By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)

On 5 November 2015, Treasury released an exposure draft of a proposed Small Business Restructure Rollover.

The concept behind the rollover will be welcomed, as announced in the 2015-16 Budget, to allow small businesses to change legal structure without attracting income tax liability.  The EM notes that the relief has been extended to trading stock, revenue assets and depreciating assets.

Conditions

Where the stated conditions for the rollover are satisfied, the draft proposes that the income tax law will apply as if the transfer had taken place for the asset’s rollover cost.

The key conditions are:

  1. Both the transferor and transferee is a small business entity that satisfies the maximum net asset value test, or an entity that is an affiliate or connected with such a small business entity;
  2. The asset is an asset of a business carried on by the small business entity;
  3. The transfer can involve one asset or all of the assets of the business;
  4. The restructure has the effect of changing the type of any or all of the entities and/or the number of entities that operate the business;
  5. No consideration is provided in relation to the transfer;
  6. All parties to the transaction as well as each individual that has ultimate economic ownership of the asset is an Australian resident;
  7. The transferee is not an exempt entity or a complying superannuation fund;
  8. Subject to what is stated below, the transaction does not change the individual with ultimate economic ownership or the individual’s share.

The concept of ultimate economic ownership is not defined.  The draft EM refers to ultimate economic owners as individuals who, directly or indirectly, beneficially own an asset.

There is a special rule to allow discretionary trusts to satisfy the ultimate economic ownership requirement.  The effect of the special rule is that there is no change in the ultimate economic ownership, or an individual’s share, if a trust that is a transferor and/or transferee elects to be a family trust under the trust loss provisions and every individual who had ultimate economic ownership before or after the transaction is a member of the family group of the relevant trust.

Opportunities

The budget announcement noted that current CGT rollover relief is limited to individuals (and trustees) who incorporate, but all other entity type changes have the potential to trigger a CGT liability.

One of the effects of the rollover must be to change the type of an entity or the number of entities that operate the business.  This would allow a restructure, for example, from a sole trader to a discretionary trust, from a company to a sole trader, unit trust or partnership, or from a partnership to a unit trust without triggering assessable amounts for CGT assets, trading stock, depreciable assets or revenue assets.

  • Commonwealth legislation can only deal with Commonwealth taxes.  The proposal itself does not provide any relief from stamp duty.  The stamp duty consequences will need to be taken into account in assessing the value of utilising the rollover.

Until 1 November 2008, trust restructures could be implemented without triggering a CGT liability.  At least for clients located in Queensland, there was also a stamp duty exception that could be used in conjunction with the trust restructure.  The Small Business Restructure Rollover will allow tax-free restructures of business assets in trusts that satisfy the turnover/net asset requirements, without having to grapple with any issues in the small business concessions such as the retirement exemption requirements.

The proposal provides significant flexibility in satisfying the ultimate economic ownership requirement where discretionary trusts are involved.  This will provide a number of opportunities to accommodate estate planning.

Drawbacks

The budget announcement was stated to apply to small businesses with aggregated annual turnover of less than $2 million.  Other small business concessions apply where the entity satisfies either a $2 million turnover test or a net asset value test (only one test need be satisfied).  The proposed draft requires that the entity satisfy both the turnover test and the net asset value test – a greater restriction.

Consideration:

  • Condition 4 requires that no consideration is provided in relation to the transfer.  This raises a number of issues including the application of Division 7A, deductibility of interest and meeting the requirements of liability commitments.  These issues may be overcome through the assumption of liabilities.
  • Consideration is not a term that is defined.  It has been held in various contexts to include the assumption of liabilities or anything which moves the conveyance or transfer (e.g. Commr of State Revenue (NSW) v Dick Smith Electronics Pty Ltd [2005] HCA 3).  The alleged purpose of requiring no consideration is that it alleviates the need for complex cost base and integrity rules for new membership interests.
  • Businesses will always have creditors and liabilities related to their assets.  Not allowing the new structure to assume obligations to creditors and liabilities complicates the restructure (requiring debtors and other assets to be retained to meet these obligations).
  • In other rollovers, the assumption of liabilities is permitted.  There seems no basis to exclude the potential for an assumption of liabilities.

Division 7A: Division 7A applies to tax certain transactions, including payments, as a dividend.  Payments include the transfer of property for consideration that is less than market value. Some may assume that because the condition requires no consideration, the full value of the asset transferred may be taxed as a dividend.  This is not the case. The rollover provides that the income tax law is to apply as if the transfer took place at rollover cost (even though it is in fact no consideration).  The effect is Division 7A will apply to tax the unrealised gain as a dividend (assuming the company has a distributable surplus, which would usually be expected where it has an unrealised gain).  The policy of Division 7A and the rollover could be accommodated by excluding unrealised gains from the calculation of payment.

The budget announcement stated that the measure recognises that new small businesses might choose an initial legal structure that they later find does not suit them when the business is more established.  The EM (para 1.6) on the other hand refers to restructuring to help a business to continue to develop and grow, to avoid unnecessary compliance costs from complex structures or to adapt to current conditions.  I suggest a structure may not suit simply because the taxpayer did not obtain advice or received inappropriate advice.

Examples of small business structures that may no longer be suitable include: a business owner may wish to separate one or more valuable assets from the business operating entity, a discretionary trust may prefer a unit trust or company to introduce equity participants, a company owned by one or more individuals may prefer a company owned by a discretionary trust, a company may prefer a unit trust or discretionary trust structure, a small business structure may own non-business assets which is no longer desirable.

Assets covered: The rollover is restricted to assets of a business (s328 – 440 (1) (a)).  The rollover could not be used to exclude non-business assets.  It might be suggested that the assets of the business could be transferred to a separate entity using this rollover and indirectly achieve the same result. Such a transfer to the same kind of entity will not satisfy the effect requirements.

Separation of assets: it might be desirable to separate one or more valuable assets used in relation to the business into a separate entity.  Whilst the condition in point 1 above allows the transfer of a single asset, it is difficult to see how that would change the entities through which the business is operated.

Liquidation of companies: On the liquidation of a company, the distributions to shareholders are taxed as a dividend to the extent the dividend is attributable to income (with an extended meaning of that term) and the remainder is taxed under the CGT provisions.  The requirement for there to be no consideration may in certain instances result in the company deriving a greater amount of income for accounting purposes which would then cause a greater amount of the liquidator’s distribution to be attributable to income.

Transfers to companies: Caution must always be exercised when considering a restructure from a structure involving individuals and trusts to a company.  Individuals and trusts enjoy more generous CGT concessions than companies.  The effect of restructuring an appreciating asset from an individual/trust structure to a company is to convert the capital gain into a company gain that will not be eligible for the CGT discount and subject to restrictions in respect of the active asset reduction (potentially taxable as a dividend on distribution).

Equity changes: A structure may not be considered suitable merely because the equity interests are not suitably structured.  For example, a company may be established with mum and dad as shareholders in circumstances where with proper advice another structure may have been considered prudent.  The proposed rollover does not accommodate changes in equity.  Whilst it might be considered that the assets could be restructured into a suitably structured entity, it cannot be the same type of entity (for example a company owned by a holding company or one or more trusts) because that will not satisfy Condition 4 (effect of rollover requirements).

Conclusion

The proposed restructure is generous in certain terms, including the classes of assets covered and the flexibility associated with the context of ultimate economic ownership.

The rollover provides a significant opportunity for small businesses to restructure into a different form of entity with minimal tax impact.

However, as currently drafted there are a number of drawbacks for which taxpayers will require considered advice and direction for effective implementation.