The small business concessions can be very generous by reducing or even eliminating the tax on a capital gain made from selling a business (or shares in a company), or an asset used in the business. For example, in combination with the general 50% discount on capital gains, these concessions can reduce tax on a capital gain to nil.

Behind the small business concessions lurks a web of complex rules that must be carefully navigated before being eligible for the nil tax result. 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 (goodwill, land, shares) which has yielded the capital gain must have been used in carrying on a business over certain periods of time

In the first case, a person carried on a business of building, bricklaying and paving. He also owned a block of land on which rested a couple of sheds used to store tools, equipment and materials. He also parked work vehicles and trailers on the land, and occasionally some limited preparatory work was done on the land. The issue was whether the land was an “active asset” 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 seems rather harsh – the taxpayer may appeal to the Full Federal Court.

ATO win #2: Shares 

Another condition that must be satisfied in order to be eligible for 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 be equal to or less than $6 million just before the sale. Certain assets usually aren’t counted, such as the family home and superannuation member accounts.

When an asset is sold to an unrelated arm’s length party, the sale price is usually the asset’s market value. However, market value in certain circumstances may be a different amount.

In the second 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 transaction. At $5.9 million, plus other assets, the shareholder in this case had assets exceeding 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. Because the buyer bought the whole company, a premium arguably was paid because the buyer obtained control of the company. But because the seller had only a minority shareholding, he argued that the market value of his ⅓ stake was worth less than $5.9 million on the basis that the share price should not include any premium for control of the company. His lower market value figure would result his net assets being less than 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 obtaining 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 with tax payable on the capital gain.

ATO win #3: Same shares, different tack 

Same person in #2 above, having another argument over 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. This is common in many business sales. In this case, the seller is giving two items of property to the buyer: 1) the shares, and 2) a right (not to compete). The vendor shareholder argued that the $5.9 million sale price should be apportioned 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 only comes into existence upon executing the contract – the right does not exist just before. Therefore, the portion of the sale price allocated to restrictive covenant does not 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 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 sale. 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 such an apportionment would not have mattered.  The shareholder still has a right of appeal to the Federal Court.

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