MLC 703 Principles of Income Tax Law

During May 2010 Julie purchased a business that manufactured high quality business suits. Specifically, the purchase consisted of Julie paying $900 000 for the factory premises that manufactured the suits. She also paid $200 000 for the
goodwill of this business. She ran this business as a sole trader.

In September 2013, the factory premises owned by Julie had some windows broken due to a storm. Julie paid $5000 to have these repaired. She also renovated the staff kitchen on the factory premises. This cost her $30 000 in materials and paying for tradespeople. She also put in 50 hours of her own work to this renovation by doing the tiling herself, which saved her $4000 that she would have otherwise have had to pay the tiler.In May 2016 it became increasingly uneconomical to run the factory due to high labour costs. As a result, Julie, who was 52 at the time, decided to no longer continue running her business. Approximately a year later, she entered into the following contracts on 15 May 2017:
• Bill would purchase the goodwill of her business for $500 000. However,Bill did not purchase the factory premises as he intended to have the suits sold by the business manufactured in a lower cost country.
• The factory premises were to be sold to a property developer for $1.5m.The property developer intended to demolish the factory premises and build high rise residential apartments in its place.
• Bill was to pay Julie $15 000 a year for the next 3 years in return for Julie agreeing to not operate a competing business for that time. For the full period that Julie had owned her business annual revenue was over
$3m.

In June 2017 Julie wanted a new challenge so purchased all the shares in a company called CLR Pty Ltd for $1m. CLR’s assets consisted of:
• A rural residential rental property valued at $250,000; and
• A small shoe manufacturing factory worth $750,000.

At the time of entering the various contracts on May 2017 Julie’s assets also included:
• Her main residence in Altona worth $1m, which had no mortgage on it.
• An investment property in Footscray worth $700 000 with a $600 000 mortgage.
• $200 000 in her superannuation account.
• A holiday unit on the Gold Coast worth $250 000 (unmortgaged). Julie stayed there every year for a few months. Over the Christmas period she would also rent it out for 3 weeks to friends at $500 per week, which was lower than the typical market value rent of $800 per week.
• A holiday house in Ballarat worth $300 000 (unmortgaged). Julie used this solely as a weekend getaway for herself.
• A 42% interest in a company called SHR Pty Ltd. The total net worth of SHR Pty Ltd is $1m, and its only assets are listed shares on the Australian Stock Exchange.

Required

Advise Julie on the Capital Gains Tax implications regarding the above transactions– please ensure that your discussion includes advice on whether she can take advantage of the CGT Small Business Concessions to reduce the amount of tax payable on her Capital Gains. Please assume that none of the payments received by Julie regarding the May 2017 agreements constitute ordinary income.

It is apparent that Melissa has an employment contract which entitles her to a performance based bonus whose higher limit is $ 15,000. As a result, this contractual right that Melissa has can be equated to the presence of the right to compensation. As per the relevant details, it is apparent that the employer is willing to pay a sum of $ 50,000 for the right to give up the bonus which would be enacted by suitably modifying the existing contract to delete bonus provision. It is apparent that giving up this right can be equated to giving up of an asset for a total of $ 50,000. This is in accordance with the tax ruling TR 95/35.

With regards to ascertaining whether the concerned receipt is income or capital, the underlying circumstances and the cause for which the receipt has been extended needs to be taken into consideration as highlighted in the FC of T v. Slaven 84 ATC 4077; (1984) 15 ATR 242. It is apparent that in the given case as the compensation has been extending for giving up a right which essentially constitutes an asset, hence the payment derived therein would be considered as capital. Thus $ 50,000 compensation received by Melissa would not be termed as either ordinary or statutory income.

In accordance with s. 6(5) ITAA 1997, ordinary income may be defined as income which tends to arise on account of ordinary concepts. One of the key categories of ordinary income is employment income and related allowances. Typically these allowances are of regular nature and received by the taxpayer irrespective of any expenses or cost being incurred. In the given case, payment is being extended for ensuring that all professional employees at head office including Melissa do not utter any negative comment to the media. Hence, this compensation is not being derived on the basis of her services offered to the organisation. Instead, these are being extended so as to limit the freedom and right to opinion about the employer to the media. Thus, keeping in mind the purpose, the circumstance and nature of ayment, in accordance with the FC of T v. Slaven case, it is fair to conclude that the payment of $ 4,000 would not be treated as ordinary income under s.6(5) for Melissa.

For the given question, there are two aspects namely to determine the amount of capital gains based on the given information and also to determine if it is possible for Julie to take advantage of the CGT concessions that the government offers for small businesses.

Qualification as a small business

In order to qualify for CGT concessions available to a small business, one of the following three conditions must be satisfied (section 152-10, ITAA 1997).

• The annual turnover of the small business must be less than $ 2 million
• The concerned asset is not actively used but is passively associated for carrying on business by a small business which happens to be an affiliate or a related entity
• The cumulative value of the net CGT assets that the given individual holds along with the related entities must not exceed $ 6 million at the time of the capital event actually taking place. The CGT assets for the net asset test would not include the assets that are used by the taxpayer and the related entities for their personal enjoyment or use. Further, the house to the extent not used for production of income would be excluded from this test. Besides, the superannuation funds would also be excluded.

The eligibility criteria has been highlighted and now based on the information provided in the case, it needs to be ascertained if any of the three conditions highlighted above are satisfied or not.

• It is known that the annual turnover of the factory owned by Julie is $ 3 million and hence it fails to satisfy the turnover condition.
• Also, it is apparent that the active asset which is the machine is not used by anyone else but by Julie herself and thus the passive asset usage test is also not satisfied in the given case.
• The net CGT asset held by Julie at the time of disposal of the factory are highlighted below.

Factory along with the business goodwill = $ 1.5 million + $0.5 million = $ 2 million

Main residence in Altona (Not Included) = $ 0

Investment property (Not for personal enjoyment or use, hence included) = 700000-600000 = $100,000 or $ 0.1 million

Superannuation amount (Not included) = $ 0

Holiday house in Ballart (For personal use only, hence not included) = $ 0

Holiday unit on Gold Coast (Majorly for personal use only but three weeks during Christmas used to derive income) = (3/53)*250000 = $ 14,151 or $ 0.014 million

Holding interest in SHR Pty Ltd = 42% of 1 million = $ 0.42 million

Therefore net assets for Julie as on May 15, 2017 = 2+ 0.1+0.014 +0.42 = $ 2.534 million

Since the net assets are lesser than $ 6 million on the date of disposal of the active asset, hence Julie would be entitled for CGT concessions available for small businesses.

Computation of Capital Gains 

In the given case, there are two CGT assets as outlined below.

• Factory Premises (Capital Asset as per s. 108-5, ITAA 1997)
• Goodwill attached to the business (Capital Asset as per TR 1999/16)

Further, in order to compute the capital gains, besides the selling price, the cost base of the CGT asset is also required. The cost base tends to contain the following.

• Acquisition price of the asset
• Incidental costs linked to asset acquisition and disposal
• CGT asset owing cost
• The capital costs that are incurred in order to enhance or preserve the asset value
• The capital costs incurred in title defending or preservation of ownership

Factory Premises

Selling price of the asset (May 2016) = $ 1.5 million

Acquisition price of the asset (May 2010) = $ 0.9 million

Repair cost of windows = $ 5,000 (these would be expensed and hence not capitalised, thus not part of the cost base)

Renovation of kitchen staff = 30000 + 4000 = $ 34,000 (These would be included in the cost base as these are termed as capital improvements)

Hence, capital base of the asset = 900,000 + 34,000 = $ 934,000

Thus, capital gains on CGT asset sale = 1,500,000 – 934,000 = $ 566,000

 Goodwill

Selling price of the asset (May 2016) = $ 500,000

Acquisition price of the asset (May 2010) = $ 200,000

Thus, capital gains on CGT asset sale = 500,000 – 200,000 = $ 300,000

Total capital gains for Julie = 566000 + 300000 = $ 866,000

It is apparent that the holding period of both the assets is greater than one year and hence the above capital gains are essentially long term. As a result, the taxable capital gains In line with discount method (s. 115-25) = 50% of 866,000 = $ 433,000. 

CGT concessions for small businesses 

The various concessions in relation to CGT that are available to small businesses are as highlighted below. 

• Exemption for 15 years – If an active asset has been owned by the business for a continuous period of15 years and the person concerned is older than 55 years or incapacitated on a permanent basis, then 100% exemption on capital gains irrespective of the underlying amount would be available (Subdivision 152B ITAA 1997).
• Active asset reduction by 50% - For small businesses, a discount of 50% is already available on the long term gains arising from sale of active asset (s. 115-25, ITAA 1997). However, if the eligibility for CGT concessions is found, then additional reduction of 50% on the capital gains arising from sale of active asset can be availed (Subdivision 152C ITAA 1997).
• Exemption on retirement – The active asset sale related capital gains can be exempted to the extent of $ 500,000 which is a lifetime limit. However, if the concerned person is less than 55 years in age, then the exempted capital gains would have to be parked into the retirement savings account or complying super fund (Subdivision 152D ITAA 1997).
• Rollover- A part or 100% of the capital gains arising from sale of active asset can be deferred for a time period stretching upto two years or more if there is an acquisition of replacement asset or money is spent on capital improvement in relation to an existing asset by the concerned taxpayer (Subdivision 152E ITAA 1997).

It is noteworthy that an active asset if the same is owned by the concerned person and used for carrying on with the business. Further, active asset also includes any goodwill or other intangible asset related to the business that is owned solely or in form of a partnership firm.

It is apparent that the active asset (i.e. factory machinery & goodwill) have been held for less than 15 years and hence complete exemption from capital gains is not permissible. It is possible for Julie to claim a further 50% discount on the capital gains derived and this would reduce the gains further and hence limit the capital gains tax liability.

Additional option available to her is that she can park the funds equivalent to the capital gains of $ 433,000 in a super or retirement savings account and claim exemption on payment of capital gains tax assuming that she has not availed more than $ 67,000 before this under this provision. But considering that Julie has invested $ 1 million in CLR Pty where $0.75 million is for the factory, thus, under rollover provision all the capital gains arising from factory premises sale can be rolled over.

In the recent times, owing to the rising fiscal deficit coupled with future estimates, there is discussion amongst policy makers with regards to the existing tax system and enhancing the overall efficiency of the same while assuring higher revenue. One of the low hanging fruits in this regard is an increase in the GST (Goods and Services Tax) which would bring in incremental revenue that could be used to lower the personal income tax rates and eliminate other inefficient taxes that the government currently levies. Research in this regards has been carried out by CPA Australia which is of the opinion that the incremental net benefit worth $ 27.5 billion can be reaped by increasing the GST rate to 15% from the 10% level currently applicable. According to KPMG, the incremental revenue realised from incremental GST could be upward of $ 43 billion annually if there are no exemptions to application of GST. This is huge incremental revenue which can be apparent from the fact that in 2026-2027, the total annual Federal spending on health is estimated to be around $ 45 billion. CPA suggests that the incremental revenues raised through GST could be used to eliminate some inefficient state taxes coupled with reduced personal income tax along with providing incremental boost to the GDP.

The taxes that are perhaps the most efficient and need to be removed are stamp duties, insurance taxes coupled with property related conveyancing duties. With these changes enacted along with reduced income taxes, the CPA has estimated that incremental average annual benefit that each Australian household would realise is estimated at $ 750. Further, an incremental GDP is also estimated as it has been assumed that lower personal tax rate would provide incentive for the people to work more and hence would tend to lower unemployment to practically zero. However, there are some economists which indicate that the assumptions of CPA seem too aggressive and unrealistic and thus the actual gains could be significantly lesser.

Further, there are also concerns from certain quarters that higher benefits in absolute terms would be available to those households which have higher income in comparison to the households having lower income levels. Also if the speculative efficiency gains are put aside on GST, the balancing of GST increase with proportionate decrease in income tax rates might be a zero sum game. This is because for the taxpayers it not the after tax income that matter but the amount of goods and services that they can avail from that amount which would not change if the GST gains are nullified through decrease in personal income tax. 

From the above, it is apparent that there are varied opinions in relation to the relative merits of increasing the rate of GST. However, as apparent from the Henry Review there is no denying that the government needs to reform the tax system which still continues to remain complex and also plug the various loopholes so as to ensure that objectives of a good taxation system are served or not. Further, while the GST and personal income tax are often viewed as alternative and hence configured as a tax switch, it is worthwhile to see the two in isolation and critically discuss their relative merits in relation to fairness, efficiency along with other revenue considerations. This would allow tolook at more innovative solutions for augmenting resources and simplifying the tax structure rather than just limiting to a tax switch with GST and personal income tax. 

GST tends to perform poorly on the fairness aspect considering the regressive nature of the tax. Even though the tax exemptions provided for basic items is aimed at the poor or sections that are economically weaker, but the benefits are reaped by all the sections. Further, considering that the richer section of society tend to spend more in absolute terms on the various basis necessities such as food, hence the amount of exemption enjoyed by the rich under the GST regime is considerably higher than that enjoyed by the economically weaker sections. It is estimated that the GST is levied on the exempted items at the current rate would generate an incremental revenue of about $ 9 billion from the top 40% of the households. It is estimated that only 40% of this $ 9 billion would be sufficient to compensate the GST payments collected by the bottom 60% of the households.  Hence, GST is clearly ill targeted which is obvious considering that it is an indirect tax. Fairness on the other hand tends to be higher for personal income tax which tends to be progressive and thus levies a higher tax rate for people with higher levels of income which achieves the stated goal of equity. 

Even though personal income tax generates equity but it also creates disincentives to work for those who are at the extreme and thus have a significantly high marginal tax rate. This tends to lead to economic costs which are considering higher than witnessed in the case of consumption tax that is broad based such as GST. The main strength of GST is that it is more broad based as compared to personal income tax and hence it more efficient. Also, the extent of distortion in economic decisions brought about by GST is considerably lesser when compared with personal tax. With regards to collection of GST, the cost incurred in collection is also lesser considering GST returns is filed by businesses unlike personal income tax which has to be filed by every individual in the working age. As a result, the compliance costs in relation to GST are significantly lower in comparison to personal income tax. The high cost incurred by the individual taxpayers is highlighted in the following diagram. 

 Also, it is noticeable that in the personal income tax, there are a host of concessions available which makes the whole system complex. This is not the case with GST where there is higher objectively and lower complexity which tends to lead to lower tax compliance costs. Further, since the GST returns are typically filed by businesses, most of these are taking the aid of technology which leads to savings of compliance cost which is potentially huge. 

From the above discussion, it is apparent that both GST and personal income tax have their own respective merits and demerits. As a result, a robust tax system requires a healthy mix comprising of both the direct and the indirect tax. Further, the current GST tax rate of 10% in Australia is lower than the applicable rate in host of other nations including the neighbour New Zealand which has already increased the GST rate to 15%. Thus, the government does have the scope of raising the GST particularly if there is assurance to the people that taxation burden would not increase as only the tax mix is to be altered by the government.  Hence, the change in the tax mix would tend to enhance the overall efficiency of the taxation system while reducing the dependence of the government on income tax which currently is quite substantial. However, it must be noticed that a balance of the two taxes has to be maintained and reducing either to very low levels would be detrimental to the objectives of a sound taxation system. 

Also, even while the government should go ahead with the change in tax mix through increasing the GST and reducing the income tax, it is also imperative that the inefficient taxes must be done away with on account of incremental collections from GST. Further, the various tax expenditures that are adversely impacting the government revenue must also be rationalised as a host of these are not well targeted or fail to achieve the desired objective.  This would ensure that the tax revenue is being judiciously utilised while ensuring that the various objectives of sound taxation system are met to the best possible extent. 

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