Contributed by Domenic Festa, Principal, Steps Law
Amendments to the small business capital gains tax (CGT) concessions were introduced into parliament in the Treasury Laws Amendment (Tax Integrity and Other Measures) Bill 2018 on 28 March 2018 and passed by the House of Representatives on 10 May 2018. This follows the release of an exposure draft on 8 February 2018. There are few changes made to the Bill from the exposure draft.
The amendments follow the government announcement in the 2017 Budget in what might be considered rather cryptic terms:
“The Government will amend the small business CGT concessions to ensure that the concessions can only be accessed in relation to assets used in a small business or ownership interests in a small business. This measure will take effect from 1 July 2017.”
The concessions (prior to the amendment) sought to limit their application to a small business by requiring that the taxpayer either satisfy a small business entity/$2m turnover test or a $6m net asset value test. It was generally accepted that the small business entity test did not apply on a sale of shares, since it required the carrying on of a business. Some taxpayers had sought to overcome that restriction and apply the small business entity/turnover test on a sale of shares (see further below).
In that context, it might have been inferred that the government announcement was addressing the application of the small business entity test on a sale of shares (see below). The actual provisions, are much broader than that.
The small business CGT concessions contain additional basic conditions where the CGT asset subject to disposal is shares in a company or interests in a trust. Before these changes, the additional basic conditions required that either the taxpayer was a CGT concession stakeholder in the object company or trust, or CGT concession stakeholders in the object company or trust together have a small business participation percentage in the taxpayer of at least 90%.
The amendments made by the Bill expand the additional basic conditions to:
- exclude the small business entity/turnover test in certain circumstances
- add a modified active asset test
- add a separate and modified net asset value test to be applied to the object entity.
The amendments are stated to address a number of integrity issues.
Consideration of the integrity issues
Mischief/Integrity issue 1 — applying the small business entity test on a sale of shares
David Jones owns a 20% interest in David Jones Pty Ltd. David Jones Pty Ltd has a net value of $56m. David has no liabilities. David sells his 20% interest for $11.2m to an unrelated third party on 12 March 2018. On 1 April 2018, David acquires a small laundry business which has an annual turnover of $800,000. Neither David, nor any of his associates, carry on a business activity. In preparing his income tax return, David applies the small business CGT concessions claiming he satisfies the small business entity test (through the operation of the laundry in the year of sale). He decides to run the risk on any potential application of Pt IVA regarding the purpose of commencing the small laundry business.
To address this integrity issue, the amendments include an additional basic condition that if the taxpayer does not satisfy the maximum net asset value test, the taxpayer must be carrying on a business just before the CGT event (s 152-10(2)(b) of ITAA 1997).
It is to be noted that the amendments do not exclude the small business entity test on a sale of shares, but prevent establishing a small business after sale to qualify for the concessions. In itself, this change is not complicated. Complications arise from the other amendments made by the Bill.
Integrity issue 2 — modified active asset test
The amendments made to the active asset test are fourfold:
- exclude equity interests (and assets owned by entities in which the equity interest is held (invested entities)) where the object entity has less than 20% participation percentage
- exclude equity interests where the invested company or trust does not satisfy either the small business entity/turnover test or a modified net asset value test
- limit financial instruments and cash from assisting shares to qualify as active assets, and
- looking through to the underlying assets of invested entities to determine whether the 80% requirement is satisfied, rather than applying the 80% test to each level in the chain.
The explanatory memorandum is not clear on what integrity issues these amendments address. There are two separate situations that may be relevant: applying the concessions in respect of a holding in a substantial but not widely held entity and accessing the concessions for passive assets held within a group.
Example 2 (holding in a substantial entity)
Geraldine Smith owns 30% of the shares in Combined Fashion Enterprises Pty Ltd, a retailer and wholesaler of fashion items. The net value of the company is less than $6m. Approximately five years ago, the company was approached by a business associate of one of its directors to make an investment in a cotton manufacturer. The company acquired a 2.7% interest. The manufacturer has less than 50 members and is not a widely held company. The net value of the manufacturer is now $50m and the value of the 2.7% interest is $1.35m. The gross value of assets used in the business of Combined Fashion Enterprises Pty Ltd, excluding the investment in the manufacturer, is $3.2m. Under the amendments, the interest in the manufacturer is not an active asset resulting in an active asset percentage for shares in Combined Fashion Enterprises Pty Ltd of 70.33%. Geraldine does not satisfy the 80% test.
Under the current tests, the shares in the cotton manufacturer are active assets as satisfying the 80% test. The amendments prevent these shares from satisfying the 80% test.
However, the amendments will also apply in circumstances that are against the policy of the concessions. An obvious example is where the share investment is one that is inherently connected with the business of the object entity.
Example 3 (holding in a substantial entity)
Assume the same facts as example 2 except the company is Combined Farming Enterprises Pty Ltd and the investment is in a cooperative inherently connected with the business of the company.
Example 4 (passive assets)
Peter Savvy holds 40% of the shares in Savvy Investments P/L, a holding company (HC) of a chain of entities. The active asset percentages of the entities in the chain are: HC — 80% shares in C1, 20% passive investments; C1 — 80% shares in C2, 20% passive investment; C2 — 80% shares in C3, 20% passive investments; C3 — 80% shares in C4, 20% passive investments; C4 — 80% business assets, 20% passive investments. The market value of active assets of C4 is $3m including $2m in financial instruments and cash. The active asset percentage for the group is 32.77%, well under the 80% requirement, but satisfying the tests under the current rules.
In order for Peter to take advantage of the small business CGT concessions, predominantly to his portfolio of passive investments, he would need to find a purchaser willing to acquire both the underlying business and the structure. It would be rare that Peter could find such a buyer. Look through requirements impose an unnecessary burden on the majority of taxpayers for the sake of attacking the less than 0.1%.
If the issue of the ATO relates to utilising the small business concessions in combination with the consolidation regime, they would be better addressed with an integrity rule in that situation, rather than subjecting the majority to unnecessary complication.
As the amendments are drafted, it will require a taxpayer to apply two separate tests — that in s 152-40(3) of ITAA 1997, and the modified test in s 152-10(2A). The test in s 152-40(3) only applies on a sale of shares. There are no circumstances where the test in s 152-40(3) will apply where the modified test does not also apply. It would be much simpler for amendments directly to s 152-40(3) rather than introducing two separate tests.
Simple Solution: Limit shares eligible to satisfy the active asset test to those in which at least one CGT concession stakeholder of the object entity is a CGT concession stakeholder (in other words, an individual that has a participation percentage of at least 20%). Example 4 is not realistic, would rarely arise in practice, does not require specific provisions attacking the majority.
On a sale of shares, the concessions currently require satisfaction of an 80% test. In the current test, the market value of financial instruments and cash that is inherently connected with the business are included in the numerator so as not to prevent satisfaction of 80% test.
It should be noted that financial instruments and cash can only be taken into account where they are inherently connected with the business. Significant holdings that are not so inherently connected will cause the shares to fail the test.
The exposure draft proposed to exclude financial instruments and cash unless held as trading stock (it would be a strange event when that would have ever occurred), the company or trust is an Australian financial services licensee, authorised representative of such a licensee, holds the licence under consumer credit protection legislation or a credit representative in the consumer credit protection legislation, and issues the instruments in the course of carrying on its business. This would have essentially made financial instruments and cash not active in all other cases (the majority).
The final Bill has walked away from those extensive amendments and exclude financial instruments and cash where they are required for a purpose of assisting an entity to satisfy the active asset test.
Integrity issue 3 — modified net asset value test
Example 5 (based on Miley’s case (2017 ATC ¶20-640))
David holds a 20% interest in Bing Enterprises Pty Ltd. Bing Enterprises has developed a search engine of particular interest to Microsoft Corporation. Microsoft acquires all of the shares in Bing Enterprises for $25m — attributing a value of $5m to David’s shares. The only other asset David owns is his family home held in his personal name. On these facts, David satisfies the net asset value test and is eligible for the concessions.
The amendments seek to overcome this integrity issue by requiring the object entity to satisfy a modified net asset value test which lowers the threshold from 40% to 20%.
Is it suitable to replace the 40% threshold with a 20% threshold?
The thrust of the turnover and net asset value tests is to include the net assets of a taxpayer, affiliates, and controlling entities. 40% is used as a proxy for control.
The explanatory memorandum to the Tax Laws Amendment (2006 Measures No 7) Bill 2006 (which introduced the significant individual test) explained that the amendments were extending the concessions to those with an active participation in the business, and it was considered 20% was a proxy for active participation (to be distinguished from control). There was no stated link between the 20% significant individual test and the application of the net asset value test.
There is a difference between active participation and control, and in accordance with the policy of the legislation to include entities on the basis of control, the 20% percentage is not appropriate.
Limits to the 20% threshold
While the net asset value test is often referred to as requiring a 40% threshold, that is not strictly accurate. An entity with a greater than 40% interest will not be considered as connected if another entity is considered to control the object entity. In the ordinary case where a person has a 20% interest in an object entity, there will often be another person with a greater percentage that has actual control of the object entity (50%). In those circumstances, the threshold of 20% under the modified net asset value test will not apply. These amendments are considered unnecessary and attacking a small number of taxpayers (who fall within the intended policy of the legislation), complicating the issues for the majority.
Much of the integrity concerns could be addressed by two simple amendments:
- the small business entity/turnover test does not apply on disposal of shares unless the business was carried on prior to contemplation of the disposal of shares
- exclude shares as active assets unless at least one CGT concession stakeholder of the object entity is also a CGT concession stakeholder.