Small businesses: getting the net asset value test and your capital gains liability right — recent case

Small businesses need to be certain they are entitled to small business tax concessions before they apply the concessions to any CGT liability.

A recent case highlights that the Australian Taxation Office will impose severe financial penalties on any small business operator that assumes it satisfies the conditions for eligibility of the small business tax concessions without taking reasonable care to investigate.

Importantly, if a small business has assets exceeding $6 million it will not be eligible to receive any small business tax concessions.

Nicole Siemensma

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Tips for small businesses when assessing whether they are eligible for small business tax concessions

Small businesses need to be able to show the Commissioner that they have taken reasonable care in concluding that they are eligible for small business tax concessions.

These steps will help them to show they have taken that level of care:

• properly documenting the net asset position of a small business and its connected entities, just before the event that will result in a capital gain;
• ensuring that any liabilities recorded for the small business are related to an asset of that small business (and are not in fact an asset held by other connected entities); and
• ensuring that a CGT asset is an active asset, and doesn't fall within one of the exemptions described in section 152-40(4) of the Income Tax Assessment Act 1997, which would result in the CGT asset not being considered an active asset.

Remind me: what is an 'active asset'?

A CGT asset is an active asset if a small business owns the asset and:

• it is used in the course of carrying on the small business or a connected entity of the small business; or
• if the CGT asset is an intangible asset, it is inherently connected with the small business or a connected entity of the small business[1].

Remind me: what are the available small business tax concessions and how do you become eligible for them?

The small business tax concessions are:

• the 15 year exemption which allows a small business to disregard a capital gain from a CGT asset it has owned for at least 15 years[2];
• the small business 50% reduction which allows a small business to reduce a capital gain by 50%[3];
• the small business retirement concession which allows you to disregard a capital gain from a CGT asset, if the capital proceeds are used in connection with your retirement[4]; and
• the small business roll-over concession which allows you to defer a capital gain from a CGT event in relation to one or more small business assets[5].

A small business must satisfy the following basic conditions, before it considers reducing its CGT liability by applying any of the above small business tax concessions:

• a CGT event happens in relation a CGT asset of the business in an income year;
• the event would (apart from applying any small business relief) have resulted in the gain;
• just before the CGT event, the maximum net asset value of the small business did not exceed $6 million; and
• the CGT asset satisfies the active asset test[6].

It is important to note that even if a small business satisfies these basic conditions, each particular concession has its own set of conditions which also need to be satisfied before a tax concession is applied to a CGT liability.

Summary of Tingari Village North Pty Ltd and Commissioner of Taxation

Facts

Mr and Mrs Harris are the sole directors and members of Tingari Village North Pty Ltd (Tingari Village).

In 1996, Tingari Village purchased land and improvements known as Tingari Village North Mobile Home Park (the Park). In 1996, the Park had 66 mobile homes and by 2005 had expanded to 77 mobile homes. In November 2005, the Park was sold at a capital profit of $2,141,292.

Tingari Village applied the small business 50% reduction tax concession and the small business retirement tax concession to its capital gain from selling the Park. This caused Tingari Village's net capital gain to be disclosed at $70,646 in its income tax return from the year ended 30 June 2006.

The Commissioner:

• was not persuaded that Tingari Village was entitled to apply the small business retirement tax concessions;
• amended its assessment to increase the net capital gain to $2,141,292; and
• imposed a penalty of 50% (or 25% as referred to below) of the tax shortfall amount due to recklessness in its calculations.

Tingari Village appealed the Commissioner's decision.

What were the issues in this case?

The Tribunal considered these issues:

• did the Park satisfy the active asset test and, importantly, was it an asset mainly used to derive rent; and
• was the net value of assets owned by Tingari Village and its connected entities, just before the sale of the Park, over $5 million[7].

For the purpose of calculating the net value of assets, the connected entities of Tingari Village, due to Mr and Mrs Harris being the sole directors and members, were:

• J H Property Investment Pty Ltd (J H Property), as trustee of the J & J Harris Unit Trust and the Jeff Harris Family Trust;
• Jeff Harris Aviation Pty Ltd; and
• Jeff Harris Developments Pty Ltd.

What did the parties argue?

The Commissioner argued that Tingari Village was not entitled to the small business tax concessions because:

• the Park was not an active asset because it was an asset used as a business to derive rent[8]; and
• the Park did not satisfy the net asset value test as its net value of CGT assets was $6,312,462.

Tingari Village had the following opposite arguments:

• the Park was an active asset, because it was a business that offered accommodation and other services to those who resided in the Park[9]; and
• the Park did satisfy the net asset value test as its net value of CGT assets was $3,976,170.

The difference between the parties' calculations was mainly due to Tingari Village including a liability of J H Property for the face value of a commercial bill of $1.65 million. This commercial bill was the result of Mr and Mrs Harris borrowing money from National Australia Bank to purchase units in the J & J Harris Unit Trust and to on-lend a portion to J H Property, as trustee of the J & J Harris Unit Trust. Mr and Mrs Harris argued that the liability to the National Australia Bank was a liability in the hands of J H Property. Just before the sale of the Park, J H Property still owed Mr and Mrs Harris (and Mr and Mrs Harris still owed National Australia Bank) $508,889[10].

What was at stake?

At stake was Tingari Village's income tax return for the year ended June 2006, being re-assessed by the Commissioner to:

• increase the capital gains liability from the sale of the Park to $2,141,292, being the full capital proceeds from the sale; and
• to include the severe tax penalty of 25% of the tax shortfall arising from Tingari Village incorrectly applying the small business tax concessions to reduce its capital gain liability[11].

Tribunal's Decision

The Tribunal decided that Tingari Village was not entitled to apply the small business tax concessions to its capital gain liability from selling the Park because:

• it was satisfied that the Park was not an active asset because, for the following reasons, it was used mainly as a business to derive rent:
  • the payments for rent were made under a residential tenancy agreement, in the form prescribed under the Residential Parks Regulation 2006, for the right to occupy a residential site in the Park[12];
  • the residential tenancy agreement conferred a right on residents to exclusive possession of the sites on which their moveable homes were installed;
  • the residential tenancy agreement was drafted as a lease, as it included the normal provisions you would see in a lease, being, a right for the grantor to enter the premises and inspect, an express right of the residents to quiet enjoyment of the residential site, a right of the residents to be given possession upon commencement of the agreement and a right of the grantor to enter the premises upon non-payment of rent; and
  • the other benefits that the Park offered to its residents, did not prevent the Park from being an asset mainly used to derive rent. The services offered were not the kind of personal services provided by hotels, boarding houses or lodges and the primary purposes of the other benefits was to attract more potential residents to reside at the Park[13].
• Tingari Village's CGT assets did exceed $5 million, because the commercial bill of $1.65 million could not be considered a liability pursuant to section 152-20 of the Income Tax Assessment Act 1997, for the following reasons:
  • just before the sale of the Park, no demand had been made by the National Australia Bank on J H Property or Mr and Mrs Harris for the balance of the loan owed, being $508,889;
  • the face value of the commercial bill, being $1.65 million, cannot be included as a liability where the balance of the loan owed, being $508,889, has also been included as a liability. The inclusion of the face value of the commercial bill and the outstanding balance results in a liability of $2.1 million being recorded, which the Tribunal concluded was an 'absurdity'; and
  • the liability of the commercial bill was not a liability that is related to any asset of J H Property. The liability is purely a result of a loan taken out by Mr and Mrs Harris which was used to purchase units in the J & J Harris Unit Trust and to on-lend to J H Property.

As the Tribunal concluded to affirm the Commissioner's decision, the Tribunal also imposed a tax shortfall penalty at a rate of 25%.

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• [1] Section 152-40(1) of the Income Tax Assessment Act 1997.
• [2] Subdivision 152-B of the Income Tax Assessment Act 1997.
• [3] Subdivision 152-C of the Income Tax Assessment Act 1997.
• [4] Subdivision 152-D of the Income Tax Assessment Act 1997.
• [5] Subdivision 152-E of the Income Tax Assessment Act 1997.
• [6] Section 152-10(1) of the Income Tax Assessment Act 1997.
• [7] Please note that section 152-15 of the Income Tax Assessment Act 1997 now states that the allowed maximum net asset value is $6 million.
• [8] Section 152-40(4)(e) of the Income Tax Assessment Act 1997.
• [9] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233 at 20.
• [10] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233 at 49.
• [11] The tax penalty was reduced from 50% to 25% because the Commissioner softened its stance and decided that the incorrect income tax return was due to a lack of reasonable care and not recklessness.
• [12] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233 at 31.
• [13] Tingari Village North Pty Ltd and Commissioner of Taxation [2010] AATA 233 at 43.