House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello MP)

Chapter 1 - The small business framework

Outline of chapter

1.1 Schedule 1 amends the Income Tax Assessment Act 1997 (ITAA 1997) to provide a single definition of a 'small business entity' for the purpose of accessing any of the small business tax concessions. Item 2 in Schedule 3 amends the ITAA 1997 to list the concessions available to small business entities.

Context of amendments

1.2 The current tax laws contain a number of special arrangements for smaller businesses (variously defined), which are often loosely referred to as 'small business concessions'. Each concession has its own set of eligibility criteria based on the particular group of taxpayers being targeted. The criteria are tailored to the specific characteristics, policy objectives and constraints of each particular regime.

1.3 Multiple eligibility criteria across small business concessions, however justifiable when considered individually, are a source of complexity and unnecessary compliance costs for small businesses.

1.4 Table 1.1 outlines the current threshold eligibility tests for the concessions under the simplified tax system (STS), the goods and services tax (GST), the capital gains tax (CGT), the fringe benefits tax (FBT) and the pay as you go (PAYG) instalments.

1.5 Under the new small business framework, eligibility for all these concessions will be based on one test about the size of the business. Small businesses will be able to access these concessions provided they also satisfy any additional criteria that currently apply to each concession that do not relate to determining whether the taxpayer is a small business.

1.6 Amendments to the existing STS, CGT, GST, FBT, and PAYG instalments provisions to give small business entities access to those concessions are discussed in Chapter 4. Consequential amendments to the wine producer's rebate under the wine equalisation tax are also discussed in Chapter 4.

Summary of new law

1.7 An entity is a small business entity if it:

•

carries on a business; and

•

satisfies the $2 million aggregated turnover test.

1.8 These two elements together are referred to as the 'small business entity test'.

1.9 Any entity that satisfies the small business entity test can choose to access the following concessions (subject to any additional criteria set out in the particular concessions):

•

CGT 15-year asset exemption;

•

CGT 50 per cent active asset reduction;

•

CGT retirement exemption;

•

CGT roll-over;

•

simplified depreciation rules;

•

simplified trading stock rules;

•

immediate deduction for certain prepaid business expenses;

•

choice to account for GST on a cash basis;

•

annual apportionment of GST input tax credits;

•

choice to pay GST by instalments;

•

FBT car parking exemption; and

•

PAYG instalments based on gross domestic product (GDP) adjusted notional tax.

1.10 Partners in partnerships that are small business entities can also access the small business CGT concessions (see Chapter 4).

Comparison of key features of new law and current law

Detailed explanation of new law

The small business entity test

1.11 This chapter discusses the small business entity test, including the notion of 'carrying on a business', and describes the three ways in which an entity can satisfy the $2 million aggregated turnover test. The actual method for calculating an entity's aggregated turnover, and what needs to be included in it, is discussed in Chapter 2.

1.12 An entity is a small business entity if it:

•

carries on a business; and

•

satisfies the $2 million aggregated turnover test.

1.13 These two elements together are referred to as the small business entity test. Small business entities are eligible for the concessions listed in section 328-10. [Schedule 3, item 2, section 328-10 of the ITAA 1997]

1.14 The $2 million aggregated turnover test applies to the business income of the entity, not to each business conducted by the entity.

Example 1.1

Edward is a sole trader who carries on two businesses, one as a robotics manufacturer and another as a software developer. Edward is a small business entity. It is Edward, not the robotics manufacturing or the software development business that needs to satisfy the small business entity test.

Edward satisfies the aggregated turnover test when both of his businesses, considered together, have a turnover of less than $2 million.

1.15 A definition of 'small business entity' is inserted into the Dictionary of the ITAA 1997. [Schedule 1, item 7, definition of 'small business entity' in subsection 995-1(1) of the ITAA 1997]

Carrying on a business

1.16 To be a small business entity, an entity must carry on a business. [Schedule 1, item 1, paragraph 328-110(1)(a) of the ITAA 1997]

1.17 'Business' is defined broadly in the ITAA 1997 to include 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'. Carrying on a business is not defined in the tax law and therefore takes its ordinary meaning.

Winding up a business

1.18 An entity is taken to be carrying on a business for the purposes of the small business entity test in an income year if:

•

the entity is winding up a business it formerly carried on; and

•

it was a small business entity in the income year that it stopped carrying on the business.

[Schedule 1, item 1, subsection 328-110(5) of the ITAA 1997]

1.19 This rule ensures that a small business entity continues to be eligible for small business concessions while it is winding up a business it previously carried on.

1.20 An entity winding up a business will need to calculate what their turnover would have been had the entity carried on the business for the entire income year. The rules relating to this are discussed in Chapter 2.

The $2 million aggregated turnover test

1.21 There are three ways an entity can satisfy the $2 million aggregated turnover test:

•

the entity's aggregated turnover for the previous income year was less than $2 million;

•

the entity's aggregated turnover for the current income year, worked out as at the first day of the income year, is likely to be less than $2 million; or

•

the entity's aggregated turnover for the current income year, worked out as at the end of the current income year is actually less than $2 million.

1.22 These tests relate to the timing of the calculation and the relevant time period for the calculation (as discussed below). The meaning of aggregated turnover is discussed in Chapter 2.

Test 1: The entity's aggregated turnover in the previous income year was less than $2 million

1.23 If an entity's aggregated turnover in the previous income year was less than $2 million it satisfies the $2 million aggregated turnover test regardless of its likely or actual aggregated turnover for the current year. [Schedule 1, item 1, subparagraph 328-110(1)(b)(i) of the ITAA 1997]

1.24 Most small business entities will only need to consider this test because their aggregated turnover in the previous income year will be under $2 million.

Example 1.2

In the 2007-08 income year, Michael carried on an IT consultancy business. His aggregated turnover for that income year was $1.9 million.

For the 2008-09 income year, Michael is a small business entity because his aggregated turnover for 2007-08 was less than $2 million. This is irrespective of his likely or actual turnover in the 2008-09 income year.

Test 2: The entity's aggregated turnover in the current income year is likely to be less than $2 million

1.25 Even if last year's aggregated turnover was greater than $2 million, an entity will satisfy the $2 million aggregated turnover test if it is likely that its aggregated turnover for the current income year will be less than $2 million. [Schedule 1, item 1, subparagraph 328-110(1)(b)(ii) of the ITAA 1997]

1.26 In Test 2 an entity's aggregated turnover is worked out as at the first day of the income year. References to as at the first day of the income year mean that the assessment needs to be based on the entity's state of affairs that existed as at the first day of the income year. It does not mean that the assessment of the entity's situation must be performed on the first day of the income year. [Schedule 1, item 1, paragraph 328-110(2)(a) of the ITAA 1997]

Example 1.3

Rick is carrying on a business in the 2007-08 income year. He did not assess his eligibility to be a small business entity, because he decided that none of the concessions would be suitable for his business needs.

However, on 1 January 2008 Rick starts thinking about selling one of his business assets and is therefore seeking to determine whether he satisfies the small business entity test in order to access small business CGT concessions.

Rick needs to work out his aggregated turnover as at 1 July 2007. However he may do this at any time in the income year. Undertaking the calculation in mid-January does not affect the result.

What is meant by references to 'likely'

1.27 Any reference to likely means that, on the balance of probabilities, it is more likely than not that the entity's aggregated turnover will be under $2 million.

Example 1.4

Hua carries on a business and had an aggregated turnover of $1.8 million in the 2006-07 income year, and $2.1 million in the 2007-08 income year.

Hua is planning to retire in the 2008-09 income year. When she retires, she intends to gradually ease out of work by not taking on any new customers (rather than selling the business as a going concern). In the income year that Hua starts this process, her aggregated turnover will fall under $2 million.

Hua does not satisfy Test 1 for the 2008-09 income year because her aggregated turnover in 2007-08 was greater than $2 million.

However, it is more likely than not that she will begin winding down her business in the 2008-09 income year and her aggregated turnover is therefore likely to fall below $2 million. Consequently, she satisfies Test 2.

Also, the exception to Test 2 (discussed in paragraph 1.31) will not apply to Hua, given that her aggregated turnover in the 2006-07 income year was less than $2 million.

1.28 Whether an entity's aggregated turnover is likely to be less than $2 million is an objective test. Some factors to consider in determining whether it is likely an entity's aggregated turnover would be under $2 million include:

•

the entity's aggregated turnover in previous income years;

•

exceptional sales or particular product lines last year that will not occur this year;

•

whether the entity is likely to have reduced staff this year;

•

whether the operating hours of the business will decrease;

•

whether aspects of the location of the business, or its industry, indicates a declining turnover (eg, if a drought is declared in an area, or if prices in the industry decline); or

•

whether the business will face increased competition.

Example 1.5

In the 2007-08 income year, a company carried on a professional painting business. The company's aggregated turnover for that income year was $2.5 million, and it had 11 staff.

On 1 July 2008, the company received resignation letters from eight of its 11 employees. The company's sole director anticipates that it will be difficult to replace these workers during the current income year.

For the 2008-09 income year, the company would fail the $2 million aggregated turnover test under Test 1, because its aggregated turnover in the previous income year was greater than $2 million.

However, given that the company's director anticipates difficulty with replacing its staff, it is likely that its aggregated turnover will be under $2 million for the 2008-09 income year.

Starting to carry on a business in the current income year

1.29 If the entity starts to carry on a business part-way through an income year, they work out their aggregated turnover as at the day they started to carry on a business, rather than working out their aggregated turnover as at the beginning of the income year. [Schedule 1, item 1, paragraph 328-110(2)(b) of the ITAA 1997]

1.30 However, entities that start carrying on a business in the current income year need to calculate what their turnover would have been had the entity carried on the business for the entire income year. The rules relating to this are discussed in Chapter 2.

Exception: If the entity's aggregated turnover in the previous two income years was greater than $2 million

1.31 An entity cannot use Test 2 if its aggregated turnover in each of the previous two income years (worked out as at the end of those years) was greater than $2 million. However, the entity may be able to access some of the small business concessions at the end of the income year if its turnover for that year was actually under $2 million (see paragraphs 1.33 to 1.36). [Schedule 1, item 1, subsection 328-110(3) of the ITAA 1997]

1.32 This exception prevents abuse of the 'likely' test. It will also reduce the need for the Commissioner of Taxation to engage in costly compliance activities in order to establish that an entity with aggregated turnover greater than $2 million for multiple consecutive years is not likely to have an aggregated turnover of less than $2 million this year.

Example 1.6

The income year is 2009-10, and David is attempting to determine whether he satisfies the $2 million aggregated turnover test. In the 2007-08 and 2008-09 income years he carried on a business as a surfboard maker and his aggregated turnover was $2.2 million and $2.4 million respectively.

In both of those years he claimed he was a small business entity under Test 2, on the grounds that it was likely that his aggregated turnover would be under $2 million.

David will not be a small business entity for the 2009-10 income year under Test 2, even if it is likely that his aggregated turnover will be under $2 million for that year. This is because his aggregated turnover in the previous two income years was greater than $2 million.

However, David may be able to rely on Test 3 (see paragraphs 1.33 to 1.36) in order to access some of the small business concessions if his aggregated turnover actually turns out to be under $2 million as at the end of the 2009-10 income year.

Test 3: The entity's aggregated turnover for the current income year is less than $2 million

1.33 The final test applies to the entity's aggregated turnover in the current income year, worked out as at the end of that income year. The turnover calculation is based on the entity's actual aggregated turnover for the income year in which the concessions are sought. [Schedule 1, item 1, subsection 328-110(4) of the ITAA 1997]

1.34 If the entity started to carry on a business part-way through the income year, they need to calculate what their turnover would have been had the entity carried on the business for the entire income year (in line with paragraph 1.30).

1.35 This rule exists so that, despite an entity's previous aggregated turnover, or the entity's likely aggregated turnover, an entity is a small business entity if its actual aggregated turnover is less than $2 million in an income year.

1.36 An entity that is a small business entity by means of Test 3, determined at the end of an income year, will not be able to access the concessions that are used throughout an income year, namely:

•

paying PAYG instalments based on GDP-adjusted notional tax;

•

accounting for GST on a cash basis;

•

making an annual apportionment of GST input tax credits for acquisitions and importations that are partly creditable; and

•

paying GST by quarterly instalments.

Example 1.7

Jenny carried on an agricultural business in the 2008-09 income year. In the 2007-08 income year her aggregated turnover was $3 million and, as a result, she fails Test 1 of the $2 million aggregated turnover test.

At the beginning of the 2008-09 income year, it is likely that her aggregated turnover will continue to be greater than $2 million.

However, on 1 January 2009, a bushfire destroys part of her property. As a result of this unanticipated event, her actual aggregated turnover for the 2008-09 ends up being just $500,000.

When filling out her 2008-09 tax returns, Jenny may access the income tax concessions (including CGT) and the FBT concession provided that she meets the additional criteria for each concession. However, Jenny may not access the GST and PAYG instalment concessions.

Application and transitional provisions

1.37 These amendments apply to the 2007-08 income year and later income years.

Winding up a business

1.38 Transitional arrangements apply for any entity that, in an income year before the 2007-08 income year, was an STS taxpayer and stopped carrying on any business. These entities can continue to use STS concessions in the 2007-08 and later income years if they are winding up the business they previously carried on (see Chapter 4 for more details).