SENATE

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP) THIS MEMORANDUM TAKES ACCOUNT OF AMENDMENTS MADE BY THE HOUSE OF REPRESENTATIVES TO THE BILL AS INTRODUCED

Chapter 2 - Entities eligible to be Simplified Tax System taxpayers

Outline of chapter

2.1 This Chapter explains the circumstances in which an entity:

•

is eligible to be an STS taxpayer; and

•

is grouped with another entity.

[Schedule 1, item 1, Subdivision 328-F]

Context of reform

2.2 The eligibility rules ensure that only businesses that meet specific criteria can enter the STS.

2.3 The grouping rules ensure that businesses that are part of a larger group of entities do not gain access to the STS.

Comparison of key features of new law and current law

Detailed explanation of new law

Meaning of STS taxpayer

2.4 An entity is eligible to be an STS taxpayer for an income year if:

•

it carries on a business during that year;

•

the STS average turnover of the business and related businesses for the year is less than $1 million net of GST credits; and

•

the business and related businesses have depreciating assets with values less than $3 million at the end of that year.

[Schedule 1, item 1, subsection 328-365(1)]

2.5 However, entities that are unable to meet the general eligibility test in section 328-365 have the option of recalculating their STS average turnover by either using actual turnover for the current year, or estimating their group turnover for the current year plus the estimated group turnovers for the following 2 years. [Schedule 1, item 1, section 328-370]

2.6 The value of a depreciating asset for an income year, means basically the cost of the asset less any amounts representing decline in value that have been deducted or are deductible against it under the proposed Division 40 of the ITAA 1997 or the proposed Division 328 of this Bill. The general and long life STS pools and low-value pools are each treated as a single depreciating asset and the closing pool balance of each will reflect the pools value for the income year. In establishing whether the value of an entitys assets and its grouped entities total less than $3 million, the closing pool balance of each pool will need to be added to the adjustable value of any depreciating assets of the entity and its grouped entities which have not been subject to the pooling arrangements. [Schedule 1, item 1, subsection 328-365(2)]

2.7 The limit on the total value of depreciating assets that an entity and its grouped entities can have at the end of an income year, will ensure that entities with low turnover in early years of operation but with large investments in capital assets are not eligible to enter the STS.

Example 2.1

In 2002-2003, 2 mining businesses, Ore Co and Iron Co, form a joint venture to mine copper. The income in the early years is minimal while the start-up costs are large. Ore Co supplies the large trucks to take away the raw material while Iron Co supplies the excavation equipment.

The total value of the assets both businesses have is approximately $4 million.

While both Ore Co and Iron Co are carrying on a business and their STS average turnover is less than $1 million, the fact that the value of their depreciating assets is worth more than $3 million will mean that neither entity will be eligible to be an STS taxpayer.

2.8 The limit on the total value of depreciating assets is not anticipated to affect primary production businesses with turnover under $1 million. Example 20 shows the type and value of assets used in a typical primary production business.

Example 2.2

A business is a mixed cropping (wheat, oats) and grazing (sheep, beef cattle) farm of 2,000 - 3,000 acres in NSW Central West.

The turnover of the business is $480,000 per annum.

Assets are replaced at the end of their effective life, with no residual value.

Values in the attached schedule are 1999 prices, verified from ABARE Farm Survey.

Item	Quantity	Effective life	Total value $
Offset disc plough	1	10 years	45,000
Disc plough	1	10 years	25,000
Chisel plough	1	10 years	30,000
Scarifier	1	10 years	30,000
Air seeder	1	10 years	80,000
Dams	15	40 years	75,000
Fences	100 km	33 years	170,500
Combine harvester	1	7 years	200,000
Motor cycle (1 * 2 wheel and 1 * 4 wheel)	2	3 years	10,000
Sheep dip (galvanised iron, spray dip)	1	20 years	8,000
Grain silo (iron)	12	33 years	36,000
Stock yard (1 sheepyard, 1 cattleyard)	2	20 years	18,000
Rainwater tank (galvanised iron)	4	20 years	14,000
Tractor (2 * large, 2 * small)	4	7 years	420,000
Stock trailer	1	10 years	3,000
Box trailer	2	10 years	1,400
Woolshed	1	50 years	30,000
TOTAL VALUE			1,195,900

This example shows that a primary production business of this type will not be excluded from entry to the STS because of the depreciating assets test ^[F1] .

Can a partnership be an STS taxpayer?

2.9 The $1 million threshold applies to partnerships in the same manner as for other entities such as companies, trusts, and individuals. This is consistent with the general treatment of partnerships under other provisions of the income tax law. Although partnerships are not liable to income tax, they are treated as entities for the purposes of calculating their net income or loss for an income year. Accordingly, a partnership is an STS taxpayer in an income year if it is carrying on a business, its STS average turnover is less than $1 million and the value of depreciating assets is less than $3 million.

Meaning of STS average turnover

2.10 An entitys STS average turnover for an income year is generally calculated using the average of the entitys STS group turnovers of any 3 years out of the preceding 4. Where an entity has been in business for less than 4 years, the STS average turnover is calculated by working out the average turnover for the number of years the business has been operating. [Schedule 1, item 1, section 328-370]

2.11 Entities that may have had an unusually high turnover in any one of the preceding 4 years have the option to disregard the group turnover of that particular year when calculating their STS average turnover.

Example 2.3

Abacus has an accounting practice which wishes to enter the STS for the 2001-2002 income year. The practices group turnovers for the preceding 4 years are:

•

1997-1998 - $00 million;

•

1998-1999 - $00 million;

•

1999-2000 - $1 million; and

•

2000-2001 - $10 million.

The 2000-2001 income year produced abnormal turnover. In calculating the sum of STS group turnover, The practice can use the turnover for the 1997-1998, 1998-1999 and 1999-2000 income years.

The practices STS average turnover for the year 2001-2002 using the above 3 years group turnovers is $00 million so the practice may be eligible to enter the STS.

2.12 If an entity or any of its related entities were not in business for the whole time in a year of income, the entity, when calculating its STS average turnover, is to make a reasonable estimate of what its or the related entitys turnover would have been for that income year had the business been carried on for the whole year. [Schedule 1, item 1, subsection 328-370(2)]

Example 2.4

Kevin commences his locksmith business on 1 January 2002. He would like to enter the STS. He calculates his STS average turnover to be $420,000 - calculated as below.

He estimates his turnover for the period 1 January 2002 to 30 June 2002 to be $200,000.

He estimates that if he had been in business for the period 1 July 2001 to 31 December 2001 his turnover would have been $190,000.

Therefore, the total estimate for the 2002 income year is $390,000.

His estimated turnover for income year 2002-2003 is $420,000, and the 2003-2004 income year is $450,000.

The total of STS group turnover for the 3 years is $10 million and the number of averaging years is 3.

His STS average turnover is $420,000 and Kevin may be eligible to be an STS taxpayer.

2.13 The dictionary in the ITAA 1997 is amended to include the definition of STS average turnover. [Schedule 2, item 20]

Closing down a business

2.14 An entity is taken to be carrying on a business in a year if:

•

the entity is closing down a business they formerly carried on [Schedule 1, item 1, paragraph 328-365(3)(a)] ; and

•

it was an STS taxpayer when it stopped carrying on the business [Schedule 1, item 1, paragraph 328-365(3)(b)] .

2.15 The above rule ensures that an entity does not need to decide whether it carried on a business in the year in which it ceased business. The provision also ensures that entities are not required to change their method of accounting for tax purposes during the closing down phase.

Recalculating average turnover

2.16 Entities whose STS average turnover exceeds $1 million using the test in section 328-365 or entities that do not have a turnover to use, are eligible to look forward and recalculate their STS average turnover. [Schedule 1, item 1, subsection 328-370(3)]

2.17 When recalculating their STS average turnover for an income year entities use their STS group turnover for the present year or a reasonable estimate of the turnover for that year plus a reasonable estimate of their STS group turnovers for the following 2 years, if any. The sum of these group turnovers is then divided by those years to give an STS average turnover figure. [Schedule 1, item 1, subsection 328-370(3)]

2.18 Where an entity or any of its related entities commences business during a year of income, the entity, when calculating its STS average turnover, makes a reasonable estimate of what its or its related entitys turnover would have been for that income year had the business been carried on for the full year. [Schedule 1, item 1, subsection 328-370(4)]

Reasonable estimate

2.19 When making a reasonable estimate of its turnover, an entity would normally take into account considerations such as:

•

any orders placed and/or forward contracts entered into;

•

the amount that could have been generated in turnover for a full income year based on a pro-rating of the turnover for the part of a year provided this is typical of the turnover in a full year;

•

the type of business activity undertaken, considering the nature and type of turnover of similar businesses in that industry; and

•

the current size and investment in the activity.

Example 2.5

Gunter has carried on a butchery business for the last 10 years through 2 of his shops in the city. Gunters turnover from the 2 shops has always exceeded $1 million ($750,000 for one and $520,000 for the other) so he has never been eligible to be an STS taxpayer.

In the 2003-2004 income year Gunter turns 55 and wants to ease himself into retirement so he sells one of his city shops.

Now that Gunter has only one shop he can reasonably estimate that the turnover from that butcher shop, for the 2004-2005 income year and the next 2 income years, will not exceed $1 million.

Gunter recalculates his STS average turnover on the basis of his circumstances and now may be eligible to be an STS taxpayer.

2.20 The generic penalties regime in Division 284 of Schedule 1 to the Taxation Administration Act 1953 will apply to any estimate that proves not to have been reasonable.

Meaning of STS group turnover

2.21 An entitys STS group turnover for an income year is the sum of:

•

the value of the business supplies made during the year by the entity; and

•

the value of business supplies made during the year by the grouped entities while they were grouped with the entity.

The STS group turnover is reduced by any supplies made between the entity and the grouped entities or between the grouped entities themselves. [Schedule 1, item 1, subsection 328-375(1)]

2.22 The dictionary in the ITAA 1997 is amended to include the definition of STS group turnover. [Schedule 2, item 21]

Meaning of value of the business supplies

2.23 The concept of the value of the business supplies is based on the terms defined in the GST Act and is defined in section 995-1 of the ITAA 1997.

2.24 The value of the business supplies an entity makes during an income year is the sum of the values of all the taxable supplies the entity made during the year in the ordinary course of carrying on a business (calculated exclusive of GST payable on supplies) and the prices of the other supplies made in the ordinary course of carrying on the business. Both price and value are defined in section 9-75 of the GST Act.

2.25 The GST Act explains the method of working out the value of a taxable supply. A taxable supply is defined in section 9-5 of the GST Act and is one on which GST is payable. The value of a taxable supply is worked out as 10/11 of the price of the supply. This calculation excludes the GST payable on the supply (the other 1/11).

2.26 If the supply is not a taxable supply, the price of all the non-taxable supplies made during the year in the ordinary course of carrying on a business is added to the value of all taxable supplies. The price of a supply is generally the amount of money an entity pays for the supply. Supplies that are not taxable include those that are GST-free and input taxed for the purposes of the GST Act.

2.27 It is anticipated that for the first few years that the STS operates, an entity may need to work out the value of their business supplies using the price of the supply. This is because for those early years an entity will be taking into account pre-GST turnover from supplies that were not a taxable supply. The main turnover test looks back on the 4 preceding years. Over the initial years of the STS, entities will use a combination of both pre and post GST years.

2.28 Value of business supplies does not include:

•

supplies not made in the ordinary course of carrying on a business - for example, sale of a capital asset, goods taken for own use and renting premises (unless the rental activity constitutes a business activity);

•

supplies that constitute an insurance recovery or the principal component of a loan are disregarded when calculating turnover [Schedule 1, item 1, subsection 328-375(3)] ; and

•

things that do not constitute the making of a supply - for example, dividend receipts.

Gambling supplies

2.29 To maintain consistency between GST and the income tax laws, gambling supplies for STS purposes are accorded the same treatment as that for GST purposes. As such, the method used for calculating the value of the business supplies in respect of gambling is different to that described in paragraphs 20 to 2.27. Where a taxable supply that an entity makes during the income year includes gambling supplies, an amount equal to 11 times the entitys global GST amount as defined in section 126-10 of the GST Act is included when working out the STS average turnover rather than using the value of the business supplies. [Schedule 1, item 1, subsection 328-375(2)]

2.30 The dictionary in the ITAA 1997 is amended to include the definition of global GST amount. [Schedule 2, item 15]

2.31 The effect of the change for gambling supplies is to provide that the amount included in the calculation of STS group turnover is simply the difference between the total amount wagered and total monetary prizes paid out. Total amounts wagered is the sum of the consideration for all gambling supplies that are attributable to that tax period. Total monetary prizes are the sum of prizes paid or payable in money (including casino chips) in that tax period.

Regulations may alter the calculation of STS group turnover

2.32 This Bill proposes that regulations can be made to provide a different calculation of STS group turnover. It has been suggested that there may be other supplies (like gambling supplies) which generate an unusually high turnover. The ability to make regulations to adjust the calculation of STS group turnover will enable the Government to further consider such cases and make any necessary adjustments where required. The regulations, however, cannot have the affect of increasing the amount of an entitys group turnover calculation. [Schedule 1, item 1, subsection 328-375(4)]

When is an entitys turnover grouped?

2.33 An entitys turnover will be grouped with that of another entity where:

•

either entity controls the other;

•

both entities are controlled by the same third entity; or

•

the entities are STS affiliates of each other.

[Schedule 1, item 1, section 328-380]

2.34 The grouping rules are designed to ensure that businesses that are part of a larger group of entities do not gain access to the STS. However, the grouping rules also ensure that unrelated entities are not inadvertently grouped and that only entities that are related to each other are grouped.

2.35 Irrespective of whether an entity that controls another entity, or is controlled by another entity wishes to participate in the STS, the turnover of that entity will still be grouped with those entities that it controls, or that are controlled by it that wish to enter the STS. For example, there may be 5 entities in a group and only 3 wish to enter the STS. The STS group turnovers of all 5 will be taken into account when calculating the STS average turnover for those 3 wishing to enter the STS.

Who is an STS affiliate?

2.36 An entitys (the first entitys)STS affiliate is an entity (the second entity) that acts or could reasonably be expected to:

•

act in accordance with the directions or wishes of the first entity in relation to the affairs of the second entitys business; or

•

act in concert with the first entity in relation to the affairs of the second entitys business.

[Schedule 1, item 1, subsection 328-380(8)]

2.37 Two or more partners in a partnership are not each others STS affiliates merely because one partner acts or could reasonably be expected to act in concert with the other in relation to the affairs of the partnership business. [Schedule 1, item 1, subsection 328-380(9)]

2.38 The STS affiliate rule ensures that related persons such as a husband and wife will not be grouped where they each run unrelated businesses.

2.39 The dictionary in the ITAA 1997 is amended to include the definition of STS affiliate. [Schedule 2, item 19]

2.40 The following factors will be amongst those that will be considered in arriving at any decision about whether another entity is an affiliate of another entity. None of these factors is seen as definitive in its own right but generally an entity would not be an affiliate of another entity where each entity:

•

has different employees;

•

has different business premises;

•

has separate bank accounts;

•

never consult each other on business matters; and

•

conduct their businesses independently in all regards.

The STS affiliate rules ensure that businesses that genuinely operate in isolation, that is, independently of each other are not automatically grouped.

Example 2.6

Stefan and Maria are husband and wife. They both share in the running of their household. Stefan operates a bakery with a turnover of $700,000 while Maria runs a cleaning business with a turnover of $500,000. They both have separate bank accounts for their businesses and have nothing to do with each others business. Both businesses are run from different locations and they have their own employees. Neither Stefan nor Maria control the management of the others business.

In this situation, even though they are married and live together, they are not each others STS affiliates because they do not act in concert with each other in respect of their businesses.

In this example, both Marias cleaning business and Stefans Bakery may be eligible to be an STS taxpayer.

Meaning of control

Companies, sole traders and certain trusts

2.41 An entity would be regarded as controlling another entity where that entity either alone or together with its STS affiliates can enjoy a certain level of benefit from another entity. Such a benefit can arise where the entity:

•

either alone or together with its STS affiliates legally or beneficially owns; or

•

has the right to acquire legal or beneficial ownership of interests in the other entity that give between them the right to receive:

-

at least 40% of any distribution of income or capital by the other entity; or

-

the right to exercise or control the exercise of at least 40% of the voting power in the other entity.

[Schedule 1, item 1, subsections 328-380(2) and (3)]

2.42 Where an entitys control percentage in another entity is at least 40% but less than 50%, the Commissioner can ignore the interest of that entity in the other entity if the first entity can satisfy the Commissioner that a third entity actually controls the other entity. [Schedule 1, item 1, subsection 328-380(7)]

Example 2.7

Chandra owns a restaurant with a turnover of less than $1 million and has inherited his fathers 42% interest in a software company. The other 58% of the software company is owned by a person with whom Chandra has had no dealings whatsoever. The turnover of Chandras restaurant will not be grouped with the turnover of the software company as Chandra can demonstrate that the software company is controlled by the other person with the 58% interest.

Non-fixed trusts

2.43 The tests of control discussed in paragraph 20 are not appropriate for non-fixed trusts because a beneficiary may not have any entitlement to a distribution of income or capital until certain events occur. For example, a beneficiary of a discretionary trust does not have any entitlement until the trustee actually exercises a discretion to distribute to particular beneficiaries.

2.44 The first test used in the STS to identify the control of a non-fixed trust for the purposes of the grouping rules looks at the receipt, by the entity or its STS affiliates, of distributions from non-fixed trusts. This test will only group an entity with a non-fixed trust where the entity or its STS affiliates, or the entity and its STS affiliates have received a distribution from the trustee of the trust of $100,000 or more in any one of the last 4 income years. [Schedule 1, item 1, paragraph 328-380(4)(a)]

Example 2.8

For the 2001-2002 income year Lucretia, who is a solicitor, has an STS average turnover of $200,000. Her great uncle Bob controls the Uncle Bob Family Trust. Lucretia is a beneficiary of the trust by virtue of her relationship.

The Uncle Bob Family Trust operates a very successful cable making business overseas and has an annual turnover in excess of $250 million.

Lucretia has not seen her great uncle for many years and has not received a distribution from the trust. In fact, Lucretia is not even aware that she is a beneficiary of the trust.

In 2004-2005, the trust distributes $80,000 to all beneficiaries with a blood relationship to Uncle Bob.

In this situation, this rule will not apply to group the turnover of the trust with Lucretias turnover from her law practice. This is because the distribution does not exceed $100,000 and it could not be said that Lucretia has any control over Uncle Bobs Family Trust.

The following year, Lucretia has a turnover of $400,000 and also receives from the trust a distribution of $200,000.

Since Lucretia has received a distribution in excess of $100,000, her turnover of $400,000 for the 2005-2006 income year will be grouped with the whole turnover of the trust of $300 million. Therefore, her group turnover for the purpose of the STS is $3000 million.

2.45 The other test looks at whether or not the entity or its STS affiliates are capable of directly or indirectly obtaining the beneficial enjoyment of the capital or income of the non-fixed trust. [Schedule 1, item 1, paragraph 328-380(4)(b)]

Partnerships

2.46 An entity would be said to be controlling a partnership where the entity and/or its STS affiliates between them have the right to receive at least 40% of the partnership net income or have at least a 40% interest in assets used by the partnership in its business (other than assets leased to the partnership). [Schedule 1, item 1, subsection 328-380(5)]

2.47 A partnership would be said to be controlling another entity (namely, another partnership, a trust or a company) where a partner or partners in the partnership have the right to receive between them at least 40% of the partnership net income or have at least 40% interest in the assets used in the partnership business and the same partner or partners:

•

also have the right to receive between them at least 40% of:

-

any distribution of income or capital from a trust;

-

the net income of another partnership, or have at least a 40% interest in the assets used in that partnership business; or

-

any distribution of income or capital by a company, or have the power to exercise control of at least 40% of the voting power in the company; or

•

if the other entity is a non-fixed trust it would be grouped with the trust under subsection 328-380(4) for similar reasons as explained in paragraphs 20 to 2.44.

[Schedule 1, item 1, subsections 328-380(5) and (6)]

Example 2.9

Lyn, David and Ross are partners in a partnership (P1) which operates an accounting practice, specialising in insolvency. The partnership has a turnover of $800,000.

The sharing of partnership profits and losses is governed by a partnership agreement. The agreement specifies that profits and losses of P1 are shared in the following way:

•

Lyn with a 30% share;

•

David with a 20% share; and

•

Ross with a 50% share.

Lyn, David and Ross also operate another partnership (P2) which is an accounting practice specialising in taxation. The turnover of the second partnership is $600,000.

A partnership agreement specifies that the profit and losses of P2 are to be shared in the following way:

•

Lyn with a 50% share;

•

David with a 20% share; and

•

Ross with a 30% share.

P1 and P2 operate in concert with each other and share assets and common business premises. Lyn, David and Ross have unfettered control of both partnerships.

As Lyn, David and Ross together have the right to receive amongst them over 40% of the net income of P1 and P2, the grouping rules will operate to treat P1 as controlling P2. As such, P1 will add the turnover of P2 to its own when working out its STS group turnover and P2 will add P1s turnover to its when calculating its STS group turnover.

In this example, P1 and P2 will not be eligible to be STS taxpayers as the STS average turnover of both partnerships exceeds $1 million. This assumes that the turnover of past (or future) years is not significantly different.

Indirect control of an entity

2.48 The control tests are designed to look through business structures that include interposed entities. However, only controlled entities are taken into account in tracing interests. The indirect control rule has been adopted to avoid complex tracing requirements for an entity. If an entity directly controls a second entity, and the second entity controls (whether directly or indirectly) a third entity, the first entity is also taken to control the third entity. [Schedule 1, item 1, subsection 328-380(2)]

Example 2.10

Matthew Co controls Simpson Co and Nareena Co but not Oslo Co.

Example 2.11: How to work out STS group turnover

Alpha Co and Beta Co, who are unrelated to each other, own 50% each of the issued capital of Gamma Pty Ltd. As well, Alpha owns 100% of Delta Pty Ltd. The structure of Alpha and Betas business affairs is illustrated below:

STS group turnovers of these entities for the income year is calculated as follows:

Alpha

Alpha controls both Gamma and Delta. The value of business supplies will be grouped as below:

Beta

Beta controls Gamma only.

Gamma

Gamma is controlled by both Alpha and Beta and is related to Delta as Delta is also controlled by Alpha.

Delta

Delta is wholly controlled by Alpha and is related to Gamma as Gamma is also controlled by Alpha.

Results

If Alpha wished to join the STS it would not be precluded on grounds of its group turnover for this year alone.

If Beta wished to join the STS it would not be precluded on grounds of its group turnover for this year alone.

If Delta wished to join the STS it would not be precluded on grounds of its group turnover for this year alone.

If Gamma wished to join the STS it may be precluded on grounds of its group turnover.