Common issues arising from the small business CGT concessions

Since the introduction of the small business CGT (SBCGT) concessions in September 1999, they have gone through many changes, often with the aim of reducing compliance costs and increasing the availability of the concessions for small business taxpayers. However, most practitioners agree that the rules for access to the SBCGT concessions are inherently complex despite the amendments. This article seeks to explore some of these complexities, specifically satisfying the significant individual requirement and the importance of timing where passively held assets are used in a business of a connected entity.

Significant individual where there is more than one share class on issue

Having a significant individual is a fundamental requirement for access to the SBCGT concessions. For example, where the asset sold is a share or trust interest, having a significant individual is a precondition for the additional basic conditions (s.152-10(2)). Where the taxpayer is a company or a trust, establishing that there is a significant individual for the requisite test period is one of the conditions for access to both the small business 15-year exemption and the small business retirement exemption. A significant individual is also a prerequisite for establishing a CGT concession stakeholder.

A significant individual is defined to be an individual who has a small business participation percentage (SBPP) in the test entity of at least 20%. A CGT concession stakeholder is defined to be an individual who is a significant individual or a spouse of a significant individual that has a SBPP in the test entity of greater than 0%. The test for working out an entity’s SBPP in another entity varies. For a company, the SBPP is determined by reference to an entity’s percentage of voting, dividend and capital rights; if the percentages of the various categories of rights are different the lowest percentage applies.

The complexity in establishing a significant individual/CGT concession stakeholder increases in the situation where the taxpayer is a company or a trust (where equity members have fixed income and capital entitlements), and the company/trust has more than one class of equity interests (with different rights) on issue. This is illustrated by the following example:

Example 1

Bedrock Co Pty Ltd sold its business in FY2023. Since its incorporation, up to the time of sale, it has 2 share classes on issue, A and B.  Fred and Barney are equal shareholders of the A class shares and those shares have the rights to vote, and the right to participate in any dividend or capital distributions from Bedrock Co.

Wilma and Betty are equal shareholders of the B class shares and those shares have no rights to vote and no rights to capital. However, they are entitled to receive any dividend distribution from Bedrock Co. The B class shares are not redeemable.

The Board has the discretion to pay dividends to one class of shareholder to the exclusion of other classes. Fred and Barney as holders of all A share class each have a 50% voting power and 50% rights to capital. However, neither of them have a fixed right to dividends (as the Board could declare and pay dividends to the B class shares and exclude A class shares). Thus, Fred and Barney would have a 0% right to dividends. As the SBPP is based on the smallest percentage, each of Fred and Barney would have a SBPP in Bedrock Co of 0%.

Even though Wilma and Betty each have a 50% right to dividends, applying the smallest percentage principle, their SBPP in Bedrock Co would also be 0% (because the B class shares do not carry any voting nor capital rights, and also because their rights to dividends is also discretionary).

In this case Bedrock Co has no significant individuals and this would make it impossible for the company to qualify for access to either the small business 15-year exemption or the small business retirement exemption. The former requires Bedrock Co to have (amongst other things) a significant individual for a total of 15 years. The latter requires Bedrock Co to satisfy the significant individual test just before the CGT event and to make a payment of the CGT exempt amount to at least one of its CGT concession stakeholders.

What if…

We note  that an entity satisfies the significant individual test if the entity had at least one significant individual just before the CGT event. For a company or a trust whose members have fixed entitlements to income and capital (otherwise known as a ‘fixed trust’), there may be some planning opportunities (subject to costs) to restructure the capital of the relevant entity so as to be able to establish a significant individual just before the CGT event.

What if Bedrock Co in the above example restructures its share capital (way in advance) before it sold its business by redeeming and cancelling all its B class shares? In this case Fred and Barney would be its only shareholders in the year when it disposes of its business. Fred and Barney, as equal owners of A class shares, would each be entitled to receive 50% of any dividend and capital distributions. They are also entitled to exercise 50% of the votes in Bedrock Co. Fred and Barney would thus qualify as significant individuals.

What if instead of redeeming and cancelling all of the B class shares, Fred and Barney subscribed for B class shares so that they, together with Wilma and Betty, are all equal holders of the B class shares? If so,  Fred and Barry would each hold 25% of the B class shares, and they will always receive a dividend of at least 25% (regardless of what class of shares the dividend is declared). In this case Fred and Barry will each have a SBPP of 25% and thus qualify as significant individuals.

Depending on the timing of the restructure of Bedrock Co’s share capital, it may provide Bedrock Co an opportunity that would otherwise not have been available to qualify for at least the small business retirement exemption. Naturally, any restructure of share capital must be commercially driven.

We note that redeemable preference shares are ignored for working out an entity’s SBPP. Thus, another alternative mechanism for distributing discretionary dividends could be the issue of redeemable shares.

As illustrated, if a company or a trust has on issue more than one class of equity with different rights, this could be an impediment for access to the SBCGT concessions. This is particularly the case for the small business 15-year exemption where the timing to establish a significant individual also covers an aggregate period of 15 years during which the company/trust owns the subject CGT asset.

The importance of timing where passively held assets are used in a business of a connected entity

To separate commercial business risks from business assets, it is not unusual for the business to be operated through a legal structure that is separate from the asset owning entity. An example is farmland owned by mum and dad and is used or made available for use in a primary production business operated through a different entity e.g., a partnership, company or trust structure. Usually, the primary production entity is closely related to mum and dad (the asset owners), such that they are connected, and the farmland passes the active asset test. Depending on the value of the farming land and the size of the farming business, this may be an impediment to the asset owners for access to the SBCGT concessions when they dispose of the farming land. In this case, the timing of when the primary production business ceases to operate on the land becomes relevant. This is illustrated by the following example:

Example 2

Mum and Dad are joint owners of farming land which they have held for a total of 30 years. Mum, in partnership with Dad, operated a farming business on the said land for the first 15 years. Then they sold the farming business to a company (Trading Co). The ordinary shareholders of Trading Co are Son 55%, Mum 5%, and Dad 40%. Trading Co carried on the same farming business on the farmland owned by Mum/Dad for another 14 years then sold its business (or alternatively ceased its business) in FY2022. Trading Co’s annual gross turnover from its primary production business is generally within the vicinity of $600K in an income year. One year after Trading Co sold/ceased its business, Mum and Dad sold the farmland in FY2023 for $8 million. For FY2023 Mum’s and Dad’s combined net worth including their respective share in the farming land is $13 million, which causes each of them to fail the maximum net asset value test in the year of sale.

From an active asset test perspective, the farming land qualified as an active asset for the requisite ownership test period. However, because the asset owners had ceased their primary production business that they had previously carried on, they are unable to qualify as a CGT small business entity. Thus, the only other basic condition that might be available for Mum and Dad is the passively held condition in s.152-10(1A).

Passively held assets–affiliates and entities connected with you

(1A) The conditions in this subsection are satisfied in relation to the * CGT asset in the income year if:

(a) your * affiliate, or an entity that is * connected with you, is a * CGT small business entity for the income year; and

(b) you do not carry on a * business in the income year (other than in partnership); and

(c) if you carry on a business in partnership–the CGT asset is not an interest in an asset of the partnership; and

(d) in any case–the CGT small business entity referred to in paragraph (a) is the entity that, at a time in the income year, carries on the business (as referred to in subparagraph 152-40(1)(a)(ii) or (iii) or paragraph 152-40(1)(b)) in relation to the CGT asset.

Whilst Trading Co is connected with Dad, it sold/ceased its primary production business as of 30 June 2022 (a year before the farmland is sold), and thus cannot qualify as a small business CGT entity. In this case both Mum and Dad are precluded from being eligible for the SBCGT concessions as not all of the conditions in s.152-10(1A)  are met.

What if…

What if Trading Co had continued to operate its primary production business on the land up 2 July 2022? In this case, Trading Co (an entity connected with Dad) would have qualified as a CGT small business entity as it would have carried on a business for the income year ended 30 June 2023. Additionally, the farmland would also have been used by Trading Co at a time in FY2023 in its business. By delaying Trading Co’s business activities on the farmland from being wound up or otherwise sold, this would result in Dad satisfying all of the s.152-10(1A) requirements in relation to his interest in the farming land. This would provide  Dad with an opportunity to access the SBCGT concessions that would otherwise be unavailable.

The above examples highlight some of the complex hurdles faced by practitioners when grappling with  eligibility for access to the SBCGT concessions. Planning ahead will naturally allow for early identification and resolution of potential risks areas and could be a fundamental factor for access to the SBCGT concessions.

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