Small Business CGT Concessions - Company business sale or share sale?

For those looking to exit their businesses, there is no simple answer to this question.

Initially, we need to consider in whose interest we are looking for the ‘best’ outcome – the company or the shareholder? Ideally, in many small businesses, these two groups are one and the same, and will agree on the option selected.

When selling a small business that is operated by a company, the best outcome will depend upon many factors, some of which include:

1. Does the company hold a specific license or authority that enables the business to trade? If so, often the shares in the company will be sold to enable the existing company to seamlessly continue to operate the business;
2. How much risk is associated with the existing corporate structure – the purchaser may prefer to buy the business (rather than the shares) to mitigate any risk of prior year claims surfacing that relate to the company (notwithstanding warranties contained in the share purchase/sale agreement);
3. Who holds the existing shares in the company – individuals, trusts or another company? Where discretionary trusts hold the shares, who is the distribution to be made to in the year of the CGT event (and in the prior 15 years where the Small Business 15 year Exemption is to be utilized)? Also, are any direct or indirect shareholders spouses of each other?;
4. How many shareholders does the company have? Do they all agree to sell their shares?
5. Does the company own other assets that it would like to retain after the sale?

There may be very different taxation and cashflow outcomes where the company sells its business compared with the sale of the shares in the company.

Where a company sells its business, it is unable to access the 50% CGT discount to reduce the capital gain, which is only available to individuals. The 50% CGT discount is applied after any prior or current year losses are utilized, and prior to the small business CGT concessions being applied, to reduce the resulting capital gain by 50%. Also, where the 50% Active Asset Reduction is utilized, these sale proceeds are generally unable to be immediately distributed by the company to the shareholders.

The taxation and cash flow differences based on the type of sale (business or shares) may lead shareholders to prefer to sell their shares, whereas many purchasers find it much more beneficial from a tax perspective to purchase the business, especially where deductions are immediately available, such as where depreciable plant, equipment and other assets are acquired.

The share sale versus business sale question may result in diametrically opposed positions for sellers and purchasers, with negotiation possibly resulting in both the business and shares being sold. Some sellers undertaking a share sale may find it difficult to meet the requirements of the additional tests to access the CGT small business concessions, and so may opt for a business sale to obtain a better tax outcome.

The requirement that a shareholder is a CGT concession stakeholder in the company (generally a 20% or greater interest) just before the CGT event may enable those with larger shareholdings to access this concession, while excluding those with smaller interests, resulting in differing positions for shareholders as to which option (business or share sale) is preferred.

Regardless of the type of sale being considered, if you are a shareholder of the company, it is essential that you seek professional advice that considers all of your personal circumstances before proceeding with either a business or share sale.

This article will consider a simple scenario, where directors of a company operating a small business have been approached by a purchaser to sell the business operated by the company, and the purchaser is open to either a business sale or share sale.

Prerequisites to access the CGT Small Business Concessions

The small business CGT concessions enable a seller to disregard, reduce or defer some or all of the taxable gain on disposal of an ‘active asset’.

An active asset is one that is used, and held ready for use, in the course of carrying on a business by you, your affiliate or an entity connected with you. It can be a tangible or intangible asset, but the CGT concessions don’t extend to depreciating assets and stock on hand on the sale of a business.

An asset must have been active for more than half of the ownership period, or 7.5 years where it has been owned for more than 15 years. The ownership time period is measured from the date of acquisition to either the date of sale, or the date the business ceased to be an active asset, if this occurred before sale.

Note, 80% of the market value of assets held by the company must be active assets – this includes the assets of the business itself, as well as the financial instruments and cash that are inherently connected to the business. Where the company owns passive assets (property, shares, interests in other companies), these may need to be valued to determine whether the market value of the active assets of the company exceeds 80% of the market value of the total assets of the company.

To be eligible to access the concessions, the aggregated turnover (aggregated with connected entities and affiliates) of the business must be less than $2m. Control determines 'connection', and can include entities that control as well as those that are controlled, either directly, indirectly or in concert with affiliates.

The alternate test is based on the net market value of assets of the business, affiliates and connected entities where they are less than $6m.

Both tests use the control percentage of 40% to determine which individuals and entities turnover and assets are to be included.There are also specific rules for passive assets used in a connected small business, interests in a partnership and assets used in the partnership business.

Note, the requirement to consider levels of aggregated turnover may exclude a business from accessing these concessions where it is part of a larger operating group (internal group transactions between the entities may be excluded from the aggregated turnover tests). Similarly, assets held outside a business by other entities connected with the business may also result in the net market value of assets exceeding $6m.

We recommend that you speak to your accountant or professional advisor to determine whether your business meets the basic requirements to access the CGT small business concessions before proceeding.

Selling the Business

For a business sale, on the basis that you meet the active asset requirements, turnover and/or net asset tests, and other requirements, you will be able to access the small business concessions. In some instances, this may be a much simpler option than the alternative of meeting the additional tests required to access the concessions for the sale of shares in the company.

Some of the taxation issues to be considered when selling the business include:

1. The nature of the assets being sold (tangible or intangible) and whether the contract price is required to be allocated to specific assets or presented as one contract price (stock is often identified as a separate value to be calculated on settlement);
2. Both stock on hand and depreciating assets are revenue assets, and are not included in the small business CGT concession calculation, with profit on sale being separately calculated on the disposal of these assets;
3. Are there any assets owned by the company and used in the business that are not included in the sale?
4. Is the sale price inclusive or exclusive of GST?

GST is a separate matter to be considered. On the basis that the business being sold is registered, or required to be registered, for GST, the additional conditions under the ‘GST - Sale of a Going Concern provisions’ must be met to enable the sale to be GST Free.

These conditions include that all things necessary to operate the business are included in the sale; the business is operated until the day of settlement; the supply is for consideration; both vendor and purchaser are registered (or required to be registered) for GST and have agreed in writing that the sale is a GST Free sale of a going concern – see GSTR 2002/5 on the ATO website for further detail.

Sale of a Share in a Company

Where the business has met the requirements to access the CGT small business concessions, but the decision is made to sell the shares in the company rather than the business being sold out of the company, the concessions are not automatically applied to the capital gain on the sale of the shares in the same way that they would have been to the business sale.

There are a number of additional conditions that must all be met for the entity owning the shares to be able to apply the CGT small business concessions to a share sale. These tests are designed to ensure that the shares being sold are themselves active assets.

There are a couple of key terms to be discussed before we consider the additional conditions.

• Significant individual – where an individual’s direct and indirect interests in the company total at least 20% of the interests in the company. Only an individual can be a significant individual (a company or trust can’t be a significant individual);
• CGT concession stakeholder – either a significant individual or the spouse of a significant individual with a 20% or more interest in the company (note, the spouse of a CGT concession stakeholder must have a small business participation percentage greater than zero);
• Total small business participation percentage – total of the direct and indirect interests in the company. It is the smallest percentage of each of the following that is applied to the shareholding:
  • Percentage of voting rights that the shareholder may exercise;
  • Percentage of dividend payments that the shareholder is entitled to receive:
  • Percentage of return of capital the shareholder is entitled to receive.

Where all issued shares are ‘ordinary shares’, and all shares have the same entitlement to vote, receive dividends and capital distributions, the small business direct and indirect percentages will most likely be a reflection of the number of shares held.

Where different classes of shares have been issued (other than redeemable shares), for example, dividend only shares, the total small business participation percentage for that shareholder may be zero, as it is smallest percentage of voting (zero), dividends (100%) and capital (zero) interests will be applied to the total shareholding.

The additional tests to be met to access the small business CGT concessions, where shares in a company are to be sold, include:

1. Where no-one has obtained financial instruments or cash to assist an entity to meet the active asset concession, the shares may be considered active assets;
2. Where the company selling the shares controls any other entities, those interests are also considered in whether the modified active asset test is met (see below);
3. The person or entity that owns shares in the company operating the business is either a small business entity in their own right or meets the net asset test;
4. Just before entering into the contract for the sale of the shares, the vendor was a CGT concession stakeholder in the company and all CGT concession stakeholders had a total small business participation percentage of 90% in the company;
5. The modified connected entity rule is met – this is where the company must include the turnover of it’s affiliates and other entities connected with it to determine whether total turnover exceeds $2m, where the test to determine who is a connected entity is a 20% interest (half the general small business connected entity measure for the company operating the business). The 20% rate is the deemed ‘control’ percentage when looking at related entities on the sale of a share in the company;
6. The modified active asset 80% test is applied – this is looking at the interests in other companies and trusts which are held by the company whose shares are being sold. Where the ultimate significant individual (the individual, trust beneficiary or company shareholder) has a 20% or more direct and indirect interest in other entities, these interests must be included when determining whether more than 80% of the assets of the company selling it’s shares are active assets;

Example:

Paper Plane Pty Ltd (PPPL) is a small business (turnover less than $2m) that was created 10 years ago and has developed innovative methods of manufacturing aircraft components from recycled materials. PPPL meets the requirements to access the small business CGT concessions. The company has been approached to sell either its business or its shares to a competitor. The sale price is $2.4m and it is assumed 100% of this relates to goodwill and equipment (cost base $200k).

Jan has a discretionary trust (JT) that owns 50% of the shares in PPPL. Jan’s trust holds only the shares in PPPL and no other assets or business interests. Jan will be the sole beneficiary in the year of the CGT sale event.

Peter has a discretionary trust (PT) that own the other 50% of the shares in PPPL. In addition to the shares held in PPPL, Peter has a small business that he also operates through PT. Peter will be the sole beneficiary in the year of the CGT sale event.

Jan and Peter are the founding shareholders of PPPL, both hold ordinary shares with identical voting, dividend and capital rights and are not related to each other. They are unsure as to whether the tax outcome would be best if the business or shares in the company were to be sold.

On the basis that both the sale of the business or sale of the shares will enable access to the CGT small business concessions, following discusses the possible outcomes.

Outcome on Sale of the Business

If the business is sold by the company, in the absence of any capital or revenue losses, and with access to the small business CGT concessions:

The options for the balance of $1,100,000 include:

1. Tax can be paid by the company in the year of the CGT event on this amount (currently at 25% for a base rate entity). The balance of the sale proceeds may then be available to distribute as fully franked dividends;
2. The CGT retirement exemption may be applied ($500,000 is the lifetime limit per significant individual for this exemption), with the $500,000 being contributed to a complying superannuation fund or retirement savings account on behalf of significant individuals of CGT concession stakeholders under 55 years of age in the proportion of their shareholding – for those over 55 years of age, the funds may be paid directly to the CGT concession stakeholders. There are record keeping requirements and the timing of payments into superannuation are critical for successfully accessing this concession;
3. The CGT small business roll-over may be applied to the remaining gain. If the retirement exemption is accessed and $500,000 was contributed each for Jan and Peter (on the basis that neither had previously accessed the CGT small business retirement exemption) the remaining balance for the small business roll-over would be $100,000. Within 2 years of the date of the CGT business sale event the company must have acquired active assets that will be offset against any amount deferred under the small business roll-over concession. Any of the small business roll-over amount remaining after 2 years will either be assessable income and subject to tax at that time, or may be distributed to CGT concession stakeholders under the CGT retirement exemption (only where their lifetime limit has not previously been reached).

Generally, options 2 and/or 3 will be selected. The issue remains that $1,100,000 under the CGT 50% Active Asset reduction remains 'trapped' within the company – this amount may be released on the winding up of the company as a liquidator’s distribution at a future time.

Outcome on Sale of the Shares

Both Jan and Peter need to consider the additional small business CGT tests where they decide to sell their shares in PPPL, as follows:

- No financial instruments or cash were obtained to assist the company in meeting the active asset test,

- PPPL does not own interests in any other companies, so this does not need to be considered for the modified asset test.

- Regarding the entity holding the shares in the company, PT operates a small business and JT holds only the shares in PPPL. We have assumed that the combined net assets of JT, PT and PPL are less than the $6m net asset value threshold.

- The shareholders must be CGT Concession stakeholders just before the CGT event.

JT and PT each own 50% of PPPL, so both of these entities are connected to PPPL.

Outcome for JT

If Jan receives 100% of the distribution from JT in the year of the CGT event (on the basis that JT doesn’t have losses carried forward in excess of the expected gain), she is a significant individual of JT. As the sole beneficiary for the year, Jan meets the 90% small business participation percentage in JT.

JT has a direct small business participation percentage of 50% in PPPL. Individually, Jan also has an indirect small business participation percentage of 50% in PPPL, as she receives 100% of the distribution from JT in the year of the CGT event.

As Jan’s small business participation percentage exceeds 20% in PPPL, she is considered a significant individual and CGT concession stakeholder of PPPL.

Note, if Jan received a 50% distribution from JT with the remaining 50% being received by one other individual beneficiary, this would also ensure that the indirect small business participation in PPPL for each beneficiary would be more than 20%.

Outcome for PT

If Peter receives 100% of the distribution from PT in the year of the CGT event (on the basis that PT doesn’t have losses carried forward in excess of the expected gain), he is a significant individual of PT. As the sole beneficiary for the year, Peter meets the 90% small business participation percentage in PT.

PT has a direct small business participation percentage of 50% in PPPL. Individually, Peter also has an indirect small business participation percentage of 50% in PPPL, as he receives 100% of the distribution from PT in the year of the CGT event.

As Peter’s small business participation percentage exceeds 20% in PPPL, he is considered a significant individual and CGT concession stakeholder of PPPL.

Note, if Peter received a 50% distribution from PT with the remaining 50% being received by one other individual beneficiary, this would also ensure that the indirect small business participation in PPPL for each beneficiary would be more than 20%.

For JT, PPPL is also connected to PT, and for PT, PPPL is also connected to JT. These connections need to be considered to determine whether the company and connected entities exceed the $6m net asset threshold.

On the basis that all of the additional tests for the sale of a share in the company are met, following may be the outcome for Jan and Peter, where each of their respective trusts distribute 100% of the income and capital to them during the year:   

Jan and Peter may choose to contribute the remaining capital gain to a superannuation fund under the CGT retirement exemption where they are under 55 years of age, or if over 55 years of age, they may choose to retain these amounts. Another option for the remaining capital gain is to select the CGT small business rollover option for the following two years and invest this amount in full or part in other active assets. Where any amount of the gain remains after the two years, the CGT retirement exemption may still be accessed. Alternately the remaining gain at this time may be subject to income tax in the individuals hands.

In summary, as can be seen from this simple example, there may be a taxation and cashflow benefit to the shareholder of a small business for the shares to be sold in the company, rather than where the business is sold by the company. There are many variables to consider when an offer to sell business assets is received, and taxation and cashflow are only two of these. Where the shareholders are also employed by the company, as in many small businesses, this adds an additional layer of complexity to the decision making process.

A successful business or share sale is often many years in the making, with the business being prepared and presented in the best possible light for the eventual sale. Consideration early in this process as to whether a business or share sale will be pursued may impact whether new shareholders are introduced to the company in the interim, how trust distributions of company dividends received are made in the current or future year, and other decisions of both directors and shareholders.

This article is not intended to be considered advice for any individual or entity, but to simply raise some of the questions that a director or shareholder may ask their accountant or professional advisor when approached to sell a small business. It is always recommended that you seek professional advice from the outset in relation to any small business share or business sale, to ensure the best taxation and cashflow outcome is obtained, where possible.

More information is available from the ATO website at:

https://www.ato.gov.au/businesses-and-organisations/income-deductions-and-concessions/income-and-deductions-for-business/concessions-offsets-and-rebates/small-business-cgt-concessions

Michelle Wilson

January 2024