Edited version of your written advice

Authorisation Number: 1051209323669

Date of advice: 7 April 2017

Ruling

Subject: Income Tax: Capital gains tax: Subdivision of Land

Question 1

Did the Landowners of the two blocks of land hold these assets as trading stock under section 70‐30 of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer:

Yes.

Question 2

Are the proceeds from the disposal of the two blocks of land assessable income according to ordinary concepts under section 6-5 of the ITAA 1997?

Answer:

Yes.

Question 3

Are the proceeds from the disposal of the two blocks of land assessable income pursuant to section 15-15 of the ITAA 1997, being income arising from the carrying on or carrying out of a profit-making undertaking or plan?

Answer:

No.

Question 4

Are the proceeds from the disposal of the two blocks of land subject to the capital gains tax (“CGT”) provisions under Parts 3-1 and 3-3 of the ITAA 1997?

Answer:

No.

Question 5

Do the portions of the Sale Proceeds that are required to be paid to Developer form part of the cost base of the two blocks of land pursuant to Subdivision 110‐A of the ITAA 1997?

Answer:

No.

This ruling applies for the following periods:

30 June 20KK

30 June 20LL

30 June 20MM

30 June 20NN

30 June 20OO

The scheme commences on:

30 June 20KK

Relevant facts and circumstances

Members of a family ('Landowners') owned an adjoining 2 parcels of land. The adjoining properties have a combined land size of over 100 hectares.

The Landowners and the Developer entered into a Development Agreement in 20FF. Under the Development Agreement, the Landowners granted the Development Rights to the Developer to do all things necessarily or desirable to undertake the Project in accordance with the Development Agreement.

When the Development Agreement was entered into- the properties were zoned as Inter Urban Break only. The Relevant Parliament only included the properties within the Urban Growth Boundary ('UGB') in 20HH.

In 20II a decision was made to dispose of the properties as two individual titles, rather than continuing with the Project.

Sale Contracts for these two properties were entered in 20KK. The purchaser is an unrelated third‐party, who will ultimately develop, sub‐divide and on‐sell the subdivided lots. The settlement date of the first Sale Contact was the later of: 42 months after the day of sale, or 12 months after settlement of the second Sale Contract. The settlement date of the second Sale Contract was the later of: 30 months after the day of sale, or 18 months after settlement of the first Sale Contract.

As at the date of the Sale Contracts, there has been no development on either of the two properties. The Precinct Structure Plan ('PSP') was still in draft form awaiting incorporation into the Planning Scheme.

After entering into the Sale Contracts, the Landowners and the Developer then entered into a Deed of Variation and Termination in relation to the original Development Agreement.

First parcel of land

The first parcel of land (comprising XX% of the total size of the adjoining properties) was acquired before 20 September 1985 in equal shares by a XX and XY.

The property was used as a farm for approximately 60 years. It was also the main residence of the XX and XY. The business ceased Z years ago. The land was then used to raise cattle and grain by a related family entity.

The related entity is leasing the land from the Landowners. The rental charge is below market value, and only some of the Landowners are paid rent.

The XX passed away in 20EE and gave their one-half share of the property to their X children equally. One of their children also passed away in 20GG, and gave their share of the property to their partner.

The XY passed away in 20JJ. The legal title to their share of the property has not yet transferred in accordance with their Will. Thus, the estate of the XY was a party to the Sale Contracts.

Second parcel of land

The second parcel of land (comprising ZZ% of the total size of the adjoining properties) was acquired in 1986 by the XX, XY, child and another family member in equal shares.

The property was also used by the XX and XY (and later by a related entity), for the purpose of a primary production business. Similarly, the related entity was leasing the land from the Landowners under market value.

The XX's interest in the land was passed under their Will to their children in 2007. When one of their children passed away in 20GG, their share of the property was passed to their partner.

The XY passed away in 20JJ. The legal title to their share of the property has not yet transferred in accordance with their Will. Thus, the estate of the XY was a party to the Sale Contracts.

The Developer

Although the Landowners had, amongst themselves, given some consideration to a potential subdivision and sale of the properties after the XX passed in 20EE, no efforts had been made to secure the sale of the properties. The Landowners were contacted by the Developer regarding the potential acquisition of the properties in 20FF. The Developer was not in a position to purchase the properties from the Landowners outright. Further, given the substantial size of the properties and the state of the property market in 20FF the Landowners could not have readily sold the properties in another manner. Thus, given the opportunistic nature of the offer made by the Developer, the Landowners entered into the Development Agreement.

The Landowners did not seek any alternative development offers in relation to the properties. They did not appoint or engage a Project Manager to deal with the Developer on their behalf. The Landowners did not prepare any business plans, budgets, timelines or financial statements in relation to the potential disposal of the properties.

Development Agreement

The Development Agreement grants development rights to the Developer to do all things which the Developer considers necessary or desirable to undertake the Project in accordance with the Development Agreement. The Developer could act in its own name or to the extent necessary or desirable in the name of the Landowners, either by way of exercise of power of attorney or as the agent of the Landowners. The expressed authority conferred on the Developer under this term was comprehensive. It is more than just a limited power of attorney to signing and execution of documents.

The Landowners must also grant a real property mortgage over the Properties to the Developer to secure the repayment of an On Loan Facility and the performance by the Landowners of their other obligations under the Agreement.

The Development Agreement provides that all decisions relating to the business and affairs of the Project will be made at meetings of the Management Committee. There were X Members on the Management Committee. The Developer appointed Z Members, and the Landowners appointed Z Members.

The parties will be entitled to the sale proceeds accordingly:

(a) the Landowners will be entitled to be paid an initial property value amount less the On Loan Facility;

(b) the Developer will be entitled to payment of an amount equivalent to the On Loan Facility and the reimbursement of all Costs; and

(c) the balance (if any) will be paid to the Developer and the Owner in equal shares.

Deed of Variation and Termination

The Deed provides an amount to be paid to the Developer for surrendering its development rights. Consistent with the Development Agreement, the Landowners will be entitled to an initial property value amount, whilst the Developer will be entitled to reimburse project costs that they incurred. The remainder will be split in equal shares between the Landowners and the Developer.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 25(1)

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 15-15

Income Tax Assessment Act 1997 subsection 15-15(1)

Income Tax Assessment Act 1997 subsection 15-15(2)

Income Tax Assessment Act 1997 paragraph 15-15(2)(a)

Income Tax Assessment Act 1997 Division 70

Income Tax Assessment Act 1997 section 70-10

Income Tax Assessment Act 1997 section 70-30

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 subsection 110-45(1B)

Income Tax Assessment Act 1997 section 118-20

Reasons for decision

Question 1

Summary

The Landowners of the two blocks of land held these assets as trading stock under section 70‐30 of the Income Tax Assessment Act 1997 ('ITAA 1997').

Detailed reasoning

Division 70 of the ITAA 1997 deals with the tax treatment of trading stock. Further, Taxation Determination TD 92/124 Property Development: in what circumstances is land treated as 'trading stock'? provides that land is treated as trading stock for income tax purposes if it is held for the purpose of resale and a business activity which involves dealing in land has commenced.

The principle in Californian Copper Syndicate v Harris (1904) 5 TC 159 states that the mere realisation of capital assets, such as land, do not give rise to income according to ordinary concepts if the realisation is carried out in the most advantageous manner.

However, the realisation of the two parcel of land in this case involves entering into an arrangement to rezone, subdivide and significantly develop the land in a business-like manner prior to sale. Therefore, the Landowners are found to be engaged in a business of subdivision, development and sale, and have ventured the land into that business rather than merely realising a capital asset in the most advantageous way (Federal Commissioner of Taxation v Whitfords Beach Pty Ltd (1982) 82 ATC 4031).

Where land is sold on revenue account, the sale proceeds are assessable as ordinary income. The circumstances where land is sold on revenue account include:

● Where the sale of land occurs in the course of carrying on a business of property subdivision and sale. In this situation the trading stock provisions in Division 70 of the ITAA 1997 applies.

● Even where the sale of land is not regarded as part of carrying on a business of property subdivision and sale, an isolated business transaction or a transaction entered into with the purpose of profit making by sale would give rise to assessable income. In such an instance, the profit from an isolated business transaction constitutes ordinary income and is assessable as such under section 6-5 of the ITAA 1997. (This is discussed in Question 2.)

The decision of the Full High Court in Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 is relevant when considering whether a person or entity is carrying on a business, or alternatively is earning ordinary income by way of deriving a profit from an isolated profit-making undertaking or scheme. Similarly, Taxation Rulings TR 97/11 and TR 92/3 should also be applied.

The basic distinction between a development and sale of property as part of a business, or alternatively, a 'profit making' undertaking or scheme is that the latter will generally be a one-off and not carried out in an overly organised or systematic manner. However, the overriding purpose and intention of the person entering into the venture must be to make a profit.

Business of Property Subdivision and Sale

Where a business is being carried on is a question of fact determined on the facts of the case. The test is whether, on the balance of probabilities, it is more likely than not that it applies to the facts of this case. The following factors support the conclusion that the Landowners have commenced the business of property subdivision and sale.

The level of financial risk borne by the Landowners

It is relevant to consider the level of risk assumed by the parties. Albeit the Developer (the agent) was considered the decision-maker, they incurred little risk because the costs were ultimately the burden of the Landowners.

Firstly, the Development Agreement provides that the Landowners are required to grant a real property mortgage over the properties to the Developer to secure the repayment of the On Loan Facility.

Further, based on the distribution clause of the Development Agreement and the Termination Deed - the Developer will recover all relevant costs before the profits are shared by the parties. The terms of the agreements confirm the Landowners bear a substantial financial risk. Although certain costs might have been carried by the Developer initially, these costs are recoverable before the Landowners receive their final proceeds. The Termination Deed further indicates that even when subdivision and development did not commence- the development expenses and risks were still bore by the Landowners.

Another significant aspect of the agreements is the profit sharing arrangement. These factors together indicate that the Landowners are likely in business or profit-making undertaking.

The scope, scale, duration and degree of complexity of the subdivision and development

When considering the scope, duration and degree of complexity of the subdivision and development- the evidence supports that the eventual sales are less likely a mere realisation.

The Landowners had a profit making intention when they entered into the original arrangement. The Development Agreement was entered in 20FF. The Project contemplated under the Development Agreement was the carrying out of future capital and other works to subdivide, construct, improve or develop the Property for the purpose of a rural and/or residential subdivisional estate or as determined in accordance with the Agreement.

The PSP provided more details regarding the works contemplated. It planned for considerable developmental works (i.e. works extending to constructing dwellings, shops and amenities) and the duration of the Project goes well beyond what is necessary to prepare the land to be sold as smaller parcels.

It is noted, however, that no actual development eventuated. The Relevant Parliament only included the properties within the UGB in 20HH. The Developer decided to discontinue with the Project in 20II. As such, a decision was made to dispose of the properties as two individual titles, rather than subdivide and develop the properties.

The Landowners and another 3^rd party entered into Sale Contracts for the disposal of the two parcels of land in 20KK. The Landowners and the Developer then entered into the Deed of Variation and Termination.

Whether the Landowners held the land for considerable period prior to entering into the Development Agreement

It is accepted that the XY originally acquired their half share of the first parcel of land on capital account for farming purpose and used it as their main residence. It is also accepted that the second parcel of land was acquired for farming purpose. Further, it is conceded that if the children acquired the land by way of inheritance, they could not be said to have had a profit making purpose at the time of acquiring the land. However, it does not mean the Landowners, at some later stage, did not change their intention to venture the land into a business of profitable resale or property subdivision.

It is also noted that most of the Landowners who inherited the properties in 20EE did not hold the properties for a considerable period prior to entering into the Development Agreement in 20FF.

The relevant intention of the Landowners is their intention at the time of acquiring the land in question. Therefore, the manner in which the land was acquired, and purpose for the acquisition of the land are relevant. Given the fact that there was only a short period of time between the Landowners inheriting the properties and when they entered into the Development Agreement, it provides a strong inference that there was an intention of profitable resale. It also shows that they did not have an intention to retain the properties as an investment, or use them to conduct farming or other non-development activities.

Extent of farming activity conducted on the land prior to arrangement

The Landowners (except the XY and one child) have not conducted farming on the properties. Although most of the Landowners conducted primary production business elsewhere, they did not conduct a primary production business on either of the properties.

The XX and XY ran a farm on the properties prior to 2000. Then it was run by one of their children through a related entity he had interest in. The related entity was leasing the properties from the Landowners for primary production. Further, the income derived from the primary production business was minimal in recent years.

Thus, even if one child conducted primary production activities on the properties (i.e. through the related entity) - by an objective consideration of the circumstances they still have a profit making purpose (i.e. to sell the land for a profit rather than to make a living from the primary production activities). The primary production activities were continued to be carried out but did not have significant substance.

Whether the Landowners originally acquired the property as investment

The children entered into the Development Agreement shortly after they inherited their interest. Further, the purpose of the XY's estate was to administer and distribute the properties to the beneficiaries. On these facts, the Landowners did not acquire the properties as an investment (e.g. to derive rental income or for long-term capital appreciation).

Some Landowners were paid minimal rent under a verbal agreement, and not all the Landowners received a share of the payment. The rent payment was not market value. Furthermore, soon after entering into the Development Agreement, the Landowners made applications to the authorities to rezone the properties. This indicates the properties were acquired with an intention of subdivision and development even if they were rented out for a period of time.

The Landowners apply for rezoning and planning approvals

Soon after the children inherited the properties, they actively sought rezoning (through the arrangement entered into with the Developer). The Relevant Government had originally left the properties out from the UGB and classified them as 'Inter Urban Break' (which cannot be developed into residential communities). However, the Developer lodged an appeal with the Tribunal.

The Z Members of the Management Committee representing the Landowners also attended the Tribunal. They were observers at the Tribunal. External consultants (i.e. solicitor and town planner) were engaged to represent the Landowners and the Developer at the Tribunal. The engagement of professionals and consultants is recognised as a normal part of the approval process. Therefore, their engagements do not necessarily mean the Landowners' role in the rezoning and planning was limited or passive.

The level of active involvement of the Landowners in the activities

The terms of the Development Agreement supported the conclusion that the Landowners had the intention to develop and sell the land, and were also involved in the process of rezoning the land. The evidence from the Minutes of the Management Committee supported that the owner representatives attended various meetings regarding the re-zoning of the properties. The Landowners' participation was not minimal, and their responsibilities were not just mandatory tasks.

Furthermore, the terms of the Development Agreement provide that the Developer could act in its own name or to the extent necessary or desirable in the name of the Landowners, either by way of exercise of power of attorney or as the agent of the Landowners. The expressed authority conferred on the Developer under this term was comprehensive.

Based on the principle of agency, therefore, it cannot maintain that the Landowners intended and/or had a passive role with respect to the Project. Where the Developer acted as an agent- the works performed by the Developer (e.g. the engagement of consultants and contractors, involvement in rezoning, planning approvals, council permits and environmental approvals) could be activities performed under the principal and agent relationship.

Accordingly, on the balance of probabilities, weighing all the facts as a whole, the Commissioner is satisfied that the Landowners have commenced the business of property subdivision and sale.

Treating land as trading stock

The term 'trading stock' is defined very widely to include anything produced, manufactured or acquired, that is held for manufacture, sale or exchange in the ordinary course of business (section 70-10 of the ITAA 1997). This is taken to include tangible items, such as land.

Taxation Determination TD 92/124 provides that land will be treated as trading stock for income tax purposes if it is held for the purpose of resale and the 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, subdivision and sale by a business commenced for that purpose would lead to the land being treated as trading stock.

An item can qualify as trading stock if it is held for manufacture, sale or exchange. Therefore it is its current use, rather than the purpose of its original acquisition, which is relevant in determining whether or not the item constitutes trading stock.

Section 70-30 of the ITAA 1997 applies where an item which is already owned by the taxpayer (but is not held as trading stock) starts being held as trading stock.

In Whitfords Beach Pty Ltd v Federal Commissioner of Taxation (1983) 83 ATC 4277, the Full Federal Court held that the relevant date as to when the land is 'committed to' or 'ventured into' a land development business is when the intention to take steps to develop and subdivide the land is formed, and activities directed to that end began. In order to determine this question, it is important to look at the owners' purpose and any activities.

As discussed above, there was an intention of profitable resale when the children inherited the properties and subsequently entered into the Development Agreement.

It is also accepted that the purpose of landholding could alter (e.g. from holding the properties for farming to using them in carrying on a business of property subdivision and sale) and in such circumstances the properties change from being held as capital assets to trading stock.

Furthermore, the activities of the Landowners in this case amounted to a business activity which involved dealing in the land. The properties are treated as trading stock when the Landowners entered into the Development Agreement and conducted the activities of rezoning the land.

Question 2

Summary

The proceeds from the disposal of the two blocks of land are assessable income according to ordinary concepts under section 6-5 of the ITAA 1997.

Detailed reasoning

As per Question 1, the sales of the two properties are regarded as part of carrying on a business of property subdivision and sale. Therefore, the proceeds are assessable income under section 6-5 of the ITAA 1997.

Even where the sales of land are not regarded as part of carrying on a business of property subdivision and sale, the facts in this case support the determination that it is an isolated business transaction or a transaction entered into with the purpose of profit making by sale. In such an instance, the profits from an isolated business transaction also constitute ordinary income and are assessable under section 6-5 of the ITAA 1997.

In Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199 at 211, the High Court stated that:

…a receipt may constitute income, if it arises from an isolated operation or commercial transaction entered into otherwise than in the ordinary course of the carrying on of the taxpayer's business, so long as the taxpayer entered into the transaction with the intention or purpose of making a relevant profit or gain from the transaction.

Similarly, in paragraph 12 of Taxation Ruling TR 92/3, the Commissioner has stated that for a transaction to be characterised as a 'business operation' or a 'commercial transaction', it is sufficient that the transaction is business or commercial in character. Further, paragraph 13 of TR 92/3 states that the relevant factors in determining whether an isolated transaction amounts to a business operation or commercial transaction include:

1) the nature of the entity undertaking the operation or transaction;

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

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

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

5) the manner in which the operation or transaction was entered into or carried out;

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

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

8) the timing of the transaction or the various steps in the transaction.

These factors were considered based on the circumstances of the case. The same facts and indicia considered in Question 1 previously apply here also.

When considering the Landowners' intention, 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 was a significant purpose.

The intent of the Landowners who inherited the properties was profit making from an isolated transaction. These Landowners had the purpose of rezoning and subdividing after they acquired the properties. Conversely, the XY and child who acquired the property for farming originally could have changed their intention and ventured the land into profitable resale and property subdivision. Similarly, the partner and estate of the XY would have acquired the same profit-making purpose when they acquired the properties and stepped in the shoes of the deceased person.

Notwithstanding that the Project was terminated - the net profit made on the sale of properties should still be assessable income. The profit is still income because:

● The intention or purpose of the Landowners in entering into the profit-making transaction 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.

This conclusion is also consistent with the view in TD 92/126. The example in the TD provides that the taxpayer purchases broad acres of land with the intention of development and subdivision into residential blocks for sale. After purchase, the property market suffers a downturn and the taxpayer's expected source of finance fails to materialise. The land lies idle until it is eventually sold some years later. The net profit on the sale of the land is still assessable income under subsection 25(1) of the ITAA 1936.

Accordingly, on the balance of probabilities, weighing all the facts as a whole, the Commissioner is satisfied that the receipts from the properties are profits either: from an isolated transaction; or because the Landowners have commenced the business of property subdivision and sale (as discussed in Question 1 above).

It follows then that these receipts are assessable income according to ordinary concepts under section 6-5 of the ITAA 1997.

Question 3

Summary

The proceeds from the disposal of the two blocks of land are not assessable income pursuant to section 15-15 of the ITAA 1997 (being income arising from the carrying on or carrying out of a profit-making undertaking or plan).

Detailed reasoning

Subsection15-15(1) of the ITAA 1997 includes in assessable income profit arising from the carrying on or carrying out of a profit-making undertaking or plan. However, subsection 15-15(2) of the ITAA 1997 provides that such a profit will not be assessable under the section if it:

(a) is assessable as ordinary income under section 6-5; or

(b) arises in respect of the sale of property acquired on or after 20 September 1985.

As determined in Question 2 above, the receipts from the sale of the properties constitute ordinary income and are assessable under section 6-5 of the ITAA 1997.

Therefore, paragraph 15-15(2)(a) of the ITAA 1997 applies to exclude the application of subsection 15-15(1) of the ITAA 1997 in this case.

Question 4

Summary

The proceeds from the disposal of the two blocks of land are not subject to the capital gains tax provisions under Parts 3-1 and 3-3 of the ITAA 1997.

Detailed reasoning

A CGT asset is defined in section 108-5 of the ITAA 1997 and includes any kind of property. Specifically, each parcel of land is a CGT asset.

A capital gain or a capital loss arises where a CGT event happens to each of your parcel of land.

However, section 118-20 of the ITAA 1997 provides that a capital gain you make is reduced if the amount is otherwise assessable under another provision of the ITAA 1997.

Therefore, whilst a CGT event may in fact happen, if an amount is otherwise included as ordinary assessable income under section 6-5 of the ITAA 1997 then any capital gain will be disregarded to the extent of that ordinary income included.

Therefore, the receipts from the disposal of the two blocks of land are not subject to the capital gains tax provisions.

Question 5

Summary

The portions of the Sale Proceeds that are required to be paid to the Developer do not form part of the cost base of the two blocks of land pursuant to Subdivision 110‐A of the ITAA 1997.

Detailed reasoning

As determined in Questions 1 and 2 above, where the activities of the Landowners constitute the carrying on of an actual business, or carrying out of a transaction in a commercial manner, any profits made on the realisation of the asset are assessable to the taxpayer as income under section 6-5 of the ITAA of the 1997. As these transactions are on revenue account, correspondingly, any expenditure required to be paid to the Developer should also be treated consistently.

Relevantly, when calculating the assessable profit, deductions are available where the expenditures are incurred in gaining or producing your assessable income, or in carrying on a business for the purpose of gaining or producing your assessable income.

Furthermore, the cost base of an asset does not include any costs the Landowners have incurred for which they have claimed or can claim a deduction.

Therefore, when determining this question, the Landowners should consider the application of subsection 110-45(1B) of the ITAA 1997. It provides the expenditure does not form part of the second or third element of the cost base to the extent that you have deducted or can deduct it.

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