Tax Rambling

We finally have some long-feared changes to the small business CGT concessions. These are in the Treasury Laws Amendment (Tax Integrity and Other Measures) Bill 2018 and have now passed the Parliament.

These changes propose to add additional basic conditions for these concessions to apply, but only where the CGT asset is share in a company or interest in a trust. If it is not a share or a unit there are no changes.

Remember that these amendments apply to CGT events that occur on or after 1 July 2017. The Government states that this “retrospective application is consistent with the Budget announcement by the Government on 9 May 2017 to ensure the small business CGT concessions are only available in relation to assets used in a small business and ownership interests in small businesses.”

The big change – looking through to the object entity

If I am selling shares or units, one of the questions I need to ask is if I am a small business entity or if I pass the maximum net assets test. But under the new rule I also have to ask if the object entity, being the entity that I own shares or units in, is a small business entity or passes the maximum net assets test.

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019-20 income years. The net value of Big Pty Ltd’s CGT assets exceeds $100 million throughout this period.

On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

If the object entity does not pass these tests, the small business CGT concessions do not apply to the sale of the shares or units in the object entity.

George carries on a small gardening business. George is a CGT small business entity for the 2019-20 income year.

George holds all of the units in G Trust, a trust that holds a number of investments in other entities but which does not carry on a business. The total value of the investments held by G Trust also means that it does not satisfy the maximum net asset value test.

On 17 February 2020, George sells the units it holds in G Trust. George is not eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if George satisfied the basic conditions for relief, he cannot satisfy the new condition as G Trust is not a CGT small business entity (as it does not carry on a business) and does not satisfy the maximum net asset value test.

When working out if the object entity is a CGT small business entity or satisfies the maximum net asset value test, the turnover or assets of entities that may control the object entity are disregarded. This ensures that the outcomes for taxpayers do not depend upon the income or assets of third parties.

Further, for these purposes (and only these purposes), an entity is treated as controlling another entity if it has an interest of 20 per cent or more, rather than 40 per cent or more. This means that more entities are considered to be ‘connected with’ one another for the purpose of this test and need to count the assets or turnover of the other entity towards their aggregate turnover or the total net value of their CGT assets.

Tien owns 20 per cent of the shares in Investment Co, a company that carries on an investment business. Investment Co is a CGT small business entity for the 2020-21 income year.

Investment Co holds 20 per cent of Van Co, a transport company. Van Co’s turnover and assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year.

On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain.

Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition.

For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van Co’s shares. As a result, for this purpose, Investment Co’s turnover and assets include the turnover and assets of Van Co. As Van Co is not a CGT small business entity and does not satisfy the maximum net asset value test, Investment Co is also treated as not satisfying these requirements (despite its status under the general rules in the tax law).

A welcome change – retrospective small BUSINESS entities

Another change proposed in this Bill is the taxpayer must have carried on business just prior to the CGT event happening. This ensures that entities do not benefit from this concession where the relevant business activities are too remote to justify the entity receiving a concession for business activities.

However, this requirement does not apply to taxpayers that satisfy the maximum net asset value test in relation to the CGT event.

The technical change – modified active asset test for the sale of shares and units

There is an additional new condition that requires that, to pass the active asset test, for the lesser of seven and a half years or at least half the period a taxpayer has held the share or interest, at least 80 per cent of the sum of the:

• total market value of the assets of the object entity (disregarding any shares in companies or interests in trusts); and
• total market value of the assets of any entity (a later entity) in which the object entity had a small business participation percentage of greater than zero, multiplied by that percentage

must have related to assets that are:

• active assets; or
• cash or financial instruments that are inherently connected with a business carried on by the object entity or a later entity.

Further, if these assets are held by a later entity, being an entity that is owned by the object entity, the assets will only be active at a time if the later entity is an entity:

• that is, at the relevant time, either:
  • a CGT small business entity; or
  • satisfies that maximum net asset value test in relation to the capital gain; and
• in which the taxpayer has a small business participation percentage of at least 20 per cent or is a CGT concession stakeholder at the relevant time.

In determining if an entity is a CGT small business entity or satisfies the maximum net asset value test at a time, do not include the turnover or value of assets of entities that can control the object entity and control is an interest of 20% or more

What does this all mean??? In effect, when selling a share or a unit, the active asset test in is modified to adopt a look-through approach. Rather than treating shares or interests as active assets based on the activities of the underlying company, the modified test looks through such membership interests to include the proportionate amount of the value of the assets of other entities to which the interests relate.

And remember, it only includes a percentage of the later entity assets based on ownership. And remember, any asset of a later entity will not be an active asset if the later entity is not either a small business entity or passes the maximum net assets test AND the taxpayer has a 20% or greater ownership of.

But the best way to understand this is to look at an example or three…

Jesse carries on a small lapidary business as a sole trader. He is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Jesse owns 50 per cent of the shares in A Co. A Co carries on a business providing cleaning services and is a CGT small business entity in the 2019-20 income year.

A Co also owns 10 per cent of B1 Pty Ltd and 15 per cent of B2 Pty Ltd. Both of these companies are also CGT small business entities in the 2019-20 income year. These companies are not affiliates of A Co.

There has been no significant change in the activities or holdings of A Co, B1 Pty Ltd or B2 Pty Ltd over the period Jesse has owned his shares.

On 9 November 2019, Jesse sells his interest in A Co.

In working out if this interest satisfies the modified active asset test, when working out the total value of the assets of A Co, Jesse must disregard the value of the shares A Co holds in B1 Pty Ltd and B2 Pty Ltd and include 10 per cent of the value of the assets of B1 Pty Ltd and 15 per cent of the value of the assets of B2 Pty Ltd.

Further, for this purpose none of the assets of B1 Pty Ltd and B2 Pty Ltd are active assets for A Co. Jesse’s small business participation percentage in B1 Pty Ltd is 5 per cent (i.e. his 50 per cent stake in A Co multiplied by A Co’s 10 per cent stake in B1 Pty Ltd). Similarly, his small business participation percentage in B2 Pty Ltd is 7.5 per cent (i.e. his 50 per cent stake in A Co multiplied by A Co’s 15 per cent stake in B2 Pty Ltd).

Still think this is hard… I do!

Charlotte owns 35 per cent of the shares in Colour Co. Colour Co carries on a business of wholesaling paint and related products and is a CGT small business entity (according to the general rules) in the 2019-20 income year.

Colour Co owns 20 per cent of the shares in three pigment suppliers Red Co, Green Co and Blue Co. Red Co and Blue Co are both CGT small business entities for the 2019-20 income year (and have been since Colour Co acquired its interest) according to the general rules. Green Co is not and has never been a CGT small business entity as it exceeds the turnover threshold.

On 3 March 2020, Charlotte sells her shares in Colour Co.

In working out if this interest satisfies the modified active asset test, when working out the total value of the assets of Colour Co, Charlotte must disregard the value of the shares Colour Co holds in Red Co, Blue Co and Green Co and include 20 per cent of the value of the assets of these companies.

Further, for the purposes of the modified active asset test, assets of later entities are only active if the entity is a CGT small business entity or satisfies the maximum net asset value test.

Green Co is not a CGT small business entity as its turnover is too high.

Additionally, Charlotte must treat Red Co, Blue Co and Green Co as being connected with Colour Co and with each other for the purposes of the test, because Colour Co holds 20 per cent of the shares of each entity.

Because they are treated as being connected with Green Co, Red Co and Blue Co are also treated as not being CGT small business entities for these purposes.

As a result, Charlotte is not able to treat the assets of Red Co, Blue Co or Green Co as active assets for the purposes of this test unless the entities satisfy the maximum net asset value test.

Still confused… so am I…

Arnold carries on a small marketing business as a sole trader. He is a CGT small business entity (according to the general rules) for the 2019-20 income year.

Arnold also owns 20 per cent of Channel Investments Trust, a trust that invests in a wide range of widely held trusts and companies.

Channel Investments Trust has assets with a total net market value of $2 million, of which $1.95 million consists of shares in companies and units in trusts. Channel Investments Trust has never had a small business participation percentage exceeding 10 per cent in any other entity.

On 20 April 2020, Arnold sells his interest in Channel Investments Trust. Arnold is not eligible to access the CGT concessions under Division 152 for any resulting capital gain.
While Arnold may satisfy the basic conditions for relief for the capital gain, he does not satisfy the new conditions.

The investment in Channel Investments Trust does not satisfy the modified active asset test as 97.5 per cent of its assets are shares and interests in trusts that are considered passive assets as its small business participation percentage in the relevant entities is less than 20 per cent.

I have spent some time working with the Inland Revenue Division of the Solomon Island. Way back in 2005 the Solomon Island Government introduced subsection 20(2A) into their income tax legislation. It states:

By 1 July 2019 the Australian tax system will catch up with our neighbours (this is and unfair criticism as the Solomon Island IRD collects a lot more final withholding taxes than we do in Australia).

In Treasury Laws Amendment (Black Economy Taskforce Measures No. 2) Bill 2018 the Government is proposing a similar rule for the Australian tax system – denying an income tax deduction for certain payments if the associated withholding obligations have not been complied with.

In summary, a deduction is not allowed in relation to a payment:

• of salary, wages, commissions, bonuses or allowances to an employee;
• of directors’ fees;
• to a religious practitioner;
• under a labour hire arrangement; or
• for a supply of services — excluding supplies of goods and supplies of real property — where the payee has not quoted its ABN

if the PAYG Withholding regime applied to the payment, the payer was required to withhold an amount and the payer did not withhold an amount from the payment or did not notify the Commissioner when required to do so.

Miss your withholding… miss your deduction.

But there are a few exceptions to this rule

1. The deduction is only denied where no amount has been withheld at all or no notification is made to the Commissioner. Withholding an incorrect amount will not affect the entitlement to a deduction. Neither does reporting the wrong amount.

2. This change does not apply to an obligation to withhold a nil amount from a payment, or to report a nil amount that must be paid to the Commissioner.

3. If an employer that makes a payment to an employee they believe to be a contractor, they will not be denied a deduction if, had the employer been correct in characterising the employee as a contractor, the employer would not have been required to withhold or withheld under no ABN withholding.

Example 1.1 Incorrectly classified employee payments (from the EM)

Super Express Deliveries Pty Ltd carries on a business as a bicycle courier service. Super Express Deliveries engages around 30 bicycle couriers to enable it to fulfil orders from its customers.

Super Express Deliveries seeks legal advice about the engagement of the bicycle couriers. The advice concludes the bicycle couriers are independent contractors and are not employees. To this end, Super Express Deliveries requires each of its bicycle couriers to obtain an ABN and provide it to the company. Super Express Deliveries concludes that it did not have to withhold any amounts from the payments it made to couriers.

The Commissioner conducts an audit of Super Express Deliveries and decides that the bicycle couriers are employees of Super Express Deliveries. After considering the Commissioner’s reasons and legal authorities, Super Express Deliveries does not dispute this conclusion and agrees to begin fulfilling its withholding obligations on this basis.
The deduction available to Super Express Deliveries for its previous payments to bicycle couriers is not affected by its failure to withhold.

Super Express Deliveries is still subject to penalties for its failure to withhold.

4. A deduction that would otherwise be denied under these amendments is maintained in the original income year if the taxpayer voluntarily notifies the Commissioner, in the approved form, of their mistake before the Commissioner commences an audit or other compliance activity.

Example 1.2 Voluntary notification (from the EM)

Caleb carries on a business as a mechanic. Caleb does not have any employees until he hires an apprentice, Bianca, in May 2020.

Caleb is not aware that he must withhold an amount from Bianca’s wages.

Caleb visits his accountant in September 2020 to prepare his 2019-20 income tax return. He mentions his expenditure to pay Bianca’s wages. Caleb’s accountant advises Caleb he should have been withholding from the wage payments.

Caleb notifies the Commissioner of his mistake. Caleb may still be subject to penalties for his failure to withhold. However, he is entitled to claim the deduction for the cost of Bianca’s wages in his 2019-20 income tax return.

So, from 1 July 2019 it will be very important to get your withholding correct. If you don’t withhold and you lose your deduction (for a company employer that would be an immediate 30% penalty, plus the normal withholding penalties).

What does this mean for paying a director’s salary in June where you know they have other deductions so that there will be no tax on this amount? Vary the withholding or withhold $1 or be ready to tell the Commissioner about it if he comes looking…

For Fathers Day My boys bought me a new electric shaver… All I could think about was tax avoidance…

That is because in 1698, the cleanly shaved Emperor of Russia, in a hope to make Russia men look more European, instituted a Beard Tax. If you have a beard you have to pay a tax.

But how do you prove you have paid your tax? This was an important question as the police would forcibly and publicly shave those who had a beard and had not paid the tax.

The solutions was that when you paid your tax you were given a medallion to show the tax was paid. You had to keep it on you when in public to prove to the police you were allowed to have your beard. The medallion looked like this:

And just to prove that even a tax as simple as a Beard Tax can be made complicated by public servants… There were multiple rates of Beard Tax. Unfortunately it was not based on the bushiness of the beard, but on the person it was on…

• Imperial Court, military, or government members – 60 rubles annually
• Wealthy merchants – 100 rubles annually
• Merchants and townsfolk – 60 rubles annually
• Muscovites – 30 rubles annually; and
• Peasants – two half-kopeks (100th of a ruble) every time they entered a city.

I have been getting asked a lot of questions about travel and accomodation deductions…

They are normally about a contractor or employee who is working away from their home far enough away they can’t just come home each night. They live in Geelong but work in Melbourne, they live in Perth and work in Darwin…

The answer to all these questions is generally found in the 18 example in draft Taxation Ruling TR 2017/D6.

And yes, I know the heading says employees but it applies to employers through the otherwise deductible rule, and the Commissioner uses its reasoning when giving private rulings for contractors…

Lets have a look at one of the 18 examples. This is a reminder that once you are no longer “traveling away from home for work” but a rather “living away from home for work” the accommodation become non deductible…

In “Tax myths busted!”, Commissioner of Taxation, www.ato.gov.au, 30 June 2018 

The Commissioner has identified the top 10 tax myths and misunderstandings that are those involved in preparing individual tax returns have, including tax agents prepared and self-prepared returns. And generally, they relate to substantiation of work related deductions.

MYTH #1: Claim $150 for clothing and laundry, 5,000 kilometres at 66 cents for car related expenses, or $300 for work-related expenses

The first and main myth the Commissioner identifies is that everyone can automatically claim $150 for clothing and laundry, 5,000 kilometres at 66 cents for car related expenses, or $300 for work-related expenses, even if they didn’t spend the money.

The Commissioner states that these are just record-keeping exemptions that provide relief from the need to keep receipts in certain circumstances.

However, they are not an automatic entitlement or a “standard deduction” for everyone.

While you don’t need receipts for claims under $300 for work related expenses, $150 for laundry and 5,000 kilometres, you still must have spent the money, it must be related to earning your income, and you must be able to explain how you calculated your claim.

But let’s look at where these myths come from…

$300 standard deduction???

The rules regarding the required substantiation for work related deductions are found in Division 900 (and Division 28) of the ITAA97.

Division 900 covers substantiation requirements for work expenses (Subdivision 900-B), car expenses (Subdivision 900-C) and business travel expenses (Subdivision 900-D).

These substantiation rules only apply to individuals (section 900-5), and only applies to employees or those who have similar withholding as employees (see list in section 900-12).

Section 900-15 states that even if a “work expense” meets the conditions for a deduction (for example section 8-1), there will be no deduction unless the individual substantiates it “by getting written evidence.”

Under section 900-30, a work expense is a loss or outgoing you incur in producing your salary or wages and includes travel and meal allowance expenses, Division 40 deductions and section 25-60, 25-65 and 25-100 deductions.

The written evidence must be retained for 5 years from the due day for lodging an income tax return or when the return is lodged, whichever is later (section 900-25).

There is a “small total of expenses” exception. Subsection 900-35(1) ITAA97 states:

If the total of all the *work expenses (including *laundry expenses, but excluding *travel allowance expenses and *meal allowance expenses) that you want to deduct is $300 or less, you can deduct them without getting written evidence or keeping travel records.

To be clear, the $300 rule is just a relief of having to have written evidence of a certain type, which are explained in Myth #2 below.

One more time… While you don’t need receipts for claims under $300 for work related expenses, $150 for laundry and 5,000 kilometres, you still must have spent the money, it must be related to earning your income, and you must be able to explain how you calculated your claim.

MYTH #2: “I don’t need a receipt, I can just use my bank or credit card statement”.

The Commissioner states this is only the case if the statement meets the written evidence requirements in Division 900.

What is written evidence is covered in Subdivision 900-E. It states that written evidence can be a document from the supplier of the goods or services the expense is for. The document must set out:

• The name or business name of the supplier; and
• The amount of the expense, expressed in the currency in which it was incurred; and
• The nature of the goods or services (if the document the supplier gave you does not specify the nature of the goods or services, you may write in the missing details yourself); and
• The day the expense was incurred (if the document does not show the day the expense was incurred, you may use a bank statement or other reasonable, independent evidence that shows when it was paid); and
• The day it is made out.

In Practice Statement Law Administration PSLA 2005/7 (as updated to July 2015), the Commissioner states:

Where the above documents are insufficient, we accept the following documents (or combinations of documents) as acceptable evidence of expenses:

• bank statements
• credit card statements
• BPAY reference numbers, combined with bank statements, or
• BPAY reference numbers, combined with tax invoices.

So, if the credit card statement or bank statement does not cover this information then there is no deduction. And in many cases the credit card will not have what the good or service actually is!

I don’t feel like a pathetic tax advisor any more. You see, for the past 10 months I have not been able to answer the question “What is the company tax rate?”

I know I find the answer in the Tax Rates Act. And I know the Tax Rates Act tells me that:

• From 1 July 2015, corporate entities that were small business entities (less than $2m turnover and carrying on a business) were given the 28.5% tax rate.
• From 1 July 2016 the rate dropped to 27.5% for these small business entities (but now less than $10m turnover and carrying on a business).
• From 1 July 2017 the rate stayed at 27.5% but was now available to “base rate entities” and the turnover threshold for a base rate entity was $25 million.
• From 1 July 2018 the rate stayed at 27.5% but was now available to “base rate entities” and the turnover threshold for a base rate entity was $50 million.

This all sounds very easy, except to work out the rate for the 2015/16 year and the 2016/17 year I need to know if the company is carrying on a business. And for the 2017/18 and following years I need to know what is a “base rate entity”. And on top of this I need to not just know what the company tax rate is, but I also need to know how to work out the imputation rate for each of these years.

So, let’s work through each on these questions…

Question #1: Company Tax Rate for 2015/16 and 2016/17 – Am I carrying on a business?

Last year the Commissioner released a Draft Ruling (Draft Taxation Ruling TR 2017/D7 Income tax: when does a company carry on a business within the meaning of section 23AA of the Income Tax Rates Act 1986?). In this Draft Ruling the Commissioner states he believes that most companies will be carrying on a business. He states that a share investment company and a family company with income consisting only of an unpaid trust entitlement, which it reinvests, even if it is just under a loan agreement back to the trust.

This is much broader than any of us would have thought. So, what do we do regarding whether companies are carrying on a business and therefore might get the 28.5% or the 27.5% rate.

The Commissioner has answered this question in Practical Compliance Guideline PCG 2018/D5. In this Guideline the, Commissioner states he will not allocate compliance resources specifically to conduct reviews of whether corporate tax entities have applied the correct rate of tax or franked at the correct rate in the 2015-16 and 2016-17 income years unless he becomes aware that a corporate tax entity’s assessment of whether they were carrying on a business in the 2015-16 or 2016-17 income years was plainly unreasonable.

What does this mean? It appears that a company under the turnover threshold in the 2015/16 and 2016/17 year can use either company tax rates as long as it is not unreasonable to do so.

Lesson #1: If a company has a turnover of less than $2 million in the 2015/16 year or less than $10 million in the 2016/17 year you can almost choose which company tax rate.

Question #2: For the 2017/18 and following years, what is a base rate entity?

The Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Act 2018 amends the Rates Act to ensure that, from 1 July 2017, a corporate tax entity will not qualify for the lower corporate tax rate of 27.5% if more than 80% of its assessable income is “base rate passive income”.

Base rate entity passive income is defined as:

• A distribution or dividend by a corporate tax entity, other than a non-portfolio dividend (10% holding). Dividends derived by a holding company which are made by a wholly-owned subsidiary company will not be base rate entity passive income of the holding company;
• Franking credits attached to such a distribution;
• A non-share dividend made by a company;
• Interest or a payment in the nature of interest;
• A royalty;
• Rent;
• A gain on a qualifying security;
• A net capital gain;
• An amount that is included in the assessable income of a partner in a partnership or a beneficiary of a trust estate to the extent that the amount is referable to another amount that is base rate entity passive income. Therefore, an amount that flows through a trust to a corporate tax entity will retain its character for the purposes of determining whether or not the amount is base rate entity passive income of the corporate tax entity.

Lesson #2: If a company has a turnover of less than $25 million in the 2017/18 year or less than $50 million in the 2018/19 year, to work out what tax rate that applies you need to consider the percentage of the income of the company that is base rate passive income. Less than 80% and the company tax rate is 27.5%, more than 80% and the company tax rate is 30%.

Question #3: How does this all work for imputation?

There are three answers to this question.

Lesson #3: For the 2015/16 the imputation rate was always 30%. It did not matter whether the company tax rate for the year for a company was 28.5%, they could still frank dividends at 30%.

Easy.

Lesson #4: For the 2016/17 year the rule was that whatever your company tax rate was, was your imputation rate. If the company tax rate was 27.5% the imputation rate was 27.5%. If the company tax rate was 30% the imputation rate was 30%.

There are new rules that apply from 1 July 2017 that were in the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Act 2018.

Under these rules, as a company will not know its aggregated turnover, the amount of its base rate entity passive income, or the amount of its assessable income for an income year until after the end of that income year, it will not know its company tax rate when it pays a dividend during the year.

Therefore, to calculate the imputation rate, the company must assume that:

• Its aggregated turnover for the income year is equal to its aggregated turnover for the previous income year;
• Its base rate entity passive income for the income year is equal to its base rate entity passive income for the previous income year; and
• Its assessable income for the income year is equal to its assessable income for the previous income year.

Also, if the corporate tax entity did not exist in the previous income year, its corporate tax rate for imputation purposes for an income year will be the lower corporate tax rate of 27.5%.

Lesson #5: From 1 July 2017, to work out the imputation rate the company needs to look at last year’s turnover and the percentage of base rate passive income in the previous year. If the percentage is less than 80% and the turnover is under the threshold the dividend can be franked at 27.5%. Otherwise, it is taxed at 30%.

Given that I have criticised for my recent comments on tax agent prepared returns making inappropriate claims for work related deductions, I decided to put a paper together on the work related deduction rules to help tax agents.

I hope this paper is informative and helpful.

Work and travel deductions