“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

 

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Taxing issues for departing taxpayers

The following article originally appeared in the November 2016 issue of The Taxpayer. This is the monthly journal of Tax & Super Australia (formerly Taxpayers Australia).

taxing-issues-for-departing-taxpayers

If you have any questions abou the issues raised in the article, please don’t hesitate to leave a comment, send me an email or contact me via LinkedIn.

There are a number of excellent articles in the magazine and I encourage you to get hold of a copy.

I will be contributing regularly to The Taxpayer. My next article will appear in December and will be on rental income and the small business CGT concessions.

Simon

Small Business CGT Concessions: Small Business Entity Test – Part 1

In this post we’ll start to cover how a taxpayer can satisfy the small business entity test. This test was introduced for CGT events happening from the 1 July 2007 onwards as an alternative to the maximum net asset value test. It is a lot easier to apply and therefore taxpayers would normally look to this first before the net asset test.

To be a ‘small business entity’ the taxpayer must carry on a business and satisfy the $2m aggregated turnover test.

Carrying on a business

Whether or not a business is being carried on will normally be quite obvious and I don’t intend to talk about it here at great length (though it could make an interesting post for another time). However, if you are unsure whether or not a business is carried on I would suggest looking at the table at paragraph 18 in Tax Ruling TR 97/11 as a starting point.

It is quite common (at least amongst my clients) for one entity to own most of the assets while another entity (an affiliate or connected entity) runs the business. In the past this caused problems but under the current rules the small business entity test will still be satisfied where:

  • The entity that carries on the business is a small business entity and is connected to or is an affiliate of the taxpayer (i.e. the asset holding entity)
  • The taxpayer does not carry on a business itself (other than in partnership) and
  • The asset is used in the business carried on by the taxpayer’s affiliate or connected entity

 $2m aggregated turnover test

This test looks at whether the taxpayer, together with any connected entities and affiliates (a detailed explanation of what these terms mean will come in my next post) had, or is expected to have, a turnover of $2m or less. The test can be satisfied by looking at:

  • Actual turnover in the prior income year
  • Actual turnover in the current income year (i.e the year in which the CGT event happened) or
  • Estimated turnover in the current income year (obviously determined before the year is over).

Only one of these three needs to be satisfied.

 Turnover

Turnover is the GST-exclusive amount of income derived in the ordinary course of business, excluding from dealings with connected entities and affiliates (to avoid double-counting). It would typically include sales and interest from business bank accounts but wouldn’t include capital gains, dividends and passive rental income.

Some other points to note;

The method of determining turnover you choose must be used for all other connected entities and affiliates. You can’t choose a different method for each entity.

If using the estimated turnover method (i.e. at the start of the income year it appears likely that the aggregated turnover will be less than $2m) the onus is on the taxpayer to prove that the estimate is sound. The Explanatory Memorandum lists factors to consider when making this estimate.

The taxpayer cannot use the estimated turnover test if they carried on a business in the previous two income years and in both those years turnover exceeded $2m.

If the business was carried on for only part of the income year the taxpayer should use a reasonable estimate of what the turnover would have been if it were carried on for the entire year.

In my next post I’ll go into some detail about the aggregated part of the aggregated turnover test. That is, what are connected entities, what are affiliates, what gets included and what gets excluded.

 Image

My favourite type of turnover – an apple turnover

Small Business CGT Concessions – Intro to the Basic Conditions

In order to access any of the concessions, the taxpayer must first satisfy the basic conditions set out in Subdivision 152-A. Some conditions require further tests to be passed but all, at a minimum, require these basic conditions to be met;

  1. A CGT event must happen in relation to a CGT event (except K7) of the taxpayer and this CGT event must result in a capital gain (so is not relevant to assets acquired before 20 September 1985).
  1. The  taxpayer satisfies at least one of the following;
  1. The taxpayer is a ‘small business entity’
  2. The taxpayer satisfies the ‘maximum net asset value test’
  3. The taxpayer is a partner in a partnership that is a small business entity and the CGT asset is an interest in an asset of the partnership or
  4.  The conditions in s 152-10(1A) or (1B) are met. I’ll explain these later.
  5. If the CGT asset is a share in a company or an interest in a trust then further conditions to do with ‘CGT concession stakeholders’ are met.

In my next post we’ll start to get stuck in to the details, first looking at how a taxpayer can be a ‘small business entity’. Spoiler alert – it’s all about having turnover of less than $2m but as you’d expect there’s a bit more too it than that.

Cheers,

Simon