As part of its 2017-18 Budget on 9 May 2017, the Government announced proposed amendments to the tax law which would limit the application of the small business CGT concessions (SBCGT Concessions).

In keeping with its promise, on 8 February 2018, the Government released exposure draft legislation and explanatory material for public consultation (Draft Legislation).

In the words of the Treasurer, the proposed changes are an ‘integrity rule designed to prevent taxpayers from accessing the concessions for assets which are unrelated to their small business, such as by arranging their affairs so that their ownership interests in larger businesses do not count towards the tests for determining eligibility for the concessions’.

The Draft Legislation is seeking to prevent the SBCGT Concessions from being used by taxpayers with significant wealth in a manner which is inconsistent with the underlying policy intention. One example of such behaviour is set out below:

John is not carrying on a business and has a net worth of over $100 million. Among other things, John owns 25% of the shares in Trader Pty Ltd, a large private company with net assets exceeding $100 million and an annual turnover in excess of $10 million.

John wishes to sell his shares in Trader Pty but does not currently satisfy the necessary tests to be eligible for the SBCGT Concessions. That is, John is not a small business entity and fails the maximum net asset value test.

In order to become eligible to for the SBCGT Concessions, John purchases a small business in his own name, namely a corner store, with a turnover of approximately $500,000 per year.

In the following income year, John decides to sell his shares in Trader Pty Ltd. As he is now a small business entity, he is able to apply to the SBCGT Concessions to reduce the capital gain on the sale of his shares in Trader Pty Ltd which otherwise meet the active asset test and CGT concession stakeholder test.

While the Draft Legislation can be lauded for addressing the integrity issues head-on, it struggles to adhere to the underpinning policy of the SBCGT Concessions of reducing the tax cost and compliance burden for small business. That is, the Draft Legislation adds a further degree of complexity to existing provisions which are already perceived as complex.

Of great concern, and something which afflicts tax law amendments from time to time, the Draft Legislation will exclude many genuine small taxpayers from obtaining the SBCGT Concessions in an effort to prevent the troublesome few from accessing them. That is, it penalises the many for the sins of the few.

Moreover, under the shield of its original announcement on 9 May 2017, the Government has proposed that the new rules will have retrospective effect and apply to CGT events happening on or after 1 July 2017.

This means that taxpayers may have a significantly larger than expected tax bill where CGT assets have been sold after 30 June 2017, and the existing SBCGT Concession rules have been applied.

New CGT rules

Under the Draft Legislation, the existing basic conditions for relief set out in subs 152-10(1) of the ITAA 1997 will remain unchanged. However, for capital gains relating to shares in a company or interests in a trust, the Draft Legislation proposes significant amendments.

The table below provides a comparison between the current SBCGT rules and the changes proposed in the Draft Legislation.

Current SBCGT Rules Proposed new SBCGT Rules
The current SBCGT Concession rules apply the following additional basic conditions for capital gains relating to shares in a company or interests in a trust (Object Entity):
  1. if the relevant taxpayer is an individual, either the taxpayer or their spouse (must be a ‘CGT concession stakeholder’ in the Object Entity) or
  2. if the relevant taxpayer is a company or trust, CGT concession stakeholders in the Object Entity must together hold (directly or indirectly) at least 90% of the interests in the taxpayer.
The Draft Legislation proposes that additional basic conditions will apply for capital gains relating to shares in a company or interests in a trust (Object Entity) as follows:
  1. either the taxpayer must be a CGT concession stakeholder in the Object Entity, or CGT concession stakeholders in the Object Entity must hold at least 90% of the interests in the taxpayer
  2. unless the taxpayer satisfies the maximum net asset value test (MNAVT), the taxpayer must have carried on a business just prior to the CGT event
  3. the Object Entity must carry on a business just prior to the CGT event, and either be a CGT small business entity for the income year or satisfy the MNAVT and
  4. the shares or interests in the Object Entity must satisfy a modified active asset test.

Immediately, it can be seen that the requirement for the Object Entity to meet the MNAVT or small business entity test will exclude taxpayers who are presumably outside the integrity concern.

For example, a taxpayer owns 30% of a company with a MNAVT of $10 million, such that their interest is only worth $3 million. The taxpayer otherwise meets the MNAVT or small business entity test. They will be precluded from applying the SBCGT Concessions as the Object Entity (ie the company) doesn’t meet the MNAVT or small business entity test. This would seem to be collateral damage.

Additionally, the requirement that the Object Entity be carrying on a business just prior to the relevant CGT event would prevent taxpayers from applying the SBCGT Concessions to a capital distribution received upon the liquidation or winding-up of an entity; even if the shares in the Object Entity met the active asset test for the requisite period of time. Again, this would seem to be collateral damage.

In order to satisfy the modified active asset test under the Draft Legislation, at least 80% of the sum of the following must be active assets (or certain cash and financial instruments as described below):

  • total market value of the assets of the Object Entity (disregarding any shares in companies or interests in trusts) and
  • total market value of the assets of any entity in which the Object Entity has a small business participation percentage of greater than zero (referred to in the Draft Legislation as a ‘later entity’) – multiplied by that percentage.

For the purpose of the modified test, the Draft Legislation also proposes changes which restrict when cash and financial instruments will be included in the 80% test. Cash will only be included where it is inherently connected with a business carried on by an entity and held as trading stock. A financial instrument will be included where it is inherently connected with a business carried on by the entity and either:

  • held as trading stock or
  • issued by the entity in the course of a financial services business (within the meaning of the Corporations Act 2001) or credit activity (within the meaning of the National Consumer Credit Protection Act 2009) covered by an Australian financial services licence or a licence under the National Consumer Credit Protection Act 2009.

The current SBCGT Concession rules treat shares or interests as active assets based on the underlying assets of the company or trust. Conversely, the modified test looks through membership interests to include the proportionate amount of the value of the assets of other entities to which the membership interests ultimately relate. Practically, this may make it more difficult for taxpayers to satisfy the active asset test for capital gains relating to shares in a company or interests in a trust. It also increases the compliance burden of determining if the active asset test is met.

Under the Draft Legislation, when working out if the Object Entity satisfies the MNAVT or is a CGT small business entity:

  • the turnover or assets of entities that may control the Object Entity would be disregarded and
  • an entity would be treated as controlling another entity if it has an interest of 20% or more (rather than 40% or more as is currently provided for in s 328-125 of the ITAA 1997).

This will mean that more entities are ‘connected with’ each other for the purpose of calculating the turnover and assets of the Object Entity.

The following example is provided in the explanatory memorandum to the Draft Legislation:

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity for the 2019-20 income year.

Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with an annual turnover in excess of $20 million in both 2018-19 and 2019-20. The net value of Big Pty Ltd’s CGT assets exceeds $100 million throughout this period.

On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

Integrity improvement, but retrospectivity and compliance burden

In summary, the Draft Legislation will provide a significant integrity improvement to the SBCGT Concessions. Specifically, the requirement for an Object Entity to be a CGT small business entity or satisfy the MNAVT would make it more difficult for taxpayers to arrange their affairs so that their ownership interests in larger businesses do not count towards the tests for determining eligibility for the SBCGT Concessions.

For the time being, however, it appears that this will come at the cost of retrospectivity and also an added degree of complexity to provisions which are intended to reduce the tax cost and compliance burden for small business. There are also likely to be possible unintended victims of the changes.

Is there an alternative?

An alternative, and perhaps simpler, approach to that proposed in the Draft Legislation may be to amend the current SBCGT Concession rules to require that the relevant CGT asset have a sufficient link to the relevant small business carried on by the taxpayer. This solution would likely have required less amendment to the current legislation, resulted in a significant integrity improvement and perhaps also provided the Government with an opportunity to simplify the rules – and therefore reduce the tax cost and compliance burden for small business.

The Government is seeking stakeholders’ views on the Draft Legislation, and responses are open until 28 February 2018.