CFS highlights grey areas with CGT exemption rules

Under the 15-year exemption, the business owner will not pay CGT when they dispose of an active asset if they meet the requirements. To be eligible, they must be aged 55 years or older and retiring, or be permanently incapacitated, and must have continuously owned the asset for at least 15 years.

CFS senior technical services manager Linda Bruce said the tax laws don’t define exactly what the connection between retirement and the CGT event is, which can be frustrating for advisers and tax practitioners.

“The ATO states in its publications that it doesn’t need to be a permanent and everlasting retirement from the workforce. However the ATO is looking to see a significant reduction in the working hours that the individual works or a significant change in the nature of their present activities for it to be considered in connection with retirement,” Ms Bruce explained in the CFS podcast.

Mr Day said that while the definition of retirement in this situation is not as prescriptive of the SIS definition, the individual needs to be selling an asset, and while they may not be going immediately into full-time retirement, they do need to be scaling down into retirement. 

“So they’re dropping hours significantly in relation to the sale of this asset with a view that this sale is connected with and leading into their retirement, but it doesn’t mean you have to stop working straight away,” Mr Day clarified. 

Whether or not the individual is considered to be retiring can therefore have a significant impact on tax and super outcomes for the client, said Ms Bruce. 

She gave the example of a client Lilly, who is 60 years old and ran a successful business in her individual name as a sole trader. 

“She ran the business for more than 15 years, and she sells the business for $3 million and all the specific rules can be met to qualify for the small business CGT concessions,” Ms Bruce explained.

“The underlying gross capital gains from the sale are $2.5 million and let’s assume the CGT event is in connection with Lilly’s retirement. Lilly could qualify for the 15-year exemption, then for tax purposes, the whole entire $3 million from the sale is now exempt from the capital gains tax, we don’t have to worry about the capital gains tax. 

“Now for contribution purposes, the sale proceeds are $3 million, Lilly is able to contribute up to $1.615 million under the lifetime CGT cap into super, so that’s really huge, and on top of that, Lilly may be able to make further non-concessional and concessional contributions to super depending on the circumstances.”

If, on the other hand, the CGT event is not in connection with Lilly’s retirement, and we cannot see a significant reduction in working hours, Ms Bruce said that, unfortunately, she would not be eligible for the 15-year exemption. 

“Lilly will have to go for other exemptions instead. If the capital gains are really small, and it’s only around $100,000 or $200,000, then you can just use the retirement exemption. 

“In this case, however, the capital gains are huge, we’re talking about $2.5 million so we need to go through other concessions. We can apply the 50 per cent CGT discount and make it $1.25 million, then we can apply the 50 per cent active assets reduction discount to discount it to $625,000.

“We can then apply the retirement exemption, which has a cap of $500,000, so the left over gain will be taxed at Lilly’s marginal tax rate,” she explained.

Ms Bruce noted it would also won’t be able to contribute as much into super.  

“Very often we hear cases where small business owners have sold their business, they’re hired back by the new owner and they’re doing exactly the same activities as they were doing previously, or maybe a little less or a little more. If that’s the case, unfortunately, that’s not retiring, and the CGT event will not be in connection with their retirement,” she cautioned.  

Mr Day said that under the sale arrangement, the owner who is buying the business might refuse to buy the business unless the previous owner promises to work full-time hours over a 12- to 18-month period while they start running the business. 

“If they sign up to that, then forget having a connection to retirement because there’s been a non-substantial decrease in responsibilities or hours, but in that situation, they then qualify for the retirement exemption,” he explained.

“Obviously some people simply won’t be able to sell their business without doing the workout period, but if it is possible to reduce your hours of work, then by being nice to the new owner and agreeing to do 40 hours of work per week, you might have just cost yourself a $125,000 capital gain.”

Ms Bruce said it’s also important to note that the ATO has stated in their publications that it is possible to sell an asset prior to retirement, but the time frame specified by the ATO is very short. 

“So if the client is engaging with the owner and just working for a month or two, the sale could well still be in connection with their retirement, but if the time frame is longer as in three or six months or even 12 months, then we just don’t know, and most likely, the answer is no, but we don’t know for sure,” she said.

“In that case, to avoid missing a really good tax and super opportunity, it’s worthwhile engaging a tax accountant and going to the ATO to obtain a private ruling to [determine whether] they are retiring.”