Capital gains small business tests catch out another taxpayer – but the reason why is unusual

The capital gains tax (CGT) small business concessions have been around for some time. As I have said many times in the past, they are valuable concessions but are often complicated to work through.

Read more: CGT small business concessions continue to catch SMEs out

A recent decision of the Federal Court has seen yet another taxpayer miss out on claiming the concessions, although the circumstances were a little unusual. As often is the case, it is a little technical.

The Federal Court confirmed the face value of a $1.1 million debt owed to the taxpayer had to be taken into account under the maximum net asset value test for the purposes of determining if the taxpayer qualified for the CGT small business concessions. This was despite the taxpayer’s claim that the debt was statute barred from recovery under relevant state legislation and therefore had a nil value. As a result, the amount of the debt was included in the test (and therefore pushed him over the then $6 million asset threshold) and the taxpayer failed to qualify for the concessions.

The taxpayer was both a beneficiary and the trustee of a family trust that held units in a unit trust, which operated a finance broking business. The unit trust sold the business in the 2008 income year for a capital gain of $500,000 to which the taxpayer was entitled. The taxpayer argued that in determining whether the “maximum net asset value” (MNAV) test was satisfied, a debt of $1.1 million owed to the family trust (a “connected entity” for the purposes of the test), resulting from a loan it made to him, had a nil value and was not to be taken into account under the test. The taxpayer argued that the debt was “statute-barred” from recovery under the six-year statute of limitations in section 35(a) or 42(1) of the South Australian Limitation of Actions Act 1936.

However, in the decision of the Administrative Appeals Tribunal (AAT) at first instance, the Tribunal found this was not the case on the basis that the debt had been legally acknowledged by the trustee of the family trust as being recoverable (by way of signing the relevant balance sheets) and was legally in existence at the relevant time. Therefore, the AAT found the face value of the debt was to be included in the MNAV test and that the taxpayer failed to qualify for the concessions.

Before the Federal Court, the taxpayer first argued the AAT wrongly determined that the debt was recoverable and had wrongly found there was no acknowledgement contained in writing signed by the taxpayer or by his agent as required by the Act to find that the debt was still in existence and not statute barred from recovery. Alternatively, the taxpayer argued if this issue was not an appealable question of law, then the signing of the balance sheet could not amount to an acknowledgement of a debt for the purposes of the Act as it at best was an acknowledgement of an asset, and not of “a debt owing”.

In dismissing the taxpayer’s appeal and confirming that the amount of $1.1 million was to be included in the MNAV test (and that therefore the taxpayer failed to qualify for the concessions), the Federal Court found the statutory time limit in the South Australian legislation did not by itself have the effect of extinguishing the trust’s claim in contract for repayment of the loan after six years. This was because the court found that while the section may “bar the remedy”, it did not bar “the cause of action”. Instead, the Court said the section (and similar legislation) acted to create a defence, which could be raised by a debtor or defendant in an action against them and which, moreover, could be waived by a debtor or defendant.

The Court also found another provision of the Act allowed a court to extend such a limitation period and that it was possible that an arm’s length trustee in this case would seek such an extension. The Court also noted it would be difficult to see how the taxpayer in this case as a debtor-beneficiary of the trust would raise the statute of limitation defence when in his capacity as trustee of the trust, he also had fiduciary duties to act in the best interests of the trust.

Accordingly, the Federal Court ruled the family trust’s claim against the taxpayer could not be regarded as statute-barred and therefore the debt owed to it could not be regarded as having no value. The $1.1 million debt was therefore included in the test and the taxpayer failed to qualify for the concessions as a result because the inclusion of the debt took him over the $6 million asset threshold.

While this case turned more on the issue of a statute of limitations, it illustrates the complexity that can arise when someone is trying to satisfy the relevant small business tests. It is not necessarily straightforward. 

Terry Hayes is the editor-in-chief of tax news reporting at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.