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Ruling

Subject: Section 40-880 deduction corporate owned rental property

Questions and Answers:

1. Is your company carrying on a business?

No.

2. Can your start up expenses be claimed under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No.

This ruling applies for the following periods:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You are an Australian resident taxpayer.

You recently personally purchased a membership in an overseas property company. Your membership included the set up of an overseas company, valued at around $X.

You also incurred sundry expenses, such as print outs, specialist literature, office supplies and accounts set up and communication expenses, mainly for local and overseas calls and internet usage.

An overseas company was registered to undertake real estate investments. No office is planned overseas in the first years of operation however setting up a company was required to access the services of the overseas property company.

To date, your company has purchased one residential rental property. Financial constraints have inhibited other property acquisitions.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 40-880

Income Tax Assessment Act 1936 Section 6

Reasons for decision

Your company is an Australian resident company for tax purposes

Subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) provides a 'resident' or 'resident of Australia' includes:

a company…which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.

Taxation Ruling TR 2004/15 contains the Commissioner's view about the residence status of companies not incorporated in Australia. Paragraph 11 of TR 2004/15 provides that a company not incorporated in Australia whose income earning outcomes are largely dependent on the investment decisions made in respect of its assets, carries on its business where these decisions are made.

For example, in the High Court of Australia case of Malayan Shipping Company Ltd v. Commissioner of Taxation (Cth) 71 CLR 156, it was held a Singapore registered company, which chartered a tanker ship and made client bookings via agents in London England, carried on the business in Melbourne Australia because the central management and control was in Australia.

Therefore, in your case, your company is an Australian resident company for tax purposes.

The phrase 'carries on business in Australia'

Importantly, paragraph 43 of TR 2004/15 distinguishes between the phrase 'carries on a business' for residency purposes (under subsection 6(1) of the ITAA 1936) and for income tax deduction purposes (for example, under sections 8-1 and 40-880 of the ITAA 1997).

Paragraph 43 of TR 2004/15 explains an investment company, which does not carrying on business for income tax deduction purposes, will carry on a business for the purposes of subsection 6(1) of the ITAA 1936.

Thus, in its footnote, paragraph 43 of TR 2004/15 cites the example of the Federal Court case of Kennedy Holdings & Property Management Pty Ltd v. FC of T 92 ATC 4918 (Kennedy Holdings), where it was held a company, which co-owned one commercial rental property, was not carrying a business for the purposes of the income tax deduction provisions, even though it carries on business in Australia for residency purposes.

Carrying on a business of rental properties

As mentioned, in the Federal Court case of Kennedy Holdings, it was held a company, which co-owned one commercial rental property, was not carrying a business for the purposes of the income tax deduction provisions.

The decision in Kennedy Holdings is consistent with the Commissioner's view found in the Tax Office publication Rental properties 2011-12 (NAT 1729-6.2012), which on page 4 states:

A person who simply co-owns an investment property or several investment properties is usually regarded as an investor who is not carrying on a rental property business, either alone or with the other co-owners. This is because of the limited scope of the rental property activities and the limited degree to which a co-owner actively participates in rental property activities.

Similarly, Taxation Ruling IT 2423, which is about whether rental income constitutes proceeds of business for withholding tax purposes, states:

A conclusion that an individual is carrying on a business of letting property would depend largely upon the scale of operations. An individual who derives income from the rent of one or two residential properties would not normally be thought of as carrying on a business. On the other hand if rent was derived from a number of properties or from a block of apartments, that may indicate the existence of a business.

In respect to company ownership of rental property, IT 2423 states that: (i) whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case; and (ii) generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual.

IT 2423 cites the cases of Lilydale Pastoral Co. Pty. Ltd. v. FCT 87 ATC 4235; 18 ATR 508 (Lilydale) and American Leaf Blending Co. Sdn Bhd v. Director-General of Inland Revenue (Malaysia) [1978] 3 All E.R (American Leaf Blending Co) to support the view that it would be difficult to displace the prima facie inference that the gainful use of a company's property in letting it out for rent would constitute the carrying on of a business or an undertaking of a business or commercial kind.

In Lilydale, the taxpayer company had purchased a total of five properties, four of which were industrial properties; the fifth was a residential home unit. However, the court did not explicitly rule the taxpayer was carrying on a business for income tax purposes. Instead, the court merely ruled their activities of renting commercial properties met the definition of an 'enterprise' in section 128A of the ITAA 1936.

In American Leaf Blending Co, Lord Diplock took into account the activity of the company and the duration of the leases, as follows:

The carrying on of 'business', no doubt, usually calls for some activity on part of whoever carries it on, though, depending on the nature of the business, the activity may be intermittent with long intervals of quiescence in between. In the instant case, however, there was evidence before the Special Commissioners of activity in and around the letting of its premises by the company during each of the five years that had elapsed since it closed down its former tobacco business. There were three successive lettings of the warehouse area negotiated with different tenants; there was the removal of the machinery from the factory area which made it available for use for storage and a separate letting of the area to a fresh tenant; and as recently as October 1968 there was the negotiation of a letting to a single tenant of both the factory area and the warehouse.

We note the Privy Council decision of Lord Diplock, being from a foreign legal system, is not binding in Australia (refer to paragraph 121 of Taxation Ruling TR 2001/13).

In your case, our view is your company is not carrying on a business for income tax deduction purposes because its proposed activity overseas is merely that of passive investment in a relatively small number of residential rental properties, which will be managed by a property manager.

Currently, your company owns one residential rental property overseas, thus its actual scale is very small. Also, the capital employed, which is another indicator of a business (refer to Taxation Ruling TR 97/11), currently subject to financial constraints, is also relatively small in relation to a bona fide rental property business.

Our view is your case is similar to the decision made in Kennedy Holdings, where the company co-owned one commercial rental property and the Australian court decided it was not carrying on a business.

Our view is your case is distinguished from Lilydale, where the Australian court ruled the taxpayer was carrying on an 'enterprise' (rather than a 'business') and where the taxpayer owned four industrial properties.

Our view is your case is distinguished from American Leaf Blending Co, where the English court ruled the taxpayer was carrying on business by renting the business assets, i.e., factory area and warehouse, of the taxpayer's former tobacco business. A company renting its former factory is a different situation to an individual buying a small rental property through a company out of necessity.

As for the more sophisticated aspects of your business plan, we consider does not lend any weight to your company carrying on a business because it does not change the passive nature of the company activities.

Also, your business plan is merely speculative and, in itself, does not constitute a business operation. Paragraph 69A of Taxation Ruling TR 2001/14 provides a taxpayer starts to carry on business activity when they have made a decision to commence the business activity, acquired the minimum level of business assets to allow that business activity to be carried on and actually commenced business operations; that a mere intention to start carrying on the business activity will not be sufficient.

In short, your company owns one residential rental property. Thus, it has not commenced the more sophisticated operations that are speculated in your business plan.

Section 40-880

Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision.

Taxation Ruling TR 2011/6, which is about section 40-880 of the ITAA 1997, states the capital expenditure must be business related. Paragraph 69 states:

Under paragraphs 40-880(2)(a), 40-880(2)(b) and 40-880(2)(c), the taxpayer can deduct capital expenditure they incur if it is in relation to their business, or in relation to a business that used to be carried on or is proposed to be carried on.

The phrase 'proposed to be carried on' allows the scope for an individual taxpayer to claim an eligible deduction in relation to a corporate business activity proposed to be carried on.

In your case, the expenditure that is the subject of this private ruling is not business capital expenditure. Instead, it is expenditure related to investment activity. Therefore, a deduction for the expenditure is not available to you under section 40-880 of the ITAA 1997.

In addition, as you incurred the expenditure personally, the expenditure cannot be included in the capital gains tax (CGT) cost base of a CGT asset under sections 110-25 and 110-35 of the ITAA 1997 (and under 110-55 when a loss is made) because the company is the holder of the CGT asset.

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