On Wed 18.10.2017, the Commissioner issued draft ruling: TR 2017/D7 on whether a company is ‘carrying on a business’ for the purpose of the staged reduction of company tax rates, which is to be found in s23AA of the Income Tax Rates Act 1986.
That section specifies which companies are to be taxed at the lower 27.5% rate, calling them “base rate entities”. Apart from the turnover threshold test ($10m for the 2016-17 year; $25m for 2017-18 and $50m for the 2018-19 year), the section sets the other test as ‘carrying on a business’. This caused two problems.
- The first is that it’s not always clear when a person is carrying on a business – leading to uncertainty about whether a company had correctly self assessed itself as paying tax at the lower 27.5% rate (and similarly, franking at the lower 27.5% rate).
- The other problem was that it started to emerge that the Commissioner had a wider view of when a company was carrying on a business than many thought was correct (essentially ignoring the difference between passive investing and carrying on a business).
There was taxpayer resistance to the Commissioner’s wider view of when a company carries on a business because companies might have investments in companies paying 30% tax and receiving 30% franked dividends, which it couldn’t pass on to its shareholders at the 30% rate, if this investment activity were to be treated as ‘carrying on a business’. The problem was that the missing 2.5% of the franking credit was then trapped inside the company until it had some untaxed profits, which it could then use to pass out the franking credits.
To deal with this problem, the Government has just introduced a replacement test, which is that the Company have not more than 80% ‘passive income’ as defined (in new s23AB of the Rates Act). This reinstated the ‘passive income’ distinction, which taxpayers expected, and created a much more certain test. This change is to be made by the Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (see related TM article). There do not seem to be any political ‘headwinds’ that might prevent this Bill passing, but it will only apply from 1 July 2017, leaving the old ‘carrying on business’ as the relevant test for the 2016-17 year. So this ruling still has application (albeit for only one year and otherwise for flow on application, in other areas, which the Commissioner tries to limit).
In this draft Ruling, the Commissioner refers to some old, and likely correct, case law that says that Companies are different from individuals as they don’t have private or domestic purposes and will much more readily be found to be carrying on a business, than an individual or a trust, if their activities are commercial and intended to earn a profit (i.e. a return).
The Draft Ruling addresses key law relating to companies – which is “any gainful use to which a company puts its assets will, on its face, amount to carrying on a business”. Paragraph 11 of the Draft Ruling sets this out.
11. While these indicia are relevant to companies, companies are typically formed for the purpose of carrying on a business[12] and in Westleigh[13] and American Leaf[14], it was observed that where a company aims to make, and has a prospect of profit, it is presumed that the company intends to, and does in fact, carry on a business. However, the presumption can be rebutted if it can be shown that, on the facts, the company had no aim or prospect of making a profit.[15] In American Leaf Diplock LJ further observed that any gainful use to which a company puts its assets will, on its face, amount to the carrying on of a business. An analysis of the indicia of when a business is carried on will assist in determining whether a company satisfies these criteria with the result the presumption arises. [(12) Brookton per Aickin J at (1981) 147 CLR 441, 470; Westleigh [1924] 1 KB 390; American Leaf at [1979] AC 676, 684; (13) Westleigh; (14) American Leaf; (15) Westleigh per Pollock MR at [1924] 1 KB 390, 408-409; Spassked Pty Limited v. Commissioner of Taxation [2003] FCAFC 282]
The Draft Ruling goes on to show how a company’s position is different from, say, an individual.
14. Limited and NL companies are typically formed for the purpose of carrying on a business and are unlike individuals, who may have multiple purposes for undertaking an activity.[18] Unlike individuals, a company’s profitable activities are unlikely to be in the nature of a hobby or be undertaken to meet a domestic need. Thus its profit making activities are unlikely to have a domestic or personal nature. [(18) Korean Syndicate at (1930) 12 TC 181, 201]
15. For these reasons, the profit-making activities of a company will normally have a fundamentally different character to those of an individual. This difference has led the courts to observe that profit-making activities, such as receiving rent from property, will not give rise to the presumption that an individual is carrying on a business, whereas it would if those same activities are undertaken by a company.[19] [(19) American Leaf at [1979] AC 676, 684]
The Draft Ruling notes that a company’s purpose and prospects of making a profit are crucial.
20. Whether a company’s activities have a purpose and prospect of profit is critical in determining whether it is carrying on a business.[27] Where they do, it is likely the other indicators will also support the conclusion that it is carrying on a business. This is ultimately a question of fact to be determined in light of all the circumstances. [(27) American Leaf at [1979] AC 676, 684; Westleigh; Murry at [1998] HCA 42, [54]; Whitfords per Fisher J at 79 ATC 4648, 4659; Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? at (47)-(54)]
Further, a company’s relevant profit making purpose could be determined from its role in a group of companies.
22. If a company is a member of a group of companies its purpose, and whether it carries on a business may be determined by reference to its role within the group[30], the activities of the wider group[31], and the intended activities of any of its subsidiaries at the time they are set up.[32] [(30) Spassked; News Australia Holdings Pty Ltd v. Commissioner of Taxation [2017] FCA 645; (31) FCT v. Total Holdings (Australia) Pty Ltd (1979) 43 FLR 217; 79 ATC 4279 (Total Holdings); FC of T v. EA Marr & Sons (Sales) Ltd (1984) 2 FCR 326 (EA Marr); (32) Brookton per Mason J at (1981) 147 CLR 441, 453; Spassked]
Then applying this, the Commissioner notes situations where a company has been held to be carrying on business (surprising, if you’re still thinking about the passive investment v’s active business distinction).
30. A company has been held to carry on business where its ongoing activities are relatively limited and its key activities consist of:
- letting the company’s premises for rent on an ongoing basis[45] [(45) American Leaf.]
- leasing its plant to its subsidiaries for no fee[46] [(46) EA Marr.]
- providing secretarial, budgeting and financial services to its subsidiaries that carry on active businesses[47] [(47) Carapark Holdings Ltd v. Federal Commissioner of Taxation [1967] HCA 5; (1967) 115 CLR 653 at p. 659. (Carapark).]; and
- holding shares in subsidiary companies which are engaged in trading.[48] [(48) Brookton per Gibbs CJ at (1981) 147 CLR 441, 445 and Mason J at (1981) 147 CLR 441, 453.]
And finally (to complete the ‘horror’ of those who were expecting a ‘passive investment’ v’s active trading business distinction) the Commissioner notes the following.
43. Examples of cases where the courts have held a company was carrying on a business include where a company:
- is a holding company that has an expectation of receiving dividends from its subsidiaries[(72) In Korean Syndicate, Atkin LJ observed being a holding company was a well-known method of carrying on business at (1930) 12 TC 181, 205.], where it:
- acquired the shares in its subsidiaries by way of gift[(73) Brookton per Mason J at (1981) 147 CLR 441, 453]
- made interest bearing loans to those subsidiaries and provided management services to the group[(74) Carapark.]
- leased plant and equipment to its subsidiaries free of charge[(75) EA Marr.], or
- made interest-free loans to those subsidiaries[(76) Total Holdings.]
- holds and rents out single[(77) R & D Holdings; Lilydale Pastoral Co. Pty. Ltd. v. Federal Commissioner of Taxation 87 ATC 4235 cf. Kennedy, where this view was formed in the context of characterising a one-off lease payment made by the company. In finding that the payment was capital in nature, Hill J said that a different view may have been reached if the company’s business ‘consisted of granting leases and obtaining surrenders of them as part of the normal ebb and flow of the business’ (at [1992] FCA 645, [17]). or multiple real properties[(78) American Leaf; R & D Holdings; CMI Services Pty Ltd v. Federal Commissioner of Taxation; 90 ATC 4428 at 4437 (CMI).]
- invested in real property, intended to be held indefinitely for the purpose of deriving rent, and subsequently sells the property for profit[(79) CMI cf. Equitable Life and General Insurance Co. Ltd. v. Federal Commissioner of Taxation 21 ATR 364; (1990) 93 ALR 609, where, on the facts, the company was not found to carry on such a business.], and
- receiving interest and royalties.[(80) Korean Syndicate.]
This, probably correct, view of the law, relating to when companies (as opposed to other entities) carry on business shows why the statutory retreat to a ‘passive income’ test came about.
In the light of this, the Commissioner seems aware of the difference in expectations in the taxpaying community, in the article he put on his website, when he said he would take a ‘facilitative approach’ to compliance, meaning that he would not select companies for audit based on their determination of whether they were carrying on a business in the 2016-17 income year, unless their decision is plainly not reasonable.
[ATO website: TR 2017/D7, Reducing company tax rates; FJM; LTN 199, 18/10/17; TM related article; another related TM article; TM Oct 2017]