The basic conditions are the biggest hurdle to take before you can claim the small business CGT concessions. If you get over these, you are on the home run. For a share sale you have to jump through even more hurdle. So let’s keep it simple and look at an asset sale to start with.
Basic Conditions for an Asset Sale
The basic conditions are the gateway to the small business CGT concessions. They apply to all four small CGT concessions the same way. No 15-year exemption, no retirement exemption, no 50% asset reduction and no rollover exemption if you don’t pass these basic conditions.
The basic conditions live in s152. That section covers a lot of ground.
s152-10 (1) A capital gain …may be reduced or disregarded …if the following basic conditions are satisfied…
So we need to go through these basic conditions. Here is how.
(a) Do you have a CGT event for a CGT asset?
Pretty much anything in a business is a CGT asset, so the question should really be: Do you have a CGT event for a CGT asset that is actually treated as a CGT asset?
Trading stock, plant and equipment, patents and receivables are not. So you look for goodwill, land, trademarks and the lot.
(b) Do you have a capital gain?
If you don’t have a capital gain, you don’t need a concession. It all starts with a capital gain:
s152-10 (1) A capital gain …
Those are the very first words – a capital gain.
(c) Do you qualify?
This step is all about you. Whether you qualify. Or your client or a hypothetical taxpayer in general. But let’s assume it is you selling the CGT asset. Simpler that way.
But before we do that, we need to take a detour:
Do you have affiliates?
Affiliates are fuzzy. There is no clear yes or no. An individual or company is your affiliate if you tell them how to run their business. Or in the words of s328:
s328-130(1): An individual or a company is an affiliate of yours if the individual or company acts…in accordance with your directions or wishes…in relation to the affairs of the business of the individual or company.
Think of this as an unofficial anti-avoidance provision. So that Aunty Jane doesn’t end up owning your business on paper only.
Partners in a partnership or directors in a company are not affiliates just because of that relationship. There must be more going on than just that.
s328-130 (2):….an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share.
Only an individual or company can be an affiliate since they are a legal entity. A trust, SMSF or partnership can’t be an affiliate since they are not a separate legal entity. However, the individuals or companies within these relationships can be.
Did you notice how we skipped from s152 to s328? Section 328 does a lot of heavy lifting around the basic conditions.
Do you have connected entities?
Connected entities are a lot easier to work out. There is a clear yes or no. Entities are connected if either of you controls the other or both of you are controlled by a third entity. The magic number is 40%. If you hold at least 40%, there is an assumption of control.
s328-125 (2): An entity …controls another entity if … the first entity together with its affiliates own… interests …(the control percentage ) that is at least 40% of any distribution of income …or… any distribution of capital .. or…at least 40% of the voting power…
So you include any rights affiliates hold. That’s why you started with affiliates in the first place.
For a discretionary trust you look at the capital and income distributions over the past 4 years before the year of the CGT event. Did the trust in any year pay at least 40% of the income or capital distribution to a beneficiary or their affiliates? If yes, those beneficiaries are taken to control the discretionary trust.
So at less than 40% there is no control. From 50% upwards there is definitely control. But from 40% to 50% there is room for the Commissioner’s discretion if you can show that somebody else has control.
s328-125 (6): If the control percentage … is at least 40%, but less than 50%, the Commissioner may determine that the first entity does not control the other entity …if the Commissioner thinks that the other entity is controlled by an entity other than…the first entity or any of its affiliates.
So now you got your affiliates and you got your connected entities. It is time to crunch some numbers.
(c)(i) Do you pass the Small Business Entity Turnover Test?
The Small Business Entity Turnover test is the easier one to work out. And the harder one to pass. But if you pass this one, you can skip the maximum net asset value test.
It all depends on passing this:
s152-10(1): A capital gain may be reduced …if .. you are a CGT small business entity…You are a CGT small business entity... if…you are a small business entity….
So you need to be a small business entity. A small business entity is defined in s328-110:
s328-110(1): You are a small business entity if…you carry on a business in the current…and… previous year …and your aggregated turnover for the previous year was less than $10 million [or] your aggregated turnover for the current year is likely to be less than $10 million.
And then s152-10 brings the threshold down from $10m to $2m.
s152-10 (1AA) (b):…you would be a small business entity for the income year if each reference in section 328-110 to $10 million were a reference to $2 million.
Aggregated turnover means that you include affiliates and connected entities per s328-115.
s328-115 (1): Your aggregated turnover … is the sum of …your annual turnover … and…of any entity … connected with you …and…of any entity … that is an affiliate of yours.
And 328-120 limits the annual turnover to ordinary income. So no capital gains and no franking credits.
s328-120 (1): An entity‘s annual turnover is the total ordinary income that the entity derives …in the ordinary course of carrying on a business.
And that’s it. If you pass this test, you can skip the maximum net asset value test and go straight to the active asset test.
(c)(ii) Do you pass the Maximum Net Asset Value Test?
This test is your second chance. This one is harder to work out but easier to pass. It now all depends on passing this bit:
s152-10 (1) (c) (ii): A capital gain …may be reduced …if .. you satisfy the maximum net asset value test.
So how do you tick this one off? The magic number is $6m. Stay below $6m and you will get there. The relevant time is just before the CGT event. So timing is important. And remember to throw affiliates and connected entities into the pot.
s152-15: You satisfy the maximum net asset value test if just before the CGT event…the sum of the following does not exceed $6m: the net value of the CGT assets of yours; ..of entities connected with you;..of affiliates of yours or entities connected with your affiliates…
This net value of CGT assets per s152-20 might be positive, negative or nil.
s152-20 (1): The net value of the CGT assets …is the amount…obtained by subtracting from ..the market values of those assets the sum of…liabilities ..related to the assets; …provisions for annual leave;…long service leave;…unearned income;…tax liabilities.
There is one important thing to watch out for. All assets are CGT assets apart from a few exclusions, so you include all assets in the MNAV test, even if those are not treated as CGT assets due to the overlap-rules and specific income provisions.
Disregarded Assets
Not every asset goes into the MNAV calculation. Some assets are out. The most important ones are shares and units in a connected entity per s152-20(2)(a). Because the net value already includes the value of the underlying assets. Including these again would be double counting. Think of consolidated financial statements. Same concept. But you can still include any loan you have on these shares or units.
s152-20(2)(a): In working out the net value of the CGT assets of an entity: disregard shares, units or other interests (except debt) in another entity that is connected with the first-mentioned entity or with an affiliate of the first-mentioned entity, but include any liabilities related to any such shares, units or interests;
The other big group you disregard are personal use assets, main residence and superannuation.
s152-20(2)(b):…if the entity is an individual, disregard… assets being used solely for the personal use and enjoyment of the individual, or the individual‘s affiliate…and… the individual‘s main residence …and…a right to …a superannuation fund …and… a policy of insurance on the life of an individual.
But here is a dangerous trap that can cost dearly. If a dwelling produces assessable income, it no longer counts as a disregarded asset. The typical example is the beach house the family uses for personal use and enjoyment (tick) but rents out for part of the year (untick). Here is s152-20 again:
s152-20 (2A):…if…a dwelling..was used, during all or part of the ownership period… to produce assessable income ..and..the individual satisfied paragraph 118-190(1)(c) (about interest deductibility) at least to some extent; include such amount as is reasonable having regard to the extent to which that paragraph was satisfied.
Affiliates and Connected Entitites
Now it gets complicated. You can disregard assets of affiliates and connected entities if these assets are not used in a business. So you only include business assets.
But you can still disregard business assets if the connection only comes through an affiliate. Here is s152-20:
s152-20(3): In working out the net value of the CGT assets of…your affiliate…or…an entity…connected with your affiliate…include only those assets that are used…in the carrying on of a business by you or another entity connected with you …[and] …disregard assets … used …in the carrying on of a business by an entity that is connected with you only because of your affiliate.
Luckily s152 gives an example:
You and your husband 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 disregard the newsagency company‘s assets in working out whether you satisfy the maximum net asset value test because, although the company is “connected” with you, it is so connected only because of your affiliate (your husband).
(c)(iii) Are you a partner in a partnership?
So you didn’t pass the turnover test, maybe because you don’t carry on a business as a sole trader. You didn’t pass the maximum net asset value test. But s152-10 gives you a third door in if you are a partner in a partnership. You can claim the CGT concessions if the partnership passes the small business entity turnover test
s152-10(c)(iii): A capital gain …may be reduced or disregarded …if you are a partner in a partnership that is a CGT small business entity …and the CGT asset is an interest in an asset of the partnership.
The test looks at the entire partnership, not your proportionate interest.
(c)(iv) Does an affiliate or connected entity use your assets?
Small business owners often hold business assets such as trademarks and real property in a safe harbour entity, outside of the operating entity in order to keep it safe. The operating entity and safe harbour entity are usually connected entities. This safe harbour entity usually doesn’t carry on a business, so doesn’t pass the turnover test. It often holds assets of more than $6m, so doesn’t pass the maximum net asset value test either. But this safe harbour entity might still meet the basic conditions because of this clause in s152-10:
s152-10 (1) (c) (iv): A capital gain …may be reduced or disregarded …if …the conditions mentioned in subsection (1A) or (1B) are satisfied in relation to the CGT asset in the income year;
This is a lifeline. 1A says it doesn’t matter that the safe harbour entity as the legal owner fails every test so far. As long as it doesn’t carry on a business but the affiliate or connected entity aka operating entity does. And as long as they are the ones actually using the asset in their business passing the turnover test.
s152-10 (1A) The conditions…are satisfied in relation to the CGT asset …if…your affiliate or an entity that is connected with you, is a CGT small business entity …and… you do not carry on a business …[but this]…CGT small business entity …carries on the business …in relation to the CGT asset.
1B puts this scenario into a partnership context, but otherwise works like 1A.
So that’s it. That was a hard one. Let’s assume you passed one of these four and can move on.
(d) Does the CGT asset satisfy the Active Asset Test?
So step 4 was all about you. This one is all about the actual asset. A CGT asset can only pass the basic conditions if the CGT asset satisfies the active asset test in s 152 -35.
A CGT asset satisfies the active asset test if..you have owned the asset for 15 years or less and the asset was an active asset …for …at least half of the period …or…you have owned the asset for more than 15 years and the asset was an active asset ..for …at least 7 1 / 2 years.
Timing
The active asset test looks at the period of ownership. And not a specific point in time like a CGT event. It looks at how you used the asset while you owned it. If you stopped trading within 12 months of the CGT event (or longer if allowed by the Commissioner), you might still be ok.
s152-35 (2): The period…begins when you acquired the asset and…ends at the earlier of the CGT event and…the cessation of the business…if the ..business ceased … in the 12 months before ..or a longer period that the Commissioner allows.
Active use
An active asset is defined as:
s152-40 (1): A CGT asset is an active asset if…you own the asset ..and it is used …in …carrying on a business …by you; your affiliate; or another entity that is connected with you.
Intangible
An active asset can be an intangible asset. Examples are goodwill, a trademark or a restrictive covenant. In fact, goodwill is often the biggest active asset when selling a business apart from real property.
Inherently connected is the key phrase. If an intangible asset is not actively used as such, look for inherently connected.
s152-40 (b): A CGT asset is an …[active] intangible asset..[if]..you own it and it is inherently connected with a business that is carried on ..by you, your affiliate, or another entity that is connected with you.
Goodwill is by definition inherently connected.
Excluded since Not Active
Certain assets are specifically excluded from being active assets. They are shares and units, financial instruments as well as assets deriving passive income,
s152-40 (4): The following CGT assets cannot be active assets … shares in a company… interests in a trust… financial instruments …an asset whose main use …is to derive interest, an annuity, rent, royalties or foreign exchange gains…
Financial instruments receive a long list of examples in s152-40,
s152-40 (4) (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)…
So these are the exclusions. But there are exceptions. Like an exception to an exception. Some excluded assets are actually included in the pool of active assets.
Included
So shares and units are by definition not active assets. But they can be active assets if they meet certain conditions – think 80% or widely held.
A share in an Australian resident company is an active asset if the total market value of active assets, financial instruments and cash inherently connected with the business is 80% or more of the market values of all of assets of the company. The same goes for trusts.
s152-40 (1): A CGT asset is…an active asset …if…you own it and … it is either a share in a company …or an interest in a trust ..and..the total of the market values of the active assets ..and..any financial instruments .. and any cash … inherently connected with such a business…is 80% or more of the market value of all of the assets of the company or trust.
A share in a widely held company is an active asset if held by a CGT concession stakeholder of this company or trust (subs s 152-40(4) and (5))). The same goes for an interest in a widely held trust.
So let’s assume you passed the turnover or MNAV test in step 4and the asset passed the active test in step 5. If you are a sole trader, partnership or discretionary trust. You are done. That’s all you needed to sort out.
But if you are a company or unit trust, there is one more important step, and this can be a huge hurdle again.
By the way: Are you a CGT concession stakeholder?
So far we assumed that it is you selling the asset or the business. Or your partnership or discretionary trust. And not a company or trust. And we assumed that the asset is not a parcel of shares or an interest in a trust.
But what if it is? What if it is a company or trust selling the asset? Or the asset is shares or a trust interest? Then you need to get over a few more hurdles. But that is a huge and complicated topic in itself for two reasons: 1) The rules are complicated and 2) have just changed big time. There will be additional conditions to meet and some of the conditions will get tightened from what they currently are. So let’s keep that for next time.
Conclusion
So these are the steps you need to go through to see whether you meet the basic conditions in s152-A. If you do, the rest is easy and fun.
But if the set up involves a company or unit trust, then you still have a long way to go. But that is another story.
MORE
Small Business CGT Concessions
Disclaimer: Tax Talks does not provide financial or tax advice. All information on Tax Talks is of a general nature only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 23 March 2020
