Senate

Explanatory Memorandum

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

Chapter 3 - Small business taxpayers

Outline of Chapter

3.1 This Chapter introduces the concept of 'small business taxpayer'. Small business taxpayers retain access to the following features of the current law that generally are being repealed for other taxpayers:

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accelerated depreciation for plant and equipment;

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balancing adjustment offsetting; and

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immediate deductions for certain advance business expenditure.

3.2 The test to determine who is a small business taxpayer is set out in new Subdivision 960-Q of the ITAA 1997, inserted by item 22 of Schedule 2 to this Bill.

Context of Reform

3.3 The Government's announcement of the New Business Tax System foreshadowed the introduction of the Simplified Tax System for small business taxpayers to ease their compliance burden. The principal features of the Simplified Tax System are:

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A cash accounting regime under which income and expenditure will generally be recognised only as they are received and paid.

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A simplified depreciation arrangement under which depreciating assets costing less than $1,000 each will be written-off immediately and other depreciating assets with an effective life of less than 25 years will be pooled and depreciated at the diminishing value rate of 30%. Depreciating assets with an effective life of 25 years or more will be written-off at their effective life rates.

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A simplified treatment of trading stock which will mean that small business taxpayers will need to account only for significant changes in the levels of their trading stock.

3.4 The Simplified Tax System will commence on 1 July 2001. Pending that, small business taxpayers are to retain access to the following features of the current law:

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accelerated depreciation for plant and equipment used in their business activities other than predominantly in leasing activities;

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balancing adjustment offsetting; and

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immediate deductions for advance expenditure on the provision of services in relation to their business activities if those services are to be rendered within 13 months.

3.5 This Chapter deals only with the meaning of 'small business taxpayer'. The explanation of the changes to the current law mentioned above and the implications for small business taxpayers is contained in the following chapters:

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Chapter 2 - Balancing adjustment offsetting.

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Chapter 4 - Accelerated depreciation.

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Chapter 9 of the Explanatory Memorandum to the New Business Tax System (Integrity and Other Measures) Bill 1999 Deducting prepayments.

Summary of new law

Meaning of small business taxpayer

3.6 A taxpayer is a small business taxpayer for an income year if the taxpayer carried on a business during that year and the taxpayer's average turnover for the year is less than $1 million.

3.7 Generally, average turnover is based on the turnover for the income year and the preceding 2 income years. If a business was not carried on in one or both of the 2 years preceding the income year, it will be the average of the turnover of those years in which a business was carried on. So, for example, the average turnover of a taxpayer commencing a business for the first time in a year of income will be the same as the turnover for that year.

3.8 For the income years before the proposed commencement of the Simplified Tax System (i.e. 1 July 2001), taxpayers have the option of basing their average turnover on their actual turnover for the year plus their estimated turnover for the following 2 years. This will ensure that the greatest number of taxpayers will qualify as small business taxpayers.

Turnover grouped with that of controlled entities

3.9 To prevent taxpayers splitting their businesses to be treated as small business taxpayers, a taxpayer's turnover will be grouped with that of entities it controls or is controlled by. These grouping measures are based on those that apply under the current CGT roll-over relief for small business.

Meaning of group turnover

3.10 Broadly, a taxpayer's group turnover for an income year means the sum of the values of all supplies of goods and services that the taxpayer and its controlled or controlling entities made during the year to third parties in the ordinary course of carrying on of a business, exclusive of GST payable on the supplies.

3.11 Turnover does not include supplies that are not made in the ordinary course of carrying on of a business. So, the sale of assets not acquired or used for trading purposes would not count as turnover. Examples of such assets include a manufacturer's plant and goods taken for private use by a retailer.

3.12 Turnover does not include things that are not supplies, such as dividend receipts, and non-business supplies as is usually the case for interest and rent received by an individual.

Application

3.13 The definition of small business taxpayer applies to the income year in which the date of announcement (i.e. 21 September 1999) occurred and later years.

Comparison of key features of new law and current law

3.14 There is no equivalent 'small business taxpayer' concept in the current income tax law. There is a small business test for CGT purposes, but it is based on net assets.

Detailed explanation of new law

3.15 The meaning of small business taxpayer is contained in new Subdivision960-Q, which is to be inserted into the ITAA 1997.

Meaning of small business taxpayer

3.16 A taxpayer is a small business taxpayer for an income year if the taxpayer carried on a business in that year and the taxpayer's 'average turnover' for the year is less than $1 million. A taxpayer's average turnover will generally be based on actual turnover for the current year and the preceding 2 years. However, taxpayers have the option of recalculating their average turnover for any of the income years before the 2001-2002 income year based on actual turnover for the year and their estimated turnover for the following 2 years. [Item 22, Schedule 2, section 960-335; item 6, Schedule 6, definition of 'small business taxpayer' inserted into subsection 995-1(1)]

Can a partnership be a small business taxpayer?

3.17 The threshold will apply to partnerships in the same manner as for other entities such as companies, trusts and individuals. That is consistent with the general treatment of partnerships under income tax law. Although partnerships are not liable to income tax, they are treated as entities for the purposes of calculating their net income and loss for an income year. Accordingly, a partnership will be a small business taxpayer in an income year if its average turnover for the year is less than $1million.

Meaning of average turnover

3.18 A taxpayer's average turnover for an income year is the average of the taxpayer's 'group turnovers' for the year and the preceding 2 years, if any. Taxpayers can only average the years in which they carry on a business, except where they are winding up a business. So, for example, if a taxpayer has carried on a business for the current and previous year only, the taxpayer would average only those 2 years. [Item 22, Schedule 2, section960-340; item 1, Schedule 6, definition of 'average turnover' inserted into subsection 995-1(1))]

Winding up a business

3.19 A taxpayer is taken to be carrying on a business in a year if:

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the taxpayer is winding up a business they formerly carried on; and

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the taxpayer was a small business taxpayer at the time that they stopped carrying on the business.

3.20 This avoids the need to decide whether winding up a business constitutes the carrying on of a business. This rule ensures that taxpayers are not forced to change their method of tax accounting during the winding up phase. [Item 22, Schedule 2, section960-355]

Meaning of group turnover

3.21 A taxpayer's group turnover for an income year is the sum of the 'value of the business supplies' made by the taxpayer and entities connected with the taxpayer during the year. However, this does not include any supplies made between the taxpayer and its connected entities or between those connected entities when they were both connected with the taxpayer [item 22, Schedule 2, subsection960-345(1); item 2, Schedule 6, definition of 'group turnover' inserted into subsection 995-1(1)] . Example 3.1 shows how to calculate group turnover.

Meaning of 'value of business supplies'

3.22 The concept of 'value of business supplies' is based on terms defined in the GST Act.

3.23 The value of business supplies an entity makes during an income year is the sum of the values of the supplies the entity made during the year in the ordinary course of carrying on a business [subsection960-345(2); item 8, Schedule 6, definition of 'value of business supplies' inserted into subsection 995-1(1))] . The method of working out the value of a supply depends on whether or not the supply is a 'taxable supply'.

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If the supply is a taxable supply (i.e. one on which the GST is payable), its value is worked out as 10/11 of the price of the supply, so excluding the GST payable on the supply [paragraph 960-345(2)(a)] .

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If the supply is not a taxable supply, its value is the same as the price of the supply [paragraph 960-345(2)(b)] . These supplies include those that are GST-free and input taxed for the purposes of the GST Act.

3.24 The term 'price' has the same meaning as in the GST Act (refer to section 9-75 of that Act). A definition of 'taxable supply', referring to the GST Act, is inserted into the ITAA 1997 [item 7, Schedule 6, definition of 'taxable supply' inserted into subsection 995-1(1))] .

3.25 Group turnover does not include:

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supplies not made in the ordinary course of carrying on a business for example, the proceeds of sale of a capital asset, goods taken for own use and rental and interest receipts (unless the rental or lending activities constitute business activities); and

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

Linkage with CGT small business roll-over relief

3.26 The concept of group turnover draws on the existing concept of 'connected with' employed in the CGT roll-over relief provisions for small business taxpayers. These CGT provisions are contained in Division 123 of the ITAA 1997. The following provides an explanation of the term 'connected with'.

Meaning of 'connected with'

3.27 An entity is connected with another entity if it 'controls' that other entity, is controlled by that other entity or it and that other entity are controlled by the same entity (subsection 123-60(1)).

Meaning of control

The 50% or more test

3.28 An entity controls another entity if it and/or its 'small business CGT affiliates':

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beneficially own interests in the other entity ^[F1] that carry between them the right to receive 50% or more of any distribution of income or capital by the other entity, or have the right to acquire the beneficial ownership of such interests (paragraph 123-60(2)(a)); or

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if the other entity is a company beneficially own shares in the company that carry between them the right to exercise, or control the exercise of, 50% or more of the voting power in the company, or have the right to acquire beneficial ownership of such shares (paragraph 123-60(2)(b)).

3.29 The meaning of 'small business CGT affiliate' is discussed in paragraph 3.39 to 3.41.

The 40% to less than 50% test

3.30 An entity also controls another entity if it and/or its 'small business CGT affiliates':

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beneficially own interests in the other entity that carry between them the right to receive 40% or more, but less than 50%, of any distribution of income or capital by the other entity, or have the right to acquire the beneficial ownership of such interests (paragraph 123-60(4)(a)); or

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if the other entity is a company beneficially own shares in the company that carry between them the right to exercise, or control the exercise of, 40% or more, but less than 50%, of the voting power in the company, or have the right to acquire beneficial ownership of such shares (paragraph 123-60(4)(b)).

3.31 The rules in paragraph 3.30 do not apply if the Commissioner is satisfied, or thinks it reasonable to assume, that a third party controls that other entity.

Discretionary trusts

3.32 An entity is taken to control a discretionary trust if the entity and/or its 'small business CGT affiliates':

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are the trustee or trustees of the trust and are not the public trustee of a State or Territory; or

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have the power to determine the manner in which the trustee or trustees exercise the power to make any payment of income or capital to, or for the benefit of, beneficiaries of the trust (paragraph 123-60(2)(c)).

3.33 As well, a beneficiary of a discretionary trust is taken to beneficially own interests in any distribution of income or capital of the trust equal to the maximum percentage of the income or capital of the trust that the trustee of the trust has the power to pay to, or apply for the benefit of, the beneficiary (subsection 123-60(5)). However, that rule does not apply to certain public entities that could benefit from a discretionary trust because another beneficiary of the trust has an interest in the public entity (subsection 123-60(6)).

3.34 Subsection 123-60(5) links with paragraphs 123-60(2)(a) and (4)(a) above. So, for example, if a beneficiary of a discretionary trust could receive 50% or more of the income or capital of the trust, the beneficiary would be taken to control the trust under paragraph 123-60(2)(a).

3.35 A special rule applies in cases where the entity working out its group turnover is a discretionary trust. As described in paragraph 3.32, paragraph 123-60(2)(c) treats the trustee of a discretionary trust, or a person who has the power to determine the manner in which the trustee distributes the income or capital of the trust, as controlling the trust.

3.36 However, that rule does not apply if a beneficiary which section 123-60 treats as controlling the trust (e.g. by reason of their potential entitlement to a distribution of trust income or capital) is neither a 'small business CGT affiliate' of the trustee of the trust nor of the person who has that power of determination.

3.37 This Bill is amending subsection 123-60(3) so that it will apply appropriately when a discretionary trust is working out its group turnover. [Item 16 of Schedule 2]

Indirect control of entity

3.38 An entity that controls a second entity is taken to also control any entity that the second entity directly or indirectly controls. However, that generally is not the case if the second entity is a public entity (subsections123-60(7) and (8)).

Meaning of small business CGT affiliate

3.39 The concept of 'small business CGT affiliate' is defined in section 123-55. For the purposes of these small business taxpayer measures, it is relevant only to the process of working out whether an entity controls another entity, as described above. If a taxpayer controls an entity, it needs to take the value of the business supplies made by that entity into account in working out whether it is a small business taxpayer.

3.40 A person is a small business CGT affiliate of a taxpayer if:

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the taxpayer is an individual and the person is their spouse or child under the age of 18 years; or

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the person acts, or could reasonably be expected to act, in accordance with the taxpayer's directions or wishes, or in concert with the taxpayer.

3.41 However, partners are not taken to be affiliates of each other simply by reason of the fact that they are in partnership with each other. The nature of partnership arrangements is that the partners usually act in concert, and in accordance with each other's wishes. Accordingly, that alone is not enough to make them affiliates of each other (subsection 123-55(2)).

Recalculating average turnover for the opening years

3.42 In working out whether they are small business taxpayers for an income year before the 2001-2002 income year, taxpayers have the option of recalculating their average turnover using their group turnover for the year plus a reasonable estimate of their group turnover, if any, for the following 2 years. [Item 22, Schedule 2, section 960-350]

Example 3.1: How to work out group turnover

A and B, who are unrelated to each other, own 50% each of the issued capital of Company C. As well, A owns 100% of D. Diagram 3.1 illustrates the structure of A and B's business affairs.

The following are the values of the business supplies made by those entities in an income year.

The following are the calculations of those entities group turnovers for the income year.

A's group turnover

A is connected with both C and D. It therefore needs to find the sum of the value of business supplies made by the 3 of them reduced by any supplies made between the 3 of them.

Application and transitional provisions

3.43 The small business taxpayer measures apply to the income year in which 21 September 1999 occurs and later years [subitem 28(1), Schedule2] . That year will normally be the 1999-2000 income year, but for some late balancers, it could be the 1998-1999 income year.