Taxation Considerations in the Purchase and Sale of a Business. Greg Vale

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1 Taxation Considerations in the Purchase and Sale of a Business Presented by Level 12, 111 Elizabeth Street SYDNEY NSW 2000 T: F: W: E:

2 Binetter Vale Lawyers TABLE OF CONTENTS About the Author Disclaimer iv v A GENERAL CONSIDERATIONS IMPORTANCE OF THE INCOME AND CAPITAL DISTINCTION CGT CONCESSIONS Division 115 Discount capital gains What is the discount capital gain concession? Who is entitled to claim the general 50% discount? Does it apply to all assets? What is the discount available? What happens with capital losses? Can the discount pass to the beneficiaries of a trust? Can I use indexation to reduce the capital gain even further? Division 152 Small Business Concessions What are the small business capital gain tax concessions? What are the eligibility criteria? What is a small business entity? How do you pass the maximum net asset value test? Can you, as a partner making a gain on the sale of partnership assets, still access the small business CGT concession where the partner or the partnership fails the $6 million maximum net asset value test? Can passively held investment assets qualify for the sale business CGT concessions? How do you pass the active asset test? How do you pass the significant individual test? How do you pass the CGT concession stakeholder test? i

3 What happens if you pass the eligibility criteria? What is the small business 15-year exemption? What is the small business 50% reduction? What is the small business retirement exemption? NEED FOR PRE-SALE PLANNING Sale of business Sale of shares COMPARATIVE BUSINESS STRUCTURES Sole Proprietor ( Bill ) Company (Bill as sole shareholder) CGT Consequences of Company selling business assets CGT Consequences of Bill selling his shares in the Company Business Owned by a Discretionary Trust CGT Consequences upon sale of business Company owned by Trust Sale of Business by the Company CGT consequences if Shares in the Company are Sold B TAXATION CONSIDERATIONS FOR THE VENDOR APPORTIONMENT OF THE SALE PRICE LAND AND BUILDINGS PLANT AND EQUIPMENT LEASED PREMISES PLANT AND EQUIPMENT LEASES TRADING STOCK DEBTORS GOODWILL LICENCES/FRANCHISE RIGHTS RESTRICTIVE COVENANTS WORK IN PROGRESS PREPAYMENTS EMPLOYEE ENTITLEMENTS TERMINATION PAYMENTS INTELLECTUAL PROPERTY POST SALE COSTS C TAXATION CONSIDERATIONS FOR THE PURCHASER APPORTIONMENT OF THE PURCHASE PRICE ii

4 2. LAND AND BUILDINGS PLANT AND EQUIPMENT LEASE PREMIUMS PLANT AND EQUIPMENT LEASES TRADING STOCK DEBTORS WORK IN PROGRESS PREPAYMENTS ANNUAL AND LONG SERVICE LEAVE TERMINATION PAYMENTS WARRANTIES AND INDEMNITIES D STAMP DUTY CONSIDERATIONS STAMP DUTY ON THE AGREEMENT FOR SALE STAMP DUTY ON LEASE INSTRUMENTS E GST CONSIDERATIONS LIABILITY FOR GST GST BASICS GOING CONCERN EXEMPTION REASON FOR CLAIMING EXEMPTION ATO RULING ON GOING CONCERN EXEMPTION GSTR 2002/ ELEMENTS OF THE EXEMPTION Supply The vendor supplies all of the things necessary for the continued Things necessary for the continued operation of the enterprise The vendor supplies The vendor must carry on the enterprise until the day of supply Carry on the enterprise The day of supply Part of a business The purchaser must be registered or required to be registered Both parties must have agreed in writing that the supply is of a going concern ADJUSTMENT EVENTS iii

5 Taxation Considerations in the Purchase and Sale of a Business A GENERAL CONSIDERATIONS 1. Importance of the income and capital distinction There is an opportunity to save your clients money by structuring the sale and purchase of the business in the most tax advantageous manner. This opportunity arises because of the possibility of different rates of tax. The rates of tax payable differ depending on the nature of the asset whether the asset is a revenue asset or a capital asset and in the event that the asset is a capital asset the type of taxpayer deriving the capital gain. Revenue assets include trading stock, plant and equipment, intellectual property and land purchased with the intention to sell at a profit. Any gain on the sale of such assets will result in a tax rate based on the individual s marginal rate of tax, being up to 46.5%. Whilst the company rate of income tax is only 30%, one must look at the after tax cost of getting the cash in the hands of the individual where they will usually want the cash. Capital assets include assets acquired for the purpose of deriving income, which could include land, contractual rights, and the goodwill associated with business assets. The rate of capital gains tax (CGT) payable on the sale of capital assets depends on whether any of the CGT concessions apply. The possible rates of tax payable on capital gains varies from 0% to 46.5%. Obviously, clients will be much happier if the sale of the business is structured so that they pay as little tax as possible. 2. CGT concessions Capital gains made on assets disposed of after 11.45am (ACT time) on 21 September 1999 may be reduced by the discount CGT concession in Division 115 of the Income Tax Assessment Act 1997 ( ITAA 1997 ) and the various small business CGT concessions in Division 152 of the ITAA This paper sets out the current law (as at 22 September 2009) in respect of the discount CGT and small business CGT concessions. The concessions have been amended on numerous occasions, so different criteria would apply for earlier income years.

6 2.1 Division 115 Discount capital gains What is the discount capital gain concession? The discount capital gains tax concession allows certain taxpayers who derive a capital gain from an asset held for more than 12 months, to include only part of the nominal capital gain (being that amount of the gain excluding any indexation) in their assessable income. The two criteria to be satisfied are: the gain is made by an eligible taxpayer; and the gain arises from a CGT event happening to an asset held for the qualifying time Who is entitled to claim the general 50% discount? To be a discount capital gain the capital gain must be made by an individual, or a complying superannuation entity, or a trust: section of the ITAA If a company makes a capital gain, then the Division 115 concession is not available. This creates a bias away from using a company to hold assets which are likely to produce a capital gain How long does the asset need to be held before you are entitled to the discount? At least 12 months. The requirement to have held the asset for 12 months is found in section of the ITAA To be a discount capital gain the capital gain must result from a CGT event happening to a CGT asset that was acquired at least 12 months before the CGT event When does the 12 month period start? Section of the ITAA 1997 provides some special rules about the time of acquisition. These special rules relate mainly to CGT roll-overs and death, and provide that the date of acquisition is at an earlier time than that when the taxpayer became the owner of the asset Can you extend the period of ownership by entering into an option agreement? No. Certain gains are excluded from being treated as discount capital gains. Section prevents a capital gain from being a discount capital gain if the CGT event 2

7 occurred under an agreement made within 12 months of acquiring the CGT asset. This section provides that options and other similar arrangements can not be used to extend the ownership period. The time of entry into an option is when the provisions require you to determine the 12 month period. If the contract disposing of the asset was as a result of the exercise of an option, and the option was entered into within 12 months of acquiring the asset, then no matter how long the asset was actually held, the Division 115 concession will not be available How do you work out whether the 12 month period has been passed when the asset sold is shares in a company or units in a trust? You must look at the period of ownership of the underlying assets of the company or trust not the period of ownership of the shares or units. Section of the ITAA 1997 has been included to deny a taxpayer a discount capital gain on a share in a company, or an interest in a trust, if the taxpayer would not have had discount capital gains on the majority of CGT assets underlying the share in the company or interest in the trust. This section is to stop persons having a number of companies sitting on the shelf and maturing for 12 months, using those companies to acquire short term investments, and then selling the shares of those companies and claiming the Division 115 discount. When claiming the Division 115 discount capital gain on the disposal of shares, it is necessary to look at the underlying assets of the private company. If three conditions are satisfied then the capital gain made on the shares will not be a discount capital gain: subsection (3). The conditions are: (a) (b) (c) The shareholder and its associates must hold more than 10% of the rights to profits and capital. The total of the cost bases of CGT assets that the company owned at the time of the CGT event and had acquired less than 12 months before is more than half of the total of the cost bases of the CGT assets the company owned at the time of the event. The amount worked out under subsection (6) is more than half of the amount worked out under subsection (7). 3

8 This is a complicated formula which I will not go into here. The purpose of the formula, however, is to ensure the discount capital gain concession can only be claimed in legitimate cases. As originally drafted, the legislation only included the second condition, but this lead to the section basically never allowing the sale of shares to qualify as a discount capital gain. This was because each item of trading stock, or each receivable, or each piece of cash, was its own CGT asset. As these assets are continually changing and being replaced, the second condition was invariably failed. The introduction of the third condition removes the effect of the continuing change of certain assets of a business in determining whether the capital gain on the sale of shares is a discount capital gain Does it apply to all assets? No. The discount capital gain provisions and the small business CGT concessions only reduce assets subject to the capital gains tax regime. Depreciating and other assets subject to Division 40 of the ITAA 1997 (depreciation and capital deduction provision) will be taxed as ordinary income and can not claim the benefit of the discount capital gain provisions or the small business CGT concessions. Division 40 applies to a number of business assets including plant and equipment and intellectual property. The proceeds on the sale of a business will need to be properly apportioned amongst all of the assets of the business. To the extent that the proceeds are apportioned to plant and equipment and intellectual property no CGT concessions can be claimed What is the discount available? For individuals and trusts, the discount is 50%: section of the ITAA That is, only half of the nominal capital gain made is included in assessable income and potentially subject to tax. The effective result is that the maximum rate of tax for a capital gain made by an individual that satisfies the conditions in Division 115 of the ITAA 1997, is 23.25%. Where a trust makes the capital gain, provided it is distributed to an individual, then the same result arises. The discount available to superannuation funds is 33⅓: section of the ITAA That is, the effective rate of tax paid by a complying superannuation fund is 10% on any qualifying capital gain rather than the general superannuation tax rate of 15% What happens with capital losses? Capital losses are applied before applying the CGT discount. 4

9 2.1.7 Can the discount pass to the beneficiaries of a trust? Yes. But the beneficiary is required to re-determine if it is entitled to the discount by assuming that it had made the gain. Division 115 has special rules dealing with how a discount capital gain made by a trust is taxable in the hands of the beneficiary of the trust. Because not all beneficiaries are entitled to the Division 115 discount if they made the gain directly, special rules are needed to prevent those beneficiaries from indirectly gaining the concession through distributions from trusts. Subsection (3) has the effect that any discount taken by the trustee is grossed up, and the beneficiary is taken to have made a capital gain equal to the share of the nominal capital gain made by the trustee of the trust. Subsection (4) then deems the capital gain that the beneficiary has been deemed to have made to qualify as a discount capital gain if the beneficiary is an entity that is entitled to claim a discount capital gain. That is, beneficiaries that are companies include all of their share of the nominal gain made by the trustee of the trust; beneficiaries that are individuals or trustees include only 50% of their share of the nominal gain made by the trustee of the trust; and beneficiaries that are complying superannuation entities include only two-thirds of their share of the nominal gain made by the trustee of the trust. Subsection (6) then gives the beneficiary a deduction for the income year for that part of the trust amount that is attributable to the trust s net capital gain and assessable under section This deduction is necessary to prevent double taxation on the gain Can I use indexation to reduce the capital gain even further? No. At the time of introducing the Division 115 concession, the Government removed the ability to take into account inflation when calculating the discount capital gain. This was known as indexation. So for assets acquired before 21 September 1999, the taxpayer will have a choice of calculating its assessable income when it makes a capital gain. The taxpayer may choose the Division 115 discount or may choose the indexation method. Where calculating the amount of the capital gain with indexation provides a better result, then obviously the taxpayer would not choose to calculate its assessable income in accordance with Division

10 2.2 Division 152 Small Business Concessions Division 152 of the ITAA 1997 brings together all of small business capital gains tax relief s into one area with a common set of eligibility criteria. The importance of structuring ownership of assets to qualify for these concessions can not be over-emphasised given that with the Division 115 concession it is possible to pay no tax on a qualifying capital gain What are the small business capital gain tax concessions? There are potentially four small business CGT concessions that may be able to be claimed. The concessions may allow a taxpayer to receive the entire capital gain tax free. The concessions are: small business 15 year concession; small business 50% reduction; small business retirement exemption; small business rollover relief. The ability of a taxpayer to claim one or more of the small business CGT concessions depends on whether the taxpayer can satisfy all of the eligibility criteria What are the eligibility criteria? Division 152 of the ITAA 1997 brings together all of the small business capital gains tax concessions into one area, with a common set of eligibility criteria. The criteria are: (a) (b) (c) a CGT event happens to a CGT asset of the taxpayer; the event would have resulted in a capital gain for the taxpayer; the taxpayer: (i) (ii) (iii) is a small business entity (see of Part A this paper); or satisfies the maximum net asset value test (see of Part A of this paper); or 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 (see Part A of this paper); or 6

11 (iv) (v) does not carry on a business and owns a CGT asset that is used in the business of its affiliate or an entity connected with the taxpayer that is a small business entity (see Part A of this paper); or is a partner in a partnership that is a small business entity and does not otherwise carry on business and own a CGT asset (which is not a partnership asset) that is used in the business of the partnership (see Part A of this paper), and (d) the CGT asset satisfies the active asset test. If the capital gain is made in respect of a share in a company or an interest in a trust, then one of the following additional conditions must be satisfied just before the CGT event: (e) (f) the taxpayer is a CGT concession stakeholder; or the taxpayer is an entity in which CGT concession stakeholders have a small business participation percentage of at least 90% What is a small business entity? A small business entity is defined in section of the ITAA A taxpayer is a small business entity if the taxpayer: carries on a business; and satisfies the $2 million aggregated turnover test. Business is defined broadly in section 995 to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee. Carrying on is not defined in the tax law, and so therefore takes its ordinary meaning. However, provisions deem the business to still being carried on if the taxpayer is winding up the business or has stopped carrying on the business in that income year. A person who is a partner in a partnership in an income year, is not, in his or her capacity as a partner, a small business entity for the income year. A partner in a partnership business cannot be regarded as a small business entity. Partners must use the specific eligibility criteria relating to partnerships. There are three ways an entity can satisfy the $2 million aggregated turnover test, being where the aggregated turnover: (i) for the previous income year was less than $2 million; or 7

12 (ii) (iii) for the current income year, worked out as at the first day of the income year, is likely to be less than $2 million; or for the current income year, worked out as at the end of the current income year, is actually less than $2 million What is aggregated turnover? Aggregated turnover is defined in section of the ITAA An entity s aggregated turnover is the sum of the following: (a) (b) (c) the total ordinary income that the entity derives in the income year in the ordinary course of carrying on business ( annual turnover ); the annual turnover of other entities connected with the entity at any time during the income year; and the annual turnover of any affiliate of the entity at any time during the income year. Aggregated turnover does not include amounts derived from dealings between the taxpayer and their connected entities and affiliates. Ordinary income means income accordingly to ordinary (common law) concepts and excludes statutory income, including capital gains What are entities connected with the entity? The meaning of connected with is defined in section of the ITAA 1997 and is basically a 40% control test (directly and indirectly). An entity is connected with the other entity if: (a) (b) one of the entities controls the other entity; or the two entities are controlled by the same third entity. The following rules apply to all entities, except discretionary trusts: (i) an entity controls another entity where the first entity or its affiliates, or the first entity and its affiliates between them, beneficially own, or have the right to acquire the beneficial ownership of, interests in the other entity that between them give the right to receive at least 40% of any distribution of either income, net income of the partnership (if the other entity is a partnership), or capital by the other party: section: subparagraph (2)(a); or 8

13 (ii) if the other entity is a company, an entity alone or together with affiliates must also beneficially own, or has the right to acquire beneficial ownership of, interests in the company that carry between them the right to exercise or control the exercise of at least 40% voting power in the company: subparagraph (2)(b). There are two ways in which an entity can control a discretionary trust: (i) (ii) Where the trustee acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity or its affiliates (subsection (3)); by satisfying a 40% ownership test where for any of the four income years before the relevant income year (subsection (4)): the trustee paid any income or capital of the trust to or for the benefit of the entity and its affiliates; and the amount paid or applied to the entity and/or its affiliates is at least 40% of the total amount of income or capital paid or applied by the trustee for that income year. Where an entity directly controls another entity, and that other entity controls (directly or indirectly) a third entity, the first entity is taken to control the third entity: subsection (7). This rule applies to all entities including discretionary trusts. The control test is no longer satisfied where a trustee nominates the entity as one of the four beneficiaries (where the trust had a tax loss or no taxable income and made no distribution for that income year). However, for the purpose of the active asset test (see of Part A of this paper), an entity is taken to control another entity when the first entity is nominated as controlling beneficiary: subsection (1) and section Who are affiliates? An affiliate is defined in section of the ITAA It means any individual or company who acts, or could reasonably be expected to act in accordance with the taxpayer s directions or wishes, or in concert with the taxpayer, in relation to the affairs of the business of the individual or company. Trusts, partnerships and superannuation funds are not capable of being affiliates. Those entities are grouped under the connected with tests. 9

14 An individual or company is not automatically an affiliate merely because of a business relationship. Likewise, a spouse or child of a taxpayer is not automatically an affiliate. However, for certain tests and eligibility criteria, a spouse or child will be deemed to be an affiliate of a taxpayer. The Explanatory Memorandum to the Taxation Laws Amendment (2006 Measures No. 7) Bill 2006 ( Bill ) which introduced the relevant changes suggests that the following factors may have a bearing on whether an individual or a company is an affiliate of an entity to the extent that they show that two or more entities are acting in concert: 1. family or close personal relationships; 2. financial relationship or dependencies; 3. relationships created through links such as common directors, partners or shareholders; 4. the degree to which the entities consult with each other on business matters; or 5. whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity. The ATO has issued several rulings which deal with the interpretation of the definition of affiliate. The rulings however deal with the phrase in different legislative contexts or in respect of earlier legislative versions of the small business CGT concessions when the tests were different to that being considered in this advice. Accordingly it is difficult to find satisfactory comfort let alone to be able to rely on the rulings. Broadly the Commissioner of Taxation asserts that whether an entity could reasonably be expected to act in accordance with the wishes of the taxpayer involves an examination of the relationship between the parties, and whether that relationship together with inferences drawn from events or patterns of behaviour show that the taxpayer stands in a relationship of control or influence over the potential affiliate. Whether a potential affiliate acts in concert with the taxpayer involves examining whether the entities act together in pursuit of a common goal or objective. Some of the factors that are taken into account include: The existence of a close family relationship between the parties; 10

15 The lack of any formal agreement between the parties prescribing 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; The actions of the parties; Any financial relationship between the parties; The independence of their relative affairs. In Taxation Ruling TR2002/6, the Commissioner of Taxation gave his views as to how he would interpret the meaning of the term STS affiliate in former subsection (8) of the ITAA This ruling provides guidance as to how the ATO will interpret the term affiliate in the present context. The ATO highlighted that the term in concert is not defined under the ITAA 1997 and therefore is to be construed according to its ordinary meaning and legislative context. In this context, a potential affiliate will only be regarded as acting in concert with another entity where: 1. it is acting together with the other in pursuit of a common goal or objective; and 2. that common goal or objective is the carrying on of a business by the potential affiliate with a substantial degree of connection with or dependence on the business carried on by the other entity. Example A company is owned and directed by the taxpayer s children. The taxpayer retains underlying control of the business by controlling the financing of the company, and his children tend to consult him in respect of business decisions. In this case, the company was considered to act in accordance with the taxpayer s wishes or in concert with the taxpayer and was therefore considered to be an affiliate of the taxpayer. Source: ATO ID 2001/712 11

16 Example An individual conducts a video rental business through a company. The company leases premises on arms length terms from a discretionary trust. The trustees and beneficiaries of the discretionary trust are the individual s parents. In this case, the trust was not considered to be a small business CGT affiliate of the company. There was no evidence indicating that the company and the trust act together in pursuit of a common goal or purpose or that the company is able to direct the trust in connection to the shop. Despite the family relationship between the controller of the company and the controllers of the trust, the lease arrangement was on a commercial basis and the trust was not expected to be participating in the business activities of the company or to be reasonably be expected to act in accordance with the directions or wishes of or in concert with the company. Source: Taxation Determination TD 2006/79 Whether an entity is an affiliate of another is ultimately a question of fact which cannot be ascertained for certain without applying for a private ruling from the Commissioner What is meant by a reference to likely to be less than $2 million? A reference to likely means that, on the balance of probabilities, it is more likely than not that the entity s aggregated turnover will be under $2 million. Whether for the current income year, the aggregated turnover is likely to be less than $2 million is an objective test. Some factors to consider include: the entity s aggregated turnover in previous income years; exceptional sales or particular product lines last year that will not occur this year; whether the entity is likely to have reduced staff this year; whether the operating hours of the business will decrease; whether any aspect of the location of the business, or its industry, indicates a declining turnover (e.g., if a drought is declared in an area, or if prices in the industry decline); or whether the business will face increased competition. 12

17 Source: Paragraph 1.28 of the Explanatory Memorandum of Tax Laws Amendment (Small Business) Act If the aggregated turnover in each of the previous two income years (worked out as at the end of those years) was greater than $2 million, the entity cannot rely on the likely test: subsection (3) What about an entity which starts carrying on a business part way through an income year? Although the aggregated turnover for the purpose of the likely to be less than $2 million test is worked out as at the first day of the current income year, if the entity starts to carry on a business part way through an income year, then the aggregated turnover is worked out as at the day that the entity starts to carry on the business: subsection (2). However, for the purpose of the test, the entity will need to calculate what their turnover would have been had the entity carried on the business for the entire income year How do you pass the maximum net asset value test? A taxpayer satisfies the maximum net asset value test after 1 July 2007 if, just before the time of the CGT event (being the time of exchange of contract), the sum of the following amounts does not exceed $6,000,000: (a) (b) (c) the net value of CGT assets of the taxpayer; the net value of CGT assets of any entities connected with the taxpayer; and the net value of the CGT assets of any affiliates of the taxpayer or entities connected with any affiliate of the taxpayer Is the $6,000,000 threshold indexed? No. The threshold is fixed at $6,000,000 so the ability of taxpayers to utilise the concessions will diminish over time with inflation. The threshold was increased from $5,000,000 on and from 1 July The $5,000,000 threshold applies for the period from 21 September 1999 to 30 June Nevertheless, irrespective of the threshold, all taxpayers who qualify as a small business entity (aggregated turnover of less than $2 million) will qualify for the small business CGT concessions irrespective of the actual asset value. 13

18 How do you work out the net value of CGT assets? It is the net value of assets and any liabilities related to the assets that are taken into account: subsection (1). Subsection (1) specifically lists provisions for annual leave, long service leave, unearned income and tax liabilities as amounts that can be subtracted from the market value of the CGT assets. The Commissioner of Taxation had released three interpretive decisions, ATO ID 2004/ , setting out his interpretation of subsection (1). These interpretive decisions have now been withdrawn and replaced by Taxation Determination TD 2007/14. TD 2007/14 provides that subsection (1) does not require each liability to be directly related to a particular asset. The liabilities may relate to the assets of the entity more generally. The Commissioner states: The liabilities of the entity that are related to the assets also include liabilities that although not directly related to only one particular asset, but which relate to the assets of the entity more generally for example, a bank overdraft or other short term financing facilities that provide working capital for the operation of the business. TD 2007/14 also states: In the context of subsection (1), liabilities extend to legally enforceable debts due for payment and to presently existing obligations to pay either a sum certain or ascertainable sums. The term does not extend to contingent liabilities, future obligations or expectancies. Some examples of amounts that are not included in liabilities in the context of subsection (1) are: provisions for possible obligation to pay damages in a pending lawsuit; provisions for liabilities in respect of earn-out contract; provision for guarantee of a loan; provisions for long service and annual leave entitlements; provisions for income and other taxes prior to liability arising; accounting liabilities arising as a result of receiving prepaid income; expenses that are not yet due; and provisions in general for such things as quantity rebate and the like. 14

19 Source: Paragraph 20 of Appendix 1 in the Taxation Determination TD 2007/14. A commission payable to a business broker would usually not be able to be taken into account in determining the net asset value of a vendor of a business. This is because the test must be undertaken at the time immediately before exchange of contracts, whereas the obligation to pay a business broker would not usually arise until completion of the contract. The unpaid present entitlements recorded as liabilities of a trust are liabilities that are related to the assets. As such, those liabilities should be counted in determining the net asset value of the trusts. Subsection (1) allows the negative net value of an entity to be offset against the positive net value of another entity Do you count the value of your interest in a connected entity? No. The value of shares or other interests in another entity is ignored where the other entity is connected to the first entity this is to prevent double counting Are any assets excluded from the maximum net asset value test? Yes. The following assets of an individual are not taken into account: (a) (b) (c) (d) assets used solely for the personal use and enjoyment of the individual or their affiliates; market value of a property that is the individual s main residence, to the extent that the main residence is not used to produce assessable income; amounts in superannuation funds for the benefit of the individual; and a life insurance policy on the individual. Example Ben owns a house that has a market value of $750,000 just before applying the net assets test. Ben owned the house for 12 years. For the first 3 years 20% of it was used for producing assessable income, for the following 2 years it was used 40% for producing assessable income, for 2 years it was used solely as a main residence and the for the last 5 years it was used 10% for producing assessable income. Ben s dwelling has had 15.8% income producing use: (3/12 x 20%) + (2/12 x 40%) + (2/12 x 0%) + (5/12 x 10%) Ben will include $79,000 in his net asset test ($750,000 x 15.8%) 15

20 Ben has a liability of $500,000 attached to the house. Therefore 15.8% of the liability ($63,200) is also included in the net asset test. Source: Example 1.9 in the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 7) Act What are entities connected with you? The meaning of connected with is defined in section of the ITAA 1997 which is detailed in of Part A of this paper Who are affiliates? An affiliate is defined in section of the ITAA 1997 which is detailed in of Part A of this paper Do you count all assets of your affiliates? No. You only include those assets of your affiliate or an entity that is connected with your affiliate that are used or held ready for use in a business carried on by the taxpayer or another entity connected with the taxpayer (whether the business is carried on alone or jointly with others). Further, subsection (4) disregards assets that are used or held ready for use in carrying on a business by an entity that is connected with you only because of your affiliate. Example You and your husband sell a florist s business that you jointly carry on. Your husband also wholly owns a company that carries on a newsagency business. You yourself have no other involvement with the newsagency business. Under subsection (4), you disregard the newsagency company s assets in working out whether you satisfy the maximum net asset value test because, although the company is connected with you, it is so connected only because of your affiliate (your husband). Source: Example accompanying subsection (4) Can you, as a partner making a gain on the sale of partnership assets, still access the small business CGT concession where the partner or the partnership fails the $6 million maximum net asset value test? Yes. If a partner makes a capital gain on the disposal of an asset that is a partnership asset, and the partnership is a small business entity, then the third criteria is satisfied. A partner cannot satisfy the small business test if the turnover of the partner is not relevant. You must look at the turnover of the partnership as a whole. 16

21 Only if the partnership qualifies as a small business entity can the partner potentially use the small business CGT concessions, unless the partner can separately qualify by passing the maximum net asset value test. An asset will only be a partnership asset if the asset is owned by the partners in accordance with their respective partnership interests. If the asset is not a partnership asset, then the conditions in of Part A of this paper need to be satisfied to potentially use the small business CGT concessions Can passively held investment assets qualify for the sale business CGT concessions? Sometimes. In order for the sale of a passive investment to be eligible for the small business CGT concessions the following conditions under section (1A) of the ITAA 1997 must be satisfied: (a) (b) (c) (d) the taxpayer s affiliate, or an entity that is connected with the taxpayer is a small business entity for the income year; and the taxpayer does not carry on a business in the income year (other than in partnership); and if the taxpayer carries on business in partnership, the CGT asset is not an interest in an asset of the partnership; and in any case, the small business entity referred to in paragraph (a) is the entity that, at a time in the income year, carries on the business in a prescribed manner in relation to the CGT asset Are there special rules for working out whether the entity is a small business entity? Yes. For the purposes determining whether an entity is a small business entity (and in particular whether the $2 million turnover threshold can be satisfied) special rules in section of the ITAA 1997 cause the relevant taxpayer and entity to be affiliates or connected with each other. Accordingly, the turnover of both entities must be counted. 17

22 Can passive investment assets of an individual used in the business carried on by the spouse of a taxpayer qualify for the small business CGT concessions? Yes. Section of the ITAA 1997 provides that spouses and children under the age of 18 are taken to be affiliates of the taxpayer for certain passively held CGT assets. The impact of this provision gives taxpayers potentially wider access to the small business CGT concessions Can an entitiy still be a small business entity when its business is being wound up? Yes. Even though it is a condition to be a small business entity that the entity is carrying on business, section of the ITAA 1997 provides access to the small business CGT concessions where the asset being sold during a year (including a year after the business has ceased) in which the business is being wound up. In order to obtain the benefit of section of the ITAA 1997, it would need to be demonstrated that the asset was used, or held ready for use or was inherently connected with the business that was carried out in the income year that the business ceased to operate Can a passive investment asset that you provide to a partnership of which you are a partner for use on the partnership s business qualify for the small business CGT concessions? Sometimes. In order for the sale of a passive investment asset provided to a partnership to use in its business to obtain the small business CGT concessions the following conditions under section (1B) of the ITAA 1997 must be satisfied: (a) (b) (c) (d) (e) the taxpayer is a partner in a partnership in the income year; and the partnership is a small business entity for the income year; and the taxpayer does not carry on a business in the income year (other than in partnership); and the CGT asset is not an interest in an asset of the partnership; and the business carried on by the taxpayer as a partner in the partnership referred to in paragraph (a) is the business that the taxpayer, at a time in the income year, carry on in the prescribed manner in relation to the CGT asset. 18

23 Are there special rules for working out whether the partnership is a small business entity? Yes. For the purposes determining whether the partnership is a small business entity (and in particular whether the $2 million turnover threshold can be satisfied) special rules in section cause the relevant taxpayer and the partnership to be affiliates or connected with each other. Accordingly, the turnover of both entities must be counted How do you pass the active asset test? A CGT asset satisfies the active asset test if the asset is an active asset of the taxpayer. The asset will be an active asset if it satisfies the definition in section of the ITAA A CGT asset satisfies the active asset test if: (a) (b) the taxpayer owned the asset for 15 years or less and the asset was an active asset for at least half of the period; or the taxpayer owned the asset for more than 15 years and the asset was an active asset for a total of 7½ years or more during the period. The period begins when the taxpayer acquired the asset and ends at the earlier of the CGT event or, if the relevant business ceased to be carried on in the 12 months before that time, the cessation of the business. Section of the ITAA 1997 does not require that the asset be an active asset just before the CGT event. Accordingly, passive assets may qualify depending on their history of use. Example You acquire a building in 2000 from which you carry on your business. The building is used in the business until 2006 when the growth of your business means you need to move the business to larger leased premises. You rent your building for another 4 years before selling it. Even though the building has been leased passively for 4 years before it is sold, the building still qualifies as an active asset. 19

24 What is an active asset? The meaning of active asset is defined in section of the ITAA At any given time, an asset is an active asset if the taxpayer owns it, and: (a) the asset (whether the asset is tangible or intangible) is used, or held ready for use, in the course of carrying on a business that is carried on (whether alone or in partnership) by: (i) (ii) (iii) the taxpayer; or the taxpayer s affiliate; or another entity that is connected with the taxpayer; or (b) (c) if the asset is an intangible asset the asset is inherently connected with a business that is carried on (whether alone or in partnership) by the taxpayer, the taxpayer s affiliate, or another entity that is connected with the taxpayer; is a share in a company that is an Australian resident, or an interest in a trust that is an Australian resident and the total of the market values of the active assets of the company or trust, and the market value of any financial instruments and any cash of the company or trust that are inherently connected with a business it carries on, is 80% or more of the market value of all of the assets of the company or trust. Financial instruments and any cash of the company or trust are not active assets, but they count towards satisfaction of the 80% test provided they are inherently connected with a business it carries on. There is no need to apply the 80% test continually provided the test has been passed at a previous time and it is reasonable to conclude the share or interest will be active at the later time: subsection (3A). Further, failing to meet the 80% test for a temporary time will no longer result in the asset failing the test: subsection (3B) Can you trace active assets through chains of entities? Yes, provided the total of the market values of the active assets of the company or trust is 80% or more of the market value of all of the assets of the company or trust. Example Ben owns 100% of the shares in Holding Co which, in turn, owns 100% of the shares in Operating Co (both are resident companies). The only assets of 20

25 Holding Co are the shares in Operating Co and all of Operating Co s assets are active assets. As Operating Co satisfies the 80% test, the shares owned by Holding Co in Operating Co are active assets. As those shares are the only assets owned by Holding Co, Holding Co also satisfies the 80% test and therefore the shares owned by Ben in Holding Co are also active assets. Source: ATO Advanced Guide to the CGT concessions for small business Are all assets active assets? No. Certain assets are excluded from being active assets. These exclusions are found in subsection (4) and include: (a) (b) financial instruments such as loans, debentures, promissory notes; and an asset whose main use in the course of carrying on the business is to derive interest, an annuity, rent, royalties, or foreign exchange gains unless the asset is an intangible asset and has been substantially developed altered or improved by the taxpayer so that its market value has been substantially enhanced or where its main use for deriving rent was only temporary. In determining the main use of an asset the taxpayer is to: (a) (b) disregard any personal use or enjoyment of the asset by the taxpayer; and treat any use by the taxpayer s affiliate, or an entity that is connected with the taxpayer, as the taxpayer s use Does a business cease when it is sold? Yes. This is relevant for determining the period that assets are active. There is a rule that allows you to treat the test period ending when the business ceases, provided they are sold within 12 months of the cessation of the business. If an asset is sold after 12 months of the business ceasing, then the test period usually ends when the asset is sold. Example Jane carried on a business from premises she owned. In June 2003 she sold the business but retained ownership of the premises. In December 2003 Jane sold the premises and made a capital gain. As Jane sold the premises within 12 months of selling the business and the premises were an active asset just before the sale of the business, the premises can satisfy the active asset test if the other aspects of the test are also satisfied. Source: ATO Advanced Guide to the CGT concessions for small business. 21

26 How are rental properties that are partly used in a business treated? It is unclear how Division 152 of the ITAA 1997 operates on real property that is partly used for a business and partly held for an investment purpose. There are three potential interpretations: 1. all of the property qualifies as an active asset and as a result the small business CGT concessions can be claimed on the whole of the capital gain that the taxpayer made on the sale of the property; 2. only that part of the property which is used in the taxpayer s business qualifies as an active asset and only part of the capital gain derived by the taxpayer which relates to that part can benefit from the small business CGT concessions; 3. the property does not constitute an active asset and none of the capital gain made on its sale can benefit from the small business CGT concessions. In my view apportionment is not possible in respect of claiming the small business CGT concessions and all or none of the capital gain from the sale of a property can benefit from the small business CGT concessions. Whether the capital gain can be reduced by the small business CGT concessions will be a question of fact based on the main use of the property. This view is supported by the Commissioner of Taxation s comments in Interpretative Decision ATO ID 2003/253. In ATO ID 2003/253 a property that 45% of the land and 80% of the rental was related to business use qualified as an active asset and the Commissioner ruled that all of the capital gain was able to benefit from the small business CGT concessions What happens on the death of the taxpayer? If a CGT asset forms part of the estate of a deceased individual who would have been entitled to reduce or disregard a capital gain under Division 152, and that asset devolves to the legal personal representative or passes to a beneficiary or devolves to a trustee of a trust established by the will of the individual, that legal personal representative, beneficiary or trustee can reduce or disregard a capital gain in the same way as the deceased would have in relation to any CGT event that happens within 2 years of the individual s death. Where an asset has was owned by joint tenants and one of them dies and the interest in the asset is acquired by the surviving joint tenant(s), and the deceased individual would have been entitled to reduce or disregard a capital gain under Division 152, then 22

27 the surviving joint tenant(s) can claim the concessions as if they were the deceased individual and the CGT event happens within 2 years of the individual s death How do you pass the significant individual test? Section of the ITAA 1997 provides that the significant individual test is satisfied if, just before the CGT event, there was at least one significant individual. A significant individual is defined in section of the ITAA A person is a significant individual in a company or a trust if they have a small business participation percentage in the company or trust of at least 20%. A small business participation percentage is the sum of the direct small business participation percentage and the indirect small business participation percentage: section of the ITAA Pursuant to section of the ITAA 1997, a taxpayer s direct small business participation percentage is: (a) (b) (c) in the case of a company, the smaller of the percentage of the voting power in the company, the percentage of any dividend that the company may pay or the percentage of any distribution of capital that the company may make, legally and equitably held by the taxpayer; in the case of a unit trust, the smaller of the percentage of any distribution of income or the distribution of capital made to the taxpayer; and in the case of a discretionary trust, the smaller of the percentage of income or capital distributions made to the taxpayer for the income year in question. Where shares in a company or units in a unit trust carry only reduced rights, the resulting direct small business participation percentage is correspondingly reduced. Example Peter has shares that entitle him to 30% of any dividends and distributions of Coffee Co. The shares do not carry any voting rights. Peter s direct small business participation percentage in Coffee Co is 0%. Source: Example 1.1 Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 7) Act A taxpayer can have a small business participation percentage in an entity indirectly via an interposed entity. Pursuant to section , a taxpayer s indirect small business participation percentage is calculated by multiplying the taxpayer s direct 23

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