Business owner benefits

Many business owners view the sale of their company as the main opportunity to make a significant contribution to their SMSF. Colonial First State FirstTech senior technical manager Linda Bruce explores how they are able to achieve this aim through the small business CGT concessions.

A company is a separate legal entity that can offer benefits such as the ability to retain earnings and protect a business owner’s personal assets. As such, a company is a popular business structure for small business owners to operate their business from.

Just like other entities, when a company sells a capital gains tax (CGT) asset, it may be able to use one or more of the small business CGT concessions to eliminate, reduce or defer capital gains arising from the CGT event where the relevant qualifying conditions are met.

However, even if the sale proceeds received by a company are exempt from CGT, there may be tax consequences when the company distributes the sale proceeds to its shareholders. This may also affect the amount an indiviudual business owner can contribute to super using their lifetime CGT cap.

This article looks at these challenges in detail and explores potential strategies to overcome them.

Please note, all legislative references in this article are to the Income Tax Assessment Act 1997, unless otherwise indicated.

Overview of small business CGT concessions for superannuation

Four small business CGT concessions are available to eliminate, reduce or defer the capital gains on disposing of an eligible CGT asset, namely:

1) Small business 15-year exemption – Allows the disposer to entirely disregard capital gains from a CGT event and there is no need to apply any other CGT concessions.

2) Small business 50 per cent active asset reduction – Reduces a capital gain by 50 per cent. Often used in conjunction with the small business retirement exemption or rollover relief.

3) Small business retirement exemption – Reduces the taxable capital gain from a CGT event by a lifetime limit of $500,000 for each eligible individual.

4) Small business rollover relief – Allows a disposer to defer all or part of a capital gain resulting from the CGT event.

The qualifying conditions are complex and are outside the scope of this article. For further information, please visit the ATO’s Small Business CGT Concessions page.

15-year exemption

The 15-year exemption is the most generous of the four concessions. Upon qualification, a company disposer can entirely disregard a capital gain arising from disposing of a CGT asset.

Section 152-125 then allows the company to distribute the sale proceeds paid to the company entity, that is, the disposer, to its CGT concession stakeholder(s) tax-free, that is neither franked nor unfranked dividends, if the following conditions are met:

• the amount distributed to the company’s CGT concession stakeholder(s) is limited to the CGT exempt amount (that is, the sale proceeds less cost base),

• the distribution is made in accordance with a CGT concession stakeholder’s small business participation percentage, and

• the distribution is paid by the company within the time limit, which is generally two years after the relevant CGT event.

Issues and strategy considerations

1. Distributing the cost base amount

Section 152-125 only allows the CGT exempt amount, the sale proceeds less cost base, to be paid out of the company taxfree, not the entire sale proceeds.

Depending on how the purchase of the CGT asset was originally funded, for example, whether it was executed using capital injection by a shareholder or retained profits, distributing the cost base amount out of the company to its individual CGT concession stakeholders may or may not result in significant tax consequences for the individual. Here:

– the distribution that represents the repayment of the outstanding shareholder loan can be paid tax-free, and

– the distribution that represents the retained profits is generally a franked dividend and taxed in the hands of the individual.

2. Super contributions using the lifetime CGT cap

Section 292-100 (4) allows a company’s CGT concession stakeholder to contribute their share of the sale proceeds, not just the CGT exempt amount, to super using their lifetime CGT cap, However, the company must make a payment within the required timeframe, generally two years after the CGT event, to the individual CGT concession stakeholder first.

Where the company only distributes part of the sale proceeds to the relevant individual(s) to avoid significant tax consequences, the individual’s super contribution using the CGT cap is limited to the distribution they received from the company during the two-year period mentioned above.

The individual, if eligible to contribute to superannuation, then has 30 days from receiving the payment to contribute to super using their lifetime CGT cap.

Note, the ATO’s CGT cap election form must be submitted to the super fund before or when the contribution is made

Planning point:

Where the cost base of the CGT asset was funded through the company’s retained profits, the entity may decide to only distribute the CGT-exempt amount to its relevant stakeholders tax-free, section 152125, and retain the cost base amount in the company to avoid significant tax payable by the relevant individual(s).

The company may then distribute the cost base amount out to the relevant individual(s) over several years as dividends to reduce the impact of including the dividends in the individual’s assessable income.

This strategy can effectively reduce the tax payable by a relevant stakeholder on receiving the dividends, however, any payments made by the company outside the two-year timeframe generally cannot be contributed to super using the lifetime CGT cap.

As an alternative, the company may wish to distribute the cost base amount out of the company before the two-year period ends and a Division 7A loan agreement may be used to avoid having the payment treated as dividends. Advisers should collaborate with clients’ tax accountants to establish how best to distribute the cost base amount out of the company.

50 per cent active asset reduction

If the 15-year exemption is not available to a company disposer, an examination of whether the retirement exemption or rollover relief is available should take place.

As the amount of capital gain that can be disregarded by the retirement exemption is limited by the $500,000 lifetime cap per individual CGT concession stakeholder, where the capital gain exceeds the limit, the company may choose to use the 50 per cent active asset reduction before applying the retirement exemption (or the rollover relief first and then the retirement exemption when CGT event J5 or J6 occurs).

Issues and strategy considerations

The amount of the capital gain that is exempt by the 50 per cent active asset reduction forms part of the company’s capital profits reserve account. Although the company is not liable to pay tax on this CGT exempt amount, when the amounts are distributed to shareholders, the distribution generally is an unfranked dividend and is taxable at the individual shareholders’ marginal tax rate.

An exception is when the distribution from the company’s capital profits reserve account is made by a liquidator under section 47 of the Income Tax Assessment Act 1936 and covered by ATO Taxation Determination 2001/14.

This means where it is appropriate to liquidate the company, and when a liquidator makes the final distributions out of the company’s capital profits reserve representing the cancellation of the shares, the distributions are treated as capital proceeds of rather than ordinary income for the shareholder.

The shareholder can then assess whether any CGT concessions can be applied, such as the general 50 per cent CGT discount or one or more of the small business CGT concessions, to reduce or eliminate the capital gain on receiving the capital proceeds relating to the shares bought back and cancelled by the company. Significant tax savings may be achieved under this option.

It is important to note the lifetime CGT cap may be available to part or all of the capital proceeds for the cancellation of the shares.

Retirement exemption

To qualify for the retirement exemption, section 152-325 requires that the company makes a payment representing the CGT amount it has chosen to disregard to one or more of its individual CGT concession stakeholders. A lifetime CGT limit of $500,000 applies to each individual stakeholder.

Where the conditions specified by section 152-325 are met, the payment that represents the amount the company chose to disregard using the retirement exemption is tax free.

The individual generally has 30 days to contribute the distribution made by the company to their super fund using their lifetime CGT cap. It’s important to note that where an individual stakeholder is under age 55, the company must make the payment directly to the individual’s super fund as part of the qualifying conditions to use the retirement exemption.

Issues and strategy considerations

As is the situation with the 15-year exemption, tax law does not provide a mechanism that allows the cost base amount to be distributed to shareholders tax effectively.

Depending on how the cost base of the CGT asset was originally funded, via retained profits or via a shareholder capital injection, distributing sale proceeds representing the cost base amount may or may not have tax consequences. It is important to work with a professional tax accountant to work out a tax-effective way of accessing the cost base amount.

In contrast to the 15-year exemption, only the CGT-exempt amount the company chooses to disregard using the retirement exemption may be contributed to super using the lifetime CGT cap, where all conditions are met. The cost base amount and any amount discounted by the 50 per cent active asset reduction cannot be contributed to super using the individual stakeholder’s lifetime CGT cap.