An evaluation of the Capital Gains Tax concessions for ... · PDF fileAn evaluation of the Capital Gains Tax concessions for small business WAYNE WILSON MARRIAGE ... Taxation.2 The

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An evaluation of the Capital Gains Tax concessions for small business

WAYNE WILSON MARRIAGE

(student no. 00851540)

A thesis submitted to the Faculty of Business of Queensland University of

Technology in fulfilment of the requirements for the degree of

Masters of Business

June 2006

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ABSTRACT

The small business Capital Gains Tax (CGT) concessions1 were introduced by the

Federal Treasurer on 21 September 1999. The provisions are based on the

landmark Review of Business Taxation.2 The Federal Government’s intention was

to remove impediments to efficient asset management, improve capital mobility,

reduce complexity and compliance costs and generally, make Australia’s CGT

regime internationally competitive.3

Division 152 contains four separate small business concessions. In order to

qualify for the four CGT concessions, the small business must satisfy stringent

tests (basic conditions). It is possible that the small business will receive

significant concessional treatment if these basic conditions are satisfied.

Commentary by academics and tax practitioners indicate that the small business

CGT concessions are excessively complex. There is concern that the provisions

are not achieving their desired outcomes. This thesis involves a critical evaluation

of Division 152 against the traditional criteria for a good tax system,4 using a legal

research methodology designed by Wade.5 Within Wade’s framework, the

research includes a comparative analysis of the Australian and United Kingdom

legislative provisions for small business CGT concessions. This comparison is

undertaken with a view to highlighting strengths and weaknesses in the respective

legislation to better meet the goals of equity, efficiency and simplicity. The

culmination of this thesis will be the proposal of policy recommendations to

Subdivision 152-A.

This thesis states the law available as at 30 April 2006. In the light of this, an

appendix is inserted to cover changes since this date.

1 ITAA 1997 Division 152.

2 Review of Business Taxation, (1999b) A tax system redesigned, report, Canberra: AGPS, (July).

3 P Costello, ‘The New Business Tax System’ (Press Release 058 21/09/1999).

4 Adam Smith proposed four maxims that should apply to taxes in his book titled ‘An Inquiry into the Nature and Causes of the Wealth of Nations’. Smith’s

maxims present a clear call for equity, simplicity and efficiency and this is generally accepted as the basic criteria for a good tax system.

5 John Wade, ‘Writing Thesis and Reports – TCAGONARM - an Acronym for structure’ (1999) Bond Law Review 1-13.

.

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ACKNOWLEDGEMENTS

I would like to sincerely thank my two supervisors – Dr Norman Katter and

Professor Myles McGregor-Lowndes. Myles pushed my research to its limits and

the thesis is a better product thanks to him. Norm has provided me with advice,

suggestions and moral support at the most critical stages of this thesis. I am sure

that the future students of QUT who are fortunate enough to have Norm as a

supervisor will prosper and have great success.

I must also acknowledge the School of Accountancy and Centre of Philanthropy

and Nonprofit Studies for their resources, support and advice. A special thanks

goes to Chris Ryan for her understanding, thoughtfulness and valuable time.

Thanks so much.

Stephen Marsden, I thank you for being a friend, mentor and role model

throughout this whole process. Half way through this thesis, I didn’t know

whether to thank you or put a bomb in your letterbox. Having said that, and with

hindsight on my side, you continue to be one of my closest friends and an

inspiration on all fronts.

I would also like to thank Roger Willett, Peter Best, Jeff Ham, Trevor Stanley,

Don Abel and Michael Hocken for their support and encouragement. I enjoy

sharing the workplace with you.

Finally, I would like to thank my family, especially my father Clive and partner

Sara. A project of this nature is a lot of work and it takes a special person to watch

you work on the weekend and be supportive during the process. I could not have

done it without you both.

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STATEMENT OF ORIGINAL AUTHORSHIP

The work contained in this dissertation has not been previously submitted for a degree

or diploma at any other tertiary education institution. To the best of my knowledge

and belief, the dissertation contains no material previously published or written by

another person, except where due reference is made.

Signed ……………………………………….

Date……………………………………..

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TABLE OF CONTENTS

Abstract iiAcknowledgments

iii

Statement Author iv CHAPTER ONE 1

INTRODUCTION

1.1 Introduction 11.2 The four CGT concessions 41.3 Objective and structure 101.4 Significance of the small business CGT concessions and the need for reform 111.5 Methodology 141.6 Capital Gains Tax statistics 191.7 Summary 22 CHAPTER TWO 23

REVIEW OF SUBDIVISION 152-A AND THE CRITERIA FOR A GOOD TAX SYSTEM

2.1 Introduction 232.2 Background 242.2.1 Capital Gains Tax – the early years 252.3 Objectives of the legislation 292.4 Overview of Division 152 302.5 The Legislation 312.5.1 The CGT event 322.5.2 The Maximum Net Asset Value Test 332.5.3 The Active Asset Test 362.5.4 The controlling Individual/CGT stakeholder Test 372.6 Problem areas in Division 152 382.6.1 Problematic areas within the Maximum Net Asset Test 392.6.2 The literature on the Maximum Net Asset Test 462.6.3 Issues within the Active Asset Test 492.6.4 The literature on the Active Asset Test 512.6.5 Issues within the Controlling Individual Test 542.6.6 The literature on the Controlling Individual Test 542.6.7 Other issues 572.7 Criteria for a good tax system 582.7.1 Equity 602.7.2 Efficiency 622.7.3 Simplicity 652.8 Conclusion 68 CHAPTER THREE 70

BOARD OF TAXATION REVIEW OF SUBDIVISION 152-A

3.1 Introduction 703.2 Maximum Net Asset Value Test 723.2.1 Maximum Net Asset Value Test and Equity 723.2.2 Maximum Net Asset Value Test and Efficiency 743.2.3 Maximum Net Asset Value Test and Simplicity 753.3 The Active Asset Test 773.3.1 The Active Asset Test and Equity 783.3.2 The Active Asset Test and Efficiency 793.3.3 The Active Asset Test and Simplicity 80

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3.4 The Controlling Individual/CGT stakeholder Test 813.4.1 The Controlling Individual/CGT stakeholder Test and Equity 823.4.2 The Controlling Individual/CGT stakeholder Test and Efficiency 853.4.3 The Controlling Individual/CGT stakeholder Test and Simplicity 873.5 Recommendations made in submissions 883.5.1 Maximum Net Asset Value Test 893.5.2 The Active Asset Test 913.5.3 The Controlling Individual/CGT stakeholder Test 933.6 Summary 94 CHAPTER FOUR 96

CGT BUSINESS CONCESSIONS IN THE UK

4.1 Introduction 964.2 Development of CGT in the UK 974.3 Statistical overview of CGT in the UK 1004.4 An overview of UK CGT legislation 1014.5 CGT business concessions in the UK 1034.6 Taper Relief 1034.6.1 Literature on Taper Relief 1094.6.2 Cases on Taper Relief 1114.7 Retirement Relief 1144.7.1 Literature on Retirement Relief 1204.7.2 Cases on Retirement Relief 1234.8 Summary 125 CHAPTER FIVE 127

SYNTHESIS AND POLICY RECOMMENDATIONS TO SUBDIVISION 152-A

5.1 Introduction 1275.2 Policy reasons for proposed amendments (maximum net asset test) 1285.3 Policy reasons for proposed amendments (active asset test) 1315.4 Summary of proposed new law (maximum net asset test) 1345.5 Summary of proposed new law (active asset test) 1415.6 Conclusion 145 CHAPTER SIX 147

CONCLUSION

6.1 Introduction 1476.2 Summary of results 1486.3 Limitations 1536.4 Future research 154 OTHER

References 155Appendix 163

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CHAPTER ONE

INTRODUCTION

1.1 Introduction

This thesis examines the small business capital gains tax (CGT) concessions

contained in the Income Tax Assessment Act 1997.1 In particular, the focus is on the

conditions that must be satisfied to access these concessions. The small business

sector plays an important role in the Australian economy as it contributes heavily to

employment and economic growth.2 It is estimated that there were 1,233,200 private

sector small businesses in Australia during 2000-01, which represented 97% of all

private sector businesses. These small businesses employed almost 3.6 million people,

49% of all private sector employment.3 The huge contribution made by this sector to

the Australian economy is a motivating factor for this thesis.

Australia was one of the last OECD4 countries to impose a general tax on capital

gains5 with the introduction of Part IIIA (Sections 160A to 160ZZU) of the ITAA

1936, effective from 20 September 1985. The taxation of capital gains was introduced

to remove an unfair advantage that existed where a taxpayer derived a capital amount

(previously tax-free) compared to other taxpayers who derived income amounts

(which were taxed).6

1 This legislation will be referred to in short as the ITAA 1997.

2 P Costello, ‘The New Business Tax System’ (Press Release 058 21/09/1999).

3Australian Bureau of Statistics, Small Business in Australia (2001).

<http://www.abs.gov.au/ausstats/[email protected]/e8ae5488b598839cca25682000131612/97452f3932f44031ca256c5b00027f19!OpenD

ocument> at 11 May 2006.

4 The Organisation for Economic Co-operation and Development has 30 member countries sharing a commitment to democratic

government and the market economy. Australia is a member of this group.

5 R. Woellner, S.Barkoczy, S.Murphy and C.Evans, Australian Taxation Law (16th ed, 2006) 317.

6 Ibid.

2

Accordingly, CGT has applied in respect of the disposal of assets acquired on or after

20 September 1985. Assets acquired prior to that date are normally exempt from CGT

and are usually referred to as pre-CGT assets. The CGT regime does not levy a separate

tax on capital gains. According to Sections 6-5 and 6-10 of the ITAA 1997, a taxpayer

is assessed on all ordinary income and statutory income derived during the relevant

income year. Any net capital gain is statutory income7 and is taxed at the taxpayer’s

marginal tax rate.8 Typical events that may result in a capital gain (or capital loss)

include the disposal of real estate, shares in a company, or interests in a trust. Put

simply, CGT is a tax on the profit associated with the realisation of an asset not in the

ordinary course of a taxpayer’s business.

Most OECD countries have CGT regimes in place. Australia’s tax regime, like those

of Canada, New Zealand and the United States, has its origins in the United Kingdom.

However, the disparate CGT regimes of these countries share few common principles.

According to a report on an international comparison of Australia’s taxes, ‘the two

general approaches to taxing capital gains within the OECD are to:

• treat capital income as ordinary income which is taxed at personal income tax

rates (this is the Australian approach); or

• separate capital income from ordinary income, and tax it at different rates’.9

Table 1.1 summarises the top marginal tax rate for capital gains on shares within the

OECD-10 for 2005-2006. For short term gains,10 Australia’s top marginal rate

7 ITAA 1997 Section 102-5.

8 Taxpayers in Australia pay tax on assessable income on a sliding scale basis. The more income earned, the higher the tax rate.

9 R. Warburton and P.Hendy, International Comparison of Australia’s Taxes (2006) Australian Government Treasury

<http://comparativetaxation.treasury.gov.au/content/default.asp> at 14 May 2006 201.

10 Short term holdings are greater than one year but less than two years.

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(24.3%) is the third highest of the OECD-1011 while for long term gains, Australia’s

rate of 24.3% is the second highest.12 Switzerland (a member of the OECD-10), does

not tax capital gains on shares while the Netherlands only does so for gains on

substantial shareholdings (greater than 5%).

Table 1.1 - CGT on shares within OECD-10

Country One to two years percent Two years plus percent

Australia 24.3 24.3

Canada 23.2 23.2

Ireland 20 20

Japan 10 10

Netherlands 25 25

New Zealand 0 0

Spain 15 15

Switzerland 0 0

United Kingdom 40 24

United States 20.3 20.3

Source: Summarised from Table 6.2 International comparison of Australian taxes.

Section 1.2 of this chapter will introduce the four small business CGT concessions

and discuss the concessional treatment given to small business taxpayers. Section 1.3

will then set out the overall objective and structure of this thesis while section 1.4 will

discuss the need for reform within this division of the tax legislation. Section 1.5 will

outline the methodology employed by this thesis to evaluate conditions for access to

11 Members of the OECD-10 are Australia, Canada, Ireland, Japan, the Netherlands, New Zealand, Spain, Switzerland, the

United Kingdom and the United States. All countries in this group have similar structures for personal income tax.

12 Warburton and Hendy, above n 9, 207.

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the small business CGT concessions. Finally, section 1.6 will provide some further

background that will help put the Australian CGT system in context.

1.2 The four CGT concessions

This section will introduce the four CGT concessions and provide additional

background useful for an examination of the legislation. This will provide a broader

knowledge of the topic and assist in the interpretation of the rest of the thesis.

Division 152 of the ITAA 1997 provides four principal CGT concessions. If a small

business taxpayer satisfies the conditions for access to one or more of these

concessions, the tax payable on a capital gain may be substantially reduced or

eliminated by applying in turn each of those concessions. The four principal CGT

concessions available to small businesses are:

1. A full CGT exemption on an asset held for at least 15 years;13

2. A 50% ‘active asset’ reduction;14

3. A retirement exemption;15 and

4. A rollover relief.16

Each of the four CGT concessions has associated ‘Basic Conditions’ that need to be

satisfied17. In general, if these access requirements are satisfied, it is possible that the

capital gain will receive concessional treatment.

13 ITAA 1997 Subdivision 152-B.

14 ITAA 1997 Subdivision 152-C.

15 ITAA 1997 Subdivision 152-D.

16 ITAA 1997 Subdivision 152-E. Rollover relief allows a capital gain on the sale of an active asset to not be assessable but

instead to be used in reducing the cost base of replacement assets, subject to the satisfaction of conditions.

17 ITAA 1997 Subdivision 152-A.

5

The small business 15-year exemption

A small business entity can disregard a capital gain arising from a CGT asset if the

entity continuously owned the CGT asset for 15 years before the CGT event, and if

the entity is an individual, the individual retires or is permanently incapacitated.18

Where the entity is a company or trust, it will qualify for the concessions if it had a

controlling individual throughout the period of ownership and the controlling

individual just before the CGT event retires or is permanently incapacitated.19

While the active asset test normally requires the CGT asset to be active for at least

half of the period of ownership, this rule is modified for the small business 15-year

exemption. The CGT asset needs to have been an active asset for at least half of the

15 year period ending at the time of the CGT event or when the business ceased.20

While it is a requirement of the small business 15-year exemption that the CGT asset

has been continuously owned for at least 15 years and must satisfy the modified active

asset test, special treatment is given to CGT assets acquired under rollover relief in

terms of Subdivision 124-B (assets compulsorily acquired, lost or destroyed) or

Subdivision 126-A (marriage breakdown). For such involuntary disposals, the

legislation allows continuation of the ownership period.21 Generally, the replacement

asset is treated as having been acquired when the original asset was acquired.22

18 ITAA 1997 Section 152-100.

19 ITAA 1997 Section 152-110.

20 ITAA 1997 Section 152-35(b)(ii).

21 ITAA 1997 Section 152-115.

22 ITAA 1997 Section 152-45 and Section 152-115.

6

A capital gain that qualifies for the 15-year exemption is disregarded entirely and is

not taken into account under the method statement in subsection 102-5(1).23 On the

other hand, if the disposal of a long-term asset results in a capital loss, the loss may be

used to reduce other capital gains.

Where a capital gain made by a company or trust qualifies for the small business 15-

year exemption and is disregarded for CGT purposes, the company or trust may

distribute the gain to a CGT concession stakeholder within two years of the CGT

event as an exempt amount.24

Small Business 50% reduction

If a small business entity does not qualify for the 15-year exemption, but the taxpayer

satisfies the relevant ‘basic conditions’, a 50% reduction is available.25 This may be in

addition to the general CGT discount that is available to individuals and trusts.26 A

small business taxpayer can potentially reduce the capital gain to 25% of the original

capital gain amount by first applying the general CGT discount27 and then applying

the small business 50% reduction.28

23 ITAA 1997 Section 152-1.

24 ITAA 1997 Section 152-125.

25 ITAA 1997 Section 152-200.

26 ITAA 1997 Section 152-200.

27 The general CGT discount may apply to a gain arising from a CGT event that occurs after 21 September 1999 (ITAA 1997

Section 115-15), from an asset that a taxpayer has owned for at least 12 months before the CGT event (ITAA 1997 Section 115-

25) and where the taxpayer did not choose to use the indexation method to calculate the gain (ITAA 1997 Section 115-20). If the

gain is made by an individual or a trust, the discount percentage is 50% (ITAA 1997 paragraph 115-100(a)). If the gain is made

by a complying superannuation entity, the discount percentage is 331/3% (ITAA 1997 paragraph 115-100(b)). The general CGT

discount is not available to a company.

28 ITAA 1997 Section 152-205.

7

The taxpayer will apply any current year capital losses, and any unapplied net capital

losses against the capital gain the taxpayer has made during the current year.29 The

capital gain may be further reduced by the small business retirement exemption or

small business rollover, or both. If the taxpayer qualifies for both concessions the

taxpayer can choose the order in which those concessions are to be applied.30

Small business retirement exemption

A small business taxpayer can disregard a capital gain from a CGT event if the capital

proceeds are used in connection with the taxpayer’s retirement.31 A lifetime limit of

$500,000 applies to this concession.32 To the extent available, the capital gain can be

disregarded by a taxpayer aged 55 or more, or if the taxpayer is younger, the capital

proceeds from the sale of the business must be rolled into a complying superannuation

fund, an approved deposit fund or retirement savings account.33

The small business retirement exemption is usually applied in conjunction with the

small business 50% reduction. An individual can effectively apply the general CGT

discount, the small business 50% reduction and finally apply the retirement exemption

so that only 25% of the original gain counts towards the threshold of $500,000.34

The exemption is limited to individual persons carrying on business as sole traders or

as partners, and to private companies/trusts which have one or two controlling

individuals. If the company/trust has no controlling individual (for example, because 29 ITAA 1997 Section 152-205.

30 ITAA 1997 Section 152-210.

31 ITAA 1997 Subdivision 152-D.

32 ITAA 1997 Section 152-315.

33 ITAA 1997 Section 152-305.

34 ITAA 1997 Section 152-300.

8

control is equally dispersed among more than two people) the exemption is not

available.35 An individual does not have to retire and make an actual Eligible

Termination Payment (ETP)36 to choose the small business retirement exemption.

The amount that the individual chooses for the retirement exemption is treated as if it

was an ETP and retirement in these circumstances is not a prerequisite. However,

where the payment is from a company or a trust, there must be a termination from an

'office' for the payment to qualify as an ETP. According to ATO ID 2002/493

A company can choose to disregard all or part of a capital gain under the small business retirement exemption if, amongst other things, the conditions set out in section 152-325 of ITAA 1997 are satisfied. Subsection 152-325(1) of ITAA 1997 requires a company to make an eligible termination payment in relation to a CGT concession stakeholder each time it receives an amount of capital proceeds from a CGT event for which it has chosen the retirement exemption. An eligible termination payment in relation to a person means any payment made in respect of the person in consequence of the termination of any employment of the person. Employment includes the holding of an office (subsection 27A(1) of the Income Tax Assessment Act 1936). It is sufficient that there is a termination of an employment and that the payment is made in consequence of that termination. It does not matter that the employment is one of a number of employments held by a person. In this situation the CGT concession stakeholder will cease to be an employee of the taxpayer on the sale of the business. The CGT concession stakeholder will not continue to perform duties nor be re-engaged to perform duties which are similar to those which have been terminated. It will not matter that the CGT concession stakeholder will continue as a director of the company. In these circumstances an employment has terminated and that termination is the reason for the payment. The payment is considered an eligible termination payment. 37

ATO ID 2002/493 was withdrawn in March 2005 and replaced by the Advanced

Guide to CGT concessions for small business.38 The requirements for termination of

an office have not changed.

35 ITAA 1997 Section 152-305.

36 An eligible termination payment (ETP) includes a lump sum payment from a superannuation entity and many payments made

as a result of termination of employment (eg. golden handshake payment).

37 ATOID 2002/493 (Withdrawn 11/3/2005).

38 ATO, Advanced Guide to CGT concessions for small business (NAT 3359) Australian Tax Office

<http://www.ato.gov.au/businesses/content.asp?doc=/content/1367.htm > at 6 May 2006.

9

Small business rollover relief

The small business rollover concession allows a taxpayer to defer the making of a

capital gain from a CGT event in relation to an active asset.39 To access the relief, the

taxpayer must acquire a replacement asset within rigorous time constraints. The

replacement asset must be or become an active asset.40 A replacement asset does not

have to fulfil the same purpose as the original asset nor does it have to be used in the

same business. ATOID 2003/147 comments:

The word 'replacement' in paragraph 152-410(b) of the ITAA 1997 extends to something that takes the place of, or substitutes for, the original asset. The CGT asset chosen does not have to be used for the same or a similar purpose to the purpose for which the original asset was used. Nor does the CGT asset necessarily have to be used in the same business as the original asset was used. If one or more active assets are chosen to replace the original asset, then this is sufficient for those assets to be a 'replacement asset' for the purposes of paragraph 152-410(b) of the ITAA 1997. Therefore, the hotel acquired by the taxpayer within two years after the disposal of the land is a replacement asset for the purposes of paragraph 152-410(b) of the ITAA 1997.41

If the replacement asset is a share in a company or an interest in a trust, a small

business entity, or an entity connected with that small business entity, must be a

controlling individual of that company or the trust just after the share or interest is

acquired.42

Where rollover is chosen, the capital gain can be rolled over to the extent that it does

not exceed the total of the first and second elements in the cost base of the

replacement asset. The capital gain rolled over is then disregarded.43 The effect of the

rollover is that capital gain is ignored to the extent that it does not exceed the total of

the first and second elements of the replacement asset.

39 ITAA 1997 Section 152-400.

40 ITAA 1997 Section 152-410.

41 ATOID 2003/147.

42 ITAA 1997 Section 152-420.

43 ITAA 1997 Section 152-415.

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1.3 Objective and Structure

It has been well documented by numerous parties that the small business CGT

concessions are excessively complex.44 As such, there is speculation that the

provisions are not achieving their desired outcomes. The objective of this thesis is to

critically evaluate Sub-division 152-A and identify any deficiencies in the legislation

as a basis for formulating policy recommendations for access to the small business

CGT concessions.

In Chapter Two a detailed examination of the small business CGT concessions will be

made. Also, the literature will be reviewed to highlight academic and professional

opinion on the strengths and weaknesses of subdivision 152-A and to establish

suitable criteria for a good tax system.

In Chapter Three these criteria will be used as the basis for an analysis of Subdivision

152-A. This analysis will utilise and examine the submissions to the Board of

Taxation in its recent review of the small business CGT concessions.

Chapter Four will examine the development of CGT concessions for small business in

the UK jurisdiction where CGT was introduced some 20 years before its inception in

Australia. The UK experience will provide insight that will be useful for evaluation of

the Australian legislation.

44 Chris Evans, ‘CGT: choosing the right course’ (Paper presented at the Taxation Institute of Australia Victorian and

Tasmanian State Conventions, 2000) 277, and Lance Cunningham ‘CGT Traps for Small Businesses’ (2003) 26 CCH Tax Week.

11

In Chapter Five this thesis will draw on the findings of earlier chapters to propose

recommendations for addressing any significant deficiencies that have been identified

in the legislation, thereby providing the basis for an improved tax system.

Finally, limitations of the research are discussed and proposals for further study are

outlined in Chapter Six.

1.4 Significance of the small business CGT concessions

As mentioned above, this thesis will focus on the conditions to access the small

business CGT concessions contained in Subdivision 152-A. When a taxpayer satisfies

certain conditions, this Subdivision may allow access to further CGT relief so that the

capital gain can be reduced by one or more of the four concessions. An analysis of the

elements that control access to these concessions is considered in the following

chapter. At this point, brief consideration will be given to the significance of the

concessions and the need for change.

To illustrate the rationale and significance of the small business CGT concessions,

consider the following simple example:

12

Example 1

Andrew, aged 47, operates a small business as a sole trader. The net value of his CGT

assets and those of related entities does not exceed $5 million. Andrew has owned a

small parcel of land for four years and used it in business for the last three years.

Andrew has sold the land and made a capital gain of $100,000 when he disposed of it.

The general CGT discount will reduce Andrew’s capital gain to $50,000.

Andrew has passed the maximum net asset test and the land qualifies as an active

asset. As Andrew is a sole trader, the controlling individual/CGT concession

stakeholder test is not relevant.

Andrew does not qualify for the small business 15-year exemption. If he did, he could

disregard the capital gain entirely without considering the remaining concessions.

Andrew also satisfies the basic conditions for the small business 50% reduction.

Hence his $50,000 capital gain is reduced by a further 50% to $25,000.

Andrew is left with a capital gain of $25,000. He could also use the small business

retirement exemption but as he is under 55 he would need to rollover the proceeds

into a superannuation fund. Alternatively, he could apply the $25,000 to the purchase

of a replacement active asset. Either strategy could be used to eliminate any remaining

capital gain.

13

This simple example illustrates the main benefits of the small business concessions,

which is the substantial reduction or elimination of CGT. There is no doubt that the

concessions are a significant potential benefit to those who meet the access

requirements. However, the tests that determine this access have attracted much

criticism with respect to their complexity and perceived lack of fairness.

Evans noted that ‘in recent decades the small business sector has become an

increasingly important constituency in Australia’.45 He noted further that

Governments have been keen to assist small business to prosper by offering taxation

incentives.46 Evans surveyed tax practitioners with respect to the small business CGT

concessions and examined the impact of associated compliance costs.47 Evans found

that the vast majority of respondents agreed that the small business CGT concessions

were hard to understand.48 A small majority thought that the changes introduced in

1997 had made the small business CGT concessions more onerous to apply.49

In August 2004, the ATO published its ‘Compliance Program 2004-05’. This was the

third year that the general compliance approaches to managing the Australian revenue

system had been published. Michael Carmody stated that the reason for publishing

this program was ‘to share with the community the strategies we have in place and the

results we have achieved’. 50

45 Chris Evans, The operating costs of taxing the capital gains of individuals: A comparative study of the Australia and the UK,

with particular reference to the compliance cost of certain tax design features (Ph.D thesis, UNSW, 2003) 214.

46 Ibid.

47 Ibid 221.

48 Ibid 221.

49 Ibid 221.

50 ATO, Compliance Program 2004-05 (2005).

14

The ATO classifies businesses with an annual turnover of less than $2 million as

micro-business. There are approximately 2.3 million micro-businesses registered in

the revenue system, comprising 96% of all businesses and contributing just over 12%

of total taxation revenue. The ATO openly acknowledges the interpretation and

compliance problems associated with the small business CGT concessions. In its

‘Compliance Program 2004-05’ the ATO stated:

Capital gains tax compliance is a problem area for micro-business taxpayers. We have found that: (i) there is a low level of knowledge and understanding of capital gains tax; (ii) records are inadequate, making the calculation of capital gains very difficult; (iii) capital gains tax is being incorrectly calculated; (iv) in some instances, gains are being omitted from income tax returns, and (v) the small business concessions (which allows a 50% reduction of capital gains tax payable for certain assets) is being applied incorrectly.51

So the compliance and supervision problems associated with the small business CGT

concessions are universally acknowledged. However, they are not problems that can

be dismissed as trivial because these concessions contribute significantly to the

strength of an important sector of the Australian economy, helping small business

taxpayers to succeed in business and to provide for their retirement. It would be of

considerable benefit if the legislation can be improved so that costs associated with

compliance and administration are reduced.

1.5 Methodology This section considers the methodology for evaluation of Subdivision 152-A. The

framework for the research design adopted in this thesis follows the analytical and

normative model developed by Wade.52 This framework for legal research is aimed at

providing guidance for theses and writings in the area of law reform. The model is

51 Ibid.

52 John Wade, ‘Writing Thesis and Reports – TCAGONARM - an Acronym for structure’ (1999) Bond Law Review 1-13.

15

designated by the acronym TCAGONARM. The nine letters provide a research

structure and a checklist to avoid any serious analytical omissions as follows:

Topic – What is it? Definitions of Terminology;

Current events – What is currently happening? What has happened?

Alleged critiques of defects in the current situation;

Goals of desirable system;

Options for change;

Necessary action to move from the current situation to each of the options;

Alleged benefits and disadvantages of each of the possible options for change;

Recommending the most advantageous or least detrimental option; and

Monitoring or measuring the outcome of the recommended change.

‘T’ is for topic or terminology. This introductory chapter has provided an overview of

the topic.

‘C’ is for current events. Academic writings, commentary and ATO Interpretive

Decisions as well as practitioner views will be examined with a view to evaluating

professional opinion as to the strengths and deficiencies in the legislation. This

literature review will be undertaken in Chapter Two. The benefits brought to a legal

discussion by the inclusion of a literature review or historical background are

described by Wade:

A useful historical glimpse of the view of many researchers from different disciplines on what has happened, is happening and what options for change have been tested or suggested historically … A literature review tends to induce respect and humility, and foreshadow the repetitive themes of the whole thesis.53

53 Ibid.

16

‘A’ is for alleged defects in the current situation. Having described current events the

next step is to collect systematically the alleged defects or critiques of the current

situation from different interest groups. Section 2.5 considers the basic conditions that

must be satisfied for entitlement to any of the small business CGT concessions.

Section 2.6 examines specific problems that practitioners and taxpayers face from

Division 152. Four areas of contention are examined to illustrate some of the issues.

For each area, the view of the ATO is provided along with views expressed by

respected authors.

‘G’ is for the various goals that will be identified from the research. Section 2.7 will

examine suitable criteria for evaluating an effective tax system and will review

literature that has applied these criteria to the analysis of the CGT regime in general

and the small business CGT concessions in particular. Wade confirms that ‘it is

essential to unearth and clarify the multiple generalised goals and values to be

balanced in a desirable system’.54

‘O’ is for the various options for meeting the goals that have been identified. The

publicly available major submissions made to the Board of Taxation in its review of

Division 152 contain suggestions for change. By further application of the same

evaluation criteria, Chapter Three will examine these submissions and Chapter Four

will proceed to examine the development of the CGT regime in the United Kingdom.

In this way, further options for changes to Subdivision 152-A will be evaluated.

54 Ibid.

17

Within Wade’s framework, the research in Chapter Four will follow ‘The Method of

Comparative Law’ as discussed by Zweigert and Kotz.55 This approach suggests that

‘every investigation in comparative law starts with the posing of a question or the

setting of a working hypothesis - in brief an idea’. The author suggests that ‘often it is

the feeling of dissatisfaction with the solution in one’s own system that drives one to

inquire whether perhaps other legal systems may have produced something better’.56

The next process is to make comparisons. The comparatist wants to find in a foreign

system the rules which are functionally equivalent to those which interest him in his

native law. This will require imagination and discipline. Finally, the process ends

after evaluating the discoveries and by drawing conclusions.

The process of comparison will commence with a brief discussion of CGT business

concessions in the UK along with other historical background and will culminate in a

final comparison of the legislative provisions between the two countries. McGregor-

Lowndes has described important elements of the methodology as follows:57

Proper consideration needs to be given in the design of a research project to minimise these problems. Most relate (this refers to problematic areas) to becoming familiar with not only the foreign law, but also its application, cultural roots and context.58

Corcoran, in a paper that discusses Comparative Law Methodology,59 reviews the

methodological variations that have developed reporting that Montesquieu examines

the spirit of the laws,60 Lambert compares the law, history of the law and then the

55 K Zweigert and H Kötz, An Introduction to Comparative Law (1987) 45.

56 Ibid 30.

57 Myles McGregor-Lowndes, ‘Comparitive Corporate Law: A Response To Papers by Suzanne Corcoran and Eugene Clark’

(1996) 3 Canberra Law Review 81.

58 McGregor-Lowndes refers to corporate law when discussing the comparative research method but the discussion applies

equally to other legal areas.

59 Susanne Corcoran, ‘Comparative Corporate Law Research Methodology’ (1996) 3 Canberra Law Review 54.

60 Ibid.

18

legislation itself,61 while De Cruz sees the methodology as developing into two

separate streams, legislative comparative law and scholarly comparative law.62

Palmer argued that the methodology should be adjusted to suit the task and the

available resources:

there is not, and indeed cannot be, a single exclusive method that comparative law research should follow. The tasks of teaching, research, of law reform, or historical investigation are too varied and contingent to be achieved by a single approach. It would be a serious blow if all matters had to be analysed from one angle or perspective, or treated with the same detail and depth, or prepared to the same degree or in the same way. Instead there should be a sliding scale of methods and the best approach will always be adapted in terms of the specific purposes of the research, the subjective abilities of the researcher, and the affordability of the costs. It cannot be said a priori that one method is always better than another until we know these variables. It is also shown that prescriptions about method must carefully distinguish the principal user groups, for the complex methods of scholars may be unworkable in the practical world where comparisons must be cost-justified. The message from Mount Olympus must not be that comparative law is always forbidding and difficult. The discipline must be accessible and its methods must be flexible.63

According to Thuronyi, an advantage of the comparative methodology is that:

it makes us aware that what is obvious or implicit in our national system either may not be so obvious or is explicitly condemned in other systems. For instance, in some countries courts have held that tax laws should be applied only within their literal terms, while in others the courts have had no difficulty interpreting the laws with a view to giving full effect to the lawmakers’ presumed intent. 64

According to Zweigert and Kötz:

Comparative law offers the law student a whole new dimension; from it he can learn to respect the special legal cultures of other peoples, he will understand his own law better, he can develop the critical standards which might lead to its improvement, and he will learn how rules of law are conditioned by social facts and what different forms they can take. 65

61 Ibid.

62 Ibid.

63 Vernon Valentine Palmer , From Lerotholi to Lando: Some Examples of Comparative Law Methodology (2004) The Berkeley

Electronic Press <http://www.bepress.com/gj/frontiers/vol4/iss2/art1.> at 23 May 2006.

64 Victor Thuronyi (ed), Tax Law Design and Drafting (2000) xxxv.

65 Zweigert and Kötz, above n 55, 19.

19

The final step of comparative law according to Zweigert and Kotz66 is to evaluate the

discoveries and conclusions. The remaining letters of the acronym TCAGONARM

provide a checklist for this step:

‘N’ is for the necessary actions connected with implementing the options.

‘A’ is for the need to address alleged benefits and disadvantages of the options.

‘R’ is for the final recommendations that filter through these processes.

‘M’ is for the measurement and monitoring of outcomes.

Chapter Five will follow this structure. It will review the recommendations for change

presented in the preceding chapters and from them identify the most advantageous

options. The recommendations for policy change will then be presented. The final

step of measurement and monitoring will be addressed by Chapter Six to the extent

that it will discuss limitations of the research and proposals for further research. This

thesis states the law available as at 30 April 2006. An appendix has been inserted to

cover the changes since that date.

1.6 CGT Statistics

The following discussion will provide background to put the Australian CGT system

in context. The statistics were noted from the ATO Website on 6 May 2006 with

respect to the 2003-2004 financial year.67

66 Ibid.

67 ATO, Tax Statistics 2003-04, Australian Tax Office

<http://www.ato.gov.au/taxprofessionals/content.asp?doc=/content/70906.htm> at 6 May 2006.

20

For the 2003-2004 financial year, 813,755 individuals, 15,928 companies and 51,031

funds all derived taxable net capital gains totalling $15.8 billion. The total CGT

payable on this amount was $4.9 billion. This was less than the GST of $35.4 billion

but greater than the luxury car tax of $297.9 million and wine equalization tax of

$681.7 million. Total revenue from taxes was $198.732 billion. The data indicates that

CGT contributes a relatively small percentage of total taxation revenue.

Individuals with net capital gains accounted for only 9% of the total population of

taxable individuals. Similarly, companies with net capital gains accounted for only

5% of the total population of taxable companies. Superannuation funds with net

capital gains accounted for 31% of taxable funds.

For both individuals and companies, the proportion of taxpayers with net capital gains

to the number of taxable taxpayers increases as taxable incomes increase. For

example, 5.7% of individuals with taxable income less than or equal to $20,000 had

net capital gains. Among individuals with taxable income between $100,001 and

$500,000, 24.2% had net capital gains, while among individuals with taxable income

greater than $5 million, 61.7% had net capital gains. This reinforces the general

perception that lower income earners are less likely to derive a capital gain.

The 2005 Tax Expenditures Statement provides details of concessions, benefits and

incentives delivered to taxpayers through the tax system.68 This report considers the

actual cost of the preference or the monetary cost to the Government for allowing the

concession. The largest tax expenditure is the concessional treatment of funded

68 Commonwealth Treasury, Tax Expenditure Statement 2005 (2006) 1.

21

superannuation which is estimated to provide a benefit to taxpayers of around $15.5

billion in 2005-06. The CGT discount for individuals and trusts is estimated to be $4.4

billion in the 2005-06 year. The Tables below show that the monetary cost to the

Government for the various small business concessions is relatively low in

comparison. The Government did not provide an estimated financial cost when the

concessions were introduced but the explanatory memorandum indicated that the cost

to the revenue system should be small.69 The concession having the largest impact on

Treasury coffers is the 50% active asset discount which is expected to cost $310

million per year between now and the 2008-09 financial year. The other concessions

have a minor impact on revenue.

Table 1.2 Cost of the small business retirement exemption ($m)70

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

$55 $85 $120 $185 $190 $185 $190 $200

Table 1.3 Cost of the small business 15-year exemption ($m)71

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

$5 $10 $16 $13 $14 $14 $15 $15

Table 1.4 Cost of the small business rollover relief ($m)72

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

$40 $75 $85 $125 $130 $125 $130 $135

69 Explanatory Memorandum, New Business Tax System (Capital Gains Tax) (1999) (Cth) 2.

70 Ibid 115.

71 Ibid.

72 Ibid 140.

22

Table 1.5 50% Cost of the small business 50% reduction ($m)73

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

$130 $160 $220 $300 $310 $300 $310 $320

1.7 Summary

In this introductory chapter, the important role of the small business sector in the

Australian economy has been noted. This chapter has discussed CGT generally and

introduced the small business CGT concessions contained in Division 152 and the

significance of this legislation has been identified.

The structure and objectives of this thesis have been discussed. Chapter Two will

review the relevant literature in relation to accessing and evaluating the small business

CGT concessions. Documentary evidence from the ATO, practitioners and authors

will also be considered. The criteria for a good tax system will also be identified.

73 Ibid.

23

CHAPTER 2

REVIEW OF SUBDIVISION 152-A

AND THE CRITERIA FOR A GOOD SYSTEM

2.1 Introduction

The purpose of this chapter is to review the literature with respect to CGT and to

identify suitable criteria for evaluating CGT regimes. When considering the

submissions to the Board of Taxation in the next chapter, these criteria will be applied

to critique the small business CGT concessions and to make policy recommendations.

The first section of this chapter will provide some background regarding the

development of Australian income tax law up to the introduction of the small business

relief provisions also known as the small business CGT concessions contained in

Division 152. This will be followed by an overview of Subdivision 152-A.

Requirements for access to the small business CGT concessions will then be analysed

on the basis of information available from the ATO. ATO rulings and literature will

be examined with a view to providing an account of the rules for access to the small

business CGT concessions, with particular focus on areas that may be of concern in

terms of interpretation and certainty. The literature about the attributes of an

acceptable taxation system will be reviewed to articulate the benchmarks for the

present and proposed small business CGT provisions.

24

2.2 Background

In Australia, as elsewhere, the principal drivers for major change to tax law have

historically been those external pressures that overwhelm limited budgetary resources.

For example, Australian tax law has been largely shaped by the two world wars of the

last century:

The first Federal income tax was not levied until 1916 to finance Australia's role in World War I. The States continued to levy income taxes up until World War II when the Commonwealth took sole responsibility for income taxation in order to fund the war effort. …. The Commonwealth introduced legislation in May 1942 which imposed a uniform, high rate of tax and proposed to reimburse the States for their income tax forgone. …. Four State Governments challenged the validity of Commonwealth's legislation and the Uniform Tax Case 1942 established priority to the Commonwealth for funds from income tax. In 1946, the Commonwealth announced it would retain its control over income tax. The States subsequently withdrew from the income taxing field in exchange for Commonwealth loans and grants. 74

With reference to other changes over many years, Jeffrey Waincymer states:

The vast majority of changes have been piece-meal in nature. Many are politically motivated tax expenditures.75

Debates about tax reform flourished during the 1970s and 1980s. Structural reform

commenced in the mid 1980s and continued through into the year 2000. As in many

other countries, there was common acknowledgment that imminent global economic

changes needed to be addressed with some urgency:

Tax reform is about looking at our tax system as a whole, and designing a new system which will allow us to properly compete in the global economy. Payroll taxes, capital gains tax, FBT and our international tax system - just to pick a few - greatly disadvantage Australian businesses, and therefore jobs…Tax reform is about looking at our tax system as a whole, and designing a new system which will allow us to properly compete in the global economy. 76

74 John Harrison, Total Tax Review: Major Reform Issues, Current Issues Brief 1996-97. Parliamentary Library, Parliament

House, Canberra <http://www.aph.gov.au/library/pubs/CIB/1996-97/97cib7.htm> at 25 June 2004.

75 J Waincymer, Australian Income Tax Principles and Policy (1998) 56.

76 Taxation Institute of Australia, ‘Piecemeal approach to tax reform will not work’ (Press Release, 5th August 1998).

25

The debate intensified in the months leading up to the introduction of CGT. The latter

half of 1985 saw in rapid succession:

• Publication of the Treasury Draft White Paper on Tax Reform in June;77

• Convening of a national Tax Summit in July;78

• Commencement of Reform of the Australian Taxation System in September.79

2.2.1 Capital Gains Tax – the early years

Prior to 20 September 1985, capital gains were not taxed in Australia. The policy

question of whether capital gains should be taxed was first addressed by a royal

commission on taxation that was appointed in 1920.80 No legislative changes resulted.

In 1964, a group of academics appointed by the Social Science Research Council of

Australia and chaired by Professor R I Downing published Taxation in Australia: An

agenda for Reform. They concluded ‘that the equity case for a capital gains tax was

overwhelming but because of largely administrative concerns they recommended that

capital gains should not be included in income’.81 In 1973, the Whitlam Government

imposed a tax on short term capital gains which was well known by its section

number, section 26AAA.82 The Government indicated that the purpose of the

amendment was to increase certainty and reduce abuse.83

The ITAA 1936 provided for limited taxation of capital gains via another section.

Section 26(a) which later became section 15-15 ITAA 1997 included in assessable 77 Department of Treasury, Draft White Paper: Reform of the Australian Tax System, June 1985, 39

78 The Treasurer, 'Reform of the Australian Taxation System', Statement by the Treasurer, 19 Sep 1985.

79 John Harrison, 'Background Paper 1 1997-98' The GST Debate - A Chronology (1997) Parliament of Australia

<http://www.aph.gov.au/library/pubs/bp/1997-98/98bp01.htm> at 25 August 2005.

80 Australia, Royal Commission on taxation, Reports 1-5, 1921.

81 R Krever, N Brooks, A Capital Gains Tax for New Zealand (1990) 33.

82 ITAA 1936 Section 26AAA.

83 Krever, above n 81.

26

income the profit arising from the sale of property when the property was acquired for

the purpose of making a profit. Its major shortcoming was its reliance on the

determination of the intention of the taxpayer and this led to the call for a more

general tax on capital gains.84

Tax avoidance schemes including so-called ‘bottom of the harbour’ schemes were

highlighted in the 1982 report of the Costigan Royal Commission.85 For the general

election of December 1984 the Labor party campaigned on a promise of tax reform

and was returned to office. In a statement made on 19 September 1985, the Federal

Treasurer announced the Government’s intention to introduce a capital gains tax.86

The CGT regime is not a separate tax or taxing Act in its own right. Taxation of capital

gains was introduced into Part IIIA (comprising Sections 160A to 160ZZU of the ITAA

1936) from 20 September 1985 to remove an unfair advantage that existed if a taxpayer

derived a capital amount (which was tax-free) compared to another taxpayer who

derived income amounts (which were taxed). Woellner considers ‘the failure to

formally include capital gains in the tax base before 1985 gave rise to both horizontal

and vertical inequity. Vertical inequity was particularly emphasised in the debate as the

better-off in the community are more likely to make capital gains’.87

In 1985 the ITAA 1936 was amended to provide a 20% exemption up to a maximum

of $1 million for the gain on the sale of a small business.88 Other small business CGT

84 Woellner, above n 5, 319.

85 P N Grabosky, Wayward governance : illegality and its control in the public sector (1989) 145.

86 Krever, above n 82.


88 Ibid 466.

27

concessions introduced over a decade later included an asset replacement rollover

relief (Division 17A)89 and a retirement exemption (Division 17B).90

The ITAA 1936 sections relating to CGT had become cumbersome and tedious. They

were re-written in 1998 and are now found in Parts 3-1 and 3-3 of the ITAA 1997

(Divisions 100 to 152). The policy behind this legislation was to ensure that the

growth and development of small business were not constrained by a lack of capital.91

The original 20% goodwill exemption was increased to 50% for certain taxpayers.92

Unfortunately, rules for access to the concessions remained inconsistent and

complex.93 For example, a business exemption threshold ($2,248,000 for 1997-98)

applied to the goodwill exemption while a $5 million net asset test threshold applied

to the roll-over relief and the retirement exemption.

Further structural reform was signalled in August 1998 when the Treasurer appointed

Mr John Ralph AO to chair a Review of Business Taxation.94 The review committee

released a discussion paper containing a proposed Charter of Business Taxation.95

This charter included three interdependent major objectives for the future

development of the business taxation system:

• Optimising economic growth;

• Promoting equity;

• Promoting simplification and certainty.

89 Taxation Laws Amendment Bill (No 4) 1996.

90 Taxation Laws Amendment Bill (No 3) 1997.

91 Explanatory Memorandum, Taxation Law Amendments Bill 1996 (Cth) 4.

92 ITAA 1997 Subdivision 118-C corresponded to ITAA 1936 section 160ZZR.

93 Ibid.

94 Review of Business Taxation, A strong Foundation (Discussion paper 1998).

95 Ibid.

28

Public submissions were invited and a final report, A Tax System Redesigned was

released in July 1999.96 The Federal Treasurer, Mr Peter Costello announced The

New Business Tax System on 21 September 1999.97 From 11.45 a.m. on 21

September 1999 the new CGT regime became law. The major changes were:

• CGT was now defined in terms of ‘assets’ and ‘events’;

• cost base indexation was frozen;

• CGT was discounted for assets held for more than one year

(not available to companies);

• new small business CGT concessions were announced and they were

consolidated into Division 152 of the ITAA 1997.

The small business CGT concessions were also changed:

• the rollover provisions were largely carried over from previous legislation;

• the goodwill concession was replaced by a 50% reduction;

• retirement exemptions were revamped;

• a 15-year ownership exemption was made available for owners who

retired or became incapacitated.

The current small business CGT concessions had joined the mixture of laws

commonly described as Australia’s ‘tax system’.

96 Review of Business Taxation, A Tax System Redesigned (Final report 1999).

97 P Costello, Treasurer of the Commonwealth of Australia, The New Business Tax System (1999)

at <http://www.rbt.treasuryy.gov.au/publications/papewr4/prelim/termsofreference.htm> at 12 May 2004.

29

2.3 Objectives of the Legislation

Regarding the new CGT regime announced on 21 September 1999, the Treasurer

noted that change had been needed for the following reasons:

There is a need to enliven and invigorate asset management, to stimulate greater participation by individuals in investment, and to achieve a better allocation of the nation's capital resources. The existing capital gains tax arrangements discourage the realisation of assets and capital mobility. Economic efficiency is reduced as a result. The measures will make the rate of capital gains tax in Australia for individuals competitive to those in other countries, particularly the United States. Removing indexation and averaging from the capital gains tax regime: • brings Australia into line with other countries; • removes complexity from the taxation law; • reduces compliance costs for taxpayers; and • in the case of averaging, removes a concession that has led to unintended outcomes.

While companies will lose the benefit of indexation from 30 September 1999, they will receive the ongoing benefit of a lower company tax rate. In addition, shareholders who are either individuals or superannuation funds will benefit through the capital gains tax reforms.98

There is wide recognition that the burden of business taxes falls more heavily on

smaller businesses and that this discourages savings and investment with detrimental

effects to the whole Australian economy.99 A principal objective of the revised

legislation was to assist small businesses to maintain a vital role in the Australian

economy. To that end, the legislation set out to rationalise and extend the previous

small business CGT concessions.100 The value of the concessions was increased,

eligibility criteria were eased and generous access provisions applied. The provisions

were merged and a reduction in compliance costs was sought.101

98 P Costello, Introducing an internationally competitive capital gains tax system (1999) Website of the Treasurer

<http://www.treasurer.gov.au/tsr/content/pressreleases/1999/downloads/d.pdf >at 15 August 2004.

99 P Costello, ‘The New Business Tax System’ (Press Release 058 21/09/1999) 17.

100 S Harrison, B Low and G Larson, Joint submission on the small business CGT concessions and discretionary trusts (2002)

<http://www.cpaaustralia.com.au/cps/rde/xchg/SID-3F57FEDF-728B4829/cpa/hs.xsl/14131_4900_ENA_HTML.htm> at 28 July

2005.

101 Costello, above n 99, Attachment E.

30

According to the Treasurer, the main underlying objective was to provide small

business people with access to funds for retirement or expansion.102 This assistance

sought to recognise the contribution to the growth of the Australian economy by

individuals who commit private capital to small business ventures, and who thereby

frequently have little in the way of additional funds. The new small business CGT

concessions were therefore designed to provide tax relief to such small business

owners in circumstances where a business is sold and another purchased, and to

owners who become incapacitated or decide to retire.103 Another benefit sought from

this targeted relief was the facilitation of a stronger savings and investment culture.104

Evans notes ‘modern taxation systems impose a heavy burden on taxpayers, and

particularly on small business taxpayers’.105 Having established this, attention now

focuses on Division 152 and in particular, Subdivision 152-A.

2.4 Overview of Division 152

The small business CGT concessions are contained in Division 152 of the ITAA 1997.

If certain conditions are satisfied, capital gains made by a small business taxpayer can

be reduced by one or more of four small business CGT concessions which are:

1. a 50% ‘active asset’ reduction,

2. a retirement exemption;

3. rollover relief; 106 and

4. a full CGT exemption on an asset held for at least 15 years.

102 Ibid.

103 Stephen Barkoczy, Core tax legislation and study guide (7th ed, 2004) 27.

104 Ibid.

105 Evans, above n 44, 65.

106 Rollover relief allows a capital gain on the sale of an active asset to not be assessable but instead to be used in reducing the

cost base of replacement assets, subject to the satisfaction of conditions.

31

In order to access these CGT concessions ‘Basic Conditions’ need to be satisfied.

These conditions are discussed in the remaining sections of this chapter.

2.5 The Legislation

Subdivision 152-A contains the basic conditions for access to the small business CGT

concessions. They are set out in Sections 152-1 to 152-60. For each test, there are

generally two or sometimes three conditions that must be satisfied. Some of the

concessions have additional specific conditions that also must be satisfied. For

example, the 15-year exemption applies only if the taxpayer retires and the CGT asset

has been owned for at least 15 years.107

For a small business taxpayer to be entitled to any of the CGT concessions, a CGT

event must happen to a CGT asset of that entity. The CGT event must occur after

11.45 a.m. on 21 September 1999 for Division 152 to apply and the taxpayer must

satisfy the basic conditions set out in Section 152-10 which are:

1. The CGT event would have resulted in a capital gain;

2. The entity satisfies the maximum net asset value test in section152-15;

3. The CGT asset satisfies the active asset test in section 152-35; and

4. The capital gain is not from CGT event K7. (CGT event K7 deals with capital

gains from CGT assets that are depreciating assets: Section 104-235).

If the above tests cannot be satisfied the concessions are not available.

107 ITAA 1997 Section 152-5.

32

If the asset being sold is a share in a company or interest in a trust, two additional

criteria must be met:

• the entity in which the interest is held must have a controlling individual at the

time of sale;108 and

• the taxpayer wishing to access the concessions must be a CGT concession

stakeholder.109

These basic conditions will now be explored in more detail.

2.5.1 The CGT Event

According to section 102-20 of the ITAA 1997, a capital gain or loss can only arise if

a CGT event happens. There are twelve categories of CGT events comprising 52 CGT

events in all. Division 104 contains a complete list of all the CGT events which can

give rise to a capital gain or loss. Each CGT event has its own rules and regulations

that determine the cause of the event, its timing and how to calculate the gain or loss.

2.5.1.1 Other CGT events examined

The small business concessions (other than rollover relief) do not apply to CGT

events J2 (change of status of a replacement asset following a small business rollover)

and J3 (change of status of a replacement share or trust interest following a small

business rollover). Where CGT events J2 or J3 occur to crystallise a deferred capital

gain, that capital gain may be eligible for further rollover relief (if conditions are

satisfied), but cannot be eligible for the CGT discount or small business 50% active

asset reduction as these concessions have potentially been applied to a capital gain.

108 ITAA 1997 Section 152-50.

109 ITAA 1997 Section 152-60.

33

Generally, the small business CGT concessions are available only if the taxpayer

owns the CGT asset and a capital gain results. The purpose of Section 152-12 is to

enable intangible assets (such as restrictive covenants and rights created in another

entity) that are inherently connected with an entity's business to satisfy the ownership

and active asset tests resulting in access to the small business CGT concessions.

While it is easy to see the application of the small business CGT concessions to the

standard CGT event (for example, the sale of assets under CGT event A1) it is

important to consider their application in relation to any CGT event apart from those

specifically excluded (as discussed above). For example, a taxpayer who grants a

lease to a third party, causing CGT event F1 to arise, can qualify for the small

business CGT concessions.110

2.5.2 The Maximum Net Asset Value Test

This test treats the small business and all of its related entities as a single economic

unit. The market value111 of all the unit's CGT assets must not exceed the $5 million

net asset112 threshold just before the CGT event happens.113 If the net assets of the

economic unit exceed $5 million, the economic unit is not considered a small business

and is therefore not eligible for the small business CGT concessions of Division 152.

110 ATO ID 2004/650.

111 The amount that a willing buyer of the asset could reasonably be expected to pay to acquire the asset from a willing seller –

this is discussed in Section 2.6.1.

112 Net Assets = Gross Assets – Liabilities.

113 ITAA 1997 Subsection 152-15.

34

The economic unit for the purpose of the maximum net asset value test can consist of

the taxpayer; a small business CGT affiliates114 of the taxpayer; connected entities115

of the taxpayer; and connected entities of the small business CGT affiliates.

An additional test applies if the small business entity is a partner in a partnership and

a CGT event happens to an asset of the partnership. In that case, the net value of the

assets of the partnership cannot exceed the maximum net asset threshold.116

2.5.2.1 Meaning of net value of CGT assets

Section 152-20 explains what is meant by the term ‘net value of the CGT assets’ of an

entity. This term is used in working out whether a small business entity satisfies the

maximum net asset value test. The net value of the CGT assets of an entity is the

amount (if any) by which the sum of the market value of those assets exceeds the sum

of the liabilities of the entity that are related to the assets. The term ‘liabilities’ as used

in subsection 152-20(1) to determine the net value of the CGT assets of an entity, has

its legal meaning. Amounts that are within the accounting meaning of the term

‘liabilities’ but not within its legal meaning, are therefore not within the scope of the

term as used in section 152-20(1). Provisions for annual leave or long service leave

would not be considered liabilities for the purpose of this test.

According to Section 152-20, certain assets are to be disregarded from the maximum

net asset test. They are shares, units or other interests (except debt) in another entity

that is connected with it, or with a small business CGT affiliate; assets of a private or 114 Discussed in Section 2.5.2.2.

115 Discussed in Section 2.5.2.3.

116 ITAA 1997 Subsection 152-15(b).

35

personal nature such as the family home and superannuation; and assets of an affiliate

not used in the business of the taxpayer who makes the CGT gain.

2.5.2.2 Small business CGT affiliate

The term ‘small business CGT affiliate’ is used in the maximum net asset value test.

The market value of assets owned by such an affiliate of an entity is taken into

account in determining if the entity satisfies the maximum net asset test.

A person is a small business CGT affiliate if the entity is an individual and the person

is the individual's spouse or child under 18 years; or the person acts, or could

reasonably be expected to act, in accordance with the entity's directions or wishes, or

in concert with the entity.117 However, a partner in a partnership of which the entity is

a partner is not the entity's affiliate only because the partner acts, or could reasonably

be expected to act, in concert with the entity in relation to the affairs of the

partnership.118

2.5.2.3 Entities connected with the small business

Section 152-30 explains when an entity is connected with another entity. This is

relevant for the maximum net asset value test. An entity is to include the net value of

CGT assets of entities connected with it when working out whether it satisfies the $5

million limit.

117 ITAA 1997 Section 152-25.

118 ITAA 1997 Section 152-25.

36

An entity is connected with another entity if either entity controls the other, or both

entites are controlled by the same third entity.119 The term ‘control’ is an integral part

of this section. The operations and definitions of control are complex and depend on

the type of structure. There are different rules for companies, trusts, superannuation

funds etc. This will be explored later in Section 2.6.

2.5.3 The Active Asset Test

The active asset test provisions are contained in Sections 152-35 to 152-45 of

Division 152. This test of eligibility for the small business CGT concessions requires

that the asset which is the subject of the CGT event giving rise to the capital gain

must be an active asset.120 A CGT asset is an active asset if it is owned by a small

business entity and is:

1. used or held ready for use by the small business entity, a small business CGT

affiliate, or an entity connected with the small business entity, in the course of

carrying on a business. An example is the small business itself or its business

premises.121

2. an intangible asset that is connected with a business carried on by the small

business entity.122 An example is goodwill.

3. a share in an Australian resident company or an interest in a resident trust

where the market value of active assets of the company/trust is 80% or more

of the market value of all the assets of the company or trust for at least 50% of

the ownership time.123

119 ITAA 1997 Section 152-30(1).

120 ITAA 1997 Section 152-35.

121 ITAA 1997 Subsection 152-40(1).



37

According to Section 152-40(4) certain assets can not be active assets. These include

an interest in a connected entity unless the 80% rule is met;124 shares in companies

unless the 80% rule is met; interests in trusts unless the 80% rule is met; financial

instruments (eg loans, debentures, bonds, promissory notes, futures contracts, forward

contracts, currency swap contracts, and a right or option in respect of a share, security,

loan or contract); and an asset whose main use in carrying on the business is to derive

interest, an annuity, rent, royalties and foreign exchange gains.

2.5.4 The Controlling Individual / CGT Stakeholder Test

The third basic condition only applies if the CGT asset that is being disposed of is a

share in a company or an interest in a trust.125 The condition has two parts, both of

which must be satisfied:

1. The trust or individual must satisfy the controlling individual test. There must

be at least one controlling individual immediately before the CGT event

happened to the active asset.126 A controlling individual for a company is an

individual who holds at least 50% of the votes and rights to distributions of

capital and income.127 For a fixed trust, the individual must be entitled to at

least 50% of the income and capital of the trust.128 Where the trust is a

discretionary trust, then an individual is a controlling individual where there

have been distributions of capital or income or both during the year and the

individual was entitled to at least 50% of the distribution.129

124 The 80% test requires that the total of the market values of the active assets of the company (and certain funds held pending

the acquisition of new active assets) is 80% or more of the market value of all of the assets of the company/trust.






38

2. The taxpayer claiming the small business relief must be a CGT concession

stakeholder in the company or trust.130 A CGT stakeholder is an individual

who is a controlling individual, or the spouse of a controlling individual.131

Having satisfied the conditions contained in Subdivision 152-A, a small business

taxpayer can then potentially access the small business CGT concessions.132

2.6 Problem Areas in Division 152

Attention is now directed to specific problems that practitioners and taxpayers

encounter in dealing with Division 152. Many of these problems result from the

complexity of the legislation. For each area, the view of the ATO is provided along

with views expressed by respected authors.

The basic facts of many interpretive decisions are published by the ATO as

Australian Taxation Office Interpretive Decisions (ATO IDs):

An ATO Interpretative Decision (ATO ID) is a summary of a decision on an interpretative issue and is indicative of the Commissioner's view on the interpretation of the law on that particular issue. ATO IDs are produced to assist ATO officers to apply the law consistently and accurately to particular factual situations.133

ATO IDs are published on the ATO web site in an initiative designed to improve the

transparency, accountability and quality of its service. Current ATO IDs have been

used to represent the views of the ATO on the problem areas in Division 152.

130 ITAA 1997 Subsection 152-10(2)(b).



133 At < http://law.ato.gov.au/atolaw/general.htm?ldbcontents.htm#atoid > at 25 June 2004

39

2.6.1 Problematic Areas within the Maximum Net Asset Value Test

Issue 1 - Discretionary Trusts and Deductible Gift Recipients (DGRs)

Initially, the drafted legislation134 as it applied to discretionary trusts was confusing

and problematic. On 16 October 2003, Senator Helen Coonan announced changes to

the net asset test for discretionary trusts. According to the press release, the measures

were to ensure that the problematic areas in terms of discretionary trusts were now

quashed. Under the original legislation, when tax exempt entities or DGRs were

potential beneficiaries of a trust, the assets of the beneficiary were taken to belong to

the small business. If the total of the assets controlled by the business exceeded $5

million, it could not access the small business CGT concessions. Many small

businesses that operate through discretionary trusts include charitable organisations as

beneficiaries. The changes came about to ensure businesses were not prevented from

accessing the CGT concessions simply because of the assets held by that charity. This

was to encourage small business to continue to include charities as beneficiaries in

their trust deeds.135

The new measures ensure that distributions to tax exempt entities and DGRs will be

ignored for the purposes of applying the new control test for discretionary trusts.136

Under the new control test, for the 2002-03 and later income years, an entity will be

taken to control a discretionary trust only if the distributions made by the trust to the

entity and/or its small business CGT associates during the test year are at least 40% of

the total distributions of the trust for that year (subject to an existing discretion

134 Introduced into the House of Representatives on 25 November 1999.

135 Minister for Revenue and Assistant Treasurer Senator Helen Coonan, ‘Capital Gains Tax Changes to Benefit Investors,

Small Business and Charities’ (Press Release C097/03, 16 October 2003).

136 ITAA 1997 Section 152-30(6).

40

available to the Commissioner of Taxation where the control percentage is between

40% and 50%).

Section 152-30 provides that an entity will control a discretionary trust if the first

entity and/or its small business CGT affiliates are trustees of the trust or have the

power to determine how the trustee exercises its power. This would cover directors

and shareholders of trustee companies and would include the appointer of a trust.137

Subsection 152-30(4) is designed to ensure that a trustee controls a discretionary trust

only if the beneficiaries do not control the trust (assuming the trustee is not a small

business CGT affiliate of the beneficiary).

In addition to the test discussed at section 152-30(2)(c) an entity will be taken to

control a discretionary trust if for any of the four income years before the income year

for which access to the small business CGT concessions is sought, the trustee paid to

or applied to138 the entity or its CGT affiliates any income or capital of the trust; or

the amount paid or applied to the entity or its CGT affiliates is at least 40% of the

total amount of income or capital paid or applied by the trustee for that year.139

Therefore, control of a discretionary trust will be attributed to:

1. a beneficiary who has received a 40% distribution of income or capital in the

previous 4 years; or

2. if no entity satisfies condition 1 and if the trust is in losses, a beneficiary who

is elected to control the trust; or

137 ATO ID 2004/698.

138 A journal entry would suffice.


41

3. if no entity satisfies 1 or 2, the trustees of the trust or those that can direct the

trustees (see above).

The consequences of a taxpayer not controlling the trust would mean assets would

escape the maximum net asset test and taxpayers could avoid having the assets of the

trust counted towards the maximum net asset test; also assets in a trust may not be

connected with a taxpayer and fail the active asset test.

As mentioned earlier, consistent with the control test for other entities (such as

companies and fixed trusts), where the control percentage is between 40% and 50%,

the Commissioner will have the discretion to determine that the entity does not

control the discretionary trust. However, if the control percentage is more than 50% in

any of the four relevant income years, the Commissioner has no discretion.140

Where the discretionary trust has incurred a tax loss in an income year, the trustee will

be unable to make distributions to its beneficiaries (and therefore a pattern of

distribution test cannot operate). In this situation, the trustee may nominate up to four

beneficiaries to be the controllers of the trust for an income year. This is to ensure that

the assets of the trust are active assets under the small business CGT concessions.

Such a nomination must be made in writing and signed by the trustee and each

nominated beneficiary.141

The small business CGT concessions apply only to active assets. Where the asset is

owned by the taxpayer (such as a trust for asset protection purposes) but the business

is carried on by another entity, it is important that the taxpayer and the other entity are

connected otherwise the active asset test will not be satisfied.

Issue 2 – The meaning of ‘Just before’

According to ATO ID 2003/745, the words ‘just before’ in section 152-15 effectively

mean ‘immediately before’. The facts of ATO ID 2003/745 are:



42

• The taxpayer was a sole trader;

• The net value of the CGT assets of the taxpayer (and other relevant entities)

was $4,995,000 on the morning of the sale of an active asset (this included

public company shares that had a market value of $1 million);

• By 11.59 a.m. that day the share price had risen 0.6% so that the market value

of the shares increased to $1,006,000 and the net value of the CGT assets

increased to $5,001,000;

• Immediately after that time, the taxpayer entered into a contract to sell their

business.

The commissioner held that the taxpayer did not satisfy the maximum net asset value

test in section 152-15 of the ITAA 1997 because ‘just before’ the CGT event the net

value of the CGT assets of the taxpayer (and other relevant entities) exceeded $5

million.

A taxpayer needs to be mindful of the timing of the sale of CGT assets. If the market

value of the CGT assets increases on the day of the CGT event, this can cause the

taxpayer to fail the maximum net asset test. It could also be noted at this point that

there is no provision for indexation of the $5 million threshold in the legislation.

There is no adjustment for inflation. According to Pederick, if the tax system is seen

to be pressing heavily on some taxpayers and lightly on others with the same tax

paying capability, then the fairness of the tax system erodes.142 A taxpayer with CGT

assets valued at $5 million would have the same paying capability as a taxpayer with

$5.001 million in CGT assets. This strikes directly at the fairness issue.

142 W Pederick, ‘Fair and square for taxation in Australia’ (1984) 19 Taxation in Australia 575.

43

Issue 3 - Meaning of net value

To satisfy the maximum net asset value test, the total net value of the CGT assets in

relation to the small business entity claiming the relief, any entities connected with the

small business entity and any small business CGT affiliates or their connected entities

cannot exceed $5 million before the CGT event.

The net value of the CGT assets of an entity is the amount (if any) by which the sum

of the market value of those assets exceeds the sum of the liabilities of the entity that

are related to the assets.143

The term ‘liabilities’ as used in subsection 152-20(1) to determine the net value of the

CGT assets of an entity has its legal meaning. It extends to a legally enforceable debt

which is payable and to a presently existing obligation to pay either a sum certain or

an ascertainable sum. It does not extend to contingent liabilities, future obligations or

expectancies.

Amounts that are within the accounting meaning of the term ‘liabilities’ but not

within its legal meaning are therefore not within the scope of the term as used in

subsection 152-20(1). Examples of amounts that are not included in the net asset

calculation include the following:

• provisions for long service and annual leave entitlements;

• provisions for income and other taxes; and

• accounting liabilities arising as a result of receiving prepaid income.

143 ATO ID 2003/745.

44

The net value is the amount by which the sum of the market values exceeds the sum

of the liabilities. It is referring to an excess, if there is one. As there cannot be a

negative excess, the lowest possible ‘net value of the CGT assets’ of an entity is zero.

ATO ID 2004/207 confirms that the lowest possible net value of the CGT assets of an

entity under subsection 152-20(1) is zero. The taxpayer cannot have a negative asset

value from one entity offsetting the asset value of other entities. Any negative net

asset value is quarantined and does not reduce the value of net assets overall.

Subsection 152-40(1)(b) confirms that intangible assets such as goodwill are active

assets. Where a business makes sales on credit in the normal course of its operations

the resulting trade debtors can reasonably be seen as an intangible asset inherently

connected with the business.144 Depreciating assets are not active assets but they must

be included in the maximum net asset test.

Issue 4 - Assets disregarded from the maximum net asset value test

Section 152-20 includes all the CGT assets of the taxpayer and related entities

regardless of whether they are located in Australia or elsewhere. However, certain

assets are excluded from the maximum net asset test:

(i) Assets in connected entities

When working out the net value of the CGT assets, the entity is to disregard shares,

units or other interests (except debt) in another entity that is connected with it, or with

a small business CGT affiliate. 145

144 ATO ID 2002/1003.

145 ITAA 1997 Subsection 152-20 (2)(a).

45

The reason for the exclusion is that, under the maximum net asset value test, the net

values of both entities are aggregated. If the entities are connected through control,

the value of the controlling entity's investment in the other will be reflected in the net

value of that other entity. To include the net value of the controlling entity's

investment in the other would therefore amount to double counting.

(ii) Assets of a private or personal nature

If the small business entity is an individual, he or she is to disregard:

• assets used solely for personal use and enjoyment (or for the personal use and

enjoyment of a small business CGT affiliate);

• a dwelling, or ownership interest in a dwelling, if used to produce assessable

income but which does not satisfy section 118-190(1)(c). This provision

concerns the deductibility of interest incurred in relation to a main residence,

resulting in only a partial CGT exemption in relation to the dwelling. This has

the effect that a dwelling is not included in net assets if it is used incidentally

for income-producing purposes. If the taxpayer has had a deduction for

interest in relation to the dwelling; the dwelling is included for the purposes of

the maximum net asset test.

• a right to, or any part of, an allowance, annuity or capital amount payable out

of a superannuation fund or approved deposit fund (ADF);

• a right to, or any part of, an asset of a superannuation fund or ADF; and

• a policy of insurance on the life of an individual.

46

(iii) Assets of an affiliate not used in business

Subsection 152-20(3) excludes particular assets from the small business maximum net

asset test. If certain assets are not used in carrying on a business, they will be

excluded from the maximum net asset test.

2.6.2 The Literature on the Maximum Net Asset Test (pre DGR changes to now)

As discussed above, in order to pass the maximum net asset value test, the small

business and its related entities must not have total assets valued at more than $5

million immediately prior to the CGT event. While this appears to be a simple

provision, problems have been identified. Evans compared the streamlined small

business concessions with those existing prior to September 1999 and came to the

conclusion that:146

The control concept in the $5 million net asset test is still incredibly broad, and will inevitably operate in a ridiculous fashion in certain circumstances. The beneficiary of a trust is deemed to own a beneficial interest in the discretionary trust equivalent to the maximum possible distribution that could be made to that beneficiary. This means that discretionary trusts will usually be connected entities even where there is little or no chance of any distributions to the beneficiary.

With reference to the heavy impact of ATO ID 2002/921 on discretionary trusts by

confirming that assets of all potential beneficiaries including charities should be

included in the net asset value test, Karen Smith described practitioner reactions as

ranging ‘from outrage to disbelief’.147

Ann O’Connell found that some taxpayers qualified for the goodwill concession

under the previous legislation but now missed out under the new provisions:

Another change from the position under the previous law relates to partnerships. There is now an additional rule that provides that the net value of the CGT assets of

146 Evans, above n 44.

147 Karen Smith ‘CGT Concessions - Ones to Watch’ (2003) CA Charter 56.

47

the partnership must not exceed $5 million. Under the previous partial exemption for gains on disposal of goodwill it was only necessary to consider the taxpayer’s interest in the partnership to see if the threshold was satisfied. This additional rule may mean that partners in a partnership with net assets of more than $5 million who previously could have benefited under the goodwill concession, may now be ineligible for the new concession. 148

While the main residence of a taxpayer is normally excluded from the maximum net

asset value test, taxpayers should be wary of circumstances where a tax deduction

may have been claimed for a portion of the mortgage interest, perhaps where the

taxpayer ran a business from a home office. In such a situation, Petersson states that

the full value of the main residence may need to be included in the maximum net asset

value test:

it may no longer be possible to argue, because of the way the provision is drafted, that only the deductible part of a home is required to be aggregated with a taxpayer’s CGT assets for the purpose of the maximum net asset value test where part of a residence is used for income-producing purposes. 149

In their 11 December 2002 ‘Joint submission on the small business CGT concessions

and discretionary trusts’, the major accounting bodies expressed their concern with

the interpretation of ATO ID 2002/921 by the ATO. According to the submission:

This interpretative decision severely limits access to the small business CGT concessions for a significant number of taxpayers who should in our view be able to benefit from the concessions -and for whom we believe such concessions were intended… The interpretative decision has in turn highlighted the inadequacies and potential unintended outcomes from the operation of subsection 152-30(5) concerning the control of a discretionary trust.150

148 Ann O’Connell ‘The CGT Concessions for Small Business’ (2000) 29 Australian Tax Review 183.

149 Geoff Petersson An Overview of the Basic Eligibility Requirements of the Small Business CGT Concessions (2000)

cgtTAXnet < http://www.users.bigpond.net.au/cgttaxnet/whatsnew.html > at 25 August 2005.

150 TIA, ICAA, CPA Aust, ‘Joint submission on the small business CGT concessions and discretionary trusts’,

(Media Release, 18 December 2002).

48

In a media release on 2 May 2002 the Treasurer, Peter Costello announced that he

would make changes designed to enhance consultation on tax issues.151 The Treasurer

also reported a change in the responsibility for tax legislation design, which would

move from the ATO to the department of Treasury.152 Despite these so-called

improvements, feedback from Treasury has been poor. The Taxation Institute of

Australia (TIA) announced on 18 June 2003 that consultation with the Treasurer was

not working effectively. The TIA reported that:

despite the joint bodies lodging a submission on the issue of trusts, charities and the small business CGT concession (dated 13 December 2002) the only correspondence received is the Minister’s acknowledgement of its receipt. There has been no updating of progress by Treasury or your office. In the meanwhile, concerns have grown due to another ATO pronouncement, which further undermines the scope of the small business CGT concession. At the ATO’s National Tax Liaison CGT forum on 11 June 2003 it was announced that although a complying superannuation fund with less than five members is not a “connected entity” for the purposes of applying the small business CGT concession tests, a non complying kind in these circumstances is likely to be regarded as a “connected entity”. 153

The Tax Law Amendments (2004 measures No 1) Bill 2004 received royal assent on

29 June 2004. Changes to Division 152 included new tests to determine when an

entity controls a discretionary trust for the purpose of applying the small business

CGT concessions. The new Subsections 152-30(5) and (6) contain control tests based

on trust distributions in the four income years before the income year for which access

to the small business CGT concessions is sought and the outcome of the test is not

compromised by distributions to exempt entities and deductible gift recipients.154

151 P Costello, ‘Reforms to community consultation processes and agency accountabilities in tax design’

(Press Release, 2 May 2002).

152 Ibid.

153 Taxation Institute of Australia, ‘Discussion Topics for meeting with Senator Helen Coonan’ (Press Release, 18 June 2003).

154 Tax Laws Amendment Bill (No1) 2004, (Cth) Schedule 3.

49

Cunningham noted that although some problems had been addressed, room remained

for further improvement:

The proposed changes to the CGT small business control test for discretionary trusts will assist many trusts, particularly those with charities as beneficiaries. However, the new rules can create some new problems for the active asset test where the assets are used in a business of an entity that is, under the current rules, connected with the owner of the asset. Under the new rules these assets may lose their active asset status. The amendments go further than excluding the assets of charitable beneficiaries of a discretionary trust from being taken into account for the $5m asset threshold. The Bill provides a completely new control test for beneficiaries of discretionary trusts. This new beneficiary control test fixes another problem with the existing rules. Some discretionary trusts have a wide range of discretionary beneficiaries, many of which are unlikely to ever receive a distribution from the trust. The new beneficiary control test will have a detrimental effect on some taxpayers. The new test will restrict the number of persons who could be seen as controlling the trusts for the purposes of the active asset test. This is of particular relevance for primary producers and other taxpayers where the assets used in the business are owned by an entity other than the entity conducting the business.155

Given the issues that exist with the maximum net asset test, it remains to review the

active asset test to determine the current context of this piece of legislation.

2.6.3 Issues within the Active Asset Test

Issue 1 - carrying on a business

Under the active asset test, a CGT asset is an active asset (subject to the exclusions) if

it is owned and used or held ready for use in the course of carrying on a business. This

is a contentious issue as determining if a taxpayer is conducting a business may often

be unclear. Consider the following examples:

• Holiday apartments owned and operated by a taxpayer are active assets under

section 152-40 if the taxpayer is conducting a business. If the apartments were

a passive investment (used to derive rent), they would not pass the test.156 It is

155 Lance Cunningham, ‘Sting in the tail for discretionary trust's new control test’ (2004) 19 CCH Tax Week 375.

156 ATO ID 2003/165.

50

also possible that an asset owned by the taxpayer and used partly for business

purposes and partly to derive rent is an active asset.157

• an asset will be an active asset if it is used or held ready for use in the course

of carrying on a business. Timing issues with respect to the sale of a CGT

asset must be considered in determining if the asset is active.158

Issue 2 - Shares in Companies and Units in Trusts

On occasion, a taxpayer may wish to sell an interest in a company or trust. Under

subsection 152-40(3), an interest in a company/trust will be an active asset at a given

time if the company/trust is an Australian resident for tax purposes, and the

company/trust passes the ‘80% test’. The 80% test requires that the total of the market

values of the active assets of the company (and certain funds held pending the

acquisition of new active assets159 is 80% or more of the market value of all of the

assets of the company/trust. An asset must be an active asset during half the relevant

period of ownership for an interest in a company/trust to meet this requirement and

the company must satisfy the 80% test throughout the same period.

To reduce confusion with the definition of active assets, the ATO has confirmed that

certain assets are active assets. They are:

• trade debtors; (ATO ID 2002/1003);

• boarding house (ATO ID 2003/657);

• holiday apartments (ATO ID 2003/655)

157 ATO ID 2003/253.

158 ATO ID 2002/354.

159 A company or trust may sell active assets from time to time and receive consideration in the form of cash or debts. If this is

the case 2 years before another CGT event happens to one of it active assets, the cash or debt amount is included as an active

asset for the purpose of the 80% active asset test.

51

• commercial storage facility (ATO ID 2003/345)

• units in a unit trust (ATO ID 2001/411)

• an interest in a property from which the taxpayer will carry on a business

(ATO ID 2002/753)

Likewise, the ATO has also confirmed that bank accounts (ATO ID 2003/167) and

commercial rental properties (ATO ID 2003/345) are not active assets.

2.6.4 The Literature on the Active Asset Test

One writer points out that Division 152 contains new definitions of what constitutes

an active asset:

The notion of an ‘active asset’ is not new but what constitutes an active asset is different under these provisions. …The treatment of shares and trust interests as active assets differs from previous treatment.160

The literature has so far shown that access to the small business CGT concessions

requires careful planning. The impact of incapacity or even death should not be

dismissed, particularly if health issues are already a concern. As will be shown, the

provisions of Division 152 that apply to any individual situation may change instantly

following death or any similarly unpredictable or uncontrollable life-changing event,

with serious consequences for the assets of a small business.161

An individual could be in circumstances where a business has ceased and a 12-month

period of grace applies for disposal of the CGT assets of the business. During this

time the assets retain their active status. However, if the individual happened to die

160 O’Connell , above n 148.

161 SJQ Legal Services Handbook <http://www.sjq.com.au/sjq/pdf/ActiveAssetConcessions-SmallBusiness.pdf> at 25 June

2004.

52

within the 12-month period of grace, the active status of any remaining assets is

immediately lost. At death the legal personal representative (LPR) becomes the owner

of the assets and the only way to maintain the active status of business assets within a

deceased estate is for the LPR to continue operating the business right up to the time

when the assets are disposed of. However, this opportunity is lost if the business

ceased at the time of death:

Where a person ceases business and disposes of the business assets within 12 months of ceasing business, the business assets will be considered to be ‘active assets’ for the small business CGT concessions. However, if the person dies and the business assets are taken over by the legal personal representative (LPR) of the deceased’s estate, the LPR will not be entitled to the small business CGT concessions unless the LPR continues on the business until the assets are sold. 162

To satisfy the active asset test in such circumstances, the LPR may need to operate the

business for a period of 12 months prior to selling the assets.163

Prestney discusses the situation where a company or unit trust is the owner of active

assets. It may be difficult for the entity to qualify for the small business CGT

concessions, and even more elusive for the owners to benefit:

(Companies) can’t access the 50% general CGT discount, and the small business CGT concessions are hard to access and often harder to retain. The 50% active asset reduction will generally be only a deferral mechanism, until the tax-sheltered gain is paid out as an unfranked dividend or treated as proceeds on disposal of shares on liquidation. And, unless the company has at least one individual owning at least 50% of the shares, the retirement exemption just won’t be available. Try telling that to a group of three partners. A unit trust with a corporate trustee can provide … full access to the 50% general CGT discount (if the unit holders are discretionary trusts or individuals). It can’t provide full access to the 50% active asset reduction because this will partly be clawed back as a CGT event E4. A unit trust can provide access to the retirement exemption and 15-year exemption only if at least 50% of the units are held by an individual. If this is the case, then the profits will be taxed at individual tax rates, probably at 48.5% if the business is remotely successful. 164

162 Lance Cunningham ‘CGT Traps for small businesses’ (2003) 26 CCH Tax Week 461.

163 Rod Dunne ,‘Tax files: Are there pitfalls with the Small Business CGT Concessions?’ ( 2003) Law Society of South

Australia Bulletin 26.

164 Sue Prestney ‘Are You Getting Enough?’(July 2002) CA Charter 18.

53

The National Tax and Accountants’ Association Ltd (NTAA) discussed the situation

where a self managed superannuation fund owns an active asset such as business

premises. The following example illustrates this issue:

Dave and Edna are the only two members of their self managed superannuation fund. They are also the trustees of the fund. Dave and Edna are the sole directors and shareholders of Black Pty Ltd, their family company. Black Pty Ltd owns and operates a retail flower shop. The superannuation fund owns the business premises from which Black Pty Ltd operates. The fund leases the premises to Black Pty Ltd. When the superannuation fund sells the business premises it wishes to avail itself of the small business relief in Division 152. Based on the ATO’s comments referred to above the business premises will not be an active asset because Black Pty Ltd is not connected with the fund for the purposes of paragraph 152-40(1)(c). 165

One of the major issues with Division 152 is that it burdens business owners with the

dilemma of a trade-off between protecting business assets and providing for their

retirement. Ownership of critical assets through a self managed superannuation fund

and/or trust is considered to be good practice for asset protection. However, Division

152 places assets protected in this manner outside the scope of the small business

CGT concessions. The legislation should not negate good business practice. It should

be possible for small business taxpayers to access the concessions and retain the asset

protection available under the law.

Further issues of this nature will now be discussed by considering the controlling

individual test.

165 NTAA, ‘NTLG CGT Subcommittee Minutes June 2003’ (2003) Australian Tax Office

<http://www.ato.gov.au/taxprofessionals/content.asp?doc=/content/40685.htm&page=1#H37> at 29 July 2005.

54

2.6.5 Issues with the Controlling Individual Test

Issue 1 - Different share Classes

There is no controlling individual if a shareholder owns 50% of the class A shares but

the company has a class B share with dividend rights at the discretion of directors. In

this case no one shareholder has the right to receive at least 50% of any dividend

distribution that the company has made. If a company has different share classes, all

classes must be taken into account to determine if the company has a controlling

individual.166 There must be the same controlling individual in all classes of shares.

Issue 2 - Discretionary Trusts

An individual is a controlling individual of a discretionary trust during an income year

if:

• the trust made a distribution of income or capital, or both, during that year,

and

• the individual was beneficially entitled to at least 50% of the total income

distributions and at least 50% of the total capital distributions made by the

trust in that year.

Therefore a trust with different income and capital beneficiaries will not satisfy the

controlling individual test.167

2.6.6 The Literature on the Controlling Individual Test

ATO ID 2003/746 clearly indicates that where shares of different classes exist, there

can be a controlling individual only if after allowing for the maximum potential

166 ATO ID 2003/746.

167 ATO ID 2003/1114.

55

dilution of distributions, there remains one individual who is left with the right to at

least 50% of distributions of both capital and income.

Cunningham168 addressed the subject matter of ATO ID 2003/746 and recommended

that for any company that has different classes of shares, where there may be a future

need to use either the 15-year asset exemption or the retirement exemption, steps

should be taken to review the constitution and take appropriate action to ensure the

company has a controlling individual in compliance with the requirements of this test.

Other requirements for the particular concessions will need to be met in due course.

Issues to do with a controlling individual could be avoided by use of a simple

business structure. However, Evans noted reasons for the popularity of the more

complex structures:

The existing small business concessions have often predisposed small business taxpayers to operate as sole traders or partnerships, given the restrictive conditions that apply to controlling individuals where other entities are involved, and given other difficulties that companies and trusts can face in accessing the concessions. This creates tensions with other, commercial, considerations, such as the desire to use companies and trusts in order to provide a layer of protection if things turn sour.169

Burchill warned that many common business structures will not qualify for the small

business CGT concessions. The reasons frequently involve the controlling individual

test. Older businesses in particular will face this difficulty:

Many older businesses are inappropriately structured to take full advantage of these concessions on a future sale. 170

A legal service handbook about the small business concessions made this observation

about the same issue: 168 Lance Cunningham ‘CGT Traps for Small Businesses’ (2003) 26 CCH Tax Week.


170 Keith Burchill, ‘Do You Want to Retire Early?’ Tax News Winter 2002 (Hall Chadwick).

56

Satisfying the tests, however, may not be possible for many longstanding ownership structures and will require careful attention when ownership structures are being established or reviewed. Frequently the opportunity to utilise the concessions in the short to medium term will be lost because a person dies before an asset can be realised.171

Sue Prestney drew attention to a lack of justifiable logic where application of the

controlling individual test to a closely held company resulted in the determination that

it has no controlling individual or CGT concession stakeholders:

I am constantly embarrassed by having to explain (certainly I cannot justify) the absurdity and inequity of some of the requirements. A common example is where two families investing in an SME miss out on concessions simply because the shares are held equally between the two husbands and wives, and therefore there is no ‘controlling individual’.172

The same writer also noted the opposite outcomes under the controlling individual test

for commonly used business structures that differ little in substance:

I cannot understand why a company that is owned 50% each by two brothers qualifies for the entire exemption (of up to $500,000 each), when a company that is owned 25% each by two brothers and their wives does not qualify. Nor does a company owned 50% each by the two brothers’ family trusts qualify, even if those trusts have a ‘controlling individual’. … The whole issue of structure is a nightmare to explain to clients. 173

Evans drew attention to inconsistent definitions within Division 152, which provides a

broad definition of control for the maximum net asset test but a narrow definition of

control for the concept of a controlling individual:

In contrast the control concept in the controlling individual test is very narrow. Small business CGT affiliates’ interests cannot be used, and the individual must control votes (where they exist), rights to income and rights to capital (all three, not just any one of the three) to be able to prove that she/he is a controlling individual. Where tiered structures are used (e.g. chains of companies), it will often be difficult to show the existence of a controlling individual, as the legislation does not appear to permit any tracing through intermediate entities to find an ultimate controlling individual. 174

The same definition inconsistency was noted by Petersson:

171 SJQ Legal Services Handbook, above n 161.

172 Sue Prestney, ‘Just Dreaming?’ (2004) 75(1) CA Charter 42.

173 Sue Prestney ,‘Are You Getting Enough?’ (2002) 73(6) CA Charter 18.


57

The continuing requirement for a 50% or more interest in a company or trust would appear to be at odds with the adoption of a 40% or more control of entity test in Sec 152-30(2) ITAA 97 for determining whether a taxpayer has passed the maximum net asset value test. 175

Prestney queried the fairness of a regime that requires taxpayers to incur costly

professional advice in order to be told they do not qualify for the concessions:

While it may give us (practitioners) an intellectual challenge to duck and weave through complex provisions, someone has to bear the costs. A small business owner who has been able to access the CGT concessions may be able to bear the costs. However, a small business owner who has missed out because of some seemingly arbitrary provision in the law may be more inclined ‘to shoot the messenger’. 176

2.6.7 Other Issues

In the June 2005 edition of ‘The Taxagent’ the ATO discussed CGT issues and

highlighted recent concerns with the small business concessions. Compliance

problems regarding the maximum net asset test included:

• failure to establish market valuations just before the CGT event. Some

taxpayers are relying on valuations from previous CGT events or from prior

years balance sheets;

• not including the market value of goodwill;

• not accounting for the value of bank accounts and loans on the day of the CGT

event;

• failure to include the net asset position of connected or affiliated entities; and

• incorrectly including including contingent liabilites in the net asset calculation.

Other problematic areas detected were:

175 G Petersson, Selling a Small Business - The CGT Strategies (2002 Revised edition) 71

176 Prestney, above n 174.

58

• Errors in failing to satisfy the controlling individual test when claiming the

small business retirement exemption;

• incorrect usage of capital losses to offset capital gains;

• incorrect asset valuations where there is a disposal of a CGT asset to a

connected entity;

• incorrect claiming of pre CGT asset status; and

• complete omission of CGT events.177

2.7 Criteria for a Good Tax System

This section will examine suitable criteria for evaluating an effective tax system and

will review literature that has applied these criteria to the analysis of the CGT regime

in general and the small business CGT concessions in particular.

In the 18th century Adam Smith proposed four maxims that should apply to taxes:178

1. The subjects of every state ought to contribute towards the support of the

Government, as nearly as possible, in proportion to their respective abilities;

2. The tax which each individual is bound to pay ought to be certain, and not arbitrary.

The time of payment, the manner of payment, the quantity to be paid, ought all to be

clear and plain to the contributor, and to every other person.

3. Every tax ought to be levied at the time, or in the manner, in which it is most likely to

be convenient for the contributor to pay it.

4. Every tax ought to be so contrived as both to take out and to keep out of the pockets

of the people as little as possible over and above what it brings into the public

Treasury of the state.

177 ATO, ‘CGT Hotspots: small to medium enterprises’ (2005) The Taxpayer 39.

178 Adam Smith, An inquiry into the nature and causes of the wealth of nations, 1952 edn.

59

Smith’s maxims present a clear call for equity, simplicity and efficiency, with a

specific perceptive concern regarding administrative and compliance costs.

Recent agreement with Smith is found in a World Bank paper:

Theory suggests that tax administration performance should ultimately be evaluated with respect to the three requirements of simplicity, efficiency and equity. 179

The appropriateness of these criteria is accepted by Australian Federal

Governments.180 In 2002 the Commonwealth Department of the Treasury again

endorsed the use of these criteria for assessing the acceptability of taxation measures:

Taxation measures should meet revenue objectives (or other public policy objectives) and have regard to the principles of economic efficiency, horizontal and vertical equity, certainty and transparency whilst minimising compliance and administrative costs. By meeting these aims, taxation measures contribute to the wellbeing of Australians, either directly or by providing the revenue base to finance Government services.181

According to the Government, Division 152 was introduced into the ITAA 1997 to

streamline the existing CGT concessions for small businesses and provide for a

further concession in certain disposal circumstances.182 The Federal Treasurer, Mr

Peter Costello announced on 21 September 1999 that,

Stage 1 would introduce an internationally competitive capital gains tax regime which will create the environment for achieving higher economic growth, more jobs, and improved saving as well as providing a sustainable revenue base so that the Government can continue to deliver services for the community.183

The criteria of equity, simplicity and efficiency will be used to assess the current

legislation. Some further comment regarding each is appropriate.

179 World Bank, Evaluating Tax Policy and Administration (2002) <http://www1.worldbank.org/publicsector/tax/theme5.html>

at 25 June 2004.

180 Department of Treasury, Draft White Paper: Reform of the Australian Tax System, June 1985.

181 Department of Treasury, The Treasury Annual Report 2002-03 (2003) Australian Government Treasury

<http://www.treasury.gov.au/documents/709/HTML/docshell.asp?URL=02_Part1.asp> at 30 July 2005.

182 New Business Tax System (Capital Gains Tax) Bill 1999 (Cth).

183 The Treasurer, 'The New Business Tax System', Press Release (No.058), 21 September 1999

at < http://www.treasurer.gov.au/tsr/content/pressreleases/1999/058.asp > at 28 June 2004

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2.7.1 Equity

The concept of tax system equity has two components described as horizontal equity

and vertical equity. Horizontal equity relates to those concepts of fairness and social

justice that demand equal treatment for all people in similar economic circumstances.

According to Freebairn

Horizontal inequity means that people in similar circumstances pay different overall taxes…Most people consider horizontal inequity to be unfair. 184

The consequences of horizontal inequity in taxation were explored by Pederick:

I cannot overstate the importance to tax policy of fairness in terms of equality of treatment of taxpayers in essentially equivalent positions and its corollary that the taxpayer’s duty is to be determined by the substance of the situation and not by giving weight to artful disguise. If the tax system and its administration are seen as operating so as to press heavily on some but lightly on other taxpayers in essentially the same circumstances, with essentially the same tax paying capability, then the confidence of the citizenry in the fairness and justness of the system, of their Government, erodes. 185

Ralph, Albert and Joss (1999) affirmed that the business income tax system should

meet reasonable standards of horizontal equity.186 This requires that business income

earned in similar economic circumstances should be taxed in a similar way. In other

words, regardless of the legal structure, a company, partnership or trust should be

taxed in the same manner. Clearly, the small business CGT concessions should meet

this standard, given that in most cases, they are directed at the taxation of individuals.

Vertical equity requires that there be some kind of 'fairness' relationship between

people on different incomes. In other words, those who have more should pay more.

Equity has close ties with both equality and fairness.187 ‘Fairness requires that equally

184 John Freebairn,’Taxation Reform: Some Economic Issues’, (1997) 30 Australian Economic Review 57.

185 W.H. Pederick, Fair and square taxation in Australia (1984) 575

186 Review of Business Taxation, A Tax System Redesigned (Final report 1999).

187 C Pateman, ‘The Concept of Equity’ in P Troy (ed), A Just Society, (1991) 22.

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situated taxpayers pay equal taxes and those better off pay more. This will ensure both

horizontal and vertical equity’ as described above.188

(i) CGT – the Impact on Equity

Equity problems in the taxation system prior to 1985 were attributed to the

narrowness of the taxation base, specifically the lack of tax on capital. The Draft

White paper written in 1985 accepted that the lack of a comprehensive CGT was

detrimental to existing mechanisms for achieving both horizontal and vertical equity:

The current treatment of capital gains violates the principles of horizontal equity since it discriminates in favour of people who obtain some or all of their income in the form of capital gains. It also conflicts with the principle of vertical equity since the ownership of capital is more heavily concentrated among the higher income groups. What currently amounts to very concessional treatment of capital gains, therefore, tends to benefit the primarily better-off in the community and reduces the effective progression of the personal income tax system. 189

Krever described how the lack of a comprehensive CGT prior to 1985 was allowing

the principle of vertical equity to be abused:

The equity concerns arose out of the fact that gains such as property income or business income, that were derived by higher income taxpayers, proved easiest to clothe with the attributes of tax-free capital gains while labour income (wages and salaries), derived by lower income taxpayers, was almost impossible to recharacterise as capital gains. The exemption for capital gains thus undermined the entire principle of progressive taxation – the ratio of taxes to income could actually fall with increased real world income instead of rise as the rate scale at least intended. 190

Introduction of the CGT was predicted to result in improved equity. While CGT may

raise only a small fraction of overall taxes, the literature indicates that it plays a more

important role. The essential role of the CGT is not to raise revenue but to act as a

‘backstop’ or integrity measure to the income tax system.191

188 Alvin Rabushka, ‘India: Is a flat rate the answer’ (Feb 5 2000) Businessline 1

189 Department of Treasury, Draft White Paper: Reform of the Australian Tax System, (1985) 77.

190 R Krever, 'The Taxation of Capital Gains' in Burgess & Ross (ed), Income Taxation: A Critical Analysis (1991) 56.

191 Chris Evans, ‘Taxing Personal Capital Gains: Operating Cost Implications’, Australian Tax Research Foundation, 2003.

62

2.7.2 Efficiency

Economic efficiency seeks optimum outputs through efficient allocation of scarce

resources. This requires a market mechanism that introduces no distortions.192 It is

self-evident that inefficiencies associated with the raising of tax revenue can never be

totally eliminated. There will always be some impact on economic efficiency.193

However, reforms should seek to reduce inefficiencies so that no tax bears heavily on

any person’s business decisions.194 The Australian Chamber of Commerce and

Industry described economic efficiency in the taxation system to mean:

taxation impacting neutrally on taxpayer groups and economic sectors; commercial decisions must not be skewed by tax considerations.195

Likewise, Waincymer counselled strongly against any tax that of itself would cause

individuals to make different investment decisions.

If the tax system is inconsistent and some types of return are taxed more heavily than others, investors will make investment decisions on the basis of a new criterion – where they can get the highest after-tax rate of return. So long as the distinction between taxable gains and non-taxable (or preferentially taxed) gains is based on apparently economically irrational judicial canons, there is a substantial risk that tax-induced investment biases may result in a dangerous misallocation of much of the nation’s investment capital. 196

An efficient tax system should be designed to keep tax distortions to the minimum

necessary for raising revenue and maintaining an equitable tax burden.197 However,

the Draft White Paper stated that lack of a comprehensive CGT:

… distorts investment decisions by encouraging investment in assets offering returns in the form of capital gains. Investments in property, for example is encouraged at the

192 J Scott, Corporations, Classes and Capitalism, (1985) 21

193 P Abelson, ‘Reforming Australian Taxation’ in P Abelson (ed), The Tax Reform Debate: the Economics of the Options

(1998) 5

194 Ibid 51.

195 Dr Steven Kates, Taxation - Principles of Taxation Policy, at

<http://www.acci.asn.au/text_files/policies/Taxation_2003.pdf> at 16 December 2003.

196 Waincymer, above n 76, 27

197 A Auerbach & J R Hines, Taxation and Economic Efficiency (Working paper 8181), at

<http://www.nber.org/papers/w8181> at 16 December 2003.

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expense of assets such as bonds or loans where returns are mainly in the form of taxable income streams.198

Distortions caused by the lack of a comprehensive tax on capital gains were addressed

by the introduction of CGT in 1985. The general changes introduced in September

1999 brought further improvements but there was both praise and criticism for the

accompanying small business CGT concessions.

(i) CGT – the Impact on Efficiency

Warnings about the potential to produce market distortions were being made within

days of the announcement of the new CGT regime. Synergies available over the asset

life cycle from a combination of negative gearing and the general CGT discount had

been quickly identified:

The Federal Government’s decision to slash capital gains tax will multiply the tax kick of using negative gearing for investments … “You only have to do the numbers and they are radically improved: when you negatively gear you get an interest deduction at 48.5% when you are generating [capital gains] taxed at only half that rate.” PricewaterhouseCoopers tax partner Mr Michael Forsdick said yesterday. KPMG tax partner Mr Michael Doolan said … “Providers of investment products will increasingly try to devise products with prospects of capital gains coupled with some gearing.” 199

Paul Kenny warned of the potential to dilute the integrity function of the CGT and the

negative impact on horizontal equity:

Additionally, such preferential treatment of capital gains can result in a negative income tax where taxpayers negatively gear capital assets. Taxpayers obtain a full tax deduction for interest yet receives [sic] a tax break on the capital gain. This exacerbates the horizontal inequity between those who negatively gear and those who do not. 200

Kenny found similar potential for distortions in the 15-year ownership concession:

198 Department of Treasury, Draft White Paper: Reform of the Australian Tax System, (1985) 78

199 F Buffini, ‘Negative Gearing Gets Kickalong’, Financial Review (Sydney), 23 September 1999, 33

200 P Kenny, Submission to the Economics References Committee - Inquiry into the structure and distributive effects of the

Australian tax system, 2003.

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Commentators have noted Australia’s seventy years of experience in exempting capital gains from taxation resulted in: conservative investments and savings into large blue chip companies, real estate and holiday homes and low yielding tax advantaged assets. Thus they found such policies fail to promote small business, entrepreneurial activities and a successful dynamic economy.201

If the provisions of Division 152 were efficient, the choice of business structure

would not be influenced. However, it would appear that Division 152 is having

considerable impact on taxpayers, practitioners and professional bodies with respect

to this issue. Small businesses, whether new or well established, are undertaking

structure reviews to assess their eligibility for the small business CGT concessions. A

leading accounting and business advisory firm raised the following problem:

Since the commencement of these rules, the concessions have been difficult to access for discretionary trusts. This is due to the fact that current law can deem a beneficiary of the trust to control the trust in certain circumstances. This results in the assets of the trust beneficiary being aggregated with the assets of the trust. This makes it difficult for the trustee to satisfy the threshold test requiring that net assets do not exceed $5 million.202

Geoff Petersson was former national technical director of the TIA. He concluded that

‘although the eligibility criteria has been relaxed to some degree, many small

businesses will not, however, be able to avail themselves of the concessions.’203

He further criticised:

It is of interest to note that the original small business concessions introduced by the Coalition Government in 1997 are now into their third version of enabling legislation with many additional amendments having been added during that time. This is itself alarming, but what is of perhaps greater concern is that the flaws in the original version of the concessions have been carried through both succeeding versions, though the current version does include some corrections of note, though most are minor.204

Suggested improvements in efficiency will be a desired outcome of the research.

201 Ibid.

202 William Buck, Small business CGT Concessions, (2004) at

<http://www.williambuck.com.au/html/tax_watch/PDF/TaxWatch - March 2004.pdf> on 25 June 2004

203 G Petersson, An overview of the Basic Eligibility Requirements of the Small Business CGT Concessions

< http://www.cgttaxnet.com.au > at 25 June 2004

204 Ibid.

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2.7.3 Simplicity

In a simple taxation system taxpayers would have little difficulty in understanding

their obligations. The laws would be capable of straightforward comprehension and

certain in their application.205 In its Draft White Paper, the Government decided that,

for ease of conveying meaning, for reducing compliance costs and for avoiding

unnecessary litigation, the tax system should be as simple as possible.206

Simplicity is facilitated by low costs of compliance and administration.207 In fact, the

literature shows that a simple tax system should yield a package of benefits:208

1. low costs of compliance for taxpayers;

2. lower costs of administration for the ATO;

3. higher rate of compliance;

4. higher accuracy in determining liabilities; and

5. improved awareness of decision consequences.

As stated by the American Institute of Certified Practicing Accountants (AICPA),

Simplicity in the tax system is important to both the taxpayer and those who administer the various taxes. Complex rules lead to errors and disrespect for the system that can reduce compliance. Simplicity is important both to improve the compliance process and to enable taxpayers to better understand the tax consequences of transactions in which they engage in or plan to engage in.209

205 Dr Steven Kates, above n 196


207 R.Albon, Taxation Policies in the Eighties (1986) 21.

208 AICPA, ‘Guiding principals for taxation simplification’, Tax Policy Concept Statement No 2 (2002).

209 AICPA, ‘Guiding principals of good tax policy: A framework for evaluating tax proposals’, Tax Policy Concept Statement

No 1, (2001) at <http://ftp.aicpa..org/public/downlaod/members/div/tax/3-01.pdf> at 17 December 2003

66

Where simplicity is absent, complexity exists. Complexities faced by taxpayers may

be present at three separate levels, as identified by McCaffery: 210

Technical complexity Relates to comprehension of an

isolated piece of legislation.

Structural complexity Relates to the complex matrix

of legislation.

Compliance complexity Relates to the variety of tasks

imposed on the taxpayer.

(i) CGT Concessions – the Impact on Simplicity

Research into compliance costs for CGT was commissioned by the ATO and carried

out by an independent research team from the Australian Taxation Studies Program

(ATAX) at the University of New South Wales. Data for the fiscal years 1994-95 and

1997-98 confirmed significant compliance costs first identified in earlier

uncommissioned research by Pope.211 Coleman and Evans212 reported that of 18 cost

driving factors identified by the studies, the top six were:

• Complexity of the legislation;

• Frequent changes to the legislation;

• Record keeping requirements;

• The number of rules and exceptions;

• Valuation Issues;

• The complexity of the small business concessions.

210 E J McCaffery ‘The Holy Grail of Tax Simplification’ (1990) Wisconsin Law Review 1267.

211 J.Pope, ‘Compliance costs of taxation: policy implications’, (1991) 8(4) Australian Tax Forum.

212 C Coleman & C Evans ‘Tax Compliance Issues for Small Business in Australia’ (Paper presented at the Small Business Tax

Symposium, UNSW, 2003) 147.

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The streamlined CGT concessions introduced in Division 152 did little to reduce

complexity. Division 152 contains over 9000 words and Coleman and Evans found

that taxpayers face complexity at all three levels identified by McCaffery. From

studies of compliance costs, Evans concluded that CGT cannot be made simple and

also that available concessions contribute to the complexity:

The literature suggests that … CGT compliance costs tend to rise over time (and not just because more taxpayers are involved with the tax)... The taxation of capital gains will always be difficult to justify on the grounds of simplicity. There is little consensus as to what should and should not be included within the capital gains base. The inclusion of a variety of deeming provisions and preferences (such as exclusions, exemptions and roll-overs) as a result of the essential compromises that have to be made (and the consequent distortions that arise) is always likely to add to the complexity of the provisions.213

Evans followed with pointed criticisms of the small business CGT concessions:

And there is also an irony at work that must not be overlooked. Building in preferences to the tax system comes at a cost to simplicity. The more choice that is given to taxpayers, and the more concessions that become available, the higher the compliance costs become (and often the administrative costs follow suit). Taxpayers, and particularly the business lobby, need to be mindful that they cannot always have it both ways. Concessions such as the recently introduced and extensive small business reliefs in Australia may reduce the tax liabilities of individuals in business. But they will also inevitably increase the costs of complying with CGT for those taxpayers. ... Australia’s CGT small business concessions are arguably more generous than those in any other CGT regime and practitioners may be reluctant to criticise them too openly for fear of losing that generosity.214

The literature confirms that the small business CGT concessions fail reasonable tests

of simplicity. Suggestions for improved simplicity will therefore be a desired outcome

of the research.

213 C Evans, above n 192

214 Ibid.

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2.8 Conclusion

The CGT has substantially increased the equity, efficiency and simplicity of the

Australian tax system. Krever argued:

almost every major industrial country in the world taxes capital gains, and the fact that in most jurisdictions the tax on capital gains has been increased in recent years to broaden their tax bases and lower their marginal tax rates, are perhaps themselves overwhelming evidence of the case for a tax on capital gains. The debate is no longer over whether capital gains should be taxed but instead is over the details of taxing capital gains. 215

Traditionally the arguments for and against taxing capital gains have been organised

around the tax criteria of equity, efficiency and simplicity. In practice, the interests of

these criteria conflict at times and it becomes difficult to strike a balance. According

to the World Bank:

Recognising the possibility that there may be a trade-off between simplicity and other objectives is a necessary condition for good tax policy making but is not, by itself, sufficient. There has to be in place a method for resolving conflicts of interest between tax administrators (who are seeking high revenue at low cost) and taxpayers (who vary in their capacity to pay and in the compliance costs they incur). In addition it needs to be recognised that the way tax is collected, as well as the design of tax policy, will influence perceptions of the fairness and efficiency of the tax system.216

While Coleman and Evans acknowledged that taxpayers ‘might well accept that a

more equitable tax system comes at the cost of a higher compliance burden’, their

research also showed that in Division 152 taxpayers ‘face what they perceive to be

inequitable taxes and high compliance costs as well’.217 Freebairn described a sound

foundation for reasonable balance between equity, simplicity and efficiency:

Broad and comprehensive tax bases with minimal exemptions and deductions have good tax design criteria advantages; continuity and security of revenue flows; lower tax rates to achieve a revenue target; lessened incentives and rewards for tax avoidance and for lobbying; neutrality of taxation of related choice options and

215 Krever, above n 82, 41.

216 Roger Bowles, Administrative Simplicity and Equity (2001) World Bank,

<http://www1.worldbank.org/publicsector/tax/administrativeconvenience.html> at 25 June 2004

217 Coleman and Evans, above n 213.

69

smaller deadweight costs of taxation; horizontal equity; a firmer building block for vertical equity; and simplicity. 218

Kenny argued that the introduction of preferences in the form of the generous small

business CGT concessions has not been without damage:

the paper found that the CGT preferences seriously damaged equity and arguably impeded efficiency. Overall given the great expansion of CGT related rules CGT has become more complex. 219

Considerations of equity provide important reasons for the inclusion of CGT in the

tax system. Without CGT, taxation avoidance would increase. While CGT has an

important place within the taxation system, associated preferences such as the small

business CGT concessions do increase complexity. However, the Government has

indicated that the concessions are designed to provide small business people with

access to funds for retirement or expansion.220

Chapter Three will review submissions made to the Board of Taxation with respect to

Division 152 and will proceed to examine the problematic areas of the legislation

through the criteria for a good tax system.

218 J Freebairn, ‘Tax Reform: An Unfinished Agenda?’ in P Dawkins and P Kelly (ed), Hard Heads, Soft Hearts (2003) 185

219 P Kenny ‘A review of the 1999 Australian Capital Gains Tax Reforms’ (Paper presented at the Tax Research Network

conference, Oxford UK, 2003)

220 Chapter2 Section 2.3.

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CHAPTER THREE

BOARD OF TAXATION REVIEW OF DIVISION 152

3.1 Introduction

This chapter will review submissions made to the Board of Taxation in its review of

Division 152 and of the small business CGT concessions. The submissions give

insight into the problematic areas of the legislation as seen by the professional

accounting bodies, taxation bodies and other industry partners.

The Board of Taxation was established by the Government in August 2000 to advise

the Treasurer on the development and implementation of taxation legislation as well

as the ongoing operation of the tax system.221 The creation of the Board was a

recommendation of the Ralph Review of Taxation.222 The call for an independent

entity came from the perception among businesses and their advisors that their views

in the development of the taxation system were not effectively being heard.223 The

charter of the Board is to ‘contribute a business and broader community perspective to

improving the design of taxation laws and their operation’.224

In 2005 the Board of Taxation called for submissions from taxation professional

bodies and interested parties inviting comment on Division 152. The Board made this

comment:

One of the functions of the Board of Taxation is to review legislation to assess its quality and effectiveness… The Board’s intention in undertaking the post-implementation review is not to reopen debates about the merits of the policy intent of

221 Department of Treasury, The Board of Taxation: its role and current activities (2005) Department of Treasury

<http:www.treasury.gov.au/documents/108/HTML/docshell.asp?URL=5_board.asp> at 25 September 2005.

222 Ibid.

223 Ibid.

224 Ibid.

71

the measure. The intention instead is to gauge how effective the legislation has been in delivering the policy intent. The reviews are designed to establish if the legislation is having its intended effect and to find out whether its implementation can be improved.225

The purpose of this review was to establish whether Division 152:

• Gives effect to government policy intent with a focus on compliance and

administration costs;

• Is expressed in a clear and simple manner;

• Avoids substantive unintended consequences;

• Takes account of commercial practices; and

• Provides certainty.226

In Australia, there is no one organisation that represents all tax practitioners.227 The

population of tax practitioners is fragmented over several organisations.228 At the time

of writing, not all submissions to the Board of Taxation were available for review.229

Submissions from the major taxation players were publicly available and all six of

these have been considered. These submissions were from the following bodies:

• Australian Chamber of Commerce and Industry (ACCI)

• CPA Australia (CPA)

• The Institute of Chartered Accountants in Australia (ICAA)

• The National Farmers Federation (NFF)

• Taxation Institute of Australia (TIA)

• Taxpayers Australia Inc (TA)

225 Board of Taxation, ‘A post implementation Review of the quality and effectiveness of the small business CGT concessions

in Division 152 of the Income Tax Assessment Act 1997 – A report to the Treasurer’ (2006) 3.

226 Ibid.

227 Ibid.


229 Further submissions were made available when the Board of Taxation released its report to the Treasurer.

72

The submissions varied in length and complexity. All commented on problem areas of

the legislation and recommended changes to Subdivision 152-A. In particular, the

maximum net asset test received special attention with a common cry for change.

The Board of Taxation released its findings three weeks before the finalisation of this

thesis. The findings of the Board of Taxation and the analysis of other submissions

will be appended to this thesis as a postscript.

This thesis will consider Subdivision 152-A in a holistic way and will go beyond the

Board’s mandate by addressing recommendations for policy changes. This chapter

will use the traditional criteria of equity, efficiency and simplicity to evaluate what the

available submissions had to say about the principal tests controlling access to the

small business CGT concessions, namely the maximum net asset test (Section 3.2),

the active asset test (Section 3.3), and the controlling individual test and CGT

stakeholder test (Section 3.4). Conclusions will then be drawn regarding the

consensus on changes required to Subdivision 152-A (Section 3.5).

3.2 Maximum Net Asset Value Test

This test is described in detail at section 2.5.2 of the previous chapter.

3.2.1 Maximum Net Asset Test and Equity

The principles of equity in taxation are described at section 2.7.1 of the previous

chapter. All submissions found equity issues with the $5 million limit of this test and

its other complexities. All submissions called for a review of the test. The NFF

commented:

73

The $5 million CGT asset threshold unfairly discriminates against farmers whose businesses have a high level of capital due to the importance of land in farming…. exposes taxpayers to variable and subjective property valuations which can fluctuate significantly depending on market conditions ... Many farmers find themselves over the limit yet by other measures such as turnover, profit, staffing and market power, they would be a small business.230

The NFF recommended that the Board of Taxation reconsider the threshold so that

equity issues are addressed and farmers who deserve access to the concessions by all

other criteria be able to access them. The NFF noted that other tests such as those that

pertain to the simplified tax system could provide an alternative to the maximum net

asset test.231 The clear impact on equity is noted as follows:

NFF notes that the eligibility criteria for the Simplified Tax System is a potential model ie. that to qualify a small business must have turnover less than $1 million and have depreciable assets of under $3 million. One of the problems of the STS model is that the turnover limit excludes many farmers who are legitimate small businesses but due to the nature of farming have a high turnover, but low profit margin. Another issue is that turnover has no relationship to capital or profit.232

Various submissions questioned the monetary ceiling of the maximum net asset test

and whether the amount of $5 million truly distinguishes a small business. The ICAA

made this comment:

The real value of the $5 million threshold has eroded over time and is now much too low especially taking into account previous increases in the CPI and also the significant rises in property prices during the last few years.233

With horizontal equity dictating fairness and social justice, how can it be fair or

equitable that a taxpayer earning $5,000,001 not access the concessions where a

taxpayer with a few dollars less in net assets can potentially sell their active asset and

pay no CGT? Given the effects of inflation and the increases in land values, what

should the new threshold be? The TIA recommended:

230 NFF, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business

capital gains tax concessions (2005) <http://www.taxboard.gov.au/> at 21 May 2006.

231 Ibid.

232 Ibid.

233 ICAA, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business


74

the threshold is a fixed amount which does not contain any provision for shading out. As a result, this hardline approach does encourage costly/artificial maneuvering to ensure taxpayers fall within the concession. Consideration should be given to applying a shade out where assets values start exceeding the threshold.234

3.2.2 Maximum Net Asset Test and Efficiency

As discussed in Section 2.7.2, reforms should seek to reduce inefficiencies so that no

tax bears heavily on any business decision. For example, if capital gains were not

taxed at all, taxpayers would have a huge incentive to structure transactions that were

capital in nature rather than as income. Would the taxpayer make the same

commercial decision if the tax had not been introduced? The concept of neutrality

would best describe this principle.

Submissions made only indirect reference to efficiency issues. The ICAA identified

that minor business use of residential properties is an issue.235 The submission

commented:

When working out the net value of the CGT assets of an individual, subparagraph 152-20(2)(b)(ii) allows the main residence of the individual, or the individual's ownership interest in a main residence, to be disregarded provided the main residence is not used, to any extent, for income producing purposes. However, if there is any income producing use, the entire market value of the main residence is taken into account albeit less any related liabilities, e.g., a mortgage is included in the calculation of the net value of the CGT assets. It is submitted that only the market value of that part of the main residence that was actually used to produce income should be included in that calculation. Arguably the policy of the small business CGT concessions would not have been to take into account the entire market value of a main residence that was only partly used to produce income. Given the significant increases in property prices in recent years, minor income-producing use of a main residence could result in an unintended consequence of a substantive nature being the failure of the maximum net asset value test by a growing number of taxpayers.236

Clearly, a taxpayer may decide to change business premises so as to comply with the

test. This strikes directly at the heart of efficiency.

234 TIA, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business


235 ICAA, above n 233.

236 Ibid.

75

The new connected entity test will impact on the decisions of trustees when making

distributions of income to trust beneficiaries. Beneficiaries who would normally

receive income from a trust may miss out as the consequences for the trustee of

making that distribution could result in adverse circumstances. CPA Australia’s

submission stated:

Section 152-15 includes in the $5 million net asset value ceiling the net value of CGT assets of entities connected with the taxpayer. The old section 152-30(5), which brought within the ‘connected’ net other trusts under which a beneficiary might benefit, was clearly inappropriate and unworkable. Unfortunately, it was replaced with similarly deficient rules, The new section 152-30(5) looks at distributions of income or capital within the previous four years and the relevant taxpayer is taken to control the trust if they or one or more of their small business CGT affiliates received at least 40% of any income or capital which was distributed. A simple example of the inappropriate application of this rule is where a trust confers an entitlement to capital on an individual, say to enable them to buy a house. It might be that they would never again benefit under this trust. If that was the only capital year distributed in that year, the assets of the trust would be take into account for the purposes of applying the $5 million net asset value ceiling, even though the relevant taxpayer (or their small business CGT affiliate) might never receive any further benefit from the trust.237

3.2.3 Maximum Net Asset Test and Simplicity

Simplicity is achieved where laws are capable of straightforward comprehension and

are certain in their application.238 For the maximum net asset test to satisfy the

simplicity criteria, the layperson taxpayer should be able to resolve most CGT

calculations and require little assistance with interpretation of the division. In fact, the

opposite has occurred. The maximum net asset test is the most complex of the tests in

Subdivision 152-A. The ICAA comments that the net asset test is ‘confusing and not

expressed in a clear, simple and comprehensible manner’. 239 The ICAA referred to

three main areas of contention regarding the maximum net asset test:

237 CPA, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business




76

• the wording of subsection 152-20(4)(b) uses a triple negative which therefore

makes the section difficult to understand;240

• complexities arise upon a partner disposing of an asset in a partnership. The

definition and use of partnership assets within the maximum net asset test is

problematic; 241

• assets are connected for the purpose of the maximum net asset test. In this

case, the provisions are confusing and not clear.242

CPA Australia also found that the test was confusing:

The issue for consideration regarding compliance and administration costs is whether the actual compliance and administration costs arising under the current small business CGT concession provisions are commensurate with those foreshadowed in the Regulation Impact Statement for the measure. The Regulation Impact Statement stated: • streamlining the (former) CGT small business concessions will reduce complexity

and provide small business taxpayers with greater flexibility in accessing the benefits, and

• implementation of the measure is not expected to give rise to any significant increase

in administration costs for the ATO. It is clear from the comments that follow in this submission that the current small business CGT concessions are complex and often appear to have unintended consequences. In other words, it is clear that while the changes to the former CGT provisions have improved their coverage and flexibility somewhat, there has been no corresponding reduction in complexity, nor in the associated compliance costs for taxpayers and their advisers. We are not in a position to comment on the precise impact of the changes on the ATO's administration costs but they would presumably not be significant. 243

The ACCI represents over 350,000 businesses Australia wide including the top 100

companies, over 55,000 enterprises employing between 20 and 100 people, and over

240 Ibid.

241 Ibid.

242 Ibid.

243 CPA, above n 237.

77

280,000 enterprises employing less than 20 people.244 The ACCI surveyed its

members with respect to compliance difficulties they have with a range of taxes,

including CGT. These findings were detailed in their submissions and showed

‘compliance difficulties associated with the capital gains tax are an important problem

for 45 percent of all firms surveyed, being substantially more important for small

firms (49 percent) than larger firms (40 percent)’.245 The research also showed that all

businesses regardless of size were concerned about the complexity of the tax system.

In summary, the submissions clearly indicate that the ‘maximum net asset test’ is not

equitable, efficient or simple. The $5 million threshold is not commercially realistic

and clearly distorts the decisions of taxpayers. Moreover, it is the most complex of all

the tests. As with any of the tests, its removal would need to be considered very

carefully but possible changes to the test may be the way forward. Section 3.5 will

discuss the recommendations and suggestions for a new improved definition.

3.3 The Active Asset Test

This test requires that the asset giving rise to the CGT event is an active asset.

A CGT asset is an active asset if it meets the definition in Section 152-40. This test is

described in detail at section 2.5.3 of the previous chapter. The CGT asset has to be an

active asset at certain times just before the CGT event and if the business ceased to be

carried on in the last 12 months, at the cessation of the business.246

244 ACCI, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business


245 Ibid.


78

3.3.1 Active Asset Test and Equity

The submissions expressed concerns that the active asset test diminished the equity of

the small business CGT concessions. The main problems related to treatment of cash,

shares, and contingent claims. Regarding cash reserves, the ICAA stated:

There is no reason why cash should not more generally be treated as an active asset. Cash is currently excluded either because it is held as Australian currency or in a bank account. The ATO, in Board of Taxation cases (refer ATO ID 2003/167 and ATO ID 2003/168), consider that the exception for financial instruments in paragraph 152-40(4)(d) applies.

Cash reserves are often maintained by businesses to meet working capital requirements, e.g., payment of expenses, acquisition of plant, etc. We note that the ATO, in ATO ID 2002/1003, takes the view that trade debtors are active assets because they are a "business facilitation mechanism that assists in the conduct of the business". Our view is that cash reserves can often be described as such and that to treat cash differently to trade debtors is to penalise those companies and trusts that hold large cash reserves due to the nature of the business they carry on or for working capital purposes.247

The ICAA expressed concern regarding the common situation where the sale of a

business may include an immediate payment and the right to a future payment based

on criteria applying to subsequent years of income. When this right is eventually

exercised or expires, a capital gain or loss may arise. The ATO takes the view in

Taxation Ruling TR 93/15 that this right is a separate asset for CGT purposes.248

If a capital gain eventuates, the small business CGT concessions will not be available

because the right does not satisfy the definition of an active asset (refer ATO ID

2002/766). This capital gain clearly relates back to the sale of the business and the

ICAA contends that this common commercial practice should not be excluded from

the benefits of the small business CGT concessions.249

247 Ibid.

248 Ibid.

249 Ibid.

79

The TIA draws attention to intellectual property and in-house software developed by a

taxpayer. These may comprise important business assets and typically the proceeds

on disposal of such items should qualify for the small business CGT concessions.250

Submissions have called for an improved definition of an active asset to improve

equity. Equity requires equal treatment for all taxpayers in similar economic

circumstances and that those who have more should pay more. In terms of equity, the

definition of active asset needs to be relaxed so that equitable outcomes can be

obtained.

3.3.2 Active Asset Test and Efficiency

The ACCI, CPA, and ICAA all noted that the requirement for assets to remain active

right up to the time of sale is onerous and restrictive in some situations. One example

is found with deceased estates where the legal personal representative (LPR) may

come under pressure to carry on the business of a taxpayer who has died. However,

CPA Australia draws attention to situations where the LPR will not have the required

expertise, or will not meet the legal or licensing requirements to operate the business

of a solicitor, accountant, medical practitioner, builder, or even a taxi operator.

Consequently, the active status of the assets cannot be maintained.

One suggestion was for the LPR to be allowed sufficient time to dispose of the

business without having the requirement of continuing to operate it.251 Another

opinion was that any entitlements to the small business CGT concessions accruing to

250 TIA, above n 234.


80

the taxpayer should remain accessible to the LPR during the process of administering

the deceased estate.252

The NFF described a problem with some similarities where some farmers, perhaps

facing declining health or advancing years, have for good reason leased out their

property for a short number of years. The NFF expressed concern that these taxpayers

would have to come out of retirement and work the farm again in order to qualify for

the CGT concessions. Of course, such problems are not restricted to farmers.253

The submissions clearly indicated that efficiency issues do exist in the active asset

test, but the problems are relatively minor and can easily be addressed.

3.3.3 Active Asset Test and Simplicity

Problems relating to definitions were noted by most submissions. The TIA expressed

concerns that trade debts and bank accounts were classed as ‘financial instruments’

and excluded from the definition of active assets.254 Situations where this may be

particularly relevant are described:

First, shares are only active assets if 80% of the market value of the assets held by the company are active assets. Hence, movements in bank accounts and trade debtors affect whether the shareholder will or will not obtain the concessions. The 80% test is measured at the time of the CGT Event. Further, if a shareholder had rolled the capital gain into new shares that were active assets at the time of the rollover, CGT Event J2 would undo the rollover and trigger a capital gain if less than 80% of the assets of the company were active assets.

An identical outcome would apply if the taxpayer were dealing with units in a unit trust instead of shares in a company.


253 NFF, above n 230.


81

Notwithstanding that trade debts are integral to a business, a taxpayer could be disadvantaged by making sales shortly before a CGT event thereby converting trading stock into a higher value of trade debt.255

In its submission, the TA drew attention to the definition whereby an active asset

includes an asset that is used by an entity that is connected with the entity. Where the

connection involves a discretionary trust, the trust must have previously distributed to

that entity more than 40% of the income or capital distributed in any of the past four

income years.256

The ACCI also noted various problems with the definition of active assets (relating to

cash, contingent claims, shares and deceased estates). The submission concluded that:

the current CGT concessions for small business are complex and difficult to use, even for practitioners. Therefore, it is unlikely that the concessions have met their original policy intentions. 257

In summary, to address the issues in relation to cash, contingent claims, shares and

deceased estates, simple changes to the definition of ‘active assets’ may be

appropriate and would make this test more equitable, efficient and simple. Section 3.5

will discuss the recommendations and suggestions for a new improved definition.

3.4 The Controlling Individual / CGT Stakeholder Test

This third test applies only if the CGT asset is a share in a company or an interest in a

trust and was described in detail in the previous chapter at section 2.5.4.

255 Ibid.

256 TA, Submission to Board of Taxation: Post-implementation review of the quality and effectiveness of the small business


257 ACCI, above n 244.

82

3.4.1 The Controlling Individual / CGT Stakeholder Test and Equity

Submissions drew attention to this test as being the source of many of the inequities

inherent in the legislation. The inconsistent treatment by this test of different business

structures was described by some submissions as discriminatory. The submissions

did not focus on the legislative wording of the controlling individual/CGT stakeholder

tests as there is little confusion with respect to the operations of this test. The

submissions pointed out the inequities of dissimilar outcomes for entities with very

little difference in their businesses structures.

For a new business starting up after the introduction of the small business CGT

concessions, it is not difficult to select a structure that will provide asset protection

and still meet all the requirements of the controlling individual / CGT stakeholder test.

However, long-established businesses commonly have structures that do not give

taxpayers access to the small business CGT concessions and in most cases these

structures cannot be changed without incurring a CGT liability.

To provide owners with a degree of asset protection, businesses are often operated

through an interposed entity. However, the use of an interposed entity means that the

conditions for a controlling individual cannot be met even though ownership of the

business assets is easily traced. The submission from TA warned that:

the interposed entity can never be a controlling individual and is not a spouse to the controlling individual. Therefore, the small business CGT concessions will not be available if an individual taxpayer owns his or her business indirectly through an interposed entity.258

258 TA, above n 256.

83

A common concern is illustrated in the submission from the ICAA. Examples are

given where two taxpayers have the same beneficial interest in their business. One

taxpayer directly owns all of the shares in a holding company and an operating

company. The test concludes that the companies have a controlling individual and the

taxpayer is able to fully access all the concessions that are available.

In contrast, another taxpayer owns all of the shares in a holding company, but the

holding company owns all of the shares in the operating company. In this instance,

the test concludes that the operating company has no controlling individual and no

CGT concession stakeholder, so the taxpayer cannot access any retirement or rollover

concessions with respect to the operating company. In the words of the TA

submission:

the small business CGT concessions measures do not allow a trace through to the ultimate beneficial individual owners of the interests.259

Further, a company with three (3) equal owners is described in the CPA submission as

being at a disadvantage. The submission made this point:

There are many cases where a small private company has a number of shareholders who have combined their capital and expertise to form a viable business. It is unjust that these businesses should be denied access to the small business concessions on the basis that they do not have a controlling individual. We question the need for a controlling individual test and recommend that this requirement be removed.260

Adding to the complexity, the controlling individual test is not applied when a

partnership interest is disposed of, and there is no effective restriction on the number

of partners. So a business carried on as a partnership could access the concessions, as

could a partnership of discretionary trusts.

259 Ibid.


84

One of the goals of the Board of Taxation was to determne if the legislation gives

consideration to current commercial practice. There is no practical reason as to why

three equal partners in a partnership should access the concessions whereas three

company shareholders should not qualify. When common business structures are

excluded from access to the small business CGT concessions in this manner, it must

be concluded that the legislation does not give adequate consideration to current

commercial practice.

In discussing the need to accrue a 15 year period of ownership to access the

retirement exemption, the TIA gave warning that a business restructure may reset the

clock:

The requirement that there must be a controlling individual for a 15 year period does not take into account restructures that may have taken place over the life of the business. For example where a sole trader has rolled the business into a wholly owned company and taken advantage of Rollover Relief under Division 122 during that 15 year period.261

These examples emphasise the complex nature of assessing access to the small

business CGT concessions and highlight the different outcomes to taxpayers in

substantially similar situations. There can be no policy reason why different

outcomes should be imposed on the ultimate owners in any of the examples provided.

In its submission, the ICAA contended that the stated policy intent of providing

greater flexibility in accessing the concessions has failed because the access tests do

not take account of actual taxpayer circumstances and commercial practices.

Therefore the controlling individual / CGT stakeholder test does not deliver a desired


85

standard of consistency with respect to business structures in common use. As the

submission from TA stated:

It would appear a discriminatory outcome would arise between taxpayers in substantially the same circumstances who adopted different ownership structures.262

CPA Australia clearly agreed with this opinion:

Among other things, the outcomes which arise from the application of the ‘controlling individual’ test seem to be clearly inequitable and at odds with the primary purpose of the small business CGT concessions. 263

A further issue of equity may arise in connection with the death of a taxpayer who has

qualified for the retirement or disability concession. The intention that this

concession is clearly intended to benefit taxpayers who are ageing or permanently

incapacitated adds to the relevance of concerns that where the taxpayer dies before the

business assets are sold, this concession is lost to the spouse or family of the taxpayer.

The TIA called for clarification as to whether this outcome is in line with policy

intentions:

The executor or trustee of the deceased estate is not a controlling individual as they do not hold their interest legally and beneficially. This is significant because for the period of time between the death of the controlling individual and the time the business is sold by the estate, there is no controlling individual. Therefore, the requirements of sections 152-105 and 152-110 are not satisfied. Consequently, we consider that clear direction should be given in relation to whether the concession is intended to apply to sales of businesses that arise as a result of the death of the controlling individual.264

3.4.2 The Controlling Individual / CGT Stakeholder Test and Efficiency

The submission from the ICAA described a further situation where the small business

CGT concessions cannot be accessed by taxpayers using common business structures:




86

A common structure through which businesses are carried on is in a unit trust that is owned by one or more discretionary trusts. Such structures are typically set up for asset protection purposes for small to medium-sized family businesses. As it is common for the husband and wife, or business principals, to be at risk, owning units in the business vehicle is not desirable and one or more discretionary trusts are therefore established. When a unit in a unit trust is disposed of, one of the basic conditions to access the small business CGT concessions, as set out in paragraph 152-10(2)(a) of the Income Tax Assessment Act 1997, is that the trust must satisfy the controlling individual test. In the case of a unit trust, that test generally requires that an individual must have been beneficially entitled to at least 50% of the income and capital of the trust just before the CGT event, Where a unit trust is owned by one or more discretionary trusts, there will be no controlling individual even if more than 50% of the income and capital is distributed to a particular individual. Accordingly, none of the small business CGT concessions will be available. This is the view taken by the Australian Taxation Office in ATO Interpretative Decision ATO ID 2003/455. In contrast, the concessions will be available where an individual holds a controlling stake in the units in a unit trust.265

The TIA commented that the scenario raised by the ICAA above will also cause the

taxpayer to fail the CGT concession stakeholder test.266

The ICAA commented that as the purpose of Division 152 was to provide greater

flexibility in accessing the various CGT concessions and therefore, the concessions

would be more efficient.267 As mentioned in Section 3.4.1, it is not difficult to select a

structure that will provide asset protection and still meet all the requirements of the

controlling individual / CGT stakeholder test. It was established in Chapter Two that

many taxpayers will choose structures that will allow access to the concessions yet

would choose a different structure in the absense of Division 152. The submissions

made unanimous comment on this issue.




87

3.4.3 The Controlling Individual / CGT Stakeholder Test and Simplicity

The need to reduce complexity was a common theme of the submissions. The

interaction between all of the sections of Subdivision 152-A was found to be

confusing and complex. The submission from CPA Australia called for reduced

complexity:

If there is to be the aggregation of interests for net asset value test purposes, there ought also to be aggregation for the purposes of determining whether there is a controlling individual. Such inconsistency adds to the complexity of these rules.268

The submission by CPA Australia also addressed the complexities of the controlling

individual test and questioned the need for this test before offering some ideas for its

simplification:

As noted above, there is only the need for a controlling individual in some circumstances. This complicates these rules by differentiating between a sale of shares/units and other active assets, and then complicates them further by requiring a controlling individual under (only) the 15-year asset and retirement exemptions. Among other things, the outcomes which arise from the application of the ‘controlling individual’ test seem to be clearly inequitable and at odds with the primary purpose of the small business CGT concessions. We query whether this test (i.e. the need for there to be a controlling individual) is essential. In the event, however, that the controlling individual test is retained, it is our view that the percentage required to have a controlling individual be reduced from 50% to 40%. This reduction would ensure consistency within the Division 152 provisions. As the connected entity test states that a control percentage will be 40%, it is our view that the controlling individual test should utilise the same percentage.269

With particular reference to the complications associated with the controlling

individual / CGT stakeholder test, the submission from CPA Australia noted:

268 CPA, above n 237

269 Ibid.

88

As Division 152 stands at present, it is quite conceivable that the cost of specialist tax advice could exceed the apparent tax saving in some circumstances. This is clearly inappropriate on an on-going basis.270

The ACCI simply stated the controlling individual test was complex and unclear271

while the ICAA reasoned that inconsistency had added to the complexity:

where the CGT asset disposed of is a share in a company or an interest in a trust, there is an additional basic condition that the company or trust satisfies the controlling individual test. As discussed in Section 1 of this submission, this test has resulted in the non-accessibility of the small business CGT concessions in the context of many commonly used structures…. This lack of consistency has increased the complexity of the provisions as well as the compliance costs involved in determining when the various concessions will be available.272

In summary, the controlling individual test / CGT stakeholder test has so many

inconsistencies in its application that they surely cannot be the result of policy intent.

The calls to redress the exclusion of many taxpayers using common business

structures from access to the small business CGT concessions clearly demonstrates

the need to revisit the requirements of this test.

3.5 Recommendations made in submissions

This thesis will now review the recommendations for changes to Subdivision 152-A

that were submitted to the Board of Taxation. These recommendations will be

synthesised in Chapter Five so as to provide insight for a suggested redraft of the

Subdivision. By combining the finding of the submissions with the lessons learnt

from the UK legislators in their 40 years of CGT experience, this thesis will

implement a rational, logical and impartial process for developing the necessary

changes that should be considered for improved access to the small business CGT

concessions. 270 Ibid.

271 ACCI, above n 244

272 ICAA, above n 233

89

3.5.1 The maximum net asset test

Table 3.1 - Issues addressed by submissions

Submission

$5m Threshold

not indexed

Connected entity test

flawed

STS potential

model

Common business structure problems

Main residence

issues Other

ACCI X X X

CPA X X X X X

ICAA X X X X

NFF X X X

TA X X X X

TIA X X X X Note: X in box indicates that the issue was addressed in the submission.

Table 3.1 reflects the problematic areas as indicated by the submissions to the Board

of Taxation. All submissions recommended modifications to the maximum net asset

test and suggested the indexation or revaluation of the $5 million threshold. Specific

recommendations included:

• the threshold should be increased and indexed to maintain real value;273

• the threshold is too low given increases in property values since 1999;274

• the threshold should be indexed with the consumer price index (CPI).275

Four of the six submissions made comment on commonly used business structures not

having access to the concessions and requested that this be amended. The ICAA

requested that ‘the concessions needed to be improved by extending the availability of

the concession to various common structures’.276 CPA Australia requested that

273 Ibid.




90

‘Division 152 provisions be appropriately amended to address the inability of many

small business operators to access the various concessions’ that result from the current

complex legislation and poor tax advice to taxpayers by advisors.277

Three of the six submissions addressed the main residence exemption and the effect

that this has on Division 152 and the maximum net asset test. The ICAA explained:

when working out the net value of the CGT assets of an individual, subparagraph 152- 20(2)(b)(ii) allows the main residence of the individual, or the individual's ownership interest in a main residence, to be disregarded provided the main residence is not used, to any extent, for income producing purposes. However, if there is any income producing use, the entire market value of the main residence is taken into account albeit less any related liabilities, e.g., a mortgage is included in the calculation of the net value of the CGT assets. It is submitted that only the market value of that part of the main residence that was actually used to produce income should be included in that calculation. Arguably the policy of the small business CGT concessions would not have been to take into account the entire market value of a main residence that was only partly used to produce income. Given the significant increases in property prices in recent years, minor income-producing use of a main residence could result in an unintended consequence of a substantive nature being the failure of the maximum net asset value test by a growing number of taxpayers.278

Recommendations were made by various submissions which were unique to each

stakeholder. For example, TA requested that:

• the ATO issue guidelines on how a small business is to value its assets when

considering the maximum net asset test;

• address the uncertainty with respect to cash amounts being counted in the

maximum net asset test; and

• allow a trace through of beneficial ownership to allow many common business

structures access to the concessions. 279




91

In summary, common themes appeared in all of the submissions and there was no

shortage of suggestions to address the current legislative complexities and problems

contained in the maximum net asset test. It has been noted that only one of the

submissions280 looked to other legislative models to find a solution to the complexities

that lie within this test.

3.5.2 The Active asset test

Table 3.2 - Issues addressed by submissions

Submission Cash balances

Deceased estates

Sale of business

Lump sum

payments

Simplified definition

Active asset test

broadened

ACCI

CPA X X

ICAA X X X

NFF X

TA X

TIA X X X Note: X in box indicates that the issue was addressed in the submission.

Table 3.2 reflects the problematic areas as indicated by the submissions to the Board

of Taxation. While the active asset test is seen to need some simplification, it has

attracted far less criticism than the maximum net asset test.

The TA submission considered the new test for discretionary trusts contained in

Section 152-40 of the ITAA 1997. The test as originally enacted was discussed in


92

Section 2.6.2 of this thesis but the new test which is now in force is not problem free.

TA commented:

An active asset is an asset that is used in the course of carrying on a business. An active asset includes an asset that is used by an entity that is connected with the entity. An entity is connected with a discretionary trust if the discretionary trust has previously distributed to that entity more than 40% of the income or capital distributed by the trustee for that particular income year in any of the past four income years. Accordingly, where an associated entity uses an asset held by a discretionary trust in its business but the trustee of the discretionary trust did not make a distribution to the associated entity in any of the previous four income years just before the disposal of the asset, the asset will not be considered to be an active asset. This is on the basis that the associated entity is not treated as a connected entity of the discretionary trust. As a result, the discretionary trust will not be able to access the small business COT concessions in respect of the asset disposed of. Recommendation The meaning of ‘active assets’ to be broadened to include assets used by an associate (as defined under section 318 of ITAA 1936) in the course of carrying on a business. 281

The NFF called for the active asset test to be simplified and for greater certainty with

respect to this test.282 The ACCI submission commented:

There are various problems with the definition of active assets (relating to cash, contingent claims, shares and deceased estates). The requirement that assets be active at the time of sale is onerous and too restrictive. Rulings on the concessions should be made soon.283

The TIA suggested that intellectual property and in house software be considered as

active assets as :

The proceeds on disposal of items of intellectual property and in-house software are not brought to tax under the CGT provisions. Rather, they are taxed as the disposal of depreciating assets under the capital allowance provisions of Division 40 of the 1997 Act. These are often critical business assets having been developed by the vendor, with no taxation relief upon disposal, where the policy behind the CGT concessions would suggest that there should be such relief. 284

This thesis will suggest adjustments to the active asset test in Chapter Five.

281 TA, above n 256




93

3.5.3 The Controlling Individual / CGT Stakeholder Test

Submissions from the NFF, TIA and the ACCI made no recommendation for changes

to the controlling individual / CGT stakeholder test. However, CPA Australia called

for the test to be removed entirely:

Among other things, the outcomes which arise from the application of the controlling individual test seem to be clearly inequitable and at odds with the primary purpose of the small business CGT concessions. A common example is where a company with three (3) equal owners is at an unfair disadvantage compared to a business with, say, a 60% majority owner and two (2) other minority owners. There are many cases where a small private company has a number of shareholders who have combined their capital and expertise to form a viable business. It is unjust that these businesses should be denied access to the small business concessions on the basis that they do not have a controlling individual. We question the need for a controlling individual test and recommend that this requirement be removed.285

The ICAA described inconsistencies with the controlling individual test:

It is not uncommon for a business to be carried on through a unit trust that has three or more equal unit holders. If units in the unit trust are sold, the concessions will not be available because the controlling individual test is not passed as required by subsection 152-10(2). However, if the business was carried on in a partnership, there is no effective restriction on the number of partners. That is, the controlling individual test is not applied when a partnership interest is disposed of. Furthermore, a partnership of discretionary trusts could access the concessions…… The controlling individual test must also be passed before the concessions are available in respect of a disposal of shares in a company that has more than two shareholders……The lack of consistency has increased the complexity of the provisions as well as the compliance costs involved in determining when the concessions will be available.286

The TA submission considered the controlling individual / CGT stakeholder tests with

respect to complex business structures including the use of interposed entities.287 It

suggested a trace-through approach so that the taxpayer who effectively owns a

business through an interposed entity can claim relief under Division 152.288



287 An interposed entity is an entity (for example company or trust) that sits between the taxpayer and the assets of that entity of

which the taxpayer is the ultimate owner.


94

The submissions raised clear issues with the controlling individual / CGT stakeholder

test and changes were suggested. Removal of this test would make the concessions

available to many taxpayers who presently miss out for no substantial reason apart

from their past choice of business structure. Removal of this test would considerably

reduce the complexity of Subdivision 152-A and improve equity and efficiency.

3.6 Summary

The purpose of this chapter has been to consider the publicly available submissions

made to the Board of Taxation in its review of Division 152289 with a view to

evaluating Subdivision 152-A against the criteria of equity, efficiency and simplicity.

The submissions have expressed concerns with all of the tests discussed in Chapter

Three and many have provided possible solutions the problematic areas, thereby

shedding light on the options available to re-draft the Subdivision.

The submissions have clearly called for changes to the maximum net asset test with

many alternatives being suggested. A ‘patch job’ change to this test would be an

inappropriate. The test clearly needs to be reformulated based on the lessons of

accumulated experience. With the many alternate versions of ‘small business’ that lie

within the ITAA itself, surely an existing definition could be applied to solve the

problem. As discussed in Section 3.2.1, the Simplified Tax System is an existing

piece of legislation that could be potentially used or adapted to address the problems

and issues of the maximum net asset test. In Chapter Five, this thesis will consider the

proposal put forward by the NFF.

289 Board of Taxation, above n 226.

95

With regard to the active asset test, while the submissions clearly requested change,

relatively minor amendment would be required for this test to meet the criteria of

equity, efficiency and simplicity.

Of all the tests contained in Subdivision 152-A, it was the controlling individual /

CGT stakeholder test that was described in one submission as ‘clearly inequitable and

at odds with the primary purpose of the small business CGT concessions’.290 Removal

of this test would result in the concessions being made available to common business

structures, thereby negating the need for many taxpayers to restructure their business

entities to qualify for the concessions. Most importantly, as discussed in Section 3.5,

the removal of this test would assist Subdivision 152-A to meet the criteria of equity,

efficiency and simplicity.

The review of the small business CGT concessions by the Board of Taxation has

attracted submissions that have provided valuable assistance in analysing and

critiquing Subdivision 152-A.

In Chapter Four this thesis will consider the CGT concessions for business in the UK.

Further issues may thereby be identified that have not been considered in this Chapter,

providing a wider range of options to consider for the proposed re-draft of the

legislation in Chapter Five.


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CHAPTER FOUR

CGT BUSINESS CONCESSIONS IN THE UK

4.1 Introduction

Chapter One has indicated that CGT business concessions also exist in the UK. The

CGT regime of the UK will be examined with respect to policy, statistical data and

historical evidence so as to provide guidance. Comparison with the current Australian

small business CGT provisions will provide a basis for consideration of policy

recommendations to Sub-division 152-A in Chapter Five.

Chapter Two examined suitable criteria for evaluating an effective tax system and

reviewed literature that analysed the Australian CGT regime. In this literature,

argument for and against the taxing of capital gains is consistently organised around

the traditional tax criteria of equity, economic efficiency and simplicity. It has been

established in Chapter Two that the OECD, IMF and many governments consider

equity, efficiency and simplicity when evaluating taxation systems and therefore the

UK CGT regime will be considered in the light of these same criteria.

The UK regime has been chosen as the country for comparison as the Australian

regime is fundamentally based on that of the UK.291 Other jurisdictions considered

were South Africa, Ireland and Canada but these were rejected as they did not offer a

major contribution for change. For example, while South Africa has CGT concessions

for small business, their CGT system is relatively new and their concessions are now

too similar to those of Australia. Useful points of comparison may develop over the

coming years.


97

As mentioned in Section 1.7, within the framework of Wade,292 this thesis will use a

comparative method as discussed by Zweigert and Kotz.293 The comparatist wants to

find in a foreign system the rules which are functionally equivalent to those which are

of interest in their native law. Given this charter, Section 4.2 will discuss the

development of the UK CGT regime since its introduction in the 1960s. Section 4.3

will contain an analysis of Inland Revenue statistics that will put the UK CGT in

context. Section 4.4 will discuss the CGT provisions as contained in the Taxation of

Chargeable Gains Act 1992. This section will provide a general overview of the

legislation and its operation. Section 4.5 will introduce the CGT concessions for

business in the UK. Section 4.6 and Section 4.7 will then provide details of taper

relief and retirement relief respectively, including key aspects of their operation and

the policy that may be relevant for the Australian redraft.

4.2 Development of CGT in the UK

Australia and the UK are members of the Organisation for Economic Co-operation

and Development (OECD). In both countries CGT is a relatively small portion of the

taxation mix and both countries give favourable tax treatment to capital gains. In

general terms there is little uniformity in the treatment of capital gains across OECD

countries, except that it appears to be light in its contribution to the tax mix.294 Both

countries have amended their CGT regimes over a number of years in attempts to

improve the model. The introduction and subsequent withdrawal of indexation in both

countries provide examples of this.

292 Wade, above n 52.

293 Zweigeret and Kotz, above n 55.

294 Thomas Dalsgaard, ‘The Tax System in New Zealand: An appraisal and option for change’ (Working Paper No 281, OECD

Economics Department, 2001).

98

The UK CGT regime commenced in the 1960s, over twenty years before CGT was

introduced into Australia. A short-term CGT was introduced in the UK in 1962.295 Its

scope was limited to short-term gains arising within 6 months of an acquisition of an

asset or three years in the case of real property. In 1965 the law was amended to tax

short-term gains on all assets arising within 12 months and a long-term CGT was

introduced, charged at a rate of 30%, and was separate from the existing income

tax.296 There were various reliefs for small disposals and small gains.

In 1971, the Government amended the Finance Act and abolished the charge to CGT

on death.297 The Act introduced an exemption from tax where disposals of an

individual did not exceed £500 in one year.298 The next major amendment to the

Finance Act occurred in 1978. This legislation was devoted to introducing relieving

provisions to small business namely ‘hold-over relief’ for gifts of business assets and

agricultural land, including shares in family companies.299 In 1978 a CGT tax-free

threshold was introduced, and a reduced rate of 15% on gains by individuals between

£1,000 and £5,000, with tapering relief available for gains up to £9,500.300 The UK

legislation expanded from 27 sections in 1965 to 160 sections in 1979.

A 1982 amendment provided for indexation of the annual exempt amount and for an

indexation allowance against gains, calculated by reference to the market value of the

asset at 31 March 1982, and increases in the retail price index after that date.301

295 Finance Act 1962 (UK) Sections 10-16.

296 Finance Act 1965 (UK) Sections 17 & 18.

297 Finance Act 1971 (UK) Section 59.


299 Finance Bill 1978 (UK) Clause 37.



99

Initially, no indexation was given in respect of the first 12 months of ownership even

if the asset was held for a longer period. However, the Finance Act 1985 permitted

indexation to commence from the time at which the expenditure was incurred.302

Following major reductions in income tax rates, income and CGT tax rates were

aligned in 1988 so that capital gains were effectively taxed at marginal rates.303

Thereafter, capital gains were, in broad terms, after deducting allowances and reliefs,

taxed at the top marginal rate.

In 1998, changes were implemented that froze indexation of the cost base.304 A

system of taper relief305 was introduced that tapered chargeable gains according to the

length of time held since 5 April 1998.306 The taper was more generous for business

assets than for non-business assets.

In 2000 business asset taper relief was accelerated to mature after four years instead

of ten years and the definition of business assets was extended.307 In 2002 the

business asset taper relief was further accelerated to mature after two years instead of

four.308 In 2004 the definition of business assets was again extended to cover all assets

used for an individual’s trade irrespective of whether the owner is involved in




305 Taper relief is a concession that reduces a capital gain. The longer the asset is held, the greater the relief.


307 Finance Act 2000 (UK) Sections 66 and 67.


100

carrying on the trade concerned.309 Business reliefs will be discussed later in this

chapter.

4.3 Statistical overview of CGT in the UK

Every year the Office of Inland Revenue publishes National Statistics which provide

useful background information for this thesis. The latest statistics available for

Australia at the time of writing this thesis were for the 2001-02 year.

According to HM Revenue and Customs,310 during the 2001-02 financial year there

were 124,000 taxable individuals and 17,000 taxable trustees with net capital gains

totalling £5.4 billion. Total capital gains tax payable for these entities was estimated

to be £1.6 billion during this period.311 CGT comprised less than three percent of

income tax receipts collected by the Office of Inland Revenue in 2002-03.312

In the UK in 2001-02, taxpayers liable to income tax numbered 28.6 million, but only

141,000 were liable to pay CGT.313 The small percentage is due to the fact that many

taxpayers are not exposed to CGT owing to the annual exempt amount which for the

2001-02 year was £7,500. The provisional figures for that year indicated that 125,000

taxpayers made gains of less than £25,000, including 104,000 with gains of less than

£10,000.314 Typically, while taxpayers of all income ranges recorded capital gains, the

largest gains were made by taxpayers earning higher incomes.315 As in previous years,


310 National Statistics (2006) HM Revenue & Customs <http://www.hmrc.gov.uk/stats/> at 20 July 2006.

311 Ibid, Capital gains tax - Table 14.1.

312 Ibid, Tax receipts and taxpayers - Table 1.2.

313 Ibid, Tax receipts and taxpayers - Table 1.4.



101

the small percentage of the population who paid CGT contributed just a small amount

to the taxation base.

The UK Tax Expenditures Statement provides details of concessions, benefits and

incentives delivered to taxpayers through the tax system.316 This report shows the cost

to the Government for allowing the concessions. The largest tax expenditure is the

‘personal allowance’ which is essentially a yearly exemption amount for most

taxpayers. This is estimated to cost £38.2 billion in the 2005-06 year. The main

residence exemption is estimated to be £12.5billion in the 2005-06 year while taper

relief is estimated to cost £4.5billion. The UK Government did not release estimates

with respect to the cost of small business CGT relief.

4.4 An overview of UK CGT Legislation

The UK Capital Gains Tax concessions are contained in the Taxation of Chargeable

Gains Act 1992 (TCGA92). CGT is charged on gains realised on the disposal of assets

by individuals, personal representatives and trustees.317 Corporation tax is charged on

the capital gains of companies.

For CGT purposes, the disposal of an asset includes any occasion when the beneficial

ownership of part or all of an asset is transferred from one person to another (although

most transfers between husband and wife are treated as giving rise to neither gain nor

loss).318 Types of disposal include sales, gifts, exchanges or generally when the owner

316 Ibid, Tax expenditures and ready reckoners - Table 1.5.

317 Taxation of Chargeable Gains Act 1992 (UK) Section 1(1)

318 Taxation of Chargeable Gains Act 1992 (UK) Section 22(1).

102

of an asset derives a capital sum from it, but the death of an individual is not treated

as a disposal.

The capital gain is broadly calculated as the difference between acquisition costs and

disposal proceeds. In some circumstances the market value of the asset at the time of

acquisition or disposal is used. Expenditure which has increased the asset value may

be deducted, as may the incidental costs of acquisition/disposal. There are various

reliefs and exemptions which may reduce the amount of CGT to be paid. For

example, there is normally no CGT liability on the disposal of a taxpayer’s main

residence.319

Capital losses may be deducted from gains chargeable in the tax year in which the

losses are incurred or if these gains are insufficient, the unused losses may be carried

forward to be deducted from gains in later tax years. Capital losses may be carried

back to earlier tax years in only very limited circumstances.320 The current CGT

system generally only taxes gains that have arisen since March 1982, with relief for

inflation up to April 1998321 and taper relief after that date. Chargeable gains, after

reliefs, are taxed at rates equivalent to an individual’s marginal income tax rate as if

they were an additional amount of taxable income.322 Taper relief can potentially

reduce the amount of CGT by reference to the type of asset (business or non-business)

and the length of time the asset is held. 323

319 Taxation of Chargeable Gains Act 1992 (UK) Section 222.


321 Taxation of Chargeable Gains Act 1992 (UK) Sections 35 and 53.


323 Taxation of Chargeable Gains Act 1992 (UK) Section 2A.

103

4.5 CGT Business Concessions in the UK

Like many countries the UK taxes capital gains on a preferential basis. For example,

when assets are disposed of for a gain but the proceeds are utilised in the purchase of

new assets for employment in business, relief from CGT is provided.324 Individual

taxpayers carrying on a business who decide to incorporate are similarly entitled to

relief.325 Such a form of ‘rollover’ relief is very similar to the Australian experience.

However, there are some notable differences. Concessions directed solely at small

business are not a feature of the UK CGT regime. Concessions are available to all

businesses regardless of size. Yet the percentage of CGT in the tax mix is roughly two

percent in both countries. The main CGT concessions available to UK businesses are

taper relief and the retirement exemption. These concessions will now be discussed.

4.6 Taper Relief

Taper relief reduces chargeable gains occurring on or after 6 April 1998.326 The relief

is given after all other reliefs and allowable losses. The amount of the reduction

depends on how long the asset was held and whether the asset is business or non

business. According to Evans:327

The Review of Business Taxation in Australia acknowledges that this measure would assist business ... proponents also see it as a crude adjustment to ameliorate tax on the illusory gains caused by inflation. It is a means of overcoming the problem of the gain being wholly attributed to the one year of realization. The purpose of the 1998 reform is to promote enterprise, to reward risk taking and to encourage long term investment.328

324 P Whiteman, Capital Gains Tax (4th ed, 1998) 332.


326 Finance Bill 1998 (UK) Section 119.


328 UK, Parliamentary Debates, House of Commons, 29 April 1998, 371 (Dawn Primarolo).

104

The UK Government considered a taper relief several times before its introduction in

1998. In the late 1970s inflation rose to over 25% a year in the UK.329 In October

1977 the Inland Revenue issued for comment and discussion a note that examined the

administrative aspects of tapering, indexation and other schemes that addressed

inflation.330 On that occasion indexation was considered the better alternative. When

taper relief was introduced in 1998 the stated policy aim was to encourage a long-term

view on holding investments.331 The taper relief signalled the withdrawal of complex

CGT features, chief among those being the indexation allowance.332

According to the Finance Act 1998, the chargeable gain is reduced according to the

length of the period held with preferential treatment for business assets.333 For

business assets, the chargeable gain is reduced 7.5% for every 12 months held with a

maximum reduction of 75% after 10 years.334 A higher-rate taxpayer can potentially

reduce chargeable gains to 10% in respect of business assets. The taper is applied

after allowance for capital losses.335

The UK Government debated the complexity of taper relief in 1999. It was contended

on the parliament floor that:

For ordinary taxpayers, there are three rates on earned income 10, 23 and 40 per cent. For dividend tax, we have 10 and 32.5 per cent. For capital and savings, we have 20 and 40 per cent. For trust income, we have 20, 23 and 34 per cent. For those receiving children's tax credit in the years to come, there will be a tapered tax rate and, at some stage, people will be paying a tax rate of 46.7 per cent. That is before we get to the many rates that have been introduced with the CGT taper relief. The number of rates has gone up, and that is

329 Barry Bracewell-Milnes, United Kingdom Capital Gains Tax – Indexation v Taper Relief (1978).

330 Ibid.


332 Ibid 371.




105

why we propose that the Government say, when they introduce their Budget report, how many allowances, rates and reliefs there are as a result of the Budget. Complexity comes not only from policy changes, but from the administrative detail, regulations and rules that come from the tax authorities, be it the Inland Revenue or Customs and Excise. Those are the root of the compliance costs for business. A business man, even someone employing only one or two people must read all the information and regulations to ensure that he complies. Also, he must understand them--and that can take some doing. This is not just a one-off exercise. Employers must keep up to date because the tax law is forever changing. For small businesses, huge compliance costs are involved.336

The policy changed in 2000 to ‘encourage wider share ownership amongst employees

and provide strong incentives to outside investors, so called business angel investors

to invest in unlisted trading companies … the changes were intended to provide a

significant boost to overall productivity in trading companies’.337 Business Angels338

are an important source of income for small business. Estimates suggest that between

£500 million and £1 billion per annum is invested in around 3000 to 6000 small

businesses.339 The overwhelming majority of angels contribute less than £250,000.340

The Finance Act 2000 introduced a number of reforms to CGT taper relief. The most

significant alterations made to taper relief were to the definition of business assets and

the acceleration of the relief for business assets.341 Section 66 of the Finance Act

accelerated the rate of business taper to four years rather than ten. The bonus year for

business assets which had been acquired before 17 March 1998 was abolished.342

336 UK, Parliamentary Debates, House of Commons, 5 July 1999, 782 (Edward Davey).

337 HM Treasury explanatory notes in 2000.

338 The enterprise investment scheme helps new small companies to access money, contacts and management skills.

339Finding the money to develop your business , (2006) Alexander Sloan Chartered Accountants

<http://www.alexandersloan.co.uk/newsletter/business_matters_spring_2004/develop.html> at 10 June 2006.

340 Ibid.


342 Assets acquired before 17 March 1998 qualified for a bonus year to be added to the ownership period after 5 April 1998.

106

The complexity of taper relief again reached the parliament floor and Mr Edward

Davey343 made the following comments:

Two years ago, long-termism meant taper relief of 10 years. In the pre-Budget report in November 1999, the Government proposed taper relief of five years. Moving on from a CGT regime to promote long-termism, they are now saying that there should be taper relief for only four years. As a result of these changes we have inconsistency and complexity. That is bad tax legislation. 344

The pre-budget report known as the fifth report stated the following concerns:

On matters of detail, the current thresholds for qualification as a business asset were criticised as excessively high, inflexible and potentially perverse in their effect. The 5 per cent threshold for employees was described as discriminatory: Mr Perry of the CBI told us that "we cannot see why there should be any threshold at all". The 25 per cent for others, apparently a threshold inherited from the retirement relief regime, was described as too high to be of benefit to business angels, who typically hold only around 5 or 10 per cent of a company's equity. There is also concern at the limited nature of rollover relief for those selling their shares and reinvesting the proceeds in other companies. The CBI told us that the system did not encourage "serial investors in start-ups to sell on their stake to more mature venture capitalists and then re-invest in new enterprises"….There is evidently a strong case for lowering the thresholds for qualification for the more generous CGT taper for "business assets", in particular for employees. 345

In answer to public criticism which is discussed in below at 4.6.2, in 2001 the UK

Government took submissions from interested bodies with respect to CGT and its

simplification. 346 Taper relief was by far the single biggest issue raised. Of the 24

submissions received, 21 focused on taper relief. Riches made his summation as

follows:

It can therefore be seen that whatever the Governments stated intentions of simplifying the capital gains tax regime and providing comprehensible incentives to business, the nature of the legislation results in a rather different position. The taper relief legislation contains a large number of overly restrictive definitions or extremely wide ranging anti-avoidance provisions. The apportionment rules are sufficiently complex to cause many practical problems with their application and will require extensive spreadsheet analysis to calculate the optimum timing of disposals. The uncertainties over the definition of “trading company” and “holding company of trading group” will create difficulties. 347

343 Mr Edward Davey was the deputy in Treasury for the Liberal Democrats.

344 UK, Parliamentary Debates, House of Commons, 17 April 2000, 744 (Edward Davey).

345 Trade and industry - fifth report, House of Commons (2006) para 14

346 HM Treasury.

347 J Riches, Changing the landscape: Revised Taper Relief (2001) 134.

107

In 2001 the definition of ‘business asset’ in relation to interests in trading companies

was widened. Employees disposing of shares in non-trading companies in which they

worked had previously been entitled to relief as long as they did not have a material

interest in the company (i.e. < 10%).348 Changes in the Finance Act 2001 brought

relaxed qualifying conditions which meant that employees of investment companies

could obtain the same tax relief as employees of trading companies. The definition of

a trading company was problematic.349 Before 6 April 2000, shares and securities only

qualified for relief where the taxpayer could exercise at least 25% of the voting rights

in the trading company or where the individual worked full-time and exercised 5% of

the voting rights. There was no distinction between listed and unlisted companies. The

Paymaster General commented:

Two principles govern access to the more generous business assets rate of capital gains tax taper relief. The first is to encourage desirable investment by compensating for risk in, for example, unlisted trading companies. The second is to encourage employees to align their interests, so to speak, with those of the company for which they work, through share ownership…The changes that the Government made last year provided real and positive encouragement to entrepreneurial investment and greater employee share ownership. Our aim is to provide the right conditions to boost productive business activity. 350

The Finance Act 2002 modified the taper to mature after two years rather than four.

According to Treasury, ‘The reduction in the length of the taper is intended to provide

an increased incentive for successful entrepreneurs to invest in successive businesses.

It is also intended to encourage more general investment by individuals in business

assets, particularly in new and growing companies for which equity investments are a

vital source of capital’.351 Other measures introduced included changes to definitions

of holding companies and trading companies and the inclusion of certain debentures

in the meaning of business assets. The Finance Bill 2002 stated that ‘these 348 Finance Bill 2001 (UK) Schedule 26.

349 UK, Parliamentary Debates, House of Commons, 3 May 2001, Finance Bill in Standing Committee A (Mr Howard Flight)

350 Ibid.


108

amendments were designed to tackle the problem of enveloping assets, where a

person obtains additional taper relief by arranging that an asset which has been held

for a short time is held by a company the shares in which have been held longer than

the asset in question. The disposal of the asset is effected by disposing of the shares

with the consequence of a greater amount of taper relief’.352

In 2004 the definition of business asset was again extended to cover all assets used for

business purposes irrespective of whether the owner is involved in carrying on the

trade concerned. The following shareholdings qualify for business asset taper relief:

• all shares and securities in unlisted trading companies;

• shares and securities in listed trading companies where the taxpayer is an

employee or an officer;

• shares and securities in listed trading companies were the taxpayer is an

individual or trustee who is able to exercise at least 5% of the voting rights in

the company; and

• All shares and securities in an unlisted or listed non-trading company where

the taxpayer is an employee.

According to the explanatory notes of the Finance Bill 2003, the changes relaxed the

conditions that determined whether business assets qualified for taper relief.353 The

main effect was that assets used for the purposes of trade carried on by individuals,

trustees of settlements, personal representatives or certain partnerships, would qualify

as business assets irrespective of whether the owner of the asset is involved in the


353 Finance Bill 2003 (UK) Clause 159 Explanatory Memorandum.

109

trade concerned. This assisted landlords who rented commercial property to taxpayers

carrying on trading activities.354

4.6.1 Literature on Taper relief

There has been much discussion and debate about taper relief in the UK. While some

articles do little more than restate the legislation and discuss its operations, this

section will discuss articles which analyse the exemption and its interpretation.

The problem areas associated with taper relief are not only recognised by

parliamentarians but are also acknowledged by academics and practitioners alike. As

mentioned previously, taper relief was introduced in 1998. Gunn commented:

I predict that the new tapered tax will come to be held in even greater contempt by Mr and Mrs United Kingdom. It is arbitrary and lacking in intellectual reasoning. It is a weird concoction of dissonant ideas with occasional unbelievable results …The idea of fairness should be reinterpreted as ‘political necessity’. No-one disputes that short term gains should pay some tax, if only to protect income avoidance mechanisms, but taxes on long term gains tend to be regarded as a deterrent to savings, which seams to contradict other Government objectives.355

The controversy of the introduction of taper relief was widespread. It represented a

major overhaul of the CGT regime. The consultation process involved in developing

the new legislation revealed widely different views and contributed little to the new

legislation. 356 Those who called for taper relief had hoped the model adopted would

follow other European countries like Portugal.357 Chamberlain argued that many

complications exist including the definition of business assets, the potential unfairness

for businesses using rollover relief and the treatment of loss situations to name a few.

However, Chamberlain did not agree that the changes had achieved simplification:


355 M Gunn, ‘Short Sharp Shock? An overview of the new capital gains tax taper relief’ (1998) 141 Taxation 271.

356 E Chamberlain, ‘Chargeable gains – sections 120 to 126 and 140 to 141’ (1998) 5 British Tax Review 471.

357 Portugal had a taper period of just 12 months.

110

The Government has argued that tapering relief and the other changes represent a simplification of the CGT regime. It is hard to see how this can be the case since for the foreseeable future we now have to contend with indexation, retirement relief and tapering relief…The loss relief provisions will result in greater compliance costs. 358

Kevin Slevin, a chartered tax advisor discussed the complexity of the legislation and

wrote with regard to taper relief:359

there is the age-old problem of the Government announcing a new relief, but being so concerned that taxpayers will exploit it for tax avoidance purposes that the Parliamentary draftsman makes the legislation inpenetrable…If you want an indication of how complex this subject really is, and how it needs to be checked and checked again, here's a short history lesson. Taper relief was introduced in 1998 …. It was not long before the Institute of Chartered Accountants in England and Wales was lobbying the Government to take radical action to overhaul the new measure calling for swift action before the anomalies and distortions which were emerging became serious problems… Taper relief was revised in 1999, 2000, 2001 and 2002. Just to remind you, in the 2002 Budget the maximum rate of taper relief became available after business assets had been held for two years, not four years as before. The new provision applies to disposals made on or after 6th April 2002, not just to disposal of assets held for more than two years after that date. So is that it? I doubt it - in fact I would be most surprised if the annual round of changes was interrupted in 2003. Why? Because taper relief has introduced many new complications to a personal and trust capital gains tax regime that is already extremely complex.360

The British Venture Capital Association (BVCA),361 a group that represents investors

and entrepreneurs commented:

Since the introduction of the tapering relief legislation, there have continued to be a number of anomalies in the detailed rules which we would like to see addressed. The BVCA has in the past proposed that a simple flat rate of capital gains tax would be desirable but appreciates that the introduction of such a change is unlikely in the current climate. As an easily implemented interim measure, we would propose instead a further simplification of the taper relief rules. This would involve a simple two-tier system for both business and non-business assets such that gains on assets held for less than one year would be fully taxable, but gains on assets held for more than one year would bear tax at an effective 10% rate for business assets and 20% for non-business assets.

358 E Chamberlain, above n 356.

359 Kevin Slevin began his tax career with the Inland Revenue and is now a prominent UK tax consultant. He writes regularly

for Taxation Magazine and has published a number of books on taxation issues and lectures throughout the UK on tax planning.

360 Kevin Slevin, Have you got taper relief taped? (2005) <http://solomonhare.co.uk/solomonhare/pressoffice> at 31 July 2005.

361 The BVCA represents the majority of UK-based private equity and venture capital firms.

111

This would be a considerable relaxation in the rules for taxation of gains arising on non-business assets. However, it would operate to the benefit of growing businesses in the UK, by reducing the tax payable by private investors on such shares. The Government would therefore be encouraging a far wider population of private investors to invest in the shares of growing companies which do not meet the business asset tests. This would provide a boost to the market for the shares of such companies and assist their capital raising efforts.362

As mentioned previously, when the increased rates of business asset taper relief were

introduced, much has hinged on whether a particular security would qualify as a

business asset. The Chartered Institute of Taxation (CIOT) was disappointed with the

Revenue’s interpretation of the legislation and described the taper relief rules as

having no discernible policy reason on this issue.363 Simon McKie, chairman of the

CIOT Capital Taxes sub-committee, made this comment regarding the haphazard

development of the regime:

We believe that it is an accident of the interaction of many complex rules, introduced and amended frequently over a long period of time, many having no direct connection with the new regime for capital gains tax first introduced in 1998. As the CIOT has stated before, we believe that this regime was not fully thought through before it was enacted. What we are seeing now is the consequence of the resulting uncertain and unclear legislation. We do not think that this is helpful to businesses or acts as an incentive to enterprise.364

4.6.2 Cases on taper relief

There are a number cases on the issue of taper relief, but two recent cases will be

examined in this section which discuss contentious issues within the legislation and

the view taken by HM Inspector of Taxes. These cases have been chosen as they well

illustrate the complex issues in terms of interpretation of the legislation and the

differing viewpoints that occur.

362 Budget submission attachment (2004) BVCA <http://www.bvca.co.uk/publications/budget2004/> at 31 July 2005.

363 Simon McKie, Technical note - Capital Gains Tax Taper relief: meaning of security (2001) The Chartered Institute of

Taxation < http://www.tax.org.uk/showarticle.pl?id=236> at 1 August 2005.

364 Ibid.

112

The case of O'Sullivan v HM Inspector of Taxes (2004)365 provides an example of the

appropriate level of taper relief on the sale of an asset. In this case, for the year 1999-

2000, the taxpayer declared total chargeable gains exceeding £7,100 (the minimum

threshold) arising from the sale on 21 May 1999 of a single share in a close company

generating net proceeds of sale of £1,229,790. The share had originally been

purchased for £1. The net gain on sale was £1,229,788.58 after relief. To this a taper

rate of 85% (15% reduction) was applied, showing a taxable gain of £1,045,320.29.

This figure was entered into the appropriate boxes in the self-assessment return, and

the appropriate amount of tax shown due.

On 9 October 2001, the taxpayer submitted an amendment reducing the tax due. The

basis for the reduction was the assertion that the rate of relief for the capital gain

should have been stated as 75% not 15%, and that accordingly the amount of tax due

was significantly overstated.

The dispute was about the application of section 2A of the Taxation of Chargeable

Gains Act 1992 (taper relief) to an asset held for some time before the section came

into effect (5 April 1998). This case illustrates the sharp difference that can result by

tapering the gain from a disposal as compared to indexing the original acquisition

cost. If the old indexation provisions had applied, what we know as the purchase price

would have been indexed by 43%.366 Under taper relief, the holding period is

calculated as the period after 5 April 1998 for which the asset had been held at the

365 O'Sullivan v HM Inspector of Taxes [2004] EWHC 2130 (Ch)

366 In this case of little benefit as the purchase price was £1.

113

time of its disposal plus one year. The disposal took place on 21 May 1999. Only

whole years count so the period was two years, as the inspector argued.367

Clearly, the indexation method would not have been beneficial to the taxpayer in this

example but this case raises equity issues in terms of assets purchased many years

before 5 April 1998 (the introduction of taper relief) yet only receiving the benefit of

an asset held for a much shorter period.

In the case of Daniels v Revenue and Customs [2005]368 a capital gain qualified for

taper relief concessions and the taxpayer was further entitled to deferral relief for

reinvestments under the Enterprise Investment Scheme (EIS). The order in which the

two reliefs were applied produced a different taxation liability and this was the issue

of contention.

The taxpayer argued that the taper relief concessions should be applied before the EIS

reduction. The Revenue argued for the reverse order, resulting in a larger tax liability.

The courts found in favour of the Revenue noting that the ‘1992 Act was not ideal’

and that ‘It would be unsurprising if the result of the decision in this present appeal

were that the deferral relief in respect of the EIS available to taxpayers was less than

had been thought’.369

In conclusion, Evans surveyed practitioners in his study of the impact of tax design on

the operating costs of the UK CGT regime. Concern of UK practitioners about taper

367 Despite the fact that the asset had been held for more than 10 years.

368 Daniels v Revenue [2005] SpC 489/05

369 Ibid.

114

relief was evident with specific attention being given to the complexity of the CGT

legislation, the frequency of change of that legislation and the record keeping

requirements. Taper relief was considered to be a major driver of compliance costs.

Having considered the opinions of Practitioners, Treasury and Academics, Evans

summarised as follows:

It is fair to say that it is a policy that has lead to significant compliance and compliance cost problems. Neither practitioners nor revenue authorities are yet happy with the mechanics of the relief. Further, extensive change is likely……The Government has made it clear that a complete taper is not politically acceptable, and that the divide between business assets and other assets must be maintained. But these policy constraints militate against a simple and easily applied taper relief with the result that the professional tax bodies and practitioners will continuously be pushing for adhoc solutions to the compliance cost problem caused by taper relief. 370

Further analysis of taper relief will be discussed in Chapter Five.

4.7 Retirement Relief

Generally speaking, CGT concessions in the UK for business have been available to

businesses of all sizes. However, the ceiling or upper limit applied to retirement relief

effectively restricts the availability of this exemption to the small business sector.371

When introduced, the retirement relief legislation was contained in Section 34 of the

Finance Act 1965, and later consolidated as Section 124 of the Capital Gains Tax Act

1979. It has been developed by successive amendments, some giving statutory effect

to what had started as extra-statutory concessions. For disposals after 6 April 1985 the

old combination of legislation, concession and statements of practice was replaced by



115

a new code.372 Those provisions were amended by the Finance Act 1991 and have

now been consolidated as sections 163 and 164 of the Taxation of Chargeable Gains

Act 1992 and Schedule 6 thereto (with yet further amendments made by the Finance

Act 1996).

With respect to the early years of the retirement exemption, Evans commented:

pressure mounted in the UK in the 1970s and early 1980s for the inclusion of a CGT concession that would provide an exemption for business taxpayers who disposed of a business, or of business assets, in order to fund their retirement Equity considerations underpinned this pressure It was argued that business taxpayers who had ploughed their profits back into the business were disadvantaged (when they came to sell the business and retire, facing a large tax liability) in comparison to employees who were able to obtain tax concessions in respect of their pension contributions during their working lives. For business taxpayers, the value of the business represented their pension fund, To lose a large swathe of that fund to taxation at the point of retirement was, it was claimed, inequitable.373

The debate for small business concessions reached a high point in the late 1970s with

tax changes intended to benefit small businesses being introduced in Budgets from

1979 to 1988. The overall objective was within Government policy of encouraging

enterprise.374 In the 1984 and 1985 budget retirement relief was extended to landlords

enabling the taxpayer/owner of such properties to claim the same deductions as

traders and the retirement exemption amount was increased to £100,000.375 The relief

was given to an individual who had reached the age of 60 or who had retired from

pursuing his or her previous occupation below that age because of ill health.376 In the

case of certain disposals of assets the individual had to retire from the business

372 Finance Act 2000 (UK) Sections 69 and 70 and Schedule 20.


374 UK, Written answers, House of Commons, 27 April 1989, 595 (Norman Lamont).

<http://www.publications.parliament.uk/pa/cm/cmvo151.htm> at 10 June 2006.

375 Ibid

376 Finance Act 1985 (UK) Section 69(1).

116

concerned but was free to pursue some other occupation.377 The assets that qualified

for relief were as follows:

• The whole or part of a business whether carried on by a sole trader or

partnership;

• Assets used in business when disposed of within a permitted period of time

after the business had ceased;

• Shares in companies provided the company is a trading company or holding

company of a trading group and the individual was a full time director;

• Assets owned by the individual and used by him or her in employment other

than as a director of a family company;

• Assets owned by an individual but used for the purposes of a partnership or a

family owned company from which he or she is withdrawing; and

• Settled property comprising of shares in a family company or business assets

subject to certain conditions.

In 1987 the exemption amount was increased to £125,000 with radical changes in the

following year enabling a 50% discount for gains between £125,000 and £500,000.378

In his 1991 budget statement Mr Norman Lamont stated the policy intention:

In this country, there are 50,000 large companies paying the main rate of corporation tax, nearly 1 million other companies and 3 million unincorporated businesses, many of them very small, employing a handful of people at most. We should never forget those firms. My measures are designed to benefit businesses in each of those categories … one way in which we can help business men and women to reap the rewards of their efforts is to improve the relief available to them when they retire and have to realise the asset that they have created. That is why I propose to reduce the qualifying age for capital gains tax retirement relief from 60 to 55, and to raise the limits on it. From today, the first £150,000 of capital gains and half of the next £450,000 will be exempt from capital gains tax. This will be a powerful incentive to entrepreneurs to start new businesses.379

377 Finance Act 1985 (UK) Section 70(7).

378 Ibid.

379 UK, Parliamentary Debates, House of Commons, 19 March 1991, 169 (Norman Lamont).

117

Further development of policy was announced by Mr Lamont in 1993:

The current capital gains tax regime provides generous annual exemptions to those who make regular capital gains from trading in shares, but it is much less generous to the entrepreneur. Typically, he sells shares in his own company only once, so has only one year's annual exemption to set against gains built up by hard work over a lifetime. Thus, for every £100 taken out of the old company at the margin, he has only £60 to invest in a new one. It is hardly surprising that entrepreneurs complain that they are locked in by the CGT regime, and prevented from investing their talents elsewhere. For this reason, I propose in future to defer the payment of CGT for any entrepreneur whose gains from the sale of his own company are reinvested in another qualifying unquoted trading company, or companies. I know that this will be widely welcomed by the venture capital industry. I also propose to relax the conditions for CGT retirement relief by reducing the qualifying shareholding from 25 per cent to 5 per cent and to extend this relief to cover full-time employees as well as directors. These changes will cost £50 million in a full year. 380

In the same year, The Chancellor of the Exchequer Mr. Kenneth Clarke proposed the

following changes to CGT and policy rationale.

In 1991, we increased the capital gains tax relief for business people who sell up on retirement, by providing a complete exemption from capital gains tax on the first £150,000 of capital gains and a half exemption on the next £450,000. I now propose to increase those limits to £250,000 and £750,000 respectively. By rewarding those who have been successful in the past, that individual facing a capital gains charge should be able to defer the tax indefinitely by reinvesting those gains in an unquoted trading company.381

In the Finance Bill 1998, it was announced that retirement relief would be phased out

from 6 April 1999. The thresholds were to be reduced annually in equal stages from

the years 1999-2000 to 2002-03 so that the relief will cease to exist by 2003-04.

According to the explanatory memorandum, the changes were part of proposed wider

reforms of CGT. The legislative changes were to encourage long-term investment,

promote entrepreneurial activity and introduce a fairer tax system.382 The phasing out

of indexation and retirement relief and the replacement of these systems with taper

380 UK, Parliamentary Debates, House of Commons, 16 March 1993, 189 (Norman Lamont).

381 UK, Parliamentary Debates, House of Commons, 30 November 1993, 937 (Kenneth Clarke).


118

relief was designed to lead to simplification of the CGT system.383 The five year

phasing out period was considered reasonable by the Government, the purpose being

to balance complexity with equity.384

According to Dawn Primarolo:

The introduction of a more generous taper also removes the need for a separate exemption of a slice of business gains, which retirement relief currently provides for the over-50s. We have taken the opportunity to remove from the system a complex relief that has given rise to high compliance costs and much litigation. The relief will be phased out over a five-year period as the benefit of the taper builds up. The withdrawal of that relief is also part of a move toward a fairer tax system, in which everyone who realises a substantial gain will pay some tax at the reduced level under the taper. That is crucial to the Government's reforms. 385

More fundamental changes to the structure of CGT were proposed in the March 1998

budget. These reforms followed consultations on the taxation of capital gains as

announced in the July 1997 Budget. A total of 171 submissions were received of

which 75 were from representative bodies and 96 from individuals. The responses

were varied and contained many issues. An extract from Inland Press Release No 16

summarises the submissions:

A minority of submissions called for the abolition of capital gains tax. But other representations pointed out that this would not provide for a fair tax system, and would also encourage avoidance through the conversion of income into gains. It was commonly suggested that having a taper in place of indexation would favour long-term investment. Most who commented on the point thought that this would be a good thing, although there was also a view that it would not be desirable to use the tax system to influence behaviour in this way. Various forms of taper were suggested to reduce the taxable gain over time, with many wanting it to operate over a short period and to reduce the gain to zero. These suggestions did not, however, consider the effects that such a taper would have on the yield from capital gains tax. The Government's proposals respond to these views by abolishing indexation for non-corporate taxpayers for periods after April 1998 and by replacing it with a taper. The taper should both reward long-term investment and be simpler to operate than indexation.

383 UK, Written answers, House of Commons, 20 April 1998, 399 (Dawn Primarolo)

<http://www.publications.parliament.uk/pa/cm/cmhansrd.htm> at 10 June 2006.



119

It will not entail the significant compliance costs that would be caused by regularly rebasing the tax to meet the same objective. The proposal for the taper also reflects a general desire that the system of capital gains taxation should encourage enterprise. This is achieved by having a more generous taper for business assets. This taper will reduce the percentage of the gain that is chargeable to 25 per cent (for assets held for 10 years or more), which is equivalent to a reduction in the rate of tax from 40 per cent to 10 per cent for a higher rate taxpayer.386

Initially the amount of relief was £125,000 plus half the gains between £125,000 and

£500,000, a total of £312,500. In the 1999-2000 year, this had been extended to

£250,000 and half the gains between £500,000 and £1,000,000, a total of £625,000.

The amount of relief actually available depends on the length of time the relevant

conditions were continuously satisfied prior to the end of the qualifying period. The

relief is 10% if the minimum one year period is satisfied and it increases in a straight

progression to 100 % after a 10 year period.

Evans surveyed practitioners in his study of the impact of tax design on the operating

costs of the UK CGT regime.387 The survey sought practitioner opinion on the

retirement exemption. Evans concluded that practitioners were neutral as to retirement

relief being a significant driver of compliance costs.

It would be possible to examine the intricacies of UK retirement relief legislation in

greater depth, but from a comparative perspective, the principles already discussed are

sufficient for comparison with the current Australian small business CGT provisions

and for guidance in developing the suggestions for changes to Sub-division 152-A

that will be addressed in Chapter Five.

386 HM Treasury, ‘Capital Gains Tax Reform’ (Press Release, 17 March 1998).


120

4.7.1 Literature on Retirement Relief

This thesis will now review the literature concerning the UK retirement relief and

discuss the quality of the exemption itself. Chapter Five will present a comparison of

the UK retirement relief with the provisions of the Australian small business CGT

concessions within the theoretical framework discussed in Section 1.7.

As noted in Section 4.2, CGT has existed in the UK for more than 30 years. Over this

time, authors have discussed its traps and pitfalls. The UK CGT concessions for small

business have some resemblance to those contained in Australia’s Division 152 and

share similar types of problems to those discussed in Chapter Two. So that the

evolving nature of the UK law can be perceived, academic writings that offer some

insight and possible solutions will be examined in a chronological pattern.

According to an editorial in the Taxation Journal in 1984, teething problems with the

legislation had much to do with it being drafted before the era of widespread

consultation.388 The early retirement relief provisions contained many anomalies and

matters of uncertain construction.389 Most of these remained in place until debate on

the Finance Bill 1978 resulted in amendments to the legislation on 30 March 1979.390

The editorial notes that some authors argued that the retirement exemption was

unnecessary because retirement annuities and other such vehicles could be used to

provide for retirement. However, the view prevailed that cash flow requirements did

not allow most business proprietors to afford such a luxury. 391

388 Editorial, ‘The future of retirement relief’ (1984) Taxation 551.

389 Ibid.

390 Ibid.

391 Ibid 552.

121

The editorial went on to support the following:

• Extension of retirement relief to the disposal of all business assets whether or

not they are related to the disposal of the whole or part of the business. This

would simplify the regime by eliminating an area open to disputes: changes

were required to timing issues on disposals. The editorial presented the

example of a father owning free hold farming land who passes the business to

his son and can no longer access the concession on the sale of his land.

• Reform to allow the disposal of family company shares issued to non-trading

holding companies. The editorial suggested that the legislation should perceive

the family group as a whole.

• Removal of requirement to be a ‘family company’. Contrasting examples were

presented. An individual retaining less than 25% of the issued share capital

and having no ‘family’ members interested in other shares is denied retirement

relief whereas a member of a partnership will qualify no matter how great or

small the interest. The editorial suggested that the relief should be available to

any shareholder who is a full time working directors.

Although the legislation had evolved in a positive direction since 1984, pitfalls and

anomalies still existed in the retirement relief at December 1989 when Wallis392

provided a summary of the provisions. The issues noted are typical of contemporary

articles on retirement relief:

• Central to the relief is the requirement that the individual concerned has attained the age of 60 at the time the disposal takes place. It is generally not necessary for the individual concerned to actually retire.

• Maximum relief is only available where the individual or his family trading company

own the business for a minimum of 10 years prior to disposal taking place. Where a

392 T Wallis, ‘Retirement Relief Pitfalls’ (1989) Taxation 302.

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company is involved, the individual must be a full time working director throughout the period. There are specific rules for family companies which are trading companies or holding companies, throughout the relevant period which challenge the equity of the legislation.

• Early cessation of a business can cause complexities for the taxpayer. The taxpayer

must be 60 when the business ceases and disposal of the asset must take place within 12 months of the business ceasing. There are allowances for ill-health.

• Retirement relief applies on the disposal of shares in family trading companies.

Relief will be restricted if, during a ten-year period under consideration, the shareholding of an individual fell below the 25 percent limit given to other family members, or five percent where there are other family shareholders. Relief could be lost if, with other family members, a five percent holding was maintained but the overall family shareholding fell at some stage to 50 percent or less.

• The legislation recognises that an individual may work for more than one company as

a director but complexities still exist. ‘The problem arises where there is an individual who is a director of a family trading company but who is also a director of other companies whose interests are diverse so as to be excluded from the definition of a commercial association of companies’. Even though the individual works for these companies full-time, he or she is outside the scope of retirement relief.393

The phasing out of retirement relief and its replacement by the taper relief was spread

over five years commencing in 1999-2000. The thresholds for retirement relief were

reduced annually until the relief ceased to exist by 2003-04. Over the same period,

entitlement to the new taper relief would accrue. Just months into the transition

period, it was evident that taxpayers were rearranging their business structures to

crystallise entitlements to retirement relief and prepare for taper relief. According to

Houghton:394

Locking into retirement relief can have considerable financial benefits. But there are pitfalls. Whether it is beneficial depends primarily on the intentions of the shareholder, i.e. to sell or pass on the shares, in his lifetime or upon death. 395

While some trade-off of efficiency and/or equity may be the expected price of

improved simplicity (a major reason for change as shown in Section 2.7.3), it is a

subject of debate as to whether the extent of the distortion had been expected.

393 Ibid.

394 Wendy Houghton, ‘Crystal Clear Retirement’(1999) Taxation 84.

395 Ibid 85.

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4.7.2 Cases on Retirement Relief

Given the articles which have dealt with retirement relief, case law can now be

analysed. Three significant cases on retirement relief will be examined which discuss

effectively the sale of active assets in the UK. Active assets were discussed previously

in Section 2.5.3 as this term is fundamental to the small business CGT regime. These

cases have been chosen as they best illustrate the issues with business assets in the

UK and the agenda is to determine any learning experiences that may help develop

the new CGT legislation.

In Atkinson v Dancer, the taxpayer carried on mixed farming activities on 89 acres,

22 of which were owned freehold.396 In 1981, the taxpayer reduced his farming

activities due to failing health, and decided to wind down the egg production side of

the business. The taxpayer disposed of nine acres of land which had nothing to do

with the business segment that had ceased trading though the land was used in other

business activities. It was held that the disposal did not constitute part of the business

and no retirement relief was awarded.

In Mannion v Johnson, the taxpayer carried on a business on 78 acres of land and in

1982, he decided partially to retire because of ill-health.397 He sold 17 acres on 3

April 1984 and 18 acres on 6 December 1984. In the year following the sale, the

taxpayer ceased growing corn, decreased his cattle business and reduced the growing

of potatoes. The courts held that there were only reductions in the scale of the

activities of the taxpayer.

396 Atkinson v Dancer [1988] Simons Tax Cases 758.

397 Mannion v Johnston [1988] Simons Tax Cases 758.

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These two cases concerned retirement relief under section 124 of the Capital Gains

Tax Act 1979. According to Justice Gibson, any disposal in part of farmland property

should ideally be accompanied by a disposal of certain other assets and equipment

relevant to the farming being carried out on the land being sold. What is essential is

that some particular business activity goes with the disposal so that it simply does not

generate a reduction in the business assets of the vendor but gives a significant change

to the business being carried on. Justice Gibson also commented that separate asset

disposals must be treated separately and cannot be combined to see if a disposal of a

business has taken place.

In Plumbly v Spencer, the taxpayer on 29 January 1988 (who had attained the age of

60 years) disposed of 163 acres (about 65 hectares) of agricultural land.398 Until the

disposal a private company used the property to carry on a farming business. The

company had owned the business for some 40 years, and at all material times it was a

trading company. It was the taxpayer’s family company and the taxpayer was a full-

time working director (in each case, within the meanings in Schedule 20, paragraph

1). The company paid rent to the taxpayer for the use of the land. On the disposal of

the land the company ceased to trade. The taxpayer did not dispose of his shares in the

company or make any other disposal capable of constituting an ‘associated disposal of

assets’. In this case, the scope of the legislation was expressed to be that:

The general legislative purpose of retirement relief is reasonably clear, that is to afford special relief to an individual at or near retirement age who has devoted a part of his or her working life to a trading enterprise, either as a sole trader or as a partner or as a full-time working director of a family company. The relief is granted in respect of a ‘material disposal’ of ‘business assets’ by an individual who has attained a specified age (60 years for 1987-8 but since reduced to 50 years) or has retired on ill-health grounds below that age.399

398 Plumbly v HM Inspector Of Taxes [1999] Ch RVF 97/0304/B.

399 Ibid.

125

Where there is a disposal of assets formerly used in a company which has ceased to

trade, relief may be due. The case of Plumbly v Spencer makes it clear that section

163(4) extends to individuals who own assets which were used by a company at the

date the company ceased trading, subject to the relevant conditions in section

163(2)(b) & (4) being met.400 Justice Lightman found:

It might be thought more anomalous if Mr Harbour had been denied any business relief, after the company had been farming for 40 years, because of his (or his advisers’) omission to take one or other of two otherwise fairly pointless steps (that is the transfer of the farming business to Mr Harbour personally just before its cessation, or the disposal of his shares in the dormant company).401

It is apparent from these cases that despite development over a 30-year period, the UK

legislation required further interpretation from the courts. Given that the Australian

legislation has provisions with many similarities to the UK CGT regime, comparison

would indicate that there will be cases where the Australian legislation will also

require legal interpretation.

4.8 Summary

CGT preferences have existed in the UK jurisdiction since 1965 where capital gains

were initially taxed at a flat rate of 30%.402 An annual exempt amount is also a feature

of the UK CGT regime but has yet to make an appearance in the Australian CGT

system.403 Relief for business has been in the form of a taper relief and a retirement

relief. Both forms of relief have been available to all UK taxpayers, providing a policy

lesson as to equity, efficiency and simplicity.

400 Taxation of Chargeable Gains Act 1992 (UK) Section 163 (2) (b), (4).

401 Ibid.

402 Finance Act 1965 (UK) Sections 17 & 18.

403Finance Act 1971 (UK) Section 57.

126

Taper relief works on the premise that the longer an asset is held, the greater the relief

available to the taxpayer. When introduced in 1998, taper relief had considerable

complexity and both parliamentarians and respected authors agreed the legislation

was a cause of confusion and inequity. The UK Government has since simplified the

definition of business asset so as to extend relief to most CGT assets used in business

and also extend the availability of taper relief to the majority of shareholders in a

working family company. These policies will assist in the formulation of

recommendations for changes to Subdivision 152-A.

When in operation, retirement relief assisted small business taxpayers. Most

importantly, the legislation addressed equity by limiting the benefits to the wealthy,

efficiency by making the exemption available to the majority of taxpayers and

simplicity by placing a simple ceiling on the relief available, although the literature

acknowledged the existence of some complexities.

The background to CGT in the UK shows that statistically, the revenue contribution is

a similar percentage as for the Australian regime. However, as the UK regime has

been in place some 20 years longer, a number of useful policy lessons have been

made evident. While there is much to learn from the UK experience with retirement

relief and taper relief, it is not intended to recommend a direct transplant of any UK

legislation into the Australian system.

Chapter Five will consider the UK policy lessons in making recommendations for

changes to Subdivision 152-A.

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CHAPTER FIVE

SYNTHESIS AND POLICY RECOMMENDATIONS TO SUBDIVISION 152-A

5.1 Introduction

The previous chapters of this thesis have confirmed the traditionally accepted criteria

for a good tax system and that with respect to these criteria Subdivision 152-A does

nothing to raise the standard for the Australian tax system. Accordingly, Chapter Five

will reflect upon the content of the previous chapters and put forward policy

recommendations for change. Similar to Explanatory Memoranda, the

recommendations in this chapter will outline the policy underpinning the

recommendation and give examples. The result being a policy statement that

legislative drafters could potentially draw upon. The changes will consider the

suggestions from the submissions to the Board of Taxation discussed in Chapter

Three and the UK learning experiences discussed in Chapter Four.

It is imperative that the reforms suggested in this chapter result in greater equity,

efficiency and simplicity. The changes should aim to make the concessions available

to the broad range of commonly used business structures instead of to a select few. In

this way, taxpayers would not be under pressure to restructure their affairs for no

reason other than to access the concessions. This would reduce the need to further

complicate business structures and taxpayers may be left with a better understanding

of the structure used.

128

According to the respondents to the Board of Taxation as discussed in Chapter Three

the maximum net asset test requires a major overhaul. The Simplified Tax System

(STS) model was listed as a possible solution in the NFF404 submission and this will

be analysed further in Section 5.2.

Respondents also asked for minor amendments to the active asset test. Chapter Four

considered the UK CGT system and a wider definition of business asset was noted.

Amendments to the active asset test based on this definition will be discussed in

Section 5.3.

Recommendations for removal of the controlling individual test and CGT concession

stakeholder test were discussed in Chapter Three and will not be considered again in

this chapter.

The policy recommendations to Subdivision 152-A will be presented in Section 5.4.

Section 5.2 Policy reasons for proposed amendments (maximum net asset test)

The Board of Taxation submissions clearly stated that the maximum net asset test in

its current form is unworkable. Evans commented:

The existence of arbitrary, artificial and ill understood distinctions in the tax system is one of the major sources of complexity, inefficiency and inequity. The $5 million net asset test that currently separates small business taxpayers from the rest represents one of the most complex, convoluted and unworkable pieces of legislation that has been enacted. The elimination of that boundary line would represent a major improvement in the current CGT regime.405

When considering possible alternatives, Evans suggests that ‘there is no inherent

reason why a test based on the value of business assets, rather than, say, turnover, or 404 NFF, above n 230.


129

number of employees should be used to enable some to access very generous

concessions from which others are excluded’.406 His comments on this test suggest

change is required and confirms the comments made in Chapter Three.

A solution based on an existing piece of legislation, the Simplified Tax System was

suggested by the NFF. The STS has a number of conditions including a test based on

the entity’s turnover. The advantages of using an existing piece of legislation are

obvious. They would include:

• Taxpayers may already have some understanding of the STS.

• Practitioners have known this legislation for some years.

• The ATO provides material about the STS including booklets, fact sheets etc.

The STS was introduced in 2001 and benefits small business in a number of ways

including:

• Reduced levels of tax;

• Simpler rules for determining income and deductions;

• Simpler capital allowances and trading stock requirements; and

• Reduced compliance costs.407

A common definition of ‘small business’ for both CGT and income tax would be a

welcome outcome. The proposal will draw upon the existing wording and rules of the

STS contained in Division 328 of the ITAA 1997. It would be relevant at this point to

406 Ibid.


130

briefly consider the STS rules so as to formulate the policy recommendations. To be

eligible for the STS, a taxpayer must satisfy three conditions.408 They are:

• A taxpayer must carry on a business in that year.409

• The taxpayer must have an STS turnover of less than $1 million for that

year.410

• The total adjustable values of depreciable assets411 held at the end of the year

by the STS taxpayer and any grouped entities must be less than $3 million.412

This chapter proposes a turnover test only and does so based on a precedent

announced by the Government. In a press release dated 24 May 2004, Senator Helen

Coonan announced that small business would get a carve-out from the debt/equity tax

rules for related party ‘at-call’ loans to help reduce compliance costs and red tape.413

The debt equity rules are contained in Division 974 and distinguish between debt and

equity interests in a company. During the public consultation process, small business

expressed concern about the disproportionate compliance costs associated with this

legislation.414 Senator Coonan announced a carve out to help small business and

reduce compliance costs.415 According to the press release:

The maximum net asset value test is consistent with that used for the small business CGT tax concession. The concession is limited to those companies who, together with their related entities, have CGT assets with a net value that does not exceed $5 million. Where the amount of any deductions in respect of the loan in that year does not exceed $100,000, the interest deductibility cap will be satisfied.416

408 ITAA 1997 Section 328-365(1)

409 ITAA 1997 Section 328-365(1)(a)

410 ITAA 1997 Section 328-365(1)(b)

411 This is the closing values of depreciable assets

412 ITAA 1997 Section 328-365(1)(c)

413 Coonan, ‘At Call Loans Red Tape to be Cut for Small Business’ (Press Release, 24 May 2004).

414 Ibid.

415 Ibid.

416 Ibid.

131

In press release No. 063 on 15 July 2005, the Minister for Revenue and Assistant

Treasurer, The Hon Mal Brough MP, announced:

Originally changes were to apply to companies which had capital gains tax (CGT) assets with a net value of $5 million or less and annual deductions in relation to the loan of $100,000 or less. However, further consultation with industry has helped to simplify the rules further. As a result of these consultations and further consideration by Government, the proposed changes will now apply to companies with an annual turnover of less than $20 million. This is a much better outcome for small businesses.417

On the basis of this amendment, it is proposed that a turnover test be applied to the

small business CGT concessions. This would be a viable alternative given the small

business carve out within the debt/equity rules.

As an anti-avoidance measure, the STS contains grouping provisions which stop

larger businesses simply splitting into smaller entities to stay within the threshold.418

The turnover is based on the STS taxpayer and its grouped entities. It would be

consistent to apply these same provisions to the proposed Subdivision 152-A as this

would result in greater equity with the simplicity trade-off being minor. Furthermore,

there has been little controversy noted by academics, practitioners and the

professional bodies with these provisions.

Section 5.3 Policy reasons for proposed amendments (active asset test)

The submissions to the Board of Taxation have been discussed in Chapter Three and

these submissions requested a broader definition for an active asset.419 The Taxation

417 The Assistant Treasurer, ‘At Call Loans to Small Business to be Treated as Debt” (Press Release, 15 July 2005).

418 ITAA 1997 Section 328-370


132

Institute of Australia (TIA) cited intellectual property and in-house software as assets

where relief is overlooked yet by principle, should be allowed.420

In terms of equity, these issues need to be addressed. Fairness and social justice would

suggest that many assets falling outside the current definition of ‘active asset’ should

be afforded the same allowances. Efficiency or neutrality issues would suggest that

assets used in business should be treated similarly, regardless of whether they are

small or large, or used by employee, contractor, or in any employment context.

In the UK taper relief regime, the definition of business assets has been subject to

constant tinkering. In 2001 the UK government undertook a survey on the existing

CGT framework and invited discussion of the taper relief provisions.421 Taper relief

was identified by 21 out of 24 submissions as a difficult area with the difference

between business and non-business assets being a major issue.422 The complexity of

taper relief was considered by many UK practitioners to be a significant driver of

compliance costs.423

The Australian government has indicated that it is vital for business taxpayers to

provide for their retirement.424 It is often the case that business owners have limited

access to outside investors and are required to plough large amounts of their savings

into their businesses rather than traditional superannuation vehicles. There is little


421 HM Treasury, Enterprise for All - The Challenge for the Next Parliament (Press Release, 18/06/2001) < http://www.hm-treasury.gov.uk/newsroom_and_speeches/press/2001/press2001_index.cfm > at 10 June 2006.

422 HM Revenue & Customs, Summary of replies to public consultation on CGT simplification (2002)

<http://www.hmrc.gov.uk/cgt/archive.htm> at 10 June 2006.


424 Costello, above n 99, Attachment E.

133

point to maintaining a distinction between active assets and other business assets at

the time of a taxpayer’s retirement. Controls on the amounts that a taxpayer may

apply toward retirement are already present in the superannuation legislation and

these should suffice to limit the benefits available to wealthier taxpayers.

Many countries, including the UK allow rollover relief when the proceeds of an asset

are reinvested into similar assets. In this case, the seller is deemed to have acquired

the replacement asset at a cost base equal to the asset being sold, thus deferring the

CGT liability. There are reasonable grounds, based on equity and efficiency criteria,

for extending these concessions to small business.425 In terms of equity, rollover relief

should be available for involuntary disposals such as compulsory acquisitions,

corporate takeovers, destruction of assets through natural disasters and marital

breakup disposals etc.426 On grounds of efficiency, a case can be made for deferral of

the capital gain where taxpayers are rolling the proceeds of the disposal of one asset

into a bigger asset, in order to grow a business.427 A case could also be made for

rollover or deferral when there is a legal change in ownership but no real economic

change such as an asset being transferred within a wholly owned corporate group.428

The rollover concessions and retirement concessions are essential to small business.

For the active asset test to be made simpler and broadened to include most business

CGT assets, there would arise an accompanying need to keep the policy changes

revenue neutral. To that end, removal of the 50% small business reduction and the 15


426 Ibid.

427 Ibid.

428 Ibid.

134

year exemption should be considered. Rationalisation of the small business CGT

concessions in this manner would result in improved equity, efficiency and simplicity.

It now remains to consider the policy changes to Subdivision 152-A based on the

recommendations above.

Section 5.4 Summary of proposed new law (maximum net asset test)

It has been shown that the maximum net asset test is clearly a problematic area with

submissions to the Board of Taxation supporting this position. It is evident from

Section 3.2 that submissions did not consider the maximum net asset test equitable,

efficient or simple. Further, the $5 million threshold was not considered to be

commercially realistic.

The culmination of this thesis is the summary presented over the following pages. The

current law as at 8 May 2006 is reflected on the pages to the left and the proposals for

policy changes to Subdivision 152-A are presented on the facing pages.

The proposals bring improved equity, efficiency and simplicity to the small business

CGT concessions. The proposals have been distilled by applying these criteria to a

consideration of the recommendations to the Board of Taxation, the UK experience

and comments from academics and authors discussed in Chapter Two.

Examples will also be given to illustrate the working of the proposed new law.

135

Current Law Summary - Maximum Net Asset Test

The maximum net asset test is satisfied if, just before the CGT event, the sum of the net

value of the CGT assets owned by:

(a) the small business entity;

(b) any entities connected with the small business entity; and

(c) any small business CGT affiliates of the small business entity or entities

connected with such affiliates,

does not exceed $5,000,000.429

If the taxpayer is a partner in a partnership and the CGT event happens in relation to a

CGT asset of the partnership, the net value of the CGT assets of the partnership must not

exceed $5,000,000.430

The ‘net value of the CGT assets’ is discussed in Section 152-20. Section 152-30

explains when an entity is ‘connected with’ another entity. ‘Small business CGT

affiliate’ is discussed in Section 152-25.

The maximum net asset test treats the small business and all of its related entities as one

unit. If the net value of the unit's assets exceeds $5,000,000, the unit is not eligible for

the small business CGT concessions.

Section 152-20 explains what is meant by the term ‘net value of the CGT assets’ of an entity.

This term is used in working out whether a small business entity satisfies the maximum net asset

value test in Section 152-15 — broadly, an entity satisfies the test if its CGT assets, and the

assets of connected entities and affiliates, have a value of $5,000,000 or less.

429 ITAA 1997 Section 152-15.

430 Ibid.

136

Proposed New Law

To pass the turnover test, the entity’s annual turnover must be less than $20 million in

the year of the CGT event. An entity's annual turnover is to be calculated in the same

way that it is for Simplified tax System (STS) purposes. An entity will be grouped with

another entity if the STS conditions in section 328-380 are satisfied.431

The grouping rules are an anti-avoidance provision measure to prevent entities

subdividing to gain access to the offset.

To be eligible, the taxpayer must be connected with the small business entity.

The value of the business supplies made in an income year by an entity is grouped with

that of another entity if:

(1) either entity controls the other entity;

(2) both entities are controlled by the same third entity; or

(3) the entities are ‘STS affiliates’ of each other.

An entity is an STS affiliate of a taxpayer if the entity 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 entity's business

Evidence of a reasonable expectation to act may also be drawn from:

• familial or other close personal relationships;

• financial and business relationships and dependencies; or

• common stakeholders such as directors, partners and shareholders and the ability to

influence the potential STS affiliate's actions in relation to a substantial part of the

business.

431 The following commentary is based on the CCH commentary regarding ITAA 1997 Section 328-380

137

Current Law Summary - Maximum Net Asset Test (continued)

Working out the net value:

The net value of the assets of an entity is the amount (if any) by which the market value

of those assets exceeds the liabilities of the entity that are related to those assets.432

What assets are disregarded?

Shares, units or other interests (except debt) in another entity that is connected with the

first entity (or a small business CGT affiliate of the first entity) are ignored. If the

taxpayer is an individual, the following assets are also ignored:

• assets being used solely for the personal use and enjoyment of the individual or a

small business CGT affiliate of the individual

• the individual's ownership interest in a dwelling if the individual uses the dwelling

to produce assessable income to any extent but does not claim any interest

deductions on borrowings relating to the dwelling

• a right to any allowance, annuity or capital amount payable out of a superannuation

fund or ADF

• a right to any asset of a superannuation fund or ADF

• a life insurance policy.

Assets of an affiliate not used in business

When working out the net value of the CGT assets of an entity that is a small business

CGT affiliate or of an entity connected with the small business CGT affiliate, disregard

assets of that entity that are not used, or held ready for use, in carrying on a business that

the entity, or a connected entity, carries on (sect152-20(3), (4)). The business may be

carried on alone or jointly with others.

432 ITAA 1997 Section 152-20

138

Proposed New Law (continued)

An example of two or more entities acting in concert would be if two taxpayers act

together in pursuit of a common business objective with a substantial degree of

connection or dependence. The Commissioner lists the following factors as being

relevant in determining the degree of connection between two entities:

• the nature and level of the business supplies between the two entities;

• whether the businesses share common facilities and resources;

• capacity to share day-to-day management and decision-making processes;

• financial independence;

• the flow of profits;

• the nature of the business; and

• common customers and suppliers.

Further examples of grouping can be found within the explanatory memorandum of

section 328-380.

139

Example 1

Chandra owns a restaurant with a turnover of $5 million and has inherited his fathers

42% interest in a software company. The other 58% of the software company is

owned by a person with whom Chandra has had no dealings whatsoever. The software

company has a turnover of $50 million per annum.

The turnover of Chandras restaurant will not be grouped with the turnover of the

software company as Chandra can demonstrate that the software company is

controlled by the other person with the 58% interest. 433

Example 2

Lyn, David and Ross are partners in a partnership (P1) which operates a

manufacturing business. The partnership has a gross annual turnover of $8,000,000.

The sharing of partnership profits and losses is governed by a partnership agreement.

The agreement specifies that profits and losses of P1 are shared in the following way:

• Lyn with a 30% share;

• David with a 20% share; and

• Ross with a 50% share.

Lyn, David and Ross also operate another partnership (P2) which is a retail chain.

The turnover of the second partnership is $16,000,000.

A partnership agreement specifies that the profit and losses of P2 are to be shared in

433 Adapted from Explanatory Memorandum, Simplified Tax System, 2000 (Cth)

140

the following way:

• Lyn with a 50% share;

• David with a 20% share; and

• Ross with a 30% share.

P1 and P2 operate in concert with each other and share assets and common business

premises. Lyn, David and Ross have unfettered control of both partnerships.

As Lyn, David and Ross together have the right to receive amongst them over 40% of

the net income of P1 and P2, the grouping rules will operate to treat P1 as controlling

P2. As such, P1 will add the turnover of P2 to its own when working out its STS

group turnover and P2 will add P1s turnover to its when calculating its STS group

turnover.

In this example, P1 and P2 will not be eligible to be STS taxpayers as the STS

average turnover of both partnerships exceeds $20 million. This assumes that the

turnover of past (or future) years is not significantly different. 434

434 Adapted from Explanatory Memorandum, Simplified Tax System, 2000 (Cth).

141

Section 5.5 Summary of proposed new law (active asset test)

Respondents to the Board of Taxation have suggested changes to the active asset

test435 in relation to treatment of cash, contingent claims, shares and deceased estates.

The minor changes suggested provide improved equity, efficiency and simplicity.

Current Law Summary – Active Asset

A CGT asset satisfies the active asset test if the asset was an active asset of the entity

just before the earlier of:

• the CGT event; and

• the cessation of business, if the business ceased to be carried on in the last 12

months (or such further time as the Commissioner allows).

In addition, the asset must have been an active asset of the entity during at least half

of the period beginning at the later of:

• the date of acquisition; and

• 15 years before the earlier of the above times if the entity owned the asset for

more than 15 years,

and ending at that earlier time.

Special rules which modify the time requirements in the active asset test where there

has been a roll-over as a result of a marriage breakdown or compulsory acquisition are

contained in section 152-45.

Section 152-40 explains what is meant by an ‘active asset’. This term is relevant for

the active asset test in section 152-35. The active asset test must be satisfied before a

taxpayer qualifies for the small business concessions.

435 Section 3.3

142

Proposed New Law

An asset is a business asset and subject to small business CGT relief if it is:

• a CGT asset used for the purpose of a trade, profession or vocation carried on by

the taxpayer (either alone or in partnership), or a trust or company.; and

• If the taxpayer is a trust or company, the taxpayer must be employed by that

company or trust.

Furthermore, a business asset can include:

Intangible assets such as goodwill and restrictive covenants;

Assets used or held ready for use in the course of carrying on a business by an entity

connected with the taxpayer are subject to the relief; and

Any other CGT asset used in a business environment.

The employment test is very generous and will apply to any taxpayer working part

time in any business. The general rule is that if superannuation is paid for that

employee, he or she can apply the proceeds on any CGT business asset to their

retirement. The rollover concessions will also apply under the superannuation test.

(This is the test above which falls within the ‘business asset test’).

If the taxpayer retires and is no longer an employee, the taxpayer will have 2 years

from their termination date to buy another business asset or roll the funds into a

complying superannuation fund. A complying superannuation fund will lock the

proceeds away under the existing superannuation system and provide for the

taxpayers retirement.

Beneficiaries of business trusts and company shareholders are not discriminated

against as long as they are employed by the company or trust and the superannuation

test is met.

143

Current Law Summary – Active Asset (continued)

Active asset — used in a business

A CGT asset is an active asset of a taxpayer at a given time if, at that time, the

taxpayer owns it and:

• the taxpayer uses it, or holds it ready for use, in the course of carrying on a

business

• it is an intangible asset inherently connected with a business carried on by the

taxpayer (eg goodwill, the benefit of a restrictive covenant), or

• it is used, or held ready for use, in the course of carrying on a business by the

taxpayer's small business CGT affiliate (section 152-25) or another entity

connected with the taxpayer (section 152-30).

Active asset — shares and trust interests

An asset is also an active asset of a taxpayer at a given time if, at that time, the

taxpayer owns it and:

• it is a share in an Australian resident company or an interest in a trust resident for

CGT purposes for that income year, and

• the total of: (a) the market values of the active assets of the company or trust;

and (b) any capital proceeds received by the company or trust during the

previous two years from CGT events happening to its active assets and that are

held in the form of cash or debt pending the acquisition of new active assets, is

at least 80% of the market value of all the assets of the company or trust (section

152-40(3).

Section 152-40 lists assets that cannot be active assets

144

Example 1

David is a plumber and is self employed.

David satisfies the maximum turnover test. David sells part of his client base and

signs an agreement not to trade within the state of Queensland.

As the CGT asset meets the wide definition of ‘business asset’, David can roll the

proceeds into his superannuation fund and access the $500,000 retirement exemption.

David could purchase another ‘business asset’ and apply for rollover relief.

Example 2

Mary is employed by ABC Pty Ltd and owns 5% of the shares of that company.

Mary decides to sell her shares and start a new business as a sole trader.

Mary and her related entities satisfy the turnover test.

Mary can sell her shares in ABC and roll them into superannuation fund and access

the $500,000 retirement exemption.

Mary could purchase any new ‘business asset’ and apply for rollover relief.

145

Section 5.6 Conclusion

This chapter has considered policy changes to Subdivision 152-A on the basis of

improved equity, efficiency and simplicity. The general policy recommendation is to

rationalize the concessions and allow the relief measures for most CGT assets used in

a working environment.

Many business owners find it difficult to provide for their retirement. This was

documented earlier in Section 2.3 and the Treasurer, Peter Costello, acknowledged

this when he introduced the legislation.436

Businesses collect taxes on behalf of the government and remittance is required even

before all collections are received. Remitting these taxes results in heavy drains on

cash flow. Also, superannuation payments, made annually under the old system, are

now required quarterly and late payment results in the loss of valuable tax deductions.

On this basis, preferential treatment for business (not just small business) is justified.

Providing small business taxpayers with broad access to a rational set of small

business CGT concessions is prudent and fits with the objectives of the Government

to facilitate the self-funded retirement of small-businesses owners.

With respect to both business assets and business structures, the present legislation

failed the test criteria. The changes suggested would improve simplicity and

efficiency, particularly in that additional layers of tests are replaced by tests already in

common use. Equity too would be much improved by allowing the concessions to

those taxpayers using common business structures who are presently excluded

436 Costello, above n 99.

146

without justification. Taxpayers would thereby be better able to provide both for their

business plans and for their retirement. With the $500,000437 lifetime limit on the

retirement exemption, and the separate controls present in the superannuation

legislation, the benefits for wealthier taxpayers are suitably limited.

The purpose of this chapter has been to consider proposed changes to the small

business CGT concessions, and to put forward policy recommendations for change.

The conclusions are that the small business CGT concessions would be improved by:

• replacing the maximum net asset test with a more generous turnover test

allowing more small business taxpayers to access the concessions;

• broadening the active asset test to incorporate all CGT assets used in business

by an employee;

• removing the controlling individual and CGT concession stakeholder tests.

It is suggested that these proposals should be considered for adoption into law.

The concluding Chapter Six will summarise the findings of this thesis, discuss the

limitations of the research and explore future research possibilities.

437 This should be indexed with inflation.

147

CHAPTER 6

CONCLUSION

6.1 Introduction Chapter One of this thesis discussed the importance of the small business sector in the

Australian economy. Small businesses account for almost all private sector businesses

and provide about half of all private sector employment and contribute heavily to

economic growth.438

Chapter One also discussed the concept of taxing capital gains and looked at CGT

statistics across the OECD. It reviewed the four small business CGT concessions and

their current operation within Division 152, whereby a small business taxpayer may

be entitled to further CGT relief if the conditions set out in Subdivision 152-A are

satisfied. By applying one or more of these concessions, the tax payable on a capital

gain can be substantially reduced or even eliminated.

The evidence in Chapter Two has shown that Division 152 is complex and fails to

meet the criteria of equity, efficiency and simplicity. The objective of this thesis has

been to examine the tests for access to the small business CGT concessions as

contained in Sub-division 152A, and to critically evaluate them against accepted

criteria for a good tax system, thereby identifying any deficiencies in the legislation as

a basis for the formulation of proposed policy recommendations.

438 Section 1.1.

148

6.2 Summary of results The following is a summary of the results given the objective above.

6.2.1 Equity

Principles of equity require that all people in similar economic circumstances should

be treated equally.439 By extension, any concept of fairness also requires that where

economic circumstances differ, those who have more should pay more.

In recognition of the solid contribution made by small business to the Australian

economy, the provision of equitable concessions to this sector would assist it to

flourish and benefit the wider community.

The capital requirements of small business can require an owner to make large cash

contributions to keep a business solvent. This thesis has discussed the funding

burdens falling on small business owners and the accompanying diminished ability to

make traditional retirement savings. This thesis considers it equitable for small

business taxpayers to use their business assets as retirement savings. The small

business CGT concessions, if equitable, provide a means to address this issue.

Chapter Four discussed the concept of business angels in the UK and this thesis

considers that assistance in the developmental stages of a new small business should

be encouraged. An existing concession that addresses this concept is the Simplified

Tax System. Whatever concessions are provided, they need to be based solidly on the

principles of fairness.

439 Section 2.7.1

149

With respect to the retirement relief, the lifetime limit of $500,000 and the general

constraints within the superannuation legislation combine to address issues of equity.

Evans argued that the retirement concession should not be disconnected from the

superannuation system:

Business persons were not precluded from using the same retirement savings vehicles as other taxpayers, and so should not receive preferential treatment. But this view may be unduly harsh. It is certainly the case that small business owners find it impossible to save for their retirement. Preferential treatment may be justifiable so long as there is a clear link between the CGT concessions and the existing superannuation system.440

The turnover threshold recommended in Chapter Five, or any other measure used to

define a small business should be regularly reviewed. In addition to these

considerations, principles of equity would require that all business CGT assets should

be considered for concessional treatment. The recommendation in Chapter Five for a

broader definition of business asset is made on the basis of equity.

The submissions received by the Board of Taxation in its review of the small business

CGT concessions have called for an improved definition of active asset on the

grounds of equity. The research revealed the two dimensions of equity; one calling for

equal treatment for all taxpayers in similar economic circumstances and the other

requiring that those who have more should pay more. In terms of equity, the research

found that the definition of active asset needs to be relaxed so that more equitable

outcomes are obtained. The policy recommendations in Chapter Five have addressed

this issue.


150

After tinkering for many years with the definition of business assets for purposes of

CGT relief,441 in 2004 the UK extended the definition to cover most assets used for

business purposes.442 The clear calls for a broader definition of active assets have

been documented and the recent UK policy change was one of the main drivers for

the recommendation made in Chapter Five.

Section 3.5.3 recommended the removal of the controlling individual / CGT

concessional stakeholder test to considerably reduce the complexity of Subdivision

152-A and therefore increase equity. There is no justification in equity terms for the

inability of many shareholders to access the small business CGT concessions. Two

equal shareholders or a shareholder and their spouse are the only company taxpayers

that can potentially access the concessions. The submissions in Chapter Three to the

Board of Taxation highlighted this issue. The CGT concession stakeholder test does

not take additional steps to address this issue in any case. In summary, there were

equity reasons to make changes to all tests contained in Subdivision 152-A.

6.2.2 Efficiency

Efficiency is associated with neutrality and this refers to the lack of distorting

influences. Tax preferences can clearly influence business decisions. If the proposed

policy amendments to Subdivision 152-A are efficient, there will be no impact with

respect to the fundamental choices made by a business.

441 Section 4.6

442 Ibid.

151

Since the introduction of CGT in 1985, there has been some form of preferential

treatment for small business capital gains.443 Taxpayers investing in small business

can benefit substantially from the small business CGT concessions. The current policy

of taxing small business taxpayers on a concessional basis seems to be here to stay.

While this policy could be criticised for a lack of neutrality, it has been a deliberate

policy of the Government to assist a vital sector of the Australian economy.

The maximum net asset test lacks efficiency and policy amendments have been

recommended by this thesis. While efficiency arguments could be made for its

complete removal, a less profound but likely more acceptable recommendation has

been made to align the test with other current Government policy respecting small

business, namely the $20 million turnover test of the STS which is considered by the

current Government to be equitable, efficient and simple.

The present concessions favour business investment in active assets and this may lead

to a growing imbalance in the allocation of economic resources away from non-active

assets. Considerations of efficiency require that the concession should be available for

all CGT assets used in small business, thereby removing any influence on the

allocation of scarce business resources. Submissions to the Board of Taxation

considered circumstances where CGT assets should have received preferential

treatment by Division 152.444 This was a driving influence with respect to the

‘business asset’ policy recommendation.

443 Section 2.2.1

444 Section 3.3.2

152

Perhaps the most controversial policy recommendation of this thesis is the removal of

the controlling individual / CGT stakeholder test. On efficiency grounds this test is

fundamentally flawed with many submissions to the Board of Taxation attacking its

inconsistent treatment of business structures commonly used in the market place.

Nowhere in the Treasurer’s press releases or in any explanatory memorandum does

the Government discuss that the policy behind the concessions is to assist ‘mum and

dad companies only’. Submissions, literature and academics speak in concert on this

issue because the legislation is clearly having an adverse effect on efficiency. Policy

amendments to Division 152 were considered on the basis of improved efficiency.

6.2.3 Simplicity

Section 2.7.3 has discussed simplicity and its role in evaluation of taxation systems.

Simplicity is achieved where laws are capable of straightforward comprehension and

are certain in their application.445 Simplicity should enable taxpayers to compute their

own tax liabilities with little assistance from taxation advisors. Simplification of

Subdivision 152-A was clearly an issue for respondents to the Board of Taxation in its

review of Division 152.446 Evans concluded from his studies on Division 152 that:

the Australian small business concessions are clearly a concern for practitioners. It is evident that most of them find them difficult to understand. In addition, a majority of practitioners find them more difficult to apply now than they were five years ago.447

This thesis has addressed simplicity in the following manner. In an attempt to align

the definitions of small business across two forms of taxation legislation, policy

change to the maximum net asset test has been suggested. Drawing on the carve out

for small business contained in the debt/equity rules, this thesis proposes changes that


446 Chapter Four.


153

are consistent with other taxation legislation. With respect to the retirement relief, the

recommendation has been to maintain connections to the superannuation legislation.

Extension of the active asset test to incorporate all CGT assets used in small business

will remove another area of complexity. For further simplification, the controlling

individual test should be replaced with an ‘employment test’.

This thesis has considered six major submissions to the Board of Taxation, the UK

CGT experience for business, and comments from respected authors. By drawing on

these and on existing legislation that is well understood by practitioners, the final

policy proposals bring improved simplicity to the small business CGT concessions.

6.3 Limitations

The Board of Taxation had not released its findings at the time of writing Chapter

Three but did so before the submission of this thesis to examiners. An examination of

the report of the Board of Taxation will be contained in an appendix.

This thesis has focused solely on the UK as an external point of reference and has not

examined other countries that have similar concessions for small business. While

South Africa has similar CGT concessions for small business, they have been in place

for a short time and insufficient data is available to set them in context.

Finally, the focus of this thesis is on Subdivision 152-A and it does not examine

Division 152 as a whole. The Board of Taxation will consider the other concessions in

its review of the small business CGT concessions. It is also noted that this thesis has

154

not been constricted by the same limits as were placed on the Board of Taxation. This

will be discussed in Appendix One.

6.4 Future research

This thesis has revealed several areas of potential research. The recommendations of

this thesis could provide subject matter of further interest to major industry players

and accounting bodies. In connection with the recommendations made by this thesis,

it would be of interest to consider cost estimates by modelling the financial effect on

Government revenues.

This thesis has noted that various definitions of small business are found within the

Income Tax Assessment Act and also within the Corporations Act. This raises

questions as to why one accepted definition cannot be applied to the simplified tax

system, the small business CGT concessions and the future small business incentives.

It is suggested that progress towards a more equitable, efficient and simple taxation

system would be achieved by the introduction into both acts of a common definition

for small business and consideration should be given to the potential for alignment of

this definition with that of a non-reporting company.

A future study opportunity would be to examine the South African CGT concessions

for small business which are very similar to those in Australia. As the statistical data

matures, a valuable source for study and comparison will develop.

155

REFERENCES 1. Articles, Books and reports Abelson, P, ‘Reforming Australian Taxation’ in Abelson, P (ed) The Tax Reform Debate: The Economics of the Options. Albon, R, ‘Taxation Policies in the Eighties’ (1986)21. ATO, ‘Compliance Progran 2004–05’ (2005) ATO, ‘CGT Hotspots: Small to medium enterprises’ (2005) The Taxpayer 39. ATO, ‘Tax Statistics 2003–04’. Auerbach, A & Hines, J R, ‘Taxation and Economic Efficiency’ (Working paper 8181) Australian Bureau of Statistics, ‘Small business in Australia’ (2001) Burchill, K, ‘Do You Want to Retire Early?’ Tax News Winter 2002 (Hall Chadwick) Coleman, C & Evans, C, ‘Tax Compliance Issues for Small Businesses in Australia’ (2003). Commonwealth Treasury, ‘Tax Expenditure Statement 2005’ (2006). Corocoran, S, ‘Comparative Corporate Law Research Methodology’ (1996) 3 Canberra Law Review 54. Costello, P, ‘The New Business Tax System’ (Press release 058 21/09/1999) Cunningham, L, ‘Sting in the tail for discretionary trust’s new control test’ (2004) 19 CCH Tax Week 375. Cunningham, L, ‘CGT Traps for Small Businesses’ (2003) 26 CCH Tax Week 461. Dunn, R, ‘Tax files: Are there pitfalls with the Small Busniness CGT Concessions?’ (2003) Law Society of South Australia Bulletin 26. Evans, C, ‘CGT: Choosing the right course’ (2000). Evans, C, ‘The Operating costs of taxing he capital gains of individuals: A Comparative study of the Australia and the UK, with particular reference to the compliance cost of certain tax design features’ (Ph.D Thesis, UNSW 2003) Evans, C, ‘Taxing Personal Capital Gains: Operating Cost Implications’ Australian Tax Research Foundation, Research Study #40 (2003).

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Freebairn, John, ‘Taxation Reform: Some Economic Issues’, (1997) 30 Australian Economic Review 57. Grabosky, P.N, ‘Wayward governance : Illegality and its control in the public sector’ (1989) 145. Harrison, J, ‘Total Tax Review: Major Reform Issues, Current Issues Brief’ 1996–97, Parliamentary Library, Canberra. Kates, DR S, ‘Taxation – Principles of Taxation Policy’ (2003) Krever, R, ‘The Taxation of Capital Gains’ in Burgess & Ross, Income Taxation: A Critical Analysis(1991) 56 – 95. Krever, R, Brooks, N, ‘A Capital Gains Tax for New Zealand’ (1990). McCaffery, E J, ‘The Holy Grail of Tax Simplification’ (1990) Wisconsin Law Review 1267. McGregor–Lowndes, M, ‘Comparative Corporate Law: A Response To Papers by Suzanne Corcoran and Eugene Clark’ (1996) 3 Canberra Law Review 81. O’ Connell, A, ‘The CGT Concessions for Small Businesses’ in Grant Cathro Capital Gains Tax Pateman, C, ‘The Concept of Equity’ in Troy, P, ‘A Just Society’. Pederick, W.H, ‘ Fair and square taxation in Australia’ (1984). Peterson, G, ‘An Overview of the Basic Eligibility Requirements of the Small Business CGT Concessions’(2004). Peterson, G, ‘Selling a Small Business – The CGT Strategies’ (2002 Revised Edition). Pope, J, ‘Compliance costs of taxation: policy implications’, Australian Tax Forum, V11, 1994 Prestney, S, ‘Are You Getting Enough?’ (2002) CA Charter. Prestney, S, ‘Just Dreaming?’ (2004) CA Charter. Pwsweick, W, ‘Fair and square for taxation in Australia’ (1984) 19 Taxation in Australia 575. Rabushka, A, ‘India: Is a flat rate the answer’ (2000) Ralph, J.T, Albert, R.H and Joss, R.L, (1999) ‘A Tax System Redesigned’. Scott, J, ‘Corporations, Classes and Capitalism’, (1985).

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SJQ Legal Services Handbook. Smith, A, ‘An Inquiry into the Nature and Causes of he Wealth of Nations’ (1952 ed) Smith, K, ‘CGT Concessions – Ones to Watch’ (2003) CA Charter 56. Thuronyi, Victor (ed), Tax Law Design and Drafting (2000) xxxv Valentine Palmer, Vernon, ‘From Lerotholi to Lando : Some Examples of Comparative Law Methodology’ (2004). Waeburton, R and Hendy P, ‘International Comparison of Australia’s taxes’ (2006) Wade, John, ‘Writing Thesis and Reports – TCAGONARM – an acronym for structure’ (1999) Bond Law Review 1 – 13. Wainecymer, J, ‘Australian Income Tax Principles and Policy’ (1998). Wallis, T, ‘Retirement Relief Pitfalls’ (1989) Taxation 302. Whiteman, P, ‘Capital Gains Tax’ (4th ed 1998) 332. William Buck Tax Watch, ‘Small business CGT Concessions’ (2004). Woellner, R. Barkocky, Murphy, S and Evans, C, ‘Australian Taxation Law’ (16th Edition). Zweigert, K and Kotz, H, ‘An Introduction to Comparative Law’ (1987).

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2. Case Law Atkinson v Dancer (1998) STC 758 Daniels v Revenue and Customs (2005) UKSPC 00489 Mannion v Johnson (1998) STC 758 O’Sullivan v HM Inspector of Taxes (2004) EWHC 2130 (Ch) Plumbly & Ors v HM Inspector of Taxes (1999) Ch RVF 97/0304/B 3. Legislation Finance Act 1962 (UK). Finance Act 1965 (UK). Finance Act 1971 (UK). Finance Act 1971 (UK). Finance Act 1978 (UK). Finance Act 1978 (UK). Finance Act 1982 (UK). Finance Act 1985 (UK). Finance Act 1998 (UK). Finance Act 2000 (UK). Finance Act 2002 (UK). Finance Act 2003 (UK). Finance Bill 1998 (UK). Finance Bill 2001 (UK). Income Tax Assessment Act 1936 (cth). Income Tax Assessment Act 1997 (cth). New Business Tax System (Capital Gains Tax) Bill 1999 (cth). Taxation Laws Amendment Bill (No 4) 1996.

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Taxation Laws Amendment Bill (No 3) 1997. Taxation of Changeable Gains Act 1992 (UK). 4.Other Sources ATOID 2003/209 ATOID 2002/354 ATOID 2002/493 ATOID 2002/1003 ATOID 2003/165 ATOID 2003/253 ATOID 2003/745 ATOID 2003/746 ATOID 2003/1114 ATOID 2004/650 ATOID 2004/698 ACCI, ‘CGT Concessions for Small Businesses, Submissions to the Board of Taxation’ (2005). AICPA, ‘Tax Policy Concept Statement No 1 – Guiding principles of good tax policy: A framework for evaluating tax proposals’ (2001) AICPA, ‘Tax Policy Concept Statement No 2 – Guiding principles for taxation simplification’ (2002). Alexander Sloan Chartered Accountants, ‘Finding money to develop your business’ (2006). Barkoczy, S, ‘Core Tax Legislation and Study Guide’ (7th Edition, 2004) 27 – 28. Board of Taxation, ‘A post implementation Review of the quality and effectiveness of the small business CGT concessions in devision 152 of the Income Tax Assessment Act 1997 – ‘A report to the Treasurer’ (2006). Bowles, R, ‘Administrative Simplicity and Equity’.

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Bracewell-Milnes, B, ‘United Kingdom Capital Gains Tax - Indexation v Taper Relief’ (1978). BVCA, Budget submission 2004 (2004) BVCA website. Chamberlain, E, ‘Chargeable gains – section 120 – 126, 140 – 141’ (1998) British Tax Review 471. Clark, K, ‘Budget Statement 1993’, House of Common Debates for10 November 1993 (1993). Coonan, ‘At Call Loans Red Tape to be Cut for Small Business’ (Press Release, 24 May 2004). Costello, P, ‘Reforms to community consultation processes and agency accountabilities in tax design’ (Press Release, 2 May 2002) Costello, P, ‘The New Business Tax System’ (1999) Costello, P, ‘Introducing an Internationally Competitive Gains Tax System’ (1999), Website of the Treasurer. Costello, P, ‘The New Business Tax System’ (Press Release 058 21/09/1999). CPA Australia, ‘Board of Taxation: Post-implementation review of the quality and effectiveness of the small business capital gains tax concessions, submission’ (2005) Dalsgaard, T, ‘The Tax System in New Zealand: An appraisal and option for change’ (Working Paper No 281, OECD Economics Department, 2001). Department of Treasury, ‘The Board of Taxation: It’s role and current activities’ (2005) Department of Treasury, ‘The Treasury Annual Report 2002-03’ (2003) Australian Government (2005) Davey, E, ‘House of Commons Hansard Debates’ 5 July 1999 (1999) 782. Davey, E, ‘House of Commons Hansard Debates’ 17 April 2000 (2000)744. Explanatory Memorandum Finance Bill 1998, Clause 138. Explanatory Memorandum, New Business Tax System (Capital Gains Tax) (1999) (Cth). Explanatory Memorandum, Taxation Law Amendments Bill 1996 (Cth). Freebairn, J, ‘Tax Reform: An Unfinished Agenda?’ (2002), The University of Melbourne.

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Gunn, Malcolm, ‘Short Sharp Shock? An overview of the new capital gains of tax taper relief’ (1998) 141 Taxation 271. Harrison, J, Background Paper 1 1997–98 ‘The GST Debate – A Chronology’ (1997) Parliament of Australia. Harrison, S, Low, Barry, Larson, G, ‘Joint submission on the small business concessions and discretionary trusts’ (2002). HM Treasury, ‘Capital Gains Tax Reform’ (Press Release, 17 March 1998). House of Commons Standing Committee A, pt 2, 3 May 2001, Mr Flight, Clause 159, Explanatory Memorandum 2003. House of Commons, ‘Trade and Industry Fifth Report’ 2 March 2000. ICAA, Board of Taxation: ‘Post-implementation review of the quality and effectiveness of the small business capital gains tax concessions, submission’ (2005) Inland Revenue, ‘2002 Tax Statistics’ (2005) HM Revenue and Customs, ‘Main Tax Expenditures and Structural Relief’ (2006) HM Treasury explanatory notes in 2000. Houghton, W, ‘Crystal Clear Retirement’ (1999) Taxation 84. Kenny, P, ‘Submission to inquiry into the structure and distributive effects of the Australian Tax System’. Kenny, P, ‘A review of the 1999 Australian Capital Gains Tax Reforms’. Lamont, N, Budget Statement 1991, House of Commons Debates for 19 March 1991 (1991) 169. Lamont, N, Budget Statement 1993, House of Commons Debates for 16 March 1993 (1991) 189 McKie, S, ‘Capital Gains Tax Taper Relief: Meaning of security technical note’ (2001), The Chartered Institute of Taxation. National Farmers Federation, ‘Board of Taxation: Post-implementation review of the quality and effectiveness of the small business capital gains tax concessions, submission’ (2005). NTAA, ‘NTLG CGT Subcommittee Minutes June 2003’ (2003) Australian Tax Office. Primarolo, D, House of Commons Hansard Debates 29 April 1998 (1998) 371.

162

Primarolo, D, ‘House of Commons Hansard Debates 29 April 1998 (1998) 375. Primarolo, D, ‘House of Commons Hansard Debates 29 April 1998 (1998) (pt32) Primarolo, D, ‘House of Commons Hansard Debates 29 April 1998 (1998) (pt33) Primarolo, D, ‘House of Commons Hansard Written Answers for 20 April 1998 (pt 2) Review of Business Taxation, ‘A Strong Foundation’, Discussion paper (1998) Review of Business Taxation, ‘A Tax System Redesigned’ (1999). Riches, J, ‘Changing the landscape: Revised Taper Relief’ (2001) 134. Tax Laws Amendment Bill (No1) 2004, Schedule 3, Cth, Canberra. SJQ Legal Services Handbook (2004) Slevin, K, ‘Have you got taper relief? Or do you need a health check?’ (2005) Taxation 551, Editorial, ‘The Future of Retirement Relief’ (1984). Taxation Institute of Australia: ‘Discussion Topics for meeting with Senator Helen Coonan’ (Press Release, 18 June 2003) Taxation Institute of Australia, ‘Piecemeal approach to tax reform will not work’ (Press Release 5th August 1998). The Assistant Treasurer, ‘At Call Loans to Small Business to be Treated as Debt’ (Press Release, 15 July 2005). The Taxpayer, ‘Board of Taxation – Post-implementation review of the small business capital gains tax concessions, submission’ (2005). The Treasurer, ‘The New Business Tax System’, Press Release (No.058) (1999) The Treasurer, ‘Reform of the Australian Taxation System’, Statement by the Treasurer, Canberra, AGPS, 1985. TIA, ICAA, CPA Aust, ‘Joint submission on the small business CGT Concessions and discretionary trusts’ (Media Release, 18 December 2002). TIA, ‘Small business CGT Post Implementation Review’ (2005). Treasury, ‘Draft White Paper: Reform of the Australian Tax System’ AGPS, (1985). World Bank, ‘Evaluating Tax Policy and Administration’ (2002).

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APPENDIX

BOARD OF TAXATION SUBMISSIONS

Introduction

Following the completion of the research for this thesis, a number of relevant

developments have taken place. The purpose of this appendix is to briefly review

these developments to the extent that they relate to the findings of this thesis.

The report by the Board of Taxation on its post-implementation review of the small

business CGT concessions was released on 9 May 2006. The recommendations in the

report and the response by the Government are outlined in the Treasurer's Press

Release No 038 of 9 May 2006.

For purposes of research for this thesis, early access had been made available to six

submissions from major representative bodies to the Board of Taxation. The

remainder of the submissions did not become available until the public release date.

The submissions came from:

• Appleton, Richard

• Australian Chamber of Commerce and Industry

• Australian Forest Growers

• Burton, Dr Mark, Law School, University of Canberra

• Cedar Sales

• CPA Australia

• Department of Agriculture, Fisheries and Forestry

• Grant Thornton

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• Hayes Knight

• Hepworth & Co Pty Ltd

• Housing Industry Association

• Leung, Bill - Lowenstein Sharp Pty Ltd

• National Farmers’ Federation

• National Institute of Accountants

• Nissen Kestel Harford

• Taxation Institute of Australia

• Taxpayers Australia

• The Institute of Chartered Accountants in Australia

• The National Tax and Accountants’ Association

• The Pharmacy Guild of Australia

The review by the Board of Taxation was tightly constrained by the scope of its

mandate, which differed from the wider goals of this thesis. In that context, the

recommendations of the Board will not be examined in detail. However, it will be

useful to review the content of the submissions, as well as the changes made by the

Government in its response to the report of the Board of Taxation. The Board of

Taxation made 39 recommendations.1 The Treasurer’s press release stated:

Of these, 26 recommendations seek legislative amendments and 13 relate to administrative matters. The Government has accepted all but one of the legislative amendment recommendations, 3 with minor amendments favouring the taxpayer, (see the attachment for further details). The Australian Taxation Office (ATO) has accepted all recommendations relating to administrative matters.2

1 ‘Capital gains tax (CGT): government response to the board of taxation’s report on the post-implementation review of the small

business CGT concessions and other improvements’ (Press Release 2006/038).

2 Ibid.

165

All major areas of concern addressed by the submissions were reviewed in Chapter

Three. Although the additional submissions added some new content, that content

supported the major themes already discussed in Chapter Three.

It may be useful to summarise the submissions made regarding the maximum net

asset test and the active asset test. This appendix will not give a detailed consideration

to submissions on the controlling individual / CGT stakeholder test as there is little

added to the submissions previously reviewed.

The maximum net asset test

Submissions drew attention to the following issues:

• The definition of small business was different throughout the Income Tax

Assessment Act and should be standardised.

• Whatever monetary amount or method was used to determine a small

business, adjustments for inflation should be included;

• The $5 million threshold was inadequate and should be increased;

• The threshold should have a shading out mechanism to prevent the use of

uncommercial practices so as to comply with the test;

• Submissions considered the existing STS system as an alternative model;

• It was argued that the maximum net asset test did not allow for many common

business structures used by small business;

• It was suggested the legislation dealing with a main residence used partially or

wholly for income producing purposes should be amended;

• Submissions considered the connected entity test to be flawed.

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Table A1 indicates the areas for which amendments were recommended.

Table A1 - Recommendations for amendments

Submission Index $5m

threshold

Connected entity test

flawed

STS Model

Common business structure problems

Main residence

issues Other

ACCI X X X

CPA X X X X X

ICAA X X X X

NFF X X X

TA X X X X

TIA X X X X

R.Appleton

AFG X

Dr Burton X X

Cedar Sales X X

DAFF X X

Grant Thornton X X

Hayes Knight X X

Hepworth Co

HIA

L Sharp X X

NIA X X

NKH

Pharmacy Guild X X

NTAA

Note: X in box indicates that the issue was addressed in the submission.

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The active asset test

Submissions drew attention to the following issues:

• If a company or trust has large cash balances when a taxpayer disposes of a

share in a company or interest in a trust, the taxpayer will not be entitled to

access the concessions to reduce any capital gain;

• If the sale of an active asset results in an upfront payment with further

instalments over a period of time based on performance, any capital gain that

arises from the further instalments will not qualify for the concessions.

• If a business owner dies, the legal personal representative needs to continue to

carry on the business or the active asset test will not be satisfied.

• Submissions argued that first generation farmers owning land and later renting

farmland should have the right to access the small business CGT concessions.

• The active asset concession should apply to assets such as intellectual property

and in-house software

Table A2 indicates the areas for which amendments were recommended.

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Table A2 - Recommendations for amendments

Submission Cash balances

Deceased estates

Sale of Business

Lump Sum

Payments

Simplified definition

– complexity

issues

Active Asset test

broadened

ACCI

CPA X X

ICAA X X X

NFF X

TA X X

TIA X X X

R.Appleton X

AFG X

Dr Burton X

Cedar Sales X

DAFF X X

Grant Thornton X

Hayes Knight X

Hepworth Co

HIA

L Sharp

NIA

NKH X X

Pharmacy Guild

NTAA

Note: X in box indicates that the issue was addressed in the submission.

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Budget 2006-07

The 2006-07 budget was handed down on 9 May 2006. In his budget speech, the

Treasurer of the Federal Government, Mr Peter Costello mentioned:

This Budget takes progress much further with a range of measures which will reduce the complexity faced by small business. These include changes to make the Simplified Tax System more attractive, aligning thresholds for small businesses to make it easier for them to understand their eligibility for various concessions, and simplifying and extending access to the small business capital gains tax concessions. These changes will provide benefits worth $435 million to small business over the next four years.3

The Government has indicated that it will reduce taxes on business by $4.2 billion

over four years and will introduce a number of reforms to further simplify the tax

system for small business.4 The Government considers that these measures will

reduce compliance costs for small business and allow more taxpayers to be eligible

for the small business tax arrangements.

The budget implemented most of the recommendations contained in the report by the

Board of Taxation and also addressed some of the complexity associated with small

business tax law by announcing a range of simplification measures that would:

• align a range of small business measures set at turnover levels of between

$1 million and $2 million;

• align certain methodologies by which turnover is calculated under the STS and

goods and services tax;

• increase the STS annual turnover threshold from $1 million to $2 million;

• remove the $3 million depreciating assets test from the STS eligibility

requirements altogether; and

3 P Costello, Budget speech 2006-07 <http://www.budget.gov.au/2006-07/speech/html/Speech.htm> at 27 August 2006.

4 The Treasurer, Continuing Business Tax Reform (2006) Budget 2006/07

<http://www.budget.gov.au/2006-07/ministerial/html/treasury-05.htm> at 27 August 2006.

170

• increase the net assets threshold for the small business CGT concessions from

$5 million to $6 million;

• allow STS taxpayers to be eligible for the small business CGT concessions

without having to satisfy the net assets threshold and to pay quarterly pay as

you go instalments on the basis of GDP-adjusted notional tax;

• introduce a number of measures that will simplify and extend small business

access to CGT concessions in response to the Board of Taxation's post

implementation review of small business CGT arrangements;

• extend access to the small business CGT concessions by replacing the 50%

controlling individual test with a 20% significant individual test that can be

satisfied either directly or through interposed entities

• extend depreciating asset roll-over relief under the uniform capital allowance

regime to situations where a sole trader, trustee or partnership in the STS

disposes of all the assets in an STS pool to a wholly-owned company; and

• increase certain fringe benefits tax thresholds.5

In summarising the changes, points made by the National Tax & Accountants'

Association (NTAA) included:6

New 20% test allows easier access to all the small business concessions. • Small shareholders can now take advantage of the concessions • Huge benefits for multi–tiered business structures Active asset test now made easier to pass • Assets no longer need to be active at the time of sale. • Former business premises can now be rented and remain an active asset; • More shares and units will now qualify for the CGT concessions. • Entities owned by non–individuals can now claim the concessions

5 Ibid.

6 NTAA, Tax Hotspots, 2006.

171

The new 20% significant individual test is acknowledged to be an improvement to the

controlling individual / CGT stakeholder test. However, in terms of equity, if a

taxpayer is a shareholder/unitholder and employee of a business entity, the taxpayer

should have access to the small business CGT concessions no matter what the size or

percentage of ownership. The recommendation for removal of the controlling

individual / CGT stakeholder test was supported by this thesis and this viewpoint has

not changed. Nevertheless, all the changes implemented are welcomed and supported.

Costings associated with these small business measures are as follows:

Cost to revenue of aligning definitions in the tax laws

2006-07 2007-08 2008-09 2009-10

ATO Revenue ($m) - -1.0 -55.0 -71.0

The Government will simplify and improve alignment of various small business tax relief arrangements contained in the tax laws, including the simplified tax system (STS), capital gains tax (CGT), goods and services tax, fringe benefits tax and pay as you go (PAYG) instalments. This measure will apply from the start of the 2007-08 income year. This measure will: • increase the STS annual turnover threshold from $1 million to $2 million; • remove the $3 million depreciating assets test from the STS eligibility requirements; • increase the net assets threshold for the CGT small business concessions from

$5 million to $6 million; and • allow STS taxpayers to be eligible for the CGT small business concessions without

having to satisfy the net assets threshold and to pay quarterly PAYG instalments on the basis of GDP-adjusted notional tax.7

Cost to revenue of small business CGT amendments

2006-07 2007-08 2008-09 2009-10

ATO Revenue ($m) - -92.0 -97.0 -101.0

7 Treasury, Budget Paper No. 2, Part 1: Revenue Measures

< http://www.budget.gov.au/2006-07/bp2/html/bp2_revenue-07.htm > at 27 August 2006.

172

The Government will implement all but one of the recommendations of the Board of Taxation's post-implementation review of the small business capital gains tax (CGT) concessions. The amendments will ensure that the concessions are simpler, clearer and fairer. They will also reduce compliance costs for small business. The Government will improve the operation of the small business CGT concessions by making changes to the maximum net asset value test, the active asset test, the 15-year exemption, the retirement exemption, the small business roll-over, and how the concessions apply to partnerships. In addition to these amendments, the Government will provide improved access to the concessions by replacing the current 50 per cent controlling individual test with a more generous 20 per cent significant individual test. The significant individual test will be able to be satisfied either directly or indirectly through one or more interposed entities. These measures will apply to CGT events that happen in the 2006-07 and later income years.8

The National Tax Liaison Group Losses and CGT subcommittee convened in Sydney

on 7 June 2006. The budgetary amendments to Division 152 were discussed and in

particular, the Treasurer’s press release statements 38/2006 and 39/2006. The meeting

noted the following:

• the legislation will be in place by the end of 2006-07 income year; however, it

is recognised that the changes apply from 1 July 2006;

• For the purposes of confidential consultation, it is likely the draft legislation

will be released to members of the subcommittee;

• In addition, it announced the replacement of the 50% controlling individual

test with a 20% significant individual test that can be satisfied either directly

or indirectly through one or more interposed entities;

• It was noted that Treasury will provide members with a number of worked

examples (attached at the end of this appendix) as to how the new test is likely

to apply, noting there will be no restrictions on the distribution of these

examples. Members were invited to provide feedback on the examples.

8 Ibid.

173

• In response to the need for tax advisers to have guidance on these issues, the

Tax Office notes that various Guides will be updated electronically in the near

future; however, there are some limitations until the legislation is enacted.

• The Treasury noted that an additional small business measure, which includes

changes to increase the net assets threshold from $5 million to $6 million for

the CGT small business concessions and allow STS taxpayers to be eligible

for the concessions without having to satisfy the net assets threshold, was

announced in the press release No 39. The timing of the legislation that will

cover these amendments is not yet known.9

The examples provided at the end of this appendix will indicate that there is room for

further improvements with respect to the criteria of equity, efficiency and simplicity.

The Government has persisted with complex diagrams resembling organisational

charts that are far from simple. Equity and efficiency will only be proven after the

legislation comes into existence. The ramifications for taxpayers who use company

and trust structures will continue to be complex.

The amended legislation tries to extrapolate existing concepts of what constitutes a

‘small business’ but there are other ways by which this need could have been

addressed. It is considered that the criteria of equity, efficiency and simplicity are

addressed better by the definition as put forward by this thesis for access to the small

business CGT concessions.

9 NTLG meeting as above.

174

Conclusion

The detail to the changes recommended in 2006-07 is not available as yet but most

amendments are welcomed and are in alignment with the recommendations of this

thesis. The predicted cost to the revenue system is low when compared to predicted

personal tax cuts worth $36.7 billion over four years announced in the same budget.

The move to align the definition of small business across GST, CGT and the STS

system is a step in the right direction. According to the Treasurer’s press release:

This package improves alignment across the main small business regimes of the STS, CGT and GST and will simplify the tax affairs of over two million small businesses, including 65,000 businesses that will become eligible for the STS.10

The Government is yet to reveal if the turnover threshold will be indexed or aligned

with inflation.

While the Government has increased the maximum net asset threshold to $6 million,

the changes to the maximum net asset test and its provisions can only be described as

‘tinkering’. While the adjustments are generally welcomed in terms of equity and

fairness, in the emerging reality simplicity may prove to be the loser. Future research

will be required to ascertain whether the Government has met its objectives and pass

final judgment on whether the legislation has become simpler, clearer and fairer.

10 Press release 039/2006

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Draft NTLG Losses and CGT subcommittee minutes - 7 June 2006

Business structure

Individual 1 is a significant individual of Company B – they have an indirect interest of 66.6% in Company B. The new significant individual test ‘looks through’ interposed entities.

Individual 2 is a significant individual of Company B – they have a direct interest of 33.3%. The new significant individual test only requires a 20% interest (rather than the previous controlling individual test that required a 50% interest).

Appendix B2

Controlling/significant individual examples

Old law (controlling individual) @ 50% (direct only)

Example 1 (direct interest < 50%)

Operating Co carries on business. Mum, Dad and their adult son each own 331/3% of the shares in the company and are all actively engaged in running the business.

Operating Co does not have a controlling individual in this situation. This is because no individual holds the legal and equitable interests in shares that carry the right to exercise at least 50% of the voting power and receive at least 50% of any income or capital distributions.

Example 2 (50% interest held indirectly)

Small Business Co (SBC) conducts a professional services business. It has two shareholders, Company A and Company B, which each own 50% of SBC shares. Candy owns 100% of the shares in Company A and Heidi owns a 100% of the shares in Company B.

SBC does not have a controlling individual in this situation. This is because no individual directly holds the legal and equitable interests in shares that carry the right to exercise at least 50% of the voting power and receive at least 50% of any income or capital distributions.

176

Although Candy and Heidi each effectively own 50% of the shares in SBC they are not controlling individuals of SBC because they do not directly own the shares in SBC. Company A and Company B are also not controlling individuals because they are not individuals.

New law (significant individual): @ 20% (direct or indirect)

Example 3 (direct interest of at least 20%)

Pastoral Co carries on a primary production business. Mum, Dad and their 3 children each own 20% of the shares in the company.

Pastoral Co has a significant individual in this situation. In fact, all 5 shareholders are significant individuals because they each hold at least 20% of the shares in Pastoral Co.

Example 4 (indirect interest of at least 20%)

Acme Co carries on a landscaping business. Company A owns 100% of the shares in Acme Co and Company B owns 50% of the shares in Company A. Wily owns 40% of the shares in Company B.

In this situation, Wily indirectly owns 20% (that is, 40% x 50% x 100%) of the shares in Acme Co through the various interposed companies. As such, Wily is a significant individual of Acme Co.

Appendix B3

Business structure

Scenario 1: asset sale

If the assets of C Co are sold and the proceeds of sale are distributed:

1.1: A1 and A2 will each qualify as significant individuals by virtue of having at least 20% of the shares in C Co and as such they will be CGT concession stakeholders; and

1.2: B1 and B2 can also qualify provided trust B makes a distribution of all of its income and capital for the year ended 30 June 2007 (or at least 33.33% of its income or capital) to B1 and/or B2. If say B1 receives the distribution B1 should be a significant individual. Following on from this, B1 should also be a CGT concession stakeholder. B2 is also a CGT Concession Stakeholder as B2 is the spouse of a significant individual (B1) with an interest in C Co.

Scenario 2: share sale

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If the B family decides to sell its interests in C Co, and all the shares of B1, B2 and trust B in C Co are sold.

2.1: Because the CGT asset in question is a share in a company, the two additional basic conditions in 152-10(2) must both be satisfied. The company must pass the significant individual test and ‘you’ (the entity that owns the shares) must be a CGT concession stakeholder in the company.

2.2: Paragraph 152 10(2)(a) is satisfied because the company has at least one significant individual (both A1 and A2).

2.3: B1 will be a significant individual (on the basis of a distribution as per paragraph 1.2 above) and accordingly a concession stakeholder. Accordingly, both paragraphs 152-10(2)(a) and (b) will be satisfied and B1 will qualify for the concessions.

2.4: B2 will qualify for the concessions on the basis of being a CGT concession stakeholder by virtue of being a spouse of a significant individual.

2.5: Trust B does not qualify for the concessions because it must be a CGT concession stakeholder. A CGT concession stakeholder will be either a significant individual or a stakeholder spouse of a significant individual. Trust B (as a discretionary trust) is neither a significant individual (not an individual) nor a spouse. Accordingly, Trust B will not qualify for any of the concessions because a basic condition is not satisfied.

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An evaluation of the Capital Gains Tax concessions for ... · PDF fileAn evaluation of the Capital Gains Tax concessions for small business WAYNE WILSON MARRIAGE ... Taxation.2 The