Capital gains tax opportunities for retirees

The introduction of the ‘Tax Laws Amendment (2006 measures No. 7) Bill 2006’, which has passed through both houses of Federal Parliament effective March 29, 2007, and now awaits royal assent, has provided further clarification to the various capital gains tax (CGT) small business concessions, which are outlined below.

Introduction

The three basic conditions to be able to utilise the small business concessions for this financial year are:

~ Maximum net asset value of $5 million taking into account the negative net asset value of connected entities. Net value includes assets less related liabilities of an entity and provision for annual leave, long service leave, unearned income and tax liabilities.

~ Active asset — asset is active if it is used, or held ready for use, in carrying on a business by the taxpayer, the taxpayer’s small business CGT affiliate, or a connected entity.

Requires the asset to be active for the lesser of 7.5 years, or half the period of ownership. Asset does not need to be an active asset just before the CGT event. If business ceases within 12 months before the CGT event, the relevant period is from acquisition until the business ceases. If the business owns the asset for greater than 15 years, the asset only needs to be active for a period totalling at least 7.5 years.

~ 20 per cent significant individual test — the 20 per cent significant individual test can now be satisfied directly or indirectly. Under the previous laws, this was only available for controlling individuals under direct ownership.

Change in terminology/concepts applying for CGT events happening in the 2006-07 incremental year: Stakeholder’s control percentage changing to ‘stakeholder’s participation percentage’ (s 152-125(2) and (3) ITAA 1997).

Maximum net asset value

You satisfy this test if the net asset value is a maximum of $5 million of the CGT assets owned by:

~ you; or

~ any entities ‘connected with you’; or

~ any of your ‘small business CGT affiliates’ or entities connected with your small business CGT affiliates are only included if those assets are used, or held ready for use, in a business carried on by you or by an entity connected with you.

Under a partnership structure, only an individual’s share in the structure is included in the maximum net asset value.

Under a small business CGT affiliate, a person is not automatically another person’s small business CGT affiliate because of a business relationship. For example, co-directors and co-trustees are not necessarily affiliates.

Example:

Peter has CGT business assets valued at $7.2 million, with liabilities relating to the assets of $1.1 million. He has a $100,000 provision of annual leave for employees, $20,000 of unearned income and $50,000 for tax liabilities for the financial year. Total asset value is $5.93 million.

A separate company, Bike Company, has assets of $2 million, with $3 million of debt. Peter owns 70 per cent of the shares in Bike Company. This is an entity connected to him; therefore, Peter’s net asset value is reduced to $4.93 million and passes the maximum net asset value test.

Developments to rule from July 1, 2007

Released back in November 2006 and then again in the Exposure Draft Tax Laws Amendment (Small Business) Bill 2007 released on February 7, the Government announced further opportunities to help small businesses access the CGT concessions by changing the eligibility to the simplified tax system (STS) to:

~ increase the STS average turnover threshold from $1 million to $2 million; and

~ remove the $3 million depreciating asset test.

Businesses under the STS will be exempt from the net maximum asset value test.

Active asset test

Example:

Alice ran a farming business on a property that she has owned for 17 years. She ran the farm for three years, and then leased it to an unrelated party for five years. She then ran the farm for another five years before retiring and leasing the farm for another four years before selling it.

The farm satisfies the active asset test because it was actively used in Alice’s farming business for at least seven years (given her ownership was greater than 15 years), even though the period was not continuous and the property was not used in the business just before it was disposed of.

Active asset test — 80 per cent rule

To determine whether a share in a company or an interest in a trust is an active asset, it is necessary to look through the company or trust and establish whether 80 per cent of the entity is active. Cash and financial instruments are counted towards the 80 per cent test provided they are inherently connected with the business.

Taxpayers are not required to continually apply the 80 per cent test if the test has been passed at some stage and there is no reason to think the test will be failed at the later time.

An example of when it will be reasonable to think the share or trust interest is still an active asset is when there have been no significant changes to the assets or liabilities of the company or trust.

Where there has been significant change and the 80 per cent test is reapplied and is not met, the share or trust interest will still be an active asset provided that the failure of the test is only temporary.

80 per cent test

Example:

Georgina buys shares in a company that buys a property in order to start a farm. The property makes up 50 per cent of the asset value of the company. For the first year that she owns the shares, the company does not actively use the property. After that time, the company starts the farming business. The property is not active for the first year; therefore, the company does not pass the 80 per cent test. The shares are not treated as active because the company failed the 80 per cent test for an extended period of time (not just a temporary failure).

20 per cent significant individual test — direct and indirect ownership

An entity’s indirect small business participation percentage in a company or trust is calculated by multiplying together the entity’s direct participation percentage in an interposed entity and the interposed entity’s total participation percentage.

Example:

Melissa’s direct ownership is 10 per cent. Her indirect ownership is more complex. As there are two interposed entities between Melissa and Company C, we need to calculate each company separately.

Have a look at Melissa’s indirect percentage in Company C via Company A:

~ Company A’s direct percentage is 0 per cent in Company C.

~ Company A’s indirect percentage in Company C is 20 per cent.

50% x (0% + 20%) = 10%

Melissa’s indirect percentage in Company C via Company B is:

~ Company B’s direct percentage is 40 per cent in Company C.

~ Company B’s indirect percentage is 0 per cent in Company C.

20% X (40% + 0%) = 8% Total = 28%

Where there are interposed entities and CGT concession stakeholders, the test must satisfy the 90 per cent rule. This test only applies if there is an interposed entity between the CGT concession stakeholder and the company or trust in which the shares or interests are held. The interposed entity satisfies the test if 90 per cent of the participation percentages in that entity are held by CGT concession stakeholders of the company or trust in which the shares or interests are held.

Example:

Anna is a significant individual and a CGT concession stakeholder of the company and has an 80 per cent small business participation percentage in trust.

Bill, a CGT concession stakeholder of the company, has a 15 per cent small business participation percentage in trust.

Deborah, who is not a CGT concession stakeholder of the company, has a 5 per cent small business participation percentage in trust.

At least 90 per cent of the participation percentages in the trust are held by CGT concession stakeholders of the company. The trust satisfies the ownership requirement if it sells its shares in the company to access the small business CGT concessions.

15-year rule

To access the 15-year rule and be exempt from CGT, there must be a significant individual of a company or trust for any period or periods totalling 15 years during the period of ownership. This doesn’t need to be the same significant individual at all times.

The company or trust must make the payment relating to the exempt amount within two years of the CGT event. Payments to stakeholders under this exemption are exempt amounts to the extent the payment is equal to or less than the stakeholder’s participation percentage.

Example:

Julie owned 10 per cent of the shares in Juice Company for 18 years from 1987 to 2005. For five years (1987 to 1992) she owned another 10 per cent and was a significant individual. For a different 10 years (1995-2005), another person (Edward) was a significant individual.

The significant individual requirement is met for Julie’s shares.

Juice Company had a factory for the past 18 years, which it wishes to sell with a capital gain liability. Juice Company will satisfy the significant individual requirement in relation to the factory and be exempt from any capital gains tax liability.

Exemption — superannuation contribution

There are opportunities this financial year to contribute more into super via the CGT small business relief. These contributions are exempt from the non-concessional cap, but only up to a separate lifetime contribution limit of $1 million indexed. Once the individual reaches $1 million of contributions arising from CGT small business relief, any excess contributions will be included in the non-concessional contributions cap. The $1 million exemption applies to the following contributions:

~ up to $500,000 contribution under CGT retirement exemption;

~ capital proceeds from the disposal of an asset that is eligible for the 15-year rule; and

~ capital proceeds that would have qualified for the 15-year rule, but the disposal of asset results in no capital gains or capital loss, pre-CGT asset, or disposed of before 15 years due to permanent incapacity of person.

The contributor of the contribution must notify the trustee prior to or at the time of contribution so it goes against the CGT cap. The contribution must be made no later than:

~ lodgement of the tax return; or

~ 30 days after receiving capital proceeds.

The CGT stakeholder must receive payment from the entity within two years of the CGT event and contribute within 30 days of receiving.

The CGT exempt component attributed to a concession stakeholder is treated as a personal contribution by that stakeholder, even if it is contributed directly from the company or trust. Any payments to employees are deemed to be payments in consequence of employment. There is no need to actually terminate employment (previously required).

It’s not necessary to receive actual capital proceeds in order to access the retirement exemption, therefore, it’s available even if the active asset is gifted and a market value substitution rule applies. In order to access the exemption on a gain made by a company or trust for which there are no actual proceeds, the company or trust must make a payment of the disregarded capital gain to at least one of its CGT concession stakeholders.

Strategy opportunity

If the stakeholder is less than age 55, the payment must be paid into super based on age at the time the choice is made. The CGT exempt amount must be contributed as a personal contribution if the stakeholder is less than age 55 and can’t claim a deduction.

If the stakeholder is age 55 or over they may be eligible to contribute the funds as a personal contribution and may be eligible to claim a tax deduction.

Note that if the stakeholder is age 65 or over, they must meet the contribution rules for that financial year, so the timing of selling the business and stopping work is an important element.

Case study — gifting business

Paul, age 59, wants to gift a proportion of his financial planning practice (company owned) to his son. The total business is valued at $1,300,000, with an unrealised capital gain of $1,000,000. Paul could gift 60 per cent of his shares in the business in parcels of 20 per cent, which could be one parcel each year over the next three years.

Share in the 2006-07 financial year:

$1,300,000 X .20 = $260,000 business value.

Gain of $200,000 X 50% discount (personal) = $100,000.

Meaning, each year the deemed $100,000 assessable capital gain could utilise the retirement exemption and the total business value could be passed on to Paul’s son with no proceeds and no CGT.

Paul is going to sell the remaining 40 per cent to his son in years four and five. The proceeds will be $520,000 with no CGT payable due to the retirement exemption election, meaning that the total value could be contributed to super within the $500,000 CGT retirement exemption cap, as it’s not part of the non-concessional cap. The remaining $320,000 could be contributed as an undeducted contribution or, if eligible, Paul could claim a personal deduction up to the $100,000 concessional cap each year.

Sam Rubin is IOOF senior technical services manager.