House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 2 Improving the integrity of the small business CGT concessions

Outline of chapter

2.1 Schedule 2 to the Bill amends the ITAA 1997 to include additional conditions that must be satisfied to apply the small business CGT concessions to capital gains. The new conditions ensure that the small business CGT concessions in Division 152 of the ITAA 1997 are only available for CGT assets that are either used or held ready for use in the course of a small business or are an interest in a small business.

2.2 All legislative references in this Chapter are to the ITAA 1997 unless the contrary is indicated.

Context of amendments

Operation of existing law

2.3 Division 152 provides four concessions that can permit small businesses or, in some cases, their owners to reduce, defer or disregard certain capital gains.

2.4 These four CGT concessions are:

•

the 15-year exemption (Subdivision 152-B);

•

the 50 per cent asset reduction (Subdivision 152-C);

•

the retirement exemption (Subdivision 152-D); and

•

the replacement asset rollover (Subdivision 152-E).

2.5 Section 152-10 sets out the basic conditions that all taxpayers must satisfy in relation to a CGT event before they can be entitled to these concessions in relation to any resulting capital gain. To satisfy these conditions:

•

the taxpayer must:

-

be a CGT small business entity for the income year (broadly, an entity that carries on a business and has an aggregated turnover of less than $2 million) (see subparagraph 152-10(1)(c)(i));

-

if the asset is an interest in an asset of a partnership that is a CGT small business entity for the income year - be a partner in that partnership (see subparagraph 152-10(1)(c)(iii));

-

if the taxpayer does not carry on a business in the income year (other than in a partnership) and the asset is not an interest in an asset of such a partnership - be affiliated, connected with or a partner in an entity that is both a CGT small business entity and carries on the business in which the asset is an active asset (see subparagraph 152-10(1)(c)(iv)); or

-

not have CGT assets (including the CGT assets of related entities) with a net value exceeding $6 million (the maximum net asset value test - see section 152-15) (see subparagraph 152-10(1)(c)(ii)), and

•

the asset must satisfy the active asset test (see sections 152-35 and 152-40).

2.6 Additional basic conditions apply if the asset is a share in a company or an interest in a trust (the object entity). In this situation, subsection 152-10(2) provides that the concessions are only available for a taxpayer if:

•

the taxpayer is a CGT concession stakeholder in the object entity (i.e. broadly the taxpayer or their spouse holds an interest entitling them to at least 20 per cent of the voting rights, capital distributions and income distributions of the object entity); or

•

at least 90 per cent of the interests in the object entity have been held by entities that are CGT concession stakeholders in the taxpayer.

CGT small business entities

2.7 CGT small business entity is a more recently introduced concept that is defined in subsection 152-10(1AA). Broadly, it limits access to the CGT small business concessions to small business entities with aggregated turnover in an income year that does not exceed the previous small business turnover threshold of $2 million, rather than the new threshold of $10 million.

2.8 Small business entity is defined in section 328-110. Broadly, an entity is a small business entity for an income year if the entity carries on business in the income year and either:

•

carried on business in the previous income year with aggregated turnover not exceeding $10 million; or

•

is likely to have aggregated turnover for the current income year not exceeding $10 million.

Budget announcement

2.9 In the 2017-18 Budget the Government announced it would amend the small business CGT concessions to ensure that the concessions can only be accessed in relation to assets used in a small business or interests in a small business, with effect from 1 July 2017.

Summary of new law

2.10 The amendments include additional basic conditions that must be satisfied for a taxpayer to apply the CGT small business concessions to a capital gain arising in relation to a share in a company or an interest in a trust (the object entity).

2.11 Broadly, the conditions require that:

•

if the taxpayer does not satisfy the maximum net asset value test, then they must have carried on a business just before the CGT event;

•

the object entity must either be a CGT small business entity or satisfy the maximum net asset value test (applying a modified rule about when entities are 'connected with' other entities), and

•

the share or interest must satisfy a modified active asset test that looks through shares in companies and interests in trusts to the activities and assets of the underlying entities.

Comparison of key features of new law and current law

Detailed explanation of new law

2.12 Schedule 2 amends Division 152 of the ITAA 1997 to include additional basic conditions that must be satisfied for a capital gain of a taxpayer to be reduced or disregarded under that Division. The new conditions are intended to prevent the concessions from being inappropriately applied to interests in large businesses.

2.13 Consistent with this purpose, the additional basic conditions only apply to capital gains relating to CGT assets that are a share in a company or interest in a trust (the object entity). [Schedule 2, item 2, subsection 152-10(2)]

2.14 These conditions apply on an entity basis. A taxpayer at the top of a chain of companies or trusts may not qualify for the concessions in respect of shares or interests it holds (for example, because the chain includes an entity with an interest in a large business). However, another taxpayer in the same chain of companies or trusts may qualify for the concessions in respect of shares or interests it holds in a small business.

2.15 There are broadly three additional basic conditions relating to the modified active asset test, the taxpayer and the object entity.

Modified active asset test

2.16 In order to satisfy the first new condition, for the lesser of seven and a half years or at least half the period a taxpayer has held the share or interest at least 80 per cent of the sum of the:

•

total market value of the assets of the object entity (disregarding any shares in companies or interests in trusts); and

•

total market value of the assets of any entity (a later entity) in which the object entity had a small business participation percentage of greater than zero, multiplied by that percentage

must have related to assets that are:

•

active assets; or

•

cash or financial instruments that are inherently connected with a business carried on by the object entity or a later entity.

[Schedule 2, item 2, paragraph 152-10(2)(a) and paragraphs 152-10(2A)(a) and (b)]

2.17 Further, if these assets are held by a later entity (see paragraph 2.20), the assets will only be active at a time if the later entity is an entity:

•

that is, at the relevant time, either:

-

a CGT small business entity; or

-

satisfies that maximum net asset value test in relation to the capital gain; and

•

in which the taxpayer has a small business participation percentage of at least 20 per cent or is a CGT concession stakeholder at the relevant time.

2.18 In determining if an entity is a CGT small business entity or satisfies the maximum net asset value test at a time, this test also operates differently to the ordinary rules. First, it does not include the turnover or value of assets of entities that can control the object entity. This ensures that the outcomes for taxpayers do not depend upon the income or assets of third parties for which the taxpayer has no control.

2.19 Secondly, for the purposes of this test, an entity is treated as controlling another entity at a time if it has an interest of 20 per cent or more in that other entity at that time, rather than 40 per cent or more. This means that more entities are considered to be 'connected with' one another for the purpose of this test and need to count the assets or turnover of the other entity towards their aggregate turnover or total net CGT assets. Also, in working out if one entity controls another for these purposes, any determinations by the Commissioner under subsection 328-125(6) are disregarded.

2.20 In effect, for the purposes of this test, the active asset test in section 152-35 is modified to adopt a look-through approach. Rather than treating shares or interests as active assets based on the activities of the underlying company, the modified test looks through such membership interests to include the proportionate amount of the value of the assets of other entities (referred to as later entities) to which the interests ultimately relate.

2.21 Thirdly, the modified test only treats assets as 'active' if they meet additional requirements. Assets that are not cash or financial instruments must be used in carrying on the business of a later entity (see above) that does not have both significant turnover and assets. Assets that are cash or financial instruments must be inherently connected with such a business. However, the inclusion of cash and financial instruments is subject to an integrity rule. If cash or financial instruments are acquired or held for a purpose that includes ensuring the entity satisfies the new additional basic conditions they are disregarded. The rule is similar to the integrity rule for pre-CGT assets in subsection 104-230(8). Its application is expected to be limited, but it ensures there is no incentive for taxpayers to engage in artificial arrangements to seek to allow entities to satisfy the test.

2.22 Finally, the assets must also be held by an entity in which the taxpayer either has a small business participation percentage of 20 per cent or more or is a CGT concession stakeholder. An individual is a CGT concession stakeholder in a company or trust if, broadly, the individual or their spouse has a CGT small business participation percentage of 20 per cent or more in the company or trust (see sections 152-50, 152-55 and 152-60).

2.23 This condition prevents the concession from being available for interests in entities if most of the value of the assets of the entity is unrelated to its business activities. In such cases, while the entity carries on a small business, most of the value of the interest held by the taxpayer is not attributable to the small business and it is not appropriate for the small business concessions to apply to the disposal of the interest.

2.24 The condition also recognises that an investment is effectively passive in nature if an entity has an interest of less than 20 per cent in another entity.

Example 2.1 : Holding company

Jesse carries on a small lapidary business as a sole trader. He is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Jesse owns 50 per cent of the shares in A Co. A Co carries on a business providing cleaning services and is a CGT small business entity in the 2019-20 income year.

A Co also owns 10 per cent of B1 Pty Ltd and 15 per cent of B2 Pty Ltd. Both of these companies are also CGT small business entities in the 2019-20 income year. These companies are not affiliates of A Co.

There has been no significant change in the activities or holdings of A Co, B1 Pty Ltd or B2 Pty Ltd over the period Jesse has owned his shares.

On 9 November 2019, Jesse sells his interest in A Co.

In working out if this interest satisfies the modified active asset test, when working out the total value of the assets of A Co, Jesse must disregard the value of the shares A Co holds in B1 Pty Ltd and B2 Pty Ltd and include 10 per cent of the value of the assets of B1 Pty Ltd and 15 per cent of the value of the assets of B2 Pty Ltd.

Further, for this purpose none of the assets of B1 Pty Ltd and B2 Pty Ltd are active assets for A Co. Jesse's small business participation percentage in B1 Pty Ltd is 5 per cent (i.e. his 50 per cent stake in A Co multiplied by A Co's 10 per cent stake in B1 Pty Ltd). Similarly, his small business participation percentage in B2 Pty Ltd is 7.5 per cent (i.e. his 50 per cent stake in A Co multiplied by A Co's 15 per cent stake in B2 Pty Ltd).

Example 2.2 : Connected entities and the modified active asset

Charlotte owns 35 per cent of the shares in Colour Co. Colour Co carries on a business of wholesaling paint and related products and is a CGT small business entity (according to the general rules) in the 2019-20 income year.

Colour Co owns 20 per cent of the shares in three pigment suppliers Red Co, Green Co and Blue Co. Red Co and Blue Co are both CGT small business entities for the 2019-20 income year (and have been since Colour Co acquired its interest) according to the general rules. Green Co is not and has never been a CGT small business entity as it exceeds the turnover threshold.

On 3 March 2020, Charlotte sells her shares in Colour Co.

In working out if this interest satisfies the modified active asset test, when working out the total value of the assets of Colour Co, Charlotte must disregard the value of the shares Colour Co holds in Red Co, Blue Co and Green Co and include 20 per cent of the value of the assets of these companies.

Further, for the purposes of the modified active asset test, assets of later entities are only active if the entity is a CGT small business entity or satisfies the maximum net asset value test.

Green Co is not a CGT small business entity as its turnover is too high.

Additionally, Charlotte must treat Red Co, Blue Co and Green Co as being connected with Colour Co and with each other for the purposes of the test, because Colour Co holds 20 per cent of the shares of each entity.

Because they are treated as being connected with Green Co, Red Co and Blue Co are also treated as not being CGT small business entities for these purposes.

As a result, Charlotte is not able to treat the assets of Red Co, Blue Co or Green Co as active assets for the purposes of this test unless the entities satisfy the maximum net asset value test.

Example 2.3 : Small investments

Arnold carries on a small marketing business as a sole trader. He is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Arnold also owns 20 per cent of Channel Investments Trust, a trust that invests in a wide range of widely held trusts and companies.

Channel Investments Trust has assets with a total net market value of $2 million, of which $1.95 million consists of shares in companies and units in trusts. Channel Investments Trust has never had a small business participation percentage exceeding 10 per cent in any other entity.

On 20 April 2020, Arnold sells his interest in Channel Investments Trust. Arnold is not eligible to access the CGT concessions under Division 152 for any resulting capital gain.

While Arnold may satisfy the basic conditions for relief for the capital gain, he does not satisfy the new conditions.

The investment in Channel Investments Trust does not satisfy the modified active asset test as 97.5 per cent of its assets are shares and interests in trusts that are considered passive assets as its small business participation percentage in the relevant entities is less than 20 per cent.

Condition relating to the taxpayer

2.25 In order to satisfy the second new condition, the taxpayer must generally have carried on business just prior to the CGT event happening. This ensures that entities do not benefit from this concession where the relevant business activities are too remote to justify the entity receiving a concession for business activities. [Schedule 2, item 2, paragraph 152-10(2)(b)]

2.26 However, this requirement does not apply to taxpayers that satisfy the maximum net asset value test in relation to the CGT event. In this case, eligibility to access the concession relates to the size of the taxpayer, not any related small business activities. [Schedule 2, item 2, paragraph 152-10(2)(b)]

Conditions relating to the object entity

2.27 To satisfy the final new condition, the object entity (see paragraph 1.13) must either be a CGT small business entity or satisfy the maximum net asset value test in relation to the capital gain. This prevents the concession being available for interests in entities that are carrying on a business that is not a small business as it has both substantial aggregate turnover and net assets. [Schedule 2, item 2, paragraphs 152-10(2)(c)]

2.28 When working out if the object entity is a CGT small business entity or satisfies the maximum net asset value test, the turnover or assets of entities that may control the object entity are disregarded. This ensures that the outcomes for taxpayers do not depend upon the income or assets of third parties. [Schedule 2, item 2, subparagraphs 152-10(2)(c)(iii) and (iv)]

2.29 Further, for these purposes (and only these purposes), an entity is treated as controlling another entity if it has an interest of 20 per cent or more, rather than 40 per cent or more. This means that more entities are considered to be 'connected with' one another for the purpose of this test and need to count the assets or turnover of the other entity towards their aggregate turnover or the total net value of their CGT assets. [Schedule 2, item 2, subparagraph 152-10(2)(c)(iv)]

2.30 Also, in working out if one entity controls another for these purposes, any determinations by the Commissioner under subsection 328-125(6) are disregarded. [Schedule 2, item 2, subparagraph 152-10(2)(c)(v)]

Example 2.4 : Investment in large business

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019-20 income years. The net value of Big Pty Ltd's CGT assets exceeds $100 million throughout this period.

On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

Example 2.5 : Indirect investment in large business

Tien owns 20 per cent of the shares in Investment Co, a company that carries on an investment business. Investment Co is a CGT small business entity (according to the general rules) for the 2020-21 income year.

Investment Co holds 20 per cent of Van Co, a transport company. Van Co's turnover and assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year.

On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition.

For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van Co's shares. As a result, for this purpose, Investment Co's turnover and assets include the turnover and assets of Van Co. As Van Co is not a CGT small business entity and does not satisfy the maximum net asset value test, Investment Co is also treated as not satisfying these requirements (despite its status under the general rules in the tax law).

Example 2.6 : Passive investment entities

George carries on a small gardening business. George is a CGT small business entity for the 2019-20 income year.

George holds all of the units in G Trust, a trust that holds a number of investments in other entities but which does not carry on a business. The total value of the investments held by G Trust also means that it does not satisfy the maximum net asset value test.

On 17 February 2020, George sells the units it holds in G Trust. George is not eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if George satisfied the basic conditions for relief, he cannot satisfy the new condition as G Trust is not a CGT small business entity (as it does not carry on a business) and does not satisfy the maximum net asset value test.

Consequential amendments

2.31 Schedule 2 also makes a number of consequential amendments to the ITAA 1997, including updating guide material to reflect the substantive amendments. [Schedule 2, item 1, section 152-5]

2.32 These amendments also change the existing structure of subsection 152-10(2) to accommodate the new conditions. These structural changes do not make any substantive changes to the operation of the pre-existing condition. [Schedule 2, item 2, subsection 152-10(2) and paragraph 152-10(2)(d)]

Application and transitional provisions

2.33 The amendments made by Schedule 2 commence on the first day of the first quarter to start after the day of Royal Assent. [clause 2]

2.34 The amendments apply to CGT events that occur on or after 1 July 2017. [Schedule 2, item 3]

2.35 This retrospective application is consistent with the Budget announcement by the Government on 9 May 2017 to ensure the small business CGT concessions are only available in relation to assets used in a small business and ownership interests in small businesses.

2.36 Taxpayers that sought to access the concessions in relation to the disposal of assets on or after 1 July 2017 where this is not consistent with the amended law do not receive the benefit of these concessions. This includes taxpayers that have sought to access the small business retirement exemption to reduce their CGT liability by contributing amounts to superannuation (in this case the amount contributed is not exempt from CGT and is a non-concessional contribution to superannuation for the relevant financial year).

2.37 This measure is an integrity measure. While its retrospective application may disadvantage some taxpayers that have sought to access the concessions after announcement, this application is necessary to minimise the scope for entities to inappropriately access the small business CGT concessions in the period after the measure was announced but before legislation is enacted.