CGT PRACTICE Insights - Geelong Accounting | Practice Insights Selling a Small Business – The CGT Strategies 4th Edition September 2004 TAX a division of information exchange Selling

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CGT Practice Insights

Selling a Small Business

– The CGT Strategies

4th Edition

September 2004

TAXa division of information exchange

http://www.ifx.info

Selling a Small Business – The CGT Strategies

Contents PREFACE .......................................................................................................................................x

CHAPTER 1 – INTRODUCTION ...............................................................................................1

¶1.000 INTRODUCTION ................................................................................................................2 ¶1.010 REMOVAL OF INDEXATION.......................................................................................3

¶1.011 One year holding rule........................................................................................................4 ¶1.020 CALCULATION OF CAPITAL GAINS .........................................................................6

¶1.021 Working out net capital gain or loss .................................................................................6 ¶1.022 Non-discount capital gains..............................................................................................10 ¶1.023 New sec 115-45...............................................................................................................17 ¶1.024 Discount percentage........................................................................................................19 ¶1.025 Calculation example........................................................................................................19 ¶1.026 Example applying ATO approach...................................................................................23 ¶1.027 Choice .............................................................................................................................23 ¶1.028 Application of Subdivision 115-D – tax relief for shareholders in listed

investment companies (LICs).........................................................................................24 ¶1.030 CALCULATING CGT LOSSES....................................................................................24

¶1.031 Applying losses to other concessionally taxed capital gains...........................................25 ¶1.040 REMOVAL OF AVERAGING..........................................................................................25

¶1.041 Transitional rules.............................................................................................................25 ¶1.042 Transitional rules for trust distributions..........................................................................29

¶1.050 TRUSTS – HOW TO CALCULATE CAPITAL GAINS AND LOSSES.........................31 ¶1.051 New sec 115-215 – assessing presently entitled beneficiaries........................................31 ¶1.052 Cost base adjustment for fixed trusts ..............................................................................37 ¶1.053 Commentary on the superseded provisions applying to payments made prior

to 1 July 2001 .................................................................................................................47

¶1.054 Discretionary trusts .........................................................................................................53 ¶1.055 Distribution streaming.....................................................................................................54 ¶1.056 Chains of trusts................................................................................................................54 ¶1.057 Child maintenance trusts .................................................................................................55 ¶1.058 Transitional rule for trusts...............................................................................................55

¶1.060 COMPANIES – HOW TO CALCULATE CAPITAL GAINS AND LOSSES.................56

¶1.061 Interests in trusts held by a company ..............................................................................56 ¶1.070 REMOVAL OF PLANT AND EQUIPMENT FROM THE CGT REGIME.....................57

¶1.071 Statutory licences ............................................................................................................58 ¶1.072 Application of new provisions to existing plant .............................................................58 ¶1.073 New CGT event K7.........................................................................................................60

¶1.080 TIPS TO MAXIMISE THE CONCESSION BENEFITS...............................................62

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Selling a Small Business – The CGT Strategies CHAPTER 2 SMALL BUSINESS CONCESSIONS ...............................................................65

¶2.000 SMALL BUSINESS CONCESSIONS OVERVIEW.....................................................65 ¶2.010 BASIC CONDITIONS FOR RELIEF ............................................................................66 ¶2.020 MAXIMUM NET ASSET VALUE TEST .....................................................................66

¶2.021 What is the time for determining the net asset threshold? ..............................................69 ¶2.022 Net value of the CGT assets............................................................................................70 ¶2.023 Meaning of small business CGT affiliate........................................................................80 ¶2.024 Partnerships and partners ................................................................................................82 ¶2.025 Control of discretionary trust ..........................................................................................83 ¶2.026 Assistant Treasurer’s announcement to introduce amendments to limit

application of sec 152-30(5)...........................................................................................86 ¶2.027 Amendments introduced 19 February 2004....................................................................88 ¶2.028 Commentary on amendments..........................................................................................91 ¶2.029 Commentary on previous provisions ............................................................................102 ¶2.0291 Meaning of “connected with” and “control”...............................................................105

¶2.030 ACTIVE ASSET TEST ................................................................................................111 ¶2.031 Example where business has ceased within 12 months of the sale of active

asset ..............................................................................................................................112 ¶2.032 Meaning of “active asset” .............................................................................................114 ¶2.033 Assets held as cash pending the acquisition of new assets ...........................................116 ¶2.034 ATO interpretative decisions on active assets...............................................................117 ¶2.035 Redundant assets not longer used in a business ............................................................118 ¶2.036 Shares held under bare trust ..........................................................................................119 ¶2.037 Guest houses/boarding houses, etc................................................................................119 ¶2.038 Loans.............................................................................................................................121 ¶2.039 Restrictive covenants as active assets ...........................................................................121 ¶2.0391 Licence of business as an active asset.........................................................................121 ¶2.0392 Forfeited deposits........................................................................................................122 ¶2.0393 Performance clauses....................................................................................................122 ¶2.0394 Whether assets held in a super fund can be active asset .............................................126 ¶2.0395 Involuntary disposals ..................................................................................................127

¶2.040 CONTROLLING INDIVIDUAL TEST .......................................................................128 ¶2.041 Discretionary trusts .......................................................................................................131 ¶2.042 The treatment of the small business concessions and consolidation.............................132

¶2.050 CGT CONCESSION STAKEHOLDER.......................................................................133

CHAPTER 3 15-YEAR RETIREMENT EXEMPTION .......................................................135

¶3.000 15-YEAR RETIREMENT EXEMPTION........................................................................135 ¶3.001 Losses retained..............................................................................................................136

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Selling a Small Business – The CGT Strategies ¶3.010 15-YEAR EXEMPTION FOR INDIVIDUALS...........................................................136

¶3.011 Sale of shares or an interest in a trust............................................................................138 ¶3.012 Meaning of “retirement” ...............................................................................................139 ¶3.013 Retirement “in connection with” the disposal...............................................................140 ¶3.014 Permanent incapacity ....................................................................................................140 ¶3.015 Main residence exemption ............................................................................................141

¶3.020 15-YEAR EXEMPTION FOR COMPANIES AND TRUSTS ....................................142 ¶3.030 INVOLUNTARY DISPOSALS ...................................................................................144 ¶3.040 DISCRETIONARY TRUSTS.......................................................................................145 ¶3.050 PAYMENTS TO CGT CONCESSION STAKEHOLDERS........................................146

¶3.051 Pre-CGT gains also exempt when distributed...............................................................148 ¶3.060 SALE OF ASSET AFTER “RETIREMENT”..................................................................148

CHAPTER 4 50% SMALL BUSINESS REDUCTION .........................................................151

¶4.000 50% SMALL BUSINESS REDUCTION.........................................................................151 ¶4.001 Applying the small business 50% reduction .................................................................151 ¶4.002 Restrictive covenants ....................................................................................................153 ¶4.003 Dilemma for small business conducted through a company.........................................153

CHAPTER 5 RETIREMENT EXEMPTION AVAILABLE FOR CONSOLIDATED GROUP...........................................................................................................................155

¶5.070 RETIREMENT EXEMPTION AVAILABLE FOR CONSOLIDATED GROUP ..........155

¶5.000 SMALL BUSINESS RETIREMENT CONCESSION.....................................................155 ¶5.001 Retirement concession now applies where entity disposed of ......................................156

¶5.010 ELIGIBILITY FOR RETIREMENT EXEMPTION........................................................157 ¶5.011 Where no capital proceeds ............................................................................................158 ¶5.012 ATO view......................................................................................................................158

¶5.020 WHEN TO ROLL OVER CAPITAL PROCEEDS .........................................................160 ¶5.021 Where proceeds paid into super fund before retirement exemption chosen .................163

¶5.030 CHOICE TO BE MADE IN WRITING...........................................................................163 ¶5.040 APPLYING THE EXEMPTION WHERE COMPANY OR TRUST .............................165

¶5.041 Trust ..............................................................................................................................167 ¶5.042 ETP – must it be paid in consequence of the termination of employment?..................167

¶5.043 Can an ETP under sec 152-325(1) be made to an employee who remains a director? .......................................................................................................................169

¶5.044 Property sold to super fund and proceeds directed back to fund...................................171 ¶5.045 Making ETPs where payments received in installments...............................................171 ¶5.046 More than one CGT concession stakeholder ................................................................171 ¶5.047 Delaying payment of capital proceeds ..........................................................................172 ¶5.048 Application of sec 109 ITAA 36? .................................................................................172

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Selling a Small Business – The CGT Strategies ¶5.049 Consequences of choice ................................................................................................174

¶5.050 CGT RETIREMENT EXEMPTION LIMIT....................................................................174 ¶5.060 EX GRATIA PAYMENTS ..............................................................................................175 ¶5.070 RETIREMENT EXEMPTION AVAILABLE FOR CONSOLIDATED GROUP ..........175

CHAPTER 6 SMALL BUSINESS ROLL-OVER...................................................................178

¶6.010 SMALL BUSINESS ROLL-OVER .................................................................................178 ¶6.011 No five-year limitation but gains quarantined...............................................................179

¶6.020 ELIGIBILITY FOR ROLL-OVER ..................................................................................180 ¶6.021 Time to choose roll-over ...............................................................................................180

¶6.030 REPLACEMENT ASSET CONDITIONS.......................................................................182 ¶6.031 Type of replacement asset.............................................................................................185 ¶6.032 Subdivision 124-B roll-over..........................................................................................187 ¶6.033 CGT roll-over implications where work in progress amount is included as

income under sec 15-50 ITAA 97 ................................................................................187

¶6.040 CHANGE OF STATUS OF AN ACTIVE ASSET..........................................................187 ¶6.041 Rules where an individual who has obtained a roll-over dies.......................................187

CHAPTER 7 SCRIP FOR SCRIP ROLL-OVER ...................................................................188

¶7.000 SCRIP FOR SCRIP ROLL-OVER...................................................................................188 ¶7.010 SMALL/MEDIUM BUSINESS OPPORTUNITIES .......................................................189 ¶7.020 SCRIP FOR SCRIP ELIGIBILITY REQUIREMENTS ..................................................190

¶7.021 Substantially the same terms.........................................................................................195 ¶7.022 Part application of the roll-over ....................................................................................195 ¶7.023 Pre-CGT interests..........................................................................................................196 ¶7.024 Like for like...................................................................................................................197 ¶7.025 Satisfying the requirements where shares or interests already held by offeror.............198

¶7.026 In consequence of single arrangement ..........................................................................201 ¶7.027 Roll-over extended to “downstream” acquisitions in company cases...........................203 ¶7.028 Limited roll-over for pre-CGT original interests ..........................................................203 ¶7.029 Cost base of interests acquired by holder in target entity .............................................204 ¶7.0291 Form of joint election and cost base notice.................................................................212 ¶7.0292 CUFS and CDIs ..........................................................................................................214 ¶7.0293 Requirement for unit holders to have a vested and indefeasible interest to a

share of the income and in the capital of a trust..........................................................214 ¶7.0294 Original interest holder ...............................................................................................215

¶7.030 NON-WIDELY HELD ENTITIES ..................................................................................216 ¶ 7.031 “Arm’s length” dealings...............................................................................................217

¶7.040 LINKED GROUPS...........................................................................................................222 ¶7.050 APPLYING THE ROLL-OVER ......................................................................................223

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Selling a Small Business – The CGT Strategies ¶7.051 Partial roll-over .............................................................................................................224

¶7.060 EXCEPTIONS – WHERE NO ROLL-OVER AVAILABLE..........................................228 ¶7.061 First exception...............................................................................................................228 ¶7.062 Second exception ..........................................................................................................228 ¶7.063 Third exception .............................................................................................................229 ¶7.064 “Fourth exception”........................................................................................................229

¶7.070 SCRIP FOR SCRIP CLASS RULINGS...........................................................................230

CHAPTER 8 DEMERGERS.....................................................................................................237

¶8.000 BACKGROUND ..............................................................................................................237 ¶8.010 ELIGIBILITY RULES .....................................................................................................238

¶8.011 Further requirements .....................................................................................................239 ¶8.012 Further concessions and consequences under the demerger roll-over ..........................240 ¶8.013 Consolidations, losses and franking credits ..................................................................240

¶8.020 IMPACT ON SMALL/MEDIUM BUSINESS ................................................................241 ¶8.030 DEMERGER EXAMPLE ................................................................................................241 ¶8.040 THE RULES IN MORE DETAIL....................................................................................243

¶8.041 What is a demerger?......................................................................................................243 ¶8.042 Types of demerger ........................................................................................................244 ¶8.043 Exclusion of discretionary trusts...................................................................................245 ¶8.044 Transfer of non-ownership assets..................................................................................246 ¶8.045 Types of “ownership interests” .....................................................................................246 ¶8.046 Market value – near enough is good enough ................................................................246 ¶8.047 Exclusion for employee share schemes and dual listed company voting

shares............................................................................................................................246 ¶8.048 Exclusion of off-market share buybacks.......................................................................247 ¶8.049 Cost base adjustments ...................................................................................................247 ¶8.0491 Cost base adjustments where roll-over not chosen .....................................................248 ¶8.0492 Consequences for members of demerger group..........................................................248 ¶8.0493 Time of acquisition for new interests..........................................................................250

¶8.050 DIVIDEND RELIEF ........................................................................................................250 ¶8.051 No relief under sec 118-20 where new interests acquired under a foreign

demerger are disposed..................................................................................................251 ¶8.052 Transitional rules...........................................................................................................251

¶8.060 STAMP DUTY CONSIDERATIONS .............................................................................251

CHAPTER 9 RESTRUCTURING RELIEF............................................................................252

¶9.000 RESTRUCTURING RELIEF...........................................................................................252 ¶9.001 No CGT roll-over for depreciating assets under Subdivision 124-N............................258 ¶9.002 Roll-over from company to individual..........................................................................259

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Selling a Small Business – The CGT Strategies ¶9.003 Risk for current sales.....................................................................................................260

¶9.010 CGT ROLL-OVER FOR FINANCIAL SERVICES REFORM ......................................260 ¶9.020 RESTRUCTURING DISCRETIONARY TRUSTS ........................................................260

CHAPTER 10 SALE OF BUSINESS BY ENTITY TRANSFER..........................................262

¶10.000 SALE OF BUSINESS BY ENTITY TRANSFER .........................................................262 ¶10.010 SALE OF COMPANY SHARES OR UNITS IN A TRUST.........................................262

¶10.011 Sale of business assets and liquidation of company....................................................263 ¶10.020 TRANSFER OF DISCRETIONARY TRUST? .............................................................265

CHAPTER 11 SUCCESSION PLANNING.............................................................................267

¶11.000 SUCCESSION PLANNING ..........................................................................................267 ¶11.010 INVOLUNTARY DISPOSAL ROLL-OVERS TO BE EXTENDED...........................269 ¶11.020 GAINS ON THE DISPOSAL OF INTERPOSED NON-RESIDENT ENTITIES ........269

¶11.030 PREVENTING LOSS DUPLICATION AND VALUE SHIFTING .............................270

CHAPTER 12 NEW VALUE SHIFTING RULES .................................................................274

¶12.000 INTRODUCTION ..........................................................................................................274 ¶12.010 OVERVIEW...................................................................................................................275 ¶12.020 IMPACT ON SMALL/MEDIUM BUSINESS ..............................................................276 ¶12.030 THE RULES IN SUMMARY ........................................................................................277

¶12.031 Direct Value Shifts......................................................................................................277 ¶12.032 Who is a controller? ....................................................................................................277 ¶12.033 Where effect of shift reversed within four years.........................................................277 ¶12.034 Where only partial value shift .....................................................................................277 ¶12.035 Working out the consequences of a value shift...........................................................278 ¶12.036 Issuing rights for no consideration..............................................................................278 ¶12.037 Issuing shares at a premium ........................................................................................278 ¶12.038 Neutral value shifts .....................................................................................................279 ¶12.039 Direct value shift involving a debt interest in a company...........................................281

¶12.040 DIRECT VALUE SHIFTS INVOLVING CREATED RIGHTS OVER NON-DEPRECIATING PROPERTY ....................................................................................282

¶12.050 INDIRECT VALUE SHIFTS.........................................................................................283 ¶12.051 Mixed group shifts, for example units/shares .............................................................284 ¶12.052 Land transferred at cost...............................................................................................284

¶12.060 PART IVA......................................................................................................................285

CHAPTER 13 EXTENSION TO PART IVA ..........................................................................287

¶13.000 EXTENSION TO PART IVA ........................................................................................287 ¶13.001 Further amendments....................................................................................................287 ¶13.002 Small business structures ............................................................................................288

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Selling a Small Business – The CGT Strategies ¶13.003 Income to capital .........................................................................................................288

CHAPTER 14 ATO'S COMPLIANCE PROGRAM FOR 2004-05 ......................................292

¶14.000 ATO’S COMPLIANCE PROGRAM FOR 2004-05......................................................292 ¶14.010 CGT AUDIT CHECKS ..................................................................................................293

¶14.011 Record keeping ...........................................................................................................293 ¶14.012 Oral evidence ..............................................................................................................294 ¶14.013 Obtaining valuations ...................................................................................................294 ¶14.014 Tax advice records ......................................................................................................295

CHAPTER 15 - CASE STUDIES .............................................................................................297

¶15.000 CASE STUDIES – INTRODUCTION...........................................................................297 ¶15.010 CASE STUDY 1 – BUSINESS THROUGH FAMILY DISCRETIONARY TRUST ..298

¶15.011 Answer − Pre-Ralph....................................................................................................298 ¶15.012 Position under the new CGT regime...........................................................................299

¶15.020 CASE STUDY 2 – HUSBAND AND WIFE BUSINESS PARTNERSHIP..................300 ¶15.021 Answer − Pre-Ralph....................................................................................................300 ¶15.022 Position under the new CGT regime...........................................................................300

¶15.030 CASE STUDY 3 – MORE THAN ONE BUSINESS HELD.........................................301 ¶15.031 Question 3(a)...............................................................................................................301 ¶15.032 Question 3(b)...............................................................................................................301 ¶15.033 Question 3(c)...............................................................................................................301 ¶15.034 Question 3(d)...............................................................................................................301 ¶15.035 Question 3(e)...............................................................................................................302

¶15.040 CASE STUDY 4 – SOLE TRADER..............................................................................302 ¶15.041 Question 4(a)...............................................................................................................302 ¶15.042 Question 4(b)...............................................................................................................303 ¶15.043 Question 4(c)...............................................................................................................303

¶15.050 CASE STUDY 5 – GRAZING PARTNERSHIP – LAND HELD BY ONE PARTNER ....................................................................................................................303

¶15.051 Question 5(a)...............................................................................................................303 ¶15.052 Question 5(b)...............................................................................................................304 ¶15.053 Question 5(c)...............................................................................................................304

¶15.060 CASE STUDY 6 – SOLE TRADER – STATEMENT OF TERMINATION PAYMENTS SCHEDULE ...........................................................................................305

¶15.061 Question 6(a)...............................................................................................................305 ¶15.062 Question 6(b)...............................................................................................................305

¶15.070 CASE STUDY 7 – COMPANY BUSINESS RENTING PROPERTY HELD BY SHAREHOLDER .........................................................................................................305

¶15.071 Question 7(a)...............................................................................................................305 ¶15.072 Question 7(b)...............................................................................................................306

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Selling a Small Business – The CGT Strategies ¶15.073 Question 7(c)...............................................................................................................306

¶15.080 CASE STUDY 8 – APPLYING ROLL-OVER RELIEF...............................................307 ¶15.090 CASE STUDY 9 – TRACKING RETIREMENT EXEMPTION FUNDS

THROUGH SUPER FUND..........................................................................................307 ¶15.100 CASE STUDY 10 – USING ROLL-OVER TO REORGANISE OPERATING

ENTITY ........................................................................................................................308 ¶15.110 CASE STUDY 11 – PART SALE BY PARTNERSHIP ...............................................308 ¶15.120 CASE STUDY 12 – FARMING PARTNERSHIP – RETIREMENT PLANNING ......309

¶15.130 CASE STUDY 13 – SALE OF BUSINESS BY PARTNERSHIP – CONTINUED EMPLOYMENT...........................................................................................................310

¶15.140 CASE STUDY 14 – VARIATION OF PARTNERSHIP...............................................310 ¶15.150 CASE STUDY 15 – SHAREFARMING AGREEMENT WITH COMPANY .............311

¶15.160 CASE STUDY 16 – PRE-CGT PROPERTY ACQUIRED BY WIDOW LEASED TO PARTNERSHIP .....................................................................................................312

¶15.170 CASE STUDY 17 – HUSBAND AND WIFE PARTNERSHIP PROPERTY ROLL-OVER............................................................................................................................313

¶15.180 CASE STUDY 18 – FARM HELD AS JOINT PROPERTY WITH SHARE FARMING AGREEMENT LATER ESTABLISHED WITH FAMILY DISCRETIONARY TRUST.........................................................................................314

¶15.190 CASE STUDY 19 – SPLITTING FAMILY PROPERTIES..........................................316 ¶15.200 CASE STUDY 20 – FAMILY DISCRETIONARY TRUST CONDUCTING

FARMING OPERATIONS ..........................................................................................316 ¶15.210 CASE STUDY 21 – SOLE TRADER – AVAILABLE OPTIONS ...............................317 ¶15.220 CASE STUDY 22 – FAMILY DISCRETIONARY TRUST WITH LAND HELD

BY FAMILY MEMBERS ............................................................................................318 ¶15.230 CASE STUDY 23 – FIVE-PERSON PARTNERSHIP .................................................319 ¶15.240 CASE STUDY 24 – RENTAL PROPERTY BUSINESS OPERATED BY

COMPANY...................................................................................................................320 ¶15.250 CASE STUDY 25 – SALE OF COMPANY SHARES .................................................321 ¶15.260 CASE STUDY 26 – SALE OF CHILD CARE CENTRE .............................................322 ¶15.270 CASE STUDY 27 – SALE OF MEDICAL PRACTICE COMPANY ..........................323

APPENDIX 1 SMALL BUSINESS AND OTHER CONCESSIONS CHECKLISTS .........336

APPENDIX 2 TREASURER’S PRESS RELEASE OF 23 DECEMBER 1999....................342

APPENDIX 3 ATO CGT AND GST SURVEY AND QUESTIONNAIRE...........................346

IMPORTANT NOTE For copyright and disclaimer, see the end of this document.

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Preface

On 16 October 2003 the Assistant Treasurer, Senator Helen Coonan, announced long overdue changes to ensure that small businesses operating through discretionary trusts can more readily benefit from the CGT concessions. These changes are contained in the Tax Laws Amendment (2004 New Measures No.1) Act 2004 introduced into Parliament in February. These changes are essential reading for all advisers and others interested in making use of the extensive CGT small business concessions. In this new edition of Selling a Small Business – The CGT Strategies each of these changes is examined in detail. Although they appear simple, the changes contain a number of issues that need to be understood, including: • important transitional rules that apply only during the current financial

year; and • the allowance, for a limited period, of previous invalid claims to the

concessions to be correctly claimed. Also included in this updated edition are references to the many Australian Taxation Office Interpretative Decisions issued in the last 6 months, making it more authoritative than ever.

Developments that have come to notice by 1 September 2004 have been also incorporated.

Geoff Petersson

September 2004

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Chapter 1

Introduction

¶1.000 INTRODUCTION

¶1.010 REMOVAL OF INDEXATION

¶1.011 One year holding rule

¶1.020 CALCULATION OF CAPITAL GAINS

¶1.021 Working out net capital gain or loss¶1.022 Non-discount capital gains¶1.023 New sec 115-45¶1.024 Discount percentage¶1.025 Calculation example¶1.026 Example applying ATO approach¶1.027 Choice¶1.028 Application of Subdivision 115-D – tax relief for shareholders in listed

investment companies (LICs)

¶1.030 CALCULATING CGT LOSSES

¶1.031 Applying losses to other concessionally taxed capital gains

¶1.040 REMOVAL OF AVERAGING

¶1.041 Transitional rules¶1.042 Transitional rules for trust distributions

¶1.050 TRUSTS – HOW TO CALCULATE CAPITAL GAINS AND LOSSES

¶1.051 New sec 115-215 – assessing presently entitled beneficiaries¶1.052 Cost base adjustment for fixed trusts¶1.053 Commentary on the superseded provisions applying to payments made prior

to 1 July 2001 ¶1.054 Discretionary trusts¶1.055 Distribution streaming¶1.056 Chains of trusts¶1.057 Child maintenance trusts¶1.058 Transitional rule for trusts

¶1.060 COMPANIES – HOW TO CALCULATE CAPITAL GAINS AND LOSSES

¶1.061 Interests in trusts held by a company

¶1.070 REMOVAL OF PLANT AND EQUIPMENT FROM THE CGT REGIME

¶1.071 Statutory licences¶1.072 Application of new provisions to existing plant¶1.073 New CGT event K7

¶1.080 TIPS TO MAXIMISE THE CONCESSION BENEFITS

1



This Portfolio examines and explores the effect of the major changes to the CGT regime affecting the sale of a small business introduced by the Coalition Government in 1999 and subsequent CGT Business Tax Reform changes. In particular, the recently introduced demerger concessions and the new value shifting provisions are discussed. In this introduction there is a brief overview of the history of the initial legislative measures enacted.

Following the Government’s announcement on 21 September 1999 with its initial response to the Ralph Report (Review of Business Taxation – A Tax System Redesigned, July 1999) the first package of four Bills was introduced on 21 October 1999 to give effect to the CGT proposals.

On 25 November 1999 the Government announced its agreement with the ALP on business taxation, paving the way for the passage of these Bills and the second installment of Bills was introduced the following day.

In keeping with the approach to the legislation for “A New Tax System”, the title of each of the Bills introduced starts with the phrase “New Business Tax System”.

In so far as the Bills sought to give effect to the changes to the CGT regime, they correctly describe that what the Government announced on 21 September 1999 does indeed amount to a new tax system – for the changes alter the very foundations of the existing CGT regime as it has operated over the previous 14 years. It is perhaps still too early, however, to say whether the changes can be truly described as reform, or as even improving the existing regime. What can be said is that for small business the changes offer an opportunity, for those who can take advantage of them, to virtually eliminate CGT liabilities on the sale or restructuring of the business or on the sale of business assets.

Recent comments by the Reserve Bank in its submission to the Productivity Commission’s review of housing affordability suggested that the current CGT regime was impacting adversely on house prices. For example, if investors using negative gearing to buy residential property are able to pay only 24.25% on any profits (using CGT discount benefits by holding the property for at least 12 months, see below) rather than having to pay the full marginal tax rate of 48.5%, there is a strong incentive for investors to pursue such property, thus pushing up prices. There is of course a real question whether an investor buying for short term gain would in fact qualify for the CGT discount.

The Productivity Commission in its draft Report released on 18 December 2003 rejected the need for further CGT reform indicating that the current CGT regime with its effective discounted rates for individuals along with negative gearing should not be altered to deal specifically with housing costs because these measures applied to all assets generally. So far the Government’s informal responses to the draft Report would suggest that there is no likelihood that the present Government would seek to pare back the current very favourable CGT regime. This was confirmed by the Treasurer in his Press Release of 23 June 2004 (No. 051).

The first installment of Bills containing the CGT changes were approved by the Senate on 29 November 1999 and are, of course, now law. The amending Acts are:

• New Business Tax System (Integrity and Other Measures) Act 1999 (the “Other Measures Act”); and

• New Business Tax System (Capital Allowances) Act 1999 (the “Capital Allowances Act”).

The only relevant provisions affecting CGT contained in the Capital Allowances Act deal with the removal of plant and equipment from the CGT regime.

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Selling a Small Business – The CGT Strategies The Other Measures Act contains amendments dealing with the freezing of indexation, the 50% individual and trust concession and associated changes for complying superannuation funds, together with changes with the way capital losses are to be treated under the new CGT concessions.

The Other Measures Act introduced a new Division – Division 115 – which deals in part with the calculation of capital gains made in trusts and their treatment when distributed. The provisions contained in Subdivision 115-C are of interest in providing an indication of Government thinking in relation to the future tax treatment of trusts now that the previously proposed entity taxation regime for trusts is no longer proceeding. Subdivision 115-C was re-enacted in the second installment of Bills, discussed below, to accommodate consequential changes flowing from the introduction of the small business concessions in their application to trusts.

The second installment of Bills introduced by the Government in 1999 (also now law) gave effect to most of the balance of the Government’s announcement on 21 September 1999 in so far as it related to CGT and was passed by the Senate on 29 November 1999. These measures are:

• New Business Tax System (Capital Gains Tax) Act 1999 (the “NBTS (CGT) Act”); and

• New Business Tax System (Income Tax Rates) Act (No 2) 1999 (the “No 2 Rates Act”).

The first Act, which amended ITAA 97, contained the rewritten small business concessions, the scrip for scrip roll-over and the venture capital measures. The second Act abolished averaging and provided transitional provisions to preserve its benefits for gains made prior to 21 September 1999.

This Portfolio covers the further changes to the above amendments contained in the New Business Tax System (Miscellaneous) Act (No 2) 2000 (“NBTS(M)2 Act 2000”). These cover the amendments to the scrip for scrip roll-over and changes to the treatment of “tax-free” distributions from trusts under the new CGT regime. Also covered are important amendments introduced by the Taxation Laws Amendment Act (No 7) 2000 which removed a number of anomalies that were contained in the original major changes.

As in the case of the last revision of this Portfolio in March 2003 there have been a very large number of Interpretative Decisions (IDs) issued by the ATO during the previous 6 months, which are available to assist taxpayers in applying the new law. Relevant IDs issued during this period have been noted in the text and where illustrative, reproduced in full.

Looked at as a package, one of the fundamental changes for business coming out of the measures is that instead of approaching the sale of a business from the assumption that the assets of the business need to be transferred to achieve the most effective result, now the starting point ought to be that of the transfer of the business entity. This is particularly so where that entity is a company, thus giving access to the general 50% discount on the sale of the shares in the entity, as a starting point for the CGT concessions. In many cases, additional concessions will also be available.

Note also that the ATO has produced a short update covering CGT developments during the 2003-04 income year which is accessible at the ATO’s website at www.ato.gov.au/taxprofessionals.

The law is stated as at 1 September 2004.

¶1.010 REMOVAL OF INDEXATION

In accordance with the Government’s announcement of 21 September 1999, the Other Measures Act amends ITAA 97 to provide that indexation adjustments will be frozen as at 30 September 1999 for all taxpayers. This means that for assets acquired during the September


Selling a Small Business – The CGT Strategies 1999 quarter or subsequently, capital gains will be determined as nominal gains without regard to CPI movements.

Because the original CGT grandfathering date of 20 September 1985 will continue to be relevant to all CGT assets, effectively there are now three broad classes of CGT assets that need to be considered in any analysis of the impact of CGT in relation to a business. These are:

assets acquired prior to 20 September 1985;

assets acquired between 20 September 1985 and 11:45 am (ACT Time) on 21 September 1999; and

assets acquired after 11:45 am (ACT Time) on 21 September 1999.

Given the somewhat elective nature of CGT, the first two classes of CGT assets will continue to exist for many years to come.

For individuals, trusts and complying superannuation entities where assets have been acquired prior to 21 September 1999, there is now a choice to pay CGT on either the frozen indexed capital gain or 50% of the nominal gain for individuals and trusts. In the case of superannuation entities the choice is the frozen indexed capital gain or 66 2/3% of the nominal gain, that is, a discount of 33 1/3% applies.

This choice is on an asset-by-asset basis (see sec 114-5(2) ITAA 97).

For individuals and trusts with assets acquired after 21 September 1999 and held for one year or more, CGT will be determined by bringing into their or its assessable income 50% of the net nominal gain. This provides a maximum effective rate on nominal gains for individuals of 24.25% (i.e. 50% of the top marginal rate) for capital assets held for one year or more.

Note the decision in Dolby v FCT [2002] FCA 165 concerning the method of calculating indexed cost base in relation to Telstra shares acquired under T1 where it was held that the cost base could be indexed on the total price of the shares from the time of the first installment payment. See ID 2003/87.

¶1.011 One year holding rule

New sec 115-25(1) ITAA 97 provides that the 50% general concession for individuals, trusts and complying superannuation entities only applies where an asset has been held for one year or more (“at least 12 months”). See Taxation Determination 2002/10, which expresses the view that the CGT discount is only available if the CGT event happens on the date following the anniversary date of the acquisition of the asset. The TD provides the following example to illustrate the ATO’s view:

5. John sold an asset on 2 February 2002 that he acquired on 2 February 2001. In deciding whether John acquired the asset at least 12 months before the CGT event it is necessary to determine whether there is [a] clear year between 2 February 2001 (date of acquisition) and 2 February 2002 (date of CGT event). A clear year starting on 3 February 2001 (date of acquisition excluded) ends at the end of 2 February 2002. Because there is not at least 12 months between the relevant dates, John cannot apply the CGT discount to his capital gain. If John had sold the asset on 3 February 2002 his capital gain would have been a discount capital gain.

The TD acknowledges that this interpretation is not obvious but says that there is a very clear body of law supporting it. In this regard the TD states:

2. The use of the words ‘at least’ in subsection 114-10(1) and subsection 115-25(1) requires a clear period of 12 months (that is a clear year) to expire between the acquisition of the CGT asset and the happening of the CGT event: Carapanayoti & Co Ltd v. Comptoir Commercial Andre & Cie SA [1972] Lloyd's Rep 139 (cited with approval in Forster v. Jododex Australia Pty Ltd (1972) 127 CLR 421), Ex parte


Selling a Small Business – The CGT Strategies McCance: Re Hobbs (1926) 27 SR NSW 35 and Halsbury's Laws of England 4th ed reissue, vol 45(2) at page 202, paragraph 234. In our view, both the day of acquisition and the day on which the CGT event happens must be excluded in reckoning the 12 month period. So, a period of 365 whole days (or in a leap year 366 whole days) must elapse between the day on which the CGT asset was acquired and the day on which the CGT event happens.

The 12-month rule is critical, and applies generally from the date of contract or, where there is no contract, the time of the change of ownership. These rules come from sec 115-25(1) ITAA 97, which fixes upon the defined term “acquire”. The definition sec 995-1(1) ITAA 97 refers the reader back to Division 109, Part 3-1 ITAA 97 which contains the general and specific acquisition timing rules.

Off the plan purchases

ID 2003/456 confirms that under an off the plan contract for the purchase of a town house, the discount will become available where the town house is sold after 12 months from the date of the original contract. In the case in question the taxpayer sold his interest in the town house before the construction was completed. This was not relevant to the application of the discount concession, the relevant CGT asset in question being the bundle of rights created under the original contract.

Time of CGT event

In determining whether the discount will be available it is necessary to determine the time of the relevant CGT event. Normally the time of the CGT event will be clear. In ID 2003/822 the ATO considered the question when did CGT event A1 take place in the Xstrata Holdings Pty Ltd takeover of MIM Holdings Ltd. The ID concludes that the CGT event takes place at the time of the change of ownership of the taxpayer’s shares took place. The takeover in that case was by way of a scheme of arrangement.

In ID 2003/1137 the question arose whether a payment for a share that had been previously sold would be eligible for the CGT discount. The ID provides as follows:

Issue Does a CGT event in Division 104 of the Income Tax Assessment Act 1997 (ITAA 1997) happen when a payment is made to the taxpayer in respect of a share that they previously owned in a company?

Decision

Yes. CGT event C2 in section 104-25 of the ITAA 1997 happens in respect of the right of the former shareholder to receive the payment, because the right is discharged or satisfied.

Facts

The taxpayer acquired shares in a company after 19 September 1985. The taxpayer owned the shares at the record date for a return of capital to shareholders. The taxpayer sold those shares after the record date but before the payment date. The taxpayer received the payment on the payment date.

Reasons for Decision

The capital gains tax consequences of a payment made by a company in respect of a share are founded on the legal nature of a share as a bundle of rights; see for example,


Selling a Small Business – The CGT Strategies the description of the legal nature of a share by Farwell J in Borland's Trustee v. Steele Bros & Co Ltd [1901] 1 Ch 279 at 288. As a result, to the extent that the constituent rights attaching to a share are a bundle of rights that cannot be dealt with separately, those rights are not treated as separate CGT assets to which capital gains tax consequences can apply (see Taxation Ruling TR 94/30). Accordingly, CGT event C2 will not happen in respect of the right of a continuing shareholder to receive a distribution from a company that ends because it is discharged or satisfied by payment. However, where a former shareholder retains a right to receive a distribution after they have ceased to own a share, the right has been separated and is no longer a part of the bundle of rights that make up the share. In these circumstances, the right to payment is a separate asset to which capital gains tax consequences can apply. When the company makes the payment to the former shareholder, CGT event C2 happens as the right is discharged or satisfied (paragraph 104-25(1)(b) of the ITAA 1997). If the full cost base (or reduced cost base) of the share has previously been applied in working out a capital gain or loss made when a CGT event happened to that share - for example, when the former shareholder disposed of the share - then, in applying subsection 104-25(3) of the ITAA 1997 to work out the capital gain for the ending of the right, the right will have a nil cost base. Because the right to payments from the company was inherent in the share during the time that it was owned, then for the purposes of Subdivision 109-A of the ITAA 1997 the right is considered to have been acquired at the time when the share was acquired. Consequently, if the share was originally acquired by the former shareholder at least 12 months before the payment, a capital gain from the right may qualify as a discount capital gain under subsection 115-25(1) of the ITAA 1997 (provided the other conditions in Subdivision 115-A of the ITAA 1997 are satisfied). No other CGT event happens when the payment is made. CGT event G1 does not happen as one of the requirements for that event is that you own the share at the time when the company makes a payment to you: paragraph 104-135(1)(a) of the ITAA 1997.

Date of decision: 3 December 2003

Practice point

The Government’s original announcement on 21 September 1999 stated that the concession was to apply only to disposals after 1 October 1999. This date is not reflected in the Other Measures Act. As discussed at ¶1.020 below, the critical time and date is 11:45 am (ACT Time) 21 September 1999. Given the Government’s announcement, it is unlikely that many transactions that were likely to be subjected to CGT were entered into between that time and 1 October 1999. However, care should be exercised when advising in relation to transactions entered into during and around this period to ensure that, where, for example, the 50% concession is claimed, the CGT event took place after 11:45 am on 21 September 1999.

¶1.020 CALCULATION OF CAPITAL GAINS

The changes to the CGT regime announced by the Government on 21 September 1999 constituted a fundamental change to the way CGT is calculated, which means that taxpayers and advisers need to rethink their approach to CGT, particularly in relation to the sale or restructure of a business.

¶1.021 Working out net capital gain or loss


Selling a Small Business – The CGT Strategies Schedule 9 of the Other Measures Act inserts a new sec 100-50 and new sec 102-5(1) into ITAA 97 to provide a new overview and operative provision showing how capital gains and losses are worked out under the new regime. These changes were themselves amended by the NBTS (CGT) Act to take account of the new and revamped small business concessions which came into effect on 10 December 1999.

Whilst the changes to these provisions do not appear to drastically alter the calculation process, they need to be well understood as their effect is fundamental. One reason for this is because of the “choice” that has been introduced for assets acquired after 19 September 1985 and before 21 September 1999 for individuals and trusts. The choice is either to adopt the frozen indexed cost base method or to adopt the 50% of nominal gains method, so the calculation process has become effectively more complex.

To fully understand these provisions, it is necessary to consider new Division 115 to learn about the concepts of “discount capital gains”, “non-discount capital gains” and “discount percentage”.

The Guide to Division 115 states by way of overview that a discount capital gain remaining after the application of any capital losses and net capital losses from previous years is reduced by the discount percentage.

Discount capital gains

Sections 115-5, 115-10, 115-15, 115-20 and 115-25 set out the essential requirements for a capital gain to be a discount capital gain. These are:

• it must be made by an individual, complying superannuation entity or trust;

• it must result from a CGT event happening after 11:45 am (ACT Time) on 21 September 1999;

• the gain must not have been worked out by reference to the indexed cost base; and

• the gain must result from a CGT event happening to a CGT asset that was acquired by the entity making the gain at least 12 months before the CGT event.

The ATO in ID 2003/199 confirmed that the concession is open to non-residents who otherwise satisfy the basic requirements as set out above.

ID 2003/652 confirms that a capital gain made by a public trading trust may be eligible to apply the concession to a capital gain made by it.

It is important to appreciate that a discount capital gain is a subset of an ordinary capital gain. This is not stated as such in the legislation but is able to be deduced from the conclusion that if the capital gain is not a discount capital gain, then it will still be a capital gain. What is potentially confusing is that a capital gain can be either a discount capital gain or a non-discount capital gain in the hands of the one taxpayer, but if, say, made by a company, it can only be a non-discount capital gain.

In order to work out net capital gains one must first distinguish and then segregate discount capital gains and non-discount capital gains.

For capital gains for assets acquired prior to 21 September 1999 there is a choice as to whether a gain will be a discount capital gain or a non-discount capital gain. This is achieved by new sec 110-25(7) and (8). In the case of complying superannuation funds and trusts the relevant trustee makes the choice (see sec 110-25(8) ITAA 97).

Section 115-30 ITAA 97 is an important provision as it provides special timing rules for the purpose of determining whether a gain can be a discount capital gain. It deals with assets affected by same asset roll-overs, including scrip for scrip roll-overs (see Divisions 122 and 124 ITAA 97), and replacement assets roll-overs (see Division 126 ITAA 97) and death, and broadly seeks to preserve the original date of the acquisition.


Selling a Small Business – The CGT Strategies By Taxation Laws Amendment Act (No 7) 2000, a new sec 115-30(1) was introduced to clarify and extend its intended operation with effect from 21 September 1999. The provision is as follows:

Entity is treated as acquiring some CGT assets early

(1) Sections 115-25, 115-40 and 115-45 (the affected sections) apply as if an entity (the acquirer) had acquired a *CGT asset described in an item of the table at the time mentioned in the item:

When the acquirer is treated as having acquired a CGT asset

Item The affected sections apply as if the acquirer had acquired this CGT asset:

At this time:

1 A *CGT asset the acquirer *acquired in circumstances giving rise to a *same-asset roll-over

(a) when the entity that owned the CGT asset before the roll-over *acquired it; or

(b) if the asset has been involved in an unbroken series of roll-overs—when the entity that owned it before the first roll-over in the series *acquired it

2 A *CGT asset that the acquirer *acquired as a replacement asset for a *replacement-asset roll-over

(a) when the acquirer acquired the original asset involved in the roll-over; or

(b) if the acquirer acquired the replacement asset for a roll-over that was the last in an unbroken series of replacement-asset roll-overs—when the acquirer acquired the original asset involved in the first roll-over in the series

3 A *CGT asset the acquirer *acquired as the *legal personal representative of a deceased individual, except one that was a *pre-CGT asset of the deceased immediately before his or her death

When the deceased *acquired the asset





At this time:

4 A *CGT asset that *passed to the acquirer as the beneficiary of a deceased individual’s estate, except one that was a *pre-CGT asset of the deceased immediately before his or her death

When the deceased *acquired the asset

5 A *CGT asset that:

(a) the acquirer *acquired as the *legal personal representative of a deceased individual; and

(b) was a *pre-CGT asset of the deceased immediately before his or her death

When the deceased died

6 A *CGT asset that:

(a) *passed to the acquirer as the beneficiary of a deceased individual’s estate; and

(b) was a *pre-CGT asset of the deceased immediately before his or her death

When the deceased died

7 The interest (or share of an interest) the acquirer is taken under section 128-50 to have *acquired in another *CGT asset that the acquirer and another individual held as joint tenants immediately before he or she died

When the deceased *acquired his or her interest in the other CGT asset





At this time:

8 A *CGT asset that is a *share or right where:

(a) the share or right was *acquired under an *employee share scheme; and

(b) the share or right was acquired from an *employee share trust; and

(c) if the share is a *qualifying share or the right is a *qualifying right—the acquirer made an election under section 139E of the Income Tax Assessment Act 1936

When the acquirer first acquired a beneficial interest in the share or right

Note: Under section 128-50, the acquirer is taken to acquire the interest of a deceased individual in a CGT asset the acquirer and the deceased held as joint tenants immediately before the deceased’s death (or an equal share of that interest if there are other surviving joint tenants).

Whenever you are dealing with an asset that falls into one or other of the categories referred to in the above table, it is necessary to check whether its time of acquisition has been modified by the table for the purposes of determining whether the asset will qualify for the general discount.

Note that if an individual becomes an Australian resident for the first time, CGT assets owned by the individual (other than assets having a necessary connection with Australia or pre-CGT assets) are treated by sec 136-40(3) as being acquired at the time the individual becomes an Australian resident. Section 115-30 does not change this rule – so if, say, a new resident sold shares in his business within 12 months after becoming an Australian resident, he would not qualify for the general CGT discount. This is confirmed by ID 2003/628.

Whilst not covered specifically by sec 115-30, it was confirmed at the National Tax Liaison Group – CGT Subcommittee meeting of 13 June 2001 that where an asset has been acquired under an option to purchase, the period of the option is not counted as part of the 12-month qualifying period. ID 2003/128 provides an example that the time of the relevant CGT may be modified by specific provisions. In this ID the ATO took the view that shares under an employee share acquisition plan were acquired, by virtue of sec 109-10 ITAA 97, at the time when the contract resulting from the exercise of the option is entered into and not when the contract for the acquisition of the option was entered into.

¶1.022 Non-discount capital gains

The only amendment to the CGT provisions in ITAA 97 made by the Other Measures Act that defines the term non-discount capital gain was in the method statement in sec 102-5(1) ITAA 97 by Step 3 where the term was defined as being the sum of the amounts of capital gains remaining after Step 2, except discount capital gains. However, this method statement was substituted by a new statement to enable the small business concessions introduced by the NBTS (CGT) Act to be taken into account, so there is now no reference to non-discount capital gains in the legislation.


Selling a Small Business – The CGT Strategies New Division 115 ITAA 97 mostly refers to capital gains that are “not discount capital gains”, which is the same thing. So any capital gain that is not a discount capital gain will be a non-discount capital gain, for example indexed capital gains, capital gains from disposals of assets held for less than 12 months and gains from “created” assets.

The classification of gains that are discount capital gains and non-discount capital gains is critical in determining a taxpayer’s net capital gains.

Section 115-25 ITAA 97 contains two lists of CGT events which are intended to help taxpayers determine whether a gain is a discount capital gain or not. Basically it identifies CGT events which, by their very nature, do not deal with CGT assets that will have been held for 12 or more months, e.g. CGT events D1 and H2 (old sec 160M(6) and (7)) and therefore cannot give rise to a discount capital gain.

Section 115-25(2) makes clear that assets affected by CGT events D4 (relating to land over which a “conservation covenant” is entered into), E8 (relating to an interest or part interest in a trust) and K6 (which applies to pre-CGT shares or trust interests where more than 75% of the assets of a company or trust are post-CGT, see TR 2004/D6 for application) are eligible for the general discount.

The following table is reproduced from the Explanatory Memorandum (EM) to the Other Measures Act and sets out the events referred to in the table following sec 115-25(3):

CGT events that do not qualify for the CGT discount

D1 Creating contractual or other rights – the CGT event happens upon the creation of the right.

D2 Granting an option – the CGT event happens upon granting, renewal or extension of the option.

D3 Granting a right to mining income – the CGT event happens upon granting the right to mining income.

E9 Creating a trust over future property – the CGT event happens at the time of the agreement to hold future trust property.

F1 Granting a lease – the CGT event happens upon the grant, renewal or extension of the lease by the lessor.

F2 Granting a long-term lease – the CGT event happens upon the grant, renewal or extension of a long-term lease by the lessor.

F5 Lessor receives payment for changing lease – the CGT event happens on the varying or waiver of the terms of the lease.

H2 Receipt for event relating to a CGT asset – the CGT event happens at the time of the act, transaction or event.

K1 Partial realisation of intellectual property right – the CGT event happens on realisation or on entering into a contract for realisation.

Note: Section 104-205 ITAA 97 providing CGT event K1 was repealed with effect from 30 June 2001. Section 115-25(3) now includes CGT events J2 (change of status of replacement asset for a roll-over under Subdivision152-E) and J3 (change of circumstances where a share or interest is a replacement asset for a roll-over under Subdivision152-E).

An example of where determining the appropriate CGT event becomes important arises in TR 99/18 (now withdrawn, see history below) which deals with lease surrender receipts and payments. In the ruling at para 14 the view is taken that a lease surrender receipt of a lessor is


Selling a Small Business – The CGT Strategies assessable under CGT event H2 (about receipts for events relating to CGT assets) in sec 104-155 ITAA 97. The ruling states that:

…[t]his is because the surrender of a lease is an act, transaction, or event that occurs in relation to a CGT asset that the lessor owns. The relevant CGT asset is the land of the lessor. The lessor’s reversionary interest in the land changes to an unencumbered freehold.

On this view, therefore, such a payment would not qualify for the 50% general discount. Unfortunately the ruling does not consider (see para 52 et seq) why CGT event H2 is the only relevant CGT event that could apply. The ruling does not, for example, discuss why CGT event F5 does not apply nor CGT event C2. CGT event H2 (as with CGT event D1) can only apply where no other event is applicable (see sec 102-25 ITAA 97).

CGT event F5 is probably confined to variations of leases, not transactions that bring a lease to an end, but see ID 2002/769 dealing with a payment to the lessor by the lessee at the end of the lease for not painting the house the subject of the lease as required under its terms. However, CGT event C2 specifically contemplates that gains in respect of payments made to a lessor in respect of a pre-CGT lease are disregarded leaving the clear impression that CGT event C2 applies in respect of payments to a lessor to end a post-CGT lease (see sec 104-25(5)(b)(i)). On this basis CGT event H2 could not apply, and the gain in respect of the payment could be a discount gain if the lease had been on foot for at least 12 months since CGT event C2 is not an event referred to in the table following sec 115-25(3).

The view expressed in the ruling proceeds on the basis that the relevant asset is not the lease or right to receive lease payments that the lessee is being relieved of but the underlying land of the lessor. If that is correct, then CGT event C2 has no application since it only applies to intangible CGT assets. At para 52 reliance is placed on comments made by Hill J in Kennedy Holdings and Property Management Pty Ltd v FCT 92 ATC 4918 at 492 to support the view that the relevant asset is land. The difficulty with relying on the comments in that case is that they were made in a very different context, namely, the lessor in that case had paid money to the lessee to give up the lease. In other words what the lessor was paying for was the release of the land so the land could be let at a better rent. In a case where the consideration is paid by the lessee to the lessor to enable the lessee to be relieved of the burden of the rental and other obligations under the lease, it is difficult to see that the transaction is in substance about the land, but is rather about the obligations arising under the lease.

This issue was raised at the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 where the ATO indicated that the concerns would be drawn to the attention of the ATO’s Taxation Rulings Unit for consideration. The Minutes of the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 noted the following:

Following the subcommittee meeting, the representations of the professional bodies at that meeting were submitted to the Rulings Panel. The panel has decided that CGT event C2, rather than CGT event H2, is the relevant event for a lessor receiving a lease surrender payment.

The Tax Office is in the process of deciding how best to implement this decision (for example, an addendum to TR 1999/18, Taxation Determination on the issue etc).

The Minutes of the 11 June 2003 CGT Subcommittee meeting record the following:

Lease surrender payments It was agreed at the last subcommittee meeting that the relevant event for the lessor in respect of lease surrender receipts is CGT event C2 rather than CGT event H2. This is contrary to the position adopted in Taxation Ruling TR 1999/[1]8. On granting a lease the lessor acquires a CGT asset, and if the lessor receives a lease surrender receipt CGT event C2 occurs in relation to that asset. TR 1999/18 has been withdrawn and is being rewritten to confirm that CGT event C2 is the relevant CGT event, and to


Selling a Small Business – The CGT Strategies address related issues. ATO ID 2003/520 has issued on this subject as an interim measure.

See also now ID 2004/566 confirming that the discount will be available where the lease was granted at least 12 months before the surrender payment. See also ID 2004/265 as to what costs may be included in the cost base of the lease in relation to a lease surrender.

Section 115-40 – first anti-avoidance rule

Section 115-40 ITAA 97 provides that a capital gain from a CGT event is not a discount capital gain if the CGT event occurred under an agreement made within 12 months from acquiring the asset.

The EM says that:

…[t]his rule will prevent taxpayers inappropriately taking advantage of the CGT discount by seeking to extend artificially the period of ownership of the asset that produces the capital gain.

This provision has potentially a very broad application should the ATO choose to apply it to its full potential. The reason for its potentially very wide application is that it refers to “agreements” made within 12 months of acquiring an asset. The term “agreement”, though not generally defined in ITAA 97 (c.f. sec 995-1 definition of “arrangement”), is a term that has a broad meaning and is not necessarily confined to written contracts. Therefore if, for example, an owner of an asset is approached by a potential purchaser who wants to buy the asset and the owner says “sorry I can’t sell it just yet, because if I did I would be liable for full CGT on my gains because I haven’t held it for 12 months – come back next month and I will sell it to you then”, then arguably the parties have an agreement to which new sec 115-40 ITAA 97 could apply.

It may be that the courts, when confronted with a case involving such a fact situation, would be inclined to take the view that no binding agreement had been entered into: c.f. Kiwi Brands v FCT 99 ATC 4001, but now see the High Court’s decision in FCT v Sara Lee Household and Body Care (Australia) Pty Ltd [2000] HCA 35. However, until such time, it must be remembered that a taxpayer has the onus of proof when dealing with the ATO in such matters.

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000 the ATO indicated that the section would probably not apply in the above example. However, it was noted that it would apply in the case of an “option” or irrevocable offer. Further, an agreement, in the ATO’s view, did not need to be a written agreement.

The scope of sec 115-40 was again raised at the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001. Clarification was sought as to whether the section:

…would not apply to call options where the option gives the purchaser the right to require the vendor to sell the asset? It appears that call options should not be affected by section 115-40 as the ability to require the sale of the property is with the purchaser not the vendor.

The Minutes note that:

The ATO are also requested to refer to the recent draft ruling TR 2001/D12 [see now TR 2002/3] in which a distinction was made between put and call options in the context of whether they constitute a contingent entitlement to acquire a CFC or FIF. In the context of that draft ruling the issue was whether the ‘purchaser’ has a contingent right to purchase the interests in the CFC or FIF and the draft ruling determined that a call option would generally result in a contingent entitlement to acquire and that generally a put option would not. This draft ruling is looking at the position from the purchaser’s position. However, when applying the rationale in that


Selling a Small Business – The CGT Strategies draft ruling to the context of section 115-40 the treatment has to be turned around because the relevant taxpayer in section 115-40 is the ‘vendor’.

As the call option does not give the vendor the ability to require the purchaser to purchase the asset the vendor has no control over whether the sale will or will not go ahead and therefore does not give the vendor any ability to manipulate their entitlement to the CGT discount.

The ATO stated that section 115-40 is intended to apply in circumstances where put or call options have been used. Section 115-40 is an essential integrity provision intended to have effect beyond legally binding contracts. Legally binding contracts would already give effect to a disposal under the normal timing rules.

The availability of the CGT discount is limited to where there is essentially unfettered ownership of the asset for at least 12 months. The CGT discount should only be accessible where the taxpayer is exposed to both ‘up-side’ and ‘down-side’ risks during the period of ownership. The 12-month minimum period is relatively generous; for example, in the United States the required period is 18 months before the taxpayer is eligible for the capped individual CGT rate.

Taxation Ruling TR 2001/D12 [now TR 2002/3] applies in a different context – the focus of the draft ruling is on whether or not the seller has an absolute entitlement to acquire the asset (see paragraphs 22 to 29 of the draft ruling). The draft ruling also focuses on the entity that holds the asset to which the CGT event happens.

The ATO also indicated that in relation to converting preference shares, conversion may be merely a feature of the asset acquired (a share) and not involve ‘a CGT event occurring under an agreement’ in terms of section 115-40.

In a case such as the one described above, it may be possible for the parties to agree that the vendor should be indemnified by the purchaser in respect of the difference in CGT payable by the vendor should the ATO take the view in, say, a subsequent audit that the vendor was not entitled to the discount. This is not as impossible as it first might appear since the actual difference in tax might not be great when the general discount is combined with the small business concessions.

It is perhaps arguable that the section is not triggered where the original agreement under which the CGT asset is acquired contains a clause that permits the disposal of the asset back to the vendor or to a nominee. So if, for example, the clause permits the previous vendor to reacquire the asset and the clause is activated within 12 months from the date of the acquisition, arguably sec 115-40 would not be triggered provided the disposal did not actually take place until at least 12 months from the acquisition. The argument here is that the CGT event would not occur “under an agreement you made within 12 months of acquiring the CGT asset” (sec 115-40) since the event would have been made under the original agreement to acquire the asset.

The decision of the Full Federal Court in FCT v Dulux Holdings Pty Limited & Orica Limited [2001] FCA 1344 discusses when an asset is disposed of under an agreement. It was held that the rights under the liability assumption agreement there considered were disposed of at the time of the performance of the agreement rather than at the date of the agreement, see also ID 2002/941 where this case is cited in relation to the time of a CGT event C2. Such a view may assist in such a case although it is strongly arguable that sec 115-40 actually contemplates that there must be a second agreement that is separate from the original agreement before it can apply. However, at the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 further clarification was sought (item 7.1) it was noted that:

The Tax Office accepted that the Full Federal Court decision in the Dulux and Orica cases establishes general principles on the timing of disposals (by satisfaction) of


Selling a Small Business – The CGT Strategies rights assets, that is, that such a disposal would not be under that contract, under which the rights arose.

The Tax Office does not propose any further action in relation to the judgment, unless a problem is identified with the decision.

Section 115-45 – second anti-avoidance provision

Section 115-45 might be called a “Robert Holmes à Court”* special because it seeks to deny capital gains arising from the disposal of shares or interests in a trust from treating the gain as a discount capital gain in certain circumstances. These are where the total of the cost bases of CGT assets acquired in the entity less than 12 months before the relevant CGT event is more than half of the total of cost bases of the assets of the entity at the time of the disposal. By Taxation Laws Amendment Act (No 7) 2000, introduced on 29 June 2000, a new, much more limited, anti-avoidance provision was substituted, with effect from 21 September 1999, and is discussed below.

* Robert Holmes à Court was well known for using an existing shelf company to hold shares acquired in the course of a takeover battle so that if the takeover did not succeed, the shares in the shelf company could be sold rather than the shares acquired so as to avoid sec 25A ITAA 36 as it existed before 23 August 1983 when it was amended to deal with such cases.

The former provision, provided as follows:

115-45 Capital gain from equity in an entity with newly acquired assets

Your *capital gain from a *CGT event is not a discount capital gain (despite section 115-5 and subsection 115-30(3)) if:

(a) the CGT event happened to a *CGT asset that is:

(i) a *share in a company; or

(ii) an interest in a trust; and

(b) the total of the *cost bases of *CGT assets *acquired by the company or trust (as appropriate) less than 12 months before the time of the CGT event is more than half of the total of the *cost bases of the *CGT assets of the company or trust at that time.

This provision was far too broadly cast in that the test applied to all CGT assets (whether exempt or not), including trading stock, cash and receivables, looking at their cost base rather than their market value. It was likely, therefore, that few shareholders would have been able to satisfy the section’s requirements. This was especially so where, in the case of a sale of business operated by a company, the goodwill is likely to have a low cost base but the company would have been likely to have, in terms of cost base value, significant trading stock together with cash and receivables, all of which, by definition, will have been held by the company for less than 12 months.

Example

Costello & Co operates a book selling business started seven years ago from scratch, which is now worth $1m. Mr Costello and his wife are the only shareholders and have received an offer for the company of $1.15m that they wish to accept. The cost base values of its CGT assets as at 15 December 1999 (settlement day) are as follows:

Plant and equipment $20,000

Goodwill nil

Trading stock $100,000


Selling a Small Business – The CGT Strategies Debtors $5,000

Cash at bank $25,000

Total of cost bases $150,000

The plant and equipment is more than 12 months old. 75% of the trading stock is less than 12 months old. There is no debt more than six months old.

The total cost base values of the CGT assets of Costello & Co that are less than 12 months old are $105,000. As this is more than half the total of the cost bases of the CGT assets of the company, former sec 115-45 would have applied to deem the capital gain on the shares held by the Costellos to not be a discount capital gain. They would therefore not be eligible for the 50% concession, though they may have been eligible for the small business active asset concession.

A further difficulty was that as the calculation for the old section was required to be undertaken at the time of the relevant CGT event (i.e. the date of the sale of the shares) it may not have been possible in advance of the sale to know whether the section would be triggered.

Further, if the Costellos were to seek to dispose of trading stock or debtors in order to avoid the operation of the section, it would be open to the ATO to seek to apply Part IVA.

The above example highlights that even though trading stock and plant and equipment used in a business are not subject to CGT, they are still CGT assets. However, gains from the disposal of such assets are “disregarded” for CGT purposes (see sec 118-25 (trading stock) and new sec 118-24 ITAA 97 (depreciating assets and section 73BA depreciating assets)).

Former sec 115-45 had even more adverse consequences where, for example, an investment unit trust liquidated its major CGT assets and held the proceeds of the sales as cash. In such a case the disposal of units in the trust would have been likely to trigger the former section. In the Full Federal Court decision of Brooks v FCT [2000] FCA 721, there is a suggestion that “cash”, that is Australian currency, at least under the former CGT provisions, is not an asset for CGT purposes. Under the rewrite of the CGT law this issue was left unclear, but see TD 2002/25 (previously TD 1999/D65), which takes the view that Australian currency is not a CGT asset when used as legal tender. However, accepting that “cash” is not a CGT asset, where the asset is in the form of a chose in action, for example a debt, including money held in a bank account, it is difficult to argue that it is not a CGT asset since a chose in action clearly falls within the current definition of “asset” in sec 108-5 ITAA 97.

Unlike CGT event K6 (old sec 160ZZT ITAA 36) the former sec 115-45 did not exclude trading stock from the calculation, although the threshold applying there is that the post-CGT assets must be more than 75% of the net value of the company or trust.

Former sec 115-45 ITAA 97 was also expressed to override the special timing rules applying where assets have been rolled over into a company (referred to above – new sec 115-30 ITAA 97) or where assets have been rolled out of a company even though the roll-over may have no tax avoidance motive.

Fortunately, the former provision did not operate where the shares or trust interests were held in an entity with at least 300 members. This was provided by sec 115-50 which contained elaborate provisions for ensuring that the exception is not flouted by introducing “20/75” rules (which also applies to the new provision).

The exclusion of the former and the new sec 115-45 ITAA 97 where the shares or trust interest is in an entity with at least 300 members will mean that where a scrip for scrip roll-over is used with a “widely held” entity (with 300 or more members) the shares or units in the widely held entity will be able to be disposed of after 12 months as discount capital gains without fear of falling foul of sec 115-45.



¶1.023 New sec 115-45

The Government announced, on 16 June 2000, that it would introduce amendments to overcome one of the major flaws in the new CGT regime that operated to deny the CGT discount concession to holders of shares in private companies and to interest holders in private trusts. The substituted provision operates as with the original as from 21 September 1999. This means that transactions entered into after that date and before the introduction of the new provision will not be denied discount gain status even if the original provision would have operated to deny the concession – assuming that the concession would not be denied under the new provision.

Under the former provision it operated to deny the 50% discount in cases where shares in a private company are sold and, at the time of the sale, the total of the cost bases of CGT assets acquired by the company less than 12 months before the sale is more than 50% of the total of the cost bases of the CGT assets of the company.

As previously enacted, the section denied the concession in virtually every case where a business is carried on by an entity because the trigger test looks at cost base values rather than market values and applies to current assets such as trading stock and debtors. So, for example, a company operating a business started from scratch, where the main CGT asset is goodwill worth $1m, was likely to fail the test as the cost base value of the goodwill would have been nil.

Under the substituted provision:

• It provides taxpayers with an alternative test (based on net notional capital gain) to the existing cost base test.

- The alternative test allows the membership interest holder to be eligible for the CGT discount if the net notional capital gain made on assets held by the relevant entity at the time of the CGT event and acquired within the previous 12 months is 50% or less of the net notional capital gain on all assets held by the entity at that time.

- Net notional net capital gain is calculated as if the entity had disposed of all its CGT assets for market value just before the membership interest holder’s CGT event.

- This alternative test ensures that the new section applies appropriately in relation to exempt assets such as pre-CGT assets, cars, trading stock and depreciable plant; to cash and receivables; to internally generated goodwill; and to assets acquired in the 12 months before the CGT event that have already been disposed of.

• It provides a 10% de minimis rule in relation to the test.

- This means that portfolio investors (investors and their associates with less than a 10% equity interest in an entity) are excluded from the operation of the tests.

• It ensures that the special rules about time of acquisition in sec 115-30 apply for the purposes of sec 115-45.

• It ensures that where an entity pays a non-assessable amount to an interest holder, any capital gain arising from that payment should be capable of being a discount capital gain.

- This ensures, for example, that a capital gain from CGT event E4 (sec 104-70) arising from a non-assessable payment to a trust interest holder exceeding the trust interest’s cost base will be a discount capital gain if the original capital gain in the trust was a discount capital gain and the trust interest has been owned for at least 12 months.


Selling a Small Business – The CGT Strategies The substituted section provides as follows:

115-45 Capital gain from equity in an entity with newly acquired assets

Purpose of this section

(1) The purpose of this section is to deny you a *discount capital gain on your *share in a company or interest in a trust if you would not have had *discount capital gains on the majority of *CGT assets (by cost and by value) underlying the share or interest if:

(a) you had owned them for the time the company or trust did; and

(b) *CGT events had happened to them when the CGT event happened to your share or interest.

When a capital gain is not a discount capital gain

(2) Your *capital gain from a *CGT event happening to:

(a) your *share in a company; or

(b) your *trust voting interest, unit or other fixed interest in a trust;

is not a discount capital gain if the 3 conditions in subsections (3), (4) and (5) are met. This section has effect despite section 115-5 and subsection 115-30(2). Note: This section does not prevent a capital gain from being a discount capital gain if:

(a) there are at least 300 members or beneficiaries of the company or trust and control of the company or trust is not and cannot be concentrated (see section 115-50); or

(b) the capital gain is from CGT event E4 due to payments from the discounted parts of the trust’s discount capital gains (see section 115-60).

You had at least 10% of the equity in the entity before the event

(3) The first condition is that, just before the *CGT event, you and your *associates beneficially owned:

(a) at least 10% by value of the *shares in the company (except shares that carried a right only to participate in a distribution of profits or capital to a limited extent); or

(b) at least 10% of the *trust voting interests, issued units or other fixed interests (as appropriate) in the trust.

Cost bases of new assets are more than 50% of all cost bases of entity’s assets

(4) The second condition is that the total of the *cost bases of *CGT assets that the company or trust owned at the time of the *CGT event and had *acquired less than 12 months before then is more than half of the total of the *cost bases of the *CGT assets the company or trust owned at the time of the event. Note: Section 115-30 may affect the time when the company or trust is treated as having

acquired a CGT asset.

Net capital gain on entity’s new assets would be more than 50% of net capital gain on all the entity’s assets

(5) The third condition is that the amount worked out under subsection (6) is more than half of the amount worked out under subsection (7).

(6) Work out the amount that would be the *net capital gain of the company or trust for the income year if:



(a) just before the *CGT event, the company or trust had *disposed of all of the *CGT assets that it owned then and had *acquired less than 12 months before the *CGT event; and

(b) it had received the market value of those assets for the disposal; and

(c) the company or trust did not have any *capital gains or *capital losses from *CGT events other than the disposal; and

(d) the company or trust did not have a *net capital loss for an earlier income year.

Note: Section 115-30 may affect the time when the company or trust is treated as having acquired a CGT asset.

(7) Work out the amount that would be the *net capital gain of the company or trust for the income year if:

(a) just before the *CGT event, the company or trust had *disposed of all of the *CGT assets that it owned then; and

(b) it had received the market value of those assets for the disposal; and

(c) all of the *capital gains and *capital losses from those assets were taken into account in working out the net capital gain, despite any rules providing that one or more of those capital gains or losses are not to be taken into account in working out the net capital gain; and

(d) the company or trust did not have any *capital gains or *capital losses from *CGT events other than the disposal; and

(e) the company or trust did not have a *net capital loss for an earlier income year.

Three points about the substituted section may be noted. First, it would appear that the 10% test cannot apply where, for example, shares or interests in a trust are held by a trust, since a trust will not hold the interests “beneficially”, as required by proposed sec 115-45(3).

Secondly, the second condition in the substituted sec 115-45(4) is limited to CGT assets held at the time of the disposal. Previously, the test looked at CGT assets whenever acquired.

Thirdly, in working out the total gain for all of the entity’s CGT assets, under sec 115-45(7)(c) for the purpose of the third test, you cannot take into account potential concessions available such as the small business concessions. However, there appears to be nothing to prevent you from taking into account such concessions for the notional gains on the assets acquired within 12 months of the disposal.

Since its introduction, the new sec 115-45 appears not to have caused difficulties in practice. This is largely because in the case of the sale of a typical business entity, the third test will not be able to be satisfied. In other words, it will be unlikely that the notional gains from assets acquired in the previous 12 months will exceed total notional gains.

It is noted that there have been no Rulings or Interpretative Decisions issued since its introduction, c.f. ID 2003/652.

¶1.024 Discount percentage

New sec 115-100 ITAA 97 sets out the basic rule that the discount percentage for an amount of a discount capital gain for an individual or trust is 50%, and for a capital gain made by a complying superannuation entity it is 33 1/3%.

ID 2003/48 states that the discount percentage to be applied to a capital gain made by non-complying super fund is 50%.

¶1.025 Calculation example


Selling a Small Business – The CGT Strategies A new sec 100-50 ITAA 97, showing how to calculate CGT in simplified terms, was inserted into the Guide in Division 100 by the Other Measures Act, and amended by the NBTS (CGT) Act, and is reproduced below:

100-50 How to work out your net capital gain or loss

1. Reduce your capital gains for the income year, in the order you choose, by your capital losses for the income year. (If the capital losses for the income year exceed the capital gains, the difference is your net capital loss. You cannot deduct a net capital loss from your assessable income.)

2. Reduce any remaining capital gains, in the order you choose, by any unapplied net capital losses for previous income years.

3. Reduce any remaining discount capital gains by the discount percentage. To find out what is a discount capital gain and the discount percentage:

see Division 115.

4. If you carry on a small business, apply the small business concessions in further reduction of your capital gains (whether or not the gains are discount capital gains).

For the small business concessions: see Division 152.

5. Add up:

(a) any remaining capital gains that are not discount capital gains; and

(b) any remaining discount capital gains.

The total is your net capital gain.

For the rules on working out your net capital gain or loss: see Division 102.For the rules on working out your net capital gain or loss: see Division 102.

Note that the relevant new operative provisions inserted by the Other Measures Act and by the NBTS (CGT) Act are new sec 102-3 ITAA 97 and a new sec 102-5(1). The critical current method statement introduced by the NBTS (CGT) Act in sec 102-5(1) provides as follows:

(1) Your assessable income includes your net capital gain (if any) for the income

year. You work out your net capital gain in this way:

Working out your net capital gain

Step 1. Reduce the *capital gains you made during the income year by the *capital losses (if any) you made during the income year.

Note 1: You choose the order in which you reduce your capital gains. You have a net capital loss for the income year if your capital losses exceed your capital gains: see section 102-10.

Note 2: Some provisions of this Act (such as Divisions 104 and 118) permit or require you to disregard certain capital gains or losses when working out your net capital gain.

Step 2. Apply any previously unapplied *net capital losses from earlier income years to reduce the amounts (if any) remaining after the reduction of *capital gains under step 1 (including any *capital gains not reduced under that step because the *capital losses were less than the total of your capital gains).



Note 1: Section 102-15 explains how to apply net capital losses.

Note 2: You choose the order in which you reduce the amounts.

Step 3. Add up the amounts of *capital gains (if any) remaining after step 2, except amounts of *discount capital gains. The sum is the non-discounted capital gain.

Note 1: Only some entities can have discount capital gains, and only if they have capital gains from CGT assets acquired at least a year before making the gains. See Division 115.

Note 2: If you do not have any amounts of discount capital gains remaining after step 2, your non-discounted capital gain is your net capital gain (so you can go straight to step 6). This will be so if you had no discount capital gains or all you had were reduced to nil in step 1 or 2.

Step 4. Reduce by the *discount percentage each amount of a *discount capital gain remaining after step 2 (if any).

Step 5. Add up each amount of a *discount capital gain remaining after step 4. The sum is the discounted capital gain.

Step 6. Add up the non-discounted capital gain and the discounted capital gain. The sum is your net capital gain for the income year.

Note: For exceptions and modifications to these rules: see section 102-30.

The amendment to sec 102-5 ITAA 97 makes it clear that it is the taxpayer who chooses whether to apply their losses to the discount capital gains or to the non-discount capital gains, assuming that a taxpayer has both types of gain in a year of income.

Let’s see how the provisions work in practice.

Example

Boris has a capital gain of $25,000 from the sale of his CBA shares that were sold on 1 November 1999 within 12 months of acquisition (i.e. a non-discount capital gain). Boris also has a discount capital gain of $100,000 from the sale of an investment property also sold on 1 November 1999 that had been held for two years. Boris realises that with the small CPI increases over the last few years his indexed capital gain from the investment property would be only slightly less than the $100,000 nominal capital gain, and so he has no real choice but to treat the gain as a discount gain to obtain the benefit of the 50% concession.

Boris has current year capital losses of $9,000 and has a choice as to how to apply these losses.

Choice 1

Non-discount gain 25,000

Less loss $9,000

Net gain $16,000 $16,000

Discount gain $100,000

Less 50%

Discount$ 50,000

Reduced gain $50,000 $50,000


Selling a Small Business – The CGT Strategies Total net gain $66,000

Choice 2

Non-discount gain $25,000

Net gain $25,000 $25,000


Less loss $9,000

Net gain $91,000

Less 50%

Discount $45,500

Reduced gain $45,500 $45,500

Total net gain $70,500

In Choice 1, Boris has reduced his non-discount capital gain by the amount of the current year capital losses, thus obtaining full benefit of the losses. As can be seen from the Choice 2 calculation, choosing to reduce a discount gain by the amount of a capital loss will result in more tax being payable because the effect of being required to reduce it by the loss before the discount percentage is applied reduces the value of the loss by amount of the discount – in this example by 50%. This will always be the case where there are no non-discount capital gains since the taxpayer will not have the option of applying the losses against non-discount capital gains.

Remember that even though it is now more than three years since the introduction of the new regime and that the likelihood that a better result will be obtained from treating a gain from a pre-19 September 1999 asset as a non-discount capital gain will be remote, it is still necessary to consider the options open to the taxpayer in each case.

Practice point

Whilst in the above example there are two separate choices open to the taxpayer, from a practical point of view there is no real choice since to make the wrong choice is to pay more tax. In the event that a client has lodged his/her return and has not made the correct choice to ensure that the lowest amount of CGT has been paid, there is no obligation on the part of the ATO to draw this to attention since the choice made by a taxpayer is a matter for the taxpayer. However, where a taxpayer has made a wrong choice in calculating his CGT liability, it will still be possible to seek to amend the return within the normal amendment period.

Application of the anti-overlapping rule in sec 118-20

The ATO in ID 2003/694 has clarified its view on the application of the rule in sec 118-20 in relation to discount capital gains. Under the ID, the view is expressed that sec 118-20 is applied before the discount rule is applied. The ATO reasoning is set out below:

Subsection 102-5(1) of the ITAA 1997 provides a five step process to work out a taxpayer’s net capital gain. Relevantly step 1 requires the taxpayer to reduce the capital gains they made during the income year by any capital losses made during the income year. Step 3 reduces any capital gain remaining after steps 1 and 2 by the CGT discount. ‘Note 2’ under step 1 of subsection 102-5(1) points out that Divisions 104, 118 and Subdivision 152-B require the taxpayer to disregard certain capital gains or capital losses when working out their net capital gain. To prevent double taxation, section 118-20 of the ITAA 1997 reduces a capital gain to the extent that it is otherwise included in assessable or exempt income. Section


Selling a Small Business – The CGT Strategies 118-20 applies to reduce a capital gain prior to the five step net capital gain calculation process. Since the profit arising from the sale of the asset has been included in the taxpayer's assessable income under section 6-5 of the ITAA 1997, the taxpayer, in working out their net capital gain, reduces the amount of the capital gain by the amount so assessable before applying the CGT discount.

The reasoning here is not altogether convincing, since steps 1 and 2 do not deal specifically with sec 118-20 and the Table following sec 102-5(1) appears to operate in the reverse, that is that the discount is applied first once losses are applied. Moreover, sec 118-20 appears as a later provision in the ITAA 97 after Div 115 suggesting as a matter of interpretation that it applies after the discount has been applied. However, since the ATO has expressed its view, to adopt a different view will be to invite an amended assessment.

¶1.026 Example applying ATO approach

Mark makes an assessable profit from the sale of a unit of $100,000. His capital gain is $150,000. This might be the case because some expenses incurred by Mark cannot be included in his cost base, for example repairs that were able to be otherwise deducted. Applying the ID the position would be as follows:

Assessable profit $100,000

Capital gain $150,000

Reduced gain $50,000

CGT Discount $25,000

Assessable capital gain $25,000

If the discount could be applied initially to reduce the gain to $75,000, the net capital gain in this example would be then able to be reduced to nil under sec 118-20.

¶1.027 Choice

Individuals and trusts

The choice between the new 50% CGT concession for individuals and trusts and frozen indexation is provided by new sec 102-3(1), 110-25(7) and (8) and 114-5(2) inserted by items 2, 11 and 12 of Schedule 9 of the Other Measures Act.

A taxpayer’s choice will depend on both the period that a taxpayer has held a pre-September 1999 quarter asset and the amount of nominal gain, as illustrated in the following simple examples.

Example 1

Buffy acquired an investment property in December 1990 for $450,000. She accepts an offer on it on 1 October 1999 for $600,000.

As the property has been held for more than one year Buffy has the option of returning 50% of the nominal gain or the indexed gain.



Calculation of indexed capital gain

Disposal proceeds $600,000

Indexed cost base 123.4/106.0 = 1.164 x 450,000 = $523,800

-----------


-----------

50% of nominal capital gain ($150,000) $75,000

As 50% of discount capital gain is slightly less than the indexed gain, Buffy would choose to bring into her assessable income 50% of the discount capital gain, that is $75,000.

Example 2

To continue the above example, assume that this time Buffy can only realise $550,000 on the sale of her investment property.

Calculation of indexed capital gain

Disposal proceeds $550,000


------------


------------


As 50% of the nominal gain is more than the indexed gain, Buffy would choose to bring into her assessable income the lower figure.

¶1.028 Application of Subdivision 115-D – tax relief for shareholders in listed investment companies (LICs)

See ID 2002/360, which considers the application of the discount concession to LICs.

¶1.030 CALCULATING CGT LOSSES

The significant change to the CGT regime with effect from 21 September 1999 is the way in which CGT losses are now required to be applied to offset capital gains. As discussed at ¶1.020 “Calculation example” above, the value of CGT losses is effectively halved where the taxpayer is an individual, trust or reduced by 1/3 in the case of a complying superannuation fund, where the taxpayer chooses to treat capital gains as discount capital gains and has no non-discount capital gains against which to offset capital losses.

The purpose of this change is to limit the cost to the revenue of the concession. Just as under the previous CGT regime nominal losses were required to be offset against indexed gains a new mismatch is now enshrined in the new regime.

Whilst the nominal value of capital losses can be utilised where non-discount capital gains have been made in an income year, for most taxpayers the only capital gain they may have in any one year of income will be likely to be a discount capital gain. As was the case prior to 21 September 1999, where capital losses are realised they must be used to offset against a capital gain when it arises. There is no option open to a taxpayer to carry forward a capital loss into a year when non-discount capital gains will be available to be set off against the gain.



¶1.031 Applying losses to other concessionally taxed capital gains

The amendments introduced by the NBTS (CGT) Act confirm that the value of capital losses will be further affected when applied to reduce other concessionally taxed capital gains, for example the 50% active asset exemption (now called the small business 50% reduction). This is a significant change since, prior to 21 September 1999, under the 50% goodwill exemption, only 50% of the full capital gain was effectively taxed, as under sec 118-250 ITAA 97 50% of the gain was required to be “disregarded”. Under this treatment capital losses, offset against the reduced gain, were effectively worth twice the value of the assessable gain on the goodwill.

This change is discussed below at ¶4.000.

Net exempt income – “CGT concession amount”

ID 2003/967 (now withdrawn) and ID 2004/120 confirm the ATO’s view that the “CGT concession amount” of a discount capital gain does not form part of net exempt income for the purposes of sec 36-20 ITAA 97 for the purposes of calculating losses. This means that a taxpayer who has applied the CGT discount is not required to reduce his/her income losses by the amount of the CGT concession amount.

¶1.040 REMOVAL OF AVERAGING

In accordance with the Government’s statement, as from 11:45 am (ACT Time) on 21 September 1999 averaging was abolished.

As noted above, the amendments necessary to give effect to this change to the Income Tax Rates Act 1986 (see Schedule 9, notes 2 and 3) are contained in the No 2 Rates Act. They contain important transitional provisions designed to preserve the benefit of averaging for taxpayers who have disposed of CGT assets during the 1999/00 income year but prior to 21 September 1999; that is, where an individual or trust has disposed of CGT assets between 1 July 1999 and 21 September 1999.

¶1.041 Transitional rules

Broadly speaking, what the transitional provisions seek to do is to provide for an adjustment for the difference between the tax that would have been payable by a taxpayer, who has made a capital gain prior to 21 September 1999 and who would have been entitled to the benefit of averaging, and the tax payable under the new system.

ID 2002/789 notes that there is no provision in the transitional provisions which provides for the pro rata of averaging based on the period for which an asset was owned prior to 21 September 1999.

Particular care needs to be taken in advising taxpayers who may have realised CGT assets prior to 21 September 1999 and who may be eligible to benefit from the averaging provisions to ensure that their entitlement to the partial averaging benefit is calculated correctly.

As stated in the EM to the No 2 Rates Act a “recalculated net capital gain” is used so it is possible to identify only the additional tax from the removal of averaging, rather than the combined effect of several different measures. This approach, the EM states, allows the tax on capital gains throughout the year to be measured on a consistent basis.

Practice point

The actual calculation process adopted is, unfortunately, particularly complex having regard to the likely small amounts of tax involved in most cases. In those cases where apportionment is required, it is likely that the amount of the benefit will be less than the professional fees incurred in undertaking the relevant calculations, unless the averaging benefit is very large. It may be that the actual calculation can be left to the ATO in most cases.


Selling a Small Business – The CGT Strategies The EM goes on to state that consistent measurement allows a meaningful apportionment of the additional tax. In making gross adjustment amount calculations, it is necessary to disregard the indexation changes and the CGT discount. This means that capital gains throughout the year are worked out using the indexation rules applying in the first part of the year, and without applying the CGT discount rules.

Item 22 of the No 2 Rates Act contains a “method statement” which shows how to work out the “gross adjustment amount”, as follows:

Method statement

Step 1. Work out the amount that would have been your basic income tax liability for the income year if the amendments made by:

(a) Schedules 8 and 9 to the New Business Tax System (Integrity and Other Measures) Act 1999; and

(b) Schedule 1 to the New Business Tax System (Capital Gains Tax) Act 1999;

had not been made.

Step 2. Work out the amount that would have been your basic income tax liability for the income year if the amendments made by:

(a) Schedules 8 and 9 to the New Business Tax System (Integrity and Other Measures) Act 1999; and

(b) Schedule 1 to the New Business Tax System (Capital Gains Tax) Act 1999; and

(c) Part 1 of this Schedule;

had not been made.

Step 3. Subtract the amount worked out under step 2 from the amount worked out under step 1. The result is the gross adjustment amount.

If the result is zero or negative, you are not entitled to any reduction.

Step 1 in the method statement requires the calculation of a taxpayer’s CGT liability for the 1999/00 income year on the basis that the capital gains, whether before or after 21 September 1999, are indexed but no averaging is available. Note here that, under this calculation, CPI movements taking place after the September 1999 quarter can be taken into account. The CPI figures for December 1999, March and June 2000 are, respectively, 124.1, 125.2 and 126.2.

Step 2 in the method statement requires the calculation of the taxpayer’s CGT liability for the 1999/00 income year for all capital gains on the basis that averaging is available for the entire income year. By subtracting the Step 2 amount (with averaging) from the Step 1 amount (with no averaging) the “gross adjustment amount” is obtained (Step 3).

The EM contains the following example:

Example 1.1

Sally bought two CGT assets in 1990. She sold one asset in July 1999 when it had a cost base of $2,200, including $200 indexation worked out using the September 1999 indexation number. The capital proceeds were $3,000, giving a capital gain of $800. She sold the second asset in November 1999 for $3,200. Sally chose not to include indexation in the cost base, and had no capital losses. The cost base without indexation was $2,000, and she made a discount capital gain of $1,200. She reduced the capital gain by 50% to $600 under the new rules.


Selling a Small Business – The CGT Strategies When she works out her gross adjustment amount, Sally does not need to recalculate the July gain of $800, because it was not calculated under the new rules. The November gain was calculated under the new rules, and she recalculates it to include indexation in the cost base. She uses the indexation number for the December 1999 quarter when the CGT event happened. She does not reduce the gain by any discount percentage. If no other CGT events happened during the year, the sum of the July capital gain and the recalculated November capital gain would be Sally’s notional net capital gain for the year. She would use this amount instead of her actual capital gain in steps 1 and 2 of the method statement in section 22 of the ITRA 1986.

(The CPI figures for December 1999, March and June 2000 are, respectively, 124.1, 125.2 and 126.2.) The EM then states that the “gross adjustment amount” is multiplied by the “capital gain adjustment percentage” to give the amount of the reduction. The “capital gain adjustment percentage” identifies the portion of the gross adjustment amount attributable to CGT events happening before 21 September 1999. It is worked out by dividing the “pre-announcement net capital gain amount” by the “modified net capital gain amount” (see item 24 of the No 2 Rates Act). Item 24 provides as follows:

24 Working out the amount of your reduction

(1) The amount of the reduction in your basic income tax liability is worked out using the formula:

Gross adjustment amount Capital gain adjustment percentage×

Working out your capital gain adjustment percentage

(2) Your capital gain adjustment percentage is the percentage worked out using the following formula:

Pre - announcement net capital gain amountModified net capital gain amount

100×

By item 23(1) the “pre-announcement net capital gain amount” is the amount of the “modified net capital gain amount” disregarding any capital gains or losses arising after 21 September

calculate the gross adjustment amount (i.e. the indexed

ese are treated as

ked to any additional tax from removing CGT averaging (see item 23 of the No 2 Rates

he EM and illustrates the adjustments required to the “modified net income amount” where:

1999.

The EM notes that the “modified net capital gain amount” is worked out in the same way as the notional net capital gain used to gain), but with two further changes.

First, any net capital losses from earlier income years are disregarded. Threlating to the year as a whole, and irrelevant for apportionment purposes.

The second change is that gains and losses making up any portion of the “notional net capital gain” attracting the higher tax rates applying to certain children’s income are disregarded. As stated in the EM, these amounts have never attracted the CGT averaging concession, and are not linAct).

The following example is taken from t



Example 1.2

Peter was 17 at the end of the 1999–2000 income year. He is a ‘prescribed person’ under the rules in Division 6AA of the ITAA 1936. Accordingly, unless his income is ‘excepted’ under Division 6AA rules, it will attract a higher rate of tax. He sells one asset in July 1999 and another in November 1999, making a capital gain from each CGT event. He acquired the first asset with earnings from a part time job. The second was a gift from his parents. He makes a capital gain from both sales. The first gain is excepted from the Division 6AA rates but the second is not. In working out his net capital gain Peter applies a net capital loss from the previous income year.

In working out his gross adjustment amount, Peter recalculates his capital gains in the same way as Sally did in Example 1.1, and subtracts his loss from the previous year. In working out his modified net capital gain amount, his starting point is the recalculated notional net capital gain. However, he adds back the previous year’s loss, and subtracts the recalculated capital gain from the November CGT event because it did not qualify for CGT averaging.

The EM states that the “pre-announcement net capital gain amount” is worked out in the same way as the “modified net capital gain amount”, except that capital gains and losses from CGT events happening after the start time are ignored (see item 23 of the No 2 Rates Act). The EM provides the following example:

Example 1.3

The starting point for Peter’s ‘pre-announcement net capital gain amount’ is the ‘modified net capital gain amount’ in Example 1.2. If he had no other CGT events for the year, it would need no further adjustment. The recalculated capital gain from the November CGT event has already been subtracted. If that gain had also been ‘excepted’ from the Division 6AA rates, he would have retained it in his modified net capital gain amount, but subtracted it from his ‘pre-announcement net capital gain amount’. He would do this because it related to a CGT event after the start time.

Peter’s ‘pre-announcement net capital gain amount’ is divided by his ‘modified net capital gain amount’ to arrive at his ‘capital gain adjustment percentage’. His ‘gross adjustment amount’ is multiplied by this percentage to give the amount of his reduction. As the last step in calculating his basic income tax liability for the 1999-2000 year, the reduction is subtracted from what would otherwise be the basic income tax liability on his taxable income. His taxable income uses his actual net capital gain, and not the recalculated notional net capital gain used in working out the reduction.

Coming back to Example 1.1 from the EM, it will be recalled that: Sally bought 2 CGT assets in 1990. She sold one asset in July 1999 when it had a cost base of $2,200, including $200 indexation worked out using the September 1999 indexation number. The capital proceeds were $3,000, giving a capital gain of $800. She sold the second asset in November 1999 for $3,200. Sally chose not to include indexation in the cost base, and had no capital losses. The cost base without indexation was $2,000, and she made a discount capital gain of $1,200. She reduced the capital gain by 50% to $600 under the new rules. When she works out her gross adjustment amount, Sally does not need to recalculate the July gain of $800, because it was not calculated under the new rules. The November gain was calculated under the new rules, and she recalculates it to include indexation in the cost base. She uses the indexation number for the December 1999 quarter when the CGT event happened. She does not reduce the gain by any discount percentage. If no other CGT events happened during the year, the sum of the July capital gain and the recalculated November capital gain would be Sally’s notional net capital gain for


Selling a Small Business – The CGT Strategies the year. She would use this amount instead of her actual capital gain in steps 1 and 2 of the method statement in section 22 of the ITRA 1986.

Assuming that Sally’s indexed capital gain from the sale in December 1999 of the second CGT asset was $1,000 and the amount of the averaging benefit on both indexed gains would have been, say, $200. Assume further, that Sally did not have any carry forward capital losses or current year capital losses, then the amount of Sally’s tax reduction would be calculated as follows:

Method statement step 1 amount $1,800 Method statement step 2 amount $1,600 Gross adjustment amount $200 Capital gains adjustment % 800 100 1,800 = 44.44% Amount of reduction 200 x 44.44% = $88.88

¶1.042 Transitional rules for trust distributions

The following example from the EM shows how the transitional provisions apply in relation to a beneficiary under a trust that distributes a capital gain that it makes:

Example 1.4

James is over 18 and owns units in a unit trust. The trust has an actual net capital gain of $15,000 and a notional net capital gain of $20,000. The share of the net income of the trust estate assessable to James under paragraph 97(1)(a) of the ITAA 1936 includes one half of the actual net capital gain of the trust estate, or $7,500.

In working out a notional net capital gain for his gross adjustment amount calculation, James disregards any Subdivision 115-C capital gain/s. Instead, he includes a notional capital gain of one half of the notional net capital gain of the trust, or $10,000.

The trust has a modified net capital gain amount of $28,000, worked out by adding back $8,000 prior year net capital losses applied in its notional net capital gain of $20,000. Before the start time, the trustee made a capital gain of $12,000 and a capital loss of $5,000. Therefore, the trust has a ‘pre-announcement net capital gain amount’ of $7,000 ($12,000 – $5,000). The trustee works out the trust’s ‘capital gain adjustment percentage’ of 25% by dividing the ‘pre-announcement net capital gain amount’ of $7,000 by the ‘modified net capital gain amount’ of $28,000.

James multiplies the $10,000 notional capital gain from the trust included in his notional net capital gain (and hence in his ‘modified net capital gain amount’) by the trustee’s ‘capital gain adjustment percentage’ of 25%. The resulting amount of $2,500 is taken into account, along with any of his own capital gains and losses made before the start time, in working out his ‘pre-announcement net capital gain amount’. In practice, the trustee could perform the necessary calculations and simply tell James how much to include in his ‘gross adjustment amount’ and ‘pre-announcement net capital gain amount’ for his share of the net income of the trust.

The EM provides the following example to illustrate the application of the transitional provisions to a trustee:



Example 1.5

Assume that the trustee of another trust (T2) also owns units in the trust in Example 1.4 (T1). The entire net income of T2 is assessed to individual beneficiaries. The T2 trustee works out a notional net capital gain and a capital gain adjustment percentage for T2 to enable the T2 beneficiaries to calculate their reductions. The T2 trustee makes the same type of calculations as James in relation to its interest in T1.

Practice point

Where, under a trust, gains realised between 1 July and 21 September 1999 can be streamed to particular beneficiaries, there is scope to maximise the advantage of averaging by distributing those gains to beneficiaries who can most take advantage of those gains, i.e. beneficiaries with little or no other income. Note this option was only available in respect of distributions made in the 1999/2000 income year.

Interaction with the small business CGT concessions

The EM indicates that when working out the “gross adjustment amount”, it is necessary to assume that the new small business CGT concessions in Division 152 ITAA 97 have not been enacted. This means that the notional net capital gain is calculated using the former small business relief provisions in Subdivisions 118-C and 118-F ITAA 97 (the goodwill and small business retirement exemptions) and Division 123 ITAA 97 (the small business roll-over relief).

By items 22 and 25 the small business concessions apply as though any necessary choices had been made.

The EM indicates that any concessions notionally applied must be such that it would have been available in the actual circumstances. Example 1.6 from the EM illustrates:

Example 1.6

Jenny, aged 40, disposed of her business assets, including goodwill, in November 1999. Regardless of how she applied the proposed new small business CGT concessions in determining her actual net capital gain, she may work out her ‘gross adjustment amount’ as though she had chosen some other form of relief under the earlier rules. However, she must have satisfied the relevant requirements. For example, she could not notionally apply the Subdivision 118-C goodwill exemption if the business exemption threshold was exceeded. Any notional Subdivision 118-F retirement exemption would depend on the necessary ETP roll-over actually being made. The amount of any notional Division 123 replacement asset roll-over would depend on the choice of a replacement asset.

As in any other reduction calculation, Jenny also recalculates her November 1999 capital gains (before notionally disregarding any amount) using full indexation where applicable and without any CGT discount.

The above example illustrates the conceptually difficult approach adopted under the transitional rules. It is possible that, though Jenny is not actually eligible for any of the new small business concession, for example because of the generic eligibility rules as a partner in a partnership with net assets of more than $5m, she would be notionally eligible under the now repealed goodwill exemption in calculating the amount of the tax reduction, even though the disposal actually took place after that exemption was repealed.

It is thought that the statement in Example 1.6 above, that “any notional Subdivision 118-F retirement exemption would depend on the necessary ETP roll-over actually being made”, does not correctly reflect item 25.



¶1.050 TRUSTS – HOW TO CALCULATE CAPITAL GAINS AND LOSSES

Of particular interest is new Subdivision 115-C introduced by the Other Measures Act, which provides rules for dealing with trusts with net capital gains. This Subdivision is significant because the treatment of capital gains realised in a trust has for some considerable time been subject to uncertainty.

Under the NBTS (CGT) Act the whole of Subdivision 115-C was substituted with an amended Subdivision to take account of the effect of the small business 50% reduction. Care needs to be taken to ensure that only the current version is used.

What the Guide to the Subdivision confirms is that the Subdivision seeks to ensure that capital gains made by a trust continue to retain their character as capital gains in the hands of the beneficiaries to enable the beneficiaries to claim the 50% individual concession and the small business 50% reduction, if applicable. However, as will be seen, this is not what happens in the case of fixed and unit trusts in respect of the small business 50% reduction.

Generally “pass through” of the concession, where available, is sought to be achieved by doubling the discount capital gain made by the trustee that has been distributed to the beneficiaries and by deeming it to be a discount capital gain where it is received by a beneficiary that is entitled to the 50% concession, that is an individual, another trust or super fund. Where the small business 50% reduction has been claimed by the trust in addition to the general discount, the amount of the gain is multiplied by four.

What this means is that trusts will need to identify those parts of their distributions that are discount capital gains and those parts which are non-discount capital gains as well as small business gains eligible for the 50% small business reduction.

¶1.051 New sec 115-215 – assessing presently entitled beneficiaries

New sec 115-215 is the main operative provision of the Subdivision and seeks to treat beneficiaries as having certain extra capital gains (grossed up in the case of discount capital gains) and then gives to the beneficiaries a deduction against assessable income if they would ordinarily have included in their assessable income capital gains from the trust under sec 97(1)(a), 98A(1) (non-resident beneficiaries) or 100(1) ITAA 36.

The section is important to understand and is reproduced below:

115-215 Assessing presently entitled beneficiaries

Purpose

(1) The purpose of this section is to ensure that appropriate amounts of the trust estate’s net income attributable to the trust estate’s *capital gains are treated as a beneficiary’s capital gains when assessing the beneficiary, so:

(a) the beneficiary can apply *capital losses against gains; and

(b) the beneficiary can apply the appropriate *discount percentage (if any) to gains.

Application

(2) This section treats you as having certain extra *capital gains, and gives you a deduction, if:

(a) you are the beneficiary of the trust estate; and

(b) your assessable income for the income year includes an amount (the trust amount):

(i) under paragraph 97(1)(a) of the Income Tax Assessment Act 1936; or


Selling a Small Business – The CGT Strategies (ii) under subsection 98A(1) of that Act because you are a beneficiary

described in subsection 98(4) of that Act; or

(iii) under subsection 100(1) of that Act.

Extra capital gains

(3) For each *capital gain (the trust gain) of the trust estate, Division 102 applies to you as if you had:

(a) if the trust gain was not reduced under either step 3 of the method statement in subsection 102-5(1) (*discount capital gains) or Subdivision 152-C (small business 50% reduction)—a capital gain equal to the part (if any) of the trust amount that is attributable to the trust gain; and

(b) if the trust gain was reduced under either step 3 of the method statement or Subdivision 152-C but not both (even if it was further reduced by the other small business concessions)—a capital gain equal to twice the part (if any) of the trust amount that is attributable to the trust gain; and

(c) if the trust gain was reduced under both step 3 of the method statement and Subdivision 152-C (even if it was further reduced by the other small business concessions)—a capital gain equal to 4 times the part (if any) of the trust amount that is attributable to the trust gain.

(4) For each *capital gain of yours mentioned in paragraph (3)(b) or (c):

(a) if the relevant trust gain was reduced under step 3 of the method statement in subsection 102-5(1)—Division 102 also applies to you as if your capital gain were a *discount capital gain, if you are the kind of entity that can have a discount capital gain; and

(b) if the relevant trust gain was reduced under Subdivision 152-C—the capital gain remaining after you apply step 3 of the method statement is reduced by 50%. Note: This ensures that your share of the trust estate’s net capital gain is taxed as if it were

a capital gain you made (assuming you made the same choices about cost bases including indexation as the trustee).

(4A) To avoid doubt, subsection (3) treats you as having a *capital gain for the purposes of Division 102, despite section 102-20.

Section 118-20 does not reduce extra capital gains

(5) To avoid doubt, section 118-20 does not reduce a *capital gain that subsection (3) treats you as having for the purpose of applying Division 102.

Deduction

(6) You can deduct for the income year the part (if any) of the trust amount that is attributable to the trust estate’s *net capital gain mentioned in subsection 102-5(1). Note: This deduction ensures you are not taxed twice on the part of the trust amount that is

attributable to the trust estate’s net capital gain.

Note ID 2002/913 concerning the application of sec 98(4).

Note that by Taxation Laws Amendment Act (No 7) 2000, introduced on 29 June 2000, subsec (4A) was inserted to make clear that subsec (3) is intended to give rise to an assessable capital gain notwithstanding that there is no new CGT event. The main operative provision is subsec (3) which makes clear that what is brought into a beneficiary’s assessable income is an extra


Selling a Small Business – The CGT Strategies amount which is the sum of the non-discount capital gains, and double the amount of the discount capital gain or four times the amount reduced by both the discount capital gains percentage and the small business 50% reduction. Note that the method statement in sec 102-5(1) is reproduced at ¶1.020 above.

Section 115-215(4)(a) operates to ensure that part of the extra amount that is a discount capital gain can be treated as a discount capital gain in the hands of a taxpayer that can have a discount capital gain, that is an individual. Section 115-215(4)(b) enables any beneficiary to treat a gain that was reduced by a trust as a small business 50% reduction as a small business capital gain in its hands – this can be a company, individual or trust.

New sec 115-215(6) provides a deduction in respect of the capital gains that would otherwise be assessed to a beneficiary, to overcome the potential double taxation created by new subsec (3). The relevant EMs make no reference to why it was thought necessary to adopt this cumbersome method of passing through a trust the benefit of the 50% discount and small business concessions. Presumably the approach is designed primarily to ensure that a company cannot benefit from the general 50% concession.

ID 2002/964 illustrates the operation of the section. It is set out below:

Capital gains tax: trusts: calculation of beneficiary’s net capital gain

Issue

Can a beneficiary of a trust, who is assessable under section 97 of the Income Tax Assessment Act 1936 (ITAA 1936), treat their share of a trust net capital gain (included in the net income of the trust estate) as a capital gain for the purpose of calculating their own net capital gain?

Decision

No. No amount included in assessable income of a beneficiary under section 97 of the ITAA 1936 is treated as a capital gain for the purpose of calculating the beneficiary’s net capital gain. The beneficiary is entitled to a deduction under subsection 115-215(6) of the Income Tax Assessment Act 1997 (‘ITAA 1997’) in respect of the amount.

Facts

An Australian resident beneficiary, who is not under a legal disability, is presently entitled to a share of trust income in the 2002 income year.

The beneficiary’s share of the net income of the trust for the 2002 income year consisted of a discount capital gain of $5 million.

The beneficiary had a $15 million net capital loss from an earlier income year.

The beneficiary calculated their net capital gain for the year as follows:

Section 97 of the ITAA 1936 ‘capital gain’ amount $5 million

Section 115-215 of the ITAA 1997 capital gain $10 million

$15 million

less carried forward capital losses ($15 million) nil

The beneficiary calculated a loss for the 2002 income year as follows:

Trust distribution (treated as a capital gain) nil

Net capital gain/loss nil

less deduction under subsection 115-215(6) of the ITAA 1997 $5 million

Assessable income (loss) $(5 million)




A beneficiary who is not under a legal disability and who is presently entitled to a share of the income of a trust must include in their assessable income their share of the net income of the trust estate (section 97 of the ITAA 1936).

Subdivision 115-C of the ITAA 1997 sets out rules for calculating a beneficiary’s net capital gain if they are entitled to a distribution from a trust that includes a net capital gain.

Section 115-215 of the ITAA 1997 treats a beneficiary as having capital gains in addition to those they have from a CGT event happening. For each part of a trust capital gain that was reduced by the CGT discount and which is included in the beneficiary’s income under section 97 of the ITAA 1936, the beneficiary is treated as having made a capital gain equal to twice the trust capital gain (paragraph 155-215(3)(b) of the ITAA 1997).

Subsection 115-215(6) of the ITAA 1997 provides a beneficiary with a deduction to the extent that a capital gain has been included in assessable income under section 97 of the ITAA 1936. This deduction ensures that the beneficiary is not taxed twice on the trust capital gain (i.e. under section 97 of the ITAA 1936 and under Subdivision 115-C of the ITAA 1997).

In this case, the beneficiary should calculate their net capital gain for the 2002 income year as follows:

section 115-215 of the ITAA 1997 capital gain $10 million

less carried forward capital losses $10 million

Net capital gain nil

Carry forward net capital loss $5 million

The beneficiary’s assessable income/loss for the 2002 income year is calculated as follows:

Trust distribution $5 million

less deduction under subsection 115-215(6) of the ITAA 1997($5 million)

Net capital gain nil

Assessable income (loss) nil

Date of decision: 2 September 2002

Section 115-215 continues to present interpretative difficulties in practice. For example, where it seeks to apply to a gain that has been distributed through more than one trust, because the trust or trusts lower in the chain have not actually made the gain received, it cannot be said that that trust’s gain is reduced under, say, Subdivision 152-C in such a trust (see sec 115-215(4)(b)). The reference in sec 115-215(4)(b) to “the relevant trust gain” must be read as being the gain from the head trust. To assist here, regard may be had to the purpose of the section, as set out in subsec (1), in overcoming such interpretative difficulties.

The decision of Merkel J in Harris v FCT 48 ATR 434, 3 February 2002, in which the judge adopted a purposive approach to reflect the intent of sec 82AAE ITAA 36 in striking down controlling shareholder superannuation schemes, is a timely reminder that tax legislation, as with other legislation, needs to be read consistently with its intended purpose. Note the appeal in this case was dismissed, see Harris v FCT [2002] FCAFC 226 by Sackville, Kenny and Allsop JJ.


Selling a Small Business – The CGT Strategies The only example provided in this part of the EM to the Other Measures Act of a distribution by a trust to a company illustrating how the company is denied the benefit of the 50% concession is reproduced below:

Example 11.5

A fixed trust makes a capital gain of $1,000 as a result of an A1 event happening to a CGT asset that the trustee has owned for more than 12 months. In calculating the net income under section 95 of the ITAA 1936 the trustee chooses to claim the CGT discount, resulting in a net income for the trust of $2,500, including the discounted capital gain of $500. There is one beneficiary, a company, that is presently entitled to the net income of the trust. The company will gross up the discounted capital gain component to $1,000. The company is not eligible to apply the CGT discount to that grossed up capital gain. This means that the company will include in its assessable income for the year the net trust distribution of $2,000, and the capital gain amount of $1,000.

Note that the example makes no reference to the deduction under new subsec (6) or that the grossed up amount is a deemed extra amount.

Where, in the above example, the beneficiary is an individual, who chooses to treat that part of the distribution that represents a discount capital gain as a discount capital gain, the gain would be grossed up (i.e. doubled) to $1,000 as in the case of the corporate beneficiary. The individual beneficiary would then be entitled to deduct any capital losses he or she has and then apply the 50% discount to the balance. This is the extra gain a beneficiary is deemed to receive. The actual gain distributed is intended to be included in assessable income with a corresponding deduction under new sec 115-215(6) cancelling it out.

The result in Example 11.5 above for the individual beneficiary would be as follows:

Assessable income

Section 97(1)(a) amount $2,500

New sec 115-215(3) gross up amount $1,000

($500 x 2)

Gross assessable income attributable from trust $3,500

Less new sec 115-215(6) deduction $500

Sub total $3,000

Less capital losses (if any) nil

Less 50% discount percentage

on capital gains $500

Net amount $2,500

Where an individual beneficiary has capital losses, if these are to be used to reduce the amount of a discount capital gain, in accordance with the requirements of the steps set out under new sec 102-50, the capital losses must first be offset against that grossed up discount capital gain, see also ID 2002/964 set out above.

The following example illustrates how to calculate capital gains where the gain is both a discount capital gain and eligible for the small business 50% reduction, discussed at ¶4.000 below:

Example

The M Family Trust is a discretionary trust which carries on business in factory premises acquired by the trust post-CGT. It disposes of these premises in January


Selling a Small Business – The CGT Strategies 2000 and a nominal capital gain of $300,000 is made in circumstances such that both the discount capital gain concession and the 50% active business asset concession apply. The trust has no other capital gains and has no capital losses or unrecouped net capital losses. The other net income of the trust amounts to $200,000.

The trust’s net capital gain will be reduced to:

$75,000 (i.e. ½ x $300,000)

2

If the net income is assessable equally to two individual beneficiaries (A and B), each of the beneficiaries will calculate his/her CGT position in relation to the trust as follows:

Amount of capital gain attributable to net income of trust

(the “trust amount”) $37,500

Add: Capital gain included under sec 115-215 $37,500 x 4 $150,000

Less: Discount capital gain concession 75,000

$75,000

Less: Active business asset concession 37,500 37,500

$75,000

Less: Deduction under sec 115-215(6) 37,500

Amount on which beneficiary taxed $37,500

Assume that one of the beneficiaries is not an individual but is a company not acting as trustee. The company beneficiary’s position would be as follows:

Amount of capital gain attributable to net income of trust (the “trust amount”)

$37,500

Add: Capital gain included under sec 115-215 ITAA 97 $37,500 x 4 150,000

$187,500

Less: Active business asset concession ½ x $150,000 75,000

$112,500

Less: Deduction under sec 115-215(6) 37,500

Amount on which company beneficiary taxed $75,000

Where the trust has capital losses, these are applied first to reduce any capital gains before applying the concessions, in accordance with the method statement in sec 102-5. If the capital losses are more than the gain, then there will be no net gain applicable to a presently entitled beneficiary and it would appear that sec 115-215 will have no application.

Similarly, if the trust has income losses, after first applying any capital losses and concessions, the net gain is then applied against the income loss. Again, if the income losses are more than the net gain, then there will be no assessable income applicable to a presently entitled beneficiary and it would appear that sec 115-215 will have no application.

In cases where capital and/or income losses of the trust exceed the capital gains, the distribution of the “tax free” gains will be subject to CGT event E4 where the beneficiary is not a discretionary object under the trust. See below for a discussion of the application of CGT event E4. CGT event will also apply where the “tax free” components of gains in a trust are distributed.


Selling a Small Business – The CGT Strategies Sections 115-220 and 115-225 provide special rules to deny some or all of the concessions in certain circumstances. Under sec 115-220 where a trustee is assessed under sec 98(3) ITAA 36 in respect of a non-resident company beneficiary, the trustee is denied the benefit of the general discount by requiring the trustee in effect to double the amount reduced under step 3 of the method statement in sec 102-5(1).

Under sec 115-225 where a trustee is assessed under sec 99A ITAA 36 both the 50% general concession and the small business reduction are denied to the trustee, see ID 2003/749 which confirms this application. This is consistent with the penalty nature of sec 99A.

Public trading trust

ID 2003/798 confirms the ATO view that a unit holder is not entitled to the CGT discount in respect of a discount capital gain made by a public trading trust.

The ID states that “…[a]s the public trading trust’s ‘net income’ does not fall under that definition at subsection 95(1) of the ITAA 1936 and the unit holder does not include the distribution in their assessable income under paragraph 97(1)(a) of the ITAA 1936, subsection 98A(1) of the ITAA 1936 or subsection 100(1) of the ITAA 1936, the taxpayer cannot adjust the amount of the capital gain received in terms of section 115-215 of the ITAA 1997”.

Corporate unit trust

ID 2003/802 confirms the ATO’s view that an individual unit holder in a corporate unit trust is not entitled to the CGT discount in respect of a CGT distribution made by the trust. As with ID 2003/798 noted above, this ID confirms, however, that the trust in each case will be entitled to the discount.

¶1.052 Cost base adjustment for fixed trusts

The introduction of the general discount and the extension of the small business concessions has created an unintended nightmare for the operation of CGT event E4 (old sec 160ZM, and now sec 104-70) which basically operates to reduce the cost base of interests and units in a trust and to tax the excess once the cost base had been reduced to nil when the trust distributes “tax free” amounts.

When the general discount measure was initially introduced, a hasty amendment to the provision (sec 104-70(7A)) was enacted to seek to address the consequences of the distribution of “tax free” amounts (i.e. the untaxed 50%) arising in a fixed trust from the realisation of a discount capital gain in the trust that were sought to be distributed to the beneficiaries of the trust. The amendments sought to prevent CGT event E4 applying to such amounts in cases where the beneficiary would not have been entitled to the general discount had the gain been realised directly. The amendments also tried unsuccessfully to deal with a beneficiary who had capital losses with a differing treatment where the beneficiary was the trustee of a superannuation fund given that the discount for such a fund is only 33 1/3%.

The initial amendments to sec 104-70 were contained in the Other Measures Act (Schedule 9, item 6). Some further consequential amendments were made to section 104-70 by the NBTS (CGT) Act.

There have been two further attempts to correctly reflect the intended treatment, discussed below. The result is continued confusion for practitioners. This is ironic because one of the very few policy improvements made by the 1997 CGT rewrite was to simplify the cost base adjustment provision, and the benefits of that simplification have now been lost.

These initial amendments were, as noted above, intended to reduce the amount of the cost base reduction where a trustee has distributed an amount that represents the untaxed part of a discount capital gain to certain beneficiaries, for example a company.

The amendments did not, however, alter the previous position of an individual beneficiary under a fixed or unit trust where the untaxed portion of a discount capital gain is distributed.


Selling a Small Business – The CGT Strategies In other words, where an individual received a distribution of a discount capital gain from a trust, being both the taxed and untaxed amount, sec 104-70 operated, as previously, and required a cost base adjustment in relation to the untaxed amount received. Where the cost base is reduced to zero the excess was taxable as a capital gain. The effect of this is to claw back half of the 50% discount in such cases (see para 11.42 of the EM to the Other Measures Act (reproduced below)).

Where an individual beneficiary received a distribution from a fixed trust of both taxed and untaxed amounts representing both discount capital gains and small business 50% reductions, the position became worse because the tax-free portion would have been 75% of the total distribution and that proportion would be subject to the operation of sec 104-70 ITAA 97. To the extent that the sec 104-70 gain is itself a discount capital gain, that the gain would not qualify as a gain to which the small business 50% reduction would apply unless the interest is an “active asset” − for discussion, see below under the heading “Treatment of CGT event E4 (sec 104-70) gain”.

The Treasurer’s announcement on 22 February 1999 that collective investment vehicles (CIVs) would not be subject to the entity tax regime made clear that cost base reductions would continue to apply in relation to distributions of capital gains. However, at that time the Government had not announced its 50% individual and trusts capital gains concession. A spokesperson for the Treasurer was reported in the Australian Financial Review (1 December 1999) as saying that there were no plans by the Government to place individual investors in CIVs on the same footing as individual investors making direct investments.

With the release of the now aborted Exposure Draft legislation for the entity tax regime in October 2000, the Government announced that all fixed trusts would be excluded from the proposed regime but was silent as to the issue of cost base reductions. However, in a report in the Australian Financial Review (20 January 2001) it was stated that the Investment and Financial Services Association Limited (IFSA) had welcomed a clarification received from the Federal Treasurer, Peter Costello, on the application of CGT to managed investments under the proposed new business tax arrangements which was to take effect on 1 July 2001.

The report quoted IFSA CEO, Lyn Ralph, as saying that the Treasurer’s letter to IFSA emphatically confirmed that thousands of Australians who have interests in managed investments would receive the full benefits of the Government’s CGT relief measures. Importantly, these benefits would be in line with those accruing to people who choose to invest directly.

The Treasurer formally announced the changes to the calculation of the cost base of units and interests in fixed trusts on 22 March 2001 (Release No 16). The Treasurer indicated that as from 1 July 2001:

• a cost base adjustment would not be required for the 50% general discount distributions paid on or after 1 July 2001; but

• a cost base adjustment would be required for non-assessable amounts associated with building allowances.

In a Press Release (PR No 33 of 31 July 2001) the Assistant Treasurer announced transitional details in so far as the initiative applied to chains of trusts where an investor invested through one trust which received gains from interests in other trusts where the amounts had been paid to a trustee since 21 September 1999 and 1 July 2001. In this situation the Assistant Treasurer indicated that a cost base adjustment would not be required under CGT event E4 if:

• a non-assessable amount attributed to the CGT discount had been paid to a trustee on or after 11:45 am ACT time on 21 September 1999 and before 1 July 2001; and

• the amount is paid to the trustee in respect of a unit or interest in a fixed trust that is not a complying superannuation fund; and



• the interest has not been disposed of by the trustee before 1 July 2001.

Note that payments of non-assessable building allowances passed though a chain of trusts during the transition period between 21 September 1999 and 1 July 2001, do not benefit from the concession. Note also that payments made after 1 July 2001 are subject to the rules announced by the Treasurer.

Shortly after these announcements, the ATO indicated that it would be prepared to accept returns prepared on the basis of the Treasurer’s announcement, subject to the enactment of legislation giving effect to the announcements.

The amendments to give effect to these changes, operating from 1 July 2001 were introduced in Schedule 3 of the Taxation Laws Amendment Act (No. 5) 2001 (TLAA5 2001) and which are discussed below.

The changes contained in TLAA5 2001 to give effect to the Treasurer’s announcement repealed the existing sec 104-70, 104-71 and 104-72 and introduced new provisions with effect from 1 July 2001, are set out as follows:

104-70 Capital payment for trust interest: CGT event E4

(1) CGT event E4 happens if:

(a) the trustee of a trust makes a payment to you in respect of your unit or your interest in the trust (except for *CGT event A1, C2, E1, E2, E6 or E7 happening in relation to it); and

(b) some or all of the payment (the non-assessable part) is not included in your assessable income.

To avoid doubt, in applying paragraph (b) to work out what part of the payment is included in your assessable income, disregard your share of the trust’s net income that is subject to the rules in subsection 115-215(3). Note 1: Subsections 104-71(1) (tax-exempted amounts), 104-71(3) (tax-free amounts) and

104-71(4) (CGT concession amounts) can affect the calculation of the non-assessable part.

Note 2: The non-assessable part includes amounts (tax-deferred amounts) associated with the small business 50% reduction, frozen indexation, building allowance and accounting differences in income.

Note 3: A payment made to you after you stop owning the unit or interest in the trust forms part of the capital proceeds for the CGT event that happened when you stopped owning it.

(2) The payment can include giving property (see section 103-5).

(3) The time of the event is:

(a) just before the end of the income year in which the trustee makes the payment; or

(b) if another *CGT event (except CGT event E4) happens in relation to the unit or interest or part of it after the trustee makes the payment but before the end of that income year—just before the time of that other CGT event.

(4) You make a capital gain if the sum of the amounts of the non-assessable parts of the payments made in the income year made by the trustee in respect of the unit or interest is more than its *cost base. Note: You cannot make a capital loss.

(5) If you make a *capital gain, the *cost base and *reduced cost base of the unit or interest are reduced to nil.


Selling a Small Business – The CGT Strategies Note: A capital gain under section 160ZM of the Income Tax Assessment Act 1936 is also

taken into account for the purposes of this subsection: see subsection 104-70(3) of the Income Tax (Transitional Provisions) Act 1997.

(6) However, if that sum is not more than the *cost base:

(a) the cost base is reduced by that sum; and

(b) the *reduced cost base is reduced by that sum (without the adjustment in subsection 104-71(3)).

Example: Mandy owns units in a unit trust that she bought on 1 July 1998 for $10 each. During the 1999-2000 income year the trustee makes 4 non-assessable payments of $0.50 per unit. If at the end of the income year Mandy’s cost base for each unit (including indexation) would otherwise be $10.10, the payments require that it be reduced by $2, giving a new cost base of $8.10. If Mandy sells the units (CGT event A1) in the 2000-01 year for more than their cost base at that time, she will make a capital gain equal to the difference.

Note: Cost base adjustments are made only under Subdivision 125-B if there is a roll-over under that Subdivision for CGT event E4 happening as a result of a demerger.

[See ID 2002/1034, which confirms that where the tax free distribution is greater than the reduced cost base but less than the cost base, the reduced cost base is reduced to nil. See also ID 2003/36 in relation to CGT event G1.]

Exceptions

(7) A *capital gain you make from *CGT event E4 is disregarded if you *acquired the *CGT asset that is the unit or interest before 20 September 1985.

(8) CGT event E4 does not happen to the extent that the payment is reasonably attributable to a *LIC capital gain.

Note. Subsection (8) inserted by No. 169 of 2001, sec 3, and Sch 4 item 5, applicable to LIC capital gains made by listed investment companies on or after 1 July 2001.

104-71 Adjustment of non-assessable part

(1) In working out the non-assessable part referred to in section 104-70, disregard any part of the payment that is:

(a) *non-assessable non-exempt income; or

(c) paid from an amount that has been assessed to the trustee; or

(d) paid from an amount that is *personal services income included in your assessable income, or another entity’s assessable income, under section 86-15; or

(e) repaid by you; or

(f) compensation you paid that can reasonably be regarded as a repayment of all or part of the payment; or

(g) an amount referred to in section 152-125 (which exempts a payment of a small business 15-year exemption amount) as an exempt amount.

The payment can include giving property (see section 103-5).

(2) However, the non-assessable part is not reduced by any part of the payment that you can deduct.

(3) The amount of the non-assessable part referred to in section 104-70 is adjusted to exclude any part of it that is attributable to:

(a) an amount that is not included in the assessable income of an entity because of:



(i) section 124ZM or 124ZN (which exempt income arising from *shares in a *PDF) of the Income Tax Assessment Act 1936; or

(ii) section 159GZZZZE (which exempts certain payments related to infrastructure borrowings) of that Act; or

(b) proceeds from a *CGT event that happens in relation to *shares in a company that was a *PDF when that event happened.

(4) The amount of the non-assessable part referred to in section 104-70 for an entity shown in the table is adjusted to exclude the amount or amounts applicable to the entity under the table.

Adjustment of non-assessable part

Item Entity Amount excluded

1 Any entity So much of the amount of a *discount capital gain excluded from the *net capital gain of the trust making the payment because of step 3 of the method statement in subsection 102-5(1) and that is reflected in the payment to the entity

2 Individual, company or trust that has a *capital loss or *net capital loss to reduce its *capital gain described in paragraph 115-215(3)(b) where the trust gain referred to in subsection 115-215(3) is reduced under Subdivision 152-C

1/2 of the amount of the capital loss or net capital loss

3 Individual or trust that has a *capital loss or *net capital loss to reduce its *capital gain described in paragraph 115-215(3)(c)


4 Company that has a *capital loss or *net capital loss to reduce its *capital gain described in paragraph 115-215(3)(c) where:

(a) that capital loss or net capital loss is more than 1/2 of the trust gain referred to in subsection 115-215(3); and

(b) that trust gain is reduced by an amount (the reduction amount) under Subdivision 152-C

The excess of the reduction amount over the Subdivision 152-C reduction to the paragraph 115-215(3)(c) amount



Adjustment of non-assessable part

Item Entity Amount excluded

5 *Complying superannuation entity that has a *capital loss or *net capital loss to reduce its *capital gain described in paragraph 115-215(3)(b) where:


(b) that trust gain is reduced under Subdivision 152-C


6 *Complying superannuation entity that has a *capital loss or *net capital loss to reduce its *capital gain described in paragraph 115-215(3)(c) where:


(b) that trust gain is reduced by an amount (also the reduction amount) under Subdivision 152-C

The excess of the reduction amount over the Subdivision 152-C reduction to the paragraph 115-215(3)(c) amount

7 Any entity receiving the payment where the trust making the payment, or another trust that is part of the same *chain of trusts, has a *capital loss or *net capital loss to reduce its *capital gain described in subsection 115-215(3)

The proportion of the capital loss or net capital loss reflected in the payment

Example: Claude is paid $100 by the trustee of a unit trust. The trustee advises that the amount comprises $50 CGT discount, $25 small business 50% reduction and $25 net income from a capital gain made by the trust.

In applying the rules in Subdivision 115-C of the Income Tax Assessment Act 1997, Claude reduces his capital gain of $100 by a $20 net capital loss from an earlier year. He then reduces the remaining $80 gain by $40 (CGT discount) and $20 (small business 50% reduction) leaving a net capital gain of $20.

In applying the rules in CGT event E4, the $100 payment is reduced by $25 (being the amount assessed under section 97 of the Income Tax Assessment Act 1936). It is further reduced by $50 under item 1 of the table and $5 under item 3. Claude’s non-assessable part is $20.

Effectively, CGT event E4 applies to the $20 small business 50% reduction allowed to Claude in applying Subdivision 115-C of the Income Tax Assessment Act 1997.

Note 1: Step 3 of the method statement in subsection 102-5(1) (see table item 1) reduces by 50% the trust’s discount capital gains remaining after applying capital losses and earlier net capital losses. That 50% is excluded from the trust’s net capital gain.


Selling a Small Business – The CGT Strategies Note 2: Subdivision 152-C (small business 50% reduction—see table items 2, 3, 4,

5, 6 and 7) reduces by 50% the trust’s capital gains or discount capital gains remaining after applying step 3 of the method statement in subsection 102-5(1). That 50% is also excluded from the trust’s net capital gain.

Note 3: Paragraph 115-215(3)(b) or (c) (see table items 2, 3, 4, 5 and 6) treats a beneficiary as having an extra capital gain if an amount of the trust’s net income that is included in the beneficiary’s assessable income is attributable to trust gains that were reduced by step 3 of the method statement in subsection 102-5(1) and/or the small business 50% reduction.

(5) A chain of trusts consists of 2 or more trusts where at least one of these conditions is satisfied for each of the trusts:

(a) the trustee of the trust owns units or interests in another of the trusts; or

(b) the trustee of another of the trusts owns units or interests in the trust.104-72 Reducing your capital gain under CGT event E4 if you are a trustee

104-72 Reducing your capital gain under CGT event E4 if you are a trustee

(1) A *capital gain you make under subsection 104-70(4) is reduced if:

(a) you are the trustee of another trust that is a *fixed trust and is not a *complying superannuation entity; and

(b) you are taken to have a *capital gain under paragraph 115-215(3)(b) or (c) (your notional gain) in respect of a corresponding trust gain (the trust gain); and

(c) some or all (the attributable amount) of the total of the non-assessable parts referred to in subsection 104-70(4) is attributable to proceeds from the trust gain.

(2) The *capital gain is reduced (but not below 0) by the lesser of:

(a) your notional gain; and

(b) the attributable amount.

Note: sec 104-71(a) and (b) was amended in 2003 with effect for the 2003/04 income year as part of the measure to standardise the treatment of non-assessable non-exempt income. The effect of this change is to widen the range of payments disregarded for the purposes of CGT event E4. An example under the small business concessions of non-assessable non-exempt income arises under the 15-year exemption in sec 152-110(2) ITAA 97.

Commentary

Whilst describing the current position under CGT event E4 as an unintended nightmare, the new provisions are probably not quite so daunting if it can be kept in mind that their intent is merely to change the law as from 1 July 2001 so that:

• a cost base adjustment is not now required for the 50% general discount distributions paid on or after that date to those entities entitled to receive the discount; but

• a cost base adjustment is required for non-assessable amounts associated with building allowances under Division 43 ITAA 97.

The position with respect to the 50% small business active asset reduction is unchanged in that the benefit will be effectively lost when the “tax free” amount is distributed through a unit or fixed trust to a beneficiary.

The change relating to Division 43 building allowances is reflected in the new sec 104-71(1) which now contains the list of basis exclusions from the non-assessable amount. Because they are not now excluded, there is no reference to Division 43, unlike previous sec 104-70(7)(a).


Selling a Small Business – The CGT Strategies The fact that from 1997, at least, Division 43 allowances claimed will reduce the cost base of an asset and thereby will be likely to be reflected in any realised gains, means that the change to CGT event E4 effectively imposes double taxation on these amounts! Nowhere in the Government’s public statements, nor the EM, is there an explanation for this change. The EM notes that it will produce additional revenue of $40m per annum after 10 years. The EM also notes that the changes were cleared by the relevant peak industry bodies, so one must assume that the change of treatment to building allowances under CGT event E4 was accepted as a trade off for the change to the treatment of the tax free component of discount gains.

Practice warning

Where building allowances amounts have been accumulated in a trust over a number of years, particular care needs to be exercised in distributing them to avoid if possible the unfettered consequences of the application of the new rule.

New sec 104-70 operates quite differently from the old section in relation to discount gains. Under the old section, for it to work in relation to discount gains and the 50% small business reduction, the non-assessable amount probably needed to be derived from the deemed “extra gain” created by sec 115-215(3) because of the operation of sec 115-215(6) which provided a deduction equal to the sec 97(1)(a), 98A(1) or 100(1) (ITAA 36) assessable income amounts. Under the new sec 104-70, the non-assessable amount is intended to be derived from the sec 97(1)(a), 98A(1) or 100(1) (ITAA 36) assessable income amounts. This has been sought to be made clear by the paragraph at the end of sec 104-70(1) beginning with the words, “(t)o avoid doubt…”. That paragraph seeks to make clear that in working out the non-assessable amount, you ignore the “extra gain” deemed to arise in sec 115-215(3). Unfortunately it is not entirely clear whether that paragraph is actually referring to that amount or to the actual trust gain.

One of the consequences of the approach adopted by new sec 104-70 is that it became necessary to extend the operation of new sec 104-71 to eliminate double taxation in some cases. For example, if a company received from a unit trust a $100 distribution that was a discount gain in the trust’s hands, the deemed extra amount of $50, multiplied by two by sec 115-215(3), would be fully taxable because the company would not be entitled to the discount – being a company (see sec 115-215(4)(a)). Under sec 104-70(1)(b) the non-assessable part would be $50 (the amount of the payment, i.e. $100 less the sec 97 amount, i.e. $50 (the trusts assessable income after applying the general discount)). Unless this amount is reduced, the company would be assessable on $150 (assuming a nil cost base for its units). Section 104-71(4), item 1 appears to be intended to perform this function.

New sec 104-71 reverts to the use of a table following subsec (4) (similar to the table in the original sec 104-70(7A)) to adjust the amount of the non-assessable amount. This table appears to operate correctly to provide appropriate adjustments in each circumstance covered. In applying the table, it must be remembered that more than one item may apply to a particular case with the result that more than one amount may be able to be excluded.

New sec 104-72 performs a similar function to its predecessor in seeking to ensure that the benefit of a discount gain passed through a chain of fixed or unit trusts can be passed through to the ultimate beneficiary. Note, the term “chain of trusts” is defined in sec 104-71(5), as set out above.

The example following the table should be closely read to help gain an understanding of the operation of the new provisions. The example is repeated below for convenience:



Example

Claude is paid $100 by the trustee of a unit trust. The trustee advises that the amount comprises $50 CGT discount, $25 small business 50% reduction and $25 net income from a capital gain made by the trust.

In applying the rules in Subdivision 115-C of the Income Tax Assessment Act 1997, Claude reduces his capital gain of $100 by a $20 net capital loss from an earlier year. He then reduces the remaining $80 gain by $40 (CGT discount) and $20 (small business 50% reduction) leaving a net capital gain of $20.

In applying the rules in CGT event E4, the $100 payment is reduced by $25 (being the amount assessed under section 97 of the Income Tax Assessment Act 1936). It is further reduced by $50 under item 1 of the table and $5 under item 3. Claude’s non-assessable part is $20.

Effectively, CGT event E4 applies to the $20 small business 50% reduction allowed to Claude in applying Subdivision 115-C of the Income Tax Assessment Act 1997.

As mentioned in Note 1 following the Example, Step 3 of the method statement in sec 102-5(1) (referred to in item 1 of the table) reduces by 50% the trust’s discount capital gains remaining after applying capital losses and earlier net capital losses. That 50% is excluded from the trust’s net capital gain.

The references to the small business 50% reduction (see items 2, 3, 4, 5, 6 and 7 in the table) reduces by 50% the trust’s capital gains or discount capital gains remaining after applying step 3 of the method statement in sec 102-5(1). That 50% is also excluded from the trust’s net capital gain.

Section 115-215(3)(b) or (c) (see items 2, 3, 4, 5 and 6 in the table) treats a beneficiary as having an extra capital gain if an amount of the trust’s net income that is included in the beneficiary’s assessable income is attributable to trust gains that were reduced by step 3 of the method statement in sec 102-5(1) and/or the small business 50% reduction.

The following example is provided by the EM:

Example 3.2

On 15 August 2001, Chris received a payment of $600 from the Adams Family Unit Trust. The trustee advised Chris that this amount comprised $150 that was included in the net income of the trust after claiming the 50% CGT discount and the small business 50% reduction. Also included in the payment was $300 from the CGT discount and $150 from the small business 50% reduction allowed against that capital gain.

In applying CGT event E4 to the payment, Chris first reduces the $600 payment by $150, being the amount of the net income assessed to him under section 97. Chris then reduces the remaining $450 balance by a further $300, being the amount that represents the CGT discount allowed against the capital gain made by the trust. Chris’ non-assessable part is $150, which represents the amount of the small business 50% reduction that Chris was allowed when applying the rules in Subdivision 115-C of the ITAA 1997.

Assuming the cost base of Chris’ units in the trust is nil, Chris makes a capital gain of $150 under CGT event E4. If Chris has owned his units in the trust for at least 12 months, the 50% CGT discount reduces this capital gain to $75.

The following example adapts the facts from the example in sec 104-71 but assumes that the beneficiary is a company.



Example

Assuming the same facts in the sec 104-71 example, but this time the beneficiary is a company, Claude Co, which received the $100 comprising $50 CGT discount and $25 small business 50% reduction.

Applying the rules in Subdivision 115-C, Claude Co reduced the gain of $100 by a $20 net capital loss from an earlier year. The company then reduced the remaining $80 gain by $40 (small business 50% reduction) leaving a net capital gain of $40. Being a company, it is not entitled to the benefit of the general CGT discount.

Applying the rules in CGT event E4, the $100 payment is reduced by $25 (being the amount assessed under sec 97). It is further reduced by $50 by item 1 of the table leaving an amount of $25 to which CGT event E4 will apply. Note item 4 in the table only applies where the company’s capital loss is more than one-half of the unreduced trust gain – in this example $100.

To illustrate the application of item 4, assume that Claude Co had a capital loss of $60. This is more than one-half of the trust gain so the item will apply. The amount excluded from the non-assessable amount will be the excess of the amount that the company can reduce its extra gain after applying the loss of $60 to the extra amount of $100, that is $40 less 50% = $20 (this is the “reduction amount”) and the Subdivision 152-C reduction in sec 115-215(3)(c), that is $25. In other words $5 can be excluded from the non-assessable amount under item 4.

A similar process is required to be undertaken in items 5 and 6. It must be said that the relative complexity of this process is far from satisfactory bearing in mind that the adjustments relate solely to the 50% small business reduction under Subdivision 152-C which is intended to be able to be applied in a relatively straightforward fashion.

ID 2002/1034 confirms the ATO view that where a non-assessable payment is made to a beneficiary which is greater than the reduced cost base of the unit but less than the cost base, sec 104-70 is intended to have the effect of reducing the reduced cost base to nil.

Transitional measure

Item 4 of Schedule 3 of the TLAA5 2001 provided for the transitional provisions announced by the Assistant Treasurer applying to payments made on or after 11.45 am, by legal time in the ACT, on 21 September 1999 and before 1 July 2001, as follows:

4 Transitional

(1) The amount of the non-assessable part referred to in section 104-70 of the Income Tax Assessment Act 1997 is reduced by a further amount if:

(a) the trustee of a trust makes a payment to you in respect of your unit or your interest in the trust; and

(b) the payment is made on or after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 and before 1 July 2001; and

(c) you are the trustee of a trust that is not a complying superannuation entity; and

(d) a discount capital gain is excluded from the net capital gain of the trust making the payment because of step 3 of the method statement in subsection 102-5(1) of that Act.

(2) The reduction is so much of the excluded discount capital gain as is reflected in the payment.



¶1.053 Commentary on the superseded provisions applying to payments made prior to 1 July 2001

The amendments to sec 104-70 made by the Other Measures Act and the NBTS (CGT) Act sought to adjust the amount of the “tax-free” distributions caught by sec 104-70 (CGT event E4) to reflect the presence of capital losses held by a beneficiary. These amendments did not accurately reflect the positions of different beneficiary entities. Accordingly, by the NBTS(M)2 Act 2000, the previous amendments to sec 104-70 are repealed and, with effect from 21 September 1999, two new sections, sec 104-71 and sec 104-72, inserted. These provisions provide as follows:

104-71 Effect on non-assessable part if trustee claimed general discount or small

business reduction

When this section applies

(1) If:

(a) *CGT event E4 happens because of a payment to you (the actual payment); and


(c) all or some of the non-assessable part under section 104-70 of the actual payment is attributable to proceeds from the trust gain;

follow the steps in this section to determine whether the non-assessable part (the original non-assessable part) of the actual payment is reduced.

Work out the maximum non-assessable part of a notional payment to you of your notional gain

(2) First, work out what would have been under section 104-70 the non-assessable part (the maximum non-assessable part) of a payment if:

(a) the whole of the payment had been attributable to proceeds from the trust gain; and

(b) the payment had been the only payment to you, by the trustee, of an amount so attributable; and

(c) the amount of the payment had been:

(i) if the trustee did not include indexation in the *cost base of the *CGT asset in working out the trust gain—the amount of your notional gain under paragraph 115-215(3)(b) or (c); or

(ii) if the trustee did include indexation in the *cost base—what would have been the amount of your notional gain if the trustee had worked out the trust gain without indexation.

Note: If more than one beneficiary is presently entitled to a share of the income of the relevant trust estate, the notional gain for each beneficiary will be only so much of the trust gain (calculated without indexation) as that beneficiary is presently entitled to.

Example: A trust has a trust gain of $10,000 which is reduced to $5,000 under subsection 102-5(1) by the general concession. David, the sole beneficiary of the trust, includes that $5,000 in his assessable income under Division 6 of Part III (trust income) of the Income Tax Assessment Act 1936.


Selling a Small Business – The CGT Strategies If David had received a capital payment of $10,000 from the proceeds of the

trust gain, the non-assessable part under section 104-70 would have been $5,000: the $10,000 reduced by the $5,000 already included in David’s assessable income. That non-assessable part is the maximum non-assessable part.

Work out the concession amount for your notional gain

(3) Next, work out the total (the concession amount) of:

(a) the amount (if any) by which the choice of indexation reduced your notional gain from what it would have been without the indexation; and

(b) the amount (if any) by which your notional gain was reduced under step 3 of the method statement in subsection 102-5(1) (discount capital gains); and

(c) the amount (if any) by which your notional gain was reduced under paragraph 115-215(4)(b) (small business 50% reduction).

(If none of those amounts exists, the concession amount is nil.) Note: For a company, the concession amount will be nil unless the company is eligible for the small business 50% reduction.

Example: David is taken to have a notional gain of $10,000 under paragraph 115-215(3)(b). David applies $2,000 worth of losses leaving a gain of $8,000. That gain is reduced by $4,000 because of the general discount of 50%, leaving a gain of $4,000. David’s concession amount is $4,000.

Working out the maximum excluded amount

(4) Then, compare the maximum non-assessable part with the concession amount:

(a) if the maximum non-assessable part is greater:

(i) the difference is the maximum excluded amount; and

(ii) subsection (5) applies; but

(b) otherwise, the original non-assessable part is not reduced by this section. Note: The maximum excluded amount is the maximum amount by which non-assessable

parts of payments attributable to proceeds from the trust gain can be reduced.

Example: David’s maximum excluded amount is $1,000 ($5,000 - $4,000).

Is the concession amount used up?

(5) Compare the original non-assessable part of the actual payment with the concession amount:

(a) if the original non-assessable part is greater, subsection (6) applies to reduce it; but

(b) otherwise, the original non-assessable part is not reduced. Note: If the original non-assessable part of this payment is not reduced, you may be able to

reduce the non-assessable part of a later payment that is attributable to the proceeds from the same trust gain.

Example: David receives an actual payment of $9,500 with an original non-assessable part of $4,500. This amount is greater than the concession amount of $4,000, so subsection (6) reduces the original non-assessable part.

Amount of reduction

(6) The original non-assessable part of the actual payment is reduced by the lesser of:

(a) the amount by which the original non-assessable part of the actual payment exceeds the concession amount; and


Selling a Small Business – The CGT Strategies (b) the maximum excluded amount.

Example: David’s original non-assessable part of $4,500 exceeds the concession amount of $4,000 by $500. This is less than the maximum excluded amount of $1,000. David therefore reduces his original non-assessable by $500 and includes only $4,000 as a non-assessable part under section 104-70.

Effect of previous payments from proceeds of the trust gain

(7) Subsections (5) and (6) apply differently if before the actual payment, the trustee made:

(a) a payment to you to which section 104-70 applied and all or some of the non-assessable part of which was attributable to proceeds from the trust gain (whether or not the non-assessable part was reduced by subsection (6) of this section); or

(b) 2 or more payments of that kind.

Reducing the concession amount if you have received previous payments

(8) The concession amount is reduced (but not below 0) by the non-assessable part of each previous payment of that kind (as reduced under subsection (6), if it was reduced). Example: David receives another payment that is attributable to the proceeds from the same trust

gain.

In applying this section to the second payment, he therefore reduces his concession amount of $4,000 to nil because of the $4,000 non-assessable part (as reduced under subsection (6)) of the first payment.

Reducing the maximum excluded amount if you have reduced previous non-assessable parts

(9) The maximum excluded amount is reduced (but not below 0) by the amount (if any) by which the non-assessable part of each previous payment was reduced by subsection (6). If the maximum excluded amount is reduced to 0, the original non-assessable part of the actual payment is not reduced. Example: In applying this section to David’s second payment, the maximum excluded amount of

$1,000 is reduced by $500 (the amount by which the original non-assessable part of the first payment was reduced under subsection (6)). His maximum excluded amount becomes $500.

104-72 Reducing your capital gain under CGT event E4 if you are a trustee

(1) A *capital gain you make under subsection 104-70(4) is reduced if:

(a) you are the trustee of another trust that is a *fixed trust; and


(c) all or some (the attributable amount) of the total of the non-assessable parts referred to in subsection 104-70(4) is attributable to proceeds from the trust gain.

(2) The *capital gain is reduced (but not below 0) by the lesser of:

(a) your notional gain; and

(b) the attributable amount.



Effect of previous reduction under this section

(3) Subsection (2) applies differently if, because of your notional gain, this section has previously reduced a *capital gain you made under subsection 104-70(4) because of payments made to you by the trustee in an earlier income year in respect of your unit or interest.

(4) Subsection (2) applies as if your notional gain were reduced by the amount of each such previous reduction.

The EM to the Other Measures Act provides the following commentary on the original amendment:

Distribution by a trustee of excluded gain amounts

11.42 A distribution by the trustee of the amount of capital gain that is excluded from the net income of the trust because the trustee claimed the CGT discount may be a non-assessable amount for the purposes of section 104-70 of the ITAA 1997. If the non-assessable amount is distributed to an individual beneficiary who has received the benefit of the CGT discount (in calculating the capital gain that he includes in his net capital gain), section 104-70 will reduce the cost base of the individual beneficiary’s interest in the trust. Once the cost base of the beneficiary’s interest in the trust is reduced to nil a capital gain may arise (CGT event E4). This capital gain may also qualify for the CGT discount.

11.43 In order to prevent an element of double taxation of a beneficiary of a trust who receives such a non-assessable amount, and who is a company or a complying superannuation entity, there will be no cost base adjustment under section 104-70 for that part of the trust capital gain which is excluded from the calculation of the net income of the trust because the trustee claimed the CGT discount. [Item 5, and item 6, subsection 104-70(7A)]

Example 11.11

In Example 11.5, the company included in its assessable income a net capital gain of $1,000 being the grossed up amount of the share of the net income of the trust that was attributable to the discounted gain. The net income of the trust does not include that part of the capital gain that represents the CGT discount. If the trustee later decides to distribute that excluded amount to the company beneficiary, there will be no adjustment under section 104-70 of the cost base of the company’s interest in the trust.

11.44 On distribution of the excluded gain amount by the trustee, there will also be no cost base adjustments under section 104-70 to the extent to which the beneficiary of the trust has applied ‘personal’ capital losses against the grossed up trust capital gain. The beneficiary will need to identify which capital gains he has chosen to apply against his capital losses, particularly if the excluded gain amount is distributed in a later year of income than that in which the grossed up ‘trust’ gain was assessed.

Example 11.12

In Example 11.8, the beneficiary applied ‘personal’ capital losses of $400 against the grossed up trust discounted capital gain of $1000 (twice that part of the net income of the trust that was attributable to a discounted capital gain). On distribution by the trustee to that beneficiary of the excluded gain amount, $200 of the distribution of $500 has effectively been offset against capital losses. No cost base adjustment under section 104-70 will apply to that part of the distribution. The


Selling a Small Business – The CGT Strategies remaining $300 will be applied to reduce the cost base of the beneficiary’s interest in the fixed trust.

As noted in para 11.44 of the EM set out above, there is a reduction of the amount of the cost base reduction where losses have been applied by a beneficiary. This is presumably because it was thought that not to reduce the amount of the non-assessable amount by the amount of the reduction allowed for the beneficiary’s capital losses, would operate to deny the benefit of those losses.

Treatment of CGT event E4 (sec 104-70) gain

Where a CGT liability arises under sec 104-70 as a result of a distribution of a non-assessable amount by a trustee from a fixed or unit trust that is a discount capital gain, the assessable gain arising under sec 104-70 may itself be able to benefit from the 50% individual discount where the four requirements for the concession can be met (see ¶1.020 “Calculation of Capital Gains” above).

So, for example, an individual beneficiary who receives a “tax-free” distribution after 21 September 1999 may face a CGT liability because the distribution exceeds the cost base of his/her trust interest. He/She will, by definition, meet the first two requirements for a capital gain to be a discount capital gain (sec 115-10 and 115-20). The third requirement as to ignoring indexation (sec 115-20) can be met but does potentially give rise to a dilemma for the beneficiary (discussed below).

By Taxation Laws Amendment Act (No 7) 2000, introduced on 29 June 2000, a new sec 115-20 was introduced with effect from 21 September 1999 to clarify the operation particularly in relation to cases where CGT assets have been rolled over. The re-enacted provision is as follows:

115-20 Discount capital gain must not have indexed cost base

(1) To be a *discount capital gain, the *capital gain must have been worked out:

(a) using a *cost base that has been calculated without reference to indexation at any time; or

(b) for a capital gain that arose under *CGT event K7—using the *cost of the *depreciating asset concerned.

Note: A listed investment company must also calculate capital gains without reference to indexation in order to allow its shareholders to access the concessions in Subdivision 115-D.

(2) For the purposes of working out whether the *capital gain is a *discount capital gain and the amount of that gain, the *cost base taken into account in working out the capital gain may be recalculated without reference to indexation if the cost base had an element including indexation because of another provision of this Act. This subsection has effect despite that other provision. Note: This lets a capital gain of an entity (the gain entity) on a CGT asset be a discount

capital gain even if:

(a) another provision of this Act (such as a provision for a same-asset roll-over or Division 128) set the gain entity’s cost base for the asset by reference to the cost base for the asset when it was owned by another entity (the earlier owner), and the earlier owner’s cost base for the asset included indexation; or

(b) another provision of this Act (such as a provision for a replacement-asset roll-over) set the cost base of the asset by reference to the cost base of the original asset involved in the roll-over, and the original asset’s cost base included indexation.

Example: In 1995 Elizabeth acquired land from her ex-husband under an order made by a court under the Family Law Act 1975. Section 160ZZM of the Income Tax Assessment Act


Selling a Small Business – The CGT Strategies 1936 treated her as having paid $56,000 for the land, equal to her ex-husband’s indexed cost base for it. His cost base for the land then was $40,000.

In 2000, she sold the land for capital proceeds of $150,000.

Her discount capital gain on the land is $110,000 (equal to the capital proceeds less the cost base for the land without indexation).

(3) This section does not apply to a *capital gain worked out under subsection 104-255(3) (about carried interests).

Under the fourth requirement, the taxpayer can treat the gain as a discount capital gain if “the capital gain resulted from a CGT event happening to a CGT asset that was acquired by the entity making the capital gain at least 12 months before the CGT event”. This requirement is able to be satisfied where the interest in the trust has been held for 12 months or more. In such a case it can be said that CGT event E4 “happens” to the trust interest of a beneficiary.

Note that the 12-month requirement relates to the entity making the capital gain that will normally be the trust where distributions are made (see new sec 115-25). In the present case the capital gain is made by the beneficiary under sec 104-70 by virtue of the reduction in cost base to nil, so the relevant asset to satisfy the 12-month rule will be the trust interest.

As to the third requirement for a capital gain to be a discount capital gain, if, say, the indexed cost base of the beneficiary’s interest was originally $100 and the indexed cost base was $115, a capital gain of $5 would result under CGT event E4 if the non-assessable amount was $120. The $5 gain could not then benefit from the 50% concession as it would have been worked out by reference to the indexed cost base. To calculate the discount capital gain the unindexed cost base would need to be used resulting in a gain of $20 which, if reduced by 50%, would still be more than the non-discount capital gain.

As noted above, where an individual beneficiary receives a distribution from a fixed trust of both taxed and untaxed amounts representing both discount capital gains and small business 50% reductions, the position originally became worse because the tax-free portion would be 75% of the total distribution and that proportion was subject to the operation of sec 104-70 ITAA 97 – now of course it will only be the component that relates to the 50% small business component. To the extent that the sec 104-70 gain is itself a discount capital gain, it would appear that the gain would not qualify as a gain to which the small business 50% reduction would apply again, unless the interest in the trust is an “active asset” (see ¶4.000 below).

Example

The Victory Unit Trust has a capital gain of $40,000, which is a discount capital gain and is eligible to the small business 50% reduction. The taxed and untaxed components of the gain are distributed to Jackie, one of four beneficiaries. Jackie has a nil cost base in her trust interest.

Jackie would receive $2,500 as a taxed gain, which would be required to be multiplied by four at which point the 50% discount could be applied and the small business 50% reduction and so have a $2,500 capital gain. As to the untaxed amount of $2,500 (applying new sec 104-71), provided Jackie has held her interest in the trust for 12 months the CGT event E4 under sec 104-70 would qualify as a discount gain but not qualify for the small business 50% reduction as the trust interest would not be an active asset. Her capital gain on the CGT event E4 would therefore be $1,250. Her total net capital gains on the distribution would be $3,750 ($2,500 + $1,250).

Note: Had Jackie been a “controlling individual” in relation to the trust, her interest would have been an “active asset” (see discussion at ¶4.000 below).

Note also that sec 115-45 (see discussion at ¶1.020) could have applied to distributions before 1 July 2001 to deny discount gain status to Jackie’s CGT event E4 gain if the trust failed the test in sec 115-45 by having more than 50% of its cost base values in assets less than 12 months old. As noted at ¶1.020 sec 115-45 was amended to limit its unintended effects. A


Selling a Small Business – The CGT Strategies subsidiary amendment (former sec 115-60, see below) limited its application in relation to CGT event E4 to cases where the trust gain was not itself a discount gain. So, provided the interest had been held for 12 months or more and the gain in the trust to which the distribution relates was a discount gain, the CGT event E4 will itself be a discount gain. Section 115-60 did this, and provided as follows:

115-60 Discount capital gain from CGT event E4

Purpose of this section

(1) The purpose of this section is to ensure that section 115-45 does not prevent your *capital gain from *CGT event E4 happening in the income year in relation to your unit or interest in a trust from being a *discount capital gain, if the gain is attributable to *CGT assets the trust *acquired at least 12 months before the event. Note: Basically, you make a capital gain from CGT event E4 if the trustee of a trust makes

one or more payments to you in relation to your interest in the trust, and the parts of those payments that are not included in your assessable income add up to more than the cost base of your interest: see section 104-70.

(2) Section 115-45 does not prevent your *capital gain described in subsection (1) of this section from being a *discount capital gain if the gain is not more than the sum of the amounts that are:

(a) amounts of the non-assessable parts (mentioned in section 104-70) of the payments made to you in the income year by the trustee in respect of the unit or interest as described in that section; and

(b) attributable to *discount capital gains made by the trust. Note 1: The non-assessable parts of the payments may be from amounts not included

in the trust’s net income under Division 6 of Part III of the Income Tax Assessment Act 1936, such as the discount percentage of amounts of discount capital gains of the trust remaining after applying any capital losses and net capital losses of the trust.

Note 2: If your capital gain from CGT event E4 is a discount capital gain, you must work it out using the cost base of your unit or interest in the trust worked out under section 115-20 without reference to indexation, despite Divisions 110 and 114 (which are about indexation).

With the change announced by the Treasurer operating from 1 July 2001 excluding discount gains from the application of CGT event E4, sec 115-60 was repealed with effect from 1 July 2001. Now, sec 115-45 simply does not apply to the discount gains received through a fixed or unit trust. Although it is unlikely to ever be an issue, it might be argued that the effect of sec 115-45 is to deny discount gain status to certain CGT events where the relevant conditions for its application were present. On that basis, sec 104-71 wouldn’t apply as there would be no relevant “discount capital gain” upon which to operate.

¶1.054 Discretionary trusts

In the case of a beneficiary of a discretionary trust receiving distributions from capital gains made by the trust, the most recent amendments made to sec 104-70 do not appear to affect the position with respect to such distributions. So, currently, whilst the benefit of the 50% small business reduction is partially clawed back in the case of a beneficiary under a fixed or unit trust, in the case of a beneficiary under a discretionary trust there is no claw back in respect of such distributions.

Taxation Determination TD 97/15 (and Addendum TD 99/15A) made it clear that the then sec 104-70 did not apply to “tax-free” payments from a discretionary trust. Further, the ATO issued draft Taxation Determination TD 1999/D67 which confirmed the ATO view that sec


Selling a Small Business – The CGT Strategies 104-70 does not apply to default beneficiaries in a discretionary trust. This draft does not appear to have been finalised as at 1 February 2003. Note, however, that draft TDs are not strictly binding on the ATO.

Whilst the new sec 104-70 does not appear to alter the position, TD 2001/26 appears to raise some doubt as to the ATO’s present view. That TD was issued to set out the CGT position of beneficiaries who renounce their “interests” under a discretionary trust as a consequence of social security benefit changes. Paragraph 2 of the TD provides as follows:

2. A beneficiary of a discretionary trust who has no interest in either the assets or the income of the trust before the exercise of any discretion by the trustee as to the allocation of those assets or income can renounce their interest in the trust. In these circumstances, however, any capital gain the beneficiary makes from the renunciation of an interest acquired on or after 20 September 1985 is likely to be nil because its cost base is likely to be nil and the market value of the interest at the time of the renunciation would generally be nil. A capital gain or capital loss made on an interest acquired before 20 September 1985 is disregarded: subsection 104-25(5).

This statement suggests that beneficiaries do have an interest in a discretionary trust. Later comments in the determination suggest that the view may only apply to default beneficiaries, but, nevertheless, care needs to be taken having regard to the apparent change of view.

Taxation Determination TD 2003/28 confirms that CGT event E4 does not apply to a mere object or default beneficiary under a discretionary trust.

Note ID 2002/894 which confirms that a beneficiary cannot apply capital losses made by a discretionary trust to reduce capital gains distributed to the beneficiary.

Hybrid trusts

At the 11 June 2003 meeting of the National Tax Liaison Group CGT Subcommittee the ATO confirmed its view that in relation to a hybrid trust that has “special units” under which a discretionary distribution may be made distributions under the special units would not trigger CGT event E4.

¶1.055 Distribution streaming

The practical requirement of trustees now needing to identify the two classes of capital gains raises the issue whether trusts will be able to stream distributions to corporate and individual or trust beneficiaries according to whether the gain is a discount capital gain or a non-discount capital gain. The amendments made by the Other Measures Act, and subsequently, do not appear to contain any specific measures to prevent streaming. However, under sec 115-215(3) and (4) each beneficiary is assessed on both discount capital gains and non-discount capital gains. Although not conclusive in precluding streaming, the wording of these provisions suggest some care would need to be exercised in seeking to stream gains to particular beneficiaries.

The relevant EM does not discuss this issue.

Note also that for the 1999/00 income year considerable advantages could have been obtained by streaming, say, indexed gains on assets disposed of before 21 September 1999 to a beneficiary who could have benefited from averaging.

¶1.056 Chains of trusts

Section 115-215 is intended to apply where capital gains are passed through more than one trust. For example, suppose a business is operated by one discretionary trust for the benefit of a family discretionary trust. If the operating entity realises a capital gain of, say, $1m and it is eligible for both the 50% discount and the 50% small business reduction, effectively its taxable gain will be $250,000. If this amount is distributed to the family discretionary trust, under sec 115-215 the amount would be required to be grossed up to $1m and then reduced


Selling a Small Business – The CGT Strategies back to $250,000 (assuming the discretionary trust has no capital losses). If the taxable gain is distributed to the individual beneficiaries, however, it is the view of the ATO that sec 115-215(3)(a) would apply so that no further gross up and reduction is required by the individuals so that the individuals receive the full benefit of the concessions on that part of the taxable gain distributed. One potential difficulty with sec 115-215 is that where the capital gain has not arisen in an intermediary trust (as in our example the actual gain arises in the operating trust), it cannot be said that the intermediary trust had its gain reduced by either the 50% discount or the 50% small business reduction, as required by sec 115-215(3)(b) and (c).

It is now clear that in the common scenario where, say, a unit trust distributes to a family discretionary trust, the benefit of the 50% general discount will be able to be passed through the family trust. However, distribution of the “tax-free” component of the 50% small business reduction will be subject to CGT event E4 at the discretionary trust level.

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the ICAA raised the related issue involving a disposal of:

…that chains of entities cannot gain access to the small business tax concessions for disposals of entities in a chain of entities due to the restrictive application of the controlling individual test in section 152-50.

This is true in relation to the retirement exemption where there must be a controlling individual of the entity disposing of the active asset, see ¶2.040 below.

The Minutes note that:

The professional bodies asked for the policy rationale for not requiring cost base reductions for payments representing the CGT discount by trustees to unitholders and others with trust interests, but requiring them for similar payments representing the small business 50% reduction.

The ATO stated that the CGT discount was introduced to reward patient investment and that the Government had decided to provide that concession whether the taxpayer invests directly or indirectly. The small business concessions on the other hand are intended to allow the operator to re-invest the proceeds of sale back into the business or to provide for retirement. Allowing the proceeds to pass out tax-free outside of retirement would be inconsistent with this policy.

The professional bodies noted that in many cases a small business operator would carry on a business through a trust and the business will be disposed of entirely. The small business operator would then take on another different business. The provisions should, the professional bodies submitted, provide a ‘look-through’ mechanism to determine what the proceeds are to be used for. The ATO noted these observations.

¶1.057 Child maintenance trusts

The 50% individual concession will be available in relation to capital gains distributed from an “excepted” child maintenance trust.

It would appear that, where capital gains from a trust subject to Division 6AA ITAA 36 are distributed, it is open to the trustee to treat eligible capital gains as discount capital gains and distribute the benefit to the beneficiaries. Where, for example, penalty rates are applied to capital gains distributed to a minor, the 50% discount would operate to reduce the amount of the capital gain distributed, effectively halving the current 47% tax on the entire income where the taxable income is in excess of $1,446 (current for 2001-2002).

¶1.058 Transitional rule for trusts

The Treasurer on 23 December 1999 issued a Press Release (set out in full at Appendix 2) clarifying what will be the position of assets held in trusts as at 1 July 2001 – the time of the then proposed commencement of the new entity tax regime. Broadly, the intention was that


Selling a Small Business – The CGT Strategies capital gains from assets held in a trust as at 23 December 1999 disposed of on or after 1 July 2001 would be able to be treated as discount capital gains and be able to be distributed to the beneficiaries under the trust as discount capital gains in the hands of the beneficiaries (see further discussion at ¶8.000 below).

Although not stated in the Press Release, it was intended that, for example, the small business concessions would also be able to be distributed to beneficiaries after 1 July 2001 in respect of a realisation of assets after that date where the assets were held by the trust at 23 December 1999. This view was expressed by the Treasury representative at the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000.

Following the release of the Exposure Draft legislation for the entity tax regime in October 2000, there had been considerable public criticism of the proposal and of the decision by Government to exclude all fixed trusts from the regime. The Treasurer in his Press Release of 22 March 2001 (No 16) stated that the Government would not be proceeding with this draft legislation and as a consequence the current law would continue to apply to trusts (with the change announced in that Press Release as to the flow through of the tax-free component of discount gains).

Whilst there appear to be no current plans for the Government to resurrect its proposals for entity taxation, it cannot be assumed that at some future stage the plan or some modification of the original proposal will not be unveiled. In this regard, it appears that the Board of Taxation is currently working on proposals to crack down on the use of trusts for tax avoidance purposes, though no announcement has been made by the Board.

¶1.060 COMPANIES – HOW TO CALCULATE CAPITAL GAINS AND LOSSES

Capital gains earned by companies cannot be treated as discount capital gains because sec 115-10 requires that the gain must be made by an individual, complying superannuation entity or a trust. Accordingly, there will be no change in the way a capital gain will be calculated by a company subject only to the freezing of indexation as at the September 1999 quarter for assets acquired by a company prior to 11:45 am (ACT Time) 21 September 1999. There is no change for the calculation of losses by a company.

Since companies are not able to treat capital gains arising in respect of assets acquired before 21 September 1999 as discount capital gains, capital gains on such assets will always be calculated as frozen indexed gains.

Capital gains on assets held by a company acquired after 21 September 1999 (but effectively during the September quarter) will be calculated on the full nominal gain.

¶1.061 Interests in trusts held by a company

If a company holds, for example, units in a unit trust and the unit trust realises a capital gain of $1,000 that is eligible for both the 50% discount and the 50% reduction under Subdivision 152-C it would appear by sec 115-215 that if the trust were to distribute the taxable gain of $250 to the company, by sec 115-215(3)(c), the company would be required to multiply the amount by four grossing up the gain back to $1,000. As the company is not an entity eligible for a discount gain, the gain can only be reduced by 50% under sec 15-215(4)(b). So the company would be assessable on $500 even though it has only received a distribution of $250.

This anomaly is intended to be overcome when the “tax-free” amount of the capital gain is distributed to the company by the trust. When the trust distributes the remaining $750 in our example, sec 104-71 (reproduced above) will operate to reduce the amount by the amount of the original trust 50% discount, so the $750 is reduced by $500 so the company would be assessable under CGT event E4 on $250 less the company’s cost base in the units held by it in the unit trust. The net result for the company will be that it will be assessable on a maximum of $750 of the whole $1,000 distributed (ignoring its cost base in its units in the trust).



¶1.070 REMOVAL OF PLANT AND EQUIPMENT FROM THE CGT REGIME

As from 21 September 1999 disposals of plant and equipment were excluded from the CGT regime. The new Capital Allowances regime which commenced on 1 July 2001 introduced by the New Business Tax System (Capital Allowances) Act 2001 (Capital Allowance Act) subsumed the former concepts of “plant and equipment” into the new term “depreciating assets” in a new Division 40 ITAA 97.

One consequence of the new Capital Allowances regime has been the repeal of sec 104-205 (CGT event K1) which dealt with the partial realisation of intellectual property. Care should be exercised before assuming that with the repeal of this provision all intellectual property automatically falls within the Capital Allowances regime as a depreciating asset. For example, a provisional patent does not appear to fall within either the former definition or new definition of “intellectual property”. This suggests that a provisional patent may still fall under the CGT regime.

Item 10 of Schedule 1 of the Capital Allowances Act inserts into ITAA 97 the following (now substituted) provision:

118-24 Plant

A *capital gain or *capital loss you make from a *CGT asset is disregarded if, at the time of the *CGT event, the asset is:

(a) your *plant; or

(b) if you are a partner, plant of the partnership; or

(c) if you are absolutely entitled to the asset as against the trustee of a trust (disregarding any legal disability), plant of the trustee.

The amendment made by item 10 applies to a CGT event happening after 11.45 am (ACT Time) on 21 September 1999.

By sec 292 of the New Business Tax System (Capital Allowances – Transitional and Consequential) Act 2001 (Act No 77 of 2001) (which refers to the Capital Allowances Act as “the New Act”) a new sec 118-24 was substituted as a consequential change arising from the introduction of a new CGT event K7 to deal with the disposal of depreciating assets where there has been partial private use (discussed below). New sec 118-24 (as further amended by Act No 170 of 2001) provides as follows:

118-24 Depreciating assets and section 73BA depreciating assets

(1) A *capital gain or *capital loss you make from a *CGT event that is also a *balancing adjustment event that happens to a *depreciating asset or a section 73BA depreciating asset (within the meaning of section 73BB of the Income Tax Assessment Act 1936) is disregarded if the asset was:

(a) a depreciating asset you *held; or

(b) if you are a partner, a depreciating asset of the partnership; or

(c) if you are absolutely entitled to the asset as against the trustee of a trust (disregarding any legal disability), a depreciating asset of the trustee;

where the decline in value of the asset was worked out under Division 40 or Division 328, or would have been if the asset had been used.

(2) However, subsection (1) does not apply to a *capital gain or *capital loss you make from *CGT event K7 happening.


Selling a Small Business – The CGT Strategies This provision, unlike its predecessor, may unwittingly allow an exemption of a capital gain that is rolled over under the small business roll-over provisions (see ¶6.030) into a CGT exempt asset such as a car because of the way that subsec (1) has been drafted by making the exemption depend on a CGT event that is also a balancing adjustment event. This approach may appear to override CGT event J2, which would normally catch the gain, because the CGT event J2 would also be a balancing adjustment event. The contrary argument is that CGT event J2 is a two-stage event, that is you must have first chosen the small business roll-over. See now ID 2002/641, which expresses the ATO view that CGT event would apply to the disposal of a car that had been acquired as a replacement asset.

¶1.071 Statutory licences

ID 2002/755 raises an interesting issue in relation to statutory licences. The ID considers whether a marine park permit is a depreciating asset under sec 40-30(1) ITAA 97. The view expressed by the ATO is that the permit was not a depreciating asset but an “intangible asset” but not one within the definition in subsec 995-1(1) ITAA 97 of an item of “intellectual property” which is included in the definition of “depreciating assets” in sec 40-30(2).

The licence therefore falls within the definition of CGT asset in sec 108-5(1) ITAA 97.

The ID notes that the licence would fall under the meaning of a statutory licence as defined under sec 124-140 ITAA 97 which provides for a roll-over for such assets.

This ID is instructive when considering what business assets will be potentially subject to CGT under the post 1 July 2001 capital allowances environment.

¶1.072 Application of new provisions to existing plant

Sections 40-10 and 40-12 of the Income Tax (Transitional Provisions) Act 1997 provide as follows:

40-10 Plant

(1) This section applies to you if:

(a) you have deducted or can deduct amounts for plant under Division 42 of the Income Tax Assessment Act 1997 (the former Act) as in force just before it was amended by the New Business Tax System (Capital Allowances) Act 2001, or you could have deducted amounts under that Division for the plant if you had used it, or had it installed ready for use, for the purpose of producing assessable income before that day; and

(b) either:

(i) you hold the plant at 1 July 2001; or

(ii) subparagraph (i) does not apply and you were the owner or quasi-owner of the plant at the end of 30 June 2001.

(2) Division 40 of the Income Tax Assessment Act 1997 as amended by the New Business Tax System (Capital Allowances) Act 2001 (the new Act) applies to the plant on this basis:

(a) the amount that was your undeducted cost at the end of 30 June 2001 becomes the plant’s opening adjustable value; and

(b) you use the same cost, effective life and method that you were using under Division 42 of the former Act; and

(c) if you excluded an amount from your assessable income under section 42-290 of the former Act for a balancing adjustment event that occurred on or before 11.45 am, by legal time in the Australian Capital


Selling a Small Business – The CGT Strategies Territory, on 21 September 1999—the cost of the plant, and its opening adjustable value, are reduced by that amount; and

(d) if subparagraph (1)(b)(ii) applies to you—you are treated as the holder of the plant while you are its holder or while the circumstances under which you would have been the owner or quasi-owner of the plant under the former Act continue. Note: There are special rules for entities that have substituted accounting periods: see

section 40-65.

(3) If you were using a rate for the plant under subsection 42-160(1) or 42-165(1) of the former Act just before 1 July 2001, or would have been using such a rate if you had used it, or had it installed ready for use, for the purpose of producing assessable income before that day, Division 40 of the new Act applies to the plant on this basis:

(a) for the diminishing value method—replace the component in the formula in subsection 40-70(1) of the new Act that includes the plant’s effective life with the rate you were using; and

(b) for the prime cost method:

(i) replace the component in the formula in subsection 40-75(1) of the new Act that includes the plant’s effective life with the rate you were using; and

(ii) increase the plant’s cost under Division 42 of the former Act by any amounts included in the second element of the plant’s cost after 30 June 2001.

Note 1: Recalculating effective life will have no practical effect for an entity to whom subsection (3) applies because the component in the relevant formula that relies on effective life has been replaced.

Note 2: STS taxpayers work out the decline in value of their depreciating assets under Division 328.

40-12 Plant acquired after 30 June 2001

(1) This section applies to you if:

(a) you entered into a contract to acquire an item of plant before 1 July 2001 and you acquired it after 30 June 2001; or

(b) you started to construct an item of plant before 1 July 2001 and you complete its construction after 30 June 2001.

(2) Division 40 of the new Act applies to the plant.

(3) If you entered into the contract, or started to construct the plant, at or before 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999, you replace the component in the formula in subsection 40-70(1) or 40-75(1) of the new Act that includes the plant’s effective life with the rate you would have been using if you had acquired it, or completed its construction, before 1 July 2001 and had used it, or had it installed ready for use, for the purpose of producing assessable income before that day.

In general terms, where plant and equipment has been acquired prior to 11:45 am (ACT Time) 21 September 1999 and is disposed of after that time, the excess of disposal proceeds over the frozen indexed cost base (as at 30 September 1999) will be taxed as a balancing charge (see now sec 40-285 ITAA 97).


Selling a Small Business – The CGT Strategies For plant and equipment acquired after 11:45 am (ACT Time) 21 September 1999 any excess over its original cost will be taxed as a balancing charge (see now sec 40-285 ITAA 97).

These changes generally mean that separate records for CGT will no longer need to be kept for depreciating assets acquired after the change. This will not be the case where such assets have been used partially for private or non-income producing purposes.

It is noted that the trade-off for removing plant and equipment from the CGT regime is that all CGT concessions, including the new 50% concessions, will of course not be available in respect of such assets.

¶1.073 New CGT event K7

By sec 259 of the New Business Tax System (Capital Allowances – Transitional and Consequential) Act 2001 a new CGT event, CGT event K7, has been created to deal with partial private use or non-income producing use of depreciating assets. The new provisions are as follows:

104-235 Balancing adjustment events for depreciating assets and section 73BA

assets: CGT event K7

(1) CGT event K7 happens if:

(a) a *balancing adjustment event occurs for a *depreciating asset you *held; and

(b) at some time when you held the asset, you used it, or had it *installed ready for use, for a purpose other than a *taxable purpose.

(1A) However, subsection (1) does not apply if you are an eligible company (within the meaning of section 73B of the Income Tax Assessment Act 1936) and the *depreciating asset is a section 73BA depreciating asset (within the meaning of section 73BB of that Act).

(1B) CGT event K7 also happens if:

(a) you are an eligible company; and

(b) a *balancing adjustment event occurs for a section 73BA depreciating asset you *held; and

(c) at some time when you held the asset:

(i) you used it other than for a taxable purpose or the purpose of the carrying on by or on behalf of you of research and development activities (within the meaning of section 73B of the Income Tax Assessment Act 1936); or

(ii) you had it installed ready for use other than for a taxable purpose. Subsections 104-235(1A) and (1B) inserted by No 170 of 2001, s 3 and Sch 2 item 81A, applicable

to assessments for the income year in which 1 July 2001 occurs and for later income years.

(2) The time of *CGT event K7 is when the *balancing adjustment event occurs.

(3) Any *capital gain or *capital loss is worked out:

(a) under section 104-240; or

(b) under section 104-245 if the *depreciating asset was allocated to a low-value pool.

(4) A *capital gain or *capital loss you make is disregarded if:



(a) the *depreciating asset or the section 73BA depreciating asset is a *pre-CGT asset; or

(b) you can deduct an amount for the asset’s decline in value under Division 328 (about STS taxpayers) for the income year in which the *balancing adjustment event occurred.

104-240 Working out capital gain or loss for CGT event K7: general case

(1) You make a capital gain if the *termination value of the *depreciating asset or

the section 73BA depreciating asset is more than its *cost. The amount of the *capital gain is:

wher

sum of red

(b)

r for the purpose of the carrying

total decline is73BA depreciating asset since you started to *hold it.

(2) ital loss if the *cost of the *depreciating asset or the section 73BA depreciating asset is more than its *termination value. The amount of the *capital loss is:

e:

uctions is the sum of:

(a) in the case of the *depreciating asset - the reductions in your deductions for the asset under section 40-25; or

in the case of the section 73BA depreciating asset - the reductions that would have been required under section 40-25 (including as applied for the purposes of section 73BC of the Income Tax Assessment Act 1936) on the assumption that when you used the asset either for a taxable purpose oon by or on behalf of you of research and development activities you used it for a taxable purpose.

the decline in value of the *depreciating asset or the section

Note: The CGT concepts of cost base and capital proceeds are not relevant for this event.

You make a cap

where:

sum of reductions and total decline have the same meanings as in subsection (1).

104-245 Working out capital gain or loss for CGT event K7: pooled assets

capital gain if the *depreciating asset’s *termination value is more *cost. The amount of the *capital gain is:

(1) You make a than its

where:


Selling a Small Business – The CGT Strategies taxable use fraction is the taxable use percentage (expressed as a fraction) that you estimated for the asset when you allocated it to the pool. Note: The CGT concepts of cost base and capital proceeds are not relevant for this event.

(2) You make a capital loss if the *depreciating asset’s *cost is more than its termination value. The amount of the *capital loss is: *

where:

taxable use fraction has the same meaning as in subsection (1).

The following example, inserted after sec 118-10 to illustrate the application of the new deprecipotentia

angs it in her home. On gs it in the lobby. Gayle

to Anna for $700 on 2 January 2002.

r the 2001-02 income year?

The cost of the print is $450. Gayle chooses to use the prime cost method to calculate its decline in value.

ating assets regime in relation to a partially exempt CGT asset, also illustrates the l application of the new CGT event:

Example

On 10 July 2001, Gayle buys a print for $450 and h30 November 2001 she takes the print to her office and hanself assesses the effective life of the print to be seven years.

Gayle sells the print

How much can Gayle deduct fo

The print’s decline in value is:

$450 177365

100%7 years

× ×

= $31

Gayle can deduct $6 as the taxable use portion of the decline in value under Division 40:

34177

31×

Due to the balancing adjustment event that occurred on 2 January 2002, $54 is included in Gayle’s assessable income for the 2001-02 income year under section 40-285. The amount is reduced for non-taxable use by section 40-290.

A capital gain of $202 is disregarded under this section because the asset is a

stments on the death of the owner of depreciable property and ID 2003/1132

T issue under the new

collectable acquired for less than $500.

For recent Interpretative Decisions dealing with new CGT event K7 see ID 2003/5 dealing with a merger of registered clubs, ID 2002/617, ID 2002/618 and ID 2002/619 dealing with balancing adjudealing with the disposal of pre-CGT land.

¶1.080 TIPS TO MAXIMISE THE CONCESSION BENEFITS

The following tips should be kept in mind whenever advising on a CGCGT regime:



• never assume that the 50% individual concession will always produce the best result;

always deduct capital losses from a non-disc• ount capital gain where both non-discount

•

• d by deferring realisation until an

• this may preclude the individual being able to treat

•

way out here is not to sell to

ether distributions of capital gains under a trust can be made under a power rather than a fixed entitlement;

capital gains and discount capital gains are available;

always ensure that distributions from trusts are properly identified;

• check the date of a CGT event to see if it occurred before 21 September 1999 so averaging benefits can be used, if applicable;

tax on unrealised capital gains can still be minimiseincome year where income will be low, for example until retirement as the CGT tax liability is calculated at marginal rate;

new capital assets acquired for a business should be held by an individual owner rather than by the operating entity (butincome earned by the operating entity as its income);

when selling more than 10% of the shares in a company with a membership of less than 300, care needs to be taken to ensure that sec 115-45 is not breached at the date of sale, and to this end a balance sheet of CGT assets made as of the date of sale should be prepared to evidence compliance;

• oral agreements should not be entered into committing yourself to the sale of a CGT asset after the 12 months ownership period has expired – the onlythe offeror, though in some cases the purchaser may be prepared to provide an indemnity (but see ID 2002/958 where the ATO take the view that an indemnity received will be “any other property” received as part of the capital proceeds);

• consider whdiscretionary

• recognise that a parcel of shares is actually a bundle of separate CGT assets and the calculation of gains should be determined both on an individual basis (egg treating some as non-discount gains) and on a parcel basis to see which method produces the best result.

Practice point

ID 2002/248 highlights the need to be sure that what may be thought to be a pre-CGT asset and therefore CGT free may in fact not be pre-CGT. The case considered concerned the sale of the goodwill of a sole practice that had originally commenced before September 1985 but had been subsequently transferred into a company but then later transferred back to the individual. In this case the goodwill as held by the practitioner was a post asset. Note, there may be some circumstances where it can be established that goodwill has remained in the hands of the individual although if the practice was transferred in accordance with IT 2503 to obtain the advantage of that Ruling it could not be argued that there was no transfer.

Practice point

ID 2002/259 confirms the ATO view that capital gains made by an association that benefits from the mutuality principle cannot disregard capital gains from the disposal of its assets. The ID in particular rejected the potential application of sec 118-12 ITAA 97 (assets used to produce exempt income) in such a case saying that mutual income is not “exempt income”. Note that sec 118-12 was substituted by Act No.66 2003 as a consequence of the measure to standardise the treatment of non-assessable non-exempt income.



Chapter 2

Small business concessions overview

¶2.000 SMALL BUSINESS CONCESSIONS OVERVIEW

¶2.010 BASIC CONDITIONS FOR RELIEF

¶2.020 MAXIMUM NET ASSET VALUE TEST

¶2.021 What is the time for determining the net asset threshold?

¶2.022 Net value of the CGT assets

¶2.023 Meaning of small business CGT affiliate

¶2.024 Partnerships and partners

¶2.025 Control of discretionary trust

¶2.026 Assistant Treasurer’s announcement to introduce amendments to limit application of sec 152-30(5)

¶2.027 Amendments introduced 19 February 2004

¶2.028 Commentary on amendments

¶2.029 Commentary on previous provisions

¶2.0291 Meaning of “connected with” and “control”

¶2.030 ACTIVE ASSET TEST

¶2.031 Example where business has ceased within 12 months of the sale of active asset

¶2.032 Meaning of “active asset”

¶2.033 Assets held as cash pending the acquisition of new assets

¶2.034 ATO interpretative decisions on active assets

¶2.035 Redundant assets not longer used in a business

¶2.036 Shares held under bare trust

¶2.037 Guest houses/boarding houses, etc.

¶2.038 Loans

¶2.039 Restrictive covenants as active assets

¶2.0391 Licence of business as an active asset

¶2.0392 Forfeited deposits

¶2.0393 Performance clauses

¶2.0394 Whether assets held in a super fund can be active asset

¶2.0395 Involuntary disposals

¶2.040 CONTROLLING INDIVIDUAL TEST


¶2.042 The treatment of the small business concessions and consolidation

¶2.050 CGT CONCESSION STAKEHOLDER



¶2.000 SMALL BUSINESS CONCESSIONS OVERVIEW

The NBTS (CGT) Act contains crucial amendments to the CGT law to give effect to the four small business concessions now available to business. These are:

• the 15-year retirement exemption;

• the 50% active asset exemption;

• the simplified retirement exemption; and

• the simplified roll-over concession.

These concessions apply to CGT events happening after 11:45 am (ACT Time) on 21 September 1999 and must be considered whenever you or a client are contemplating the disposal of all or part of a small business. The major change that the Government has made in introducing these concessions is to permit small businesses to obtain the benefit of one or more of the concessions at any one time rather than to require a small business to choose only one concession at a time.

The 50% individual discount is also likely to be available for sole traders and partners. Where the business is operated through an entity, the 50% individual discount, together with some of the small business concessions, may be able to be accessed where the business entity itself is disposed of.

On its face the approach in combining concessions is an extraordinarily generous one, for businesses that are able to benefit. It means that the prospect of crippling CGT liabilities arising in the event that a business is sold, as under the previous regime, has been virtually eliminated for those businesses.

Of course, not all successful small business owners can bank on reaping a capital gain when they come to sell. If, for example, sale of a business is dependent on the gaining of approval of the transfer of the business premises lease or on the negotiating of a new lease with the existing landlord, the goodwill value of the business can be steeply eroded. This illustrates that CGT is of course just one of many issues to consider in buying or selling a business.

Although the eligibility criteria has been relaxed to some degree, many small businesses will not, however, be able to avail themselves of the concessions.

There are two main reasons for the limited availability of the concessions, both of which were a feature of the original small business roll-over concession and the retirement exemption. First, the way in which the $5m maximum net asset threshold for each concession is calculated means that many small businesses will be over that figure, particularly businesses operated through a discretionary trust, see below. Secondly, many businesses will be excluded from benefiting from all of the concessions because they have been structured so that there is no one owner who has a 50% or more ownership interest in the business as is required where ownership interests (e.g. shares in a company or units in a trust) are sold.

Also partners in partnerships with net assets of more than $5m who previously could have benefited under the 50% goodwill exemption, may now be ineligible under the new common eligibility criteria.

Whilst a particular small business owner may be ineligible to benefit under the small business concessions, all is not necessarily lost as the owner may be able to make use of the scrip for scrip roll-over in some cases, as discussed at ¶7.000 below, or the demerger provisions, discussed at ¶9.020.

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 the enabling legislation with many additional amendments having been added during that time. This is itself alarming, but what


Selling a Small Business – The CGT Strategies 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.

¶2.010 BASIC CONDITIONS FOR RELIEF

Section 152-10 ITAA 97 sets out the basic conditions for relief that are common to each of the four small business concessions. The four basic conditions are as follows:

(a) that a CGT event happens in relation to a CGT asset that you own in an income year;

(b) the CGT event would have given rise to a capital gain;

(c) you satisfy the maximum net asset value test; and

(d) the CGT asset satisfies the active asset test.

In addition, sec 152-10(2) provides two additional basic conditions. These apply where the CGT asset is a share in a company or an interest in a trust (i.e. a unit in a unit trust or an interest in a fixed trust). In these cases, the company or trust must satisfy the “controlling individual” test and the taxpayer must be a “CGT concession stakeholder” in the company or trust. The term “CGT concession stakeholder” is a new one and is discussed at ¶2.050 below.

The requirement at par 152-10(1)(a) was considered by the ATO in ID 2004/650 in relation to whether it could be satisfied where CGT event F1 happened in relation to the grant of a lease. The view was taken that the requirement is satisfied as the underlying property may be taken to be the relevant asset for the purposes of the par.

The requirement at par 152-10(1)(b) above, whilst apparently performing no obvious role, means that, in its application to the small business roll-over, the status of pre-CGT assets cannot be preserved.

Section 152-12 (inserted by Act No 173 of 2000 with effect from 21 December 2000 and applying as from 21 September 1999) provides as follows:

152-12 Special conditions for CGT event D1

(1) Paragraphs 152-10(1)(a) and (d) do not apply in the case of *CGT event D1.

(2) Instead, it is a basic condition that the right you create that triggers the *CGT event must be inherently connected with a *CGT asset of yours that satisfies the active asset test (see section 152-35).

The purpose of this provision is to ensure that the small business concessions can apply to capital gains arising where no existing CGT asset is disposed of, for example, where a taxpayer who is carrying on business enters into a restrictive covenant not to carry on the business in a particular location for, say, a two-year period and receives $50,000 as consideration for entering into the covenant. CGT event D2 would apply to the $50,000 less any expenses associated with giving the covenant. Because no existing asset is disposed of by the taxpayer, he/she would not qualify under the basic conditions as, arguably, no CGT event would happen in relation to the taxpayer’s business.

¶2.020 MAXIMUM NET ASSET VALUE TEST

This test is satisfied if a small business taxpayer’s net assets do not exceed $5m. Whilst all of the basic qualifying requirements need to be applied correctly, this test is of critical importance because of its complexity, and it therefore needs to be thoroughly understood before sound advice can be provided to clients.

Because of its importance, the topic has been considered in some detail through the use of appropriate examples.


Selling a Small Business – The CGT Strategies Before considering the practical application of the test, it is noteworthy to reflect that had the $5m threshold been indexed since it was first introduced on 1 July 1997, it would have been $5.724m as at July 2002. In other words, the threshold has eroded by more than 14% in the 5 years since the original concessions were introduced up to 2002. Given that indexation adjustments are no longer a feature of the CGT regime (except in relation to the threshold for separate CGT assets, see sec 108-70(2)(a)) it is unlikely that the threshold will be adjusted for some time.

Practice point

Many of the relevant provisions for the test have been taken from former Division 123, Part 3-3 ITAA 97, with some modifications, and provide a potential minefield for taxpayers and practitioners alike. It cannot be emphasised too greatly that a failure to properly apply this test, particularly in relation to discretionary trusts, is likely to result in substantial CGT liabilities for a taxpayer. However, the Government’s announcement on 16 October 2003 that amendments will be introduced to alleviate some of the difficulties that have arisen in relation to discretionary trusts will go some way to improving the position. See below for a discussion on the amendments.

It is also noted that the $1m average turnover threshold test for the Simplified Tax System (STS) for small business taxpayers which commenced on 1 July 2001 uses a similar test for determining the average turnover for an STS taxpayer’s grouped entities where the annual turnover must be less than $3m (see sec 328-356, 328-380 ITAA 97).

The basic requirements of the maximum net asset value test are contained in sec 152-15 ITAA 97 which provides as follows:

152-15 Maximum net asset value test

You satisfy the maximum net asset value test if, just before the *CGT event:

(a) the sum of the following amounts does not exceed $5,000,000:

(i) the *net value of the CGT assets of yours;

(ii) the net value of the CGT assets of any entities *connected with you;

(iii) the net value of the CGT assets of any *small business CGT affiliates of yours or entities connected with your small business CGT affiliates (not counting any assets already counted under subparagraph (ii)); and Note: Some assets aren’t included in the definition of net value of the CGT

assets: see subsections 152-20(2) and (3).

(b) if you are 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 does not exceed $5,000,000.

Note. The words in brackets in subpar (a)(iii) were added by Act No 173 of 2000 (Schedule 3 item 6) with effect from 21 December 2000.

See IDs 2003/44 and 2003/45 (“just before” the time of the CGT event and 2003/166 (Australian currency), discussed below.

The term “entity” is defined in sec 960-100 via sec 995-1(1) ITAA 97 to include individuals, trusts, companies, etc.

There are a number of elements to the test that must be applied with particular care. As noted above, failure to satisfy the test at the relevant time (i.e. the time the relevant CGT event happens) means that none of the four concessions will be able to be availed of.


Selling a Small Business – The CGT Strategies Broadly speaking, what the test seeks to determine is whether the relevant taxpayer has net CGT assets of not more than $5m. To illustrate how the test works, it is useful to examine a number of practical examples.

To determine the $5m limit, the test requires the aggregation of the taxpayer’s net CGT assets with the taxpayer’s spouse and children under the age of 18 as well as persons (and entities) who are expected to act in accordance with the taxpayer’s wishes (see definition of “small business CGT affiliate” in sec 152-25 ITAA 97). Also aggregated with the net CGT assets of the taxpayer are the net CGT assets of any entities “connected” with the taxpayer.

Entities “connected” with the taxpayer are defined in sec 152-30 ITAA 97 to mean entities that are controlled by the taxpayer, or that control the taxpayer, or entities which are controlled by a third party which also controls the taxpayer, see discussion below.

It should be noted that once it is determined that an entity is “connected” with the taxpayer, the whole of that entity’s new asset value is included in the calculation of the $5m limit, not just the proportion of the controlling interest.

To see how the test applies, let’s look at a simple example.

Example

Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. Helen has recently inherited an unencumbered share portfolio worth $4.75m from her elderly mother who had lived with her and Rodney.

In this example, Helen does not qualify for any of the small business concessions because she fails the maximum net asset test as her net assets exceed $5m.

In the above example, Helen’s $1,000 bank account would be required to be counted for the purposes of the test, but not Rodney’s (see sec 152-20(3), discussed below).

ID 2004/207 deals with an important issue, namely whether individual assets where the related liabilities exceed the assets value may result in a negative net value that may be available to offset against other assets. The ATO takes the view that no offsetting is permitted. The text of the ID is set out below:

CGT Small business concessions: maximum net asset value test - net value of the

CGT assets - lowest possible net value is zero

Issue

In determining 'the net value of the CGT assets' of an entity under subsection 152-20(1) of the Income Tax Assessment Act 1997 (ITAA 1997) is zero the lowest possible net value?

Decision

Yes. In determining 'the net value of the CGT assets' of an entity under subsection 152-20(1) of the ITAA 1997 the lowest possible net value is zero.

Facts

The taxpayer company carries on business. Two individuals each own 50% of the shares in the company. The company sold a business asset on 31 October 2003 and is considering the possible application of the small business capital gains tax (CGT) concessions in Division 152 of the ITAA 1997. In order to qualify for these concessions, the


Selling a Small Business – The CGT Strategies company must, among other things, determine if it satisfies the $5 million maximum net asset value test. In considering that test, the taxpayer must determine the net value of its CGT assets and that of certain related entities. Just before the company sold the asset, an entity that was connected with the company had relevant liabilities the total of which exceeded the total of the market values of its assets.

Reasons for decision

One of the basic conditions that must be satisfied to qualify for the small business CGT concessions is the $5 million maximum net asset value test in section 152-15 of the ITAA 1997. Broadly, the net value of the CGT assets of the taxpayer and certain related entities must not exceed $5 million just before the relevant CGT event. The 'net value of the CGT assets' of an entity is the amount (if any) by which the sum of the market values of those assets exceeds the sum of the liabilities of the entity that are related to the assets (subsection 152-20(1) of the ITAA 1997). The subsection refers to an amount (if any) by which one sum exceeds another sum. That is, it is referring to an excess, if there is one. As there cannot be a negative excess, the lowest possible value of the 'net value of the CGT assets' of an entity is nil. Accordingly, a negative net value can not be established by the company to offset against the net values of its related entities to determine if the maximum net asset value test is satisfied. Date of decision: 23 December 2003

It is noted that where in a business there is a general overdraft or other liability that relates to a number of assets in the business, it would appear that the better approach would be to treat the assets as a bundle and not seek to apportion a part of the liability to each asset. Whilst generally there is unlikely to be an issue of the kind raised in ID 2004/207 in such a case, it might arise where, for example, the value of one asset had dropped significantly after the general overdraft or loan had been acquired. It is submitted that the approach taken in ID 2004/207 would not be required in such a case and that it would be appropriate merely to treat the assets as a bundle.

¶2.021 What is the time for determining the net asset threshold?

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 2.10) the ATO confirmed the basis for determining the time to apply the test:

Under the small business concessions, the $5m net asset threshold is required to be determined ‘just before’ the CGT event. When is this point of time? For example, say a sole trader had net assets of $4,995,000, including shares in a public company which had a market value of $1m on the morning of the sale by him of an active asset, but at 11.59am that day the share price jumped by 0.6% to $1,060,000 and he signed the sale agreement at midday.

Would this mean he would not qualify for the concession?

Tax Office response

In this example the $5m net asset test would not be satisfied and accordingly the concessions would not be available. The words ‘just before’ in section 152-15 effectively mean ‘immediately before’.

The Tax Office also noted that the test only requires satisfaction at a single point in time, that is, just before, rather than requiring satisfaction for the entire period of ownership of the asset.

See ID 2003/745, which deals with and confirms this example. The ID deals with the case of the sale of a farm property and confirms that it is the date of the entering into the sale contract


Selling a Small Business – The CGT Strategies that is the relevant time of the CGT event under sec 104-10(3)(a) ITAA 97. See also ID 2003/744. ID 2003/45 confirms the ATO’s view that it is not sufficient that the assets of the taxpayer are under $5m on the same day as the CGT event, they must be $5m or less “immediately before” the actual event.

¶2.022 Net value of the CGT assets

Section 152-20 ITAA 97 defines the term “net value of the CGT assets” for the purpose of the net asset value test. Subsection (2) looks at the market value of each relevant asset owned by a taxpayer and deducts any liabilities that are related to each asset. It is arguable, however, that the liabilities of an entity can be aggregated without the need to specifically relate each liability to a separate asset of the entity. This is because sec 152-20(1) focuses on the “sum” of the market value of the assets, and the “sum” of the liabilities, but see ID 2004/207 set out above.

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 guidance was sought by the ICAA on the issue of the treatment of general liabilities such as bank overdrafts and liabilities under bill facilities, or general loans for working capital.

The ATO indicated that non-contingent liabilities relating to a particular asset or to the assets of the business more generally (such as a bank overdraft) may be taken into account, see now ID 2004/205 confirming this view. The ATO stated that “the test under former section 160ZZN of the ITAA 1936 applied in a different context. Provisions for income tax, for example, do not qualify as a non-contingent liability”. The reference to former sec 160ZZN is to the roll-over available when transferring an asset into a wholly owned company (see now Division 122-A) under which contingent liabilities such as provision for income tax may be taken into account in applying the roll-over. The ATO has now confirmed that contingent liabilities cannot be taken into account in applying the test, see ID 2004/206.

ID 2003/166 confirms the ATO’s view that Australian currency, that is notes and coins, will be treated as part of the net assets for the purposes of the test. The ID notes that Australian currency is not a CGT asset under sec 108-5 ITAA 97 when used as legal tender, see TD 2002/25.

Excluded from the term “net value of the CGT assets” are the following assets (see sec 152-20(2)):

• assets used solely for the personal use and enjoyment of an individual taxpayer and the taxpayer’s small business CGT affiliates (i.e., effectively, the family);

• the taxpayer’s main residence;

• any rights under a superannuation fund or approved deposit fund; and

• a life insurance policy.

Example

Let’s recall the previous example.

Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. Helen has recently inherited a share portfolio worth $4.75m from her elderly mother who had lived with her and Rodney.

Helen’s spends her savings on entertainment and personal items just before the time of the sale of the business.

This time, Helen would satisfy the net asset value test because the personal items bought by her are disregarded as being assets used solely for her personal use within


Selling a Small Business – The CGT Strategies the meaning of sec 152-20(2)(b)(i) ITAA 97, and her net assets to be taken into account for the purposes of the test are then $5m (ie they do not exceed $5m).

Practice points

One way to bring a client under the $5m threshold would appear to be to arrange for the taxpayer to acquire exempt assets; for example, buying a superannuation policy out of existing funds will reduce the taxpayer’s net assets for the purpose of the test. There is obviously a potential Part IVA application here as, arguably, the taking of such a step to acquire a superannuation policy falls foul of sec 177C(2)(a)(ii) ITAA 36.

Paying a dividend

What about paying a dividend out of a company as a way of reducing net assets? It sounds fine but it may not work where the tax payable in respect of the dividend is not payable at the time of the relevant CGT event, that is the sale of the business or entity. Note also that merely paying a dividend to the controlling shareholders will not reduce the company’s net asset value since the amount of the dividend will be part of the shareholder’s assets which would need to be aggregated with the company’s net assets, see sec 152-30 discussed below.

Pre-paying tax

Pre-paying tax may not work either if the tax paid is not “due” at the time of payment or rather at the time of the relevant CGT event, see Clyne v DCT (1981) 12 ATR 173 per Gibbs J.

The exclusions from the test are broadly the same as contained in the former Division 123 but, in the case of the main residence exemption, the exclusion has been extended to ensure that incidental business use by the taxpayer of the taxpayer’s main residence will not disqualify the home from the exclusion provided the usage is not such as to require apportionment under the main residence exemption – in other words, so long as the usage is such that no part of any mortgage interest could be claimed, the home is excluded (see sec 152-20(2)(b)(ii)) ITAA 97). It should be pointed out that merely refraining from claiming such interest will not enable the main residence to be excluded, if in fact the taxpayer is entitled to make a deduction for part of the mortgage interest. This is a significant change as previously any business usage of the taxpayer’s home would operate to require net value of the house to be counted for the purpose of the maximum net asset value test.

Example

Let’s return again to the previous example. Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. Helen has recently inherited a share portfolio worth $4.75m from her elderly mother who had lived with her and Rodney. Helen and Rodney own a home worth $300,000 (with a $100,000 mortgage) which contains a study which they use to do the bookwork of the business at night. In this example, the net value home ($200,000) is not required to be counted for the purposes of the maximum net asset value test since the usage would not enable Helen and Rodney to claim a portion of the interest on their home as a tax deduction (see Handley v FCT (1981) 148 CLR 182, Taxation Ruling 93/30 and sec 118-190(1)(c) ITAA 97).



Practice point

An interesting by-product of the change illustrated in the example above is that sec 152-20(2)(b)(ii)) ITAA 97 has been drafted so as to refer to sec 118-190(1)(c) ITAA 97 which is the provision in the main residence exemption that excludes from the exemption a portion of a residence used for income-producing purposes where interest paid in respect of the residence referable to that portion would have been deductible.

Thus distinguishing between interest deductible usage (e.g. an identifiable part of a residence such as a surgery) and a non-interest deductible part (e.g. a home study) 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 purposes of the maximum net asset value test where part of a residence is used for income-producing purposes.

Another important change to the definition of the term “net value of the CGT assets” that was not contained in former Division 123 is provided by the original sec 152-20(3) ITAA 97. What that provision did was to exclude from assets required to be included in working out the maximum net asset value test assets that are owned by a small business CGT affiliate but are not used by the taxpayer in carrying on the business. This can best be illustrated by an example.

Example

Let’s return again to the previous example. Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. But this time Helen’s mother is still alive, but frail, and living with Helen and Rodney. In this example it is arguable that the elderly mother’s share portfolio would be required to be included as part of Helen’s maximum net value of assets because under sec 152-25 ITAA 97, which defines the meaning of the term “small business affiliate”, the mother is a “small business affiliate” of Helen as she “acts, or could reasonably be expected to act, in accordance with [Helen’s] directions or wishes, or in concert with” (see FCT v Newton (1957) 96 CLR 577 and cf. TR 2002/61/D16) Helen, see also ID 2001/712 set out below. However, the new provision would enable the shares to be disregarded for the purposes of the maximum net asset value test since they are “not used, or held ready for use, in carrying on a business that [Helen], or an entity connected with [Helen], carry on…”

Section 152-20(3), as originally drafted, had limited application where a small business CGT affiliate had entities connected with it. This was because what sec 152-15(a)(iii) does is to require the aggregation with the taxpayer’s net CGT assets and the CGT assets of an entity that is connected to a small business CGT affiliate of the taxpayer. The following example illustrates this:

Example

Let’s return again to the previous example.


Selling a Small Business – The CGT Strategies Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. Assuming that Helen’s mother is a small business CGT affiliate of Helen, if Helen’s mother controls a company, the net assets of the company would be required to be aggregated with Helen’s, notwithstanding that the CGT assets held by the company are not used in Helen’s business.

Clearly, if sec 152-20(3) as originally enacted was intended to exclude CGT assets of small business CGT affiliates not used in the relevant taxpayer’s business, it made little sense to count similar assets that are held in a connected entity of the small business CGT affiliate.

However, Taxation Laws Amendment Act (No 7) 2000, introduced on 29 June 2000, amended sec 152-20(3) to make it clear that non-business assets held by entities connected with a small business CGT affiliate will not be required to be counted for the purposes of the maximum net asset value test. This amendment operates from 21 September 1999. The amendment repealed the original subsec (3) and substituted two new provisions:

(3) Subsection (4) applies in working out the net value of the CGT assets of an entity that is:

(a) your *small business CGT affiliate; or

(b) *connected with your small business CGT affiliate.

(4) Disregard assets of that entity that are not used, or held ready for use, in the carrying on of a *business (whether alone or jointly with others) by:

(a) you; or

(b) an entity *connected with you (unless the connection with you is only because of your *small business CGT affiliate).

Example: You and your husband decide to sell a florist’s business that you jointly carry on. Your husband also wholly owns a company that carries on a newsagency business. You yourself have no other involvement with the newsagency business.

You need to work out whether you satisfy the maximum net asset value just before the sale. For this purpose, you disregard the newsagency company’s assets. This is because, even though the company is “connected” with you, in that your small business CGT affiliate (i.e. your husband) owns it (see section 152-30), this connection arises only because your husband controls the company.

Whilst the intention of the new provisions is fairly apparent from a reading of the example, the actual operative provision (subsec (4)) is far from clear. This issue was raised at the National Tax Liaison Group – CGT Subcommittee meeting of 6 June 2001 by the CPA Australia. The Minutes of the meeting recorded the following response from the ATO:

The facts are:

• Taxpayer and husband conduct a florist’s business in partnership. They decide to sell, and each partner wishes to claim the small business relief.

• The husband also wholly owns a company that carries on a newsagency business. The taxpayer has no other involvement with that business.

(see ATO Handout reproduced below containing at this bullet point an addition to this explanation seeking to make clear that subsections 152-20(3) & (4) can apply to entities that are both connected with you and with your small business CGT affiliate)

ATO noted that under section 15AD of the Act Interpretation Act 1901 where an Act includes an example of the operation of a provision, and that example is inconsistent


Selling a Small Business – The CGT Strategies with the provision, then the example should be read down. The ATO view was that the example is consistent with and was genuinely illustrative of, the provision in subsection 152-20(4). The drafter confirmed that the effect of the provision was what he had in mind when drafting the subsection and example.

The important words were contained in paragraph 152-20(4)(b) – ‘(unless the connection with you is only because of your small business CGT affiliate)’ – which could be translated as saying that you treat paragraph (b) as not being there at all and only apply paragraph 152-20(4)(a). That means that you disregard assets unless they are used in carrying on a business by you.

It was noted that the provision is difficult to construe because of the triple negative contained within the words of the subsection. It is possible to explain the provisions in subsections 152-20(3) & (4) as follows:

‘In working out the net value of the CGT assets of your small business CGT affiliate or of an entity that is connected with your small business CGT affiliate including assets only if:

• they are used in carrying on a business by you; or

• they are used in carrying on a business by an entity connected with you provided the connection arises because of something more than your small business CGT affiliate. ‘

The professional bodies expressed a preference for a technical correction to remove the triple negative, or a Taxation Determination to clear up the confusion. The ATO stated that the minutes to this meeting will have to suffice for the time being. The bodies’ request for a Taxation Determination was noted.

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 2.18) the National Tax Agents and Accountants raised the further clarification:

In determining whether a taxpayer satisfies the $5,000,000 asset value test under section 152-15, you have to include the net value of the CGT assets of any small business CGT affiliate or entities connected with your small business CGT affiliate (subparagraph 152-15(a)(iii)). If your spouse controls a company (that you have no other connection with), the value of both your spouse’s shares and the assets of the company will be disregarded by virtue of paragraph 152-20(2)(a) and subsections 152-20(3) and (4) respectively, when calculating the net value of the CGT assets. However, if your spouse does not control the company as per section 152-30 (say 39% interest in the company), it appears that the value of the shares held by the spouse would not be disregarded because paragraph 152-20(2)(a) only applies where the shares are in an entity that is ‘connected’ (controlled) by the small business CGT affiliate. If this interpretation is correct, it appears to be an inequitable result in that a taxpayer who has a spouse who holds, say, $2,000,000 worth of shares in a company which the spouse controls, that $2,000,000 would not be included in the taxpayer’s maximum net asset value test, whereas if the spouse held the same value of shares in a company that the spouse did not control, the $2,000,000 would be included in the maximum net asset value test. Has the Tax Office any other interpretation of the provisions that gives a more equitable result? Tax Office response

Although the value of shares in a company your spouse controls would be disregarded under paragraph 152-20(2)(a), it would also be disregarded under subsection 152-20(4) as an asset of your affiliate that is not used in carrying on a business by you or an entity connected with you. As such, where your spouse does


Selling a Small Business – The CGT Strategies not control the company, the value of the shares would still be excluded under subsection 152-20(4).

By item 2.19 the ATO noted that the assets of superannuation funds should not be included in determining the $5m threshold as a connected entity under sec 152-30 because the taxpayer will not be said to “control” the assets in the relevant sense.

At the following CGT Subcommittee meeting held on 27 November 2002 the following Handout was provided to clarify the ATO explanation to make clear that subsec 152-20(3) and (4) can apply to entities that are both connected with you and with your small business CGT affiliate:

Handout

Agenda item

Net value of CGT assets: clarification of example in subsection 152-20(4) This issue was raised previously by CPA Australia in the NTLG CGT Subcommittee meeting of 13 June 2001. The Tax Office wishes to clarify an aspect of its response to that question. Maximum net asset value test - Sections 152-20(3) and (4): is the example correct?

Facts

Taxpayer and husband conduct a florist’s business in partnership. They decide to sell, and each partner wishes to claim small business relief. The husband also wholly owns a company that carries a newsagency business. The taxpayer has no other involvement with that business.

Issue

The ‘Example’ appearing after section 152-20(4) suggests that you do not have to include the value of the newsagency business when applying the maximum net asset value test of section 152-15.

Is this correct? Analysis

A. In applying the maximum net asset value test, section 152-15(a) directs you to consider the assets of three categories of entity:

I. the taxpayer II. entities connected with the taxpayer III. Small business CGT affiliates (‘Affiliates’) of the taxpayer, and entities connected with those affiliates.

B. The concept of ‘connected’ entities is explained in section 152-30. In the present case, the company which operates the newsagency business is connected to the taxpayer by virtue of the husband's share ownership [category (II)] and also connected to an affiliate of the taxpayer for the same reason [category (III)]. C. Section 152-20(3) provides that the exclusion in section 152-20(4) only applies in working out the net value of the CGT assets of an entity that is an affiliate of the taxpayer or connected with such an affiliate. This appears to be a reference to category (iii) of section 152-15(a).


Selling a Small Business – The CGT Strategies D. If an entity falls within both category (ii) and category (iii), is it excluded by section 152-20(4)? The example in the legislation clearly suggests it is, but do the terms of the provisions support that view?

Tax Office response The facts are:

Taxpayer and husband conduct a florist’s business in partnership. They decide to sell, and each partner wishes to claim the small business relief.

The husband also wholly owns a company that carries on a newsagency business. The taxpayer has no other involvement with that business.

Subsections 152-20(3)&(4) may apply to an entity that would, but for the double counting exclusion in subparagraph 152-15(a)(iii), be included in the maximum net asset value test under both subparagraphs 152-15(a)(ii) & (iii). If an entity is connected with you and also connected with your small business CGT affiliate, the entity is still nevertheless connected with your small business CGT affiliate so that subsections 152-20(3)&(4) may apply to that entity. The Tax Office noted that under section 15AD of the Act Interpretation Act 1901 where an Act includes an example of the operation of a provision, and that example is inconsistent with the provision, then the example should be read down. The Tax Office view was that the example is consistent with and was genuinely illustrative of, the provision in subsection 152-20(4). The drafter confirmed that the effect of the provision was what he had in mind when drafting the subsection and example. The important words were contained in paragraph 152-20(4)(b) – ‘(unless the connection with you is only because of your small business CGT affiliate)’ – which could be translated as saying that you treat paragraph (b) as not being there at all and only apply paragraph 152-20(4)(a). That means that you disregard assets unless they are used in carrying on a business by you. It was noted that the provision is difficult to construe because of the triple negative contained within the words of the subsection. It is possible to explain the provisions in subsections 152-20(3) & (4) as follows: ‘In working out the net value of the CGT assets of your small business CGT affiliate or of an entity that is connected with your small business CGT affiliate including assets only if:

they are used in carrying on a business by you; or they are used in carrying on a business by an entity connected with

you provided the connection arises because of something more than your small business CGT affiliate’.

The professional bodies expressed a preference for a technical correction to remove the triple negative, or a Taxation Determination to clear up the confusion. The Tax Office stated that the minutes to this meeting will have to suffice for the time being. The bodies’ request for a Taxation Determination was noted. Note: This clarifies that subsections 152-20(3)&(4) can apply to entities that are both connected with you and with your small business CGT affiliate.

Whilst the explanation provided by the ATO at the 2001 Meeting and the follow up Meeting in November 2002 as to the intended operation of subsec 152-20(3) and (4) provides


Selling a Small Business – The CGT Strategies assistance in straightforward cases as illustrated in the example following subsec (4), it provides no indication of the potential for alternative interpretations which may give the provisions a much wider operation. One immediate problem with its explanation is that it appears to ignore the potential operation of the unqualified nature of para 152-20(4)(a). For example, it might be said that para 152-20(4)(a) may be read in isolation given that it appears that it is an alternative case. This would mean that business and non business assets of any entity that is either your small business CGT affiliate or connected with your small business CGT affiliate (i.e. the entities referred to in subsec (3)) that are not used in your business can be disregarded. Under sec 152-30 just about any entity that is connected with your small business CGT affiliate will be treated as an entity “connected with” you. This means that the actual operation of subsec 152-20(3) and (4) may become critical in many cases. It may even operate to alleviate the untrammeled operation of sec 152-30(5) in relation to discretionary trusts where the relevant taxpayer has a small business CGT affiliate.

The argument to limit the operation of subsec 152-20(3) and (4) is presumably that para 152-20(4)(b) would have no operation if para 152-20(4)(a) is not confined to cases dealing with the taxpayer’s small business CGT affiliates or entities connected with the taxpayer’s small business CGT affiliate (ie the entities referred to in subsec (3)). That is, para 152-20(4)(a) it is not intended to deal with cases where the related entity is directly connected with the taxpayer. The difficulty with this argument is that there is nothing to indicate that subsec 152-20(3) and (4) were intended only to deal with assets of entities of a small business CGT associate and the assets of the associates – apart that is from the fact that the original provision (subsec (3)) sought to deal only with those assets. There is nothing in the relevant EM to assist. Given the extensive use of mandatorily defined terms (see sec 152-30) it is not surprising that their strict application can give rise to uncertainty. It would appear at the very least that there is a reasonably arguable case for a broader application. As these provisions are untested in the Courts, it is difficult to know how they would be approached. Clearly, however, given that the small business concessions are intended to provide relief for small business taxpayers, in an appropriate case, it would be expected that the Court may take a sympathetic view towards the taxpayer.

At the 11 June 2003 National Tax Liaison Group – CGT Subcommittee meeting the NIA put forward an example where the operation of sec 152-20(3) and (4) would produce differing results. The example is reproduced below:

Clarification is sought whether and when the net value of rental properties under various ownership structures is taken into account when calculating whether a taxpayer satisfies the maximum net asset value test.

Example 1

Sam, a sole trader, is selling his business and wishes to obtain small business relief under Division 152. Sam is single and does not have any children. Sam jointly owns with Bob (a friend) two residential rental properties, each with a market value of $1 million. The rental properties are not mortgaged and they are owned by Sam and Bob as tenants in common in equal shares.

Analysis of Example 1

Under section 152-15 Sam needs to add together the net value of the following:

his own CGT assets (refer to subparagraph 152-15(a)(i)) assets of entities connected with him (subparagraph 152-15(a)(ii)) assets of his small business CGT affiliates, and assets of the entities connected with his small business CGT affiliates

(subparagraph 152-15(a)(iii)).


Selling a Small Business – The CGT Strategies The value established is subject to a number of exclusions contained in section 152-20. Entity is defined in section 960-100 to include a partnership. Partnership is defined in section 995-1 to include a tax law partnership. As Sam and Bob are in receipt of income jointly from the rental properties they are in partnership within the meaning of that term in section 995-1. Further, as Sam has the right to receive more than 40% of the income/capital from the partnership it seems he is taken to control the partnership under subsection 152-30(2) and therefore the partnership is connected with Sam under subsection 152-30(1). As Sam’s 50% ownership interest in the rental properties is his interest in a connected entity, the tax law partnership, his 50% ownership interest that would otherwise be counted under subparagraph 152-15(a)(i) is disregarded pursuant to paragraph 152-20(2)(a). Under subparagraph 152-15(a)(ii), however, Sam must include the net value of the CGT assets of any entities connected with him, again subject to the exclusions in section 152-20. It appears that the exclusion of assets not used in the relevant business provided by subsection 152-20(4) will only operate with respect of the entities listed in subsection 152-20(3). This view is taken in the ATO response in the minutes of NTLG CGT subcommittee meeting of 6 June 2001. If this is the case, then the rental properties not used for any business are only disregarded when the partnership is a small business CGT affiliate of Sam, or connected with a small business CGT affiliate of Sam. As Sam is single with no children and assuming he does not have other small business CGT affiliates (other than the ones that may arise from the tax law partnership of the joint ownership of rental properties), it becomes vital to consider whether the tax law partnership is a small business CGT affiliate of Sam. It could be argued that the tax law partnership is a small business CGT affiliate of Sam by virtue of paragraph 152-25(1)(b). Paragraph 152-25(1)(b) refers to a person and this could include the tax law partnership. Section 995-1 simply states person includes a company. This indicates it is not limited to individuals so arguably includes a tax law partnership. The next step is to examine whether the tax law partnership acts, or could reasonably be expected to act, in accordance with Sam’s directions or wishes, or in concert with Sam. It appears there has been no formal taxation ruling on this issue. However, it may be of assistance to consider the Commissioner’s view on the interpretation of the similarly worded STS affiliate definition in subsection 328-380(8) as expressed in TR 2002/6. An analysis of TR 2002/6 indicates the task of determining whether a person acts, or could reasonably be expected to act, in accordance with another person’s directions or wishes, or in concert with that other person is not an easy one. However, it may well be the case that the outcome depends on how well Sam is getting along with Bob in respect of the partnership’s affairs. If Bob works well with Sam in respect of their jointly own properties it seems that the partnership is a small business CGT affiliate of Sam because of paragraph 152-25(1)(b). In this case, the net value of the rental properties


Selling a Small Business – The CGT Strategies would be totally excluded from the maximum net asset test due to the operation of subsection 152-20(4). On the other hand, if it is evident that the relationship between Bob and Sam has deteriorated to the point that they can no longer work together, and indeed they have conflicting views and desires for the rental properties, it could be argued that the tax partnership is NOT a small business CGT affiliate of Sam. Consequently the total net value of the rental properties cannot be excluded from the maximum net asset test, as subsection 152-20(4) does not apply. Based on the above analysis, it seems that although Sam’s interest in the rental properties is always 50% or $1 million, the value to be included in the maximum net asset test can be either nil or $2 million, depending on the relationship between Sam and Bob.

Example 2

Sam is a sole trader and owns a rental property worth $1 million in a discretionary trust. Sam and his wife are the only shareholders and directors of the trustee company.

Analysis Arguably, the discretionary trust is a small business affiliate under paragraph 152-25(1)(b) as Sam and his wife control the trust. On this basis, it is arguable that the $1 million worth of property in the trust is excluded from the maximum net asset value test because of the operation of paragraph 152-20(a) and subsections 152-20(3) and (4).

ATO comments & Action item

The ATO is to consider this issue further and to provide an update at the next meeting.

The Minutes of the November 2003 meeting of the Subcommittee contain the following ATO comments:

Tax Office comments

Example 1

With respect to the question whether a partnership might be an affiliate of a partner, the Tax Office considers that this is unlikely to be the case. The paragraph 152-25(1)(b) definition of affiliate is not directed at the relationship between the ‘controller’ of an entity and the entity itself. The relationship in these situations is considered to be dictated more by obligations imposed by law, formal agreements, fiduciary obligations and the like. It is also considered that Bob is unlikely to be an affiliate of Sam for the same reasons, regardless of how they act in relation to the operation of the rental properties. In this regard it can further be noted that subsection 152-25(2) requires something more than just the parties acting in concert with each other in relation to the affairs of the partnership.

Example 2

Similarly, in relation to example 2, it is considered in general that companies and trusts are not affiliates of the various officer/entities/persons that are related to the company or trust in various capacities, such as the trustees or beneficiaries of a trust


Selling a Small Business – The CGT Strategies and the directors or shareholders of a company or trustee company. This is for the same reasons as outlined above in example 1. It is considered that the discretionary trust is not an affiliate of Sam in this situation.

Note, the answer provided by the ATO in relation to Example 2 does not mean that the trust is not “connected with” Sam by reason of another test so, for example, if Sam receives at least 40% of the distributions of the trust in an income year, he would be connected with the trust.

¶2.023 Meaning of small business CGT affiliate

The ATO has issued an Interpretative Decision on the application of the term “small business CGT affiliate” as defined in sec 152-25. ID 2001/712 provides as follows:

Capital Gains Tax: CGT small business relief: small business CGT affiliate

Issue

Is a company owned and directed by the taxpayer's children the taxpayer's small business CGT affiliate for the purposes of the small business CGT concessions in Division 152 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. The company will be the taxpayer’s small business CGT affiliate. As the taxpayer has actively participated in their children’s farming business, the company could reasonably be expected to act in concert with the taxpayer in accordance with section 152-25 of the ITAA 1997.

Facts

The taxpayer and their spouse were partners in a partnership which acquired farmland in 1986. They formulated a succession plan to enable their children to take over the farming operations. In accordance with the plan, a new company was formed which was owned and directed by the taxpayer's children (‘the company’). The company then acquired the stock and plant and entered into a lease agreement (which imposed certain restrictions on their farming activities) for use of the farmland.

With the company owning the stock and plant of the farming business the children could make their own decisions relating to the farm program. The taxpayer, however, retained financial control through provision of working capital and the use of the farmland via the lease agreement. The children consult with the taxpayer before making decisions concerning the farming business. The taxpayer has continued to work unpaid on the farm performing duties such as driving machinery, machinery maintenance, fencing, and general farm work.


One of the basic conditions for the small business CGT concessions is that the active asset test must be satisfied (section 152-10 of the ITAA 1997). Amongst other things, an asset will be an active asset if it is used or held ready for use in the course of carrying on a business by a small business CGT affiliate (subparagraph 152-40(1)(c)(i) of the ITAA 1997). The term ‘small business CGT affiliate’ is defined in section 152-25 of the ITAA 1997. A person is a small business CGT affiliate of a taxpayer if the person acts, or could reasonably be expected to act in accordance with the taxpayer’s directions or wishes, or in concert with the taxpayer. Section 995-1 of the ITAA 1997 defines ‘person’ to include a company. Extensions to the small business CGT concessions were outlined in the Treasurer’s Press Release No. 76 of 1998. The Press Release explains the additional situations


Selling a Small Business – The CGT Strategies that the CGT small business concessions should now apply to. It was the intention of the Government at the time of introducing these additional measures that the concessions were to apply to small businesses where a non-operating entity held some of the business assets providing these assets were used actively in a business. In this case the farmland is held by the taxpayer for use in the farming business conducted by the company. The company's activities are limited by the finance that the taxpayer provides and are also constrained by the clauses in the lease agreement. In addition the taxpayer continues to work on the farm for no remuneration and the children refer to the taxpayer for advice on matters concerning the running of the farming business. As the taxpayer is actively involved in the business and is consulted in business decisions it is considered that the company acts or could reasonably be expected to act in concert with the taxpayer. Therefore the company owned and directed by the taxpayer's children is considered to be the taxpayer's small business CGT affiliate.

Date of decision: 28 September 2001

Year of income: Year ending 30 June 2002

Whilst this interpretation will be of assistance in many cases, particularly in applying sec 152-20(4), it does illustrate that the ATO may take a prima facie view that in most family situations entities owned by one member of the family will be small business CGT affiliates of the other members. This will not in fact always be the case and care may be needed to make clear at the time of a particular transaction that a family member is not an affiliate. For example, where one member of a family operates a separate business that may provides services on an arm’s length basis to another business operated by the family.

ID 2003/450 is another good illustration of the kind of situation where the various factors need to be considered in order to make a decision. The relevant parts of the ID are reproduced below:

Issue

If a taxpayer owns land on which their brother operates a farming business, is the taxpayer's brother a small business CGT affiliate of the taxpayer under paragraph 152-25(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. In the circumstances described, the brother is the taxpayer’s small business CGT affiliate under paragraph 152-25(1)(b) of the ITAA 1997. As the brother's business is carried on with a substantial degree of dependence on the taxpayer’s agreement to allow him to use the land, the brother could reasonably be expected to act in concert with the taxpayer in accordance with paragraph 152-25(1)(b) of the ITAA 1997.

Facts

The taxpayer owns a 25% interest in land acquired after 19 September 1985. The taxpayer’s brother owns the other 75% interest. They acquired their interests under their father’s will and own the land as tenants in common. The land has been owned by family members for over 50 years and has been actively farmed during that time. With the taxpayer’s consent, all of the property is used to conduct a farming business by a partnership (the taxpayer's brother and his spouse). This arrangement has been in place since the property was acquired from their father’s estate and is based on family considerations. The taxpayer is not involved in the operation of the farming business and derives no income from the land. The taxpayer’s brother makes all the decisions regarding the use and maintenance of the land.




One of the basic conditions of the small business CGT concessions in Division 152 of the ITAA 1997 is that the active asset test must be satisfied (paragraph 152-10(1)(d) of the ITAA 1997). A CGT asset is an active asset if, among other things, it is owned by the taxpayer and used or held ready for use in the course of carrying on a business by a small business CGT affiliate (subparagraph 152-40(1)(c)(i) of the ITAA 1997). The term ‘small business CGT affiliate’ is defined in section 152-25 of the ITAA 1997. A spouse or child of the taxpayer under 18 years is a small business CGT affiliate. A person is also a small business CGT affiliate of a taxpayer if the person acts, or could reasonably be expected to act, in accordance with the taxpayer's directions or wishes, or in concert with the taxpayer. Whether a person acts, or could reasonably be expected to act, in accordance with the taxpayer's directions or wishes, or in concert with the taxpayer is a question of fact dependent on all the circumstances of the particular case. No one factor will necessarily be determinative. Relevant factors that may support a finding that a person acts, or could reasonably be expected to act, in accordance with the taxpayer’s directions or wishes, or in concert with the taxpayer include:

• the existence of a close family relationship between the parties,

• the lack of any formal agreement between the parties prescribing how the parties are to act in relation to each other,

• the likelihood that the way the parties act, or could reasonably be expected to act, in relation to each other would be based on the relationship between the parties rather than on formal agreements and

• the actions of the parties.

In this case, a very close family relationship exists between the parties. The taxpayer owns an interest in the land which, with their consent, is used by their brother (in partnership with his spouse) to carry on the farming business. Farming operations were previously conducted on the land for many years by the taxpayer’s father. The arrangement in respect of the use of the land is based on family considerations. Although the taxpayer is not involved in the operation of the farming business the brother’s business is carried on with a substantial degree of dependence on the taxpayer’s agreement to allow him to use the taxpayer’s share of the land. There is clearly an understanding between them about the use of the land. In these circumstances, it is accepted that the brother acts or could reasonably be expected to act in concert with the taxpayer. Therefore, the brother is the taxpayer’s small business CGT affiliate under paragraph 152-25(1)(b) of the ITAA 1997 and the taxpayer’s interest in the land is an active asset. Date of decision: 19 May 2003

In ID 2004/538 deals with the case of a couple where the spouses are permanently separated. The ATO takes the view that the parties are small business CGT affiliates nonetheless.

¶2.024 Partnerships and partners

Section 152-15(b) imposes an additional rule in relation to partners under the maximum net asset value test. The additional rule is that the net assets of the partnership must not exceed $5m. This means that a partner in a business whose interest in the business is worth well under $5m would nevertheless be disqualified under the maximum net asset value test if the partnership’s net assets are $5m or more.


Selling a Small Business – The CGT Strategies A related rule is contained in sec 152-25(2) that ensures that partners are not treated as small business CGT affiliates merely because they are fellow partners in a partnership. Thus it does not preclude aggregation where there is another link, for example where the partners are husband and wife. The rule in sec 152-25(2) is somewhat perverse because, where the relevant taxpayer entity is a partner, the rule in sec 152-15(b) would preclude the taxpayer from qualifying under the maximum net asset value test if the net value of the partnership’s assets is more than $5m anyway. The rule in sec 152-25(2) would only be of assistance where the net value of the partnership was under $5m, but the other assets of the taxpayer would bring his/her assets over the $5m, if aggregated with the other partnership assets.

Example

Max is an equal partner in a business partnership with two other persons. The net value of the partnership is $3m. Max runs a second unrelated business as a sole trader. The net value of its assets is $3.5m. Max’s net assets for the purpose of the maximum net asset value test are $4.5m ($3.5m plus his $1m interest in the partnership).

In the above example, it may be observed that, but for sec 152-25(b), sec 152-20(3) and (4) would apply to enable the net assets of the other partners’ interests to be ignored – in other words sec 152-25(2) would be unnecessary in such a case. However, sec 152-25(2) is still necessary because without it the net value of the assets of the other partners would be brought in as affiliates where the partnership business was related to Max’s other business.

It is interesting to note that sec 152-25(2) may apply differently in a partnership with a larger number of partners than say with a two- or three-person partnership. This may be by virtue of the fact that with a larger number partnership (assuming its net assets are still not more than $5m, otherwise the issue never arises) there is likely to be less personal interaction between the partners.

¶2.025 Control of discretionary trust

Whilst the change introduced by new sec 153-20(3) and (4) ITAA 97 is a welcome one, it was not intended to overcome the major difficulty in applying the maximum net asset value test in relation to discretionary trusts though as noted at ¶2.000 above, there would appear to be a reasonably arguable position available in some cases where the taxpayer has a “small business CGT affiliate”, see ID 2001/712 set out above.

The difficulty arises because of sec 152-30(5) (previously sec 123-60(5) in Division 123 ITAA 97 (set out at “Meaning of ‘connected with’ and ‘control’” below) and, prior to that, sec 160ZZPN(5) ITAA 36) which deems a potential beneficiary under a discretionary trust to own the maximum amount of capital and income that can be distributed to the beneficiary under the trust. The effect of this provision is to enable such a beneficiary to be treated as having “control” of the discretionary trust if, for example, under the trust, the trustees have the power to distribute 40% or more of the assets or income to any of the beneficiaries.

The provisions which deem control of an entity are contained in sec 152-30 ITAA 97 and apply in the first instant to deem one entity to control another if the first entity controls the rights to 40% or more of the income or capital of the second entity, see discussion below.

So, by applying sec 152-30(5) to a potential beneficiary under a discretionary trust who, under the terms of the trust, could be paid 40% or more of the income or capital of the trust, is deemed to own that income or capital, and therefore, by sec 152-30(2), will be deemed to control the entity. Applying sec 152-30(1), such a person is deemed to be “connected with” the second entity. In turn, for the purposes of the maximum net asset value test, the whole of the assets of the discretionary trust are then required to be aggregated with the taxpayer entity even though in reality the taxpayer may never receive a distribution under the discretionary trust.



Example

Let’s return again to the Helen examples, above. It will be recalled that Helen is a sole trader who owns a milk bar, which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. Helen and Rodney each have bank accounts with approximately $1,000 in each. This time Helen’s mother is robust and holds her $4.75m share portfolio in a discretionary trust under which Helen is a potential capital and income beneficiary to the whole of the trust corpus. Section 153-30(5) ITAA 97 would operate to treat Helen as being the beneficial owner of the entire $4.5m and by virtue of sec 152-30(2)(a) ITAA 97 would be treated as controlling the trust. By virtue of sec 152-30(1) ITAA 97 Helen would be “connected with” the trust. So by sec 152-15(a)(ii) the net value of the CGT assets of the trust would be aggregated with Helen’s to determine whether she is able to satisfy the maximum net asset value test.

It is important to note here that where sec 152-30(5) ITAA 97 and sec 152-30(2) ITAA 97 apply to treat a discretionary trust as connected with a taxpayer, there is no let-out as in the case of a small business CGT affiliate where the assets of the affiliate are not used in the taxpayer’s business (see earlier example). In other words, it does not matter that the assets of the discretionary trust have no business use, they are still taken into account to determine whether the taxpayer can satisfy the maximum net asset value test. As indicated above, however, if it can be argued that Helen’s mother is a “small business CGT affiliate” of Helen’s, subsec 152-20(4) can apply to enable the assets in the trust to be disregarded.

The ATO recently issued ID 2002/921(withdrawn) confirming that it will apply a literal interpretation of subsec 152-30(5). The ID is reproduced below:

CGT – Small Business Concessions – Discretionary Trusts

Issue

If gift deductible or income tax exempt bodies or the like are beneficiaries under a discretionary trust and the trustee has the power to pay any or all of the income or capital of the trust to those bodies are they connected with the trust in terms of section 152-30 of the Income Tax Assessment Act 1997 (ITAA 1997) for the purposes of the maximum net asset value test under sub-paragraph 152-15(a)(ii) of the ITAA 1997?

Decision

Yes. The gift deductible or income tax exempt bodies are taken to have a 100% interest in the discretionary trust under subsection 152-30(5) of the ITAA 1997 and are therefore taken to control the trust under subsection 152-30(2) of the ITAA 1997. The bodies are therefore connected with the discretionary trust under subsection 152-30(1) of the ITAA 1997 for the purposes of the maximum net asset value test under sub-paragraph 152-15(a)(ii) of the ITAA 1997.

Facts

A discretionary trust conducted a business. The trust disposed of the assets of the business and a capital gain was realised. The deed of the trust provided for a number of classes of beneficiary. All classes of beneficiary were identical as to their ability to receive income or capital of the trust.


Selling a Small Business – The CGT Strategies One of the classes of beneficiary included any charitable trust or any society, authority, institution, church, religious order or person or entity which at the time of distribution of income of the trust is exempt from income tax or at that time a tax deduction would be available for a monetary gift to that entity or person. This group is referred to in this ATO ID as gift-deductible bodies.

The trust deed provides that the trustee has the power to pay any or all of the income or capital of the trust to any of the beneficiaries.


In order to address the question at issue it has to be established whether a class of beneficiary referred to here as gift-deductible bodies satisfies the criterion certainty test under trust law (McPhail v. Doulton (1971) AC 424). Lord Wilberforce remarked in this case at p449 that: ‘a trustee with a duty to distribute, particularly among a potentially very large class, would surely never require the preparation of a complete list of names, which anyhow would tell him little that he needs to know. He would examine the field, by class and category; might indeed make diligent and careful inquiries, depending on how much money he had to give away and the means at his disposal, as to the composition and needs of particular categories and of individuals within them; decide upon certain priorities or proportions, and then select individuals according to their needs or qualifications.’

The Administrative Appeals Tribunal in Case U201 87 ATC 1122 at 1127; AAT Case 133 (1987) 18 ATR 3964 adopted Lord Wilberforce's view, expressed in McPhail v Doulton, that the objects of a trust power should form a class which is not so large or arbitrary that it cannot be said for certain that a particular person was within the settlor's contemplation as an object of his bounty (noted in Taxation Ruling IT 2462).

We consider that the class of beneficiary referred to as gift-deductible bodies would form a class that is not so large or arbitrary such that a trustee of a discretionary trust can say for certain whether any entity would be within the range of benefit as contemplated by the settlor. Thus it is considered that this class of beneficiary is a valid class of beneficiary of the trust. That is a trustee of a discretionary trust could determine with certainty whether any entity would be within, or excluded from, this class of beneficiary. A basic condition of eligibility for the capital gains tax concessions for small business in Division 152 of the ITAA 1997 is that the net value of CGT assets of the entity and related entities, including entities connected with it does not exceed $5 million under section 152-15 of the ITAA 1997. Subsection 152-30(1) of the ITAA 1997 describes how entities are connected with each other. It says that an entity will be connected to another entity if:

• either entity controls the other entity; or

• both entities are controlled by the same third entity.

To determine if a beneficiary controls a discretionary trust that beneficiary is taken, under subsection 152-30(5) of the ITAA 1997, to have an interest in any distribution of income or capital of the trust equal to the maximum percentage of the income or capital that the trustee could distribute to that beneficiary under the trust deed, regardless of the actual distribution. If that interest is at least 40% the beneficiary is taken to control the discretionary trust under subsection 152-30(2) of the ITAA 1997. This may, depending on the terms of the trust deed, result in several or all of the beneficiaries of a discretionary trust being taken to control the trust.


Selling a Small Business – The CGT Strategies A gift-deductible body is a beneficiary of the trust and according to the trust deed is capable of receiving all the income or capital of the trust to the exclusion of all other beneficiaries. Accordingly, it is taken to have a 100% interest in the trust, to control the trust and therefore to be connected with the trust. The net value of the CGT assets of the gift-deductible body must be taken into account when applying the maximum net asset value test to the trust.

Date of decision: 2 August 2002

Whilst the presence of this ID will potentially deter many taxpayers from availing themselves to the small business concessions, it may result in further remedial legislation to limit the obviously far too broad a reach of subsec 152-30(5), though it must be remembered that its predecessor was limited by what is now subsec 152-30(6) (see next heading). Nevertheless, as indicated above, there are good arguments available to limit its application where the relevant taxpayer has a small business CGT affiliate. In addition, it is certainly open to argue as a matter of interpretation that subsec 152-30(5) must be limited in its reach. The provision has not as yet been tested in the Court, and as noted in relation to subsecs 152-20(3) and (4), given that the small business concessions are intended to provide relief for small business taxpayers, in an appropriate case, it would be expected that the Court may take a sympathetic view towards the taxpayer.

The issue was again raised with the Commissioner of Taxation, Michael Carmody, at the 2 September 2003 National Tax Liaison Group (NTLG) meeting and the ATO reiterated the position indicating that it had been unable to find an administrative solution to the problem.

¶2.026 Assistant Treasurer’s announcement to introduce amendments to limit application of sec 152-30(5)

On 16 October 2003 the Assistant Treasurer, Senator Helen Coonan, announced significant changes to the operation of the CGT small business concessions in so far as they apply to discretionary trusts. The Press Release is reproduced, in part, below together with the relevant part of the Attachment:

C097/03 16 October 2003

CAPITAL GAINS TAX CHANGES TO BENEFIT INVESTORS, SMALL

BUSINESS AND CHARITIES

Changes to strengthen the equity and fairness of the capital gains tax (CGT) law were announced today by the Minister for Revenue and Assistant Treasurer, Senator Helen Coonan. “The changes will increase access to the concessional treatment of certain capital gains and will particularly benefit investors, small businesses and charities”, Senator Coonan said. The first change will improve access to the small business CGT concessions. “In 1999 the Government simplified, streamlined and extended the small business CGT concessions. These concessions recognise the vital role of small business in creating jobs for Australia’s future by providing small business people with access to funds for expansion or retirement,” Senator Coonan said. The change will ensure that small businesses operating through discretionary trusts can more readily benefit from the CGT concessions. Currently, when tax exempt entities or deductible gift recipients are potential beneficiaries of the trust, the assets of the beneficiary are taken to belong to the small business. If the total of the assets controlled by the business exceeds $5 million, it cannot access the small business CGT concessions.


Selling a Small Business – The CGT Strategies “Many small businesses that operate through a discretionary trust include charitable organisations as a beneficiary,” Senator Coonan said. “The changes will ensure those businesses are not prevented from accessing the CGT concessions simply because of the assets held by that charity. This will encourage small businesses to continue to include charities as beneficiaries”, Senator Coonan said. … “The amendments will overcome concerns raised by the tax profession and industry. This approach demonstrates, in a practical way, the Government’s responsiveness to suggestions directed at improving the tax system. The Government has listened and acted,” Senator Coonan said. The Government will consult further with the tax profession and industry in developing legislation to implement these changes. Additional technical detail relating to these changes is attached (see Attachment A).

ATTACHMENT A Small Business CGT Concessions There are four small business CGT concessions. These are: • the small business 15 year exemption; • the small business 50% active asset reduction; • the small business retirement exemption; and • the small business roll-over. The small business CGT concessions apply only if, among other things, the net value of the CGT assets of an entity and of other entities that it controls is $5 million or less. If a small business entity is treated as controlling a discretionary trust, assets of all beneficiaries of the trust must be taken into account. For example, if a charitable institution is a potential beneficiary of the trust, assets of the charity are taken to belong to the small business entity for this purpose. The control test for discretionary trusts will be amended with effect from 21 September 1999 – that is, the date from which the simplified, streamlined and extended small business CGT concessions first applied. Distributions to tax exempt entities and tax deductible gift recipients will now be ignored for the purposes of applying the new control test for discretionary trusts. 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 per cent of the total distributions of the trust for that year (subject to an existing discretion available to the Commissioner of Taxation where the control percentage is between 40 per cent and 50 per cent). Consistent with other patterns of distribution tests in the income tax law, the test year will be determined by considering distributions made by the trust to the entity and/or its small business CGT associates in the income year immediately before the year in which the relevant CGT event happened and in each of the three income years before that. The test year will be the income year during which those distributions were the highest. As a transitional measure, for the 2001-02 and prior income years, an entity will be taken to control a discretionary trust if the distributions made by the trust to the entity and/or its small business CGT associates in the income year in which the relevant CGT event happened are at least 40 per cent of the total distributions of the trust for


Selling a Small Business – The CGT Strategies that year (subject to the Commissioner’s existing discretion where the control percentage is between 40 per cent and 50 per cent).

This announcement is a long overdue recognition of the difficulties that have faced practitioners and taxpayers in applying the CGT small business concessions since their original incarnation. Up to the time of the Press Release there had been no indication from the Government that it would act to deal with the issue. Whilst it is of great comfort that the announcement states that the amendments will be retrospective back to the introduction of the concessions, until the proposed amendments are enacted care needs to be taken to ensure that action is not taken that will prejudice their application when enacted.

¶2.027 Amendments introduced 19 February 2004

The Government introduced the amendments into the House of Representatives on 19 February 2004.These amendments were passed without change, receiving assent on 29 June 2004 .

The amendments are fairly straightforward and seek to reflect the thrust of the Minister’s Press Release, though they are no without some limitations.

The amendments as contained in Schedule 3 of the Tax Laws Amendment (2004 Measures No. 1) Act 2004 and are set out below in full:

Schedule 3—Small business CGT relief and discretionary trusts

Income Tax Assessment Act 1997

1 Paragraph 152-30(2)(a)

Before “beneficially own”, insert “except where the other entity is a

discretionary trust—”.

2 At the end of subsection 152-30(2)

Add:

Note: There are further rules relating to discretionary trusts in

subsections (4) to (6C).

3 Subsection 152-30(3)

After “subsection (2)”, insert “or (5)”.

4 Subsections 152-30(5) and (6)

Repeal the subsections, substitute:

Control of discretionary trust

(5) An entity (the first entity) controls a discretionary trust if, for any

of the 4 income years before the income year for which relief is

sought for a *CGT event under this Division:

(a) the trustee paid to, or applied for the benefit of:

(i) the first entity; or

(ii) one or more of the first entity’s *small business CGT affiliates; or

(iii) the first entity and one or more of the first entity’s small business CGT affiliates;

any of the income or capital of the trust; and

(b) the amount paid or applied is at least 40% (the control


Selling a Small Business – The CGT Strategies percentage) of the total amount of income or capital paid or

applied by the trustee for that income year.

(6) An entity does not control a discretionary trust because of

subsection (5) if the entity is:

(a) an *exempt entity; or

(b) a *deductible gift recipient.

(6A) The trustee of a discretionary trust may, for an income year for

which the trust had a *tax loss and for which the trustee did not pay

or apply any income or capital of the trust, nominate not more than

4 beneficiaries as being controllers of the trust.

Note: The trust might not have had the funds to make a distribution for that

income year, which would prevent it from being controlled in that

year. The trustee may wish to make the nomination to ensure that a

relevant CGT asset is treated as an active asset (see section 152-40).

(6B) This section has effect as if each nominated beneficiary controlled

the trust during the relevant income year in the way described in

this section.

(6C) A nomination must be in writing and signed by the trustee and by

each nominated beneficiary.


Repeal the subsection, substitute:

(8) However, if an entity (the first entity) controls an entity of a kind

referred to in subsection (9) (the public entity), this section does

not, merely because of subsection (7), apply to the first entity as if

it controlled any other entity that is controlled by the public entity.

(9) The kinds of entities are:

a company *shares in which (except shares that carry the right to a fixed rate of *dividend) are listed for quotation in the official list of an *approved stock exchange; or

a *publicly traded unit trust; or a *mutual insurance company; or a *mutual affiliate company; or a company (other than one covered by paragraph (a)) all the shares in

which are beneficially owned by one or more of the following:

(i) a company covered by paragraph (a);

(ii) a publicly traded unit trust;

(iii) a mutual insurance company;

(iv) a mutual affiliate company.



Selling a Small Business – The CGT Strategies Omit “(within the meaning of subsection 152-30(6))”, substitute “of a

kind referred to in subsection 152-30(9)”.

7 Application of amendments

The amendments made by this Schedule apply to CGT events

happening after 11.45 am, by legal time in the Australian Capital

Territory, on 21 September 1999.

8 Transitional: general

(1) In this item and in item 9: assent day means the day on which this Act receives the Royal Assent.

(2) The subsection 152-30(5) of the Income Tax Assessment Act 1997 inserted by this Schedule applies to assessments for the 1999-2000, 2000-01 and 2001-02 income years as if the reference to any of the 4 income years before the income year for which relief is sought for a CGT event under Division 152 of that Act were a reference to the income year for which that relief is sought.

(3) The following subitems apply in relation to:

CGT event that happened before the assent day; and an entity who becomes eligible to make a choice under Division 152 of the

Income Tax Assessment Act 1997 in relation to that event because of this Schedule.

(4) Despite subsection 103-25(1) of the Income Tax Assessment Act 1997, any such choice must be made by the entity by the latest of: the day the entity lodges its income tax return for the income year in which

the relevant CGT event happened; and 12 months after the assent day; and a later day allowed by the Commissioner of Taxation.

(5) The period within which the entity must acquire a replacement asset as mentioned in subsection 152-420(1) or (2) of the Income Tax Assessment Act 1997 ends on the latest of: (a) 2 years after the happening of the last CGT event in the income year for

which the entity obtained the small business roll-over; and (b) 12 months after the assent day; and (c) a later day allowed by the Commissioner of Taxation.

(6) The period within which a replacement asset the entity acquires must be an active asset as mentioned in subsection 152-420(4) of the Income Tax Assessment Act 1997 (if it is not an active asset when acquired) ends on the latest of: (a) 2 years after the happening of the last CGT event in the income year for

which the entity obtained the small business roll-over; and (b) 12 months after the assent day; and (c) a later day allowed by the Commissioner of Taxation.

9 Transitional: choice

(1) This item applies to CGT events that happen no later than the end of the 2003-04 income year.

(2) Subject to subitem (3), an entity can choose that Division 152 of the

Income Tax Assessment Act 1997 apply to such a CGT event as if the

amendments made by this Schedule had not been made.


Selling a Small Business – The CGT Strategies (3) However, subsection 152-30(6) inserted by item 4 of this Schedule applies to

those CGT events. (4) A choice under this item must be made by the latest of:

(a) the day the entity lodges its income tax return for the income year in which the relevant CGT event happened; and

(b) 12 months after the assent day; and (c) a later day allowed by the Commissioner of Taxation.

¶2.028 Commentary on amendments

The main provisions of the amendments are new subsecs (5), (6), (6A), (6B), and (6C). Equally important are the transitional provisions enabling taxpayers to claim the small business concessions in respect of CGT events that took place after 11:45am on 21 September 1999.

New sec 152-30(5) is vastly watered down compared to the existing provision and operates directly to deem control, unlike the previous provision. Basically control of a discretionary trust will only be deemed to arise if during any of the previous four years at least 40% of the distributions (see discussion below) are applied to a beneficiary.

It is noted that a feature of the amendments that is mentioned in the Attachment to the Minister’s Press Release is that there is a discretion in the Commissioner to disregard deemed control where the percentage distribution in a year is between 40% and 50% where the Commissioner is satisfied that control of the entity rests in another entity, appears to have been achieved indirectly, relying on existing sec 152-30(3). It is unlikely that this discretion will be readily applied given the strict interpretation applied by the ATO in ID 2003/846, see discussion below.

The point to note is that control will be deemed to arise directly under new subsec (5) whereas under the previous provision a beneficiary was only taken to beneficially own a potential distribution. Control, therefore, was deemed by the subsequent application of sec 152-30(2). Under the new provision, this step is unnecessary and as a consequence, subsec (3) has been amended to apply it to new subsec (5).

The more important point to note about the prospective application of new sec 152-30(5) is that control will be deemed if a 40% or more distribution has been made in any of the previous four years. This means that from now on, if a small business entity is a beneficiary of a discretionary trust, and wishes to make use of the small business concessions at any time in the future and does not wish the assets of the discretionary trust to be counted in determining its net assets for the purposes of the $5m test, it will be necessary to ensure that the discretionary trust does not make to it or its small business CGT affiliates a distribution of 40% or more during any of the previous four years. This could be difficult to determine or indeed to plan for having regard to the potential wide application of the small business CGT affiliate definition in sec 152-25.

Deemed “control” not same as “controlling individual”

One important point to be aware of here is that the deemed control arising from new sec 152-30(5) is irrelevant in determining whether there will be a “controlling individual” for the purposes of sec 152-55(3) which deals with discretionary trusts. Under that provision there will be a controlling individual of a discretionary trust is there has been a distribution of 50% or more of income or capital to a beneficiary during the income year in which a relevant CGT event takes place. The existence of a controlling individual is necessary for a discretionary trust to take advantage of the retirement exemption and the 15-year exemption

Control percentage

New subsec (5) deems control for the purposes of sec 152-30 where at least 40% of the total amount of income or capital has been paid or applied in a year. It would appear that separate


Selling a Small Business – The CGT Strategies distributions of income and capital distributions are intended to be aggregated to produce a 40% amount having regard to the use of the words “total amount”. So it would be necessary to aggregate, say, distributions of 25% of the income and 15% of the capital and compare the total distributions to determine if the distributions paid in aggregate to a beneficiary total at least 40%. In the example given if the amount of capital is only small the fact that it amounts to 15% of the capital distributions may not be enough for the aggregate distributions to a single beneficiary to amount to 40%. To illustrate, beneficiary A receives 15% of the $100 of capital distributed and 25% of the $100,000 income distributed. However, the total amount of the distribution is $25,100 which is less than 40% of the total distributions of $100,100. There is a potential further complication where some of the total distributions have been paid or applied to an exempt entity or deductible gift recipient. That is, where distributions made to these entities, the entities are not deemed to control the trust (see below) and there is no adjustment of the total amount of distributions in applying the 40% test to other beneficiaries. The effect of this is to lessen the chance that a non-charitable beneficiary will be deemed to control a trust. In some cases distributions made to a charity may be able to be made to ensure that a non-charitable beneficiary does not breach the 40% threshold.

The need for aggregation is clearer in the case where part of the income distributed is “applied” and part of the income is “paid” – it would appear that the total amount of income would be required to be aggregated. This approach accords with the natural meaning of the words used.

The EM to the Taxation Laws Amendment (2004 Measures No.1) Act 2004 does not make clear whether the provision is intended to require aggregation of percentages of income and capital though the commentary appears to assume that aggregation is required, see para 3.18. The language used in the new provision contrasts with existing sec 152-30(2) that refers to “at least 40% … of any distribution of income or capital” which suggests non-aggregation. Whilst the use of the word “total” in new subsec (5) suggests the need for aggregation, it is curious that the new provision is intended to require a different approach from existing sec 152-30(2). There has been no Ruling or ID issued to assist on this point in respect of sec 152-30(2). The position may also be compared with sec 152-55(3) which makes very clear that the 50% required there applies to both income and capital distributions.

Given the room for doubt, care needs to be taken in cases where there have been distributions of both income and capital.

Timing of distributions

The EM at para 3.20 states:

Frequently distributions from trusts for an income year are made after the end of that income year. Consistent with the Commissioner’s long standing administrative practices, for the purpose of applying the new control test, distributions that are paid to or applied for the benefit of the entity within two months following the end of an income year will generally be taken to be paid or applied for that preceding income year.

Acknowledgment of this practice may assist those taxpayers who are planning to dispose of their business during the current income year (2003-04) or a subsequent year if, for example, they had made a substantial distribution from their trust in the current income year prior to the introduction of the amendments.

Distributions to exempt entities and deductible gift recipients

New subsec (6) excludes from any calculation under new subsec (5) distributions made to exempt entities and entities where deductions are allowed where a gift is made to them.



Loss years

The amendments make special provision where a trust makes a loss in a relevant income year allowing a trustee to nominate up to four beneficiaries as being controllers. The idea behind this novelty is to permit the application of the definition of “active asset” in sec 152-40 to apply in cases where the asset is held in a trust but the business is conducted by another entity. For example, under the previous law, a sole trader may have used business premises owned by his/her family trust. Under existing sec 152-40(c)(ii), the asset will be an active asset as it is held in an entity “connected with” the taxpayer when read with existing sec 152-30. This was because previous sec 152-30(5) read with sec 152-30(2)(a) deemed the sole trader as a beneficiary of the family trust to be a controller of the trust. By allowing a trustee to nominate beneficiaries to be controllers of the trust in years where, by virtue of there being no distributions, there can be no deemed controllers, this previous position is preserved.

Form of nomination

A suitable nomination form is set out below:


Section 152-30(6A) Nomination

…(name of trustee)…………………. of ……………being the Trustee of the ………………Family Trust which trust incurred a loss for the income year …., hereby nominate the following beneficiary/beneficiaries whose signature/signatures appear below their names to be controllers of the said Trust for the said income year, for the purposes of section 152-30(6A)

(1)……(add name of beneficiary)…..

-------------------------------------------------

signature of beneficiary


------------------------------------------------



------------------------------------------------



-----------------------------------------------


signature/seal of Trustee

-----------------------------------------------

Trustee

Date:

Note: Each nomination form must be signed by the trustee and by each nominated beneficiary.

Indirect control

Previous sec 152-30(7) applied the control tests in the section through a chain of entities but this provision was limited in its applications in relation to public companies and the like (public entities) where under a discretionary trust deed a public entity could be a potential


Selling a Small Business – The CGT Strategies beneficiary (e.g. under trust deeds it is commonly provided that a public entity will be a beneficiary where another beneficiary has an interest in such a public entity) of the trust and, therefore, by previous subsec (5) be deemed to control the trust. Previous sec 152-30(8) limited the application of the indirect control test in subsec (7) in relation to public entities to cases where, say, a small business entity was deemed to control a public entity and that public entity controls a third entity. In such a case, the small business entity would only be treated as controlling the third entity if it actually controls the third entity, for example if it holds 50% of the shares in the third entity. However, new subsec (5) only operates on actual distributions so that if at least 40% of the total amount of distributions of income or capital is actually paid to a public entity in an income year, the public entity would be treated as controlling the trust and the previous limitation in subsec (8) applying to the indirect control test will continue. This means that in the example above, if the public entity is deemed to control a small business entity, it is nevertheless, still necessary to limit the application of sec 152-30(7) in relation to public entities.

Transitional concession

The important transitional concession contained in the amendments (see item 8) allows the application of the new provision to determine control to apply to the year in which the CGT event took place where the CGT event took place in the income years 1999-2000, 2000-01 or 2001-02. Thus, if the CGT event took place in 2001-02, it is only necessary to look at distributions occurring in that year to determine which entities controlled the trust.

Whilst this concession is particularly generous and will assist taxpayers who either did not claim the small business concessions because of the potential application of existing sec 152-30(5) or who incorrectly claimed the concessions, either because of incorrect advice as to the operation of that provision or because the provision was overlooked, it will not cover all cases.

Example 1

In January 2002 George sold his vitamin manufacturing business, which produced a capital gain of $1m for George. George’s tax adviser was told incorrectly by the ATO that although George was a beneficiary of a family trust set up by his brother Colin, he did not need to take the trust’s assets into account in determining whether he was eligible to apply the small business concessions. In the income year 2001-02 George received no distributions from his brother’s trust. Under the amendments George will be able to make a valid choice to apply the small business concessions.

Example 2

Assume the same facts as above but this time George, who is a trustee of his brother’s family trust, receives a distribution of $1,000 of capital from the trust as a gift in November 2001. As there were no other distributions made that income year because of Colin’s large number of property acquisitions, George will be treated as having control of his brother’s family trust and its significant assets will put George over the $5m maximum net asset value test threshold. Having received the distribution in 2001 there is no way now that George can retrospectively remove himself as a controller of the family trust.

Extension of time to choose concession

Under item 8(4) of Schedule 3, taxpayers who wish to avail themselves of the retrospective application of the amendments have 12 months from the day of the Royal Assent (29 June 2004) to apply the small business concessions, ie until 29 June 2005. Note that this date is not dependent upon the time of lodgment of a return. There is a discretion invested in the Commissioner to allow the application to be made after the 12-month period has elapsed. It


Selling a Small Business – The CGT Strategies would be expected that extensions would be rarely granted, c.f. Re Isaacs and the FCT (27 February 2004, AAT, PJ Lindsay, Senior Member.

Will previous choice of small business concessions where not available be valid under the new provision?

There is potential dilemma for taxpayers and their advisers if a taxpayer had mistakenly chosen the small business provisions on the basis, say, that it had been assumed that previous sec 152-30(5) did not operate to preclude their application at the time he/she sold their business. The question that arises is whether it will now be necessary to make a further choice to apply the concessions once the amendments become law.

It would appear that it would be necessary to make a valid choice now that the amendments have become law. The difficulty that arises is how is such a choice is made now if the relevant return has been lodged some years ago. Under sec 103-25(1) the making of a choice required under the CGT provisions must be made by the day for making the return for the year in which the relevant CGT event happened or within such further time as the Commissioner allows. By sec 103-25(2) the way the return is prepared will be sufficient evidence of the making of the choice, except where the small business retirement exemption is chosen (where the choice is to be in writing) or where the small business roll-over is chosen, where a longer time is allowed. Having regard to the potential difficulties involved, it is expected that the ATO will provide some guidance to taxpayers now that the amendments have passed as to how best to ensure that the concessions can be chosen. Note, for example, the 50% reduction applies automatically, subject to a taxpayer choice to limit its application, see sec 152-220 ITAA 97.

The guidance could take the form of a general dispensation of the need for taxpayers who have erroneously claimed the concessions because of sec 152-30 for whatever reason to notify the ATO. In other words, the ATO may accept that returns previously lodged on the assumption that some or all of the small business concessions were available but for the operation of existing sec 152-30 will not be disturbed in any subsequent audit action. This could probably be achieved by the Commissioner generally extending the time for making relevant choices until such time as the Commissioner required them to be made. This would be a sensible approach given the potentially large numbers of taxpayers involved and would only leave those taxpayers who did not claim the concessions since 1999 but who will be now eligible to make the necessary amended returns.

It would appear that until any such guidance is provided, in a case where the concessions are to be applied where they were previously assumed to apply, the ATO should simply be advised once the amendments have been enacted that the relevant choices have subsequently been made. As noted above, under the proposed amendments, there is a time limit for making the choice. Basically the amendments allow a 12-month window from the date of the Royal Assent (29 June 2004), though there is provision for the Commissioner to allow further time.

In cases where a choice is made after the CGT event, it is noted that the controller nomination facility under new sec 152-30(6A) discussed above is available as this provision operates in relation to CGT events happening after 11:45am on 21 September 1999. It appears that there is no time limit imposed for making nominations under this provision but it should be made at the same time as making the choice.

Choosing not to apply the amendments to CGT events occurring after Royal Assent.

There may be some cases where it is disadvantageous to apply the amendments in relation to a CGT event that happens in the income year (2003-04). Item 9 of Schedule 3 provides a choice for taxpayers not to apply the amendments made by Schedule 3 in such a case, with one exception. That is, new subsec (6) will apply to exclude from the application of previous sec 152-30(5) distributions made to exempt entities and deductible gift recipients – in other words if a taxpayer chooses not to apply the amendments to a CGT event taking place in


Selling a Small Business – The CGT Strategies 2003-04, previous sec 152-30(5) will apply but the taxpayer can ignore the existence of beneficiaries under the trust that are exempt entities and deductible gift recipients.

It would appear that a taxpayer can choose not to apply the amendments, as modified, under item 9 whether the taxpayer is the discretionary trust in question or another entity.

The EM provides no example to illustrate the kind of circumstances that a taxpayer may wish to avail himself/herself of under this provision. Perhaps where a taxpayer has taken steps to amend their trust deed prior to the introduction of the amendments, say to exclude public entities as beneficiaries, there may be no need to rely on the amendments. However, in such a case, there is a potential risk in not applying them if the beneficiary class is still very broad.

Perhaps a more likely scenario would arise where to rely on the amendments would be to preclude an asset held by a discretionary trust being treated as an active trust, if say no further distributions are able to be made from the trust to enable it to be treated as being controlled by a small business operator who is a beneficiary under the trust. In such a case, under the amendments, the beneficiary not having received a 40% or more distribution in the 2003-04 year, would not be treated as controlling the trust so the assets in the trust may not be active assets under sec 152-40(1)(c)(ii) dealing with assets used or held ready for use, in the course of carrying on a business by another entity that is connected with the taxpayer. It is assumed, perhaps too hastily, that in such a case the other entity cannot qualify as the small business CGT affiliate of the taxpayer so as to allow sec 152-40(1)(c)(i) to apply.

Time for making choice

The time for making the choice not to apply the amendments is limited by subitem 9(4), set out below:

(4) A choice under this item must be made by the latest of:

(a) the day the entity lodges its income tax return for the income year in which the relevant CGT event happened; and

(b) 12 months after the assent day; and

a later day allowed by the Commissioner of Taxation.

Although the provision does provide for an extension of time to make the choice, given its potentially concessionary nature, it is expected that extensions will be rare, see comment above on extension of time to choose the concession.

Potential difficulty where “active asset” dependant on deemed control

The above scenario illustrates a potential weakness with the amendment’s ongoing application, i.e. to CGT events happening in income years after 2003-04 where reliance is necessary on deemed control of a discretionary trust where the trust holds assets that may be treated as active assets only if by virtue of the deemed control they are “connected with” a business carried on by another entity. The ATO has issued an ID dealing with an example where this limitation is illustrated. ID 2004/665 provides as follows:

Issue

Is a building owned by a discretionary trust that is used in the business of a beneficiary of the trust, an active asset of the discretionary trust, under paragraph 152-40(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No. In this instance as the beneficiary is not able to satisfy the control test for the discretionary trust under subsection 152-30(5) of the ITAA 1997, they will not be a connected entity of the discretionary trust. Since the building is not used by an entity


Selling a Small Business – The CGT Strategies connected with the discretionary trust or a small business CGT affiliate, the building is not an active asset under paragraph 152-40(1)(c) of the ITAA 1997.

Facts

A discretionary trust owned a building which it leased to a person who is a member of one of the classes of potential beneficiaries of the trust. The potential beneficiary operated their business from the building. The trust sold the building during the year ending 30 June 2005 and made a capital gain. During the last four income years before the 2004-05 income year, that beneficiary did not receive any distributions from the trust. However, the trust had made distributions to other beneficiaries for each of those income years. The potential beneficiary does not have any small business CGT affiliates and is not itself a small business CGT affiliate of the trust. That beneficiary is not in a position to influence the trustee's power to make distributions.


For the small business CGT concessions in Division 152 of the ITAA 1997 to apply to the capital gain, the building must satisfy the active asset test. The active asset test requires generally, that an asset must be an active asset for half the period of ownership and just before the CGT event, such as the disposal of the asset. (There are modified rules if the business ceases or the asset has been owned for more than 15 years). Under paragraph 152-40(1)(c) of the ITAA 1997, a CGT asset is an active asset if a taxpayer owns it and it is used, or held ready for use, in the course of carrying on a business by either:

• a small business CGT affiliate of the taxpayer; or

• an entity connected with the taxpayer.

Paragraph 152-30(1)(a) of the ITAA 1997 states an entity is connected with another entity if either entity controls the other entity in the way described in section 152-30 of the ITAA 1997. Subsections 152-30(5) and 152-30(6) of the ITAA 1997 contain conditions which determine the control of a discretionary trust.

Subsection 152-30(5) in Division 152 of the ITAA 1997 states that:

An entity (the first entity) controls a discretionary trust if, for any of the 4 income years before the income year for which relief is sought for a *CGT event under this Division:

(a) the trustee paid to, or applied for the benefit of: (i) the first entity; or (ii) one or more of the first entity's *small business CGT affiliates; or (iii) the first entity and one or more of the first entity's small business CGT

affiliates; any of the income or capital of the trust; and (b) the amount paid or applied is at least 40% (the control percentage) of the total

amount of income or capital paid or applied by the trustee for that income year. ( * denotes a term defined in subsection 995-1(1) of the ITAA 1997. ) In this case, the potential beneficiary did not receive any distributions from the discretionary trust in the last four income years. That beneficiary does not have any small business CGT affiliates. Therefore that beneficiary will not satisfy the test for control of the discretionary trust in subsection 152-30(5) of the ITAA 1997.


Selling a Small Business – The CGT Strategies The potential beneficiary will also not control the discretionary trust under paragraph 152-30(2)(c) of the ITAA 1997. Accordingly, that beneficiary is not connected with the trust. As the building is not used by an entity connected with the discretionary trust or a small business CGT affiliate, the building is not an active asset under paragraph 152-40(1)(c) of the ITAA 1997. Date of decision: 20 July 2004

Other IDs illustration the application of the amendments

ID 2004/664 provides a handy example on how to apply the new provisions in a typical situation. The ID provides as follows:

Issue

Are the beneficiaries 'connected entities' of the discretionary trust in terms of section 152-30 of the Income Tax Assessment Act 1997 (ITAA 1997) for the purpose of the maximum net asset value test under subparagraph 152-15(a)(ii) of the ITAA 1997?

Decision

Yes. In this instance, some of the beneficiaries are connected entities of the discretionary trust for the purpose of the maximum net asset value test under subparagraph 152-15(a)(ii) of the ITAA 1997.

Facts

In July 2004, a family discretionary trust sold the business it had conducted for a number of years and realised a capital gain on the sale of the business premises. The deed constituting the trust specifies a number of beneficiaries who are eligible to receive the income or capital of the trust. The discretionary trust made the following net income from its business operations in each of the years ended:

30 June 2004 $20,000

30 June 2003 $15,000

30 June 2002 $10,000

30 June 2001 $5,000

The trust made distributions of its net income to the beneficiaries as follows:

Beneficiary Year of income ended 30 June

2004 2003 2002 2001

B1 $6,000 $2,000 $2,000 $1,000

B2 $3,000 $2,000 $1,000 $1,000

B3 $1,500 $0 $4,000 $1,000

B4 $1,500 $1,000 $1,000 $1,000



B5 $3,000 $5,000 $0 $1,000

Total $15,000 $10,000 $8,000 $5,000

The trust made no distributions of capital to the beneficiaries in each of these years. B2 is the spouse of B1. B3 is the 20 year old child of B1 and B2. B4 is an elderly relative of B2. B5 is a 'deductible gift recipient' in terms of section 30-227 of the ITAA 1997.


One of the basic eligibility conditions for the small business CGT concessions is the maximum net asset value test in section152-15 of the ITAA 1997. This test provides that the maximum net value of the assets of an entity and entities connected with it and the entity's small business CGT affiliates, must not exceed $5 million. Subsection 152-30(1) of the ITAA 1997 states: An entity is connected with another entity if: (a) either entity controls the other entity in the way described in this section; or (b) both entities are controlled in that way by the same third entity. Subsection 152-30(5) in Division 152 of the ITAA 1997 states that: An entity (the first entity) controls a discretionary trust if, for any of the 4 income years before the income year for which relief is sought for a *CGT event under this Division: (a) the trustee paid to, or applied for the benefit of:

(i) the first entity; or (ii) one or more of the first entity's *small business CGT affiliates; or (iii) the first entity and one or more of the first entity's small business CGT

affiliates; any of the income or capital of the trust; and

(b) the amount paid or applied is at least 40% (the control percentage) of the total amount of income or capital paid or applied by the trustee for that income year.

( * denotes a term defined in subsection 995-1(1) of the ITAA 1997. ) The following are the percentage of distributions made by the trust to the beneficiaries in the respective income years:

Beneficiary Year of income ended 30 June

2004 2003 2002 2001

B1 40.0% 20.0% 25.0% 20.0%

B2 20.0% 20.0% 12.5% 20.0%

B3 10.0% 0.0% 50.0% 20.0%

B4 10.0% 10.0% 12.5% 20.0%

B5 20.0% 50.0% 0.0% 20.0%

Total 100.0% 100.0% 100.0% 100.0%


Selling a Small Business – The CGT Strategies B1 and B3 control the trust as they received at least 40% of the distribution in one of the four income years before the year in which the CGT event happened. B2 also controls the trust, although they do not receive more than 40% of the trust distributions, because they, with their small business CGT affiliate, B1, received at least 40% of the distribution in three of the four income years before the year in which the CGT event happened. B4 does not control the trust as they did not receive a distribution in excess of 40% in any one of the four income years before the year in which the CGT event happened. Although B5 did receive a distribution in excess of 40% in one of the four income years preceding the year in which the CGT event happened, it cannot control the trust in accordance with subsection 152-30(6) of the ITAA 1997, which states: An entity does not control a discretionary trust because of subsection (5) if the entity is: (a) an *exempt entity; or (b) a *deductible gift recipient. As B1, B2 and B3 control the trust they will be connected entities of the trust in accordance with paragraph 152-30(1)(a) of the ITAA 1997. Note 1: The above control test applies to CGT events happening after 11.45am, by legal time in the Australian Capital Territory, on 21 September 1999. However transitional rules apply for CGT events that happened before the end of the 2003-04 income year where a taxpayer can choose to apply the previous control test for discretionary trust (with the modification that assets of the potential beneficiaries that are exempt entities or deductible gift recipients do not need to be taken into account). Note 2: The control test is further modified for the 2000, 2001 and 2002 income years so that the test is based on actual distributions made in the income year for which access to the small business CGT concession is sought and not the actual distributions made in any of the four income years before the income year for which access to small business CGT concession is sought. Date of decision: 20 July 2004

ID 2004/663, set out below illustrates the simple point that deductible gift recipients cannot be taken to control a discretionary trust even where the distributions to a particular deductible gift recipient is more than 40% of the distributions from the trust for a particular income year. The ID provides as follows:

Issue

Can a 'deductible gift recipient' control a discretionary trust under subsection 152-30(5) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No. Even if the 'deductible gift recipient' did receive a distribution of income or capital in excess of 40% in one of the four income years preceding the year in which the CGT event happened, it cannot control the trust due to the operation of subsection 152-30(6) of the ITAA 1997.

Facts

In July 2004, a family discretionary trust sold the business it had conducted for a number of years and realised a capital gain on the sale of the business premises. The deed of the trust specifies a number of beneficiaries, all of which are eligible to receive the income or capital of the trust.


Selling a Small Business – The CGT Strategies The discretionary trust made the following net income from its business operations in each of the years ended:

30 June 2004 $20,000

30 June 2003 $15,000

30 June 2002 $10,000

30 June 2001 $5,000

The trust made distributions of its net income to a 'deductible gift recipient' in terms of section 30-227 of the ITAA 1997, as follows:

30 June 2004 $3,000

30 June 2003 $7,500

30 June 2002 $0

30 June 2001 $1,000

The trust made no distributions of capital to the beneficiaries in each of these years.


Subsection 152-30(5) in Division 152 of the ITAA 1997 states that: An entity (the first entity) controls a discretionary trust if, for any of the 4 income years before the income year for which relief is sought for a *CGT event under this Division: (a) the trustee paid to, or applied for the benefit of:

(i) the first entity; or (ii) one or more of the first entity's *small business CGT affiliates; or (iii) the first entity and one or more of the first entity's small business CGT

affiliates; any of the income or capital of the trust; and

(b) the amount paid or applied is at least 40% (the control percentage) of the total amount of income or capital paid or applied by the trustee for that income year.

(* denotes a term defined in subsection 995-1(1) of the ITAA 1997.) The 'deductible gift recipient' received at least 40% of the distributions made by the trust, in one of the four income years before the year in which the CGT event happened, that is, in the 2003 year. However subsection 152-30(6) of the ITAA 1997 states: An entity does not control a discretionary trust because of subsection (5) if the entity is:


Selling a Small Business – The CGT Strategies (a) an *exempt entity; or (b) a *deductible gift recipient.

Although the deductible gift recipient did receive a distribution in excess of 40% in one of the four income years preceding the year in which the CGT event happened, it cannot control the trust in accordance with subsection 152-30(6) of the ITAA 1997. Note 1: The above control test applies to CGT events happening after 11.45am, by legal time in the Australian Capital Territory, on 21 September 1999. However, transitional rules apply for CGT events that happened before the end of the 2004 income year, where a taxpayer can choose to apply the previous control test for discretionary trusts (with the modification that assets of the potential beneficiaries that are exempt entities or deductible gift recipients do not need to be taken into account). Note 2: The control test is further modified for the 2000, 2001 and 2002 income years so that the test is based on actual distributions made in the income year for which access to the small business CGT concession is sought and not the actual distributions made in any of the four income years before the income year for which access to small business CGT concession is sought. Date of decision: 20 July 2004

¶2.029 Commentary on previous provisions

Where listed company a beneficiary

Section 152-30(5) ITAA 97 is limited in its application by sec 152-30(6) which seeks to prevent it applying to various public entities where another beneficiary of the trust, for example an individual, has an interest in the entity. The provision was added to the original provision (sec 160ZZPN(5) ITAA 36) to prevent it applying in cases where the discretionary trust was the operating entity of the business.

The effect of sec 152-30(5) in such cases is to require the aggregation of all of the CGT assets of all potential beneficiaries under the discretionary trust. Section 152-30(6) applies where, as under many discretionary trust deeds, a trustee is empowered to make a distribution to an entity where an individual beneficiary has an interest in the entity. For example, it may be a shareholding in a listed company (BHP is the example that triggered the original amendment). The provision ensures that the CGT assets of the listed company aren’t required to be aggregated with those of the discretionary trust operating entity.

Despite the limiting effect, sec 152-30(5), like its predecessors, will continue to be a stumbling block for small business seeking to avail themselves of the small business CGT concessions.

The last example illustrates how a small business taxpayer may be precluded from satisfying the maximum net asset value test where the taxpayer happens to be a potential beneficiary under a discretionary trust. This will happen even if there is absolutely no prospect of the small business taxpayer benefiting under the discretionary trust.

In the last example it is postulated that Helen is a potential beneficiary under the discretionary trust that is controlled by her mother. Even in such a case there can be no certainty that Helen would benefit under the trust in the future even if she had received distributions from it in the past.

Where the relationship between the controller of the trust and the small business beneficiary is more distant, the likelihood of the small business beneficiary receiving distributions of income, let alone capital, becomes even more remote. Yet so long as the small business taxpayer is within the class of beneficiaries that can receive distributions at the discretion of


Selling a Small Business – The CGT Strategies the trustee, sec 152-30(5) read with sec 152-30(1) and (2) and sec 152-15 will apply to treat the net value of the assets of the trust as part of the small business taxpayer’s net CGT assets.

Where operating entity is a discretionary trust

Where the operating entity is a discretionary trust it will be even more difficult to qualify under the maximum net assets value test because of the usually broad class of persons and entities that can benefit under the trust. Therefore, assets of such beneficiaries will be required to be aggregated with the assets of the operating entity.

Example

Let’s return again to the previous example. Helen is a sole trader who owns a milk bar which she runs with her husband, Rodney. The net CGT assets of the milk bar, including goodwill and real property, have a market value of $250,000. But this time the milk bar is operated through a discretionary trust, with a corporate trustee. Helen, her husband and children are the primary beneficiaries. Other than their home, they have no other CGT assets and Helen’s mother is destitute. Under the trust deed the trustee has the usual broad discretionary powers to make distributions to Helen’s family, her husband’s family and to charitable bodies. Because each member of the beneficiary class is entitled under the trust to receive all of the income or capital of the trust, each is by virtue of sec 152-30(5) read with sec 152-30(1) and (2) connected with the small business operating entity (i.e. the trustee) and so, for the purposes of sec 152-15, the CGT assets of each beneficiary, including the assets of charities who are beneficiaries, are required to be aggregated. Clearly, given the potential breadth of such a class of beneficiaries, it is unlikely that the net value of the aggregated assets of the class of beneficiaries would satisfy the maximum net asset value test.

In the above example, it is assumed that Helen would be able to obtain relevant financial information about each of the members of the class of beneficiaries. She may be able to satisfy herself in relation to the family members but it would be impossible to ascertain the value of the CGT assets of all charities within the class of charitable beneficiaries under the trust.

Note that a public charity may not fall within any of the classes of public entities, for example listed companies, referred to in sec 152-30(6) ITAA 97 which is designed to alleviate, to some extent, the difficulties associated with sec 152-30.

Practice point

Should discretionary trusts be converted to fixed or unit trusts or should a family trust election be made to overcome the difficulty?

The first point to note is that merely making a family trust election will not overcome the effects of sec 152-30(5) because the provision operates on the theoretical powers of the trustee under the trust.

Amending the trust deed by limiting the class or classes of beneficiary that may benefit under the trust may be possible without triggering a resettlement. In this regard, reference should be made to the ATO’s Creation of a new trust – Statement of Principles, August 2001. Note that the decision upon which the ATO based its views took into account the decision of the High Court in FCT v Commercial Nominees of Australia Ltd [2001] HCA 33.

Any attempt to convert the trust into a fixed or unit trust would also expose the beneficiaries to claw back under CGT event E4, see discussion at ¶1.050.



At the 11 June 2003 National Tax Liaison Group Subcommittee meeting the NTAA asked whether a resettlement would result from such a change. The ATO took the view that in general there would be no resettlement but each case would need to be looked at on its merits. The ATO noted that examples 5.5.3 and 5.5.5 in the Statement of Principles were analogous. Note, since that meeting the Assistant Treasurer issued her Press Release of 16 October 2003 indicating that legislation will be introduced modifying the operation of sec 152-30(5). See above.

Unrelated discretionary trust

Section 152-30(5) becomes an even greater headache if one considers whether Helen is a beneficiary under an unrelated discretionary trust.

Example

Continuing the earlier example, Helen is a sole trader but is within a beneficiary class of a private charitable discretionary trust established to promote the interests of business women. The trust has substantial CGT assets − well in excess of $5m. The trust makes annual awards, that are little publicised, to worthy business women who are usually known to the trustees of the trust. As Helen is a potential, though unlikely, beneficiary of the trust, she is deemed to be connected with it, and as she controls her operating entity trust, both trusts are deemed to be connected with each other (see sec 152-30(1)(b)) and so its net CGT assets are required to be aggregated with hers in applying the maximum net asset value test to the discretionary trust operating Helen’s business. The difficulty is that Helen is unaware of the existence of the trust (though the trust is well known to the ATO) and she assumes that she has satisfied the test and may choose to apply the range of the small business concessions in respect of her capital gain.

The ATO’s secrecy requirements prevent it from disclosing the existence of trusts to potential beneficiaries, but on audit four years later the ATO disallow the concessions as Helen, unaware of the other trust, failed the maximum net asset value test. At the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000 the ATO indicated that it would not seek to impose the usual level of penalty tax in such a situation. Cold comfort indeed! At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 this issue was again raised. The Minutes record the following:

The NTAA said that from a practical perspective most discretionary trusts cannot satisfy the maximum net asset value test as a result of subsection 152-30(5). Example: If the trustee of a discretionary trust has a complete and unfettered discretion to distribute as much income as it likes to one or more of the objects of the trust, each one of those objects will have a control percentage of 100% as a result of subsection 152-30(5). This means every object of the discretionary trust will be connected with the discretionary trust and therefore the net value of each object’s CGT assets must be taken into account in determining whether the discretionary trust satisfies the maximum net asset value test. In a typical discretionary trust deed the objects include a wide range of relatives of the principals behind the trust as well as many other entities, including charities. The practical effect of the sub-section is that the $5 million threshold will often be exceeded. If the ATO agrees that in these circumstances a discretionary trust will not satisfy the maximum net asset value test, does the ATO agree that if the discretionary trust deed is amended to limit each object’s entitlement to income and capital to less than 40% this problem will be overcome? Would such an amendment give rise to any CGT implications (refer to the Commissioner’s August 2001 Statement of Principles on the


Selling a Small Business – The CGT Strategies creation of a new trust)? Would the Commissioner apply Part IVA if such an amendment was made? The ATO agreed that there may be difficulties satisfying the provisions. Any amendment to a trust deed may raise trust resettlement issues and the ATO noted that this type of restructuring may attract the general anti-avoidance provisions of Part IVA of the ITAA 1936.

The professional associations asked whether this issue was encompassed in the Board of Taxation’s review of entity taxation. The ATO members of the subcommittee were not aware of this issue being considered in that context.

The professional bodies asked if it was possible to apply a pattern of distribution test. The ATO stated that there was no statutory authority to do that and that any administrative solution would need to be reconcilable with what Parliament had enacted.

The ATO also stated that it expected auditors would take a practical approach within the law."

The views expressed in ID 2002/921 suggest that the approach of the ATO’s auditors is unlikely to be “practical”.

Practice point

When advising clients on the small business concessions it may be appropriate to include in any letter of advice a disclaimer to the following effect:

Disclaimer re entitlement to CGT Small Business Concessions

We understand that the total net value of your assets and of those entities connected with you for the purposes of qualifying under the CGT small business concessions are $5m or less. As we have explained to you, under the CGT small business provisions the $5m limit seeks to include the net assets of discretionary trusts under which you may be a beneficiary without your knowledge and under which it is extremely unlikely that you would ever benefit. We understand that you have made such enquiries as are appropriate to ascertain the existence of such trusts and are unaware of the existence of any relevant trusts. Accordingly, our advice to you is made on the basis that, on the information provided by you to us, you are not a beneficiary or in a class of beneficiaries of a discretionary trust that may affect your entitlement to the CGT small concessions.

¶2.0291 Meaning of “connected with” and “control”

Section 152-30 ITAA 97 follows the previous provision, sec 123-60 of Division 123 of Part 3-3 ITAA 97, in providing the basic definitions of “connected with” in subsec (1) which depend on the definitions of “control” of an entity in subsec (2), (3), and (4).

Section 152-30 provides as follows:

152-30 Meaning of connected with the entity

(1) An entity is connected with another entity if: (a) either entity controls the other entity in the way described in this section; or (b) both entities are controlled in that way by the same third entity. Control of entity: 40% or more of rights

(2) An entity (the first entity) controls another entity if the first entity, its *small business CGT affiliates or the first entity together with its small business CGT affiliates: (a) beneficially own, or have the right to acquire the beneficial ownership of,

interests in the other entity that carry between them the right to receive at


Selling a Small Business – The CGT Strategies least 40% (the control percentage) of any distribution of income or capital by the other entity; or

(b) if the other entity is a company—beneficially own, or have the right to acquire beneficial ownership of, shares in the company that carry between them the right to exercise, or control the exercise of, at least 40% (the control percentage) of the voting power in the company; or

(c) if the other entity is a discretionary trust:

(i) are the trustee or trustees of the trust (other than the Public Trustee of a State or Territory); or

(ii) have the power to determine the manner in which the trustee or trustees of the trust exercise the power to make any payment of income or capital to or for the benefit of beneficiaries of the trust.

(3) If the control percentage in subsection (2) is at least 40%, but less than 50%, then the Commissioner may determine that the first entity does not control the other entity if the Commissioner is satisfied, or thinks it reasonable to assume, that the other entity is controlled by an entity other than, or by entities that do not include, the first entity or any of its *small business CGT affiliates.

Exception for trusts

(4) Paragraph (2)(c) does not apply if: (a) a beneficiary of the trust mentioned in that paragraph controls the trust in

the way described in this section; and

(b) that beneficiary is not a *small business CGT affiliate of any of the trustees of that trust or of a person who has the power of determination mentioned in subparagraph (2)(c)(ii).

Control of discretionary trust

(5) If the trustee or trustees of a discretionary trust have the power to pay to, or apply for the benefit of, an entity any income or capital of the trust, this section applies to the entity as if the entity beneficially owned interests in any distribution of income or capital of the trust equal to the maximum percentage of the income or capital that the trustee is empowered to pay to, or apply for the benefit of, the entity.

(6) Subsection (5) does not apply to the entity if the entity is one of these (a public entity):

(a) a company *shares in which (except shares that carry the right to a fixed rate of *dividend) are listed for quotation in the official list of an *approved stock exchange;

(b) a *publicly traded unit trust;

(c) a *mutual insurance company;

(d) a *mutual affiliate company; (e) a company (other than one covered by paragraph (a)) all the shares in

which are beneficially owned by one or more of the following:

(i) a company covered by paragraph (a);

(ii) a publicly traded unit trust;

(iii) a mutual insurance company;

(iv) a mutual affiliate company;


Selling a Small Business – The CGT Strategies and the trustee or trustees have the power mentioned in that subsection only because another beneficiary of the trust has an interest in the entity.

Indirect control of entity

(7) This section applies to an entity that directly controls a second entity as if it also controlled any other entity that is directly, or indirectly by any other application or applications of this section, controlled by the second entity.

(8) However, if an entity (the first entity) controls a public entity, this section does not, merely because of subsection (7), apply to the first entity as if it controlled any other entity that is controlled by the public entity.

One change of significance made in 1999 is that the current provisions do not provide for a conclusive 50% or more test as previously provided in Division 123, but rely instead on a general 40% or more test (in subsec (2)). As provided previously, this test can be displaced where the interest is at least 40% but less than 50%, if the Commissioner is satisfied in effect that another party controls the entity. The change to the “control” test arguably represents an unfortunate broadening of the test. The effect is subtle in that where previously interests between 40% and 50% were only treated as giving control under a secondary test with a let out where the Commissioner exercised his discretion, now, under the primary test, these interests will be caught. The Commissioner may still exercise his discretion but, from a practical point of view, it would appear that the intention is to discourage the exercise of the discretion.

It would be open to a taxpayer to seek a private ruling on the exercise of the discretion, under the self-assessment regime, in an appropriate case. Where, however, no ruling is sought, a taxpayer will generally be required to place himself or herself in the shoes of the Commissioner in the exercise of the discretion by adopting a reasonably arguable position.

The subsection provides only a minimal indication of the matters that would need to be taken into account in exercising the discretion. What would generally need to be established is that the other entity is actually controlled by someone other than the taxpayer or a small business CGT affiliate of the taxpayer.

So, for example, if it would be difficult for the taxpayer to actually exercise control because the other shareholders in a company were associated with each other, and controlled more than 50% of the shares, then it could be assumed that the taxpayer, for the purposes of sec 152-30(3), would satisfy the Commissioner. It is doubtful that a taxpayer could claim the benefit of the discretion simply because he or she did not, as a matter of fact, actually exercise control. ID 2003/846 would support this view. In this ID the ATO expressed the view that the Commissioner has no discretion under sec 152-30(3) to exercise the benefit of the doubt in respect of a shareholder with more than 40% but less than 50% of the shares in a company where the only other shareholders all hold minor holdings, that is there is no other shareholder with at least 40% of the shares. In its Reasons for Decision, the ATO states:

For the company to be controlled by a third entity the third entity must have a control percentage of at least 40% in the company. That is, it must control the company in the way described in subsection 152-30(2) of the ITAA 1997. The interests of several entities are not added together to determine this control percentage (apart from the interests of any small business CGT affiliates of the third entity). In other words, for the Commissioner to be able to consider the exercise of the discretion in subsection 152-30(3) of the ITAA 1997 there must be a single, identifiable third entity that has a control percentage (including the interests of any small business CGT affiliates) of at least 40% in the company. If this is not the case the Commissioner cannot determine that the first entity does not control the company.

It is not clear what the basis for this view is, but as a rule of thumb, it at least provides a clear indication of the kind of cases where a favourable exercise of discretion will be forthcoming.


Selling a Small Business – The CGT Strategies In terms of self assessment, it would clearly be dangerous to seek to apply the discretion where there was no other single shareholder with 40% or more of the shares.

ID 2002/271 provides a useful example of the application of sec 152-30. It provides as follows:

Capital Gains Tax – Small Business Concessions – Connected Entities

Issue

Are a discretionary trust and a company, whose shareholders are beneficiaries of the trust, connected with each other for the purposes of the maximum net asset value test under sub-paragraph 152-15(a)(ii) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. As the company controls the discretionary trust, the trust and the company are entities that are connected with each other for the purposes of the maximum net value asset test.

Facts

The discretionary trust carried on a primary production business on land which was the property of the trust. The trust disposed of the land and a capital gain was realised on disposal of that land. The trust seeks to apply the provisions allowing small business relief in respect of that capital gain. The trust acknowledges that the sum of the net value of its CGT assets and the net assets of a company, if connected, may be assumed to exceed $5,000,000. On that basis, the trust would not satisfy the maximum net asset value test for the purposes of section 152-15 of the ITAA 1997 if the trust were required to include the net value of CGT assets of the company for the purposes of paragraph 152-15(a) of the ITAA 1997. According to the Deed of Settlement of the discretionary trust, there are five individual ‘primary beneficiaries’. Each of these five individuals can be said to control the trust by the operation of subsection 152-30(5) of the ITAA 1997 as each is entitled to receive 100% of the distributions from the trust. The Deed of Settlement also nominates other ‘discretionary beneficiaries’, including any company or trust in which the ‘primary beneficiaries’ are shareholders or beneficiaries. The company has as its beneficial shareholders three of the individual ‘primary beneficiaries’.


To determine if an entity is eligible for the capital gains tax concessions for small business, the maximum net value of assets of the entity, entities connected with it and the entity’s CGT affiliates must not exceed $5 million under section 152-15 of the ITAA 1997. Subsection 152-30(1) of the ITAA 1997 describes how entities are connected with each other. It says that an entity will be connected to another entity if:

• either entity controls the other entity; or

• both entities are controlled by the same third entity.

In relation to discretionary trusts, subsection 152-30(5) of the ITAA 1997 describes how a trust can be controlled by a beneficiary.


Selling a Small Business – The CGT Strategies To determine if a beneficiary controls a discretionary trust that beneficiary is taken to have an interest in any distribution of income or capital of the trust equal to the maximum percentage of the income or capital that the trustee could distribute to that beneficiary under the trust deed, regardless of the actual distribution. If that interest is at least 40% the beneficiary is taken to control the family trust. This may, depending on the terms of the trust deed, result in several or all of the beneficiaries of a discretionary trust being taken to control the trust. As the shares in the company are either legally or beneficially owned by the ‘primary beneficiaries’ of the trust, the company is a discretionary beneficiary. This is because the Deed of Settlement states that the trustee can in its discretion pay or apply the income of the trust to any one of the beneficiaries named in the clause including a company in which the ‘primary beneficiaries’ are shareholders. The company is a beneficiary of the trust and according to the trust deed is capable of receiving all the income of the trust to the exclusion of all other beneficiaries, thus making the company connected with the trust in terms of subsection 152-30(5) of the ITAA 1997. The company therefore controls the trust in the way described in subsection 152-30(5) of the ITAA 1997. As the company controls the trust they are connected to each other. The net value of the CGT assets of the company must be taken into account when applying the maximum net asset value test to the trust.

Date of decision: 15 November 2001

Note, this ID was withdrawn as a consequence of the amendments contained in the Tax Laws Amendment (2004 Measures No.1) Act 2004.

See also ID 2002/620 dealing with the case where a company and a discretionary trust are both controlled by a third entity. In such a case the company and discretionary trust are connected with each other. Note that ID 2002/620 has been withdrawn because the ATO is reconsidering the position stated in light of the views expressed in ID 2002/921 reproduced at ¶2.020 above.

ID 2003/1110 confirms that sec 152-30(7) does not operate to make beneficiaries under a discretionary trust connected with each other. It confirms that the subsection only applies where in a case where a second entity controls a third entity, will the first entity be treated as controlling the third entity, see further discussion in the EM to NBTS(CGT) Act 1999.

Active assets and superannuation funds

At the 11 June 2003 meeting of the National Tax Liaison Group CGT Subcommittee the NIA raised the issue whether a super fund could be an connected entity for the purposes of applying the extended definition of active asset in sec 152-40(1)(c)(ii). The relevant extract from the Minutes is as follows:

The ATO’s response in item 2.9 of the 7 August 2002 minutes indicates that a superannuation fund is unlikely to be a connected entity with a taxpayer for the purposes of section 152-30. Does this mean a superannuation fund is unable to obtain small business relief in the following example?

Example

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


Selling a Small Business – The CGT Strategies 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). In commenting on the above could the ATO please provide a more detailed analysis than its response to item 2.9 as to why, or why not, it considers the two entities not to be connected with each other?

ATO comments & Action item

The ATO is to consider this issue further and to provide an update at the next meeting.

The minutes from the November 2003 meeting contain the following response:

Tax Office comments

The Tax Office confirmed its view that the (complying) superannuation fund and the company are not connected in this situation for the purposes of section 152-30. There are a number of possible ways two entities may be connected with each other under section 152-30. Two entities are connected with each other if either entity controls the other or they are both controlled by the same third entity (subsection 152-30(1)). An entity will control another entity if the aggregation of its interests and its affiliates’ interests in the other entity meet the specified control percentage (generally 40% – subsection 152-30(2)). In this particular case, there is no direct connection between the entities (that is, the superannuation fund does not hold any shares in the company) so for the entities to be connected it would need to be via the aggregation of any affiliate interests or they would need to be controlled by the same third entity. Dave and Edna, as 50% each shareholders in the company, both control the company and are therefore both connected with the company. However, it is considered that Dave and Edna, in either their member capacity or their trustee capacity, do not control, and are therefore not connected with, the superannuation fund under subsection 152-30(2). Members of a superannuation fund do not have beneficial ownership, or the right to acquire beneficial ownership, of interests carrying the right to distributions of income or capital. Moreover, a superannuation fund does not make distributions of income or capital but rather makes payments of benefits. Similarly, trustees of a superannuation fund also do not beneficially own (or have the right to acquire) interests in the fund carrying the right to receive distributions of income or capital. Accordingly, the superannuation fund and the company are not controlled by the same third entity (the control of a superannuation fund is effectively sourced in the regulatory regime relating to superannuation funds). In essence, the control of a superannuation fund is effectively sourced in the regulatory regime relating to superannuation funds (that is, the various prudential requirements and regulations that prescribe the operations of superannuation funds). The Tax Office also considers that neither the members nor the trustees of a superannuation fund would be small business CGT affiliates of the superannuation fund. The members would not act or be expected to act in accordance with the superannuation fund’s directions or wishes or in concert with the fund. They are in essence independent of, or at arm’s length to, the fund. The member/superannuation fund relationship is not the type of relationship that accords with the affiliate definition.


Selling a Small Business – The CGT Strategies Similarly, the trustees of a superannuation fund would also not be expected to act in accordance with the superannuation fund’s directions and wishes or in concert with the fund. Again, the broad regulatory regime relating to superannuation funds strictly controls the operation of superannuation funds, the role of trustees and the relationship between a trustee and the fund. Accordingly, as Dave and Edna, in either their member or trustee capacity of the superannuation fund are not affiliates of the superannuation fund, the superannuation fund does not control the company via the aggregation of any affiliate interests under subsection 152-30(2). The company is therefore not connected with the superannuation fund under subsection 152-30(1). The Tax Office also takes the view that the company is not an affiliate of the superannuation fund in this situation. It is considered that the simple fact that the company uses the fund’s land in its business does not give rise to an affiliate relationship under paragraph 152-25(1)(b). As referred to above, it is the regulatory regime that dictates the operation of superannuation funds. It is not considered that a complying superannuation fund would be involved in directing the actions of other parties or would act in concert with other parties in the manner contemplated by paragraph 152-25(1)(b). As the company is not connected with the superannuation fund and is also not an affiliate of the superannuation fund, the superannuation fund’s land is not an active asset and small business relief is not available. However, it should be noted of course that the superannuation fund would not in any case have been entitled to the 15 year exemption or the retirement exemption because it would not have a controlling individual.

Further, ID 2004/147 issued on 16 February 2004 confirms that neither the trustee nor the beneficiaries will be treated as controlling a super fund, see text of the ID at ¶2.0394 below. The ID deals with a typical two person corporate entity carrying on a business with a two person super fund and the fund owns all the units in a unit trust which owns assets some of which are used in the business. According to the ID sec 152-30(5) would not apply to treat either beneficiary as being in control of the fund.

¶2.030 ACTIVE ASSET TEST

The “active asset” test is relatively straightforward and is contained in sec 152-35 ITAA 97 which provides as follows:

152-35 Active asset test

A *CGT asset satisfies the active asset test if the asset was an *active asset of yours: (a) just before the earlier of:

(i) the *CGT event; and (ii) if the relevant business ceased to be carried on in the last 12 months or any

longer period that the Commissioner allows—the cessation of the business; and

(b) during at least half of the period beginning at the later of: (i) when you acquired the asset; and (ii) if you have owned the asset for more than 15 years—15 years before the

time that applies under paragraph (a);

and ending at the time that applies under paragraph (a).


Selling a Small Business – The CGT Strategies The points to note about this test are that it introduces a maximum period during which to satisfy the requirement for an asset to be an active asset. This requirement appears to reflect the qualifying period for the 15-year retirement exemption. Also, there is a new discretion to permit the Commissioner to extend the 12-month period within which a CGT asset is disposed of where the taxpayer’s business has ceased to be carried on.

In ID 2002/862, the ATO takes the view that where interests in property have been acquired at different times, each interest must separately satisfy the active asset test.

The circumstances in which the Commissioner may allow further time would normally arise where, for example, difficulties have arisen with the sale of the CGT asset after the cessation of the business, c.f. TD 2000/40 (previously TD 1999/D57) which deals with the question what are “special circumstances” for the purposes of sec 124-75(3) ITAA 97, see also ID 2002/1000. In ID 2003/713, in allowing an additional 22 months from the date of the sale of the business of a company where the balance of the capital proceeds were to be paid 15 months after the sale and the company was then wound up six months later, the ATO noted the matters taken into account, as follows:

• evidence of an acceptable explanation for the period of extension requested and that it would be fair and equitable in the circumstances to provide such an extension;

• prejudice to the Commissioner which may result from the additional time being allowed, however the mere absence of prejudice is not enough to justify the granting of an extension;

• unsettling of people, other than the Commissioner, or of established practices;

• fairness to people in like positions and the wider public interest; and

• the consequences to the taxpayer in granting an extension.

Compare ID 2003/26 where the taxpayer made no concerted effort to dispose of the land in question and the Commissioner declined to exercise his discretion.

It would be open to a taxpayer to seek a private ruling on the exercise of the discretion, under the self-assessment regime. Where no ruling is sought, a taxpayer will generally be required to place him or herself in the shoes of the Commissioner in the exercise of the discretion by adopting a reasonably arguable position. This approach may involve some risk.

ID 2002/629 considers whether a farm property was an active asset “just before the CGT event” for the purposes of sec 152-35(a) in circumstances where the farm had been actively used but at the time of the CGT event was not actually being used for farming because of health and other problems of the taxpayer. The ID considered that the farm continued to be held read for use at the relevant time. See also IDs 2003/44 and 2003/45.

¶2.031 Example where business has ceased within 12 months of the sale of active asset

The following example taken from the Minutes of the 11 June 2003 meeting of the National Tax Liaison Group – CGT Subcommittee illustrates an application of sec 152-35(a)(ii):

Sometimes when a business is sold the purchaser wishes to acquire the business premises in one entity and the business and other business assets in another entity. For example, Mary operates a restaurant from premises which she also owns. Mary agrees to sell the restaurant business, including business premises, to John. For asset protection purposes John will acquire the restaurant business in his own name and his family trust will acquire the business premises. Assuming Mary satisfies the maximum net asset value test, the sale of the business premises to John’s family trust should be the sale of an active asset and therefore Mary should be entitled to small business relief under Division 152.


Selling a Small Business – The CGT Strategies However, Mary is concerned about the GST implications of the sale of the restaurant business to John and the sale of the business premises to John’s family trust. She reads GSTR 2002/5 and, in particular, paragraphs 131 to 136. GSTR 2002/5 confirms that unless Mary undertakes some tax planning both the sale of the business and business premises will not be GST-free under section 38-325 of the GST Act. Paragraphs 133 to 136 of GSTR 2002/5 essentially tell Mary to sell the restaurant business to John and at the same time grant a lease of the business premises to him. The following day Mary should sell the business premises, subject to the lease to John, to John’s family trust. If she undertakes this tax planning suggested by GSTR 2002/5 the sale of the restaurant business and the sale of the business premises will both be the supply of a going concern and therefore should be GST-free. If Mary undertakes such tax planning as suggested in GSTR 2002/5 will she be entitled to the small business relief under Division 152 in respect of the sale of the business premises? The concern being the business premises will not be an active asset just before their sale. Just before their sale Mary is not carrying on the restaurant business as it is being carried on by John and the main use of the business premises at that point in time is to derive rent. Arguably, from Mary’s perspective, the business premises’ main use for deriving rent was only temporary (refer subparagraph 152-40(4)(e)(ii)) and therefore it should still be an active asset. Of concern is that John’s family trust will lease the business premises to John after the trust has acquired it. If the ATO’s view is that the sale of the business premises is not the sale of an active asset in the above example and in example 21 in GSTR 2002/5 the NTAA requests that an appropriate warning be included at the end of paragraph 134 in GSTR 2002/5. ATO comments The ATO takes the view that the reference to ‘the relevant business ceased to be carried on’ in subparagraph 152-35(a)(ii) includes a reference to a business that is sold, that is, the relevant business has ceased to be carried on by the particular taxpayer. It is not limited to a business that ends in the sense that no one continues to carry it on. (This view will shortly issue in an ATO Interpretative Decision). Accordingly, in the above ‘sale of business’ scenario the relevant test time for paragraph 152-35(a) purposes is just before the cessation of the business, i.e. the sale of the business, because that pre-dates the CGT event, i.e. the sale of the premises. As the premises are used in the course of carrying on the business just before the sale of the business that aspect of the active asset test is satisfied and assuming it has been so used for at least half the relevant period the active asset test will be satisfied. As an additional comment on the scenario it can be noted that, as the premises are not used (by Mary) in the course of carrying on a business after the sale of the business, subsection 152-40(1) will not be satisfied after that time and therefore the temporary main use to derive rent exception in subparagraph 152-40(4)(e)(ii) is not relevant.

Update

ATO ID 2003/504 issued 4 July 2003 which deals with the above.

This example is also a good illustration of the need to consider GST issues when selling a business.

In ID 2003/503, the ATO considered a case where there was no cessation of a taxpayer’s spouse’s business. There his spouse sold part of her business and relocated the remaining business to other premises. As there had been no cessation in the ATO’s view, a subsequent sale of the taxpayer’s premises would not attract the small business concessions because there would be no active asset of the taxpayer or of his spouse. Note, the case considered in this ID illustrates how the relevant business can be that of a small business CGT affiliate. Had the


Selling a Small Business – The CGT Strategies spouse’s business ceased, the premises would have continued to be an active asset for another 12 months, or longer, subject to the favourable exercise of the Commissioner’s discretion.

¶2.032 Meaning of “active asset”

Section 152-40 defines the term, “active asset”, as follows:

152-40 Meaning of active asset

(1) A *CGT asset is an active asset at a given time if, at that time, you own it and:

(a) use it, or hold it ready for use, in the course of carrying on a *business; or (b) it is an intangible asset that is inherently connected with a business that you

carry on (for example, goodwill or the benefit of a restrictive covenant); or (c) it is used, or held ready for use, in the course of carrying on a business by:

(i) your *small business CGT affiliate; or

(ii) another entity that is *connected with you.

(2) Subsection 392-20(1) is disregarded in determining, for the purposes of subsection (1) of this section, whether an entity is carrying on a *business. Note: An entity would be taken to be carrying on a primary production business under

subsection 392-20(1) if the business is carried on by a trust and the entity is presently entitled to trust income.

(3) A *CGT asset is also an active asset at a given time if, at that time, you own it and:

(a) it is either a *share in a company that is an Australian resident at that time or an interest in a trust that is a *resident trust for CGT purposes for the income year in which that time occurs; and

(b) the total of:

(i) the market values of the active assets of the company or trust; and

(ii) any *capital proceeds that the company or trust received, during the 2 years before that time, from *CGT events happening to its active assets and that the company or trust holds in the form of cash or debt pending the acquisition of new active assets;

is 80% or more of the market value of all of the assets of the company or trust. Example: Paragraph 152-35(b) requires a CGT asset to have been an active asset over a

period of time. For a share in an Australian resident company to meet this requirement, the company would have to satisfy the 80% test in this subsection throughout that same period.

Exceptions

(4) However, the following *CGT assets cannot be active assets:

(a) interests in an entity that is *connected with you, other than *shares and interests covered by subsection (3);

(b) shares in companies, other than shares covered by subsection (3); (c) interests in trusts, other than interests covered by subsection (3); (d) financial instruments (such as 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);



(e) an asset whose main use in the course of carrying on the *business mentioned in subsection (1) is to derive interest, an annuity, rent, royalties or foreign exchange gains unless:

(i) the asset is an intangible asset and has been substantially developed, altered or improved by you so that its market value has been substantially enhanced; or

(ii) its main use for deriving rent was only temporary. Example: A company uses a house purely as an investment property and rents it out.

The house is not an active asset because the company is not using the house in the course of carrying on a business. If, on the other hand, the company ran the house as a guest house the house would be an active asset because the company would be using it to carry on a business and not to derive rent.

This section broadly follows the former provision, sec 123-80 in Division 123 of Part 3-3 ITAA 97, with some modification and clarifications.

The current provision applies to all CGT assets used in a business of a taxpayer where the asset is held in an entity connected with the taxpayer, or where it is held in a small business CGT affiliate (sec 152-40(1)(c) ITAA 97). ID 2002/405 confirms that where premises are owned by two individuals and are leased to a company whose shares are owned by the individuals, the premises will be an active asset for the purposes of sec 152-40(1)(c)(ii).

Previously, but only since 13 August 1998, this relaxation only extended to land held in connected entities or affiliates. The extension may only have limited application now that plant and equipment is excluded from the CGT regime (see ¶1.070 above). In applying to all CGT assets, it does, however, remove any doubt as to whether some kinds of interests in land, for example pastoral leases, were covered by the previous provision.

A further change contained in sec 152-40(3) ITAA 97, set out above, is the new 80% test where the assets are shares in a company or interests in a fixed trust. The example following that subsection seeks to illustrate that the 80% rule must be satisfied for at least half the period of ownership that the company or trust held its active assets, with the 15-year limit applying as per sec 152-35(b).

There is an issue here whether if say the 80% test can be satisfied in respect of a company during the first five years of an ownership period of 10 years so that it can be said that the 50% test in sec 152-35(b) will be satisfied to enable the shares in the company to be treated as active assets. The problem appears to be here that the active asset definition relating to shares in sec 152-40(3) refers to shares being active assets “at a given time” provided they can satisfy the 80% requirements. The actual active asset test in sec 152-35 is in two parts. The first limb requires that an asset in question be an “active asset” (as determined by sec 152-40) just before the earlier of relevant CGT event or at the time of the cessation of the relevant business. In the example given here, as the 80% test was only satisfied in the first five years, the first limb of the active asset test would not be satisfied.

In the case where a company is in liquidation and the shares are to be cancelled, see ID 2003/844 where the ATO takes the view that the relevant business is the business of the liquidating company. This means that the 80% test may be able to be satisfied at that time, in circumstances where it would not be able to be satisfied at the time of the cancellation of the shares. Note ID 2003/844 replaces ID 2003/715, which was withdrawn to clarify the reasons given. The short answer given in the later ID is the same.

ID 2003/714 considered whether moneys held on trust in a bank account for the clients of the relevant business could be treated as part of the asset of the business for the 80% test. The ATO took the view that they could not. It is difficult to argue with this view in the circumstances of that case.



Practice point There is some uncertainty as to whether shares in a company or interests in a trust can be “active assets” for the purposes of the small business concessions where there is no “controlling individual” in respect of the company or trust. The point to note here is that shares or interests will be “active assets” under sec 152-40 if they meet the 80% test. Under sec 152-10(2), for the concessions to apply there needs to be a controlling individual of the company or trust and the relevant taxpayer must be a CGT concession stakeholder. However, satisfying the 80% test can be critical in cases where the conditions referred to in sec 152-10(2) are not present. For example, a holding company holds shares in a subsidiary which carries on a business. The individual owners of the shares in the holding company will be able to avail themselves of the concessions under Division 152 in this situation where the shares held in the holding company are “active assets” because the subsidiary company can satisfy the 80% test, and the holding company can also satisfy the 80% test. It will satisfy the 80% test if it holds no assets other than the shares in the subsidiary company or its other assets amount to less than 20% of its total assets. At the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000 the ATO confirmed this view.

It should be noted that sec 152-40(3) recognises by subpara (ii) that at the time the shares or trust interests are disposed of, the company or trust may have proceeds from the sale of active assets, and such proceeds are treated for the purposes of the 80% test as active assets.

Example

Barry and Robin hold all the shares in Whitwoods Pty Ltd, which operates a furniture manufacturing business established by the company in 1989. The company has goodwill worth $0.8m and shares worth $200,000. The company also has the proceeds from the sale of a truck, also acquired in 1989 and used continuously by the company for its business, which had been sold 12 months previously (i.e. before 21 September 1999). The sale realised $2,500. Barry and Robin have accepted an offer to sell their shares for $1m. The shares arguably will be active assets because goodwill together with the $2,500 capital proceeds from the truck ($802,500) amount to slightly more than 80% of the total market value of all the assets of the company ($1,002,500) and satisfy the requirement that the assets were active assets for more than half of the period of ownership by the company. The inclusion of capital proceeds during the two-year period prior to the sale arguably can include the proceeds, in this example, from the sale of the truck, notwithstanding that the sale proceeds from the truck if sold now (i.e. after 21 September 1999) would be disregarded for CGT purposes. It is not clear that this matters as, even if the sale of the truck were to occur after 21 September 1999, the sale proceeds would still be “capital proceeds”. See discussion below.

¶2.033 Assets held as cash pending the acquisition of new assets

Under sec 152-40(3)(b)(ii) the proceeds from the sale of the truck in the above example can only qualify as part of the active assets of the company if they are held in cash or debt pending the acquisition of new active assets This is a serious limitation since, in many cases, where a small business owner is seeking to take advantage of the Division 152 concessions, he/she is in the process of retiring and unlikely to be holding realised gains for the purpose of acquiring new active assets. Appropriate planning should overcome such a problem in most cases, however, but see discussion below in relation to loans.

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 2.3) the ATO noted the potential difficulty with sec 152-40(3)(b)(ii) in a case where assets


Selling a Small Business – The CGT Strategies had been sold down over a period. No suggestions were offered by the ATO for overcoming the problem.

¶2.034 ATO interpretative decisions on active assets

There have been a number of IDs on what the ATO regards as an “active asset”. The following IDs are of interest:

• ID 2001/378 (withdrawn, see ID 2004/7, below) – CGT small business concessions – meaning of “active asset”. Answer –intellectual property disposed of prior to 1 July 2001 was an active asset.

• ID 2002/354 – CGT – small business roll-over relief – active assets – asset “held ready for use” – land on which a shed was to be built was sold before shed built. Answer – not “held ready for use”, therefore, not active asset.

• ID 2002/629 – CGT – small business concessions – active asset – just before the CGT event – this ID considered whether a not fully operational farm was an active asset at the relevant time. Answer - the ID accepted that it was.

• ID 2002/630 – CGT – taxi licence: active asset. Answer – not an active asset where leased to another – this ID relies on FCT v Murry (1998) 155 ALR 67; (1998) 39 ATR 129; (1998) 72 ALJR 1065; (1998) 193 CLR 605; 98 ATC 458.

• ID 2002/631 – CGT – small business concessions – active asset – ready for use – this ID (dealing with the same facts as ID 2002/629) considered whether a not fully operational farm was an active asset at the relevant time. Answer – the ID accepted that it was.

• ID 2002/753 – CGT: small business roll-over/replacement active asset/main residence. Answer – a 30% interest in property can be an active asset.

• ID 2002/766– CGT – contingent and unascertainable amounts and the small business concessions. Answer – not an active asset but separate asset and when disposed of the taxpayer would not be carrying on a business.

• ID 2002/785 – CGT – small business relief – active asset – poker machine entitlement. Answer – yes.

• ID 2002/787 – Capital gains tax – small business relief – active asset – freehold of a hotel. Answer – yes, the taxpayer owned the leasehold of the hotel and was considering purchasing the freehold.

• ID 2002/820 (now withdrawn, overturned by ID 2003/655, see below) – CGT – active asset – strata unit in motel complex. Answer – no as owner not in business, and income was rent, see sec 152-40(4)(e)(ii).

• ID 2002/1003 – CGT – small business concessions – active assets – trade debtors. Answer – yes, a debt is an intangible asset and not excluded under sec 152-40(4)(d).

• ID 2003/165 – CGT – small business concessions – active assets – disposal by Legal Personal Representative (LPR) after taxpayer’s death. Answer – no, where the LPR does not carry on the business after death.

• ID 2003/167 – CGT – small business concessions – active assets – bank accounts. Answer – no, the ATO takes the view that a bank account is a financial instrument under sec 152-40(4)(d).

• ID 2003/168 – CGT – small business concessions – active assets – Australian currency. Answer – no, notes and coins are excluded under sec 152-40(4)(d).

• ID 2003/250 – CGT – dairy industry deregulation and small business concessions – active assets – payment right. Answer – no.



• ID 2003/253 – CGT – small business concessions – active assets – main use of asset where part business and part rental use. Answer – yes, in the particular circumstances where most of the income was from business use.

• ID 2003/345 – CGT – small business concessions – active assets – commercial storage facility. Answer – yes, it was a business.

• ID 2003/485 – CGT – small business concessions – disposal of shares in non-resident company. Answer – no, see sec 152-40(3).

• ID 2003/655 – CGT – small business concessions – active assets – holiday apartments. Answer – yes, it was a complex of six apartments operated as a business.

• ID 2003/656 – CGT – small business concessions – active assets – commercial rental properties. Answer – no, not a business.

• ID 2003/657 – CGT – small business concessions – active assets – boarding house. Answer – yes, it was a business providing room cleaning etc.

• ID 2003/844 – CGT – small business concessions – active asset test – company liquidations and cancellation of shares – relevant business ceases. Answer – the relevant business is the business of the company that has ceases to operate.

• ID 2004/7 – CGT – small business concessions – active assets – intangible asset used in a connected entity’s business. Answer – yes, it covers the case where business assets were leased to connected entity.

• ID 2004/378- CGT – small business concessions - active assets – joint ownership of a share. Answer – yes, the requirements of sec 152-10(2) can be satisfied and the company must still satisfy 80% test.

¶2.035 Redundant assets not longer used in a business

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 2.5) the view was expressed that assets no longer used in a business may not qualify for the small business concessions because “just before the CGT event” they are not active assets. The Minutes note:

Mr X is a sole trader who carries on business from premises that he owns. The premises are post-CGT and have only been used for business purposes. Mr X is expanding and moves into larger premises. Six months after moving premises, Mr X enters into a contract to sell the premises (which have been rented short-term to an external party). Will the land satisfy the active asset test? What if Mr X vacated the premises only one month before entering into a contract to sell and the premises remained vacant for that time? What about a week? What about one day? The NTAA view is that the land will not satisfy the active asset test because neither subparagraph 152-35(a)(i) nor (ii) is satisfied.

Tax Office response

The Tax Office confirmed the NTAA’s view. To satisfy the active asset test in section 152-35, the CGT asset must have been an active asset just before the CGT event and for at least half the period of ownership (assuming the business has not ceased and the asset has been owned for less than 15 years). If the asset is not used or held ready for use in the course of carrying on a business just before its sale, then it will not satisfy the active asset test. Accordingly, if the premises are entirely vacated six months before their sale, the active asset test will not be satisfied. The same result follows where the premises are vacated less than six months before the sale. This result arises because the words ‘just before’ in paragraph 152-35(a)


Selling a Small Business – The CGT Strategies effectively mean ‘immediately before’. The Tax Office noted that where the main business activity is moved to new premises, the active asset status of the old premises might be maintained if they were used to store business materials, tools or the like, or used for some similar ancillary business purpose. It would be a question of fact whether the old premises were used in the course of carrying on a business. Further, if the old premises were used in such a manner and also rented out to another party, the question would arise whether at the time just before their sale the main use of the premises was to derive rent such that the premises would be excluded from being an active asset under paragraph 152-40(4)(e). However, where such renting is only short-term, then it is likely that the main use to derive rent (if that was the case) would be regarded as only temporary under subparagraph 152-40(4)(e)(ii) such that the premises would not be excluded from being an active asset.

Item 2.6 of the 7 August 2002 Minutes notes that the assets sold by a legal personal representative (LPR) after the death of the business operator that were used in a business carried on by the deceased will not be active assets at the relevant time as the LPR will not be carrying on a business. See ID 2003/165, noted above. This ID accepts that if the LPR carries on the deceased business the assets will be active assets.

Also, according to the Minutes, the premises are also not an active asset of “yours”, that is, the LPR, just before the cessation of the business (subparagraph 152-35(a)(ii)) because at that time they are not an asset of the LPR. ID 2003/165 recognises that this will not be a problem if the LPR carries on the business after the death of the deceased.

¶2.036 Shares held under bare trust

A question arises as to the status of a share for the active asset test where there is, say, a husband and wife operated business, and one party may hold his/her spouse’s shares in the operating company in their name but for the benefit of the other. This would include a bare trust which is essentially any trust relationship where the beneficiary has an absolute right to call for the legal ownership of the asset to be transferred into his/her name. See sec 106-50 which treats the beneficial owner as the owner of the asset for CGT purposes.

It would appear that the beneficial interest held by the other shareholder could be regarded as an active asset provided the requirements in sec 152-40(3) can be met. The main requirement of that provision is that “you own it”. This requirement appears to suggest not mere beneficial ownership but legal ownership. However, where in Division 152 the drafter has sought to make that distinction, the reference is made to a shareholder “holding the legal and equitable interest in shares” (see sec 152-55 “Meaning of controlling individual”).

The main difficulty would appear to be that, whilst the interest could be treated as an active asset, the holder would only be able to benefit from the concessions if he/she were a CGT concession stakeholder (see sec 152-60); this is because of the additional requirement under sec 152-10(2). For an individual to be a CGT concession stakeholder, sec 152-60(b) requires the person being a spouse to hold both the legal and equitable interests in their shares in the company. This provision would appear to override sec 106-50 ITAA 97.

Particular care needs to be taken in cases involving bare trusts. It may well be that no such trust exists. Inherently, it is likely that the only evidence of such a trust will be the statement of one of the parties whom the ATO may not regard as a truthful witness.

About the only circumstance where a company operated by a husband and wife may not be able to fully benefit from the concessions because all the shares are held in one name would be where the parties wish to avail themselves of the retirement exemption (see ¶5.000).

¶2.037 Guest houses/boarding houses, etc.

The example following sec 152-40(4) is valuable since it largely removes the uncertainty that has existed as to the status of guest houses and the like under the earlier small business


Selling a Small Business – The CGT Strategies provisions. Note, however, ID 2002/820 referred to above dealing with strata units in a motel complex. The different result will basically depend on whether the accommodation unit is held for rental income purposes or whether a business is carried on. Two new IDs noted above further explain the situation. ID 2003/655 deals with a holiday apartment block of six units that was taken to be a business and in doing so overturned ID 2002/820, as was the boarding house considered in ID 2003/657. In the case of the boarding house, the rooms were serviced daily by the operator.

It is instructive to consider the reasons for decision in ID 2003/655, set out as follows:

For a CGT asset of a business to be an active asset for the purposes of Division 152 of the ITAA 1997, it must firstly satisfy one of the ‘positive tests’ in subsection 152-40(1) of the ITAA 1997 and then also not be excluded by one of the exceptions in subsection 152-40(4) of the ITAA 1997. Under paragraph 152-40(1)(a) of the ITAA 1997 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. However, paragraph 152-40(4)(e) of the ITAA 1997 provides that an asset whose main use in the course of carrying on the business is to derive rent cannot be an active asset (unless that main use was only temporary). That is, even if the asset is used in a business it will not be an active asset if its main use is to derive rent. The term ‘rent’ has been described as follows:

• the amount payable by a lessee to a lessor for the use of the leased premises (C.H. Bailey Ltd v. Memorial Enterprises Ltd [1974] 1 All ER 1003 at 1010; United Scientific Holdings Ltd v. Burnley Borough Council [1977] 2 All ER 62 at 76, 80, 86, 93, 99),

• a tenant’s periodical payment to an owner or landlord for the use of land or premises ( Australian Oxford Dictionary , 1999, Oxford University Press, Melbourne),

• recompense paid by a tenant to a landlord for the exclusive possession of corporeal hereditaments. The modern conception of rent is a payment which a tenant is bound by contract to make to his landlord for the use of the property let (Halsbury’s Laws of England 4th Edition Reissue, Butterworths, London 1994, Ch 27(1) ‘Landlord and tenant’, paragraph 212).

Where residential units are operated as holiday apartments, the issue arises as to whether the occupants of the apartments are tenants/lessees or only have licences to occupy. Ultimately this is a question of fact depending on all the circumstances involved. Relevant factors include whether the occupier has a right to exclusive possession (Radaich v. Smith (1959) 101 CLR 209 at 222), the degree of control retained by the owner and the extent of any services provided by the owner such as room cleaning, provision of meals, supply of linen and shared amenities (Appah v. Parncliffe Investments Ltd. [1964] 1 All ER 838; Marchant v. Charters [1977] 3 All ER 918). In this case, the apartments are operated similarly to a motel. No lease agreements are entered into and the guests do not receive exclusive possession of the apartment they are staying in. Instead, they simply have a right (licence) to occupy the apartment on certain conditions. As well, the usual length of stay by guests is very short term (between 1 - 7 nights). Room cleaning and clean linen is also provided to guests. These facts indicate that the relationship between the taxpayer and those staying in the holiday apartments is not that of landlord/tenant under a lease agreement. Accordingly, the income derived is not ‘rent’ and therefore the paragraph 152-40(4)(e) exclusion does not apply.


Selling a Small Business – The CGT Strategies As the holiday apartments are used by the taxpayer in the course of carrying on a business, they are active assets under section 152-40 of the ITAA 1997.

¶2.038 Loans

It is arguable that trade debts are not excluded under sec 152-40(4)(d) on the basis that they are not “loans” or other financial instruments of a kind referred to in para (d), but see now ID 2002/1003 noted above, which confirms this view.

Similarly, cash at bank ought not to be excluded under para (e) where it is part of the circulating or operating capital of a business, even if it is held in an interest bearing account. Arguably, it is not a “loan” under para (d) either, though bank deposits are sometimes thought of as loans to the bank. Arguably, this is not the kind of loan that para (d) is contemplating. In this regard, a loan to a shareholder, whether or not secured under a “Division 7A agreement” is likely to be regarded as a loan to which para (d) does apply. The references in sec 152-40(3)(b)(ii) to capital proceeds held in the form of cash or debt ought not preclude an argument in relation to operating capital as an active asset.

However, in ID 2003/167 dealing with bank accounts, noted above, the ATO has taken a restrictive view that these assets are “financial instruments”. This matter was discussed at the 11 June 2003 National Tax Liaison Group CGT Subcommittee meeting where it confirmed its view as expressed in ID 2003/167.

The importance of these arguments will only arise in the context of the 80% test (dealing with shares as active assets, see sec 152-40(3)) since it is unlikely that there will be any relevant capital gains arising on the disposal of such assets.

¶2.039 Restrictive covenants as active assets

Section 152-40(1)(b) gives, as an example of an active asset, “the benefit of a restrictive covenant”. This strongly suggests that where a business is sold and the vendor gives a restrictive covenant as part of the consideration for the covenant as part of the sale, the vendor will not be entitled to any of the small business concessions for that part of the consideration, as the vendor will not have disposed of the benefit of a restrictive covenant.

It is suggested that, in the absence of the example in para (b), a covenant given by a vendor would be an active asset. Arguably, the mere presence of the example may not preclude such an asset from being an active asset, c.f. Brooks v FCT [2000] FCA 721 where the Full Federal Court rejected the presence of an example in sec 104-150(1) (forfeiture of deposits) as controlling the meaning of the section. Given the uncertainty of the position, however, care is needed to ensure that the value of any restrictive covenant is kept to a minimum.

It is noted, however, that in TR 1999/16 the ATO accepts that, where goodwill is disposed of and a covenant is provided, the sale consideration will be treated as applying to the goodwill only.

¶2.0391 Licence of business as an active asset

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the ATO indicated that the NTAA had raised the following issue:

[W]hether goodwill can be an active asset of an entity if used in carrying on business by a connected entity. For example, an individual owns a business including goodwill. The individual licenses the business (including goodwill) to a trust that is connected with the individual. When the individual sells the business (including goodwill), is the goodwill an active asset?

The ATO’s response is recorded in the Minutes as follows:

The ATO stated that paragraph 152-40(1)(b) was inserted to remove any doubts arising under paragraph 152-40(1)(a) that a taxpayer can ‘use’ only physical assets in the course of carrying on the business. The purpose and effect of paragraph 152-


Selling a Small Business – The CGT Strategies 40(1)(b) is to extend (not impliedly limit) paragraph 152-40(1)(a). Paragraph152-40(1)(c) in turn supplements both paragraphs (a) and (b). It is not clear in the example who owns the goodwill and the legal effect of the granting of the licence. There may be two businesses involved. The answer depends on the precise facts.

In view of the ATO’s answer care needs to be exercised here. Note also that the exception in sec 152-40(4)(e) may be applicable in certain cases. As noted above, ID 2004/3 clarifies the ATO position.

See also ID 2002/630 (Capital gains tax – Taxi licence: active asset) noted above where the ATO took the view that the licence was not an active asset.

¶2.0392 Forfeited deposits

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 2.4) the ATO confirmed that the small business concessions could apply to a deposit forfeited triggering CGT event H1 (which deals with forfeited deposits) in relation to the sale of an active asset. The Minutes note in relation to the view expressed:

This is consistent with the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 7) of 2000 that introduced, among other things, some minor CGT changes. In particular, in relation to Item 46 of Schedule 4 of that Bill, the Explanatory Memorandum states (in part): ‘Ensure that the CGT small business concessions could apply, as intended, to capital gains arising from creating rights. These amendments favour taxpayers and restore the position in the ITAA 1936.The previous small business concessions in the ITAA 1997 had already applied to most CGT events involving creating rights inherently linked to carrying on a business. This is because the concessions applied to capital gains from CGT events that happened in relation to a CGT asset.For example, CGT events D2 (granting an option), D3 (granting a right to income from mining) and F1 (granting a lease) involve underlying assets which satisfy the nexus requirement that the CGT event happens in relation to the CGT asset. CGT event D1 (creating contractual or other rights) also typically involves an underlying asset. For creating rights under a restrictive covenant, business goodwill is the relevant underlying asset, CGT event D1, however, can apply where the CGT event does not happen in relation to an underlying asset. This amendment, therefore, provides special rules for CGT event D1 to overcome this difficulty.’

The ATO has issued ID 2003/346 confirming this view. The ID notes that the position is different from the situation in TR 1999/19 (para 6 of the Addendum) where the sale of the land there in question proceeded and the proceeds from the forfeitured deposit were treated as part of the capital proceeds from the sale.

¶2.0393 Performance clauses

In Taxation Ruling TR 93/15 the view is taken that, where an asset is disposed of for a lump sum and an unascertainable amount, the vendor is taken to have received money (i.e. the lump sum) and property other than money. The right to the contingent and unascertainable amount is acquired under the contract for the disposal of the asset and the date of the making of that contract is the acquisition date for the right. The cost base for the right is its market value at the time of its acquisition. The practical consequence of this is that a capital gain may accrue when the purchaser pays an amount pursuant to the right over and above the value of the right at the time of the original sale. It would appear that this later gain would not be in respect of an active asset or the purposes of Division 152, though it may qualify as a discount gain. Accordingly, care is needed to be exercised where entering into contracts for the sale of a


Selling a Small Business – The CGT Strategies business which may contain performance clauses involving the payment of amounts subsequent to the date of the sale based on the performance.

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the ATO indicated that TR 93/15 did not apply to sales where a fixed amount was payable in the future. The ATO stated that the total amounts receivable would be treated as capital proceeds (sec 116-20(1)).

At the subsequent National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 further clarification was sought (item 2.11):

A small business taxpayer sold its business under a performance based contract involving an immediate payment at the time of sale with a further contingent unascertainable sum payable a few years later based on business profit at that time. The total amount possibly payable under the agreement together with any other assets of the company was well below the $5m maximum net asset value test prescribed in the CGT small business concessions. Following receipt of the further proceeds under the contract, a Private Ruling application was lodged with the Tax Office requesting a ruling on the application of the new CGT small business concessions to the further sum received. The Tax Office concluded that the CGT concessions did not apply to the receipt of the further sums. The Private Ruling decision is largely based on the Commissioner's opinion in Taxation Ruling TR 93/15 that the future payments under the contract are separate property rights. TR 93/15 was issued on 27 May 1993 well before the current small business CGT concessions were legislated by Parliament. From discussions at various seminars and professional forums it would appear that many sale of business agreements commonly contain these earn out provisions. Accordingly, it seems incongruous that the CGT small business concessions were not intended to cover these situations. Is this the intended consequence of the legislation?

Tax Office response

This issue was raised at the previous TLG CGT Subcommittee meeting (28 November 2001 – agenda item 3.2). As noted in the minutes of that meeting, the Tax Office view is that the new asset acquired upon the sale of the business, that is, the right to a contingent and unascertainable amount, does not qualify for the small business concessions as it is not an active asset. This is also reflected in the ATO Interpretative Decision (ATO ID) 2002/766 that issued on 31 July 2002.

See ID 2002/766 (CGT – Contingent and unascertainable amounts and the small business concessions) noted above, where the view is taken by the ATO that the “asset” is not an active asset but a separate asset and when disposed of by the taxpayer the taxpayer would not usually be carrying on a business at that point in time.

One approach here would be to provide under the sale contract fixed amounts payable over a period perhaps subject to performance conditions. By making the payments fixed they will be part of the original consideration for the business and able to benefit under the concessions. If not subsequently paid, it may be necessary to seek an amendment to the earlier income tax return – assuming that there was CGT still to pay after the application of the concessions.

The National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 (item 7.3) considered an issue involving the sale of a pre-CGT business under a contract with a performance clause: The Minutes note:

The ICAA asked whether the Tax Office discussed with Government the outcome of applying Marren v Ingles to installment sales. The ICAA contends that there would be many cases where such an application removes pre-CGT status from sale proceeds and/or causes inappropriate changes to or complications in calculating cost base.


Selling a Small Business – The CGT Strategies (This issue was agenda item 3.2 at the last NTLG CGT subcommittee meeting held on 28 November 2001 – installment sales: payment made more than 12 months after sale of business). This item was supplemented prior to the meeting by the ICAA with the following example: ‘Assume the seller has disposed of a pre-CGT business for a lump sum payment of $1m plus deferred installment payments to be spread over 5 consecutive years. The receipt of the deferred installment payments will depend on the profitability of the business to be assessed on a year to year basis. The business is a pre-CGT asset and accordingly the lump sum payment received from the sale of the business will be exempt from capital gains tax. In TR 93/15, the ATO ruled that where there is a disposal of an asset for a lump sum plus a right to a contingent and unascertainable amount; there are effectively two separate assets. This has been reconfirmed, with elaborations, in the NTLG (CGT) Subcommittee minutes of 28 November 2001. However, since the High Court decision in Orica and the ATO interpretation approach in relation to Orica (the look-through approach, which is well documented in the ATO Orica discussion paper of 1998) there appears to be a clear reasonably arguable position that the analysis of the installment proceeds should look through to the underlying asset and that the ATO should not apply the capital gains tax provisions to the contractual rights arising as consideration for the disposal of the underlying asset. There is now a disconnection between ATO practice and court authority on these issues, particularly regarding disposals of pre-CGT assets. The ICAA submits that the ATO should either confirm an administrative program to resolve these issues (notably, an addendum to TR 93/15 to accept that the overall proceeds are to be treated as one amount regarding the underlying disposal of the business) or to confirm that this issue has been passed to the Federal Treasury tax legislative function for technical corrections of the law.’

Tax Office response & comments

In respect to the supplementary example, the Tax Office confirmed the application of TR 93/15. The right to a contingent and unascertainable amount was property and not money. The capital proceeds rules required the identification of proceeds at the time of the relevant event (the sale of the business assets) and if an amount of money could not be quantified at that time then the right to the contingent and unascertainable amount was property. There was no scope in the provisions to look through the right to the contingent and unascertainable amount. Mr Kirkwood (ICAA) stated that there is a proposition that all the proceeds, including the subsequent profits from the business, are in respect of a pre-CGT asset – thus the application of the Marren v Ingles decision. This is inconsistent with the Tax Office's approach of treating the transaction as giving rise to two separate items of property – the post-CGT proceeds are in respect of a post-CGT asset, being the right to those proceeds. The right materialises post-CGT. Mr Kirkwood stated that it would be reasonable to spread the proceeds over the period and not at one point in time. This is a general issue of timing and consideration. The earn out is referable to a pre-CGT asset. The discussions then mostly centred on the point of time at which future contingent and unascertainable profits should be recognised and a profits emerging basis was suggested, although the external members acknowledged that the CGT provisions worked on the basis that all capital proceeds (whether an amount of money or the


Selling a Small Business – The CGT Strategies market value of property) are taken into account at the beginning of the transaction, that is, whenever a CGT event happens. The Tax Office also noted that the discharge or satisfaction of the right, said to be in relation to pre-CGT business assets, could give rise to a post-CGT capital loss. The professional bodies advised that their concern was not with losses but with the proceeds which related to the pre-CGT business. The Tax Office advised that, although the policy of the CGT provisions was not to tax on a profit-emerging basis, they would bring the concerns raised by subcommittee members to the attention of Treasury.

This matter was further considered at the 11 June 2003 meeting of the Subcommittee. The Minutes note:

Without legislation dealing specifically with installment sales and ‘work-out’ arrangements (which usually include provisions which make the calculation of amounts receivable over time impossible until specified events have occurred) taxpayers will be caught in the trap of having most of the ‘deferred’ proceeds treated as arising from new or successively created CGT events thereby denying pre-CGT status where the original asset was pre-CGT, causing the calculation of cost base to be difficult, or resulting in loss of access to small business concessions. The ICAA would like to see legislation which focuses on capital proceeds relating back to the original asset sold and spreading cost base in some equitable manner – possibly evenly over the period of the receipts or, in ‘extreme cases’, with ‘look-back’ adjustments. There are also problems with the small business CGT concessions. This was demonstrated by Interpretative Decision ID 2002/766 (which was also raised at the August 2002 meeting). This ID considered the issue of whether the small business CGT concessions can apply to a contingent and unascertainable amount which, depending on the performance of the business sold, is payable in the future. Based on TR 93/15, the ATO view is that this right to future payments is a separate CGT asset acquired at the date of disposal of the business assets. When a payment is received in regard to this right in the future, the payment represents proceeds from the disposal, or part disposal, of that right (ie CGT event C2 occurs) and not the business assets. The separate right to receive future payments will not qualify as an ‘active asset’, and the small business CGT concessions cannot apply to it. ATO comments The ATO advised that it is possible that earn-out rights may be assessed as ordinary income and hence the CGT small business concessions and pre-CGT status of the business assets become irrelevant. Other areas of the ATO will be consulted on this issue before the matter can be raised with Treasury. Action item An update will be provided to the subcommittee at the next meeting.

The minutes of the November 2003 meeting note as follows:

A progress report on the review of TR 93/15 was distributed to subcommittee members for discussion. A submission paper on the review of TR 93/15 prepared by the ICAA was tabled at the meeting and distributed to subcommittee members. The Tax Office noted that the ICAA’s proposal to look through the rights asset to the money which was ultimately received in relation to the right had been discussed previously by the subcommittee. A significant difficulty in the look through approach arose from the fact that, while what was ultimately received was clearly money, at the time of the event (when capital proceeds had to be taken into account), no amount of money could be identified.


Selling a Small Business – The CGT Strategies The Tax Office was willing to consider any technical analysis that addressed this problem. Any comments should be provided to Ms Skinner (Tax Office).

Note the ATO issued a series of IDs in 2003 (IDs 2003/635, 2003/636, 2003/637 and 2003/638) dealing with the treatment of capital proceeds paid by way of installments over 10 years. These are instructive and are contrasted with the position in respect of performance clause payments under a sale of business contract. The IDs illustrate that if payment is agreed to be made over a period of time by way of installments, this does not enable any CGT payable to be deferred.

¶2.0394 Whether assets held in a super fund can be active asset

At the 11 June 2003 National Tax Liaison Group – CGT Subcommittee the NIA raised the question whether business premises owned by the proprietors’ super fund would qualify as an active asset under sec 152-40(1)(c) given the ATO’s previously expressed view that a super fund is not a connected entity of the main beneficiaries of the fund. The relevant extract from the Minutes is reproduced at ¶2.020 above, see “Active assets and superannuation funds”. No conclusion is expressed in the Minutes. Arguably, it could be said that the fund is a small business CGT affiliate of the beneficiaries if they can be said to act in accordance with their directions or in concert with them, see sec 152-25(1). This problem illustrates the tension between, on the one hand, a desire to qualify under the $5m threshold by not including certain related parties, and the desire to apply the concessions to those parties.

The ATO has now released ID 2004/147 dealing with this issue. The ID confirms the ATO position that neither the trustees nor the beneficiaries “control” a complying super fund for the purposes of sec 152-30.

The ID provides as follows:

Issue

Do the trustees or the members of a complying superannuation fund 'control' the superannuation fund in the way described in section 152-30 of the Income Tax Assessment Act 1997 (ITAA 1997)? Decision No. Neither the trustees nor the members of a complying superannuation fund control the superannuation fund in the way described in section 152-30 of the ITAA 1997. Facts The taxpayer, a company, carries on business. Two individuals (husband and wife) each own 50% of the shares in the company. The two individuals are also the only members and the trustees of a complying superannuation fund. The superannuation fund owns all the units in a unit trust which itself owns certain assets, some of which are used in the company's business. The taxpayer company intends to sell a business asset and seek access to the small business capital gains tax (CGT) concessions in Division 152 of the ITAA 1997. Accordingly, the company must determine whether it satisfies the $5 million maximum net asset value test and, in considering that test, whether the superannuation fund and the unit trust are connected entities. Reasons for Decision Under subsection 152-30(1) of the ITAA 1997 an entity is 'connected with' another entity if either entity controls the other entity in the way described in section 152-30 or both entities are controlled in that way by the same third entity. Under paragraph 152-30(2)(a) of the ITAA 1997, an entity 'controls' another entity if it (together with any small business CGT affiliates) beneficially owns, or has the right to acquire the beneficial ownership of, interests in the other entity that carry between


Selling a Small Business – The CGT Strategies them the right to receive at least 40% of any distribution of income and capital by the other entity. However, the members of a complying superannuation fund do not beneficially own, or have the right to acquire beneficial ownership of, interests carrying the right to distributions of income or capital. Moreover, a superannuation fund does not distribute income or capital as such, but rather pays benefits on the occurrence of certain events. Similarly, the trustees of a complying superannuation fund also do not beneficially own, or have the right to acquire beneficial ownership of, interests in the fund carrying the right to receive distributions of income or capital. Accordingly, neither the trustees nor the members of a complying superannuation fund control the fund under paragraph 152-30(2)(a) of the ITAA 1997. Further, as a complying superannuation fund will not be a discretionary trust, the control rules in paragraph 152-30(2)(c) and subsection 152-30(5) will not apply to make the trustees or the members control the fund. Therefore, neither the trustees nor the members of a complying superannuation fund control the fund in the way described in section 152-30. In this particular case, although the two individuals both control the taxpayer company under paragraph 152-30(2)(b) of the ITAA 1997 (they both own 50% of the shares in the company), the superannuation fund and the company are not controlled by the same third entity and are therefore not connected under paragraph 152-30(1)(b) because the individuals do not control the fund. On a similar basis, the unit trust and the company are also not connected. It is also considered that neither the members nor the trustees of a complying superannuation fund are small business CGT affiliates of the fund under paragraph 152-25(1)(b) of the ITAA 1997. Therefore, although the two individuals both control the company, the superannuation fund itself does not control the company (via the aggregation of its affiliates' interests) under subsection 152-30(2) of the ITAA 1997, because the individuals are not small business CGT affiliates of the fund, and therefore the fund is not connected with the company under paragraph 152-30(1)(a). Date of decision: 19 December 2003

Despite this ID, in certain circumstances it may be possible to argue that a member of a find is a controller and that the assets of the fund are active assets. Moreover, it is doubtful whether the ATO view that the members of a fund are not the beneficial owners of a fund’s assets, particularly in the case of one or two member funds or where a member has become entitled to receive assets in the fund, cf sec 152-30(2)(a) where a member has a right to acquire the beneficial ownership of interests that entitle the member to at least 40% of the capital interests held by the fund. A careful consideration of the terms of the trust will be necessary before accepting the ATO position in such cases.

¶2.0395 Involuntary disposals

Section 152-45 ITAA 97 extends the active asset concept to certain cases where an asset has been compulsorily acquired or where a taxpayer has received an asset for which there has been roll-over relief in relation to a marriage breakdown. The section is set out below:



152-45 Continuing time periods for involuntary disposals

Assets compulsory acquired, lost or destroyed

(1) If a * CGT asset is an asset (the new asset) you acquired to satisfy the requirement in subsection 124- 70(2) or 124-75(2) for a roll-over under Subdivision 124-B, then the active asset test in section 152- 35 applies as if:

(a) you had acquired the new asset when you acquired the old asset; and

(b) the new asset had been your * active asset at all times when the original asset was your active asset; and

(c) the new asset had not been your active asset at all times when the original asset was not your active asset.

Note 1: Subdivision 124-B allows you to choose a roll-over if your CGT asset is compulsorily acquired, lost or destroyed.

Note 2: If this subsection applies to a CGT asset, then section 152- 115 (which is about continuing time periods) will apply for the 15-year exemption.

Marriage breakdowns

(2) If you were the transferee of a * CGT asset for which there has been a roll-over under Subdivision 126-A, then you may choose that the active asset test in section 152- 35 applies as if:

(a) you had acquired the asset when the transferor acquired the asset; and

(b) the asset had been an * active asset of yours at all times when the asset was an active asset of the transferor; and

(c) the asset had not been an active asset of yours at all times when the asset was not an active asset of the transferor.

Note 1: Section 103- 25 tells you when the choice must be made.

Note 2: There is a roll-over under Subdivision 126-A if CGT assets are transferred because of a marriage breakdown.

Note 3: If you don't make the choice, the time of acquisition is simply the time of the transfer.

Note 4: Making the choice here has certain consequences for the 15-year exemption: see section 152-115.

The provision seeks to ensure that the replacement assets in the case of a compulsory acquisition under sec 124-70(2) or 124-75(2), and the rolled over assets under a marriage breakdown, can be treated as active assets as if there had been no change of ownership in the original assets.

¶2.040 CONTROLLING INDIVIDUAL TEST

As mentioned above (¶2.010) the controlling individual test is an important test under the small business relief provisions providing as it does the basis for relief at the entity ownership level rather than relief to the direct owner of the business assets. The test is also important for the retirement exemption (see ¶3.000) where a business is conducted through a company or trust and the business assets are disposed of.

The related “CGT concession stakeholder” concept was introduced to provide relief for spouses of controlling individuals, and is discussed at ¶2.050 below.

Section 152-50 ITAA 97 states simply that an entity satisfies the controlling individual test if the entity had at least one controlling individual, just before the CGT event.

Section 152-55 ITAA 97 defines who can be a controlling individual in relation to companies and trusts. It is an important provision and is set out below:



152-55 Meaning of controlling individual

Companies

(1) An individual is a controlling individual of a company at a time if, at that time, the individual holds the legal and equitable interests in *shares, other than *redeemable shares, that carry (between them) the right to exercise at least 50% of the voting power in the company and receive at least 50% of any *dividend the company may pay and of any distribution of capital the company may make.

Trusts

(2) An individual is a controlling individual of a trust (where entities have entitlements to all the income and capital of the trust) at a time if, at that time, the individual is beneficially entitled to at least 50% of the income and capital of the trust.

(3) An individual is a controlling individual of a trust (where entities do not have entitlements to all the income and capital of the trust) at a time if, during the income year in which the time occurs: (a) the trust made a distribution of income or capital, or both; and (b) the individual was beneficially entitled to at least 50% of the total of the

distributions of income made by the trust during the income year; and (c) the individual was beneficially entitled to at least 50% of the total of the

distributions of capital made by the trust during the income year.

As was previously the case under Divisions 17A and 17B of Part IIIA ITAA 36 and under the rewritten Divisions, there continues to be a requirement that, for an individual to be a controlling individual, the individual must have at least 50% of the legal and equitable interests in the company. However, under the new provisions the individual need not be also an employee of the company. This relaxation also applies to trusts. For practical purposes, discussed below at ¶5.040, it is important that the controlling individual be an employee.

It was indicated by the Treasurer in his Press Release of 21 September 1999 that there was to be some relaxing of the controlling individual requirements to recognise a wider range of interests. This was interpreted as enabling an individual with, say, less than a 50% interest in a company or trust to be recognised as a controlling individual. This has not occurred, but a new concept, as noted above, of “CGT concession stakeholder” has been introduced instead (discussed below) which will allow the spouse of a controlling individual with less than a 50% share or trust interest to benefit from the CGT concessions, provided there is in fact a controlling individual with at least a 50% interest in the shares or units, as the case may be.

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 (see at ¶2.020 above).

As was the case in the earlier version of the definition of “controlling individual” in relation to a trust interest, a distinction is drawn between fixed trusts and other trusts. Particular care needs to be taken here to ensure that what appears to be a unit or other fixed trust is in fact a trust that meets the requirements of a fixed trust being one under which a beneficiary is beneficially entitled to at least 50% of both the income and the capital of the trust. Where a trustee of a trust has some discretionary powers of distribution in respect of some part of the income of the trust income this may be sufficient to preclude a fixed beneficiary of a right to 50% of the income or capital. If the right to receive distributions varies from year to year, this may also be sufficient to disqualify an individual controller.

A careful reading of the trust deed will usually be sufficient to determine this.


Selling a Small Business – The CGT Strategies (Note that there is a definition of “fixed entitlement” in sec 995-1(1) but the reference in sec 152-55 is to “entitlement” so that definition does not apply here.)

The requirement as to an entitlement to 50% of the capital of a fixed trust should be read, as is explicit in the case of a company, as being entitled to 50% of the capital of a trust upon its winding up.

ID 2003/455 confirms that there cannot be a controlling individual of a unit trust if all the units are held by a discretionary trust even if the discretionary trust makes appropriate distributions to an individual.

In the case of a deceased estate where there are different beneficiaries as to income and capital, ID 2003/1114 confirms that that there cannot be a controlling individual for the purposes of sec 152-55(2).

ID 2002/813 confirms the ATO view that in determining whether an individual shareholder is a controlling individual different classes of shares, other than redeemable shares, must be taken into account. The ID does not indicate how various classes of shares are to be valued in determining this issue. A common sense approach should be applied. So, for example, if a shareholder held only 50% of the voting shares that were of a class that didn’t carry the rights to dividends, it could not be said that he/she was a controlling individual. He/she would be if in addition to his/her 50% voting non-dividend shares, he/she held 50% of the dividend shares which didn’t carry a right to a vote.

At the National Tax Liaison Group – CGT Subcommittee meeting held on 27 November 2002 the following item was discussed:

6.4. Small business concessions – controlling individual [Sponsor: NIA (additional agenda item)]

The NIA submitted the following additional issue at this meeting: Controlling individual is defined in section 152-55 of the ITAA 1997. It requires that the individual holds shares that carry the right to receive at least 50% of any dividends from the company. Assume a company is controlled by an individual who has 60% of the shares, with full voting, dividend and capital entitlements but there is one D class share issued to a key employee. The D class share has dividend rights only, payable at the discretion of the directors. Does the existence of the D class share affect the ability of the 60% shareholder to pass the controlling individual test?

Tax Office response

Whether the existence of the D class share will affect the ability of the company to pass the controlling individual test broadly depends on whether the interests of the 60% shareholder can potentially be diluted or reduced to below 50%. If a potential distribution to the D class shareholder can reduce the interests of the 60% shareholder to below 50%, then that shareholder does not hold shares that carry between them the right to receive at least 50% of any distribution made. In this situation, the shareholder may receive 60% of a distribution if the discretion to make a distribution to the D class shareholder is not exercised but they may get less than 50% of any distribution if the discretion is exercised. As such, they are not a controlling individual. Alternatively, if the shareholder’s right to receive 60% of any distribution made could not be affected by the exercise of the discretion, then the shareholder would be a controlling individual.


Selling a Small Business – The CGT Strategies In any case, if there was potential to make a distribution on the D class share separately from any other distribution that might be made on the other shares, the company will not have a controlling individual because the 60% shareholder in the above scenario will not have the right to receive at least 50% of the potential D class distribution.

The ATO in ID 2003/348 confirmed that a shareholder of a company who held at least 50% of each of the 2 classes of shares issued by the company would satisfy the controlling individual test. In the case under consideration, the company was able to choose which class of share was entitled to receive dividends. By contrast, in ID 2003/746 the fact that there was no single shareholder holding at least 50% of all the classes of shares meant that the discretion to make distributions to any shareholder class precluded the company from being able to have a controlling individual for the purposes of sec 152-55(1), see also ID 2003/811.

Does a distribution of income or capital for the purposes of sec 152-55(3) need to be assessable income or capital?

There does not appear to be any requirement in sec 152-55(3) for a distribution to be out of assessable income or capital. So, for example, if losses in a trust were such as to eliminate assessable income or capital gains from the trust, the trust could still make a distribution of income or capital which would satisfy the requirement in sec 152-55(3). The fact that sec 152-55(3) doesn’t refer to “assessable” income is understandable in that the focus of the provision is on determining control, not assessability as in say sec 115-215(2)(b).


Section 152-55(3) ITAA 97 represents a significant relaxation of the former requirements in respect of “controlling individuals” of discretionary trusts. Effectively all that is required under sec 152-55(3) for a person to be a “controlling individual” is that there must be made, during the year of income in which the relevant CGT event took place, a distribution to the person of at least 50% of the total distributions made during the income year. In previous editions of this Portfolio the view was expressed that what this meant from a practical point of view was that the controller of the trust needed to ensure that the trustee makes a distribution to him/her of a nominal amount and makes no other distribution. This was suggested to ensure that the controller had received at least 50% of the distributions made as at the time of the relevant CGT event. It was also suggested that if there needed to be two “controlling individuals”, then each could receive the same nominal distribution.

The ATO has confirmed that the words “at a time” in sec 152-55(3) are intended to mean that as long as there has been a 50% or more distribution to an individual at a time during the relevant income year (i.e. the year of income that the capital gain was realised) then that individual will be a controlling individual of the trust for the purposes of Division 152.

Example

Syd, who is 65, runs a gift shop through a discretionary trust and decides to retire. The business is sold for $250,000 representing a capital gain of $200,000 for the trust. Syd decides to choose the retirement exemption and the trust distributes to Syd the entire proceeds of the sale – there have been no other distributions during the year of income prior to that date. Therefore Syd will be a “controlling individual” of the trust just before the sale (see sec 152-50) and eligible to receive the capital gain on the sale of the business under the retirement exemption tax free, assuming he is otherwise eligible, see ¶5.050 below.

Whilst the ATO view is generous and is not doubted, there is merit still in making a nominal distribution to a beneficiary/beneficiaries who is/are intended to be the controlling individuals in relation to a capital gain. The ATO view also presents a potential trap where, for example,


Selling a Small Business – The CGT Strategies the proceeds of the gain must be distributed as an ETP to the proposed controlling individual (see 152-305 ITAA 97). Will the payment of an ETP be accepted as a distribution of capital or income of the trust? Whilst the answer is probably “yes”, care needs to be exercised.

Note also that sec 152-55(3) does not make provision in the case of a discretionary trust that does not make a distribution in a particular year of income, since for most purposes the only relevant income year is the year in which the CGT event occurs and an appropriate distribution can be made then. However, provision is made under the 15-year exemption in Subdivision 152-B (sec 152-120) where the requirement for a controlling individual in the case of a discretionary trust is waived where no distribution is made during a loss year. Under the 15-year exemption there must be a “controlling individual” during the whole 15-year period.

¶2.042 The treatment of the small business concessions and consolidation

At the 11 June 2003 meeting of the National Tax Liaison Group – CGT Subcommittee the CPAA and ICAA raised concern about the potential interaction between the small business concessions and the consolidation provisions. The Minutes record the following discussion:

Is the ATO able to clarify how the small business CGT concessions will operate within the context of consolidation? Specifically, in order for a company to claim the 15 year exemption, it must have continuously owned the CGT asset for the whole period and it must have had a controlling individual test at all times during the ownership period. Prior to the introduction of consolidation, where an asset was rolled over, the 15 year period would restart subject to an exception where the roll-over was attributable to a marriage breakdown or an involuntary disposal. Under consolidation however, a consolidated group is to be treated as a single entity and transfers of assets are permitted without taxation consequences within a consolidated group. Assuming that a consolidated group satisfies the basic conditions as set out in Subdivision 152-A of the ITAA 1997, how will the small business CGT concessions be applied under consolidation? By way of example, Company A wholly owns Company B. Company A is owned by shareholder A and B each of whom has a 50% interest (i.e. they satisfy the controlling individual test for Company A). Company A and Company B elect to consolidate. At the time of consolidating, Company B has owned an asset for 14 years. Two years after the group has consolidated, the asset is disposed of for a capital gain of $2,000,000. Is company A able to claim the 15 year exemption under the single entity concept? Would it make any difference if the asset was transferred from Company B to Company A after the consolidated group had formed? At the last meeting of the committee, the ICAA stated that there was a need to identify CGT issues associated with the implementation of the consolidations regime. The ATO advised that the Losses and CGT Centre of Expertise would have a report prepared at and available at this meeting identifying all CGT issues that interact with consolidations. (This matter raised by the ICAA relates to update on consolidation and CGT issues at agenda item 3.1). (i) As an example, can the ATO advise how the controlling individual test in section 152-50 of the ITAA 1997 applies where there is a consolidated group of companies? Attention is drawn to the position of a consolidated group that satisfies the $5 million net assets test in Div 152. A subsidiary company sells its assets. In the normal course of considering access to the retirement exemption, the case will fail as the subsidiary


Selling a Small Business – The CGT Strategies does not have a controlling individual. However (broadly speaking) section 701-1 indicates that the group is regarded as the taxpayer. If the ultimate parent which is the head company has a controlling individual then the impact of section 701-1 would appear to provide that the controlling individual test is satisfied in a consolidated group. Please confirm. (ii) Similarly, there is a head company with Subco 1, which in turn owns Subco 2 which are all in a consolidated group. If Subco 1 sells its shares in Subco 2 and head company has a controlling individual, will that satisfy the controlling individual test on the single entity basis? We are not aware of any specific relevant exclusion in the consolidation rules that the single entity rule does not operate for Div 152.

ATO comments

The consolidation and CGT provisions do not contain any modifications relating to the interactions between consolidation and the small business CGT concessions. These matters are being raised with the Consolidation Centre of Expertise.

A recently issued ID, ID 2004/43, considers the position of the application of the retirement exemption provisions in the case of a consolidated small business consisting of a head company and a subsidiary that carried on a business. The ATO confirmed that the concession would be available in this case on the basis that the consolidated entity was treated for tax purposes as a single entity. ID 2004/43 has now been withdrawn and is replaced by TD 2004/D16 which confirms the view taken in the ID. See ¶6.000 below.

It is expected that further IDs and Taxation Rulings will be made available to assist practitioners in this area.

¶2.050 CGT CONCESSION STAKEHOLDER

As noted above, the introduction of the “CGT concession stakeholder” concept is a significant change operating from 21 September 1999. The concept enables a spouse of a “controlling individual” who is a shareholder or interest holder under a trust to benefit under the small business concessions. Broadly, it applies where a spouse has less than a 50% interest in the company or trust. For drafting purposes, a CGT concession stakeholder also includes the controlling individual.

The example following sec 152-10(2) ITAA 97 illustrates the concept:

Example: Ann and her spouse Brett carry on a business through a company in which Ann owns 40% of the shares and Brett 60%. Ann sells her shares and wants to claim the small business concessions. The condition in paragraph (a) is satisfied because Brett’s 60% makes him a controlling individual of the company. The condition in paragraph (b) is satisfied because Ann is a CGT concession stakeholder in the company, in that Ann owned some shares just before the CGT event and was the spouse of a controlling individual (Brett) at that time.

The relevant conditions referred to in the above example are that, in relation to a CGT asset that is a share in a company or an interest in a trust, the controlling individual test in sec 152-50 ITAA 97 is satisfied in relation to the entity, and that the taxpayer, to be eligible for a small business concession, must be a CGT concession stakeholder.

Section 152-60 ITAA 97 defines a CGT concession stakeholder, as follows:



152-60 Meaning of CGT concession stakeholder

CGT concession stakeholder of a company or trust means:

(a) a *controlling individual of the company or trust; or (b) in the case of a company—a spouse of a controlling individual of the company, if

the spouse holds the legal and equitable interests in any amount of shares in the company; or

(c) in the case of a trust mentioned in subsection 152-55(2)—a spouse of a controlling individual of the trust, if the spouse is beneficially entitled to any of the income or capital of the trust; or

(d) in the case of a trust mentioned in subsection 152-55(3)—a spouse of a controlling individual of the trust, if, during the income year referred to in that subsection, the trust made a distribution of income or capital to which the spouse was beneficially entitled.

The first point to note about this definition is that under para (b) a spouse who merely holds shares in a company as trustee for their spouse cannot be a CGT concession stakeholder – there must be a legal and equitable interest in the shares held by the spouse. So, for example, in a company with two issued shares, one held by the husband and the other held for the benefit of the husband by his wife, since the wife would not be a CGT concession stakeholder, the retirement exemption (see ¶4.000 below) would only be available in relation to the husband up to his $500,000 lifetime limit, rather than each spouse being entitled to make use of their separate $500,000 lifetime limits. Likewise, where the husband held the legal interest to the shares, one for the benefit of himself and one for his wife, the wife would not be a CGT concession stakeholder.

Section 152-60(c) ITAA 97 applies to fixed trusts, and sec 152-60(d) applies to non-fixed trusts. It is noted that, in relation to a non-fixed trust, the requirement in sec 152-60(d) is that the trust must have made a distribution to the spouse in the income year in which the relevant disposal takes place. As discussed in ¶2.040 above, the distribution cannot be the actual distribution of the concessional gain but needs to be at least a nominal distribution just before the relevant CGT event for the purposes of sec 152-50.

The term “spouse” in sec 152-60 is defined in sec 995-1 ITAA 97 to include persons who, although not legally married, live with one another on a genuine domestic basis as the person’s husband or wife.



Chapter 3

15-year retirement exemption

¶3.000 15-YEAR RETIREMENT EXEMPTION

¶3.001 Losses retained

¶3.010 15-YEAR EXEMPTION FOR INDIVIDUALS

¶3.011 Sale of shares or an interest in a trust

¶3.012 Meaning of “retirement”

¶3.013 Retirement “in connection with” the disposal

¶3.014 Permanent incapacity

¶3.015 Main residence exemption

¶3.020 15-YEAR EXEMPTION FOR COMPANIES AND TRUSTS

¶3.030 INVOLUNTARY DISPOSALS

¶3.040 DISCRETIONARY TRUSTS

¶3.050 PAYMENTS TO CGT CONCESSION STAKEHOLDERS

¶3.051 Pre-CGT gains also exempt when distributed

¶3.060 SALE OF ASSET AFTER “RETIREMENT”

¶3.000 15-YEAR RETIREMENT EXEMPTION

This concession was a late addition to the small business concessions as it was not part of the Ralph Review’s recommendations. On its face it looks quite generous but, upon analysis, it will not be available to many small business taxpayers. In particular, the $5m maximum net asset value test will disqualify many potential beneficiaries for the reasons discussed at ¶2.020 above.

Further, 15 years is a long time to hold an asset in a small business environment and the concession may be counterproductive to some small businesses who may wish to expand or diversify but fear that by doing so they will lose the potential benefit of the concession.

Practice point

The retirement exemption only applies to disposals of assets (which can be existing assets) after 20 September 2000 because, prior to that date, there will be no post-CGT asset that will have been held for the 15-year qualifying period.

Of particular interest is that the exemption applies, as with the other CGT small business concessions, to the disposal of company shares and trust interests where there is a controlling individual.

The 15-year requirement in practice may be difficult for most taxpayers to comply with, even assuming that they have continued in business for the minimum 15-year period.

To illustrate – the 15-year requirement means, in effect, that a business will be the same business for the entire 15-year period where the main source of potential capital gain is likely


Selling a Small Business – The CGT Strategies to arise from the disposal of goodwill. Unless the business is the same business during the whole of that period, the 15-year requirement will not have been complied with.

In the High Court’s decision in FCT v Murry 98 ATC 4585, the Court indicated that where the clientele of a business changes over time (the Paddington pub example), the goodwill may become a different asset. In TR 99/16 this issue is played down to some extent. However, now that the stakes have been raised by providing for a full exemption, the ATO may not be so willing to adopt such a concessionary approach in future.

Another potential problem area is that, for the exemption to apply, a taxpayer must actually retire, unlike the current retirement exemption. It is not clear whether this suggests that there will be a tightening of the current exemption.

¶3.001 Losses retained

Because the exemption enables a taxpayer to totally disregard a capital gain, prior year or current year capital losses are not dissipated and can be used to reduce other capital gains.

¶3.010 15-YEAR EXEMPTION FOR INDIVIDUALS

For the exemption to apply, the following conditions need to be satisfied by an individual (sec 152-105 ITAA 97):

• the basic conditions for CGT small business relief are met;

• the CGT asset has been held continuously for a 15-year period;

• if the CGT asset is a company share or interest in a trust, there must have been a controlling individual during the whole ownership period; and

• the individual must be 55 or over and the disposal of the CGT asset must be in connection with the individual’s retirement; alternatively, the individual is permanently incapacitated at the time of the relevant CGT event.

The four basic conditions are discussed at ¶2.010 above, and in summary are:

• that a CGT event happens in relation to a CGT asset that you own in an income year;

• the CGT event would have given rise to a capital gain;

• the maximum net asset value test must be satisfied; and

• the CGT asset satisfies the active asset test.

Where the basic and additional conditions are met, the exemption is automatic. Section 152-105 ITAA 97 enables an individual meeting them to “disregard” the capital gain in relation to the asset or assets. Since the exemption operates on an asset-by-asset basis, the qualifying conditions need to be tested against each asset disposed of – this means in practice that the asset is an active asset and that it has been held for 15 or more years. The section provides as follows:

152-105 15-year exemption for individuals

If you are an individual, you can disregard any *capital gain arising from a *CGT event if all of the following conditions are satisfied:

(a) the basic conditions in Subdivision 152-A are satisfied for the gain;

(b) you continuously owned the *CGT asset for the 15-year period ending just before the CGT event; Note: Section 152-115 allows for continuation of the period if there is an involuntary

disposal of the asset.


Selling a Small Business – The CGT Strategies (c) if the CGT asset is a *share in a company or an interest in a trust—at all

times during the whole period for which you owned the CGT asset, the company or trust had a *controlling individual (even if it was not the same controlling individual during the whole period); Note: There is an exception for discretionary trusts that have tax losses in an income year:

see section 152-120.

(d) either:

(i) you are 55 or over at the time of the CGT event and the event happens in connection with your retirement; or

(ii) you are permanently incapacitated at the time of the CGT event.

Practice point

When selling a business care is needed to ensure that excessive valuations are not placed on trading stock and plant and equipment, as, although technically CGT assets, any “gains” on their disposal will be assessable as ordinary income.

It should be noted that there is no restriction of the kind of CGT event that may qualify for exemption under the concession.

The ownership period is relatively inflexible in that it must be a continuous period of ownership − it cannot be a broken period that in total amounts to 15 years. There is, however, a limited exception where there has been a compulsory acquisition or a divorce settlement (discussed below), but otherwise the requirement is fixed. Care needs to be exercised to ensure that the 15-year continuous ownership period is in fact satisfied.

Example

Edward has run a health food store since 1970 as a sole trader. He acquired the premises from which it operates on 30 September 1985 for $100,000. The premises are now worth $600,000. He plans to retire in December 2002 when the store will be sold. During the 1992 recession, as a precautionary measure to protect himself against his creditors, Edward executed a transfer on the premises in favour of his wife, which was never registered. Edward did not pay the CGT that would have arisen on the transfer either. It is arguable that Edward would be able to satisfy the 15-year requirement because at best Edward had intended only that his wife hold the premises in trust for him. Since the transfer was never registered, nor, according to Edward, was it ever intended to be registered, it would have no legal effect to pass title (see Brunker v Perpetual Trustee Company Limited (1937) 57 CLR 555).

A more difficult question arises if, say, Edward had provided the premises as security for a loan. It could be argued that the requirement for continuous “ownership” as required by sec 152-105(b) is not met in these circumstances (cf sec 152-55(1) which refers to an individual holding “the legal and equitable interests in shares”). In this regard, it is noted that the exception in sec 104-10(7) ITAA 97 excluding the operation of CGT event A1 where a disposal of an asset is made to provide or redeem a security does not assist in this case because that exception is limited to cases involving CGT event A1. The better view is that merely giving property for security for a loan in normal circumstances would not be sufficient to breach the 15-year ownership requirement. Continuity of ownership may be argued to have been satisfied on the basis that the mortgagor does not part with the essential qualities of ownership but merely some aspects of it which would be insufficient to disqualify the taxpayer under sec 152-105(b).

If, in the above example, Edward’s wife had owned the premises during the whole 15-year period she may be able to qualify under the exemption on the basis that the premises are an


Selling a Small Business – The CGT Strategies active asset (as they are used in a small business CGT affiliate (see sec 152-40(1)(c)(i) ITAA 97)). However, if Edward’s wife was not actively involved in the business and was not otherwise working, she may not be able to satisfy the requirement that the disposal was in connection with her “retirement”. Arguably, “retirement” must involve a cessation from remunerated work. Note, Edward’s wife would qualify for the 50% individual discount and the 50% reduction (assuming she could otherwise satisfy the other eligibility criteria, see ¶4.000).

¶3.011 Sale of shares or an interest in a trust

Where the CGT asset is a share in a company or an interest in a trust, the additional requirement that there be a controlling individual during the “whole period” is curious (but welcome) in that sec 152-105(c) makes clear that it does not have to be the same controlling individual during the whole ownership period. Just why this is so is not clear. It is not discussed in the EM to the NBTS (CGT) Act. Presumably, it is in recognition of the potential difficulties in satisfying the requirement over the 15-year period.

The requirement that there needs to be a controlling individual during the “whole period” of ownership appears to refer to the qualifying period of 15 years (see sec 152-105(c)) rather than to a longer ownership period, if any. This is consistent with the approach adopted in sec 152-35 where only the last 15 years is considered for the purpose of the active asset test. However, the better view is that the requirement applies to the whole period of ownership.

The requirement in sec 152-105(c) needs to be linked to the requirement in sec 152-50 as part of the basic conditions that the company or trust must have a controlling individual just before the relevant CGT event, and that sec 152-10(2)(b) requires the taxpayer to be a CGT concession stakeholder (i.e. a “controlling individual” or a spouse of the controlling individual). So, while there must be a controlling individual just before the sale of the shares or interest in a trust under sec 152-50, there is no requirement that the controlling individual must sell his/her interest for the exemption to be available to a CGT concession stakeholder who is not a “controlling individual”.

Example

Michaela holds 20% of the shares in Small Business Pty Ltd which operates a mushroom farm. The company has owned the farm since October 1987 when the company was formed. The company has been owned by two controlling individuals since that time and Michaela has held her shares continuously since that time. The current controlling individual, Rex, is Michaela’s husband, and has held his 80% interest since 1990. He acquired his interest from Ray’s estate. Ray had started the farm with Michaela in 1985. Michaela wants to retire in November 2002 and sell her shares to Rex and claim the 15-year exemption as she believes that all the other conditions will be able to be satisfied. She will be eligible to claim the exemption as she will have held her shares for 15 years at that time, she is a CGT concession stakeholder and there has been a controlling individual during the whole of the 15 years prior to the CGT event (i.e. the sale of her shares).

Note the 15-year period is calculated from the date of the CGT event happening to the CGT assets the subject of the exemption. Note also that for shares to be eligible under the 15-year exemption, the relevant entity must satisfy the 80% test in sec 152-40 (see ¶2.030).

Example

Continuing the above example, unbeknown to Michaela, Ray held half of his 80% shareholding in trust for James, his silent partner.


Selling a Small Business – The CGT Strategies In this example, Michaela will not be eligible for the exemption since there was not a controlling individual during the whole of the 15 years before the sale of the shares as, although Ray held the legal title to the shares, he only held 40% of the beneficial interest in those shares with James holding the other 40%. The ATO may have information as to the interest of James since, when Ray transferred the shares to Rex, James declared his capital gain on the shares in his return for the 1991 income year. Since Michaela has no knowledge of the arrangement between Ray and James, she claims the exemption. On an audit four years later Michaela is subjected to a 75% culpability penalty plus interest on her capital gain of $100,000 as the ATO auditors maintain that she must have known that Ray was not a controlling individual (see TR 94/4).

¶3.012 Meaning of “retirement”

There is no definition of “retirement” in new Division 152, nor in Parts 3-1 or 3-3 (ITAA 97) (c.f., however, sec 26AC ITAA 36), nor was there a definition in Division 118-F since the retirement exemption did not impose a retirement condition under those provisions. The EM contains no additional guidance. The word, however, is used in the context of a person being 55 or over (i.e. the usual minimum retiring age) and so would indicate that for the exemption to apply the taxpayer must actually retire in the usual sense of that word. The alternative condition is that the taxpayer is permanently incapacitated. Just what “retirement” means in the current economic environment is not so clear. It would seem that, provided the taxpayer’s active income-earning activities ceased either wholly or substantially, this would be sufficient. It would be doubtful if a taxpayer had no intention of actually retiring from the workforce and merely ceased working in the business disposed of with a view to looking for other full-time work after the sale. Given that it is not uncommon for a retiree to undertake some part-time work after retirement or perhaps re-enter the workforce subsequent to retirement, it is arguable that neither event would preclude a taxpayer from satisfying the retirement condition for the purposes of the exemption, provided that, at the time of the relevant CGT event, there was an intention to genuinely retire. It would appear that the question as to whether a person has retired is a question of fact (see Sukumaran v FCT (2000) 44 ATR 537).

ID 2003/864, reproduced below, is instructive as to the ATO’s current thinking on what constitutes “retirement”:

Issue

If a taxpayer sells their business, ceases to be self employed and then commences some employment with another party on a much reduced scale, is there a ‘retirement’ under subparagraph 152-105(d)(i) of the Income Tax Assessment Act 1997 (ITAA 1997) for the purposes of the small business 15-year exemption? Decision Yes. In the particular circumstances described, there is a ‘retirement’ under subparagraph 152-105(d)(i) of the ITAA 1997 for the purposes of the small business 15-year exemption, even though the taxpayer has not permanently left the workforce. Facts The taxpayer, a sole trader, sold the business they had carried on for many years and made a capital gain on the disposal of the land used to conduct the business. The taxpayer owned the land for at least 15 years and was over 55 at the time of the sale. The taxpayer agreed to be employed by the new owner for a few hours each week for two years. Reasons for Decision


Selling a Small Business – The CGT Strategies One of the conditions that must be satisfied to qualify for the small business 15-year exemption is that the relevant individual must be either:

• 55 or over at the time of the CGT event giving rise to the capital gain and the event happens in connection with their retirement; or

• permanently incapacitated at that time (paragraphs 152-105(d) and 152-110(1)(d) of the ITAA 1997).

Therefore, unless the individual is permanently incapacitated at the time of the CGT event the individual must retire and the CGT event must happen in connection with that retirement. Whether there is a ‘retirement’ for the purposes of the 15-year exemption will depend on the circumstances of each particular case. However, it is considered for the term to be satisfied, there must at least be a significant reduction in the number of hours the individual is engaged in present activities, or a significant change in the nature of present activities. It is not necessary for there to be a permanent and everlasting retirement from the workforce. In this case, the taxpayer sold the business they had conducted for many years and in doing so permanently or indefinitely ceased their activity of being self employed. The taxpayer was over 55 at the time. As part of the arrangements, the taxpayer agreed to be employed by the new owner on a much reduced scale, that is, for a few hours a week for two years, compared with the level of his previous activities. Having regard to all the facts it is considered these circumstances constitute a ‘retirement’ under subparagraph 152-105(d)(i) of the ITAA 1997 for the purposes of the small business 15-year exemption and the sale of the land happened in connection with that retirement. The exemption will be available if the other conditions are satisfied. Date of decision: 3 September 2003

Practice point

The requirement should not ordinarily preclude a small business owner from acting as a consultant to the new owner following the sale of the business. Care will need to be taken in drafting the sale contract to ensure that it is clear that the former owner’s obligations to assist the new owner are not inconsistent with the retirement condition.

¶3.013 Retirement “in connection with” the disposal

Another issue that arises is that it appears that the retirement must be “in connection with” the disposal. This raises the question whether there must be something more than an incidental connection. In other words, is the fact that a taxpayer ceased working in his/her business once it is sold simply a necessary consequence of the sale, or is something more required for it to be a sufficient connection? It would appear that it is a sufficient connection if the cessation is part of a desire on the part of the taxpayer to actually retire from the workforce. The examples in the EM to the NBTS (CGT) Act are consistent with this view (see also the ATO's view at ¶3.060 below set out in ID 2001/606).

¶3.014 Permanent incapacity

ID 2003/328 discusses the meaning of “permanent incapacity”. The ID is reproduced below:



Issue

For the purposes of the small business 15-year exemption, was the taxpayer ‘permanently incapacitated at the time of the CGT event’ as required by subparagraph 152-105(d)(ii) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. For the purposes of the small business 15-year exemption, the taxpayer was ‘permanently incapacitated at the time of the CGT event’ as required by subparagraph 152-105(d)(ii) of the ITAA 1997.

Facts

The taxpayer was a partner in a partnership that acquired a business after 19 September 1985. The taxpayer developed certain health problems that continued to deteriorate. They became incapable of effectively operating the business. The business was sold during the income year ended 30 June 2003. At the time of the sale the taxpayer was under 55 years of age. The taxpayer's doctor stated in writing at the time the business was sold that the taxpayer ‘suffers ill health to the extent that they are unlikely to be able to engage again in gainful employment for which they are reasonably qualified, trained or experienced’.


Under the small business 15-year exemption in section 152-105 of the ITAA 1997, an individual can disregard a capital gain arising from a CGT asset they have owned for at least 15 years if certain conditions are satisfied. One of those conditions is that the individual is either 55 or over at the time of the CGT event and the event happens in connection with their retirement; or the individual is permanently incapacitated at the time of the CGT event. The term ‘permanent incapacity’ is used elsewhere within the retirement and superannuation provisions of the law and its meaning in those provisions may assist in providing some indication of its meaning for the purposes of the small business 15-year exemption. Having regard to the other provisions in which the term is used, a broadly indicative description of permanent incapacity is: ill health (whether physical or mental), where it is reasonable to consider that the person is unlikely, because of the ill-health, to engage again in gainful employment for which the person is reasonably qualified by education, training or experience. The incapacity does not necessarily need to be permanent in the sense of everlasting. In this case the taxpayer developed severe health problems that deteriorated to the point where they are incapable of operating the business and, as a result, the business was sold. In these circumstances, it is considered that, at the time of the CGT event, the taxpayer is unlikely to be able to engage again in gainful employment for which they are reasonably qualified and this is supported by medical evidence. Accordingly, it is considered the taxpayer was ‘permanently incapacitated at the time of the CGT event’ for the purposes of subparagraph 152-105(d)(ii) of the ITAA 1997. The taxpayer may therefore qualify for the small business 15-year exemption if the other conditions for exemption are satisfied. Date of decision: 3 April 2003

¶3.015 Main residence exemption


Selling a Small Business – The CGT Strategies Where the main residence exemption is available in part to a taxpayer who works from home, the 15-year exemption may be available to exempt that part of the non-exempt gain arising on the disposal of the home, c.f. sec 152-215.

¶3.020 15-YEAR EXEMPTION FOR COMPANIES AND TRUSTS

Section 152-110 ITAA 97 sets out the conditions for the exemption to apply where a company or trust disposes of active assets that have been held for 15 or more years. The section broadly follows the requirements of the exemption for individuals but applies them at the entity level.

For the exemption to apply, the following conditions need to be satisfied by the company or trust (sec 152-110):

• the basic conditions for CGT small business relief are met;

• the CGT asset has been held by the entity continuously for a 15-year period;

• at all times during the whole period for which the entity owned the asset, the entity had a controlling individual (but not necessarily the same one); and

• an individual who was a controlling individual of the company or trust must be 55 or over and the disposal of the CGT asset must be in connection with the individual’s retirement; alternatively, the individual is permanently incapacitated at the time of the CGT event.

The four basic conditions are discussed at ¶2.010 above, and in summary are:



• the maximum net asset value test is satisfied; and


The section provides as follows:

152-110 15-year exemption for companies and trusts

(1) An entity that is a company or trust can disregard any *capital gain arising from a *CGT event if all of the following conditions are satisfied:

(a) the basic conditions in Subdivision 152-A are satisfied for the gain;

(b) the entity continuously owned the *CGT asset for the 15-year period ending just before the CGT event; Note: Section 152-115 allows for continuation of the period if there is an involuntary

disposal of the asset.

(c) at all times during the whole period for which the entity owned the asset, the entity had a *controlling individual (even if it was not the same controlling individual during the whole period); Note: There is an exception for discretionary trusts that have tax losses in an income

year: see section 152-120.

(d) an individual who was a controlling individual of the company or trust just before the CGT event either:

(i) was 55 or over at that time and the event happened in connection with the individual’s retirement; or

(ii) was permanently incapacitated at that time.



(2) Any *ordinary income or *statutory income the company or trust *derives from a *CGT event that would be covered by subsection (1) (assuming the event gave rise to a *capital gain, even if it didn’t) is neither assessable income nor *exempt income.

Note subsec (2) amended by Act No. 66 2003 as part of the measure to standardise the treatment of non-assessable non-exempt income. The amendment added the words, “*ordinary income or *statutory” after the word, “any”.

Practice point

Where the basic and additional conditions are met, the exemption from CGT is automatic (see sec 152-110(1) ITAA 97). What is interesting is that sec 152-110(2) seeks to ensure that there can be no assessable income from the CGT event, nor will it be treated as exempt income. But for this provision, it could be argued by the ATO in a particular case that, although an exemption from CGT applies, the proceeds from the CGT event are ordinary income and are, therefore, assessable. The EM contains no discussion of this issue. After 15 years of ownership though, one might presume that there is little likelihood that any profits from the sale of the business would be treated as assessable income. Of course, that is not how the law operates.

Note: There is no equivalent provision that applies in relation to the main residence exemption and so, in the absence of such a provision, it remains possible in an appropriate case for the ATO to treat the proceeds of the sale of a home that is exempt from CGT as ordinary income.

Since the exemption operates on an asset-by-asset basis, the qualifying conditions need to be tested against each asset disposed of.

TD 2004/D14 confirms the ATO view that the period of ownership of an asset held by a subsidiary member who brings it into a consolidated group can be counted for the purpose of satisfying the 15 year requirement in par 152-110(1)(b). See also TD 2004/D15 which confirms the ATO view that the transfer of an asset within a consolidated group doesn’t affect eligibility under sec 152-110.

As with the exemption applying at the individual level, there is no restriction on the kind of CGT event that may qualify for exemption under the concession. One difference to note, however, is that where the exemption applies to a company or trust the company or trust cannot apply the exemption to shares or interests in a trust that it disposes of. This is because of the requirement under sec 152-10(2)(b), whereby the relevant taxpayer (i.e. a company or trust) must be a CGT concession stakeholder in the company or trust in which it holds the shares or interests. Since a company or trust cannot be a “controlling individual” or have a “spouse”, by definition a company or trust cannot be a CGT concession stakeholder in another entity.

Let’s see how the exemption might work in a typical business situation.

Example

Martin runs a coffee shop through a discretionary trust which he has operated since December 1988. Martin set up the business at that time and has run the business profitably in each year of operation distributing to himself the profits annually. The goodwill is now considerable and he plans to retire in December 2004 when he turns 55, assuming he can find a buyer for the business. The clientele of the business has changed somewhat over the last 15 years. Although still operating from the same premises, when the business opened it catered to students and provided inexpensive light meals.


Selling a Small Business – The CGT Strategies Now Martin prides himself on being able to offer 40 different coffee blends and, consequently, many of his customers are coffee connoisseurs. It is assumed that Martin’s trust can satisfy the basic conditions. The question arises whether the trust will have continuously owned the goodwill of the business for 15 years. This turns on whether the ATO will accept that the goodwill of the business now is the same goodwill as when the business was commenced. In accordance with TR 99/16, it is likely that the ATO would accept that the essential character of the business has not changed – it is still a coffee shop even though it has developed to cater for a more sophisticated clientele. Martin will satisfy the requirement that there was a controlling individual during the whole of the ownership period since he has received at least 50% of the distributions in each year of operation. Provided he does not sell the business before he turns 55, he will meet the age requirement. He will then need to retire. Accordingly, under sec 152-110(2) ITAA 97 the capital gain from the disposal of the goodwill of the business would be neither assessable nor exempt in the hands of the operating trust or beneficiary (see ¶3.050 below).

The requirement that there needs to be a controlling individual at all times during the “whole period” of ownership does not appear in sec 152-110 to refer to only the qualifying period of 15 years, c.f. sec 152-105(c), discussed at ¶3.010 above. This is not consistent with the approach adopted in sec 152-35 where only the last 15 years is considered for the purpose of the active asset test. Whilst it can perhaps be argued that only the last 15-year period is relevant, the better view is that the requirement applies to the whole period of ownership.

¶3.030 INVOLUNTARY DISPOSALS

Section 152-115 ITAA 97 makes specific provision for cases where an involuntary disposal of a CGT asset has occurred to enable the taxpayer to treat any replacement asset as having been acquired at the time the original asset was acquired, for the purposes the 15-year exemption. The section applies in two situations: where roll-over has been chosen under Subdivision 124-B ITAA 97 where a CGT asset is compulsorily acquired, lost or destroyed; and where there has been a roll-over because of a marriage breakdown.

Continuity will be assured under sec 152-115(1) where either a taxpayer receives a replacement asset, with or without additional compensation (see sec 124-70(2) ITAA 97), or where the taxpayer has received compensation money and has either purchased a replacement asset or incurred expenditure to repair or restore the original asset (see sec 124-75(2) ITAA 97).

Under sec 152-115(2) specific provision is made where a taxpayer has applied roll-over in relation to an asset that has been acquired because of a marriage breakdown. This provision is linked to sec 152-45, discussed above at ¶2.030, which provides for continuity for the purpose of the active asset test. If a choice is made under sec 152-45, then the taxpayer is automatically treated as having acquired the asset at the time the asset was acquired by the former spouse.

The minutes of the National Tax Liaison Group CGT Subcommittee meeting of 27 November 2002 record, as follows:

6.2. Rollover under Subdivision 122-A or 122-B and the small business concessions (Sponsor: NIA)

An individual taxpayer rolls over their business or partnership interest to a company under a Subdivision 122-A or 122-B rollover and the business assets have been held for say 10 to 20 years. The business is expected to continue for the foreseeable future in the company until the individual(s) retire in say 10 years (the main reason for the rollover is to limit the liability of the individuals from litigation). However, if they sell the business on retirement they will not be entitled to the 15 year exemption on


Selling a Small Business – The CGT Strategies disposal of the business assets by the company because the assets have not been held by the company for more than 15 years. This is despite the fact that the taxpayer/partners have had control over the assets for more than 15 years. Contrast this with the situation where the business was run through the company for the whole time the assets were held, that is, for more than 15 years. In this case the company would be entitled to the 15 year exemption and would be able to pay the exempt capital gain out to the controlling shareholder/s tax free. This seems to be inconsistent in that the taxpayer/partners will have an underlying ownership and control for more than the 15-year period in both situations. Could the Tax Office give any explanation of this inconsistency?

Tax Office response

The Tax Office stated that the requirement in the 15 year exemption for continual ownership of at least 15 years is not based on any indirect or underlying ownership but rather direct ownership by the relevant entity making the gain. There are only limited situations where prior periods can be taken into account and these are compulsory acquisition, loss or destruction and marriage breakdown (which are all forms of involuntary disposals). The legislation reflects the stated policy that if an asset is subject to a rollover (other than as a result of an involuntary rollover provision) the period of ownership commences again. Therefore, the clock is reset for rollovers other than involuntary rollovers.

¶3.040 DISCRETIONARY TRUSTS

Section 152-120 seeks to alleviate the requirement in the controlling individual test as it applies in relation to a discretionary trust whereby for a discretionary trust to have a controlling individual in a year of income, an individual must have received 50% or more of the income from the trust in that year. What sec 152-120 does is to relieve an entity of that requirement where the trust “did not make a distribution of income or capital if the trust had a *tax loss for that income year”. Note that the provision does not apply where the trust did not make a distribution because it merely broke even for the relevant year or it otherwise did not make a tax loss. “Tax loss” is defined in sec 995-1 to mean a tax loss worked out under sec 36-10, 165-70 or 175-35 ITAA 97. Note there are some qualifications mentioned following the definition, in particular, reference is made to sec 268-60 of Sch 2F of ITAA 36 about how to work out a trust tax loss.

The application of the relief mechanism in sec 152-120 is obvious where, for example, the 15-year exemption is applies at the trust level. However, sec 152-120 is also expressed to apply where an individual applies the exemption in relation to a trust interest. Normally this would only be likely to occur where the taxpayer has a fixed interest in the trust. However, because of the dichotomy of trusts into fixed trusts and other trusts in sec 152-55(2) and (3), sec 152-120 can usefully apply at an individual level where the trust is not a fixed trust as defined in sec 152-55(2) but there are beneficiaries, or a beneficiary, who have or has an “interest” in the trust.

Example

Recalling the previous example, Martin runs a coffee shop through a discretionary trust which he has operated since December 1988. Martin set up the business at that time and has run the business profitably in each year of operation, distributing to himself the profits annually. If under the terms of the trust Martin has a right to 50% of the capital and income and the trustee has a discretionary power to make Martin and others in a defined class distributions of the balance of the income or capital, Martin would have an interest in the trust, but the trust would not be a fixed trust within sec 152-55(2).


Selling a Small Business – The CGT Strategies Martin may be able to sell his interest in the trust, and, if so, could claim the 15-year exemption in relation to the interest, assuming that all other conditions are satisfied, although it is more likely that he would only be able to sell the business assets in the trust.

¶3.050 PAYMENTS TO CGT CONCESSION STAKEHOLDERS

Section 152-125 ITAA 97 ensures that payments by a company or trust to the shareholders or interest holders who are CGT concession stakeholders will be exempt from tax (both CGT and ordinary income tax) where any payment is made, within two years after the CGT event, up to the amount of the capital gain. The section provides as follows:

152-125 Payments to company’s or trust’s CGT concession stakeholders are

exempt

(1) This section applies if:

(a) under section 152-110, a *capital gain of a company or trust is disregarded; or

(b) under section 152-110, an amount of income is treated as neither assessable income nor *exempt income of the company or trust; or

(c) paragraph (a) of this subsection would have applied to an amount except that the *capital gain was disregarded anyway because the relevant *CGT asset was *acquired before 20 September 1985.

In this section, that amount is called the exempt amount.

(2) Any payment the company or trust makes (whether directly or indirectly through one or more interposed entities) within 2 years after the *CGT event to an individual who was a *CGT concession stakeholder of the company or trust just before the event is not taken into account in determining the taxable income of the company or trust, the individual or any of the interposed entities.

(3) However, subsection (2) applies only to the extent that the total of the payments made by the company or trust to a particular *CGT concession stakeholder for an exempt amount does not exceed the following limit:

Stakeholder' s controlpercentage Exempt amount×

where:

s

(a) by the CGT

(b) cession

(c) a single

(d) ad 2 CGT concession stakeholders just before the CGT event—50% each.

takeholder’s control percentage means:

in the case of a company—the percentage of the interests in *shares in the company of the kind mentioned in subsection 152-55(1) heldconcession stakeholder just before the *CGT event; or

in the case of a trust mentioned in subsection 152-55(2)—the percentage of the income and capital of the trust to which the CGT constakeholder was beneficially entitled just before the CGT event; or

in the case of a trust mentioned in subsection 152-55(3) that had CGT concession stakeholder just before the CGT event—100%; or

in the case of a trust mentioned in subsection 152-55(3) that h



Note that the provision only applies to a CGT concession stakeholder. As discussed above at ¶2.050, a CGT concession stakeholder is limited to an individual controller and his/her spouse where the spouse holds shares in the company or an interest in a trust or receives distributions

stakeholder’s control percentage” in the company as a

e are two CGT concession f the untaxed amount.

The EM provides the following examples:

5-year distribution exemption. The amount mpt

mes for the income year an amount of $6,000 and $4,000 respectively.

n must include the

olling individual in the

needs to be over 55 or permanently incapacitated. Payments to both then will be tax free.

from the trust entity.

The amount of the untaxed payment is further limited by reference to the stakeholder’s interest in the company or trust. In the case of a company, the amount that can be received untaxed by a stakeholder is the “proportion of the untaxed amount.

The rules differ for trusts. If the trust is a fixed trust the calculation is the same as for a shareholder of a company, but based on the percentage of the interest holder’s share of the income and capital. In the case of non-fixed trusts, if there is only one CGT concession stakeholder there is no reduction of the untaxed amount. If therstakeholders each is taken to receive 50% o

Example 1.7

Joe is a controlling individual of Company X, owning 60% of the shares in the company. Joe’s wife, Anne, owns the remaining 40% of the shares in the company. The company makes a capital gain of $10,000 and is able to disregard that capital gain under the small business 15-year exemption as both Joe and Anne are planning to retire. Six months after the CGT event, the company distributes the amount of the exempt capital gain to the shareholders. As CGT concession stakeholders, Joe and Anne both qualify for the small business 1that is exe is calculated as follows: For Joe: 60% of $10,000 = $6,000 For Anne: 40% of $10,000 = $4,000 If it is decided to distribute $8,000 each to Joe and Anne, they can exclude from their assessable inco

Example 1.8

The M family discretionary trust has as its beneficiaries the members of the M family and 2 employees of the family business carried on by the trustee of the trust. Mrs M and Mr M are the controlling individuals of the discretionary trust, and are therefore CGT concession stakeholders. Their 3 children are treated as small business affiliates. The trustee of the trust sells a CGT asset of the business and makes a capital gain of $50,000 that qualifies for the small business 15-year exemption, as Mr M plans to retire from the family business. The trustee distributes that amount equally to Mrs M and Mr M and to the 3 children. As CGT concession stakeholders, Mrs M and Mr M are each able to treat the distribution of $10,000 as an exempt amount. Their 3 childredistribution in their assessable incomes for the year.

This EM example is misleading. Since both Mr and Mrs M are CGT concession stakeholders they would be entitled to distribute the whole of the $50,000 to themselves ($25,000 each – see sec 152-125(3)(d)) “tax free”. It does not make sense to pay $30,000 of the gain to their children who would not be entitled to any concession. Further, payment of three-fifths of the gain to the children might preclude the parents from being contrrelevant income year if there were no other payments made to them.

Under this concession, if there is more than one controlling individual, only one of them


Selling a Small Business – The CGT Strategies As noted above (see Practice Point in relation to sec 152-110(2) (which ensures that no income tax is payable arising from a CGT event by the company or trust)), the approach adopted in Subdivision 152-B is generous. Section 152-125 ITAA 97 may be able to be used to extract tax-free distributions from a company or trust arising from non-CGT profits held in the entity.

Example

The Golden Egg Pty Ltd has operated a manufacturing business for the past 15 years and has built up considerable reserves of approximately $1m. Graeme is the founder of the business and wants to retire as he is now 65. He is a controlling individual in relation to the company holding eight shares, with his wife Sheryl holding the remaining two shares. The goodwill of the business is also worth $1m but with a negligible cost base. It is assumed that the company qualifies for the 15-year exemption upon the sale of the business yielding a $1m capital gain on the goodwill. By virtue of sec 152-110(1) ITAA 97 the company can disregard the capital gain on the goodwill. By sec 152-110(2) any “income” from the sale of the goodwill is neither assessable nor exempt. Under sec 152-125, if within two years of the sale of the goodwill the company makes a distribution of the $1m in reserves in proportion to their shareholding to Graeme (as to $800,000) and Sheryl ($200,000), the distribution is totally tax free. Graeme and Sheryl may decide to hold the company as an investment vehicle using the proceeds of the sale of the goodwill to invest in shares or other income earning assets for use in their retirement. Alternatively, they may seek to sell the shares in the company and claim the 50% individual concession on the capital gain (subject to not falling foul of sec 115-45 (see discussion at ¶1.020)), or seek to make use of the scrip for scrip roll-over by exchanging their shares in the company for shares in a listed company.

Section 152-125 permits distributions to CGT concession stakeholders to be made through interposed entities. An example where a payment may be made through an entity would be where the entity was interposed after the CGT event. Note that as this concession only applies where the entity has a “controlling individual” at the time of the CGT event, at least 50% of the shares or interests will need to be held directly.

¶3.051 Pre-CGT gains also exempt when distributed

The Taxation Laws Amendment Act (No 7) 2000 introduced on 29 June 2000 a new sec 152-125(1) with effect from 21 September 1999 to clarify to application of the section. It is interesting to note that sec 152-125(1)(c) (reproduced above) allows the distribution of pre-CGT gains out of a company tax free without the need to liquidate the company. The EM states that the purpose of the amendment is to:

Ensure that capital gains made by companies or trusts on pre-CGT active assets, held for at least 15 years, are exempt when distributed to CGT concession stakeholders. [Schedule 3, item 10, subsection 152-125(1)]

Note also new sec 104-71(g), which makes it clear that a payment out of a fixed trust under Subdivision 152-B does not give, rise to CGT event E4.

¶3.060 SALE OF ASSET AFTER “RETIREMENT”

In ID 2001/606 (withdrawn) the question considered was whether the sale of the taxpayer's share in a private company, after their retirement, was an “event that happens in connection with the taxpayer’s retirement” pursuant to sec152-105(d)(i) ITAA 97.


Selling a Small Business – The CGT Strategies The ATO took the view that the sale of the share in the private company is an event that is connected to the retirement of the taxpayer pursuant to sec 152-105(d)(i), notwithstanding that the sale occurred after retirement.

The facts of the case and reasons given, as stated in the ID, were as follows.

The taxpayer had a family business that was taken over by their children. The taxpayer owned a share in the private company that operated the business. The share was acquired more than 15 years ago. The taxpayer is over 55 years of age and has officially retired. The taxpayer intends to sell the shares. The taxpayer meets the basic conditions for the small business concessions under Subdivision 152-A of the ITAA 1997. There has been a controlling individual of the company at all times during the period of ownership of the share in the company as required under subsection 152-105(c) of the ITAA 1997. The market value of the active assets of the company is more than 80% of the value of all assets of the company as required for the share to be an active asset of the company under subsection 152-40(3) of the ITAA 1997. Reasons for Decision Subdivision 152-B of the ITAA 1997 allows an individual taxpayer to disregard a capital gain on a CGT asset they have continuously owned for 15 years (section 152-105 of the ITAA 1997). Subparagraph 152-105(d)(i) of the ITAA 1997 requires that, in addition to the basic requirements, the CGT event must happen in connection with the taxpayer's retirement. There is no statutory definition of ‘retirement’. The word ‘retirement’ is defined in the Macquarie Dictionary to mean ‘the withdrawal from office, business or active life’. The Shorter Oxford English Dictionary gives a number of meanings for 'retirement' including ‘The act of falling back, retreating or receding from a place or position. The act of withdrawing into seclusion or privacy; withdrawal from something. Withdrawal from occupation or business activity.’ The Explanatory Memorandum (EM) to the New Business Tax System (Capital Gains Tax) Bill 1999 makes the following comments about the requirement to be retiring as one of the conditions for the concession:

‘1.5 ... the disposal is related to a person retiring ...’ and

‘1.68...an individual small business tax payer...must be...at least 55 years old and using the capital proceeds for their retirement.’

The taxpayer is over 55 years of age and has ‘officially’ retired. They are now completing the process of retirement by disposing of their share in the company. It is therefore considered that the sale of the share is an event that is linked to the taxpayer’s retirement. The conditions in Subdivisions 152-A & 152-B are satisfied by the taxpayer, who is, therefore, eligible for the CGT Small Business 15 year exemption. Date of decision: 10 July 2001.

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the ATO provided some additional commentary on the meaning of the phrase “in connection with the individual’s retirement” in sec 152-110(1)(d)(i) and the similar phrase in sec 152-105(d)(i).

The ATO stated that in framing the provisions for the 15-year retirement exemption, various definitions of “retirement” in tax and superannuation law were examined. These were too restrictive for this purpose, and it was decided not to include a definition to ensure that the law applied flexibly and appropriately. At Attachment A to the Minutes some example were provided to assist practitioners:



Attachment A: Agenda item 4.2

Examples on the issue of what is ‘in connection with the individual’s retirement’ for the CGT small business 15 year exemption The following example is indicative of where there would be a ‘retirement’ for the 15 year exemption: 1. A small business operator, aged 55 or more, sells their business and under the

terms of sale agrees to be employed by the new owner for a few hours each week for two years. The sale of the business would be in connection with the small business operator’s retirement. The operator has permanently or indefinitely ceased their activity of being self employed and has commenced gainful employment on a much reduced scale with another party, although still performing similar activities.

On the other hand, the following example is indicative of where a CGT event would not be ‘in connection with retirement’:

2. A small business operator and spouse are both pharmacists, both over 55 and carry on business through two pharmacies. They sell one (and make a capital gain) and accordingly reduce their working hours from 60 hours per week each to 45 and 35 hours per week respectively. It is true that there has been some change to their present activities in terms of hours worked and location. However, there has not been a significant reduction in the number of hours or a significant change in the nature of their activities and therefore on this basis there has been no ‘retirement’.

If, on the other hand, one spouse reduces their hours to nil and stops working there would be a significant reduction in the number of hours (ie, to nil) that that spouse was engaged in the business activities. The sale would be in connection with the retirement of that spouse.

The words ‘in connection with’ in the phrase ‘in connection with retirement’ can apply even if the CGT event occurs at some time before retirement. These cases all the more turn on their own particular facts but could include the following type of example:

3. A small business operator, aged 55 or more, sells some business assets as part of a wind down in business activity ahead of selling the business. Within a short period (say, six months) they sell the business and end their present activities. If it can be shown that the earlier CGT event was integral to a plan to cease their activities and retire, the CGT event may be accepted as happening in connection with retirement.

Similarly, the words ‘in connection with’ can also apply where the CGT event occurs sometime after the act of retirement. It is considered that the word ‘retirement’ may refer to both the act of retirement and the continuing state of retirement. Again, this type of case would turn on its own particular facts and would need to be considered on a case by case basis but could include the following type of example:

4. A small business operator ‘retires’ and the children take over the running of the business. Soon afterwards (say, within six months), some business assets are sold and a capital gain is made. There may be several reasons that prompted the sale of the assets. If there is no relevant connection with the small business operator’s business, the small business concessions would not be available. If it can be shown that the reason for disposal of the equipment is connected to retirement and the later sale is integral to the small business operator’s retirement plan, the sale may be accepted as happening in connection with retirement.



Chapter 4

50% small business reduction

¶4.000 50% SMALL BUSINESS REDUCTION

¶4.001 Applying the small business 50% reduction

¶4.002 Restrictive covenants

¶4.003 Dilemma for small business conducted through a company

¶4.000 50% SMALL BUSINESS REDUCTION

Subdivision 152-C ITAA 97 is a short Subdivision that, by sec 152-205, provides for the small business 50% reduction where the basic conditions in Subdivision 152-A are satisfied.

The Subdivision also seeks to make clear the relationship between the four small business concessions contained in Division 152 ITAA 97. In this regard sec 152-210 makes clear that a taxpayer qualifying for the 50% reduction may additionally qualify for either the small business retirement exemption or the small business roll-over, or both.

By sec 152-210(2), a taxpayer entitled to both the small business retirement exemption and the roll-over may choose the order in which to apply them. These concessions and the 50% reduction apply in addition to the 50% individual and trust discount, see sec 152-200.

Section 152-215 ITAA 97 ensures that the 15-year exemption has priority over the other small business concessions by providing that, where it applies, the other concessions do not. The 15-year exemption may also be distinguished from the others by being an outright exemption that is not affected by the existence of capital losses as is the case with the 50% individual concession. There do not appear to be any circumstances where a taxpayer would not wish the 15-year exemption to apply if he/she were otherwise eligible. Presumably, the automatic application of that exemption could be prevented if the individual did not “retire” so it could not be said that the relevant CGT event did not happen in connection with the taxpayer’s retirement.

¶4.001 Applying the small business 50% reduction

The important thing to remember when applying the small business 50% reduction is that, as with the 50% individual discount, it only applies after current and prior year capital losses have been deducted. Further, the small business 50% reduction only applies after the 50% individual reduction has been applied (sec 152-205).

The example following sec 152-205 provides:

Example: For an individual (other than one who opts to claim indexation instead of the discount), the discount percentage that applies under step 3 of the method statement is 50%. Therefore, the combined effect of the discount percentage and this section would be to reduce the original capital gain by a total of 75%. For an individual who opts to claim indexation, or a company, there is no discount percentage, so the individual or company would simply get the 50% reduction under this section.

To recap, the four basic conditions for eligibility for the small business 50% reduction are:





• you satisfy the maximum net asset value test; and


As discussed at ¶2.010 above, sec 152-10(2) provides two additional basic conditions where the CGT asset is a share in a company or an interest in a trust (i.e. a unit in a unit trust or an interest in a fixed or hybrid trust). In these cases, the company or trust must satisfy the “controlling individual” test and the taxpayer must be a “CGT concession stakeholder” in the company or trust.

Thus, as with the 15-year exemption and the other small business concessions, the small business 50% reduction can apply both at the ownership level as well as at the business operating entity level (whether individual, company or trust).

Where the basic and additional conditions are met, the exemption is automatic – sec 152-205, which requires the net capital gain be reduced by 50%. Since the reduction operates on an asset-by-asset basis, the qualifying conditions need to be tested against each CGT asset disposed of.

However, an amendment, introduced by the Taxation Laws Amendment Act (No 7) 2000 on 29 June 2000, inserted a new section, sec 152-220, which enables a taxpayer to choose not to apply the 50% active asset reduction. The effect of this amendment is to enable a taxpayer to take a greater tax-free ETP under the small business retirement exemption, if the taxpayer or relevant entity so chooses. This can be of particular advantage where a business is carried on in a company, and by choosing to take the entire gain as an ETP it may be able to be distributed out of the company tax free. This amendment applies from 21 September 1999. See ID 2002/745, which considered whether the automatic application of the 50% reduction precluded a taxpayer choosing to apply the retirement exemption to the whole of the capital gain. This ID appears to proceed incorrectly on the basis that sec 152-220 would not have otherwise applied in the case considered. See also ID 2002/792, which confirmed that the ATO will allow further time under sec 103-25 for a taxpayer to choose the retirement exemption in cases where a return had been lodged before the enactment of sec 152-220.

In ID 2003/104 the ATO indicated that where a taxpayer has included in his return capital gains without any consideration of the small business concessions, that does not constitute the making of a choice and thereby preclude the application of the 50% reduction in sec 152-205 ITAA 97. The ID explains that the 50% reduction applies automatically and the taxpayer is able to amend his/her return in such a case notwithstanding that the general rule under sec 103-25(1) is that the making of a choice is evidence by the lodging of a return. In the case considered, the taxpayer’s agent had failed to consider the application of the small business concessions when making his return. The taxpayer’s new agent detected the oversight and immediately notified the ATO.

It should be noted that there is no restriction on the kind of CGT event that may qualify for reduction under the concession.

As noted above, sec 152-210(1) ITAA 97 provides the mechanism under which a small business may also choose to apply the small business retirement exemption, or the small business roll-over, or both. Section 152-210(2) enables a taxpayer applying both these other concessions to determine the order in which they are applied.

Example

Garry is 45 and sells his paving business for $100,000 on 1 February 2004. The proceeds from the sale are made up of a capital gain on the goodwill of $60,000, a capital gain of $25,000 on a restrictive covenant given to the purchaser, and $5,000 furniture and fittings (WDV).


Selling a Small Business – The CGT Strategies Garry has a capital loss of $10,000 from his sale of shares in December 20020. He plans to buy another business after a one year holiday. Calculation of capital gains

Non-discount gain $25,000

Less loss $10,000

Net gain $15,000 $15,000*


Less 50% discount $30,000

Reduced gain $30,000 $45,000

Less small business 50%

reduction $22,500

Total net gain $22,500

As discussed at ¶6.010, the amount of $22,500 may be disregarded for the income year 2003/04 as Garry has chosen to roll over the amount into another business. This is conditional upon the cost base of the new business assets exceeding $22,500 and that the new assets are acquired within two years from the happening of the last CGT event during 2003/04.

*The 50% small business reduction will be available to Garry in respect of the gain on the restrictive covenant as it would be an asset inherently connected with an active asset, see sec 152-12 (see discussion at ¶2.010 above).

¶4.002 Restrictive covenants

It should be noted in the above example that care needs to be taken in identifying individual gains. In this example, the sale proceeds were not wholly for goodwill which would normally be a discount capital gain if it has been held for more than one year. Any restrictive covenants, on the other hand, will, by definition, not be discount capital gains as they will not have been held for 12 months. As such, their value should be agreed to by the parties, and this amount will normally be accepted by the ATO, c.f. TR 96/24 concerning lease premiums.

In the above example, had the parties to the sale been able to agree that the value of the restrictive covenant was, say, only $10,000 with a consequential increase in the amount of the capital gain for the goodwill to $75,000, the non-discount capital gain could be fully off-set against Garry’s loss and CGT would only have been payable on $18,750 had Garry not decided to roll over that amount.

Better still, in TR 1999/16 the ATO indicated that it will accept that, where goodwill is disposed of and a covenant is provided, the sale consideration will be treated as applying to the goodwill only. It may be assumed, unless this ruling is withdrawn, that this approach will be acceptable when applying Division 152 concessions.

¶4.003 Dilemma for small business conducted through a company

Where a small business is conducted through a company where the small business retirement exemption would be available (see ¶5.000 and following) a dilemma can arise in that should the controller decide to sell the business assets, whilst the company would be able to take advantage of the 50% small business reduction and the retirement exemption, this may still leave a considerable amount of CGT for the company to pay.

For example, if the gain was $2m, the 50% reduction would apply to reduce this to $1m, but if there were only one controller, the maximum that could be applied under the retirement exemption would be $500,000, leaving the company with a $500,000 taxable gain. If, on the other hand, the shares in the company could be sold for the $2m, the 50% general exemption


Selling a Small Business – The CGT Strategies (subject to sec 115-45) and 50% reduction could be applied successively to reduce the gain in the controller’s hands to $500,000 and the retirement exemption could be applied to the balance, leaving a nil taxable gain. This issue is discussed at ¶10.000.



Chapter 5

Small business retirement concession

¶5.000 SMALL BUSINESS RETIREMENT CONCESSION

¶5.001 Retirement concession now applies where entity disposed of

¶5.010 ELIGIBILITY FOR RETIREMENT EXEMPTION

¶5.011 Where no capital proceeds

¶5.012 ATO view

¶5.020 WHEN TO ROLL OVER CAPITAL PROCEEDS

¶5.021 Where proceeds paid into super fund before retirement exemption chosen

¶5.030 CHOICE TO BE MADE IN WRITING

¶5.040 APPLYING THE EXEMPTION WHERE COMPANY OR TRUST

¶5.041 Trust

¶5.042 ETP – must it be paid in consequence of the termination of employment?

¶5.043 Can an ETP under sec 152-325(1) be made to an employee who remains a director?

¶5.044 Property sold to super fund and proceeds directed back to fund

¶5.045 Making ETPs where payments received in installments

¶5.046 More than one CGT concession stakeholder

¶5.047 Delaying payment of capital proceeds

¶5.048 Application of sec 109 ITAA 36?

¶5.049 Consequences of choice

¶5.050 CGT RETIREMENT EXEMPTION LIMIT

¶5.060 EX GRATIA PAYMENTS

¶5.070 RETIREMENT EXEMPTION AVAILABLE FOR CONSOLIDATED GROUP

¶5.000 SMALL BUSINESS RETIREMENT CONCESSION

The small business retirement concession is in Subdivision 152-D of Part 3-3 ITAA 97 and broadly re-enacts the former concession in Division 118-F of Part 3-3 ITAA 97, repealed with effect from 21 September 1999.

A curiosity of the small business retirement exemption highlighted with the introduction of the 15-year exemption is that under the 15-year exemption a taxpayer is required to retire, but under the retirement exemption a taxpayer does not.

One proposed change announced on 21 September 1999 to the small business retirement exemption that did not find its way into the new provisions was the proposal to extend the kinds of membership interests that an individual taxpayer may hold in order to qualify as a controlling individual of a company or trust. Some further relief, however, was provided by


Selling a Small Business – The CGT Strategies the introduction of the CGT concession stakeholder concept extending the concessions to spouses of a “controlling individual” who held a non-controlling interest in the entity (see ¶2.050 above).

¶5.001 Retirement concession now applies where entity disposed of

A minor, though important, change to the concession introduced through the basic conditions (discussed above at ¶2.010) is that it is now possible for taxpayers to dispose of the operating entity. Previously, where a business was operated through a company or trust, to access the exemption, it was necessary for the operating entity to dispose of the business assets. Only taxpayers who are controlling individuals will be able to access the exemption at the ownership level where the “look through” rule will apply to ensure that 80% of the entity’s assets are active for at least 50% of the ownership period.

The following further changes have been made to the eligibility requirements of the retirement exemption:

• a controlling individual will no longer be required to be both a director and an employee of a company;

• a director of a company will no longer be required to resign as a director at the time of accessing the exemption through a company entity (though in practice this may be necessary if not an employee).

In earlier editions of this Portfolio it was stated that it would appear also that prior year losses no longer need to be used before accessing the exemption. This statement is incorrect. The method statement in sec 102-5 makes it clear that current and prior losses need to be applied before the general discount (if available) and the small business concessions (other than the 15-year exemption).

The major change with the retirement exemption is that taxpayers will no longer be required to make a choice between it or the other small business concessions. Whilst still a choice as to whether to take advantage of the concession, the difference now is that small business taxpayers will be able to take advantage of more than one concession in respect of each CGT asset. This change has the capacity to allow eligible small businesses, depending on the business structure, to virtually eliminate CGT liabilities arising from the sale of their business or business assets.

Example

Ralph started a retailing business, Ralph’s Sporting Attire, in 1986 as a sole trader. The business has been successful. In June 1990 Ralph acquired a warehouse costing $500,000. He plans to retire in 2005 at age 60 when he thinks the goodwill of the business will be worth about $4m. Ralph sells the warehouse for $1.2m in November 2002.

Calculation of capital gain on warehouse

Disposal proceeds $1,200,000




(individual exemption – note that this

exemption applies first)

50% remaining nominal gain ($350,000) $175,000


Selling a Small Business – The CGT Strategies (small business exemption)

Ralph can choose to apply the small business retirement exemption to the $175,000 and eliminate the remaining CGT liability on the disposal. Note: Ralph does not actually have to retire at this time to obtain the benefit of the current retirement exemption. Alternatively, he may choose to roll over the CGT liability by acquiring another active asset. When Ralph sells his business in 2005 he can take the proceeds from the sale of the goodwill of his business CGT free as he will have (hopefully) held the same goodwill continuously for 15 years. If the net “business” assets of Ralph’s business exceed $5m at this time he would not be eligible for the exemption.

As noted at ¶4.000, an amendment introduced by the Taxation Laws Amendment Act (No 7) 2000 on 29 June 2000 adds a new section, sec 152-220, which enables a taxpayer to choose not to apply the 50% active asset reduction. The effect of this amendment enables a taxpayer to take a greater tax-free ETP under the small business retirement exemption, if the taxpayer or relevant entity so chooses. This could be of advantage where a business is carried on in a company, and by choosing to take the entire gain as an ETP it may be able to be distributed out of the company tax free. This amendment is intended to apply from 21 September 1999.

¶5.010 ELIGIBILITY FOR RETIREMENT EXEMPTION

To qualify for the retirement exemption a taxpayer must, by sec 152-305 ITAA 97, satisfy the four basic conditions in sec 152-10. To recap, they are:





Essentially, these are the only eligibility criteria to obtain the exemption where the taxpayer is an individual.

ID 2003/658 confirms that there is no obligation on an individual to cease their business activities and retire in order to choose the small business retirement exemption under sec 152-305(1) ITAA 97. The position with respect to a business operator run through a company or trust and who is an employee of the company or trust is different because an eligible termination payment must be actually paid, see discussion below at ¶5.040.

Section 152-305(1)(b) ITAA 97, however, provides that if the taxpayer is under 55 then, as before, the exempt amount must be rolled over into a superannuation fund. If the taxpayer is over 55, the exempt amount is received as an exempt capital gain.

Practice point

The critical time for determining whether a taxpayer is able to receive the exempt amount directly or is required to pay it into a super fund is determined by sec 152-305(1)(b). This provision looks at the time “just before receiving an amount of the capital proceeds from the CGT event”. This is a change from the previous provision (sec 118-405(1)(g)), which took the time from the relevant CGT event.

In most cases the time will be the same since the receipt of all or part of the capital proceeds may occur at the time of the CGT event, for example upon an exchange of contracts, a deposit will be paid.

If the deposit is held in a trust account by a business broker, it would appear that no amount has been received at the time of the exchange. So the payment of all or part of the capital proceeds may occur after the CGT event. If, say, a holding deposit had been paid to the


Selling a Small Business – The CGT Strategies taxpayer rather than to the broker before the exchange of contracts, care would need to be taken in such a case to ensure that the taxpayer’s 55th birthday did not occur after the receipt of the holding deposit, if it was intended to pay the exempt amount directly to the taxpayer and not into a super or roll-over fund.

Where a taxpayer is under age 55 at the time of a payment of the capital proceeds to him directly, the taxpayer may still be able to qualify for the exemption provided the exempt amount was in fact paid into a super fund as soon as practicable after its receipt. Note here that it does not matter that only a small part of the capital proceeds are received, for example a holding deposit. Once any part of the proceeds are received by a taxpayer under 55, the whole of the exempt amount is required to be paid into a superannuation fund. Note that this may not be the case where the capital gain is realised in an entity (see below at ¶5.040, “Delaying payment of capital proceeds”).

¶5.011 Where no capital proceeds

An interesting aspect of the retirement exemption is that it can apply where a business or business asset is transferred for no or nominal consideration. This may be desired where, for example, the business is proposed to be passed to a family member as a gift. One issue to be aware of is that if the gift is made by a taxpayer who is under 55 at the time of the gift, it is arguable that the concession cannot be chosen unless there are at least some capital proceeds received from the gift, see sec 152-305(1)(b) ITAA 97. This should not be a problem as by virtue of sec 152-310(3) ITAA 97 the market substitution rule in sec 116-30 is treated as not applying.

The presence of sec 152-310(3) may enable the retirement exemption limit of $500,000 (see below) to be overcome in some cases.

Whilst it would be open for a gift to be made of the business or a business asset from a company, it would appear that it may not be a desirable course if the retiring owner wishes to receive some compensation for the “gift”. For example, it may be better to treat the market value of the business as a debt owing to the retiring owner so as to be able to treat it as an ETP in his hands if say paid over a period rather than run the risk of such payments being treated as ordinary income. Care needs to be exercised here where repayments are made over a period of years, if an amount needs to be rolled over into a super fund if the taxpayer is under 55, see sec 152-305(1)(b) and 152-325(1) ITAA 97.

Care would also need to be exercised in the case of a gift to ensure that the gift was a genuine gift. The important point to note is that the disposal of the active assets, having regard to the ATO’s view expressed below, should be undertaken on an arm’s length basis for full consideration. If a debt is created at this point, care should be taken to ensure that any application of the debt forgiveness provisions are taken into account, see Div 245 in Sch 2C ITAA 36.

¶5.012 ATO view

The ATO, however, takes the view that the concession is not available where no cash consideration is provided, and where the cash consideration is less than the market value of the active assets, the concession is only available in respect of the cash consideration. See ID 2002/269 and discussion at the 7 August 2002 meeting of the National Tax Liaison Group – CGT Subcommittee meeting where it was explained that the original concession was never intended to apply where inadequate consideration was provided and that this was reflected in the statement in sec 152-300 (“What this Subdivision is about”) ITAA 97 which refers to the concession being available if the capital proceeds are used in connection with your retirement.

The Minutes note:



Tax Office response

The ATO ID reflects the Tax Office view that capital proceeds must be received for the small business retirement exemption in Subdivision 152-D of the ITAA 1997 to apply. Similarly, where the capital proceeds are less than the market value of the asset and the market value substitution rule in section 116-30 has applied, the retirement exemption is available only to the extent of the actual capital proceeds received. The market value substitution rule is disregarded. The Explanatory Memorandum to the Bill introducing the original retirement exemption in Division 17B of the ITAA 1936 (TLAB (No.3) 1997) indicates clearly (at paragraph 1.62 – reproduced below) that capital proceeds must be received. ‘1.62 The effect of new subsection 160ZZPZO(1) is that a taxpayer must actually receive consideration for the disposal of an asset in order to claim the CGT retirement exemption. This is consistent with the Government's policy of providing a CGT exemption on disposal of the assets of a small business where the proceeds are used for retirement.’ This is also reflected in section 152-300 (Guide to Subdivision 152-D). If there was a concern about a policy issue, the matter could be taken up with Treasury.

In ID 2004/240 the ATO consider what are the “capital proceeds” when the retirement exemption is chosen in respect of a capital gain arising under CGT event J2 (change of status where a CGT asset has been rolled over under Subdiv 152-E) or CGT event J3 (change of circumstances where a CGT asset being a share in a company or interest in a trust) has been rolled over under Subdiv 152-E). The ATO takes the view that the capital proceeds will be the original proceeds under which the Subdiv 152-E roll-over was chosen. The ID confirming the ATO’s view as set out above, notes that if there were no actual proceeds at that time, then no retirement exemption will be available.

ID 2004/240 was issued after the matter was raised at the 12 November 2003 meeting of the National Tax Liaison Group – CGT Subcommittee. The Minutes provide as follows:

8.6. Technical problem in applying retirement exemption (Subdivision 152-D) in relation to the net capital gain arising from CGT event J2 (LCA)

There appears to be a practical problem in applying the small business retirement exemption to a gain under CGT event J2 because several key provisions in Subdivision 152-D appear to require that the taxpayer will have received capital proceeds as a consequence of the CGT event. For example:

i. section 152-310 – the Act applies to you as if the capital proceeds from the CGT event were an eligible termination payment

ii. section 152-325 – each time a company or trust receives an amount of capital proceeds from a CGT event for which it makes a choice, the company or trust make an eligible termination payment.

The difficulty is that there are no capital proceeds or deemed capital proceeds as a result of CGT event J2 occurring. The taxpayer is simply deemed to make a capital gain equal to the amount previously disregarded under Subdivision 152-E (subsection 104-185(3)). The Tax Office has previously considered whether a taxpayer deriving a capital gain arising as a result of the application of the market value substitution rule would be eligible to apply the small business retirement exemption in relation to that gain (refer ATO ID 2002/269 and the minutes of the NTLG CGT subcommittee meeting in August 2002).


Selling a Small Business – The CGT Strategies The Tax Office appears to regard that the small business retirement exemption cannot be claimed in those circumstances. However, this position is different from the J2 issue because subsection 152-310(3) specifically requires that the portion of capital proceeds calculated under the market value substitution rule must be disregarded. However, there is a concern that, if the provisions of Subdivision 152-D are interpreted strictly, the retirement exemption in Subdivision 152-D may not apply unless the taxpayer can identify an amount of capital proceeds. Background (a) CGT event J2 occurs where:

(i) a taxpayer has previously claimed the replacement asset rollover under Subdivision 152-E, and

(ii) the replacement asset stops being an active asset. (b) It appears to be intended that the gain which arises as a result of CGT event J2 (J2

gain) will be eligible for further relief under some of the small business CGT concessions.

(c) The taxpayer cannot claim the 15 year exemption (Subdivision 152-B) or the 50% small business discount (Subdivision 152-C) in respect of the J2 gain (subsection 152-10(4)).

The implication is that the taxpayer should be entitled to claim the small business replacement asset rollover and/or the small business retirement exemption which are not expressly excluded by subsection 152-10(4) (assuming they can satisfy the other requirements for those exemptions). In the addendum to the Tax Office booklet Capital gains tax concessions for small business (NAT 3359) the Tax Office indicates that the retirement exemption can apply to CGT event J2 or J3 capital gains. Tax Office comments The Tax Office view is that, consistent with the legislative intention, the retirement exemption is available for the crystallised capital gains made from CGT events J2 and J3. The Tax Office considers that, for the purposes of the retirement exemption, the capital proceeds from CGT event J2 or J3 are the capital proceeds from the original CGT event and they are taken to be received at the time CGT event J2 or J3 happens.

Action item

8.6.1: The Tax Office proposes to issue a pre-emptive ATO Interpretative Decision setting out this position. ]A draft copy of this pre-emptive ATO Interpretative Decision was distributed to subcommittee members at the meeting.

Update

ATO ID 2004/240 issued 19 March 2004.

¶5.020 WHEN TO ROLL OVER CAPITAL PROCEEDS

Subdivision 152-D is silent as to when the exempt amount is required to be paid into a super fund. Presumably, as with the previous provisions, it would need to be paid into a fund upon receipt or shortly thereafter.

Section 152-305(1)(b) ITAA 97 read with sec 152-310(2) operates to require a taxpayer under 55, choosing to apply the retirement exemption, to pay the amount to be exempted into a super fund as if it were an eligible termination payment (ETP) within the meaning of Subdivision AA of Division 2 of Part III ITAA 36. Under sec 27A(12) ITAA 36 an ETP is


Selling a Small Business – The CGT Strategies required to be paid “immediately” into a superannuation fund or to an Approved Deposit Fund, or RSA; there is, therefore, a question as to the manner in which the payment must be made to comply with sec 152-305(1)(b).

The ATO issued TD 96/36 to provide guidance for taxpayers in meeting the obligation under sec 27A(12). The Determination relevantly provides:

1. An ETP qualifies for roll-over relief from personal income tax if it is paid to a complying superannuation fund, a complying approved deposit fund or to a provider of an eligible annuity immediately after it is made (subsection 27A(12)). The word immediately implies ‘prompt, vigorous action, without any delay’ (R v. The Justices of Berkshire (1879) 4 QBD 469 per Cockburn CJ at 471) and that the making of the ETP and payment to the roll-over fund takes place ‘without any other intervening occurrence’ (R v. Horseferry Road Metropolitan Stipendiary Magistrate, ex p Siadatan [1991] 1 All ER 324 at 329).

2. A roll-over of an ETP will therefore be regarded as having been immediately paid to a roll-over fund where:

• the funds are electronically transferred from the payer to the roll-over fund nominated by the taxpayer;

• the payer draws a cheque payable solely to the roll-over fund nominated by the taxpayer and sends the cheque directly to the roll-over fund; or

• the payer draws a cheque payable solely to the roll-over fund nominated by the taxpayer and sends the cheque to the taxpayer or his or her representative who, in turn, forwards it to the roll-over fund together with any other documents required to complete the investment.

A roll-over will not be regarded as having been immediately paid to a roll-over fund where:

• the funds are transferred under the instructions of the taxpayer, either electronically or by negotiation of a cheque, to an account for the taxpayer or other party distinct from the originally nominated roll-over fund; or

• the funds are otherwise put to any intervening purpose not incidental to completing the roll-over.

It is incumbent on all parties to act expeditiously to complete a roll-over. 3. In order for a taxpayer to make roll-over decisions, a payer is required to provide

the taxpayer with an opportunity to elect that the ETP be rolled over to one or more nominated roll-over funds prior to making the payment. However, circumstances sometimes arise where a payer either fails to give the taxpayer an opportunity to elect a roll-over, or fails to effect a roll-over as instructed and consequently pays the ETP direct to the taxpayer. In both these situations, the subsequent payment of the ETP to the roll-over fund will be regarded as having been immediately paid to the roll-over fund if the taxpayer promptly elects to roll-over the ETP and deposits the payment with a roll-over fund without having put the funds to any intervening purpose. Such roll-over payments made within 7 days of payment of the original ETP will generally be acceptable.

4. A period greater than 7 days may be acceptable if, for example-

• either the taxpayer or a dependant of the taxpayer was seriously ill;

• the taxpayer had to go on an unavoidable overseas trip; or

• the taxpayer’s place of residence was remote from available roll-over facilities.


Selling a Small Business – The CGT Strategies 5. An extended period will not be justified where, for example:-

• the taxpayer was given an opportunity by the payer to elect to roll-over but, for whatever reason, failed to act on that opportunity; or

• it is clear the taxpayer had no intention of preserving the payment. For example, if the taxpayer used the payment to finance a particular venture and after coming into funds from another source seeks to roll-over an amount equal to the whole or a part of the original ETP.

6. Taxpayers who wish to roll-over an ETP outside the suggested 7 day time period should request approval from the Tax Office at which the taxpayer normally lodges his or her tax return. For more information about what a taxpayer needs to do to roll-over some or all of an ETP, contact the Tax Office for a Roll-Over Fact Sheet or get the booklet Superannuation and Other Termination Payments from any Tax Office.

Taxation Determination TD 96/36 is not entirely relevant where an individual taxpayer is obliged to make a roll-over payment under sec 152-305(1)(b) since there will be no employer paying the amount in question to the taxpayer although it is indicative as to how the ATO would apply the provision in the context of a roll-over of a deemed ETP by a taxpayer under sec 152-305 ITAA 97. At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001, it was confirmed that the ATO would apply TD 96/36 in such cases (see extract from Minutes below at ¶5.040).

Care also needs to be taken to ensure that where the taxpayer will need to roll over the exempt amount that adequate capital proceeds are received from the purchaser to enable payment of the “CGT exempt amount” that is required to be rolled over into a super fund or paid to a life company or registered organisation for an annuity (see sec 27A(12)(c) ITAA 36).

At the 11 June 2003 National Tax Liaison Group – CGT Subcommittee meeting the ATO confirmed the view that the requirement to roll over the capital proceeds from a CGT event into a super fund does not arise until the choice is made to apply the exemption. The discussion is recorded in the Minutes as follows:

When does the CGT small business retirement exempt amount have to be rolled over into a superannuation fund? (NIA)

The Subdivision 152-D CGT retirement exemption is available for an individual who is under 55 years of age if they roll over the amount equal to the CGT exempt amount to a superannuation fund. The CGT exempt amount is treated as an eligible termination payment (ETP) under section 152-10. The amount must be rolled over to the superannuation fund immediately after the ETP is made (see subsection 27A(12) and section 27D of the 1936 Act). However, this is not necessarily the time the capital proceeds are received. Section 152-10 states that for the purposes of the Act (including the 1936 Act), the ETP is deemed to be made the later of when you make the choice to use the exemption or when you receive the amount. Section 103-25 says you can make the choice by the time you lodge the relevant tax return. It appears from this that you can use the funds for some other purpose between the time you receive the capital proceeds and the time you lodge the relevant return. However, the Explanatory Memorandum that accompanied the original CGT retirement exemption provisions in the 1936 Act (Div 17B) said that the proceeds must be rolled over immediately after the receipt of the actual proceeds for the disposal. The relevant provisions in Division 17B are virtually the same as the relevant provisions in Subdivision 152-D of the 1997 Act. Could the ATO please comment on when the CGT exempt amount has to be rolled over into a superannuation fund?



ATO comments

The position is as suggested in the question. If an individual chooses the retirement exemption then subsection 152-310(2) deems the capital proceeds to be an ETP made to the individual at the later of when they made the choice and when they received the amount. If the taxpayer is under 55 just before they receive an amount of capital proceeds, an amount equal to the ETP referred to in subsection 152-310(2) must be rolled over. However, there is no deemed ETP under subsection 152-310(2) until at least the choice is made. Therefore, where capital proceeds are received prior to the choice being made there is no requirement to rollover until the choice is made. Once the choice is made an amount equal to the ETP must be rolled over immediately in accordance with the normal ETP requirements (see ATO ID 2003/845). It is noted that the Division 17B Explanatory Memorandum (EM) does refer to an immediate rollover upon receipt although it states it is the ETP (which will not exist until a choice is made) that must be rolled over. The later EMs (to Subdivision 118-F and 152) clearly specify it is the ETP that must be rolled over.

¶5.021 Where proceeds paid into super fund before retirement exemption chosen

A potential issue arises in this case if, for example, the capital proceeds are to be used by the super fund to purchase a new asset which is intended to be used in the taxpayer’s business (note the in-house asset rules in sec 69-85 Superannuation Industry (Supervision) Act 1993). Normally, the capital proceeds would not need to be paid into the fund until the concession is “chosen”. If the precise amount of the “exempt amount” is not known at the time the capital proceeds are needed by the super fund to complete its purchase, a dilemma arises whether the capital proceeds can be paid into the fund before the “choice” is made. Section 27A(12) requires an ETP to be “paid” into a fund. If the retirement exemption “choice” has not been made at the time the capital proceeds are paid into the fund, the capital proceeds may not be an ETP at that time.

There may be some scope for the return of an amount paid in “error” in such circumstances.

¶5.030 CHOICE TO BE MADE IN WRITING

Where an individual chooses to apply the retirement exemption in respect of a capital gain, the process is one of “choice” for which there are normally no formal requirements as such. Section 103-25(4) has been amended by the NBTS (CGT) Act to make an exception to the general rule, so that the choice under sec 152-315 effectively must be made in writing since, by subsec (4), a taxpayer must specify the CGT exempt amount in writing.

Section 103-25 also makes clear that the “choice” must be made by the day a taxpayer lodges his/her return for the year in which the relevant CGT event occurs, or such further time as the Commissioner may allow.

Under sec 152-315(1) a taxpayer can choose to disregard all or part of a capital gain to which the Subdivision applies. This means that, for example, if a capital gain of $100,000 is made on the disposal of an asset, subject to the limits discussed below, that amount or any lesser amount may be chosen as the CGT exempt amount. There is, as before, a general limit of $500,000 as the maximum amount of capital gain that can be disregarded under the retirement exemption concession (discussed at ¶5.050 below).

As mentioned above, sec 152-315(4) requires that the CGT exempt amount must be “specified in writing”. The provision contains no other guidance but so long as a taxpayer records in writing the CGT exempt amount in relation to each application of the retirement exemption, this will be sufficient. The following form would be suitable:




Small Business Retirement Exemption CGT Exempt Amount Specification

For the purpose of sec 152-315(4) of the Income Tax Assessment Act 1997, I …………………………………….. of……………………………………………………… Tax File Number…………. hereby specify $………. as the CGT exempt amount in respect of the disposal of ( here describe asset) on (date).

Signed

Taxpayer’s Name

Notes.

1. This specification is required to be made on or before the date for lodgment of the income tax return for the year of income in which the disposal took place. It should be kept with a copy of the return.

2. The CGT exempt amount must not be greater than the amount of the capital gain that has arisen in relation to the asset disposed of.

Where an individual taxpayer reduces a capital gain in respect of an active asset under the individual 50% discount concession and the 50% active asset concession, the remaining gain could be eliminated by the taxpayer choosing to apply the retirement exemption. In such a case the CGT exempt amount that would need to be specified would be the capital gain remaining.

Example

Paul runs a pet shampoo business which he sells for $60,000. His goodwill is valued at $50,000 and the balance of the sale proceeds are for stock and a vehicle. The capital gain on the goodwill is $50,000. It is a discount capital gain. Paul wants to use his entitlement to the retirement exemption to eliminate his potential CGT liability on the sale. The calculation of the CGT exempt amount would be as follows: Capital gain $50,000 Less 50% discount $25,000Subtotal $25,000 Less 50% active asset discount $12,500Subtotal $12,500 The amount of “CGT exempt amount” to be specified in writing for sec 152-315(4) ITAA 97 will be $12,500. If Paul is under 55 this amount would need to be rolled over.

It is possible that in some cases the actual amount to be specified in writing will not be known at the time that the “choice” must be made. For example, the taxpayer may be uncertain whether a discount gain is available or the inclusion of some cost base elements may be subject to a ruling request. Section 152-315 does not provide any relief for such cases and it would appear that all that a taxpayer could do would be to either seek to delay the making of the “choice” by seeking further time (see sec 103-25(b)), or perhaps specify alternative CGT exempt amounts. Specifying alternative CGT exempt amounts is likely to be sufficient compliance with the requirements of sec 152-315(4) as it may be argued that each amount specified satisfies this requirement. It is unlikely that the ATO would treat the specification as not complying since its purpose is merely to provide evidence of the application of the retirement exemption.

The tightening of the format of loss transfer agreements (see TR 98/12) ought not to be seen as indicative of the ATO’s attitude in the present case since there the use of a formula to


Selling a Small Business – The CGT Strategies specify the amount of the loss to be transferred affects more than one taxpayer as it is in the form of an agreement between the transferor and transferee. If the amount to be transferred is uncertain, a question may arise as to whether there has been any amount transferred.

See ID 2003/238 confirming that an executor in preparing the tax return for the deceased may make the choice to apply the retirement exemption in respect of a capital gain made by the deceased prior to his death. Note this ID dealt with the former provisions but would apply equally to the present provisions.

¶5.040 APPLYING THE EXEMPTION WHERE COMPANY OR TRUST

As previously noted, a company or trust may access the retirement exemption where the operating assets (active assets) are sold. In addition to satisfying the four basic conditions in Subdivision 152-A ITAA 97 a company or trust must have a controlling individual and must make an ETP (discussed below) to either or both of the CGT concession stakeholders in accordance with the requirements of sec 152-325 ITAA 97.

Section 152-325 provides as follows:

152-325 Company or trust conditions

(1) Each time a company or trust receives an amount of *capital proceeds from a *CGT event for which it makes a choice under this Subdivision, the company or trust must make an *eligible termination payment in relation to each of its *CGT concession stakeholders.

(2) If there are 2 such stakeholders, the amount of each such *eligible termination payment is to be worked out by reference to each individual’s percentage (see subsection 152-315(5)) of the relevant *CGT exempt amount.

(3) The payment must be made by the later of: (a) 7 days after it makes the choice; and

(b) 7 days after it receives an amount of *capital proceeds from the *CGT event.

(4) In working out those *capital proceeds, disregard: (a) section 103-10 (which deals with proceeds that are applied for your benefit

rather than being paid directly to you); and (b) the market value substitution rule (see section 116-30).

(5) The amount of the *eligible termination payment, or the sum of the amounts of the eligible termination payments, required to be made under subsection (1) must be equal to the lesser of:

(a) the amount of *capital proceeds received; and

(b) the relevant *CGT exempt amount.

(6) If this section requires the company or trust to make 2 or more *eligible termination payments to a single stakeholder (whether or not by the same time), the company or trust may meet that requirement by making one payment or by making separate payments.

(7) If a stakeholder is under 55 just before receiving an *eligible termination payment under subsection (1) (disregarding section 103-10), an amount equal to that payment must be rolled over (within the meaning of Subdivision AA of Division 2 of Part III of the Income Tax Assessment Act 1936) except by being paid as mentioned in paragraph 27A(12)(c) of that Act.


Selling a Small Business – The CGT Strategies Note: Paragraph 27A(12)(c) of the Income Tax Assessment Act 1936 deals with payments to life

companies or registered organisations to purchase certain annuities.

The operation of sec 152-325 is best understood by reference to an example.

Example

Vanstone Guns Pty Ltd operates a toy gun manufacturing business which commenced in 1989. The driving force behind the business is Rodney who holds 50% of the shares. The other 50% of the shareholding is held by Rodney’s de facto partner Margaret. Rodney who is 50 and Margaret, 44, have no significant superannuation savings and plan to continue in the business for at least another several years before retiring. The company owns its factory premises. The premises are presently worth $500,000. They were acquired for $100,000 in December 1989. Rodney and Margaret want to acquire the premises in their own names and seek advice whether they can make use of the small business concessions. They have borrowed from their bank to fund the purchase of the premises for $500,000 and acquired the premises as joint tenants on 1 February 2003. Under the contract of sale exchanged on 1 December 2002, the full price was payable on settlement. The company has a frozen indexed capital gain of $375,600 ($500,000 – ($100,000 x 123.4/99.2)). Note that the 50% general discount does not apply to companies. The company can meet the basic conditions under Subdivision 152-A as a CGT event happens in relation to a CGT asset which results in a gain to the company; it is assumed that the company can meet the maximum net asset value test; and the premises are an active asset. For the purposes of sec 152-305(2) ITAA 97, the company satisfies the controlling individual test. By sec 152-305(2)(c) the company must satisfy the conditions in sec 152-325. The first condition in sec 152-325 applicable in this example is that the company must make an ETP to each of its CGT concession stakeholders within seven days of its receipt of the capital proceeds from the sale of the factory premises or within seven days of choosing the exemption. To make the ETPs the employment of Rodney and Margaret must be first terminated. As both Rodney and Margaret both qualify as individual controllers both are CGT concession stakeholders (see sec 152-55 ITAA 97). Note, if Margaret’s shareholding was held on trust for Rodney, Margaret would not be a CGT concession stakeholder in this example as, even though she is Rodney’s spouse for the purposes of the definition, she would need to hold at least some equitable interest in the shares in the company. By sec 152-325(2) and sec 152-315(5) Rodney and Margaret need to agree on their “individual’s percentage” of the capital proceeds that should be paid to each as an ETP. As each are acquiring a 50% interest in the factory premises, they agree that each should receive 50% (see below for written form specifying the percentage for each). By sec 152-325(3) the ETPs must be made by the later of seven days after the company makes the choice, and seven days after it receives an amount of capital proceeds. Since the choice need not be made until the time of the preparation of the company’s return for the 2002/03 year of income (being the year in which the CGT event took place) (see sec 103-25(1)), it is open to the company to delay paying the ETPs until the expiration of the seven days from that time.


Selling a Small Business – The CGT Strategies By sec 152-325(5), the total amount of the ETPs cannot be more than the lesser of the CGT exempt amount and the capital proceeds. The amount of the capital proceeds is $500,000. The amount of the CGT exempt amount is: Capital gain on the premises $375,600 Less 50% active asset concession $187,800Exempt amount $187,800 Each ETP will be $93,900 As both Rodney and Margaret will be under 55 as at the date of payment (i.e. within seven days of lodging the company’s income tax return), the ETP amount for each must be paid into Rodney and Margaret’s respective superannuation funds or roll-over funds. Note: Division 152 contains nothing to prevent Rodney and Margaret from obtaining the retirement benefit even though they have acquired from their company the factory premises instead of selling to an independent third party, subject to any potential Part IVA application (see ¶13.000 below).

¶5.041 Trust

ID 2004/121 provides an example where the concession can be claimed where the business is operated through a trust. The case in point was a deceased estate where the executor had carried on the business of the deceased who apparently operated as a sole trader. The ATO take the view the concession would only be available once a beneficiary becomes absolutely entitled to the business assets. It is clear from this ID that the ATO would deny the retirement concession if the executor disposed of the business before this time since there is unlikely to be any CGT concession stakeholder to which payments could be made in accordance with the requirements of sec 152-325. See related IDs ID 2003/176 and ID 804 and TD 2003/D23.

¶5.042 ETP – must it be paid in consequence of the termination of employment?

The new provisions have created some uncertainty in their application to an entity in that there is now no longer a requirement that a “controlling individual” (CGT concession stakeholders) be an employee of the entity. This then begs the question whether, in order for the entity to satisfy the requirements of sec 152-325 that it make an ETP in relation to each of its CGT concession stakeholders, they must be employees of the entity.

Note ID 2003/748 confirms in clear terms the ATO’s view that there must be an actual ETP and it can be either in respect of the determination of employment or of a directorship.

There is a slight argument that what sec 152-325(1) does is to effectively treat the payment to the CGT concession stakeholders as an ETP. The difficulty with this argument is that, unlike sec 152-310(2) (applying to sole traders and partners) which in fact does just that in language that makes plain that the payment is a deemed ETP, sec 152-325 proceeds on the assumption that the entity is able to make an ETP to its CGT concession stakeholders. Also, in the case of deemed payments under sec 152-310(2), para (ja) of the definition of “eligible termination payment” in sec 27A(1) ITAA 36 was specifically added to make clear that a payment referred to in sec 152-310(2) is taken to be an ETP. There is no equivalent for payments made by an entity under sec 152-325(1). It would appear, therefore, that the provisions assume that the payment will be an ETP because of the circumstances of the payment. If the entity were simply to pay the capital proceeds to its shareholders in purported exercise of its choice to apply the retirement exemption, the payment would be in danger of being treated as a dividend.

Accordingly, it is necessary to ensure that the payment to the CGT concession stakeholders are ETPs. Normally the CGT concession stakeholders will be employees of the entity, either under common law or under a contract of employment, so this shouldn’t be a problem. Note that the current provisions no longer contain a provision which applies the Superannuation Guarantee (Administration) Act 1992 definition of “employee”, which includes directors. If


Selling a Small Business – The CGT Strategies the CGT concession stakeholders are not employees of the entity prior to the receipt by the entity of any part of the capital proceeds (as effectively required by sec 152-325(1)), then it is a relatively simple matter to ensure that they become employees. Note that the definition of “eligible termination payment” contains some 23 different categories of payments that are ETPs. For example, by para (h) any payment made in respect of a taxpayer of a residual capital value of a qualifying annuity is an ETP. So, if the entity is able to bring the payment to its CGT concession stakeholders under one of the definition’s paragraphs other than para (a) (i.e. termination of employment), it will have satisfied the requirement. Obviously, in most cases a simple termination will be the easiest.

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 a number of questions were raised concerning the operation of sec 152-325. The Minutes provide as follows:

The NTAA asked several questions that essentially concerned the eligible termination payment (ETP) provisions. The ATO stated that the CGT rules complement the ETP rules. Before the CGT rules can apply, the payment must be classified as an ETP. These issues raise questions of ETP policy and interpretation. The ATO undertook to include responses in these minutes. The questions and ATO responses, which have been provided by its Superannuation Business Line, are set out below. These responses are necessarily general and depend on the particular facts. A taxpayer can request a legally binding private ruling in relation to particular cases. Will the requirements of subsection 152-325(7) be satisfied in the following circumstances: The Bloggs Family Trust wishes to obtain the retirement exemption in Subdivision 152-D. It sells the asset in October 2001 and receives payment at settlement in November 2001. The trust makes the relevant choice on 14 February 2003 when it lodges its 2002 tax return. Assume all other relevant conditions are satisfied, the CGT exempt amount is $50,000 and Fred (aged 49) is a CGT concession stakeholder. ATO response: Subsection 152-325(7) would be satisfied if the ETP roll-over requirements are satisfied. Will subsection 152-325(7) be satisfied if: (a) the trust pays a $50,000 ETP to Fred on 15 February 2003 and on 16 February

2003 Fred pays $50,000 into his complying superannuation fund (being the roll-over fund)? Arguably yes because subsection 152-325(1) requires a $50,000 ETP to be made to Fred. Subsection (7) then requires an amount equal to $50,000 to be rolled-over. Also under paragraph 27A(12)(a) of the ITAA 1936 the requirement is that a payment be made to a complying superannuation fund immediately after the ETP is made?

ATO response: Generally, the requirements would not be satisfied as the amount is to be paid directly to Fred’s complying superannuation fund. However, if the conditions of TD 96/36 are satisfied, such a transaction would be acceptable. (b) the trust pays the $50,000 directly to the complying superannuation fund without

paying it to Fred first? TD 96/36 indicates yes, but subsection 152-325(7) indicates the ETP must be paid to Fred before the rollover is made?

ATO response: Yes, making the payment directly to the rollover fund satisfies the requirements of subsection 152-325(7) and of the ETP provisions as explained in TD 96/36. (c) the same as (a) except Fred transfers a property worth $50,000 or more to the

complying superannuation fund in lieu of paying cash to satisfy the roll-over requirement? Assume the transfer of the property does not breach the SIS Act. Does the use of the term ‘amount’ in subsection 152-325(7) allow non-cash


Selling a Small Business – The CGT Strategies payments to be made? ATO response: No, this transaction would not satisfy the requirements. The property has come from Fred and is not the ETP. The ETP is the $50,000 and it cannot be paid to Fred on the understanding that he substitutes something for the $50,000 that will be transferred into the fund. Therefore, the transfer of the property cannot be treated as a rollover. It would be treated as an undeducted contribution if the transaction was permitted under the Superannuation Industry (Supervision) Act 1993.

(d) the trust lends $50,000 (being part of the sale proceeds) to Fred in December 2001 and then pays the ETP to Fred on 15 February 2003 by journal entry. For example:

Dr ETP expense $50,000 Cr Loan account – Fred $50,000

Fred then pays $50,000 into his complying superannuation fund on 16 February 2003 to satisfy the roll-over requirement.

ATO response: No, this transaction would not satisfy the requirements. The loan to Fred in December 2001 results in the money being used for an intervening purpose. Fred is able to make use of the funds gained from selling the asset before funds are paid into the complying superannuation fund. TD 96/36 requires that, for an ETP to qualify for rollover relief, it must be immediately paid to a complying superannuation fund. Paragraph 2 of TD 96/36 specifically excludes any payment where the funds are otherwise put to an intervening purpose. As Fred has use of the funds before their payment into the complying superannuation fund, the funds have been put to an intervening purpose. Therefore, example (d) does not satisfy the rollover requirements in subsection 27A(12) of the ITAA 1936.

¶5.043 Can an ETP under sec 152-325(1) be made to an employee who remains a director?

ID 2002/493 confirms that a CGT concession stakeholder who is paid an EPT for the purposes of sec 152-325(1) upon termination of his/her employment can remain a director of the company. ID 2003/748 confirms that an ETP that satisfies sec 152-325 in respect of a controlling individual who is both an employee and a director can be either in respect of the employment or the directorship.

The minutes of the National Tax Liaison Group – CGT Subcommittee meeting of 12 November 2003 contain the following explanation:

In order for a company or trust to obtain a small business retirement exemption in Subdivision 152-D, under section 152-325 the company or trust must make an ETP in relation to each of its CGT concession stakeholders. (a) Where the taxpayer is a company and the CGT concession stakeholder is both a

director of the company and a common law employee of the company, if the CGT concession stakeholder resigns as an employee must they also resign as a director in order to satisfy section 152-325? Can they be paid an ETP if they merely resign as a common law employee but continue as a director of the company?

(b) If the taxpayer is a trust and the CGT concession stakeholder is a common law employee of the trust as well as a director of the corporate trustee, must the CGT concession stakeholder resign as a director of the corporate trustee as well as a common law employee of the trust in order to be paid an ETP for the purposes of section 152-325?

(c) If the taxpayer is a company and the CGT concession stakeholder is not a common law employee of the company (for example, where the company owns the asset but the business is being carried on by a connected entity) is it possible to satisfy the requirement under section 152-325 to pay an ETP to the CGT concession stakeholder by the CGT concession stakeholder resigning as a director


Selling a Small Business – The CGT Strategies of the company? The definition of ‘employment’ in section 27A ITAA 1936 includes the holding of an office and so resigning as a director should suffice for the purposes of the company being able to pay an ETP to the CGT concession stakeholder.

(d) If the taxpayer is a trust and the CGT concession stakeholder is a director of the corporate trustee but is not a common law employee of the trust, can the requirement for an ETP to be paid to the CGT concession stakeholder be satisfied if the CGT concession stakeholder resigns as a director of the corporate trustee?

Tax Office comments

In the situations outlined in scenarios (a) & (c) a bona fide resignation in either an employee capacity or a director capacity is sufficient to satisfy the ETP requirement. If the stakeholder resigns as a common law employee it is unnecessary for them to also resign as a director. If they resign as a director it is unnecessary for them to also resign as an employee. ATO Interpretative Decisions ATO IDs 2002/493 and 2003/748 specifically cover this issue. ATO ID 2002/493 directly covers the situation referred to in (a). The situation in (c) was addressed at a previous meeting (agenda item 2.2, NTLG CGT subcommittee meeting of 7 August 2002). An ETP in relation to a person means (subject to certain exceptions) any payment made in respect of the person in consequence of the termination of any employment of the person (paragraph (a) of the ETP definition in subsection 27A(1) of the ITAA 1936). ‘Employment’ includes the holding of an office (subsection 27A(1)). Taxation Ruling TR 2003/13 issued on this subject on 23 October 2003. Termination of employment, including office, will be satisfied if the person resigns/retires in a bona fide manner either as an employee or as a director. (b) As per the response above, there is no need to resign as a director of the corporate

trustee if the person has resigned as a common law employee of the trust. (d) The issue is whether a payment by the trust to a stakeholder of the trust upon the

resignation of that stakeholder as a director of the corporate trustee of the trust satisfies the paragraph 27A(1)(a) definition of ETP.

As there is a termination of employment, the issue is whether the payment is made ‘in consequence’ of that termination. The meaning of the phrase ‘in consequence of’ in an ETP context is the subject of Taxation Ruling TR 2003/13 which was released on 23 October 2003. That ruling states: ‘the Commissioner considers that a payment is made in respect of a taxpayer in

consequence of the termination of the employment of the taxpayer if the payment “follows as an effect or result of” the termination. In other words, but for the termination of employment, the payment would not have been made to the taxpayer.

The phrase requires a causal connection between the termination and the payment, although the termination need not be the dominant cause of the payment. The question of whether a payment is made in consequence of the termination of employment will be determined by the relevant facts and the circumstances of each case.’

Whether a payment made in this type of situation is made in consequence of the termination of the directorship will depend on the particular circumstances of the case. However, generally it would be accepted that this would be the case and this part of the ETP requirements would be satisfied.



¶5.044 Property sold to super fund and proceeds directed back to fund

In ID 2003/505 the ATO confirmed the retirement exemption is available in a case where the taxpayer, a sole trader, sold a commercial property used in his business to his super fund and then directed that the proceeds be paid back into the fund. The ID considers that Part IVA would not be applied in such a case.

ID 2003/454 confirms that in the case dealt with in ID 2003/505, the direction that the proceeds be paid to the super fund satisfied the requirement in sec 152-310(2) that the taxpayer has received the capital proceeds of the sale.

¶5.045 Making ETPs where payments received in installments

In ID 2002/566 the ATO express the view that where capital proceeds are received in instalments in the case of a company or trust, the company or trust must make ETPs from the proceeds to the maximum extent possible under sec 152-325. The ID notes:

Subsection 152-325(5) of ITAA 1997 requires the amount of the eligible termination payment required to be paid under subsection 152-325(1) of ITAA 1997 to be equal to the amount of the instalment where the instalment is less than or equal to the capital gain that is to be disregarded. Eligible termination payments must be made in this manner until the total of the eligible termination payments made equals the amount of the capital gain to be disregarded.

Note that under sec 152-315(1) the taxpayer “chooses” the amount to be disregarded which can be any amount up to the full capital gain.

ID 2002/494 confirms that PTsETPs made under sec 152-325(1) can continue over a period of years where the purchase price for the CGT assets disposed of are payable in instalments. Care needs to be taken to ensure that the reason for the payments to the CGT concession stakeholders is in consequence of the termination of their employment or office.

¶5.046 More than one CGT concession stakeholder

By sec 152-315(5) where a company or trust makes a choice to apply the retirement exemption and there are two CGT concession stakeholders, as in the above example, the company or trust must specify in writing the percentage of each CGT asset’s CGT exempt amount to each stakeholder. As previously, one specified percentage may be nil, but they must add up to 100%. The section provides no further guidance as to the form of the specification. A suitable form, which combines this requirement and the requirement under sec 152-315(4) that the CGT exempt amount must be specified in writing, is as follows:

Income Tax Assessment Act 1997 Small Business Retirement Exemption CGT Exempt Amount and CGT Stakeholder Specification (name of company or trust) …………………………………………………………………..of ……………………………………….Tax File No.……… for the purposes of subsection 152-315(4) of the Income Tax Assessment Act 1997 specifies that $ ….. as the CGT exempt amount in respect of the asset disposed of by it on (insert date of disposal) described below. For the purposes of section 152-315(5) the percentages for each CGT concession stakeholder are as follows: (name of CGT concession stakeholder) ......….% (name of CGT concession stakeholder) ......….% ___ 100%



(Describe here asset disposed of) sgd (Public officer/Trustee) Date/Time: Notes. 1. This specification is required to be made on or before the date for lodgment of the

income tax return for the year of income in which the disposal took place. It should be kept with a copy of the return.

2. The CGT exempt amount must not be greater than the amount of the capital gain that has arisen in relation to the asset disposed of.

3. For each of the two CGT concession stakeholders, the percentage specified in relation to the asset’s exempt amount must not result in an amount that exceeds that CGT concession stakeholders’ CGT retirement exemption limit. To comply with this requirement, the CGT exemption amount may need to be reduced in some cases.

4. The combined exemption percentages must add up to 100% although one can be nil.

Note comments in ¶5.030 concerning the scope for specifying alternative exempt CGT amounts in cases where the exempt amount has not been able to be determined.

¶5.047 Delaying payment of capital proceeds

It would appear that there is some scope in the case of the disposal of a CGT asset from an entity, to prevent a portion of the capital proceeds from being paid into a CGT concession stakeholder’s super fund if the relevant CGT event occurs before the person has turned 55; but say the balance of the proceeds are not paid until after that time (see sec 152-325(1) and (7)).

¶5.048 Application of sec 109 ITAA 36?

The ATO in ID 2003/743 considered the application of sec 109 ITAA 36 where a taxpayer company had chosen to pay an amount under the retirement exemption into a super fund on behalf of its controlling individual. The ID is reproduced below:

Issue

Will any part of a payment of $500 000 made by the taxpayer, a private company, under section 152-325 of the Income Tax Assessment Act 1997 (ITAA 1997) be considered by the Commissioner to be unreasonable under subsection 109(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision

No. The payment of $500 000 made by the taxpayer, a private company, under section 152-325 of the ITAA 1997 will not be considered by the Commissioner to be unreasonable, in any part, under subsection 109(1) of the ITAA 1936.

Facts

The taxpayer is a private company with only a single shareholder who was employed in the business operated by the company as the business manager. After five years of working in and managing the business the shareholder/employee decided to retire, having reached retirement age. The company then disposed of the business assets in order to provide a retirement benefit to the retiring shareholder/employee. The company made a capital gain on the disposal and chose to disregard $500 000 of the capital gain in accordance with


Selling a Small Business – The CGT Strategies section 152-315 of the ITAA 1997. The capital gains tax exempt amount for the assets under consideration is therefore $500 000. The company immediately made a payment of $500 000 under section 152-325 of the ITAA 1997 to the shareholder/employee who retired. The company chose the small business retirement exemption and satisfied the requirements of Subdivisions 152-A and 152-D of the ITAA 1997.


For a company to choose the small business retirement exemption in Subdivision 152-D of the ITAA 1997 it must, among other things, make an eligible termination payment (ETP) in accordance with section 152-325 of the ITAA 1997. This ETP must satisfy the definition of ‘eligible termination payment’ in subsection 27A(1) of the ITAA 1936. Under subparagraph (a)(v) of that definition an amount that is deemed to be a dividend is excluded from being an ETP. Thus any payment or part thereof considered to be unreasonable and deemed to be a dividend will not satisfy section 152-325 of the ITAA 1997 and the retirement exemption will not be available. Taxation Ruling IT 2621 outlines the factors and circumstances the Commissioner will take into consideration when determining whether a payment is unreasonable under section 109 of the ITAA 1936. Paragraph 13 of IT 2621 states that when forming an opinion under section 109 of the ITAA 1936 the Commissioner must take all the circumstances of the case into account. In Ferris v. Federal Commissioner of Taxation (1988) 20 FCR 202; (1988) 19 ATR 1705; 88 ATC 4755, it was held that the Commissioner had used the discretion under section 109 of the ITAA 1936 incorrectly because the decision as to what was reasonable was based solely on what was reasonable for superannuation purposes. It was emphasised that what is and what is not reasonable depends on the circumstances of the case and upon commercial practice. On this basis it would be incorrect for the Commissioner to base his decision as to what is reasonable solely with reference to the CGT retirement exemption limit of $500 000. In determining whether an amount paid under section 152-325 of the ITAA 1997, in order to comply with the requirements of the small business retirement exemption, is unreasonable under section 109 of the ITAA 1936 the Commissioner will take all the circumstances of the case into account. When all the circumstances of the current case are considered, a payment of $500 000 would not be unreasonable for the purposes of section 109 of the ITAA 1936. In forming this opinion under section 109 of the ITAA 1936, in this case, the Commissioner has had particular regard to:

• the purpose behind the payment

• the length of service with and level of contribution to the business by the shareholder/employee

• the election by the taxpayer to use the small business retirement exemption

• the policy intention behind the exemption and

• the level of the CGT retirement exemption limit ($500 000).

As the taxpayer has worked in the business for several years and is intending to use the small business retirement exemption, the Commissioner does not consider the payment of $500 000 to be unreasonable. Date of decision: 4 April 2003


Selling a Small Business – The CGT Strategies As a comment, it would appear that unless in a blatant case where it would be difficult to commercially justify a significant ETP, there is little danger that the ATO would seek to apply sec 109. Nevertheless, the ID does signal that there will be cases that the section will be applied and it cannot simply be ignored when applying the retirement exemption. Given that there is no similar limitation for trusts or individuals and the level of payouts that appear to be prevalent in business today, it may be observed that those occasions are likely to be rare. In this regard, the ID makes a point of the fact that the $500,000 limit under the retirement exemption is itself a factor to be taken into account.

¶5.049 Consequences of choice

Section 152-310 ITAA 97 is a machinery provision that operates to enable the CGT exempt amount in relation to that part of a capital gain chosen to be exempt, to be disregarded. As noted above, it also deems the exempt amount to be an ETP for an individual taxpayer made at the later of either when an individual chooses to apply the retirement exemption or when the amount is received.

Where a company or trust applies the retirement exemption, sec 152-310(5) deems the payment for the purposes of Subdivision AA of Division 2 of Part III of ITAA 36 to be a CGT exempt component and ensures that no deduction can be obtained by the company or trust for the amount. As noted above, it does not deem the payment to be an ETP so it must actually be an ETP – in other words, the payment must be in respect of the termination of the employment of a CGT concession stakeholder or otherwise fall within the definition in sec 27A of an ETP.

¶5.050 CGT RETIREMENT EXEMPTION LIMIT

As with the previous concession, the retirement exemption is limited to a lifetime limit of $500,000 for each taxpayer. This limit is provided by sec 152-320 ITAA 97. The retention of the limit has become a little meaningless in practical terms for most taxpayers because of the extension of the former goodwill exemption into a general 50% active asset exemption, which is required to be applied before applying the retirement exemption. What this means is that the amount of capital gain requiring relief is reduced so that a lesser proportion of the $500,000 lifetime limit will be required in a typical application to eliminate a taxable capital gain. Where the business is conducted by an individual taxpayer as a sole trader who is eligible for the 50% individual discount or through a trust, the need to resort to the retirement exemption is even less.

Example

Kerry sells his small business for $1m. For the purpose of the example it is assumed that the sale involves a single asset, e.g. goodwill with a nil cost base, and that Kerry is eligible for the small business concessions as well as the individual discount.

The calculation of CGT applying the various concessions is as follows:

Capital gain $1,000,000 Less 50% discount $500,000 Less 50% active asset exemption $250,000Assessable capital gain $250,000

CGT exempt amount for retirement exemption $250,000

Prior to 21 September 1999, Kerry’s assessable capital gain of $1m would have only been able to be reduced by $500,000 under the retirement exemption, assuming he had little in the way of superannuation savings, so that he would be left with the balance of approximately $500,000 upon which to pay CGT. In other words, his lifetime $500,000 CGT retirement exemption limit would have been eliminated in one application. Under the example above, Kerry will be able to dip into the retirement exemption on future occasions to mop up any


Selling a Small Business – The CGT Strategies residual taxable capital gains after applying the other concessions, up to his remaining CGT retirement exemption limit ($250,000).

Note that transitional provisions apply to carry over any old CGT retirement exemption limits that existed as at 21 September 1999, see item 62 of Part 3 of Schedule 1 of the NBTS (CGT) Act.

Because of sec 152-310(3) ITAA 97 excluding the operation of the market value substitution rule, it is arguable that the $500,000 limit could be circumvented if the active assets were gifted by a taxpayer. As noted above at ¶5.010, the ATO does not accept the view that the concession will apply where there is either no consideration, or in respect of the difference between the actual consideration and the market value of the assets.

¶5.060 EX GRATIA PAYMENTS

ID 2002/385 dealing with the potential application of GCT event H2 (receipt for an event relating to a CGT asset) in relation to an ex gratia payment from a foreign government to a merchant seaman raises the possibility that there may be some scope for ex gratia payments in the context of a sale of business. This would be chiefly where, for example, an individual may have sold of his/her business in circumstances where the price was less favourable to the individual and the purchaser after the event may wish to recognise in some way the circumstances of the vendor. The ID takes the view that as the recipient did not receive the payment in relation to an asset, there was no CGT event H2.

¶5.070 RETIREMENT EXEMPTION AVAILABLE FOR CONSOLIDATED GROUP

As noted at ¶2.040 above, ID 2004/43 (now withdrawn) considered the position of the application of the retirement exemption provisions in the case of a consolidated small business consisting of a head company and a subsidiary that carried on a business. The ATO confirmed that the concession would be available in this case on the basis that the consolidated entity was treated for tax purposes as a single entity. The relevant parts of the ID are reproduced below:

Issue

For the purpose of applying the small business retirement exemption, is the controlling individual condition in paragraph 152-305(2)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) applied to the head company of a consolidated group rather than the subsidiary member of the group that actually sells an asset?

Decision

Yes. The effect of the single entity rule in subsection 701-1(1) of the ITAA 1997 is that the controlling individual condition in paragraph 152 305(2)(b) of the ITAA 1997 is applied to the head company of a consolidated group for the purposes of the small business retirement exemption.

Facts

All the shares in H Co are owned by an individual. H Co is the head company of a consolidated group consisting of H Co and Sub Co. Sub Co carries on a small business. In the 2004 income year Sub Co sold an asset. For the purposes of working out H Co's liability to income tax for that income year, H Co is taken to have sold the asset and made a capital gain. H Co wishes to treat the capital gain as exempt under the small business retirement exemption in Subdivision 152 D of the ITAA 1997. H Co satisfies all of the basic conditions in section 152-10 of the ITAA 1997.




Apart from the basic conditions in section 152-10 of the ITAA 1997, a company wishing to claim the small business retirement exemption (in this case the head company of the consolidated group) must satisfy the controlling individual test: paragraph 152-305(2)(b) of the ITAA 1997. The controlling individual test is satisfied if the company had at least one controlling individual just before the CGT event: section 152-50 of the ITAA 1997. An individual is a controlling individual of a company if, at that time, the individual holds the legal and equitable interest in shares, other than redeemable shares, that carry the right to exercise at least 50% of the voting power in the company and receive at least 50% of any dividend or distribution of capital the company may pay: subsection 152-55(1) of the ITAA 1997. If Sub Co were not a member of a consolidated group it would not qualify for the retirement exemption because it could not satisfy the controlling individual test (all the shares in Sub Co being owned by H Co). An issue arises as to whether the single entity rule in subsection 701-1(1) of the ITAA 1997 affects the application of the controlling individual test for entities that are part of a consolidated group. Under the single entity rule, subsidiary members of a consolidated group are taken to be parts of the head company and not separate entities when working out the group's income tax liability or loss. This means that actions of subsidiaries are treated as actions of the head company for the purposes of working out the income tax liability or losses of a consolidated group. Therefore, the controlling individual test must be applied to the group's head company with the result, in this case, that H Co satisfies the test in section 152-50 of the ITAA 1997 and will be able to claim the small business retirement exemption to the capital gain made on the disposal of the asset. The result in this case, while different from that which would arise had Sub Co not been a member of a consolidated group, is consistent with the fundamental principles underpinning the consolidation regime. Date of decision: 24 December 2003

The critical reasoning in the above ID is that sec 701-1(1) in requiring entities in a group to be treated as a single entity is treated as overriding the provisions of Division 152 so that, as in the case considered by the ID, but for the fact that the companies were part of a consolidated group neither the head company nor the subsidiary would have been entitled to the retirement concession. Having established the applicability of sec 701-1(1) it may reasonably assumed that the ATO will be prepared to apply the concessions in other situations where the entities involved have been consolidated.

TD 2004/D16 provides as follows:

Income tax: consolidation: capital gains: if a subsidiary member of a

consolidated group sells an asset which is taken for income tax purposes to have

been disposed of by the head company, is the controlling individual condition in

paragraphs 152-110(1)(c) or 152-305(2)(b) of the Income Tax Assessment Act

1997 applied to the head company of the consolidated group?

Preamble

This document is a draft for industry and professional comment. As such, it represents the preliminary, though considered views of the Australian Taxation Office. This draft may not be relied on by taxpayers and practitioners as it is not a


Selling a Small Business – The CGT Strategies ruling for the purposes of Part IVAAA of the Taxation Administration Act 1953. It is only final Taxation Determinations that represent authoritative statements by the Australian Taxation Office.

1. Yes. The effect of the single entity rule in section 701-1 of the Income Tax Assessment Act 1997 (ITAA 1997) is that the controlling individual condition in paragraph 152-110(1)(c) or 152-305(2)(b) of the ITAA 1997 is applied to the head company of the consolidated group.

2. An entity wishing to apply either the small business 15 year exemption or the small business retirement exemption to a capital gain from an active asset must satisfy the controlling individual conditions in paragraph 152-110(1)(c) or 152-305(2)(b) of the ITAA 1997 respectively. Paragraph 152-110(1)(c) requires that the entity have a controlling individual at all times when it owned the asset (even if it was not the same controlling individual throughout that period). Paragraph 152-305(2)(b) requires that the entity have at least one controlling individual just before the CGT event.

3. Under the single entity rule, subsidiary members of a consolidated group are taken to be parts of the head company and not separate entities for income tax purposes. A CGT event from the sale of an asset by a subsidiary member is generally taken to happen to the head company of the consolidated group and any capital gain or loss is also made by the head company.

4. Accordingly, the head company of a consolidated group must satisfy the controlling individual conditions in paragraphs 152-110(1)(c) or 152-305(2)(b) of the ITAA 1997 if it wishes to reduce a capital gain that it has made by applying the small business 15 year exemption or the small business retirement exemption.

5. An individual is a controlling individual of a company if, at that time, the individual holds the legal and equitable interest in shares, other than redeemable shares, that carry the right to exercise at least 50% of the voting power in the company and receive at least 50% of any dividend and 50% of any distribution of capital the company may pay (subsection 152-55(1) of the ITAA 1997).

Note 1: It should not be assumed that the exemption in section 152-125 will apply for payments, to CGT concession stakeholders, that are attributable to amounts for which the head company obtains an exemption. The single entity rule is not relevant for entities outside the group. The Tax Office will give further consideration to this issue.

Note 2: This Taxation Determination does not apply to intra-group assets.

Example

6. All the shares in H Co are owned by an individual. H Co is the head company of a consolidated group consisting of H Co and Sub Co. Sub Co carries on a business.

7. In the 2004 income year Sub Co sold an asset. For the purposes of working out H Co's liability to income tax for that income year, H Co is taken to have sold the asset and made a capital gain. H Co wishes to treat the capital gain as exempt under the small business retirement exemption in Subdivision 152-D of the ITAA 1997. H Co satisfies all of the basic conditions in section 152-10 of the ITAA 1997.

8. As a result of the single entity rule, the controlling individual test is applied to the group's head company with the result, in this case, that H Co will be able to claim the small business retirement exemption in relation to the capital gain made on the disposal of the asset.

Date of effect

9. When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).



Chapter 6

Small business roll-over

¶6.010 SMALL BUSINESS ROLL-OVER

¶6.011 No five-year limitation but gains quarantined

¶6.020 ELIGIBILITY FOR ROLL-OVER

¶6.021 Time to choose roll-over

¶6.030 REPLACEMENT ASSET CONDITIONS

¶6.031 Type of replacement asset

¶6.032 Subdivision 124-B roll-over

¶6.033 CGT roll-over implications where work in progress amount is included as income under sec 15-50 ITAA 97

¶6.040 CHANGE OF STATUS OF AN ACTIVE ASSET

¶6.041 Rules where an individual who has obtained a roll-over dies

¶6.010 SMALL BUSINESS ROLL-OVER

A major consequential change to the roll-over with the extension of the goodwill exemption to all active assets is that taxpayers no longer need to identify goodwill and non-goodwill capital gains. This means that the separate roll-over rules for such gains have been eliminated. Those rules applied under the previous regime to ensure that taxpayers didn’t try to convert non-goodwill assets into goodwill then claim the 50% exemption on the subsequent disposal of the goodwill asset. This change greatly simplifies the new roll-over provisions in Subdivision 152-E of Part 3-3 ITAA 97 now occupying just four pages of text.

The minor changes as set out above in relation to the retirement exemption (see ¶5.000 above) apply to the roll-over concession to rationalise the eligibility criteria for both concessions.

As with the small business retirement exemption, the roll-over concession continues under the new provisions but with the option of choosing to take advantage, in addition, of the existing and new concessions, where available. This change also makes the roll-over of less importance in that the potential liability to capital gain from the disposal of a business or CGT asset is greatly reduced for small business taxpayers who are eligible for the other concessions.

Having a far smaller potential CGT liability after applying other concessions means that less emphasis needs to be placed on the roll-over; alternatively, a taxpayer who may have previously looked to making use of the roll-over may decide to bypass it altogether.

Example

Carmody’s Courier Co is operated through a discretionary trust with a corporate trustee. Mr Carmody, the operator, wants to sell the business and buy a vineyard. Prior to the introduction of the new small business concessions, Mr Carmody was planning to roll over the likely $250,000 capital gain on the sale of his courier business made up of mostly goodwill.


Selling a Small Business – The CGT Strategies He now thinks that, rather than rolling over the $250,000 capital gain which would have meant buying a vineyard with a significant goodwill component, it may be better to eliminate the capital gain altogether by applying the 50% reduction as well as the 50% discount capital gains concession that applies at the trust level and claim the retirement exemption on the balance. The calculation would be as follows:

Capital gain $250,000 Less 50% discount $125,000 Less 50% active asset exemption $62,500Assessable capital gain $62,500

CGT exempt amount for retirement exemption $62,500

As Mr Carmody is under 55, the $62,500 would need to be paid into his superannuation fund as an ETP. The trust would be able to retain the balance of the gain to be used to acquire a less developed vineyard that could be built up over time.

Because there is now no distinction between goodwill and non-goodwill assets, the roll-over is now more flexible. In the above example, had Mr Carmody’s capital gain consisted of mostly goodwill capital gain, prior to 21 September 1999, he would not have been able to use the roll-over to acquire a non-goodwill asset such as a recently established vineyard with little in the way of goodwill.

¶6.011 No five-year limitation but gains quarantined

Another change that should be noted is that there is no longer a limitation on how frequently the roll-over may be utilised. Previously, an asset could not be rolled over within five years of an earlier application of the concession. This change was not announced in the Treasurer’s Press Release of 21 September 1999.

However, to prevent open slather there is a restriction on access to further concessions under Division 152 in respect of the rolled-over amount. Section 152-10(4), as introduced by the NBTS (CGT) Act 1999, operated to deny further Division 152 concessions (other than further roll-overs) in respect of the rolled-over amount. An amendment introduced by the Taxation Laws Amendment Act (No 7) 2000 on 29 June 2000 now allows the small business retirement exemption to be applied in respect of a rolled-over amount, as from 21 September 1999.

The effect of sec 152-10(4) is to require the taxpayer to quarantine the rolled-over amount indefinitely in relation to the replacement asset to ensure that upon a future CGT event the only concessions allowed would be a further roll-over or the small business retirement exemption.

Example

Philip rolls over $100,000 into a new business, the goodwill of which was acquired for $150,000. Accordingly, its cost case is reduced to $50,000. After 10 years Philip sells the business and obtains $500,000 for the goodwill. His capital gain of $450,000 will be required to be separated into two classes: $100,000 quarantined gain and $350,000. The $350,000, subject to eligibility, will be entitled to all of the CGT small business concessions including the 50% individual discount. The quarantined gain of $100,000, assuming eligibility, will only be entitled to a further small business roll-over or retirement exemption.

Note that a capital gain arising from a disposal of, or change of use of, a replacement asset (which will include a rolled-over amount) cannot be a discount capital gain, as the relevant CGT events (CGT event J2 and J3) are excluded from the discount gain regime, see sec 115-25(3)(ha) and (hb).



Practice point

In practice, assuming that a small business otherwise qualifies, that is the taxpayer has “business” assets of $5m or less, the 50% reduction would always be applied in the first instance to reduce the amount of taxable gain by 50% unless the business was conducted by a sole trader or partnership. At that point, a decision would be made as to the choice of further concessions. For example, if the business was operated by a company the company may choose to roll over the remaining 50% of the gain.

¶6.020 ELIGIBILITY FOR ROLL-OVER

To qualify for the roll-over a taxpayer must, by sec 152-405 ITAA 97, satisfy the four basic conditions in sec 152-10. To recap, they are:





Additionally, sec 152-405 provides that a taxpayer must acquire a replacement asset within the period of one year before, and two years after, the happening of the last CGT event in the income year in which the roll-over is obtained. As under the previous concession, the form of the roll-over is that the cost base of the replacement asset is reduced to the extent of the capital gain rolled over (see sec 152-415 ITAA 97).

Example

Returning to the last example, it will be recalled that Carmody’s Courier Co is operated through a discretionary trust with a corporate trustee. Mr Carmody, the operator, wants to sell the business and buy a vineyard. Prior to the introduction of the new small business concessions, Mr Carmody was planning to roll over the likely $250,000 capital gain on the sale of his courier business made up of mostly goodwill. He now thinks that, rather than rolling over the $250,000 capital gain which would have meant buying a vineyard with a significant goodwill component, it may be better to eliminate the capital gain altogether by applying the 50% reduction as well as the 50% discount capital gains concession that applies at the trust level and claim the retirement exemption on the balance. Mr Carmody acquires a vineyard for $100,000 and decides to roll over the remaining taxable capital gain into the vineyard as his replacement asset. The capital gain remaining after applying the 50% discount and the 50% reduction is $62,500. The cost base of the replacement asset would be reduced to $37,500. Had the vineyard only cost $60,000, the trust would pay CGT on the excess, that is $2,500.

¶6.021 Time to choose roll-over

Section 152-410 ITAA 97 is headed “When you can obtain the roll-over”. The section is slightly repetitive in that it repeats the basic eligibility requirements for the roll-over contained in the previous section. Despite the heading to sec 152-410, it does not actually indicate the time when roll-over is obtained but rather sets out the conditions that must be met before roll-over can be obtained.

As with the retirement concession, roll-over is a taxpayer “choice” for which there are no formal requirements as such. Section 103-25 makes this clear. This section was amended by the NBTS (CGT) Act to make clear that the “choice” may be made within two years from the last CGT event in the relevant year of income rather than, as would normally be the case,


Selling a Small Business – The CGT Strategies where a “choice” is required to be made, that is by the day a taxpayer lodges his/her return for the year in which the relevant CGT event occurs, or such further time as the Commissioner may allow.

Section 103-25(2) says that the way a taxpayer makes his/her return is sufficient evidence of the making of the choice. Where as in the present case the “choice” is to disregard the capital gain, it is possible that a taxpayer who “forgot” to include a capital gain in his return and who otherwise satisfies the requirement of Subdivision 152-E might be taken to have made a choice.

Perhaps the greater dilemma for a taxpayer is whether to include in his return a capital gain from the disposal of a CGT asset where it is intended to roll over the gain but no replacement asset has been acquired at the time at which the taxpayer’s return is required to be lodged for the relevant year of income.

Example

Returning to the last example, it will be recalled that Carmody’s Courier Co is operated through a discretionary trust with a corporate trustee. Mr Carmody, the operator, wants to sell the business and buy a vineyard. Prior to the introduction of the new small business concessions, Mr Carmody was planning to roll over the likely $250,000 capital gain on the sale of his courier business made up of mostly goodwill. He now thinks that, rather than rolling over the $250,000 capital gain which would have meant buying a vineyard with a significant goodwill component, it may be better to eliminate the capital gain altogether by applying the 50% reduction as well as the 50% discount capital gains concession that applies at the trust level and claim the retirement exemption on the balance. This time Mr Carmody sells his business on 15 May 2002. He plans to roll over his taxable capital gain from the sale of his courier business into a vineyard but, at the time that he needs to make the operating trust’s tax return, he has yet to find a suitable property. This is fine as by not including the gain in the trust’s return for the income year 2001/02, this is evidence that the trust has chosen the roll-over. The only problem is that, not having acquired a replacement asset at that time, the trustee has not satisfied the requirement in sec 152-410(b) and (c) that it choose one or more CGT assets as replacements and that the replacement assets satisfy the conditions in sec 152-420. Strictly speaking, therefore, the roll-over is not available at this point in time. The trustee would need to return the capital gain in the 2001/02 return and seek an amendment once the replacement assets have been acquired. Under sec 152-410(b), the latest time that the trust can acquire a replacement asset is 15 May 2004 assuming that the last CGT event in the 2001/02 year under which roll-over was available to Mr Carmody was 15 May 2002.

If Mr Carmody has not been able to find a replacement asset for the trust by 15 May 2004, sec 152-420(1) allows the period to be extended in certain circumstances, discussed below.

Replacement asset not acquired – remission of penalty

ID 2003/686 (withdrawn) considered the case, under the former provisions, where due to ill health a taxpayer did not acquire a replacement asset. The ID notes that “the taxpayer did not have an assessable capital gain until the expiration of the two year period after the CGT event happened, and it was the non-acquisition of a replacement asset by the taxpayer due to ill health that resulted in the taxpayer requesting an amendment to include the disregarded capital gain from the small business roll-over claimed under Division 123 of the ITAA 1936”. In view of the taxpayer’s health circumstance, the Commissioner exercised his discretion under sec 227(3) to remit the tax shortfall penalties under secs 226G, 226H, 226J, 226K, 226L and 226M ITAA 36.


Selling a Small Business – The CGT Strategies In ID 2003/687(withdrawn) the ATO considered the position of the taxpayer in ID 2003/686 in respect of the general interest charge (GIC). Applying the principles set out in IT 2444 the Commissioner remitted the GIC for the two-year period within which the taxpayer had to acquire a replacement asset, but applied it from the day after the end of the relevant two-year period to the date of the taxpayer’s amendment request.

Note, with the withdrawal of ID 2003/94, the ATO are currently reviewing their position on the application of the GIC.

Can you change your mind?

Interpretative Decision ID 2002/945 confirms the ATO view that once a choice is made to apply the roll-over and a replacement asset is acquired, the taxpayer cannot change his/her mind and apply the retirement exemption. The ATO’s reasons for the decision are set out below:

A choice between inconsistent courses of action, once made, is binding and cannot be withdrawn or recanted - unless this is specifically provided for. See Scarf v. Jardine (1882) 7 AppCas 345; Motor Oil Hellas (Corinth) Refineries SA v. Shipping Corporation of India (The "Kanchenjunga") [1990] 1 Lloyd's rep 391, 397 (Lord Goff of Chieveley); The Commonwealth v. Verwayen (1990) 170 CLR 394; (1990) 64 ALJR 540; (1990) 95 ALR 321. Accordingly, a choice made for the small business roll-over in Subdivision 152-E of the ITAA 1997 is irrevocable and cannot later be changed. The taxpayer is not able to later choose the small business retirement exemption in Subdivision 152-D of the ITAA 1997 after having previously chosen the small business roll-over. This reflects the general rule that applies to the making of choices throughout the Income Tax Assessment Act 1936 and the ITAA 1997. Paragraph 103-25(1)(b) of the ITAA 1997 allows the Commissioner to grant an extension of time in which to make a choice. However, paragraph 103-25(1)(b) has no application once a taxpayer has made a choice.

There is nothing contained in the ITAA 1997 that would permit the Commissioner to allow the taxpayer to change the choice originally made.

See ID 2002/1014(withdrawn) confirming for the same reasons that a change of mind to apply the 50% goodwill exemption under former Div 123 after choosing the roll-over is not permitted. But see ID 2002/739 for the reverse situation. In that case, no choice was considered to have been made so as not to prevent the taxpayer later choosing the roll-over, see also ID 2003/103 (noted above). The ATO in ID 2003/102 indicated that it will allow an extension of time to apply the roll-over where in the situation discussed in ID 2003/103 no choice had been made due to an oversight by the taxpayer’s agent.

As a practical matter, so long as the return for the relevant year has not been lodged with the ATO, even where a replacement asset has been acquired, it would not be too late to decide to apply the retirement exemption, see ¶5.010, above. In the case considered in ID 2002/945, the taxpayer had actually lodged his return.

¶6.030 REPLACEMENT ASSET CONDITIONS

Section 152-420 ITAA 97 seeks to set out conditions that must be complied with for a replacement asset to qualify under the roll-over. The section restates the period within which a replacement asset is required to be acquired (contained in sec 152-405(2) and 152-410(b)) and provides for an extension of time within which to acquire a replacement asset.

The power to extend the time limit has been strangely drafted in an apparent attempt to provide an automatic extension in defined but limited circumstances. The heading to sec 152-420(2) is “Extension of time if all reasonable steps taken” but the provisions following do not appear to provide illumination of this statement. The extension of time provided by sec 152-


Selling a Small Business – The CGT Strategies 420(2) is limited to occasions where all or part of the proceeds from the sale of the existing CGT asset are not received in full by the end of the two-year period after the sale of an existing CGT asset, and then the taxpayer later receives part of the amount. The provision allows then a further 12 months from the receipt of the additional payment but only if the taxpayer acquires a replacement asset where the first and second elements of the cost base are at least equal to the additional proceeds. The EM provides no guidance on this provision.

By sec 152-420(3), the Commissioner is given a general power to extend the initial two-year period and the 12-month period in sec 152-420(2). Given the highly proscribed nature of the circumstances in which an extension is allowed automatically in subsec (2), there may be some question as to the intended scope of the discretion given to the Commissioner in subsec (3).

TD 2000/40 (previously TD 1999/D57), dealing with what are “special circumstances” for the purposes of sec 124-75(3) ITAA 97, may provide some assistance as to the circumstances in which the Commissioner will exercise his discretion under sec 152-420(3). Even though the occasion for the exercise of the discretion does not require “special circumstances”, given the limited nature of the extension in sec 152-420(2), it is likely that the discretion would be exercised sparingly. For an example where the Commissioner exercised his discretion in favour of a taxpayer under sec 152-420(3), see ID 2001/619. The ID set out the matters that were taken into account, as follows:

Determining if the discretion would be exercised the Commissioner has considered the following factors:

there should be evidence of an acceptable explanation for the period of extension requested and that it would be fair and equitable in the circumstances to provide such an extension;

account must be had to any prejudice to the Commissioner which may result from the additional time being allowed, however the mere absence of prejudice is not enough to justify the granting of an extension;

account must be had of any unsettling of people, other than the Commissioner, or of established practices;

there must be a consideration of fairness to people in like positions and the wider public interest;

whether there is any mischief involved; and

a consideration of the consequences.

Having considered the relevant factors above and the specific circumstances of this case, including:

the negotiation process commenced within the relevant period for small business roll-over under 152-420(1) of the ITAA 1997;

the replacement assets were acquired a short time outside the relevant period under 152-420(1) of the ITAA 1997;

the delays in the negotiation process caused by the purchaser were beyond the control of the rule,

The Commissioner will exercise the discretion under subsection 152-420(3) of the ITAA 1997 to extend the period for acquiring the replacement asset from April 2000 to February 2000, i.e., 14 months before the date of disposal of Business A.



Example

Returning to the last example, it will be recalled that Carmody’s Courier Co is operated through a discretionary trust with a corporate trustee. Mr Carmody, the operator, wants to sell the business and buy a vineyard. Prior to the introduction of the new small business concessions, Mr Carmody was planning to roll over the likely $250,000 capital gain on the sale of his courier business made up of mostly goodwill. He now thinks that, rather than rolling over the $250,000 capital gain which would have meant buying a vineyard with a significant goodwill component, it may be better to eliminate the capital gain altogether by applying the 50% reduction as well as the 50% discount capital gains concession that applies at the trust level and claim the retirement exemption on the balance. This time Mr Carmody does not receive the final 10% of the proceeds (totaling $30,000) within the two-year period ending 15 May 2004, but on 10 June 2004 receives the final payment. Because of the delay in receiving the payment, he had not bought his vineyard by 15 May 2004. Provided Mr Carmody acquires his vineyard within the 12-month period commencing on 10 June 2004, he will be able to roll over the remaining $62,500 capital gain. In this example, Mr Carmody will be unlikely to have any difficulty in meeting the requirement that the replacement asset he acquires during the further 12-month period must cost at least the amount of the additional payment, that is $30,000.

“Note 1” following sec 152-420(2) makes clear that, if the replacement asset acquired in the 12-month extension period does not equal in value the amount of the additional amount received, the excess will be assessable. This appears to be inconsistent with the subsection in that the subsection appears to make the extension conditional on acquiring a replacement asset worth more than the additional payment. In other words, if the condition is not met, no extension of the time to acquire a replacement asset is allowed under the provision and the whole of the taxable gain would be assessable. It would be open to a taxpayer in such a case to seek an extension under sec 152-420(3). It may be commented that the circumstances in which a taxpayer would need to rely upon sec 152-320(2) are likely to be fairly rare.

The National Tax Liaison Group – CGT Subcommittee Minutes of the meeting of 28 November 2001 record the following issue:

The NTAA asked whether a flaw exists in the small business rollover so that an extension of time granted under subsection 152-420(3) is ineffective unless the replacement asset is active when acquired. Example: A CGT event happens on 28 November 2001 in relation to an original asset for which the taxpayer wants to choose the rollover. This is the last event in the 2001-02 income year for which the rollover will be chosen. The taxpayer wishes to choose business premises as a replacement asset but the business premises are not acquired until 10 December 2003 (the date of making the contract). Settlement does not take place until 10 February 2004, at which time the replacement asset is used in the relevant business. If the Commissioner grants an extension of time under subsection 152-420(3) to 10 December 2003, it seems that the replacement business premises will still not qualify as a replacement asset. To qualify as a replacement asset the asset must be an active asset when acquired, or by the end of two years after the relevant CGT event – see subsection 152-420(4). In this example, as the two year period has expired, the asset must be an active asset when acquired. As the date of acquisition for CGT purposes is the date of making the contract (see section 109-5) and as the replacement asset is not active until settlement, the condition is not satisfied. Although the Commissioner has a discretion to extend


Selling a Small Business – The CGT Strategies the time limit under subsection 152-420(1), he or she does not have a discretion to extend the time limit under subsection 152-420(4). The ATO acknowledged that in some cases it may be difficult to satisfy the requirements. It will consider this issue further.

It would appear that the better view is that the replacement asset would be an active asset at the time the contract was exchanged. It cannot be assumed that merely because the purchase has not been completed that the asset acquired at the time of exchange, that is an equitable interest in the property, is not an asset that cannot be “used” in a broad sense by the business. For example, a sign at the business’s existing premises indicating a move to the new premises would be indicative of such “use”.

ID 2003/175 confirms that the roll-over is not available if the replacement asset is acquired by a different, albeit, related entity.

¶6.031 Type of replacement asset

Section 152-420(4) ITAA 97 sets out the basic condition that must be met in respect of a replacement asset. The requirement is that it must be an active asset at the time when it is acquired as a CGT asset, or by the end of two years after the last CGT event during the year in which the roll-over is applied. Effectively this gives a taxpayer up to two years in which to commence using the replacement asset after its acquisition, or at least hold it ready for use (see sec 152-40(1)(a)).

In practice, an asset would usually be held ready for use immediately upon acquisition but this will not always be the case where, for example, significant set-up procedures need to be undertaken. Bearing in mind that CGT no longer applies to plant and equipment, it is thought that there are unlikely to be many instances where a CGT asset that had been acquired as a replacement asset would not be held ready for use immediately upon acquisition.

Note that any period during which a replacement asset is not used or held ready for use in the taxpayer’s or a connected entity’s business (see sec 152-40(1)(c)), that time will need to be taken into account in determining whether the asset meets the active asset test in sec 152-35.

In ID 2003/147, the ATO expressed the view that a replacement asset does not have to fulfill the same function as the original asset it replaces. Thus a hotel can be a replacement asset for a block of land.

Replacement asset a share or interest in a trust

By sec 152-420(5) a replacement asset can be a share in a company or an interest in a trust. In such cases the taxpayer seeking roll-over relief or an entity connected with the taxpayer must be a controlling individual of the company or trust just after the share or interest is acquired. This represents an extension of the previous provision (sec 123-75 ITAA 97) which did not permit interests in trusts to be a replacement asset.

Note that where a replacement asset is a share in a company or an interest in a trust it would appear that the active asset requirement in sec 152-420(4) is also required to be satisfied as subsec (4) is a general provision applying to all cases, see also sec 104-190(1)(c) which contemplates that the share or interest will be an active asset. While it could be argued that the requirement in sec 152-420(5) that there be a “controlling individual” is satisfied, it is doubtful whether such an argument would be accepted by the ATO.

The example following sec 152-420(5) provides an illustration of an application of the provision and is taken from the previous provision:

Example: Joseph owns 50% of the shares in Company A and Company B. He is therefore a controlling individual of the companies (see section 152-55). The companies are connected with Joseph (see section 152-30) because he controls both of them.


Selling a Small Business – The CGT Strategies Company A owns land which it leases to Joseph for use in a business. It

sells the land at a profit and buys shares in Company B.

The replacement asset test is satisfied because Joseph is connected with Company A and is a controlling individual of Company B.

Note: If a replacement asset is a share in a company and the status of the company changes, or you or an entity connected with you ceases to be its controlling individual, you may make a capital gain: see section 104-190 (CGT event J3). Special rules apply if you die: see section 152-425.

It is noted that the controlling individual requirement in sec 152-420(5) applies, as before, to cases where a connected entity is a controlling individual of the company or trust in which the share or interest is acquired. As the example above illustrates, this extension can only apply where the taxpayer is not an individual because, although individuals under sec 152-25 can be small business CGT affiliates, for example spouses, they are not “connected with” each other, see sec 152-30.

Example

Josephine wants to acquire a 10% interest in the Material Unit Trust (MUT) as a replacement asset for the purposes of the small business roll-over. The 10% interest in the MUT does not satisfy the replacement asset test even though her husband Joseph already owns 90% of the MUT and is therefore a controlling individual of the MUT. This is because Josephine and Joseph, although married, and therefore small business CGT affiliates, are not "connected with” each other within the meaning of that term as defined in sec 152-30. This is so even though, as small business CGT affiliates, Josephine is deemed to control the MUT and is therefore deemed to be “connected with” the MUT for the purposes of Division 152.

Replacement asset a depreciating asset

There is no limitation under the roll-over on the kind of replacement asset that can be rolled over, apart from it being an “asset” (see ID 2002/641 which confirms the ATO view that a depreciating asset such as a car could be acquired as a replacement asset). The effect of rolling over a capital gain under Subdivision 152-E is to simply defer the gain. This is achieved by CGT event J2 in sec 104-185, set out below:

104-185 Change of status of replacement asset for a roll-over under Subdivision 152E: CGT event J2

(1) CGT event J2happens if you choose a *CGT asset as a replacement asset for a small business roll-over under Subdivision 152-E and:

(a) the asset is not a *share in a company or a unit in a unit trust and it stops being your *active asset; or

(b) the asset is a *share in a company or a unit in a unit trust and *CGT event A1, C2, E1, E2, G3 or I1 happens in relation to it; or

(c) the asset becomes your *trading stock; or

(d) you make a testamentary gift of the asset under the Cultural Bequests Program; or

(e) you start to use the asset solely to produce your *exempt income or *non-assessable non-exempt income.

Note 1: The full list of CGT events is in section 104-5.

Note 2: CGT event J2 can also happen in relation to a capital gain you rolled-over under Division 17A of Part IIIA of the Income Tax Assessment Act 1936 or Division 123 of


Selling a Small Business – The CGT Strategies the Income Tax Assessment Act 1997 if the status of the replacement asset changes: see section 104-185 of the Income Tax (Transitional Provisions) Act 1997.

(2) The time of the event is when the change in the status of the asset happens.

(3) You make a capital gain equal to the amount of the notional capital gain that you disregarded for the asset under Division 123. Example: Peter disposes of an asset for $10,000, making a notional capital gain of $2,000. He

buys 2 replacement assets for $5,000 each and obtains a roll-over under Subdivision 152-E.$1,000 of the notional capital gain is disregarded for each replacement asset. One of the replacement assets becomes Peter's trading stock. Peter will make a capital gain of $1,000 as a result of CGT event J2 happening.

Section 104-185 amended by No 101 of 2003, s 3 and Sch 6 item 20, by substituting “CGT event J2'” for `”CGT event J1'” in note 2, effective 21 December 2000. Note, this fixes an incorrect cross-reference.

Section 104-185(1) amended by No 66 of 2003, s 3 and Sch 3 item 97, by inserting “or *non-assessable non-exempt income” after “*exempt income'”, applicable to assessments for the 2003-04 income year and later income years.

It is possibly arguable that under the current sec 118-24, which enables capital gains on depreciating assets to be disregarded, that that section may operate to override CGT event J2 (see discussion at ¶1.070).

¶6.032 Subdivision 124-B roll-over

In ID 2003/129 the ATO confirms that where a taxpayer is eligible to apply the roll-over under Subdivision 152-E and Subdivision 124-B, it is open to the taxpayer to choose either roll-over. The ID notes that the rule under the small business roll-over applying CGT event J2 (discussed below) does not apply under the Subdivision 124-B roll-over.

¶6.033 CGT roll-over implications where work in progress amount is included as income under sec 15-50 ITAA 97

At the 11 June 2003 National Tax Liaison Group – CGT Subcommittee meeting the ATO raised the issue concerning the correct treatment of work in progress. The Minutes note:

The ATO advised that it has received private ruling requests on the availability of CGT rollover for capital gains arising in respect of partnership assets, including work-in-progress, and the restructure of a partnership into a corporate entity. In the context of a rollover of gains arising from dealings with partnership assets, any payments or receipts for work in progress will be assessable as income under section 15-50 of the ITAA 1997 (‘your assessable income includes a *work in progress amount that you receive’) and section 118-20 of the ITAA 1997 will operate to reduce the capital gain to the extent it is included in assessable income. CGT rollover cannot provide relief from tax on non-CGT income. ATO ID 2003/358 has issued addressing the operation of section 15-50.

¶6.040 CHANGE OF STATUS OF AN ACTIVE ASSET

Where a replacement asset ceases to be an active asset CGT events J2 (active assets other than shares and interests) and J3 (shares and interests) apply to capture any capital gains that may arise upon the cessation. As noted above, CGT events J2 and J3 do not attract the 50% individual and trust discount, and only a further roll-over or the retirement exemption is available.

¶6.041 Rules where an individual who has obtained a roll-over dies

Section 152-425 ITAA 97 seeks to ensure that, where an individual dies, CGT events J2 or J3 are not triggered, provided the status of the replacement asset does not change. The provision deals separately with cases where the asset has devolved to the individual’s estate and cases where the asset passes directly to a beneficiary of the deceased individual.



Chapter 7

Scrip for scrip roll-over

¶7.000 SCRIP FOR SCRIP ROLL-OVER

¶7.010 SMALL/MEDIUM BUSINESS OPPORTUNITIES

¶7.020 SCRIP FOR SCRIP ELIGIBILITY REQUIREMENTS

¶7.021 Substantially the same terms

¶7.022 Part application of the roll-over

¶7.023 Pre-CGT interests

¶7.024 Like for like

¶7.025 Satisfying the requirements where shares or interests already held by offeror

¶7.026 In consequence of single arrangement

¶7.027 Roll-over extended to “downstream” acquisitions in company cases

¶7.028 Limited roll-over for pre-CGT original interests

¶7.029 Cost base of interests acquired by holder in target entity

¶7.0291 Form of joint election and cost base notice

¶7.0292 CUFS and CDIs

¶7.0293 Requirement for unit holders to have a vested and indefeasible interest to a share of the income and in the capital of a trust

¶7.0294 Original interest holder

¶7.030 NON-WIDELY HELD ENTITIES

¶ 7.031 “Arm’s length” dealings

¶7.040 LINKED GROUPS

¶7.050 APPLYING THE ROLL-OVER

¶7.051 Partial roll-over

¶7.060 EXCEPTIONS – WHERE NO ROLL-OVER AVAILABLE

¶7.061 First exception

¶7.062 Second exception

¶7.063 Third exception

¶7.064 “Fourth exception”

¶7.070 SCRIP FOR SCRIP CLASS RULINGS

¶7.000 SCRIP FOR SCRIP ROLL-OVER

One of the most important changes to the CGT regime in 1999 was the roll-over relief for scrip for scrip takeovers and mergers. The roll-over in Subdivision 124-M applies to transactions taking place from 10 December 1999, the date of the Royal Assent of the NBTS (CGT) Act. It is intended to be reviewed after five years – that is at the end of 2004.


Selling a Small Business – The CGT Strategies Although the new roll-over is located in Division 124 ITAA 97 dealing with replacement asset roll-overs, it does not rely on the general provisions of Subdivision 124-A. It would appear that the main reason for this is that the new scrip for scrip roll-over does not preserve the status of pre-CGT assets.

The roll-over has potentially a wide application as it is not be limited to “widely” held or listed companies, as recommended by the Ralph Report, but applies to all companies and fixed trusts (see “Small/medium business opportunities” discussed at ¶7.010 below).

The only significantly limiting criterion that applies is that the acquiring entity is required to acquire at least 80% of the voting interests of the target entity as a result of a takeover offer to all the holders of those interests.

The 80% threshold was thought to be a difficult hurdle for many potential public takeovers at the time it was introduced. However, the market readily adjusted to this threshold once it became law.

One potentially limiting factor under the concession is that Subdivision 124-M effectively requires that the offeror entity must provide shares or interests in it or its ultimate holding company.

Of particular interest is that the measure does not seek to impose strict requirements as to the kinds of interest that can be exchanged in relation to widely held entities, though a broad “like for like” requirement applies. So, for example, if shares are sought in the target entity, shares will be required to be provided in the takeover entity. Some further restrictions apply to non-widely held entities (see ¶7.030 below). Primarily, the restriction here is that equivalent value be exchanged.

In his Press Release announcing the commencement of the roll-over on 10 December 1999, the Treasurer noted that in the EM to the NBTS (CGT) Act it was indicated the Government was examining options for dealing with the cost base of assets acquired by an interposed entity as part of a takeover or merger.

A significant number of amendments were contained in the NBTS(M)2 Act 2000 to give effect to cost base rules for assets acquired by an interposed entity from the exchanging taxpayer. The amendments recognise, as do scrip for scrip roll-overs in other countries, that a market value cost base is generally not appropriate given that a capital gain is not fully recognised in a full scrip for scrip exchange.

¶7.010 SMALL/MEDIUM BUSINESS OPPORTUNITIES

The scrip for scrip roll-over has a potentially huge application to small and medium business. For example, under the measure a small business operated as a company or through a trust could merge with another small/medium company without the owner of the business realising a CGT liability. Alternatively, and perhaps more importantly, a “small” business operator who may not otherwise qualify for any existing small business CGT concessions may, under the scrip for scrip measure, be able to dispose of his/her business for shares in a listed company or multinational.

By exchanging shares or trust units in their business for, say, listed shares in the takeover company or trust, a small business person can effectively dispose of his/her business with a minimal exposure to CGT by converting inherently illiquid assets (i.e. shares in his/her private company) into inherently liquid assets (i.e. shares in a listed company whether listed on the ASX or elsewhere).

Shares acquired in a listed company in exchange for shares in a small business may then be able to be disposed of as and when the former small business owner desires. This means that a small business vendor can limit CGT on realisations to accord with his/her income/capital needs, subject to any limitations that the acquiring entity may impose under the terms of the deal.


Selling a Small Business – The CGT Strategies It is also apparent that the scrip for scrip measure will be potentially available to a business operated through a discretionary trust with a corporate trustee where the shares in the corporate trustee were exchanged for shares in the takeover company, though there is likely to be some buyer resistance to such transactions.

¶7.020 SCRIP FOR SCRIP ELIGIBILITY REQUIREMENTS

The main operative provisions for the scrip for scrip roll-over are sec 124-780 and 124-781 ITAA 97, which were originally inserted by NBTS (CGT) Act 1999, but were substituted with a new version by the NBTS(M)2 Act 2000. The sections are reproduced below. The roll-over’s basic requirements may be summarised as follows:

You may choose to roll over a capital gain in respect of your share or trust interest acquired on or after 20 September 1985 where:

• there is a single arrangement under which an acquiring entity makes an offer to acquire your shares or interests in your company, or trust and the shares or interests of the other shareholders or interest holders, in exchange for shares or interests in the acquiring company or trust or the ultimate holding company of a wholly-owned company group;

• the acquiring entity, as a result of the arrangement, becomes the holder of 80% or more of the voting rights in your company or trust;

• the arrangement is one that at least all the owners of shares or interests could participate in on substantially the same terms;

• you are an Australian resident just before the disposal of the shares or interest (discussed at ¶7.060 below);

• you (the taxpayer) and the offeror are not members of the same wholly-owned group just before the disposal of the taxpayer’s interest; and

• neither the offeror nor the offeree are discretionary trusts.

Section 124-780 and 124-781 provide as follows:

124-780 Replacement of shares

(1) There is a roll-over if:

(a) an entity (the original interest holder) exchanges:

(i) a *share (the entity’s original interest) in a company (the original entity) for a share (the holder’s replacement interest) in another company; or

(ii) an option, right or similar interest (also the holder’s original interest) issued by the original entity that gives the holder an entitlement to acquire a share in the original entity for a similar interest (also the holder’s replacement interest) in another company; and

(b) the exchange is in consequence of a single *arrangement that satisfies subsection (2); and

(c) the conditions in subsection (3) are satisfied; and

(d) if subsection (4) applies, the conditions in subsection (5) are satisfied. Note 1: There are some exceptions: see section 124-795.

Note 2: The original interest holder can obtain only a partial roll-over if the capital proceeds for its original interest includes something other than its replacement interest: see section 124-790.


Selling a Small Business – The CGT Strategies Example 1: You can get a roll-over if you exchange your shares in one entity for shares

in another entity or if you exchange options in one entity for options in another entity. You cannot get a roll-over if you exchange options for shares.

Example 2: Examples of arrangements that could be involved include:

a company takeover, whether or not it is regulated by the Corporations Act 2001, resulting in a company owning 80% or more of another company’s shares.

a scheme of arrangement governed by the Corporations Act 2001 that involves a cancellation of some interests in an original entity resulting in another entity owning 80% or more of the interests in the original entity.

Conditions for arrangement

(2) The *arrangement must:

(a) result in:

(i) a company (the acquiring entity) that is not a member of a *wholly-owned group becoming the owner of 80% or more of the *voting shares in the original entity; or

(ii) a company (also an acquiring entity) that is a member of such a group increasing the percentage of voting shares that it owns in the original entity, and that company or members of the group becoming the owner of 80% or more of those shares; and

(b) be one in which at least all owners of *voting shares in the original entity (except a company referred to in paragraph (a)) could participate; and

(c) be one in which participation was available on substantially the same terms for all of the owners of interests of a particular type in the original entity. Note 1: The 80% or more requirement is satisfied if the acquiring entity ends up owning

at least 80% of the voting shares in the original entity. This may include shares held before the arrangement started.

Note 2: Participation will be on substantially the same terms if, for example, matters such as those referred to in subsections 619(2) and (3) of the Corporations Act 2001 affect the capital proceeds that each participant can receive.

Conditions for roll-over

(3) The conditions are:

(a) the original interest holder *acquired its original interest on or after 20 September 1985; and

(b) apart from the roll-over, it would make a *capital gain from a *CGT event happening in relation to its original interest; and

(c) its replacement interest is in a company (the replacement entity) that is:

(i) the company referred to in subparagraph (2)(a)(i); or

(ii) in any other case—the *ultimate holding company of the *wholly-owned group; and

(d) the original interest holder chooses to obtain the roll-over or, if section 124-782 applies to it for the arrangement, it and the replacement entity jointly choose to obtain the roll-over; and


Selling a Small Business – The CGT Strategies (e) if that section applies, the original interest holder informs the replacement

entity in writing of the *cost base of its original interest worked out just before a CGT event happened in relation to it. Note: If the original interest holder also exchanges a CGT asset that it acquired before

20 September 1985, the cost base of any interest received in exchange for it is worked out under section 124-800.

Further roll-over conditions in certain cases

(4) The conditions specified in subsection (5) must be satisfied if the original interest holder and an acquiring entity did not deal with each other at *arm’s length and:

(a) neither the original entity nor the replacement entity had at least 300 *members just before the *arrangement started; or

(b) the original interest holder, the original entity and an acquiring entity were all members of the same *linked group just before that time. Note: There are some cases where a company will not be regarded as having 300

members: see section 124-810.


(a) the market value of the original interest holder’s *capital proceeds for the exchange is at least substantially the same as the market value of its original interest; and

(b) its replacement interest carries the same kind of rights and obligations as those attached to its original interest.

CUFS

(6) This section applies to the holder of a Chess Unit of Foreign Security as if the holder held the underlying interests that the unit represents. Note: A Chess Unit of Foreign Security is an interest, traded on the Australian Stock Exchange, in

a foreign share, unit or interest.

(7) A company is the ultimate holding company of a *wholly-owned group if it is not a *100% subsidiary of another company in the group.

124-781 Replacement of trust interests

(1) There is a roll-over if:

(a) an entity (also the original interest holder) exchanges:

(i) a unit or other interest (also the holder’s original interest) in a trust (also the original entity) for a unit or other interest (also the holder’s replacement interest) in another trust (also the acquiring entity); or

(ii) an option, right or similar interest (also the holder’s original interest) issued by the original entity that gives the holder an entitlement to acquire a unit or other interest in the original entity for a similar interest (also the holder’s replacement interest) in another trust (also the acquiring entity); and

(b) entities have *fixed entitlements to all of the income and capital of the original entity and the acquiring entity; and

(c) the exchange is in consequence of an *arrangement that satisfies subsection (2); and

(d) the conditions in subsections (3) and (4) are satisfied.


Selling a Small Business – The CGT Strategies Note 1: There are some exceptions: see section 124-795.

Note 2: The original interest holder can obtain only a partial roll-over if the capital proceeds for its original interest includes something other than its replacement interest: see section 124-790.

Conditions for arrangement

(2) The *arrangement must:

(a) result in the acquiring entity owning 80% or more of the *trust voting interests in the original entity or, if there are none, 80% or more of the units or other interests in the original entity; and

(b) be one in which at least all owners of trust voting interests (or of units or other interests) in the original entity (except the acquiring entity) could participate; and

(c) be one in which participation was available on substantially the same terms for all of the owners of interests or units of a particular type in the original entity.

Conditions for roll-over


(a) the original interest holder *acquired its original interest on or after 20 September 1985; and

(b) apart from the roll-over, it would make a *capital gain from a *CGT event happening in relation to its original interest; and

(c) it chooses to obtain the roll-over or, if section 124-782 applies to it for the *arrangement, it and the trustee of the acquiring entity jointly choose to obtain the roll-over; and

(d) if that section applies to it, it informs that trustee in writing of the *cost base of its original interest as at the time just before a CGT event happened in relation to it. Note: If the original interest holder also exchanges a CGT asset that it acquired before

20 September 1985, the cost base of any interest received in exchange for it is worked out under section 124-800.

Further roll-over conditions in certain cases

(4) These conditions must be satisfied if the original interest holder and the trustee of the acquiring entity did not deal with each other at *arm’s length and neither the original entity nor the acquiring entity had at least 300 beneficiaries just before the *arrangement started:

(a) the market value of the original interest holder’s *capital proceeds for the exchange is at least substantially the same as the market value of its original interest; and

(b) its replacement interest carries the same kind of rights and obligations as those attached to its original interest.

Note: There are some cases where a trust will not be regarded as having 300 beneficiaries: see section 124-810.

CUFS

(5) This section applies to the holder of a Chess Unit of Foreign Security as if the holder held the underlying interests that the unit represents.


Selling a Small Business – The CGT Strategies Note: A Chess Unit of Foreign Security is an interest, traded on the Australian Stock Exchange, in

a foreign share, unit or interest.

Meaning of trust voting interest

(6) A trust voting interest in a trust is an interest in the trust that confers rights of the same or a similar kind as the rights conferred by a *voting share in a company.

The first thing to note about the sections is that they apply only where a taxpayer “chooses” to obtain roll-over, see sec 124-780(3)(d) and 124-781(3)(c). Where an individual chooses to apply the roll-over in respect of a capital gain, there are no formal requirements as such to comply with, although it is desirable to create some evidence of the making of the choice other than simply relying on the absence of capital gains being returned in the taxpayer’s income tax return.

Section 103-25 ITAA 97 makes clear that the “choice” must be made by the day a taxpayer lodges his/her return for the year in which the relevant CGT event occurs, or such further time as the Commissioner may allow. See ID 2002/892 as to the circumstances where the Commissioner will allow further time to choose the roll-over.

See ID 2003/362, which confirms that a taxpayer may choose not to apply the roll-over to all interests exchanged.

ID 2002/239 makes an interesting point that the time to test whether an acquiring entity is a wholly owned member of a group in not when the take-over offer is made but when the first target shares are acquired. The reasons for the ID include the following:

In Hunter Valley Developments Pty Ltd and Ors v. Cohen (1984) 58 ALR 305; (1984) 3 FCR 344; (1984) 7 ALD 315, Wilcox J summarised principles to guide the exercise of a discretion. These principles are of a general nature applicable where there is a discretionary power to extend a procedural time limit and have been applied to the exercise of the power of the Commissioner to extend time in the following cases: Lighthouse Philatelics Pty Ltd v Federal Commissioner of Taxation (1991) 103 ALR 156; 22 ATR 707; (1991) 25 ALD 257; (1991) 32 FCR 148; 91 ATC 4942. Comcare v A'Hearn (1993) 119 ALR 85; 94 ATC Case 15/94; 28 ATR AAT Case 9399; 94 ATC Case 18/94; 28 ATR AAT Case 9192A. With respect to the exercise of the discretion contained in paragraph 103-25(1)(b) of the ITAA 1997 the Commissioner has considered the following factors:

(1) there should be evidence of an acceptable explanation for the period of extension requested and that it would be fair and equitable in the circumstances to provide such an extension.

(2) account must be had to any prejudice to the Commissioner which may result from the additional time being allowed, however the mere absence of prejudice is not enough to justify the granting of an extension

(3) account must be had of any unsettling of people, other than the Commissioner, or of established practices

(4) there must be a consideration of fairness to people in like positions and the wider public interest

(5) whether there is any mischief involved; and (6) a consideration of the consequences to the taxpayer in granting an

extension.

The taxpayer sought further time to choose scrip for scrip roll-over only a short time after they had lodged their income tax return. If additional time was allowed, there would be no prejudice to the Commissioner, nor would there be any unsettling of


Selling a Small Business – The CGT Strategies people or of established practices. Anyone in a similar position would be able to request a similar extension and there was no mischief involved in the request. The consequence of allowing further time is that the scrip for scrip roll-over would be available, enabling the taxpayer to take advantage of the choice allowed in the legislation.

¶7.021 Substantially the same terms

ID 2003/177 considered the meaning of the requirement in sec 124-780(2)(c) of the term, “substantially the same terms for all owners of interests of a particular type” in relation to a proposed roll-over where the target company had 2 separate classes of shares. The ID provides as follows:

Issue

Does an arrangement satisfy the requirement in paragraph 124-780(2)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) that participation in it be on ‘substantially the same terms for all owners of interests of a particular type’ if different offers are made to separate classes of shareholders?

Decision

Yes. The arrangement will satisfy the requirement in paragraph 124-780(2)(c) of the ITAA 1997 providing the offer to shareholders within each class of share is on substantially the same terms.

Facts

A company made a takeover offer in relation to all of the shares in Company X. The issued share capital of Company X consists of 2 classes of shares. The holders of one class of share have no special rights to participate in the profits of Company X. The holders of the other class of share have special rights that allow priority participation in the profits of the non-core business of Company X. Because of the different rights attaching to the shares in each class, the takeover offer that has been made to each class of shareholders is different.


One of the conditions that has to be satisfied for a shareholder to qualify for scrip for scrip roll-over under Subdivision 124-M of the ITAA 1997 is that participation in the scrip for scrip arrangement must have been on substantially the same terms for all the owners of interests of a particular type in the original entity (paragraph 124-780(2)(c) of the ITAA 1997). In this case, the difference in the rights attaching to each class of share is sufficient for each class of share to be regarded as a different type of interest for the purposes of paragraph 124-780(2)(c) of the ITAA 1997. Accordingly, if each shareholder within each class of share is able to participate in the arrangement on substantially the same terms, the requirement in paragraph 124-780(2)(c) of the ITAA 1997 will be satisfied. Date of decision: 9 December 2002

¶7.022 Part application of the roll-over

In ID 2003/363 the ATO confirmed that a taxpayer is not required to apply the roll-over to all the interests exchanged if the circumstances of the taxpayer are such as to obtain advantage by not applying it to all such interests. In the case in point, the taxpayer has pre-existing capital losses. Utilising those loses at the time of the roll-over might make sense if, for example, the shares to be acquired under the roll-over were proposed to be held long term.


Selling a Small Business – The CGT Strategies The ID notes that the roll-over applies in respect of each share or interest the subject of the roll-over and there is no requirement in Subdivision 124-M that the taxpayer apply the roll-over to all his/her interests. The way the taxpayer prepares his/her return is sufficient evidence of the making of a choice, though it might be prudent for an additional note to be made evidencing the choice.

See discussion at ¶7.051 “Partial roll-over”.

¶7.023 Pre-CGT interests

The second thing to note about the sections is that they do not apply to pre-CGT assets, that is assets acquired on or before 20 September 1985. This means that, if a taxpayer holds pre-CGT shares in a company and receives an offer that otherwise qualifies for a scrip for scrip roll-over, accepting the offer will result in the effective conversion of the pre-CGT shares into new post-CGT shares, though no CGT event would arise upon the acceptance of the offer. The cost base for the new post-CGT shares or interest in a trust will be the market value of the new shares or interest at the time of the transaction (see sec 110-25(2)(b) and sec 103-5 ITAA 97). Note, however, the amendments introduced by the NBTS(M)2 Act 2000 deal with roll-over for pre-CGT shares where acceptance of a scrip for scrip offer would trigger CGT event K6, as discussed below.

Typically, a taxpayer holding shares or interests the subject of a takeover offer might hold both pre-CGT and post-CGT shares or interests rather than just pre-CGT shares or interests, or just post-CGT shares or interests.

Example

Damian acquires 1000 shares in Ab Co Ltd in 1984 for $2,000 and subsequently acquired 2,000 shares in the company in 1989 for which he paid $8,000. Damian receives an offer from Raider Ltd (made to all shareholders in Ab Co Ltd) for his shares in Ab Co Ltd on the basis that for each share he holds in Ab Co Ltd he will receive one share in Raider, which at the time of the offer are selling at $10 each (the buy quote is $9.90). Damian wishes to accept the offer since Ab Co Ltd has performed poorly in recent times and its shares are selling at $8.50 on the ASX. The shares in Raider Ltd that Damian receives for his pre-CGT shares in Ab Co Ltd will have a cost base of their market value at the time the offer becomes unconditional (ie where acceptances reach 80%) (see TD 39). The ASX market buy quote of the Raider Ltd shares at that time is $10.10. This will be Damian’s cost base for those shares exchanged for his pre-CGT shares. The cost base for the balance of his shares in Raider Ltd will be the original cost base of his post-CGT Ab Co Ltd shares, that is $4 plus brokerage, etc.

New sec 124-800 ITAA 97 (as inserted by NBTS(M)2 Act 2000) seeks to deal with the situation in the above example and confirms that the first element of the cost base of any asset acquired (i.e. a proportion of the shares in Raider Ltd) are their market value just after the taxpayer acquires them. Arguably this section does nothing other than to confirm that roll-over will be available for the post-CGT component of a portfolio of pre- and post-CGT shares. The section provides as follows:

124-800 Interest received for pre-CGT interest

(1) If, in consequence of the *arrangement, you exchange an interest that you *acquired before 20 September 1985 for an interest in the replacement entity, the first element of the *cost base and *reduced cost base of the interest in the replacement entity is its market value just after you acquired it.



(2) The *cost base and *reduced cost base of the interest in the replacement entity is reduced if all or part of a *capital gain from *CGT event K6 happening is disregarded because of subsection 104-230(10). The amount of the reduction is the amount of the *capital gain you disregard under that subsection.

Note 1: The full list of CGT events is in section 104-5.

Note 2: Subsection 104-230(10) provides that a capital gain from CGT event K6 is disregarded to the extent that you could have chosen a roll-over under this Subdivision if your original interest had been post-CGT.

Reasonable basis

The EM to the NBTS (CGT) Act 1999 at para 2.28 indicated that an offeree can determine on a “reasonable basis” what capital proceeds he/she has received for particular interests. The example contained in the EM is as follows:

Example 2.4

Norman has 200 shares in Wanted Ltd; 100 were acquired pre-CGT and 100 were acquired post-CGT. Acquirer Ltd makes an offer to acquire those shares. The offer provides these alternatives:

• Offer 1: $10 for each Wanted share; and

• Offer 2: 1 share in Acquirer for 2 shares in Wanted.

If Norman accepts Offer 1 for his pre-CGT shares and Offer 2 for his post-CGT shares he can choose to obtain a full roll-over for his post-CGT shares. Although roll-over is not available for his pre-CGT shares, any gain from them is disregarded. If Norman accepts Offer 1 for his post-CGT shares and Offer 2 for his pre-CGT shares, no roll-over is available as he has not received any replacement equity for those of his shares that otherwise qualify for roll-over. If Norman accepts Offer 1 for some of his post-CGT shares and Offer 2 for others, he can choose to obtain a partial roll-over to the extent he has applied his Wanted shares to Offer 2 (discussed at paragraph 2.38).

¶7.024 Like for like

While sec 124-780(1) and 124-781(1) are expressed so as to allow for a wide variety of interests in companies and trusts respectively, the advantage is lost to some extent by the limitation placed on the type of interest that may be exchanged. The insertion by the NBTS(M)2 Act 2000 of separate sections dealing respectively with shares and trust interests makes clear that there can be no roll-over under Subdivision 124-M of shares for interests in a trust, as previously prohibited by former sec 124-780(2). The provisions impose a “like for like” requirement so that, although an interest in a share can be exchanged for an interest in another share, it cannot be exchanged for an interest in a trust. However, in the Attachment to the Treasurer’s Press Release of 21 September 1999, it was indicated that there would be no restriction on an exchange of ordinary shares for preference shares. The requirement in sec 124-780(2)(b) and 124-781(2)(b), set out above, that a company or trust makes an offer to all of the holders of interests in the original entity, is cast very broadly The primary requirement is that the offer be for the whole of the relevant interests and not merely a partial takeover offer.

In ID 2003/893 the ATO took the view that the roll-over was available to a taxpayer who was offered ordinary shares for his redeemable preference shares. ID 2003/197 confirms that roll-over is not available for a unit in a public trading trust exchanged for a share in a company.



¶7.025 Satisfying the requirements where shares or interests already held by offeror

It had been suggested (CGT reform forgets small shareholders, AFR 17 January 2000, p 5) in relation to the original provision that, where an offeror already holds a portion of shares or interests in an offeree, the roll-over is not available. The article suggested this was because of the requirement in former sec 124-780(1)(b) ITAA 97 that an offeror must make an offer to “all” of the holders of the shares or interests in the offeree and an offeror already holding some shares or interests in the offeree could not make such an offer. The new provisions make it clear that it does not matter that an offeror already holds some shares or interests in a target company or trust. Nevertheless, the ATO issued TD 2001/50 and TD 2001/52 to further clarify the position. The TDs provide:

Taxation Determination 2001/50

Income tax: capital gains: scrip for scrip roll-over: can a company (or a wholly-owned group of companies) ‘become’ the owner of 80% or more of the voting shares in another company (an original entity), in terms of paragraph 124-780(2)(a) of the Income Tax Assessment Act 1997, as a result of an arrangement even if the company (or group) owned some of those shares before the arrangement?

…

1. Yes. A company or wholly owned group of companies can become the owner of 80% or more of the voting shares in another company even if the company or group owned 80% or more of those shares before the arrangement provided that they owned a greater percentage after the arrangement.

2. Subparagraph 124-780(2)(a)(i) requires that the arrangement result in the company which is the acquiring entity becoming the owner of 80% or more of the voting shares in the original entity. The subparagraph merely requires a view of the percentage ownership of voting shares after the arrangement. Note 1 after paragraph 124-780(2)(c) recognises that shares held before the arrangement started can be taken into account in considering the 80% or more requirement.

3. If the acquiring entity owns some voting shares in the original entity before the arrangement but as a result of the arrangement owns 80% or more voting shares in the original entity after the arrangement, the acquiring entity will have become the owner of 80% or more of the voting shares in the original entity. This will be so even if the acquiring entity started out owning 80% or more of the voting shares in the original entity provided that it owned a greater percentage after the arrangement. In terms of subparagraph 124-780(2)(a)(i), the arrangement will result in the acquiring entity becoming the owner of 80% or more of the voting shares in the original entity provided that it started out owning fewer voting shares than it did after the arrangement. There is no minimum number or percentage of shares that the acquiring entity must acquire as result of the arrangement.

4. Subparagraph 124-780(2)(a)(ii) requires that the arrangement result in either the company (which is the acquiring entity and is a member of a wholly-owned group) or the members of the group becoming the owner of 80% or more of the voting shares in the original entity. It should be construed in a similar manner.

Example 1

5. A Co owns 70% of the voting shares in B Co. A Co makes a takeover offer for the remaining shares in B Co. As a result of the takeover A Co acquires a further 15% of the shares in B Co. The takeover has resulted in A Co becoming the owner of 85% of the shares in B Co.



Example 2

6. Members of the A Co wholly-owned group of companies own 83% of the voting shares in B Co. A member of the group makes a takeover offer for the remaining shares in B Co. As a result of the takeover, members of the A Co group acquire a further 0.6% of the shares in B Co. The takeover has resulted in members of the A Co group becoming the owners of 83.6% of the shares in B Co.

Taxation Determination - 2001/52

Income tax: capital gains: scrip for scrip roll-over: can a company ‘increase’ the percentage of voting shares that it owns in another company (an original entity), in terms of subparagraph 124-780(2)(a)(ii) of the Income Tax Assessment Act 1997, as a result of an arrangement if it owned no shares in that company before the arrangement?

…

1. Yes. A company can increase the percentage of voting shares that it owns in an original entity even if it started out owning no voting shares. The ordinary English usage of the word ‘increase’ is to have more of something than at an earlier time or to make or become greater or more in number.

2. Subparagraph 124-780(2)(a)(ii) requires that the arrangement result in the company which is the acquiring entity increasing the percentage of voting shares that it owns in the original entity. The subparagraph therefore requires a comparison between the ownership of voting shares before the arrangement and after it starts. If the acquiring entity owns no voting shares in the original entity before the arrangement but as a result of the arrangement owns voting shares in the original entity, the acquiring entity will have increased the percentage of voting shares it owns in the original entity. In terms of subparagraph 124-780(2)(a)(ii), the arrangement will result in the acquiring entity increasing its percentage ownership of voting shares in the original entity.

3. Some commentators have suggested an alternative view that there cannot be an ‘increase’ from a starting point of zero. We do not agree with this view. It does not accord with the ordinary

meaning of the word ‘increase’. Nor does it promote the purpose or object of the scrip of the scrip roll-over provisions.

Example

4. B Co makes a takeover offer for all of the shares in T Co. Before the takeover B Co owned no shares in T Co. After the takeover B Co owns 85% of the shares in T Co. The takeover has resulted in B Co increasing the percentage of voting shares that it owns in T Co to 85%.

Commissioner of Taxation

22 November 2000

The requirement in sec 124-780(2)(a) and sec 124-781(2)(a) that the acquiring entity acquire at least 80% of the voting shares in a offeree company or 80% of the voting interests of a trust (or otherwise, the interests of the trust that carry at least 80% of the right to the income and capital of the trust) may give rise to problems in practice where the takeover is not friendly since any offer will need to be conditional upon acceptance, in most cases, by 80% of the share or interest holders. As noted above, although the figure of 80% is higher than has


Selling a Small Business – The CGT Strategies normally been the case prior to the introduction of this measure, it has become the accepted norm now.

The sections extend the kind of interests that may be rolled over to “an option, right or similar interest issued by the original entity”. As with the primary requirements this extension is also limited by a “like for like” rule, so “options for options” or “rights for rights” are fine, but not “shares for options” or “options for shares”. This rule, whilst inconvenient, may not in practice impose too severe an impediment on offerors so long as equivalent interests can be offered to interest holders in the offeree.

Example

LBI Ltd has targeted R C Mathews Pty Ltd, a medium-sized family-owned publishing business, as a desirable addition to its Publishing Division. R C Mathews Pty Ltd has issued some 10,000 shares to members of the Mathews family since it began operations in 1986. In addition, two options to acquire 2,000 shares each have been issued to the two elder Mathews brothers, James and Barry. LBI Ltd can structure its takeover offer to satisfy Subdivision 124-M provided it makes its offer to all the shareholders of R C Mathews Pty Ltd and offers to the two elder brothers similar options in LBI Ltd.

The example in the EM to the NBTS (CGT) Act 1999 shows that the offer cannot be a “mixed” one:

Example 2.3

Julie owns 1,000 shares in Holiday Ltd. She also owns 200 options to acquire preference shares in Holiday. Travel Ltd makes an unconditional takeover offer for Holiday offering 2 Travel shares for each Holiday share and one Travel share for each Holiday option. Julie accepts the offer and receives 2,200 Travel shares. Julie can choose roll-over in respect of the 1,000 Holiday shares she exchanged. Roll-over is not available in respect of the Holiday options as she received shares in exchange for options. If Julie had received options in Travel in exchange for her options in Holiday, roll-over would also have been available.

In TD 2002/22 (originally issued as TD 2001/D13 on 14 November 2001) the ATO appears to be prepared to widen slightly the general “like for like” rule at least in relation to sec 124-781. The TD is set out below:

Capital gains: scrip for scrip roll-over: can the exchange of an interest (not being amount) in a trust for a unit in a unit trust satisfy the requirements in subparagraph 124-781(1)(a)(i) of the Income Tax Assessment Act 1997?

1. Yes. Subparagraph 124-781(1)(a)(i) of the Income Tax Assessment Act 1997 (ITAA 1997), in referring to an exchange of 'a unit or other interest ... in a trust' for ‘a unit or other interest ... in another trust’ encompasses an exchange of any of the following:

a unit in a unit trust for a unit in another unit trust;

a unit in a unit trust for an interest (not being a unit) in a trust;

an interest (not being a unit) in a trust for a unit in a unit trust; and

an interest (not being a unit) in a trust for an interest (not being a unit) in another trust.

2. However, the holders of units or interests must satisfy the requirement in paragraph 124-781(1)(b) of the ITAA 1997 that the holders of the interests in the original entity and the holders of the interests in the acquiring entity have ‘fixed entitlements’ to all of the income and capital of the respective trusts both before


Selling a Small Business – The CGT Strategies and after the exchange. The expression ‘fixed entitlement’ of a beneficiary, under a trust instrument, to a share of income or of the capital of a trust, is defined in subsection 272-5(1) in Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936) to be a vested and indefeasible interest in the share of income of the trust that the trust derives from time to time, or of the capital of the trust.

3. Futhermore, if:

• the original interest holder and the trustee of the acquiring entity did not deal with each other at arm's length, and

• neither the original entity nor the acquiring entity had at least 300 beneficiaries just before the arrangement started, subsection 124-781(4) of the ITAA 1997 requires these conditions to be also satisfied:

the market value of the original interest holder's capital proceeds for the exchange is at least substantially the same as the market value of its original interest; and

its replacement interest carries the same kinds of rights and obligations as those attached to its original interest.

Example

4. The Bottles Trust provides that each beneficiary is presently entitled to the income and capital of the trust in proportion to the capital subscribed by that beneficiary or his or her predecessor in title. While the interests are fixed the capital is not divided into units. The Bottles Trust is not a unit trust. The Cans Unit Trust provides that each beneficiary is presently entitled to the income and capital in proportion to the number of units held. This trust is a unit trust.

5. The trustee of the Bottles Trust makes an offer to acquire all of the units in the

Cans Unit Trust. Under the arrangement, the unitholders in the Cans Unit Trust will exchange their units for an interest in the Bottles Trust. The beneficiaries of the Bottles Trust and the unitholders in the Cans Unit Trust have fixed entitlements to all of the income and capital of the respective trusts. Subsection 124-781(4) of the ITAA 1997 does not apply to the arrangement. Provided the other conditions in Subdivision 124-M of the ITAA 1997 for roll-over are satisfied a unitholder in Cans Unit Trust can choose scrip for scrip roll-over in relation to the exchange of their units in the Cans Unit Trust for an interest in the Bottles Trust.

Note:

6. An arrangement must meet the other conditions in Subdivision 124-M of the ITAA 1997 for scrip for scrip roll-over to be available.


23 October 2002

¶7.026 In consequence of single arrangement

Of importance is the requirement in sec 124-780(1)(b) that the offeror obtains 80% of the shares or interests in the offeree, “in consequence of a single arrangement”, see also sec 124-781(c). The EM to the NBTS (CGT) Act 1999 provided two examples illustrating the requirement as to the meaning of “in consequence”:



Example 2.1

Tall Ships Ltd makes a scrip for scrip takeover offer for 100% of the shares in Pacific Cruises Ltd. Tall Ships receives 92% acceptances and consequently acquires the remaining 8% of shares in Pacific Cruises under the compulsory acquisition rules in the Corporations Law. The shareholders in Pacific Cruises whose shares are compulsorily acquired are eligible for scrip for scrip roll-over.

Example 2.2

Green Bottles Ltd makes a scrip for scrip offer for Tincans Ltd. Green Bottles acquires 62% of the shares in Tincans through acceptances of the offer. Roll-over is not available to the shareholders in Tincans as Green Bottles did not acquire 80% of the shares. Green Bottles continues to acquire Tincans shares on the market increasing its shareholding to 70%. Green Bottles makes a new scrip for scrip offer to Tincans shareholders and as a consequence increases its shareholding to 85%. The shareholders in Tincans who accepted this second offer are eligible for scrip for scrip roll-over.

The EM to the NBTS (CGT) Act 1999 notes that the requirement means that the offer needs to occur before the acquisition and have a casual or other connection with it.

The concept of “a single arrangement” was introduced by the NBTS(M)2 Act 2000. Paragraph 11.23 of the EM to the NBTS(M)2 Act 2000 states:

11.23 What constitutes a single arrangement is a question of fact. Relevant factors in determining whether what takes place is part of a single arrangement would include, but not be limited to, whether there is more than one offer or transaction, whether aspects of an overall transaction occur contemporaneously, and the intention of the parties in all the circumstances as evidenced by objective facts. The following examples illustrate this point.

Example 11.1

Green Bottles Ltd proposes a scrip for scrip takeover for Tincans Ltd. Tincans has 2 classes of voting shares and options on issue. In respect of each type of interest Green Bottles makes an identical takeover offer to each holder. Green Bottles acquires 62% of the shares in Tincans through acceptances of the offer. Roll-over is not available to the shareholders in Tincans as Green Bottles did not acquire 80% of the shares under this arrangement. Six months later Green Bottles makes a second scrip for scrip offer to Tincans shareholders (a new arrangement) and as a consequence increases its shareholding to 85%. Co-incidentally the terms of the offer are substantially the same as the original arrangement. The shareholders in Tincans who accepted the offer under the second arrangement are eligible for scrip for scrip roll-over. Roll-over is still not available for the shareholders that participated in the first arrangement as the 80% threshold was not reached as a result of that arrangement even though both arrangements were on substantially the same terms.

Example 11.2

Jumbo Ltd makes a takeover offer for shares in Hippo Ltd (both are resident companies listed on the Australian Stock Exchange). Jumbo offers 2 of its shares for every 10 Class A Hippo shares and 1 share for every 20 Class B Hippo shares. As the


Selling a Small Business – The CGT Strategies offer in respect of both classes of shares are made concurrently they are considered to form part of one arrangement for the purposes of the roll-over. Jumbo obtains ASIC approval to establish a nominee sale arrangement for odd-lot shareholders. Shares in Jumbo that would otherwise be allocated to former Hippo shareholders are allocated to a nominee for sale if the shares do not constitute a marketable parcel. This does not prevent the arrangement being on substantially the same terms for all shareholders of a particular type.

ID 2002/274 confirms that the single arrangement requirement is satisfied where under one contract shares are exchanged in two or more stages.

¶7.027 Roll-over extended to “downstream” acquisitions in company cases

A further change introduced by the NBTS(M)2 Act 2000 allowed for roll-over where a subsidiary company acquires the shares of the target and the holders of the target shares receive, in their place, shares in the holding company. These take-overs, as noted in the EM, are known as “downstream acquisitions”, see sec 124-780(3)(c).

Note that roll-over for downstream takeovers is only available for companies. Also, the acquiring company and the company issuing replacement shares must be part of a 100% company group.

¶7.028 Limited roll-over for pre-CGT original interests

As noted above, the amendments introduced by the NBTS(M)2 Act 2000 provide for roll-over of a pre-CGT original interest where its disposal would result in a capital gain under CGT event K6. As explained in the EM to that Act, that event applies on the disposal of interests in certain private companies and trusts if at least 75% of the net value of the company or trust is represented by post-CGT acquired property. See ID 2002/85 for a practical explanation of the operation of CGT event K6, see TR 2004/D6 for application.

Where roll-over is chosen in respect of the disposal of pre-CGT interests where CGT event K6 would be triggered, a modified form of roll-over is provided in this case. As noted in the EM the roll-over requires the holder to:

• disregard a capital gain under CGT event K6 to the extent that roll-over would have been available had the original interest been acquired on or after 20 September 1985, see sec 104-230(10); and

• effect a cost base reduction of the replacement interests by the amount of the CGT event K6 gain that is disregarded (see sec 124-800(2)).

It would appear that it may be possible to have a negative cost base if the K6 gain is greater than the market value of the replacement asset. There is no CGT event that would require the excess over market value to be brought into income at the time of the roll-over.

Limit on discount

The minutes of the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 note that the NIA raised an issue concerning the potential unavailability of the general discount for new shares or interests acquired in return for pre-CGT shares or interests:

If an individual or trust taxpayer has post-CGT shares, they can use the scrip for scrip rollover and then if within 12 months they dispose of the new shares they can obtain the CGT discount on the disposal (provided it is within 12 months of the purchase of the original shares). However, if the same taxpayer had pre-CGT shares, the scrip for scrip rules do not apply (there is no tax on the disposal), but in this case the disposal of the new shares within 12 months of the scrip for scrip exchange will not be eligible for the CGT discount. Does the ATO recognise the inequity in this situation and is there any likelihood that there will be amendments to rectify the situation?


Selling a Small Business – The CGT Strategies The ATO stated that the treatment of pre-CGT shares in a scrip for scrip exchange reflects a deliberate policy position. The Government (consistent with a Ralph Report recommendation) decided that the scrip for scrip rollover should not preserve pre-CGT status. The rationale for the rollover arose from the cash-flow difficulties of meeting a tax liability at the time of a takeover and this is not an issue in relation to pre-CGT assets. The Government also decided that the post-CGT replacement shares for pre-CGT original shares should have a market value cost base. The policy underpinning the CGT discount requires the owner to hold the asset for at least 12 months with any potential for an increase in value of the asset being subject to the CGT rules. Comparable treatment arises with inherited assets (subsection 115-30(1), table items 3 to 6). If a pre-CGT asset of the deceased passes to a beneficiary, the CGT discount clock is reset at death. The professional bodies asked whether the market value cost base given to the post-CGT shares that replaced the pre-CGT original shares was central to the resetting of the CGT discount clock. Was this in acknowledgment of the fact that it is important not to confer a ‘double taxation benefit’ of having a market value cost base, but having the CGT discount clock begin from acquisition of the pre-CGT original shares? The ATO confirmed that this was important to the policy thinking. The professional bodies suggested that a solution to concerns about this ‘double benefit’ could be to allow the exchanging taxpayer to choose to apply either market value cost base or the cost base of the pre-CGT original shares. Only if they chose a market value cost base should they not be entitled to take into account the pre-CGT period of ownership for qualifying for the CGT discount. The ATO noted these observations.

At the subsequent National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 further clarification was sought (item 8.1) this issue was raised again without joy.

Inadvertent choice of discount does not preclude roll-over

See ID 2002/891, which explains that the roll-over is not precluded where the taxpayer inadvertently applies the CGT general discount to a gain arising on the disposal of the original shares.

¶7.029 Cost base of interests acquired by holder in target entity

The ATO issued TD 2002/4 to provide guidance on the cost base of shares or interests acquired in return for shares or interests given up. The TD is set out below. Note the reference to the special rule applying in a scrip for scrip roll-over at para 10 of the TD:

Income tax: capital gains: what is the first element of the cost base and reduced cost base of a share in a company you acquire in exchange for a share in another company in a takeover or merger?

…

Date of effect

This Determination applies to shares acquired on or after its date of issue. For shares acquired in a ‘target’ company before the date of issue of this Determination, however, Taxation Determination 39 applies in relation to the time at which the market value of the shares are valued. This Determination does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of the Determination (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).



General

1 If property other than money is given in respect of acquiring a CGT asset, the first element of the asset’s cost base and reduced cost base (that is, broadly speaking, the asset’s acquisition cost) is the market value of that property at the time of acquisition (paragraph 110-25(2)(b) of the Income Tax Assessment Act 1997 ).

2 If you acquire a share by issue or allotment, the time of acquisition is when you enter into the contract to acquire the share or, if you acquire it other than under a contract, when the share is issued or allotted (section 109-10 item 2).

Takeover offer

Unconditional takeover offer

3 If you accept an unconditional takeover offer from a ‘bidder’ company for your share in a ‘target’ company, and the capital proceeds for your ‘target’ company share is a share in the ‘bidder’ company, you are taken to have acquired the ‘bidder’ company share for the market value of your ‘target’ company share as at the time you enter into the contract to acquire the ‘bidder’ company share, that is, when you accept the offer.

Example

4. Aaron owns 100 shares in XYZ Ltd. ABC Ltd makes an unconditional takeover offer to acquire XYZ Ltd, exchanging 2 shares in XYZ Ltd for each share in ABC Ltd. Each share in XYZ Ltd is worth $4.50 at the time of the offer. Aaron accepts the offer. At the time Aaron accepts the offer the market value of an XYZ Ltd share is $4.40. The first element of the cost base and reduced cost base of each ABC Ltd share is $8.80 (that is 2 x $4.40). If the market value of an XYZ Ltd share was $4.60 at the time Aaron accepted the offer, the first element of the cost base and reduced cost base for each ABC Ltd share would have been $9.20.

Effect of a conditional offer

5. It is important to clearly understand the nature and effect of particular conditions of a contract. There is a clear difference between a condition which is precedent to the formation or existence of a contract (referred to in this Taxation Determination as a ‘condition precedent to formation of a contract’) and a condition which is precedent to the obligation of a party to perform their part of the contract (referred to in this Taxation Determination as a ‘condition precedent to performance of a contract’). In the former case, non-fulfilment of the condition prevents a binding contract from coming into existence. No contractual rights enforceable by the parties are created unless and until the condition is fulfilled. In the latter case, a binding contract exists which creates rights capable of enforcement, though the obligation of a party to the contract (or perhaps of both parties) to perform their part of the contract depends on fulfilment of the condition. Non-fulfilment of the condition entitles one or both parties to terminate the contract.

6. The fact that a takeover offer is subject to a condition will not generally affect the time when the contract is entered into. Most conditions operate as conditions precedent to performance of a contract that is, they do not prevent the contract from coming into existence. In these cases, the contract exists and it is made when the offer is accepted and not when it becomes unconditional.

7. However, if an offer from a ‘bidder’ company for shares in a ‘target’ company is one which is subject to a condition precedent to the formation of a contract, the contract does not come into existence until the condition is satisfied. In this case, the


Selling a Small Business – The CGT Strategies date of acquisition of the ‘bidder’ company shares is the later of the date that the condition is met or the offer is accepted.

8. The status of a particular condition depends on the intention of the parties to the contract as expressed in their contract but will usually be described in the offer documents issued by a ‘bidder’ company. For example, the takeover offer that SingTel Australia Investment Ltd made in respect of C&W Optus Limited shares (see Class Ruling CR 2001/17) was subject to a condition precedent to formation of the contract that the Treasurer raises no objections to the takeover under foreign investment policy. The offer that Wesfarmers Retail Pty Ltd (Wesfarmers) made to Howard Smith Limited (Howard Smith) shareholders (see Class Ruling CR 2001/51) was subject to a condition precedent to performance of the contract that Wesfarmers acquire ownership of 90% of the shares in Howard Smith.

Scheme of arrangement

9. If the ‘bidder’ company shares are acquired under a court ordered scheme of arrangement, the first element of their cost bases and reduced cost bases will be determined having regard to the market value of the ‘target’ company shares on the date that the scheme of arrangement becomes effective.

Special scrip for scrip roll-over rules

10. Special rules apply to the calculation of the cost base of a share acquired under a scrip for scrip roll-over if the provisions contained in Subdivision 124-M apply.

11. If a full roll-over is chosen, the first element of the cost base of each share in the ‘bidder’ company (referred to as ‘the replacement entity’ in those provisions) is determined by reasonably attributing to it the cost base of each share in the ‘target’ company (referred to as ‘the original entity’ in those provisions): subsection 124-785(2).

Example

12 .Able exchanges 1 share in Small Co. with a cost base of $9 for a class X share and a class Y share in Big Co. An X class share in Big Co. has a market value of $5 and a Y class share has a market value of $10. The first element of the cost bases of the shares would be $3 and $6 respectively.

Target company share acquired before 20 September 1985

13. If a share in a ‘target’ company was acquired before 20 September 1985, a share in the ‘bidder’ company may be exchanged in consequence of an arrangement that satisfies the conditions in subsection 124-780(2). In this case, the first element of the cost base and reduced cost base of the share in the ‘bidder’ company will be its market value just after its acquisition (subsection 124-800(1)). It is not necessary that the arrangement be one for which a shareholder in the ‘target’ company actually chooses a roll-over.

14. If the share in the ‘target’ company were acquired before 20 September 1985, and the arrangement is not one that satisfies the conditions in subsection 124-780(2), the first element of cost base and reduced cost base of the share in the ‘bidder’ company will be the market value of the share in the ‘target’ company at the time of its acquisition. This is in line with the principles discussed in paragraph 1 of this Taxation Determination.

Note 1:

This Taxation Determination rewrites and replaces Taxation Determination TD 39.



Note 2:

This Taxation Determination does not consider how the first element of the cost base and reduced cost base would be calculated if the capital proceeds for a ‘target’ company share includes something other than a share in the ‘bidder’ company.


23 January 2002

Previous draft:

Previously released in draft form as TD 2001/D9

Related Rulings/Determinations:

CR 2001/17; CR 2001/51

Note that an Addendum to this TD was issued in 2003 seeking to clarify how the first

element of the cost base and reduced cost base of shares acquired under a takeover or

merger effected by a scheme of arrangement is determined.

See below at ¶7.050 (Applying the roll-over) where sec 124-785 is set out. That section

deals with the issue of cost base in relation to the shares or interests acquired by a

taxpayer choosing the roll-over.

Cost base of interests acquired by acquiring entity

It should be noted that the amendments made by NBTS(M)2 Act 2000 only require a cost base transfer from original interest holders that are likely to have some influence over the acquiring entity.

New sec 124-782 contains the following example to illustrate the operation of the section:

Example:

Robert Co has 3 shareholders: Antill Co with 300 shares, Rachael Co 400 shares and Margaret Co 300 shares. The cost base of each share is $1 and market value is $2. Margaret Co is owned by two shareholders, John and Paul, who each have 50 shares. The market value of each share is $20.

Under an arrangement, Robert Co cancels the shares of Antill Co and Rachael Co. They receive 30 and 40 shares respectively in Margaret Co, which becomes the sole shareholder in Robert Co. The market value of Antill Co’s and Rachael Co’s shares in Margaret Co is equivalent to the market value of their cancelled shares in Robert Co. Robert Co also issues 700 shares to Margaret Co, reflecting the $1,400 total market value of the shares issued by Margaret Co to Antill Co and Rachael Co. Before and after the arrangement, Margaret Co’s shares in Robert Co were worth $2 each. It is necessary to reasonably allocate the cost bases of the cancelled shares (700 x $1) to the 700 shares issued by Robert Co to Margaret Co. In this case, an allocation of $1 per share would be reasonable.

Note: If no new shares are issued by Robert Co, the cost base of the original shares that Margaret Co holds would not be adjusted.

The EM to the NBST(M)2 Act 2000 provides the following commentary in relation to the changes introduced by that Act. These changes are important, and it is worthwhile reproducing the explanation in full:



Why are cost base rules required?

11.32 At present Subdivision 124-M does not specify the first element of the cost base (i.e. acquisition cost) of an original interest in the hands of the acquiring entity. The effect of the general CGT cost base rules is that usually these interests will have an acquisition cost equal to their market value. 11.33 A ‘step-up’ to market value for an acquisition cost where no capital gain has been recognised creates a structural CGT issue involving potential tax deferral. For example, there is a deferral opportunity because the acquiring entity (in which original interest holders have an interest) can choose to sell the interests in the original trust or company (that have a market value cost base) rather than their underlying assets (on which a greater gain may be realised). This would allow the original interest holders to benefit from the reinvested untaxed gains attributable to gains on the assets of the original entity. Other jurisdictions (USA and Canada) do not allow a market value cost base. 11.34 The Treasurer’s Press Release No 87 of 10 December 1999 recognises that a market value cost base for the acquiring entity is generally not appropriate where a capital gain is not recognised for the transfer. However, it also recognises that requiring a cost base transfer from original interest holders may impose significant compliance costs, especially where the original entity is widely held. 11.35 The proposed amendments will require a cost base transfer only from original interest holders that are likely to have some influence over the acquiring entity.

How will the cost base rules operate?

11.36 Generally, the first element of the cost base of interests acquired by an acquiring entity will be determined under the general rules about cost base in Divisions 110 and 112 of the ITAA 1997. However, a cost base transfer will apply to interests in respect of which a roll-over was obtained in 2 cases only. 11.37 The first case is where, on an associate-inclusive basis, an entity has a 30% or more stake (significant stake) in the original entity before the arrangement and in the entity in which its replacement interests are held just after the arrangement. [Schedule 5, item 4, subsection 124-782(1) and subsections 124-783(1), (6) and (7)] 11.38 For a widely held entity (generally one with 300 or more shareholder/beneficiaries), it will be assumed that no interest holder has a ‘significant stake’ in it if that assumption is reasonable. It would not be reasonable to make that assumption if, for example, evidence is available from which a reasonable person would conclude that there may be an interest holder with a ‘significant stake’. [Schedule 5, item 4, subsection 124-783(8)]

Example 11.3

Yellow Co has 3 million ordinary shares on issue of which Brown Co holds 1 million. Mr Brown owns all the shares in Brown Co. A 1:3 takeover offer is made by Green Co for all the ordinary shares in Yellow Co. Before the takeover, Green Co has 1 million ordinary shares on issue. Mr Brown owns 600,000 ordinary shares in Green Co. Brown Co receives 333,333 shares in Green Co as part of the takeover arrangement. Immediately before the takeover arrangement, Brown Co owned 33% of the original entity Yellow Co. This is a significant stake. Immediately after the takeover arrangement, Brown Co and Mr Brown (an associate of Brown Co) together own 933,333 shares out of the 2 million shares on issue in Green Co. Again this is a significant stake.


Selling a Small Business – The CGT Strategies In order for roll-over to be obtained on the transfer of the shares by Brown Co to Green Co, there must be a joint roll-over choice by these companies. If this occurs, the cost base of the shares for Brown Co will become the first element of their cost base for Green Co.

Example 11.4

If Mr Brown had only 10,000 shares in Green Co just before the takeover arrangement, then the significant stake test would not be satisfied. Although Brown Co owned a 33% stake in Yellow Co before the arrangement, Brown Co and Mr Brown would own only 343,333 shares out of the 2 million shares in the acquiring company (Green Co) immediately thereafter. This is less than 30%. There would be no cost base transfer in this case. 11.39 An additional significant stake test applies if an acquiring entity for an arrangement is an original interest holder. In this case any other original interest holder may also be a significant stakeholder if:

• it had a significant stake in the original entity before the arrangement; and

• just after the arrangement it is an associate of the entity in which it holds replacement interests.

[Schedule 5, item 4, subsection 124-783(2)]

11.40 This test operates on an equivalent basis to the primary test taking into account associate interests that may not be appropriately counted where the acquiring entity is an original interest holder.

Example 11.5

Shares in Adventure Co are held as follows:

• Atlantis Co – 45%;

• Euphoria Co – 25%; and

• widely-held by 500 unrelated entities – 30%.

Ivory Tower Co owns 90% of the shares in Atlantis Co and 75% of the shares in Euphoria Co. Atlantis Co makes an offer to acquire shares it does not hold in Adventure Co in exchange for shares in Atlantis Co. Atlantis Co is an associate of Euphoria Co just before the arrangement (see section 318 of the ITAA 1936). On an associate-inclusive basis Euphoria Co had a 70% stake (45% + 25%) in Adventure Co prior to the arrangement. This is a significant stake. If Euphoria Co and Atlantis Co jointly elect for roll-over on Euphoria’s shares in Adventure Co, their cost base will be transferred to Atlantis Co regardless of whether or not it has a significant stake in Atlantis Co immediately after the arrangement. This is because Euphoria Co and Atlantis Co are associates just after the arrangement. As Adventure Co is widely-held just before the arrangement the common stake test (see paragraph 11.41) will not apply. 11.41 The second case where a cost base transfer may be required is where an interest is part of an 80% or more common holding (a common stake) of interests (determined on an associate-inclusive basis) in a non-widely-held original entity just before the arrangement and in a non-widely-held replacement entity just after the arrangement. [Schedule 5, item 4, subsection 124-782(1) and subsections 124-783(3), (5), (9) and (10)]



Example 11.6

Charles, Ian, Peter and David, who are unrelated businessmen, each holds 25% of the 100 units in a small unit trust (Print Trust) which runs a printing business. Each unit has a market value of $250. They wish to reorganise the business by setting up a ‘holding’ trust (Hold Trust) that they, and their spouses, will control and in which they will all have an investment. Hold Trust is capitalised with $10 million and 50 units are issued to each of the 4 businessmen and their spouses. The trustee of Hold Trust makes an offer to each of Charles, Ian, Peter and David to acquire their units in Print Trust in exchange for units in Hold Trust. The market value of the replacement units is substantially the same as the original units. None of the stakes held by Charles, Ian, Peter and David qualifies as a significant stake. However, they each have a common stake in Print Trust and Hold Trust, because together they, with their associated spouses, have 100% of the rights to income and capital of both trusts. Provided Charles, Ian, Peter and David elect with Hold Trust for roll-over, the first element of cost base of their replacement interests in Hold Trust will be the cost base of their original interests in Print Trust. The first element of Hold Trust’s interests in Print Trust will be the cost base of those same original interests in Print Trust. 11.42 An additional test applies if an acquiring entity for an arrangement is an original interest holder. Reflecting the fact that in this case direct and indirect interests in the original entity are maintained, another original interest holder (i.e. apart from the acquiring entity) may also have a common stake if the:

• original entity is not widely-held just before the arrangement; and

• replacement entity is not widely-held just after the arrangement. [Schedule 5, item 4, subsection 124-783 (4) and (5)]

Example 11.7

Adventure Co has 3 non-associated shareholders: • Atlantis Co with 70% of its ordinary shares; • Euphoria Co with 15% of its ordinary shares; and • Capable Co with 15% of its ordinary shares.

All the shares in Atlantis Co are held by Ivory Tower A Co and B Co. Atlantis Co makes an offer to Euphoria Co and Capable Co to buy out their minority interests in Adventure Co in exchange for shares in Atlantis Co. Atlantis Co obtains a 15% holding from Euphoria Co and 5% from Capable Co, taking it to an 90% interest in Adventure Co. Neither Euphoria Co nor Capable Co had a significant stake in Adventure Co prior to the arrangement so the significant stakeholder test will not apply. However, Adventure Co was not widely-held before the arrangement and Atlantis Co was not widely-held after the arrangement. Because Atlantis Co was an original interest holder, there will be a cost base transfer in respect of the shares acquired from Euphoria Co and Capable Co. 11.43 In determining whether the above percentage tests for cost base transfer are met, all pre and post-CGT interests will be taken into account. However, as noted at paragraph 11.36 there is a cost base transfer only for those interests for which roll-over is obtained.


Selling a Small Business – The CGT Strategies 11.44 An original interest holder with a ‘significant stake’ or ‘common stake’, can obtain the scrip for scrip roll-over only where a joint election is made with the replacement entity in respect of the interest. While cost base transfer is not an issue that will directly affect the replacement entity in a downstream arrangement, it is considered appropriate to require it (as the ultimate holding company of the wholly-owned group) to make the election. The ultimate holding company will be part of the overall arrangement and would be expected to consult closely with the acquiring entity, or entities if more than one. In some cases involving cancellation of interests there may be more than one acquiring entity and the original interest holder would be unable to determine with which entity it was required to make a joint election. [Schedule 5, item 4, paragraphs 124-780(3)(d) and 124-781(3)(c)] 11.45 If a joint roll-over election is made, there will be a transfer of cost base from the original interest holder to the acquiring entity. The joint election will not need to be lodged with the Commissioner but must be in writing and include the interest holder’s cost base details so that the acquiring entity can properly determine its acquisition cost. [Schedule 5, item 4, paragraphs 124-780(3)(e) and 124-781(3)(d)] 11.46 If a joint election is not made in respect of an interest forming part of a significant or common stake, scrip for scrip roll-over will not apply to it and the acquiring entity will determine its first element of cost base for it under the normal cost base rules. The acquiring entity may indicate to interest holders that have a significant stake or common stake its unwillingness to make a joint election at the start of the scrip for scrip arrangement. This may occur, for example, because the acquiring entity does not want to take on a potential tax liability that belonged to the holder of a significant stake or common stake. 11.47 For a downstream acquisition where the acquiring subsidiary issues debt or equity to the ultimate holding company, the acquisition cost to the ultimate holding company for that debt or equity will be based on the acquisition cost (as set out in paragraphs 11.36 to 11.46) for the shares in the original company that the subsidiary acquires. [Schedule 5, item 4, section 124-784]

Example 11.8

Target Co has 3 associated shareholders Able Co, Better Co and Competent Co that each holds 300 shares. Each share has a cost base of $200 and a market value of $333. Sub Co (a 100% subsidiary of Parent Co which holds 200 shares) makes a 1:3 offer to acquire all the shares in Target Co in exchange for shares in Parent Co. Before the takeover, Parent Co is worth $300,000 and is owned by 2 shareholders, Dependable Co and Efficient Co, each with 150 shares. Sub Co is worth $300,000. As part of the arrangement, Sub Co issues 200 shares to Parent Co making the total number of shares on issue to Parent Co 400. Able Co, Better Co and Capable Co each has (on an associate inclusive basis) a significant stake in Target Co before the arrangement and in Parent Co after the arrangement. They choose, with Parent Co, for roll-over. Each of the 900 shares acquired by Sub Co obtains a first element of cost base of $200. The total of these cost bases ($180,000) is reasonably apportioned to the 200 shares issued by Sub Co to Parent Co as follows: $180,000/200 = $900 per share. 11.48 In a downstream arrangement, a loan may be recorded by the ultimate holding company to the acquiring entity representing the value of the replacement interests issued by it. Under the cost base transfer rules, the cost base allocated to the debt (an asset of the ultimate holding company) may be less than its market value. If that debt is assigned to an independent third party for cash, so that the group indirectly realises the value of the original entity, it is not inappropriate that a capital gain arises on that transaction. However, if the loan is merely repaid by the acquiring entity, any capital


Selling a Small Business – The CGT Strategies gain made on the debt from that repayment is disregarded. This is appropriate because, within the group, there has been no realisation of any value of the original entity. [Schedule 5, item 4, subsection 124-784(3)]

¶7.0291 Form of joint election and cost base notice

There is no form prescribed by the legislation for a joint election under sec 124-780(3)(e) and sec 124-781(3)(d) where sec 124-782 applies (i.e. where a cost base transfer or allocation is required), nor indeed is the election actually required to be in writing. However, where sec 124-782 applies, the original entity holder must inform the replacement entity or trustee or the acquiring entity in writing of the cost base of its original interest worked out just before a CGT event happened in relation to it. At para 11.45 of the EM (reproduced above) it is stated that the joint election need not be lodged with the Commissioner but must be in writing and include the interest holder’s cost base details so that the acquiring entity can properly determine its acquisition cost. This statement is obviously indicative of ATO thinking; it does not necessarily represent the legal position.

From a practical point of view, it would appear that the requirement to provide a written notice to the replacement entity of the cost base of the original holder’s original interest is legally necessary for the roll-over to be obtained, so there is unlikely to be a situation arising where it might be necessary to argue that the joint roll-over choice had been made notwithstanding that no written cost base notice had been provided. Section 103-25 (dealing with choices) has not been modified to override the general rule about making choices in the case of roll-overs under Subdivision 124-M.

Note: If a written cost base notice is lost or destroyed, this does not invalidate the roll-over, although it may be necessary by other means to provide evidence that the notice had been provided at the time the choice was made. In this regard, sec 124-780(3)(e) and sec 124-781(3)(d) do not actually state when the notice is required to be provided. It would appear that it would be necessary for a notice to be provided at least before the time at which the original holder lodges his/her return for the income year in which the arrangement took place, otherwise the conditions for the roll-over would not have been completed and the original holder would be required to return any capital gain in his/her income tax return.

The following combined forms may be used to provide a record of a joint choice and cost base notice. Separate forms are provided for companies and for trusts.

Income Tax Assessment Act 1997 – Section 124-780(3)(d) & (e)

(Company) Joint Scrip for Scrip Roll-over Choice and Cost Base Notification

……………………………………………………………………………………………………. of ……………………………………………… Tax file Number………………………. (the Original Interest Holder) AND …………………………………………………………... of …………………………………………………Tax File Number………………………… (the Replacement Entity) jointly choose to obtain scrip for scrip rollover under section 124-780 of the Income Tax Assessment Act 1997 in respect of the interests in ……………………………………………………………………………………………………of …………………………………………………Tax File Number…………………… (the Original Entity) referred to in the Notice below disposed of on …………………… (date of arrangement). Notice pursuant to section 124-780(3)(e) of the Income Tax Assessment Act 1997 The Original Interest Holder by this notice informs the Replacement Entity details set out in the Schedule below of the cost base of its original interests in the Original Entity.



Signed Original Interest Holder Signed Public Officer Replacement Entity Date

The Schedule Interest date acq’d acquis’n

costs incid costs non-cap

costs cap exp other

cap exp

Note 1. This Form does not need to be lodged with the ATO but a copy should be retained by the Original Interest Holder and the Replacement Entity. Note 2. Where the replacement entity is not the entity making the acquisition offer, the replacement entity and not the entity making the acquisition offer, must make the joint choice in this form. This is the form for trusts:

Income Tax Assessment Act 1997 - Section 124-781(3)(c) & (d) (Trusts)

Joint Scrip for Scrip Roll-over Choice and Cost Base Notification ………………………………………………………………………………………………. of …………………………………………………… Tax file Number………………………….. (the Original Interest Holder) AND …………………………………………………………... of …………………………………………………..Tax File Number………………………… (the Trustee of the Acquiring Entity) jointly choose to obtain scrip for scrip rollover under section 124-781 of the Income Tax Assessment Act 1997 in respect of the interests in ……………………………………………………………………………………………..….…of ……………………………………………………Tax File Number………………………... (the Original Entity) referred to in the Notice below disposed of on ……………………(date of arrangement). Notice pursuant to section 124-781(3)(d) of the Income Tax Assessment Act 1997 The Original Interest Holder by this notice informs the trustee of the Acquiring Entity details set out in the Schedule below of the cost base of its original interests in the Original Entity. Signed Original Interest Holder Signed



Trustee of the Acquiring Entity Date

The Schedule Interest date acq’d acquis’n

costs incid costs non-cap

costs cap exp other

cap exp

Note. This Form does not need to be lodged with the ATO but a copy should be retained by the Original Interest Holder and the Trustee of the Acquiring Entity.

¶7.0292 CUFS and CDIs

Sections 124-780(6) and 124-781(6) extend the roll-over to the holder of a Chess Unit of Foreign Security (CUFS) as if the holder held the underlying interests that the unit represents. In an Addendum (CR 2001/17A) to CR 2001/17 dealing with the proposed takeover of Cable & Wireless Optus Limited by SingTel Australia Investment Ltd it is stated that:

Optus shareholders who accept the takeover offer will receive Chess Depository Instruments (“CDIs”) rather than actual SingTel share scrip. Each CDI represents an underlying SingTel share. CDIs are a mechanism which facilitates the electronic transfer of shares on the Australian Stock Exchange (“ASX”). CDIs are units of beneficial interests in securities where the legal title is held by an Australian depository entity. That entity in the present case will be Chess Depository Nominee Pty Ltd (“CDN”), a wholly-owned subsidiary of the ASX. CDN will be recognised under Singapore law as the holder of such SingTel shares.

The CDIs are Chess Units of Foreign Security in terms of the ASX's Securities Clearing House Business Rules. See ID 2003/913.

¶7.0293 Requirement for unit holders to have a vested and indefeasible interest to a share of the income and in the capital of a trust

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the NIA raised the following issue:

The scrip for scrip roll-over for units in a unit trust require the unit holders have a vested and indefeasible interest to a share of all the income and capital of the trust (see paragraph 124-781(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997), the definition of fixed entitlement in section 995-1 of the 1997 Act and section 272-5 of Schedule 2F of the 1936 Act). However, if the unit holders have the right to amend the deed or the trustee has a right of indemnity from the income or capital of the trust, it may be arguable that the unit holders do not have an indefeasible interest in the income and capital of the trust. If this was the correct interpretation most unit trusts would not be entitled to use the scrip for scrip roll-over. What is the ATO's reaction to this?

ATO Response

Paragraph 124-781(1)(b) of the ITAA 1997 provides that one of the conditions for scrip for scrip roll-over on the exchange of a unit or an interest in a trust is that entities have fixed entitlements to all of the income and capital of the original entity and the acquiring entity.


Selling a Small Business – The CGT Strategies The meaning of fixed entitlement is determined by reference to 272-5 of Schedule 2F to the Income Tax Assessment Act 1936. This section provides that where a beneficiary has a vested and indefeasible interest in a share of the income or capital of a trust that they will be considered to have a fixed entitlement. The words ‘vested’ and ‘indefeasible’ are to be given their ordinary trust law meaning (see for example FC of T v Harmer & Ors 90 ATC 4672 (1990) 24 FCR 237; Dwight v Federal Commissioner of Taxation (1992) 37 FCR 178; (1992) 107 ALR 407; 92 ATC 4192; 23 ATR 236; and Walsh Bay Developments Pty Ltd & Anor v FC of T 95 ATC 4378. Whether particular entities have vested and indefeasible interests for the purposes of section 272-5 can only be determined on a case by case basis, after having regard to all of the terms and conditions of the relevant trust instrument. Consequently, it is not possible to provide a final answer to the question raised. However, clearly the existence of a clause of the trust deed giving unit holders the right to amend either the trust deed of the original entity and/or the trust deed of the acquiring entity is an important factor in determining this question. This will also be the case where a trustee has power to amend the trust deed. Additionally, where such power to amend the trust deed exists, the issue of whether the exercise of such power would result in a resettlement of the relevant trust may also require consideration. Where a trustee of a unit trust incurs a liability in pursuance of carrying out the duties under the trust, and is not in breach of trust, a trustee will generally be entitled to be indemnified against those liabilities from the trust assets. In effect, the trustee in such a situation has a charge or lien over those assets (see Vacuum Oil Company Proprietary Limited v Wiltshire (1945) 72 CLR 319; and Octavo Investments Proprietary Limited v Knight & Anor (1979) CLR 319). In such a situation, the right of the trustee to be indemnified, of itself, will not mean that the unit holders do not have fixed entitlements to the income and capital of the trust (Dwight v F C of T).

¶7.0294 Original interest holder

At the National Tax Liaison Group – CGT Subcommittee meeting of 28 November 2001 the ATO confirmed that the term “original interest holder” in sec 124-780 was not intended to limit the scope of the roll-over to particular shareholders. The Minutes note:

The LCA raised the following issue: The definition of original interest holder is in section 124-780. This provides that ‘there is a roll-over if...an entity (the original interest holder) exchanges...a share (the entity’s original interest) in a company (the original entity) for a share (the holder’s replacement interest) in another company’. Officers of the ATO have suggested that an entity may be an original interest holder whether or not it exchanges an original interest for a replacement interest. This is not tenable in the light of the definition. Under the definition, an entity is not an original interest holder unless it exchanges a share for another share. If it does not exchange a share, it is not an original interest holder – it is merely an entity. It is only if it fulfils the conditions of the paragraph that it becomes the original interest holder to which the paragraph refers. A consequence of the ATO’s interpretation of the definition of original interest holder would be that if the acquiring entity holds even one share out of a million in the original entity, all other shareholders are deemed to be common stakeholders, and, subject to section 124-782 (unless there are 300 or more members), the 80% test becomes irrelevant. Was this the intent of the provisions? The ATO stated that the purpose and effect of the provisions are to refer to all holders of interests in the original entity at the commencement of the arrangement


Selling a Small Business – The CGT Strategies irrespective of whether they in fact exchange any interests under the arrangement. This is not a definition as such but rather a drafting technique (a ‘tag’) used to identify which entity is being referred to. The ‘tag’ needs to be read in context. The neighbouring provisions of subsections 124-783(2) and (4) clearly contemplate an original interest holder not being an entity that is in fact exchanging interests.

The views expressed above would apply equally to the term used sec 124-781.

¶7.030 NON-WIDELY HELD ENTITIES

Sections 124-780(4) and (5) and 124-781(4) and (5) ITAA 97 impose two additional conditions where entities are not dealing with each other “at arm’s length” and either the offeror or the offeree has less than 300 members. The first condition is that that the market value of the rolled-over interests must be at least substantially the same as the original interests. The second condition is that the rights and obligations attaching to the replacement interests must be of the same kind as those attaching to the original interests. The EM to the NBTS(M)2 Act 2000 notes that the modifications (noted above in italics) will make the conditions easier to satisfy in practice without detracting from the integrity they give to the scrip for scrip measures.

The additional conditions also apply where the interests of the taxpayer, the offeror and offeree are all members of the same “linked group” just before the transaction takes place (see discussion at ¶7.040 below).

The further conditions are fairly straightforward and appear to be no more than a reinforcement of the basic conditions that apply where the offeror and offeree are dealing with each other at arm’s length.

The arm’s length trigger for the additional conditions is perhaps justifiable, therefore, on the basis that if, in fact, the parties are not so acting, then the additional conditions to ensure against value shifting are needed (see the below discussion on the new value shifting regime below). However, since the further trigger is used, namely, that either the offeror and offeree have less than 300 members each, then the arm’s length trigger would appear to be redundant. It may have been simpler to just use the 300-member trigger.

Practice point

The double trigger does offer some scope for roll-over relief to be available where the offeror and offeree entities do not have the requisite 300 members each and do not wish to offer exactly the “same” rights or obligations for the replacement interests, provided they can establish that they are acting at arm’s length.

Just what kinds of “rights and obligations” the second condition applies to is not entirely clear. It appears, however, that the requirement under the new sections is less stringent than under the original sec 124-780(5) which required that the rights and obligations be the “same” rather than “the same kind”. This is confirmed by the EM, as noted above. The introduction of the word, “kind” suggests that there is now scope for minor variation, see discussion of the phrase “goods of a kind” in Diethelm Manufacturing Pty Ltd v FCT (1993) 44 FCR 450 where it was considered that the phrase denoted a genus of goods.

The question remains, however, to what extent can the conditions vary? Do they apply, for instance, to a loan guarantee that has been provided by the offeree shareholders, or must it spring from the actual share or interest so that, in the case of a share, it only applies to rights and obligations that are to be found in the constituent documents of the issuing company? It would appear that the better view here is that such an obligation attaches to the share and not to the shareholder. Neither the EM to the NBTS (CGT) Act 1999, nor the EM to the NBTS(M)2 Act 2000 provide guidance on this issue.


Selling a Small Business – The CGT Strategies In the case of “rights”, the question may be more difficult. For example, shareholders may be bestowed rights as shareholders, for example staff discounts, by directors’ resolution. Arguably, such rights are caught. The EM provides no guidance on this issue.

The condition that the market value of the capital proceeds for exchange must be at least substantially the same as the market value of the original interest may be difficult in practice to establish in the absence of an independent valuer’s report. The requirement that the values must be “substantially” the same is potentially a difficult one where a precise valuation cannot be obtained but only a range of valuations. Presumably, so long as the respective interests were broadly within the same range of values, this would suffice.

¶ 7.031 “Arm’s length” dealings

In considering what might be considered to be “arm’s length” for the purposes of sec 124-780(4) the discussion in Granby Pty Ltd v FCT (1995) 30 ATR 400; 95 ATC 4240 per Lee J is useful as TD 95/63 states that the ATO accepts the views of the Court in that case. Lee J said:

The expression “dealing with each other at arm’s length” involves an analysis of the manner in which the parties to a transaction conducted themselves in forming that transaction. What is asked is whether the parties behaved in the manner in which parties at arm’s length would be expected to behave in conducting their affairs. Of course, it is relevant to that enquiry to determine the nature of the relationship between the parties, for if the parties are not parties at arm’s length the inference may be drawn that they did not deal with each other at arm's length. When Hill J. considered the meaning of similar words in sub-s.102AG(3) of the Act in The Trustee for the Estate of the late A.W. Purse No 5 Will Trust v. Federal Commissioner of Taxation 91 A.T.C. 4,007 he said as follows 4,014-4,015:

“There are two issues, relevant to the present problem, to be determined under sec. 102AG(3). The first is whether the parties to the relevant agreement were dealing with each other at arm’s length in relation to that agreement. The second is whether the amount of the relevant assessable income is greater than the amount referred to in the subsection as the “arm's length amount”.

The first of the two issues is not to be decided solely by asking whether the parties to the relevant agreement were at arm’s length to each other. The emphasis in the subsection is rather upon whether those parties, in relation to the agreement, dealt with each other at arm’s length. The fact that the parties are themselves not at arm's length does not mean that they may not, in respect of a particular dealing, deal with each other at arm’s length. This is not to say that the relationship between the parties is irrelevant to the issue to be determined under the subsection.”

His Honour approved of the following statement by Davies J. in respect of the use of like words in sub-s. 26AAA(4) of the Act in Barnsdall v. Federal Commissioner of Taxation 88 ATC 4565 at 4568:

“However, sec. 26AAA(4) used the expression “not dealing with each other at arm's length”. That term should not be read as if the words “dealing with” were not present. The Commissioner is required to be satisfied not merely of a connection between a taxpayer and the person to whom the taxpayer transferred, but also of the fact that they were not dealing with each other at arm's length. A finding as to a connection between the parties is simply a step in the course of reasoning and will not be determinative unless it leads to the ultimate conclusion.”


Selling a Small Business – The CGT Strategies Whatever the meaning of the expression may be in equity (see: Australian Trade Commission v. W.A. Meat Exports Pty. Ltd. (1987) 75 A.L.R. 287 at 291; Barnsdall at 4,567- 4,568) for the purpose of sub-s. 160ZH(9) of the Act the term ‘at arm’s length’ means, at least, that the parties to a transaction have acted severally and independently in forming their bargain. Whether parties not at arm’s length have dealt with each other at arm's length will be a matter of fact. As Hill J. stated in Furse at 4,015, determination of the manner in which parties not at arm’s length have dealt with each other requires ‘an assessment whether in respect of that dealing they dealt with each other as arm’s length parties would normally do, so that the outcome of their dealing is a matter of real bargaining’. If the parties to the transaction are at arm’s length it will follow, usually, that the parties will have dealt with each other at arm’s length. That is, the separate minds and wills of the parties will be applied to the bargaining process whatever the outcome of the bargain may be. That is not to say, however, that parties at arm’s length will be dealing with each other at arm's length in a transaction in which they collude to achieve a particular result, or in which one of the parties submits the exercise of its will to the dictation of the other, perhaps, to promote the interests of the other. As in Minister of National Revenue v. Merritt 69 D.T.C. 5,159 at 5,166 where the parties to the transaction were parties at arm's length, the terms of a loan transaction made between them had been dictated by a unilateral decision of one of them and no independent will in the formation of that transaction had been exercised by the other. It followed that it could not be said that the parties had dealt with each other at arm's length at the material time. (c.f. Robinson v. Minister of National Revenue [1987] 1 C.T.C. 2,055.) Counsel for Granby submitted that to deal at arm’s length the parties must engage in ‘real bargaining’. By that argument counsel sought to apply the observations of Hill J. in Furse on the dealing of parties not at arm’s length to the dealing of parties at arm’s length. Counsel submitted that once the Tribunal found that there had been ‘no real bargaining’ between the lessor corporations and the, partnership when the vehicles and drilling rigs were purchased by the partnership, the Tribunal should have found that the parties had not been dealing with each other at arm’s length in connection with the acquisition of those assets by the partnership. However, there was no evidence that the lessor corporations and the partnership acted in concert with an ulterior purpose, or that the lessor corporations accepted dictation or instruction from the partnership to the exclusion of the exercise of the independent minds of the corporations, when the partnership acquired the motor vehicles and drilling rigs from the corporations. In accepting the amounts tendered by the partnership to purchase those assets the lessor corporations made decisions which, they perceived, served the interests of the businesses conducted by them. ‘Residual values’ were set by the lessor corporations to safeguard the capital they, as financiers, invested in the chattel purchase and lease transactions they entered into and their decisions to accept consideration which did not exceed ‘residual values’ when the chattels were sold were decisions made for, and according to the requirements of, the businesses they conducted. The independent will of the lessor corporations was not merged in collusive activity with the partnership nor subjugated to direction from the partnership. It follows that there was no evidence that the lessor corporations and the partnership dealt with each other, other than at arm's length.”

ID 2004/498 provides an example where the original shareholders and the acquiring company were not dealing with each other at arm’s length. The ID is as follows:

Issue

Did a shareholder in a closely-held company deal with another company at arm's length for the purposes of subsection 124-780(4) of the Income Tax Assessment Act


Selling a Small Business – The CGT Strategies 1997 (ITAA 1997) under an arrangement that involved the acquisition of the shareholder's shares in exchange for ordinary and redeemable preference shares (equivalent in value to the original shares)?

Decision

No. The parties did not deal with each other at arm's length for the purposes of subsection 124-780(4) of the ITAA 1997. While the consideration paid for the original shares was equivalent to their market value, the acquiring entity had no bargaining power in relation to the transaction and did not act independently to the shareholders as a group.

Facts

The shareholder is one of a small group of shareholders who own all the ordinary shares in a closely held company (original entity). All the shares were acquired after 19 September 1985. A restructure is implemented whereby a new company (acquiring entity) is incorporated and acquires all the shares in the original entity in exchange for the issue of ordinary shares and redeemable preference shares. The original shareholders own all the shares in the acquiring entity in the same proportion as they did in the original entity. Based on independent valuations, the consideration paid by the acquiring entity is reasonably equivalent to the market value of the shares in the original entity. Each shareholder obtained their own professional advice and acted in their own interests in deciding whether to enter the restructure but they agreed as a group to the major terms and characteristics of the restructure including the amount paid as consideration for their shares. The creation and capital structure of the acquiring company are part of these terms and conditions.


To qualify for scrip for scrip roll-over relief under Subdivision 124-M of the ITAA 1997, a shareholder must satisfy the conditions in subsection 124-780(5) of the ITAA 1997 if subsection 124-780(4) of the ITAA 1997 applies (paragraph 124-780(1)(d) of the ITAA 1997). Subsection 124-780(4) of the ITAA 1997 applies if the shareholder in the original entity and the acquiring entity did not deal with each other at arm's length and: (a) neither the original entity nor the replacement entity (in this case the acquiring

entity) had at least 300 members just before the arrangement started; or (b) the original interest holder, the original entity and an acquiring entity were all

members of the same linked group just before that time. As the original and acquiring entities in this case had fewer than 300 members before the arrangement started, subsection 124-780(4) of the ITAA 1997 will apply if the shareholder and the acquiring entity did not deal at arm's length in relation to the transaction. The structure of subsections 124-780(4) and 124-780 (5) of the ITAA 1997 indicate the phrase 'dealing at arm's length' is not to be construed as meaning the parties exchange their shares for a fair price or market value. A condition to be met in subsection 124-780(5), that the market value of the capital proceeds received by the shareholders is substantially the same as the market value of their original interest, must be met only if the original interest holder and acquiring entity 'did not deal with each other at arm's length' and fall within paragraphs 124-780(4)(a) or (b). 'Arm's length' is defined at subsection 995-1(1) of the ITAA 1997 as:


Selling a Small Business – The CGT Strategies 'in determining whether parties deal at arm's length, consider any connection between them and any other relevant circumstances.' The Commissioner is therefore required to consider not only the relationship or connection between the shareholder and the acquiring entity but also the nature and circumstances of the dealing. When determining whether the shareholder dealt with the acquiring entity at arm's length it is the collective bargaining power of the group of shareholders against the acquiring entity which must be considered (Elmslie and Others v. Commissioner of Taxation (1993) 46 FCR 576; 26 ATR 611; (1993); 93 ATC 4964). As the restructure occurred in accordance with terms and conditions agreed between the shareholders it is considered that the newly incorporated acquiring company did not bargain as a party dealing at arm's length with these shareholders. Accordingly, for the shareholder to be able to choose scrip for scrip roll-over they must satisfy the conditions in subsection 124-780(5) of the ITAA 1997 including that the shares carry the same kind of rights and obligations. As the redeemable preference shares do not carry the same kind of rights and obligations as the original shares, roll-over is not available to the extent that the original shares were exchanged for those redeemable preference shares. Date of decision: 21 April 2004

Section 124-810 ITAA 97 provides a “20/75” test in similar terms to the test in sec 115-50 (discussed at ¶1.020) to deal with cases where, although a company or trust may have 300 members or beneficiaries, 75% of the entitlement to income or capital is concentrated in the hands of 20 or less individuals.

Example

The Faulty Hotel Trust (FHT) operates a successful hotel business in Western Australia. An international hotel group (IHG Inc) has approached the Faulty family, who control the business, with an offer to buy the business. IHG Inc is in fact controlled by a WA identity that is related to the Faulty family. Since the Faulty family believe that they would not qualify under any of the small business concessions, they seek your advice whether it would be possible to roll over their interests in the Trust for shares in IHG Inc that are listed on the US Stock Exchange. The FHT is a unit trust with 100 units held by each of the four adults in the two families that manage the hotel. The Faulty Family Trust owns 100 units in the FHT and the Faulty Family No 2 Trust owns 1200 units in the FHT. There are, in total, 27 family members who may receive distributions under these trusts. The FHT Employees Superannuation Trust Fund holds 250 units in the FHT. Each of the hotel’s 300 permanent full and part-time staff has been issued with one unit in the FHT. All units have equal rights to the income and capital of the Trust. There are more than 300 members of the FHT and, therefore, the conditions in sec 124-781(4) requiring that the market value, and rights and obligations, of the rolled-over interests must be at least substantially the same as the original interest where entities are not dealing with each other “at arm’s length”, may not apply. There is a further initial question whether the mere fact that IHG Inc is controlled by an individual who is related to the Faulty family means that the offeror and the individual Faulty family members are not dealing with each other at arm’s length. Arguably, it is the relevant offeror entity, not an individual behind it that needs to be considered, although the Courts would normally look to the controlling mind behind an entity. Assuming that the parties are not dealing with each other at arm’s length, the next question is whether sec 124-810 is triggered so as to treat FHT as having less than 300 members.


Selling a Small Business – The CGT Strategies It would appear that the Faulty Family hold between them 1,700 of the total 2,250 units issued which would give them the right to 75.56% of the trust’s income and share in its capital. On this basis, sec 124-810(3) would apply to treat the FHT as having fewer than 300 members for the purposes of sec 124-781(4)(a). This means that the conditions in sec 124-781(4) would need to be complied with. In other words, the market value, and rights and obligations, of the rolled-over interests must be substantially the same kind as the original interests. A more fundamental problem arises in that it is not possible to roll over units for shares (see sec 124-781(1)(a)(i)). However, if the IHG Inc has a unit trust in the group or is prepared to, say, establish one, there is no reason why a roll-over could not be undertaken, if the offer were to be made by that entity. In this example, because the conditions in sec 124-781(4) have been arguably triggered, care would need to be taken to ensure that the market value of any units in the unit trust established by the IHG Inc are at least substantially the same as the units in the FHT. Another issue is that with 300 of the 2,250 units in the FHT being held by individual employees and 250 units being held by the FHT Employees Superannuation Trust Fund, it may be difficult to achieve an 80% acceptance rate. No additional inducement would be able to be made to the holders of these units since sec 124-781(2)(c) would appear to preclude such an offer. The residency requirement conditions in sec 124-795(1) for the roll-over for those unitholders in the FHT that were Australian residents just after the offer becomes unconditional (ie upon acceptance) will be met. Since the replacement entity is unlikely to be an Australian resident, any non-Australian resident unitholders in the FHT would not qualify for roll-over (see sec 124-795(1)).

Section 124-810(5) contains a further anti-avoidance measure that applies where there is a possibility of varying the rights attaching to shares or interests that would have the effect of enabling the 75/20 test to be breached. The provision provides as follows:

Possible variation of rights etc.

(5) This subsection applies to a company or trust if, because of:

(a) any provision in the entity’s constituent document, or in any contract, agreement or instrument:

(i) authorising the variation or abrogation of rights attaching to any of the *shares, units or other fixed interests in the entity; or

(ii) relating to the conversion, cancellation, extinguishment or redemption of any of those interests; or

(b) any contract, *arrangement, option or instrument under which a person has power to acquire any of those interests; or

(c) any power, authority or discretion in a person in relation to the rights attaching to any of those shares, units or interests;

it is reasonable to conclude that the rights attaching to any of those interests are capable of being varied or abrogated in such a way (even if they are not in fact varied or abrogated in that way) that, directly or indirectly, subsection (3) or (4) would apply to the entity.

In the above example, had the Faulty family not failed the 75/20 test in sec 124-810(3), it would appear that sec 124-810(5) would apply because, with a majority of units in the FHT, the Faulty family may be able to alter to Trust’s terms to vary the rights attaching to the units to enable them to receive either 75% of the income or capital of the trust. Section 124-810(3)


Selling a Small Business – The CGT Strategies is very broadly cast, and, as such, there is little scope to exclude the further tests requiring substantially the same market value for the new interests as the old with the same conditions in accordance with sec 124-781(4).

Section 124-783

The Minutes of the National Tax Liaison Group – CGT Subcommittee meeting of 27 November 2002 include the following item:

8.1. The application of section 124-783 (Sponsor: NIA)

Could the Tax Office confirm the intention of subsection 124-783(4) which states: ‘If an acquiring entity for an arrangement is an original interest holder, each other original interest holder that has a replacement interest is a common stakeholder for the arrangement.’ This provision, in conjunction with subsection 124-782(1) and paragraph 124-780(3)(d), means that where the acquiring entity or the original entity has less than 300 members and the acquiring entity is an original interest holder of the original entity (that is, holds any amount of shares or units in the original entity before the takeover, even as low as 0.000001%), the original interest holders of the target entity have to get the acquiring entity’s approval to obtain rollover. The acquiring entity may not want to give this approval as the cost base for the interests it acquires in the original entity under the takeover will be the cost bases for those interests that the original interest holders had before transferring them under the takeover. This would apply even where the acquiring entity had a minimal original interest and was dealing at arm's length with the original interest holders. Compare this to the situation where the acquiring entity had no original interests in the original entity before the takeover. The original interest holders do not require an agreement with the acquirer in order to get the rollover. In addition, it appears that if the above interpretation is correct there would be no need for the significant stakeholder test in cases of less than 300 members. Could the Tax Office confirm that this is their interpretation of the provisions and, if so, is there an explanation why there is an inequitable position between the situation where the acquiring entity has no original interests in the original entity and where the acquiring entity has a minimal original interest in the original entity?

Tax Office response

The Tax Office acknowledged that the significant stakeholder test may have no practical application in the circumstances mentioned. However, the provision needs to be understood in the context that only direct holdings are tested. Where the acquiring entity holds interests in the target entity, holders of other direct interests may themselves hold interests in the acquiring entity, which give them an indirect interest in the target entity. To negate this possibility, a tracing regime would be required. This would increase complexity. Mr Burge (Treasury) noted that subsection 115-45 in relation to the CGT discount also does not have a tracing provision. Not having tracing through interposed entities in these kinds of provisions promotes legislative, administrative and compliance simplicity. If a tracing provision were considered desirable for subsection 124-783(4), it would seem to be equally desirable for provisions such as section 115-45.

¶7.040 LINKED GROUPS

Section 124-780(4)(b), set out above, provides an alternative condition to the 300 member test where the taxpayer and the offeror do not deal with each other at arm’s length. The condition is that the taxpayer, the offeror and offeree are all members of the same “linked group” of


Selling a Small Business – The CGT Strategies companies just before the transaction. Note that there is no equivalent provision for trusts. The definition of “linked group” is found in sec 170-260 ITAA 97 (via sec 995-1(1) ITAA 97) and was added to ITAA 97 by the Other Measures Act to deal with the disposal of loss assets within majority owned groups, see ¶11.030. The definition section provides as follows:

170-260 Linked group

(1) Companies that are linked to one another are a linked group.

(2) Two companies are linked to each other if:

(a) one of them has a controlling stake in the other; or

(b) the same entity has a controlling stake in each of them.

(3) For the purposes of this section, an entity has a controlling stake in a company at a particular time if the entity, or the entity and the entity’s *associates between them:

(a) are able at that time to exercise, or control the exercise of, more than 50% of the voting power in the company (either directly, or indirectly through one or more interposed entities); or

(b) have at that time the right to receive for their own benefit (either directly, or indirectly through one or more interposed entities) more than 50% of any dividends that the company may pay; or

(c) have at that time the right to receive for their own benefit (either directly, or indirectly through one or more interposed entities) more than 50% of any distribution of capital of the company.

(4) If:

(a) apart from this subsection, an interest that gives an entity and its *associates (if any):

(i) the ability to exercise, or control the exercise of, any of the voting power in a company; or

(ii) the right to receive dividends that a company may pay; or (iii) the right to receive a distribution of capital of a company;

would, in the application of paragraph (3)(a), (b) or (c), be counted more than once; and

(b) the interest is both direct and indirect;

only the direct interest is to be counted.

See ID 2003/780 for an example of a linked group.

¶7.050 APPLYING THE ROLL-OVER

Section 124-785 sets out the consequences of choosing the scrip for scrip roll-over. The section provides as follows:

124-785 What is the roll-over?

(1) A *capital gain you make from your original interest is disregarded.

(2) You work out the first element of the *cost base of each *CGT asset you received as a result of the exchange by reasonably attributing to it the cost base (or the part of it) of your original interest for which it was exchanged and for which you obtained the roll-over.



(3) In applying subsection (2), you reduce the *cost base of your original interest (just before you stop owning it) by so much of that cost base as is attributable to an ineligible part (see section 124-790).

(4) The first element of the *reduced cost base is worked out similarly. Example 1: Lyn exchanges 1 share with a cost base of $10 for another share. The cost base of the

new share is $10.

Example 2: Glenn exchanges 2 shares with cost bases of $10 and $11 respectively for one new share. The cost base of the new share is $21.

Example 3: Wayne exchanges 1 share with a cost base of $9 for share A with a market value of $5 and share B with a market value of $10. The cost base of share A is $3 and the cost base of share B is $6.

As stated in sec 124-785(1) any capital gain arising from the disposal of a share or interest in respect of which roll-over is chosen, is disregarded. By sec 124-785(2) the first element of the cost base of the replacement share or interest is determined by “reasonably attributing” to it the cost base of the disposed share or interest. The simple examples following sec 124-785 illustrate how it is intended to calculate the first element of the cost base of the replacement asset.

It is noted that by its ID 2001/755 the ATO takes the view that the time of the CGT event in the case of a takeover offer made subject to a condition precedent that the Treasurer raise no objections to the takeover, is when the offer becomes unconditional.

¶7.051 Partial roll-over

The term, “ineligible part” used in sec 124-785(3) is defined in sec 124-790 which provides, as follows:

124-790 Partial roll-over

(1) The original interest holder can obtain only a partial roll-over if its *capital proceeds for its original interest includes something (the ineligible proceeds) other than its replacement interest. There is no roll-over for that part (the ineligible part) of its original interest for which it received ineligible proceeds.

(2) The *cost base of the ineligible part is that part of the cost base of your original interest as is reasonably attributable to it. Example: Ken owns 100 shares in Aim Ltd. Those shares have a cost base of $2.

Ken accepts an offer from LBZ Ltd to acquire those shares. The offer is 1 share in LBZ (market value $4) plus $1 for each Aim share.

Ken chooses the roll-over to the extent that he can.

The cost base of the ineligible part is [$100 × $200] ÷ $500 = $40.

Ken makes a capital gain of $100 − $40 = $60.

Note that the NBTS(M)2 Act 2000 repealed and substituted the original subsec (1) and repealed subsec (3).

The example following sec 124-790(2) illustrates how to determine a partial capital gain that is realised where something other than a share or interest in a trust is exchanged for an existing share or trust interest. The underlying assumption is that a full roll-over is only obtained where a share or interest is exchanged for another share or interest. So that if something else is received in return for a share or interest, then the assumption is made that not all of the share or interest has been rolled over. It is noted that sec 124-780 originally made clear (in para (2)(a)(ii) and (2)(b)(ii)) that a roll-over was available where cash and


Selling a Small Business – The CGT Strategies shares are offered. There is now no equivalent reference in sec 124-780 and 124-781. This means that the authority for a partial roll-over is to be found in sec 124-790.

The cost base of the “ineligible part” of the Ken’s shares in the example following sec 124-790(2) relates to each of the 100 shares Ken holds in Aim Ltd.

Another way of calculating the cost base of the “ineligible part” of the original shares (i.e. Aim Ltd) is to apportion the ineligible part in relation to each share held:

The cost base of each Aim Ltd share is $2

The total value of the offer is $500

The value of the ineligible part is $100

Therefore 100/500 or 1/5 of the offer represents the “ineligible part”.

Applying this to the cost base of each Aim Ltd share:

1 x $2 = $0.40 5

The cost base for the ineligible part of Ken’s 100 shares will be 100 x $0.40= $40

Ken’s capital gain will be $100 (“ineligible proceeds”) less $40 = $60

The cost base for each of Ken’s new shares will be:

Original cost base less cost base of ineligible part $2 - $0.40 = $1.60

The cost base for Ken’s new parcel of shares will be $1.60 x 100 = $160

The EM to the NBTS (CGT) Act 1999 contains two examples of partial roll-overs. They are as follows:

Example 2.6

Patrick owns 100 shares in Windsor Ltd each with a cost base of $9. He accepts a takeover offer from Regal Ltd which provides for Patrick to receive one Regal share plus $10 cash for each share in Windsor. Patrick receives 100 shares in Regal and $1,000 cash. Just after Patrick is issued shares in Regal each is worth $20. Patrick has received $10 cash for each of his 100 Windsor shares and so has ineligible proceeds of $1,000. In this case it is reasonable to allocate a portion of the cost base of the original shares having regard to the proportion that the ineligible proceeds bears to the total proceeds ($3,000). That is: $1,000 × $900 = $300 $3,000 Patrick makes a capital gain calculated as follows:

Ineligible proceeds $1,000

less Cost base $ 300

Capital gain $ 700

The cost base of each of Patrick’s Regal shares is calculated as follows: $900 - $300 = $6 100

Example 2.7

Adventure Rail Ltd makes an offer to acquire shares in Thomas Ltd. The offer provides these alternatives:



• Offer 1: 1 Adventure Rail share plus $1 for each Thomas share; or

• Offer 2: $5 for each Thomas share.

David chooses to accept the offers as follows:

• Offer 1 in respect of 50 post-CGT shares with a cost base of $2 each; and

• Offer 2 in respect of 50 post-CGT shares with a cost base of $6 each.

At the time he accepts the offer, the market value each Adventure Rail share is $4. David makes a capital gain on the disposal of the ineligible part of Thomas shares under Offer 1, (i.e. on the cash component of the offer), calculated as follows:

Ineligible proceeds (50 × $1) $50

less Cost base $1 × $100 $20 $5

Capital gain $30

The cost base of each Adventure Rail share David receives under Offer 1 is calculated as follows:

$100 – $20 = $1.60 50

David makes a capital loss on the disposal of Thomas shares under Offer 2, calculated as follows:

Capital proceeds (50 × $5) $250

less Reduced cost base (50 × $6) $300

Capital loss $50

Prior to the introduction of the scrip for scrip roll-over, part cash and part share offers were common with the cash component intended to compensate the offeree for any liability to CGT arising on the disposal of the existing shares or interests. It appears that now that offerees can roll over any capital gain, the incidence of part security and part cash offers has declined. However, in some instances, for example, where the offeree is not an Australian resident and the offeror is not, no roll-over will be permitted (see sec 124-795(1), discussed below). In such takeovers where there are significant non-Australian resident shareholders, and the offeror is also a non-resident, it is likely that part cash offers may still be attractive.

A partial roll-over will also arise where there is a mixture of assets offered, for example shares in the offeror plus units in a related trust for shares in the offeree entity. In such a case, the units would be the ineligible part because of the share-for-share rule in sec 124-780.

The EM to the NBTS (CGT) Act 1999 contains an example that illustrates that an offer can be “mixed” where the interests are in the same broad category, for example shares:

Example 2.5

Lila owns ordinary shares in Reef Ltd. She accepts a takeover offer from Heron Ltd under which she receives one ordinary share and one preference share for each Reef share. The market value of Heron shares just after Lila acquires them is $20 for each ordinary share and $10 for each preference share. The cost base of each Reef share just before Lila ceased to own them was $15. This cost base is apportioned to each of Lila’s Heron shares as follows:

Ordinary share: 20 × 15 = $10 30


Selling a Small Business – The CGT Strategies Preference share: 10 × 15 = $5 30

ID 2002/100 set out below, is instructive:

Income Tax: Capital Gains tax: Partial scrip for scrip roll-over: ineligible

proceeds

Issue

Is the taxpayer, a shareholder who exchanges shares in one company for shares and a right to an undetermined number of shares in another company entitled to a full scrip for scrip roll-over under Subdivision 124-M of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No. The taxpayer is only entitled to a partial scrip for scrip roll-over under section 124-790 of the ITAA 1997.

Facts

Under a share sales agreement, the shareholders have sold shares in a company (the original entity) in exchange for:

• shares in another company (the acquiring entity) and

• a right to receive a number of shares in the acquiring entity equal to one times the combined earnings before interest and tax of the original entity for year ended 30 June 2001, upon completion of the audited financial accounts of the original entity for that year;

The requirements of Subdivision 124-M of the ITAA 1997 have been satisfied.


The taxpayer is entitled to choose scrip for scrip roll-over to the extent that the taxpayer’s shares are exchanged for shares in the acquiring company. Subsection 124-780(1) of the ITAA 1997 requires that a replacement interest must be of the same kind as the original interest, e.g., a share for a share. Subsection 124-790(1) of the ITAA 1997 provides that there is no roll-over to the extent that the capital proceeds from shares includes something other than a ‘replacement interest’ which is referred to in this subsection as ‘ineligible proceeds.’ Ineligible proceeds are not limited to cash, e.g., a right to be issued shares that cannot be ascertained until a future date, is not a replacement asset for a share for the purposes of subsection 124-780(1) of the ITAA 1997. In these circumstances only partial roll-over is available as the taxpayer has accepted a right to shares which cannot be ascertained until a future date. Under subsection 124-790(2) of the ITAA 1997 a reasonable part of the cost base of the taxpayer’s shares in the original entity can be taken into account in working out the capital gain from the receipt of the ineligible proceeds. The Commissioner considers it is reasonable to allocate a portion of the cost base of the original shares having regard to the proportion that the ineligible proceeds bears to the total proceeds. Date of decision: 10 December 2001



¶7.060 EXCEPTIONS – WHERE NO ROLL-OVER AVAILABLE

Section 124-795 ITAA 97 sets out three main situations where roll-over is not available. These exceptions are:

• if you are not an Australian resident, unless at the time the new share or interest is acquired the offeror is an Australian resident or resident trust;

• if a capital gain on the replacement interest would be otherwise disregarded, unless because of another roll-over;

• if the taxpayer and the offeror are members of the same wholly-owned group.

Note that, as from 13 April 2000, the scrip for scrip roll-over for arrangements involving a non-resident original company and a non-resident acquiring company is only available if the original company has at least 300 members, or the acquiring company has at least 300 members or is a wholly-owned subsidiary of a non-resident ultimate holding company that has at least 300 members.

¶7.061 First exception

The first exception can be illustrated by an example.

Example

Continuing the example following sec 124-790(2), it will be recalled that Ken owns 100 shares in Aim Ltd. Those shares have a cost base of $2. Ken accepts an offer from LBZ Ltd to acquire those shares. The offer is one share in LBZ (market value $4) plus $1 for each Aim share. If Ken is not an Australian resident and the offeror, LBZ Ltd, is not an Australian resident, Ken would not be entitled to scrip for scrip roll-over relief. Ken would be eligible for relief if, however, LBZ Ltd was an Australian resident. Under Division 136 ITAA 97 a share or interest in a share in a company will have a necessary connection with Australia (and therefore potentially be subject to CGT) if the company is resident. Similarly an interest in a trust will have a necessary connection with Australia if the trust is a resident trust (see sec 995-1(1) ITAA 97. The non-resident exception does not apply where the replacement asset is a share in an Australian resident company or resident trust because the replacement asset will itself have the necessary connection with Australia and therefore be potentially assessable in the hands of a non-resident.

¶7.062 Second exception

The example noted in sec 124-795 ITAA 97 of the second category of exceptions is that of trading stock. The purpose of the exception is to prevent the conversion of CGT assets potentially subject to tax at some future point in time into exempt assets so as to use the scrip for scrip roll-over as an exemption mechanism.

Section 124-795(2)(a), which provides the second exception, has been drafted in a way that raises some potential difficulties. The provision says “you cannot claim the roll-over if any capital gain you might make from your replacement interest would be disregarded (except because of a replacement asset)”. By focusing on what might happen to the replacement asset, the provision creates a dilemma for a taxpayer.

One obvious issue that can be quickly put to one side is that if an individual receives a share or interest in a trust as a replacement asset under the roll-over that is eligible for the 50% individual concession (a discount gain), the eligibility for this concession would not preclude the individual from obtaining roll-over relief since discount capital gains do not involve a “disregarding” of a capital gain but a “reduction” of the gain (see sec 102-5(1)). However, this is not the case where a gain may be disregarded under the 15-year exemption for small


Selling a Small Business – The CGT Strategies businesses or the retirement exemption for small businesses. The dilemma is that at the time of the roll-over, a taxpayer may not know whether the replacement asset will be eligible for a future exemption.

Example

Fiona agrees to merge her small software distribution business with another software company, Wigi-soft Pty Ltd, by exchanging the shares in her company for shares in Wigi-soft, giving her a 50% interest in that company. Because her interest in Wigi-soft makes her a controlling individual of that company, Fiona may be able to claim the small business retirement exemption or the 15-year exemption on the eventual sale of her shares in Wigi-soft. This means that Fiona won’t be able to obtain scrip for scrip roll-over for the disposal of her shares in her company and she will not have been eligible for the small business roll-over if she was not a controlling individual of her company or was otherwise ineligible.

The second exception has potentially, and perhaps theoretically, heavy compliance costs, therefore, because it will generally be necessary to determine whether either the scrip for scrip roll-over is available or whether the small business concessions are available. As the example above illustrates, there will be cases where, having undertaken that exercise, it will be concluded that no relief is available The EM to the NBTS (CGT) Act 1999 contains no guidance on this issue.

¶7.063 Third exception

The third exemption provided by sec 124-795(2)(b) is intended to exclude the roll-over from being available to group entities. It is curious, therefore, that the NBTS(M)2 Act 2000, in repealing sec 124-790(3) which originally excluded discretionary trusts, enacted a new subsec (3) which seeks to make clear that scrip for scrip roll-over is not available if roll-over is available under Division 122 (disposal of assets to a wholly-owned company) or Division 124-G (company reorganisations) apply.

¶7.064 “Fourth exception”

There is perhaps what might be called a “fourth” exception. As noted above, sec 124-795(3) originally made clear that discretionary trusts were not eligible for roll-over. With the introduction of sec 124-781, the exclusion of discretionary trusts is incorporated as part of the eligibility requirements for trusts in sec 124-781(1)(b) which, like former sec 124-795(3), seeks to apply to discretionary trusts which are identified by reference to the absence of “fixed entitlements” as defined by sec 272-5 of Schedule 2F (Trust Losses and Other Deductions) (ITAA 36) (via sec 995-1(1) ITAA 97). The section is as follows:

272-5 Fixed entitlement to share of income or capital of a trust

(a) If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a ' fixed entitlement' to that share of the income or capital.

(b) Case where interest not defeasible

If:

(a) a person holds units in a unit trust; and

(b) the units are redeemable or further units are able to be issued; and

(c) if units in the unit trust are listed for quotation in the official list of an approved stock exchange the units held by the person will be redeemed, or any further units will be issued, for the price at which other units of the same kind in the unit trust are offered for sale on


Selling a Small Business – The CGT Strategies the approved stock exchange at the time of the redemption or issue; and

(d) if the units are not listed as mentioned in paragraph (c) - the units held by the person will be redeemed, or any further units will be issued, for a price determined on the basis of the net asset value, according to Australian accounting principles, of the unit trust at the time of the redemption or issue;

then the mere fact that the units are redeemable, or that the further units are able to be issued, does not mean that the person's interest, as a unit holder, in the income or capital of the unit trust is defeasible.

(c) Deemed fixed entitlement

If:

(a) a beneficiary with an interest in a share of income that the trust derives from time to time, or of the capital of a trust, does not have a fixed entitlement to the share; and

(b) the Commissioner considers that the beneficiary should be treated as having the fixed entitlement, having regard to:

(i) the circumstances in which the entitlement is capable of not vesting or the defeasance can happen; and

(ii) the likelihood of the entitlement not vesting or the defeasance happening; and

(iii) the nature of the trust;

the beneficiary has the fixed entitlement.

It is noted that sec 272-5(3) limits the circumstances in which a trust would be otherwise treated as a discretionary trust. See Practice Statement PS 2002/11 on the interpretation of this section.

¶7.070 SCRIP FOR SCRIP CLASS RULINGS

The ATO indicated in CR 2001/1 that class rulings could be issued in relation to scrip for scrip roll-overs. There have been a number issued since the introduction of the concession. See, for example, CR 2001/5 (Defiance Mining NL), CR 2001/17 (Cable & Wireless), CR 2001/39 (Mayne Nickless), CR 2001/51 (Howard Smith) and CR 2001/85 (Trans Urban). More recently, see CR 2003/86 (Colonial First State Development Trust), CR 2003/89 (Jupiters Limited and TABCORP) and CR 2003/90 (AMP Diversified Property Trust and Stockland) and CR 2003/90ER. The relevant parts of CR 2001/5 are reproduced below:

Income tax: capital gains: scrip for scrip roll-over: acquisition of Medical Monitors Pty Ltd by Defiance Mining NL

Class of persons

3. The shareholders and optionholders of Medical Monitors Pty Ltd (‘MM’) who enter into the proposed Share Sale and Subscription Agreement (on the same terms as the draft 3 dated 14.3.2001) in accordance with which Defiance Mining NL (‘Defiance’) will acquire all of the shares and options in MM and in return will issue a combination of ordinary shares and converting preference shares for every MM share acquired and will issue options for every MM option acquired.



Qualifications

4. Scrip for scrip roll-over is not available under section 124-780 for interests in a company that were acquired prior to 20 September 1985 (paragraph 124-780(3)(a)). This Ruling does not apply to shares or options in MM that were acquired for CGT purposes before that date.

5. Scrip for scrip roll-over is only available for interests that, apart from the roll-over, would have given rise to a capital gain on a CGT event happening in relation to them (paragraph 124-780(3)(b)). This Ruling does not apply to shares or options in MM that would not give rise to a capital gain on disposal to Defiance.

6. Special rules apply for the purposes of scrip for scrip roll-over if an original interest holder is a significant stakeholder for an arrangement. In determining whether an entity has a significant stake in another entity, interests held by associates are taken into account (section 124-783). This Ruling is made on the basis that none of the shareholders in MM is an associate just before the arrangement commences or if there are associates, the 30% stake threshold is not met for any MM shareholder.

7. Scrip for scrip roll-over is not available if any capital gain from a replacement interest might be disregarded - except because of a roll-over (paragraph 124-795(2)(a)). This Ruling does not apply to shares or options if capital gains from the replacement interests in Defiance might be so disregarded.

8. The Commissioner makes this Ruling based on the precise arrangement identified in this Ruling.

9. The class of persons defined in this Ruling may rely on its contents provided the arrangement described below at paragraph 13 to 23 is carried out in accordance with the details of the arrangement provided in this Ruling.

10. If the arrangement described in this Ruling is materially different from the arrangement that is actually carried out:

(a) this Ruling has no binding effect on the Commissioner because the arrangement entered into is not the arrangement on which the Commissioner has ruled; and

(b) this Ruling may be withdrawn or modified.

11. A Class Ruling may only be reproduced in its entirety. Extracts may not be reproduced. Because each Class Ruling is subject to copyright, except for any use permitted under the Copyright Act 1968 no Class Ruling may be reproduced by any process without prior written permission from the Commonwealth. Requests and enquiries, concerning reproduction and rights should be addressed to:

The Manager

Legislative Services, AusInfo

GPO Box 1920

CANBERRA ACT 2601.

Date of effect

12. This Class Ruling applies to years of income commencing both before and after its date of issue.

Arrangement

13. The arrangement that is the subject of the Ruling is described below. This description is based on the following documents. These documents, or relevant parts of them, as the case may be, form part of and are to be read with this description. The


Selling a Small Business – The CGT Strategies relevant documents or parts of documents incorporated into this description of the arrangement are:

* application for the class ruling dated 9 March 2001 in relation to the proposed acquisition of Medical Monitors Pty Ltd by Defiance Mining NL; and

* proposed Share Sale and Subscription Agreement (draft 3 dated 14.3.2001); and

* further correspondence from Deloitte Touche Tohmatsu dated 21 March 2001, 23 March 2001 and 26 March 2001.

Note: certain information received from Defiance Mining NL and Deloitte Touche Tohmatsu has been provided on a commercial-in-confidence basis and will not be disclosed or released under Freedom of Information Legislation.

14. Defiance will acquire 100% of the shares and options in MM in accordance with a proposed Share Sale and Subscription Agreement (on the same terms as the draft 3 dated 14.3.2001) entered into between both of those companies and all of the shareholders of MM.

15. Under the agreement Defiance will issue a combination of ordinary shares and converting preference shares for every MM share held and will issue a combination of options for every MM option held.

16. Each MM shareholder will receive ordinary shares and ‘Class A’, ‘Class B’ and ‘Class C’ converting preference shares in proportion to their current shareholding. The converting preference shares will convert to a set number of ordinary shares on satisfaction of the conditions outlined below.

17. The ‘Class A’ converting preference shares will convert to a set number of ordinary shares upon:

(a) execution of a joint venture agreement between MM and its US joint venture partner regarding the joint venture in the USA; and

(b) receipt by MM of a written opinion from its US joint venture partner that it believes that the projections excluding Ancillary Reserves in MM's business plan for the financial years 2002 and 2003 are achievable with respect to projected revenues and expenses.

18. ‘Class B’ and ‘Class C’ converting preference shares will convert to a set number of ordinary shares if MM achieves specified revenue targets by particular dates.

19. If the requirements for conversion are not met the converting preference shares will be redeemed or cancelled.

20. Every MM optionholder will receive ‘Class A’, ‘Class B’, ‘Class C’ and ‘Class D’ options in proportion to their current option holdings. Each class of options will have different rights.

21. ‘Class A’ options may be exercised immediately.

22. ‘Class B’ options may be exercised only upon:

(a) execution of a joint venture agreement between MM and its US joint venture partner regarding the joint venture in the USA; and

(b) receipt by MM of a written opinion from its US joint venture partner that it believes that the projections excluding Ancillary Reserves in MM's business plan «for» the financial years 2002 and 2003 are achievable with respect to projected revenues and expenses.

23. ‘Class C’ and ‘Class D’ options may be exercised only if MM achieves specified revenue targets by particular dates.



Ruling

24. Subject to the qualifications in paragraphs 4 to 11 of this Ruling, the shareholders and optionholders of MM may choose in accordance with paragraph 124-780(3)(d) to obtain scrip for scrip roll-over under section 124-780 in respect of the disposal to Defiance of their MM shares and options and the issue to them of Defiance shares and options.

25. No CGT event will happen if the converting preference Defiance shares are later converted into ordinary Defiance shares without being redeemed or cancelled.

26. If the requirements for conversion are not met and the converting preference Defiance shares are redeemed or cancelled, CGT event C2 in section 104-25 (about cancellation, surrender and similar endings of intangible CGT assets) will happen. The capital proceeds will be determined under Division 116.

Explanations

Availability of scrip for scrip roll-over

Replacement interest requirement - subsections 124-780(1), (4) and (5)

27. Roll-over is available if a share in a company is exchanged for a share in another company. Similarly, roll-over is available if an option in one company is exchanged for an option in another company. There is no requirement that the shares or options carry the same kinds of rights and obligations unless subsection 124-780(4) applies.

28. Paragraph 2.25 in the explanatory memorandum (‘EM’) accompanying the New Business Tax System (Capital Gains Tax) Bill 1999, states ‘This requirement will be satisfied if a share in a company is exchanged for a share in another company... even if the rights attaching to the share... are different .’ (emphasis added)

29. Further, example 2.5 in the EM demonstrates that full scrip for scrip roll-over is available if ordinary shares are exchanged for a combination of ordinary and preference shares.

30. Subsection 124-780(4) will not apply in this case. It applies if the original interest holder and the acquiring entity did not deal at arm's length and one of the following is satisfied:

(a) neither the original entity nor the replacement entity was widely held just before the arrangement started; or

(b) the original interest holder, and the original and acquiring entities were members of the same linked group just before that time.

31. Regardless of whether Defiance and the MM shareholders and optionholders are dealing at arm's length paragraph 124-780(4)(a) will not apply because Defiance has more than 300 members just before the arrangement started (with the twenty largest Defiance shareholders having less than 75% of the interests in the company). Paragraph 124-780(4)(b) cannot apply because Defiance and MM are not members of a linked group just before the arrangement started.

Requirements regarding the arrangement – paragraph 124-780(1)(b) and subsection 124-780(2)

32. Paragraph 124-780(1)(b) and subsection 124-780(2) require that the shares and options are exchanged consequence of a single arrangement:

* that results in the acquiring entity (Defiance) becoming the owner of at least 80% of the voting shares in the original entity (MM); and


Selling a Small Business – The CGT Strategies * in which all of the owners of voting shares in MM are able to participate; and

* in which participation is available on substantially the same terms for all interest holders of a particular type.

33. These conditions are satisfied because Defiance will acquire all of the shares and options in MM in accordance with the proposed Share Sale and Subscription Agreement referred to in paragraph 13. Under that draft agreement the consideration payable to each MM shareholder and optionholder is to be in proportion to their existing holding in MM.

Other requirements in subsection 124-780(3)

34. Paragraph 124-780(3)(a) provides that roll-over is only available «for» interests that were acquired by MM shareholders and optionholders on or after 20 September 1985. This Ruling is qualified in respect of this requirement: see paragraph 4.

35. Paragraph 124-780(3)(b) restricts roll-over to interests that would otherwise have given rise to a capital gain. This Ruling is qualified in respect of this requirement: see paragraph 5.

36. Paragraph 124-780(3)(c) requires that shareholders and optionholders seeking roll-over must receive replacement interests in the acquiring entity or its ultimate holding company. This requirement is satisfied because all replacement interests will be in Defiance which is not a 100% subsidiary of an ultimate holding company.

37. Paragraph 124-780(3)(d) provides that roll-over is available for an interest holder that is a significant or common stakeholder only if the replacement entity (Defiance) jointly elects for roll-over.

38. An interest holder is a significant stakeholder for an arrangement if it had a significant stake (30%) in the original entity before the arrangement and in the replacement entity after the arrangement: subsection 124-783(1). Alternatively, if the acquiring entity for an arrangement is an original interest holder in the original entity before the arrangement, its associates may be significant stakeholders: subsection 124-783(2).

39. As the largest shareholder in MM has, without consideration of interests of associates, a less than a 30% shareholding and on the basis that interests of any associates do not cause the 30% threshold to be met (see paragraph 6) there is no significant stakeholder under subsection 124-783(1) for this arrangement. As Defiance is not an original interest holder in MM just before the arrangement there is no significant stakeholder under subsection 124-783(2).

40. No interest holder is a common stakeholder for an arrangement if either the original entity or the replacement entity had at least 300 members just before the arrangement started: subsection 124-783(5). As Defiance had more than 300 members just before the arrangement (and the twenty largest Defiance shareholders have less than 75% of the interests in the company) there is no common stakeholder for this arrangement.

Exceptions in section 124-795

41. Scrip for scrip roll-over is not available if an exception in section 124-795 applies. As both Defiance and MM are incorporated in Australia both are Australian resident entities. The exceptions in subsections 124-795(1),(4) and (5) therefore will not apply.

42. The exception in paragraph 124-795(2)(a) may apply if for example the replacement interests in Defiance are trading stock. This Ruling is qualified in this regard by paragraph 7.


Selling a Small Business – The CGT Strategies 43. None of the other exceptions in paragraph 124-795(2)(b) or subsection 124-795(3) could apply in this case.

CGT consequences if the preference shares automatically convert to ordinary shares on satisfaction of the various conditions

44. In accordance with Taxation Ruling TR 94/30, the mere conversion of the converting preference Defiance shares into ordinary Defiance shares will not give rise to a CGT event.

45. Paragraph 8 of TR 94/30 provides that

‘A variation in rights attaching to a share…does not result in a full disposal of an asset for the purposes of Part IIIA unless there is a cancellation or redemption of the share. …[I]t is not relevant to consider whether the variation is slight (such as a small change to the nominal value of shares) or more significant (such as disposing of the preference to receive dividends).’

46. Similarly, paragraph 9 of TR 94/30 goes on to provide that the variation does not amount to a part disposal. Example 4 of the Ruling illustrates that there are no CGT consequences from the mere conversion of converting preference shares to ordinary shares.

CGT consequences if the converting preference shares are redeemed or

cancelled

47. CGT event C2 in section 104-25 will happen if the converting preference shares are redeemed or cancelled. A capital gain arises from CGT event C2 if the capital proceeds are more than the cost base of the shares. A capital loss arises from CGT event C2 if the capital proceeds are less than the reduced cost base of the shares.

48. If the market value substitution rule in section 116-30 applies to determine the capital proceeds received in respect of the redemption or cancellation of the converting preference Defiance shares, subsection 116-30(3A) provides that the market value is determined as if the redemption or cancellation had not occurred and was never proposed to occur.

49. The market value substitution rule will apply if the actual capital proceeds for redemption or cancellation of the shares are more or less than the market value of the shares at the time of CGT event C2 (see subparagraph 116-30(2)(b)(ii)).

50. As explained in Taxation Determination TD 10 taxpayers can choose to obtain a valuation from a qualified valuer or compute their own valuation. If it is considered appropriate the ATO may challenge a valuation.

Detailed contents list

51. Below is a detailed contents list for this Class Ruling:

Paragraph What this Class Ruling is about ............................................................................. 1 Tax law(s) ................................................................................................................ 2 Class of persons ..................................................................................................... 3 Qualifications .......................................................................................................... 4 Date of effect ....................................................................................................... 12 Arrangement ......................................................................................................... 13 Ruling ..................................................................................................................... 24 Explanations ........................................................................................................... 27


Selling a Small Business – The CGT Strategies Availability of scrip for scrip roll-over ................................................................. 27 Replacement interest requirement - subsections 124-780(1), (4) and (5) ........... 27 Requirements regarding the arrangement - paragraph 124-780(1)(b) and

subsection 124-780(2) ............................................................................. 32 Other requirements in subsection 124-780(3) ...................................................... 34 Exceptions in section 124-795 .................................................................... 41 CGT consequences if the preference shares automatically convert to

ordinary shares on satisfaction of the various conditions ................................. 44 CGT consequences if the converting preference shares are redeemed or cancelled................................................................................................................. 47 Detailed contents list .............................................................................................. 51 Commissioner of Taxation 11 April 2001

See also ID 2002/411 concerning the ineligible proceeds component in relation to the Stockland Trust Group takeover of Advance Property Fund.



Chapter 8

Demergers

¶8.000 BACKGROUND

¶8.010 ELIGIBILITY RULES

¶8.011 Further requirements

¶8.012 Further concessions and consequences under the demerger roll-over

¶8.013 Consolidations, losses and franking credits

¶8.020 IMPACT ON SMALL/MEDIUM BUSINESS

¶8.030 DEMERGER EXAMPLE

¶8.040 THE RULES IN MORE DETAIL

¶8.041 What is a demerger?

¶8.042 Types of demerger

¶8.043 Exclusion of discretionary trusts

¶8.044 Transfer of non-ownership assets

¶8.045 Types of “ownership interests”

¶8.046 Market value – near enough is good enough

¶8.047 Exclusion for employee share schemes and dual listed company voting shares

¶8.048 Exclusion of off-market share buybacks

¶8.049 Cost base adjustments

¶8.0491 Cost base adjustments where roll-over not chosen

¶8.0492 Consequences for members of demerger group

¶8.0493 Time of acquisition for new interests

¶8.050 DIVIDEND RELIEF

¶8.051 No relief under sec 118-20 where new interests acquired under a foreign demerger are disposed


¶8.060 STAMP DUTY CONSIDERATIONS

¶8.000 BACKGROUND

The genesis of the demerger concessions, like most concessions, arises from agitation from special interest groups – in this case interests representing big business – over recent years for the need for concessions to facilitate corporate group reconstructions. The premise, which tends to be difficult to argue against, is that unless concessions are granted company groups will put up with inefficient group structures until such time as the Government of the day alters the law to facilitate their restructuring with consequent general economic benefits


Selling a Small Business – The CGT Strategies flowing to the community, with effectively no loss of revenue since the restructures would not be done otherwise.

It is of note that one of the first demergers to take place under the concessions involved BHP Billiton’s demerging of BHP Steel.

A basic proposal for relief was recommended in the Ralph Report (see A Tax System Redesigned, Recommendation 19.4). The Report took the view that it was sufficient for relief to be confined to widely held entities and that it provide for exemptions for member entities only. The Report saw the demerger concessions as a mirror of the scrip for scrip roll-over provided for takeovers.

The Government, in close consultation with business and tax practitioners, has gone far beyond the limited recommendation in the Ralph Report. The concessions were originally outlined in a Press Release dated 6 May 2002 issued by the Assistant Treasurer, Senator Helen Coonan. Under the concessions which operate from 1 July 2002, relief is available for both widely held and non-widely held companies and trusts. CGT relief is provided at the member and entity level and, most generously, an exemption is provided from the existing dividend rules.

Relief is available in respect of a holding of as little as 20% of the interests in an entity. This is a significant break from the traditional approach to inter-group concessions where generally entities need to be wholly owned.

The concessions are primarily to be contained in new Division 125 of Part 3-3 of the ITAA 97 and are found in Schedule 16 of the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002 (the Amending Act). The Amending Act was introduced into Parliament on 27 June 2002 and was passed into law as No. 90 of 2002.

The measure operates from 1 July 2002.

The amendments contained an unusual provision designed to assist listed groups entering into demerger arrangements before the Bill became law, as was the case with the BHP Billiton demerger (see item 54 of Schedule 16 and ¶8.052 below).

¶8.010 ELIGIBILITY RULES

Relief under the measure hinges on the “happening” of a demerger. A demerger happens to a demerger group when the group restructures and under the restructure:

• at least 80% of the interests owned by the group in an entity are either transferred or issued to the owner(s) of the interests in the group’s head entity;

• a CGT event (e.g. CGT event G1 (capital payment for shares) or E4) happens to the owners of the original interests in the head entity, or the owners simply acquire a new interest on or after 1 July 2002;

• just before the restructuring, more than 50% of the original interests in the group’s head entity were owned by Australian residents, or by foreign residents whose new interests will have the “necessary connection with Australia” just after they acquire them;

• they satisfy the proportionate ownership test under which each head entity interest owner just after the restructure owns the same proportion, or as near as practically possible, of ownership interests in the demerged entity as they had in the head entity before the restructure, see ID 2003/323, and also ID 2003/1054 where this requirement was treated as satisfied where the numbers of new shares are rounded up or down to equal whole numbers;

• they satisfy the market value test under which the market value, or a reasonable approximation thereof, of the remaining original interests and the new interests must


Selling a Small Business – The CGT Strategies reasonably have been expected to be not less than the market value of the original interests held; and

• they satisfy the like kind test under which, for example, share or option holders in the head entity receive new shares or other options or similar combinations, and holders of units or interests in a trust receive new units or other interests in a trust. Under this requirement a shareholder can, for example, receive share options rights or similar interests to acquire shares but cannot receive units or other interests in a trust.

The simplest example of a demerger would involve a two-member company group where the head company holds all the shares in the subsidiary company where it is proposed to transfer all the shares in the subsidiary company to the shareholders of the head company.

Where the demerger requirements are satisfied, as in the simple example above, the head company would be able to disregard any capital gain or loss it would have made on the transfer of the subsidiary’s shares to its shareholders.

In so far as the receipt of the shares in the subsidiary by the shareholders in the head company gives rise to a capital gain or loss to the shareholder’s existing shares, for example because of CGT event G1, the gain is disregarded and the cost bases of the existing shareholders’ shares are apportioned between the cost base of their existing shares in the head company and their new shares in the demerged entity.

Further relief is provided from the effect of sec 44 ITAA 36 in that, to the extent that the distribution of the shares in the subsidiary would otherwise be treated as an assessable or exempt dividend in the shareholder’s hands, the shares are deemed not to be either assessable income or exempt income. There is a further requirement here in order to qualify for this treatment; that is, at least 50% of the CGT assets in the demerged entity have been used directly or indirectly in the subsidiary’s business.

¶8.011 Further requirements

The main qualifier for the demerger concessions is that there must be a holding of more than 20% in the group member. The 20% plus requirement for a company is defined in the usual way to mean the right to receive more than 20% of any distribution of income or capital or the right to exercise or control the exercise of more than 20% of the voting power. For a trust the requirement is confined to the right to receive more than 20% of any distribution of income or capital by the trustee. The important point to note is that a bare 20% interest is not sufficient. It must be more than 20%. Given that this is a very modest requirement, it is unlikely to be a particularly difficult hurdle for most groups contemplating use of the concession.

Another very important requirement is that the interest owners of the head entity must not receive cash or something other than new interests in the demerged entity (see sec 125-70(1)(e) ITAA 97. This contrasts with the scrip for scrip roll-over where if the offer is partly for scrip and partly for shares, there can be a partial roll-over. It would appear that the stricter rule for demergers would not preclude the new interests themselves carrying rights to benefits such as shareholder discounts, but care would need to be exercised here.

Note that the ATO has confirmed in ID 2004/455 that sec 125-70(1)(d) ITAA 97 does not preclude original shareholders being required to provide consideration for their new interests. Section 125-70(1)(d) requires as one of the conditions for demerger relief that the acquisition by entities of new interests happens only because those entities own or owned original interests.

Interest holders must choose whether to apply the roll-over with a consequential adjustment of the cost base of their original interests, but even where the roll-over is not chosen, they must still make the same cost base adjustment. For demerger member entities, there is no choice whether to apply the roll-over where a demerger happens. Presumably, the view was taken that relief would be required whenever a member entity is demerged from a group. It


Selling a Small Business – The CGT Strategies would not be too difficult to preclude a roll-over happening, if that was desired, by deliberately failing one or other of the necessary requirements for a demerger.

There are some circumstances where the roll-over is not permitted. The main exception is where another CGT roll-over can be utilised (see sec 125-7055(53)). There is a similar exception for the scrip for scrip roll-over but limited to roll-overs under Division 122 and Subdivision 124-G (see sec 124-795(3) ITAA 97). This means that if scrip for scrip is available under a proposed arrangement, the demerger roll-over will not be able to be used.

Note the new trust restructure roll-over to a company discussed at ¶9.000 below.

The other notable exceptions are that the demerger roll-over is not available for a trust that is a discretionary trust (see sec 125-65(2) ITAA 97) or a superannuation fund. Note that although a discretionary trust as part of a group can’t use the demerger provisions, that does not mean that a trustee of a discretionary trust as a shareholder or the holder of interests in a group can’t obtain the benefits of the demerger, see ID 2003/1051. ID 2003/1052 confirms that the trustee of a super fund as the holder of interests in a group may also choose to benefit from the demerger provisions.

Under sec 125-100, where a demerger has occurred in respect of some of the interests in a member of a demerger group, the group is precluded from demerging the remaining interests in the member. Under the provisions at least 80% of the interests in a member must be demerged. So where this has occurred, the remaining interests cannot be demerged. However, this does not prevent a subsequent demerger of the demerged interests, for example where the shareholder of the head entity is a subsidiary of another group.

¶8.012 Further concessions and consequences under the demerger roll-over

The basic roll-over concessions are further enhanced with a number of sweeteners, although some of the further concessions may be seen as more consequential than concessional.

Unlike the scrip for scrip roll-over, pre-CGT interests are preserved and expanded so that new interests received under a demerger, where the holder of existing ownership interests that were pre-CGT interests, will also be pre-CGT interests.

CGT event J1 (company ceasing to be member of wholly owned group after roll-over) is treated as not happening to a demerged entity or to any other member of the group where CGT event A1 (disposal) or C2 (cancellation or surrender) happens to a demerging entity under a demerger.

This feature is important where, for example, as part of the sale of a business, either a demerged entity is proposed to be subsequently sold or the demerged entity may be proposed to be retained and the main entity disposed of.

Where there is a capital loss made by a member of a demerger group that has been attributed to a value shift under a demerger the loss is required to be reduced by an amount reasonably attributable to the reduction in the market value of the asset realised (see sec 125-165). Along the same vein, under sec 125-170 if, because of a demerger, the value of an asset is reduced and that asset is transferred after the demerger and the transferor gets a roll-over, the reduced cost base of the asset is reduced by the decrease in value caused by the demerger. The note following sec 125-170 indicates that these rules are intended to deal with value shifts that might occur under a demerger.

Corporate unit trusts and public trading trusts are to be treated as if they were companies for the purposes of the concessions.

¶8.013 Consolidations, losses and franking credits

The demerger provisions operate independently of the consolidation regime so that it is possible for a consolidated group to demerge one or all of its members. Similarly, continuity of ownership tests for losses will continue to apply so care needs to be taken when considering


Selling a Small Business – The CGT Strategies a demerger where losses are present. The demerger provisions also are not intended to change the treatment of franking credits at the entity level. It would appear that it would be possible to frank a demerger dividend.


Whilst the new concessions are not intended to apply to discretionary or family trusts and therefore potentially exclude many existing family or small business entities (but see ID 2003/1051 noted above), the important point to note is that, as originally recommended by the Ralph Report, small/medium business would have been totally excluded. See the discussion below at ¶8.043 concerning possible application to discretionary trusts where there is a corporate trustee.

The discretionary trust exclusion, whilst unfortunate, further reflects on the Government’s continued refusal to provide any roll-over relief for businesses wishing to move out of a discretionary trust operating entity. Nevertheless, there is still some scope for such groups where, for example, a discretionary or family trust holds the shares in a head company or fixed trust where the company or fixed trust has subsidiaries (see ID 2003/1051). The head company or fixed trust along with their subsidiaries can be treated as demerger groups and the subsidiaries themselves can be demerged under the concession with all the benefits being available.

In small and medium business corporate or fixed trust groups, there would appear to be considerable advantage in being able to use the demerger concessions in not only restructuring the group but also as a means of transferring and/or deferring capital gains and, possibly, converting income into capital gains.

For example, it may be appropriate as an initial step to selling off a business in a subsidiary, to demerge the subsidiary so that the shares in the subsidiary will be held in the shareholders’ hands prior to the ultimate sale of the subsidiary. In this way, capital gains on the sale will flow to the shareholders and be taxed as capital gains in their hands rather than as gains in the head company’s hands. Gains realised this way with the benefit of the CGT general discount (c.f. ID 2003/1031 dealing with the discount where demerger not chosen) and also the small business active asset reduction (where eligible) would be likely to be far more beneficial to the shareholders than if the holding company had sold the subsidiary, or the business had been sold directly out of the subsidiary, even taking into account the cost base adjustment under the demerger.

In the 2003 edition of this Portfolio it was indicated that there was no provision was made to allow new interests acquired under a demerger to be treated as having been acquired at the time of the original interests. This was incorrect. The definition of “replacement-asset roll-overs” in sec 995-1 refers to the list of replacement-asset roll-overs in sec 112-115. Section 112-115 was amended at the time of the insertion of the demerger provisions to include a reference to demergers (item 14C). This means that the general 50% discount will be available immediately after a demerger if the original interests had been held for at least 12 months at the time of the demerger. As noted above, even if the demerger roll-over is not chosen, the 50% discount will still be immediately available in respect of the newly acquired interests under the demerger provided the basic requirements of the 50% discount are satisfied in relation to the original interests.

It should be noted that the EM to the Amending Act mentions at para 15.4 that specific integrity rules for non-widely held entities are proposed to be introduced “at the earliest opportunity”. As at 1 March 2004, no amendments have been introduced.

¶8.030 DEMERGER EXAMPLE

The EM to the Amending Act is remarkably free of examples to illustrate how the concessions operate. This contrasts with the scrip for scrip roll-over EM. This either reflects


Selling a Small Business – The CGT Strategies the haste with which the EM was prepared or perhaps indicates a desire to leave obscured the potential of the concession. In this regard, there is no definition in the Amending Act or significant discussion in the EM as such as to what can constitute a demerger. This was deliberate in that the Government recognised that demergers can take many forms and the discretionary powers given to the Commissioner of Taxation in new sec 45B (discussed at ¶8.052 below) will certainly operate to limit the use of the concession at least in those cases where the restructuring relies on the making of a tax-free dividend. The ATO has to date issued a number of class rulings dealing with demergers affecting shareholders in public companies which give some insight into the application of the provisions, see for example CR 2003/10 (Income tax: Special Dividend, Capital Reduction and Related Scheme of Arrangement for the Demerger of Rinker Group Limited from CSR Limited), 2003/13 (Income tax: CSR Limited Demerger – CSR Universal Share/Option Plan) and CR 2003/107 (Income tax: AMP Limited: Demerger, Capital Adjustment and Scheme of Arrangement).

The demerger provisions contain a running example which gives some colour to the potential scope of the concession. It also illustrates how the concessions apply and how the cost base adjustments will operate. It is helpful to set out this example in full:

Example: Peter owns shares (his original interests) in Company A, a public company. Company B is a wholly owned subsidiary of Company A. Company A announces a demerger utilising a proportionate capital reduction and the disposal of all its shares in Company B to its 320,000 shareholders. Following the demerger all of the shareholders in Company A, including Peter, will own all of the shares in Company B (their new interests).

To continue the example from subsection 125-55(1), Peter owns 400 post-CGT shares in Company A. Companies A and B are both members of a demerger group. Company A is the head entity of the demerger group and Company B is a demerger subsidiary.

Company A proceeds to demerge 100% of its shares in Company B to its shareholders.

Company A enters into a proportionate capital reduction, returning 40 cents per share to its ordinary shareholders. Peter is entitled to $160 (40c times 400 shares) under the capital reduction.

For Peter, the capital reduction amount of $160 is compulsorily applied to acquire Company A’s shares in Company B, at $6.75 (a discount of 10% to current market value). Company A rounds up the fractional amounts in calculating the number of whole shares to be distributed to each shareholder. This gives Peter 24 shares in Company B (160 divided by 6.75, rounded up to the nearest whole number).

To continue the example from subsection (1), Company A concludes, given the circumstances of the demerger, that the market values of Peter’s and the other shareholders’ shares in A and B are expected to be greater than their original interests in Company A, and advises the shareholders of this position. (This concerns the satisfying of the market value test.)

To continue the example from subsection 125-70(3), Company A advises its shareholders that Company B at that time represents 5% of the market value of the group as a whole. Peter’s cost base for each of his shares in A is $4.60, and Peter recalculates his cost base as follows:

Total cost base = $1,840 (4.60 x 400 shares)

to be spread over 400 shares in A and 24 shares in B


Selling a Small Business – The CGT Strategies 5% of 1840 = 92

92 ÷ 24 shares = $3.83 per B share

1840 – 92 = 1748

1748 ÷ 400 = $4.37 per A share

¶8.040 THE RULES IN MORE DETAIL

¶8.041 What is a demerger?

Although proposed sec 125-70 sets out the basic requirements for a demerger to “happen”, and the example, set out above, is used to illustrate the happening of a demerger (as noted above), the provisions are deliberately vague in their application so that there will be some doubt just exactly what demergers will be eligible for relief.

The measure has been drafted with the provision of both CGT roll-over relief and a separate exemption for dividends (see ¶8.052 below) where the demerger involves the provision of a dividend within the existing broad definition of “dividend”. The Commissioner has power to determine that the dividend exemption is not available in cases where the Commissioner considers that the payments are paid in order to obtain non-assessable dividends or the payments are in substitution for dividends. The making of a determination does not affect the availability of the CGT relief, only the relief in respect to the dividend.

The determination power contains a list of “relevant circumstances” that must be had regard to in concluding that in effect the dividend should not be exempt. The EM at para 15.63 states that the dividend component of a “genuine demerger” will not result in either assessable or exempt income for the ownership interest owner. Whilst the intention is reasonably clear that only “genuine demergers” should benefit from the concessions, from a taxpayer’s viewpoint it might be said that unless a ruling is obtained from the Commissioner in advance of the demerger taking place, there can be no certainty that relief in respect of the dividend payment will be available.

Although not all demergers will necessarily involve a dividend payment, most corporate demergers will, having regard to the wide definition of a dividend in sec 6 ITAA 36. So, if there is any prospect that the dividend exemption could be denied, that would, in most cases, put paid to the demerger transaction. The unusual aspect of the anti-avoidance or so-called integrity measures is that (as noted above) the CGT relief provided under the measure is not subject to the same risk. Under sec 177C(2) ITAA 36 the general anti-avoidance provision cannot apply where a taxpayer has simply exercised a choice to apply relief such as that to be provided by Division 125. It can, of course, apply if part of the arrangement is designed to make a taxpayer eligible for the choice, etc, in circumstances where the taxpayer would not have otherwise been eligible to make the choice.

This will be the position at least in relation to demerger transactions involving widely held entities. As noted at ¶7.020 above it is proposed to introduce further integrity provisions to apply to non-widely held entities that seek to obtain the benefit of the demerger provisions. By foreshadowing such a measure in the EM, it should be assumed that any such provision will operate from the date of introduction of the Amending Act, that is 27 June 2002. It might be observed that probably the threat of further amendments has a greater deterrent effect than the actual provisions themselves given the very wide current application of Part IVA. One can only speculate that any specific integrity measure aimed at preventing entities from obtaining CGT relief under the demerger concessions would seek to apply a similar approach to Part IVA. On this basis, it would appear that if a proposed demerger would not reasonably fall foul of Part IVA (assuming sec 177C(2) did not exclude Part IVA’s potential application), then a taxpayer would have reasonable certainty that the concessions will not be denied.

For example, in the case of a demerger undertaken as a preliminary step to the eventual disposal of the demerged entity, it is suggested that such a transaction is as much or indeed


Selling a Small Business – The CGT Strategies more of a genuine demerger than the case where there is no subsequent disposal of the entity by the group.

This is where the whole concept of demerger relief becomes rather difficult. Essentially a demerger of an entity or group of entities taking advantage of roll-over relief is undertaken for purposes that will include tax purposes. If the roll-over relief were not available, the demerger would not be undertaken except in exceptional circumstances. Whilst, of course, commercial arguments can be mounted for demerging entities within a group, if it would not make commercial sense to do it without tax relief, it is hard to seriously argue that it makes commercial sense, in terms of motive, if tax concessions will be available. In other words, if it is Government policy to allow groups to demerge in certain circumstances by providing tax relief for that purpose, it will be very difficult for the Commissioner to refuse relief in all but the most blatant tax-driven cases.

Of course, the Commissioner’s view may not necessarily coincide with the Government’s apparent intention in introducing the concession. Some assistance can perhaps be gleaned from the Press Release issued by Senator Coonan on 6 May 2002. In that release, she said that “[t]ax relief for demergers will increase efficiency by allowing greater flexibility in restructuring businesses, providing an overall benefit to the economy”. She went on to say that “[t]he Government has implemented this latest measure in business tax reform to enhance the competitiveness of Australia’s business sector”. These statements do not indicate how the relief will benefit the economy or enhance the competitiveness of the Australian business sector. They do suggest, however, that it will be very difficult for the ATO to distinguish between genuine and non-genuine demergers particularly where fundamentally there is no difference between, for example, the BHP Billiton demerger involving the demerger of BHP Steel, and a demerger of an entity from a family company group.

As at 1 March 2004, no amendments have been introduced to give effect to the Government’s intention.

¶8.042 Types of demerger

As noted above, and confirmed at para 15.26 of the EM, a demerger happens when all the conditions for a restructure are satisfied. The EM notes that there is no defined mechanism for a demerger. This, as noted above, is deliberate given the almost infinite number of ways that an entity group might wish to restructure “that best suits the needs of the entity group” (see EM Table following para 15.14).

The EM suggests that a demerger might happen via a capital reduction that is satisfied by the transfer or issue of ownership interests in the demerged entity. The EM also suggests that it might happen via a declaration of dividend that is satisfied by the transfer or issue of the ownership interests in the demerged entity, or by some combination of those mechanisms. It would appear that the relevant provision upon which these suggestions is based is proposed sec 125-70(1)(b). That provision refers to a restructuring under which members of the demerger group “dispose” of (at least 80% of) their ownership interests in another member to the owners of the original interests in the head entity; or where (at least 80% of) their ownership interests in another member “end and new interests are issued to owners of original interests in the head entity”, or some combination. It is interesting that the EM focuses on the financing side (dividend or capital reduction) of a restructure, as does the example contained in the Amending Act (set out at ¶8.030 above), whereas, essentially, under sec 125-70(1)(b) the crucial requirement is a transfer of the ownership interests, or the ending and issue of new ownership interests in a member of the group, or combination. There is no reason, for example, why the transfer of ownership interests could not be made for full consideration – in such a case the full CGT concessions would still be available.

What the analysis of sec 125-70(1)(b) confirms is that provided the basic conditions are satisfied under the restructure it can take virtually any form. See for example ID 2003/10


Selling a Small Business – The CGT Strategies dealing with the demerger by CSR of its interest in the Rinker Group where sec 125-70(1)(b) was satisfied by the issue of 935 million shares by Rinker to the existing CSR shareholders.

See ID 2003/915 in regard to application of demerger provisions where option holders rights reduced. The ATO took the view that no CGT event was involved, relying on sec 104-155(5)(g) ITAA 97 to exclude the operation of CGT event H2. This ID points to the need to test any proposal by reference to its effects.

Importantly under the demerger provisions, there is no time limit within which it must take place, although this is a consideration that the Commissioner can take into account in determining whether to deny dividend relief in respect of the demerger (see sec 45B(8)(i)(i)). This would appear to provide wide scope for creative structures to be developed for entity groups that will be able to take advantage of the concessions provided. The mere fact that the policy is to deny relief to some entities, for example discretionary trusts, would not necessarily, therefore, preclude a restructure around a discretionary trust that otherwise satisfied the basic conditions (discussed at ¶8.043 below). Whilst such restructures will necessarily be constrained by the as yet unveiled “integrity’ measures, as argued below, there is a limit, given the very nature of the concession, as to how far it can be constrained in practice.

¶8.043 Exclusion of discretionary trusts

The EM at para 15-18 states that the reason for excluding discretionary trusts from the concession is because it is difficult to establish with any degree of certainty the real economic ownership of the assets of the trust and also whether that ownership has been maintained. As noted above although a discretionary trust as part of a group can’t use the demerger provisions, that does not mean that a trustee of a discretionary trust as a shareholder or the holder of interests in a group can’t obtain the benefits of the demerger, see ID 2003/1051.

Under sec 125-65(2) it is provided that “[a] trust cannot be a member of a demerger group unless *CGT event E4 is capable of applying to all units of the trust and interests in the trust”. The note following the provision is that a discretionary trust cannot be a member of a demerger group. The drafting is interesting in that it appears that this is the first time that a reference to CGT event E4 has been used to seek to define discretionary trusts (but see sec 124-855 set out below). The fact that this approach depends on an ATO interpretation of the application of CGT event E4 (see TD 97/15 and its Addendum) means that if a court were to take a different view from the ATO over the application of CGT event E4, certain discretionary trusts may then be able to be demerged.

In any event, it is arguable (based on the ATO’s view that a beneficiary under a discretionary trust has no interest in the trust) that, for example, a hybrid trust could be a member of a demerger group, since, in so far as it had units or interests, CGT event E4 could apply to all of those units or interests. One practical consequence and possibly the reason for drafting the provision in this way is that following the release of the Exposure Draft on the now defunct Entity Regime at the end of 2000, doubts surfaced that many existing unit and other trusts assumed to be “fixed trusts” were not in fact fixed trusts. At the 11 June 2003 meeting of the National Tax Liaison Group –CGT Subcommittee the ATO expressed the view that a hybrid trust which has “special units” with entitlement to discretionary distributions would not be a trust that is eligible to be a member of a demerger group as CGT event E4 does not apply to all units in the trust. Query whether a hybrid trust that did not issue “special units” but merely provided for discretionary distributions would qualify.

It is interesting that if, for example, a discretionary trust as the head entity of a family or small business group were to issue units or interests to all of its beneficiary class – this would only be practicable if the beneficiary class were relatively confined – it would become an entity that would be eligible to be a member of a demerger group and could therefore demerge subsidiary entities. Arguably, such a change to a discretionary trust would not give rise to a new trust. Although the ATO’s Creation of a New Trust – Statement of Principles (August


Selling a Small Business – The CGT Strategies 2001) does not include such a change as an example of a new trust being created, it is likely that the ATO would take the view that a new trust was created in such a case. Note the grant of interests or units would not trigger CGT event E3 (converting a trust to a unit trust) as this applies only where the beneficiaries are absolutely entitled.

There may also be an argument that the issue of interests or units is part or first step of the group restructuring, and because the demerger concession is to facilitate group restructuring, sec 177C(2)(a)(ii) ITAA 97 may not apply. Section 177C(2)(a)(ii) seeks to ensure that schemes designed to allow a taxpayer to choose or elect to obtain the benefit of a tax concession are in fact subject to the application of Part IVA.

Another interesting possibility under the Amending Act as now drafted is that it is arguable that a head entity could be the corporate trustee of a discretionary trust even though the discretionary trust cannot be such a member. This could only be of value if the shareholders of the trustee were able to benefit under the trust which would normally be the case. It would not matter that the discretionary trust was not a member of the demerger group. This scenario would only work where the subsidiary entities to be demerged were themselves companies. This is because of the “like for like” rule in sec 125-70(1)(e); see ID 2003/874 for a discussion of the operation of this provision where the ATO accepted that it was satisfied in the case where the original interests were shares and options and the new interests in the demerged entity were shares only.

¶8.044 Transfer of non-ownership assets

ID 2003/633 makes clear that the demerger provisions will not apply to the transfer to shareholders of non-ownership assets such as business assets owned by an operating company. This would appear to follow from a reading of the definition in sec 125-60(1) ITAA 97 of “ownership interest”. See also ID 2003/632 confirming that companies which only own shares in other companies can apply the demerger provisions.

¶8.045 Types of “ownership interests”

The range of ownership interests that will qualify under the demerger provisions (see sec 125-60(1) ITAA 97) is fairly broad and includes options, rights and similar interests issued by a company.

The ATO in ID 2003/913 confirmed that a Chess Unit of Foreign Security (CUFS) is an ownership interest for the purposes of the demerger provisions.

ID 2003/1053 confirms that where shareholders can sell their new shares in a demerged entity through a sale facility established by the head entity the requirement in sec 125-70/91)(c) that shareholders only receive ownership interests will be satisfied.

¶8.046 Market value – near enough is good enough

Evidence of practitioner input can be seen with sec 125-70(4)(b) where, in applying the market value test, an anticipated reasonable approximation of the market value of the ownership interests is sufficient. This provision probably provides sufficient flexibility to determine market values based on reasonable hypotheses without the need for formal asset-by-asset valuations. The EM notes that if circumstances outside the control of the demerger group occur such as a general stock market downturn, this would not affect the application of the test.

¶8.047 Exclusion for employee share schemes and dual listed company voting shares

In determining whether the proportionate interests will be maintained, partly paid qualifying shares and rights, or partly paid interests in a trust, employee share schemes are excluded under Division 13A ITAA 36, as are dual listed company voting shares. There is a limit of 3% applying under the exception for ESS interests. That is interests under ESSs can only be ignored if they represent not more than 3% of the total ownership interests in the entity. See ID 2003/690 and ID 2003/691 as to the application of fringe benefit rules where an ESS trust


Selling a Small Business – The CGT Strategies acquires interests under a demerger. See also ID 2003/692 where shares allotted directly to employees in respect of shares held by them in the head entity – held not to be a fringe benefit.

¶8.048 Exclusion of off-market share buybacks

A share buyback for the purposes of Division 16K of Part III of ITAA 36 is not a demerger (see sec 125-70(4)).

See ID 2003/1094 which discusses the application of sec 45B ITAA 36 where an on-market buyback is not related to a demerger. A share buyback can be a demerger.

¶8.049 Cost base adjustments

Under sec 125-80(2) where roll-over is chosen, the first element of the cost base and reduced cost base of each remaining interest are required to be adjusted on a “reasonable” basis. The example given in the provision is set out above at ¶8.030.

The Reasons for Decision in ID 2003/83 set out below are useful in their discussion of the operation of the cost base reduction process:

Division 125 of the ITAA 1997 allows a CGT roll-over when a CGT event happens to original interests in a company under a “demerger” and new or replacement interests are received in the demerged company. A shareholder can choose whether to apply the CGT roll-over relief. Irrespective of whether CGT roll-over relief is chosen a shareholder is required to make adjustments to the cost bases of their shares in the head company and the demerged company. Section 125-80 of the ITAA 1997 sets out what the roll-over is and the cost base rules. It specifies the cost base adjustments that have to be made to a shareholder’s head company and demerged company shares if roll-over relief is chosen. Section 125-85 of the ITAA 1997 states that even if roll-over is not chosen, the cost base allocation rules in section 125-80 still apply. Subsection 125-80(2) of the ITAA 1997 explains how a shareholder must calculate the cost base of their post-CGT new interests (demerged company shares) and their remaining original interests (head company shares). As all the head company shares that the taxpayer owned on the demerger date are post-CGT shares, all the shares received in demerged company are also post-CGT. Subsection 125-80(2) of the ITAA 1997 states that the sum of the cost bases of the taxpayer’s post-CGT shares in the head company just before the demerger must be apportioned between their post-CGT new interests (demerged company shares) and their remaining original interests (head company shares). The apportionment between these head company shares and demerged company shares must be on a basis that is reasonable having regard to the market values of the head company and the demerged company just after the demerger. The head company determined the percentage of the market value of the group as a whole that the demerged company represented. The cost bases of the taxpayer’s shares in the head company may be spread across their shares in the head company and the demerged company based on this determination by the head company.

Note that ID 2003/642 confirms that the frozen indexed cost base cannot be used in respect of a replacement share under the demerger provisions where the original interests were acquired after 21 September 1999.

Cost base allocation rules apply where there is no gain or loss

ID 2003/914 makes clear that the cost base allocation rules will still apply even where there is no capital gain or capital loss happening to the original interests. This is because sec 125-55


Selling a Small Business – The CGT Strategies does not require there to be a capital gain or capital loss but merely that a CGT event happens to a taxpayer’s original interests. The effect of choosing to apply the roll-over in such a case would be to permit the spreading of cost base across the existing and newly acquired interests. This may be of advantage in some cases.

¶8.0491 Cost base adjustments where roll-over not chosen

An interesting aspect of the roll-over concession at the ownership interest level is that if the owner chooses not to apply the roll-over, the shareholder or interest holder must still make the same cost base adjustment as is required where the roll-over is chosen (see sec 125-90).

For example, if a tax free distribution were made to a unit holder in circumstances where the distribution would trigger a capital gain under CGT event E4 and the unit holder chose not to apply the roll-over, the capital gain would be determined on the unit holder’s adjusted cost base.

It is not entirely clear what the position is intended to be where roll-over is chosen in respect of a capital gain under CGT event E4. By sec 125-80(1) the gain is disregarded and by sec 125-80(2) the interest’s cost base is reduced by such amount as is reasonable – see the cost base adjustment in the example at ¶8.030 above. By sec 104-70(5) ITAA 97 where a capital gain arises under CGT event E4, the cost base and reduced cost base are reduced to nil, see also sec 104-135(3) for CGT event G1. It would appear that sec 125-80(2) would override sec 104-70(5) in this case. This would be one of the effects of sec 125-95 which seeks to ensure that no other cost base adjustment can be made as a result of the demerger.

Where the original interests are pre-CGT interests and the roll-over is not chosen, sec 125-85 does not require an adjustment. Section 125-85 only applies to post-CGT interests. This is not immediately apparent from a reading of sec 125-85. However, ID 2003/1050 makes it clear that this is the ATO view. It is not entirely clear what is the basis for this view. The explanation in ID 2003/1050 states merely:

However, section 125-85 does not apply to a pre-CGT original interest in the head entity. The cost base spreading rule under subsection 125-80(2) of the ITAA 1997 applies to a new interest, if that interest was acquired because the taxpayer owned a post-CGT original interest. The demerger cost base spreading rule does not apply to a new interest acquired because the taxpayer owned a pre-CGT original interest. Consequently, where a CGT event happens to a pre-CGT original interest and rollover is not chosen, the cost base and reduced cost base of a new interest in a demerged entity is calculated under the general cost base rules in Subdivision 110-A of the ITAA 1997 and the cost base general modification rules in Subdivision 112-A of the ITAA 1997. Date of decision: 14 November 2003

See also ID 2003/875. The ATO have now clarified the operation of sec 125-90 in relation to pre-CGT interests where no CGT event happens to such interests. In ID 2004/457 and ID 2004/456 the view is expressed that sec 125-90 has no application. In particular, ID 2004/456 confirms that the cost base adjustment rules in sec 125-90(2) do not apply to a new interest, received in respect of an original interest that was acquired before 20 September 1985, if no CGT event happens to that original interest.

¶8.0492 Consequences for members of demerger group

Subdivision 125-C contains the operative provisions dealing with the consequences for members of a demerger group. The central provision is sec 125-155 which provides that capital gains and capital losses made by a demerging entity from CGT events A1, C2, C3 or K6 happening to its ownership interests are disregarded, see ID 2002/1101.


Selling a Small Business – The CGT Strategies Section 125-160 provides that CGT event J1 (company ceasing to be a member of a wholly owned group) does not happen to a demerged entity or a member of a demerger group under a demerger. Compare, however, ID 2002/1102 where it was considered that the section will apply where a capital gain has been transferred by a company to a taxpayer pursuant to Subdivision 126-B (dealing with the transfer of assets between two companies in the same group).

Section 125-165 requires an adjustment for a capital loss where a value shift arises under a demerger.

In ID 2004/635 the ATO has confirmed its view that where there is a direct value shift under a demerger, the consequences are dealt with exclusively under the demerger provisions.

The ID provides as follows:

Issue

Are there capital gains consequences for a demerging entity under Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) if, under a demerger as defined in section 125-70 of the ITAA 1997, a direct value shift happens as a result of new interests in the demerged entity being issued at a discount?

Decision

No. There are no capital gains consequences for the demerging entity under Division 725 of the ITAA 1997 as a result of the direct value shift that happens under the demerger. The consequences for the demerging entity are instead determined exclusively under Division 125 of the ITAA 1997.

Facts

There are three Australian resident shareholders in Company A, an Australian resident company. Each shareholder is an associate of the other shareholders. Company A is the owner of the only share (a post-CGT share) on issue in subsidiary Company B. Company A has not made a choice to form a consolidated group. Under an arrangement, Company B (the demerged entity) issues shares to the shareholders in Company A (the demerging entity), in the same proportions as their Company A shareholdings. No consideration is to be provided to Company B for the shares. The arrangement satisfies the definition of a demerger in section 125-70 of the ITAA 1997. As a result of the issue of shares at a discount by Company B, there is a reduction in the market value of the share that Company A holds in Company B, resulting in a direct value shift. The conditions set out in section 725-50 of the ITAA 1997 for there to be consequences under Division 725 of the ITAA 1997 as a result of the direct value shift are satisfied.


Sections 125-165 and 125-170 of the ITAA 1997 are specific provisions which determine the consequences for the demerging entity as a result of any value shift, whether indirect or direct (as in this case), which happens under a demerger. This is confirmed by the note to subsection 125-170(2) of the ITAA 1997 which states: The rules in section 125-165 and this section deal with any value shift that might occur under the demerger (emphasis added) and avoid the need for the general value shifting regime to apply.


Selling a Small Business – The CGT Strategies The interpretation is also supported by the explanatory material for New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Bill 2002 where it is stated at paragraph 15.67 of the revised Explanatory Memorandum: Other cost base adjustment rules do not apply if a CGT asset's reduced cost base is reduced, because of a demerger. Accordingly, the demerging entity Company A will not be required to make cost base and reduced cost base adjustments under Division 725 of the ITAA 1997 and will not make a capital gain under capital gains tax (CGT) event K8 in section 104-250 of the ITAA 1997 as a result of the direct value shift. However, a capital loss that is later realised on the interest that Company A holds in the demerged entity Company B will be reduced to the extent to which it is reasonably attributable to a reduction in value that happens under the demerger (section 125-165 of the ITAA 1997). Date of decision: 16 July 2004

See also ID 2004/636 and ID 2004/637.

¶8.0493 Time of acquisition for new interests

In ID 2003/639 the ATO took the view that where the original interests of a shareholder were acquired at different times and the shareholder received one new share in the demerged entity, sec 115-30(1) (dealing with acquisition times) should apply to treat the single new share as being acquired at the earlier of the two acquisition dates. See also ID 2003/640 where the facts were that there were more than two original interests. The ATO took the view that the relevant acquisition time for the new interests should be the time that the majority of the original interests were acquired. See also ID 2003/641 where different parcels of original shares were involved and the replacements shares were treated as being acquired at the same time as the original parcels, determined on a reasonable basis of identification.

Trap

ID 2003/916 deals with a case where the taxpayer held shares in the head entity of a demerger group and as a result of a demerger by the group obtained new shares which were sold shortly after they were acquired. In other words, the new interests were demerged from another member of the group and not the head entity. The ATO took the view that as there was no CGT event in respect of the shares held by the taxpayer, as required by sec 115-30(1), then that section did not apply to the taxpayer’s new interests, so the taxpayer was not entitled to the general discount. Note other benefits of the demerger provisions would not be available in this case to the that shareholder, for example disregarding the CGT event because the requirements of sec 125-55(1)(d) would not be satisfied, that is a CGT event happens to your original interests. Note, CGT event H2 is excluded by sec 104-155(5)(g).

Application of Division 149 (old sec 160ZZS – change in underlying interests)

ID 2003/452 is interesting because it discusses the effect of the demerger provisions where the assets of an entity are pre-CGT and Div 149 can potentially apply to require them to be treated as post-CGT assets. In the case in discussion, it was considered that there was no underlying change in ownership as a consequence of the demerger as the individuals still had 100% of the underlying interests in the pre-CGT asset, indirectly through the ownership of all the shares in the holding company which itself owned all the shares in the entity.

¶8.050 DIVIDEND RELIEF

Section 44 ITAA 36 has been amended to provide by new subsec (2) to (6) that a demerger dividend (to be defined in sec 6 ITAA 36 to include the total market value of distributions by way of ownership interests issued or transferred in a demerged entity) will be neither assessable nor exempt income.

The main requirement for dividend relief is that at least 50% of the market value of the CGT assets owned by the demerged entity are used directly or indirectly in a business carried on by


Selling a Small Business – The CGT Strategies the entity or its subsidiaries. According to the EM the purpose of the rule is to ensure that the demerged entity is a viable independent entity capable of conducting business in its own right.

Under sec 44(2) a demerging entity may elect in writing that the dividend relief will not be available in respect of the demerger dividend to the group’s shareholders. This election can only apply in respect of the total distribution and to all shareholders.

Whilst this concession appears too good to be true, it is subject to a significantly revamped sec 45B (this section currently allows the Commissioner to treat as dividends amounts being paid under a scheme to provide a capital benefit) allowing the Commissioner to make a written determination denying relief to all or part of a demerger dividend. It was indicated in the Assistant Treasurer’s Press Release of 6 May 2002 that this “integrity rule” is “unlikely to apply to a demerger of an active business where there is a reasonable proportionate allocation of the shareholder funds (including share capital accounts) of the demerging entity, unless particular circumstances of the demerger suggest otherwise”.

Note, where sec 45B does not apply to a demerger dividend, Subdivision 7A of Part III ITAA 36 does not apply to the dividend (see sec 109RA).

It would appear that at least in the case of listed groups it will be necessary for a class ruling to be obtained in respect of a proposed demerger to ensure as far as it is possible that the Commissioner did not subsequently make a determination under sec 45B or otherwise seek to deny the demerger concessions, for example under Part IVA.

At the National Tax Liaison Group – CGT Subcommittee meeting held on 12 November 2003, it was noted that a Practice Statement on the application of sec 45B to demergers is being prepared. The Practice Statement is intended to include discussion on Part IVA.

¶8.051 No relief under sec 118-20 where new interests acquired under a foreign demerger are disposed

ID 2004/57 provides a timely reminder that if the new interests are acquired under a demerger undertaken by on off-shore group, they will not qualify for demerger relief under Australian law. In such a case, the new interests acquired will be treated as an assessable dividend. If they are subsequently disposed of, sec 118-20 will not apply to reduce the capital gain by reference to the amount of the “dividend” received from the head company being the share in the new entity. This is because the dividend relates to the original shares held by the taxpayer. ID 2004/57 dealt with a demerger of a Danish company and the resident shareholder received new shares in a newly created demerged company. See also ID 2002/771 and 772 dealing with the cost base issues arising in relation to the same transaction.


The Amending Act provided a transitional concession that where a listed company group seeks to demerge after 1 July 2002 and before the Amending Act receives the Royal Assent, it may choose to apply sec 45B ITAA 36 as that section now stands, rather than the new sec 45B.

¶8.060 STAMP DUTY CONSIDERATIONS

There appears to be no proposal to seek to exempt demergers from State and Territory stamp duties applying in respect of unquoted securities, although some States currently provide limited relief for restructures (e.g. sec 281 Duties Act 1997 (NSW) – though this provision is limited to the transfer of property within a group). As with any group restructuring, care needs to be taken to consider all potential aspects, for example, where land rich entities are involved duty at conveyancing rates may be payable.



Chapter 9

Restructuring relief

¶9.000 RESTRUCTURING RELIEF

¶9.001 No CGT roll-over for depreciating assets under Subdivision 124-N

¶9.002 Roll-over from company to individual

¶9.003 Risk for current sales

¶9.010 CGT ROLL-OVER FOR FINANCIAL SERVICES REFORM

¶9.020 RESTRUCTURING DISCRETIONARY TRUSTS

¶9.000 RESTRUCTURING RELIEF

The Treasurer announced in the Press Release issued on 11 November 1999 proposals for further roll-over relief, detailed at Attachment K to the Press Release. The Treasurer indicated that “measures will be introduced to provide ongoing relief for roll-overs into companies and fixed trusts and transitional roll-over relief for fixed trusts restructuring into a company and for companies restructuring to CIVs (collective investment vehicles), provided certain conditions are satisfied”.

These proposals relate to the Government’s intention to introduce the entity tax regime (now to be called the “unified entity regime”) from 1 July 2001.

However, as is noted at ¶1.050 above, the Treasurer in his Press Release of 22 March 2001 (No 16) stated that the Government would not be proceeding with the draft legislation for the entity regime and as a consequence the current law would continue to apply to trusts (with the change announced in that Press Release as to the flow through of the tax-free component of discount gains).

Whilst there appear to be no current plans for the Government to resurrect its proposals for entity taxation, it cannot be assumed that at some future stage the plan or some modification of the original proposal will not be unveiled.

It was indicated in Attachment K that the Government will seek early consultations with the States and Territories with the objective of removing any tax obstacles to entity restructuring, such as stamp duties. As at 1 March 2003 there have been no specific announcements as to this matter although it must be assumed that no action is likely at this stage in view of the Treasurer’s Press Release of 22 March 2001.

It appears that the Government’s earlier decision to provide further roll-over relief arises out of the Ralph Review Report (Recommendations 13.10 and 13.11) which recommended that there should be ongoing relief for roll-overs into entities where there was no change in economic ownership and for transitional relief for restructuring in some cases.

The key features of the proposals, as set out in Attachment K, were as follows:

• ongoing relief will be provided for the transfer of all assets, or the transfer of an entire business, from an individual, partnership or joint venture of individuals to a company or fixed trust where the underlying economic interests in the assets or business remain unchanged, and the tax values of the assets immediately after the transfer is completed are


Selling a Small Business – The CGT Strategies the same as the tax values immediately prior to the transfer, commencing with effect from 1 July 2001;

• transitional roll-over relief will be provided for the transfer of all assets, or the direct transfer of an entire business from a fixed trust to a company, provided that the underlying economic interests in the assets or business remain unchanged, all assets are transferred on the same date and the fixed trust ceases to exist after the transfer is complete, and the tax values of the assets immediately after the transfer is completed are the same as the tax values immediately prior to the transfer, with effect from 1 pm AEST, 11 November 1999 and until 1 July 2001; and

• transitional roll-over relief will be provided for the transfer of all the assets, or the direct transfer of an entire business from a company to a unit trust that will be taxed under the CIV regime provided that the underlying economic interests in the assets or business remain unchanged, all assets are transferred on the same date, the entity ceases to exist after the transfer is complete and, if the transfer occurs before the commencement of the CIV regime, the net unit trust elects to be taxed as a trading trust between the date of transfer of the assets to the unit trust and commencement of the CIV regime, and the tax values of the assets immediately after the transfer is completed are the same as the tax values immediately prior to the transfer, with effect from 1 pm AEST, 11 November 1999 and until 1 July 2001.

It is noted that the first roll-over proposed at bullet point 1 above appears very similar to that currently provided by Division 122-A of Part 3-3 of ITAA 97, although the proposal is expressed to also apply to a joint venture. Another difference is that there is currently no provision for roll-over from an individual to a fixed trust. According to the Ralph Report, this roll-over will permit CGT roll-over relief for trading stock which is not presently subject to roll-over relief. It is not entirely clear what is envisaged here since trading stock is not subject to CGT in any event. Presumably what is intended is that as part of the roll-over, trading stock would be transferred into the new entity as part of the business assets without the necessity for the separate transfer of the trading stock. No mention of this issue is made in Attachment K. As indicated at bullet point 1, this proposed roll-over is intended to have ongoing operation, as from 1 July 2001.

The two proposed transitional roll-overs appear to provide a limited opportunity to move from a fixed trust to a company or from a company to a unit trust that will be taxed as a CIV.

By Taxation Laws Amendment Act No. 4 2002 new Subdivision 124-N was introduced to provide restructuring relief where one or more trusts dispose of all their assets to a company and the trust or trust’s units or interests are replaced by shares in the company and the trust or trusts are wound up within six months of the restructure. The new Subdivision applies from 29 June 2002. The operative provisions of the new Subdivision provides as follows:

124-855 What this Subdivision deals with

(1) A roll-over may be available for a restructuring (a trust restructure) if:

(a) a trust, or 2 or more trusts, (the transferor) *dispose of all of their *CGT assets to a company limited by *shares (the transferee); and

(b) *CGT event E4 is capable of applying to all of the units and interests in the transferor; and

(c) the requirements in section 124-860 are met. Note: A roll-over is not available for a restructure undertaken by a discretionary trust.

(2) For 2 or more transferors, units and interests

in each transferor must be owned in the same proportions by the same

beneficiaries.



Example: Matthew and Jaclyn each own 50% of the units

in the Spring Unit Trust and the Dale Unit trust. All of the assets of both

trusts are disposed of to Jonathon Pty Ltd. A roll-over for a trust restructure

is available if the other requirements of this Subdivision are met.

124-860 Requirements for roll-over

(1) All of the *CGT assets owned by the transferor must be disposed of to the transferee during the *trust restructuring period. However, ignore any CGT assets retained by the transferor to pay existing or expected debts of the transferor.

(2) The trust restructuring period for a trust restructure:

(a) starts just before the first *CGT asset is *disposed of to the transferee under the trust restructure, which must happen on or after 11 November 1999; and

(b) ends when the last CGT asset of the transferor is disposed of to the transferee.

(3) The transferee must not be an *exempt entity.

(4) The transferee must be a company that:

(a) has never carried on commercial activities; and

(b) has no *CGT assets other than small amounts of cash or debt; and

(c) has no losses of any kind. Example: It could be a shelf company.

(5) Subsection (4) does not apply to a transferee that is the trustee of the transferor.

(6) Just after the end of the *trust restructuring period:

(a) each entity that owned interests in a transferor just before the start of the trust restructuring period must own replacement interests in the transferee in the same proportion as it owned those interests in that transferor; and

(b) the *market value of the replacement interests each of those entities owns in the transferee must be at least substantially the same as the market value of the interests it owned in the transferor or transferors just before the start of the trust restructuring period.

Note: Any assets in the company just before the start

of the trust restructuring period may affect the ability of owners of units or

interests to comply with paragraph (6)(b).

(7) For the purposes of subsection (6), ignore any *shares in the transferee that:

(a) just before the start of the *trust restructuring period, were owned by entities who together owned no more than 5 shares; and

(b) just after the end of that period, represented such a low percentage of the total market value of all the shares that it is reasonable to treat other entities as if they owned all the shares in the transferee.

Example: To continue the example in subsection 124-855(2), assume that Jonathon Pty Ltd was a shelf company organised for Matthew and Jaclyn by their solicitor, Indira.

Indira owned the 2 shares in Jonathon Pty Ltd before the trust restructuring period. The company issues Matthew and Jaclyn 5,000 shares each.

In these circumstances, it is reasonable to treat Matthew and Jaclyn as if they owned all the shares in Jonathon Pty Ltd.


Selling a Small Business – The CGT Strategies (8) The transferee must be an Australian resident.

124-865 Entities both choose the roll-over

A roll-over is only available for the transferor and transferee if both the transferor and transferee choose to obtain it. Note 1: If they do so, the consequences for the

transferor and transferee are set out in section 124-875.

Note 2: An entity that owns a unit or interest in the

transferor can also choose to obtain a roll-over: see section 124-870.

124-870 Roll-over for owner of units or interests in a trust

(1) You can choose to obtain a roll-over (whether or not the transferor and transferee choose to obtain a roll-over, and even if *CGT event J4 applies) if:

(a) you own units or interests in the transferor (your original interests); and

(b) the ownership of all your units or interests ends under a trust restructure in exchange for *shares in the transferee (your replacement interests).

Note 1: The roll-over consequences are set out in Subdivision 124-A. The original assets are your units and interests in the transferor. The new assets are your shares in the transferee.

Note 2: The effect of the roll-over may be reversed if the transferor does not cease to exist within 6 months: see section 104-195.

(2) You must make the choice for each of your original interests.

(3) An entity that is not an Australian resident cannot choose a roll-over under this section unless the replacement interests the entity *acquires in the transferee have the *necessary connection with Australia just after their acquisition.

(4) If you choose a roll-over, you cannot make a *capital loss from a *CGT event that happens to your original interests during the *trust restructuring period. Note: The rule in subsection (4) prevents a

capital loss arising on your units or interests after the trust assets have

been disposed of to the company trust before your shares are issued to you.

Exception: trading stock

(5) This section does not apply to your ownership of an original interest ending if:

(a) the interest was an item of your *trading stock and the corresponding replacement interest becomes an item of your trading stock when you *acquire it; or

(b) the interest was not an item of your trading stock but the corresponding replacement interest becomes an item of your trading stock when you acquire it.

124-875 Effect on the transferor and transferee

Capital gains and losses disregarded (1) Any *capital gain or *capital loss from *CGT event A1 happening to the transferor under the trust restructure is disregarded (even if *CGT event J4 applies).

Note: The effect of the roll-over may be reversed if the transferor does not

cease to exist within 6 months: see section 104-195.



Cost base is transferred

(2) The first element of the *cost base and *reduced cost base (for the transferee) of each *CGT asset that the transferee *acquires under the trust restructure is the same as the cost base and reduced cost base of that asset (for the transferor) just before that acquisition. Note: For the cost base and reduced cost base of interests in the transferee:

see Subdivision 124-A.

Pre-CGT assets retain their status

(3) If the transferor *acquired any of the *CGT assets *disposed of to the transferee under the trust restructure before 20 September 1985, the transferee is taken to have acquired it before that day.

(4) However, subsection (3) is taken never to have applied to such an asset of the transferee if subsection 104-195(4) (CGT event J4) applies to the transferee in relation to the asset.

Exception: trading stock

(5) This section does not apply to a *CGT asset if:

(a) the asset was an item of *trading stock of the transferor and becomes an item of trading stock of the transferee; or

(b) the asset was not an item of trading stock of the transferor but becomes an item of trading stock of the transferee when the transferee *acquires it.

What is clear from the original announcement and the note following new sec 124-855(1)(c) is that the Government was and is not presently minded to provide roll-over relief for businesses established under a discretionary trust. This appears to follow the view reflected in the Ralph Report at page 482 where it is stated that:

A rollover from a discretionary trust to an individual, partnership or joint venture cannot preserve continuity of ownership, as discretionary objects do not have proportionate interests in assets before such a transfer. The transitional rules for treating capital gains on existing assets in trusts and the proposed rules for the return of capital by discretionary trusts mean that a discretionary trust will be able in practice to distribute its transitional assets under the new system without triggering tax liability on unrealised gains. The transitional assets will be available for reinvestment as contributed capital. As there is no immediate adverse consequence of transition to the new system, special rollovers for discretionary trusts to encourage restructuring before transition to the new system are unnecessary.

The reasoning in this statement is somewhat difficult to follow given the transitional roll-over relief proposed to be provided, but its conclusion is clear.

ID 2002/955 considers the availability of the roll-over where one of the beneficiaries is a discretionary beneficiary. The ID is set out below:

Capital gains tax: Trust to company rollover

Issue

Is a trust to company rollover available under Subdivision 124-N of the Income Tax Assessment Act 1997 (ITAA 1997) where one of the beneficiaries of the trust owns an interest in the trust that only has a discretionary income entitlement and no capital entitlement?



Decision

No. Paragraph 124-855(1)(b) of the ITAA 1997 requires that CGT event E4 (capital payments for trust interest) in section 104-70 of the ITAA 1997 must be capable of applying to all interests in the trust. CGT event E4 does not apply where a trust interest is merely discretionary.

Facts

The taxpayer carries on a business through a unit trust. The trust has two classes of unitholders. One class owns interests with capital and income rights. The other class, comprising of a single unit holder, owns an interest with a discretionary income entitlement and no capital entitlement.


Section 124-850 of the ITAA 1997 states that an entity may obtain rollover where a trust disposed of all of its assets to a company and units or interests in the trust are replaced with shares in the company. Section 124-855 of the ITAA 1997 outlines when rollover for trust restructuring may be available. Specifically paragraph 124-855(1)(b) of the ITAA 1997 states that in order for the rollover to be available CGT event E4 must be capable of applying to all the interests in the trust. A beneficiary with only a discretionary interest in a trust does not own an interest of the nature or character referred to in section 104-70 of ITAA 1997. CGT event E4 cannot apply to an interest in a trust where a beneficiary only owns an interest with a discretionary income entitlement and no capital entitlement Therefore paragraph 124-855 (1)(b) of the ITAA 1997 is not satisfied and the rollover contained in Subdivision 124-N of the ITAA 1997 is not available.

Date of decision: 27 August 2002

See also ID 2003/388 which confirms that all assets must be transferred to the new entity. Also of particular interest is ID 2003/276 which confirms that the roll-over under Subdivision 124-N is available where the assets of the trust are transferred to the trustee company.

ID 2003/644 confirms that where the original trust is not wound up within the time required CGT event J4 will operate to impose tax on the new entity. See also related IDs 2003/645, 2003/646 and 2003/646.

The new roll-over (Subdivision 124-N) will, subject to any potential application of Part IVA, enable businesses conducted through a trust or trusts to be rolled over into a new corporate entity just before sale of the company to a purchaser. This concession is likely to appeal to would be purchasers because it enables them to acquire the target business in a new entity unencumbered by previous business or tax activities that might be a disincentive for a potential purchaser to take on.

The application of the roll-over is straight forward and should be able to be availed of provided the trust structure is wound up within the six months allowed. The roll-over is activated by “choosing” it. Section 103-25(2) says that the way a taxpayer makes his/her return is sufficient evidence of the making of the choice.

Section 124-870(4) precludes any capital loss arising in respect of interests held in the original trust entity from the winding up.

At the National Tax Liaison Group – CGT Subcommittee meeting of 27 November 2002 the following item was considered:



7.1. CGT event J4 and rollover under Subdivision 124-N (Sponsor: NTAA)

CGT event J4 can be triggered where a trust fails to cease to exist after rollover under Subdivision 124-N. Under subsection 104-195(4) it appears that a capital gain can be triggered in relation to pre-CGT assets. Is this correct and, if so, was this intended? The NTAA view is that in relation to an asset rolled over from a unit trust to a company, any pre-CGT assets of the trust will generally retain their pre-CGT status in the hands of the company – refer to subsection 124-875(3). However, if CGT event J4 applies, then a capital gain can arise even though the assets and units are pre-CGT assets. There is nothing in CGT event J4 to disregard the capital gain where it is a pre-CGT asset. In addition, in calculating the capital gain under CGT event J4, the cost base of the asset is taken to be the asset's original cost base – subsection 124-875(2).

Tax Office response

CGT event J4 does apply in the way suggested and this was intended. CGT event J4 can apply to both pre- and post-CGT assets of a trust transferred to a company under a trust restructure. In working out the capital gain or capital loss under subsection 104-195(4), the asset's original cost base is used. If, at the time of the trust restructure, rollover had not been claimed, a pre-CGT asset of the trust acquired by the company would have received a market value acquisition element cost base. The capital gain or loss made under CGT event J4 is the difference between this market value and the asset's original cost base. The fact that CGT event J4 can apply to both pre- and post-CGT assets was intended and is meant to encourage the parties involved in the trust restructure to complete the process that provides them with the concessions they originally sought. If CGT event J4 were to apply, it is likely this is a consequence of a decision of the parties to fail to complete the restructure. Where rollover under a trust restructure is chosen, CGT event J4 would not normally be triggered. While a six-month period is allowed for the trust to cease to exist, this period can be extended if the delay is the result of circumstances outside the control of the trustee. This additional feature should enable the parties to fulfil the requirements of the trust restructure provisions and remove the possibility of CGT event J4 applying.

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 further clarification was sought (item 12.1). A question was raised as to the availability of the CGT discount in respect of replacement interests acquired under the roll-over where they are disposed of within 12 months of the roll-over even though the original interests were acquired more than 12 months before the disposal. This matter was held over until the next meeting of the Subcommittee which was held on 27 November 2002. The Minutes of that meeting noted “[t]he Tax Office acknowledged that there is an issue in the circumstances described and that it will be raised with Treasury”. There does not appear to have been any announcement on this matter since that meeting.

¶9.001 No CGT roll-over for depreciating assets under Subdivision 124-N

At the National Tax Liaison Group – CGT Subcommittee meeting of 11 June 2003 the following item raised by the CPAA was considered:

Subdivision 124-N allows a unit trust to transfer all of its assets to a clean company, the shares in which are to be owned by the unit holders in the same proportions as their original unit holdings. The effect of the roll-over is that the unit trust can ignore any capital gains it makes on the transfer of its assets to the company and the company inherits the cost base or reduced cost base of each CGT asset transferred.


Selling a Small Business – The CGT Strategies The roll-over provisions however do not apply to ‘non-CGT assets’ like depreciating assets such as intellectual property. This appears to be inconsistent with other roll-over provisions such as Subdivisions 122-A, 122-B and 126-B which effectively provide such roll-over relief for non CGT assets through the application of section 40-340 of the capital allowance provisions. While the issue is not CGT specific, the lack of roll-over relief under Subdivision 124-N appears to be inconsistent with the roll-over relief afforded under other CGT roll-over Subdivisions. Can the ATO confirm whether the lack of similar roll-over relief under Subdivision 124-N is merely an oversight? ATO comments The ATO advised that the omission of the rollover under Subdivision 124-N from the table in subsection 40-340(1) of the ITAA 1997 appears to have been an oversight and Treasury have been advised.

Note the following comments have been overtaken now that the entity tax regime is no longer likely to be introduced in the foreseeable future.

As noted at ¶1.050 above, the Treasurer on 23 December 1999 issued a Press Release (set out in full at Appendix 2) seeking to clarify what will be the position of assets held in trusts as at 1 July 2001 – the time of the commencement of the new entity tax regime. The Press Release stated, in part:

Where assets are acquired by a trust after 23 December 1999 and disposed of on or after 1 July 2001, a trust taxed like a company will be taxed at the entity rate on any gain. For assets disposed of by a trust on or after 1 July 2001, where the assets were acquired by the trust on or before 23 December 1999, the trust will be able to benefit from the CGT discount available to individuals (or has the option of applying frozen indexation if the asset was acquired at or before 11.45am, AEST 21 September 1999) in determining the trust’s assessable income. Amounts excluded from a trust’s assessable income will, on distribution, be treated as a return of contributed capital of the trust, consistent with the general transitional rules for trusts that become subject to entity taxation.

Thus the critical date is 23 December 1999. Assets held in a trust as at that date and disposed of after the commencement of the entity tax regime on 1 July 2001 will be able to benefit from the CGT discount available to individuals in determining the trust’s assessable income. As stated in the Facts Sheet accompanying the Treasurer’s Press Release, no gross up will apply to the distributions.

The statement, however, makes no mention of the ability of a trust to pass through the small business concessions in respect of assets held by the trust as at 23 December 1999. As confirmed at the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000 the ATO indicated that it is intended that the concessions in respect of pre-existing assets as at 23 December 1999 would be able to be passed through.

¶9.002 Roll-over from company to individual

There is, of course, no CGT roll-over relief when transferring assets from a wholly owned company to its individual shareholder. The ATO has even issued an interpretative decision to confirm this! See ID 2002/1019.

Practice point

ID 2002/172 expressed the view that a roll over under Subdivision 122-A is not available where assets owned jointly are transferred into a company. The case dealt with a husband and


Selling a Small Business – The CGT Strategies wife who jointly owned shares in company A and wished to transfer them into a new company.

The ID notes that roll-over may be available if each owner rolled over their interest to a separate company in which they owned all of the shares.

¶9.003 Risk for current sales

Given that the entity tax regime as proposed by the Government under its Exposure Draft legislation effectively only applied to discretionary trusts, any decision to sell a business operated by a discretionary trust must be based on the possibility that the entity regime, if introduced, may affect the ability of the ultimate owners of the business to receive the proceeds from the trust. It must be said that the risk presently is remote.

¶9.010 CGT ROLL-OVER FOR FINANCIAL SERVICES REFORM

The Minister for Revenue and Assistant Treasurer announced on 21 February 2003 changes to the tax law to allow for roll-over for eligible financial service providers moving into the Financial Services Reform regime.

The amendments are contained in Taxation Laws Amendment Bill (No. 7) 2003, which was introduced on 26 June 2003. It is expected that this Bill will be passed during the Autumn 2004 sittings.

¶9.020 RESTRUCTURING DISCRETIONARY TRUSTS

It would appear that at present there is no pressing need from a tax viewpoint to consider restructuring current discretionary trusts especially with the lack of a general roll-over where there is no present intention to dispose of the business.

Whether the introduction of a 30% tax rate for companies provides an incentive will depend on the circumstances of particular businesses. For example, the opportunity to accumulate excess income in a company may be more attractive where the options for income splitting under a trust are limited.

How then would a business operating through a discretionary trust be restructured? The following example shows that, in a typical case, it cannot be assumed that CGT liabilities will not be triggered, despite the assumptions made at p 482 of the Ralph Report, set out at ¶9.000 above.

Example

Colin and Richard run a supermarket through a discretionary trust (“the C&RDT”) with a corporate trustee, C&R Pty Ltd. The beneficiaries of the discretionary trust are Colin’s and Richard’s respective families. The shareholders of the corporate trustee are Colin and Richard each holding one share. Colin and Richard each have family discretionary trusts (FDTs) used for investment purposes. Colin’s FDT holds mainly long-term share investments and Richard’s holds the freehold to the supermarket which is leased on commercial terms to the C&RDT. A superannuation fund has also been established for Colin and Richard. The goodwill of the business is worth approximately $1m. The business has operated for 10 years through the C&RDT. The C&RDT has no other significant CGT assets. Colin approaches you for advice as to whether the business should continue to be operated by the C&RDT. Colin explains that he never really understood how the trust worked and would be more comfortable if the business was operated through a company. Both Colin and Richard each have prior year capital losses of $100,000 from an unsuccessful manufacturing venture operated as a partnership.


Selling a Small Business – The CGT Strategies As discussed above, there is no general roll-over that will allow the business to be rolled over to a corporate entity or to Colin and Richard, nor is one proposed. Assuming that the C&RDT meets the small business maximum net asset value test (this would look at both Colin’s and Richard’s business assets as well as assets of the C&RDT and the assets of all other beneficiaries of the trust) and the other small business basic eligibility conditions, the C&RDT could sell the business to C&R Pty Ltd. The C&RDT would be entitled to claim both the discount capital gains concession and the small business 50% reduction, leaving an assessable capital gain of approximately $250,000 (assuming a nil cost base for the goodwill). This taxable gain could be distributed equally to Colin and Richard and each could use their losses to off-set them against the gains. However, the distributions would first need to be grossed up by multiplying the amount received by four:

Distribution to Colin $125,000

Grossed up amount $500,000

Less capital losses $100,000

Net gain $400,000

Apply 50% individual discount $200,000

Apply 50% small business

reduction $100,000

Assessable capital gain $100,000

This approach would mean that Colin and Richard would each have to pay CGT on gains of $100,000 to transfer the business C&R Pty Ltd. Note 1: Colin and Richard would be entitled to apply the small business retirement exemption if they had received 50% of the income distributions in the current income year. However, as both are under 55, the assessable gains each would be entitled to ($125,000) would need to be paid as an ETP into a superannuation fund. This would make it practically difficult to choose the exemption given that they would need to fund C&R Pty Ltd to enable it to acquire the business. Note 2: This example does not consider the effect of State stamp duties.

An alternative approach might be for C&R Pty Ltd to simply start the business in its name at, say, the end of the lease to the C&RDT of the business premises. Such a strategy may run foul of the expanded Part IVA, discussed below.

Practice point

One important further planning consideration is that where a business is operated through a discretionary trust, because of the unfortunate operation of subsec 152-30(5) ITAA 97, discussed at ¶2.020 under the heading “Control of a Discretionary Trust”, it will be difficult for such a business to benefit from any of the small business concessions. Note, however, the Assistant Treasurer’s 16 October 2003 Press Release announcing changes to this provision, also discussed at ¶2.020.

Do not be tempted to convert a discretionary trust into a fixed trust to take advantage of the new roll-over in Subdivision 124-N without close consideration of the potential CGT impact of the conversion. See discussion on discretionary trusts at ¶8.043 above.

See ID 2002/393, which deals with the determination of the cost base of company shares distributed to a beneficiary of a discretionary trust. See also ID 2002/365 concerning the disposal of CGT assets to beneficiaries at less than market value.



Chapter 10

Sale of business

¶10.000 SALE OF BUSINESS BY ENTITY TRANSFER

¶10.010 SALE OF COMPANY SHARES OR UNITS IN A TRUST

¶10.011 Sale of business assets and liquidation of company

¶10.020 TRANSFER OF DISCRETIONARY TRUST?

¶10.000 SALE OF BUSINESS BY ENTITY TRANSFER

With the introduction of the 50% general discount, where all other factors are equal, there is a strong incentive to transfer the business entity to a purchaser rather than sell the assets of the business out of the operating entity. Before the introduction of the general discount there was generally a reluctance on the part of prospective purchasers to acquire an operating entity as a means to acquiring a business. The main reason for this was that acquiring the entity carried with it the risk of unforeseen liabilities and other risks being taken on by the purchaser.

The availability of the 50% general discount to individuals and trusts together with the ability, where an individual is a controlling individual of the entity, to obtain one or more of the small business concessions means that in many cases the most tax effective way for the individual or trustee vendor to dispose of a business is for the entity to be sold.

One would expect that where the vendor seeks to dispose of the entity, that is the shares in an operating company or units in a unit trust rather than the assets of the entity, there may be a basis for the purchaser to negotiate a lower purchase price. This does not necessarily follow. Depending on the purchaser, for example a public company, there may be no serious basis for such a purchaser to seek to discount the purchase price. In recent experience over the last few years, that appears to be the case.

In order to make the operating entity saleable, however, it may be necessary to subject the entity to a full audit by an independent accounting firm and for the individual vendor to offer suitable indemnities to the purchaser. In practice, such indemnities would not be significantly broader than the normal indemnity that would be required of a vendor when selling the business assets.

Obviously, the operating entity would need to be otherwise in a saleable condition with owner loan accounts being finalised either before or on settlement. With the introduction of Division 7A, this should not present a problem for most vendors.

¶10.010 SALE OF COMPANY SHARES OR UNITS IN A TRUST

Perhaps the main concern with the disposal of an operating entity for most business owners who have operated the business from start up will be the fact that their cost base for their ownership interests will be likely to be only of nominal or nil value. This means that the capital gain on the sale of the shares or units may be greater than the capital gain that would arise within the entity itself – though this is unlikely to be the case in a start up business where the main asset within the entity is the goodwill.


Selling a Small Business – The CGT Strategies When planning the sale of the operating entity, it will be necessary to compare the likely CGT result in each scenario bearing in mind that the purchaser may seek to apply a discount on the sale of the entity. As noted above, this won’t always be the case, and, therefore, the comparison should be undertaken on the basis that the sale proceeds will be the same in each case.

¶10.011 Sale of business assets and liquidation of company

In any exercise to consider the benefits of selling the shares in a company as a means of disposing of its business it is necessary to weigh the tax effect of the alternative approach of selling the business assets and liquidating the company. Taxation Determination TD 2001/14 conveniently sets out the ATO view on how the distribution of concessional amounts from realised capital gains will be treated upon liquidation of the company. This TD was previously issued in final form as TD 95/14 and in draft form as TD 1999/D25.

The TD provides as follows:

Income tax: capital gains: how is a distribution of the ‘exempt’ 50% component of a capital gain attributable to goodwill (as worked out in accordance with paragraph 47(1A)(b) of the Income Tax Assessment Act 1936 (‘the 1936 Act’)) treated for the purposes of:

(a) sections 47 and 44 of the 1936 Act; and

(b) the capital gains provisions in the Income Tax Assessment Act 1997 (‘the 1997 Act’);

when a company’s business ends and the capital gain is distributed to shareholders by a liquidator in the course of winding up the company?

…

1. A distribution by a liquidator of the ‘exempt’ 50% component of a capital gain attributable to goodwill (as worked out in accordance with paragraph 47(1A)(b) of the 1936 Act, that is, disregarding indexation) is not deemed to be a dividend under subsection 47(1). [A reference in this Determination to ‘the “exempt” 50% component’, in relation to a capital gain attributable to goodwill, refers to that part of the capital gain which, for the purposes of paragraph 47(1A)(b) of the 1936 Act, is disregarded by subsection 118-250(1) of the 1997 Act or which is subject to a small business 50% reduction under section 152-205 in Subdivision 152-C of the 1997 Act].

2. The ‘exempt’ 50% component is not ‘income derived by the company’ according to ordinary concepts for the purposes of subsection 47(1) of the 1936 Act. Nor is it ‘income derived by the company’ under the extended definition of that expression in subsection 47(1A) of the 1936 Act.

3. The ‘exempt’ 50% component does not come within the extended definition of ‘income derived by a company’ in subsection 47(1A) of the 1936 Act because it is a ‘capital gain that is disregarded’ within the meaning of that expression in Step 1 of the method statement in paragraph 47(1A)(b). Specifically, this is because:

• if section 118-250 applies - subsection 118-250(1) disregards half of the capital gain; or

• if, from 21 September 1999 (see Note 2), section 152-205 applies - a capital gain attributable to goodwill is reduced by 50% in accordance with Step 4 in the method statement in subsection 102-5(1) of the 1997 Act. The amount by which the capital gain is reduced is appropriately treated as a capital gain that is ‘disregarded’ for the purposes of subsection 47(1A).


Selling a Small Business – The CGT Strategies 4. Being a capital gain disregarded under Step 1 of the method statement in paragraph 47(1A)(b), the ‘exempt’ 50% component is not included in the net capital gain of the company under Step 2 of that method statement.

5. For the capital gains provisions in the 1997 Act, the distribution by the liquidator of the ‘exempt’ 50% component represents capital proceeds for the cancellation of the shares (CGT event C2: section 104-25) in the case of a final distribution or an interim distribution which is followed within 18 months by the dissolution of the company: see section 104-25 and subsection 104-230(6). It is an amount to which CGT event G1 (about capital payments for shares) in section 104-135 of the 1997 Act applies in the case of other interim liquidation distributions in respect of post-CGT shares.

Example

Company’s position

6. X Pty Ltd, a resident company, was incorporated and acquired a business after 19 September 1985. The business was acquired for $1,100,000 and of that amount its goodwill was acquired for $100,000. The business was sold and the goodwill disposed of for $200,000 in the company’s 1998-99 year of income.

7. Assuming the cost base of the goodwill after indexation was $110,000, the company made a capital gain of $90,000 of which $45,000 was exempt under section 118-250. The company paid tax of $16,200 on the gain (that is 36% x $45,000).

8. The company transferred the after-tax amount of $83,800 to its capital profits reserve.

9. The company was placed in liquidation. The liquidator distributed $83,800 appropriated from the capital profits reserve.

Shareholder’s position

10. Subsection 47(1), read with subsection 47(1A), deems a shareholder to have received a dividend to the extent that an amount would have been a capital gain to the company disregarding indexation.

11. In this particular case, the capital gain to the company (disregarding indexation, as subsection 47(1A) requires) would have been $100,000. Fifty percent ($50,000) would have qualified for exemption under section 118-250. The balance of the distribution ($33,800 -that is $50,000 less $16,200 tax paid) is deemed by subsection 47(1) to be a dividend.

12. If the distribution is a final distribution or an interim distribution followed within 18 months by the dissolution of the company, the full amount of $83,800 would represent capital proceeds for the cancellation of the shares and would need to be taken into account in calculating the extent of any capital gain or loss in respect of the cancellation. Subsection 118-20(1) would operate to ensure an appropriate reduction is made to any capital gain that would otherwise arise to the extent of the $33,800 deemed dividend.

13. If the distribution is an interim distribution not followed within 18 months by the dissolution of the company, the application of section 104-135 would need to be considered in relation to the amount of the distribution that is not deemed to be a dividend (that is $50,000 [$83,800 - $33,800]).

Note 1:

14. This Determination rewrites and replaces Taxation Determination TD 95/14 which is now withdrawn.



Note 2:

15. Section 118-250 has been repealed. Division 152 of the 1997 Act (about small business relief) has now been inserted and applies to assessments for the income year including 21 September 1999 and all later income years, if a CGT event happens after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999: item 61 in Schedule 1 to the New Business Tax System (Capital Gains Tax) Act 1999. Division 152, among other small business relief, replaces the former 50% goodwill exemption with a 50% active asset reduction for all businesses with net assets of $5 million or less. Goodwill is an active asset for the purposes of Division 152: subsection 152-40(1) of the 1997 Act. A capital gain attributable to goodwill may be reduced by section 152-205 of the 1997 Act by 50% - in accordance with Step 4 in the method statement in subsection 102-5(1) of the 1997 Act. To the extent the liquidation distribution represents the amount of the reduction, it will not be taken to be a dividend - under the extended definition in subsection 47(1) of the 1936 Act - for the purposes of section 44 of the 1936 Act. The same applies to reductions of capital gains on active assets other than goodwill.


13 June 2001

The principles applied in the above Determination will also apply in relation to any pre-CGT gains held by a company.

The ATO confirmed at the National Tax Liaison Group – CGT Subcommittee meeting of 7 August 2002 that the CGT discount and small business concessions may also be available in respect of the cancellation of shares held by a CGT concession stakeholder upon the liquidation of the company. The ATO noted the following caution:

If, however, the company’s active assets are progressively sold before the cessation of the business such that the market values of the active assets fall below the 80% threshold in subparagraph 152-40(3)(b)(i), it is likely the shares will not be active assets just before the cessation of the business. This is because it is unlikely, in a liquidation context, that the proceeds from the sale of the active assets will be held pending the acquisition of new active assets such that they could be counted in the 80% test under subparagraph 152-40(3)(b)(ii).

Note TD 2000/7, which confirms the ATO position that company shares come to an end when the company is deregistered, and not when it is liquidated.

See ID 2003/865, which considers the application of CGT event A1 to a transfer of shares in a company in administration. See also ID 2003/1024 concerning the application of CGT event E1 in relation to a declaration of trust over shares in a company in administration.

Note the withdrawal of TD 95/15 following the introduction of para 118-20(1B)(b) ITAA 97, which provides that a capital gain is not reduced by an amount included in assessable income under section 160AQT ITAA 1936. This would occur where a final dividend to a shareholder is franked.

See ID 2004/150 which considers that legal fees incurred in a winding up may form part of the cost base of a debt owed by the company.

¶10.020 TRANSFER OF DISCRETIONARY TRUST?

There may be practical reasons why it is not appropriate to seek to dispose of the controlling interests and rights under a discretionary trust used as an operating entity. If, for example, the trust is a family trust and a family trust election has been made in respect of the trust, there are clearly difficulties in seeking to “transfer” the trust to a new owner. This may not necessarily be a problem where the “transfer” is to a member of the original family group.


Selling a Small Business – The CGT Strategies Assuming that there is no need to alter the terms of the trust, transfer of the trust could be effected by the simple matter of transferring the shares in the trustee company at their market value based on the assumption that control of the shares gives control of the trust. The main difficulty for the vendor will be that although the vendor will be a controlling individual of the trustee company, there may be some doubt that the requirements of sec 152-40(3) would be satisfied so as to allow the vendor of the corporate trustee’s shares to be active assets. That provision requires that where an asset is a share, not less than 80% of the assets of the company must be themselves active assets. If the trustee company has no assets other than the de facto right to control the trust by virtue of being named in the trust deed as the trustee, a question arises whether those “rights” would fall within the definition of “active asset” in sec 152-40. Paragraph 152-40(1)(b) includes intangible assets that are inherently connected with a business that the relevant holder of the assets carries on – this could be the trustee. Given the potential for argument, a cautious vendor may not be prepared to take the risk that the ATO may seek to deny the small business concessions on this basis. Nevertheless, there is no doubt that the vendor could apply the general 50% discount to the sale of the trustee company’s shares. In a case where the small business concessions were not otherwise available, this may well be desirable. At present, however, the benefit of the 50% general discount can be passed through a trust by the trustee, so this may be the better approach.



Chapter 11

Other changes

¶11.000 SUCCESSION PLANNING

¶11.010 INVOLUNTARY DISPOSAL ROLL-OVERS TO BE EXTENDED

¶11.020 GAINS ON THE DISPOSAL OF INTERPOSED NON-RESIDENT ENTITIES

¶11.030 PREVENTING LOSS DUPLICATION AND VALUE SHIFTING

¶11.000 SUCCESSION PLANNING

The scope of this Portfolio is not intended to extend to a full treatment of sucession planning for small business. Nevertheless it is useful to reproduce ID 2003/1189 which looks at certain aspect of buy/sell agreements. The ID provides as follows:

Issue

Are the proceeds from a life insurance policy, payable on the death of the insured person, assessable income under sections 6-5, 6-10, 15-30 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

No. The proceeds from the life insurance policy are not assessable income as they are a receipt of capital.

Facts

The partners entered into a business succession agreement to ensure both that the business is preserved for the surviving partners and that the estate of the deceased partner receives an amount equivalent to the worth of the partner’s equity in the business. Under the terms of a business succession agreement, each of the partners of a business takes out life insurance policies on their own lives, with the other partners as the beneficiaries of the policies. The agreement provides that on the death of a partner, the remaining partners have the right to acquire the interests in the business of a deceased partner at an agreed market value. Conversely the legal personal representative of the estate of the deceased partner has the right to require the surviving partners to purchase the interest of the deceased partner. The surviving partners use the proceeds (a lump sum payment) from the life insurance policy to fund the acquisition of the interests in the business of the deceased partner. Reasons for Decision The courts have had occasion over the years to examine the meaning of ‘a policy of life insurance’. It has been found that life insurance policies exhibit the following characteristics:

• the insurer agrees to pay the insured a sum of money when a particular event occurs



• the particular event is contingent on the duration of human life, and

• in consideration for the payment at a later date the insured pays the insurer a smaller amount or a number of smaller amounts (premiums).

The courts have also examined the nature of the proceeds from life insurance policies. In Marac Life Assurance Ltd v. Commissioner of Taxation [1986] 1 NZLR 694 the Court of Appeal concluded:

Nothing in the Income Tax Act 1976 specifically exempts proceeds of life insurance policies from income tax, but it is common ground that traditionally such proceeds have been treated as capital; and this view is supported by In re The Income Tax Acts (1900) 26 VLR 297.

The decision in Marac Life Assurance was applied by the Federal Court of Australia in NM Superannuation Pty. Ltd. v. Young & Anor (1993) 41 FCR 182; (1993) 7 ANZ Insurance Cases 61-163.

Ordinary Income and Statutory Income.

Section 6-5 of the ITAA 1997 provides that the assessable income of Australian residents includes the ordinary income derived directly or indirectly from all sources. Ordinary income includes income from rendering personal services, income from property and income from carrying on a business. Other characteristics of income that have evolved from case law include receipts that:

• are earned

• are expected

• are relied upon, and

• have an element of periodicity, recurrence or regularity.

Although the proceeds from a life insurance policy can be said to be expected and relied upon, this expectation arises from taking out an insurance policy, rather than from a relationship within which personal services are performed. The payment is made in a lump sum so it does not have an element of periodicity, recurrence or regularity. The proceeds from a life insurance policy do not relate to personal services, property or the carrying on of a business. Therefore, the proceeds are not considered to be income according to ordinary concepts under section 6-5 of the ITAA 1997. Section 6-10 of the ITAA 1997 provides that amounts that are not ordinary income but are included in assessable income by another provision, are called statutory income. Payments made under a life insurance policy may come under compensation – insurance or indemnity for loss of assessable income under section 15-30 of the ITAA 1997. The proceeds from a life insurance policy represent payment of a benefit contingent on the termination of human life. The compensation amount generally bears the character of that which it is designed to replace. The compensation in this particular case is to replace the capital asset and will be regarded as capital receipt. Section 6-15 of the ITAA 1997 provides that if an amount is not ordinary income and is not statutory income, it is not assessable income. Date of decision: 30 June 2003

See also ID 2004/1190 dealing with the treatment of put and call options under a succession agreement. See ID 2004/668 dealing with buy/sell agreements which confirms that the time of an agreement entered into with a condition precedent is the time that the condition precedent takes effect.



¶11.010 INVOLUNTARY DISPOSAL ROLL-OVERS TO BE EXTENDED

The Treasurer announced in his Press Release (No. 074) issued on 11 November 1999 proposals to extend the scope of involuntary disposal roll-overs (see Subdivision 124-B, Part 3-3 ITAA 97), detailed at Attachment M to the Press Release. The changes will enable roll-over to be obtained in three cases where, prior to the announcement, no roll-over was available. The three cases to be covered are:

• roll-over will be available where a replacement asset is acquired where a private body acquires the original asset through recourse to a statutory power, for example a privately owned company acquires land to build a motorway;

• roll-over will also apply where the sale is negotiated prior to the formal exercise of compulsory acquisition powers – this change will seek to place a private company with compulsory acquisition powers in the same position as an Australian government agency; and

• roll-over will be available where a landowner whose land is compulsorily subject to a mining lease sells the land to the mining company and acquires a replacement asset where the mining operation would “significantly affect” the landowner’s use of the land.

These changes are intended to apply from 11 November 1999 (i.e. disposals occurring after 1 pm AEST). Legislation to give effect to the changes had not yet been introduced into Parliament as at 1 February 20043.

It is noted that the Treasurer’s Press Release makes clear that the extension of the roll-over where a compulsory power is exercised by a non-government entity, will not apply to compulsory acquisitions of minority interests under the Corporations Law/Corporations Act (2001). However, it would appear that, where a takeover offer has been made that otherwise satisfies the requirements of the scrip for scrip roll-over (see above at ¶7.000), the minority interests would normally be entitled to apply that roll-over.

¶11.020 GAINS ON THE DISPOSAL OF INTERPOSED NON-RESIDENT ENTITIES

The Treasurer also announced in his Press Release issued on 11 November 1999 proposals to counter the avoidance by non-residents of Australian CGT by disposing of an interposed entity holding Australian assets rather than the assets themselves. This change is detailed at Attachment I to the Press Release and follows Recommendation 21.7 of the Ralph Report. The issue was canvassed in 2nd Ralph Discussion Paper, “A Platform for Consultation” at pp 649-650.

The Treasurer’s announcement states that the measure will be targeted at tax avoidance rather than commercial transactions. To this end, the anti-avoidance measure will not apply where the gain on the sale of an interposed entity is subject to tax in a broad recognised exemption listed country or would have been subject to tax in such a country except for recognised roll-over relief.

The issue arises out of the Full Federal Court decision in FCT v Lamesa Holdings BV 97 ATC 4752; (1997) 36 ATR 589. That case involved a Netherlands company that sold shares in an Australian listed company. The Australian listed company held Australian land interests through two 100% owned subsidiaries. The Netherlands company neither had a base in Australia nor carried on business in Australia, other than to acquire and resell the Australian listed shares.

The question at issue was whether the company had alienated “real property” in Australia within the meaning of article 13 of the Netherlands-Australia Double Tax Agreement (DTA). Article 13 provides an exception to the general rule in article 7(1) which provides that the profits of a Netherlands’ enterprise are taxable only in the Netherlands unless the enterprise carries on a permanent establishment in Australia.


Selling a Small Business – The CGT Strategies The Court concluded that the gains from the sale of Australian listed shares by the Netherlands company were not caught by article 13. The reasoning of the Court means that article 13 does not apply where real property is held through a company at the bottom of a chain of companies and the shares in one of the higher companies are sold.

As noted in the Ralph Report, no CGT is payable where the non-resident entity is sold because membership interests in foreign entities are not included in the list of assets with the necessary connection with Australia (see sec 136-25 ITAA 97) but membership interests in resident entities are included (other than portfolio interests in widely held trusts and listed companies).

The Treasurer made an earlier announcement on 27 April 1998 (Press Release 39/1998) that the law was to be amended to ensure that it applies to profits arising from the indirect alienation of real property by a non-resident with effect from midday AEST, 27 April 1998. Legislation to give effect to this change is contained in Taxation Laws Amendment Act (No 11) 1999 (now Act No. 114, 2000).

The amendment overrides affected treaties (i.e. those with equivalent articles to article 13 of the Netherlands-Australia DTA by a new section inserted into the International Tax Agreements Act 1953, as follows:

3A Alienation of real property through interposed entities

(1) This section applies if:

(a) an agreement makes provision in relation to income, profits or gains from the alienation or disposition of shares or comparable interests in companies, or of interests in other entities, whose assets consist wholly or principally of real property (within the meaning of the agreement) or other interests in relation to land; and

(b) this Act gave that provision the force of law before 27 April 1998.

(2) For the purposes of this Act, that provision is taken to extend to the alienation or disposition of shares or any other interests in companies, and in any other entities, the value of whose assets is wholly or principally attributable, whether directly, or indirectly through one or more interposed companies or other entities, to such real property or interests.

(3) However, subsection (2) applies only if the real property or land concerned is situated in Australia (within the meaning of the relevant agreement).

(4) If, after the commencement of this section, this Act is amended so as to give the force of law to an amendment or substitution of a provision mentioned in subsection (1), this section ceases to apply to that provision from the time that the amendment of the Act takes effect.

(5) In this section:

entity has the same meaning as in the Income Tax Assessment Act 1997, but does not include an individual in his or her personal capacity.

The Treasurer’s Press Release of 11 November 1999 stated that the new law would apply from 1 July 2001 but the amendment actually operates from 27 April 1998.

¶11.030 PREVENTING LOSS DUPLICATION AND VALUE SHIFTING

The Treasurer’s announcement of 21 September 1999 included details of some specific CGT anti-avoidance measures to prevent loss duplication and value shifting in corporate groups. The measures which are contained in the Other Measures Act are summarised below:



Loss duplication on transfer of revenue losses − as from 22 February 1999 to the commencement of the entity tax system (1 July 2001) where revenue losses are transferred from a company in a chain, the cost base of the company’s shares will be reduced to reflect the loss in value of the company’s assets (see Recommendation 6.18 of the Ralph Report).

These provisions are now located in Subdivision 170-C of Division 170 of Part 3-5 ITAA 97. Section 170-205 provides as follows:

170-205 Object of Subdivision

Interests in the loss company

(1) The main object of this Subdivision is to ensure that, if an amount of a *tax loss or *net capital loss is transferred by a company to another company in the same *wholly-owned group, the loss transferred is not duplicated by a member of the group.

(2) Duplication could occur by the making of a *capital loss, or the reduction of a *capital gain, from a *CGT event that happens in relation to an equity interest held (directly or indirectly) in the loss company or by the making of a capital loss in relation to a debt interest held (directly or indirectly) in the loss company.

Interests in the income company or gain company

(3) This Subdivision may also require an adjustment to the cost base and reduced cost base of an equity or debt interest held (directly or indirectly) by a group company in the income company or gain company.

(4) This adjustment is to reflect an increase in the market value of the interest because of the transfer of the loss if the increase is still reflected in the market value of the interest when a *CGT event happens in relation to the interest.

Duplication of unrealised losses − as from 11:45 am (ACT Time) 21 September 1999 where a change in the majority ownership in a company with unrealised losses changes, those losses will not be available to be deducted against gains when realised unless the company satisfies the same business test (Recommendation 6.10).

These provisions are to be found in Subdivision 165-CC. Particular care needs to be exercised when transferring shares in a company with unrealised net losses.

Disposal of loss assets within majority-owned groups − as from 11:45 am (ACT Time) 21 September 1999 the rules requiring compulsory roll-over of loss assets transferred within wholly-owned groups are extended to majority owned groups. A majority owned group is defined as one that is majority owned directly or indirectly by the same individuals or entity (including a trust), and their associates.

This measure is found in new Subdivision 170-D. Section 170-250 provides:

170-250 What this Subdivision is about

This Subdivision provides that there is a deferral of a *capital loss or deduction if a company (the originating company) that is a member of a *linked group disposes of a *CGT asset to, or creates a CGT asset in, another entity that:

(a) is a company that is also a member of the linked group; or



(b) is a connected entity of the originating company or an *associate of such a connected entity;

and the disposal or creation of the asset would have resulted in the originating company making a capital loss or becoming entitled to a deduction.

Linked groups are discussed at ¶7.040 above in relation to the scrip for scrip roll-over. The introduction of this measure needs to be carefully noted because of its potentially wide application.

Value shifting through forgiveness of debts – a new Division 139 was introduced to adjust the cost base of shares of subsidiary companies where value is shifted by debt forgiveness. It applied from 22 February 1999.

Division 139 applied, as stated by sec 139-5, to companies under common ownership that can shift value between themselves by forgiving, or substantially and permanently reducing the value of, debts.

The Division required adjustments to the cost base of direct and indirect interests in those companies where value has been shifted in that way. The Division has now been overtaken by the new general value shifting provisions as discussed in detail in Chapter 12.

The old operative provision sec 139-10 provided as follows:

139-10 When this Division may affect you

(1) You may have to make an adjustment under this Division if:

(a) a company (the debtor company) has an obligation to pay a debt to another company (the creditor company); and

(b) you have a *share in, a loan to or an indirect interest in the creditor company or a share in or an indirect interest in a share in the debtor company; and

(c) the conditions in subsection (3) or (4) are satisfied.

Exception

(2) No adjustment is required if the debtor company is a *100% subsidiary of the creditor company.

Conditions

(3) The conditions are that:

(a) *CGT event C2 (the trigger event) happens to the debt or part of it (the surrendered amount) at a time (the forgiveness time) on or after 22 February 1999; and

(b) the creditor company and debtor company are *under common ownership at the forgiveness time; and

(c) there is a shift in value from the creditor company to the debtor company as a result of the trigger event because the *capital proceeds the creditor company receives or is entitled to receive from the trigger event are less than the market value of the surrendered amount (at the forgiveness time).

(4) The conditions are that:


Selling a Small Business – The CGT Strategies (a) there is a substantial and permanent reduction in the value of the debt

because of something done (also the trigger event) by the creditor company or by both companies at a time (also the forgiveness time) on or after 22 February 1999; and

(b) the creditor company and debtor company are *under common ownership at the forgiveness time; and

(c) there is a shift in value from the creditor company to the debtor company as a result of the trigger event because the money, and market value of other property (if any), that the creditor company receives or is entitled to receive for that reduction is less than the amount of the reduction.



Chapter 12

New general value shifting rules


¶12.010 OVERVIEW


¶12.030 THE RULES IN SUMMARY

¶12.031 Direct Value Shifts

¶12.032 Who is a controller?

¶12.033 Where effect of shift reversed within four years

¶12.034 Where only partial value shift

¶12.035 Working out the consequences of a value shift

¶12.036 Issuing rights for no consideration

¶12.037 Issuing shares at a premium

¶12.038 Neutral value shifts

¶12.039 Direct value shift involving a debt interest in a company

¶12.040 DIRECT VALUE SHIFTS INVOLVING CREATED RIGHTS OVER NON-DEPRECIATING PROPERTY

¶12.050 INDIRECT VALUE SHIFTS

¶12.051 Mixed group shifts, for example units/shares

¶12.052 Land transferred at cost

¶12.060 PART IVA


The new General Value Shifting Rules (GVSR) replaces existing Division 138 (Value shifting between companies under common ownership), Division 139 (Value shifting through debt forgiveness) and Division 140 (Share value shifting) (Part 3-3 ITAA 97) with three new expanded Divisions 723, 725 and 727 found in the New Business Tax System (Consolidation, Value Shifting, Demergers and Other Measures) Act 2002 (the Amending Act).

The new rules apply from 1 July 2002. It is noteworthy that since their introduction the ATO has issued only a small number of IDs on their operation (see e.g. ID 2003/247, ID 2003/768, ID 2003/890, ID 2003/891, ID 2003/892 and ID 2003/1139 (exempt entity)). There have been no Rulings issued.

The changes were originally briefly alluded to by the Treasurer in his 21 September 1999 Press Release (No 58 of 1999) that outlined the Government’s extensive proposals for business tax reform. The value shifting changes were foreshadowed in the context of “providing a system of consolidation for groups of companies and trusts” (see Attachment K to the Press Release). The original proposals were developed into Recommendations 6.12 – 6.16 of the Ralph Report (A Tax System Redesigned).


Selling a Small Business – The CGT Strategies The clear message that is intended to be conveyed by the new provisions, as with the previous provisions, is that if you stick to market value for all transactions involving assets and interests in companies and trusts there is nothing to worry about. However, the sheer complexity and volume of the new measures, covering as they do 135 pages of new legislation and another 196 pages of EM, mean that practitioners could be forgiven for thinking that this message is not quite as simple as it sounds.

Taxation Laws Amendment Bill (No.9) 2003 was introduced into the lower house on 4 December 2003 and contained certain transitional measures relating to the new regime. Their purpose is to exclude value shifts that deal with the provision of services. The changes are intended to apply to value shifts that occur before a losing entity’s 2003/04 income year.

¶12.010 OVERVIEW

The GVSR, like the pre-existing law, covers three main areas. These are:

• Direct Value Shifting (DVS) (Division 725) in a single company or trust, for example a DVS scheme might involve the simple issuing of shares in a company at a discount that results in changes to the value of the existing shareholding.

• DVS involving rights created over non-depreciating assets (Division 723), for example a scheme to grant a lease over land held by a trust to a beneficiary of the trust for less than arm’s length consideration, then selling the land for a lower market value.

• Indirect Value Shifting (IVS) within company and trust groups (Division 727), for example transferring assets from one subsidiary to another for less than full market consideration.

The main point to note is that the GVSR applies equally to companies and trusts, and not just to fixed trusts but to fixed and non-fixed trusts. The potential impact, therefore, will be that the rules will apply across the board to the most common business entities, although partnerships and the like are not brought within the net in most cases. The approach under the GVSR to dealing with value shifts is much the same as the existing limited measures, and those measures will continue to apply to value shifts that have occurred generally before 1 July 2002.

Another significant change under the GVSR is that it is not in fact confined to capital gains. Gains of a revenue nature will also be caught, including gains in relation to trading stock. Where gains are both capital and revenue in nature, the existing overlap provision, sec 118-20 ITAA 97, will apply to reduce the capital gains to the extent of the revenue gain.

As with the existing law, there is no need to establish a tax avoidance purpose or motive for the rules to apply – if the arrangement falls within the GVSR, the provisions apply automatically either to cause a capital or revenue gain or to require a cost base or other adjustment.

The good news is that there are new and extended de minimis exceptions and other safe harbour rules for those not willing to risk exposure. For example, a special relieving rule is proposed where a DVS is reversed within four years. Given the broad potential reach of the new regime, however, it may not always be apparent that a transaction may give rise to proscribed value shifting.

The de minimis exceptions proposed will exclude the GVSR where:

• in the case of a DVS, the total value shifted under the scheme is less than $150,000;

• there are shortfalls of less than $50,000 in respect of DVS where rights are created over non-depreciating assets; and



• in the case of IVS, where shifts do not exceed $50,000.

Of course, coming within these limits does not guarantee that the general anti-avoidance provision in Part IVA ITAA 36 will not be applied to a scheme in any event. The proposed move to a blanket $150,000 threshold for DVS should make it easier for small/medium businesses to determine whether the rules will apply. The previous threshold was $100,000 or 5% of the total interests. Still, accurate market valuations obtained at the time of a relevant transaction are likely to be necessary in most cases to ensure that a position taken can be defended in any subsequent ATO audit.

Keeping in mind the mantra of market value – the GVSR can be avoided completely by:

• only issuing interests, whether equity or loans, for full market value;

• only creating rights over non-depreciating assets for full market value; and

• only dealing at arm’s length with related entities.

The new provisions, as previously, provide no guide to assist in determining market value in cases, for example, where there is no readily available market.


The GVSR contain both good news and bad news for small/medium businesses. The good news is that the higher de minimis exceptions and simplified thresholds should assist significantly in determining whether value shifting will be an issue.

Also, the proposed rules provide for a further blanket exception for small business from the IVS rules where the business is eligible to be in the STS (i.e. with an average turn-over of less than $1m) or for the CGT small business concessions which apply where net assets of the entity and associates and affiliates are less than $5m.

The bad news is that by extending the value shifting to fixed and non-fixed trusts, there will be a considerable loss of the flexibility for trusts as a business or investment entity, though probably not sufficient to consider discarding an existing trust structure or entity in favour of a company or some other entity or structure.

Discretionary trusts, in particular, will be affected. For example, value shifting can occur in a situation as simple as where the terms of a pre-existing loan made to the trust are renegotiated to relieve the trust of its repayment obligations because of changed economic conditions.

Because of the inherent nature of discretionary trusts under which beneficiaries are not regarded as having interests in the trust or its assets, the normal DVS and IVS rules will not apply.

As in the above example, the greatest danger will be from Division 723 (DVS involving rights created over non-depreciating assets) either inadvertently or where concerted efforts are made to try to reduce the impact of CGT on the disposal of its assets. Nevertheless, the proposed DVS and IVS rules are able to apply to hybrid discretionary trusts where fixed interests under the trust are altered. This could arguably arise where, in an exercise of the discretionary powers under the trust, value is shifted out of the trust to the detriment of fixed or other interest holders under the trust.

Perhaps of even greater concern is that Division 723 can also apply to individuals as tax entities, for example, a sole trader or partner in a partnership. Particular care will now need to be exercised where rights are created between related parties. For example, a sole trader who holds the head lease of his/her business premises could (subject to the $50,000 de minimis threshold) fall foul of the Division if a right under the lease was created in favour of his/her spouse for inadequate consideration.



¶12.030 THE RULES IN SUMMARY

¶12.031 Direct Value Shifts

The requirements for a DVS are fairly straightforward. Under sec 725-50, the required elements for a DVS that has tax consequences (i.e. a capital gain or income gain or cost base adjustment) under Division 725 are set out below:

• there must be a scheme involving equity or loan interests in a target entity;

• the target entity is a company or trust;

• the controlling entity test is satisfied;

• the participants under the scheme (either the target entity, controller or active participant) do something to which the decrease in the market value of the “down interests” and increase in the “up interests” are reasonably attributable;

• the total change in value in the “down interests” is at least $150,000 (see ID 2003/768 for an example of an application of this exclusion); and

• the taxpayer is the owner of either an affected down interest or up interest.

There are a number of new terms that are largely self-explanatory but are precisely defined. It will be necessary to examine carefully the relevant definition provisions when testing any actual proposed transaction. In this regard, “down interests” and “up interests” are the terms defined to refer to equity or loan interests that are affected by a value shifting scheme.

There is also a definition for “active participants”. These are basically entities (individual, company, trust, partnerships, etc – see sec 960-100 ITAA 97) involved in relation to a closely held target entity, that is, one having fewer than 300 members. In the case of a discretionary trust, these are deemed to have fewer than 300 members. ¶12.032 Who is a controller?

Whilst there is no definition of a “controller” as such, sec 727-355 to 725-375 deal with the concept of “control (for value shifting purposes)”. Broadly, these provisions set out 50% stake tests for companies and fixed trusts, and separate 40% tests similar to the small business CGT concessions in Division 152 of Part 3-3 ITAA 97. There are separate tests for non-fixed trusts; for example, a person will be a controller for value shifting purposes if he/she has power to remove the trustee.

¶12.033 Where effect of shift reversed within four years

Where the value shift is reversed within four years, the tax consequences of the DVS are ignored (see sec 725-90). This may give rise to an assessment in an earlier year needing to be amended when the reversal takes place outside the time for lodging the return relating to the original shift.

¶12.034 Where only partial value shift

In what appears to be a very significant concession to the otherwise automatic operation of the DVS rules, under sec 725-165, where it is reasonable to conclude that the increase or decrease in market value is only partly caused by the doing of things under the scheme, the DVS rules only apply to that extent. For example, if under a value shifting scheme where shares were issued at a discount causing the existing shares to fall in value, and if it could be reasonably shown that part of the fall in value was in fact due to other factors such as the target entity’s bank requiring repayment of a loan, this could be taken into account. The change in value and may be sufficiently large to bring the transaction under the de minimis threshold.



¶12.035 Working out the consequences of a value shift

To work out the tax consequences for a taxpayer under the DVS rules it is necessary to consult the various tables contained in Division 725, Sub-div 725-D. There are separate tables for “taxing events” that generate a capital gain, and tables for adjusting the values of CGT assets. New CGT event K8 will apply where a taxing event happens to a down interest.

In addition, there are tables dealing with changes in the value of interests held as CGT assets and separate tables for assets held as trading stock or revenue assets.

Whilst in theory these tables seek to cover all possible combinations in an easy-to-follow format, the resulting provisions are both complex and lengthy. A simple example is item 1 of the table in sec 725-245. It provides, in effect, that where a pre-CGT asset that is neither a revenue asset nor trading stock has increased in value, the increase will be treated as a capital gain under new CGT event K8.

There is then a separate provision (sec 725-365) to work out the actual gain – this is done in broad terms on a proportionate basis, as under the pre-existing law. There are separate provisions to work out other adjustments to the cost base which can be either a decrease or an uplift. The application of these provisions where necessary will, no doubt, impose considerable compliance costs.

To illustrate the application of the new rules, the EM provides the following example:

Example 7.1

Lee owns all one million A class shares in company Wolf Pty Ltd, which have a market value of $20 each, and Yorgie owns one million B class shares in the same company, which have a market value of $10 each. Lee and Yorgie agree to vary the rights attaching to both classes of shares, resulting in the market value of the A class shares decreasing by $10 each and the market value of the B class shares increasing, also by $10 each. The total market value of Lee’s A class shares has fallen by $10 million and the total market value of Yorgie’s B class shares has increased correspondingly by $10 million. Thus, there has been a direct value shift from Lee to Yorgie of $10 million. This has the same economic effect as if Lee disposed of half of his shareholding to Yorgie. Assuming the total cost base for all Lee’s shares is $5 million, Lee makes capital gains of $7.5 million and his total cost bases for the A class shares is reduced to $2.5 million. Yorgie must make cost base uplifts to avoid double taxation. Assuming his shares had cost bases of $4 million his cost bases in total are increased to $14 million.

¶12.036 Issuing rights for no consideration

There would appear to a potential flaw in the DVS rules in relation to schemes involving the issue of equity or loan interests. It appears that under sec 723-150 the definition of issuing equity or loan interest at a “discount” appears to require that there be some consideration either in money or property. Unless an equity or loan interest in the target company or trust is issued as a discount there can be no DVS. Therefore, issuing the equity or loan interest for no consideration would presumably not give rise to DVS.

¶12.037 Issuing shares at a premium

ID 2003/890 considered a case where shares were issued to the two shareholders of the company at a premium to market value. The ID is as follows:



Issue

Do the direct value shifting provisions in Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to the issue of new shares at a premium to market value?

Decision

No. The direct value shifting provisions in Division 725 of the ITAA 1997 do not apply to the issue of new shares at a premium to market value because no interests in the company have decreased in value.

Facts

A company has two shareholders B and C. At 30 June 2002 each shareholder owned 50% of the issued shares in the company. After 30 June 2002, the company entered into an arrangement in which shares were issued at a premium to market value to shareholder B.


Where a direct value shift (DVS) occurs that has consequences under Division 725 of the ITAA 1997, the rules in the Division apply to modify the adjustable values of affected interests to take account of material changes in market value that are attributable to the DVS. The rules in Division 725 may also generate a capital gain on those interests that have decreased in market value as a result of the DVS. Division 725 of the ITAA 1997 can only apply to a scheme if there is a DVS as defined under section 725-145 of the ITAA 1997. A DVS will occur when:

• there is a decrease in the market value of one or more equity interests in a company and either:

• equity interests in the company are issued at a discount to market value; or

• there is an increase in the market value of one or more equity interests in the company; and

• the changes in market value and the issue of equity interests are reasonably attributable to things done under the scheme.

The company has raised additional capital by issuing shares at a premium to market value to shareholder B. This has increased the market value of both shareholders' existing shares. The market value of the newly-issued shares at all times was the same as the market value of the other shares in the company and has not decreased. Therefore, a DVS has not occurred under section 725-145 of the ITAA 1997 because there has not been a decrease in the market value of any interests in the company. The issue of shares at a premium to market value is not subject to the consequences in Division 725 of the ITAA 1997. Date of decision: 17 September 2003

¶12.038 Neutral value shifts

ID 2003/892 considers the situation where both shareholders in a two-person company receive options at less then market value. The ID is reproduced below:

Issue

When options to acquire additional shares were issued to the shareholder at less than their market value, was the direct value shift (DVS) from the shareholder’s existing


Selling a Small Business – The CGT Strategies shares a neutral value shift for the shareholder under section 725-220 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision

Yes. Section 725-220 of the ITAA 1997 only requires that the sum of discounts received by a shareholder on the issue of the options be equal to the sum of market value decreases for that shareholder’s shares.

Facts

A company has two shareholders, company N and company E. As a result of an arrangement entered into after 30 June 2002, the company issued options at a discount to market value to both shareholders. The effect of issuing the options at a discount was a reduction in the market value of the existing shares of $100,000 for each shareholder. The total discount received by each shareholder was $100,000. There is a DVS and both shareholders are affected by the direct value shifting rules.


Where a direct value shift (DVS) occurs that has consequences under Division 725 of the ITAA 1997, the rules in the Division apply to modify the adjustable values of affected interests to take account of material changes in market value that are attributable to the DVS. The rules in Division 725 may also generate a capital gain on those interests that have decreased in market value as a result of the DVS. Pursuant to section 725-220 of the ITAA 1997 there will be a neutral DVS if the total decrease in market value of an entity’s interests that have decreased in value as a result of the DVS (down interests) is equal to the sum of:

• the total increase in market value of that entity's interests that have increased in value as a result of the DVS (up interests); and

• the total discounts given on the issue of interests (up interests) to that entity as a result of the DVS.

There is no requirement for any of the interests to be of the same kind. If section 725-220 of the ITAA 1997 applies to a shareholder under the arrangement, then the consequences provided for in Division 725 apply to that shareholder as if the DVS were only from their down interests (shares) to their up interests (options). These consequences are set out in Subdivisions 725-D to 725-F. The DVS from the issue of the options has resulted in the $100,000 fall in market value of each shareholder’s shares and a discount of $100,000 was given on the issue of options to each shareholder. The total decrease in market value of each shareholder’s down interests was equal to the total discounts given on the issue of their up interests. The issue of the options was a neutral shift under section 725-220 for each shareholder in the company because the total decrease in market value of their shares was equal to the total discounts given on the issue of their options. There is no requirement for the interests to be of the same kind. Date of decision: 29 August 2003



¶12.039 Direct value shift involving a debt interest in a company

The ATO issued ID 2003/247 dealing with debt interests in a company. The ID illustrates the application of the requirement under sec 725-210 that the consequences for a “down interest” also depend on whether it has a “pre-shift gain” or a “pre-shift loss”.

Note, secs 725-205 and 725-210 are the general provisions dealing with the consequences of a DVS and must be read with Subdivision 725-D which contain the tables setting out the consequences for each asset affected.

The relevant parts of ID 2003/247 are as follows:

Issue

For the purposes of Division 725 of the Income Tax Assessment Act 1997 (ITAA 1997), is there a pre-shift loss for a debt interest that decreases in value under a scheme if, immediately before the decrease, the market value of the debt interest was equal to its cost base and reduced cost base?

Decision

Yes. Subsection 725-210(3) of the ITAA 1997 provides that an interest has a pre-shift loss if, immediately before the decrease time, its market value was equal to, or less than, its adjustable value. As a result, there will be consequences for the adjustable value of the debt provided the other threshold conditions mentioned in Division 725 are satisfied.

Facts

The market value of a debt owed by a company is equal to its cost base and reduced cost base. Something is done under a scheme involving interests in the company that causes a decrease in the market value of the debt and an increase in the market value of shares in the company.


Where there is a direct value shift involving interests in an entity under a scheme, and the tests in sections 725-50 and 725-70 of the ITAA 1997 are satisfied with respect to a particular individual, there may be consequences for interests that the individual holds that reduce in value because of something done under the scheme (‘down interests’). For a ‘down interest’ that is not held as a revenue asset or held as trading stock, these consequences are worked out by referring to the tables in sections 725-245 and 725-250 of the ITAA 1997. Some of the items in the table in section 725-250 of the ITAA 1997 identify particular consequences for down interests having pre-shift losses. Whether an interest has a pre-shift loss depends on the relationship between the market value of the interest, immediately before the decrease time when the interest decreases in value, and its adjustable value (for example, cost base). Where an interest has more than one adjustable value, the existence of a pre-shift loss is determined for each of those values. Subsection 725-210(3) of the ITAA 1997 provides that an interest has a pre-shift loss if, immediately before the decrease time, it has a market value that is equal to or less than its adjustable value. So where a debt decreases in value under a scheme, and immediately before the decrease time its market value is equal to its cost base and reduced cost base, it has a pre-shift loss for each of those adjustable values.


Selling a Small Business – The CGT Strategies As a result, if the value is shifted to another interest of the individual’s or to an interest that is held by another affected owner, items 5 and 7 in the table in section 725-250 of the ITAA 1997 are applied to work out reductions for the cost base and reduced cost base of the debt. Note: Where value is shifted from a debt interest that is held as a revenue asset or as trading stock, a similar table in section 725-335 of the ITAA 1997 is applied to work out reductions for the interest’s adjustable values (including adjustments to cost base and reduced cost base). Date of decision: 18 February 2002

¶12.040 DIRECT VALUE SHIFTS INVOLVING CREATED RIGHTS OVER NON-

DEPRECIATING PROPERTY

Division 723 greatly expands and extends former Division 139 (Value shifting through debt forgiveness). The former Division was limited to debt forgiveness between companies under common ownership. The proposed Division applies to any entity, that is individuals and partnerships, not just to companies and trusts holding non-depreciating property with the potential for either CGT and/or revenue gains. This means that it will no longer be possible to assume that everyday transactions undertaken in relation to small/medium closely held entities or sole traders can be entered into without regard to their potential value shifting consequences.

The impact of the new rules will be particularly felt in the case of family discretionary trusts, as noted above.

To illustrate what might be a typical application of the rules to a company, the EM provides the following example:

Example 7.2

Fry Co owns land with a reduced cost base of $40 million and a market value of $45 million. Fry Co grants a 6 year lease to Jones Trust, an associate, for no premium and no rental is to be paid under the lease. The market value of the land decreases by $10 million to $35 million as a result of the creation of this right. Fry Co then disposes of its reversionary interest in the land to a third party in an arm’s length dealing for $35 million. This ensures Fry Co and its associate retain rent free use of the land for the 6 years, and that a capital loss of $5 million would but for the DVS rule be realised. However, economically, no loss has been suffered. This DVS rule denies Fry Co the $5 million capital loss. If Fry Co did not sell the land until after the 6 year period had expired, there would be no reduction to any capital loss made on its realisation because the right no longer affects its market value.

Division 723 thus applies whenever there has been a shifting of value from a non-depreciating asset held by an entity (individual, company, trust or partnership) by the creation of some right in respect of the asset for less than full market value. The tax consequences will arise at the time of full or part realisation of the non-depreciating asset.

By way of elaboration the EM states that:


Selling a Small Business – The CGT Strategies 9.3 If a right is created over an underlying asset in a related party (e.g. an associate) and either no consideration, or less than market value consideration, is received for the right, current tax law does not universally require that the market value of the right be used to determine the tax consequences of the creation. 9.4 For example, CGT event D1 (section 104-35 of the ITAA 1997) does not have the effect that capital proceeds equal to market value are taken to have been received in circumstances where a right over an underlying asset is created in an associate and no capital proceeds are actually received in return for the right. Also, if a lease is granted and the lease premium for CGT event F1 is less than the market value of the lease, the market value substitution rule in the CGT provisions does not deem the market value to have been received (see section 116-25).

Only the $50,000 de minimis exception will apply to exclude its application where the under value is less than that amount, which means that most minor transactions will be excepted from the application of the Division, but not necessarily from Part IVA. The provision of a $50,000 threshold will mean that in practice it will be difficult for the ATO to claim that the Division applies, especially in cases where some consideration is provided. This is because the issue will involve difficult valuation questions for rights where, in many cases, no objective market values can be obtained.

It is of interest to note that the Division does not apply where the non-depreciated asset is actually disposed of for a gain, or where the market value of the affected asset is not reduced by the existence of the created asset at the time of realisation.

There are some additional important exclusions. For example, rights created by will or codicil in relation to a non-depreciating asset or under intestacy laws are excluded. Also excluded are rights arising in respect of conservation covenants over the land.

Also, if a gain is realised in respect of a right created within four years of the underlying asset being realised, the reduction of the loss in respect of the underlying asset is able to be reduced by the amount of the gain. This relief only applies where the underlying asset is realised at the time of the right being created. In such cases, it would be necessary to seek an amendment to the return in respect of the income year in which the realisation of the underlying asset was made (see sec 723-15(3)).

Whilst creating rights over depreciating property would seem an obvious way to avoid the rules, in practice there is likely to be little opportunity or purpose in undertaking such a transaction for tax reasons.

¶12.050 INDIRECT VALUE SHIFTS

For the most part Division 727 dealing with IVS will not affect small/medium entities where either the entity is eligible to be an STS or would otherwise qualify for the small business CGT concessions. With the introduction of the Consolidations regime, for those small/medium groups that consolidate, IVS is simply not an issue because under the Consolidation regime intra-group asset transfers have no tax impact. Otherwise, provided assets are dealt with at arm’s length within a group, IVS will not be a problem.

The main purpose of the IVS rules is to ensure that groups that do not consolidate are not able to gain advantage through intra-group asset transfers by, for example, generating capital losses. The IVS rules also apply in relation to wholly owned and non-wholly owned entities of non-consolidated groups and non-wholly owned entities of consolidated groups. This represents a significant change under the new IVS rules. Former Division 138 only applied to entities that were wholly owned. The new IVS rules will apply to entities that are at least 80% owned.

As noted above, the IVS rules apply to fixed and non-fixed trusts.


Selling a Small Business – The CGT Strategies The EM sets out a summary of when an IVS takes place:

An indirect value shift occurs if:

• economic benefits are provided by one entity to another (whether or not it receives anything in return) ‘in connection with’ a scheme;

• the entities are not dealing at arm’s length;

• the market value of the benefits received is not equal to the market value of the benefits provided, such that there is a losing entity and a gaining entity;

• the losing entity must be either a company or a trust (except certain superannuation entities); and

• the gaining entity can be any kind of entity.

The EM provides the follow example of an IVS:

Example 7.3

Down Co transfers an asset with a market value of $300,000 to the Up Trust in return for a single cash payment of $100,000, in a non-arm’s length dealing. Ming owns all of the shares in Down Co and all the interests in Up Trust. As a consequence, the market value of Ming’s shares in Down Co has declined by $200,000 and the market value of her interests in Up Trust has increased by $200,000. There has been an indirect value shift of $200,000 from Ming’s shares in Down Co to her interests in Up Trust.

¶12.051 Mixed group shifts, for example units/shares

The new IVS rules can apply to a value shift in a group where, for example, the value of units in a unit trust held in a group entity causes shares in another entity in the group to increase or vice versa.

¶12.052 Land transferred at cost

ID 2003/89 deals with the transfer of land at cost and is of interest because it was one of the first IDs issued on the new value shifting regime. The operative parts of the ID are reproduced below:

Issue

Does the exclusion from the indirect value shifting rules in section 727-220 of the Income Tax Assessment Act 1997 (ITAA 1997) (for the transfer of an asset for at least its cost) apply, when land is transferred at cost and the cost is more than the market value of the land?

Decision

No. The exclusion in section 727-220 of the ITAA 1997 does not apply when land is transferred for more than its market value, because value does not shift from the transferor of the land to the transferee.

Facts

Company C controls both company G and company L. There is no entity that controls company C. A non arm’s length transaction was entered into after 30 June 2002 under which company G transferred land held on capital account to company L for $10 million. At


Selling a Small Business – The CGT Strategies the time when company G transferred it to company L, the land's cost base was $10 million and its market value was $8 million. All of company C’s interests in company G were acquired before company G acquired the land that was transferred. Company C is the only affected owner (under Division 727 of the ITAA 1997) of company G.


An indirect value shift (IVS) may have consequences under section 727-100 of the ITAA 1997 when the losing entity is a company or trust, the losing and gaining entity are controlled by the same entity or they have common owners and they were not dealing at arm’s length in providing some of the benefits. If an IVS has consequences, it may result in the reduction of realised losses or gains, or in adjustments to the tax values of interests in the entities that have gained or lost value as a result of the IVS. Pursuant to section 727-150 of the ITAA 1997 there will be an IVS when the market value of economic benefits provided by one entity (the losing entity) to another entity (the gaining entity) exceeds the market value of benefits provided by the gaining entity in connection with a scheme. The benefits provided by the losing entity are referred to as the ‘greater benefits’. An IVS will have no consequences under section 727-220 of the ITAA 1997 if the following requirements are satisfied:

• The greater benefits must consist entirely of:

• the losing entity transferring a CGT asset to the gaining entity; or

• a right to have the losing entity transfer an asset to the gaining entity.

• There must be lesser benefits and, at the time of the IVS, the total market value of the lesser benefits must not be less than the greatest of:

• the asset’s cost base at that time

• the asset’s cost

• the asset’s market value immediately before the most recent time an affected owner has acquired a direct or indirect equity interest in the entity, since the entity acquired the asset.

If section 727-220 of the ITAA 1997 were to apply in this case, the IVS would have no consequences for company C's equity interests held in company L and company G. In this transaction, company L (the losing entity) has provided $10 million consideration (the greater benefits) to company G (the gaining entity) for land valued at $8 million (the lesser benefits). Section 727-220 would not apply in relation to the transfer of the land, because the ‘greater benefits’ do not consist of the losing entity transferring land to the gaining entity. The exclusion in section 727-220 does not apply to the transfer of the land for more than its market value, because value has not shifted from the transferor of the land to the transferee. As a result, the IVS will be covered by Subdivision 727-F of the ITAA 1997 if no other exclusion applies. Date of decision: 17 September 2003

¶12.060 PART IVA

As noted above, the introduction of the GVSR will not displace the potential application of the general anti-avoidance provision, Part IVA, though where the GVSR applies to adjust


Selling a Small Business – The CGT Strategies assessable income, or otherwise requires cost base or other adjustments, Part IVA would not be applied.

An interesting point to note is that although the GVSR is by name a “general” integrity regime in the same way as Part IVA is a general anti-avoidance rule, from a legal interpretational point of view, the GVSR is in fact specific in that it will apply only to a specific area of activity, unlike Part IVA. In terms of priority, the GVSR will apply first because it has automatic application. Where its application has no tax consequences, for example the value of a DVS in question is below $150,000, Part IVA may still then be theoretically applied. Given that under the so-called New Business Tax System, with the introduction of a number of specific “integrity” provisions less reliance is being placed on Part IVA, it may reasonably be assumed that Part IVA will not be applied by the ATO in every case where the new integrity rules are not triggered.



Chapter 13

Extension to Part IVA

¶13.000 EXTENSION TO PART IVA

¶13.001 Further amendments

¶13.002 Small business structures

¶13.003 Income to capital

¶13.000 EXTENSION TO PART IVA

As part of the introduction of the new CGT regime, Part IVA was amended with a view to ensure that taxpayers will not seek to enter into schemes designed to take advantage of the reduction in the effective rate of CGT. New sec 177C(4) and (5) have been added by the Other Measures Act (see item 20A of Schedule 9), added during the course of debate in the Senate. The provisions provide as follows and apply from 21 September 1999:

177C(4) [Application of para (1)(a) to schemes]

To avoid doubt, paragraph (1)(a) applies to a scheme if:

(a) an amount of income is not included in the assessable income of the taxpayer of a year of income; and

(b) an amount would have been included, or might reasonably be expected to have been included, in the assessable income if the scheme had not been entered into or carried out; and

(c) instead, the taxpayer or any other taxpayer makes a discount capital gain (within the meaning of the Income Tax Assessment Act 1997) for that or any other year of income.

177C(5) [General application of Part]

Subsection (4) does not limit the generality of any other provision of this Part.

It is not entirely clear whether these provisions have had any particular impact. Arguably, the provisions have no effect where income is converted into a discount capital gain since the discount capital gain will be brought into the income of the taxpayer in any event. Given the circumstances of the introduction of the provisions, the Government did not think that the provisions were necessary to protect the revenue and the amendments were “forced” on the Government by the combined Opposition parties.

¶13.001 Further amendments

However, the Treasurer announced in his Press Release issued on 11 November 1999 proposals to further amend Part IVA, detailed at Attachment D to the Press Release. The changes flow from Recommendations 6.3 to 6.5 of the Ralph Report and will provide an improved “reasonable hypothesis” test and an expanded concept of “tax benefit”. They will also enable the Commissioner to issue a single determination in respect of a scheme.

These changes were originally intended to operate as from 11 November 1999 but it has since been indicated that they will only operate as from the time the relevant legislation is introduced (see Australian Tax Handbook 2003, ATP, para 44 090).


Selling a Small Business – The CGT Strategies The original announcement also indicated that the expanded concept of “tax benefit” will require a consistent penalty structure to apply to all forms of tax avoidance. At present the penalty regime applies only to tax benefits that result in less tax being paid, but not to losses that have been crystallised but not utilised.

The proposed change to the “reasonable hypothesis test” is intended to provide legislative guidance to the Commissioner as to what is a reasonable hypothesis. This rather begs the question as to exactly what the change will be to the current provision. It must be assumed that the change will seek to expand the Commissioner’s powers further rather than merely to clarify them. It is understood that what is intended is that taxpayers will not be able to argue that there was no benefit in that, had they not entered into the scheme, they would have paid no tax – the so-called “counter factual” argument.

Perhaps the most alarming of the proposed changes to Part IVA announced on 11 November 1999 is the proposal to permit the Commissioner to make a single determination in respect of a scheme. This will permit the Commissioner to outlaw any scheme by simply issuing a Ruling or Taxation Determination or even making an announcement by Press Release that a particular arrangement is a scheme to which Part IVA applies.

While previously the Commissioner has, from time to time, issued rulings or press releases seeking to do this, for example split loans, the application of Part IVA in such cases very much depended upon the circumstances of individual taxpayers. In the split loans ruling the Commissioner sought to focus on the intention of the relevant financial institution offering the loan facility. It has been far from clear whether this approach would be effective where it could be shown that the sole or dominant purpose in entering into the scheme was not tax related.

¶13.002 Small business structures

The changes to the CGT regime that have been made need to be considered closely to determine their effect on particular entities and individual structures.

With some of the changes, for example the discount capital gains concession for individuals and the 50% small business reduction, there is a strong incentive for some businesses to restructure to enable them to benefit from these and other changes. Clearly such a restructuring would be a scheme for the purposes of Part IVA ITAA 36 and may be liable to be attacked by the Commissioner.

At the National Tax Liaison Group – CGT Subcommittee meeting of 7 June 2000 the ATO indicated that most straightforward structural changes would be likely to be left intact by the ATO. The ATO at the meeting referred, by way of illustration, to the approach in TD 95/4 in which the ATO had indicated that of itself the simple disposition of an income-producing asset by a natural person to a wholly-owned private company is not an arrangement to which the Commissioner will seek to apply Part IVA, but other factors may alter his view. This Determination was issued at the urging of a number of professional bodies to provide guidance to taxpayers following a reduction in the company tax rate from 39% to 33%.

¶13.003 Income to capital

With the reduction of the effective rate of CGT for individuals there will also be considerable incentive for individuals to seek to take advantage of this change by seeking to convert what might otherwise be income into capital. What needs to be remembered is that since the introduction of the CGT regime, the courts have shifted ground on the income/capital distinction and on schemes to convert income streams into capital as the High Court’s decision in FCT v Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 illustrates.

For many small businesses to take advantage of the lower effective CGT rate for individuals, all that needs to be done is to make use of negative gearing to acquire active assets such as commercial premises, rather than to embark upon a potentially risky restructuring. Income tax


Selling a Small Business – The CGT Strategies can be effectively minimised by such investments held personally, and, by availing oneself of the CGT concessions, most or all of any ultimate capital gain on the disposal of the asset will be free of tax.

At this stage there is no suggestion that Part IVA would, or indeed could, apply to such a strategy. However, if income-producing assets presently held in an operating entity are shifted into the individual controller’s name, there is a risk that the ATO may no longer treat the operating entity as an income-producing entity.

The ATO may seek to assess the controller in respect of the entity’s income as being income from personal exertion in accordance with IT 2121 and related rulings.

The ATO continues to focus on aggressive tax planning and for this reason extreme care needs to be taken in relation to any sale of business transaction where tax considerations need to be taken into account. In the High Court decision in Commissioner of Taxation v Consolidated Press Holdings Ltd & Ors [2001] HCA 32 the Court confirmed that in applying the general anti-avoidance provision, Part IVA (ITAA 36), the purpose of the taxpayer’s tax advisers may be taken into account in determining relevant purpose in relation to a scheme. The High Court also confirmed that the existence of a commercial or other purpose along with a tax purpose is not in itself sufficient reason to conclude that the scheme will not be caught by the provisions. These conclusions mean that extreme care now needs to be exercised in advising taxpayers.

The ATO’s recent initiative of issuing “Investor Alerts” to deal with aggressive tax schemes also needs to be kept in mind. Investor alerts are posted on the ATO’s website (www.ato.gov.au). Note Taxpayer Alert TA 2003/3 dealing with avoidance of CGT utilising a trust structure. The relevant parts of this Alert are reproduced below:

This Taxpayer Alert describes an arrangement involving the sale of capital gains tax (CGT) assets. The arrangement seeks to ensure that on the sale of the CGT assets to an arm’s length party the taxable capital gains are streamed to a tax preferred entity, such as a charity, whilst the original owners of the assets receive the sale proceeds free of any CGT liability. DESCRIPTION The alert applies to arrangements having the following features:

1. Assets owned by an individual or under a partnership or trust structure are disposed of to a special purpose company (‘SPC’). Roll-over relief is claimed under Division 122 of the Income Tax Assessment Act 1997 (‘ITAA 1997’).

2. A ‘bare’ trust (First Trust) is created over the SPC assets with the sole beneficiary of the trust being the SPC. The trust deed allows further beneficiaries to be appointed with the consent of the original beneficiary. First Trust is a discretionary trust but is referred to as a hybrid or convertible trust.

3. SPC consents to the trustee appointing new beneficiaries of the First Trust which are trustees of other trusts and may be associates of the promoter of the arrangement.

4. A second trust is created (Second Trust) of which the beneficiaries are the original owner/s of the assets. The assets are then sold to this Second Trust for a nominal amount. However, the promoter argues that this sale for CGT purposes is deemed to have occurred at market value. This means that the First Trust has a deemed capital gain and the Second Trust acquires the assets with a market value cost base.

5. The Second Trust sells the assets for market value to a third party purchaser.

6. The Second Trust claims to have no taxable capital gain and distributes the sale proceeds (after deducting the promoter’s fees) to the original owners in an arguably tax free manner, for example, as a loan or capital distribution.


Selling a Small Business – The CGT Strategies 7. The First Trust returns the deemed assessable capital gain and distributes this to the

newly appointed beneficiaries, which in turn distribute this income to a beneficiary which has significant capital losses or is tax exempt such as a charity. No funds are actually received by the charity or other beneficiary.

FEATURES WHICH THE ATO CONSIDERS GIVE RISE TO TAXATION ISSUES The ATO considers that the arrangement outlined above gives rise to taxation issues which include:

(a) Whether the initial disposal to SPC is an effective rollover under Division 122 to defer the making of a capital gain;

(b) Whether the declaration of trust over the SPC assets is a CGT event under Division 104 of the ITAA 1997;

(c) Whether the appointment of new beneficiaries to the First Trust results in a new trust being created;

(d) Whether the amounts received on the disposal by the Second Trust are assessable as ordinary income under section 6-5 of the ITAA 1997;

(e) Whether the entity which ultimately derives the deemed capital gain is exempt from tax or has deductible losses;

(f) Whether Part IVA of the ITAA 1936 applies as:

i. the arrangement seems artificial and lacks an ordinary business purpose in its design and execution; and

ii. it appears the dominant purpose of entering the arrangement is to provide tax relief to the original owners of the asset. The owners avoid an assessable capital gain upon subsequent sale to an arm’s length third party.

The Australian Taxation Office is examining these arrangements. Date of Effect: 24 June 2003

The above arrangement contrasts with the comments made at the 11 June 2003 National Tax Liaison Group – CGT Subcommittee meeting where it was said:

The ATO noted that there was a potential for the application of Part IVA in the context of demergers and the CGT small business concessions – where the taxpayer is required to make choices there is the possibility that those choices may attract Part IVA. The ATO noted that Part IVA was designed so that arrangements of a normal business or family kind, including those of a tax planning nature, will be beyond the scope of Part IVA. In this context, demergers and the CGT small business concessions were put in place to advance business and promote economic activity and the purpose of both measures was to give concessionary tax treatment where basic conditions were satisfied. The ATO advised that its focus would be to look at arrangements from a practical family or normal commercial perspective, and, if the arrangements are entered into for normal family or commercial purposes there would not be any Part IVA implications. In some cases, it may be difficult to draw the line on the reasons for entering into demerger arrangements, but the emphasis will be on the way the demerger is carried out.


Selling a Small Business – The CGT Strategies Mr Davies suggested that a paper outlining a number of scenarios be prepared and that any issues or concerns could be outlined in that paper and provided to the subcommittee for a decision to be made as to the best way of disseminating these issues. With respect to Part IVA and making choices in relation to concessions offered by the Act, the ATO made reference to the comments of Lockhart J. in Pettigrew v. FCT 90 ATC 4124 at p.4126 as being helpful. His Honour said: ‘This principle [was] an attempt to reconcile the general provisions of section 260 with the numerous specific and particular provisions of the Act, reliance upon which by a taxpayer may alter the incidence of income tax or defeat a liability to income tax which would otherwise arise. ...If the taxpayer [did] no more than is specifically permitted by the relevant section of the Act there [was] no room for the operation of s.260. Resort to the “choice principle” is denied by sec.260 where a situation is devised to gain the advantage of a particular section of the Act which has no sensible or practical basis or justification in a business or family sense, and where resort to the section is for the purpose or purposes which include the purpose of conferring a tax benefit upon the taxpayer such that it is a misuse of the section or of the benefits which it is designed to confer on those who legitimately resort to it. If in all the circumstances the use of the specific or particular provision of the Act warrants the description of an “abuse” of it...sec.260 will apply.’

As noted at ¶5.040 above, in ID 2003/505 the ATO confirmed the retirement exemption is available in a case where the taxpayer, a sole trader, sold a commercial property used in his business to his super fund and then directed that the proceeds be paid back into the fund. The ID considers that Part IVA would not be applied in such a case. This ID suggests that in most cases where taxpayers are simply applying the concessions to their particular circumstances, Part IVA should not be an issue.

See also TD 2003/3, which considers the application of Part IVA to a complex arrangement designed to avoid CGT in a non-consolidated corporate group.



Chapter 14

ATO’s compliance program for 2004–05

¶14.000 ATO’S COMPLIANCE PROGRAM FOR 2004-05

¶14.010 CGT AUDIT CHECKS

¶14.011 Record keeping

¶14.012 Oral evidence

¶14.013 Obtaining valuations

¶14.014 Tax advice records

¶14.000 ATO’S COMPLIANCE PROGRAM FOR 2004-05

The release of the ATO’s Compliance Program for 2003–04 in early January 2004 was a timely reminder that the ATO is always potentially in the background ready to scrutinise transactions that may impact on the Revenue. The recent release of the Compliance Program for the current year, which can be accessed on the ATO’s web site, provides some detail as to the kinds of matters that it is interested in at present and once again there is a focus on capital gains.

The 2003-04 Program stated in regard to CGT:

We continue to focus on capital gains tax planning, which is often associated with a business event such as a restructure, merger, acquisition or disposal of a business or asset. We have concerns about arrangements involving complex structures and intra-group transactions that are seemingly designed to shield real capital gains from tax. Some arrangements include exploitation of the capital gains tax rollover provisions.

This statement follows previous reports in the press indicating that the ATO will be targeting CGT as a major tax audit focus. See for example ATO Guns For Schemes To Minimise CGT Liability, AFR 14 November 2002, p 3.

Normally the ATO will be made aware of liability for CGT arising in relation to the sale of a business or business assets at the time a return is lodged, indicating that the taxpayer has disposed of a CGT asset or assets. The ATO is not, of course, dependent upon a taxpayer disclosing in his/her income tax return that a CGT asset has been disposed of. With GST, the ATO may become aware of a change in a taxpayer’s circumstances through changes in the quarterly or monthly BAS, or indirectly though contact with the ATO by a buyer of the business seeking, for example, a private ruling, or through ASIC or land titles records. This year the ATO is conducting increased audit activity in relation to GST in connection with the sale of business assets. It goes without saying that where a business has been contacted by the ATO under this program, care needs to be exercised to ensure that the business’ CGT obligations have been properly discharged.

At the National Tax Liaison Group – CGT Subcommittee meeting held on 27 November 2002 the ATO informed the participants of the CGT and GST survey that was proposed to be conducted. A copy of the detailed questionnaire is reproduced at Appendix 3. An update on the matter was provided at the 11 June 2003 meeting in the following terms:


Selling a Small Business – The CGT Strategies Mr Allen (ATO) informed the subcommittee that the small business CGT questionnaire which was issued by the Hobart branch of the ATO was developed to gauge the impact of the small business CGT concessions on taxpayers, and the level of understanding of the measures in the community. Preliminary findings were disappointing as to the accuracy of claims made, with no proper calculation of the net gain or whether the entity qualifies for the concessions the result in many cases. As a result, several cases are now to be the subject of specific issue audit in respect of their concessions claims. There have been two primary areas of risk identified from the responses. The primary risk is whether the subject entity qualifies under the $5 million net asset test. The other major risk area is retirement exemption claims. Further analysis and sampling is planned, together with increased compliance focus on these claims. The ATO agreed to examine publications and website materials on the small business concessions to see what else could be done to assist taxpayers and their advisors to increase awareness in this area. The ICAA and CPA Australia are to provide a list of basic questions on which they are receiving phone calls, to assist in the development of these materials.

The Minutes also note: …[t]hat there will be an increased compliance focus on capital gains in response to a number of issues that have been noted over recent years. It appears that aggressive capital gains tax planning advice has increased in recent years from all levels of the tax industry. The ATO intends to combat aggressive tax planning arrangements. The ATO has been given additional funding for compliance risk work.

¶14.010 CGT AUDIT CHECKS

This section seeks to bring together common sense matters that should be noted and/or attended to in the course of a sale of a business to ensure that, in the event of an enquiry by the ATO following the sale, the taxpayer is able to appropriately answer any ATO query.

¶14.011 Record keeping

Have adequate records been kept of the sale transaction that explain the transaction bearing in mind that an ATO enquiry may be some years after the event?

Adequate records include the relevant contract for sale documents, valuations obtained, requests for advice, copies of advice obtained and copies of any title documents of CGT assets transferred.

The transaction records should be kept together and retained indefinitely irrespective of the record keeping time limits. In any event sec 121-25 ITAA 97 provides that records must be retained until the end of five years after it becomes certain that no CGT event can happen, such that the records could reasonably be expected to be relevant to working out whether you have made a capital gain or loss. The obligation here is a broad one and it will not always be clear when it has expired. Failure to retain CGT records is an offence. By sec 121-25(2A) it is a “strict liability” offence, meaning that the offence is still committed even if the loss or failure is unintentional. It is uncertain whether there has ever been a prosecution for failing to keep CGT records, however, the real penalty is likely to be an adverse assessment with the usual heavy onus on the taxpayer to establish that the assessment is excessive. Without records, this will be almost impossible. Failure to keep records may also impact on the level of culpability penalties that the ATO determines are applicable in a particular case.


Selling a Small Business – The CGT Strategies Another reason for keeping CGT records indefinitely is that if a purchaser’s records become lost or destroyed, a vendor may be able to assist the purchaser, with or without an appropriate fee.

For advisers, the keeping of transaction records on behalf of clients can be one way of ensuring that they are retained, although there are likely to be storage costs involved. These costs may be outweighed where clients can be retained.

The general time limit for CGT records can be abrogated if the ATO notifies the taxpayer that records are no longer required to be kept or in the case of a company, it has finally been dissolved, see sec 121-25(4).

¶14.012 Oral evidence

Oral evidence of the existence of a trust may be sufficient in some cases, for example, where the parties involved have acted consistently with the existence of a trust. In many such cases this won’t be the case if, say, no trust tax returns have been lodged. If, say, shares in a company are held in trust for a spouse by the other spouse, the absence of returns would not be fatal although, ultimately, they may be necessary to convince the ATO that the trust exists.

If documents have been lost, this will not necessarily be fatal for CGT purposes. For example, if a trust deed or company memorandum and articles cannot be located at the time of sale it may be desirable to make a record of the oral evidence of their contents. This could be in the form of a memorandum or, better still, a statutory declaration made at the time of the sale.

¶14.013 Obtaining valuations

The need for valuations can be critical for CGT purposes. TD 10 deals with valuations for CGT assets. It provides:

Capital Gains: What are acceptable valuations for CGT purposes?

1. Where the “market value” of an asset needs to be determined, taxpayers can choose to:

(i) obtain a detailed valuation from a qualified valuer; or,

(ii) compute their own valuation based on reasonably objective and supportable data.

Capital Gains: What are acceptable valuations for CGT purposes?

Example:

A taxpayer owns a unit in a block of 10 units and needs to obtain its market value for CGT purposes.

The taxpayer chooses not to approach a qualified valuer in this case.

A valuation based on contemporaneous sales of similar units in that block of units would be acceptable. Note: The ATO may challenge valuations where appropriate.


10 September 1991

Where transactions are not at arm’s length, it may pay to obtain a valuation from a qualified valuer or at least other independent evidence of valuation.



¶14.014 Tax advice records

In the case of the CGT small business concessions in particular, there is, of course, much room for interpretational differences. Often the only record of the reason why a particular amount of CGT has been returned will be found in written tax advice. The advice may take many forms from short memos to formal opinions of counsel. Obviously where there is no record of advice having been provided, the ATO investigator will be able to make up his/her own mind as to what has happened. For example, if the taxpayer’s return for the relevant income year shows that there was no relevant CGT event or that there was no capital gains from the event, it would be open to the ATO investigator to conclude that it is a case of non-disclosure of income resulting in tax evasion. If the taxpayer or his/her adviser can produce a relevant contemporaneous record of advice to establish why there was no income returned or why there was no CGT event, this may satisfy the ATO or at least eliminate the possibility that the matter will be dealt with as tax evasion.

It will depend on the circumstances of the case whether a copy of the advice and any accompanying written request should be made available to the ATO, or whether legal professional privilege, or confidentiality in the case of advice from an accountant of tax agent, should be claimed. Guidelines prepared in conjunction with the relevant professional bodies have been issued by the ATO in relation to claims for privilege or client confidentiality. As a general rule, however, where relevant advice has been obtained that can be offered to the ATO to establish the basis for the taxpayer’s treatment of relevant transactions, it is more likely that the ATO will be sympathetic to the taxpayer’s cause. It goes without saying that advisers need to obtain their client’s consent before providing the ATO with copies of any advice they may have, whether or not it has been prepared by them.



Chapter 15

Case studies

¶15.000 CASE STUDIES – INTRODUCTION

¶15.010 CASE STUDY 1 – BUSINESS THROUGH FAMILY DISCRETIONARY TRUST

¶15.011 Answer − Pre-Ralph

¶15.012 Position under the new CGT regime

¶15.020 CASE STUDY 2 – HUSBAND AND WIFE BUSINESS PARTNERSHIP



¶15.030 CASE STUDY 3 – MORE THAN ONE BUSINESS HELD

¶15.031 Question 3(a)

¶15.032 Question 3(b)

¶15.033 Question 3(c)

¶15.034 Question 3(d)

¶15.035 Question 3(e)

¶15.040 CASE STUDY 4 – SOLE TRADER




¶15.050 CASE STUDY 5 – GRAZING PARTNERSHIP – LAND HELD BY ONE PARTNER




¶15.060 CASE STUDY 6 – SOLE TRADER – STATEMENT OF TERMINATION PAYMENTS SCHEDULE



¶15.070 CASE STUDY 7 – COMPANY BUSINESS RENTING PROPERTY HELD BY SHAREHOLDER




¶15.080 CASE STUDY 8 – APPLYING ROLL-OVER RELIEF



¶15.090 CASE STUDY 9 – TRACKING RETIREMENT EXEMPTION FUNDS THROUGH SUPER FUND

¶15.100 CASE STUDY 10 – USING ROLL-OVER TO REORGANISE OPERATING ENTITY

¶15.110 CASE STUDY 11 – PART SALE BY PARTNERSHIP

¶15.120 CASE STUDY 12 – FARMING PARTNERSHIP – RETIREMENT PLANNING

¶15.130 CASE STUDY 13 – SALE OF BUSINESS BY PARTNERSHIP – CONTINUED EMPLOYMENT

¶15.140 CASE STUDY 14 – VARIATION OF PARTNERSHIP

¶15.150 CASE STUDY 15 – SHAREFARMING AGREEMENT WITH COMPANY

¶15.160 CASE STUDY 16 – PRE-CGT PROPERTY ACQUIRED BY WIDOW LEASED TO PARTNERSHIP

¶15.170 CASE STUDY 17 – HUSBAND AND WIFE PARTNERSHIP PROPERTY ROLL-OVER

¶15.180 CASE STUDY 18 – FARM HELD AS JOINT PROPERTY WITH SHARE FARMING AGREEMENT LATER ESTABLISHED WITH FAMILY DISCRETIONARY TRUST

¶15.190 CASE STUDY 19 – SPLITTING FAMILY PROPERTIES

¶15.200 CASE STUDY 20 – FAMILY DISCRETIONARY TRUST CONDUCTING FARMING OPERATIONS

¶15.210 CASE STUDY 21 – SOLE TRADER – AVAILABLE OPTIONS

¶15.220 CASE STUDY 22 – FAMILY DISCRETIONARY TRUST WITH LAND HELD BY FAMILY MEMBERS

¶15.230 CASE STUDY 23 – FIVE-PERSON PARTNERSHIP

¶15.240 CASE STUDY 24 – RENTAL PROPERTY BUSINESS OPERATED BY COMPANY

¶15.250 CASE STUDY 25 – SALE OF COMPANY SHARES

¶15.260 CASE STUDY 26 – SALE OF CHILD CARE CENTRE

¶15.270 CASE STUDY 27 – SALE OF MEDICAL PRACTICE COMPANY

¶15.000 CASE STUDIES – INTRODUCTION

These case studies are drawn from actual cases, many of which have a primary production character. The comments are intended to be indicative only of the operation of former Division 17B and Division 17A ITAA 36 and the new Division 152 ITAA 97 and are not to be taken as definitive advice on the tax consequences of each case.

The appropriate course for individual taxpayers will depend on many factors, such as their age at the time of sale, the amount of existing super contributions and their future intentions.

The comments on the case studies should be read together, as comments made in relation to one case study may also be applicable to another case study.


Selling a Small Business – The CGT Strategies Note that before the introduction of Division 152 with effect from 21 September 1999, the Divisions 17A and 17B had been overtaken by Division 123 and Subdivision 118-F, respectively, under the CGT rewrite. These provisions did not substantially alter the law.

Note: Where action is taken to rearrange affairs to take advantage of Division 152, care needs to be taken to ensure that Part IVA does not have potential application. Although not likely where, for example, a trust entity is abandoned as the business entity, the application of Part IVA could be clearly applied in such a case where care was not taken to establish a new business.

¶15.010 CASE STUDY 1 – BUSINESS THROUGH FAMILY DISCRETIONARY

TRUST

Husband and wife, 59 and 50, operate a business through a family discretionary trust. The beneficiaries under the trust are the husband and wife and their three adult children.

For the last three years the husband and wife have each received 50% of the trust distributions. The business was started from scratch by the husband and wife 10 years ago. They have both been employed by the trust for the 10-year period during which the business has operated.

The husband has a rental property worth $150,000.

The assets of the business include plant and equipment worth $50,000 and debtors and loans worth $202,000.

The liabilities of the business are an overdraft of $110,000 and a loan of $115,000, creditors and sundry, $20,000.

The husband wants to retire and has accumulated superannuation contributions of $280,000. The wife has accumulated superannuation contributions of $120,000. They can sell the business for $300,000 with $250,000 for the goodwill.


This case illustrates that the retirement exemption may not always be the best option.

It is assumed that the business assets of the trust, as the relevant taxpayer (note that the assets of the husband and wife would be required to be aggregated individually with the trust), are $5 million or less.

Since the husband and wife have only each received 50% of the trust distributions in the last three years, they would only qualify as “controlling individuals” for those three years. This means that the trust would be entitled only to a pro rata exemption. The legislation in such cases allows the taxpayer to determine the ownership period of the asset from the 1992/93 income year if this produces a better pro rata exemption. In this case the exemption available would be approximately 50% (i.e. three years/six years) of the $250,000 goodwill capital gain. Obviously, the longer the sale was delayed the greater the pro rata exempt amount would be.

As the wife is under 55, any payment from the CGT exempt proceeds of the sale would have to be paid into a superannuation fund or ADF or retirement savings account.

The husband could receive his share of the CGT exempt part of the proceeds totally tax free as he is over 55. It would be open to the husband and wife to agree to determine that the husband should receive the entire CGT exempt component from the trust as his ETP as this could be received tax free. The trust’s Division 17B election would need to specify in such a case that the husband’s exemption percentage is 100% and the exemption percentage for the wife would be 0%.


Selling a Small Business – The CGT Strategies Note that the exempt amount able to be received by the husband and wife would be well under the $500,000 lifetime exemption limit, and would not exceed their lump sum reasonable benefit limit (RBLs) (taking into account their existing super contributions).

Both the husband and wife would need to have their employment terminated by the trust to enable the trust to make the election to apply the retirement exemption. There is nothing in the legislation that would, however, require them not to work again or not to establish a new business.


The capital gain of approximately $250,000 on the goodwill of the business would be eligible for both the 50% individual discount gain and the 50% active asset reduction. The balance of the taxable gain of $62,500 could be received by the husband totally tax free under the retirement exemption. As he is over 55, he could receive the amount directly. As the wife is under 55 and would therefore need any ETP to be paid to her super fund, it would make sense for her to agree with her husband to receive this amount.

The 50% active asset reduction is available because the trust satisfies the basic conditions of eligibility. The four basic conditions are:





The retirement exemption will be available if the trust satisfies the four basic conditions and:

• the trust satisfies the controlling individual test (sec 152-50); and

• the trust conditions in sec 152-325 are satisfied.

The controlling individual test for a discretionary trust will be satisfied if an individual had received during the relevant income year (i.e. for the sale of the business) at least 50% of the total income distributions and was beneficially entitled to at least 50% of the capital distributions. In this example the husband and wife will be CGT concession stakeholders. There is no need to pro-rate the amount of the exempt amount under the new regime.

In order to satisfy the requirements of sec 152-325 ITAA 97 the trust must make an ETP to either the husband or wife or both within (the later of) seven days of the “choice” decision to apply the exemption, or seven days of the receipt of the capital proceeds.

Note that the exempt amount able to be received by the husband would be well under his $500,000 lifetime exemption limit, and would not exceed his lump sum RBL (taking into account his existing super contributions).

The distribution by the trust of the $150,000 “tax-free” amount of the capital gain after applying the discount exemption and active asset reduction would not be subject to any claw back under CGT event E4 (old sec 160ZM ITAA 36).

The sale of the plant and equipment has no CGT consequences assuming it is used wholly for business purposes. If the plant and equipment have been acquired prior to 11:45 am (ACT Time) 21 September 1999 and are disposed of after that time, the excess of disposal proceeds over the frozen indexed cost base (as at 30 September 1999) will be taxed as a balancing charge.



¶15.020 CASE STUDY 2 – HUSBAND AND WIFE BUSINESS PARTNERSHIP

Husband and wife, aged 42 and 40, have conducted a business as a partnership for the last eight years. There are no prior year capital losses and they do not have any other business investments.

The assets of the business are: stock $12,000, plant and equipment $5,000, goodwill $50,000, and debtors and other assets $110,000.

Their liabilities are an overdraft of $35,000, creditors of $70,000, and a loan of $20,000.

They can sell the business for $300,000 with $250,000 allocated to goodwill.

The partners do not wish to retire. The husband would prefer to work for wages, but the wife wishes to purchase a new business for herself.

Can the husband get relief under the retirement exemption whilst the wife gets roll-over relief for the new business?


Yes, assuming the husband and wife will otherwise qualify for the retirement exemption and the roll-over concession (the basic criteria for each concession are shared), it would be open to the husband to elect to benefit from the retirement exemption under Division 17B, and for the wife to elect to roll over her share of the capital gain, in respect of the goodwill, under Division 17A.

Each partner is able to obtain a separate concession because, as partners, the legislation treats each as separate taxpayers with the respective partnership interests being able to be dealt with as each pleases. This would not be the case if the business had been conducted through a company or trust.

The husband would have to pay his share of the sale into a super fund, ADF or retirement savings account as he is under 55.


Yes. The basic position remains unchanged under the new CGT regime but each would first be eligible for both the 50% individual discount gain and the 50% active asset reduction on their respective shares of the capital gains from the sale of the business of the partnership.

Assuming that the only capital gain arising from the sale of the business relates to the goodwill and that each is entitled to a half share, their respective capital gains would be approximately $125,000. Each would be eligible for both the 50% individual discount gain and the 50% active asset reduction (assuming eligibility under Division 152 in respect of the active asset reduction). Their respective gains would therefore be reduced to $31,250. The husband could choose to apply the retirement exemption and pay the amount into his super fund as he is under 55. He would pay no CGT on the sale.

Note that there is no contributions tax on the payment to the super fund.

The wife may roll over her remaining capital gain into another business or active asset and pay no CGT on the sale.

Note that, for the purpose of the maximum net asset value test, each partner is tested separately on their business asset. As the partners are spouses, their business assets are required to be aggregated to determine whether they have business assets of $5 million or less. Under the new regime, a residence is not required to be included in the $5m if business usage amounts to no more than use of a room as of a home office. If part of the residence is used for the business in circumstances where mortgage interest could be deducted in part (whether or not there is in fact a mortgage), the whole of the net value of the home would need to be counted as part of the business assets for the purpose of the $5m test.



¶15.030 CASE STUDY 3 – MORE THAN ONE BUSINESS HELD


If a person has three small businesses in three different companies can he/she “retire” from them at different times for the purposes of the retirement exemption?

Answer − Pre-Ralph

Yes.

Position under the new CGT regime

Yes. With the greater flexibility under the new regime, the taxpayer may wish to consider other options, for example making use of the discount gains and active assets reduction which will limit the taxable gains that may then be exempted under Subdivision 152-D.

The 15-year exemption, which operates from 20 September 2000, however, requires that an individual actually retire as a condition to obtaining the exemption.


What are the time limits?


There are no time limits. However, the maximum amount that can be exempt from CGT is $500,000 and, if the taxpayer is under 55 at the time of the sale, the exempt amount would need to be paid into a super or roll-over fund. This is a lifetime exemption and reduces each time an election is made under Division 17B by the amount of the CGT exempt amount.


New Subdivision 152-D does not alter the position here.


Can a person work again after they have “retired”?

Under what conditions?


Yes, there are no conditions, but care must be taken to ensure that the employment of a controlling individual of a company is actually terminated at the time at which the election is made.


The position has not changed, but note the answer to Question 3(b).

¶15.034 Question 3(d)

A person has two businesses in the one company. Can he/she retire from one business in preparation for retiring from the second at a different time?


Theoretically he/she could retire from the company at the time of the sale of the first business, but as his/her employment must actually be terminated at the time the company makes the election, extreme care would be needed to be exercised if he/she were to be later re-employed by the company prior to the sale of the second business by the company.

It is noted that, if the controlling individual is both an employee and a director of the company, the requirement for the termination of the employment of the person at the time of the first sale could be satisfied by simply terminating his/her common law employment, but not his/her directorship. At the time of the sale of the second business by the company it


Selling a Small Business – The CGT Strategies would be necessary to terminate the directorship of the controlling individual since he/she would only be a controlling individual, assuming he/she has a 50% or better interest in the company, by virtue of his/her directorship (employment is defined by the legislation to include a directorship).


Under Division 152, a controlling individual of a company does not need to be an employee or director but merely needs to hold the legal and equitable interests in at least 50% of the shares in the company. Nevertheless, to access the retirement exemption, an ETP needs to be paid in respect of the controlling individual, which assumes that there is a termination of an employment relationship. So it would be necessary to formally terminate any “employment” arrangement prior to making the ETP in respect of the sale.

¶15.035 Question 3(e)

A sole trader has a primary production property and a town business. He sells the property for retirement but cannot at the same time sell the town business. Can he still “retire” from the property and eventually the town business for the purposes of the retirement exemption?


Subject to the comments above, yes.


The position is unchanged

¶15.040 CASE STUDY 4 – SOLE TRADER

The taxpayer is a sole trader who has owned the business since 1993 and is 52 years old. She expects to receive $200,000, which will be all capital gain.

The taxpayer is a member of a self-funded superannuation fund established in 1996 with two members − husband and wife.

It is the intention of the taxpayer to sell the business, a licensed post office, and to look for employment or, failing this, to purchase other small businesses, until she is able to receive a pension from the super fund at age 55.


If the proceeds of the sale are invested for 12 months until employment is found or a new business is purchased, can the income from the investment be used for personal use without having to reimburse it and still claim the full exemption on the proceeds?


Yes, the income would be assessable as normal income. Until the election under either Division 17A or 17B there is no requirement to hold the sale proceeds in a special fund and the taxpayer is free to do with it what she likes. Obviously, if no election is made it will be subject to CGT (i.e. 50% of the amount would be taxable assuming the gain is goodwill). The elections under either Division 17A or 17B are required to be made by the date for lodgment of her return for the year in which the business is sold.


The position as to the use of the proceeds from the sale does not change under Division 152. However, no formal election is required to be made to access the retirement exemption or roll-over concession; instead, the taxpayer makes a “choice” which is evidenced by the way the taxpayer’s return is made. Where a choice is made to access the retirement exemption, the taxpayer would need to make a payment to her super fund as she will be under 55 at the time of the sale of her business. The payment, which must be made to the fund immediately after


Selling a Small Business – The CGT Strategies making the choice to apply the exemption, is deemed to be an ETP, see sec 152-310(2) ITAA 97. Note also that the taxpayer must make a written notification to be kept with the tax records of the “CGT exempt amount” chosen.

The taxpayer’s capital gain would qualify for the 50% individual discount. This would reduce it to $100,000. She would also be entitled to the active asset reduction, reducing her taxable gain to $50,000, assuming that the taxpayer is able to qualify under the eligibility criteria for the small business concessions. The active asset reduction replaces the 50% goodwill exemption.


Can the taxpayer use some part of the proceeds (e.g. $30,000) for personal use, and roll over the balance and claim the exemption from the rolled over amount?


Yes, but it would be fully taxable, the 50% goodwill exemption would not be available.


Because of the availability of the 50% individual discount and active asset reduction, the taxpayer would not need to pay tax on the small portion of her gain that she plans to use for personal use. Given that approximately $150,000 of the gain could be received totally tax free, with only the balance being required to be rolled over or paid into her super fund to gain the further concessions, the taxpayer may wish to reconsider her future plans.


If part of the proceeds are used to buy another business, can the balance be paid into the taxpayer’s superannuation fund and the balance of the gain be exempted under Division 17B?


No, if an election in respect of an asset is made under Division 17A, no other CGT concessions are available.


Yes, under the new regime, the small business concessions can be applied cumulatively. This is not the case with the 15-year exemption which, if available, will totally exempt any capital gains, making the other concessions unnecessary.

In addition to applying the small business concessions cumulatively, an individual taxpayer or trust may also make use of the 50% individual discount.

¶15.050 CASE STUDY 5 – GRAZING PARTNERSHIP – LAND HELD BY ONE

PARTNER


Mum and Dad operate a grazing partnership on land owned by Dad only. The partnership pays all expenses in relation to the land. Upon sale of the land, can any capital gain by Dad be applied to superannuation under Division 17B? Are improvements on the land that have been treated as separate assets for depreciation and CGT purposes (e.g. fencing, etc) treated any differently?


Dad can claim the exemption under Division 17B in respect of the sale of the land, assuming he otherwise qualifies. This is because he is the relevant taxpayer under Division 17B as a partner in a partnership, and the gain from the sale of the land under the partnership arrangement would be his.


Selling a Small Business – The CGT Strategies Where improvements on the land are treated as separate assets for CGT purposes, the position will be the same, assuming that Dad owns them. This may depend on the partnership agreement. It is necessary to make a separate election for each CGT asset disposed of in respect of which there is a capital gain. In relation to depreciated improvements there may be no need to make an election where there is no capital gain.


Dad would first claim the 50% individual discount in respect of the capital gain on the sale of the land. He would then be able to claim the active asset exemption, assuming he otherwise qualifies under the small business concessions under Division 152. He can choose to pay the remaining 25% of the capital gain into his super fund, assuming he has not previously reached his RBL limit.

Note here that because the capital gain is first reduced by the 50% individual discount and then by the active asset reduction, effectively the value of the retirement exemption is quadrupled – in other words, the $500,000 lifetime limit under the retirement exemption will reduce less quickly.

Note that since depreciated assets are no longer taxed under the CGT regime, any notional capital gains arising would not benefit from the small business or individual concessions.


What is the situation if the grazing business is operated by a family trust on Dad’s land?


This will depend on the arrangement under which Dad’s land is used by the trust. If Dad merely rents the land, neither Division 17A nor 17B will be available as the asset will not be an “active asset” of Dad’s. Nor will it be an active asset of the trust.

Note that amendments announced on 13 August 1998 provide that, as from that date, where, as in this case, the land may have been merely leased to the trust, the small business concessions become available where the business is “connected with” the taxpayer or it is the taxpayer’s “small business CGT affiliate”.


Assuming that the basic eligibility criteria are able to be satisfied, the small business concessions would be available to Dad.


If replacement assets are acquired under Division 17A, does the new business have to be operated by exactly the same owners or in the same names for the roll-over provisions to apply?


No, where the taxpayer is a member of a partnership it is the partner's interest in the asset to which the roll-over applies. This means that if the taxpayer acquires an interest in a new partnership as the replacement asset, it does not matter that there are new members of the partnership.


There is no change here under Division 152.



¶15.060 CASE STUDY 6 – SOLE TRADER – STATEMENT OF TERMINATION

PAYMENTS SCHEDULE


A sole trader aged 60 sells her business, with taxable capital gains resulting. To claim the exemption under Division 17B, is the taxpayer responsible for completion of a Statement of Termination Payments schedule? What paperwork is required to be completed to report the payment to the ATO in relation to the taxpayer's RBL? When does this have to be completed?


(a) An election under Division 17B must be made.

(b) An RBL form must be provided to the ATO by the taxpayer by the 14th day of the month following payment.

No Statement of Termination Payments form is required where the taxpayer is a sole trader or partner.


The taxpayer must “choose” to apply the exemption by lodging his return in a way that indicates that the exemption has been chosen. The taxpayer will still need to lodge an RBL form with the ATO by the 14th day of the month following payment.


If this sole trader is under 55, and elects to roll over the capital gain into superannuation, what are the requirements for the paperwork and the timing of its completion?


(a) An election under Division 17B must be made.

(b) A Rollover Payments Notification form needs to be lodged with the super fund.


(a) A “choice” must be made (see Question 4(a) above).

(b) A Rollover Payments Notification form needs to be lodged with the super fund.

¶15.070 CASE STUDY 7 – COMPANY BUSINESS RENTING PROPERTY HELD BY

SHAREHOLDER

Individuals own the real estate property of two businesses that are rented by two companies. One property is pre-CGT and the other is post-CGT.

Company 1 owns a business that was purchased by the individual owners pre-CGT and rolled into the company.

Company 2 owns a business that was purchased post-CGT.

The businesses and real estate were sold after July 1997. Each company is an employer and may contribute into a self-managed superannuation fund on behalf of the individuals who are the only members of the fund. The members are aged between 45 and 49.


Is it possible to roll over the capital gains on the sale of the business goodwill in Company 2 into the super find?




Assuming Company 2 (being the relevant taxpayer for Division 17B purposes but noting that the individual’s assets and Company 1’s asset will need to be aggregated to determine this) has net business assets that do not exceed $5 million, and the individuals are “controlling individuals” (generally being 50% shareholders and employees of the company), it would be possible to use Division 17B to roll over the capital gain on the goodwill into the controlling individuals’ super funds. This will depend on the amount of the gain involved and the level of contributions that have already been made in respect of the individuals.

Where an election is made by a company under Division 17B, it would be necessary to terminate the relevant employment of the controlling individuals.


On the basis of the same assumptions made above, Company 2 would first be entitled to the 50% active asset reduction on the goodwill. The company could then distribute the remaining capital gain to the respective shareholders’ super funds as ETPs. Under sec 152-315 ITAA 97 it is necessary for the company to specify in writing the CGT exempt amount and the percentage of each CGT asset’s exempt amount that is attributable to each controlling individual.

As noted in relation to Case Study 3 above, although it is not entirely clear under the new provisions, the cautious approach would be to formally terminate any employment prior to making the ETP in respect of the sale. Where the controlling individuals are not employees, it is probably necessary to terminate their directorships instead.


Other than rolling into the super fund, what other options are available for reducing possible profits on sale?


It is noted that there would be no relief in respect of the post-CGT real estate held by the individuals.

Note that, as from 13 August 1998, land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this case study the company would be a small business CGT affiliate of the individuals.

Another option available to Company 2 might be the 50% goodwill exemption, although this exemption has a lower net asset threshold. If the small business retirement exemption is not used, the gain could be rolled over under Division 17A by the company investing in another business.


Since the real estate is held by the individual shareholders, so long as it has been held for at least 12 months, the shareholders will be entitled to the 50% individual discount on the nominal capital gain. Also they will probably be entitled to the 50% active asset reduction as it is used in an entity connected to them. The remaining capital gain could then be eligible for the small business retirement exemption.

If the company did not want to roll over the remaining 50% capital gain, it may prefer to pay the lower rate of company tax on that amount and hold the net proceeds in the company, or use the proceeds to buy another business.


How can the pre-CGT profit on the sale of the goodwill in Company 1 be distributed (is there a need to do this)?




There are obviously difficulties under the current law for distributing tax-free capital gains from a company. Particular care needs to be taken with the introduction of amendments to Division 7A ITAA 36. Presumably the better approach is to liquidate and distribute the tax-free capital gains. These would not be regarded as a dividend provided it could be shown in the books of the company that the distribution was made exclusively from the tax-free gains. Note that the shares in the company would also be pre-CGT shares, subject to sec 104-230 ITAA 97 (this section replaces sec 160ZZT).


The position here has not changed.

¶15.080 CASE STUDY 8 – APPLYING ROLL-OVER RELIEF

What is the practicality of lodging a tax return after roll-over relief applies, and when/how is tax paid if roll-over is not done until the second year (i.e. acquisition of a new business)?


Section 160ZZPQ(1)(f) ITAA 36 requires an election to be made to obtain the roll-over concession on or before the date for lodging the taxpayer’s return for the income year in which the disposal took place. If an election is not made within the period allowed no roll-over is permitted. Note that, strictly speaking, the election cannot be delayed by holding off lodging a return, although the ATO accepts that it can.

Section 160ZZPT(1A) ITAA 36 will require that replacement assets must be nominated within two years from the last disposal. If no nomination is made within the required period, CGT on the gain becomes payable (see sec 160ZZPT(5)).


Under Subdivision 152-E ITAA 97 a taxpayer “chooses” whether to roll over a gain. The choice is signified by not including an amount of a capital gain in the return for the year in which the disposal took place.

Where a replacement asset has not been acquired within the two-year period allowed after the last CGT event within the relevant income year, there is scope under sec 152-420(2) ITAA 97 to extend the time by a further 12 months where additional proceeds are received under sec 116-45(2).

¶15.090 CASE STUDY 9 – TRACKING RETIREMENT EXEMPTION FUNDS

THROUGH SUPER FUND

How is the roll-over money tracked in a super fund when it is later paid out to the recipient, for example allocated pension? Is it an undeducted purchase price (not subject to tax) or an amount subject to tax with a 15% rebate?


A Rollover Payments Notification form (ROPN) is required to be given to a roll-over fund to ensure that the fund can identify the moneys received by the fund under Division 17B.

The legislation creates a new category of ETP, a “CGT exempt component”, which is similar to an undeducted contribution. The CGT exempt component is able to be paid out of a fund totally tax free once the beneficiary reaches the age of 55.


There is no change under new Division 152.



¶15.100 CASE STUDY 10 – USING ROLL-OVER TO REORGANISE OPERATING

ENTITY

How may the roll-over into another business concession (Division 17A) be utilised if, say, an existing company wanted to transfer its operation over to:

(a) a discretionary trust; or

(b) a unit trust of which it is only one of the unit holders?

The Treasurer announced in the Press Release issued on 11 November 1999 proposals for further roll-over relief, detailed at Attachment K to the Press Release. The Treasurer indicated that “measures will be introduced to provide ongoing relief for roll-overs into companies and fixed trusts and transitional roll-over relief for fixed trusts restructuring into a company and for companies restructuring to CIVs, provided certain conditions are satisfied”. However, these proposals will not assist in a restructuring in the present case.

Given that the Government’s original proposal to introduce the entity tax regime in 2001 has been shelved, it is questionable whether it is desirable to move the business from a company to a trust.

¶15.110 CASE STUDY 11 – PART SALE BY PARTNERSHIP

Father aged 63, mother aged 58, son aged 39 and daughter-in-law aged 38. The partnership has farmed together since March 1993.

One half of the farm was sold on 26 September 1997, which results in an indexed capital gain for each partner of $62,818.

Father and mother want to set up a self-managed superannuation fund.

How can Mum and Dad take advantage of the new legislation?

If they remain employed, can the roll-over relief be gained at a later stage when the other half of the farm is sold?


The roll-over concession would probably not be of much advantage as it would only be available if the existing company were to acquire a new business.

The retirement exemption (Division 17B) may be useful as it would enable the business to be transferred to a new entity − it could be either a discretionary trust or unit trust associated with the shareholders of the company, assuming the transfer price is an arm’s length price. Funds from the disposal by the company could then be received by the shareholders (who are controlling individuals) tax free from the company as ETPs if the shareholders were over 55. It would, of course, be possible for the trust to borrow the purchase price.


The small business concessions in new Division 152 do not greatly assist in restructuring, but it does provide greater flexibility. Obviously though, if the disposal of the business by the company was made to either a discretionary trust or unit trust on an arm’s length basis, assuming that the four basic eligibility conditions were able to be met, the 50% active asset reduction coupled with the retirement exemption would make the reorganisation more tax effective.

Under the new concept of CGT concession stakeholder under the retirement exemption, it is now possible for a spouse of a controlling individual of a company to also receive up to the full $500,000 lifetime limit by way of an ETP even though the spouse is not a controlling individual.




The legislation looks at partners individually for both the roll-over concession and the retirement exemption. There is one additional restriction where partnership interests are sold and that is that, in determining the net value of a partner’s business assets for the purposes of the $5 million threshold test, the total net value of the partnership assets must not exceed $5 million.

In this case each partner could individually elect to apply the retirement exemption. The son and daughter-in-law, however, would need to roll over their share of the capital gain into a roll-over fund as they are both under 55.

When the other half of the farm is sold, assuming they continue in business as partners, the retirement exemption would be available to exempt the remaining capital gains up to the $500,000 lifetime limit for each partner (as reduced by the capital gain exempted under the election made in respect of the $62,818).

Note that, as from 13 August 1998, land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. Note that, in this case study, the son and daughter-in-law would be a small business CGT affiliate of the father and mother if the son and daughter-in-law act, or could reasonably be expected to act, in accordance with the parents' directions or wishes, or in concert with them (see FCT v Newton (1957) 96 CLR 577 and c.f. TR 2001/D16).

It is noted that each partner could individually take advantage of the roll-over concession under Division 17A if they acquired replacement assets up to the amount of the gain.


The individual partner’s capital gain of $62,818 would be able to be significantly reduced by the 50% individual discount and the 50% active asset reduction, before each partner decided to choose the retirement exemption. Note, however, that the gain of $62,818 is calculated as an indexed capital gain.

With any sale after 21 September 1999 of property held before that date, the taxpayer has the option to decide whether to calculate the capital gain as an indexed gain (with indexation up to 30 September 1999) and forgo the individual 50% individual discount. Where a taxpayer uses the frozen indexed cost base, this does not prevent the 50% active asset reduction from then applying.

As before, the son and daughter-in-law would need to pay their remaining taxable gains into a roll-over fund or super funds.

¶15.120 CASE STUDY 12 – FARMING PARTNERSHIP – RETIREMENT

PLANNING

Mum, aged 62, and Dad, aged 59, purchased a farm in December 1992 for $700,000.

The unindexed cost base is $900,000 with improvements to the property.

The sale price is $2.25 million.

What strategies should they look at if they:

(a) plan to sell the farm;

(b) plan to pass on the farm to their family members?


If they sell the farm, Mum and Dad could each receive up to the current maximum lump sum RBL amount of $485,692 (1999/2000) completely tax free assuming they have no other super contributions. As their potential capital gain (ignoring indexation) is approximately $1.35


Selling a Small Business – The CGT Strategies million ($675,000 each) it would mean that the difference between their individual capital gain of $675,000 and $485,692 would be subject to CGT. This liability could be eliminated if they opted for the higher pension RBL of $971,382 by taking at least 50% of their super contributions as a pension. Again, the viability of this option would depend on whether they had previously made super contributions to a fund, and how much those contributions were.

Obviously if the farm is intended to be kept in the family it could be passed by will and this would defer any CGT liability. The farm could be leased to their family members to provide Mum and Dad with an income.


If they sell the farm now, Mum and Dad would be eligible for both the 50% individual discount and the 50% active asset reduction. Based on a nominal gain of $675,000 each, their taxable gain, after applying the two 50% discounts, would be $168,750. They could each receive that amount tax free under the retirement exemption as they have no super contributions. It is well under the current maximum lump sum RBL amount of $485,692 (1999/2000), $506,092 (2000/2001), $529,373 (2001/2002), $562,195 (2002/2003).

As before, if the farm is intended to be kept in the family it could be passed by will and this would defer any CGT liability. The farm could be leased to their family members to provide Mum and Dad with an income.

¶15.130 CASE STUDY 13 – SALE OF BUSINESS BY PARTNERSHIP – CONTINUED

EMPLOYMENT

The business is operated as a partnership with two partners, both partners also work for wages with another employer who makes super contributions on their behalf. Both partners are under 55 and their combined assets are under $5 million.

Can the capital gains on the disposal of the partnership business be rolled over into their individual super funds? If “yes”, what procedures are involved?


Each partner would be able to independently elect to obtain the benefit of Division 17B by rolling over their share of the capital gain into their individual super fund. Once the written election is made, a Rollover Payments Notification form would need to be completed and lodged by the partners.


Under the new CGT regime, before choosing to apply the retirement exemption each partner would first be entitled to apply the 50% individual discount and then the 50% active asset reduction reducing their respective capital gains to 25% of their nominal gain. The partners would then need to consider whether to choose to apply the retirement exemption in respect of the remaining gain. It is noted that under the new CGT regime the decision to choose the retirement exemption is easier as it will impact more lightly than previously on their $500,000 lifetime limit.

The procedure for choosing the exemption still involves completing a Rollover Payments Notification form to be lodged by each partner choosing the exemption.

¶15.140 CASE STUDY 14 – VARIATION OF PARTNERSHIP

Mum and Dad own a farm, purchased in 1986, and operate it as a joint partnership until 1990. They then form a family partnership with their sons and farm the land in a new partnership name.


Selling a Small Business – The CGT Strategies Mum and Dad still retain the land in their joint names. In 1995 they revert to farming the land by themselves again, and in 1997 they sell the farm. They place all their proceeds in a superannuation fund and receive a pension from the fund.

What roll-over relief is available and what rate of tax does the super fund pay on the contribution?


Assuming that the mother and father otherwise qualify in terms of assets, Division 17B would apply as the land arguably has been used as an active asset in a business during more than half of the period in which the parents owned the land (see sec 160ZZPQ(1)(d) ITAA 97). Alternatively, although the parents have used the land in more than one business this still satisfies sec 160ZZPL(3) as being an “active asset” of the taxpayers.

The payment of the proceeds of the sale into a super fund will be partially exempt in the hands of the fund, that is to the extent of the exempt capital gain (see sec 27A, 27AA, 27D, 267(1) and 274 ITAA 36). The exempt component is deemed to be an ETP.

Assuming Mum and Dad are both over 55 (as they are being paid a pension by their fund) it would have been open to them to take the proceeds in cash totally tax free.


Under the new CGT regime if the land were to be sold now the land would be an active asset of Mum and Dad as it has been used in a business operated by Mum and Dad who would both qualify for the 50% individual discount and for the 50% active asset reduction assuming they still qualify under the maximum net asset value test. It does not matter that there have been other persons also involved in the business.

As to the balance of the taxable gain (i.e. 25% of the nominal gain), Mum and Dad would each be entitled to take it tax free assuming that both were over 55, or otherwise paid into their super funds free of contributions tax.

By opting for a pension Mum and Dad’s RBL would be each $971,382 (1999/2000), $1,062,181 (2000/2001), $1,058,742 (2001/2002), and $1,124,384 (2002/2003). Each would be unlikely to have reached that limit under the new CGT regime since they would need to apply only approximately ¼ of the amount of the capital gain that under the previous regime would need to be exempted.

More of the individual lifetime limit of $500,00 now known as the “CGT retirement exemption limit” would be preserved under the new CGT regime since less taxable capital gain would remain after the 50% individual discount and 50% active asset exemption have been applied.

In order to access the 50% individual discount, Mum and Dad would need to forgo the benefit of the indexed cost base. Mum and Dad are able to make this choice separately.

¶15.150 CASE STUDY 15 – SHAREFARMING AGREEMENT WITH COMPANY

Husband and wife purchase jointly a cane farm pre-1985. They operate the farm as a joint partnership. They purchase jointly another farm in January 1993 for $240,000 and farm it in the partnership.

In December 1994 they form a company and begin to operate the farming operation through the company. A share farming agreement is put in place between the company and the husband and wife as landholders.

The shareholders and directors are the husband and wife. They now wish to sell the second farm to purchase a bigger one. The sale price will be $600,000 and the proceeds of the sale are to be contributed to their super fund which is going to purchase the new farm.


Selling a Small Business – The CGT Strategies Is roll-over relief applicable?

What rate of tax does the super fund pay on making the contribution?

What planning should the husband and wife do if they are to get the roll-over relief?


Assuming the parents otherwise qualify in terms of net assets, they would be eligible for relief under either Division 17A or 17B in relation to the sale of the second farm. This view is based on the argument that the owners of land the subject of a share farming arrangement would be carrying on a business and the land would be an “active asset”. Ultimately the answer will depend on the terms of the share farming agreement and other factors pointing to the conclusion that they carried on a business.

Note that as from 13 August 1998 land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this example, the company would be a small business CGT affiliate of the husband and wife.

Since the husband and wife want to buy a bigger farm, it would make more sense to apply Division 17A and roll over the capital gain on its disposal into the new property. Each spouse would need to make an election under Division 17A.


The nominal capital gain under the new regime would be $360,000. As the husband and wife have held the farm for more than 12 months, it would qualify for the 50% individual discount. The farm would be an active asset of the husband and wife for the purposes of the small business concessions and so each would also be entitled to the 50% active asset reduction assuming that they do not trigger the $5 million maximum net asset value test. Each partner would then have a taxable capital gain remaining of just $45,000 ($180,000/2=$90,000/2=$45,000).

The husband and wife may then either choose to apply the retirement exemption or the roll-over in respect of the remaining capital gains.

Under Division 152 there is now a particular disincentive to make use of the roll-over. The disincentive is that the amount of the gain rolled over is quarantined indefinitely so that, on any future sale of the replacement property acquired by the husband and wife, the amount of the roll-over (2 x $45,000) would be clawed back and fully taxed as it would not be eligible for any CGT concession. Section 115-25(2) would prevent it from being eligible for the 50% individual discount and sec 152-10(4) would preclude eligibility for the small business concessions, other than future roll-overs or the retirement exemption. Note that any additional capital gain made by the husband and wife on a future sale of the new property would not be otherwise precluded from the CGT concessions then available.

Since the husband and wife would effectively be receiving almost all of the proceeds from the sale of their second property tax free, it may not now make sense for their super fund to buy the new property but rather for the new property to be purchased in their own names.

There is also a problem with the fund not being able to borrow to acquire the new property – presumably the funds for the new property could be contributed to the fund by the husband and wife. Whether it makes sense for the fund to acquire the property may depend on the likely rental income, etc.

¶15.160 CASE STUDY 16 – PRE-CGT PROPERTY ACQUIRED BY WIDOW

LEASED TO PARTNERSHIP

Husband owns a farm purchased pre-1985. He and his wife farm the land in a joint partnership, with a lease between the partnership and husband in place. The husband passes away in July 1997 and leaves the farm to the wife.


Selling a Small Business – The CGT Strategies What planning should the wife do at this point in time?

Down the track the wife finds she cannot handle the farm and decides to sell.

What is her capital gains situation?

What future planning should she do if she is going to place the farm proceeds into her superannuation fund?


The wife will acquire the farm for CGT purposes at its market value at the date of death of the husband. No CGT would arise if she immediately sold the property.

The wife would be able to get the Division 17B exemption (assuming she otherwise qualifies) in respect of any subsequent gain on the farm provided she continues to use the property as a farm or in another business enterprise. She should be careful to ensure that she continues to actively work the farm. Any share farming agreement would need to be carefully scrutinised to ensure that she was able to continue to be entitled to claim the Division 17B exemption.

If she is already over 55, she may consider alternative options to investing the proceeds in super.


No change has occurred with acquisitions of pre-CGT assets on death. For the purpose of taking advantage of the 50% individual discount, the wife is taken to have acquired the asset when the deceased acquired it.

Assuming that the farm continues to be an active asset, the wife would be eligible for the 50% active asset reduction in addition to the 50% individual discount and the small business roll-over and retirement exemption.

If she continues to farm the asset for the 15-year period from the date of death of her husband, she could be eligible for the 15-year retirement exemption if she otherwise satisfies the basic eligibility criteria, in particular the $5 million maximum net asset value test. Note here that there is no provision under this concession, which permits the 15-year period to be counted from the original date of acquisition by her husband.

¶15.170 CASE STUDY 17 – HUSBAND AND WIFE PARTNERSHIP PROPERTY

ROLL-OVER

Husband and wife purchase land and erect a major building on it in January 1998 and operate a business from the building. The land and business are held jointly.

Subsequently the land and business is sold to buy a different type of business.

What roll-over relief will they get and what planning should they make?


The husband and wife would be in partnership and each would be entitled to roll-over relief under Division 17A, assuming that they otherwise qualify under the Division in relation to their net assets.

It might not be desirable to seek to take advantage of the relief provided by Division 17A as they may have significant capital gain in relation to the land. This would mean that roll-over relief could not be obtained in relation to some of this gain if, for example, the asset to be acquired in the new business consisted mostly of goodwill and amounted to more than the capital gain on the goodwill in relation to the business to be sold. This is because, under Division 17A, the capital gain on non-goodwill assets cannot be rolled over in relation to goodwill assets that are goodwill.




The partners each would be eligible firstly for the 50% individual discount thus reducing their potential capital gain to half, though any capital losses would need to be first applied. As the property was acquired before 21 September 1999, it would be necessary to compare the result applying the frozen indexed cost base, though given the relatively short time since the land and building were acquired, it is most probable that 50% of the nominal gain would give the better result even if there are capital losses to apply.

Assuming that the partners are able to qualify under the small business concessions, the partners would next be entitled to apply the 50% active asset reduction, effectively reducing their respective capital gains to 25% of the nominal gain.

The partners could then choose to roll over the remaining capital gains.

Under the new CGT regime, there is no longer a requirement to distinguish between goodwill and non-goodwill capital gains as there is now no restriction on the type of replacement assets that can be acquired having regard to whether the asset disposed of was a goodwill asset or non-goodwill asset.

As noted in the response to Case Study 15, there is now a disincentive to use the small business roll-over as the amount of the gain rolled over is quarantined indefinitely so that on any future sale of the replacement property acquired by the partners the concession would be clawed back and fully taxed as it would not be eligible for any future CGT concession. Section 115-25(2) would prevent it from being eligible for the 50% individual discount and sec 152-10(4) would preclude eligibility for the small business concessions, other than future roll-overs or the retirement exemption. Note that any additional capital gain made by the partners on a future sale of the new property would not be otherwise precluded from the CGT concessions then available.

¶15.180 CASE STUDY 18 – FARM HELD AS JOINT PROPERTY WITH SHARE

FARMING AGREEMENT LATER ESTABLISHED WITH FAMILY

DISCRETIONARY TRUST

Husband and wife purchase a farm in March 1989. The land is purchased in joint names for $282,000. They develop the land and farm it in partnership.

On 1 June 1996 a discretionary family trust is set up and a share farming agreement is put in place between the trust and the husband and wife. The trustee of the trust is a company of which the shareholders and directors are the husband and wife.

They wish to sell this farm to purchase a bigger one and expect to realise $2,000,000 on the current farm.

Do they get roll-over relief?

If they contribute capital gains to their super fund and the super fund purchases the new farm via a unit trust, what is the situation?

What planning ahead should they undertake to gain the roll-over relief?


Assuming that the parties otherwise qualify in terms of the value of their net assets, they would be eligible under both Divisions 17A and 17B for relief in relation to their farm.

Eligibility would, however, depend on the effect of the share farming agreement. Assuming that under the agreement they are individually carrying on business, their respective interests in the farm would be an “active asset”. The fact that the husband and wife operated the farm in partnership up to 1996 would be able to be taken into account in determining whether the asset was an “active asset” during more than half the ownership period for the purposes of sec


Selling a Small Business – The CGT Strategies 160ZZPQ(1)(d). Alternatively, the parties could revert to the individual partnership before selling.

As noted in Case Study 15, as from 13 August 1998, land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this Case Study, the trust would be a small business CGT affiliate of the husband and wife.

Since the parties want to buy a bigger farm, it would be better to buy it directly using Division 17A to defer the CGT, rather than using up their $500,000 lifetime limit under Division 17B. The exemption could be utilised at a later time, say when selling the bigger farm.


The husband and wife would each be eligible for the 50% individual discount thus reducing their potential nominal capital gain to half, though any capital losses would need to be first applied.

As the farm was acquired before 21 September 1999, it would be necessary to determine the result applying the frozen indexed cost base, and, given the relatively long period since the farm was acquired, it is possible that the frozen indexed method would give the better result if there are sufficient capital losses to apply, although this is unlikely where the gain is large, as in the present case.

The frozen indexed cost base for the farm would be $374,496 (123.4/92.9 x $282,000) disregarding the cost of improvements) so the gain ($1,625,504) would still be greater than 50% of the nominal gain of, say, $859,000.

Assuming that the partners are able to qualify under the small business concessions, the husband and wife would next be entitled to apply the 50% active asset reduction, effectively reducing their respective capital gains to 25% of the nominal gain, say $429,500.

The husband and wife could then choose to roll over the remaining capital gains.

As previously noted, under the new CGT regime, there is no longer a requirement to distinguish between goodwill and non-goodwill capital gains as there is now no restriction on the type of replacement assets that can be acquired having regard to whether the asset disposed of was a goodwill asset or non-goodwill asset.

As noted in the response to Case Study 15, there is now a disincentive to use the small business roll-over as the amount of the gain rolled over is quarantined indefinitely so that on any future sale of the replacement property acquired by the partners the concession would be clawed back and fully taxed as it would not be eligible for any future CGT concession. Section 115-25(2) would prevent it from being eligible for the 50% individual discount and sec 152-10(4) would preclude eligibility for the small business concessions, other than future roll-overs or the retirement exemption.

If the husband and wife are planning to further roll over the new farm and acquire a third farm, then this restriction may not be of concern. However, given that they are planning to acquire a property for $2 million, at the time of any subsequent purchase they may no longer qualify under the $5 million maximum net asset value test and so it does not make much sense to plan on being able to make use of a further small business roll-over in this situation.

Under the new CGT regime, therefore, it may be seen as a better option to choose to apply the retirement exemption for the balance of the gain to eliminate the tax entirely. On the assumption that the husband and wife are both under 55, the remaining capital gain would need to be paid into their super fund.

Whether the husband and wife can use their super fund to acquire the new farm indirectly would need to be carefully considered having regard to the new in-house asset rules that apply to super funds. In any event, with the availability of the 50% individual discount, this is now a strong reason for acquiring the new farm directly. The husband and wife would need to


Selling a Small Business – The CGT Strategies consider whether it is desirable for a significant portion of their funds to be tied up in their super fund.

¶15.190 CASE STUDY 19 – SPLITTING FAMILY PROPERTIES

Two brothers own two farms − a home farm purchased pre-1985 and one purchased in 1993 for $500,000.

Both farms are farmed by a family partnership of six members. This partnership has operated since the home farm was purchased.

On 1 July 1995 the brothers decide to split the farms so they can go their own way. The valuation at the date of the split is $900,000 for each farm.

Brother 1 receives the home farm, so one half now becomes a post-CGT asset.

Brother 1 sells his half in the second farm for $900,000.

Both brothers farm each of their farms via a family discretionary trust.

What is the position when Brother 1 sells his half share in the second farm to Brother 2?

What is the situation when Brother 1 disposes of his home farm?


In this case study Brother 1 has retained his original pre-1985 share of the home farm and owns the other half post-1985.

Brother 2 had purchased his first half of the second farm in 1993 and the second half in 1995.

CGT would have been payable by Brother 1 at the time of the 1995 sale.

In the case of Brother 1, if he is carrying on a business he would be eligible for relief under Division 17A or Division 17B assuming he otherwise qualifies. However, since his farming business is carried on by his family trust, it could not be said he is carrying on business.

As noted in Case Study 15, as from 13 August 1998, land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this case study, the trusts would be small business CGT affiliates of the brothers.

In the case of the disposal of the home farm, Brother 1 may be able to gain the benefit of the principal residence exemption in respect of a portion of the post-CGT interest.


In the case of Brother 1, as the home farm is used by his small business CGT affiliate, that is the trust, to carry on the business, he would be eligible for relief under Division 152 assuming he otherwise qualifies. He would also be entitled to the 50% individual discount on the post-CGT half.

Brother 1 may be able to gain the benefit of the principal residence exemption in respect of a portion of the post-CGT interest.

¶15.200 CASE STUDY 20 – FAMILY DISCRETIONARY TRUST CONDUCTING

FARMING OPERATIONS

Husband and wife own farmland and fixed improvements. Their family trust owns the crop and stools and, therefore, conducts the farming business. There is no lease agreement in place.

What action can be taken prior to selling the farm in order to enable the husband and wife to use Division 17B?




On the basis that the trust conducts the business, Division 17B would not be available as the trust does not also own the farm. If the husband and wife business were now to undertake the farming business, they would become eligible to the concession once they had carried on business in partnership for more than half their ownership period (see sec 160ZZPQ(1)(d) ITAA 97). There may be an argument that would enable them to claim the concession immediately on the basis that the farm has always been an “active asset”.

Note that there is potential for Part IVA to be applied on the change of business.

Alternatively, there may be some scope for the goodwill exemption to apply once they commenced business in partnership.

As noted in Case Study 15, as from 13 August 1998 land, used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this case study, the trusts would be small business CGT affiliates of the husband and wife.


The absence of a lease between the husband and wife and the trust would not prevent the concessions under Division 152 from applying. The asset, that is the farm, merely needs to be “used, or held ready for use, in the course of carrying on a business by…your small business CGT affiliate…or another entity that is connected with you” (see sec 152-40(1)(c) ITAA 97).

¶15.210 CASE STUDY 21 – SOLE TRADER – AVAILABLE OPTIONS

An individual aged 52 has sold a bus run for $50,000 with goodwill representing $40,000. The sale price of the bus ($10,000) is 100% taxable as recouped depreciation. The cost price of the goodwill is nil.

What options are available to minimise the tax payable?


The proceeds from the capital gain in respect of the goodwill could be rolled over into a super fund under Division 17B, assuming all eligibility conditions are met, or the funds could be utilised to acquire a new business within two years of the sale.

Alternatively, the 50% goodwill exemption would be available.


The position of an individual taxpayer has greatly improved under the new regime.

The individual would be eligible firstly for the 50% individual discount thus reducing his/her potential capital gain to half, though any capital losses would need to be first applied. As the property was acquired before 21 September 1999, it would be necessary to determine the result applying the frozen indexed cost base. Obviously, if the bus run had been established by the individual then the cost base for the goodwill will be negligible and so it is most probably that the 50% discount calculation would provide the better result.

Assuming that the individual is able to qualify under the small business concessions, he/she would next be entitled to apply the 50% active asset reduction, effectively reducing his/her capital gain to 25% of the nominal gain.

The individual could then decide to choose to roll over the remaining capital gain.

Under the New CGT Regime, there is no longer a requirement to distinguish between goodwill and non-goodwill capital gains as there is now no restriction on the type of replacement assets that can be acquired having regard to whether the asset disposed of was a goodwill asset or non-goodwill asset. This change would not affect the individual in this case study as the gain was from goodwill.


Selling a Small Business – The CGT Strategies As noted in the response to Case Study 15, there is now a disincentive to use the small business roll-over as the amount of the gain rolled over is quarantined indefinitely so that on any future sale of the replacement property acquired by the partners the concession would be clawed back and fully taxed as it would not be eligible for any future CGT concession. Section 115-25(2) would prevent it from being eligible for the 50% individual discount and sec 152-10(4) would preclude eligibility for the small business concessions, other than future roll-overs or the retirement exemption. Note that any additional capital gain made by the individual on a future sale of the new property would not be otherwise precluded from the CGT concessions then available.

Given that, with the application of the 50% individual discount and the 50% active asset reduction, the remaining gain is only $10,000, the individual may be content to pay tax on that at their marginal rate which may well be less than the maximum rather than tie up the funds in a super fund. Alternatively, the balance of the gain could be paid into his/her super fund or, if he/she does not have a personal fund, a roll-over fund.

The money would be withdrawn when the individual reaches age 55 totally tax free.

¶15.220 CASE STUDY 22 – FAMILY DISCRETIONARY TRUST WITH LAND HELD

BY FAMILY MEMBERS

Mother and father A and B have owned and farmed land prior to 1970 so have no CGT problems.

In September 1993 A and B sold approximately half the land to their son and daughter-in-law C and D. The land is held in two separate titles so A and B, and C and D, own their own land each as joint tenants.

A family trust is set up to conduct the business of cane farming on both parcels of land.

C and D now wish to sell their land and leave the district. This action has, in turn, resulted in A and B also now wishing to dispose of their land.

The land and assets were sold by A and B to C and D for $250,000 in September 1993 and their present value is estimated at $650,000.


The proceeds from the sale by A and B would not be subject to CGT as the land is a pre-CGT asset.

However, the proceeds from the sale by C and D would be subject to CGT. As the family trust conducts the business, C and D would not be able to benefit from Division 17B. If they were to commence business in their own right, they may be able to argue that the Murry decision (98 ATC 4585; (1998) 39 ATR 129) could apply and that goodwill exists as a separate asset in relation to the business. Also there is a possible argument that Division 17B could apply on the basis that they have owned an “active asset” throughout the ownership period, notwithstanding that the land has been farmed by the trust.

Note that there is potential for Part IVA to be applied on change of business.

As noted in Case Study 15, as from 13 August 1998 land used by a small business CGT affiliate is eligible for the small business retirement exemption and roll-over concessions. In this case study, the trust would be a small business CGT affiliate of C and D.


There is no change under the new CGT regime for A and B.

C and D would each be eligible for the 50% individual discount thus reducing their potential nominal capital gain to half, though any capital losses would need to be first applied.


Selling a Small Business – The CGT Strategies As C and D’s interest in the farm was acquired before 21 September 1999, it would be necessary to determine which method gave the better result − applying the frozen indexed cost base or 50% of nominal gains. Given the relatively long period since interest in the farm was acquired, it is possible that the frozen indexed method would give the better result if there are sufficient capital losses to apply, although unlikely where the gain is large (ie the nominal gain is $400,000), as in the present case.

The frozen indexed cost base for their interest in the farm would be $281,000 ((123.4/109.8 x $250,000) disregarding the cost of improvements), so the frozen indexed gain ($369,000) would still be greater than 50% of the nominal gain of $400,000.

Assuming that the partners are able to qualify under the small business concessions, C and D would next be entitled to apply the 50% active asset reduction, effectively reducing their respective capital gains to 25% of the nominal gain, say $100,000.

C and D could then decide to choose to roll over the remaining capital gains.

As previously noted, under the new CGT regime, there is no longer a requirement to distinguish between goodwill and non-goodwill capital gains as there is now no restriction on the type of replacement assets that can be acquired having regard to whether the asset disposed of was a goodwill asset or non-goodwill asset.

As noted in the response to Case Study 15, there is now a disincentive to use the small business roll-over as the amount of the gain rolled over is quarantined indefinitely so that on any future sale of the replacement property acquired by the partners the concession would be clawed back and fully taxed as it would not be eligible for any future CGT concession. Section 115-25(2) would prevent it from being eligible for the 50% individual discount and sec 152-10(4) would preclude eligibility for the small business concessions, other than future roll-overs and the retirement exemption.

¶15.230 CASE STUDY 23 – FIVE-PERSON PARTNERSHIP

Five individuals, a father and four sons, own a cane farm which has been sold for an indexed capital gain of approximately $130,000. The father is aged 65 but the sons are all under 40.

At this stage they have not made any decision as to what use the sale proceeds are to be put.

What options are available to them in order to minimise the CGT having regard to the relatively long period of time before the sons reach retirement age.


Much will depend upon what the members of the family wish to do with the proceeds. As it is assumed that the farm was conducted as a partnership and they otherwise qualify under Division 17B (note here the rule for partnerships that the net value of the partnership must not exceed $5 million), it would be open to the father to make an election in respect of his share of the capital gains and receive it tax free.

Each son may wish to elect likewise but as each is under 55 the proceeds would need to be rolled over into a super or other preservation fund. If the sons are interested in buying another property or other business they could each make an election under Division 17A and defer CGT on their gains.

Another alternative open to them would be to seek to apply the Murry decision in relation to the farm and pay tax on only 50% of the goodwill portion of the gain. In view of the High Court’s decision in Murry, that the value of a statutory licence in relation to the cane farm does not represent the holder’s goodwill, this option would have limited appeal.

Given the fairly modest capital gain for each member, and depending on their other income for the income year in question, they may well be entitled to the benefit of the CGT averaging provisions which could substantially reduce the actual tax liability.




The partners would be able to apply the 50% individual discount to the nominal gain (which presumably will be higher than the $130,000 indexed gain) and then apply the 50% active asset discount. This would leave each with a taxable assessable gain of $6,500 (using $130,000 as the amount of the nominal gain).

The father could choose to apply his remaining gain as an exempt amount under the retirement exemption, and, as he is over 55, take the money as cash, tax free.

The brothers may either choose to roll over their share of the remaining gains into a new business or pay it into a super or roll-over fund.

Given that under the new CGT regime the amount remaining to be taxed after applying the 50% individual discount and 50% reduction is very modest, it may be simpler just to pay tax on the balance.

With the abolition of averaging as from 21 September 1999, the partners would no longer be able to make use of that concession. Some scope for averaging, however, continues where the timing of the disposal can be determined to enable it to arise in a year of income where the taxpayer has little or no other income. So, for example, a small business owner may wish to sell his/her business and retire. By selling the business at the start of an income year some “backdoor averaging” may be able to be achieved in respect of any residual capital gain remaining after applying the new concessions.

¶15.240 CASE STUDY 24 – RENTAL PROPERTY BUSINESS OPERATED BY

COMPANY

The property is owned by a partnership of two and is rented to a company of which the partners are the only members.

The company operates an accommodation business using the property rented from the two partners.


The owners of the property would not be eligible under Division 17A or 17B as the property is not used by them in the course of a business carried on by them.

Note that amendments announced on 13 August 1998 provided that, as from that date, where, as in this case, the land may have been merely leased to the trust, the small business concessions become available where the business is “connected with” the taxpayer or it is the taxpayer’s “small business CGT affiliate”.

If they were to commence business in their own right, there is a possible argument that Division 17A or 17B could apply on the basis that they have owned an “active asset” throughout the ownership period, notwithstanding that the land has been rented to the company.

Note that there is potential for Part IVA to be applied on change of business.


Under the new CGT regime it is now clear that a guesthouse will be regarded as an active asset – see example following sec 152-40(4)(e)(ii) ITAA 97. Under the previous regime there was considerable doubt that guesthouses and backpacker hotels could be treated as active businesses since the assets were deriving mainly rental income.

As property is used in a business by the partners’ connected entity, then, under sec 152-40(c)(ii), the property would be an active asset and, assuming that the partners otherwise satisfy the eligibility criteria under Division 152, would be able to claim the concessions


Selling a Small Business – The CGT Strategies under that Division. The partners would be eligible for the 50% individual discount if they had held the property for 12 months or more.

¶15.250 CASE STUDY 25 – SALE OF COMPANY SHARES

Question 25

A husband and wife establish an internet business from scratch in 1995. The business is operated through a company with the husband holding 80% of the shares and his wife holding the remaining 20%. The business is now successful after some years struggle and the owners have been offered $5 million for the business. It has minimal debts.

The owners want to know the best way to sell their business − the husband is 55 and his wife is 54, and they wish to retire to the south coast and run a health farm.


If the company were to sell the business it would probably be entitled to claim the retirement exemption up to the husband’s lifetime limit of $500,000 on the basis that he was paid an ETP up to that amount (note the lump sum RBL is $485,692 (1999/2000), $506,092 (2000/2001), $562,195 (2002/2003)), assuming that the net assets of the company and the husband and wife did not exceed the $5 million threshold. As the wife has less than a 50% interest in the company, she is not a controlling individual so is not eligible to benefit under the retirement exemption. The balance of the gain, which would be close to $4 million less the retirement exemption amount, would be fully taxable in the hands of the company at the company tax rate.

Alternatively, the company may elect to roll over the capital gain from the sale of the business into the proposed health farm. After five years the replacement asset, that is the health farm, could be sold or rolled over again and any CGT concessions would be again available.

The sale of the business would not attract the 50% goodwill exemption as it would appear that its net assets are greater than the threshold for this exemption ($2,275,000 for 1999/00).

The husband and wife might be able to sell their shares in the company as a means of selling the business. However, as only the husband is a controlling individual, only he would be able to access the retirement exemption or the roll-over. Full CGT would be payable by the wife on the sale of her shares.


If the company were to sell the business it would probably be entitled to claim the 50% active asset reduction and the retirement exemption up to both the husband’s and wife’s lifetime limit of $500,000 on the basis that they were paid an ETP up to that amount (note the lump sum RBL is $485,692 (1999/2000), $506,092 (2000/2001), $562,195 (2002/2003)), assuming that the net assets of the company and the husband and wife did not exceed the $5 million threshold.

Even though the wife has less than a 50% interest in the company, and is a not controlling individual, she is a CGT concession stakeholder (being a shareholder and the spouse of the controlling individual) so is eligible to benefit under the retirement exemption.

Assuming that the husband and wife both had minimal superannuation savings, they would both be able to receive close to $500,000 each under the retirement exemption, leaving around $1.5 million upon which the company would be assessable. It would be open to the company to roll over this amount into the new business – effectively eliminating entirely the tax on the gain.

As noted in Case Study 15, under Division 152 there is now a particular disincentive to make use of the roll-over. The disincentive is that the amount of the gain rolled over is quarantined indefinitely so that on any future sale of the replacement property acquired by the company,


Selling a Small Business – The CGT Strategies the amount of the roll-over (say $1 million) would be clawed back and fully taxed as it would not be eligible for any other CGT concession, other than another roll-over or the retirement exemption.

If the husband and wife are able to sell their shares in the company as a means of selling the business, this approach would potentially enable them to additionally benefit from the 50% individual discount. One point to watch here is that the operation of sec 115-45 ITAA 97 may apply in some cases (see ¶1.020).

Given that the small business concessions and the scrip for scrip roll-over now make it attractive for the owners of small businesses to sell their shares rather than the business assets of the company, it is likely that there will be less resistance to such an approach from potential business purchasers.

¶15.260 CASE STUDY 26 – SALE OF CHILD CARE CENTRE

Question 26

A single father acquired in 1989 a large property for $600,000 with the assistance of his bank. His plan was to use the property partly as a residence and partly as a child care centre of which he would be the operator. For most of the period of ownership, two rooms in the business part of the building were let to other businesses as offices.

The father has been offered $2 million for the property by a developer. He wants to sell it and buy a smaller home from which he can work as a customer services officer for a large financial organisation.


The father would be entitled to the main residence exemption on that part of the building that was his main residence. The apportionment of the building could be done on a floor area basis, though other bases may be acceptable (see TR 93/30).

The father would be entitled to the retirement exemption in respect of the part of the property used as a child care centre as this would be an active asset. As it is assumed he is under 55, the amount of the capital gain referable to the child care centre (up to the father’s lifetime limit of $500,000 and subject to his RBL) would be required to be paid into his super or roll-over fund.

It would appear that, as the property is being sold to a developer, any goodwill associated with the child care centre has only nominal value and there would be little apparent scope for the 50% goodwill exemption to apply.

There would be no concessions on that part of the building used for rented offices.

If he used the remaining proceeds of the sale for his new house after having elected to apply the retirement exemption, he would not be entitled to any further concessions.

If he used the remaining proceeds of the sale for his new house, whether or not having chosen to apply the retirement exemption, he may be able to choose to roll over part of the remaining taxable gain in respect of the office in the new house. Eligibility here would depend on whether the office could be said to be used in the course of carrying on a business. As a customer service officer of a company working from home, it may be that he would be regarded as an employee of that company and not engaged in business.


The father would be entitled to the main residence exemption on that part of the building that was his main residence. The apportionment of the building could be done on a floor area basis, though other bases may be acceptable, see TR 93/30.


Selling a Small Business – The CGT Strategies The father would then be entitled to the 50% individual discount as he has held the property for more than 12 months. It would still be necessary to calculate the proportionate frozen indexed capital gain; though, as the gain is fairly large in comparison to the cost base, it is likely that the 50% individual discount on the nominal gain would produce the better result.

The father would also be entitled to the 50% active asset reduction on the part of the property used for the child care centre. He would also be entitled to the retirement exemption in respect of the part of the property used as a child care centre. As it is assumed he is under 55, the amount of the capital gain referable to the child care centre (up to the father’s lifetime limit of $500,000 and subject to his RBL) would be required to be paid into his super or roll-over fund.

Whilst any goodwill associated with the child care centre may only be of nominal value to the developer, this would be irrelevant under the new CGT regime as whatever value can be attributed under the sale to the child care centre would be eligible for the active asset reduction.

No concessions would be available to the father for the rented offices.

¶15.270 CASE STUDY 27 – SALE OF MEDICAL PRACTICE COMPANY

A medical practitioner who has incorporated his practice in accordance with IT 2503 (under which the ATO permitted practitioners to incorporate to enable them to provide superannuation benefits) was one of a five-member medical partnership that had been approached by a corporate medical group to buy out the practice with offers of employment for the practitioners in the newly acquired practice.

All the shares in the practitioner’s practice company were owned by the practitioner.


It was originally envisaged that the practice companies would each sell their interests in the practice. One issue to note here is what is the practice company’s interest in the partnership. There was no formal documentation of the agreement to transfer the interest to the company. Given that the company had been formed to take advantage of the ruling which required that the practice be transferred to the company it was reasonable to make the assumption that the company was the owner of a share of the practice goodwill.

For the company to sell its interests in the practice, it would be entitled to the 50% active asset reduction. The company would also be entitled to apply the retirement exemption on the balance. Alternatively, given that the gain was less than $500,000 (the retirement exemption limit) the company could choose to apply the retirement exemption to the whole of the gain. The advantage of this approach is that it enables the exempt amount to be extracted from the company. The amount would need to be paid as an ETP to the practitioner – for such a payment to be made, the practitioner’s employment with the company would need to be terminated which would be necessary in any event. As the practitioner was under 55 at the time, it would be necessary to pay this amount into his super fund. Given that the practitioner already has substantial super savings and he was keen to immediately access a part of the proceeds from the sale, this option was not proceeded with.

The alternative approach was to sell the shares in the company to the purchaser. This was acceptable to the purchaser who was agreeable to pay the same amount for the shares as had been offered for the practice assets. Under this approach, the 50% general discount applies firstly, then the active asset reduction. It would then be open to the practitioner to apply the retirement exemption to the balance of the gain. Under this approach only 25% of the gain would be paid into his super fund.

See ID 2002/248 on whether goodwill can be a pre-CGT asset if transferred back from the practice company to the individual.



Appendix 1

Small business and other concessions checklists (The purpose of these checklists is to provide a quick ready reference to determine likely eligibility rather than as a final check to compliance in relation to a particular transaction.)

Small business 15-year exemption checklist

A CGT event must happen in relation to a CGT asset that you own in an income year.

The CGT event would have given rise to a capital gain.

The maximum net asset value test must be satisfied by the taxpayer.

The CGT asset satisfies the active asset test.

The CGT asset must have been held continuously for a 15-year period.

Where the CGT asset is a share in a company or an interest in a trust (i.e. a unit in a unit trust or an interest in a fixed trust), the company or trust must satisfy the “controlling individual” test and the taxpayer must be a “CGT concession stakeholder” in the company or trust.

If the CGT asset is a share in a company or an interest in a trust, the 80% look through rule applies requiring 80% of the entity’s assets to be active.

If the CGT asset is a company share or interest in a trust, there must have been a controlling individual during the whole ownership period.

The individual must be 55 or over and the disposal of the CGT asset must be in connection with the individual’s retirement; alternatively, the individual must be permanently incapacitated at the time of the CGT event.

If the exemption is claimed by an entity, at all times during the whole period for which the entity owned the asset, the entity had a controlling individual (but not necessarily the same one).

Capital losses not affected.

Applies automatically.

Small business 50% reduction checklist

That a CGT event happens in relation to a CGT asset that you own in an income year.




Where the CGT asset is a share in a company or an interest in a trust (i.e. a unit in a unit trust or an interest in a fixed or hybrid trust), the company or trust must satisfy the “controlling individual” test and the taxpayer must be a “CGT concession stakeholder” in the company or trust.


Applies automatically after capital losses deducted unless you choose not to apply it.


Selling a Small Business – The CGT Strategies Where capital gains are discount capital gains, the discount is applied first after capital

losses taken into account.

Small business retirement concession checklist

A CGT event must happen in relation to a CGT asset that a taxpayer owns in an income year.




If the taxpayer is under 55, the exempt amount must be rolled over into a superannuation fund, otherwise the exempt amount is received as an exempt capital gain.

If the CGT asset is a share in a company or an interest in a trust, the 80% look through rule applies requiring 80% of the entity’s assets to be active and the individual taxpayer will need to be a controlling individual.

Taxpayers may choose the exemption in addition to applying the discount capital gains concession, small business 50% reduction, and roll-over.

Exempt amount must be specified in writing.

Where more than one CGT concession stakeholders their “individual’s percentage” must be specified in writing.

ETP payment by an entity must be made the later of seven days after the choice to apply the exemption or seven days after the entity receives an amount of capital proceeds.

The ETP paid by an entity must fall within the definition of an ETP in sec 27A ITAA 36, for example it is paid in consequence of the termination of the recipient’s employment.

The $500,000 lifetime limit applies.

Small business roll-over checklist

A CGT event must happen in relation to a CGT asset that you own in an income year.





The taxpayer must choose to apply the roll-over but no formal requirements required.

Choice must be made within two years of last roll-over event in relevant income year.

Replacement asset must be acquired within one year before and two years after last roll-over event – there is some scope to extend this period.

Replacement assets must be active at time when acquired or by the end of two years after relevant CGT event.

Where the replacement asset is a share in a company or an interest in a trust the taxpayer must become a controlling individual of the new entity.

The effect of the roll-over is to reduce the first element of the cost base of the replacement asset – any excess is assessable.

Roll-over applies to all assets whether goodwill or non-goodwill.


Selling a Small Business – The CGT Strategies Change of use or disposal may trigger capital gain and the “roll-over” amount will be

subject to full taxation, though it can be rolled over again or benefit from the retirement exemption.

Taxpayers may choose the roll-over in addition to applying the discount capital gains concession, small business 50% reduction, and retirement exemption.

Scrip for scrip checklist

A taxpayer may choose to roll over a capital gain in respect of a share or trust interest acquired on or after 20 September 1985 where:

The offeror makes an offer to all of the holders of shares or interests in the offeree in exchange for shares or interests in the offeror.

The offeror acquires at least 80% of the voting rights of the offeree in consequence of the offer.

The taxpayer is an Australian resident just before the disposal of the shares or interest.

“Like for like” only.

Where either offeror or offeree entity has less then 300 members and is not acting at arm’s length, the value of the exchanged shares or interests must be at least substantially the same and the rights and obligations must also be of the same kind.

Roll-over not available if:

the taxpayer is not an Australian resident, unless new share or interest has a necessary connection with Australia;

capital gain otherwise disregarded;

the taxpayer and offeror are members of same wholly-owned group;

offeree or offeror is a discretionary trust.

Cost base transfer to acquiring entity required where:

on an associate-inclusive basis, an entity has a 30% or more stake (significant stake) in the original entity before the arrangement and in the entity in which its replacements interests are held;

any other original interest holder is an associate of the entity which holds the replacement interests just after the arrangement is completed;

should the Commissioner treat interest as a significant stake notwithstanding entity widely held;

an interest is part of an 80% or more common holding of interests (determined on an associate-inclusive basis) in a non-widely held original interest just before the arrangement and in a non-widely held replacement entity just after the arrangement;

if an acquiring entity is an original interest holder, each other original interest holder that has a replacement interest is a common stakeholder.

Demerger checklist

For a demerger there must be:

a holding of more than 20% in the group member;

at least 80% of the interests owned by the group in an entity are either transferred or issued to the owner of the interests in the group's head entity;


Selling a Small Business – The CGT Strategies a CGT event (e.g. CGT event G1 (capital payment for shares), or E4) happens to the

owners of the original interests in the head entity, or the owners simply acquire a new interest on or after 1 July 2002;

just before the restructuring, more than 50% of the original interests in the group’s head entity were owned by Australian residents, or by foreign residents whose new interests will have the “necessary connection with Australia” just after they acquire them;

they satisfy the proportionate ownership test under which each head entity interest owner just after the restructure owns the same proportion, or as near as practically possible, of ownership interests in the demerged entity as they had in the head entity before the restructure;

they satisfy the market value test under which the market value, or a reasonable approximation thereof, of the remaining original interests and the new interests must reasonably have been expected to be not less than the market value of the original interests held;

they satisfy the like kind test under which, for example, share or option holders in the head entity receive new shares or other options or similar combinations, and holders of units or interests in a trust receive new units or other interests in a trust. Under this requirement a shareholder can, for example, receive share options rights or similar interests to acquire shares but cannot receive units or other interests in a trust;

no cash or something other than new interests in the demerged entity received by the interest owners of the head entity; and

interest holders must choose whether to apply the roll-over with a consequential adjustment of the cost base of their original interests, but even where the roll-over is not chosen, they must still make the same cost base adjustment.

Note Further:

the roll-over is not permitted where another CGT roll-over can be utilised;

pre-CGT interests are preserved and expanded;

CGT event J1 (company ceasing to be member of wholly owned group after roll-over) is treated as not happening to a demerged entity or to any other member of the group where CGT event A1 (disposal) or C2 (cancellation or surrender) happens to a demerging entity under a demerger;

Where there is a capital loss made by a member of a demerger group that has been attributed to a value shift under a demerger the loss is required to be reduced by an amount reasonably attributable to the reduction in the market value of the asset realised (see sec 125-165);

if, because of a demerger, the value of an asset is reduced and that asset is transferred after the demerger and the transferor gets a roll-over, the reduced cost base of the asset is reduced by the decrease in value caused by the demerger;

corporate unit trusts and public trading trusts are to be treated as if they were companies for the purposes of the concessions;

the demerger provisions operate independently of the consolidation regime so that it is possible for a consolidated group to demerge one or all of its members; and

continuity of ownership tests for losses will continue to apply so care needs to be taken when considering a demerger where losses are present.

Venture capital exemption checklist

For a venture capital entity to qualify under the venture capital exemption it must:


Selling a Small Business – The CGT Strategies be a non-resident of Australia;

not be a prescribed dual resident;

be a foreign superannuation fund;

be exempt from tax in a specified jurisdiction – currently Canada, France, Germany, Japan, UK and USA;

be exempt from tax in that jurisdiction;

be registered with the PDF Board under Part 7A of the PDF Act 1992;

make an application for registration within 30 days from the first investment; and

make an eligible investment.

An eligible investment must:

be made in a resident investment vehicle;

be by way of venture capital equity by way of shares or unit or other interest in the investment company or trust;

be held at risk; and

be held for at least 12 months.

A resident investment vehicle is:

a company or fixed trust that is an Australian resident;

its total assets must not exceed $50m at the time of the new investment (including the new investment); and

it does not have property development or ownership of land as its primary activity.



Appendix 2 Treasurer’s Press Release of 23 December 1999 TREASURER

NO. 093

CAPITAL GAINS TAX TREATMENT OF ASSETS ACQUIRED BY TRUSTS

Today I am announcing further details on the capital gains tax (CGT) treatment of assets disposed of by trusts after 1 July 2001, the date from which trusts will be taxed like companies. This announcement will provide certainty for taxpayers about the CGT treatment for assets disposed of by trusts.

The New Business Tax System (Integrity and Other Measures) Act 1999 sets out the capital gains tax treatment of assets disposed of by trusts prior to 1 July 2001. For assets disposed of by a trust prior to 1 July 2001, the trustee is able to benefit from the CGT discount available to individuals in determining the net income of the trust (or has the option of applying frozen indexation if the asset was acquired at or before 11.45 am, AEST 21 September 1999). That part of a beneficiary’s share of the net income of the trust that is attributable to a discounted gain will be grossed up by the amount of the discount before applying the CGT discount appropriate to the beneficiary. Existing cost base adjustments for distributions of non-assessable amounts (i.e. the discount or indexation component) apply but are modified for complying superannuation entities and companies to the extent a discounted amount has been assessed via the gross-up outlined above. Where assets are acquired by a trust after 23 December 1999 and disposed of on or after 1 July 2001, a trust taxed like a company will be taxed at the entity rate on any gain.

For assets disposed of by a trust on or after 1 July 2001, where the assets were acquired by the trust on or before 23 December 1999, the trust will be able to benefit from the CGT discount available to individuals (or has the option of applying frozen indexation if the asset was acquired at or before 11.45 am, AEST 21 September 1999) in determining the trust’s assessable income. Amounts excluded from a trust’s assessable income will, on distribution, be treated as a return of contributed capital of the trust, consistent with the general transitional rules for trusts that become subject to entity taxation.

The arrangements relating to disposals on or after 1 July 2001 are to be legislated in 2000.

The attached fact sheet provides a detailed explanation of the CGT treatment of assets acquired by trusts.

CANBERRA

23 December 1999



FACT SHEET

The New Business Tax System

What is the CGT Treatment of Assets Held by Trusts?

What is the treatment of assets acquired before 21 September 1999 and disposed of prior to 1 July 2001?

Prior to 1 July 2001, where a trust disposes of a CGT asset acquired at or before 11.45 am AEST 21 September 1999, the trustee will have the option of choosing either the 50% discount or frozen indexation in calculating the trust’s net income (these options will continue to be available when trusts are taxed like companies). If the 50% discount is chosen, that part of a beneficiary’s share of the net income of the trust will be grossed up by the amount of the discount. The beneficiary will then be able to offset any capital losses and themselves claim the appropriate CGT discount (namely 50% for an individual and 331/3% for a complying superannuation entity). If the frozen indexation option is chosen, or no CGT concession is available for the capital gain, current trust assessment rules apply, and there is no adjustment to that part of the beneficiary’s share of the net income of the trust. Any non-assessable amount distributed to a beneficiary of a trust will be subject to cost base adjustment rules, which only affect fixed interests in trusts. (Any capital gain arising to beneficiaries who are individuals or superannuation funds from those cost base adjustments will also be eligible for the general 50% /331/3% discount rule – see below for further details).

What is the treatment of assets acquired after 21 September 1999 and disposed of prior to 1 July 2001?

Where assets are acquired by a trust after 11.45 am AEST 21 September 1999, held for at least 12 months and disposed of before 1 July 2001, the trust will apply the 50% discount rule. The gross-up arrangements and cost base adjustments described above will also apply.

What happens if a beneficiary receives a tax-free distribution from a trust of the CGT discount that was allowed to the trustee?

As noted above, if a beneficiary’s interest in the trust is not fixed, there are no CGT consequences for a beneficiary receiving a distribution out of the excluded gain amount (i.e. the CGT discount). If a beneficiary’s interest in the trust is fixed, then a cost base adjustment may apply. For example, if a trustee chooses a 50% exclusion for an asset disposed of prior to 1 July 2001, then, on distribution of the excluded amount:

• individual beneficiaries’ cost bases will be reduced by the full excluded amount, consistent with current cost base adjustment rules.

• superannuation fund beneficiaries will face a partial cost base adjustment.

• for corporate beneficiaries, no cost base adjustment (as this amount has been assessed via the gross-up).



Example:

A fixed trust has three beneficiaries – an individual, a company and a superannuation fund, each with a fixed one-third entitlement to the income and capital of the trust. The trust has an asset acquired prior to 21 September 1999 which it has owned for more than a year. The cost base of the asset is $100 and the cost base with frozen indexation as at 30 September 1999 is $200. On 2 October 1999, the trust disposes of the asset for $400. The nominal gain is $300 (half of which is $150) and the indexation adjusted gain is $200. To minimise the trust’s net income, the trustee chooses the 50% discount and includes only $150 in the trust’s net income. The remaining $150 of excluded gain is also distributed equally to the beneficiaries. For the individual, their assessable income will include their $50 share of the trust’s net income. The cost base of their interest in the unit trust will be reduced by $50 (their share of the distributed excluded gain). If the cost base of the unit was $10, the cost base is reduced to nil and there is a capital gain of $40. If the unit was owned for at least 12 months, the individual can apply the 50% discount and reduce the gain to $20. For the superannuation fund, its assessable income will include its $50 share of the trust’s net income, effectively grossed up by a third – for total assessable income of $67. The cost base of its interest in the unit trust will be reduced by $33 (in respect of the $50 of excluded gain), with any capital gain arising then (or on later disposal) eligible for the 331/3 % CGT discount. For the company, its assessable income will include its $50 share of the trust’s net income grossed up by 100% – for total assessable income of $100. No cost base adjustment is made in respect of the $50 excluded gains, as that amount has already been effectively brought to tax by the grossing up.

What is the treatment of assets acquired on or before 23 December 1999 and disposed of on or after 1 July 2001?

On or after 1 July 2001, on the disposal of assets acquired on or before 23 December 1999, a trust will apply the 50% discount rule (or it will have the option of applying frozen indexation if the asset was acquired before 11.45 am AEST 21 September 1999) in determining the trust’s assessable income. No gross up rules will apply.

Amounts excluded from a trust’s assessable income by the discount will, on distribution to beneficiaries, be treated as a return from contributed capital of the trust, consistent with the general transitional rules for trusts that become subject to entity taxation.

The profits first rule will not apply to excluded amounts distributed in the same income year as when they arose.

What is the treatment of assets acquired after 23 December 1999 and disposed of on or after 1 July 2001?

Where assets are acquired by a trust after 23 December 1999 and sold on or after 1 July 2001, a trust taxed like a company will be taxed at the entity rate on any gain.

A member will be assessable on profit distributions received from the trust, with a credit for any tax paid on the gain at the trust level.

What will be the treatment of assets acquired by trusts that elect to be collective investment vehicles on or after 1 July 2001?

For trusts on or after 1 July 2001 that elect to be collective investment vehicles, a flow-through treatment will apply regardless of when an asset was purchased, with no choice of frozen indexation allowed.



What is in the first tranche of legislation which has been passed by Parliament?

The ‘A New Business Tax System (Integrity and Other Measures) Act 1999’ covers acquisitions before or after 21 September 1999 where disposals occur prior to 1 July 2001.

The Act also freezes the indexation component at 30 September 1999.

The arrangements relating to disposals on or after 1 July 2001 are to be legislated in 2000.

The information in this Fact Sheet is intended to tell you about the Government's response to the Review of Business Taxation, and contains general information only. You should not rely on it for advice. For advice on how the Government's announcement might affect your particular circumstances, you may wish to seek professional advice. The Commonwealth is not responsible for any action you take which relies on information in this Fact Sheet. The information in this Fact Sheet is current as at 23/12/1999.

For further information:

• www.treasury.gov.au (for additional fact sheets)

• www.treasurer.gov.au (for press releases)

• www.rbt.treasury.gov.au (for RBT Report, Draft Legislation and Explanatory Notes)

• Government Info Shops (for RBT Report, Draft Legislation and Explanatory Notes)



Appendix 3

ATO CGT and GST survey and questionnaire

The Small Business Concessions under Capital Gains Tax We would like to let you know about a project that may affect some of your members. The Tax Office is undertaking a project to assess the level of understanding of, and compliance with, the Small Business relief provisions under Division 152 of the Income Tax Assessment Act 1997 as part of the Tax Office’s responsibility for monitoring compliance with taxation legislation. The Small Business Concessions were introduced to help small businesses that satisfied the basic conditions for relief reduce their capital gains tax liability by claiming concessional treatment. The first stage of this project will involve sending a detailed questionnaire to a small sample of taxpayers who have claimed the Small Business concessions in their return for either of the years ended 30 June 2000 or 2001. The questionnaire will require details of the CGT event(s) in respect of which the Small Business concessions have been claimed, and evidence that the entity satisfies the several qualifying tests. A sample copy of the questionnaire for the year ended 30 June 2001, compiled to apply to a company that has used the indexation method and claimed for an active asset reduction and small business, is attached for your information. The scope of each questionnaire may vary with the specific circumstances of each case. The questionnaire for the year ended 30 June 2000 also covers the Capital Gains regime that applied before the current small business concessions were introduced on the 21st of September 1999. It may also be necessary for further correspondence to be issued, or for field officers to contact some taxpayers to clarify and resolve certain issues, depending on replies to these questionnaires. The project may be extended to more taxpayers if warranted by the level of compliance evidenced by this sample. The Tax Office will use the findings from this project to assist in determining future strategies to assist taxpayers meet their obligations under this legislation. The Small Business SME Team in the Hobart Office will co-ordinate this project, and will be the initial point of contact for all Small Business concessions questionnaires sent to taxpayers Australia wide. If direct contact by field officers is required, this will be coordinated through a branch office in the taxpayer's home state. The first questionnaires are expected to be sent in late September, 2002. PALU can be contacted if you or your members require any further assistance in relation to this project.



Sample questionnaire

Re: Capital Gains Tax (CGT) – Xxxxx Xxxxxxx Pty Ltd The Tax Office is undertaking an examination of entities that have claimed one or more of the Small Business concessions under Division 152 of the Income Tax Assessment Act 1997 in relation to a CGT event. Division 152 provides small businesses with a range of concessional treatments for capital gains on the condition that certain tests are met. The Company has shown a net capital gain in its tax return for the year ended 30 June 2001 and it has claimed concessional treatment in respect of that gain. The Company has been selected as part of a random sample for a review of its claim for the Small Business concession(s). The Company is asked to provide details of the CGT event and the calculations used to make the Small Business concession claim(s). The concessions themselves are only applied to reduce the current year capital gain after the cost base of each asset involved in the CGT event is established, after the choice has been made between whether to apply the indexation or the CGT discount method, and after current and prior year capital losses have been offset. Consequently, information is also sought to confirm these aspects of the calculation. The nature of the calculations to establish current year capital gains after applying current year capital losses, prior year capital losses, the indexation or CGT discount method, and the tests to be met before these concessions can be claimed, suggests that detailed working records are likely to be available to help the company answer the questions in this letter. As a preamble to each of the sets of questions shown below, a brief outline of the legislative requirements has been included to put this request for information into context, but the company may need to seek more detailed advice on its specific circumstances. In addition to the CGT considerations, Goods and Services Tax (GST) applies after 1 July 2000 to the majority of sales of capital assets by an enterprise in the course of its business. With some exceptions, GST applies to all capital business assets including real property, plant and equipment, rights, licences and leases. Please provide the information requested below in relation to any GST obligation that arose as a consequence of both the CGT event, in respect of which the company has claimed the Small Business concession(s), and any other sale of business assets, including depreciated plant and motor vehicles, that occurred during the year ended 30 June 2001.

Questions Capital Proceeds The capital proceeds from a CGT event are the total of: 1. the money you have received, or are entitled to receive, in respect of the event

happening, and 2. the market value of any other property you have received, or are entitled to receive,

in respect of the event happening (worked out as at the time of the event) (subsection 116-20(1)).

In respect of each capital gains tax event you had during the 2000/2001 income year, please provide the following information: • the date each event occurred • a description of the asset(s) sold in connection with each event


Selling a Small Business – The CGT Strategies • the amount of the capital proceeds received for each asset and the total amount of

capital proceeds for each CGT event, and • the total of all capital proceeds from all events for the income year.

The indexation, CGT Discount and ‘other’ methods of calculating the net Capital Gain The Small Business concessions may be claimed against the amount of net capital gain for each asset involved in a CGT event. However, to derive the net capital gain, the unindexed cost base of each asset must be calculated. A decision must also be made as to which of the indexation, CGT discount or 'other' methods will be used to calculate the capital gain for each asset. This choice depends on a number of factors outlined in the explanatory notes below. If the indexation method is chosen, the capital gain is calculated as the result of the capital proceeds, less the indexed cost base. Then any current year capital losses and any prior year capital losses are applied to produce the 'current year capital gain after applying capital losses', before the Small Business concessions are applied. If the CGT discount method is chosen, the capital gain is calculated as the result of the capital proceeds, less the cost base. Then any current year capital losses and any prior year capital losses are applied to produce the 'current year capital gain after applying capital losses'. The CGT discount percentage is then applied to produce the 'current year capital gain after capital losses and discount', before the Small Business concessions are applied. The 'other' method only applies where the asset has been owned for less than 12 months and neither the indexation nor the CGT discount methods apply. In this case, the capital gain is calculated as the result of the capital proceeds, less the cost base. Then any current year capital losses and any prior year capital losses are applied to produce the 'current year capital gain after applying capital losses', before the Small Business concessions are applied. If any capital gains tax worksheets were prepared when calculating the net capital gain to which the Small Business concessions were applied, please provide copies of the completed worksheets.

Cost Base of Assets The five elements that make up the cost base of an asset, as described in Section 110-25, are: 1. the money paid, or the market value of any property given, to acquire the asset 2. incidental costs incurred to acquire the asset or that relate to a CGT event that

happens to an asset (Section 110-35) 3. non-capital costs of ownership of the CGT asset 4. capital expenditure incurred to increase the asset’s value, and 5. capital expenditure incurred to establish, preserve or defend your title to the asset, or

a right over the asset. Note: Expenditure does not form part of the second or third elements of the asset's cost base to the extent that you can deduct or have deducted it. Please provide the following information in respect of each asset sold as part of the CGT event: • full details of the amount of money paid, or the market value of any property given, to

acquire each asset, including the original purchase price and date of purchase


Selling a Small Business – The CGT Strategies • full details of any incidental costs incurred to acquire each asset or that relate to a

CGT event that happened to an asset (section 110-35), to the extent that those costs were included in the calculation of the cost base

• full details of any non-capital costs of ownership of each CGT asset, to the extent they have not and cannot be claimed as deductions

• full details of any capital expenditure incurred to increase each asset’s value, including the cost of any capital improvements and the date those improvements were completed

• full details of any capital expenditure incurred to establish, preserve or defend your title to each asset, or a right over an asset, including an explanation of the circumstances surrounding the expenditure, and

• the calculated cost base for each asset sold as part of the capital gains tax event. Indexation All elements of the cost base, except the third element, can be indexed. This means that the amount of each relevant element is multiplied by an indexation factor based on the Consumer Price Index. This effectively increases the cost base by the inflation figure. The indexation method can be used if: 1. a capital gains tax event happens to an asset acquired before 11.45am on 21

September 1999, and 2. the asset has been held for 12 months or more. Indexation was frozen on 30 September 1999 and the cost base can only be indexed up to the September 1999 quarter. The discount method can not be applied to net capital gains calculated using an indexed cost base. Was indexation applied to any part of the calculation of the cost base of each asset sold as part of the capital gains tax event? If so, please provide the following information in respect of the calculation of the cost base: • details of the indexation calculation for each element of the cost base for each asset,

including the indexation rates applied to the calculation of each element. Capital losses Section 102-15 provides that net capital losses are applied against net capital gains in the order in which they were made. In addition, they can only be applied to the extent that they have not yet already been applied. In practice, current year capital losses are deducted from current year capital gains to produce the net capital gain for the current year. Then any net capital losses from prior years are deducted, applying the oldest first until they are either all absorbed, leaving a net current year gain, or they extinguish the current year gain, leaving a net loss to be carried forward. Please provide the following information in respect of the calculation of the ‘current year capital gain after applying capital losses’: • details of any current year capital losses applied, including details of the asset and

sale which produced each loss • details of any prior year capital losses applied, including details of the asset and sale

which produced each loss, and the year each loss occurred • evidence that any prior year losses, applied in calculating the 'current year capital gain

after applying capital losses', have not already been applied in previous years' returns, and

• the amount of the gain remaining after capital losses, if any, were applied.



The Small Business concessions in relation to Capital Gains Tax The Small Business concessions In order to be entitled to claim any of the Small Business concessions, the CGT event in question must have occurred after 11:45am, by legal time in the Australian Capital Territory, on 21/09/1999, and each of the following major basic conditions must be satisfied: 1. the maximum net asset value test, under which there is a $5,000,000 limit on the net

value of assets that the small business entity and related entities own just before the disposal of the asset

2. an active asset test, and where the CGT asset is a share in a company or an interest in a trust: 3. a controlling individual test, in conjunction with which, an individual claiming the

concession is a CGT concession stakeholder in the company or trust. Maximum net asset value test (Subdivision 152-A) A small business entity satisfies the maximum net asset value test if the total net value of CGT assets owned by: 1. the small business entity 2. any small business CGT affiliates of the small business entity 3. any entities connected with the small business entity, and 4. any entities connected with a small business CGT affiliate of the small business entity,

does not exceed $5,000,000 just before the CGT event that results in the capital gain for which the concessions are sought.

The net value of the CGT assets of an entity is the sum of the market values of those assets less any liabilities of the entity relating to those assets (subsection152-20(1)). In respect of the calculation of total net value of CGT assets held by the entity just before the CGT event for which the company has claimed the Small Business concession, please provide the following: • details of all of the assets held by the entity just before the asset(s) was/were disposed

of, including any assets that were excluded from the calculations for the maximum net asset value test

• where any asset was excluded from that calculation, the reason that each asset was excluded

• evidence of the company's calculation of the net value of CGT assets held just before the CGT event in respect of which the Small Business concession has been claimed, including:

o the basis upon which market value was arrived at for each asset, including plant used or held ready for use in the business of the entity

o the original cost of each asset and date of purchase o the value of any capital improvements made to each asset and the date(s) of

completion of those improvements, and o details of any liabilities of the entity relating to those assets and used in the

company's calculation of net value, including the original capital sum borrowed, the date of the original loan and the date and amount of any subsequent loan or draw-down, and the balance of capital just before disposal.



The maximum net asset value test requires that the calculation of total net value of CGT assets also takes into account the net value of assets held by the types of related entities described below. Related entities include any small business CGT affiliates of the small business entity, any entities connected with the small business entity, and any entities connected with a small business CGT affiliate of the small business entity. An individual's spouse or child under 18 years is a small business CGT affiliate of that individual. An individual that acts, or could reasonably be expected to act, either in accordance with the small business entity's directions or wishes, or in concert with the small business entity, is also a small business CGT affiliate. (section 152-25) An entity is connected with another entity if either entity controls the other entity, or both entities are controlled by the same third entity. (subsection 152-30(1)) Furthermore, an entity controls another entity if it, its small business CGT affiliate or both of them together: 1. beneficially own, or have the right to acquire beneficial ownership of, interests in the

other entity that give the right to receive at least 40% (the control percentage) of any distribution of income or capital by the other entity (paragraph 152-30(2)(b)), or

2. if the other entity is a company, beneficially own, or have the right to acquire beneficial ownership of, shares in the company that give at least 40% of the voting power in the company (paragraph 152-30(2)(b)).

An entity controls a discretionary trust if the entity, its small business CGT affiliate or both of them together: 1. is the trustee of the discretionary trust (other than the Public Trustee of a State or

Territory), or 2. has the power to determine how the trustee makes distributions of income and/or

capital (paragraph 152-30(2)(c)). To determine if a potential beneficiary controls a discretionary trust that beneficiary is taken to have an interest in any distribution of income or capital of the trust equal to the maximum percentage of the income or capital that the trustee could distribute to that beneficiary under the trust deed, regardless of the actual distribution. If a trust deed has the effect that a beneficiary may receive up to 100% of the income or capital of the trust, irrespective of the actual percentage distributed, then that beneficiary is treated as though it has a 100% interest in the trust. Consequently, the beneficiary will be treated as though it controls the trust for the purposes of the maximum net asset value test. Please provide the following details of those related entities whose assets have been taken into account in calculating the net value of CGT assets for the maximum net asset value test in relation to the Small Business concession claimed: • the full name, trading name and business address or registered office of each entity • where the entity is other than an individual, the tax file number of each entity • a description of the company's relationship with that entity, including any changes

over time • details of all of the assets held by that entity just before the asset(s) was/were

disposed of, including any assets that were excluded from the calculations for the maximum net asset value test

• where any asset was excluded from that calculation, the reason this was done in respect of each asset so excluded, and


Selling a Small Business – The CGT Strategies • evidence of the company’s calculation of the net value of CGT assets held by each

related entity just before the disposal of asset(s) in respect of which the Small Business concession has been claimed, including:

the basis upon which market value was arrived at for each asset, including plant used or held ready for use in the business of the entity

the original cost of each asset and date of purchase the value of any capital improvements made to each asset and the

date(s) of completion of those improvements, and details of any liabilities of the entity relating to those assets and used

in the company's calculation of net value, including the original capital sum borrowed, the date of the original loan and the date and amount of any subsequent loan or draw-down, and the balance of capital just before disposal.

Active asset test (Subdivision 152-A) The active asset test requires the CGT asset to be an active asset both at a particular time and for half a particular period. In order to qualify for this concession, the following conditions must be met: • the CGT asset must have been an active asset of the small business entity just before

the earlier of: the CGT event, and if the small business ceases and the CGT event happens within 12

months of the business ceasing - when the small business ceased, and at least half of the period beginning at the later of: when the CGT asset was acquired, and 15 years before the CGT event or cessation of the business if that

occurred before the CGT event; and ending at the time of the CGT event or the small business ceasing.

In respect of the disposal of the asset(s) for which the company has claimed the Small Business concession, please provide the following: • details of each asset involved in the CGT event that satisfies the active asset test • documentary evidence to show that each asset disposed of was either:

used or held ready for use in the course of carrying on a business, by the small business entity, by a small business CGT affiliate, or by an entity connected with the small business entity, or

an intangible asset that is inherently connected with a business carried on by the small business entity

• the date each asset came into the ownership of the entity claiming the concession, and • a description of the use to which each asset had been put between its acquisition and

its disposal to show that it has been used or held ready for use for more than half of the period of its ownership.

A share in a company or an interest in a trust is also an active asset at a given time if: • the company or trust is an Australian resident, and • the total of:

the market values of the active assets of the company or trust, and



of any capital proceeds that the company or trust received, during the two years before that time, from CGT events happening to its active assets and that the company or trust holds in the form of cash or debt pending the acquisition of new active assets

is 80% or more of the market value of all of the assets of the company or trust (subsection 152-40(3)).

If the asset disposed of, and for which the company has claimed the Small Business concession, was a share in a company or an interest in a trust, please provide the following: • documentary evidence that the company or trust was an Australian resident at that

time, and • documentary evidence that the 80% of market value test under subsection 152-40(3)

(as described above) has been satisfied. If the above basic conditions for relief are satisfied, there are four types of Small Business concession available. As the company has claimed the following concession(s) in the company’s return for the year ended 30 June 2001, please provide the information requested in respect of the concessions claimed. 50% active asset reduction (Subdivision 152-C) A small business entity that makes a capital gain that does not qualify for the small business 15 year exemption can get the small business 50% active asset reduction if the basic conditions described above are satisfied. There are no further conditions to be satisfied. The entity can choose not to apply the active asset reduction to a particular gain before applying the Small Business retirement exemption and/or the Small Business rollover (section 152-220). Small business rollover (Subdivision 152-E) The small business rollover allows a small business entity to defer the making of a capital gain from a CGT event happening in relation to a small business asset if it acquires a replacement asset(s) and certain conditions are satisfied. In addition to satisfying the basic conditions for relief, the following additional conditions must be met in order to qualify for this concession: the small business entity chooses one or more CGT assets as replacement assets

within the period starting one year before and ending two years after the last CGT event happens in the income year for which it is choosing the rollover, and

the replacement asset is acquired within that same period (the Commissioner may extend the time limit), and

the replacement asset must be an active asset when it is acquired or an active asset by the end of two years after the last CGT event happens in the income year for which it is choosing the rollover, and

if the replacement asset is a share in a company or an interest in a trust, the small business entity or an entity connected with that small business entity must be a controlling individual of that company or trust just after it acquires the share or interest.

If these conditions are satisfied and the rollover is chosen, the amount of capital gain remaining after other concessions have applied is disregarded, to the extent it does not exceed the total of: the acquisition consideration of the replacement asset (that is, the first element of the

cost base of the replacement asset), and



any incidental costs associated with that acquisition (that is, the second element of the cost base of the replacement asset).

If there is an amount of the capital gain that cannot be so disregarded, a capital gain is made equal to that amount. In respect of the disposal of an asset for which the company claimed this concession, please provide the following: a description of the asset(s) in respect of which this concession has been claimed the date of the CGT event created by that disposal a description of the CGT asset(s) chosen as replacement assets the date on which each of the replacement assets was chosen the date on which each of the replacement assets was acquired the date on which each of the replacement assets became active assets where the replacement asset is a share in a company or an interest in a trust,

documentary evidence that the small business entity or an entity connected with that small business entity was a controlling individual of that company or trust just after it acquired the share or interest

documentary evidence of the acquisition consideration of the replacement asset, and documentary evidence of any incidental costs associated with that acquisition.

Goods and Services Tax in relation to the supply of capital assets A GST registered business enterprise (or a business enterprise required to be registered for GST) will incur a GST liability on the disposal of a capital asset. A capital asset may be a motor vehicle, manufacturing machinery or land and buildings. A GST liability occurs because the disposal of a capital asset constitutes a supply as defined in Section 9-10, A New Tax System (Goods and Services Tax) Act 1999. 9-10 Meaning of supply supply includes any of these: a supply of goods a supply of services a provision of advice or information a grant, assignment or surrender of real property a creation, grant, transfer, assignment or surrender of any right a financial supply an entry into, or release from, an obligation: to do anything, or to refrain from an act, or to tolerate an act or situation

The value of the capital asset sold must be included on the BAS at G1 as part of total supplies made during the relevant tax period. Please provide the following information regarding Goods and Services Tax in relation to the Capital Gains Tax event in respect of which the company has claimed the Small Business Concession(s) and any other sale of business assets, including depreciated plant and motor vehicles, which occurred during the year ended 30 June 2001.


Selling a Small Business – The CGT Strategies In relation to the Capital Gains Tax event in respect of which the company has claimed the Small Business Concession(s), please provide the following: a description of the steps taken to establish whether any Goods and Services Tax

obligation arose as a consequence of the Capital Gains Tax event the nature of any exemption or exception under which Goods and Services Tax does

not apply to that Capital Gains Tax event, and if Goods and Services Tax was payable in respect of any part of that Capital Gains

Tax event, the basis of the calculation for the amount payable, and the period and date of the Business activity statement in which the GST collected from that event has been notified.

In relation to any items of plant or capital equipment that were sold in conjunction with the Capital Gains Tax event referred to above, please provide the following:

a description of each item of plant, including name, type, model, and the purpose for which it was used

the original purchase price and date of purchase of each item of plant the written down value of each item of plant for depreciation purposes at the time of

sale the date of sale, the sale price, the amount of any Goods and Services Tax that was

included in the price the period and date of the Business activity statement in which the Goods and

Services Tax collected from each sale has been notified, and the amount included in label G1 from the sale of any items of plant or capital equipment on each statement, and

the nature of any exemption or exception under which Goods and Services Tax does not apply to that sale of plant or capital equipment.

In relation to any items of plant or capital equipment that were sold other than in conjunction with the Capital Gains Tax event referred to above, and were shown as ‘depreciable assets sold’ in the ‘Financial and other information’ section of the company’s income tax return for the year ended 30 June 2001, please provide the following:

the original purchase price and date of purchase of each item of plant sold the written down value for depreciation purposes at the time of sale the date of sale,

the sale price, the amount of any Goods and Services Tax that was included in the price

the period and date of the Business activity statement in which the Goods and Services Tax collected from each sale has been notified, and the amount included in label G1 from the sale of any items of plant or capital equipment on each statement, and the nature of any exemption or exception under which Goods and Services Tax does not apply to that sale of plant or capital equipment.




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