How to leverage Capital Gains Tax concessions effectively to reduce your liabilities

If you're running a business, you've probably heard about the Capital Gains Tax, or CGT. You may even have dealt with it before. The Capital Gains Tax is undoubtedly one of the most complex concepts within the Australian business tax code. That's why most SMEs hire a tax professional to help them work out their tax obligations. It's a smart choice; tax laws can have precise use cases that can become overwhelming fast. But that doesn't mean they're unfathomable.

What is CGT and when do you have to pay it?

CGT is a tax paid on any net capital gains you’ve made in a specific financial year. This tax will be added to your annual tax returns when you lodge them.

Capital gains refers to the profit/income you’ve gained by selling any primary assets of your business. For example, Bruce decides to sell his grocery store business, so he’ll pay tax on the amount he gains by selling the business. This amount is calculated after deducting the cost he bought it for—also known as the base cost. Let’s say Bruce bought the shop for $500,000 and, after running the business for 25 years, he sells it for $2 million. Bruce is liable to pay tax on his capital gains of $1,500,000 (2,000,000-500,000).

The date of your CGT event is crucial because it determines which financial year you declare your gains on your tax return. In some unique cases, the date of your CGT event also dictates your liability and which concessions you can apply for.

What are the types of CGT events?

The ATO lists a total of 54 instances of CGT events, including highly-specific events such as the end of residency (the individual/trust stops being an Australian resident), gains received for granting and modifying leases, and more.

For most small business owners, CGT events are of two main types:

• Selling or disposing of an asset
• Loss of an asset due to natural and human causes

1. Selling or disposing of an asset

In this scenario, the date of the CGT event is the date of your legal contract, and not the dates you propose, discuss, or settle the sale.

2. Loss of an asset due to natural and human causes

Includes theft, natural disasters, and vandalism. The date of the CGT event is the date you receive compensation for your loss. Your capital gain would be your compensation amount minus the base cost of the asset.

If you replace your asset using the compensation, you can defer your capital gains under the small business rollover concession. This is called an involuntary disposal of your CGT asset.

If you don’t receive a compensation, you should consider that a capital loss and record the date of the CGT event as the date in which you discovered the loss, or the date of the incident.

What are CGT concessions?

Your CGT is calculated on your capital gains, after you’ve applied any CGT concessions. Fortunately, for most businesses, extensive concessions may apply. These can reduce your capital gains so you don’t have to pay any taxes on them. It’s a process, though.

To be eligible for CGT concessions, you must meet at least one of these two conditions:

• You must be a small business
• Your net asset value should be equal to or less than $6 million

Meeting the first condition: What’s a small business?

For CGT purposes, you’re a small business if you have an aggregated turnover less than $2 million. This applies to sole traders, partnerships, trusts, and companies.

Aggregated turnover includes the value of your business and the value of any affiliates or business connections you may have. There are three ways to calculate your aggregated turnover:

Use your previous year's aggregated turnover

If it’s less than $2 million, you’re eligible for CGT concessions as a small business.

Estimate your aggregated turnover for the current year

Consider your previous years’ turnovers to estimate your current turnover. While doing this, you have to remember that your businesses may have grown, and they may have turnover of more than $2 million. That's why you should consider any operational changes you've made recently or plan to make in the current year. Changes in business operations include staffing, working hours, remote working, introducing or discontinuing products or services, your pricing strategy, and your market competition.

Calculate your actual aggregated turnover for the current year

If it exceeds $2 million, you’re not eligible for CGT concessions as a small business. However, you may still be considered a small business entity by the ATO for other rules or legislation.

12-month CGT discount

If you run a small business and you’ve held your asset for more than 12 months, you immediately qualify for a 50% reduction on your gains. It's optional, and it applies to sole traders, partnerships, and trusts. This is called the CGT discount.

If the asset is owned through a superannuation fund, you can receive up to 33.33% of this CGT discount. However, this discount doesn’t apply to companies.

Even if you’re not a small business, you may still be eligible for certain CGT concessions if you meet the second condition.

Meeting the second condition: What’s net asset value?

Net asset value refers to the total market value of your CGT asset, minus any liabilities you may have.

For instance, if you own a cafe and you’re selling your business to someone else, you’ll be calculating the net asset value of all your business assets. This includes your land, buildings, and equipment, as well as intangible assets such as goodwill.

Once you’ve calculated the value of those assets, you have to deduct your liabilities, such as loans and debts, financial obligations, tax liabilities, long service leave, and annual leave.

Which assets you should include and exclude from your calculation depends on your business arrangements. For example, if you’re a sole trader selling your business, your home won’t be included in the calculation.

However, if you’ve used your home, or a portion of it, to run your business—as storage, spare office, packaging area—you’ll have to assess how much of the house’s value has been used for the business. To calculate this, you’ll take into account the current market value of the house, how long you’ve owned it, and how long you’ve used it for your business. That’ll help you identify the income-producing value of your home. If you’ve used your home for short periods in a year to run your business (such as 6 months in one year, 12 months in another, and none at all in the third year), you’ll calculate the percentage for each year, add them together, and calculate the exact amount of assessable income you’ve earned from your home.

The net value of all your assets should be equal to or less than $6 million just before CGT event. So if you sell your business to Mark on the 1st of December, 2022 but you draw up the contract only on the 15th of January, 2023, your net asset value should be less than $6 million as of the 15th of January. This is the Maximum Net Asset Value test.

What if you're in a partnership business?

When you calculate the asset value, consider assets of the business and any assets owned by the partners or affiliates that are still used in the business. For example, if you run a cafe as a partnership business, and your partner, Sarah, owns some of the equipment you use to run the business, you have to include the value of that equipment. However, if Sarah is also a partner in a separate salon business, assets used for that salon business don't apply, even if Sarah owns them.

If you’re not a small business (if your aggregated income is higher than $2 million) and your net asset value exceeds $6 million, you won’t be eligible for any CGT concessions.

Applying CGT concessions

There are four types of CGT concessions. To be eligible for any of these, you should pass either the small business entity (SBE) test or the net asset value (NAV) test. Based on your circumstances, you could be eligible for more than one concession.

1. Small business 15-year exemption

This applies only if you’re over 55, you’ve held an active asset for more than 15 years, AND you’re either retiring or permanently incapacitated. In this case, you can entirely disregard your capital gains.

You won’t have to pay tax on that particular gain, and you don’t have to apply any other concessions. You can choose to take your capital gains as a bulk cash sum or transfer it into a super account.

Note that this exemption takes priority over the others. If this applies to you, you don't have to consider any other exemptions—including the 50% CGT discount because it doesn't alter your capital gains.

If the small business 15-year exemption doesn't apply to you, use the 50% CGT discount and then apply any or all of the following concessions on your remaining capital gains.

2. Small business 50% active asset reduction

If your asset qualifies as an active asset, you’ll be eligible to reduce your capital gain by a further 50%. Going back to Bruce in our example above, his capital gains were $1,500,000. He will first apply the general CGT discount on his gain, getting to an assessable gain of $750,000.

Because he’d been using his store to run his business on a daily basis, it’s classified as an actively held asset, which gives Bruce a further 50%, leaving him with an assessable income of $375,000.

3. Small business retirement exemption

This is a great way to save your capital gains for when you retire.

Under this exemption, you can completely disregard your capital gains, if—

• You're an individual satisfying the basic conditions for CGT exemptions
• You're under 55 years of age, and
• You've kept a written record of your gains

The catch, though, is that after you've applied other concessions, you have to transfer the remainder of your gains into an approved super account or retirement savings account. This is so you can save your profits while you continue to run your business.

However, you don’t have to transfer your gains to your super or retirement account right away. You must only make the contribution when you decide you want to use this particular exemption. So if you’re 54 when you receive your gains but you turned 55 before your tax returns are due, you won’t have to contribute the funds to a super or retirement account.

Based on your business' specific circumstances and the type of CGT event, there may be additional conditions. Read more about them on the ATO website.

If you’re eligible for this concession, you should apply it after you’ve applied your CGT discount and your active asset reduction. You can also apply this instead of the 50% active asset deduction, but we suggest using all concessions you're eligible for.

4. Small business rollover

You can use this concession if you’re getting a replacement asset with the gains from selling a previous asset. If applicable, you can defer your gains wholly or partly, depending on the cost of your new asset. Essentially, you’re rolling over your CGT liability to a later year when you might sell the asset.

There are a few steps to go through before you apply this concession. First, adjust you gains against any capital losses you may have incurred. For example, if your capital gains are 1,500,00 and you’ve incurred a loss of 500,000, you should deduct that amount before you apply any concessions.

Once you’ve done that, apply the CGT discount of 50%, which will leave you with an assessable capital gain of $500,000. If the asset’s been active in the business, apply a further 50% using the active asset reduction. That’ll give you a $250,000 worth of assessable income.

You can then apply the rollover concession on the $250,000. If your replacement asset costs only a portion of the assessable income, say $100,000, you can also apply the small business retirement exemption for the remaining $150,000 of your assessable income.

When you're applying your concessions, remember to go through them in the following order of priority:

1. Small business 15-year concession
2. 50% CGT discount
3. 50% active asset reduction
4. Retirement exemption
5. Rollover concession

How to calculate CGT?

(Sale value of an asset - cost base) - net losses = net gain

(Net gain * 50% CGT discount) * 50% active asset reduction = assessable income

Apply the small business retirement exemption and/or small business rollover concession to your assessable income to reduce it to nil.

If you don’t apply those exemptions or are are ineligible to do so, add your assessable income to your annual tax return. Your final tax amount will depend on your income margin.

Use the CGT record keeping tool to track gains and losses from your CGT events in a particular financial year.

Selling shares or trust interest
So far, we've discussed how to go about applying CGT concessions when you sell physical assets. If you're selling your shares in a company or interest in a trust, there are further conditions.

To be eligible for CGT concessions, you should meet one of the following additional conditions:

• You should be a CGT concession stakeholder in the company or trust
• Your CGT concession holders should have a small business participation percentage of over 90%

Let's break all of that down.

Who is a CGT concession holder?

A CGT concession holder is either—

• A significant individual - an person who holds at least 20% of small business participation in the trust or company, including both direct and indirect participation.

A company or trust can also be a 'significant individual' if there's at least one person in the company or trust that's a significant individual before the shares or interest are sold (CGT event).

• The spouse of a significant individual who also holds some percentage (above zero) of small business participation in the trust or company.

What's the small business participation percentage?

Your small business participation percentage is the total value of your direct and indirect participation in a company or trust.

Indirect small business participation occurs when you have a third party between you and the company. They are called interposed entities. For example, let's say Jack and Jill run The Eucalypt Trust with Jack owning 80% and Jill owning 20% of distributions. The Eucalypt Trust also owns 95% of shares in The Snow Gum Company.

While Jack and Jill have direct participation in The Eucalypt Trust, they also have indirect participation in The Snow Gum Company. To calculate their indirect participation percentage, we'll multiply each of their direct participation in the trust and the total ownership percentage. So:

• Jack's indirect participation percentage in The Snow Gum Company: 80% * 95% = 76%
• Jill's indirect participation percentage in The Snow Gum Company: 20% * 95% = 19%

Your direct participation percentage is based on whether you're selling shares of a company or interest in a trust.

If you're selling a company's shares:

Whether you're a sole trader, partnership, trust, or company, your direct participation percentage is the smallest value percentage of either your:

• Voting power in the company whose shares you're selling - ignore all redeemable and jointly-held shares
• Dividend payments
• Capital distribution

For example, if you hold 20% of dividends, 45% of capital distribution, and 18% of voting rights, you should only consider 18%—the smallest value percentage. These make up your direct small business participation.

If you're selling interest in a trust:

When business entities are entitled to all of the profit and capital of the trust,

Your direct participation percentage is the lowest of either:

• Your entitlement in the trust's income
• Your entitlement to the trust's capital

When business entities aren't entitled to all of the profit and capital of the trust,

Your direct participation percentage is the lowest of either:

• Income distributions you're entitled to during that income year
• Capital distributions you're entitled to during that income year

If the trust makes no profit or incurs a loss, and you didn't contribute any income or capital to the trust in a specific income year, your direct participation percentage will be the same as the previous income year.

Your small business participation will be zero in both of the following situations:

• The trust earned an income without a tax loss, and therefore didn't distribute the income
• The trust (and trustee) has never distributed income in any of the previous years

When do you need to have a small business participation percentage of over 90%?

If you're selling shares in a company and are not a CGT concession shareholder, do the 90% test. If you pass, you may be eligible for CGT concessions.

As a non-CGT concession shareholder, when you sell your shares, you should hold at least 90% of that company's shares. This is most common in partnerships and trusts that have multiple owners, where each person holds a portion of shares. For example, let's say Red, Gold, and Purple are the three primary stakeholders of a trust called The Sweet Potato. This trust owns shares in The Kumura Company. If the the trust wants to sells its shares and be eligible for CGT concessions, its stakeholders—Red, Gold, and Purple—together should've held at least 90% of The Kumura Company's shares.

Learn more about selling company shares or trust interest on the ATO website.

Selling inherited property

One of the most common assets the ATO excludes from CGT is the sale of private residences. If you inherited property that you intend to sell, you may be exempt from paying CGT.

To be exempt from CGT on inherited property:

• It should include a main residence
• You should sell the house as part of your property sale

For instance, let's say you inherit a cattle property with a barn and a house. If you sell the land and retain the house and barn, you'll still have to pay CGT on your sale. To be exempt, you should sell the land (and/or the barn) and the house together.

If you or your benefactor (the person you inherited the property from) was a foreign resident, the house exemption doesn't apply. Whichever way you sell your property, you're still liable to pay CGT.

The ATO has a comprehensive questionnaire to help assess your CGT when selling inherited property. Check it out.

Wrapping up

This blog is not tax advice. Use it as a general guide to understanding CGT conditions. Many of us who run small businesses tend to overly worry at tax time because there's just so much to learn and know. If you can compartmentalise all that information and focus on what applies to you, it becomes easier to process what guidelines you have to meet. That's what we've hoped to achieve in this post. If this helps, let us know! And if you'd like us to cover anything else, leave a note in the comments below.