“Hotel, Motel, Holiday Inn” – Deriving Rent and the small business CGT concessions

The following article appeared in the December edition of ‘The Taxpayer’ by Tax & Superannuation Australia. Unfortunately I cannot upload a PDF or link to the article so the unformated text below will have to suffice. Please contact me if you would like to discuss anything in this article.

 

“Hotel, Motel, Holiday Inn”[1] – Deriving Rent and Accessing the Small Business CGT Concessions

Simon Dorevitch examines the pitfalls of satisfying the active asset test for assets which are used to derive rent.

Back to basics: The active asset test

To access the small business CGT concessions, certain conditions must first be satisfied. One such condition is that the CGT asset satisfies the active asset test. Satisfying this test requires the asset to be an active asset of the taxpayer for the lesser of 7.5 years and half of the relevant ownership period.

A CGT asset is an active asset at a time if it is used, or held ready for use, in the course of carrying on a business by the taxpayer, their affiliate or an entity connected with them (relevant entities).

However, 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. When determining the main use of the asset, the taxpayer is instructed to disregard any personal use or enjoyment of the asset by them and to treat any use by their affiliate or entity connected with them as their own use.

Carrying on a business

To qualify as an active asset, a tangible CGT asset must be used or held ready for use in the course of carrying on a business by the taxpayer or a relevant entity. There is no conclusive test for determining whether a business is being carried on. However, in Tax Ruling TR 97/11, the ATO has enumerated several indicators of a business that may be relevant, including;

  • The size, scale and permanency of the activity
  • Repetition and regularity of the activity
  • Whether the activity is planned, organised and carried on in a systematic and businesslike manner
  • The expectation, and likelihood, of a profit

It is highly likely that the operator of a hotel would be conducting a business. In contrast, most residential rental activities are a form of investment and do not amount to carrying on a business. However, the following examples indicate that it is possible to conduct a rental property business.

Example 1 – Taxpayer was conducting rental property business[2]

The taxpayers owned eight houses and three apartment blocks (each comprising six residential units), making a total of 26 properties. They actively managed the properties, devoting a significant amount of time (an average of 25 hours per week) to them. The ATO concluded that the taxpayers were carrying on a business.

Example 2 – Taxpayer was conducting rental property business [3]

The taxpayer owned nine rental properties. Although they were managed by an agent, the taxpayer spent considerable time undertaking tasks in connection with the properties. Despite finding that the taxpayer’s methods were unsophisticated and un-business-like, the AAT concluded that the taxpayer was carrying on a business.

TIP – PASSIVE ASSETS USED IN THE BUSINESS OF AN AFFILIATE OR CONNECTED ENTITY

The Small Business CGT Concessions may still be available where the taxpayer (i.e. owner of the asset) is not carrying on a business. This would be the case, for example, where the CGT asset is used in a business carried on by the taxpayer’s affiliate or connected entity and this other entity is a ‘small business entity’ (broadly one with a turnover less than $2m).

Deriving rent

An asset whose main use by the taxpayer is to derive rent cannot be an active asset (unless this main use was only temporary).

It has been argued that this exception does not apply to properties where the taxpayer carries on a business of leasing properties, but rather only to passive investment assets. The AAT rejected this argument, stating clearly that it does not matter if the taxpayer is in the business of leasing properties or not. [4]

There is no statutory definition of rent that is relevant in this context so the term takes on its common law meaning.

Where there is a question of whether the amount paid constitutes rent, a key factor to consider is whether the occupier has a right to exclusive possession of the property. If such a right exists, the payments involved are likely to be rent. Conversely, if the arrangement allows the occupier only to enter and use the premises for certain purposes and does not amount to a lease granting exclusive possession, the payments involved are unlikely to be rent.

Other relevant factors include the degree of control retained by the owner, the extent of any services performed by the owner (such as room cleaning, provision of meals, supply of linen and shared amenities) and the length of the arrangement.

Example 3 – Payments for use of a commercial storage facility were not rent[5]

Christine carries on a business of providing commercial storage space. Each space is available for hire periods of 1 week or more. She provides office facilities, on-site security, cleaning and various items of equipment for sale or loan. The agreements provide that in certain circumstances Christine can relocate the client to another space or enter the space without consent and that the client cannot assign the rights under the agreement. Having regard to all the circumstances, the ATO concluded that the amounts received by Christine were not rent.

Example 4 – Payments for occupancy of boarding house were not rent[6]

David operates an 8-bedroom boarding house. The average length of stay is 4-6 weeks. Visitors are required to leave the premises by a certain time and David retains the right to enter the rooms. David pays for all utilities and provides cleaning and maintenance, linen and towels and common areas such as a lounge room, kitchen and recreation area. The ATO concluded that the amounts received by David were not rent.

Example 5 – Payments for occupancy of holiday apartments were not rent[7]

Linda owns a complex of 6 holiday apartments, advertised collectively as a motel. Each is booked for periods not exceeding 1 month, with most bookings being for less than 1 week. Guests do not have exclusive possession of their apartment, but rather only a right to occupy on certain conditions. Clean linen, meal facilities and cleaning are provided to guests. The ATO found that Linda’s income was not rent.

Example 6 – Payments for short stays in a caravan park were not rent[8]

The taxpayer owned and operated a caravan park that consisted of fully-furnished self-contained cabins, caravans set up on blocks and sites for guests with their own caravans. Guests also had access to a shared amenities block. The ATO ruled that short-term guests (those staying less than 3 months) did not pay rent while long-term guests (3 months or longer) did.

Example 7 – Payments for occupancy of mobile home park were rent[9]

The taxpayer owned and operated a mobile home park that consisted of 77 sites and a ‘community hall’ with shared facilities such as a kitchen, toilet and recreation area. In reaching the conclusion that the payments for use of the park were rent, the AAT found that the following factors were relevant; the park owner agreed to give vacant possession to a resident on a certain date, the resident was granted exclusive possession and had the right of quiet enjoyment, and the residential site was occupied as the resident’s ‘principal place of residence’.

Example 8 – Payments for short stays in holiday unit were rent[10]

The taxpayer owned a holiday home that was used to provide short term tourist accommodation (i.e. stays of about one to two weeks). Crockery, cutlery and linen were provided but cleaning was done only after the occupants departed. The AAT found there to be little doubt that the occupants regarded themselves as having rented the unit for the period of their stay and as having exclusive possession. Therefore, the payments did constitute rent.

What is the main use?

Where a CGT asset is used partly to derive rent and partly in the business of the taxpayer or relevant entity, it will be necessary to determine the ‘main use’ of the asset. This is because an asset whose main use by the taxpayer is to derive rent cannot be an active asset (unless the main use for deriving rent was only temporary).

The term main use is not defined in Division 152 (which contains the small business CGT reliefs). Tax Determination TD 2006/78 states that no single factor will necessarily be determinative and resolving the matter is likely to involve a consideration of factors such as;

  • The comparative areas of use of the premises,
  • The comparative times of use of the asset and, most importantly.
  • The comparative level of income derived from the different uses of the asset.

Example 9 – Mixed use[11]

Mick owns land on which there are several industrial sheds. He uses one shed (45% of the land area) to conduct a motorcycle repair business and leases the other sheds (55% of the land by area) to unrelated third parties. The income derived from the repair business is 80% of the total income, while the income derived from leasing the other sheds is only 20% of the income. Having regard to all the circumstances, the ATO considers that the main use of Mick’s land is not to derive rent.

Example 10 – Mixed use[12]

The taxpayer owned a shopping centre. Most the shops (constituting 73% of the floor space) were rented by unrelated shopkeepers but some (27% of the floor space) were used by the taxpayer to conduct business. Despite this, the ATO ruled that the main use of the shopping centre was not to derive rent because the majority (63%) of the income generated from the asset was from the business and only 27% was generated from rent.

In a recent AAT case[13], the taxpayer argued that the word ‘use’ in ‘main use’ could include non-physical uses such as holding a property for the purposes of capital appreciation. This argument was rejected, with the AAT finding that the concept of use was a reference only to physical use.

Treat use by affiliate/connected entity as taxpayer’s own

When determining the main use of the asset the taxpayer is instructed to treat any use by a relevant entity as their own use.

Example 11 – Use by affiliate[14]

John rents 80% of a property to his affiliate Peter and uses the remaining 20% in his business. Peter uses 60% of the area rented to him in his business and rents the remaining 40% to an unrelated party. 32% of the property (80% x 40%) is being treated as being used to derive rent. However, the remaining 68% is either actually used in John’s business (20%) or is treated as being used in his business (48%, being 80% x 60%). Therefore, the main use of the property is not to derive rent.

 

Ignore private use

When determining the main use of the asset the taxpayer is also instructed to disregard their own personal use or enjoyment of the asset. This point can be illustrated by the following example;

Example 12 – Private use disregarded[15]

Neil rents 60% of a property to his affiliate Andrea, uses 15% in his business and the remaining 25% for his own personal use.  Because personal use by the owner or relevant entity is ignored in determining the property’s main use, the above proportions must be adjusted. Following the adjustments Neil rents 80% (60% x (100/75)) of the property to Andrea and uses 20% (15% x 100/75) in his business.

Is the main use only temporary?

Finally, a CGT asset whose main use is to derive rent will not be precluded from being an active asset if this main use is only temporary. There is scarce guidance regarding what is  considered temporary in this context. However, in the context of whether a share in a company or interest in a trust is an active asset, an example in the explanatory memorandum[16] indicates that a failure to satisfy the 80% look-through test for two weeks would be of a temporary nature only and therefore would not prevent the share or interest from being an active asset.

 

As always I would like to remind readers that

  1. The article does not constitute advice and is not intended to be comprehensive. While I have attempted to ensure the accuracy of the article I do not give any assurances. Please seek your own professional advice.
  2. The views in the article are mine alone and do not necessarily represent those of my employer or Tax  & Superannuation Australia

[1] Rapper’s Delight by Sugar Hill Gang, 1979

[2] ATO’s Guide for rental property owners (NAT 1729-06.2016)

[3] YPFD and Commissioner of Taxation [20-14] AATA 9

[4] Jakjoy Pty Ltd v FACT [2013] AATA 526

[5] Example 2 of Tax Determination TD 2006/78

[6] Example 3 of Tax Determination TD 2006/78

[7] Example 4 of Tax Determination TD 2006/78

[8] PBR 1012886042948

[9] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233

[10] Carson and Commissioner of Taxation [2008] AATA 156

[11] Example 5 of Tax Determination TD 2006/78

[12] PBR 70707

[13] The Executors of the Estate of the late Peter Fowler v FCT [2016] AATA 416

[14] Example 2.13 of Explanatory Memorandum to Tax Laws Amendment (2009 Measures No. 2) Act 2009

[15] Example 2.14 of Explanatory Memorandum to Tax Laws Amendment (2009 Measures No. 2) Act 2009

[16] Example 1.12 of Explanatory Memorandum to Tax Laws Amendment (2006 Measures No. 7) Act 2007

 

Advertisements

Small business CGT concessions – Connected entities

It’s been a while since my last post because, well let’s face it – there are more enjoyable ways to spend your free time than writing about tax. However, this week I had the opportunity to advise two separate clients on the small business CGT concessions and figured I would take it as a sign that I should finally continue my series on small business CGT concessions. Today’s post will be about connected entities.

When applying the aggregated turnover test (and similarly when applying the maximum net asset value test as we shall see in a future blog post) a connected entity’s turnover is taken into account. That is, when determining if aggregated turnover of a taxpayer is $2m or less, it is necessary to count the turnover of its connected entities. To do this it will obviously be necessary to first identity which entities are connected.

One entity is connected with another entity if either entity controls the other entity or both entities are controlled by the same third entity.  When thinking about connected entities key number to remember is 40% because control will generally occur if the control percentage is 40% or more. However, the Commissioner does have the power to determine that control does not exist if the percentage is between 40 and 50% (say because another entity owns 50-60%). Remember also that control can be direct or indirect such as where an entity directly controls a second entity and this second entity directly controls a third.

There are different rules for establishing control for different types of entities so I will consider each separately;

Companies

A shareholder will have a 40% control percentage where, together with its affiliates (more on that in my next post) it beneficially owns shares that have the right to at least 40% of any dividends paid, any distributions of capital or voting power.

Unit Trusts

A unit holder will have a 40% control percentage where, together with its affiliates it beneficially owns units that have the right to at least 40% of any distributions of income or distributions of capital. Unlike companies there is no equivalent voting power test.

Discretionary Trusts

There are two ways an entity can control a discretionary trust.

The first way is by influencing  a trustee – where the trustee acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity, its affiliates or the entity acting together with its affiliates (deep breath). Some of the factors to consider when determining this include

How the trustee has acted in the past

The relationship between the entity and trustee

The amount of any property or services transferred to the trust by the entity  and

Any arrangement or understanding between the entity and any person who has benefited under the trust in the past

This test seems to have some strange consequences. On a strict reading, this rule seems to suggest that a sole director of a corporate trustee would be connected but not an individual acting in their own right as trustee. If the corporate trustee has two directors and decisions are made by them jointly neither one of them will control the trustee.  Finally, according to the Commissioner, an appointor will control a discretionary trust, even if it has no day-to-day involvement.

The other way to determine control of a discretionary trust is to look at the pattern of distributions in the previous four income years (excluding the current year in question).  A beneficiary controls a discretionary trust in an income year if at least 40% of the trust’s income or capital is paid/applied for the benefit of it and/or its affiliates.

Some things to note include;

According to new rules which apply to CGT events on or after 27 June 2011, if a trust is unable to establish a beneficiary-controller because it is unable make a distribution, the trustee may nominate up to 4 beneficiaries as controllers. This would occur where the trust had a tax loss or no net income and the trustee did not make a distribution of income or capital for that year.

It is income or capital but these are considered separately. If a beneficiary receives 35% of each they will not control the trust but a beneficiary who receives 40% of one and 0% of the other will.

Exempt entities and deductible gift recipients (e.g. charities) cannot be treated as controlling, regardless of the percentage of distributions made to them.

Partnerships

Even though a partnership is not a separate legal entity, it can be a connected entity. A partner  will be connected with a partnership if he/she/it is entitled to receive at least 40% of the income or net income of the partnership or at least 40% of distributions of capital

Hybrid Trusts

These would probably be considered under the discretionary trust rules.

Superfund

Although a super fund is a type of trust, the Commissioner’s view is that it will not be connected with any of its members or trustee. This opens up opportunities to reduce your net assets by contributing funds or assets into a super fund. Of course the contribution rules will need to be considered before doing this.

 

In my next post I’ll write about affiliates.

Cheers,

Simon