It is very common for a small business to restructure to facilitate growth or adapt to commercial needs. By ‘restructure’ we refer to the process of changing the legal structure used to operate a business. Legal structures include the following:
- Sole Trader
The small business restructure rollover (SBRR) was introduced to prevent income tax consequences from being a disincentive for small businesses considering a restructure. Without the availability of some form of taxation relief, a restructure which involves the transfer of assets from one entity to another would typically trigger various taxation points.
This includes the happening of a CGT event in respect of CGT assets, assessable income on the transfer of revenue assets, a balancing adjustment event in respect of the transfer of depreciable assets, and the derivation of assessable income for the value of trading stock transferred. The SBRR is distinct from other concessional rollovers in that it permits the small business entity to restructure without being strictly required to move into a company structure.
Eligibility for the SBRR requires satisfaction of a number of conditions including the following:
- Transferor and Transferee are eligible entities.
- Transferor and Transferee are tax resident entities.
- Transferred assets constitute active assets.
- There is a genuine restructure of an ongoing business.
- There is no material change to ultimate economic ownership upon restructure.
- The rollover is elected to apply.
Element 1: Transferor and Transferee are eligible entities
A small business entity is an entity which carries on a business and has an aggregated turnover of less than $10 million.
- ‘Aggregated turnover’ is annual turnover of the entity, plus annual turnover of connected entities and affiliates (with certain exclusions such as turnover amounts that would otherwise be double-counted).
- ‘turnover’ is ordinary income and does not include statutory income e.g. capital gains. It is preferrable to compare turnover to gross income rather than to profit.
- ‘Annual turnover’ may be satisfied by reference to previous income year turnover, projected current year turnover or actual current year turnover. Note that the second option is not available where the business has exceeded the turnover threshold for at least the two previous income years. Note also that special rules apply to calculating turnover for a business which is carried on for only part of an income year.
Element 2: Transferor and Transferee are tax resident entities
The transferor and transferee must each be an Australian resident for tax purposes.
Element 3: Transferred assets constitute active assets
The SBRR technically applies on an asset-by-asset basis and is only available in respect of transferred assets that are ‘active asset’. An active asset is an asset that is owned and is used, or held ready for use, in the course of carrying on a business that is carried on by the taxpayer, an affiliate or another entity that is connected with the taxpayer. ‘Active assets’ can also include intangible assets inherently connected with the business and potentially shareholdings and trust interests, provided certain tests are satisfied. That asset must be in an active state for a minimum of either
(i) 7.5 years, or
(ii) half of the ownership period of the asset.
For example, a shop space is purchased by Tom in 2010 and is leased out until 2013. It is then used as the premises for his sole trader business from 2013 – 2023. In this instance, the shop space was owned for 13 years, but was actively used in a business for 10 years, being greater than both (i) 7.5 years and (ii) half of the ownership period of the asset.
If acquired in 1990, the shop space would continue to be an active asset as it was used in the course of carrying a business for greater than 7.5 years. Any assets which are not ‘active assets’ will not be eligible for rollover relief under the SBRR. This would typically include loans and potentially shareholdings and trust interests.
Element 4: There is a genuine restructure of an ongoing business
The term ‘genuine restructure of an ongoing business’ is without further definition in the tax legislation. However, the meaning of the term is contemplated in the Explanatory Memorandum related to the Tax Laws Amendment (Small Business Restructure Roll-over) Bill 2016 and in the ATO published ruling LCR 2016/3.
In the ruling, the ATO highlights that a ‘genuine restructure of an ongoing business’ is clearly a concept designed to be considered on a case-by-case basis after assessment of all relevant circumstances. However, broadly speaking the ATO position is that a ‘genuine restructure of an ongoing business’ is one that could be ‘reasonably expected to deliver benefits to small business owners in respect of their efficient conduct of the business’.
The factors that might support a conclusion of genuine restructure of an ongoing business include the following:
- That there is a good faith commercial arrangement undertaken in a real and honest sense to facilitate growth, innovation and diversification; adapt to changed conditions; reduce administrative burdens or cash flow difficulties.
- It is a genuine restructure of the way the business is conducted, as distinct from a divestment opportunity.
- The economic ownership of restructured assets is maintained.
- The owners continue to operate the same business, merely through a different structure. This is evidenced by demonstrating continued use of transferred assets as active assets of the business, continued employment of key personnel, and continuity in patterns of production, supplies, sales or services.
- The legal entity is the one that would have been adopted initially by the business had competent professional advice been obtained at the commencement of the business.
- Lower tax can be a valid reason for restructure. For example, the ruling indicates that it is acceptable for a sole trader on the highest marginal rate to convert into a company structure for the purposes of reducing tax on business profits. However, arrangements which are contrived to access the tax benefits of the SBRR will not be considered genuine.
Examples could include restructuring in order to:
- create artificial losses
- establish a permanent non-recognition of a gain or the creation of artificial timing advantages
- achieve tax outcomes that do not reflect the reality of the taxpayer’s economic situation
The ruling also makes it clear that restructures for succession planning or intergenerational wealth transfer purpose will not be a valid cause for restructure.
The ruling sets-out a number of useful examples regarding when the SBRR will and will not be available. The substance of these examples is set out below.
Eligible for SBRR
- Example 1: Restructure for asset protection.
- Example 2: Maintaining essential employees by issuing these employees with equity in the business shortly after a restructure.
- Example 3: Restructure to attract capital investors.
- Example 4: Restructure to reduce the administrative burden of being in a company structure.
Not Eligible for SBRR
- Example 5: Restructure as a preliminary step to disposal of a business.
- Example 6: Restructure for the purposes of intergenerational transfer of the business.
- Example 7: Restructure as a tax-effective tool to extract wealth from the business.
Example 8 – 13
If you are concerned whether a restructure will qualify as a ‘genuine restructure of an ongoing business’, there is a safe harbour rule that automatically deems the restructure to be genuine where the following conditions are satisfied within three years from when the transaction takes effect:
- There is no change in ultimate economic ownership of the significant assets of the business transferred.
- Significant assets continue to be active assets.
- There is limited private use of those significant assets.
However, be aware that the ATO will have an issue with contrived arrangements that are designed to enable the taxpayer to satisfy the safe harbour rule. If it is determined that the arrangement was entered into for a sole or dominant purpose of tax elimination, reduction or deferral, the ATO has power to cancel the tax benefit received. There is no time limitation imposed on the ATO to make such a determination.
Element 5: There is no material change to ultimate economic ownership of business assets upon restructure
Essentially, the underlying persons who own the business assets must continue to do so in approximately the same proportions in the new entity upon restructure. For example, take Tom who runs a business as a sole trader and is considering restructuring into a company. Tom must be issued 100% of the shares in the company as part of the restructure.
In this way, he continues (indirectly through his shareholding in the company) to be ultimate economic owner of any business assets transferred. If Tom issued shares to his sister Magnolia as part of the restructure, there would be a material change to ultimate economic ownership of the relevant transferred assets and the SBRR would not be available.
There are difficulties in determining economic ownership in respect of discretionary trusts. This is because beneficiaries do not generally have fixed entitlements to assets held within the trust. Unfortunately, the economic ownership requirement regularly creates problems for discretionary trusts looking to access the SBRR for a restructure into or out of a discretionary trust.
The tax law does provide a form of concession dealing with this issue in instances where a family trust election is made. The transfer of assets to or from the family trust will not change ultimate economic ownership where either the persons who had economic ownership of the assets and transferred these into the family trust OR the persons who are transferred assets from the trust as part of a restructure away from a trust are members of the family group.
The decision to implement a family trust election can have serious and permanent ramifications for the operation of the trust. You should seek professional advice before implementing an election.
Element 6: The rollover is elected to apply
The decision to apply the SBRR is simply a matter of completing the relevant tax return/s in a manner consistent with the SBRR applying.
Consequences of the rollover applying
The consequences of the rollover are:
- There are no “direct consequences under the income tax law”. Effectively, the income tax law (which includes the CGT law) is switched off. However, the legislation does say “to avoid doubt” that the switching off of the income tax law does not apply to anything that happens in relation to the asset that does not directly relate to the transfer or in respect of the ownership of the asset at any time.
- The tax law applies in relation to the asset as if the transfer takes place for the “asset’s rollover cost”. This concept is explained below.
- Pre-CGT assets retain their pre-CGT status. This does not apply to pre-CGT revenue assets.
- There is a provision that sets the cost base of membership interests that are issued in consideration of the transfer of assets under the rollover. For example, shares may be issued by a company in consideration for the transfer to it of the goodwill of a business. The first element of the new membership interest is the sum of the rollover costs (see below) of the transferred assets that are neither depreciating assets nor pre-CGT assets less any liabilities of the transferor that the transferee undertakes to discharge in respect of the transferred assets.
- It may be that a capital loss would arise in relation to membership interests after the transaction takes effect. For example, an asset may be transferred from a transferor unit trust that devalues the units in the trust. If the units in the trust were then disposed of, a capital loss may result from the disposal of the units due to the loss of the asset in the trust. Where this occurs, to the extent caused by the rollover, the capital loss is disregarded. This applies to relevant capital losses that arise for both transferor and transferee entities.
- It may be that small business rollover under the small business CGT provisions has previously been chosen for an asset. The asset is the replacement asset as required by that rollover (Subdivision 152-E). This asset is then transferred under the small business restructure rollover. The issue is that CGT events J2, J5 and J6 require the transferor of the asset, in relation to the small business rollover under Subdivision 152-E, to have made choices so that those CGT events do not apply. When the asset is transferred under the small business restructure rollover to the transferee, the ability to make those choices is taken away. Due to this, the legislation overcomes the problem by deeming the transferee to be the entity (the transferor) that chose to use the small business rollover. This means that CGT events J2, J5 and J6 will not operate and there will not be a capital gain.
Tricks and Tips
- For the purposes of satisfying the 12-month ownership period requirement under the general CGT discount, the transferee entity is deemed to have acquired the asset from the date of transfer. Therefore, the transferee (if not a company – companies are not eligible for the CGT discount) should consider holding onto transferred CGT asset for at least 12-months after transfer.
- There are limits on the way a business can be restructured. For example, a sole trader moving into company structure may ideally seek to insert a discretionary trust as shareholder of the company for asset protection purposes. However, the ‘economic ownership’ test would likely be failed in this instance meaning no roll-over relief under the SBRR despite the restructure being undertaken for an authentic commercial purpose.
- The SBRR only applies a rollover in respect of income tax events. The SBRR will not provide a rollover in respect the application of goods and services tax or any state-imposed taxes such as transfer duty. There may be separate rollover relief available in respect of these alternative taxes. However, specific advice should be sought regarding eligibility.
- The benefit of the SBRR is that assets can be transferred to multiple entities or from multiple entities into a single entity. Of course, satisfaction of the economic ownership requirement would need to be considered.
- A restructure will not be genuine if it appears to be motivated by a succession planning or intergenerational wealth transfer purpose.
- Keep records that support your reasons for the decision to restructure. This may be used as evidence to support your eligibility for the SBRR.
- It is common for taxpayers to apply for private binding rulings to obtain certainty on eligibility for the SBRR.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.