Rules aimed at preventing big businesses from accessing tax concessions aimed at small businesses have become bewilderingly complex.
How to steer a path through tricky aggregation territory
The aggregation rules originally designed to stop larger businesses from accessing tax concessions targeting small businesses now apply widely across the tax law. This article explains the operation of these complex rules.
Rules originally designed for small business concessions
When the aggregation rules were introduced with effect from 1 July 2001, few outside the micro-business space took much notice. After all, the grouping provisions were designed to ensure large businesses did not disaggregate their operations into several smaller entities to gain access to the former Simplified Tax System (STS). An entity could enter the STS if its average annual turnover – grouped with entities that it controlled, or was controlled by, and its STS affiliates – was less than $1 million.
With effect from 1 July 2007, the provisions in Division 328 of ITAA 1997 were rewritten to replace the STS regime with the small business entity (SBE) regime. The term ‘aggregated turnover’ replaced ‘STS average turnover’. Additionally, the terms ‘small business CGT affiliate’ in former section 152-25 of ITAA 1997, ‘connected with’ in former section 152-30, and ‘STS affiliate’ and ‘control’ in former section 328-380 were replaced with updated concepts of ‘connected with’ in section 328-125 and ‘affiliate’ in section 328-130 respectively.
More significantly, the turnover threshold to determine whether an entity could apply the concessional SBE rules was increased on 1 July 2007 to $2 million. While this increase was welcomed at the time, the terms ‘connected with’ and ‘affiliate’ (aggregation concepts) remained generally confined to the SBE regime (the aggregated turnover test in section 328-115) and the small business CGT concessions (the $2 million aggregated turnover test as an alternative to the $6 million maximum net asset value (MNAV) test).
Notably, the aggregation concepts are also relevant to the active asset test in the small business CGT concessions.
Interest in the aggregation rules broadened when the turnover threshold for the SBE regime was further increased with effect from 1 July 2016 to $10 million, and again on 1 July 2020 to $50 million to extend certain small business concessions to medium-sized businesses. However, the turnover threshold remains $2 million for the purpose of the small business CGT concessions.
Due to their complexity, it would be ambitious to even contemplate covering the full depth and breadth of the aggregation rules in this article; however, some of the major considerations are laid out below.
Meaning of ‘connected with’
Broadly, an entity is ‘connected with’ another entity under section 328-125 if either entity ‘controls’ the other, or they are commonly controlled by the same third entity. This is primarily what could be described as a ‘mechanical’ provision in that it works by applying prescriptive rules to a taxpayer’s circumstances. Control is based on one entity having a ‘control percentage’ in another entity (other entity) of at least 40 per cent. How this is measured varies depending on whether the other entity is a company, a discretionary trust, a non-discretionary trust or a partnership.
To remove any doubt, an individual may hold the requisite control percentage of at least 40 per cent in a company, a trust or a partnership which results in that entity and the individual being connected with each other. However, an entity cannot have a control percentage in an individual.
Entities other than discretionary trusts
At a basic level, where the other entity is a company, an entity is connected with that company if it holds shares in the company that carry the right to:
- Receive at least 40 per cent of any dividends or capital distributed by the company, or
- Exercise at least 40 per cent of the voting power in the company.
Where the other entity is a trust other than a discretionary trust, an entity is connected with that trust if it holds interests (e.g., units) in the trust that carry the right to receive at least 40 per cent of any income or capital distributed by the trust.
Where the other entity is a partnership, an entity is connected with that partnership if it holds interests in the partnership that carry the right to receive at least 40 per cent of:
- Any income or capital distributed by the partnership, or
- The net income of the partnership.
Two special rules apply where the other entity is a discretionary trust:
- Under the trustee rule, an entity is connected with that discretionary trust if the trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity.
- Under the beneficiary rule, an entity is connected with a discretionary trust for an income year if at least 40 per cent of the trust’s income or capital paid or applied was paid to or applied for the benefit of the entity in any of the four income years before that income year.
This rule can be particularly complex because it relies on the trust law meaning of distributions of ‘trust income’ and ‘trust capital’ (that is, the meaning under the trust deed as modified by any powers exercised by the trustee under the deed); not accounting or income tax concepts. A useful golden rule is that if a trustee distributes at least 40 per cent of trust income or trust capital to a beneficiary in an income year, that beneficiary is connected with the trust for the following four income years.
Further rules to address particular circumstances
The above discussion summarises the basic operation of the ‘connected with’ rule, but the complexity of applying these rules increases when additional provisions are considered.
The following special rules address particular circumstances that may apply:
- When determining whether an entity holds a ‘control percentage’ in the other entity of at least 40 per cent, the entity is grouped with its affiliates. For example, if an entity holds 25 per cent of the shares in a company, and the entity’s affiliate holds 15 per cent of the shares, the entity will be taken to control the company and is therefore connected with it.
- When applying the beneficiary rule above, disregard beneficiaries that are tax-exempt or a deductible gift recipient.
- Where the control percentage held by an entity is at least 40 per cent but less than 50 per cent, the Commissioner can determine that control is held by another entity.
- Control may be established by way of indirect control through a chain of entities (with exceptions for certain entities such as where the other entity is a listed company).
- The trustee of a discretionary trust may wish to nominate up to four beneficiaries to be controllers of a trust for an income year.
- The requisite control percentage is reduced from 40 per cent to 20 per cent where the small business CGT concessions are sought to be applied to a CGT asset that is a share in a company or an interest in a trust.
Determining the control percentage takes a concerted effort of itself. However, once the control percentage has been calculated, the next task is to determine when the control exists for the purpose of the particular test. For example, for the purpose of the:
- $6 million MNAV test – the control is determined just before the CGT event.
- The aggregated turnover test to be an SBE – the requisite control exists for an income year if the control percentage is at least 40 per cent at any time in that income year.
- The active asset test – a CGT asset owned by one entity that is used in a business carried by another entity will be an active asset if the requisite control exists for at least 50 per cent of the ownership period of the CGT asset (capped at 7½ years).
Another layer of complexity is added when these timing rules are modified for discretionary trusts. Broadly, control is measured for any of the four income years before the income year:
- In which the CGT event happens (MNAV test).
- In which the turnover test is sought to be satisfied (aggregated turnover test), or
- That counts towards the active asset period
Meaning of ‘affiliate’
An entity is an affiliate of another entity under section 328-130 if the first entity:
- Is an individual or a company
- Carries on a business, and
- Acts, or could reasonably be expected to act, in accordance with the directions or wishes of, or in concert with, the other entity in relation to the business of the individual or company.
This is a far more subjective provision and can be much more difficult to apply to a taxpayer’s circumstances. Whether an individual or a company is an affiliate of another entity is a question of fact and is dependent on all the circumstances of the case.
The law assists somewhat by clarifying that an individual or a company is not an affiliate merely because of the nature of a business relationship. For example, a partner in a partnership is not an affiliate of another partner merely because they act in concert with that other partner.
Importantly, unlike the ‘connected with’ rule, being an affiliate is a one-way relationship. Automatic reciprocation does not follow merely because an individual or a company is an affiliate of another entity. The factors need to be re-examined when looking back the other way.
Aggregation rules now apply more widely
The inclusion of integrity provisions across the tax law has been a mainstay feature but, increasingly, provisions well beyond the scope of the small business concessions draw on these grouping concepts. This is because in designing tax policy, the aggregation rules and related aggregation concepts are considered a suitable way to ensure businesses do not disaggregate their operations into multiple smaller entities to gain access to concessions offered to, generally, larger businesses, but which are still limited by a turnover threshold.
Such concessions include the following:
- Small business income tax offset: $5 million.
- SBE regime (specifically, the simplified depreciation rules, the simplified trading stock rules and the small business restructure roll-over): $10 million.
- GST (choosing to account on a cash basis, annual apportionment election and choosing to pay GST by instalments): $10 million.
- Two-year period of review for amending income tax returns: $10 million.
- Research and development refundable tax offset: $20 million.
- Base rate entity rules (lower corporate tax rate): $50 million.
- Immediate deduction for start-up expenses and prepaid expenses: $50 million.
- FBT exemption for small business car parking and multiple work-related portable electronic devices: $50 million.
- GST (choosing to use a simplified accounting method): $50 million.
- PAYG instalments based on GDP-adjusted notional tax: $50 million.
- Settling excise duty and excise-equivalent customs duty monthly on eligible goods: $50 million.
- Taxation of financial arrangements regime: $100 million.
- The recently ended temporary full expensing measure and loss carry back for companies: $5 billion.
In trying to navigate these complex rules, the following steps may assist:
- Start with identifying the entity that is the taxpayer (it helps to draw this on a schematic diagram).
- Determine which measure you seek to apply to the entity, for example, the aggregated turnover test, the $6 million MNAV test or the active asset test.
- If the relevant test is the aggregated turnover test, determine which turnover threshold applies to the measure.
- Determine which entities are connected with, or are affiliates of, the entity that is the taxpayer (consider the Commissioner’s discretion, the indirect control rule and any exceptions).
- Apply the aggregation rules to determine whether the entity satisfies the relevant test.
Many calls and advocacy efforts over the years have been made to streamline and simplify these provisions, but it seems that any policy changes in this space run counter to this objective; the complexity has only increased. The rules place disproportionate compliance burdens on small businesses and their advisers and remain ripe for holistic reform.
Robyn Jacobson is the senior advocate at the Tax Institute.