Australia: Are you being genuine? - Small business roll-over relief for "genuine" restructures

Under the Small Business Restructure Roll-over (Div 328-G) , which was introduced to much fanfare last year, small business owners are allowed to change the legal structure of their businesses without incurring a capital gains tax liability to a trust, provided that the economic ownership of the business does not materially change. This is an important legal change as there is no other roll-over that allows you to change from any structure to a trust.

This article discusses why you may restructure and when this roll-over may be used.

Why restructure?

A restructure is generally warranted due to a need to adapt to changing circumstances and sometimes because it was not thought through on initial establishment.

A small business entity (including an individual) may wish to change the legal structure of their business for any of the following reasons:

  • To provide greater asset protection;
  • To raise new capital;
  • To incentivise essential employees to remain with the business;
  • To minimise compliance issues;
  • To simplify their affairs;
  • To minimise tax exposure.

As is always good practice, personal assets and, where possible, assets used in your business should be kept separate from trading risk, and company and trust structures always offer greater asset protection than businesses operating as sole traders or partnerships.

What requirements you need to satisfy

To qualify for the roll-over, the restructure must involve a small business (a business with a turnover of less than $2 million) or an entity that is connected or affiliated with a small business1.

Further, the assets that are transferred as part of the restructure must be active assets that are:

  • CGT assets;
  • trading stock;
  • revenue assets; or
  • depreciating assets.

Additionally, the roll-over will only apply where a restructure does not "materially" change the "ultimate economic ownership" of the transferred assets, including each individual's share of the economic ownership where there is more than one economic owner. The question of what is a material change in ultimate economic ownership is less than clear. For instance, is a 98% change in the economic ownership of assets material for the purposes of the roll-over or will it be considered material if only 80% of the ownership changes? Evidently, there is no clear-cut answer to this question.

Notably, this is the first CGT roll-over relief that has allowed restructures from companies to discretionary trusts. However, read in context, it appears to only deal with the transfer of business assets of an entity and not a transfer of shares or units2. This view is consistent with the position of the Commissioner as set out in his Law Companion Guidelines (referred to below).

Restructure must be "genuine"

The most contentious part of the roll-over rules is the requirement that the transfer of assets form part of a "genuine restructure of an ongoing business". This is an integrity measure that is likely to catch out many small business owners who are considering a restructure3.

The question is, what actually constitutes a genuine restructure of an ongoing business? In contrast to s 83-175, which provides a definition of the term "genuine redundancy payment" and sets out conditions that need to be met under that definition, there is no attempt to explain what is meant by the term "genuine restructure" in the Act4. Instead, the task of elucidating the term has been left to the Explanatory Memorandum ("EM") that accompanied the Bill for the roll-over5.

It is notable that according to the EM, the genuine restructure test was intended to be broad "to cover the wide range of fact situations to which the roll-over will apply". The EM nonetheless attempts to narrow down the scope of the test by setting out circumstances that are deemed to satisfy the test and ones which do not.

The Commissioner has taken up and built upon the approach set out in the EM in the ATO Law Companion Guidelines (see LCG 2016/3 "Small Business Restructure Roll-over: genuine restructure of an ongoing business and related matters").6

According to the Guidelines, features that point to a transfer of assets forming part of a genuine restructure of an ongoing business include:

  • It is a bona fide commercial arrangement undertaken to:
    • facilitate growth, innovation and diversification;
    • adapt to changed conditions; or
    • reduce administrative burdens, compliance costs and/or cash flow impediments;
  • There is continity of use of the transferred assets, of employment of key personnel, and of production, supplies, sales or services
  • It results in a structure likely to have been adopted had the small business owners obtained appropriate professional advice when setting up the business.

According to the Commissioner, features which indicate that a restructure is not genuine include:

  • Where the restructure is a preliminary step to facilitate the economic realisation of assets, or takes place in the course of a winding down to transfer wealth between generations;
  • Where the restructure effects an extraction of wealth from the assets of the business (including accumulated profits) for personal investment, consumption or use outside of the business;
  • Where artificial losses are created or there is a bringing forward of their recognition;
  • The restructure effects a permanent non-recognition of gain or the creation of artificial timing advantages; or
  • There are other tax outcomes that do not reflect economic reality.

These features are either stated in or are otherwise consistent with the general tenor of the EM.

Whilst the Commissioner states that restructures that are contrived or unduly tax driven may lead to the conclusion that the genuine restructure requirement is not satisfied, the Commissioner nonetheless acknowledges that tax considerations are factors that can be taken into account. For example, it is permissible for a sole trader subject to the highest marginal rate to move to a company structure to access the lower corporate tax rate.

However, the line between those tax considerations that can be taken into account under the condition and those which cannot is unclear. As such, if tax considerations are a major reason why a restructure is sought, care must be taken to ensure that this does not disqualify your business from availing itself of the roll-over7.

It is necessary to note, however, that a court interpreting the legislation is only entitled to refer to the extrinsic materials (such as the EM) if it considers the words in the legislation ambiguous. Further, the courts will often divine the meaning of ambiguous words by looking at the way they have been interpreted in other cases, before consulting the EM. They will seldom, if at all, consider the guidelines and public rulings8 issued by the Commissioner. It therefore remains to be seen whether the courts choose to adopt the same approach taken in the EM and the ATO Guidelines.

Rather than follow the position in the EM, the courts may choose to develop their approach to the genuine restructure test by reference to the safe harbour rule that has been included with the roll-over. This is because the courts will generally interpret words used in legislation by reference to the text and structure of the legislation rather than, as noted above, through recourse to extrinsic materials.

The safe harbour rule was included in the legislation as an attempt to provide small business owners with some certainty in satisfying the genuine restructure condition. Under the safe harbour rule, the genuine restructure condition will be taken to be satisfied if, for three years9 following the restructure:

  1. there is no change in the ultimate economic ownership of the significant assets of the business;
  2. those assets continue to be active assets of the business; and
  3. there is no material use of those assets for private purposes.

As can be seen, the three conditions contained in the safe harbour rule are much more limited than the indicia said to evidence a genuine restructure used in the EM. If the courts' approach to the genuine restructure test is drawn from and informed by only the three conditions, the roll-over may apply to a wider range of circumstances and will be more favourable to small business owners. We will have to wait for a case to come before the courts.

Non-CGT tax implications

The EM and the Commissioner warn that small business owners still need to take into account consequences not affected by the roll-over, such as stamp duty or GST, when contemplating a restructure.

Footnotes

1 This means that the rollover can apply where there is a restructure involving an entity that is not carrying on a business but is holding assets that are used by a related entity that is small business.

2 Whilst there is no express prohibition, there is a reference in the EM to relief for the transfer of shares being dealt with by Div 615.

3 As was the case when, responding to considerable public anger, Parliament sought to ameliorate the harshness of Div 7A by providing the Commissioner with a discretion to overlook "honest mistakes" (s109RB), words chosen like "genuine restructure" leave the Commissioner in a position to deny relief where his view might not accord with the politicians' expectations of the amendments to the law they passed.

4 One could be forgiven for thinking that the use of the work "genuine" might simply be the opposite to "sham": for recent examples concerning whether a loan was a sham as opposed to "genuine", see Millar [2015[ FCAFC 94 at [46] & [83} & Normandy Finance [2016] FCAFC 180 at [66].

5 That is more than can be said of the EM that accompanied the introduction of the demerger roll-over in 2002 with respect to the meaning of "genuine demergers" in s 45B. The absence of any substantial explanation of that term caused considerable confusion amongst taxpayers and their advisers as to the scope of the roll-over. It is a telling fact that the term "genuine" is no longer included in the wording of the demerger roll-over provision.

6 LCG 2016/3 is a binding Public Ruling, which means that the Commissioner is obliged to provide taxpayers the treatment specified in the Ruling if it ends up being more favourable to the taxpayer than the law actually provides.

7 In any event, as the general anti-avoidance provision (Part IVA) disregards restructures where the dominant purpose of a party to the restructure is to avoid tax, as a minimum, the restructure under Div 328-G must have a non-tax purpose(s) which, viewed objectively, outweighs any tax purpose.

8 Unless it is alleged by the taxpayer that the Commissioner has not given the taxpayer the benefit of the ruling. In contrast, the AAT, as it is an administrative tribunal rather than a court, will consider the Commissioner's rulings as it stands "in the shoes of the Commissioner".

9 One would have thought that if the restructure met the conditions of the safe harbour but the owner then receives an unexpected offer to sell, which is taken up within the 3 years, the Commissioner should nonetheless consider the restructure to have been genuine.

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Jonathan B Slade
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