Tag Archives: Capital gains tax

Budget housing and CGT reforms – the missing path to fairness

The recent 2026 Federal Budget has announced transitional measures to impose:

the abolition of negative gearing on residential property other than new builds;
a minimum 30% capital gains tax (CGT) rate; and
abolition of the general 50% CGT discount with a proposed return to the indexation of cost base as was in place before 1999 before the price increases in residential housing then turbocharged when compared to incomes.

But is this fair?

The announcements have been attacked notably by entrepreneurs who purport to speak for small business start-ups and tech innovators as being anti-business and as a sop to aspiration.

Are they? Can I answer this free of the bias of politics and instead rely on a forty year career advising on Australian taxes understanding that some political parties have aligned themselves with the entrepreneurs’ position?

I suggest:

their claim that the abolition of the CGT 50% discount hurts small business claim is a furphy. The Federal Treasurer Mr. Chalmers referred to the four small business CGT concessions (small business concessions) and exemptions that can still be applied to reduce the taxable capital gains on CGT assets used actively in a business.[1] Often the reduction in CGT after the small business concessions are applied is to a very low overall rate which leaves little or zero CGT to be paid[2]. Often CGT does not apply to business assets at all[3]. So the entrepreneurs’ fairness gripe should really be about whether the small business concessions are adequate once the CGT 50% discount is taken away and a minimum 30% CGT is imposed by the measures should there be any taxable gain remaining after the small business concessions are applied; and
it is disappointing that these activists and party political decision makers, who are often diligent in taking accurate professional tax advice on their own affairs, are less concerned whether their views about these measures that impact the rest of us are accurate.

More about this later in this piece but let me:

first ask: will potential entrepreneurs be deterred from becoming wealthy, or if I should use the euphemism, high net worth? because of high taxes should they make a lot of money or will they be more interested in the opportunity to become wealthy and make the money they will keep? and
move to what would make the measures fairer and more aligned with the objectives of the measures which I understand to be:
comparable, or at least more comparable, income taxation of gains from capital with gains from personal exertion: notably that of workers who earn wages and salary; and
removing tax advantages to investors, which other taxpayers cover or pay for, of negative gearing and the CGT 50% discount so that young people and others, who principally earn their income from personal exertion, can compete for a limited stock of housing on a more equal footing.

What tax professionals like me appreciate is the tax policy which most distorts housing affordability in Australia is the very generous and complete CGT main residence exemption (MRE) given to ensure the family home isn’t subjected to CGT at all. This is where the disparity been taxation of personal exertion income and gaining from owning property becomes really apparent. Can I say it isn’t necessarily in my professional interest to call out how the CGT MRE becomes a rort. I earn professional income from advising on the lucrative extent of the CGT MRE in complex and borderline cases, and I may continue to do so should the CGT MRE continue as it is. The CGT MRE legislation I work with reveals that the parliament has gone to great and sometimes surprising lengths to ensure doctrinal integrity of no CGT on the family home[4].

Consider a home presently up for sale at Wategos Beach, Byron Bay. (The owner is not my client; I heard about this in the news). This home was up for sale for $75m but, as of May 2026, the seller is looking for $50-$60m.

The land was purchased for $3.7m in 2014.

Let us assume demolition costs of the shack that stood on the site when the owner bought it and that capital costs of building a mansion on the site were about $10.3m meaning costs of around $14m all up.

Let us also:

assume that the budget announcements are an otherwise reasonable basis on which gains from property may be fairly taxed: that is by indexing the cost (cost base) of the property to the owner so the owner is taxed on the true gain and is relieved of tax on the impact of inflation on costs accepting that inflationary drift while the property was owned by the owner doesn’t reflect real gain; and
say this home sells soon for $55m.

The magnitude of capital gain to which CGT could apply, should there be no CGT MRE and after allowing for an upwards inflation adjustment in the cost base, is in the order of $36.5m.[5]

Income from personal exertion/work – nurse lifetime tax comparison

Assume a nurse on a middle income in the low‑to‑mid $80,000s pays, say, $18,000 in income tax per year.[6]

Over a 35‑year career, that’s ≈ 18,000 × 35 = $630,000 of lifetime income tax on, and Medicare contribution by, the nurse.

Now let us compare $17.2m (tax foregone on the $36.5m indexed gain on the Wategos Beach sale) to see how many nurses lifetimes it takes to cover this tax foregone:

17.2 ÷ 0.63m ≈ 27.3.

So 27 nurses’ full working lifetimes of income tax and Medicare payments are needed to make up for the tax and Medicare lost on the indexed and untaxed gain on this one Wategos Beach main residence because the capital gain on the family home is fully exempt under the CGT main residence rules.

I should not pretend this exceptional capital gain at Wategos Beach, which I use to highlight the inequity of the CGT MRE, commonly occurs at these levels around the country. But equally the number of cases where lesser multiples of tax on nurses working lifetimes, say 5 to 15? are being lost in CGT MREs extended are being lost all over the country should not be understated.

Could the CGT MRE be withdrawn or changed?

Introducing CGT on the family home is political anathema. I infer that an exemption from CGT on the family home was a political cost of introducing the CGT in 1985 just as exemptions on food, education and health came to be political costs of introducing the goods and services tax in 1999.

But if the sale and likely gain at Wategos Beach, Byron Bay reveals anything it reveals the CGT MRE could be altered and be better targeted, at least, so it becomes less exclusive (to home owners) and regressive. There is a case for limits on the CGT not collected because of the CGT MRE which nurses and other workers, many of whom are unable, or never will be able, to become home owners able to use the CGT MRE, can be called on to cover with their taxes.

To my mind this can be remedied with a CGT MRE cap.

A CGT MRE cap

How would that work? Actually there are already lifetime CGT caps in the CGT small business concessions which the entrepreneurs’ group may think inconsequential but let me return to them later.

A cap on capital gains on homes eligible for the CGT MRE could be imposed on Australian taxpayers on a lifetime basis: singles and couples use of the CGT MRE could be restricted during their lifetime. In other words the MRE could be redesigned so the MRE wouldn’t exempt the whole capital gain on an unlimited basis on every family home a well heeled home owner ever sells but instead limits their lifetime usage of the family home CGT free privilege on the basis that other taxpayers, principally workers and others who earn their living and pay taxes from their personal exertion, are funding and covering for these taxes not paid.

It seems to me, given what I have said about the political toll on whoever may introduce CGT on the sale of the family home, a CGT MRE cap would need to be generous to be palatable.

A generous MRE cap?

A cap has to be big enough so that most ordinary households will never hit it. That is cap policy would need the generosity, courtesy of other taxpayers like nurses, of no CGT on the average home, but the cap would be low enough so that very large gains start to be taxed.

Typical Australian house prices as reflected in median house values are well below $2m even in the big cities; only a minority of properties see multi‑million‑dollar gains over a single ownership.

Maybe caps could be in this range:

individuals: $2–3 million of real capital gains? or
couples: in the range of, say, $4–6 million of gains?

depending on whether they too are indexed to ensure they will continue to stand higher than median home prices.

At these levels:

nearly all ordinary owner‑occupiers, including those in expensive cities who move several times, would still pay no CGT on their home sales over their lifetimes; and
very large capital gains, like on Wategos Beach, Byron Bay, could still be partially exempt, up to the cap, but most of the gain would be taxable, greatly reducing the number of nurse working lifetimes needed to offset the forgone tax.

These caps would still let people own and sell quite expensive homes tax‑free, while signalling that the CGT MRE is not intended to allow well resourced home owners to shelter many millions of dollars of untaxed capital gains at enormous community cost.

Implementation

To implement CGT MRE caps with a minimum of grandfathering in pursuit of fairness and equity, the home sales caught could be grandfathered to sales of homes, or purchases and sales after certain dates on or after the introduction of a CGT MRE cap regime. But I don’t see reason to grandfather the cap itself. That is historical use, and not just use after introduction of a cap, of the CGT MRE by people can be counted against their MRE CGT cap to ascertain whether they have cap remaining with which they can reduce the CGT on the gain on their next sale of their home.

Not only is there the political challenge of reforming the CGT MRE there is a significant practical problem: Under the Australian CGT system, uses of the CGT MRE have not been reported and tracked by the Australian Taxation Office (ATO). That is capital gains free of CGT made on the sale of homes have not been returned in income tax returns to the ATO. But this problem is not insurmountable.[7]

Using the cap before you buy

The present CGT MRE is of absolutely no use to nurses, workers, and other people who are yet to buy a home to whom the budget measures are meant to be targeted. This is what the “property ladder” and getting “in the market” has been all about – getting on the bottom rung of the ladder with:

a home to live in; and
a tax shelter to grow equity in the home tax free thanks to the CGT MRE.

For a yet-to-be-first-home buyer (YTBFHB) who cannot yet afford to enter the housing market, denying access to the CGT 50% discount and a 30% minimum CGT on investment gains stifles the policy intent of measures aimed at assisting their first home acquisition. Saving for a deposit on a first home will be impeded by CGT on investment growth as the individual builds capital through savings and portfolio accumulation. As investments are realised and rebalanced over time, CGT, after the proposed budget changes, reduces the net proceeds available for reinvestment and ultimately diminishes the after-tax capital available to a YTBFHB for a first-home deposit.

As I see it, this is where the CGT MRE cap can help if the cap, or least some of it, is portable strictly to YTBFHBs. That is: why not allow a single or a couple YTBFHB to transfer some of their yet to be used CGT MRE cap to apply to investments in a portfolio being used to fund or finance their first home?

Further I do not follow the need for a 30% minimum CGT which applies under the measures even where a resident taxpayer’s whole assessable income, including capital gains, falls below $45,000 which means capital gains on investments will be taxed at a higher marginal rate than, say, income from personal exertion or income from business activity: the measures are directed at evening up taxation of income from property and taxation of income from personal exertion. If the policy objective is parity between taxation of gains from property and gains from personal exertion, why replace a CGT discount that taxed capital gains more favourably than labour with a rule that taxes capital gains more heavily than labour?

Under the pre-1999 CGT rules which taxed indexed capital gains, applicable marginal rates were averaged to ameliorate the effect of a capital gain taking a taxpayer into a higher tax bracket. Unlike with the similar minimum 30% income tax which is to apply to discretionary trust beneficiaries, there seems to be no anti-income splitting purpose behind the 30% minimum CGT initiative. Or is the argument taxpayers will deliberately reduce their income in a tax year before they realise property (CGT assets) that have increased in value?[8]

Involved but doable

A CGT MRE cap wouldn’t be a simple evolution of the current CGT law but it would be doable. Nuance would be needed when figuring out to whom the cap applies. If couples are to be assessed against the cap, which seems necessary to stop spouses double dipping for the MRE, there would need to be exceptions for edge cases. For instance where someone who is a YTBFHB:

enters into a relationship and lives with someone who has become a home owner; and

the relationship ends and occupation by the YTBFHB of the home ends after a short time;

that person could be allowed to resume YTBFHB status.

Given allowing every YTBFHB the full generous CGT MRE cap of $2-4m would seriously impact CGT collections by government there is a case for restricting the portable part of a CGT MRE cap considerably further so investments of a YTBFHB, which become CGT free (by the way, more generous than the CGT 50% discount) are limited to say $500,000? $500,000 and saved (taxed) salary may be enough to significantly help a YTBFHB buy their way into a moderately priced first home.

Entrepreneurs, tech founders and the small business concessions

Let’s return to entrepreneurs and the small business concessions. If their point is that the small business concessions are not enough not to stifle aspiration then let us understand more precisely when an entrepreneur or a tech start up founder will qualify for the small business concessions.

The media often reports that the concessions are limited to businesses with turnover below $2 million. The reality is more generous.[9]

Are the aspirations of entrepreneurs and startup founders who may become too wealthy to apply the small business concessions really impacted because of that.[10]

But I struggle to see how this group is more in need of CGT relief than YTBFHBs who presently struggle to buy a home and to whom the budget measures are purportedly directed.

Which aspiration that is more worthy of support by other taxpayers?

The small business concessions lifetime cap experience

Among the small business concessions rules, there is a $500,000 cap which works to limit CGT exemption on small business gains with great similarity to the CGT MRE cap I am canvassing here. This is the lifetime cap on the small business retirement exemption.[11]

Eligible entrepreneurs can currently access a $500,000 lifetime retirement exemption and have no more than 50% of remaining gains to which the small business concessions apply subjected to CGT on their sale of business goodwill and, where it is subject to CGT, capital interests in intellectual property they own.

As stated the entrepreneurs and tech founders’ criticism hardly reflects their actual experience of the tax law on which they are likely not expert and on which they likely rely on accountants’ advice. Significant categories of intellectual property used in business have never enjoyed the benefit of the CGT 50% discount in the first place., the CGT 50% discount has never been available to reduce tax when selling much intellectual property (IP) applied by tech innovative businesses. Where IP is depreciable viz. where depreciation deductions allow the cost of the IP to be written off over a period of years, gains on sale of the IP over the written down value is assessable as a balancing charge which is not treated as a capital gain under the income tax system.

Entrepreneurs aspirations and indexation

If the concern is truly aspiration, whose aspiration deserves greater support from the tax system: established entrepreneurs seeking lower taxation of realised business wealth, or YTBFHBs seeking to accumulate enough capital to enter the housing market?

Can I suggest that indexation of:

costs in determining taxable net capital gains;
the $2m aggregated turnover test and $6m aggregated MNAV test thresholds of the small business concessions perhaps with phase outs; and
a CGT MRE cap (commencing at $2m?) and its portable part (commencing at $500,000??); and
the $500,000 lifetime small business CGT retirement exemption cap;

are fairer aspirations and it is YTBFHBs, rather than entrepreneurs and tech innovators, who have the more compelling economic case for shelter from taxes made up for by the taxes paid by other Australians.

[1] the small business concessions referred to are the small business 50% reduction, the small business 15 year exemption, the small business retirement exemption and the small business rollover which take effect under the Division 152 of the Income Tax Assessment Act 1997

[2] where the small business CGT 15 year exemption applies or the small business retirement exemption applies to sub $1m capital gains which in any case is a far lower rate than 50% rate after the CGT 50% discount is applied

[3] most business assets are depreciable plant and equipment so gains on them, should they have value after their use in a business and being written down, are subjected to assessable balancing charges rather than taxable capital gains

[4] this is particularly apparent in how the CGT MRE rules are extended in the cases of absences i.e. cases where a home owner is not living in their home for a long period, cases where owners are transitioning between homes and to deceased estates and beneficiaries where a home owner has died to keep the CGT MRE at distance from being a “death tax”

[5] The costs of the home to the owner – nominal cost base

Land purchase: $3.7m.

Demolition + new build: $10.3m.

Total nominal cost base: 3.7 + 10.3 = $14.0 million.

Apply indexation from 2017 to mid‑2026

I understand the land was purchased in 2014 with the build costs incurred later. Let’s now say the weighted average time when all costs were incurred was 2017 with the build known to have finished after that. From CPI data, a reasonable index factor from a 2017 average to early/mid‑2026 is about 1.32 (prices roughly 32% higher at the time of sale in 2026).

Indexed cost base to the owner of acquiring and building the home is then: $14.0m × 1.32 ≈ $18.50m.

Indexed capital gain at a $55m sale price

So we have

• Inferred sale price: $55m.

• Indexed capital gain: 55.0 − 18.5 ≈ $36.5m.

• Possible CGT on the sale if it was paid on the indexed capital gain at the top marginal rate plus Medicare (about 47%): ≈ 36.5 × 0.47 ≈ $17.2m.

[6] This is a rough, ball‑park figure for a full‑time worker in the middle brackets in the Australian income tax system; the actual number depends on taxable income, deductions, and current thresholds. Typical tax plus Medicare per year ≈ $18,000 on a salary around the low‑to‑mid 80,000s.

[7] Despite holding no or negligible historical CGT MRE use data on taxpayers, the government and the ATO has wide and unrestricted access to property information collected in the states and territories. Along with title information about residential property, most Australian state and territory governments have allowed a principal place of residence exemption from their land taxes and so the ATO would have access to a significant trove of data with which to:

• ascertain and verify how much CGT MRE people have applied to exempt gains on sales of their homes up to introduction of a MRE cap regime and

• track MRE cap usage in earnest.

Coupled with that the government could require taxpayers, who seek to apply a capped CGT MRE, to complete a once off lifetime main residence return/statement to the ATO which sets out:

• Australian homes where the applicant for a MRE has lived;

• the homes among them where the taxpayer has realised their stake in the home; and

• those homes where the MRE has been used and where remaining lifetime cap to the applicant should be reduced.

[8] the idea that CGT will skew taxpayer behaviour so they will earn less income to bring down their effective rate of CGT, and the CGT system therefore needs to be protected from that by a 30% minimum CGT, is an idea in parallel to the entrepreneurs’ thinking that, with higher CGT on them if that is in fact right, they too will behave to earn less income. The Tax Justice Network has done work on global econometrics which reveal that very few entrepreneurs, wealthy business owners and their acolytes, who may threaten to leave the country after progressive tax changes are implemented in their home country; actually leave – The Millionaire Exodus Myth

[9] Generally speaking a business owner can qualify as a small business owner eligible for the small business concessions where their business has a turnover of less than $2m. An entrepreneur can also qualify to use the small business concessions if they satisfy the $6m maximum net asset value (MNAV) test. This is best simply illustrated with an example. An entrepreneur and spouse who have a business with a turnover of $3m, who fail the $2m turnover test but who have:

• a home they own worth $8m;

• personal assets of $1m; and

• $6m in superannuation between them;

(being excluded assets none of which count against the $6m MNAV) and $5m in other assets net of debt viz. $20m in overall wealth; can still qualify for the small business concessions so long as there are no related entitles, associates and entities related to those associates with further assets which take the aggregated group tested to $6m or over. Or an entrepreneur with twice that wealth and who thus fails the $6m MNAV test but whose business(es) has a turnover of $1.6m can similarly qualify under the $2m turnover test where those same related entitles et al. don’t own businesses which aggregate with that turnover to then take aggregated turnover over $2m in the tax year in which the capital gain is made.

[10] Admittedly the small business concessions have their confronting side – be a few dollars over satisfying either test and fail both the $2m turnover and the $6m MNAV test and the small business concessions are wholly denied to the business owners. That is the business owners won’t be considered eligibly small business. That is there is no phase out. Also the $2m and the $6m used in the respective tests are not indexed and have not been increased for nearly nineteen years since their introduction as basic conditions for the small business concessions. So there may be some fairness case for indexation of those numbers.

[11] Briefly and generally, where the conditions for this small business concession are met, an individual behind a business can be exempted on up to $500,000 in taxable net capital gains on small business assets during their lifetime. So a CGT MRE cap is hardly a novel idea. It too hasn’t been indexed or increased from $500,000 in the nineteen years since the inception of the small business retirement exemption.

The retirement requirements of this small business concession are not demanding: either the capital gains must be paid into preserved complying superannuation where the individual is under the age of 55 years or where the individual has reached 55 they can either pocket the tax fee capital gains of up to $500,000 or pay them into superannuation at his or her option.

Can the CGT main residence exemption be used to save tax on a profitable property development?

In my August 2022 blog:

The capital gains tax main residence exemption, affordable housing and caps – The capital gains tax main residence exemption, affordable housing and caps https://wp.me/p6T4vg-rg

I considered the generous, unlimited and regressive CGT main residence (MR) exemption under Australian income tax and pondered the extent to which the CGT MR exemption has contributed to housing unaffordability. As I said in that post, for those who occupy and turnover homes they own in Australia, the CGT MR exemption delivers uncapped tax free uplifts in wealth as prices rise.

But the line can be overstepped.

A’s residential building project

Let us take A who has significantly benefitted from tax free CGT uplifts on previous sales of A’s former homes:

A acquires real estate which can be subdivided and on which two homes can be built.
A’s idea with this acquisition is to move in to one of the homes (Lot 1) once it is built and occupiable.
But A doesn’t plan to live in Lot 1 long term. A’s plans are to sell Lot 1 and Lot 2 with completed dwellings for a hoped for profit.
Will the CGT MR exemption enable A to enjoy profits from the project tax free?

The Commissioner of Taxation can treat the above development for sale as an adventure in the nature of trade to sell the land and buildings for profit. The occupation by A of Lot 1 as A’s home is incidental to the project. This differs from another case where, say, B uses real estate, on which B’s existing home is located, for a development where B subdivides, builds and sells where there was clearly an initial time pre-project where the real estate was only used by B as B’s home.

Proceeds or profits from sales and ordinary income

Where a project is a development for sale at a profit, such as in A’s case for the whole time and, in B’s case, for the phase of development to sale, the proceeds or profits can be treated as ordinary income by the Commissioner based on cases and tax principles referred to in:

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income

in which profits or gains in the ordinary course of business and from profit-making undertakings or schemes are considered.

Where proceeds or profits from sales are ordinary income arising either in the ordinary course of business or in a profit-making venture and also produce (otherwise taxable) capital gains then, due to section 118-20 of the Income Tax Assessment Act 1997, the proceeds or profits are treated as ordinary income and capital gains are not taxed. That is CGT does not apply and CGT principles, concessions and exemptions don’t apply to gains or losses made on income account.

So in A’s case, where the proceeds or profits from the sales of Units 1 and 2 are ordinary income:

no CGT MR exemption can be applied to reduce tax on Unit 1 as there is no taxable capital gain; and
further, no 50% CGT discount can be applied to reduce the extent to which proceeds or profits on sales are included in A’s assessable income as ordinary income

even though A is a resident individual generally entitled to such capital gain concessions.

Commissioner on the lookout

A’s plans to sell are not necessarily:

going to be obvious to; or
reported to;

the Commissioner particularly in the early stages of the A’s project. However that should change once Lot 1 and Lot 2 do sell. That is because:

the Commissioner is on the lookout for residential real estate developments that are an adventure in the nature of trade and are an enterprise under goods and services tax (GST) rules:

Miscellaneous Taxation Ruling MT 2006/1 The New Tax System: the meaning of entity carrying on an enterprise for the purposes of entitlement to an Australian Business Number

and it is Australian Business Number and GST information gathering by the Commissioner that may well reveal that A’s project is to develop and sell. The project can then be a review or audit target where proceeds and profits have not been returned by A as ordinary income.

New residential premises and GST taxable supplies

The sales of Units 1 and 2 are taxable supplies of new residential premises for GST where the sales happen within five years of when Units 1 and 2 are built and occupied as residences.

Generally the sale of a someone’s home is not treated as a taxable supply however that reassurance, considered at paragraph 11 of:

Goods and Services Tax Ruling GSTR 2003/3 Goods and services tax: when is a sale of real property a sale of new residential premises?

does not apply if the sale occurs as part of a profit making undertaking of scheme viz. where the supply is in the course of an enterprise and is not a mere realisation of the owner’s home: see paragraph 263 of MT 2006/1 et al.

Project trading stock or taxation of project profit?

What of B? How would B be taxed on income account when B’s earlier use of real estate was exclusively as B’s private home? When B sells B will be dealing with two events treated like sales for tax over an earlier and a later period. CGT and the CGT MR exemption can apply up to when B’s property is put to B’s development for sale project. But at that point B can be taken to have put the property to use as trading stock and section 70-30 of the ITAA 1997 applies to treat B as having sold the property and as having re-acquired the property as trading stock even though B continues to own the property [possibilitity 1].

In:

Taxation Determination TD 92/124 Income tax: property development: in what circumstances is land treated as ‘trading stock’?

the Commissioner states:

Land is treated as trading stock for income tax purposes if:

• it is held for the purpose of resale; and

• a business activity which involves dealing in land has commenced.

Even where the development for sale is not considered to be a “business activity”, but is nonetheless an isolated transaction within the ambit of TR 92/3; B’s profits, not B’s sale proceeds, can comprise the assessable income of B from the the development [possibility 2]. Those profits are based on the value of the property as a cost at the time the property is ventured to the development based on the High Court decision in F.C. of T. v. Whitfords Beach Pty. Ltd. (1982) HCA 8; 150 CLR 355.

The use as a home phase and the project development to sale phase are treated separately for tax either with possibility 1 and possibility 2.

GST, enterprise and creditable acquisitions

As A’s (or B’s) project leads to taxable supplies of new residential premises it will follow that A’s project is an enterprise requiring A to be registered for GST: see MT 2006/1. When that is understood by A, A may then register for the GST on a timely basis positioning A to more easily claim project expenses as creditable acquisitions and obtain GST credit or refunds.

That opportunity gets complicated where the new dwellings on Lots 1 and 2 may come to be used by A once built – say privately as A’s main residence, or say where held and used to earn rent, rather than sold, in which cases creditable acquisition claims on activity statements may need to be adjusted under GST rules due to A’s change in creditable purpose.

C the builder

Let us now consider C who, like A, has significantly benefitted from tax free uplifts, questionably, on previous sales of C’s former homes using the CGT MR exemption. But C is or has become a professional builder and C’s buy, build/renovate and sell for a profit can be understood and characterised as C’s business activity/profit making venturing after C’s real estate owning history is fully understood. The frequency and amount of those previous tax free uplifts taken with claims of the CGT MR exemption is a part of that history.

The cases and tax principles referred to TR 92/3 mean that C can still be taxed on income account, and cannot access the CGT MR exemption on this next project, even where C uses a dwelling built/renovated by C as C’s home during times when the dwellings C builds or renovates become occupiable.

Cases raising the income/capital dichotomy and these complications do not necessarily have the same tax outcomes and will turn on their own whole factual story.

CGT small business concessions and exotic share classes

Exotic share classes, such as redeemable preference shares and dividend only (dividend access [DA]), shares are a longstanding concern for a private company seeking to access the small business CGT concessions (the Concessions) in Division 152 of the Income Tax Assessment Act (ITAA) 1997. Exotic share classes can derail qualification as a significant individual and thence as a CGT concession stakeholder for all shareholders of the company. The consequences are that a private company, otherwise eligible for the Concessions:

will not be eligible in some cases; and
in more or all cases, where the company is eligible and can apply the Concessions, shareholders of the Company with an insufficient small business participation percentage (SBPP) won’t be able to individually participate in the Concessions along with the company.

Why does this happen?

It’s due to the structure of section 152-70 of the ITAA 1997 which, in the case of a company, determines SBPP based on the “the smaller or smallest”:

… percentage that the entity has because of holding the legal and equitable interests in shares in the company:
(a) the percentage of the voting power in the company; or
(b) the percentage of any dividend that the company may pay; or
(c) the percentage of any distribution of capital that the company may make;
or, if they are different, the smaller or smallest.

Illustration

So a DA share may entitle a shareholder to dividends but not to voting rights or distributions of capital. Dividends of a company with DA shares can be declared on shares in the DA class only so other shareholders of the company, entitled to:

voting rights and distributions of capital e.g. ordinary shareholders; but
not to dividends as they are diverted to the DA share class;

leaves all shareholders with a zero SBPP. The SBPP is driven by the smallest of (a), (b) and (c) above and, in the case of the example ordinary shareholders, it is (b) that is zero. Zero is less than the 20% SBPP needed for a shareholder to be a significant individual: section 152-55.

What to do with dormant DA shares?

But what if a company on the verge of making a capital gain to which the Concessions can apply:

has a DA shareholder who could receive dividends declared to the DA class; but
desists from paying dividends on the DA class and all dividends are instead payable to ordinary shareholders?

Broadly this was what happened in Commissioner of Taxation v Devuba Pty Ltd [2015] FCAFC 168. I have no first-hand knowledge of the background to the case but I imagine Devuba’s experienced tax lawyer, Gregory Ganz, was aware of and advised on section 152-70 in the years in the lead up to the profitable sale of shares in another company, Primacy Underwriting Agency Pty Ltd, for $4,381,645 by Devuba Pty. Ltd. on 19 May 2010.

The DA share dilemma

I can see he and Devuba faced a dilemma. If, by 19 May 2010:

the DA shareholder still held the DA share then section 152-70 could apply to reduce the ordinary shareholders’ SBPPs to zero because Devuba “may pay” dividends on the DA class, This is the view that the Commissioner of Taxation was to take and contest in the case;
Devuba had redeemed or cancelled the DA share so that dividends would no longer be paid on DA shares there would have been a CGT event, probably CGT event C2, on which the DA shareholder would be taxed with the value of the capital proceeds, based on the market value substitution rule, being attended by valuation uncertainty; or
Devuba altered the rights of the DA shareholder so that dividends would no longer be paid on DA shares then CGT impacts and comparable valuation uncertainty would have arisen under the value shifting rules in Part 3-95 of the ITAA 1997 which had commenced to operate from 2002.

In the event Devuba went to the share sale on 19 May 2010 with the DA shareholder still holding the DA share. However, on 1 September 2008, the directors had passed a resolution in the accordance with Article 83 of the Memorandum and Articles of Association of Devuba that dividends were not to be paid on the DA share class until the directors passed a resolution to do so. Effectively this was a somewhat soft touch moratorium on DA class dividends probably insufficient or thought insufficient to trigger an alteration in rights which would have attracted value shifting CGT consequences.

“May pay”

Devuba figured dividends Devuba “may pay” on the DA class became zero as a matter of fact and likelihood because of this resolution. On the other hand the Commissioner took the view that Devuba could nonetheless legally pay dividends to the DA shareholder and so the ordinary shareholders had a SBPP of zero due to (b).

The Federal Court and the Full Federal Court agreed with Devuba. It was found that Devuba was unable to pay dividends immediately before 19 May 2010 to the DA shareholder with the moratorium in place. The courts found that the moratorium was valid and effective under the Memorandum and Articles of Association such that dividends that Devuba “may pay” on the DA class were zero. It followed that the percentage of dividends Devuba “may pay” to ordinary shareholders gave the ordinary shareholders sufficient SBPP to meet the relevant SBPP thresholds for the Concessions relevant in the case.

Exotic share class problem with the Concessions persists

This case shows the concern mentioned at the outset persists: Issued DA shares can still drive SBPP to zero and deprive ordinary shareholders of a company of the Concessions even where dividends are not paid to the DA class. Only with nuanced planning, an understanding of the constitution of a company and its interaction with the terms of the relevant exotic share class can help overcome a SBPP problem caused by an exotic share class with SBPP and the Concessions.

Even further income tax trouble

And income tax problems with exotic share classes like DA shares don’t end there. DA shares used for tax minimisation are considered aggressive tax planning and are the subject of the Commissioner’s:

Taxpayer Alert TA 2012/4 Accessing private company profits through a dividend access share arrangement attempting to circumvent taxation laws

which contains a lengthy list of bases on which the Commissioner can and will tax distributions on DA shares including treatment of DA share class distributions as dividend stripping under Part IVA of the ITAA 1936. Exotic share class can also have unexpected consequences under the debt equity rules in Division 974 of the ITAA 1997.

Reflection

Although the outcome in Devuba was technical and based on its particular facts, it marks a divergent, realistic and perhaps reassuring approach to the enquiry into dividends a company may pay. That stands in comparison to the unrealistic and dogmatic approach taken particularly by Revenue NSW and under the Duties Act (NSW) 1997 (DA NSW) to the questions of:

whether a trustee or trustees may become beneficiaries of a trust for the purposes of obtaining concessional duty on a change of trustee of a trust under sub-section 54(3) of the DA NSW; and
whether foreign person or persons may become a beneficiaries of a trust for the purposes of foreign person stamp duty and land tax surcharges under section 104J of the DA NSW;

obliging substantial, sometimes legally unachievable and largely unnecessary trust deed amendments before it can be accepted that such persons will never take a percentage of a trust as a beneficiary of the trust oblivious to perceivable facts, likelihoods and evidence that such a beneficiary would ever take.

The capital gains tax main residence exemption, affordable housing and caps

CGT beginnings

With wage and salary earners taxable on virtually every dollar they earn from their work, sources from the Asprey Report (1975) through to the tax summit of 1985 identified the lack of a capital gains tax as a tax regressive unfairness in the Australian income tax system which then relied on a narrower tax base. Before the CGT, gains on investments made by their owners escaped income tax and allowed already wealthier people to step up their wealth untaxed where less wealthy typically working people who paid their taxes could not.

Still it would have been near unthinkable for the Hawke Keating government of 1985 to have introduced the capital gains tax, which then was a partisan political and controversial proposal, into the Australian income tax system without CGT relief on the family home following the tax summit.

In those days a greater proportion of working people and middle Australia owned their own homes. So the exemption now legislated as the CGT main residence (MR) exemption in Division 118 of the Income Tax Assessment Act (ITAA) 1997, then not thought especially regressive, was a political price the government then had to pay to have a constituency-supported capital gains tax in the Australian income tax mix at all.

The uncontained housing tax exemption

But the breadth of the CGT MR exemption has made the CGT MR exemption itself regressive.

The CGT MR exemption is unlimited and especially generous when compared to CGT relief given in other countries.

The CGT MR exemption has these characteristics:

generally, where there is no income-earning use of a home and a taxpayer is or is taken to have occupied the home as their main residence while he or she has owned it, any capital gain on the home is fully exempted from the Australian CGT;
there is no qualifying length of ownership period to wait before the CGT MR exemption can be applied to exempt CGT on sale of an Australian home – the owner can live there for a month, rent the property out for five years, go overseas, come back and sell the (former) home and claim the full exemption – see section 118-145 of the ITAA 1997; and
a taxpayer can turnover any number of homes and keep claiming the exemption from CGT on every successive capital gain. In other words there are no limits on the amount of, or numbers of tax free step ups in, wealth a taxpayer can achieve with no taxation by selling each of their successive and possibly more expensive homes.

This has made Australian home ownership an incomparably attractive investment for tax reasons. This frustrates wider social housing objectives such as opportunity and ability for the populace to securely house themselves when they cannot afford to compete in the housing market especially as long term renting in Australia is not so secure either.

Sources of unaffordable housing

The CGT MR exemption has indisputably contributed to unaffordible housing both as a tax shelter, as a driver of demand for real estate and as an improver of the financial case to own an expensive home. To what extent is not for a tax lawyer, who is no econometrician, to judge. The CGT MR exemption may not even be the greatest contributor to unaffordable housing in Australia. Housing markets around the world are elevated due to the abundance of money injected into major economies by quantitative easing. But in Australia add:

dark money laundered through Australian real estate attributable to persisting slack regulation of money flows into Australia, including continuing failure by government to commence the 2007 AML/CTF measures to expand the range of oversight of AUSTRAC to non-financial businesses and professions including the legal, accounting and real estate professions: see my 2017 blog – Sluggish anti-money laundering reform in Australia https://wp.me/p6T4vg-6J and The Lucky Laundry by Nathan Lynch https://cutt.ly/JCwVAyK;
housing financialisation; and
light and regressive taxation of housing in Australia;

to the reasons why Australian residential property prices have reached the unaffordable levels they have.

The wrong culprit

Light taxation has been widely canvassed in the media as a contributor to unaffordable housing but journalists and commentators frequently focus on the 50% CGT discount for investors and negative gearing as the tax system causes of unaffordable housing unfortunately ignoring the CGT MR exemption or even the various land tax exemptions that Australian state and territory governments extend which shelter owner-occupied homes from state taxation too.

The 50% CGT discount was an inexplicable 1999 adjustment to sound original design of the CGT in 1986. It replaced the indexation of cost (base) which was to ensure an investor paid tax only on a real capital gain after adjusting for inflation but at ordinary income tax rates so the CGT could work fairly and progressively as designed. The 50% CGT discount instead effectively and regressively reduced the income tax rate on investment capital gains made by property investors, as it turned out, during a period of negligible inflation which the 50% discount was meant to overtly but more crudely counter. Now inflation is back so a nuanced policy response may be to scrap the 50% CGT discount and to revert back to the 1986 indexation of cost which should never have been altered in the first place.

In contrast to the CGT MR exemption, the 50% CGT discount has a waiting period, 12 months – see section 115-25 of the ITAA 1997, which is not much, and is limited to 50% as a highest discount to individuals. Like the CGT MR exemption, availability is not limited or capped to those who qualify and this is a boon to investors in the property market although major investors and developers need to be tax wary that their property investment activity is not treated by the Commissioner of Taxation as a business of profit-making by sale with the consequences that:

proceeds of sale of investment in housing become taxable as ordinary income;
thus CGT relief, such as the 50% CGT discount, is unavailable – see section 118-20 of the Income Tax Assessment Act (ITAA) 1997; and
their activities become an enterprise where they must charge the goods and services tax (GST) to buyers for reasons set out in Miscellaneous Taxation Ruling MT 2006/1.

Tax relief saving for a home?

The CGT MR exemption is of no benefit to someone who is saving for a home, but does not have a home yet, whom one would think would be the focus of a real and progressive tax exemption to house. Capital gains made on investments by someone saving for a home are not exempt from tax, and get no better than the 50% CGT discount I have maligned in this post, which is odd when it is understood the tax system gives already housed wealthier citizens, who may turnover a series of homes of increasing value and for increasing gains, full tax relief on each gain made on their homes through the CGT MR exemption.

For the CGT MR exemption to be fairer, and to discourage home buyers from taking on higher mortgages to get into the housing market where ruin may be more likely than gain, could the CGT MR exemption extend to capital gains made by persons who are saving for a home or who are yet to own home on portfolio assets set aside to buy a home they hold in the interim? Clearly the former First Home Saver’s Account scheme, which was an utter failure and repealed in 2014, was not ambitious enough and was a false move to help those accumulating what they need to buy a home.

A cap on the CGT main residence exemption?

A limit or cap could be put on the CGT MR exemption that a taxpayer can use to exempt capital gains on his or her home during their lifetime. This would take heat out of the housing market.

An arguably generous lifetime cap of $A 1 million would still bring in substantial additional CGT revenue that could fund social and universal housing and reduce the CGT MR exemption rort by those who take large or multiple full exemptions on their turnover of increasingly expensive homes. The CGT system already uses a lifetime limit in the small business CGT retirement exemption rules in Subdivision 152-D of the ITAA 1997 and caps now limit contributions that can be put into tax concessional superannuation on tax fairness and equity grounds.

A home turnover limitation?

In many countries in Europe a holding period of less than five years can cause capital gains on assets including the family home to be taxable. Tax relief cuts in where an asset is held for longer. Are their approaches something Australia should also consider when looking at tax exemptions and concessions for housing?

Challenge

There is no doubt changes that really improve Australian housing affordability and address inequitable and fiscally disastrous untethered tax exemptions will be politically fraught especially when there are so many interests vested in the present tax system who may lose with change. In the bigger picture lightly taxed property gains and unquarantined negative gearing deductions can be seen as scourges when proper taxation, orthodox monetary policy and extended oversight of criminal money flows could be used to re-balance the housing investment market with the social housing needs of Australia’s citizens.

Foreign income tax offsets and discount capital gains – the Burton effect

Non-residents* no longer have entitlement to the 50% capital gains tax discount (the Discount) on their Australian capital gains, save grandfathering, but the inverse isn’t true: Residents* can apply the Discount to foreign capital gains that meet the requirements of the Discount in their Australian tax.

The CGT discount

Obtaining the Discount principally requires:

the entity who made the gain being an individual either directly or as the beneficiary of a trust [50% discount] or a superannuation fund [33⅓% discount] : section 115-100 of the Income Tax Assessment Act [ITAA] 1997). That is the entity is not a company. Companies are ineligible for the Discount;
the CGT asset on which the gain is made was held for at least twelve months: section 115-25; and
the gain made is not otherwise treated income under the ITAA 1997. So where a gain is both assessable income and a capital gain under the ITAA 1997 the gain is not taxed as a capital gain and so the Discount cannot apply too: section 118-20.

How taxation of foreign income works

Broadly foreign capital gains are included in the Australian assessable income of a resident just as domestic capital gains are. Resident taxpayers are taxed on income from all worldwide sources: sections 6-5 and 6-10. Notable exceptions are foreign income of companies from:

their foreign branches with an permanent establishment in those foreign places: section 23AH of the ITAA 1936; and
foreign subsidiaries of Australian resident companies or where a company has non-portfolio (at least 10%) holding in a foreign company: section 768-5 of the ITAA 1997.

Foreign income, including of capital gains, of a resident is separately taxed (or exempted) under Australian tax rules even where the foreign income has been, or is to be, taxed under a foreign regime. To address the prospect of double (foreign and domestic) taxation of foreign income a foreign income tax offset (FITO) is available: Division 770 of the ITAA 1997. Australian tax on foreign income can be offset by a FITO for the foreign tax a resident taxpayer has paid, as a non-resident typically but dual tax residence is possible, in the foreign place the foreign income came from.

Double tax and double tax treaties

Australia has double (bilateral) tax treaties with many countries including all large countries and major trading partners which:

mutually allow source taxation of income of non-residents of each country (jurisdiction) at tax rates lower than both non-treaty rates and domestic rates on some forms of foreign income – this reduces foreign tax and, consequently the FITO needed to offset that foreign tax; and
provide a structure to alter domestic tax law, if need be, to prevent situations where taxpayers will be taxed in both places (double tax) on the same income.

The tax treaties reserve rights to a treaty partner to tax real estate where a taxpayer is resident in the other jurisdiction and taxation of capital gains made on the realisation of real estate, unlike typically interest, dividends and royalties, is not capped at lower rates in the treaties. Broadly this means Australian residents, as non-resident taxpayers, pay foreign capital gains taxes at rates comparable to, or even higher than, the taxes locals pay on capital gains made on foreign real estate.

It follows that foreign capital gains tax can be significant. Can this foreign tax payment be used as a FITO to offset the CGT on an Australian Discount capital gain? The FITO available to offset Discount capital gains on real estate and other investments was considered by the Full Federal Court in Burton v Commissioner of Taxation [2019] FCAFC 141.

Burton v Commissioner of Taxation

In Burton v Commissioner of Taxation it was found that 50% only of US tax paid on a capital gain made on US investments by an Australian resident individual taxpayer was offsettable against the individual’s Australian tax as a FITO.

The reason for this finding is technical but can be understood as follows:

In essence a FITO under section 770-10 of the ITAA 1997 is strictly confined to foreign income that is subject to foreign tax. Under the Discount regime in Division 115 and under section 102-5 of the ITAA 1997 only the net capital gain after applying the Discount, which is 50% in the case of a resident individual, is included in assessable income. It follows that a component of a capital gain taxed as a foreign capital gain is not taxed in Australia where the capital gain is a discount capital gain under Division 115. That is a Discount capital gain to an Australian resident individual taxable on their worldwide income that arises from a capital gain made in the US is made up of:

50% that is taxed in the US which is included in Australia assessable income as net capital gain; and
50% that is taxed in the US but which is not included in assessable income in Australia viz. it is exempt from tax in Australia.

The Full Federal Court confirmed that a FITO is only available in relation to the first of these 50% categories. Logan J. stated at paragraphs 84 and 86:

84. Read in context, the text of s 770-10 is, in my view, fatal to the success of the alternative foundation of Mr Burton’s appeal, grounds 1 to 4 of which challenge the correctness of the conclusion adverse to him reached by the learned primary judge in relation to the allowance of foreign tax offsets under s 770-10 of the 1997 Act. An amount of foreign tax paid only counts towards a tax offset if it was paid “in respect of an amount that is all or part of an amount included in your assessable income for the year”.
….
86. Section 770-10 looks to “an amount that is all or part of an amount included in your assessable income for the year”. The term “assessable income” is defined in s 995-1 of the 1997 Act, which is not the same as “income” as understood for the purposes of the Convention. As defined in the 1997 Act, assessable income includes “ordinary income” (s 6-5) and, materially, what is termed “statutory income” (s 6-10). One form of statutory income included in assessable income is a net capital gain included pursuant to s 102-5(1) of the 1997 Act. As a matter of ordinary language flowing from the text of s 770-10 and, in turn, s 102-5(1), it is only the net capital gain which is, in each instance, included in Mr Burton’s assessable income. Regard to ss 6-5, 6-10 and 102-5 highlights that the phraseology “included in your assessable income” is pervasive in the 1997 Act. There is no contextual warrant for construing “included in” as extending to an amount which is used for computation of an amount that is included in assessable income. The learned primary judge (at [113] – [114]) reached just such a conclusion. That conclusion was correct, for the reasons given by his Honour.
Burton v Commissioner of Taxation [2019] FCAFC 141 at paras. 84 and 86

Repercussions

This outcome is quirky and is entirely due to the laboured statutory drafting of the CGT provisions which is in part consequence of laudable efforts to rewrite and improve the Australian legislation with the advent of the ITAA 1997. If, instead, the taxation of discount capital gains had been governed by a rate set in less intelligible and obscure fine print in the Income Tax Rates Act 1986 as say 50% of the rate otherwise applicable, with that net rate to apply to the whole capital gain; then the whole of the US tax paid on the capital gain could have been offsettable as a FITO. In other words a half of the FITO would not have been lost to Mr. Burton due to the clash of legislative style with treaty terms.

But that is not the case. Accordingly Australian residents with Discount capital gains which are foreign capital gains need to ensure FITO claims in their Australian income tax return reduce the foreign tax claimed by the discount percentage to ensure no FITOs are claimed for the non-assessable/exempt component of the foreign capital gain that technically arises under the Australian CGT legislation.

^{*In this post resident and non-resident respectively mean resident and non-resident for tax purposes: see “resident of Australia” defined in sub-section 6(1) of the ITAA 1936.}

Keeping the CGT main residence exemption when working from home

Only a partial exemption from capital gains tax (CGT) is available to the extent a main residence is used for an income-producing use: section 118-190 of the Income Tax Assessment Act (ITAA) 1997.

As the CGT main residence exemption is, or can be, so valuable – there is often no bigger tax break to an individual in their lifetime; an individual working in their business or their employment from a home they own will be looking to preserve the full CGT main residence exemption (MRE) where they can.

Setting the scene

For most taxpayers opportunity to claim the full CGT MRE will be straight forward. The Australian Taxation Office (ATO) website

Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

re-assures a home owner simply working from home from a desk, chair and a computer that a full CGT MRE will be available where the ATO states:

Generally, when you sell your home CGT doesn’t apply. However, if you used any part of your home for business purposes, you may have to pay CGT. CGT won’t apply if any of the following occurred with your home-based business:
– You operated your business from a rented home.
– You didn’t have an area specifically set aside for your business activities.
– You operated your business through a company or trust.
You only have to pay CGT for periods when you used your home for your business.
Home-based business and CGT implications | Australian Taxation Office https://cutt.ly/ZDOjOWt

But the ATO’s page isn’t the whole story. The ATO’s first dot point is so obvious that it shouldn’t be in the list but is helpful to any renters that may happen on to this page of course. The ATO’s second dot point is reassuring especially as all that is physically needed by many workers working from home is that chair, desk and computer. This derives from the distinction between homes with a place of business and those not with a place of business and how they are treated for the CGT MRE considered later in this blog. The third dot point is partly right. What about, though, where a related company or trust, which is a separate entity to an individual owning his or her home:

pays rent to the owner for the use of the home?; or
meets or helps meet the expenses of the owner of the home?

Separate entity – related company or trust

Let’s say Fred owns his own home and Fred has a related company from which Fred conducts his business from home. If the company rents a room in the home then the CGT MRE is reduced to a partial CGT exemption when Fred sells his home as:

Fred has earned rental income from the company, a separate legal entity; and
Fred will either have deducted, or could have deducted, interest on money borrowed put to the home, if any – see paragraph 118-190(1)(c) and sub-section 118-190(2);

as section 118-190 then applies.

Don’t charge rent

If Fred is the sole owner of his company then an obvious first measure of tax planning to ensure Fred keeps the full CGT MRE is for Fred not to charge rent to the company.

But where Fred charges no rent to the company this has implications for expenses like heating and cooling and other expenses Fred incurs, and has no rent to cover, when the company occupies his home for no charge and carries on its business from there remembering:

Fred is not entitled to deduction for the expenses of his company which is a separate entity to him and which are essentially private to him; and
the company is not entitled to a deduction for expenses for which Fred, rather than the company, is responsible even where the company pays those expenses (without considering fringe benefits tax implications where Fred is also an employee of the company as well as a shareholder).

Can the company instead reimburse Fred, sustain deductions for the expenses of the home it meets as business expenses and not disturb the CGT MRE position of Fred?

Legalities – a licence!

Firstly the company is, as stated, a separate legal entity to Fred. To clarify its basis for using Fred’s home, the company and Fred should document what the company can do at his home.

Secondly a document between Fred and the company under which the company can enter and use Fred’s home to run its business without paying rent to Fred is likely not a lease. It is a licence to enter the home granted by Fred and to do the things at the home which Fred allows the company to do under the licence.

Thirdly the licence terms can specify and delimit the home expenses of Fred which the company will reimburse to Fred.

Running expenses vs. occupancy expenses

The Commissioner of Taxation’s Taxation Ruling TR 93/30 Income tax: deductions for home office expenses explains two significant dichotomies:

Firstly TR 93/30 distinguishes between running expenses, being the costs of living at a home, and occupancy expenses which are the costs of owning a home. These examples are given:

Occupancy expenses – relating to ownership or use of a home which are not affected by the taxpayer’s income earning activities (i.e., occupancy expenses). These include rent, mortgage interest, municipal and water rates, land taxes and house insurance premiums.
Running expenses – relating to the use of facilities within the home. These include electricity charges for heating/cooling, lighting, cleaning costs, depreciation, leasing charges and the cost of repairs on items of furniture and furnishings in the office.
Paragraph 6 of TR 93/30

Secondly, from the tax cases on the issue, TR 93/30 draws a distinction between an area of a home to be treated as a place of business and an area of a home which is not to be so treated. This ties back to the ATO observation in the second dot point on Home-based business and CGT implications about a part of a home specifically set aside for business activities.

Safe harbour for a full CGT MRE

To my mind a CGT MRE safe harbour for Fred would be for the licence:

to allow Fred reimbursement by the company for running expenses related to the use of the home by the company for business purposes; and
to preclude reimbursement by the company for occupancy expenses;

to Fred. Then the ATO would have no reason to treat payments by the company to Fred or payments by the company to meet expenses of the home on Fred’s behalf as either rent or as contributions to Fred’s occupancy expenses so that the CGT MRE of Fred then diminishes to a partial exemption where these payments do not exceed the applicable running expenses that Fred can recover under the licence.

On the other hand a reimbursement of occupancy expenses to Fred is an indicator to the ATO that Fred is allowing a physical part of the home itself, whether or not that part is a place of business or not based on the indicators of a place of business described in TR 93/30 (see below), to be used by the company in its business to earn income and a notional apportionment between use as a main residence and income earning leading to a diminished partial CGT MRE under section 118-195 might then follow.

Sole trader or partnership

Where the owner of the home is a sole trader, or where the owners of the home are carrying on a business in partnership, then the issue of licence to enter and use the home and reimbursement of home expenses to owners as separate entities won’t arise.

In those cases closely abiding by TR 93/30 can give home owners working from home safe harbour from a partial CGT MRE so long as:

1. the home has no place of business viz like:

the area is clearly identifiable as a place of business;
the area is not readily suitable or adaptable for use for private or domestic purposes in association with the home generally;
the area is used exclusively or almost exclusively for carrying on a business; or
the area is used regularly for visits of clients or customers.
from paragraph 5 of TR 93/30. A home-based doctor’s surgery is given as an example of a place of business in paragraph 4 of TR 93/30.

2. tax deduction claims by the sole trader or partnership are constrained to running expenses and occupancy expenses are excluded from those tax deduction claims.

ZBFF v. C. of T. – AAT finds no loophole at the heart of capital gains tax

… must be one of Wilde’s …

Oscar Wilde’s quip “no good deed goes unpunished” opened Deputy President McCabe’s decision in the 2 February 2021 Administrative Appeals Tribunal (AAT) case of ZBFF v. Commissioner of Taxation [2021] AATA 275. It prefaced his introduction to the matter at hand in ZBFF: whether a good deed will go untaxed. ZBFF is an insight into the possibility of loophole, or lack of symmetry between assessable proceeds and tax allowable costs, at the heart of the capital gains tax (CGT) provisions of the Income Tax Assessment Act (ITAA) 1997. Lawyers for the taxpayer endeavoured to find what turned out to be elusive before this AAT.

A good deed for an old friend going through a divorce

The good deed for an old friend, whom the AAT referred to by the pseudonym of Mr. Green, was done by the taxpayer (the appellant), a wealthy businessman, who was willing and able to help out Mr. Green on his divorce in 2006. Rather than see Mr. Green lose his home in a divorce settlement, the taxpayer arranged for the taxpayer’s family trust (TFT):

to purchase Mr. Green’s home from Mr. Green for its (2006) value; and
to allow Mr. Green a right of occupancy so he could continue to occupy the home after the TFT’s purchase.

2016 sale of the home for a profit

The TFT sold the home in 2016 and the net proceeds of sale, being the sale price less the TFT’s cost of acquisition and its holding costs, were all paid over to Mr. Green.

The taxpayer and the TFT took nothing and sought to take nothing for their beneficence to Mr. Green.

Mr. Green not taxed on his windfall?

The decision doesn’t say as much, as the case did not concern Mr. Green’s affairs, but it might be presumed that Mr. Green wasn’t taxable or taxed on the proceeds of the 2016 sale (the Net Proceeds) paid over by the TFT to Mr. Green: going untaxed by virtue of the good deed:

Why might Mr. Green escape tax on the Net Proceeds he received? Mr. Green had no property interest or CGT asset in the home from 2006, and it would seem (presumption again) that the Commissioner sought not to assess Mr. Green on a capital gain based on the Net Proceeds he received from the TFT from the standpoint of either or both of CGT event D1 or CGT event H2 occurring. If there had been a capital gain the CGT main residence exemption could not have been applied by Mr. Green in the absence of his ownership interest in the home made out under section 118-130 of the ITAA 1997 from that time.

Instead the taxpayer, as the beneficiary of the TFT entitled, was assessed on an assessable capital gain on the 2016 sale.

In the dispute over this assessment of the taxpayer before the AAT the taxpayer was required to establish the terms of the arrangement with Mr. Green:

which was only partly in writing, having been put to writing sometime after the arrangement was entered into, and otherwise oral; and
the terms of which were contested by the Commissioner.

The AAT accepted that there was an agreement between the taxpayer and Mr. Green as contended for by the taxpayer.

Downside of leaving Mr. Green without rights to the Net Proceeds

Still the absence of a clear term in the arrangement as to what the TFT would do with the Net Proceeds (if any), after already paying the purchase price to Mr. Green back in 2006, a term that may enable the Commissioner to tax Mr. Green on his receipt of the gain; prejudiced the taxpayer who was left with a hard road to establish that the taxpayer, as a beneficiary of the TFT, wasn’t taxable on the Net Proceeds to the TFT unreduced.

The evidence before the AAT was that Mr. Green was willing to let the TFT retain the profits on a later sale, viz. retain the Net Proceeds, but, in the event in 2016, the TFT opted not to retain them. It could be inferred that the payment over of the Net Proceeds to Mr. Green following the sale in due course was a gift to Mr. Green of an amount the TFT was otherwise entitled to keep.

The hard road

Still the taxpayer contended before the AAT that the payment of the Net Proceeds to Mr. Green was a cost to the TFT which:

increased the TFT’s cost base of the home;
reduced the capital proceeds to the TFT from the 2016 sale; and/or
caused the TFT to make an off-setting capital loss;

or, alternatively was a cost to which a deduction under section 40-880 of the ITAA 1997 could be applied by the TFT.

The taxpayer asserted that the payment of the Net Proceeds was fifth element expenditure “to preserve or defend your ownership of, or rights to” the CGT asset which could be included in the CGT asset’s cost base in accord with sub-section 110-25(6) of the ITAA 1997. A difficulty for the taxpayer with his fifth element argument was that the danger identified, supposedly necessitating that the TFT defend its title to the CGT asset, was the equitable interest in the CGT asset Mr. Green might have or assert under his arrangement/agreement with the taxpayer. The AAT rejected this argument as the taxpayer could not establish any interest in the home that Mr. Green might plausibly have.

The AAT disposed of the taxpayer’s other technical arguments that somehow the payment of the Net Proceeds should be allowed to/offset by the TFT to reduce the net capital gain. Some arguments of the taxpayer relied on the taxpayer’s questionable position, given the context of the good deed, that the taxpayer was dealing with Mr. Green at arm’s length.

The arm’s length obstacle

The AAT preferred the Commissioner’s contention that the parties were not dealing at arm’s length, with paragraph 112-20(1)(c) of the ITAA 1997 applicable to include market value, rather than amounts actually paid to Mr. Green, in the TFT’s cost base of the home.

The taxpayer’s contention that section 40-880 applied failed as the taxpayer could not establish, from evidence put to the AAT, that the TFT was carrying on a business and that there was any nexus between the payment of the Net Proceeds and that business.

Symmetry prevails

The taxpayer was hopeful for a mismatch or lack of symmetry between:

those provisions relating to CGT events in the ITAA 1997 that bring capital proceeds into net capital gains and into assessable income in section 102-5 of the ITAA 1997 and then to tax that presumably did not apply to Mr. Green’s receipt of the Net Proceeds on the one hand; and
the provisions which would reduce the assessable capital gain to the TFT on the other hand;

in pursuit of a reduction in the amount of the Net Proceeds assessable to him as a net capital gain by the amount of the TFT’s payment of the Net Proceeds.

According to the AAT in ZBFF the symmetry holds. The payment of the Net Proceeds by the TFT was indistinguishable from a gift by the TFT to Mr. Green in the tax law analysis. Mr. Green may not have been assessable on the gain reflected by the Net Proceeds but the taxpayer/TFT was.

Will the taxpayer, a wealthy businessman who can afford to appeal, appeal to the Full Federal Court?

Determining the AAT fee on a tax appeal to the AAT

The applicable fees to appeal

Unless a taxpayer is disadvantaged and qualifies for a concessional $100 fee – see our blog post: Small business now has its own dedicated taxation division of the AAT at https://wp.me/p6T4vg-dx, fees for review of the Commissioner of Taxation’s decisions reviewable by the AAT are now:

$952 for review by the Taxation & Commercial Division; and
$511 for for review by the Small Business Taxation Division (SBTD).

These fees have gone up since our blog post in March 2019.

Who can appeal to the SBDT?

As explained in our earlier blog post, appeal to the SBTD is available where the appellant is a small business entity under section 328-110 of the Income Tax Assessment Act (ITAA) (C’th) 1997. A small business entity is an entity (see section 960-100 of the ITAA 1997) carrying on business with an aggregated turnover of less than $10 million in an income year.

Multiple decisions – single fee on an applicant

Where the appeal is against more than one decision that relates to the appellant, the AAT can allow appeals to be dealt with together so only one fee applies. For instance, if a taxpayer is appealing against decisions to disallow a series of objections against multiple assessments of tax across multiple tax periods then the AAT can apply a single fee.

The AAT also allows for a single fee to be imposed on an “organisation” rather than separately on each of the members of the organisation applying to appeal.

Partnership CGT SBDT appeal

We have a client seeking review of objections against multiple assessments of income tax in the SBTD. The client is a partnership under State law (viz. a general law partnership carrying on business) and is a section 328-110 small business entity eligible to appeal to the SBTD.

The appeal concerns decisions by the Commissioner to disallow objections by the partners against income tax assessments seeking reduction in amounts included as assessable net capital gains to the partners in a series of income years.

Net capital gains made on partnership assets are assessed as income to the partners individually in a partnership. That is capital gains on partnership assets are not included in partnership income nor are they included in a partnership’s income tax return.

Soon after the introduction of capital gains tax (CGT) in September 1985 to include capital gains in assessable income it became apparent that it was impractical to assess partnership capital gains as partnership income to partnerships. Not only is a partnership not a legal owner of partnership property, and thus not apparent as the entity against which to assess a gain on a CGT asset, partnership property is often not owned by partners in the same names or proportions as partners share in the income and losses of the partnership.

Should a single fee have applied to the partnership?

The treatment of a partnership as an entity for some purposes, but not for others, can be confusing. It is via the small business entity regime that our client, a partnership, qualifies as a small business entity and this also impacts how the capital gains on partnership assets in dispute are assessed to the partners. The partnership is an “organisation”. Should a single fee apply to appeals by all of the partners of the partnership relating to the partnership asset CGT issues which are in common to all of the partners?

For the moment the AAT Registry say no. The AAT Registry has sought the $511 fee from each of the partners and has raised the appeals as separate cases (at odds with how the Australian Taxation Office dealt with binding private ruling applications and objections from the client in substance). The AAT Registry have raised the prospect that partners can seek to have their cases combined into one case and can seek a refund of the further instances of the $511 fee at a later point in the proceedings.

If the client is successful in obtaining a refund of the additional $511 fees we will update this story with a comment below.

Offshoring of non-resident capital gains – the India experience of Vodafone and Cairn Energy

Two Indian tax cases that have now largely run their course illustrate difficulties faced by countries determined to tax major economic activity in their own territory by non-residents.

India stands out as a rare jurisdiction determined to tax major foreign investors that greatly gain from economic activity there.

The cases show how difficult it can be to prevent profit shifting to tax havens, such as the Cayman Islands which features in each of the cases considered in this blog. The Cayman Islands is a haven of financial secrecy with no direct resident taxation of companies that can attain Cayman resident status.

The Indian cases have comparable facts and have followed a similar course:

Vodafone

In 2007 Vodafone Group PLC (British) sought to re-organise its nationwide telecommunications business in India. So Vodafone International Holdings BV (VIHBV) acquired the share capital of a Cayman Islands holding company from Hutchison Telecommunication International Ltd giving Vodafone Group PLC 67% control of Hutch Essar, an Indian joint venture company that owned the business’s Indian telecommunications licences.

A “crore” is 10⁷. The Indian Income Tax Department sought to tax VIHBV on a capital gain of around Rs 12,000 crore with penalties on the transfer of telecommunications licences, the capital assets of the Indian business, re-organised between non-residents.

Cairn

In 2006-7 Cairn Energy PLC (British) re-organised the largest privately owned oil and gas business in India by transferring its shares in Cairn India Holdings, a Cayman Islands company to Cairn India, an Indian company.

In 2011 Cairn India merged with Vedanta Resources, another Indian mining conglomerate. The Indian Income Tax Department sought to tax a capital gain of around Rs 24,500 crore on these transfers of the capital assets of the Cairn India business.

Source taxation

The capital gains reflected growth and the increase in value in Indian-based business assets. India sought to subject these Indian-based gains to taxation based on their source in India.

Vodafone contested their assessment and was successful before the Supreme Court of India. The Supreme Court found that the Indian Tax Department couldn’t tax VIHBV, a non-resident, on gains it realised in the Vodafone re-organisation as there was no relevant capital asset of VIHBV of, or facilitation of a look-through to a capital asset in, the Indian Income-tax Act 1961 in its pre-amendment version.

Following that loss in the Supreme Court the Indian government amended the Income-tax Act 1961 with the Finance Act 2012 to retrospectively target indirect gains made by non-residents on realisation of Indian capital assets. Section 9(1)(i) of the Income-tax Act 1961, with retrospective effect from 1961, treats income in the nature of capital gains from the direct or indirect transfers of Indian capital assets between non-residents as Indian-sourced income.

The retrospectivity was justified as a “clarification” of how the Indian tax law is to apply but the impact of the amendment suggest this government descriptor was euphemistic.

Comparison with Australian tax on indirect gains on non-residents’ assets

There is no comparable between Section 9(1)(i) of the Income-tax Act 1961 of India and the Australian and most other taxation systems where source taxation of gains on moveable assets made by non-residents is generally not pursued unless the non-resident has a direct interest in an asset used in a local business permanent establishment.

Australia has conformed with OECD model treaty conventions, and so most Australian treaties are based on, or are comparable to the OECD model convention which provides:

4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State.
Article 13(4) of the OECD model convention

This substantially confines when Australia and these other places will tax non-residents on their disposals of shares in companies. That is the source country only taxes gains on shares of a non-resident who is resident of the other treaty state where shares reflect immovable interests such as in real estate, mines, forests, fisheries etc.

The rationale of the confinement, as I understand it, is to avoid double and multiple taxation arising when countries tax dealings by non-residents outside of, or with no connection to, their own country especially understanding the country where a person is resident is expected to tax the person on their worldwide income. But the confinement in Article 13(4) and the like excludes the right to tax indirect gains enjoyed by non-residents on movable property that does have a true connection with the country such as the movable business property in India of Vodafone and Cairn owned by Cayman Islands companies.

So these treaties don’t concede rights to countries to tax a non-resident to gains on shares reflecting growth in capital assets used in a local business realised indirectly through a sale of company shares of the non-resident. Instead that right to tax is ceded to the treaty partner where the owner of the shares is tax resident in that other country.

Comparison with taxes on business profits under OECD-like treaties

This is in contrast to business profits with a source in, say, Australia where Australia has first right to tax non-residents under OECD model-like articles when a non-resident, though tax resident in the other treaty country, has a permanent establishment in Australia.

In other words Australia, like many other countries but unlike India, generally does not pursue source income taxation of gains on Australian assets of non-residents made outside of a business permanent establishment. Capital gains on Australian assets realised by non-residents, and not just treaty partner residents, that are not Taxable Australian Property (I capitalise this defined term in the Income Tax Assessment Act (ITAA) 1997) are not subjected to the Australian CGT regime under Division 855 of the ITAA 1997 though capital gains of non-residents made on Taxable Australian Property which extends to:

immovable real estate, mines, etc. and interests in them – see section 855-25 of the ITAA 1997: that is, indirect interests in these too are Taxable Australian Property, and options to acquire them; and
assets that are business assets used in permanent establishment though:
- inclusion of permanent establishment business assets in Taxable Australian Property can be subject to treaty constraints; and
- indirect interests in business assets used in permanent establishment are not included in Taxable Australian Property;

(see the table in section 855-15 of the ITAA 1997;)

are subject to Australian CGT.

The limits on non-residents relying on treaty protection to resist Australian tax on indirect capital gains are also evident in Australia in Resource Capital Fund IV LP v Commissioner of Taxation [2019] FCAFC 51 which again featured the Cayman Islands. The Full Federal Court found that a Cayman Islands limited partnership with U.S. resident limited partners could not invoke Article 13 in the Australia USA Double Tax Treaty to prevent Australia taxing capital gains on sales of shares in a limited partnership (treated as a company under Australian tax law) which held interests in immovable mining assets in Australia.

Australian opportunities for non-residents and tax havens

Where Australian shares or other business assets aren’t or don’t reflect interests in immovable property or direct interests in permanent establishment assets (other than Taxable Australian Assets in Australia’s case) then Australia and other OECD member states generally don’t look to tax non-residents on gains on them say by imposing withholding taxes to assure collection from non-residents.

It follows that these countries give non-residents based in low-tax jurisdictions, or non-residents who structure their holdings through tax havens, much opportunity to invest in movable Australian assets including brands, digital assets, designs, licences, other intellectual property and goodwill on a virtual CGT free basis.

It is known that the rather extreme minimal or zero tax outcomes these non-residents can access by offshoring their interests are a principal driver of “private equity” opportunities where restructure into, or using, either genuine or contrived non-resident ownership is a common feature.

Desirable destinations for foreign investment

Australia and other OECD nations supposedly encourage and compete for foreign investment by their light touch of capital gains on moveable property connected to local business which non-residents can realise their interests in offshore. Patent boxes, conduit foreign income exemptions, CGT participation exemptions come to mind as light touches on non-residents onshore.

Clearly, and rather dramatically, the Indian government is not so willing to give up the huge tax revenue at stake although there is awareness in India about the impact of their policy of pursuing non-residents for taxes on India-generated capital gains on India as a desirable destination for foreign investment.

The retrospectivity stumbling block

India also tried to introduce General Anti Abuse Rules (GAAR) in 2012 to retrospectively attack the Vodafone and Cairn arrangements however India was not able to implement their GAAR until 2018-19.

The retrospective elements of Section 9(1)(i) of the Income-tax Act 1961 and the proposed GAAR are controversial and the retrospective application of Section 9(1)(i) by the Indian Tax Department, especially with the imposition of penalty, now appears to be its stumbling block in its pursuit of Vodafone and Cairn.

Both Vodafone and Cairn have lately been able to rely on international treaties (not tax treaties) to resist Indian taxation under the retrospective law on the basis that imposition of the retrospective law was unfair and inequitable.

Treaty arbitration

India and the Netherlands entered into a Bilateral Investment Treaty in 1995. In the Vodafone case VIHBV obtained an order against the Indian government for violation of the treaty at the Permanent Court of Arbitration (The Hague, Singapore seat) as the tax, interest and penalties assessed to VIHBV under retrospective legislation violated the fair and equitable treatment of Dutch investment required under the treaty. Simply stated VIHBV was held to account against a tax law that was not in place at the time it undertook Vodafone India re-organisation and when VIHBV would have returned its income in India.

In December 2020, three months after the Vodafone arbitration, Cairn obtained a similar arbitrated order under a similar Bilateral Investment Treaty between the UK and India.

The Indian government can still pursue rights under these treaties to appeal to the High Court in Singapore however they will be aware that this court will be reluctant to disturb Permanent Court of Arbitration findings. Nevertheless it is surprising that both arbitrations treated the Vodafone investment as Dutch and the Cairn investment as British respectively even though the investments in India in both cases were by Cayman Islands entities presumably outside of the coverage of these bilateral investment treaties.

Conclusion

It seems clear enough that countries with the will and fortitude to do so, like India, can impose tax laws which bring gains on offshore holdings of non-residents which indirectly reflect or look through to gains on onshore capital assets used in local businesses to local tax. However these countries will be pitted against powerful interests willing to structure through tax havens and keen to resist taxes relying on any weakness in the imposition of their tax collecting law.

In that context legislation that takes effect retrospectively, even where effective under local law, is a serious flaw in the international treaty domain. Further, like in the Vodafone and Cairn cases, these countries may find tax pursuit of non-residents stymied by:

treaty commitments;
international norms largely set and dominated by the OECD nations; and
reputational risk that the country does not welcome foreign investment;

with tax havens like the Cayman Islands and others ever ready to facilitate offshore realisation of gains effectively tax free for their clients.

Aggregating for dual $6m MNAV tests following 2018 small business CGT concession integrity changes – with the aid of chess!

Those seeking the small business capital gains tax (CGT) concessions in the 2018 and later income years need to be wary of modified small business CGT concession integrity rules which apply from 8 February 2018 by virtue of Schedule 2 of the Treasury Laws Amendment (Tax Integrity and Other Measures) Act 2018 (TIOMA).

The small business CGT concessions in Division 152 of the Income Tax Assessment Act (ITAA) 1997 may look straight forward but there are subtle complications within the misnamed “basic” conditions for the relief which can be matrixlike. The small business CGT concessions are generous so perhaps it is right that rules to protect their integrity, as ramped up by the TIOMA, are more complicated than the rules that ordinarily impose a CGT liability on sales of small business related CGT assets.

Share or interest sales need to meet additional basic conditions

For CGT events involving sales of shares in companies or interests in trusts “additional” basic conditions have commenced with the TIOMA. The additional basic conditions go further than what I describe here. In this post I wish to focus on the significance of the dual $6m maximum net asset value tests that the TIOMA initiates. So in the below considerations I am going to assume that the other basic conditions for the small business CGT concessions, including the additional basic conditions, such as the dual active asset test, which also needs to be considered following the introduction of the TIOMA, will be met.

The dual MNAV and SBE tests

The dual $6m maximum net asset value (MNAV) tests are alternative tests with the similarly dual small business entity ($2m aggregated turnover) (SBE) tests which apply where the small business CGT relief is sought on a sale of shares in a company or an interest in a trust. The dual MNAV tests and SBE tests separately test both the taxpayer (“you”) and the object entity which is the relevant company or trust in which the shares are or interest is held by the taxpayer as the case may be. To obtain relief under the basic conditions, and under the additional basic conditions set out in sub-section 152-10 as revised by the TIOMA, the dual tests must be separately satisfied to obtain any small business CGT concession relief:

Taxpayer must satisfy	AND	Object entity must satisfy
MNAV test or SBE test		Modified MNAV test or SBE test and carried on business up to day of sale

When the object entity MNAV test becomes vital

In practice, there is a significant slew of sales of shares or trust interests where the object entity won’t satisfy the SBE test because of:

an aggregated annual turnover of the object entity of more than $2 million; or
alternatively, the object entity may satisfy that SBE test but paragraph 152-10(2)(a) may apply because the object entity ceased to carry on its business some time before the sale.

In those cases the object entity also needs to satisfy the MNAV test even where the taxpayer has separately satisfied either of the MNAV test or the SBE test or both.

Satisfaction of the MNAV test by the object entity may thus be vital to the availability of the small business CGT concessions to a taxpayer selling shares or a trust interest. Where the object entity, let us say a private company with multiple owners, is worth more than $6m overall, this may well be a problem for minority owners who otherwise are:

on or over the 20% significant individual/CGT stakeholder threshold; or
with net asset value (NAV) under $6m who sell their shares looking for the small business CGT concessions.

The Explanatory Memorandum with the TIOMA gives the following example:

Example 2.4: Investment in large business

Karen carries on a small consulting business as a sole trader. She is a CGT small business entity (according to the general rules) for the 2019-20 income year. Karen also owns 30 per cent of the shares in Big Pty Ltd, a large private company with annual turnover in excess of $20 million in both the 2018-19 and 2019 CGT assets exceeds $100 million throughout this period. On 1 October 2019, Karen sells her shares in Big Pty Ltd. She would not be eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Karen satisfies the other basic conditions for relief, she cannot satisfy the new condition. Big Pty Ltd is not a CGT small business entity in the 2019-20 income year. It also does not satisfy the maximum net asset value test in relation to the capital gain, as its net assets exceed $6 million immediately prior to the CGT event happening (being in excess of $100 million for the entire income year).

MNAV test complexities

Like the SBE test with aggregated turnover of the taxpayer, affiliates and their connected entities, compliance with the MNAV test relies on, or more specifically NAV (net asset value) must stay under the relevant $6m limit after, aggregation.

Before aggregation is considered there is a flip side: the exclusions from the MNAV test: The substantial exclusions are confined to individual taxpayers viz. interests in an individual’s main residence, personal use assets, superannuation and insurance: section 152-20 of the ITAA 1997. The other exclusions in this section are largely to prevent accounting anomalies with:

accounting provisions; and
the double counting of the value of an asset indirectly held in an entity and the value of the stake in the entity including the asset, representing the same value, in NAV.

Liabilities are also excluded from NAV where they relate to assets so the MNAV test can be a maximum net asset value test.

The value of assets that are not excluded are tallied in NAV when applying the MNAV test. Then aggregation must be done. Just like with the complexity of small business CGT concessions integrity more generally, MNAV tests and sometimes qualification for the concessions, involve a hierarchy of constructs which, for the purposes of illustration, can be loosely compared to the pieces on a chessboard one’s opponent in chess may hold:

Chess piece: King

Div 152 construct: The taxpayer

Comment: If the King falls, it’s game over. If either NAV of the taxpayer or (modified) NAV of the object entity exceeds $6m in each required MNAV test the basic condition is failed unless there is a pathway to compliance through the SBE test as described above.

Chess piece: Queen

Div 152 construct: An affiliate

Comment: Although an affiliate is not the taxpayer (or object entity), the NAV of the affiliate also counts/aggregates to the taxpayer (or object entity) when applying the MNAV test to the taxpayer (or object entity), in all directions including NAV aggregated from connected (and Oconnected in the case of an object entity – see below) entities of the affiliate. Affiliates remain determined under section 328‑130 without modification by TIOMA.

Chess piece: Bishop

Div 152 construct: Connected entities

Comment: The whole of the NAV of the connected entity (excluding the exclusions described above) counts in the MNAV test. So if a taxpayer, or an affiliate, has a stake of 50% in a connected entity X, all (100%) of X’s net value is aggregated to the taxpayer’s NAV (including NAV relating to the stake in X of minority stakeholders unrelated to the taxpayer or affiliate). If Y is a connected entity of X then aggregate all (100%) of Y’s net value to the taxpayer’s NAV too.

Chess piece: Knight

Div 152 construct: Oconnected entities

Comment: The Oconnected entity (my terminology – I thought of using “controlled entity” which is in contrast to a connected entity which can either control or be controlled by the other entity it is connected to. But controlled entity is misleading for, as we shall see, only a 20% stake, hardly control in any sense, is needed to trigger this link) is a new construct introduced with the additional basic conditions in the TIOMA relating to the object entity.

The NAV of a Oconnected entity is aggregated to the NAV of the object entity but it is look through forward to aggregate and not look through back too (unlike “controlled by the other entity” which can connect too to a connected entity). For instance, the object‑entity notional tests in section 152‑10(2B), aggregation ‘looks through’ forward to entities controlled by the object entity using section 328‑125 with a 20% threshold, but does not ‘look back’ to unrelated co‑owners or controllers of the object entity, unless they are separately directly connected with the object entity on the modified basis or separately affiliates.

Example: If O (the object entity) controls Q at or above 20% under section 328‑125 (as notionally modified), Q is a later entity and Q’s CGT assets are included in O’s MNAV notional test; by contrast, P, an unrelated co‑owner of O, is not a later entity and P’s own net assets are excluded from O’s notional tests, aside from P’s proportional interest reflected in O itself.

In chess the Knight moves in a weird way so the Knight is the allegory chosen here!

Chess piece: Pawn

Div 152 construct: Asset or investment of the above

Comment: A pawn generally moves one space in chess. $1 in value of an asset or investment owned by a taxpayer or object entity, which is not excluded, counts $1 to the NAV of the taxpayer or an object entity. $1 in value of an asset or investment owned by affiliates, connected entities and Oconnected entities, which are not excluded, count $1 to the affiliate, connected entity and Oconnected entity, as the case may be, but if that NAV is in an affiliate, a connected entity or a Oconnected entity of the taxpayer or object entity in applying the dual tests, the whole NAV of the relevant entity is aggregated to the taxpayer/object entity, not its proportionate NAV based on percentage stake. i.e. A percentage stake is only used for an interest in an entity where the entity the interest is held in is not an affiliate, connected entity or, in the case of the object entity MNAV test, an Oconnected entity.

I don’t play chess and I accept my chess analogy with the workings of the MNAV tests is far from perfect. My endeavour is to make this consideration of the hierarchical workings of the MNAV tests a little more comprehendible and so, perhaps, if you are still reading by this point I have succeeded? If the comparison with chess conveys:

that counts of over $6m by either of the taxpayer NAV or the object entity NAV will generally mean failure of a basic condition for the Division 152 CGT relief so can lead to loss of the game; and
that high value pieces accelerate aggregation of NAV to the $6m limit. That is they can move more than one space: every $1 of a stake a taxpayer (or object entity) in a connected entity (or Oconnected entity), and affiliates and their connected entities without needing any stake in the affiliate of the taxpayer (or object entity) will generally aggregate more than $1 to NAV as the value of others’ stakes in these entities will count to the NAV attributed to the taxpayer (or object entity) too.

The modified MNAV test of the object entity & the modified Oconnected entity

The NAV for controlled entities of an object entity is different due to sub-paras 152-10(2)(c)(iii), (iv) & (v) in the TIOMA:

The threshold between unrelated entity, counted simply as an asset or investment (pawn) to NAV and connected entity (bishop) consistent with other tests of control in the ITAA 1936 and the ITAA 1997 is 40% with a discretion given to the Commissioner where:

there is 40% or over and under a 50% stake; and
it can be established to the Commissioner that some other entity controls the entity that would otherwise be the connected entity.

In practice this means expect the Commissioner to de-connect A from connection with X if A owned 48% of X and B (unconnected to A) owned 52% of X.

When applying the object entity MNAV test, sub-paras 152-10(2)(c)(iii), (iv) & (v) have operation so that the threshold is lowered to a 20% stake in the other entity. That is enough “control” to make the other entity, otherwise an asset or investment, an Oconnected entity (knight). This is apparent from another example in the Explanatory Memorandum with the TIOMA:

Example 2.5: Indirect investment in large business

Tien owns 20 per cent of the shares in Investment Co, a company that carries on an investment business. Investment Co is a CGT small business entity (according to the general rules) for the 2020-21 income year. Investment Co holds 20 per cent of Van Co, a transport company. Van’s assets mean that it is not a CGT small business entity in the 2020-21 income year and does not satisfy the maximum net asset value test at any point during the income year. On 15 May 2021, Tien sells his shares in Investment Co. He is not eligible to access the Division 152 CGT concessions for any resulting capital gain. Even if Tien satisfies the other conditions, he cannot satisfy the new condition requiring the object entity be a CGT small business entity or satisfy the maximum net asset value test due to the modifications that apply when determining this matter for the purposes of this condition. For the purposes of this condition, Investment Co is considered to be connected with Van Co, as Investment Co holds 20 per cent of Van.

As stated in the table above there is no look through back so in a case where an object entity has a stake of 21% of X, the NAV in entities connected to X by virtue of the remaining 79% stakes in X are excluded from the object entity NAV although the NAV of the assets of X, including that relating to the other stakeholders, counts to the object entity NAV.