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This edited version has been archived due to the length of time since original publication. It should not be regarded as indicative of the ATO's current views. The law may have changed since original publication, and views in the edited version may also be affected by subsequent precedents and new approaches to the application of the law.

You cannot rely on this record in your tax affairs. It is not binding and provides you with no protection (including from any underpaid tax, penalty or interest). In addition, this record is not an authority for the purposes of establishing a reasonably arguable position for you to apply to your own circumstances. For more information on the status of edited versions of private advice and reasons we publish them, see PS LA 2008/4.

Edited version of your written advice

Authorisation Number: 1051198339800

Date of Advice: 29 March 2017

Ruling

Subject: Income Tax ~ Property Development

Question 1

Is the Developer entitled to a deduction, in the year invoiced by the Landowner, for the Participation Fee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) pursuant to the Development Agreement?

Answer

No

Question 2

Is the Developer entitled to a deduction in the year it is invoiced by the Project Manager, for 50% of Project Costs under section 8-1 of the ITAA 1997 pursuant to the Development Agreement?

Answer

No

Question 3

Is the Project Manager, entitled to a deduction for the Project Costs it incurs in the year under section 8-1 of the ITAA 1997 pursuant to the Development Agreement?

Answer

Yes

Question 4

Does the Developer derive assessable income pursuant to section 6-5 when it invoices the Landowner pursuant to the Development Agreement for 50% of the Net Proceeds from land sales as a Development Fee?

Answer

No

Question 5

Does the Developer have trading stock on hand at year end, in respect of any interest in relation to or in respect of the Land that it may have under the Development Agreement in relation to the Land?

Answer

No

Question 6

If the payment of the participation fee is not deductible for the taxpayer, and the answer to Question 1 is no, can the newly formed tax law partnership, which holds the trading stock asset, elect to hold the trading stock asset at its market value pursuant to paragraph 70-30(1)(a) of the ITAA 1997 as at the date of the Development Agreement?

Answer

Yes

Question 7

Is the Developer required by section 70-35 of the ITAA 1997 to include the Project Costs it incurs in the value of trading stock on hand at the start of the income year and the end of the income year in the calculation of value of each item of trading stock if it elects to value the trading stock at its cost?

Answer

No

This ruling applies for the following periods:

1 July 2016 to 30 June 2022

The scheme commences on:

1 July 2016

Relevant facts and circumstances

Background:

The Taxpayer is a broad acre residential land developer.

The Taxpayer is the head company of a consolidated group for income tax purposes.

The Taxpayer's ordinary business activities include either.

Acquiring interests in land for development and resale; or

Developing other entities' land for a fee; or

Earning a share of income from, and charging fees to, partly owned partnerships, trusts or companies which own land; or

The Taxpayer may acquire an interest in land directly or via a wholly owned company trust or partnership or via a partly owned company, trust or partnership.

Fee income for developing and selling land owned by parties other than the Taxpayer comprises:

A fee for selling land, usually based on a percentage of the sale proceeds;

A fee for managing development of the land, usually expressed as a percentage of the final sales proceeds for the land and payable when the land is sold; and

A fee comprising costs of development of land (such as consultants, earthworks, road construction and provision of sewage, power and water etc) incurred by the Taxpayer in its own right on land owned by the land owner and invoiced typically in 30 or 60 days after incurred.

In 20XX, the Landowner entered into negotiations with the Taxpayer in relation to a broad acre land development.

The sale is subject to obtaining relevant zoning approval.

The Taxpayer invited another land developer to be a XX:YY partner in the land development.

The other land developer directly or indirectly through wholly or partly owned entities also carries on a business of land development comprising approximately X lots per annum.

Development Agreement:

The parties have entered into an agreement in 2015 (the Development Agreement).

The parties to the agreement are:

The Landowner.

Joint venture between the Taxpayer and other land developer (Developer).

The Taxpayer (Project Manager) has entered into a Project Management Agreement and Exclusive Selling Agreement with the Landowner and Developer in relation to the Land.

In broad terms, subject to certain conditions precedent being satisfied, the Development Agreement envisages that the Landowner will continue to legally own the Land but allow the Developer to develop it into residential lots.

The Developer will pay an upfront fee to the Landowner known as a Participation Fee and be entitled to a Development Fee of X% of the net proceeds from sale of developed lots after GST, project management fees, administration fee and selling fees.

The Developer and Landowner will jointly appoint the Project Manager and pay it at settlement of each block a Project Management Fee and Selling Fee.

The Development Agreement provides that the Project Manager will initially incur X% of Project Costs (costs of carrying out the Project such as planning fees, earthmoving costs, construction of roads, provision of sewage, electricity and other services but excluding the land cost and holding costs) but will invoice them XX:YY to the Developer and Landowner, typically in the following month.

The Landowner and Developer must establish the Management Committee to manage the project.

The Management Committee may act for and bind the Owner and Developer in regard to any matter in relation to the Project, including the Sale of the Lots- unless contrary to the Development Agreement.

The Landowner and Developer must use their respective endeavours to arrange a Facility to enable the parties to complete the project.

The Landowner and Developer will borrow from a bank to fund Project Costs and will each bear their own interest expense and share of holding costs.

Although the loan will be several, the Landowner will grant the bank a limited recourse mortgage over the Land as security. If expenditures exceed a specified loan to value ratio both parties must pay additional costs on a XX:YY basis from other sources.

The Development Agreement has two phases.

The first phase-involves obtaining approval from the governing authority to rezone the land for residential and other purposes. The Landowner will pay the Project Manager a fee of $X to complete the zoning application and is responsible for X% of any additional costs.

Under the second phase, if the application is successful, the Agreement provides:

The parties are not joint venturers, partners or agents of each other;

The Developer is required to pay to the Landowner in consideration of allowing it to participate in the land development project a Participation Fee of X% of the value of the land plus GST after rezoning;

The Project Manager initially will incur X% of the Project Costs; which will be on billed XX:YY to the Developer and Landowner usually in the following month;

For developing the land and incurring X% of Project Costs, and for co-ordinating marketing and sales activities, the Developer is entitled to receive a Development Fee of X% of net sales proceeds. Broadly, this is the sale price of a lot less GST, settlement costs, unpaid project costs, and Project Management, Selling Fees.

Project Management Agreement:

In accordance with the Project Management Agreement, the Project Manager is entitled to invoice:

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5,

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1997 Section 70-5,

Income Tax Assessment Act 1997 Section 70-30,

Income Tax Assessment Act 1997 Section 70-35,

Income Tax Assessment Act 1997 Section 995-1 and

Income Tax Assessment Act 1936 Section 92.

Reasons for decision

Question 1

Is the Developer entitled to a deduction, in the year invoiced by the Landowner, for the Participation Fee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) pursuant to the Development Agreement?

Summary

The payment of the Participation Fee by the Developer to the Landowner is considered capital in nature on the basis that the payment of the Participation Fee is a fee to enter into a tax law partnership between the Developer and Landowner. Therefore, the Developer is not entitled to a deduction for the Participation Fee.

Detailed reasoning

In determining whether the payment of the Participation Fee is deductible for the Developer, it is necessary to firstly consider whether the payment gives rise to a tax law partnership between the Developer and the Landowner.

Tax Law Partnership

Section 995-1 of the ITAA 1997 defines a partnership to mean:

The definition of person under section 995-1 of the ITAA 1997 includes a company.

Taxation Ruling TR 94/8 Income Tax: whether business is carried on in partnership (including 'husband and wife' partnerships) outlines the factors taken into account in deciding whether persons are carrying on business as partners for income tax purposes.

Paragraph 3 of the TR provides that the question of whether a partnership exists is one of fact. The existence of a partnership is evidenced by the actual conduct of the parties towards one another and towards third parties during the course of carrying on business.

Paragraph 4 of the TR lists a range of factors in deciding whether persons are carrying on business as partners in a given year of income which include the following:

While the weight to be given to these factors is not exhaustive and varies with the individual circumstances, the entitlement to a share of net profits is essential (Paragraph 5 of the TR).

Application to Taxpayer

While the Development Agreement states that there is no tax law partnership between the parties for income tax or CGT purposes, the question of whether a partnership exists for income tax law purposes, is a question of fact, and is not determined by the description ascribed to it by the parties. This was affirmed in Radaich v Smith (1959) 101 CLR 209 where McTiernan J said: “the parties cannot by the mere words of their contract turn it into something else. Their relationship is determined by the law and not by the label they choose to put on it”.

Therefore, merely entering into a Development Agreement and making the statement that it is not a tax law partnership in that agreement will not in itself mean that it is not a tax law partnership. Whether a tax law partnership existed is determined by applying the law to the entirety of the facts in this case.

When one considers the entirety of the facts attendant to the matter, it is evident that the Landowner and Developer are in joint receipt of income from the development project pursuant to the Development Agreement.

The agreement provides that there is a joint bank account in both the Landowner and Developer's names that is nominated by the Management Committee as the account the Owner and Developer will use for the Project. It is the account into which all monies and from which all monies owing to anybody must be paid.

The Landowner and Developer are jointly liable to the expenses of the development project with finances jointly obtained under the Development Agreement.

The Development Agreement requires the Landowner and Developer to establish a Management Committee to manage the project.

The Development Agreement provides that the Landowner and Developer must use their respective endeavours to arrange a Facility to enable the parties to complete the project.

Further, the Development Agreement provides that the Landowner and Developer must enter into and sign all documents required by the Financier in connection with the Facility, including a mortgage, given by the Landowner, limited to recourse over the property, to secure the Facility required to fund the Project Costs in the form approved by the Management Committee.

While legally the Landowner retains legal title to the land, in reality the manner in which the Development Agreement is structured ensures the Developer obtains the benefits of the land as if they held it in partnership, as evidenced by the following:

The Agreement provides the Developer the necessary access and possession to develop, market and sell the Land.

The Participation Fee was equal to X% of the Land value plus GST after rezoning.

The Developer is entitled to receive X% of net sales proceeds from the selling of the Land.

The Agreement requires as security for payment of the Development Fee and any other monies owing to the Developer, the Owner must, on or before the start date give the Developer a mortgage over the Property limited to an amount equal to X% of the value of the Property at any time.

Therefore, due to the fact that the Landowner and Developer are both entitled to a joint receipt of income as well as taking into account each of the above factors, it is considered that upon payment of the Participation Fee by the Developer to the Landowner to participate in the project, this will give rise to a tax law partnership between the Landowner and Developer.

Deductibility of Participation Fee

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income, or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except to the extent that such loss or outgoing is, inter alia, of capital, or of a capital nature.

For losses and outgoings incurred in carrying on a business, the term 'necessarily incurred' is taken to mean 'clearly appropriate or adapted for' (Ronpibon Tin NL v Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 326).

Capital or of a capital nature

In determining whether the payment of the Participation Fee is capital in nature, the decision in Sun Newspapers Ltd v Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) is a leading authority on the distinction between revenue and capital expenditure, where Dixon J stated:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure or organisation set up or established for the earning of profit and the process by which such an organisation operates to obtain regular returns by means of regular outlay.

Another relevant consideration as described in Sun Newspapers by Dixon J, is assessing the character of the expenditure:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical outlay to cover its use or enjoyment for periods commensurate with the payment by making a final provision or payment so as to secure future use or enjoyment. (Emphasis added).

Subsequently, in Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634, Dixon J reaffirmed his approach:

The contrast between the two forms of expenditure corresponds to the distinction between the acquisition of the means of production and the use of them; between establishing or extending a business organisation and carrying on the business, between the implements employed in work and the regular performance of the work in which they are employed; between an enterprise itself and the sustained effort of those engaged in it.

More recently in GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413 the High Court pointed out that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure is a critical factor in determining the character of what is paid.

Character of advantage sought

In relation to the character of the advantage sought by the expenditure it is necessary to examine whether the expenditure secures an enduring benefit for the business. This test was outlined in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 (British Insulated) at 213 - 214 by Viscount Cave where he stated:

“But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital. “

As stated by Dixon J in Sun Newspapers, the character of the advantage sought by the making of the expenditure is the chief, if not the critical, factor in determining the character of what is paid. The nature or character of the expenditure will therefore follow the advantage that is sought to be gained by incurring the expenditure. If the advantage to be gained is of a capital nature, then the expenditure incurred in gaining the advantage will also be of a capital nature.

The commercial reality of the transactions against the requirements of the contractual terms such that neither is not the sole deciding factor, but a factor to be considered. As such, the Commissioner has focussed on what the Taxpayer got in return for the expenditure, in accordance with the comments of Windeyer J in BP Australia Ltd v Federal Commissioner of Taxation [1965] ALR 381 [8]:

Regard ought therefore to be had to what it was sought to acquire and to the relation of that to the taxpayers undertaking or business. These, rather than the form of the transaction or the mechanics of the acquisition, are what appear to me to be deciding factors. In other words, it is what the particular taxpayer got for his money, rather than how he got it that is important.

The payment of the Participation Fee is an initial outlay by the Developer to bring into existence a tax law partnership between the Landowner and Developer. In considering the nature of the advantage sought, the Developer acquires the right to participate in the project, undertake development on the Land as well as receive income jointly in partnership with the Landowner upon the sale of individual lots, known as the Development Fee. Therefore, the Participation Fee is expenditure which brings into existence an advantage for the enduring benefit of a trade.

The manner in which the expenditure is to be used, relied upon or enjoyed

According to Dixon J in Sun Newspapers, when considering the manner in which the expenditure is to be enjoyed, regard must be had to the recurrent nature of the returns it produces and how long it will likely endure.

In this case, the advantage sought by the Developer from payment of the Participation Fee is the derivation of the Development Fee. This income and the rights under the Agreement will cease on the Project Completion Date. The Estimated Project Completion Date in the Agreement will depend upon how long planning approvals take and demand for individual lots but may exist for 15 to 20 years.

The means adopted to obtain it

The final consideration as described in Sun Newspapers by Dixon J, in assessing the character of the expenditure look at the means adopted to obtain the benefit.

In National Australia Bank v Federal Commissioner of Taxation (1997) 80 FCR 1352; 97 ATC 5153; (1997) 37 ATR 378 (NAB), the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The Full Federal Court held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The Full Court determined that the payment was in the nature of a marketing expense and had a revenue rather than a capital aspect.

The lump sum in NAB was a once and for all payment where the absence of recurrence suggests that an outgoing is of a capital nature, but it is not conclusive.

In Labrilda Pty Ltd v Deputy Commissioner of Taxation [1996] ATC 4303, the taxpayer paid an up-front accreditation fee for participation in the Team Park Program conducted by the principal, Mobil Oil. Under that program, Mobil granted the right to the taxpayer to carry on its service station business using the “Mobil System”. The specific program was designed to provide its participants with necessary training, marketing advice, advertising, promotion and other such assistance in setting up the business.

The majority in that case concluded that the taxpayer's expenses in relation to the above were of capital nature and not deductible as outgoings incurred in carrying on of the business. The expenses were more concerned with the business structure and characterised as expenditure which established the profit-yielding structure of the taxpayer's business.

It is considered that the payment of the Participation Fee, which is a lump sum, was made in consideration for the Landowner to allow the Developer to participate in the Project and acquire a beneficial; interest in the Land under the Development Agreement, where the Developer is entitled to a joint receipt of income and as a result, create a tax law partnership between the Landowner and Developer. Furthermore, whilst not determinative, the fact that the payment is made as a lump sum indicates that the payment was made as a once and for all payment for more of a capital purpose.

Application to Taxpayer

From analysing each of the above factors, it is considered that the Developer is not entitled to a deduction under section 8-1 of the ITAA 1997 on the basis that the Participation Fee is expenditure incurred to acquire an interest in the sale of all lots and enter into a tax law partnership with the Landowner. Therefore, the expenditure is considered capital in nature.

Question 2

Is the Developer entitled to a deduction in the year it is invoiced by the Project Manager, for X% of Project Costs under section 8-1 of the ITAA 1997 pursuant to the Development Agreement?

Summary

The amount invoiced by the Project Manager to the Developer is considered to be expenditure incurred by the tax law partnership, not by the Developer, and therefore is not deductible for the Developer. The tax law partnership will be entitled to a deduction for the Project Costs, however the partnership will need to bring to account any difference between the value of the tax law partnership trading stock on hand at the start and at the end of the income year in accordance with Division 70 of the ITAA 1997. The Developer is assessed on its share of the Net Partnership Profit or Loss pursuant to section 92 of the Income Tax Assessment Act 1936 (ITAA 1936) which determines the income and deduction of partners.

Detailed reasoning

As established in Question 1, the Developer and Landowner have entered into a tax law partnership. Accordingly, it follows that any expenditure on formation of the tax law partnership would be considered to be that of the tax law partnership and not the Developer.

Section 92 of the ITAA 1936 determines income and deductions of a Partner where subsection 92(1) provides that the assessable income of a partner in a partnership shall include:

In considering the deductibility for the tax law partnership, the tax law partnership must account for its trading stock in accordance with Section 70-5 of the ITAA 1997 where subsection 70-5(3) provides that:

You must bring into account any difference between the value of your trading stock on hand at the start and at the end of the income year. This is done in such a way that, in effect:

Section 70-35 of the ITAA 1997 is the provision which requires a taxpayer to include the value of its trading stock in working out its assessable income and deductions.

Subsection 70-35(1) of the ITAA 1997 provides:

If you carry on a business, you compare:

The tax law partnership will be entitled to a deduction for the Project Costs, however it will need to bring to account any difference between the value of the tax law partnership trading stock on hand at the start and at the end of the income year in accordance with Division 70 of the ITAA 1997.

Application to Taxpayer

The Developer is not entitled to a deduction under section 8-1 of the ITAA 1997 in the year it is invoiced by the Project Manager as this expenditure forms part of the trading stock of the tax law partnership and is considered to be incurred by the tax law partnership and not the Developer. This expenditure will be deductible for the tax law partnership rather than the Developer which will need to account for the difference in trading stock from the start and end of the income year in accordance with Division 70 of the ITAA 1997.

Therefore, the Developer will be assessed on its own individual interest in the net income of the partnership in accordance with section 92 of the ITAA 1936. The Developer will receive a share of partnership profits and loss which needs to be recorded in its income tax return.

Question 3

Is the Project Manager, entitled to a deduction for the Project Costs it incurs in the year under section 8-1 of the ITAA 1997 pursuant to the Development Agreement?

Summary

The Project Manager is entitled to a general deduction pursuant to section 8-1 of the ITAA 1997 in the year the Project Costs are incurred. Project Costs include payments to consultants and contractors engaged by the Project Manager to develop the Land. The Project Manager must incur the Project Costs to earn its Project Management Fee income and will on bill the Project Costs to the Developer (X%) and Landowner (Y%).

Detailed reasoning

As set out under the Development Agreement, the Project Manager is required to incur Z% of the Project Costs. The costs are on billed by invoice within a reasonable time to the Developer and Landowner, who are each invoiced B% of the Project Costs.

It is considered that the Project Costs incurred by the Project Manager are outgoings of a revenue nature and are deductible when invoiced to the Project Manager by various contractors and consultants. In the context of the Project Manager's business, the expenditure incurred on the Project Costs is part of the ordinary process by which the Project Manger operates to earn assessable income being the Project Cost and Project Management Fee.

The Project Costs are necessarily incurred by the Project Manager to earn the share of assessable income comprising Project Costs on billed to the Developer and Landowner and in earning the Project Management Fee and Selling Fee, from the Developer and Landowner. The reimbursement for the costs, which are paid to the Project Manager by the Developer and Landowner, is considered assessable income in the hands of the Project Manager. The Project Costs are regular outgoings incurred to earn the various fees and reimbursement for costs. This is not capital or capital in nature and therefore, the Project Manager is entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 when it incurs the expenditure.

Question 4

Does the Developer derive assessable income pursuant to Section 6-5 of the ITAA 1997 when it invoices the Landowner pursuant to the Development Agreement for C% of the Net Proceeds from land sales as a Development Fee?

Summary

As established the Landowner and the Developer have entered into a tax law partnership and the Development Fee forms part of the tax law partnership agreement. Therefore, the Developer does not derive assessable income from the Development Fee pursuant to Section 6-5 of the ITAA 1997. Rather, the Developer is assessed on its share of the tax law partnership's net income in accordance with Section 92 of the ITAA 1936.

Detailed reasoning

As discussed in Question 2, any expenditure on formation of the tax law partnership would be considered to be that of the tax law partnership and not the Developer. The Developer, by invoicing the Landowner D% of the Net Proceeds from Land sales as a Development Fee, does not derive assessable income as this is merely part of the mechanics of how the Partnership profits are paid to the Developer.

Rather, the Developer will be assessed on its own individual interest in the net income of the partnership in accordance with Section 92 of the ITAA 1936 where income and deductions of a partner is determined. Therefore, the Developer's entitlement to a Development Fee will be assessable to the Developer in its capacity as a partner, where it is in a tax law partnership with the Landowner.

Question 5

Does the Developer have trading stock on hand at year end, in respect of any interest in relation to or in respect of the Land that it may have under the Development Agreement in relation to the Land?

Summary

The payment of the Participation Fee, by the Developer to the Landowner gives rise to the formation of a tax law partnership. On formation of the tax law partnership, the purpose of holding the Land changes from being held as a CGT asset by the individual partners, to being Land held as trading stock of the tax law partnership and not of the individual partners.

Detailed reasoning

Section 70-10 of the ITAA 1997 provides the meaning of trading stock where Subsection 70-10 (1) defines trading stock to include:

Anything produced, manufactured or acquired that is held for the purposes of manufacture, sale or exchange in the ordinary course of a business; and

Livestock;

Paragraph 1 of TD 92/124 Income tax: property development: in what circumstances is land treated as 'trading stock?' states:

Paragraph 2 of the TD provides that:

Both the required purpose and the 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.

Where a taxpayer carries on business, all trading stock on hand at the start of the income year and all trading stock on hand at the end of that year are taken into account in working out the taxpayer's taxable income pursuant to section 70-35 of the ITAA 1997.

Section 28 of the Income Tax Assessment Act 1936 requires that the value of all “trading stock on hand” at the beginning and at the end of a year of income is taken into account in ascertaining the taxable income of a taxpayer carrying on a business. Taxation Ruling No IT 2670 INCOME TAX: “MEANING OF TRADING STOCK ON HAND” considers where trading stock is “on hand”.

Trading stock is on hand if the taxpayer has the power to dispose of the stock. Generally, the power of disposal lies with the person who owns the stock. Australian courts have developed two rules for determining when trading stock is on hand for the purposes of section 28 of the ITAA 1936 - the “dispositive power” test and the “business reality” test. In this case, it is necessary to consider the dispositive power test.

Dispositive Power Test

Under the dispositive power test, an item of trading stock will be on hand if the taxpayer has the power to sell or dispose of the item, notwithstanding that the item may not be in the physical possession of the taxpayer. Where the property in trading stock passes to a taxpayer so that they have the ability to deal with the goods, the trading stock will be considered to be on hand for the purposes of section 28, irrespective of its actual physical possession or ownership (All States Frozen Foods Pty Ltd v FCT (1990) 20 ATR 1874; 90 ATC 4175; 21 FCR 457).

Application to Taxpayer

The Participation Fee paid by the Developer to the Landowner constitutes the formation of a tax law partnership. Prior to the Development Agreement being entered into, the Landowner did not own the Land as trading stock and instead was held as a CGT asset.

The newly formed tax law partnership now holds the Land as trading stock pursuant to section 70-10 of the ITAA 1997 on the basis that the Land is held for the purpose of sale in the ordinary course of business while a business activity involving dealing in the Land has commenced by entering into the Development Agreement.

Further, the trading stock is considered to be on hand for the purposes of section 28 of the ITAA 1936, as the tax law partnership has the power to sell or dispose of the Land in accordance with the dispositive power test.

Therefore, the Developer has acquired trading stock upon entering into the Development Agreement as a partner in the tax law partnership with the Landowner, not as an individual party.

Question 6

If the payment of the participation fee is not deductible for the taxpayer and the answer to Question 1 is no, can the newly formed tax law partnership, which holds the trading stock asset, elect to hold the trading stock asset at its market value pursuant to paragraph 70-30(1)(a) of the ITAA 1997 as at the date of the Development Agreement?

Summary

The newly formed tax law partnership, which now holds the trading stock asset, can elect to hold the trading stock asset at its market value pursuant to paragraph 70-30(1)(a) of the ITAA 1997 as at the date of the Development Agreement.

Detailed reasoning

The Participation Fee paid by the Developer to the Landowner constitutes the formation of a tax law partnership as discussed in Question 1. On the formation of a partnership, each partner has a separate cost base and reduced cost base for the partners interest in each CGT asset of the partnership (subsection 106-5(2) of the ITAA 1997). Therefore when the partnership is formed on entering into the Development Agreement, the Landowner disposed of one half of their interest in the Land to the Developer. Therefore, CGT event A1 (section 104-10 of the ITAA 1997) will happen to that part of the Landowner's interest in the land at the time they enter into the Development Agreement.

On the other side of the transaction, the Developer will acquire X% of the interest in the Land, from this A1 event happening, which is a CGT asset. The cost base of the Developer's interest in X% of the Land is worked out in accordance with Divisions 110 of the ITAA 1997. As the Participation Fee was money paid by the Developer in respect of acquiring its interest in the partnership to hold the Land, this fee would be included in the Developers cost base of land (subject to the parties dealing at arm's length, refer to section 116-30 of ITAA 1997).

Section 104-220 of the ITAA 1997 covers where a CGT asset starts being trading stock pursuant to CGT event K4. Subsection 104-220(1) provides that CGT event K4 happens if you start holding as trading stock a CGT asset you already own but do not hold as trading stock and you elect under paragraph 70-30(1)(a) of the ITAA 1997 to be treated as having sold the asset for its market value.

Prior to the payment of the Participation Fee by the Developer, the Landowner did not own the Land as trading stock. Upon payment of the Participation Fee and subsequent formation of a tax law partnership between the Developer and Landowner, the purpose of holding the land changed to one of holding the Land as trading stock.

Paragraph 70-30(1)(a) of the ITAA 1997 provides:

If you start holding as trading stock an item you already own, but do not hold as trading stock, you are treated as if:

    (a) Just before it became trading stock, you had sold the item to someone else (at arm's length) for whichever of these amounts you elect:

    (b) Its cost (as worked out under subsection (3) or (4);

    (c) Its market value just before it became trading stock;

Therefore the tax law partnership will need to elect whether they wish hold the trading stock at cost, or its market value just before it became trading stock (refer subsection 70-30(1). Depending on what the partnership elects, this will determine the tax effect on the partnership from a trading stock perspective, and the CGT affect for the respective partners for the CGT event K4 happening.

From the perspective of the Developer, as the Participation Fee is meant to equal Y% of the market value of the Land at the time of entering into the Development Agreement, the CGT consequences theoretically should be the same whether or not the partnership elects the trading stock to be at market value or cost. This is because the cost should equal market value. Therefore, theoretically there should be no capital gain or capital loss on the triggering of the K4 event for the Developer.

Question 7

Is the Developer required by section 70-35 of the ITAA 1997 to include the Project Costs it incurs in the value of trading stock on hand at the start of the income year and at the end of the income year in the calculation of value of each item of trading stock if it elects to value the trading stock at its cost?

Summary

The newly formed tax law partnership, rather than the Developer is required to include the Project Costs it incurs in the value of trading stock on hand at the start of the income year and at the end of the income year in calculating its taxable income pursuant to section 70-35 of the ITAA 1997.

Detailed reasoning

Section 70-35 of the ITAA 1997 is the provision which requires a taxpayer to include the value of its trading stock in working out its assessable income and deductions.

Subsection 70-35(1) of the ITAA 1997 provides that if you carry on a business, you compare:

As discussed in Question 5, the newly formed tax law partnership has acquired trading stock through the payment of the Participation Fee by the Developer.

Therefore, it is the tax law partnership, not the Developer that is required by section 70-35 to include the Project Costs it incurs in the value of trading stock on hand in calculating its assessable income and deductions. The tax law partnership is required to take into account the cost of trading stock on hand at the end of the year.

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