Capital gains tax has an enormous impact on the business and tax structuring of small businesses. Thus it is essential to maintain a close watch over changes to capital gains tax law.
A few changes will come into force from 1 July 2007, noteworthy is the increase in the net asset value test from A$5 million to A$6 million. Some of the changes already effective from 1 July 2006 are discussed in this article.
The intention of all such changes is to ease the impact of capital gains tax on small businesses in Australia.
The old 50% “controlling individual” test has been changed in the following respects:
- it is replaced with a new 20% “significant individual” test; and
- in the application of the significant individual test, indirect interests through interposed entities can be taken into consideration (ie a right is now available to the taxpayer to “look through” interposed entities.
Four capital gains tax concessions remain available for small business
These changes should be seen in the context of the four capital gains tax concessions available to small business. Each should be considered in tax planning work, ideally years before decisions are made to sell assets, thus triggering due payment of any capital gains. The four concessions available are:
- 15 year asset exemption;
- 50% active asset reduction;
- retirement exemption; and
The changes will also be beneficial only if the most important condition for the application of such small business concessions is satisfied. This is that the net asset value of the taxpayer and connected entities must not exceed A$5 million. This threshold will be increased to A$6 million with effect from 1 July 2007.
Business and tax structuring – striking a balance
Prior to the 1 July 2006 changes, if the asset in respect of which the capital gains tax concession is claimed is a share in a company or an interest in a trust, then the company or the trust must satisfy the 50% controlling individual test.
In the case of a company, a controlling individual is a person who holds at least 50% of the voting, dividend and capital distribution rights of the company.
An individual will be considered as a controlling individual of a trust if the individual is beneficially entitled or actually receives at least 50% of any capital and income distributions of the trust. The accompanying first graphic illustrates this arrangement for business and tax structuring.
Key observations regarding the structure in the first graphic are:
- the structure does not provide 50% controlling individual interest to the beneficiaries of the discretionary trusts; and
- the beneficiaries do not have a fixed interest in the discretionary trusts and therefore in the company or the trust.
As a consequence upon sale of the company shares or trust units, the beneficiaries will not enjoy the small business capital gains tax concessions in the structure illustrated in the first graphic.
To overcome this problem discretionary trusts have been compelled to form partnerships (in place of companies or trusts to run their business). This is because partnerships, unlike companies or trusts, are not required to satisfy the 50% controlling individual test for the small business CGT concessions to apply.
In this second business or tax structuring graphic, the partnership carries on the business.
Since partnership interest is a capital gains tax asset, the beneficiaries became entitled to the small business capital gains tax concessions when the discretionary trustee sells its partnership interest.
The substitution of the 50% controlling individual test with the 20% significant individual test makes it easier for the taxpayers to satisfy the test to be entitled to small business CGT concessions in the future.
Further, the changes allow the 20% significant individual interest to be established even through interposed entities.
The change to the 20% significant individual test may now be used to increase the maximum of people who can benefit from the concessions to at least eight (as compared to two before the changes which took place on 1 July 2006).
If the business and tax structuring used in your business does not benefit from the capital gains tax concessions for small business then it may be time to restructure.