The small business CGT concessions offer fantastic tax savings when selling a business and have several key requirements, including that one or more active assets must be sold.
Considering that it is such a fundamental requirement for applying the small business CGT concessions, deciding whether an asset is “active” is not always as easy or straightforward as it sounds.
The basic condition for accessing the small business CGT concessions is that the taxpayer must either have an aggregated turnover of less than $2m[i] or aggregated net assets with a value not exceeding $6m,[ii] with extra requirements when selling shares in a company.
None of that matters, however, unless the asset being sold is an active asset,[iii] which is broadly defined in the legislation and has been the subject of much interpretation by the courts and the ATO as it is a concept that depends on the specific facts and circumstances in each case.
What is an “active asset”?
For the purposes of the small business CGT concessions, an active asset is one that the taxpayer owns and uses, or holds ready for use, in the course of carrying on a business.[iv]
Active assets may be tangible, such as land and buildings and equipment, or intangible, such as goodwill, patents, copyrights and other intellectual property (for example, software).
When selling shares in a company, the shares will be active at a point in time if the market value of its active assets equal at least 80% of the total market value of all of the company’s assets.[v]
It is conceivable that intangible assets may not meet the requirement that they be used in the relevant business; the rules require that such intangible assets must also be inherently connected with the business that is being carried on by the taxpayer to qualify as an active asset.
The asset must have been active for the lesser of 7.5 years and one-half of the relevant ownership period. This means that, if an asset has been an active asset for at least 7.5 years, it will be an active asset indefinitely, regardless of when it is sold or any other uses of the asset.[vi]
In addition, if an asset is used or held ready for use by a taxpayer’s affiliate, or another entity connected to the taxpayer, in the course of carrying on its business, then that asset will also be treated as active when sold.[vii]
A critical point is that assets whose main use is to derive rent, even in the course of carrying on a business, are specifically excluded from qualification as active assets.[viii] However, applying this exclusion is not straightforward and the ATO has provided guidance by way of examples in TD 2006/78, explaining when premises used by a business will and will not satisfy the active asset test. In any case, as discussed below, the specific circumstances of each situation need to be carefully considered.
So, what exactly does it mean to be “carrying on a business”?
Unfortunately, there is no definitive test as to whether a business is being carried on. However, in TR 2019/1, the ATO has indicated that the following factors may be relevant:
- the intention to carry on a business;
- the expectation, and likelihood, of a profit;
- the size, scale and permanency of the activity; and
- whether the activity is repetitive and regular and organised in a business-like manner.
Example 1. Property used in carrying on a business that qualifies as an active asset
Ron owns the Very Good Building & Development Company. Ron uses one of its properties for storage only, while the activities of building, bricklaying and paving take place at building sites. It is reasonable to argue that the property is still used in the course of carrying on the company’s business, and is not merely preparatory, so should be treated as an active asset.
Support for Ron’s example can be found in the recent Federal Court decision, Eichmann v FCT,[ix] where the definition of “active asset” was given a broad meaning. The relevant factors are the use of an asset and whether the asset is used in the course of carrying on that business, which involve issues of fact and degree and should be applied in a concessional way.
There have also been a number of cases where the taxpayer has successfully argued that conduct of a rental property business is carrying on a business. In one such case, YPFD and FCT,[x] the taxpayer owned nine rental properties and, although they were managed by an agent, devoted a considerable amount of time undertaking tasks in connection with the properties.
Despite the taxpayer’s methods being relatively unsophisticated, the Administrative Appeals Tribunal concluded that the taxpayer was carrying on a business. However, while it is possible to carry on a rental property business, the courts have rejected arguments that an asset whose main use is to “derive rent” is an active asset even if it used in carrying on a business.
When will the main use of a property be treated as deriving rent?
Recent private binding rulings and cases suggest that, where the occupier has a right to exclusive possession of the property, payments involved are likely to be rent. On the other hand, if the occupier is only allowed to enter and use the premises for certain purposes (which do not amount to exclusive possession), the payments involved are unlikely to be rent.
Other factors to consider include the degree of control retained by the owner and the extent of services provided (eg providing meals, room cleaning, supplying linen and shared amenities).
Some common scenarios have been analysed by the courts and the ATO, including the examples set out in TD 2006/78 and private rulings given to taxpayers, which help to illustrate the specific factors that will determine whether an asset is used to derive rent or whether it is an active asset.
Example 2. Short-term accommodation
Ann operates the Pawnee Guest House, where visitors must leave the premises by a certain time. Ann has the right to enter rooms at any time, she provides common areas and offers services such as cleaning and meals, and she has the right to move residents to another room in the house at short notice. The ATO does not consider this to be a landlord/ tenant relationship and the property will be an active asset.
This can be contrasted with the decision in Tingari Village North Pty Ltd and FCT,[xi] where residents of a mobile home park were held to be paying rent for their sites despite the provision of additional services and the availability of common facilities.
Example 3. Provision of commercial storage
Chris runs Eagleton Storage Solutions, offering storage sheds for short or longer-term hire, with 24-hour security and various other services, and with the right to relocate clients to another shed and, importantly, to enter without their consent. The ATO accepts this would not be a rental arrangement, and the asset would be active.
There are, however, many other examples in ATO private rulings where short-term commercial storage providers were treated as receiving rent, so their properties were not active assets, with the deciding factors usually being a lack of other services and arrangements giving exclusive possession.
Example 4. Owning and operating a shopping centre
Donna operates Pawnee Mall, a large shopping centre with a wide range of tenants who enjoy the use of substantial common areas and a range of services. While the ATO does not dispute the scale and commercial nature of Donna’s business, its view remains that, as her tenants each have exclusive access to their shops under their leases, Donna is receiving rent and the property cannot be active. The ATO has consistently rejected private ruling requests seeking active asset treatment for operators of shopping centres, often with very substantial operations.
What does “main use” mean and how is it determined?
The term “main use” is not defined in the legislation and a number of factors will be relevant, such as the comparative areas of use of the premises between deriving rent and other purposes, the comparative periods of use, and the comparative levels of income derived from the asset.
It would appear, based on a review of relevant ATO examples, that the most important consideration is the comparative levels of income derived.
Example 5. Properties used for both business and rental purposes
Andy owns land on which there are several industrial sheds. He uses one shed (45% of the land by area) as a production studio for his business as a children’s entertainer and he leases the other sheds (55% of the land by area) to two unrelated third parties, Ben and Tom. The income derived from Andy’s business is 80% of his total income, with the rest derived from leasing the other sheds. Having regard to all circumstances, the ATO’s view is that Andy’s “main use” of the land is not to derive rent, but rather the rental use is secondary to his business activities.
In a recent case, The Executors of the Estate of the late Peter Fowler and FCT,[xii] the term “use” was argued to include “non-physical” uses, such as holding a property for the purpose of capital appreciation, but the tribunal held that the concept of “use” referred only to physical use.
Can passively held assets still meet the definition of “active asset”?
Generally, owners of passively held assets (such as factories, warehouses or office buildings) are not carrying on a business and therefore cannot access the small business CGT concessions. However, an exception is when a taxpayer owns a passively held asset that is used in the small business carried on by an affiliate or an entity connected to the taxpayer.
Example 6. Property used by spouse in running a business
With reference to example 5, instead of owning the land himself, the land is owned by Andy’s wife April, who leases it to Andy so he can carry on his business. While spouses are not usually “affiliates” for the small business CGT concessions, a special rule applies in a situation like this to “deem” Andy to be April’s affiliate, which makes the land an active asset for April because it is used in Andy’s business.
Sale of intellectual property, including software
Taxpayers must be able to show that intellectual property (IP) is not merely being used to derive rent or royalties and that the asset was not simply developed for sale. In other words, it is essential to show that the IP was held for use in an active business.
Developing IP that might be a target for a would-be purchaser may still be part of a company’s business plan. However, in order to claim that it is an active asset, it is still necessary to show that using the IP in the course of carrying on the business was the main objective.
Example 7. Software sold after building up subscriber base
Leslie has developed software for managing all of a city’s parks and recreation facilities, and after initially testing it in Pawnee and nearby cities, she has ambitious plans to expand her business nationally and globally. Leslie has built up a significant subscriber base so that, as she refines the software, she is earning revenue from using it in her business, which gives her a strong argument for treating it as an active asset when she receives an offer to sell.
There is little ATO guidance in relation to the classification of software and other items of IP as active assets, and careful consideration should be given to both the financial and non-financial aspects of each case.
There are many factors to consider when selling your business, of which tax is just one — albeit a very important one. It is therefore vital to seek advice from a qualified tax professional to understand the likely consequences, as well as information on any relevant small business CGT concessions that may be available.
[i] S 152-10(1AA) of the Income Tax Assessment Act 1997 (Cth) (ITAA97).[ii] S 152-15 ITAA97. [iii] S 152-10(1)(d) ITAA97. [iv] S 152-40 ITAA97. [v] S 152-40(3) ITAA97. [vi] S 152-35 ITAA97. [vii] S 152-47 ITAA97. [viii] S 152-40(4)(e) ITAA97. [ix] [2020] FCAFC 155. [x] [2014] AATA 9.[xi] [2010] AATA 233. [xii] [2016] AATA 416.