Tax Brief. 5 April A Bet Each Way. Facts. Sherlinc Enterprises Pty Ltd v FCT (2004) AATA 113

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1 Tax Brief 5 April 2004 A Bet Each Way Sherlinc Enterprises Pty Ltd v FCT (2004) AATA 113 The AAT has found that a purported choice to apply the now repealed replacement asset rollover under Div 123 was not a choice for the purposes of the Income Tax Assessment Act 1997 ( the Act ). As a result, the AAT have held that the applicant was not precluded from applying the former 50% goodwill exemption concession under the repealed s Facts The applicant was the trustee (and a beneficiary) of a Family Trust ( the trust ) which carried on a business. In the 1998/1999 income year the applicant sold the business and realised a capital gain on goodwill ( the capital gain ). The amount of the capital gain was $165,605. On 5 June 2000 the applicant lodged the trust s 1998/1999 income tax return. The trust return disclosed nil net capital gains and a capital gains tax small business net roll-over amount of $165,605, being the full amount of the capital gain. In 2001, the applicant, by letter to the Commissioner, requested an amended assessment for the 1998/99 year, stating that the trustee has elected to distribute this capital gain to Sherlinc Enterprises Pty Ltd, since the two year time limit to acquire a replacement asset under the small business replacement asset rollover which was previously elected, had expired. On the basis of this request, the Commissioner issued an amended assessment to the applicant for the year ended 30 June 1999, which assessed the beneficiary on the whole of the capital gain. The amended assessment also imposed additional tax penalties for understatement of income and for interest which were later remitted. The applicant subsequently objected to the amended assessment on the ground that only 50% of the capital gain should have been included in the applicant s

2 taxable income for the purposes of the amended assessment because the trust was entitled to a 50% goodwill exemption pursuant to s of the Act. Relevant Law In the 1998/99 year, s (1) of the Act provided that in certain circumstances, if the ownership of the business of an entity changed, and the entity made a capital gain attributable to the goodwill of the business, half of the capital gain is disregarded. However, s of the Act created an exception to the partial goodwill exemption, stating that the exemption does not apply, and is taken never to have applied, to the goodwill if the entity makes a choice for the goodwill under Division 123 (about roll-overs for the assets of small businesses). Division 123 allowed a replacement asset rollover where, inter alia, a replacement asset is acquired within two years of the CGT event which created the capital gain. The section stated: You can choose to obtain a roll-over if: a CGT event (the trigger event) happens in an income year (the roll-over year) in relation to one or more CGT assets (the original asset) that you own; and the original asset satisfies the requirements set out in section ; and the trigger event would have resulted (apart from the roll-over) in you making a *capital gain (the notional capital gain); and you would have a *net capital gain for the roll-over year (apart from the rollover); and the maximum net asset value requirements set out in section are satisfied; and not later than 2 years after the last trigger event during the roll-over year for which you choose a small business roll-over, you choose one or more CGT assets as replacements (the replacement asset), and the replacement asset satisfies the requirements set out in section ; and you did not choose to disregard all or part of the capital gain from the trigger event under Subdivision 118-F. Issue The principal issue decided by the Tribunal was whether the initial purported election to apply the replacement asset rollover in the first income tax return for 2 A Bet Each Way

3 the 1998/1999 year, amounted to a choice to apply this rollover for the purposes of s , and therefore, precluded the applicant from later applying the s goodwill exemption in substitution for the replacement asset rollover via an amended assessment, in circumstances where the requirements for the replacement asset rollover had not been satisfied. Applicant s Submission The applicant contended that it was precluded from making the relevant choice to apply Division 123, until it had chosen a replacement asset. In particular, the applicant submitted that it had, at no stage, satisfied the requirements of paragraphs (f) and (g) of s because it did not choose a relevant replacement asset for the sale of the business. In addition, the applicant submitted that s (3)(b) supported this construction. Section (3)(b) provided an exception to the general rule that a choice is made for CGT purposes, by the manner in which tax returns are lodged, for the choice required to be made to apply the Div 123 rollover. Under s (3)(b), a taxpayer was allowed up to two years to make the choice of replacement assets. The applicant contended that a taxpayer could only choose a small business asset roll-over once a replacement asset had been acquired, hence the exception to the general rule about choices to accommodate those instances where the replacement asset was acquired after the date for lodging the return for the income year in which the relevant CGT event happened. Commissioner s Submission The respondent contested the applicant s interpretation of ss and (3) of the Act. The respondent submitted that the applicant could, and did, make a choice for the goodwill under Division 123 of the Act in the trust return because s (f) did not operate to preclude the applicant from choosing the roll-over before it had chosen a replacement asset. Paragraph (f), in the respondent s submission, enabled the applicant to choose a replacement asset over a 2 year period without losing the deferral concession of the chosen rollover. The respondent further submitted that by force of s1-3 of the Act, Division 123 should be interpreted as having the same meaning as the old law in Division 17A of the 1936 Act. Division 123 was a rewrite of Division 17A of the Income Tax Assessment Act 1936 ( the 1936 Act ) which had the effect that if a taxpayer did not nominate a replacement asset in respect of a net roll-over amount within the relevant time limit of two years, a capital gain equal to that amount accrued to the taxpayer for the year of income in which the disposal occurred. Under Division 17A, a taxpayer would only be eligible to apply the rollover if the taxpayer made a 3 A Bet Each Way

4 written election to that effect on or before the date of lodgement of the taxpayer s return for the disposal year of income. Decision Member Barton went into detail on the first issue of whether s.1-3(2) of the Act required the ordinary meaning of s of the Act to be looked through and given the same meaning as the relevant provisions of Division 17A of the 1936 Act. In finding that the two provisions express different ideas for the purposes of s.1-3(2), the Member stated that: [Section 1-3(2)] operates in circumstances where the Act appears to have expressed an idea from the 1936 Act using different words to achieve a clearer and simpler style. Where there is a clear coincidence of ideas, the ideas are not to be taken to be different because the idea is expressed in the Act using different forms of the words in the 1936 Act. A rewritten provision should not be construed differently from the original on the basis of a mere difference in drafting style. Idea is not defined in the Act. Its ordinary dictionary meanings include the aim or purpose, Oxford Dictionary of English, 2nd edition (2003). If one proceeds on the basis that this was the meaning intended by the legislature then, in the view of the Tribunal, the relevant idea expressed in the 1936 Act is materially different from that expressed in the Act in Division 123. Member Barton found that from the ordinary unambiguous meaning of the provisions referred to the precondition for the operation of s.1-3(2) was absent in the case of the Division 123 rewrite of Division 17A. On this point, the Member stated that: The aim of Division 17A was to require taxpayers to elect small business asset roll-over relief in the disposal year of income regardless of whether they were in a position to nominate a replacement asset whereas Division 123 permitted a taxpayer to choose small business asset roll-over relief once certain pre-conditions were met including the requirement that the taxpayer nominate a replacement asset. The legislature has not used different words to achieve a clearer or simpler style of English in expressing the same idea but has expressed a different idea. Having found that s.1-3(2) did not apply, the Member found that the second amended assessment was excessive, since the applicant could not, and so did not, make a choice in the trust return for the goodwill of the business under Division 123 for the purposes of s of the Act. On this second issue of whether an effective choice had been made in the initial income tax return, Member Barton clearly stated that it was common cause at the hearing that the applicant had at no stage satisfied the requirements of paragraphs (f) and (g) because it did not choose a relevant replacement asset for the goodwill within two 4 A Bet Each Way

5 years of the sale of the business. In making these comments, Member Barton provided a helpful opinion on the scope of s generally: The word can has not been defined for the purposes of the Act. According to the second edition (2003) of the Oxford Dictionary of English the word can apart from expressions denoting capability or requesting or expressing permission, means be permitted to. Clearly Parliament is prescribing by s103-25(1) that taxpayers must make choices they are permitted to make under Part 3-1 or Part 3-3 by the day they lodge their income tax returns for the year in which the relevant CGT event happened or within a further time allowed by the Commissioner Taxpayers who prepare their income tax returns on the basis of choices they are not permitted to make under Part 3-1 or Part 3-3 are doing no more than purporting to make the choices in question. Section prescribes the time and method for making permitted choices and does not operate to validate a choice, such as that contained in s123-10, in circumstances where the preconditions for making the choice have not been met. State of Law Division 123 and Subdivision 118-C of the Act were repealed in 1999 for years including 21 September 1999 and all later income years. The small-business concessions are now contained in Division 152 of the 1997 Act. In particular, the drafting of the small business roll-over for replacement assets in Subdivision 152-E of the 1997 Act, would arguably lead to the same interpretation as was afforded to Division 123 in this decision, that is, that the choice to apply Division 152-E may only be made within the two year bracket allowed under s , and only where the relevant replacement asset has been acquired. Appeal An appeal in this matter was lodged with the Federal Court on 3 March Comment Although the relevant operative provisions which were the subject of this decision have been repealed, this decision provides a helpful consideration of the limitations of two fundamental sections of the 1997 Tax Act which are rarely the subject of judicial comment and are prone to wide misinterpretation due to their broad nature. In this regard, the limits afforded to s.1-3, by the AAT, will hopefully be repeated in the Federal Court, in order to lift the precedential value of this sound interpretation. 5 A Bet Each Way

6 The approach taken by the AAT in analysing the scope and operation of the choice provision in s of the 1997 Act is sensible and clearly congruent with the legislative intent of the provision. However, similar and new problems arise under the new rules in Division 152, and accordingly there is a necessity for the ATO to provide a statement of opinion on the application of s , particularly having regard to its pervasive nature throughout the CGT provisions. Currently, under s of the 1997 Act, the small business 50% reduction is an automatic concession which does not require a choice to be made for its application. However, under s , a taxpayer is empowered to make a choice not to apply the small business 50% reduction. Under s , a taxpayer is also empowered to choose the order in which the small business retirement exemption (Subdivision 152-D) and small business roll-over for replacement assets (Subdivision 152-E), is to be applied to a capital gain which has been reduced under the small business 50% reduction. Since the choice not to apply the 50% reduction will be made in the first (and arguably, not any subsequent amended) return lodged for the income year in which the gain is made, the decision in Sherlinc raises numerous arguments as to how a taxpayer should prepare this first tax return and supporting tax records, where the replacement asset is not acquired in the income year the gain is made. One approach would be to claim the 50% reduction in the first year, with a subsequent amended return for the later year in which the choice to apply the roll-over is validly made. Another approach would be for a taxpayer to claim the roll-over in the first income year and return a nil amount in respect of CGT on that gain,but indicate in its records that the claim was for both the 50% reduction and the rollover, in order to provide an argument that a choice was made not to apply the 50% reduction. In addition to this issue, there is ambiguity as to whether the power to disregard a gain under the 15-year exemption in Subdivision 152-B is a choice for the purposes of s , and therefore, whether there is an option to apply this exemption in an amended return where it has not been evidently applied in an earlier return. The issues which arise in respect of the interaction of s with the rest of the CGT provisions are fraught with ambiguity, and therefore, the need for ATO pronouncements on these issues should be of immediate concern. 6 A Bet Each Way

7 This article written by Luke Fullager appeared in the May 2004 edition Vol 38 (10) of Taxation in Australia, the journal of the Taxation Institute of Australia. These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax A Bet Each Way