Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 3 - Small business capital gains tax relief and discretionary trusts
Outline of chapter
3.1 Schedule 3 to this bill amends the ITAA 1997 to improve the operation of the test that is used to determine when an entity controls a discretionary trust for the purpose of applying the small business CGT concessions.
3.2 The modified test will ensure that, subject to transitional arrangements, an entity will be taken to control a discretionary trust only if, for any of the four income years before the income year for which access to the small business CGT concessions is sought:
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- the trustee paid to, or applied for the benefit of, the entity and/or its small business CGT affiliates any income or capital of the trust; and
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- the amount paid or applied to the entity and/or its small business CGT affiliates is at least 40% of the total amount of income or capital paid or applied by the trustee for that income year (subject to the Commissioner's discretion where the amount paid or applied to the entity and/or its small business CGT affiliates is between 40% and 50%).
3.3 Distributions to exempt entities and deductible gift recipients (DGRs) will be ignored for the purposes of applying the new control test.
3.4 In addition, for an income year in which the discretionary trust has a tax loss and for which the trustee does not make any distribution of income or capital, the trustee may nominate up to four beneficiaries as being controllers of the trust.
Context of amendments
3.5 The small business CGT concessions are:
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- the small business 15 year exemption;
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- the small business active asset reduction;
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- the small business retirement exemption; and
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- the small business roll-over.
3.6 A small business entity can access the small business CGT concessions only if it satisfies some basic conditions for relief. One of those basic conditions is the maximum net asset value test. To pass the maximum net asset value test, the entity (together with its small business CGT affiliates and any connected entities) must not own assets with a total net value of more than $5 million.
3.7 A small business CGT affiliate includes a taxpayer's spouse, a child under 18 years of age, and any entity that acts or could reasonably be expected to act in accordance with the taxpayer's directions or wishes or in concert with the taxpayer.
3.8 Broadly, an entity is connected with another entity if either entity controls the other, or both entities are controlled by the same third entity.
3.9 Currently, an entity is taken to control a discretionary trust if the entity and/or its small business CGT affiliates are the trustees of the trust or have the power to determine the manner in which the trustees exercise the power to make any payment of income or capital to or for the beneficiaries of the trust.
3.10 In addition, an entity is taken to control a discretionary trust if:
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- the trustee has the power to pay to, or apply for the benefit of, the entity and/or its small business CGT affiliates any of the income or capital of the trust; and
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- the amount that can be paid or applied in any income year is at least 40% of the total distributions of income or capital of the trust (subject to the Commissioner's discretion where the potential distribution is between 40% and 50%).
3.11 The practical effect of the control test for a small business entity that operates through a discretionary trust is that the assets of all beneficiaries of the trust, whether potential or actual, are counted as assets of the entity for the purposes of applying the maximum net asset value test. The total net value of assets held by these actual and potential beneficiaries often exceeds $5 million. Consequentially, many small businesses that operate through a discretionary trust are technically unable to access the small business CGT concessions.
Summary of new law
3.12 Subject to transitional arrangements, an entity will be taken to control a discretionary trust under the small business CGT concessions if, for any of the four income years before the income year for which access to the small business CGT concessions is sought:
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- the trustee paid to, or applied for the benefit of, the entity and/or its small business CGT affiliates any income or capital of the trust; and
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- the amount paid or applied to the entity and/or its small business CGT affiliates is at least 40% of the total amount of income or capital paid or applied by the trustee for that income year (subject to the Commissioner's discretion where the amount paid or applied to the entity and/or its small business CGT affiliates is between 40% and 50%).
3.13 Exempt entities and DGRs will not be treated as controlling a discretionary trust irrespective of the percentage of distributions made to them.
3.14 In addition, for an income year in which the discretionary trust has a tax loss and for which the trustee does not make any distribution of income or capital, the trustee may nominate up to four beneficiaries as being controllers of the trust.
| New law | Current law |
|---|---|
| Subject to transitional arrangements, an entity will be taken to control a discretionary trust if, for any of the four income years before the income year for which access to the small business CGT concessions is sought:
Exempt entities and DGRs will not be treated as controlling a discretionary trust irrespective of the percentage of distributions made to them. In addition, for an income year in which the discretionary trust has a tax loss and for which the trustee does not make any distribution of income or capital, the trustee may nominate up to four beneficiaries as being controllers of the trust. |
An entity is taken to control a discretionary trust if:
|
Detailed explanation of new law
3.15 The control test for discretionary trusts under the small business CGT concessions will be modified.
3.16 An entity will still be taken to control a discretionary trust if the entity and/or its small business CGT affiliates are the trustees of the trust or have the power to determine the manner in which the trustees exercise the power to make any payment of income or capital to or for the beneficiaries of the trust. [Schedule 3, items 1 and 2, subsection 152-30(2)]
3.17 In addition, an entity (the first entity) will be taken to control a discretionary trust if, for any of the four income years before the income year for which access to the small business CGT concessions is sought:
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- the trustee paid any income or capital of the trust to or for the benefit of the first entity, one or more of the first entity's small business CGT affiliates, or the first entity and one or more of its small business CGT affiliates; and
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- the amount paid or applied to the entity and/or its small business CGT affiliates 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.
[Schedule 3, item 4, subsection 152-30(5)]
3.18 Consistent with the control test for other entities (such as companies and fixed trusts), where the control percentage is between 40% and 50%, the Commissioner will have a discretion to determine that the entity does not control the discretionary trust. However, if the control percentage is more than 50% in any of the four relevant income years, the Commissioner's discretion does not apply. [Schedule 3, item 3, subsection 152-30(3)]
3.19 Amounts paid to, or applied for the benefit of, exempt entities (i.e. an entity that is exempt from tax) and DGRs (i.e. entities to which donations of $2 or more are tax deductible) will be ignored for the purposes of applying the new control test. [Schedule 3, item 4, subsection 152-30(6)]
3.20 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.
3.21 If a discretionary trust has incurred a tax loss in an income year, the trustee typically cannot make distributions to its beneficiaries. The trustee of a discretionary trust in these circumstances can nominate up to four beneficiaries as being the controllers of the trust for that income year. The nomination must be in writing and signed by the trustee and by each nominated beneficiary. [Schedule 3, item 4, subsections 152-30(6A) to (6C)]
3.22 The trustee of a discretionary trust may wish to choose up to four beneficiaries to be controllers of the trust to ensure that the assets of the trust are active assets under the small business CGT concessions. In this regard, a CGT asset is an active asset if, among other things, the asset is used, or held ready for use, in the course or carrying on a business by the entity, a small business CGT affiliate or a connected entity (section 152-40).
3.23 The current control test for discretionary trusts is based on whether the trustee has the power to pay to, or apply for the benefit of, the entity and/or its small business CGT affiliates any of the income or capital of the trust. For these purposes, potential distributions to a public entity are disregarded if the trustee has the power to make the distribution to that public entity only because another beneficiary has an interest in the entity. Public entities are currently defined in subsection 152-30(6) to include, among other things, companies listed on a stock exchange and publicly traded unit trusts.
3.24 The new control test for discretionary trusts is based on actual distributions. Consistent with the control test for other entities (such as companies and fixed trusts), actual distributions to public entities should be taken into account for the purpose of applying the new control test for discretionary trusts.
3.25 The definition of 'public entity' is relevant for the purpose of determining when an entity has indirect control of an entity under the control test for the small business CGT concessions (subsections 152-30(7) and (8)). Therefore, as a consequential amendment, the definition of 'public entity' has been relocated and cross references to that definition are updated. [Schedule 3, items 5 and 6, subsections 152-30(8) and (9) and subsection 152-305(3)]
Application and transitional provisions
3.26 The amendments apply to relevant CGT events happening after 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999 - that is, from the date of application of the revised small business CGT concessions.
3.27 In this regard, the amendments will generally be beneficial to taxpayers. They have been actively sought by industry and will ensure that the small business CGT concessions operate as intended.
3.28 However, to ensure that taxpayers are not disadvantaged in relation to past transactions by the amendments, a transitional rule applies for CGT events that happen before the end of the 2003-2004 income year. Under the transitional rule, a taxpayer can choose to apply the existing control test for discretionary trusts (with the modification that assets of potential beneficiaries that are exempt entities or DGRs do not need to be taken into account). The choice to apply the transitional rule must be made by the latest of:
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- the day the entity lodges its income tax return for the income year in which the relevant CGT event happened;
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- 12 months after the date of Royal Assent; or
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- a later day allowed by the Commissioner.
[Schedule 3, item 9]
3.29 The way in which the taxpayer prepares his or her income tax return is sufficient evidence of the making of this choice.
Modification of the new control test for the 2001-2002 and prior income years
3.30 The new control test for discretionary trusts is based on actual distributions made in any of the four income years before the income year for which access to the small business CGT concessions is sought.
3.31 As a transitional rule, to reduce compliance costs, the control test will be modified for the 1999-2000, 2000-2001 and 2001-2002 income years so that it is based on actual distributions made in the income year for which access to the small business CGT concessions is sought. [Schedule 3, subitem 8(2)]
Transitional extension of time periods
3.32 To ensure taxpayers are not disadvantaged, transitional rules will apply in relation to:
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- CGT events that happened before the date of Royal Assent; and
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- entities who become eligible to make a choice under the amended small business CGT concessions.
[Schedule 3, subitem 8(3)]
3.33 The small business CGT concessions require taxpayers to make choices. For example, the small business retirement exemption and the small business roll-over are available only if the taxpayer chooses to obtain them. Section 103-25 requires any choices to be made by:
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- the day the entity lodges its income tax return for the income year in which the relevant CGT event happened; or
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- within a further time allowed by the Commissioner.
3.34 The transitional rule will allow for a choice to be made by the entity by the latest of:
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- the day the entity lodges its income tax return for the income year in which the relevant CGT event happened;
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- 12 months after the date of Royal Assent; or
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- a later day allowed by the Commissioner.
[Schedule 3, subitem 8(4)]
3.35 To obtain the small business roll-over, the taxpayer must generally acquire a replacement asset within the period starting one year before and ending two years after the happening of the relevant CGT event (subsection 152-420(1)). This period can be extended in certain circumstances (subsection 152-420(2)).
3.36 In addition, the replacement asset must be an active asset when it is acquired, or by the end of two years after the happening of the relevant CGT event (subsection 152-420(4)).
3.37 The transitional rule will extend the period for acquiring the replacement asset and the period within which the asset must be an active asset to the latest of:
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- two years after the happening of the last CGT event in the income year for which the entity obtained the small business roll-over;
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- 12 months after the date of Royal Assent; or
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- a later day allowed by the Commissioner.
[Schedule 3, subitems 8(5) and (6)]