Edited version of your written advice

Authorisation Number: 1013028525445

Date of advice: 2 June 2016

Ruling

Subject: Property development expenses

Question

Are you entitled to a deduction for professional and engineering fees and other development costs in the years incurred?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 20ww

Year ending 30 June 20xx

Year ending 30 June 20yy

Year ending 30 June 20zz

The scheme commenced on

1 July 20vv

Relevant facts

You and your spouse purchased property several years ago. The property included commercial blocks which have been rented since purchase.

Your intention when purchasing the property was to redevelop the site once the new local area plans were gazetted.

Following the plans gazettal and associated rezoning, you wish to build multiple units on the site. The current blocks will be demolished as part of the development.

In 20vv, you started to incur costs, such as professional and engineering fees in relation to the development.

The council application for the property development was lodged.

The council approval may take some time for approval. The application for development consent requires exhaustive documentation and expense with no guarantee of a successful result.

When the development consent is given, the construction certificate is done and financing is in place, the blocks will then be demolished. You hope the development will be completed approximately two years after this.

You are intending to sell x% of the units on completion for a profit.

You and your spouse also own another rental property which you previously developed.

You and your spouse have also developed other property held in other entity names. Any future property purchases will be purchased by the other entities.

You engage a property manager for rent collection and other professionals for your property development.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

When determining how amounts of income and/or expenditure in relation to real property are to be treated for tax purposes, it is necessary to consider whether the income and/or expenditure is of a revenue or capital nature.

Generally the proceeds from transactions involving the sale of real property will be assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) where they are income from a business activity or profits from an isolated commercial transaction. Alternatively, where the sale of real property is not part of a business or an isolated commercial transaction any profit or loss will be subject to the capital gain tax provisions.

We need to determine whether the profit or gain from the sale of the units will be:

• assessable ordinary income under section 6-5 of the ITAA 1997 from carrying on a business of property development,

• assessable as ordinary income under section 6-5 of the ITAA 1997 on the basis that the development will constitute an isolated commercial transaction with a view to a profit, or

• a mere realisation of a capital asset and only assessable under the CGT provisions of the ITAA 1997.

Carrying on a business of property development

In determining whether activities are a business, it is necessary to examine the facts and circumstances of each particular case. No single factor is determinative; rather it will be a combination of factors that will lead to a conclusion as to the character of the activities.

In Federal Commissioner of Taxation v McDonald (1987) 18 ATR 957; 87 ATC 4541, Beaumont J said at ATR p 968; ATC p 4550:

The reference to "business" . . . indicates a "commercial enterprise as a going concern": see Hope v Bathurst City Council (1980) 144 CLR 1 at 8; 12 ATR 231 at 236 per Mason J. Purely domestic transactions are thus excluded from the definition: see Fletcher, op cit p 28. The "business" must be "carried on". This suggests some active occupation or profession: see IRC v The Marine Steam Turbine Co Ltd (1919) 12 TC 174 per Rowlatt J at 179.' . . . 'On the other hand, in the case of a private individual as distinct from a company, "it may well be that the mere receipt of rents from properties that he owns raises no presumption that he is carrying on a business." see American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue (1979) AC 676 per Lord Diplock at 684.

and at ATR page 969; ATC page 4552, where Beaumont J continued:

Their investment involved little, if any, active participation from either party ... This was not a case of the active joint participation by the parties in a business activity. Rather, it was a case of a renting out of premises without the provision of other services of the kind discussed in Wertman, supra. In my view, there was here a mere investment in property rather than a partnership in the properties or their profits.

The intention to make a profit is not, on its own, sufficient to establish that a business is being carried on.

Although you have developed other properties in the past held by other entities, it is not considered that your current scale or volume of operations as joint owners in the property is sufficient to make it a business for tax purposes. The repetition and regularity of business activities is not present.

You own another property which is rented. However, your activities as joint rental property owners are not currently conducted on a sufficient scale to be considered to be a business. Therefore, any proceeds you will receive from the sale of the units will not be derived in the course of carrying on a business.

Profits from an isolated transaction

Profits arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium)). 

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 of the ITAA 1997 as ordinary income. TR 92/3 should be read in conjunction with Taxation Ruling TR 92/4 Income tax: whether losses on isolated transactions are deductible.

TR 92/3 defines the term 'isolated transactions' as:

• transactions outside the ordinary course of business of a taxpayer carrying on a business, and

• transactions entered into by non-business taxpayers.

If a taxpayer makes a profit from a transaction or operation, that profit is income if the transaction or operation is not in the course of the taxpayer's business but:

• the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain, and

• the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

Whether an isolated transaction is business or commercial in character will depend on the circumstances of each case. TR 92/3 lists the following factors to be considered:

a) the nature of the entity undertaking the operation or transaction; if a taxpayer is a corporation with substantial assets rather than an individual, that may be an indication that the operation is commercial in nature;  

b) the nature and scale of other activities undertaken by the taxpayer;

c) the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

d) the nature, scale and complexity of the operation or transaction;

e) the manner in which the operation or transaction was entered into or carried out; this factor would include whether professional agents and advisers are used;

f) the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

g) if the transaction involves the acquisition and disposal of property, the nature of that property; and

h) the timing of the transaction or the various steps in the transaction, for example, if the relevant transaction consists of the acquisition and disposal of property, the holding of the property for many years may indicate that the transaction was not business or commercial in nature.

In contrast, paragraph 36 of TR 92/3 notes that the courts have often said that a profit on the mere realisation of an investment is not income, even if the taxpayer goes about the realisation in an enterprising way. However, if a transaction satisfies the elements set out above it is generally not a mere realisation of an investment.

It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose.

The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit making at the time of acquiring the property.

The case of McCurry v. Commissioner of Taxation [1998] FCA 512; (1998) 98 ATC 4487; (1998) 39 ATR 121 involved the construction and subsequent sale of three units and whether the profits on the sales were assessable as ordinary income. The case turned primarily on whether the taxpayer had constructed the units for the purpose of making a profit on resale or alternatively to be held as rental investments.

Therefore to determine whether your property development has a profit making intention or purpose the Commissioner must consider whether an objective consideration of the facts and circumstances at the time of entering into the contract support a profit making purpose on resale.

In your case, the property was acquired as joint owners as opposed to by a business structure. You have carried on similar profit making schemes through other entities which would add support to the argument that this transaction is commercial in nature. The significant money required suggests the transaction has a commercial nature. It is considered that you have approached the transaction in a businesslike way. You have sought expert advice from professionals, engineers, a town planner and others.

What you propose doing involves substantially more than merely realising your asset. You will be significantly improving the property and increasing its value.

Your purpose in developing the land is to make a profit from the subsequent sale of the units. Despite putting the property to an alternative use for a time, the intention of deriving a profit through resale still remains.

The Commissioner accepts that you had a profit making intention when purchasing the property and that the intended property development is of a commercial nature having regard to the factors in TR 92/3.

Allowable deductions

Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent that it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining

assessable income or, in other words, of an income-producing expense

(Lunney v. FC of T; (1958) 100 CLR 478 (Lunney's case)),

• there must be a nexus between the outgoing and the assessable income so

that the outgoing is incidental and relevant to the gaining of assessable

income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

• it is necessary to determine the connection between the particular outgoing

and the operations or activities by which the taxpayer most directly gains or

produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v.

FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Income from an isolated transaction such as property development is derived at settlement of the contract, when the vendor has done all that is required in order to recover the payments due in respect of the sale (Gasparin v FC of T (1994) 121 ALR 179, (1994) 28 ATR 130, (1994) 50 FCR 73, 94 ATC 4280).

Therefore where a person is not in business and the property is held on revenue account for a profit making purpose, the expenses are usually offset at the time the profit is declared for tax purposes.

This is confirmed in Taxation Determination TD 92/126 Income tax: property development: if in an isolated commercial transaction land is acquired for the purpose of development, subdivision and sale but the development and subdivision do not proceed, how is a profit on a sale of the land treated for income tax purposes?

which states

"In calculating the profit on the sale of the land the cost of the land is deducted from the proceeds of sale."

Also in Commercial and General Acceptance Ltd v. FC of T 77 ATC 4375; (1977) 7 ATR 716) it stated.

…if an investor's activities amount to an isolated business transaction that is not the carrying on of a business, outgoings are only deductible on completion of the transaction. It is then that the final profit, or loss, is calculated for income tax purposes

In your case you and your spouse are not carrying on a business of property development in relation to this jointly owned property. Your property development is part of an isolated transaction.

The development may not be completed for several years. Your ongoing costs are incurred at a point too soon to be deductible immediately.

Expenses which relate to the earning of the income from the sale of the property are deductible in the year in which the profit is made. That is the outgoings are offset against the sale proceeds to arrive at a net profit figure.

Therefore as part of an isolated transaction, deductions for on-going construction expenses incurred from February 2013 are not deductible to you until the completion of the transaction. That is, your professional and engineering expenses as well as other costs in this property development are only deductible on completion of the development.

Your property development expenses do not relate to the earning of your assessable rental income from your other jointly owned property and therefore are not deductible against this rental income under section 8-1 of the ITAA 1997.

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