By Domenic Festa (Accredited Tax Specialist and Chartered Tax Adviser)
The Tax Laws Amendment (Small Business Restructure Roll-over) Act 2016 implements the Small Business Restructure Rollover announced in the 2015-16 Budget. It is operative for restructures that occur on or after 1 July 2016
The concept behind the rollover will be welcomed, 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 Bill proposes that a transfer of an asset has no direct consequences under the income tax law.
The key conditions are:
- A transaction that is, or is a part of, a genuine restructure of an ongoing business (see further below).
- Both the transferor and transferee is a small business entity (that is, an entity that carries on business with aggregated turnover (which includes affiliates and connected entities) of less than $2 million), or an entity that is an affiliate, connected with or a partner in a small business entity.
- The transferor and each transferee choose to apply the roll‑over.
- Subject to what is stated below, the transaction does not change the individual with ultimate economic ownership or the individual’s share.
- The asset is an active asset at the time the transfer takes effect.
- Each party to the transaction is an Australian resident.
- The transferee is not an exempt entity or a complying superannuation fund.
A key condition is the requirement for a genuine restructure (not defined). A safe harbour provides that a transaction will be considered a genuine restructure where, for the period of three years following the transaction, in respect of significant assets, there is no change in ultimate economic ownership (other than trading stock), they continue to be active assets and there is no material use for private purposes. The term significant assets is not defined. The conditions of this safe harbour may cause a gloss to be placed on the ordinary meaning of genuine restructure and limit the usefulness of the rollover. For example, use of the rollover to restructure an entity to allow the admission of minority equity participants (such as key employees) would not satisfy the conditions of the safe harbour.
The safe harbour is not the only basis upon which a transaction will be considered a genuine restructure. A restructure that falls within the ordinary meaning of genuine restructure will be eligible for the rollover. The EM to the Bill states ‘The genuine restructure principle distinguishes genuine restructures from artificial or inappropriately tax-driven schemes.’ It then lists a number of factors that indicate a genuine restructure (para 1.20).
The concept of ultimate economic ownership is also not defined. The EM refers to ultimate economic owners as individuals who, directly or indirectly, beneficially own an asset.
In the absence of special provisions, beneficiaries of a discretionary trust would not satisfy the requirement of economic ownership. 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. To satisfy this condition, it is not necessary (in our view) to limit the beneficiaries of the trust to include only those individuals that have ultimate economic ownership before or after the restructure.
Where the conditions for the rollover are satisfied, the transfer of an asset is stated to have no direct consequences under the income tax law. A note to the legislation also states that the transfer of the asset is not treated as a payment of a dividend under Division 7A (one of the issues under the Exposure Draft).
Other consequences provided in the Bill include:
- The cost of the asset in the hands of the transferee is its cost base under the relevant taxation regime (CGT, trading stock, depreciating assets or revenue asset).
- Pre-CGT assets are taken to have been acquired by the transferee prior to 20 September 1985.
- Special provision for cost base of membership interests issued as part of the restructure and the cost base of membership interests held in the transferee.
- Transition of prior use of the small business rollover in Subdivision 152-E to the transferee.
- The ownership period of the asset for the 15 year exemption is not restarted (although the ownership period is restarted for the CGT discount).
The Exposure Draft had required a taxpayer to satisfy both the $2 million turnover test and the $6 million net asset value test. The latter requirement has been removed.
Other elements that have been removed from the Exposure Draft are that the transaction be implemented for no consideration (which raised several issues) and that the restructure change the type of entity or number of entities which operate the business. The EM contemplates no consideration, market value consideration or any other amount.
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.
A characteristic of all existing rollovers is they are rigid in their application and restructures result in ownership in a company or the same type of entity (e.g. unit trust). The Small Business Restructure Rollover is notable in that it allows significant flexibility.
For example, the proposed rollover allows a restructure 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.
- The rollover is concerned with income tax. The proposal itself does not provide any relief from stamp duty or other Commonwealth taxes (e.g GST and FBT). Stamp duty and other taxation consequences will need to be considered in assessing the value of utilising the rollover.
At least for clients located in Queensland, a stamp duty exception could be used in conjunction with a trust restructure. The Small Business Restructure Rollover will allow tax-free restructures of business assets in trusts that satisfy the turnover requirements, without having to grapple with 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.
Limitations
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 for equity ownership may have been considered prudent. The proposed rollover does not accommodate changes in equity. In such a case, a transfer to another suitably structured company/entity is permitted, but stamp duty consequences may significantly differ and there may be commercial advantages of utilising the same entity (ABN history, etc).
Examples of small business structures that may need restructuring 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 active assets (s328 – 430 (1) (d)). The rollover could not be used to separate non-business assets.
Separation of assets: it might be desirable to separate one or more valuable assets into a separate entity. Separation of non-business assets could be achieved indirectly by transferring business assets to a separate entity. However, the non-business assets would continue to be exposed to potential claims of the business in respect of transactions that occurred prior to the restructure.
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 is not be eligible for the CGT discount and restrictions on utilising the small business CGT concessions (significant individual requirements, active asset reduction potentially taxable as a dividend on distribution).
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, there are some limitations that need to be taken into account.