What can go wrong with capital gains tax contributions

Deborah Wixted explains what happens when good capital gains tax contributions go bad.

Eligible small business clients who have disposed of active business assets are able to make capital gains tax (CGT) contributions of up to $1.155 million in 2010-11.

While this contribution concession is a very valuable way in which small business clients can convert their business wealth into retirement savings, particular care must be taken in the delivery of advice in this area, since there are a number of traps that can unravel the entire strategy.

Ensuring a full assessment of the client’s position and working closely with their accountant or taxation adviser can help ensure success with a CGT contribution strategy.

What goes wrong? 

Due to their complexity, it is possible for a client to fail one or more of the CGT small business tests. Following are some of the areas where this commonly occurs, along with an outline of steps that can be taken to minimise non-compliance.

Incorrectly identifying assets counted in the net asset value test

One of the key tests to qualify as a small business entity is for the net market value of the assets of that entity, any connected entities and any of its affiliates to be less than $6 million.

It is important when applying this test to focus on two aspects:

Taking into account the correct entities

In the most straightforward case, this may be a simple task (ie, a small business operated by a sole trader who personally owns all business and personal assets).

However, if assets used in the business are owned by the business owner’s family members or are held in other structures such as trusts or companies, then they too must also be included. 

Correctly including the relevant assets of the entities

Having identified the correct entities, the next requirement is to ensure that the correct assets are counted.

Here, it is important to note that it is not just the active business assets that count towards the $6 million limit – passive business assets, including those not subject to CGT on disposal, and non-business assets may also be included.

The family home, interests in super, life insurance policies and personal use assets are generally excluded from this limit.

Incorrectly valuing assets for the net asset value test

As noted above, this test is required to include assets at their net market value (ie, their market value less the value of any liabilities relating to those assets and provisions for leave, unearned income and tax liabilities).

While certain assets may be held at historical or cost value on the small business entity’s books for accounting purposes, this is insufficient when applying the small business entity tests.

Miscalculating active asset period

An asset is an active asset if it is used or held ready for use in the course of carrying on the business of the taxpayer, an affiliate or a connected entity.

To qualify, this must be the case for at least half of the period the asset has been owned, to a maximum of 7.5 years (ie, where the asset has been owned for 15 years or more).

Particular attention should be paid to real property assets with a changing use.

Periods of time where the property is leased to an unrelated party and its main purpose is the derivation of rental income will generally not count to the active asset period. 

What happens when the client is not eligible to make a CGT contribution already received?

As a consequence of failing to meet the small business CGT concession criteria, clients could face a much higher CGT liability than otherwise expected.

However, taking the right action may avert excess contributions tax that may arise if a CGT contribution has been made which must now be reclassified as non-concessional contribution. 

Superannuation Industry (Supervision) Act 1993 (SIS) Regulation 7.04(3) means that a super fund must not accept any fund-capped contributions that exceed the fund-capped limit relevant to the client.

This is $450,000 for a client under age 65 for any part of the financial year, and $150,000 for a client who is 65 or older at the start of the financial year.

SIS Regulation 7.04(4) then requires the fund to return the excess to the contributor within 30 days of becoming aware that the fund-capped limit has been exceeded.

While CGT contributions are not considered fund-capped contributions, non-concessional contributions are.

Therefore, upon becoming aware that a contribution previously received as a CGT contribution is now to be considered a non-concessional contribution, the fund may at that point make an assessment against the fund-capped limit and return any excess.

Doing so may then ensure that excess non-concessional contributions are avoided or minimised.

A 180-degree turn: basing advice assuming no CGT relief applies

An alternative excess contribution situation may arise where super contributions advice is given without taking into account the effects of small business CGT concessions for which the client may be eligible.

The key point in this case is that doing so can result in a very different estimate of the amount and source of the client’s taxable income for the year, and affect any application of the 10 per cent test relating to eligibility to claim a tax deduction for personal contributions. 

Case study

James, aged 67, derives salary income of $20,000 in a year and sells an active business property for a potential gross capital gain of $400,000.

Advice is given to James on the basis that this capital gain will be eligible for the 50 per cent individual discount only, resulting in a net taxable gain of $200,000.

Consequently, in the belief that no more than 10 per cent of his assessable income of $220,000 is attributable to employment, James makes the following super contributions:

• $50,000 personal deductible (concessional) contribution; and
• $150,000 personal non-concessional contribution.

In preparing James’ tax return for the year, his taxation adviser advises that James qualifies for small business CGT concessions, and chooses to utilise the CGT retirement exemption to exempt the $200,000 net gain from tax. James’ final position for the year is $20,000 of salary only, with no other assessable income.

As James cannot meet the 10 per cent test, no deduction is claimed in his tax return for the $50,000 personal contribution he has already made.

Since no deduction has been claimed for the $50,000 contribution, the ATO counts it towards James’ non-concessional cap and James receives an excess contributions assessment for $50,000.

James contacts the super fund to request that his $150,000 non-concessional contribution be re-classified as a CGT contribution.

However, the fund trustee advises that, as no CGT cap election form was given to it on or before the time the relevant contribution was made, it cannot do so.

A successful super contribution strategy, where small business CGT concessions may be available, requires:

• Confirming the client’s position in relation to eligibility for the concessions;
• Confirming the effect this is estimated to have on their overall tax position for the year;
• Clarification of the amount of CGT contributions to be made; and 
• The provision of a completed CGT cap election form no later than when the relevant contribution is made.

Deborah Wixted is executive manage, technical services, at Colonial First State.