordance with the judicial comments above and guidelines set down in Taxation Rulings IT 2423 and TR 97/11, we have assessed the various indicators of whether a business is being carried on. You have regularity and repetition to your activities, and you both had a profit making intention and have made a profit. However, with only X rooms available during most of the time you were conducting the activity, your activities do not show the size or scale necessary to be characterised as carrying on a business of short stay accommodation. And while you keep records and budget income and expenditure, you do this at a level that is no more than a well organised investor might. The return of $XXX,000 over nine years from the venture was at most an investment level return – a business would expect a significantly higher rate of return on capital and labour invested. Spending five hours a week managing and maintaining the rooming house is proportional to the scale of the activity. However activities are not organised in a businesslike fashion along the lines of businesses engaged in short term accommodation activities. You have not provided a level of services additional to the letting of property that would meet the test in McDonald’s case . The switch back of Unit 2 from short-term accommodation activities to rental after a short period is indicative of an investment approach. There is little indication that you intended to engage in business - no business plans have been presented and no evidence of business like behaviour has been offered. After weighing up the various indicators, the Commissioner has determined that you are not engaged in a business. Accordingly, the income that you received from the property is not from the carrying on of a business; rather it is better characterised as income from an investment in property. As you are not considered to be carrying on a business the property is not an active asset and therefore does not satisfy the active asset test in section 152-35 of the ITAA 1997. | Detailed Reasoning - Question 2: Although you do not satisfy the active asset test because you are not carrying on a business, for the sake of completeness we will also consider how the rental exclusion in paragraph 152-40(4)(e) of the ITAA 1997 would apply if you were considered to be carrying on a business. Paragraph 152-40(4)(e) provides that an asset whose main use by you is to derive rent cannot be an active asset unless the main use of deriving rent was only temporary. Taxation Determination TD 2006/78 discusses the circumstances in which premises used in the business of providing accommodation for reward can be active assets notwithstanding the exclusion in paragraph 152-40(4)(e) of the ITAA 1997. Whether an asset's main use is to derive rent will depend upon the particular circumstances of each case. A key factor in determining whether an occupant of premises is a lessee (and therefore paying rent) is whether the occupier has a right to exclusive possession ( Radaich v. Smith (1959) 101 CLR 209). If premises are leased to a tenant under a lease agreement granting exclusive possession, the payments involved are likely to be rent and the premises will not be 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 less likely to be rent. For example, if residential units are operated as holiday apartments, the issue arises as to whether the occupants of the apartments are tenants/lessees or only have licences to occupy. This will be a question of fact depending on all the circumstances involved. Relevant factors to consider in determining this question include: ● whether the occupier has a right to exclusive possession ● 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. Allen (1966) 1 NSWR 572; Appah v. Parncliffe Investments Ltd [1964] 1 All ER 838 and Marchant v. Charters [1977] 3 All ER 918). However, many arrangements involving short stay accommodation are unlikely to be active assets because no business is being carried on or, even if a business is being carried on, it amounts to the derivation of rent. This is because in many cases the services provided are not sufficient to change the nature of the income from passive to active. For example, if meals or daily cleaning are not provided, the payment would be almost entirely for the use of property. In Carson & Anor v FC of T [2008] AATA 156 ( Carson's case) , the taxpayers provided short-term tourist accommodation to the public. The subject asset was one unit, presumably within a group of residential units. Occupants generally stayed for one or two weeks. Crockery, cutlery and linen were included but cleaning was done only after each stay. The taxpayers relied on TR 2006/78 and contended that the unit was an active asset for the purposes of the small business CGT concessions. The AAT held that the main use of the property was to derive rent and therefore it was excluded from being an active asset. Although no formal agreement was signed, there was a landlord/tenant relationship in that the occupants of the unit would no doubt regard themselves as having rented the unit and having exclusive possession thereof. In the case of Swan V Uecker [2016] VSC 313; 50 VR 74 (Swan V Uecker) it was stated that just because an accommodation agreement referred to a licence rather than a lease, it did not mean that there was not possession by the occupant and therefore a lease: “the characterisation of an agreement … as a lease or a licence depends upon the proper construction of that agreement—looking to substance and not form—and having regard to relevant surrounding circumstances.“ While a landlord may reserve the right to enter the rooms to enforce conditions of the accommodation agreement, or to evict residents who have breached the conditions, this alone does not invalidate the general possession by a resident of their room. In the Relevant State, residents of registered rooming houses have an individual agreement with their rooming house owner or manager. They have exclusive possession of their rooms, and a right to access shared communal facilities. Where money is received in exchange for accommodation, the presumption will be that the income is rent. Where the occupants do not enjoy exclusive possession, it is less likely to be rent. However, even with exclusive possession, if an owner provides a significant level of service over and above the accommodation in exchange for the income, they may rebut the presumption that it is rent. Whether an occupant has, or reasonably expects that they have exclusive possession is a question of fact that turns on the individual situation. Even when a landlord claims that the occupant does not enjoy exclusive possession, it is a question of examining the facts to determine whether this is so. Application to your circumstances You have owned the property for more than 15 years and used it in your accommodation activities for more than seven and a half years. Unit 1 represents more than half of the total area of the property, and more than half of the income earned in the relevant period. The same reasoning that applied in Carson’s case and Swan v Uecker can be applied to your situation, as the facts are similar. In your case, you do not provide additional services such as meals or daily cleaning of the common areas or the rooms. The services you did supply are no more than would be supplied to tenants in a furnished short term rental situation. Cleaning of the common internal areas and gardening are services to property rather than services to occupants. Having regard to all the facts, we consider that the relationship between you and the residents is more properly characterised as that of landlord/tenant. In addition, under Relevant legislation, occupants of rooming houses have exclusive possession of their rooms. No formal lease agreement was signed. Residents were given rules to follow and warned that if they breached the rules they would be evicted. Residents would have reasonably believed they had control and exclusive possession over their individual room for the duration of their stay. While you reserved the right to enter rooms to clean and to confirm rules were being followed, and to evict residents who were not following the rules, this is still within the bounds of a short-term lease arrangement. You have provided details of the time you spent cleaning and maintaining the property. We do not consider they provide a significant value adding service to the residents over and above the benefit provided by the accommodation. In other words, the money you receive from the residents is almost entirely for their use of the room for accommodation, not for the other services provided. Accordingly, the payments you received from the residents are considered rent. As the main use of the property was to derive rent, the property is excluded from being an active asset by virtue of paragraph 152-40(4)(e) of the ITAA 1997. Consequently, even if you were considered to be engaged in a business of providing short term accommodation, you would not be able to access the small business CGT concessions in Division 152 of the ITAA 1997 in relation to the capital gain you made from the sale of the property.