5 tax tips for navigating the small business CGT concessions
Remember your spouse and children’s birthdays…and that they are no longer automatically your affiliates.
Whether a person is an “affiliate” is relevant in numerous small business CGT concession contexts, including when applying the maximum net asset value, small business and active asset tests. Therefore, it is important to remember that the definition of affiliate has changed.
Since 1 July 2007, an individual or a company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the business of the individual or company. An important corollary of this definition is that an individual or company can only be an affiliate if they are carrying on a business. A trust or superannuation fund cannot be an affiliate.
It is more likely that a person acts, or could reasonably be expected to act, in accordance with the directions or wishes of another (or in concert with them) where there is a close family relationship between the parties and a lack of formal agreement between the parties dictating how they are to act.
However, an individual or company is not an affiliate with another merely because of the business relationship that the parties share. In one case, the Administrative Appeals Tribunal (AAT) rejected the Commissioner’s argument that one of the directors of the taxpayer (and the son of the controller) was a small business affiliate of the company. The AAT found that the son’s actions were explicable on the basis of the son’s position as a director and employee of the taxpayer.
Consider whether the beneficiaries can sense a pattern.
Whether an entity is connected with another entity is relevant in the context of applying the small business entity, maximum net asset value and active asset tests. Broadly, connection is dependent upon “control” – whether one entity controls the other, or both entities are controlled by a common third entity. A “control percentage” is generally one of 40% or more (subject to the Commissioner’s discretion where the percentage is between 40% and 50%).
In the context of a discretionary trust (which does not have fixed ownership interests), control can be established via influence over the trustee or by the “pattern of distributions” rule. While the finer points of this rule can be quite complex, some aspects worth keeping in mind include:
- Control can only be established in the year after a sufficient distribution (of 40% or more) is made – not in the year of the distribution. Furthermore, once a beneficiary has received a sufficient distribution, that beneficiary will be connected to the trust for the next four years. This highlights the importance of carefully selecting beneficiaries and planning trust distributions, particularly in the years approaching an anticipated CGT event.
- Where a discretionary trust does not make a distribution in an income year (for example because it made a tax loss) the trustee may nominate up to four beneficiaries as being controllers of the trust. This nomination must be in writing and signed by both the trustee and the nominated beneficiary(ies).
- It is not usual for a discretionary trust to distribute some of its income to an exempt entity or deductible gift recipient (ie. charity). Where this occurs, a special rule exists to ensure that these beneficiaries do not control the trust under the pattern of distributions control rule.
Time has a most influential list – think about yours
As mentioned above, an entity with significant influence over a trustee can be found to have control over the discretionary trust. An entity controls a discretionary trust (and is therefore connected to it), if the trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of that entity and/or their affiliates. This definition shares similarities with, but is broader than, the definition of affiliate discussed at Tip 1.
Some of the factors that may be relevant in determining whether such influence exists over the trustee include:
- the way in which the trustee has acted in the past
- the relationship between the entity and the trustee
- the amount of any property or services transferred to the trust by the entity, and
- any arrangement or understanding between the entities and a person or persons who have benefited under the trust in the past.
The ATO was, but is no longer, of the view that the appointor of a discretionary trust (with the right to appoint and remove trustees) does not automatically control the trust under this particular test.
The application of this control rule was considered in the case of Gutteridge v FCT. At issue was whether the daughter of Mr Gutteridge controlled the trust under this influence test. While the daughter was sole director and shareholder of the trustee, the evidence showed that she was merely a figurehead who rubber-stamped decisions made by her father. Therefore, the AAT held that the father, and not the daughter, controlled the trust. This case demonstrates that substance should be given primacy over form – even to the extent that a sole director and shareholder of a trustee cannot be said to automatically exert significant influence over that trustee.
Significant individuals & CGT concession stakeholders
Trying for a better class of shareholder can lead to significant problems.
There are numerous aspects of the small business CGT concessions where it is important to have a “significant individual” and/or a “CGT concession stakeholder”. Broadly, a significant individual in a company or trust is one who has a “small business participation percentage” of 20% or more. A CGT concession stakeholder is a significant individual or the spouse of a significant individual who has a small business participation percentage of greater than zero.
Therefore, the concept of small business participation percentage is crucial. This percentage is the lowest percentage of the individual’s direct and indirect:
- voting power in the company
- entitlement to any dividend that the company may pay, and
- entitlement to any distribution of capital that the company may make.
Where a company has different classes of shares and the discretion to pay a dividend to one class of shareholder to the exclusion of another, no shareholder can be said to have an entitlement to any dividend that the company may pay. This means that the company will not have a significant individual or a CGT concession stakeholder. While it may be beneficial to stream dividends to certain shareholders (eg. those on lower income levels), creating different classes of shares should only be done with extreme caution if it is envisaged that the small business CGT concessions may ultimately be accessed. At a minimum, the benefits should be considered against the potential costs.
The small business 15-year exemption
Know when it is time to go.
The small business 15-year exemption is the most generous of the four small business CGT concessions. Where the conditions are satisfied, the entire capital gain, regardless of the amount, is fully disregarded. Two of these conditions (in cases other than permanent incapacity) are that a relevant individual must be aged 55 years or over when the CGT event happens, and the CGT event must happen in relation to their retirement.
The ATO, in an earlier publication Advanced Guide to Capital Gains Tax Concessions for Small Business, states that retirement must involve, at a minimum, a significant reduction in the number of hours the individual works or a significant change in the nature of their activities. This guide contains an example of a taxpayer who reduces their hours from 60 hours per week to 35. In that case it was held that there had not been a retirement.
Occasionally, a purchaser will ask the vendor to stay on in the business for a transitional period after a sale. If faced with such a request, taxpayers should be careful to ensure that agreeing to do so does not jeopardise their access to the 15-year exemption. Provided this transitional period is less than six months, access to the exemption should not be at risk.
The ATO has published some detailed information on their website. Please contact us if you have any questions in relation to your specific situation.
WL Advisory is a Chartered Accounting firm specialising in accounting, tax and advisory services for Individuals and small businesses. For more information, please visit our website on www.wladvisory.com.au.