The Australian Taxation Office (ATO) has increased compliance and audit activity in respect of entities seeking to access the capital gains tax concessions afforded to small businesses under Division 152 of the Income Tax Assessment Act 1997 (Cth) (ITAA97). Many disputes as to the application of the concessions relate to characterisation issues, specifically whether an item constitutes an asset or liability of the relevant entity for the tests set out in Division 152.

Breakwell’s case

In Breakwell v FCT [2015] FCA 1471 (Breakwell’s case), the Federal Court (on appeal from a decision of the Administrative Appeals Tribunal (AAT)) was asked to consider whether a debt owed to a trust was an asset of the trust for the purpose of determining whether the trust satisfied the maximum net asset value test (MNAVT) in section 152-15 of the ITAA97.

The taxpayer contended that the debt had no value (and should be treated as such for the purpose of the MNAVT) because the debt was an undocumented, on demand debt that was older than six years and unable to be recovered under the relevant limitation of actions legislation. In issuing an amended assessment, the ATO disagreed with this taxpayer’s view and included an amount equal to the book value of the debt as an asset of the trust for the purpose of the MNAVT.

In the first instance, the AAT confirmed the ATO’s amended assessment on the basis that the taxpayer (who was also the trustee of the trust) had acknowledged the debt annually by signing the trust’s accounts and therefore “refreshed” the limitation period under the limitation of actions legislation.

In confirming the ATO’s amended assessment and the decision of the AAT, the Federal Court held that:

  • limitation of action legislation acted as a defence to an entity that may have a contract sought to be enforced against it, but the effect was not to extinguish the cause of action (i.e. right to seek to enforce the loan);
  • as the limitation of action legislation gave the court the ability to extend a limitation period, the taxpayer should had been aware that the statutory period does not leave him absolutely and forever immune from suit;
  • also relevant was that the taxpayer was the trustee of the trust and as the limitation of action legislation provided a defence to the trust’s remedy, the court expected that the taxpayer would honour its obligations as trustee and not raise a limitation defence to the detriment of the trust;
  • limitation of action legislation provided that there is no limitation period where a trust brings an action to recover trust property, which would be the case in respect of seeking to recover the loan proceeds.

Key learnings

Breakwell’s case is a further example that the application of the small business CGT concessions is complicated and can often transcend the application of the tax law to properly characterise whether an item is an asset or liability of the relevant entity for the tests set out in Division 152.

The consequences for an entity that applies the small business CGT concessions only to have the ATO amend the assessment are significant including:

  • costs incurred reviewing and contesting an amended assessment;
  • practical issues if an amount was paid into superannuation;
  • funding the payment of an unexpected income tax liability and any associated interest and penalties.

It is therefore critical that proper planning and characterisation issues be considered before seeking to apply the small business CGT concessions to limit or defer a capital gain.