If you own multiple properties or are looking to transfer a property to a trust , read on as Eddie Chung explains the latest ruling on these issues and how it may affect you.
There have been a number of common law cases that have gone through the courts recently, which may affect property owners and their arrangements. As case law constitutes binding legal precedents, it will be helpful if you are aware of some of these decisions in case they apply to your situation.
1. Is my property an ‘active asset’ under the small business capital gains tax (CGT) concessions?
There is a difference between holding a property as a passive investment as opposed to carrying on a business leasing properties. Under the small business CGT concessions, if your properties qualify as ‘active assets’, rather than passive investments, you may be eligible for the small business CGT concessions (which include the 15-year exemption, active asset 50% reduction, retirement exemption, and small business roll-over), which are in addition to the 50% CGT discount. These concessions can be very powerful and may have the effect of substantially reducing your CGT liability on the sale of your property or even eliminating the tax liability altogether.
In the case Jakjoy Pty Ltd v FCT, the taxpayer owned multiple commercial investment properties and argued that as the directors and shareholders of the taxpayer (which is a company) had spent considerable time each week looking after the leasing of its properties (including meeting with tenants, inspecting properties, negotiating leases, undertaking repairs and maintenance of the property, etc), it was carrying on a leasing business and the properties should therefore be treated as ‘active assets’ for the purposes of the small business CGT concessions.
The case went before the Administrative Appeals Tribunal (AAT), which found that the properties were not active assets. The AAT ruled that in determining whether a property is an ‘active asset’ for the purposes of the small business CGT concessions, the law requires one to examine how the property is put to use, rather than determine the nature of the taxpayer’s business. In other words, even if the taxpayer was carrying on a property leasing business, the fact that the properties were rented out to derive passive rental income meant that they were not capable of being ‘active assets’.
For completeness, this case serves as a timely reminder that just because you are holding multiple properties does not necessarily mean that you are carrying on a property leasing business. To argue that you are carrying on a property leasing business, you need to be able to demonstrate that the properties are not simply generating rental income in their own right but significant peripheral work is required to be done to derive the income of the business.
Other general factors that suggest the existence of a business should also be present, eg, the leasing activities and operations are conducted in a systematic and business-like manner, a business plan is in place, etc. In many ways, being able to say that investing in multiple properties constitutes a property leasing business is more of an exception than the norm.
2. Am I eligible for the 50% CGT discount if I transfer a property from my name to my trust?
This case, Healey v FCT, did not involve the transfer of property per se but the legal principle may very well extend to the transfer of property. Generally, if you sign a contract to transfer a property, the contract date is the relevant date of the disposal for CGT purposes under ‘CGT event A1’, which applies to a simple disposal of a CGT asset. Having said that, multiple CGT events may sometimes apply to a single transaction. In these cases, the law specifically says that the CGT event that is more specific to the transaction will be the one that applies.
In this case, a company transferred some shares to a related trust. The shares were transferred by way of a standard transfer form, which was dated 1 May 2004. For whatever reason, the shares were not actually transferred to the trust until 9 December 2005. Meanwhile, the trust entered into contract to sell the shares on 2 November 2005 (which was before the trust actually acquired the shares) and the shares were physically transferred to the purchaser on 31 January 2006.
The trust applied the 50% CGT discount on the sale of the shares on the basis that it acquired the shares back on 1 May 2004 and by the time the shares were sold on 2 November 2005, it had held the shares for at LAWleast 12 months. The Commissioner of Taxation challenged the trust’s eligibility for the 50% CGT discount on the share sale.
The Federal Court ruled in favour of the Commissioner on the basis that the relevant CGT event for the original share transfer to the trust was CGT event E2, rather than CGT event A1, due to the fact that the former was more specific to the circumstance in question.
Specifically, the law states that CGT event E2 happens if “you transfer a CGT asset to an existing trust”. Under CGT event E2, the timing of acquisition of the CGT asset by the transferee is the time when the asset is transferred, rather than the date of contract.
Further, the Federal Court noted that the word ‘transfer’ should not be construed narrowly, which means actions such as a sale or a gift would constitute a transfer.
Applying CGT event E2 to the case, the original transfer of the shares to the trust in question only happened when the shares were physically transferred, which was on 9 December 2005. As the shares were sold by the trust under CGT event A1 on 2 November 2005, the trust had not held the shares for at least 12 months (or not even a single day!) and therefore did not qualify for the 50% CGT discount.
The moral behind the story is – if a trust is disposing, say, a property, you should check the actual date on which the property was originally transferred to the trust (ie, count from the settlement date, rather than the contract date) to determine if the trust has held the property for at least 12 months. If the trust does not satisfy the ‘12 month rule’, it may be prudent to obtain a private ruling from the Commissioner of Taxation beforehand to determine the acquisition time of the property before applying the 50% CGT discount in respect of the sale.
3 Is it safe to buy a property under the GST-free supply of a going concern?
Under the GST law, if a seller sells a property to a purchaser under a GST-free supply of a going concern, the seller will not have any GST liability on the sale. However, if the purchaser intends that “the supplies made through the enterprise to which the supply relates will be supplies that are neither taxable supplies nor GST-free supplies”, the purchaser will have an increasing adjustment for GST purposes and become liable to GST on one-tenth of the contract price.
By way of an example, if a seller sells a property to a purchaser for $500,000 and the parties agree in writing to apply the GST-free supply of a going concern exemption, the purchaser will have an increasing adjustment of 1/10 x $500,000 = $50,000 if the purchaser intends that the supplies made through the enterprise to which the property sale relates will neither be taxable supplies nor GST-free supplies. However, the determination of such an intention is far from straightforward as demonstrated in the case MBI Properties v FCT.
In this case, the taxpayer purchased three apartments from the seller under a GST-free supply of a going concern. The apartments were subject to leases that were previously granted to a lessee, who agreed to operate a scheme under which the relevant apartment was to be used as part of an enterprise of supplying serviced apartments. Each contract of sale allowed the purchaser to participate in the scheme by specific election.
It was accepted that the apartments were not commercial residential premises in the hands of either the seller or the purchaser, ie, the supply of the apartments by the seller or the purchaser were input taxed supplies of residential premises that were neither taxable supplies nor GST-free supplies. However, the supply of the apartments by the lessee to guests as part of its enterprise of supplying serviced apartments was a supply of commercial residential premises, which was a taxable supply.
The Commissioner of Taxation tried to argue that, in concluding whether the purchaser had intended that the supplies made through the enterprise to which the property sale related would neither be taxable supplies nor GST-free supplies, all that was required was that the purchaser 5927objectively intended that the supplies made through the lessee’s enterprise of supplying serviced apartments (which was related to the property sale) would neither be taxable supplies or GST-free supplies after settlement. This would have been the case as the supply of the apartments was input taxed from the perspective of the purchaser.
In contrast, the purchaser argued that their intention of whether to continue supplying the apartments as part of the lessee’s enterprise of supplying serviced apartment had no relevance; rather, it was the purchaser’s intention in respect of their own activities that was relevant.
In other words, the Federal Court was required to decide whose intention was relevant when determining if an increasing adjustment would apply. In the first instance, the Federal Court sided with the Commissioner.
The Full Federal Court subsequently reversed the Federal Court’s decision and found in favour of the taxpayer due to the following rationale:
1. Neither the purchaser nor the seller of the apartments made any new or continuing supplies to the tenant following the sale of the apartments – given that the seller had already made the supplies to the lessee under the leases when they were originally granted, the purchaser could not intend to make any input taxed supplies at settlement; accordingly, the increasing adjustment provisions could not apply to the purchaser; and
2. The increasing adjustment would only apply in respect of the intended supplies to be made by the purchaser itself – the supplies that were intended to be made under the enterprise to which the property sale related (ie, the lessee’s enterprise of supplying serviced apartments) had no relevance, irrespective of whether such supplies were to be made by the seller or any other party.
While the Full Federal Court decision appears to be a win for the taxpayer, the decision may have inadvertently thrown a spanner in the works. According to the decision, once a lease is granted, the supply does not continue for the term of the lease, which is contrary to the previous understanding that a lease is a continuing, progressive, or periodic supply. By extension of logic, the case has now created a number of uncertainties:
(i) Would the seller have an ongoing GST liability in respect of the grant of the lease throughout the lease period, even after the property is sold (notwithstanding that the answer to this question is ‘no’ according to the Commissioner’s own determination in GSTD 2012/2)?
(ii ) Would the purchaser be liable to GST at all in respect of any leases that were assigned to it after settlement? What if the purchaser renews or renegotiates the lease?
(iii) If a purchaser previously acquired a residential property under a GST-free supply of a going concern and had paid GST due under an increasing adjustment, should the purchaser now seek a refund of the GST paid if the relevant Business Activity Statement may still be amended under the allowed amendment period?
Perhaps the biggest uncertainty in all of this is whether a purchaser of residential premises should agree with the seller that the supply of a property would be subject to the GST-free supply of a going concern. Given the uncertainties stirred up by this case, the conservative approach, from the purchaser’s perspective, may simply be not to agree for the GST-free supply of a going concern to apply until the law becomes more certain in this area.
Eddie Chung is partner, tax & advisory, property & construction, at BDO (Qld) Pty Ltd. Contact firstname.lastname@example.org or call (07) 3237 5927objectively
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional. The article is provided for general information only and the author and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.
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