New Tax Rules for Small Businesses Seeking to Restructure

By Alexis Kokkinos - February 15, 2016

The Government has introduced legislation into Parliament containing new tax provisions to make it easier for small business owners to restructure by allowing them to disregard tax gains or losses which would otherwise be realised where business assets are transferred from one entity to another.

A.    Release of legislation for Small Business Entity restructure roll-over

The Government has introduced Tax Laws Amendment (Small Business Restructure Roll-Over) Bill 2016 (“the Bill”) into the Parliament.  If passed, this legislation will enable Australian resident Small Business Entities (“SBEs”) to restructure the way their business and associated assets are owned, without crystallising an income gain or loss. Businesses will qualify for the roll-over if they meet the existing SBE requirements in the Income Tax Assessment Act (“ITAA”).

The legislation will enable SBEs to disregard any tax gain or loss made on the transfer of their business or assets into the new structures. This will allow SBEs who established their business operations in the wrong structure to transfer into a more appropriate structure without having to pay income tax.

This bulletin provides a summary of who can access the new legislation, how it will work and the start date.

B.    Are the new provisions useful?

While the legislation has taken some time to be implemented, Pitcher Partners has been involved in significant consultation with Treasury and the Board of Taxation to help ensure that the provisions achieve their intended outcome. That is, to allow SBEs an opportunity to restructure without tax consequence.  On this, the provisions are one of the first that allow income tax gains (and not just capital gains) to be rolled over under a restructure. 

While the provisions have become more complicated in the process, we believe that the final product provides an excellent means to facilitate small business restructuring.  

Integrity rules have also been introduced during the process to ensure that the restructure provisions are not exploited and that they only apply in a genuine restructure. While this may increase the complexity of the provisions, the Government has listened to submissions and provided safe harbours and other mechanisms to appropriately manage those integrity provisions.  

While taxpayers will need to seek advice on applying the new provisions, we believe that the provisions go a long way in achieving their intended objective by allowing SBEs significant flexibility on the restructure of their assets.

C.    When will the new provisions apply?

Once the legislation is passed, the amendments are aimed at applying to all taxable gains that occur under a restructure where the gain arises on or after 1 July 2016.  Accordingly, the provisions will apply to the transfer of depreciating assets, trading stock, revenue assets and CGT assets.  

D.    How do the new provisions work?

SBE taxpayers will be provided an optional roll-over where they transfer an active asset of their business to another small business entity as part of a “genuine business restructure”, where the ultimate economic ownership (“UEO”) of the asset (directly or indirectly) does not change.

Where an individual operates as a sole trader, they hold the UEO. Where the entity is a company, the provisions will look at the ultimate shareholders to determine the UEO. The provisions specifically provide for the inclusion of discretionary trusts as an eligible entity type by utilising the existing Family Trust Election (“FTE”) rules as a test of the UEO. 

By way of example, where an individual transfers their business to a newly established discretionary trust, the UEO will be deemed not to have changed where the trust has made a FTE and the individual is part of the same family group.

The provisions provide that there are no direct tax consequences that occur in respect of an asset that is transferred under the roll-over provision.  However, the acquirer of the asset is effectively taken to acquire the asset for its roll-over cost (irrespective of the amount paid for the asset).  The roll-over cost is an amount that (if received) would not give rise to a profit/gain or loss.  For example if the cost base of an asset is $100 and the market value of the asset is $200, the roll-over cost is equal to $100.

Where membership interests are provided as consideration for the transfer of assets, the first element of the cost base of the new membership interests will be the sum of the roll-over cost of assets transferred that are not pre-CGT or depreciating assets plus the adjustable values of the transferred depreciating assets less any liabilities the new entity has undertaken to discharge associated with those assets.

E.    Can consideration be paid for the transfer of assets?

It is at the discretion of the small business owner whether consideration is to be provided in respect of the restructure. The transfer of assets as a part of a “genuine restructure” can be done for no consideration.

Conversely, as stated in the Explanatory Memorandum (“EM”), the transferor and transferee may agree to transfer the assets at cost in order to eliminate any future unrealised gains on membership interests in the transferor entity. 

The roll-over provisions do not deal with transferring liabilities to the transferee (acquirer).  Liabilities could be transferred under a separate transaction (not subject to the roll-over).   However, one would need to consider the consequences that may occur (e.g. foreign exchange gains, debt forgiveness provisions, etc.).

An integrity rule (loss denial rule) has been included to ensure that a capital loss on membership interests cannot be realised as a direct result of the restructure. This is to ensure that capital losses cannot be artificially manufactured through the restructure transaction or subsequent to it.  An example of this would be if assets are transferred out of a company and a loss is subsequently made on the shares in the company.

It will however be important to consider all factors associated with the transfer of assets and liabilities such as legal, commercial and fiduciary obligations placed on corporations or trustees of trusts before undertaking a restructure.
Where the restructure is part of a contrived arrangement to create losses or remove profits from an entity, it will be possible for Part IVA to apply in order to deny access as a “genuine restructure”.

F.    What taxes are ignored under the roll-over?

Whilst tax consequences that would otherwise result from the transaction are disregarded, the exclusion does not cover GST or Stamp Duty. It will therefore be important to consider any potential application of these to a restructure.

G.    Who will qualify for the new provisions?

To be eligible for the roll-over, each party to the transfer must be either:

  • a SBE;
  • an entity that has an “affiliate” that is a SBE;
  • “connected” with an entity that is a SBE; or 
  • a partner in a partnership that is a SBE.

An SBE is an entity that carries on a business and has aggregated turnover for the current year which is likely to be less than $2 million or its turnover for the previous year was less than $2 million.

Unlike the existing small business CGT concessions, the maximum net asset value (“MNAV”) test is not a requirement for access to the restructure roll-over provisions. One of the continuing difficulties with the small business CGT concessions is determining asset values for the purpose of the MNAV test.  The assets of the small business being transferred must be active assets used by and in connection with the small business. Other assets such as related-party loans and passive investments such as listed shares are not included as eligible assets for the restructure roll-over.

H.    How do the provisions interact with Division 7A?

Division 7A can treat payments by a company (of cash or property) as a deemed dividend to a shareholder or associate.  However, where the transfer of an asset by a company under the roll-over would otherwise be treated as a payment (and thus a deemed dividend) for Division 7A purposes, its application is disregarded under the provisions.

In our view there is  uncertainty as to the application of Division 7A where consideration is provided for the transfer of an asset and an obligation to pay remains outstanding at the lodgment date of the transferor’s income tax return.

On the current wording of the Bill it is open to conclude that an indirect consequence under the income tax law may arise on the transfer of the asset in this situation (being the application of Division 7A) which could mean that Division 7A may still apply as a result of the transfer despite the policy intent of the Bill to ensure that no income tax consequences result from a transfer under the provisions. For example, if a loan is created indirectly from the transfer of assets by a company, it is unclear at the moment whether the loan would be subject to Division 7A. On the reading of the legislation, we believe that there is a risk that this is the case.

Finally, if a company is transferring its assets and one of those assets is a Division 7A loan, the Division 7A loan would not be subject to the roll-over provisions. This is because the Division 7A loan is likely to be treated as a passive asset and thus will not qualify for roll-over as the provisions require assets to pass the “active asset” test. 

I.    Are there any new (special) rules included in the provisions?

There are a number of new provisions that have been included in the legislation. Some of these rules will give SBEs flexibility to transfer into a more suitable structure for the operation of their business. However, there are also a number of integrity provisions that have been introduced.

i.    Genuine restructures

As the roll-over provisions are quite concessionary, it is possible that the provisions could be exploited for purposes other than business restructures.  Accordingly, the Government has introduced an integrity rule.

The transfer of the business and/or associated assets needs to be part of a “genuine restructure” of an ongoing business in order for the roll-over to apply. The provisions are intended to apply only where the entity type or number of entities changes and not where the UEO changes (as distinguished from inappropriately tax driven schemes).

Unfortunately, this aspect of the provisions will result in uncertainty in when a roll-over will apply (subject to the safe harbour rule discussed below).  It will be a question of fact as to whether a restructure is “genuine”, which is to be determined having regard to all the facts and circumstances around the restructure.  While the legislation does not provide any detail on this test, the EM provides the following factors that would indicate a “genuine” restructure.

  1. It is a bona fide commercial arrangement undertaken to enhance business efficiency.
  2. The business continues to operate after the transfer, through a different entity structure but under the same UEO.
  3. The transferred assets continued to be used in the business.
  4. The restructure results in a structure likely to have been adopted had the business owners obtained appropriate professional advice when setting up the business.
  5. The restructure is not artificially or unduly tax driven.
  6. The restructure does not result in a divestment or a preliminary step to facilitate the economic realisation of assets.

ii.    Safe harbour test

To overcome some of the uncertainty in applying the “genuine restructure” test, the legislation includes a “safe harbour” rule.  Under the safe harbour, a transaction will be taken to be part of a genuine restructure if, in the 3 year period after the transaction takes effect: (a) there is no change to the UEO of the significant assets of the business; (b) those significant assets continue to be active assets; and (c) there is no significant or material use of those assets for private purposes.

We believe that the inclusion of this safe harbour provides an excellent simple and effect means to help overcome the uncertainty that would otherwise arise in applying a test that is otherwise highly fact specific. 

iii.    Effect on acquisition dates of assets

With the exception of pre-CGT assets which will retain their pre-CGT status following a restructure, assets transferred as a part of the restructure will have a refreshed acquisition date being the date of the restructure. Even ignoring the 3 year safe harbour rule, this means that a the availability of the general 50% CGT discount will be pushed back at least 12 months from the date of the restructure.

iv.    Interaction with existing small business CGT concessions

For small businesses that have already chosen to apply the small business CGT roll-over in relation to a CGT asset, those provisions will apply to the transferee in a restructure roll-over as if they had made the choice, and not the transferor.

Amendments will also be made to existing provisions to ensure assets acquired by the transferee under a “genuine restructure” will carry the transferor’s acquisition date for the purpose of the 15 year and significant individual rules when applying the small business CGT concessions.

v.    Some entity types are excluded

Whilst the provisions will allow for restructure transfers to and from discretionary trusts, exempt entities and complying superannuation funds are excluded. This means that assets such as land and buildings cannot be transferred into a self-managed superannuation fund even though there may be no change in UEO.  Furthermore, the provisions will only apply to Australian resident entities.

Please contact Pitcher Partners for further information as to how this new roll-over will provide opportunities for small businesses to restructure into more appropriate legal structures in order to develop, grow and maximise business efficiency.

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