The small business concessions can be very generous in reducing or even eliminating the tax impost on a capital gain you make from selling your business (or your company), or an asset used in the business. For example, in combination with the general 50% discount on capital gains, these concessions can reduce your tax bill on a capital gain in the millions to nil in fairly mundane circumstances.
But that simple allure masks a deeper reality. Like with any generous tax concession, behind these small business concessions lurks a web of complex rules that must be carefully navigated before one can claim with confidence that they qualify. This is highlighted by three recent cases the ATO won, resulting in these concessions being denied.
ATO win #1: Land
A number of conditions must be satisfied in order to apply one or more of the small business concessions to a capital gain. One of the conditions is called the “active asset test”. Broadly, this requires the asset on which you made the capital gain (eg, goodwill, land) to be used in carrying on a business over certain periods of time (shares can qualify). But it’s not as straightforward as it sounds.
In this case, a person carried on a business of building, bricklaying and paving. He also owned a block of land on which there were a couple of sheds used to store tools, equipment and materials, as well as on the open space. He also parked work vehicles and trailers there, and occasionally some limited preparatory work was done on the land. The issue was whether the land was an “active asset”, that is, whether it was used in carrying on the business.
In the Administrative Appeals Tribunal (AAT), the taxpayer won. But the ATO appealed to the Federal Court, and won, overturning the AAT decision. The Court found that the above use was insufficiently connected to the normal day-to-day activities of the business. Accordingly, the land was not an “active asset”, and thus could not satisfy the active asset test. Therefore, the small business capital gains tax concessions were not available to reduce the capital gain made on the sale of the land. This decision does seem rather harsh. It remains to be seen whether the taxpayer appeals to the Full Federal Court.
ATO win #2: Shares
Another condition that must be satisfied in order to apply the small business concessions is the $6 million net asset value test. Broadly, the assets of the person or entity making the gain (plus those of related parties), less related liabilities, must total to $6 million or less just before the sale. Certain assets usually aren’t counted, such as the family home.
When an asset is sold to an arm’s length party, the sale price is the typical basis for pegging its market value, but it’s possible for its market value, in certain circumstances, to be a different amount.
In this case, three shareholders each owned ⅓ of a company. They all sold their shares for $17.7 million – $5.9 million each – in an arm’s length deal. At $5.9 million, plus other assets, the shareholder pursuing the case exceeded the $6 million net asset value threshold. But he argued that $5.9 million, despite being the sale price, was not the market value of his shares. As the buyer bought the whole company, a premium arguably was paid because the buyer obtained control of the company. But as the seller had only a minority shareholding, the market value of his ⅓ stake in its own right was something less than $5.9 million, reflecting removal of any control premium. And his lower market value figure would result his coming in at below the $6 million threshold.
Similar to #1, the shareholder won in the AAT, but the ATO appealed to the Federal Court, and won, overturning the AAT. A discount in value might be appropriate where a minority interest is being sold as a stand-alone, and that would be reflected in the actual sale price. However, in this circumstance, all the shareholders were selling under one deal, and so the buyer was in fact getting control. Accordingly, the $5.9 million – reflecting a value with a control premium – in the circumstances, was the market value of the individual shareholder’s ⅓ stake. Result: $6 million threshold exceeded; no small business capital gains tax concessions.
ATO win #3: Same shares, different tack
Same person in #2 above, having another go over the $6 million net asset value test. This time, the issue related to a restrictive covenant entered into with the buyer, whereby the sellers agreed not to compete with the buyer. Pretty standard in business sales. It means the seller is giving two items of property to the buyer: 1) the shares, and 2) a right (to not be competed against). The vendor shareholder argued that it was appropriate to divide the $5.9 million sale price between the shares and the right.
The key point here is that asset values are required to be measured just before executing the sale contract. The restrictive covenant right (item 2) only comes into existence upon executing the contract – it doesn’t exist just before. Therefore, the argument went, the portion of the sale price allocated to it doesn’t form part of the net asset value equation. The remaining value allocated to the shares would be something less than $5.9 million, resulting in – you guessed it – the shareholder coming in at below the $6 million threshold.
Unfortunately, he lost. Again. The AAT ruled that an asset sale doesn’t happen in a vacuum, and the asset’s market value reflects the terms of the impending deal. Accordingly, any value in the restrictive covenant right was embedded in the value of the shares. Thus, the market value of the shares was the full $5.9 million, meaning the shareholder did not satisfy the $6 million net asset value test. Again, no small business tax concessions.
Interestingly, there has been a general view (albeit untested until now) that allocating a portion of a sale price to a restrictive covenant was effective in removing that amount from the $6 million net asset value test. In this case, the contract didn’t actually divide the sale price between the shares and the restrictive covenant right, but it seems that wouldn’t have mattered. As this was an AAT decision, we’ll have to wait and see if this time the shareholder appeals to the Federal Court.
The lesson from these cases is to make no assumptions about qualifying for the small business capital gains tax concessions. Pre-planning can go a long way in shaping the outcomes, and your individual circumstances matter. Nexia’s Business Horizon Review seeks to identify things that could cause you to miss out on these generous concessions, even many years out from a sale – and there are some frequent culprits.
Talk to your trusted Nexia advisor about how we can ensure that you extract the maximum value from exiting your business, even if that’s still years away.