Case Study: The story of the Aussie tech start-up, the tax time bomb and the extra CGT
By Harrison Dell, Senior Associate
Business structures need to be reviewed at critical events in the business cycle, otherwise a highly successful venture on one hand can create a tax nightmare down the track.
Often an operating company owned by a family trust is the recommended structure for Australians operating a business. It makes good sense, as it allows income splitting, access to the 50% CGT discount at the shareholder level and caps operating income at the corporate tax rate. Variations of this structure are common, such as interposing a holding company between the trust and operating company for greater asset protection.
This case study is a cautionary tale for all who help businesses with their tax structuring and any business owners looking to leave Australia (even temporarily).
Mr Unicorn started a tech business in 2015 that sells and develops special software. Around 30 June 2018, Mr Unicorn wanted to access capital from the US to substantially grow the business and to eventually list the company on the NASDAQ. He wishes to use a US LLC (‘limited liability corporation’) as the head company for commercial reasons.
The business is carried on by Unicorn AUS Pty Ltd, which is wholly owned by the Unicorn Family Trust. Unicorn AUS Pty Ltd is valued at approximately $5 million AUD around 30 June 2018.
Below is a diagram of the initial structure:
The Recommended Restructure
Mr Unicorn was advised to use a scrip-for-scrip rollover (Subdivision 124-M of the Income Tax Assessment Act 1997 (ITAA97)) to interpose a US LLC between the Unicorn Family Trust and Unicorn AUS Pty Ltd, named Unicorn Holdings LLC. This was recommended by Mr Unicorn’s Australian tax advisor as the effect of the rollover is to disregard any capital gain or loss arising from the Unicorn Family Trust transferring its shares in Unicorn AUS Pty Ltd to Unicorn Holdings LLC. Mr Unicorn was happy with this advice as it was cheap to implement, he paid no CGT now and it achieved his goal of a US holding company for raising further funds to grow the business.
Unicorn Holdings LLC was a US tax resident company. Mr Unicorn moved to Los Angeles and controlled the company, so Mr Unicorn ceased to be an Australian tax resident. While CGT event E1 (ceasing to be an Australian tax resident) happened for Mr Unicorn, he had minimal assets in his own name so CGT event I1 had little impact. Unicorn AUS Pty Ltd and the Unicorn Family Trust remained as Australian tax residents, as an Australian company remains an Australian tax resident and Mr Unicorn’s son acted as trustee of the Unicorn Family Trust.
Below is a diagram of the updated structure:
The planned success happened; the software business of Unicorn AUS Pty Ltd was booming and Silicon Valley private equity firms could not invest enough. In 2019, sales grew 20 times and Unicorn AUS Pty Ltd had annual revenue of $100 million AUD and had started to turn a substantial profit. In June 2019, Mr Unicorn (via the Unicorn Family Trust) decided to sell $20 million AUD worth of the shares in Unicorn Holdings LLC to private equity firms to reap some rewards from his hard work.
The tax calculation for the Unicorn Family Trust is as below:
|Capital Proceeds||$20 million|
|Gross capital gain||$19,999,998|
|Net capital gain (after the 50% discount)||$10 million (approx.)|
100% of the capital gain
Since Mr Unicorn is a non-resident beneficiary of an Australian trust, he is not eligible for the 50% CGT discount. Mr Unicorn will instead be taxed on $19,999,998 with the majority at the top marginal rate of 45%. This will result in a tax bill of approximately $9 million. Tax is paid by the trustee of the Unicorn Family Trust under subsection 98(2A) of the Income Tax Assessment Act 1936 (Cth) (ITAA36) as affected by section 115-220 of the ITAA97.
The 50% CGT discount was also denied to a non-resident beneficiary in the recent case Greensill v FCT  FCA 559 (Greensill) and aligns with the ATO view in Taxation Determination TD 2019/D6 and TD 2019/D7. While Greensill is on appeal and the ATO view is in draft, the current prevailing view is that non-residents are not eligible for the 50% CGT discount in respect of capital gains made by Australian resident discretionary trusts.
Of course, hindsight is 20:20 when it comes to tax optimisation. However, a much simpler restructure could have been used to align Mr Unicorn’s goals of a US LLC without being shackled to 47% tax rates on capital gains in Australia. No doubt that Mr Unicorn could not have accurately predicted the wild success of his business, but given the option to pay some Australian tax now to save millions he may well have chosen to back himself and his business to succeed.
The problem with Mr Unicorn’s structure is the Unicorn Family Trust is a ticking time bomb, ready to explode when it receives a capital gain and distributes it to non-residents.
Using the Small Business CGT Concessions to defuse the tax time bomb
When Mr Unicorn left Australia, he may have been eligible to claim the Small Business CGT Concessions contained in Division 152 of the ITAA97. Those concessions could have been used to restructure the Unicorn group in preparation for the migration of the business and Mr Unicorn to the US.
The strategy would be for the Unicorn Family Trust to transfer its shares in Unicorn AUS Pty Ltd to a US LLC, with the US LLC owned directly by Mr Unicorn (or perhaps by another US resident entity).
This restructure is shown in the below diagram:
The Unicorn Family Trust would have the following CGT calculation if Unicorn AUS Pty Ltd had a market value of $5m AUD:
|Capital Proceeds (market value)||$5,000,000|
|Gross capital gain||$4,999,998|
|50% CGT Discount||-$2,499,999|
|Small Business Reduction||-$1,249,999.50|
|Retirement Exemption (amount to be contributed to super)||-$500,000|
|Net capital gain||$749,999.50|
|Approximate tax for beneficiary (@47%)||$352.499.76|
The tax liability can be deferred for two years under the small business rollover and the contribution of $500,000 into superannuation can be done at the end of the two-year period.
For the above strategy to work:
- care would need to be taken to ensure that the beneficiary of the Unicorn Family Trust is an Australian tax resident when the capital gain on the restructure arises (likely at 30 June), so that the 50% CGT discount can be claimed;
- the election under CGT event I1 to disregard Mr Unicorn’s capital gains should also not be made, as making this election will result in the shares in Unicorn Holdings LLC becoming ‘Taxable Australian Property’ under Division 855 of the ITAA97 and therefore subject to continuing taxation in Australia; and
- the tax implications of cross border financing should be considered. For example, if Unicorn Holdings LLC were to loan funds to Unicorn AUS Pty Ltd to grow the business, transfer pricing and thin capitalisation should be considered. This can be managed by an appropriate mix of equity and debt to fund the Australian operations.
Care should also be taken to ensure that distributions made by the Unicorn Family Trust are not made solely to circumvent the CGT issues described above. There are specific and general anti-avoidance rules (such as section 100A of the ITAA36) which can undermine this strategy and impose significant penalties.
This is a complex strategy requiring eligibility for the Small Business CGT Concessions, managing the beneficiaries of the Unicorn Family Trust, the special CGT event on becoming a non-resident of Australia for tax purposes and timing issues. However, it could have been enormously effective to reduce Mr Unicorn’s Australian tax from almost $9 million to around $350,000.
The moral of this story is to always get specialist advice before engaging in a major transaction or restructure of your affairs. With careful planning and foresight, better tax outcomes can be achieved.
A background as an ATO auditor, a decade in the family cinema business and a bachelor of psychology make Harrison an incredible problem solver. His unique insights give practical solutions for all tax and duty matters with a special interest in trusts, business succession planning, international tax and corporate tax issues. Harrison can do more than just heavy lifting with ATO dealings, he’s also an amateur powerlifter.