Minimising CGT: navigating the rules of active assets

One of the fundamental requirements for applying capital gains tax (CGT) concessions is the asset being sold must be ‘active’ and this is not always as easy or straight-forward as it sounds.

The basic conditions that must be satisfied to access small business CGT concessions are that the taxpayer must either have an aggregated turnover of less than $2 million or aggregated net assets with a value not exceeding $6 million, with extra requirements when selling shares in a company. 

None of that matters, however, unless the asset being sold is an active asset, which is broadly defined in the legislation and has been the subject of much interpretation by the courts and the Australian Taxation Office (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 CGT concessions, an active asset is one the taxpayer owns and uses, or holds ready for use, in the course of carrying on a business.

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Active assets may be tangible, such as land and buildings and equipment, or intangible, such as goodwill, patents, copyrights and other intellectual property, such as 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.

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’s sold or any other uses of the asset.

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.

A critical point is 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. 

However, applying this exclusion is not straightforward and the ATO has provided guidance by way of examples in ‘Taxation Determination 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, the ATO has indicated in ‘Taxation Ruling TR 2019/1’ 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. 

CASE STUDIES

There have 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 Commissioner of Taxation [2014] AATA 9, 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 (AAT) concluded the taxpayer was carrying on a business.

However, while it’s 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. 

A hypothetical example of an asset being used in the course of carrying on a business is Ron, who owns the Very Good Building and 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’s reasonable to argue 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. 

This example is highlighted by the recent Federal Court decision, Eichmann v Commissioner of Taxation [2020] FCAFC 155, 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 of that business, which involve issues of fact and degree, and should be applied in a concessional way. 

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 (e.g., 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 illustrate the specific factors that will determine whether an asset is used to derive rent, or if it is an active asset.

The first one is short stay accommodation – say, for example, that 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, provides common areas and offers services such as cleaning and meals, and 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 v Commissioner of Taxation [2010] AATA 233, 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.

Secondly, provision of commercial storage can sometimes be treated as rent depending on the specific arrangements. As an example, Chris runs Eagleton Storage Solutions, offering storage sheds for short or longer-term hire, with 24-hour security and various other services, 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.

Finally, the ATO has consistently rejected arguments seeking active asset treatment raised by operators of shopping centres, often with very substantial operations. To illustrate, 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.

WHAT IS DETERMINED BY MAIN USE?

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 review of relevant ATO examples that the most important consideration is the comparative level of income derived. 

As an example, Andy owns land on which there are several industrial sheds. He uses one shed – which is 45% of the land area – as a production studio for his business as a children’s entertainer and 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 would be that Andy’s ‘main use’ of the land is not to derive rent, but rather the rental use is secondary to his business activities.

Further, in a recent AAT case, 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 – The Executors of the Estate of the late Peter Fowler v FCT [2016] AATA 416).

WHAT ABOUT PASSIVELY-HELD ASSETS? 

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 used in the small business carried on by an affiliate or an entity connected to the taxpayer. 

So, hypothetically, Andy did not own the land; rather, it was owned by his wife, April, who leased it to Andy so he could carry on his business. While spouses are not usually “affiliates” for 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’s used in Andy’s business. 

In the case of intellectual property, not only it is essential to show the IP is not merely being used to derive rent or royalties but the taxpayer must also convincingly argue the asset wasn’t simply developed for sale, rather it 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, to claim they are active assets, it is still necessary to show that using the IP in the course of carrying out the business was the main objective.   

For example, Leslie has developed software for managing recreation facilities, and built up a subscriber base so that as she refines the software she is earning revenue from using it in her business, which is her argument for treating it as an active asset if it were to be sold.

There is little ATO guidance in relation to these situations and careful consideration needs to be given to both the financial and non-financial factors specific to 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 vital to seek advice from a qualified tax professional to understand the likely consequences as well as information on any relevant CGT concessions available. 

Peter Bembrick is tax partner and Katherine Lloyd is tax manager at HLB Mann Judd.