Significant Individual Test: Tips & Case Studies


by Michelle Hartman, Deloitte Touche Tohmatsu

Released June 2012

ABOUT THIS PROGRAM

This program focuses on the “significant individual test”, which is fundamentally important when claiming the small business CGT concessions when a business is sold.

Increasing ATO audits in this area further emphasise to the need to get the “practical bits” right.

With this in mind, the program covers tips on practical issues and problems – and strategies for dealing with them.

The program illustrates and reinforces key learning via three “real world” case studies.

Disclaimer

This paper has been prepared for education purposes and is not the provision of tax advice.

Background

The small business CGT concessions allow an eligible taxpayer to reduce their capital gain by various concessions1.

To access the small business concessions, the taxpayer must first satisfy certain basic conditions. The three major basic conditions are:

  1. the entity must be a small business entity or a partner in a partnership that is a small business entity, or the net value of assets that the entity and related entities own must not exceed $6,000,000;

  2. the CGT asset must be an active asset;

  3. if the asset is a share or interest in a trust, there must be a CGT concession stakeholder just before the CGT event, and the entity claiming the concession must be a CGT concession stakeholder in the company or trust or CGT concession stakeholders in the company or trust must have a small business participation percentage in the entity of at least 90%.

Only individuals can be considered a CGT concession stakeholder. Special tracing rules apply where a business is operated though a company or trust.

The purpose of this paper is to outline the meaning of a CGT concession stakeholder and ‘significant individual’ and provide some practical examples of its operation.

The purpose of the significant individual test

The significant individual test (the Test) was introduced effective 1 July 2006 to improve access to the small business CGT concessions, and replaced the former controlling individual 50% test.  The Test  is a proxy for the individual’s active participation in a small business and reflects the fact that there is typically minimal separation between significant underlying ownership and management in small businesses. Put more simply, those who own a small business tend to run the business2.

As a result of the introduction of the Test, the number of individuals who should be able to access the small business concessions has increased.  A company or trust can have up to 4 significant individuals plus their spouses (i.e. 8 individuals in total) who can potentially access the concessions where a small business is operated through a company or trust.

When is a significant individual required?

A CGT concession stakeholder and significant individual is a precondition to accessing the small business CGT concessions when:

  1. The asset being disposed of is a share in a company or an interest in a trust.

The shareholder or holder of the trust interest (if a fixed trust) / trust beneficiary (if a discretionary trust) must be a CGT concession stakeholder in the company or trust. Where the company or trust is held indirectly through interposed entities, the CGT concession stakeholders must have at least a 90% participation interest in the interposed entity; and

  1. A company or trust is disposing of an active asset and:

When is an individual a CGT concession stakeholder and significant individual?

A CGT concession stakeholder is:

An individual is a significant individual in a company or a trust if:

What is a direct participation interest?

A direct participation interest in a company is the  percentage of:

If the percentages of voting rights and rights to dividends or capital distributions are different, the lowest percentage is relevant. Redeemable preference shares are ignored.

Example:

Peter has shares that entitle him to 30 per cent of any dividends and capital distributions of Coffee Co. The shares do not carry any voting rights.

Peter's direct small business participation percentage in Coffee Co is zero per cent3

For a trust, where individuals have entitlements to all the income and capital of the trust, the direct small business participation percentage is the percentage of the income and capital of the trust that the entity is beneficially entitled to receive.

Where the trust is a non-fixed trust (such as a discretionary trust), the direct participation interest is the percentage of distributions of income and capital that the individual is beneficially entitled to during an income year.  If the trust makes distributions of income and capital, the beneficiary must receive at least 20% of both distributions to be considered a significant individual.

If the trust did not make a distribution of income or capital during the income year it will not have a significant individual during that income year.

Similarly to a company, if the individual’s rights to income and capital are different, the lowest percentage counts.

The indirect small business participation percentage is determined by multiplying the individual’s direct small business participation percentage in another entity (intermediate entity) by the sum of the intermediate entity’s direct and/or indirect small business participation percentage in another entity.

Example:

Discretionary Trust owns 100 per cent of the shares in Operating Company; therefore Discretionary Trust has a 100 per cent direct interest (and no indirect interest) in Operating Company.

Anna receives 80 per cent of the distributions from Discretionary Trust; therefore she has a direct participation percentage of 80 per cent in Discretionary Trust.

To find Anna's participation percentage in Operating Company, multiply together Anna's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

80% x 100% = 80%

Anna has an 80 per cent participation percentage in Operating Company and is therefore a significant individual of Operating Company.

Bill receives 15 per cent of the distributions from Discretionary Trust; therefore he has a direct participation percentage of 15 per cent in Discretionary Trust.

To find Bill's participation percentage in Operating Company, multiply together Bill's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

15% x 100% = 15%

Bill has a 15 per cent participation percentage in Operating Company and is therefore not a significant individual of Operating Company. (As a spouse of a significant individual with a participation percentage greater than zero in the entity, Bill will be a CGT concession stakeholder. See paragraph 1.23.)

Deborah receives 5 per cent of the distributions from Discretionary Trust; therefore she has a direct participation percentage of 5 per cent in Discretionary Trust. To find Deborah's participation percentage in Operating Company, multiply together Deborah's direct participation percentage in Discretionary Trust and Discretionary Trust's total participation percentage in Operating Company.

5% x 100% = 5%

Deborah has a 5 per cent participation percentage in Operating Company and is therefore not a significant individual of Operating Company. (Deborah is not a CGT concession stakeholder.)

Tips and traps

  1. Issuing shares with different rights (such as limited voting power or discretionary rights to dividends) may cause issues with satisfying the significant individual test. This is because it is the lowest percentage of voting, dividend and capital rights that is taken into account in determining a participation interest in a company.

If a shareholder has voting rights and only discretionary rights to dividends then their participation interest in the company will be nil (i.e. as they do not have a fixed right to dividends).

There may be an alternative way to control voting power or as a mechanism for distributing discretionary dividends, such as issuing redeemable shares – as redeemable preference shares are ignored in determining significant individuals.

Another mechanism is to ensure that the shareholders with the voting and capital rights have at least a 20% entitlement to any dividend paid by issuing them the same class of discretionary dividend shares.

For example:

A Co Pty has 2 ordinary shareholders Bill and Ben, each hold 50% of the ordinary shares. The company has also issued A class shares, held equally by Bill, Ben, Fred and Wilma.

The company has the discretion to pay dividends on either the A class shares or the ordinary shares. As Bill and Ben each hold 25% of the A class shares, they have a minimum right to dividends of 25% (as regardless of what class of shares the dividend is declared, they will always receive a dividend).  They each have a 50% voting power and rights to capital and a 25% right to dividends, therefore they each have a 25% interest in the company and satisfy the significant individual test.

If however, they did not hold the A class shares, Bill and Ben would have a 0% interest in dividends (as the company could declare and pay dividends on the A class shares and exclude the ordinary shares) and neither would be considered a significant individual.

If the different classes of shares are not required consider cancelling the shares well in advance of any CGT event where a significant individual may be required.

  1. Where a business is operated by a company or trust, the company or trust must have a significant individual in order to access the retirement exemption or the 15 year exemption. 

The retirement exempt amount can be paid (directly or indirectly) to a CGT concession stakeholder without regard to the percentage participation interest the CGT concession stakeholder has in the company or trust (capped at a maximum $500,000 amount over a lifetime). However, the 15 year exemption requires that the amount be paid to the CGT concession stakeholder in proportion to their interest in the company or trust.

  1. Consider the annual pattern of trust distributions: is there a significant individual each year? If not, should there be (for example if the trust may potentially access the 15 year exemption which requires a significant individual for 15 years)?

  2. If the number of investors means that no investor will have a 20% interest, consider establishing a partnership structure (or a partnership of trusts) in lieu of a trust or company.  If a partnership structure is used, the significant individual test does not apply and the partner’s individual interest in the partnership is relevant.

For example:

10 investors plan to establish a business, each having an equal interest in the business, i.e. 10%.  If the individuals incorporate a company and each are issued with 10% of the shares (whether held personally or via family entities), none will be considered a significant individual as each only holds a 10% interest. If the company shares are sold, or if the company sells an asset and realises a capital gain, none of the investors will be eligible to access the small business CGT concessions.

If however, the individuals operate the business via a partnership, it is the individual’s interest in the partnership that is relevant, i.e. 10%, and the significant individual test does not apply. Therefore, if a partnership asset is sold at a gain, and the partner satisfies the basic conditions (i.e. active asset test, $6 million net asset value test), the partner may potentially access the small business concessions.

  1. Note that income does not mean taxable income – it is the (accounting / trust) income of the trust that is relevant. Therefore – review the terms of the trust and the definition of income and ensure the percentage distributions are sufficient to establish a significant individual. The distributions should be considered before year end – after year end it is too late!

For example:

Trust A owns 100% of the shares in Company X.  The company sold an asset and realised a capital gain which should qualify for the small business CGT concessions. In order to access the retirement exemption, Company X must have a significant individual.

As a trust owns the shares, we are required to look through the trust to determine if there is indirectly a significant individual in Company X. This requires a review of the trust distributions in the year of the CGT event.

Trust A did not derive any income in the 2011 year and as a result the trustee did not make any distributions. In February 2012 the tax agent realises what has happened and it is too late to rectify. Company X does not have a significant individual.

It would have been simple to qualify for the retirement exemption if Trust A and the tax agent had considered the distributions prior to year:

  1. Take care in steaming income and capital to discretionary trust beneficiaries. As discussed above, the significant individual test counts the lowest percentage of income or capital distribution.

For example:

Trust A has sold an active asset during the 2011 year and realised a capital gain which qualifies for the small business CGT concessions. In order to access the retirement exemption, Trust A must have a significant individual.

At the end of the 2011 year, Trust A resolves to make a distribution of capital and streams 100% of the capital to Charlie.  20% of the income is distribution to Alan and the balance to Jake (Alan’s son).

Trust A does not have a significant individual: Alan has participation interest of 0% (i.e. the lowest of capital and income entitlements). Charlie also has a participation interest of 0% (i.e. as he has no rights to income).  Therefore, the retirement exemption is not available.

If however, the trustee had resolved to distribute at least 20% of the capital to Alan and at least 20% of the income to Charlie, the trust would have 2 significant individuals for the 2011 year.

Remember – the actual distribution in the year of the capital gain is important (as shown above). Ensure that you consider the distributions carefully.

CASE STUDIES

Case Study 1

Facts:

Questions:

  1. If the ordinary and A class shares have equal rights to dividends, which shareholders are CGT concession stakeholders in Operating Company Pty Ltd?

  2. If Operating Company Pty Ltd has the discretion to pay dividends to either class of shares, which shareholders are CGT concession stakeholders in Operating Company Pty Ltd?

Answer 1:

Answer 2:

As Operating Company Pty Ltd has the discretion to pay dividends on either class of shares, Tom and Jennifer no longer have rights to at least 20% of any dividend paid (as dividends could be paid on the A class shares and the ordinary shares excluded).  This means that Operating Company Pty Ltd does not have any significant shareholders.

Tips:

Case Study 2

Facts:

Question:

  1. If the shares in Operating Company are sold, or alternatively the business is sold out of Operating Company - who are the significant individuals?

  1. How should the distributions be made to give rise to as many significant individuals as possible?

Answer 1:

Operating Company Pty Ltd has one significant individual, being Uncle. Uncle has an indirect participation interest of 27% in Operating Company (ie 90% x 30%).  CGT concession stakeholders will also have a 90% participation interest in Family Trust C – as Uncle has received 90% of the distribution. Note that Aunt will not be a CGT concession stakeholder as she is not the spouse of Uncle and is not considered a significant individual in her own right as she does not have at least a 20% participation interest in Operating Company.

Mum, Dad, Brother and Sister are significant individuals of Family Trust A but not of Operating Company – each only has an indirect interest of 12.5% (ie 25% x 50%).

Husband is a significant individual of Family Trust B, but not of Operating Company – as he only has an indirect interest of 18% (ie 90% x 20%).  Wife cannot be a CGT concession stakeholder as Husband is not a significant individual.

Therefore, if the shares in Operating Company were sold, the small business CGT concessions would potentially only be available to Trust C and Uncle.

Answer 2:

Family Trust A could have distributed 40% to Dad, 40% to Brother (or sister) and 20% to Mum.  If so:

Family Trust B could have distributed 100% to Husband and he would be a significant individual with a 20% indirect participation interest in Operating Company (ie 100% x 20%).

Case Study 3:

Background facts:

Questions:

  1. Does the Trust have a significant individual and can the Trust access the 15 year exemption?

  2. Would the answer to question 1 be the same if the A and B class shares in Smith Co had equal rights to dividends?

Answer 1:

No – the Trust does not have a significant individual.

The significant individual test requires tracing through trust distributions to determine who has a  participation interest in the Trust of at least 20%.

Brian and Sara each only received 5% of the Trust distributions for last 15 years, therefore their direct participation interest is 5%.

As Brian and Sara are also shareholders in Smith Co, we trace through Smith Co to determine their indirect participation interest in the Trust via Smith Co.

Each has 50% of the voting rights and rights to return of capital, however they only have discretionary rights to dividends (ie as the company could declare a dividend on one class of share and exclude the other). As the lowest interest is relevant, ie 0% rights to dividends, they each are not significant individuals in Smith Co or the Trust.

Therefore the Trust does not have a significant individual and cannot access the 15 year or retirement exemption.

Notwithstanding the lack of significant individual, the Trust may access the 50% active asset and rollover relief (subject to satisfying the basic conditions of relief and the relevant conditions).

Answer 2:

If the A and B Class shares in Smith Co had equal rights to dividends, Brian and Sara would each have a participation interest of 50% in Smith Co (as they would receive 50% of any dividend paid).

Therefore, Brian and Sara would both be significant individuals in the Trust with a 45% indirect interest and a 5% direct interest in the Trust. 

In this case, the 15 year exemption should be available.

FOOTNOTES

  1. Division 152 of the Income Tax Assessment Act 1997

  2. Explanatory Memorandum: Tax Laws Amendment (2006 Measures No 7) Act 2007

  3. Tax Laws Amendment (2006 Measures No 7) Act 2007

STUDY POINTS

  1. To access the small business concessions, the taxpayer must first satisfy certain basic conditions.

What are they?

  1. In what circumstances is a “significant individual” a precondition to accessing the small business CGT concessions?

  2. What is a “direct participation interest” for the purposes of the significant individual test?

  3. If a shareholder in a company has voting rights but only discretionary rights to dividends, what is their participation interest in the company?

  4. “The 15 year exemption requires that the exempt amount be paid to the CGT concession stakeholder in proportion to their interest in the company or trust.”

True or false?

  1. “Where a small business is operated through a company or trust, the company or trust can have up to 6 significant individuals plus their spouses (i.e. 12 individuals in total) who can potentially access the concessions.”

True or false? Explain.