TAX IN PRACTICE CONVERTING FROM A TRUST TO A COMPANY

Transcription

1 TAX IN PRACTICE CONVERTING FROM A TRUST TO A COMPANY MAY 2012

2 ABOUT PRACTISING TAX Practising Tax is a specialist tax information provider. Practising Tax is a team of passionate tax professionals with diverse experience ranging from Big 4 accounting firms, top tier law firms, private practice, ATO and tax education providers. Practising Tax is unrivalled in the quality, accuracy and approachability of its product. We pride ourselves on ensuring that our clients get the most up-to-date, easy to understand and practical tax information available. CONTACT DETAILS Melbourne PO Box 6152 Hawthorn VIC 3122 Ph: (03) Fax: (03) Jenny Daborn jdaborn@practisingtax.com.au Karen Goodfellow kgoodfellow@practisingtax.com.au 2013 Practising Tax Pty Ltd. Except as permitted by the Copyright Act 1968, these materials must not be reproduced in whole or in part without the express written consent of Practising Tax Pty Ltd. These materials are intended to be used as a guide only. They should not be relied upon as a substitute for professional advice regarding actual facts or circumstances. Practising Tax Pty Ltd, its employees and agents do not accept any liability for any injury, loss or damage resulting from any person acting, or refraining to act, in reliance on all or part of these materials.

3 TABLE OF CONTENTS RESTRUCTURING FROM TRUST TO COMPANY... 1! CONSIDERING WHETHER TO TRANSFER A BUSINESS FROM TRUST TO COMPANY.. 1! TRANSFER OF A BUSINESS FROM TRUST TO COMPANY - ROLL-OVER OR SALE?... 2! CASE STUDY RESTRUCTURING FROM TRUST TO COMPANY... 4! FACTS... 4! CONSIDERATIONS... 5! IS THE BUSINESS PRE-CGT?... 5! ARE THE BASIC CONDITIONS FOR SMALL BUSINESS CGT RELIEF SATISFIED?... 5! ARE THERE EXTERNAL CIRCUMSTANCES WHICH MAY RENDER CONVERTING TO A WHOLLY-OWNED COMPANY INAPPROPRIATE OR UNACCEPTABLE?... 5! CAN THE SMALL BUSINESS 15-YEAR EXEMPTION BE ACCESSED BY THE TRUST?... 5! CAN THE SMALL BUSINESS RETIREMENT EXEMPTION BE ACCESSED BY THE TRUST?... 5! WILL A ROLL-OVER TO A WHOLLY-OWNED COMPANY OR A SALE TO A PRIVATE COMPANY PRODUCE A BETTER RESULT?... 6! SUMMARY OF INCLUSIONS IN ASSESSABLE INCOME... 11! ROLL-OVER TO WHOLLY-OWNED COMPANY BY INDIVIDUAL OR TRUSTEE... 12! INTRODUCTION... 12! OVERVIEW... 12! REQUIREMENTS TO BE SATISFIED... 14! RELEVANT CGT EVENTS... 14! CONSIDERATION RECEIVED FOR THE CGT EVENT... 14! SHAREHOLDING IN TRANSFEREE COMPANY... 18! TYPE OF ASSETS... 18! RESIDENCY REQUIREMENTS... 19! MAKING A CHOICE TO USE THE ROLL-OVER... 19! CONSEQUENCES OF APPLYING THE ROLL-OVER... 20! CONSEQUENCES FOR INDIVIDUAL OR TRUSTEE... 20! CONSEQUENCES FOR THE COMPANY ACQUIRING THE ASSET... 25! OTHER ISSUES... 27! TRANSFER OF TRADING STOCK... 27! ROLL-OVER OF DEPRECIATING ASSETS... 27! GST IMPLICATIONS OF ROLLING A BUSINESS OVER TO A COMPANY... 28! ROLLING OVER A BUSINESS FROM A TRUST WITH UNPAID PRESENT ENTITLEMENTS... 28! PROCESS TO BE FOLLOWED... 29! CASE STUDY TRUSTEE TO COMPANY ROLL-OVER... 31! FACTS... 31! SOLUTION... 34! PROCESS TO BE FOLLOWED... 34! JOURNAL ENTRIES GIVING EFFECT TO THE TRANSFER OF BUSINESS... 38! 8. BALANCE SHEETS REFLECTING TRANSFER OF BUSINESS... 40! Page i

4 BUSINESS STRUCTURES - SCENARIO... 44! BACKGROUND... 44! POSSIBLE STRUCTURING SOLUTION... 45! FINANCING ALTERNATIVE ! FINANCING ALTERNATIVE ! Page ii

5 Restructuring from trust to company CONSIDERING WHETHER TO TRANSFER A BUSINESS FROM TRUST TO COMPANY The Commissioner s views in TR 2010/3 (regarding the Div 7A consequences of declaring UPEs in favour of a family company) have significantly curtailed the benefits of carrying on a business in a discretionary trust and using a bucket company to effectively retain access to trust income while capping tax on that income at 30%. It is for this reason that, in some circumstances where a discretionary combined with a bucket company may have previously been the business structure of choice, a company may now equally, if not more effective. In such circumstances consideration may be given to whether it is appropriate to transfer an existing business from a discretionary trust to a private company. The following issues are relevant to this decision making process: the CGT consequences of transferring business assets; the income tax consequences of transferring trading stock; the balancing adjustment consequences of transferring depreciating assets; and the GST consequences of the discretionary trust making a supply of business assets to the private company. Other issues to consider include state duty payable on business transfers, and any administrative consequences of restructuring (such as transferring employees, customer agreements, equipment leases etc.). Page 1

6 TRANSFER OF A BUSINESS FROM TRUST TO COMPANY - ROLL-OVER OR SALE? When a decision has been made to transfer a business from discretionary trust to private company, consideration should be given to whether the business assets should be rolled-over (such that CGT relief is available under Subdiv 122-A) or sold to the private company (thereby triggering a capital gain which may be able to be reduced or eliminated by the small business CGT concessions in Div 152). Consideration Is the business pre-cgt? Are the following basic conditions for small business CGT relief satisfied: the trust is a small business entity or it passes the $6 million net asset test? Comment If the business is pre-cgt the same asset roll-over provided by Subdiv 122-A will ensure that the business assets retain their pre-cgt assets in the hands of the company. If the discretionary trust does not satisfy the basic conditions for the small business CGT concessions, then roll-over relief under Subdiv 122-A should be considered. the CGT assets are active assets? Can the small business 15 year exemption be accessed by the trust? Have the relevant assets been owned by the trust for at least 15 years? If the trust can access the small business 15 year exemption the capital gain will be permanently disregarded in its entirety. Has the trust had a significant individual for at least 15 years during which it owned the asset? Is a significant individual of the trust 55 or over and retiring (or permanently incapacitated)? Can the small business retirement exemption be accessed by the trust? Does the trust satisfy the significant individual test (i.e. does an individual have a 20% ʻinterestʼ in the trust just before the CGT event)? If the trust can access the small business retirement exemption its capital gain will be permanently disregarded (up to a lifetime limit of $500,000 for each CGT concession stakeholder in the trust). If all CGT concession stakeholders in the trust are under 55 years old, does the trust have access to sufficient cash to contribute capital proceeds to superannuation? Page 2

7 Consideration Are there external circumstances which may render the structuring requirements of Subdiv 122-A (in particular the requirement that the company be wholly-owned by the trust) inappropriate or unacceptable (e.g. industry regulations require the company to be completely or partially owned by individual shareholders)? Will access to the small business CGT concessions be available when the business is ultimately disposed of by the company (e.g. sold to third parties)? Does the restructure involve a transfer of depreciating assets? Comment Roll-over relief under Subdiv 122-A will not be available where the requirements are not satisfied. It follows that a sale from the trust to the private company (to which Div 152 may be applied) provides significantly greater flexibility in terms of the shareholding in the private company. This will be of greater significance where rollover under Div 122-A has been chosen. That is because the capital gain which would otherwise be taxable to the trust upon transfer to the company, is merely deferred until the business is ultimately disposed of. Balancing adjustment roll-over relief for transfer of depreciating assets will be available only if the trust is able to choose CGT roll-over relief under Subdiv 122-A. It follows that the structuring requirements of Subdiv 122-A (e.g. the requirement that the company be wholly-owned by the trust) must be satisfied in order to obtain balancing adjustment roll-over relief. Note: There is no requirement that roll-over relief under Subdiv 122-A actually be chosen. Page 3

8 Case study Restructuring from trust to company FACTS Bill and Mary Smith are a married couple. They are both 40 years of age and don t have any children. In January 2005 Bill and Mary started a furniture manufacturing business. A bank loan for $1.5 million was taken out at the time to fund the start-up costs. The loan is secured against the business and for this reason the trust has limited access to cash. The business is operated through a discretionary trust. The beneficiaries of the trust are Bill, Mary and B&M Pty Ltd. Bill and Mary are both significant individuals in the trust (i.e. they have a 20% interest in the trust). Given the Commissioner s views regarding the Div 7A consequences of declaring UPEs in favour of a family company, Bill and Mary have decided to transfer the business from the discretionary trust to a private company. Other than trading stock and depreciating assets, the business has only internally generated goodwill. The market value of the goodwill is $1,000,000. The total net asset value of CGT assets owned by the trust is $3,500,000. In order to give affect to the transfer from discretionary trust to company should the business assets: be rolled-over (such that CGT relief is available under Subdiv 122-A); or sold to the private company (thereby triggering a capital gain which may be able to be reduced or eliminated by the small business CGT concessions in Div 152)? Page 4

9 CONSIDERATIONS Is the business pre-cgt? The manufacturing business was established in 2005 and is therefore not pre-cgt. As there are no pre-cgt assets to protect there is no clear preference to use Subdiv 122-A roll-over. Are the basic conditions for small business CGT relief satisfied? The basic conditions for small business CGT relief are satisfied: the trust passes the $6 million net asset value test (total net assets $3,500,000); goodwill is an active asset. The taxpayer is therefore able to apply the concessions in Div 152 if it considers it appropriate. Are there external circumstances which may render converting to a wholly-owned company inappropriate or unacceptable? There is nothing in the facts to suggest that converting to a wholly-owned company is inappropriate or unacceptable. It follows roll-over relief in Subdiv 122-A is an acceptable option on its face. Can the small business 15-year exemption be accessed by the trust? The small business 15-year exemption cannot be accessed by the trust on the basis that, inter alia, the assets have not been owned by the trust for at least 15 years (the business was started only in 2005). Can the small business retirement exemption be accessed by the trust? The small business retirement exemption can be prima facie accessed by the trust (i.e. there is at least one significant individual in the trust). Page 5

10 However, as both Bill and Mary are under 55 years old, the trust must make a payment equal to the lesser of the exempt amount or the capital proceeds from the sale to a complying superannuation fund. As the trust does not have access to sufficient cash to contribute capital proceeds to superannuation, the trust cannot avail itself of the small business retirement exemption. Will a roll-over to a wholly-owned company or a sale to a private company produce a better result? Based on the above considerations, there is no clear justification for the trust choosing a roll-over to a wholly owned company over a sale to a private company (or vice versa). As such, consideration must be given to the comparative tax effect of each alternative. This needs to assessed both at the point the roll-over or sale occurs and also the subsequent sale of the assets in the company to a third party. Assume that, at the time of the restructure (whatever its form): the cost base of the goodwill is nil; and the market value of the goodwill is $1 million. Alternative 1 Roll-over to a wholly owned company Transfer of goodwill from trust to company The following diagram illustrates the consequences of rolling over the goodwill for both the trust and the company. Page 6

11 Note: The shares received as consideration for the disposal are non-redeemable and their market value is substantially the same as the market value of the goodwill disposed of (s (3)(a)). The capital gain made by the trust ($1 million capital proceeds - nil cost base = $1 million) from the disposal is disregarded (s (1)). The cost base of the goodwill in the hands of the company is equal to the cost base of the goodwill at the time of disposal (s (2)). Sale of goodwill to third party and cancellation of trust s shares The consequences of Bill and Mary arranging for the company to sell its assets at a time when their market value is $2 million, followed by liquidation of the company, is explored below. Company CGT event A1 Capital proceeds $2,000,000 Less cost base ($0) Capital gain $2,000,000 Less general 50 percent discount Less 50 percent reduction N/A ($1,000,000) Ultimate gain $1,000,000 Trust Liquidator s distribution (s 47) Distribution $1,700,000 Less amounts not paid out of profits Assessable distribution ($1,000,000) $700,000 Page 7

12 CGT event C2 Capital proceeds $1,700,000 Less cost base ($0) Capital gain $1,700,000 Less s reduction Less general 50 percent discount Less 50 percent reduction ($700,000) ($500,000) ($250,000) Ultimate gain $250,000 Note: Companies are not eligible for the general 50 percent discount (s ). The 50 percent CGT reduction is effectively lost on distribution to shareholders as it will be distributed as an unfranked dividend. The trust must satisfy the basic conditions for small business CGT concessions just before cancellation of the shares for the 50 percent reduction to be available (Subdiv 152-C). The shares in the company will be active provided that at least 80 percent of the market value of the company s assets (being $1,600,000) are active (s (3)). Alternative 2 Sale to a private company Transfer of goodwill from trust to company For the sake of illustration, assume that shares with a market value equal to the market value of the goodwill are received as consideration for the sale of the goodwill to the private company. The following diagram illustrates the consequences of the sale for both the trust and the company. Page 8

13 CGT event A1 happens to the trust upon the sale of the goodwill. Capital proceeds $1,000,000 Less cost base ($0) Capital gain $1,000,000 Less general 50 percent discount Less 50 percent reduction ($500,000) ($250,000) Ultimate gain $250,000 By applying the CGT roll-over, the gain of $250,000 on the disposal of the goodwill is deferred until the a change happens to the shares (e.g. the shares are sold or cancelled) (CGT event J2). Sale of goodwill to third party and cancellation of trust s shares The consequences of Bill and Mary arranging for the company to sell its assets at a time when their market value is $2 million, followed by liquidation of the company, is explored below. Page 9

14 Company: Capital proceeds $2,000,000 Less cost base ($1,000,000) Capital gain $1,000,000 Less general 50 percent discount Less 50 percent reduction N/A ($500,000) Ultimate gain $500,000 Trust: Liquidator s distribution (s 47) Distribution $1,850,000 Less amounts not paid out of profits Assessable distribution ($1,500,000) $350,000 CGT event C2 Capital proceeds $1,850,000 Less cost base ($1,000,000) Capital gain $850,000 Less s reduction Less general 50 percent discount Less 50 percent reduction ($350,000) ($250,000) ($125,000) Ultimate gain $125,000 Page 10

15 Note: The rolled-over gain will crystallise upon cancellation of the shares (CGT event J2). The trust must satisfy the basic conditions for small business CGT concessions just before cancellation of the shares for the 50 percent reduction to be available (Subdiv 152-C). The shares in the company will be active provided that at least 80 percent of the market value of the company s assets (being $1,600,000) are active (s (3)). The trust is eligible for the general 50 percent discount provided that the shares are acquired at least 12 months before they are sold (s (a)(ii)). Summary of inclusions in assessable income Transaction Entity Trust to company roll-over Sale to private company Transfer of goodwill from trust to company Sale of goodwill to third party and cancellation of trustʼs shares Trust $0 $0 Company $1,000,000 $500,000 Trust $700,000 (Franked dividend) $350,000 (Franked dividend) $250,000 (CGT event C2) $125,000 (CGT event C2) $250,000 (CGT event J2) All other things being equal, a sale from trust to company which triggers a capital gain to which the small business CGT concessions can be applied will give a better result than a Subdiv 122-A roll-over. That is because the small business 50 percent reduction is a permanent tax saving, whereas roll-over relief is merely a timing difference (as it simply defers the capital gain). Page 11

16 Roll-over to wholly-owned company by individual or trustee INTRODUCTION Subdiv 122-A provides optional roll-over relief where: an asset, or all the assets of a business, are transferred by an individual or a trustee to a wholly-owned company; or certain rights are created by an individual or a trustee in a wholly-owned company. These materials provide an overview of: the consequences of applying the optional roll-over relief; and the requirements that must be satisfied for roll-over relief to be available to the taxpayer. Overview Subdiv 122-A provides a combination of replacement asset and same asset CGT roll-over relief when an individual or trust transfers an asset or assets to a whollyowned company, as follows: Replacement asset roll-over the individual or trust replaces the transferred asset with shares in the company. Any capital gain or loss triggered by the transfer is disregarded. The cost base of the replacement shares in the hands of the individual or trust is taken to be equal to the cost base of the transferred asset or assets. Same asset roll-over the cost base of the transferred asset or assets in the hands of the wholly-owned transferee company is taken to be the cost base of the asset in the hands of the individual or trust. Page 12

17 Private company CGT asset CGT asset Shares Private company 100% Private company CGT asset Page 13

18 REQUIREMENTS TO BE SATISFIED Subdiv 122-A sets out the requirements that must be satisfied to obtain roll-over relief where assets are transferred to, or created in, a wholly-owned company. Relevant CGT events An individual or a trustee can choose to obtain roll-over relief only in respect of the following CGT events: CGT event A1 disposing of a CGT asset, or all the assets of a business 1, to the company; CGT event D1 creating contractual or other rights in the company; CGT event D2 granting an option to the company; CGT event D3 granting the company a right to income from mining; and CGT event F1 granting a lease to the company, or renew or extend a lease. Consideration received for the CGT event For roll-over relief to be available, any consideration received by the taxpayer for the CGT event happening must be only: non-redeemable shares in the company; or where there s a disposal non-redeemable shares in the company and the company undertaking to discharge one or more liabilities in respect of the asset or assets of the business. (Sections (1) and (2)) 1 An asset used partly in a business and partly for other purposes (e.g. a commercial building part of which is used as a retail outlet for the taxpayer's business and the rest is rented out by the taxpayer to two other unrelated businesses) is an asset of the business for the purpose of the roll-over (ATO ID 2005/218). Page 14

19 Warning: In the Commissioner s view there is no requirement that consideration be actually received by the transferor entity i.e there is no requirement that shares in the transferee company be issued or transferred to the transferor provided that the transferor own all the shares in the company just after the CGT event (ATO ID 2004/94). It follows that roll-over relief will be available where the transferor disposes of an asset to a company in which they own all of the issued shares and are not issued with any new shares or paid any other form of consideration by the company. Where this happens the special rules for determining the cost base of the transferor s shares in the transferee company (outlined below) will not apply. Receiving shares as consideration Shares received as consideration for the CGT event happening (either by way of issue or transfer 2 ) must satisfy the following requirements: the shares must be non-redeemable; and their market value must be substantially the same as the following: Circumstances Market value of shares issued Disposal Market value of shares issued must be substantially the same as the market value of the asset or assets disposed of, less any liabilities assumed by the company in respect of the asset or assets (s (3)(a)). Where market value is different to what it would otherwise be only because of contingent liabilities attaching to the asset or assets, the difference is ignored (s (4)). Creation Market value of shares issued must be substantially the same as the market value of the CGT asset created (s (3)(b)). 2 ATO ID 2004/95 (withdrawn) Page 15

20 Assumption of liabilities Roll-over relief will be available, where a company undertakes to discharge a liability in respect of an asset, only if the liability satisfies the following conditions: the liability must be in respect of transferred assets; 3 the amount of the liability must not exceed the maximum amount outlined in the following table (s (1)(b)): 3 The requirement that shares received as consideration for the transfer of assets have a market value which takes into account only liabilities in respect of the asset or assets transferred, effectively means that roll-over will not be available if the transferee company assumes any liabilities which do not relate to the asset or assets transferred. Page 16

21 Type of roll-over Nature of asset Liability cannot exceed Trust disposes of a CGT asset to company Trust disposes of all the assets of a business to company Post-CGT asset Pre-CGT asset All assets are post-cgt All assets are pre-cgt Some assets are post-cgt and some are pre-cgt Assetʼs cost base Assetʼs market value Sum of: market value of trading stock market value of depreciating assets cost base of other assets Sum of market value of all assets For liabilities in respect of post-cgt assets, sum of: market value of trading stock market value of depreciating assets cost base of other assets For liabilities in respect of pre-cgt assets, sum of market value of all assets In order to determine whether a particular liability satisfies these requirements it may be necessary to determine which assets that liability is in respect of (if any). The following rules in s must be used in order to do this: a liability incurred for the purposes of a business that is not a liability in respect of a specific asset or assets is taken to be a liability in respect of all assets (e.g. a bank overdraft); and if a liability is in respect of two or more assets, it is taken to be in respect of each asset in proportion to their market value. Page 17

22 Shareholding in transferee company The taxpayer must own all the shares in the transferee company just after the CGT event (s (1)). The following points should be noted in this regard: Where the transferor is a trust with joint trustees, all the shares in the transferee company must be jointly owned by the trustees (ATO ID 2004/8). No roll-over is available where the asset to be rolled-over is jointly owned by two or more people. That is because the requirement that all shares in the company are owned by the transferor cannot be satisfied. This is so notwithstanding that the shares acquired in exchange for the asset rolled-over may be held in the same proportions as the taxpayers held interests in the asset (ATO ID 2002/172 (withdrawn)). 4 Shares in the transferee company must be owned by the taxpayer in the same capacity as it owned the transferred assets just before the transfer (s (1)). For example, if the taxpayer was a trustee who owned the transferred assets on trust, the shares must also be held on trust (presumably the same trust) 5 Warning! Roll-over relief will not be available where the ordinary and statutory income of the company is tax-exempt for the income year of the CGT event (s (5)). Type of assets Roll-over relief is not available for the following types of assets: collectables; personal use assets; decorations awarded for valour or brave conduct; and assets that become trading stock of the company just after the disposal or the creation of the asset (unless the asset was the taxpayer s trading stock at the time of disposal). (Section (2)) 4 Roll-over may be available if each owner rolled over their interest to a separate company in which they owned all of the shares. 5 Section 160ZZN(4)(c) (the 1936 Act equivalent of subdiv 122-A) requires that the shares be held on the same trust. The Explanatory Memorandum to Taxation Laws Improvement Act (No. 1) 1998 (which introduced Subdiv 122-A) suggests that the rewritten provision does not explicitly refer to a requirement that the shares be held on the same trust because a different trust would be a different entity in accordance with the definition of 'entity' in s , so that roll-over relief would not be available in any event. Page 18

23 Further, depreciating assets and trading stock cannot be rolled over unless they are part of the disposal of all the assets of a business (i.e. depreciating assets and trading stock cannot be rolled over individually) (s (2)). Residency requirements For roll-over relief to be available, the individual or trustee and the company must be residents at the time of the CGT event (ss (6)(a) and (7)(a)). Special rules apply where the individual, trust or company is a non-resident for tax purposes (s (6)(b)). Making a choice to use the roll-over The choice must be made by the day the taxpayer lodges the tax return for the income year in which the CGT event to which roll-over relief is to apply happened, or within such further time as the Commissioner allows (s (1)). The choice to use roll-over relief is evidenced by the way in which the income tax return of the taxpayer is prepared (s (2)). Page 19

24 CONSEQUENCES OF APPLYING THE ROLL-OVER There are consequences for both the individual or trustee and the company in applying the roll-over. Consequences for individual or trustee If a taxpayer chooses to take advantage of roll-over relief in relation to the disposal or creation of an asset, any capital gain or loss the taxpayer makes from the disposal or creation is disregarded (ss (1), (1), (1)). The roll-over is a replacement asset roll-over because the asset being disposed of or created is being replaced by shares in the company. In this context, roll-over relief effectively operates to defer the tax which would otherwise be payable on the disposal or creation of an asset, to the disposal of the shares in the company (the shares being the replacement assets). The cost base (and reduced cost) of each share received as consideration for the disposal or creation will depend on whether the assets being rolled-over are: pre-cgt assets; post-cgt assets; or a combination of pre-cgt assets and post CGT assets. Note: Where the transferor disposes of an asset to a company in which they own all of the issued shares and are not issued with any new shares or paid any other form of consideration by the company, the special rules for determining the cost base of the transferor s shares in the transferee company (outlined below) will not apply (ATO ID 2004/94). Cost base of shares if all assets are pre-cgt assets Where all the assets that are being rolled-over are pre-cgt assets, the shares in the company are also taken to be pre-cgt assets (s ). Page 20

25 An exception to this rule is where any of the assets being disposed of are depreciating assets or trading stock (s (2)). In that case, the percentage of shares that are taken to be pre-cgt assets is as follows: Market value of assets excl. depreciating assets and trading stock - liabilities assumed Market value of all assets - liabilities assumed (Section (2)) The remaining shares that are not pre-cgt assets are taken to be post CGT-asset. The cost base (and reduced cost) of each of those post-cgt shares is calculated as follows: Market value of depreciating assets and trading stock - liabilities assumed Number of post - CGT shares (Section (3)) Note: The market value is to be determined by reference to the market value at the time of the disposal (s (4)). Page 21

26 Practising Tax methodology The following methodology can be used to determine the cost base of each share received as consideration where all the assets being rolled-over are pre-cgt assets. Step 1: Step 2: Step 3: Step 4: Determine whether any of the assets being disposed of are depreciating assets and/or trading stock. If ʻyesʼ, go to Step 2. If ʻnoʼ, the shares in the company are taken to be pre-cgt assets and any capital gain or loss from the disposal of the shares is disregarded. Determine the market value of all assets being rolled-over that are not depreciating assets and/or trading stock (less any liabilities the company assumes in respect of those assets). Determine the market value of depreciating assets and/or trading stock being rolled-over (less any liabilities the company assumes in respect of those assets). Calculate the percentage of shares taken to be pre-cgt assets using the following formula: Step 5: Calculate the number of post-cgt shares using the following formula: Step 6: Calculate the cost base of each post-cgt share using the following formula: Market value of depreciating assets and trading stock - liabilities assumed Number of post - CGT shares Page 22

27 Cost base of shares if all assets are post-cgt assets Where all assets being rolled-over are post-cgt assets, the first element of the cost base (and reduced cost base) of each share received by the taxpayer is calculated as follows: Circumstances Disposal Cost base (reduced cost base) of each share Asset's cost base or reduced cost base - Amount of liabilities assumed Number of shares (Sections (2), (1)) NOTE: If the assets of the business being rolled-over include depreciating assets and/or trading stock, the cost base of each share must also include the market value of such assets (s (1)(a)). Creation (Section (2)) Practising Tax methodology The following methodology can be used to determine the cost base of each share received as consideration where all the assets being rolled-over are post-cgt assets. Step 1: Are post-cgt assets being disposed of? If ʻyesʼ, go to Step 2 If ʻnoʼ, go to Step 4. Step 2: Step 3: Determine the market value of any depreciating assets and trading stock being rolled-over. Determine the cost base of all assets being rolled-over that are not depreciating assets and/or trading stock. Page 23

28 Step 4: Step 5: Determine the amount of liabilities the company undertakes to discharge in respect of assets being transferred. Calculate the cost base (or reduced cost base) of each share received using the following formula: Step 6: Where an asset is created, calculate the cost base of each share received using the following formula: Cost base of shares if assets are a combination of pre-cgt assets and post-cgt assets The number of shares that are taken to be pre-cgt assets will be limited where the business assets that are being rolled-over are a combination of pre-cgt assets and post-cgt assets (s ). In those circumstances, the percentage of shares that are taken to be pre-cgt assets is calculated as follows: Market value of pre- CGT assets excl. depreciating assets and trading stock - liabilities assumed Market value of all assets - liabilities assumed (Section (1) The remaining shares that are not pre-cgt assets are taken to be post-cgt assets. The cost base (and reduced cost) of each of those post-cgt shares is calculated as follows: Market value of depreciating assets and trading stock + cost base or reduced cost base of post -CGT assets - liabilities assumed Number of post - CGT shares (Section (2)) Note: The market value and cost base are both to be determined by reference to the market value and cost base at the time of the disposal (s (4)). Page 24

29 Practising Tax methodology The following methodology can be used to determine the cost base of each share received as consideration where the assets rolled-over are a combination of pre- CGT assets and post-cgt assets. Step 1: Determine the market value of pre-cgt assets excluding any depreciating assets or trading stock that are being rolled-over. Step 2: Step 3: Determine the market value of all assets being rolled-over. Calculate the percentage of shares that are taken to be pre-cgt assets using the following formula: Step 4: Calculate the number of post-cgt shares using the following formula: Total number of shares - (Percentage of pre - CGT shares x Total number of shares) Step 5: Step 6: Determine the market value of any depreciating assets and trading stock being roll-over. Calculate the cost base (or reduced cost base) of each post-cgt share using the following formula: Consequences for the company acquiring the asset Where a taxpayer chooses to take advantage of roll-over relief in relation to the disposal or creation of assets in a wholly-owned company, there are CGT consequences for the company acquiring those assets (ss , ). The cost base (or reduced cost base) of the acquired asset in the hands of the company is determined as follows: Page 25

30 Circumstances Cost base (or reduced cost base) of asset Asset disposed of by the individual or trustee Post-CGT asset assetʼs cost base (or reduced cost base) at the time of the disposal (s (2)). Pre-CGT asset capital gain or loss is disregarded (s (3), Div 104)). Asset created by the individual or trustee Expenditure incurred by the individual or trustee in creating the asset Page 26

31 OTHER ISSUES Transfer of trading stock The transfer of trading stock to a wholly-owned company does not attract any rollover relief. The transfer will be treated as a disposal of trading stock outside the ordinary course of business such that the assessable income of the transferor includes the market value of the stock on the date of the transfer (s 70-90). Roll-over of depreciating assets Balancing adjustment roll-over relief applies automatically in circumstances where CGT roll-over relief for transfers to a wholly-owned company is available. Note: While automatic balancing adjustment roll-over relief requires CGT roll-over to be available in the circumstances, there is no requirement for the taxpayer to have elected for CGT roll-over relief to apply. Balancing adjustment roll-over relief has the following consequences: any balancing adjustment that would otherwise be included in the transferor s assessable income or be an allowable deduction is disregarded (s (1)); and the wholly-owned company can claim deductions for the asset s decline in value as if there had been no change in ownership. In doing so, the transferee company can deduct the decline in value of the asset using: the same method that the transferor was using; and the same effective life (or remaining effective life 6 if the relevant method is the prime cost method) that the transferor was using. (Section (2)) The first element of cost of the depreciating asset for the transferee company is the adjustable value of the asset just before the balancing adjustment event occurred (s (2) Item 6). 6 Remaining effective life for these purposes is any period of an asset s effective life which is yet to elapse as at the time of the balancing adjustment event (s 40-75(4)(b)). Page 27

32 GST implications of rolling a business over to a company The transfer of business assets to a wholly-owned company will be a prima facie taxable supply for GST purposes (on the assumption that the transferor is registered for GST). However, the supply may be GST-free if it is the supply of a going concern (s ). In order to ensure that no GST is payable on the transfer it is important to ensure that the following steps are taken: the transferee company is registered for GST; the transferor and the company have agreed in writing that the supply is of a going concern; and the transferor supplies to the company all of the things that are necessary for the continued operation of the business. 7 In the event that the asset transfer does not involve all things necessary for the continued operation of the business, the transferor will be required to remit GST equal to 1/11 th of the consideration received for the transfer (i.e. 1/11 th of the market value of the shares issued to the transferor). The company should be entitled to a credit for this amount. Rolling over a business from a trust with unpaid present entitlements When rolling over a business from a trust to a wholly-owned company it may be necessary to deal with UPEs owing from the trust to a corporate beneficiary. Where the UPE (which does not constitute an actual loan from the company to the trust) arose prior to, and has been frozen as at, 16 December 2009 (being the date of issue of the Commissioner s preliminary views in TR 2009/D8 regarding the Div 7A consequences of trust entitlements) there appears to be no adverse consequences of leaving the UPE outstanding in the transferee trust. For other UPEs, consider converting them into an actual loan from the company to the trust. The wholly-owned company can then undertake to discharge this liability as part of the roll-over, on the basis that it is a liability which relates to all of the assets of the business. 8 There will presumably be no Div 7A consequences of doing so because the loan will be from one private company to another (s 109K). 7 Refer to GSTR 2002/5 for the Commissioner s views on the circumstances in which a supply of a going concern is GST-free. 8 Take care to ensure that the assumption of this liability by the wholly-owned company does not result in the total liabilities assumed by the company exceeding the maximum outlined in s , otherwise access to CGT roll-over will be jeopardised. Page 28

33 PROCESS TO BE FOLLOWED 1. Identify/incorporate transferee company. Note: An existing company wholly-owned by the transferor entity may be a suitable transferee company. Note: A corporate beneficiary of the trust will not be a suitable transferee company unless its shares are wholly-owned by the trustee of the trust. Note: The trustee company will not be a suitable transferee company because it cannot be wholly-owned by itself. 2. Where required, transfer/issue shares to transferor individual/trustee (so that all shares are owned by the transferor entity). Note: There is no requirement that shares be issued or transferred, provided that all shares in the transferee company are owned by the taxpayer just after the transfer. 3. Transfer assets of the business to the transferee company Note: There is no requirement to transfer all assets of the business to the transferee company. It may be appropriate in some circumstances (for tax and/or commercial reasons) to leave some assets behind in the transferor entity:! As there is no roll-over relief for transfer of trading stock 9 it may be considered appropriate to leave inventory in the transferor entity.! If there is a risk of debts going bad, consider having debtors retained by the transferor entity, on the basis that the transferee company will not be entitled to a deduction if and when the debt goes bad because it will not have included the debt in its assessable income when it was raised (as required by s 25-35). 4. Transfer liabilities as considered appropriate Note: Where shares are received in consideration for the transfer of assets, liabilities which do not relate to the asset or assets transferred cannot be assumed by the company. Where a liability relates partially to a transferred asset, and partially to another asset, it must be apportioned in accordance with the market value of those assets. 9 There is no roll-over relief available for the transfer of trading stock. The assessable income of the individual or trustee taxpayer will include the market value of the stock on the date of transfer (s 70-90). Page 29

34 Note: There is no requirement to transfer liabilities of the business to the transferee company i.e. such liabilities can remain with the transferor if desired. Note: Where such liabilities are transferred, they cannot exceed the sum of the market values of trading stock and depreciating assets and the cost bases of other assets (or market value if those assets are pre- CGT) Determine the cost base of the transferorʼs shares in the company received as consideration for transfer of the business assets. Note: Where no shares are received by the transferor (i.e. where an existing company owned by the transferor is used as the transferee company) the cost base of those shares remains unchanged. 6. Determine the cost base of the transferred business assets in the hands of the company. 10 Where one or more of the business assets are pre-cgt, liabilities transferred in respect of those assets cannot exceed the sum of the market values of those assets. Page 30

35 Case study Trustee to company rollover FACTS The ABC Discretionary Trust is an Australian resident trust which operates a chain of beauty salons. For various reasons, the trust is now looking into transferring the business into a newly incorporated company. The company will be incorporated in Australia. On the basis that the trust otherwise satisfies the requirements for CGT roll-over relief under Subdiv 122-A, the trust would like to know what is practically required to give affect to the roll-over. The balance sheet of the trust is documented below: Page 31

36 Page 32

37 The relevant cost bases and market values of the assets are as follows: The building is ineligible for capital works deduction under Div 43. The notes to the accounts also indicate that there are accrued employee leave entitlements (contingent liabilities) with a market value of $185,000. Page 33

38 SOLUTION Process to be followed 1. Identify/incorporate transferee company As an existing wholly-owned company does not exist, the trust will need to incorporate a transferee company. This company must apply for a new ABN and TFN, and register for GST where appropriate. 2. Transfer assets of the business to the transferee company The trust needs to decide which assets to transfer to the transferee company. As it is the intention of the trust to transfer the entire business to the transferee company, all assets except receivables (for reasons explained below) will need to be transferred. Note: There is no requirement under Subdiv 122-A to transfer all assets of the business to the transferee company to qualify for roll-over relief. It is simply a matter for commercial judgement. Assets Cash assets Being transferred? Yes Comments Receivables No Generally speaking, for bad debts to be deductible the debt must have been included in the taxpayerʼs assessable income (s 25-35(1)(a)). Accordingly, a bad debt deduction will not be available if the receivables are transferred to a company, on the basis that the company has not included the debt in their assessable income (i.e. the debt has been included in the assessable income of the trust and therefore the deduction belongs to the trust). Page 34

39 Assets Being transferred? Comments Inventory Yes There is no roll-over relief for transfer of trading stock. The assessable income of the trustee will include the market value of the stock on the date of transfer (s 70-90). On that basis, the trustee may choose whether to: transfer all trading stock to the transferee company at the time of restructure; transfer the trading as required by the business (thereby deferring the inclusion in assessable income); or leave the trading stock in the trust. For the purposes of this illustration, it is assumed that all the inventory is transferred to the company at the time of restructure. Prepayments Property, plant and equipment Goodwill Yes Yes Yes Note: Transfer of trading stock will generate $28,930 profit on sale. The company will record the acquisition of the trading stock for market value to reflect the profit paid by the trust. The facts make it clear the building is ineligible for a capital works deduction under Div 43. However, in the event that the building was eligible for capital works deductions, the trust would make a profit on sale to the company which would result in an increase in the unpaid entitlements balance of the corporate beneficiary (e.g. if the building had a cost base of $300,000 and a cumulative capital works deduction of $17,630 had been claimed, a profit of $17,630 will be included in the trust s distributable income). 3. Transfer liabilities as considered appropriate A decision needs to be made regarding which liabilities to assign to the transferee company. In making this decision regard must be had to: the rule that the liabilities being transferred must be in respect of the assets being transferred; and the requirement that the relevant liability cannot exceed the cost base of the asset to which it relates (or market value if the relevant asset is trading stock or a depreciating asset). Page 35

40 Liability Does amount relate to assets being transferred? Is the liability being transferred? Amount of the liability Does the liability exceed MV or CB? Trade creditors Inventory $95,200 (MV) Yes $55,000 No PAYG withholding payable No N/A N/A N/A Tax payable No N/A N/A N/A Trust entitlements 11 (pre-16/12/09) No N/A N/A N/A Bank loan Building Bank loan Plant and equipment Building $282,370 (CB) Plant and equipment $660,970 (MV) Yes $225,600 No Yes $458,660 No TOTAL $739,260 Important! As cash assets are being transferred to the transferee company, PAYG withholding payable ($21,110) and tax payable ($82,400) should be extinguished prior to transferring the cash assets. On that basis, the cash assets will be reduced to $802,940 ($906,450-$21,110-$82,400) prior to the restructure. As the trust entitlements have been quarantined as at 16 December 2009, there appear to be no adverse consequences to leaving them outstanding in the trust. 11 Not strictly a liability. Page 36

41 4. Where required, transfer/issue shares to trustee For roll-over relief to be available, the consideration received by the taxpayer must be only non-redeemable shares in the company and the company s undertaking to discharge liabilities in respect of the transferred assets of the business. The general rule is that the market value of the shares received as consideration for the transfer must be substantially the same as the market value of the transferred business assets, less any liabilities assumed by the company (s (3)(a)). The exception to this rule is where the difference is due to the possibility of liabilities attaching to the transferred assets i.e. contingent liabilities (e.g. accrued leave entitlements). In that case the market value of the shares can reflect those contingent liabilities without breaching the requirement that the market value of the shares be substantially the same as the market value of the transferred assets. The notes to the financial accounts indicate that there are accrued employee leave entitlements with a market value of $185,000. The market value of the transferred assets, less the liabilities assumed is as follows: It follows that the market value of the shares is approximately $1,880,950 ($2,065, ,000). The market value of each share is therefore $ Determine the cost base of the trust s shares in the company received as consideration As all the assets of the business are post-cgt asset, the cost base of each share can be calculated in accordance with the practising tax methodology for the disposal of post-cgt assets. Page 37

42 Step 1: Step 2: Step 3: Post-CGT assets being disposed of The market value of depreciating assets and trading stock being rolled-over is $756,170 (660, ,200) The cost base of the assets being rolled-over (cash, prepayments, building, goodwill) is $1,558,410 ($802, , , ,000) Step 4: The amount of the liabilities being assumed (trade creditors, bank loan building, bank loan P&E) is $739,260 (55, , ,660) Step 5: Cost base of each share received using the following formula: $756,170 + $1,558,410 - $739,260 1,000,000 = $1.58 Step 6: N/A 6. Determine the cost base of the transferred business assets in the hands of the company The cost base of the transferred business assets in the hands of the company is the assets cost base at the time of the disposal (s (2)). Transferred CGT assets Cost base at the time of disposal Cost in the hands of the company Cash assets $802,940 $802,940 Inventory $16,100 $16,100 Building $282,370 $282,370 Goodwill $457,000 $457,000 Journal entries giving effect to the transfer of business The transfer of the business assets (and their associated liabilities) is reflected in the accounts as follows: ABC Discretionary Trust Payment of liabilities not being transferred (excl. trust entitlements): Page 38