The following article originally appeared in the June 2017 edition of The Taxpayer journal published by Taxpayers Australia (formerly Tax & Super Australia).
The small business CGT concessions are amongst Tax & Super Australia’s most popular helpline topics. Guest writer Simon Dorevitch from A&A Tax Legal Consulting gives some practitioner advice on getting it right and getting the most for your clients.
The small business reliefs in Division 152 of the ITAA97 are some of the most generous concessions contained in the tax acts. However, they can also be complex and confusing. This article provides practical advice on how to help your client satisfy the maximum net asset value, small business entity and active asset tests.
- It is never too early to formulate an escape plan
When setting up a structure for a new client, advisors should consider the effect of the proposed structure on potential exit strategies. The small business CGT concessions are one of the best exit strategies that exist and therefore, advisors should consider how their advice may impact their client’s ability to access and maximise the concessions in the future.
While all structures (companies, trusts, partnerships and sole traders) can access the small business CGT concessions, there are situations where a discretionary trust may receive greater advantages. For example, a company may find that it can reduce a capital gain via the small business 50% reduction, but not have sufficient franking credits to pass on this benefit to shareholders in a tax-effective manner. Similarly, a unit trust may access the concessions but find that some of the benefit is undone via the application of CGT event E4 (unit trust makes a non-assessable payment).
Naturally the small business CGT concessions are only one factor that should be considered. A client that intends to conduct research and development activities may not appreciate an advisor who guides them towards a trust, only to find that the R&D tax incentive is only available to companies.
- Don’t just ‘set and forget’
It is important to continually monitor developments in the law as well as decisions of the courts and AAT and guidance issued by the Commissioner for any changes which may affect your client. This is especially true of the small business CGT concessions, which are the subject of frequent changes in law and interpretation.
Thought should also be given to triggering a CGT event (for example via a sale to an associate) when a client is on the verge of no longer satisfying the $6m maximum net asset value test. While this plan may incur costs (such as stamp duty) and may require making a payment into superannuation, it would provide an uplift in the cost base of the relevant assets – thereby creating a tax saving on the ultimate sale to a third party. It is necessary to monitor the client in order to identify the most appropriate time to take this action.
- Ask and you shall receive
There are numerous situations where, in order to correctly apply the small business CGT concessions, an advisor needs to gather historical information on a client. For example, satisfying the active asset test depends on the use of an asset over time, not only in the year of the CGT event. Additionally, a client’s ability to apply the small business retirement exemption will depend on whether it has been accessed before (and if so how much of the $500,000 lifetime limit remains).
An advisor may be approached by an existing business to act as their new accountants. As the new advisor, it would be wise to ask for more of the previous accountants than the prior year tax return and financial reports. It may be that these documents alone will not provide all the information needed to assess the new client’s eligibility for the small business CGT concessions when the time comes.
MAXIMUM NET ASSET VALUE TEST
- Know what to count…
Satisfying the maximum net asset value test requires that the total of the net value of the taxpayer’s CGT assets, and the net value of the CGT assets of connected entities and affiliates (associated entities), does not exceed $6m. Net assets refers to the value of the assets after subtracting liabilities that are related to those assets and certain provisions.
A CGT asset is defined as any kind of property or a legal or equitable right that is not property. Depreciating assets and trading stock are both CGT assets. Do not exclude these assets merely because the profit on their disposal is taxed under a different regime. Similarly, while CGT assets acquired before 20 September 1985 may not attract CGT on disposal, they are still taken into account for the purpose of this test. The same is true of non-taxable Australian property held by non-resident taxpayers.
The provisions that may be deducted are exhaustively listed as provisions for annual leave, long service leave, unearned income and tax liabilities. Be careful not to overlook these provisions if they are not disclosed in the financial statements.
- …and know that what doesn’t count can matter a great deal
When applying the maximum net asset value test, certain assets may be disregarded. By maximising these exclusions, it may be possible to bring the aggregated net assets of a taxpayer and associated entities below $6m. This may be done, for example, by:purchasing or improving an excluded asset
maximising superannuation contributions, or
making a bona fide gift to a recipient who is not connected to the taxpayer.
An asset that is owned by an individual and is being used solely for the personal use and enjoyment of that individual or their affiliate is an excluded asset. A holiday home may be an example of such an asset, but vacant land on which an individual intends to construct a holiday home will not qualify.
The ATO’s view, as expressed in ATO ID 2011/37, is that the use of an asset over its entire ownership period should be considered – not only how the assets was being used at the time of the CGT event. The Commissioner believes that any non-personal use of an asset at any stage of its ownership period can render the asset ineligible to be disregarded. In its Altnot decision1, the AAT found instead that one must look to what was happening in ‘the time surrounding’ the CGT event. The taxpayer argued that the director’s interest in a family holiday home was an excluded asset since, just before the relevant CGT event, it was being used for his personal use and enjoyment. The AAT ruled that, due to the home’s use as a rental property over the prior seven years, it was not being used solely for his personal use and enjoyment.
The ATO did take a more concessional approach in ATO ID 2011/40, where it determined that the personal use of an individual’s holiday house where rent was not paid, did not mean that the property was not an asset being used solely for the personal use and enjoyment of the individual or their affiliate.
An individual’s main residence is another example of an excluded asset, though it would not be fully excluded if the individual used it for income producing purposes, such that they could claim a deduction for interest during part of the part of the ownership period. A deduction for interest (if any were incurred) would be available if a part of the home were set aside exclusively as a place of business, was clearly identifiable as such and was not readily adaptable for private use. A doctor’s surgery located within a home is an example. Income producing use by an individual other than the owner would not prevent the dwelling to be excluded. Therefore, a doctor working from home may be well advised to ensure that their spouse owns the house outright.
- Raise those liabilities
As mentioned above, the net value of the CGT assets is determined in part by identifying the liabilities of the entity that are related to included CGT assets. Therefore, by maximising these liabilities, a taxpayer increases the likelihood of satisfying the maximum net asset value test. The courts have looked at this aspect of the test on multiple occasions.
In Byrne Hotels2, the court allowed the taxpayer to include some contingent liabilities. It ruled that the real estate agent commission incurred on a sale was an included liability just before the CGT event, even though the taxpayer was invoiced after the sale, and that it was contingent on the sale being completed. Similarly, legal fees issued after the sale could be taken into account, to the extent that they related to work done before the CGT event.
In Scanlon3, it was determined that the passing of a resolution by the Board of Directors cannot, by itself, create a legal or equitable liability. Unless there is an enforceable agreement binding the company, no liability arises. In this case, the directors passed a resolution that the company would pay an ETP to them in consequence of the termination of their employment (upon sale of shares in the company).
- Timing is everything
When it comes to the small business CGT concessions, it is important to get the timing right. This is particularly true is the context of the maximum net asset value test, which must be satisfied ‘just before the CGT event’. Great care, therefore, should be taken when entering into a Heads of Agreement or similar arrangement prior to the conclusion of the contract. In Confidential4, the AAT decided that CGT event A1 happened when a Heads of Agreement was executed, and not when the formal Contract of Sale was signed. This was despite the fact that it was common practice in the industry that a party who had signed a Heads of Agreement could back out at any time if dissatisfied with the results of their due diligence enquiry. The AAT said that “if the terms of the document indicate that the parties intended to be bound immediately, effect must be given to that intention”. It ruled that the parties had agreed to the sale in question and the essentials of this agreement were set out in the Heads of Agreement document. Accordingly, CGT event A1 occurred when the Heads of Agreement was signed and the maximum net asset value test was applied at this date.
In Scanlon5, shareholders signed a letter indicating their agreement to sell their shares. The letter stipulated a requirement of exclusive dealing between the parties and made reference to certain conditions precedent (including that the purchaser would undertake due diligence). The AAT found that CGT event A1 happened when the letter was signed, not when the ultimate contract was executed. The Tribunal emphasised that the issue depends on the intention of the parties as objectively ascertained from the relevant documents and that the existence of a condition precedent (such as a due diligence enquiry) will usually only be a condition precedent to the performance of the contract and not its making.
Getting the timing right will sometimes depend on correctly identifying the correct CGT event. The law says that, if more than one CGT applies to a transaction, taxpayers must apply the ‘most specific’ CGT event. In Healy6 the taxpayer argued that CGT event A1 applied. The Federal Court, however, ruled that event E2 (transfer of an asset to a trust) applied instead. This meant that the relevant CGT event occurred at an earlier time and the 50% CGT discount was not available.
- Do not assume that the sale price is the market value
The maximum net asset value test asks taxpayers to obtain a market value of relevant CGT assets. Market value is to be determined in accordance common law principals, chiefly the principals set out in Spencer v Commonwealth7.
In most cases, the market value of an asset will be the price agreed to by parties dealing at arm’s length. However, there are cases where the courts have found that market value and sale price have diverged. This may occur where a buyer is willing to pay more than an asset’s intrinsic value because it has a particular adaptability or usefulness to them (eg a parcel of land that a neighbour wanted to acquire).
Market value and sales price may also diverge in cases of aggregated disposals. In Miley8, the taxpayer was one of three equal shareholders who sold their shares to a single purchaser. The AAT agreed with Mr Miley’s argument that the amount he received included a premium for control of the company and found that the correct enquiry was directed towards determining the market value of Mr Miley’s shares alone.
Syttadel Holdings9 is another case that demonstrates that market value is not always equal to sales price – even where the parties deal at arm’s length. Though the taxpayer and ATO disagreed over the market value of a marina, both parties agreed that it was substantially less than the sale price.
Taxpayers who wish to argue that the proceeds from the sale of an asset are greater than its market value (for example to reduce the value of assets under the maximum net asset value test) should remember that they bear the onus of proof. It is not enough to merely find flaws in the ATO’s valuation. It would be wise to obtain the services of an independent professional valuer – preferably one with relevant experience in the asset being valued. Tax law is rife with examples of the courts failing to accept a valuation because the methodology was flawed10 so the valuer should clearly document the process they undertook and be prepared to justify it in a dispute.
SMALL BUSINESS ENTITY TEST
- Consider taking some time off
If the maximum net asset value test cannot be satisfied, the small business entity test must be. In the context of the small business CGT concessions, this requires that the entity carry on a business and have an aggregated turnover (ie. including associated entities) that does not exceed $2m.
There is not a much that a business owner can practically do in order to satisfy the small business entity test. When selling a business, owners typically seek to maximise the sale price and therefore purposefully running down a business (e.g. by operating it part time) in order to cause turnover to drop below $2m is not usually an attractive option.
However, in limited circumstances, this course of action may produce the most optimal result. For example, where a business owns a parcel of land that has appreciated in value considerably – especially if it has owned it for 15 years or more.
ACTIVE ASSET TEST
- Don’t look back in anger
But do look back at an asset’s use over its relevant ownership period to determine whether it satisfies the active asset test. Unfortunately, some practitioners incorrectly assume that an asset that is currently active has always been so.
If the asset has been owned for less than 15 years, it must have been an active asset for at least half of the ownership period.
Once an asset has been active for 7.5 years, it will always satisfy the active asset test no matter how long the asset has been owned. From that point, if it ceases to be active for any reason, this will not prevent it from satisfying the active asset test.
Whether a share or unit is an active asset depends on the underlying assets. Broadly, they will be active if 80% or more of the market value of all assets of the company or trust are active or otherwise included. A share (rather than asset) sale is often preferable to the vendor, so disposing of any non-active assets (especially pre-CGT assets if possible) to enable the shares or units to get above this 80% threshold may be advisable.
- Sometimes being in business isn’t enough
Certain assets are specifically excluded from being an active asset. One such exclusion applies to assets whose main use by the taxpayer is to derive rent, unless the main use for deriving rent was only temporary.
There is a misconception among some advisers that this exception does not apply where the taxpayer carries on a business of leasing properties. The AAT has rejected this argument, stating clearly that it does not matter if the taxpayer is in the business of leasing properties or not.11
That is not to say that all income derived from allowing third parties to use property is considered ‘rent’ for the purposes of the exclusion. The AAT and the ATO have at various times previously ruled that income derived from a commercial storage facility, boarding house, holiday apartments12 and caravan park13 were not rent. However, it was found that payments for short stays in a holiday unit were rent.14 The key factor to consider is whether the occupier has a right to exclusive possession of the property.
1: Altnot v FCT  AATA 140. Note that Altnot was appealed to the Federal Court but this aspect of the decision was not disputed.
2: Byrne Hotels Queensland  FCAFC 127
3: Scanlon and FCT  AATA 725
4: Confidential and FCT  AATA 756
5: Scanlon and FCT  AATA 725
6: Healy v FCT  FCA 269
7: Spencer v Commonwealth  5 CLR 418
8: Re Miley and FCT  AATA 73. It is understood that this case will be appealed in the Federal Court.
9: Syttadel Holdings Pty Ltd and FCT  AATA 589
10: See, for example, Venturi v FCT  AATA 588
11: Jakjoy Pty Ltd v FCT  AATA 526
12: Tax Determination TD 2006/78
13: Tingari Village North Pty Ltd and Commissioner of Taxation  AATA 233
14: Carson and Commissioner of Taxation  AATA 156