Understanding capital gains tax: Terry Hayes

The biggest 'sleeper' issue in Australian taxation is capital gains tax. Capital gains tax (CGT) has been around for over 25 years now but it continues to bedevil SMEs (and others).

As time goes on, more and more assets will fall into the CGT net. We may not have a death duty in the strict sense, but wealth and asset transfers by an ageing population will cause CGT to become an issue for many.

Among other things, the tax law provides a range of concessions to reduce, eliminate or roll over a capital gain made on a CGT asset that has been used in a small business. These concessions are as follows:

• The 15-year exemption – an individual small business taxpayer is entitled to a full exemption from CGT, for example, the sale of an asset that is subject to CGT, where the asset has been continuously held for 15 years, the taxpayer is at least 55-years-old, and the sale of the asset occurs in connection with the retirement of the taxpayer. The 15-year exemption has priority over the other small business CGT concessions.
• 50% concession – a capital gain on an “active asset” (ie. an asset used in carrying on the business) used in the business can be reduced by 50% if certain conditions are met.
• Retirement exemption – basically, a taxpayer can elect to disregard a capital gain on the sale of a business asset up to a lifetime limit of $500,000. If the taxpayer is under 55 at the time of choosing to apply this concession, the amount of the gain must be rolled over to a complying super fund or retirement savings account within the specified time limits. If the taxpayer was 55-years or over, the gain can be taken tax-free. This exemption cannot be used if the 15-year exemption applies.
• Rollover for replacement assets – in essence, where assets are sold and replaced by new assets, any capital gain on the sale of the old assets can be ignored up to the value of the replacement asset.

As usual, and as expected, there are numerous hoops (i.e., basic conditions) that need to be jumped through before access can be gained to these concessions.

There are two basic conditions that must be met for a capital gain made by a business to qualify for the small business concessions:

(1)  The business must satisfy either (a) the "maximum net asset value" test, or (b) the "small business entity" test, or (c) be a partner in a partnership that is a "small business entity" where the CGT asset is an interest in an asset of the partnership.

(2)  The CGT asset that gives rise to the gain must be an "active asset" that is, an asset used in carrying on the business.

It is the maximum net asset value test I will look at in this column. In general, under the maximum net asset value test, in order to access the concessions, the net value of all the CGT assets of the business must not exceed $6 million (it used to be $5 million some years ago).

A recent case before the Administrative Appeals Tribunal (AAT) highlighted the difficulties that can arise in meeting this test.

As might be expected, meeting this basic test requires obtaining valuations of assets, and that's where difficulties can arise.

In the AAT case, a company owned three properties. During the 2005 income year, a "CGT event" happened in relation to the company when it disposed of a property it owned. The company claimed small business relief from capital gains tax on the basis that it satisfied the then $5 million maximum net asset value test. However, the valuation of the property concerned ultimately caused the business to fail that test.

Unless the company's valuation was accepted in each case, the net value of all relevant CGT assets would exceed the $5 million limit and the CGT relief claimed would not be available. In the end, the company's valuations were not accepted.

The matter turned on the valuation by the business' valuer and the Commissioner's valuer of one industrial and two residential blocks of units owned by related entities. The three properties were all located in the Illawarra area. One was an industrial site in Albion Park and the other two properties were residential sites, each of them containing a block of residential home units.

The AAT said valuation was not an exact science – a true but unfortunate statement given the importance of valuations in so many tax matters. In this case, the valuers used three valuation methodologies:

Direct comparison – where reasonably contemporaneous sales of other properties are used to estimate the value of the subject property.

Capitalisation – where the value of a property is derived by dividing the presumed rental income achievable, by a “capitalisation rate”. For example, a capitalisation rate of 5% represents an expectation that the value of the property would be recovered over 20 years. If the income capable of being generated is $100,000 per annum, then the estimated value of the property would be $2 million ($100,000 multiplied by 20).

Summation – where the estimated value of the land is added to the estimated value of the improvements on it, to produce an estimated value of the property as a whole.

The AAT preferred the Commissioner's valuation, and found that the taxpayer's valuations were not reasonable in the circumstances, despite concerns with various aspects of the Commissioner's valuations (for example, assumptions made by the valuer).

Among other things, the AAT found the following problems with the approach adopted by the taxpayer's valuer:

• the lack of suitability of the comparison properties selected;
• the lack of evidence of recent sales for the direct comparison method;
• the use of estimates of income-generating potential for one of the properties rather than actual figures that were available;
• the application of the comparable sales method was not transparent; and
• failure to explain why he used a particular value per square metre for the land of one of the properties.

Accordingly, the AAT concluded that the valuations relied on by the company were not reasonable. The difference between the valuations by the Commissioner and the company was over $650,000.

In tax law, the taxpayer bears the burden of proving that the Tax Commissioner's assessments were excessive, and in cases where valuations were at issue, a taxpayer could not do this by simply proving that the valuations relied on by the Commissioner were wrong. Rather, the AAT said a taxpayer must positively establish that its own valuations are right, or at least more reasonable than the Commissioner's valuations.

This case is a useful reminder to SMEs about the importance of obtaining accurate and supportable valuations of assets where the CGT small business concessions are being sought.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions .

This article originally appeared on SmartCompany.

Image courtesy of Flickr.