House of Representatives

Explanatory Memorandum

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

Chapter 2 - Aggregated turnover

Outline of chapter

2.1 Schedule 1 amends the Income Tax Assessment Act 1997 (ITAA 1997) to create the concept of aggregated turnover, which is used for determining whether an entity is a small business entity.

2.2 Schedule 3, item 165, amends the Income Tax (Transitional Provisions) Act 1997 to allow for transitional arrangements for the calculation of aggregated turnover in the 2005-06 and 2006-07 income years.

Context of amendments

2.3 Currently, access to the simplified tax system (STS) and goods and services tax (GST) concessions rely on the concept of 'turnover'. However, turnover is defined differently in each case. Other concessions rely on other measures of business size such as the net value of assets, instalment income, or ordinary and statutory income.

2.4 Furthermore, both the STS and the small business capital gains tax (CGT) concessions contain grouping rules which are designed to stop larger businesses from artificially splitting their operations to gain access to the concessions. While these rules are similar, they vary in a number of ways.

2.5 The small business entity test discussed in Chapter 1 is based on satisfying a $2 million aggregated turnover test. This Bill introduces a single concept of aggregated turnover to determine eligibility for the STS, GST, CGT, fringe benefits tax (FBT) and pay as you go (PAYG) instalment, small business concessions.

Summary of new law

2.6 This chapter outlines how an entity calculates its aggregated turnover in order to determine whether it satisfies the aggregated turnover test described in Chapter 1.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7 This chapter describes the method an entity uses to calculate its aggregated turnover for the purposes of determining whether it satisfies the $2 million aggregated turnover test discussed in Chapter 1.

Steps to calculate aggregated annual turnover

2.8 For an entity to calculate its aggregated turnover, it must first calculate its annual turnover, secondly apply the aggregation rules, and thirdly calculate its aggregated turnover.

2.9 Note - an entity's aggregated turnover is the same as its annual turnover if no other entities need to be aggregated with it.

Step 1: calculating annual turnover for the income year

2.10 An entity's annual turnover for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business. [Schedule 1, item 1, subsection 328-120(1) and item 4, definition of 'annual turnover' in subsection 995-1(1) of the ITAA 1997]

2.11 Some special rules apply to certain entities and certain dealings (see paragraphs 2.17 to 2.30).

The basic rule: ordinary income in the ordinary course of carrying on a business

2.12 'Ordinary income' is a term defined in section 6-5 of the ITAA 1997 as 'income according to ordinary concepts'.

2.13 An entity's annual turnover therefore includes all income according to ordinary concepts derived in the ordinary course of carrying on a business, but not other income, such as salary or wages.

Example 2.1

Pamela is employed as a senior manager in a multi-national corporation, and also carries on a business as a professional musician. Her ordinary income derived as a manager in the 2007-08 income year was $2 million. Her ordinary income derived in carrying on a business as a professional musician was $100,000.

Pamela's turnover for the purposes of step 1 is $100,000. Any income derived not in the ordinary course of carrying on a business, such as employment as a manager, does not need to be included in her annual turnover calculation.

What does 'in the ordinary course of carrying on a business' mean?

2.14 The phrase 'in the ordinary course of carrying on a business' is not defined in income tax law. It must therefore be interpreted according to its ordinary meaning.

2.15 In general, income is derived in the ordinary course of carrying on a business if the income is of a kind that is regularly or customarily derived by the entity in the course of carrying on its business, arising out of no special circumstance or unusual event. Similarly, the income is derived in the ordinary course of carrying on a business if the income, although not regularly derived, is a direct result of the normal activities of the business.

2.16 Ordinary income may be derived in the ordinary course of carrying on a business even if it is not the main type of ordinary income derived by the entity. Similarly, the income does not need to account for a significant part of the entity's overall receipts. It is sufficient that the ordinary income is of a kind derived regularly or customarily in the carrying on of a business.

Rules that apply for certain entities and transactions

Sales of retail fuel

2.17 The STS average turnover test provided for regulations to be made to allow for different methods of calculating turnover for certain entities. Such a regulation was made for the purposes of fuel retailers, recognising that entities involved in the sale of retail fuel will often have high levels of turnover with a very low margin, so that the ordinary turnover figure would not be a true indicator of size. This Bill retains that result by bringing the effect of this regulation in to the ITAA 1997. [Schedule 1, item 1, subsection 328-120(3) of the ITAA 1997]

2.18 The result is that, for the purposes of calculating its turnover, an entity disregards any income derived from the sale of retail fuel.

2.19 Retail fuel is defined as taxable fuel within the meaning of the Fuel Tax Act 2006 , that is sold by retail. [Schedule 1, item 6, definition of 'retail fuel' in subsection 995-1(1) of the ITAA 1997]

Exclusion of amounts relating to GST

2.20 Any amounts that are non-assessable non-exempt income under section 17-5 of the ITAA 1997 are excluded from an entity's turnover. [Schedule 1, item 1, subsection 328-120(2) of the ITAA 1997]

2.21 Section 17-5 describes two types of amounts as non-assessable non-exempt income (both of which are excluded from the entity's turnover):

•

GST on a taxable supply (within the meaning of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act)); and

•

any increasing adjustment (within the meaning of the GST Act) that relates to a supply, an acquisition, or arises in circumstances that give rise to a recoupment that is included in assessable income.

2.22 The effect of this provision is that an entity does not include amounts relating to GST when working out their turnover.

Dealings with associates

2.23 If an entity has a dealing with an associate that was not at arm's length, the entity needs to include in its turnover any ordinary income that would have resulted from that dealing as if the dealing had been at arm's length. [Schedule 1, item 1, subsection 328-120(4) of the ITAA 1997]

2.24 This rule ensures that amounts of income derived from non-arm's length transactions are properly accounted for when considering the entity's turnover.

2.25 Note that dealings between the entity and an associate that is a relevant entity for the purposes of these provisions are excluded from the calculation of turnover (see paragraph 2.64).

2.26 The term 'associate' is a defined term in the ITAA 1997 and has the meaning given by section 318 of the Income Tax Assessment Act 1936 .

2.27 The application of the associates rule would typically involve the substitution of the market value for the actual amount of ordinary income derived from the good or service being sold. However, the entity may take into account discounts, for example, that would have been offered had the dealing been at arm's length.

Example 2.2

Jamila carries on a business as a photo developer and Peter carries on a business as a wedding photographer. Jamila is a daughter of Peter, and therefore is his associate. Over the course of a year, Jamila developed 200 films for Peter and only charged him the amount it cost her to develop the films, with no profit margin.

Given that this is a non-arm's length transaction between associates, the amount that Jamila needs to include in her turnover is the ordinary income she would have derived from the developing of those 200 films had the transaction been at arm's length. A useful guide for the amount that should be used would be the price she would charge for any regular customer (taking into account bulk discounts etc).

Note that any income Jamila derives from Peter is disregarded if Peter is an affiliate of Jamila's under the aggregation rules (see paragraph 2.25)

Where an entity carries on a business for part of the income year

2.28 If an entity carries on a business for part of the income year only, its turnover must be worked out using a reasonable estimate of what the turnover would have been if the entity had carried on a business for the whole of the income year. [Schedule 1, item 1, subsection 328-120(5) of the ITAA 1997]

2.29 The intent of this provision is to ensure that the eligibility test of turnover, as an indicator of the size of a business, is based on income for a full year. Without this rule, entities that carry on a business for part of an income year would have a lower turnover than is truly representative of the size of the business.

Example 2.3

Cayleigh commenced carrying on a business on 1 June 2008, and her turnover from 1 June to 30 June was $200,000. Applying her turnover for a month to a full year, a reasonable estimate of her annual turnover for the 2007-08 income year is $2.4 million.

However, if there is something about her business that indicates that the month of June would be expected to have a particularly high or low turnover, then the reasonable estimate of her turnover would vary from the result under the equation.

An example of this may be if she carries on a ski equipment hiring business and would therefore be expected to have a high turnover in the month of June compared with her average monthly turnover. As a result, her reasonable estimate of her turnover may be less than that calculated as a simple lineal projection.

Regulations may alter the calculation of annual turnover

2.30 This Bill provides for regulations to be made that may set out different calculations of annual turnover [Schedule 1, item 1, subsection 328-120(6) of the ITAA 1997] . The regulations, however, can only have the affect of reducing the amount of an entity's annual turnover.

Step 2: apply the aggregation rules if necessary

2.31 An entity needs to determine whether another entity's annual turnover needs to be aggregated with its turnover.

2.32 The annual turnover of other entities needs to be aggregated with an entity (the test entity) if:

•

the test entity is an affiliate of another entity; or

•

the test entity is connected with another entity.

2.33 The rules that determine when an entity needs to count the turnover of another entity are referred to as the aggregation rules.

When is an entity an affiliate of another entity?

2.34 An individual or company is an affiliate of an entity where that individual or company acts, or could reasonably be expected to act:

•

in accordance with the entity's directions or wishes in relation to the affairs of that individual or company's business; or

•

in concert with the entity in relation to the affairs of the individual or company's business.

2.35 The definition of 'affiliate' is inserted into the Dictionary of the ITAA 1997. The affiliate rules are designed to ensure that entities that genuinely carry on independent businesses are not aggregated. [Schedule 1, item 2, definition of 'affiliate' in subsection 995-1(1), and item 1, subsection 328-130(1) of the ITAA 1997]

2.36 The following factors may have a bearing on whether an individual or company is an affiliate of an entity to the extent that they show that two or more entities are acting in concert:

•

family or close personal relationships;

•

financial relationships or dependencies;

•

relationships created through links such as common directors, partners, or shareholders;

•

the degree to which the entities consult with each other on business matters; or

•

whether one of the entities is under a formal or informal obligation to purchase goods or services or conduct aspects of their business with the other entity.

2.37 None of these factors are determinative in their own right.

2.38 A spouse or a child under the age of 18 years is not automatically an affiliate. This is a change to the current CGT law and is discussed in more detail in Chapter 4.

Example 2.4

Rose and Sam are husband and wife. They both share in the running of their household. Rose carries on a cleaning business with an aggregated turnover of $1.7 million while Sam carries on a bakery with an aggregated turnover of $1.5 million. They both have separate bank accounts for their businesses and have nothing to do with each other's businesses. Both businesses are run from different locations and they have their own employees. Neither Rose nor Sam control the management of the other's business.

Even though Rose and Sam are married, neither is an affiliate of the other. The reason is that they do not act in concert with each other in respect of their businesses, and neither acts in accordance with the directions or wishes of the other.

2.39 Similarly, an individual or company is not automatically an affiliate merely because of a business relationship [Schedule 1, item 1, subsection 328-130(2) of the ITAA 1997] . For example, co-directors, co-trustees or partners are not necessarily affiliates. Also, directors are not automatically affiliates of the company of which they are a director, nor would the company automatically be an affiliate of the directors.

Entities that cannot be an affiliate

2.40 Only an individual or company can be an affiliate of another entity. Entities (for tax purposes) such as trusts, partnerships, and superannuation funds are not capable of being affiliates of entities.

When is an entity connected with another entity?

2.41 The definition of 'connected with' is amended in the Dictionary of the ITAA 1997 to mean that an entity is connected with another entity if one of the entities controls the other entity, or if the two entities are controlled by the same third entity. [Schedule 1, item 5, definition of 'connected with' in subsection 995-1(1) of the ITAA 1997; Schedule 1, item 1, subsection 328-125(1) of the ITAA 1997]

2.42 Some control rules apply to all entities except discretionary trusts, others apply only to discretionary trusts, and some rules apply to any entity.

Rules that apply to all entities except discretionary trusts

The 40 per cent ownership test

2.43 An entity controls another entity where the first entity or its affiliates, or the first entity and its affiliates between them beneficially own, or have the right to acquire the beneficial ownership of, interests in the other entity that between them give the right to receive at least 40 per cent of any distribution of either:

•

income;

•

if the other entity is a partnership - the net income of the partnership; or

•

capital,

by the other entity. This is known as the control percentage. [Schedule 1, item 1, paragraph 328-125(2)(a) of the ITAA 1997]

2.44 The reference to partnerships ensures that a partner of a partnership that is receiving 40 per cent or more of the net income of the partnership will be taken to control that partnership.

2.45 Where an entity has legal ownership of the interests in the other entity, but not beneficial ownership of those interests, it will not be regarded as controlling that entity. If the entity is a partner in a partnership, that entity's interest in that partnership is a type of interest that gives the partner the right to receive a distribution of income or capital by the partnership.

Example 2.5

Patricia is the sole trustee of XYZ non-discretionary trust. Patricia is also a beneficiary of XYZ non-discretionary trust, and beneficially owns 30 per cent of any distribution of income from the trust.

Although she is the sole trustee, Patricia does not control the trust. She only beneficially owns 30 per cent of its income, and therefore does not exceed the control percentage.

Company-specific test: 40 per cent of voting rights

2.46 An additional test applies for the control by entities of companies. If either this test, or the 40 per cent ownership test is satisfied, then that entity controls the company.

2.47 Control of a company will be established if an entity alone or together with affiliates beneficially own, or has the right to acquire beneficial ownership of, interests in the company with at least 40 per cent of the voting power in the company. [Schedule 1, item 1, paragraph 328-125(2)(b) of the ITAA 1997]

Example 2.6

Pam carries on a business as a sole trader. She also owns interests in XYZ Company that gives her 30 per cent of the voting rights in that company. Sean, an affiliate of Pam, also owns interests in XYZ Company that gives him 30 per cent of the voting rights in that company.

As Sean is an affiliate of Pam, Pam controls XYZ Company, notwithstanding that her voting rights are below the control percentage. This is because Pam's interests, together with Sean's, amount to giving them the right to exercise more than 40 per cent of the voting rights in XYZ Company.

Pam would therefore need to include the turnover of both XYZ Company and Sean when determining whether or not she satisfies the $2 million aggregated turnover test.

Rules that apply to discretionary trusts

2.48 There are two ways in which an entity can control a discretionary trust:

•

where a special 40 per cent ownership test is satisfied [Schedule 1, item 1, subsection 328-125(4) of the ITAA 1997]; or

•

where the trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity [Schedule 1, item 1, subsection 328-125(3) of the ITAA 1997].

The 40 per cent ownership test for discretionary trusts

2.49 An entity is taken to control a discretionary trust for an income year if, for any of the four income years before that income year:

•

the trustee paid any income or capital of the trust to or for the benefit of the first entity, its affiliates, or the first entity and its affiliates [Schedule 1, item 1, paragraph 328-125(4)(a) of the ITAA 1997]; and

•

the amount paid or applied to the entity and/or its affiliates is at least 40 per cent of the total amount of income or capital paid or applied by the trustee for that income year [Schedule 1, item 1, paragraph 328-125(4)(b) of the ITAA 1997].

Example 2.7

Gavin is trying to determine whether he is a small business entity for the 2011-12 financial year. In the 2008-09 income year, Gavin received a distribution from a discretionary trust. That distribution constituted 70 per cent of the total amount of the income distributed by the trust in that financial year. Gavin will be taken to control that trust because he received a distribution of income in 2008-09 in excess of 40 per cent of the total amount of income distributed in that year.

2.50 Amounts paid to, or applied for the benefit of, exempt entities (ie, an entity that is exempt from income tax) and deductible gift recipients (ie, entities to which donations of $2 or more are tax deductible) are not relevant in determining whether these entities control discretionary trusts. [Schedule 1, item 1, subsection 328-125(5) of the ITAA 1997]

Trustees acting in accordance with other entities

2.51 If a trustee of a discretionary trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of an entity (the first entity), its affiliates or the first entity together with its affiliates, then the first entity will control the discretionary trust. [Schedule 1, item 1, subsection 328-125(3) of the ITAA 1997]

2.52 Whether a trustee is accustomed or might reasonably be expected to act in accordance with the directions or wishes of another, is determined having regard to all the circumstances of the case. For example, the mere presence in the trust deed of a requirement that the trustee should have no regard to such directions or wishes would not prevent the examination of the actual circumstances to determine whether an entity controls the trust.

2.53 Some factors which might be considered include:

•

the way in which the trustee has acted in the past;

•

the relationship between the entities and the trustee;

•

the amount of any property or services transferred to the trust by the entities; and

•

any arrangement or understanding between the entities and a person or persons who have benefited under the trust in the past.

Rules that apply to all entities

Indirect control of an entity

2.54 If an entity (the first entity) directly controls a second entity, and that second entity also controls (whether directly or indirectly) a third entity, the first entity is taken to control the third entity. [Schedule 1, item 1, subsection 328-125(7) of the ITAA 1997]

2.55 This test is designed to look through business structures that include interposed entities.

Example 2.8

Matthew Co controls Simpson Co and Nareena Co, but not Oslo Co or Meniotta Co.

2.56 Certain entities such as public companies and publicly traded trusts have a very diffuse and regularly traded ownership and, as a result, it can be a complicated and difficult process to trace interests through these types of entities. Therefore, if one of these entities is interposed between a first and a third entity, the first entity will not control the third entity merely because of its interests in the interposed public company or trust. [Schedule 1, item 1, subsection 328-125(8) of the ITAA 1997]

2.57 The types of entities are:

•

companies whose shares are listed for quotation in the official list of an approved stock exchange, unless those shares are of a type that carry the right to a fixed rate of dividend;

•

publicly traded unit trusts;

•

mutual insurance companies;

•

mutual affiliate companies; and

•

any company where all of its shares are beneficially owned by one or more of any of the entities listed above.

Example 2.9

Joanna controls a publicly traded unit trust. This publicly traded unit trust in turn controls a company. There are no other relationships of control between Joanna and the company.

Joanna will not be taken to control the company through the indirect control of an entity rule. This is because the indirect control test does not apply to any entities controlled by the publicly traded unit trust.

2.58 The mere presence of an interposed entity does not result in a chain of ownership being broken. In Example 2.8, if Simpson Co was a public company, Matthew Co would not be taken to control Nareena Co. However, if Matthew Co controlled Nareena Co in some other way, such as directly owning interests in Nareena Co, then Matthew Co would control Nareena Co.

The Commissioner's discretion

2.59 Where an entity's interest in another entity is at least 40 per cent but less than 50 per cent the Commissioner may choose to ignore the interest of that entity in the other entity if the Commissioner determines that a third entity actually controls the other entity. [Schedule 1, item 1, subsection 328-125(6) of the ITAA 1997]

2.60 The Commissioner may think that another entity controls the entity either based on fact or on a reasonable assumption or inference. Whether or not the third entity has a 40 per cent interest may assist in determining whether the third entity controls the other entity, but it is not decisive.

Example 2.10

Chandra owns a restaurant with a turnover of less than $2 million and has inherited his father's 42 per cent interest in a software company. The other 58 per cent of the software company is owned by the manager of the company, and Chandra has had no dealings with the manager whatsoever.

The turnover of Chandra's restaurant will not be aggregated with the turnover of the software company if the Commissioner thinks that the software company is actually controlled by the other person with the 58 per cent interest.

Step 3: calculating aggregated turnover for the income year

2.61 An entity's aggregated turnover is the sum of the relevant annual turnovers, excluding certain amounts. Schedule 1, item 1, subsection 328-115(1) of the ITAA 1997]

Relevant annual turnovers

2.62 'Relevant annual turnovers' consist of the sum of:

•

the annual turnover of the entity seeking to satisfy the $2 million aggregated turnover test;

•

the annual turnover of any of the entity's affiliates (discussed in paragraphs 2.34 to 2.40); and

•

the annual turnover of any entity connected with the entity (discussed in paragraphs 2.41 to 2.60).

[Schedule 1, item 1, subsection 328-115(2) of the ITAA 1997]

2.63 The entity's affiliates and entities that are connected with it are called 'relevant entities' in the provisions.

Amounts that are excluded from the aggregated turnover calculation

2.64 There are three classes of ordinary income excluded from aggregated turnover to avoid double-counting:

•

ordinary income derived by the entity from a dealing with a relevant entity;

•

ordinary income derived by a relevant entity from a dealing with another relevant entity; and

•

ordinary income derived by a relevant entity while it was not a relevant entity.

[Schedule 1, item 1, subsection 328-115(3) of the ITAA 1997]

Income derived by an entity from a dealing with a relevant entity

2.65 If an entity derives any income from a relevant entity the income does not need to be included in the aggregate turnover calculation [Schedule 1, item 1, paragraph 328-115(3)(a) of the ITAA 1997] . As relevant entities are considered as a single entity, rather than multiple entities, transactions between them do not constitute part of their aggregated turnover.

Income derived by a relevant entity from a dealing with another relevant entity

2.66 Similarly, if income is derived by a relevant entity from a dealing with another relevant entity, then that amount is excluded from the aggregated turnover calculation [Schedule 1, item 1, paragraph 328-115(3)(b) of the ITAA 1997] . An example of this may be a dealing between:

•

a trust that is connected with an individual; and

•

a company that is an affiliate of that same individual.

2.67 Any income derived from a dealing between the trust and the company is an excluded amount under the aggregated turnover calculation.

Example 2.11

Victoria is an affiliate of Lorin under the aggregation rules. Victoria is also connected with Export Company.

Victoria does not need to include income from any dealing with Lorin or Export Company in her aggregated turnover calculation.

Further, any dealing between Lorin and Export Company does not need to be included in Victoria's aggregated turnover.

Income derived from a relevant entity while they were not required to be aggregated with the entity

2.68 Only income derived by an entity while it was connected to, or an affiliate of, the other entity is required to be included in the aggregated turnover calculation. [Schedule 1, item 1, paragraph 328-115(3)(c) of the ITAA 1997]

Example 2.12

From 1 July 2007 to 31 December 2007, Nerida beneficially owned interests in QYX Pty Ltd that carry between them the right to receive 50 per cent of any distribution from QYX Pty Ltd.

On 1 January 2008, Nerida disposed of her interest in QYX Pty Ltd.

Nerida was only connected with QYX Pty Ltd from 1 July 2007 to 31 December 2007 and therefore only needs to include the ordinary income derived by QYX Pty Ltd during that period of time in her aggregated turnover. The income derived by QYX Pty Ltd from 1 January 2008 to 30 June 2008 is an excluded amount for the purposes of Nerida's aggregated turnover in the 2007-08 income year.

Application and transitional provisions

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

2.70 Different application dates apply for certain concessions available to small business entities (see Chapter 4 for details).

2.71 If an entity has to work out its aggregated turnover for the 2005-06 or 2006-07 income year to determine whether it is a small business entity, the rules about aggregated turnover apply as if they had been in force for that year. [Schedule 3, item 165, subsection 328-110(2) of the Income Tax (Transitional Provisions) Act 1997]

2.72 If an entity has an aggregated turnover for 2006-07 not under $2 million and wishes to rely on its likely aggregated turnover for the 2007-08 income year to qualify as a small business entity, it needs to consider its aggregated turnover for the 2005-06 income year. To make it easier for an entity to work out its eligibility in these circumstances, the entity can use its STS group turnover figure for the 2005-06 year (as an alternative to working out its aggregated turnover figure). The entity's STS group turnover figure will be very similar to its aggregated turnover amount. [Schedule 3, item 165, subsection 328-110(3) of the Income Tax (Transitional Provisions) Act 1997]

2.73 There are special transitional arrangements in determining control of discretionary trusts for the purposes of the form STS concessions (see Chapter 4 for details).