Edited version of your written advice

Authorisation Number: 1012794534713

Ruling

Subject: Non-commercial losses - Commissioner's discretion - Trading Stock

Question 1

Is X partnership carrying on a business of property development?

Answer

No

Question 2

Is the land trading stock within the meaning of section 70-10 of the Income Tax Assessment Act 1997 in the hands of X partnership?

Answer

No

Question 3

Will the Commissioner exercise the discretion in paragraph 35-55(1)(c) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include any losses from the business activity in the calculation of your taxable income for the 2013-14 to the 2014-15 financial years?

Answer

No

This ruling applies for the following periods

Year ending 30 June 2014

Year ending 30 June 2015

The scheme commenced on

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

These documents form part of and are to be read with this description. The relevant documents are:

• Your original Private Ruling application

• Further information received regarding with your original application

• Your objection application

• Further information provided relating to your new private ruling

X Partnership ('You') purchased a fully operational accommodation business (Property A) in the late 1990's. You traded on the site for a number of years. You intended to build a new accommodation business on the site and you held the land as a fixed asset.

You obtained a quote to build a new accommodation business on the property in the early 2000's. You did not proceed with that but you developed an adjacent site with the construction and sale of X residential units approximately ten years ago.

During the X-unit development one partner was instrumental in engaging and directing the architects, planning consultants and builders and the other partner sourced materials and carried out the fit out and furnishing of every apartment.

In the early 2000's you purchased another accommodation business property, which is rented to an associate entity which trades from the property.

The accommodation business at Property A was demolished and construction funding for the new accommodation business was approved in the mid 2000's.

You also purchased two other accommodation businesses in partnership with family members, at other locations. These businesses traded for several years and an associated entity retains one property.

Due to the general economic climate the development of Property A was put on hold. You then abandoned the idea of constructing a similar accommodation business.

You then lodged an application to construct a number of residential units and received development consent in 200X.

Approximately three years later you entered into a contract to sell the site for $X million but the deal was not completed and the land remained vacant.

Approximately three years after that you entered into a 'Joint Venture Agreement' with X, an entity with property development expertise, to develop Property A with an expectation to make a profit on the eventual sale of the units.

You also shared expenses in relation to the Joint Venture. You have not provided a copy of the original 'Joint Venture Agreement' with X.

At this point the land was reclassified in your own 20XX partnership accounts as a purchase of trading stock, at cost price of x. This amount included the original purchase price plus associated fees and stamp duty together with capitalised interest and holding costs, such as land tax and rates in the intervening period from purchase.

The parties then proposed an improved development application to increase the number of units on the site to approximately Y. This process commenced immediately involving an architect, planning consultant and a feasibility study. Each party agreed to invest an amount into this process which has been spent on costs to date. A revised development application was submitted to the council and approval was issued in mid 20XX.

In late 20XX, you entered into a new partnership agreement with two other parties, one of which was your original Joint Venture partner. The other partner owns the construction company that is proposed to undertake construction of the units and is an experienced developer specialising in apartment blocks.

This partnership will be referred to in this ruling as the XYZ Partnership.

The partnership has not applied for a TFN

Under the XYZ Partnership Agreement the parties agree to:

• Commit to STAGE 1 of the project

• No further costs or commitment until a certain number of sales contracts are achieved. The sales must be within a certain value to warrant progressing to STAGE 2.

• Proceed with the project and move forward into STAGE 2, if STAGE 1 is successful

Invoices have been raised to each party from an associated entity with you who dealt with the initial payment of costs before they were allocated to the respective partners as to one third each.

A draft feasibility study projected a profit based on the sale of all of the apartments, to be split three ways. An increased profit is now anticipated.

A certain number of pre-sales are required by the financier before the construction of the development can commence.  Contracts have been issued on X properties to date. 

It is anticipated that sales will commence in the year to 30 June 2015.

Until the pre-sales target has been met construction will not commence, but it is anticipated that construction will start in the 2016 financial year. It is anticipated that the development will be completed between in the 2018-19 financial year.

You have had lengthy discussions with the bank regarding finance for the project, including obtaining and discussing valuations.

Signing has been erected at the site which also involved a process of reviewing and agreeing to the drafts with the real estate agent.

You are also involved in other building projects through an associated entity, and you are project managing the development of your own home.

You state that your involvement is active, in that you will be directing and micro-managing the entire process for this development, as you do with every business activity that you undertake, to ensure that the maximum value is obtained for the units.

You have previously appointed planning consultants after obtaining quotes from more than one, and worked closely with these consultants, involving numerous meetings and correspondence to obtain the first and revised planning approval.

The process has involved appointing an architect to draw up plans for which you attended meetings to discuss drafts and the final version to submit to council.

The other two partners to the development propose to contribute sufficient cash by way of direct payment of an amount each to the bank. In exchange the bank will discharge the mortgage on the property.

In recognition of the payment made to the bank, you propose to enter into a binding agreement to recognise these equity contributions. This will be an agreement which sets out the full and complete terms of the joint venture, including profit sharing. A documented copy of this proposed agreement has not been provided.

You propose to contribute the value of land (at an agreed notional value for the purposes of contribution into the XYZ Partnership).

Y and Z will each have contributed amounts to the bank and as the first funds become available to commence development each of Y and Z will contribute further funds towards construction costs. This is anticipated to be a requirement of the construction finance lender, who will take a first mortgage over the property.

At that point in time each of the co-venturers will have an agreed equity position of $x each. Funds will be drawn down from the Development Financier until the development is completed.

Your partnership will retain legal ownership of the land and will sell the units on behalf of the XYZ Partnership.

The land value will be apportioned for each unit at the time of sale of each unit. You propose to assess the disposal of the land on a per lot basis when each of the units are sold.

The land accounted for as trading stock by in your accounts has been accounted for at a lesser market value as at 30 June 2014 in accordance with a valuation by a certified property valuer on a 'no pre-sales' basis.

This write-down has resulted in a loss claim in the year ended 30 June 2014.

You do not meet the income requirement of Division 35 of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 6-5

Income Tax Assessment Act 1997 - Division 35

Income Tax Assessment Act 1997 - Section 70-10

Income Tax Assessment Act 1997 - Subsection 995-1(1)

Reasons for decision

Summary

On the facts provided, we do not consider a business of property development to have commenced with respect to your proposed property development, either in your own right or as a partner of the XYZ partnership. Therefore, the land cannot be trading stock in your hands.

As we do not consider you have commenced carrying on a business of property development, Division 35 does not apply.

Detailed reasoning

Carrying on a business of property development

Subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) defines 'business' to include 'any profession, trade, employment, vocation or calling, but does not include occupation as an employee'. This definition, however, simply states what activities may be included in a business.

Taxation Ruling TR 97/11 provides the Commissioner's view of the factors used to determine if you are in business for tax purposes. These factors are:

• whether the activity has a significant commercial purpose or character

• whether the taxpayer has more than just an intention to engage in business

• Whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

• whether there is regularity and repetition of the activity

• whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

• whether the activity is planned, organised and carried on in a business-like manner such that it is described as making a profit

• the size, scale and permanency of the activity, and

• whether the activity is better described as a hobby, a form of recreation, or sporting activity.

In determining whether a taxpayer is carrying on a business, no one indicator will be decisive. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the large or general impression gained from looking at all the indicators and whether these indicators provide the operations with a commercial flavour.

A business of land development is taken to have commenced when a taxpayer embarks on a definite and continuous cycle of operations designed to lead to the sale of the land.

It is not necessary that the acquisition of land be repetitive. A single acquisition of land for the purpose of development and sale may constitute a business. (Tax Determination TD 92/124).

Commencement of business

We do not consider that XYZ partnership is carrying on a business of property development in its own right in the years ending 30 June 2013 and 30 June 2014. The previous property development activity by XYZ is limited to the construction of X units a number of years previously. We do not consider that you conducted definite and continuous cycle of operations regarding the development and sale of land for a finding that this partnership carried on a business of property development, notwithstanding that you may have considerable experience in motel operations and some property development experience. There were significant periods of time when there were no active operations leading to the sale of land.

We also do not consider that the partnership was carrying on a business in partnership will Y in the 2012-13 or 2013-14 financial years. Though the parties proposed developing the land as part of a joint venture, this original joint venture did not proceed.

Whether a business activity has started to be carried on by the XYZ partnership

The first requirement concerning when a business activity starts to be carried on is one that usually arises in relation to the deductibility of expenses incurred in the establishment of a business activity. The actual date of commencement of a business is a question of fact (see Goodman Fielder Wattie Ltd v . FC of T 91 ATC 4438 at 4446; (1991) 22 ATR 26 at 35).

For a business activity to have commenced a person must 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'.

We believe that when a business activity commences is like the question of whether a business is being carried on at all and depends on the 'large or general impression gained' (Martin v . FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551).

Decision to commence

The chain of events leading to the commencement or start-up of a business activity often begins with a mere intention to establish the business activity. This is developed by researching the proposed business and, in some instances, by experiment. This process culminates in a final decision on whether to commence business. Not all *businesses commence in such an orderly fashion of course.

The intention and purpose of the taxpayer in engaging in the activity is relevant to when a business commences. However, a mere intention to commence a business activity is not enough: Goodman Fielder Wattie . The taxpayer must have more than an intention to commence business. There must be activity.

In Esso Australia Resources Ltd v . FC of T 97 ATC 4371 at 4382; (1997) 36 ATR 65 at 77-78 Sundberg J stated:

'While the taxpayer may have had the intention ultimately to engage in production, that is not sufficient in itself to constitute a business activity.'

Sundberg J went on to say that 'commitment' was missing on the facts of the case. See also Brennan J in Inglis v . FC of T 80 ATC 4001 at 4004-4005; (1979) 10 ATR 493 at 496-497.

Whitfords Beach Pty Ltd v . FC of T 83 ATC 4277; (1983) 14 ATR 247 is one of the few cases that has examined the issue of the commencement of a business activity and the factors to consider when determining the commencement of a business activity. These factors were a consideration of the taxpayer's purpose and the taxpayer's activities. Bowen CJ, Morling and Fitzgerald JJ said, at ATC 4282; ATR 253:

'Of course it does not follow that all the activities engaged in by the taxpayer were necessarily in the course of that business or that some of them were not merely preparatory to it. In order to determine when the taxpayer's relevant business commenced and when its land or the various parts of it were committed to or ventured in that business, it is necessary to have regard both to the taxpayer's purposes and to its activities.' (emphasis added)

Business structure

Most business activities have a structure that provides the framework of the business, or their 'profit yielding subject'. It is usually a collection of capital assets. What the particular capital assets are will depend on the particular business activity. In Calkin v. CIR [1984] 1 NZLR 440 Richardson J said at 446-447:

'Clearly it is not sufficient that the taxpayer has made a commitment to engage in business: he must first establish a profit - making structure and begin ordinary business operations .' (emphasis added)

For a business activity to commence, an appropriate business structure should also be in place. As to what this structure will consist of, and its size, this will be a question of fact and degree, and depend on the nature of the business activity. A suitable structure might even be established by the execution of certain documents, where independent contractors with the necessary capital assets are engaged. Even though the taxpayer may have no physical assets themselves, their rights as against the independent contractor secure use of such assets, and those rights can properly be said to be capital assets in the taxpayer's hands. However, each case will need to be determined on its own facts and having regard to industry norms.

Business operations

As noted in Inglis , the level of activity is important. The extent of activity will also determine whether a business activity has commenced and is in its start-up phase. Activity will support the taxpayer's claims to have commenced a business activity. Brennan J in Inglis made it clear that there must be activity when he said at ATC 4004; ATR 496:

'The carrying on of a business is not a matter merely of intention. It is a matter of activity. Yet the degree of activity which is requisite to the carrying on of a business varies according to the circumstances in which the supposed business is being conducted. Little activity may suffice for carrying on a business that does not call for much activity, as in Thomas and in Ferguson .' (emphasis added)

The following factors are taken into consideration in determining whether a property development business exists in relation to the development and sale of land by the XYZ partnership.

• The parties agreed to enter into the XYZ Partnership Agreement specifically for the development project at A property.

• The intention of the partnership is to have approximately X units built for the purpose of sale.

• In the A property development, there is an expectation that the partnership will make a profit on the eventual sale of the units and an intention by the partners to share in these profits.

• The parties may intend that the project will proceed to Stage 2, but to date there has been no commitment to proceed to Stage 2.

• the parties agree to share all holding and development costs for the A property site together with a second site.

• The same partners are intending to develop a second site and construct units thereon.

It is accepted that the parties can demonstrate an intention to develop the property. This intention is not in dispute.

However, the partners in the XYZ Partnership have made it clear in the Agreement that to proceed to the core requirements of the development, including executing agreements regarding financing, construction and management of the development ('Phase 2') a certain number of pre-sales must be achieved. This number has since been revised down. Up until this point, as the parties can still withdraw from the proposed development, we do not consider that the partners of the XYZ Partnership can demonstrate the necessary commitment required for definite and continuous operations leading to the sale of property.

We consider that the activities of the partners, to date, are preliminary to carrying on a business of property development, therefore we do not consider that you, as a partner of the XYZ partnership, have commenced to carrying on a business of property development.

Trading Stock

Section 70-10 of the ITAA 1997 defines trading stock as including anything produced, manufactured or acquired that is held for the purposes of manufacture, sale or exchange in the ordinary course of a business.

Property cannot be trading stock unless it is an asset of a business of trading in property of that kind. Moreover the property must be acquired in the course of carrying on that business.

In in Taxation Determination TD 92/124, the Commissioner confirmed the position taken by the Full High Court in St Hubert's Island Pty Ltd v. Federal Commissioner of Taxation (1978) 138 CLR 210; 78 ATC 4104; (1978) 8 ATR 452 that the required purpose and business activity must be present before land is treated as trading stock. The business activity is taken to have commenced when a taxpayer embarks on a definite and continuous cycle of operations designed to lead to the sale of the land.

In John v. Federal Commissioner of Taxation (1989) 166 CLR 417; (1989) 20 ATR 1; 89 ATC 4101, the majority of the High Court held that an item will be trading stock if 'the person is a trader in the goods which are claimed to be trading stock.'

Special rules apply to land acquired as a capital asset that is subsequently held as trading stock (refer s.70-30 of 1997 ITAA). Costs attributable to the capital asset (other than interest and rates and taxes) form the basis of the cost price of the trading stock at that time. Alternatively, the incoming trading stock may be valued at its market value. However, if valued at market value a CGT liability will arise.

The land was reclassified in your 20XX accounts as having been ventured into the 'business' as trading stock.

In your case, we do not consider the land is trading stock in your hands as you are not carrying on a business in their own right, nor do we consider that a property development business has been commenced by either the Joint Venture between you and Y or the XYZ partnership.

Rather, we consider that you are proposing to contribute the land as a capital contribution to the XYZ partnership if a certain number of pre-sales are made and the parties commit to proceed with the development. It will not be 'trading stock' in their hands for the purposes of section 70-10 of the ITAA 1997.

Commissioner's discretion

The Commissioner's discretion at section 35-55 of the ITAA 1997 can only be exercised for individuals (alone or in partnership) who have commenced carrying on a business. As we do not consider you have commenced carrying on a business of property development this section is not applicable and it follows that the Commissioner's discretion cannot apply.

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