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CASE 47/97

Members:
SA Forgie DP
KL Beddoe SM
JD Horrigan

Tribunal:
Administrative Appeals Tribunal

Decision date: 31 October 1997

SA Forgie (Deputy President)

On 21 September, 1995, the applicant applied for review of decisions of a delegate of the respondent, the Commissioner of Taxation (``the Commissioner''), regarding objections which had been lodged against assessments issued in relation to the years ending 30 June, 1992 and 1993. In both cases, the Commissioner's decision was dated 24 July, 1995. In so far as the year ending 30 June, 1992 is concerned, the applicant had lodged its objection on 13 May, 1993 to an assessment issued on 20 May, 1993. In so far as the year ending 30 June, 1993 is concerned, the applicant had lodged its objection on 6 June, 1994 to an assessment issued on 13 May, 1994. Both objections were amended pursuant to an order made by Senior Member Muller on 24 May, 1996.

2. At the hearing, the applicant was represented by Mr Keane QC with Mr Hack of counsel and the Commissioner by Mr Fraser QC with Ms Holmes of counsel. The documents lodged pursuant to section 37 of the Administrative Appeals Tribunal Act 1975 (``the T documents'') were admitted in evidence together with other documentary and oral evidence which we have considered in preparing these reasons.

Background

3. The applicant carries on a business of developing and subdividing undeveloped or broadacre land and selling the subdivided lots in Queensland and New South Wales. It does so by acquiring such land, obtaining appropriate approvals and carrying out various construction work to prepare lots of land for sale.

4. Written evidence as to the processes followed by a developer in subdividing broadacre land and marketing it in each State was given by both the applicant's General Manager, Administration and Land Development, and by Mr David Perkins, a townplanner and an associate of Brannock Humphreys, who are Planning and Environmental Consultants. While the details of the procedures vary a little between the States the general schemes are similar. Unless we make specific reference to the procedure in New South Wales, the procedures we will outline are those which are followed in Queensland.

5. There are generally six stages to be completed after the purchase of the broadacre land: rezoning, subdivision approval, engineering and design process, construction process, plan sealing process and registration of titles.

6. After consultations with a variety of experts such as a consultant surveyor and town planner, consulting engineer, landscape architect and a geotechnical engineer, the applicant instructs the consultant surveyor and town planner to prepare a concept layout of the development. There then follow discussions with various officials and members of the local authority and its planning committees as well as with officials of the State. The local authority's requirements in relation to infrastructure such as roads, lot sizes, water and sewerage are noted together with their requirements as to the environment and open space. The State's requirements in relation to matters such as education and transport are also noted.

7. In light of the various State and local authority requirements, the applicant prepares a rezoning report to accompany its application for rezoning lodged under the appropriate State legislation. In general terms, the application is advertised a period is allowed for interested persons to review the application and lodge any objections they may have with the local authority.

8. Once the advertising period is completed, the local authority reviews the application and any objections. If it is approved, that approval is generally given subject to the provision of certain services and to the subdivision's meeting certain criteria as to such matters as parkland, access, visual and noise standards. Time is allowed for appeals against the approval before it is submitted to the appropriate State department to ensure that the State's requirements have been met and, ultimately, to arrange the gazettal of the rezoning.

9. The second stage in the development of the subdivision can then be taken. A subdivision application to the local authority is prepared by the developer with the consultants.

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It may relate to the first stage of development and normally comprises a detailed plan showing the road layout and how the conditions of the rezoning approval will be met. Once a subdivision permit has been issued, the applicant can carry out detailed engineering survey and design on that stage of the development.

10. A detailed engineering survey to determine the existing ground levels over the proposed road and lot locations begins the third stage of the development. The consulting engineer prepares the subdivision guidelines in accordance with the local authority's subdivision guidelines as to such matters as water and sewerage reticulation, road and drainage design and minimum fall requirements on the lots. A full set of engineering drawings are lodged with the local authority for engineering approval. Once that approval is given, the fourth stage of the development can begin.

11. The fourth stage is the construction of the development or, at least, of that particular stage. Tenders are called for. The successful tenderer, officials from the local authority and the consulting engineer discuss the proposed construction programme. The local authority nominates the stages at which it wishes to inspect the construction works.

12. Once the local authority has accepted that the subdivision has been constructed according to their requirements, there follows a period during which the applicant is responsible for the correct functioning of the services and facilities on the subdivision. That period extends for several months. At the end of the period, the local authority inspects the services and facilities to ensure that all are satisfactory. If the local authority is satisfied, it accepts all responsibility for the services and facilities.

13. The sealing of the plans is the fifth stage. The applicant lodges with the local authority a plan of survey prepared by the consulting surveyor. That gives details of the geometrical aspects of each lot, easement requirements and park and road dedications. Also lodged with the local authority are the documents required to transfer the parks and access restriction strips to the local authority and those required in relation to the easements over the lots. The applicant makes any payments necessary for water, sewerage, roads and parks and headworks at this stage. Other documentation lodged relates to the provision of services such as telephonic and electrical services.

14. Once the local authority has satisfied itself that the development complies with the conditions stipulated in the rezoning approval and the subdivision permit and that all is correct, the plan is sealed. It is normally sealed by the Mayor and the Chief Executive Officer of the local authority. In Queensland, it is only now that the applicant may advertise for sale the lots subdivided from freehold land (Land Sales Act (Qld), section 8 ). It may be possible to see the subdivided lots at an earlier stage in New South Wales. Also at this stage, areas such as the parks, open spaces and roads and services contained in those areas become the responsibility of the local authority.

15. The sixth stage relates to the registration of titles. Once the plan of survey has been sealed, that plan and other documentation are lodged with the Titles Office. The plan is registered and the titles to the lots are issued shortly afterwards. Once the plan is registered, the broadacre land is subdivided and ownership of areas such as parks and roads vests in the Crown and those areas are no longer held by the applicant (Land Title Act 1994, sections 49 and 51 ).

16. It is apparent from this outline of the steps in the development that the applicant is obliged to incur certain costs if it is to obtain from the local authority the approvals necessary to enable it to proceed with the development and so with its business. The costs associated with those approvals fall into two categories which we will deal with in more detail later but which can be summarised as:

  • • ``dedicated infrastructure costs'' - these are the applicant's costs of acquiring and undertaking work on those parts of its broadacre land which, after subdivision, are vested in the Crown or a public authority. The costs also include any necessary legal costs. Infrastructure comprising services and facilities such as roads, sewerage, drainage, electricity and parks are constructed on those parts of the land. We will refer to those parts of the land as the ``infrastructure land''.
  • • ``external costs'' - these are costs incurred by the applicant as a condition of its obtaining approval from a local authority to its subdivisions. They are not costs paid for any work physically done by the

    ATC 489

    applicant on the broadacre land but do include payments made to a local authority for headworks and other costs incurred for works which are external to the subdivision but which are required as a condition of obtaining subdivision approval.

The issues

17. The central issues in this case concern the manner in which the dedicated infrastructure costs and external costs of the development should be treated for the purposes of the Act. In essence the issues are:

  • • whether the infrastructure land and the facilities on that land are trading stock;
  • • whether, at the end of the year of income during which infrastructure land and facilities are vested in the local authority, the value of the applicant's trading stock on hand is reduced by the dedicated infrastructure costs; and
  • • whether the external costs form part of the value of the applicant's trading stock consisting of subdivided lots.

18. We have accepted that the applicant's dedicated infrastructure costs and external costs can be deducted under section 51 of the Income Tax Assessment Act 1936 (``the Act'').

The submissions

19. On behalf of the applicant, Mr Keane argued that the infrastructure land and the infrastructure facilities are part of its trading stock for the purpose of section 28 . When, during the year of income, that land and those facilities vest in the local authority, the value of the applicant's trading stock is reduced by their cost. This would mean that the value of trading stock is determined by the cost of subdivided lots on hand less the dedicated infrastructure costs.

20. On behalf of the Commissioner, Mr Fraser submitted that the expenditure in acquiring and developing the broadacre land is deductible under sub-sections 51(1) and 51(2) in the year in which it is incurred. That expenditure also forms part of the cost of the broadacre land and, subsequently, of the subdivided lots. It is part of its value in terms of section 28 . The effect of that section is to ``set- off'' the deduction under sub-sections 51(1) and 51(2) against assessable income which may arise because of the corresponding increase in the cost of the broadacre land or, later, the subdivided lots held by the applicant until the sale of those lots. After the sale of the subdivided lots, the gross proceeds of sale form part of the applicant's assessable income under sub-section 25(1) in the year in which the lots are sold. The operation of section 28 at that time brings into account against that assessable income a deduction for the excess of opening stock cost over closing stock cost.

21. The external infrastructure costs, both Mr Keane and Mr Fraser agreed, are deductible under sub-section 51 and do not as such become part of the applicant's trading stock. Mr Fraser further argued that the costs form part of the cost price of the subdivided lots. Mr Keane, however, submitted that they are not expenses of a capital nature.

The legislative framework

22.  Sub-section (1) of section 51 the Income Tax Assessment Act 1936 (``the Act'') provides that:

``All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.''

23. Costs incurred in the purchase of trading stock are allowable deductions under sub- section 51(1) . Sub-section 51(2) specifically provides that:

``Expenditure incurred or deemed to have been incurred in the purchase of stock used by the taxpayer as trading stock shall be deemed not to be an outgoing of capital or of a capital nature.''

Trading stock ``includes anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange, and also includes livestock;'' ( sub-section 6(1) ).

24. Where a taxpayer is carrying on a business, trading stock is taken into account in ascertaining whether or not the taxpayer has a taxable income. Account is taken of the value of the trading stock on hand at the beginning of the year and that on hand at the end of the year ( sub-section 28(1) ). Where the value of the trading stock at the end of the year exceeds that at the beginning, the taxpayer's assessable

ATC 490

income includes the value of the excess ( sub- section 28(2) ). Where the value of the trading stock at the beginning of the year exceeds the value of that at the end, the amount of the excess is an allowable deduction ( sub-section 28(3) ). The effect of section 29 is that the value of trading stock taken into account at the end of a year of income becomes its value at the beginning of the year of income immediately following it.

25. The manner in which the value of trading stock is assessed is the subject of section 31 . Under sub-section 31(1) , the value of each article of trading stock, other than livestock, is to be either its cost price, market selling value or the price at which it can be replaced. It is for the taxpayer to choose one or other of these three methods of valuation.

Consideration

26. Both parties agreed that broadacre land acquired by the applicant as a land developer for the purpose of development and subdivision and subsequent sale of the subdivided lots is trading stock within the meaning of the Act. They also agreed that the subdivided lots held after the subdivision has occurred are also trading stock of a land developer.

27. These propositions are consistent with the judgements of the majority (Mason and Jacobs JJ, Murphy J concurring) of the High Court in
FC of T v St Hubert's Island Pty Ltd 78 ATC 4104; (1977-1978) 138 CLR 210. As Mason J said:

``If trading stock according to its ordinary meaning denotes land as well as goods and commodities, it must follow that land may form part of the trading stock of a business before it has been converted into the condition in which it is intended to be sold. Just as raw materials and partly manufactured goods form part of the trading stock of a manufacturer, so also virgin land which has been acquired by a land developer for the purpose of improvement, subdivision and sale in the form of allotments will form part of his trading stock. If the statutory definition of `trading stock' in sec. 6(1) were an exclusive and comprehensive definition it might be possible to draw a distinction between land and goods and to assert that the presence of the word `manufacture' in that definition has a restricted effect so as to exclude land acquired for the purpose of improvement and development antecedent to sale, thereby overcoming the argument that land so acquired is none the less land acquired for the purpose of sale within the meaning of the definition.

But the statutory definition is inclusive only and no distinction should be drawn between goods on which work is to be done before they are converted into the condition in which they are intended to be sold and land on which work is to be done before it is converted into the condition in which it is intended to be sold.

Once it is accepted that land acquired for the purpose of improvement and development as a preliminary to sale in allotments in its improved form constitutes part of the trading stock of the land developer's business, notwithstanding that the land as acquired differed in condition from the land as intended to be sold, the issue in the present case is whether the land in question was acquired by the respondent taxpayer for its business as a land developer, that is, for improvement and development as a preliminary to sale in subdivided allotments. That substantial work remained to be undertaken in connexion with the land before it would achieve the condition in which it was intended to be sold is an immaterial consideration. It is enough that the respondent was carrying on the business of a land developer and that it acquired the land in the course of carrying on that business. The facts as outlined by the primary judge make it plain that the land was acquired by the respondent taxpayer for this very purpose.''

(ATC pages 4113-4114; CLR pages 228-229)

28. The time at which a developer holds trading stock in the form of subdivided allotments rather than in the form of broadacres, or in addition to the broadacres it otherwise holds, occurs at the time at which the subdivided allotments become identifiable and segregated components distinct from the broadacres (
Barina Corporation Limited v FC of T 85 ATC 4847, Rogers J).

29. The question whether property which had clearly been identified as trading stock in the past continued to be trading stock in the changed circumstances of the taxpayer was considered by the High Court in the earlier case of
FC of T v James Patrick Murphy (1961) 12 ATD 366

ATC 491

; (1961) 106 CLR 146. It was concerned with that question in the context of sub-section 36(1) of the Act. Pursuant to that section, the Commissioner had treated the sale of livestock as assessable income while allowing as a deduction an amount for the cost of those livestock. Sub-section 36(1) provides, among other matters, that the value of ``property being trading stock'' is to be included in a taxpayer's assessable income where he or she disposes of that property by sale, gift or otherwise, that property constitutes or constituted the whole or part of the assets of a business which the taxpayer is or was carried on by the taxpayer and the disposal was not in the ordinary course of carrying on that business.

30. The taxpayer had formerly carried on business as a grazier but had sold the property to a company and leased the livestock to that company. The company could not dispose of the livestock without the taxpayer's consent. The taxpayer argued that the expression ``trading stock'' is used in the Act only in relation to a business. As he was not carrying on a business, the livestock did not come within the description of ``being trading stock''.

31. The High Court noted that the definition of ``trading stock'' has two limbs. The first limb ``... provides an historical test, making decisive the purposes for which the taxpayer produced, manufactured, acquired or purchased the property.'' (ATD page 369; CLR page 154) The second concerned only livestock and so the physical nature of that particular type of property. There is nothing in the Act, the court said, to tie the expression ``trading stock'' to a period in which the taxpayer carries on a business. It is enough that it had a history or character as the taxpayer's trading stock. There ``... is no grammatical incongruity in its being referred as being trading stock of a business which was carried on by taxpayer.'' (ATD page 369; CLR page 154) Apart from the grammatical justification for its finding, the Court continued that:

``... In s. 36, the connexion of property with a business of the taxpayer goes to the root of the reasoning upon which the provision is constructed; but it is reasoning which is valid whether the carrying on of the business by the taxpayer be current or past. The connexion with a business having supplied the ground for an allowable deduction under s. 51 of the outgoing incurred in the acquisition, it supplies also the logical basis for an inclusion in assessable income of the value obtained or foregone upon the disposal, whether the disposal be during the carrying on of the business by the taxpayer or at any time thereafter. For the case where a disposal occurs after the taxpayer has gone out of the business, s. 36 insists upon the former connexion of the property with the business by describing it as having constituted the whole or part of the assets of a business, s. 36 insists upon the former connexion of the property with the business by describing it as having constituted the whole or part of the assets of a business which was carried on by the taxpayer. But it is with complete consistency that even in that case the section refers to the property as still `being trading stock'.''

(ATD page 369; CLR pages 154-155)

32. Murphy was applied by Ryan J in
Kratzmann's Hardware Pty Ltd v FC of T 85 ATC 4138 in the context of shares. The shares had been acquired as trading stock but had been converted to investments before being realised to pay a debt. For the purposes of sub-section 36(1) , they retained their character as trading stock despite their previous severance from the taxpayer's trading stock.

33. In summary, it seems to us that the authorities establish that we must first characterise the property which is said to be trading stock. We must do so in order to determine whether it satisfies the historical test that it was, in the words of the definition of ``trading stock'' in sub-section 6(1) ``... produced, manufactured, acquired or purchased for the purposes of manufacture, sale or exchange...'' during a period when the taxpayer was carrying on a business. If particular property has been trading stock in the hands of the taxpayer, it will remain trading stock so far as that taxpayer is concerned. The taxpayer may, however, transform property (such as broadacre land) which is trading stock into another form of property (such as subdivided lots) which is also trading stock. In characterising the property, accounting principles cannot prevail (St Hubert's Island, ATD page 4113; CLR page 228 (per Mason J),
Philip Morris Ltd v FC of T 79 ATC 4352 at 4357 (per Jenkinson J) and
FC of T v Citibank & Ors 93 ATC 4691 at 4698-4700 (per Jenkinson J).)

ATC 492

34. As agreed, the applicant's trading stock comprised broadacre land when it purchased it for the purpose of development and subdivision and subsequent sale of subdivided allotments. As it developed the land, physical changes were made to the broadacres. Those physical changes included roads, paths, service connections and infrastructure. As the development proceeded, the boundaries of the individual allotments to be sold would have been clearly marked as would the boundaries of what was to become the infrastructure land. Despite those physical changes to the broadacre land and despite the developer's clear intention to divide the land in the manner indicated by the physical changes, the trading stock in the developer's hands remains the broadacre land at all times before the plan is registered. That is so because, until the registration of that plan, the only identifiable and segregated component is the broadacre land.

35. The moment at which the applicant no longer holds trading stock in the form of broadacre land but in the form of subdivided allotments (or subdivided allotments and the balance of the broadacre land as broadacres) is the moment at which the plan of subdivision was registered and the subdivided allotments became the subject of separate titles. At the very same moment, the infrastructure land became the subject of separate titles and was transferred to the local authority. It is only at that moment that the infrastructure land became an identifiable and segregated component separate from any other land. At the same moment, the infrastructure land is held not by the applicant but by the local authority.

36. It follows that, at no time, can it be said that the infrastructure land was, in the hands of the taxpayer, an identifiable and segregated component distinct from the broadacre land it otherwise held. Therefore, even though the infrastructure land was developed during a period when the taxpayer was carrying on a business, it could not at any time be said to be part of its trading stock.

37. The developer has clearly incurred a cost in relation to the infrastructure land but the next issue to be considered is how that cost is to be treated for taxation purposes. It cannot be regarded as simply ``wasted'' or a ``waste product'' whose cost is to be disregarded. That is clear from the analogy of leather used by Rogers J in Barina. Rogers J considered the merits of a taxpayer's argument that a nil value should be ascribed to land equivalent to what we have described as infrastructure land. If that argument were accepted, the taxpayer would not count as part of the cost of its trading stock that part of the broadacres to be dedicated to infrastructure land at some time in the future.

38. In rejecting that argument, Rogers J said:

``If the appellant's approach to the problem is correct, its manifestations could be quite curious. Assume a leather merchant purchased the hide of a cow for the purpose of selling the leather to a shoe manufacturer. The shoe manufacturer demands that the hide be cut into leather required for twelve pairs of shoes. That will use say 95% of the hide but there are bits and pieces that have to be thrown away. The merchant, on the appellant's approach may, prior to cutting up the hide, value it at 95% of cost so far as the sections he will be utilizing are concerned and at nil market value for the bits and pieces. The fact that he knows at the time of purchase that he will have to throw away bits and pieces, and calculates the price he pays with the knowledge that only 95% of the hide will be saleable, is irrelevant if one follows the appellant's approach. That would be an odd result from the statutory endeavour to throw up a more accurate barometer of the financial results of a business.''

(page 4853)

39. Application of the principles apparent in this passage leads to the conclusion that the cost of the raw material, in this case the broadacre land, cannot be reduced by deducting the cost of the material (infrastructure land) which will not be incorporated in the trading stock (subdivided allotments) which the developer ultimately offers for sale.

40. Should the cost of the subdivided allotments incorporate the cost of the infrastructure land? The case of
Kelwood Corporation Limited v Minister of National Revenue (1969) 69 DTC 641 was cited by Mr Fraser as reflecting the commercial reality in instances when a developer transfers land to a local authority. Kelwood is a decision of a Tax Appeal Board which considered a land transfer in the Canadian City of Calgary. Kelwood was a land developer which had purchased for an amount of $185,000 some 80 acres of land on 28 January, 1966. That purchase was made at the very end of the Canadian financial year

ATC 493

ending 31 January, 1966. Kelwood also held another 30 acres of land. On 31 January, 1966, it transferred the 80 acres to the local authority for the purposes of a golf course. It did so for a consideration of $1.

41. The issue for the Tax Appeal Board was whether Kelwood should be permitted to write off in the 1966 financial year the total cost of the 80 acres, less $1, or whether that amount should be treated as an expense incurred by it as part of the overall cost of its developing its 30 acre subdivision. The Tax Appeal Board considered the issue in light of sub-section 14(2) of the Income Tax Act, RSC 1952, chapter 148 which provides:

``For the purpose of computing income, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.''

42. The Tax Appeal Board concluded that Kelwood's sale of the land could not be regarded as a loss occurring in the 1966 year as Kelwood had received for its land the consideration for which it had bargained. It found that:

``... while the arrangement between Kelwood and the City, as set out in the Agreement dated January 31, 1966, involved the transfer of the legal title to the 80.62-acre parcel of land mentioned earlier to the City for the purposes of a 9-hole golf course - the said arrangement in its essence was not a simple sale at all but a combined operation by a substantial and experienced land developer (it has been operating since 1953) and an enterprising municipality wherein each stood to achieve its own particular objective, Kelwood's objective being to provide building lots which would outshine those being offered for sale by competing land developers, the City's objective being to provide a green belt within its boundaries and an amenity for its ratepayers. Thus, it may be taken that Kelwood received for its 80.62-acre parcel of land exactly the consideration for which it bargained, namely, the sum of $1.00 and certain other valuable consideration in the form of a 9-hole golf course for the benefit of residents of its Maple Ridge subdivision.''

(page 644)

43. The costs in connection with the acquisition of the 80 acres were treated as an expense in connection with the development of its 30 acre subdivision. Kelwood was permitted to deduct a part of those costs in the 1967 financial year. That part was calculated to reflect the same proportion to the whole costs as the total of front feet of residential land sold in the development as at 31 January, 1967 bore to the whole of the lots calculated on the basis of total front feet of residential land in the development.

44. We have considered this case at length for, initially at least, it appears to be very similar to the facts of the present case. We are aware, however, that we must take care in applying the conclusion in a Canadian case to a factual situation to be determined according to Australian law. In this particular case, we have been particularly cautious as we would query whether the case would have been decided in the same way were it to have been heard in Australia. Applying the definition of ``trading stock'' in sub-section 6(1) and the principles in St Hubert's Island, it is arguable that Kelwood held two items of trading stock: the 30 acres of broadacre land which it intended to subdivide and 80.62 acres of broadacre land which it intended to transfer to the City of Calgary in exchange for $1 and the City's undertaking to develop a golf course upon the land. It is also arguable that both parcels of land constituted the assets, or part of the assets, of the business carried on by Kelwood. There would have to be a real question in Australia as to whether the 80.62 acres was transferred to the City of Calgary in the ordinary course of Kelwood's carrying on that business. If it were found that the land had not been transferred in the ordinary course of that business, then the application of sub-section 36(1) of the Act would need to be considered. If it were to apply, it would lead to the result that:

``... the value of that property shall be included in the assessable income of the taxpayer, and the person acquiring that property shall be deemed to have purchased it at a price equal to that value.''

45. Putting aside our concerns related to the particular provisions of Australian law, we do not think that Kelwood can be taken to support a view that the expenses of land transferred to a local authority must necessarily be treated as part of the expenses of the development of

ATC 494

subdivided allotments. It is apparent from the reasons of the Tax Appeal Board that it reached that conclusion only after a careful analysis of the character of the transfer of the land. Its true character, it found, was to further the mutual, and quite proper, interests of both Kelwood and the local authority. The local authority acquired a golf course which was both a public amenity and a green belt within its boundaries. Kelwood, in turn, was able to offer subdivided allotments which were very close to a golf course. As a result, it was able to offer subdivided allotments which Kelwood believed would be more attractive to a potential purchaser than lots which were not similarly located. There was no finding by the Board that Kelwood was under any obligation to transfer the land or to enter any arrangement with the local authority in order to continue with its subdivision, to develop the lots or that its expenditure was a pre-requisite of its selling the lots.

46. Just as the Tax Appeal Board characterised the sale of the land and the business of the developer to ascertain the purpose of the transfer, Jenkinson J analysed the process of the manufacture of cigarettes. He did so in
Philip Morris Ltd v FC of T 79 ATC 4352 in order to determine whether a direct (or variable) costing method or an absorption (or conventional) method should be adopted in valuing trading stock comprising finished cigarettes. Under the direct costing method, only the cost of materials of which the cigarettes were made and the wages of those employees directly involved in the manufacturing process were taken into account. The absorption method took into account those costs together with the wages of employees less directly involved in the manufacturing process, such as inspectors and those engaged in quality control, and amounts referable to the maintenance and repair of plant and machinery used in the manufacturing process.

47. Jenkinson J continued with an analysis of the accounting principles behind a direct costing method and those behind the absorption method. With regard to the former, he found that it was directed to measuring the gains or losses of a business.

``... The value is the expression of an allocation of expense between that period and the next and the direct costing method justifies itself, not as accurately indicating what the article has cost the manufacturer to make, but as accurately indicating what contribution to the manufacturer's gains for the year in which it was manufactured the holding of the article at the end of the year has made.''

(page 4360)

48.  Sub-section 31(1) , however, is not directed to measuring gains and losses. It:

``... is merely a measure of a value at a particular time... The gain or loss is to find expression only in the amount by which the aggregate of closing stock values exceeds or falls below the aggregate of opening stock values.''

(page 4360)

49. The cost price, therefore, had to reflect the expenditure by the taxpayer in the course of purchasing the materials and undertaking the manufacturing processes to bring the article to the state where it became part of his, her or its trading stock on hand. Where it is necessary to ascertain the expenditure referable to a single item where the manufacturer has made many identical articles, Jenkinson J found it appropriate to allocate an equal share of the expenditure incurred in the manufacture of them all. In the case of cigarettes, Jenkinson J concluded that:

``The expenditure incurred in respect of the manufacture of cigarettes during the year should be shared among finished cigarettes and `work in progress'. If work in progress be put to one side for the present, the apportionment of that expenditure should be made as to attribute to each cigarette manufactured during the year an equal amount as the cost of that cigarette, except where the evidence shows that the manufacture of some cigarettes occasioned expenditure of greater magnitude....''

(pages 4360-4361)

50. His Honour went on to consider the costs to be taken into account in calculating the cost of trading stock. After considering the method of averaging of the cost of tobacco leaf used in manufacturing the various brands of cigarettes, he went on to consider the manner in which the costs of testing and analysing the cigarettes were to be dealt with. He said:

``The appellant subjects samples of the materials of which cigarettes are made to regular testing and analysis in order to determine various physical and chemical properties of the materials. The aggregate in

ATC 495

the year of income of the wages of those engaged in these activities, the price of materials employed in the processes (other than the materials of which cigarettes are made) and certain expenses of repairing the equipment used and of necessary travel by some of those employed in this work (all of which expenditure was designated, in documents tendered in evidence `quality control') was included by the Commissioner in his calculation of the cost of trading stock on hand at the end of the year.

Most of the information obtained as a result of those activities is utilized to maintain and improve the qualities which are considered desirable in the cigarettes which the appellant manufactures. Insofar as the activities are carried on for that purpose the expenditure is, I think, part of the cost of manufacturing cigarettes and ought to be apportioned as an element of the cost of trading stock on hand in the same way as I have indicated the wages of the fixers and inspectors ought to be apportioned.''

(page 4361)

51. There was evidence in the case that some of the information about quality control and the qualities of cigarettes was required for the promotion and sale of cigarettes. Although the evidence then before him did not justify his making a finding that this was so, Jenkinson J said that:

``... It may be that those circumstances justify some apportionment of the expenditure between the manufacturing and the selling operations of the appellant.''

(page 4361)

52. His Honour went on to decide that the appellant's expenditure for the removal and disposal of waste material was incurred in manufacturing cigarettes and so should be included in apportioning their cost. So too should the cost of maintaining, modifying and repairing machinery and other plant and equipment used in the manufacturing process unless that cost was referable to the installation of plant and equipment. If it was so referable, the cost should be capitalised.

53. Mr Fraser's argument that the dedicated infrastructure costs and external costs should be regarded as part of the value of the broadacre land and, subsequently, of the subdivided lots was centred upon the nature of the applicant's business. Its business, he said, is to sell subdivided lots of land so that income is received and profit generated. It is not engaged in the business of the development of roads, parks and other facilities so that it may donate them, free of charge, to a local authority. The applicant incurred the dedicated infrastructure costs only because it was required to do so before it could engage in its business of selling subdivided lots. Consequently, the dedicated infrastructure costs it incurred form part of the cost price of the subdivided lots.

54. We agree with Mr Fraser that the dedicated infrastructure costs and external costs should be regarded as part of the costs of the broadacre land before the registration of the plan and so before the transfer of the infrastructure land to the local authority and the creation of the subdivided allotments.

55. We also agree with him that the applicant is engaged in the sale of subdivided lots but we also consider that this is only part of its business. The applicant's business is more properly described as developing and subdividing broadacre land and selling the subdivided lots. The sale of the subdivided lots is the end devoutly to be achieved but the development of the broadacre land is no less a part of the applicant's business. The infrastructure land is developed and transferred by the applicant for the purpose of enabling it to complete the subdivision and to sell the subdivided lots. It is developed and transferred so that the applicant may subdivide the allotments which are recognised as trading stock once they have become identifiable lots and may legally be sold. It is the cost price of the subdivided allotments which we must ascertain. It is their ``actual cost'' which is the cost price (
Australasian Jam Co. Pty. Ltd. v FC of T (1953) 10 ATD 217 at 221; (1953) 88 CLR 23 at 31 (Fullagar J) of ``producing'' or ``manufacturing'' the subdivided allotments.

56. The applicant produced written evidence of the costs allocated to the infrastructure land and to the subdivided allotments in each of the applicant's estates. The Chief Accountant for the applicant made a lengthy statement. He analysed the categories of expenditure and set out the types of costs allocated to each category. Those categories were:

  • ``(a) General - this covers expenditure specifically on lots, for example, select lot clearing, construction of dams, soil tests on

    ATC 496

    fill specifically on lots, fencing, site office expenses and the like;
  • (b) Survey - this covers all surveying costs including preparation of rezoning and subdivisional applications and, where necessary, the costs of clearing undertaken specifically for the purpose of pegging of survey lines;
  • (c) Engineer - the costs of engineering consultants are included here. In New South Wales, the Hunter Water Board does its own design and supervision and these payments have been included under this category. Also included under this category are fees charged by local authorities to check engineering drawings;
  • (d) Landscape architect - these costs are landscape architect's fees, tree planting and street planting;
  • (e) Council fees - rezoning fee, subdivisional fees and development checking fees have been allocated to this category;
  • (f) Soil testing - laboratory tests, density tests, payment [sic] thickness design in relation to roadworks and the like have been allocated to this category;
  • (g) Electricity reticulation/Telecom/street lighting - contribution to the various power authorities eg, SEQEB, WBBEB, shortland electricity, along with Telecom trenching costs are allocated here. The electrical engineering design, supervision and progress payments to electrical contractors are also included along with the cost of providing street lighting. Credits for refundable electricity bonds have been included;
  • (h) Roadworks, drainage, water and sewerage contracts - most times these are part of an overall contract with regular progress payments. In New South Wales `day labour' contracts have been used. Hire of plant and machinery, supply of materials, pipes etc, provision of labour and direct supervision are allocated to this category. Where work has been undertaken on behalf of a local authority, any costs reimbursed by the local authority have been credited to this category. The columns shown in Section 3 Section 6 of Annexure C for expenditures under this head vary according to the type of services which had to be provided;
  • (i) Headworks - these are payments made to local authorities as contributions to external facilities eg, external roadworks, water supply and sewerage and the like;
  • (j) Council sundries, plan registration - to this category are allocated:-
    • • Title lodgement fees and plan registration fees; Sealing fees;
    • • Plan examination fees;
    • • Council bond fee;
    • • Sec. 149 certificates fees.''

(Exhibit A, paragraph 13)

57. The Accountant stated that, once apportioned, the costs were attributed to allotments and to roads, parks and external works. That exercise was done in consultation with external consultants whom the applicant had engaged to undertake the original work. The methodology was explained by the consultant surveyor and civil engineer in relation to two of the applicant's developments. He provided a breakup of the proportion of costs against roads and roads/reserves and those against subdivided allotments and stated that he had an intimate knowledge of the applicant's project accounts, construction techniques and timetabling and computer account data management. His methodology for the dissection of the costs for those two developments was: 

``1 Planning, Surveying, Council   100% lots
application fees

2 Engineering road design          100% roads

3 Road construction                100% roads

4 Stormwater drainage              proportional according
construction                       to length contained in
                                   roads/reserves and
                                   length in lots.

5 Water                            100% roads

6 Sewer                            proportional according
                                   to length contained in
                                   roads/reserves and
                                   length in lots

7 Electricity                      100% roads

8 Lot preparation, slashing etc    100% lots''

(Annexure ``C'' to Exhibit ``C'')

58. The Accountant went on to analyse and apportion the costs incurred in the applicant's other developments. While there are variations, the principles are similar to those adopted in the two to which we have referred.

59. Mr David Boymal, a member of the Australian Accounting Standards Board, gave evidence as to the accounting principles to be applied in a case such as this (Exhibit G). The essence of his lengthy and carefully prepared report is that there are no accounting standards or principles which have been developed to assist in the determination of the issue in this case. In Mr Boymal's professional opinion,

``... Developers are often placed in a position that the payments, even if the payments are unrelated to the development lots, must be paid in order to gain regulatory approvals. Merely because the councils and authorities have the power to withhold approval for subdivision into separate lots, sale of the developed lots or further development, and that the payments are usually made prior to such approval being granted, does not characterise the amounts as being a cost incurred in converting the land from undeveloped lots into developed lots.

In substance, the non-conversion infrastructure costs described can be more appropriately regarded as costs incurred in obtaining approval to sell the developed land in small lots, or the legal approval to sell the lots in a particular way. Such costs are not considered to be a costs of `production', `manufacture' or `conversion', as the costs are not directly or indirectly involved in converting the land into developed lots, and would more appropriately be regarded as selling costs or costs in the nature of selling costs.''

(Exhibit G, Annexure ``DGB2'')

60. Professor Anderson and Professor Zimmer prepared an opinion for the Commissioner regarding the accounting principles which are applicable in a case such as this (Exhibit 4). They prepared a report in which they analysed the economic attributes of real estate development costs and alternative accounting treatments. After doing so, they concluded that the infrastructure land cannot be regarded as an asset because:

``• there is usually no intention to derive revenues from the sales of these areas by themselves. Since no transaction is expected to occur across a market, the description `trading stock' is inappropriate.

• there is no intention by the developer to control special purpose areas, or exclude access to them. Therefore under SAC4 such areas would not qualify for recognition as an asset.

Accordingly, it is our view that since special purpose areas cannot exist as an asset in the books of a developer, costs of these areas cannot be capitalised in any separate asset account for amortisation over the project life.''

(Exhibit 4, page 15)

61. This conclusion led Professor Anderson and Professor Zimmer to eliminate separate capitalisation as an option. In their view, it left:

``... a choice between the immediate write- off and allocation to lots for costs of special purpose areas. Our opinion is that the most appropriate treatment of such costs is to allocate them to lots for recognition as an expense at sale. Our opinion is based on:

  • • the fact that the allocation to lots provides a more robust matching of revenues with the costs that generate them
  • • consistent support in both Australian and U.S. authoritative accounting statements for the allocation to lots treatment.

These conclusions provided the basis for our opinions on the specific issues upon which we were required to comment...:

Issue 1: Our opinion is that the appropriate method for dealing with costs of special purpose areas is to allocate these costs to lots which are to be made available for sale.

Issue 2: Our review of the attributes of external infrastructure costs and authoritative accounting statements does not provide us with any compelling reason for treating external infrastructure costs differently from internal infrastructure or other costs of developing special purpose areas.

ATC 498

Issue 3: Our conclusion is that the matching principle will dictate the appropriate treatment of costs in multi-stage dev- elopments. Where, for example, a developer is reasonably certain that stages beyond the first stage will be developed, such costs should be deferred to form part of the costs of the later stage development.''

(Exhibit 4, pages 15-16)

62. Although we have considered the accounting evidence, we are mindful of the words of caution expressed in cases such as St Hubert's Island, Philip Morris and Federal Commissioner of Taxation v Citibank (see paragraph 33 above) regarding the application of accounting principles. It seems to us that those words are equally applicable in considering the ``cost price'' of the subdivided allotments as that term is used in sub-section 31(1) of the Act.

63. There can be no doubt that, together with the headworks, the infrastructure land and the services upon that land may enhance the value of the subdivided allotments. Value is, however, a different matter from cost price and it is with the latter with which we are concerned. It is the cost price of the subdivided allotments.

64. What are the subdivided allotments that are trading stock in the hands of the applicant? It could be said that each allotment comprises simply the land which may have perhaps been levelled and filled and upon which there may be such installations as sewerage and drainage pipes. It could be said, as does the applicant, that only the costs that can be regarded as its cost price are the costs of the purchase of the land and its preparation and the installation of the sewerage and drainage pipes on the land.

65. It seems to us that viewing the subdivided allotments in this way is not a realistic view of what they really are. The subdivided allotments do not stand in isolation from the rest of the development. Taken as a whole, the development provides serviced subdivided allotments and not simply subdivided allotments. The applicant as a developer is in the business of selling serviced subdivided allotments and not simply subdivided allotments. The nature of the services provided may vary from one development to another but this does not make the subdivided allotments anything other than serviced. Those services may include electricity, telephone, water, sewerage and drainage and roads, lighting, kerbing and footpaths. Those services may only come to the boundary of the subdivided allotments so that the purchaser must arrange for the connection of services such as sewerage and drainage, electricity, water and telephone onto the allotment he or she has purchased. Alternatively, they may be provided to some extent on each of the subdivided allotments. Either way, each of the allotments is an allotment to which services are available either on the allotment itself or by being readily connected.

66. It seems to us that the direct costs of providing services, whatever they may be, to each subdivided allotment is part of the cost price of each of those subdivided allotments. The fact that the applicant is required to provide the services in order to obtain approval for a particular subdivision does not detract from the fact that the cost of providing the services is a cost of developing serviced subdivided allotments. There would be no difference if it had decided to provide services to the subdivided allotments in addition to those required by the local authority. The costs of providing all of the services to the serviced subdivided allotments must be counted as part of the cost price of the formation of the subdivided allotments.

67. That cost price will also include such direct costs as the cost of the land comprising the subdivided allotments, the cost of surveying the allotments and the land required for the services and the cost of clearing, levelling, excavating and filling the land as required.

68. Costs related to such matters as surveying, engineering and soil testing must each be analysed to determine whether it is related to the formation of each serviced subdivided allotment or whether it should be attributed to the general costs of the development.

69. The cost price of the subdivided allotments will also include the external costs in so far as those costs are directly related to the provision of services to the development and so to the subdivided allotments.

70. Not all of the costs incurred by the applicant in developing the broadacre land and forming subdivided allotments can be attributed to the formation of those allotments. The cost of land set aside for parks and reservations and the like and any facilities built upon that land

ATC 499

cannot be attributed in that way as setting aside such land cannot be regarded as providing a service to the subdivided allotments. Parks and reservations may or may not be regarded as enhancing the outlook of those allotments adjoining the park or reservation. They may or may not be regarded as providing a facility for relaxation for persons who choose and who may be permitted to use them. They may or may not increase the marketability of those allotments and they may or may not increase their value. Whether they do or do not, the costs of establishing those parks and reservations have not been incurred in the cost of forming the subdivided allotments or providing services to them. There is no evidence to suggest that the parks and reservations exist solely for the use of the potential owners of the subdivided allotments. They cannot be regarded, then, as a service provided to the subdivided allotments. The cost of their establishment is more properly regarded as a cost of the development as a whole.

71. In some instances, the applicant has been required to contribute moneys to the local authority for such matters as tree planting for the subdivision. There is no specific evidence with regard to their location. Even so, it is reasonable to suppose that some or all of the allotments may benefit from such tree planting. If the trees are planted on the subdivided allotments themselves, we would regard their cost as being part of the cost price of the subdivided allotments. Those that are planted outside the boundaries of the subdivided allotments cannot be said to be a cost of forming a serviced subdivided allotment. Those costs are properly costs of the development.

72. The applicant has been required on some occasions to contribute to the local authority a fixed sum for each allotment on the basis that the local authority would spend the money on such matters as the general upgrading of the roads in the area or the provision of amenities and services in the locality. These costs are too remote from the formation of serviced subdivided allotments to be regarded as part of their costs. The money contributed may never be used by the local authority for the direct benefit of the subdivided allotments. It is more properly a part of the cost of the development.

73. Council fees, which include subdivisional and development checking fees, are not directly attributable to the formation of subdivided allotments but are attributable to the development as a whole.

74. The applicant argued that the external infrastructure costs are remote from the site. While their expenditure may enhance the value of the subdivided lots, they cannot be said to be a cost of the subdivided lots. We do not consider that it is possible to make any general finding about the external costs. They must be examined to ascertain whether they are directly attributable to the services provided to the subdivided allotments. In the case of drainage and sewerage, for example, the headworks may include the provision of sewerage and drainage connections to the boundary of the subdivision. Those costs are directly connected with the provision of sewerage and drainage on each of the subdivided allotments. Where there is no such connection with the provision of services to the subdivided allotments, the costs are not part of their cost price but should be regarded as part of the cost of the development.

75. For the reasons we have given, we set aside the objection decisions under review and remit the matters to the respondent with directions that the assessments be amended to give effect to our reasons for decision. Liberty to apply will be reserved to both parties.

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