Every so often the ATO creates new tax law that makes it not only worthwhile to be in business, but specifically, to be in a “start-up” horse breeding and/or racing business
Such law is known as “The Simplified Tax System” (STS) and it has only been operative, in its current form, since 1 July 2005. The “old” STS was originally introduced on 1 July 2001.
As a result of the audit, my dealings with the ATO have increased enormously over the past 12 months - to absolute record levels. My constant dealings with them has certainly bought into sharper focus as to what they expect of a horse racing business and GST enterprise.
The intention of the STS is to provide an optional tax system for small business owners and to relieve them of a substantial part of their tax compliance burden. It must be emphasised that the STS does not apply to non-business taxpayers that have income from passive investments such as a rental property or shares.
This article will go into some detail about the operations of the STS and how they can specifically assist horse breeders and owners. The beauty of the STS is that it applies to individuals and other entities (e.g. companies). Just to keep you on your toes, I’ll conclude with more changes to the STS announced in the latest 2006 Federal Budget, these being operative from 1 July 2007
The Government has estimated that over one million businesses (i.e. 95% of all businesses, and 99% of farming businesses) would be eligible for the STS. Around 65% of these businesses operate as individuals or partnerships.
The Government has identified that the take-up rate for the “old” STS is only around 20%, which is significantly lower than the Government’s take-up rate of around 90% when the STS was first introduced. In addition, the Government has identified that the simplified (cash) accounting arrangements, which I will explain below, have acted as a major disincentive to small business entering the STS. This explains why there has been constant changes to the STS since originally introduced.
THE CURRENT STS RULES
Who is eligible for the STS?
Criteria 1 - A tax business is carried on in that year (self-explanatory), i.e. the activity cannot be a “hobby”. My other articles discuss the ATO “business” tests for racing and/or breeding at length. Refer also my web site at www.carrazzo.com.au;
Criteria 2 - STS average turnover for that year is less than $1m. The average is generally based on three of the previous four years, or the current year plus an estimate for the two subsequent years; and
Criteria 3 – depreciating assets held by at the end of the year are valued at less than $3m.
Note - Land is not a depreciating asset, but improvements and fixtures are treated as separate from the land and may be depreciating assets.
What is "STS average turnover"?
There are two methods of calculating STS average turnover.
For an established horse business, the first method is based upon turnover in prior years. If the result is greater than $1m, i.e. too high for eligibility to be an STS taxpayer, the taxpayer uses the second method, which is based upon turnover for the current year and estimated turnover for the subsequent two years. The second method may also be used here the business owner was not carrying on a business in any of the prior four years
First calculation method - STS average turnover
A taxpayer's STS average turnover is worked out using the following formula:
Sum of relevant STS group turnovers + number of averaging years
"Sum of relevant group turnovers" is:
"Number of averarging years" is:
What is "STS group turnover"?
A taxpayer's Simplified Tax System (STS) group turnover for an income year is the total of:
In effect, the STS turnover is not only what the small business itself generates, but also related entities of the business owner. Accordingly, many wealthy breeders will not be able to access the STS as their other businesses will generate too much turnover.
Example 1 - calculating STS turnover using the first method
David wishes to enter the STS for 2005/2006. His yearling sales income for the four years 2000/01 to 2003/04 are $1.2m, $1.5m, $1.25m and $700,000 respectively. David ignores the highest year and averages the other three years, i.e. ($1.2m + $1.25 + $700,000) ÷ 3 = $1.05m. David’s STS average turnover under the first calculation exceeds the $1m limit, so he does not qualify under this calculation.
However, David may qualify under the second calculation, which computes the average of his actual or estimated STS group turnover for 2005/06 and his estimated STS group turnovers for 2006/07 and 2007/08 (see below).
Second calculation method – STS average turnover
If the taxpayer's STS average turnover based on past years' turnover is too high for STS taxpayer eligibility, a different calculation is to be used based upon the current and future years. The second calculation is made in the following manner:
(1) the taxpayer works out their actual or reasonably estimated STS group turnover for the present year and a reasonable estimate of it for each of the two following income years (ignoring any of those years that the taxpayer does not expect to be carrying on a business at any time in that year); and
(2)the taxpayer then works out the average of their STS group turnovers for those years.
Example 2 - calculating STS turnover using the second method
Following on Example 1 above, David estimates that his yearling sales income for 2005/06, 2006/07 and 2007/08 will be $800,000, $850,000 and $900,000 respectively. His STS average turnover for 2005/06 under the second calculation is the average of these three amounts, i.e. $850,000. He is eligible to be an STS taxpayer for 2005/06.
If the taxpayer or a grouped entity carried on a business for only part of the present year, the taxpayer should use a reasonable estimate of what the taxpayer's STS group turnover would have been if the taxpayer and the grouped entity had carried on a business for the whole of the year.
Depreciating assets held by at the end of the year are valued at less than $3m
Essentially, the value of a "depreciating asset" at a particular time is its cost (including the costs of installation, enhancements, etc) less its cumulative "decline in value" (cumulative depreciation). For most newly-purchased assets, the adjustable value is simply the cost.
Example 3 - value of a "depreciating asset"
David acquired a float for his breeding business that cost $100,000 on 1 July 2003 and was looking to enter the STS in the 2005/06 tax year. The value of the tractor on 30 June 2006, for STS purposes, was $40,000, i.e. cost $100,000 less $60,000 of depreciation written-off relating to this asset since 1 July 2003.
Features of the STS
The STS has three main features:
(1) Depreciation benefits – depreciable assets costing less than $1,000 are generally written-off in the year of purchase. Most other assets are allocated to an STS pool, and enjoy accelerated rate of depreciation (i.e. generally, 15% in the first year and 30% in the second year);
(2) Reduced compliance - requirements for trading stock in some circumstances; and
(3)Prepayment benefits - an STS taxpayer can claim an immediate deduction for certain prepaid business expenses, e.g. service fees.
From 1 July 2005, the removal of the STS "cash accounting" rules will mean that STS taxpayers will no longer be required to account for their income and deductions only when received and paid respectively, instead an STS taxpayer will need to adopt either cash or accruals method for recognizing their income for tax purposes, unless the STS taxpayer continues to use the STS "cash accounting" method under the "old" rules.
A taxpayer that joins the STS is subject to all of the STS rules but can choose not to apply the main STS trading stock modifications.
Expanded summary of the STS benefits
Prepaid expense benefits
An immediate deduction is available for prepaid expenses paid by STS taxpayers provided the period during which the services will be provided is no more than 12 months in duration and ends in the next income year.
Depreciation (capital allowances)
The main features of the depreciation (capital allowances) provisions of the STS are as follows:
depreciating assets costing less than $1,000 are deductible when acquired, but the deduction is still limited to the extent of business use;
with limited exceptions, depreciating assets costing $1,000 or more are allocated to either a general STS pool (for assets with an effective life of less than 25 years) or a long life STS pool (for assets with an effective life of 25 years or more); and
deductions for "pooled assets" are allowed at the rate of 30% of the opening pool balance for the general STS pool and 5% for the long life STS pool. These are equivalent to diminishing value rates. A deduction at half the normal rate of 15% is allowed for an asset (or an improvement to an existing asset) in its first year of business use, in effect, treating all such assets as if they were acquired half-way through the year.
Expanded summary of the STS benefits
The normal trading stock provisions apply to STS taxpayers, but are modified slightly in certain circumstances, the major one being:
where the reasonably estimated value of an STS taxpayer's trading stock at the end of a year differs by less than $5,000 from the value of their trading stock at the start of the year, the STS taxpayer does not have to perform a stocktake or account for the change.
If you are using the "write-down" rules for valuing closing stock of mares and stallions, this basis is quite impractical and not recommended.
Is the Simplified Tax System really simple?
Whether the STS is simple depends largely upon the circumstances of the individual small business taxpayer. Some small businesses will be able to avoid the complexities and benefit from the simplification features. Others will find that certain aspects are complex, or of little benefit to them.
Taxpayers that will benefit most from the STS
Small business taxpayers likely to benefit most from the STS include:
taxpayers that frequently acquire depreciating assets costing less than $1,000;
taxpayers that use their depreciating assets 100% for business purposes. The pooling system for depreciating assets provides generous deductions and is also very simple to operate where the taxpayer uses the assets 100% for business purposes;
business taxpayers for whom access to deductions for prepaid amounts under the 12-month rule would be significant;
taxpayers that, under the STS, will be able to avoid performing year-end stocktakes or adjusting their assessable income or deductions to reflect changes in trading stock from year to year.
Generally, these taxpayers would have businesses where the value of trading stock is unlikely to vary from its current level by $5,000 or more, and it is easy to make a reasonable estimate confirming that the change is less than this amount.
MORE PROPOSED CHANGES TO THE STS
As part of the measures announced in the 2006 Federal Budget, it is proposed that from 1 July 2007:
the STS average turnover threshold will be increased from $1m to $2m; and
the $3m depreciating assets test will be abolished.
In another major win for small business taxpayers, STS taxpayers, from 1 July 2007, will not need to satisfy the $6 million "net asset value test" to be eligible for the special small business capital gains tax (CGT) concessions.
If enacted, the budget changes will apply from 1 July 2007 and will make it easier for small business taxpayers to qualify to enter the STS.
Example 4 – breeder qualifies for STS under new rules
Frank, a commercial horse breeder, wishes to enter the STS from the 2008 income year. His STS group turnovers for the last four income years are as follows: $1.6m (2004), $1.5m (2005), $1.4m (2006) and $1.3m (2007).
Using the turnover for the 2005 to the 2007 years (the three lowest years can be chosen), Frank’s STS average turnover is $1.4m (i.e.[$1.5m+$1.4m+$1.3m] ÷3). Based on the current threshold of $1m, Frank is not eligible to enter the STS as his STS average turnover exceeds this amount.
However, under the proposed Budget changes, Frank would be able to enter the STS from the 2008 income year, as his STS average turnover is less than the proposed new limit of $2m.
You are welcome to contact me if you wish me to clarify or expand upon any of the matters raised in this article.
PAUL CARRAZZO CPA
CARRAZZO CONSULTING CPAs
22 BLACKWOOD ST, NORTH MELBOURNE VIC 3051
PH: (03) 9329 7044
FAX: (03) 9329 8355
MOB: 0417 549 347
Web Site: www.carrazzo.com.au
Any reader intending to apply the information in this article to practical circumstances should independently verify their interpretation and the information's applicability to their particular circumstances with an accountant specialising in this area.
Reproduced with permission from the Australian Bloodhorse Review
© Copyright 2007
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